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BA 495 – Business Strategy
Instructions for Individual Writing Assignment
Each student will prepare and submit 4 one-page write-up assignments. The purpose of these write-ups is to allow students to practice applying strategy constructs in the readings to the client project & current events. You must pick one concept from the readings from that week (or the previous week) and write about its application to your client and a current business event.
Please follow the following instructions and format for each assignment:
· Pick one concept from our readings. You must choose a different topic for each assignment.
· In the first paragraph:
define the concept(s) from the reading or class discussion IN YOUR OWN WORDS (do not quote the concept from the book or any source you use). Hint: by illustrating your definition with an example, it will demonstrate to me your understanding of the concept.
· Second paragraph:
apply the concept(s) to your client, or class discussion(s). Make sure you focus on the strategic implications of how or why the concept(s) is/are relevant
or
not relevant to your application. Please include an example to illustrate your concept. It’s perfectly fine to determine that the concept doesn’t fit your client. If you do so, please explain why and provide examples. P11
· Third paragraph
: apply the concept(s) to a current business issue in the news from the last 6 months. Make sure you focus on the strategic implications of how or why the concept(s) is/are relevant the current business event. In this paragraph, you must provide in-text citation of your news source.
· Fourth paragraph: For each assignment, you will use and apply one of the four UNST Business Goals to your client. For application of each of these UNST goals, I have provided some guiding questions (prompts) below to use in your write-up, these are suggestions so you can either follow them (or follow a few of them) or choose a different route. In either case, you must discuss the UNST goal effectively.
· Reference page: Cite the news source for the current business issue from 3rd paragraph
· Your writeup must be: 1 to 11/4 page, single spacing, 12 pt Times New Roman, 1-inch margins
· The UNST goals to be addressed in each write-up are as follows:
1. Assignment #1: Communication. What are the core features of communication that will ensure a good outcome in how you communicate with your client and your team members? What previous experiences could you draw on for this? Provide 1 example of how effective communication facilitated your work and 1 example of how poor communication hinder it. What are the most important aspects of communication that you have learned throughout your time as a business undergraduate student? What has not worked? Think about both oral and verbal communication.
2. Assignment #2: Diversity, Equity, and Social Justice. How can differences between group members help or hinder the project’s progress or outcomes? For any challenges, how can you overcome them? In recognizing the positive aspects of diversity, how can they be better harnessed in your project work to support your client better? How is your client or client’s organization different from the examples/contexts in which you have studied business so far? What can you learn from these differences? How might you apply that? How does your client address or face issues of diversity, equity, or social justice? How do you suggest that your client work on these issues?
3.
Assignment #3: Ethics and Social Responsibility
: What new insights regarding social or environmental challenges have you developed based upon your experience with this class and/or your client? Based on your experience in this class, what social or grassroots efforts have you learned about that can help to improve the lives of others? How do these impact the lives of communities or the natural environment? How has your perspective on specific environmental or social issues evolved since you began this class? Does your client address environmental or social issues in an appropriate way? Why or why not? Do you see a tension between your client’s goals and social/environmental well-being? How would you reconcile that tension?
4. Assignment #4: Critical Thinking: As this skill is used throughout the term on all your BA 495 assignments and tasks, you do not need to write a fourth paragraph regarding this UNST goal.
· Grading Scale and formatting:
· Format: 1 to 11/4 page, single spacing, 12 pt Times New Roman, 1-inch margins
· Grading: The assignments will be graded based on a 4 point grading scale. Points will be given based on the following point system:
· 1 point each for completion of the following tasks on the assignments:
· 1 point for defining a concept
· 1 point for applying to client
· 1 point for applying to business recent business issue & for proper citation (both in-text and reference/work cited page)
· 1 point for applying the relevant UNST goal
· Points will also be deducted for improper formatting, poor writing, etc
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FOURTH EDITION
Strategic
Management
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Frank T. Rothaermel
Georgia Institute of Technology
FOURTH EDITION
Strategic
Management
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STRATEGIC MANAGEMENT, FOURTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-
Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2015,
and 2013. No part of this publication may be reproduced or distributed in any form or by any means, or stored
in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but
not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 LWI 21 20 19 18
Bound:
ISBN 978-1-259-92762-1 (student edition)
MHID 1-259-92762-8 (student edition)
ISBN 978-1-260-14192-4 (instructor edition)
MHID 1-260-14192-6 (instructor edition)
Looseleaf:
ISBN 978-1-260-14186-3
MHID 1-260-14186-1
Product Developers: Lai T. Moy
Executive Marketing Manager: Debbie Clare
Content Project Managers: Mary E. Powers (Core), Keri Johnson (Assessment)
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Compositor: SPi Global
All credits appearing on page or at the end of the book are considered to be an extension of the copyright
page.
Library of Congress Cataloging-in-Publication Data
Names: Rothaermel, Frank T., author.
Title: Strategic management: concepts / Frank T. Rothaermel, Georgia
Institute of Technology.
Description: Fourth Edition. | Dubuque: McGraw-Hill Education, 2018. |
Revised edition of the author’s Strategic management, [2017]
Identifiers: LCCN 2017049706 | ISBN 9781259927621 (paperback)
Subjects: LCSH: Strategic planning. | Management. | BISAC: BUSINESS &
ECONOMICS / Management.
Classification: LCC HD30.28 .R6646 2018 | DDC 658.4/012—dc23 LC record available
at https://lccn.loc.gov/2017049706
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website
does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education
does not guarantee the accuracy of the information presented at these sites.
mheducation.com/highered
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DEDICATION
To my eternal family for their love, support, and sacrifice: Kelleyn, Harris,
Winston, Roman, Adelaide, Avery, and Ivy.
—FRANK T. ROTHAERMEL
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vi
PART ONE / ANALYSIS 2
CHAPTER 1 What Is Strategy? 4
CHAPTER 2 Strategic Leadership: Managing the Strategy Process 30
CHAPTER 3 External Analysis: Industry Structure, Competitive Forces,
and Strategic Groups 64
CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core
Competencies 106
CHAPTER 5 Competitive Advantage, Firm Performance, and Business
Models 144
PART TWO / FORMULATION 180
CHAPTER 6 Business Strategy: Differentiation, Cost Leadership,
and Blue Oceans 182
CHAPTER 7 Business Strategy: Innovation, Entrepreneurship,
and Platforms 218
CHAPTER 8 Corporate Strategy: Vertical Integration and
Diversification 264
CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers,
and Acquisitions 308
CHAPTER 10 Global Strategy: Competing Around the World 338
PART THREE / IMPLEMENTATION 376
CHAPTER 11 Organizational Design: Structure, Culture, and Control 378
CHAPTER 12 Corporate Governance and Business Ethics 418
PART FOUR / MINICASES 447
HOW TO CONDUCT A CASE ANALYSIS 528
PART FIVE / FULL-LENGTH CASES Available through McGraw-Hill Create
www.McGrawHillCreate.com/Rothaermel
CONTENTS IN BRIEF
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MINICASES /
1 Michael Phelps: The Role of Strategy in Olympics and
Business 448
2 PepsiCo’s Indra Nooyi: Performance with Purpose 450
3 Yahoo: From Internet Darling to Fire Sale 453
4 How the Strategy Process Killed Innovation at
Microsoft 456
5 Apple: The iPhone Turns 10, so What’s Next? 459
6 Nike’s Core Competency: The Risky Business of
Creating Heroes 463
7 Dynamic Capabilities at IBM 466
8 Starbucks after Schultz: How to Sustain a Competitive
Advantage? 470
9 Business Model Innovation: How Dollar Shave Club
Disrupted Gillette 474
10 Competing on Business Models: Google vs.
Microsoft 476
11 Can Amazon Trim the Fat at Whole Foods? 481
12 LEGO’s Turnaround: Brick by Brick 484
13 Cirque du Soleil: Searching for a New Blue Ocean 488
14 Wikipedia: Disrupting the Encyclopedia Business 491
15 Disney: Building Billion-Dollar Franchises 494
16 Hollywood Goes Global 498
17 Samsung Electronics: Burned by Success? 503
18 Does GM’s Future Lie in China? 509
19 Flipkart vs. Amazon in India: Who’s Winning? 512
20 Alibaba—China’s Ecommerce Giant: Challenging
Amazon? 516
21 HP’s Boardroom Drama and Divorce 520
22 UBS: A Pattern of Ethics Scandals 524
FULL-LENGTH CASES /
All available through McGraw-Hill Create,
www.McGrawHillCreate.com/Rothaermel
Uber Technologies*
Starbucks Corporation*
Netflix, Inc.*
Walmart*
The Walt Disney Company*
Tesla, Inc. >>
Apple Inc. >>
Amazon.com, Inc. >>
Best Buy Co., Inc. >>
Facebook, Inc. >>
McDonald’s Corporation >>
Alphabet’s Google >>
Delta Air Lines, Inc. >>
UPS in India >>
The Movie Exhibition Industry >>+
Space X* +
Kickstarter: Using Crowdfunding to Launch
a New Board Game +
Better World Books and the Triple Bottom Line
General Electric after GE Capital
IBM at the Crossroads
Merck & Co., Inc.
Grok: Action Intelligence for Fast Data
Make or Break at RIM: Launching BlackBerry 10
MINICASES & FULL-LENGTH CASES
* NEW TO THE FOURTH EDITION >> REVISED AND UPDATED FOR THE FOURTH EDITION + THIRD-PARTY CASE
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CHAPTERCASES /
1 Tesla’s Secret Strategy 5
2 Sheryl Sandberg: Leaning in at Facebook 31
3 Airbnb: Disrupting the Hotel Industry 65
4 Dr. Dre’s Core Competency: Coolness Factor 107
5 The Quest for Competitive Advantage: Apple vs.
Microsoft 145
6 JetBlue Airways: Finding a New Blue Ocean? 183
7 Netflix: Disrupting the TV Industry 219
8 Amazon.com: To Infinity and Beyond 265
9 Little Lyft Gets Big Alliance Partners 309
10 Sweden’s IKEA: The World’s Most Profitable
Retailer 339
11 Zappos: Of Happiness and Holacracy 379
12 Uber: Most Ethically Challenged Tech
Company? 419
STRATEGY HIGHLIGHTS /
1.1 Teach for America: How Wendy Kopp Inspires
Future Leaders 12
1.2 Merck: Reconfirming Its Core Values 18
2.1 Starbucks CEO: “It’s Not What We Do” 44
2.2 BP “Grossly Negligent” in Gulf of Mexico
Disaster 55
3.1 BlackBerry’s Bust 71
3.2 The Five Forces in the Airline Industry 75
4.1 Applying VRIO: The Rise and Fall of Groupon 119
4.2 When Will P&G Play to Win Again? 125
5.1 Interface: The World’s First Sustainable
Company 165
5.2 Threadless: Leveraging Crowdsourcing to Design
Cool T-Shirts 166
6.1 Dr. Shetty: “The Henry Ford of Heart
Surgery” 200
6.2 How JCPenney Sailed Deeper into the Red
Ocean 208
7.1 Standards Battle: Which Automotive Technology
Will Win? 230
7.2 GE’s Innovation Mantra: Disrupt Yourself! 248
8.1 Is Coke Becoming a Monster? 276
8.2 The Tata Group: Integration at the Corporate
Level 289
9.1 How Tesla Used Alliances Strategically 315
9.2 Kraft’s Specialty: Hostile Takeovers 326
10.1 The Gulf Airlines Are Landing in the
United States 347
10.2 Walmart Retreats from Germany, and Lidl Invades
the United States 351
11.1 W.L. Gore & Associates: Informality and
Innovation 386
11.2 Sony vs. Apple: Whatever Happened to Sony? 400
12.1 GE’s Board of Directors 430
12.2 Why the Mild Response to Goldman Sachs
and Securities Fraud? 435
CHAPTERCASES & STRATEGY HIGHLIGHTS
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PART ONE / ANALYSIS 2
CHAPTER 1
WHAT IS STRATEGY? 4
CHAPTERCASE 1
Tesla’s Secret Strategy 5
1.1 What Strategy Is: Gaining and Sustaining
Competitive Advantage 6
What Is Competitive Advantage? 8
1.2 Vision, Mission, and Values 11
Vision 11
Mission 13
Values 17
1.3 The AFI Strategy Framework 19
1.4 Implications for Strategic Leaders 20
CHAPTERCASE 1 / Consider This… 21
CHAPTER 2
STRATEGIC LEADERSHIP: MANAGING THE STRATEGY
PROCESS 30
CHAPTERCASE 2
Sheryl Sandberg: Leaning in at Facebook 31
2.1 Strategic Leadership 32
What Do Strategic Leaders Do? 33
How Do You Become a Strategic Leader? 33
The Strategy Process Across Levels: Corporate, Business,
and Functional Managers 36
2.2 The Strategic Management Process 38
Top-Down Strategic Planning 38
Scenario Planning 39
Strategy as Planned Emergence: Top-Down and Bottom-Up 41
2.3 Stakeholders and Competitive Advantage 47
Stakeholder Strategy 48
Stakeholder Impact Analysis 50
2.4 Implications for Strategic Leaders 55
CHAPTERCASE 2 / Consider This… 56
CHAPTER 3
EXTERNAL ANALYSIS: INDUSTRY STRUCTURE,
COMPETITIVE FORCES, AND STRATEGIC GROUPS 64
CHAPTERCASE 3
Airbnb: Disrupting the Hotel Industry 65
3.1 The PESTEL Framework 67
Political Factors 68
Economic Factors 68
Sociocultural Factors 70
Technological Factors 70
Ecological Factors 70
Legal Factors 72
3.2 Industry Structure and Firm Strategy: The Five
Forces Model 73
Industry vs. Firm Effects In Determining Firm
Performance 73
Competition In the Five Forces Model 74
The Threat of Entry 76
The Power of Suppliers 79
The Power of Buyers 80
The Threat of Substitutes 82
Rivalry Among Existing Competitors 83
A Sixth Force: The Strategic Role of Complements 88
3.3 Changes over Time: Entry Choices and Industry
Dynamics 90
Entry Choices 90
Industry Dynamics 92
3.4 Performance Differences within the Same Industry:
Strategic Groups 93
The Strategic Group Model 93
Mobility Barriers 95
3.5 Implications for Strategic Leaders 96
CHAPTERCASE 3 / Consider This… 97
CHAPTER 4
INTERNAL ANALYSIS: RESOURCES, CAPABILITIES,
AND CORE COMPETENCIES 106
CHAPTERCASE 4
Dr. Dre’s Core Competency: Coolness Factor 107
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4.1 Core Competencies 110
4.2 The Resource-Based View 113
Two Critical Assumptions 114
The Vrio Framework 115
Isolating Mechanisms: How to Sustain A Competitive
Advantage 120
4.3 The Dynamic Capabilities Perspective 124
4.4 The Value Chain and Strategic Activity
Systems 128
The Value Chain 128
Strategic Activity Systems 130
4.5 Implications for Strategic Leaders 133
Using Swot Analysis to Generate Insights From External
and Internal Analysis 134
CHAPTERCASE 4 / Consider This… 135
CHAPTER 5
COMPETITIVE ADVANTAGE, FIRM PERFORMANCE,
AND BUSINESS MODELS 144
CHAPTERCASE 5
The Quest for Competitive Advantage:
Apple vs. Microsoft 145
5.1 Competitive Advantage and Firm Performance 146
Accounting Profitability 146
Shareholder Value Creation 153
Economic Value Creation 155
The Balanced Scorecard 161
The Triple Bottom Line 164
5.2 Business Models: Putting Strategy into Action 165
The Why, What, Who, and How of Business Models
Framework 167
Popular Business Models 168
Dynamic Nature of Business Models 170
5.3 Implications for Strategic Leaders 171
CHAPTERCASE 5 / Consider This… 172
PART TWO / FORMULATION 180
CHAPTER 6
BUSINESS STRATEGY: DIFFERENTIATION, COST
LEADERSHIP, AND BLUE OCEANS 182
CHAPTERCASE 6
JetBlue Airways: Finding a New Blue Ocean? 183
6.1 Business-Level Strategy: How to Compete
for Advantage 185
Strategic Position 186
Generic Business Strategies 186
6.2 Differentiation Strategy: Understanding Value
Drivers 188
Product Features 191
Customer Service 191
Complements 191
6.3 Cost-Leadership Strategy: Understanding Cost
Drivers 192
Cost of Input Factors 194
Economies of Scale 194
Learning Curve 196
Experience Curve 199
6.4 Business-Level Strategy and the Five Forces:
Benefits and Risks 201
Differentiation Strategy: Benefits and Risks 201
Cost-Leadership Strategy: Benefits and Risks 203
6.5 Blue Ocean Strategy: Combining Differentiation
and Cost Leadership 204
Value Innovation 205
Blue Ocean Strategy Gone Bad: “Stuck In the Middle” 207
6.6 Implications for Strategic Leaders 210
CHAPTERCASE 6 / Consider This… 211
CHAPTER 7
BUSINESS STRATEGY: INNOVATION,
ENTREPRENEURSHIP, AND PLATFORMS 218
CHAPTERCASE 7
Netflix: Disrupting the TV Industry 219
7.1 Competition Driven by Innovation 221
The Innovation Process 222
7.2 Strategic and Social Entrepreneurship 225
7.3 Innovation and the Industry Life Cycle 227
Introduction Stage 228
Growth Stage 230
Shakeout Stage 233
Maturity Stage 234
Decline Stage 234
Crossing the Chasm 235
7.4 Types of Innovation 242
Incremental vs. Radical Innovation 243
Architectural vs. Disruptive Innovation 245
7.5 Platform Strategy 249
The Platform vs. Pipeline Business Models 249
The Platform Ecosystem 250
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7.6 Implications for Strategic Leaders 254
CHAPTERCASE 7 / Consider This… 254
CHAPTER 8
CORPORATE STRATEGY: VERTICAL INTEGRATION
AND DIVERSIFICATION 264
CHAPTERCASE 8
Amazon.com: To Infinity and Beyond 265
8.1 What Is Corporate Strategy? 268
Why Firms Need to Grow 268
Three Dimensions of Corporate Strategy 269
8.2 The Boundaries of the Firm 271
Firms vs. Markets: Make or Buy? 272
Alternatives on the Make-or-Buy Continuum 274
8.3 Vertical Integration along the Industry Value
Chain 278
Types of Vertical Integration 279
Benefits and Risks of Vertical Integration 281
When Does Vertical Integration Make Sense? 283
Alternatives to Vertical Integration 284
8.4 Corporate Diversification: Expanding Beyond
a Single Market 285
Types of Corporate Diversification 287
Leveraging Core Competencies for Corporate
Diversification 291
Corporate Diversification and Firm Performance 293
8.5 Implications for Strategic Leaders 297
CHAPTERCASE 8 / Consider This… 298
CHAPTER 9
CORPORATE STRATEGY: STRATEGIC ALLIANCES,
MERGERS, AND ACQUISITIONS 308
CHAPTERCASE 9
Little Lyft Gets Big Alliance Partners 309
9.1 How Firms Achieve Growth 310
The Build-Borrow-Buy Framework 310
9.2 Strategic Alliances 313
Why Do Firms Enter Strategic Alliances? 314
Governing Strategic Alliances 317
Alliance Management Capability 320
9.3 Mergers and Acquisitions 323
Why Do Firms Merge With Competitors? 323
Why Do Firms Acquire Other Firms? 325
M&A and Competitive Advantage 327
9.4 Implications for Strategic Leaders 329
CHAPTERCASE 9 / Consider This… 330
CHAPTER 10
GLOBAL STRATEGY: COMPETING AROUND
THE WORLD 338
CHAPTERCASE 10
Sweden’s IKEA: The World’s Most Profitable Retailer 339
10.1 What Is Globalization? 342
Stages of Globalization 343
State of Globalization 344
10.2 Going Global: Why? 346
Advantages of Going Global 346
Disadvantages of Going Global 350
10.3 Going Global: Where and How? 353
Where In the World to Compete? The Cage Distance
Framework 353
How Do MNES Enter Foreign Markets? 357
10.4 Cost Reductions vs. Local Responsiveness:
The Integration-Responsiveness Framework 358
International Strategy 359
Multidomestic Strategy 360
Global-Standardization Strategy 360
Transnational Strategy 361
10.5 National Competitive Advantage: World Leadership
in Specific Industries 362
Porter’s Diamond Framework 364
10.6 Implications for Strategic Leaders 366
CHAPTERCASE 10 / Consider This… 367
PART THREE / IMPLEMENTATION 376
CHAPTER 11
ORGANIZATIONAL DESIGN: STRUCTURE, CULTURE,
AND CONTROL 378
CHAPTERCASE 11
Zappos: Of Happiness and Holacracy 379
11.1 Organizational Design and Competitive
Advantage 381
Organizational Inertia: The Failure of Established Firms 382
Organizational Structure 384
Mechanistic vs. Organic Organizations 385
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11.2 Strategy and Structure 387
Simple Structure 387
Functional Structure 388
Multidivisional Structure 390
Matrix Structure 394
11.3 Organizing for Innovation 398
11.4 Organizational Culture: Values, Norms, and
Artifacts 401
Where Do Organizational Cultures Come From? 403
How Does Organizational Culture Change? 404
Organizational Culture and Competitive Advantage 405
11.5 Strategic Control-and-Reward Systems 407
Input Controls 408
Output Controls 408
11.6 Implications for Strategic Leaders 409
CHAPTERCASE 11 / Consider This… 410
CHAPTER 12
CORPORATE GOVERNANCE AND BUSINESS
ETHICS 418
CHAPTERCASE 12
Uber: Most Ethically Challenged Tech Company? 419
12.1 The Shared Value Creation Framework 421
Public Stock Companies and Shareholder Capitalism 421
Creating Shared Value 423
12.2 Corporate Governance 425
Agency Theory 426
The Board of Directors 428
Other Governance Mechanisms 430
12.3 Strategy and Business Ethics 433
Bad Apples vs. Bad Barrels 434
12.4 Implications for Strategic Leaders 437
CHAPTERCASE 12 / Consider This… 438
PART FOUR / MINICASES 447
PART FIVE / FULL-LENGTH CASES
All available through McGraw-Hill Create,
www.McGrawHillCreate.com/Rothaermel
Company Index 539
Name Index 545
Subject Index 547
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Frank T. Rothaermel
Georgia Institute of Technology
FRANK T. ROTHAERMEL (PH.D.) is a Professor of Strategy & Innovation, holds
the Russell and Nancy McDonough Chair in the Scheller College of Business at
the Georgia Institute of Technology (GT), and is an Alfred P. Sloan Industry Stud-
ies Fellow. He received a National Science Foundation (NSF) CAREER award,
which “is a Foundation-wide activity that offers the National Science Founda-
tion’s most prestigious awards in support of . . . those teacher-scholars who most
effectively integrate research and education” (NSF CAREER Award description).
Frank’s research interests lie in the areas of strategy, innovation, and entre-
preneurship. Frank has published over 30 articles in leading academic journals
such as the Strategic Management Journal, Organization Science, Academy of
Management Journal, Academy of Management Review, and elsewhere. Based
on having published papers in the top 1 percent based on citations, Thomson
Reuters identified Frank as one of the “world’s most influential scientific
minds.” He is listed among the top-100 scholars based on impact over more
than a decade in both economics and business. Bloomberg Businessweek named
Frank one of Georgia Tech’s Prominent Faculty in its national survey of business
schools. The Kauffman Foundation views Frank as one of the world’s 75 thought
leaders in entrepreneurship and innovation.
Frank has received several recognitions for his research, including the Sloan
Industry Studies Best Paper Award, the Academy of Management Newman Award, the Strategic
Management Society Conference Best Paper Prize, the DRUID Conference Best Paper Award, the
Israel Strategy Conference Best Paper Prize, and is the inaugural recipient of the Byars Faculty
Excellence Award. Frank currently serves (or served) on the editorial boards of the Strategic Man-
agement Journal, Organization Science, Academy of Management Journal, Academy of Manage-
ment Review, and Strategic Organization.
Frank regularly translates his research findings for wider audiences in articles in the MIT Sloan
Management Review, The Wall Street Journal, Forbes, and elsewhere. To inform his research Frank
has conducted extensive field work and executive training with leading corporations such as Amgen,
Daimler, Eli Lilly, Equifax, GE Energy, GE Healthcare, Hyundai Heavy Industries (South Korea),
Kimberly-Clark, Microsoft, McKesson, NCR, Turner (TBS), UPS, among others.
Frank has a wide range of executive education experience, including teaching in programs at GE
Management Development Institute (Crotonville, NY), Georgia Institute of Technology, George-
town University, ICN Business School (France), Politecnico di Milano (Italy), St. Gallen University
(Switzerland), and the University of Washington. He received numerous teaching awards for excel-
lence in the classroom including the GT-wide Georgia Power Professor of Excellence award.
When launched in 2012, Frank’s Strategic Management text received the McGraw-Hill
1st Edition of the Year Award in Business & Economics. His Strategic Management text has been
translated into Mandarin, Korean, and Greek. Several of his case studies are Most Popular among the
cases distributed by Harvard Business Publishing.
Frank held visiting professorships at the EBS University of Business and Law (Germany), Singapore
Management University (Tommie Goh Professorship), and the University of St. Gallen (Switzerland).
He is a member of the Academy of Management and the Strategic Management Society.
Frank holds a PhD degree in strategic management from the University of Washington; an MBA
from the Marriott School of Management at Brigham Young University; and is Diplom-Volkswirt
(M.Sc. equivalent) in economics from the University of Duisburg-Essen, Germany. Frank completed
training in the case teaching method at the Harvard Business School.
VISIT THE AUTHOR AT: http://ftrStrategy.com/
ABOUT THE AUTHOR
©Tony Benner
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PREFACE
The market for strategy texts can be broadly separated into two overarching categories:
traditional, application-based and research-based. Traditional, application-based strategy
books represent the first-generation texts with first editions published in the 1980s. The
research-based strategy books represent the second-generation texts with first editions
published in the 1990s. I wrote this book to address a needed new category—a third
generation of strategy text that combines into one the student-accessible, application-
oriented frameworks of the first-generation texts with the research-based frameworks of
the second-generation texts.
The market response to this unique approach to teaching and studying strategy was
overwhelmingly enthusiastic. Enthusiasm and support increased with each subsequent edi-
tion. I’m truly grateful for the sustained support.
To facilitate an enjoyable and refreshing reading experience that enhances student
learning and retention, I synthesize and integrate strategy frameworks, empirical research,
and practical applications with current real-world examples. This approach and emphasis
on real-world examples offers students a learning experience that uniquely combines rigor
and relevance. As Dr. John Media of the University of Washington’s School of Medicine
and life long researcher on how the mind organizes information explains:
How does one communicate meaning in such a fashion that learning is improved? A simple
trick involves the liberal use of relevant real-world examples, thus peppering main learning
points with meaningful experiences. . . . Numerous studies show this works. . . . The greater
the number of examples . . . the more likely the students were to remember the informa-
tion. It’s best to use real-world situations familiar to the learner. . . . Examples work because
they take advantage of the brain’s natural predilection for pattern matching. Information is
more readily processed if it can be immediately associated with information already present
in the brain. We compare the two inputs, looking for similarities and differences as we encode
the new information. Providing examples is the cognitive equivalent of adding more handles
to the door. [The more handles one creates at the moment of learning, the more likely the
information can be accessed at a later date.] Providing examples makes the information more
elaborative, more complex, better encoded, and therefore better learned.*
Strategic Management brings conceptual frameworks to life via examples that cover
products and services from companies with which students are familiar, such as Facebook,
Google, Tesla, Starbucks, Apple, McDonald’s, Disney, Airbnb, and Uber. Liberal use of
such examples aids in making strategy relevant to students’ lives and helps them internal-
ize strategy concepts and frameworks. Integrating current examples with modern strategy
thinking, I prepare students with the foundation they need to understand how companies
gain and sustain competitive advantage. I also develop students’ skills to become success-
ful leaders capable of making well-reasoned strategic decisions in a globalized and turbu-
lent 21st century.
I’m pleased to introduce the new 4th edition of Strategic Management. My distinctive
approach to teaching and transmitting strategy not only offers students a unique learning
experience that combines theory and practice, but also provides tight linkages between
concepts and cases. In this new 4th edition, I build upon the unique strengths of this prod-
uct, and continue to add improvements based upon hundreds of insightful reviews and
*Source: Medina, J. (2014), Brain Rules: 12 Principles for Surviving and Thriving at Work, Home, and School (pp. 139–140).
(Seattle: Pear Press).
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important feedback from professors, students, and working professionals. The hallmark
features of this text continue to be:
■ Student engagement via practical and relevant application of strategy concepts using a
holistic Analysis, Formulation, and Implementation (AFI) Strategy Framework.
■ Synthesis and integration of empirical research and practical applications combined
with relevant strategy material to focus on “What is important?” for the student and
“Why is it important?”
■ Emphasis on diversity by featuring a wide range of strategic leaders from different
backgrounds and fields, not just in business, but also in entertainment, professional
sports, and so forth.
■ Coverage of an array of firms, including for-profit public (Fortune 100) companies,
but also private companies (including startups) as well as non profit organizations.
All of them need a good strategy!
■ Global perspective, with a focus on competing around the world, featuring many lead-
ing companies from Asia, Europe, and Latin America, as well as the United States.
I was fortunate to study, live, and work across the globe, and I attempt to bring this
cosmopolitan perspective to bear in this text.
■ Direct personal applications of strategy concepts to careers and lives to help internal-
ize the content (including the popular myStrategy modules at the end of each chapter).
■ Industry-leading digital delivery option (Create), adaptive learning system (Smart-
Book), and online assignment and assessment system (Connect).
■ Standalone module on How to Conduct a Case Analysis.
■ High-quality Cases, well integrated with text chapters and standardized, high-quality
teaching notes; there are two types of cases that come with this text:
■ 12 ChapterCases begin and end each chapter, framing the chapter topic
and content.
■ 22 MiniCases (Part 4 of the book), all based on original research, provide
dynamic opportunities for students to apply strategy concepts by assigning them
as add-ons to chapters, either as individual assignments or as group work, or by
using them for class discussion.
I have taken great pride in authoring all 12 ChapterCases, Strategy Highlights (2 per
chapter, for a total of 24), and 22 MiniCases. This additional touch allows quality control
and ensures that chapter content and cases use one voice and are closely interconnected.
Both types of case materials come with sets of questions to stimulate class discussion or
provide guidance for written assignments. The instructor resources offer sample answers
that apply chapter content to the cases.
In addition to these in-text cases, 23 full-length Cases, with 20 of them (that is almost
90 percent!) authored or co-authored by me specifically to accompany this textbook, are
available through McGraw-Hill’s custom-publishing Create program (www.McGrawHill-
Create.com/Rothaermel). Full-length cases NEW to the 4th edition are:
∙ Uber
∙ Netflix
∙ Starbucks
∙ Disney
∙ Walmart
∙ SpaceX
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Popular cases about Apple, Amazon, Facebook, McDonald’s, Tesla, and Best Buy
among several others are significantly updated and revised. Robust and structurally updated
case teaching notes are also available and accessible through Create; financial data for
these cases may be accessed from the Instructor Resource Center in the Connect Library.
What’s New in the 4th Edition?
I have revised and updated the 4th edition in the following ways, many of which were
inspired by conversations and feedback from the many users and reviewers of the prior
editions.
OVERVIEW OF MAJOR CHANGES IN 4E:
■ New A-head section on “Changes over Time: Entry Choices and Industry Dynamics”
in Chapter 3.
■ New A-head section on “The Value Chain and Strategic Activity Systems” in Chapter 4.
■ New A-head section “Platform Strategy” in Chapter 7.
■ New A-head section “Organizing for Innovation” in Chapter 11 (closed and open
innovation).
■ All new or updated and revised ChapterCases (including: Tesla, Sheryl Sandberg at
Facebook, Airbnb, Uber vs. Lyft, IKEA, and Zappos).
■ All new or updated and revised StrategyHighlights (two per chapter).
■ New or fully updated and revised MiniCases (four new, 18 revised and updated).
■ Fully updated and revised full-length cases, including most popular cases such as
Apple, McDonald’s, Best Buy, Amazon, Facebook, Delta Air Lines, Alphabet’s
Google, etc.
In detail:
CHAPTER 1
■ New ChapterCase: “Tesla’s Secret Strategy.”
■ New Strategy Highlight: “Teach for America: How Wendy Kopp Inspires Future
Leaders.”
■ Improved chapter flow through moving the updated section on “Vision, Mission, and
Values” into Chapter 1 (from Chapter 2).
CHAPTER 2
■ New ChapterCase: “Sheryl Sandberg: Leaning in at Facebook.”
■ Improved chapter flow through moving the updated section on “Stakeholder Strategy”
into Chapter 2 (from Chapter 1).
CHAPTER 3
■ New ChapterCase: “Airbnb: Disrupting the Hotel Industry.”
■ New A-head section on “Changes over Time: Entry Choices and Industry Dynamics.”
■ Improved chapter flow through moving the updated section on industry and firm
effects into Chapter 3 (from Chapter 1).
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CHAPTER 4
■ New A-head section on “The Value Chain and Strategic Activity Systems.”
■ New Strategy Highlight: “When Will P&G Play to Win Again?”
CHAPTER 5
■ New section on “the Why, What, Who, and How of Business Models Framework.”
■ Extended and updated discussion of business models to include new popular applica-
tions and examples, with a more in-depth discussion.
■ Extended and updated discussion of competitive advantage and firm performance
using the ongoing competition between Apple and Microsoft as an example through-
out the chapter, including comparing the same two companies along different metrics
and approaches to assess competitive advantage. Added a stronger dynamic element.
CHAPTER 6
■ New section on the learning curve concept applied to Tesla’s manufacturing process
with real-world data and graphic illustration.
CHAPTER 7
■ New A-head section “Platform Strategy.”
■ New Strategy Highlight “Standards Battle: Which Automotive Technology Will Win?”
CHAPTER 8
■ Updated and revised ChapterCase featuring Amazon’s corporate strategy through ver-
tical integration and diversification.
■ Updated and expanded section on parent-subsidiary relationship, featuring GM and
(former) subsidiaries Opel and Vauxhall in Europe.
CHAPTER 9
■ New ChapterCase: “Little Lyft Gets Big Alliance Partners,” featuring the smaller
ride-hailing competitor’s astute use of strategic alliances with strong partners such as
GM and Alphabet’s Waymo to compete against Uber.
■ New Strategy Highlight “How Tesla Used Alliances Strategically”.
CHAPTER 10
■ New section on “Globalization 3.1: Retrenchment?”
■ Updated and revised ChapterCase: “Sweden‘s IKEA: The World’s Most Profitable
Retailer,” highlighting IKEA’s strategy on competing in both developed and emerging
economies across the world.
■ New Exhibit 10.4 juxtaposing: “Advantages and Disadvantages of International
Expansion”.
■ Updated and revised Strategy Highlight: “Walmart Retreats from Germany, and Lidl
Invades the United States,” highlighting how disruptors of the German grocery indus-
try (Aldi and Lidl) are challenging Walmart on its home turf.
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CHAPTER 11
■ New A-head Section “Organizing for Innovation” (closed and open innovation).
■ New Strategy Highlight: “Sony vs. Apple: Whatever Happened to Sony?”
■ New Exhibit 11.11 juxtaposing: “Advantages and Disadvantages of Different Organi-
zational Structures”.
CHAPTER 12
■ Updated and revised ChapterCase: “Uber: Most Ethically Challenged Tech Company?”
including co-founder and long-time CEO Travis Kalanick’s forced resignation in the
wake of several ethics scandals.
■ Updated and revised Strategy Highlight: “Why the Mild Response to Goldman Sachs
and Securities Fraud?”
MINICASES
■ Added four-new: Yahoo, IBM, Dollar Shave Club, and Disney.
■ Updated and revised the most popular 18 MiniCases from the third edition.
■ Stronger focus on non-U.S. firms, especially on global competitors from Asia and
Europe.
■ Stronger focus on U.S. companies competing in China and India, facing strong
domestic competitors.
FULL-LENGTH CASES
■ All cases—including the new and revised cases plus all cases from the previous edi-
tions that were authored by Frank T. Rothaermel—are available through McGraw-Hill
Create: http://www.mcgrawhillcreate.com/Rothaermel.
■ Added five new, author-written full-length Cases: Netflix, Starbucks, Uber, Walmart,
and Disney.
■ Added one new, full-length Case: SpaceX by David R. King
■ Revised and updated the most popular cases including: Amazon, Apple, Alphabet’s
Google, Best Buy, Facebook, McDonald’s, Tesla, Delta Air Lines, and UPS in India,
among others.
■ Updated and revised the popular case “The Movie Exhibition Industry” by Steve Gove.
■ Case Strategic Financial Analyses (SFAs) include financial data in e-format for analysis.
CONNECT
Connect, McGraw-Hill’s online assignment and assessment system, offers a wealth of
content for both students and instructors. Assignable activities include the following:
■ SmartBook, one of the first fully adaptive and individualized study tools, provides
students with a personalized learning experience, giving them the opportunity to prac-
tice and challenge their understanding of core strategy concepts. SmartBook has been
extremely well received by strategy instructors across the globe. It allows the instruc-
tor to set up all assignments prior to the semester, to have them auto-released on pre-
set dates, and to receive auto-graded progress reports for each student and the entire
class. Students love SmartBook because they learn at their own pace, and it helps
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them to study more efficiently by delivering an interactive reading experience through
adaptive highlighting and review.
■ Interactive Application Exercises (such as Whiteboard Animation video cases,
MiniCase case analyses, click-and-drag activities, and new case exercises for Ama-
zon, Apple, Tesla, McDonald’s, Best Buy, and Facebook) that require students to
apply key concepts and so to close the knowing and doing gap, while providing
instant feedback for the student and progress tracking for the instructor.
■ Running case, an activity that begins with a review of a specific company and its
applied strategy using appropriate tools (e.g., PESTEL, Porter’s five forces, VRIO,
SWOT, and others). The analysis progresses from a broad perspective to the appro-
priate company-level perspective—i.e., from global to industry to strategic group to
company and within a firm. Students will develop a complete strategy analysis for
the company and consider several scenarios for improving the company’s competitive
advantage. The scenarios will include a financial analysis and justification and ulti-
mately provide a specific recommendation. Connect provide a running case example
for Hewlett-Packard (now HP Inc. and Hewlett Packard Enterprise).
■ Resources for financial analysis (such as strategic financial ratios, templates for
strategic financial analysis, and financial ratio reviews) that provide students with the
tools they need to compare performance among firms and to refresh or extend their
working knowledge of major financial measures in a strategic framework.
CREATE
■ CREATE, McGraw-Hill’s custom-publishing tool, is where you access the full-length
cases (and Teaching Notes) that accompany Strategic Management (http://www.
mcgrawhillcreate.com/Rothaermel). You can create customized course packages in
print and/or digital form at a competitive price point.
■ Through CREATE, you will be able to select from 20 author-written cases and 3
instructor-written cases that go specifically with the new 4th edition, as well as cases
from Harvard, Ivey Darden, NACRA, and much more! You can: Assemble your own
course, selecting the chapters, cases (multiple different formats), and readings that
will work best for you. Or choose from several ready-to-go, author-recommended
complete course solutions, which include chapters, cases, and readings, pre-loaded in
CREATE. Among the pre-loaded solutions, you’ll find options for undergrad, MBA,
accelerated, and other strategy courses.
INSTRUCTOR RESOURCES
Located in the Connect Library under the Instructor’s Resources tab, instructors will find
tested and effective tools to support teaching:
■ The updated and revised Teacher’s Resource Manual (TRM) includes thorough
coverage of each chapter, as well as guidance for integrating Connect—all in a single
resource. Included in this newly combined TRM, which retains favorite features of the
previous edition’s Instructor’s Manual, is the appropriate level of theory, framework,
recent application or company examples, teaching tips, PowerPoint references, critical
discussion topics, and answers to end-of-chapter exercises.
■ The PowerPoint (PPT) slides, available in an accessible version for individuals with
visual impairment, provide comprehensive lecture notes, video links, and company
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examples not found in the textbook. Options include instructor media-enhanced slides
as well as notes with outside application examples.
■ The Test Bank includes 100–150 questions per chapter, in a range of formats and
with a greater-than-usual number of comprehension, critical-thinking, and application
(or scenario-based) questions. It’s tagged by learning objectives, Bloom’s Taxonomy
levels, and AACSB compliance requirements. Many questions are new, and especially
written for the new 4th edition.
■ The Video Guide includes video links that relate to concepts from chapters. The
video links include sources such as Big Think, Stanford University’s Entrepreneurship
Corner, The McKinsey Quarterly, ABC, BBC, CBS, CNN, ITN/Reuters, MSNBC,
NBC, PBS, and YouTube.
Any list of acknowledgments will almost always be incomplete, but I would like to thank
some special people without whom this text would not have been possible. First and fore-
most, my wife Kelleyn, and our children: Harris, Winston, Roman, Adelaide, Avery, and
Ivy. Over the last few years, I have worked longer hours than when I was a graduate student
to conduct the research and writing necessary for this text and accompanying case studies
and other materials. I sincerely appreciate the sacrifice this has meant for my family.
The Georgia Institute of Technology provided a conducive, intellectual environment
and superb institutional support to make this project possible. I thank Russell and Nancy
McDonough for generously funding the endowed chair that I am honored to hold. I’m
grateful for Dean Maryam Alavi and Senior Associate Dean Peter Thompson for providing
the exceptional leadership that allows faculty to fully focus on research, teaching, and ser-
vice. I have been at Georgia Tech for 15 years, and could not have had better colleagues—
all of whom are not only great scholars but also fine individuals whom I’m fortunate to
have as friends: Marco Ceccagnoli, Annamaria Conti, Jonathan Giuliano, Stuart Graham,
Matt Higgins, David Ku, John McIntyre, Alex Oettl, Pian Shu, Eunhee Sohn, and Laurina
Zhang. We have a terrific group of current and former PhD students, many of whom had a
positive influence on this project, including Shanti Agung (Drexel University), Drew Hess
(Washington and Lee University), Kostas Grigoriou (McKinsey), Congshan Li, Jaiswal
Mayank (Rider University), Nicola McCarthy, German Retana (INCAE Business School,
Costa Rica), Maria Roche, Briana Sell Stenard (Mercer University), Jose Urbina, Carrie
Yang (University of Chicago), and Wei Zhang (Singapore Management University).
I was also fortunate to work with McGraw-Hill, and the best editorial and market-
ing team in the industry: Michael Ablassmeir (director), Susan Gouijnstook (man-
aging director), Lai T. Moy (senior product developer), Debbie Clare (executive
marketing manager), Mary E. Powers and Keri Johnson (content project managers), Matt
Diamond (senior designer), and Haley Burmeister (editorial coordinator). Bill Teague,
content development editor, worked tirelessly and carefully on the fourth edition manu-
script. I’m also indebted to Ann Torbert and Karyn Lu for invaluable editorial guidance
on prior editions.
ACKNOWLEDGMENTS
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ACKNOWLEDGMENTS xxi
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I’m more than grateful to the contributions of great colleagues on various resources that
accompany this new edition of Strategic Management:
■ Heidi Bertels (College of Staten Island, CUNY) on the Test Bank and SmartBook
■ John Burr (Purdue University) on the Video Guide
■ Melissa Francisco (University of Central Florida) on the accessible PowerPoint
Presentations
■ Anne Fuller (California State University, Sacramento), on Connect, Teacher’s
Resource Manual, and End-of-Chapter Material
■ David R. King (Florida State University) on select Full-length Cases and Full-length
Case Teaching Notes
■ Chandran Mylvaganam (Northwood University) on the MiniCase Teaching Notes
Shawn Riley (Kutztown University) for his expert reviews on the Case Exercises,
Case SFAs, and MiniCase Case Analyses
I’d also like to thank the students at Georgia Tech, in the undergraduate and full-time
day MBA, and the evening and executive MBA programs, as well as the executive MBA
students from the ICN Business School in Nancy, France, on whom the materials were
beta-tested. Their feedback helped fine-tune the content and delivery.
Last, but certainly not least, I wish to thank the reviewers and focus group attendees
who shared their expertise with us, from the very beginning when we developed the pro-
spectus to the final teaching and learning package that you hold in your hands. The review-
ers have given us the greatest gift of all—the gift of time! These very special people are
listed starting on page xxii.
Frank T. Rothaermel
Georgia Institute of Technology
Web: ftrStrategy.com
Email: frank@ftrStrategy.com
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This book has gone through McGraw-Hill Education’s thorough development process.
Over the course of several years, the project has benefited from numerous developmental
focus groups and symposiums, from hundreds of reviews from reviewers across the coun-
try, and from beta-testing of the first-edition manuscript as well as market reviews of the
of subsequent editions on a variety of campuses. The author and McGraw-Hill wish to
thank the following people who shared their insights, constructive criticisms, and valuable
suggestions throughout the development of this project. Your contributions have improved
this product.
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University College
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York, Staten Island
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REVIEWERS AND SYMPOSIUM ATTENDEES
THANK YOU . . .
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PART
Analysis
CHAPTER 1 What Is Strategy?
CHAPTER 2 Strategic Leadership: Managing the Strategy Process
CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models
1
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Part 1: Analysis
Part 1: Analysis
Part 2: Formulation
1. What Is Strategy?
3. External Analysis: Industry Structure,
Competitive Forces, and Strategic
Groups
4. Internal Analysis: Resources,
Capabilities, and Core Competencies
5. Competitive Advantage, Firm
Performance, and Business Models
6. Business Strategy: Differentiation, Cost
Leadership, and Blue Oceans
7. Business Strategy: Innovation,
Entrepreneurship, and Platforms
8. Corporate Strategy: Vertical
Integration and Diversification
9. Corporate Strategy: Strategic Alliances,
Mergers and Acquisitions
10. Global Strategy: Competing Around
the World
11. Organizational Design: Structure,
Culture, and Control
Getting
Started
External and
Internal
Analysis
Formulation:
Business
Strategy
Formulation:
Corporate
Strategy
Implementation
Gaining &
Sustaining
Competitive
Advantage
12. Corporate Governance and Business
Ethics
2. Strategic Leadership: Managing
the Strategy Process
Part 3: Implementation
Part 2: Formulation
The AFI Strategy Framework
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CHAPTER What Is Strategy?
Chapter Outline
1.1 What Strategy Is: Gaining and Sustaining
Competitive Advantage
What Is Competitive Advantage?
1.2 Vision, Mission, and Values
Vision
Mission
Values
1.3 The AFI Strategy Framework
1.4 Implications for Strategic Leaders
Learning Objectives
LO 1-1 Explain the role of strategy in a firm’s quest
for competitive advantage.
LO 1-2 Define competitive advantage, sustainable
competitive advantage, competitive disad-
vantage, and competitive parity.
LO 1-3 Describe the roles of vision, mission, and
values in a firm’s strategy.
LO 1-4 Evaluate the strategic implications of
product-oriented and customer-oriented
vision statements.
LO 1-5 Justify why anchoring a firm in ethical core
values is essential for long-term success.
LO 1-6 Explain the AFI strategy framework.
1
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Tesla’s Secret Strategy
IN 2017, TESLA INC.— an American manufacturer of
all-electric cars—boasted a market capitalization1 of over
$60 billion, an appreciation of more than 1,400 percent
over its initial public offering price in 2010. How can a
California startup achieve a market valuation that exceeds
that of GM, the largest car manufacturer in the world,
making some 10 million vehicles a year? The answer:
Tesla’s Secret Strategy. In a blog entry on Tesla’s website
in the summer of 2006, Elon Musk, Tesla’s co-founder
and CEO, explained the startup’s master plan:2
1. Build sports car.
2. Use that money to build
an affordable car.
3. Use that money to
build an even more
affordable car.
4. While doing above,
also provide zero-
emission electric power
generation options.
5. Don’t tell anyone.
Let’s see if Tesla stuck
to its strategy. In 2008, Tesla
introduced its first car: the
Roadster, a $110,000 sports
coupe with faster accel-
eration than a Porsche or a
Ferrari. Tesla’s first vehicle
served as a prototype to demonstrate that electric vehicles can
be more than mere golf carts. Tesla thus successfully com-
pleted Step 1 of the master plan.
In Step 2, after selling some 2,500 Roadsters, Tesla
discontinued its production in 2012 to focus on its next
car: the Model S, a four-door family sedan, with a base
price of $73,500 before tax credits. The line appeals to
a somewhat larger market and thus allows for larger
production runs to drive down unit costs. The Model S
received an outstanding market reception. It was awarded
not only the 2013 Motor Trend Car of the Year, but also
received the highest score of any car ever tested by Con-
sumer Reports (99/100). Tesla manufactures the Model S
in the Fremont, California, factory that it purchased from
Toyota. By the end of 2016, it had sold some 125,000 of
the Model S worldwide.
Hoping for an even broader customer appeal, Tesla
also introduced the Model X, a crossover between an SUV
and a family van with futuristic falcon-wing doors for
convenient access to second- and third-row seating. The
$100,000 starting sticker price of the Model X is quite
steep, however; thus limiting mass-market appeal. Techni-
cal difficulties with its innovative doors delayed its launch
until the fall of 2015.
Tesla has now reached Step 3 of its master plan. In
2017, Tesla delivered the company’s newest car: the
Model 3, an all- electric
compact luxury sedan,
with a starting price of
$35,000. Tesla received
some 375,000 preorders
within three months
of unveiling its model.
Many of the want-to-be
Tesla owners stood in
line overnight, eagerly
awaiting the open-
ing of the Tesla stores
to put down a $1,000
deposit to secure a spot
on the waiting list for
the Model 3, a car they
had never even seen,
let alone taken for a
test drive. By the time Tesla delivered the first 30 cars
of its new Model 3 (to Tesla employees for quality test-
ing and appreciation of their hard work), the California
car maker had received over 500,000 preorders. This cus-
tomer enthusiasm amounted to $500 million in interest-
free loans for Tesla. The Model 3 was slated for delivery
by late 2017. Tesla hoped to sell 500,000 total vehicles
by the end of 2018. To accomplish this ambitious goal,
Musk also promised that Tesla would increase its annual
production from 50,000 in 2015 to 1 million vehicles a
year by 2020.
CHAPTERCASE 1
Tesla’s Model X with falcon wing doors. ©Bloomberg/Getty Images
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LO 1-1
Explain the role of
strategy in a firm’s
quest for competitive
advantage.
WHY IS TESLA SO SUCCESSFUL? In contrast, the big-three U.S. automakers—
Ford, GM, and Chrysler—struggled during the first decade of the 21st century, with
both GM and Chrysler filing for bankruptcy protection.
If once-great firms can fail, why is any company successful? What enables some firms
to gain and then sustain their competitive advantage over time? How can managers influ-
ence firm performance? These are the big questions that define strategic management.
Answering these questions requires integrating the knowledge you’ve obtained in your
studies of various business disciplines to understand what leads to superior performance,
and how you can help your organization achieve it.
Strategic management is the integrative management field that combines analysis,
formulation, and implementation in the quest for competitive advantage. Mastery of stra-
tegic management enables you to view an organization such as a firm or a nonprofit outfit
in its entirety. It also enables you to think like a general manager to help position your
organization for superior performance. The AFI strategy framework embodies this view of
strategic management. It will guide our exploration of strategic management through the
course of your study.
In this chapter, we lay the groundwork for the study of strategic management. We’ll
introduce foundational ideas about strategy and competitive advantage. We then move
from thinking about why strategy is important to considering the role an organization’s
vision, mission, and values play in its strategy. Next, we take a closer look at the compo-
nents of the AFI framework and provide an overview of the entire strategic management
process. We conclude this introductory chapter, as we do with all others in this text, with
a section titled Implications for Strategic Leaders. Here we provide practical applications
and considerations of the material developed in the chapter. Let’s begin the exciting jour-
ney to understand strategic management and competitive advantage.
1.1 What Strategy Is: Gaining and Sustaining
Competitive Advantage
Strategy is a set of goal-directed actions a firm takes to gain and sustain superior per-
formance relative to competitors.4 To achieve superior performance, companies compete
for resources: New ventures compete for financial and human capital, existing companies
compete for profitable growth, charities compete for donations, universities compete for
the best students and professors, sports teams compete for championships, while celebri-
ties compete for media attention.
As highlighted in the ChapterCase, Tesla, a new entrant in the automotive industry, is com-
peting with established U.S. companies such as GM, Ford, and Chrysler and also with for-
eign automakers Toyota, Honda, Mercedes, and BMW, among others, for customers. In any
Step 4 of Musk’s master plan for Tesla aims to pro-
vide zero-emission electric power generation options. To
achieve this goal, Tesla acquired SolarCity, a solar energy
company, for more than $2 billion in the fall of 2016. This
joining creates the world’s first fully integrated clean-tech
energy company by combining solar power, power storage,
and transportation. A successful integration of Tesla and
SolarCity, where Musk is also chairman and an early inves-
tor, would allow completion of Step 4 of Tesla’s master plan.
Step 5: “Don’t tell anyone”—thus the ChapterCase title
“Tesla’s Secret Strategy.”3
You will learn more about Tesla by reading this chapter; related ques-
tions appear in “ChapterCase 1 / Consider This . . . .”
strategic
management An
integrative management
field that combines
analysis, formulation,
and implementation in
the quest for competitive
advantage.
strategy The set of
goal-directed actions
a firm takes to gain
and sustain superior
performance relative to
competitors.
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competitive situation, a good strategy enables a firm to achieve superior performance relative
to its competitors. This leads to the question: What is a good strategy?
1. A diagnosis of the competitive challenge. This element is accomplished through analy-
sis of the firm’s external and internal environments (Part 1 of the AFI framework).
2. A guiding policy to address the competitive challenge. This element is accomplished
through strategy formulation, resulting in the firm’s corporate, business, and functional
strategies (Part 2 of the AFI framework).
3. A set of coherent actions to implement the firm’s guiding policy. This element is
accomplished through strategy implementation (Part 3 of the AFI framework).
Let’s revisit ChapterCase 1 to see whether Tesla, Inc. is pursuing a good strategy. Tesla
appears to be performing quite well when considering indicators such as stock apprecia-
tion, where it outperforms its competitors by a wide margin. The high appreciation of
Tesla stock points to investors’ expectations of future growth. By other measures, such as
generating profits, Tesla underperforms compared to established car companies. Losses
are common for startups early on, especially if the business requires large upfront invest-
ments such as building new factories, which Tesla was required to do. What we can say at
this point is that Tesla seems to be starting with a promising strategy and is in the process
of gaining a competitive advantage. But can Tesla sustain its advantage over time? Let’s
use the three elements of a good strategy to assess how Tesla CEO Elon Musk could turn
an early lead into a sustainable competitive advantage.
THE COMPETITIVE CHALLENGE. A good strategy needs to start with a clear and criti-
cal diagnosis of the competitive challenge. Musk, Tesla’s co-founder and CEO, describes
himself as an “engineer and entrepreneur who builds and operates companies to solve
environmental, social, and economic challenges.”5 Tesla was founded with the vision to
“accelerate the world’s transition to sustainable transport.”6
To accomplish this mission, Tesla must build zero-emission electric vehicles that are
attractive and affordable. Beyond achieving a competitive advantage for Tesla, Musk is
working to set a new standard in automotive technology. He hopes that zero-emission elec-
tric vehicles will one day replace gasoline-powered cars.
Tesla’s competitive challenge is sizable: To succeed it must manufacture attractive and
affordable vehicles using its new technology, which will compete with traditional cars running
on gasoline. It also needs the required infrastructure for electric vehicles, including a network of
charging stations to overcome “range anxiety”7 by consumers; many mass-market electric vehi-
cles cannot drive as far on one charge as gasoline-powered cars can with a full tank of gas. Gas
stations can be found pretty much on any corner in cities and every couple of miles on highways.8
A GUIDING POLICY. After the diagnosis of the competitive challenge, the firm needs to for-
mulate an effective guiding policy in response. The formulated strategy needs to be consis-
tent, often backed up with strategic commitments such as sizable investments or changes to
an organization’s incentive and reward system—big changes that cannot be easily reversed.
Without consistency in a firm’s guiding policy, employees become confused and cannot
make effective day-to-day decisions that support the overall strategy. Without consistency
in strategy, moreover, other stakeholders, including investors, also become frustrated.
To address the competitive challenge, Tesla’s current guiding policy is to build a cost-
competitive mass-market vehicle such as the new Model 3 (this is also Step 3 in Tesla’s
“Secret Strategy,” as discussed in the ChapterCase). Tesla’s formulated strategy is consis-
tent with its mission and the competitive challenge identified. It also requires significant
strategic commitments such as Tesla’s $5 billion investment in a new lithium-ion battery
Good strategy A
strategy is good when
it enables a firm to
achieve superior
performance. It consists
of three elements:
(1) a diagnosis of the
competitive challenge;
(2) a guiding policy to
address the competitive
challenge; and (3) a
set of coherent actions
to implement a firm’s
guiding policy.
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8 CHAPTER 1 What Is Strategy?
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plant in Nevada, the so-called Gigafactory. Batteries are the most critical component for
electric vehicles. To accomplish this major undertaking, Tesla has partnered with Pana-
sonic of Japan, a world leader in battery technology.
COHERENT ACTIONS. Finally, a clear guiding policy needs to be implemented with a set of
coherent actions. Tesla appears to implement its formulated strategy with actions consistent
with its diagnosis of the competitive challenge. To accomplish building a cost-competitive
mass-market vehicle, Tesla must benefit from economies of scale, which are decreases in
cost per vehicle as output increases. To reap these critical cost reductions, Tesla must ramp
up its production volume. This is a huge challenge: Tesla aims to increase its production
output by some 20 times, from 50,000 cars built in 2015 to 1 million cars per year by
2020. Tesla’s retooling of its manufacturing facility in Fremont, California, to rely more
heavily on cutting-edge robotics as well as its multibillion-dollar investment to secure an
uninterrupted supply of lithium-ion batteries are examples of actions coherent with Tesla’s
formulated strategy. At the same time, Tesla is further building out its network of charg-
ing stations across the United States and globally. To fund this initiative, it announced that
using the company’s charging network will no longer be free for new Tesla owners.
To accomplish the lofty goal of making zero-emission electric motors the new standard
in automotive technology (rather than gas-powered internal combustion engines), Tesla
decided to make its proprietary technology available to the public. Musk’s hope is that
sharing Tesla’s patents will expand the overall market size for electric vehicles as other
manufacturers, such as BMW with its i3 line of vehicles, can employ Tesla’s technology.
In review, to create a good strategy, three steps are crucial. First, a good strategy defines
the competitive challenges facing an organization through a critical and honest assessment
of the status quo. Second, a good strategy provides an overarching approach on how to deal
with the competitive challenges identified. The approach needs to be communicated in
policies that provide clear guidance for employees. Last, a good strategy requires effective
implementation through a coherent set of actions.
WHAT IS COMPETITIVE ADVANTAGE?
Competitive advantage is always relative, not absolute. To assess competitive advantage,
we compare firm performance to a benchmark—that is, either the performance of other
firms in the same industry or an industry average. A firm that achieves superior perfor-
mance relative to other competitors in the same industry or the industry average has a
competitive advantage.9 In terms of stock market valuation, Tesla has appreciated much
more in recent years than GM, Ford, or Chrysler, and thus appears to have a competitive
advantage, at least on this dimension.
A firm that is able to outperform its competitors or the industry average over a pro-
longed period has a sustainable competitive advantage. Apple, for example, has enjoyed
a sustainable competitive advantage over Samsung in the smartphone industry for over a
decade since its introduction of the iPhone in 2007. Other phone makers such as Microsoft
(which purchased Nokia) and BlackBerry have all but exited the smartphone market, while
new entrants such as Xiaomi and Huawei of China are trying to gain traction.
If a firm underperforms its rivals or the industry average, it has a competitive
disadvantage. For example, a 15 percent return on invested capital may sound like
LO 1-2
Define competitive
advantage, sustainable
competitive advantage,
competitive disadvantage,
and competitive parity.
competitive advantage Superior
performance relative to other competitors in
the same industry or the industry average.
competitive disadvantage
Underperformance relative to other
competitors in the same industry or the
industry average.
sustainable competitive
advantage Outperforming competitors or the
industry average over a prolonged period of time.
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superior firm performance. In the consulting
industry, though, where the average return
on invested capital is often above 20 percent,
such a return puts a firm at a competitive
disadvantage. In contrast, if a firm’s return
on invested capital is 2 percent in a declin-
ing industry, like newspaper publishing,
where the industry average has been negative
(–5 percent) for the past few years, then the
firm has a competitive advantage. Should
two or more firms perform at the same level,
they have competitive parity. In Chapter 5,
we’ll discuss in greater depth how to evaluate
and assess competitive advantage and firm
performance.
To gain a competitive advantage, a firm
needs to provide either goods or services consumers value more highly than those of its
competitors, or goods or services similar to the competitors’ at a lower price. The rewards
of superior value creation and capture are profitability and market share. Elon Musk is
particularly motivated to address global warming, and thus formed Tesla to build electric
vehicles with zero emissions. Sara Blakely, the founder and CEO of Spanx, the global
leader in the shapewear industry, is motivated to change women’s lives. Sam Walton was
driven by offering lower prices than his competitors when creating Walmart, the world’s
largest retailer. For Musk, Blakely, Walton, and numerous other entrepreneurs and busi-
nesspeople, creating shareholder value and making money is the consequence of filling
a need and providing a product, service, or experience consumers wanted, at a price they
could afford.
The important point here is that strategy is about creating superior value, while contain-
ing the cost to create it, or by offering similar value at lower cost. Managers achieve these
combinations of value and cost through strategic positioning. That is, they stake out a
unique position within an industry that allows the firm to provide value to customers, while
controlling costs. The greater the difference between value creation and cost, the greater
the firm’s economic contribution and the more likely it will gain competitive advantage.
Strategic positioning requires trade-offs, however. As a low-cost retailer, Walmart has
a clear strategic profile and serves a specific market segment. Upscale retailer Nordstrom
has also built a clear strategic profile by providing superior customer service to a higher
end, luxury market segment. Although these companies are in the same industry, their
customer segments overlap very little, and they are not direct competitors. Walmart and
Nordstrom have each chosen a distinct but different strategic position. The managers make
conscious trade-offs that enable each company to strive for competitive advantage in the
retail industry, using different competitive strategies: cost leadership versus differentiation.
In regard to the customer service dimension, Walmart provides acceptable service by low-
skill employees in a big-box retail outlet offering “everyday low prices,” while Nordstrom
provides a superior customer experience by professional salespeople in a luxury setting.
A clear strategic profile—in terms of product differentiation, cost, and customer
service—allows each retailer to meet specific customer needs. Competition focuses on
creating value for customers (through lower prices or better service and selection, in this
example) rather than destroying rivals. Even though Walmart and Nordstrom compete in
the same industry, both can win if they achieve a clear strategic position through a well-
executed competitive strategy. Strategy, therefore, is not a zero-sum game.
competitive
parity Performance of
two or more firms at the
same level.
Spanx founder and CEO
Sara Blakely, a graduate of
Florida State University, is
the world’s youngest female
billionaire.
©ZUMA Press Inc/Alamy
Stock Photo
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10 CHAPTER 1 What Is Strategy?
rot27628_ch01_002-029.indd 10 10/30/17 08:11 PM
The key to successful strategy is to combine a set of activities to stake out a unique stra-
tegic position within an industry. Competitive advantage has to come from performing dif-
ferent activities or performing the same activities differently than rivals are doing. Ideally,
these activities reinforce one another rather than create trade-offs. For instance, Walmart’s
strategic activities strengthen its position as cost leader: Big retail stores in rural locations,
extremely high purchasing power, sophisticated IT systems, regional distribution centers,
low corporate overhead, and low base wages and salaries combined with employee profit
sharing reinforce each other, to maintain the company’s cost leadership.
Since clear strategic positioning requires trade-offs, strategy is as much about deciding
what not to do, as it is about deciding what to do.10 Because resources are limited, manag-
ers must carefully consider their strategic choices in the quest for competitive advantage.
Trying to be everything to everybody will likely result in inferior performance. In addition,
operational effectiveness, marketing skills, and other functional expertise all strengthen
a unique strategic position. Those capabilities, though, do not substitute for competitive
strategy. Competing to be similar but just a bit better than your competitor is likely to be a
recipe for cut-throat competition and low profit potential.
Let’s take this idea to its extreme in a quick thought experiment: If all firms in the same
industry pursued a low-cost position through application of competitive benchmarking,
all firms would have identical cost structures. None could gain a competitive advantage.
Everyone would be running faster, but nothing would change in terms of relative strategic
positions. There would be little if any value creation for customers because companies
would have no resources to invest in product and process improvements. Moreover, the
least-efficient firms would be driven out, further reducing customer choice.
To gain a deeper understanding of what strategy is, it may be helpful to think about
what strategy is not.11 Be on the lookout for the following major hallmarks of what strategy
is not:
1. Grandiose statements are not strategy. You may have heard firms say things like, “Our
strategy is to win” or “We will be No. 1.” Twitter, for example, declared its “ambition
is to have the largest audience in the world.”12 Such statements of desire, on their own,
are not strategy. They provide little managerial guidance and often lead to goal conflict
and confusion. Moreover, such wishful thinking frequently fails to address economic
fundamentals. As we will discuss in the next section, an effective vision and mission
can lay the foundation upon which to craft a good strategy. This foundation must be
backed up, however, by strategic actions that allow the firm to address a competitive
challenge with clear consideration of economic fundamentals, in particular, value cre-
ation and costs.
2. A failure to face a competitive challenge is not strategy. If the firm does not define
a clear competitive challenge, employees have no way of assessing whether they are
making progress in addressing it. Managers at the now-defunct video rental chain
Blockbuster, for example, failed to address the competitive challenges posed by new
players Netflix, Redbox, Amazon Prime, and Hulu.
3. Operational effectiveness, competitive benchmarking, or other tactical tools are not
strategy. People casually refer to a host of different policies and initiatives as some sort
of strategy: pricing strategy, internet strategy, alliance strategy, operations strategy, IT
strategy, brand strategy, marketing strategy, HR strategy, China strategy, and so on. All
these elements may be a necessary part of a firm’s functional and global initiatives to
support its competitive strategy, but these elements are not sufficient to achieve com-
petitive advantage. In this text, though, we will reserve the term strategy for describing
the firm’s overall efforts to gain and sustain competitive advantage.
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1.2 Vision, Mission, and Values
The first step to gain and sustain a competitive advantage is to define an organization’s
vision, mission, and values. Managers must ask the following questions:
■ Vision. What do we want to accomplish ultimately?
■ Mission. How do we accomplish our goals?
■ Values. What commitments do we make, and what guardrails do we put in place, to act
both legally and ethically as we pursue our vision and mission?
The vision is the first principle that needs to be defined because it succinctly identi-
fies the primary long-term objective of the organization. Strategic leaders need to begin
with the end in mind.13 In fact, early on strategic success is created twice. Leaders create
the vision in the abstract by formulating strategies that enhance the chances of gaining
and sustaining competitive advantage, before any actions of strategy implementation are
taken in a second round of strategy creation. This process is similar to building a house.
The future owner must communicate her vision to the architect, who draws up a blueprint
of the home for her review. The process is iterated a couple of times until all the home-
owner’s ideas have been translated into the blueprint. Only then does the building of the
house begin. The same holds for strategic success; it is first created through strategy for-
mulation based on careful analysis before any actions are taken. Let’s look at this process
in more detail.
VISION
A vision captures an organization’s aspiration and spells out what it ultimately wants to
accomplish. An effective vision pervades the organization with a sense of winning and
motivates employees at all levels to aim for the same target, while leaving room for indi-
vidual and team contributions.
Tesla’s vision is to accelerate the world’s transition to sustainable transport. The goal is
to provide affordable zero-emission mass-market cars that are the best in class. SpaceX
is a spacecraft manufacturer and space transport services company, also founded by Elon
Musk, whose inspirational vision is to make human life multi planetary. To achieve this goal,
SpaceX aims to make human travel to Mars not only possible but also affordable. Moreover,
SpaceX also sees a role in helping establish a self-sustainable human colony on Mars.14
Employees in visionary companies tend to feel part of something bigger than them-
selves. An inspiring vision helps employees find meaning in their work. Beyond monetary
rewards, it allows employees to experience a greater sense of purpose. People have an
intrinsic motivation to make the world a better place through their work activities.15 This
greater individual purpose in turn can lead to higher organizational performance.16 Basing
actions on its vision, a firm will build the necessary resources and capabilities through
continuous organizational learning, including learning from failure, to translate into reality
what begins as a stretch goal or strategic intent.17
To provide meaning for employees in pursuit of the organization’s ultimate goals,
vision statements should be forward-looking and inspiring. Strategy Highlight 1.1 shows
how Wendy Kopp, the founder of Teach for America, uses an inspiring vision to effec-
tively and clearly communicate what TFA ultimately wants to accomplish, while providing
a stretch goal.
It’s not surprising that vision statements can be inspiring and motivating in the non-
profit sector. Many people would find meaning in wanting to help children attain an excel-
lent education (TFA) or wanting to be always there, touching the lives of people in need,
the vision of the American Red Cross. But what about for-profit firms?
LO 1-3
Describe the roles of
vision, mission, and values
in a firm’s strategy.
vision A statement
about what an
organization ultimately
wants to accomplish; it
captures the company’s
aspiration.
strategic intent
A stretch goal
that pervades the
organization with a
sense of winning,
which it aims to
achieve by building the
necessary resources
and capabilities through
continuous learning.
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Teach for America: How Wendy Kopp Inspires
Future Leaders
unattractive, low-status job into a high-prestige professional
opportunity. Kopp works to eliminate educational inequality
by enlisting the nation’s most promising future leaders in the
effort. Thus to be chosen for TFA is a badge of honor.
In the first four months after creating TFA, Kopp received
more than 2,500 applicants. Her marketing consisted of fly-
ers in dorm rooms. During its first academic year (1990–91),
TFA was able to serve five states and reached some 36,000
students. After 25 years, during the 2015–16 academic year,
some 20,000 TFA corps members were teaching in 36 states
(and Washington, D.C.) and more than 1,000 schools. To date,
TFA has reached over 10 million students.
To see how all three components—vision, mission, and
values—work together, see Exhibit 1.1, which provides a snap-
shot of aspirations at Teach for America.
While initially targeted at college seniors, today, one-third
of all TFA corps members applied as graduate students or
professionals. In 2015, TFA added 4,100 new teachers to its
corps from over 27,300 applications, representing more than
800 colleges and universities throughout the United States.
This equates to about 15 percent acceptance, roughly equiv-
alent to the admission rate of highly selective universities
such as Northwestern, Cornell, or University of California,
Berkeley. TFA’s teaching cohort is also much more diverse
than the national average: While some 20 percent of teach-
ers nationwide are people of color, about 50 percent of TFA
corps members are. TFA corps members receive the same
pay as other first-year teachers in the local school district.
Most importantly, TFA makes a significant positive impact
on students. Some 95 percent of all school principals work-
ing with TFA members say these teachers make a positive
difference. A study commissioned by the U.S. Department
of Education found that students being taught by TFA corps
members showed significantly higher achievement, especially
in math and science.
In 2016, after celebrating its 25th anniversary, TFA CEO
Elisa Villanueva Beard recalls that she was inspired to sign
up for TFA (when a freshman in high school) by Wendy Kopp’s
“audacity to believe young people could make a profound dif-
ference in the face of intractable problems standing between
the ideals of a nation I loved and a starkly disappointing real-
ity; who were bound by a fierce belief that all children, from
American Indian reservations in South Dakota to Oakland to
the Rio Grande Valley to the Bronx, should have the opportu-
nity to write their own stories and fulfill their true potential.”18
Strategy Highlight 1.1
Wendy Kopp, Teach for America founder.
©Bloomberg/Getty Images
Teach for America (TFA) is a cadre of future leaders who work
to ensure that underprivileged youth get an excellent educa-
tion. The nonprofit organization recruits both graduates and
professionals to teach for two years in economically disadvan-
taged communities in the United States. TFA’s vision is: One
day, all children in this nation will have the opportunity to
attain an excellent education.
The idea behind TFA was developed by then-21-year-old
Wendy Kopp as her college senior thesis (in 1989). Kopp was
convinced that young people generally search for meaning
in their lives by making a positive contribution to society.
The genius of Kopp’s idea was to turn on its head the social
perception of teaching—to make what could appear to be an
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VISION One day, all children in this nation will have the opportunity to attain an excellent education.
MISSION Our mission is to enlist, develop, and mobilize as many as possible of our nation’s most promising
future leaders to grow and strengthen the movement for educational equity and excellence.
VALUES Transformational Change: We seek to expand educational opportunity in ways that are life-
changing for children and transforming for our country. Given our deep belief in children and
communities, the magnitude of educational inequity and its consequences, and our optimism about the
solvability of the problem, we act with high standards, urgency, and a long-term view.
Leadership: We strive to develop and become the leaders necessary to realize educational
excellence and equity. We establish bold visions and invest others in working towards them. We work
in purposeful, strategic, and resourceful ways, define broadly what is within our control to solve,
and learn and improve constantly. We operate with a sense of possibility, persevere in the face of
challenges, ensure alignment between our actions and beliefs, and assume personal responsibility for
results.
Team: We value and care about each other, operate with a generosity of spirit, and have fun in the
process of working together. To maximize our collective impact, we inspire, challenge, and support each
other to be our best and sustain our effort.
Diversity: We act on our belief that the movement to ensure educational equity will succeed only if
it is diverse in every respect. In particular, we value the perspective and credibility that individuals
who share the racial and economic backgrounds of the students with whom we work can bring to our
organization, classrooms, and the long-term effort for change.
Respect & Humility: We value the strengths, experiences, and perspectives of others, and we
recognize our own limitations. We are committed to partnering effectively with families, schools, and
communities to ensure that our work advances the broader good for all children.
EXHIBIT 1.1 / Teach for America: Vision, Mission, and Values
SOURCE: www.teachforamerica.org.
Visionary companies, such as 3M, General Electric, Procter & Gamble (P&G), and
Walmart, provide more aspirational ideas that are not exclusively financial. The upscale
retailer Nordstrom’s vision, for example, is to provide outstanding service every day, one
customer at a time. Visionary companies often outperform their competitors over the long
run. Tracking the stock market performance of companies over several decades, strategy
scholars found that visionary companies outperformed their peers by a wide margin.19
A truly meaningful and inspiring vision makes employees feel they are part of something
bigger. This is highly motivating and, in turn, can improve firm financial performance.
MISSION
Building on the vision, organizations establish a mission, which describes what an organi-
zation actually does—that is, the products and services it plans to provide, and the markets
in which it will compete. People sometimes use the terms vision and mission interchange-
ably, but in the strategy process they differ.
■ A vision defines what an organization wants to accomplish ultimately, and thus the
goal can be described by the infinitive form of the verb starting with to. As discussed in
Strategy Highlight 1.1, TFA’s vision is to attain an excellent education for all children.
■ A mission describes what an organization does; it defines how the vision is accom-
plished and is often introduced with the preposition by. Accordingly, we can recast
Mission Description
of what an organization
actually does—the
products and services it
plans to provide, and the
markets in which it will
compete.
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TFA’s mission that it will achieve its vision by enlisting, developing, and mobilizing as
many as possible of our nation’s most promising future leaders to grow and strengthen
the movement for educational equity and excellence. (See Exhibit 1.1).
To be effective, firms need to back up their visions and missions with strategic
commitments, in which the enterprise undertakes credible actions. Such commitments are
costly, long-term oriented, and difficult to reverse.20 However noble the mission state-
ment, to achieve competitive advantage companies need to make strategic commitments
informed by economic fundamentals of value creation.
As mentioned in the ChapterCase, Tesla is investing billions of dollars to equip its car
factory in California with cutting-edge robotics and to build the Gigafactory producing
lithium-ion batteries in Nevada. These investments by Tesla are examples of strategic
commitments because they are costly, long-term, and difficult to reverse. They are clearly
supporting Tesla’s vision to accelerate the world’s transition to sustainable transport.
Tesla hopes to translate this vision into reality by providing affordable zero-emission mass-
market cars that are the best in class, which captures Tesla’s mission.
VISION STATEMENTS AND COMPETITIVE ADVANTAGE. Do vision statements help firms
gain and sustain competitive advantage? It depends. The effectiveness of vision statements
differs by type. Customer-oriented vision statements allow companies to adapt to chang-
ing environments. Product-oriented vision statements often constrain this ability. This is
because customer-oriented vision statements focus employees to think about how best to
solve a problem for a consumer.21
Clayton Christensen shares how a customer focus let him help a fast food chain increase
sales of milk shakes. The company approached Christensen after it had made several
changes to its milk-shake offering based on extensive customer feedback but sales failed to
improve. Rather than asking customers what kind of milk shake they wanted, he thought of
the problem in a different way. He observed customer behavior and then asked customers,
“What job were you trying to do that caused you to hire that milk shake?”22 He wanted to
know what problem the customers were trying to solve. Surprisingly he found that roughly
half of the milk shakes were purchased in the mornings, because customers wanted an easy
breakfast to eat in the car and a diversion on long commutes. Based on the insights gained
from this problem-solving perspective, the company expanded its milk-shake offerings to
include healthier options with fruit chunks and provided a prepaid dispensing machine to
speed up the drive-through, and thus improve customers’ morning commute. A customer
focus made finding a solution much easier.
You could say that the restaurant company had a product orientation that prevented its
executives from seeing unmet customer needs. Product-oriented vision statements focus
employees on improving existing products and services without consideration of underly-
ing customer problems to be solved. Our environments are ever-changing and sometimes
seem chaotic. The increased strategic flexibility afforded by customer-oriented vision
statements can provide companies with a competitive advantage.23 Let’s look at both types
of vision statements in more detail.
PRODUCT-ORIENTED VISION STATEMENTS. A product-oriented vision defines a business
in terms of a good or service provided. Product-oriented visions tend to force managers to
take a more myopic view of the competitive landscape. Consider the strategic decisions of
U.S. railroad companies. Railroads are in the business of moving goods and people from
point A to point B by rail. When they started in the 1850s, their short-distance competition
was the horse or horse-drawn carriage. There was little long-distance competition (e.g.,
ship canals or good roads) to cover the United States from coast to coast. Because of their
LO 1-4
Evaluate the strategic
implications of
product-oriented and
customer-oriented vision
statements.
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monopoly, especially in long-distance travel, these companies were initially extremely
profitable. Not surprisingly, the early U.S. railroad companies saw their vision as being in
the railroad business, clearly a product-based definition.
However, the railroad companies’ monopoly did not last. Technological innovations
changed the transportation industry dramatically. After the introduction of the automo-
bile in the early 1900s and the commercial jet in the 1950s, consumers had a wider range
of choices to meet their long-distance transportation needs. Rail companies were slow to
respond; they failed to redefine their business in terms of services provided to the con-
sumer. Had they envisioned themselves as serving the full range of transportation and
logistics needs of people and businesses across America (a customer-oriented vision), they
might have become successful forerunners of modern logistics companies such as FedEx
or UPS.
Recently, the railroad companies seem to be learning some lessons: CSX Railroad is
now redefining itself as a green-transportation alternative. It claims it can move one ton of
freight 423 miles on one gallon of fuel. However, its vision remains product-oriented: to be
the safest, most progressive North American railroad.
CUSTOMER-ORIENTED VISION STATEMENTS. A customer-oriented vision defines a busi-
ness in terms of providing solutions to customer needs. For example, “We provide solu-
tions to professional communication needs.” Companies with customer-oriented visions
can more easily adapt to changing environments. Exhibit 1.2 provides additional exam-
ples of companies with customer-oriented vision statements. In contrast, companies that
define themselves based on product-oriented statements (e.g., “We are in the typewriter
business”) tend to be less flexible and thus more likely to fail. The lack of an inspiring
needs-based vision can cause the long-range problem of failing to adapt to a changing
environment.
Customer-oriented visions identify a critical need but leave open the means of how to
meet that need. Customer needs may change, and the means of meeting those needs may
change with it. The future is unknowable, and innovation is likely to provide new ways
to meet needs that we cannot fathom today.24 For example, consider the need to transmit
information over long distances. Communication needs have persisted throughout the mil-
lennia, but the technology to solve this problem has changed drastically over time.25 Dur-
ing the reign of Julius Caesar, moving information over long distances required papyrus,
ink, a chariot, a horse, and a driver. During Abraham Lincoln’s time, railroads handled this
task, while an airplane was used when Franklin Delano Roosevelt was president. Today,
EXHIBIT 1.2 /
Companies with
Customer-Oriented
Vision Statements
Alibaba: To make it easy to do business anywhere.
Amazon: To be Earth’s most customer-centric company, where customers can find and discover
anything they might want to buy online.
Better World Books: To harness the power of capitalism to bring literacy and opportunity to
people around the world.
Facebook: To make the world more open and connected.
GE: To move, cure, build, and power the world.
Google: To organize the world’s information and make it universally accessible and useful.
Nike: To bring inspiration and innovation to every athlete in the world.
SpaceX: To make human life multi planetary.
Tesla: To accelerate the world’s transition to sustainable energy.
Walmart: To be the best retailer in the hearts and minds of consumers and employees.
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we use connected mobile devices to move information over long distances at the speed of
light. The problem to be solved—moving information over long distance—has remained
the same, but the technology employed to do this job has changed quite drastically. Chris-
tensen recommends that strategic leaders think hard about how the means of getting a job
done have changed over time and ask themselves, “Is there an even better way to get this
job done?”
It is critical that an organization’s vision should be flexible to allow for change and
adaptation. Consider how Ford Motor Co. has addressed the problem of personal mobility
over the past 100 years. Before Ford entered the market in the early 1900s, people trav-
eled long distances by horse-drawn buggy, horseback, boat, or train. But Henry Ford had
a different idea. In fact, he famously said, “If I had listened to my customers, I would have
built a better horse and buggy.”26 Instead, Henry Ford’s original vision was to make the
automobile accessible to every American. He succeeded, and the automobile dramatically
changed how mobility was achieved.
Fast-forward to today: Ford Motor Co.’s vision is to provide personal mobility for
people around the world. Note that it does not even mention the automobile. By focusing
on the consumer need for personal mobility, Ford is leaving the door open for exactly how
it will fulfill that need. Today, it’s mostly with traditional cars and trucks propelled by
gas-powered internal combustion engines, with some hybrid electric vehicles in its lineup.
In the near future, Ford is likely to provide vehicles powered by alternative energy sources
such as electric power or hydrogen. In the far-reaching future, perhaps Ford will get into
the business of individual flying devices. Throughout all of this, its vision would still
be relevant and compel its managers to engage in future markets. In contrast, a product-
oriented vision would have greatly constrained Ford’s degree of strategic flexibility.
MOVING FROM PRODUCT-ORIENTED TO CUSTOMER-ORIENTED VISION STATEMENTS. In
some cases, product-oriented vision statements do not interfere with the firm’s success
in achieving superior performance and competitive advantage. Consider Intel Corp., one
of the world’s leading silicon innovators. Intel’s early vision was to be the preeminent
building-block supplier of the PC industry. Intel designed the first commercial micropro-
cessor chip in 1971 and set the standard for microprocessors in 1978. During the personal
computer (PC) revolution in the 1980s, microprocessors became Intel’s main line of busi-
ness. Intel’s customers were original equipment manufacturers that produced consumer
end-products, such as computer manufacturers HP, IBM, Dell, and Compaq.
In the internet age, though, the standalone PC as the end-product has become less
important. Customers want to stream video and share selfies and other pictures online.
These activities consume a tremendous amount of computing power. To reflect this shift,
Intel in 1999 changed its vision to focus on being the preeminent building-block supplier
to the internet economy. Although its product-oriented vision statements did not impede
performance or competitive advantage, in 2008 Intel fully made the shift to a customer-
oriented vision: to delight our customers, employees, and shareholders by relentlessly
delivering the platform and technology advancements that become essential to the way we
work and live. Part of this shift was reflected by the hugely successful “Intel Inside” adver-
tising campaign in the 1990s that made Intel a household name worldwide.
Intel accomplished superior firm performance over decades through continuous adap-
tations to changing market realities. Its formal vision statement lagged behind the firm’s
strategic transformations. Intel regularly changed its vision statement after it had accom-
plished each successful transformation.27 In such a case, vision statements and firm perfor-
mance are clearly not related to one another.
It is also interesting to note that customer-oriented visions also frequently change
over time. When Telsa was founded in 2003, its mission was to accelerate the world’s
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transition to sustainable transport. Over the last decade or so, Tesla completed several
steps of its initial master plan (as detailed in the opening case), including providing zero-
emission electric power generation options (Step 4), through the acquisition of the Solar-
City. Tesla, therefore, no longer views itself as a car company but as a fully integrated
clean-tech company. To capture this ambition more accurately Tesla changed its vision
to accelerate the world’s transition to sustainable energy. To reposition Tesla as an inte-
grated clean-tech energy company, in 2017, Tesla changed its official name from Tesla
Motors to Tesla, Inc.
Taken together, empirical research shows that sometimes vision statements and firm
performance are associated with one another. A positive relationship between vision state-
ments and firm performance is more likely to exist under certain circumstances:
■ The visions are customer-oriented.
■ Internal stakeholders are invested in defining the vision.
■ Organizational structures such as compensation systems align with the firm’s vision
statement.28
The upshot is that an effective vision statement can lay the foundation upon which to
craft a strategy that creates competitive advantage.
VALUES
While many companies have powerful vision and mission statements, they are not enough.
An organization’s values also need to be clearly articulated in the strategy process. A core
values statement matters because it provides touchstones for the employees to understand
the company culture. It offers bedrock principles that employees at all levels can use to
deal with complexity and to resolve conflict. Such statements can help provide the organi-
zation’s employees with a moral compass.
Consider that much of unethical behavior, while repugnant, may not be illegal. Often
we read the defensive comment from a company under investigation or fighting a civil
suit that “we have broken no laws.” However, any firm that fails to establish extra-legal,
ethical standards will be more prone to behaviors that can threaten its very existence.
A company whose culture is silent on moral lapses breeds further moral lapses. Over time
such a culture could result in a preponderance of behaviors that cause the company to ruin
its reputation, at the least, or slide into outright legal violations with resultant penalties and
punishment, at the worst.
Organizational core values are the ethical standards and norms that govern the behav-
ior of individuals within a firm or organization. Strong ethical values have two important
functions. First, ethical standards and norms underlay the vision statement and provide
stability to the strategy, thus laying the groundwork for long-term success. Second, once
the company is pursuing its vision and mission in its quest for competitive advantage, they
serve as guardrails to keep the company on track.
The values espoused by a company provide answers to the question, how do we accom-
plish our goals? They help individuals make choices that are both ethical and effective
in advancing the company’s goals. Strategy Highlight 1.2, featuring the pharmaceutical
company Merck, provides an example of how values can drive strategic decision making,
and what can happen if a company deviates from its core values.
One last point about organizational values: Without commitment and involvement from
top managers, any statement of values remains merely a public relations exercise. Employ-
ees tend to follow values practiced by strategic leaders. They observe the day-to-day deci-
sions of top managers and quickly decide whether managers are merely paying lip service
to the company’s stated values. Organizational core values must be lived with integrity,
LO 1-5
Justify why anchoring a
firm in ethical core values
is imperative for long-
term success.
core values
statement Statement
of principles to guide an
organization as it works
to achieve its vision
and fulfill its mission,
for both internal
conduct and external
interactions; it often
includes explicit ethical
considerations.
Organizational
core values Ethical
standards and norms
that govern the behavior
of individuals within a
firm or organization.
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Merck: Reconfirming Its Core Values
Merck’s vision is to preserve and improve human life. The
words of founder George W. Merck still form the basis of the
company’s values today: We try to never forget that medicine
is for the people. It is not for profits. The profits follow,
and if we have remembered that, they have never failed to
appear.29
ENDING RIVER BLINDNESS In 1987, Ray Vagelos, a
former Merck scientist turned CEO, announced the company would
donate its recently discovered drug Mectizan, without charge, to
treat river blindness. For centuries, river blindness—a parasitic
disease that leads to loss of eyesight—plagued remote communi-
ties in Africa and other parts of the world. Merck’s executives
formed a novel private-public partnership, the Mectizan Donation
Program (MDP), to distribute the drug in remote areas, where
health services are often not available.
After more than 25 years, more than 1 billion treatments,
and some 120,000 communities served, the disease had
effectively been eradicated. Merck’s current CEO, Kenneth
Frazier, announced himself “humbled” by the result of the
company’s value-driven actions.30
WITHDRAWING VIOXX In the case of another drug,
though, Merck’s values were brought into question. Vioxx was a
painkiller developed to produce fewer gastrointestinal side effects
than aspirin or ibuprofen. Once the Food and Drug Administration
(FDA) approved the new drug in 1999, Merck engaged in typical big
pharma promotional practices:
• Heavy direct-to-consumer advertising via TV and other
media.
• Luxury doctor inducements, including consulting con-
tracts and free retreats at exotic resorts.
Merck’s new drug was a blockbuster, generating revenues
of $2.5 billion a year by 2002 and growing fast.
Allegations began to appear, however, that Vioxx caused
heart attacks and strokes. Critics alleged that Merck had sup-
pressed evidence about Vioxx’s dangerous side effects from
early clinical trials. In 2004, Merck voluntarily recalled the
drug. Merck’s CEO at the time, Raymond Gilmartin, framed
the situation in terms of knowledge learned after the initial
release. He said he received a phone call from the head
of research. “He told me that our long-term safety study
of Vioxx was showing an increased risk of cardiovascular
events compared to placebo, and the trial was being discon-
tinued. . . . After analyzing the data further and consulting
with outside experts, the Merck scientists recommended that
we voluntarily withdraw the drug.”31
Regardless of what Merck knew when, the voluntary
withdrawal reconfirmed in a costly way its core value that
patients come before profits. Merck’s reputation damaged,
its stock fell almost 30 percent, eradicating $27 billion in
market value almost overnight—an amount much greater than
the estimated net present value of the profits that Merck
would have obtained from continued sales of Vioxx. Merck
has been hit by lawsuits ever since; legal liabilities have cost
the company up to $30 billion thus far.
Some corporate social responsibility experts argue that
Merck should have never put Vioxx on the market in the first
place, or that it should have at least provided up front, clear
assessments of the risks associated with Vioxx.32
Strategy Highlight 1.2
Kenneth Frazier, CEO of Merck.
©Bloomberg/Getty Images
especially by the top management team. Unethical behavior by top managers is like a virus
that spreads quickly throughout an entire organization. It is imperative that strategic lead-
ers set an example of ethical behavior by living the core values. Strategic leaders have a
strong influence in setting an organization’s vision, mission, and values. This is the first
step in the entire strategic management process, which is captured in the AFI strategy
framework to which we turn next.
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1.3 The AFI Strategy Framework
How do organizations craft and execute a strategy that enhances their chances of achieving
superior performance? A successful strategy details a set of actions that managers take to
gain and sustain competitive advantage. Effectively managing the strategy process is the
result of three broad tasks:
1. Analyze (A)
2. Formulate (F)
3. Implement (I)
The tasks of analyze, formulate, and implement are the pillars of research and knowl-
edge about strategic management. Although we will study each of these tasks one at a time,
they are highly interdependent and frequently happen simultaneously. Effective managers
do not formulate strategy without thinking about how to implement it, for instance. Like-
wise, while implementing strategy, managers are analyzing the need to adjust to changing
circumstances.
We’ve captured these interdependent relationships in the AFI strategy framework
shown in Exhibit 1.3. This framework (1) explains and predicts differences in firm per-
formance, and (2) helps managers formulate and implement a strategy that can result
in superior performance. In each of the three broad strategy tasks, managers focus on
specific questions, listed below. We address these questions in specific chapters, as
indicated.
LO 1-6
Explain the AFI strategy
framework.
EXHIBIT 1.3 /
The AFI Strategy
Framework
1. What Is Strategy?
3. External Analysis: Industry
Structure, Competitive
Forces, and Strategic
Groups
4. Internal Analysis:
Resources, Capabilities,
and Core Competencies
5. Competitive Advantage,
Firm Performance, and
Business Models
6. Business Strategy:
Differentiation, Cost Leadership,
and Blue Oceans
7. Business Strategy: Innovation,
Entrepreneurship, and Platforms
8. Corporate Strategy: Vertical
Integration and Diversification
9. Corporate Strategy: Strategic Alliances,
Mergers and Acquisitions
10. Global Strategy: Competing
Around the World
11. Organizational Design:
Structure, Culture, and Control
Getting
Started
External and
Internal
Analysis
Formulation:
Business
Strategy
Formulation:
Corporate
Strategy
Implementation
Gaining &
Sustaining
Competitive
Advantage
12. Corporate Governance
and Business Ethics
2. Strategic Leadership:
Managing the Strategy
Process
Part 1: Analysis
Part 1: Analysis
Part 2: FormulationPart 2: Formulation
Part 3: Implementation
AFI strategy
framework A model
that links three
interdependent strategic
management tasks—
analyze, formulate,
and implement—that,
together, help managers
plan and implement
a strategy that can
improve performance
and result in competitive
advantage.
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20 CHAPTER 1 What Is Strategy?
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Strategy Analysis (A) Topics and Questions
■ Strategic leadership and the strategy process: What roles do strategic leaders play? What
is the firm’s process for creating strategy and how does strategy come about? What is the
relationship between stakeholder strategy and competitive advantage? (Chapter 2)
■ External analysis: What effects do forces in the external environment have on the firm’s
potential to gain and sustain a competitive advantage? How should the firm deal with
them? (Chapter 3)
■ Internal analysis: What effects do internal resources, capabilities, and core competen-
cies have on the firm’s potential to gain and sustain a competitive advantage? How
should the firm leverage them for competitive advantage? (Chapter 4)
■ Competitive advantage, firm performance, and business models: How does the firm
make money? How can one assess and measure competitive advantage? What is the
relationship between competitive advantage and firm performance? (Chapter 5)
Strategy Formulation (F) Topics and Questions
■ Business strategy: How should the firm compete: cost leadership, differentiation, or
value innovation? (Chapters 6 and 7)
■ Corporate strategy: Where should the firm compete: industry, markets, and geogra-
phy? (Chapters 8 and 9)
■ Global strategy: How and where should the firm compete: local, regional, national, or
international? (Chapter 10)
Strategy Implementation (I) Topics and Questions
■ Organizational design: How should the firm organize to turn the formulated strategy
into action? (Chapter 11)
■ Corporate governance and business ethics: What type of corporate governance is most
effective? How does the firm anchor strategic decisions in business ethics? (Chapter 12)
The AFI strategy framework shown in Exhibit 1.3 is repeated at the beginning of each
part of this text to help contextualize where we are in our study of the firm’s quest to gain
and sustain competitive advantage. In addition, the strategy process map, presented at the
end of Chapter 1, illustrates the steps in the AFI framework in more detail. The different
background shades correspond to each step in the AFI framework. This strategy process
map highlights the key strategy concepts and frameworks we’ll cover in each chapter. It
also serves as a checklist when you conduct a strategic management analysis.
We next turn to the Implications for Strategic Leaders section to provide practical appli-
cations and considerations of the material discussed in this chapter.
1.4 Implications for Strategic Leaders
Strategy is the art and science of success and failure. The difference between success and
failure lies in an organization’s strategy. A good strategy defines the competitive challenge,
provides a guiding policy, and is implemented by coherent actions. Superior performance
is the consequence of a good strategy. Moreover, strategic leaders appreciate the fact that
competition is everywhere; this awareness infuses the other elements of strategy. You need
a good strategy to deal with competition.
To create a powerful foundation upon which to formulate and implement a good strat-
egy, strategic leaders need to articulate an inspiring vision and mission backed up by
ethical core values. Customer-oriented or problem-defining vision statements are often
correlated with firm success over long periods of time. This is because they allow firms
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CHAPTER 1 What Is Strategy? 21
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In 2016, 10 years after Tesla’s initial “secret strategy,” Elon
Musk unveiled the second part of his master plan for the
company (“Master Plan, Part Deux”) to continue the pursuit
of its vision “to accelerate the advent of sustainable energy.”
Again, CEO Musk detailed a set of stretch goals:33
1. Create stunning solar roofs with seamlessly integrated
battery storage.
2. Expand the electric vehicle product line to address all
major segments.
3. Develop a self-driving capability that is 10 times safer
than manual via massive fleet learning.
4. Enable your car to make money for you when you aren’t
using it.
In the updated strategy, Step 1 leverages the integration of
SolarCity. The new Tesla company is now a fully integrated
sustainable energy company, combining energy generation
CHAPTERCASE 1 Consider This . . .
with energy storage from
SolarCity. It provides energy
generation via beautiful new
solar roofs that look like regu-
lar shingles, but cost less, all
things considered, and last lon-
ger. Tesla also offers its Powerwall to residential consumers,
which allows customers to store the solar energy captured
on their roofs for later use. Energy generation, therefore,
becomes decentralized. This implies that consumers are able
to generate and use energy without being dependent on any
utility, and are able to sell back excess energy to utilities.
Indeed, consumers will generate not only energy for the use
of their Tesla cars but also enough to cover the energy needs
of the entire house.
In Step 2, Tesla is planning to expand the lineup of its
electric vehicles to address all major segments, including
pickup trucks, buses, and heavy-duty semis.
Tesla’s new solar roof, with
a Tesla car and Powerwall in
the garage.
©Tesla/Newscom
strategic flexibility to change in order to meet changing customer needs and exploit exter-
nal opportunities. Another important implication of our discussion is that all employees
should feel invested in and inspired by the firm’s vision and mission. Different companies
use different tactics to achieve such commitment; some firms annually invite all employees
to review and revise the statement of firm values; others ask employees to rank themselves,
their departments, and management on success relative to the vision and mission. Belief in
a company’s vision and mission motivates its employees.
The strategic leader also realizes that the principles of strategic management can be applied
universally to all organizations. Strategy determines performance whether in organizations
large or small, multinational Fortune 100 companies, for-profit or nonprofit organizations,
in the private or the public sector, and in developed as well as emerging economies. A good
strategy is more likely when strategic leaders apply the three-step AFI strategy framework:
1. Analyze the external and internal environments.
2. Formulate an appropriate business and corporate strategy.
3. Implement the formulated strategy through structure, culture, and controls.
Keep in mind that strategic leaders are making decisions under conditions of uncer-
tainty and complexity. They must carefully monitor and evaluate the progress toward key
strategic objectives and make adjustments by fine-tuning any strategy as necessary. We
discuss how this is done in the next chapter where we focus on strategic leaders and the
strategic management process.
This content is also relevant directly for you beyond the classroom: Applying the tools
and frameworks developed in this text allows you to help your organization be more suc-
cessful. You can also apply the strategic management toolkit to your own career to pursue
your professional and other goals (see the myStrategy modules at the end of each chapter).
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22 CHAPTER 1 What Is Strategy?
In Step 3, Tesla is aiming to further develop the self-
driving capabilities of its vehicles. The goal is to make self-
driving vehicles 10 times safer than manual driving, and thus
being able to offer fully autonomous vehicles.
Fully autonomous driving capabilities are required for
Tesla to fulfill Step 4 of the new master plan: Turn your car
into an income-generating asset. The idea is to offer an Uber-
like service made up of Tesla vehicles, but without any driv-
ers. On average, cars are used less than three hours during a
day. The idea is that your autonomous-driving Tesla will be
part of a shared vehicle fleet when you are not using your car.
This will drastically reduce the total cost of ownership of a
Tesla vehicle, and it will also allow pretty much anyone to
ride in a Tesla as a result of the sharing economy.34
Questions
1. Do you agree with the assessment that Elon Musk
and Tesla successfully fulfilled their first master plan
published in 2006? Why or why not? Buttress your
arguments.
2. As of today, does Tesla have a good strategy? Why or
why not? How do you know?
3. Describe the rationale behind Tesla’s new master plan.
How does this new strategy help Tesla fulfill its vision?
“Master Plan, Part Deux” in its entirety is on Tesla’s
blog: https://www.tesla.com/blog/master-plan-part-deux
4. Apply the three-step process for crafting a good strat-
egy outlined in the chapter (diagnose the competitive
challenge, derive a guiding policy, and implement a
set of coherent actions) to each element of the new
master plan. On which steps of the new master plan
has Tesla made the most progress? Explain. Also,
which recommendations would you have for Elon
Musk? Support your arguments with examples and
observations.
This chapter detailed what strategy and competitive
advantage is. It described the roles of vision, mission,
and values in a firm’s strategy. It also set the stage for
further study of strategic management by introducing the
AFI strategy framework, as summarized by the follow-
ing learning objectives and related take-away concepts.
LO 1-1 / Explain the role of strategy in a
firm’s quest for competitive advantage.
■ Strategy is the set of goal-directed actions a firm
takes to gain and sustain superior performance
relative to competitors.
■ A good strategy enables a firm to achieve supe-
rior performance. It consists of three elements:
1. A diagnosis of the competitive challenge.
2. A guiding policy to address the competitive
challenge.
3. A set of coherent actions to implement the
firm’s guiding policy.
■ A successful strategy requires three integrative
management tasks—analysis, formulation, and
implementation.
LO 1-2 / Define competitive advantage, sus-
tainable competitive advantage, competitive
disadvantage, and competitive parity.
■ Competitive advantage is always judged relative
to other competitors or the industry average.
■ To obtain a competitive advantage, a firm must
either create more value for customers while
keeping its cost comparable to competitors, or it
must provide the value equivalent to competitors
but at a lower cost.
■ A firm able to outperform competitors for pro-
longed periods of time has a sustained competi-
tive advantage.
■ A firm that continuously underperforms its
rivals or the industry average has a competitive
disadvantage.
■ Two or more firms that perform at the same level
have competitive parity.
■ An effective strategy requires that strategic trade-
offs be recognized and addressed—for example,
between value creation and the costs to create
the value.
TAKE-AWAY CONCEPTS
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CHAPTER 1 What Is Strategy? 23
LO 1-3 / Describe the roles of vision, mission,
and values in a firm’s strategy.
■ A vision captures an organization’s aspirations.
An effective vision inspires and motivates mem-
bers of the organization.
■ A mission statement describes what an organiza-
tion actually does—what its business is—and
why and how it does it.
■ Core values define the ethical standards and
norms that should govern the behavior of indi-
viduals within the firm.
LO 1-4 / Evaluate the strategic implications of
product-oriented and customer-oriented vision
statements.
■ Product-oriented vision statements define a busi-
ness in terms of a good or service provided.
■ Customer-oriented vision statements define busi-
ness in terms of providing solutions to customer
needs.
■ Customer-oriented vision statements provide
managers with more strategic flexibility than
product-oriented missions.
■ To be effective, visions and missions
need to be backed up by hard-to-reverse
strategic commitments and tied to economic
fundamentals.
LO 1-5 / Justify why anchoring a firm in
ethical core values is essential for long-term
success.
■ Ethical core values underlay the vision statement
to ensure the stability of the strategy, and thus lay
the groundwork for long-term success.
■ Ethical core values are the guardrails that help
keep the company on track when pursuing its mis-
sion and its quest for competitive advantage.
LO 1-6 / Explain the AFI strategy
framework.
■ The AFI strategy framework (1) explains and
predicts differences in firm performance, and (2)
helps managers formulate and implement a strat-
egy that can result in superior performance.
■ Effectively managing the strategy process is the
result of three broad tasks:
1. Analyze (A)
2. Formulate (F)
3. Implement (I)
AFI strategy framework (p. 19)
Competitive advantage (p. 8)
Competitive disadvantage (p. 8)
Competitive parity (p. 9)
Core values statement (p. 17)
Good strategy (p. 7)
Mission (p. 13)
Organizational core values (p. 17)
Strategic intentS (p. 11)
Strategic management (p. 6)
Strategy (p. 6)
Sustainable competitive
advantage (p. 8)
Vision (p. 11)
KEY TERMS
DISCUSSION QUESTIONS
1. The text discusses strategic trade-offs that are
different between Walmart and Nordstrom even
though they are in the same industry. Think of
another industry that you know fairly well and
select two firms there that also have made very
different choices for these trade-offs. Describe
some of the differences between these firms. What
type of trade-off decisions have these firms made?
2. What characteristics does an effective mission
statement have?
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24 CHAPTER 1 What Is Strategy?
ETHICAL/SOCIAL ISSUES
1. In the discussion about Merck (Strategy Highlight
1.2) it is clear the firm has followed a socially
responsible path by donating more than 1 billion
drug treatments to remedy river blindness in
remote African communities. Yet Merck must also
meet shareholder responsibilities and make profits
on drugs in use in more affluent societies. How
should a responsible firm make these trade-offs?
What steps can strategic leaders take to guide
organizations on these challenging issues?
2. The list below shows a sample of various vision/
mission statements. Match the company with its
corresponding statement. Also identify whether
the statements are principally customer-oriented
or product-oriented.
Vision/Mission Statement Type of Statement Matched Company Company
To be our customers’ favorite place and way to eat and drink. 1. Alibaba
To supply the consumer and our customers with the finest,
high-quality products.
2. AutoNation
To help women feel great about themselves and their potential. 3. Barnes & Noble
To provide a global trading platform where practically
anyone can trade practically anything.
4. CarMax
To operate the best omni-channel specialty retail business
in America.
5. Darden Restaurants
To provide our customers great quality cars at great
prices with exceptional customer service.
6. Dole Foods
To be financially successful through great people
consistently delivering outstanding food, drinks and
service in an inviting atmosphere.
7. eBay
To be America’s best run, most profitable automotive retailer. 8. Estée Lauder
Bringing the best to everyone we touch and being the best
in everything we do.
9. Facebook
To develop the social infrastructure to give people the
power to build a global community that works for all of us.
10. KFC
To give everyone the power to create and share ideas and
information instantly, without barriers.
11. Manpower
To be the best worldwide provider of higher-value staffing
services and the center for quality employment opportunities.
12. McDonald’s
To sell food in a fast, friendly environment that appeals to
pride-conscious, health-minded consumers.
13. Spanx
To build the future infrastructure of commerce. 14. Twitter
3. The “job to do” approach discussed with the
Clayton Christensen milk-shake example can
be useful in a variety of settings. Even when
we are the customers ourselves sometimes we
don’t look for better solutions because we get
into routines and habits. Think about a situa-
tion you sometimes find frustrating in your own
life or one you hear others complaining about
frequently. Instead of focusing on the annoy-
ance, can you take a step back and look for the
real job that needed doing when the frustration
occurred? What other options can be developed
to “do the job” that may lead to less irritation in
these situations?
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How Much Are Your Values Worth
to You?
H ow much are you willing to pay for the job you want? This may sound like a strange question, since your employer will pay you to work, but think again. Consider how much
you value a specific type of work, or how much you would want
to work for a specific organization because of its values.
A study shows scientists who want to continue engaging in
research will accept some $14,000 less in annual salary to work
at an organization that permits them to publish their findings
in academic journals, implying that some scientists will “pay
to be scientists.” This finding appears to hold in the general
business world too. In a survey, 97 percent of Stanford MBA
students indicated they would forgo some 14 percent of their
expected salary, or about $11,480 a year, to work for a company
that matches their own values with concern for stakeholders
and sustainability. According to Monster.com, an online career
service, about 92 percent of all undergraduates want to work
for a “green” company. These diverse examples demonstrate
that people put a real dollar amount on pursuing careers in sync
with their values.
On the other hand, certain high-powered jobs such as man-
agement consulting or investment banking pay very well, but
their high salaries come with strings attached. Professionals in
these jobs work very long hours, including weekends, and often
take little or no vacation time. These workers “pay for pay” in
that they are often unable to form stable relationships, have lit-
tle or no leisure time, and sometimes even sacrifice their health.
People “pay for”—make certain sacrifices for—what they value,
because strategic decisions require important trade-offs.35
1. Identify your personal values. How do you expect these
values to affect your work life or your career choice?
2. How much less salary would (did) you accept to find employ-
ment with a company that is aligned with your values?
3. How much are you willing to “pay for pay” if your dream
job is in management consulting or investment banking?
mySTRATEGY
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CHAPTER 1 What Is Strategy? 25
SMALL GROUP EXERCISES
//// Small Group Exercise 1
The chapter applies the three elements of a good strat-
egy to Tesla for insights into the company’s possible
competitive advantage. As a group, choose a differ-
ent firm that is well known to the students. Assign
the competitive challenges and company guiding
policies and search the internet for information about
the firm’s actions. As a group discuss key actions the
firm has taken and decide if they seem to be coherent.
Does the firm demonstrate measures of a competitive
advantage? If yes, does it look to be sustainable?
//// Small Group Exercise 2
Strategy Highlight 1.1 discusses the importance of
the inspiring vision developed at Teach for America.
In your group search the internet for other nonprofit
organizations (Red Cross, Habitat for Humanity, etc.).
Which of them has vision or mission statements that
are appealing to donors, employees, and clients? Do
these statements seem relevant in today’s environment
or are they outdated? What improvements can you
create for these organizational statements?
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26 CHAPTER 1 What Is Strategy?
1. Market capitalization = Share price x
Number of shares outstanding.
2. Musk, E. (2006, Aug. 2), “The secret
Tesla Motors Master Plan (just between
you and me),” Tesla website, http://bit.
ly/29Y1c3m.
3. This ChapterCase is based on: Hoang, H.,
and F. T. Rothaermel (2016), “How to manage
alliances strategically,” MIT Sloan Manage-
ment Review, Fall, 58(1): 69–76; Ramsey,
M. (2016, Mar. 30), “A lot riding on Tesla’s
Model 3 unveiling,” The Wall Street Journal;
Ramsey, M., and C. Sweet (2016, Aug. 1),
“Tesla and SolarCity agree to $2.6 billion
deal,” The Wall Street Journal; and Pulliam,
S., M. Ramsey, and I. J. Dugan (2016, Aug.
15), “Elon Musk sets ambitious goals at
Tesla—and often falls short,” The Wall Street
Journal.
4. This section draws on: McGrath, R.G.
(2013), The End of Competitive Advantage:
How to Keep Your Strategy Moving as Fast as
Your Business (Boston, MA: Harvard Busi-
ness Review Press); Rumelt, R. (2011), Good
Strategy, Bad Strategy: The Difference and
Why It Matters (New York: Crown Business);
Porter, M.E. (2008), “The five competitive
forces that shape strategy,” Harvard Busi-
ness Review, January: 78–93; Porter, M.E.
(1996), “What is strategy?” Harvard Business
Review, November–December: 61–78; and
Porter, M.E. (1980), Competitive Strategy:
Techniques for Analyzing Competitors (New
York: The Free Press).
5. As quoted in: Rothaermel, F. T., and D.
King (2015), “Tesla Motors, Inc.,” McGraw-
Hill Education Case Study MHE-FTR-032.
6. Khouri, A., and S. Masunaga (2015,
May 1), “Tesla’s Elon Musk and his big ideas:
A brief history,” Los Angeles Times.
7. Range anxiety denotes the concern that an
electric vehicle has insufficient range to reach
its destination on a single charge. Tesla’s
cars can go some 250 miles per charge. The
lower cost Nissan Leaf (~$30k) can go some
85 miles per charge, while GM’s Chevy Bolt
can drive some 200 miles per charge, based
on EPA estimates. The average American
drives about 40 miles per day. http://www.
fueleconomy.gov/
8. The discussion of Tesla throughout
this chapter is based on Rothaermel, F.T.,
and D. King (2015), Tesla Motors, Inc.,
McGraw-Hill Education Case Study MHE-
FTR-032, and Hoang, H., and F. T.
Rothaermel (2016), “How to manage alli-
ances strategically,” MIT Sloan Management
Review, Fall, 58(1): 69–76; Ramsey, M.
(2016, Mar. 30), “A lot riding on Tesla’s
Model 3 unveiling,” The Wall Street Journal;
Ramsey, M., and C. Sweet (2016, Aug. 1),
“Tesla and SolarCity agree to $2.6 billion
deal,” The Wall Street Journal; Pulliam, S., M.
Ramsey, and I. J. Dugan (2016, Aug. 15),
“Elon Musk sets ambitious goals at Tesla—
and often falls short,” The Wall Street
Journal; and Ramsey, M. (2014, Jun. 12),
“Tesla Motors offers open licenses to its
patents,” The Wall Street Journal.
9. This section draws on Porter, M.E. (2008,
Jan.) “The five competitive forces that shape
strategy,” Harvard Business Review; Porter,
M.E. (1996), “What is strategy?” Harvard
Business Review, November–December; and
Porter, M.E. (1989), Competitive Strategy
(New York: Free Press).
10. Rumelt, R.P. (2011), Good Strategy, Bad
Strategy: The Difference and Why It Mat-
ters (New York: Crown); and Porter, M.E.
(1996), “What is strategy?” Harvard Business
Review, November–December.
11. Rumelt, R.P. (2011), Good Strategy, Bad
Strategy: The Difference and Why It Mat-
ters (New York: Crown); and Porter, M.E.
(1996), “What is strategy?” Harvard Business
Review, November–December.
12. Koh, Y., and K. Grind (2014, Nov. 6),
“Twitter CEO Dick Costolo struggles to
define vision,” The Wall Street Journal.
13. Covey, S.R. (1989), The 7 Habits of
Highly Effective People: Powerful Lessons
in Personal Change (New York: Simon &
Schuster).
14. Musk, E. (2011, Sept. 29), “SpaceX
vision and mission statement,” presentation to
The National Press Club, Washington, DC,
http://bit.ly/2frJx4f
15. Frankl, V.E. (1984), Man’s Search for
Meaning (New York: Simon & Schuster).
16. Pink, D.H. (2011), The Surprising Truth
about What Motivates Us (New York: River-
head Books).
17. Hamel, G., and C.K. Prahalad (1989),
“Strategic intent,” Harvard Business
Review, May–June: 64–65; Hamel, G.,
and C.K. Prahalad (1994), Competing for
the Future (Boston, MA: Harvard Busi-
ness School Press); and Collins, J.C., and
J.I. Porras (1994), Built to Last: Successful
Habits of Visionary Companies (New York:
HarperCollins).
18. Quote drawn from 2015 Teach
for America annual report (http://bit.
ly/2gguko8), which is also a source for
this Strategy Highlight. Other sources:
2016–2017 Teach for America press
kit (http://bit.ly/2fnrKO2); Simon, S.
(2013, Sept. 10), “New study finds Teach
for America recruits boost student achieve-
ment in math,” Politico; Kopp, W. (2011), A
Chance to Make History: What Works
and What Doesn’t in Providing an Excel-
lent Education for All (Philadelphia, PA:
Public Affairs); Xu, Z., J. Hannaway, and
C. Taylor (2008, Mar. 27), “Making a dif-
ference? The effect of Teach for America on
student performance in high school,” Urban
Institute; “Wendy Kopp Explains Teach for
America,” http://bit.ly/2gy1iTy (video 4.05
min); and Kopp, W. (2001), One Day, All
Children. . .: The Unlikely Triumph of Teach
for America and What I Learned Along
the Way (Cambridge, MA: Perseus Book
Group).
19. Collins, J.C., and J.I. Porras (1994),
Built to Last: Successful Habits of Visionary
Companies (New York: HarperCollins); Col-
lins, J.C. (2001), Good to Great: Why Some
Companies Make the Leap . . . And Others
Don’t (New York: HarperBusiness).
20. Dixit, A., and B. Nalebuff (1991), Think-
ing Strategically: The Competitive Edge in
Business, Politics, and Everyday Life (New
York: Norton); and Brandenburger, A.M.,
and B.J. Nalebuff (1996), Co-opetition (New
York: Currency Doubleday).
21. For academic work on using a problem-
solving perspective as the basis for under-
standing the firm, see Nickerson, J., and
T. Zenger (2004), “A knowledge-based
theory of the firm—the problem-solving
perspective,” Organization Science 15:
617–632.
22. This example is drawn from Clayton
Christensen’s work as described in Kane, Y.I.
(2014), Haunted Empire: Apple After Steve
Jobs (New York: HarperCollins), 191.
23. Germain, R., and M.B. Cooper (1990),
“How a customer mission statement affects
company performance,” Industrial Market-
ing Management 19(2): 47–54; Bart, C.K.
(1997), “Industrial firms and the power of
mission,” Industrial Marketing Manage-
ment 26(4): 371–383; and Bart, C.K. (2001),
“Measuring the mission effect in human intel-
lectual capital,”Journal of Intellectual Capi-
tal 2(3): 320–330.
24. Christensen, C. (1997), The Innovator’s
Dilemma (New York: HarperCollins).
25. Kane, Y.I. (2014), Haunted Empire:
Apple After Steve Jobs (New York:
HarperCollins), 191.
ENDNOTES
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CHAPTER 1 What Is Strategy? 27
26. “The three habits . . . of highly irritating
management gurus,” The Economist, October
22, 2009.
27. Burgelman, R.A., and A.S. Grove
(1996), “Strategic dissonance,” California
Management Review 38: 8–28; and Grove,
A.S. (1996), Only the Paranoid Survive:
How to Exploit the Crisis Points that Chal-
lenge Every Company (New York: Currency
Doubleday).
28. Bart, C.K., and M.C. Baetz (1998), “The
relationship between mission statements and
firm performance: An exploratory study,” Jour-
nal of Management Studies 35: 823–853.
29. As quoted in: Collins, J. (2009), How the
Mighty Fall. And Why Some Companies Never
Give In (New York: HarperCollins), 53.
30. http://www.merck.com/about/featured-
stories/mectizan1.html.
31. Gilmartin, R.V. (2011, Oct. 6), “The
Vioxx recall tested our leadership,” Harvard
Business Review Blog Network.
32. The Merck river blindness case and the
quote by CEO Kenneth Frazier draw from:
http://www.merck.com/about/featured-stories/
mectizan1.html. The Vioxx example draws
from “Jury finds Merck liable in Vioxx death
and awards $253 million,” The New York
Times, August 19, 2005; Heal, G. (2008), When
Principles Pay: Corporate Social Responsibil-
ity and the Bottom Line (New York: Columbia
Business School); Collins, J. (2009), How the
Mighty Fall. And Why Some Companies Never
Give In (New York: HarperCollins); and Wang,
T., and P. Bansal (2012), “Social responsibility
in new ventures: profiting from a long-term ori-
entation,” Strategic Management Journal 33:
1135–1153.
33. Musk, E. (2016, Jul. 20), “Master Plan,
Part Deux,” http://bit.ly/2aa5LHv.
34. Other sources: Ramsey, M. (2016, Jul.
21), “Elon Musk unveils plans for new Tesla
vehicle types,” The Wall Street Journal.
35. Based on Stern, S. (2004), “Do scien-
tists pay to be scientists?”Management Sci-
ence 50(6): 835–853; and Esty, D.C., and A.S.
Winston (2009), Green to Gold: How Smart
Companies Use Environmental Strategy to
Innovate, Create Value, and Build Competitive
Advantage, revised and updated (Hoboken,
NJ: John Wiley).
Final PDF to printer
C
H
A
P
T
E
R
1
W
ha
t I
s
S
tr
at
eg
y?
G
ai
ni
ng
a
nd
S
us
ta
in
in
g
C
om
pe
tit
iv
e
A
dv
an
ta
ge
V
is
io
n,
M
is
si
on
, V
al
ue
s
A
na
ly
si
s,
F
or
m
ul
at
io
n,
Im
pl
em
en
ta
tio
n
(A
FI
) F
ra
m
ew
or
k
C
H
A
P
T
E
R
2
S
tr
at
eg
ic
L
ea
de
rs
hi
p:
M
an
ag
in
g
th
e
S
tr
at
eg
y
Pr
oc
es
s
C
or
po
ra
te
, B
us
in
es
s,
a
nd
F
un
ct
io
na
l S
tr
at
eg
y
To
p-
D
ow
n
S
tr
at
eg
ic
P
la
nn
in
g
S
ce
na
ri
o
Pl
an
ni
ng
S
tr
at
eg
y
as
P
la
nn
ed
E
m
er
ge
nc
e
S
ta
ke
ho
ld
er
S
tr
at
eg
y
S
ta
ke
ho
ld
er
Im
pa
ct
A
na
ly
si
s
C
H
A
P
T
E
R
5
C
om
pe
tit
iv
e
A
dv
an
ta
ge
, F
ir
m
P
er
fo
rm
an
ce
,
an
d
B
us
in
es
s
M
od
el
s
A
cc
ou
nt
in
g
Pr
of
ita
bi
lit
y
S
ha
re
ho
ld
er
V
al
ue
C
re
at
io
n
Ec
on
om
ic
V
al
ue
C
re
at
io
n
B
al
an
ce
d
S
co
re
ca
rd
Tr
ip
le
B
ot
to
m
L
in
e
B
us
in
es
s
M
od
el
s
C
H
A
P
T
E
R
6
B
us
in
es
s
S
tr
at
eg
y:
D
iff
er
en
tia
tio
n,
C
os
t L
ea
de
rs
hi
p,
an
d
B
lu
e
O
ce
an
s
G
en
er
ic
B
us
in
es
s
S
tr
at
eg
ie
s
Va
lu
e
D
ri
ve
rs
a
nd
D
iff
er
en
tia
tio
n
S
tr
at
eg
y
C
os
t
D
ri
ve
rs
a
nd
C
os
t-L
ea
de
rs
hi
p
S
tr
at
eg
y
Va
lu
e
D
ri
ve
rs
, C
os
t
D
ri
ve
rs
, a
nd
B
lu
e
O
ce
an
S
tr
at
eg
y
“S
tu
ck
in
t
he
M
id
dl
e”
C
H
A
P
T
E
R
3
Ex
te
rn
al
A
na
ly
si
s:
In
du
st
ry
S
tr
uc
tu
re
, C
om
pe
tit
iv
e
Fo
rc
es
, a
nd
S
tr
at
eg
ic
G
ro
up
s
PE
S
TE
L
Fr
am
ew
or
k
Po
rt
er
’s
F
iv
e
Fo
rc
es
M
od
el
S
tr
at
eg
ic
C
om
pl
em
en
ts
En
tr
y
C
ho
ic
es
In
du
st
ry
D
yn
am
ic
s
S
tr
at
eg
ic
G
ro
up
s
C
H
A
P
T
E
R
4
In
te
rn
al
A
na
ly
si
s:
R
es
ou
rc
es
, C
ap
ab
ili
tie
s,
an
d
C
or
e
C
om
pe
te
nc
ie
s
C
or
e
C
om
pe
te
nc
ie
s
R
es
ou
rc
e-
B
as
ed
V
ie
w
(R
B
V
)
V
R
IO
F
ra
m
ew
or
k
D
yn
am
ic
C
ap
ab
ili
tie
s
Pe
rs
pe
ct
iv
e
Va
lu
e
C
ha
in
A
na
ly
si
s
St
ra
te
gi
c
A
ct
iv
ity
S
ys
te
m
s
SW
O
T
A
na
ly
si
s:
In
te
gr
at
in
g
Ex
te
rn
al
&
In
te
rn
al
A
na
ly
se
s
Th
e
St
ra
te
gi
c
M
an
ag
em
en
t P
ro
ce
ss
M
ap
A
N
A
LY
S
IS
FO
R
M
U
LA
TI
O
N
C
H
A
P
T
E
R
8
C
or
po
ra
te
S
tr
at
eg
y:
Ve
rt
ic
al
In
te
gr
at
io
n
an
d
D
iv
er
si
fic
at
io
n
B
ou
nd
ar
ie
s
of
t
he
F
ir
m
Ve
rt
ic
al
In
te
gr
at
io
n
al
on
g
th
e
In
du
st
ry
V
al
ue
C
ha
in
Ty
pe
s
of
C
or
po
ra
te
D
iv
er
si
fic
at
io
n
C
or
e
C
om
pe
te
nc
e-
M
ar
ke
t
M
at
ri
x
B
C
G
G
ro
w
th
-S
ha
re
M
at
ri
x
C
H
A
P
T
E
R
9
C
or
po
ra
te
S
tr
at
eg
y:
S
tr
at
eg
ic
A
lli
an
ce
s,
a
nd
M
er
ge
rs
&
A
cq
ui
si
tio
ns
B
ui
ld
-B
or
ro
w
-B
uy
F
ra
m
ew
or
k
S
tr
at
eg
ic
A
lli
an
ce
s
A
lli
an
ce
M
an
ag
em
en
t
C
ap
ab
ili
ty
H
or
iz
on
ta
l I
nt
eg
ra
tio
n
C
H
A
P
T
E
R
1
0
G
lo
ba
l S
tr
at
eg
y:
C
om
pe
tin
g
A
ro
un
d
th
e
W
or
ld
G
lo
ba
liz
at
io
n
G
oi
ng
G
lo
ba
l:
W
hy
?,
W
he
re
?,
a
nd
H
ow
?
Th
e
C
AG
E
D
is
ta
nc
e
Fr
am
ew
or
k
Th
e
In
te
gr
at
io
n-
R
es
po
ns
iv
en
es
s
Fr
am
ew
or
k
Po
rt
er
’s
D
ia
m
on
d
Fr
am
ew
or
k
C
H
A
P
T
E
R
1
1
O
rg
an
iz
at
io
na
l D
es
ig
n:
S
tr
uc
tu
re
, C
ul
tu
re
, a
nd
C
on
tr
ol
S
im
pl
e
S
tr
uc
tu
re
Fu
nc
tio
na
l S
tr
uc
tu
re
M
ul
tid
iv
is
io
na
l S
tr
uc
tu
re
M
at
ri
x
S
tr
uc
tu
re
O
pe
n
vs
. C
lo
se
d
In
no
va
tio
n
O
rg
an
iz
in
g
fo
r
C
om
pe
tit
iv
e
A
dv
an
ta
ge
C
on
tr
ol
a
nd
R
ew
ar
d
S
ys
te
m
s
C
H
A
P
T
E
R
1
2
C
or
po
ra
te
G
ov
er
na
nc
e
an
d
B
us
in
es
s
Et
hi
cs
Th
e
S
ha
re
d
Va
lu
e
Fr
am
ew
or
k
S
ep
ar
at
io
n
of
O
w
ne
rs
hi
p
an
d
C
on
tr
ol
A
ge
nc
y
Th
eo
ry
B
oa
rd
o
f
D
ir
ec
to
rs
O
th
er
G
ov
er
na
nc
e
M
ec
ha
ni
sm
s
B
us
in
es
s
Et
hi
cs
a
nd
S
us
ta
in
ab
le
C
om
pe
tit
iv
e
Ad
va
nt
ag
e
IM
PL
EM
EN
TA
TI
O
N
M
er
ge
rs
a
nd
A
cq
ui
si
tio
ns
(M
&
A
)
C
H
A
P
T
E
R
7
B
us
in
es
s
S
tr
at
eg
y:
In
no
va
tio
n,
E
nt
re
pr
en
eu
rs
hi
p,
an
d
Pl
at
fo
rm
s
Th
e
4
I’s
: I
de
a,
In
ve
nt
io
n,
In
no
va
tio
n,
&
Im
ita
tio
n
S
tr
at
eg
ic
a
nd
S
oc
ia
l E
nt
re
pr
en
eu
rs
hi
p
In
no
va
tio
n
an
d
th
e
In
du
st
ry
L
ife
C
yc
le
C
ro
ss
in
g
th
e
C
ha
sm
Te
ch
no
lo
gy
a
nd
M
ar
ke
ts
: T
yp
es
o
f
In
no
va
tio
n
Pl
at
fo
rm
v
s.
P
ip
el
in
e
B
us
in
es
s
M
od
el
s
Pl
at
fo
rm
E
co
sy
st
em
rot27628_ch01_002-029.indd 28 10/30/17 08:11 PM
Final PDF to printer
C
H
A
P
T
E
R
1
W
ha
t I
s
S
tr
at
eg
y?
G
ai
ni
ng
a
nd
S
us
ta
in
in
g
C
om
pe
tit
iv
e
A
dv
an
ta
ge
V
is
io
n,
M
is
si
on
, V
al
ue
s
A
na
ly
si
s,
F
or
m
ul
at
io
n,
Im
pl
em
en
ta
tio
n
(A
FI
) F
ra
m
ew
or
k
C
H
A
P
T
E
R
2
S
tr
at
eg
ic
L
ea
de
rs
hi
p:
M
an
ag
in
g
th
e
S
tr
at
eg
y
Pr
oc
es
s
C
or
po
ra
te
, B
us
in
es
s,
a
nd
F
un
ct
io
na
l S
tr
at
eg
y
To
p-
D
ow
n
S
tr
at
eg
ic
P
la
nn
in
g
S
ce
na
ri
o
Pl
an
ni
ng
S
tr
at
eg
y
as
P
la
nn
ed
E
m
er
ge
nc
e
S
ta
ke
ho
ld
er
S
tr
at
eg
y
S
ta
ke
ho
ld
er
Im
pa
ct
A
na
ly
si
s
C
H
A
P
T
E
R
5
C
om
pe
tit
iv
e
A
dv
an
ta
ge
, F
ir
m
P
er
fo
rm
an
ce
,
an
d
B
us
in
es
s
M
od
el
s
A
cc
ou
nt
in
g
Pr
of
ita
bi
lit
y
S
ha
re
ho
ld
er
V
al
ue
C
re
at
io
n
Ec
on
om
ic
V
al
ue
C
re
at
io
n
B
al
an
ce
d
S
co
re
ca
rd
Tr
ip
le
B
ot
to
m
L
in
e
B
us
in
es
s
M
od
el
s
C
H
A
P
T
E
R
6
B
us
in
es
s
S
tr
at
eg
y:
D
iff
er
en
tia
tio
n,
C
os
t L
ea
de
rs
hi
p,
an
d
B
lu
e
O
ce
an
s
G
en
er
ic
B
us
in
es
s
S
tr
at
eg
ie
s
Va
lu
e
D
ri
ve
rs
a
nd
D
iff
er
en
tia
tio
n
S
tr
at
eg
y
C
os
t
D
ri
ve
rs
a
nd
C
os
t-L
ea
de
rs
hi
p
S
tr
at
eg
y
Va
lu
e
D
ri
ve
rs
, C
os
t
D
ri
ve
rs
, a
nd
B
lu
e
O
ce
an
S
tr
at
eg
y
“S
tu
ck
in
t
he
M
id
dl
e”
C
H
A
P
T
E
R
3
Ex
te
rn
al
A
na
ly
si
s:
In
du
st
ry
S
tr
uc
tu
re
, C
om
pe
tit
iv
e
Fo
rc
es
, a
nd
S
tr
at
eg
ic
G
ro
up
s
PE
S
TE
L
Fr
am
ew
or
k
Po
rt
er
’s
F
iv
e
Fo
rc
es
M
od
el
S
tr
at
eg
ic
C
om
pl
em
en
ts
En
tr
y
C
ho
ic
es
In
du
st
ry
D
yn
am
ic
s
S
tr
at
eg
ic
G
ro
up
s
C
H
A
P
T
E
R
4
In
te
rn
al
A
na
ly
si
s:
R
es
ou
rc
es
, C
ap
ab
ili
tie
s,
an
d
C
or
e
C
om
pe
te
nc
ie
s
C
or
e
C
om
pe
te
nc
ie
s
R
es
ou
rc
e-
B
as
ed
V
ie
w
(R
B
V
)
V
R
IO
F
ra
m
ew
or
k
D
yn
am
ic
C
ap
ab
ili
tie
s
Pe
rs
pe
ct
iv
e
Va
lu
e
C
ha
in
A
na
ly
si
s
St
ra
te
gi
c
A
ct
iv
ity
S
ys
te
m
s
SW
O
T
A
na
ly
si
s:
In
te
gr
at
in
g
Ex
te
rn
al
&
In
te
rn
al
A
na
ly
se
s
Th
e
St
ra
te
gi
c
M
an
ag
em
en
t P
ro
ce
ss
M
ap
A
N
A
LY
S
IS
FO
R
M
U
LA
TI
O
N
C
H
A
P
T
E
R
8
C
or
po
ra
te
S
tr
at
eg
y:
Ve
rt
ic
al
In
te
gr
at
io
n
an
d
D
iv
er
si
fic
at
io
n
B
ou
nd
ar
ie
s
of
t
he
F
ir
m
Ve
rt
ic
al
In
te
gr
at
io
n
al
on
g
th
e
In
du
st
ry
V
al
ue
C
ha
in
Ty
pe
s
of
C
or
po
ra
te
D
iv
er
si
fic
at
io
n
C
or
e
C
om
pe
te
nc
e-
M
ar
ke
t
M
at
ri
x
B
C
G
G
ro
w
th
-S
ha
re
M
at
ri
x
C
H
A
P
T
E
R
9
C
or
po
ra
te
S
tr
at
eg
y:
S
tr
at
eg
ic
A
lli
an
ce
s,
a
nd
M
er
ge
rs
&
A
cq
ui
si
tio
ns
B
ui
ld
-B
or
ro
w
-B
uy
F
ra
m
ew
or
k
S
tr
at
eg
ic
A
lli
an
ce
s
A
lli
an
ce
M
an
ag
em
en
t
C
ap
ab
ili
ty
H
or
iz
on
ta
l I
nt
eg
ra
tio
n
C
H
A
P
T
E
R
1
0
G
lo
ba
l S
tr
at
eg
y:
C
om
pe
tin
g
A
ro
un
d
th
e
W
or
ld
G
lo
ba
liz
at
io
n
G
oi
ng
G
lo
ba
l:
W
hy
?,
W
he
re
?,
a
nd
H
ow
?
Th
e
C
AG
E
D
is
ta
nc
e
Fr
am
ew
or
k
Th
e
In
te
gr
at
io
n-
R
es
po
ns
iv
en
es
s
Fr
am
ew
or
k
Po
rt
er
’s
D
ia
m
on
d
Fr
am
ew
or
k
C
H
A
P
T
E
R
1
1
O
rg
an
iz
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rot27628_ch01_002-029.indd 29 10/30/17 08:11 PM
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CHAPTER Strategic Leadership:
Managing the Strategy
Process
Chapter Outline
2.1 Strategic Leadership
What Do Strategic Leaders Do?
How Do You Become a Strategic Leader?
The Strategy Process across Levels: Corporate,
Business, and Functional Managers
2.2 The Strategic Management Process
Top-Down Strategic Planning
Scenario Planning
Strategy as Planned Emergence: Top-Down and
Bottom-Up
2.3 Stakeholders and Competitive Advantage
Stakeholder Strategy
Stakeholder Impact Analysis
2.4 Implications for Strategic Leaders
Learning Objectives
LO 2-1 Explain the role of strategic leaders and
what they do.
LO 2-2 Outline how you can become a strategic leader.
LO 2-3 Describe the roles of corporate, business,
and functional managers in strategy formu-
lation and implementation.
LO 2-4 Evaluate top-down strategic planning, scenario
planning, and strategy as planned emergence.
LO 2-5 Assess the relationship between stake-
holder strategy and sustainable competitive
advantage.
LO 2-6 Conduct a stakeholder impact analysis.
2
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Sheryl Sandberg: Leaning in at
Facebook
IN 2008, FACEBOOK was a scrappy underdog in social
media. Myspace was the dominant player, and despite
four years of trying, Facebook was still in second place.
But Facebook CEO Mark Zuckerberg was about to make
a genius move: He persuaded Sheryl Sandberg to leave
Google and join Facebook as chief operating officer
(COO).
As the new second in command, Sandberg brought
all the business skills that Zuckerberg lacked. She had
demonstrated her versatility at Google and was already
renowned for her sales, business development, public pol-
icy, and communications
prowess.
In contrast, Zuckerberg
was more a computer
hacker by heart. He liked
working to build the best
product to fulfill Face-
book’s vision to “make
the world more open and
connected.” But he pre-
ferred coding to business
deals, and freely admitted
that he lacked the skill
set to successfully run a
business. The story of the
startup got the Hollywood
treatment in the film, The
Social Network, in 2010.
Today it’s only a partial simplification of their roles
to say that Zuckerberg brings in the users, and Sandberg
brings in the money. Their close collaboration earns deep
respect within both Facebook and Silicon Valley, where
many technology companies envy their synergistic leader-
ship. To appreciate what she brought to Facebook, look
what she achieved at Google.
YEARS IN THE GOOGLEPLEX
By the time she left Google, Sandberg was vice president
of global online sales and operations. She had joined the
company in 2001, leading a staff of 300 to develop the
company’s two online advertising programs, AdSense and
AdWords. Today these initiatives drive most of Google’s
revenues. Eric Schmidt, Google’s CEO at the time,
praised her as a “superstar.” Under her watch, Sandberg’s
group had grown to 4,000 employees, or about a quarter
of Google’s work force.
FACEBOOK TODAY
Sandberg can claim credit for much of the success of Face-
book today. As the dominant worldwide social network, it
has some 2 billion monthly users. By one report, Ameri-
cans spend one-third of their internet time on Facebook,
most of it from mobile devices. In 2017, Facebook was the
fourth most valuable company on the planet, with a market
capitalization of almost $500 billion (just behind Apple,
Alphabet, and Microsoft, but ahead of Amazon).
Facebook creates value
by matching advertisers
with users. Google does
the same, but by different
means. Google deals in
objective recommenda-
tions based on its propri-
etary search algorithms
analyzing billions of
websites (e.g., “find the
best sitcom on Wednes-
day night”). Facebook
organizes its own users’
data based on their social
network (e.g., “find the
best sitcom on Wednes-
day night based on what
my friends like”). Together, Google and Facebook capture
more than half of all online ad spending, reaching $140 bil-
lion in 2017.
COMPARE FACEBOOK’S EARLY YEARS
Today’s social media giant was started in 2004 in a dorm
room at Harvard by then 19-year-old Mark Zuckerberg
and three college pals. Facebook lagged Myspace in
money and users. Myspace was acquired by News Corp.
for close to $600 million in 2005, while Facebook was
kept alive by cash injections from Microsoft, Yahoo, and
a Russian investment group. Until 2009, Myspace was rid-
ing high with more users.
CHAPTERCASE 2
Sheryl Sandberg, Facebook COO. ©Bloomberg/Getty Images
31
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LO 2-1
Explain the role of
strategic leaders and
what they do.
strategic leadership
Executives’ use of
power and influence to
direct the activities of
others when pursuing an
organization’s goals.
SANDBERG TODAY
As Facebook’s COO, Sandberg focuses on operations, rev-
enue, and international reach. She steps up in unexpected
areas when needed, such as when she successfully completed
a round of funding for Facebook after its chief financial
officer had left suddenly. On numerous occasions she has
mitigated Zuckerberg’s public relations challenges. Many
consider Sandberg the “professional face” of Facebook.
LEANING IN
Sandberg is a vocal advocate for women in leadership. Her
popular TED talk, “Why We Have Too Few Women Lead-
ers,” has over 7 million views. Her 2013 book, Lean In:
Women, Work, and the Will to Lead, shot to the bestseller
list. In both, Sandberg speaks about the low number of
female leaders in today’s society and how to overcome this
situation. By highlighting both external as well as internal
factors, Sandberg provides deep insights of why there are
so few women in leadership positions. While her advice to
women on dealing with internal factors is not without con-
troversy, there is no question that her leaning in has made a
difference at Facebook.
In 2012, Sandberg was appointed to the board of direc-
tors, making her the first woman to join Facebook’s govern-
ing body. Time magazine included Sandberg in its annual
list of the 100 Most Influential People, while Forbes maga-
zine named her the Most Powerful Woman in Tech in its
2016 annual ranking.1
You will learn more about Sheryl Sandberg and her leadership
at Facebook by reading this chapter; related questions appear in
“ChapterCase 2 / Consider This. . . .”
HOW DO STRATEGIC LEADERS like Sheryl Sandberg guide their companies to
gain and sustain a competitive advantage? How do strategic leaders formulate and
implement their companies’ strategies? How do they lead and motivate employees? In
Chapter 2, we move from thinking about why strategy is important to considering the role
strategic leaders play. We look at how strategic leaders guide and manage the strategy pro-
cess across different levels in the organization. We explore some of the frameworks they
use to develop strategy. We also move beyond an understanding of competitive advantage
solely as superior firm financial performance, and introduce the framework of stakeholder
strategy. This allows us to appreciate the role of business in society more broadly. And
finally, we summarize some of the most important practical insights in our Implications
for Strategic Leaders.
2.1 Strategic Leadership
Executives whose vision and decisions enable their organizations to achieve competitive
advantage demonstrate strategic leadership.2 Strategic leadership pertains to executives’
use of power and influence to direct the activities of others when pursuing an organization’s
goals.3 Power is defined as the strategic leader’s ability to influence the behavior of other
organizational members to do things, including things they would not do otherwise.4 Stra-
tegic leaders can draw on position power as vested in their authority, for example as chief
executive officer (CEO), as well as informal power, such as persuasion to influence others
when implementing strategy.
In leading Facebook to become the most successful social network and one of the most
valuable companies worldwide, Sheryl Sandberg has clearly demonstrated effective strate-
gic leadership. As chief operating officer, Sandberg has tremendous position power because
she is the second in command at Facebook and reports only to CEO Mark Zuckerberg.
Sandberg’s business development skills are legend: She transformed a money-losing outfit
into a titan of online advertising, with some $30 billion in annual revenues. She designed
and implemented Facebook’s business model (how it makes money). In particular, Sand-
berg has attracted high-profile advertisers by demonstrating how Facebook can place
32
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precisely targeted and timed ads when it matches what
it knows about each user, based on that person’s social
networks, with the advertisers’ targets. Less quantifi-
able, but perhaps an even more valuable contribution,
Sandberg provides “adult supervision and a professional
face” for a firm populated by socially awkward com-
puter geeks.5
While the effect of strategic leaders may vary, they
clearly matter to firm performance.6 Think of great busi-
ness founders and their impact on the companies they
built—Mark Zuckerberg at Facebook, Elon Musk at
Tesla and SpaceX, Jack Ma at Alibaba, Oprah Winfrey
with her media empire, and Jeff Bezos at Amazon.
There are also many strategic leaders who have shaped
and revitalized existing businesses: Sheryl Sandberg at
Facebook, Angela Ahrendts at Apple (former CEO of
Burberry, a luxury fashion house), Mary Barra at GM,
Indra Nooyi at PepsiCo, Howard Schultz at Starbucks,
and Satya Nadella at Microsoft.7
At the other end of the spectrum, some CEOs have massively destroyed shareholder
value: Ken Lay at Enron, John Sculley at Apple, Bernard Ebbers at WorldCom, Charles
Prince at Citigroup, Richard Fuld at Lehman Brothers, Richard Wagoner at GM, Robert
Nardelli at The Home Depot and later Chrysler, Martin Winterkorn at VW, and Ron
Johnson at JCPenney, among many others.
Why do some leaders create great companies or manage them to greatness, while oth-
ers lead them into decline and sometimes even demise? To answer that question, let’s first
consider what strategic leaders actually do.
WHAT DO STRATEGIC LEADERS DO?
What do strategic leaders do that makes some more effective than others? In a study of
more than 350 CEOs, strategy scholars found that they spend, on average, 67 percent
of their time in meetings, 13 percent working alone, 7 percent on e-mail, 6 percent on
phone calls, 5 percent on business meals, and 2 percent on public events such as ribbon-
cutting for a new factory (see Exhibit 2.1).8 Other studies have also found that most man-
agers prefer oral communication: CEOs spend most of their time “interacting— talking,
cajoling, soothing, selling, listening, and nodding—with a wide array of parties inside
and outside the organization.”9 Surprisingly given the advances in information tech-
nology, CEOs today spend most of their time in face-to-face meetings. They consider
face-to-face meetings most effective in getting their message across and obtaining the
information they need. Not only do meetings present data through presentations and ver-
bal communications, but they also enable CEOs to pick up on rich nonverbal cues such
as facial expressions, body language, and mood, that are not apparent to them if they use
e-mail or Skype, for example.10
HOW DO YOU BECOME A STRATEGIC LEADER?
Is becoming an ethical and effective strategic leader innate? Can it be learned? According
to the upper-echelons theory, organizational outcomes including strategic choices and
performance levels reflect the values of the top management team.11 These are the individ-
uals at the upper levels of an organization. The theory states that strategic leaders interpret
upper-echelons theory
A conceptual
framework that
views organizational
outcomes—strategic
choices and
performance levels—as
reflections of the values
of the members of the
top management team.
LO 2-2
Outline how you can
become a strategic
leader.
Indra Nooyi, PepsiCo CEO.
©Bloomberg/Getty Images
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Level-5 leadership
pyramid A conceptual
framework of leadership
progression with five
distinct, sequential
levels.
Working Alone
13%
E-mail
7%
Calls
6%
Business Meals
5%
Public Events
2%
Face-to-Face Meetings
67%
EXHIBIT 2.1 /
How CEOs Spend
Their Days
SOURCE: Data from O.
Bandiera, A. Prat, and R.
Sadun (2012), “Management
capital at the top: Evidence
from the time use of CEOs,”
London School of Economics
and Harvard Business School
Working Paper.
situations through the lens of their unique perspectives, shaped by personal circumstances,
values, and experiences. Their leadership actions reflect characteristics of age, education,
and career experiences, filtered through personal interpretations of the situations they face.
The upper-echelons theory favors the idea that effective strategic leadership is the result of
both innate abilities and learning.
In the bestseller Good to Great, Jim Collins explored over 1,000 good companies to
find 11 great ones. He identified great companies as those that transitioned from average
performance to sustained competitive advantage. He measured that transition as “cumu-
lative stock returns of almost seven times the general market in the 15 years following
their transition points.”12 A lot has happened since the book was published over a decade
ago. Today only a few of the original 11 stayed all that great, including Kimberly-Clark
and Walgreens. Some fell back to mediocrity; a few no longer exist in their earlier form
or at all. Anyone remember Circuit City or Fannie Mae? Let’s agree that competitive
advantage is hard to achieve and even harder to sustain. But his study remains valuable
for its thought-provoking observations. Studying these large corporations, Collins found
consistent patterns of leadership among the top companies, as pictured in the Level-5
leadership pyramid in Exhibit 2.2.13 The pyramid is a conceptual framework that shows
leadership progression through five distinct, sequential levels. Collins found that all the
companies he identified as great were led by Level-5 executives. So if you are interested
in becoming an ethical and effective strategic leader, the leadership pyramid suggests the
areas of growth required.
According to the Level-5 leadership pyramid, effective strategic leaders go through
a natural progression of five levels. Each level builds upon the previous one; the indi-
vidual can move on to the next level of leadership only when the current level has
been mastered. On the left (in Exhibit 2.2) are the capabilities associated with each
level. But not all companies are Fortune 500 behemoths. On the right we suggest that
the model is valuable as well to the individual looking to develop the capacity for greater
professional success.
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At Level 1, we find the highly capable individual who makes productive contributions
through her motivation, talent, knowledge, and skills. These traits are a necessary but not
sufficient condition to move on to Level 2, where the individual attains the next level of
strategic leadership by becoming an effective team player. As a contributing team member,
she works effectively with others to achieve common objectives. In Level 3, the team player
with a high individual skill set turns into an effective manager who is able to organize
the resources necessary to accomplish the organization’s goals. Once these three levels are
mastered, in Level 4, the effective professional has learned to do the right things, meaning
she does not only command a high individual skill set and is an effective team player and
manager, but she also knows what actions are the right ones in any given situation to pursue
an organization’s strategy. Combining all four prior levels, at Level 5, the strategic leader
builds enduring greatness by combining willpower and humility. This implies that a Level-5
executive works to help the organization succeed and others to reach their full potential.
As detailed in the ChapterCase, Facebook CEO Mark Zuckerberg highly values Sheryl
Sandberg, the COO. Here he says why: “She could go be the CEO of any company that
she wanted, but I think the fact that she really wants to get her hands dirty and work, and
doesn’t need to be the front person all the time, is the amazing thing about her. It’s that
low-ego element, where you can help the people around you and not need to be the face of
all the stuff.”14 Clearly, Sandberg is a Level-5 executive: She builds enduring greatness at
Facebook through a combination of skill, willpower, and humility.
EXHIBIT 2.2 / Strategic Leaders: The Level-5 Pyramid
Adapted to compare corporations and entrepreneurs
Builds enduring greatness through a combination of
willpower and humility.
Presents compelling vision and mission to
guide groups toward superior performance.
Does the right things.
Is efficient and effective in organizing
resources to accomplish stated goals
and objectives. Does things right.
Uses high level of individual
capability to work effectively
with others in order to
achieve team objectives.
Makes productive
contributions through
motivation, talent,
knowledge, and skills.
Level 5:
Executive
Level 4:
Effective Leader
Level 3:
Competent Manager
Level 2:
Contributing Team Member
Level 1:
Highly Capable Individual
EntrepreneurCorporationCapabilities
Di
st
in
ct
p
os
iti
on
s
wi
th
in
c
or
po
ra
te
s
tru
ct
ur
e
Pe
rs
on
al
g
ro
wt
h
in
re
sp
on
se
to
b
us
in
es
s
ne
ed
s
SOURCE: Adapted from Collins, J. (2001), Good to Great: Why Some Companies Make the Leap . . . And Others Don’t (New York: HarperCollins), 20.
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36 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
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THE STRATEGY PROCESS ACROSS LEVELS: CORPORATE,
BUSINESS, AND FUNCTIONAL MANAGERS
According to the upper-echelons theory, strategic leaders primarily determine a firm’s abil-
ity to gain and sustain a competitive advantage through the strategies they pursue. Given
the importance of such strategies, we need to gain a deeper understanding of how they are
created. The strategy process consists of two parts: strategy formulation (which results
from strategy analysis) and strategy implementation.
Strategy formulation concerns the choice of strategy in terms of where and how to
compete. In contrast, strategy implementation concerns the organization, coordination,
and integration of how work gets done. In short, it concerns the execution of strategy. It is
helpful to break down strategy formulation and implementation into three distinct areas—
corporate, business, and functional.
■ Corporate strategy concerns questions relating to where to compete as to industry,
markets, and geography.
■ Business strategy concerns the question of how to compete. Three generic business
strategies are available: cost leadership, differentiation, or value innovation.
■ Functional strategy concerns the question of how to implement a chosen business strat-
egy. Different corporate and business strategies will require different activities across
the various functions.
Exhibit 2.3 shows the three areas of strategy formulation and implementation.
Although we generally speak of the firm in an abstract form, individual employees
make strategic decisions—whether at the corporate, business, or functional level. Cor-
porate executives at headquarters formulate corporate strategy. Think of corporate exec-
utives including Sheryl Sandberg (Facebook), John Flannery (GE), Virginia Rometty
(IBM), Mukesh Ambani (Reliance Industries), Mary Barra (GM), or Marillyn Hewson
(Lockheed Martin). Corporate executives need to decide in which industries, markets,
and geographies their companies should compete. They need to formulate a strategy
LO 2-3
Describe the roles of
corporate, business, and
functional managers in
strategy formulation and
implementation.
strategy formulation
The part of the strategic
management process
that concerns the
choice of strategy in
terms of where and how
to compete.
strategy implementation
The part of the
strategic management
process that concerns
the organization,
coordination, and
integration of how work
gets done, or strategy
execution.
EXHIBIT 2.3 /
Strategic Formulation
and Implementation
across Levels:
Corporate, Business,
and Functional
Strategy
Option 1
Cost Leadership
Corporate
Where to Compete
Business
How to Compete
Functional
How to Implement
Function 1 Function 2 … … Function n
Option 2
Differentiation
Option 3
Value Innovation
Headquarters
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that can create synergies across business units that may be quite dif-
ferent, and determine the boundaries of the firm by deciding whether
to enter certain industries and markets and whether to sell certain divi-
sions. They are responsible for setting overarching strategic objectives
and allocating scarce resources among different business divisions,
monitoring performance, and making adjustments to the overall portfo-
lio of businesses as needed. The objective of corporate-level strategy is
to increase overall corporate value so that it is higher than the sum of the
individual business units.
Business strategy occurs within strategic business units (SBUs), the
standalone divisions of a larger conglomerate, each with its own profit-
and-loss responsibility. General managers in SBUs must answer business
strategy questions relating to how to compete in order to achieve superior
performance. Within the guidelines received from corporate headquarters,
they formulate an appropriate generic business strategy, including cost
leadership, differentiation, or value innovation, in their quest for competi-
tive advantage.
Rosalind Brewer, (former) president and CEO of Sam’s Club, pursued
a somewhat different business strategy from the strategy of parent com-
pany Walmart. By offering higher-quality products and brand names with
bulk offerings and by prescreening customers via required Sam’s Club
memberships to establish creditworthiness, Brewer achieved annual rev-
enues of roughly $60 billion. This would place Sam’s Club in the top 50 in the Fortune 500
list. Although as CEO of Sam’s Club, Brewer was responsible for the performance of this
strategic business unit, she reported to Walmart’s CEO, Doug McMillon, who as corporate
executive oversees Walmart’s entire operations, with close to $500 billion in annual rev-
enues and over 11,000 stores globally.15
Within each strategic business unit are various business functions: accounting, finance,
human resources, product development, operations, manufacturing, marketing, and cus-
tomer service. Each functional manager is responsible for decisions and actions within
a single functional area. These decisions aid in the implementation of the business-level
strategy, made at the level above (see Exhibit 2.3).
Returning to our ChapterCase, COO Sheryl Sandberg determines Facebook’s corporate
strategy jointly with CEO Mark Zuckerberg. Facebook, with some 15,000 employees, is a
far-flung internet firm with its various services available in more than 90 languages, and
with offices in more than 30 countries.16 Together, they are responsible for the perfor-
mance of the entire organization, and decide:
■ What types of products and services to offer.
■ Which industries to compete in.
■ Where in the world to compete.
One example of Sandberg’s effective strategic leadership is Facebook’s turnaround
beginning in 2013 when it did not have much of a mobile presence. Part of the problem
was the inferior quality of the mobile app; Zuckerberg had initially built Facebook for
the desktop personal computer, not for mobile devices. Sandberg initiated a company-
wide “mobile first” initiative focusing its engineers and marketers on mobile. The success
of this turnaround strategy is stunning: Today Facebook is a mobile advertising pow-
erhouse, generating over 80 percent of its revenues ($30 billion annually) from mobile
advertising.17
strategic business
units (SBUs)
Standalone divisions of
a larger conglomerate,
each with their
own profit-and-loss
responsibility.
Rosalind Brewer, Sam’s
Club president and CEO
(2012–2017).
©AP Images/April L Brown
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38 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
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2.2 The Strategic Management Process
An effective strategic management process lays the foundation for sustainable competitive
advantage. Strategic leaders design a process to formulate and implement strategy. In the
prior section, we gained insight into the corporate, business, and functional levels of strat-
egy. Here we turn to the process or method by which strategic leaders formulate and imple-
ment strategy. When setting the strategy process, strategic leaders rely on three approaches:
1. Strategic planning.
2. Scenario planning.
3. Strategy as planned emergence.
This order also reflects how these approaches were developed: strategic planning, then
scenario planning, and then strategy as planned emergence. The first two are relatively
formal, top-down planning approaches. The third approach begins with a strategic plan but
offers a less formal and less stylized approach. Each approach has its strengths and weak-
nesses, depending on the circumstances under which it is employed.
TOP-DOWN STRATEGIC PLANNING
The prosperous decades after World War II resulted in tremendous growth of corporations.
As company executives needed a way to manage ever more complex firms more effec-
tively, they began to use strategic planning.18 Top-down strategic planning, derived from
military strategy, is a rational process through which executives attempt to program future
success.19 In this approach, all strategic intelligence and decision-making responsibilities
are concentrated in the office of the CEO. The CEO, much like a military general, leads the
company strategically through competitive battles.
Exhibit 2.4 shows the three steps of analysis, formulation, and implementation in a
traditional top-down strategic planning process. Strategic planners provide detailed ana-
lyses of internal and external data and apply it
to all quantifiable areas: prices, costs, margins,
market demand, head count, and production
runs. Five-year plans, revisited regularly, pre-
dict future sales based on anticipated growth.
Top executives tie the allocation of the annual
corporate budget to the strategic plan and moni-
tor ongoing performance accordingly. Based on
a careful analysis of these data, top managers
reconfirm or adjust the company’s vision, mis-
sion, and values before formulating corporate,
business, and functional strategies. Appropri-
ate organizational structures and controls as
well as governance mechanisms aid in effective
implementation.
Top-down strategic planning more often rests
on the assumption that we can predict the future
from the past. The approach works reasonably
well when the environment does not change
much. One major shortcoming of the top-down
strategic planning approach is that the formu-
lation of strategy is separate from implemen-
tation, and thinking about strategy is separate
LO 2-4
Evaluate top-down
strategic planning,
scenario planning, and
strategy as planned
emergence.
strategic management
process Method put
in place by strategic
leaders to formulate
and implement a
strategy, which can lay
the foundation for a
sustainable competitive
advantage.
top-down strategic
planning A rational,
data-driven strategy
process through
which top management
attempts to program
future success.
EXHIBIT 2.4 / Top-Down Strategic Planning in the AFI
Framework
• Structure, Culture, & Control
• Corporate Governance & Business Ethics
• Corporate Strategy
• Business Strategy
• Functional Strategy
Analysis
Formulation
Implementation
• Vision, Mission, and Values
• External Analysis
• Internal Analysis
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from doing it. Information flows one way only: from the top down. Another shortcoming
of the strategic planning approach is that we simply cannot know the future. There is no
data. Unforeseen events can make even the most scientifically developed and formalized
plans obsolete. Moreover, strategic leaders’ visions of the future can be downright wrong,
a few notable exceptions to the contrary.
At times, strategic leaders impose their visions onto a company’s strategy, structure,
and culture from the top down to create and enact a desired future state. Under its co-
founder and longtime CEO Steve Jobs, Apple was one of the few successful tech compa-
nies using a top-down strategic planning process.20 Jobs felt that he knew best what the
next big thing should be. Under his top-down, autocratic leadership, Apple did not engage
in market research, because Jobs firmly believed that “people don’t know what they want
until you show it to them.”21 Based on an in-depth study resulting in his 700-page Steve
Jobs biography, Walter Isaacson distills Jobs’ 14 lessons in strategic leadership, including:
push for perfection, tolerate only “A” players, bend reality, among others.22
The traditional top-down strategy process served Apple well as it became the world’s
most valuable company. Apple’s strategy process has become more flexible under Tim
Cook, Jobs’ successor as CEO, and the company is trying to incorporate the possibilities of
different future scenarios and bottom-up strategic initiatives.23
SCENARIO PLANNING
Given that the only constant is change, should managers even try to strategically plan for
the future? The answer is yes—but they also need to expect that unpredictable events will
happen. Strategic planning in a fast-changing environment happens in a similar fashion
to the planning in a fire department.24 There is no way to know where and when the next
emergency will arise, nor can we know its magnitude beforehand. Nonetheless, fire chiefs
put contingency plans in place to address a wide range of emergencies along different
dimensions.
In the same way, scenario planning asks those “what if” questions. Similar to top-down
strategic planning, scenario planning also starts with a top-down approach to the strategy
process. In addition, in scenario planning, top management envisions different scenarios,
to anticipate plausible futures in order to derive strategic responses. For example, new laws
might restrict carbon emissions or expand employee health care. Demographic shifts may
alter the ethnic diversity of a nation; changing tastes or economic conditions will affect con-
sumer behavior. Technological advance may provide completely new products, processes,
and services. How would any of these changes affect a firm, and how should it respond?
Scenario planning takes place at both the corporate and business levels of strategy.
Typical scenario planning addresses both optimistic and pessimistic futures. For
instance, strategy executives at UPS identified a number of issues as critical to shaping its
future competitive scenarios: (1) big data analytics; (2) being the target of a terrorist attack,
or having a security breach or IT system disruption; (3) large swings in energy prices,
including gasoline, diesel and jet fuel, and interruptions in supplies of these commodities;
(4) fluctuations in exchange rates or interest rates; and (5) climate change.25 Managers then
formulate strategic plans they could activate and implement should the envisioned optimis-
tic or pessimistic scenarios begin to appear.
To model the scenario-planning approach, place the elements in the AFI strategy frame-
work in a continuous feedback loop, where analysis leads to formulation to implementa-
tion and back to analysis. Exhibit 2.5 elaborates on this simple feedback loop to show the
dynamic and iterative method of scenario planning.
The goal is to create a number of detailed and executable strategic plans. This allows the
strategic management process to be more flexible and more effective than the more static
scenario
planning Strategy
planning activity in
which top management
envisions different
what-if scenarios to
anticipate plausible
futures in order
to derive strategic
responses.
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strategic planning approach with one master plan. In the analysis stage, managers brainstorm
to identify possible future scenarios. Input from several different levels within the organization
and from different functional areas such as R&D, manufacturing, and marketing and sales is
critical. UPS executives considered, for example, how they would compete if the price of a
barrel of oil was $35, or $100, or even $200. Managers may also attach probabilities (highly
likely versus unlikely, or 85 percent likely versus 2 percent likely) to different future states.
Although managers often tend to overlook pessimistic future scenarios, it is imperative
to consider negative scenarios carefully. Exporters such as Boeing, Harley-Davidson, or
John Deere would want to analyze the impact of shifts in exchange rates on profit mar-
gins. They might go through an exercise to derive different strategic plans based on large
exchange rate fluctuations of the U.S. dollar against major foreign currencies such as the
euro, Japanese yen, or Chinese yuan. What if the euro depreciated to below $1 per euro, or
the Chinese yuan depreciated rather than appreciated? How would Disney compete if the
dollar were to appreciate so much as to make visits by foreign tourists to its California and
Florida theme parks prohibitively expensive?
Strategic leaders need also consider how black swan events might affect their strategic
planning. In the past, most people assumed that all swans are white, so when they first
encountered swans that were black, they were surprised.26 Examples of black swan events
include the 9/11 terrorist attacks, the British exit from the European Union (Brexit), and
the European refugee and migrant crisis. The BP oil spill was a black swan for many busi-
nesses on the Gulf Coast, including the tourism, fishing, and energy industries. We discuss
the BP Deepwater Horizon explosion and its consequences in much more detail in Strategy
Highlight 2.2, in the next section. Such black swan events were considered to be highly
EXHIBIT 2.5 /
Scenario Planning
within the AFI
Strategy Framework
Feedback Loop
Monitoring Performance
Analysis
Formulation
Implementation
Develop Strategic
Plans to Address
Future Scenarios
Execute Dominant
Strategic Plan
Dis
car
d D
om
ina
nt
Pla
n if
Ne
ces
sar
y
Create Strategic
Options
Through Developing
Alternative Plan(s)
Identify Multiple
Future Scenarios
Activate and Execute
New Plan if Necessary
black swan
events Incidents
that describe highly
improbable but high-
impact events.
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improbable and thus unexpected, but when they did
occur, each had a very profound impact.
The metaphor of a black swan, therefore,
describes the high impact of a highly improbable
event. In the UPS scenario planning exercise, a ter-
rorist attack or a complete security breach of its IT
system are examples of possible black swan events.
Looking at highly improbable but high-impact
events allows UPS executives to be less surprised
and more prepared should they indeed occur.
In the formulation stage in scenario planning,
management teams develop different strategic plans
to address possible future scenarios. This kind of
what-if exercise forces managers to develop detailed
contingency plans before events occur. Each plan
relies on an entire set of analytical tools, which we will introduce in upcoming chapters. They
capture the firm’s internal and external environments when answering several key questions:
■ What resources and capabilities do we need to compete successfully in each future scenario?
■ What strategic initiatives should we put in place to respond to each respective scenario?
■ How can we shape our expected future environment?
By formulating responses to the varying scenarios, managers build a portfolio of future
options. They then continue to integrate additional information over time, which in turn
influences future decisions. Finally, managers transform the most viable options into full-
fledged, detailed strategic plans that can be activated and executed as needed. The scenarios
and planned responses promote strategic flexibility for the organization. If a new scenario
should emerge, the company won’t lose any time coming up with a new strategic plan. It
can activate a better suited plan quickly based on careful scenario analysis done earlier.
In the implementation stage, managers execute the dominant strategic plan, the option
that top managers decide most closely matches the current reality. If the situation changes,
managers can quickly retrieve and implement any of the alternate plans developed in the
formulation stage. The firm’s subsequent performance in the marketplace gives managers
real-time feedback about the effectiveness of the dominant strategic plan. If performance
feedback is positive, managers continue to pursue the dominant strategic plan, fine-tuning
it in the process. If performance feedback is negative, or if reality changes, managers con-
sider whether to modify further the dominant strategic plan in order to enhance firm per-
formance or to activate an alternative strategic plan.
The circular nature of the scenario-planning model in Exhibit 2.5 highlights the con-
tinuous interaction among analysis, formulation, and implementation. Through this inter-
active process, managers can adjust and modify their actions as new realities emerge. The
interdependence among analysis, formulation, and implementation also enhances organi-
zational learning and flexibility.
STRATEGY AS PLANNED EMERGENCE: TOP-DOWN AND
BOTTOM-UP
Critics of top-down and scenario planning argue that strategic planning is not the same as
strategic thinking.27
In fact, they argue the strategic planning processes are often too regimented and confin-
ing. As such, they lack the flexibility needed for quick and effective response. Managers
©Bernd Wolter/Shutterstock
.com RF
dominant strategic
plan The strategic
option that top
managers decide most
closely matches the
current reality and
which is then executed.
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42 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
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engaged in a more formalized approach to the strategy process may also fall prey to an
illusion of control, which describes a tendency by managers to overestimate their ability
to control events.28 Hard numbers in a strategic plan can convey a false sense of security.
According to critics of strategic planning, to be successful, a strategy should be based on
an inspiring vision and not on hard data alone. They advise that strategic leaders should
focus on all types of information sources, including soft sources that can generate new
insights, such as personal experience, deep domain expertise, or the insights of front-line
employees. The important work, according to this viewpoint, is to synthesize all avail-
able input from different internal and external sources into an overall strategic vision. An
inspiring vision in turn should then guide the firm’s strategy (as discussed in Chapter 1).
In today’s complex and uncertain world, the future cannot be predicted from the past
with any degree of certainty. Black swan events can profoundly disrupt businesses and
society. Moreover, the other two approaches to planning just discussed do not account suf-
ficiently for the role employees at all levels of the organization may play. This is because
lower-level employees not only implement the given strategy, but they also frequently
come up with initiatives on their own that may alter a firm’s strategy. In many instances,
front-line employees have unique insights based on constant and unfiltered customer feed-
back that may elude the more removed executives. Moreover, hugely successful strategic
initiatives are occasionally the result of serendipity, or unexpected but pleasant surprises.
In 1990, for example, online retailing was nonexistent. Today, almost all internet users
have purchased goods and services online. As a total of all sales, online retailing was about
20 percent in 2017 and expected to double by 2026.29 Given the success of Amazon as the
world’s leading online retailer, brick-and-mortar companies such as Best Buy, The Home
Depot, JCPenney, Sears, and even Walmart have all been forced to respond and adjust
their strategy. Others such as Kmart or Radio Shack filed for Chapter 11 bankruptcy (and
later reorganized), while Circuit City, Borders, and others, went out of business altogether.
Given the more or less instant global presence of online retailers,30 Alibaba is emerging
as the leading internet-based wholesaler connecting manufacturers in China to retailers in
the West, as well as a direct online retailer. In a similar fashion, Uber and Lyft, the app-
based ride-hailing services, are disrupting the existing taxi and limousine businesses in
many metropolitan areas around the world. Having been protected by decades of regula-
tions, existing taxi and limo services scramble to deal with the unforeseen competition.
Many try through the courts or legislative system to block Uber and Lyft, alleging the
ride-sharing services violate safety and other regulations. Another sharing economy new
venture, Airbnb, an online platform that allows users to list or rent lodging of residential
properties, is facing a similar situation.
The critics of more formalized approaches to strategic planning, most notably Henry
Mintzberg, propose a third approach to the strategic management process. In contrast to
the two top-down strategy processes discussed above, this one is a less formal and less
stylized approach to the development of strategy. To reflect the reality that strategy can be
planned or emerge from the bottom up, Exhibit 2.6 shows a more integrative approach to
managing the strategy process. Please note that even in strategy as planned emergence, the
overall strategy process still unfolds along the AFI framework of analysis, formulation, and
implementation.
According to this more holistic model, the strategy process also begins with a top-down
strategic plan based on analysis of external and internal environments. This analysis com-
pletes the first stage of the AFI framework (see Exhibit 2.6). Top-level executives then
design an intended strategy—the outcome of a rational and structured, top-down strategic
plan. Exhibit 2.6 illustrates how parts of a firm’s intended strategy are likely to fall by the
wayside because of unpredictable events and turn into unrealized strategy.
illusion of control A
tendency by people
to overestimate their
ability to control events.
intended strategy The
outcome of a rational
and structured top-down
strategic plan.
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A firm’s realized strategy is generally formulated through a
combination of its top-down strategic intentions and bottom-up
emergent strategy. An emergent strategy describes any unplanned
strategic initiative bubbling up from deep within the organization. If
successful, emergent strategies have the potential to influence and
shape a firm’s overall strategy.
The strategic initiative is a key feature in the strategy as a planned
emergence model. A strategic initiative is any activity a firm pur-
sues to explore and develop new products and processes, new mar-
kets, or new ventures. Strategic initiatives can come from anywhere.
They could emerge as a response to external trends or come from
internal sources. As such, strategic initiatives can be the result of top-
down planning by executives, or they can also emerge through a bottom-up process. Many
high-tech companies employ the planned emergence approach to formulate strategy. For
example, the delivery-by-drone project at Amazon.com was conceived of and invented by a
low-level engineer. Even relatively junior employees can come up with strategic initiatives
that can make major contributions if the strategy process is sufficiently open and flexible.31
The arrows in Exhibit 2.6 represent different strategic initiatives. In particular, strategic
initiatives can bubble up from deep within a firm through:
■ Autonomous actions.
■ Serendipity.
■ Resource-allocation process (RAP).32
AUTONOMOUS ACTIONS. Autonomous actions are strategic initiatives undertaken by
lower-level employees on their own volition and often in response to unexpected situa-
tions. Strategy Highlight 2.1 illustrates that successful emergent strategies are sometimes
the result of autonomous actions by lower-level employees.
EXHIBIT 2.6 /
Realized Strategy
Is a Combination of
Top-Down Intended
Strategy and
Bottom-Up Emergent
Strategy
Realized
Strategy
Unrealized Strategy
• Unpredictable Events
Intended Strategy
• Top-Down Strategic Plan
Bottom-Up
Emergent Strategy
• Autonomous Actions
• Serendipity
• Resource Allocation
Process
Analysis
Formulation
Implementation
realized strategy
Combination of intended
and emergent strategy.
emergent strategy Any
unplanned strategic
initiative bubbling up
from the bottom of the
organization.
Amazon Prime Air is a future
service that will deliver pack-
ages up to five pounds in 30
minutes or less using small
drones.
©Amazon/Zuma Press/
Newscom
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autonomous
actions Strategic
initiatives undertaken by
lower-level employees
on their own volition
and often in response to
unexpected situations.
Starbucks CEO: “It’s Not What We Do”
Diana, a Starbucks store manager in Southern California,
received several requests a day for an iced beverage
offered by a local competitor. After receiving more than
30 requests one day, she tried the beverage herself.
Thinking it might be a good idea for Starbucks to
offer a similar iced beverage, she requested that
headquarters consider adding it to the product
lineup. Diana had an internal champion in Howard
Behar, then a top Starbucks executive. Behar pre-
sented this strategic initiative to the Starbucks
executive committee. The committee voted down the
idea in a 7:1 vote. Starbucks CEO Howard Schultz
commented, “We do coffee; we don’t do iced drinks.”
Diana, however, was undeterred. She experi-
mented until she created the iced drink, and
then she began to offer it in her store. When
Behar visited Diana’s store, he was shocked to see this new
drink on the menu—all Starbucks stores were supposed to
offer only company-approved drinks. But Diana told him the
new drink was selling well.
Behar flew Diana’s team to Starbucks headquarters in
Seattle to serve the iced-coffee drink to the executive
committee. They liked its taste, but still said no. Then
Behar pulled out the sales numbers that Diana had
carefully kept. The drink was selling like crazy:
40 drinks a day the first week, 50 drinks a day
the next week, and then 70 drinks a day in the
third week after introduction. They had never seen
such growth numbers. These results persuaded the
executive team to give reluctant approval to intro-
duce the drink in all Starbucks stores.
You’ve probably guessed by now that we’re talk-
ing about Starbucks Frappuccino. Frappuccino is
now a multibillion-dollar business for Starbucks. At
one point, this iced drink brought in more than
20 percent of Starbucks’s total revenues, which
were $23 billion in 2017.33
Strategy Highlight 2.1
©Ian Dagnall/Alamy Stock Photo
Functional managers such as Diana, the Starbucks store manager featured in Strategy
Highlight 2.1, are much closer to the final products, services, and customers than the more
removed corporate- or business-level managers. They also receive much more direct cus-
tomer feedback. As a result, functional managers may start strategic initiatives based on
autonomous actions that can influence the direction of the company. To be successful,
however, top-level executives need to support emergent strategies that they believe fit with
the firm’s vision and mission. Diana’s autonomous actions might not have succeeded or
might have got her in trouble if she did not garner the support of a senior Starbucks execu-
tive. This executive championed her initiative and helped persuade other top executives.
Internal champions, therefore, are often needed for autonomous actions to be successful.
Although emergent strategies can arise in the most unusual circumstances, it is impor-
tant to emphasize the role that top management teams play in this type of strategy process.
In the strategy-as-planned-emergence approach, executives need to decide which of the
bottom-up initiatives to pursue and which to shut down. This critical decision is made on
the basis of whether the strategic initiative fits with the company’s vision and mission,
and whether it provides an opportunity worth exploiting. Executives, therefore, continue
to play a critical role in the potential success or failure of emergent strategies because they
determine how limited resources are allocated.
After initial resistance, as detailed in Strategy Highlight 2.1, the Starbucks executive team
around CEO Howard Schultz fully supported the Frappuccino strategic initiative, provid-
ing the resources and personnel to help it succeed. During his tenure at General Electric,
then CEO Jeffrey Immelt decided to move ahead with a strategic initiative to buy the wind
energy company Enron Wind from the bankruptcy proceedings of Enron because he saw the
strategic initiative Any
activity a firm pursues
to explore and develop
new products and
processes, new markets,
or new ventures.
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acquisition as supporting the company’s vision and mission.34 But the initiative only sur-
vived to get Immelt’s attention because of the tireless persistence of a mid-level engineer who
saw its future value. GE provided appropriate resources and structures to grow this emergent
strategy into a major strategic initiative that’s now worth billions of dollars.
SERENDIPITY. Serendipity describes random events, pleasant surprises, and accidental
happenstances that can have a profound impact on a firm’s strategic initiatives.
There are dozens of examples where serendipity had a crucial influence on the course
of business and entire industries. The discovery of 3M’s Post-it Notes or Pfizer’s Viagra,
first intended as a drug to treat hypertension, are well known.35 Less well known is the
discovery of potato chips.36 The story goes that in the summer of 1853, George Crum
was working as a cook at the Moon Lake Lodge resort in Saratoga Springs, New York.
A grumpy patron ordered Moon resort’s signature fried potatoes. These potatoes were
served in thick slices and eaten with a fork as was in the French tradition. When the patron
received the fries, he immediately returned them to the kitchen, asking for them to be cut
thinner. Crum prepared a second plate in order to please the patron, but this attempt was
returned as well. The third plate was prepared by an annoyed Crum who, trying to mock
the patron, sliced the potatoes sidewise as thin as he could and fried them. Instead of being
offended, the patron was ecstatic with the new fries and suddenly other patrons wanted to
try them as well. Crum later opened his own restaurant and offered the famous “Saratoga
Chips,” which he set up in a box and some customers simply took home as a snack to be
eaten later. Today, PepsiCo’s line of Frito-Lay’s chips are a multibillion-dollar business.
How do strategic leaders create a work environment in which autonomous actions and
serendipity can flourish? One approach is to provide time and resources for employees to
pursue other interests. Google, the online search and advertising subsidiary of Alphabet,
for example, organizes the work of its engineers according to a 70-20-10 rule. The major-
ity of the engineers’ work time (70 percent) is focused on its main business (search and
ads).37 Google also allows its engineers to spend one day a week (20 percent) on ideas
of their own choosing, and the remainder (10 percent) on total wild cards such as a Proj-
ect Loon, which places high-altitude balloons into the stratosphere to create a high-speed
wireless network with global coverage. Google reports that half of its new products and
services came from the 20 percent rule, including Gmail, Google Maps, Google News,
and Orkut.38 With the restructuring of Google into a corporation with multiple strategic
business units, engineers spending their 10 percent time on total wild cards do so within
Google X, its research and development unit.39
RESOURCE-ALLOCATION PROCESS. A firm’s resource-allocation process (RAP)
determines the way it allocates its resources and can be critical in shaping its real-
ized strategy.40 Emergent strategies can result from a firm’s resource-allocation pro-
cess (RAP).41 Intel Corp. illustrates this concept.42 Intel was created to produce DRAM
(dynamic random-access memory) chips. From the start, producing these chips was the
firm’s top-down strategic plan, and initially it worked well. In the 1980s, Japanese com-
petitors brought better-quality chips to the market at lower cost, threatening Intel’s position
and obsoleting its top-down strategic plan. However, Intel was able to pursue a strategic
transformation because of the way it set up its resource-allocation process. In a sense, Intel
was using functional-level managers to drive business and corporate strategy in a bottom-
up fashion. In particular, during this time Intel had only a few fabrication plants (called
“fabs”) to produce silicon-based products. It would have taken several years and billions of
dollars to build additional capacity by bringing new fabs online.
With constrained capacity, Intel had implemented the production-decision rule to maximize
margin-per-wafer-start. Each time functional managers initiated a new production run, they
serendipity Any
random events,
pleasant surprises,
and accidental
happenstances that can
have a profound impact
on a firm’s strategic
initiatives.
resource-allocation
process (RAP) The
way a firm allocates
its resources based on
predetermined policies,
which can be critical
in shaping its realized
strategy.
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were to consider the profit margins for DRAM chips and for microprocessors, the “brains” of
personal computers. The operations managers then could produce whichever product delivered
the higher margin. By following this simple rule, front-line managers shifted Intel’s production
capacity away from the lower-margin DRAM business to the higher-margin microprocessors
business. The firm’s focus on microprocessors emerged from the bottom up, based on resource
allocation. Indeed, by the time top management finally approved the de facto strategic switch,
the company’s market share in DRAM had dwindled to less than 3 percent.43
Taken together, a firm’s realized strategy is frequently a combination of top-down stra-
tegic intent and bottom-up emergent strategies, as Exhibit 2.6 shows. This type of strategy
process is called planned emergence. In that process, organizational structure and sys-
tems allow bottom-up strategic initiatives to emerge and be evaluated and coordinated by
top management.44 These bottom-up strategic initiatives can be the result of autonomous
actions, serendipity, or the resource allocation process.
Exhibit 2.7 compares and contrasts the three different approaches to the strategic man-
agement process: top-down strategic planning, scenario planning, and strategy as planned
emergence.
planned
emergence Strategy
process in which
organizational structure
and systems allow
bottom-up strategic
initiatives to emerge
and be evaluated and
coordinated by top
management.
EXHIBIT 2.7 / Comparing and Contrasting Top-Down Strategic Planning, Scenario Planning, and Strategy as
Planned Emergence
Strategy
Process Description Pros Cons Where Best Used
Top-Down
Strategic
Planning
A rational
strategy process
through which
top management
attempts to
program future
success; typically
concentrates
strategic
intelligence and
decision-making
responsibilities in
the office of the
CEO.
• Provides a clear
strategy process
and lines of
communication.
• Affords coordination
and control of various
business activities.
• Readily accepted and
understood as process
is well established
and widely used.
• Works relatively
well in stable
environments.
• Fairly rigid and inhibits
flexibility.
• Top-down, one-way
communication limits
feedback.
• Assumes that the future can
usually be predicted based
on past data.
• Separates elements of
AFI framework so that top
management (analysis &
formulation) are removed
from line employees
(implementation).
• Highly regulated and
stable industries
such as utilities,
e.g., Georgia Power
in Southeast United
States or Areva,
state-owned nuclear
operator in France.
• Government
• Military
Scenario
Planning
Strategy-planning
activity in which
top management
envisions different
what-if scenarios to
anticipate plausible
futures in order
to plan optimal
strategic responses.
• Provides a clear
strategy process
and lines of
communication.
• Affords coordination
and control of various
business activities.
• Readily accepted and
understood as process
is well established
and widely used.
• Provides some
strategic flexibility.
• Top-down, one-way
communication limits feedback.
• Separates elements of
AFI framework so that top
management (analysis &
formulation) are removed
from line employees
(implementation).
• As the future is unknown,
responses to all possible
events cannot be planned.
• Leaders tend to avoid planning
for pessimistic scenarios.
• Fairly stable industries,
often characterized
by some degree of
regulation such as
airlines, logistics, or
medical devices,
e.g., American Airlines,
Delta Air Lines, and
United Airlines; FedEx
and UPS; Medtronic.
• Larger firms in
industries with a small
number of other large
competitors (oligopoly).
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Strategy
Process Description Pros Cons Where Best Used
Strategy
as Planned
Emergence
Blended strategy
process in which
organizational
structure and
systems allow both
top-down vision and
bottom-up strategic
initiatives to emerge
for evaluation and
coordination by top
management.
• Combines all elements
of the AFI framework
in a holistic and
flexible fashion.
• Provides provisional
direction through
intended strategy.
• Accounts for
unrealized strategy
(not all strategic
initiatives can be
implemented).
• Accounts for emergent
strategy (good
ideas for strategic
initiatives can bubble
up from lower levels
of hierarchy through
autonomous actions,
serendipity, and RAP).
• The firm’s realized
strategy is a
combination of
intended and
emergent strategy.
• Highest degree of
strategic flexibility
and buy-in by
employees.
• Unclear strategy process and
lines of communication can
lead to employee confusion
and lack of focus.
• Many ideas that bubble up
from the bottom may not be
worth pursuing.
• Firms may lack a clear
process of how to evaluate
emergent strategy,
increasing the chances of
missing mega opportunities
or pursuing dead ends; may
also contribute to employee
frustration and lower morale.
• New ventures and
smaller firms.
• High-velocity industries
such as technology
ventures.
• Internet companies;
e.g., Airbnb, Alibaba,
Alphabet (parent
company of Google),
Amazon, Facebook,
Twitter, and Uber.
• Biotech companies;
e.g., Amgen, Biogen,
Gilead Sciences,
Genentech, and
Genzyme.
2.3 Stakeholders and Competitive Advantage
Companies with a good strategy generate value for society. When firms compete in their
own self-interest while obeying the law and acting ethically, they ultimately create value.
Value creation occurs because companies with a good strategy are able to provide products
or services to consumers at a price point that they can afford while making a profit at the
same time. Both parties benefit from this trade as each captures a part of the value created.
In so doing, they leave society better off.45
Value creation in turn lays the foundation for the benefits that successful economies can
provide: education, infrastructure, public safety, health care, clean water and air, among
others. Superior performance allows a firm to reinvest some of its profits and to grow,
which in turn provides more opportunities for employment and fulfilling careers. Although
Google (a division of Alphabet) started as a research project in graduate school by Larry
Page and Sergey Brin in the late 1990s, some 20 years later it had become one of the most
valuable companies in the world with some $650 billion in market capitalization and over
75,000 employees, not to mention the billions of people across the world who rely on it for
information gathering and decision making, which is free for the user.46
LO 2-5
Assess the relationship
between stakeholder
strategy and sustainable
competitive advantage.
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Strategic failure, in contrast, can be expensive. Once a leading technology company,
Hewlett-Packard was known for innovation, resulting in superior products. The “HP way
of management” included lifetime employment, generous benefits, work/life balance, and
freedom to explore ideas, among other perks.47 However, HP has not been able to address
the competitive challenges of mobile computing or business IT services effectively. As a
result, HP’s stakeholders suffered. Shareholder value was destroyed massively. The com-
pany also had to lay off tens of thousands of employees. Its customers no longer received
the innovative products and services that made HP famous.
The contrasting examples of Alphabet and HP illustrate the relationship between indi-
vidual firms, competitive advantage, and society at large. Successful firms ultimately cre-
ate value for society. Recently, this relationship received more critical scrutiny due to major
shocks to free market capitalism.48 In particular, the implicit trust relationship between the
corporate world and society at large has deteriorated because of the arrival of several black
swans. One of the first black swan events of the 21st century occurred when the account-
ing scandals at Enron, Arthur Andersen, WorldCom, Tyco, Adelphia, and others, came to
light. Those events led to bankruptcies, large-scale job loss, and the destruction of billions
of dollars in shareholder value. As a result, the public’s trust in business and free market
capitalism began to erode.
Another black swan event occurred in the fall of 2008 with the global financial crisis,
which shook the entire free market system to its core.49 A real estate bubble had developed
in the United States, fueled by cheap credit and the availability of subprime mortgages.
When that bubble burst, many entities faced financial duress or bankruptcy—those who
had unsustainable mortgages, investors holding securities based on those mortgages, and
the financial institutions that had sold the securities. Some went under, and others were
sold at fire-sale prices. Home foreclosures skyrocketed as a large number of borrowers
defaulted on their mortgages. House prices in the United States plummeted by roughly 30
percent. The United States plunged into a deep recession. In the process, the Dow Jones
Industrial Average (DJIA) lost about half its market value.
The impact was worldwide. The freezing of capital markets during the global financial
crisis triggered a debt crisis in Europe. Some European governments (notably Greece)
defaulted on government debt; other countries were able to repay their debts only through
the assistance of other, more solvent European countries. This severe financial crisis not
only put Europe’s common currency, the euro, at risk, but also led to a prolonged and deep
recession in Europe. In the United States, the Occupy Wall Street protest movement was
born out of dissatisfaction with the capitalist system. Issues of income disparity, corporate
ethics, corporate influence on governments, and ecological sustainability were key drivers.
Although these black swan events in the business world differed in their specifics, two
common features are pertinent to our study of strategic management.50 First, these events
demonstrate that managerial actions can affect the economic well-being of large numbers
of people around the globe. Most of the events resulted from executive actions (or inac-
tions) within a few organizations, or compounded across a specific industry or govern-
ment. The second pertinent feature relates to stakeholders—organizations, groups, and
individuals that can affect or be affected by a firm’s actions.51 This leads us to stakeholder
strategy, which we discuss next.
STAKEHOLDER STRATEGY
Stakeholders have a vested claim or interest in the performance and continued survival of
the firm. Stakeholders can be grouped by whether they are internal or external to a firm.
As shown in Exhibit 2.8, internal stakeholders include employees (including executives,
managers, and workers), stockholders, and board members. External stakeholders include
stakeholders
Organizations, groups,
and individuals that can
affect or are affected by
a firm’s actions.
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customers, suppliers, alliance partners, creditors, unions, communities, governments at
various levels, and the media.
All stakeholders make specific contributions to a firm, which in turn provides differ-
ent types of benefits to different stakeholders. Employees contribute their time and talents
to the firm, receiving wages and salaries in exchange. Shareholders contribute capital in
the hope that the stock will rise and the firm will pay dividends. Communities provide
real estate, infrastructure, and public safety. In return, they expect that companies will
pay taxes, provide employment, and not pollute the environment. The firm, therefore, is
embedded in a multifaceted exchange relationship with a number of diverse internal and
external stakeholders.
If any stakeholder withholds participation in the firm’s exchange relationships, it can
negatively affect firm performance. The aerospace company Boeing, for example, has a
long history of acrimonious labor relations, leading to walk-outs and strikes. This in turn
has not only delayed production of airplanes but also raised costs. Or think about the dif-
ferent stakeholders in the global financial crisis discussed above. Borrows who signed up
for subprime mortgages are stakeholders (in this case, customers) of financial institutions.
When they defaulted in large numbers, they threatened the survival of these financial insti-
tutions and, ultimately, of the entire financial system.
Stakeholder strategy is an integrative approach to managing a diverse set of stakehold-
ers effectively in order to gain and sustain competitive advantage.52 The unit of analysis
is the web of exchange relationships a firm has with its stakeholders (see Exhibit 2.8).
Stakeholder strategy allows firms to analyze and manage how various external and inter-
nal stakeholders interact to jointly create and trade value.53 A core tenet of stakeholder
strategy is that a single-minded focus on shareholders alone exposes a firm to undue risks.
Simply putting shareholder interest above all else can undermine economic performance
and even threaten the very survival of the enterprise. A strategic leader, therefore, must
understand the complex web of exchange relationships among different stakeholders. With
that understanding, the firm can proactively shape the various relationships to maximize
the joint value created and manage the distribution of this larger pie in a fair and transpar-
ent manner. Effective stakeholder management exemplifies how strategic leaders can act
stakeholder
strategy An integrative
approach to managing
a diverse set of
stakeholders effectively
in order to gain and
sustain competitive
advantage.
EXHIBIT 2.8 / Internal and External Stakeholders in an Exchange Relationship with the Firm
External
Stakeholders
• Customers
• Suppliers
• Alliance Partners
• Creditors
• Unions
• Communities
• Governments
• Media
Internal
Stakeholders
Be
ne
fit
s
Be
ne
fit
s
Be
ne
fit
s
Be
ne
fit
s
Co
nt
rib
ut
io
ns
Co
nt
rib
ut
io
ns
• Employees
• Stockholders
• Board Members
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to improve firm performance, thereby enhancing the firm’s competitive advantage and the
likelihood of its continued survival.54
Taken together, strategy scholars have provided several arguments as to why effective
stakeholder management can benefit firm performance:55
■ Satisfied stakeholders are more cooperative and thus more likely to reveal information
that can further increase the firm’s value creation or lower its costs.
■ Increased trust lowers the costs for firms’ business transactions.
■ Effective management of the complex web of stakeholders can lead to greater organi-
zational adaptability and flexibility.
■ The likelihood of negative outcomes can be reduced, creating more predictable and
stable returns.
■ Firms can build strong reputations that are rewarded in the marketplace by business
partners, employees, and customers. Most managers do care about public perception
of the firm, and frequently celebrate and publicize high-profile rankings such as the
“World’s Most Admired Companies” published annually by Fortune.56 In 2016, the top
five companies in this ranking were Apple, Alphabet, Amazon, Berkshire Hathaway
(the conglomerate led by Warren Buffett), and Disney. Because of its continued inno-
vation in products, services, and delivery, Apple has been ranked as the world’s most
admired company for the past several years by Fortune.
STAKEHOLDER IMPACT ANALYSIS
The key challenge of stakeholder strategy is to effectively balance the needs of various
stakeholders. The firm needs to ensure that its primary stakeholders—the firm’s share-
holders and other investors—achieve their objectives. At the same time, the firm needs
to recognize and address the concerns of other stakeholders—employees, suppliers, and
customers—in an ethical and fair manner, so that they too are satisfied. This all sounds
good in theory, but how can strategic leaders go about this in practice?
Stakeholder impact analysis provides a decision tool with which strategic leaders can
recognize, prioritize, and address the needs of different stakeholders. This tool helps the
firm achieve a competitive advantage while acting as a good corporate citizen. Stakeholder
impact analysis takes strategic leaders through a five-step process of recognizing stake-
holders’ claims. In each step, they must pay particular attention to three important stake-
holder attributes: power, legitimacy, and urgency.57
■ A stakeholder has power over a company when it can get the company to do something
that it would not otherwise do.
■ A stakeholder has a legitimate claim when it is perceived to be legally valid or other-
wise appropriate.
■ A stakeholder has an urgent claim when it requires a company’s immediate attention
and response.
Exhibit 2.9 depicts the five steps in stakeholder impact analysis and the key questions to
be asked. Let’s look at each step in detail.
STEP 1: IDENTIFY STAKEHOLDERS. In Step 1, strategic leaders ask, “Who are our stake-
holders?” In this step, the strategic leaders focus on stakeholders that currently have, or
potentially can have, a material effect on a company. This prioritization identifies the most
powerful internal and external stakeholders as well as their needs. For public-stock compa-
nies, key stakeholders are the shareholders and other providers of capital. If shareholders
LO 2-6
Conduct a stakeholder
impact analysis.
stakeholder impact
analysis A decision
tool with which
managers can recognize,
prioritize, and address
the needs of different
stakeholders, enabling
the firm to achieve
competitive advantage
while acting as a good
corporate citizen.
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are not satisfied with returns to investment, they will sell the company’s stock, leading to
a fall in the firm’s market value. If this process continues, it can make the company a take-
over target, or launch a vicious cycle of continued decline.
A second group of stakeholders includes customers, suppliers, and unions. Local com-
munities and the media are also powerful stakeholders that can affect the smooth opera-
tion of the firm. Any of these groups, if their needs are not met, can materially affect the
company’s operations.
For example, Boeing opened a new airplane factory in South Carolina to move produc-
tion away from its traditional plant near Seattle, Washington. South Carolina is one of 28
states in the United States that falls under the right-to-work law in which employees in
unionized workplaces are allowed to work without being required to join the union. In
contrast to its work force in Washington state, the South Carolina plant is nonunionized,
which should lead to fewer work interruptions due to strikes and Boeing hopes to higher
productivity and improvements along other performance dimensions (like on-time deliv-
ery of new airplanes). In 2014, Boeing announced that its new 787 Dreamliner jet would
be exclusively built in its nonunionized South Carolina factory.58
STEP 2: IDENTIFY STAKEHOLDERS’ INTERESTS. In Step 2, strategic leaders ask, “What
are our stakeholders’ interests and claims?” Managers need to specify and assess the
interests and claims of the pertinent stakeholders using the power, legitimacy, and
urgency criteria introduced earlier. As the legal owners, shareholders have the most
legitimate claim on a company’s profits. However, the wall separating the claims of
ownership (by shareholders) and of management (by employees) has been eroding. Many
companies incentivize top executives by paying part of their overall compensation with
stock options. They also turn employees into shareholders through employee stock own-
ership plans (ESOPs). These plans allow employees to purchase stock at a discounted
rate or use company stock as an investment vehicle for retirement savings. For example,
Alphabet, Coca-Cola, Facebook, Microsoft, Southwest Airlines, Starbucks, and Walmart
all offer ESOPs. Clearly, the claims and interests of stakeholders who are employed
by the company, and who depend on the company for salary and other benefits, will
be somewhat different from those of stakeholders who merely own stock. The latter
are investors who are primarily interested in the increased value of their stock holdings
EXHIBIT 2.9 /
Stakeholder Impact
Analysis
STEP 2
STEP 1 Who are our stakeholders?
What are our stakeholders’ interests and claims?
What opportunities and threats do our stakeholders present?
What economic, legal, ethical, and philanthropic responsibilities
do we have to our stakeholders?
What should we do to effectively address the
stakeholder concerns?
STEP 3
STEP 4
STEP 5
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through appreciation and dividend payments. Executives, managers, and workers tend to
be more interested in career opportunities, job security, employer-provided health care,
paid vacation time, and other perks.
Even within stakeholder groups there can be significant variation in the power a stake-
holder may exert on the firm. For example, public companies pay much more attention
to large investors than to the millions of smaller, individual investors. Shareholder activ-
ists, such as Bill Ackman, Carl Icahn, or T. Boone Pickens, tend to buy equity stakes in a
corporation that they believe is underperforming to put public pressure on a company to
change its strategy. Examples include the takeover battle at Dell Computer (which founder
Michael Dell subsequently took private), the pressure on PepsiCo to spin off its Frito-Lay
brand, or on Yahoo to sell itself to Verizon, which it did. Even top-performing companies
are not immune to pressure by shareholder activists.59 As a result of a sustained competi-
tive advantage over the last decade, Apple had not only become the most valuable com-
pany on the planet but also amassed some $200 billion in cash in the process. Apple CEO
Tim Cook faced significant pressure from Carl Icahn, who held roughly $4 billion worth
of Apple stock, to buy back more of its shares and thus to further raise Apple’s share price.
Cook obliged, and Apple bought back a significant amount of stock, using its cash to but-
tress its share price.
Although both individual and activist investors may claim the same legitimacy as stock-
holders, shareholder activists have much more power over a firm. They can buy and sell a
large number of shares at once, or exercise block-voting rights in the corporate governance
process (which we’ll discuss in detail in Chapter 12). Shareholder activists frequently also
demand seats on the company’s board to more directly influence its corporate governance,
and with it exert more pressure to change a company’s strategy. These abilities make activ-
ist investors powerful stakeholders, with urgent and legitimate claims.
STEP 3: IDENTIFY OPPORTUNITIES AND THREATS. In Step 3, strategic leaders ask,
“What opportunities and threats do our stakeholders present?” Since stakeholders have
a claim on the company, opportunities and threats are two sides of the same coin. Con-
sumer boycotts, for example, can be a credible threat to a company’s behavior. Some
consumers boycotted Nestlé products when the firm promoted infant formula over breast
milk in developing countries. PETA60 called for a boycott of McDonald’s due to alleged
animal-rights abuses.
In the best-case scenario, managers transform such threats into opportunities. Sony
Corp. of Japan, for example, was able to do just that.61 During one holiday season, the
Dutch government blocked Sony’s entire holiday season shipment of PlayStation game
systems, valued at roughly $500 million, into the European Union because of a small but
legally unacceptable amount of toxic cadmium discovered in one of the system’s cables.
This incident led to an 18-month investigation in which Sony inspected over 6,000 sup-
plier factories around the world to track down the source of the problem. The findings
allowed Sony to redesign and develop a cutting-edge supplier management system that
now adheres to a stringent extended value chain responsibility.
STEP 4: IDENTIFY SOCIAL RESPONSIBILITIES. In Step 4, strategic leaders ask, “What
economic, legal, ethical, and philanthropic responsibilities do we have to our stakehold-
ers?” To identify these responsibilities more effectively, scholars have advanced the notion
of corporate social responsibility (CSR). This framework helps firms recognize and
address the economic, legal, ethical, and philanthropic expectations that society has of the
business enterprise at a given point in time.62 According to the CSR perspective, strategic
corporate social
responsibility (CSR)
A framework that
helps firms recognize
and address the
economic, legal, social,
and philanthropic
expectations that
society has of the
business enterprise at a
given point in time.
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leaders need to realize that society grants shareholders the right and privilege to create a
publicly traded stock company. Therefore, the firm owes something to society.63 CSR pro-
vides strategic leaders with a conceptual model that more completely describes a society’s
expectations and can guide strategic decision making more effectively. In particular, CSR
has four components:
■ Economic responsibilities
■ Legal responsibilities
■ Ethical responsibilities
■ Philanthropic responsibilities64
Economic Responsibilities. The business enterprise is first and foremost an economic
institution. Investors expect an adequate return for their risk capital. Creditors expect the
firm to repay its debts. Consumers expect safe products and services at appropriate prices
and quality. Suppliers expect to be paid in full and on time. Governments expect the firm
to pay taxes and to manage natural resources such as air and water under a decent steward-
ship. To accomplish all this, firms must obey the law and act ethically in their quest to gain
and sustain competitive advantage.
Nobel laureate Milton Friedman views the economic responsibility of the firm as its pri-
mary objective, as captured in his famous quote: “There is one and only one social respon-
sibility 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.”65
Legal Responsibilities. Laws and regulations are a society’s codified ethics, embody-
ing notions of right and wrong. They also establish the rules of the game. For example,
business as an institution can function because property rights exist and contracts can be
enforced in courts of law. Strategic leaders must ensure that their firms obey all the laws
and regulations, including but not limited to labor, consumer protection, and environmen-
tal laws.
One far-reaching piece of U.S. legislation in terms of business impact, for example, is
the Patient Protection and Affordable Care Act (PPACA), more commonly known as the
Affordable Care Act (ACA) or Obamacare. Key provisions of this federal law include,
among others, that firms with 50 or more full-time employees must offer affordable health
insurance to their employees and dependents, or pay a fine for each worker. This makes it
harder for entrepreneurs to grow their ventures above this threshold. One reaction of many
small businesses has been to reduce the number of full-time workers to 49 employees and
add part-time employees only, which do not fall under this provision. Another reaction of
employers is to offer lower wages to compensate for higher health care costs. Moreover,
health insurance providers are no longer allowed to deny coverage based on preexisting
medical conditions. As a consequence, health care premiums have been rising as the over-
all risk pool of insurers is less healthy.66
Ethical Responsibilities. Legal responsibilities, however, often define only the minimum
acceptable standards of firm behavior. Frequently, strategic leaders are called upon to go
beyond what is required by law. The letter of the law cannot address or anticipate all possi-
ble business situations and newly emerging concerns such as internet privacy or advances
in DNA testing, genetic engineering, and stem-cell research.
A firm’s ethical responsibilities, therefore, go beyond its legal responsibilities. They
embody the full scope of expectations, norms, and values of its stakeholders. Strategic
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leaders are called upon to do what society deems just and fair. Starbucks, for example,
developed an ethical sourcing policy to help source coffee of the highest quality, while
adhering to fair trade and responsible growing practices. On the other hand, Starbucks has
been criticized for not paying an adequate amount of taxes in the United Kingdom. Albeit
entirely legal, Starbucks did pay very little in corporate income taxes since opening its first
store in the United Kingdom in 1998 (around $13.5 million total). In an attempt to silence
the critics, to stop protests, and to please the British government, Starbucks volunteered
an additional tax payment of $16 million for the 2013–14 tax year, despite having no legal
obligation to do so.67
Philanthropic Responsibilities. Philanthropic responsibilities are often subsumed under
the idea of corporate citizenship, reflecting the notion of voluntarily giving back to soci-
ety. Over the years, Microsoft’s corporate philanthropy program has donated more than
$3 billion in cash and software to people who can’t afford computer technology.68
The pyramid in Exhibit 2.10 summarizes the four components of corporate social
responsibility.69 Economic responsibilities are the foundational building block, followed
by legal, ethical, and philanthropic responsibilities. Note that society and shareholders
require economic and legal responsibilities. Ethical and philanthropic responsibilities
result from a society’s expectations toward business. The pyramid symbolizes the need for
firms to carefully balance their social responsibilities. Doing so ensures not only effective
strategy implementation, but also long-term viability.
STEP 5: ADDRESS STAKEHOLDER CONCERNS. Finally, in Step 5, the firm asks, “What
should we do to effectively address any stakeholder concerns?” In the last step in stake-
holder impact analysis, strategic leaders need to decide the appropriate course of action for
the firm, given all of the preceding factors. Thinking about the attributes of power, legiti-
macy, and urgency helps to prioritize the legitimate claims and to address them accord-
ingly. Strategy Highlight 2.2 describes how the U.S. government legitimized claims by
thousands of businesses and individuals in the aftermath of the BP oil spill in the Gulf of
Mexico, causing the claims to become of great urgency to BP.
EXHIBIT 2.10 /
The Pyramid of
Corporate Social
Responsibility
SOURCE: Adapted from
Carroll, A. B. (1991), “The
pyramid of corporate social
responsibility: Toward the
moral management of
organizational stakeholders,”
Business Horizons,
July–August: 42.
Philanthropic
Responsibilities
Ethical
Responsibilities
Legal
Responsibilities
Economic
Responsibilities
Corporate
citizenship
Do what is
right, just, and fair
Laws and regulations are society’s
codified ethics
Define minimum acceptable standard
Gain and sustain competitive advantage
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BP “Grossly Negligent” in Gulf of Mexico
Disaster
On April 20, 2010, an explosion occurred on BP’s Deepwater
Horizon oil drilling rig off the Louisiana coastline, killing 11 work-
ers. The subsequent oil spill continued unabated for over three
months. It released an estimated 5 million barrels of crude oil
into the Gulf of Mexico, causing the largest environmental disas-
ter in U.S. history. Two BP employees even faced manslaughter
charges. The cleanup alone cost BP $14 billion. Because of
the company’s haphazard
handling of the crisis, Tony
Hayward, BP’s CEO at the
time, was fired.
Technical issues aside,
many experts argued that
BP’s problems were sys-
temic, because BP’s strate-
gic leaders had repeatedly
failed to put an adequate
safety culture in place.
In 2005, for example, BP
experienced a catastrophic
accident at a Texas oil refin-
ery, which killed 15 work-
ers. A year later, a leaking
BP pipeline caused the largest oil spill ever on Alaska’s
North Slope. BP’s strategic focus on cost reductions, initi-
ated by its strategic leaders a few years earlier, may have
significantly compromised safety across the board. In a fall
2014 ruling, a federal judge declared that BP’s measures
to cut costs despite safety risks “evince an extreme devia-
tion from the standard of care and a conscious disregard of
known risks.”70
In the aftermath of the oil spill, BP faced thousands of
claims by many small-business owners in the tourism and
seafood industries. These business owners were not power-
ful individually, and pursuing valid legal claims meant facing
protracted and expensive court proceedings. As a collective
organized in a class-action lawsuit, however, they were pow-
erful. Moreover, their claims were backed by the U.S. govern-
ment, which has the power to withdraw BP’s business license
or cancel current permits and withhold future ones. Collec-
tively, the small-business owners along the Gulf Coast became
powerful BP stakeholders, with a legitimate and urgent claim
that needed to be addressed. In response, BP agreed to pay
over $25 billion to settle
their claims and cover other
litigation costs.
Even so, this was not
the end of the story for BP.
The oil company was found
to have committed “gross
negligence” (reckless and
extreme behavior) by a
federal court. Additional
fines and other environ-
mental costs added another
$8.5 billion. BP’s total
tab for the Gulf of Mexico
disaster was $56 billion! BP
CEO Bob Dudley sold about
$40 billion in assets, turning BP into a smaller company that
aims to become more profitable in coming years.
Moreover, claiming that BP displayed a “lack of business
integrity” in handling the gulf oil spill, the Environmental
Protection Agency (EPA) banned BP from any new contracts
with the U.S. government. This put BP at a major competitive
disadvantage, because it is unable to acquire new leases for
oil field exploration in the United States, or to continue as
a major supplier of refined fuel to the armed forces, among
other federal contracts.71
Strategy Highlight 2.2
SOURCE: U.S. Coast Guard
2.4 Implications for Strategic Leaders
Executives whose vision and decisions enable their organizations to achieve competitive
advantage demonstrate strategic leadership. Effective strategic leaders use position as well
as informal power and influence to direct the activities of others when implementing the
organization’s strategy. To gain and sustain a competitive advantage, strategic leaders need
to put an effective strategic management process in place. They need to design a process
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that supports strategy formulation and implementation. In particular, strategic leaders have
three options in their strategic toolkit: top-down strategic planning, scenario planning, and
strategy as planned emergence. Each of the three strategy processes has its strengths and
weaknesses.
Strategic leaders also need to consider the rate of change and firm size, both of which
factors affect the effectiveness of a chosen strategy process. The rate of change, internally
and externally, can suggest the more useful planning approach. In a slow-moving and sta-
ble environment, top-down strategic planning might be the most effective. In a fast-moving
and changeable environment, strategy as planned emergence might be the most effective.
As to firm size, larger firms tend to use either a top-down strategic planning process or
scenario planning. Smaller firms may find it easier to implement strategy as planned emer-
gence when feedback loops are short and the ability to respond quickly is keen.
For instance, a nuclear power provider such as Areva in France, providing over 75 percent
of the country’s energy and with the long-term backing of the state, might do well using a
top-down strategy approach. Take the issue of disaster planning. Nuclear accidents, while
rare, have a tremendous impact as seen in Chernobyl, Russia, and Fukushima, Japan, so
power providers need to be prepared. Areva might use scenario planning to prepare for
such a black swan event. Contrast this with fast-moving environments. Internet-based com-
panies, such as Alibaba, Alphabet, Amazon, Facebook, or Uber, tend to use strategy as
planned emergence. In this process, every employee plays a strategic role. When a firm
is using top-down planning or scenario planning, lower-level employees focus mainly
on strategy implementation. As the examples in this chapter have shown, however, any
employee, even at the entry level, can have great ideas that might become strategic initia-
tives with the potential to transform companies.
Strategic leaders are also mindful of the organization’s internal and external stakehold-
ers, because they have a vested claim or interest in the performance and continued survival
of the firm. Using a stakeholder strategy approach enables strategic leaders to manage a
diverse set of stakeholders effectively in order to gain and sustain competitive advantage.
Here we conclude our discussion of the strategic management process, which marks the
end of the “getting started” portion of the AFI framework. The next three chapters cover the
analysis part of the framework, where we begin by studying external and internal analyses
before taking a closer look at competitive advantage, firm performance, and business models.
During her decade as a strategic leader at Facebook, Sheryl
Sandberg has seen the firm become the most successful social
network ever, anywhere. But Facebook has new challenges.
First, there are continued concerns about user privacy.
Facebook has long been criticized for alleged lax handling of
user information and an opaque privacy policy that changed
frequently. More recently, the hot-button privacy issue came
up again as Facebook stopped merging the user data obtained
from the messaging app WhatsApp, which it bought for
almost $20 billion in 2014, with its own. In response to a
CHAPTERCASE 2 Consider This . . .
court ruling in Germany, Face-
book announced it would pause
the ongoing merging process.
This, however, will decrease
Facebook’s ability to finely tar-
get its ads based on a user’s fine-
grained social profile.
Next, critics attacked Face-
book for the rise of fake news
items populating users’ news
Facebook CEO Mark
Zuckerberg and Facebook
COO Sheryl Sandberg.
(left): ©David Ramos/Getty
Images, (right): ©Justin Sullivan/
Getty Images
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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 57
feeds. This rise stems from Facebook’s algorithms that give
prominence to information with higher user engagement.
Outrageous headlines—a hallmark of fake news items—
solicit high levels of user interest. Some critics complained
that populating news feeds with misinformation skewed the
outcome of the 2016 U.S. presidential election. CEO Mark
Zuckerberg dismissed this charge as a “pretty crazy idea.”
Nonetheless, Facebook decided to follow Google’s lead
and to bar fake news sites from using its online advertising,
thereby reducing their prominence.
The issue of fake news in some ways points to a larger
crisis: The ever louder criticism that Facebook is now
more a news organization than a simple social network.
Critics want to see a higher degree of responsibility, simi-
lar to that shown by traditional publishers. Roughly half of
Americans of all ages (and a higher percentage of youth)
get their political news on Facebook. Facebook maintains
that it is agnostic on news content (real news, anyway).
Sandberg has publicly addressed the fake news issue
directly, but less so Facebook’s responsibilities as a new
kind of news publisher.
The issue may not go away. It did not help Facebook’s
case that in late 2016 news broke that Facebook had already
developed a censorship tool, one that could be used to let the
firm monitor news for quality control. Apparently the censor-
ship tool is meant to persuade China to let Facebook back
into the country. In China, access to news is heavily managed
by the state; China is potentially the largest single online
market in the world.72
Questions
1. Describe Sheryl Sandberg’s strategic leadership. Which
qualities stand out to you, and why? Is she an effective
strategy leader? Why, or why not?
2. What current challenges (as detailed in this Chap-
terCase) is Facebook facing? How should Sand-
berg deal with each of them? Please make specific
recommendations.
3. What are the main issues Sandberg brings to the fore in
her TED talk, titled “Why We Have Too Few Women
Leaders”? You can view the 15-minute talk here:
http://bit.ly/1czSD6n. How can your awareness of these
issues help you to be a more effective strategic leader?
How can these issues be addressed?
4. Rumors persist that Sandberg might pursue a politi-
cal career in the future (she was chief of staff to Larry
Summers, former Treasury secretary under President
Bill Clinton). Do you think Sandberg would make a
good politician? Do you think the required qualities of
strategic leadership are the same or similar in business
and politics? Why or why not? Support your arguments.
This chapter examined the role strategic leaders play,
delineated different processes to create strategy, and
explained how to conduct a stakeholder impact analy-
sis. We summarize the discussion in the following
learning objectives and related take-away concepts.
LO 2-1 / Explain the role of strategic leaders
and what they do.
■ Executives whose vision and decisions enable
their organizations to achieve competitive advan-
tage demonstrate strategic leadership.
■ Strategic leaders use formal and informal power
to influence the behavior of other organizational
members to do things, including things they
would not do otherwise.
■ Strategic leaders can have a strong (positive or
negative) performance impact on the organiza-
tions they lead.
LO 2-2 / Outline how you can become a stra-
tegic leader.
■ To become an effective strategic leader, you need
to develop skills to move sequentially through
five different leadership levels: highly capable
individual, contributing team member, compe-
tent manager, effective leader, and executive (see
Exhibit 2.2)
■ The Level-5 strategic leadership pyramid applies
to both distinct corporate positions and personal
growth.
TAKE-AWAY CONCEPTS
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58 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
LO 2-3 / Describe the roles of corporate,
business, and functional managers in strategy
formulation and implementation.
■ Corporate executives must provide answers to the
question of where to compete, whether in indus-
tries, markets, or geographies, and how to create
synergies among different business units.
■ General managers in strategic business units must
answer the strategic question of how to compete
in order to achieve superior performance. They
must manage and align the firm’s different func-
tional areas for competitive advantage.
■ Functional managers are responsible for implement-
ing business strategy within a single functional area.
LO 2-4 / Evaluate top-down strategic plan-
ning, scenario planning, and strategy as
planned emergence.
■ Top-down strategic planning is a sequential, lin-
ear process that works reasonably well when the
environment does not change much.
■ In scenario planning, managers envision what-if
scenarios and prepare contingency plans that can
be called upon when necessary.
■ Strategic initiatives can be the result of top-down
planning or can emerge through a bottom-up
process from deep within the organization. They
have the potential to shape a firm’s strategy.
■ A firm’s realized strategy is generally a combination
of its top-down intended strategy and bottom-up
emergent strategy, resulting in planned emergence.
LO 2-5 / Assess the relationship between
stakeholder strategy and sustainable competi-
tive advantage.
■ Stakeholders are individuals or groups that
have a claim or interest in the performance and
continued survival of the firm. They make spe-
cific contributions for which they expect rewards
in return.
■ Internal stakeholders include stockholders,
employees (for instance, executives, managers,
and workers), and board members.
■ External stakeholders include customers, suppli-
ers, alliance partners, creditors, unions, communi-
ties, governments at various levels, and the media.
■ Several recent black swan events eroded the pub-
lic’s trust in business as an institution and in free
market capitalism as an economic system.
■ The effective management of stakeholders is nec-
essary to ensure the continued survival of the firm
and to sustain any competitive advantage. This is
achieved through stakeholder strategy.
LO 2-6 / Conduct a stakeholder impact
analysis.
■ Stakeholder impact analysis considers the needs
of different stakeholders, which enables the firm
to perform optimally and to live up to the expec-
tations of good citizenship.
■ In a stakeholder impact analysis, managers pay
particular attention to three important stakeholder
attributes: power, legitimacy, and urgency.
■ Stakeholder impact analysis is a five-step process
that answers the following questions for the firm:
1. Who are our stakeholders?
2. What are our stakeholders’ interests and claims?
3. What opportunities and threats do our stake-
holders present?
4. What economic, legal, ethical, and philan-
thropic responsibilities do we have to our
stakeholders?
5. What should we do to effectively address the
stakeholder concerns?
Autonomous actions (p. 43)
Black swan events (p. 40)
corporate social responsibility
(CSR). (p. 52)
Dominant strategic plan (p. 41)
Emergent strategy (p. 43)
Illusion of control (p. 42)
Intended strategy (p. 42)
Level-5 leadership
pyramid (p. 34)
Planned emergence (p. 46)
Realized strategy (p. 43)
Resource-allocation process
(RAP) (p. 45)
Scenario planning (p. 39)
Serendipity (p. 45)
Stakeholders (p. 48)
Stakeholder impact analysis (p. 50)
KEY TERMS
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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 59
Stakeholder strategy (p. 49)
Strategic business unit (SBU) (p. 37)
Strategic initiative (p. 43)
Strategic leadership (p. 32)
Strategic management process (p. 38)
Strategy formulation (p. 36)
Strategy implementation (p. 36)
Top-down strategic planning (p. 38)
Upper-echelons theory (p. 33)
DISCUSSION QUESTIONS
1. In what situations is top-down planning likely
to be superior to bottom-up emergent strategy
development?
2. This chapter introduces three levels appropriate
for strategic considerations (see Exhibit 2.3). In
what situations would some of these levels be
more important than others? For example, what
issues might be considered by the corporate level?
What do you see as the primary responsibilities
of corporate-level executives? When might the
business-level managers bear more responsibility
for considering how to respond to an issue?
In what situations might the functional-level man-
agers have a primary responsibility for consider-
ing an issue? How should the organization ensure
the proper attention to each level of strategy as
needed?
3. Identify an industry that is undergoing intense
competition or is being featured in the business
press. Discuss how scenario planning might be
used by companies to prepare for future events.
Can some industries benefit more than others
from this type of process? Explain why.
ETHICAL/SOCIAL ISSUES
1. BP’s experience in the Gulf of Mexico has made
it the poster company for how not to manage
stakeholder relationships effectively (see Strategy
Highlight 2.2). What advice would you give to
BP’s managers to help them continue to rebuild
stakeholder relationships in the Gulf region and
beyond? How can BP repair its damaged repu-
tation? Brainstorm ways that top management
might leverage the experience gained by reactions
in the Gulf and use that knowledge to motivate
local managers and employees in other locales to
build stakeholder relationships proactively so that
BP avoids this type of negative publicity.
2. This chapter discusses some of the key strategic
leadership issues (such as privacy and fake news)
facing Facebook leaders Sheryl Sandberg and
Mark Zuckerberg. Consider other firms men-
tioned in the chapter such as Amazon, PepsiCo,
Uber, VW, and Starbucks. What social and ethical
issues do the leaders of these firms face today?
Choose a firm or industry and explore the rel-
evant controversial issues it faces. How should
strategic leaders address the major issues you
have identified?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
In many situations, promising ideas emerge from the
lower levels of an organization, only to be discarded
before they can be implemented. It was only extraor-
dinary tenacity and disregard for the policy of selling
only corporate-approved drinks that permitted the
Frappuccino to “bloom” within Starbucks (see Strat-
egy Highlight 2.1).
Some scholars have suggested that companies set
aside up to 2 percent of their budgets for any manager
with budget control to be able to invest in new ideas
within the company.73 Thus, someone with a $100,000
annual budget to manage would be able to invest
$2,000 in cash or staff time toward such a project.
Multiple managers could go in together for somewhat
larger funds or time amounts. Through such a process,
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Who are your stakeholders?
H ow do you think about accomplishing your goals? One way to strategize your success is to use a version of the stakeholder impact analysis. On a personal level, your
internal stakeholders might be immediate family members, and
close personal friends. External stakeholders could be neigh-
bors, peers, funding sources, and managers.
A key aspect presented in this chapter is to consider
the point of view of a variety of stakeholders in meeting the
goals of the firm. The same logic applies to many of your own
personal or career goals as well. For instance, let’s say you are
close to graduating from a university. How do your stakeholders
view your job and career prospects? Do they want you to stay
close to home? Do they encourage you to start a new business?
As noted in the chapter, stakeholders will have different
points of view and also different levels of impact upon your
successes or failures.
1. List your personal goals. Which stakeholders are supportive
of these goals? Which are likely to try to block these goals?
2. Develop a plan to address key stakeholder concerns from
each perspective. Can you find a pathway in the stake-
holder analysis to build support for your key goals?
3. What would it take to implement your ideas/plans to move
forward with these goals?
mySTRATEGY
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60 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
the organization could generate a network of “angel
investors.” Small funds or staff time could be invested
in a variety of projects. Approval mechanisms would
be easier for these small “seed-stock” ideas, to give
them a chance to develop before going for bigger
funding at the top levels of the organization.
What problems would need to be addressed to
introduce this angel-network idea into a firm? Use a
firm someone in your group has worked for or knows
well to discuss possible issues of widely distributing
small funding level approvals across the firm.
//// Small Group Exercise 2
Form small groups of three to four students. Search the
internet on the following topic and debate your findings.
The chapter includes a discussion of black swan
events that were improbable and unexpected yet had
an extreme impact on the well-being of individuals,
firms, and nations. Nassim Nicholas Taleb, author of
The Black Swan, has argued that policy makers and
decision makers need to focus on building more robust
organizations or systems rather than on improving
predictions of events. This notion is reflected in the
response to the predicted increase in powerful storms
and storm surges. Hurricanes Katrina (which devas-
tated New Orleans and parts of the Gulf Coast) and
Sandy (which wreaked havoc on the New Jersey coast)
have stimulated discussions about how to not only
build a more resilient infrastructure and buildings, but
also develop more flexible and effective responses.
For each group, search the internet for options and
plans to (1) build more sustainable communities that
would help areas cope with superstorms, or droughts,
and (2) organize responses to black swan events more
effectively. Brainstorm additional recommendations
that you might make to policy makers.
1. This ChapterCase is based on: Auletta,
K. (2011, July 11), “A woman’s place,” The
New Yorker, July 11; Holms, A. (2013, Mar.
4), “Maybe you should the read book: The
Sheryl Sandberg backlash,” The New Yorker;
Kantor, J. (2013, Feb. 21), “A titan’s how-to
on breaking the glass ceiling,” The New York
Times; “The 2013 Time 100 [The 100 Most
Influential People],” Time, April 18, 2013;
Rothaermel, F.T., and M. McKay (2015),
“Facebook, Inc.,” McGraw-Hill Education
Case Study 121159420477; Sandberg, S.
(2010), “Why We Have Too Few Women
Leaders,” TED talk, http://bit.ly/1czSD6n;
Sandberg, S. (2013), Lean In: Women, Work,
and the Will to Lead (New York: Knopf);
Vara, V. (2015, Mar. 8), “Sheryl Sandberg’s
divisive pitch to #LeanInTogether,” The New
Yorker; “Imperial ambitions,” The Economist,
April 9, 2016; “How to win friends and influ-
ence people,” The Economist, April 9, 2016;
“Robber barons and silicon sultans,” The
Economist, January 3, 2015; “The feminist
mystique,” The Economist, March 16, 2013;
ENDNOTES
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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 61
“The World’s Most Powerful Women in Tech
2016,” Forbes, June 6, 2016; and Parker,
G.G., M.W. Van Alstyne, and S.P. Choudary
(2016), Platform Revolution: How Networked
Markets Are Transforming the Economy—And
How to Make Them Work for You (New York:
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2. Finkelstein, S., D.C. Hambrick, and A.A.
Cannella (2008), Strategic Leadership: The-
ory and Research on Executives, Top Manage-
ment Teams, and Boards (Oxford, UK: Oxford
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Cannella (2008), Strategic Leadership: The-
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ment Teams, and Boards (Oxford, UK: Oxford
University Press); and Yulk, G. (1998), Lead-
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4. Pfeffer, J. (1994), Managing with Power:
Politics and Influence in Organizations
(Boston, MA: Harvard Business School Press).
5. “The acceptable face of Facebook,” The
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6. Hambrick, D.C., and E. Abrahamson
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1427–1441.
7. “The 100 best performing CEOs in the
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8. Bandiera, O., A. Prat, and R. Sadun (2012),
“Managerial capital at the top: Evidence from
the time use of CEOs,” London School of Eco-
nomics and Harvard Business School Working
Paper; and “In defense of the CEO,” The Wall
Street Journal, January 15, 2013. The patterns
of how CEOs spend their time have held in a
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9. Finkelstein, S., D.C. Hambrick, and A.A.
Cannella (2008), Strategic Leadership: The-
ory and Research on Executives, Top Manage-
ment Teams, and Boards (Oxford, UK: Oxford
University Press), 17.
10. Bandiera, O., A. Prat, and R. Sadun
(2012), “Managerial capital at the top: Evi-
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11. Hambrick, D.C. (2007), “Upper echelons
theory: An update,” Academy of Management
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The organization as a reflection of its top
managers,” Academy of Management Review
9: 193–206.
12. Collins, J.C. (2001), Good to Great: Why
Some Companies Make the Leap . . . And Oth-
ers Don’t (New York: HarperBusiness), 3.
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Some Companies Make the Leap . . . And Oth-
ers Don’t (New York: HarperBusiness).
14. As quoted in Auletta, K. (2011, July 11),
“A woman’s place,” The New Yorker.
15. 2016 Walmart Annual Report at http://
bit.ly/1r2LXuV; see also Bowman, J. (2015,
May 12), “The Largest Retailer in History:
How Walmart Sales Reached $500 Billion,”
Motley Fool.
16. 2016 Facebook Annual Report.
17. 2016 Facebook Annual Report; and
Seetharaman, D. (2016, April 28), “Facebook
revenue soars on ad growth,” The Wall Street
Journal.
18. For a superb treatise of the history of
strategy, see Freedman, L. (2013), Strategy: A
History (New York: Oxford University Press).
19. This discussion is based on Mintzberg, H.
(1993), The Rise and Fall of Strategic Plan-
ning: Reconceiving Roles for Planning, Plans,
and Planners (New York: Simon & Schuster);
and Mintzberg, H. (1994), “The fall and rise
of strategic planning,” Harvard Business
Review, January–February: 107–114.
20. Isaacson, W. (2011), Steve Jobs (New
York: Simon & Schuster). See also: Isaacson,
W. (2012, Apr.), “The real leadership lessons
of Steve Jobs,” Harvard Business Review.
21. Jobs, S. (1998, May 25) “There is sanity
returning,” BusinessWeek.
22. Isaacson, W. (2011), Steve Jobs (New
York: Simon & Schuster). See also: Isaacson,
W. (2012, Apr.), “The real leadership lessons of
Steve Jobs,” Harvard Business Review.
23. “CEO Tim Cook pushes employee-
friendly benefits long shunned by Steve Jobs,”
The Wall Street Journal, November 12, 2012.
24. Grove, A.S. (1996), Only the Paranoid
Survive: How to Exploit the Crisis Points that
Challenge Every Company (New York: Cur-
rency Doubleday).
25. UPS 2014 Investor Conference Presenta-
tions, Thursday, November 13; and UPS 2013
Annual Report.
26. Talib, N.N. (2007), The Black Swan: The
Impact of the Highly Improbable (New York:
Random House).
27. Mintzberg, H. (1993), The Rise and Fall
of Strategic Planning: Reconceiving Roles for
Planning, Plans, and Planners (New York:
Simon & Schuster); and Mintzberg, H. (1994),
“The fall and rise of strategic planning,”
Harvard Business Review, January-February:
107–114.
28. Thompson, S.C. (1999), “Illusions of
control: How we overestimate our personal
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29. “FTI Consulting projects U.S. online
retail sales to approach $440 billion in 2017:
online market share expected to nearly double
by 2026,” Global Newswire, November 1,
2016, http://bit.ly/2gChcMs.
30. Kotha, S., V. Rindova, and F.T.
Rothaermel (2001), “Assets and actions:
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by U.S. internet firms: An empirical analysis
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32. Arthur, B.W. (1989), “Competing tech-
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by historical events,” Economic Journal
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(1970), Managing the Resource Allocation
Process (Boston, MA: Harvard Business
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(2005), From Resource Allocation to Strat-
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interaction of strategic behavior, corporate
context, and the concept of strategy,” Acad-
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Burgelman, R.A. (1983), “A process model of
internal corporate venturing in a major diver-
sified firm,” Administrative Science Quarterly
28: 223–244.
33. Based on: Howard Behar, retired presi-
dent, Starbucks North America and Starbucks
International, (2009), Impact Speaker Series
Presentation, College of Management,
Georgia Institute of Technology, October 14.
See also Behar, H. (2007), It’s Not About the
Coffee: Leadership Principles from a Life at
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34. John Rice, GE vice chairman, president,
and CEO, GE Technology Infrastructure
(2009, May 11), presentation at Georgia
Institute of Technology.
35. See MiniCase “Strategy and Serendipity:
A Billion-Dollar Bonanza,” http://mcgrawhill-
create.com/rothaermel.
36. This example is drawn from: “Crispy
‘Saratoga chips’ potato chips invented in Sara-
toga,” at www.saratoga.com/news/saratoga-
chips.cfm; and “George Crum,” at http://
lemelson.mit.edu/resources/george-crum.
37. Levy, S. (2011), In the Plex: How Google
Thinks, Works, and Shapes Our Lives (New
York: Simon & Schuster).
38. Mayer, M. (2006, May 11), “Nine les-
sons learned about creativity at Google,”
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rot27628_ch02_030-063.indd 62 10/30/17 07:47 PM
62 CHAPTER 2 Strategic Leadership: Managing the Strategy Process
presentation at Stanford Technology Ventures
Program.
39. Barr, A., and R. Winkler (2015, Aug.
10), “Google creates parent company called
Alphabet in restructuring,” The Wall Street
Journal.
40. Bower, J.L., and C.G. Gilbert (2005),
From Resource Allocation to Strategy
(Oxford, UK: Oxford University Press).
41. Bower, J.L. (1970), Managing the
Resource Allocation Process (Boston, MA:
Harvard Business School Press); Bower, J.L.,
and C.G. Gilbert (2005), From Resource
Allocation to Strategy (Oxford, UK: Oxford
University Press); Burgelman, R.A. (1983),
“A model of the interaction of strategic behav-
ior, corporate context, and the concept of
strategy,” Academy of Management Review 8:
61–71; and Burgelman, R.A. (1983), “A pro-
cess model of internal corporate venturing in
a major diversified firm,” Administrative Sci-
ence Quarterly 28: 223–244.
42. Burgelman, R.A. (1994), “Fading memo-
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exit in dynamic environments,” Administrative
Science Quarterly 39: 24–56.
43. Burgelman, R.A., and A.S. Grove (1996),
“Strategic dissonance,” California Manage-
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from the oil majors,” Strategic Management
Journal 24: 491–517; Brown, S.L., and K.M.
Eisenhardt (1997), “The art of continuous
change: Linking complexity theory and time-
based evolution in relentlessly shifting organi-
zations,” Administrative Science Quarterly 42:
1–34; Farjourn, M. (2002), “Towards an
organic perspective on strategy,” Strategic
Management Journal 23: 561–594; Mahoney,
J. (2005), Economic Foundation of Strategy
(Thousand Oaks, CA: Sage); and Burgelman,
R.A., and A.S. Grove (2007), “Let chaos
reign, then rein in chaos—repeatedly: Manag-
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ity,” Strategic Management Journal 28(10):
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45. Smith, A. (1776), An Inquiry into the
Nature and Causes of the Wealth of Nations,
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and Co.).
46. Levy, S. (2011), In the Plex: How
Google Thinks, Works, and Shapes Our Lives
(New York: Simon & Schuster); and www.
wolframalpha.com/input/?i=google.
47. “The HP Way,” see www.hpalumni.org/
hp_way.htm; and Packard, D. (1995), HP
Way: How Bill Hewlett and I Built Our Com-
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48. This discussion draws on: Carroll, A.B.,
and A.K. Buchholtz (2012), Business &
Society: Ethics, Sustainability, and Stake-
holder Management (Mason, OH: South-
Western Cengage); Porter, M.E., and M.R.
Kramer (2011), “Creating shared value:
How to reinvent capitalism—and unleash
innovation and growth,” Harvard Business
Review, January–February; Parmar, B.L.,
R.E. Freeman, J.S. Harrison, A.C. Wicks, L.
Purnell, and S. De Colle (2010), “Stakeholder
theory: The state of the art,” Academy of Man-
agement Annals 4: 403–445; and Porter, M.E.,
and M.R. Kramer (2006), “Strategy and soci-
ety: The link between competitive advantage
and corporate social responsibility,” Harvard
Business Review, December: 80–92.
49. See the discussion by Lowenstein, R.
(2010), The End of Wall Street (New York:
Penguin Press); Paulson, H.M. (2010), On the
Brink: Inside the Race to Stop the Collapse
of the Global Financial System (New York:
Business Plus); and Wessel, D. (2010), In
FED We Trust: Ben Bernanke’s War on the
Great Panic (New York: Crown Business).
50. Parmar, B.L., R.E. Freeman, J.S.
Harrison, A.C. Wicks, L. Purnell, and S.
De Colle (2010), “Stakeholder theory: The
state of the art,” Academy of Management
Annals 4: 403–445.
51. Phillips, R. (2003), Stakeholder Theory
and Organizational Ethics (San Francisco:
Berrett-Koehler); Freeman, E.R., and J.
McVea (2001), “A stakeholder approach
to strategic management,” in Hitt, M.A.,
E.R. Freeman, and J.S. Harrison (eds.), The
Blackwell Handbook of Strategic Manage-
ment (Oxford, UK: Blackwell), 189–207; and
Freeman, E.R. (1984), Strategic Manage-
ment: A Stakeholder Approach (Boston, MA:
Pitman).
52. To acknowledge the increasing impor-
tance of stakeholder strategy, the Strategic
Management Society (SMS)—the lead-
ing association for academics, business
executives, and consultants interested in
strategic management—has recently created
a stakeholder strategy division; see http://
strategicmanagement.net/. Also see Ander-
son, R.C. (2009), Confessions of a Radical
Industrialist: Profits, People, Purpose—Doing
Business by Respecting the Earth (New York:
St. Martin’s Press); Sisodia, R.S., D.B. Wolfe,
and J.N. Sheth (2007), Firms of Endearment:
How World-Class Companies Profit from
Passion and Purpose (Upper Saddle River,
NJ: Prentice-Hall Pearson); and Svendsen,
A. (1998), The Stakeholder Strategy: Profit-
ing from Collaborative Business Relation-
ships (San Francisco: Berrett-Koehler).
53. Parmar, B.L., R.E. Freeman, J.S. Har-
rison, A.C. Wicks, L. Purnell, and S. De Colle
(2010), “Stakeholder theory: The state of the
art,” Academy of Management Annals 4: 406.
54. Parmar, B.L., R.E. Freeman, J.S.
Harrison, A.C. Wicks, L. Purnell, and S.
De Colle (2010), “Stakeholder theory: The
state of the art,” Academy of Management
Annals 4: 406.
55. Parmar, B.L., R.E. Freeman, J.S. Harrison,
A.C. Wicks, L. Purnell, and S. De Colle
(2010), “Stakeholder theory: The state of the
art,” Academy of Management Annals 4: 406.
56. “The World’s Most Admired Compa-
nies,” Fortune (2016), http://fortune.com/
worlds-most-admired-companies/.
57. Eesley, C., and M.J. Lenox (2006), “Firm
responses to secondary stakeholder action,”
Strategic Management Journal 27: 765–781;
and Mitchell, R.K., B.R. Agle, and D.J. Wood
(1997), “Toward a theory of stakeholder iden-
tification and salience,” Academy of Manage-
ment Review 22: 853–886.
58. Ostrower, J. (2014, July 30), “Boeing to
build stretched 787–10 in South Carolina,”
The Wall Street Journal.
59. Benoit, D. (2014, Feb. 10), “Icahn ends
Apple push with hefty profit,” The Wall Street
Journal.
60. People for the Ethical Treatment of Ani-
mals (PETA) is an animal-rights organization.
61. This example is drawn from: Esty, D.C.,
and A.S. Winston (2006), Green to Gold: How
Smart Companies Use Environmental Strategy
to Innovate, Create Value, and Build Competi-
tive Advantage (Hoboken, NJ: Wiley).
62. This discussion draws on: Carroll, A.B.,
and A.K. Buchholtz (2012), Business & Soci-
ety: Ethics, Sustainability, and Stakeholder
Management (Mason, OH: South-Western
Cengage); Carroll, A.B. (1991), “The pyramid
of corporate social responsibility: Toward the
moral management of organizational stake-
holders,” Business Horizons, July–August:
39–48; and Carroll, A.B. (1979), “A three-
dimensional, conceptual model of corporate
social performance,” Academy of Management
Review 4: 497–505.
63. For an insightful but critical treatment of
this topic, see the 2003 Canadian documen-
tary film The Corporation.
64. For recent empirical findings concern-
ing the relationship between corporate social
responsibility and firm performance, see
Barnett, M.L., and R.M. Salomon (2012),
“Does it pay to be really good? Addressing
the shape of the relationship between social
and financial performance,” Strategic Man-
agement Journal, 33: 1304–1320; Wang, T.,
and P. Bansal (2012), “Social responsibility
in new ventures: Profiting from a long-term
orientation,”Strategic Management Journal
33: 1135–1153; and Jayachandran, S., K.
Kalaignanam, and M. Eilert (2013), “Prod-
uct and environmental social performance:
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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 63
Varying effect on firm performance,” Strate-
gic Management Journal, 34: 1255–1264.
65. Friedman, M. (1970, Sept. 13), “The
social responsibility of business is to increase
its profits,” The New York Times Magazine.
66. Armour, S. (2015, Oct. 25), “ACA premi-
ums jump 25%; administration acknowledges
extended enrollment,” The Wall Street
Journal.
67. “Wake up and smell the coffee: Star-
bucks’s tax troubles are a sign of things to
come for multinationals,” The Economist,
December 15, 2012.
68. Gates, B. (2008, Aug. 11), “How to help
those left behind,” Time.
69. Carroll, A.B. (1991), “The pyramid of
corporate social responsibility: Toward the
moral management of organizational stake-
holders,” Business Horizons, July–August:
39–48.
70. Gilbert, D., and J. Scheck (2014, Sept. 4),
“BP is found grossly negligent in Deepwater
Horizon disaster,” The Wall Street Journal.
71. Kent, S., and C.M. Matthews (2016, Apr.
26), “BP results still hurt by Gulf of Mexico
spill,” The Wall Street Journal; Gilbert, D.,
and J. Scheck (2014, Sept. 4), “BP is found
grossly negligent in Deepwater Horizon
disaster,” The Wall Street Journal; Gara, T.
(2012, Nov. 28), “U.S. government slams BP’s
‘lack of business integrity,’” The Wall Street
Journal; “BP and the Deepwater Horizon
disaster,” The Economist, November 15, 2012;
Fowler, T. (2012), “BP slapped with record
fine,” The Wall Street Journal, November 15;
and Fowler, T. (2012, Mar. 4), “BP, plaintiffs
reach settlement in Gulf oil spill,” The Wall
Street Journal.
72. Huddleston Jr., T. (2016, Dec. 8), “Sheryl
Sandberg says fake news on Facebook didn’t
sway the election,” Fortune; “False news
items are not the only problem besetting Face-
book,” The Economist, November 26, 2016;
and Isaac, M. (2016, Nov. 22), “Facebook
said to create censorship tool to get back into
China,” The New York Times; White, Z., B.
White, and T. Romm (2016, Oct. 23), “Liber-
als wary as Facebook’s Sandberg eyed for
Treasury,” Politico.
73. Hamel, G. (2007), The Future of Manage-
ment (Boston, MA: Harvard Business School
Publishing).
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CHAPTER External Analysis:
Industry Structure,
Competitive Forces, and
Strategic Groups
Chapter Outline
3.1 The PESTEL Framework
Political Factors
Economic Factors
Sociocultural Factors
Technological Factors
Ecological Factors
Legal Factors
3.2 Industry Structure and Firm Strategy: The Five
Forces Model
Industry vs. Firm Effects in Determining Firm
Performance
Competition in the Five Forces Model
The Threat of Entry
The Power of Suppliers
The Power of Buyers
The Threat of Substitutes
Rivalry among Existing Competitors
A Sixth Force: The Strategic Role of Complements
3.3 Changes over Time: Entry Choices and Industry
Dynamics
Entry Choices
Industry Dynamics
3.4 Performance Differences within the Same
Industry: Strategic Groups
The Strategic Group Model
Mobility Barriers
3.5 Implications for Strategic Leaders
Learning Objectives
LO 3-1 Generate a PESTEL analysis to evaluate the
impact of external factors on the firm.
LO 3-2 Differentiate the roles of firm effects
and industry effects in determining firm
performance.
LO 3-3 Apply Porter’s five competitive forces to
explain the profit potential of different
industries.
LO 3-4 Examine how competitive industry structure
shapes rivalry among competitors.
LO 3-5 Describe the strategic role of complements
in creating positive-sum co-opetition.
LO 3-6 Explain the five choices required for market
entry.
LO 3-7 Appraise the role of industry dynamics and
industry convergence in shaping the firm’s
external environment.
LO 3-8 Generate a strategic group model to reveal
performance differences between clusters
of firms in the same industry.
3
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Airbnb: Disrupting the Hotel
Industry
IN 2007, BRIAN CHESKY
and Joe Gebbia were
roommates in San
Francisco. Both were
industrial designers,
people who shape the
form and function of
everything from coffee
cups to office furniture
to airplane interiors.
But since work gigs
were hit-and-miss for
the aspiring industrial
designers, they could
not afford their rent
payments. On a whim,
they decided to send out
an e-mail on the distribution list for an upcoming industrial
design conference in their hometown: “If you’re heading
out to the [industrial design conference] in San Francisco
next week and have yet to make accommodations, well,
consider networking in your jam-jams. That’s right. For an
affordable alternative to hotels in the city, imagine your-
self in a fellow design industry person’s home, fresh awake
from a snooze on the ol’ air mattress, chatting about the
day’s upcoming events over Pop Tarts and OJ.”
Three people took up the offer, and the two roommates
made some money to subsidize their rent payments. But
more importantly, Chesky and Gebbia felt that they had
stumbled upon a new business idea: Help people rent out
their spare rooms. They then brought on computer scien-
tist Nathan Blecharczyk, one of Gebbia’s former room-
mates, to create a website where hosts and guests could
meet and transact, naming their site AirBedandBreakfast.
com (later shortened to Airbnb). The three entrepreneurs
tested their new site at the 2008 South by Southwest
(SXSW), an annual music, film, and interactive media
conference. SXSW also serves as an informal launch pad
for new ventures; for example, Twitter, the social net-
working and news site, was unveiled at SXSW just a year
earlier to great fanfare. Airbnb’s launch at SXSW flopped,
however, because the conference organizers had exclusive
contracts with local hotels (a fact the Airbnb founders
only learned after the
event), and so confer-
ence organizers didn’t
drive any traffic to
Airbnb’s site.
Not to be discour-
aged, Airbnb decided
to take advantage of
the anticipated short-
age of hotel rooms in
Denver, Colorado, the
site of the Democratic
National Convention
(DNC) in the sum-
mer of 2008. After all
hotels were booked,
the founders prepared
media releases with
titles such as “Grass-
roots Housing for Grassroots Campaign,” which Obama
supporters loved. As luck would have it, Airbnb was cov-
ered in both The New York Times and The Wall Street
Journal. And the newly designed Airbnb site worked! It
facilitated about 100 rentals during the DNC. Soon after
the event, however, website traffic to Airbnb’s site fell
back to zero. To keep going, Chesky and Gebbia decided
to become cereal entrepreneurs, creating “Obama-O’s: The
breakfast of change” and “Cap’n McCains: A maverick in
every bite,” with illustrated images of the 2008 presiden-
tial candidates on 1,000 cereal boxes. After sending sam-
ples to their press contacts and subsequent coverage in the
media, the limited edition cereal sold out quickly, providing
enough cash to keep going with Airbnb a bit longer.
The fledgling venture’s breakthrough came in 2009
when it was accepted into a program run by Y Combinator,
a start-up incubator that has spawned famous tech compa-
nies such as Dropbox, Stripe, and Twitch.tv. In exchange
for equity in the new venture, these start-up accelerators
provide office space, mentoring, and networking oppor-
tunities, including with venture capitalists looking to
fund the next “big thing.” In 2010, Airbnb received fund-
ing from Sequoia Capital, one of the most prestigious
venture capital firms in Silicon Valley, having provided
early-stage capital to companies such as Apple, Google,
CHAPTERCASE 3
©Mike Windle/Getty Images Entertainment/Getty Images
“Brian Chesky, Joe Gebbia, and Nathan Blecharczyk founded Airbnb
on a shoestring budget in 2008. Today, Airbnb is the largest hospitality
platform globally.”
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HOW CAN AN INTERNET startup based on the idea of home sharing disrupt the
global hotel industry, long dominated by corporate giants such as Marriott, Hilton,
or Intercontinental? One reason is that Airbnb, now the world’s largest accommodation
provider, owns no real estate. Instead, Airbnb uses a business model innovation to circum-
vent traditional entry barriers into the hotel industry. Just like Uber, Facebook, or Amazon,
Airbnb provides an online platform for sellers (hosts) and buyers (renters) to connect and
transact (we’ll take a closer look at “Platform Strategy” in Chapter 7). While traditional
hotel chains need years and millions of dollars in real estate investments to add additional
capacity (finding properties, building hotels, staffing and running them, etc.), Airbnb’s
inventory is basically unlimited as long as it can sign up users with spare rooms to rent.
Even more importantly, Airbnb does not need to deploy millions of dollars in capital to
acquire and manage physical assets or manage a large cadre of employees. For example,
Marriott has almost 250,000 employees, while Airbnb’s headcount is some 2,500 employ-
ees (only 1 percent of Marriott’s). Thus, Airbnb can grow much faster and respond much
more quickly to local circumstances affecting the demand and supply of accommodations.
The competitive intensity in the hotel industry is likely to increase especially in high-
traffic metropolitan cities such as New York, Paris, Dubai, and Seoul.
In this chapter, we present a set of frameworks to analyze the firm’s external environment—
that is, the industry in which the firm operates, and the competitive forces that surround the
firm from the outside. We move from a more macro perspective to a more micro understand-
ing of how the external environment affects a firm’s quest for competitive advantage. We
begin with the PESTEL framework, which allows us to scan, monitor, and evaluate changes
and trends in the firm’s macroenvironment. Next, we study Porter’s five forces model of
competition, which helps us to determine an industry’s profit potential. Depending on the
firm’s strategic position, these forces can affect its performance for good or ill. We also take
a closer look at the choices firms must make when considering entry in an industry. We then
move from a static analysis of a firm’s industry environment to a dynamic understanding
of how industries and competition change over time. We also discuss how to think through
entry choices once an attractive industry has been identified. Next we introduce the strategic
group model for understanding performance differences among clusters of firms in the same
industry. Finally, we offer practical Implications for Strategic Leaders.
Oracle, PayPal, YouTube, and WhatsApp. Although not a
first mover in the peer-to-peer rental space, Airbnb, while
at Y Combinator, was the first one to figure out that a sleek
website with professional photos of available rentals made
all the difference. In addition, Airbnb developed a seamless
transaction experience between hosts and guests, allowing it
to make a bit over 10 percent on each transaction conducted
on its rental site. Timing was now much more fortuitous,
with the global financial crisis in full swing, people were
looking for low-cost accommodations while hosts were try-
ing to pay rent or mortgages to keep their homes.
In 2017, a mere 10 years after the two roommates had
sent out the fateful e-mail inviting complete strangers to
share their apartment with them, Airbnb was valued at a
whopping $31 billion! This makes Airbnb the fourth most
valuable private company on the planet, just after Uber ($68
billion); Didi Chuxing, basically China’s version of Uber
($50 billion); and Xiaomi, a Chinese smartphone maker
(46 billion). Even more stunning, Airbnb’s $31 billion
valuation exceeds that of Marriott, the world’s largest
hotel chain. And just like global hotel chains, Airbnb uses
sophisticated pricing and reservation systems for guests to
find, reserve, and pay for rooms to meet their various travel
needs. In this sense, Airbnb is a new entrant that competes
in the global hotel industry. Indeed, with more than 3 mil-
lion listings in over 65,000 cities basically anywhere in the
world (except North Korea), Airbnb offers more accom-
modations than the three biggest hotel chains combined:
Marriott, Hilton, and Intercontinental.1
You will learn more about Airbnb by reading this chapter; related
questions appear in “ChapterCase3 / Consider This. . . .”
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3.1 The PESTEL Framework
A firm’s external environment consists of all the factors that can affect its potential to gain
and sustain a competitive advantage. By analyzing the factors in the external environment,
strategic leaders can mitigate threats and leverage opportunities. One common approach to
understanding how external factors impinge upon a firm is to consider the source or prox-
imity of these factors. For example, external factors in the firm’s general environment are
ones that managers have little direct influence over, such as macroeconomic factors (e.g.,
interest or currency exchange rates). In contrast, external factors in the firm’s task environ-
ment are ones that managers do have some influence over, such as the composition of their
strategic groups (a set of close rivals) or the structure of the industry. We will now look at
each of these environmental layers in detail, moving from a firm’s general environment to
its task environment. Following along in Exhibit 3.1, we will be working from the outer
ring to the inner ring.
The PESTEL model groups the factors in the firm’s general environment into six
segments:
■ Political
■ Economic
■ Sociocultural
■ Technological
■ Ecological
■ Legal
Together these form the acronym PESTEL. The PESTEL model provides a relatively
straightforward way to scan, monitor, and evaluate the important external factors and
trends that might impinge upon a firm. With more open markets and international trade
in recent decades, the PESTEL factors have become more global. Such factors create both
opportunities and threats.
LO 3-1
Generate a PESTEL
analysis to evaluate the
impact of external factors
on the firm.
PESTEL model
A framework that
categorizes and
analyzes an important
set of external factors
(political, economic,
sociocultural,
technological,
ecological, and legal)
that might impinge
upon a firm. These
factors can create
both opportunities and
threats for the firm.
EXHIBIT 3.1 /
The Firm within Its
External Environment,
Industry, and Strategic
Group, Subject to
PESTEL Factors
External Environment
Political Economic
Sociocultural
TechnologicalEcological
Firm
Industry
External Environment
Legal
Strategic Group
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POLITICAL FACTORS
Political factors result from the processes and actions of government bodies that can influ-
ence the decisions and behavior of firms.2
Although political factors are located in the firm’s general environment, where firms
traditionally wield little influence, companies nevertheless increasingly work to shape
and influence this realm. They do so by applying nonmarket strategies—that is, through
lobbying, public relations, contributions, litigation, and so on, in ways that are favor-
able to the firm.3 For example, hotel chains and resort owners have challenged Airbnb
in courts and lobbied local governments, some of which passed regulations to limit or
prohibit short-term rentals. Local residents in New York, San Francisco, Berlin, Paris,
and many other cities are also pressuring local governments to enact more aggressive
rules banning short-term rentals because they argue that companies such as Airbnb
contribute to a shortage of affordable housing by turning entire apartment complexes
into hotels or transforming quiet family neighborhoods into all-night, every-night party
hot spots.
Political and legal factors are closely related, as political pressure often results in
changes in legislation and regulation; we discuss legal factors below.
ECONOMIC FACTORS
Economic factors in a firm’s external environment are largely macroeconomic, affecting
economy-wide phenomena. Managers need to consider how the following five macroeco-
nomic factors can affect firm strategy:
■ Growth rates.
■ Levels of employment.
■ Interest rates.
■ Price stability (inflation and deflation).
■ Currency exchange rates.
GROWTH RATES. The overall economic growth rate is a measure of the change in the
amount of goods and services produced by a nation’s economy. Strategic leaders look to
the real growth rate, which adjusts for inflation. This real growth rate indicates the cur-
rent business cycle of the economy—that is, whether business activity is expanding or
contracting. In periods of economic expansion, consumer and business demands are rising,
and competition among firms frequently decreases. During economic booms, businesses
expand operations to satisfy demand and are more likely to be profitable. The reverse is
generally true for recessionary periods, although certain companies that focus on low-cost
solutions may benefit from economic contractions because demand for their products or
services rises in such times. For customers, expenditures on luxury products are often the
first to be cut during recessionary periods. For instance, you might switch from a $4 venti
latte at Starbucks to a $1 alternative from McDonald’s.
Occasionally, boom periods can overheat and lead to speculative asset bubbles. In the
early 2000s, the United States experienced an asset bubble in real estate.4 Easy credit,
made possible by the availability of subprime mortgages and other financial innovations,
fueled an unprecedented demand in housing. Real estate, rather than stocks, became the
investment vehicle of choice for many Americans, propelled by the common belief that
house prices could only go up. When the housing bubble burst, the deep economic reces-
sion of 2008–2009 began, impacting in some way nearly all businesses in the United States
and worldwide.
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LEVELS OF EMPLOYMENT. Growth rates directly affect the level of employment. In boom
times, unemployment tends to be low, and skilled human capital becomes a scarce and
more expensive resource. As the price of labor rises, firms have an incentive to invest
more into capital goods such as cutting-edge equipment or artificial intelligence (AI).5 In
economic downturns, unemployment rises. As more people search for employment, skilled
human capital is more abundant and wages usually fall.
INTEREST RATES. Another key macroeconomic variable for managers to track is real
interest rates—the amount that creditors are paid for use of their money and the amount
that debtors pay for that use, adjusted for inflation. The economic boom during the early
years in the 21st century, for example, was fueled by cheap credit. Low real interest
rates have a direct bearing on consumer demand. When credit is cheap because interest
rates are low, consumers buy homes, automobiles, computers, and vacations on credit;
in turn, all of this demand fuels economic growth. During periods of low real interest
rates, firms can easily borrow money to finance growth. Borrowing at lower real rates
reduces the cost of capital and enhances a firm’s competitiveness. These effects reverse,
however, when real interest rates are rising. Consumer demand slows, credit is harder to
come by, and firms find it more difficult to borrow money to support operations, pos-
sibly deferring investments.
PRICE STABILITY. Price stability—the lack of change in price levels of goods and
services—is rare. Therefore, companies will often have to deal with changing price
levels, which is a direct function of the amount of money in any economy. When there
is too much money in an economy, we tend to see rising prices—inflation. Indeed, a
popular economic definition of inflation is too much money chasing too few goods and
services.6 Inflation tends to go with lower economic growth. Countries such as Argen-
tina, Brazil, Mexico, and Poland experienced periods of extremely high inflation rates
in recent decades.
Deflation describes a decrease in the overall price level. A sudden and pronounced drop
in demand generally causes deflation, which in turn forces sellers to lower prices to moti-
vate buyers. Because many people automatically think of lower prices from the buyer’s
point of view, a decreasing price level seems at first glance to be attractive. However,
deflation is actually a serious threat to economic growth because it distorts expectations
about the future.7 For example, once price levels start falling, companies will not invest in
new production capacity or innovation because they expect a further decline in prices. In
recent decades, the Japanese economy has been plagued with persistent deflation.
CURRENCY EXCHANGE RATES. The currency exchange rate determines how many dol-
lars one must pay for a unit of foreign currency. It is a critical variable for any com-
pany that buys or sells products and services across national borders. For example, if the
U.S. dollar appreciates against the euro, and so increases in real value, firms need more
euros to buy one dollar. This in turn makes U.S. exports such as Boeing aircraft, Intel
chips, or John Deere tractors more expensive for European buyers and reduces demand
for U.S. exports overall. This process reverses when the dollar depreciates (decreases in
real value) against the euro. In this scenario it would take more dollars to buy one euro,
and European imports such as LVMH luxury accessories or BMW automobiles become
more expensive for U.S. buyers.
In a similar fashion, if the Chinese yuan appreciates in value, Chinese goods imported
into the United States are relatively more expensive. At the same time, Chinese purchasing
power increases, which in turn allows their businesses to purchase more U.S. capital goods
such as sophisticated machinery and other cutting-edge technologies.
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In summary, economic factors affecting businesses are ever-present and rarely static.
Managers need to fully appreciate the power of these factors, in both domestic and global
markets, to assess their effects on firm performance.
SOCIOCULTURAL FACTORS
Sociocultural factors capture a society’s cultures, norms, and values. Because sociocul-
tural factors not only are constantly in flux but also differ across groups, strategic leaders
need to closely monitor such trends and consider the implications for firm strategy. In
recent years, for example, a growing number of U.S. consumers have become more health-
conscious about what they eat. This trend led to a boom for businesses such as Chipotle,
Subway, and Whole Foods. At the same time, traditional fast food companies McDonald’s
and Burger King, along with grocery chains such as Albertsons and Kroger, have all had to
scramble to provide healthier choices in their product offerings.
Demographic trends are also important sociocultural factors. These trends capture
population characteristics related to age, gender, family size, ethnicity, sexual orientation,
religion, and socioeconomic class. Like other sociocultural factors, demographic trends
present opportunities but can also pose threats. The most recent U.S. census revealed that
55 million Americans (16.4 percent of the total population) are Hispanic. It is now the
largest minority group in the United States and growing fast. On average, Hispanics are
also younger and their incomes are climbing quickly. This trend is not lost on companies
trying to benefit from this opportunity. For example, MundoFox and ESPN Deportes (spe-
cializing in soccer) have joined Univision and NBC’s Telemundo in the Spanish-language
television market. In the United States, Univision is now the fifth most popular network
overall, just behind the four major English-language networks (ABC, NBC, CBS, and
Fox). Likewise, advertisers are pouring dollars into the Spanish-language networks to pro-
mote their products and services.8
TECHNOLOGICAL FACTORS
Technological factors capture the application of knowledge to create new processes and
products. Major innovations in process technology include lean manufacturing, Six Sigma
quality, and biotechnology. The nanotechnology revolution, which is just beginning, prom-
ises significant upheaval for a vast array of industries ranging from tiny medical devices to
new-age materials for earthquake-resistant buildings.9 Recent product innovations include
the smartphone, wearable devices such as smart watches, and high-performing electric
cars such as the Tesla Model S. As discussed in the ChapterCase, Airbnb launched a radi-
cal process innovation of offering and renting rooms based on a business model leveraging
the sharing economy. If one thing seems certain, technological progress is relentless and
seems to be picking up speed.10 Not surprisingly, changes in the technological environment
bring both opportunities and threats for companies. Given the importance of a firm’s inno-
vation strategy to competitive advantage, we discuss the effect of technological factors in
greater detail in Chapter 7.
Strategy Highlight 3.1 details how BlackBerry fell victim by not paying sufficient atten-
tion to the PESTEL factors.
ECOLOGICAL FACTORS
Ecological factors involve broad environmental issues such as the natural environment,
global warming, and sustainable economic growth. Organizations and the natural environ-
ment coexist in an interdependent relationship. Managing these relationships in a responsi-
ble and sustainable way directly influences the continued existence of human societies and
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BlackBerry’s Bust
A pioneer in smartphones, BlackBerry was the undisputed
industry leader in the early 2000s. IT managers preferred
BlackBerry. Its devices allowed users to receive e-mail and
other data in real time globally, with enhanced security fea-
tures. For executives, a BlackBerry was not just a tool to
increase productivity—and to free them from their laptops—
but also an important status symbol. As a consequence, by
2008 BlackBerry’s market cap had peaked at $75 billion. Yet
by 2017, this lofty valuation had fallen by almost 95 percent
to a mere $3.9 billion. What happened?
Being Canadian, Jim Balsillie, BlackBerry’s longtime co-
CEO, not surprisingly sees ice hockey as his favorite sport.
He likes to quote Wayne Gretzky, whom many consider the
best ice hockey player ever: “Skate to where the puck is going
to be, not to where it is.” Alas, BlackBerry did not follow that
advice. BlackBerry fell victim to two important PESTEL factors
in its external environment: sociocultural and technological.
Let’s start with technology. The introduction of the
iPhone by Apple in 2007 changed the game in the mobile
device industry. Equipped with a camera, the iPhone’s slick
design offered a user interface with a touchscreen including
a virtual keyboard. The iPhone connected seamlessly to cel-
lular networks and Wi-Fi. Combined with thousands of apps
via the Apple iTunes store, the iPhone provided a powerful
user experience, or as the late Steve Jobs said, “the internet
in your pocket.”
However, BlackBerry engineers and executives initially
dismissed the iPhone as a mere toy with poor security fea-
tures. Everyday users thought differently. They had less con-
cern for encrypted software security than they had desire
for having fun with a device that allowed them to text, surf
the web, take pictures, play games, and do e-mail. Although
BlackBerry devices were great in productivity applications,
such as receiving and responding to e-mail via typing on its
iconic physical keyboard, they provided a poor mobile web
browsing experience.
The second external development that helped erode
BlackBerry’s dominance was sociocultural. Initially, mobile
devices were issued top-down by corporate IT departments.
The only available device for execs was a company-issued
BlackBerry. This made life easy for IT departments ensur-
ing network security. Consumers, however, began to bring
their personal iPhones to work and used them for corporate
communication and productivity applications. This bottom-
up groundswell of the BYOT (“bring your own technology”)
movement forced corporate IT departments to open up their
services beyond the BlackBerry.
Caught in the oncoming gale winds of two PESTEL
factors—technological and sociocultural—BlackBerry was
pushed backward in the smartphone market. Unlike Gretzky,
it failed to skate where the puck was going to be and there-
fore continued to focus on its existing customer base of
corporate IT departments and government. Later, feeble
modifications in product lineup appeared to be “too little, too
late.” Apple continued to drive innovation in the smartphone
industry by bringing out more advanced iPhone models and
enhancing the usefulness of its apps for the various business
and productivity applications.
Let’s think about the rapid progress in mobile computing.
BlackBerry, once an undisputed leader in the smartphone
industry, did not recognize early enough or act upon changes
in the external environment. Consumer preferences changed
quickly as the iPhone and later the iPad became available.
Professionals brought their own Apple or other devices to
work instead of using company-issued BlackBerrys. Although
the Canadian technology company made a valiant effort to
make up lost ground with its new BlackBerry 10 operating
system and several new models, it was too little, too late.11
Strategy Highlight 3.1
NHL great Wayne Gretzky, shown here in 1999,
his final season with the New York Rangers, holds
the record for most career regular-season goals.
©AP Images/JIM ROGASH
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the organizations we create. Managers can no longer separate the natural and the business
worlds; they are inextricably linked.12
Negative examples come readily to mind, as many business organizations have con-
tributed to the pollution of air, water, and land, as well as depletion of the world’s natural
resources. BP’s infamous oil spill in the Gulf of Mexico destroyed fauna and flora along
the U.S. shoreline from Texas to Florida. This disaster led to a decrease in fish and wildlife
populations, triggered a decline in the fishery and tourism industries, and threatened the
livelihood of thousands of people. It also cost BP more than $50 billion and one-half of its
market value (see Strategy Highlight 2.2).
The relationship between organizations and the natural environment need not be adver-
sarial, however. Ecological factors can also provide business opportunities. As we saw in
ChapterCase 1, Tesla is addressing environmental concerns regarding the carbon emis-
sions of gasoline-powered cars by building zero-emission battery-powered vehicles. To
generate the needed energy to charge the batteries in a sustainable way, Tesla integrated
with SolarCity to provide clean-tech energy services for its customers, including decentral-
ized solar power generation and storage via its Powerwall.
LEGAL FACTORS
Legal factors include the official outcomes of political processes as manifested in laws,
mandates, regulations, and court decisions—all of which can have a direct bearing on a
firm’s profit potential. In fact, regulatory changes tend to affect entire industries at once.
Many industries in the United States have been deregulated over the past few decades,
including airlines, telecom, energy, and trucking,
among others.
As noted earlier, legal factors often coexist
with or result from political will. Governments
especially can directly affect firm performance
by exerting both political pressure and legal
sanctions, including court rulings and industry
regulations. Consider how several European
countries and the European Union (EU) apply
political and legal pressure on U.S. tech compa-
nies. European targets include Apple, Amazon,
Facebook, Google, and Microsoft—the five
largest U.S. tech companies—but also start-
ups such as Uber, the taxi-hailing mobile app.
Europe’s policy makers seek to retain control
over important industries ranging from transportation to the internet to ensure that prof-
its earned in Europe by Silicon Valley firms are taxed locally. The EU parliament even
proposed legislation to break up “digital monopolies” such as Google. This proposal
would require Google to offer search services independently as a standalone company
from its other online services, including Google Drive, a cloud-based file storage and
synchronization service. But the EU wariness extends beyond tax revenue: The euro-
zone has much stronger legal requirements and cultural expectations concerning data
privacy. Taken together, political/legal environments can have a direct bearing on a
firm’s performance.
Multiple PESTEL factors, for instance, are affecting the implementation of autonomous
vehicles for commercial and private use. Companies such as Uber, Alphabet (through its
Waymo unit), and Tesla are ready to deploy driverless cars, but political and legal factors are
providing serious challenges and are delaying the widespread use of autonomous vehicles.
The Waymo driverless
car, displayed during a
2016 Google event in
San Francisco, marks
another step in an effort
to revolutionize the way
people get around. Instead
of driving themselves, people
will be chauffeured in
software-controlled vehicles
if Waymo, automakers, and
ride-hailing services such as
Uber realize their vision.
©AP Images/Eric Risberg
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3.2 Industry Structure and Firm Strategy:
The Five Forces Model
INDUSTRY VS. FIRM EFFECTS IN DETERMINING FIRM
PERFORMANCE
Firm performance is determined primarily by two factors: industry and firm effects.
Industry effects describe the underlying economic structure of the industry. They attribute
firm performance to the industry in which the firm competes. The structure of an industry
is determined by elements common to all industries, elements such as entry and exit barri-
ers, number and size of companies, and types of products and services offered. In a series
of empirical studies, academic researchers have found that about 20 percent of a firm’s
profitability depends on the industry it is in.13 To more fully comprehend how external
factors affect firm strategy and performance, we take a closer look in this chapter at an
industry’s underlying structure.
Firm effects attribute firm performance to the actions strategic leaders take. In
Chapter 4, we look inside the firm to understand why firms within the same industry differ,
and how differences among firms can lead to competitive advantage
For now, the key point is that strategic leaders’ actions tend to be more important in
determining firm performance than the forces exerted on the firm by its external envi-
ronment.14 Empirical research studies indicate that a firm’s strategy can explain up to
55 percent of its performance.15 Exhibit 3.2 shows these findings.
Although a firm’s industry is not quite as important as the firm’s strategy within its
industry, they jointly determine roughly 75 percent of overall firm performance. The
remaining 25 percent relates partly to business cycles and other effects.
We now move one step closer to the firm (in the center of Exhibit 3.1) and come to the
industry in which it competes. An industry is a group of incumbent companies facing
more or less the same set of suppliers and buyers. Firms competing in the same industry
tend to offer similar products or services to meet specific customer needs. Although the
PESTEL framework allows us to scan, monitor, and evaluate the external environment
to identify opportunities and threats, industry analysis provides a more rigorous basis
not only to identify an industry’s profit potential—the level of profitability that can be
expected for the average firm—but also to derive implications for one firm’s strategic
position within an industry. A firm’s strategic position relates to its ability to create value
for customers (V) while containing the cost to do so (C). Competitive advantage flows to
firm effects Firm
performance attributed
to the actions managers
take.
LO 3-2
Differentiate the roles of
firm effects and industry
effects in determining
firm performance.
industry effects Firm
performance attributed
to the structure of the
industry in which the
firm competes.
EXHIBIT 3.2 /
Industry, Firm,
and Other Effects
Explaining Superior
Firm Performance
Up to 55%
~25%
~20%
Other Effects
(Business Cycle Effects,
Unexplained Variance)
Firm Effects
Industry Effects
industry A group of
incumbent companies
that face more or
less the same set of
suppliers and buyers.
industry analysis
A method to (1) identify
an industry’s profit
potential and (2) derive
implications for a firm’s
strategic position within
an industry.
strategic position
A firm’s strategic profile
based on the difference
between value creation
and cost (V − C ).
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the firm that is able to create as large a gap as possible between the value the firm’s product
or service generates and the cost required to produce it (V − C).
Michael Porter developed the highly influential five forces model to help managers
understand the profit potential of different industries and how they can position their
respective firms to gain and sustain competitive advantage.16 By combining theory from
industrial organization economics with hundreds of detailed case studies, Porter derived
two key insights that form the basis of his seminal five forces model:
1. Rather than defining competition narrowly as the firm’s closest competitors to explain
and predict a firm’s performance, competition must be viewed more broadly, to also
encompass the other forces in an industry: buyers, suppliers, potential new entry of
other firms, and the threat of substitutes.
2. The profit potential of an industry is neither random nor entirely determined by
industry-specific factors. Rather, it is a function of the five forces that shape competi-
tion: threat of entry, power of suppliers, power of buyers, threat of substitutes, and
rivalry among existing firms.
COMPETITION IN THE FIVE FORCES MODEL
Because the five forces model has especially powerful implications for strategy and com-
petitive advantage, we will explore it in some detail. We start with the concept of competi-
tion. The first major insight this model provides is that competition involves more than just
creating economic value; firms must also capture a significant share of it or they will see
the economic value they create lost to suppliers, customers, or competitors. Firms create
economic value by expanding as much as possible the gap between the value (V) the firm’s
product or service generates and the cost (C) to produce it. Economic value thus equals V
minus C. To succeed, creating value is not enough. Firms must also be able to capture a
significant share of the value created to gain and sustain a competitive advantage.
In Porter’s five forces model, competition is more broadly defined beyond the firm’s clos-
est competitors (e.g., Nike versus Under Armour, The Home Depot versus Lowe’s, Merck ver-
sus Pfizer, and so on) to include other industry forces: buyers, suppliers, potential new entry
of other firms, and the threat of substitutes. Competition describes the struggle among these
forces to capture as much of the economic value created in an industry as possible. A firm’s
strategic leaders, therefore, must be concerned not only with the intensity of rivalry among
direct competitors, but also with the strength of the other competitive forces that are attempt-
ing to extract part or all of the economic value the firm creates. When faced with competition
in this broader sense, strategy explains how a firm is able to achieve superior performance.
The second major insight from the five forces model is that it enables managers to not
only understand their industry environment but also shape their firm’s strategy. As a rule
of thumb, the stronger the five forces, the lower the industry’s profit potential—making the
industry less attractive for competitors. The reverse is also true: the weaker the five forces,
the greater the industry’s profit potential—making the industry more attractive. Therefore,
from the perspective of a strategic leader of an existing firm competing for advantage in
an established industry, the company should be positioned in a way that relaxes the con-
straints of strong forces and leverages weak forces. The goal of crafting a strategic position
is of course to improve the firm’s ability to achieve and sustain a competitive advantage.
Strategy Highlight 3.2 provides an overview of the five competitive forces that shape
strategy, with an application to the U.S. domestic airline industry. We will take up the topic
of competitive positioning in Chapter 6 when studying business-level strategy in more detail.
Taking a closer look at the U.S. domestic airline industry in Strategy Highlight 3.2
shows how the five forces framework is a powerful and versatile tool to analyze industries.
five forces model
A framework that
identifies five forces
that determine the profit
potential of an industry
and shape a firm’s
competitive strategy.
LO 3-3
Apply Porter’s five
competitive forces
to explain the profit
potential of different
industries.
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The Five Forces in the Airline Industry
Although many of the mega-airlines such as American, Delta,
and United have lost billions of dollars over the past few
decades and continue to struggle to generate consistent
profitability, other players in this industry have been quite
profitable because they were able to extract some of the eco-
nomic value created. The airlines, however, benefited from
a windfall because the prices for jet fuel fell from a high of
$3.25 per gallon (in 2011) to $1.50 (in 2015), giving some
reprieve to cash-strapped airlines. Nonetheless, competition
remains intense in this industry.
Entry barriers are relatively low, resulting in a number
of new airlines popping up. To enter the industry (on a small
scale, serving a few select cities), a prospective new entrant
needs only a couple of airplanes, which can be rented; a few
pilots and crew members; some routes connecting city pairs;
and gate access in airports. Indeed, despite notoriously low
industry profitability, Virgin America entered the U.S. mar-
ket in 2007. Virgin America is the brainchild of Sir Richard
Branson, founder and chairman of the Virgin Group, a UK con-
glomerate of hundreds of companies using the Virgin brand,
including the international airline Virgin Atlantic. Its business
strategy is to offer low-cost service between major metropoli-
tan cities on the American East and West Coasts. (In 2016,
Alaska Airlines acquired Virgin America for $2.6 billion).
To make matters worse, substitutes are also read-
ily available: If prices are seen as too high, customers can
drive their cars or use the train or bus. As an example, the
route between Atlanta and Orlando (roughly 400 miles) used
to be one of Delta’s busiest and most profitable. Given the
increasing security delays at airports, more and more people
now prefer to drive. Taken together, the competitive forces
are quite unfavorable for generating a profit potential in the
airline industry: low entry barriers, high supplier power, high
buyer power combined with low customer switching costs,
and the availability of low-cost substitutes. This type of hos-
tile environment leads to intense rivalry among existing air-
lines and low overall industry profit potential.
In the airline industry, the supplier power is also
strong. The providers of airframes (e.g., Boeing or Airbus),
makers of aircraft engines (e.g., GE or Rolls-Royce), air-
craft maintenance companies (e.g., Goodrich), caterers (e.g.,
Marriott), labor unions, and airports controlling gate access
all bargain away the profitability of airlines. Moreover, large
corporate customers can contract with airlines to serve all of
their employees’ travel needs; such powerful buyers fur-
ther reduce profit margins for air carriers. To make matters
worse, consumers primarily make decisions based on price.
As a consequence of these powerful industry forces, the
nature of rivalry among airlines is incredibly intense.
In inflation-adjusted dollars, ticket prices have been falling
since industry deregulation in 1978. Thanks to internet travel
sites such as Orbitz, Travelocity, and Kayak, price compari-
sons are effortless. Consumers benefit from cut-throat price
competition between carriers and capture significant value.
Low switching costs and nearly perfect information combine
to strengthen buyer power.
The surprising conclusion is that while the mega-airlines
themselves (i.e., American, Delta, and United) frequently
struggle to make a profit, the other players in the industry—
such as the suppliers of aircraft engines, aircraft mainte-
nance companies, IT companies providing reservation and
logistics services, caterers, airports, and so on—are quite
profitable, all extracting significant value from the air trans-
portation industry. Customers also are better off, as ticket
prices have decreased and travel choices increased.17
Strategy Highlight 3.2
The five forces model allows strategic leaders to analyze all players using a wider industry
lens, which in turn enables a deeper understanding of an industry’s profit potential. More-
over, a five forces analysis provides the basis for how a firm should position itself to gain
and sustain a competitive advantage. We are now ready to look more closely at each of the
five competitive forces.
As Exhibit 3.3 shows, Porter’s model identifies five key competitive forces that managers
need to consider when analyzing the industry environment and formulating competitive strategy:
1. Threat of entry.
2. Power of suppliers.
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3. Power of buyers.
4. Threat of substitutes.
5. Rivalry among existing competitors.
THE THREAT OF ENTRY
The threat of entry describes the risk that potential competitors will enter the industry.
Potential new entry depresses industry profit potential in two major ways:
1. With the threat of additional capacity coming into an industry, incumbent firms may
lower prices to make entry appear less attractive to the potential new competitors,
which would in turn reduce the overall industry’s profit potential, especially in indus-
tries with slow or no overall growth in demand. Consider the market for new micro-
waves. Demand consists of the replacement rate for older models and the creation of
new households. Since this market grows slowly, if at all, any additional entry would
likely lead to excess capacity and lower prices overall.
2. The threat of entry by additional competitors may force incumbent firms to spend more
to satisfy their existing customers. This spending reduces an industry’s profit potential,
especially if firms can’t raise prices. Consider how Starbucks has chosen to constantly
upgrade and refresh its stores and service offerings. Starbucks has over 13,000 U.S. stores
and more than 25,000 globally. By raising the value of its offering in the eyes of the con-
sumers, it slows others from entering the industry or from rapidly expanding. This allows
Starbucks to hold at bay smaller regional competitors, such as Peet’s Coffee & Tea, with
fewer than 200 stores mostly on the West Coast, and prevents smaller national chains,
such as Caribou Coffee, with 415 stores nationally, from increasing the level of competi-
tion. Starbucks is willing to accept a lower profit margin to maintain its market share.
Of course, the more profitable an industry, the more attractive it is for new competi-
tors to enter. There are, however, a number of important barriers to entry that raise the
costs for potential competitors and reduce the threat of entry. Entry barriers, which are
EXHIBIT 3.3 /
Porter’s Five Forces
Model
SOURCE: Porter, M. E.
(2008, Jan.). “The five
competitive forces that
shape strategy,” Harvard
Business Review.
Rivalry
among
Existing
Competitors
Bargaining Power
of Suppliers
Bargaining
Power of Buyers
Threat of New
Entrants
Threat of Substitute
Products or Services
threat of entry
The risk that potential
competitors will enter
an industry.
entry barriers
Obstacles that
determine how easily
a firm can enter an
industry and often
significantly predict
industry profit potential.
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advantageous for incumbent firms, are obstacles that determine how easily a firm can enter
an industry. Incumbent firms can benefit from several important sources of entry barriers:
■ Economies of scale.
■ Network effects.
■ Customer switching costs.
■ Capital requirements.
■ Advantages independent of size.
■ Government policy.
■ Credible threat of retaliation.
ECONOMIES OF SCALE. Economies of scale are cost advantages that accrue to firms with
larger output because they can spread fixed costs over more units, employ technology more
efficiently, benefit from a more specialized division of labor, and demand better terms
from their suppliers. These factors in turn drive down the cost per unit, allowing large
incumbent firms to enjoy a cost advantage over new entrants that cannot muster such scale.
We saw the important relationship between scale and production cost in ChapterCase 1
when featuring Tesla, a U.S. manufacturer of all-electric vehicles. Usually entrants into the
broad automobile industry need large-scale production to be efficient. Tesla leveraged new
technology to circumvent this entry barrier. Yet, reaching sufficient manufacturing scale to
be cost-competitive is critical for Tesla as it is moving more into the mass market.
To benefit from economies of scale, Tesla is introducing new models, helping it move
away from small-scale and costly production of niche vehicles to larger production runs of
cars with a stronger mass-market appeal. Tesla’s first vehicle, the Roadster (costing over
$110,000) was more or less a prototype to prove the viability of an all-electric car that outper-
forms high-performance traditional sports cars. For consumers, it created a new mind-set of
what electric cars can do. Tesla ended production of the Roadster to focus more fully on its
next model: the family sedan, Model S (over $70,000). Tesla’s manufacturing scale increased
more than 50-fold, from some 2,500 Roadsters to 125,000 Model S’s. The all-electric car
company is hoping for an even broader customer appeal
with its Model 3, a smaller and lower-priced vehicle
(starting at $35,000) that will allow the new company
to break into the mass market and manufacture many
more cars. Tesla CEO Elon Musk set an audacious goal
of selling 500,000 cars a year by 2018, which is needed
for the company to be profitable.18 Tesla’s new product
introductions over time are motivated by an attempt to
capture benefits that accrue to economies of scale. To
capture benefits from economies of scale including
lower unit cost, Musk hopes that Tesla can increase its
production volume from a mere 50,000 vehicles in 2015
to 1 million cars a year by 2020.
NETWORK EFFECTS. Network effects describe the
positive effect that one user of a product or service has on the value of that product or ser-
vice for other users. When network effects are present, the value of the product or service
increases with the number of users. This is an example of a positive externality. The threat
of potential entry is reduced when network effects are present.
For example, Facebook, with 2 billion active users worldwide, enjoys tremendous net-
work effects, making it difficult for more recent entrants such as Google Plus to compete
effectively. We will discuss network effects in more detail in Chapter 7.
network effects The
value of a product or
service for an individual
user increases with the
number of total users.
Facebook CEO Mark
Zuckerberg speaks about
Facebook Graph Search, intro-
duced in 2013. Facebook’s 2
billion active users reinforce
its strong network effects.
©AP Images/Jeff Chiu
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CUSTOMER SWITCHING COSTS. Switching costs are incurred by moving from one sup-
plier to another. Changing vendors may require the buyer to alter product specifications,
retrain employees, and/or modify existing processes. Switching costs are onetime sunk
costs, which can be quite significant and a formidable barrier to entry. For example, a firm
that has used enterprise resource planning (ERP) software from SAP for many years will
incur significant switching costs when implementing a new ERP system from Oracle.
CAPITAL REQUIREMENTS. Capital requirements describe the “price of the entry ticket”
into a new industry. How much capital is required to compete in this industry, and which
companies are willing and able to make such investments? Frequently related to economies
of scale, capital requirements may encompass investments to set up plants with dedicated
machinery, run a production process, and cover start-up losses.
Tesla made a sizable capital investment of roughly $150 million when it purchased
the Fremont, California, manufacturing plant from Toyota and upgraded it with a highly
automated production process using robots to produce cars of the highest quality at large
scale.19 This strategic commitment, however, is dwarfed by the $5 billion that Tesla is
investing to build its battery “gigafactory” in Nevada.20 The new factory allows Tesla to
not only secure supplies of lithium-ion batteries, the most critical and expensive compo-
nent of an all-electric car, but also build as many as 1 million vehicles a year.21 In such
cases, the likelihood of entry is determined by not only the level of capital investment
required to enter the industry, but also the expected return on investment. The potential
new entrant must carefully weigh the required capital investments, the cost of capital, and
the expected return. Taken together, the threat of entry is high when capital requirements
are low in comparison to the expected returns. If an industry is attractive enough, efficient
capital markets are likely to provide the necessary funding to enter an industry. Capital,
unlike proprietary technology and industry-specific know-how, is a fungible resource that
can be relatively easily acquired in the face of attractive returns.
ADVANTAGES INDEPENDENT OF SIZE. Incumbent firms often possess cost and quality
advantages that are independent of size. These advantages can be based on brand loy-
alty, proprietary technology, preferential access to raw materials and distribution channels,
favorable geographic locations, and cumulative learning and experience effects.
Tesla has loyal customers, which strengthens its competitive position and reduces
the threat of entry into the all-electric car segment, at least by other start-up compa-
nies.22 Unlike GM or Ford, which spend billions each year on advertising, Tesla doesn’t
have a large marketing budget. Rather, it relies on word of mouth. It luckily has its own
“cool factor” of being different, similar to Apple in its early days. Tesla can back this per-
ception with beautifully designed cars of top-notch quality made domestically in Califor-
nia. Indeed, when Consumer Reports tested the Model S, the usually understated magazine
concluded: “The Tesla Model S is the best car we ever tested.”23 In addition, many Tesla
owners feel an emotional connection to the company because they deeply believe in the
company’s vision “to accelerate the world’s transition to sustainable energy.”
Preferential access to raw materials and key components can bestow absolute cost
advantages. As mentioned, lithium-ion batteries are not only the most expensive and
critical parts of an all-electric vehicle, but they are also in short supply. Tesla’s new bat-
tery “gigafactory” will afford it independence from the few worldwide suppliers, such
as Panasonic of Japan, and also likely bestow an absolute cost advantage.24 This should
further reduce the threat of new entry in the all-electric vehicle segment, assuming no
radical technological changes are to be expected in battery-cell technology in the next
few years.
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Favorable locations, such as Silicon Valley for Tesla, often present advantages that other
locales cannot match easily, including access to human and venture capital, and world-
class research and engineering institutions.
Finally, incumbent firms often benefit from cumulative learning and experience effects
accrued over long periods of time. Tesla now has more than 10 years of experience in
designing and building high-performance all-electric vehicles of superior quality and
design. Attempting to obtain such deep knowledge within a shorter time frame is often
costly, if not impossible, which in turn constitutes a formidable barrier to entry.
GOVERNMENT POLICY. Frequently government policies restrict or prevent new entrants.
Until recently, India did not allow foreign retailers such as Walmart or IKEA to own stores
and compete with domestic companies in order to protect the country’s millions of small
vendors and wholesalers. China frequently requires foreign companies to enter joint ven-
tures with domestic ones and to share technology.
In contrast, deregulation in industries such as airlines, telecommunications, and truck-
ing have generated significant new entries. Therefore, the threat of entry is high when
restrictive government policies do not exist or when industries become deregulated.
CREDIBLE THREAT OF RETALIATION. Potential new entrants must also anticipate how
incumbent firms will react. A credible threat of retaliation by incumbent firms often deters
entry. Should entry still occur, however, incumbents are able to retaliate quickly, through
initiating a price war, for example. The industry profit potential can in this case easily
fall below the cost of capital. Incumbents with deeper pockets than new entrants are able
to withstand price competition for a longer time and wait for the new entrants to exit the
industry—then raise prices again. Other weapons of retaliation include increased product
and service innovation, advertising, sales promotions, and litigation.
Potential new entrants should expect a strong and vigorous response beyond price com-
petition by incumbent firms in several scenarios. If the current competitors have deep pock-
ets, unused excess capacity, reputational clout with industry suppliers and buyers, a history
of vigorous retaliation during earlier entry attempts, or heavy investments in resources
specific to the core industry and ill-suited for adaptive use, then they are likely to press
these advantages. Moreover, if industry growth is slow or stagnant, incumbents are more
likely to retaliate against new entrants to protect their market share, often initiating a price
war with the goal of driving out these new entrants.
In contrast, the threat of entry is high when new entrants expect that incumbents will
not or cannot retaliate. For example, in the southeastern United States, TV cable company
Comcast has entered the market for residential and commercial telephone services and
internet connectivity (as an ISP, internet service provider), emerging as a direct competitor
for AT&T. Comcast also acquired NBC Universal, combining delivery and content. AT&T
responded to Comcast’s threat by introducing U-verse, a product combining high-speed
internet access with cable TV and telephone service, all provided over its fast fiber-optic
network.
THE POWER OF SUPPLIERS
The bargaining power of suppliers captures pressures that industry suppliers can exert on
an industry’s profit potential. This force reduces a firm’s ability to obtain superior perfor-
mance for two reasons: Powerful suppliers can raise the cost of production by demanding
higher prices for their inputs or by reducing the quality of the input factor or service level
delivered. Powerful suppliers are a threat to firms because they reduce the industry’s profit
potential by capturing part of the economic value created.
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To compete effectively, companies generally need a wide variety of inputs into the pro-
duction process, including raw materials and components, labor (via individuals or labor
unions, when the industry faces collective bargaining), and services. The relative bargain-
ing power of suppliers is high when
■ The supplier’s industry is more concentrated than the industry it sells to.
■ Suppliers do not depend heavily on the industry for a large portion of their revenues.
■ Incumbent firms face significant switching costs when changing suppliers.
■ Suppliers offer products that are differentiated.
■ There are no readily available substitutes for the products or services that the suppliers offer.
■ Suppliers can credibly threaten to forward-integrate into the industry.
In Strategy Highlight 3.2, we noted that the airline industry faces strong supplier power.
Let’s take a closer look at one important supplier group to this industry: Boeing and Airbus,
the makers of large commercial jets. The reason airframe manufacturers are powerful sup-
pliers to airlines is because their industry is much more concentrated (only two firms) than
the industry it sells to. Compared to two airframe suppliers, there are hundreds of com-
mercial airlines around the world. Given the trend of large airlines merging to create even
larger mega-airlines, however, increasing buyer power may eventually balance this out
a bit. Nonetheless, the airlines face nontrivial switching costs when changing suppliers
because pilots and crew would need to be retrained to fly a new type of aircraft, main-
tenance capabilities would need to be expanded, and some routes may even need to be
reconfigured due to differences in aircraft range and passenger capacity. Moreover, while
some of the aircraft can be used as substitutes, Boeing and Airbus offer differentiated prod-
ucts. This fact becomes clearer when considering the most recent models from each com-
pany. Boeing introduced the 787 Dreamliner to capture long-distance point-to-point travel
(close to an 8,000-mile range, sufficient to fly nonstop from Los Angeles to Sydney), while
Airbus introduced the A-380 Superjumbo to focus on high-volume transportation (close to
900 passengers) between major airport hubs (e.g., Tokyo’s Haneda Airport and Singapore’s
Changi International Airport). When considering long-distance travel, there are no readily
available substitutes for commercial airliners, a fact that strengthens supplier power.
All in all, the vast strengths of these factors lead us to conclude that the supplier power
of commercial aircraft manufacturers is quite significant. This puts Boeing and Airbus in a
strong position to extract profits from the airline industry, thus reducing the profit potential
of the airlines themselves.
Although the supplier power of Boeing and Airbus is strong, several factors moderate
their bargaining positions somewhat. First, the suppliers of commercial airliners depend
heavily on commercial airlines for their revenues. Second, Boeing and Airbus are unlikely to
threaten forward integration and become commercial airlines themselves. Third, Bombardier
of Canada and Embraer of Brazil, both manufacturers of smaller commercial airframes, have
begun to increase the size of the jets they offer and thus now compete with some of the
smaller planes such as Boeings 737 and Airbus A-320. Finally, industry structures are not
static, but can change over time. In the past few years, several of the remaining large domestic
U.S. airlines have merged (Delta and Northwest, United and Continental, and American and
U.S. Airways), which changed the industry structure in their favor. There are now fewer but
even larger airlines remaining. This fact increases their buyer power, which we turn to next.
THE POWER OF BUYERS
In many ways, the bargaining power of buyers is the flip side of the bargaining power
of suppliers. Buyers are the customers of an industry. The power of buyers concerns the
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pressure an industry’s customers can put on the producers’ margins in the industry by
demanding a lower price or higher product quality. When buyers successfully obtain price
discounts, it reduces a firm’s top line (revenue). When buyers demand higher quality and
more service, it generally raises production costs. Strong buyers can therefore reduce
industry profit potential and a firm’s profitability. Powerful buyers are a threat to the pro-
ducing firms because they reduce the industry’s profit potential by capturing part of the
economic value created.
As with suppliers, an industry may face many different types of buyers. The buyers of
an industry’s product or service may be individual consumers—like you or me when we
decide which provider we want to use for our wireless devices. In many areas, you can
choose between several providers such as AT&T, Sprint, T-Mobile, or Verizon. Although
we might be able to find a good deal when carefully comparing their individual service
plans, as individual consumers we generally do not have significant buyer power. On the
other hand, large institutions such as businesses or universities have significant buyer
power when deciding which provider to use for their wireless services, because they are
able to sign up or move several thousand employees at once.
The power of buyers is high when
■ There are a few buyers and each buyer purchases large quantities relative to the size of
a single seller.
■ The industry’s products are standardized or undifferentiated commodities.
■ Buyers face low or no switching costs.
■ Buyers can credibly threaten to backwardly integrate into the industry.
In addition, companies need to be aware of situations when buyers are especially price
sensitive. This is the case when
■ The buyer’s purchase represents a significant fraction of its cost structure or procure-
ment budget.
■ Buyers earn low profits or are strapped for cash.
■ The quality (cost) of the buyers’ products and services is not affected much by the qual-
ity (cost) of their inputs.
The retail giant Walmart provides perhaps the most potent example of tremendous
buyer power. Walmart is not only the largest retailer worldwide (with 12,000 stores and
over 2 million employees), but it is also one of the largest companies in the world (with
some $500 billion in revenues in 2017). Walmart is one of the few large big-box global
retail chains and frequently purchases large quantities from its suppliers. Walmart lever-
ages its buyer power by exerting tremendous pressure on its suppliers to lower prices and
to increase quality or risk losing access to shelf space at the largest retailer in the world.
Walmart’s buyer power is so strong that many suppliers co-locate offices
next to Walmart’s headquarters in Bentonville, Arkansas, because such
proximity enables Walmart’s managers to test the suppliers’ latest products
and negotiate prices.
The bargaining power of buyers also increases when their switching costs
are low. Having multiple suppliers of a product category located close to
its headquarters allows Walmart to demand further price cuts and quality
improvements because it can easily switch from one supplier to the next.
This threat is even more pronounced if the products are non-differentiated
commodities from the consumer’s perspective. For example, Walmart can
easily switch from Rubbermaid plastic containers to Sterlite containers by offering more
shelf space to the producer that offers the greatest price cut or quality improvement.
©niloo138/123RF
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Buyers are also powerful when they can credibly threaten backward integration. Back-
ward integration occurs when a buyer moves upstream in the industry value chain, into the
seller’s business. Walmart has exercised the threat to backward-integrate by producing a
number of products as private-label brands such as Equate health and beauty items, Ol’Roy
dog food, and Parent’s Choice baby products. Taken together, powerful buyers have the
ability to extract a significant amount of the value created in the industry, leaving little or
nothing for producers.
In regard to any of the five forces that shape competition, it is important to note that
their relative strengths are context-dependent. For example, the Mexican multinational
CEMEX, one of the world’s leading cement producers, faces very different buyer power
in the United States than domestically. In the United States, cement buyers consist of a
few large and powerful construction companies that account for a significant percent-
age of CEMEX’s output. The result? Razor-thin margins. In contrast, the vast majority of
CEMEX customers in its Mexican home market are numerous, small, individual customers
facing a few large suppliers, with CEMEX being the biggest. CEMEX earns high profit
margins in its home market. With the same undifferentiated product, CEMEX competes in
two different industry scenarios in terms of buyer strength.
THE THREAT OF SUBSTITUTES
Substitutes meet the same basic customer needs as the industry’s product but in a different
way. The threat of substitutes is the idea that products or services available from outside
the given industry will come close to meeting the needs of current customers.25 For exam-
ple, many software products are substitutes to professional services, at least at the lower
end. Tax preparation software such as Intuit’s TurboTax is a substitute for professional
services offered by H&R Block and others. LegalZoom, an online legal documentation
service, is a threat to professional law firms. Other examples of substitutes are energy
drinks versus coffee, videoconferencing versus business travel, e-mail versus express
mail, gasoline versus biofuel, and wireless telephone services versus Voice over Internet
Protocol (VoIP), offered by Skype or now many apps such as Facebook’s WhatsApp or
Tencent’s WeChat.
A high threat of substitutes reduces industry profit potential by limiting the price the
industry’s competitors can charge for their products and services. The threat of substitutes
is high when:
■ The substitute offers an attractive price-performance trade-off.
■ The buyers cost of switching to the substitute is low.
The movie rental company Redbox, which uses 44,000 kiosks in the United States
to make movie rentals available for just $2, is a substitute for buying movie DVDs. For
buyers, video rental via Redbox offers an attractive price-performance trade-off with low
switching costs in comparison to DVD ownership. Moreover, for customers that view only
a few movies a month, Redbox is also a substitute for Netflix’s on-demand internet movie
streaming service, which costs $9.99 a month. Rather than a substitute, however, Redbox is
a direct competitor to Netflix’s DVD rental business, where plans cost $7.99 a month (for
one DVD out at a time).
In addition to a lower price, substitutes may also become more attractive by offering
a higher value proposition.26 In Spain, some 6 million people travel annually between
Madrid and Barcelona, roughly 400 miles apart. The trip by car or train takes most of the
day, and 90 percent of travelers would choose to fly, creating a highly profitable business
for local airlines. This all changed when the Alta Velocidad Española (AVE), an ultra-
modern high-speed train, was completed in 2008. Taking into account total time involved,
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high-speed trains are faster than short-haul flights. Passengers travel in greater comfort
than airline passengers and commute from one city center to the next, with only a short
walk or cab ride to their final destinations.
The AVE example highlights the two fundamental insights provided by Porter’s five
forces framework. First, competition must be defined more broadly to go beyond direct
industry competitors. In this case, rather than defining competition narrowly as the firm’s
closest competitors, airline executives in Spain must look beyond other airlines and con-
sider substitute offerings such as high-speed trains. Second, any of the five forces on its
own, if sufficiently strong, can extract industry profitability. In the AVE example, the threat
of substitutes is limiting the airline industry’s profit potential. With the arrival of the AVE,
the airlines’ monopoly on fast transportation between Madrid and Barcelona vanished, and
with it the airlines’ high profits. The strong threat of substitutes in this case increased the
rivalry among existing competitors in the Spanish air transportation industry.
RIVALRY AMONG EXISTING COMPETITORS
Rivalry among existing competitors describes the intensity with which companies within
the same industry jockey for market share and profitability. It can range from genteel to
cut-throat. The other four forces—threat of entry, the power of buyers and suppliers, and
the threat of substitutes—all exert pressure upon this rivalry, as indicated by the arrows
pointing toward the center in Exhibit 3.3. The stronger the forces, the stronger the expected
competitive intensity, which in turn limits the industry’s profit potential.
Competitors can lower prices to attract customers from rivals. When intense rivalry
among existing competitors brings about price discounting, industry profitability erodes.
Alternatively, competitors can use non-price competition to create more value in terms
of product features and design, quality, promotional spending, and after-sales service and
support. When non-price competition is the primary basis of competition, costs increase,
which can also have a negative impact on industry profitability. However, when these
moves create unique products with features tailored closely to meet customer needs and
willingness to pay, then average industry profitability tends to increase because producers
are able to raise prices and thus increase revenues and profit margins.
The intensity of rivalry among existing competitors is determined largely by the follow-
ing factors:
■ Competitive industry structure.
■ Industry growth.
■ Strategic commitments.
■ Exit barriers.
COMPETITIVE INDUSTRY STRUCTURE. The competitive industry structure refers to
elements and features common to all industries. The structure of an industry is largely
captured by
■ The number and size of its competitors.
■ The firm’s degree of pricing power.
■ The type of product or service (commodity or differentiated product).
■ The height of entry barriers.27
Exhibit 3.4 shows different industry types along a continuum from fragmented to con-
solidated structures. At one extreme, a fragmented industry consists of many small firms
and tends to generate low profitability. At the other end of the continuum, a consolidated
LO 3-4
Examine how competitive
industry structure
shapes rivalry among
competitors.
competitive industry
structure Elements and
features common to all
industries, including
the number and size of
competitors, the firms’
degree of pricing power,
the type of product or
service offered, and the
height of entry barriers.
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industry is dominated by a few firms, or even just one firm, and has the potential to be
highly profitable. The four main competitive industry structures are:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly
Perfect Competition. A perfectly competitive industry is fragmented and has many small
firms, a commodity product, ease of entry, and little or no ability for each individual firm
to raise its prices. The firms competing in this type of industry are approximately similar
in size and resources. Consumers make purchasing decisions solely on price, because the
commodity product offerings are more or less identical. The resulting performance of the
industry shows low profitability. Under these conditions, firms in perfect competition have
difficulty achieving even a temporary competitive advantage and can achieve only competi-
tive parity. Although perfect competition is a rare industry structure in its pure form, mar-
kets for commodities such as natural gas, copper, and iron tend to approach this structure.
Modern high-tech industries are also not immune to the perils of perfect competition.
Many internet entrepreneurs learned the hard way that it is difficult to beat the forces of
perfect competition. Fueled by eager venture capitalists, about 100 online pet supply stores
such as pets.com, petopia.com, and pet-store.com had sprung up by 1999, at the height of
the internet bubble.28 Cut-throat competition ensued, with online retailers selling products
below cost. When many small firms are offering a commodity product in an industry that
is easy to enter, no one is able to increase prices and generate profits. To make matters
worse, at the same time, category-killers such as PetSmart and PetCo were expanding rap-
idly, opening some 2,000 brick-and-mortar stores in the United States and Canada. The
EXHIBIT 3.4 / Industry Competitive Structures along the Continuum from Fragmented to Consolidated
Industry Competitive Structures
Monopolistic
Competition
Form
Features
Fr
ag
me
nt
ed
Co
ns
ol
id
at
ed
Perfect
Competition
• Many small firms
• Firms are price takers
• Commodity product
• Low entry barriers
• Many firms
• Some pricing power
• Differentiated product
• Medium entry barriers
• Few (large) firms
• Some pricing power
• Differentiated product
• High entry barriers
• One firm
• Considerable pricing power
• Unique product
• Very high entry barriers
Oligopoly Monopoly
Resulting Profit Potential
Low High
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ensuing price competition led to an industry shakeout, leaving online retailers in the dust.
Looking at the competitive industry structures depicted in Exhibit 3.4, we might have pre-
dicted that online pet supply stores were unlikely to be profitable.
Monopolistic Competition. A monopolistically competitive industry has many firms,
a differentiated product, some obstacles to entry, and the ability to raise prices for a rela-
tively unique product while retaining customers. The key to understanding this industry
structure is that the firms now offer products or services with unique features.
The computer hardware industry provides one example of monopolistic competition.
Many firms compete in this industry, and even the largest of them (Apple, ASUS, Dell, HP,
or Lenovo) have less than 20 percent market share. Moreover, while products between com-
petitors tend to be similar, they are by no means identical. As a consequence, firms selling a
product with unique features tend to have some ability to raise prices. When a firm is able to
differentiate its product or service offerings, it carves out a niche in the market in which it has
some degree of monopoly power over pricing, thus the name “monopolistic competition.”
Firms frequently communicate the degree of product differentiation through advertising.
Oligopoly. An oligopolistic industry is consolidated with a few large firms, differentiated
products, high barriers to entry, and some degree of pricing power. The degree of pricing
power depends, just as in monopolistic competition, on the degree of product differentiation.
A key feature of an oligopoly is that the competing firms are interdependent. With only
a few competitors in the mix, the actions of one firm influence the behaviors of the oth-
ers. Each competitor in an oligopoly, therefore, must consider the strategic actions of the
other competitors. This type of industry structure is often analyzed using game theory,
which attempts to predict strategic behaviors by assuming that the moves and reactions
of competitors can be anticipated.29 Due to their strategic interdependence, companies in
oligopolies have an incentive to coordinate their strategic actions to maximize joint perfor-
mance. Although explicit coordination such as price fixing is illegal in the United States,
tacit coordination such as “an unspoken understanding” is not.
The express-delivery industry is an example of an oligopoly. The main competitors in
this space are FedEx and UPS. Any strategic decision made by FedEx (e.g., to expand
delivery services to ground delivery of larger-size packages) directly affects UPS; likewise,
any decision made by UPS (e.g., to guarantee next-day delivery before 8:00 a.m.) directly
affects FedEx. Other examples of oligopolies include the soft drink industry (Coca-Cola
versus Pepsi), airframe manufacturing business (Boeing versus Airbus), home-improvement
retailing (The Home Depot versus Lowe’s), toys and games (Hasbro versus Mattel), and
detergents (P&G versus Unilever).30
Companies in an oligopoly tend to have some pricing power if they are able to differen-
tiate their product or service offerings from those of their competitors. Non-price competi-
tion, therefore, is the preferred mode of competition. This means competing by offering
unique product features or services rather than competing based on price alone. When one
firm in an oligopoly cuts prices to gain market share from its competitor, the competitor
typically will respond in kind and also cut prices. This process initiates a price war, which
can be especially detrimental to firm performance if the products are close rivals.
In the early years of the soft drink industry, for example, whenever PepsiCo lowered
prices, Coca-Cola followed suit. These actions only resulted in reduced profitability for
both companies. In recent decades, both Coca-Cola and PepsiCo have repeatedly demon-
strated that they have learned this lesson. They shifted the basis of competition from price-
cutting to new product introductions and lifestyle advertising. Any price adjustments are
merely short-term promotions. By leveraging innovation and advertising, Coca-Cola and
PepsiCo have moved to non-price competition, which in turn allows them to charge higher
prices and to improve industry and company profitability.31
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Monopoly. An industry is a monopoly when there is only one, often large firm supply-
ing the market. The firm may offer a unique product, and the challenges to moving into
the industry tend to be high. The monopolist has considerable pricing power. As a conse-
quence, firm and thus industry profit tends to be high. The one firm is the industry.
In some instances, the government will grant one firm the right to be the sole supplier
of a product or service. This is often done to incentivize a company to engage in a venture
that would not be profitable if there was more than one supplier. For instance, public utilities
incur huge fixed costs to build plants and to supply a certain geographic area. Public utilities
supplying water, gas, and electricity to businesses and homes are frequently monopolists. As
examples, Georgia Power is the only supplier of electricity for some 2.5 million customers in
the southeastern United States. Philadelphia Gas Works is the only supplier of natural gas in
the city of Philadelphia, Pennsylvania, serving some 500,000 customers. These are so-called
natural monopolies. Without them, the governments involved believe the market would not
supply these products or services. In the past few decades, however, more and more of these
natural monopolies have been deregulated in the United States, including airlines, telecommu-
nications, railroads, trucking, and ocean transportation. This deregulation has allowed compe-
tition to emerge, which frequently leads to lower prices, better service, and more innovation.
While natural monopolies appear to be disappearing from the competitive landscape, so-
called near monopolies are of much greater interest to strategists. These are firms that have
accrued significant market power, for example, by owning valuable patents or proprietary
technology. In the process, they are changing the industry structure in their favor, generally
from monopolistic competition or oligopolies to near monopolies. These near monopolies
are firms that have accomplished product differentiation to such a degree that they are in a
class by themselves, just like a monopolist. The European Union, for example, views Google
with its 90 percent market share in online search as a “digital monopoly.”32 This is an envi-
able position in terms of the ability to extract profits by leveraging its data to provide tar-
geted online advertising and other customized services, so long as Google can steer clear of
monopolistic behavior, which may attract antitrust regulators and lead to legal repercussions.
INDUSTRY GROWTH. Industry growth
directly affects the intensity of rivalry
among competitors. In periods of high
growth, consumer demand rises, and
price competition among firms frequently
decreases. Because the pie is expanding,
rivals are focused on capturing part of that
larger pie rather than taking market share
and profitability away from one another.
The demand for knee replacements, for
example, is a fast-growing segment in the
medical products industry. In the United
States, robust demand is driven by the
need for knee replacements for an aging
population as well as for an increasingly
obese population.
The leading competitors are Zimmer
Biomet, DePuy, and Stryker, with significant share held by Smith & Nephew. Competition
is primarily based on innovative design, improved implant materials, and differentiated
products such as gender solutions and a range of high-flex knees. With improvements to
materials and procedures, younger patients are also increasingly choosing early surgical
The prosthetic for knee
replacement is a fast-growing
market segment in the
medical products industry.
©BSIP/Getty Images
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intervention. Competitors are able to avoid price competition and, instead, focus on dif-
ferentiation that allows premium pricing.
In contrast, rivalry among competitors becomes fierce during slow or even negative
industry growth. Price discounts, frequent new product releases with minor modifications,
intense promotional campaigns, and fast retaliation by rivals are all tactics indicative of an
industry with slow or negative growth. Competition is fierce because rivals can gain only
at the expense of others; therefore, companies are focused on taking business away from
one another. Demand for traditional fast food providers such as McDonald’s, Burger King,
and Wendy’s has been declining in recent years. Consumers have become more health-
conscious and demand has shifted to alternative restaurants such as Subway, Chick-fil-A,
and Chipotle. Attempts by McDonald’s, Burger King, and Wendy’s to steal customers from
one another include frequent discounting tactics such as dollar menus. Such competitive
tactics are indicative of cut-throat competition and a low profit potential in the traditional
hamburger fast food industry.
Competitive rivalry based solely on cutting prices is especially destructive to profitability
because it transfers most, if not all, of the value created in the industry to the customers—
leaving little, if anything, for the firms in the industry. While this may appear attractive to
customers, firms that are not profitable are not able to make the investments necessary to
upgrade their product offerings or services to provide higher value, and they eventually leave
the industry. Destructive price competition can lead to limited choices, lower product quality,
and higher prices for consumers in the long run if only a few large firms survive.
STRATEGIC COMMITMENTS. If firms make strategic commitments to compete in an
industry, rivalry among competitors is likely to be more intense. Strategic commitments
are firm actions that are costly, long-term oriented, and difficult to reverse. Strategic com-
mitments to a specific industry can stem from large, fixed cost requirements, but also from
noneconomic considerations.33
For example, significant strategic commitments are required to compete in the airline
industry when using a hub-and-spoke system to provide not only domestic but also interna-
tional coverage. U.S. airlines Delta, United, and American have large fixed costs to main-
tain their network of routes that affords global coverage, frequently in conjunction with
foreign partner airlines. These fixed costs in terms of aircraft, gate leases, hangars, mainte-
nance facilities, baggage facilities, and ground transportation all accrue before the airlines
sell any tickets. High fixed costs create tremendous pressure to fill empty seats. An airline
seat on a specific flight is perishable, just like hotel rooms not filled. Empty airline seats
are often filled through price-cutting. Given similar high fixed costs, other airlines respond
in kind. Eventually, a vicious cycle of price-cutting ensues, driving average industry prof-
itability to zero, or even negative numbers (where the companies are losing money). To
make matters worse, given their strategic commitments, airlines are unlikely to exit an
industry. Excess capacity remains, further depressing industry profitability.
In other cases, strategic commitments to a specific industry may be the result of more
political than economic considerations. Airbus, for example, was created by a number
of European governments through direct subsidies to provide a countervailing power to
Boeing. The European Union in turn claims that Boeing is subsidized by the U.S. govern-
ment indirectly via defense contracts. Given these political considerations and large-scale
strategic commitments, neither Airbus nor Boeing is likely to exit the aircraft manufactur-
ing industry even if industry profit potential falls to zero.
EXIT BARRIERS. The rivalry among existing competitors is also a function of an industry’s exit
barriers, the obstacles that determine how easily a firm can leave that industry. Exit barriers
strategic commitments
Firm actions that
are costly, long-term
oriented, and difficult to
reverse.
exit barriers Obstacles
that determine how
easily a firm can leave
an industry.
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comprise both economic and social factors. They include fixed costs that must be paid regard-
less of whether the company is operating in the industry or not. A company exiting an industry
may still have contractual obligations to suppliers, such as employee health care, retirement
benefits, and severance pay. Social factors include elements such as emotional attachments to
certain geographic locations. In Michigan, entire communities still depend on GM, Ford, and
Chrysler. If any of those carmakers were to exit the industry, communities would suffer. Other
social and economic factors include ripple effects through the supply chain. When one major
player in an industry shuts down, its suppliers are adversely impacted as well.
An industry with low exit barriers is more attractive because it allows underperforming
firms to exit more easily. Such exits reduce competitive pressure on the remaining firms
because excess capacity is removed. In contrast, an industry with high exit barriers reduces
its profit potential because excess capacity still remains. All of the large airlines featured
in Strategy Highlight 3.2 (American, Delta, and United) have filed for bankruptcy at one
point. Due to a unique feature of U.S. Chapter 11 bankruptcy law, however, companies may
continue to operate and reorganize while being temporarily shielded from their creditors
and other obligations until renegotiated. This implies that excess capacity is not removed
from the industry, and by putting pressure on prices further reduces industry profit potential.
To summarize our discussion of the five forces model, Exhibit 3.5 provides a checklist
that you can apply to any industry when assessing the underlying competitive forces that
shape strategy. The key take-away from the five forces model is that the stronger the forces,
the lower the industry’s ability to earn above-average profits, and correspondingly, the
lower the firm’s ability to gain and sustain a competitive advantage. Conversely, the weaker
the forces, the greater the industry’s ability to earn above-average profits, and correspond-
ingly, the greater the firm’s ability to gain and sustain competitive advantage. Therefore,
managers need to craft a strategic position for their company that leverages weak forces
into opportunities and mitigates strong forces because they are potential threats to the
firm’s ability to gain and sustain a competitive advantage.
A SIXTH FORCE: THE STRATEGIC ROLE OF COMPLEMENTS
As valuable as the five forces model is for explaining the profit potential and attractiveness
of industries, the value of Porter’s five forces model can be further enhanced if one also
considers the availability of complements.34
A complement is a product, service, or competency that adds value to the original product
offering when the two are used in tandem.35 Complements increase demand for the primary
product, thereby enhancing the profit potential for the industry and the firm. A company is a
complementor to your company if customers value your product or service offering more when
they are able to combine it with the other company’s product or service.36 Firms may choose to
provide the complements themselves or work with another company to accomplish this.
For example, in the smartphone industry, Alphabet’s Google complements Samsung.
The Korean high-tech company’s smartphones are more valuable when they come with
Google’s Android system installed. At the same time, Google and Samsung are increasingly
becoming competitors. With Google’s acquisition of Motorola Mobility, the online search
company launched its own line of smartphones and Chromebooks. This development illus-
trates the process of co-opetition, which is cooperation by competitors to achieve a strategic
objective. Samsung and Google cooperate as complementors to compete against Apple’s
strong position in the mobile device industry, while at the same time Samsung and Google
are increasingly becoming competitive with one another. While Google retained Motorola’s
patents to use for development in its future phones, and to defend itself against competitors
such as Samsung and Apple, Alphabet (Google’s parent company) sold the manufacturing
arm of Motorola to Lenovo, a Chinese maker of computers and mobile devices.
complement A product,
service, or competency
that adds value to the
original product offering
when the two are used
in tandem.
complementor
A company that provides
a good or service that
leads customers to value
your firm’s offering
more when the two are
combined.
LO 3-5
Describe the strategic
role of complements in
creating positive-sum
co-opetition.
co-opetition Coopera-
tion by competitors to
achieve a strategic
objective.
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The threat of entry is high when:
√ The minimum efficient scale to compete in an industry is low.
√ Network effects are not present.
√ Customer switching costs are low.
√ Capital requirements are low.
√ Incumbents do not possess:
Brand loyalty.
Proprietary technology.
Preferential access to raw materials.
Preferential access to distribution channels.
Favorable geographic locations.
Cumulative learning and experience effects.
√ Restrictive government regulations do not exist.
√ New entrants expect that incumbents will not or cannot retaliate.
The power of suppliers is high when:
√ Supplier’s industry is more concentrated than the industry it sells to.
√ Suppliers do not depend heavily on the industry for their revenues.
√ Incumbent firms face significant switching costs when changing suppliers.
√ Suppliers offer products that are differentiated.
√ There are no readily available substitutes for the products or services that the suppliers offer.
√ Suppliers can credibly threaten to forward-integrate into the industry.
The power of buyers is high when:
√ There are a few buyers and each buyer purchases large quantities relative to the size of a single seller.
√ The industry’s products are standardized or undifferentiated commodities.
√ Buyers face low or no switching costs.
√ Buyers can credibly threaten to backwardly integrate into the industry.
The threat of substitutes is high when:
√ The substitute offers an attractive price-performance trade-off.
√ The buyer’s cost of switching to the substitute is low.
The rivalry among existing competitors is high when:
√ There are many competitors in the industry.
√ The competitors are roughly of equal size.
√ Industry growth is slow, zero, or even negative.
√ Exit barriers are high.
√ Incumbent firms are highly committed to the business.
√ Incumbent firms cannot read or understand each other’s strategies well.
√ Products and services are direct substitutes.
√ Fixed costs are high and marginal costs are low.
√ Excess capacity exists in the industry.
√ The product or service is perishable.
EXHIBIT 3.5 /
The Five Forces
Competitive Analysis
Checklist
SOURCE: Adapted from
M.E. Porter (2008), “The five
competitive forces that shape
strategy,” Harvard Business
Review, January.
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In 2017, Google acquired HTC’s smartphone engineering group for $1.1 billion. The
Taiwanese smartphone maker developed the Google Pixel phone. With this acquisition,
Google is making a commitment to handset manufacturing, unlike in the Motorola deal
which was more motivated by intellectual property considerations. 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.
3.3 Changes over Time: Entry Choices
and Industry Dynamics
ENTRY CHOICES
One of the key insights of the five forces model is that the more profitable an industry, the
more attractive it becomes to competitors. Let’s assume a firm’s strategic leaders are aware
of potential barriers to entry (discussed above), but would nonetheless like to contem-
plate potential market entry because the industry profitability is high and thus quite attrac-
tive. Exhibit 3.6 shows an integrative model that can guide the entry choices firms make.
LO 3-6
Explain the five choices
required for market entry.
EXHIBIT 3.6 /
Entry Choices
SOURCE: Based on and
adapted from Zachary, M.A.,
P.T. Gianiodis, G. Tyge Payne,
and G.D. Markman (2014),
“Entry timing: enduring lessons
and future directions,” Journal
of Management 41: 1409;
and Bryce, D.J., and J.H.
Dyer (2007), “Strategies
to crack well-guarded
markets,” Harvard Business
Review, May: 84–92.
When?
-Entry timing
-Stage of industry life cycle
-Order of entry
How?
-Leverage existing assets
-Reconfigure value chains
-Establish niches
What?
-Type of entry:
Scale, commitment,
product and/or service,
business model etc.
Where?
-Leverage existing assets
-Reconfigure value chains
-Establish niches
Who?
-Identify the players:
Incumbents, entrants,
suppliers, customer,
other stakeholder
ENTRY
CHOICES
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Rather than considering firm entry as a discrete event (i.e., simple yes or no decision), or
a discrete event composed of five parts, this model suggests that the entry choices firms
make constitute a strategic process unfolding over time.
In particular, to increase the probability of successful entry, strategic leaders need to
consider the following five questions:37
1. Who are the players? Building on Porter’s insight that competition must be viewed in a
broader sense beyond direct competitors, the who are the players question allows strategic
leaders to not only identify direct competitors but also focus on other external and internal
stakeholders necessary to successfully compete in an industry, such as customers, employ-
ees, regulators, and communities (see discussion of stakeholder strategy in Chapter 2).
2. When to enter? This question concerns the timing of entry. Given that our perspective
is that of a firm considering potential entry into an existing industry, any first-mover
advantages are bygones. Nonetheless, the potential new entrant needs to consider at
which stage of the industry life cycle (introduction, growth, shakeout, maturity, or
decline) it should enter. We are taking a deep dive into the industry life cycle and how
it unfolds over time in Chapter 7.
3. How to enter? One of the challenges that strategic leaders face is that often the most
attractive industries in terms of profitability are also the hardest to break into because
they are protected by entry barriers. Thus, the how to enter question goes to the heart
of this problem.
■ One option is to leverage existing assets, that is to think about a new combination
of resources and capabilities that firms already possess, and if needed to combine
them with partner resources through strategic alliances. Although Circuit City went
bankrupt as an electronics retailer, losing out to Best Buy and Amazon, a few years
earlier it recombined its existing expertise in big-box retailing including optimiza-
tion of supply and demand in specific geographic areas to create CarMax, now the
largest used-car dealer in the United States and a Fortune 500 company.
■ Another option of is to reconfigure value chains. This approached allowed Skype
to enter the market for long-distance calls by combining value chains differently
(offering VOIP rather than relying on more expensive fiber-optic cables), and thus
compete with incumbents such as AT&T.
■ The third option is to establish a niche in an existing industry, and then use this beach-
head to grow further. This is the approach the Austrian maker of Red Bull used when
entering the U.S. soft drink market, long dominated by Coca-Cola and PepsiCo. Its
energy drink was offered in a small 8.3-ounce can, but priced at multiples compared
to Coke or Pepsi. This allowed retailers to stock Red Bull cans in small spaces such
as near the checkout counter. In addition, Red Bull initially used many nontraditional
outlets as points of sale such as nightclubs and gas stations. This approach created a
loyal following from which the energy drink maker could expand its entry into the
mainstream carbonated beverage drink in the United States and elsewhere. Indeed,
energy drinks are now one of the fastest growing segments in this industry.
4. What type of entry? The what question of entry refers to the type of entry in terms of
product market (e.g., smartphones), value chain activity (e.g., R&D for smartphone
chips or manufacturing of smartphones), geography (e.g., domestic and/or interna-
tional), and type of business model (e.g., subsidizing smartphones when providing
services). Depending on the market under consideration for entry, firms may face
unique competitive and institutional challenges. For example, discount carrier Spirit
Airlines’ unbundling of its services by charging customers separately for elements such
as checked luggage, assigned seating, carry-on items, and other in-flight perks such as
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drinks met with considerable backlash in 2007 when introduced. Yet this marked the
starting point of Spirit Airlines’ strategic positioning as an ultra-low-cost carrier and
enabled the company to add many attractive routes, and thus to enter geographic mar-
kets it was not able to compete in previously.
5. Where to enter? After deciding on the type of entry, the where to enter question refers
to more fine-tuned aspects of entry such as product positioning (high end versus low
end), pricing strategy, potential partners, and so forth.
INDUSTRY DYNAMICS
Although the five forces plus complements model is useful in understanding an industry’s
profit potential, it provides only a point-in-time snapshot of a moving target. With this
model (as with other static models), one cannot determine the changing speed of an indus-
try or the rate of innovation. This drawback implies that managers must repeat their analy-
sis over time to create a more accurate picture of their industry. It is therefore important
that managers consider industry dynamics.
Industry structures are not stable over time. Rather, they are dynamic. Since a consolidated
industry tends to be more profitable than a fragmented one (see Exhibit 3.4), firms have a
tendency to change the industry structure in their favor, making it more consolidated through
horizontal mergers and acquisitions. Having fewer competitors generally equates to higher
industry profitability. Industry incumbents, therefore, have an incentive to reduce the number
of competitors in the industry. With fewer but larger competitors, incumbent firms can miti-
gate the threat of strong competitive forces such as supplier or buyer power more effectively.
The U.S. domestic airline industry (featured in Strategy Highlight 3.2) has witnessed
several large, horizontal mergers between competitors, including Delta and Northwest,
United and Continental, Southwest and AirTran, as well as American and U.S. Airways.
These moves allow the remaining carriers to enjoy a more benign industry structure. It
also allows them to retire some of the excess capacity in the industry as the merged airlines
consolidate their networks of routes. The merger activity in the airline industry provides
one example of how firms can proactively reshape industry structure in their favor. A more
consolidated airline industry is likely to lead to higher ticket prices and fewer choices for
customers, but also more profitable airlines.
In contrast, consolidated industry structures may also break up and become more frag-
mented. This generally happens when there are external shocks to an industry such as
deregulation, new legislation, technological innovation, or globalization. For example, the
emergence of the internet moved the stock brokerage business from an oligopoly controlled
by full-service firms such as Merrill Lynch and Morgan Stanley to monopolistic competi-
tion with many generic online brokers such as Ameritrade, E*Trade, and Scottrade.
Another dynamic to be considered is industry convergence, a process whereby for-
merly unrelated industries begin to satisfy the same customer need. Industry convergence
is often brought on by technological advances. For years, many players in the media
industries have been converging due to technological progress in IT, telecommunications,
and digital media. Media convergence unites computing, communications, and content,
thereby causing significant upheaval across previously distinct industries. Content pro-
viders in industries such as newspapers, magazines, TV, movies, radio, and music are all
scrambling to adapt. Many standalone print newspapers are closing up shop, while others
are trying to figure out how to offer online news content for which consumers are willing
to pay.38 Internet companies such as Google, Facebook, Instagram (acquired by Facebook),
LinkedIn (acquired by Microsoft), Snap, Pinterest, and Twitter are changing the industry
structure by constantly morphing their capabilities and forcing old-line media companies
LO 3-7
Appraise the role of
industry dynamics and
industry convergence
in shaping the firm’s
external environment.
industry convergence
A process whereby
formerly unrelated
industries begin to
satisfy the same
customer need.
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such as News Corp., Time Warner, and Disney to adapt. A wide variety of mobile devices,
including smartphones, tablets, and e-readers, provide a new form of content delivery that
has the potential to make print media obsolete.
3.4 Performance Differences within the Same
Industry: Strategic Groups
In further analyzing the firm’s external environment to explain performance differences,
we now move to firms within the same industry. As noted earlier in the chapter, a firm
occupies a place within a strategic group, a set of companies that pursue a similar strategy
within a specific industry in their quest for competitive advantage (see Exhibit 3.1).39 Stra-
tegic groups differ from one another along important dimensions such as expenditures on
research and development, technology, product differentiation, product and service offer-
ings, market segments, distribution channels, and customer service.
To explain differences in firm performance within the same industry, the strategic
group model clusters different firms into groups based on a few key strategic dimen-
sions.40 Even within the same industry, firm performances differ depending on strategic
group membership. Some strategic groups tend to be more profitable than others. This dif-
ference implies that firm performance is determined not only by the industry to which the
firm belongs, but also by its strategic group membership.
The distinct differences across strategic groups reflect the business strategies that firms
pursue. Firms in the same strategic group tend to follow a similar strategy. Companies in
the same strategic group, therefore, are direct competitors. The rivalry among firms within
the same strategic group is generally more intense than the rivalry among strategic groups:
Intra-group rivalry exceeds inter-group rivalry. The number of different business strategies
pursued within an industry determines the number of strategic groups in that industry. In most
industries, strategic groups can be identified along a fairly small number of dimensions. In
many instances, two strategic groups are in an industry based on two different business strate-
gies: one that pursues a low-cost strategy and a second that pursues a differentiation strategy
(see Exhibit 3.7). We’ll discuss each of these generic business strategies in detail in Chapter 6.
THE STRATEGIC GROUP MODEL
To understand competitive behavior and performance within an industry, we can map the
industry competitors into strategic groups. We do this by:
■ Identifying the most important strategic dimensions such as expenditures on research and
development, technology, product differentiation, product and service offerings, cost struc-
ture, market segments, distribution channels, and customer service. These dimensions are
strategic commitments based on managerial actions that are costly and difficult to reverse.
■ Choosing two key dimensions for the horizontal and vertical axes, which expose
important differences among the competitors.
■ Graphing the firms in the strategic group, indicating each firm’s market share by the
size of the bubble with which it is represented.41
The U.S. domestic airline industry (featured in Strategy Highlight 3.2) provides an
illustrative example. Exhibit 3.7 maps companies active in this industry. The two strate-
gic dimensions on the axes are cost structure and routes. As a result of this mapping, two
strategic groups become apparent, as indicated by the dashed circles: Group A, low-cost,
point-to-point airlines (Alaska Airlines, Frontier Airlines, JetBlue, Southwest Airlines,
and Spirit Airlines) and Group B, differentiated airlines using a hub-and-spoke system
LO 3-8
Generate a strategic
group model to reveal
performance differences
between clusters of firms
in the same industry.
strategic group
The set of companies
that pursue a similar
strategy within a
specific industry.
strategic group model
A framework that
explains differences in
firm performance within
the same industry.
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(American, Delta, and United). The low-cost, point-to-point airlines are clustered in the
lower-left corner because they tend to have a lower cost structure but generally serve fewer
routes due to their point-to-point operating system.
The differentiated airlines in Group B, offering full services using a hub-and-spoke
route system, comprise the so-called legacy carriers. They are clustered in the upper-right
corner because of their generally higher cost structures. The legacy carriers usually offer
many more routes than the point-to-point low-cost carriers, made possible by use of the
hub-and-spoke system, and thus offer many different destinations. For example, Delta’s
main hub is in Atlanta, Georgia.42 If you were to fly from Seattle, Washington, to Miami,
Florida, you would stop to change planes in Delta’s Atlanta hub on your way.
The strategic group mapping in Exhibit 3.7 provides additional insights:
■ Competitive rivalry is strongest between firms that are within the same strategic
group. The closer firms are on the strategic group map, the more directly and intensely
they are in competition with one another. After a wave of mergers, the remaining mega-
airlines—American, Delta, and United—are competing head-to-head, not only in the U.S.
domestic market but also globally. They tend to monitor one another’s strategic actions
closely. While Delta faces secondary competition from low-cost carriers such as South-
west Airlines (SWA) on some domestic routes, its primary competitive rivals remain the
other legacy carriers. This is because they compete more on providing seamless global ser-
vices within their respective airline alliances (SkyTeam for Delta, Oneworld for American,
and Star Alliance for United) than on low-cost airfares for particular city pairs in the United
States. Nonetheless, when Delta is faced with direct competition from SWA on a particular
domestic route (say from Atlanta to Chicago), both tend to offer similar low-cost fares.
■ The external environment affects strategic groups differently. During times of eco-
nomic downturn, for example, the low-cost airlines tend to take market share away
from the legacy carriers. Moreover, given their generally higher cost structure, the
EXHIBIT 3.7 /
Strategic Groups and
Mobility Barrier in
U.S. Domestic Airline
Industry
Co
st
S
tr
uc
tu
re
High
Low HighRoutes
Mobility
Barrier
Group A
Low-cost,
point to point
Group B
Differentiated,
hub and spoke
Delta United
Airlines
American
Airlines
Southwest
Airlines
JetBlue
Frontier
Airlines
Spirit
Airlines
Alaska
Airlines
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legacy carriers are often unable to stay profitable during recessions, at least on domes-
tic routes. This implies that external factors such as recessions or high oil prices favor
the companies in the low-cost strategic group. On the other hand, given a number of
governmental restrictions on international air travel, the few airlines that are able to
compete globally usually make a tidy profit in this specific industry segment.
■ The five competitive forces affect strategic groups differently. Barriers to entry,
for example, are higher in the hub-and-spoke (differentiated) airline group than in the
point-to-point (low-cost) airline group. Following deregulation, many airlines entered
the industry, but all of these new players used the point-to-point system. Since hub-
and-spoke airlines can offer worldwide service and are protected from foreign com-
petition by regulation to some extent, they often face weaker buyer power, especially
from business travelers. While the hub-and-spoke airlines compete head-on with the
point-to-point airlines when they are flying the same or similar routes, the threat of
substitutes is stronger for the point-to-point airlines. This is because they tend to be
regionally focused and compete with the viable substitutes of car, train, or bus travel.
The threat of supplier power tends to be stronger for the airlines in the point-to-point,
low-cost strategic group because they are much smaller and thus have weaker negotia-
tion power when acquiring new aircraft, for example. To get around this, these airlines
frequently purchase used aircraft from legacy carriers. This brief application of the
five forces model leads us to conclude that rivalry among existing competitors in the
low-cost, point-to-point strategic group is likely to be more intense than within the dif-
ferentiated, hub-and-spoke strategic group.
■ Some strategic groups are more profitable than others. Historically, airlines clustered
in the lower-left corner tend to be more profitable when considering the U.S. domestic
market only. Why? Because they create similar, or even higher, value for their customers
in terms of on-time departure and arrival, safety, and fewer bags lost, while keeping their
cost structure well below those of the legacy carriers. The point-to-point airlines have
generally lower costs than the legacy carriers because they are faster in turning their
airplanes around, keep them flying longer, use fewer and older airplane models, focus on
high-yield city pairs, and tie pay to company performance, among many other activities
that all support their low-cost business model. The point-to-point airlines, therefore, are
able to offer their services at a lower cost and a higher perceived value, resulting in more
pricing options, and thus creating the basis for a competitive advantage.
MOBILITY BARRIERS
Although some strategic groups tend to be more profitable and therefore more attractive than
others, mobility barriers restrict movement between groups. These are industry-specific
factors that separate one strategic group from another.43 The dimensions to determine a
strategic group are mobility barriers, which are strategic commitments. These are actions
that are costly and not easily reversed such as the firm’s underlying cost structure because
it is based on managerial commitments resulting in hard-to-reverse investments.
The two groups identified in Exhibit 3.7 are separated by the fact that offering inter-
national routes necessitates the hub-and-spoke model. Frequently, the international routes
tend to be the remaining profitable routes left for the legacy carriers; albeit the up-and-
coming Persian Gulf region carriers, in particular Emirates, Etihad Airways, and Qatar
Airways, are beginning to threaten this profit sanctuary.44
This economic reality implies that if carriers in the lower-left cluster, such as SWA
or JetBlue, would like to compete globally, they would likely need to change their point-
to-point operating model to a hub-and-spoke model. Or they could select a few profitable
mobility barriers
Industry-specific factors
that separate one
strategic group from
another.
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international routes and service them with long-range aircrafts such as Boeing 787s or Airbus
A-380s. Adding international service to the low-cost model, however, would require manage-
rial commitments resulting in significant capital investments and a likely departure from a
well-functioning business model. Additional regulatory hurdles reinforce these mobility bar-
riers, such as the difficulty of securing landing slots at international airports around the world.
Despite using its point-to-point operating system, SWA experienced these and many
other challenges when it began offering international flights to selected resort destina-
tions such as Aruba, Cabo San Lucas, Cancun, the Bahamas, and Jamaica: changes to
its reservation system, securing passports for crew members, cultural-awareness training,
learning instructions in foreign languages, and performing drills in swimming pools on
how to evacuate passengers onto life rafts. All of these additional requirements result in a
somewhat higher cost for SWA to servicing international routes.45
3.5 Implications for Strategic Leaders
At the start of the strategic management process, it is critical for managers to conduct a
thorough analysis of the firm’s external environment to identify threats and opportunities.
The initial step is to apply a PESTEL analysis to scan, monitor, and evaluate changes and
trends in the firm’s macroenvironment. This versatile framework allows managers to track
important trends and developments based on the source of the external factors: political,
economic, sociocultural, technological, ecological, and legal. When applying a PESTEL
analysis, the guiding consideration for strategic leaders should be the question of how the
external factors identified affect the firm’s industry environment.
Exhibit 3.1 delineates external factors based on the proximity of these external factors
by gradually moving from the general to the task environment. The next layer for managers
to understand is the industry. Applying Porter’s five forces model allows strategic leaders
to understand the profit potential of an industry and to obtain clues on how to carve out a
strategic position that makes gaining and sustaining a competitive advantage more likely.
Follow these steps to apply the five forces model:46
1. Define the relevant industry. In the five forces model, industry boundaries are drawn
by identifying a group of incumbent companies that face more or less the same sup-
pliers and buyers. This group of competitors is likely to be an industry if it also has
the same entry barriers and a similar threat from substitutes. In this model, therefore,
an industry is defined by commonality and overlap in the five competitive forces that
shape competition.
2. Identify the key players in each of the five forces and attempt to group them into
different categories. This step aids in assessing the relative strength of each force.
For example, while makers of jet engines (GE, Rolls-Royce, Pratt & Whitney) and
local catering services are all suppliers to airlines, their strengths vary widely. Seg-
menting different players within each force allows you to assess each force at a fine-
grained level.
3. Determine the underlying drivers of each force. Which forces are strong, and which
are weak? And why? Keeping with the airline example, why is the supplier power of jet
engine manufacturers strong? Because they are supplying a mission-critical, highly dif-
ferentiated product for airlines. Moreover, there are only a few suppliers of jet engines
worldwide and no viable substitutes.
4. Assess the overall industry structure. What is the industry’s profit potential? Here
you need to identify forces that directly influence industry profit potential, because not
all forces are likely to have an equal effect. Focus on the most important forces that
drive industry profitability.
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The final step in industry analysis is to draw a strategic group map. This exercise allows
you to unearth and explain performance differences within the same industry. When ana-
lyzing a firm’s external environment, it is critical to apply the three frameworks intro-
duced in this chapter (PESTEL, Porter’s five forces, and strategic group mapping). Taken
together, the external environment can determine up to roughly one-half of the perfor-
mance differences across firms (see Exhibit 1.1).
Although the different models discussed in this chapter are an important step in the
strategic management process, they are not without shortcomings. First, all of the models
presented are static. They provide a snapshot of what is actually a moving target and do
not allow for consideration of industry dynamics. However, changes in the external envi-
ronment can appear suddenly, for example, through black swan events. Industries can be
revolutionized by innovation. Strategic groups can be made obsolete through deregula-
tion or technological progress. To overcome this important shortcoming, strategic leaders
must conduct external analyses at different points in time to gain a sense of the underlying
dynamics. The frequency with which these tools need to be applied is a function of the rate
of change in the industry. The mobile app industry is changing extremely fast, while the
railroad industry experiences a less volatile environment.
Second, the models presented in this chapter do not allow strategic leaders to fully
understand why there are performance differences among firms in the same industry or
strategic group. To better understand differences in firm performance, we must look inside
the firm to study its resources, capabilities, and core competencies. We do this in the next
chapter by moving from external to internal analysis.
Even though Airbnb is at $31 billion one of the most valu-
able private startups in the world and offers more accommo-
dations than the three largest hotel chains (Marriott, Hilton,
and Intercontinental) combined, not all is smooth sailing.
In particular, PESTEL factors discussed in this chapter are
creating major headwinds for Airbnb. Take regulation, for
example. In late 2016, New York state strengthened legisla-
tion first passed in 2010. In particular, it is illegal in New
York to rent out entire apartments in residential blocks for
less than 30 days. (It still remains legal if the renter is living
in the apartment at the same time, so “true space sharing” is
still possible.) Fines increased to $1,000 for the first offense,
rising to $7,500 for repeat offenders. This creates major prob-
lems for Airbnb because New York City is by far the largest
market for the internet venture, with some 35,000 accommo-
dations available for rent.
The issue for Airbnb is that about one-third of those list-
ings are from hosts with multiple offerings in the same city.
In particular, commercial landlords found out that it is more
profitable to convert some apartments into short-term rentals
CHAPTERCASE 3 Consider This . . .
and to offer them via Airbnb than to sign long-term rentals
with just one tenant, which often fall under some sort of rent
control in New York City. Although this tactic increases the
landlord’s return on investment and profits, it creates all kinds
of negative externalities. Neighbors complain about noisy
tourists partying all night. Some apartments get ransacked or
are used for illegal activities such as drug deals and prostitu-
tion. New Yorkers expressed their frustration by scrawling on
Airbnb posters: “The dumbest person in your building is pass-
ing out keys to your front door!” On a more macro level, some
argue that Airbnb drives out affordable rental space in many
metropolitan cities where apartments are already scarce.
Other cities such as Paris, Berlin, and Barcelona face similar
problems and passed laws with stiff penalties, fining offend-
ers over $100,000!
Questions
1. Have you ever used Airbnb, either as a renter or a host?
What were some of the positives and some of the nega-
tives of your experience? Explain.
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98 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
2. How was an internet startup able to disrupt the hotel
industry, long dominated by giants such as Marriott and
Hilton, which took decades to become successful world-
wide hospitality chains? Explain.
3. Why is it that PESTEL factors can have such a
strong impact on the future of a business? Do you
support legislation such as that passed in New York
(and elsewhere), or do you think it has more to do
with protecting vested interests such as the hotel
industry?
4. Citing the Digital Millennium Copyright Act (DMCA),
Airbnb is challenging the New York law and others
in the United States, arguing that it merely operates a
digital marketplace, and thus is not responsible for the
content that users place on its site. Do you think Airbnb
has a strong argument? Why or why not?
5. Are you concerned that the concept of the sharing econ-
omy could be abused by unscrupulous “entrepreneurs”
and thus give the entire novel concept a bad reputa-
tion? Why or why not? Explain.
This chapter demonstrated various approaches to ana-
lyzing the firm’s external environment, as summa-
rized by the following learning objectives and related
take-away concepts.
LO 3-1 / Generate a PESTEL analysis to
evaluate the impact of external factors on the
firm.
■ A firm’s macroenvironment consists of a wide
range of political, economic, sociocultural, tech-
nological, ecological, and legal (PESTEL) factors
that can affect industry and firm performance.
These external factors have both domestic and
global aspects.
■ Political factors describe the influence govern-
mental bodies can have on firms.
■ Economic factors to be considered are growth
rates, interest rates, levels of employment, price
stability (inflation and deflation), and currency
exchange rates.
■ Sociocultural factors capture a society’s cultures,
norms, and values.
■ Technological factors capture the application of
knowledge to create new processes and products.
■ Ecological factors concern a firm’s regard for
environmental issues such as the natural environ-
ment, global warming, and sustainable economic
growth.
■ Legal factors capture the official outcomes of the
political processes that manifest themselves in
laws, mandates, regulations, and court decisions.
LO 3-2 / Differentiate the roles of firm
effects and industry effects in determining firm
performance.
■ A firm’s performance is more closely related to
its managers’ actions (firm effects) than to the
external circumstances surrounding it (industry
effects).
■ Firm and industry effects, however, are interde-
pendent. Both are relevant in determining firm
performance.
LO 3-3 / Apply Porter’s five competi-
tive forces to explain the profit potential of
different industries.
■ The profit potential of an industry is a function of
the five forces that shape competition: (1) threat
of entry, (2) power of suppliers, (3) power of
buyers, (4) threat of substitutes, and (5) rivalry
among existing competitors.
■ The stronger a competitive force, the greater the
threat it represents. The weaker the competitive
force, the greater the opportunity it presents.
■ A firm can shape an industry’s structure in its
favor through its strategy.
TAKE-AWAY CONCEPTS
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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 99
LO 3-4 / Examine how competitive industry
structure shapes rivalry among competitors.
■ The competitive structure of an industry is
largely captured by the number and size of com-
petitors in an industry, whether the firms possess
some degree of pricing power, the type of prod-
uct or service the industry offers (commodity or
differentiated product), and the height of entry
barriers.
■ A perfectly competitive industry is characterized
by many small firms, a commodity product, low
entry barriers, and no pricing power for individual
firms.
■ A monopolistic industry is characterized by many
firms, a differentiated product, medium entry bar-
riers, and some pricing power.
■ An oligopolistic industry is characterized by few
(large) firms, a differentiated product, high entry
barriers, and some degree of pricing power.
■ A monopoly exists when there is only one (large)
firm supplying the market. In such instances, the
firm may offer a unique product, the barriers to
entry may be high, and the monopolist usually has
considerable pricing power.
LO 3-5 / Describe the strategic role of
complements in creating positive-sum
co-opetition.
■ Co-opetition (cooperation among competitors)
can create a positive-sum game, resulting in a
larger pie for everyone involved.
■ Complements increase demand for the primary
product, enhancing the profit potential for the
industry and the firm.
■ Attractive industries for co-opetition are
characterized by high entry barriers, low exit
barriers, low buyer and supplier power, a low
threat of substitutes, and the availability of
complements.
LO 3-6 / Explain the five choices required
for market entry.
■ The more profitable an industry, the more attrac-
tive it becomes to competitors, who must consider
the who, when, how, what, and where of entry.
■ The five choices constitute more than parts of a
single decision point; their consideration forms a
strategic process unfolding over time. Each choice
involves multiple decisions including many
dimensions.
■ Who includes questions about the full range of
stakeholders, and not just competitors; when,
questions about the industry life cycle; how, about
overcoming barriers to entry; what, about options
among product market, value chain, geography,
and business model; and where, about prod-
uct positioning, pricing strategy, and potential
partners.
LO 3-7 / Appraise the role of industry
dynamics and industry convergence in shaping
the firm’s external environment.
■ Industries are dynamic—they change over time.
■ Different conditions prevail in different indus-
tries, directly affecting the firms competing in
these industries and their profitability.
■ In industry convergence, formerly unrelated
industries begin to satisfy the same customer
need. Such convergence is often brought on by
technological advances.
LO 3-8 / Generate a strategic group model
to reveal performance differences between
clusters of firms in the same industry.
■ A strategic group is a set of firms within a spe-
cific industry that pursue a similar strategy in
their quest for competitive advantage.
■ Generally, there are two strategic groups in an
industry based on two different business strate-
gies: one that pursues a low-cost strategy and a
second that pursues a differentiation strategy.
■ Rivalry among firms of the same strategic group
is more intense than the rivalry between strategic
groups: intra-group rivalry exceeds inter-group
rivalry.
■ Strategic groups are affected differently by the
external environment and the five competitive
forces.
■ Some strategic groups are more profitable than
others.
■ Movement between strategic groups is restricted
by mobility barriers—industry- specific
factors that separate one strategic group from
another.
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100 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
Competitive industry
structure (p. 83)
Complement (p. 88)
Complementor (p. 88)
Co-opetition (p. 88)
Entry barriers (p. 76)
Exit barriers (p. 87)
Firm effects (p. 73)
Five forces model (p. 74)
Industry (p. 73)
Industry analysis (p. 73)
Industry convergence (p. 92)
Industry effects (p. 73)
Mobility barriers (p. 95)
Network effects (p. 77)
PESTEL model (p. 67)
Strategic commitments (p. 87)
Strategic group (p. 93)
Strategic group model (p. 93)
Strategic position (p. 73)
Threat of entry (p. 76)
KEY TERMS
DISCUSSION QUESTIONS
1. Why is it important for any organization (firms,
nonprofits, etc.) to study and understand its exter-
nal environment?
2. How do the five competitive forces in Porter’s
model affect the average profitability of the indus-
try? For example, in what way might weak forces
increase industry profits, and in what way do
strong forces reduce industry profits? Identify an
industry in which many of the competitors seem
to be having financial performance problems.
Which of the five forces seems to be strongest?
3. This chapter covers the choices firms make
in entering new markets (LO 3-6). Reflect on
ChapterCase 3 and discuss how Airbnb might
have answered these questions in Exhibit 3.6.
4. How do mobility barriers affect the structure of
an industry? How do they help us explain firm
differences in performance?
ETHICAL/SOCIAL ISSUES
1. One of the world’s largest car manufacturers,
Volkswagen (VW), admitted to criminal wrong-
doing in 2017. The firm confirmed that it sys-
tematically cheated on emissions tests related to
its two-liter diesel engines. These engines were
designed in 2005 to meet more rigorous U.S.
emission standards taking effect in 2007. Appar-
ently the new engines did not perform as planned
and the company then designed a software feature
to artificially pass the emissions testing process.
Road testing in 2014 uncovered a large differ-
ence between EPA-measured emissions and
the actual output of the vehicles. This was then
further investigated by several legal entities. In
September 2015 the CEO of VW lost his job over
the scandal. The financial cost to the firm is cur-
rently more than $20 billion and could go above
$25 billion in fines and consumer compensation
for nearly 11 million vehicles with this “defeat
device” software.47
a. The external environment of the global auto-
mobile industry is quite complex. Regula-
tions vary from country to country and in the
United States even from one state to another in
some cases. Firms must be prepared to antici-
pate and respond to these external forces. It
appears VW’s response to the design issue, in
this case, was neither ethical nor legal. Why
do you think VW made the decisions it did
regarding this emissions problem in the late
2000s? What could VW have done differently?
b. In January 2017, a U.S. grand jury indicted
six current and former VW executives for
their alleged role in the emissions scandal
and its subsequent cover-up. The U.S. Justice
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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 101
Department decided to bring charges against
these executives after a 16-month criminal
investigation by the FBI. In the past, it has
been rare for executives to be personally
indicted for company misconduct. Do you
agree with the decision to go after individual
managers in this case? Why or why not?
c. What are the competitive implications of the
actions of VW? Does this situation impact the
industry rivalry that is discussed in the five
forces model, for instance?
2. The chapter notes that national governments
provide incentives for industry growth. One such
example is for the purchase of electric vehicles
(EVs). Norway, for example, has provided tax
discounts for electric vehicles since the 1990s.
Norway waives a substantial automobile import
tax on EVs sold inside the country. Largely as a
result of these policies, 22 percent of the auto-
mobiles owned in Norway were electric powered
in 2015. This compares with 0.5 percent in the
United States, 0.8 percent in China, and 1.1 per-
cent in the United Kingdom in 2015.48
a. What is the appropriate role for governments
to encourage or discourage certain purchas-
ing behaviors? You may note many national
governments have for decades collected addi-
tional taxes on tobacco and alcohol products
as a measure to try to moderate consumption
of these items.
b. As a strategist in a major firm, how would you
seek to position your company in light of such
current and potential future governmental
policies?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Your group is a team of KraftHeinz Co. (www.
kraftheinzcompany.com) marketing interns. The com-
pany has asked you to propose new guidelines for help-
ing it promote food to children in a socially responsible
way. As the fifth-largest consumer packaged food and
beverage company globally, KraftHeinz’s 2016 sales
exceeded $26 billion. The company projects steady
growth, but would like your help in boosting growth.
One of Kraft’s largest brands is Oscar Mayer Lunch-
ables, described as making lunch fun and targeted to
busy parents who want a quick lunch to send with their
children to school or keep on hand as an after-school
snack. One of the options is Lunchables with Juice,
Nachos Cheese Dip, and Salsa. However, controversy
is growing about the social responsibility of directly
marketing to children when the food is unhealthy—
high in fat, sugar, and salt, but low in nutrition. There
is a societal concern with the growing rate of obesity
in children and the increased incidence of diabetes
that results from childhood obesity.
Kraft would like to have a reputation as a socially
responsible company. Accordingly, Kraft would like
to create internal guidelines that will help it market
Lunchables (as well as other packaged food items)
responsibly and gain the approval of medical profes-
sionals, parents, and watchdog groups.49
1. Visit the Kraft food website (www.lunchables.
com) and review the Lunchables products, as
well as other packaged food products that Kraft
offers. Discuss among your group members the
extent to which the product options are healthy
choices.
2. Identify other actions that Kraft might take to
demonstrate that it is a food company that genu-
inely cares about children’s health and a company
that would like to help reverse the trend of increas-
ing childhood obesity.
3. If your group believes that the company is not
responsible for personal choices that consumers
make to eat unhealthy food, then describe how
the company should respond to activist groups
and public health officials that are urging compa-
nies to stop producing and marketing unhealthy
foods.
//// Small Group Exercise 2
One industry with an impact on both undergraduate
and MBA students is textbook publishing. Traditional
printed textbooks are being challenged on one hand by
self-publishing firms offering very low prices for spe-
cific instructor materials, and on the other hand by a
need to offer digital resources that substitute for printed
materials. Large textbook publishers are increasingly
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Is My Job the Next One Being
Outsourced?
T he outsourcing of IT programming jobs to India is now commonly understood after years of this trend. How-ever, more recently some accounting functions have
also begun to flow into India’s large technically trained and
English-speaking work force. For example, the number of U.S.
tax returns completed in India rose dramatically from 2003 to
2011 (25,000 in 2003 to 1.6 million in 2011). Some estimate
that over 20 million U.S. tax returns will be prepared in India
within the next few years. Outsourcing accounting functions
may affect the job and career prospects for accounting-oriented
business school graduates. Tax accountants in Bangalore, India,
are much cheaper than those in Boston or Baltimore. Moreover,
tax accountants in India often work longer hours and can there-
fore process many more tax returns than U.S.-based CPAs and
tax accountants during the crunch period of the U.S. tax filing
system.51 Other services once thought to be immune to off-
shoring are also experiencing vulnerability. One example is the
rise in medical tourism for major medical treatments to handle
everything from joint replacements, weight loss, dental prob-
lems, and infertility. It is estimated that over 14 million patients
traveled from one country to another seeking medical treatment
in 2016 alone.52
1. Which aspects of accounting do you think are more likely to
resist the outsourcing trends just discussed? Think about what
aspects of accounting are the high-value activities versus the
routine standardized ones. (If it’s been a while since you took
your accounting courses, reach out for information to some-
one in your strategy class who is an accounting major.)
2. What industries do you think may offer the best U.S. (or
domestic) job opportunities in the future? Which indus-
tries do you think may offer the greatest job opportunities
in the global market in the future? Use the PESTEL frame-
work and the five forces model to think through a logical
set of reasons that some fields will have higher job growth
trends than others.
3. Do these types of macroenvironmental and industry trends
affect your thinking about selecting a career field after
college? Why or why not? Explain.
mySTRATEGY
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102 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
investing in adaptive learning systems such as Wiley-
PLUS, Cengage MindTap, and McGraw-Hill Connect.
Complicating factors for the publishers is the chang-
ing business model of renting textbooks (printed and
electronic). U.S. university book rental was about
25 percent of student purchasing volume in 2015.50
Use the five forces model (with complements) to
think through the various impacts such technology
shifts may have on the textbook industry. Include in
your response answers to the following questions.
1. How should managers of a textbook publishing
company respond to such changes?
2. Will the shifts in technology and business models
be likely to raise or lower the textbook industry
profits? Explain.
1. This ChapterCase is based on: “All eyes on
the sharing economy,” The Economist, March
9, 2013; “New York deflates Airbnb,” The
Economist, October 27, 2016; Austin, S., C.
Canipe, and S. Slobin (2015, Feb. 18), “The
billion dollar startup club,” The Wall Street
Journal (updated January 2017),
http://graphics.wsj.com/billion-dollar-club/;
Parker, G.G., M.W. Van Alstyne, S.P. Choudary
(2016), Platform Revolution: How Networked
Markets Are Transforming the Economy—And
How to Make Them Work for You (New York:
Norton); Pressler, J. (2014, Sept. 23), “The
dumbest person in your building is passing out
keys to your front door!” New York; Stone, B.
(2017), The Upstarts: How Uber, Airbnb, and
the Killer Companies of the New Silicon Val-
ley Are Changing the World (New York: Little,
Brown and Co.); Tabarrok, A. (2017, Jan. 30),
“How Uber and Airbnb won,” The Wall Street
Journal.
ENDNOTES
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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 103
2. For a detailed treatise on how institutions
shape the economic climate and with it firm
performance, see: North, D.C. (1990), Institu-
tions, Institutional Change, and Economic
Performance (New York: Random House).
3. De Figueireo, R.J.P., and G. Edwards
(2007), “Does private money buy public pol-
icy? Campaign contributions and regulatory
outcomes in telecommunications,” Journal
of Economics & Management Strategy 16:
547–576; and Hillman, A.J., G. D. Keim, and
D. Schuler (2004), “Corporate political activ-
ity: A review and research agenda,” Journal of
Management 30: 837–857.
4. Lowenstein, R. (2010), The End of Wall
Street (New York: Penguin Press).
5. Brynjolfsson, E., and A. McAfee
(2014), The Second Machine Age: Work,
Progress, and Prosperity in a Time of Brilliant
Technologies (New York: Norton).
6. “Professor Emeritus Milton Friedman dies
at 94,” University of Chicago press release,
November 16, 2006.
7. Lucas, R. (1972), “Expectations and the
neutrality of money,” Journal of Economic
Theory 4: 103–124.
8. “Media companies are piling into the His-
panic market. But will it pay off?” The Econo-
mist, December 15, 2012.
9. Woolley, J.L., and R. M. Rottner (2008),
“Innovation policy and nanotech entrepre-
neurship,” Entrepreneurship Theory and
Practice 32: 791–811; and Rothaermel, F.T.,
and M. Thursby (2007), “The nanotech vs.
the biotech revolution: Sources of incumbent
productivity in research,” Research Policy
36: 832–849.
10. Afuah, A. (2009), Strategic Innovation:
New Game Strategies for Competitive Advan-
tage (New York: Routledge); Hill, C.W.L., and
F.T. Rothaermel (2003), “The performance of
incumbent firms in the face of radical techno-
logical innovation,” Academy of Management
Review 28: 257–274; and Bettis, R., and M.A.
Hitt (1995), “The new competitive landscape,”
Strategic Management Journal 16 (Special
Issue): 7–19.
11. For an in-depth discussion of BlackBerry
and the smartphone industry, see Burr, J.F.,
F.T. Rothaermel, and J. Urbina (2015),
Case MHE-FTR-020 (0077645065), “Make
or Break at RIM: Launching BlackBerry
10,” http://create.mheducation.com; Dvorak,
P. (2011), “BlackBerry maker’s issue: Gadgets
for work or play?” The Wall Street Journal,
September 30; Dyer, J., H. Gregersen, C.M.
Christensen (2011), The Innovator’s DNA:
Mastering the Five Skills of Disruptive
Innovators (Boston, MA: Harvard Business
Review Press); Ycharts.com.
12. Academy of Management, ONE Division,
2013 domain statement; Anderson, R.C.
(2009), Confessions of a Radical Industrialist:
Profits, People, Purpose—Doing Business by
Respecting the Earth (New York: St. Martin’s
Press); and Esty, D.C., and A.S. Winston
(2009), Green to Gold: How Smart Compa-
nies Use Environmental Strategy to Innovate,
Create Value, and Build Competitive Advan-
tage, revised and updated (Hoboken, NJ: John
Wiley & Sons).
13. This interesting debate unfolds in the
following articles, among others: Misangyi,
V.F., H. Elms, T. Greckhamer, and J.A.
Lepine (2006), “A new perspective on a
fundamental debate: A multilevel approach
to industry, corporate, and business unit
effects,” Strategic Management Journal 27:
571–590; Hawawini, G., V. Subramanian,
and P. Verdin (2003), “Is performance driven
by industry- or firm-specific factors? A new
look at the evidence,” Strategic Manage-
ment Journal 24: 1–16; McGahan, A.M.,
and M.E. Porter (1997), “How much does
industry matter, really?” Strategic Man-
agement Journal 18: 15–30; Rumelt, R.P.
(1991), “How much does industry matter?”
Strategic Management Journal 12: 167–185;
and Hansen, G.S., and B. Wernerfelt (1989),
“ Determinants of firm performance: The
relative importance of economic and orga-
nizational factors,” Strategic Management
Journal 10: 399–411.
14. Misangyi, V.F., H. Elms, T. Greckhamer,
and J.A. Lepine (2006), “A new perspec-
tive on a fundamental debate: A multilevel
approach to industry, corporate, and business
unit effects,” Strategic Management Journal
27: 571–590; Hawawini, G., V. Subramanian,
and P. Verdin (2003), “Is performance driven
by industry- or firm-specific factors? A new
look at the evidence,” Strategic Management
Journal 24: 1–16; McGahan, A.M., and M.E.
Porter (1997), “How much does industry mat-
ter, really?” Strategic Management Journal
18: 15–30; Rumelt, R.P. (1991), “How much
does industry matter?” Strategic Management
Journal 12: 167–185; and Hansen, G.S., and
B. Wernerfelt (1989), “Determinants of firm
performance: The relative importance of eco-
nomic and organizational factors,” Strategic
Management Journal 10: 399–411.
15. Misangyi, V.F., H. Elms, T. Greckhamer,
and J.A. Lepine (2006), “A new perspec-
tive on a fundamental debate: A multilevel
approach to industry, corporate, and business
unit effects,” Strategic Management Journal
27: 571–590; Hawawini, G., V. Subrama-
nian, and P. Verdin (2003), “Is performance
driven by industry- or firm-specific fac-
tors? A new look at the evidence,” Strategic
Management Journal 24: 1–16; McGahan,
A.M., and M.E. Porter (1997), “How much
does industry matter, really?” Strategic Man-
agement Journal 18: 15–30; Rumelt, R.P.
(1991), “How much does industry matter?”
Strategic Management Journal 12: 167–185;
and Hansen, G.S., and B. Wernerfelt (1989),
“Determinants of firm performance: The
relative importance of economic and orga-
nizational factors,” Strategic Management
Journal 10: 399–411.
16. The discussion in this section is based on:
Magretta, J. (2012), Understanding Michael
Porter: The Essential Guide to Competition
and Strategy (Boston, MA: Harvard Business
Review Press); Porter, M.E. (2008, Jan.),
“The five competitive forces that shape strat-
egy,” Harvard Business Review; Porter, M.E.
(1980), Competitive Strategy: Techniques for
Analyzing Industries and Competitors (New
York: Free Press); and Porter, M.E. (1979),
“How competitive forces shape strategy,”
Harvard Business Review, March–April:
137–145.
17. Strategy Highlight 3.2 is drawn from:
Porter, M.E. (2008), “The five competitive
forces that shape strategy,” An Interview with
Michael E. Porter: The Five Competitive
Forces that Shape Strategy, Harvard Busi-
nessPublishing video; “Everyone else in the
travel business makes money off airlines,” The
Economist, August 25, 2012; “How airline
ticket prices fell 50% in 30 years (and nobody
noticed),” The Atlantic, February 28, 2013;
U.S. gallon of jet fuel prices; author’s inter-
views with Delta executives.
18. Musk continues to upgrade expectations.
In 2015 he set the 500,000 benchmark to be
met by 2020. A year later the deadline was set
for 2018. Stoll, D., and M. Ramsey (2015),
“Tesla first-quarter car deliveries rise above
10,000,” The Wall Street Journal; Goliya, K.,
and A. Sage (2016, May 5), “Tesla puts pedal
to the metal, 500,000 cars planned in 2018,”
Reuters.
19. Hull, D. (2014, July 22), “Tesla idles Fre-
mont production line for Model X upgrade,”
San Jose Mercury News; and Vance, A. (2013,
July 18), “Why everybody loves Tesla,”
Bloomberg Businessweek.
20. Ramsey, M. (2014, Sept. 3), “Tesla to
choose Nevada for battery factory,” The Wall
Street Journal.
21. Ramsey, M. (2014, Feb. 26), “Tesla plans
$5 billion battery factory,” The Wall Street
Journal.
22. Walsh, T. (2014, Sept. 2), “The cult
of Tesla Motors Inc: Why this auto-
maker has the most loyal customers,” The
Motley Fool.
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104 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
23. Tesla Model S road test, Consumer
Reports, http://www.consumerreports.org/cro/
tesla/model-s/road-test.htm.
24. Wang, U. (2013, Nov. 5), “Tesla considers
building the world’s biggest lithium-ion bat-
tery factory,” Forbes.
25. Whether a product is a substitute
(complement) can be estimated by the cross-
elasticity of demand. The cross-elasticity
estimates the percentage change in the quan-
tity demanded of good X resulting from a
1 percent change in the price of good Y.
If the cross-elasticity of demand is greater
(less) than zero, the products are substitutes
(complements). For a detailed discussion, see:
Allen, W.B., K. Weigelt, N. Doherty, and E.
Mansfield (2009), Managerial Economics
Theory, Application, and Cases, 7th ed. (New
York: Norton).
26. This example, as with some others in
the section on the five forces, is drawn from
Magretta, J. (2012), Understanding Michael
Porter: The Essential Guide to Competition
and Strategy (Boston, MA: Harvard Business
Review Press).
27. Because the threat of entry is one of the
five forces explicitly recognized in Porter’s
model, we discuss barriers to entry when
introducing the threat of entry above. The
competitive industry structure framework is
frequently referred to as the structure-conduct-
performance (SCP) model. For a detailed
discussion, see: Allen, W.B., K. Weigelt, N.
Doherty, and E. Mansfield (2009), Manage-
rial Economics Theory, Application, and
Cases, 7th ed. (New York: Norton); Carlton,
D.W., and J.M. Perloff (2000), Modern
Industrial Organization, 3rd ed. (Reading,
MA: Addison-Wesley); Scherer, F.M., and D.
Ross (1990), Industrial Market Structure and
Economic Performance, 3rd ed. (Boston, MA:
Houghton Mifflin); and Bain, J.S. (1968),
Industrial Organization (New York: John
Wiley & Sons).
28. Besanko, D., E. Dranove, M. Hanley,
and S. Schaefer (2010), The Economics of
Strategy, 5th ed. (Hoboken, NJ: John Wiley
& Sons).
29. Dixit, A., S. Skeath, and D.H. Reiley
(2009), Games of Strategy, 3rd ed. (New
York: Norton).
30. When there are only two main competi-
tors, it’s called a duopoly and is a special case
of oligopoly.
31. Yoffie, D.B., and R. Kim (2011), “Coca-
Cola in 2011: In Search of a New Model,”
Harvard Business School Case 711-504,
June (revised August 2012). See also, Yoffie,
D.B., and Y. Wang (2002, Jan.), “Cola Wars
Continue: Coke and Pepsi in the Twenty-First
Century,” Harvard Business School
Case 702-442 (revised January 2004,
et seq).
32. “Trustbusting in the internet age:
Should digital monopolies be broken up?”
The Economist, November 29, 2014; and
“Internet monopolies: Everybody wants to
rule the world,” The Economist, November
29, 2014.
33. See Chang, S-J., and B. Wu (2013),
“Institutional barriers and industry dynam-
ics,” Strategic Management Journal 35:
1103–1123. Discussion of this new and
insightful research offers an opportunity to
link the PESTEL analysis to the five forces
analysis. The study focuses on the competi-
tive interaction between incumbents and new
entrants as a driver of industry evolution.
It investigates the impact of institutional
characteristics (political, legal, and socio-
cultural norms in PESTEL analysis) unique
to China on productivity and exit hazards
of incumbents versus new entrants. China’s
environment created a divergence between
productivity and survival that shaped indus-
try evolution. It also offers an illustration of
the role that liability of newness plays in new
entrant survival.
34. Brandenburger, A.M., and B. Nalebuff
(1996), Co-opetition (New York: Currency
Doubleday); and Grove, A.S. (1999), Only
the Paranoid Survive (New York: Time
Warner).
35. Milgrom, P., and J. Roberts (1995),
“Complementarities and fit strategy, structure,
and organizational change in manufacturing,”
Journal of Accounting and Economics 19, no.
2-3: 179–208; and Brandenburger, A.M., and
B. Nalebuff (1996), Co-opetition (New York:
Currency Doubleday).
36. In this recent treatise, Porter also high-
lights positive-sum competition. See: Porter,
M.E. (2008), “The five competitive forces that
shape strategy,” Harvard Business Review,
January.
37. This discussion is based on Zachary,
M.A., P.T. Gianiodis, G. Tyge Payne, and
G.D. Markman (2014), Entry timing: Endur-
ing lessons and future directions, Journal
of Management, 41: 1388-1415; and Bryce,
D.J.,+ and J.H. Dyer (2007), Strategies to
crack well-guarded markets, Harvard Busi-
ness Review, May: 84-92. I also gratefully
acknowledge the additional input received by
Professors Zachary, Gianiodis, Tyge Payne,
and Markman.
38. “Reading between the lines,” The Econo-
mist, March 26, 2009; and “New York Times
is near web charges,” The Wall Street Journal,
January 19, 2010.
39. Porter, M.E. (1980), Competitive Strat-
egy: Techniques for Analyzing Industries
and Competitors (New York: Free Press);
Hatten, K.J., and D.E. Schendel (1977),
“Heterogeneity within an industry: Firm
conduct in the U.S. brewing industry,” Jour-
nal of Industrial Economics 26: 97–113;
and Hunt, M.S. (1972), Competition in the
Major Home Appliance Industry, 1960–
1970, unpublished doctoral dissertation,
Harvard University.
40. This discussion is based on: McNa-
mara, G., D.L. Deephouse, and R. Luce
(2003), “Competitive positioning within
and across a strategic group structure: The
performance of core, secondary, and soli-
tary firms,” Strategic Management Journal
24: 161–181; Nair, A., and S. Kotha (2001),
“Does group membership matter? Evidence
from the Japanese steel industry,” Strategic
Management Journal 22: 221–235; Cool,
K., and D. Schendel (1988), “Performance
differences among strategic group mem-
bers,” Strategic Management Journal 9:
207–223; Hunt, M.S. (1972), Competition in
the Major Home Appliance Industry, 1960–
1970, unpublished doctoral dissertation,
Harvard University; Hatten, K.J., and D.E.
Schendel (1977), “Heterogeneity within an
industry: Firm conduct in the U.S. brewing
industry,” Journal of Industrial Economics
26: 97–113; and Porter, M.E. (1980), Com-
petitive Strategy: Techniques for Analyzing
Industries and Competitors (New York:
Free Press), 102
41. In Exhibit 3.7, United Airlines is the
biggest bubble because it merged with Conti-
nental in 2010, creating the largest airline in
the United States. Delta is the second-biggest
airline in the United States after merging with
Northwest Airlines in 2008.
42. American’s hub is at Dallas-Fort Worth;
Continental’s is at Newark, New Jersey;
United’s is at Chicago; and U.S. Airways’ is at
Charlotte, North Carolina.
43. Caves, R.E., and M.E. Porter (1977),
“From entry barriers to mobility barriers,”
Quarterly Journal of Economics 91:
241–262.
44. Carey, S. (2015, Mar. 16.), “U.S. airlines
battling gulf carriers cite others’ experience,”
The Wall Street Journal.
45. Carey, S. (2014, Oct. 14), “Steep learning
curve for Southwest Airlines as it flies over-
seas,” The Wall Street Journal.
46. Porter, M.E. (2008), “The five competi-
tive forces that shape strategy,” Harvard
Business Review, January; and Magretta, J.
(2012), Understanding Michael Porter: The
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rot27628_ch03_064-105.indd 105 10/30/17 07:49 PM
CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 105
Essential Guide to Competition and Strategy
(Boston, MA: Harvard Business Review
Press): 56–57.
47. “U.S. indicts six Volkswagen executives
in emissions scandal,” The Wall Street Jour-
nal, January 11, 2017, and “Volkswagen’s
emissions bill could surpass $25 billion,” The
Wall Street Journal, February 1, 2017.
48. Markovich, T. (2017, Feb. 27), “Norway
Looks to Eliminate Gas and Diesel Auto Sales
by 2025 with EV and Plug-In Incentives”,
Car & Driver; Cobb, J. (2016, Jan. 18), “Top
Six Plug-in Vehicle Adopting Countries –
2015,” HybridCars.com.
49. Corporate website; Orciari, M. (2013,
Mar. 12), “Industry self-regulation permits
junk food ads in programming popular with
children,” Yale News, accessed online; Moss,
M. (2013, Feb. 24), “How the fast food indus-
try creates and keeps selling the crave,” The
New York Times Magazine.
50. Benson-Armer, R., J. Sarakatsannis and
K. Wee (2014, Aug.), “The future of text-
books,” McKinsey on Society.
51. The myStrategy module is based on:
Friedman, T. (2005), The World Is Flat: A
Brief History of the Twenty-first Century
(New York: Farrar, Strauss & Giroux); and
ValueNotes, http://www.sourcingnotes.com/
content/view/197/54/.
52. “Medical Tourism Statistics and
Facts,” Patients Beyond Borders web-
site, accessed April 27, 2017, at http://
www.patientsbeyondborders.com/
medical-tourism-statistics-facts.
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CHAPTER Internal Analysis:
Resources, Capabilities,
and Core Competencies
Chapter Outline
4.1 Core Competencies
4.2 The Resource-Based View
Two Critical Assumptions
The VRIO Framework
Isolating Mechanisms: How to Sustain a Competitive
Advantage
4.3 The Dynamic Capabilities Perspective
4.4 The Value Chain and Strategic Activity Systems
The Value Chain
Strategic Activity Systems
4.5 Implications for Strategic Leaders
Using SWOT Analysis to Generate Insights from
External and Internal Analysis
Learning Objectives
LO 4-1 Differentiate among a firm’s core competen-
cies, resources, capabilities, and activities.
LO 4-2 Compare and contrast tangible and intan-
gible resources.
LO 4-3 Evaluate the two critical assumptions
behind the resource-based view.
LO 4-4 Apply the VRIO framework to assess the com-
petitive implications of a firm’s resources.
LO 4-5 Evaluate different conditions that allow a
firm to sustain a competitive advantage.
LO 4-6 Outline how dynamic capabilities can enable
a firm to sustain a competitive advantage.
LO 4-7 Apply a value chain analysis to understand
which of the firm’s activities in the process
of transforming inputs into outputs generate
differentiation and which drive costs.
LO 4-8 Identify competitive advantage as residing in
a network of distinct activities.
LO 4-9 Conduct a SWOT analysis to generate
insights from external and internal analysis
and derive strategic implications.
4
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Dr. Dre’s Core Competency:
Coolness Factor
IN 2014, DR. DRE —whose real name is Andre Young—
was celebrated as the first hip-hop billionaire after Apple
acquired Beats Electronics for $3 billion. Dr. Dre has a
long track record as a suc-
cessful music producer,
rapper, and entrepreneur.
Known for his strong
work ethic, he expects
nothing less than perfec-
tion from the people he
works with—similar to
some of the personal-
ity attributes ascribed
to the late Steve Jobs,
co-founder and longtime
CEO of Apple.
Although Dr. Dre cre-
ated and subsequently sold
several successful music
record labels, as an entre-
preneur he is best known as
co-founder of Beats Elec-
tronics with Jimmy Iovine, also an entrepreneur and record
and film producer. Both are considered to be some of the best-
connected businesspeople in the music industry, with personal
networks spanning hundreds of both famous and up-and-
coming artists. Founded in 2008, Beats Electronics is known
globally for its premium consumer headphones, Beats by
Dr. Dre, which he claims allows the listeners to “hear all the
music.” Since early 2014, the company also offers the stream-
ing music subscription service Beats Music. Beats’ vision is to
“bring the energy, emotion, and excitement of playback in the
recording studio to the listening experience and introduce an
entirely new generation to the possibilities of premium sound
entertainment.”1 Many acoustics experts maintain, however,
that playback of digitally compressed MP3 audio files is infe-
rior in comparison to high fidelity. Moreover, the sound qual-
ity of Beats headphones is considered poor in comparison to
other premium-brand headphones such as those by Bose, JBL,
Sennheiser, and others.
Why then would Apple pay $3 billion to acquire Beats
Electronics? This was by far the largest acquisition in Apple’s
history. Two main reasons: First, Apple is hoping that some of
Beats’ coolness will spill over to its brand, which has become
somewhat stale. Apple’s iPhones, for example, have become
a somewhat standardized commodity given the successful
imitation by Samsung and others, although Apple has high
expectations for its 10th anniversary iPhone, released in the
fall of 2017. Second,
although Apple is the
world’s largest music
vendor with 800 mil-
lion accounts on iTunes
Store, the industry is
being disrupted. Con-
tent deliv ery, especially
in music but also video
(think Netflix), is mov-
ing rapidly from own-
ership via downloads to
streaming on demand.
As a consequence,
music downloads have
been declining in the
past few years.
BEATS’ COOLNESS FACTOR
Beats by Dr. Dre achieved an unprecedented coolness fac-
tor with celebrity endorsements not only from music icons
but also athletes, actors, and other stars. Before Beats, no
musician endorsed audio headphones in the same way as a
basketball player such as Michael Jordan endorsed his line
of Nike shoes, Air Jordan. Dr. Dre was the first legend-
ary music producer to endorse premium headphones. In
addition, he created custom Beats for stars such as Justin
Bieber, Lady Gaga, and Nicki Minaj. Other music celebri-
ties including Skrillex, Lil Wayne, and will.i.am endorsed
Beats by wearing them in their music videos and at live
events and mentioning them on social media. But Beats did
not stop at musicians. Famous athletes—basketball super-
stars LeBron James and Kobe Bryant, tennis player Serena
Williams, and soccer stars Cristiano Ronaldo and Neymar
Jr.—wear Beats by Dr. Dre in public and endorse the brand
in advertisements.
Dr. Dre, left, and Jimmy Iovine are co-founders of Beats. Following Apple’s
acquisition of Beats, Dre and Iovine continue to work together to keep Beats
relevant and tied to current artists.
©Kevin Mazur/WireImage/Getty Images
CHAPTERCASE 4
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DISRUPTION IN CONTENT DELIVERY
Content delivery is rapidly moving from ownership through
downloads to renting via online streaming. This disruption
in the business model is most visible in movies, as the suc-
cess of Netflix demonstrates, but is also gaining steam in
music. Apple is a laggard in music streaming when compared
to leaders such as Pandora with 250 million users and Spo-
tify with 100 million users (of whom 50 million are paying
customers). Apple’s initial attempt at online music stream-
ing service, iTunes Radio created in 2013, has been falling
flat. After disrupting the music download space with iTunes
in 2003, Apple is now being disrupted by others that lead
in music streaming. Apple is hoping that by acquiring Beats
Music it can become a leader in the music streaming space.
Renamed Apple Music, the service now has 20 million
paid subscribers. Yet it faces competition in the “coolness
space”? with the music streaming service Tidal, founded by
rap mogul Jay Z. Tidal has exclusive release contracts with
superstar artists such as Kanye West, Rihanna, and Beyoncé
(who is married to Jay Z). Tidal, however, only has some
2 million paid subscribers. The network provider Sprint,
nonetheless, acquired one-third of Tidal in 2017.2
You will learn more about Beats Electronics by reading
this chapter; related questions appear in “ChapterCase 4 /
Consider This. . . .”
ONE OF THE KEY messages of this chapter is that a firm’s ability to gain and sus-
tain competitive advantage is partly driven by core competencies—unique strengths
that are embedded deep within a firm. 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. So what are core com-
petencies of Beats by Dr. Dre? Beats succeeds not because it provides the best possible
acoustic experience, but because it functions as a fashion statement that communicates
coolness.3 The iconic headphones are worn by celebrities from music, movies, and sports.
Even fashion designer Marc Jacobs had models wear Beats headphones during runway
shows. The extent to which Beats succeeds at product placements with celebrities across
the world is unprecedented. The genius behind Beats is creating a perception that if you
want to be as cool as one of your heroes, you need to shell out hundreds of dollars to wear
plastic headphones in public.
Beats’ unique strengths in establishing a brand that communicates coolness is built upon
Dr. Dre’s intuition and feel for music and cultural trends; Dr. Dre is one of music’s sav-
viest marketing minds. Although the sound quality of Beats headphones is good enough,
they mainly sell as a fashion accessory for their coolness factor and brand image. Dr. Dre
relies on gut instinct in making decisions, while shunning market research. This approach
is quite similar to Apple’s late co-founder Steve Jobs who made no secret of his disdain for
market research because he believed that consumers don’t really know what they want until
someone else shows it to them.
Beats’ core competency in marketing allows the company to differentiate its products
from rival offerings because it is able to create higher perceived value for its customers.
In turn, Beats’ core competency affords the firm a competitive advantage. It is hugely
successful: Beats holds some 65 percent market share in the premium headphone market,
priced at $100 and up. Beats’ competitive advantage was rewarded with a $3 billion acqui-
sition by Apple.
In this chapter, we study analytical tools to explain why differences in firm performance
exist even within the same industry. For example, why does Beats Electronics outperform
Audio-Technica, Bose, JBL, Skullcandy, Sennheiser, and Sony in the high-end, premium
headphone market? Since these companies compete in the same industry and face similar
external opportunities and threats, the source for some of the observable performance dif-
ference must be found inside the firm. When discussing industry, firm, and other effects in
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explaining superior performance, we noted that up to 55 percent of the overall performance
differences is explained by firm-specific effects (see Exhibit 3.2). Looking inside the firm
to analyze its resources, capabilities, and core competencies allows us to understand the
firm’s strengths and weaknesses. Linking these insights from a firm’s internal analysis
to the ones derived in Chapter 3 on external analysis allows managers to determine their
strategic options. Ideally, firms want to leverage their internal strengths to exploit external
opportunities, and to mitigate internal weaknesses and external threats.
Exhibit 4.1 depicts how and why we move from the firm’s external environment to
its internal environment. To formulate and implement a strategy that enhances the firm’s
chances of gaining and sustaining competitive advantage, the firm must have certain types of
resources and capabilities that combine to form core competencies. The best firms consci-
entiously identify their core competencies, resources, and capabilities to survive and suc-
ceed. Firms then determine how to manage and develop internal strengths to respond to the
challenges and opportunities in their external environment. In particular, firms conduct the
evaluation and development of internal strengths in the context of external PESTEL forces
and competition within its industry and strategic group.
The firm’s response is dynamic. Rather than creating a onetime and thus a static fit, the
firm’s internal strengths need to change with its external environment in a dynamic fash-
ion. At each point the goal should be to develop resources, capabilities, and competencies
that create a strategic fit with the firm’s environment. The forward motion of those envi-
ronmental forces must also be considered. The chapter will provide a deeper understanding
of the sources of competitive advantage that reside within a firm.
To gain a better understanding of why and how firm differences explain competitive
advantage, we begin this chapter by taking a closer look at core competencies. Next, we
introduce the resource-based view of the firm to provide an analytical model that allows
us to assess resources, capabilities, and competencies and their potential for creating a
sustainable competitive advantage. We discuss the dynamic capabilities perspective, a
model that emphasizes a firm’s ability to modify and leverage its resource base to gain
EXHIBIT 4.1 /
Inside the Firm:
Competitive
Advantage based on
Core Competencies,
Resources, and
Capabilities
Political Economic
Sociocultural
TechnologicalEcological
Industry
Legal
Inside the Firm:
Core Competencies,
Resources, and Capabilities
Strategic Group
External Environment
External Environment
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110 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
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and sustain a competitive advantage in a constantly changing environment. We then turn
our attention to the value chain analysis to gain a deeper understanding of the internal
activities a firm engages in when transforming inputs into outputs. Next, we take a closer
look at strategic activity systems. Here, a firm’s competitive advantages resides in a net-
work of interconnected and reinforcing activities. We conclude with Implications for Stra-
tegic Leaders, with a particular focus on how to use the SWOT analysis to obtain strategic
insights from combining external with internal analysis.
4.1 Core Competencies
Let’s begin by taking a closer look at core competencies. These are unique strengths,
embedded deep within a firm. 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. The important point here is that
competitive advantage can be driven by core competencies.4
Take Honda as an example of a company with a clearly defined core competency. Its
life began with a small two-cycle motorbike engine. Through continuous learning over
several decades, and often from lessons learned from failure, Honda built the core compe-
tency to design and manufacture small but powerful and highly reliable engines for which
it now is famous. This core competency results from superior engineering know-how and
skills carefully nurtured and honed over several decades.
Honda’s business model is to find a place to put its engines.
Today, Honda engines can be found everywhere: in cars,
SUVs, vans, trucks, motorcycles, ATVs, boats, generators,
snowblowers, lawn mowers and other yard equipment, and
even small airplanes. Due to their superior performance,
Honda engines have been the most popular in the Indy Rac-
ing League (IRL) since 2006. Not coincidentally, this was
also the first year in its long history that the Indy 500 was
run without a single engine problem.
One way to look at Honda is to view it as a company with a
distinct competency in engines and a business model of find-
ing places to put its engines. That is, underneath the products
and services that make up the visible side of competition lies
a diverse set of invisible competencies that make this happen.
These invisible core competencies reside deep within the
firm. Companies, therefore, compete as much in the product
and service markets as they do in developing and leverag-
ing core competencies. Although invisible by themselves,
core competencies find their expression in superior products and services. Exhibit 4.2
identifies the core competencies of a number of companies, with application examples.
Since core competencies are critical to gaining and sustaining competitive advantage,
it is important to understand how they are created. Companies develop core competencies
through the interplay of resources and capabilities. Exhibit 4.3 shows this relationship.
Resources are any assets such as cash, buildings, machinery, or intellectual property that
a firm can draw on when crafting and executing a strategy. Resources can be either tan-
gible or intangible. Capabilities are the organizational and managerial skills necessary to
LO 4-1
Differentiate among a
firm’s core competencies,
resources, capabilities,
and activities.
Honda promotes its
expertise with engines
by sponsoring race car
driver Danica Patrick.
©AP Images/Julio Cortez
core competencies Unique strengths, embed-
ded deep within a firm, that are critical to
gaining and sustaining competitive advantage.
resources Any assets that a firm can draw
on when formulating and implementing a
strategy.
capabilities Organizational and managerial
skills necessary to orchestrate a diverse set
of resources and deploy them strategically.
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Company Core Competencies Application Examples
Amazon.com • Superior IT capabilities.
• Superior customer service.
• Online retailing: Largest selection of items online.
• Cloud computing: Largest provider through Amazon
Web Services (AWS).
Apple • Superior industrial design in integration of
hardware and software.
• Superior marketing and retailing experience.
• Establishing an ecosystem of products and services
that reinforce one another in a virtuous fashion.
• Creation of innovative and category-defining mobile
devices and software services that take the user’s
experience to a new level (e.g., iMac, iPod, iTunes,
iPhone, iPad, Apple Pay, and Apple Watch).
Beats
Electronics
• Superior marketing: creating a perception of coolness.
• Establishing an ecosystem, combining hardware
(headphones) with software (streaming service).
• Beats by Dr. Dre and Beats Music.
Coca-Cola • Superior marketing and distribution. • Leveraging one of the world’s most recognized
brands (based on its original “secret formula”) into a
diverse lineup of soft drinks.
• Global availability of products.
ExxonMobil • Superior at discovering and exploring fossil-fuel–
based energy sources globally.
• Focus on oil and gas (fossil fuels only, not
renewables).
Facebook • Superior IT capabilities to provide reliable social
network services globally on a large scale.
• Superior algorithms to offer targeted online ads.
• Connecting 2 billion social media users worldwide.
• News feed, timeline, graph search, and stories.
General
Electric
• Superior expertise in industrial engineering,
designing and implementing efficient management
processes, and developing and training leaders.
• Providing products and services to solve tough
engineering problems in energy, health care, and
aerospace, among other sectors.
Google (a
subsidiary
of Alphabet)
• Superior in creating proprietary algorithms based
on large amounts of data collected online.
• Software products and services for the internet
and mobile computing, including some mobile
devices (Pixel phone, Chromebook).
• Online search, Android mobile operating system,
Chrome OS, Chrome web browser, Google Play,
AdWords, AdSense, Google docs, Gmail, etc.
Honda • Superior engineering of small but powerful and
highly reliable internal combustion engines.
• Motorcycles, cars, ATVs, sporting boats,
snowmobiles, lawn mowers, small aircraft, etc.
IKEA • Superior in designing modern functional home
furnishings at low cost.
• Superior retail experience.
• Fully furnished room setups, practical tools for all
rooms, do-it-yourself.
McKinsey • Superior in developing practice-relevant
knowledge, insights, and frameworks in strategy.
• Management consulting; in particular, strategy
consulting provided to company and government leaders.
Netflix • Superior in creating proprietary algorithms-based
individual customer preferences.
• DVD-by-mail rentals, streaming media (including
proprietary) content, connection to game consoles.
Tesla • Superior engineering expertise in designing high-
performance battery-powered motors and power trains.
• Superior expertise in decentralized power storage and
management based on renewable (solar) energy.
• Model S, Model X, and Model 3.
• Powerwall, solar roof tiles, and complete rooftop
solar systems.
Uber • Superior mobile-app–based transportation and logistics
expertise focused on cities, but on global scale.
• Uber, UberX, UberBlack, UberLUX, UberSUV, etc.
EXHIBIT 4.2 / Company Examples of Core Competencies and Applications
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112 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
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orchestrate a diverse set of resources and to deploy them strategically. Capabilities are by
nature intangible. They find their expression in a company’s structure, routines, and culture.
As shown in Exhibit 4.3, such competencies are demonstrated in the company’s activi-
ties, which can lead to competitive advantage, resulting in superior firm performance.
Activities are distinct and fine-grained business processes such as order taking, the physi-
cal delivery of products, or invoicing customers. Each distinct activity enables firms to
add incremental value by transforming inputs into goods and services. In the interplay of
resources and capabilities, resources reinforce core competencies, while capabilities allow
managers to orchestrate their core competencies. Strategic choices find their expression in a
set of specific firm activities, which leverage core competencies for competitive advantage.
The arrows leading back from competitive advantage to resources and capabilities indicate
that superior performance in the marketplace generates profits that can be reinvested into
the firm (retained earnings) to further hone and upgrade a firm’s resources and capabilities
in its pursuit of achieving and maintaining a strategic fit within a dynamic environment.
We should make two more observations about Exhibit 4.3 before moving on. First, core
competencies that are not continuously nourished will eventually lose their ability to yield
a competitive advantage. And second, in analyzing a company’s success in the market,
it can be too easy to focus on the more visible elements or facets of core competencies
such as superior products or services. While these are the outward manifestation of core
competencies, what is even more important is to understand the invisible part of core com-
petencies. As to the first point, let’s consider the consumer electronics industry. For some
years, Best Buy outperformed Circuit City based on its strengths in customer-centricity
(segmenting customers based on demographic, attitudinal, and value tiers, and configuring
stores to serve the needs of the customer segments in that region), employee development,
and exclusive branding. Although Best Buy outperformed Circuit City (which filed for
bankruptcy in 2009), more recently Best Buy did not hone and upgrade its core competen-
cies sufficiently to compete effectively against Amazon.com, the world’s largest online
retailer. Amazon does not have the overhead expenses associated with maintaining build-
ings or human sales forces; therefore, it has a lower cost structure and thus can undercut in-
store retailers on price. When a firm does not invest in continual upgrading or improving
EXHIBIT 4.3 /
Linking Core
Competencies,
Resources,
Capabilities,
and Activities
to Competitive
Advantage
Competitive
AdvantageActivities
Core
Competencies
Reinvest, Hone, & Upgrade
Reinforce
Leverage
Orchestrate
Reinvest, Hone, & Upgrade
Capabilities
Resources
activities Distinct and
fine-grained business
processes that enable
firms to add incremental
value by transforming
inputs into goods and
services.
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core competencies, its competitors are more likely to develop equivalent or superior skills,
as did Amazon. This insight will allow us to explain differences between firms in the same
industry, as well as competitive dynamics, over time. It also will help us identify the strat-
egy with which firms gain and sustain a competitive advantage and weather an adverse
external environment.
As to the second point, we will soon introduce tools to help bring more opaque aspects
of a firm’s core competencies into the daylight to be seen with clarity. We start by looking
at both tangible and intangible resources.
4.2 The Resource-Based View
To gain a deeper understanding of how the interplay between resources and capabilities
creates core competencies that drive firm activities leading to competitive advantage, we
turn to the resource-based view of the firm. This model systematically aids in identifying
core competencies.5 As the name suggests, this model sees resources as key to superior
firm performance. As Exhibit 4.4 illustrates, resources fall broadly into two categories:
tangible and intangible. Tangible resources have physical attributes and are visible.
Examples of tangible resources are labor, capital, land, buildings, plant, equipment, and
supplies. Intangible resources have no physical attributes and thus are invisible. Exam-
ples of intangible resources are a firm’s culture, its knowledge, brand equity, reputation,
and intellectual property.
Consider Google (since 2015 a subsid-
iary of Alphabet, which is a holding com-
pany overseeing a diverse set of activities).
Alphabet’s tangible resources, valued at
$34 billion, include its headquarters (The
Googleplex)6 in Mountain View, California,
and numerous server farms (clusters of
computer servers) across the globe.7 The
Google brand, an intangible resource, is
valued at roughly $230 billion (number one
worldwide)—almost seven times higher than
the value of Alphabet’s tangible assets.8
Google’s headquarters provides examples
of both tangible and intangible resources. The
Googleplex is a piece of land with a futuris-
tic building, and thus a tangible resource. The
location of the company in the heart of Silicon
Valley is an intangible resource that provides
access to a valuable network of contacts and
gives the company several benefits. It allows
Google to tap into a large and computer-savvy
work force and access graduates and knowl-
edge spillovers from a large number of uni-
versities, which adds to Google’s technical
and managerial capabilities.9 Another benefit
LO 4-2
Compare and contrast
tangible and intangible
resources.
EXHIBIT 4.4 / Tangible and Intangible Resources
Intangible
• Culture
• Knowledge
• Brand Equity
• Reputation
• Intellectual Property
Invisible,
No Physical Attributes
• Patents
• Designs
• Copyrights
• Trademarks
• Trade Secrets
Tangible
Visible,
Physical Attributes
• Labor
• Capital
• Land
• Buildings
• Plant
• Equipment
• Supplies
Resources
resource-based view A model that sees
certain types of resources as key to superior
firm performance.
intangible resources Resources that do
not have physical attributes and thus are
invisible.
tangible resources Resources that have
physical attributes and thus are visible.
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stems from Silicon Valley’s designation as having the largest concentration of venture capital
in the United States. This proximity benefits Google because venture capitalists tend to pre-
fer local investments to ensure closer monitoring.10 Google received initial funding from the
well-known venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital, both
located in Silicon Valley.
Competitive advantage is more likely to spring from intangible rather than tangible
resources. Tangible assets, such as buildings or computer servers, can be bought on the open
market by anyone who has the necessary cash. However, a brand name must be built, often
over long periods of time. Google (founded in 1998) and Amazon.com (founded in 1994,
and with a brand value of $100 billion) accomplished their enormous brand valuations fairly
quickly due to a ubiquitous internet presence, while the other companies in the global top-10
most valuable brands—Apple, Microsoft, AT&T, Facebook, Visa, Verizon, McDonald’s,
and IBM—took much longer to build value and have it recognized in the marketplace.11
Note that the resource-based view of the firm uses the term resource much more broadly
than previously defined. In the resource-based view of the firm, a resource includes any
assets as well as any capabilities and competencies that a firm can draw upon when formu-
lating and implementing strategy. In addition, the usefulness of the resource-based view
to explain and predict competitive advantage rests upon two critical assumptions about the
nature of resources, to which we turn next.
TWO CRITICAL ASSUMPTIONS
Two assumptions are critical in the resource-based model: (1) resource heterogeneity
and (2) resource immobility.12 What does this mean? In the resource-based view, a firm
is assumed to be a unique bundle of resources, capabilities, and competencies. The first
critical assumption—resource heterogeneity—comes from the insight that bundles of
resources, capabilities, and competencies differ across firms. This insight ensures that ana-
lysts look more critically at the resource bundles of firms competing in the same industry
(or even the same strategic group), because each bundle is unique to some extent. For
example, Southwest Airlines (SWA) and Alaska Airlines both compete in the same stra-
tegic group (low-cost, point-to-point airlines, see Exhibit 3.7). But they draw on different
resource bundles. SWA’s employee productivity tends to be higher than that of Alaska
Airlines, because the two companies differ along human and organizational resources. At
SWA, job descriptions are informal and employees pitch in to “get the job done.” Pilots
may help load luggage to ensure an on-time departure; flight attendants clean airplanes to
help turn them around at the gate within 15 minutes from arrival to departure. This allows
SWA to keep its planes flying for longer and lowers its cost structure, savings that SWA
passes on to passengers in lower ticket prices.
The second critical assumption—resource immobility—describes the insight that
resources tend to be “sticky” and don’t move easily from firm to firm. Because of that
stickiness, the resource differences that exist between firms are difficult to replicate and,
therefore, can last for a long time. For example, SWA has enjoyed a sustained competitive
advantage, allowing it to outperform its competitors over several decades. That resource
difference is not due to a lack of imitation attempts, though. Continental and Delta both
attempted to copy SWA, with Continental Lite and Song airline offerings, respectively.
Neither airline, however, was able to successfully imitate the resource bundles and firm
capabilities that make SWA unique. Combined, these insights tell us that resource bundles
differ across firms, and such differences can persist for long periods. These two assump-
tions about resources are critical to explaining superior firm performance in the resource-
based model.
LO 4-3
Evaluate the two critical
assumptions behind the
resource-based view.
resource heterogeneity
Assumption in the
resource-based view
that a firm is a bundle of
resources and capabil-
ities that differ across
firms.
resource immobility
Assumption in the
resource-based
view that a firm has
resources that tend to
be “sticky” and that do
not move easily from
firm to firm.
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Note, by the way, that the critical assumptions of the resource-based model are fun-
damentally different from the way in which a firm is viewed in the perfectly competitive
industry structure introduced in Chapter 3. In perfect competition, all firms have access
to the same resources and capabilities, ensuring that any advantage that one firm has will
be short-lived. That is, when resources are freely available and mobile, competitors can
move quickly to acquire resources that are utilized by the current market leader. Although
some commodity markets approach this situation, most other markets include firms whose
resource endowments differ. The resource-based view, therefore, delivers useful insights
to managers about how to formulate a strategy that will enhance the chances of gaining a
competitive advantage.
THE VRIO FRAMEWORK
Our tool for evaluating a firm’s resource endowments is a framework that answers the ques-
tion of what resource attributes underpin competitive advantage. This framework is implied
in the resource-based model, identifying certain types of resources as key to superior firm
performance.13 For a resource to be the basis of a competitive advantage, it must be
Valuable,
Rare, and costly to
Imitate. And finally, the firm itself must be
Organized to capture the value of the resource.
Following the lead of Jay Barney, one of the pioneers of the resource-based view of
the firm, we call this model the VRIO framework.14 According to this model, a firm can
gain and sustain a competitive advantage only when it has resources that satisfy all of the
VRIO criteria. Keep in mind that resources in the VRIO framework are broadly defined to
include any assets as well as any capabilities and competencies that a firm can draw upon
when formulating and implementing strategy. So to some degree, this presentation of the
VRIO model summarizes all of our discussion in the chapter so far.
Exhibit 4.5 captures the VRIO framework in action. You can use this decision tree to
decide if the resource, capability, or competency under consideration fulfills the VRIO
EXHIBIT 4.5 / Applying the VRIO Framework to Reveal Competitive Advantage
Sustainable
Competitive
Advantage
Is the Resource, Capability, or Competency…
and Is the Firm…
Valuable?
Rare?
Organized
to Capture
Value?
Temporary
Competitive
Advantage
Competitive
Parity
Competitive
Disadvantage
YES
YES
YES YES
NO
NO
NO
Imitation
Costly?
Temporary
Competitive
Advantage
NO
VRIO framework A the-
oretical framework that
explains and predicts
firm-level competitive
advantage.
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requirements. As you study the following discussion of each of the VRIO attributes, you
will see that the attributes accumulate. If the answer is “yes” four times to the attributes
listed in the decision tree, only then is the resource in question a core competency that
underpins a firm’s sustainable competitive advantage.
VALUABLE. A valuable resource is one that enables the firm to exploit an external
opportunity or offset an external threat. This has a positive effect on a firm’s competi-
tive advantage. In particular, a valuable resource enables a firm to increase its economic
value creation (V − C). Revenues rise if a firm is able to increase the perceived value of its
product or service in the eyes of consumers by offering superior design and adding attrac-
tive features (assuming costs are not increasing). Production costs, for example, fall if the
firm is able to put an efficient manufacturing process and tight supply chain management
in place (assuming perceived value is not decreasing). Beats Electronics’ ability to design
and market premium headphones that bestow a certain air of coolness upon wearers is a
valuable resource. The profit margins for Beats designer headphones are astronomical: The
production cost for its headphones is estimated to be no more than $15, while they retail for
$150 to $450, with some special editions over $1,000. Thus, Beats’ competency in design-
ing and marketing premium headphones is a valuable resource in the VRIO framework.
RARE. A resource is rare if only one or a few firms possess it. If the resource is com-
mon, it will result in perfect competition where no firm is able to maintain a competitive
advantage (see discussion in Chapter 3). A resource that is valuable but not rare can lead
to competitive parity at best. A firm is on the path to competitive advantage only if it pos-
sesses a valuable resource that is also rare. Beats Electronics’ ability and reach in product
placement and celebrity endorsements that build its coolness factor are certainly rare. No
other brand in the world, not even Apple or Nike, has such a large number of celebrities
from music, movies, and sports using its product in public. Thus, this resource is not only
valuable but also rare.
COSTLY TO IMITATE. A resource is costly to imitate if firms that do not possess the resource
are unable to develop or buy the resource at a reasonable price. If the resource in question is
valuable, rare, and costly to imitate, then it is an internal strength and a core competency. If
the firm’s competitors fail to duplicate the strategy based on the valuable, rare, and costly-to-
imitate resource, then the firm can achieve a temporary competitive advantage.
Beats’ core competency in establishing a brand that communicates coolness is built
upon the intuition and feel for music and cultural trends of Dr. Dre, one of music’s savviest
marketing minds. Although the sound quality of Beats headphones is good enough, they
mainly sell as a fashion accessory for their coolness factor and brand image. Because its
creator Dr. Dre relies on gut instinct in making decisions rather than market research, this
resource is costly to imitate. Even if a firm wanted to copy Beats’ core competency—how
would it go about it? The music and trend-making talent as well as the social capital of
Dr. Dre and Jimmy Iovine, two of the best-connected people in the music industry, might
be impossible to replicate. Even Apple with its deep talent pool decided not to build its
own line of premium headphones but rather opted to acquire Beats Electronics’ line for
$3 billion, and to put employment contracts in place that make Dr. Dre and Jimmy Iovine
senior executives at Apple Inc. The combination of the three resource attributes (V + R + I)
has allowed Beats Electronics to enjoy a competitive advantage (see Exhibit 4.5).
A firm that enjoys a competitive advantage, however, attracts significant attention from
its competitors. They will attempt to negate a firm’s resource advantage by directly imitat-
ing the resource in question (direct imitation) or through working around it to provide a
comparable product or service (substitution).
LO 4-4
Apply the VRIO framework
to assess the competitive
implications of a firm’s
resources.
valuable resource One
of the four key criteria
in the VRIO framework.
A resource is valuable
if it helps a firm exploit
an external opportunity
or offset an external
threat.
rare resource One of
the four key criteria in
the VRIO framework. A
resource is rare if the
number of firms that
possess it is less than
the number of firms
it would require to
reach a state of perfect
competition.
costly-to-imitate
resource One of the
four key criteria in the
VRIO framework. A
resource is costly to imi-
tate if firms that do not
possess the resource
are unable to develop
or buy the resource at a
comparable cost.
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Direct Imitation. We usually see direct imitation, as a way to copy
or imitate a valuable and rare resource, when firms have diffi-
culty protecting their advantage. (We discuss barriers to imitation
shortly.) Direct imitation is swift if the firm is successful and intel-
lectual property (IP) protection such as patents or trademarks, for
example, can be easily circumvented.
Crocs, the maker of the iconic plastic clog, fell victim to direct
imitation. Launched in 2002 as a spa shoe at the Fort Lauderdale,
Florida, boat show, Crocs experienced explosive growth, selling
millions of pairs each year and reaching over $650 million in rev-
enue in 2008. Crocs are worn by people in every age group and walk
of life, including celebrities Sergey Brin, Matt Damon, Heidi Klum, Adam Sandler, and
even Kate Middleton, the Duchess of Cambridge. To protect its unique shoe design, the
firm owns several patents. Given Crocs’ explosive growth, however, numerous cheap imi-
tators have sprung up to copy the colorful and comfortable plastic clog. Despite the patents
and celebrity endorsements, other firms were able to copy the shoe, taking a big bite into
Crocs’ profits. Indeed, Crocs’ share price plunged from a high of almost $75 to less than
$1 in just 13 months.15
This example illustrates that competitive advantage cannot be sustained if the
underlying capability can easily be replicated and can thus be directly imitated. Com-
petitors simply created molds to imitate the shape, look, and feel of the original Crocs
shoe. Any competitive advantage in a fashion-driven industry, moreover, is notori-
ously short-lived if the company fails to continuously innovate or build such brand
recognition that imitators won’t gain a foothold in the market. Crocs was more or less
a “one-trick pony.”
Beats Electronics, on the other hand, created an ecosystem of hardware (Beats by Dr.
Dre) and software (Beats Music) that positively reinforce one another. Beats by Dr. Dre are
the installed base that drives demand for Beats Music (now called Apple Music). As Apple
Music’s music streaming and celebrity-curated playlists become more popular, demand for
Beats headphones further increases. With increasing demand, Apple Music services also
become more valuable as its proprietary algorithms have more data to work with. Continu-
ous innovation by churning out new headphone designs combined with the unique cool-
ness factor of Dr. Dre make direct imitation attempts difficult.
Substitution. The second avenue of imitation for a firm’s valuable and rare resource is
through substitution. This is often accomplished through strategic equivalence. Take the
example of Jeff Bezos launching and developing Amazon.com.16 Before Amazon’s incep-
tion, the retail book industry was dominated by a few large chains and many independent
mom-and-pop bookstores. As the internet was emerging in the 1990s, Bezos was looking
for options in online retail. He zeroed in on books because of their non-differentiated com-
modity nature and easiness to ship. In purchasing a printed book online, customers knew
exactly what they would be shipped, because the products were identical, whether sold
online or in a brick-and-mortar store. The only difference was the mode of transacting and
delivery. Taking out the uncertainty of online retailing to some extent made potential cus-
tomers more likely to try this new way of shopping.
The emergence of the internet allowed Bezos to come up with a new distribution system
that negated the need for retail stores and thus high real-estate costs. Bezos’ new business
model of ecommerce not only substituted for the traditional fragmented supply chain in
book retailing, but also allowed Amazon to offer lower prices due to its lower operating
costs. Amazon uses a strategic equivalent substitute to satisfy a customer need previously
met by brick-and-mortar retail stores.
Tiffany & Co. has developed
a core competency–elegant
jewelry design and crafts-
manship delivered through
a superior customer
experience–that is valuable,
rare, and costly for competi-
tors to imitate. The company
vigorously protects its trade-
marks, including its Tiffany
Blue Box, but it never trade-
marked the so-called Tiffany
setting for diamond rings,
used now by many jewelers.
The term has been co-opted
for advertising by other
retailers (including Costco),
which now maintain it is a
generic term commonly used
in the jewelry industry.
©Lucas Oleniuk/Getty Images
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Combining Imitation and Substitution. In some instances, firms are able to combine
direct imitation and substitution when attempting to mitigate the competitive advan-
tage of a rival. With its Galaxy line of smartphones, Samsung has been able to imitate
successfully the look and feel of Apple’s iPhones. Samsung’s Galaxy smartphones use
Google’s Android operating system and apps from Google Play as an alternative to
Apple’s iOS and iTunes Store. Samsung achieved this through a combination of direct
imitation (look and feel) and substitution (using Google’s mobile operating system and
app store).17
More recently Amazon has opened a new chapter in its competitive moves by its acqui-
sition of the brick-and-mortar Whole Foods in 2017. As we will see in ChapterCase 8,
Amazon’s entry into high-end groceries involves both imitation and substitution.
ORGANIZED TO CAPTURE VALUE. The final criterion of whether a rare, valuable, and
costly-to-imitate resource can form the basis of a sustainable competitive advantage
depends on the firm’s internal structure. To fully exploit the competitive potential of its
resources, capabilities, and competencies, a firm must be organized to capture value—
that is, it must have in place an effective organizational structure and coordinating systems.
(We will study organizational design in detail in Chapter 11.)
Before Apple or Microsoft had any significant share of the personal computer mar-
ket, Xerox’s Palo Alto Research Center (PARC) invented and developed an early word-
processing application, the graphical user interface (GUI), the Ethernet, the mouse
as a pointing device, and even the first personal computer. These technology break-
throughs laid the foundation of the desktop-computing industry.18 Xerox’s invention
competency built through a unique combination of resources and capabilities was
clearly valuable, rare, and costly to imitate with the potential to create a competitive
advantage.
Due to a lack of appropriate organization, however, Xerox failed to appreciate and
exploit the many breakthroughs made by PARC in computing software and hardware.
Why? Because the innovations did not fit within the Xerox business focus at the time.
Under pressure in its core business from Japanese low-cost competitors, Xerox’s top
management was busy pursuing innovations in the photocopier business. Xerox was
not organized to appreciate the competitive potential of the valuable, rare, and inimi-
table resources generated at PARC, if not in the photocopier field. Such organizational
problems were exacerbated by geography: Xerox headquarters is on the East Coast in
Norwalk, Connecticut, across the country from PARC on the West Coast in Palo Alto,
California.19 Nor did it help that development engineers at Xerox headquarters had a dis-
dain for the scientists engaging in basic research at PARC. In the meantime, both Apple
and Microsoft developed operating systems, graphical user interfaces, and application
software.
If a firm is not effectively organized to exploit the competitive potential of a valuable,
rare, and costly-to-imitate (VRI) resource, the best-case scenario is a temporary competi-
tive advantage (see Exhibit 4.5). In the case of Xerox, where management was not support-
ive of the resource, even a temporary competitive advantage would not be realized even
though the resource meets the VRI requirements.
In summary, for a firm to gain and sustain a competitive advantage, its resources and
capabilities need to interact in such a way as to create unique core competencies (see
Exhibit 4.3). Ultimately, though, only a few competencies may turn out to be those specific
core competencies that fulfill the VRIO requirements.20 A company cannot do everything
equally well and must carve out a unique strategic position for itself, making necessary
trade-offs.21 Strategy Highlight 4.1 demonstrates application of the VRIO framework.
organized to capture
value One of the four
key criteria in the
VRIO framework. The
characteristic of having
in place an effective
organizational structure,
processes, and systems
to fully exploit the
competitive potential
of the firm’s resources,
capabilities, and
competencies.
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Applying VRIO: The Rise and Fall of Groupon
After graduating with a degree in music from Northwestern
University, Andrew Mason spent a couple of years as a web
designer. In 2008, the then 27-year-old founded Groupon,
a daily-deal website that connects local retailers and other
merchants to consumers by offering goods and services at
a discount. Groupon creates marketplaces by bringing the
brick-and-mortar world of local commerce onto the internet.
The company basically offers a “group-coupon.” If more than
a predetermined number of Groupon users sign up for the
offer, the deal is extended to all Groupon users. For exam-
ple, a local spa may offer a massage for $40 instead of the
regular $80. If more than say 10 people sign up, the deal
becomes reality. The users prepay $40 for the coupon, which
Groupon splits 50-50 with the local merchant. Inspired by
how Amazon.com has become the global leader in ecom-
merce, Mason’s strategic vision for Groupon was to be the
global leader in local commerce.
Measured by its explosive growth, Groupon became one
of the most successful recent internet startups, with over
260 million subscribers and serving more than 500,000
merchants in the United States and some 50 countries.
Indeed, Groupon’s success attracted a $6 billion buyout offer
by Google in early 2011, which Mason declined. In November
2011, Groupon held a successful initial public offering (IPO),
valued at more than $16 billion with a share price of over
$26. But a year later, Groupon’s share price had fallen 90
percent to just $2.63, resulting in a market cap of less than
$1.8 billion. In early 2013, Mason posted a letter for Grou-
pon employees on the web, arguing that it would leak anyway,
stating, “After four and a half intense and wonderful years as
CEO of Groupon, I’ve decided that I’d like to spend more time
with my family. Just kidding—I was fired today.”
Although Groupon is still in business, it is just one compet-
itor among many, and not a market leader. What went wrong?
The implosion of Groupon’s market value can be explained
using the VRIO framework. Its competency to drum up more
business for local retailers by offering lower prices for its
users was certainly valuable. Before Groupon, local merchants
used online and classified ads, direct mail, yellow pages, and
other venues to reach customers. Rather than using one-way
communication, Groupon facilitates the meeting of supply and
demand in local markets. When Groupon launched, such local
market-making competency was also rare. Groupon, with its
first-mover advantage, seemed able to use technology in a way
so valuable and rare it prompted Google’s buyout offer. But
was it costly to imitate? Not so much.
The multibillion-dollar Google offer spurred potential
competitors to reproduce Groupon’s business model. They
discovered that Groupon was more of a sales company than
a tech venture, despite perceptions to the contrary. To target
and fine-tune its local deals, Groupon relies heavily on human
labor to do the selling. Barriers to entry in this type of busi-
ness are nonexistent because Groupon’s competency is built
more on a tangible resource (labor) than on an intangible
one (proprietary technology). Given that Groupon’s valuable
and rare competency was not hard to imitate, hundreds of
new ventures (so-called Groupon clones) rushed in to take
advantage of this opportunity. Existing online giants such as
Google, Amazon (via LivingSocial), and Facebook also moved
in. The spurned Google almost immediately created its own
daily-deal version with Google Offers.
Also, note that the ability to imitate a rare and valuable
resource is directly linked to barriers of entry, which is one
of the key elements in Porter’s five forces model (threat of
new entrants). This relationship allows linking internal analy-
sis using the resource-based view to external analysis with
the five forces model, which also would have predicted low
industry profit potential given low or no barriers to entry.
To make matters worse, these Groupon clones are often
able to better serve the needs of local markets and specific
population groups. Some daily-deal sites focus only on a spe-
cific geographic area. As an example, Conejo Deals meets
the needs of customers and retailers in Southern California’s
Conejo Valley, a cluster of suburban communities. These
hyper-local sites tend to have much deeper relationships and
expertise with merchants in their specific areas. Since they
are mostly matching local customers with local businesses,
moreover, they tend to foster more repeat business than
the one-off bargain hunters that use Groupon (based in Chi-
cago). In addition, some daily-deal sites often target specific
groups. They have greater expertise in matching their users
with local retailers (e.g., Daily Pride serving LGBT commu-
nities; Black Biz Hookup serving African-American business
owners and operators; Jdeal, a Jewish group-buying site in
New York City; and so on).
Strategy Highlight 4.1
(continued)
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ISOLATING MECHANISMS: HOW TO SUSTAIN
A COMPETITIVE ADVANTAGE
Although VRIO resources can lay the foundation of a competitive advantage, no competi-
tive advantage can be sustained indefinitely.23 Several conditions, however, can offer some
protection to a successful firm by making it more difficult for competitors to imitate the
resources, capabilities, or competencies that underlie its competitive advantage. Barriers
to imitation are important examples of isolating mechanisms because they prevent rivals
from competing away the advantage a firm may enjoy; they include:24
■ Better expectations of future resource value.
■ Path dependence.
■ Causal ambiguity.
■ Social complexity.
■ Intellectual property (IP) protection.
This link ties isolating mechanisms directly to one of the criteria in the resource-based
view to assess the basis of competitive advantage: costly (or difficult) to imitate. If one,
or any combination, of these isolating mechanisms is present, a firm may strengthen its
basis for competitive advantage, increasing its chance to be sustainable over a longer
period of time.
BETTER EXPECTATIONS OF FUTURE RESOURCE VALUE. Sometimes firms can acquire
resources at a low cost, which can lay the foundation for a competitive advantage later
when expectations about the future of the resource turn out to be more accurate than those
held by competitors. Better expectations of the future value of a resource allows a firm to
gain a competitive advantage. If such better expectations can be systematically repeated
over time, it may help in sustaining a competitive advantage.
A real estate developer illustrates the role that the future value of a resource can play.
She must decide when and where to buy land for future development. Her firm may gain
a competitive advantage if she buys a parcel of land for a low cost in an undeveloped rural
area 40 miles north of San Antonio, Texas—in anticipation that it will increase in value
with shifting demographics. Let’s assume, several years later, that an interstate highway
is built near her firm’s land. With the highway, suburban growth explodes as many new
neighborhoods and shopping malls are built. Her firm is now able to develop this particu-
lar piece of property to build high-end office or apartment buildings. The value creation
far exceeds the cost, and her firm gains a competitive advantage. The resource has sud-
denly become valuable, rare, and costly to imitate, gaining the developer’s firm a competi-
tive advantage.
LO 4-5
Evaluate different
conditions that allow
a firm to sustain a
competitive advantage.
“Finding your specific group” or “going hyper local” allows
these startups to increase the perceived value added for
their users over and above what Groupon can offer. Although
Groupon aspires to be the global leader, there is really no
advantage to global scale in serving local markets. This is
because daily-deal sites are best suited to market experi-
ence goods, such as haircuts at a local barber shop or a
meal in a specific Thai restaurant. The quality of these goods
and services cannot be judged unless they are consumed.
Creation of experience goods and their consumption happens
in the same geographic space.
Once imitated, Groupon’s competency to facilitate local
commerce using an internet platform was neither valuable
nor rare. As an application of the VRIO model would have
predicted, Groupon’s competitive advantage as a first mover
would only be temporary at best (see Exhibit 4.5).22
isolating mechanisms
Barriers to imitation
that prevent rivals from
competing away the
advantage a firm may
enjoy.
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Other developers could have bought the land, but once the highway was announced,
the cost of the developer’s land and that of adjacent land would have risen drastically,
reflecting the new reality and thus negating any potential for competitive advantage.
The developer had better expectations than her competitors of the future value of the
resource, in this case the land she purchased. If this developer can repeat such “better
expectations” over time in a more or less systematic fashion, her firm is likely to have a
sustainable competitive advantage. If she cannot, she was simply lucky. Although luck
can play a role in gaining an initial competitive advantage, it is not a basis for a sustain-
able competitive advantage.
PATH DEPENDENCE. Path dependence describes a process in which the options one faces
in a current situation are limited by decisions made in the past.25 Often, early events—
sometimes even random ones—have a significant effect on final outcomes.
The U.S. carpet industry provides an example of path dependence.26 Roughly 85 percent
of all carpets sold in the United States and almost one-half of all carpets sold worldwide
come from carpet mills located within 65 miles of one city: Dalton, Georgia. While the
U.S. manufacturing sector has suffered in recent decades, the carpet industry has flour-
ished. Companies not clustered near Dalton face a disadvantage because they cannot read-
ily access the required know-how, skilled labor, suppliers, low-cost infrastructure, and so
on needed to be competitive.
But why Dalton? Two somewhat random events combined. First, the boom after World
War II drew many manufacturers South to escape restrictions placed upon them in the
North, such as higher taxation or the demands of unionized labor. Second, technological
progress allowed industrial-scale production of tufted textiles to be used as substitutes
for the more expensive wool. This innovation emerged in and near Dalton. This historical
accident explains why today almost all U.S. carpet mills are located in a relatively small
region, including world leaders Shaw Industries and Mohawk Industries.
Path dependence also rests on the notion that time cannot be compressed at will. While
management can compress resources such as labor and R&D into a shorter period, the
push will not be as effective as when a firm spreads out its effort and investments over a
longer period. Trying to achieve the same outcome in less time, even with higher invest-
ments, tends to lead to inferior results, due to time compression diseconomies.27
Consider GM’s problems in providing a competitive alternative to the highly successful
Toyota Prius, a hybrid electric vehicle. Its problems highlight path dependence and time
compression issues. The California Air Resource Board (CARB) in 1990 passed a man-
date for introducing zero-emissions cars, which stipulated that 10 percent of new vehicles
sold by carmakers in the state must have zero emissions by 2003. This mandate not only
accelerated research in alternative energy sources for cars, but also led to the development
of the first fully electric production car, GM’s EV1. GM launched the car in California and
Arizona in 1996. Competitive models followed, with the Toyota RAV EV and the Honda
EV. In this case, regulations in the legal environment fostered innovation in the automobile
industry (see discussion of PESTEL forces in Chapter 3).
Companies not only feel the nudge of forces in their environment but can also push
back. The California mandate on zero emissions, for example, did not stand.28 Several
stakeholders, including the car and oil companies, fought it through lawsuits and other
actions. CARB ultimately gave in to the pressure and abandoned its zero-emissions
mandate. When the mandate was revoked, GM recalled and destroyed its EV1 elec-
tric vehicles and terminated its electric-vehicle program. This decision turned out to
be a strategic error that would haunt GM a decade or so later. Although GM was the
leader among car companies in electric vehicles in the mid-1990s, it did not have a
competitive model to counter the Toyota Prius when its sales took off in the early 2000s.
path dependence
A situation in which
the options one faces
in the current situation
are limited by decisions
made in the past.
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The Chevy Volt (a plug-in hybrid), GM’s first major competition to the Prius, was
delayed by over a decade because GM had to start its electric-vehicle program basically
from scratch. While GM sold about 50,000 Chevy Volts worldwide, Toyota sold over
6 million Prius cars. Moreover, when Nissan introduced its all-electric Leaf in 2010,
GM did not have an all-electric vehicle in its lineup. In the meantime, Nissan sold over
250,000 Leafs worldwide.
Not having an adequate product lineup during the early 2000s, GM’s U.S. market share
dropped below 20 percent in 2009 (from over 50 percent a few decades earlier), the year
it filed for bankruptcy. GM subsequently reorganized under Chapter 11 of the U.S. bank-
ruptcy code, and relisted on the New York Stock Exchange in 2010.
Collaborating with LG Corp. of Korea, GM introduced the Chevy Bolt, an all-electric
vehicle in 2017.29 Although some of its features, such as a 230-mile range on a single
charge, look attractive, it remains to be seen if the Chevy Bolt will do well in the mar-
ketplace. This is because competition did not stand still either. In the meantime, Tesla
(featured in ChapterCase 1) is hoping that its new Model 3 will take the mass market of
electric cars by storm, as it is priced at some $35,000, much lower than its luxury cars
(Model S and Model X).
One important take-away here is that once the train of new capability development has
left the station, it is hard to jump back on because of path dependence. Moreover, firms
cannot compress time at will; indeed, learning and improvements must take place over
time, and existing competencies must constantly be nourished and upgraded.
Strategic decisions generate long-term consequences due to path dependence and time-
compression diseconomies; they are not easily reversible. A competitor cannot imitate or
create core competencies quickly, nor can one buy a reputation for quality or innovation on
the open market. These types of valuable, rare, and costly-to-imitate resources, capabili-
ties, and competencies must be built and organized effectively over time, often through a
painstaking process that frequently includes learning from failure.
CAUSAL AMBIGUITY. Causal ambiguity describes a situation in which the cause and
effect of a phenomenon are not readily apparent. To formulate and implement a strategy
that enhances a firm’s chances of gaining and sustaining a competitive advantage, man-
agers need to have a hypothesis or theory of how to compete. A hypothesis is simply a
specific statement that proposes an explanation of a phenomenon (such as competitive
advantage), while a theory is a more generalized explanation of what causes what, and
why. This implies that managers need to have some kind of understanding about what
causes superior or inferior performance, and why. Comprehending and explaining the
underlying reasons of observed phenomena is far from trivial, however. Everyone can see
that Apple has had several hugely successful innovative products such as the iMac, iPod,
iPhone, and iPad, combined with its hugely popular iTunes services, leading to a decade of
a sustainable competitive advantage. These successes stem from Apple’s set of V, R, I, and
O core competencies that supports its ability to continue to offer a variety of innovative
products and to create an ecosystem of products and services.
A deep understanding, however, of exactly why Apple has been so successful is very
difficult. Even Apple’s managers may not be able to clearly pinpoint the sources of their
success. Is it the visionary role that the late Steve Jobs played? Is it the rare skills of
Apple’s uniquely talented design team around Jonathan Ive? Is it the timing of the com-
pany’s product introductions? Is it Apple CEO Tim Cook who adds superior organizational
skills and puts all the pieces together when running the day-to-day operations? Or is it a
combination of these factors? If the link between cause and effect is ambiguous for Apple’s
managers, it is that much more difficult for others seeking to copy a valuable resource,
capability, or competency.
causal ambiguity
A situation in which
the cause and effect of
a phenomenon are not
readily apparent.
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SOCIAL COMPLEXITY Social complexity describes situations in which different social
and business systems interact. There is frequently no causal ambiguity as to how the indi-
vidual systems such as supply chain management or new-product development work in
isolation. They are often managed through standardized business processes such as Six
Sigma or ISO 9000. Social complexity, however, emerges when two or more such sys-
tems are combined. Copying the emerging complex social systems is difficult for competi-
tors because neither direct imitation nor substitution is a valid approach. The interactions
between different systems create too many possible permutations for a system to be under-
stood with any accuracy. The resulting social complexity makes copying these systems
difficult, if not impossible, resulting in a valuable, rare, and costly-to-imitate resource that
the firm is organized to exploit.
Look at it this way. A group of three people has three relationships, connecting every
person directly with one another. Adding a fourth person to this group doubles the number
of direct relationships to six. Introducing a fifth person increases the number of relation-
ships to 10.30 This gives you some idea of how complexity might increase when we com-
bine different systems with many different parts.
In reality, firms may manage thousands of employees from all walks of life. Their inter-
actions within the firm’s processes, procedures, and norms make up its culture. Although
an observer may conclude that Zappos’ culture, with its focus on autonomous teams in a
flat hierarchy to provide superior customer service, might be the basis for its competitive
advantage, engaging in reverse social engineering to crack Zappos’ code of success might
be much more difficult. Moreover, an organizational culture that works for online retailer
Zappos, led by CEO and chief happiness officer Tony Hsieh, might seed havoc for an
aerospace and defense company such as Lockheed Martin, led by CEO Marillyn Hewson.
This implies that one must understand competitive advantage within its organizational and
industry context. Looking at individual elements of success without taking social com-
plexity into account is a recipe for inferior performance, or worse.
INTELLECTUAL PROPERTY PROTECTION. Intellectual property (IP) protection is a crit-
ical intangible resource that can also help sustain a competitive advantage. The five major
forms of IP protection are:31
■ Patents
■ Designs
■ Copyrights
■ Trademarks
■ Trade secrets
The intent of IP protection is to prevent others from copying legally protected products
or services. In many knowledge-intensive industries that are characterized by high research
and development (R&D) costs, such as smartphones and pharmaceuticals, IP protection
provides not only an incentive to make these risky and often large-scale investments in the
first place, but also affords a strong isolating mechanism that is critical to a firm’s abil-
ity to capture the returns to investment. Although the initial investment to create the first
version of a new product or service is quite high in many knowledge-intensive industries,
the marginal cost (i.e., the cost to produce the next unit) after initial invention is quite low.
For example, Microsoft spends billions of dollars to develop a new version of its Windows
operating system; once completed, the cost of the next “copy” is close to zero because it is
just software code distributed online in digital form. In a similar fashion, the costs of devel-
oping a new prescription drug, a process often taking more than a decade, are estimated to
be over $2.5 billion.32 Rewards to IP-protected products or services, however, can be high.
Marillyn Hewson is CEO of
Lockheed Martin, a global
player in aerospace, defense,
security, and advanced
technology. Facing ever
more complex challenges,
such firms only thrive with
a strong organization and a
powerful CEO like Hewson.
©Bloomberg/Getty Images
social complexity
A situation in which dif-
ferent social and busi-
ness systems interact
with one another.
intellectual property
(IP) protection
A critical intangible
resource that can pro-
vide a strong isolating
mechanism, and thus
help to sustain a com-
petitive advantage.
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During a little over 14 years on the market, Pfizer’s Lipitor, the world’s best-selling drug,
accumulated over $125 billion in sales.33
IP protection can make direct imitation attempts difficult, if not outright illegal. A
U.S. court, for example, has found that Samsung infringed in some of its older models on
Apple’s patents and awarded some $600 million in damages.34 In a similar fashion, Dr. Dre
attracted significant attention and support from other artists in the music industry when he
sued Napster, an early online music file-sharing service, and helped shut it down in 2001
because of copyright infringements.
IP protection does not last forever, however. Once the protection has expired the inven-
tion can be used by others. Patents, for example, usually expire 20 years after a patent is
filed with the U.S. Patent and Trademark Office. In the next few years, patents protecting
roughly $100 billion in sales of proprietary drugs in the pharmaceutical industry are set to
expire. Once this happens, producers of generics (drugs that contain the same active ingre-
dients as the original patent-protected formulation) such as Teva Pharmaceutical Industries
of Israel enter the market, and prices fall drastically. Pfizer’s patent on Lipitor expired in
2011. Just one year later, of the 55 million Lipitor prescriptions, 45 million (or more than
80 percent) were generics.35 Drug prices fall by 20 to 80 percent once generic formulations
become available.36
Taken together, each of the five isolating mechanisms discussed here (or combi-
nations thereof) allow a firm to extend its competitive advantage. Although no com-
petitive advantage lasts forever, a firm may be able to protect its competitive advantage
(even for long periods) when it has consistently better expectations about the future
value of resources, when it has accumulated a resource advantage that can be imitated
only over long periods of time, when the source of its competitive advantage is causally
ambiguous or socially complex, or when the firm possesses strong intellectual property
protection.
4.3 The Dynamic Capabilities Perspective
A firm’s external environment is rarely stable (as discussed in Chapter 3). Rather, in many
industries, the pace of change is ferocious. Firms that fail to adapt their core competencies
to a changing external environment not only lose a competitive advantage but may even go
out of business.
We’ve seen the merciless pace of change in consumer electronics retailing in the United
States. Once a market leader, Circuit City’s core competencies were in efficient logistics
and superior customer service. But the firm neglected to upgrade and hone them over time.
As a consequence, Circuit City was outflanked by Best Buy and online retailer Amazon,
and went bankrupt. Best Buy encountered the same difficulties competing against Amazon
just a few years later. Core competencies might form the basis for a competitive advantage
at one point, but as the environment changes, the very same core competencies might later
turn into core rigidities, retarding the firm’s ability to change.37
A core competency can turn into a core rigidity if a firm relies too long on the com-
petency without honing, refining, and upgrading as the environment changes.38 Over
time, the original core competency is no longer a good fit with the external environment,
and it turns from an asset into a liability. Strategy Highlight 4.2 shows how Procter &
Gamble failed to hone and upgrade its core competencies. As a consequence, P&G’s
strategy was no longer a good fit with a changing environment, leading to a competitive
disadvantage.
The reason reinvesting, honing, and upgrading of resources and capabilities are so cru-
cial to sustaining any competitive advantage is to prevent competencies from turning into
LO 4-6
Outline how dynamic
capabilities can enable
a firm to sustain a
competitive advantage
core rigidity A former
core competency that
turned into a liability
because the firm failed
to hone, refine, and
upgrade the competency
as the environment
changed.
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When Will P&G Play to Win Again?
With revenues of some $65 billion and business in basically
every country except North Korea, Procter & Gamble (P&G) is
the world’s largest consumer products company. Some of its
category-defining brands include Ivory soap, Tide detergent,
Febreze air freshener, Crest toothpaste, and Pampers diapers.
Among its many offerings, P&G has more than 20 consumer
brands in its lineup that each achieve over $1 billion in annual
sales. P&G’s iconic brands are a result of a clearly formulated
and effectively implemented business strategy. The company
pursues a differentiation strategy and attempts to create
higher perceived value for its customers than its competitors
by delivering products with unique features and attributes.
Creating higher perceived value generally goes along
with higher product costs due to greater R&D and promotion
expenses, among other things. Successful differentiators are
able to command a premium price for their products, but they
must also control their costs. Detailing how P&G created many
market-winning brands, P&G’s long-term CEO A.G. Lafley pub-
lished (with strategy consultant Roger Martin) the best-selling
book Playing to Win: How Strategy Really Works in 2013.
In recent years, however, P&G’s strategic position has weak-
ened considerably, and P&G seems to be losing rather than win-
ning. P&G lost market share in key “product-country combinations,”
including beauty in the United States and oral care in China, amid
an overall lackluster performance in many emerging economies.
As a consequence, profits have declined. With P&G’s sustained
competitive disadvantage, its stock market valuation has fallen—by
some $50 billion in 2015 alone. Meanwhile, its competitors such
as Unilever, Colgate-Palmolive, and Kimberly-Clark posted strong
gains. Many wonder, when will P&G play to win again?
Some of P&G’s problems today are the result of attempt-
ing to achieve growth via an aggressive acquisition strategy
in the 2000s. Given the resulting larger P&G revenue base,
future incremental revenue growth for the entire company was
harder to achieve. A case in point is P&G’s $57 billion acquisi-
tion of Gillette in 2005, engineered by then-CEO Lafley. The
value of this acquisition is now being called into question.
Although Gillette dominates the retail space of the $3 billion
wet shaving industry, P&G was caught off guard by how quickly
razor sales moved online. Turned off by the high prices and
the inconvenience of shopping for razors in locked display
cases in retail stores, consumers flocked to online options
in droves. The online market for razor blades has grown from
basically zero just a few years ago to $300 million. Although
this is currently only 10 percent of the overall market, the
online market continues to grow rapidly. Disruptive online
startups such as Dollar Shave Club and Harry’s offer low-cost
solutions via monthly subscription plans online.
Perhaps even more troubling is that P&G focused mainly
on the U.S. market to leverage its existing competencies.
Rather than inventing new category-defining products, P&G
added more features to its established brands such as Olay’s
extra-moisturizing creams and ultra-soft and sensitive Char-
min toilet paper, while raising prices. Reflecting higher value
creation based on its differentiation strategy, P&G gener-
ally charges a 20 to 40 percent premium for its products in
comparison to retailers’ private-label and other brands. The
strategic decision to focus on the domestic market, combined
with incrementally adding minor features to its existing prod-
ucts, created serious problems for P&G.39
Strategy Highlight 4.2
©Zhang Peng/LightRocket/Getty Images
core rigidities (see Exhibit 4.3). This ability to hone and upgrade lies at the heart of the
dynamic capabilities perspective. We defined capabilities as the organizational and mana-
gerial skills necessary to orchestrate a diverse set of resources and to deploy them strate-
gically. Capabilities are by nature intangible. They find their expression in a company’s
structure, routines, and culture.
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The dynamic capabilities perspective adds, as the name suggests, a dynamic or time ele-
ment. In particular, dynamic capabilities describe a firm’s ability to create, deploy, mod-
ify, reconfigure, upgrade, or leverage its resources over time in its quest for competitive
advantage.40 Dynamic capabilities are essential to move beyond a short-lived advantage
and create a sustained competitive advantage. For a firm to sustain its advantage, any fit
between its internal strengths and the external environment must be dynamic. That is, the
firm must be able to change its internal resource base as the external environment changes.
The goal should be to develop resources, capabilities, and competencies that create a stra-
tegic fit with the firm’s environment. Rather than creating a static fit, the firm’s internal
strengths should change with its external environment in a dynamic fashion.
A lack of strategic fit with a changing environment created at least two problems for
Procter & Gamble in recent years (see Strategy Highlight 4.2). First, following the deep
recession of 2008–2009, U.S. consumers moved away from higher-priced brands, such as
those offered by P&G, to lower-cost alternatives. Moreover, P&G’s direct rivals in branded
goods, such as Colgate-Palmolive, Kimberly-Clark, and Unilever, were faster in cutting
costs and prices in response to more frugal customers. P&G also fumbled launches of
reformulated products such as Tide Pods (detergent sealed in single-use pouches) and the
Pantene line of shampoos and conditioners. The decline in U.S. demand hit P&G espe-
cially hard because the domestic market delivers about one-third of sales, but almost two-
thirds of profits for the company. Second, by focusing on the U.S. market, P&G not only
missed out on the booming growth years that the emerging economies experienced during
the 2000s, but it also left these markets to its rivals. As a consequence, Colgate-Palmolive,
Kimberly-Clark, and Unilever all outperformed P&G in recent years.
As a result of its sustained competitive disadvantage, P&G also had a revolving door in
its executive suites. From 2013 to 2015, P&G went through three CEOs. After 30 years with
P&G, the former Army Ranger Robert McDonald was appointed CEO in 2009, but was
replaced in spring 2013 in the face of P&G’s deteriorating performance. The company’s board
of directors brought back A.G. Lafley. This was an interesting choice because Lafley had pre-
viously served as P&G’s CEO from 2000 to 2009, and some of the strategic decisions that led
to a weakening of P&G’s strategic position were made under his watch. Lafley served a sec-
ond term as CEO from 2013 to 2015. In late 2015, P&G named David Taylor as the new CEO,
again promoting from within, while Lafley served as executive chairman until June 2016.
To strengthen its competitive position, P&G launched two strategic initiatives. First,
P&G began to refocus its portfolio on the company’s 70 to 80 most lucrative product-
market combinations, which are responsible for 90 percent of P&G’s revenues and almost
all of its profits. Some argue that P&G had become too big and spread out to compete
effectively in today’s dynamic marketplace. To refocus on core products such as Tide,
Pampers, and Olay (these three brands account for more than 50 percent of the company’s
revenues), P&G has sold or plans to divest almost 100 brands in its far-flung product port-
folio, including well-known brands such as Iams pet food, Duracell batteries, Wella sham-
poos, Clairol hair dye, and CoverGirl makeup, but mainly a slew of lesser-known brands.
Part of this strategic initiative is also to expand P&G’s presence in large emerging
economies. As an example, P&G launched Tide in India and Pantene shampoos in Brazil.
Moreover, P&G began to leverage its Crest brand globally, to take on Colgate-Palmolive’s
global dominance in toothpaste. Yet, the relatively strong dollar in recent years is hurt-
ing P&G’s international results. Second, P&G implemented strict cost-cutting measures
through eliminating all spending not directly related to selling. As part of its cost-cutting
initiative, P&G also eliminated thousands of jobs.
The goal of the two strategic initiatives is to increase the perceived value of P&G’s brands in
the minds of the consumer, while lowering production costs. The combined effort should—if
successful—increase P&G’s economic value creation (V − C). The hope is that P&G’s revised
dynamic capabilities A
firm’s ability to create,
deploy, modify, reconfig-
ure, upgrade, or lever-
age its resources in its
quest for competitive
advantage.
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business strategy would strengthen its strategic position and help it achieve a better strategic
fit with the new environment. This should increase the likelihood that P&G can achieve a
competitive advantage again. Through a number of investments in its intangible resource base,
P&G is upgrading its dynamic capabilities, which had been neglected for a number of years as
the consumer-products company failed to change with a changing environment.
Not only do dynamic capabilities allow firms to adapt to changing market conditions,
but they also enable firms to create market changes that can strengthen their strategic
position. These market changes implemented by proactive firms introduce altered circum-
stances, to which more reactive rivals might be forced to respond.
Apple’s dynamic capabilities allowed it to redefine the markets for mobile devices and
computing, in particular in music, smartphones, and media content. For the portable music
market through its iPod and iTunes store, Apple generated environmental change to which
Sony and others had to respond. With its iPhone, Apple redefined the market for smart-
phones, again creating environmental change to which competitors such as Samsung, Black-
Berry, and Google (with its Motorola Mobility unit) needed to respond. Apple’s introduction
of the iPad redefined the media and tablet computing market, forcing competitors such as
Amazon and Microsoft to respond. With the introduction of the Apple Watch it is attempting
to shape the market for computer wearables in its favor. Dynamic capabilities are especially
relevant for surviving and competing in markets that shift quickly and constantly, such as the
high-tech space in which firms such as Apple, Google, Microsoft, and Amazon compete.
In the dynamic capabilities perspective, competitive advantage is the outflow of a
firm’s capacity to modify and leverage its resource base in a way that enables it to gain and
sustain competitive advantage in a constantly changing environment. Given the accelerated
pace of technological change, in combination with deregulation, globalization, and demo-
graphic shifts, dynamic markets today are the rule rather than the exception. As a response,
a firm may create, deploy, modify, reconfigure, or upgrade resources so as to provide value
to customers and/or lower costs in a dynamic environment. The essence of this perspective
is that competitive advantage is not derived from static resource or market advantages, but
from a dynamic reconfiguration of a firm’s resource base.
One way to think about developing dynamic capabilities and other intangible resources
is to distinguish between resource stocks and resource flows.41 In this perspective, resource
stocks are the firm’s current level of intangible resources. Resource flows are the firm’s
level of investments to maintain or build a resource. A helpful metaphor to explain the dif-
ferences between resource stocks and resource flows is a bathtub that is being filled with
water (see Exhibit 4.6).42 The amount of water in the bathtub indicates a company’s level of
a specific intangible resource stock—such as its dynamic capabilities, new-product devel-
opment, engineering expertise, innovation capability, reputation for quality, and so on.43
Intangible resource stocks are built through investments over time. These resource flows
are represented in the drawing by the different faucets, from which water flows into the
tub. These faucets indicate investments the firm can make in different intangible resources.
Investments in building an innovation capability, for example, differ from investments made
in marketing expertise. Each investment flow would be represented by a different faucet.
How fast a firm is able to build an intangible resource—how fast the tub fills—depends
on how much water comes out of the faucets and how long the faucets are left open.
Intangible resources are built through continuous investments and experience over time.
Organizational learning also fosters the increase of intangible resources. Many intangible
resources, such as IBM’s expertise in cognitive computing, take a long time to build. IBM’s
quest for cognitive computing began in 1997 after its Deep Blue computer (based on arti-
ficial intelligence) beat reigning chess champion Garry Kasparov. It has invested close to
$25 billion to build a deep capability in cognitive computing with the goal to take advan-
tage of business opportunities in big data and analytics. Its efforts were publicized when its
dynamic capabilities
perspective A model
that emphasizes a
firm’s ability to mod-
ify and leverage its
resource base in a
way that enables it to
gain and sustain com-
petitive advantage in
a constantly changing
environment.
resource stocks The
firm’s current level of
intangible resources.
resource flows The
firm’s level of invest-
ments to maintain or
build a resource.
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Watson, a supercomputer capable of answering questions posed in natural language, went
up against 74-time Jeopardy! quiz show champion Ken Jennings and won. Watson has
demonstrated its skill in many professional areas where deep domain expertise is needed
when making decisions in more or less real time: a wealth manager making investments,
a doctor working with a cancer patient, an attorney working on a complex case, or even a
chef in a five-star restaurant creating a new recipe. Moreover, cognitive computer systems
get better over time as they learn from experience.
How fast the bathtub fills, however, also depends on how much water leaks out of the
tub. The outflows represent a reduction in the firm’s intangible resource stocks. Resource
leakage might occur through employee turnover, especially if key employees leave. Signif-
icant resource leakage can erode a firm’s competitive advantage. A reduction in resource
stocks can occur if a firm does not engage in a specific activity for some time and forgets
how to do this activity well.
According to the dynamic capabilities perspective, the managers’ task is to decide
which investments to make over time (i.e., which faucets to open and how far) in order
to best position the firm for competitive advantage in a changing environment. Moreover,
managers also need to monitor the existing intangible resource stocks and their attrition
rates due to leakage and forgetting. This perspective provides a dynamic understanding
of capability development to allow a firm’s continuous adaptation to and superior perfor-
mance in a changing external environment.
4.4 The Value Chain and Strategic Activity Systems
THE VALUE CHAIN
The value chain describes the internal activities a firm engages in when transforming
inputs into outputs.44 Each activity the firm performs along the horizontal chain adds
incremental value—raw materials and other inputs are transformed into components that
are assembled into finished products or services for the end consumer. Each activity the
firm performs along the value chain also adds incremental costs. A careful analysis of the
EXHIBIT 4.6 /
The Bathtub
Metaphor: The Role of
Inflows and Outflows
in Building Stocks of
Intangible Resources
SOURCE: Figure based on
metaphor used in I. Dierickx
and K. Cool (1989), “Asset
stock accumulation and
sustainability of competitive
advantage,” Management
Science 35: 1504–1513.
Outflows
Leakage, Forgetting
Inflows
Investments in Resources
Intangible Resource Stocks
(Dynamic Capabilities, New-Product Development,
Engineering Expertise, Innovation Capability,
Reputation for Quality, Supplier Relationships,
Employee Loyalty, Corporate Culture, Customer
Goodwill, Know-How, Patents, Trademarks . . .)
LO 4-7
Apply a value chain
analysis to understand
which of the firm’s
activities in the process
of transforming inputs
into outputs generate
differentiation and which
drive costs.
value chain
The internal activities
a firm engages in when
transforming inputs into
outputs; each activity
adds incremental value.
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value chain allows managers to obtain a more detailed and fine-grained understanding of
how the firm’s economic value creation (V − C) breaks down into a distinct set of activities
that help determine perceived value (V) and the costs (C) to create it. The value chain con-
cept can be applied to basically any firm, from those in manufacturing industries to those
in high-tech ones or service firms.
A firm’s core competencies are deployed through its activities (see Exhibit 4.3).
A firm’s activities, therefore, are one of the key internal drivers of performance differences
across firms. Activities are distinct actions that enable firms to add incremental value at
each step by transforming inputs into goods and services. Managing a supply chain, run-
ning the company’s IT system and websites, and providing customer support are all exam-
ples of distinct activities. Activities are narrower than functional areas such as marketing,
because each functional area is made up of a set of distinct activities.
To build its uniquely cool brand image, Beats Electronics engages in a number of dis-
tinct activities. Its iconic Beats headphones are designed by Dr. Dre. To create special edi-
tions such as lightweight Beats for sports, Dr. Dre taps into his personal network and works
with basketball stars such as Kobe Bryant. Once designed, Beats manufactures its high-
end headphones (before the Apple acquisition, that was done in conjunction with Monster
Cable Products, a California-based company). Other distinct activities concern the market-
ing and sales of its products. Beats has not only marketing savvy in product placement and
branding with a large number of celebrities across different fields, but it also uses the same
savvy in other distinct activities such as packaging and product presentation to create a
premium unboxing experience and superb displays in retail outlets—especially important
now that its products are in Apple stores. In sum, a number of distinct activities along the
value chain are performed to create Beats by Dr. Dre, from initial design to a unique sales
experience and after-sales service.
As shown in the generic value chain in Exhibit 4.7, the transformation process from
inputs to outputs is composed of a set of distinct activities. When a firm’s distinct activi-
ties generate value greater than the costs to create them, the firm obtains a profit mar-
gin (see Exhibit 4.7), assuming the market price the firm is able to command exceeds
the costs of value creation. A generic value chain needs to be modified to capture the
EXHIBIT 4.7 /
A Generic Value
Chain: Primary and
Support Activities
Su
pp
ly
Ch
ai
n
M
an
ag
em
en
t
After-Sales
Service
M
ar
ke
tin
g
&
Sa
le
s
Di
st
rib
ut
io
n
Op
er
at
io
ns
Primary Activities
Research & Development
Information Systems
Human Resources
Accounting & Finance
Firm Infrastructure, including Processes, Policies, & Procedures
Support Activities
Margin
Margin
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130 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
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activities of a specific business. Retail chain American Eagle Outfitters, for example,
needs to identify suitable store locations, either build or rent stores, purchase goods and
supplies, manage distribution and store inventories, operate stores both in the brick-and-
mortar world and online, hire and motivate a sales force, create payment and IT systems
or partner with vendors, engage in promotions, and ensure after-sales services including
returns. A maker of semiconductor chips such as Intel, on the other hand, needs to engage
in R&D, design and engineer semiconductor chips and their production processes, pur-
chase silicon and other ingredients, set up and staff chip fabrication plants, control quality
and throughput, engage in marketing and sales, and provide after-sales customer support.
As shown in Exhibit 4.7, the value chain is divided into primary and support activities.
The primary activities add value directly as the firm transforms inputs into outputs—
from raw materials through production phases to sales and marketing and finally customer
service, specifically
■ Supply chain management.
■ Operations.
■ Distribution.
■ Marketing and sales.
■ After-sales service.
Other activities, called support activities, add value indirectly. These activities include
■ Research and development (R&D).
■ Information systems.
■ Human resources.
■ Accounting and finance.
■ Firm infrastructure including processes, policies, and procedures.
To help a firm achieve a competitive advantage, each distinct activity performed needs
to either add incremental value to the product or service offering or lower its relative cost.
Discrete and specific firm activities are the basic units with which to understand competi-
tive advantage because they are the drivers of the firm’s relative costs and level of differen-
tiation the firm can provide to its customers. Although the resource-based view of the firm
helps identify the integrated set of resources and capabilities that are the building blocks
of core competencies, the value chain perspective enables managers to see how competi-
tive advantage flows from the firm’s distinct set of activities. This is because a firm’s core
competency is generally found in a network linking different but distinct activities, each
contributing to the firm’s strategic position as either low-cost leader or differentiator.
STRATEGIC ACTIVITY SYSTEMS
A strategic activity system conceives of a firm as a network of interconnected activi-
ties.45 Strategic activity systems are socially complex and causally ambiguous, thus
enhancing the possibility that a competitive advantage can be sustained over time. While
one can easily observe several elements of a strategic activity system, the capabilities nec-
essary to orchestrate and manage the network of distinct activities cannot be so easily
observed and therefore are difficult to imitate.
Let’s assume Firm A’s activity system, which lays the foundation of its competitive
advantage, consists of 25 interconnected activities. Attracted by Firm A’s competitive
advantage, competitor Firm B closely monitors this activity system and begins to copy
it through direct imitation. Moreover, Firm B is very good at copying; it achieves a
90 percent accuracy rate. Will Firm B, as the imitator, be able to copy Firm A’s activity
primary activities Firm
activities that add value
directly by transforming
inputs into outputs as
the firm moves a prod-
uct or service horizon-
tally along the internal
value chain.
support activities Firm
activities that add
value indirectly, but are
necessary to sustain pri-
mary activities.
LO 4-8
Identify competitive
advantage as residing
in a network of distinct
activities.
strategic activity
system The conceptu-
alization of a firm as
a network of intercon-
nected activities.
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system and negate its competitive advantage? Far from it. Firm A’s activity system is
based on 25 interconnected activities. Because each of Firm A’s 25 activities is copied
with a 90 percent accuracy, Firm B’s overall copying accuracy of the entire system is
0.9 × 0.9 × 0.9 . . . , repeated 25 times. The probabilities quickly compound to render
copying an entire activity system nearly impossible. In this case, Firm B’s “success” in
copying Firm A’s activity system is 0.925 = 0.07, meaning that Firm B’s resulting activ-
ity system will imitate Firm A’s with only a 7 percent accuracy rate. Thus, the concept
of the strategic activity system demonstrates the difficulty of using imitation as a path to
competitive advantage.
Strategic activity systems need to evolve over time if a firm is to sustain a competi-
tive advantage. Procter & Gamble’s difficulties discussed in Strategy Highlight 4.2 show
what happens if a firm’s strategic activity system does not evolve. This generally leads to
a competitive disadvantage, because the external environment changes and also because
a firm’s competitors get better in developing their own activity systems and capabilities.
Managers need to adapt their firm’s strategic activity system by upgrading value-creating
activities that respond to changing environments. To gain and sustain competitive advan-
tage, strategic leaders may add new activities, remove activities that are no longer relevant,
and upgrade activities that have become stale or somewhat obsolete. Each of these changes
would require changes to the resources and capabilities involved.
Let’s consider The Vanguard Group, one of the world’s largest investment compa-
nies.46 It serves individual investors, financial professionals, and institutional investors
such as state retirement funds. Vanguard’s mission is to help clients reach their financial
goals by being their highest-value provider of investment products and services.47 Since its
founding in 1929, Vanguard has emphasized low-cost investing and quality service for its
clients. Vanguard’s average expense ratio (fees as a percentage of total net assets paid by
investors) is generally the lowest in the industry.48 The Vanguard Group also is a pioneer in
passive index-fund investing. Rather than picking individual stocks and trading frequently
as done in traditional money management, a mutual fund tracks the performance of an
index (such as the Standard & Poor’s 500 or the Dow Jones 30), and discourages active
trading and encourages long-term investing.
Despite this innovation in investing, Vanguard’s strategic activity system needed
to evolve over time as the company grew and market conditions as well as competitors
changed, in order to gain and sustain a competitive advantage. Let’s compare how The
Vanguard Group’s strategic activity developed over the past 20 years, from 1997 to 2017.
In 1997, The Vanguard Group had less than $500 million of assets under management.
It pursued its mission of being the highest-value provider of investment products and ser-
vices through its unique set of interconnected activities depicted in Exhibit 4.8. The six
larger ovals depict Vanguard’s strategic core activities: strict cost control, direct distribu-
tion, low expenses with savings passed on to clients, offering of a broad array of mutual
funds, efficient investment management approach, and straightforward client communica-
tion and education. These six strategic themes were supported by clusters of tightly linked
activities (smaller circles), further reinforcing the strategic activity network.
The needs of Vanguard’s customers, however, have changed since 1997. Exhibit 4.9
shows Vanguard’s strategic activity system in 2017. Twenty years later, The Vanguard
Group had grown some eight times in size, from a mere $500 billion (in 1997) to $4 trillion
(in 2017) of assets under management.49
Again, the large ovals in Exhibit 4.9 symbolize Vanguard’s strategic core activities that
help it realize its strategic position as the low-cost leader in the industry. However, the
system evolved over time as Vanguard’s management added a new core activity— customer
segmentation—to the six core activities already in place in 1997 (still valid in 2017).
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132 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
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EXHIBIT 4.8 /
The Vanguard Group’s
Activity System in
1997
SOURCE: Adapted from N.
Siggelkow (2002), “Evolution
toward fit,” Administrative
Science Quarterly 47: 146.
1997
Wary of
small growth
funds
A broad array of
mutual funds
excluding some fund
categories
Very low
expenses,
savings passed
on to clients
Straightforward
client
communication
and education
Efficient investment
management approach
offering good,
consistent performance
Strict cost
control
Direct
distribution
Emerging
market
funds
Limited
international
funds
Redemption
fees
Employee
bonuses tied
to cost
savings
No
broker-dealer
relation
No
commissions
to brokers
Only
three retail
locations
Limited
advertising
budget
No
first-class
travel for
executives
Long-term
investment
Shareholder
education
Online
information
access
Actively
spread
philosophy
Reliance
on word
of mouth
Emphasis
on bonds and
equity index
funds
In-house
management
for standard
funds
No-load
requirements
No
marketing
changes
EXHIBIT 4.9 /
The Vanguard Group’s
Activity System in
2017
Economies
of scale
A broad array of
mutual funds
excluding some fund
categories
Very low
expenses
passed on to
clients
Straightforward
client
communication
and education
Efficient investment
management approach
customizes solutions
Strict cost
control
Direct
distribution
Customer
segmentation
Emerging
market
funds
Limited
international
funds
Redemption
fees
Employee
bonuses tied
to cost
savings
No
broker-dealer
relation
No
commissions
to brokers
Only
three retail
locations
Limited
advertising
budget
No
first-class
travel for
executives
Long-term
investment
Shareholder
education
Online
information
access
Actively
spread
philosophy
Reliance
on word
of mouth
Emphasis
on bonds and
equity index
funds
In-house
management
for standard
funds
No-load
requirements
Create
best-selling
index funds
Keep
traditional
investors
2017
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Vanguard’s managers put in place the customer-segmentation core activity, along with two
new support activities, to address a new customer need that could not be met with its older
configuration. Its 1997 activity system did not allow Vanguard to continue to provide qual-
ity service targeted at different customer segments at the lowest possible cost. The 2017
activity-system configuration allows Vanguard to customize its service offerings: It now
separates its more traditional customers, who invest for the long term, from more active
investors, who trade more often but are attracted to Vanguard funds by the firm’s high
performance and low cost.
The core activity Vanguard added to its strategic activity system was developed with
great care, to ensure that it not only fit well with its existing core activities but also fur-
ther reinforced its activity network. For example, the new activity of “Create best-selling
index funds” also relies on direct distribution; it is consistent with and further reinforces
Vanguard’s low-cost leadership position. As a result of achieving its “best-selling” goal,
Vanguard is now the world’s second-largest investment-management company, just behind
BlackRock, with $5 trillion of assets under management. This allows Vanguard to ben-
efit from economies of scale (e.g., cost savings accomplished through a larger number of
customers served and a greater amount of assets managed), further driving down cost. In
turn, by lowering its cost structure, Vanguard can offer more customized services without
raising its overall cost. Despite increased customization, Vanguard still has one of the low-
est expense ratios in the industry. Even in a changing environment, the firm continues to
pursue its strategy of low-cost investing combined with quality service. If firms add activi-
ties that don’t fit their strategic positioning (e.g., if Vanguard added local retail offices in
shopping malls, thereby increasing operating costs), they create “strategic misfits” that are
likely to erode a firm’s competitive advantage.
The Vanguard Group’s core competency of low-cost investing while providing quality
service for its clients is accomplished through a unique set of interconnected primary and
support activities including strict cost control, direct distribution, low expenses with sav-
ings passed on to clients, a broad array of mutual funds, an efficient investment manage-
ment approach, and straightforward client communication and education.
In summary, a firm’s competitive advantage can result from its unique network of
activities. The important point, however, is that a static fit with the current environment
is not sufficient; rather, a firm’s unique network of activities must evolve over time to
take advantage of new opportunities and mitigate emerging threats. Moreover, by using
activity-based accounting (which first identifies distinct activities in an organization, and
then assigns costs to each activity based on estimates of all resources consumed) and by
benchmarking the competition, one can identify core competence. In Chapter 5, we take a
closer look at how to measure and assess competitive advantage.
4.5 Implications for Strategic Leaders
We’ve now reached a significant point: We can combine external analysis from Chapter 3
with the internal analysis just introduced. Together the two allow you to begin formulating
a strategy that matches your firm’s internal resources and capabilities to the demands of
the external industry environment. Ideally, strategic leaders want to leverage their firm’s
internal strengths to exploit external opportunities, while mitigating internal weaknesses
and external threats. Both types of analysis in tandem allow managers to formulate a strat-
egy that is tailored to their company, creating a unique fit between the company’s internal
resources and the external environment. A strategic fit increases the likelihood that a firm
is able to gain a competitive advantage. If a firm achieves a dynamic strategic fit, it is likely
to be able to sustain its advantage over time.
LO 4-9
Conduct a SWOT analysis
to generate insights from
external and internal
analysis and derive
strategic implications.
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USING SWOT ANALYSIS TO GENERATE INSIGHTS FROM
EXTERNAL AND INTERNAL ANALYSIS
We synthesize insights from an internal analysis of the company’s strengths and weak-
nesses with those from an analysis of external opportunities and threats using the SWOT
analysis. Internal strengths (S) and weaknesses (W) concern resources, capabilities, and
competencies. Whether they are strengths or weaknesses can be determined by applying the
VRIO framework. A resource is a weakness if it is not valuable. In this case, the resource
does not allow the firm to exploit an external opportunity or offset an external threat. A
resource, however, is a strength and a core competency if it is valuable, rare, costly to imi-
tate, and the firm is organized to capture at least part of the economic value created.
External opportunities (O) and threats (T) are in the firm’s general environment and can
be captured by PESTEL and Porter’s five forces analyses (discussed in the previous chap-
ter). An attractive industry as determined by Porter’s five forces, for example, presents an
external opportunity for firms not yet active in this industry. On the other hand, stricter reg-
ulation for financial institutions, for example, might represent an external threat to banks.
A SWOT analysis allows the strategist to evaluate a firm’s current situation and future
prospects by simultaneously considering internal and external factors. The SWOT analysis
encourages managers to scan the internal and external environments, looking for any relevant
factors that might affect the firm’s current or future competitive advantage. The focus is on
internal and external factors that can affect—in a positive or negative way—the firm’s ability
to gain and sustain a competitive advantage. To facilitate a SWOT analysis, managers use a
set of strategic questions that link the firm’s internal environment to its external environment,
as shown in Exhibit 4.10, to derive strategic implications. In this SWOT matrix, the horizon-
tal axis is divided into factors that are external to the firm (the focus of Chapter 3) and the
vertical axis into factors that are internal to the firm (the focus of this chapter).
In a first step, managers gather information for a SWOT analysis in order to link internal
factors (Strengths and Weaknesses) to external factors (Opportunities and Threats). Next,
managers use the SWOT matrix shown in Exhibit 4.10 to develop strategic alternatives
for the firm using a four-step process:
1. Focus on the Strengths–Opportunities quadrant (top left) to derive “offensive” alterna-
tives by using an internal strength to exploit an external opportunity.
2. Focus on the Weaknesses–Threats quadrant (bottom right) to derive “defensive” alterna-
tives by eliminating or minimizing an internal weakness to mitigate an external threat.
3. Focus on the Strengths–Threats quadrant (top right) to use an internal strength to mini-
mize the effect of an external threat.
4. Focus on the Weaknesses–Opportunities quadrant (bottom left) to shore up an internal
weakness to improve its ability to take advantage of an external opportunity.
SWOT analysis
A framework that allows
managers to synthesize
insights obtained from
an internal analysis of
the company’s strengths
and weaknesses (S
and W) with those
from an analysis of
external opportunities
and threats (O and
T) to derive strategic
implications.
EXHIBIT 4.10 /
Strategic Questions
within the SWOT
Matrix
In
te
rn
al
to
F
ir
m
External to Firm
Strategic Questions Opportunities Threats
Strengths How can the firm use internal
strengths to take advantage of
external opportunities?
How can the firm use internal
strengths to reduce the
likelihood and impact of
external threats?
Weaknesses How can the firm overcome
internal weaknesses that prevent
it from taking advantage of
external opportunities?
How can the firm overcome
internal weaknesses that will
make external threats a reality?
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In a final step, the strategist needs to carefully evaluate the pros and cons of each strate-
gic alternative to select one or more alternatives to implement. Managers need to carefully
explain their decision rationale, including why other strategic alternatives were rejected.
Although the SWOT analysis is a widely used management framework, a word of cau-
tion is in order. A problem with this framework is that a strength can also be a weakness
and an opportunity can also simultaneously be a threat. Earlier in this chapter, we discussed
the location of Google’s headquarters in Silicon Valley and near several universities as a
key resource for the firm. Most people would consider this a strength for the firm. How-
ever, California has a high cost of living and is routinely ranked among the worst of the
U.S. states in terms of “ease of doing business.” In addition, this area of California is along
major earthquake fault lines and is more prone to natural disasters than many other parts
of the country. So is the location a strength or a weakness? The answer is “it depends.” In
a similar fashion, is global warming an opportunity or threat for car manufacturers? If gov-
ernments enact higher gasoline taxes and make driving more expensive, it can be a threat.
If, however, carmakers respond to government regulations by increased innovation through
developing more fuel-efficient cars as well as low- or zero-emission engines such as hybrid
or electric vehicles, it may create more demand for new cars and lead to higher sales.
To make the SWOT analysis an effective management tool, the strategist must first con-
duct a thorough external and internal analysis, as laid out in Chapters 3 and 4. This sequen-
tial process enables the strategist to ground the analysis in rigorous theoretical frameworks
before using SWOT to synthesize the results from the external and internal analyses in
order to derive a set of strategic options.
You have now acquired the toolkit with which to conduct a complete strategic analysis
of a firm’s internal and external environments. In the next chapter, we consider various
ways to assess and measure competitive advantage. That chapter will complete Part 1, on
strategy analysis, in the AFI framework (see Exhibit 1.3).
ALTHOUGH MANY observers are convinced that Apple pur-
chased Beats Electronics for the coolness of its brand and
to gain a stronger position in the music industry, others are
suggesting that what Apple is really buying are the talents
that Beats co-founder Jimmy Iovine and Dr. Dre bring to the
table. Since the death of Steve Jobs, Apple’s visionary leader,
the company has been lacking the kind of inspired personal-
ity it needs to remain a cultural icon. The critics argue that
what Apple really needs is someone with a creative vision
combined with a wide-reaching industry network and the
ability to close a deal, especially in music where the person-
alities of celebrities are known to be idiosyncratic. In music
jargon, Apple is in need of a “front man.” With the acquisi-
tion of Beats, it got two of the greatest creative talents in the
music industry, with a long successful track record and deep
and far-reaching networks.
CHAPTERCASE 4 Consider This . . .
Iovine is of the opinion that
Beats had always belonged with
Apple. Iovine and Dr. Dre set out
to model Beats Electronics after
Apple’s unique ability to marry
culture and technology. Intrigu-
ingly, both Iovine and Dr. Dre
took on senior positions at Apple. They continue to link Beats
with today’s top talent, even as some celebrities, such as Ariana
Grande and Rihanna, take a leaf from the Beats playbook.
Some singers now burnish personal brands with limited release
headphones from other vendors; Grande’s wireless Cat Ear
Headphones (Brookstone, $150) and Rihanna’s bedazzled tiara
(Friends/Dolce & Gabanna, $9,000) are just two examples.
That Beats’ founders keep ongoing roles indicates how
much Apple’s culture has changed under CEO Tim Cook.
Dr. Dre and Jimmy Iovine of
Beats.
©Kevin Mazur/WireImage/
Getty Images
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136 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
Indeed, Iovine and Dr. Dre were not the first superstars from
flashy industries he brought to Apple. In 2013, Apple hired
former Burberry CEO Angela Ahrendts to head its retail opera-
tions. Bringing in superstars from the flashy industries of music
or fashion to Apple, let alone into senior executive roles, would
have been unthinkable under Jobs. Under his top-down leader-
ship, only Apple products introduced to the public by himself
in well-rehearsed theatrical launches were allowed to shine.
Questions
1. Which music streaming service do you use, if any? Why
are you using this particular service and not others? Are
you a paid subscriber? Why or why not?
2. The ChapterCase argues that Beats Electronics’ core
competency lies in its marketing savvy and in Dr. Dre’s
coolness factor. Do you agree with this assessment?
Why or why not?
3. If you believe that Apple bought Beats Electronics
to bring Jimmy Iovine and Dr. Dre into Apple, what
are the potential downsides of this multibillion-dollar
“acqui-hire” (an acquisition to hire key personnel)?
4. If Beats Electronics’ core competencies are indeed
intangibles, such as coolness and marketing savvy, do
you think these competencies will remain as valuable
under Apple’s ownership? Why or why not?
5. The ChapterCase provides at least three theories why
Apple purchased Beats Electronics. Briefly sketch each
of them. Which of those do you believe is most accu-
rate, and why?
This chapter demonstrated various approaches to ana-
lyzing the firm’s internal environment, as summarized
by the following learning objectives and related take-
away concepts.
LO 4-1 / Differentiate among a firm’s core com-
petencies, resources, capabilities, and activities.
■ Core competencies are unique, deeply embedded,
firm-specific strengths that allow companies to
differentiate their products and services and thus
create more value for customers than their rivals,
or offer products and services of acceptable value
at lower cost.
■ Resources are any assets that a company can draw
on when crafting and executing strategy.
■ Capabilities are the organizational and manage-
rial skills necessary to orchestrate a diverse set of
resources to deploy them strategically.
■ Activities are distinct and fine-grained business pro-
cesses that enable firms to add incremental value by
transforming inputs into goods and services.
LO 4-2 / Compare and contrast tangible and
intangible resources.
■ Tangible resources have physical attributes and
are visible.
■ Intangible resources have no physical attributes
and are invisible.
■ Competitive advantage is more likely to be based
on intangible resources.
LO 4-3 / Evaluate the two critical assump-
tions behind the resource-based view.
■ The first critical assumption—resource
heterogeneity—is that bundles of resources, capa-
bilities, and competencies differ across firms. The
resource bundles of firms competing in the same
industry (or even the same strategic group) are
unique to some extent and thus differ from one
another.
■ The second critical assumption—resource
immobility—is that resources tend to be “sticky”
and don’t move easily from firm to firm. Because
of that stickiness, the resource differences that
exist between firms are difficult to replicate and,
therefore, can last for a long time.
LO 4-4 / Apply the VRIO framework to
assess the competitive implications of a firm’s
resources.
■ For a firm’s resource to be the basis of a competi-
tive advantage, it must have VRIO attributes:
TAKE-AWAY CONCEPTS
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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 137
valuable (V), rare (R), and costly to imitate (I).
The firm must also be able to organize (O) in
order to capture the value of the resource.
■ A resource is valuable (V) if it allows the firm to
take advantage of an external opportunity and/or
neutralize an external threat. A valuable resource
enables a firm to increase its economic value cre-
ation (V − C).
■ A resource is rare (R) if the number of firms
that possess it is less than the number of firms
it would require to reach a state of perfect
competition.
■ A resource is costly to imitate (I) if firms that do
not possess the resource are unable to develop or
buy the resource at a comparable cost.
■ The firm is organized (O) to capture the value of
the resource if it has an effective organizational
structure, processes, and systems in place to fully
exploit the competitive potential.
LO 4-5 / Evaluate different conditions
that allow a firm to sustain a competitive
advantage.
■ Several conditions make it costly for competitors
to imitate the resources, capabilities, or compe-
tencies that underlie a firm’s competitive advan-
tage: (1) better expectations of future resource
value, (2) path dependence, (3) causal ambiguity,
(4) social complexity, and (5) intellectual prop-
erty (IP) protection.
■ These barriers to imitation are isolating mecha-
nisms because they prevent rivals from competing
away the advantage a firm may enjoy.
LO 4-6 / Outline how dynamic capabilities
can enable a firm to sustain a competitive
advantage.
■ To sustain a competitive advantage, any fit
between a firm’s internal strengths and the exter-
nal environment must be dynamic.
■ Dynamic capabilities allow a firm to create,
deploy, modify, reconfigure, or upgrade its
resource base to gain and sustain competitive
advantage in a constantly changing environment.
LO 4-7 / Apply a value chain analysis to
understand which of the firm’s activities
in the process of transforming inputs into
outputs generate differentiation and which
drive costs.
■ The value chain describes the internal activities
a firm engages in when transforming inputs into
outputs.
■ Each activity the firm performs along the hori-
zontal chain adds incremental value and incre-
mental costs.
■ A careful analysis of the value chain allows man-
agers to obtain a more detailed and fine-grained
understanding of how the firm’s economic value
creation breaks down into a distinct set of activi-
ties that helps determine perceived value and the
costs to create it.
■ When a firm’s set of distinct activities is able to
generate value greater than the costs to create it,
the firm obtains a profit margin (assuming the
market price the firm is able to command exceeds
the costs of value creation).
LO 4-8 / Identify competitive advantage as
residing in a network of distinct activities.
■ A strategic activity system conceives of a firm as
a network of interconnected firm activities.
■ A network of primary and supporting firm activi-
ties can create a strategic fit that can lead to a
competitive advantage.
■ To sustain a competitive advantage, firms need
to hone, fine-tune, and upgrade their strategic
activity systems over time, in response to changes
in the external environment and to moves of
competitors.
LO 4-9 / Conduct a SWOT analysis to gener-
ate insights from external and internal analysis
and derive strategic implications.
■ Formulating a strategy that increases the chances
of gaining and sustaining a competitive advan-
tage is based on synthesizing insights obtained
from an internal analysis of the company’s
strengths (S) and weaknesses (W) with those
from an analysis of external opportunities (O)
and threats (T).
■ The strategic implications of a SWOT analy-
sis should help the firm to leverage its internal
strengths to exploit external opportunities, while
mitigating internal weaknesses and external
threats.
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138 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
Activities (p. 112)
Capabilities (p. 110)
Causal ambiguity (p. 122)
Core competencies (p. 110)
Core rigidity (p. 124)
Costly-to-imitate
resource (p. 116)
Dynamic capabilities (p. 126)
Dynamic capabilities perspec-
tive (p. 127)
Intangible resources (p. 113)
Intellectual property (IP) protec-
tion (p. 123)
Isolating mechanisms (p. 120)
Organized to capture
value (p. 118)
Path dependence (p. 121)
Primary activities (p. 130)
Rare resource (p. 116)
Resource-based view (p. 113)
Resource flows (p. 127)
Resource heterogeneity (p. 114)
Resource immobility (p. 114)
Resource stocks (p. 127)
Resources (p. 110)
Social complexity (p. 123)
Strategic activity system (p. 130)
Support activities (p. 130)
SWOT analysis (p. 134)
Tangible resources (p. 113)
Valuable resource (p. 116)
Value chain (p. 128)
VRIO framework (p. 115)
KEY TERMS
DISCUSSION QUESTIONS
1. Why is it important to study the internal
resources, capabilities, and activities of firms?
What insights can be gained?
2. a. Conduct a value chain analysis for McDon-
ald’s. What are its primary activities? What
are its support activities? Identify the activi-
ties that add the most value for the customer.
Why? Which activities help McDonald’s to
contain cost? Why?
b. In the past few years, McDonald’s has made
a lot of changes to its menu, adding more
healthy choices and more higher-priced items,
such as those offered in McCafé (e.g., pre-
mium roast coffee, antibiotic-free chicken,
and fruit smoothies), and has also enhanced
its in-restaurant services (e.g., free, unlimited
Wi-Fi; upgraded interiors). Did McDonald’s
new priorities—in terms of a broader,
healthier menu and an improved in-restaurant
experience—require changes to its traditional
value chain activities? If so, how? Try to
be as specific as possible in comparing the
McDonald’s from the recent past (focusing on
low-cost burgers) to the McDonald’s of today.
3. The resource-based view of the firm identifies
four criteria that managers can use to evaluate
whether particular resources and capabilities are
core competencies and can, therefore, provide a
basis for sustainable competitive advantage. Are
these measures independent or interdependent?
Explain. If (some of) the measures are interde-
pendent, what implications does that fact have for
managers wanting to create and sustain a com-
petitive advantage?
ETHICAL/SOCIAL ISSUES
1. As discussed in this chapter, resources that are
valuable, rare, and costly to imitate can help
create a competitive advantage. In many cases,
firms try to “reverse-engineer” a particular
feature from a competitor’s product for their
own uses. It is common, for example, for
smartphone manufacturers to buy the new-
est phones of their competitors and take them
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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 139
apart to see what new components and features
the models have implemented. However, this
sort of corporate behavior does not stop with
hardware products. With hundreds of millions
of users and rapid growth, China is considered
to be one of the most lucrative online markets
worldwide. Baidu (baidu.com), a Chinese web
services company, has allegedly adapted many
of the search tools that Google uses. Baidu,
however, modifies its searches inside China
(its major market) to accommodate government
guidelines. In protest over these same guide-
lines, in 2010 Google left the Chinese market
and is running its Chinese search operations
from Hong Kong. Google no longer censors
its online searches as requested by the Chinese
government. Baidu has an estimated 78 percent
market share in online search in China, and
Google less than 15 percent.50
It is legal to take apart publicly available prod-
ucts and services and try to replicate them and
even develop work-arounds for relevant patents.
But is it ethical? If a key capability protected
by patents or trademarks in your firm is being
reverse-engineered by the competition, what are
your options for a response? Also, how do you
evaluate Google’s decision to move its servers to
Hong Kong?
2. The chapter mentions that one type of resource
flow is the loss of key personnel who move to
another firm. Assume that the human resources
department of your firm has started running ads
and billboards for open positions near the office
of your top competitor. Your firm is also run-
ning Google ads on a keyword search for this
same competitor. Is there anything unethical
about this activity? Would your view change if
this key competitor had just announced a major
layoff?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Brand valuations were mentioned in the chapter as
a potential key intangible resource for firms. Some
product brands are so well established the entire cat-
egory of products (including those made by competi-
tors) may be called by the brand name rather than the
product type. In your small group, develop two or
three examples of this happening in the marketplace.
In any of the cases noted, does such brand valuation
give the leading brand a competitive advantage? Or
does it produce confusion in the market for all prod-
ucts or services in that category? Provide advice to the
leading brand as to how the firm can strengthen the
brand name.
//// Small Group Exercise 2
Strategy Highlight 4.1 explains the rise and fall
of Groupon. The company’s strategic vision was
to be the global leader in local commerce, based
on a core competency that could be described as
“local market-making.” Numerous competitors took
advantage of low barriers to entry and the easy imi-
tation of Groupon’s combined competency of some
technology skills with sales skills, so that Groupon
found its competitive advantage was only tempo-
rary. Groupon continues to compete but needs your
advice on how to build dynamic capabilities that
might help it pursue the vision of becoming a global
leader in local commerce. How might Groupon rein-
vest or upgrade its technology and sales skills so
it builds a global customer base? For example, are
there new products or services that would meet the
needs of global clients in each of the local markets?
Should they try to compete with the newer “hyper-
local” offerings or move in a different direction?
Brainstorm ways that Groupon might add value for
its customers. How might Groupon build relation-
ships with clients that are more socially complex,
making Groupon’s competencies more difficult to
imitate?
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Looking Inside Yourself: What Is My
Competitive Advantage?
W e encourage you to apply what you have learned about competitive advantage to your career. Spend a few minutes looking at yourself to discover your
own competitive advantage. If you have previous work experi-
ence, these questions should be from a work environment per-
spective. If you do not have any work experience yet, use these
questions to evaluate a new workplace or as strategies for pre-
senting yourself to a potential employer.
1. Write down your own strengths and weaknesses. What
sort of organization will permit you to really leverage
your strengths and keep you highly engaged in your work
(person–organization fit)? Do some of your weaknesses
need to be mitigated through additional training or mentor-
ing from a more seasoned professional?
2. Personal capabilities also need to be evaluated over time.
Are your strengths and weaknesses different today from
what they were five years ago? What are you doing to
make sure your capabilities are dynamic?
3. Are some of your strengths valuable, rare, and costly to
imitate? How can you organize your work to help capture
the value of your key strengths (or mitigate your weak-
nesses)? Are your strengths specific to one or a few
employers, or are they more generally valuable in the
marketplace? In general, should you be making investments
in your human capital in terms of company-specific or
market-general skills?
4. As an employee, how could you persuade your boss that
you could be a vital source of sustainable competitive
advantage? What evidence could you provide to make such
an argument?
mySTRATEGY
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140 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
1. Source: “People Aren’t Hearing All The
Music,” Beats By Dre. www.beatsbydre.com/
aboutus.
2. www.beatsbydre.com; Hufford, A. and
H. Karp (2017, Jan. 23), “Sprint to Buy
33% of Jay Z’s Tidal Music Service,” The
Wall Street Journal. Eels, J., “Dr. Dre
and Jimmy Iovine’s school for innova-
tion,” The Wall Street Journal November
5, 2014; Brownlee, M. (2014, Aug. 30),
“The truth about Beats by Dre!,” August
30, YouTube video, www.youtube.com/
watch?v=ZsxQxS0AdBY; “The sound of
music,” The Economist, August 24, 2014;
Karp, H., “Apple’s new Beat: What Steve
Jobs and Dr. Dre have in common,” The
Wall Street Journal, June 6, 2014; Cohen,
M., “Apple buys Beats to regain music
mojo,” The Wall Street Journal, May 29,
2014; “Can you feel the Beats?” The Econo-
mist, May 28, 2014; Karp, H., “Apple-Beats
Electronics: The disrupter is disrupted,” The
Wall Street Journal, May 9, 2014; Karp,
H., and D. Wakabayashi, “Dr. Dre, Jimmy
Iovine would both join Apple in Beats
deal,” The Wall Street Journal, May 9,
2014; “Beats nicked,”The Economist, May
13, 2014; and “The legacy of Napster,” The
Economist,September 13, 2013.
3. The discussion of Beats Electronics
throughout the chapter is based on: www.
beatsbydre.com; Eels, J. (2014, Nov. 5), “Dr.
Dre and Jimmy Iovine’s school for innova-
tion,” The Wall Street Journal; Brownlee,
M. (2014, Aug. 30), “The truth about Beats
by Dre!”, YouTube video, www.youtube.
com/watch?v=ZsxQxS0AdBY; “The sound
of music,” The Economist, August 24, 2014;
Karp, H. (2014, June 6), “Apple’s new Beat:
What Steve Jobs and Dr. Dre have in com-
mon,” The Wall Street Journal; Cohen, M.
(2014, May 29), “Apple buys Beats to regain
music mojo,” The Wall Street Journal; “Can
you feel the Beats?” The Economist, May 28,
2014; Karp, H. (2014, May 9), “Apple-Beats
Electronics: The disrupter is disrupted,” The
Wall Street Journal; Karp, H., and D.
Wakabayashi (2014, May 9), “Dr. Dre, Jimmy
Iovine would both join Apple in Beats deal,”
The Wall Street Journal; “Beats nicked,” The
Economist, May 13, 2014; and “The legacy of
Napster,” The Economist, September 13, 2013.
4. Prahalad, C.K., and G. Hamel (1990), “The
core competence of the corporation,” Harvard
Business Review, May–June.
5. This discussion is based on: Amit, R., and
P.J.H. Schoemaker (1993), “Strategic assets
and organizational rent,” Strategic Manage-
ment Journal 14: 33–46; Peteraf, M. (1993),
“The cornerstones of competitive advantage,”
Strategic Management Journal 14: 179–191;
Barney, J. (1991), “Firm resources and sus-
tained competitive advantage,” Journal of
Management 17: 99–120; and Wernerfelt, B.
(1984), “A resource-based view of the firm,”
Strategic Management Journal 5: 171–180.
6. Google is working to outdo the existing
Googlepex headquarters in Mountain View.
In 2015, the company sought permission
to build a 3.4 million-square-foot campus
across four pieces of land near the edge of
San Francisco Bay. The futuristic site, to be
completed in 2020, will be covered by canopy
structures that can be rearranged in a flexible
manner. See “Silicon Valley headquarters:
ENDNOTES
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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 141
Googledome, or temple of doom?” The Econ-
omist, March 7, 2015.
7. Tangible resources are listed under “Prop-
erty and Equipment” in the Consolidated
Balance Sheet, see Alphabet / Google Annual
Report, 2016, https://abc.xyz/investor/
index.html.
8. “Top 100 most valuable global brands
2016,” report by Millward Brown, WPP,
http://www.millwardbrown.com/brandz/
top-global-brands/2016.
9. For a discussion on the benefits of being
located in a technology cluster, see Rothaer-
mel, F.T., and D. Ku (2008), “Intercluster
innovation differentials: The role of research
universities,” IEEE Transactions on Engineer-
ing Management 55: 9–22; and Saxenian, A.
L. (1994), Regional Advantage: Culture and
Competition in Silicon Valley and Route 128
(Cambridge, MA: Harvard University Press).
10. Stuart, T., and O. Sorenson (2003), “The
geography of opportunity: Spatial heterogene-
ity in founding rates and the performance of
biotechnology firms,” Research Policy 32:
229–253.
11. “Top 100 most valuable global brands
2016,” report by Millward Brown, WPP,
http://www.millwardbrown.com/brandz/
top-global-brands/2016.
12. This discussion is based on: Amit, R., and
P.J.H. Schoemaker (1993), “Strategic assets
and organizational rent,” Strategic Manage-
ment Journal 14: 33–46; Barney, J. (1991),
“Firm resources and sustained competitive
advantage,” Journal of Management 17:
99–120; Peteraf, M. (1993), “The corner-
stones of competitive advantage,” Strategic
Management Journal 14: 179–191; and Wer-
nerfelt, B. (1984), “A resource-based view of
the firm,” Strategic Management Journal 5:
171–180.
13. This discussion is based on: Barney, J.,
and W. Hesterly (2014), Strategic Manage-
ment and Competitive Advantage, 5th ed.
(Upper Saddle River, NJ: Pearson Prentice
Hall); Amit, R., and P.J.H. Schoemaker
(1993), “Strategic assets and organizational
rent,” Strategic Management Journal 14:
33–46; Barney, J. (1991), “Firm resources and
sustained competitive advantage,” Journal of
Management 17: 99–120; Peteraf, M. (1993),
“The cornerstones of competitive advantage,”
Strategic Management Journal 14: 179–191;
and Wernerfelt, B. (1984), “A resource-based
view of the firm,” Strategic Management
Journal 5: 171–180.
14. Barney, J., and W. Hesterly (2014), Stra-
tegic Management and Competitive Advan-
tage, 5th ed. (Upper Saddle River, NJ: Pearson
Prentice Hall); and Barney, J. (1991), “Firm
resources and sustained competitive advan-
tage,” Journal of Management 17: 99–120.
15. Crocs’ share price hit an all-time high of
$74.75 on October 31, 2007. By November
20, 2008, the share price had fallen to $0.94.
16. For a detailed history of the creation
and growth of Amazon.com, see Stone, B.
(2013), The Everything Store: Jeff Bezos and
the Age of Amazon (New York: Little, Brown
and Co.).
17. “U.S. judge reduces Apple’s patent award
in Samsung case,” The Wall Street Journal,
March 1, 2013; and “Apple wins big in patent
case,” The Wall Street Journal, August 24,
2012.
18. Chesbrough, H. (2006), Open Innovation:
The New Imperative for Creating and Profit-
ing from Technology (Boston, MA: Harvard
Business School Press).
19. In 1968, Xerox moved its headquarters
from Rochester, New York, to Norwalk,
Connecticut.
20. Prahalad, C.K., and G. Hamel (1990),
“The core competence of the corporation,”
Harvard Business Review, May–June.
21. Porter, M.E. (1996), “What is strategy?”
Harvard Business Review, November–
December: 61–78.
22. Groupon Annual Report, 2012; Groupon
investor deck, March 2013; “Don’t weep for
Groupon ex-CEO Andrew Mason,” The Wall
Street Journal, March 1, 2013; “Groupon
CEO fired as daily-deals biz bottoms out,”
Wired, February 28, 2013; “Struggling Grou-
pon ousts its quirky CEO,” The Wall Street
Journal, February 28, 2013; “Why Groupon
is over and Facebook and Twitter should fol-
low,” Forbes, August 20, 2012; “Groupon:
Deep discount,” The Economist, August 14,
2012; “The economics of Groupon,” The
Economist, October 22, 2011; “In Groupon’s
$6 billion wake, a fleet of startups,” The New
York Times, March 9, 2011; and Godin, S.
(2008), Tribes: We Need You to Lead Us (New
York: Portfolio).
23. This discussion is based on: Mahoney,
J.T., and J.R. Pandian (1992), “The resource-
based view within the conversation of strategic
management,” Strategic Management Jour-
nal 13: 363–380; Barney, J. (1991), “Firm
resources and sustained competitive advan-
tage,” Journal of Management 17: 99–120;
Dierickx, I., and K. Cool (1989), “Asset stock
accumulation and sustainability of competitive
advantage,” Management Science 35: 1504–
1513; and Barney, J. (1986), “Strategic factor
markets: Expectations, luck, and business strat-
egy,” Management Science 32: 1231–1241.
24. Lippman, S.A., and R. P. Rumelt
(1982), “Uncertain imitability: An analysis
of interfirm differences in efficiency under
competition,” The Bell Journal of Economics
13: 418–438.
25. Arthur, W.B. (1989), “Competing tech-
nologies, increasing returns, and lock-in
by historical events,” Economics Journal
99: 116–131; and Dierickx, I., and K. Cool
(1989), “Asset stock accumulation and sus-
tainability of competitive advantage,” Man-
agement Science 35: 1504–1513.
26. Krugman, P. (1993), Geography and
Trade (Cambridge, MA: MIT Press); and
Patton, R.L. (2010), “A history of the U.S.
carpet industry,” Economic History Associa-
tion Encyclopedia, http://eh.net/encyclopedia/
article/patton.carpet.
27. Dierickx, I., and K. Cool (1989), “Asset
stock accumulation and sustainability of com-
petitive advantage,” Management Science 35:
1504–1513.
28. For a detailed discussion of how several
stakeholders influenced the CARB to with-
draw zero-emissions standard, see: Sony Pic-
tures’ documentary “Who Killed the Electric
Car?” www.whokilledtheelectriccar.com/
29. Colias, M. (2016), “GM Says Chevy Bolt
Electric Car to Get 238-Mile Range,” The
Wall Street Journal, September 16; Sparks, D.
(2017, Mar. 7), “Chevy Bolt U.S. deliveries
decline in February,” The Motley Fool.
30. More formally, the number of relation-
ships (r) in a group is a function of its group
members (n), with r = n(n − 1)/2. The
assumption is that two people, A and B, have
only one relationship (A ← → B), rather
than two relationships (A → B and A ← B).
In the latter case, the number of relation-
ships (r) in a group with n members doubles,
where r = n(n − 1).
31. This discussion is based on: Hallenborg,
L., M. Ceccagnoli, and M. Clendenin (2008),
“Intellectual property protection in the global
economy,” Advances in the Study of Entrepre-
neurship, Innovation, and Economic Growth
18: 11–34; and Graham, S.J.H. (2008), “Beyond
patents: The role of copyrights, trademarks, and
trade secrets in technology commercialization,”
Advances in the Study of Entrepreneurship,
Innovation, and Economic Growth 18: 149–171.
32. “Cost to develop and win marketing
approval for a new drug is $2.6 billion,” Tufts
Center for the Study of Drug Development,
November 2014.
33. “Lipitor becomes world’s top-selling
drug,” Associated Press, December 28, 2011.
34. Sherr, I. (2013), “U.S. judge reduces
Apple’s patent award in Samsung case,” The
Wall Street Journal, March 1; and Vascellaro,
J.E. (2012, Aug. 25), “Apple wins big in
patent case,” The Wall Street Journal.
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142 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies
35. Loftus, P. (2014, Mar. 2), “Lipitor: Pfizer
aims to sell over-the-counter version,” The
Wall Street Journal.
36. “Drug prices to plummet in wave of
expiring patents,” Drugs.com, www.drugs.
com/news/prices-plummet-wave-expiring-
patents-32684.html.
37. Leonard-Barton, D. (1992), “Core capa-
bilities and core rigidities: A paradox in man-
aging new product development,” Strategic
Management Journal 13: 111–125.
38. Leonard-Barton, D. (1995), Wellsprings
of Knowledge: Building and Sustaining the
Sources of Innovation (Boston, MA: Harvard
Business School Press).
39. This Strategy Highlight is based on:
“Gillette, bleeding market share, cuts prices
of razors,” The Wall Street Journal, April 4,
2017; “P&G names David Taylor as CEO,”
The Wall Street Journal, July 29, 2015;
“Razor sales move online, away from Gil-
lette,” The Wall Street Journal, June 23,
2015; “Strong dollar squeezes U.S. firms,”
The Wall Street Journal, January 27, 2014;
“P&G to shed more than half its brands,”
The Wall Street Journal, August 1, 2014;
“P&G’s Billion-Dollar Brands: Trusted, Val-
ued, Recognized,” Fact Sheet, www.pg.com;
Lafley, A.G., and R.L. Martin (2013), Playing
to Win: How Strategy Really Works (Bos-
ton, MA: Harvard Business Review Press);
“Embattled P&G chief replaced by old boss,”
The Wall Street Journal, May 23, 2013; “At
Procter & Gamble, the innovation well runs
dry,” Bloomberg Businessweek, September
6, 2012; “P&G’s stumbles put CEO on hot
seat for turnaround,” The Wall Street Journal,
September 27, 2012; and “A David and Gil-
lette story,” The Wall Street Journal, April
12, 2012.
40. This discussion is based on: Peteraf, M.,
G. Di Stefano, and G. Verona (2013), “The
elephant in the room of dynamic capabili-
ties: Bringing two diverging conversations
together,” Strategic Management Journal
34: 1389–1410; Rothaermel, F.T., and A.M.
Hess (2007), “Building dynamic capabilities:
Innovation driven by individual-, firm-, and
network-level effects,” Organization Science
18: 898–921; Eisenhardt, K.M., and Martin,
J. (2000), “Dynamic capabilities: What are
they?” Strategic Management Journal 21:
1105–1121; and Teece, D.J., G. Pisano, and
A. Shuen (1997), “Dynamic capabilities and
strategic management,” Strategic Management
Journal 18: 509–533.
41. Dierickx, I., and K. Cool (1989), “Asset
stock accumulation and sustainability of com-
petitive advantage,” Management Science 35:
1504–1513.
42. Dierickx, I., and K. Cool (1989), “Asset
stock accumulation and sustainability of com-
petitive advantage,” Management Science 35:
1504–1513.
43. Eisenhardt, K.M., and J. Martin (2000),
“Dynamic capabilities: What are they?” Stra-
tegic Management Journal 21: 1105–1121.
44. This discussion is based on: Porter,
M.E. (1985), Competitive Advantage: Creat-
ing and Sustaining Superior Performance
(New York: Free Press); Porter, M.E. (1996),
“What is strategy?”Harvard Business Review,
November–December: 61–78; Siggelkow,
N. (2001), “Change in the presence of fit:
The rise, the fall, and the renaissance of Liz
Claiborne,” Academy of Management Journal
44: 838–857; and Magretta, J. (2012), Under-
standing Michael Porter. The Essential Guide
to Competition and Strategy (Boston, MA:
Harvard Business School Press).
45. This discussion draws on: Porter, M.E.
(1996), “What is strategy?”Harvard Business
Review, November–December: 61–78.
46. This discussion draws on: Porter, M.E.
(1996), “What is strategy?”Harvard Busi-
ness Review, November–December: 61–78;
and Siggelkow, N. (2002), “Evolution toward
fit,” Administrative Science Quarterly 47:
125–159.
47. https://careers.vanguard.com/vgcareers/
why_vgi/story/mission.shtml.
48. “Funds: How much you’re really paying,”
Money, November 2005; and https://personal.
vanguard.com/us/content/Home/WhyVan-
guard/AboutVanguardWhoWeAreContent.jsp.
49. Krouse, S. (2017, Feb. 10), “Vanguard
reaches $4 trillion for first time,” The Wall
Street Journal.
50. “Special report: China and the internet,”
The Economist, April 6, 2013; “How Baidu
won China,” Bloomberg Businessweek,
November 11, 2010; and “China search engine
market update for Q4 2013,” China Internet
Watch, March 11, 2014.
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144
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CHAPTER Competitive Advantage,
Firm Performance, and
Business Models
Chapter Outline
5.1 Competitive Advantage and Firm Performance
Accounting Profitability
Shareholder Value Creation
Economic Value Creation
The Balanced Scorecard
The Triple Bottom Line
5.2 Business Models: Putting Strategy into Action
The Why, What, Who, and How of Business Models
Framework
Popular Business Models
Dynamic Nature of Business Models
5.3 Implications for Strategic Leaders
Learning Objectives
LO 5-1 Conduct a firm profitability analysis using
accounting data to assess and evaluate
competitive advantage.
LO 5-2 Apply shareholder value creation to assess
and evaluate competitive advantage.
LO 5-3 Explain economic value creation and differ-
ent sources of competitive advantage.
LO 5-4 Apply a balanced scorecard to assess and
evaluate competitive advantage.
LO 5-5 Apply a triple bottom line to assess and
evaluate competitive advantage.
LO 5-6 Use the why, what, who, and how of business
models framework to put strategy into action.
5
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145
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The Quest for Competitive
Advantage: Apple vs. Microsoft
APPLE AND MICROSOFT have been fierce rivals since their
arrival in the mid-1970s. Although Apple has been dominat-
ing more recently, in the early decades of the PC revolution,
Microsoft was the undisputed leader. With its Windows oper-
ating system, Microsoft set the standard in the world of per-
sonal computers. Some 90 percent of all PCs run Windows.
Once users are locked into
Windows, which generally
comes preloaded on the
computer they purchased,
they then want to buy appli-
cations that run seamlessly
with the operating system.
The obvious choice for
users is Microsoft’s Office
Suite (containing Word,
Excel, PowerPoint, Outlook,
and other software pro-
grams). Microsoft’s business
model was to create a large
installed base of users for
its PC operating system and
then make money selling
application software such as
its ubiquitous Office Suite.
Microsoft then went on to replicate with its corporate cus-
tomers this hugely successful business model of setting the
standard in operating systems combined with bundling dis-
counted application suites. Once servers became ubiquitous
in corporations, Microsoft offered IT departments e-mail
systems, databases, and other business applications that were
tightly integrated with Windows. As a consequence, some
80 percent of Microsoft’s revenues were either tied directly
or indirectly to its Windows franchise. Microsoft’s strategy
of focusing on setting the industry standard allowed it to cre-
ate a strong strategic position and to extract high profits for
many years. Microsoft’s bundling strategy with Office, com-
bining different application services that run seamlessly in
one discounted product offering, allowed Microsoft to over-
take IBM, once the most valuable tech company. By 2000,
Microsoft was the most valuable company globally with
some $510 billion in market capitalization.
In contrast, at roughly the same time, Apple was strug-
gling to survive with less than 5 percent market share in the
PC market. Near bankruptcy in 1997, Apple’s revitalization
took off in the fall of 2001 when it introduced the iPod,
a portable digital music player. Eighteen months later, the
Cupertino, California, company soared even higher when it
opened the online store iTunes, quickly followed by its first
retail stores. Apple’s stores earn the highest sales per square
foot of any retail outlets, including luxury stores.
Apple didn’t stop there. In 2007, the company revolu-
tionized the smartphone market with the introduction of the
iPhone. Just three years
later, Apple introduced
the iPad, reshaping the
publishing and media
industries. Further, for
each of its iPod, iPhone,
and iPad lines of business,
Apple followed up with
incremental product inno-
vations extending each
product category. By the
fall of 2012, Apple had
become the most valuable
company in the world
with some $620 billion
market capitalization.
In 2015, the high-
tech company introduced
Apple Watch, a wearable computer that is fully integrated
with the iOS Apple operating system, running basically all
the apps available for the iPhone. Not to be stopped, Apple
introduced its 10th anniversary iPhone in 2017 to great fan-
fare, with a curved screen and priced at about $1,000. In the
same year, Apple’s market capitalization had further risen to
more than $750 billion.
The comparison of Microsoft and Apple over time shows
that competitive advantage is transitory. Given the rough-
and-tumble competition combined with relentless technolog-
ical progress and innovation, it is hard to gain a competitive
advantage in the first place, and it is even harder to sustain it.1
You will learn more about Apple and Microsoft by reading
this chapter; related questions appear in “ChapterCase 5 /
Consider This . . . .”
NOTE: A financial ratio review related to this Chapter-
Case is available in Connect.
CHAPTERCASE 5
One of the few photos depicting Steve Jobs (Apple co-founder and
longtime CEO) and Bill Gates (Microsoft co-founder and longtime CEO)
together shows the erstwhile archrivals apparently enjoying each other’s
company. Taken at All Things Digital 5 in 2007.
©Reprinted by permission of WSJ, Copyright July 8, 2007, Dow Jones
& Company, Inc.
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GAINING AND SUSTAINING competitive advantage is the defining goal of stra-
tegic management. Competitive advantage leads to superior firm performance. To
explain differences in firm performance and to derive strategic implications—including
new strategic initiatives—we must understand how to measure and assess competitive
advantage. We devote this chapter to studying how to measure and assess firm perfor-
mance. In particular, we introduce three frameworks to capture the multifaceted nature
of competitive advantage. The three traditional frameworks to measure and assess firm
performance are
■ Accounting profitability.
■ Shareholder value creation.
■ Economic value creation.
We then will introduce two integrative frameworks, combining quantitative data with
qualitative assessments:
■ The balanced scorecard.
■ The triple bottom line.
Next, we take a closer look at business models to understand more deeply how firms put
their strategy into action to make money. We conclude the chapter with practical Implica-
tions for Strategic Leaders.
5.1 Competitive Advantage and Firm Performance
It is easy to compare two firms and identify the better performer as having competi-
tive advantage. But simple comparisons have their limitations. How can we understand
how and why a firm has competitive advantage? How can we measure it? How can we
understand that advantage within the bigger picture of an entire industry and the ever-
changing external environment? And what strategic implications for managerial actions
do we derive from our assessments? These apparently simple questions do not have
simple answers. Strategic management researchers have debated them intensely for the
past few decades.2
To address these key questions, we will develop a multidimensional perspective for
assessing competitive advantage. Let’s begin by focusing on the three standard perfor-
mance dimensions:3
1. What is the firm’s accounting profitability?
2. How much shareholder value does the firm create?
3. How much economic value does the firm generate?
These three performance dimensions tend to be correlated, particularly over time.
Accounting profitability and economic value creation tend to be reflected in the firm’s
stock price, which in turn determines in part the stock’s market valuation.
ACCOUNTING PROFITABILITY
As we discussed in Chapter 1, strategy is a set of goal-directed actions a firm takes to gain
and sustain competitive advantage. Using accounting data to assess competitive advantage
and firm performance is standard managerial practice. When assessing competitive advan-
tage by measuring accounting profitability, we use financial data and ratios derived from
publicly available accounting data such as income statements and balance sheets.4 Since
competitive advantage is defined as superior performance relative to other competitors in
LO 5-1
Conduct a firm
profitability analysis using
accounting data to assess
and evaluate competitive
advantage.
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the same industry or the industry average, a firm’s managers must be able to accomplish two
critical tasks:
1. Accurately assess the performance of their firm.
2. Compare and benchmark their firm’s performance to other competitors in the same
industry or against the industry average.
Standardized financial metrics, derived from such publicly available accounting data as
income statements and balance sheets, fulfill both these conditions. Public companies are
required by law to release these data, in compliance with generally accepted accounting
principles (GAAP) set by the Financial Accounting Standards Board (FASB), and as audited
by certified public accountants. Publicly traded firms are required to file a Form 10-K (or
10-K report) annually with the U.S. Securities and Exchange Commission (SEC), a federal
regulatory agency. The 10-K reports are the primary source of companies’ accounting data
available to the public. The fairly stringent requirements applied to accounting data that are
audited and released publicly enhance the data’s usefulness for comparative analysis.
Accounting data enable us to conduct direct performance comparisons between different
companies. Some of the profitability ratios most commonly used in strategic management
are return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and
return on revenue (ROR). In the “How to Conduct a Case Analysis” module (at the end of
Part 4, following the MiniCases), you will find a complete presentation of accounting mea-
sures and financial ratios, how they are calculated, and a brief description of their strategic
characteristics.
One of the most commonly used metrics in assessing firm financial performance is
return on invested capital (ROIC), where ROIC = (Net profits / Invested capital).5 ROIC
is a popular metric because it is a good proxy for firm profitability. In particular, the ratio
measures how effectively a company uses its total invested capital, which consists of
two components: (1) shareholders’ equity through the selling of shares to the public, and
(2) interest-bearing debt through borrowing from financial institutions and bondholders.
As a rule of thumb, if a firm’s ROIC is greater than its cost of capital, it generates value;
if it is less than the cost of capital, the firm destroys value. The cost of capital represents a
firm’s cost of financing operations from both equity through issuing stock and debt through
issuing bonds. To be more precise and to be able to derive strategic implications, however,
managers must compare their ROIC to other competitors and the industry average.
APPLE VS. MICROSOFT. To demonstrate the usefulness of account-
ing data in assessing competitive advantage and to derive strategic
implications, let’s revisit the comparison between Apple and Micro-
soft that we began in ChapterCase 5, and investigate the sources
of performance differences in more detail.6 Exhibit 5.1 shows the
ROIC for Apple and Microsoft as of fiscal year 2016.7 It further
breaks down ROIC into its constituent components. This provides
important clues for managers on which areas to focus when attempt-
ing to improve firm performance relative to their competitors.
Apple’s ROIC is 18.3 percent, which is 4.6 percentage points
higher than Microsoft’s (13.7 percent). This means that for every
$1.00 invested in Apple, the company returned almost $1.18, while
for every $1.00 invested in the company, Microsoft returned $1.13.
Since Apple was 33 percent more efficient than Microsoft at gen-
erating a return on invested capital, Apple had a clear competitive
advantage over Microsoft. Although this is an important piece of
Tim Cook, Apple CEO.
©Scott Olson/Getty Images
News/Getty Images
Satya Nadella, Microsoft CEO.
©Brian Smale/Microsoft/
Getty Images
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EXHIBIT 5.1 /
Comparing Apple and
Microsoft: Drivers of
Firm Performance
(2016)8
SOURCE: Analysis of publicly
available data.
Return on Revenue (ROR) =
(Net Profits /Revenue)
Microsoft: 21.5%
Apple: 20.6%
Return on Invested Capital (ROIC) =
NOPAT / (Total Stockholders’ Equity +
Total Debt – Value of Preferred Stock)
Microsoft: 13.7%
Apple: 18.3%
R&D/Revenue
Apple: 4.7%
Microsoft: 14.1%
SG&A/Revenue
Apple: 6.6%
Microsoft: 22.6%
Tax Rate
Apple: 7.3%
Microsoft: 3.5%
Working Capital /Revenue
Apple: 12.9%
Microsoft: 94.1%
PPE /Revenue
Apple: 12.5%
Microsoft: 21.5%
Working Capital Turnover =
(Revenue / Invested Capital)
Apple: 88.9%
Microsoft: 63.5%
Intangibles /Revenue
Apple: 1.5%
Microsoft: 4.4%
COGS/Revenue
Apple: 60.9%
Microsoft: 38.4%
information, managers need to know the underlying factors driving differences in firm
profitability. Why is the ROIC for these two companies different?
Much like detectives, managers look for clues to solve that mystery: They break down
ROIC into its constituents (as shown in Exhibit 5.1)—return on revenue and working
capital turnover—to discover the underlying drivers of the marked difference in firm
profitability.
We start with the first component of ROIC. Return on revenue (ROR) indicates how
much of the firm’s sales is converted into profits. Apple’s ROR was 20.6 percent, while
Microsoft’s ROR was 21.5 percent. For every $100 in revenues, Apple earns $20.60 in
profit, while Microsoft earns $21.50 in profit. On this metric, Microsoft had a slight edge
over Apple. Keep in mind, however, that Apple’s 2016 revenues were $218 billion, while
Microsoft’s were $86 billion. Thus, Apple is more than 2.5 times larger than Microsoft
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in terms of annual sales. As we investigate the differences in ROIC further, we will also
discover that Microsoft has a higher cost structure than Apple, and that Apple is able to
charge a much higher margin for its products and services than Microsoft.
To explore further drivers of this difference, we break down return on revenue into three
additional financial ratios:
■ Cost of goods sold (COGS) / Revenue.
■ Research & development (R&D) expense / Revenue.
■ Selling, general, & administrative (SG&A) expense / Revenue.
The first of these three ratios, COGS / Revenue, indicates how efficiently a company
can produce a good. On this metric, Microsoft turns out to be much more efficient than
Apple, with a difference of 22.5 percentage points (see Exhibit 5.1). This is because
Microsoft’s vast majority of revenues comes from software and online cloud services, with
little cost attached to such digitally delivered products and services. In contrast, Apple’s
revenues were mostly from mobile devices, combining both hardware and software.
In particular, the iPhone made up some two-thirds (or over $145 billion) of Apple’s total
revenues in 2016.
Even though Apple is more than two times as large as Microsoft in terms of revenues,
it spends much less on research and development or on marketing and sales. Both of these
help drive down Apple’s cost structure. In particular, the next ratio, R&D / Revenue, indi-
cates how much of each dollar that the firm earns in sales is invested to conduct research
and development. A higher percentage is generally an indicator of a stronger focus on inno-
vation to improve current products and services, and to come up with new ones.
Interestingly, Apple is much less R&D intensive than Microsoft. Apple spent
4.7 percent on R&D for every dollar of revenue, while Microsoft spent almost three
times as much (14.1 percent R&D). Even considering the fact that Microsoft’s revenues
were $86 billion versus Apple’s $218 billion, Microsoft ($12 billion) spent more on
R&D in absolute dollars than Apple ($10 billion). For every $100 earned in revenues
Microsoft spent $14.10 on R&D, while Apple only spent $4.70. For more than a decade
now, Microsoft generally spends the most on R&D in absolute terms among all technol-
ogy firms.
In contrast, Apple has spent much less on research and development than other firms in
the high-tech industry, in both absolute and relative terms. Apple’s co-founder and long-
time CEO, the late Steve Jobs, defined Apple’s R&D philosophy as follows: “Innovation
has nothing to do with how many R&D dollars you have. When Apple came up with the
Mac, IBM was spending at least 100 times more on R&D. It’s not about money. It’s about
the people you have, how you’re led, and how much you get it.”9
The third ratio in breaking down return on revenue, SG&A / Revenue, indicates how
much of each dollar that the firm earns in sales is invested in sales, general, and adminis-
trative (SG&A) expenses. Generally, this ratio is an indicator of the firm’s focus on mar-
keting and sales to promote its products and services. For every $100 earned in revenues
Microsoft spent $22.60 on sales and marketing, while Apple spent $6.60.
Again, Microsoft ($19.4 billion) not only outspent Apple ($14.4 billion) in absolute
terms in marketing and sales expenses, but its SG&A intensity was more than 3.4 times
as high as Apple’s. Microsoft is spending significantly more to rebuild its brand, espe-
cially on Microsoft CEO Satya Nadella’s new strategic initiative of “mobile first, cloud
first.”10 A focus on cloud computing on mobile devices marks a significant departure from
Microsoft’s Windows-centric strategy for PCs under his predecessor, Steve Ballmer. Yet,
by 2017, the Windows and Office combination still generates about 40 percent of Micro-
soft’s total revenues and 75 percent of its profits. Microsoft is working hard to transition
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the Office business from the old business model of standalone software licenses ($150 for
Office Home & Student) to repeat business via cloud-based subscriptions such as Office
365 Home & Student (which is $70 per year).
We also note, for completeness, that Apple’s effective tax rate in 2016 was 7.3 percent
(with a net income of $45 billion), while that of Microsoft was 3.5 percent (with a net
income of $17 billion).
The second component of ROIC is Working Capital Turnover (see Exhibit 5.1), which
is a measure of how effectively capital is being used to generate revenue. In more general
terms, working capital entails the amount of money a company can deploy in the short
term, calculated as current assets minus current liabilities. This is where Apple outper-
forms Microsoft by a fairly wide margin (88.9 percent vs. 63.5 percent). For every dollar
that Apple puts to work, it realizes $89.90 of sales, while Microsoft realizes $63.50 of
sales for every dollar invested; a difference of $26.40 in sales for every dollar invested.
This implies that Apple is more than 40 percent more efficient than Microsoft in turning
invested capital into revenues.
This significant difference provides an important clue for Microsoft’s managers to dig
deeper to find the underlying drivers in working capital turnover. This enables managers
to uncover which levers to pull in order to improve firm financial performance. In a next
step, therefore, managers break down working capital turnover into other constituent finan-
cial ratios, including Working Capital / Revenue; Plant, Property, and Equipment (PPE) /
Revenue; and Intangibles / Revenue. Each of these metrics is a measure of how effective a
particular item on the balance sheet is contributing to revenue.
The working capital to revenue ratio indicates how much of its working capital the firm
has tied up in its operations. Apple (with a working capital to revenue ratio of 12.9 percent)
operates much more efficiently than Microsoft (working capital to revenue ratio of 94.1
percent), because it has much less capital tied up in its operations. One reason is that Apple
outsources its manufacturing. The vast majority of Apple’s manufacturing of its products
is done in China by low-cost producer Foxconn, which employs over 1.3 million people.
Moreover, Apple benefits from continued strong demand for its products (especially the
iPhone), as well as an effective management of its global supply chain. Rather than out-
sourcing manufacturing to Foxconn or other original equipment manufacturers (OEMs),
Microsoft owns and operates some of its manufacturing facilities. They are also located
in countries with a generally higher cost structure (e.g., Brazil and Mexico, among others)
than China.
Although Apple’s installed base of iPhone users globally is more than 530 million, one
significant area of future vulnerability for Apple is the fact that about 60 to 70 percent of
its annual revenues is based on sales of a single product—the iPhone, depending on model
year. Moreover, China accounts for more than 20 percent of Apple’s total revenues, a mar-
ket that is becoming more and more volatile for the Cupertino-based tech company. These
are pressing issues that Apple CEO Tim Cook needs to address in order to sustain Apple’s
competitive advantage.
The PPE over revenue ratio indicates how much of a firm’s revenues are dedicated to
cover plant, property, and equipment, which are critical assets to a firm’s operations but
cannot be liquidated easily. One reason Microsoft’s PPE to revenue ratio (21.5 percent)
is significant higher than that of Apple (12.5 percent) is the fact that Microsoft invests
huge amounts of money to build its cloud business, Azure. To do so, it needs to build
hundreds of data centers (large groups of networked computer servers used for the
remote storage, processing, or distribution of large amounts of data) across the globe,
a costly proposition reflected in high PPE expenditures on a much lower revenue base
than Apple. On the upside, Azure is already reporting some $10 billion in sales, second
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only to Amazon’s AWS with $12 billion in sales as the world’s largest cloud-computing
services provider.
One ratio that points toward possible stronger performance in the future is Micro-
soft’s higher Intangibles / Revenue ratio when comparing it to Apple’s (see Exhibit 5.1).
Intangible assets do not have physical attributes (see discussion of intangible resources
in Chapter 4), and include a firm’s intellectual property (such as patents, copyrights, and
trademarks), goodwill, and brand value. One way to think about this is that intangibles are
the missing piece to be added to a firm’s physical resource base (that is plant, property,
and equipment and current assets) to make up a company’s total asset base. With a higher
Intangibles / Revenue ratio (albeit from a lower revenue base), Microsoft (4.4 percent)
seems to be building a stronger intangible intensity (Intangibles / Revenue) compared with
Apple (1.5 percent), which might position Microsoft stronger for innovation in future busi-
ness areas such as cloud computing.
A second area of future growth for Microsoft is likely to be artificial intelligence
(AI). For example, algorithms combing through vast amounts of data on professionals and
their networks might be able to tell sales staff on which leads to spend most of their time.
This explains why Microsoft paid $26 billion in 2016 to acquire LinkedIn, a professional
social network with some 100 million monthly active users.
A deeper understanding of the fundamental drivers for differences in firm profitability
allows managers to develop strategic approaches. For example, CEO Satya Nadella could
rework Microsoft’s cost structure, in particular, its fairly high R&D and SG&A spending.
Perhaps, R&D dollars could be spent more effectively. Apple generates a much higher
return on its R&D spending. Microsoft’s sales and marketing expenses also seem to be
quite high, but may be needed to rebuild Microsoft’s brand image with a new focus on
mobile and cloud computing.
LIMITATIONS OF ACCOUNTING DATA. Although accounting data tend to be readily avail-
able and we can easily transform them into financial ratios to assess and evaluate competi-
tive performance, they also exhibit some important limitations:
■ All accounting data are historical and thus backward-looking. Accounting profitabil-
ity ratios show us only the outcomes from past decisions, and the past is no guarantee
of future performance. There is also a significant time delay before accounting data
become publicly available. Some strategists liken making decisions using accounting
data to driving a car by looking in the rearview mirror.11 While financial strength cer-
tainly helps, past performance is no guarantee that a company is prepared for market
disruption.
■ Accounting data do not consider off–balance sheet items. Off–balance sheet items,
such as pension obligations (quite large in some U.S. companies) or operating leases
in the retail industry, can be significant factors. For example, one retailer may own all
its stores, which would properly be included in the firm’s assets; a second retailer may
lease all its stores, which would not be listed as assets. All else being equal, the second
retailer’s return on assets (ROA) would be higher. Strategists address this shortcoming
by adjusting accounting data to obtain an equivalent economic capital base, so that
they can compare companies with different capital structures.
■ Accounting data focus mainly on tangible assets, which are no longer the most impor-
tant.12 This limitation of accounting data is nicely captured in the adage: Not everything
that can be counted counts. Not everything that counts can be counted.13 Although
accounting data capture some intangible assets, such as the value of intellectual prop-
erty (patents, trademarks, and so on) and customer goodwill, many key intangible assets
Satya Nadella, Microsoft CEO.
©Brian Smale/Microsoft/
Getty Images
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are not captured. Today, the most competitively important assets tend to be intangibles
such as innovation, quality, and customer experience, which are not included in a firm’s
balance sheets. For example, Apple’s core competency in designing beautiful and user-
friendly mobile devices embedded within a large ecosystem of various services such as
ApplePay is not a balance sheet item, but nonetheless a critical foundation in its quest
for competitive advantage.
INTANGIBLES AND THE VALUE OF FIRMS. Intangible assets that are not captured in
accounting data have become much more important in firms’ stock market valuations over
the last few decades. Exhibit 5.2 shows the firm’s book value (accounting data capturing
the firm’s actual costs of assets minus depreciation) as part of a firm’s total stock market
valuation (number of outstanding shares times share price). The firm’s book value captures
the historical cost of a firm’s assets, whereas market valuation is based on future expecta-
tions for a firm’s growth potential and performance. For the firms in the S&P 500 (the 500
largest publicly traded companies by market capitalization in the U.S. stock market, as
determined by Standard & Poor’s, a rating agency), the importance of a firm’s book value
has declined dramatically over time. This decline mirrors a commensurate increase in the
importance of intangibles that contribute to growth potential and yet are not captured in a
firm’s accounting data.
In 1980, about 80 percent of a firm’s stock market valuation was based on its book
value with 20 percent based on the market’s expectations concerning the firm’s future per-
formance. This almost reversed by 2000 (at the height of the internet bubble), when firm
valuations were based only 15 percent on assets captured by accounting data. The impor-
tant take-away is that intangibles not captured in firms’ accounting data have become
much more important to a firm’s competitive advantage. By 2015, about 75 percent
of a firm’s market valuation was determined by its intangibles. This explains why in
2017 Alphabet, Google’s parent company ($580 billion), is valued over 10 times more
than GM ($50 billion), or why Facebook
($400 billion) is valued almost four times
as much as Boeing ($110 billion).
So what have we learned about
accounting profitability? Key financial
ratios based on accounting data give us
an important tool with which to assess
competitive advantage. In particular,
they help us measure relative profit-
ability, which is useful when comparing
firms of different sizes over time. While
not perfect, these ratios are an impor-
tant starting point when analyzing the
competitive performance of firms (and
thus are a critical tool for case analysis).
Again, see the “How to Conduct a Case
Analysis” module at the end of Part 4.
We next turn to shareholder value cre-
ation as a second traditional way to mea-
sure and assess competitive advantage,
attempting to overcome the shortcom-
ings of a backward-looking internal focus
on mostly tangible assets inherent in
accounting profitability.
EXHIBIT 5.2 / The Declining Importance of Book Value in a Firm’s
Stock Market Valuation, 1980–2015
90%
80%
70%
100%
20%
80%
55%
45%
85%
15%
25%
75%
60%
50%
40%
30%
20%
10%
0%
1980 1990 2000 2015
Not Captured in Book Value Book Value
SOURCE: Analysis and depiction of data from Compustat, 1980–2015.
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SHAREHOLDER VALUE CREATION
Shareholders—individuals or organizations that own one or more shares of stock in a
public company—are the legal owners of public companies. From the shareholders’ per-
spective, the measure of competitive advantage that matters most is the return on their risk
capital,14 which is the money they provide in return for an equity share, money that they
cannot recover if the firm goes bankrupt. In September 2008, the shareholders of Lehman
Brothers, a global financial services firm, lost their entire investment of about $40 billion
when the firm declared bankruptcy.
Investors are primarily interested in a company’s total return to shareholders, which is
the return on risk capital, including stock price appreciation plus dividends received over a
specific period. Unlike accounting data, total return to shareholders is an external and forward-
looking performance metric. It essentially indicates how the stock market views all available
public information about a firm’s past, current state, and expected future performance, with
most of the weight on future growth expectations. The idea that all available information about
a firm’s past, current state, and expected future performance is embedded in the market price
of the firm’s stock is called the efficient-market hypothesis.15 In this perspective, a firm’s share
price provides an objective performance indicator. When assessing and evaluating competi-
tive advantage, a comparison of rival firms’ share price development or market capitalization
provides a helpful yardstick when used over the long term. Market capitalization (or market
cap) captures the total dollar market value of a company’s total outstanding shares at any given
point in time (Market cap = Number of outstanding shares × Share price). If a company has
50 million shares outstanding, and each share is traded at $200, the market capitalization is
$10 billion (50,000,000 × $200 = $10,000,000,000, or $10 billion).16
All public companies in the United States are required to report total return to share-
holders annually in the statements they file with the Securities and Exchange Commission
(SEC). In addition, companies must also provide benchmarks, usually one comparison to
the industry average and another to a broader market index that is relevant for more diversi-
fied firms.17 Since competitive advantage is defined in relative terms, these benchmarks
allow us to assess whether a firm has a competitive advantage. In its annual reports, Micro-
soft, for example, compares its performance to two stock indices: the NASDAQ computer
index and the S&P 500. The computer index includes over 400 high-tech companies traded
on the NASDAQ, including Apple, Adobe, Google, Intel, and Oracle. It provides a com-
parison of Microsoft to the computer industry—broadly defined. The S&P 500 offers a
comparison to the wider stock market beyond the computer industry. In its 2016 annual
report, Microsoft shows that it outperformed both the NASDAQ computer index and the
S&P 500 over the last year, while performing roughly at the same levels in previous years.
Effective strategies to grow the business can increase a firm’s profitability and thus its
stock price.18 Indeed, investors and Wall Street analysts expect continuous growth. A firm’s
stock price generally increases only if the firm’s rate of growth exceeds investors’ expecta-
tions. This is because investors discount into the present value of the firm’s stock price what-
ever growth rate they foresee in the future. If a low-growth business like Comcast (in cable
TV) is expected to grow 2 percent each year but realizes 4 percent growth, its stock price will
appreciate. In contrast, if a fast-growing business like Apple in mobile computing is expected
to grow by 10 percent annually but delivers “only” 8 percent growth, its stock price will fall.
Investors also adjust their expectations over time. Since the business in the slow-growth
industry surprised them by delivering higher than expected growth, they adjust their expec-
tations upward. The next year, they expect this firm to again deliver 4 percent growth. On
the other hand, if the industry average is 10 percent a year in the high-tech business, the
firm that delivered 8 percent growth will again be expected to deliver at least the industry
average growth rate; otherwise, its stock will be further discounted.
LO 5-2
Apply shareholder value
creation to assess and
evaluate competitive
advantage.
shareholders Individu-
als or organizations that
own one or more shares
of stock in a public
company.
risk capital The money
provided by sharehold-
ers in exchange for
an equity share in a
company; it cannot be
recovered if the firm
goes bankrupt.
total return to share-
holders Return on risk
capital that includes
stock price appreciation
plus dividends received
over a specific period.
market capitalization
A firm performance
metric that captures the
total dollar market value
of a company’s total out-
standing shares at any
given point in time.
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In ChapterCase 5, we noted that Apple was the most valuable company on the planet.
In 2017, Apple’s market cap was over $750 billion. Consistent with the notion that a firm’s
market capitalization reflects its future growth expectations, the next four largest compa-
nies are all tech companies: Alphabet ($580 billion), Microsoft ($500 billion), Amazon.
com ($430 billion), and Facebook ($400 billion).
Considering stock market valuations (Share price × Number of outstanding shares)
over the long term provides a useful metric to assess competitive advantage. Exhibit 5.3
shows the stock market valuations for Apple and Microsoft from 1990 until 2017. Micro-
soft was once the most valuable company worldwide (in December 1999 with close to
$600 billion in market cap), but its market valuation dropped in the following decade. The
valuation declined because Microsoft struggled with the transition from desktop to mobile
and cloud-based computing. CEO Satya Nadella vows to move Microsoft away from its
Windows-only business model to compete more effectively in a “mobile first, cloud first
world.”19 It appears that Nadella’s strategic initiative is bearing fruit as investors appear
to be pleased with how well Microsoft is performing in future growth areas such as cloud
computing. With its Azure offering, Microsoft holds a strong position just after Amazon’s
AWS but way ahead of Google’s cloud, the number-three contender in this space. Since a
low of about $220 billion in early 2013, Microsoft’s market cap more than doubled to over
$500 billion by 2017. Nonetheless, Microsoft remains below Apple, as Exhibit 5.3 shows
using market cap as its metric. But Microsoft is catching up—so stay tuned! This shows
again that it is difficult to gain a competitive advantage and even harder to sustain it over a
prolonged period of time. Competitive advantage is transitory!
LIMITATIONS OF SHAREHOLDER VALUE CREATION. Although measuring firm perfor-
mance through total return to shareholders and firm market capitalization has many advan-
tages, just as with accounting profitability, it has its shortcomings:
■ Stock prices can be highly volatile, making it difficult to assess firm performance,
particularly in the short term. This volatility implies that total return to shareholders
is a better measure of firm performance and competitive advantage over the long term
EXHIBIT 5.3 / Stock Market Valuations of Apple and Microsoft (in $ billion), 1990–2017
$750
M
ar
ke
t C
ap
ita
liz
at
io
n
$650
$550
$450
$350
$250
$150
$50
20152010200520001995
AppleMicrosoft
Microsoft’s
competitive
advantage
over Apple
Apple’s
competitive
advantage
over Microsoft
$752.04
$507.54
SOURCE: Depiction of publicly available data.
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(as shown in Exhibit 5.3), because of the “noise” introduced by market volatility, exter-
nal factors, and investor sentiment.
■ Overall macroeconomic factors such as economic growth or contraction, the unem-
ployment rate, and interest and exchange rates all have a direct bearing on stock
prices. It can be difficult to ascertain the extent to which a stock price is influenced
more by external macroeconomic factors (as discussed in Chapter 3) than by the firm’s
strategy (see also Exhibit 3.2 highlighting firm, industry, and other effects in overall
firm performance).
■ Stock prices frequently reflect the psychological mood of investors, which can at times
be irrational. Stock prices can overshoot expectations based on economic fundamentals
amid periods like the internet boom, during which former Federal Reserve Chairman
Alan Greenspan famously described investors’ buoyant sentiments as “irrational exu-
berance.”20 Similarly, stock prices can undershoot expectations during busts like the
2008–2009 global financial crisis, during which investors’ sentiment was described as
“irrational gloom.”21
ECONOMIC VALUE CREATION
The relationship between economic value creation and competitive advantage is funda-
mental in strategic management. It provides the foundation upon which to formulate a
firm’s competitive strategy for cost leadership or differentiation (discussed in detail in
Chapter 6). For now, it is important to note that a firm has a competitive advantage when it
creates more economic value than rival firms. What does that mean?
Economic value created is the difference between a buyer’s willingness to pay for a
product or service and the firm’s total cost to produce it. Let’s assume you consider buy-
ing a laptop computer and you have a budget of $1,200. You have narrowed your search
to two models, one offered by Firm A, the other by Firm B. Your subjective assessment
of the benefits derived from owning Firm A’s laptop is $1,000—this is the absolute maxi-
mum you’d be willing to pay for it, or the reservation price. For example, this could be
a more or less generic, run-of-the-mill Dell laptop. In contrast, you value Firm B’s laptop
model at $1,200 because it has somewhat higher performance, is more user-friendly, and
definitely has a higher “coolness factor.” Think of Apple’s MacBook Pro with Retina Dis-
play. Given that you value Firm B’s laptop by $200 more than Firm A’s model, you will
purchase a laptop from Firm B (and, in this case, end up paying as much as your reserva-
tion price allows).
Let’s move now from your individual considerations to the overall market for laptop
computers in order to derive implications for firm-level competitive advantage. To simplify
this illustration, only Firm A and Firm B are competing in the market for laptops. Assum-
ing that both Firm A and Firm B have the same total unit cost of producing the particular
laptop models under consideration ($400) and the market at large has preferences similar to
yours, then Firm B will have a competitive advantage. This is because Firm B creates more
economic value than Firm A (by $200), but has the same total cost, depicted in Exhibit 5.4.
The amount of total perceived consumer benefits equals the maximum willingness to pay,
or the reservation price. This amount is then split into economic value creation and the
firm’s total unit cost. Firm A and Firm B have identical total unit cost, $400 per laptop.
However, Firm B’s laptop (e.g., Apple’s MacBook Pro) is perceived to provide more util-
ity than Firm A’s laptop (e.g., Dell’s generic laptop), which implies that Firm B creates
more economic value ($1,200 – $400 = $800) than Firm A ($1,000 – $400 = $600). Taken
together, Firm B has a competitive advantage over Firm A because Firm B creates more
economic value. This is because Firm B’s offering has greater total perceived consumer
LO 5-3
Explain economic value
creation and different
sources of competitive
advantage.
economic value created
Difference between
value (V ) and cost (C),
or (V − C).
reservation price
The maximum price a
consumer is willing to
pay for a product or ser-
vice based on the total
perceived consumer
benefits.
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EXHIBIT 5.4 / Firm B’s Competitive Advantage: Same Cost as Firm A but Firm B Creates More Economic Value
$1,000
Economic
Value Created
$600
Total
Perceived
Consumer
Benefits
=
=
=
Maximum
Willingness
to Pay
Reservation
Price
Reservation
Price
$400
Cost
$400
Firm A
$1,200
Total
Perceived
Consumer
Benefits
$1,000
Economic
Value Created
$800
=
=
=
Maximum
Willingness
to Pay
$400
Cost
$400
$200
Firm B
Firm B
Competitive
Advantage
$1,000
$1,200
EXHIBIT 5.5 / Firm C’s Competitive Advantage: Same Total Perceived Consumer Benefits as Firm D but Firm C
Creates More Economic Value
$1,200
Economic
Value Created
$600
$600
Cost
$600
$300
Firm D
Firm C
Competitive
Advantage
$1,200$1,200
Total
Perceived
Consumer
Benefits
Economic
Value Created
$900
=
=
=
Maximum
Willingness
to Pay
Reservation
Price
$1,200
Total
Perceived
Consumer
Benefits
=
=
=
Maximum
Willingness
to Pay
Reservation
Price
$600
$300 Cost
$300
Firm C
benefits than Firm A’s, while the firms have the same total cost. In short, Firm B’s advan-
tage is based on superior differentiation leading to higher perceived value. Further, the
competitive advantage can be quantified: It is $200 (or, $1,200 – $1,000) per laptop sold for
Firm B over Firm A (see Exhibit 5.4).
Exhibit 5.4 shows that Firm B’s competitive advantage is based on greater economic
value creation because of superior product differentiation. In addition, a firm can achieve
competitive advantage through a second avenue. In particular, competitive advantage can
also result from a relative cost advantage over rivals, assuming both firms can create the
same total perceived consumer benefits.
As shown in Exhibit 5.5, two different laptop makers each offer a model that has the
same perceived consumer benefits ($1,200). Firm C, however, creates greater economic
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value ($900, or $1,200 – $300) than that of Firm D ($600, or $1,200 – $600). This is
because Firm C’s total unit cost ($300) is lower than Firm D’s ($600). Firm C has a relative
cost advantage over Firm D, while both products provide identical total perceived con-
sumer benefits ($1,200). In this example, Firm C could be Lenovo with lower cost struc-
ture than Firm D, which could be HP, but both firms offer the same value. As Exhibit 5.5
shows, Firm C has a competitive advantage over Firm D because it has lower costs. Firm
C’s competitive advantage over Firm D is in the amount of $300 for each laptop sold. Here,
the source of the competitive advantage is a relative cost advantage over its rival.
So far we have looked at situations in which products are priced at the maximum a con-
sumer might be willing to pay. But markets generally don’t work like that. More often, the
economic value created is shared among the producer and the consumer. That is, most of
the time consumers are able to purchase the product at a price point below the maximum
they are willing to spend. Both the seller and the buyer benefit.
For ease in calculating competitive advantage, three components are needed. These will
help us to further explain total perceived consumer benefits and economic value created in
more detail:
1. Value (V)
2. Price (P)
3. Cost (C)
Value denotes the dollar amount (V) a consumer attaches to a good or service. Value
captures a consumer’s willingness to pay and is determined by the perceived benefits a
good or service provides to the buyer. The cost (C) to produce the good or service matters
little to the consumer, but it matters a great deal to the producer (supplier) of the good or
service since it has a direct bearing on the profit margin.
Let’s return to our laptop example from Exhibit 5.4, in which two firms sold their lap-
tops at different prices ($1,000 for Firm A and $1,200 for Firm B), even though the costs
were the same ($400). In each case, the price matched the consumer’s maximum willing-
ness to pay for the particular offering. Subtracting the costs, we found that Firm A created
an economic value of $600 while Firm B created an economic value of $800, thus achiev-
ing a competitive advantage. In most market transactions, however, some of the economic
value created benefits the consumer as well.
Again, let’s revisit the example depicted in Exhibit 5.4. The consumer’s preference was
to buy the laptop from Firm B, which she would have done because it matched her reser-
vation price. Let’s assume Firm B’s laptop is actually on sale for $1,000 (everything else
remains constant). Assume the consumer again chose to purchase the laptop of Firm B
rather than the one offered by Firm A (which she considered inferior). In this case, some
of the economic value created by Firm B goes to the consumer. On a formula basis, total
perceived value of Firm B’s laptop ($1,200) splits into economic value created (V – C =
$800) plus total unit cost (C = $400), or: V = (V – C) + C.
The difference between the price charged (P) and the cost to produce (C) is the profit,
or producer surplus. In the laptop example in Exhibit 5.6, if the price charged is $1,000,
the profit is P − C = $1,000 − $400 = $600. The firm captures this amount as profit per
unit sold. As the consumer, you capture the difference between what you would have been
willing to pay (V) and what you paid (P), called consumer surplus. In our example, the
consumer surplus is V − P = $1,200 − $1,000, or $200. Economic value creation there-
fore equals consumer surplus plus firm profit, or (V − C) = (V − P) + (P − C). In the
laptop example:
Economic value created ($1,200 − $400) = Consumer surplus ($1,200 − $1,000) +
Producer surplus ($1,000 − $400) = $200 + $600 = $800.
value The dollar amount
(V) a consumer attaches
to a good or service; the
consumer’s maximum
willingness to pay; also
called reservation price.
profit Difference
between price charged
(P) and the cost to pro-
duce (C), or (P − C);
also called producer
surplus.
producer surplus
Another term for profit,
the difference between
price charged (P) and
the cost to produce (C),
or (P − C); also called
profit.
consumer
surplus Difference
between the value a
consumer attaches to a
good or service (V) and
what he or she paid for
it (P), or (V − P).
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The relationship between consumer and producer surplus is the reason trade happens: Both
transacting parties capture some of the overall value created. Note, though, that the distribution
of the value created between parties need not be equal to make trade worthwhile. In the exam-
ple illustrated in Exhibit 5.6, the consumer surplus is $200, while profit per unit sold is $600.
In some cases, where firms offer highly innovative products or services, the relation-
ship can be even more skewed. The entry-level model of the Apple Watch retailed for
$349, when introduced in 2015. And it sold well, selling twice as many watches as iPhones
in each device’s first year.22 An analysis by an independent engineering team, however,
revealed that the firm’s total cost in terms of materials and labor for the Apple Watch is
no more than $84.23 Thus, Apple’s profit for each watch sold is an estimated $265, with a
profit margin of 315 percent.
The economic value creation framework shows that strategy is about
1. Creating economic value.
2. Capturing as much of it as possible.
In contrast to Apple, consider Amazon as a counterexample: It is creating a large amount
of value for its customers, but it is not capturing much, if any, of it (at this point). Amazon has
had several years of negative net income as it attempts to build a stronger position in a variety
of businesses. With its online retail business, Amazon.com is creating significant value for its
customers (especially its Prime members) as well as third-party sellers that use its platform, but
Amazon is comfortable in taking minor or no profit in doing so. Its cloud-computing service,
Amazon Web Services (AWS), moreover, is also creating tremendous value for the businesses
that run their computing needs on AWS, businesses including Airbnb, Comcast, Foursquare,
NASA, and even the CIA (and formerly WikiLeaks), but Amazon’s “profit” margin is a nega-
tive 1 to 2 percent. In fact, Amazon’s comfort level appears to bear on its acquisition of Whole
Foods. Even at the high end, the grocery industry has thin margins. Before Amazon acquired
it, Whole Foods had been under stockholder pressure to increase margins by lowering costs
for better shareholder returns. Now Whole Foods under Amazon becomes the grocery indus-
try’s worst nightmare: It can deliver negative margins and still stockholders applaud. Even if
Amazon had no plans to reap synergies between in-store and online tactics, now Whole Foods
becomes supercompetitive with its potential ability to lower prices.24 Indeed, on its first day
after closing the acquisition of Whole Foods, Amazon dropped prices at its new grocery chain
by more than 30 percent on more than 100 grocery staples.
EXHIBIT 5.6 / The Role of Consumer Surplus and Producer Surplus (Profit)
$1,200Consumer Surplus
$200
Producer Surplus
or Profit
=$600
$1,000
$400
Price
=$1,000
Firm B
$1,200
$1,000
Economic
Value Created
$200 + $600
=$800
$400
Cost
=$400
Cost
=$400
Firm B
Total
Perceived
Consumer
Benefits
=
=
=
Maximum
Willingness
to Pay
Reservation
Price
$1,200
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In this case, Amazon’s customers are capturing the value that Amazon is creating. Jeff
Bezos, Amazon CEO, however, is focused on long-term performance rather than short-
term profitability. Amazon’s investors don’t seem to mind Bezos’ long-term orientation,
because Amazon’s some $430 billion in market cap makes it the fourth most valuable
company on the planet.
Exhibit 5.7 illustrates how the components of economic value creation fit together con-
ceptually. On the left side of the exhibit, V represents the total perceived consumer ben-
efits, as captured in the consumer’s maximum willingness to pay. In the lower part of the
center bar, C is the cost to produce the product or service (the unit cost). It follows that
the difference between the consumers’ maximum willingness to pay and the firm’s cost
(V − C) is the economic value created. The price of the product or service (P) is indicated
in the dashed line. The economic value created (V − C), as shown in Exhibit 5.7, is split
between producer and consumer: (V − P) is the value the consumer captures (consumer
surplus), and (P − C) is the value the producer captures (producer surplus, or profit).
Competitive advantage goes to the firm that achieves the largest economic value cre-
ated, which is the difference between V, the consumer’s willingness to pay, and C, the cost
to produce the good or service. The reason is that a large difference between V and C gives
the firm two distinct pricing options: (1) It can charge higher prices to reflect the higher
value and thus increase its profitability, or (2) it can charge the same price as competitors
and thus gain market share. Given this, the strategic objective is to maximize V − C, or the
economic value created.
Applying the notion of economic value creation also has direct implications for firm
financial performance. Revenues are a function of the value created for consumers and the
price of the good or service, which together drive the volume of goods sold. In this per-
spective, profit (Π) is defined as total revenues (TR) minus total costs (TC):
Π = TR − TC, where TR = P × Q, or price times quantity sold
Total costs include both fixed and variable costs. Fixed costs are independent of con-
sumer demand—for example, the cost of capital to build computer manufacturing plants
EXHIBIT 5.7 /
Competitive
Advantage and
Economic Value
Created: The Role of
Value, Cost, and Price
(V – P )
=
Consumer
Surplus
(P – C )
=
Firm’s
Profit=
V
=
Total
Perceived
Consumer
Benefits
Consumer’s
Maximum
Willingness
to Pay
=
Reservation
Price
P = Price
(V – C )
=
Economic
Value
Created
C
Firm’s
Cost
=
C
Firm’s
Cost
=
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or an online retail presence to take direct orders. Variable costs change with the level of
consumer demand—for instance, components such as different types of display screens,
microprocessors, hard drives, and keyboards.
Rather than merely relying on historical costs, as done when taking the perspective of
accounting profitability (introduced earlier), in the economic value creation perspective,
all costs, including opportunity costs, must be considered. Opportunity costs capture the
value of the best forgone alternative use of the resources employed.
An entrepreneur, for example, faces two types of opportunity costs: (1) forgone wages
she could be earning if she was employed elsewhere and (2) the cost of capital she invested
in her business, which could instead be invested in, say, the stock market or U.S. Trea-
sury bonds. At the end of the year, the entrepreneur considers her business over the last
12 months. She made an accounting profit of $70,000, calculated as total revenues minus
expenses, which include all historical costs but not opportunity costs. But she also real-
izes she has forgone $60,000 in salary she could have earned as an employee at another
firm. In addition, she knows she could have earned $15,000 in interest if she had bought
U.S. Treasury bills with a 2 percent return instead of investing $750,000 in her business.
The opportunity cost of being an entrepreneur was $75,000 ($60,000 + $15,000). There-
fore, when considering all costs, including opportunity costs, she actually experienced an
economic loss of $5,000 ($75,000 − $70,000). When considering her future options, she
should stay in business only if she values her independence as an entrepreneur more than
$5,000 per year, or thinks business will be better next year.
LIMITATIONS OF ECONOMIC VALUE CREATION. As with any tool to assess competitive
advantage, the economic value creation framework also has some limitations:
■ Determining the value of a good in the eyes of consumers is not a simple task.
One way to tackle this problem is to look at consumers’ purchasing habits for their
revealed preferences, which indicate how much each consumer is willing to pay
for a product or service. In the earlier example, the value (V) you placed on the
laptop—the highest price you were willing to pay, or your reservation price—was
$1,200. If the firm is able to charge the reservation price (P = $1,200), it cap-
tures all the economic value created (V – C = $800) as producer surplus or profit
(P – C = $800).
■ The value of a good in the eyes of consumers changes based on income, preferences,
time, and other factors. If your income is high, you are likely to place a higher value
on some goods (e.g., business-class air travel) and a lower value on other goods (e.g.,
Greyhound bus travel). In regard to preferences, you may place a higher value on a
ticket for a Lady Gaga concert than on one for the New York Philharmonic (or vice
versa). As an example of time value, you place a higher value on an airline ticket that
will get you to an important business meeting tomorrow than on one for a planned trip
to take place eight weeks from now.
■ To measure firm-level competitive advantage, we must estimate the economic value
created for all products and services offered by the firm. This estimation may be a
relatively easy task if the firm offers only a few products or services. However, it
becomes much more complicated for diversified firms such as General Electric or the
Tata Group that may offer hundreds or even thousands of different products and ser-
vices across many industries and geographies. Although the performance of individual
strategic business units (SBUs) can be assessed along the dimensions described here, it
becomes more difficult to make this assessment at the corporate level (more on this in
our discussion of diversification strategy in Chapter 8).
opportunity costs
The value of the best
forgone alternative
use of the resources
employed.
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The economic value creation perspective gives us one useful way to assess competi-
tive advantage. This approach is conceptually quite powerful, and it lies at the center of
many strategic management frameworks such as the generic business strategies (which we
discuss in the next chapter). However, it falls somewhat short when managers are called
upon to operationalize competitive advantage. When the need for “hard numbers” arises,
managers and analysts frequently rely on firm financials such as accounting profitability or
shareholder value creation to measure firm performance.
We’ve now completed our consideration of the three standard dimensions for measur-
ing competitive advantage—accounting profitability, shareholder value, and economic
value. Although each provides unique insights for assessing competitive advantage, one
drawback is that they are more or less one-dimensional metrics. Focusing on just one per-
formance metric when assessing competitive advantage, however, can lead to significant
problems, because each metric has its shortcomings, as listed earlier. We now turn to two
more conceptual and qualitative frameworks—the balanced scorecard and the triple bot-
tom line—that attempt to provide a more holistic perspective on firm performance.
THE BALANCED SCORECARD
Just as airplane pilots rely on a number of instruments to provide constant information
about key variables—such as altitude, airspeed, fuel, position of other aircraft in the vicin-
ity, and destination—to ensure a safe flight, so should managers rely on multiple yardsticks
to more accurately assess company performance in an integrative way. The balanced
scorecard is a framework to help managers achieve their strategic objectives more effec-
tively.25 This approach harnesses multiple internal and external performance metrics in
order to balance both financial and strategic goals.
Exhibit 5.8 depicts the balanced-scorecard framework. Managers using the balanced score-
card develop appropriate metrics to assess strategic objectives by answering four key ques-
tions.26 Brainstorming answers to these questions ideally results in measures that give managers
a quick but also comprehensive view of the firm’s current state. The four key questions are:
1. How do customers view us? The customer’s perspective concerning the company’s
products and services links directly to its revenues and profits. Consumers decide
their reservation price for a product or
service based on how they view it. If
the customer views the company’s offer-
ing favorably, she is willing to pay more
for it, enhancing its competitive advan-
tage (assuming production costs are well
below the asking price). Managers track
customer perception to identify areas to
improve, with a focus on speed, quality,
service, and cost. In the air-express indus-
try, for example, managers learned from
their customers that many don’t really
need next-day delivery for most of their
documents and packages; rather what
they really cared about was the ability to
track the shipments. This discovery led
to the development of steeply discounted
second-day delivery by UPS and FedEx,
combined with sophisticated real-time
tracking tools online.
LO 5-4
Apply a balanced
scorecard to assess and
evaluate competitive
advantage.
balanced scorecard
Strategy implementa-
tion tool that harnesses
multiple internal and
external performance
metrics in order to
balance financial and
strategic goals.
EXHIBIT 5.8 / Balanced-Scorecard Approach to Creating and
Sustaining Competitive Advantage
How do shareholders view us?
Ho
w
do
c
us
to
me
rs
vi
ew
u
s?
How do we create value?
COMPETITIVE
ADVANTAGE
W
ha
t c
or
e
co
mp
et
en
ci
es
d
o
we
n
ee
d?
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2. How do we create value? Answering this question challenges managers to develop
strategic objectives that ensure future competitiveness, innovation, and organizational
learning. The answer focuses on the business processes and structures that allow a firm
to create economic value. One useful metric is the percentage of revenues obtained
from new-product introductions. For example, 3M requires that 30 percent of revenues
must come from products introduced within the past four years.27 A second metric,
aimed at assessing a firm’s external learning and collaboration capability, is to stipu-
late that a certain percentage of new products must originate from outside the firm’s
boundaries.28 Through its Connect + Develop program, the consumer products com-
pany Procter & Gamble has raised the percentage of new products that originated (at
least partly) from outside P&G, from 15 to 35 percent.29
3. What core competencies do we need? This question focuses managers internally, to
identify the core competencies needed to achieve their objectives and the accompany-
ing business processes that support, hone, and leverage those competencies. As men-
tioned in Chapter 4, Honda’s core competency is to design and manufacture small but
powerful and highly reliable engines. Its business model is to find places to put its
engines. Beginning with motorcycles in 1948, Honda nurtured this core competency
over many decades and is leveraging it to reach stretch goals in the design, develop-
ment, and manufacture of small airplanes.
Today, consumers still value reliable, gas-powered engines made by Honda. If con-
sumers start to value electric motors more because of zero emissions, lower mainte-
nance costs, and higher performance metrics, among other possible reasons, the value
of Honda’s engine competency will decrease. If this happens, then Tesla’s core com-
petency in designing and building high-powered battery packs and electric drivetrains
will become more valuable. In turn, Tesla (featured in ChapterCase 1) might then be
able to leverage this core competency into a strong strategic position in the emerging
all-electric car and mobility industry.
4. How do shareholders view us? The final perspective in the balanced scorecard is
the shareholders’ view of financial performance (as discussed in the prior section).
Some of the measures in this area rely on accounting data such as cash flow, operat-
ing income, ROIC, ROE, and, of course, total returns to shareholders. Understand-
ing the shareholders’ view of value creation leads managers to a more future-oriented
evaluation.
By relying on both an internal and an external view of the firm, the balanced scorecard
combines the strengths provided by the individual approaches to assessing competitive
advantage discussed earlier: accounting profitability, shareholder value creation, and eco-
nomic value creation.
ADVANTAGES OF THE BALANCED SCORECARD. The balanced-scorecard approach is
popular in managerial practice because it has several advantages. In particular, the bal-
anced scorecard allows managers to:
■ Communicate and link the strategic vision to responsible parties within the organization.
■ Translate the vision into measurable operational goals.
■ Design and plan business processes.
■ Implement feedback and organizational learning to modify and adapt strategic goals
when indicated.
The balanced scorecard can accommodate both short- and long-term performance met-
rics. It provides a concise report that tracks chosen metrics and measures and compares them
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to target values. This approach allows managers to assess past performance, identify areas
for improvement, and position the company for future growth. Including a broader perspec-
tive than financials allows managers and executives a more balanced view of organizational
performance—hence its name. In a sense, the balanced scorecard is a broad diagnostic tool.
It complements the common financial metrics with operational measures on customer satis-
faction, internal processes, and the company’s innovation and improvement activities.
As an example of how to implement the balanced-scorecard approach, let’s look at FMC
Corp., a chemical manufacturer employing some 5,000 people in different SBUs and earn-
ing over $3 billion in annual revenues.30 To achieve its vision of becoming “the customer’s
most valued supplier,” FMC’s managers initially had focused solely on financial metrics
such as return on invested capital (ROIC) as performance measures. FMC is a multibusi-
ness corporation with several standalone profit-and-loss strategic business units; its overall
performance was the result of both over- and underperforming units. FMC’s managers had
tried several approaches to enhance performance, but they turned out to be ineffective. Per-
haps even more significant, short-term thinking by general managers was a major obstacle
in the attempt to implement an effective business strategy.
Searching for improved performance, FMC’s CEO decided to adopt a balanced-
scorecard approach. It enabled the managers to view FMC’s challenges and shortcomings
from a holistic, company perspective, which was especially helpful to the general manag-
ers of different business units. In particular, the balanced scorecard allowed general man-
agers to focus on market position, customer service, and product introductions that could
generate long-term value. Using the framework depicted in Exhibit 5.7, general managers
had to answer tough follow-up questions such as: How do we become the customer’s most
valued supplier, and how can my division create this value for the customer? How do we
become more externally focused? What are my division’s core competencies and contribu-
tions to the company goals? What are my division’s weaknesses?
Implementing a balanced scorecard allowed FMC’s managers to align their different
perspectives to create a more focused corporation overall. General managers now review
progress along the chosen metrics every month, and corporate executives do so on a
quarterly basis. Implementing a balanced-scorecard approach is not a onetime effort, but
requires continuous tracking of metrics and updating of strategic objectives, if needed. It
is a continuous process, feeding performance back into the strategy process to assess its
effectiveness (see Chapter 2).
DISADVANTAGES OF THE BALANCED SCORECARD. Though widely implemented by
many businesses, the balanced scorecard is not without its critics.31 It is important to note
that the balanced scorecard is a tool for strategy implementation, not for strategy formula-
tion. It is up to a firm’s managers to formulate a strategy that will enhance the chances
of gaining and sustaining a competitive advantage. In addition, the balanced-scorecard
approach provides only limited guidance about which metrics to choose. Different situ-
ations call for different metrics. All of the three approaches to measuring competitive
advantage—accounting profitability, shareholder value creation, and economic value
creation—in addition to other quantitative and qualitative measures can be helpful when
using a balanced-scorecard approach.
When implementing a balanced scorecard, managers need to be aware that a failure to
achieve competitive advantage is not so much a reflection of a poor framework but of a
strategic failure. The balanced scorecard is only as good as the skills of the managers who
use it: They first must devise a strategy that enhances the odds of achieving competitive
advantage. Second, they must accurately translate the strategy into objectives that they can
measure and manage within the balanced-scorecard approach.32
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Once the metrics have been selected, the balanced scorecard tracks chosen metrics and
measures and compares them to target values. It does not, however, provide much insight
into how metrics that deviate from the set goals can be put back on track.33
THE TRIPLE BOTTOM LINE
Today, managers are frequently asked to maintain and improve not only the firm’s eco-
nomic performance but also its social and ecological performance. CEO Indra Nooyi
responded by declaring PepsiCo’s vision to be Performance with Purpose defined by
goals in the social dimension (human sustainability to combat obesity by making its prod-
ucts healthier, and the whole person at work to achieve work/life balance) and ecological
dimension (environmental sustainability in regard to clean water, energy, recycling, and so
on), in addition to firm financial performance.
Being proactive along noneconomic dimensions can make good business sense. In
anticipation of coming industry requirements for “extended producer responsibility,”
which requires the seller of a product to take it back for recycling at the end of its life,
the German carmaker BMW was proactive. It not only lined up the leading car-recycling
companies but also started to redesign its cars using a modular approach. The modular
parts allow for quick car disassembly and reuse of components in the after-sales market
(so-called refurbished or rebuilt auto parts).34 Three dimensions—economic, social, and
ecological—make up the triple bottom line, which is fundamental to a sustainable strat-
egy. These three dimensions are also called the three Ps: profits, people, and planet:
■ Profits. The economic dimension captures the necessity of businesses to be profitable
to survive.
■ People. The social dimension emphasizes the people aspect, such as PepsiCo’s initia-
tive of the whole person at work.
■ Planet. The ecological dimension emphasizes the relationship between business and
the natural environment.
As the intersection of the three ovals (profits, people, and planet) in Exhibit 5.9 suggests,
achieving positive results in all three areas can lead to a sustainable strategy. Rather than
emphasizing sustaining a competitive advantage over time, sustainable strategy means
a strategy that can be pursued over time without detri-
mental effects on people or the planet. Using renewable
energy sources such as wind or solar power, for example,
is sustainable over time. It can also be good for profits, or
simply put “green is green,” as Jeffrey Immelt was fond
of saying before retiring in 2017 as CEO at GE. GE’s
renewable energy business brought in more than $9 bil-
lion in revenues in 2016 (up from $3 billion in 2006).35
Like the balanced scorecard, the triple bottom line
takes a more integrative and holistic view in assessing
a company’s performance.36 Using a triple-bottom-line
approach, managers audit their company’s fulfillment
of its social and ecological obligations to stakeholders
such as employees, customers, suppliers, and communi-
ties as conscientiously as they track its financial perfor-
mance.37 In this sense, the triple-bottom-line framework
is related to stakeholder theory, an approach to under-
standing a firm as embedded in a network of internal and
external constituencies that each make contributions and
LO 5-5
Apply a triple bottom line
to assess and evaluate
competitive advantage.
Planet Profits
People
SUSTAINABLE
STRATEGY
EXHIBIT 5.9 / Sustainable Strategy: A Focus on the
Triple Bottom Line
The simultaneous pursuit of performance along social, economic, and ecological
dimensions provides a basis for a triple-bottom-line strategy.
triple bottom line
Combination of eco-
nomic, social, and
ecological concerns—
or profits, people, and
planet—that can lead to
a sustainable strategy.
sustainable strategy
A strategy along the
economic, social, and
ecological dimensions
that can be pursued
over time without detri-
mental effects on people
or the planet.
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Interface: The World’s First Sustainable
Company
The Atlanta-based Interface Inc. is the world’s largest manu-
facturer of modular carpet with annual sales of roughly
$1 billion. What makes the company unique is its strategic
intent to become the world’s first fully sustainable company.
In 1994, founder Ray Anderson set a goal for the company
to be “off oil” entirely by 2020. That included not using any
petroleum-based raw materials or oil-related energy to fuel
the manufacturing plants.
According to Collins and Porras in Built to Last, their
classic study of high-performing companies over long peri-
ods of time, this is an example of a “BHAG—a big hairy auda-
cious goal.” BHAGs are bold missions declared by visionary
companies and are a “powerful mechanism to stimulate prog-
ress.”38 Weaning Interface off oil by 2020 is indeed a BHAG.
Many see the carpet industry as an extension of the petro-
chemical industry, given its heavy reliance on fossil fuels and
chemicals in the manufacturing, shipping, and installation of
its products.
Today, Interface is not only the global leader in modular
carpet but also in sustainability. It offers innovative products
such as its Cool Carpet, the world’s first carbon-neutral floor
covering. Interface’s customers reward it with a willingness
to pay a higher price for its environmentally friendly prod-
ucts. The company estimates that between 1996 and 2008,
it saved over $400 million due to its energy efficiency and
use of recycled materials.
Interface’s business model is changing the carpet indus-
try. Speaking of sustainability as a business model, Anderson
concluded:
Sustainability has given my company a competitive
edge in more ways than one. It has proven to be
the most powerful marketplace differentiator I have
known in my long career. Our costs are down, our
profits are up, and our products are the best they
have ever been. Sustainable design has provided an
unexpected wellspring of innovation, people are galva-
nized around a shared higher purpose, better people
are applying, the best people are staying and working
with a purpose, the goodwill in the marketplace gener-
ated by our focus on sustainability far exceeds that
which any amount of advertising or marketing expen-
diture could have generated—this company believes
it has found a better way to a bigger and more legiti-
mate profit—a better business model.39
Strategy Highlight 5.1
expect consideration in return (see the discussion in Chapter 2). For an example of how
Interface, a global leader in the carpet industry, uses a triple-bottom-line approach to gain
and sustain a competitive advantage, read Strategy Highlight 5.1.
5.2 Business Models: Putting Strategy into Action
Strategy is a set of goal-directed actions a firm takes to gain and sustain superior per-
formance relative to competitors or the industry average. The translation of strategy into
action takes place in the firm’s business model, which details the firm’s competitive tac-
tics and initiatives. Simply put, the firm’s business model explains how the firm intends
to make money. The business model stipulates how the firm conducts its business with its
buyers, suppliers, and partners.40
How companies do business can sometimes be as important, if not more so, to gain-
ing and sustaining competitive advantage as what they do. Indeed, a slight majority
(54 percent) of senior executives responded to a recent survey stating that they consider
business model innovation to be more important than process or product innovation.41 This
is because product and process innovation is often more costly, is higher risk, and takes
longer to come up with in the first place and to then implement. Moreover, business model
innovation is often an area that is overlooked in a firm’s quest for competitive advantage,
LO 5-6
Use the why, what, who,
and how of business
models framework to put
strategy into action.
business model Stipu-
lates how the firm con-
ducts its business with
its buyers, suppliers,
and partners in order to
make money.
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Threadless: Leveraging Crowdsourcing to
Design Cool T-Shirts
Threadless, an online design community and apparel store
(www.threadless.com), was founded in 2000 by two students
with $1,000 as start-up capital. Jake Nickell was then at the
Illinois Institute of Art and Jacob DeHart at Purdue Univer-
sity. After Nickell had won an online T-shirt design contest,
the two entrepreneurs came up with a business model to
leverage user-generated content. The idea is to let consum-
ers “work for you” and turn consumers into prosumers, a
hybrid between producers and consumers.
Members of the Threadless community, which is some
3 million strong, do most of the work, which they consider
fun: They submit T-shirt designs online, and community mem-
bers vote on which designs they like best. The designs receiv-
ing the most votes are put in production, printed, and sold
online. Each Monday, Threadless releases 10 new designs
and reprints more T-shirts throughout the week as inventory
is cleared out. The cost of Threadless T-shirts is a bit higher
than that of competitors, about $25.
Threadless leverages crowdsourcing, a process in which
a group of people voluntarily perform tasks that were tradi-
tionally completed by a firm’s employees. Rather than doing
the work in-house, Threadless outsources its T-shirt design
to its website community. The concept of leveraging a firm’s
own customers via internet-enabled technology to help pro-
duce better products is explicitly included in the Threadless
business model. In particular, Threadless is leveraging the
wisdom of the crowds, where the resulting decisions by many
participants in the online forum are often better than deci-
sions that could have been made by a single individual. To
more effectively leverage this idea, the crowds need to be
large and diverse.
At Threadless, the customers play a critical role across
the entire value chain, from idea generation to design, mar-
keting, sales forecasting, and distribution. The Threadless
business model translates real-time market research and
design contests into quick sales. Threadless produces only
T-shirts that were approved by its community. Moreover,
it has a good understanding of market demand because it
knows the number of people who participated in each design
contest. In addition, when scoring each T-shirt design in a
contest, Threadless users have the option to check “I’d buy
it.” These features give the Threadless community a voice in
T-shirt design and also coax community members into mak-
ing a purchasing commitment. Threadless does not make any
significant investments until the design and market size are
determined, minimizing its downside.
Not surprisingly, Threadless has sold every T-shirt that it
has printed. Moreover, it has a cult-like following and is outper-
forming established companies American Eagle, Old Navy, and
Urban Outfitters with their more formulaic T-shirt designs.42
Strategy Highlight 5.2
Jacob DeHart, Jake Nickell, and Jeffrey Kalmikoff created Threadless, an
online company that sells millions of dollars’ worth of T-shirts annually.
©Rene Johnston/Getty Images
and thus much value can be unlocked by focusing on business model innovation. Strategy
Highlight 5.2 takes a closer look at how the online startup Threadless uses business model
innovation to gain a competitive advantage in the highly competitive apparel industry.
Perhaps most important, a firm’s competitive advantage based on product innovation,
such as Apple’s iPhone, is less likely to be made obsolete if embedded within a business
model innovation such as Apple’s ecosystem of services that make users less likely to leave
Apple for a competing product, even if a competitor’s smartphone by itself is a better one.
Indeed, Apple counts more than 530 million iPhone users embedded within its ecosys-
tem made up of many different products and services including iTunes, iOS, App Store,
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iCloud, Apple Pay, and so on. Rather than a substitute, business model innovation com-
plements product and service innovation, and with it, raises the barriers to imitation. This
in turn allows a firm that successfully combines product and business model innovation
to extend its competitive advantage, as Apple has done for over a decade since the intro-
duction of the iPod and iTunes business model in 2001. This radical business innovation
allowed Apple to link music producers to consumers, and benefit from each transaction.
Apple extended its locus of innovation from mere product innovation to how it conducts its
business. That is, Apple provided a two-sided platform for exchange between producers and
consumers to take place (see discussion in Chapter 7 on platform strategy for more details).
THE WHY, WHAT, WHO, AND HOW OF BUSINESS MODELS
FRAMEWORK
To come up with an effective business model, a firm’s managers need to transform their
strategy of how to compete into a blueprint of actions and initiatives that support the over-
arching goals. Next, managers implement this blueprint through structures, processes,
culture, and procedures. The framework shown in Exhibit 5.10 guides managers through
the process of formulating and implementing a business model by asking the important
questions of the why, what, who, and how. We illuminate these questions by focusing on
Microsoft, also featured in ChapterCase 5.
The Microsoft example lets us see how a firm can readjust its business model respond-
ing to business challenges.
1. Why does the business model create value? Microsoft’s new “mobile first, cloud first”
business model creates value for both customers and stockholders. Customers always
have the latest software, can access it anywhere, and can collaborate online with other
EXHIBIT 5.10 /
The Why, What, Who,
and How of Business
Models Framework
SOURCE: Adapted from
R. Amit and C. Zott (2012),
“Creating value through
business model innovation,”
MIT Sloan Management
Review 53, no. 3, 41–49.
What activities need to be
performed to create and
deliver the offerings
to customers?
Why does the business
model create value?
(revenue + cost models)
What?
Why?
How are the offerings to the
customers created?
(linking of activities)
How?Who?
Who are the main
stakeholders performing
the activities?
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users. Users no longer need to upgrade software or worry about “backward compatibil-
ity,” meaning the ability to read old (Word) files with new (Word) software. Microsoft
enjoys steady revenue that over time provides greater fees than the earlier “perpetual
license” model, significantly reduces the problem of software piracy, and balances the
cost of ongoing support with the ongoing flow of revenues.
2. What activities need to be performed to create and deliver the offerings to customers?
To pivot to the new “mobile first, cloud first” business model, Microsoft is making
huge investments to create and deliver new offerings to its customers. The Redmond,
Washington-based company needed to rewrite much of its software to be functional in
a cloud-based environment. CEO Satya Nadella also decided to open the Office suite
of applications to competing operating systems including Google’s Android, Apple’s
iOS, and Linux, an open-source operating system. In all these activities, Microsoft’s
Azure, its cloud-computing service, plays a pivotal role in its new business model.
3. How are the offerings to the customers created? Microsoft shifted most of its resources,
including R&D and customer support, to its cloud-based offerings to not only make
them best in class, but also to provide a superior user experience.
4. Who are the main stakeholders performing the activities? Microsoft continues to focus
on both the individual end consumer as well as on more profitable business clients.
Microsoft’s Azure is particularly attractive to its business customers. For example,
Walmart, still the largest retailer globally with some 12,000 stores staffed by over
2 million employees and revenues of some $500 billion, runs its cutting-edge IT logis-
tics on Microsoft’s Azure servers, rather than Amazon’s AWS service, a major compet-
itor to Walmart. Likewise, The Home Depot, one of the largest retailers in the United
States, also uses Microsoft Azure for its computing needs.
To appreciate the value of this change in business model, we should consider for a
moment the problems the change allows Microsoft to address.
■ Before, with the perpetual license model, Microsoft had revenue spikes on the sale but
zero revenues thereafter to support users and produce necessary updates. Now, Micro-
soft matches revenues to its costs and even comes out further ahead, in that after two
years or so, Microsoft makes more money off a software subscription than a standalone
software license.
■ Before, customers had a financial disincentive to keep their software current. Now,
users always have the latest software, can access it anywhere, and can collaborate
online with other users without worries about backward compatibility.
■ Perhaps most impressively, the new model deals effectively with software piracy. Before,
Microsoft suffered tremendous losses through software piracy. This affects consumers
too, as the cost of piracy is borne by legal consumers to a large degree. Now, pirating
cloud-based software is much more difficult, because Microsoft can easily monitor how
many users (based on unique internet protocol [IP] addresses) are using the same log-in
information at different locations and perhaps even at the same time. Once the provider
suspects piracy, it tends to disable the accounts as this goes against the terms of service
agreed upon when purchasing the software, not to mention that copyright infringements
are illegal. Indeed, the scope of the piracy problem is driven home by the survey-based
claim that some 60 percent of computer users confess to pirating software.43
POPULAR BUSINESS MODELS
Given their critical importance to achieving competitive advantage, business models are
constantly evolving. Below we will discuss some of the more popular business models:44
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■ Razor–razor-blades
■ Subscription
■ Pay-as-you-go
■ Freemium
■ Wholesale
■ Agency
■ Bundling
Understanding the more popular business models today will increase the tools in your
strategy toolkit.
■ Razor–razor-blades. The initial product is often sold at a loss or given away for free to
drive demand for complementary goods. The company makes its money on the replace-
ment part needed. As you might guess, it was invented by Gillette, which gave away its
razors and sold the replacement cartridges for relatively high prices. The razor–razor-
blade model is found in many business applications today. For example, HP charges little
for its laser printers but imposes high prices for its replacement toner cartridges.
■ Subscription. The subscription model has been traditionally used for print magazines
and newspapers. Users pay for access to a product or service whether they use the
product or service during the payment term or not. Microsoft uses a subscription-based
model for its new Office 365 suite of application software. Other industries that use
this model presently are cable television, cellular service providers, satellite radio,
internet service providers, and health clubs. Netflix also uses a subscription model.
■ Pay-as-you-go. In the pay-as-you-go business model, users pay for only the services
they consume. The pay-as-you-go model is most widely used by utilities providing
power and water and cell phone service plans, but it is gaining momentum in other
areas such as rental cars and cloud computing such as Microsoft’s Azure. News provid-
ers such as The New York Times and The Wall Street Journal have created “pay walls”
as a pay-as-you-go option.
■ Freemium. The freemium (free + premium) business model provides the basic features
of a product or service free of charge, but charges the user for premium services such
as advanced features or add-ons.45 For example, companies may provide a minimally
supported version of their software as a trial (e.g., business application or video game)
to give users the chance to try the product. Users later have the option of purchasing a
supported version of software, which includes a full set of product features and product
support. An ultra low-cost business model is quite similar to freemium: a model in
which basic service is provided at a low cost and extra items are sold at a premium. The
business pursuing this model has the goal of driving down costs. Examples include
Spirit Airlines (in the United States), Ryanair (in Europe), or AirAsia, which provide
minimal flight services but allow customers to pay for additional services and upgrades
à la carte, often at a premium.
■ Wholesale. The traditional model in retail is called a wholesale model. Let’s look at
the book publishing industry as an example. Under the wholesale model, book publish-
ers would sell books to retailers at a fixed price (usually 50 percent below the recom-
mended retail price). Retailers, however, were free to set their own price on any book
and profit from the difference between their selling price and the cost to buy the book
from the publisher (or wholesaler).
■ Agency. In this model the producer relies on an agent or retailer to sell the product,
at a predetermined percentage commission. Sometimes the producer will also control
the retail price. The agency model was long used in the entertainment industry, where
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agents place artists or artistic properties and then take their commission. More recently
we see this approach at work in a number of online sales venues, as in Apple’s pricing
of book products or its app sales. (See further discussion following.)
■ Bundling. The bundling business model sells products or services for which demand is
negatively correlated at a discount. Demand for two products is negatively correlated
if a user values one product more than another. In the Microsoft Office Suite, a user
might value Word more than Excel and vice versa. Instead of selling both products for
$120 each, Microsoft bundles them in a suite and sells them combined at a discount,
say $150. This bundling strategy allowed Microsoft to become the number-one pro-
vider of all major application software packages such as word processing, spreadsheets,
slide show presentation, and so on. Before its bundling strategy, Microsoft faced strong
competition in each segment. Indeed, Word Perfect was outselling Word, Lotus 1-2-3
was outselling Excel, and Harvard Graphics was outselling PowerPoint. The problem
for Microsoft’s competitors was that they did not control the operating system (Win-
dows), which made their programs less seamless on this operating system. In addition,
the competitor products to Microsoft were offered by three independent companies, so
they lacked the option to bundle them at a discount.
DYNAMIC NATURE OF BUSINESS MODELS
Business models evolve dynamically, and we can see many combinations and permutations.
Sometimes business models are tweaked to respond to disruptions in the market, efforts
that can conflict with fair trade practices and may even prompt government intervention.
COMBINATION. Telecommunications companies such as AT&T or Verizon, to take one
industry, combine the razor–razor-blade model with the subscription model. They fre-
quently provide a basic cell phone at no charge, or significantly subsidize a high-end
smartphone, when you sign up for a two-year wireless service plan. Telecom providers
recoup the subsidy provided for the smartphone by requiring customers to sign up for
lengthy service plans. This is why it is so critical for telecom providers to keep their churn
rate—the proportion of subscribers that leave, especially before the end of the contractual
term—as low as possible.
EVOLUTION. The freemium business model can be seen as an evolutionary variation on the
razor–razor-blade model. The base product is provided free, and the producer finds other
ways to monetize the usage. The freemium model is used extensively by open-source soft-
ware companies (e.g., Red Hat), mobile app companies, and other internet businesses. Many
of the free versions of applications include advertisements to make up for the cost of sup-
porting nonpaying users. In addition, the paying premium users subsidize the free users.
The freemium model is often used to build a consumer base when the marginal cost of add-
ing another user is low or even zero (such as in software sales). Many online video games,
including massive multiplayer online games and app-based mobile games, follow a variation
of this model, allowing basic access to the game for free, but charging for power-ups, cus-
tomizations, special objects, and similar things that enhance the game experience for users.
DISRUPTION. When introducing the agency model, we mentioned Apple and book pub-
lishing, and you may already know how severely Amazon disrupted the traditional whole-
sale model for publishers. Amazon took advantage of the pricing flexibility inherent in the
wholesale model and offered many books (especially e-books) below the cost that other
retailers had to pay to publishers. In particular, Amazon would offer newly released best-
sellers, such as Dan Brown’s novels, for $9.99 to promote its Kindle e-reader. Publishers
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and other retailers strongly objected because Amazon’s retail price was lower than the
wholesale price paid by retailers competing with Amazon. Moreover, the $9.99 e-book
offer by Amazon made it untenable for other retailers to continue to charge $28.95 for
newly released hardcover books (for which they had to pay $14 to $15 to the publish-
ers). With its aggressive pricing, Amazon not only devalued the printed book, but also
lost money on every book it sold. It did this to increase the number of users of its Kindle
e-readers and tablets.
RESPONSE TO DISRUPTION. The market is dynamic, and in the above example, book
publishers looked for another model. Many book publishers worked with Apple on an
agency approach, in which the publishers would set the price for Apple and receive 70
percent of the revenue, while Apple received 30 percent. The approach is similar to the
Apple App Store pricing model for iOS applications in which developers set a price for
applications and Apple retains a percentage of the revenue.
Use of the agency model was intended to give publishers the leverage to raise e-book
prices for retailers. Under the agency model, publishers could increase their e-book profits
and price e-books more closely to prices of printed books. Publishers inked their deals
with Apple, but how could they get Amazon to play ball? For leverage, publishers withheld
new releases from Amazon. This forced Amazon to raise prices on newly released e-books
in line with the agency model to around $14.95.
LEGAL CONFLICTS. The rapid development of business models, especially in response
to disruption, can lead producers to breach existing rules of commerce. In the above
example, the publishers’ response prompted an antitrust investigation. In 2012 the Depart-
ment of Justice determined that Apple and major publishers had conspired to raise prices
of e-books. To settle the legal action, each publisher involved negotiated new deals with
retailers, including Amazon. A year later, Apple was found guilty of colluding with several
major book publishers to fix prices on e-books and had to change its agency model.46
5.3 Implications for Strategic Leaders
In this chapter, we discussed how to measure and assess competitive advantage using three
traditional approaches: accounting profitability, shareholder value creation, and economic
value creation. We then introduced two conceptual frameworks to help us understand com-
petitive advantage in a more holistic fashion: the balanced scorecard and the triple bottom
line. Exhibit 5.11 summarizes the concepts discussed.
Competitive advantage is reflected in superior firm performance.
• We always assess competitive advantage relative to a benchmark, either using competitors or the industry average.
• Competitive advantage is a multifaceted concept.
• We can assess competitive advantage by measuring accounting profit, shareholder value, or economic value.
• The balanced-scorecard approach harnesses multiple internal and external performance dimensions to balance a firm’s
financial and strategic goals.
• More recently, competitive advantage has been linked to a firm’s triple bottom line, the ability to maintain performance in the
economic, social, and ecological contexts (profits, people, planet) to achieve a sustainable strategy.
EXHIBIT 5.11 / How to Measure and Assess Competitive Advantage
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Several managerial implications emerged from our discussion of competitive advantage
and firm performance:
■ No best strategy exists—only better ones (better in comparison with others). We must
interpret any performance metric relative to those of competitors and the industry aver-
age. True performance can be judged only in comparison to other contenders in the
field or the industry average, not on an absolute basis.
■ The goal of strategic management is to integrate and align each business function and
activity to obtain superior performance at the business unit and corporate levels. There-
fore, competitive advantage is best measured by criteria that reflect overall business
unit performance rather than the performance of specific departments. For example,
although the functional managers in the marketing department may (and should) care
greatly about the success or failure of their recent ad campaign, the general manager
cares most about the performance implications of the ad campaign at the business-unit
level for which she has profit-and-loss responsibility. Metrics that aggregate upward
and reflect overall firm and corporate performance are most useful to assess the effec-
tiveness of a firm’s competitive strategy.
■ Both quantitative and qualitative performance dimensions matter in judging the
effectiveness of a firm’s strategy. Those who focus on only one metric will risk being
blindsided by poor performance on another. Rather, managers need to rely on a more
holistic perspective when assessing firm performance, measuring different dimensions
over different time periods.
■ A firm’s business model is critical to achieving a competitive advantage. How a firm
does business is as important as what it does.
This concludes our discussion of competitive advantage, firm performance, and busi-
ness models, and completes Part 1—strategy analysis—of the AFI framework. In Part 2,
we turn our attention to the next steps in the AFI framework—strategy formulation. In
Chapters 6 and 7, we focus on business strategy: How should the firm compete (cost lead-
ership, differentiation, or value innovation)? In Chapters 8 and 9, we study corporate strat-
egy: Where should the firm compete (industry, markets, and geography)? Chapter 10 looks
at global strategy: How and where (local, regional, national, and international) should the
firm compete around the world?
GIVEN MICROSOFT’S LACKLUSTER performance since 2000,
the once dominant company is now in turnaround mode.
Over time, its competitive advantage turned into a competi-
tive disadvantage, lagging behind Apple by a wide margin.
Satya Nadella’s strategic focus is to move Microsoft away
from its Windows-only business model to compete more
effectively in a “mobile first, cloud first world,” the mantra
he used in his appointment e-mail as CEO. Under his lead-
ership, Microsoft made the Office Suite available on Apple
iOS and Android mobile devices. Office 365, its cloud-based
CHAPTERCASE 5 Consider This . . .
software offering, is now avail-
able as a subscription service
starting at $6.99 per month
for personal use and $69.99
for business use. Software
applications can be accessed
on any device, any time, with
online storage, combined with
Skype’s global calling feature.
Yet, Nadella needs to work
Satya Nadella, Microsoft
CEO.
©Brian Smale/Microsoft/
Getty Images
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CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 173
hard to ensure Microsoft’s future viability because Win-
dows and Office were cash cows for so long. They are still
generating 40 percent of revenues and some 75 percent of
profits, but both continue to decline. The problem he faces
is that the gross margin of “classic” PC-based Office is
90 percent (due to Microsoft’s “monopoly” position), while
the gross margin for Office 365 is only around 50 per-
cent. The cloud computing space with Amazon, Alphabet
(Google), Apple, IBM, and others is fiercely competitive.47
Questions
1. Why is it so hard to gain a competitive advantage? Why
is it even harder to sustain a competitive advantage?
2. Looking at the different ways to assess competitive
advantage discussed in this chapter, does Microsoft
have a competitive advantage over Apple using any of
the approaches? Why or why not? In which approach is
Microsoft looking “the best”? Explain.
3. Microsoft CEO Satya Nadella has made drastic changes
to Microsoft’s strategy. What was Microsoft’s strategy
before Nadella was appointed CEO in 2014? What is it
now under his leadership? Do you agree that Nadella
has formulated a promising business model? Why or
why not?
4. How much longer do you think Apple can sustain its
competitive advantage (not just over Microsoft, but in
general)? Explain.
NOTE: A financial ratio review related to this ChapterCase is avail-
able in Connect.
This chapter demonstrated three traditional approaches
for assessing and measuring firm performance and
competitive advantage, as well as two conceptual
frameworks designed to provide a more holistic, albeit
more qualitative, perspective on firm performance.
We also discussed the role of business models in
translating a firm’s strategy into actions.
LO 5-1 / Conduct a firm profitability analysis
using accounting data to assess and evaluate
competitive advantage.
■ To measure competitive advantage, we must be
able to (1) accurately assess firm performance,
and (2) compare and benchmark the focal firm’s
performance to other competitors in the same
industry or the industry average.
■ To measure accounting profitability, we use
standard metrics derived from publicly available
accounting data.
■ Commonly used profitability metrics in strategic
management are return on assets (ROA), return
on equity (ROE), return on invested capital
(ROIC), and return on revenue (ROR). See the
key financial ratios in five tables in the “How to
Conduct a Case Analysis” guide.
■ All accounting data are historical and thus
backward-looking. They focus mainly on tangible
assets and do not consider intangibles that are
hard or impossible to measure and quantify, such
as an innovation competency.
LO 5-2 / Apply shareholder value creation
to assess and evaluate competitive advantage.
■ Investors are primarily interested in total return to
shareholders, which includes stock price apprecia-
tion plus dividends received over a specific period.
■ Total return to shareholders is an external perfor-
mance metric; it indicates how the market views all
publicly available information about a firm’s past,
current state, and expected future performance.
■ Applying a shareholders’ perspective, key met-
rics to measure and assess competitive advan-
tage are the return on (risk) capital and market
capitalization.
■ Stock prices can be highly volatile, which makes
it difficult to assess firm performance. Overall
macroeconomic factors have a direct bearing on
stock prices. Also, stock prices frequently reflect
the psychological mood of the investors, which
can at times be irrational.
TAKE-AWAY CONCEPTS
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174 CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models
■ Shareholder value creation is a better measure of
competitive advantage over the long term due to
the “noise” introduced by market volatility, exter-
nal factors, and investor sentiment.
LO 5-3 / Explain economic value creation
and different sources of competitive advantage.
■ The relationship between economic value creation
and competitive advantage is fundamental in
strategic management. It provides the foundation
upon which to formulate a firm’s competitive
strategy of cost leadership or differentiation.
■ Three components are critical to evaluating any
good or service: value (V), price (P), and cost (C).
In this perspective, cost includes opportunity costs.
■ Economic value created is the difference between
a buyer’s willingness to pay for a good or service
and the firm’s cost to produce it (V − C).
■ A firm has a competitive advantage when it is able
to create more economic value than its rivals. The
source of competitive advantage can stem from
higher perceived value creation (assuming equal
cost) or lower cost (assuming equal value creation).
LO 5-4 / Apply a balanced scorecard
to assess and evaluate competitive advantage.
■ The balanced-scorecard approach attempts to
provide a more integrative view of competitive
advantage.
■ Its goal is to harness multiple internal and exter-
nal performance dimensions to balance financial
and strategic goals.
■ Managers develop strategic objectives for the bal-
anced scorecard by answering four key questions:
(1) How do customers view us? (2) How do we
create value? (3) What core competencies do we
need? (4) How do shareholders view us?
LO 5-5 / Apply a triple bottom line to assess
and evaluate competitive advantage.
■ Noneconomic factors can have a significant
impact on a firm’s financial performance,
not to mention its reputation and customer
goodwill.
■ Managers are frequently asked to maintain
and improve not only the firm’s economic
performance but also its social and ecological
performance.
■ Three dimensions—economic, social, and ecologi-
cal, also known as profits, people, and planet—
make up the triple bottom line. Achieving positive
results in all three areas can lead to a sustainable
strategy—a strategy that can endure over time.
■ A sustainable strategy produces not only positive
financial results, but also positive results along
the social and ecological dimensions.
■ Using a triple-bottom-line approach, managers
audit their company’s fulfillment of its social and
ecological obligations to stakeholders such as
employees, customers, suppliers, and communi-
ties in as serious a way as they track its financial
performance.
■ The triple-bottom-line framework is related to
stakeholder theory, an approach to understanding
a firm as embedded in a network of internal and
external constituencies that each make contribu-
tions and expect consideration in return.
LO 5-6 / Use the why, what, who, and how
of business models framework to put strategy
into action.
■ The translation of a firm’s strategy (where and
how to compete for competitive advantage) into
action takes place in the firm’s business model
(how to make money).
■ A business model details how the firm con-
ducts its business with its buyers, suppliers, and
partners.
■ How companies do business is as important to
gaining and sustaining competitive advantage as
what they do.
■ The why, what, who, and how framework guides
managers through the process of formulating and
implementing a business model.
Balanced scorecard (p. 161)
Business model (p. 165)
Consumer surplus (p. 157)
Economic value created (p. 155)
Market capitalization (p. 153)
Opportunity costs (p. 160)
KEY TERMS
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CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 175
Producer surplus (p. 157)
Profit (p. 157)
Reservation price (p. 155)
Risk capital (p. 153)
Shareholders (p. 153)
Sustainable strategy (p. 164)
Total return to shareholders (p. 153)
Triple bottom line (p. 164)
Value (p. 157)
DISCUSSION QUESTIONS
1. Domino’s Pizza has been in business more than
50 years and claims to be “#1 Worldwide in Pizza
Delivery” with over 13,000 locations. Visit the
company’s business-related website (www.biz.
dominos.com) and read the “our strengths” sec-
tion under the “Investors/Profile” tab. Does the
firm focus on the accounting, shareholder, or eco-
nomic perspective in describing its competitive
advantage?
2. For many people, the shareholder perspective is
perhaps the most familiar measure of competitive
advantage for publicly traded firms. What are
some of the disadvantages of using shareholder
value as the sole point of view for defining com-
petitive advantage?
3. Interface, Inc., is discussed in Strategy Highlight
5.1. It may seem unusual for a business-to-business
carpet company to be using a triple-bottom-line
approach for its strategy. What other industries
do you think could productively use this approach?
How would it change customers’ perceptions if
it did?
ETHICAL/SOCIAL ISSUES
1. You work as a supervisor in a manufacturing
firm. The company has implemented a balanced-
scorecard performance-appraisal system and a
financial bonus for exceeding goals. A major
customer order for 1,000 units needs to ship to a
destination across the country by the end of the
quarter, which is two days away from its close.
This shipment, if it goes well, will have a major
impact on both your customer-satisfaction goals
and your financial goals.
With 990 units built, a machine breaks. It
will take two days to get the parts and repair the
machine. You realize there is an opportunity to
load the finished units on a truck tomorrow with
paperwork for the completed order of 1,000 units.
You can have an employee fly out with the 10
remaining parts and meet the truck at the destina-
tion city once the machinery has been repaired.
The 10 units can be added to the pallet and deliv-
ered as a complete shipment of 1,000 pieces,
matching the customer’s order and your paper-
work. What do you do?
2. How do the perspectives on competitive advan-
tage differ when comparing brick-and-mortar
stores to online businesses (e.g., Best Buy ver-
sus Amazon, Barnes & Noble versus Amazon,
Old Navy versus Threadless [noted in Strategy
Highlight 5.2], Nordstrom versus Zappos, and so
on)? Make recommendations to brick-and-mortar
stores as to how they can compete more effec-
tively with online firms. What conclusions do you
draw?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
As discussed in the chapter, a balanced scorecard
views the performance of an organization through four
lenses: customer, innovation and learning, internal
business, and financial. According to surveys from
consulting firm Bain & Co., about 60 percent of firms
in both public and private sectors have used a bal-
anced scorecard for performance measures.48
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176 CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models
With your group, create a balanced scorecard for
the business school at your university. You might start
by looking at your school’s web page for a mission or
vision statement. Then divide up the four perspectives
among the team members to develop key elements for
each one. It may be helpful to remember the four key
balanced-scorecard questions from the chapter:
1. How do customers view us? (Hint: First discuss
the following: Who are the customers? The stu-
dents? The companies that hire students? Others?)
2. How do we create value?
3. What core competencies do we need?
4. How do shareholders view us? (For public uni-
versities, the shareholders are the taxpayers who
invest their taxes in the university. For private uni-
versities, the shareholders are the people or orga-
nizations that endow the university.)
1. For an in-depth discussion of Apple,
see: Rothaermel, F.T., (2017), “Apple Inc.,”
Case MHE-FTR-051-1259927628,
http://create.mheducation.com/; “Microsoft
at middle age: Opening Windows,” The
Economist, April 4, 2015; “What Satya
Nadella did at Microsoft,” The Economist,
March 16, 2017; and Mochhizuki, T.
(2017, Feb. 28), “Apple’s next iPhone
will have a curved screen,” The Wall
Street Journal.
2. This debate takes place in the following
discourses, among others: Misangyi, V.F., H.
Elms, T. Greckhamer, and J.A. Lepine (2006),
“A new perspective on a fundamental debate:
A multilevel approach to industry, corporate,
and business unit effects,” Strategic Manage-
ment Journal 27: 571–590; McNamara, G., F.
Aime, and P. Vaaler (2005), “Is performance
driven by industry- or firm-specific factors?
A reply to Hawawini, Subramanian, and
Verdin,” Strategic Management Journal 26:
1075–1081; Hawawini, G., V. Subramanian,
and P. Verdin (2005), “Is performance
driven by industry- or firm-specific factors?
A new look at the evidence: A response to
McNamara, Aime, and Vaaler,” Strategic
Management Journal 26: 1083–1086; Rumelt,
R.P. (2003), “What in the world is competitive
advantage?” Policy Working Paper 2003-105;
McGahan, A.M., and M.E. Porter (2002),
“What do we know about variance in account-
ing profitability?” Management Science 48:
ENDNOTES
//// Small Group Exercise 2
At the next big family gathering, you want to impress
your grandparents with the innovative ideas you have
learned in business school. They have decades of expe-
rience in investing in the stock market and, from their
college days, believe that economic profitability is a busi-
ness’s primary responsibility. You would like to convince
them that a triple-bottom-line approach is the modern
path to stronger economic performance. With your group
members, prepare a casual yet informative pitch you can
use to persuade them. They probably will not listen for
more than two minutes, so you know you have to be clear
and concise with interesting examples. You may want
to reinforce your argument by consulting “The Bottom
Line of Corporate Good,” published in Forbes.49 Present
your speech in whatever way your instructor requests—
to your group, to the entire class, or in an online video.
How Much Is an MBA Worth to You?
T he myStrategy box at the end of Chapter 1 asked how much you would be willing to pay for the job you want—for a job that reflects your values. Here, we look at a dif-
ferent issue relating to worth: How much is an MBA worth over
the course of your career?
Alongside the traditional two-year full-time MBA program,
many business schools also offer evening MBAs and executive
MBAs. Let’s assume you know you want to pursue an advanced
degree, and you need to decide which program format is better
for you (or you want to evaluate the choice you already made).
You’ve narrowed your options to either (1) a two-year full-time
MBA program, or (2) an executive MBA program at the same
institution that is 18 months long with classes every other week-
end. Let’s also assume the price for tuition, books, and fees is
$30,000 for the full-time program and $90,000 for the execu-
tive MBA program.
Which MBA program should you choose? Consider in your
analysis the value, price, and cost concepts discussed in this
chapter. Pay special attention to opportunity costs attached to
different MBA program options.
mySTRATEGY
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CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 177
834–851; Hawawini, G., V. Subramanian,
and P. Verdin (2003), “Is performance driven
by industry- or firm-specific factors? A new
look at the evidence,” Strategic Management
Journal 24: 1–16; McGahan, A.M., and M.E.
Porter (1997), “How much does industry mat-
ter, really?” Strategic Management Journal
18: 15–30; Rumelt, R.P. (1991), “How much
does industry matter?” Strategic Management
Journal 12: 167–185; Porter, M.E. (1985),
Competitive Advantage: Creating and Sustain-
ing Superior Performance (New York: Free
Press); and Schmalensee, R. (1985), “Do
markets differ much?” American Economic
Review 75: 341–351;
3. Rumelt, R.P. (2003), “What in the world
is competitive advantage?” Policy Working
Paper 2003-105.
4. For discussion see: McGahan, A.M., and
M. E. Porter (2002), “What do we know about
variance in accounting profitability?” Man-
agement Science, 48: 834–851.
5. (Net profits / Invested capital) is short-
hand for (Net operating profit after taxes
[NOPAT]/Total stockholders’ equity + Total
debt – Value of preferred stock). See dis-
cussion of profitability ratios in Table 1,
“When and How to Use Financial Measures
to Assess Firm Performance,” of the “How to
Conduct a Case Analysis” the guide to con-
ducting a case analysis that concludes Part 4
of the text.
6. The data for this section are drawn from
Apple and Microsoft annual reports (various
years) and a number of news articles, includ-
ing: Dou, E. (2017, Feb. 1), “Cheaper rivals
eat away at Apple sales in China,” The Wall
Street Journal; “What Satya Nadella did at
Microsoft,” The Economist, March 16, 2016;
and “iPhone, therefore I am,” The Economist,
January 30, 2016.
7. This example is based on the 2016 SEC
10-K reports for Apple and Microsoft. Con-
nect provides the financial analysis conducted
here as an exercise for a five-year time period,
2012–2016. This allows for more dynamic
considerations.
8. The complete equation for Return on
Invested Capital (ROIC) is: ROIC = (Net
Profit / Revenue) × (Revenue / Invested
Capital) = [1- ((COGS / Revenue) + (R&D /
Revenue) + (S&GA / Revenue) + (Tax / Rev-
enue))] * [1 / ((Working Capital / Revenue)
+ (PPE / Revenue) + (Intangible Assets /
Revenue) + (Long-term Marketable Securities
/ Revenue) + (Goodwill / Revenue) + (Other
Assets / Revenue))]. The calculation of work-
ing capital turnover also demands “Long-term
Assets / Revenue,” “Goodwill / Revenue,”
and “Other Assets / Revenue.” This chart
does not provide these values because they
are not closely related to firm competitive
advantage. They are included, however, in the
Teacher’s Resource Manual.
9. “The second coming of Apple through
a magical fusion of man—Steve Jobs—and
company, Apple is becoming itself again:
The little anticompany that could,” Fortune,
November 9, 1998.
10. “Satya Nadella: Mobile first, cloud first
press briefing,” Microsoft press release,
March 27, 2014.
11. Prahalad, C.K., and G. Hamel (1990),
“The core competence of the corporation,”
Harvard Business Review, May–June.
12. Baruch, L. (2001), Intangibles: Man-
agement, Measurement, and Reporting
( Washington, DC: Brookings Institution Press).
13. Cameron, W.B. (1967), Informal Sociol-
ogy: A Casual Introduction to Sociological
Thinking (New York: Random House).
14. Friedman, M. (2002), Capitalism and
Freedom, 40th anniversary edition (Chicago,
IL: University of Chicago Press).
15. Beechy, M., D. Gruen, and J. Vickrey
(2000), “The efficient market hypothesis: A
survey,” Research Discussion Paper, Federal
Reserve Bank of Australia; and Fama, E.
(1970), “Efficient capital markets: A review
of theory and empirical work,” Journal of
Finance 25: 383–417.
16. The three broad categories of companies
by market cap are large cap (over $10 billion),
mid cap ($2 billion to $10 billion), and small
cap (less than $2 billion).
17. Alexander, J. (2007), Performance
Dashboards and Analysis for Value Creation
(Hoboken, NJ: Wiley-Interscience).
18. This section draws on: Christensen, C.M.,
and M.E. Raynor (2003), The Innovator’s
Solution: Creating and Sustaining Success-
ful Growth (Boston, MA: Harvard Business
School Press).
19. “Satya Nadella: Mobile first, cloud first
press briefing,” Microsoft press release,
March 27, 2014.
20. Speech given by Alan Greenspan on
December 5, 1996, at the American Enterprise
Institute.
21. “Irrational gloom,” The Economist,
October 11, 2002.
22. Wakabayashi D. (2016, Apr. 24), “Apple’s
watch outpaced the iPhone in first year,” The
Wall Street Journal.
23. Olivarez-Giles, N., “What makes the
Apple Watch tick,” The Wall Street Journal,
April 30, 2015.
24. “Microsoft at middle age: Opening Win-
dows,” The Economist, April 4, 2015; and
Amazon.com, various annual reports. For
Amazon’s acquisition of Whole Foods, see
Stevens, L., and A. Gasparro (2017, June 16),
“Amazon to buy Whole Foods for $13.7 bil-
lion: Whole Foods would continue to operate
stores under its brand,” The Wall Street Jour-
nal, https://www.wsj.com/articles/amazon-to-
buy-whole-foods-for-13-7-billion-1497618446.
For industry response, see La Monica, P.R.,
and C. Isidore (2017, June 16), “Grocery
stocks are getting clobbered after Amazon-
Whole Foods deal,” CNN Money, http://
money.cnn.com/2017/06/16/investing/amazon-
buying-whole-foods/index.html.
25. Kaplan, R.S., and D.P. Norton (1992),
“The balanced scorecard: Measures that drive
performance,” Harvard Business Review,
January–February: 71–79.
26. Kaplan, R.S., and D.P. Norton (1992),
“The balanced scorecard: Measures that drive
performance,” Harvard Business Review,
January–February: 71–79.
27. Govindarajan, V., and J.B. Lang (2002),
3M Corporation, case study, Tuck School of
Business at Dartmouth.
28. Rothaermel, F.T., and A.M. Hess (2010),
“Innovation strategies combined,” MIT Sloan
Management Review, Spring: 12–15.
29. Huston, L., and N. Sakkab (2006), “Con-
nect & Develop: Inside Procter & Gamble’s
new model for innovation,” Harvard Business
Review, March: 58–66.
30. Kaplan, R.S. (1993), “Implementing the
balanced scorecard at FMC Corporation:
An interview with Larry D. Brady,” Har-
vard Business Review, September–October:
143–147.
31. Norreklit, H. (2000), “The balance on
the balanced scorecard—A critical analysis
of some of its assumptions,” Management
Accounting Research 11: 65–88; Jensen, M.C.
(2002), “Value maximization, stakeholder
theory, and the corporate objective func-
tion,” in Unfolding Stakeholder Thinking, ed.
J. Andriof, et al. (Sheffield, UK: Greenleaf
Publishing).
32. Kaplan, R.S., and D.P. Norton (2007),
“Using the balanced scorecard as a strategic
management system,” Harvard Business
Review, July–August; and Kaplan, R.S., and
D.P. Norton (1992), “The balanced scorecard:
Measures that drive performance,” Harvard
Business Review, January–February: 71–79.
33. Lawrie, G., and I. Cobbold (2002),
“Development of the 3rd generation bal-
anced scorecard: Evolution of the balanced
scorecard into an effective strategic perfor-
mance management tool,” 2GC Working
Paper (Berkshire, UK: 2GC Limited).
34. Senge, P.M., B. Bryan Smith, N.
Kruschwitz, J. Laur, and S. Schley (2010), The
Necessary Revolution: How Individuals and
Organizations Are Working Together to Create
a Sustainable World (New York: Crown).
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178 CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models
35. GE 2016 Annual Report, http://www.
ge.com/ar2016; Gryta T., J. Lubin, and D.
Benoit (2017, June 12), “Jeff Immelt to step
down as CEO of GE; John Flannery tales
role,” The Wall Street Journal.
36. Anderson, R.C. (2009), Confessions
of a Radical Industrialist: Profits, People,
Purpose—Doing Business by Respecting the
Earth (New York: St. Martin’s Press).
37. Norman, W., and C. MacDonald (2004),
“Getting to the bottom of ‘triple bottom line,’”
Business Ethics Quarterly 14: 243–262.
38. Collins, J.C., and J.I. Porras (1994), Built
to Last: Successful Habits of Visionary Com-
panies (New York: HarperBusiness), 93.
39. Anderson, R.C. (2009), Confessions
of a Radical Industrialist: Profits, People,
Purpose—Doing Business by Respecting
the Earth (New York: St. Martin’s Press),
5; TED talk, “Ray Anderson on the busi-
ness logic of sustainability,” www.ted.com;
and Perkins, J. (2009), Hoodwinked: An
Economic Hit Man Reveals Why the World
Financial Markets Imploded—and What We
Need to Do to Remake Them (New York:
Crown Business), 107.
40. This discussion is based on: Adner, R.
(2012), The Wide Lens. A New Strategy for
Innovation (New York: Portfolio/Penguin);
and Amit, R., and C. Zott (2012), “Creat-
ing value through business model innova-
tion,” MIT Sloan Management Review,
Spring: 41–49; see also Gassmann, O., K.
Frankenberger, and M. Csik (2015), The Busi-
ness Model Navigator: 55 Models That Will
Revolutionise Your Business (Harlow, UK:
FT Press).
41. Amit, R., and C. Zott (2012), “Creating
value through business model innovation,” MIT
Sloan Management Review, Spring: 41–49.
42. Nickell, J. (2010), Threadless: Ten Years
of T-shirts from the World’s Most Inspir-
ing Online Design Community (New York:
Abrams); Howe, J. (2008), Crowdsourcing:
Why the Power of the Crowd Is Driving the
Future of Business (New York: Crown Busi-
ness); and Surowiecki, J. (2004), The Wisdom
of Crowds (New York: Anchor Books).
43. Fitzgerald, B. (2012, June 1), “Software
piracy: Study claims 57 percent of the world
pirates software,” The Huffington Post.
44. For a fully dedicated and more in-depth
treatment of business models, see Gassmann,
O., K. Frankenberger, and M. Csik (2015),
The Business Model Navigator: 55 Mod-
els That Will Revolutionise Your Business
(Harlow, UK: FT Press).
45. Anderson, C. (2009), Free: The Future of
a Radical Price (New York: Hyperion).
46. Bray, C., J. Palazzolo, and I. Sherr (2013,
Jul. 13), “U.S. judge rules Apple colluded on
e-books,” The Wall Street Journal.
47. “Microsoft at middle age: Opening Win-
dows,” The Economist, April 4, 2015; “What
Satya Nadella did at Microsoft,” The Econo-
mist, March 16, 2017.
48. See: www.thepalladiumgroup.com for exam.
49. Scott, Ryan (2012, Sept. 14), “The bot-
tom line of corporate good,” Forbes; www.
forbes.com/sites/causeintegration/2012/09/14/
the-bottom-line-of-corporate-good/.
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PART
Formulation
CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans
CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms
CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
CHAPTER 10 Global Strategy: Competing Around the World
2
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The AFI Strategy Framework
Part 1: Analysis
Part 1: Analysis
Part 2: Formulation
1. What Is Strategy?
3. External Analysis: Industry Structure,
Competitive Forces, and Strategic
Groups
4. Internal Analysis: Resources,
Capabilities, and Core Competencies
5. Competitive Advantage, Firm
Performance, and Business Models
6. Business Strategy: Differentiation, Cost
Leadership, and Blue Oceans
7. Business Strategy: Innovation,
Entrepreneurship, and Platforms
8. Corporate Strategy: Vertical
Integration and Diversification
9. Corporate Strategy: Strategic Alliances,
Mergers and Acquisitions
10. Global Strategy: Competing Around
the World
11. Organizational Design: Structure,
Culture, and Control
Getting
Started
External and
Internal
Analysis
Formulation:
Business
Strategy
Formulation:
Corporate
Strategy
Implementation
Gaining &
Sustaining
Competitive
Advantage
12. Corporate Governance and Business
Ethics
2. Strategic Leadership: Managing
the Strategy Process
Part 3: Implementation
Part 2: Formulation
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CHAPTER Business Strategy:
Differentiation, Cost
Leadership, and Blue
Oceans
Chapter Outline
6.1 Business-Level Strategy: How to Compete for
Advantage
Strategic Position
Generic Business Strategies
6.2 Differentiation Strategy: Understanding Value
Drivers
Product Features
Customer Service
Complements
6.3 Cost-Leadership Strategy: Understanding Cost
Drivers
Cost of Input Factors
Economies of Scale
Learning Curve
Experience Curve
6.4 Business-Level Strategy and the Five Forces:
Benefits and Risks
Differentiation Strategy: Benefits and Risks
Cost-Leadership Strategy: Benefits and Risks
6.5 Blue Ocean Strategy: Combining Differentiation
and Cost Leadership
Value Innovation
Blue Ocean Strategy Gone Bad: “Stuck in the Middle”
6.6 Implications for Strategic Leaders
Learning Objectives
LO 6-1 Define business-level strategy and describe
how it determines a firm’s strategic position.
LO 6-2 Examine the relationship between value
drivers and differentiation strategy.
LO 6-3 Examine the relationship between cost driv-
ers and cost-leadership strategy.
LO 6-4 Assess the benefits and risks of differentia-
tion and cost-leadership strategies vis-à-vis
the five forces that shape competition.
LO 6-5 Evaluate value and cost drivers that may
allow a firm to pursue a blue ocean strategy.
LO 6-6 Assess the risks of a blue ocean strategy,
and explain why it is difficult to succeed at
value innovation.
6
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JetBlue Airways: Finding a New
Blue Ocean?
WHEN JETBLUE AIRWAYS took to the skies, founder David
Neeleman set out to pursue a blue ocean strategy. This
type of competitive strategy combines differentiation and
cost-leadership activities using value innovation to recon-
cile the inherent trade-offs in those two distinct strategic
positions. How is this done, and where did Neeleman’s
ideas come from?
At the age of 25,
the young entrepreneur
co-founded Morris Air,
a charter air service
that in 1993 was pur-
chased by Southwest
Airlines (SWA). Mor-
ris Air was a low-fare
airline that pioneered
many cost-saving prac-
tices that later became
standard in the indus-
try, such as e-ticketing.
After working as an
airline executive for
SWA, Neeleman went
on to launch JetBlue in
2000. When Neeleman
established JetBlue, his
strategy was to provide
air travel at even lower costs than SWA. At the same time, he
wanted to offer better service and more amenities than the
legacy carriers such as American, Delta, or United. To sum it
up, JetBlue’s Customer Bill of Rights declares its dedication to
bringing humanity back to air travel.
To implement a blue ocean strategy, JetBlue focused
on lowering operating costs while driving up perceived
customer value in its service offerings. In particular,
JetBlue copied and improved upon many of SWA’s cost-
reducing activities. It initially used just one type of air-
plane (the Airbus A-320) to lower the costs of aircraft
maintenance and pilot and crew training. It also chose to
fly point to point, directly connecting highly trafficked
city pairs. JetBlue specialized in transcontinental flights
connecting the East Coast (e.g., from its home base in New
York) to the West Coast (e.g., Los Angeles). In contrast,
legacy airlines such as American, Delta, or United use a
hub-and-spoke system. This type of operating model con-
nects many different locations via layovers at airport hubs.
The point-to-point model focuses on directly connecting
fewer but more highly trafficked city pairs. This model
lowers costs by not offering baggage transfers and sched-
ule coordination with other airlines. In addition, JetBlue
flies longer distances and transports more passengers per
flight than SWA, further driving down its costs. Initially,
JetBlue enjoyed the lowest cost per available seat-mile (an
important performance
metric in the airline
industry) in the United
States.
At the same time,
JetBlue also enhanced
its differential appeal by
driving up its perceived
value. Its mantra was to
combine high-touch—
to enhance the customer
experience—and high-
tech—to drive down
costs. Because roughly
one-third of custom-
ers prefer speaking
to a live reservation
agent, despite a highly
functional website for
reservations and other
travel-related services, JetBlue decided to use work-from-
home employees in the United States instead of follow-
ing industry best practice by outsourcing its reservation
system. Some of JetBlue’s other value-enhancing features
include high-end 100-seat Embraer regional jets with
leather seats, free movie and television programming via
DirecTV, XM Satellite Radio, along with friendly and
attentive on-board service. Other amenities include its
recently added Mint class, which is a luxury version of
first-class travel. The Mint service features small private
suites with a lie-flat bed up to 6 feet 8 inches long, a high-
resolution personal screen, and free in-flight high-speed
Wi-Fi (“Fly-Fi”). It also features other amenities such as
personal check-in and early boarding, free bag checking
CHAPTERCASE 6
JetBlue offers its Mint luxury experience, which includes a lie-flat bed up to
6 feet 8 inches long, a high-resolution personal screen, and free in-flight high-
speed Wi-Fi, on many domestic U.S. routes. Other U.S. competitors offer such
amenities only on very few routes.
©Carlos Yudica/123RF
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and priority bag retrieval after flight, and complimentary
gourmet food and alcoholic beverages in flight.
For JetBlue, pursuing a blue ocean strategy by combin-
ing a cost-leadership position with a differentiation strat-
egy resulted in a competitive advantage in its early years.
Although the idea of combining different business strat-
egies seems appealing, it is quite difficult to execute a
cost-leadership and differentiation position at the same time.
This is because cost leadership and differentiation are distinct
strategic positions. Pursuing them simultaneously results
in trade-offs that work against each other. For instance,
higher perceived customer value (e.g., providing leather
seats throughout the entire aircraft and free Wi-Fi) comes
with higher costs. These trade-offs caught up with JetBlue.
Between 2007 and 2015, the airline upstart faced severe tur-
bulence after several high-profile mishaps (e.g., passengers
stranded on the tarmac for hours after a snowstorm, emer-
gency landings, erratic pilot and crew behaviors). These
public relations disasters compounded the fundamental dif-
ficulty of resolving the need to limit costs while providing
superior customer service and in-flight amenities.
This fundamental conflict was not apparent at first. In
its early days, JetBlue could use value innovation to drive
up perceived customer value even while lowering operat-
ing costs. The approach can work when an airline is small
and connecting a few highly profitable city routes. But as
the airline grew, its blue ocean strategy started to fray. As
a consequence of such factors, JetBlue experienced a sus-
tained competitive disadvantage for a number of years. The
airline removed founder Neeleman as CEO in 2007. He left
to found Azul, a Brazilian airline, in 2008. (In 2017 Azul
was a publicly listed company on both the NYSE and the
Sao Paulo exchanges with positive results; Azul is currently
the third-largest airline in Brazil.)
Meanwhile, unable to overcome challenges in its profit
and market share, the JetBlue board of directors in 2015
accepted the resignation of then CEO David Barger and
appointed Robin Hayes to replace him. Formerly with British
Airways for almost 20 years, Hayes wasted no time in sharp-
ening JetBlue’s strategic profile, doubling down on its blue
ocean strategy as he attempted to lower operating costs while
increasing perceived value creation. To drive down costs, he
decided to add more seats to each plane, reducing legroom in
coach (now on par with the legacy carriers). Other areas of
cost savings included mainly aircraft maintenance and crew
scheduling. At the same time, Hayes also expanded the Mint
class offerings to many more flights, providing a product
that customers love and that some other airlines lack.
JetBlue is also considering adding a new airplane (Air-
bus A-321) to its fleet, which scores significantly higher
in customer satisfaction surveys than the older A-320.
Although JetBlue already flies internationally by serving
destinations in Central and South America as well as the
Caribbean, Hayes is considering adding selected flights to
Europe in the future. Flying non-stop to cities in Europe is
now possible with new Airbus A-321. Flying longer, non-
stop routes drives down costs. International routes, more-
over, tend to be much more profitable than domestic routes
because of less competition, for the time being.
JetBlue is now the sixth-largest airline in the United
States, right after the “big four” (Delta, SWA, American,
and United) and Alaska Airlines, which beat out JetBlue in
acquiring Virgin America in 2016. Noteworthy is also that
the “big four” airlines control more than 80 percent of the
U.S. domestic market, so the industry is fairly concentrated.1
You will learn more about JetBlue by reading this chapter; related
questions appear in “ChapterCase 6 / Consider This . . . .”
THE CHAPTERCASE illustrates how JetBlue ran into trouble by pursuing two dif-
ferent business strategies at the same time—a cost-leadership strategy, focused on
low cost, and a differentiation strategy, focused on delivering unique features and service.
Although the idea of combining different business strategies seems appealing, it is quite
difficult to execute a cost-leadership and differentiation position at the same time. This is
because cost leadership and differentiation are distinct strategic positions. Pursuing them
simultaneously results in trade-offs that work against each other. For instance, higher per-
ceived customer value (e.g., providing leather seats throughout the entire aircraft and free
Wi-Fi) comes with higher costs.
Many firms that attempt to combine cost-leadership and differentiation strategies end up
being stuck in the middle. In this situation, strategic leaders have failed to carve out a clear
strategic position. In their attempt to be everything to everybody, these firms end up being
neither a low-cost leader nor a differentiator (thus the phrase stuck in the middle between
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the two distinct strategic positions). This common strategic failure contributed to JetBlue’s
sustained competitive disadvantage during the 2007 to 2015 time period. Strategic leaders
need to be aware to not end up being stuck in the middle between distinct business strategies.
A clear strategic position—either as differentiator or low-cost leader—is more likely to form
the basis for competitive advantage. Although quite attractive at first glance, a blue ocean
strategy is difficult to implement because of the trade-offs between the two distinct strategic
positions (low-cost leadership and differentiation), unless the firm is successful in value
innovation that allows a reconciliation of these inherent trade-offs (discussed in detail later).
This chapter, the first in Part 2 on strategy formulation, takes a close look at busi-
ness-level strategy, frequently also referred to as competitive strategy. It deals with how
to compete for advantage. Based on the analysis of the external and internal environments
(presented in Part 1), the second step in the AFI Strategy Framework is to formulate a busi-
ness strategy that enhances the firm’s chances of achieving a competitive advantage.
We begin our discussion of strategy formulation by defining business-level strategy,
strategic position, and generic business strategies. We then look at two key generic busi-
ness strategies: differentiation and cost leadership. We pay special attention to value and
cost drivers that managers can use to carve out a clear strategic profile. Next, we relate the
two business-level strategies to the external environment, in particular, to the five forces,
to highlight their respective benefits and risks. We then introduce the notion of blue ocean
strategy—using value innovation to combine a differentiation and cost-leadership strategic
position. We also look at changes in competitive positioning over time before concluding
with practical Implications for Strategic Leaders.
6.1 Business-Level Strategy: How to Compete
for Advantage
Business-level strategy details the goal-directed actions managers take in their quest for
competitive advantage when competing in a single product market.2 It may involve a single
product or a group of similar products that use the same distribution channel. It concerns
the broad question, “How should we compete?” To formulate an appropriate business-level
strategy, managers must answer the who, what, why, and how questions of competition:
■ Who—which customer segments will we serve?
■ What customer needs, wishes, and desires will we satisfy?
■ Why do we want to satisfy them?
■ How will we satisfy our customers’ needs?3
To formulate an effective business strategy, managers need to keep in mind that compet-
itive advantage is determined jointly by industry and firm effects. As shown in Exhibit 6.1,
one route to competitive advantage is shaped by industry effects, while a second route is
determined by firm effects. As discussed in Chapter 3, an industry’s profit potential can be
assessed using the five forces framework plus the availability of complements. Managers
need to be certain that the business strategy is aligned with the five forces that shape com-
petition. They can evaluate performance differences among clusters of firms in the same
industry by conducting a strategic-group analysis. The concepts introduced in Chapter 4
are key in understanding firm effects because they allow us to look inside firms and explain
why they differ based on their resources, capabilities, and competencies. It is also impor-
tant to note that industry and firm effects are not independent, but rather they are interde-
pendent, as shown by the two-pointed arrow connecting industry effects and firm effects
in Exhibit 6.1. At the firm level, performance is determined by value and cost positions
relative to competitors. This is the firm’s strategic position, to which we turn next.
LO 6-1
Define business-level
strategy and describe
how it determines a firm’s
strategic position.
business-level
strategy The goal-
directed actions
managers take in their
quest for competitive
advantage when
competing in a single
product market.
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STRATEGIC POSITION
We noted in Chapter 5 that competitive advantage is based on the difference between the
perceived value a firm is able to create for consumers (V), captured by how much con-
sumers are willing to pay for a product or service, and the total cost (C) the firm incurs to
create that value. The greater the economic value created (V − C), the greater is a firm’s
potential for competitive advantage. To answer the business-level strategy question of how
to compete, managers have two primary competitive levers at their disposal: value (V) and
cost (C).
A firm’s business-level strategy determines its strategic position—its strategic profile
based on value creation and cost—in a specific product market. A firm attempts to stake
out a valuable and unique position that meets customer needs while simultaneously creat-
ing as large a gap as possible between the value the firm’s product creates and the cost
required to produce it. Higher value creation tends to require higher cost. To achieve a
desired strategic position, managers must make strategic trade-offs—choices between a
cost or value position. Managers must address the tension between value creation and the
pressure to keep cost in check so as not to erode the firm’s economic value creation and
profit margin. As shown in the ChapterCase, JetBlue experienced a competitive disad-
vantage for a number of years because it was unable to effectively address the strategic
trade-offs inherent in pursuing a cost-leadership and differentiation strategy at the same
time. A business strategy is more likely to lead to a competitive advantage if a firm has a
clear strategic profile, either as differentiator or a low-cost leader. A blue ocean strategy is
only successful, in contrast, if the firm can implement some type of value innovation that
reconciles the inherent trade-off between value creation and underlying costs.
GENERIC BUSINESS STRATEGIES
There are two fundamentally different generic business strategies—differentiation and cost
leadership. A differentiation strategy seeks to create higher value for customers than the
value that competitors create, by delivering products or services with unique features while
EXHIBIT 6.1 / Industry and Firm Effects Jointly Determine Competitive Advantage
COMPETITIVE
ADVANTAGE
BUSINESS
STRATEGY
• Cost Leadership
• Differentiation
• Blue OceanCOST POSITION
Relative to
Competitors
VALUE POSITION
Relative to
Competitors
WITHIN INDUSTRY
• Strategic Groups
INDUSTRY
ATTRACTIVENESS
• 5 Forces Model
• Complements
INDUSTRY
EFFECTS
FIRM
EFFECTS
strategic trade-
offs Choices between
a cost or value position.
Such choices are
necessary because
higher value creation
tends to generate higher
cost.
differentiation
strategy Generic
business strategy that
seeks to create higher
value for customers
than the value that
competitors create,
while containing costs.
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keeping costs at the same or similar levels, allowing the firm to charge higher prices to
its customers. A cost-leadership strategy, in contrast, seeks to create the same or similar
value for customers by delivering products or services at a lower cost than competitors,
enabling the firm to offer lower prices to its customers.
These two business strategies are called generic strategies because they can be used by
any organization—manufacturing or service, large or small, for-profit or nonprofit, public
or private, domestic or foreign—in the quest for competitive advantage, independent of
industry context. Differentiation and cost leadership require distinct strategic positions,
and in turn increase a firm’s chances to gain and sustain a competitive advantage.4 Because
value creation and cost tend to be positively correlated, however, important trade-offs exist
between value creation and low cost. A business strategy, therefore, is more likely to lead
to a competitive advantage if it allows firms to either perform similar activities differently
or perform different activities than their rivals that result in creating more value or offering
similar products or services at lower cost.5
When considering different business strategies, managers also must define the scope
of competition—whether to pursue a specific, narrow part of the market or go after the
broader market.6 The automobile industry provides an example of the scope of competi-
tion. Alfred P. Sloan, longtime president and CEO of GM, defined the carmaker’s mission
as providing a car for every purse and purpose. GM was one of the first to implement
a multidivisional structure in order to separate the brands into strategic business units,
allowing each brand to create its unique strategic position (with its own profit and loss
responsibility) within the broad automotive market. For example, GM’s product lineup
ranges from the low-cost-positioned Chevy brand to the differentiated Cadillac brand.
In this case, Chevy is pursuing a broad cost-leadership strategy, while Cadillac is pursu-
ing a broad differentiation strategy. The two different business strategies are integrated
at the corporate level at GM (more on corporate strategy in Chapters 8 and 9). On the
other hand, Tesla, the maker of all-electric cars (featured in ChapterCase 1), offers a
highly differentiated product and pursues only a small market segment. At this point,
it uses a focused differentiation strategy. In
particular, Tesla focuses on environmentally
conscious consumers who are willing to pay a
premium price. Going forward, Tesla is hop-
ing to broaden its competitive scope with its
new Model 3, priced at roughly half of the
existing models (Model S sedan and Model X
sport utility crossover). Taken together, GM’s
competitive scope is broad—with a focus on
the mass automotive market—while Tesla’s
competitive scope is narrow—with a focus on
all-electric luxury cars.
Now we can combine the dimensions
describing a firm’s strategic position (differ-
entiation versus cost) with the scope of com-
petition (narrow versus broad). As shown in
Exhibit 6.2, by doing so we get the two major
broad business strategies (cost leadership
and differentiation), shown as the top two
boxes in the matrix, and the focused version
of each, shown as the bottom two boxes in
the matrix. The focused versions of the two
cost-leadership
strategy Generic
business strategy that
seeks to create the
same or similar value
for customers at a lower
cost.
scope of competition
The size—narrow or
broad—of the market in
which a firm chooses to
compete.
SOURCE: Adapted from M.E. Porter (1980), Competitive Strategy. Techniques for Analyzing
Industries and Competitors (New York: Free Press).
Cost
Leadership Differentiation
Focused
Differentiation
Focused Cost
Leadership
Cost
Na
rr
ow
Br
oa
d
Differentiation
STRATEGIC POSITION
CO
M
PE
TI
TI
VE
S
CO
PE
EXHIBIT 6.2 / Strategic Position and Competitive Scope:
Generic Business Strategies
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business strategies—focused cost-leadership strategy and focused differentiation
strategy—are essentially the same as the broad generic strategies except that the com-
petitive scope is narrower. For example, the manufacturing company BIC pursues a
focused cost-leadership strategy, designing and producing disposable pens and ciga-
rette lighters at a low cost, while Mont Blanc pursues a focused differentiation strategy,
offering exquisite pens—what it calls “writing instruments”—frequently priced at sev-
eral hundred dollars.
As discussed in ChapterCase 6, JetBlue attempts to combine a focused cost-leadership
position with a focused differentiation position. Although initially successful, JetBlue has
been consistently outperformed for several years by airlines that do not attempt to straddle
different strategic positions, but rather have a clear strategic profile as either a differentia-
tor or a low-cost leader. For example, Southwest Airlines competes clearly as a broad cost
leader (and would be placed squarely in the upper-left quadrant of Exhibit 6.2). The legacy
carriers—Delta, American, and United—all compete as broad differentiators (and would
be placed in the upper-right quadrant of Exhibit 6.2). Regionally, we find smaller airlines
that are ultra low cost, such as Allegiant Air, Frontier Airlines, or Spirit Airlines, with a
very clear strategic position. These smaller airlines would be placed in the lower-left quad-
rant of Exhibit 6.2 because they are pursuing a focused cost-leadership strategy. Based on
a clear strategic position, these airlines have outperformed JetBlue over many years. The
reason is that JetBlue appears to be stuck between different strategic positions, trying to
combine a focused cost-leadership position with focused differentiation. As JetBlue grew,
the problems inherent in an attempt to straddle different strategic positions grew more
severe because JetBlue now attempts to also straddle the (broad) cost-leadership position
with the (broad) differentiation position, thus trying to be everything to everybody. Being
stuck in the middle of different strategic positions is a recipe for inferior performance and
competitive disadvantage—and this is exactly what JetBlue has experienced between 2007
and 2015. Over the past few years, JetBlue has performed roughly on par with the industry
average, as determined by the Dow Jones Airlines Index, including the big four airlines
(American, Delta, SWA, and United) as well as smaller airlines such as Alaska Airlines,
Allegiant Air, and Spirit. Part of JetBlue’s ability to close its performance gap is the highly
successful rollout of the Mint experience, which offers first-class travel at a discount.
Indeed, on routes where JetBlue offers its Mint experience (such as flying coast to coast),
the legacy airlines have dropped their first-class prices significantly to be competitive with
JetBlue. Many customers, however, feel that the Mint travel experience is superior to first-
class travel on traditional airlines.7
6.2 Differentiation Strategy:
Understanding Value Drivers
The goal of a differentiation strategy is to add unique features that will increase the
perceived value of goods and services in the minds of consumers so they are willing to
pay a higher price. Ideally, a firm following a differentiation strategy aims to achieve
in the minds of consumers a level of value creation that its competitors cannot easily
match. The focus of competition in a differentiation strategy tends to be on unique prod-
uct features, service, and new-product launches, or on marketing and promotion rather
than price.
Several competitors in the bottled-water industry provide a prime example of pursuing
a successful differentiation strategy.8 As more and more consumers shift from carbon-
ated soft drinks to healthier choices, the industry for bottled water is booming—growing
LO 6-2
Examine the relationship
between value drivers and
differentiation strategy.
focused cost-
leadership strategy
Same as the cost-
leadership strategy
except with a narrow
focus on a niche market.
focused differentiation
strategy Same as the
differentiation strategy
except with a narrow
focus on a niche market.
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about 10 percent per year. In the United States, the
per person consumption of bottled water surpassed
that of carbonated soft drinks for the first time
in 2016. Such a fast-growing industry provides
ample opportunity for differentiation. In particu-
lar, the industry is split into two broad segments
depending on the sales price. Bottled water with a
sticker price of $1.30 or less per 32 ounces (close
to one liter) is considered low-end, while those
with a higher price tag are seen as luxury items.
For example, PepsiCo’s Aquafina and Coca-
Cola’s Dasani are considered low-end products,
selling purified tap water at low prices, often in
bulk at big-box retailers such as Walmart. On the
premium end, PepsiCo introduced Lifewtr with a
splashy ad during Super Bowl LI in 2017, while
Jennifer Aniston markets Smartwater, Coca-Cola’s
premium water.
The idea of selling premium water is not new, however. Evian (owned by Danone, a
French consumer products company) and Pellegrino (owned by Nestlé of Switzerland)
have long focused on differentiating their products by emphasizing the uniqueness of their
respective natural sources (Evian hails from the French Alps while Pellegrino comes from
San Pellegrino Terme in Italy’s Lombardy region). Recent entrants into the luxury seg-
ment for bottled water have taken the differentiation of their products to new heights. Some
purveyors, such as Svalbardi, are able to charge super premium prices. At upscale retailer
Harrods in London, a bottle of Svalbardi costs about $100 for 25 ounces; the water, sold
in a heavy glass bottle, hails from Norwegian icebergs some 4,000 years old. Ordering
premium bottled water in the United States to accompany lunch has become a status sym-
bol. Indeed, many restaurants now feature water lists besides the more traditional wine
selection. “Energy waters” enhanced with minerals and vitamins are the fastest-growing
segment. Although flavored waters make up less than 5 percent of the overall market for
bottled water, they rack up 15 percent of total revenues. And this is nothing to be snuffed
at: The market for bottled water globally reached some $150 billion, and continues to grow
fast. Although a free substitute can be had from most taps in industrialized countries, the
success of many luxury brands in the bottled-water industry shows the power of differen-
tiation strategy.
A company that uses a differentiation strategy can achieve a competitive advantage as
long as its economic value created (V − C) is greater than that of its competitors. Firm A
in Exhibit 6.3 produces a generic commodity. Firm B and Firm C represent two efforts at
differentiation. Firm B not only offers greater value than Firm A, but also maintains cost
parity, meaning it has the same costs as Firm A. However, even if a firm fails to achieve
cost parity (which is often the case because higher value creation tends to go along with
higher costs in terms of higher-quality raw materials, research and development, employee
training to provide superior customer service, and so on), it can still gain a competitive
advantage if its economic value creation exceeds that of its competitors. Firm C represents
just such a competitive advantage. For the approach shown either in Firm B or Firm C,
economic value creation, (V − C)B or (V − C)C, is greater than that of Firm A (V − C)A.
Either Firm B or C, therefore, achieves a competitive advantage because it has a higher
value gap over Firm A [(V − C)B > (V − C)A, or (V − C)C > (V − C)A], which allows it
to charge a premium price, reflecting its higher value creation. To complete the relative
©anythings/Shutterstock
.com RF
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comparison, although both companies pursue a differentiation strategy, Firm B also has
a competitive advantage over Firm C because although both offer identical value, Firm B
has lower cost, thus (V − C)B > (V − C)C.
Although increased value creation is a defining feature of a differentiation strategy,
managers must also control costs. Rising costs reduce economic value created and erode
profit margins. Indeed, if cost rises too much as the firm attempts to create more perceived
value for customers, its value gap shrinks, negating any differentiation advantage. One
reason JetBlue could not maintain an initial competitive advantage was because it was
unable to keep its costs down sufficiently. JetBlue’s new management team immediately
put measures in place to lower the airline’s cost structure such as charging fees for checked
bags and reducing leg space to increase passenger capacity on each of its planes. These
cost-saving initiatives should increase its economic value creation.
Although a differentiation strategy is generally associated with premium pricing, man-
agers have an important second pricing option. When a firm is able to offer a differentiated
product or service and can control its costs at the same time, it is able to gain market share
from other firms in the industry by charging a similar price but offering more perceived
value. By leveraging its differentiated appeal of superior customer service and quality,
for example, Marriott offers a line of different hotels: its flagship Marriott full-service
business hotel equipped to host large conferences; Residence Inn for extended stay; Mar-
riott Courtyard for business travelers; and Marriott Fairfield Inn for inexpensive leisure
and family travel.9 Although these hotels are roughly comparable to competitors in price,
they generally offer a higher perceived value. With this line of different hotels, Marriott
can benefit from economies of scale and scope, and thus keep its cost structure in check.
Economies of scale denote decreases in cost per unit as output increases (more in the next
section when we discuss cost-leadership strategy). Economies of scope describe the sav-
ings that come from producing two (or more) outputs at less cost than producing each
output individually, even though using the same resources and technology. This larger dif-
ference between cost and value allows Marriott to achieve greater economic value than its
competitors, and thus to gain market share and post superior performance.
economies of
scope Savings that
come from producing
two (or more) outputs at
less cost than producing
each output individually,
despite using the
same resources and
technology.
Firm A
Disadvantage
Va
lu
e
C B
(V–C )A
(V–C )B
(V–C )C
C A
C C
Co
st
Firm B:
Differentiator
Firm C:
Differentiator
Advantage
Competitive PositionEXHIBIT 6.3 /
Differentiation
Strategy: Achieving
Competitive
Advantage
Under a differentiation
strategy, firms that suc-
cessfully differentiate their
products enjoy a com-
petitive advantage. Firm
A’s product is seen as a
generic commodity with
no unique brand value.
Firm B has the same cost
structure as Firm A but
creates more economic
value, and thus has a
competitive advantage
over both Firm A and Firm
C because (V − C )B >
(V − C )C > (V − C )A.
Although, Firm C has
higher costs than Firm
A and B, it still generates
a significantly higher eco-
nomic value than Firm A.
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Managers can adjust a number of different levers to improve a firm’s strategic position.
These levers either increase perceived value or decrease costs. Here, we will study the
most salient value drivers that managers have at their disposal (we look at cost drivers in
the next section).10 They are:
■ Product features
■ Customer service
■ Complements
These value drivers are related to a firm’s expertise in, and organization of, different
internal value chain activities. Although these are the most important value drivers, no
such list can be complete. Applying the concepts introduced in this chapter should allow
strategic leaders to identify other important value and cost drivers unique to their business.
When attempting to increase the perceived value of the firm’s product or service offer-
ings, managers must remember that the different value drivers contribute to competitive
advantage only if their increase in value creation (ΔV) exceeds the increase in costs (ΔC).
The condition of ΔV > ΔC must be fulfilled if a differentiation strategy is to strengthen a
firm’s strategic position and thus enhance its competitive advantage.
PRODUCT FEATURES
One of the obvious but most important levers that strategic leaders can adjust is product
features, thereby increasing the perceived value of the product or service offering. Adding
unique product attributes allows firms to turn
commodity products into differentiated prod-
ucts commanding a premium price. Strong R&D
capabilities are often needed to create superior
product features. In the kitchen-utensil industry,
OXO follows a differentiation strategy, highlight-
ing product features. By adhering to its philoso-
phy of making products that are easy to use for
the largest variety of possible users,11 OXO dif-
ferentiates its kitchen utensils through its patent-
protected ergonomically designed soft black
rubber grips.
CUSTOMER SERVICE
Managers can increase the perceived value
of their firms’ product or service offerings by
focusing on customer service. For example, the online retailer Zappos earned a reputation
for superior customer service by offering free shipping both ways: to the customer and for
returns.12 Zappos’s strategic leaders didn’t view this as an additional expense but rather as
part of their marketing budget. Moreover, Zappos does not outsource its customer service,
and its associates do not use predetermined scripts. They are instead encouraged to build
a relationship of trust with each individual customer. There seemed to be a good return
on investment as word spread through the online shopping community. Competitors took
notice, too; Amazon bought Zappos for over $1 billion.13
COMPLEMENTS
When studying industry analysis in Chapter 3, we identified the availability of complements
as an important force determining the profit potential of an industry. Complements add value
Trader Joe’s is a chain of
more than 400 stores, half
of which are in California
and the rest in another 38
states plus Washington,
D.C. The chain is known for
good products, value for
money, clerks in Hawaiian
shirts—and great customer
service. As just one example,
stores happily stock local
products as requested by
their communities.14
©Karsten Moran/Aurora
Photos/Alamy Stock Photo
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to a product or service when they are consumed in tandem. Finding complements, therefore,
is an important task for managers in their quest to enhance the value of their offerings.
A prime example of complements is smartphones and cellular services. A smartphone
without a service plan is much less useful than one with a data plan. Traditionally, the provid-
ers of phones such as Apple, Samsung, and others did not provide wireless services. AT&T
and Verizon are by far the two largest service providers in the United States, jointly holding
some 70 percent of market share. To enhance the attractiveness of their phone and service
bundles, phone makers and service providers frequently sign exclusive deals. When first
released, for instance, service for the iPhone was exclusively offered by AT&T. Thus, if you
wanted an iPhone, you had to sign up for a two-year service contract with AT&T.
Google, a division of Alphabet, decided to offer the important complements of smart-
phones and wireless services in-house to attract more customers.15 Google offers high-end
phones such as the Pixel 2 with cutting-edge artificial intelligence built in (via its Google
Assistant) at competitive prices. It combines this with discounted high-speed wireless ser-
vices in its Project Fi, a complementary offering. Working in conjunction with smaller
wireless service providers such as Sprint and T-Mobile, Google provides seamless wire-
less services by stitching together a nationwide network of services based on available free
Wi-Fi hotspots (such as at Starbucks) and cellular networks offered by Sprint or T-Mobile.
This not only enables wide coverage, but also reduces data usage significantly because
Google phones automatically switch to free Wi-Fi networks wherever available.
Project Fi is intended to drive more demand for Google’s phone; sales have been lack-
luster thus far. Stronger demand for Google’s phones locks more users into the Google
ecosystem as its wireless services are available only with its own phones. This provides an
example where complementary product and service offerings not only reinforce demand
for one another, but also create a situation where network externalities can arise. As more
users sign up for Project Fi, Google is able to offer faster and more reliable services
(through investing more into the latest technology, such as 5G), making its network and
with it its Google phones more attractive to more users, and so forth.
As you have just seen, the differentiation strategy covers a great deal of ground, so let’s
summarize what we have learned. By choosing the differentiation strategy as the strate-
gic position for a product, managers focus their attention on adding value to the product
through its unique features that respond to customer preferences, customer service during
and after the sale, or effective marketing that communicates the value of the product’s
features. Although this positioning involves increased costs (for example, higher-quality
inputs or innovative research and development activities), customers will be willing to pay
a premium price for the product or service that satisfies their needs and preferences. In the
next section, we will discuss how managers formulate a cost-leadership strategy.
6.3 Cost-Leadership Strategy:
Understanding Cost Drivers
The goal of a cost-leadership strategy is to reduce the firm’s cost below that of its competitors
while offering adequate value. The cost leader, as the name implies, focuses its attention and
resources on reducing the cost to manufacture a product or on lowering the operating cost to
deliver a service in order to offer lower prices to its customers. The cost leader attempts to
optimize all of its value chain activities to achieve a low-cost position. Although staking out
the lowest-cost position in the industry is the overriding strategic objective, a cost leader still
needs to offer products and services of acceptable value. As an example, GM and Korean car
manufacturer Kia offer some models that compete directly with one another, yet Kia’s cars
tend to be produced at lower cost, while providing a similar value proposition.
LO 6-3
Examine the relationship
between cost drivers and
cost-leadership strategy.
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A cost leader can achieve a competitive advantage as long as its economic value cre-
ated (V − C) is greater than that of its competitors. Firm A in Exhibit 6.4 produces a
product with a cost structure vulnerable to competition. Firms B and C show two differ-
ent approaches to cost leadership. Firm B achieves a competitive advantage over Firm
A because Firm B not only has lower cost than Firm A, but also achieves differentiation
parity (meaning it creates the same value as Firm A). As a result, Firm B’s economic value
creation, (V − C)B, is greater than that of Firm A, (V − C)A. For example, as the low-cost
leader, Walmart took market share from Kmart, which subsequently filed for bankruptcy.
What if a firm fails to create differentiation parity? Such parity is often hard to achieve
because value creation tends to go along with higher costs, and Firm B’s strategy is aimed
at lower costs. A firm can still gain a competitive advantage as long as its economic value
creation exceeds that of its competitors. Firm C represents this approach to cost leadership.
Even with lower value (no differentiation parity) but lower cost, Firm C’s economic value
creation, (V − C)C, still is greater than that of Firm A, (V − C)A.
In both approaches to cost leadership in Exhibit 6.4, Firm B’s economic value creation
is greater than that of Firm A and Firm C. Yet, both firms B and C achieve a competitive
advantage over Firm A. Either one can charge prices similar to its competitors and benefit
from a greater profit margin per unit, or it can charge lower prices than its competition and
gain higher profits from higher volume. Both variations of a cost-leadership strategy can
result in competitive advantage. Although Firm B has a competitive advantage over both
firms A and C, Firm C has a competitive advantage in comparison to Firm A.
Although companies successful at cost leadership must excel at controlling costs, this
doesn’t mean that they can neglect value creation. Kia signals the quality of its cars with
a five-year, 60,000-mile warranty, one of the more generous warranties in the industry.
Walmart offers products of acceptable quality, including many brand-name products.
The most important cost drivers that managers can manipulate to keep their costs low are:
■ Cost of input factors.
■ Economies of scale.
■ Learning-curve effects.
■ Experience-curve effects.
EXHIBIT 6.4 /
Cost-Leadership
Strategy: Achieving
Competitive
Advantage
Under a cost-leadership
strategy, firms that can
keep their cost at the low-
est point in the industry
while offering acceptable
value are able to gain a
competitive advantage.
Firm A has not managed
to take advantage of possi-
ble cost savings, and thus
experiences a competitive
disadvantage. The offering
from Firm B has the same
perceived value as Firm A
but through more effective
cost containment creates
more economic value
(over both Firm A and
Firm C because (V − C)B
> (V − C)C > (V − C)A. The
offering from Firm C has
a lower perceived value
than that of Firm A or B
and has the same reduced
product cost as with Firm
B; as a result, Firm C still
generates higher eco-
nomic value than Firm A.
Firm A
Disadvantage
Competitive Position
Advantage
Va
lu
e
C B
(V –C )B
(V –C )A
(V –C )C
C A
C C
Co
st
Firm B:
Cost Leader
Firm C:
Cost Leader
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However, this list is only a starting point; managers may consider other cost drivers,
depending on the situation.
COST OF INPUT FACTORS
One of the most basic advantages a firm can have over its rivals is access to lower-cost
input factors such as raw materials, capital, labor, and IT services. In the market for
international long-distance travel, the greatest competitive threat facing U.S. legacy
carriers— American, Delta, and United—comes from three fast-growing airlines located in
the Persian Gulf states—Emirates, Etihad, and Qatar. These airlines achieve a competitive
advantage over their U.S. counterparts thanks to lower-cost inputs—raw materials (access
to cheaper fuel), capital (interest-free government loans), labor—and fewer regulations
(for example, regarding nighttime takeoffs and landings, or in adding new runways and
building luxury airports with swimming pools, among other amenities).16 To benefit from
lower-cost IT services, the Gulf carriers also outsource some value chain activities such
as booking and online customer service to India. Together, these distinct cost advantages
across several key input factors add up to create a greater economic value creation for the
Gulf carriers vis-à-vis U.S. competitors, leading to a competitive advantage (more on the
Gulf carriers in Strategy Highlight 10.1).
ECONOMIES OF SCALE
Firms with greater market share might be in a position to reap economies of scale,
decreases in cost per unit as output increases. This relationship between unit cost and out-
put is depicted in the first (left-hand) part of Exhibit 6.5: Cost per unit falls as output
increases up to point Q1. A firm whose output is closer to Q1 has a cost advantage over
other firms with less output. In this sense, bigger is better.
In the airframe-manufacturing industry, for example, reaping economies of scale and
learning is critical for cost-competitiveness. The market for commercial airplanes is often
not large enough to allow more than one competitor to reach sufficient scale to drive
down unit cost. Boeing chose not to compete with Airbus in the market for superjumbo
jets; rather, it decided to focus on a smaller, fuel-efficient airplane (the 787 Dreamliner,
priced at roughly $250 million) that allows for long-distance, point-to-point connections.
economies of
scale Decreases in
cost per unit as output
increases.
EXHIBIT 6.5 /
Economies of
Scale, Minimum
Efficient Scale, and
Diseconomies of
Scale
Pe
r-U
ni
t C
os
t (
$)
Output (Q )
Economies of Scale
Constant Returns
to Scale Diseconomies of Scale
Q 1 Q 2
Minimum
Efficient Scale
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By 2017, it had built over 530 Dreamliners with more than 1,200 orders for the new air-
plane.17 Boeing can expect to reap significant economies of scale and learning, which
will lower per-unit cost. At the same time, Airbus had delivered 210 A-380 superjumbos
(sticker price: $430 million) with more than 100 orders on its books.18 If both companies
would have chosen to compete head-on in each market segment, the resulting per-unit cost
for each airplane would have been much higher because neither could have achieved sig-
nificant economies of scale (overall their market share split is roughly 50–50).
What causes per-unit cost to drop as output increases (up to point Q1)? Economies of
scale allow firms to:
■ Spread their fixed costs over a larger output.
■ Employ specialized systems and equipment.
■ Take advantage of certain physical properties.
SPREADING FIXED COSTS OVER LARGER OUTPUT. Larger output allows firms to spread
their fixed costs over more units. That is why gains in market share are often critical to
drive down per-unit cost. This relationship is even more pronounced in many high-tech
industries because most of the cost occurs before a single product or service is sold. Take
operating systems software as an example. Microsoft spends over $10 billion a year on
research and development (R&D).19 Between 2011 and 2015, a good part of this was spent
on developing Windows 10, its newest operating system software. This R&D expense was
a fixed cost Microsoft had to incur before a single copy of Windows 10 was sold. How-
ever, once the initial version of the new software was completed, the marginal cost of
each additional copy was basically zero, especially for copies sold in digital form online.
Given that Microsoft dominates the operating system market for personal computers (PCs)
with more than 90 percent market share, it expects to sell several hundred million copies
of Windows 10, thereby spreading its huge fixed cost of development over a large out-
put. Microsoft’s huge installed base of Windows operating systems throughout the world
allowed it to capture a large profit margin for each copy of Windows sold, after recouping
its initial investment. Microsoft has high hopes for its newest operating system with the
goal of bringing together not only PCs and mobile devices but also the Xbox One and other
Windows devices. Microsoft’s Windows 10 also drives sales for complementary products
such as the ubiquitous Microsoft Office Suite made up of Word, Excel, PowerPoint, and
Outlook, among other programs (as discussed in ChapterCase 5).
EMPLOYING SPECIALIZED SYSTEMS AND EQUIPMENT. Larger output also allows firms
to invest in more specialized systems and equipment, such as enterprise resource planning
(ERP) software or manufacturing robots. Tesla’s strong demand for its new Model 3 sedan
allows it to employ cutting-edge robotics in its Fremont, California, manufacturing plant to
produce cars of the highest quality at large scale, and thus driving down costs.
TAKING ADVANTAGE OF CERTAIN PHYSICAL PROPERTIES. Economies of scale also
occur because of certain physical properties. One such property is known as the cube-
square rule: The volume of a body such as a pipe or a tank increases disproportionately
more than its surface. This same principle makes big-box retail stores such as Walmart or
The Home Depot cheaper to build and run. They can also stock much more merchandise
and handle inventory more efficiently. Their huge size makes it difficult for department
stores or small retailers to compete on cost and selection.
Look again at Exhibit 6.5. The output range between Q1 and Q2 in the figure is consid-
ered the minimum efficient scale (MES) to be cost-competitive. Between Q1 and Q2, the
returns to scale are constant. It is the output range needed to bring the cost per unit down as
minimum efficient
scale (MES) Output
range needed to bring
down the cost per unit
as much as possible,
allowing a firm to
stake out the lowest-
cost position that is
achievable through
economies of scale.
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much as possible, allowing a firm to stake out the lowest-cost position achievable through
economies of scale. With more than 10 million Prius cars sold since its introduction in 1997,
Toyota has been able to reach the minimum efficient scale part of the per-unit cost curve.
This allows the company to offer the car at a relatively low price and still make a profit.
The concept of minimum efficient scale applies not only to manufacturing processes
but also to managerial tasks such as how to organize work. Due to investments in special-
ized technology and equipment (e.g., electric arc furnaces), Nucor is able to reach MES
with much smaller batches of steel than larger, fully vertically integrated steel companies
using older technology. Nucor’s optimal plant size is about 500 people, which is much
smaller than at larger integrated steelmakers such as U.S. Steel which often employ thou-
sands of workers per plant.20 Of course, minimum efficient scale depends on the specific
industry: The average per-unit cost curve, depicted conceptually in Exhibit 6.5, is a reflec-
tion of the underlying production function, which is determined by technology and other
input factors.
Benefits to scale cannot go on indefinitely, though. Bigger is not always better; in fact,
sometimes bigger is worse. Beyond Q2 in Exhibit 6.5, firms experience diseconomies
of scale—increases in cost as output increases. As firms get too big, the complexity of
managing and coordinating the production process raises the cost, negating any benefits to
scale. Large firms also tend to become overly bureaucratic, with too many layers of hierar-
chy. They grow inflexible and slow in decision making. To avoid problems associated with
diseconomies of scale, Gore Associates, maker of GORE-TEX fabric, Glide dental floss,
and many other innovative products, breaks up its company into smaller units. Gore Asso-
ciates found that employing about 150 people per plant allows it to avoid diseconomies of
scale. It uses a simple decision rule:21 “We put 150 parking spaces in the lot, and when
people start parking on the grass, we know it’s time to build a new plant.”22
Finally, there are also physical limits to scale. Airbus is pushing the envelope with its
A-380 aircraft, which can hold more than 850 passengers and fly up to 8,200 miles (enough
to travel nonstop from Boston to Hong Kong at about 600 mph). The goal, of course, is to
drive down the cost of the average seat-mile flown (CASM, a standard cost metric in the
airline industry). It remains to be seen whether the A-380 superjumbo will enable airlines
to reach minimum efficient scale or will simply be too large to be efficient. For example,
boarding and embarking procedures must be streamlined to accommodate more than 850
people in a timely and safe manner. Many airports around the world need to be retrofitted
with longer and wider runways to allow the superjumbo to take off and land.
Scale economies are critical to driving down a firm’s cost and strengthening a cost-
leadership position. Although managers need to increase output to operate at a minimum
efficient scale (between Q1 and Q2 in Exhibit 6.5), they also need to be watchful not to
drive scale beyond Q2, where they would encounter diseconomies. In sum, if the firm’s
output range is less than Q1 or more than Q2, the firm is at a cost disadvantage; reaching an
output level between Q1 and Q2 is optimal in regards to driving down costs. Monitoring
the firm’s cost structure closely over different output ranges allows managers to fine-tune
operations and benefit from economies of scale.
LEARNING CURVE
Do learning curves go up or down? Looking at the challenge of learning, many people
tend to see it as an uphill battle, and assume the learning curve goes up. But if we con-
sider our productivity, learning curves go down, as it takes less and less time to produce
the same output as we learn how to be more efficient—learning by doing drives down
cost. As individuals and teams engage repeatedly in an activity, whether writing computer
code, developing new medicines, or building submarines, they learn from their cumulative
diseconomies of
scale Increases in cost
per unit when output
increases.
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experience.23 Learning curves were first documented in aircraft manufacturing as the
United States ramped up production in the 1930s, before its entry into World War II.24
Every time production was doubled, the per-unit cost dropped by a predictable and con-
stant rate (approximately 20 percent).25
It is not surprising that a learning curve was first observed in aircraft manufacturing.
Highly complex, a modern commercial aircraft can contain more than 5 million parts,
compared with a few thousand for a car. The more complex the underlying process to
manufacture a product or deliver a service, the more learning effects we can expect. As
cumulative output increases, managers learn how to optimize the process, and workers
improve their performance through repetition.
TESLA’S LEARNING CURVE. Tesla’s production of its Model S vehicle provides a more
recent example, depicted in Exhibit 6.6, with the horizontal axis showing cumulative out-
put in units and the vertical axis showing per-unit cost in thousands of dollars.26
The California-based designer and manufacturer of all-electric cars made headlines in
2017 when its market capitalization overtook both GM and Ford. This was the first time
in U.S. history that the most valuable U.S. car company is not based in Detroit, Michigan,
but in Silicon Valley. In 2016, Tesla sold some 80,000 vehicles, while GM sold some
10 million. How can a start-up company that makes less than 1 percent as many vehicles
as GM have a higher market valuation? The answer: Future expected growth. Investors
bidding up Tesla’s share price count on the maker of all-electric cars to sell millions of its
new Model 3. When the Model 3 was announced in 2016, Tesla garnered some 400,000
preorders from future owners for a car that was not yet produced, let alone test-driven by
any potential buyer.
Tesla’s learning curve is critical in justifying such lofty stock market valuations, because
as production volume increases, production cost per car falls, and the company becomes
profitable. Based on a careful analysis of production reports for the Model S between 2012
and 201427, Exhibit 6.6 shows how Tesla was able to drive down the unit cost for each
car as production volume ramped up. Initially, Tesla lost a significant amount of money
on each Model S sold because of high upfront R&D spending to develop the futuristic
EXHIBIT 6.6 /
Tesla’s Learning Curve
Producing the Model S
SOURCE: Depiction of
functional relationship
estimated in J. Dyer and
H. Gregersen (2016), “Tesla’s
innovations are transforming
the auto industry,” Forbes,
August 24.
$350,000
$300,000
$250,000
$200,000
$150,000
$100,000
$50,000
$0
0 2,000 4,000 6,000 8,000 10,000 12,000
Cumulative Output (Units)
Model S $
average sales
price:
$90,000
Pe
r-
Un
it
C
os
t (
$)
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self-driving car. When producing only 1,000 vehicles, unit cost was $140,000. As produc-
tion volume of the Model S reached some 12,000 units per year (in 2014), unit cost fell
to about $57,000. Although still high, Tesla was able start making money on each car,
because the average selling price for a Model S was about $90,000.
The relationship between production volume and per-unit cost for Tesla (depicted in
Exhibit 6.6) suggests that it is an 80 percent learning curve. In an 80 percent learning
curve, per-unit cost drops 20 percent every time output is doubled. Assuming a similar
relationship holds for the Model 3 production, then per-unit cost would fall to $16,000 per
Model 3 with a cumulative production volume of 400,000 (which is the number of preor-
ders Tesla received within one week of announcing this new vehicle). Although the Model
3 base price is pegged at $35,000, the estimated average selling price is more like $50,000
given additional features and eventual expiration of a $7,500 federal tax credit for electric
vehicles (when a manufacturer hits 200,000 units). Riding down an 80 percent learning
curve, Tesla could make a profit of an estimated $34,000 per Model 3. This would translate
to a cumulative profit for Tesla of more than $13.5 billion for the Model 3 preorders alone.
This back-of-the-envelope calculation shows some of the rationale behind Tesla’s market
capitalization exceeding that of GM and Ford.
Taken together, this example highlights not only the power of the learning curve in driv-
ing down per-unit costs, but also how critical cost containment is in gaining a competitive
advantage when pursuing a differentiation strategy as Tesla does.
DIFFERENCES IN LEARNING CURVES. Let’s now compare different learning curves, and
explore their implications for competitive advantage. The steeper the learning curve, the
more learning has occurred. As cumulative output increases, firms move down the learn-
ing curve, reaching lower per-unit costs. Exhibit 6.7 depicts two different learning curves:
a 90 percent and an 80 percent learning curve. In a 90 percent learning curve, per-unit
cost drops 10 percent every time output is doubled. The steeper 80 percent learning curve
EXHIBIT 6.7 / Gaining Competitive Advantage through Leveraging Learning- and Experience-Curve Effects
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
$100
1 2 4 8 16 32 64 128 256 512 1,024 2,048 4,096
Cumulative Output (Units)
Pe
r-U
ni
t C
os
t (
$)
Firm A
Firm B
Firm C
80% Learning Curve
90% Learning Curve
Experience
Curve Effect
Learning
Curve Effect
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indicates a 20 percent drop every time output is doubled (this was the case in the Tesla
example above). It is important to note that the learning-curve effect is driven by increasing
cumulative output within the existing technology over time. That implies that the only dif-
ference between two points on the same learning curve is the size of the cumulative output.
The underlying technology remains the same. The speed of learning determines the slope
of the learning curve, or how steep the learning curve is (e.g., 80 percent is steeper than a
90 percent learning curve because costs decrease by 20 percent versus a mere 10 percent
each time output doubles). In this perspective, economies of learning allow movement
down a given learning curve based on current production technology.
By moving further down a given learning curve than competitors, a firm can gain a
competitive advantage. Exhibit 6.7 shows that Firm B is further down the 90 percent learn-
ing curve than Firm A. Firm B leverages economies of learning due to larger cumulative
output to gain an advantage over Firm A. The only variable that has changed is cumulative
output; the technology underlying the 90 percent learning curve remained the same.
Let’s continue with the example of manufacturing airframes. To be more precise, as shown
in Exhibit 6.7, Firm A produces eight aircraft and reaches a per-unit cost of $73 million per
aircraft.28 Firm B produces 128 aircraft using the same technology as Firm A (because both
firms are on the same [90 percent] learning curve), but given a much larger cumulative out-
put, its per unit-cost falls to only $48 million. Thus, Firm B has a clear competitive advantage
over Firm A, assuming similar or identical quality in output. We will discuss Firm C when
we formally introduce the impact of changes in technology and process innovation.
Learning curves are a robust phenomenon observed in many industries, not only in man-
ufacturing processes but also in alliance management, franchising, and health care.29 For
example, physicians who perform only a small number of cardiac surgeries per year can
have a patient mortality rate five times higher than physicians who perform the same
surgery more frequently.30 Strategy Highlight 6.1 features Dr. Devi Shetty of India who
reaped huge benefits by applying learning-curve principles to open-heart surgery, driving
down cost while improving quality at the same time!
Learning effects differ from economies of scale (discussed earlier) as shown:
■ Differences in timing. Learning effects occur over time as output accumulates, while
economies of scale are captured at one point in time when output increases. The
improvements in Tesla’s production costs, featured earlier, resulted from some 12,000
units in cumulative output, but it took two years to reach this volume (see Exhibit 6.6).
Although learning can decline or flatten (see Exhibit 6.7), there are no diseconomies to
learning (unlike diseconomies to scale in Exhibit 6.5).
■ Differences in complexity. In some production processes (e.g., the manufacture of
steel rods), effects from economies of scale can be quite significant, while learning
effects are minimal. In contrast, in some professions (brain surgery or the practice of
estate law), learning effects can be substantial, while economies of scale are minimal.
Managers need to understand such differences to calibrate their business-level strategy.
If a firm’s cost advantage is due to economies of scale, a manager should worry less about
employee turnover (and a potential loss in learning) and more about drops in production
runs. In contrast, if the firm’s low-cost position is based on complex learning, a manager
should be much more concerned if a key employee (e.g., a star engineer) was to leave.
EXPERIENCE CURVE
In the learning curve just discussed, we assumed the underlying technology remained con-
stant, while only cumulative output increased. In the experience curve, in contrast, we now
change the underlying technology while holding cumulative output constant.31
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Dr. Shetty: “The Henry Ford of Heart Surgery” days a week. The difference adds up. Some of Dr. Shetty’s sur-
geons perform more specialized procedures by the time they are
in their 30s than their U.S. counterparts will perform throughout
their entire careers. This volume of experience allows the cardiac
surgeons to move down the learning curve quickly, because the
more heart surgeries they perform, the more their skills improve.
With this skill level, surgical teams develop robust standard oper-
ating procedures and processes, where team members become
experts at their specific tasks.
This expertise improves outcomes while the learning-
curve effects of performing the same procedures over time
also save money (see Exhibit 6.7). Other factors provide addi-
tional cost savings. At the same time, Dr. Shetty pays his car-
diac surgeons the going rate in India, between $110,000 and
$250,000 a year, depending on experience. Their U.S. coun-
terparts earn two to three times the average Indian salary.
Dr. Shetty’s health group also reduces costs through econo-
mies of scale. By performing thousands of heart surgeries a year,
high fixed costs such as the purchase of expensive medical equip-
ment can be spread over a much larger volume. The Narayana
hospital in Bangalore has 1,000 beds (many times larger than
the average U.S. hospital with 160 beds) and some 20 operating
rooms that stay busy pretty much around the clock. This scale
allows the Narayana heart clinic to cost-effectively employ special-
ized high-tech equipment. Given the large size of Dr. Shetty’s hos-
pital, he also has significant buying power, driving down the costs
of the latest high-tech equipment from top-notch vendors such as
GE. Wherever possible, Dr. Shetty sources lower-cost inputs such
as sutures locally, rather than from the more expensive companies
such as Johnson & Johnson. Further, the Narayana heart clinic
shares common services, such as laboratories and blood bank
and more mundane services such as catering, with the 1,400-bed
cancer clinic next door. Taken together, all of these small changes
result in significant cost savings, and so create a reinforcing sys-
tem of low-cost value chain activities.
While many worry that high volume compromises quality, the
data suggest the opposite: Narayana Health’s medical outcomes in
terms of mortality rate are equal to or even lower than the best
hospitals in the United States. The American College of Cardiol-
ogy frequently sends surgeons and administrators to visit the
Narayana heart clinic. The college concluded that the clinic pro-
vides high-tech and high-quality care at low cost. Dr. Shetty now
brings top-notch care at low cost to the masses in India. Narayana
Health runs a chain of over 30 hospitals in 20 locations through-
out India and performs some 100,000 heart surgeries a year.32
Strategy Highlight 6.1
©Namas Bhojani
Open-heart surgeries are complex medical procedures and loaded
with risk. While well-trained surgeons using high-tech equipment
are able to reduce mortality rates, costs for cardiac surgeries in
the United States have climbed. Difficult heart surgeries can cost
$100,000 or more. A heart surgeon in India has driven the costs
down to an average of $2,000 per heart surgery, while delivering
equal or better outcomes in terms of quality.
Dr. Devi Shetty’s goal is to be “the Henry Ford of heart sur-
gery.” Just like the great American industrialist who applied the
learning curve to drive down the cost of an automobile to make it
affordable, so Dr. Shetty is reducing the costs of health care and
making some of the most complex medical procedures affordable
to the world’s poorest. A native of Mangalore, India, Dr. Shetty
was trained as a heart surgeon at Guy’s Hospital in London, one
of Europe’s best medical facilities. He first came to fame in the
1990s when he successfully conducted an open-heart bypass sur-
gery on Mother Teresa, after she suffered a heart attack.
Dr. Shetty believes that the key to driving down costs in
health care is not product innovation, but process innovation.
He is able to drive down the cost of complex medical procedures
from $100,000 to $2,000 not by doing one big thing, but rather
by focusing on doing a thousand small things. Dr. Shetty is apply-
ing the concept of the learning curve to make a complex proce-
dure routine and comparatively inexpensive. Part of the Narayana
Health group, Dr. Shetty’s hospital in Bangalore, India, performs
so many cardiac procedures per year that doctors are able to get
a great deal of experience quickly, which allows them to specialize
in one or two complex procedures. The Narayana surgeons per-
form two or three procedures a day for six days a week, compared
to U.S. surgeons who perform one or two procedures a day for five
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In general, technology and production processes do not stay constant. Process
innovation—a new method or technology to produce an existing product—may initiate a
new and steeper curve. Assume that Firm C, on the same learning curve as Firm B, imple-
ments a new production process (such as lean manufacturing). In doing so, Firm C initi-
ates an entirely new and steeper learning curve. Exhibit 6.7 shows this experience-curve
effect based on a process innovation. Firm C jumps down to the 80 percent learning curve,
reflecting the new and lower-cost production process. Although Firm B and Firm C pro-
duce the same cumulative output (each making 128 aircraft), the per-unit cost differs. Firm
B’s per-unit cost for each airplane, being positioned on the less-steep 90 percent learning
curve is $48 million.33 In contrast, Firm C’s per-unit cost, being positioned on the steeper
80 percent learning curve because of process innovation, is only $21 million per aircraft,
and thus less than half of that of Firm B. Clearly, Firm C has a competitive advantage over
Firm B based on lower cost per unit (assuming similar quality).
Learning by doing allows a firm to lower its per-unit costs by moving down a given
learning curve, while experience-curve effects based on process innovation allow a firm to
leapfrog to a steeper learning curve, thereby driving down its per-unit costs.
In Strategy Highlight 6.1, we saw how Dr. Shetty leveraged learning-curve effects to
save lives while driving down costs. One could argue that his Narayana Health group not
only moved down a given learning curve using best industry practice, but it also jumped
down to a new and steeper learning curve through process innovation. Dr. Shetty sums up
his business strategy based on cost leadership: “Japanese companies reinvented the process
of making cars (by introducing lean manufacturing). That’s what we’re doing in health
care. What health care needs is process innovation, not product innovation.”34
In a cost-leadership strategy, managers must focus on lowering the costs of production
while maintaining a level of quality acceptable to the customer. If firms can share the ben-
efits of lower costs with consumers, cost leaders appeal to the bargain-conscious buyer,
whose main criterion is price. By looking to reduce costs in each value chain activity,
managers aim for the lowest-cost position in the industry. They strive to offer lower prices
than competitors and thus to increase sales. Cost leaders such as Walmart (“Every Day
Low Prices”) can profit from this strategic position over time.
6.4 Business-Level Strategy and the Five Forces:
Benefits and Risks
The business-level strategies introduced in this chapter allow firms to carve out strong stra-
tegic positions that enhance the likelihood of gaining and sustaining competitive advantage.
The five forces model introduced in Chapter 3 helps managers assess the forces—threat of
entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing
competitors—that make some industries more attractive than others. With this understanding
of industry dynamics, managers use one of the generic business-level strategies to protect
themselves against the forces that drive down profitability.35 Exhibit 6.8 details the relation-
ship between competitive positioning and the five forces. In particular, it highlights the bene-
fits and risks of differentiation and cost-leadership business strategies, which we discuss next.
DIFFERENTIATION STRATEGY: BENEFITS AND RISKS
A differentiation strategy is defined by establishing a strategic position that creates
higher perceived value while controlling costs. The successful differentiator stakes out a
unique strategic position, where it can benefit from imperfect competition (as discussed
in Chapter 3) and command a premium price. A well-executed differentiation strategy
reduces rivalry among competitors.
LO 6-4
Assess the benefits and
risks of differentiation
and cost-leadership
strategies vis-à-vis the
five forces that shape
competition.
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Competitive Force Differentiation Cost Leadership
Benefits Risks Benefits Risks
Threat of entry • Protection against
entry due to intangible
resources such as
a reputation for
innovation, quality, or
customer service
• Erosion of margins
• Replacement
• Protection against entry
due to economies of
scale
• Erosion of margins
• Replacement
Power of suppliers • Protection against
increase in input prices,
which can be passed on
to customers
• Erosion of margins • Protection against
increase in input prices,
which can be absorbed
• Erosion of margins
Power of buyers • Protection against
decrease in sales
prices, because well-
differentiated products
or services are not
perfect imitations
• Erosion of margins • Protection against
decrease in sales
prices, which can be
absorbed
• Erosion of margins
Threat of
substitutes
• Protection against
substitute products due
to differential appeal
• Replacement,
especially when
faced with
innovation
• Protection against
substitute products
through further
lowering of prices
• Replacement,
especially when
faced with innovation
Rivalry among
existing
competitors
• Protection against
competitors if product
or service has enough
differential appeal to
command premium price
• Focus of competition
shifts to price
• Increasing
differentiation of
product features
that do not create
value but raise costs
• Increasing
differentiation to
raise costs above
acceptable threshold
• Protection against price
wars because lowest-
cost firm will win
• Focus of competition
shifts to non-price
attributes
• Lowering costs to
drive value creation
below acceptable
threshold
EXHIBIT 6.8 / Competitive Positioning and the Five Forces: Benefits and Risks of Differentiation and Cost-Leadership
Business Strategies
SOURCES: Based on M.E. Porter (2008), “The Five Competitive Forces That Shape Strategy,” Harvard Business Review, January; and M.E. Porter (1980), Competitive
Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press).
A successful differentiation strategy is likely to be based on unique or specialized fea-
tures of the product, on an effective marketing campaign, or on intangible resources such
as a reputation for innovation, quality, and customer service. A rival would need to improve
the product features as well as build a similar or more effective reputation in order to gain
market share. The threat of entry is reduced: Competitors will find such intangible advan-
tages time-consuming and costly, and maybe impossible, to imitate. If the source of the
differential appeal is intangible rather than tangible (e.g., reputation rather than observable
product and service features), a differentiator is even more likely to sustain its advantage.
Moreover, if the differentiator is able to create a significant difference between per-
ceived value and current market prices, the differentiator will not be so threatened by
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increases in input prices due to powerful suppliers. Although an increase in input factors
could erode margins, a differentiator is likely able to pass on price increases to its custom-
ers as long as its value creation exceeds the price charged. Since a successful differentiator
creates perceived value in the minds of consumers and builds customer loyalty, powerful
buyers demanding price decreases are unlikely to emerge. A strong differentiated position
also reduces the threat of substitutes, because the unique features of the product have been
created to appeal to customer preferences, keeping them loyal to the product. By providing
superior quality beverages and other food items combined with a great customer experi-
ence and a global presence, Starbucks has built a strong differentiated appeal. It has culti-
vated a loyal following of customers who reward it with repeat business.
The viability of a differentiation strategy is severely undermined when the focus of
competition shifts to price rather than value-creating features. This can happen when
differentiated products become commoditized and an acceptable standard of quality has
emerged across rival firms. Although the iPhone was a highly differentiated product when
introduced in 2007, touch-based screens and other once-innovative features are now stan-
dard in smartphones. Indeed, Android-based smartphones hold some 82 percent market
share, while Apple’s iOS phones hold about 18 percent.36 Several companies including
Google; Samsung and LG, both of South Korea; and low-cost leader Huawei of China are
attempting to challenge Apple’s ability to extract significant profits from the smartphone
industry based on its iPhone franchise. A differentiator also needs to be careful not to over-
shoot its differentiated appeal by adding product features that raise costs but not perceived
value in the minds of consumers. For example, any additional increase in screen resolution
beyond Apple’s retina display cannot be detected by the human eye at a normal viewing
distance. Finally, a differentiator needs to be vigilant that its costs of providing uniqueness
do not rise above the customer’s willingness to pay.
COST-LEADERSHIP STRATEGY: BENEFITS AND RISKS
A cost-leadership strategy is defined by obtaining the lowest-cost position in the industry
while offering acceptable value. The cost leader, therefore, is protected from other com-
petitors because of having the lowest cost. If a price war ensues, the low-cost leader will be
the last firm standing; all other firms will be driven out as margins evaporate. Since reap-
ing economies of scale is critical to reaching a low-cost position, the cost leader is likely to
have a large market share, which in turn reduces the threat of entry.
A cost leader is also fairly well isolated from threats of powerful suppliers to increase
input prices, because it is more able to absorb price increases through accepting lower
profit margins. Likewise, a cost leader can absorb price reductions more easily when
demanded by powerful buyers. Should substitutes emerge, the low-cost leader can try to
fend them off by further lowering its prices to reinstall relative value with the substitute.
For example, Walmart tends to be fairly isolated from these threats. Walmart’s cost struc-
ture combined with its large volume allows it to work with suppliers in keeping prices low,
to the extent that suppliers are often the party that experiences a profit-margin squeeze.
Although a cost-leadership strategy provides some protection against the five forces, it
also carries some risks. If a new entrant with new and relevant expertise enters the market,
the low-cost leader’s margins may erode due to loss in market share while it attempts to
learn new capabilities. For example, Walmart faces challenges to its cost leadership. Dollar
General stores, and other smaller low-cost retail chains, have drawn customers who prefer
a smaller format than the big box of Walmart. The risk of replacement is particularly per-
tinent if a potent substitute emerges due to an innovation. Leveraging ecommerce, Amazon
has become a potent substitute and thus a powerful threat to many brick-and-mortar retail
outlets including Barnes & Noble, Best Buy, The Home Depot, and even Walmart. Powerful
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suppliers and buyers may be able to reduce margins so much that the low-cost leader could
have difficulty covering the cost of capital and lose the potential for a competitive advantage.
The low-cost leader also needs to stay vigilant to keep its cost the lowest in the industry.
Over time, competitors can beat the cost leader by implementing the same business strategy,
but more effectively. Although keeping its cost the lowest in the industry is imperative, the
cost leader must not forget that it needs to create an acceptable level of value. If continuously
lowering costs leads to a value proposition that falls below an acceptable threshold, the low-
cost leader’s market share will evaporate. Finally, the low-cost leader faces significant dif-
ficulties when the focus of competition shifts from price to non-price attributes.
We have seen how useful the five forces model can be in industry analysis. None of
the business-level strategies depicted in Exhibit 6.2 (cost leadership, differentiation, and
focused variations thereof) is inherently superior. The success of each depends on context
and relies on two factors:
■ How well the strategy leverages the firm’s internal strengths while mitigating its weaknesses.
■ How well it helps the firm exploit external opportunities while avoiding external threats.
There is no single correct business strategy for a specific industry. The deciding factor
is that the chosen business strategy provides a strong position that attempts to maximize
economic value creation and is effectively implemented.
6.5 Blue Ocean Strategy: Combining Differentiation
and Cost Leadership
So far we’ve seen that firms can create more economic value and the likelihood of gaining
and sustaining competitive advantage in one of two ways—either increasing perceived con-
sumer value (while containing costs) or lowering costs (while offering acceptable value).
Should managers try to do both at the same
time? To accomplish this, they would need
to integrate two different strategic positions:
differentiation and low cost.37 In general the
answer is no. Managers should not pursue
this complex strategy because of the inher-
ent trade-offs in different strategic positions,
unless they are able to reconcile the conflict-
ing requirements of each generic strategy.
To meet this challenge, the strategy schol-
ars Kim and Mauborgne advance the notion
of a blue ocean strategy, which is a business-
level strategy that successfully combines dif-
ferentiation and cost-leadership activities
using value innovation to reconcile the inher-
ent trade-offs in those two distinct strategic
positions.38 They use the metaphor of an ocean to denote market spaces. Blue oceans rep-
resent untapped market space, the creation of additional demand, and the resulting oppor-
tunities for highly profitable growth. In contrast, red oceans are the known market space
of existing industries. In red oceans the rivalry among existing firms is cut-throat because
the market space is crowded and competition is a zero-sum game. Products become com-
modities, and competition is focused mainly on price. Any market share gain comes at the
expense of other competitors in the same industry, turning the oceans bloody red.
A blue ocean strategy allows a firm to offer a differentiated product or service at low
cost. As one example of a blue ocean strategy, consider Trader Joe’s, the grocer introduced
blue ocean
strategy Business-
level strategy that
successfully combines
differentiation and cost-
leadership activities
using value innovation to
reconcile the inherent
trade-offs.
Canny managers may use
value innovation to move
to blue oceans, that is, to
new and uncontested market
spaces. Shown here is the
famous “blue hole” just off
Belize.
©Mlenny/Getty Images RF
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earlier in the chapter. Trader Joe’s had (prior to its 2017 acquisition by Amazon) much
lower costs than Whole Foods for the same market of patrons desiring high value and
health-conscious foods, and the chain scores exceptionally well in customer service and
other areas. When a blue ocean strategy is successfully formulated and implemented,
investments in differentiation and low cost are not substitutes but are complements,
providing important positive spill-over effects. A successfully implemented blue ocean
strategy allows firms two pricing options: First, the firm can charge a higher price than the
cost leader, reflecting its higher value creation and thus generating greater profit margins.
Second, the firm can lower its price below that of the differentiator because of its lower-
cost structure. If the firm offers lower prices than the differentiator, it can gain market
share and make up the loss in margin through increased sales.
VALUE INNOVATION
For a blue ocean strategy to succeed, managers must resolve trade-offs between the two
generic strategic positions—low cost and differentiation.39 This is done through value
innovation, aligning innovation with total perceived consumer benefits, price, and cost
(also see the discussion in Chapter 5 on economic value creation). Instead of attempting to
out-compete your rivals by offering better features or lower costs, successful value innova-
tion makes competition irrelevant by providing a leap in value creation, thereby opening
new and uncontested market spaces.
Successful value innovation requires that a firm’s strategic moves lower its costs and
also increase the perceived value for buyers (see Exhibit 6.9). Lowering a firm’s costs
is primarily achieved by eliminating and reducing the taken-for-granted factors that the
firm’s industry rivals compete on. Perceived buyer value is increased by raising existing
key success factors and by creating new elements that the industry has not offered previ-
ously. To initiate a strategic move that allows a firm to open a new and uncontested market
space through value innovation, managers must answer the four key questions below when
formulating a blue ocean business strategy.40 In terms of achieving successful value inno-
vation, note that the first two questions focus on lowering costs, while the other two ques-
tions focus on increasing perceived consumer benefits.
Value Innovation—Lower Costs
1. Eliminate. Which of the factors that the
industry takes for granted should be
eliminated?
2. Reduce. Which of the factors should be
reduced well below the industry’s standard?
Value Innovation—Increase Perceived
Consumer Benefits
3. Raise. Which of the factors should be
raised well above the industry’s standard?
4. Create. Which factors should be created
that the industry has never offered?
The international furniture retailer IKEA,
for example, has used value innovation based
on the eliminate-reduce-raise-create frame-
work to initiate its own blue ocean and to
achieve a sustainable competitive advantage.41
LO 6-5
Evaluate value and cost
drivers that may allow
a firm to pursue a blue
ocean strategy.
EXHIBIT 6.9 / Value Innovation Accomplished through
Simultaneously Pursuing Differentiation (V ↑) and
Low Cost (C ↓)
Cost (C )
Value
Innovation
Total Perceived
Consumer Benefits (V )
SOURCE: Adapted from C.W. Kim and R. Mauborgne (2005), Blue Ocean Strategy: How to
Create Uncontested Market Space and Make Competition Irrelevant (Boston, MA: Harvard
Business School Publishing).
value innovation The
simultaneous pursuit
of differentiation and
low cost in a way that
creates a leap in value
for both the firm and the
consumers; considered
a cornerstone of blue
ocean strategy.
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ELIMINATE. IKEA eliminated several taken-for-granted competitive elements: salespeo-
ple, expensive but small retail outlets in prime urban locations and shopping malls, long
wait after ordering furniture, after-sales service, and other factors. In contrast, IKEA dis-
plays its products in a warehouse-like setting, thus reducing inventory cost. Customers
serve themselves and then transport the furniture to their homes in IKEA’s signature flat-
packs for assembly. IKEA also uses the big-box concept of locating supersized stores near
major metropolitan areas (please refer to the discussion of “Taking Advantage of Certain
Physical Properties” under “Economies of Scale” in Section 6.3).
REDUCE. Because of its do-it-yourself business model regarding furniture selection, deliv-
ery, and assembly, IKEA drastically reduced the need for staff in its mega-stores. Strolling
through an IKEA store, you encounter few employees. IKEA also reduced several other
taken-for-granted competitive elements: 25-year warranties on high-end custom furniture,
high degree of customization in selection of options such as different fabrics and patterns,
and use of expensive materials such as leather or hardwoods, among other elements.
RAISE. IKEA raised several competitive elements: It offers tens of thousands of home fur-
nishing items in each of its big-box stores (some 300,000 square feet, roughly five football
fields), versus a few hundred at best in traditional furniture stores; it also offers more than
furniture, including a range of accessories such as place mats, laptop stands, and much more;
each store has hundreds of rooms fully decorated with all sorts of IKEA items, each with a
detailed tag explaining the item. Moreover, rather than sourcing its furniture from wholesalers
or other furniture makers, IKEA manufactures all of its furniture at fully dedicated suppliers,
thus tightly controlling the design, quality, functionality, and cost of each product.
IKEA also raised the customer experience by laying out its stores in such a way that
customers see and can touch basically all of IKEA’s products, from wineglasses (six for
$2.99) to bookshelves (for less than $100).
CREATE. IKEA created a new way for people to shop for furniture. Customers stroll
along a predetermined path winding through the fully furnished showrooms. They can
compare, test, and touch all the things in the showroom. The price tag on each item con-
tains other important information: type of
material, weight, and so on. Once an item is
selected, the customer notes the item num-
ber (the store provides a pencil and paper).
The tag also indicates the location in the
warehouse where the customer can pick
up the item in IKEA’s signature flat-packs.
After paying, the customer transports the
products and assembles the furniture. The
customer has 90 days to return items for a
full refund.
In traditional furniture shopping, custom-
ers visit a small retail outlet where sales-
people swarm them. After a purchase, the
customer has to wait generally a few weeks
before the furniture is shipped because many
furniture makers do not produce items, such
as expensive leather sofas, unless they are paid for in advance. Finely crafted couches and
chairs cost thousands of dollars (while IKEA’s fabric couches retail for $399). When shop-
ping at a traditional furniture store, the customer also pays for delivery of the furniture.
Each IKEA store has a large
self-service warehouse section.
©Alex Segre/Alamy Stock Photo
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IKEA also created a new approach to pricing its products. Rather than using a “cost plus
margin approach” like traditional furniture stores when pricing items, IKEA begins with
the retail price first. For example, it sets the price for an office chair at $150, and IKEA’s
designers figure out how to meet this goal, which includes a profit margin. They need to
consider the chair from start to finish, including not only design but also raw materials
and the way the product will be displayed and transported. Only then will products go into
production.
IKEA also created several other new competitive elements that allow it to offer more
value to its customers: Stores provide on-site child care, include a cafeteria serving deli-
cious food options including Swedish delicatessen such as smoked salmon at low prices,
and offer convenient and ample parking, often in garages under the store, where escalators
bring customers directly into the showrooms.
Taken together, with all these steps to eliminate, reduce, raise, and create, IKEA orches-
trates different internal value chain activities to reconcile the tension between differentia-
tion and cost leadership to create a unique market space. IKEA uses innovation in multiple
dimensions—in furniture design, engineering, and store design—to solve the trade-offs
between value creation and production cost. An IKEA executive highlights the difficulty
of achieving value innovation as follows: “Designing beautiful-but-expensive products
is easy. Designing beautiful products that are inexpensive and functional is a huge chal-
lenge.”42 IKEA leverages its deep design and engineering expertise to offer furniture that is
stylish and functional and that can be easily assembled by the consumer. In this way, IKEA
can pursue a blue ocean strategy based on value innovation to increase the perceived value
of its products, while simultaneously lowering its cost and offering competitive prices.
It opened a new market serving a younger demographic than traditional furniture stores.
When young people the world over move into their own apartment or house, they fre-
quently furnish it from IKEA.
BLUE OCEAN STRATEGY GONE BAD: “STUCK IN THE MIDDLE”
Although appealing in a theoretical sense, a blue ocean strategy can be quite difficult to
translate into reality. Differentiation and cost leadership are distinct strategic positions that
require important trade-offs.43 A blue ocean strategy is difficult to implement because it
requires the reconciliation of fundamentally different strategic positions—differentiation
and low cost—which in turn require distinct
internal value chain activities (see Chapter 4)
so the firm can increase value and lower cost at
the same time.
Exhibit 6.10 suggests how a successfully
formulated blue ocean strategy based on value
innovation combines both a differentiation
and low-cost position. It also shows the con-
sequence of a blue ocean strategy gone bad—
the firm ends up being stuck in the middle,
meaning the firm has neither a clear differ-
entiation nor a clear cost- leadership profile.
Being stuck in the middle leads to inferior
performance and a resulting competitive dis-
advantage. Strategy Highlight 6.2 illustrates
how JCPenney failed at a blue ocean strategy
and ended up in the red ocean of cut-throat
competition.
LO 6-6
Assess the risks of a
blue ocean strategy, and
explain why it is difficult
to succeed at value
innovation.
EXHIBIT 6.10 / Value Innovation vs. Stuck in the Middle
Cost
Leadership Differentiation
Focused
Differentiation
Focused Cost
Leadership
Cost
Na
rr
ow
Br
oa
d
Differentiation
STRATEGIC POSITION
CO
M
PE
TI
TI
VE
S
CO
PE
Blue Ocean Strategy
vs.
Stuck in the Middle
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How JCPenney Sailed Deeper
into the Red Ocean
JCPenney under former CEO Ron Johnson learned the hard
way how difficult it is to change a strategic position. When
hired as JCPenney’s CEO in 2011, Johnson was hailed as a
star executive. He was poached from Apple, where he had
created and led Apple’s retail stores since 2000. Apple’s
stores are the most successful retail outlets globally in terms
of sales per square foot. No other retail outlet, not even
luxury jewelers, achieves more.
Once on board with JCPenney, Johnson immediately
began to change the company’s strategic position from a
cost-leadership to a blue ocean strategy, attempting to com-
bine the cost-leadership position with a differentiation posi-
tion. In particular, he tried to reposition the department store
more toward the high end by providing an improved customer
experience and more exclusive merchandise through in-store
boutiques. Johnson ordered all clearance racks with steeply
discounted merchandise, common in JCPenney stores, to be
removed. He also did away with JCPenney’s long- standing
practice of mailing discount coupons to its customers.
Rather than following industry best practice by testing the
more drastic strategic moves in a small number of selected
stores, Johnson implemented them in all 1,800 stores at
once. When one executive raised the issue of pretesting,
Johnson bristled and responded: “We didn’t test at Apple.”
Under his leadership, JCPenney also got embroiled in a legal
battle with Macy’s because of Johnson’s attempt to lure away
homemaking maven Martha Stewart and her exclusive mer-
chandise collection.
The envisioned blue ocean strategy failed badly, and
JCPenney ended up being stuck in the middle. Within
12 months with Johnson at the helm, JCPenney’s sales dropped
by 25 percent. In a hypercompetitive industry such as retail-
ing where every single percent of market share counts, this
was a landslide. In 2013, JCPenney’s stock performed so
poorly it was dropped from the S&P 500 index. Less than 18
months into his new job, Johnson was fired. Myron Ullman, his
predecessor, was brought out of retirement as a temporary
replacement.
JCPenney failed at its attempted blue ocean strategy and
instead sailed deeper into the red ocean of bloody compe-
tition. This highlights the perils of attempting a blue ocean
strategy because of the inherent trade-offs in the underly-
ing generic business strategies of cost leadership and dif-
ferentiation. As a result, JCPenney continues to experience a
sustained competitive disadvantage as of this writing. In the
decade preceding 2015, JCPenney underperformed the wider
stock market (measured in the S&P 500 index) by almost 150
percentage points, with the gap widening over time. To turn
around the 115-year-old company, the board appointed Marvin
Ellison as CEO in 2015. Ellison came to JCPenney from The
Home Depot, where he excelled as a strong leader focused on
effective operations. In an attempt to stem losses, JCPenney
closed some 140 retail stores across the United States out of
a total of 1,000 outlets in 2017.44
Strategy Highlight 6.2
JCPenney’s new CEO, Marvin Ellison, is charged with turning the 115-year-old
industry icon around. With a strong background in operations management and
leadership skills honed at The Home Depot, he is focusing on lowering JCPen-
ney’s cost structure while increasing perceived value offered to its customers.
©MediaPunch Inc/Alamy Stock Photo
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THE STRATEGY CANVAS The value curve is the basic component of the strategy
canvas. It graphically depicts a company’s relative performance across its industry’s
factors of competition. A strong value curve has focus and divergence, and it can
even provide a kind of tagline as to what strategy is being undertaken or should be
undertaken.
Exhibit 6.11 plots the strategic profiles or value curves for three kinds of competitors in
the U.S. airline industry. On the left-hand side, descending in price, are the legacy carri-
ers (for example, Delta), JetBlue, and finally low-cost airlines such as Southwest Airlines
(SWA). We also show the different strategic positions (differentiator, stuck in the middle,
and low-cost leader) and trace the value curves as they rank high or low on a variety of
parameters. JetBlue is stuck in the middle (as discussed in the ChapterCase). Low-cost
airlines follow a cost-leadership strategy. The value curve, therefore, is simply a graphic
representation of a firm’s relative performance across different competitive factors in an
industry.
Legacy carriers tend to score highly among most competitive elements in the airline
industry, including different seating class choices (such as first class, business class, econ-
omy comfort, basic economy, and so on), a high level of in-flight amenities such as Wi-Fi,
personal video console to view movies or play games, complimentary drinks and meals,
coast-to-coast coverage via connecting hubs, plush airport lounges, international routes
and global coverage, high customer service, and high reliability in terms of safety and
on-time departures and arrivals. As is expected when pursuing a generic differentiation
strategy, all these scores along the different competitive elements in an industry go along
with a relative higher cost structure.
In contrast, the low-cost airlines tend to hover near the bottom of the strategy can-
vas, indicating low scores along a number of competitive factors in the industry, with
no assigned seating, no in-flight amenities, no drinks or meals, no airport lounges, few
if any international routes, low to intermediate level of customer service. A relatively
lower cost structure goes along with a generic low-cost leadership strategy.
This strategy canvas also reveals key strategic insights. Look at the few competi-
tive elements where the value curves of the differentiator and low-cost leader diverge.
EXHIBIT 6.11 / Strategy Canvas of JetBlue vs. Low-Cost Airlines and Legacy Carriers
High
Low
Price Seating Class In-flight
Amenities
Meals Connections
(via hub)
Lounges International
Routes
Customer
Service
Reliability Convenience
JetBlue Stuck in
the Middle
Differentiation Strategy
Pursued by Legacy Carriers
Low-Cost Leadership Strategy
Pursued by Low-Cost Airlines
value curve Horizontal
connection of the points
of each value on the
strategy canvas that
helps strategic leaders
diagnose and determine
courses of action.
strategy
canvas Graphical
depiction of a company’s
relative performance
vis-à-vis its competitors
across the industry’s key
success factors.
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Interestingly, some cost leaders (e.g., SWA) score much higher than some differentiators
(e.g., Delta) in terms of reliability and convenience, offering frequent point-to-point con-
nections to conveniently located airports, often in or near city centers. This key divergence
between the two strategies explains why generic cost leaders have frequently outperformed
generic differentiators in the U.S. airline industry. Overall, both value curves show a con-
sistent pattern representative of a more or less clear strategic profile as either differentia-
tion or low-cost leader.
Now look at JetBlue’s value curve. Rather than being consistent such as the differ-
entation or low-cost value curves, the JetBlue value curve follows a zigzag pattern. Jet-
Blue attempts to achieve parity or even out-compete differentiators in the U.S. airline
industry along the competitive factors such as different seating classes (e.g., the high-
end Mint offering discussed in the ChapterCase), higher level of in-flight amenities,
higher-quality beverages and meals, plush airport lounges, and a large number of inter-
national routes (mainly with global partner airlines). JetBlue, however, looks more
like a low-cost leader in terms of the ability to provide only a few connections via
hubs domestically, and it recently has had a poor record of customer service, mainly
because of some high-profile missteps as documented in the ChapterCase. JetBlue’s
reliability is somewhat mediocre, but it does provide a larger number of convenient
point-to-point flights than a differentiator such as Delta, but fewer than a low-cost
leader such as SWA.
A value curve that zigzags across the strategy canvas indicates a lack of effectiveness
in its strategic profile. The curve visually represents how JetBlue is stuck in the middle
and as a consequence experienced inferior performance and thus a sustained competitive
disadvantage vis-à-vis airlines with a stronger strategy profile such as SWA and Delta,
among others.
6.6 Implications for Strategic Leaders
Strategy is never easy, even when, as in achieving competitive advantage, only a hand-
ful of strategic options are available (i.e., low cost or differentiation, broad or narrow, or
blue ocean). The best managers work hard to make sure they understand their firm and
industry effects, and the opportunities they reveal. They work even harder to fine-tune
strategy formulation and execution. When well-formulated and implemented, a firm’s
business strategy enhances a firm’s chances of obtaining superior performance. Strategic
positioning requires making important trade-offs (think Walmart versus J. Crew in
clothing).
In rare instances, a few exceptional firms might be able to change the competitive
landscape by opening previously unknown areas of competition. To do so requires
the firm reconcile the significant trade-offs between increasing value and lowering
costs by pursuing both business strategies (differentiation and low cost) simultane-
ously. Such a blue ocean strategy tends to be successful only if a firm is able to rely
on a value innovation that allows it to reconcile the trade-offs mentioned. Toyota,
for example, initiated a new market space with its introduction of lean manufactur-
ing, delivering cars of higher quality and value at lower cost. This value innovation
allowed Toyota a competitive advantage for a decade or more, until this new process
technology diffused widely. JCPenney, on the other hand, stumbled and found itself
failing on most fronts, resulting in a sustained competitive disadvantage (see Strategy
Highlight 6.2).
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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 211
Early in its history JetBlue Airways achieved a competitive
advantage based on value innovation. In particular, JetBlue was
able to drive up perceived customer value while lowering costs.
This allowed it to carve out a strong strategic position and move
to a non-contested market space. This implies that no other com-
petitors in the U.S. domestic airline industry were able to provide
such value innovation at that point in time. Rather than directly
competing with other airlines, JetBlue created a blue ocean.
Although JetBlue was able to create an initial competitive
advantage, the airline was unable to sustain it. Because JetBlue
failed in reconciling the strategic trade-offs inherent in com-
bining differentiation and cost leadership, it was unable to con-
tinue its blue ocean strategy, despite initial success. Between
2007 and 2015, JetBlue experienced a sustained competitive
disadvantage, at one point lagging the Dow Jones U.S. Airlines
Index by more than 180 percentage points in 2015.
A new leadership team CEO Robin Hayes put in place in
early 2015 is attempting to reverse this trend. The new team
made quick changes to improve the airline’s flagging profit-
ability. It is putting strategic initiatives in place to lower costs,
while also trying to further increase its value offering. To
lower operating costs, JetBlue decided to start charging $50
per checked bag instead of offering it as a free service. It also
removed the additional legroom JetBlue was famous for in
the industry. To drive up perceived customer value, JetBlue is
adding to its fleet a new airplane (Airbus A-321), which scores
significantly higher in customer satisfaction surveys than the
older A-320. Although JetBlue already flies internationally
by serving destinations in Central and South America as well
as the Caribbean, Hayes is considering adding selected flights
to Europe. Flying non-stop to cities in Europe such as London
is now possible with the new Airbus A-321. Flying longer,
non-stop routes drives down costs. International routes, more-
over, tend to be much more profitable than domestic routes
because of less competition, for the time being.
CHAPTERCASE 6 Consider This . . .
Questions
1. Despite its initial success, why
was JetBlue unable to sustain
a blue ocean strategy?
2. JetBlue’s chief marketing officer, Marty St. George, was
asked by The Wall Street Journal, “What is the biggest
marketing challenge JetBlue faces?” His response: “We
are flying in a space where our competitors are moving
toward commoditization. We have taken a position that
air travel is not a commodity but a services business.
We want to stand out, but it’s hard to break through to
customers with that message.”45
a. Given St. George’s statement, which strategic posi-
tion is JetBlue trying to accomplish: differentiator,
cost leader, or blue ocean strategy? Explain why.
b. Which strategic moves has the new CEO put in
place, and why? Explain whether they focus on
value creation, operating costs, or both simultane-
ously. Do these moves correspond to St. George’s
understanding of JetBlue’s strategic position? Why
or why not? Explain.
3. Consider JetBlue’s value curve in Exhibit 6.11. Why
is JetBlue experiencing a competitive disadvantage?
What recommendations would you offer to JetBlue to
strengthen its strategic profile? Be specific.
4. JetBlue CEO Robin Hayes is contemplating adding
international routes, connecting the U.S. East Coast
to Europe. Would this additional international expan-
sion put more pressure on JetBlue’s current business
strategy? Or would this international expansion require
a shift in JetBlue’s strategic profile? Why or why not?
And if a strategic repositioning is needed, in which
direction should JetBlue pivot? Explain.
©Carlos Yudica/123RF
This chapter discussed two generic business-level strat-
egies: differentiation and cost leadership. Companies
can use various tactics to drive one or the other of those
strategies, either narrowly or broadly. A blue ocean
strategy attempts to find a competitive advantage by cre-
ating a new competitive area, which it does (when suc-
cessful) by value innovation, reconciling the trade-offs
between the two generic business strategies discussed.
TAKE-AWAY CONCEPTS
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212 CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans
These concepts are summarized by the following learn-
ing objectives and related take-away concepts.
LO 6-1 / Define business-level strategy and
describe how it determines a firm’s strategic
position.
■ Business-level strategy determines a firm’s strategic
position in its quest for competitive advantage when
competing in a single industry or product market.
■ Strategic positioning requires that managers
address strategic trade-offs that arise between
value and cost, because higher value tends to go
along with higher cost.
■ Differentiation and cost leadership are distinct
strategic positions.
■ Besides selecting an appropriate strategic posi-
tion, managers must also define the scope of
competition—whether to pursue a specific market
niche or go after the broader market.
LO 6-2 / Examine the relationship between
value drivers and differentiation strategy.
■ The goal of a differentiation strategy is to increase
the perceived value of goods and services so that
customers will pay a higher price for additional
features.
■ In a differentiation strategy, the focus of competi-
tion is on value-enhancing attributes and features,
while controlling costs.
■ Some of the unique value drivers managers can
manipulate are product features, customer service,
customization, and complements.
■ Value drivers contribute to competitive advan-
tage only if their increase in value creation (ΔV)
exceeds the increase in costs, that is: (ΔV) > (ΔC).
LO 6-3 / Examine the relationship between
cost drivers and cost-leadership strategy.
■ The goal of a cost-leadership strategy is to reduce
the firm’s cost below that of its competitors.
■ In a cost-leadership strategy, the focus of competi-
tion is achieving the lowest possible cost position,
which allows the firm to offer a lower price than
competitors while maintaining acceptable value.
■ Some of the unique cost drivers that managers can
manipulate are the cost of input factors, economies
of scale, and learning- and experience-curve effects.
■ No matter how low the price, if there is no acceptable
value proposition, the product or service will not sell.
LO 6-4 / Assess the benefits and risks of dif-
ferentiation and cost-leadership strategies vis-
à-vis the five forces that shape competition.
■ The five forces model helps managers use generic
business strategies to protect themselves against
the industry forces that drive down profitability.
■ Differentiation and cost-leadership strategies
allow firms to carve out strong strategic positions,
not only to protect themselves against the five
forces, but also to benefit from them in their quest
for competitive advantage.
■ Exhibit 6.8 details the benefits and risks of each
business strategy.
LO 6-5 / Evaluate value and cost drivers that
may allow a firm to pursue a blue ocean strategy.
■ To address the trade-offs between differentiation and
cost leadership at the business level, managers must
employ value innovation, a process that will lead
them to align the proposed business strategy with
total perceived consumer benefits, price, and cost.
■ Lowering a firm’s costs is primarily achieved by
eliminating and reducing the taken-for-granted fac-
tors on which the firm’s industry rivals compete.
■ Increasing perceived buyer value is primarily
achieved by raising existing key success factors
and by creating new elements that the industry
has not yet offered.
■ Strategic leaders track their opportunities and
risks for lowering a firm’s costs and increasing
perceived value vis-à-vis their competitors by use
of a strategy canvas, which plots industry factors
among competitors (see Exhibit 6.11).
LO 6-6 / Assess the risks of a blue ocean
strategy, and explain why it is difficult to suc-
ceed at value innovation.
■ A successful blue ocean strategy requires that
trade-offs between differentiation and low cost be
reconciled.
■ A blue ocean strategy often is difficult because
the two distinct strategic positions require internal
value chain activities that are fundamentally dif-
ferent from one another.
■ When firms fail to resolve strategic trade-offs
between differentiation and cost, they end up
being “stuck in the middle.” They then succeed at
neither business strategy, leading to a competitive
disadvantage.
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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 213
Blue ocean strategy (p. 204)
Business-level strategy (p. 185)
Cost-leadership strategy (p. 187)
Differentiation strategy (p. 186)
Diseconomies of scale (p. 196)
Economies of scale (p. 194)
Economies of scope (p. 190)
Focused cost-leadership
strategy (p. 188)
Focused differentiation
s trategy (p. 188)
Minimum efficient scale
(MES) (p. 195)
Scope of competition (p. 187)
Strategic trade-offs (p. 186)
Strategy canvas (p. 209)
Value curve (p. 209)
Value innovation (p. 205)
KEY TERMS
DISCUSSION QUESTIONS
1. What are some drawbacks and risks to a broad
generic business strategy? To a focused strategy?
2. In Chapter 4, we discussed the internal value
chain activities a firm can perform (see
Exhibit 4.7). The value chain priorities can be
quite different for firms taking different business
strategies. Create examples of value chains for
three firms: one using cost leadership, another
using differentiation, and a third using value inno-
vation business-level strategy.
3. The chapter notes there are key differences
between economies of scale and learning effects.
Let us put that into practice with a brief example.
A company such as Intel has a complex
design and manufacturing process. For instance,
one fabrication line for semiconductors typically
costs more than $1.5 billion to build. Yet the
industry also has high human costs for research
and development (R&D) departments. Semicon-
ductor firms spend an average of 17 percent of
revenues on R&D. For comparison the automo-
bile industry spends a mere 3 percent of sales on
R&D.46 Thus Intel’s management must be con-
cerned with both scale of production and learn-
ing curves. When do you think managers should
be more concerned with large-scale production
runs, and when do you think they should be
most concerned with practices that would foster
or hinder the hiring, training, and retention of
key employees?
ETHICAL/SOCIAL ISSUES
1. Suppose Procter & Gamble (P&G) learns that
the relatively new start-up company Method
(www.methodhome.com) is gaining market
share with a new laundry detergent in West
Coast markets. In response, P&G lowers the
price of its Tide detergent from $18 to $9 for
a 150-ounce bottle only in markets where
Method’s product is for sale. The goal of this
“loss leader” price drop is to encourage Method
to leave the laundry detergent market. Is this an
ethical business practice? Why or why not?
2. In the chapter discussion on value innovation,
IKEA is noted as a firm that has successfully
applied these techniques. What roles, if any, do
sustainability and triple-bottom-line factors have
in the success of IKEA as a leader in the furniture
industry? (See Chapter 5.)
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214 CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans
SMALL GROUP EXERCISES
//// SMALL GROUP EXERCISE 1
Ryanair based in Dublin, Ireland, has been renowned in
Europe as a firm that can make a profit on a $20 ticket by
imposing numerous fees and surcharges. The airline has
sought to be the lowest of the low-cost providers in the
EU with a “no frills get you from point A to B model.”
Ryanair is on record as saying it wants to be the “Ama-
zon.com of travel in Europe” by bringing in competi-
tors’ price comparison, hotel discounts, and even concert
tickets.47 Check out the company website (www.ryanair
.com) and consider the questions that follow.
1. If you were a competitor in the European market,
such as British Airways or Lufthansa, how would
you compete against Ryanair, knowing your cost
structure would not allow price parity? If you were
a low-cost leader like EasyJet, how would you
compete against Ryanair?
2. What similarities and differences do you find about
RyanAir compared to Jet Blue from ChapterCase 6?
//// SMALL GROUP EXERCISE 2
This chapter discusses several firms in the retailing envi-
ronment. Strategy Highlight 6.2 for example covers the
struggles JCPenney has had in recent years and the clos-
ing of 140 stores across the United States. JC Penney
is far from alone in having performance challenges. By
March 2017, 21 retailers (including Macy’s, Sears, and
The Limited) had announced the closure of over 3,500
stores affecting more than 50,000 jobs just in 2017.
Several factors are impacting the retailing industry. For
example, consumer behavior in developed countries is
shifting from shopping trips to social experiences. In
2016 the amount of money spent in restaurants and bars
for the first time surpassed that spent in grocery stores
across the United States. Complicating matters for
stores such as JCPenney, Macy’s, and Nordstrom, which
are largely based in malls, is a 2017 report that showed
the United States had 1,200 malls and probably needs
less than 900. On a per capita basis, the United States
has 40 percent more shopping space than Canada and a
remarkable 1,000 percent more than Germany.48
1. The retail department store is clearly a red ocean
space right now. Your team has been asked to con-
sult for Simon Property Group (SPG in NYSE), one
of the largest U.S. operators of shopping malls. The
company wants to know how its mall space could
be repurposed. What blue ocean ideas can your
team develop to present to the executives at Simon?
Consider the positives and negatives of typical mall
sizes and locations in your answer. Stretch beyond
traditional retailing for ideas to consider.
Low-Cost and Differentiated
Workplaces
W e have studied the differences in business-level strategies closely in this chapter, but how might these differences relate directly to you? As you’ve
learned, firms using a differentiation strategy will focus on driv-
ers such as product features and customer service, while firms
using a cost-leadership strategy will prioritize cost of inputs
and economies of scale. These strategic decisions can have an
impact on an employee’s experience with the firm’s work envi-
ronment and culture.
Nordstrom, Whole Foods Market (before its 2017 acquisi-
tion by Amazon), and Wegmans Food Markets are companies
that routinely end up on Fortune’s list of “100 Best Places to
Work.” These companies use a differentiation business strategy.
In contrast, Amazon and Walmart use the cost-leadership strat-
egy; and as low-cost leaders, they do not rate nearly as well.
According to inputs from the employee review site Glassdoor.
com, only 50 percent of the employees working at Walmart
would recommend the firm to a friend. Compare this to the
72 percent who would recommend both Nordstrom and Whole
Foods, and the 80 percent who would recommend Wegmans
Food Markets. As for Whole Foods, some industry watchers
believe Amazon will enact the same tactics in dealing with work-
ers at Whole Foods as it has applied to its own warehouse work-
ers, leading to a low rating of employee satisfaction.
As you seek options for starting or growing your career, carefully
consider the strategy the firm takes in the marketplace. By no means
mySTRATEGY
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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 215
should you avoid low-cost leaders in lieu of strong differentiators
(nor should you deem all differentiators as great places to work).
Fast-paced organizations that focus on driving tangible results for
the organization offer much to learn. For example, Amazon has been
a very successful company for the past decade, and many employ-
ees have had multiple opportunities to learn enormous amounts in a
short period. The firm has also made HR and cultural changes after
a scathing New York Times article about its “bruising workplace.”
Amazon has reportedly eliminated the practice of forcing employee
rankings to follow a normal curve with only a small percentage get-
ting top scores.
Amazon employees are encouraged to criticize each other’s
ideas openly in meetings; they work long days and on week-
ends; and they strive to meet “unreasonably high” standards.
“When you’re shooting for the moon, the nature of the work is
really challenging. For some people it doesn’t work,” says Susan
Harker, a top recruiter for Amazon. The high standards and
relentless pace are a draw for many employees who are moti-
vated to push themselves to learn, grow, and create— perhaps
beyond their perceived limits. Many former employees say the
nimble and productive environment is great for learning and
the Amazon experience has really helped their careers expand.
Now consider the following questions.
1. Employees and consultants say the Amazon workplace
is the epitome of a “do more for less cost” environment.
We recognize this is a hallmark goal of a cost-leadership
business strategy. But ask yourself this key question, Is it
the type of high-pressure work environment in which YOU
would thrive?
2. Amazon has surpassed 350,000 employees, adding more than
100,000 employees in 2016 alone! The company will be offer-
ing bold new ideas and moving Amazon toward being the first
trillion-dollar retailer under an intense pressure to deliver on
its goals. The allure from this type of success is compelling and
offers tremendous rewards to many employees, shareholders,
and customers. What aspects of success are you seeking in
your professional career?
3. Before you launch into a new project, job, or firm, or even
before you make a change in industry in the effort to move
forward in your career, always consider the trade-offs that
you would and would not be willing to make.49
1. This ChapterCase is based on: McCartney,
S. (2017, Mar. 8), “Discount business class?
Thank JetBlue,” The Wall Street Journal; Leahy,
J. (2017, Apr. 17), “Azul float raises hopes for
Brazil’s stalled IPO market,” Financial Times;
Lovelace Jr., B. (2017, Apr. 11), “Brazilian
airline Azul begins trading at the NYSE, shoots
8% higher,” CNBC; Carey, S. (2016, Dec. 16),
“JetBlue unveils cost-cutting plan worth up to
$300 million by 2020,” The Wall Street Journal;
Carey, S. (2016, Jul. 26), “JetBlue considers
foray into Europe,” The Wall Street Journal;
Carey, S. (2016, Apr. 12), “JetBlue to expand its
high-end service, dubbed Mint, to more routes,”
The Wall Street Journal; Nicas, J. (2015, Mar.
27), “Pilot sues JetBlue for allegedly letting him
fly while mentally unfit,” The Wall Street Jour-
nal; Mayerowitz, S. (2015, Feb. 16), “JetBlue’s
CEO vies to please passengers, stocks,” The
Associated Press; Vranica, S. (2015, Feb. 22),
“JetBlue’s plan to repair its brand,” The Wall
Street Journal; Harris, R.L. (2015, Feb. 11),
“On JetBlue, passengers can use ApplePay,”
The New York Times; Rosenbloom, S. (2015,
Jan. 22), “Flying deluxe domestic coast-to-
coast for around $1,000,” The New York Times;
Nicas, J. (2014, Nov. 19), “JetBlue to add bag
fees, reduce legroom,” The Wall Street Journal;
Gardiner, S. (2010, Aug. 10), “Flight attendant
grabs two beers, slides down the emergency
chute,” The Wall Street Journal; “Can JetBlue
weather the storm?” Time, February 21, 2007;
“Held hostage on the tarmac: Time for a pas-
senger bill of rights?” The New York Times,
February 16, 2007; Bryce, D.J., and J.H. Dyer
(2007), “Strategies to crack well-guarded mar-
kets,” Harvard Business Review, May; Kim,
C.W., and R. Mauborgne (2005), Blue Ocean
Strategy: How to Create Uncontested Market
Space and Make Competition Irrelevant (Bos-
ton, MA: Harvard Business School Publish-
ing); Friedman, T. (2005), The World Is Flat:
A Brief History of the Twenty-First Century
(New York: Farrar, Strauss and Giroux); and
Neeleman, D. (2003, Apr. 30), “Entrepreneurial
thought leaders lecture,” Stanford Technology
Ventures Program.
2. This discussion is based on: Porter, M.E.
(2008, Jan.), “The five competitive forces that
shape strategy,” Harvard Business Review;
Porter, M.E. (1996), “What is strategy?” Har-
vard Business Review, November–December;
Porter, M.E. (1985), Competitive Advantage:
Creating and Sustaining Superior Performance
(New York: Free Press); and Porter, M.E.
(1980), Competitive Strategy: Techniques for
Analyzing Industries and Competitors (New
York: Free Press).
3. These questions are based on: Priem, R.
(2007), “A consumer perspective on value
creation,” Academy of Management Review 32:
219–235; Abell, D.F. (1980), Defining the Busi-
ness: The Starting Point of Strategic Planning
(Englewood Cliffs, NJ: PrenticeHall); and Por-
ter, M.E. (1996), “What is strategy?” Harvard
Business Review, November–December.
4. The discussion of generic business strategies
is based on: Porter, M.E. (1980), Competitive
Strategy: Techniques for Analyzing Industries
and Competitors (New York: Free Press);
Porter, M.E. (1985), Competitive Advantage:
Creating and Sustaining Superior Performance
(New York: Free Press); Porter, M.E. (1996),
“What is strategy?” Harvard Business Review,
November–December; and Porter, M.E. (2008,
Jan.), “The five competitive forces that shape
strategy,” Harvard Business Review.
5. Porter, M.E. (1996), “What is strat-
egy?” Harvard Business Review,
November–December.
6. To decide if and how to divide the market,
you can apply the market segmentation tech-
niques you have acquired in your marketing and
microeconomics classes.
7. For sources on JetBlue, see: McCartney,
S. (2017, Mar. 8), “Discount business class?
ENDNOTES
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216 CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans
Thank JetBlue,” The Wall Street Journal; Leahy,
J. (2017, Apr. 17), “Azul float raises hopes for
Brazil’s stalled IPO market,” Financial Times;
Lovelace Jr., B. (2017, Apr. 11), “Brazilian
airline Azul begins trading at the NYSE, shoots
8% higher,” CNBC; Carey, S. (2016, Dec. 16),
“JetBlue unveils cost-cutting plan worth up to
$300 million by 2020,” The Wall Street
Journal; Carey, S. (2016, Jul. 26), “JetBlue
considers foray into Europe,” The Wall Street
Journal; Carey, S. (2016, Apr. 12), “JetBlue to
expand its high-end service, dubbed Mint, to
more routes,” The Wall Street Journal; Nicas,
J. (2015, Mar. 27), “Pilot sues JetBlue for alleg-
edly letting him fly while mentally unfit,” The
Wall Street Journal; Mayerowitz, S. (2015,
Feb. 16), “JetBlue’s CEO vies to please pas-
sengers, stocks,” The Associated Press; Vranica,
S. (2015, Feb. 22), “JetBlue’s plan to repair its
brand,” The Wall Street Journal; Harris, R.L.
(2015, Feb. 11), “On JetBlue, passengers can use
ApplePay,” The New York Times; Rosenbloom,
S. (2015, Jan. 23), “Flying deluxe domestic
coast-to-coast for around $1,000,” The New York
Times; Nicas, J. (2014, Nov. 19), “JetBlue to
add bag fees, reduce legroom,” The Wall Street
Journal; Gardiner, S. (2010, Aug. 10), “Flight
attendant grabs two beers, slides down the emer-
gency chute,” The Wall Street Journal; “Can
JetBlue weather the storm?” Time, February 21,
2007; “Held hostage on the tarmac: Time for a
passenger bill of rights?” The New York Times,
February 16, 2007; Bryce, D.J., and J.H. Dyer
(2007, May), “Strategies to crack well-guarded
markets,” Harvard Business Review; Friedman,
T. (2005), The World Is Flat: A Brief History
of the Twenty-First Century (New York: Farrar,
Strauss and Giroux); and Neeleman, D. (2003,
Apr. 30), “Entrepreneurial thought leaders
lecture,” Stanford Technology Ventures Program.
8. This example is drawn from “Companies
are racing to add value to water,” The Econo-
mist, March 25, 2017.
9. Christensen, C.M., and M.E. Raynor (2003),
The Innovator’s Solution: Creating and Sustain-
ing Successful Growth (Boston, MA: Harvard
Business School Press).
10. The interested reader is referred to the
strategy, marketing, and economics literatures.
A good start in the strategy literature is the clas-
sic work of M.E. Porter: Porter, M.E. (1980),
Competitive Strategy: Techniques for Analyzing
Industries and Competitors (New York: Free
Press); Porter, M.E. (1985), Competitive Advan-
tage: Creating and Sustaining Superior Perfor-
mance (New York: Free Press); and Porter, M.E.
(2008, Jan.), “The five competitive forces that
shape strategy,” Harvard Business Review.
11. www.oxo.com/about.jsp.
12. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus).
13. “Amazon opens wallet, buys Zappos,” The
Wall Street Journal, July 23, 2009.
14. “Where in the Dickens can you find a
Trader Joe’s,” store listing at www.traderjoes.
com/pdf/locations/all-llocations ; “Ten
companies with excellent customer service,”
Huffington Post, August 15, 2014, http://www.
huffingtonpost.com/2013/08/15/ best-customer-
service_n_3720052.html.
15. Olivarez-Giles, N. (2015, Jul. 7), “Project Fi
review: Google masters Wi-Fi calling, but needs
better phones,” The Wall Street Journal; Duran
M. (2015, Jul. 7), “Google’s Project Fi wireless
service is crazy cheap. But should you switch?”
Wired.
16. “Flights of hypocrisy,” The Economist,
April 25, 2015.
17. “Boeing 787: Orders and Deliveries
(updated monthly),” The Boeing Co., March
2015, www.boeing.com.
18. www.airbus.com/en/aircraftfamilies/a380/
home/.
19. Microsoft Annual Report (various years).
20. “Nucor’s new plant project still on hold,”
The Associated Press, July 23, 2009;
www.nucor.com.
21. On strategy as simple rules, see: Sull, D.,
and K.M. Eisenhardt (2015), Simple Rules:
How to Thrive in a Complex World (New York:
Houghton Mifflin Harcourt).
22. Gladwell, M. (2002), The Tipping Point:
How Little Things Can Make a Big Difference
(New York: Back Bay Books), 185.
23. Levitt, B., and J.G. March (1988), “Organi-
zational learning,”Annual Review of Sociology
14: 319–340.
24. For insightful reviews and syntheses on the
learning-curve literature, see: Argote, L., and
G. Todorova (2007), “Organizational learning:
Review and future directions,” International
Review of Industrial and Organizational Psy-
chology 22: 193–234; and Yelle, L.E. (1979),
“The learning curve: Historical review and
comprehensive survey,” Decision Sciences 10:
302–308.
25. Wright, T.P. (1936), “Factors affecting the
cost of airplanes,” Journal of Aeronautical Sci-
ences 3: 122–128.
26. The Tesla example draws on: Dyer, J., and
H. Gregersen (2016, Aug. 24),“Tesla’s innova-
tions are transforming the auto industry,”
Forbes; Higgins T. (2017, Apr. 10), “How
Tesla topped GM as most valuable U.S. auto-
maker,” The Wall Street Journal Tech Talk;
“Tesla increases deliveries of electric cars,” The
Economist, April 6, 2017; Tesla Annual Reports
(various years); and GM Annual Reports (vari-
ous years).
27. Dyer, J., and H. Gregersen (2016, Aug. 24),
“Tesla’s innovations are transforming the auto
industry,” Forbes. The authors (in conjunction
with David Kryscynski of Brigham Young Uni-
versity) estimate that the functional relationship
between production volume and production cost
for Tesla’s Model S between 2012 and 2014 is
Y=1726.5* (X^−0.363)
Data underlying Exhibit 6.6:
Units Per-Unit Cost ($)
100 $324,464
500 $180,901
1,000 $140,659
1,500 $121,407
2,000 $109,369
2,500 $100,859
3,000 $94,400
3,500 $89,263
4,000 $85,039
4,500 $81,480
5,000 $78,422
5,500 $75,756
6,000 $73,400
6,500 $71,298
7,000 $69,406
7,500 $67,689
8,000 $66,122
8,500 $64,683
9,000 $63,354
9,500 $62,123
10,000 $60,977
10,500 $59,907
11,000 $58,903
11,500 $57,961
12,000 $57,072
28. The exact data for learning curves depicted
in Exhibit 6.7 are depicted below. A simplify-
ing assumption is that the manufacturing of
one aircraft costs $100 million, from there the
two different learning curves set in. Notewor-
thy, that while making only one aircraft costs
$100 million, when manufacturing over 4,000
aircraft the expected per-unit cost falls to only
$28 million (assuming a 90 percent learning
curve) and only $7 million (assuming an 80 per-
cent learning curve).
Data underlying Exhibit 6.7
Learning Curves
Per-Unit Cost*
Units 90% 80%
1 $100 $100
2 90 80
4 81 64
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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 217
8 73 51
16 66 41
32 59 33
64 53 26
128 48 21
256 43 17
512 39 13
1,024 35 11
2,048 31 9
4,096 28 7
* Rounded to full dollar value in millions.
29. This discussion is based on: Gulati, R.,
D. Lavie, and H. Singh (2009), “The nature
of partnering experience and the gain from
alliances,” Strategic Management Journal
30: 1213–1233; Thompson, P. (2001), “How
much did the liberty shipbuilders learn? New
evidence from an old case study,” Journal of
Political Economy 109: 103–137; Edmond-
son, A.C., R.M. Bohmer, and G.P. Pisano
(2001), “Disrupted routines: Team learning
and new technology implementation in hos-
pitals,” Administrative Science Quarterly 46:
685–716; Pisano, G.P., R.M. Bohmer, and
A.C. Edmondson (2001), “Organizational
differences in rates of learning: Evidence
from the adoption of minimally invasive
cardiac surgery,” Management Science 47:
752–768; Rothaermel, F.T., and D.L. Deeds
(2006), “Alliance type, alliance experience,
and alliance management capability in high-
technology ventures,” Journal of Business
Venturing 21: 429–460; Hoang, H., and F.T.
Rothaermel (2005), “The effect of general
and partner-specific alliance experience on
joint R&D project performance,” Academy of
Management Journal 48: 332–345; Zollo, M.,
J.J. Reuer, and H. Singh (2002), “Interorgani-
zational routines and performance in strategic
alliances,” Organization Science 13: 701–713;
King, A.W., and A.L. Ranft (2001), “Captur-
ing knowledge and knowing through impro-
visation: What managers can learn from the
thoracic surgery board certification process,”
Journal of Management 27: 255–277; and
Darr, E.D., L. Argote, and D. Epple (1995),
“The acquisition, transfer and depreciation of
knowledge in service organizations: Produc-
tivity in franchises,” Management Science 42:
1750–1762.
30. Ramanarayanan, S. (2008), “Does prac-
tice make perfect: An empirical analysis
of learning-by-doing in cardiac surgery.”
Available at SSRN: http://ssrn.com/
abstract=1129350.
31. Boston Consulting Group (1972), Perspec-
tives on Experience (Boston, MA: Boston Con-
sulting Group).
32. “Coronary artery bypass grafting,” (2015),
healthcarebluebook.com, doi:10.1016/ B978-
1-84569-800-3.50011-5; Gokhale, K. (2013),
“Heart surgery in India for $1,583 Costs
$106,385 in U.S., Bloomberg Businessweek,
July 29; and Anand, G. (2009), “The Henry
Ford of heart surgery,” The Wall Street Journal,
November 25. See also: “Cardiac Surgeon
Salary (United States),” Payscale.com, survey
updated July 18, 2015.
33. See data presented in Endnote 28.
34. Anand, G. (2009, Nov. 25), “The Henry
Ford of heart surgery,” The Wall Street Journal.
35. This discussion is based on: Porter, M.E.
(1979), “How competitive forces shape strat-
egy,” Harvard Business Review, March–April:
137–145; Porter, M.E. (1980), Competitive
Strategy: Techniques for Analyzing Industries
and Competitors (New York: Free Press); and
Porter, M.E. (2008, Jan.), “The five competitive
forces that shape strategy,” Harvard Business
Review.
36. Vincent, J. (2017), “99.6 percent of new
smartphones run Android or iOS,” The Verge,
February 16. Data drawn from Gartner, a firm
tracking the information technology indus-
try. As of Q4 2016, the exact market share for
Google’s Android was 81.7 percent and for
Apple’s iOS was 17.9 percent, thus together they
hold 99.6 percent of the entire market, which
rounds up to 100 percent.
37. This discussion is based on: Kim, C.W.,
and R. Mauborgne (2017), Blue Ocean Shift:
Beyond Competing – Proven Steps to Inspire
Confidence and Seize New Growth (New York,
NY: Hachette); Kim, C.W., and R. Mauborgne
(2005), Blue Ocean Strategy: How to Create
Uncontested Market Space and Make Competi-
tion Irrelevant (Boston, MA: Harvard Business
School Publishing); Miller, A., and G.G. Dess
(1993), “Assessing Porter’s model in terms of
its generalizability, accuracy, and simplicity,”
Journal of Management Studies 30: 553–585;
and Hill, C.W.L. (1988), “Differentiation versus
low cost or differentiation and low cost: A con-
tingency framework,” Academy of Management
Review 13: 401–412.
38. Kim, C.W., and R. Mauborgne (2005), Blue
Ocean Strategy: How to Create Uncontested
Market Space and Make Competition Irrel-
evant (Boston, MA: Harvard Business School
Publishing); Miller, A., and G.G. Dess (1993),
“Assessing Porter’s model in terms of its gen-
eralizability, accuracy, and simplicity,” Journal
of Management Studies 30: 553–585; and Hill,
C.W.L. (1988), “Differentiation versus low cost
or differentiation and low cost: A contingency
framework,” Academy of Management Review
13: 401–412
39. Kim, C.W., and R. Mauborgne (2005), Blue
Ocean Strategy: How to Create Uncontested
Market Space and Make Competition Irrelevant
(Boston, MA: Harvard Business School Publish-
ing); Miller, A., and G.G. Dess (1993), “Assessing
Porter’s model in terms of its generalizability,
accuracy, and simplicity,” Journal of Management
Studies 30: 553–585; and Hill, C.W.L. (1988),
“Differentiation versus low cost or differentiation
and low cost: A contingency framework,” Acad-
emy of Management Review 13: 401–412.
40. Kim, C.W., and R. Mauborgne (2005),
Blue Ocean Strategy: How to Create Uncon-
tested Market Space and Make Competition
Irrelevant (Boston, MA: Harvard Business
School Publishing); Miller, A., and G.G. Dess
(1993), “Assessing Porter’s model in terms of
its generalizability, accuracy, and simplicity,”
Journal of Management Studies 30: 553–585;
and Hill, C.W.L. (1988), “Differentiation ver-
sus low cost or differentiation and low cost: A
contingency framework,” Academy of Man-
agement Review 13: 401–412
41. The IKEA example is drawn from:
“IKEA: How the Swedish retailer became a
global cult brand,” Bloomberg Businessweek,
November 14, 2005; Edmonds, M., “How Ikea
works” (accessed May 6, 2015), http://money.
howstuffworks.com/; and www.ikea.com.
42. “IKEA: How the Swedish retailer became
a global cult brand,” Bloomberg Businessweek,
November 14, 2005.
43. This discussion is based on: Porter, M.E.
(1980), Competitive Strategy: Techniques for
Analyzing Industries and Competitors (New
York: Free Press); and Porter, M.E. (1996),
“What is strategy?” Harvard Business Review,
November–December: 61–78.
44. Mattioli, D. (2013), “For Penney’s heralded
boss, the shine is off the apple,” The Wall Street
Journal, February 24; Bray, C. (2013, Feb. 25),
“Macy’s CEO: Penney, Martha Stewart deal
made me ‘sick,’” The Wall Street Journal; and
Lublin, S., and D. Mattioli (2013, Apr. 8),
“Penney CEO out, old boss back in,” The Wall
Street Journal.
45. Vranica S. (2015, Feb. 22), “JetBlue’s plan
to repair its brand,” The Wall Street Journal.
46. “McKinsey on Semiconductors,” McKinsey
& Co., Autumn 2011.
47. Whyte, P., “Ryanair plans to become ‘Ama-
zon’ of European travel,” TTGDigital, August
14, 2015.
48. This small group exercise is drawn from the
following sources: Loeb, W. (2017), “These 21
retailers are closing 3,591 stores—who is next?”
Forbes.com, March 20; and Thompson, D.
(2017, Apr. 10), “What in the world is causing
the retail meltdown of 2017?” The Atlantic.
49. Sources for this myStrategy include: Kan-
tor, J., and D. Streitfeld (2015, Aug. 15), “Inside
Amazon: Wrestling big ideas in a bruising
workplace,” The New York Times; “100 best
companies to work for,” Fortune, 2014, 2015;
and www.glassdoor.com.
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CHAPTER Business Strategy:
Innovation,
Entrepreneurship, and
Platforms
Chapter Outline
7.1 Competition Driven by Innovation
The Innovation Process
7.2 Strategic and Social Entrepreneurship
7.3 Innovation and the Industry Life Cycle
Introduction Stage
Growth Stage
Shakeout Stage
Maturity Stage
Decline Stage
Crossing the Chasm
7.4 Types of Innovation
Incremental vs. Radical Innovation
Architectural vs. Disruptive Innovation
7.5 Platform Strategy
The Platform vs. Pipeline Business Models
The Platform Ecosystem
7.6 Implications for Strategic Leaders
Learning Objectives
LO 7-1 Outline the four-step innovation process
from idea to imitation.
LO 7-2 Apply strategic management concepts to
entrepreneurship and innovation.
LO 7-3 Describe the competitive implications of dif-
ferent stages in the industry life cycle.
LO 7-4 Derive strategic implications of the
crossing-the-chasm framework.
LO 7-5 Categorize different types of innovations in
the markets-and-technology framework.
LO 7-6 Explain why and how platform businesses
can outperform pipeline businesses.
7
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Netflix: Disrupting the TV Industry
JUST LIKE CABLE content providers disrupted the broadcast
model of television, companies streaming video on demand
are now disrupting the television industry once again.
The disruption by cable content providers played out in the
1980s and 1990s, upsetting a handful of broadcast networks
with cable’s dozens and then hundreds of channels. The cur-
rent wave of disruption started in the 2000s, bypassing old-line
cable content providers for direct online streaming. Now a
multitude of devices—
TV, PC, laptop, tablet,
smartphone—provides
a screen for online
streaming. Netflix, rid-
ing atop the crest of this
wave to industry lead-
ership and competitive
advantage, accounts for
more than one-third of
all downstream internet
traffic in the United
States during peak
hours!
How did Netflix
get here? It started
as an obscure online
shop renting DVDs
delivered through
U.S. mail. After being
annoyed at having to
pay more than $40 in
late fees for a Block-
buster video, Reed
Hastings started Net-
flix in 1997 to offer
online rentals of
DVDs. At the time,
the commercial internet was in its infancy; Amazon had
just made its IPO in the same year. Streaming content may
have been only a distant dream in the era of dial-up internet,
but Netflix got a head start by turning from the dwindling
VHS format and dealing with DVDs, which were cheaper
and easier to mail. An improved business model helped too.
In 1999 Netflix rolled out a monthly subscription
model, with unlimited rentals for a single monthly rate
(and no late fees!). Rental DVDs were sent in distinctive
red envelopes, with preprinted return envelopes. New
rentals would not be sent until the current rental was
returned.
Even with an innovative business model, Netflix got
off to a slow start. By 2000, it had only about 300,000
subscribers and was losing money. Hastings approached
Blockbuster, at the time the largest brick-and-mortar
video rental chain with almost 8,000 stores in the United
States. He proposed
selling Blockbuster
49 percent of Netf-
lix and rebranding it
as Blockbuster.com.
Basically the idea was
that Netflix would
become the online
presence for the huge
national chain. The
dot-com bubble had
just burst, and Block-
buster turned Netflix
down cold. Netflix,
however, survived the
dot-com bust, and by
2002, the company
was profitable and
went public. Block-
buster began online
rentals in 2004, but
by this time, Netflix
already had a sub-
scriber base of almost
4 million and a strong
brand identity. Block-
buster lost 75 percent
of its market value
between 2003 and 2005. From there it went from bad to
worse. In 2010, the once mighty Blockbuster filed for
bankruptcy.
Netflix was at the forefront of the current wave of dis-
ruption in the TV industry as it began streaming content
over the internet in 2007. And it stayed at the forefront. It
CHAPTERCASE 7
House of Cards, a Netflix original series, stars Kevin Spacey and Robin Wright.
©A-Pix Entertainment/Photofest
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INNOVATION the successful introduction of a new product, process, or business
model—is a powerful driver in the competitive process. The ChapterCase provides
an example of how innovations in technology and business models can make existing com-
petitors obsolete, and how they allowed Netflix to gain a competitive advantage.
Continued innovation forms the bedrock of Netflix’s business strategy. Using big data
analytics, in particular, Netflix introduced a number of early innovations in the video rental
business. One of the more ingenious moves by Netflix was to have each user build a queue
of movies he or she wanted to watch next. This allowed Netflix to predict future demand
for specific movies fairly accurately. Another innovation was to create a “personalized rec-
ommendation engine” for each user that would predict what each subscriber might want to
watch next based not only on a quick rating survey and the subscriber’s viewing history, but
also what movies users with a similar profile had watched and enjoyed. Based on Netflix’s
proprietary learning algorithm, the recommendations would improve over time as the user’s
preferences become more clear. This also allowed Netflix to steer users away from hit mov-
ies (where wait times for DVD rentals were long because the company only had a limited
number in its library) to lesser-known titles in its catalog. The ability to bring in the long
tail3 of demand delighted not only viewers, as they enjoyed lesser-known, but often criti-
cally acclaimed films, but also movie studios, which could now make additional money on
movies that would otherwise not be in demand. Moreover, in contrast to other players in
the media industry, Netflix was fast to catch the wave of content streaming via the internet.
Innovation allows firms to redefine the marketplace in their favor and achieve a competi-
tive advantage.4 That’s why we focus on innovation and the related topic of entrepreneur-
ship in this chapter—to celebrate innovation as a powerful competitive weapon for business
strategy formulation. We begin this chapter by detailing how competition is a process driven
by continuous innovation. Next we discuss strategic and social entrepreneurship. We then
adjusted quickly to the new options consumers had to receive
content, making streaming available on a large number of
devices including mobile phones, tablets, game consoles, and
new devices dedicated to internet content streaming such as
Roku, Apple TV, and Google Chromecast. At the same time,
more and more Americans were signing up for high-speed
broadband internet connections, making streaming content
a much more enjoyable experience. The market for internet-
connected, large, high-definition flat-screen TVs also began
to take off. Within just two years, Netflix subscriptions (then
priced at $7.99 per month) jumped to 12 million.
Old-line media executives continued to dismiss Net-
flix as a threat. In 2010, Time Warner CEO Jeff Bewkes
snubbed Netflix, saying, “It’s a little bit like, is the Alba-
nian army going to take over the world? I don’t think so.”1
Even Reed Hastings called what Netflix provided “rerun
TV.” But behind their bravado, the broadcast networks were
waking up to the Netflix threat. They stopped distributing
content to Netflix and instead made it available through
Hulu.com, an online content website jointly owned by sev-
eral major networks. In 2011, Hulu began offering original
content that was not available on broadcast or cable televi-
sion. With its lower-cost structure, the networks saw Hulu’s
streaming model as a way to test new series ideas with mini-
mal financial risk. In response, Netflix announced a move
to create and stream original content online.
But not on the cheap. Since content streaming was
Netflix’s main business, it devoted significant resources
to produce high-quality content. In 2013, Netflix released
the political drama House of Cards, followed, among oth-
ers, by the comedy-drama Orange Is the New Black and
The Crown, a biographical series about Queen Elizabeth
II. These shows proved tremendous hits and have received
many Emmys and Golden Globes.
In 2017, Netflix had 100 million subscribers worldwide,
51 million in the United States. Its revenues were $9 billion,
and its market cap was more than $60 billion. Over the past
decade, Netflix’s stock appreciated by more than 4,200 per-
centage points, while the tech-heavy NASDAQ-100 index
grew by “only” 192 percentage points in the same period.
By innovating on many dimensions, Netflix was able to not
only disrupt the TV industry, but also to gain a competitive
advantage.2
You will learn more about Netflix by reading this chapter; related
questions appear in “ChapterCase 7 / Consider This. . . .”
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take a deep dive into the industry life cycle. This helps us to formulate a more dynamic busi-
ness strategy as the industry changes over time. We also introduce the crossing-the-chasm
framework, highlighting the difficulties in transitioning through different stages of the
industry life cycle. We then move into a detailed discussion of different types of innovation
using the markets-and-technology framework. We next present insights on how to compete
in two-sided markets when discussing platform strategy. As with every chapter, we con-
clude with practice-oriented Implications for Strategic Leaders.
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 leader-
ship 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 success-
ful 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 advertis-
ing 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 NBC-
Universal.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 dif-
ferent 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.
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 rap-
idly. 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 sys-
tems 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 com-
petitive 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
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
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
LO 7-1
Outline the four-step
innovation process from
idea to imitation.
invention The
transformation of
an idea into a new
product or process,
or the modification
and recombination of
existing ones.
EXHIBIT 7.1 / Accelerating Speed of Technological Change
Years
Car
Airplane
TelephoneElectricity
VCRMicrowave
RadioTV
8475715237353328
MP3
Internet
6 10 14
Cell
Phone PC
19
50
%
O
wn
er
sh
ip
/
Us
e
(U
.S
.)
SOURCE: Depiction of data from the U.S. Census Bureau, the Consumer Electronics Association, Forbes, and the National Cable and Telecommunications Association.
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can be patented.9 A patent is a form of intellectual property, and gives the inventor exclu-
sive 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 applica-
tion. 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 pro-
vide 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 com-
petitive 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 recommen-
dation 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 commer-
cialization 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, offer-
ing 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 ser-
vices 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.
EXHIBIT 7.2 /
The Four I’s: Idea, Inven-
tion, Innovation, and
Imitation
Idea
Invention
Innovation
Imitation
patent A form of
intellectual property
that 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.
trade secret Valuable
proprietary information
that is not in the public
domain and where the
firm makes every effort
to maintain its secrecy.
innovation The
commercialization of any
new product or process,
or the modification
and recombination of
existing ones.
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Successful innovators can benefit from a number of first-mover advantages,13 includ-
ing 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 pro-
grams (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 suc-
cessfully implemented to help firms gain and sustain a competitive advantage.
The innovation process ends with imitation. If an innovation is successful in the mar-
ketplace, 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 Ama-
zon 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 Broad-
casting (21st Century Fox), and Disney/ABC Television
Group (The Walt Disney Co.), Hulu Plus uses advertise-
ments 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 high-
light videos and events such as YouTube Music Awards
and YouTube Comedy Week14. 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 of potent competitors.
first-mover advantages
Competitive benefits
that accrue to the
successful innovator.
EXHIBIT 7.3 / Innovation: A Novel and Useful Idea
That Is Successfully Implemented
Novel
INNOVATION
Useful
Implemented
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7.2 Strategic and Social Entrepreneurship
Entrepreneurship describes the process by which change agents (entrepreneurs) under-
take 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 commercial-
ize 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 suc-
cessful 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 entrepre-
neurial model.”19 His net worth today is an estimated $1 billion.
■ 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 Emi-
nem. 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 larg-
est 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 prod-
ucts 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 envi-
ronmental, 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
LO 7-2
Apply strategic
management concepts
to entrepreneurship and
innovation.
entrepreneurship The
process by which
people undertake
economic risk to
innovate—to create new
products, processes,
and sometimes new
organizations.
Dr. Dre, rapper, music and
movie producer, as well as
highly successful serial
entrepreneur.
©JC Olivera/Getty Images
Entertainment/Getty Images
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applied 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 prod-
ucts 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 engi-
neer 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 tech-
nology 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 commercial-
izing 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 con-
cepts 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, formula-
tion, 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 finan-
cial 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).
entrepreneurs
The agents that
introduce change into
the competitive system.
strategic
entrepreneurship
The pursuit of
innovation using tools
and concepts from
strategic management.
social
entrepreneurship
The pursuit of social
goals while creating a
profitable business.
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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
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 nanotechnol-
ogy 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 dif-
ferent 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.
The development of most industries follows an S-curve. Initial demand for a new prod-
uct 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
LO 7-3
Describe the competitive
implications of different
stages in the industry life
cycle.
industry life cycle
The five different
stages—introduction,
growth, shakeout,
maturity, and decline—
that occur in the
evolution of an industry
over time.
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are 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 empha-
size 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
EXHIBIT 7.4 /
Industry Life Cycle:
The Smartphone
Industry in Emerging
and Developed
Economies M
ar
ke
t S
ize
MaturityGrowthIntroduction DeclineShakeout
Smartphones–
Emerging
Economies
in 2018
Smartphones–
Developed
Economies
in 2018
Time
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customers about the product’s intended benefits, find distribution channels and comple-
mentary 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 com-
petency 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 lever-
age 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 fac-
tor positively reinforces another. Apple’s ecosystem based
on integrated hardware, software, and services providing a
superior user experience is hard to crack for competitors.
network effects
The positive effect
(externality) that one
user of a product or
service has on the value
of that product for other
users.
EXHIBIT 7.5 / Leveraging Network Effects to
Drive Demand: Apple’s iPhone
Apple iPhone
Installed Base
Value of iPhone
Demand for
iPhone
iPhone
Apps
(+)
(+) (+)
(+)
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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 demon-
strated 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
Highlight 7.1 discusses the unfolding standards battle in the automotive industry.
standard
An agreed-upon solution
about a common set of
engineering features
and design choices.
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 tem-
porary 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 appropri-
ate 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 prob-
lem, 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 Charge-
Point, 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.
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 announc-
ing 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 com-
mitment 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 acro-
nym for Leading, Environmentally friendly, Affordable, Fam-
ily car) at a plant in Smyrna, Tennessee. Toyota is expanding
Strategy Highlight 7.1
The Nissan Leaf, the world’s best-selling electric vehicle.
©VDWI Automotive/Alamy Stock Photo RF
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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 stan-
dard 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.37
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 air-
plane, 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.
product innovation
New or recombined
knowledge embodied in
new products.
process innovation
New ways to produce
existing products
or deliver existing
services.
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 pre-
dictions prove more accurate.
An alternative outcome is that neither hybrids nor elec-
tric 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
Gasoline-Powered
Combustion Engine
Old Technology
Ra
te
o
f T
ec
hn
ol
og
ica
l P
ro
gr
es
s
• Electric
• Hybrid
• Hydrogen
• Solar
• Others . . .
Next Dominant
Technology
Time
Competing
Technologies
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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 load-
ing 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 container-
ization, 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 optimiza-
tion 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 esti-
mated that containerization alone more than tripled international trade within five years of
adopting this critical process innovation.39
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 prod-
uct works and that a market exists.
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 estab-
lish and optimize standard business processes through applications of lean manufacturing,
EXHIBIT 7.7 /
Product and Process
Innovation throughout an
Industry Life Cycle
Le
ve
l o
f I
nn
ov
at
io
n
Time
Introduction Growth Shakeout Maturity Decline
Process
Innovation
Product
Innovation
Product Innovation
Process
Innovation
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Six 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 mar-
ket, 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 strate-
gic 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 gradu-
ate Sara Blakely decided to cut the feet off her pantyhose to enhance her looks when wear-
ing pants.43 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
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to 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 mar-
ket 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 con-
solidates, 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 competi-
tive 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 strat-
egy, 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 econ-
omies 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 present-
ing 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
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has high exit barriers. At this final stage of the industry life cycle, managers generally have
four strategic options: exit, harvest, maintain, or consolidate:44
■ 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 sup-
port and allocates only a minimum of human and other resources. While several com-
panies 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
In the influential bestseller Crossing the Chasm45 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 differ-
ences 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 differ-
ences 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 seg-
ments. The industry life cycle model (shown in Exhibit 7.4) follows an S-curve leading
LO 7-4
Derive strategic
implications of the
crossing-the-chasm
framework.
crossing-the-chasm
framework Conceptual
model that shows
how each stage of the
industry life cycle is
dominated by a different
customer group.
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up 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 differ-
ent 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 lag-
gards. Each stage customer segment, moreover, is also separated by smaller chasms. Both
the large competitive chasm and the smaller ones have strategic implications.
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 seg-
ments 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 indus-
try 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.46 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 imperfec-
tions 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,
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.
Technology
Enthusiasts
2.5%
Late
Majority
34%
Early
Majority
34%
Early
Adopters
13.5%
Laggards
16%
THE
CHASM
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however, 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.
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 ver-
sion of Google Glass.
Although many industry leaders, includ-
ing Apple CEO Tim Cook, agree that wear-
able 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 impor-
tant mobile devices, they suggest that there is a large chasm between the current technol-
ogy 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 adopt-
ers, as the name suggests, are eager to buy early into a new technology or product con-
cept. 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 techno-
logical performance metrics but by intuition and imagination (What can this new prod-
uct 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 tech-
nological 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.
Google Glass allows the
wearer to use the internet
and smartphone-like applica-
tions via voice commands
(e.g., conduct online search,
stream video, and so on).
©AP Images/Google/REX
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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.49
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, how-
ever, 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 adopt-
ers), filing for bankruptcy. The assets of Fisker Automotive were purchased by Wanxiang,
a Chinese auto parts maker.50
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 technol-
ogy 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 enter-
ing the market in the maturity stage. Like the early majority, they are a large customer
Tesla Motors CEO Elon Musk
(left) in front of a Tesla Road-
ster; Fisker Automotive CEO
Henrik Fisker (right) in front
of a Fisker Karma.
©Misha Gravenor
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segment, 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 tran-
sition from stage to stage in the industry life cycle is characterized by different com-
petitive 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 indus-
try. The first victim was Motorola’s Iridium, an ill-fated satellite-based telephone sys-
tem.51 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
EXHIBIT 7.9 /
Crossing the Chasm: The
Mobile Phone Industry
Galaxy
iPhone
Tre
o
Bla
ckB
err
y
Technology
Enthusiasts
2.5%
Late
Majority
34%
Early
Majority
34%
Early
Adopters
13.5%
Laggards
16%
THE
CHASMIrid
ium
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on a remote island. Motorola’s solution was to launch 66 satellites into low orbit to pro-
vide 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 unob-
structed 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 introduc-
tory stage of the industry life cycle.
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 con-
sumer 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.56 BlackBerry’s managers
identified the needs of not only early adopters (e.g., IT managers) but also the early major-
ity (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 enthu-
siasts 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, Sam-
sung with its Galaxy line of phones, having successfully imitated the look-and-feel of an
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iPhone (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.
A word of caution is in order, however: Although the industry life cycle is a useful frame-
work 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 fac-
tors that can be captured in the PESTEL framework (introduced in Chapter 3) such as fads
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
low; process
innovation high
Product innovation
at a minimum;
process innovation
at a maximum
Market Growth Slow High Moderate and slowing
down
None to moderate Negative
Market Size Small Moderate Large Largest Small to moderate
Price High Falling Moderate Low Low to high
Number of
Competitors
Few, if any Many Fewer Moderate, but large Few, if any
Mode of
Competition
Non-price
competition
Non-price
competition
Shifting from non-price
to price competition
Price Price or non-price
competition
Type of Buyers Technology
enthusiasts
Early adopters Early majority Late majority Laggards
Business-Level
Strategy
Differentiation 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
EXHIBIT 7.10 / Features and Strategic Implications of the Industry Life Cycle
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in 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 break-
through innovation.57 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 air-
planes 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 control-
lers 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 inde-
pendent 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 busi-
ness 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
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 mate-
rials used to achieve a commercial objective.59 For example, Amazon integrates dif-
ferent 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;
LO 7-5
Categorize different types
of innovations in the
markets-and-technology
framework.
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Kindle tablets; Prime; cloud-computing ser-
vices; 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 suc-
cessfully commercialized.60 Measuring an
innovation along these dimensions gives us
the markets-and-technology framework
depicted in Exhibit 7.11. Along the horizon-
tal 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 dis-
ruptive 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.
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 knowl-
edge base and steadily improves an existing product or service offering.61 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.62 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 Bom-
bardier 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.
EXHIBIT 7.11 / Types of Innovation: Combining Markets and
Technologies
Architectural
Innovation
Radical
Innovation
Disruptive
Innovation
Incremental
Innovation
Existing
Ex
is
tin
g
Ne
w
New
TECHNOLOGIES
M
AR
KE
TS
markets-and-technology framework
A conceptual model to categorize
innovations along the market (existing/
new) and technology (existing/new)
dimensions.
incremental innovation
An innovation that squarely builds on an
established knowledge base and steadily
improves an existing product or service.
radical innovation
An innovation that draws on novel methods
or materials, is derived either from an
entirely different knowledge base or from
a recombination of the existing knowledge
bases with a new stream of knowledge.
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A predictable pattern of innovation is that firms (often new ventures) use radical inno-
vation 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 pat-
tern of strategic innovation. In 1903, entrepreneur King C. Gillette invented and began sell-
ing 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 clas-
sic 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! 63 Dollar Shave Club is dis-
rupting 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).64
The Gillette example, nonetheless, shows how radical innovation created a competi-
tive 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 innova-
tion 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 eco-
nomic incentives, organizational inertia, and the firm’s embeddedness in an innovation
ecosystem.65
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 indus-
try standard has emerged and technological uncertainty is reduced. Moreover, many mar-
kets 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 monop-
olist, 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 discov-
ered drugs based on genetic engineering to overcome entry barriers to the pharmaceutical
winner-take-all
markets Markets where
the market leader
captures almost all of
the market share and
is able to extract a
significant amount of
the value created.
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industry, in which incumbents had enjoyed notoriously high profits for several decades.
Because of differential economic incentives, incumbents often push forward with incre-
mental innovations, while new entrants focus on radical innovations.
ORGANIZATIONAL INERTIA. From an organizational perspective, as firms become estab-
lished 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 rein-
force 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 incre-
mental rather than radical innovations is that they become embedded in an innovation
ecosystem: a network of suppliers, buyers, complementors, and so on.66 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.67 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.68 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 apply-
ing 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 impor-
tantly, 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 7.12.69 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,
innovation ecosystem
A firm’s embeddedness
in a complex network of
suppliers, buyers, and
complementors, which
requires interdependent
strategic decision
making.
architectural innovation
A new product in which
known components,
based on existing
technologies, are
reconfigured in a novel
way to attack new
markets.
disruptive innovation
An innovation that
leverages new
technologies to attack
existing markets from
the bottom up.
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while 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, fre-
quently 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:
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 techno-
logical 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 smart-
phones are disrupting laptops.
■ Educational organizations such as Coursera and Udacity are disrupting traditional uni-
versities 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.70 Google’s
EXHIBIT 7.12 /
Disruptive Innovation: Rid-
ing the Technology Trajec-
tory to Invade Different
Market Segments from the
Bottom Up
Segment 1
Segment 2
Segment 3
Segment 4
Pe
rfo
rm
an
ce
Time
Technology trajectory (curved line) –
used by disruptive innovator to
invade market segments from the
bottom up
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Android, 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. More-
over, Google provides Android free of charge.71 In contrast to Microsoft’s proprietary
Windows operating system, Android is open-source software, accessible to anyone for fur-
ther 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.72
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 solu-
tion, 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 exist-
ing 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 ser-
vice 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.73 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,74 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 personal-
ized digital assistant (Alexa), consumer electronics (Kindle tablets), cloud computing,
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and 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 (Seg-
ment 1 in Exhibit 7.12) by introducing low-cost innovations to preempt stealth com-
petitors. 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 fol-
lowed up with the Atom chip, a new processor that is inexpensive and consumes little
battery power, to power low-cost mobile devices.75 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 prod-
ucts 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 Euro-
pean Union. This process is called reverse innovation,76 and allows a firm to disrupt
itself. Strategy Highlight 7.2 describes how GE Healthcare invented and commercial-
ized 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.
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.
In 2002, a GE team in China, through a bottom-up strate-
gic initiative, developed an inexpensive, portable ultrasound
device, combining laptop technology with a probe and sophis-
ticated 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 pro-
cure 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 wire-
less 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.77
Strategy Highlight 7.2
GE’s Vscan is a wireless ultrasound device priced around $5,000.
©VCG/Getty Images News/ Getty Images
reverse innovation An
innovation that was
developed for emerging
economies before being
introduced in developed
economies. Sometimes
also called frugal
innovation.
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7.5 Platform Strategy
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.78
■ 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 sin-
gle 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 plat-
form 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 2016.79 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 pro-
ducers and consumers.
LO 7-6
Explain why and how
platform businesses
can outperform pipeline
businesses.
platform business An
enterprise that creates
value by matching
external producers
and consumers in a
way that creates value
for all participants,
and that depends on
the infrastructure
or platform that the
enterprise manages.
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2. The platform’s overarching purpose is to consummate matches among users and facili-
tate the exchange of goods, services, or social currency, thereby enabling value cre-
ation for all participants.
3. The platform provides an infrastructure for these interactions and sets governance con-
ditions 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 finan-
cial sector over the last few decades,80 provides a more recent example of a multi-sided
market. Credit cards facilitate more frictionless transactions between vendors and custom-
ers 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 hail-
ing 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 avail-
able 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 perspec-
tive, 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 acces-
sibility online.
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 fre-
quently outperform pipeline businesses, because of the following advantages:81
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
platform ecosystem
The market environment
in which all players
participate relative to
the platform.
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lawyers, 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 com-
petitors 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 busi-
nesses 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 inven-
tory 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
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.
EXHIBIT 7.13 / The Players in a Platform Ecosystem
PLATFORM
CONSUMERSPRODUCERS
Value and data
exchange and
feedback
Controller of platform IP
and arbiter of who may
participate and in what ways
Interfaces for the
platform
Creators of the
platform’s offerings
Buyers or users of
the offerings
PROVIDERS
OWNER
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analytics. 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 mak-
ing 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 stream-
ing. 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 host-
ing 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 subscrip-
tion service to customers, resulting in more people signing up. With more customers, Net-
flix 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).
Growing its user base is critical for Netflix to sus-
tain 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 Ama-
zon, Hulu, and premium services on Google’s YouTube.
To lock in its large installed base of users, however, Net-
flix has begun producing and distributing original con-
tent 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
EXHIBIT 7.14 / Netflix Business Model: Leveraging
Network Effects to Drive Demand
More Netflix
Subscribers
Value of Netflix
Subscription
Demand for
Netflix Services
More
Content
(+)
(+) (+)
(+)
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engine, data-driven content investments, and network infra-
structure management.
Uber. The feedback loop in network effects becomes even
more apparent when taking a closer look at Uber’s busi-
ness model. Like many platforms, Uber performs a classic
matching service. In this case, it allows riders to find driv-
ers 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 feed-
back loop. Uber provides incentives for drivers to sign up
(such as extending credit so that potential drivers can pur-
chase 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.
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, dur-
ing 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).
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, neg-
ative network effects describe the situa-
tion where more and more users exit a
platform and the value that each remain-
ing 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 rev-
enues per user too early in its existence,
while Facebook first focused on build-
ing a social media platform that allowed
for the best possible user experience
before starting to monetize its user base
through selling ads.
EXHIBIT 7.15 / Uber’s Business Model:
Leveraging Network Effects to
Increase Demand
More Demand
More Geographic
Coverage
Faster
Pickups
More
Drivers
(+)
(+) (+)
(+)
EXHIBIT 7.16 / Uber’s Network Effects with Feedback Loop
More Demand
More Geographic
Coverage
Faster
Pickups
Less Driver
Downtime
Lower
Prices
More
Drivers
(+)
(+)
(+)
(+)
(+) (+)
(+)
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7.6 Implications for Strategic Leaders
Innovation drives the competitive process. An effective innovation strategy is critical in for-
mulating 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.82 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 fre-
quently 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 formu-
late 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:83
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 sus-
tain 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.
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
CHAPTERCASE 7 Consider This. . .
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 ©A-Pix Entertainment/
Photofest
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to view many or all episodes in one sitting, without any
advertising interruptions. As of 2017, spending an esti-
mated $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?’”84
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.
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 respon-
sible for more than one-third of all downstream internet traf-
fic 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 prece-
dent, 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.”85 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 con-
nections 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 inter-
net 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 circum-
vent net neutrality rules? Is this legal? Is this ethi-
cal? Explain.
d. As ISPs will extract more fees from Netflix, the
company continues to invest heavily in its proprie-
tary “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 provid-
ers continue to extract significant value from this
industry? Apply a five forces analysis.
2. Netflix growth in the United States seems to be matur-
ing. 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.
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256 CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms
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 develop-
ment of new knowledge in a four-step process
captured in the four I’s: idea, invention, innova-
tion, 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 modifi-
cation and recombination of existing ones.
■ Innovation concerns the commercialization of an
invention by entrepreneurs (within existing com-
panies 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 implica-
tions 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 formu-
late 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 recom-
bination 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).
TAKE-AWAY CONCEPTS
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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 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 busi-
nesses 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 pro-
ducers allow platforms to fine-tune their offerings
and to benefit from big data analytics.
Architectural innovation (p. 245)
Crossing-the-chasm
framework (p. 235)
Disruptive innovation (p. 245)
Entrepreneurs (p. 226)
Entrepreneurship (p. 225)
First-mover advantages (p. 224)
Incremental innovation (p. 243)
Industry life cycle (p. 227)
Innovation (p. 223)
Innovation ecosystem (p. 245)
Invention (p. 222)
Markets-and-technology frame-
work (p. 243)
Network effects (p. 229)
Patent (p. 223)
Platform business (p. 249)
Platform ecosystem (p. 250)
Process innovation (p. 231)
Product innovation (p. 231)
Radical innovation (p. 243)
Reverse innovation (p. 248)
Social entrepreneurship (p. 226)
Standard (p. 230)
Strategic entrepreneurship (p. 226)
Trade secret (p. 223)
Winner-take-all markets (p. 244)
KEY TERMS
DISCUSSION QUESTIONS
1. Patents are discussed as part of the invention
phase of the innovation process in Exhibit 7.2.
Describe the trade-offs that are made when a firm
decides to patent its business processes or soft-
ware. Is this same trade-off applicable to tangible
hardware products made by a firm?
2. Select an industry and consider how the indus-
try life cycle has affected business strategy for
the firms in that industry over time. Detail your
answer based on each stage: introduction, growth,
shakeout, maturity, and decline.
3. Describe a firm you think has been highly innova-
tive. Which of the four types of innovation—radical,
incremental, disruptive, or architectural—did it use?
Did the firm use different types over time?
4. The chapter discussed the internet as a disruptive
innovation that has facilitated online retailing. It
also has presented challenges to brick-and-mortar
retailers. How might retailers such as Nordstrom,
Neiman Marcus, or Macy’s need to change their
in-store experience to continue to attract a flow of
customers into their stores to expand sales using
direct selling and store displays of the actual mer-
chandise? If the internet continues to grow and
sales of brick-and-mortar retailers decline, how
might the retailers attract, train, and retain high-
quality employees if the industry is perceived as
in decline?
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258 CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms
ETHICAL/SOCIAL ISSUES
1. You are a co-founder of a start-up firm making
electronic sensors. After a year of sales, your
business is not growing rapidly, but you have
some steady customers keeping the business
afloat. A major supplier has informed you it can
no longer supply your firm because it is moving
to serve large customers only, and your volume
does not qualify. Though you have no current
orders to support an increased commitment to
this supplier, you do have a new version of your
sensor coming out that you hope will increase the
purchase volume by over 75 percent and qualify
you for continued supply. This supplier is impor-
tant to your plans. What do you do?
2. GE’s development of the Vscan provides many
benefits as a lower-cost and portable ultrasound
device (see Strategy Highlight 7.2). Cardiologists,
obstetricians, and veterinarians will be able to use
the device in rural areas and developing countries.
One of the criticisms of the device, however, is
that it also facilitates the use of the technology for
gender-selective abortion. In India, for example,
there is a cultural preference for males, and the
Vscan has been used to identify gender in order
to abort an unwanted female fetus. Some argue
that gender selection is also used for economic
reasons—specifically, to alleviate the financial
strain of the common dowry practice. A daughter
would require the family to pay a dowry of cash
and gifts to the bridegroom’s family in order to
arrange a suitable marriage, while a son would
bring in a dowry of cash, jewelry, gifts, and house-
hold items to help the couple start their home.86
To what extent is GE ethically responsible for
how—and why—the Vscan is used? (To what
extent is any company ethically responsible for
how—and why—its product is used?) Note that
GE’s website states that it is an “Agent of Good.”
Consider ways that GE might become involved in
communities in India to show the company’s con-
cern for the underlying problems by improving
conditions for women. What other ways might GE
influence how its equipment is used?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Your group works for Warner Music Group (www
.wmg.com), a large music record label whose sales are
declining largely due to digital piracy and online sales
overall. Your supervisor assigns you the task of devel-
oping a strategy for improving this situation.
1. What are the key issues you must grapple with
to improve the position of Warner Music Group
(WMG)?
2. In what phase of the life cycle is the record-label
industry?
3. How does this life cycle phase affect the types
of innovation that should be considered to help
WMG be successful?
//// Small Group Exercise 2
The text discusses the pros and cons of pipeline busi-
nesses and platform businesses. Several examples
of new platform businesses are mentioned (Uber,
Airbnb, Facebook, and Alibaba, for example). Yet it
is noted that these multi-sided markets have actually
been around much longer.
1. What are some of the biggest differences in the
historical way to view platform markets and the
more modern business incarnation?
2. In your group, discuss a company that could be
moving toward a platform business or a new firm
that is developing as a platform. Sketch out a busi-
ness model for this firm and the network loop it
could be utilizing to drive demand.
3. Can you identify a pipeline business that is likely
to be disrupted by the firm you discussed in ques-
tion 2 above? What could this pipeline business do
to improve its long-term viability?
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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 259
Do You Want to Be an Entrepreneur?
R ecent years have seen a sometimes public debate around the question of whether entrepreneurs are better off skipping college. For reasons noted below, we think this
is a false debate, and we’ll explain why. But before we’re done,
we will identify an unexpected way in which a higher education
can legitimately be seen as limiting one’s ability to innovate and
start a new business.87
Let’s start by acknowledging there are complex links
between education and entrepreneurship and by explicitly
stating our point of view: The right person can become an
entrepreneur without the benefit of a college degree. But
having a college degree is no impediment to becoming an
entrepreneur and can further provide the benefit of formally
studying the dynamics of business—just as we are doing in
this class.
One volley in the debate was a provocative article in Forbes,
titled “The Secret to Entrepreneurial Success: Forget College.”
Another article listed 100 impressive entrepreneurs, none with
a college degree and some with only an elementary school edu-
cation. And while some famous entrepreneurs neglected higher
education (Mark Zuckerberg dropped out of Harvard; Steve Jobs
dropped out of Reed College), entrepreneurs are more likely to
be better educated than most business owners. Just over half of
business owners have a college degree.
And while the very different entrepreneurs in this chapter
were chosen for their business success and innovations, and
not their education, they—Jeff Bezos, Sara Blakely, Reed Hast-
ings, Elon Musk, and Jimmy Wales—all have college degrees.
On the student side, business majors are drawn to the
entrepreneurial role. Over the past 20 years, there has been
an explosion of entrepreneurial programs at business schools,
all in response to demand. Some 50 to 75 percent of MBA stu-
dents from the leading programs are becoming entrepreneurs
within 15 years of graduation.
But there is a more likely way in which higher education
could be the enemy of entrepreneurship: the impact of large
student loans. According to a new report, the higher the student
loan debt in an area, the lower the net creation of very small
businesses. The correlation of those two factors comes with
some caveats:
• These effects tend to affect only the smallest businesses,
which are more likely to take on debt that’s secured by the
founder’s own personal credit.
• The authors of the report stop short of claiming that heavy
debt burdens hamper an individual’s attempt.
• An alternate view of the data would be that students with
high debt load go directly to higher paying corporate jobs.
1. Thinking about today’s business climate, would you say that
now is a good time to start a business? Why or why not?
2. Do you see higher education as a benefit or detriment to
becoming a successful entrepreneur? Why or why not?
3. Identify both the up and down sides of taking on personal
debt to finance a higher education.
4. Explain how you would apply the strategic management
framework to enhance your startup’s chances to gain and
sustain a competitive advantage.
mySTRATEGY
1. Auletta, K. (2014, Feb. 3), “Outside the
box: Netflix and the future of television,” The
New Yorker.
2. Ramachandran, S., and T. Stynes (2016,
Oct. 26), “Netflix CEO Reed Hastings talks
with WSJ Financial Editor Dennis K. Ber-
man at the 2016 WSJDlive Conference in
Laguna Beach, CA,” https://www.youtube.
com/watch?v=pBg3q2vHCLg [25:04 min];
“Netflix steps up foreign expansion,” The
Wall Street Journal, January 20, 2015;
Ramachandran, S., and S. Sharma (2015, Mar. 3),
“NBCU plans subscription comedy video
service,” The Wall Street Journal; Vranica, S.
(2015, Mar. 10), “Streaming services hammer
cable-TV ratings,” The Wall Street Journal;
Lin, L. (2015, May 15), “Netflix in talks to
take content to China,” The Wall Street Jour-
nal; Jenkins, H.W. (2015, Mar. 2017), “Netflix
is the culprit,” The Wall Street Journal; Jakab,
S. (2015, Apr. 14), “Don’t overlook Netflix’s
bigger picture,” The Wall Street Journal;
Armental, M., and S. Ramachandran (2015,
Apr. 15), “Netflix gains more users than pro-
jected,” The Wall Street Journal; Auletta, K.
(2014, Feb. 3), “Outside the box: Netflix and
the future of television” The New Yorker; “A
brief history of the company that revolution-
ized watching of movies and TV shows,”
http://netflix.com; “A brief history of Netflix”
(2014), CNN.com, www.cnn.com/2014/07/21/
showbiz/gallery/netflix-history/; Ramach-
andran, S. (2014, Feb. 23), “Netflix to pay
ENDNOTES
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260 CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms
Comcast for smoother streaming,” The Wall
Street Journal; and Darlin, D. (2005, Aug.
20), “Falling costs of big-screen TVs to keep
falling,” The New York Times.
3. The long tail is a business model in which
companies can obtain a large part of their
revenues by selling a small number of units
from among almost unlimited choices. See
Anderson, C. (2006), The Long Tail. Why the
Future of Business Is Selling Less of More
(New York: Hachette).
4. Rothaermel, F.T., and A. Hess (2010),
“Innovation strategies combined,” MIT Sloan
Management Review, Spring: 12–15.
5. Schumpeter, J.A. (1942), Capitalism,
Socialism, and Democracy (New York:
Harper & Row); Foster, R., and S. Kaplan
(2001), Creative Destruction: Why Compa-
nies That Are Built to Last Underperform the
Market—and How to Successfully Transform
Them (New York: Currency).
6. “Comcast, GE strike deal; Vivendi to
sell NBC stake,” The Wall Street Journal,
December 4, 2009.
7. Rothaermel, F.T., and D.L. Deeds (2004),
“Exploration and exploitation alliances in
biotechnology: A system of new product
development,” Strategic Management Journal
25: 201–221; Madhavan, R., and R. Grover
(1998), “From embedded knowledge to
embodied knowledge: New product develop-
ment as knowledge management,” Journal of
Marketing 62: 1–12; and Stokes, D.E. (1997),
Pasteur’s Quadrant: Basic Science and
Technological Innovation (Washington, DC:
Brookings Institute Press).
8. Isaacson, W. (2007), Einstein: His Life and
Universe (New York: Simon & Schuster).
9. A detailed description of patents can
be found at the U.S. Patent and Trademark
Office’s website at www.uspto.gov/.
10. Hallenborg, L., M. Ceccagnoli, and M.
Clendenin (2008), “Intellectual property pro-
tection in the global economy,” Advances in
the Study of Entrepreneurship, Innovation, and
Economic Growth 18: 11–34; and Graham,
S.J.H. (2008), “Beyond patents: The role of
copyrights, trademarks, and trade secrets in
technology commercialization,” Advances in
the Study of Entrepreneurship, Innovation, and
Economic Growth 18: 149–171.
11. “Sweet secrets—obituary: Michele Fer-
rero,” The Economist, February 21, 2015.
12. Schumpeter, J.A. (1942), Capitalism, Social-
ism, and Democracy (New York: Harper &
Row). For an updated and insightful discussion,
see Foster, R., and S. Kaplan (2001), Creative
Destruction: Why Companies That Are Built
to Last Underperform the Market—and How
to Successfully Transform Them (New York:
Currency). For a very accessible discussion,
see McCraw, T. (2007), Prophet of Innovation:
Joseph Schumpeter and Creative Destruction
(Boston: Harvard University Press).
13. Lieberman, M.B., and D.B. Montgomery
(1988), “First-mover advantages,” Strategic
Management Journal 9: 41–58.
14. Winkler, R., J. Nicas, and B. Fritz (2017,
Feb. 14), “Disney severs ties with YouTube
star PewDiePie after anti-Semitic posts,” The
Wall Street Journal; “Top 100 YouTubers by
Subscribed,” Social Blade, http://socialblade.
com/youtube/top/100/mostsubscribed
accessed February 21, 2017.
15. Schramm, C.J. (2006), The Entrepreneur-
ial Imperative (New York: HarperCollins).
Dr. Carl Schramm is president of the
Kauffman Foundation, the world’s leading
foundation for entrepreneurship.
16. Schumpeter, J.A. (1942), Capitalism,
Socialism, and Democracy (New York:
Harper & Row); Foster, R., and S. Kaplan
(2001), Creative Destruction: Why Compa-
nies That Are Built to Last Underperform the
Market—and How to Successfully Transform
Them (New York: Currency).
17. Shane, S., and S. Venkataraman
(2000), “The promise of entrepreneur-
ship as a field of research,” Academy of
Management Review 25: 217–226; Alvarez,
S., and J.B. Barney (2007), “Discovery and
creation: Alternative theories of entrepre-
neurial action,” Strategic Entrepreneurship
Journal 1: 11–26.
18. Drucker, P. (1985), Innovation and Entre-
preneurship (New York: HarperBusiness), 20.
19. Auletta, K. (2014, Feb. 3), “Outside the
box: Netflix and the future of television,” The
New Yorker.
20. Greenburg, Z. O’Malley (2015), “Why
Dr. Dre isn’t a billionaire yet,” Forbes, May
5; and “Dr. Dre net worth: $710 million in
2016,” Forbes, May 5, 2016.
21. Vinton, K. (2016), “Jeff Bezos becomes
second richest person on the Forbes
400,” Forbes, October 4.
22. http://elonmusk.com/.
23. Vance, A. (2015), Elon Musk: Tesla,
SpaceX, and the Quest for a Fantastic Future
(New York: Ecco).
24. Burgelman, R.A. (1983), “Corporate
entrepreneurship and strategic management:
Insights from a process study,” Management
Science 29: 1349–1364; Zahra, S.A., and J.G.
Covin (1995), “Contextual influences on the
corporate entrepreneurship-performance rela-
tionship: A longitudinal analysis,” Journal of
Business Venturing 10: 43–58.
25. Schumpeter, J.A. (1942), Capitalism,
Socialism, and Democracy (New York:
Harper & Row).
26. U.S. Patent 381968, see www.google.
com/patents/US381968.
27. Hitt, M.A., R.D. Ireland, S.M. Camp, and
D.L. Sexton (2002), “Strategic entrepreneur-
ship: Integrating entrepreneurial and strategic
management perspectives,” in Strategic Entre-
preneurship: Creating a New Mindset, ed.
M.A. Hitt, R.D. Ireland, S.M. Camp, and D.L.
Sexton (Oxford, UK: Blackwell Publishing);
Rothaermel, F.T. (2008, Oct. 12), “Strategic
management and strategic entrepreneurship,”
Presentation at the Strategic Management
Society Annual International Conference,
Cologne, Germany.
28. Hitt, M.A., R.D. Ireland, S.M. Camp, and
D.L. Sexton (2002), “Strategic entrepreneur-
ship: Integrating entrepreneurial and strategic
management perspectives,” in Strategic Entre-
preneurship: Creating a New Mindset, ed.
M.A. Hitt, R.D. Ireland, S.M. Camp, and D.L.
Sexton (Oxford, UK: Blackwell Publishing);
Rothaermel, F.T. (2008), “Strategic manage-
ment and strategic entrepreneurship,” Presen-
tation at the Strategic Management Society
Annual International Conference, Cologne,
Germany, October 12; Bingham, C.B., K.M.
Eisenhardt, and N.R. Furr (2007), “What
makes a process a capability? Heuristics, strat-
egy, and effective capture of opportunities,”
Strategic Entrepreneurship Journal 1: 27–47.
29. www.betterworldbooks.com/info.
aspx?f=corevalues.
30. This discussion is based on: “How Jimmy
Wales’ Wikipedia harnessed the web as a
force for good,” Wired, March 19, 2013.
31. Rothaermel, F.T., and M. Thursby
(2007), “The nanotech vs. the biotech revolu-
tion: Sources of incumbent productivity in
research,” Research Policy 36: 832–849; and
Woolley, J. (2010), “Technology emergence
through entrepreneurship across multiple
industries,” Strategic Entrepreneurship Jour-
nal 4: 1–21.
32. This discussion is built on the seminal
work by Rogers, E. (1962), Diffusion of Inno-
vations (New York: Free Press). For a more
recent treatise, see: Baum, J.A.C., and A.M.
McGahan (2004), Business Strategy over
the Industry Lifecycle, Advances in Strategic
Management, Vol. 21 (Bingley, United King-
dom: Emerald).
33. Moore, G.A. (1991), Crossing the Chasm.
Marketing and Selling Disruptive Prod-
ucts to Mainstream Customers (New York:
HarperCollins).
34. This discussion is based on: Schilling,
M.A. (2002), “Technology success and failure
in winner-take-all markets: Testing a model
of technological lockout,” Academy of Man-
agement Journal 45: 387–398; Shapiro, C.,
and H.R. Varian (1998), Information Rules.
A Strategic Guide to the Network Economy
(Boston, MA: Harvard Business School
Press); Hill, C.W.L. (1997), “Establishing a
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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 261
standard: Competitive strategy and winner-
take-all industries,” Academy of Management
Executive 11: 7–25; and Arthur, W.B. (1989),
“Competing technologies, increasing returns,
and lock-in by historical events,” Economics
Journal 99: 116–131.
35. This discussion is based on: Schilling,
M.A. (1998), “Technological lockout: An
integrative model of the economic and stra-
tegic factors driving technology success and
failure,” Academy of Management Review 23:
267–284; Utterback, J.M. (1994), Master-
ing the Dynamics of Innovation (Boston,
MA: Harvard Business School Press); and
Anderson, P., and M. Tushman (1990),
“Technological discontinuities and dominant
designs: A cyclical model of technological
change,” Administrative Science Quarterly 35:
604–634.
36. This Strategy Highlight is based on:
Boston, W. (2017), “Volvo plans to go elec-
tric, to abandon conventional car engine by
2019,” The Wall Street Journal, July 5. (Note:
Since 2010, Volvo Cars is owned by the Geely
Holding Group, a Chinese car manufac-
turer.) “Tesla unlocks real-time Supercharger
occupancy data on vehicle map,” Teslarati,
February 8, 2017, http://www.teslarati.
com/tesla-unlocks-real-time-supercharger-
occupancy-data-vehicle-map/; “Tesla is now
adding new stalls to existing Supercharger
stations as a ‘top priority,’ says CEO Elon
Musk,” Electrek, January 11, 2017, https://
electrek.co/2017/01/11/tesla-supercharger-
stations-adding-stall-top-priority-elon-musk/;
“Propulsion systems: The great powertrain
race,” The Economist, April 20, 2013; “Tesla
recharges the battery-car market,” The Econo-
mist, May 10, 2013; www.teslamotors.com/
supercharger; “Renault-Nissan alliance sells
its 250,000th electric vehicle,” www
.media.blog.alliance-renault-nissan.com/
news/24-juin-10-am/#sthash.lwx1fRYG.dpuf;
“Bright sparks,” The Economist, January 15,
2009; “The electric-fuel-trade acid test,” The
Economist, September 3, 2009; “At Tokyo
auto show, hybrids and electrics dominate,”
The New York Times, October 21, 2009; and
“Risky business at Nissan,” BusinessWeek,
November 2, 2009.
37. This discussion is based on: Ceccagnoli,
M., and F.T. Rothaermel (2008), “Appropriat-
ing the returns to innovation,” Advances in
Study of Entrepreneurship, Innovation, and
Economic Growth 18: 11–34; and Teece, D.J.
(1986), “Profiting from technological innova-
tion: Implications for integration, collabora-
tion, licensing and public policy,” Research
Policy 15: 285–305.
38. Benner, M., and M.A. Tushman (2003),
“Exploitation, exploration, and process
management: The productivity dilemma
revisited,” Academy of Management Review
28: 238–256; and Abernathy, W.J., and J.M.
Utterback (1978), “Patterns of innovation in
technology,” Technology Review 80: 40–47.
39. “Containers have been more important for
globalization than freer trade,” The Economist,
May 18, 2013, presents findings from the fol-
lowing research studies: Hummels, D. (2007),
“Transportation costs and international trade
in the second era of globalization,” Journal of
Economic Perspectives 21: 131–154; Baldwin,
R. (2011), “Trade and industrialization after
globalization’s 2nd unbundling: How building
and joining a supply chain are different and
why it matters,” NBER Working Paper 17716;
and Bernhofen, D., Z. El-Sahli, and R. Keller
(2013), “Estimating the Effects of the Con-
tainer Revolution on World Trade,” Working
Paper, Lund University.
40. This discussion is based on: Benner, M.,
and M.A. Tushman (2003), “Exploitation,
exploration, and process management: The
productivity dilemma revisited,” Academy of
Management Review 28: 238–256; and Aber-
nathy, W.J., and J.M. Utterback (1978), “Pat-
terns of innovation in technology,” Technology
Review 80: 40–47.
41. www.apple.com/ipad/pricing/.
42. www.geeks.com.
43. O’Connor, C. (2012), “How Sara Blakely
of Spanx turned $5,000 into $1 billion,”
Forbes, March 14. The history of Spanx is
documented at www.spanx.com.
44. Harrigan, K.R. (1980), Strategies for
Declining Businesses (Lexington, MA: Heath).
45. Moore, G.A. (1991), Crossing the Chasm.
Marketing and Selling Disruptive Prod-
ucts to Mainstream Customers (New York:
HarperCollins).
46. We follow the customer type category
originally introduced by Rogers, E.M. (1962),
Diffusion of Innovations (New York: Free
Press) and also used by Moore, G.A. (1991),
Crossing the Chasm. Marketing and Selling
Disruptive Products to Mainstream Custom-
ers (New York: HarperCollins): technology
enthusiasts (∼2.5%), early adopters (∼13.5%),
early majority (∼34%), late majority (∼34%),
and laggards (∼16%). Rogers’ book originally
used the term innovators rather than technology
enthusiasts for the first segment. Given the spe-
cific definition of innovation as commercial-
ized invention in this chapter, we follow Moore
(p. 30) and use the term technology enthusiasts.
47. “For wearable computers, future looks
blurry,” The Wall Street Journal, May 30, 2013.
48. Barr, A. (2015, Mar. 31), “Google Lab
puts a time limit on innovations,” The Wall
Street Journal.
49. Shiller, R. (1995), “Conversation, infor-
mation, and herd behavior,” American Eco-
nomic Review 85: 181–185.
50. Brickley, P. (2014, June 3), “Creditors
agree on Chapter 11 plan with former Fisker
Automotive,” The Wall Street Journal; “How
the wheels came off for Fisker,” The Wall
Street Journal, April 24, 2013; and “A year
of few dull moments,” The New York Times,
December 21, 2012.
51. The Iridium example is drawn from:
Finkelstein, S. (2003), Why Smart Executives
Fail: And What You Can Learn from Their
Mistakes (New York: Portfolio).
52. In inflation-adjusted 2012 U.S. dollars.
The original price in 1998 was $3,000 and the
cost per minute up to $8.
53. “HP gambles on ailing Palm,” The Wall
Street Journal, April 29, 2010.
54. “What’s gone wrong with HP?” The Wall
Street Journal, November 6, 2012.
55. In 2013, RIM adopted BlackBerry as its
company name.
56. Moore, G.A. (1991), Crossing the Chasm.
Marketing and Selling Disruptive Prod-
ucts to Mainstream Customers (New York:
HarperCollins).
57. Pasztor, A. and S. Carey (2017, Jan. 15),
“Space-based flight tracking comes closer with
launch of satellites,” The Wall Street Journal.
58. Shuen, A. (2008), Web 2.0: A Strategy
Guide (Sebastopol, CA: O’Reilly Media);
Thursby, J., and M. Thursby (2006), Here or
There? A Survey in Factors of Multinational
R&D Location (Washington, DC: National
Academies Press).
59. Byers, T.H., R.C. Dorf, and A.J. Nelson
(2011), Technology Entrepreneurship: From
Idea to Enterprise (New York: McGraw-Hill).
60. This discussion is based on: Schumpeter,
J.A. (1942), Capitalism, Socialism, and
Democracy (New York: Harper & Row);
Freeman, C., and L. Soete (1997), The Eco-
nomics of Industrial Innovation (Cambridge,
MA: MIT Press); and Foster, R., and S.
Kaplan (2001), Creative Destruction: Why
Companies That Are Built to Last Underper-
form the Market—and How to Successfully
Transform Them (New York: Currency).
61. The discussion of incremental and radi-
cal innovations is based on: Hill, C.W.L., and
F.T. Rothaermel (2003), “The performance of
incumbent firms in the face of radical techno-
logical innovation,” Academy of Management
Review 28: 257–274.
62. The discussion of incremental and radi-
cal innovations is based on: Hill, C.W.L., and
F.T. Rothaermel (2003), “The performance of
incumbent firms in the face of radical techno-
logical innovation,” Academy of Management
Review 28: 257–274.
63. Luna, T. (2014, Apr. 29), “The new Gil-
lette Fusion Pro-Glide Flexball razor, to be
available in stores June 9,” The Boston Globe;
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262 CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms
and “A David and Gillette story,” The Wall
Street Journal, April 12, 2012.
64. Chakravorti, B. (2016, Jul. 28), “Unilever’s
big strategic bet on the dollar shave club,”
Harvard Business Review; and Terlep, S.
(2016, Dec. 15), “P&G’s Gillette swipes at
Harry’s in new ad campaign,” The Wall Street
Journal.
65. This discussion is based on: Hill, C.W.L.,
and F.T. Rothaermel (2003), “The perfor-
mance of incumbent firms in the face of
radical technological innovation,” Academy of
Management Review 28: 257–274.
66. Adner, R. (2012), The Wide Lens. A
New Strategy for Innovation (New York:
Portfolio); Brandenburger, A.M., and B.J.
Nalebuff (1996), Co-opetition (New York:
Currency Doubleday); and Christensen,
C.M., and J.L. Bower (1996), “Customer
power, strategic investment, and the failure
of leading firms,” Strategic Management
Journal 17: 197–218.
67. Henderson, R., and K.B. Clark (1990),
“Architectural innovation: The reconfigura-
tion of existing technologies and the failure
of established firms,” Administrative Science
Quarterly 35: 9–30.
68. This example is drawn from: Chesbrough,
H. (2003), Open Innovation. The New Impera-
tive for Creating and Profiting from Technol-
ogy (Boston, MA: Harvard Business School
Press).
69. The discussion of disruptive innovation
is based on: Christensen, C.M. (1997), The
Innovator’s Dilemma: When New Tech-
nologies Cause Great Firms to Fail (Boston,
MA: Harvard Business School Press); and
Christensen, C.M., and M.E. Raynor (2003),
The Innovator’s Solution: Creating and
Sustaining Successful Growth (Boston, MA:
Harvard Business School Press).
70. Android here is used to include Chrome
OS. “Introducing the Google Chrome OS,”
The Official Google Blog, July 7, 2009,
http://googleblog.blogspot.com/2009/07/
introducinggoogle-chrome-os.html.
71. See the discussion on business models
in Chapter 1. See also: Anderson, C. (2009),
Free. The Future of a Radical Price
(New York: Hyperion).
72. Winkler, R. (2014, Jul. 31), “Android
market share hits new record,” The Wall Street
Journal.
73. Auletta, K. (2014, Feb. 3), “Outside the
box: Netflix and the future of television,” The
New Yorker.
74. Rindova, V., and S. Kotha (2001), “Con-
tinuous ‘morphing’: Competing through
dynamic capabilities, form, and function,”
Academy of Management Journal 44:
1263–1280.
75. The new processor not only is inexpen-
sive but also consumes little battery power.
Moreover, it marks a departure from the
Wintel (Windows and Intel) alliance, because
Microsoft did not have a suitable operating
system ready for the low-end netbook mar-
ket. Many of these computers are using free
software such as Google’s Android operating
system and Google Docs for applications.
76. Govindarajan, V., and C. Trimble (2012),
Reverse Innovation: Create Far from Home,
Win Everywhere (Boston, MA: Harvard Busi-
ness Review Press).
77. This Strategy Highlight is based on:
Immelt, J.R., V. Govindarajan, and C. Trimble
(2009), “How GE is disrupting itself,” Har-
vard Business Review, October; author’s inter-
views with Michael Poteran of GE Healthcare
(October 30 and November 4, 2009); and
“Vscan handheld ultrasound: GE unveils
‘stethoscope of the 21st century,’” The Huff-
ington Post, October 20, 2009.
78. This section is based on: Parker G.
G., M. W. Van Alstyne and S. P. Choudary
(2016), Platform Revolution: How Networked
Markets Are Transforming the Economy—
and How to Make Them Work for You (New
York: Norton). Examples are updated and
revised by the author or entirely new. Other
sources include: Eisenmann, T., G. G. Parker,
and M. W. Van Alstyne (2006), “Strategies
for two-sided markets,” Harvard Business
Review, October; Gawer, A. (2014), “Bridg-
ing differing perspectives on technological
platforms: Toward an integrative frame-
work,” Research Policy, 43: 1239–1249;
Gawer, A., and M. A. Cusumano (2008), “How
companies become platform leaders,” MIT
Sloan Management Review, Winter: 28–35.
79. Kingsbury, K. (2016, Aug. 2), “Face-
book, Amazon knock Exxon from ranks of
five biggest U.S. companies,” The Wall Street
Journal.
80. Eisenmann, T., G. G. Parker, and M. W.
Van Alstyne (2006, Oct.), “Strategies for two-
sided markets,” Harvard Business Review.
81. Parker, G. G., M. W. Van Alstyne and
S. P. Choudary (2016), Platform Revolu-
tion: How Networked Markets Are Transform-
ing the Economy—and How to Make Them
Work for You (New York: Norton), Chapter 1.
82. https://www.fastcompany.com/
most-innovative-companies/2017.
83. Parker, G. G., M. W. Van Alstyne and S. P.
Choudary (2016), Platform Revolution: How
Networked Markets Are Transforming the
Economy—and How to Make Them Work for
You (New York: Norton); and Parker, G. G.
(2016), “The rise of digital platforms,” The
Shard, February, https://www.youtube.com/
watch?v=r3pykplgUiw&t=2s [15:44 min].
84. Auletta, K. (2014, Feb. 3), “Outside the
box: Netflix and the future of television,” The
New Yorker.
85. Ramachandran, S., and T. Stynes (2016),
“Netflix CEO Reed Hastings talks with WSJ
Financial Editor Dennis K. Berman at the
2016 WSJDlive Conference in Laguna Beach,
CA,” October 26, https://www.youtube.com/
watch?v=pBg3q2vHCLg [25:04 min]
86. “Gendercide in India,” The Economist,
April 7, 2011; “Sex-selective abortion,” The
Economist, June 28, 2011; “India women: One
dishonourable step backwards,” The Econo-
mist, May 11, 2012; and “India’s skewed sex
ratios,” The Economist, December 18, 2012.
87. Sources for this myStrategy include:
“Why more MBAs are becoming entrepre-
neurs straight out of business school,” Busi-
ness Insider, July 24, 2014; “Top 25 colleges
for entrepreneurs,” Entrepreneur, September
15, 2014; “Does college matter for entrepre-
neurs?” Entrepreneur, September 21, 2011;
“The secret to entrepreneurial success: Forget
college,” Forbes, July 15, 2013; “Want to be
an entrepreneur: Avoid student debt,” The
Wall Street Journal, May 26, 2015; “Full-time
MBA programs: Stanford University,” Bloom-
berg Businessweek, November 13, 2008.
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Corporate Strategy:
Vertical Integration and
Diversification
Learning Objectives
LO 8-1 Define corporate strategy and describe the
three dimensions along which it is assessed.
LO 8-2 Explain why firms need to grow, and evalu-
ate different growth motives.
LO 8-3 Describe and evaluate different options
firms have to organize economic activity.
LO 8-4 Describe the two types of vertical integra-
tion along the industry value chain: back-
ward and forward vertical integration.
LO 8-5 Identify and evaluate benefits and risks of
vertical integration.
LO 8-6 Describe and examine alternatives to verti-
cal integration.
LO 8-7 Describe and evaluate different types of
corporate diversification.
LO 8-8 Apply the core competence–market matrix
to derive different diversification strategies.
LO 8-9 Explain when a diversification strategy does
create a competitive advantage and when it
does not.
Chapter Outline
8.1 What Is Corporate Strategy?
Why Firms Need to Grow
Three Dimensions of Corporate Strategy
8.2 The Boundaries of the Firm
Firms vs. Markets: Make or Buy?
Alternatives on the Make-or-Buy Continuum
8.3 Vertical Integration along the Industry Value
Chain
Types of Vertical Integration
Benefits and Risks of Vertical Integration
When Does Vertical Integration Make Sense?
Alternatives to Vertical Integration
8.4 Corporate Diversification: Expanding Beyond a
Single Market
Types of Corporate Diversification
Leveraging Core Competencies for Corporate
Diversification
Corporate Diversification and Firm Performance
8.5 Implications for Strategic Leaders
CHAPTER
8
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Amazon.com: To Infinity and Beyond
WHEN JEFF BEZOS started Amazon.com out of a garage
in a Seattle suburb to sell books online, he furnished his
makeshift office with discarded wood doors for desks.
In less than 25 years, Amazon morphed from a fledgling
startup into one of the world’s most valuable companies,
active in far-flung businesses from ecommerce and cloud
computing to media entertainment and groceries. Yet,
wood doors turning into desks remain a staple at Amazon,
where strict cost control is paramount to this day. At the
same time, in pursuing
its mission of being the
“earth’s most customer-
centric company,” Amazon
excels at customer ser-
vice. Indeed, a recent
survey ranked Amazon
as the most well-
regarded company in the
United States.
Amazon.com’s web-
site went live in 1995
and was an instant suc-
cess with booklovers
everywhere. The online
startup set itself apart
from other internet
merchants by pioneering one-click shopping, customer
reviews, and order verification via e-mail. Next, Amazon
executed a series of strategic alliances and acquisitions to
rapidly expand its product and service offerings. In 2000,
Amazon started to offer Marketplace, which is a platform
on which independent third-party sellers can access Ama-
zon customers globally. In 2005, Amazon launched its
Prime membership service. Subscribers pay $99 a year
and receive free two-day shipping, as well as access to
Amazon’s video and music streaming services. Besides
offering every imaginable product online, it sells its own
line of consumer electronics such as tablets, e-readers,
and voice-enabled wireless devices such as Echo. Among
them, the Kindle e-reader (launched in 2007) has trans-
formed the publishing industry. Amazon holds two-thirds
market share in e-books and now sells more e-books
than print books. Launched in 2014, Echo is powered by
Amazon’s Alexa, an intelligent digital assistant that marks
Amazon’s foray into augmented reality. It plays any song
you request, reads aloud your audiobooks, shares the lat-
est news and weather forecast, controls your home’s ther-
mostat and lights, and even turns on the home alarm or
the yard’s sprinkler system. Exhibit 8.1 depicts Amazon’s
key strategic initiatives and stock market valuation over
the years.
Carrying the moniker “the everything store,” Amazon has
become the largest online retailer in the United States, with
an estimated 400 million items available, some 50 times the
number sold by Walmart,
the world’s largest tradi-
tional retailer. Globally,
only Alibaba, China’s
leading ecommerce con-
glomerate, is larger than
Amazon. Besides offering
a wide variety of products
and services, Amazon
also diversified geograph-
ically pretty much from
the outset. In 1998, it
added country-specific
sites in the United King-
dom (amazon.co.uk) and
Germany (amazon.de) to
accommodate its growing
popularity in Europe. French (amazon.fr) and Japanese (ama-
zon.co.jp) Amazon sites debuted in 2000. Today, Amazon
operates country-specific sites in more than a dozen coun-
tries, including in China (amazon.cn), and is making a major
push into India (amazon.in), where the domestic Flipkart—
started by former Amazon employees—took an early lead.
In addition to diversification in products and services
as well as geography, Amazon also integrated vertically.
Created in 2006, Amazon Web Services (AWS) is a cloud-
based computing service, including software applications,
data storage, content delivery, payment and billing sys-
tems, and other business applications. Today, AWS is the
world’s largest cloud-computing provider. It is also Ama-
zon’s most profitable business endeavor. In 2016, AWS
gross revenues were $12 billion, with $1 billion in profits.
That is, AWS’ contribution to Amazon’s total revenues of
CHAPTERCASE 8
Jeff Bezos is founder and CEO of Amazon.com, one of the world’s most
valuable companies.
©Mike Kane/Bloomberg/Getty Images
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OVER TIME, AMAZON.COM has morphed from a mere online book retailer into
the “everything store.”2 In the process, it transformed into one of the world’s larg-
est retailers (larger than both brick-and-mortar retailers such as Walmart and most other
online retailers). From books, Amazon diversified into consumer electronics, media con-
tent, cloud-computing services, and other business endeavors. Jeff Bezos decided to com-
pete in a number of different industries, some related to Amazon’s core business of online
retailing, some unrelated.
How does an online bookseller turn into one of the most valuable tech companies on
the planet? The short answer: Vertical integration and diversification! Amazon is now a
widely diversified as well as integrated technology company. Vertical integration refers
to the firm’s ownership of its production of needed inputs or of the channels by which it
distributes its outputs. Amazon, for example, now creates its own video content, which
it distributes through its streaming services. Diversification encompasses the variety of
products and services a firm offers or markets and the geographic locations in which it
competes. Amazon offers a wide range of products and services. By virtue of being an
online business, Amazon has a global presence, reinforced by country-specific investments
in specialized sites (such as amazon.de in Germany).
But how does a business such as Amazon.com decide exactly where to compete?
Answers to this important question—in terms of products and services offered, value chain
activities, or geographic markets—are captured in a firm’s corporate strategy, which we
cover in the next three chapters. In this chapter, we define corporate strategy and then look
at two fundamental corporate strategy topics: vertical integration and diversification. We
conclude the chapter with Implications for Strategic Leaders, providing a practical appli-
cation of dynamic corporate strategy at Nike and Adidas.
$136 billion was 9 percent, while its profit contribution was
74 percent. By developing its own streaming video content
(such as The Man in the High Castle, an alternative history
about the Axis winning World War II), Amazon integrated
into media production.
Amazon continues to innovate. Besides offering same-
day delivery of groceries in some metropolitan areas and
testing drones for even faster distribution, Amazon has
introduced checkout free shopping in physical retail out-
lets (AmazonGo). In 2017 it became apparent these actions
were a prelude to its acquisition of Whole Foods Market.
Amazon will use AmazonGo at Whole Foods, reduce its
labor force, and cut prices by a large margin to further grow
its business.
Another recent innovation was AmazonCampus, a student-
centered program. Amazon runs co-branded university-
specific websites (such as purdue.amazon.com) that offer
textbooks, paraphernalia such as the ubiquitous logo sweat-
shirts and baseball hats, and even ramen noodles! As part of
this new campus initiative, Amazon offers its Prime mem-
bership to students at a 50 percent discount ($49 a year)
and guarantees unlimited next-day delivery of any goods
ordered online, besides all the other Prime membership ben-
efits (free streaming of media content, lending one e-book
a month for free, discounts on hardware, etc.). To accom-
plish next-day delivery, Amazon is building fashionable
delivery centers on campus, co-branded with the local uni-
versity such as “amazon@purdue.” Once a package arrives,
students receive a text message and can then retrieve it via
code-activated lockers or from Amazon employees directly.
The on-campus delivery facilities also serve as convenient
return centers.
With a market capitalization of some $500 billion, Ama-
zon is one of the top five most valuable technology compa-
nies in the world, besides Apple, Alphabet (Google’s parent
company), Microsoft, and Facebook. Over the past decade,
Amazon’s stock appreciated by 2,000 percentage points,
while the stock market overall (as proxied by the Dow Jones
Industrial Average) grew by 62 percentage points over the
same time period.1
You will learn more about Amazon.com by reading this chapter; related
questions appear in “ChapterCase 8 / Consider This. . . .”
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8.1 What Is Corporate Strategy?
Strategy formulation centers around the key questions of where and how to compete. Busi-
ness 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 low-
ering 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 dif-
ferent geographies. Strategic leaders must formulate a corporate strategy to guide contin-
ued 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 under-
stands 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
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.
LO 8-1
Define corporate strategy
and describe the three
dimensions along which it
is assessed.
corporate strategy The
decisions that senior
management makes
and the goal-directed
actions it takes to gain
and sustain competitive
advantage in several
industries and markets
simultaneously.
LO 8-2
Explain why firms need
to grow, and evaluate
different growth motives.
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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 merg-
ers 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 gener-
ally 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 pre-
senting 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 increas-
ing 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 prob-
lem 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 corpo-
rate 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
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in 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. Simi-
larly, 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 Ama-
zon 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 com-
pete 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 con-
cepts that will guide our discussion of vertical integration, diversification, and geographic com-
petition 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 compe-
tencies.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 econo-
mies 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 con-
sequence 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 boundar-
ies. 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
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 Transaction 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.
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 nego-
tiating, monitoring, and enforcing the contract.
■ Transaction costs can occur within the firm as well. Considered internal transac-
tion 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,
LO 8-3
Describe and evaluate
different options
firms have to organize
economic activity.
EXHIBIT 8.2 /
Internal and External
Transaction Costs
Internal
Transaction
Costs
Firm B
Internal
Transaction
Costs
Firm A
External
Transaction
Costs
Market
transaction cost economics A
theoretical framework in strategic
management to explain and predict
the boundaries of the firm, which is
central to formulating a corporate
strategy that is more likely to lead
to competitive advantage.
transaction costs All internal
and external costs associated
with an economic exchange,
whether within a firm or in
markets.
external transaction
costs Costs of searching for a
firm or an individual with whom
to contract, and then negotiating,
monitoring, and enforcing the
contract.
internal transaction
costs Costs pertaining to
organizing an economic
exchange within a hierarchy;
also called administrative costs.
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monitoring, and supervising work. Internal transaction costs also include administra-
tive 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 orga-
nizational 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 trans-
acting 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 develop-
ment 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 offer-
ings. Programmers working on the original proprietary software code for the Google search
engine leveraged these skills in creating a
highly profitable online advertising busi-
ness (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 ser-
vices are based on closely guarded and pro-
prietary software code. Google, like many
leading high-tech companies such as Ama-
zon, 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 pro-
hibitively 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 insti-
tutional arrangements for organizing eco-
nomic activity, have their own distinct
advantages and disadvantages, summarized
in Exhibit 8.3.
EXHIBIT 8.3 / Organizing Economic Activity: Firms vs. Markets
• Command and control
- Fiat
- Hierarchical lines of authority
• Coordination
• Transaction-specific
investments
• Community of knowledge
• High-powered incentives
• Flexibility
• Administrative costs
• Low-powered incentives
• Principal–agent problem
• Search costs
• Opportunism
- Hold-up
• Incomplete contracting
- Specifying & measuring
performance
- Information asymmetries
• Enforcement of contracts
Ad
va
nt
ag
es
Di
sa
dv
an
ta
ge
s
MarketsFirm
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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 attrac-
tive 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 secu-
rity and managerial perks (e.g., corporate jets and golf outings) that conflict with the prin-
cipal’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 own-
ers. 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 entrepre-
neur can make potentially enough money to provide financial security for life.15
■ 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 trans-
acting 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.
principal–agent
problem Situation
in which an agent
performing activities
on behalf of a principal
pursues his or her own
interests.
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■ 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 infor-
mation 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 integrat-
ing 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 exam-
ple.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.
The important take-away here is caveat emptor—buyer beware. Information asymme-
tries 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.17
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.18 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.
SHORT-TERM CONTRACTS. When engaging in short-term contracting, a firm sends
out requests for proposals (RFPs) to several companies, which initiates competi-
tive 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 buy-
ing 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
information
asymmetry Situation
in which one party is
more informed than
another because of the
possession of private
information.
© Big Pants Production/
Shutterstock.com RF
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industry 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 contin-
uum, the next organizational forms are strategic alliances. Strategic alliances are voluntary
arrangements between firms that involve the sharing of knowledge, resources, and capabili-
ties 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 transac-
tion 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 commer-
cialized 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 ser-
vices 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.
EXHIBIT 8.4 / Alternatives on the Make-or-Buy Continuum
BUY
Arm’s-length
market
transactions
Strategic Alliances
Short-term
contracts
Long-term contracts
• Licensing
• Franchising
Equity
alliances
Joint
ventures
Parent–
subsidiary
relationship
MAKE
Activities
performed
in-house
Integration
LESS MORE
strategic alliances
Voluntary arrangements
between firms that
involve the sharing of
knowledge, resources,
and capabilities with
the intent of developing
processes, products, or
services.
licensing A form of
long-term contracting
in the manufacturing
sector that enables
firms to commercialize
intellectual property.
franchising A long-
term contract in which
a franchisor grants a
franchisee the right to
use the franchisor’s
trademark and business
processes to offer
goods and services that
carry the franchisor’s
brand name.
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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 pur-
chases an ownership share by buying stock or assets (in private companies), and thus mak-
ing 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.
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).
Is Coke Becoming a Monster?
While Americans are drinking ever more nonalcoholic bev-
erages, 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 regu-
lar 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).
Albeit late to the party, Coca-Cola decided to not miss out
completely on energy drinks, one of the fastest-growing seg-
ments 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 pri-
vately held Monster Beverage at roughly $12 billion. What
might have finally persuaded Coca-Cola to make this deci-
sion? 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 lim-
iting potential exposure of Coca-Cola’s wholesome image and
brand. Meanwhile, Monster paid about $20 million to sponsor
NASCAR’s top racing series in 2017.22
Strategy Highlight 8.1
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
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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 con-
tract). 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 Corn-
ing 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 NBCU-
niversal, 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.24
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 par-
ent 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 capi-
tal budgeting process and transfer prices, among other
areas. Other areas of potential conflict concern how cen-
tralized or decentralized a subsidiary unit should be run.
For example, although GM owned its European car-
makers (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
credible commitment
A long-term strategic
decision that is both
difficult and costly to
reverse.
joint venture
A stand-alone
organization created
and jointly owned by
two or more parent
companies.
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 relation-
ships 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 ven-
ture for the Detroit automaker. Europe is one of the most competitive automobile mar-
kets 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. Divest-
ing 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 eco-
nomics 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?28 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 verti-
cal value chains, because they depict the transfor-
mation 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 expan-
sion of a firm up or down the vertical industry
value chain is called vertical integration.
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 dif-
ferent 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,
vertical integration
The firm’s ownership
of its production of
needed inputs or of the
channels by which it
distributes its outputs.
industry value chain
Depiction of the
transformation of raw
materials into finished
goods and services along
distinct vertical stages,
each of which typically
represents a distinct
industry in which a
number of different
firms are competing.
EXHIBIT 8.5 / Backward and Forward Vertical Integration
along an Industry Value Chain
Stage 1
• Raw Materials
Stage 2
• Components
• Intermediate Goods
Stage 3
• Final Assembly
• Manufacturing
Stage 4
• Marketing
• Sales
Stage 5
• After-Sales Service
& Support
UPSTREAM
INDUSTRIES
BACKWARD VERTICAL
INTEGRATION
DOWNSTREAM
INDUSTRIES
FORWARD VERTICAL
INTEGRATION
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are 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.29
All of these companies—from the raw- materials
suppliers to the service providers—make up the
global industry value chain that, as a whole, deliv-
ers 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
Along the industry value chain, firms pursue vary-
ing degrees of vertical integration in their corpo-
rate 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 gen-
eral, 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 inte-
grated 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
E&J Gallo, the California
winery, is fully vertically
integrated, following its cor-
porate strategy mantra “from
grape to glass.” E&J Gallo is
also the largest exporter of
California wines.
©Sherri Camp/123RF
LO 8-4
Describe the two types of
vertical integration along
the industry value chain:
backward and forward
vertical integration.
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plants, 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.)
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 verti-
cally integrated allows it to control quality better and to provide the end user with a better expe-
rience. 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 retail-
ing; all other value chain activities are outsourced.
Be aware that not all industry value chain stages are equally profitable. Apple cap-
tures 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 contin-
ued 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.30
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 competi-
tors. OEMs are able to vertically inte-
grate because they acquire the skills
needed to compete in adjacent industry
value chain activities from their alliance
partners, which need to share the tech-
nology 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.31 In doing so,
HTC engaged in backward vertical
integration—moving ownership of
activities upstream to the originating
inputs of the value chain. Moreover,
EXHIBIT 8.6 / HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
Stage 1
Stage 2
• Manufacturing
Stage 3
Stage 4
• After-Sales Service & Support
• Design
• Marketing & Sales
Apple, Google, HTC, Huawei, LG, Samsung, Xiaomi
Apple, Google, HTC, Huawei, LG, Samsung, Xiaomi
Flextronics, Foxconn, HTC, Inventec, other OEMs
AT&T, Google (Project Fi), Sprint, T-Mobile,
Verizon
BACKWARD
VERTICAL
INTEGRATION
FORWARD
VERTICAL
INTEGRATION
HTC
backward vertical
integration Changes in
an industry value chain
that involve moving
ownership of activities
upstream to the
originating (inputs) point
of the value chain.
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by 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 compe-
tency 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 indus-
try value chain.32 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 ben-
efit 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.
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, including33
■ Lowering costs.
■ Improving quality.
■ Facilitating scheduling and planning.
■ Facilitating investments in specialized assets.
■ Securing critical supplies and distribution channels.
forward vertical
integration Changes in
an industry value chain
that involve 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.
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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 inte-
grated into smartphone design by acquiring One & Co., a San Francisco-based design
firm.34 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 effec-
tively 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 Veri-
zon. 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 bet-
ter 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 knowl-
edge and skills, such as mastering the routines and procedures of a specific organiza-
tion, which are not transferable to a different employer.
Investments in specialized assets tend to incur high opportunity costs because mak-
ing the specialized investment opens up the threat of opportunism by one of the partners.
Opportunism is defined as self-interest seeking with guile.37 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 Cono-
coPhillips. 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.38
RISKS OF VERTICAL INTEGRATION. It is important to note that the risks of vertical inte-
gration can outweigh the benefits. Depending on the situation, vertical integration has sev-
eral risks, some of which directly counter the potential benefits, including39
■ Increasing costs.
■ Reducing quality.
■ Reducing flexibility.
■ Increasing the potential for legal repercussions.
specialized assets
Unique assets with high
opportunity cost: They
have significantly more
value in their intended
use than in their next-
best use. They come
in three types: site
specificity, physical-
asset specificity, and
human-asset specificity.
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A higher degree of vertical integration can lead to increasing costs for a number of rea-
sons. 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. Orga-
nizational complexity increases with higher levels of vertical integration, thereby increas-
ing 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 inte-
grated 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.41
U.S. regulators such as the Federal Trade Commission (FTC) and the Justice Depart-
ment (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.42 Before engaging in
vertical integration, therefore, strategic leaders need to be aware that this corporate strat-
egy 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 enter-
prise. 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 enforc-
ers 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 look-
ing 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 short-
ages 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, rub-
ber 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
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end. 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 flexibil-
ity 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 calcula-
tors. Bowmar, which at first led the calculator market, tried to go upstream into chip manu-
facturing 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 bot-
tling plants (and later divested them again).
Rita McGrath suggested that the siren call of vertical integration looms large for com-
panies 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 rec-
ommendation 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 inte-
grates 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 with-
out the risks of full ownership of the supply chain.
ALTERNATIVES TO VERTICAL INTEGRATION
Ideally, one would like to find alternatives to vertical integration that provide similar ben-
efits 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.
Taper integration has several benefits:47
■ It exposes in-house suppliers and distributors to market competition so that per-
formance comparisons are possible. Rather than hollowing out its competencies
by relying too much on outsourcing, taper integration allows a firm to retain and
LO 8-6
Describe and examine
alternatives to vertical
integration.
vertical market failure
When the markets
along the industry value
chain are too risky, and
alternatives too costly in
time or money.
taper integration
A way of orchestrating
value activities 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 of
its distribution.
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fine-tune its competencies in upstream and down-
stream value chain activities.48
■ Taper integration also enhances a firm’s flexibil-
ity. 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 perfor-
mance in both innovation and financial performance
when compared with firms that relied more on vertical
integration or strategic outsourcing.
STRATEGIC OUTSOURCING. Another alternative to ver-
tical 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 off-
shore 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 par-
ticular, 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.
EXHIBIT 8.7 / Taper Integration along the Industry
Value Chain
IN-HOUSE SUPPLIERS
Intermediate Goods
& Components
IN-HOUSE SUPPLIERS
Assembly
& Manufacturing
IN-HOUSE
DISTRIBUTORS
Retail & Service
OUTSIDE
SUPPLIERS
Intermediate Goods
& Components
OUTSIDE
DISTRIBUTORS
Retail & Sales
strategic
outsourcing Moving
one or more internal
value chain activities
outside the firm’s
boundaries to other
firms in the industry
value chain.
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2. Product 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 mar-
kets? Coca-Cola, for example, focuses on soft drinks and thus on a single product mar-
ket. 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 diversifi-
cation 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.52 Interestingly, KFC has more restau-
rants 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.)53 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 geographi-
cally diversified Yum Brands.54
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.56
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
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concerned 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, espe-
cially 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 diversifi-
cation 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.57
There are various general diversification strategies:
■ A firm that is active in several different product markets is pursuing a product diversi-
fication strategy.
■ A firm that is active in several different countries is pursuing a geographic diversifica-
tion 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 lead-
ers 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
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:58
■ 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 domi-
nant business. Asking questions about the relationship of core competencies across busi-
ness 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.
diversification An
increase in the variety
of products and services
a firm offers or markets
and the geographic
regions in which it
competes.
product diversification
strategy Corporate
strategy in which a
firm is active in several
different product
markets.
geographic
diversification
strategy Corporate
strategy in which a
firm is active in several
different countries.
product–market
diversification
strategy Corporate
strategy in which a
firm is active in several
different product
markets and several
different countries.
LO 8-7
Describe and evaluate
different types of
corporate diversification.
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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 name-
sake 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 rev-
enue (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.59 The remaining 20 percent of revenues come from
other business activities such as motorcycle parts and accessories as well as general mer-
chandise, 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 rev-
enues 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 com-
mon 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.60 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 commercializa-
tion 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 com-
pany believes that roughly 50 percent of the world’s energy for the next 50 years will con-
tinue 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
R
70%-
95%
<70%
R R
>95%
related diversification
strategy Corporate
strategy in which a firm
derives less than 70
percent of its revenues
from a single business
activity and obtains
revenues from other
lines of business that
are linked to the primary
business activity.
related-constrained
diversification
strategy A kind of
related diversification
strategy in which
executives pursue only
businesses where they
can apply the resources
and core competencies
already available in the
primary business.
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scenario 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.61
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.62 Such an arrangement helps firms gain and sustain
competitive advantage because it allows the conglomerate to overcome institutional weak-
nesses 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 conglom-
erate that follows an unrelated diversification strategy.
<70%
R R
related-linked
diversification
strategy A kind of
related diversification
strategy in which
executives pursue
various businesses
opportunities that share
only a limited number of
linkages.
<70%
R R
The Tata Group: Integration at the
Corporate Level
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 automo-
biles. 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).
Strategy Highlight 8.2
(continued)
unrelated
diversification
strategy Corporate
strategy in which a firm
derives less than 70
percent of its revenues
from a single business
and there are few, if
any, linkages among its
businesses.
conglomerate A
company that combines
two or more strategic
business units under
one overarching
corporation; follows an
unrelated diversification
strategy.
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The Range Rover 5.0L V8 Supercharged SV Autobiography starts at $200,000.
©Bloomberg/Getty Images
Tata Nano GenX starts at $3,100.
©PUNIT PARANJPE/AFP/Getty Images
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
Tata Motors designed the Nano to wean India’s emerg-
ing middle class from mopeds and bikes, expanding the mar-
ket. 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.
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 oper-
able 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 corpo-
rate level.
FUTURE AT THE LOW END Sales of the Nano mod-
els 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 com-
petitor 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 bet-
ter. 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.63
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Exhibit 8.8 summarizes the four main types of diversification—single business, domi-
nant business, related diversification (including its subcategories related-constrained and
related-linked diversification), and unrelated diversification.
LEVERAGING CORE COMPETENCIES FOR
CORPORATE DIVERSIFICATION
In Chapter 4, when looking inside the firm, we introduced the idea that competitive advan-
tage can be based on core competencies. Core competencies are unique strengths embed-
ded 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.64 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
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).
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
>95%
70%–95% Dominant business Dominant and minor
businesses share
competencies.
Harley-Davidson
Nestlé
UPS
R
70%-
95%
Related Diversification
<70%
Related-constrained Businesses generally share
competencies.
ExxonMobil
Johnson & Johnson
Nike
<70%
R R
Related-linked Some businesses share
competencies.
Amazon
Disney
GE
R R
<70%
Unrelated
diversification
(conglomerate)
Businesses share few, if
any, competencies.
Samsung
Berkshire Hathaway
Yamaha
<70%
R R
EXHIBIT 8.8 / Four Main Types of Diversification
LO 8-8
Apply the core
competence–market
matrix to derive different
diversification strategies.
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growth. Managers respond to this relentless growth imperative by leveraging their exist-
ing 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 situa-
tion. When applying an existing or new dimension to core competencies and markets, four
quadrants emerge, each with distinct strategic implications.
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.65 Devel-
oped 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, acquir-
ing, 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 com-
pete in future markets. During the
global financial crisis in 2008, Bank
of America bought the investment
bank Merrill Lynch for $50 billion.66
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 manag-
ers 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 invest-
ment bankers to follow up.67
EXHIBIT 8.9 / The Core Competence–Market Matrix
Building
new core competencies
to protect and extend
current market position
Building
new core competencies
to create and compete
in markets of the future
Leveraging
core competencies
to improve current
market position
Redeploying and
recombining core
competencies to compete
in markets of the future
Ne
w
NewExisting
Ex
is
tin
g
CO
RE
CO
M
PE
TE
NC
E
MARKET
SOURCE: Adapted from G. Hamel and C.K. Prahalad (1994), Competing for the Future (Boston, MA: Harvard
Business School Press).
core competence–
market matrix A
framework to guide
corporate diversification
strategy by analyzing
possible combinations
of existing/new core
competencies and
existing/new markets.
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The upper-left quadrant combines new core competencies with existing market oppor-
tunities. Here, managers must come up with strategic initiatives to build new core compe-
tencies 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 Gato-
rade, which still holds close to 80 percent of the market.68
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.69 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 competi-
tion 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 exist-
ing 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.
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 ques-
tion, we need to evaluate the performance of diversified companies. The critical question
LO 8-9
Explain when a
diversification strategy
does create a competitive
advantage and when it
does not.
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to ask when doing so is whether the individual businesses are worth more under the com-
pany’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 relation-
ship between the type of diversification and overall firm performance, as depicted in
Exhibit 8.10.70 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.
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.71 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.72 Through this restructuring of the corporate portfolio, GE is now better posi-
tioned to focus more fully on its core competencies in industrial engineering and manage-
ment 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 8.2.73 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 pur-
sue related diversification are more
likely to improve their perfor-
mance. They create a diversification
premium: The stock price of related-
diversification firms is valued at
greater than the sum of their individ-
ual business units.74
Why is this so? At the most basic
level, a corporate diversification strat-
egy 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 perfor-
mance, it must do at least one of the
following:
EXHIBIT 8.10 / The Diversification-Performance Relationship
Pe
rf
or
ma
nc
e
Single
Business
Unrelated
Diversification
Related
Diversification
Related-constrained
Related-linked
Dominant
Business
Level of Diversification
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.
diversification
discount Situation in
which the stock price
of highly diversified
firms is valued at less
than the sum of their
individual business
units.
diversification
premium Situation in
which the stock price of
related-diversification
firms is valued at
greater than the sum of
their individual business
units.
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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 diversifi-
cation strategy include financial economies, resulting from restructuring and using internal
capital markets.
RESTRUCTURING. Restructuring describes the process of reorganizing and divesting busi-
ness 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 distribut-
ing beer across the world.75
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 portfo-
lio planning is the Boston Consulting Group (BCG) growth–share matrix, shown in
Exhibit 8.12.76 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 catego-
ries shape the firm’s corporate strategy.
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
EXHIBIT 8.11 /
Vertical Integration
and Diversification:
Sources of Value
Creation and 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
Related Diversification • Economies of scope
• Economies of scale
• Financial economies
■ Restructuring
■ Internal capital markets
• Coordination costs
• Influence costs
Unrelated Diversification • Financial economies
■ Restructuring
■ Internal capital markets
• Influence costs
Boston Consulting
Group (BCG) growth–
share matrix A
corporate planning tool
in which the corporation
is viewed as a portfolio
of business units,
which are represented
graphically along
relative market share
(horizontal axis) and
speed of market growth
(vertical axis). SBUs
are plotted into four
categories (dog, cash
cow, star, and question
mark), each of which
warrants a different
investment strategy.
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unstable earnings, combined with neutral or negative cash flows. The strategic recom-
mendations are either to divest the business or to harvest it. This implies stopping invest-
ment 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 con-
siderable 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 invest-
ments 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 execu-
tives 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.
EXHIBIT 8.12 /
Restructuring
the Corporate
Portfolio: The Boston
Consulting Group
Growth–Share Matrix
Question Mark
Earnings: Low, unstable, or growing
Cash flow: Negative
Strategy: Increase market
share or harvest/divest
Earnings: Low, unstable
Cash flow: Neutral or negative
Strategy: Harvest/divest
Earnings: High, stable
Cash flow: High, stable
Strategy: Hold
Earnings: High, stable, or growing
Cash flow: Neutral
Strategy: Hold or invest
for growth
Dog Cash Cow
High
Low
M
AR
KE
T
GR
OW
TH
Low
RELATIVE MARKET SHARE
High
Star
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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.77 In combination with GE’s triple-A debt rat-
ing, 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 busi-
ness 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 incremen-
tal 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.78
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, corpo-
rate strategy needs to be dynamic over
time. As firms grow, they tend to diver-
sify and globalize to capture additional
growth opportunities. Exhibit 8.13 shows
the dynamic nature of corporate strategy
through decisions made by two top com-
petitors in the sports footwear and apparel
industry: Nike and Adidas.
Adidas was founded in 1924 in Ger-
many. 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
EXHIBIT 8.13 / Dynamic Corporate Strategy: Nike vs. Adidas
Diversification
in products and services
Ve
rt
ic
al
In
te
gr
at
io
n
al
on
g
st
ag
es
o
f i
nd
us
try
va
lu
e
ch
ai
n
Nike
2013Nike
1978
Adidas
1924
Adidas
2013
Nike
2018Nike
1978
Adidas
1924
Adidas
2018
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298 CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
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decades 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 rev-
enues 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 verti-
cal 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 diversifi-
cation strategy and competitive advantage depends on the type of diversification. There
exists an inverted U-shaped relationship between the level of diversification and perfor-
mance 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 coordi-
nation 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.
ALTHOUGH AMAZON is one of the largest technology compa-
nies 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, prod-
ucts 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 Ama-
zon competes with Walmart and the Chinese ecommerce
company Alibaba. In data services and cloud computing, it
CHAPTERCASE 8 Consider This. . .
competes with Microsoft, IBM,
and others. Indeed, the list of
Amazon’s competitors keeps
increasing rapidly, as this pas-
sage from its 2016 annual report
makes clear:79
“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 [includ-
ing]: (1) online, offline, and multichannel retailers,
©Mike Kane/Bloomberg/
Getty Images
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CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 299
publishers, vendors, distributors, manufacturers, and
producers of the products we offer. . .; (2) publish-
ers, producers, and distributors of physical, digital,
and interactive media of all types and all distribu-
tion channels; (3) web search engines, comparison
shopping websites, social networks, [and] web por-
tals. . .; (4) companies that provide ecommerce ser-
vices. . .; (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, manu-
facture, market, or sell consumer electronics, tele-
communication, 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 sugges-
tions that Amazon’s ability to squeeze labor costs out of an
operation and to operate for extended periods at a loss pro-
vides 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 gro-
cery 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.80
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 corpo-
rate 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 summa-
rized 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) geogra-
phy (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 mar-
ket 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.
TAKE-AWAY CONCEPTS
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300 CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
■ Increasing 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 bet-
ter 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 verti-
cally 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 pos-
session of private information.
■ Moving from less integrated to more fully inte-
grated 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 gener-
ated 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 orig-
inating (inputs) point of the industry value chain.
■ Forward vertical integration involves moving
ownership of activities closer to the end (cus-
tomer) 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, lower-
ing costs, improving quality, facilitating schedul-
ing 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 verti-
cal 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 rev-
enues 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 strat-
egy 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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CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 301
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, man-
agers need to come up with ideas of how to lever-
age 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 rede-
ploy and recombine existing core competencies to
compete in future markets.
■ The upper-left quadrant combines new core
competencies with existing market opportuni-
ties. 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 diversifica-
tion and overall firm performance takes on the
shape of an inverted U (see Exhibit 8.10).
■ Unrelated diversification often results in a diver-
sification 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 diver-
sification 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 indi-
vidual 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 war-
rants a different investment strategy.
■ Both low levels and high levels of diversification
are generally associated with lower overall perfor-
mance, while moderate levels of diversification
are associated with higher firm performance.
Backward vertical
integration (p. 280)
Boston Consulting Group (BCG)
growth–share matrix (p. 295)
Conglomerate (p. 289)
Core competence–market
matrix (p. 292)
Corporate strategy (p. 268)
Credible commitment (p. 277)
Diversification (p. 287)
Diversification discount (p. 294)
Diversification premium (p. 294)
External transaction costs (p. 271)
Forward vertical integration
(p. 281)
Franchising (p. 275)
Geographic diversification
strategy (p. 287)
Industry value chain (p. 278)
Information asymmetry (p. 274)
Internal transaction costs (p. 271)
Joint venture (p. 277)
Licensing (p. 275)
Principal–agent problem (p. 273)
Product diversification strategy
(p. 287)
Product–market diversification
strategy (p. 287)
Related-constrained diversification
strategy (p. 288)
Related diversification
strategy (p. 288)
Related-linked diversification
strategy (p. 289)
Specialized assets (p. 282)
Strategic alliances (p. 275)
Strategic outsourcing (p. 285)
Taper integration (p. 284)
Transaction cost
economics (p. 271)
Transaction costs (p. 271)
Unrelated diversification strat-
egy (p. 289)
Vertical integration (p. 278)
Vertical market failure (p. 284)
KEY TERMS
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302 CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
ETHICAL/SOCIAL ISSUES
1. The chapter notes that some firms choose to out-
source their human resource management systems.
If a firm has a core value of respecting its employ-
ees and rewarding top performance with training,
raises, and promotions, does outsourcing HR man-
agement show a lack of commitment by the firm?
HR management systems are software applications
that typically manage payroll, benefits, hiring and
training, and performance appraisal. What are the
advantages and disadvantages of this decision?
Think of ways that a firm can continue to show its
commitment to treat employees with respect.
2. Nike is a large and successful firm in the design
of athletic shoes. It could easily decide to
forward-integrate to manufacture the shoes it
designs. Therefore, the firm has a credible threat
over its current manufacturers. If Nike has no
intention of actually entering the manufactur-
ing arena, is its supply chain management team
being ethical with the current manufacturers if
the team mentions this credible threat numerous
times in annual pricing negotiations? Why or
why not?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Agriculture is one of the largest and oldest industries
in the world. In the United States and many other coun-
tries, farmers often struggle to turn a profit given the
variabilities of weather and commodity prices. Some
working farms are turning to tourism as an additional
and complementary revenue source. A study from the
U.S. Census of Agriculture in 2012 found over 13,000
farms generated $674 million in revenues from tourist
and recreational activities. This is a 23 percent jump
over revenues in the prior agricultural census in 2007.
In 2014, in response to rapid growth, the National
Agritourism Professionals Association was formed to
help farmers learn how to add this aspect of business
to their traditional farms and ranches.
One of the most successful large companies lead-
ing this marriage of industries is a dairy farm in Indi-
ana: Fair Oaks Farms (www.fofarms.com) is home to
37,000 cows and produces enough milk to feed over
8 million people. Fair Oaks is also participating in the
education market as a popular destination for school
field trips. Other attractions include the Birthing Barn,
where calf births can be viewed live; the Cheese Fac-
tory; and Mooville, a themed outdoor play area. Fair
Oaks grew beyond the dairy and added a Pig Adven-
ture in 2014 and a Crop Adventure in 2016. Each year,
Fair Oaks Farms hosts more than 600,000 visitors
including 50,000 kids on school field trips A video of
the operation by the CEO is available at https://www.
youtube.com/watch?v=Dz_gE4887so. Such ingenious
DISCUSSION QUESTIONS
1. When Walmart decided to incorporate grocery
stores into some locations and created “supercent-
ers,” was this a business-level strategy of differen-
tiation or a corporate strategy of diversification?
Why? Explain your answer.
2. How can related diversification create a competi-
tive advantage for the firm? Keeping the advan-
tages of related diversification in mind, think back
to the example of Delta’s vertical integration deci-
sion to acquire an oil refinery—clearly an unre-
lated diversification move. What challenges might
Delta confront in operating this refinery? Think of
the strategic concepts you have learned and how
they can help you evaluate Delta’s decision.
3. Franchising is widely used in the casual dining
and fast food industry, yet Starbucks is quite suc-
cessful with a large number of company-owned
stores. In 2016 Starbucks had more than 7,800
company-owned stores in the United States. How
do you explain this difference? Is Starbucks buck-
ing the trend of other food-service stores, or is
something else going on?
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CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 303
How Diversified Are You?
C orporations diversify by investing time and resources into new areas of business. As individuals, each of us makes choices about how to spend our time and energies. Typi-
cally, we could divide our time between school, work, family, sleep,
and play. During high-stress work projects, we likely devote more
of our time to work; when studying for final exams or a profes-
sional board exam (such as the CPA exam), we probably spend
more time and effort in the “student learning” mode. This man-
ner of dividing our time can be thought of as “personal diversi-
fication.” Just as companies can invest in related or unrelated
activities, we make similar choices. While we attend college, we
may choose to engage in social and leisure activities with campus
colleagues, or we may focus on classwork at school and spend our
“play time” with an entirely separate set of people.
Using Exhibit 8.8 as a guide, list each of your major activity
areas. Think of each of these as a business. (If you are literally
“all work and no play,” you are a single-business type of personal
diversification.) Instead of revenues, estimate the percentage of
time you spend per week in each activity. (Most people will be
diversified, though some may be dominant perhaps in school
or work.) To assess your degree of relatedness and unrelated-
ness, consider the subject matter and community involved with
each activity. For example, if you are studying ballet and work-
ing as an accountant, those would be largely unrelated activities
(unless you are an accountant for a ballet company!).
1. What conclusions do you derive based on your personal
diversification strategy?
2. Do you need to make adjustments to your portfolio of
activities? Explain the reasons for your answer.
3. Let’s consider dynamics—has your level of diversification
changed over time (say, over the last five years)? Looking
toward the future, do you expect your level of diversification
to change as you complete your degree? Why or why not?
mySTRATEGY
business diversification can offer many benefits to the
agriculture industry.81
1. What other industrial or commercial industries
could benefit from such potential tourist or recre-
ational revenues? Discuss what new and comple-
mentary capabilities would need to be developed
in order to succeed.
2. In your group, list other industry combinations
you have seen be successful. Consider why you
think the combination has been a success.
//// Small Group Exercise 2
The ChapterCase 8 opener mentioned Amazon’s
Campus initiative. It was developed to compete
directly with university bookstores. This is a good cor-
porate strategy for Amazon for many reasons—among
them, it provides the company deeper access into the
shopping behavior of college students, as well as of
their media viewing purchases and habits. It also rep-
resents another large competitive threat to Barnes &
Noble, which runs more than 700 campus bookstores.
To make it beneficial for universities to partner with
Amazon, Amazon pays the schools between 0.5 and
2.5 percent of all Amazon purchases made through the
university website. Purdue University, one of the first
universities to sign on, reportedly has made $1 million
from Amazon in the first two years of the program.
Sixteen campuses had signed up by the end of 2016
with rapid continued growth expected.
In August 2015 Barnes & Noble spun off its col-
lege bookstore unit into a separate company called
Barnes & Noble Education (BNED on the NYSE).
The firm stated the split allows each business to focus
on its core. Barnes & Noble will focus on the con-
sumer retail business, which has suffered from online
shopping and digital books. The new firm will focus
on the higher education market, putting it perhaps in a
better position to seek acquisitions on its own.
1. In your small group, discuss any potential ethical
issues with Amazon paying the university admin-
istration for direct access into the school’s course
textbook system.
2. While Amazon as a firm continues to diversify
its products, services, and markets under one cor-
porate umbrella, why do firms such as Barnes &
Noble choose to split into separate firms for greater
focus on each piece of the business? Do these dif-
ferent strategies align with the core competencies
of each? It may be helpful to review Exhibit 8.9.
3. If your team was asked to consult for Barnes & Noble
Education, which corporate strategies would you
recommend to the company’s senior leadership?
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304 CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
1. This ChapterCase is based on: Stevens, L.,
and A. Gasparro (2017, June 16), “Amazon
to buy Whole Foods for $13.7 billion: Whole
Foods would continue to operate stores under
its brand,” The Wall Street Journal;
“Amazon, the world’s most remarkable firm,
is just getting started,” The Economist, March
25, 2017; “Are investors too optimistic
about Amazon?” The Economist, March
25, 2017; “Amazon Web Services: 2016 in
review,” Forbes, December 26, 2016; Bens-
inger, G. (2015, May 28), “Amazon plans
to add its own line of food,” The Wall Street
Journal; Bensinger, G. (2015), “Amazon
makes a push on college campuses,” The
Wall Street Journal, February 1; Nicas, J.,
and G. Bensinger (2015, March 20), “Tech-
nical hurdles delay drone deliveries,” The
Wall Street Journal; Stone, B. (2014), The
Everything Store: Jeff Bezos and the Age of
Amazon (New York: Back Bay Books); “How
far can Amazon go?” The Economist, June 21,
2014; “Relentless.com,” The Economist, June
21, 2014; Bensinger, G. (2014, Oct. 9), “Ama-
zon to open first brick-and-mortar site,” The
Wall Street Journal; O’Connor, C. (2013, Apr.
23), “The consumer economy: retail, and the
people inventing it,” Forbes; and Amazon
annual reports, various years.
2. Rindova, V.P., and S. Kotha (2001),
“Continuous ‘morphing’: Competing through
dynamic capabilities, form, and function,”
Academy of Management Journal 44:
1263–1280.
3. Collis, D.J. (1995), “The scope of the
corporation,” Harvard Business School Note,
9-795-139.
4. For a discussion of behavioral econom-
ics in general and executive incentives in
particular, see: Kahneman, D. (2011), Think-
ing, Fast and Slow (New York: Farrar, Straus
and Giroux); Ariely, D. (2009), Predictably
Irrational: The Hidden Forces That Shape
Our Decisions (New York: Harper Perennial);
Kahneman, D. (2003), “Maps of bounded
rationality: Psychology for behavioral eco-
nomics,” The American Economic Review
93: 1449–1475; and Thaler, R.H., and C.R.
Sunstein (2003), Nudge: Improving Deci-
sions About Health, Wealth, and Happiness
(New York: Farrar, Straus and Giroux).
5. For a discussion and detailed data on firm
performance and CEO pay for some 300
companies, see Lublin, J.S. (2015, Jun. 25),
“How much the best-performing and worst-
performing ceos got paid. WSJ ranking shows
top performers aren’t the highest paid,” The
Wall Street Journal. For a second study that
shows a significant difference in the return on
investment for higher vs. lower paid CEOs,
see Francis, T. (2016, Jul. 25), “Best-paid
CEOs run some of worst-performing compa-
nies: Analysis by MSCI calls into question
the idea that high CEO pay helps drive better
results,” The Wall Street Journal. The results
of this study indicate that $100 invested in the
20 percent of companies with the highest-paid
CEOs would have grown to $265 over 10
years. In contrast, the same amount of money
over the same time period invested in compa-
nies with the lowest-paid CEOs would have
grown to $367.
6. Kogut, B., and U. Zander (1992), “Knowl-
edge of the firm, combinative capabilities,
and the replication of technology,” Organiza-
tion Science 3: 383–397; O’Connor, G.C.,
and M. Rice (2001), “Opportunity recogni-
tion and breakthrough innovation in large
firms,” California Management Review 43:
95–116; O’Connor, G.C., and R.W. Veryzer
(2001), “The nature of market visioning for
technology-based radical innovation,” Jour-
nal of Product Innovation Management 18:
231–224.
7. Mickle, T. (2016, Sept. 28), “SABMiller, AB
InBev shareholders approve $100 billion-plus
merger,” The Wall Street Journal.
8. The literature on transaction cost economics
is rich and expanding. For important theoreti-
cal and empirical contributions, see: Folta,
T.B. (1998), “Governance and uncertainty: The
trade-off between administrative control and
commitment,” Strategic Management Journal
19: 1007–1028; Klein, B., R. Crawford, and A.
Alchian (1978), “Vertical integration, appro-
priable rents, and the competitive contracting
process,” Journal of Law and Economics
21: 297–326; Leiblein, M.J., and D.J. Miller
(2003), “An empirical examination of trans-
formation- and firm-level influences on the
vertical boundaries of the firm,” Strategic
Management Journal 24: 839–859; Leiblein,
M.J., J. J. Reuer, and F. Dalsace (2002), “Do
make or buy decisions matter? The influence
of organizational governance on technological
performance,” Strategic Management Journal
23: 817–833; Mahoney, J. (1992), “The choice
of organizational form: Vertical financial
ownership versus other methods of vertical
integration,” Strategic Management Journal
13: 559–584; Mahoney, J.T. (2005), Economic
Foundations of Strategy (Thousand Oaks, CA:
Sage); Tsang, E.W.K. (2006), “Behavioral
assumptions and theory development: the case
of transaction cost economics,” Strategic Man-
agement Journal 27: 999–1011; Williamson,
O.E. (1975), Markets and Hierarchies (New
York: Free Press); Williamson, O.E. (1981),
“The economics of organization: The trans-
action cost approach,” American Journal of
Sociology 87: 548–577; and Williamson, O.E.
(1985), The Economic Institutions of Capital-
ism (New York: Free Press).
9. This draws on Mahoney, J.T. (2005), Eco-
nomic Foundations of Strategy (Thou-
sand Oaks, CA: Sage); Williamson, O.E.
(1975), Markets and Hierarchies (New York:
Free Press); Williamson, O.E. (1981), “The
economics of organization: The transac-
tion cost approach,” American Journal of
Sociology 87: 548–577; Williamson, O.E.
(1985), The Economic Institutions of Capital-
ism (New York: Free Press); and Hart, O.,
and O. Moore (1990), “Property rights and
the nature of the firm,” Journal of Political
Economy 98: 1119–1158.
10. Highlighting the relevance of research on
transaction costs, both Ronald Coase (1991)
and Oliver Williamson (2009), who further
developed and refined Coase’s initial insight,
were each awarded a Nobel Prize in econom-
ics in the years shown.
11. Levy, S. (2011), In the Plex: How Google
Thinks, Works, and Shapes Our Lives
(New York: Simon & Schuster).
12. Grigoriou, K., and F.T. Rothaermel
(2014), “Structural microfoundations of inno-
vation: The role of relational stars,” Journal of
Management 40: 586–615.
13. This is based on: Fama, E. (1980),
“Agency problems and the theory of the firm,”
Journal of Political Economy 88: 375–390;
Jensen, M., and W. Meckling (1976), “Theory
of the firm: Managerial behavior, agency
costs and ownership structure,” Journal of
Financial Economics 3: 305–360; and Berle,
A., and G. Means (1932), The Modern Cor-
poration and Private Property (New York:
Macmillan).
14. Berle, A., and G. Means (1932), The
Modern Corporation and Private Property
(New York: Macmillan).
15. This discussion draws on: Zenger, T.R.,
and W.S. Hesterly (1997), “The disaggrega-
tion of corporations: Selective intervention,
high-powered incentives, and molecular
units,” Organization Science 8: 209–222;
and Zenger, T.R., and S.G. Lazzarini (2004),
“Compensating for innovation: Do small firms
offer high-powered incentives that lure talent
and motivate effort,” Managerial and Deci-
sion Economics 25: 329–345.
16. This discussion draws on: Akerlof, G.A.
(1970), “The market for lemons: Quality
uncertainty and the market mechanism,”
Quarterly Journal of Economics 94: 488–500.
ENDNOTES
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CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 305
17. Pisano, G.P. (1997), “R&D performance,
collaborative arrangements, and the market for
know-how: A test of the ‘lemons’ hypothesis
in biotechnology,” Working Paper No. 97-105,
Harvard Business School; Lerner, J., and R.P.
Merges (1998), “The control of technology
alliances: An empirical analysis of the bio-
technology industry,” Journal of Industrial
Economics 46: 125–156; Huston, J.H., and
R.W. Spencer (2002), “Quality, uncertainty
and the Internet: The market for cyber lem-
ons,” The American Economist 46: 50–60;
Rothaermel, F.T., and D.L. Deeds (2004),
“Exploration and exploitation alliances in
biotechnology: A system of new product
development,” Strategic Management Journal
25: 201–221; Downing, C., D. Jaffee, and N.
Walla (2009), “Is the market for mortgage-
backed securities a market for lemons?”
Review of Financial Studies 22: 2457–2494.
18. This discussion draws on: Williamson, O.
E. (1991), “Comparative economic organiza-
tion: The analysis of discrete structural alter-
natives,” Administrative Science Quarterly 36:
269–296.
19. Since short-term contracts are unlikely to
be of strategic significance, they are not sub-
sumed under the term strategic alliances, but
rather are considered to be mere contractual
arrangements.
20. Dyer, J.H. (1997), “Effective interfirm
collaboration: How firms minimize transac-
tion costs and maximize transaction value,”
Strategic Management Journal 18: 535–556.
21. This is based on: Gulati, R. (1998), “Alli-
ances and networks,” Strategic Management
Journal 19: 293–317; Ireland, R.D., M.A.
Hitt, and D. Vaidyanath (2002), “Alliance
management as a source of competitive advan-
tage,” Journal of Management 28: 413–446;
Hoang, H., and F.T. Rothaermel (2005), “The
effect of general and partner-specific alliance
experience on joint R&D project perfor-
mance,” Academy of Management Journal 48:
332–345; and Lavie, D. (2006), “The competi-
tive advantage of interconnected firms: An
extension of the resource-based view,” Acad-
emy of Management Review 31: 638–658.
22. Mickle, T., and V. Bauerlein (2017,
Feb. 21), “Nascar, once a cultural icon, hits
the skids,” The Wall Street Journal; Esterl,
M. (2015, May 26), “Coke says it’s ready
to let Monster in,” The Wall Street Journal;
Esterl, M. (2015, Mar. 26), “Soft drinks
hit 10th year of decline,” The Wall Street
Journal; Esterl, M., and J.S. Lublin (2014,
Aug. 15), “Why didn’t Coke buy all of
Monster?” The Wall Street Journal; Esterl,
M. (2014, Aug. 14), “Coca-Cola buys stake in
Monster Beverage,” The Wall Street Journal;
and McGrath, M. (2014, Aug. 14), “Coca-
Cola buys stake in Monster Beverage for
$2 Billion,” Forbes.
23. www.dowcorning.com.
24. Gustafson, K. (2017, Feb. 17), “Amazon
hints at one of its best-kept secrets: How many
Prime members it has,” CNBC.
25. “Rising from the ashes in Detroit,” The
Economist, August 19, 2010.
26. “Small cars, big question,” The Econo-
mist, January 21, 2010.
27. Colias, M., and J.D. Stoll (2017, Mar. 6),
“GM’s Opel exit is rare no-confidence vote
in European market,” The Wall Street Journal.
28. Tucker, I., and R.P. Wilder (1977),
“Trends in vertical integration in the U.S.
manufacturing sector,” Journal of Industrial
Economics 26: 81–97; Harrigan, K.R. (1984),
“Formulating vertical integration strategies,”
Academy of Management Review 9: 638–652;
Harrigan, K.R. (1986), “Matching vertical
integration strategies to competitive condi-
tions,” Strategic Management Journal 7:
535–555; Rothaermel, F.T., M.A. Hitt, and
L.A. Jobe (2006), “Balancing vertical inte-
gration and strategic outsourcing: Effects on
product portfolios, new product success, and
firm performance,” Strategic Management
Journal 27: 1033–1056.
29. Barr, A., and R. Knutson (2015, Apr. 22),
“Google Project Fi wireless service undercuts
phone plans,” The Wall Street Journal.
30. “HTC clones Nexus One, launches 3 new
phones,” Wired.com, February 16, 2010.
31. www.htc.com.
32. Mochizuki, T. (2016, Aug. 13), “Taiwan’s
Foxconn completes acquisition of Sharp,” The
Wall Street Journal.
33. Harrigan, K.R. (1984), “Formulating
vertical integration strategies,” Academy of
Management Review 9: 638–652; Harrigan,
K.R. (1986), “Matching vertical integration
strategies to competitive conditions,” Strategic
Management Journal 7: 535–555.
34. “HTC clones Nexus One, launches 3 new
phones,” Wired.com, February 16, 2010.
35. Williamson, O.E. (1975), Markets
and Hierarchies (New York: Free Press);
Williamson, O.E. (1981), “The econom-
ics of organization: The transaction cost
approach,” American Journal of Sociology 87:
548–577; Williamson, O.E. (1985), The Eco-
nomic Institutions of Capitalism (New York:
Free Press); and Poppo, L., and T. Zenger
(1998), “Testing alternative theories of the
firm: Transaction cost, knowledge based, and
measurement explanations for make or buy
decisions in information services,” Strategic
Management Journal 19: 853–878.
36. Williamson, O.E. (1975), Markets
and Hierarchies (New York: Free Press);
Williamson, O.E. (1981), “The econom-
ics of organization: The transaction cost
approach,” American Journal of Sociology 87:
548–577; Williamson, O.E. (1985), The Eco-
nomic Institutions of Capitalism (New York:
Free Press).
37. Williamson, O.E. (1975), Markets and
Hierarchies (New York: Free Press).
38. “Delta to buy refinery in effort to lower
jet-fuel costs,” The Wall Street Journal, April
30, 2012.
39. Harrigan, K.R. (1984), “Formulating
vertical integration strategies,” Academy of
Management Review 9: 638–652; Harrigan,
K.R. (1986), “Matching vertical integration
strategies to competitive conditions,” Strategic
Management Journal 7: 535–555; Afuah, A.
(2001), “Dynamic boundaries of the firm: Are
firms better off being vertically integrated in
the face of a technological change?” Academy
of Management Journal 44: 1211–1228; and
Rothaermel, F.T., M.A. Hitt, and L.A. Jobe
(2006), “Balancing vertical integration and
strategic outsourcing: Effects on product
portfolios, new product success, and firm
performance,” Strategic Management Journal
27: 1033–1056.
40. Afuah, A. (2001), “Dynamic boundaries
of the firm: Are firms better off being verti-
cally integrated in the face of a technological
change?” Academy of Management Journal
44: 1211–1228.
41. Ghemawat, P. (1993), “Commitment to a
process innovation: Nucor, USX, and thin slab
casting,” Journal of Economics and Manage-
ment Strategy 2: 133–161; Christensen, C.M.,
and M.E. Raynor (2003), The Innovator’s
Solution: Creating and Sustaining Success-
ful Growth (Boston, MA: Harvard Business
School Press).
42. “Companies more prone to go vertical,”
The Wall Street Journal, December 1, 2009.
43. This section is based on: McGrath, R.
(2009), “Why vertical integration is mak-
ing a comeback,” Harvard Business Review,
December 2; “Vertical integration: Moving on
up,” The Economist, March 7, 2009; Stuckey,
J., and D. White (1993), “When and when not
to vertically integrate,” McKinsey Quarterly,
August; and Buzzell, R.D. (1983, Jan.), “Is
vertical integration profitable?” Harvard Busi-
ness Review.
44. McGrath, R. (2009, Dec. 2), “Why verti-
cal integration is making a comeback,” Har-
vard Business Review.
45. “Vertical integration: Moving on up,” The
Economist, March 7, 2009.
46. Harrigan, K.R. (1984), “Formulating
vertical integration strategies,” Academy of
Management Review 9: 638–652.
47. This is based on: Harrigan, K.R. (1984),
“Formulating vertical integration strategies,”
Academy of Management Review 9: 638–652;
and Harrigan, K.R. (1986), “Matching vertical
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rot27628_ch08_264-307.indd 306 12/11/17 04:22 PM
306 CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification
integration strategies to competitive condi-
tions,” Strategic Management Journal 7:
535–555.
48. This is based on the following: Prahalad
and Hamel argued that a firm that outsources
too many activities risks hollowing out
(“unlearning”) its core competencies because
the firm no longer participates in key adjacent
value chain activities. A similar argument has
been made by Prahalad, C.K., and G. Hamel
(1990), “The core competence of the corpora-
tion,” Harvard Business Review, May–June;
and Teece, D.J. (1986), “Profiting from
technological innovation: Implications for
integration, collaboration, licensing and public
policy,” Research Policy 15: 285–305.
49. Rothaermel, F.T., M.A. Hitt, and L.A.
Jobe (2006), “Balancing vertical integration
and strategic outsourcing: Effects on product
portfolios, new product success, and firm
performance,” Strategic Management Journal
27: 1033–1056.
50. “Global market size of out-
sourced services from 2000 to 2016
(in billion U.S. dollars),” statista.com,
accessed on May 12, 2017, https://
www.statista.com/statistics/189788/
global-outsourcing-market-size/.
51. “Passage to India,” The Economist, June
26, 2010.
52. 2015 Yum Brands Annual Report; and
http://www.worldatlas.com/articles/the-world-
s-largest-fast-food-restaurant-chains.html.
53. 2016 Yum Brands Annual Report.
54. Benoit, D., K. Wu, and R. Crew (2016,
Sept. 2), “Yum Brands sells slice of China
business ahead of spinoff,” The Wall Street
Journal.
55. Chick-fil-A data drawn from www.chick-
fil-a.com/Company/Highlights-Fact-Sheets.
56. Technically speaking, Chick-fil-A also
operates in Canada, as it has one restaurant
in the Calgary, Alberta, airport, near the
departure gate for U.S.-bound flights. See:
Robertson, D. (2014, May 29), “U.S. fast-food
chain Chick-fil-A opens Canadian franchise,
talks down gay marriage controversy,” Cal-
gary Herald, May 29.
57. This section is based on: Rumelt, R.P.
(1974), Strategy, Structure, and Economic
Performance (Boston, MA: Harvard Business
School Press); and Montgomery, C.A. (1985),
“Product-market diversification and market
power,” Academy of Management Review 28:
789–798.
58. Rumelt, R.P. (1974), Strategy, Structure,
and Economic Performance (Boston, MA:
Harvard Business School Press). More recent
research contributions go beyond mere relat-
edness, for instance: Sakhartov, A.V., and T.
B. Folta (2015), “Getting beyond relatedness
as a driver of corporate value,” Strategic
Management Journal, 36: 1939–1959. The
authors present a more complex approach to
why some conglomerates are successful and
why some related diversification does not
add value. They argue that relatedness alone
is insufficient as a predictor. They propose
that the redeployability of potentially shared
resources and the inducement to redeploy
resources created by higher performance in
new industries versus existing industries are
also important factors.
59. 2016 Harley-Davidson Annual Report.
60. This is based on: ExxonMobil Annual
Reports; “Oil’s decline slows Exxon, Chev-
ron profit growth,” The Wall Street Journal,
January 30, 2009; “The greening of Exxon-
Mobil,” Forbes, August 24, 2009; Friedman,
T.L. (2008), Hot, Flat, and Crowded. Why We
Need a Green Revolution—And How It Can
Renew America (New York: Farrar, Straus
and Giroux); “Exxon to acquire XTO Energy
in $31 billion stock deal,” The Wall Street
Journal, December 14, 2009; and “Exxon-
Mobil buys XTO Energy,” The Economist,
December 17, 2009.
61. “The shale revolution: What could go
wrong?” The Wall Street Journal, September
6, 2012; and “U.S. oil notches record growth,”
The Wall Street Journal, June 12, 2013.
62. This is based on: Peng, M.W. (2005),
“What determines the scope of the firm
over time? A focus on institutional related-
ness,” Academy of Management Review 30:
622–633; Peng, M.W. (2000), Business Strate-
gies in Transition Economies (Thousand Oaks,
CA: Sage); and Peng, M.W., and P.S. Heath
(1996), “The growth of the firm in planned
economies in transitions: Institutions, orga-
nizations, and strategic choice,” Academy of
Management Review 21: 492–528.
63. This discussion is based on Das,
S. (2016), “Is Tiago eating into Nano
sales?” Business Standard, July 19, retrieved
May 11, 2017, from http://www.business-
standard.com/article/companies/is-tiago-
eating-into-nano-sales-116071800244_1.
html; Abrahams, D. (2015), “Tata’s Nano
goes upmarket with GenX - IOL Motor-
ing,” retrieved May 22, 2015, from www.
iol.co.za/motoring/cars/tata/tata-s-nano-
goes-upmarket-with-genx-1.1861112#.VV-
FdU9Viko; Thakkar, K. (2015), “Launch of
GenX Nano a ‘make or break’ moment for
the brand; car to be priced at Rs 2.2-2.9 lakh,”
retrieved May 22, 2015, from http://articles.
economictimes.indiatimes.com/2015-05-19/
auto/62369237_1_smart-city-car-tata-nano-
girish-wagh; McLain, S. (2013, Oct. 14),
“Why the world’s cheapest car flopped,” The
Wall Street Journal; “Ratan Tata’s legacy,”
The Economist, December 1, 2012; “A new
boss at Tata,” The Economist, December 1,
2012; “The Tata group,” The Economist,
March 3, 2011; and www.tata.com/htm/
heritage/HeritageOption1.html. See also,
Dyer, J., H. Gregersen, and C.M. Christensen
(2011), The Innovator’s DNA: Mastering the
Five Skills of Disruptive Innovators (Boston,
MA: Harvard Business Review Press).
64. Prahalad, C.K., and G. Hamel (1990),
“The core competence of the corporation,”
Harvard Business Review, May–June.
65. This discussion is based on: Burt, C., and
F.T. Rothaermel (2013), “Bank of America
and the new financial landscape,” in Rothaer-
mel, F.T., Strategic Management (New York:
McGraw-Hill), http://mcgrawhillcreate.com/
rothaermel.
66. Bank of America had long coveted
Merrill Lynch, a premier investment bank.
Severely weakened by the global financial
crisis, Merrill Lynch became a takeover tar-
get, and Bank of America made a bid. In the
process, Bank of America learned that Merrill
Lynch’s exposure to subprime mortgages and
other exotic financial instruments was much
larger than previously disclosed. Other prob-
lems included Merrill Lynch’s payments of
multimillion-dollar bonuses to many employ-
ees, despite the investment bank’s having lost
billions of dollars (in 2008). After learning
this new information, Bank of America (under
its then-CEO Ken Lewis) attempted to with-
draw from the Merrill Lynch takeover. The
Federal Reserve Bank, under the leadership
of its chairman, Ben Bernanke, insisted that
Bank of America fulfill the agreement, noting
that the takeover was part of a grand strategy
to save the financial system from collapse.
Once Bank of America shareholders learned
that Lewis had not disclosed the problems at
Merrill Lynch, they first stripped him of his
chairmanship of the board of directors and
later fired him as CEO. For a detailed and
insightful discussion on the Merrill Lynch
takeover by Bank of America, see Lowenstein,
R. (2010), The End of Wall Street (New York:
Penguin Press).
67. “Bank of America and Merrill Lynch,”
The Economist, April 14, 2010.
68. “In Gatorade war, Pepsi seems to
have deliberately given up market share to
Coke,” Business Insider, February 1, 2012;
Sozzi, B., “Gatorade turns 50: What the sports
drink must do to keep its edge,” TheStreet.
com, May 12, 2015; and Esterl, M. (2016,
Mar. 10), “Gatorade sets its sights on digital
fitness,” The Wall Street Journal.
69. “Oracle vs. salesforce.com,” Harvard
Business School Case Study, 9-705-440;
“How to innovate in a downturn,” The Wall
Street Journal, March 18, 2009; and Dyer, J.,
H. Gregersen, and C.M. Christensen (2011).
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rot27628_ch08_264-307.indd 307 12/11/17 04:22 PM
CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 307
The Innovator’s DNA: Mastering the Five
Skills of Disruptive Innovators (Boston, MA:
Harvard Business Review Press).
70. Palich, L.E., L.B. Cardinal, and C.C.
Miller (2000), “Curvilinearity in the
diversification-performance linkage: An exam-
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Strategic Management Journal 21: 155–174.
71. This is based on: Lang, L.H.P., and
R.M. Stulz (1994), “Tobin’s q, corporate
diversification, and firm performance,” Jour-
nal of Political Economy 102: 1248–1280;
Martin, J.D., and A. Sayrak (2003), “Corpo-
rate diversification and shareholder value:
A survey of recent literature,” Journal of
Corporate Finance 9: 37–57; and Rajan, R.,
H. Servaes, and L. Zingales (2000), “The cost
of diversity: The diversification discount and
inefficient investment,” Journal of Finance
55: 35–80.
72. Mann, T., and V. McGrane (2015,
Apr. 10), “GE to cash out of banking
business,” The Wall Street Journal.
73. This is based on Peng, M.W., and P.S.
Heath (1996), “The growth of the firm in
planned economies in transitions: Institu-
tions, organizations, and strategic choice,”
Academy of Management Review 21: 492–
528; Peng, M.W. (2000), Business Strategies
in Transition Economies (Thousand Oaks, CA:
Sage); Peng, M.W. (2005), “What determines
the scope of the firm over time? A focus
on institutional relatedness,” Academy of
Management Review 30: 622–633.
74. Villalonga, B. (2004), “Diversification
discount or premium? New evidence from the
business information tracking series,” Journal
of Finance 59: 479–506.
75. This section is based on: “U.S. clears
InBev to buy Anheuser,” The Wall Street
Journal, November 15, 2008; and “Blackstone
nears deal,” The Wall Street Journal, October
5, 2009.
76. Boston Consulting Group (1970), The
Product Portfolio (Boston, MA: Boston
Consulting Group); and Shay, J.P., and F.T.
Rothaermel (1999), “Dynamic competitive
strategy: Towards a multi-perspective concep-
tual framework,” Long Range Planning 32:
559–572; and Kiechel, W. (2010), The Lords
of Strategy: The Secret Intellectual History
of the New Corporate World (Boston, MA:
Harvard Business School Press).
77. GE annual reports.
78. Milgrom, P., and J. Roberts (1990), “Bar-
gaining costs, influence costs, and the organi-
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79. 2016 Amazon Annual Report: 4,
http://phx.corporate-ir.net/phoenix.
zhtml?c=97664&p=irol-reportsannual.
80. Stevens, L., and A. Gasparro (2017,
Jun. 16), “Amazon to buy Whole Foods
for $13.7 billion: Whole Foods would con-
tinue to operate stores under its brand,” The
Wall Street Journal, https://www.wsj.com/
articles/amazon-to-buy-whole-foods-for-
13-7-billion-1497618446; LaVito, E. (2017,
Jun. 15), “There’s a reason the grocery indus-
try is panicking about Amazon’s purchase
of Whole Foods,” CNBC, http://www.cnbc.
com/2017/06/16/grocery-industry-is-panicking-
about-amazons-purchase-of-whole-foods.html;
and Aziza, B. (2017, Jun. 23), “Amazon buys
Whole Foods. Now what? The story behind
the story,” Forbes, https://www.forbes.com/
sites/ciocentral/2017/06/23/amazon-
buys-whole-foods-now-what-the-story-
behind-the-story/.
81. This Small Group Exercise is based
on: The Rural Community Building
website produced by the American Farm
Bureau Federation; America’s Heartland
“Episode 311”; and Fair Oaks Farms Dairy
(www.fofarms.com).
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CHAPTER Corporate Strategy:
Strategic Alliances,
Mergers and Acquisitions
Chapter Outline
9.1 How Firms Achieve Growth
The Build-Borrow-Buy Framework
9.2 Strategic Alliances
Why Do Firms Enter Strategic Alliances?
Governing Strategic Alliances
Alliance Management Capability
9.3 Mergers and Acquisitions
Why Do Firms Merge with Competitors?
Why Do Firms Acquire Other Firms?
M&A and Competitive Advantage
9.4 Implications for Strategic Leaders
Learning Objectives
LO 9-1 Apply the build-borrow-or-buy framework to
guide corporate strategy.
LO 9-2 Define strategic alliances, and explain why
they are important to implement corporate
strategy and why firms enter into them.
LO 9-3 Describe three alliance governance mecha-
nisms and evaluate their pros and cons.
LO 9-4 Describe the three phases of alliance
management and explain how an alli-
ance management capability can lead to a
competitive advantage.
LO 9-5 Differentiate between mergers and
acquisitions, and explain why firms would
use either to execute corporate strategy.
LO 9-6 Define horizontal integration and evaluate
the advantages and disadvantages of this
option to execute corporate-level strategy.
LO 9-7 Explain why firms engage in acquisitions.
LO 9-8 Evaluate whether mergers and acquisitions
lead to competitive advantage.
9
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rot27628_ch09_308-337.indd 309 12/12/17 03:26 PM
Little Lyft Gets Big Alliance
Partners
WITH A VALUATION of close to $70 billion in 2017, Uber
is the most valuable privately held company ever. Serv-
ing some 600 cities in over 60 countries worldwide, Uber
dominates the global car-hailing app market. The number-
two competitor to Uber in the United States is Lyft, which
is also a privately held startup but only worth about one-
tenth of Uber (some $7.5 billion). What should little Lyft
do to compete against the giant Uber? Lyft is clearly the
underdog in the fiercely competitive ride-hailing app mar-
ket. Similarly to dealing with a schoolyard bully, it helps
to have strong friends. Lyft found itself powerful alliance
partners for a number of strategic reasons.
Strengthen Competitive Position. Strategic alliances with
powerful partners enable Lyft to strengthen its competitive
position against Uber. In particular, Lyft entered two important
alliances. In 2016, Lyft
formed an equity alli-
ance with GM, which
invested $500 million in
the startup. A year later,
Lyft announced an alli-
ance with Waymo, an
autonomous car tech-
nology venture and a
subsidiary of Alphabet,
which is also Google’s
parent company.
Waymo is also a
fierce rival of Uber
in the development of
self-driving car tech-
nology. When Lyft announced its alliance with Waymo
in 2017, Alphabet and Uber were entangled in a lawsuit.
In particular, Alphabet alleged that Uber stole proprietary
technology when acquiring Otto, a self-driving technol-
ogy company mainly for trucks, which was founded by
a former Waymo executive who headed its self-driving
car efforts. Thus, the alliance with Waymo allows Lyft to
strengthen its competitive position vis-à-vis Uber. Hav-
ing autonomous vehicle technology succeed is critical for
both Uber and Lyft because human drivers are the biggest
cost factor in offering rides. Moreover, autonomous-
driving technology is also expected to be safer than
human driving, resulting in fewer accidents. In addition,
since smart traffic guidance can be employed much more
easily with self-driving cars that can run 24/7, 365 days
a year, traffic congestion and delays are expected to be
much fewer, if any.
Enter New Markets. The alliance with Lyft allows
GM to tap into the second largest mobile transporta-
tion network globally. The goal is that GM’s cars will be
deployed on Lyft’s network, ideally as self-driving vehi-
cles. The equity alliance with Lyft affords GM an entry
into the mobile transportation and logistics market.
Hedge Against Uncertainty. The equity investment in
Lyft also allows GM to hedge against uncertainty. With
network effects supporting winner-take-all dynamics, it is
likely that only one or a few at best mobile transportation
companies survive in
the long run. GM is bet-
ting on Lyft and wants
to be in this new mar-
ket because the age-old
private car ownership
model is likely to shift
in favor of fleet owner-
ship and management.
Consumers will “rent”
a car for a specific ride,
rather than own the
fixed asset. Noteworthy
is that private cars in the
United States are used
only 5 percent of the time, and sit idle for most of the day.
Car owners have the fixed costs of purchasing a car, buy-
ing insurance, and maintaining the car. All this goes away
with the new business model that is likely to emerge.
Learn New Capabilities. For instance, Lyft may need
to learn how to manage large fleets of cars that it might
eventually need to own, a capability held by GM as key
supplier to many large car rental companies. In addition,
CHAPTERCASE 9
©Rydely.com
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310 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
THE CHAPTERCASE highlights how Lyft uses strategic alliances with GM and
Waymo in an attempt to close the gap with Uber. Lyft’s strategic leaders realize that
it is difficult for the much smaller ride-hailing company to catch up with Uber on its own.
Lyft thus is reaching out to powerful partners. Tapping into its partners’ resources and
expertise allows Lyft to become a much more potent rival to Uber than as a standalone
company. This example shows how strategic alliances can help firms to grow and to pos-
sibly outperform much stronger rivals.
In Chapter 8, we discussed why firms grow. In this chapter we discuss how firms grow.
In addition to internal organic growth (achieved through reinvesting profits, see discussion
of Exhibit 4.3 in Chapter 4), firms have two critical strategic options to execute corporate
strategy: alliances and acquisitions. We devote this chapter to the study of these funda-
mental pathways through which firms implement corporate strategy.
We begin this chapter by introducing the build-borrow-or-buy framework to guide cor-
porate strategy in deciding whether and when to grow internally (build), use alliances
(borrow), or make acquisitions (buy). We then take a closer look at strategic alliances
before studying mergers and acquisitions. We discuss alliances before acquisitions because
alliances are smaller strategic commitments and thus are much more frequent. Moreover,
in some cases, alliances may lead to acquisitions later, offering “try before you buy.” For
example, before Disney acquired Pixar (for $7.4 billion in 2006), the firms had a long-
standing strategic alliance, where Pixar would develop computer-animated films that Dis-
ney would market and distribute. We conclude with Implications for Strategic Leaders, in
which we discuss practical applications.
9.1 How Firms Achieve Growth
After discussing in Chapter 8 why firms need to grow, the next question that arises is: How
do firms achieve growth? Corporate executives have three options at their disposal to drive
firm growth: organic growth through internal development, external growth through alli-
ances, or external growth through acquisitions. Laurence Capron and Will Mitchell devel-
oped an insightful step-by-step decision model to guide managers in selecting the most
appropriate corporate strategy vehicle.2 Selecting the most suitable vehicle for corporate
strategy in response to a specific strategic challenge also makes successful implementation
more likely.
THE BUILD-BORROW-BUY FRAMEWORK
The build-borrow-or-buy framework provides a conceptual model that aids firms in
deciding whether to pursue internal development (build), enter a contractual arrange-
ment or strategic alliance (borrow), or acquire new resources, capabilities, and compe-
tencies (buy). Firms that are able to learn how to select the right pathways to obtain new
resources are more likely to gain and sustain a competitive advantage. Note that in the
build-borrow-or-buy model, the term resources is defined broadly to include capabilities
LO 9-1
Apply the build-borrow-
or-buy framework to guide
corporate strategy.
build-borrow-or-buy
framework Conceptual
model that aids firms
in deciding whether
to pursue internal
development (build),
enter a contractual
arrangement or
strategic alliance
(borrow), or acquire new
resources, capabilities,
and competencies (buy).
Lyft may want to learn some of the self-driving technology
from Waymo. Conversely, the Alphabet subsidiary might be
motivated to learn more about how to establish and main-
tain a large mobile logistics network that it can leverage into
more precise target advertising for its Google partner divi-
sion, or other new services it might want to offer one day.1
You will learn more about Lyft by reading this chapter; related
questions appear in “ChapterCase 9 / Consider This . . . .”
310
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 311
and competencies (as in the VRIO model discussed in Chapter 4). Exhibit 9.1 shows the
build-borrow-or-buy decision framework.
The starting point is the firm’s identification of a strategic resource gap that will impede
future growth. The resource gap is strategic because closing this gap is likely to lead to a
competitive advantage. As discussed in Chapter 4, resources with the potential to lead to
competitive advantage cannot be simply bought on the open market. Indeed, if any firm
could readily buy this type of resource, its availability would negate its potential for com-
petitive advantage. It would no longer be rare, a key condition for a resource to form the
basis of competitive advantage. Moreover, resources that are valuable, rare, and difficult
to imitate are often embedded deep within a firm, frequently making up a resource bundle
that is hard to unplug whole or in part.
The options to close the strategic resource gap are, therefore, to build, borrow, or buy.
Build in the build-borrow-buy framework refers to internal development; borrow refers to
the use of strategic alliances; and buy refers to acquiring a firm. When acquiring a firm,
you buy an entire “resource bundle,” not just a specific resource. This resource bundle, if
obeying VRIO principles and successfully integrated, can then form the basis of competi-
tive advantage.
Exhibit 9.1 provides a schematic of the build-borrow-or-buy framework. In this approach
strategic leaders must determine the degree to which certain conditions apply, either high
or low, by responding to up to four questions sequentially before finding the best course.
The questions cover issues of relevancy, tradability, closeness, and integration:
1. Relevancy. How relevant are the firm’s existing internal resources to solving the
resource gap?
2. Tradability. How tradable are the targeted resources that may be available externally?
EXHIBIT 9.1 / Guiding Corporate Strategy: The Build-Borrow-or-Buy Framework
Key
Question
Action
Buy-Borrow-
or-Build?
Build Buy
How tradable
are the targeted
resources?
How close
to your resource
partner?
How well can
you integrate the
target firm?
Contractual
Alliance
Alliance with
Equity
Revisit
build-borrow-buy
options or
reformulate strategy
Acquisition
Strategic Alliance
Internal
Development
Low
Strategic
Resource
Gap
Low High Low
High High Low High
Borrow
• Contract
• Licensing
• Equity Alliance
• Joint Venture
How relevant
are internal
resources?
SOURCE: Adapted from L. Capron and W. Mitchell (2012), Build, Borrow, or Buy: Solving the Growth Dilemma (Boston, MA: Harvard Business Review Press).
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312 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
3. Closeness. How close do you need to be to your external resource partner?
4. Integration. How well can you integrate the targeted firm, should you determine you
need to acquire the resource partner?
As shown in Exhibit 9.1, the answers to these questions lead to a recommended action
or the next question. We’ll review each in more depth.
1. HOW RELEVANT ARE THE FIRM’S EXISTING INTERNAL RESOURCES TO SOLVING THE
RESOURCE GAP? The firm’s strategic leaders start by asking whether the firm’s internal
resources are high or low in relevance. If the firm’s internal resources are highly relevant
to closing the identified gap, the firm should itself build the new resources needed through
internal development.
But how does a strategic leader know whether the firm’s resources are relevant in
addressing a new challenge or opportunity? Firms evaluate the relevance of internal
resources in two ways: they test whether resources are (1) similar to those the firm needs
to develop and (2) superior to those of competitors in the targeted area.3 If both conditions
are met, then the firm’s internal resources are relevant and the firm should pursue internal
development.
Let’s look at both conditions. Strategic leaders are often misled by the first test because
things that might appear similar at the surface are actually quite different deep down.4
Moreover, they tend to focus on the (known) similarities rather than on (unknown) dif-
ferences. Strategic leaders often don’t know how the resources needed for the existing
and new business opportunity differ. An executive at a newspaper publisher such as The
New York Times may conclude that the researching, reporting, writing, and editing activi-
ties done for a printed newspaper are similar to those done for an online one. Although the
activities may be similar, they are also different because the underlying business model and
technology for online publishing are radically different from that of traditional print media.
Managing the community interactions of online publishing as well as applying data analyt-
ics to understand website traffic and reader engagement are also elements that are entirely
new. To make the challenge even greater, online news reporting is required in real time,
24/7, 365 days a year. To make matters worse, old-line news companies are now competing
with millions of so-called citizen journalists on social media, such as Twitter, which often
have an edge on breaking news.5
The second test, determining whether your internal resources are superior to those of
competitors in the targeted area, can best be assessed by applying the VRIO framework
(see Exhibit 4.5). In the case of the print publisher, the answer to both questions is likely
a “no.” This implies that building the new resource through internal development is not
an option. The firm then needs to consider external—borrow or buy—options. This then
leads us to the next question.
2. HOW TRADABLE ARE THE TARGETED RESOURCES THAT MAY BE AVAILABLE EXTER-
NALLY? For external options, the firm needs to determine how tradable the targeted
resources may be. The term tradable implies that the firm is able to source the resource
externally through a contract that allows for the transfer of ownership or use of the resource.
Short-term as well as long-term contracts, such as licensing or franchising, are a way to
borrow resources from another company (see discussion in Chapter 8). In the biotech-
pharma industry, some producers use licensing agreements to transfer knowledge and tech-
nology from the licensor’s R&D to the licensee’s manufacturing. Eli Lilly, for example, has
commercialized several breakthrough biotech drugs using licensing agreements with new
ventures. The implication is that if a resource is highly tradable, then the resource should
be borrowed via a licensing agreement or other contractual agreement. If the resource in
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 313
question is not easily tradable, then the firm needs to consider either a deeper strategic alli-
ance through an equity alliance or a joint venture, or an outright acquisition.
3. HOW CLOSE DO YOU NEED TO BE TO YOUR EXTERNAL RESOURCE PARTNER? Many
times, firms are able to obtain the required resources to fill the strategic gap through more
integrated strategic alliances such as equity alliances or joint ventures (see Exhibit 8.4)
rather than through outright acquisition. Mergers and acquisitions are the most costly,
complex, and difficult to reverse strategic option. This implies that only if extreme close-
ness to the resource partner is necessary to understand and obtain its underlying knowl-
edge should M&A be considered the buy option. Regardless, the firm should always first
consider borrowing the necessary resources through integrated strategic alliances before
looking at M&A.
4. HOW WELL CAN YOU INTEGRATE THE TARGETED FIRM, SHOULD YOU DETERMINE
YOU NEED TO ACQUIRE THE RESOURCE PARTNER? The final decision question using the
build-borrow-buy lens is: Can you integrate the target firm? The list of post-integration
failures, often due to cultural differences, is long. Multibillion-dollar failures include the
Daimler-Chrysler integration, AOL and Time Warner, HP and Autonomy, and Bank of
America and Merrill Lynch. More than cultural differences were involved in Microsoft’s
2015 decision to write down $7.6 billion in losses (or more than 80 percent) on its $9.4
billion acquisition of Nokia some 15 months earlier. It’s now up to Microsoft CEO Satya
Nadella to decide how to compete in the mobile device arena after former CEO Steve
Ballmer made a desperate gamble on acquiring the Finnish cell phone maker.6
Only if the three prior conditions (low relevancy, low tradability, and high need for
closeness) shown in the decision tree in Exhibit 9.1 are met, should the firm’s strategic
leaders consider M&A: If the firm’s internal resources are insufficient to build, and the
resource needed to fill the strategic gap cannot be borrowed through a strategic alliance,
and closeness to the resource partner is needed, then the final question to consider is
whether the integration of the two firms using a merger or acquisition will be successful.
In all other cases, the firms should consider finding a less costly borrow arrangement when
building is not an option. Since strategic alliances are the less costly and more common
tool to execute corporate strategy, we discuss alliances first before mergers and acquisi-
tions. Per the build-borrow-buy decision framework, strategic alliances (borrow) also need
to be considered before mergers and acquisitions (buy).
9.2 Strategic Alliances
Firms enter many types of alliances, from small contracts that have no bearing on a firm’s
competitiveness to multibillion-dollar joint ventures that can make or break the company.
An alliance, therefore, qualifies as strategic only if it has the potential to affect a firm’s
competitive advantage.
Strategic alliances are voluntary arrangements between firms that involve the shar-
ing of knowledge, resources, and capabilities with the intent of developing processes,
products, or services.7 The use of strategic alliances to implement corporate strategy has
grown significantly in the past few decades, with thousands forming each year. As the
speed of technological change and innovation has increased (see discussion in Chapter 7),
firms have responded by entering more alliances. Globalization has also contributed to an
increase in cross-border strategic alliances (see discussion in Chapter 10).
Strategic alliances are attractive for a number of reasons. They enable firms to
achieve goals faster and at lower costs than going it alone. Strategic alliances may join
LO 9-2
Define strategic alliances,
and explain why they are
important to implement
corporate strategy and
why firms enter into them.
strategic
alliances Voluntary
arrangements between
firms that involve the
sharing of knowledge,
resources, and
capabilities with the
intent of developing
processes, products, or
services.
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314 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
complementary parts of a firm’s value chain, such as R&D and marketing, or they may
focus on joining the same value chain activities. In contrast to mergers and acquisitions,
strategic alliances also allow firms to circumvent potential legal repercussions including
potential lawsuits filed by U.S. federal agencies or the European Union.
A strategic alliance has the potential to help a firm gain and sustain a competitive
advantage when it joins together resources and knowledge in a combination that obeys the
VRIO principles (introduced in Chapter 4).8 The locus of competitive advantage is often
not found within the individual firm but within a strategic partnership. According to this
relational view of competitive advantage, critical resources and capabilities frequently
are embedded in strategic alliances that span firm boundaries. Applying the VRIO frame-
work, we know that the basis for competitive advantage is formed when a strategic alliance
creates resource combinations that are valuable, rare, and difficult to imitate, and the alli-
ance is organized appropriately to allow for value capture. In support of this perspective,
over 80 percent of Fortune 1000 CEOs indicated in a survey that more than one-quarter of
their firm’s revenues were derived from strategic alliances.9
WHY DO FIRMS ENTER STRATEGIC ALLIANCES?
To affect a firm’s competitive advantage, an alliance must promise a positive effect on the
firm’s economic value creation through increasing value and/or lowering costs (see discus-
sion in Chapter 5). This logic is reflected in the common reasons firms enter alliances.10
They do so to
■ Strengthen competitive position.
■ Enter new markets.
■ Hedge against uncertainty.
■ Access critical complementary assets.
■ Learn new capabilities.
STRENGTHEN COMPETITIVE POSITION. Firms frequently resort to strategic alliances
to strengthen their competitive position. Firms can also use strategic alliances to change
the industry structure in their favor.11 Moreover, firms frequently use strategic alliances
when competing in setting an industry standard (see discussion in Chapter 7). Strategy
Highlight 9.1 shows how Tesla used alliances strategically to strengthen its competi-
tive standing and to position itself advantageously in making battery-powered vehicles a
serious contender for the future standard in car propulsion, eventually obsoleting internal
combustion engines.
ENTER NEW MARKETS. Firms may use strategic alliances to enter new markets, either in
terms of products and services or geography.12
Using a strategic alliance, HP and DreamWorks Animation SKG created the Halo Col-
laboration Studio, which makes virtual communication possible around the globe.13 Halo’s
conferencing technology gives participants the vivid sense that they are in the same room.
The conference rooms of clients match, down to the last detail, giving participants the
impression that they are sitting together at the same table. DreamWorks produced the
computer-animated movie Shrek 2 using this new technology for its meetings. People with
different creative skills—script writers, computer animators, directors—though dispersed
geographically, were able to participate as if in the same room, even seeing the work on
each other’s laptops. Use of the technology enabled faster decision making, enhanced
productivity, reduced (or even eliminated) travel time and expense, and increased job
relational view
of competitive
advantage Strategic
management framework
that proposes that
critical resources and
capabilities frequently
are embedded in
strategic alliances that
span firm boundaries.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 315
How Tesla Used Alliances Strategically
Since its initial public offering in 2010, the electric-car
manufacturer Tesla has had tremendous impact. Indeed, by
2017 it had become the most valuable car company in the
United States, ahead of GM and Ford. One critical factor in
the success of the California startup is the role played by
Tesla’s strategy involving alliances with larger, more estab-
lished companies. Two key strategic alliances in particular—
one with Daimler and the other with Toyota—were crucial
to Tesla’s early success. The Daimler partnership provided
a much-needed cash injection; the Toyota partnership gave
Tesla access to a world-class automobile manufacturing facil-
ity located near its headquarters in Palo Alto, California.
Initially, Tesla, which began selling its all-electric Road-
ster model in 2008, had neither a market nor legitimacy.
Moreover, it was plagued with both thorny technical prob-
lems and cost overruns. Yet it managed to overcome these
early challenges, in part by turning prospective rivals into
alliance partners. In 2009, the year before its IPO, Tesla
worked out the alliance with Daimler, whose roots in automo-
bile engineering extend back to early days of the automobile
powered by an internal combustion engine about 130 years
ago. The deal provided Tesla with access to superior engi-
neering expertise and a cash infusion of $50 million, helping
to save the company from potential bankruptcy.
The alliance with Toyota, signed the following year, brought
other benefits. It enabled Tesla to buy the former New United
Motor Manufacturing Inc. (NUMMI) factory in Fremont,
California—created as a joint venture between Toyota and
General Motors Corp. in 1984—and to learn large-scale, high-
quality manufacturing from a pioneer of lean manufacturing.
As it happened, the NUMMI plant was the only remaining large-
scale car manufacturing plant in California, and some 25 miles
from Tesla’s Palo Alto headquarters. Without this factory, Tesla
would not have been able to initiate production planning for
its new Model 3, which received more than 350,000 preor-
ders within three months of its announcement in March 2016.
In 2014, Tesla signed another strategic alliance—this one
with Osaka-based Panasonic, the Japanese consumer elec-
tronics company and a world leader in battery technology.
As Tesla tries to position itself in the business of sustainable
and decentralized energy, the relationship with Panasonic is
significant. The two companies are jointly investing in a new
$5 billion lithium-ion battery plant in Nevada. Tesla’s ability
to attract and manage leading companies in the automotive
and other key industries as strategic alliance partners is an
important part of its formula for success.
The decisions by Daimler, Toyota, and Panasonic to col-
laborate with Tesla highlight that individual companies may
not need to own all of the resources, skills, and knowledge
necessary to undertake key strategic growth initiatives.14
Strategy Highlight 9.1
satisfaction. Neither HP nor DreamWorks would have been able to produce this technology
breakthrough alone, but moving into the videoconferencing arena together via a strategic
alliance allowed both partners to pursue related diversification. Moreover, HP’s alliance
with DreamWorks Animation SKG enabled HP to compete head on with Cisco’s high-end
videoconferencing solution, TelePresence.15 The HP and DreamWorks Animation SKG
alliance was motivated by the desire to enter a new market, in terms of products and ser-
vices offered, that neither could enter alone.
When entering new geographic markets, in some instances, governments such as Saudi
Arabia or China may require that foreign firms have a local joint venture partner before
doing business in their countries. These cross-border strategic alliances have both ben-
efits and risks. While the foreign firm can benefit from local expertise and contacts, it
is exposed to the risk that some of its proprietary know-how may be appropriated by the
foreign partner. We will address such issues in Chapter 10 when studying global strategy.
HEDGE AGAINST UNCERTAINTY. In dynamic markets, strategic alliances allow firms
to limit their exposure to uncertainty in the market.16 For instance, in the wake of the
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316 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
biotechnology revolution, incumbent pharmaceutical firms such as Pfizer, Novartis, and
Roche entered into hundreds of strategic alliances with biotech startups.17 These alliances
allowed the big pharma firms to make small-scale investments in many of the new biotech-
nology ventures that were poised to disrupt existing market economics. In some sense, the
pharma companies were taking real options in these biotechnology experiments, providing
them with the right but not the obligation to make further investments when new drugs
were introduced from the biotech companies.
A real-options perspective to strategic decision making breaks down a larger invest-
ment decision (such as whether to enter biotechnology or not) into a set of smaller deci-
sions that are staged sequentially over time. This approach allows the firm to obtain
additional information at predetermined stages. At each stage, after new information is
revealed, the firm evaluates whether or not to make further investments. In a sense, a real
option, which is the right, but not the obligation, to continue making investments, allows
the firm to buy time until sufficient information for a go versus no-go decision is revealed.
Once the new biotech drugs were a known quantity, the uncertainty was removed, and the
incumbent firms could react accordingly.
For example, in 1990 the Swiss pharma company Roche initially invested $2.1 billion
in an equity alliance to purchase a controlling interest (greater than 50 percent) in the
biotech startup Genentech. In 2009, after witnessing the success of Genentech’s drug
discovery and development projects in subsequent years, Roche spent $47 billion to pur-
chase the remaining minority interest in Genentech, making it a wholly owned subsid-
iary.18 Taking a wait-and-see approach by entering strategic alliances allows incumbent
firms to buy time and wait for the uncertainty surrounding the market and technology to
fade. Many firms in fast-moving markets subscribe to this rationale. Waiting can also be
expensive, however. To acquire the remaining less than 50 percent of Genentech some
20 years after its initial investment required a price that was some 24 times higher than the
initial investment, as uncertainty settled and the biotech startup turned out to be hugely
successful. Besides biotechnology, the use of a real-options perspective in making strate-
gic investments has also been documented in nanotechnology, semiconductors, and other
dynamic markets.19
ACCESS CRITICAL COMPLEMENTARY ASSETS. The successful commercialization of a
new product or service often requires complementary assets such as marketing, manu-
facturing, and after-sale service.20 In particular, new firms are in need of complementary
assets to complete the value chain from upstream innovation to downstream commercial-
ization. This implies that a new venture that has a core competency in R&D, for example,
will need to access distribution channels and marketing expertise to complete the value
chain. Building downstream complementary assets such as marketing and regulatory
expertise or a sales force is often prohibitively expensive and time-consuming, and thus
frequently not an option for new ventures. Strategic alliances allow firms to match comple-
mentary skills and resources to complete the value chain. Moreover, licensing agreements
of this sort allow the partners to benefit from a division of labor, allowing each to effi-
ciently focus on its core competency.
LEARN NEW CAPABILITIES. Firms also enter strategic alliances because they are moti-
vated by the desire to learn new capabilities from their partners.21 When the collaborating
firms are also competitors, co-opetition ensues.22 Co-opetition is a portmanteau describ-
ing cooperation by competitors. They may cooperate to create a larger pie but then might
compete about how the pie should be divided. Such co-opetition can lead to learning races
real-options
perspective Approach
to strategic decision
making that breaks down
a larger investment
decision into a set of
smaller decisions that
are staged sequentially
over time.
co-opetition
Cooperation by
competitors to achieve a
strategic objective.
learning
races Situations in
which both partners in
a strategic alliance are
motivated to form an
alliance for learning, but
the rate at which the
firms learn may vary.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 317
in strategic alliances,23 a situation in which both partners are motivated to form an alliance
for learning, but the rate at which the firms learn may vary. The firm that learns faster and
accomplishes its goal more quickly has an incentive to exit the alliance or, at a minimum,
to reduce its knowledge sharing. Since the cooperating firms are also competitors, learning
races can have a positive effect on the winning firm’s competitive position vis-à-vis its alli-
ance partner.
NUMMI (New United Motor Manufacturing, Inc.) was the first joint venture in the U.S.
automobile industry, formed between GM and Toyota in 1984. Recall from Chapter 8 that
joint ventures are a special type of a strategic alliance in which two partner firms create
a third, jointly owned entity. In the NUMMI joint venture, each partner was motivated to
learn new capabilities: GM entered the equity-based strategic alliance to learn the lean
manufacturing system pioneered by Toyota to produce high-quality, fuel-efficient cars at
a profit. Toyota entered the alliance to learn how to implement its lean manufacturing
program with an American work force. NUMMI was a test-run for Toyota before building
fully owned greenfield plants (new manufacturing facilities) in Alabama, Indiana, Ken-
tucky, Mississippi, Texas, and West Virginia. In this 25-year history, GM and Toyota built
some 7 million high-quality cars at the NUMMI plant. In fact, NUMMI was transformed
from worst performer (under GM ownership before the joint venture) to GM’s highest-
quality plant in the United States. In the end, as part of GM’s bankruptcy reorganiza-
tion during 2009–2010, it pulled out of the NUMMI joint venture. Toyota later sold the
NUMMI plant to Tesla (as mentioned in Strategy Highlight 9.1).
The joint venture between GM and Toyota can be seen as a learning race. Who won?
Strategy scholars argue that Toyota was faster in accomplishing its alliance goal—learning
how to manage U.S. labor—because of its limited scope.24 Toyota had already perfected
lean manufacturing; all it needed to do was learn how to train U.S. workers in the method
and transfer this knowledge to its subsidiary plants in the United States. On the other hand,
GM had to learn a completely new production system. GM was successful in transferring
lean manufacturing to its newly created Saturn brand (which was discontinued in 2010
as part of GM’s reorganization), but it had a hard time implementing lean manufacturing
in its existing plants. These factors suggest that Toyota won the learning race with GM,
which in turn helped Toyota gain and sustain a competitive advantage over GM in the U.S.
market.
Also, note that different motivations for forming alliances are not necessarily indepen-
dent and can be intertwined. For example, firms that collaborate to access critical comple-
mentary assets may also want to learn from one another to subsequently pursue vertical
integration. In sum, alliance formation is frequently motivated by leveraging economies of
scale, scope, specialization, and learning.
GOVERNING STRATEGIC ALLIANCES
In Chapter 8, we showed that strategic alliances lie in the middle of the make-or-buy con-
tinuum (see Exhibit 8.4). Alliances can be governed by the following mechanisms:25
■ Non-equity alliances
■ Equity alliances
■ Joint ventures
Exhibit 9.2 provides an overview of the key characteristics of the three alliance types,
including their advantages and disadvantages.
LO 9-3
Describe three alliance
governance mechanisms
and evaluate their pros
and cons.
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318 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
Alliance Type
Governance
Mechanism Frequency
Type of
Knowledge
Exchanged Pros Cons Examples
Non-equity
(supply, licensing,
and distribution
agreements)
Contract Most common Explicit • Flexible
• Fast
• Easy to
initiate and
terminate
• Weak tie
• Lack of
trust and
commitment
• Genentech-Lilly
(exclusive)
licensing
agreement for
Humulin
• Microsoft-IBM
(nonexclusive)
licensing
agreement for
MS-DOS
Equity (purchase of
an equity stake or
corporate venture
capital investment,
or investment in
kind such as a plant
and equipment)
Equity
investment
Less common
than non-equity
alliances, but
more common
than joint
ventures
Explicit;
exchange
of tacit
knowledge
possible
• Stronger tie
• Trust and
commitment
can emerge
• Window
into new
technology
(option value)
• Less flexible
• Slower
• Can entail
significant
investments
• Renault-Nissan
alliance based
on cross equity
holdings,
with Renault
owning 43.4%
in Nissan; and
Nissan owning
15% in Renault
• Roche’s equity
investment
in Genentech
(prior to full
integration)
Joint venture (JV) Creation of
new entity
by two or
more parent
firms
Least common Both
tacit and
explicit
knowledge
exchanged
• Strongest tie
• Trust and
commitment
likely to
emerge
• May be
required by
institutional
setting
• Can entail
long
negotiations
and
significant
investments
• Long-term
solution
• JV managers
have double
reporting
lines (2
bosses)
• Hulu, owned
by NBC
(30%), Fox
(30%), Disney-
ABC (30%),
and Turner
Broadcasting
System (10%)
• The A++
trans-Atlantic
joint venture,
owned by
United Airlines,
Lufthansa, and
Air Canada
EXHIBIT 9.2 / Key Characteristics of Different Alliance Types
NON-EQUITY ALLIANCES. The most common type of alliance is a non-equity alliance,
which is based on contracts between firms. The most frequent forms of non-equity alli-
ances are supply agreements, distribution agreements, and licensing agreements. As sug-
gested by their names, these contractual agreements are vertical strategic alliances,
non-equity
alliance Partnership
based on contracts
between firms.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 319
connecting different parts of the industry value chain. In a non-equity alliance, firms tend
to share explicit knowledge—knowledge that can be codified. Patents, user manuals, fact
sheets, and scientific publications are all ways to capture explicit knowledge, which con-
cerns the notion of knowing about a certain process or product.
Licensing agreements are contractual alliances in which the participants regularly
exchange codified knowledge. The biotech firm Genentech licensed its newly developed
drug Humulin (human insulin) to the pharmaceutical firm Eli Lilly for manufacturing,
facilitating approval by the Food and Drug Administration (FDA), and distribution. This
partnership was an example of a vertical strategic alliance: One partner (Genentech) was
positioned upstream in the industry value chain focusing on R&D, while the other partner
(Eli Lilly) was positioned downstream focusing on manufacturing and distribution. This
type of vertical arrangement is often described as a hand-off from the upstream partner
to the downstream partner and is possible because the underlying knowledge is largely
explicit and can be easily codified. When Humulin reached the market, it was the first
approved genetically engineered human therapeutic drug worldwide.26 Subsequently,
Humulin became a billion-dollar blockbuster drug.
Because of their contractual nature, non-equity alliances are flexible and easy to initi-
ate and terminate. However, because they can be temporary in nature, they also sometimes
produce weak ties between the alliance partners, which can result in a lack of trust and
commitment.
EQUITY ALLIANCES. In an equity alliance, at least one partner takes partial ownership in
the other partner. Equity alliances are less common than contractual, non-equity alliances
because they often require larger investments. Because they are based on partial ownership
rather than contracts, equity alliances are used to signal stronger commitments. Moreover,
equity alliances allow for the sharing of tacit knowledge—knowledge that cannot be codi-
fied.27 Tacit knowledge concerns knowing how to do a certain task. It can be acquired only
through actively participating in the process. In an equity alliance, therefore, the partners
frequently exchange personnel to make the acquisition of tacit knowledge possible.
Toyota used an equity alliance with Tesla, a designer and maker of electric cars (fea-
tured in ChapterCase 1 and Strategy Highlight 9.1), to learn new knowledge and gain a
window into new technology. In 2010, Toyota made a $50 million equity investment in
the California startup. In the same year, Tesla purchased the NUMMI plant in Fremont,
California, where it now manufactures its Models S, X, and 3. Tesla CEO Elon Musk
stated, “The Tesla factory effectively leverages an ideal combination of hardcore Silicon
Valley engineering talent, traditional automotive engineering talent, and the proven Toyota
production system.” Toyota in turn hopes to infuse its company with Tesla’s entrepreneur-
ial spirit. Toyota President Akio Toyoda commented, “By partnering with Tesla, my hope
is that all Toyota employees will recall that ‘venture business spirit’ and take on the chal-
lenges of the future.” Toyoda hoped that a transfer of tacit knowledge would occur, in
which Tesla’s entrepreneurial spirit would reinvigorate Toyota.28 This equity-based learn-
ing race ended in 2014 when Toyota sold its stake in Tesla.29 The Japanese automaker
is shifting away from electric cars, renewing its focus on hybrid vehicles and exploring
fuel-cell technology.
Another governance mechanism that falls under the broad rubric of equity alliances is
corporate venture capital (CVC) investments, which are equity investments by estab-
lished firms in entrepreneurial ventures.30 The value of CVC investments is estimated to
be in the double-digit billion-dollar range each year. Larger firms frequently have dedi-
cated CVC units, such as Google Ventures, Siemens Venture Capital, Kaiser Permanente
Ventures, and Johnson & Johnson Development Corp. Rather than hoping primarily for
explicit knowledge
Knowledge that can
be codified; concerns
knowing about a process
or product.
equity alliance
Partnership in which at
least one partner takes
partial ownership in the
other.
tacit knowledge
Knowledge that cannot
be codified; concerns
knowing how to do a
certain task and can be
acquired only through
active participation in
that task.
corporate venture
capital (CVC) Equity
investments by
established firms
in entrepreneurial
ventures; CVC falls
under the broader
rubric of equity
alliances.
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320 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
financial gains, as venture capitalists traditionally do, CVC investments create real options
in terms of gaining access to new, and potentially disruptive, technologies.31 Strategy
scholars find that CVC investments have a positive impact on value creation for the invest-
ing firm, especially in high-tech industries such as semiconductors, computing, and the
medical-device sector.32
Taken together, equity alliances tend to produce stronger ties and greater trust between
partners than non-equity alliances do. They also offer a window into new technology that,
like a real option, can be exercised if successful or abandoned if not promising. Equity
alliances are frequently stepping-stones toward full integration of the partner firms either
through a merger or an acquisition. Essentially, they are often used as a “try before you
buy” strategic option.33 The downside of equity alliances is the amount of investment that
can be involved, as well as a possible lack of flexibility and speed in putting together and
reaping benefits from the partnership.
JOINT VENTURES. A joint venture (JV) is a standalone organization created and jointly
owned by two or more parent companies (as discussed in Chapter 8). For example, Hulu
(a video-on-demand service) is jointly owned by NBC, Disney-ABC, Fox, and Turner
Broadcast System (TBS). Since partners contribute equity to a joint venture, they are
making a long-term commitment. Exchange of both explicit and tacit knowledge through
interaction of personnel is typical. Joint ventures are also frequently used to enter foreign
markets where the host country requires such a partnership to gain access to the market in
exchange for advanced technology and know-how. In terms of frequency, joint ventures are
the least common of the three types of strategic alliances.
The advantages of joint ventures are the strong ties, trust, and commitment that can
result between the partners. However, they can entail long negotiations and significant
investments. If the alliance doesn’t work out as expected, undoing the JV can take some
time and involve considerable cost. A further risk is that knowledge shared with the new
partner could be misappropriated by opportunistic behavior. Finally, any rewards from the
collaboration must be shared between the partners.
ALLIANCE MANAGEMENT CAPABILITY
Strategic alliances create a paradox for managers. Although alliances appear to be neces-
sary to compete in many industries, between 30 and 70 percent of all strategic alliances
do not deliver the expected benefits, and are considered failures by at least one alliance
partner.34 Given the high failure rate, effective alliance management is critical to gaining
and sustaining a competitive advantage, especially in high-technology industries.35
Alliance management capability is a firm’s ability to effectively manage three
alliance-related tasks concurrently, often across a portfolio of many different alliances (see
Exhibit 9.3):36
■ Partner selection and alliance formation.
■ Alliance design and governance.
■ Post-formation alliance management.
PARTNER SELECTION AND ALLIANCE FORMATION. When making the business case for
an alliance, the expected benefits of the alliance must exceed its costs. When one or more
of the five reasons for alliance formation are present—to strengthen competitive position,
enter new markets, hedge against uncertainty, access critical complementary resources,
or learn new capabilities—the firm must select the best possible alliance partner. Partner
LO 9-4
Describe the three phases
of alliance management
and explain how an
alliance management
capability can lead to a
competitive advantage.
alliance management
capability A firm’s
ability to effectively
manage three
alliance-related tasks
concurrently: (1) partner
selection and alliance
formation, (2) alliance
design and governance,
and (3) post-formation
alliance management.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 321
compatibility and partner commitment are necessary conditions for successful alliance for-
mation.37 Partner compatibility captures aspects of cultural fit between different firms.
Partner commitment concerns the willingness to make available necessary resources and
to accept short-term sacrifices to ensure long-term rewards.
ALLIANCE DESIGN AND GOVERNANCE. Once two or more firms agree to pursue an alli-
ance, managers must then design the alliance and choose an appropriate governance mech-
anism from among the three options: non-equity contractual agreement, equity alliances,
or joint venture. For example, in a study of over 640 alliances, researchers found that the
joining of specialized complementary assets increases the likelihood that the alliance is
governed hierarchically. This effect is stronger in the presence of uncertainties concerning
the alliance partner as well as the envisioned tasks.38
In addition to the formal governance mechanisms, interorganizational trust is a critical
dimension of alliance success.39 Because all contracts are necessarily incomplete, trust
between the alliance partners plays an important role for effective post-formation alliance
management. Effective governance, therefore, can be accomplished only by skillfully com-
bining formal and informal mechanisms.
POST-FORMATION ALLIANCE MANAGEMENT. The third phase in a firm’s alliance man-
agement capability concerns the ongoing management of the alliance. To be a source of
competitive advantage, the partnership needs to create resource combinations that obey the
VRIO criteria. As shown in Exhibit 9.4, this can most likely be accomplished if the alli-
ance partners make relation-specific investments, establish knowledge-sharing routines,
and build interfirm trust.40
Trust is a critical aspect of any alliance. Interfirm trust entails the expectation that
each alliance partner will behave in good faith and develop norms of reciprocity and fair-
ness.41 Such trust helps ensure that the relationship survives and thereby increases the
possibility of meeting the intended goals of the alliance. Interfirm trust is also important
for fast decision making.42 Several firms such as Eli Lilly, HP, Procter & Gamble, and
IBM compete to obtain trustworthy reputations in order to become the alliance “partner of
choice” for small technology ventures, universities, and individual inventors.
Indeed, the systematic differences in firms’ alliance management capability can be a
source of competitive advantage.43 But how do firms build alliance management capabil-
ity? The answer is to build capability through repeated experiences over time. In support
of this idea, several empirical studies have shown that firms move down the learning curve
and become better at managing alliances through repeated alliance exposure.44
The “learning-by-doing” approach has value for small ventures in which a few key
people coordinate most of the firms’ activities.45 However, there are clearly limitations
for larger companies. Conglomerates such as ABB, GE, Philips, or Siemens are engaged
in hundreds of alliances simultaneously. In fact, if alliances are not managed from a
EXHIBIT 9.3 /
Alliance Management
Capability
Alliance Management Capability
Partner Selection and
Alliance Formation
Alliance Design
and Governance
Post-Formation
Alliance Management
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322 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
portfolio perspective at the corporate
level, serious negative repercussions
can emerge.46 Groupe Danone, a large
French food conglomerate, lost its lead-
ing position in the highly lucrative and
fast-growing Chinese market because
its local alliance partner, Hangzhou
Wahaha Group, terminated the long-
standing alliance.47 Wahaha accused
different Danone business units of sub-
sequently setting up partnerships with
other Chinese firms that were a direct
competitive threat to Wahaha. This
example makes it clear that although
alliances are important pathways by
which to pursue business-level strategy,
they are best managed at the corporate
level.
To accomplish effective alliance
management, strategy scholars suggest
that firms create a dedicated alliance
function,48 led by a vice president or
director of alliance management and endowed with its own resources and support staff.
The dedicated alliance function should be given the tasks of coordinating all alliance-
related activity in the entire organization, taking a corporate-level perspective. It should
serve as a repository of prior experience and be responsible for creating processes and
structures to teach and leverage that experience and related knowledge throughout the rest
of the organization across all levels. Research shows that firms with a dedicated alliance
function are able to create value from their alliances above and beyond what could be
expected based on experience alone.49
Pharmaceutical company Eli Lilly is an acknowledged leader in alliance manage-
ment.50 Lilly’s Office of Alliance Management, led by a director and endowed with sev-
eral full-time positions, manages its far-flung alliance activity across all hierarchical levels
and around the globe. Lilly’s process prescribes that each alliance is managed by a three-
person team: an alliance champion, alliance leader, and alliance manager.
■ The alliance champion is a senior, corporate-level executive responsible for high-level
support and oversight. This senior manager is also responsible for making sure that the
alliance fits within the firm’s existing alliance portfolio and corporate-level strategy.
■ The alliance leader has the technical expertise and knowledge needed for the specific
technical area and is responsible for the day-to-day management of the alliance.
■ The alliance manager, positioned within the Office of Alliance Management, serves as
an alliance process resource and business integrator between the two alliance partners
and provides alliance training and development, as well as diagnostic tools.
Some companies are also able to leverage the relational capabilities obtained through
managing alliance portfolios into a successful acquisition strategy.51 Eli Lilly has an entire
department at the corporate level devoted to managing its alliance portfolio. Following up
on an earlier 50/50 joint venture formed with Icos, maker of the $1 billion-plus erectile-
dysfunction drug Cialis, Lilly acquired Icos in 2007. Just a year later, Eli Lilly outmaneu-
vered Bristol-Myers Squibb to acquire biotech venture ImClone for $6.5 billion. ImClone
EXHIBIT 9.4 / How to Make Alliances Work
Relation-Specific
Investments
Interfirm
Trust
Knowledge-Sharing
Routines
Effective Alliance
Governance
Eff
ect
ive
Al
lia
nce
Go
ver
na
nce
Effective Alliance
Governance
SOURCE: Adapted from J.H. Dyer and H. Singh (1998), “The relational view: Cooperative strategy and the
sources of intraorganizational advantage,” Academy of Management Review 23: 660–679.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 323
discovered and developed the cancer-fighting drug Erbitux, also a $1 billion blockbuster in
terms of annual sales. The acquisition of these two smaller biotech ventures allowed Lilly
to address its problem of an empty drug pipeline.52
9.3 Mergers and Acquisitions
A popular vehicle for executing corporate strategy is mergers and acquisitions (M&A).
Hundreds of mergers and acquisitions occur each year, with a cumulative value in the tril-
lions of dollars.53 Although the terms are often used interchangeably, and usually in tandem,
mergers and acquisitions are, by definition, distinct from each other. A merger describes
the joining of two independent companies to form a combined entity. Mergers tend to be
friendly; in mergers, the two firms agree to join in order to create a combined entity. In the
live event-promotion business, for example, Live Nation merged with Ticketmaster.
An acquisition describes the purchase or takeover of one company by another. Acquisi-
tions can be friendly or unfriendly. For example, Disney’s acquisition of Pixar, for exam-
ple, was a friendly one, in which both management teams believed that joining the two
companies was a good idea. When a target firm does not want to be acquired, the acquisi-
tion is considered a hostile takeover. British telecom company Vodafone’s acquisition of
Germany-based Mannesmann, a diversified conglomerate with holdings in telephony and
internet services, at an estimated value of $150 billion, was a hostile one. It was also the
largest takeover in corporate history.
In defining mergers and acquisitions, size can matter as well. The combining of two
firms of comparable size is often described as a merger even though it might in fact be an
acquisition. For example, the integration of Daimler and Chrysler was pitched as a merger,
though in reality Daimler acquired Chrysler, and later sold it. After emerging from bank-
ruptcy restructuring, Chrysler is now majority-owned by Fiat, an Italian auto manufacturer.
In contrast, when large, incumbent firms such as GE, Cisco, or Microsoft buy start-up
companies, the transaction is generally described as an acquisition. Although there is a dis-
tinction between mergers and acquisitions, many observers simply use the umbrella term
mergers and acquisitions, or M&A.
WHY DO FIRMS MERGE WITH COMPETITORS?
In contrast to vertical integration, which concerns the number of activities a firm par-
ticipates in up and down the industry value chain (as discussed in Chapter 8), horizontal
integration is the process of merging with a competitor at the same stage of the industry
value chain. Horizontal integration is a type of corporate strategy that can improve a firm’s
strategic position in a single industry. As a rule of thumb, firms should go ahead with hori-
zontal integration (i.e., acquiring a competitor) if the target firm is more valuable inside
the acquiring firm than as a continued standalone company. This implies that the net value
creation of a horizontal acquisition must be positive to aid in gaining and sustaining a
competitive advantage.
An industry-wide trend toward horizontal integration leads to industry consolidation. In
particular, competitors in the same industry such as airlines, banking, telecommunications,
pharmaceuticals, or health insurance frequently merge to respond to changes in their exter-
nal environment and to change the underlying industry structure in their favor.
There are three main benefits to a horizontal integration strategy:
■ Reduction in competitive intensity.
■ Lower costs.
■ Increased differentiation.
LO 9-5
Differentiate between
mergers and acquisitions,
and explain why firms
would use either to
execute corporate
strategy.
LO 9-6
Define horizontal
integration and evaluate
the advantages and
disadvantages of this
option to execute
corporate-level strategy.
merger The joining
of two independent
companies to form a
combined entity.
acquisition The
purchase or takeover
of one company by
another; can be friendly
or unfriendly.
hostile takeover
Acquisition in which the
target company does not
wish to be acquired.
horizontal
integration The
process of merging with
competitors, leading to
industry consolidation.
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324 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
Exhibit 9.5 previews the sources of value creation and costs in horizontal integration,
which we discuss next.
REDUCTION IN COMPETITIVE INTENSITY. Looking through the lens of Porter’s five
forces model with a focus on rivalry among competitors (introduced in Chapter 3), hori-
zontal integration changes the underlying industry structure in favor of the surviving firms.
Excess capacity is taken out of the market, and competition tends to decrease as a conse-
quence of horizontal integration, assuming no new entrants. As a whole, the industry struc-
ture becomes more consolidated and potentially more profitable. If the surviving firms
find themselves in an oligopolistic industry structure and maintain a focus on non-price
competition (i.e., focus on R&D spending, customer service, or advertising), the industry
can indeed be quite profitable, and rivalry would likely decrease among existing firms. The
wave of recent horizontal integration in the U.S. airline industry, for example, provided
several benefits to the surviving carriers. By reducing excess capacity, the mergers between
Delta and Northwest Airlines, United Airlines and Continental, Southwest and AirTran,
and American and US Airways lowered competitive intensity in the industry overall.
Horizontal integration can favorably affect several of Porter’s five forces for the sur-
viving firms: strengthening bargaining power vis-à-vis suppliers and buyers, reducing the
threat of entry, and reducing rivalry among existing firms. Because of the potential to
reduce competitive intensity in an industry, government authorities such as the Federal
Trade Commission (FTC) in the United States and/or the European Commission usually
must approve any large horizontal integration activity. Industry dynamics, however, are in
constant flux as new competitors emerge and others fall by the wayside.
In 2005, for example, the FTC did not approve the proposed merger between Staples
and Office Depot, arguing that the remaining industry would have only two competitors,
with Office Max being the other. Staples and Office Depot argued that the market for office
supplies needed to be defined more broadly to include large retailers such as Walmart and
Target. The U.S. courts sided with the FTC, which argued that the prices for end consum-
ers would be significantly higher if the market had only two category killers.54 A few years
later, however, the competitive landscape had shifted further as Walmart and Amazon had
emerged as ferocious competitors offering rock-bottom prices for office supplies. Subse-
quently, in 2013, the FTC approved the merger between Staples and Office Max. Just two
years later, the FTC also approved the merger between the now much larger Staples and
Office Depot.55
LOWER COSTS. Firms use horizontal integration to lower costs through economies of
scale and to enhance their economic value creation, and in turn their performance.56 In
industries that have high fixed costs, achieving economies of scale through large output is
critical in lowering costs. The dominant pharmaceutical companies such as Pfizer, Roche,
and Novartis, for example, maintain large sales forces (“detail people”) who call on doc-
tors and hospitals to promote their products. These specialized sales forces often number
10,000 or more and thus are a significant fixed cost to the firms, even though part of their
Corporate Strategy Sources of Value Creation (V) Sources of Costs (C)
Horizontal integration
through M&A
• Reduction in competitive intensity
• Lower costs
• Increased differentiation
• Integration failure
• Reduced flexibility
• Increased potential for legal
repercussions
EXHIBIT 9.5 /
Sources of Value
Creation and Costs in
Horizontal Integration
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 325
compensation is based on commissions. Maintaining such a large and sophisticated sales
force (many with MBAs) is costly if the firm has only a few drugs it can show the doctor.
As a rule of thumb, if a pharma company does not possess a blockbuster drug that brings
in more than $1 billion in annual revenues, it cannot maintain its own sales force.57 When
existing firms such as Pfizer and Wyeth merge, they join their drug pipelines and portfolios
of existing drugs. They are likely to have one sales force for the combined portfolio, con-
sequently reducing the size of the sales force and lowering the overall cost of distribution.
INCREASED DIFFERENTIATION. Horizontal integration through M&A can help firms
strengthen their competitive positions by increasing the differentiation of their product and ser-
vice offerings. In particular, horizontal integration can do this by filling gaps in a firm’s product
offering, allowing the combined entity to offer a complete suite of products and services.
As an example, Disney acquired Marvel for $4 billion in 2009. This acquisition cer-
tainly allowed Disney to further differentiate its product offering as an entire new lineup
of superheroes was joining Mickey’s family, besides being able to offer Marvel superhero
themed-rides and merchandise such as clothing (T-shirts, PJs, etc.) and toys. The Marvel
acquisition passed an important test of value creation because Marvel is seen as more valu-
able inside Disney than outside Disney.58 Because of economies of scope and economies
of scale, Marvel is becoming more valuable inside Disney than as a standalone enterprise.
The same argument could be made for other recent Disney acquisitions, including Pixar
(acquired for $7.4 billion in 2006) and Lucasfilm (acquired for $4 billion in 2012).
WHY DO FIRMS ACQUIRE OTHER FIRMS?
When first defining the terminology at the beginning of the chapter, we noted that an
acquisition describes the purchase or takeover of one company by another. Why do firms
make acquisitions? Three main reasons stand out:
■ To gain access to new markets and distribution channels.
■ To gain access to a new capability or competency.
■ To preempt rivals.
TO GAIN ACCESS TO NEW MARKETS AND DISTRIBUTION CHANNELS. Firms may resort
to acquisitions when they need to overcome entry barriers into markets they are currently
not competing in or to access new distribution channels. Strategy Highlight 9.2 discusses
Kraft’s history with aggressive acquisitions, both successful and otherwise, in this regard.
Firms often resort to M&A to obtain new capabilities or competencies. To strengthen
its capabilities in server systems and equipment and to gain access to the capability of
designing mobile chips for the internet of things (the concept that everyday objects such as
cell phones, wearable devices, temperature controls, household appliances, cars, etc., have
network connectivity, allowing them to send and receive data), Intel acquired Altera for
$17 billion in 2015.59
TO PREEMPT RIVALS. Sometimes firms may acquire promising startups not only to gain
access to a new capability or competency, but also to preempt rivals from doing so. Let’s
look at the acquisitions made by two of the leading internet companies: Facebook and
Alphabet’s Google.60
To preempt rivals Facebook spent more than $25 billion since 2012 buying promis-
ing startups. It acquired, among others, Instagram, a photo- and video-sharing site, for
$1 billion in 2012. Facebook then went on to buy the text messaging service startup
LO 9-7
Explain why firms engage
in acquisitions.
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326 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
Kraft’s Specialty: Hostile Takeovers
One example of a firm that pursues acquisitions aggres-
sively is Kraft, a trait that can be traced through the years.
In 2010, Kraft Foods bought UK-based Cadbury PLC for close
to $20 billion in a hostile takeover. Unlike the more diver-
sified food-products company Kraft, Cadbury was focused
solely on candy and gum. Hailing to 1824, Cadbury estab-
lished itself in markets across the globe, in concert with the
British Empire.
Kraft was attracted to Cadbury due
to its strong position in fast-growing
countries such as India, Egypt, and
Thailand and in many Latin American
markets. Cadbury held 70 percent of
the market share for chocolate in India,
with more than 1 billion people. Chil-
dren there specifically ask for “Cad-
bury chocolate” instead of just plain
“chocolate.” It is difficult for outsid-
ers like Kraft to break into emerging
economies because earlier entrants
have developed and perfected their dis-
tribution systems to meet the needs of
millions of small, independent vendors.
To secure a strong strategic position in
these fast-growing emerging markets,
therefore, Kraft felt that horizontal
integration with Cadbury was critical.
Kraft continues to face formidable
competitors in global markets, includ-
ing Nestlé and Mars, both of which are
especially strong in China.
We can see Kraft’s approach even
through its divisions. To focus its dif-
ferent strategic business units more effectively and to
reduce costs, Kraft Foods restructured in 2012. It separated
its North American grocery-food business from its global
snack-food and candy business (including Oreos and Cadbury
chocolate), which is now Mondelez International. In 2015,
Kraft Foods merged with Heinz (owned by Warren Buffett’s
Berkshire Hathaway and 3G Capital, a Brazilian hedge fund)
in a $37 billion merger, creating the fifth-largest food com-
pany in the world, behind Nestlé, Mondelez, PepsiCo, and
Unilever.
In the U.S. market, the Cadbury acquisition allows
Mondelez greater access to convenience stores, gives it a
new distribution channel, and opens a market for it that is
growing fast and tends to have high profit margins. Mon-
delez, which does not directly compete in the United States,
licenses its famous Oreo cookie to its subsidiary Nabisco.
Moreover, Mondelez licenses the sale
of Cadbury chocolate to The Her-
shey Co., the largest U.S. chocolate
manufacturer.
Hershey’s main strategic focus is
squarely on its home market. With the U.S.
population growing slowly and becoming
more health-conscious, however, Hershey
decided in 2013 to enter the Chinese mar-
ket, the world’s fastest-growing candy mar-
ket. Since its founding in 1894, Hershey’s
entry into China is the company’s first
product launch outside the United States.
Hershey’s sales growth in China, however,
has been disappointing so far. Combined
with little or no growth in the United
States, Hershey had to cut jobs in 2015.
Inheriting a penchant for hostile
takeovers from its parent Kraft Foods,
Mondelez saw an opportunity. Spot-
ting a weakness in the Hershey Co.,
Mondelez made an unsolicited takeover
offer to buy the U.S. chocolate maker
for some $23 billion. The goal was to
create the world’s largest candymaker.
But Hershey’s board rebuffed the Mon-
delez takeover bid unanimously. The Hershey Co. is owned by
the Hershey Trust, which was established by Milton Hershey
some 125 years ago. The trust’s main beneficiary is a school
for underprivileged children in Hershey, Pennsylvania, the
hometown of the namesake company.
The dominant trait of a preference for hostile takeovers
inherited from its progenitor also became apparent in 2017
Strategy Highlight 9.2
A “Cadbury loyalist” vocally opposing
Kraft’s acquisition of a company with
symbolic value in the United Kingdom.
©John HARRIS/REPORT DIGITAL-REA/Redux
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 327
WhatsApp for $22 billion in 2014, making it one of the largest tech acquisitions ever. In the
same year, Facebook paid $2 billion to acquire Oculus, a virtual reality (VR) firm.
Alphabet’s Google has also made a string of acquisitions of new ventures to preempt
rivals. In 2006, Google bought YouTube, the video-sharing website, for $1.65 billion.
Google engaged in a somewhat larger acquisition when it bought Motorola’s cell phone
unit for $12.5 billion in 2011. This was done to gain access to Motorola’s valuable pat-
ent holdings in mobile technology. Google later sold the cell phone unit to Lenovo, while
retaining Motorola’s patents. In 2013, Google purchased the Israeli start-up company
Waze for $1 billion. Google acquired Waze to gain access to a new capability and to pre-
vent rivals from gaining access. Waze’s claim to fame is its interactive mobile map app.
Google is already the leader in online maps and wanted to extend this capability to mobile
devices. Perhaps even more importantly, Google’s intent was to preempt Apple and Face-
book from buying Waze. Apple and Facebook are each comparatively weaker than Google
in the increasingly important interactive mobile map and information services segment. In
2014, Google purchased the UK-based technology startup DeepMind for $625 million to
enhance its competitive position in artificial intelligence. Moreover, this move also pre-
vented others such as Facebook or Amazon from acquiring DeepMind.
M&A AND COMPETITIVE ADVANTAGE
Do mergers and acquisitions create competitive advantage? Despite their popularity, the
answer, surprisingly, is that in most cases they do not. In fact, the M&A performance track
record is rather mixed. Many mergers destroy shareholder value because the anticipated
synergies never materialize.62 If value is created, it generally accrues to the shareholders of
the firm that was taken over (the acquiree), because acquirers often pay a premium when
buying the target company.63 Indeed, sometimes companies get involved in a bidding war
for an acquisition; the winner may end up with the prize but may have overpaid for the
acquisition—thus falling victim to the winner’s curse.
Given that mergers and acquisitions, on average, destroy rather than create shareholder
value, why do we see so many mergers? Reasons include:
■ Principal–agent problems.
■ The desire to overcome competitive disadvantage.
■ Superior acquisition and integration capability.
PRINCIPAL–AGENT PROBLEMS. When discussing diversification in the previous chap-
ter, we noted that some firms diversify through acquisitions due to principal–agent prob-
lems (see Chapter 8 discussion of managerial motives behind firm growth).64 Managers,
LO 9-8
Evaluate whether mergers
and acquisitions lead to
competitive advantage.
when Kraft Heinz made a whopping $143 hostile takeover bid
for Unilever, a British-Dutch consumer goods company. The
intent was to merge the world’s two largest packaged-food
companies. Unilever CEO Paul Polman, however, made it
clear that the multinational with a strong focus on corpo-
rate social responsibility was not interested in pursuing any
merger talks with Kraft Heinz.61
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328 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
as agents, are supposed to act in the best interest of the principals, the shareholders.
However, managers may have incentives to grow their firms through acquisitions—not
for anticipated shareholder value appreciation, but to build a larger empire, which is
positively correlated with prestige, power, and pay. Besides providing higher compensa-
tion and more corporate perks, a larger organization may also provide more job security,
especially if the company pursues unrelated diversification.
A related problem is managerial hubris, a form of self-delusion in which managers
convince themselves of their superior skills in the face of clear evidence to the
contrary.65 Managerial hubris comes in two forms:
1. Managers of the acquiring company convince themselves that they are able to man-
age the business of the target company more effectively and, therefore, create addi-
tional shareholder value. This justification is often used for an unrelated diversification
strategy.
2. Although most top-level managers are aware that the majority of acquisitions destroy
rather than create shareholder value, they see themselves as the exceptions to the rule.
Managerial hubris has led to many ill-fated deals, destroying billions of dollars. For
example, Quaker Oats Co. acquired Snapple because its managers thought Snapple was
another Gatorade, which was a successful previous acquisition.66 The difference was that
Gatorade had been a standalone company and was easily integrated, but Snapple relied on
a decentralized network of independent distributors and retailers who did not want Snapple
to be taken over and who made it difficult and costly for Quaker Oats to integrate Snapple.
The acquisition failed—and Quaker Oats itself was taken over by PepsiCo. Snapple was
spun out and eventually ended up being part of the Dr Pepper Snapple Group.
THE DESIRE TO OVERCOME COMPETITIVE DISADVANTAGE. In some instances, merg-
ers are not motivated by gaining competitive advantage, but by the attempt to overcome
a competitive disadvantage. For example, to compete more successfully with Nike, the
worldwide leader in sports shoes and apparel, Adidas (number two) acquired Reebok
(number three) for $3.8 billion in 2006. This acquisition allows the now-larger Adidas
group to benefit from economies of scale and scope that were unachievable when Adidas
and Reebok operated independently. The hope was that this would help in overcoming
Adidas’ competitive disadvantage vis-à-vis Nike. In the meantime, Under Armour has out-
performed Adidas in the U.S. market and has become the number two after Nike.
SUPERIOR ACQUISITION AND INTEGRATION CAPABILITY. Acquisition and integration
capabilities are not equally distributed across firms. Although there is strong evidence that
mergers and acquisitions, on average, destroy rather than create shareholder value, it does
not exclude the possibility that some firms are consistently able to identify, acquire, and
managerial hubris A
form of self-delusion
in which managers
convince themselves
of their superior
skills in the face of
clear evidence to the
contrary.
Sometimes the
combined value of
two companies is less
than the value of each
company separately.
Oatmeal: ©McGraw-Hill
Education/Mark Dierker,
photographer; Snapple:
©George W. Bailey/
Shutterstock.com RF
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 329
integrate target companies to strengthen their competitive positions. Since it is valuable,
rare, and difficult to imitate, a superior acquisition and integration capability, together with
past experience, can lead to competitive advantage.
Disney has shown superior post-merger integration capabilities after acquiring Pixar,
Marvel, and Lucasfilm. Disney managed its new subsidiaries more like alliances rather
than attempting full integration, which could have destroyed the unique value of the
acquisitions. In Pixar’s case, Disney kept the entire creative team in place and allowed its
members to continue to work in Pixar’s headquarters near San Francisco with minimal
interference. The hands-off approach paid huge dividends: Although Disney paid a steep
$7.4 billion for Pixar, it made some $10 billion on Pixar’s Toy Story 3 franchise revenues
alone. As a consequence, Disney has gained a competitive advantage over its rivals such as
Sony and has also outperformed the Dow Jones Industrial Average over the past few years
by a wide margin.
9.4 Implications for Strategic Leaders
The business environment is constantly changing.67 New opportunities come and go
quickly. Firms often need to develop new resources, capabilities, or competencies to take
advantage of opportunities. Examples abound. Traditional book publishers must transform
themselves into digital content companies. Old-line banking institutions with expensive
networks of branches must now offer seamless online banking services. They must make
them work between a set of traditional and nontraditional payment services on a mobile
platform. Energy providers are in the process of changing their coal-fired power plants to
gas-fired ones in the wake of the shale gas boom. Pharmaceutical companies need to take
advantage of advances in biotechnology to drive future growth. Food companies are now
expected to offer organic, all natural, and gluten-free products.
The strategic leader also knows that firms need to grow to survive and prosper, espe-
cially if they are publicly traded stock companies. A firm’s corporate strategy is critical in
pursuing growth. To be able to grow as well as gain and sustain a competitive advantage, a
firm must not only possess VRIO resources but also be able to leverage existing resources,
often in conjunction with partners, and build new ones. The question of how to build new
resources, capabilities, and competencies to grow your enterprise lies at the center of cor-
porate strategy. Strategic alliances, mergers, and acquisitions are the key tools that the
strategist uses in executing corporate strategy.
Ideally, the tools to execute corporate strategy—strategic alliances and acquisitions—
should be centralized and managed at the corporate level, rather than at the level of the
strategic business unit. This allows the company to not only assess their effect on the over-
all company performance, but also to harness spillovers between the different corporate
development activities. That is, corporate-level managers should not only coordinate the
firm’s portfolio of alliances, but also leverage their relationships to successfully engage in
mergers and acquisitions.68 Rather than focusing on developing an alliance management
capability in isolation, firms should develop a relational capability that allows for the suc-
cessful management of both strategic alliances and mergers and acquisitions. In sum, to
ensure a positive effect on competitive advantage, the management of strategic alliances
and M&A needs to be placed at the corporate level.
We now have concluded our discussion of corporate strategy. Acquisitions and alli-
ances are key vehicles to execute corporate strategy, each with its distinct advantages and
disadvantages. It is also clear from this chapter that strategic alliances, as well as mergers
and acquisitions, are a global phenomenon. In the next chapter, we discuss strategy in a
global world.
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330 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
This chapter discussed two mechanisms of corporate-
level strategy—alliances and acquisitions—as sum-
marized by the following learning objectives and
related take-away concepts.
LO 9-1 / Apply the build-borrow-or-buy framework to
guide corporate strategy.
■ The build-borrow-or-buy framework provides a
conceptual model that aids strategists in deciding
whether to pursue internal development (build),
enter a contract arrangement or strategic alliance
(borrow), or acquire new resources, capabilities,
and competencies (buy).
■ Firms that are able to learn how to select the right
pathways to obtain new resources are more likely
to gain and sustain a competitive advantage.
LO 9-2 / Define strategic alliances, and explain why
they are important to implement corporate strategy and
why firms enter into them.
■ Strategic alliances have the goal of sharing
knowledge, resources, and capabilities to develop
processes, products, or services.
■ An alliance qualifies as strategic if it has the
potential to affect a firm’s competitive advantage
by increasing value and/or lowering costs.
TAKE-AWAY CONCEPTS
ONE OTHER STRATEGIC reason Lyft entered alliances with
GM and Waymo is access to critical complementary assets.
Both Lyft and GM bring critical complementary assets
to bear in this alliance. GM has upstream core competen-
cies in manufacturing cost-competitive and reliable cars at a
large scale. Lyft, in turn, has downstream competencies by
owning the second-largest mobile transportation network
globally, and with it the data that allow Lyft to develop pro-
prietary algorithms to have cars at the right time and at the
right price.
Alphabet’s Waymo, moreover, was an early leader in
autonomous vehicle development. Where Waymo lags Tesla
in driverless car technology, however, is the fact that Tesla
has racked up more than a billion miles driven by its vehicles
themselves as Tesla owners use its innovative autopilot fea-
ture. Every time a Tesla driver engages the autopilot, Tesla
accrues more miles and with it data, allowing it to update
its software driving the cars and making its autopilot even
better. Much like Google’s Android mobile operating system
for phones, Waymo provides the software that is the brains
behind the self-driving car technology, but lacks an opportu-
nity for large-scale deployment, which constrains testing and
learning. The alliance with Lyft allows Waymo to deploy its
self-driving car technology on a large scale. The goal is to
CHAPTERCASE 9 Consider This. . .
create a fleet of autonomous GM vehicles on Lyft’s network,
driving with Waymo’s autopilot technology.
Questions
1. Describe the reasons Lyft entered strategic alliances
with GM and Waymo? Are some reasons more impor-
tant than others? Why or why not? Explain.
2. GM invested $500 million in Lyft in 2016. What are
some possible reasons GM entered an equity alliance
with Lyft? Are there any reasons GM would prefer Lyft
over Uber as an alliance partner?
3. What are some possible reasons Waymo entered an
alliance with Lyft? Are there any reasons Waymo would
prefer Lyft over Uber as an alliance partner?
4. In terms of valuations, Uber (with $70 billion) is almost
10 times more valuable than Lyft (with $7.5 billion). Uber
is active in some 600 cities worldwide, while Lyft services
some 200 (in the United States only). Uber offers about five
times as many rides as Lyft. Uber is clearly a giant com-
pared to Lyft. Do you think the strategic alliances with GM
and Waymo could help Lyft to overcome Uber’s lead? Can
you think of other reasons Lyft could end up as the winner
in the mobile transportation network competition? Explain.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 331
■ The most common reasons firms enter alliances
are to (1) strengthen competitive position, (2)
enter new markets, (3) hedge against uncertainty,
(4) access critical complementary resources, and
(5) learn new capabilities.
LO 9-3 / Describe three alliance governance
mechanisms and evaluate their pros and cons.
■ Alliances can be governed by the follow-
ing mechanisms: contractual agreements for
non-equity alliances, equity alliances, and
joint ventures.
■ There are pros and cons of each alliance gover-
nance mechanism, shown in detail in Exhibit 9.2
with highlights as follows:
Non-equity alliance’s pros: flexible, fast, easy
to get in and out; cons: weak ties, lack of trust/
commitment.
Equity alliance’s pros: stronger ties, potential for
trust/commitment, window into new technology
(option value); cons: less flexible, slower, can
entail significant investment.
Joint venture pros: strongest tie, trust/
commitment most likely, may be required by
institutional setting; cons: potentially long
negotiations and significant investments,
long-term solution, managers may have two
reporting lines (two bosses).
LO 9-4 / Describe the three phases of
alliance management and explain how an alliance
management capability can lead to a competitive
advantage.
■ An alliance management capability consists of
a firm’s ability to effectively manage alliance-
related tasks through three phases: (1) partner
selection and alliance formation, (2) alliance
design and governance, and (3) post-formation
alliance management.
■ An alliance management capability can be a
source of competitive advantage as better man-
agement of alliances leads to more likely superior
performance.
■ Firms build a superior alliance management
capability through “learning by doing” and by
establishing a dedicated alliance function.
LO 9-5 / Differentiate between mergers and
acquisitions, and explain why firms would use either
to execute corporate strategy.
■ A merger describes the joining of two indepen-
dent companies to form a combined entity.
■ An acquisition describes the purchase or takeover
of one company by another. It can be friendly or
hostile.
■ Although there is a distinction between mergers
and acquisitions, many observers simply use the
umbrella term mergers and acquisitions, or M&A.
■ Firms can use M&A activity for competitive
advantage when they possess a superior relational
capability, which is often built on superior alli-
ance management capability.
LO 9-6 / Define horizontal integration and
evaluate the advantages and disadvantages of this
option to execute corporate-level strategy.
■ Horizontal integration is the process of merging
with competitors, leading to industry consolidation.
■ As a corporate strategy, firms use horizontal
integration to (1) reduce competitive intensity,
(2) lower costs, and (3) increase differentiation.
LO 9-7 / Explain why firms engage in acquisitions.
■ Firms engage in acquisitions to (1) access new
markets and distributions channels, (2) gain
access to a new capability or competency, and
(3) preempt rivals.
LO 9-8 / Evaluate whether mergers and acquisitions
lead to competitive advantage.
■ Most mergers and acquisitions destroy shareholder
value because anticipated synergies never materialize.
■ If there is any value creation in M&A, it gener-
ally accrues to the shareholders of the firm that is
taken over (the acquiree), because acquirers often
pay a premium when buying the target company.
■ Mergers and acquisitions are a popular vehicle for
corporate-level strategy implementation for three
reasons: (1) because of principal–agent problems,
(2) the desire to overcome competitive disadvan-
tage, and (3) the quest for superior acquisition and
integration capability.
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332 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
DISCUSSION QUESTIONS
1. The chapter identifies three governing mecha-
nisms for strategic alliances: non-equity, equity,
and joint venture. List the benefits and downsides
for each of these mechanisms.
2. An alliance’s purpose can affect which gover-
nance structure is optimal. Compare a pharma-
ceutical R&D alliance with a prescription-drug
marketing agreement, and recommend a govern-
ing mechanism for each. Provide reasons for your
selections.
3. Alliances are often used to pursue business-level
goals, but they may be managed at the corporate
level. Explain why this portfolio approach to alli-
ance management would make sense.
ETHICAL/SOCIAL ISSUES
1. If mergers and acquisitions quite often end up
providing a competitive disadvantage, why do so
many of them take place? Given the poor track
record, is the continuing M&A activity a result of
principal–agent problems and managerial hubris?
What can be done to overcome principal–agent
problems? Are there other reasons for poor
performance?
2. In this chapter three main reasons are given for
why one firm would acquire another. In July
2016 Verizon announced it was going to acquire
Yahoo for $4.8 billion in cash. The announcement
discussed Verizon’s earlier purchase of AOL and
noted Yahoo would speed up the digital advertis-
ing business. Verizon noted Yahoo has over 1
billion users globally and several premium brands
in finance, news, and sports. Based on Verizon’s
information, which of the three acquisition rea-
sons seems most prevalent?
In the fall of 2016 Yahoo disclosed several
major security breaches involving more than
1.5 billion user accounts. The results of these
disclosures delayed the purchase by Verizon and
reduced the Yahoo purchase price by at least
$300 million. In June 2017 Yahoo shareholders
agreed to the final sale to Verizon, nearly a year
after the purchase was announced. What responsi-
bility do firms have for the protection of customer
data provided in the operation of their firm?
Should Verizon have backed out of the deal with
Yahoo given the scale and duration of the security
issues brought to light in the fall of 2016?
Acquisition (p. 323)
Alliance management
capability (p. 320)
Build-borrow-or-buy
framework (p. 310)
Co-opetition (p. 316)
Corporate venture capital
(CVC) (p. 319)
Equity alliance (p. 319)
Explicit knowledge (p. 319)
Horizontal integration (p. 323)
Hostile takeover (p. 323)
Learning races (p. 316)
Managerial hubris (p. 328)
Merger (p. 323)
Non-equity alliance (p. 318)
Real-options perspective (p. 316)
Relational view of competitive
advantage (p. 314)
Strategic alliances (p. 313)
Tacit knowledge (p. 319)
KEY TERMS
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 333
SMALL GROUP EXERCISES
//// Small Group Exercise 1
In this chapter, we studied horizontal integration and
the build-borrow-or-buy framework. One industry
currently consolidating is furniture manufacturing,
with thousands of manufacturers and suppliers. Manu-
facturers range from large recognizable brands, such
as Baker, Steelcase, and La-Z-Boy, to small family-
owned companies. Demand for both office furniture
and residential furniture is experiencing postrecession
growth. Analysts have observed that companies are
shopping for acquisitions as consumers are shopping
for furniture.
Charter Capital Partners in Grand Rapids, Michigan,
is a mergers and acquisitions adviser helping compa-
nies initiate, negotiate, and close deals on one com-
pany’s purchase of another. To take advantage of the
increase in M&A activity in the furniture manufactur-
ing industry, Charter recently launched a dedicated
furniture practice. Western Michigan is home to the
top three office furniture manufacturers, which is a
key segment of the industry. The sales of the top three
make up half of the industry’s $10 billion market.
Charter Capital Partners has hired your small con-
sulting team to do the basic research regarding a client
that has recently approached the group. The client is
a small manufacturer of office furniture in a medium-
sized town in Michigan. The managers are seeking
advice as they decide whether to upgrade capabilities
in order to expand sales, to find a partner with com-
plementary skills, or to sell to a larger company. The
owner has stated that the firm is like a family, and he
feels a sense of loyalty to the workers and the com-
munity. The firm has had steady sales over its history,
although it experienced a slight dip in sales during the
recession. The company is aware that other office fur-
niture manufacturers are beginning to integrate tech-
nology into the furniture. For example, one competitor
is building wireless technology into desk surfaces to
power several devices at one time and avoid the need
to plug them in. The owner sees the integration of
technology as a game changer.
Using the build-borrow-or-buy framework and
other strategic concepts, develop a set of questions to
ask the managers of this small business to help you
gather information regarding whether to hire new
employees with more sophisticated technology exper-
tise in order to build capabilities in-house or whether
to partner with another firm that already has these
capabilities. Alternatively, consider information that
could help the owner decide whether this is the time
to sell to a larger company. Your consulting team will
need adequate information to help put a value on the
firm in order to advise Charter if/when it initiates a
search for a partner or buyer.
//// Small Group Exercise 2
In Strategy Highlight 9.2 Kraft is shown to be prone
to using hostile takeovers. These acquisitions are com-
pleted over the objections of the acquired firm. As
noted in the text, mergers and acquisitions sometimes
have difficulty creating enhanced competitive advan-
tage. In your group discuss what additional burdens
a hostile takeover must overcome to generate positive
advantages for the acquiring company. How is a hos-
tile takeover more difficult than a cooperative merger
or acquisition?
What Is Your Network Strategy
for Your Career?
M ost of us participate in one or more popular social networks online such as Facebook, LinkedIn, Pinterest, Snapchat, or Twitter. While many of us spend countless
hours in these social networks, you may not have given a lot of
thought to your network strategy.
Social networks describe the relationships or ties between
individuals linked to one another. An important element of
social networks is the different strengths of ties between indi-
viduals. Some ties between two people in a network may be very
strong (e.g., soul mates or best friends), while others are weak
(mere acquaintances—“I talk to her briefly in the cafeteria at
work”). As a member of a social network, you have access to
social capital, which is derived from the connections within and
between social networks. It is a function of whom you know,
mySTRATEGY
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334 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
and what advantages you can create through those connections.
Social capital is an important concept in business. Remember
the old adage: What matters is not what you know, but whom
you know.
Some Facebook users claim to have 2,000 or more “friends.”
With larger networks, one expects to have greater social capital,
right? Though this seems obvious, academic research suggests
that humans have the brain capacity to maintain a functional
network of only about 150 people. This so-called Dunbar
number was derived by extrapolating from the brain sizes and
social networks of primates.
Far-fetched? Not necessarily. You may have a lot more
than 150 friends on Facebook or connections on LinkedIn, but
researchers call that number the social core of any network. Why
is this the case? Even though it takes only a split second to accept
a new request on Facebook or LinkedIn, relationships still need
to be groomed. To develop a meaningful relationship, you need to
spend some time with this new connection, even in cyberspace.
Social networking sites allow users to broadcast their lives
and to passively keep track of more people. They enlarge their
social networks, even though many of those ties tend to be
weak. It may come as a surprise, however, to learn that research
shows new opportunities such as job offers tend to come from
weak ties, because it is these weak ties that allow you to access
nonredundant and novel information. This phenomenon is called
strength of weak ties. So, in thinking about how to leverage
your social capital more fully as part of your career network
strategy, rather than always communicating with the same peo-
ple, it may pay for you to invest a bit more time in grooming your
weak ties.69
1. Create a list of up to 12 people at your university (or work
environment if applicable) with whom you regularly com-
municate (in person, electronically, or both). Draw your
network (place names or initials next to each node), and
connect every node where people you communicate with
also talk to one another (i.e., indicate friends of friends).
Can you identify strong and weak ties in your network?
2. Now compare your actual career-related network using a
site such as LinkedIn. Are any of your connections linked
together? With how many alumni from your university are
you linked? These alumni can provide a source of weak
ties that may help you get a foot in the door at a potential
new employer if you leverage them effectively.
1. This ChapterCase is based on: MacMillan,
D. (2016, Jan. 4), “GM invests $500 million
in Lyft, plans system for self-driving cars,”
The Wall Street Journal; Hull, D. (2016, Dec.
20), “The Tesla advantage: 1.3 billion miles
of data, Bloomberg Business; “Uber is fac-
ing the biggest crisis in its short history,” The
Economist, March 25, 2017; “The world’s
most valuable resource is no longer oil, but
data,” The Economist, May 6, 2017; “Data is
giving rise to a new economy,” The Economist,
May 6, 2017; and Bensinger, G., and J. Nicas
(2017, May 15), “Alphabet’s Waymo, Lyft to
collaborate on self- driving cars,” The Wall
Street Journal.
2. Capron, L., and W. Mitchell (2012), Build,
Borrow, or Buy: Solving the Growth Dilemma
(Boston, MA: Harvard Business Review Press).
3. Capron, L., and W. Mitchell (2012), Build,
Borrow, or Buy: Solving the Growth Dilemma
(Boston, MA: Harvard Business Review
Press), 16.
4. Hoang, H., and Rothaermel, F.T. (2010),
“Leveraging internal and external experi-
ence: Exploration, exploitation, and R&D
project performance,” Strategic Management
Journal 31: 734–758; and Gick, M.L., and
K.J. Holyoak (1987), “The cognitive basis
of knowledge transfer,” in ed. S.M. Cormier
and J. D. Hagman, Transfer of Learning (New
York: Academic Press): 9–46.
5. Gilbert, C.G. (2005), “Unbundling the struc-
ture of inertia: Resource versus routine rigidity,”
Academy of Management Journal 48: 741–763.
For an insightful and in-depth discussion of the
challenges faced by old-line media companies
in making the transition to the internet, see also:
Cozzolino, A. (2015), Three Essays on Techno-
logical Changes and Competitive Advantage:
Evidence from the Newspaper Industry (Milan:
Bocconi University); and Cozzolino, A.,
Rothaermel, F. T. (2017). Discontinuities, com-
petition, and cooperation: Coopetitive dynamics
between incumbents and entrants. Strategic
Management Journal, forthcoming.
6. Ovide, S. (2015), “Microsoft to cut 7,800
jobs on Nokia woes,” The Wall Street Journal,
July 8.
7. Gulati, R. (1998), “Alliances and net-
works,” Strategic Management Journal 19:
293–317.
8. This discussion draws on: Dyer, J.H., and
H. Singh (1998), “The relational view: Coop-
erative strategy and the sources of interorgani-
zational advantage,” Academy of Management
Review 23: 660–679.
9. Kale, P., and H. Singh (2009), “Managing
strategic alliances: What do we know now,
and where do we go from here?” Academy of
Management Perspectives 23: 45–62.
10. For a review of the alliance literature,
see Kale, P., and H. Singh (2009), “Managing
strategic alliances: What do we know now, and
where do we go from here?” Academy of Man-
agement Perspectives 23: 45–62; Lavie, D.
(2006), “The competitive advantage of inter-
connected firms: An extension of the resource-
based view,” Academy of Management Review
31: 638–658; Ireland, R.D., M.A. Hitt, and D.
Vaidyanath (2002), “Alliance management as
a source of competitive advantage,” Journal of
Management 28: 413–446; Inkpen, A. (2001),
“Strategic alliances,” in M.A. Hitt, R.E.
Freeman, and J.S. Harrison, Handbook of Stra-
tegic Management (Oxford, UK: Blackwell-
Wiley); Gulati, R. (1998), “Alliances and
networks,” Strategic Management Journal 19:
293–317; and Dyer, J.H., and H. Singh (1998),
“The relational view: Cooperative strategy and
the sources of interorganizational advantage,”
Academy of Management Review 23: 660–679.
11. Kogut, B. (1991), “Joint ventures and the
option to expand and acquire,” Management
Science 37: 19–34.
ENDNOTES
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 335
12. Markides, C.C., and P.J. Williamsen
(1994), “Related diversification, core compe-
tences, and performance,” Strategic Manage-
ment Journal 15: 149–165; and Kale, P., and
H. Singh (2009), “Managing strategic alli-
ances: What do we know now, and where do
we go from here?” Academy of Management
Perspectives 23: 45–62.
13. The author participated in the HP demo;
see also: “HP unveils Halo collaboration
studio: Life-like communication leaps across
geographic boundaries,” HP press release,
December 12, 2005.
14. This Strategy Highlight is based on:
Hoang, H., and F.T. Rothaermel (2016), “How
to manage alliances strategically,” MIT Sloan
Management Review, Fall 58(1): 69–76.
15. “Bank of America taps Cisco for Tele-
Presence,” InformationWeek, March 30, 2010.
16. Tripsas, M. (1997), “Unraveling the pro-
cess of creative destruction: Complementary
assets and incumbent survival in the typesetter
industry,” Strategic Management Journal 18:
119–142.
17. Rothaermel, F.T., and C.W.L. Hill
(2005), “Technological discontinuities and
complementary assets: A longitudinal study
of industry and firm performance,” Organi-
zation Science 16: 52–70; Hill, C.W.L., and
F.T. Rothaermel (2003), “The performance
of incumbent firms in the face of radical
technological innovation,” Academy of Man-
agement Review 28: 257–274; Rothaermel,
F.T. (2001), “Incumbent’s advantage through
exploiting complementary assets via interfirm
cooperation,” Strategic Management Journal
22: 687–699; and Rothaermel, F.T. (2001),
“Complementary assets, strategic alliances,
and the incumbent’s advantage: An empiri-
cal study of industry and firm effects in the
biopharmaceutical industry,” Research Policy
30: 1235–1251.
18. Arthaud-Day, M.L., F.T. Rothaermel,
and W. Zhang (2013), “Genentech: After
the acquisition by Roche,” case study,
in F.T. Rothaermel, Strategic Manage-
ment (New York: McGraw-Hill), http://
mcgrawhillcreate.com/rothaermel, ID#
MHE-FTR-014-0077645065.
19. Jiang, L., J. Tan, and M. Thursby (2011),
“Incumbent firm invention in emerging
fields: Evidence from the semiconductor
industry,” Strategic Management Journal 32:
55–75; Rothaermel, F.T., and M. Thursby
(2007), “The nanotech vs. the biotech revolu-
tion: Sources of incumbent productivity in
research,” Research Policy 36: 832–849.
20. This discussion is based on: Hess,
A.M., and F.T. Rothaermel (2011), “When
are assets complementary? Star scientists,
strategic alliances and innovation in the phar-
maceutical industry,” Strategic Management
Journal 32: 895–909; Ceccagnoli, M., and
F.T. Rothaermel (2008), “Appropriating the
returns to innovation,” Advances in Study of
Entrepreneurship, Innovation, and Economic
Growth 18: 11–34; Rothaermel, F.T., and W.
Boeker (2008), “Old technology meets new
technology: Complementarities, similarities,
and alliance formation,” Strategic Manage-
ment Journal 29(1): 47–77; Rothaermel,
F.T. (2001), “Incumbent’s advantage through
exploiting complementary assets via interfirm
cooperation,” Strategic Management Jour-
nal 22(6–7): 687–699; Tripsas, M. (1997),
“Unraveling the process of creative destruc-
tion: Complementary assets and incumbent
survival in the typesetter industry,” Strategic
Management Journal 18: 51, 119–142; and
Teece, D.J. (1986), “Profiting from technolog-
ical innovation: Implications for integration,
collaboration, licensing and public policy,”
Research Policy 15: 285–305.
21. Mowery, D.C., J.E. Oxley, and B.S.
Silverman (1996), “Strategic alliances and
interfirm knowledge transfer,” Strategic
Management Journal 17: 77–91.
22. Gnyawali, D., and B. Park (2011),
“Co-opetition between giants: Collaboration
with competitors for technological
innovation,” Research Policy 40: 650–663;
Gnyawali, D., J. He, and R. Madhaven (2008),
“Co-opetition: Promises and challenges,”
in ed. C. Wankel, 21st Century Management:
A Reference Handbook (Thousand Oaks, CA:
Sage), 386–398; and Brandenburger, A.M.,
and B.J. Nalebuff (1996), Co-opetition (New
York: Currency Doubleday).
23. This discussion is based on: Kale, P.,
and H. Perlmutter (2000), “Learning and
protection of proprietary assets in strate-
gic alliances: Building relational capital,”
Strategic Management Journal 21: 217–237;
Khanna, T., R. Gulati, and N. Nohria (1998),
“The dynamics of learning alliances: Com-
petition, cooperation, and relative scope,”
Strategic Management Journal 19: 193–210;
Larsson, R., L. Bengtsson, K. Henriksson,
and J. Sparks (1998), “The interorganizational
learning dilemma: Collective knowledge
development in strategic alliances,” Organiza-
tion Science 9: 285–305; Hamel, G. (1991),
“Competition for competence and interpartner
learning within international alliances,” Stra-
tegic Management Journal 12: 83–103; and
Hamel, G., Y. Doz, and C.K. Prahalad (1989),
“Collaborate with your competitors—and
win,” Harvard Business Review (January–
February): 190–196.
24. Nti, K.O., and R. Kumar (2000), “Differ-
ential learning in alliances,” in ed. D. Faulkner
and M. de Rond, Cooperative Strategy. Eco-
nomic, Business, and Organizational Issues
(Oxford, UK: University Press), 119–134.
For an opposing viewpoint, see: Inkpen, A.C.
(2008), “Knowledge transfer and international
joint ventures: The case of NUMMI and Gen-
eral Motors,” Strategic Management Journal
29: 447–453.
25. This discussion is based on: Lavie,
D. (2006), “The competitive advantage of
interconnected firms: An extension of the
resource-based view,” Academy of Manage-
ment Review 31: 638–658; Hoang, H., and
F.T. Rothaermel (2005), “The effect of general
and partner-specific alliance experience on
joint R&D project performance,” Academy of
Management Journal 48: 332–345; Ireland,
R.D., M.A. Hitt, and D. Vaidyanath (2002),
“Alliance management as a source of competi-
tive advantage,” Journal of Management 28:
413–446; and Gulati, R. (1998), “Alliances
and networks,” Strategic Management Journal
19: 293–317.
26. This discussion is based on: Hoang, H.,
and F.T. Rothaermel (2010), “Leveraging
internal and external experience: Exploration,
exploitation, and R&D project performance,”
Strategic Management Journal 31 (7):
734–758; and Pisano, G.P., and P. Mang
(1993), “Collaborative product development
and the market for know-how: Strategies and
structures in the biotechnology industry,”
in ed. R. Rosenbloom and R. Burgelman,
Research on Technological Innovation,
Management, and Policy (Greenwich, CT:
J.A.I. Press): 109–136.
27. The distinction of explicit and tacit
knowledge goes back to the seminal work
by Polanyi, M. (1966), The Tacit Dimen-
sion (Chicago, IL: University of Chicago
Press). For more recent treatments, see:
Spender, J.-C. (1996), “Managing knowl-
edge as the basis of a dynamic theory of
the firm,” Strategic Management Journal
17: 45–62; Spender, J.-C., and R.M. Grant
(1996), “Knowledge and the firm,” Strategic
Management Journal 17: 5–9; and Crossan,
M. M., H.W. Lane, R.E. White (1999),
“An organizational learning framework:
From intuition to institution,” Academy of
Management Review 24: 522–537.
28. Direct and indirect quotes above
from “Toyota and Tesla partnering to make
electric cars,” The Wall Street Journal, May
21, 2010.
29. White, J.B. (2014, Oct. 24), “Toyota
confirms sale of part of Tesla stake,” The Wall
Street Journal.
30. For an insightful treatment of CVC invest-
ments, see: Dushnitsky, G., and M.J. Lenox
(2005), “When do incumbent firms learn from
entrepreneurial ventures? Corporate venture
capital and investing firm innovation rates,”
Research Policy 34: 615–639; Dushnitsky, G.,
and M.J. Lenox (2005), “When do firms
undertake R&D by investing in new
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rot27628_ch09_308-337.indd 336 12/12/17 03:26 PM
336 CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions
ventures?” Strategic Management Journal
26: 947–965; Dushnitsky, G., and M.J. Lenox
(2006), “When does corporate venture capital
investment create value?” Journal of Business
Venturing 21: 753–772; and Wadhwa, A.,
and S. Kotha (2006), “Knowledge creation
through external venturing: Evidence from the
telecommunications equipment manufacturing
industry,” Academy of Management Journal
49: 1–17.
31. Benson, D., and R.H. Ziedonis (2009),
“Corporate venture capital as a window on
new technology for the performance of cor-
porate investors when acquiring startups,”
Organization Science 20: 329–351.
32. Dushnitsky, G., and M.J. Lenox (2006),
“When does corporate venture capital
investment create value?” Journal of
Business Venturing 21: 753–772.
33. Higgins, M.J., and D. Rodriguez (2006),
“The outsourcing of R&D through acquisi-
tion in the pharmaceutical industry,” Journal
of Financial Economics 80: 351–383; and
Benson, D., and R.H. Ziedonis (2009),
“Corporate venture capital as a window
on new technology for the performance of
corporate investors when acquiring startups,”
Organization Science 20: 329–351.
34. Reuer, J.J., M. Zollo, and H. Singh
(2002), “Post-formation dynamics in strategic
alliances,” Strategic Management Journal 23:
135–151.
35. This discussion is based on: Dyer, J.H.,
and H. Singh (1998), “The relational view:
Cooperative strategy and the sources of
interorganizational advantage,” Academy of
Management Review 23: 660–679; Ireland,
R.D., M.A. Hitt, and D. Vaidyanath (2002),
“Alliance management as a source of competi-
tive advantage,” Journal of Management 28:
413–446; and Lavie, D. (2006), “The competi-
tive advantage of interconnected firms: An
extension of the resource-based view,” Acad-
emy of Management Review 31: 638–658.
36. For an insightful discussion of alliance
management capability and alliance portfo-
lios, see: Schilke, O., and A. Goerzten (2010),
“Alliance management capability: An investi-
gation of the construct and its measurement,”
Journal of Management 36: 1192–1219;
Schreiner, M., P. Kale, and D. Corsten
(2009), “What really is alliance management
capability and how does it impact alliance
outcomes and success?” Strategic Manage-
ment Journal 30: 1395–1419; Ozcan, P., and
K.M. Eisenhardt (2009), “Origin of alliance
portfolios: Entrepreneurs, network strategies,
and firm performance,” Academy of Manage-
ment Journal 52: 246–279; Hoffmann, W.
(2007), “Strategies for managing a portfolio
of alliances,” Strategic Management Journal
28: 827–856; and Rothaermel, F.T., and D.L.
Deeds (2006), “Alliance type, alliance experi-
ence, and alliance management capability in
high-technology ventures,” Journal of Busi-
ness Venturing 21: 429–460.
37. Kale, P., and H. Singh (2009), “Managing
strategic alliances: What do we know now,
and where do we go from here?” Academy of
Management Perspectives 23: 45–62.
38. Santoro, M.D., and J.P. McGill (2005),
“The effect of uncertainty and asset cospe-
cialization on governance in biotechnology
alliances,” Strategic Management Journal 26:
1261–1269.
39. This is based on: Gulati, R. (1995), “Does
familiarity breed trust? The implications of
repeated ties for contractual choice in alli-
ances,” Academy of Management Journal
38: 85–112; and Poppo, L., and T. Zenger
(2002), “Do formal contracts and relational
governance function as substitutes or comple-
ments?” Strategic Management Journal 23:
707–725.
40. Dyer, J.H., and H. Singh (1998), “The
relational view: Cooperative strategy and
the sources of interorganizational advan-
tage,” Academy of Management Review 23:
660–679.
41. Zaheer, A., B. McEvily, and V. Perrone
(1998), “Does trust matter? Exploring the
effects of interorganizational and interpersonal
trust on performance,” Organization Science
8: 141–159.
42. Covey, S.M.R. (2008), The Speed of
Trust: The One Thing That Changes Every-
thing (New York: Free Press).
43. Dyer, J.H., and H. Singh (1998), “The
relational view: Cooperative strategy and
the sources of interorganizational advan-
tage,” Academy of Management Review 23:
660–679; Ireland, R.D., M.A. Hitt, and D.
Vaidyanath (2002), “Alliance management as
a source of competitive advantage,” Journal
of Management 28: 413–446; and Lavie,
D. (2006), “The competitive advantage of
interconnected firms: An extension of the
resource-based view,” Academy of Manage-
ment Review 31: 638–658.
44. This is based on: Anand, B., and T.
Khanna (2000), “Do firms learn to create
value?” Strategic Management Journal 21:
295–315; Sampson, R. (2005), “Experience
effects and collaborative returns in R&D alli-
ances,” Strategic Management Journal 26:
1009–1031; Hoang, H., and F.T. Rothaermel
(2005), “The effect of general and partner-
specific alliance experience on joint R&D
project performance,” Academy of Manage-
ment Journal 48: 332–345; and Rothaermel,
F.T., and D.L. Deeds (2006), “Alliance type,
alliance experience, and alliance management
capability in high-technology ventures,” Jour-
nal of Business Venturing 21: 429–460.
45. Rothaermel, F.T., and D.L. Deeds
(2006), “Alliance type, alliance experience,
and alliance management capability in high-
technology ventures,” Journal of Business
Venturing 21: 429–460.
46. Hoffmann, W. (2007), “Strategies for
managing a portfolio of alliances,” Strategic
Management Journal 28: 827–856.
47. Wassmer, U., P. Dussage, and M. Planel-
las (2010), “How to manage alliances better
than one at a time,” MIT Sloan Management
Review, Spring: 77–84.
48. Dyer, J. H., P. Kale, and H. Singh (2001),
“How to make strategic alliances work,” MIT
Sloan Management Review, Summer: 37–43.
49. Kale, P., J. H. Dyer, and H. Singh (2002),
“Alliance capability, stock market response,
and long-term alliance success: The role of
the alliance function,” Strategic Management
Journal 23: 747–767.
50. Gueth A., N. Sims, and R. Harrison
(2001), “Managing alliances at Lilly,” In
Vivo: The Business & Medicine Report, June:
1–9; and Rothaermel, F.T., and D.L. Deeds
(2006), “Alliance type, alliance experience,
and alliance management capability in high-
technology ventures,” Journal of Business
Venturing 21: 429–460.
51. Dyer, J.H., P. Kale, and H. Singh (2004),
“When to ally and when to acquire,” Harvard
Business Review, July–August.
52. Rothaermel, F.T., and A. Hess (2010),
“Innovation strategies combined,” MIT Sloan
Management Review, Spring: 12–15.
53. Hitt, M.A., R.D. Ireland, and J.S.
Harrison (2001), “Mergers and acquisi-
tions: A value creating or value destroying
strategy?” in M.A. Hitt, R.E. Freeman, and
J.S. Harrison, Handbook of Strategic Man-
agement (Oxford, UK: Blackwell-Wiley):
384–408. In 2015 alone, M&A deals valued at
over $4 trillion were announced, a record high
since 2007 before the global financial crisis;
see Mattioli, D., and D. Cimilluca (2015, Jun.
26), “Fear of losing out drives deal boom,”
The Wall Street Journal. M&A activity was
lower in 2016 and 2017; see: “Global M&A
by quarter,” in Investment Banking Scorecard,
The Wall Street Journal, at
http://graphics.wsj.com/investment-banking-
scorecard/, accessed May 19, 2017.
54. Allen, W.B., N.A. Doherty, K. Weigelt,
and E. Mansfield (2005), Managerial Eco-
nomics, 6th ed. (New York: Norton); and
Breshnahan, T., and P. Reiss (1991), “Entry
and competition in concentrated markets,”
Journal of Political Economy 99: 997–1009.
55. FitzGerald, D., and L. Hoffman (2015,
Feb. 4), “Staples inks deal to buy Office
Depot for $6.3 billion,” The Wall Street
Journal.
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CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 337
56. Brush, T.H. (1996), “Predicted change in
operational synergy and post-acquisition per-
formance of acquired businesses,” Strategic
Management Journal 17: 1–24.
57. Tebbutt, T. (2010, Jan. 29), “An insider’s
perspective of the pharmaceutical industry,”
presentation in “Competing in the Health
Sciences,” Georgia Institute of Technology.
Tebbutt is former president of UCB Pharma.
58. Smith, E., and L.A.E. Schuker (2009,
Sept. 1), “Disney nabs Marvel heroes,” The
Wall Street Journal, September 1.
59. Clark, D., D. Cimilluca, and D. Mattioli
(2015, Jun. 1), “Intel agrees to buy Altera for
$16.7 billion,” The Wall Street Journal.
60. Examples are drawn from: Dulaney, C.
(2014, Oct. 6), “Facebook completes acquisi-
tion of WhatsApp,” The Wall Street Journal;
Albergotti, R., and I. Sherr (2014, Mar. 25),
“Facebook to buy virtual reality firm Ocu-
lus for $2 billion,” The Wall Street Journal;
“Google buys Waze,” The Economist, June
15, 2013; Rusli, E.M., and D. MacMillan
(2013, Nov. 13), “Messaging service Snapchat
spurned $3 billion Facebook bid,” The Wall
Street Journal; “Insta-rich: $1 billion for
Instagram,” The Wall Street Journal,
April 10, 2012; “Google’s $12.5 billion
gamble,” The Wall Street Journal, August 16,
2011; and “Google in talks to buy
YouTube for $1.6 billion,” The Wall
Street Journal, October 7, 2006.
61. Strategy Highlight 9.2 is based on: Kraft
Foods annual reports (various years); The
Hershey Co. annual reports (various years);
Cimilluca, D., D. Mattioli, and C. Dulaney
(2015, Mar. 25), “Kraft, Heinz to merge,
forming food giant,” The Wall Street Journal;
“Mondelez can slim way to success,” The
Wall Street Journal, May 28, 2013; “Analysts
bullish on Mondelez ahead of Kraft split,” The
Wall Street Journal, October 2012; “Cadbury
accepts fresh Kraft offer,” The Wall Street
Journal, January 19, 2010; “Kraft wins a
reluctant Cadbury with help of clock, hedge
funds,” The Wall Street Journal, January 20,
2010; “Cadbury rejects Kraft’s $16.73 billion
bid,” The Wall Street Journal, September 7,
2009; “Food fight,” The Economist, Novem-
ber 5, 2017; Chaudhuri, S., A. Gasparro, A.
Steele (2017, Feb. 17), “Kraft’s $143 bil-
lion bid for Unilever highlights squeeze in
consumer goods,” The Wall Street Journal;
Chaudhuri, S. and A. Gasparro (2017, Feb.
20), “Failed $143 billion deal raises pressure
on Unilever, Kraft,” The Wall Street Journal;
and Mackintosh, J. (2017, Feb. 21),
“Kraft-Unilever deal is off, but Warren
Buffett’s anomalies live on,” The Wall Street
Journal; and the author’s personal communi-
cation with Dr. Narayanan Jayaraman, Georgia
Institute of Technology.
62. Capron, L. (1999), “The long-term per-
formance of horizontal acquisitions,” Strategic
Management Journal 20: 987–1018; Capron,
L., and J.C. Shen (2007), “Acquisitions of
private vs. public firms: Private information,
target selection, and acquirer returns,” Strate-
gic Management Journal 28: 891–911.
63. Jensen, M.C., and R.S. Ruback (1983),
“The market for corporate control: The scien-
tific evidence,” Journal of Financial Econom-
ics 11: 5–50.
64. This discussion is based on: Finkel-
stein, S. (2003), Why Smart Executives
Fail, and What You Can Learn from Their
Mistakes (New York: Portfolio); Lambert,
R.A., D.F. Larcker, and K. Weigelt (1991),
“How sensitive is executive compensation
to organizational size?” Strategic
Management Journal 12: 395–402;
and Finkelstein, S., and D.C. Hambrick
(1989), “Chief executive compensation:
A study of the intersection of markets and
political processes, Strategic Management
Journal 10: 121–134.
65. This discussion is based on: Finkelstein,
Why Smart Executives Fail, and What You
Can Learn from Their Mistakes; and
Finkelstein, S., J. Whitehead, and A.
Campbell (2009), Think Again: Why Good
Leaders Make Bad Decisions and How to
Keep It from Happening to You (Boston, MA:
Harvard Business School Press).
66. This discussion is based on: Finkelstein,
Why Smart Executives Fail, and What You
Can Learn from Their Mistakes; and Fin-
kelstein, S., J. Whitehead, and A. Campbell
(2009), Think Again: Why Good Leaders
Make Bad Decisions and How to Keep It from
Happening to You (Boston, MA: Harvard
Business School Press).
67. This section is based on: Capron, L., and
W. Mitchell (2012), Build, Borrow, or Buy:
Solving the Growth Dilemma (Boston, MA:
Harvard Business Review Press).
68. Dyer, J.H., P. Kale, and H. Singh (2004),
“When to ally and when to acquire,” Harvard
Business Review, July–August.
69. This myStrategy section is based on:
Granovetter, M. (1973), “The strength of weak
ties,” American Journal of Sociology 78:
1360–1380; and “Primates on Facebook,” The
Economist, February 26, 2009.
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CHAPTER Global Strategy:
Competing Around
the World
Chapter Outline
10.1 What Is Globalization?
Stages of Globalization
State of Globalization
10.2 Going Global: Why?
Advantages of Going Global
Disadvantages of Going Global
10.3 Going Global: Where and How?
Where in the World to Compete? The CAGE
Distance Framework
How Do MNEs Enter Foreign Markets?
10.4 Cost Reductions vs. Local Responsiveness:
The Integration-Responsiveness Framework
International Strategy
Multidomestic Strategy
Global-Standardization Strategy
Transnational Strategy
10.5 National Competitive Advantage: World
Leadership in Specific Industries
Porter’s Diamond Framework
10.6 Implications for Strategic Leaders
Learning Objectives
LO 10-1 Define globalization, multinational
enterprise (MNE), foreign direct
investment (FDI), and global strategy.
LO 10-2 Explain why companies compete abroad,
and evaluate the advantages and
disadvantages of going global.
LO 10-3 Apply the CAGE distance framework to
guide MNE decisions on which countries to
enter.
LO 10-4 Compare and contrast the different options
MNEs have to enter foreign markets.
LO 10-5 Apply the integration-responsiveness
framework to evaluate the four different
strategies MNEs can pursue when
competing globally.
LO 10-6 Apply Porter’s diamond framework to
explain why certain industries are more
competitive in specific nations than in
others.
10
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SOURCE: Depiction of data from IKEA Yearly Summaries (www.ikea.com), various years.
Sweden’s IKEA: The World’s Most
Profitable Retailer
THE WORLD’S MOST profitable global retailer is not
Walmart or the UK-based Tesco, but IKEA—a privately
owned home-furnishings company hailing from Sweden.
In 2017, IKEA owned more than 400 stores in various for-
mats worldwide in 28 countries, employed over 160,000
people, and earned revenues of more than 35 billion
euros. Exhibit 10.1 shows IKEA’s growth in the number
of stores and revenues worldwide.
Known today for its iconic blue-and-yellow big-box
retail stores, focusing on flat-pack furniture boxes com-
bined with a large do-it-yourself component, IKEA started
as a small retail outlet in 1943 by then-17-year-old Ingvar
Kamprad. Though IKEA has become a global phenom-
enon, it was initially slow to internationalize. It took 20
years before the company expanded beyond Sweden to
its neighbor Norway. After honing and refining its core
competencies—designing and offering modern, and
functional home furnishings in a unique retail experi-
ence resulting in a low cost structure—in its home market,
IKEA followed an international strategy, expanding first to
Europe and then beyond. Under this strategy, IKEA can
CHAPTERCASE 10
Sweden’s IKEA is growing quickly in both developed countries, such
as the United States and Australia, and also in emerging economies
such as China.
©testing/Shutterstock.com RF
400
450
350
300
RevenuesStores
250
200
150
100
50
0
1974 1984 1994 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
0
5
10
15
20
Re
ve
nu
es
(b
ill
io
ns
e
ur
o)
Nu
mb
er
o
f S
to
re
s
25
30
35
40
EXHIBIT 10.1 / IKEA Stores and Revenues, 1974–2016
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340
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SOURCE: Depiction of data from IKEA Yearly Summaries (www.ikea.com)
sell the same types of home furnishings across the globe with
little adaptation, although it does make some allowances for
country preferences. IKEA is present across all major mar-
kets today, having entered India and Serbia in 2017.
In recent years IKEA’s strategy has evolved. To keep
costs low, it shifted from an international strategy to a
global-standardization strategy, in which it attempts to
achieve economies of scale through effectively managing
a global supply chain. Although Asia accounts currently
for only 9 percent of its sales, IKEA sources 35 percent
of its inputs from this region. To pare costs further, IKEA
has begun to implement production techniques from auto
and electronics industries, using cutting-edge technologies
to address complexity while achieving flexibility and low
cost. IKEA’s revenues by geographic region are mainly
from Europe (69 percent), with the rest from North America
(18 percent), Asia and Australia (9 percent), and Russia
(4 percent); see Exhibit 10.2. Although IKEA’s largest mar-
ket is in Germany (14 percent of total sales), it is seeing
strong growth in China, Canada, Poland, and Australia.
The privately held company has also successfully rein-
vented itself with changing consumer demands: newer for-
mats such as smaller stores in city centers, click-and-collect
locations (small stores for retrieval of online purchases),
and more customized furniture solutions to meet the needs
of an increasingly urban population. In addition, IKEA is
investing heavily in its online presence, enabling consumers
to do all their purchasing online, and then schedule deliv-
ery, and even installation of furniture. Busy urban profes-
sionals are less inclined to spend the well-known frustrating
and long hours putting IKEA furniture together (“easy
assembly”) with the included low-quality tool and minimal
instructions. IKEA’s functional website (ikea.com) now
garners more than 2 billion hits a year. In the meantime,
IKEA’s big-box stores remain attractive destinations, with
over 1 billion visits a year, up from some 750 million just a
few years earlier.1
You will learn more about IKEA by reading this chapter; related
questions appear in “ChapterCase 10 / Consider This....”
Europe,
69%
North America,
18%
Asia
& Australia,
9%
Russia,
4%
EXHIBIT 10.2 / IKEA Sales by Geographic Region (2016)
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IT IS SOMEWHAT surprising that a privately held furniture maker from Sweden
is the world’s most profitable retailer and not a behemoth such as the U.S.-based
Walmart or the United Kingdom’s Tesco. IKEA’s success in its international markets is
critical to its competitive advantage. IKEA succeeds in both rich developed countries such
as the United States and Germany, as well as in emerging economies such as China, India,
and Russia. Hailing from a small country in Europe, IKEA earns the vast majority of its
revenues outside of its borders. Moreover, IKEA’s fastest growth is outside Europe.
IKEA intends to reach sales of 50 billion euros by 2020, up from 35 billion euros in
2016, and double its 2011 sales of 25 billion euros. It wants to own 500 profitable stores
globally by 2020, up from some 240 stores in 2006. To accomplish these lofty goals, IKEA
must get its global strategy right, especially in growing markets such as China and India.
Both are countries with more than 1 billion people each and a rapidly expanding middle
class, on which IKEA wants to capitalize.
For more and more U.S. companies, international markets offer the biggest growth
opportunities, just as they do for IKEA. Firms from a wide variety of industries—such as
Apple, Caterpillar, GE, Intel, and IBM—are global enterprises. They have a global work
force and manage global supply chains, and they obtain the majority of their revenues
from outside their home market. Once-unassailable U.S. firms now encounter formidable
foreign competitors such as Brazil’s Embraer (aerospace); China’s Alibaba (ecommerce),
Haier (home appliances), Lenovo (PCs), and Huawei (cell phones); India’s ArcelorMit-
tal (steel), Infosys (IT services), and Reliance Group (conglomerate); Germany’s Siemens
(engineering conglomerate), Daimler, BMW, and VW (vehicles); Japan’s Toyota, Honda,
and Nissan (vehicles); Mexico’s Cemex (cement); Russia’s Gazprom (energy); South
Korea’s LG and Samsung (both in electronics and appliances); and Sweden’s IKEA (home
furnishings), to name just a few. This chapter is about how firms gain and sustain competi-
tive advantage when competing around the world.
The competitive playing field is becoming increasingly global, as the ChapterCase
about the home-furnishings industry indicates. This globalization provides significant
opportunities for individuals, companies, and countries. Indeed, you can probably see
the increase in globalization on your own campus. The number of students enrolled at
universities outside their native countries quadrupled between 1980 and 2014 to over
4 million.2 By 2025, the total number is predicted to double yet again, to 8 million.3
The country of choice for foreign students remains the United States, with more than
1 million international students enrolled per year, followed by the United Kingdom. The
top five countries sending the most students to study abroad are (in rank order): China,
India, Korea, Germany, and Saudi Arabia.4
In Chapter 8, we looked at the first two dimensions of corporate strategy: managing
the degree of vertical integration, and deciding which products and services to offer (the
degree of diversification). Now we turn to the third dimension: competing effectively
around the world. The world’s marketplace—made up of some 200 countries—is a stag-
gering $76 trillion in gross domestic product (GDP), of which the U.S. market is roughly
$18 trillion, or about 24 percent.5
We begin this chapter by defining globalization and presenting stages of globalization.
We then tackle a number of questions that a firm must answer: Why should a company
go global? Where and how should it compete? We present the CAGE6 distance model
to answer the question of where the firm should compete globally and the integration-
responsiveness framework to link a firm’s options of how to compete globally with the dif-
ferent business strategies introduced in Chapter 6 (cost leadership, differentiation, and blue
ocean). We then debate the question of why world leadership in specific industries is often
concentrated in certain geographic areas. We conclude with the practical Implications for
Strategic Leaders.
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10.1 What Is Globalization?
Globalization is a process of closer integration and exchange between different countries
and peoples worldwide, made possible by falling trade and investment barriers, advances
in telecommunications, and reductions in transportation costs.7 Combined, these factors
reduce the costs of doing business around the world, opening the doors to a much larger
market than any one home country. Globalization also allows companies to source supplies
at lower costs, to learn new competencies, and to further differentiate products. Conse-
quently, the world’s market economies are becoming more integrated and interdependent.
Globalization has led to significant increases in living standards in many economies
around the world. Germany and Japan, countries that were basically destroyed after
World War II, turned into industrial powerhouses, fueled by export-led growth. The Asian
Tigers—Hong Kong, Singapore, South Korea, and Taiwan—turned themselves from
underdeveloped countries into advanced economies, enjoying some of the world’s highest
standards of living. China and India continue to offer significant business opportunities.8
Indeed, China, with $11 trillion in GDP, has become the second-largest economy world-
wide after the United States (with $18 trillion in GDP) and ahead of Japan in third place
($5 trillion GDP), in absolute terms.9 Adjusting GDP for size of population (per capita)
and adjusting for difference in cost of living (purchasing power parity), the United States
is in 12th place, China comes in at 92nd, and Japan ranks 27th. The three richest countries
in the world by income per person are Qatar, Macao (which is a Special Administrative
Region of China), and Kuwait; all of which are smaller but wealthy countries.
The engine behind globalization is the multinational enterprise (MNE)—a company
that deploys resources and capabilities in the procurement, production, and distribution of
goods and services in at least two countries. MNEs need an effective global strategy that
enables them to gain and sustain a competitive advantage when competing against other
foreign and domestic companies around the world.10 By making investments in value chain
activities abroad, MNEs engage in foreign direct investment (FDI).11
For example, the European aircraft maker Airbus invested $600 million in Mobile,
Alabama, to build jetliners.12 The new Mobile Aeroplex is a 53-acre facility where Airbus
builds the vast majority of its single-aisle A-320 jetliners. Airbus made a significant strate-
gic commitment to the U.S. market, the destination of the majority of its new jetliners; the
A-320 is mainly used in domestic U.S. air travel. Being located in Alabama allows Airbus
to be much closer to its customers and thus to receive and incorporate feedback, as individ-
ual airlines request specific customizations. It allows Airbus to take advantage of business-
friendly conditions such as lower taxes, labor cost, and cost of living, plus other incentives
provided by host states in the Southern United States. Making Airbus planes in the United
States also prevents the European company from being forced to accept import restrictions.
U.S. MNEs have a disproportionately positive impact on the U.S. economy.13 Well-
known U.S. multinational enterprises include Boeing, Caterpillar, Coca-Cola, GE, John
Deere, Exxon Mobil, IBM, P&G, and Walmart. U.S. MNEs make up less than 1 percent of
the number of total U.S. companies, but they:
■ Account for 11 percent of private-sector employment growth since 1990.
■ Employ 19 percent of the work force.
■ Pay 25 percent of the wages.
■ Provide for 31 percent of the U.S. gross domestic product (GDP).
■ Make up 74 percent of private-sector R&D spending.
As a business student, you have several reasons to be interested in MNEs. Not only can
these companies provide interesting work assignments in different locations throughout
multinational enterprise
(MNE) A company
that deploys resources
and capabilities in the
procurement, produc-
tion, and distribution of
goods and services in at
least two countries.
global strategy Part
of a firm’s corporate
strategy to gain and
sustain a competitive
advantage when compet-
ing against other foreign
and domestic companies
around the world.
foreign direct
investment (FDI) A
firm’s investments in
value chain activities
abroad.
Globalization The
process of closer inte-
gration and exchange
between different coun-
tries and peoples world-
wide, made possible by
falling trade and invest-
ment barriers, advances
in telecommunications,
and reductions in trans-
portation costs.
LO 10-1
Define globalization,
multinational enterprise
(MNE), foreign direct
investment (FDI), and
global strategy.
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the world, but they also frequently offer the highest-paying jobs for college graduates.
Even if you don’t want to work for an MNE, chances are that the organization you will be
working for will do business with one, so it’s important to understand how they compete
around the globe.
STAGES OF GLOBALIZATION
Since the beginning of the 20th century, globalization has proceeded through three notable
stages.14 Each stage presents a different global strategy pursued by MNEs headquartered
in the United States.
GLOBALIZATION 1.0: 1900–1941. Globalization 1.0 took place from about 1900 through
the early years of World War II. In that period, basically all the important business func-
tions were located in the home country. Typically, only sales and distribution operations
took place overseas—essentially exporting goods to other markets. In some instances,
firms procured raw materials from overseas. Strategy formulation and implementation, as
well as knowledge flows, followed a one-way path—from domestic headquarters to inter-
national outposts. This time period saw the blossoming of the idea of MNEs. It ended with
the U.S. entry into World War II.
GLOBALIZATION 2.0: 1945–2000. With the end of World War II came a new focus on
growing business—not only to meet the needs that went unfulfilled during the war years
but also to reconstruct the damage from the war. From 1945 to the end of the 20th cen-
tury, in the Globalization 2.0 stage, MNEs began to create smaller, self-contained copies
of themselves, with all business functions intact, in a few key countries; notably, Western
European countries, Japan, and Australia.
This strategy required significant amounts of foreign direct investment. Although it was
costly to duplicate business functions in overseas outposts, doing so allowed for greater
local responsiveness to country-specific circumstances. While the U.S. corporate head-
quarters set overarching strategic goals and allocated resources through the capital budget-
ing process, local mini-MNE replicas had considerable leeway in day-to-day operations.
Knowledge flow back to U.S. headquarters, however, remained limited in most instances.
GLOBALIZATION 3.0: 21ST CENTURY. Since 2001, we are in the Globalization 3.0 stage.
One watershed event was China’s entry into the World Trade Organization in the same
year. The World Trade Organization (WTO) is a global organization overseeing and admin-
istering the rules of trade between nations.15 The goal of the WTO is to help companies
conduct their business across borders based on multinational treaties that are negotiated
and signed by its 164 member nations.
MNEs that had been the vanguard of globalization have since become global collabo-
ration networks (see Exhibit 10.3). Such companies now freely locate business functions
anywhere in the world based on an optimal mix of costs, capabilities, and PESTEL factors.
Huge investments in fiber-optic cable networks around the world have effectively reduced
communication distances, enabling companies to operate 24/7, 365 days a year. When an
engineer in Minneapolis, Minnesota, leaves for the evening, an engineer in Mumbai, India,
begins her workday. In the Globalization 3.0 stage, the MNE’s strategic objective changes.
The MNE reorganizes from a multinational company with self-contained operations in a
few selected countries to a more seamless global enterprise with centers of expertise. Each
of these centers of expertise is a hub within a global network for delivering products and ser-
vices. Consulting companies, for example, can now tap into a worldwide network of experts
in real time, rather than relying on the limited number of employees in their local offices.
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Creating a global network of local expertise is beneficial not only in service industries,
but also in the industrial sector. To increase the rate of low-cost innovation that can then
be used to disrupt existing markets, GE organizes local growth teams in China, India,
Kenya, and many other emerging countries.16 GE uses the slogan “in country, for country”
to describe the local growth teams’ autonomy in deciding which products and services to
develop, how to make them, and how to shape the business model. Many of these low-cost
innovations, first developed to serve local needs, are later introduced in Western markets
to become disruptive innovations. Examples include the Vscan, a handheld ultrasound
device developed in China; the MAC 400, an ECG device developed in India (details fol-
low later); and the 9100c, an anesthesia system developed in Kenya.17
Some new ventures organize as global collaboration networks from the start. Logitech,
the maker of wireless peripherals such as computer mice, presentation “clickers,” and
video game controllers, started in Switzerland but quickly established offices in Silicon
Valley, California.18 Pursuing a global strategy right from the start allowed Logitech to tap
into the innovation expertise contained in Silicon Valley.19 In 2016, Logitech had sales of
over $2 billion, with offices throughout the Americas, Asia, and Europe. Underlying Logi-
tech’s innovation competence is a network of best-in-class skills around the globe. Based
on its geographic presence, Logitech can organize work continuously because its teams in
different locations around the globe can work 24/7.
Indeed, the trend toward global collaboration networks during the Globalization 3.0
stage raises the interesting question, “What defines a U.S. company?” If it’s the address
of the headquarters, then IBM, GE, and others are U.S. companies—despite the fact that a
majority of their employees work outside the United States. In many instances, the major-
ity of their revenues also come from outside the United States. On the other hand, non-U.S.
companies such as carmakers from Japan (Toyota, Honda, and Nissan) and South Korea
(Hyundai and Kia) and several engineering companies (Siemens from Germany, and ABB,
a Swiss-Swedish MNE) all have made significant investments in the United States and cre-
ated a large number of well-paying jobs.
STATE OF GLOBALIZATION
Before we delve deeper into the question of why and how firms compete for advantage
globally, a cautionary note concerning globalization is in order. Although many large firms
are more than 50 percent globalized—meaning that more than half of their revenues are
from outside the home country—the world itself is far less global.20 If we look at a number
EXHIBIT 10.3 /
Globalization 3.0: 21st
Century
Based on an optimal mix
of costs, skills, and PESTEL
factors, MNEs are orga-
nized as global collabora-
tion networks that perform
business functions
throughout the world.
SOURCE: Adapted from “A
Decade of Generating Higher
Value at IBM,” www.ibm.com,
2009.
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of different indicators, the level of globalization is no more than 10 to 25 percent. For
example, only
■ 2 percent of all voice-calling minutes are cross-border.21
■ 3 percent of the world’s population are first-generation immigrants.
■ 9 percent of all investments in the economy are foreign direct investments.
■ 15 percent of patents list at least one foreign inventor.
■ 18 percent of internet traffic crosses national borders.
These data indicate that the world is not quite flat yet,22 or fully globalized, but at best
semi-globalized. Pankaj Ghemawat reasons that many more gains in social welfare and
living standards can be had through further globalization if future integration is managed
effectively through coordinated efforts by governments.23
The European Union is an example of coordinated economic and political integration
by 28 countries (reduced to 27 after Brexit negotiations are finalized, expected in 2019), of
which 19 use the euro as a common currency. This coordinated integration took place over
several decades following World War II, precisely to prevent future wars in Europe. The EU
encompasses 500 million people, which makes it one of the largest economic zones in the
world. Indeed its GDP is a little bit larger than the United States, the largest single-country
market in the world. Although the EU has monetary authority administered through the
European Central Bank, it does not have fiscal (i.e., budgetary) authority. This important
responsibility remains with national governments. This separation between monetary and
fiscal authority allowed the sovereign debt crisis during 2009–2015 to emerge.
Continued economic development across the globe has two consequences for MNEs.
First, rising wages and other costs are likely to negate any benefits of access to low-cost
input factors. Second, as the standard of living rises in emerging economies, MNEs are
hoping that increased purchasing power will enable workers to purchase the products they
used to make for export only.24 China’s labor costs, for example, are steadily rising in tan-
dem with an improved standard of living, especially in the coastal regions, where wages
have risen 50 percent since 2005.
Some MNEs have boosted wages an extra 30 percent following labor unrest in recent
years. Many now offer bonuses to blue-collar workers and are taking other measures to
avoid sweatshop allegations that have plagued companies such as Nike, Apple, and Levi
Strauss. Rising wages, fewer workers due to the effects of China’s one-child-per-family
policy, and appreciation of the Chinese currency now combine to lessen the country’s
advantage in low-cost manufacturing.25 This shift is in alignment with the Chinese govern-
ment’s economic policy, which wants to see a move from “Made in China” to “Designed in
China,” to capture more of the value added.26 For instance, the value added of manufactur-
ing an iPhone by Foxconn in China is only about 5 percent.27
GLOBALIZATION 3.1: RETRENCHMENT? Several black swan events (that is, highly improb-
able, but high-impact events) have buffeted the world economy in recent years. The global
financial crisis between 2008 and 2010 led to a deep recession and high unemployment
in many parts of the world, including the United States. At the same time, the European
sovereign debt crisis unfolded with several countries teetering on the verge of insolvency,
leading to high unemployment in some countries. For instance, about 50 percent of the
people under 25 were unemployed in Spain and Greece. In the 2010s, the European refu-
gee crisis unfolded with millions of people being displaced. Fleeing civil war zones as well
as territory occupied by the Islamic State, over 1.3 million refugees in 2015 alone streamed
into the European Union. While the crises in the United States and the EU unfolded, China
continued to rise both in economic and political power, establishing itself as a superpower
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to be reckoned with, potentially challenging the supremacy of the United States. Other
countries, such as Russia and Turkey, appear to become more autocratic as time unfolds.
All of these macro events contributed to a rise of nationalism in the United States and
Western Europe. In 2016, the British voted to leave the European Union. Right-wing par-
ties registered strong gains in national elections in many European countries. Meanwhile,
in the United States, during his inaugural speech in 2017, President Donald Trump pro-
claimed an “America first” policy.
As a consequence, globalization is currently undergoing some retrenchment with a
stronger focus on nationalism. Rather than multinational trade deals negotiated by inter-
national bodies such as the WTO, bilateral treaties between countries are in vogue. The
future viability of entire economic trading blocs such as the European Union or NAFTA
are being questioned. Any resulting changes would likely affect cross-border trade in a
negative fashion, impacting MNEs the most. It remains to be seen whether such sentiments
will have lasting consequences over the next few years as this process of potential global-
ization retrenchment unfolds.
10.2 Going Global: Why?
The decision to pursue international expansion results from the firm’s assessment that
doing so enhances its competitive advantage and that the benefits of globalization exceed
the costs. Simply put, firms expand beyond their domestic borders if they can increase
their economic value creation (V − C) and enhance competitive advantage. As detailed
in Chapter 5, firms enlarge their competitive advantage by increasing a consumer’s will-
ingness to pay through higher perceived value based on differentiation and/or lower pro-
duction and service delivery costs. Expanding beyond the home market, therefore, should
reinforce a company’s basis of competitive advantage—whether differentiation, low-cost,
or value innovation. Here we consider both the advantages and disadvantages of expanding
beyond the home market (see Exhibit 10.4).
ADVANTAGES OF GOING GLOBAL
Why do firms expand internationally? The main reasons firms expand abroad are to
■ Gain access to a larger market.
■ Gain access to low-cost input factors.
■ Develop new competencies.
GAIN ACCESS TO A LARGER MARKET. Becoming an MNE provides significant opportuni-
ties for companies, given economies of scale and scope that can be reaped by participating
LO 10-2
Explain why companies
compete abroad, and
evaluate the advantages
and disadvantages of
going global.
EXHIBIT 10.4 /
Advantages and
Disadvantages
of International
Expansion Disadvantages
• Liability of foreignness
• Loss of reputation
• Loss of intellectual property
Advantages
• Access new markets
• Access lower-cost inputs
• Develop new competencies
International
Expansion
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The Gulf Airlines Are Landing in the
United States
Fasten your seat belts, Delta, American, and United. Severe
turbulence may be ahead.
New entrants into both the domestic and international
routes are increasing the competitive pressure on U.S. legacy
air carriers. Three airlines—Emirates, Etihad Airways, and Qatar
Airways—all from the Persian Gulf, are using a blue ocean strategy
to attract new customers. The Gulf carriers offer higher quality
at lower cost to break into international routes, the last remain-
ing profit sanctuary of U.S. carriers. The legacy carriers have
long been squeezed domestically by low-cost competitors such
as Southwest, Fron-
tier, Spirit, and others
(see Strategy Highlight
3.2). Although most of
the future growth is in
Asia, the United States
remains the world’s larg-
est air traffic market,
still holding on to one-
third of all business.
But look at the lat-
est U.S. competitors.
The Gulf carriers make
flying enjoyable again,
getting away from the
Greyhound bus feel
adopted by U.S. car-
riers to drive down
costs. At many U.S.
airlines, service has
deteriorated as air travel has become a commodity, and price
has become the main competitive weapon. A high-profile inci-
dent in 2017, as an already seated United Airlines passenger
was removed by force to make room for late-arriving crew
members hitching a ride, epitomized the service crisis in U.S.
air travel. Caught on video by smartphones, the incident went
viral, receiving global attention. Qatar Airways, one of the
Gulf carriers, was quick to update its smartphone app to say
that it “doesn’t support drag and drop of passengers.”
The Gulf airlines bring back some of the service and glam-
our that used to be associated with air travel. They offer
amenities such as higher-quality complimentary meals and
hot towels in economy, in addition, to an open bar in business
class, and private suites with showers in first class. Their
ratio of flight attendants to passengers is also greater, includ-
ing offering flying nannies to keep kids occupied, happy, and
most importantly not crying. In their home base, they build
airports reminiscent of luxury hotels with swimming pools
above the concourse for laps during layovers, high-speed
Wi-Fi, high-end conference rooms with the latest audiovisual
equipment, plush lounges, and many other amenities.
Given their location on the Persian peninsula, the Gulf airlines
offer direct flights to
major hubs in Europe,
Asia, and the United
States, using the new-
est and most modern
aircraft. Their reach via
direct flights extends
to about 80 percent of
the world’s population.
In particular, the Gulf
carriers are already
connecting Europe and
Asia, having taken away
major business from
European airlines such
as Lufthansa of Germany
and British Airways.
These so-called super-
connectors already dom-
inate the long-distance
route between Europe and Asia, growing its passengers threefold
over the past decade. Moreover, traditional international airport
hubs such as London, Frankfurt, and Amsterdam all have lost a
large share of their business to the new luxury hubs in Dubai,
Abu Dhabi, and Doha. The Gulf carriers are now attempting to
repeat this feat in the United States, offering direct flights to many
U.S. cities including Atlanta, Boston, Chicago, Dallas, Houston, Los
Angeles, Miami, New York, Philadelphia, San Francisco, Seattle,
Orlando, and Washington, D.C.
Strategy Highlight 10.1
An Emirates A-380 superjumbo jet takes off en route to the United States, flying past the famous
Burj Al Arab hotel in Dubai, United Arab Emirates.
©Balkis Press/ABACAUSA.COM/Newscom
(continued)
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in a much larger market. Companies that base their competitive advantage on economies
of scale and economies of scope have an incentive to gain access to larger markets because
this can reinforce the basis of their competitive advantage. This in turn allows MNEs to
out-compete local rivals. In Strategy Highlight 6.1, we detailed how Narayana Health, a
specialty hospital chain in India, founded and led by Dr. Devi Shetty, obtained a low-cost
competitive advantage in complex procedures such as open-heart surgery. Narayana Health
is now leveraging its low-cost, high-quality position by opening specialty hospitals in the
Cayman Islands (to serve U.S. patients) and Kuala Lumpur, Malaysia.
At the same time, some countries with relatively weak domestic demand, such as China,
Germany, South Korea, and Japan, focus on export-led economic growth, which drives
many of their domestic businesses to become MNEs. For companies based in smaller
economies, becoming an MNE may be necessary to achieve growth or to gain and sus-
tain competitive advantage. Examples include Acer (Taiwan), Casella Wines (Australia),
IKEA (featured in the ChapterCase), Nestlé (Switzerland), LEGO (Denmark), Philips
(Netherlands), Samsung (South Korea), and Zara (Spain). Unless companies in smaller
economies expand internationally, their domestic markets are often too small for them to
reach significant economies of scale to compete effectively against other MNEs. Strategy
Highlight 10.1 shows how the Persian Gulf airlines (all coming from small countries) are
entering the much larger U.S. and international markets, competing directly with legacy
carriers such as American, Delta, and United.
GAIN ACCESS TO LOW-COST INPUT FACTORS. MNEs that base their competitive advan-
tage on a low-cost leadership strategy are particularly attracted to go overseas to gain
U.S. carriers have complained that the Persian Gulf air-
lines receive unfair subsidies. CEOs of U.S. carriers have
turned to politicians in Washington to stem the onslaught of
the Gulf carriers. Customers, however, are voting with their
wallets by flocking to the Gulf carriers, enjoying competitive
prices and a better service experience. Moreover, the Gulf
carriers counter that U.S. airlines have long enjoyed tightly
regulated markets, restricting foreign competition. Moreover,
they also remind the public that each of the U.S. legacy car-
riers has used bankruptcy filings to obtain debt relief, and
that some legacy carriers received government bailouts. They
suggest that the investments made by the government owners
of the Persian Gulf carriers are merely equity investments as
done by other stockholders.
Yet even the Gulf carriers are experiencing headwinds lately.
Given the 50 percent decline in oil prices since 2014, other
international airlines have become more cost-competitive.
In addition, economic performance in the Gulf region is tightly
linked to the price of oil. With falling oil prices, the spending
power of companies in the region drops, and with it demand
for business travel, the most profitable segment for airlines.
A series of terrorist attacks at airports in the Middle East as
well as the downing of a Russian passenger jet by a bomb in
the region have contributed to a sharp decline in air travel
to and from the Middle East, including to the super-connector
hubs. Finally, restrictions imposed by the American govern-
ment on airlines flying from the region directly into the
United States, such as a laptop ban on board, have redirected
demand for air travel to European carriers, departing from
Frankfurt, Amsterdam, London, or Paris.
One thing seems clear, however; the competitive pressure
by the Gulf carriers on U.S. legacy carriers is likely to get
stronger. The Persian Gulf states have decided that interna-
tional air travel is a strategic future industry for the region.
To back up their intent, the carriers made strong strategic
commitments, not only by building the most modern and luxu-
rious airports in the world, but also by locking up about half
of the airframe makers’ future production capacity. In par-
ticular, they ordered new super-modern, long-range airplanes
made by Boeing (such as the new 787 Dreamliner) and Airbus
(such as the A-380, the superjumbo). The Gulf carriers are
already the fastest-growing airlines globally, yet they con-
tinue to push into larger markets and more attractive routes.
In the meantime, consumers enjoy the benefits of globaliza-
tion: more choice, more routes, better service and amenities,
as well as lower prices.28
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access to low-cost input factors. Access to low-cost raw materials such as lumber, iron
ore, oil, and coal was a key driver behind Globalization 1.0 and 2.0. During Globalization
3.0, firms have expanded globally to benefit from lower labor costs in manufacturing and
services. India carved out a competitive advantage in business process outsourcing (BPO),
not only because of low-cost labor but also because of an abundance of well-educated,
English-speaking young people. Infosys, TCS, and Wipro are some of the more well-
known Indian IT service companies. Taken together, these companies employ more than
250,000 people and provide services to many of the Global Fortune 500 companies. Many
MNEs have close business ties with Indian IT firms. Some, such as IBM, are engaged in
foreign direct investment through equity alliances or building their own IT and customer
service centers in India. More than a quarter of Accenture’s work force, a consultancy spe-
cializing in technology and outsourcing, is now in Bangalore, India.29 Both the CEOs of
Google (Sundar Pichai) and Microsoft (Satya Nadella) hail from India.
Likewise, China has emerged as a manufacturing powerhouse because of low labor
costs and an efficient infrastructure. An American manufacturing worker costs about
20 times more in wages alone than a similarly skilled worker in China.30 A significant
cost differential exists not only for low-skilled labor, but for high-skilled labor as well.
A Chinese engineer trained at Purdue University, for example, works for only a quarter of
the salary in his native country compared with an engineer working in the United States.31
Of course, this absolute wage disparity also reflects the relative difference in the two coun-
tries’ cost of living.
DEVELOP NEW COMPETENCIES. Some MNEs pursue a global strategy in order to develop
new competencies.32 This motivation is particularly attractive for firms that base their com-
petitive advantage on a differentiation strategy. These companies are making foreign direct
investments to be part of communities of learning, which are often contained in specific
geographic regions.33 AstraZeneca, a Swiss-based pharmaceutical company, relocated its
research facility to Cambridge, Massachusetts, to be part of the Boston biotech cluster,
in hopes of developing new R&D competencies in biotechnology.34 Cisco invested more
than $1.6 billion to create an Asian headquarters in Bangalore and support other locations
in India, in order to be in the middle of India’s top IT location.35 Likewise, Microsoft, the
third-largest tech company globally (after Apple and Alphabet, Google’s parent), has a key
research center in Bangalore, India. Unilever’s new-concept center is located in downtown
Shanghai, China, attracting hundreds of eager volunteers to test the firm’s latest prod-
uct innovations on-site, while Unilever researchers monitor consumer reactions. In these
examples, AstraZeneca, Cisco, Microsoft, and Unilever all reap location economies—
benefits from locating value chain activities in optimal geographies for a specific activity,
wherever that may be.36
Many MNEs now are replacing the one-way innovation flow from Western economies
to developing markets with a polycentric innovation strategy—a strategy in which MNEs
now draw on multiple, equally important innovation hubs throughout the world charac-
teristic of Globalization 3.0; see Exhibit 10.3. GE Global Research, for example, orches-
trates a “network of excellence” with facilities in Niskayuna, New York (United States);
Bangalore (India); Shanghai (China); and Munich (Germany). Indeed, emerging econo-
mies are becoming hotbeds for low-cost innovations that find their way back to developed
markets.37 In Bangalore, GE researchers developed the MAC 400, a handheld electrocar-
diogram (ECG).38 The device is small, portable, and runs on batteries. Although a conven-
tional ECG machine costs $2,000, this handheld version costs $800 and enables doctors to
do an ECG test at a cost of only $1 per patient. The MAC 400 is now entering the United
States and other Western markets as a disruptive innovation, with anticipated widespread
use in the offices of general practitioners and emergency ambulances.
location economies
Benefits from locating
value chain activities
in the world’s optimal
geographies for a spe-
cific activity, wherever
that may be.
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DISADVANTAGES OF GOING GLOBAL
Companies expanding internationally must carefully weigh the
benefits and costs of doing so. If the cost of going global as
captured by the following disadvantages exceeds the expected
benefits in terms of value added (C > V), that is, if the eco-
nomic value creation is negative, then firms are better off by
not expanding internationally. Disadvantages to going global
include
■ Liability of foreignness.
■ Loss of reputation.
■ Loss of intellectual property.
LIABILITY OF FOREIGNNESS. In international expansion,
firms face risks. In particular, MNEs doing business abroad
also must overcome the liability of foreignness. This liability consists of the additional
costs of doing business in an unfamiliar cultural and economic environment, and of coor-
dinating across geographic distances.39
For instance, Walmart’s problems in several international markets are in large part
because of the liability of foreignness. In particular, Walmart failed in Germany and expe-
rienced a similar fate in South Korea, where it also exited in 2006. In addition, Walmart
has tried for many years to successfully enter the fast-growing markets in Russia and India,
but with little or no success. Walmart’s success recipe that worked so well domestically
didn’t work in Germany, South Korea, Russia, or India. Strategy Highlight 10.2 illustrates
how Walmart underestimated its liability of foreignness when entering and competing in
Germany, and how it is now facing the German grocery industry disruptors, Aldi and Lidl,
on its home turf.
LOSS OF REPUTATION. One of the most valuable resources that a firm may possess is
its reputation. A firm’s reputation can have several dimensions, including a reputation for
innovation, customer service, or brand reputation. Apple’s brand, for example, stands for
innovation and superior customer experience. Apple’s reputation is also one of its most
important resources. Apple’s brand is valued at $230 billion, making it (with Google’s)
one of the two most valuable brands in the world.40 We detailed in Chapter 4 that a brand
can be the basis for a competitive advantage if it is valuable, rare, and difficult to imitate.
While cost savings can generally be achieved, globalizing a supply chain can also have
unintended side effects. These can lead to a loss of reputation and diminish the MNE’s
competitiveness. A possible loss in reputation can be a considerable risk and cost for doing
business abroad. Because Apple’s stellar consumer reputation is critical to its competitive
advantage, it should be concerned about any potential negative exposure from its global
activities. Problems at Apple’s main supplier, Foxconn, brought this concern to the fore.
Low wages, long hours, and poor working and living conditions contributed to a spate
of suicides in 2010 at Foxconn, Apple’s main supplier in China.41 The Taiwanese com-
pany, which employs more than a million people, manufactures computers, tablets, smart-
phones, and other consumer electronics for Apple and other leading consumer electronics
companies. The backlash against alleged sweatshop conditions in Foxconn prompted
Apple to work with its main supplier to improve working conditions and wages. Tim Cook,
Apple’s CEO, visited Foxconn in China to personally inspect its manufacturing facility
and workers’ living conditions. Although conditions at Foxconn have been improving,42
liability of foreignness
Additional costs of
doing business in an
unfamiliar cultural and
economic environment,
and of coordinating
across geographic
distances.
A GE team in China
developed the Vscan,
an inexpensive,
portable ultrasound
device, costing some
$5,000— rather than
the $250,000 cost
of a traditional ultra-
sound machine used in
Western hospitals. The
Vscan is now widely
used in rural areas of
developing countries
(as shown here in Viet-
nam) and has made its
entry as a disruptive
innovation in the United
States and other rich
countries.
©Thierry Falise/LightRocket
via Getty Images
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Walmart Retreats from Germany, and Lidl
Invades the United States
In 2006 and after spending billions of dollars, Walmart
exited Germany in defeat. The eight-year failure shocked an
otherwise successful company, and ghosts from the debacle
now haunt Walmart on its native shores. What went wrong?
In 1998, Walmart faced a saturated U.S. market, and Ger-
many, then the third-largest economy in the world, looked
appealing. Walmart was already active in six foreign coun-
tries, with some 500 stores. Leadership decided the com-
pany’s superior U.S. strategy—as the low-cost leader—would
travel well one more time.
Walmart acquired Germany’s 21-store Wertkauf chain and
74 hypermarkets from German retailer Spar Handels AG. And
it followed the U.S. playbook: Walmart cheer, a door greeter,
associates always available to customers, smiling and offering
help, bagging groceries at the checkout, and so on. German
employees, however, declined the transfusion of American val-
ues. No door greeters. Employees upheld the usual gruff stan-
dard of retail customer service found throughout Germany.
Worse, the first Walmart boss in Germany—installed directly
from the Arkansas headquarters—spoke no German. He
decreed that English would be the official in-house language.
Cultural differences aside, Walmart also failed to keep
prices down. The retailer lacked its domestic economies of
scale and efficient distribution centers. Moreover, German
labor laws—more protective than in the United States—drove
up costs. The prices at Walmart in Germany were not “always
low” despite the company slogan, but fell in the medium range.
Lastly, Walmart faced serious competition. Germany was
already home to retail discount powerhouses such as Aldi
and Lidl, with thousands of smaller outlets offering higher
convenience combined with lower prices. Then it faced
Metro, a large-box retailer, which started a price war when
Walmart entered Germany. In the end, a defeated Walmart
sold its stores to—guess who?—Metro!
One useful definition of strategy is to answer the ques-
tion of how to deal with competition.43 Walmart did not find
a good strategy for competing with Aldi and Lidl in Germany.
Now, Walmart is worried that Aldi and Lidl will challenge the
world’s largest retailer on its home turf. Aldi has been com-
peting in the United States since the 1970s with its own Aldi
stores (and its Trader Joe’s brand). In 2017, Lidl also entered
the United States.
Why does Walmart worry about Lidl’s entry into the U.S.
grocery business? Aldi has been highly successful with its
over 2,000 stores (and another 400-plus Trader Joe’s stores)
in the United States. Rather than focusing on large big-box
outlets, Aldi stores are small, near urban centers with high
foot traffic and easy access to public transportation or major
roads to suburbia. Moreover, Trader Joe’s, as a neighbor-
hood grocery store, has a loyal fan base. It offers mainly its
own brand-name products such as organic, vegetarian, or
imported foods at much lower prices than Whole Foods and
elsewhere. Trader Joe’s generates twice as much revenue per
square foot of retail space as Whole Foods.
Lidl is joining the fray. It already has a few dozen
stores on the U.S. East Coast, with hundreds more planned.
Similarly to Aldi, Lidl also competes on price and offers
mainly its own store brands. Another advantage: These
competitors typically offer 2,000 products rather than the
standard 40,000 or so of large supermarkets. For example,
many grocery stores sell 30 types of mustard. These German
disruptors carry only two. Products arrive shelf-ready,
minimizing stocking and inventory costs, albeit often with
a wholesale feel. All products are sold at ultra-low prices.
There are no daily or weekly specials.
Indeed, the entry of the German discounters was so suc-
cessful in the United Kingdom that Tesco, Britain’s leading
supermarket chain, had to close dozens of stores, with large-
scale layoffs. Its market cap fell almost 80 percent, from
$80 billion in 2007 to as low as $17 billion in 2017.
Strategy Highlight 10.2
Lidl, a German discounter, entered the United States in 2017. Together with
Aldi, Lidl disrupted the grocery market in the United Kingdom. Walmart execu-
tives are concerned about a repeat in the United States.
©AP Images/Steve Helber
(continued)
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Apple started to diversify its supplier base by adding Pegatron, another Taiwanese original
equipment manufacturer (OEM).45
MNEs’ search for low-cost labor has had tragic effects where local governments are
corrupt and unwilling or unable to enforce a minimum of safety standards. The textile
industry is notorious for sweatshop conditions, and many Western companies such as the
Gap (United States), H&M (Sweden), and Carrefour (France) have taken a big hit to their
reputations in factory accidents in Bangladesh and elsewhere in Southeast Asia. Hundreds
of factory workers were killed when a textile factory collapsed in Rana Plaza in 2013 on
the outskirts of Dhaka, Bangladesh.46 Although much of the blame lies with the often cor-
rupt host governments not enforcing laws, regulations, and building codes, the MNEs that
source their textiles in these factories also receive some of the blame with negative conse-
quences for their reputation. The MNEs are accused of exploiting workers and being indif-
ferent to their working conditions and safety, all in an unending quest to drive down costs.
This challenge directly concerns the MNEs’ corporate social responsibility (CSR), dis-
cussed in Chapter 2. Since some host governments are either unwilling or unable to enforce
regulation and safety codes, MNEs need to rise to the challenge.47 Walmart responded by
posting a public list of “banned suppliers” on its website. These are suppliers that do not
meet adequate safety standards and working conditions. Before the Rana Plaza accident,
Walmart had already launched a working and fire-safety academy in Bangladesh to train
textile workers.
Given the regulatory and legal void that local governments often leave, several Western
MNEs have proposed a concerted action to finance safety efforts and worker training as
well as structural upgrades to factory buildings. After earlier revelations about the frequent
practice of child labor in many developing countries, Western MNEs in the textile industry
worked together to ban their suppliers from using child labor. Ensuring ethical sourcing of
raw materials and supplies is becoming ever more important. Besides a moral responsibil-
ity, MNEs have a market incentive to protect their reputations given the public backlash in
the wake of factory accidents, child labor, worker suicides, and other horrific externalities.
LOSS OF INTELLECTUAL PROPERTY. Finally, the issue of protecting intellectual property
in foreign markets also looms large. The software, movie, and music industries have long
lamented large-scale copyright infringements in many foreign markets. In addition, when
required to partner with a foreign host firm, companies may find their intellectual property
being siphoned off and reverse-engineered.
Japanese and European engineering companies entered China to participate in building
the world’s largest network of high-speed trains worth billions of dollars.48 Companies
such as Kawasaki Heavy Industries (Japan), Siemens (Germany), and Alstom (France)
were joint venture partners with domestic Chinese companies. These firms now allege that
the Chinese partners built on the Japanese and European partners’ advanced technology
Meanwhile, Walmart prepares. With online sales, Walmart
leads the German discounters, although it trails Amazon.
Walmart’s online sales grew by more than 50 percent in
2017. This growth comes in part from a new “order online,
pick up in store” concept, with dedicated parking bays for
drive-by customers to pick up online purchases. And it
successfully improved Walmart.com, offering free, two-day
delivery for orders over $35.
Walmart is also working the basics to speed up checkout
times and lower some prices even more. And it continues to
pressure suppliers so that its prices will be 15 percent lower
than the competition’s 80 percent of the time. With Amazon
on one side (especially after its acquisition of Whole Foods
Market) and industry disruptors such as Aldi and Lidl on the
other, Walmart is sharpening its strategic position as a low-
cost leader. This competitive battle is crucial for Walmart
because groceries make up some 60 percent of its annual
revenues of $500 billion, making it the largest grocery chain
in the United States.44
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to create their own, next-generation high-speed trains. To make matters worse, they also
claim that the Chinese companies now compete against them in other lucrative markets,
such as Saudi Arabia, Brazil, and even California, with trains of equal or better capa-
bilities but offered at much lower prices. This example highlights the intellectual property
exposure that firms can face when expanding overseas.
10.3 Going Global: Where and How?
After discussing why companies expand internationally, we now turn to the question of
how to guide MNE decisions on which countries to enter and how to then enter those
countries.
WHERE IN THE WORLD TO COMPETE?
THE CAGE DISTANCE FRAMEWORK
The question of where to compete geographically is, following vertical integration and
diversification, the third dimension of determining a firm’s corporate strategy. The pri-
mary driver behind firms expanding beyond their domestic market is to strengthen their
competitive position by gaining access to larger markets and low-cost input factors and to
develop new competencies. So wouldn’t companies choose new markets solely based on
measures such as per capita consumption of the product and per capita income?
Yes and no. Consider that several countries and locations can score similarly on such
absolute metrics of attractiveness. Ireland and Portugal, for example, have similar cost
structures, and both provide access to some 500 million customers in the European Union.
Both countries use the euro as a common currency, and both have a similarly educated
work force and infrastructure. Given these similarities, how does an MNE decide? Rather
than looking at absolute measures, MNEs need to consider relative distance in the CAGE
model.
To aid MNEs in deciding where in the world to compete, Pankaj Ghemawat introduced
the CAGE distance framework. CAGE is an acronym for different kinds of distance:
■ Cultural.
■ Administrative and political.
■ Geographic.
■ Economic.49
Most of the costs and risks involved in expanding beyond the domestic market are cre-
ated by distance. Distance not only denotes geographic distance (in miles or kilometers), but
also includes, as the CAGE acronym points out, cultural distance, administrative and politi-
cal distance, and economic distance. The CAGE distance framework breaks distance into
different relative components between any two country pairs that affect the success of FDI.
Although absolute metrics such as country wealth or market size matter to some
extent—as we know, for example, that a 1 percent increase in country wealth leads to a
0.8 percent increase in international trade—the relative factors captured by the CAGE dis-
tance model matter more. For instance, countries that are 5,000 miles apart trade only 20
percent of the amount traded among countries that are 1,000 miles apart. Cultural distance
matters even more. A common language increases trade between two countries by 200
percent over country pairs without one. Thus, in the earlier example regarding which EU
country to select for FDI, a U.S. MNE should pick Ireland, while a Brazilian MNE should
select Portugal. In the latter case, Brazil and Portugal also share a historic colony–colonizer
LO 10-3
Apply the CAGE distance
framework to guide
MNE decisions on which
countries to enter.
CAGE distance
framework A decision
framework based on
the relative distance
between home and a
foreign target country
along four dimensions:
cultural distance, admin-
istrative and political
distance, geographic
distance, and economic
distance.
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relationship. This link increases the expected trade intensity between these two countries
by yet another 900 percent in comparison to country pairs where absent.
Other CAGE distance factors are significant in predicting the amount of trade between
two countries. If the countries belong to the same regional trading bloc, they can expect
another 330 percent in trade intensity. Examples include the United States, Canada, and
Mexico in NAFTA, or the member states of the European Union. If the two countries use
the same currency it increases trade intensity by 340 percent. An example is use of the euro
as the common currency in 19 EU countries.50
Exhibit 10.5 presents the CAGE distance model. In particular, it details factors that
increase the overall distance between the two countries and how distance affects different
industries or products along the CAGE dimensions.51 Next, we briefly discuss each of the
CAGE distance dimensions.52
CULTURAL DISTANCE. In his seminal research, Geert Hofstede defined and measured
national culture, the collective mental and emotional “programming of the mind” that
differentiates human groups.53 Culture is made up of a collection of social norms and
mores, beliefs, and values. Culture captures the often unwritten and implicitly understood
rules of the game.
Although there is no one-size-fits-all culture that accurately describes any nation,
Hofstede’s work provides a useful tool to proxy cultural distance. Based on data analysis
national culture The
collective mental and
emotional “programming
of the mind” that differ-
entiates human groups.
EXHIBIT 10.5 / The CAGE Distance Framework
Distance
C
Cultural
A
Administrative and
Political
G
Geographic
E
Economic
Between two
countries increases
with . . .
• Different languages,
ethnicities,
religions, social
norms, and
dispositions
• Lack of connective
ethnic or social
networks
• Lack of trust and
mutual respect
• Absence of trading
bloc
• Absence of shared
currency, monetary
or political
association
• Absence of colonial
ties
• Political hostilities
• Weak legal and
financial institutions
• Lack of common
border, waterway
access, adequate
transportation, or
communication
links
• Physical
remoteness
• Different climates
and time zones
• Different
consumer incomes
• Different costs
and quality of
natural, financial,
and human
resources
• Different
information or
knowledge
Most affects
industries or
products . . .
• With high linguistic
content (TV)
• Related to national
and/or religious
identity (foods)
• Carrying country-
specific quality
associations
(wines)
• That a foreign
government views as
staples (electricity),
as building national
reputations
(aerospace),
or as vital to
national security
(telecommunications)
• With low value-
to-weight ratio
(cement)
• That are fragile
or perishable
(glass, meats)
• In which
communications
are vital (financial
services)
• For which demand
varies by income
(cars)
• In which labor
and other cost
differences matter
(textiles)
SOURCE: Adapted from P. Ghemawat (2001), “Distance still matters: The hard reality of global expansion,” Harvard Business Review, September: 137–147.
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from more than 100,000 individuals from many different countries, four main dimensions
of culture emerged: Power distance, individualism, masculinity–femininity, and uncer-
tainty avoidance.54 Hofstede’s data analysis yielded scores for the different countries, for
each dimension, on a range of zero to 100, with 100 as the high end. More recently, Hof-
stede added two additional cultural dimensions: long-term orientation and indulgence.55
Cultural differences find their expression in language, ethnicity, religion, and social
norms. They directly affect customer preferences (see Exhibit 10.5). Because of religious
beliefs, for example, Hindus do not eat beef, while Muslims do not eat pork. In terms
of content-intensive service, cultural and language differences are also the reason global
internet companies such as Amazon or Google offer country-specific variations of their
sites. Despite these best efforts, they are often outflanked by native providers because of
their deeper cultural understanding. For example, in China the leading websites are domes-
tic ones: Alibaba in ecommerce, and Baidu in online search. In Russia, the leading ecom-
merce site is Ozon, while the leading search engine is Yandex.
Hofstede’s national-culture research becomes even more useful for managers by com-
bining the distinct dimensions of culture into an aggregate measure for each country.
MNEs then can compare the national-culture
measures for any two country pairings to
inform their entry decisions.56 The difference
between scores indicates cultural distance,
the cultural disparity between the interna-
tionally expanding firm’s home country and
its targeted host country. A firm’s decision to
enter certain international markets is influ-
enced by cultural differences. A greater cul-
tural distance can increase the cost and
uncertainty of conducting business abroad.
In short, greater cultural distance increases
the liability of foreignness.
If we calculate the cultural distance from
the United States to various countries, for
example, we find that some countries are
culturally very close to the United States.
Australia, for example, has an overall cultural
distance score of 0.02. Others are culturally
quite distant. Russia has an overall cultural
distance score of 4.42. As can be expected,
English-speaking countries such as Canada (0.12), Ireland (0.35), New Zealand (0.26), and
the United Kingdom (0.09) all exhibit a low cultural distance to the United States. Since
culture is embedded in language, it comes as no surprise that cultural and linguistic differ-
ences are highly correlated.
Culture even matters in the age of Facebook with its global reach of 2 billion users.
Most Facebook friends are local rather than across borders. This makes sense when one
considers that the online social graph that Facebook users develop in their network of
friends is actually a virtual network laid above a (pre)existing social network, rather than
forming one anew.57
ADMINISTRATIVE AND POLITICAL DISTANCE. Administrative and political distances
are captured in factors such as the absence or presence of shared monetary or political
associations, political hostilities, and weak or strong legal and financial institutions.59
cultural distance
Cultural disparity
between an internation-
ally expanding firm’s
home country and its
targeted host country.
In 2000 when Starbucks
entered the Chinese market,
it moved fast to overcome
cultural barriers by hand-
ing out key chains to help
new customers order!
Now it leverages Chinese
approaches to social media
(WeChat, Weibo, and Jiepang)
and fine-tunes its own mobile
apps and loyalty programs to
lure China’s growing middle
class. The result? Today
China is its second-largest
market and growing.58
Courtesy of Resonance China
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The 19 European countries in the eurozone, for example, not only share the same currency
but also integrate politically to some extent. It should come as no surprise then that most
cross-border trade between European countries takes place within the EU. Germany, one
of the world’s largest exporters, conducts roughly 75 percent of its cross-border business
within the EU.60 Similarly, Canada and Mexico partner with the United States in the North
American Free Trade Agreement (NAFTA), increasing trade in goods and services between
the three countries. As a result, United States is the largest trading partner for both Can-
ada and Mexico. After China, Canada and Mexico are the largest trading partners for the
United States. Colony–colonizer relationships also have a strong positive effect on bilateral
trade between countries. British companies continue to trade heavily with businesses from
its former colonies in the commonwealth; Spanish companies trade heavily with Latin
American countries; and French businesses trade with the franc zone of West Africa.
Many foreign (target) countries also erect other political and administrative barriers,
such as tariffs, trade quotas, FDI restrictions, and so forth, to protect domestic competi-
tors. In many instances, China, for example, requests the sharing of technology in a joint
venture when entering the country. This was the case in the high-speed train developments
discussed earlier. Other countries, including the United States and EU members, protect
national champions such as Boeing or Airbus from foreign competition. Industries that
are considered critical to national security—domestic airlines or telecommunications—
are often protected. Finally, strong legal and ethical pillars as well as well-functioning
economic institutions such as capital markets and an independent central bank reduce dis-
tance. Strong institutions, both formal and informal, reduce uncertainty and thus reduce
transaction costs.61
GEOGRAPHIC DISTANCE. The costs to cross-border trade rise with geographic distance.
It is important to note, however, that geographic distance does not simply capture how far
two countries are from each other but also includes additional attributes, such as the coun-
try’s physical size (Canada versus Singapore), the within-country distances to its borders,
the country’s topography, its time zones, and whether the countries are contiguous to one
another or have access to waterways and the ocean. The country’s infrastructure, includ-
ing road, power, and telecommunications networks, also plays a role in determining geo-
graphic distance. Geographic distance is particularly relevant when trading products with
low value-to-weight ratios, such as steel, cement, or other bulk products, and fragile and
perishable products, such as glass or fresh meats and fruits.
ECONOMIC DISTANCE. The wealth and per capita income of consumers is the most
important determinant of economic distance. Wealthy countries engage in relatively more
cross-border trade than poorer ones. Rich countries tend to trade with other rich countries;
in addition, poor countries also trade more frequently with rich countries than with other
poor countries. Companies from wealthy countries benefit in cross-border trade with other
wealthy countries when their competitive advantage is based on economies of experience,
scale, scope, and standardization. This is because replication of an existing business model
is much easier in a country where the incomes are relatively similar and resources, comple-
ments, and infrastructure are of roughly equal quality. Although Walmart in Canada is a vir-
tual carbon copy of the Walmart in the United States, Walmart in China is quite different.62
Companies from wealthy countries also trade with companies from poor countries to
benefit from economic arbitrage. The textile industry (discussed earlier) is a prime exam-
ple. We also highlighted economic arbitrage as one of the main benefits of going global:
access to low-cost input factors.
In conclusion, although the CAGE distance framework helps determine the attractive-
ness of foreign target markets in a more fine-grained manner based on relative differences,
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it is necessarily only a first step. A deeper analysis requires looking inside the firm (as done
in Chapter 4) to see how a firm’s strengths and weaknesses work to increase or reduce
distance from specific foreign markets. A company with a large cadre of cosmopolitan
managers and a diverse work force will be much less affected by cultural differences, for
example, than a company with a more insular and less diverse culture with all managers
from the home country. Although technology may make the world seem smaller, the costs
of distance along all its dimensions are real. The costs of distance in expanding internation-
ally are often very high. Ignoring these costs can be expensive (see Walmart’s adventure in
Germany, discussed in Strategy Highlight 10.2) and can lead to a competitive disadvantage.
HOW DO MNES ENTER FOREIGN MARKETS?
Assuming an MNE has decided why and where to enter a foreign market, the remaining
decision is how to do so. Exhibit 10.6 displays the different options managers have when
entering foreign markets, along with the required investments necessary and the control
they can exert. On the left end of the continuum in Exhibit 10.6 are vehicles of foreign
expansion that require low investments but also allow for a low level of control. On the right
are foreign-entry modes that require a high level of investments in terms of capital and other
resources, but also allow for a high level of control. Foreign-entry modes with a high level
of control such as foreign acquisitions or greenfield plants reduce the firm’s exposure to two
particular downsides of global business: loss of reputation and loss of intellectual property.
Exporting—producing goods in one country to sell in another—is one of the oldest
forms of internationalization (part of Globalization 1.0). It is often used to test whether
a foreign market is ready for a firm’s products. When studying vertical integration and
diversification (in Chapter 8), we discussed in detail different forms along the make-or-buy
continuum. As discussed in Chapter 9, strategic alliances (including licensing, franchising,
and joint ventures) and acquisitions are popular vehicles for entry into foreign markets.
Since we discussed these organizational arrangements in detail in previous chapters, we
therefore keep this section on foreign-entry modes brief.
The framework illustrated in Exhibit 10.6, moving from left to right, has been suggested
as a stage model of sequential commitment to a foreign market over time.63 Though it
does not apply to globally born companies, it is relevant for manufacturing companies that
are just now expanding into global operations. In some instances, companies are required
by the host country to form joint ventures in order to conduct business there, while some
MNEs prefer greenfield operations—building new, fully owned plants and facilities from
scratch, as Motorola did when it entered China in the 1990s.64
LO 10-4
Compare and contrast the
different options MNEs
have to enter foreign
markets.
EXHIBIT 10.6 /
Modes of Foreign-
Market Entry along
the Investment and
Control Continuum
Investment and Control
LESS MORE
SubsidiaryContract-Based
• Acquisition
• Greenfield
Exporting
Strategic Alliances
Long-term contracts
• Licensing
• Franchising
Equity
Alliances
Joint
Ventures
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■ International
■ Multidomestic
■ Global-standardization
■ Transnational68
At the end of that discussion, Exhibit 10.9 summarizes each global strategy.
INTERNATIONAL STRATEGY
An international strategy is essentially a strategy in which a company sells the same
products or services in both domestic and foreign markets. It enables MNEs to leverage
their home-based core competencies in foreign markets. An international strategy is one
of the oldest types of global strategies (Globalization 1.0) and is frequently the first step
companies take when beginning to conduct business abroad. As shown in the integration-
responsiveness framework, it is advantageous when the MNE faces low pressures for both
local responsiveness and cost reductions.
An international strategy is often used successfully by MNEs with relatively large
domestic markets and with strong reputations and brand names. These MNEs, capitalizing
on the fact that foreign customers want to buy the original product, tend to use differentia-
tion as their preferred business strategy. For example, bikers in Shanghai, China, like their
Harley-Davidson motorcycles to roar just like the ones ridden by the Hells Angels in the
United States. Similarly, a Brazilian entrepreneur importing machine tools from Germany
expects superior engineering and quality. Finally, Apple’s latest iPhone model is a desired
luxury product and status symbol the world over. An international strategy tends to rely
integration-responsive-
ness framework Strat-
egy framework that
juxtaposes the pres-
sures an MNE faces
for cost reductions and
local responsiveness
to derive four different
strategies to gain and
sustain competitive
advantage when compet-
ing globally.
10.4 Cost Reductions vs. Local Responsiveness:
The Integration-Responsiveness Framework
MNEs face two opposing forces when competing around the globe: cost reductions
versus local responsiveness. Indeed, cost reductions achieved through a global-
standardization strategy often reinforce a cost-leadership strategy at the business level.
Similarly, local responsiveness increases the differentiation of products and services,
reinforcing a differentiation strategy at the business level. Taken together, however, cost
reductions and local responsiveness present strategic trade-offs because higher local
responsiveness frequently goes along with higher costs. Conversely, a focus on cost reduc-
tions does not allow for much local responsiveness. Just like low cost and differentiation
at the business strategy level, cost reductions and local responsiveness are trade-offs when
competing globally.
One of the core drivers for globalization is to expand the total market of firms in order
to achieve economies of scale and drive down costs. For many business executives, the
move toward globalization is based on the globalization hypothesis, which states that
consumer needs and preferences throughout the world are converging and thus becoming
increasingly homogenous. Theodore Levitt stated: “Nothing confirms [the globalization
hypothesis] as much as the success of McDonald’s from [the] Champs-Élysées to Ginza, of
Coca-Cola in Bahrain and Pepsi-Cola in Moscow, and of rock music, Greek salad, Holly-
wood movies, Revlon cosmetics, Sony televisions, and Levi jeans everywhere.”65 In sup-
port of the globalization hypothesis, IKEA, as featured in the ChapterCase, sells its home
furnishings successfully in over 40 countries. Toyota is selling its hybrid Prius vehicle in
80 countries. Most vehicles today are built on global platforms and modified (sometimes
only cosmetically) to meet local tastes and standards.
The strategic foundations of the globalization hypothesis are based primarily on cost
reduction. Lower cost is a key competitive weapon, and MNEs attempt to reap significant
cost reductions by leveraging economies of scale and by managing global supply chains to
access the lowest-cost input factors.
Although there seems to be some convergence of consumer preferences across the
globe, national differences remain, due to distinct institutions and cultures. For example, in
the 1990s, Ford Motor Co. followed this one-size-fits-all strategy by offering a more or
less identical car throughout the world: the Ford Mondeo, sold as the Ford Contour and the
Mercury Mystique in North America. Ford learned the hard way, by lack of sales, that
consumers did not subscribe to the globalization hypothesis at the same level as the Ford
executives and were not yet prepared to ignore regional differences.66 In some instances,
MNEs experience pressure for local responsiveness—the need to tailor product and ser-
vice offerings to fit local consumer preferences and host-country requirements; it generally
entails higher costs. Walmart sells live animals (snakes, eels, toads, etc.) for food prepara-
tion in China. IKEA sells kimchi refrigerators and metal chopsticks in South Korea.
McDonald’s uses chicken and fish instead of beef in India and offers a teriyaki burger in
Japan, even though its basic business model of offering fast food remains the same the
world over. Local responsiveness generally entails higher cost, and sometimes even out-
weighs cost advantages from economies of scale and lower-cost input factors.
Given the two opposing pressures of cost reductions versus local responsiveness, schol-
ars have advanced the integration-responsiveness framework, shown in Exhibit 10.7.67
This framework juxtaposes the opposing pressures for cost reductions and local respon-
siveness to derive four different strategic positions to gain and sustain competitive advan-
tage when competing globally. The four strategic positions, which we will discuss in the
following sections, are
LO 10-5
Apply the integration-
responsiveness
framework to evaluate the
four different strategies
MNEs can pursue when
competing globally.
globalization hypothesis
Assumption that
consumer needs and
preferences through-
out the world are
converging and thus
becoming increasingly
homogenous.
local responsiveness
The need to tailor
product and service
offerings to fit local
consumer preferences
and host-country
requirements.
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■ International
■ Multidomestic
■ Global-standardization
■ Transnational68
At the end of that discussion, Exhibit 10.9 summarizes each global strategy.
INTERNATIONAL STRATEGY
An international strategy is essentially a strategy in which a company sells the same
products or services in both domestic and foreign markets. It enables MNEs to leverage
their home-based core competencies in foreign markets. An international strategy is one
of the oldest types of global strategies (Globalization 1.0) and is frequently the first step
companies take when beginning to conduct business abroad. As shown in the integration-
responsiveness framework, it is advantageous when the MNE faces low pressures for both
local responsiveness and cost reductions.
An international strategy is often used successfully by MNEs with relatively large
domestic markets and with strong reputations and brand names. These MNEs, capitalizing
on the fact that foreign customers want to buy the original product, tend to use differentia-
tion as their preferred business strategy. For example, bikers in Shanghai, China, like their
Harley-Davidson motorcycles to roar just like the ones ridden by the Hells Angels in the
United States. Similarly, a Brazilian entrepreneur importing machine tools from Germany
expects superior engineering and quality. Finally, Apple’s latest iPhone model is a desired
luxury product and status symbol the world over. An international strategy tends to rely
integration-responsive-
ness framework Strat-
egy framework that
juxtaposes the pres-
sures an MNE faces
for cost reductions and
local responsiveness
to derive four different
strategies to gain and
sustain competitive
advantage when compet-
ing globally.
EXHIBIT 10.7 /
The Integration-
Responsiveness
Framework: Global
Strategy Positions and
Representative MNEs
SOURCES: C.K. Prahalad
and Y.L. Doz (1987), The
Multinational Mission (New
York: Free Press); and K. Roth
and A.J. Morrison (1991),
“An empirical analysis of the
integration-responsiveness
framework in global industries,”
Journal of International
Business Studies 21:
541–564.
Infosys
Lenovo
Siemens Energy
Harley-Davidson
Rolex
Starbucks
Bridgestone
Nestlé
Philips
ABB
Bertelsmann
P&G
GLOBAL-
STANDARDIZATION TRANSNATIONAL
INTERNATIONAL
Low High
Pressure for Cost Reductions
Low
High
MULTIDOMESTIC P
re
ss
ur
e
fo
r L
oc
al
Re
sp
on
siv
en
es
s
international strategy
Strategy that involves
leveraging home-based
core competencies by
selling the same prod-
ucts or services in both
domestic and foreign
markets.
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on exporting or the licensing of products and franchising of services to reap economies of
scale by accessing a larger market.
A strength of the international strategy—its limited local responsiveness—is also a
weakness in many industries. For example, when an MNE sells its products in foreign mar-
kets with little or no change, it leaves itself open to the expropriation of intellectual prop-
erty (IP). Looking at the MNE’s products and services, pirates can reverse-engineer the
products to discover the intellectual property embedded in them. In Thailand, for example,
a flourishing market for knockoff luxury sports cars (e.g., Ferraris, Lamborghinis, and
Porsches) has sprung up.69 Besides the risk of exposing IP, MNEs following an interna-
tional strategy are highly affected by exchange-rate fluctuations. Given increasing global-
ization, however, fewer and fewer markets correspond to this situation—low pressures for
local responsiveness and cost reductions—that gives rise to the international strategy.
MULTIDOMESTIC STRATEGY
MNEs pursuing a multidomestic strategy attempt to maximize local responsiveness,
hoping that local consumers will perceive their products or services as local ones. This
strategy arises out of the combination of high pressure for local responsiveness and low
pressure for cost reductions. MNEs frequently use a multidomestic strategy when entering
host countries with large and/or idiosyncratic domestic markets, such as Japan or Saudi
Arabia. This is one of the main strategies MNEs pursued in the Globalization 2.0 stage.
A multidomestic strategy is common in the consumer products and food industries. For
example, Swiss-based Nestlé, the largest food company in the world, is known for customiz-
ing its product offerings to suit local preferences, tastes, and requirements. Given the strong
brand names and core competencies in R&D, and the quality in their consumer products
and food industries, it is not surprising that these MNEs generally pursue a differentiation
strategy at the business level. An MNE following a multidomestic strategy, in contrast with
an international strategy, faces reduced exchange-rate exposure because the majority of the
value creation takes place in the host-country business units, which tend to span all functions.
On the downside, a multidomestic strategy is costly and inefficient because it requires
the duplication of key business functions across multiple countries. Each country unit
tends to be highly autonomous, and the MNE is unable to reap economies of scale or
learning across regions. The risk of IP appropriation increases when companies follow a
multidomestic strategy. Besides exposing codified knowledge embedded in products, as
is the case with an international strategy, a multidomestic strategy also requires exposing
tacit knowledge because products are manufactured locally. Tacit knowledge that is at risk
of appropriation may include, for example, the process of how to create consumer products
of higher perceived quality.
GLOBAL-STANDARDIZATION STRATEGY
MNEs following a global-standardization strategy attempt to reap significant economies
of scale and location economies by pursuing a global division of labor based on wherever
best-of-class capabilities reside at the lowest cost. The global-standardization strategy arises
out of the combination of high pressure for cost reductions and low pressure for local respon-
siveness. MNEs using this strategy are often organized as networks (Globalization 3.0).
This lets them strive for the lowest-cost position possible. Their business-level strategy
tends to be cost leadership. Because there is little or no differentiation or local responsive-
ness because products are standardized, price becomes the main competitive weapon. To
be price competitive, the MNE must maintain a minimum efficient scale (see Chapter 6).
MNEs that manufacture commodity products such as computer hardware or offer
services such as business process outsourcing generally pursue a global-standardization
multidomestic strategy
Strategy pursued by
MNEs that attempts to
maximize local respon-
siveness, with the intent
that local consumers
will perceive them to be
domestic companies.
global-standardization
strategy Strategy
attempting to reap
significant economies
of scale and location
economies by pursu-
ing a global division of
labor based on wherever
best-of-class capabili-
ties reside at the lowest
cost.
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strategy. Lenovo, the Chinese computer manufacturer, is the maker of the ThinkPad line
of laptops, which it acquired from IBM in 2005. To keep track of the latest developments
in computing, Lenovo’s research centers are located in Beijing and Shanghai in China, in
Raleigh, North Carolina (in the Research Triangle Park), and in Japan.70 To benefit from
low-cost labor and to be close to its main markets to reduce shipping costs, Lenovo’s man-
ufacturing facilities are in Mexico, India, and China. The company describes the benefits
of its global-standardization strategy insightfully: “Lenovo organizes its worldwide opera-
tions with the view that a truly global company must be able to quickly capitalize on new
ideas and opportunities from anywhere. By forgoing a traditional headquarters model and
focusing on centers of excellence around the world, Lenovo makes the maximum use of
its resources to create the best products in the most efficient and effective way possible.”71
One of the advantages of the global-standardization strategy—obtaining the lowest cost
point possible by minimizing local adaptations—is also one of its key weaknesses. The Amer-
ican MTV network cable channel started out with a global-standardization strategy.72 The
main inputs—music videos by vocal artists—were sourced more or less globally based on
the prevailing music hits. MTV reasoned that music videos were a commodity product that
would attract worldwide audiences. MTV was wrong! As indicated by the CAGE distance
model, cultural distance most affects products with high linguistic content such as TV. Even
in a music video channel, audiences have a distinct preference for at least some local content.
Keep in mind that strategic positions are not constant; they can change over time.
Consider how MTV changed its strategic positions as it attempted to respond to the pres-
sures for both cost reduction and local responsiveness. At first, MTV followed a global-
standardization strategy. To be more responsive to local audiences, MTV then implemented
a multidomestic strategy to meet the need for local responsiveness. This led to a loss of
scale effects, especially rolling out expensive content over a large installed base of viewers.
In a move a few years later, MTV shifted its strategic position away from a multidomes-
tic strategy and is now pursuing a transnational strategy. Exhibit 10.8 tracks how MTV
changed strategic positions in its quest for competitive advantage.
TRANSNATIONAL STRATEGY
MNEs pursuing a transnational strategy attempt to combine the benefits of a localization
strategy (high local responsiveness) with those of a global-standardization strategy (lowest-
cost position attainable). This strategy arises out of the combination of high pressure for
local responsiveness and high pressure for cost reductions. A transnational strategy is gen-
erally used by MNEs that pursue a blue ocean strategy at the business level by attempting
to reconcile product and/or service differentiations at low cost.
Besides harnessing economies of scale and location, a transnational strategy also aims to
benefit from global learning. MNEs typically implement a transnational strategy through a
global matrix structure. This organizational structure combines economies of scale along spe-
cific product divisions with economies of learning attainable in specific geographic regions.
The idea is that best practices, ideas, and innovations will be diffused throughout the world,
regardless of their origination. The managers’ mantra is to think globally, but act locally.
Although a transnational strategy is quite appealing, the required matrix structure is
rather difficult to implement because of the organizational complexities involved. High
local responsiveness typically requires that key business functions are frequently dupli-
cated in each host country, leading to higher costs. Further compounding the organiza-
tional complexities is the challenge of finding managers who can dexterously work across
cultures in the ways required by a transnational strategy. We’ll discuss organizational
structure in more depth in the next chapter.
The German multimedia conglomerate Bertelsmann attempts to follow a transnational
strategy. Bertelsmann employs over 100,000 people, with two-thirds of that work force
transnational strategy
Strategy that attempts
to combine the benefits
of a localization strategy
(high local responsive-
ness) with those of a
global-standardization
strategy (lowest-cost
position attainable).
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outside its home country. Bertelsmann operates in more than 60 countries throughout
the world and owns many regional leaders in their specific product categories, including
Random House Publishing in the United States and RTL Group, Europe’s second-largest
TV, radio, and production company (after the BBC). Bertelsmann operates its over 500
regional media divisions as more or less autonomous profit-and-loss centers but attempts
to share best practices across units; global learning and human resource strategies for exec-
utives are coordinated at the network level.73
As a summary, Exhibit 10.9 provides a detailed description of each of the four global
strategies in the integration-responsiveness framework.
10.5 National Competitive Advantage: World
Leadership in Specific Industries
Globalization, the prevalence of the internet with other advances in communica-
tions technology, and transportation logistics can lead us to believe that firm location is
becoming increasingly less important.74 Because firms can now, more than ever, source inputs
globally, many believe that location must be diminishing in importance as an explanation of
firm-level competitive advantage. This idea is called the death-of-distance hypothesis.75
Despite an increasingly globalized world, however, it turns out that high-performing
firms in certain industries are concentrated in specific countries.76 For example, the leading
biotechnology, software, and internet companies are headquartered in the United States.
Some of the world’s best computer manufacturers are in China and Taiwan. Many of the
leading consumer electronics companies are in South Korea and Japan. The top mining
companies are in Australia. The leading business process outsourcing (BPO) companies are
in India. Some of the best engineering and car companies are in Germany. The world’s top
fashion designers are in Italy. The best wineries are in France. The list goes on. Although
EXHIBIT 10.8 /
Dynamic Strategic
Positioning: The MTV
Music Channel
(1)
MTV starts
by pursuing a
GLOBAL-
STANDARDIZATION
STRATEGY
(3)
Today, MTV
pursues a
TRANSNATIONAL
STRATEGY
(2)
MTV then
implements a
MULTIDOMESTIC
STRATEGY
High
Low
Low High
INTERNATIONAL
STRATEGY
Pressure for Cost Reductions
P
re
ss
ur
e
fo
r L
oc
al
Re
sp
on
siv
en
es
s
death-of-distance
hypothesis Assumption
that geographic location
alone should not lead to
firm-level competitive
advantage because firms
are now, more than ever,
able to source inputs
globally.
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Strategy Characteristics Benefits Risks
International Often the first step in internationalizing.
Used by MNEs with relatively large
domestic markets or strong exporters
(e.g., MNEs from the United States,
Germany, Japan, South Korea).
Well-suited for high-end products with
high value-to-weight ratios such as
machine tools and luxury goods that can
be shipped across the globe.
Products and services tend to have
strong brands.
Main business-level strategy tends to
be differentiation because exporting,
licensing, and franchising add additional
costs.
Leveraging core
competencies.
Economies of scale.
Low-cost implementation
through:
• Exporting or licensing (for
products)
• Franchising (for services)
• Licensing (for trademarks)
No or limited local
responsiveness.
Highly affected by exchange-
rate fluctuations.
IP embedded in product or
service could be expropriated.
Multidomestic Used by MNEs to compete in host
countries with large and/or lucrative
but idiosyncratic domestic markets (e.g.,
Germany, Japan, Saudi Arabia).
Often used in consumer products and
food industries.
Main business-level strategy is
differentiation.
MNE wants to be perceived as local
company.
Highest-possible local
responsiveness.
Increased differentiation.
Reduced exchange-rate
exposure.
Duplication of key business
functions in multiple
countries leads to high cost of
implementation.
Little or no economies of scale.
Little or no learning across
different regions.
Higher risk of IP expropriation.
Global-
Standardization
Used by MNEs that are offering
standardized products and services (e.g.,
computer hardware or business process
outsourcing).
Main business-level strategy is cost
leadership.
Location economies: global
division of labor based
on wherever best-of-class
capabilities reside at lowest
cost.
Economies of scale and
standardization.
No local responsiveness.
Little or no product
differentiation.
Some exchange-rate exposure.
“Race to the bottom” as wages
increase.
Some risk of IP expropriation.
Transnational Used by MNEs that pursue a blue
ocean strategy at the business level
by simultaneously focusing on product
differentiation and low cost.
Mantra: Think globally, act locally.
Attempts to combine
benefits of localization and
standardization strategies
simultaneously by creating a
global matrix structure.
Economies of scale, location,
experience, and learning.
Global matrix structure
is costly and difficult to
implement, leading to high
failure rate.
Some exchange-rate exposure.
Higher risk of IP expropriation.
EXHIBIT 10.9 / International, Multidomestic, Global-Standardization, and Transnational Strategies: Characteristics,
Benefits, and Risks
globalization lowers the barriers to trade and investments and increases human capital
mobility, one key question remains: Why are certain industries more competitive in some
countries than in others? This question goes to the heart of the issue of national competi-
tive advantage, a consideration of world leadership in specific industries. That issue, in
national competitive
advantage World
leadership in specific
industries.
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turn, has a direct effect on firm-level competitive advantage. Companies from home coun-
tries that are world leaders in specific industries tend to be the strongest competitors
globally.
PORTER’S DIAMOND FRAMEWORK
Michael Porter advanced a framework to explain national competitive advantage—why
some nations outperform others in specific industries. This framework is called Porter’s
diamond of national competitive advantage. As shown in Exhibit 10.10, it consists of four
interrelated factors:
■ Factor conditions.
■ Demand conditions.
■ Competitive intensity in focal industry.
■ Related and supporting industries/complementors.
FACTOR CONDITIONS. Factor conditions describe a country’s endowments in terms of
natural, human, and other resources. Other important factors include capital markets, a
supportive institutional framework, research universities, and public infrastructure (air-
ports, roads, schools, health care system), among others.
Interestingly, natural resources are often not needed to generate world-leading com-
panies, because competitive advantage is often based on other factor endowments such as
human capital and know-how. Several of the world’s most resource-rich countries (such
as Afghanistan,77 Iran, Iraq, Russia, Saudi Arabia, and Venezuela) are not home to any
of the world’s leading companies, even though some (though not all) do have in place
LO 10-6
Apply Porter’s diamond
framework to explain
why certain industries
are more competitive in
specific nations than in
others.
EXHIBIT 10.10 /
Porter’s Diamond of
National Competitive
Advantage
SOURCE: Adapted from
M.E. Porter (19901), “The
competitive advantage of
nations,” Harvard Business
Review, March–April: 78.
Factor
Conditions
Related and
Supporting
Industries/
Complementors
Demand
Conditions
Competitive
Intensity in
Focal Industry
NATIONAL
COMPETITIVE
ADVANTAGE
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institutional frameworks allowing them to be a productive member of world commerce.
In contrast, countries that lack natural resources (e.g., Denmark, Finland, Israel, Japan,
Singapore, South Korea, Switzerland, Taiwan, and the Netherlands) often develop world-
class human capital to compensate.78
DEMAND CONDITIONS. Demand conditions are the specific characteristics of demand
in a firm’s domestic market. A home market made up of sophisticated customers who
hold companies to a high standard of value creation and cost containment contributes to
national competitive advantage. Moreover, demanding customers may also clue firms into
the latest developments in specific fields and may push firms to move research from basic
findings to commercial applications for the marketplace.
For example, due to dense urban living conditions, hot and humid summers, and high
energy costs, it is not surprising that Japanese customers demand small, quiet, and energy-
efficient air conditioners. In contrast to the Japanese, Finns have a sparse population living
in a more remote countryside. A lack of landlines for telephone service has resulted in the
Finnish demand for high-quality wireless services, combined with reliable handsets (and
long-life batteries) that can be operated in remote, often hostile, environments. Cell phones
have long been a necessity for survival in rural areas of Finland. This situation enabled
Nokia to become an early leader in cell phones.79
COMPETITIVE INTENSITY IN A FOCAL INDUSTRY. Companies that face a highly com-
petitive environment at home tend to outperform global competitors that lack such intense
domestic competition. Fierce domestic competition in Germany, for example, combined
with demanding customers and the no-speed-limit autobahn make a tough environment for
any car company. Success requires top-notch engineering of chassis and engines, as well
as keeping costs and fuel consumption ($6-per-gallon gas) in check. This extremely tough
home environment amply prepared German car companies such as Volkswagen (which
also owns Audi and Porsche), BMW, and Daimler for global competition.
RELATED AND SUPPORTING INDUSTRIES/COMPLEMENTORS. Leadership in related and
supporting industries can also foster world-class competitors in downstream industries.
The availability of top-notch complementors—firms that provide a good or service that
leads customers to value the focal firm’s offering more when the two are combined—
further strengthens national competitive advantage. Switzerland, for example, leveraged
its early lead in industrial chemicals into pharmaceuticals.80 A sophisticated health care
service industry sprang up alongside as an important complementor, to provide further
stimulus for growth and continuous improvement and innovation.
The effects of sophisticated customers and highly competitive industries ripple through
the industry value chain to create top-notch suppliers and complementors. Toyota’s global
success in the 1990s and early 2000s was based to a large extent on a network of world-
class suppliers in Japan.81 This tightly knit network allowed for fast two-way knowledge
sharing—this in turn improved Toyota’s quality and lowered its cost, which it leveraged
into a successful blue ocean strategy at the business level.
It is also interesting to note that by 2010, Toyota’s supplier advantage had disappeared.82
It was unable to solve the trade-off between drastically increasing its volume and main-
taining superior quality. Toyota’s rapid growth in its quest to become the world’s leader
in volume required quickly bringing on new suppliers outside Japan. Quality standards,
however, could not be maintained. Part of the problem lies in path dependence (discussed
in Chapter 4), because Chinese and other suppliers could not be found quickly enough, nor
could most foreign suppliers build at the required quality levels fast enough. The cultural
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distance between Japan and China exacerbated these problems. Combined, these factors
explain the quality problems Toyota experienced in recent years, and highlight the impor-
tance of related and supporting industries to national competitive advantage.
10.6 Implications for Strategic Leaders
In addition to determining the degree of vertical integration and level of diversification, the
strategic leader needs to decide if and how the firm should compete beyond its home mar-
ket. Decisions along all three dimensions formulate the firm’s corporate strategy. Because
of increasing global integration in products and services as well as capital markets, the
benefits of competing globally outweigh the costs for more and more enterprises. This
is true not just for large MNEs, but also for small and medium ones (SMEs). Even small
startups are now able to leverage technology such as the internet to compete beyond their
home market.
Strategic leaders have a number of frameworks at their disposal to make global strategy
decisions. The CAGE framework allows for a detailed analysis of any country pairing.
Rather than looking at simple absolute measures such as market size, the strategist can
determine the relative distance or closeness of a target market to the home market along
cultural, administrative/political, geographic, and economic dimensions. Once decided
which countries to enter, the mode of foreign entry needs to be determined. Considerations
of the degree of investment and level of control help in this decision. Higher levels of con-
trol, and thus greater protection of IP and a lower likelihood of any loss in reputation, go
along with more investment-intensive foreign-entry modes such as acquisitions or green-
field plants (see Exhibit 10.6).
A firm’s business-level strategy (discussed in Chapter 6) provides an important clue
to possible strategies to be pursued globally. A cost leader, for example, is more likely to
have the capabilities to be successful with a global-standardization strategy. In contrast, a
differentiator is more likely to be successful in pursuing an international or multidomestic
strategy. The same caveats raised concerning a blue ocean strategy at the business level
apply at the corporate level: Although attractive on paper, a transnational strategy combin-
ing high pressures for cost reductions with high pressures for local responsiveness is dif-
ficult to implement because of inherent trade-offs.
Finally, a strategic leader must be aware of the fact that despite globalization and the
emergence of the internet, firm geographic location has actually maintained its impor-
tance. Critical masses of world-class firms are clearly apparent in regional geographic
clusters. Think of computer technology firms in Silicon Valley, medical device firms in
the Chicago area, and biotechnology firms in and around Boston. This is a worldwide phe-
nomenon. Known for their engineering prowess, car companies such as Daimler, BMW,
Audi, and Porsche are clustered in southern Germany. Many fashion-related companies
(clothing, shoes, and accessories) are located in northern Italy. Singapore is a well-known
cluster for semiconductor materials, and India’s leading IT firms are in Bangalore. Porter
captures this phenomenon succinctly: “Paradoxically, the enduring competitive advantages
in a global economy lie increasingly in local things—knowledge, relationships, and moti-
vation that distant rivals cannot match.”83
This concludes our discussion of global strategy. Moreover, we have now completed our
study of the first two pillars of the AFI framework—strategy analysis (Chapters 1 to 5) and
strategy formulation (Chapters 6 to 10). Next, we turn to the third and final pillar of the
AFI framework—strategy implementation. In Chapter 11, we’ll study what managers can
do to implement their carefully crafted strategies successfully and how to avoid failure. In
Chapter 12, we study corporate governance and business ethics.
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DESPITE ITS TREMENDOUS success, IKEA faces significant
challenges going forward. Opening new stores is critical to
drive future growth (see Exhibit 10.1). Finding new sources
of supply to support more store openings, however, is a chal-
lenge. Although demand for IKEA’s low-cost home furnish-
ings increased in the aftermath of the global financial crisis
as more customers become price-conscious, IKEA’s annual
store growth has slowed in subsequent years. This is because
its supply chain has become a bottleneck. IKEA has difficulty
finding suppliers that are a strategic fit with its highly efficient
operations. Related to this issue is the fact that wood remains
one of IKEA’s main input factors, and the world’s consumers
are becoming more sensitive to the issue of deforestation and
its possible link to global warming. In the near future, IKEA
must find low-cost replacement materials for wood.
Powerful competitors, moreover, have also taken notice
of IKEA’s success. Although IKEA is growing in North
America, it holds less than 5 percent of the home-furnishings
market. To keep IKEA at bay in the United States, Target has
recently recruited top designers and launched a wide range
of low-priced furnishings. In some European markets, IKEA
holds 30 percent market share. IKEA has also been facing
issues on the safety front and taken a hit to its corporate repu-
tation. In 2016, IKEA was forced to recall 35 million chests
and dressers in the United States and Canada, because they
were implicated in the death of several toddlers. Covered
widely in the media, the dressers tipped over easily and were
not designed to be anchored in a wall. IKEA agreed to a $50
million settlement.
Besides these external challenges, IKEA also faces sig-
nificant internal ones. Since the company’s founding in
1943, no strategic decisions have been made without Ingvar
Kamprad’s involvement and explicit approval. Kamprad
(now in his 90s) in 2013 stepped down from chairing Inter
IKEA, the foundation that owns the company. Many observ-
ers compare Kamprad’s influence on IKEA’s culture and
organization to that of the legendary Sam Walton at Walmart.
Kamprad’s three sons are taking on stronger leadership roles
at IKEA, including chairing the foundation that controls
IKEA. In 2017, IKEA appointed Jesper Brodin, a former
assistant to Ingvar Kamprad, as the new CEO.
With new leadership, IKEA is making a major push into
online sales. Unlike its competition, IKEA had been slow to
compete online, with its chief executive openly accepting that
IKEA failed to realize that the internet was not just another
CHAPTERCASE 10 Consider This. . .
fad, but rather a sig-
nificant disruptor for
retailing. IKEA’s store
traffic and website
visits are indicative
of this strategic shift.
While IKEA’s web-
site visits more than
doubled within a five-
year period (to over 2
billion a year), in-person visits to IKEA stores increased a
mere 3 percent a year (to about 1 billion in 2017).
IKEA also faces some limitations due to its complicated
ownership structure. IKEA is privately held through a com-
plex network of foundations and holding companies in the
Netherlands, Liechtenstein, and Luxembourg. This arrange-
ment provides benefits in terms of reducing tax exposure, but
also creates significant constraints in accessing large sums
of capital needed for rapid global expansion. In addition,
many EU countries as well as the United States have become
increasingly more sensitive to the issue of tax-avoidance
schemes by large multinational enterprises.
IKEA will need to address the slew of internal and exter-
nal challenges to achieve its strategic intent of doubling its
number of yearly openings in an attempt to capture a larger
slice of fast-growing markets, such as the United States, and to
make stronger in-roads in newer markets like China and India.
As more and more people are buying furniture online, IKEA
now also has to contend with the likes of Amazon, Alibaba,
and other online retailers specializing in home furnishings.
Questions
1. List IKEA’s external and internal challenges. Looking at
IKEA’s challenges, which ones do you think pose the great-
est threat? Why? How would you address the challenges?
2. Ingvar Kamprad’s influence over IKEA may have even
been stronger than that of Sam Walton over Walmart
because IKEA is a privately held company, whereas
Walmart is a public company (since 1970). Walmart
entered a period of difficulties after Sam Walton
stepped down (in 1988 at age 70). Do you think IKEA
had similar difficulties after it endured a similar leader-
ship transition in 2013, when Ingvar Kamprad stepped
down? Why or why not?
©testing/Shutterstock.com RF
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368 CHAPTER 10 Global Strategy: Competing Around the World
This chapter discussed the roles of MNEs for eco-
nomic growth; the stages of globalization; why,
where, and how companies go global; four strategies
MNEs use to navigate between cost reductions and
local responsiveness; and national competitive advan-
tage, as summarized by the following learning objec-
tives and related take-away concepts.
LO 10-1 / Define globalization, multinational
enterprise (MNE), foreign direct investment (FDI), and
global strategy.
■ Globalization involves closer integration and
exchange between different countries and
peoples worldwide, made possible by factors
such as falling trade and investment barriers,
advances in telecommunications, and
reductions in transportation costs.
■ A multinational enterprise (MNE) deploys resources
and capabilities to procure, produce, and distribute
goods and services in at least two countries.
■ Many MNEs are more than 50 percent globalized;
they receive the majority of their revenues from
countries other than their home country.
■ Product, service, and capital markets are more
globalized than labor markets. The level of
everyday activities is roughly 10 to 25 percent
integrated, and thus semi-globalized.
■ Foreign direct investment (FDI) denotes a firm’s
investments in value chain activities abroad.
LO 10-2 / Explain why companies compete abroad, and
evaluate the advantages and disadvantages of going global.
■ Firms expand beyond their domestic borders if
they can increase their economic value creation
(V − C) and enhance competitive advantage.
■ Advantages to competing internationally include
gaining access to a larger market, gaining access
to low-cost input factors, and developing new
competencies.
■ Disadvantages to competing internationally
include the liability of foreignness, the possible
loss of reputation, and the possible loss of intel-
lectual capital.
LO 10-3 / Apply the CAGE distance framework to
guide MNE decisions on which countries to enter.
■ Most of the costs and risks involved in expand-
ing beyond the domestic market are created by
distance.
■ The CAGE distance framework determines the
relative distance between home and foreign target
country along four dimensions: cultural distance,
administrative and political distance, geographic
distance, and economic distance.
LO 10-4 / Compare and contrast the different
options MNEs have to enter foreign markets.
■ The strategist has the following foreign-entry modes
available: exporting, strategic alliances (licensing
for products, franchising for services), joint venture,
and subsidiary (acquisition or greenfield).
■ Higher levels of control, and thus a greater
protection of IP and a lower likelihood of
any loss in reputation, go along with more
investment-intensive foreign-entry modes such
as acquisitions or greenfield plants.
LO 10-5 / Apply the integration-responsiveness frame-
work to evaluate the four different strategies MNEs can
pursue when competing globally.
TAKE-AWAY CONCEPTS
3. Did it surprise you to learn that both a rich developed
country (e.g., the United States and Australia) as well
as emerging economies (e.g., China and India) are the
fastest-growing international markets for IKEA? Does
this fact pose any challenges in the way IKEA ought to
compete across the globe? Why or why not?
4. What can IKEA do to continue to drive growth globally,
especially given its strategic intent to double annual
store openings?
5. Assume you are hired to consult IKEA on the topic of cor-
porate social responsibility (see the discussion in Chapter 2).
Which areas would you recommend the company be most
sensitive to, and how should these be addressed?
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CHAPTER 10 Global Strategy: Competing Around the World 369
■ To navigate between the competing pressures
of cost reductions and local responsiveness,
MNEs have four strategy options: international,
multidomestic, global-standardization, and
transnational.
■ An international strategy leverages home-based
core competencies into foreign markets, primarily
through exports. It is useful when the MNE faces
low pressures for both local responsiveness and
cost reductions.
■ A multidomestic strategy attempts to maximize
local responsiveness in the face of low pressure
for cost reductions. It is costly and inefficient
because it requires the duplication of key business
functions in multiple countries.
■ A global-standardization strategy seeks to
reap economies of scale and location by
pursuing a global division of labor based on
wherever best-of-class capabilities reside at
the lowest cost. It involves little or no local
responsiveness.
■ A transnational strategy attempts to combine the
high local responsiveness of a localization strat-
egy with the lowest-cost position attainable from
a global-standardization strategy. It also aims to
benefit from global learning. Although appealing,
it is difficult to implement due to the organiza-
tional complexities involved.
LO 10-6 / Apply Porter’s diamond framework to
explain why certain industries are more competitive in
specific nations than in others.
■ National competitive advantage, or world leader-
ship in specific industries, is created rather than
inherited.
■ Four interrelated factors explain national
competitive advantage: (1) factor conditions,
(2) demand conditions, (3) competitive intensity
in a focal industry, and (4) related and supporting
industries/complementors.
■ Even in a more globalized world, the basis for
competitive advantage is often local.
CAGE distance framework (p. 353)
Cultural distance (p. 355)
Death-of-distance hypothesis
(p. 362)
Foreign direct investment
(FDI) (p. 342)
Global-standardization
strategy (p. 360)
Global strategy (p. 342)
Globalization (p. 342)
Globalization hypothesis (p. 358)
Integration-responsiveness
framework (p. 358)
International strategy (p. 359)
Liability of foreignness (p. 350)
Local responsiveness (p. 358)
Location economies (p. 349)
Multidomestic strategy (p. 360)
Multinational enterprise
(MNE) (p. 342)
National competitive
advantage (p. 363)
National culture (p. 354)
Transnational strategy (p. 361)
KEY TERMS
DISCUSSION QUESTIONS
1. Multinational enterprises (MNEs) have an impact
far beyond their firm boundaries. Assume you are
working for a small firm that supplies a product
or service to an MNE. How might your relation-
ship change as the MNE moves from Globaliza-
tion 2.0 to Globalization 3.0 operations?
2. Professor Pankaj Ghemawat delivered a TED
talk titled “Actually, the World Isn’t Flat.” Do
you agree with his assessment that the world is
at most semi-globalized, and that we need to be
careful not to fall victim to “globalony”? View the
talk at: www.ted.com/talks/pankaj_ghemawat_
actually_the_world_isn_t_flat?language=en.
3. The chapter notes that global strategy can change
over time for a firm. MTV is highlighted as one
example in Exhibit 10.8. Conduct a web search of
a firm you know to be operating internationally
and determine its current global strategy position.
How long has the firm stayed with this approach?
Can you find evidence it had a different global
strategy earlier?
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370 CHAPTER 10 Global Strategy: Competing Around the World
ETHICAL/SOCIAL ISSUES
1. A race to the bottom may set in as MNEs search
for ever-lower-cost locations. Discuss the trade-
offs between the positive effects of raising the
standard of living in some of the world’s poor-
est countries with the drawbacks of moving jobs
established in one country to another. Does your
perspective change in light of several accidents
in textile factories in Bangladesh, Cambodia, and
elsewhere, where the cumulative death was over
1,000 workers? What responsibilities do MNEs
have?
2. Will the Globalization 3.0 strategy persist through
the 21st century? If not, what will Globaliza-
tion 4.0 look like? Several American companies
such as Apple and GE have realized that they
miscalculated the full cost of managing far-flung
production operations and are bringing produc-
tion back to the United States. Forbes magazine
put the blame on managers who were focused on
maximizing shareholder value rather than empha-
sizing the long-term future of the firm.84 That is,
some managers looked only at labor costs and
ignored the hidden costs of time and money try-
ing to communicate quality and design concerns
to workers across countries as well as unexpected
costs to the supply chain from natural disasters or
political threats. These factors combined with the
new economics of energy (e.g., growing supply
of natural gas) and new technologies (robotics,
artificial intelligence, 3-D printing, and nanotech-
nology) are rapidly changing manufacturing and
management decisions.
Discuss the factors that managers of Apple
or GE may consider as they focus on continuous
innovation rather than the cost of manufacturing.
How might governments with an interest in gen-
erating employment opportunities try to influence
the decisions of firms? What other stakehold-
ers may have an interest in bringing jobs back
onshore and thus try to influence the decisions
of firms? Consider the persuasive arguments and
deals that might be struck. With changes to the
location of production, what might Globalization
4.0 look like?
SMALL GROUP EXERCISES
//// SMALL GROUP EXERCISE 1
Many U.S. companies have become global players.
The technology giant IBM employs over 375,000 peo-
ple and has revenues of roughly $95 billion. Although
IBM is headquartered in Armonk, New York, the
vast majority of its employees (more than 70 percent)
actually work outside the United States. IBM, like
many other U.S.-based multinationals, now earns the
majority of its revenues (roughly two-thirds) outside
the United States.85 Though IBM revenues have been
dropping in recent quarters, its global business is still
a major focus for the firm.
1. Given that traditional U.S. firms such as IBM
have over 70 percent of their employees outside
the United States and earn almost two-thirds of
their revenues from outside the country, what is an
appropriate definition of a “U.S. firm”?
2. Should IKEA be considered a Swedish firm with
less than 6 percent of sales garnered from the
Swedish market? Discuss why or why not in your
groups.
3. Is there any special consideration a firm should
have for its “home country”? Is it ethical to keep
profits outside the home country in offshore
accounts to avoid paying domestic corporate
taxes?
//// SMALL GROUP EXERCISE 2
In this exercise, we want to apply the four types of
global strategy. Imagine your group works for Clif
Bar (www.clifbar.com). Founded in 1992, the firm
makes nutritious, all-natural food and drinks for sport
and healthy snacking. Clif Bar is a privately held
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CHAPTER 10 Global Strategy: Competing Around the World 371
company with some 400 employees. About 20 percent
of the company is owned by the employees through
an employee stock ownership plan (ESOP). The vast
majority of Clif Bar’s sales are in the United States.
The firm has some distribution set up in Canada
(since 1996) and the United Kingdom (since 2007).
As of 2017, Clif Bar sells limited products in only 11
other countries: Australia, Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg, Nether-
lands, and New Zealand.
Review the company’s website and news articles
for more information about the firm and its products.
1. Apply the CAGE distance framework to the foreign
countries where Clif Bar is operating. What is the rel-
ative distance of each to the United States? Rank the
order of the countries in terms of relative distance.
2. Given the results from the CAGE model, do the
chosen countries make sense? Why or why not?
3. Can you recommend three or four other coun-
tries Clif Bar should enter? Support your
recommendations.
4. What entrance strategy should the firm employ in
expanding the business to new countries? Why?
How Do You Develop a
Global Mind-set?
How can you develop the skills needed to succeed as an international leader? Researchers have developed a per-sonal strategy for building a global mind-set that will
facilitate success as an effective manager in a different cultural
setting. A global mind-set has three components: intellectual
capital, the understanding of how business works on a global
level; psychological capital, openness to new ideas and experi-
ences; and social capital, the ability to build connections with
people and to influence stakeholders from a different cultural
background.86
• Intellectual capital is considered the easiest to gain if one
puts forth the effort. You can gain global business acumen
by taking courses, but you can learn a great deal on your
own by reading publications with an international scope
such as The Economist, visiting websites that provide
information on different cultures or business operations in
foreign countries, or simply watching television programs
with an international news or culture focus. Working in
global industries with people from diverse cultures is also
a complex assignment, requiring the ability to manage
complexity and uncertainty.
• Psychological capital is gained by being receptive to new
ideas and experiences and appreciating diversity. It may be
the most difficult to develop, because your ability to change
your personality has limits. If you are enthusiastic about
adventure and are willing to take risks in new environ-
ments, then you have the attitudes needed to be energized
by a foreign assignment. It takes self-confidence and a
sense of humor to adapt successfully to new environments.
• Social capital is based on relationships and is gained
through experience. You can gain experience with diversity
simply by widening your social circle, volunteering to work
with international students, or by traveling on vacation or
through a study abroad experience.
Now that you have a description of the three components
of a global mind-set and a few ideas about how to develop the
attributes necessary for global success, consider some ways
you can develop a personal strategy that can be implemented
during your college career.
1. So that you have a better idea of where you stand now, list
your strengths and weaknesses for each component.
2. Identify your weakest area, and make a list of activities
that will help you improve your capital in that area.
3. Identify courses you could take in international business,
economics, politics, history, or art history. While you may
be required to be proficient in at least one foreign lan-
guage, learn a few words in other languages that can help
you navigate any new countries you visit.
4. Make a list of at least six activities you could do this week
to get started. For example, you could choose to work with
international students on group projects in class. Or move
on to having lunch with them. What questions could you
ask that would help you learn about their culture and about
doing business in their country? You could go to a museum
with an exhibit from another culture, an international
movie, or a restaurant with cuisine that is new to you.
If you are interested in more information, go to https://thunderbird.
asu.edu/faculty-and-research/najafi-global-mindset-institute, where
you can also take a sample survey to get an idea of the degree to
which you have the attributes needed for global success.
mySTRATEGY
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372 CHAPTER 10 Global Strategy: Competing Around the World
1. This ChapterCase is based on: “IKEA:
How the Swedish retailer became a global
cult brand,” BusinessWeek, November 14,
2005; “Flat-pack accounting,” The Economist,
May 11, 2006; “Shocking tell-all book takes
aim at Ikea,” BusinessWeek, November 12,
2009; Peng, M. (2013), Global Strategy, 3rd
ed. (Mason, OH: South-Western Cengage);
Edmonds, M. (2010), How Ikea Works, http://
money.howstuffworks.com/ikea.htm; “The
secret of IKEA’s success,” The Economist,
February 24, 2011; “IKEA to accelerate
expansion,” The Wall Street Journal, Septem-
ber 18, 2012; “Ingvar Kamprad steps back,”
The Economist, June 5, 2013; Tabuchi, H.
(2015, Jan. 28), “As profit slows, Ikea notes
need to move online,” The New York Times;
Kowitt, B. (2015, Jun. 9), “It’s Ikea’s world.
We just live in it,” Fortune; Chaudhuri, S.
(2015, Jun. 24), “IKEA experiments with
click and collect stores in U.K.,” The Wall
Street Journal; Chaudhuri, S. (2016, Jun. 28),
“IKEA to recall 29 million dressers, chests
in U.S,” The Wall Street Journal; Chaudhuri,
S. (2016, Dec. 7), “IKEA adapts to growing
urban populations,” The Wall Street Journal;
Chaudhuri, S. (2017, Jan. 29), “IKEA’s ‘open
source’ sofa invites customization,” The Wall
Street Journal; and IKEA Yearly Summaries
(www.ikea.com), various years.
2. “Foreign university students,” The Econo-
mist, August 7, 2010; and Haynie, D. (2014,
Nov. 17), “Number of international college
students continues to climb,” U.S. News &
World Report.
3. International Trends in Higher Education
2015 (Oxford: The University of Oxford),
https://www.ox.ac.uk/sites/files/oxford/Inter-
national%20Trends%20in%20Higher%20
Education%202015 .
4. McCarthy, N. (2015, Jul. 2), “These coun-
tries have the most students studying abroad,”
Forbes.
5. World Bank (2017), World Development Indi-
cators, http://wdi.worldbank.org/table/WV.1.
6. CAGE is an acronym for cultural, admin-
istrative and political, geographic, and eco-
nomic distance. The model was introduced
by Ghemawat, P. (2001, Sept.), “Distance still
matters: The hard reality of global expansion,”
Harvard Business Review.
7. Stiglitz, J. (2002), Globalization and Its
Discontents (New York: Norton).
8. “BRICs, emerging markets and the world
economy,” The Economist, June 18, 2009.
More recent events currently favor India and
China; see “What is the state of the BRIC
economies?” World Economic Forum at
https://www.weforum.org/agenda/2016/04/
what-is-the-state-of-the-brics-economies/
accessed May 24, 2017.
9. World Bank (2017), World Development
Indicators, http://wdi.worldbank.org/table/
WV.1#.
10. We define global strategy as a “strat-
egy of firms around the globe—essentially
various firms’ theories about how to compete
successfully.” This definition expands on a
narrower alternative use of the term global
strategy, which implies a global cost-leadership
strategy in standardized products. This narrower
approach we denote as global- standardization
strategy. In both of these definitions we follow
the work of M.W. Peng; see: Peng, M. (2013),
Global Strategy, 3rd ed. (Mason, OH: South-
Western Cengage) and elsewhere.
11. Caves, R. (1996), Multinational Enterprise
and Economic Analysis (New York: Cambridge
University Press); and Dunning, J. (1993),
Multinational Enterprises and the Global
Economy (Reading, MA: Addison-Wesley).
12. http://www.airbus.com/company/
americas/us/alabama/.
13. McKinsey Global Institute (2010),
Growth and Competitiveness in the United
States: The Role of Its Multinational Compa-
nies (London: McKinsey Global Institute).
14. IBM (2009), “A decade of generating
higher value at IBM,” www.ibm.com; and
Friedman, T.L. (2005), The World Is Flat:
A Brief History of the Twenty-First Century
(New York: Farrar, Straus, and Giroux).
15. A careful discussion of the WTO is
at: https://www.wto.org/english/thewto_e/
whatis_e/whatis_e.htm.
16. Immelt, J.R., V. Govindarajan, and C.
Trimble (2009, Oct.), “How GE is disrupting
itself,” Harvard Business Review; author’s
interviews with Michael Poteran of GE
Healthcare (October 30, 2009, and November
4, 2009); and “Vscan handheld ultrasound:
GE unveils ’stethoscope of the 21st century,’”
Huffington Post, October 20, 2009; and
Govindarajan, V., and C. Trimble (2012),
Reverse Innovation: Create Far from Home,
Win Everywhere (Boston, MA:
Harvard Business Review Press).
17. This process is also referred to as reverse
innovation. See: Govindarajan, V., and C.
Trimble (2012), Reverse Innovation: Create
Far from Home, Win Everywhere (Boston,
MA: Harvard Business Review Press).
18. Its two founders, one Swiss and the other
Italian, each hold master’s degrees from Stan-
ford University.
19. Saxenian, A. (1994), Regional Advantage
(Cambridge, MA: Harvard University Press);
and Rothaermel, F.T., and D. Ku (2008),
“Intercluster innovation differentials: The role
of research universities,” IEEE Transactions
on Engineering Management 55: 9–22.
20. Ghemawat, P. (2011), World 3.0: Global
Prosperity and How to Achieve It (Boston,
MA: Harvard Business Review Press). The
data presented are drawn from Ghemawat
(2011) and his TED talk “Actually, the world
isn’t flat,” June 2012. You can view this excel-
lent talk at https://www.ted.com/talks/pankaj_
ghemawat_actually_the_world_isn_t_flat.
21. The number rises to 6–7 percent if VoIP
(such as Skype) is included; Ghemawat, P.
(2012), “Actually, the world isn’t flat,” TED
talk, June, at https://www.ted.com/talks/pan-
kaj_ghemawat_actually_the_world_isn_t_flat.
22. Friedman, T.L. (2005), The World Is Flat:
A Brief History of the Twenty-First Century
(New York: Farrar, Straus, and Giroux).
23. Ghemawat, P. (2011), World 3.0: Global
Prosperity and How to Achieve It (Boston,
MA: Harvard Business Review Press).
24. “The rising power of the Chinese
worker,” The Economist, July 29, 2010.
25. “Supply chain for iPhone highlights costs
in China,” The New York Times, July 5, 2010.
26. This is based on: Friedman, T.L. (2005),
The World Is Flat: A Brief History of the
Twenty-First Century (New York: Farrar,
Straus, and Giroux); “Supply chain for iPhone
highlights costs in China,” The New York
Times, July 5, 2010; and “The rising power
of the Chinese worker,” The Economist, July
29, 2010.
27. Ghemawat, P. (2011), World 3.0: Global
Prosperity and How to Achieve It (Boston,
MA: Harvard Business Review Press).
28. Strategy Highlight 10.2 is based on:
McCartney, S. (2014, Nov. 6), “Emirates,
Etihad and Qatar make their move on the
U.S.,” The Wall Street Journal; Carey, S.
(2015, Feb. 5), “Big U.S. Airlines fault Per-
sian Gulf carriers,” The Wall Street Journal;
Carey, S. (2015, Mar. 16), “U.S. airlines bat-
tling Gulf carriers cite others’ experience,”
The Wall Street Journal; Carey, S. (2015,
Mar. 16), “Persian Gulf airlines are winning
fans in U.S.” The Wall Street Journal; “Super-
connecting the world,” The Economist, April
25, 2015; Ostroukh, A. (2015, Nov. 17),
“Russia says bomb brought down plane in
Egypt,” The Wall Street Journal; and “The
super-connector airlines face a world of trou-
bles,” The Economist, May 13, 2017.
ENDNOTES
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CHAPTER 10 Global Strategy: Competing Around the World 373
29. “A special report on innovation in emerg-
ing markets,” The Economist, April 15, 2010.
30. “The rising power of the Chinese
worker,” The Economist, July 29, 2010.
31. Friedman, T.L. (2005), The World Is Flat:
A Brief History of the Twenty-First Century
(New York: Farrar, Straus, and Giroux).
32. Chang, S.J. (1995), “International expan-
sion strategy of Japanese firms: Capability
building through sequential entry,” Acad-
emy of Management Journal 38: 383–407;
Vermeulen, F., and H.G. Barkema (1998),
“International expansion through start-up or
acquisition: A learning perspective,” Academy
of Management Journal 41: 7–26; Vermeulen,
F., and H.G. Barkema (2002), “Pace, rhythm,
and scope: Process dependence in building a
profitable multinational corporation,” Strate-
gic Management Journal 23: 637–653; and
Ghemawat, P. (2011), World 3.0: Global Pros-
perity and How to Achieve It (Boston, MA:
Harvard Business Review Press).
33. Brown, J.S., and P. Duguid (1991),
“Organizational learning and communities-of-
practice: Toward a unified view of working,
learning, and innovation,” Organization Sci-
ence 2: 40–57.
34. Owen-Smith, J., and W.W. Powell (2004),
“Knowledge networks as channels and con-
duits: The effects of spillovers in the Boston
biotech community,” Organization Science
15: 5–21.
35. Examples drawn from: “A special report
on innovation in emerging markets,” The
Economist, April 15, 2010; and “Cisco glo-
balisation centre east: A hotbed of emerging
technologies,” at http://www.cisco.com/c/en/
us/about/cisco-on-cisco/it-success-stories/
111620071.html, visited May 25, 2017.
36. Dunning, J.H., and S.M. Lundan (2008),
Multinational Enterprises and the Global
Economy, 2nd ed. (Northampton, MA:
Edward Elgar).
37. Govindarajan, V., and C. Trimble (2012),
Reverse Innovation: Create Far from Home,
Win Everywhere (Boston, MA: Harvard Busi-
ness Review Press).
38. “A special report on innovation in emerg-
ing markets,” The Economist, April 15, 2010.
39. Zaheer, S. (1995), “Overcoming the
liability of foreignness,” Academy of Manage-
ment Journal 38: 341–363.
40. “2016 BrandZ Top 100 Most Valuable
Global Brands,” report by Millward Brown,
WPP.
41. “The Foxconn suicides,” The Wall Street
Journal, May 27, 2010; Barboza, D. (2016,
Dec. 29), “How China built ‘iPhone City’
with billions in perks for Apple’s partner,”
The New York Times.
42. “When workers dream of a life beyond
the factory gates,” The Economist, December
15, 2012.
43. Porter, M.E. (1980), Competitive Strat-
egy (New York: Free Press), and Magretta, J.
(2011), Understanding Michael Porter
(Boston, MA: Harvard Business Review Press).
44. Strategy Highlight 10.2 is based on:
Knorr, A., and A. Arndt (2003), “Why did
Wal-Mart fail in Germany?” in ed. A. Knorr,
A. Lemper, A. Sell, and K. Wohlmuth,
Materialien des Wissenschaftsschwerpunktes
“Globalisierung der Weltwirtschaft,” vol. 24
(IWIM—Institute for World Economics and
International Management, Universität
Bremen, Germany); the author’s on-site
observations at Walmart stores in Germany;
and “Hair-shirt economics: Getting Germans
to open their wallets is hard,” The Econo-
mist, July 8, 2010. For a recent discussion
of Walmart’s global efforts, see: “After early
errors, Wal-Mart thinks locally to act glob-
ally,” The Wall Street Journal, August 14,
2009; Sharma, A., and B. Mukherji (2013),
“Bad roads, red tape, burly thugs slow
Wal-Mart’s passage in India,” The Wall Street
Journal, January 12; Berfield, S. (2013,
Oct. 10), “Where Wal-Mart isn’t: Four coun-
tries the retailer can’t conquer,” Bloomberg
Businessweek. For reporting regarding the
threat posed by the German discounters Lidl
and Aldi, see: “Tesco’s crisis: A hard rain,”
The Economist, September 27, 2014; “Aldi
and Lidl: Tomorrow, not quite the world,” The
Economist, March 12, 2015; “The decline of
established American retailing threatens jobs,”
The Economist, May 13, 2017; and Nassauer,
S., and H. Haddon (2017, May 16), “Why
Wal-Mart is worried about a discount German
grocer,” The Wall Street Journal.
45. “Apple shifts supply chain away from
Foxconn to Pegatron,” The Wall Street Jour-
nal, May 29, 2013.
46. “Disaster at Rana Plaza,” The Economist,
May 4, 2013; “The Bangladesh disaster and
corporate social responsibility,” Forbes,
May 2, 2013.
47. “Disaster at Rana Plaza,” The Economist,
May 4, 2013; “The Bangladesh disaster and
corporate social responsibility,” Forbes,
May 2, 2013.
48. This example is drawn from: “Train mak-
ers rail against China’s high-speed designs,”
The Wall Street Journal, November 17, 2010.
49. This section is based on: Ghemawat, P.
(2001), “Distance still matters: The hard real-
ity of global expansion,” Harvard Business
Review, September; see also Ghemawat, P.
(2011), World 3.0: Global Prosperity and
How to Achieve It (Boston, MA: Harvard
Business Review Press).
50. The euro is the official currency of the
European Union and is the official currency
in the following member countries: Austria,
Belgium, Cyprus, Estonia, Finland, France,
Germany, Greece, Ireland, Italy, Latvia, Lithu-
ania, Luxembourg, Malta, the Netherlands,
Portugal, Slovakia, Slovenia, and Spain.
51. To obtain scores for any two country pair-
ings and to view interactive CAGE distance
maps, go to www.ghemawat.com.
52. The discussion of the CAGE distance
frameworks and the attributes thereof is based
on: Ghemawat, P. (2001, Sept.), “Distance
still matters: The hard reality of global expan-
sion,” Harvard Business Review; see also
Ghemawat, P. (2011), World 3.0: Global Pros-
perity and How to Achieve It (Boston, MA:
Harvard Business Review Press).
53. Hofstede, G.H. (1984), Culture’s Conse-
quences: International Differences in Work-
Related Values (Beverly Hills, CA: Sage), 21.
The description of Hofstede’s four cultural
dimensions is drawn from Rothaermel, F.T.,
S. Kotha, and H.K. Steensma (2006), “Inter-
national market entry by U.S. Internet firms:
An empirical analysis of country risk, national
culture, and market size,” Journal of Manage-
ment 32: 56–82.
54. The power-distance dimension of national
culture focuses on how a society deals with
inequality among people in terms of physical
and intellectual capabilities and how those
methods translate into power distributions
within organizations. High power-distance
cultures, like the Philippines (94/100, with
100 = high), tend to allow inequalities among
people to translate into inequalities in oppor-
tunity, power, status, and wealth. Low power-
distance cultures, like Austria (11/100), on the
other hand, tend to intervene to create a more
equal distribution among people within orga-
nizations and society at large.
The individualism dimension of national
culture focuses on the relationship between
individuals in a society, particularly in regard
to the relationship between individual and
collective pursuits. In highly individualistic
cultures, like the United States (91/100),
individual freedom and achievements are
highly valued. As a result, individuals are only
tied loosely to one another within society. In
less-individualistic cultures, like Venezuela
(12/100), the collective good is emphasized
over the individual, and members of society
are strongly tied to one another throughout
their lifetimes by virtue of birth into groups
like extended families.
The masculinity–femininity dimension of
national culture focuses on the relationship
between genders and its relation to an indi-
vidual’s role at work and in society. In more
“masculine” cultures, like Japan (95/100),
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374 CHAPTER 10 Global Strategy: Competing Around the World
gender roles tend to be clearly defined and
sharply differentiated. In “masculine” cul-
tures, values like competitiveness, assertive-
ness, and exercise of power are considered
cultural ideals, and men are expected to
behave accordingly. In more “feminine”
cultures, like Sweden (5/100), values like
cooperation, humility, and harmony are
guiding cultural principles. The masculinity–
femininity dimension uncovered in Hofstede’s
research is undoubtedly evolving over time,
and values and behaviors are converging to
some extent.
The uncertainty-avoidance dimension of
national culture focuses on societal differences
in tolerance toward ambiguity and uncertainty.
In particular, it highlights the extent to which
members of a certain culture feel anxious
when faced with uncertain or unknown situa-
tions. Members of high uncertainty-avoidance
cultures, like Russia (95/100), value clear
rules and regulations as well as clearly struc-
tured career patterns, lifetime employment,
and retirement benefits. Members of low
uncertainty-avoidance cultures, like Singa-
pore (8/100), have greater tolerance toward
ambiguity and thus exhibit less emotional
resistance to change and a greater willingness
to take risks.
55. See: http://geert-hofstede.com/
nationalculture.html. The available data,
however, on the new dimensions are not,
at this point, as comprehensive as for the
four original dimensions. Alternatively, see
the GLOBE cultural dimensions at www.
grovewell.com/pub-GLOBE-intro.html.
56. This is based on: Kogut, B., and H. Singh
(1988), “The effect of national culture on the
choice of entry mode,” Journal of Interna-
tional Business Studies 19: 411–432; Rothaer-
mel, F.T., S. Kotha, and H. K. Steensma
(2006), “International market entry by U.S.
internet firms: An empirical analysis of coun-
try risk, national culture, and market size,”
Journal of Management 32: 56–82. Cultural
distance from the United States, for example,
is calculated as follows:
CDj = ∑
i=1
4
{(Iij − Iiu)2/Vi} /4
where Iij stands for the index for the ith
cultural dimension and jth country, Vi is the
variance of the index of ith dimension, u indi-
cates the United States, and CDj is the cultural
distance difference of the jth country from the
United States.
57. Ghemawat, P. (2012), TED talk, “Actu-
ally, the world isn’t flat,” June, at https://
www.ted.com/talks/pankaj_ghemawat_actu-
ally_the_world_isn_t_flat; and Ghemawat,
P. (2011), World 3.0: Global Prosperity and
How to Achieve It (Boston, MA: Harvard
Business Review Press).
58. “Strong revenue growth in China & Asia-
Pacific drives Starbucks’ top-line growth in
Q2,” Forbes, April 28, 2015; “Starbucks,” in
Resonance Insights, China Social Branding
Report, November 24, 2014; “Starbucks gets
even more social in China, lets fans follow
in WeChat app,” Tech in Asia, September 6,
2012.
59. Ghemawat, P. (2001, Sept. 1), “Distance
still matters: The hard reality of global expan-
sion,” Harvard Business Review.
60. See statistics provided by Eurostat at:
http://epp.eurostat.ec.europa.eu.
61. Williamson, O.E. (1975), Markets and
Hierarchies (New York: Free Press); William-
son, O.E. (1981), “The economics of organiza-
tion: The transaction cost approach,” American
Journal of Sociology 87: 548–577; and Wil-
liamson, O.E. (1985), The Economic Institu-
tions of Capitalism (New York: Free Press).
62. Ghemawat, P. (2001), “Distance still mat-
ters: The hard reality of global expansion,”
Harvard Business Review, September; Burkitt,
L. (2015, Apr. 29) “Walmart says it will go
slow in China,” The Wall Street Journal.
63. Johanson, J., and J. Vahlne (1977), “The
internationalization process of the firm,” Jour-
nal of International Business Studies 4: 20–29.
64. Fuller, A.W., and F.T. Rothaermel (2008),
“The interplay between capability develop-
ment and strategy formation: Motorola’s entry
into China,” Georgia Institute of Technology
Working Paper.
65. Levitt, T. (1983), “The globalization of
markets,” Harvard Business Review, May–
June: 92–102.
66. Mol, M. (2002), “Ford Mondeo: A
Model T world car?” in ed. F.B. Tan, Cases
on Global IT Applications and Management:
Successes and Pitfalls (Hershey, PA: Idea
Group Publishing), 69–89.
67. Prahalad, C.K., and Y.L. Doz (1987), The
Multinational Mission (New York: Free Press);
and Roth, K., and A.J. Morrison (1990), “An
empirical analysis of the integration-
responsiveness framework in global indus-
tries,” Journal of International Business Stud-
ies 21: 541–564.
68. Bartlett, C.A., S. Ghoshal, and P.W.
Beamish (2007), Transnational Management:
Text, Cases and Readings in Cross- Border Man-
agement, 5th ed. (New York: McGraw-Hill).
69. “Ditch the knock-off watch, get the
knock-off car,” The Wall Street Journal Video,
August 8, 2010.
70. www.lenovo.com/lenovo/US/en/locations.
html.
71. www.lenovo.com/lenovo/US/en/locations.
html.
72. Ghemawat, P. (2011), World 3.0: Global
Prosperity and How to Achieve It (Boston,
MA: Harvard Business Review Press).
73. Mueller, H.-E. (2001), “Developing
global human resource strategies,” paper pre-
sented at the European International Business
Academy, Paris, December 13–15; Mueller,
H.-E. (2001), “Wie global player den Kampf
um Talente führen,” Harvard Business Man-
ager 6: 16–25.
74. This section draws on: Rothaermel, F.T.,
and D. Ku (2008), “Intercluster innovation
differentials: The role of research universi-
ties,” IEEE Transactions on Engineering
Management 55: 9–22.
75. This discussion is based on: Buckley,
P.J., and P.N. Ghauri (2004), “Globalisa-
tion, economic geography and the strategy
of multinational enterprises,” Journal of
International Business Studies 35: 81–98;
Cairncross, F. (1997), The Death of Distance:
How the Communications Revolution Will
Change Our Lives (Boston, MA: Harvard
Business School Press); and Friedman, T.L.
(2005), The World Is Flat: A Brief History of
the Twenty-First Century (New York: Farrar,
Straus, and Giroux). For a counterpoint, see
Ghemawat, P. (2001), “Distance still matters:
The hard reality of global expansion,” Har-
vard Business Review, September; Ghemawat,
P. (2007), Redefining Global Strategy: Cross-
ing Borders in a World Where Differences
Still Matter (Boston, MA: Harvard Business
School Press); and Ghemawat, P. (2011),
World 3.0: Global Prosperity and How to
Achieve It (Boston, MA: Harvard Business
Review Press).
76. This section is based on: Porter, M.E.
(1990), “The competitive advantage of
nations,” Harvard Business Review, March–
April: 73–91; and Porter, M.E. (1990), The
Competitive Advantage of Nations (New York:
Free Press).
77. “U.S. identifies vast mineral riches in
Afghanistan,” The New York Times, June 13,
2010.
78. For an insightful recent discussion, see:
Breznitz, D. (2007), Innovation and the State:
Political Choice and Strategies for Growth in
Israel, Taiwan, and Ireland (New Haven, CT:
Yale University Press).
79. Nokia ceded leadership to RIM (Canada),
which subsequently stumbled. Currently,
Apple and Samsung (South Korea) are the
leaders in the smartphone industry (see
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CHAPTER 10 Global Strategy: Competing Around the World 375
discussion in Chapter 7 on the smartphone
industry).
80. Murmann, J.P. (2003), Knowledge
and Competitive Advantage (New York:
Cambridge University Press).
81. Dyer, J.H., and K. Nobeoka (2000),
“Creating and managing a high-performance
knowledge-sharing network: The Toyota
case,” Strategic Management Journal 21:
345–367.
82. This discussion is based on: “Toyota slips
up,” The Economist, December 10, 2009; “Toy-
ota: Losing its shine,” The Economist, December
10, 2009; “Toyota heir faces crises at the wheel,”
The Wall Street Journal, January 27, 2010; “Toy-
ota’s troubles deepen,” The Economist, February
4, 2010; “The humbling of Toyota,” Bloomberg
Businessweek, March 11, 2010; and “Inside
Toyota, executives trade blame over debacle,”
The Wall Street Journal, April 13, 2010.
83. Porter, M. (1998), The Competitive Advan-
tage of Nations (New York: Free Press), 77.
84. “Why Apple and GE are bringing back
manufacturing,” Forbes, December 7, 2012.
85. IBM annual reports, various years.
86. This myStrategy item is based on an
article by: Javidan, M., M. Teagarden, and
D. Bowen, (2010), “Making it overseas,”
Harvard Business Review, April: 109–113.
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PART
Implementation
CHAPTER 11 Organizational Design: Structure, Culture, and Control 378
CHAPTER 12 Corporate Governance and Business Ethics 418
3
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The AFI Strategy Framework
1. What Is Strategy?
3. External Analysis: Industry Structure,
Competitive Forces, and Strategic
Groups
4. Internal Analysis: Resources,
Capabilities, and Core Competencies
5. Competitive Advantage, Firm
Performance, and Business Models
6. Business Strategy: Differentiation, Cost
Leadership, and Blue Oceans
7. Business Strategy: Innovation, Entrepreneurship,
and Platforms
8. Corporate Strategy: Vertical
Integration and Diversification
9. Corporate Strategy: Strategic Alliances,
Mergers and Acquisitions
10. Global Strategy: Competing Around
the World
11. Organizational Design: Structure,
Culture, and Control
Getting
Started
External and
Internal
Analysis
Formulation:
Business
Strategy
Formulation:
Corporate
Strategy
Implementation
Gaining &
Sustaining
Competitive
Advantage
12. Corporate Governance and Business
Ethics
2. Strategic Leadership: Managing
the Strategy Process
Part 1: Analysis
Part 1: Analysis
Part 2: FormulationPart 2: Formulation
Part 3: Implementation
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CHAPTER Organizational Design:
Structure, Culture, and
Control
Chapter Outline
11.1 Organizational Design and Competitive
Advantage
Organizational Inertia: The Failure of Established
Firms
Organizational Structure
Mechanistic vs. Organic Organizations
11.2 Strategy and Structure
Simple Structure
Functional Structure
Multidivisional Structure
Matrix Structure
11.3 Organizing for Innovation
11.4 Organizational Culture: Values, Norms, and
Artifacts
Where Do Organizational Cultures Come From?
How Does Organizational Culture Change?
Organizational Culture and Competitive Advantage
11.5 Strategic Control-and-Reward Systems
Input Controls
Output Controls
11.6 Implications for Strategic Leaders
Learning Objectives
LO 11-1 Define organizational design and list its
three components.
LO 11-2 Explain how organizational inertia can lead
established firms to failure.
LO 11-3 Define organizational structure and
describe its four elements.
LO 11-4 Compare and contrast mechanistic versus
organic organizations.
LO 11-5 Describe different organizational structures
and match them with appropriate strategies.
LO 11-6 Evaluate closed and open innovation, and
derive implications for organizational
structure.
LO 11-7 Describe the elements of organizational
culture, and explain where organizational
cultures can come from and how they can
be changed.
LO 11-8 Compare and contrast different strategic
control-and-reward systems.
11
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Zappos: Of Happiness and
Holacracy
ZAPPOS (www.zappos.com) made its mark delivering
shoes and happiness. When Tony Hsieh (pronounced
“Shay”), CEO of Zappos, wrote about the company’s
unique approach in 2010’s Delivering Happiness, the
book joined The New York Times bestseller list. Hsieh
believes that making customers and employees happy
drives success by “delivering WOW through service.” The
result? The online shoe and clothing store grew from a
startup to become a giant in the industry. Service includes
easy online shopping with free shipping to and from its
customers and a generous
365-day return policy.
Zappos also made its
investors happy. In 2008,
just 10 years after its found-
ing, Zappos achieved more
than $1 billion in annual
sales. In 2009, Amazon.
com acquired the company
for $1.2 billion. Although
now a subsidiary of Ama-
zon, Zappos continues to
operate as an independent
brand, as Amazon main-
tains a hands-off policy.
If anything, new ideas flow up from Zappos to its par-
ent. One example: Zappos weeds out cultural misfits by
paying employees to leave after the orientation program.
Amazon CEO Jeff Bezos said the “clever people at Zap-
pos” inspired him to offer warehouse workers as much as
$5,000 to quit if they were not totally enthusiastic about
the importance of their work to Amazon’s future.1
Zappos has grown so much—receiving over 20 million
unique visitors a month to its website—that it sometimes
reorganizes to offer the best customer service possible. At
one point, to keep the organization flat and responsive to
customers, Zappos restructured into 10 separate business
units including Zappos.com, Zappos Gift Cards, Zappos IP,
and 6pm.com, among others. But in 2013, Hsieh announced
a more radical approach to organization to fight the slow
bureaucracy that affects larger companies. That structure is
called holacracy, which Hsieh explains as follows:
Research shows that every time the size of a city
doubles, innovation or productivity per resident
increases by 15 percent. But when companies get
bigger, innovation or productivity per employee
generally goes down. So we’re trying to figure out
how to structure Zappos more like a city and less
like a bureaucratic corporation. In a city, people
and businesses are self-organizing. We’re trying to
do the same thing by switching from a normal hier-
archical structure to a system called Holacracy,
which enables employees to act more like entrepre-
neurs and self-direct their work instead of report-
ing to a manager
who tells them what
to do.2
Here is what we
know about holacracy.
Often compared to a
computer’s operating
system, holacracy con-
stitutes a new organi-
zational structure for
governing and running
a company. Because it
greatly changes how
workers interact, pro-
ponents hail it as a “social technology.” Brian Robertson
developed the concept in the 2000s, working from ideas
introduced by Arthur Koestler in the 1967 book, The
Ghost in the Machine, the work in which Koestler coined
the term.3 Forgoing traditional top-down hierarchy, hol-
acracy purports to achieve control and coordination by
distributing power and authority to self-organizing groups
(so-called circles) of employees. Circles of employees are
meant to self-organize and self-govern around a specific
task, such as confirming online orders or authorizing a
customer’s credit card.
So Zappos grouped its over 1,500 employees in some
400 circles, with each employee in two or more circles.
Order is supposed to emerge from the bottom up, rather
than rely on top-down command and control. The rules
are explicit in a so-called constitution, which defines the
CHAPTERCASE 11
A flock of birds in flight, immediately shifting direction with self-regulating
unity, frequently serves as a poetic symbol of holacracy in action.
©greatonmywall/Alamy Stock Photo
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holacracy An
organizational structure
in which decision-
making authority is
distributed through
loose collections or
circles of self-organizing
teams.
power and authority of each circle. For coordination, the
employee circles overlap horizontally, and without vertical
hierarchy. The CEO’s last act as the highest-ranking person
in the organization is to sign the constitution in a symbolic
act, relinquishing all executive powers. Thereafter the former
leader becomes the “ratifier of the holacracy constitution.”
Exhibit 11.1 provides an overview comparing a tradi-
tional organizational structure with holacracy.
As often happens, a new concept sounds great in theory,
but proves hard to implement. In fact, Zappos is the first
and only large corporation to try. (Robertson, the inventor
of holacracy as an organizational form, ran a software com-
pany of 12 people where he tested his ideas.)4
You will learn more about Zappos by reading this chapter; related
questions appear in “ChapterCase 11 / Consider This. . . .”
Traditional Organizational Structure Holacracy
Static job description Dynamic roles
Top-down Self-organizing teams
Hierarchical decision making Employee senses tension as dissonance between
what is (current reality) and what could be (the
purpose). How to resolve tension is worked out in
circle meetings.
Formal authority Distributed authority
Command and control Employee autonomy
Functional areas Employee circles
Alignment via politics Transparent rules defined in constitution
Large-scale reorganizations Rapid, fluid, and constant iterations
EXHIBIT 11.1 /
Traditional
Organizational
Structure vs.
Holacracy
SOURCE: Adapted from B.
Robertson (2015), Holacracy:
The New Management
System for a Rapidly
Changing World (New York:
Henry Holt).
ZAPPOS CEO TONY HSIEH believes that about one-half of all retail transactions
in the United States will be online soon, and that people will buy from the company
with the best customer service and best selection. His strategic intent for Zappos is to
be that online store, to differentiate itself from the competition with superior service and
selection. Hsieh remains unusually thoughtful about what type of structure, culture, and
processes will advance that strategy. He initially designed Zappos as a flat organization
to help Zappos provide exceptional service, and he continued to refine its organizational
design through trial and error, with transparency, while nurturing a supportive culture by
soliciting bottom-up feedback. And he celebrated the emphasis on happiness as noted in
his book, with the understanding that happy employees are productive employees.
Yet, increased bureaucracy and a loss of productivity could not be avoided as the com-
pany grew and matured. To move Zappos forward, Hsieh proposed a new organizational
structure called holacracy, a form of social technology that Hsieh believes will allow
Zappos to pursue its purpose of delivering happiness and WOW through customer service.
This chapter opens the final part of the AFI framework: strategy implementation. Strat-
egy implementation concerns the organization, coordination, and integration of how work
gets done (see discussion in Chapter 2).
Effective strategy implementation is critical to gaining and sustaining competi-
tive advantage. Although the discussion of strategy formulation (what to do) is distinct
from strategy implementation (how to do it), formulation and implementation must be
part of an interdependent, reciprocal process to ensure continued success. That need for
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interdependence explains why the AFI framework is illustrated as a circle, rather than a
linear diagram (see Part 3 Opener). The design of an organization, the matching of strategy
and structure, and its control-and-reward systems determine whether or not an organization
that has chosen an effective strategy will be able to gain and sustain a competitive advan-
tage. As discussed in ChapterCase 11, Zappos pursues a differentiation strategy at the
business level, which it is now implementing internally and structurally through holacracy.
Whether Zappos’ strategy implementation will be successful or not remains to be seen.
In this chapter, we study the three key levers that managers have at their disposal when
designing their organizations for competitive advantage: structure, culture, and control.
Managers employ these three levers to coordinate work and motivate employees across
different levels, functions, and geographies. How successful they are in this endeavor
determines whether they are able to translate their chosen business, corporate, and global
strategy into strategic actions and business models, and ultimately whether the firm is able
to gain and sustain a competitive advantage.
We begin our discussion with organizational structure. We discuss different types of
organizational structures as well as why and how they need to change over time as success-
ful firms grow in size and complexity. We highlight the critical need to match strategy and
structure. We also present different ways to organize for innovation before taking a closer
look at corporate culture. An organization’s culture can either support or hinder its quest
for competitive advantage.5 We next study strategic control systems, which allow manag-
ers to receive feedback on how well a firm’s strategy is being implemented. We conclude
our discussion of how to design an organization for competitive advantage with practical
Implications for Strategic Leaders.
11.1 Organizational Design and
Competitive Advantage
Organizational design is the process of creating,
implementing, monitoring, and modifying the struc-
ture, processes, and procedures of an organization.
The key components of organizational design are
structure, culture, and control. The goal is to design an
organization that allows managers to effectively trans-
late their chosen strategy into a realized one.
Not surprisingly, the inability to implement strategy
effectively is the number-one reason boards of direc-
tors fire CEOs.6 Yahoo’s co-founder and CEO Jerry
Yang was ousted in 2008 precisely because he failed
to implement necessary strategic changes after Yahoo
lost its competitive advantage.7 In the two years leading up to his exit, Yahoo lost more
than 75 percent of its market value. Yang was described as someone who preferred con-
sensus among his managers to making tough strategic decisions needed to change Yahoo’s
structure. That preference, though, led to bickering and infighting. Yang’s failure to make
the necessary changes to the internet firm’s organizational structure led to a destruction of
billions of dollars in shareholder value and thousands of layoffs. A number of short-term
and interim CEOs followed Yang without much success. Then in 2012, Yahoo tapped for-
mer Google executive Marissa Mayer as president and CEO; Mayer’s turnaround efforts
focused on improving the user experience to drive mobile advertising revenues. Such a
strategic reorientation required changes in the organizational structure and culture as well.
Despite all these changes, Yahoo was not able to gain significant ground in the online
LO 11-1
Define organizational
design and list its three
components.
organizational
design The process of
creating, implementing,
monitoring, and
modifying the
structure, processes,
and procedures of an
organization.
As CEO of Yahoo, Marissa
Mayer attempted a turn-
around of the struggling
internet company by mak-
ing changes to Yahoo’s
organizational structure
and culture, among other
strategic initiatives. In the
end, a successful turnaround
of the once-leading internet
company remained elusive,
and Verizon bought Yahoo for
a mere $4.5 billion in 2017.
©AP Images/Julie Jacobson
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advertising space, which Google and Facebook continue to dominate. Once a leader in
online search and valued at over $200 billion (in 2001 at the height of the dot.com boom),
Yahoo was acquired by Verizon for a mere $4.5 billion in 2017.8
Because implementation transforms strategy into actions and business models, it
often requires changes within the organization. However, strategy implementation often
fails because managers are unable to make the necessary changes due to the effects on
resource allocation and power distribution within an organization.9 Strategic leaders
are leery about disturbing the status quo. As demonstrated by business historian Alfred
Chandler in his seminal book Strategy and Structure, organizational structure must fol-
low strategy in order for firms to achieve superior performance: “Structure can be defined
as the design of organization through which the enterprise is administered . . . structure
follows strategy.”10 This tenet implies that to implement a strategy successfully, organiza-
tional design must be flexible enough to accommodate the formulated strategy and future
growth and expansion.
Featured in the ChapterCase, Zappos provides an example of a company with flexible
organizational structure. When establishing customer service as a core competency, one of the
hardest decisions Hsieh made early was to pull the plug on drop-shipment orders. These are
orders for which Zappos would be the intermediary, relaying them to particular shoe vendors
that then ship directly to the customer. Such orders were profitable because Zappos would not
have to stock the shoes. They were also appealing because the fledgling startup was still losing
money. But the problem was twofold. The vendors were slower than Zappos in filling orders.
In addition, they did not accomplish the reliability metric that Zappos wanted for exceptional
service: 95 percent accuracy was simply not good enough! Instead, Zappos decided to forgo
drop shipments and instead built a larger warehouse in Kentucky to stock a full inventory.
This move enabled the firm to achieve close to 100 percent accuracy in its shipments, many
of which were overnight. Unlike other online retailers, Zappos stocks everything it sells in
its own warehouses—this is the only way to get the merchandise as quickly as possible with
100 percent accuracy to the customer. Strategy, therefore, is as much about deciding what to
do as it is about deciding what not to do.
ORGANIZATIONAL INERTIA: THE FAILURE
OF ESTABLISHED FIRMS
To implement a formulated business strategy successfully, structure must accommodate
strategy, not the other way around. In reality, however, a firm’s strategy often follows its
structure.11 This reversal implies that some managers consider only strategies that do not
change existing organizational structures; they do not want to confront the inertia that often
exists in established organizations.12 Inertia, a firm’s resistance to change the status quo,
can set the stage for the firm’s subsequent failure. Successful firms often plant the seed of
subsequent failure: They optimize their organizational structure to the current situation.
That tightly coupled system can break apart when internal or external pressures occur.
Note that organizational inertia is often the result of success in a particular market dur-
ing a particular time; it becomes difficult to argue with success. The pattern for successful
firms often follows a particular path:
1. Mastery of, and fit with, the current environment.
2. Success, usually measured by financial measurements.
3. Structures, measures, and systems to accommodate and manage size.
4. A resulting organizational inertia that tends to minimize opportunities and challenges
created by shifts in the internal and external environment.
LO 11-2
Explain how
organizational inertia can
lead established firms to
failure.
inertia A firm’s
resistance to change
the status quo, which
can set the stage for
the firm’s subsequent
failure.
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What’s missing, of course, is the conscious strategic decision to change the firm’s inter-
nal environment to fit with the new external environment, turning four steps leading to the
endpoint of inertia (Option A) into the kind of a virtual circle where the firm essentially
reboots and reinvents itself (Option B).
Consider that the need for structural reorganization can be especially intense in many
industries where the rate of change is high and potential disruption frequent. Consider also
that business leaders find it much easier to create and manage within developed structures
than to restructure their organizations to be where they will need to be in future.
Exhibit 11.2 shows how success in the current environment can lead to a firm’s downfall
in the future, when the tightly coupled system of strategy and structure experiences inter-
nal or external shifts.13 First, the managers achieve a mastery of, and fit with, the firm’s
current environment. Second, the firm often defines and measures success by financial
metrics, with a focus on short-term performance (see discussion in Chapter 5). Third, the
firm puts in place structures, metrics, and systems to accommodate and manage increasing
1 2 3 4
Option A
The Firm Arrives at Inertia
1 2
4 3
Option B
The Firm Rises above Inertia
(1)
Mastery of, and
Fit with, Current
Environment
(3)
Structure, Metrics,
and Systems to
Accommodate and
Manage Size
(4)
Organizational
Inertia
(2)
Success, Usually
Measured by
Financial Metrics
Internal Shifts:
– Accelerated growth
– Change in business model
– Entry into new markets
– Change in TMT
– Mergers and acquisitions
External Shifts:
– PESTEL factors
External Shifts:
– PESTEL factors
External Shifts:
– PESTEL factors
EXHIBIT 11.2 /
Organizational Inertia
and the Failure of
Established Firms to
Respond to Shifts
in the External or
Internal Environments
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firm size and complexity due to continued success. Finally, as a result of a tightly coupled
albeit successful system, organizational inertia sets in—and with it, resistance to change.
Such a tightly coupled system is prone to break apart when external and internal shifts put
pressure on the system.14 In Exhibit 11.2, inside the oval, the longer internal arrows show the
firm’s tightly coupled organizational design over time. The shorter internal arrows indicate
pressures radiating from internal shifts such as accelerated growth, a change in the business
model, entry into new markets, a change in the top management team (TMT), or mergers
and acquisitions. Accelerated growth, for example, was the reason for a decline in employee
productivity at Zappos, as discussed in the ChapterCase. The longest arrows pointing into
and piercing the boundary of the firm indicate external pressures, which can stem from
any of the PESTEL forces (political, economic, sociocultural, technological, ecological, and
legal, as discussed in Chapter 3). Strong external or internal pressure can break apart the
current system, which may lead to firm failure. To avoid inertia and possible organizational
failure, the firm needs a flexible and adaptive structure to effectively translate the formulated
strategy into action. Ideally the firm would maintain a virtuous cycle of reconsidering orga-
nization, as implied by Option B earlier in the chapter. Tony Hsieh hopes that holacracy will
help Zappos to rise above inertia and to reorganize in a more flexible and responsive fashion.
ORGANIZATIONAL STRUCTURE
Some of the key decisions managers must make when designing effective organizations
pertain to the firm’s organizational structure. That structure determines how the work
efforts of individuals and teams are orchestrated and how resources are distributed. In par-
ticular, an organizational structure defines how jobs and tasks are divided and integrated,
delineates the reporting relationships up and down the hierarchy, defines formal commu-
nication channels, and prescribes how individuals and teams coordinate their work efforts.
The key building blocks of an organizational structure are:
■ Specialization
■ Formalization
■ Centralization
■ Hierarchy
SPECIALIZATION. Specialization describes the degree to which a task is divided into sepa-
rate jobs—that is, the division of labor. Larger firms, such as Fortune 100 companies, tend to
have a high degree of specialization; smaller entrepreneurial ventures tend to have a low degree
of specialization. For example, an accountant for a large firm may specialize in only one area
(e.g., internal audit), whereas an accountant in a small firm needs to be more of a generalist
and take on many different things (e.g., internal auditing, plus payroll, accounts receivable,
financial planning, and taxes). Specialization requires a trade-off between breadth and depth of
knowledge. While a high degree of the division of labor increases productivity, it can also have
unintended side-effects such as reduced employee job satisfaction due to repetition of tasks.
FORMALIZATION. Formalization captures the extent to which employee behavior is
steered by explicit and codified rules and procedures. Formalized structures are character-
ized by detailed written rules and policies of what to do in specific situations. These are
often codified in employee handbooks. McDonald’s, for example, uses detailed standard
operating procedures throughout the world to ensure consistent quality and service.
Formalization, therefore, is not necessarily negative; often it is necessary to achieve consis-
tent and predictable results. Airlines, for instance, must rely on a high degree of formalization
to instruct pilots on how to fly their airplanes to ensure safety and reliability. Yet a high degree
LO 11-3
Define organizational
structure and describe its
four elements.
organizational
structure A key to
determining how
the work efforts of
individuals and teams
are orchestrated and
how resources are
distributed.
specialization An
organizational element
that describes the
degree to which a task
is divided into separate
jobs (i.e., the division of
labor).
formalization An
organizational element
that captures the extent
to which employee
behavior is steered by
explicit and codified
rules and procedures.
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of formalization can slow decision making, reduce creativity and innovation, and hinder cus-
tomer service.15 Most customer service reps in call centers, for example, follow a detailed
script. This is especially true when call centers are outsourced to overseas locations. Zappos
deliberately avoided this approach when it made customer service its core competency.
CENTRALIZATION. Centralization refers to the degree to which decision making is con-
centrated at the top of the organization. Centralized decision making often correlates with
slow response time and reduced customer satisfaction. In decentralized organizations such
as Zappos, decisions are made and problems solved by empowered lower-level employees
who are closer to the source of issues.
Different strategic management processes (discussed in Chapter 2) match with different
degrees of centralization:
■ Top-down strategic planning takes place in highly centralized organizations.
■ Planned emergence is found in more decentralized organizations.
Whether centralization or decentralization is more effective depends on the specific
situation. During the Gulf of Mexico oil spill in 2010, BP’s response was slow and cum-
bersome because key decisions were initially made in its UK headquarters and not onsite.
In this case, centralization reduced response time and led to a prolonged crisis. In contrast,
the FBI and the CIA were faulted in the 9/11 Commission report for not being centralized
enough.16 The report concluded that although each agency had different types of evidence
that a terrorist strike in the United States was imminent, their decentralization made them
unable to put together the pieces to prevent the 9/11 attacks.
HIERARCHY. Hierarchy determines the formal, position-based reporting lines and thus stip-
ulates who reports to whom. Let’s assume two firms of roughly equal size: Firm A and Firm B.
If many levels of hierarchy exist between the frontline employee and the CEO in Firm A, it has
a tall structure. In contrast, if there are few levels of hierarchy in Firm B, it has a flat structure.
The number of levels of hierarchy, in turn, determines the managers’ span of control—
how many employees directly report to a manager. In tall organizational structures (Firm
A), the span of control is narrow. In flat structures (Firm B), the span of control is wide,
meaning one manager supervises many employees. In recent years, firms have de-layered
by reducing the headcount (often middle managers), making the organizations flatter and
more nimble. This, however, puts more pressure on the remaining managers who have to
supervise and monitor more direct reports due to an increased span of control.17 Recent
research suggests that managers are most effective at an intermediate point where the span
of control is not too narrow or too wide.18
MECHANISTIC VS. ORGANIC ORGANIZATIONS
Several of the building blocks of organizational structure frequently appear together, creat-
ing distinct organizational forms—mechanistic or organic organizations.19
MECHANISTIC ORGANIZATIONS. Mechanistic organizations are characterized by
a high degree of specialization and formalization and by a tall hierarchy that relies on
centralized decision making. The fast food chain McDonald’s fits this description quite
well. Each step of every job such as deep-frying fries is documented in minute detail
(e.g., what kind of vat, the quantity of oil, how many fries, what temperature, how long,
and so on). Decision power is centralized at the top of the organization: McDonald’s head-
quarters provides detailed instructions to each of its franchisees so that they provide com-
parable quality and service across the board although with some local menu variations.
LO 11-4
Compare and contrast
mechanistic versus
organic organizations.
centralization An
organizational element
that refers to the degree
to which decision
making is concentrated
at the top of the
organization.
hierarchy An
organizational element
that determines the
formal, position-based
reporting lines and thus
stipulates who reports
to whom.
span of control The
number of employees
who directly report to a
manager.
mechanistic
organization.
Characterized by a high
degree of specialization
and formalization and
by a tall hierarchy that
relies on centralized
decision making.
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Communication and authority lines are top-down and well defined. To ensure standardized
operating procedures and consistent food quality throughout the world, McDonald’s oper-
ates Hamburger University, a state-of-the-art teaching facility in a Chicago suburb, where
50 full-time instructors teach courses in chemistry, food preparation, and marketing. In
2010, McDonald’s opened a second Hamburger University campus in Shanghai, China.
Mechanistic structures allow for standardization and economies of scale, and often are
used when the firm pursues a cost-leadership strategy at the business level.
ORGANIC ORGANIZATIONS. Organic organizations have a low degree of specializa-
tion and formalization, a flat organizational structure, and decentralized decision making.
Organic structures tend to be correlated with the following: a fluid and flexible information
flow among employees in both horizontal and vertical directions; faster decision making; and
higher employee motivation, retention, satisfaction, and creativity. Organic organizations also
typically exhibit a higher rate of entrepreneurial behaviors and innovation. Organic structures
allow firms to foster R&D and/or marketing, for example, as a core competency. Firms that
pursue a differentiation strategy at the business level frequently have an organic structure.
Strategy Highlight 11.1 shows how W.L. Gore & Associates uses an organic structure
to foster continuous innovation.
organic organization
Characterized by a low
degree of specialization
and formalization, a flat
organizational structure,
and decentralized
decision making.
W.L. Gore & Associates: Informality
and Innovation
W.L. Gore & Associates is the inventor of path-breaking new
products such as breathable GORE-TEX fabrics, Glide dental floss,
and Elixir guitar strings. Bill Gore, a former longtime employee of
chemical giant DuPont, founded the company with the vision to
create an organization “devoted to innovation, a company where
imagination and initiative would flourish, where chronically curi-
ous engineers would be free to invent, invest, and succeed.”20
When founding the company in 1958, Gore articulated four core
values that still guide the company and its associates to this day:
1. Fairness to each other and everyone with whom the firm
does business.
2. Freedom to encourage, help, and allow other associates to
grow in knowledge, skill, and scope of responsibility.
3. The ability to make one’s own commitments and keep them.
4. Consultation with other associates before undertaking
actions that could cause serious damage to the reputation
of the company (“blowing a hole below the waterline”).
W.L. Gore & Associates is organized in an informal and
decentralized manner: It has no formal job titles, job descrip-
tions, chains of command, formal communication channels,
written rules or standard operating procedures. Face-to-face
communication is preferred over e-mail. There is no organi-
zational chart. In what is called a lattice or boundaryless
organizational form, everyone is empowered and encouraged
to speak to anyone else in the organization. People who work
at Gore are called associates rather than employees, indi-
cating professional expertise and status. Gore associates
organize themselves in project-based teams that are led by
sponsors, not bosses. Associates invite other team members
based on their expertise and interests in a more or less ad
hoc fashion. Peer control in these multidisciplinary teams fur-
ther enhances associate productivity. Group members evalu-
ate each other’s performance annually, and these evaluations
determine each associate’s level of compensation. Moreover,
all associates at W.L. Gore are also shareholders of the com-
pany, and thus are part owners sharing in profits and losses.
Gore’s freewheeling and informal culture has been linked
to greater employee satisfaction and retention, higher per-
sonal initiative and creativity, and innovation at the firm
level. Although W.L. Gore’s organizational structure may look
like something you might find in a small, high-tech startup,
the company has 10,000 employees and over $3 billion in
revenues, making Gore one of the largest privately held com-
panies in the United States. W.L. Gore is consistently ranked
in Fortune’s “100 Best Companies to Work For” list, and has
been included in every edition of that prestigious ranking.21
Strategy Highlight 11.1
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Exhibit 11.3 summarizes the key features of mechanistic and organic structures.
Although at first glance organic organizations may appear to be more attractive than
mechanistic ones, their relative effectiveness depends on context. McDonald’s, with its
some 37,000 restaurants across the globe, would not be successful with an organic struc-
ture. Similarly, a mechanistic structure would not allow Zappos or W.L. Gore to develop
and hone their respective core competencies in customer service and product innovation.
The key point is this: To gain and sustain competitive advantage, structure must follow
strategy. Moreover, the chosen organizational form must match the firm’s business strategy.
We will expand further on the required strategy–structure relationship in the next section.
11.2 Strategy and Structure
The important and interdependent relationship between strategy and structure directly
impacts a firm’s performance. Moreover, the relationship is dynamic—changing over
time in a somewhat predictable pattern as firms grow in size and complexity. Successful
new ventures generally grow first by increasing sales, then by obtaining larger geographic
reach, and finally by diversifying through vertical integration and entering into related and
unrelated businesses.22 Different stages in a firm’s growth require different organizational
structures. This important evolutionary pattern is depicted in Exhibit 11.4. As we discuss
next, organizational structures range from simple to functional to multidivisional to matrix.
SIMPLE STRUCTURE
A simple structure generally is used by small firms with low organizational complex-
ity. In such firms, the founders tend to make all the important strategic decisions and run
EXHIBIT 11.3 / Mechanistic vs. Organic Organizations: Building Blocks of Organizational Structure
Mechanistic Organizations Organic Organizations
Specialization • High degree of specialization
• Rigid division of labor
• Employees focus on narrowly defined tasks
• Low degree of specialization
• Flexible division of labor
• Employees focus on “bigger picture”
Formalization • Intimate familiarity with rules, policies, and
processes necessary
• Deep expertise in narrowly defined domain
required
• Task-specific knowledge valued
• Clear understanding of organization’s core
competencies and strategic intent
• Domain expertise in different areas
• Generalized knowledge of how to accomplish
strategic goals valued
Centralization • Decision power centralized at top
• Vertical (top-down) communication
• Distributed decision making
• Vertical (top-down and bottom-up) as well as
horizontal communication
Hierarchy • Tall structures
• Low span of control
• Clear lines of authority
• Command and control
• Flat structures
• High span of control
• Horizontal as well as two-way vertical
communication
• Mutual adjustment
Business Strategy • Cost-leadership strategy
• Examples: McDonald’s; Walmart
• Differentiation strategy
• Examples: W.L. Gore, Zappos
LO 11-5
Describe different
organizational structures
and match them with
appropriate strategies.
simple structure
Organizational structure
in which the founders
tend to make all the
important strategic
decisions as well as
run the day-to-day
operations.
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the day-to-day operations. Examples include entrepreneurial ventures such as Facebook in
2004, when the startup operated out of Mark Zuckerberg’s dorm room, and professional
service firms such as smaller advertising, consulting, accounting, and law firms, as well as
family-owned businesses. Simple structures are flat hierarchies operated in a decentralized
fashion. They exhibit a low degree of formalization and specialization. Typically, neither
professional managers nor sophisticated systems are in place, which often leads to an over-
load for the founder and/or CEO when the firms experience growth.
FUNCTIONAL STRUCTURE
As sales increase, firms generally adopt a functional structure, which groups employees
into distinct functional areas based on domain expertise. These functional areas often cor-
respond to distinct stages in the value chain such as R&D, engineering and manufacturing,
and marketing and sales, as well as supporting areas such as human resources, finance, and
accounting. Exhibit 11.5 shows a functional structure, with the lines indicating reporting
and authority relationships. The department head of each functional area reports to the
CEO, who coordinates and integrates the work of each function. A business school student
generally majors in one of these functional areas such as finance, accounting, IT, marketing,
operations, or human resources, and is then recruited into a corresponding functional group.
W.L. Gore began as a company by operating out of Bill Gore’s basement and using a
simple structure. Two years after its founding, the company received a large manufacturing
order for high-tech cable that it could not meet with its ad hoc basement operation. At that
point, W.L. Gore reorganized itself into a functional structure. A simple structure could not
provide the effective division, coordination, and integration of work required to accom-
modate future growth.
EXHIBIT 11.4 /
Changing
Organizational
Structures and
Increasing Complexity
as Firms Grow
Organizational Complexity
Fi
rm
S
ize
Simple
Structure
Functional
Structure
Matrix
Structure
Multidivisional
Structure
functional structure
Organizational structure
that groups employees
into distinct functional
areas based on domain
expertise.
EXHIBIT 11.5 /
Typical Functional
Structure
CEO
Research &
Development
Engineering &
Manufacturing
Marketing,
Sales, & Service
Human
Resources
Finance &
Accounting
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A functional structure allows for a higher degree of specialization and deeper domain
expertise than a simple structure. Higher specialization also allows for a greater division of
labor, which is linked to higher productivity.23 While work in a functional structure tends
to be specialized, it is centrally coordinated by the CEO (see Exhibit 11.5). A functional
structure allows for an efficient top-down and bottom-up communication chain between
the CEO and the functional departments, and thus relies on a relatively flat structure.
FUNCTIONAL STRUCTURE AND BUSINESS STRATEGY. A functional structure is rec-
ommended when a firm has a fairly narrow focus in terms of product/service offerings
(i.e., low level of diversification) combined with a small geographic footprint. It matches
well, therefore, with the different business strategies discussed in Chapter 6: cost lead-
ership, differentiation, and blue ocean. Although a functional structure is the preferred
method for implementing business strategy, different variations and contexts require care-
ful modifications in each case:
■ The goal of a cost-leadership strategy is to create a competitive advantage by reduc-
ing the firm’s cost below that of competitors while offering acceptable value. The cost
leader sells a no-frills, standardized product or service to the mainstream customer.
To effectively implement a cost-leadership strategy, therefore, managers must cre-
ate a functional structure that contains the organizational elements of a mechanistic
structure—one that is centralized, with well-defined lines of authority up and down the
hierarchy. Using a functional structure allows the cost leader to nurture and constantly
upgrade necessary core competencies in manufacturing and logistics. Moreover, the
cost leader needs to create incentives to foster process innovation in order to drive
down cost. Finally, because the firm services the average customer, and thus targets the
largest market segment possible, it should focus on leveraging economies of scale to
further drive down costs.
■ The goal of a differentiation strategy is to create a competitive advantage by offering
products or services at a higher perceived value, while controlling costs. The differen-
tiator, therefore, sells a non-standardized product or service to specific market segments
in which customers are willing to pay a higher price. To effectively implement a dif-
ferentiation strategy, managers rely on a functional structure that resembles an organic
organization. In particular, decision making tends to be decentralized to foster and
incentivize continuous innovation and creativity as well as flexibility and mutual adjust-
ment across areas. Using a functional structure with an organic organization allows the
differentiator to nurture and constantly upgrade necessary core competencies in R&D,
innovation, and marketing. Finally, the functional structure should be set up to allow the
firm to reap economies of scope from its core competencies, such as by leveraging its
brand name across different products or its technology across different devices.
■ A successful blue ocean strategy requires reconciliation of the trade-offs between dif-
ferentiation and low cost. To effectively implement a blue ocean strategy, the firm
must be both efficient and flexible. It must balance centralization to control costs with
decentralization to foster creativity and innovation. Managers must, therefore, attempt
to combine the advantages of the functional-structure variations used for cost lead-
ership and differentiation while mitigating their disadvantages. Moreover, the firm
pursuing a blue ocean strategy needs to develop several distinct core competencies to
both drive up perceived value and lower cost. It must further pursue both product and
process innovations in an attempt to reap economies of scale and scope. All of these
challenges make it clear that although a blue ocean strategy is attractive at first glance,
it is quite difficult to implement given the range of important trade-offs that must
be addressed.
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A firm’s structure is therefore critical when pursuing a blue ocean strategy. The chal-
lenge that managers face is to structure their organizations so that they control cost and
allow for creativity that can lay the basis for differentiation. Doing both is hard. Achieving
a low-cost position requires an organizational structure that relies on strict budget con-
trols, while differentiation requires an organizational structure that allows creativity and
customer responsiveness to thrive, which typically necessitates looser organizational struc-
tures and controls.
The goal for managers who want to pursue a blue ocean strategy is to build an
ambidextrous organization, one that enables managers to balance and harness different
activities in trade-off situations.24 Here, the trade-offs to be addressed involve the simulta-
neous pursuit of low-cost and differentiation strategies. Notable management practices that
companies use to resolve this trade-off include flexible and lean manufacturing systems,
total quality management, just-in-time inventory management, and Six Sigma.25 Other
management techniques that allow firms to reconcile cost and value pressures are the use
of teams in the production process, as well as decentralized decision making at the level of
the individual customer.
Ambidexterity describes a firm’s ability to address trade-offs not only at one point
but also over time. It encourages managers to balance exploitation—applying current
knowledge to enhance firm performance in the short term—with exploration—searching
for new knowledge that may enhance a firm’s future performance.26 For example, while
Intel focuses on maximizing sales from its current cutting-edge microprocessors, it also
has several different teams with different time horizons working on future generations
of microprocessors.27 In ambidextrous organizations, managers must constantly analyze
their existing business processes and routines, looking for ways to change them in order to
resolve trade-offs across internal value chain activities and time.28
Exhibit 11.6 presents a detailed match between different business strategies and their
corresponding functional structures.
DISADVANTAGES OF FUNCTIONAL STRUCTURE. While certainly attractive, the func-
tional structure is not without significant drawbacks. Although the functional structure
facilitates rich and extensive communication between members of the same department, it
frequently lacks effective communication channels across departments. Notice in Exhibit
11.5 the lack of links between different functions. The lack of linkage between functions is
the reason, for example, why R&D managers often do not communicate directly with mar-
keting managers. In an ambidextrous organization, a top-level manager such as the CEO
must take on the necessary coordination and integration work.
To overcome the lack of cross-departmental collaboration in a functional structure, a
firm can set up cross-functional teams. In these temporary teams, members come from
different functional areas to work together on a specific project or product, usually from
start to completion. Each team member reports to two supervisors: the team leader and the
respective functional department head. As we saw in Strategy Highlight 11.1, W.L. Gore
employs cross-functional teams successfully.
A second critical drawback of the functional structure is that it cannot effectively
address a higher level of diversification, which often stems from further growth.29 This is
the stage at which firms find it effective to evolve and adopt a multidivisional or matrix
structure, both of which we will discuss next.
MULTIDIVISIONAL STRUCTURE
Over time, as a firm diversifies into different product lines and geographies, it gener-
ally implements a multidivisional or a matrix structure (as shown in Exhibit 11.4).
ambidextrous
organization An
organization able to
balance and harness
different activities in
trade-off situations.
ambidexterity A firm’s
ability to address trade-
offs not only at one
point but also over time.
It encourages managers
to balance exploitation
with exploration.
exploitation Applying
current knowledge
to enhance firm
performance in the
short term.
exploration Searching
for new knowledge that
may enhance a firm’s
future performance.
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The multidivisional structure (or M-form) consists of several distinct strategic business
units (SBUs), each with its own profit-and-loss (P&L) responsibility. Each SBU is oper-
ated more or less independently from one another, and each is led by a CEO (or equivalent
general manager) who is responsible for the unit’s business strategy and its day-to-day
operations. The CEOs of each division report to the corporate office, which is led by the
company’s highest-ranking executive (titles vary and include president or CEO for the
entire corporation). Because most large firms are diversified to some extent across differ-
ent product lines and geographies, the M-form is a widely adopted organizational structure.
Consider that Zappos is an SBU under Amazon, which employs a multidivisional struc-
ture. Also, W.L. Gore uses a multidivisional structure to administer its differentiation and
related diversification strategies. It has four product divisions (electronic products, indus-
trial products, medical products, and fabrics division) with manufacturing facilities in the
United States, China, Germany, Japan, and Scotland, and business activities in 30 countries
across the globe.30
A typical M-form is shown in Exhibit 11.7. In this example, the company has four
SBUs, each led by a CEO. Corporations may use SBUs to organize around different busi-
nesses and product lines or around different geographic regions. Each SBU represents a
self-contained business with its own hierarchy and organizational structure. Note that in
Exhibit 11.7, SBU 2 is organized using a functional structure, while SBU 4 is organized
using a matrix structure. The CEO of each SBU must determine which organizational
structure is most appropriate to implement the SBU’s business strategy.
EXHIBIT 11.6 /
Matching Business
Strategy and
Structure
Business Strategy Structure
Cost-leadership Functional
• Mechanistic organization
• Centralized
• Command and control
• Core competencies in efficient manufacturing and logistics
• Process innovation to drive down cost
• Focus on economies of scale
Differentiation Functional
• Organic organization
• Decentralized
• Flexibility and mutual adjustment
• Core competencies in R&D, innovation, and marketing
• Product innovation
• Focus on economies of scope
Blue ocean Functional
• Ambidextrous organization
• Balancing centralization with decentralization
• Multiple core competencies along the value chain required: R&D,
manufacturing, logistics, marketing, etc.
• Process and product innovations
• Focus on economies of scale and scope
multidivisional
structure (M-form)
Organizational structure
that consists of several
distinct strategic
business units (SBUs),
each with its own
profit-and-loss (P&L)
responsibility.
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A firm’s corporate office is supported by company-wide staff functions such as human
resources, finance, and corporate R&D. These staff functions support all of the company’s
SBUs, but are centralized at corporate headquarters to benefit from economies of scale
and to avoid duplication within each SBU. Since most of the larger enterprises are publicly
held stock companies, the president reports to a board of directors who represents the inter-
ests of the shareholders, indicated by the dashed line in Exhibit 11.7.
The president, with support from corporate headquarters staff, monitors the perfor-
mance of each SBU and determines how to allocate resources across units.31 Corporate
headquarters adds value by functioning as an internal capital market. The goal is to be
more efficient at allocating capital through its budgeting process than what could be
achieved in external capital markets. This can be especially effective if the corporation
overall can access capital at a lower cost than competitors due to a favorable (AAA) debt
rating. Corporate headquarters can also add value through restructuring the company’s
portfolio of SBUs by selling low-performing businesses and adding promising businesses
through acquisitions.
M-FORM AND CORPORATE STRATEGY. To achieve an optimal match between strategy
and structure, different corporate strategies require different organizational structures. In
Chapter 8, we identified four types of corporate diversification (see Exhibit 8.8: single
business, dominant business, related diversification, and unrelated diversification. Each is
defined by the percentage of revenues obtained from the firm’s primary activity.
■ Firms that follow a single-business or dominant-business strategy at the corporate level
gain at least 70 percent of their revenues from their primary activity; they generally
employ a functional structure.
■ For firms that pursue either related or unrelated diversification, the M-form is the pre-
ferred organizational structure.
■ Firms using the M-form organizational structure to support a related-diversification
strategy tend to concentrate decision making at the top of the organization. Doing so
EXHIBIT 11.7 /
Typical Multidivisional
(M-Form) Structure
Note that SBU 2 uses
a functional structure,
and SBU 4 uses a matrix
structure.
BOARD OF
DIRECTORS
CORPORATE
R&D
CEO
SBU 1
CEO
SBU 2
CEO
SBU 3
CEO
SBU 4
PRESIDENT CORPORATEHQ STAFF
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allows a high level of integration. It also helps corpo-
rate headquarters leverage and transfer across differ-
ent SBUs the core competencies that form the basis
for a related diversification.
■ Firms using the M-form structure to support an
unrelated-diversification strategy often decentralize
decision making. Doing so allows general managers
to respond to specific circumstances, and leads to a
low level of integration at corporate headquarters.
Exhibit 11.8 matches different corporate strategies
and their corresponding organizational structures.
In this understanding we can see how Google was
attempting to leverage unrelated diversification and
its advantages (decentralized decision making) when it announced its reorganization in
2015.32 Google split itself and created a diversified multidivisional structure overseen by
Alphabet, a new corporate entity. (For a visual of this structure, see Exhibit MC10.1 in
MiniCase 10.) As Google had become much more complex over the years with a number
of unrelated lines of businesses (think online search and longevity research), it moved
from a functional structure to a multidivisional structure. This is exactly what one would
predict based on our discussion around Exhibit 11.4, as firms change their organiza-
tional structures as they grow in size and complexity. Alphabet is the new parent com-
pany, overseeing 10 strategic business units, each with its own CEO and profit-and-loss
responsibility.
The 10 business units start with Google’s core businesses (search, ads, apps, YouTube,
Android, Chrome, and Google maps) in a single unit joined by Google X (artificial intel-
ligence, high-altitude balloons providing global internet connectivity), Waymo (self-
driving cars), Nest (smart homes), Access & Energy (broadband fiber services), Verily
(life sciences, smart contact lenses), Calico (longevity research), Side Walk Labs (urban
innovation), Google Ventures (venture capital investments in early phase startups), and
Google Capital (venture capital investments in later stage startups, similar to corporate
venture capital [CVC] investments). This sweeping restructuring allows the company
EXHIBIT 11.8 /
Matching Corporate
Strategy and
Structure
Corporate Strategy Structure
Single business Functional structure
Dominant business Functional structure
Related diversification Cooperative multidivisional (M-form)
• Centralized decision making
• High level of integration at corporate headquarters
• Co-opetition among SBUs
— Competition for resources
— Cooperation in competency sharing
Unrelated diversification Competitive multidivisional (M-form)
• Decentralized decision making
• Low level of integration at corporate headquarters
• Competition among SBUs for resources
©Pawel Kopczynski/REUTERS
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to separate its highly profitable search and advertising business from its “moon shots”
such as providing wireless internet connectivity via high-altitude balloons or developing
contact lenses that double as a “computer monitor” and provide real-time information to
the wearer.
DISADVANTAGES OF M-FORM. Moving from the functional structure to the M-form results
in adding another layer of corporate hierarchy (corporate headquarters). This goes along
with all the known problems of increasing bureaucracy, red tape, and sometimes duplica-
tion of efforts. It also slows decision making because in many instances a CEO of an SBU
must get approval from corporate headquarters when making major decisions that might
affect a second SBU or the corporation as a whole.
Also, since each SBU in the M-form is evaluated as a standalone profit-and-loss cen-
ter, SBUs frequently end up competing with each other. A high-performing SBU might
be rewarded with greater capital budgets and strategic freedoms; low-performing busi-
nesses might be spun off. SBUs compete with one another for resources such as capital and
managerial talent, but they also need to cooperate to share competencies. Co-opetition—
competition and cooperation at the same time—among the SBUs is both inevitable and
necessary. Sometimes, however, it can be detrimental when a corporate process such as
resource allocation or transfer pricing between SBUs becomes riddled with corporate poli-
tics and turf wars.
In some instances, spinning out SBUs to make them independent companies is benefi-
cial. As discussed in Chapter 8, the BCG growth-share matrix helps corporate executives
when making these types of decisions. In the last few years when owned by eBay, PayPal
outperformed its parent company. PayPal’s executives (and investors) were tired of subsi-
dizing eBay’s stagnant business. EBay had bought PayPal in the aftermath of the dot-com
stock market crash in 2002 for $1.5 billion. In 2015, eBay and PayPal were de-merged.
PayPal was spun out and became an independent company again. Now, PayPal is able to
fully unlock its value. Investors also liked separating eBay and PayPal, giving it a valua-
tion that is estimated to be as high as $100 billion; eBay’s standalone valuation is about
$35 billion.33
MATRIX STRUCTURE
To reap the benefits of both the M-form and the functional structure, many firms employ
a mix of these two organizational forms, called a matrix structure. Exhibit 11.9 shows an
example. In it, the firm is organized according to SBUs along a horizontal axis (like in the
M-form), but also has a second dimension of organizational structure along a vertical axis.
In this case, the second dimension consists of different geographic areas, each of which
generally would house a full set of functional activities. The idea behind the matrix struc-
ture is to combine the benefits of the M-form (domain expertise, economies of scale, and
the efficient processing of information) with those of the functional structure (responsive-
ness and decentralized focus).
The horizontal and vertical reporting lines between SBUs and geographic areas inter-
sect, creating nodes in the matrix. Exhibit 11.9 highlights one employee, represented by a
large dot and called out by an arrow. This employee works in a group with other employ-
ees in SBU 2, the company’s health care unit for the Europe division in France. This
employee has two bosses—the CEO of the health care SBU and the general manager (GM)
for the Europe division. Both supervisors report to corporate headquarters, which is led
by the president of the corporation (indicated in Exhibit 11.9 by the reporting lines from
the SBUs and geographic units to the president).
matrix structure
Organizational structure
that combines the
functional structure with
the M-form.
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Firms tend to use a global matrix structure to pursue a transnational strategy, in
which the firm combines the benefits of a multidomestic strategy (high local responsive-
ness) with those of a global-standardization strategy (lowest-cost position attainable). In
a global matrix structure, the geographic divisions are charged with local responsiveness
and learning. At the same time, each SBU is charged with driving down costs through
economies of scale and other efficiencies. A global matrix structure also allows the firm
to feed local learning back to different SBUs and thus diffuse it throughout the organi-
zation. The specific organizational configuration depicted in Exhibit 11.9 is a global
matrix structure.
The matrix structure is quite versatile, because managers can assign different groupings
along the vertical and horizontal axes. A common form of the matrix structure uses differ-
ent projects or products on the vertical axis and different functional areas on the horizontal
axis. In that traditional matrix structure, cross-functional teams work together on different
projects. In contrast to the cross-functional teams discussed earlier in the W.L. Gore exam-
ple, the teams in a matrix structure tend to be more permanent rather than project-based
with a predetermined time horizon.
Given the advances in computer-mediated collaboration tools, some firms have replaced
the more rigid matrix structure with a network structure. A network structure allows the
firm to connect centers of excellence, whatever their global location (see Exhibit 10.3).34
The firm benefits from communities of practice, which store important organizational
learning and expertise. To avoid undue complexity, these network structures need to be
supported by corporate-wide procedures and policies to streamline communication, col-
laboration, and the allocation of resources.35
MATRIX STRUCTURE AND GLOBAL STRATEGY. We already noted that a global matrix
structure fits well with a transnational strategy. To complete the strategy–structure rela-
tionships in the global context, we also need to consider the international, multidomestic,
EXHIBIT 11.9 /
Typical Matrix
Structure with
Geographic and SBU
Divisions
CEO
SBU 1
CEO
SBU 2
CEO
SBU 3
CEO
SBU 4
PRESIDENT
CORPORATE HQ
NORTH
AMERICA
SOUTH
AMERICA
EUROPE
MIDDLE EAST
& AFRICA
ASIA
Employee in France
Reports to Europe GM AND
CEO SBU 2 (e.g., Health Care)
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and standardization strategies discussed in Chapter 10. Exhibit 11.10 shows how different
global strategies best match with different organizational structures.
■ In an international strategy, the company leverages its home-based core competency
by moving into foreign markets. An international strategy is advantageous when the
company faces low pressure for both local responsiveness and cost reductions. Com-
panies pursue an international strategy through a differentiation strategy at the busi-
ness level. The best match for an international strategy is a functional organizational
structure, which allows the company to leverage its core competency most effectively.
This approach is similar to matching a business-level differentiation strategy with a
functional structure (discussed in detail earlier).
■ When a multinational enterprise (MNE) pursues a multidomestic strategy, it attempts
to maximize local responsiveness in the face of low pressures for cost reductions. An
appropriate match for this type of global strategy is the multidivisional organizational
structure. That structure would enable the MNE to set up different divisions based
on geographic regions (e.g., by continent). The different geographic divisions operate
more or less as standalone SBUs to maximize local responsiveness. Decision making is
decentralized.
■ When following a global-standardization strategy, the MNE attempts to reap signifi-
cant economies of scale as well as location economies by pursuing a global division
of labor based on wherever best-of-class capabilities reside at the lowest cost. Since
the product offered is more or less an undifferentiated commodity, the MNE pursues
a cost-leadership strategy. The optimal organizational structure match is, again, a mul-
tidivisional structure. Rather than focusing on geographic differences as in the multi-
domestic strategy, the focus is on driving down costs due to consolidation of activities
across different geographic areas.
DISADVANTAGES OF MATRIX STRUCTURE. Though it is appealing in theory, the matrix
structure does have shortcomings. It is usually difficult to implement: Implementing
two layers of organizational structure creates significant organizational complexity and
increases administrative costs. Also, reporting structures in a matrix are often not clear. In
particular, employees can have trouble reconciling goals presented by their two (or more)
Global Strategy Structure
International Functional
Multidomestic Multidivisional
• Geographic areas
• Decentralized decision making
Global-standardization Multidivisional
• Product divisions
• Centralized decision making
Transnational Global matrix
• Balance of centralized and decentralized decision making
• Additional layer of hierarchy to coordinate both:
— Geographic areas
— Product divisions
EXHIBIT 11.10 /
Matching Global
Strategy and
Structure
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supervisors. Less-clear reporting structures can undermine accountability by creating
multiple principal–agent relationships. This can make performance appraisals more dif-
ficult. Adding an additional layer of hierarchy can also slow decision making and increase
bureaucratic costs.
As just discussed, the development pattern of how organizational structures tend to
change in time as firms grow in size and complexity is fairly predictable: Starting with a
simple structure, then moving to functional structure, and finally implementing a multidivi-
sional or matrix structure. As featured in the ChapterCase, Zappos even went a step further.
Rapid growth and increasing complexity triggered Zappos’ move away from a multidivi-
sional structure with different business units to the radically new organizational structure,
holacracy, with its nonhierarchical, overlapping employee circles. While the organizational
structures shown in Exhibit 11.4 have been around for many decades, holacracy as an organi-
zational structure is new and yet untested in larger firms, with Zappos as the sole exception.
Exhibit 11.11 summarizes the advantages and disadvantages of different organizational
structures.
EXHIBIT 11.11 / Advantages and Disadvantages of Different Organizational Structures
Advantages Disadvantages
Simple Structure • Fast decision-making
• Nimble and responsive organization
• Integration of expertise across areas
• Given low bandwidth, organizations with simple
structures are easily pushed into “crisis mode,”
requiring “all hands on deck” (i.e., everyone
working long hours until project is completed)
• CEO overload
• Lack of domain expertise in distinct business
functions (e.g., accounting, finance, marketing,
etc.)
• Unable to accommodate growth
• No separation of strategic and day-to-day
decision making
Functional Structure • Clear, top-down lines of authority and decision
making
• Deeper domain expertise
• Higher productivity due to specialization and
division of labor
• Responsive organization
• Emergence of silos (i.e., no effective
communication across different departments)
• Growth is limited
• Employee alienation, especially in startups
that move from simple structure to functional
one
Multidivisional
Structure (M-Form)
• Accommodates growth (horizontal, vertical, and
geographic)
• Clear profit & loss responsibilities at SBU level,
run by CEO or equivalent
• Efficient processing of information
• Allows for different competitive strategies
at SBU-Ievel, while integration takes place at
corporate level
• Additional layer of corporate hierarchy
(i.e., corporate headquarters) when moving
from functional to M-Form structure
• SBUs stand in competition to one another
• Political infighting
• Opportunistic behavior by SBUs
Matrix Structure • Accommodates growth (horizontal, vertical, and
geographic)
• Combines advantages of functional structure
with M-Form
• Two layers of organizational structure create
multiple principal–agent relationships
• Slow in decision making
• Potentially inaccurate performance appraisals
• Quite difficult to implement
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11.3 Organizing for Innovation
After discussing the importance of innovation to gaining and sustaining competitive
advantage, the question arises: How should firms organize for innovation? During the
20th century, the closed innovation approach was the dominant research and development
(R&D) approach for most firms: They tended to discover, develop, and commercialize new
products internally.36 Although this approach was costly and time-consuming, it allowed
firms to fully capture the returns to their own innovations.
Several factors led to a shift in the knowledge landscape from closed innovation to open
innovation. They include:
■ The increasing supply and mobility of skilled workers.
■ The exponential growth of venture capital.
■ The increasing availability of external options (such as spinning out new ventures)
to commercialize ideas that were previously shelved or insource promising ideas and
inventions.
■ The increasing capability of external suppliers globally.
Taken together, these factors have led more and more companies to adopt an open inno-
vation approach to research and development. Open innovation is a framework for R&D
that proposes permeable firm boundaries to allow a firm to benefit not only from internal
ideas and inventions, but also from ideas and innovation from external sources. External
sources of knowledge can be customers, suppliers, universities, start-up companies, and
even competitors.37 The sharing goes both ways: Some external R&D is insourced (and
further developed in-house) while the firm may spin out internal R&D that does not fit its
strategy to allow others to commercialize it. Even the largest companies, such as AT&T,
IBM, and GE, are shifting their innovation strategy toward a model that blends internal
with external knowledge sourcing via licensing agreements, strategic alliances, joint ven-
tures, and acquisitions.38
Exhibit 11.12 depicts the closed and open innovation models. In the closed innova-
tion model (Panel A), the firm is conducting all research and development in-house,
using a traditional funnel approach. The boundaries of the firm are impenetrable. Out-
side ideas and projects cannot enter, nor does the firm allow its own research ideas
and development projects to leave the firm. Firms in the closed innovation model are
extremely protective of their intellectual property. This not only allows the firm to cap-
ture all the benefits from its own R&D, but also prevents competitors from benefiting
from it. The mind-set of firms in the closed innovation model is that to profit from R&D,
the firm must come up with its own discoveries, develop them on its own, and control
the distribution channels. Strength in R&D is equated with a high likelihood of benefit-
ing from first-mover advantages. Firms following the closed innovation model, however,
are much more likely to fall prone to the not-invented-here syndrome:39 “If the R&D
leading to a discovery and a new development project was not conducted in-house, it
cannot be good.”
As documented, the pharmaceutical company Merck suffers from the not-invented-
here syndrome.40 That is, if a product was not created and developed at Merck, it could
not be good enough. Merck’s culture and organizational systems perpetuate this logic,
which assumes that since the company hired the best people, the smartest people in the
industry must work for Merck, and so the best discoveries must be made at Merck. The
company leads the industry in terms of R&D spending, because Merck believes that if it
is the first to discover and develop a new drug, it would be the first to market. Merck is
LO 11-6
Evaluate closed and
open innovation, and
derive implications for
organizational structure.
open innovation
A framework for R&D
that proposes permeable
firm boundaries to allow
a firm to benefit not
only from internal ideas
and inventions, but also
from external ones. The
sharing goes both ways:
some external ideas and
inventions are insourced
while others are
spun out.
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one of the most successful companies by total number of active R&D projects. Perhaps
even more important, Merck’s researchers have been awarded several Nobel Prizes for
their breakthrough research, a considerable point of pride for Merck’s personnel.
In the open innovation model, in contrast, a company attempts to commercialize both
its own ideas and research from other firms. It also finds external alternatives such as
spin-out ventures or strategic alliances to commercialize its internally developed R&D.
The boundary of the firm has become porous (as represented by the dashed lines in Panel
B in Exhibit 11.12), allowing the firm to spin out some R&D projects while insourcing
other promising projects. Companies using an open innovation approach realize that great
ideas can come from both inside and outside the company. Significant value can be had
by commercializing external R&D and letting others commercialize internal R&D that
does not fit with the firm’s strategy. The focus is on building a more effective business
model to commercialize both internal and external R&D, rather than focusing on being
first to market.
One key assumption underlying the open innovation model is that combining the
best of internal and external R&D will more likely lead to a competitive advantage.
This requires that the company must continuously upgrade its internal R&D capabili-
ties to enhance its absorptive capacity—its ability to understand external technol-
ogy developments, evaluate them, and integrate them into current products or create
new ones.41 Exhibit 11.13 compares and contrasts open innovation and closed inno-
vation principles.
Strategy Highlight 11.2 provides a detailed account over time how Sony’s continued use
of a closed innovation system led to a sustained competitive advantage, while Apple lever-
aged an open innovation model for decade-long superiority, becoming the most valuable
company on the planet as a result.
EXHIBIT 11.12 / Closed Innovation vs. Open Innovation
Boundary of
the Firm
Panel A: Closed Innovation Panel B: Open Innovation
Boundary of
the Firm
Research
Projects
Research
Projects
Research Development Research
The Market
New
Market
Current
Market
Development
SOURCE: Adapted from H. Chesbrough (2003), “The area of open innovation,” MIT Sloan Management Review, Spring: 35–41.
absorptive
capacity A firm’s
ability to understand
external technology
developments, evaluate
them, and integrate them
into current products or
create new ones.
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EXHIBIT 11.13 / Contrasting Principles of Closed and Open Innovation
Closed Innovation Principles Open Innovation Principles
The smart people in our field work for us. Not all the smart people work for us. We need to work with
smart people inside and outside our company.
To profit from R&D, we must discover it, develop it, and ship it
ourselves.
External R&D can create significant value; internal R&D is
needed to claim (absorb) some portion of that value.
If we discover it ourselves, we will get it to market first. We don’t have to originate the research to profit from it; we can
still be first if we successfully commercialize new research.
The company that gets an innovation to market first will win. Building a better business model is often more important than
getting to market first.
If we create the most and best ideas in the industry, we will win. If we make the best use of internal and external ideas, we will win.
We should control our intellectual property (IP), so that our
competitors don’t profit from it.
We should profit from others’ use of our IP, and we should buy
others’ IP whenever it advances our own business model.
SOURCE: Adapted from H.W. Chesbrough (2003), Open Innovation: The New Imperative for Creating and Profiting from Technology (Boston: Harvard Business School Press).
Sony vs. Apple: Whatever Happened to Sony?
Apple’s market capitalization in 2001 was $7 billion, while
Sony’s was $55 billion. In other words, Sony was almost eight
times larger than Apple. Then most people would have picked
Sony as the company to revolutionize the mobile device
industry given its stellar innovation track record. Instead
that honor goes to Apple, when it introduced the iPod, a por-
table digital music player, in October 2001, and the iTunes
Music Store 18 months later. Through these two strategic
moves Apple redefined the music industry, reinventing itself
as not only a mobile-device but also a content-delivery com-
pany. Many observers wondered what happened to Sony, the
company that created the portable music industry by intro-
ducing the Walkman in 1979.
Sony’s strategy was to differentiate itself through the
vertical integration of content and hardware, driven by its
1988 acquisition of CBS Records (later part of Sony Enter-
tainment) and its 1989 acquisition of Columbia Pictures.
This vertical integration strategy contrasted sharply with
Sony Music division’s desire to protect its lucrative revenue-
generating, copyrighted compact discs (CDs). Sony Music’s
engineers were aggressively combating rampant music piracy
by inhibiting the Microsoft Windows media player’s ability to
rip CDs and by serializing discs (assigning unique ID num-
bers to discs). The compact disc (CD) became the dominant
Strategy Highlight 11.2
Sony created the portable music industry with the Walkman, intro-
duced in 1979.
©Chris Willson / Alamy Stock Photo
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format for selling music in 1991, replacing analog audiocas-
settes. The CD had been jointly developed by Sony and Euro-
pean electronics manufacturer Philips.
Media technology, however, soon moved to digital. With
the rise of the internet in the 1990s and use of digital music,
illegal file sharing on the internet was rampant. Napster
allowed peer-to-peer sharing of files, which meant individual
users could upload entire albums of music, to be downloaded
by anyone, with no payments going to the artists or the
record companies. While Sony focused on preventing media
players that could rip CDs, Apple was developing a digital
rights management (DRM) system to allow for legal down-
loads of digital music while protecting copyright at the same
time. The iTunes Store enabled users to legally download and
own individual songs at an attractive 99 cents. Apple’s DRM
and iTunes succeeded, protecting the music studios’ and art-
ists’ interests while creating value that enabled consumers to
enjoy portable digital music.
Sony had a long history of creating category-defining elec-
tronic devices of superior quality and design using a closed innova-
tion approach. It had all the right competencies in-house to launch
a successful counterattack to compete with Apple: electronics,
software, music, and computer divisions. Sony even supplied the
batteries for Apple’s iPod. Cooperation among strategic business
units had served Sony well in the past, leading to breakthrough
innovations such as the Walkman, PlayStation, CD, and VAIO com-
puter line. In digital music, however, the hardware and content
divisions each seemed to have its own idea of what needed to be
done. Cooperation among the Sony divisions was also hindered
by the fact that their centers of operations were spread across
the globe: Music operations were located in New York City and
electronics design was in Japan, inhibiting face-to-face communi-
cations and making real-time interactions more difficult.
Nobuyuki Idei, then CEO of Sony, learned the hard way
that the music division managers were focused on the
immediate needs of their recordings competing against the
consumer-driven market forces. In 2002, Idei shared his
frustrations with the cultural differences between the hard-
ware and content divisions:
The opposite of soft alliances is hard alliances,
which include mergers and acquisitions. Since pur-
chasing the Music and Pictures businesses, more
than 10 years have passed, and we have experi-
enced many cultural differences between hardware
manufacturing and content businesses. . . . This
experience has taught us that in certain areas
where hard alliances would have taken 10 years to
succeed, soft alliances can be created more easily.
Another advantage of soft alliances is the ability to
form partnerships with many different companies.
We aim to provide an open and easy-to-access envi-
ronment where anybody can participate, and we are
willing to cooperate with companies that share our
vision. Soft alliances offer many possibilities.42
In contrast, Apple organized a small, empowered, cross-
functional team to produce the iPod in just a few months.
Using open innovation, Apple successfully insourced many
of its components from external partners (including from
Sony and Samsung), and then integrated them. The phenom-
enal speed and success of the iPod and iTunes development
and seamless integration of hardware and software became
a structural approach that Apple applied to its successful
development and launches of other category-defining prod-
ucts such as the iPhone, iPad, and Apple Watch.
Apple’s market capitalization has grown from a paltry
$7 billion in 2001 to over $800 billion in 2017, making it the most
valuable company globally. (Apple was the first company ever to
cross the $800 billion valuation threshold). In contrast, Sony’s
market capitalization has dropped from $55 billion in 2001 to
some $45 billion in 2017. The different ways to organize and
implement innovation had a great deal to do with this outcome!43
11.4 Organizational Culture:
Values, Norms, and Artifacts
Organizational culture is the second key building block when designing organizations for
competitive advantage. Just as people have distinctive personalities, so too do organiza-
tions have unique cultures that capture “how things get done around here.” Organizational
culture describes the collectively shared values and norms of an organization’s mem-
bers.44 Values define what is considered important. Norms define appropriate employee
attitudes and behaviors.45
LO 11-7
Describe the elements of
organizational culture,
and explain where
organizational cultures
can come from and how
they can be changed.
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Employees learn about an organization’s culture through socialization, a process
whereby employees internalize an organization’s values and norms through immersion in
its day-to-day operations.46 Zappos’ new-employee orientation and immersion is now a
four-week course. Successful socialization, in turn, allows employees to function produc-
tively and to take on specific roles within the organization. Strong cultures emerge when
the company’s core values are widely shared among the firm’s employees and when the
norms have been internalized.
Corporate culture finds its expression in artifacts. Artifacts include elements such
as the design and layout of physical space (e.g., cubicles or private offices), symbols
(e.g., the type of clothing worn by employees), vocabulary, what stories are told (see the
Zappos pizza-ordering example that follows), what events are celebrated and highlighted,
and how they are celebrated (e.g., a formal dinner versus a casual barbecue when the firm
reaches its sales target).
Exhibit 11.14 depicts the elements of organizational culture—values, norms, and
artifacts—in concentric circles. The most important yet least visible element— values—is
in the center. As we move outward in the figure, from values to norms to artifacts,
culture becomes more observable. Understanding what organizational culture is, and
how it is created, maintained, and changed, can help you be a more effective manager.
A unique culture that is strategically relevant can also be the basis of a firm’s competi-
tive advantage.
As Zappos grew, its managers realized that it was critical to explicitly define a set of
core values from which to develop the company’s culture, brand, and strategy. Zappos
CEO Tony Hsieh wanted to make sure all employees understood the same set of values and
expected behaviors. Zappos’ list of 10 core values (see Exhibit 11.15) was crafted through
a bottom-up initiative, in which all employees were invited to participate.
To live up to its mission of delivering happiness, Zappos decided that exceptional
customer service should be its number-one core value. The company put several policies
and procedures in place to “deliver WOW through service.” For example, shipments
to and from customers within the United States are free, allowing customers to order
several pairs of shoes and send back (within a liberal 365 days) those that don’t fit or
organizational
culture The collectively
shared values and norms
of an organization’s
members; a key building
block of organizational
design.
EXHIBIT 11.14 / The Elements of Organizational Culture: Values, Norms, and Artifacts
Values
Norms
Artifacts At Zappos, even under its previous structure, all employees
including CEO Tony Hsieh, worked from a cubicle.
Zappos continues to celebrate the norm of happiness; employees are
encouraged to promote happiness in the workplace in creative ways.
Zappos turned to the employees themselves to articulate company values,
conspicuous in orientation, daily operations, and evaluation reviews.
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are no longer wanted. Repeat customers are automati-
cally upgraded to complimentary express shipping. One
of the most important lessons Hsieh learned is “Never
outsource your core competency!”47 Customer service,
therefore, is done exclusively in-house.
Perhaps even more importantly, Zappos does not
provide a script or measure customer service reps’ call
times. Rather, the company leaves it up to the individ-
ual member of the “Customer Loyalty Team” to deliver
exceptional customer service: “We want our reps to let
their true personalities shine during each phone call
so that they can develop a personal emotional connec-
tion with the customer.”48 In fact, one customer service
phone call lasted almost six hours! The same trust in
the customer service reps applies to e-mail communica-
tion. Zappos’ official communication policy is to “be
real and use your best judgment.”49 Most of Zappos’
more than 1,500 employees are in some type of sales function, to maintain constant con-
tact with the customer. The customer call centers are staffed 24/7, seven days a week,
365 days a year.
Zappos’ third core value, “create fun and a little weird-
ness,” encourages a unique culture based on shared experi-
ences including costume play (“cosplay”) at work, parades,
fun contests, themed courtyard events, ice cream trucks, Nerf
guns, Ping-Pong, live animals, and so on.50 One of the hardest
choices Zapponians need to make each day is choosing which
fun event to support, including trivia nights, family picnics,
pinewood derby races, talent shows, Foosball, snow sledding,
spring break days, pajama days, and karaoke. This is all just
part of another day at the Zappos office.
Besides creating a strong culture that binds employees
together through shared fun experiences, Zappos believes that
encouraging a little weirdness and fun helps people to think
outside the box and thus be more creative and innovative. All
this helps to achieve their number-one core value to “deliver
WOW through service,” but also other core values such as “do
more with less.” Taken together, employees are more engaged
in their work, not only with their hands, but also their minds
and hearts, and the company is being more innovative and nim-
ble as a whole.
WHERE DO ORGANIZATIONAL CULTURES
COME FROM?
Often, company founders define and shape an organization’s culture, which can persist for
many decades after their departure. This phenomenon is called founder imprinting.51 Found-
ers set the initial strategy, structure, and culture of an organization by transforming their vision
into reality. Famous founders who have left strong imprints on their organizations include
Steve Jobs (Apple), Walt Disney (Disney), Michael Dell (Dell), Sergey Brin and Larry Page
(Google), Oprah Winfrey (Harpo Productions and OWN, the Oprah Winfrey Network),
EXHIBIT 11.15 / Zappos 10 Core Values
1. Deliver WOW through service.
2. Embrace and drive change.
3. Create fun and a little weirdness.
4. Be adventurous, creative, and open-minded.
5. Pursue growth and learning.
6. Build open and honest relationships with communication.
7. Build a positive team and family spirit.
8. Do more with less.
9. Be passionate and determined.
10. Be humble.
SOURCE: T. Hsieh (2010), Delivering Happiness: A Path to Profits, Passion, and
Purpose (New York: Business Plus), 157–160.
The core value “creating fun
and a little weirdness” is
reflected in the relaxed and
colorful office space in the
Zappos office in Las Vegas,
Nevada.
©BRAD SWONETZ/The New
York Times/Redux
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Martha Stewart (Martha Stewart Living Omnimedia), Bill Gates (Microsoft), Larry Ellison
(Oracle), Ralph Lauren (Polo Ralph Lauren), Herb Kelleher (Southwest Airlines), and Elon
Musk (Tesla and SpaceX).
Walmart founder Sam Walton personified the retailer’s cost-leadership strategy.
At one time the richest man in America, Sam Walton drove a beat-up Ford pickup
truck, got $5 haircuts, went camping for vacations, and lived in a modest ranch home
in Bentonville, Arkansas.52 Everything Walton did was consistent with the low-cost
strategy. Walmart stays true to its founder’s tradition. Home to one of the largest
companies on the planet, the company’s Arkansas headquarters in Bentonville was
described by Thomas Friedman in his book The World Is Flat as “crammed into a
reconfigured warehouse . . . a large building made of corrugated metal, I figured it was
the maintenance shed.”53
The culture that founders initially imprint is reinforced by their strong preference to
recruit, retain, and promote employees who subscribe to the same values. In turn, more
people with similar values are attracted to that organization.54 As the values and norms
held by the employees become more similar, the firm’s corporate culture becomes stronger
and more distinct. This in turn can have a serious negative side-effect: groupthink, a situ-
ation in which opinions coalesce around a leader without individuals critically evaluating
and challenging that leader’s opinions and assumptions. Cohesive, non-diverse groups are
highly susceptible to groupthink, which in turn can lead to flawed decision making with
potentially disastrous consequences.
In addition to founder imprinting, a firm’s culture also flows from its values, especially
when they are linked to the company’s reward system. For example, Zappos established
its unique organizational culture through explicitly stated values that are connected to its
reward system (see Exhibit 11.15). To recruit people that fit with the company’s values,
Hsieh has all new hires go through a four-week training program. It covers such topics as
company history, culture, and vision, as well as customer service.55 New hires also spend
two weeks on the phone as customer service reps. What’s novel about Zappos’ approach
is that at the end of the monthlong employee orientation, the company offers an “exit
prize”: one month’s pay plus pay for the time already with Zappos. This allows the com-
pany to entice people to leave that are qualified for the job but may not fit with Zappos’
culture. Individuals who choose to stay despite the enticing offer tend to fit well with and
strengthen Zappos’ distinct culture.56
HOW DOES ORGANIZATIONAL CULTURE
CHANGE?
An organization’s culture can be one of its strongest assets, but also
its greatest liability. An organization’s culture can turn from a core
competency into a core rigidity if a firm relies too long on the com-
petency without honing, refining, and upgrading as the firm and the
environment change.57 (See discussion in Chapter 4.) Over time, the
original core competency is no longer a good fit and turns from an
asset into a liability. This is the time when a culture needs to change.
GM’s bureaucratic culture, combined with its innovative M-form
structure, was once hailed as the key to superior efficiency and man-
agement.58 However, that culture became a liability when the external
environment changed following the oil-price shocks in the 1970s and the entry of Japanese
carmakers into the United States.59 As a consequence, GM’s strong culture led to organiza-
tional inertia. This resulted in a failure to adapt to changing customer preferences for more
founder imprinting
A process by which the
founder defines and
shapes an organization’s
culture, which can
persist for decades
after his or her
departure.
groupthink
A situation in which
opinions coalesce
around a leader
without individuals
critically evaluating
and challenging that
leader’s opinions and
assumptions.
Mary Barra, General Motors CEO.
©Jeff Kowalsky/Bloomberg/
Getty Images
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fuel-efficient cars, and it prevented higher quality and more innovative designs. GM lost cus-
tomers to foreign competitors that offered these features.
More recently, GM’s strong culture was again faulted for corporate ineptitude when
delaying recalling defective cars.60 In 2014, over 25 million GM cars were recalled for
safety defects, the largest recall ever. In particular, many GM cars were eventually recalled
because of a faulty ignition switch, which could turn off the engine while driving and
thus disable the airbags. This problem has been linked to more than 120 fatalities in the
United States alone.61 GM is alleged to knowingly have withheld information about the
faulty ignition switches and delayed the needed recalls by several years. Indeed, during a
U.S. Senate hearing, GM was described as dominated by a “culture of cover-up.”62 In such
times of crisis, corporate culture must be changed to avoid such problems in the future and
to address a breakdown in the culture-environment fit.
The primary means of cultural change is for the corporate board of directors to bring
in new leadership at the top, which is then charged to make changes in strategy and struc-
ture. After all, executives shape corporate culture in their decisions on how to structure
the organization and its activities, allocate its resources, and develop its system of rewards
(see the discussion on strategic leadership in Chapter 2). In 2014, GM’s board of directors
appointed Mary Barra as CEO with the charge to fix GM’s dysfunctional corporate culture
and to make the company competitive again.
Similarly, when Marissa Mayer was appointed CEO of Yahoo in 2012, one of the first
things she did was to change the corporate culture and norms. Yahoo had become overly
bureaucratic and lost the zeal characteristic of high-tech startups. Many Yahoo employ-
ees worked from home. For those who worked in the office, weekends began Thursday
afternoons, leaving empty parking garages at Yahoo’s campus in Sunnyvale, California. In
response, Mayer withdrew the option to work remotely. All of Yahoo’s 12,000 employees
would have to come to the office. She also instituted weekly town-hall meetings (called
FYI) where she and other executives provided updates and fielded questions. All employees
were expected to attend and encouraged to participate in the Q&A. Questions were submit-
ted online during the week, and the employees voted which questions executives should
respond to. Although Mayer succeeded in reenergizing the once leading internet firm, in the
end, a successful turnaround failed and Yahoo was acquired by Verizon for a fire sale price.
ORGANIZATIONAL CULTURE AND COMPETITIVE ADVANTAGE
Can organizational culture be the basis of a firm’s competitive advantage? For this to
occur, the firm’s unique culture must help it in some way to increase its economic value
creation (V–C). That is, it must either help in increasing the perceived value of the product/
service and/or lower its cost of production/delivery. Moreover, according to the resource-
based view of the firm, the resource—in this case, organizational culture—must be valu-
able, rare, difficult to imitate, and the firm must be organized to capture the value created.
The VRIO principles (see Chapter 4) must apply even as to organizational culture itself. 63
Let’s look at two examples of how culture affects employee behavior and ultimately
firm performance:
■ If you have flown with Southwest Airlines (SWA), you may have noticed that things
are done a little differently there. Flight attendants might sing a song about the city
you’re landing in, or they might slide bags of peanuts down the aisle at takeoff.
Employees celebrate Halloween in a big way by wearing costumes to work. Some
argue that SWA’s business strategy—being a cost leader in point-to-point air travel—is
fairly simple, and that SWA’s competitive advantage actually comes from its unique
culture.64 It’s not all fun and games, though: Friendly and highly energized employees
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work across functional and hierarchical levels. Even Southwest’s pilots pitch in to help
load baggage quickly when needed. As a result, SWA’s turn time between flights is
only 15 minutes, whereas competitors frequently take two to three times as long.
■ Zappos’ number-one core value is to “deliver WOW through service.” CEO Hsieh
shares the following story to illustrate this core value in action: “I was in Santa Monica,
California, a few years ago at a Skechers sales conference. . . . [In the early hours of the
morning], a small group of us headed up to someone’s hotel room to order some food.
My friend from Skechers tried to order a pepperoni pizza from the room-service menu
but was disappointed to learn that the hotel did not deliver hot food after 11:00 p.m.
We had missed the deadline by several hours. . . . A few of us cajoled her into calling
Zappos to try to order a pizza. She took us up on our dare, turned on the speakerphone,
and explained to the (very) patient Zappos rep that she was staying in a Santa Monica
hotel and really craving a pepperoni pizza, that room service was no longer delivering
hot food, and that she wanted to know if there was anything Zappos could do to help.
The Zappos rep was initially a bit confused by the request, but she quickly recovered
and put us on hold. She returned two minutes later, listing the five closest places in the
Santa Monica area that were still open and delivering pizzas at that time.”65
In the SWA example, the company’s unique culture helps it keep costs low by turning
around its planes faster, thus keeping them flying longer hours (among many other activities
that lower SWA’s cost structure).66 In the Zappos example, providing a “wow” customer
experience by “going the extra mile” didn’t save Zappos money, but in the long run superior
experience does increase the company’s perceived value and thereby its economic value
creation. Indeed, Hsieh makes it a point to conclude the story with the following statement:
“As for my friend from Skechers? After that phone call, she’s now a customer for life.”67
Let’s consider how an organization’s culture can have a strong influence on employee
behavior.68 A positive culture motivates and energizes employees by appealing to their
higher ideals. Internalizing the firm’s values and norms, employees feel that they are part
of a larger, meaningful community attempting to accomplish important things. When
employees are intrinsically motivated this way, the firm can rely on fewer levels of hierar-
chy; thus, close monitoring and supervision are not needed as much. Motivating through
inspiring values allows the firms to tap employees’ emotions so they use both their heads
and their hearts when making business decisions. Strong organizational cultures that are
strategically relevant, therefore, align employees’ behaviors more fully with the organi-
zation’s strategic goals. In doing so, they better coordinate work efforts, and they make
cooperation more effective. They also strengthen employee commitment, engagement, and
effort. Effective alignment in turn allows the organization to develop and refine its core
competencies, which can form the basis for competitive advantage.
Applying the VRIO principles to the SWA and Zappos examples, we see that both
cultures are valuable (lowering costs for SWA and increasing perceived value created for
Zappos), rare (none of their competitors has an identical culture), non-imitable (despite
attempts by competitors), and organized to capture some part of the incremental economic
value created due to their unique cultures. It appears that at both SWA and Zappos, a unique
organizational culture can provide the basis for a competitive advantage. These cultures, of
course, need to be in sync with and in support of the respective business strategies pursued:
cost leadership for SWA and differentiation for Zappos. Moreover, as the firms grow and
external economic environments change, these cultures must be flexible enough to adapt.
Once it becomes clear that a firm’s culture is a source of competitive advantage, some
competitors will attempt to imitate that culture. Therefore, only a culture that cannot be easily
copied can provide a competitive advantage. It can be difficult, at best, to imitate the cultures
of successful firms, for two reasons: causal ambiguity and social complexity. While one can
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observe that a firm has a unique culture, the causal relationships among values, norms, arti-
facts, and the firm’s performance may be hard to establish, even for people who work within
the organization. For example, employees may become aware of the effect culture has on
performance only after significant organizational changes occur. Moreover, organizational
culture is socially complex. It encompasses not only interactions among employees across
layers of hierarchy, but also the firm’s outside relationships with its customers and suppli-
ers.69 Such a wide range of factors is difficult for any competing firm to imitate.
It is best to develop a strong and strategically relevant culture in the first few years of a firm’s
existence. Strategy scholars have documented that the initial structure, culture, and control
mechanisms established in a new firm can be a significant predictor of later success.70 In other
empirical research, founder CEOs had a stronger positive imprinting effect than non-founder
CEOs.71 This stronger imprinting effect, in turn, resulted in higher performance of firms led
by founder CEOs. In addition, consider that the vehicles of cultural change—changing leader-
ship and M&As—do not have a stellar record of success.72 Indeed, researchers estimate that
only about 20 percent of organizational change attempts are successful.73 Thus, it is even more
important to get the culture right from the beginning and then adapt it as the business evolves.
By combining theory and empirical evidence, we can see that organizational culture can
help a firm gain and sustain competitive advantage if the culture makes a positive contribu-
tion to the firm’s economic value creation and obeys the VRIO principles. Organizational
culture is an especially effective lever for new ventures due to its malleability. Firm found-
ers, early-stage CEOs, and venture capitalists, therefore, should be proactive in attempting
to create a culture that supports a firm’s economic value creation.
11.5 Strategic Control-and-Reward Systems
Strategic control-and-reward systems are the third and final key building block when
designing organizations for competitive advantage. Strategic control-and-reward
systems are internal-governance mechanisms put in place to align the incentives of prin-
cipals (shareholders) and agents (employees). These systems allow managers to specify
goals, measure progress, and provide performance feedback.
Zappos restructured its performance-evaluation system to give these values teeth: The
firm rewards employees who apply the values (shown in Exhibit 11.15) well in their day-
to-day decision making. It created an open market (referred to internally as OM) based on
an online scheduling platform that allows customer service employees to select their work
hours. The novel tweak in the OM system is that it compensates customer service employ-
ees based on a surge-pricing payment model (first popularized by the taxi-hailing service,
Uber). Hsieh states, “Ideally, we want all 10 core values to be reflected in everything we do,
including how we interact with each other, how we interact with our customers, and how we
interact with our vendors and business partners. . . . Our core values should always be the
framework from which we make all of our decisions.”74 Zappos’ 10 core values are impor-
tant to its employees; they define their identity of what it means to be working at Zappos.75
Chapter 5 discussed how firms can use the balanced-scorecard framework as a strategic
control system. Here, we discuss additional control-and-reward systems: organizational
culture, input controls, and output controls.
As just demonstrated, organizational culture can be a powerful motivator. It also can
be an effective control system. Norms, informal and tacit in nature, act as a social con-
trol mechanism. Zappos, for example, achieves organizational control partly through an
employee’s peer group: Each group member’s compensation, including the supervisor’s,
depends in part on the group’s overall productivity. Peer control, therefore, exerts a pow-
erful force on employee conformity and performance.76 Values and norms also provide
LO 11-8
Compare and contrast
different strategic
control-and-reward
systems.
strategic control-and-
reward systems
Internal-governance
mechanisms put in
place to align the
incentives of principals
(shareholders) and
agents (employees).
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control by helping employees address unpredictable and irregular situations and problems
(common in service businesses). In contrast, rules and procedures (e.g., codified in an
employee handbook) can address only circumstances that can be predicted.
INPUT CONTROLS
Input controls seek to define and direct employee behavior through a set of explicit, codified
rules and standard operating procedures. Firms use input controls when the goal is to define the
ways and means to reach a strategic goal and to ensure a predictable outcome. They are called
input controls because management designs these mechanisms so they are considered before
employees make any business decisions; thus, they are an input into the value-creating activities.
The use of budgets is key to input controls. Managers set budgets before employees
define and undertake the actual business activities. For example, managers decide how
much money to allocate to a certain R&D project before the project begins. In diversi-
fied companies using the M-form, corporate headquarters determines the budgets for each
division. Public institutions, like some universities, also operate on budgets that must be
balanced each year. Their funding often depends to a large extent on state appropriations
and thus fluctuates depending on the economic cycle. During recessions, budgets tend to
be cut, and they expand during boom periods.
Standard operating procedures, or policies and rules, are also a frequently used mech-
anism when relying on input controls. The discussion on formalization described how
McDonald’s relies on detailed operating procedures to ensure consistent quality and ser-
vice worldwide. The goal is to specify the conversion process from beginning to end in
great detail to guarantee standardization and minimize deviation. This is important when a
company operates in different geographies and with different human capital throughout the
globe but needs to deliver a standardized product or service.
OUTPUT CONTROLS
Output controls seek to guide employee behavior by defining expected results (outputs),
but leave the means to those results open to individual employees, groups, or SBUs. Firms
frequently tie employee compensation and rewards to predetermined goals, such as a spe-
cific sales target or return on invested capital. When factors internal to the firm determine
the relationship between effort and expected performance, outcome controls are especially
effective. At the corporate level, outcome controls discourage collaboration among differ-
ent strategic business units. They are best applied when a firm focuses on a single line of
business or pursues unrelated diversification.
These days, more and more work requires creativity and innovation, especially in highly
developed economies.77 As a consequence, so-called results-only-work-environments (ROWEs)
have attracted significant attention. ROWEs are output controls that attempt to tap intrinsic
(rather than extrinsic) employee motivation, which is driven by the employee’s interest
in and the meaning of the work itself. In contrast, extrinsic motivation is driven by exter-
nal factors such as awards and higher compensation, or punishments like demotions and
layoffs (the carrot-and-stick approach). According to a recent synthesis of the strategic
human resources literature, intrinsic motivation in a task is highest when an employee has:
■ Autonomy (about what to do).
■ Mastery (how to do it).
■ Purpose (why to do it).78
Today, 3M is best known for its adhesives and other consumer and industrial prod-
ucts.79 But its full name reflects its origins: 3M stands for Minnesota Mining and
output controls
Mechanisms in a
strategic control-and-
reward system that
seek to guide employee
behavior by defining
expected results
(outputs), but leave the
means to those results
open to individual
employees, groups, or
SBUs.
input controls
Mechanisms in a
strategic control-and-
reward system that seek
to define and direct
employee behavior
through a set of explicit,
codified rules and
standard operating
procedures that are
considered before the
value-creating activities.
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Manufacturing Co. Over time, 3M has relied on the ROWE framework and has morphed
into a highly science-driven innovation company. At 3M, employees are encouraged to
spend 15 percent of their time on projects of their own choosing. If any of these projects
look promising, 3M provides financing through an internal venture capital fund and other
resources to further develop their commercial potential. In fact, several of 3M’s flagship
products, including Post-it Notes and Scotch Tape, were the results of serendipity. To fos-
ter continued innovation, moreover, 3M requires each of its divisions to derive at least
30 percent of their revenues from products introduced in the past four years.
11.6 Implications for Strategic Leaders
This chapter has a clear practical implication for the strategist: Formulating an effective
strategy is a necessary but not sufficient condition for gaining and sustaining competitive
advantage; strategy execution is at least as important for success.
The key levers for strategic leaders to achieve effective strategy implementation are: struc-
ture, culture, and control. Successful strategy implementation, therefore, requires leaders to
design and shape structure, culture, and control mechanisms. In doing so, they execute a
firm’s strategy as they put its accompanying business model into action. Strategy formulation
and strategy implementation, therefore, are iterative and interdependent activities.
Some argue that strategy implementation is more important than strategy formula-
tion.80 Often, managers do a good job of analyzing the firm’s internal and external envi-
ronments to formulate a promising business, corporate, and global strategy, but then fail to
implement the chosen strategy successfully. That is why some scholars refer to implemen-
tation as the “graveyard of strategy.”81 In reality, both strategy formulation and strategy
implementation are necessary to gain and sustain a competitive advantage.
As a company grows and its operations become more complex, it adopts different orga-
nizational structures over time following a generally predictable pattern: beginning with a
simple structure, then a functional structure, and followed by a multidivisional or matrix struc-
ture. Organizing for competitive advantage, therefore, is a dynamic and not a static process. As
seen in the Zappos example discussed throughout the chapter, to maintain competitive advan-
tage, companies need to restructure as they grow and the competitive environment changes.
Organizing for innovation is another area that strategic leaders need to pay careful atten-
tion to. Many of the more successful companies have either adopted or are moving toward
an open innovation model. Strategic leaders must actively manage a firm’s internal and
external innovation activities. Internally, one can induce innovation through a top-down
process or motivate innovation through autonomous actions, a bottom-up process.82 In
induced innovation, strategic leaders need to put a structure and system in place to foster
innovation. Consider 3M: “A core belief of 3M is that creativity needs freedom. That’s
why . . . we’ve encouraged our employees to spend 15 percent of their working time on
their own projects. To take our resources, to build up a unique team, and to follow their
own insights in pursuit of problem-solving.”83 We discussed autonomous actions in detail
in Chapter 2. To not only motivate innovations through autonomous behavior, but also
ensure their possible success, internal champions need to be willing to support promising
projects. In Strategy Highlight 2.1, we detailed how Howard Behar, at that time a senior
executive at Starbucks, was willing to support the bottom-up idea of Frappuccino, which
turned out to be a multibillion-dollar business. Externally, strategic leaders must manage
innovation through cooperative strategies such as licensing, strategic alliances, joint ven-
tures, and acquisitions. These are the vehicles of corporate strategy discussed previously.
This concludes our discussion of organizational design. We now move on to our con-
cluding chapter, where we study corporate governance and business ethics.
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410 CHAPTER 11 Organizational Design: Structure, Culture, and Control
ZAPPOS’ IMPLEMENTION OF holacracy is not
going well. As a consequence, employee morale has
plummeted, and Zappos employees are no longer as
happy. In 2011, Zappos was ranked sixth in Fortune’s
“100 Best Companies to Work For” list (one of the
highest rankings for a relatively young firm). By 2015,
after it started implementing holacracy, Zappos had
dropped to rank 86! And in 2016 and 2017, Zappos
failed to place in Fortune’s “100 Best Companies to
Work For” ranking. The ranking is determined by what
employees say about their own company in anonymous
surveys—not some arbitrary external assessment.84
In 2015, Hsieh was frustrated that the transition to
holacracy, announced in 2013, was not yet complete, so
to accelerate the process, he offered a three-month sever-
ance package to employees not willing to adopt the new
structure. More than 200 employees, or some 14 percent
of Zappos’ work force, accepted the offer and quit. As of
January 2016, Zappos had lost 18 percent of its work-
force. Employees that remain with Zappos complain that
the holacracy implementation removes clear career paths
for advancement and wonder openly how hiring, firing,
and promoting will now be done. They are concerned
that relying on employee circles for making decisions
will not only induce paralysis, but also make the organi-
zation more and not less political. In sum, they find that
holacracy forces them to waste time in endless meetings
rather than getting the actual work done.
CHAPTERCASE 11 Consider This . . .
©greatonmywall/Alamy
Stock Photo
After the initial implemen-
tation struggle, Hsieh remains
committed and is doubling down
on holacracy implementation. He
expressed his frustration about the
slow process and lack of productivity gains in a lengthy e-mail
to all Zappos employees, which was subsequently leaked to
the business press. He notes that business results reportedly
remain good, and that 82 percent of the workers are staying.
At the same time, the irony that Hsieh decreed top-down that
Zappos would be implementing holacracy (or decided a few
years earlier to sell the company to Amazon.com), in a com-
pany that ostensibly celebrated democracy and participation,
wasn’t lost on the company’s workers.85
Questions
1. What elements of an organic organization are apparent
from the chapter material on Zappos? (Refer to
Exhibit 11.3.)
2. What is holacracy, and how does this organizational
structure differ from the more traditional ones discussed
in this chapter?
3. Why is Zappos experiencing significant implementation
problems with holacracy? What else could Zappos do to
help implement the new structure more effectively?
4. Do you think that holacracy is a good match with
Zappos’ business strategy? Why or why not? Explain.
This chapter explored the three key levers that manag-
ers have at their disposal when designing their firms
for competitive advantage—structure, culture, and
control—as summarized by the following learning
objectives and related take-away concepts.
LO 11-1 / Define organizational design and list
its three components.
■ Organizational design is the process of creating,
implementing, monitoring, and modifying the struc-
ture, processes, and procedures of an organization.
■ The key components of organizational design are
structure, culture, and control.
■ The goal is to design an organization that allows
managers to effectively translate their chosen
strategy into a realized one.
LO 11-2 / Explain how organizational inertia
can lead established firms to failure.
■ Organizational inertia can lead to the failure of estab-
lished firms when a tightly coupled system of strategy
and structure experiences internal or external shifts.
TAKE-AWAY CONCEPTS
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CHAPTER 11 Organizational Design: Structure, Culture, and Control 411
■ Firm failure happens through a dynamic, four-step
process (see Exhibit 11.2).
LO 11-3 / Define organizational structure and
describe its four elements.
■ An organizational structure determines how firms
orchestrate employees’ work efforts and distribute
resources. It defines how firms divide and inte-
grate tasks, delineates the reporting relationships
up and down the hierarchy, defines formal com-
munication channels, and prescribes how employ-
ees coordinate work efforts.
■ The four building blocks of an organizational
structure are specialization, formalization, cen-
tralization, and hierarchy (see Exhibit 11.3).
LO 11-4 / Compare and contrast mechanistic
versus organic organizations.
■ Organic organizations are characterized by a low
degree of specialization and formalization, a flat
organizational structure, and decentralized deci-
sion making.
■ Mechanistic organizations are described by a high
degree of specialization and formalization, and a tall
hierarchy that relies on centralized decision making.
■ The comparative effectiveness of mechanistic ver-
sus organic organizational forms depends on the
context.
LO 11-5 / Describe different organizational
structures and match them with appropriate
strategies.
■ To gain and sustain competitive advantage, not
only must structure follow strategy, but also the
chosen organizational form must match the firm’s
business strategy.
■ The strategy–structure relationship is dynamic,
changing in a predictable pattern—from simple
to functional structure, then to multidivisional
(M-form) and matrix structure—as firms grow in
size and complexity.
■ In a simple structure, the founder tends to make
all the important strategic decisions as well as run
the day-to-day operations.
■ A functional structure groups employees into dis-
tinct functional areas based on domain expertise.
Its different variations are matched with different
business strategies: cost leadership, differentia-
tion, and blue ocean (see Exhibit 11.6).
■ The multidivisional (M-form) structure consists
of several distinct SBUs, each with its own profit-
and-loss responsibility. Each SBU operates more or
less independently from one another, led by a CEO
responsible for the business strategy of the unit and
its day-to-day operations (see Exhibit 11.7).
■ The matrix structure is a mixture of two organiza-
tional forms: the M-form and the functional struc-
ture (see Exhibit 11.9).
■ Exhibits 11.8 and 11.10 show how best to match
different corporate and global strategies with
respective organizational structures.
LO 11-6 / Evaluate closed and open innova-
tion, and derive implications for organizational
structure.
■ Closed innovation is a framework for R&D that
proposes impenetrable firm boundaries. Key to
success in the closed innovation model is that the
firm discovers, develops, and commercializes new
products internally.
■ Open innovation is a framework for R&D that pro-
poses permeable firm boundaries to allow a firm to
benefit not only from internal ideas and inventions,
but also from external ones. The sharing goes
both ways: some external ideas and inventions are
insourced while others are spun out.
■ Exhibit 11.3 compares and contrasts principles of
closed and open innovation.
LO 11-7 / Describe the elements of organi-
zational culture, and explain where organiza-
tional cultures can come from and how they
can be changed.
■ Organizational culture describes the collectively
shared values and norms of its members.
■ Values define what is considered important, and
norms define appropriate employee attitudes and
behaviors.
■ Corporate culture finds its expression in artifacts,
which are observable expressions of an organiza-
tion’s culture.
LO 11-8 / Compare and contrast different
strategic control-and-reward systems.
■ Strategic control-and-reward systems are internal
governance mechanisms put in place to align the
incentives of principals (shareholders) and agents
(employees).
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412 CHAPTER 11 Organizational Design: Structure, Culture, and Control
■ Strategic control-and-reward systems allow man-
agers to specify goals, measure progress, and pro-
vide performance feedback.
■ In addition to the balanced-scorecard framework,
managers can use organizational culture, input
controls, and output controls as part of the firm’s
strategic control-and-reward systems.
■ Input controls define and direct employee behav-
ior through explicit and codified rules and stan-
dard operating procedures.
■ Output controls guide employee behavior by
defining expected results, but leave the means
to those results open to individual employees,
groups, or SBUs.
Absorptive capacity (p. 399)
Ambidexterity (p. 390)
Ambidextrous organization
(p. 390)
Centralization (p. 385)
Exploitation (p. 390)
Exploration (p. 390)
Formalization (p. 384)
Founder imprinting (p. 403)
Functional structure (p. 388)
Groupthink (p. 404)
Hierarchy (p. 385)
Holacracy (p. 380)
Inertia (p. 382)
Input controls (p. 408)
Matrix structure (p. 394)
Mechanistic organization (p. 385)
Multidivisional structure
(M-form) (p. 391)
Open innovation (p. 398)
Organic organization (p. 386)
Organizational culture (p. 401)
Organizational design (p. 381)
Organizational structure (p. 384)
Output controls (p. 408)
Simple structure (p. 387)
Span of control (p. 385)
Specialization (p. 384)
Strategic control-and-reward
systems (p. 407)
KEY TERMS
DISCUSSION QUESTIONS
1. Why is it important for an organization to have
alignment between its strategy and structure?
2. The chapter describes the role of culture in the
successful implementation of strategy. Consider
an employment experience of your own or of
someone you have observed closely (e.g., a family
member). Describe to the best of your ability the
values, norms, and artifacts of the organization.
What was the socialization process of embed-
ding the culture? Do you consider this to be an
example of an effective culture for contributing to
the organization’s competitive advantage? Why or
why not?
3. Strategy Highlight 11.1 discusses the informal orga-
nizational structure of W.L. Gore & Associates. Go
to the firm’s website (www.gore.com) and review
the company’s product scope. What commonalities
across the products would likely be enhanced by
flexible cross-functional teams? Next look in the
“about Gore” section (under the menu) of the web-
site. What would be your expectations of the type of
control and rewards systems found at W.L. Gore?
ETHICAL/SOCIAL ISSUES
1. As noted in Chapter 5, many public firms are
under intense pressure for short-term (such as
quarterly) financial improvements. How might
such pressure, in combination with output con-
trols, lead to unethical behaviors?
2. Cultural norms and values play a significant role in
all organizations, from businesses in the economic
sector to religious, political, and sports organiza-
tions. Strong organizational cultures can have many
benefits, such as those described in the Zappos
example. However, sometimes a strong organi-
zational culture is less positive. Vince Lombardi,
renowned coach of the Green Bay Packers, is often
quoted as saying, “Winning isn’t everything; it’s
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CHAPTER 11 Organizational Design: Structure, Culture, and Control 413
the only thing.” Many sports teams from junior
sports to professional sports have either explicitly
or implicitly touted this attitude as exemplary.
Others, however, argue that this attitude is what’s
wrong with sports and leads to injury, minor mis-
behavior, and criminal behavior. It encourages
players to do whatever it takes to win—from trip-
ping a player or other unsportsmanlike conduct
during middle-school sports to throwing a game as
part of gambling. Name other examples of organi-
zational culture leading to business failure, crimi-
nal behavior, or civil legal actions.
When a player hears the message as “any
action will be tolerated as long as you are win-
ning,” there can be serious consequences on and
off the field. How could leaders of sports organi-
zations communicate the will to win and develop
the necessary skills while maintaining ethical
behavior? Think of examples of coaches who
coaxed players to play by the rules and main-
tain high personal ethical standards. What other
socialization experiences could a coach use?
What is the role of team leaders in encouraging
high ethical standards while building the desire
to win?
3. What makes some strong cultures helpful in gain-
ing and sustaining a competitive advantage, while
other strong cultures are a liability to achieving
that goal?
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Your classmates are a group of friends who have
decided to open a small retail shop. The team is torn
between two storefront ideas. The first idea is to open
a high-end antique store selling household items used
for decoration in upscale homes. Members of the team
have found a location in a heavily pedestrian area near
a local coffee shop. The store would have many items
authenticated by a team member’s uncle, who is a cer-
tified appraiser.
In discussing the plan, however, two group mem-
bers suggest shifting to a drop-off store for online
auctions such as eBay. In this “reverse logistics”
business model, customers drop off items they want
to sell, and the retail store does all the logistics
involved—listing and selling the items on eBay or
Amazon, and then shipping them to buyers—for a
percentage of the sales price. They suggest that
a quick way to get started is to become a franchi-
see for a group such as “I Sold It” (www.877isoldit.
com).
1. What is the business strategy for each of these two
store concepts?
2. How would the organizational structure be differ-
ent for the concepts?
3. What would likely be the cultural differences in
the two store concepts?
4. How would the control-and-reward systems be
different?
//// Small Group Exercise 2
(Ethical/Social Issues)
The chapter describes Daniel Pink’s ROWE theory of
motivation, in which he argued that the most powerful
motivation occurs when there is an interest in the work
and the work itself has meaning. Intrinsic motivation is
highest when an employee has autonomy (about what
to do), mastery (how to do it), and purpose (why to do
it). Assume your group has been asked by your univer-
sity to brainstorm ways that the university might apply
the ROWE theory. Discuss whether you would be more
motivated and better educated if you had more auton-
omy in designing your program of study, could deter-
mine the best way for you to learn and gain mastery,
and could develop your own statement of purpose as to
why you were pursuing a particular program of study.
1. How might this change the university’s allocation
of resources (e.g., would more trained advisers
and career counselors be required, and how would
they be evaluated)?
2. If large numbers of students decided they would
learn some of the core materials best by taking an
online course, how might this affect the univer-
sity’s revenue stream? How might this change the
way professors teach courses?
3. Have each group member explain how this approach
might change his or her program of study.
4. Consider the potential pitfalls of such an approach
and how these might be addressed.
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For What Type of Organization Are You
Best-Suited?
A s noted in the chapter, firms can have very distinctive cultures. Recall that Zappos has a standing offer to pay any new hire one month’s salary to quit the company
after orientation. Zappos makes this offer to help ensure that
those who stay with the company are comfortable in its “create
fun and a little weirdness” environment.
You may have taken a personality test such as Myers-Briggs
or The Big Five. These tests may be useful in gauging compatibil-
ity of career and personality types. They are often available for
both graduate and undergraduate students at university career
placement centers. In considering the following questions, think
about your next job and your longer-term career plans.
1. Review Exhibit 11.11 and circle the organizational charac-
teristics you find appealing. Cross out those factors you
think you would not like. Do you find a trend toward either
the mechanistic or organic organization?
2. Have you been in school or work situations in which
your values did not align with those of your peers or col-
leagues? How did you handle the situation? Are there cer-
tain values or norms important enough for you to consider
as you look for a new job?
3. As you consider your career after graduation, which
control-and-reward system would you find most motivating?
Is this different from the controls used at some jobs you
have had in the past? How do you think you would perform
in a holacracy such as Zappos?
mySTRATEGY
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414 CHAPTER 11 Organizational Design: Structure, Culture, and Control
1. Jeffrey P. Bezos, founder and chief execu-
tive officer, Amazon.com, “Letter to Share-
holders,” April 2014.
2. As quoted at: www.zapposinsights.
com/about/holacracy. Also, see video:
“What Is Holacracy?” www.youtube.com/
watch?v=MUHfVoQUj54 [1:47 min]. Hsieh
announced the change to Zappos in March 2013.
3. Koestler, A. (1968), The Ghost in the
Machine (New York: Macmillan). Koestler’s
book was first published in 1967 with the first
American edition in 1968. Koestler based his
term on the earlier concept of the holon, a unit
that functions both as a whole and a part of a
larger organization.
4. In addition to quotations already
noted, this ChapterCase is based on gen-
eral discussions of holacracy, including:
Robertson, B. (2015), Holacracy: The
New Management System for a Rapidly
Changing World (New York: Henry Holt);
Robertson, B. (2015), “Holacracy: A Radi-
cal New Approach to Management,” TEDx
Grand Rapids talk, www.youtube.com/
watch?t=17&v=tJxfJGovkI [18:20 min]; “The
holes in holacracy,” The Economist, July 5,
2014; and Robertson, B. (2012), “Why not
ditch bosses and distribute power,” TEDx
Drexel University talk, www.youtube.com/
watch?v=hR-8AOccyj4 [13:00 min]; and
on specific discussions on worker reaction
to holocracy at Zappos, including: http://
about.zappos.com;www.zapposinsights.com/
about/holacracy;www.holacracy.org/; and
“What is holacracy?”www.youtube.com/
watch?v=MUHfVoQUj54 [1:47 min]; Gelles, D.
(2016, Jan. 13), “The Zappos exodus contin-
ues after a radical experiment,” The New York
Times; Gelles, D. (2015, Jul. 17), “At Zappos,
pushing shoes and a vision,” The New York
Times; Greenfield, R. (2015, Jun. 30), “How
Zappos converts new hires to its bizarre office
culture,” Bloomberg Business;
Silverman, R.E. (2015, May 20), “At Zappos,
banishing the bosses brings confusion,” The
Wall Street Journal; Silverman, R.E. (2015,
May 7), “At Zappos, some employees find
offer to leave too good to refuse,” The Wall
Street Journal; Greenfield, R. (2015, Mar.
30), “Holawhat? Meet the alt-management
system invented by a programmer and used
by Zappos,” Fast Company; McGregor, J.
(2014, Mar. 31), “Zappos to employees: Get
behind our ‘no bosses’ approach, or leave with
severance,” The Washington Post; Denning, S.
(2014, Jan. 15), “Making sense of Zappos and
holacracy,” Forbes; Sweeney, C., and J. Gos-
field (2014, Jan. 6), “No managers required:
How Zappos ditched the old corporate
structure for something new,” Fast Company;
McGregor, J. (2014, Jan. 3), “Zappos says
goodbye to bosses,” The Washington Post; and
for general background on the Zappos cul-
ture: Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus).
5. Barney, J.B. (1986), “Organizational cul-
ture: Can it be a source of sustained competi-
tive advantage?” Academy of Management
Review 11: 656–665.
6. Bossidy, L., R. Charan, and C. Burck
(2002), Execution: The Discipline of Getting
Things Done; and Herold, D.M., and D.B.
Fedor (2008), Change the Way You Lead
Change: Leadership Strategies That Really
Work (Palo Alto, CA: Stanford University
Press).
7. “Yang’s exit doesn’t fix Yahoo,” The Wall
Street Journal, November 19, 2008.
8. Seetharaman, D., and R. McMillan (2017,
Mar. 1), “Yahoo CEO Marissa Mayer takes
ENDNOTES
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CHAPTER 11 Organizational Design: Structure, Culture, and Control 415
pay cut over security breach,” The Wall Street
Journal.
9. Herold, D.M., and D.B. Fedor (2008),
Change the Way You Lead Change: Leader-
ship Strategies That Really Work (Palo Alto,
CA: Stanford University Press).
10. Chandler, A.D. (1962), Strategy and
Structure: Chapters in the History of
American Industrial Enterprise (Cambridge,
MA: MIT Press), 14.
11. Hall, D.J., and M.A. Saias (1980),
“ Strategy follows structure!” Strategic
Management Journal 1: 149–163.
12. Hill, C.W.L., and F.T. Rothaermel (2003),
“The performance of incumbent firms in
the face of radical technological innova-
tion,” Academy of Management Review 28:
257–274.
13. I gratefully acknowledge Professor Luis
Martins’ input on this exhibit.
14. In his insightful book, Finkelstein
identifies several key transition points that put
pressure on an organization and thus increase
the likelihood of subsequent failure. See:
Finkelstein, S. (2003), Why Smart Executives
Fail: And What You Can Learn from Their
Mistakes (New York: Portfolio).
15. Fredrickson, J.W. (1986), “The strategic
decision process and organizational struc-
ture,” Academy of Management Review 11:
280–297; Eisenhardt, K.M. (1989), “Making
fast strategic decisions in high-velocity envi-
ronments,” Academy of Management Journal
32: 543–576; and Wally, S., and R.J. Baum
(1994), “Strategic decision speed and firm
performance,” Strategic Management Journal
24: 1107–1129.
16. The 9/11 Report. The National Commis-
sion on Terrorist Attacks upon the United
States (2004), http://govinfo.library.unt
.edu/911/report/index.htm.
17. Child, J., and R.G. McGrath (2001),
“Organization unfettered: Organizational
forms in the information-intensive economy,”
Academy of Management Journal 44:
1135–1148; and Huy, Q.N. (2002), “Emo-
tional balancing of organizational continu-
ity and radical change: The contribution of
middle managers,” Administrative Science
Quarterly 47: 31–69.
18. Theobald, N.A., and S. Nicholson-Crotty
(2005), “The many faces of span of control:
Organizational structure across multiple
goals,” Administration and Society 36:
648–660.
19. This section draws on: Burns, T., and
G.M. Stalker (1961), The Management of
Innovation (London: Tavistock).
20. Hamel, G. (2007), The Future of Manage-
ment (Boston, MA: Harvard Business School
Press), 84.
21. This Strategy Highlight is based on:
Hamel, G. (2007) The Future of Manage-
ment (Boston, MA: Harvard Business School
Press); Collins, J. (2009), How the Mighty
Fall: And Why Some Companies Never Give
In (New York: Harper-Collins); Collins, J.,
and M. Hansen (2011), Great by Choice:
Uncertainty, Chaos, and Luck—Why Some
Thrive Despite Them All (New York: Harper-
Collins); and www.gore.com.
22. Chandler, A.D. (1962), Strategy and
Structure: Chapters in the History of Ameri-
can Industrial Enterprise (Cambridge, MA:
MIT Press).
23. Chandler, A.D. (1962), Strategy and
Structure: Chapters in the History of Ameri-
can Industrial Enterprise (Cambridge, MA:
MIT Press). Also, for a more recent treatise
across different levels of analysis, see: Ridley,
M. (2010), The Rational Optimist: How Pros-
perity Evolves (New York: HarperCollins).
24. This discussion is based on: O’Reilly,
C.A., III, and M.L. Tushman (2007), “Ambi-
dexterity as dynamic capability: Resolving the
innovator’s dilemma,” Research in Organiza-
tional Behavior 28: 1–60; Raisch, S., and J.
Birkinshaw (2008), “Organizational ambidex-
terity: Antecedents, outcomes, and modera-
tors,” Journal of Management 34: 375–409;
and Rothaermel, F.T., and M.T. Alexandre
(2009), “Ambidexterity in technology sourc-
ing: The moderating role of absorptive capac-
ity,” Organization Science 20: 759–780.
25. Hamel, G. (2006, Feb.), “The why, what,
and how of management innovation,” Harvard
Business Review.
26. March, J.G. (1991), “Exploration and
exploitation in organizational learning,” Orga-
nization Science 2: 319–340; and Levinthal,
D.A., and J.G. March (1993), “The myopia
of learning,” Strategic Management Journal
14: 95–112.
27. Author’s interviews with Intel managers
and engineers.
28. Brown, S.L., and K.M. Eisenhardt (1997),
“The art of continuous change: Linking
complexity theory and time-paced evolution
in relentlessly shifting organizations,” Admin-
istrative Science Quarterly 42: 1–34; and
O’Reilly, C.A., B. Harreld, and M. Tushman
(2009), “Organizational ambidexterity: IBM
and emerging business opportunities,” Cali-
fornia Management Review 51: 75–99.
29. Chandler, A.D. (1962), Strategy and
Structure: Chapters in the History of Ameri-
can Industrial Enterprise (Cambridge, MA:
MIT Press).
30. www.gore.com.
31. Williamson, O.E. (1975), Markets and
Hierarchies (Free Press: New York); and
Williamson, O.E. (1985), The Economic
Institutions of Capitalism (Free Press: New
York).
32. Barr, A., and R. Winkler (2015, Aug.
18), “Google creates parent company called
Alphabet in restructuring,” The Wall Street
Journal.
33. Bertoni, S. (2014, Feb. 18), “Elon Musk
and David Sacks say PayPal could top $100B
away from eBay,” Forbes; and “EBay’s split
should make investors happy—and corporate
divorces more popular,” The Economist, July
18, 2015.
34. Bryan, L.L., and C.I. Joyce (2007),
“Better strategy through organizational
design,” The McKinsley Quarterly 2: 21-29;
Hagel, J., III, J.S. Brown, and L. Davison
(2010), The Power of Pull: How Small
Moves, Smartly Made, Can Set Big Things
in Motion (Philadelphia, PA: Basic Books),
Majchrzak, A., A. Malhotra, J. Stamps, and
J. Lipnack (2004), “Can absence make a team
grow stronger?”, May; and Malhotra, A., A.
Majchrzak, and B. Rosen (2207, Mar.), “Lead-
ing far-flung teams,” Academy of Management
Perspectives.
35. Brown, J.S., and P. Duguid, “Organiza-
tional learning and communities-of-practice:
Toward a unified view of working, learning,
and innovation,” Organization Science, 2:
40-57.
36. The discussion in this section draws
mainly on Chesbrough’s seminal work,
Chesbrough, H.W. (2003), Open Innova-
tion: The New Imperative for Creating and
Profiting from Technology (Boston, MA:
Harvard Business School Press). See also
the other insightful sources referenced
here: Chesbrough, H. (2003), “The area of
open innovation,” MIT Sloan Management
Review, Spring: 35–41; Chesbrough, H.
(2007), “Why companies should have open
business models,” MIT Sloan Management
Review, Winter: 22–28; Chesbrough, H.W.,
and M.M. Appleyard (2007), “Open innova-
tion and strategy,” California Management
Review, Fall 50: 57–76; Laursen, K., and
A. Salter (2006), “Open for innovation: The
role of openness in explaining innovation
performance among U.K. manufacturing
firms,”Strategic Management Journal 27:
131–150; and West, J., and S. Gallagher
(2006), “Challenges of open innovation: The
paradox of firm investment in open-source
software,” R&D Management 36: 319–331.
37. See the recent research, for example, by:
Chatterji, A.K., and K.R. Fabrizio (2013),
“Using users: When does external knowledge
enhance corporate product innovation?” Stra-
tegic Management Journal 35: 1427–1445.
Using a sample of medical device makers
and their collaboration with physicians, this
research focuses on the conditions under
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416 CHAPTER 11 Organizational Design: Structure, Culture, and Control
which user knowledge can contribute most
effectively to corporate innovation. The
underlying literature in this field identifies
both the importance of users to corporate
innovation (20 to 80 percent of important
innovations across a number of fields were
user-sourced) and the unique quality of user-
driven innovation (users are highly motivated
to fulfill unmet needs that they have experi-
enced). Given that cross-boundary interactions
increase administrative costs and communica-
tion barriers, the study finds that user-driven
open innovation has higher benefits in the
early stages of technology life cycle and in the
development of radical innovations.
38. Rothaermel, F.T., and M.T. Alexandre
(2009), “Ambidexterity in technology
sourcing: The moderating role of absorptive
capacity,” Organization Science 20: 759–780;
Rothaermel, F.T., and A.M. Hess (2010),
“Innovation strategies combined,” MIT Sloan
Management Review 51: 13–15.
39. Katz, R., and T.J. Allen (1982), “Investi-
gating the not invented here (NIH) syndrome:
A look at the performance, tenure, and
communication patterns of 50 R&D project
groups,” R&D Management 12: 7–20.
40. Horbaczewski, A., and F.T. Rothaermel
(2013), “Merck: Open for innovation?”
Case Study MH-FTR-009-0077645065,
http://create.mcgraw-hill.com.
41. Cohen, W.M., and D.A. Levinthal (1990),
“Absorptive capacity: New perspective on
learning and innovation,” Administrative Sci-
ence Quarterly 35: 128–152; Zahra, S.A.,
and G. George (2002), “Absorptive capacity:
A review, reconceptualization, and exten-
sion,” Academy of Management Review 27:
185–203; and Rothaermel, F.T., and M.T.
Alexandre (2009), “Ambidexterity in technol-
ogy sourcing: The moderating role of absorp-
tive capacity,” Organization Science 20:
759–780.
42. Sony Annual Report 2002, year ended
March 31, 2002, Sony Corp.: 9.
43. This Strategy Highlight is based on:
“Sony CEO remains committed to con-
sumer electronics,” The Wall Street Journal,
January 7, 2015; “How Sony makes money
off Apple’s iPhone,” The Wall Street Journal,
April 28, 2015; “Sony’s blunt finance chief
takes spotlight,” The Wall Street Journal,
November 16, 2014; “White House deflects
doubts on sources of Sony Hack,” The Wall
Street Journal, December 30, 2014; “Behind
the scenes at Sony as hacking crisis unfolded,”
The Wall Street Journal, December 30, 2014;
“Japan’s electronics under siege,” The Wall
Street Journal, May 15, 2013; Hansen, M.T.
(2009), Collaboration: How Leaders Avoid
the Traps, Create Unity, and Reap Big Results
(Cambridge, MA: Harvard Business School
Press); Sony Corp., www.sony.com; and vari-
ous Sony annual reports.
44. This section draws on Barney, J.B. (1986),
“Organizational culture: Can it be a source of
sustained organizational culture?” Academy
of Management Review 11(3): 656–665;
Chatman, J.A., and S. Eunyoung Cha (2003),
“Leading by leveraging culture,” California
Management Review 45: 19–34; Kerr, J., and
J.W. Slocum (2005), “Managing corporate
culture through reward systems,” Academy
of Management Executive 19: 130–138;
O’Reilly, C.A., J. Chatman, and D.L. Caldwell
(1991), “People and organizational culture:
A profile comparison approach to assessing
person-organization fit,” Academy of Manage-
ment Journal 34: 487–516; and Schein, E.H.
(1992), Organizational Culture and Leader-
ship (San Francisco, CA: Jossey-Bass).
45. Chatman, J.A., and S. Eunyoung Cha
(2003), “Leading by leveraging culture,”
California Management Review 45: 19–34.
46. Chao, G.T., A.M. O’Leary-Kelly, S.
Wolf, H.J. Klein, and P.D. Gardner (1994),
“Organizational socialization: Its content and
consequences,” Journal of Applied Psychol-
ogy 79: 730–743.
47. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 130.
48. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 145.
49. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 177.
50. This section draws on: https://jobs.zappos
.com/life-at-zappos.
51. Nelson, T. (2003), “The persistence of
founder influence: Management, ownership,
and performance effects at initial public
offering,” Strategic Management Journal 24:
707–724.
52. A&E Biography Video (1997), Sam
Walton: Bargain Billionaire.
53. Friedman, T.L. (2005), The World Is Flat.
A Brief History of the 21st Century (New
York: Farrar, Straus and Giroux), 130–131.
54. Schneider, B., H.W. Goldstein, and D.B.
Smith (1995), “The ASA framework: An
update,” Personnel Psychology 48: 747–773.
55. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 145.
56. For many years, less than 1 percent of
new hires took Zappos up on the $2,000 offer
to quit during the training program. In recent
years Zappos has not publicized this statistic.
If there has been an increase in takers for this
offer, it may have to do with the transition
of the company from a startup—in which
there is an implied reward for stakeholders
should the enterprise be purchased—and its
post-acquisition phase.
57. Leonard-Barton, D. (1995), Wellsprings
of Knowledge: Building and Sustaining the
Sources of Innovation (Boston, MA: Harvard
Business School Press).
58. Chandler, A.D. (1962), Strategy and
Structure: Chapters in the History of Ameri-
can Industrial Enterprise (Cambridge,
MA: MIT Press).
59. Birkinshaw, J. (2010), Reinventing
Management. Smarter Choices for Getting
Work Done (Chichester, West Sussex, UK:
Jossey-Bass).
60. Boudette, N.E. (2014, June 17), “GM
CEO to testify before House panel,” The Wall
Street Journal.
61. Spector, M., and C.M. Matthews (2015,
Jul 24), “Investigators narrow GM-switch
probe,” The Wall Street Journal.
62. Hughes, S., and J. Bennett (2014, Apr. 2),
“Senators challenge GM’s Barra, push for faster
change,” The Wall Street Journal.
63. This section is based on: Barney, J.B.
(1986), “Organizational culture: Can it be
a source of sustained competitive advan-
tage?” Academy of Management Review 11:
656–665; Barney, J. (1991), “Firm resources
and sustained competitive advantage,” Journal
of Management 17: 99–120; and Chatman,
J.A., and S. Eunyoung Cha (2003), “Leading
by leveraging culture,” California Manage-
ment Review 45: 19–34.
64. Hoffer Gittel, J. (2003), The Southwest
Airlines Way (New York: McGraw-Hill); and
O’Reilly, C., and J. Pfeffer (1995), “Southwest
Airlines: Using human resources for competi-
tive advantage,” case study, Graduate School
of Business, Stanford University.
65. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 146.
66. See discussion in Chapter 4 on SWA’s
activities supporting its cost-leadership
strategy. SWA has experienced problems with
the fuselage of its 737 cracking prematurely.
See: “Southwest’s solo flight in crisis,” The
Wall Street Journal, April 8, 2011.
67. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose (New
York: Business Plus), 146.
68. Chatman, J.A., and S. Eunyoung Cha
(2003), “Leading by leveraging culture,”
California Management Review 45: 19–34.
69. Hoffer Gittel, J. (2003), The Southwest
Airlines Way (New York: McGraw-Hill).
70. Baron, J.N., M.T. Hannan, and M.D.
Burton (2001), “Labor pains: Change in
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CHAPTER 11 Organizational Design: Structure, Culture, and Control 417
organizational models and employee turn-
over in young, high-tech firms,” American
Journal of Sociology 106: 960–1012; and
Hannan, M.T., M.D. Burton, and J.N. Baron
(1996), “Inertia and change in the early years:
Employment relationships in young, high
technology firms,” Industrial and Corporate
Change 5: 503–537.
71. Nelson, T. (2003), “The persistence of
founder influence: Management, ownership, and
performance effects at initial public offering,”
Strategic Management Journal 24: 707–724.
72. See the section on mergers and acquisi-
tions in Chapter 9.
73. Herold, D.M., and D.B. Fedor (2008),
Change the Way You Lead Change: Leader-
ship Strategies That Really Work (Palo Alto,
CA: Stanford University Press).
74. Herold, D.M., and D.B. Fedor (2008),
Change the Way You Lead Change: Leader-
ship Strategies That Really Work (Palo Alto,
CA: Stanford University Press), 157–160.
75. In this video, Zappos employees speak
about what the 10 core values mean to them:
http://about.zappos.com/our-unique-culture/
zappos-core-values [3.50 min].
76. Hsieh, T. (2010), Delivering Happiness:
A Path to Profits, Passion, and Purpose
(New York: Business Plus).
77. Pink, D.H. (2009), Drive: The Surprising
Truth about What Motivates Us (New York:
Riverhead Books).
78. Pink, D.H. (2009), Drive: The Surprising
Truth about What Motivates Us (New York:
Riverhead Books).
79. 3M Co. (2002), A Century of Innovation:
The 3M Story (Maplewood, MN: The 3M Co.).
80. Bossidy, L., R. Charan, and C. Burck
(2002), Execution: The Discipline of Getting
Things Done (New York: Crown Business);
and Hrebiniak, L.G. (2005), Making Strategy
Work: Leading Effective Execution and Change
(Philadelphia: Wharton School Publishing).
81. Grundy, T. (1998), “Strategy implementa-
tion and project management,” International
Journal of Project Management 16: 43–50.
82. Burgelman, R.A. (1983), “Corporate
entrepreneurship and strategic management:
Insights from a process study,” Management
Science 29: 1349–1364; Burgelman, R.A.
(1991), “Intraorganizational ecology of strat-
egy making and organizational adaptation:
Theory and field research,” Organization Sci-
ence 2: 239–262; and Burgelman, R.A., and
A. Grove (2007), “Let chaos reign, then rein
in chaos—repeatedly: Managing strategic
dynamics for corporate longevity,” Strategic
Management Journal 28: 965–979.
83. http://solutions.3m.com/innovation/
en_US/stories/time-to-think.
84. As to how Zappos ranks on Fortune’s
annual 100 best places to work, the ranking
tends to reflect employee opinion of the previ-
ous year. Zappos placed on the list in 2009
and through 2012 its ranking moved mostly
up: 23, 15, 6, and 11. Fortune reorganizes
the URLs for its archives from time to time,
but in 2017 results for 2009 through 2013
years could be found in the format of http://
archive.fortune.com/magazines/fortune/
bestcompanies/20XX/. Specific snapshots of
results in 2013 through 2015 can be found as
follows: http://archive.fortune.com/magazines/
fortune/best-companies/2013/snapshots/31.
html; http://fortune.com/best-companies/2014/
zappos-com-38/; http://fortune.com/best-
companies/2015/zappos-com-86/. Zappos
missed the rankings in 2016 and 2017; see
http://fortune.com/best-companies/2016/ and
http://fortune.com/best-companies/2017/.
85. Gelles, D. (2015, Jul. 17), “At Zappos,
pushing shoes and a vision,” The New York
Times; Gelles, D. (2016, Jan. 13), “The Zappos
exodus continues after a radical management
experiment,” The New York Times; and Silver-
man, R.E. (2015, May 20), “At Zappos, ban-
ishing the bosses brings confusion,” The Wall
Street Journal.
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CHAPTER Corporate Governance
and Business Ethics
Chapter Outline
12.1 The Shared Value Creation Framework
Public Stock Companies and Shareholder Capitalism
Creating Shared Value
12.2 Corporate Governance
Agency Theory
The Board of Directors
Other Governance Mechanisms
12.3 Strategy and Business Ethics
Bad Apples vs. Bad Barrels
12.4 Implications for Strategic Leaders
Learning Objectives
LO 12-1 Describe the shared value creation frame-
work and its relationship to competitive
advantage.
LO 12-2 Explain the role of corporate governance.
LO 12-3 Apply agency theory to explain why and how
companies use governance mechanisms to
align interests of principals and agents.
LO 12-4 Evaluate the board of directors as the
central governance mechanism for public
stock companies.
LO 12-5 Evaluate other governance mechanisms.
LO 12-6 Explain the relationship between strategy
and business ethics.
12
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Uber: Most Ethically Challenged
Tech Company?
UBER’S VALUATION REACHED $70 billion in 2017 and
became the most valuable private startup ever. Yet in the
process of achieving such success, Uber’s unethical, if not
illegal, activity generated controversy after controversy.
Before we look more closely at those ethical issues, we
need to understand the business success that could have
tempted Uber to engage in ethical shortcuts.
RECORD-BREAKING GROWTH
In comparison, Facebook took seven years to reach a valu-
ation of $50 billion for a private, venture-capital-backed
firm; Uber only five. If we compare Uber with car rental
giant Hertz—with some 150 locations, a fleet of 500,000
cars, and about 30,000 employees—it’s astounding to learn
that Hertz reaches only about 1 percent of Uber’s valuation!
Uber reached this astronomical valuation because it
successfully expanded both in the United States and glob-
ally to some 500 cities in 70 countries. As a powerful plat-
form business, Uber’s popularity grows exponentially, as
it already transports millions of riders daily and continues
to expand rapidly here and abroad. Although Uber is still
losing money as it continues to subsidize customer fares,
its revenues race ahead, from $400 million in 2014 to
more than $8 billion in 2017.
ETHICALLY CHALLENGED?
Trailing Uber’s meteoric rise are multiple lawsuits and
accusations, often tied directly to decisions and actions
by its co-founder and now former CEO, Travis Kalanick.
Consider just some of the incidents and issues in the com-
pany’s short history:
■ Early disregard for laws, rules, and regulations. Within
months of its San Francisco launch, the local Metro Transit
Authority and the state Public Utilities Commission had to
order Uber to cease and desist. They called out Uber as
an unlicensed and illegal taxi service. Similar injunctions
followed in major markets, including New York City,
Los Angeles, Toronto, Paris, London, Berlin, and Delhi.
Uber’s response? The company ignored all such warnings.
■ Dynamic pricing. Unlike the taxi industry, in which
pricing is fixed by regulation, Uber uses dynamic pric-
ing, following the model of airlines, hotels, and other
industries. Uber’s fares go up or down based on real-
time supply and demand. During a snowstorm or on
New Year’s Eve, short Uber rides can cost hundreds of
dollars! Kalanick argued that surge pricing efficiently
matches supply and demand. But many Uber users rant
online against the practice and call it price gouging.
■ Punking the competition. Lyft, the competing ride-
share company, accused Uber of ordering over 5,000
rides from Lyft, and then canceling, so Lyft drivers lost
business from legitimate rides.
■ Punking their own drivers. Reportedly Uber told its
drivers in New York that they could not work for both
Uber and Lyft because of city regulations. No such
regulations exist.
■ Poaching drivers. As part of Uber’s secret Operation
SLOG (Supplying Long-term Operations Growth),
accusers say Uber brand ambassadors actively target suc-
cessful drivers from Lyft and other competitors to defect.
■ Poisoning competitor’s well. Startups live or die
based on access to capital. Kalanick reportedly poi-
soned Lyft’s efforts to raise venture capital, telling
investors, “Before you decide whether you want to
invest in [Lyft], just make sure you know that we are
going to be fund-raising immediately after.”2
■ Attacking critics. In 2014, Uber senior executive Emil
Michael suggested spending $1 million to hire private
CHAPTERCASE 12
Travis Kalanick, Uber’s co-founder and former CEO, came to be seen
as too much of a liability for the comfort of major Uber investors and
was pressured to resign the key post. The relentlessly ambitious and
combative entrepreneur was well aware of his reputation, which he
described during a speech celebrating Uber’s fifth anniversary: “I real-
ize that I can come off as a somewhat fierce advocate for Uber. I also
realize that some have used a different ‘a’-word to describe me.”1
©Danish Siddiqui/REUTERS
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investigators to dig up dirt on journalists who wrote dam-
aging pieces on Uber, with particular focus on Sarah Lacy,
of tech blog PandoDaily. When the remarks became pub-
lic, Michael apologized, Kalanick decried the attempt, but
Michael was not disciplined. (In June 2017, in the wake of
Kalanick’s forced resignation, Michael also resigned.)
■ Tech transfer by stealth. In 2015, Uber opened an
Advanced Tech Center in Pittsburgh to develop autono-
mous cars and sophisticated mapping services. Fund-
ing research at Carnegie Mellon University’s National
Robotics Engineering Center (NREC) brought Uber
access to the university’s scientists. A few months later,
Uber poached entire NREC research teams with sign-
ing bonuses, twice the salaries, and stock options. The
NREC was left a shell, with its entire future in question.
■ Allegations of sexual harassment and gender
discrimination. In 2017, a blog post by a former Uber
engineer went viral. It alleged rampant sexual harassment,
persistent mistreatment of female employees, and the
company’s failure to respond to complaints. The former
employee said that women engineers in her work group
dropped from 25 percent to as low as 3 percent within a
year because of the hostile work environment. She also
claimed managers downgraded her performance review
for reporting a supervising manager for harassment.
■ Slow response. It took public outcry for Kalanick to act on
the allegations of sexual harassment, although once he took
action, he went big. He hired former U.S. Attorney General
Eric Holder to lead an internal investigation, working with
Arianna Huffington, Uber’s only female board member.
■ Operation Greyball. Also in 2017, The New York
Times exposed Uber’s use of stealth technology for a
number of years to foil law enforcement and regulators
investigating Uber and its drivers. In a secret operation
code-named Greyball, Uber programmed its software to
set up GPS rings around government offices and track
low-cost phones and credit cards linked to government
accounts. Thus, when law enforcement officers posed as
Uber customers, Uber showed them dummy screens with
fake Uber cars moving, none of which would stop and
pick them up. Greyball was deployed worldwide, espe-
cially in cities where Uber was outlawed.
■ Kalanick caught on video. Kalanick did not realize he
was being filmed by a dashboard cam when an Uber
driver complained about recent fare cuts. As Kalanick
left the car, he told the driver, “You know what, some
people don’t like to take responsibility for their own
sh**,” and slammed the door. The driver uploaded the
video to social media, where it went viral.
■ Waymo lawsuit. Waymo, a unit of Alphabet (Google’s
parent company), is suing Uber for stealing Waymo’s
proprietary self-driving technology. Uber acquired the
autonomous-vehicle startup Otto, which was founded
by Anthony Levandowski, but at the same time Levan-
dowski was working for Waymo on its autonomous-
vehicle program. Waymo claims Levandowski stole
more than 14,000 proprietary files. The stakes are high
because experts predict that only one or two technol-
ogy standards will prevail for self-driving technology.
Waymo wants to become the default operating system
for self-driving cars with its proprietary technology.
FORCED TO RESIGN
Such issues came to a head in mid-2017. In May, the
results of the Holder investigation, along with 50 recom-
mendations, were delivered to the Uber board. On June
13, Kalanick took an indefinite leave of absence, citing the
recent death of his mother and his need to deal with that
personal issue. And then June 21, responding to a letter
from key investors, he formally resigned. The investors had
expressed no confidence in Kalanick’s ability to continue to
lead the company he co-founded.
A Reputation to Live Down. You could say the com-
pany developed a reputation to live down. Uber’s ethical
challenges were called out publicly throughout its rise,
and as early as 2014, venture capitalist Peter Thiel called
Uber the “most ethically challenged company in Silicon
Valley.”3 Of course, Thiel, the billionaire co-founder of
PayPal and Palantir (a data analytics company), is also an
investor in Lyft, Uber’s main competitor. Lyft (featured in
ChapterCase 9) has a valuation of only $7.5 billion, a bit
over 10 percent of Uber’s.
Its Own Worst Rival. Echoing Thiel’s assessment, The
Wall Street Journal (WSJ) argued Uber itself—rather than
Lyft or old-line taxi and limo services—is its own biggest
threat, thereby functioning as its own biggest rival. The
competitive tactics and comments by Uber executives and
constant scandals surrounding Kalanick are harming the com-
pany’s reputation and becoming a liability, the WSJ argues.
DISASTER AVERTED?
Whether symbolic or substantive, Kalanick’s resignation
may mark the point at which Uber embraced the ethical
standards required to thrive in the big leagues and for the
long term. Kalanick’s resignation may come to be seen as
the step that saved Uber from itself.4
You will learn more about Uber by reading this chapter; related
questions appear in “ChapterCase 12 / Consider This. . . .”
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THE UBER CHAPTERCASE illustrates how intricate and intertwined business eth-
ics issues and competitive advantage can be. With close to $70 billion in valuation,
Uber is riding high as the world’s most valuable private start-up firm ever. Its huge cash
pile fuels its rapid expansion in the United States and abroad. It allows Uber to subsidize
fares and to attract more drivers to its platform. All this is done to create network effects
based on a large installed base of Uber drivers and users. In what is likely to be a winner-
take-all market, Uber is planning to be the winner in mobile, on-demand logistics. In a
future history of Uber, 2017 might be seen as the year in which the company, guided by
major investors and its board, saved Uber from itself.
In this chapter, we wrap up our discussion of strategy implementation and close the circle
in the AFI framework by studying two important areas: corporate governance and business
ethics. We begin with the shared value creation framework to illuminate the link between
strategic management, competitive advantage, and society more fully. We then discuss
effective corporate-governance mechanisms to direct and control the enterprise, which a firm
must put in place to ensure pursuit of its intended goals. Next, we study business ethics, which
enable strategic leaders to think through complex decisions in an increasingly dynamic, inter-
dependent, and global marketplace. The vignettes in the ChapterCase documenting contro-
versial decisions, tactics, and statements by Uber highlight the link between business ethics
and competitive advantage. We conclude with Implications for Strategic Leaders.
12.1 The Shared Value Creation Framework
The shared value creation framework provides guidance to managers about how to recon-
cile the economic imperative of gaining and sustaining competitive advantage with cor-
porate 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 ser-
vices 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. Soci-
ety grants the right to incorporation, but in
turn expects companies to be good citizens
by adding value to society.
To fund future growth, companies fre-
quently 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 pri-
vate startups (as of the summer of 2017) are Uber, Didi Chuxing (Chinese ride-hailing
LO 12-1
Describe the shared
value creation framework
and its relationship to
competitive advantage.
In capital markets, private
companies that achieve a val-
uation of $1 billion or greater
were once rare enough to be
called unicorns.
©Catmando/Shutterstock.
com RF
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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 uni-
corns 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 need-
ing 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 prob-
lems may prevent a successful initial public offering (IPO) in the future.
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 direc-
tors 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
1. Limited liability for investors. This characteristic means the shareholders who pro-
vide 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 own-
ership 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 com-
panies, 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 nar-
rowly 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 perspec-
tive, 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 obli-
gations frequently go beyond the economic responsibility to increase profits, extending to
ethical and philanthropic expectations that society has of the business enterprise.12
shareholder capitalism
Shareholders—the
providers of the neces-
sary risk capital and the
legal owners of public
companies—have the
most legitimate claim on
profits.
EXHIBIT 12.1 /
The Public Stock
Company: Hierarchy
of Authority
EMPLOYEES
MANAGEMENT
BOARD OF
DIRECTORS
SHAREHOLDERS
STATE CHARTER
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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.
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 mar-
ket 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 exclu-
sively 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 perfor-
mance and societal progress. This dual point of view, Porter argues, will not only allow
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, 2011.0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
United
Arab
Emirates
Japan India South
Korea
Singapore U.S.A. China Brazil Germany Italy Spain
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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 per-
spective 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 strate-
gic initiative alone have reached $270 billion to date.16
To ensure that managers can reconnect economic and societal needs, Michael Porter rec-
ommends 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 oppor-
tunities, 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 organi-
zations that pursue a particular cause in the public interest and are independent of any
governments. Habitat for Humanity and Greenpeace are examples of NGOs.
shared value creation
framework A model
proposing that managers
have a dual focus on
shareholder value crea-
tion and value creation
for society.
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3. Focus 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 strate-
gic 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 communi-
ties, 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
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 gov-
ernance 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 remain-
ing 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 inter-
ested in maximizing their total compensa-
tion, 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 asym-
metry: The agents are generally better
informed than the principals. Exhibit 12.3
depicts the principal–agent relationship.
Managers, executives, and board members
tend to have access to private information
concerning important company develop-
ments that outsiders, especially investors, are
corporate governance
A system of mechanisms
to direct and control an
enterprise in order to
ensure that it pursues
its strategic goals suc-
cessfully and legally.
LO 12-2
Explain the role of
corporate governance.
EXHIBIT 12.3 / The Principal–Agent Problem
AgentPrincipal
Hires, Monitors,
and Compensates
Information
Asymmetry
Performs Work, Provides
Time and Talents
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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 sec-
onds 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.22
Information asymmetry also can breed on-the-job consumption, perquisites, and exces-
sive compensation. Although use of company funds for golf outings, resort retreats,
professional sporting events, or elegant dinners and other entertainment is an every-
day 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.23 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.24 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.
AGENCY THEORY
The principal–agent problem is a core part of agency theory, which views the firm as a
nexus of legal contracts.25 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,
LO 12-3
Apply agency theory
to explain why and
how companies use
governance mechanisms
to align interests of
principals and agents.
agency theory A theory
that views the firm as a
nexus of legal contracts.
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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 headquar-
ters 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 man-
agement. 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 dur-
ing 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 relation-
ships.26 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, there-
fore, 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 invest-
ment 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 employ-
ment 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 spe-
cific 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 responsi-
bilities 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 soci-
ety. 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.
adverse selection A
situation that occurs
when information asym-
metry increases the
likelihood of selecting
inferior alternatives.
moral hazard A
situation in which
information asymmetry
increases the incentive
of one party to take
undue risks or shirk
other responsibilities
because the costs incur
to the other party.
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In the principal–agent relationship, moral hazard describes the difficulty of the prin-
cipal 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.27 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.28 To over-
come 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
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 gover-
nance 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 divi-
dend 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, deter-
mine 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:29
■ 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 pertain-
ing 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:
LO 12-4
Evaluate the board of
directors as the central
governance mechanism
for public stock
companies.
board of directors The
centerpiece of cor-
porate governance,
composed of inside
and outside directors
who are elected by the
shareholders.
inside directors Board
members who are
generally part of the
company’s senior man-
agement team; appointed
by shareholders to
provide the board with
necessary information
pertaining to the com-
pany’s internal workings
and performance.
outside directors
Board members who
are not employees of
the firm, but who are
frequently senior execu-
tives from other firms or
full-time professionals.
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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 pic-
ture 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 responsi-
bilities. 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 con-
cepts 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.
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.30 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 finan-
cial 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 implementa-
tion. 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 perfor-
mance, there can be a conflict of interest when the CEO actually chairs the board.
CEO/chairperson
duality Situation where
the CEO of a publicly
traded company is also
the chairperson of the
board of directors.
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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 prin-
ciples aimed at ensuring that the Board is indepen-
dent 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.”31
The GE board is composed of individuals from the busi-
ness world (chairpersons and CEOs of Fortune 500 com-
panies 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 con-
sider 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 inde-
pendence, 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 demon-
strated when former CEO Jeffrey Immelt retired in 2017.
John Flannery took over in August, with Immelt sched-
uled 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.32
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 compen-
sation committee, the government and public affairs commit-
tee, and the technology and industrial risk committee.
In general, women and minorities remain underrepre-
sented 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.33
Generally, the larger the company, the greater its gender
diversity, as demonstrated in recent years by tracking differ-
ent 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.34
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.35
Strategy Highlight 12.1
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 frequently
LO 12-5
Evaluate other governance
mechanisms.
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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 sig-
nificant 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 1980.36 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.37 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).38
CEO Pay and Firm Performance. Overall, survey results also show that two-thirds of
CEO pay is linked to firm performance.39 The relationship between pay and performance
is positive, but the link is weak at best. Although agency theory would predict a posi-
tive 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 shares
stock options An incen-
tive mechanism to align
the interests of share-
holders and managers,
by giving the recipient
the right (but not the
obligation) to buy a com-
pany’s stock at a prede-
termined price sometime
in the future.
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 shares of
a publicly traded com-
pany in order to take it
private.
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of a publicly traded company in order to take it private. In short, an LBO changes the own-
ership structure of a company from public to private. The expectation is often that the pri-
vate 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 compa-
nies 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 rea-
sons 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.41 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 infor-
mation 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 ongo-
ing 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 exist-
ing 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 hos-
tile 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, how-
ever, when internal corporate-governance mechanisms have not functioned effectively and
the company is underperforming.
AUDITORS, GOVERNMENT REGULATORS, AND INDUSTRY ANALYSTS. Auditors, govern-
ment regulators, and industry analysts serve as additional external-governance mecha-
nisms. All public companies listed on the U.S. stock exchanges must file a number of
poison pill Defensive
provisions to deter
hostile takeovers by
making the target firm
less attractive.
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financial statements with the Securities and Exchange Commission (SEC), a federal regu-
latory 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 fol-
low 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 com-
panies available electronically via the EDGAR database.43 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 agen-
cies 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 rela-
tionships 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 indepen-
dent 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
Multiple, high-profile accounting scandals and the global financial crisis have placed busi-
ness 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 pro-
vide 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 offi-
cers 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, espe-
cially if there are indications that the borrower might be unable to repay the mortgage once
the interest rate moves up.49
business ethics An
agreed-upon code of
conduct in business,
based on societal
norms.
LO 12-6
Explain the relationship
between strategy and
business ethics.
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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.
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, pub-
lished 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).50 Smith’s thesis was that the entire ethical climate within Gold-
man 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 partner-
ship, 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.”51 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 organiza-
tions.52 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 organi-
zations that can create a climate in which unethical, even illegal behavior is tolerated.53
While there clearly are some people with unethical or even criminal inclinations, in gen-
eral one’s ethical decision-making capacity depends very much on the organizational con-
text. Research shows that if people work in organizations that expect and value ethical
behavior, they are more likely to act ethically.54 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.55 Yet, the ethos at Enron was all about creating
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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 Depart-
ment pursues criminal cases, often based on SEC investiga-
tions. 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 con-
sistent 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 high-
est possible rating and indicates an “extremely strong capac-
ity” 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 invest-
ment 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 pub-
licly 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.56
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 know-
ingly misleading investors and failing to disclose Paulson’s role in
Abacus. Specifically, the SEC alleged that Goldman violated its fidu-
ciary 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 with-
out 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, stat-
ing instead he wished to complete his doctoral studies and
hoped to make contributions to scholarship in the field of
economics.57
Strategy Highlight 12.2
(continued)
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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 pros-
ecutors 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.”58
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 pos-
sible. 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.59
Employees take cues from their environment on how to act. Therefore, ethical leader-
ship is critical, and strategic leaders set the tone for the ethical climate within an organiza-
tion. 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 scru-
tiny and ought to adhere to the highest ethical standards. If they do not, they cannot ratio-
nally 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 expecta-
tions, 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 for-
mally 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.60 Some argue
that management needs an accepted code of conduct,61 holding members to a high profes-
sional 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).62 Since 2009, over 6,000 MBA students from more than 300 insti-
tutions 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.”63 Having the highest personal integrity is
of utmost importance to one’s career. It takes decades to build a career, but sometimes just
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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.
CHAPTER 12 Corporate Governance and Business Ethics 437
rot27628_ch12_418-446.indd 437 11/29/17 08:22 PM
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.
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 employ-
ees 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 stake-
holders 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 con-
duct are key to the continued professionalization of management. Strategic leaders need to
live organizational core values by example.
EXHIBIT 12.4 /
The MBA Oath
Copyright ©MBA Oath
and Max Anderson. All
rights reserved. Used with
permission.
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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 scru-
tiny, 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 chair-
man, he keeps his board seat. In fact he remains one of three
company insiders on the board, along with co-founder Gar-
rett 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 regula-
tions 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 trajec-
tory 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
CHAPTERCASE 12 Consider This. . .
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.64
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 owner-
ship 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.”65 Not having to deal with
drivers must sound attractive to Uber, which has had antago-
nisms 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 rea-
sonable to assume that states will continue to remove obstacles
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
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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 cur-
rent 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 strat-
egy, explicitly to improve public relations and to lobby politi-
cians. 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.66
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 incon-
sistent with what I saw and experienced at Uber.”67
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 law-
suits 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.68
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 prob-
lem 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 suc-
cess, 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 cur-
rent challenges in rank order, and provide recommenda-
tions 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 iden-
tify connections between economic and social needs,
and then leverage them into competitive advantage.
TAKE-AWAY CONCEPTS
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440 CHAPTER 12 Corporate Governance and Business Ethics
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 rela-
tionship between owners (shareholders) and man-
agers 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 incen-
tives 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 pub-
licly 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 man-
agers 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 trad-
ing and enforce federal securities laws. Audi-
tors 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.
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CHAPTER 12 Corporate Governance and Business Ethics 441
Adverse selection (p. 427)
Agency theory (p. 426)
Board of directors (p. 428)
Business ethics (p. 433)
CEO/chairperson duality (p. 429)
Corporate governance (p. 425)
Inside directors (p. 428)
Leveraged buyout (LBO) (p. 431)
Moral hazard (p. 427)
Outside directors (p. 428)
Poison pill (p. 432)
Shared value creation
framework (p. 424)
Shareholder capitalism (p. 422)
Stock options (p. 431)
KEY TERMS
DISCUSSION QUESTIONS
1. How can a top management team lower the
chances that key managers will pursue their own
self-interests at the expense of stockholders? At
the expense of the employees? At the expense of
other key stakeholders?
2. The Business Roundtable has recommended that
the CEO should not also serve as the chairman of
the board. Discuss the disadvantages for building
a sustainable competitive advantage if the two
positions are held by one person. What are the
disadvantages for stakeholder management? Are
there situations where it would be advantageous
to have one person in both positions?
ETHICAL/SOCIAL ISSUES
1. The shared value creation framework provides
help in making connections between economic
needs and social needs in a way that transforms
into a business opportunity. Taking the role of
consultant to Nike Inc., discuss how Nike might
move beyond selling high-quality footwear and
apparel and utilize its expertise to serve a social
need. Give Nike some advice on actions the com-
pany could take in different geographic markets
that would connect economic and social needs.
2. Assume you work in the accounting department
of a large software company. Toward the end of
December, your supervisor tells you to change
the dates on several executive stock option grants
from March 15 to July 30. Why would she ask for
this change? What should you do?
3. As noted in the chapter, the average compensa-
tion for a CEO of an S&P 500 company in 2017
was $11 million, and CEO pay was 300 times the
average worker pay. This contrasts with historic
values of between 25 and 40 times the average
pay. In 2015 the U.S. Securities and Exchange
Commission (SEC) approved a rule mandating
that U.S. firms publicly disclose the gap between
their CEO annual compensation and the median
pay of the firm’s other employees.
a. What are the potentially negative effects of
this large and increasing disparity in CEO
pay?
b. Do you believe that current executive pay
packages are justified? Why or why not?
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442 CHAPTER 12 Corporate Governance and Business Ethics
SMALL GROUP EXERCISES
//// Small Group Exercise 1
Uber is a highly valued “unicorn,” with a high dis-
regard for regulations and other external factors that
would slow its growth as discussed in this chapter.
Other competing firms are taking a somewhat differ-
ent route to the ride-hailing marketplace. For example,
Lyft (discussed in ChapterCase 9) was also started in
San Francisco, and since 2012 it has been growing
across the country and more slowly internationally.
Lyft started as a ride-sharing service targeting U.S.
college students heading home for the holidays. The
firm continues to focus on building a trusting com-
munity of drivers and riders—a community that is
both social and cost-effective. In 2017 Lyft added to
a prior partnership with General Motors by allying
with Waymo (an Alphabet company). Another Uber
competitor is Didi Chuxing, a dominant ride-hailing
service in China.
In your groups, do internet research about
Uber competitors (www.lyft.com and http://www
.xiaojukeji.com/en/index.html will get you started).
1. What similarities and differences do you find in
the way these firms have implemented sometimes
similar ideas?
2. Discuss why traditional taxi companies, such as
Yellow Cabs and those needing medallions (such
as in New York City), are choosing to attempt to
prohibit these app-enabled, ride-hailing services
rather than aggressively implementing their own
app-calling systems.
//// Small Group Exercise 2
The MBA oath (shown in Exhibit 12.4) says in part,
“My decisions affect the well-being of individuals
inside and outside my enterprise, today and tomorrow.”
One example of a large firm reorienting toward this
approach is PepsiCo. In the last few years, PepsiCo has
been contracting directly with small farmers in impov-
erished areas (for example, in Mexico). What started as
a pilot project in PepsiCo’s Sabritas snack food division
has now spread to farmers in more than 15 countries
providing potatoes, corn, sunflower oil, and other prod-
ucts to the firm. PepsiCo provides a price guarantee to
farmers that is higher and much more consistent than
the previous system of using intermediaries. The farm-
ers report that since they have a firm market, they are
planting more crops. Output is up about 160 percent,
and farm incomes have tripled in recent years. The
program has benefits for PepsiCo as well. A shift to
sunflower oil for its Mexican products will replace the
80,000 tons of palm oil it imports to Mexico from Asia
and Africa, thus slashing transportation and storage
costs. The firm is expanding the farmer sustainability
program with plans to cover about 7 million acres, or
75 percent of its agricultural spending by 2025.
1. What are the benefits of this program for PepsiCo?
What are its drawbacks?
2. What other societal benefits could such a program
have in Mexico?
3. If you were a PepsiCo shareholder, would you
support this program? Why or why not?
Are You Part of Gen Y, or Will You
Manage Gen-Y Workers?
Generation Y (born between 1980 and 2001) is enter-ing the work force and advancing their careers now, as the baby boomers begin to retire in large numbers.
Given the smaller size of Gen Y compared to the baby boom-
ers, this generation received much more individual atten-
tion from their immediate and extended families. Classes in
school were much smaller than in previous generations. The
parents of Gen Y placed a premium on achievement, both
academically and socially. Gen Y grew up during a time of
unprecedented economic growth and prosperity, combined
with an explosion in technology (including laptop computers,
cell phones, the internet, e-mail, instant messaging, and online
social networks).
Gen Yers are connected 24/7 and are able to work any-
where, frequently multitasking. Due to the circumstances of
their upbringing, they are said to be tech-savvy, family- and
mySTRATEGY
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CHAPTER 12 Corporate Governance and Business Ethics 443
friends-centric, team players, achievement-oriented, but also
attention-craving.69
Some have called Generation Y the “trophy kids,” due in part
to the practice of giving all Gen-Y children trophies in competi-
tive activities, not wanting to single out winners and losers. When
coaching a group of Gen-Y students for job interviews, a consul-
tant asked them how they believe future employers view them. She
gave them a clue to the answer: the letter E. Quickly, the students
answered confidently: excellent, enthusiastic, and energetic. The
answer the consultant was looking for was “entitled.” Baby boom-
ers believe that Gen Y has an overblown sense of entitlement.
When Gen Yers bring so many positive characteristics to
the workplace, why do baby boomers view Gen-Y employees as
entitled? Many managers are concerned that these young work-
ers have outlandish expectations when compared with other
employees: They often expect higher pay, flexible work sched-
ules, promotions and significant raises every year, and generous
vacation and personal time.70 Managers also often find that for
Gen-Y employees, the traditional annual or semiannual perfor-
mance evaluations are not considered sufficient. Instead, Gen-Y
employees seek more immediate feedback, ideally daily or at
least weekly. For many, feedback needs to come in the form of
positive reinforcement rather than as a critique.
The generational tension seems a bit ironic, since the dis-
satisfied baby boomer managers are the same indulgent parents
who raised Gen Yers. Some companies, such as Google, Intel,
and Sun Microsystems (Sun), have leveraged this tension into
an opportunity. Google, for example, allows its engineers to
spend one day a week on any project of their own choosing, thus
meeting the Gen-Y need for creativity and self-determination.
Executives at Intel have learned to motivate Gen-Y employees
by sincerely respecting their contributions as colleagues rather
than relying on hierarchical or position power. The network-
computing company Sun accommodates Gen Yers’ need for
flexibility through drastically increasing work-from-home and
telecommunicating arrangements; all employees now have a
“floating office.” Netflix has eliminated all tracking of vacation
time for employees, essentially allowing unlimited days off—as
long as the work still gets done.
1. As this cohort expands in the work force, do you expect to
see a different set of business ethics take hold?
2. Are efforts such as the MBA oath (discussed in this chap-
ter) reflections of a different approach that Gen Y will
bring to the business environment, compared with prior
generations?
1. As quoted in: Stone, B. (2017), The Upstarts:
How Uber, Airbnb, and the Killer Companies of
the New Silicon Valley Are Changing the World
(New York: Little, Brown and Co.).
2. Austin, S., and D. MacMillan (2014,
Nov. 18), “Is Uber’s biggest rival itself? A
collection of controversy,” The Wall Street
Journal.
3. Thiel, P. (2014, Nov. 18), “Uber is most
ethically challenged company in Silicon
Valley,” CNN Money, http:// money.cnn.com/
2014/11/18/technology/ uber-unethical-
peter-thiel/.
4. In addition to the sources for direct quota-
tions noted earlier, this ChapterCase is based on
Bensinger, G. (2017, June 21), “Uber CEO
Travis Kalanick quits as investors revolt,” The
Wall Street Journal; “What’s behind the conflict
between Google and Uber,” The Economist,
May 8, 2017; “Here’s how much Uber made in
revenue in 2016,” Reuters, April 14, 2017;
“Uber is facing the biggest crisis in its short
history,” The Economist, March 25, 2017;
“Travis Kalanick’s uber-apology,”The Econo-
mist, March 4, 2017; Isaac, M. (2017, Mar. 3),
“How Uber deceives the authorities world-
wide,” The New York Times; Bensinger, G.
(2017, Feb. 20), “Uber to investigate sexism,
harassment claims,” The Wall Street Journal;
Fowler, S.J. (2017, Feb. 19), “Reflecting on one
very, very strange year at Uber,” https://www.
susanjfowler.com/blog/2017/2/19/reflecting-on-
one-very-strange-year-at-uber (accessed May 27,
2017); “Potholes ahead,” The Economist, June
17, 2015; “Driving hard,” The Economist,
June 13, 2015; Ramsey, M., and D. MacMillan
(2015, May 31), “Carnegie Mellon reels after
Uber lures away researchers,” The Wall Street
Journal; Austin, S., and D. MacMillan (2014,
Nov. 18), “Is Uber’s biggest rival itself?
A collection of controversy,” The Wall Street
Journal; Thiel, P. (2014,
Nov. 18), “Uber is most ethically challenged
company in Silicon Valley,” CNN Money,
http:// money.cnn.com/2014/11/18/technol-
ogy/uber-unethical-peter-thiel/; “Uber–
competitive,”The Economist, November 22,
2014; “Pricing the surge,”The Economist,
March 29, 2014; and “Tap to hail,” The Econo-
mist, October 19, 2013.
5. Porter, M.E., and M.R. Kramer (2006),
“Strategy and society: The link between
competitive advantage and corporate social
responsibility,” Harvard Business Review,
December: 80–92; and Porter, M.E., and M.R.
Kramer (2011), “Creating shared value: How
to reinvent capitalism—and unleash innova-
tion and growth,” Harvard Business Review,
January–February.
6. “The billion dollar startup club,” The Wall
Street Journal, February 18, 2015, http://
graphics.wsj.com/billion-dollar-
club/ (accessed May 29, 2017).
7. “The endangered public company,” The
Economist, March 19, 2012; the classic work
by Berle, A., and G. Means (1932), The
Modern Corporation & Private Property (New
York: Macmillan); and Monks, R.A.G., and N.
Minow (2008), Corporate Governance, 4th ed.
(West Sussex, UK: John Wiley & Sons).
8. NASDAQ was originally an acronym for
National Association of Securities Dealers
Automated Quotations, but it is now a stand-
alone term.
9. Berle, A., and G. Means (1932), The Mod-
ern Corporation & Private Property (New
York: Macmillan); and Monks, R.A.G., and
N. Minow (2008), Corporate Governance, 4th
ed. (West Sussex, UK: John Wiley & Sons).
10. This section is based on: Porter, M.E., and
M.R. Kramer (2006), “Strategy and society:
The link between competitive advantage and
corporate social responsibility,” Harvard
ENDNOTES
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444 CHAPTER 12 Corporate Governance and Business Ethics
Business Review, December: 80–92; and Porter,
M.E., and M.R. Kramer (2011), “Creating
shared value: How to reinvent capitalism—
and unleash innovation and growth,” Harvard
Business Review, January–February.
11. Friedman, M. (1962), Capitalism and Free-
dom (Chicago, IL: University of Chicago Press),
quoted in: Friedman, M., “The social responsi-
bility of business is to increase its profits,” The
New York Times Magazine, September 13, 1970.
12. Carroll, A.B., and A.K. Buchholtz (2012),
Business & Society. Ethics, Sustainability, and
Stakeholder Management (Mason, OH: South-
Western Cengage).
13. “Milton Friedman goes on tour,” The
Economist, January 27, 2011.
14. For detailed data and descriptions on
the GE Ecomagination initiative, see:
www.ge.com/about-us/ecomagination.
15. “GE to invest more in ‘green’ technol-
ogy,” The New York Times, May 10, 2005.
16. GE Sustainability Report, http://www
.gesustainability.com/performance-data/
ecomagination/ (accessed May 29, 2017).
17. Porter, M.E., and M.R. Kramer (2011), “Cre-
ating shared value: How to reinvent capitalism—
and unleash innovation and growth,” Harvard
Business Review, January–February.
18. “GE governance principles,” 2016 [PDF], 1,
www.ge.com/sites/default/files/GE_governance_
principles , accessed May 31, 2017.
19. Monks, R.A.G., and N. Minow (2008),
Corporate Governance, 4th ed. (West Sussex,
UK: John Wiley & Sons).
20. Berle, A., and G. Means (1932), The
Modern Corporation & Private Property
(New York: Macmillan); Jensen, M., and W.
Meckling (1976), “Theory of the firm: Mana-
gerial behavior, agency costs and ownership
structure,” Journal of Financial Economics
3: 305–360; and Fama, E. (1980), “Agency
problems and the theory of the firm,” Journal
of Political Economy 88: 375–390.
21. “Fund titan found guilty,” The Wall Street
Journal, May 12, 2011.
22. “Fund titan found guilty,” The Wall Street
Journal, May 12, 2011.
23. “Top 10 crooked CEOs,” Time, June 9, 2009.
24. “Thain ousted in clash at Bank of America,”
The Wall Street Journal, January 23, 2009.
25. Agency theory originated in finance; see:
Jensen, M., and W. Meckling (1976), “Theory
of the firm: Managerial behavior, agency
costs and ownership structure,” Journal of
Financial Economics 3: 305–360; and Fama,
E. (1980), “Agency problems and the theory
of the firm,” Journal of Political Economy
88: 375–390. For an application to strategic
management, see Eisenhardt, K.M. (1989),
“Agency theory: An assessment and review,”
Academy of Management Review 14: 57–74;
and Mahoney, J.T. (2005), Economic Founda-
tions of Strategy (Thousand Oaks, CA: Sage).
26. Detailed coverage of the ongoing Waymo-
Uber lawsuit can be found in: Isaac, M. (2017,
May 17), “How Uber and Waymo ended up
rivals in the race for driverless cars,” The New
York Times.
27. Fuller, A.W., and F.T. Rothaermel (2012),
“When stars shine: The effects of faculty
founders on new technology ventures,” Strate-
gic Entrepreneurship Journal, 6: 220–235.
28. Eisenhardt, K.M. (1989), “Agency theory:
An assessment and review,” Academy of Man-
agement Review 14: 57–74.
29. This section draws on: Monks, R.A.G., and
N. Minow (2008), Corporate Governance, 4th
ed. (West Sussex, UK: John Wiley & Sons);
Williamson, O.E. (1984), “Corporate gover-
nance,” Yale Law Journal 93: 1197–1230; and
Williamson, O.E. (1985), The Economic Insti-
tutions of Capitalism (New York: Free Press).
30. For a research update on the topic of CEO/
chairperson duality, see: Larcker, D.F., and B.
Tayan (2016), “Chairman and CEO. The con-
troversy of board leadership structure,”Stanford
Closer Look Series, June 24; Krause, R., and
M. Semadeni (2014), “Last dance or second
chance? Firm performance, CEO career hori-
zon, and the separation of board leadership
roles,” Strategic Management Journal 35:
808–825. This research looks at the three forms
of splitting the CEO/chairman roles: appren-
tice, departure, and demotion. They look at sev-
eral determinants of the type of split. They find
that poor firm performance is more likely to
result in a demotion split. The strength of this
relationship increases when the board is more
independent. The career horizon of the execu-
tive is also a determinant. Apprentice shifts
involve executives with the shortest career hori-
zons, while demotion shifts are associated with
executives with longer career horizons. When
performance is poor and boards are indepen-
dent, the strength of the relationship with career
horizon is magnified; see also: Flickinger, M.,
M. Wrage, A. Tuschke, and R. Bresser (2015,
Mar. 18), “How CEOs protect themselves
against dismissal: A social status perspective,”
Strategic Management Journal.
31. “GE Board of Directors,”
https://www.ge.com/investor-relations/
governance (accessed May 29, 2017).
32. For the latest listing of the GE’s board of
directors, see: www.ge.com/about-us/
leadership/board-of-directors. As of June
2017, five of 18 of the board directors are
women (27.8 percent). For gender diversity
among the Fortune 1000, see the advocacy
site 2020 Women on Boards (2020wob.com)
and its evergreen diversity index at: https://
www.2020wob.com/companies/2020-gender-
diversity-index. Accessed in May 2017 the site
listed 2016 results, showing women holding
19.7 percent of seats, up from 18.8 percent in
2015 and from 14.6 percent in 2011. See also:
“John Flannery named chairman and CEO of
GE,” GE Press Release, June 12, 2017;
https://www.genewsroom.com/press-releases/
john-flannery-named-chairman-and-ceo-ge-
283823. https://www.genewsroom.com/
press-releases/john-flannery-named-
chairman-and-ceo-ge-283823.
33. “Despite modest gains, women and
minorities see little change in representa-
tion on Fortune 500 boards,” Catalyst.org,
February 7, 2017, at http://www.catalyst.org/
media/despite-modest-gains-women-and-
minorities-see-little-change-representation-
fortune-500-boards. See the full report: http://
theabd.org/2016%20Board%20Diversity%20
Census_Deloitte_ABD_Final.PDF. As of May
2017, the GE board includes 13 men and five
women.
34. For gender diversity among the Fortune
1000, see the advocacy site, 2020 Women on
Boards and its index at https://www.2020wob.
com/companies/2020-gender-diversity-index.
Accessed in May 2017 the site listed 2016
results, showing women holding 19.7 percent
of seats, up from 18.8 percent in 2015 and
from 14.6 percent in 2011.
35. In addition to references cited, this sec-
tion is based on: Baliga, B.R., R.C. Moyer,
and R.S. Rao (1996), “CEO duality and firm
performance: What’s the fuss,” Strategic Man-
agement Journal 17: 41–53; Brickley, J.A.,
J.L. Coles, and G. Jarrell (1997), “Leadership
structure: Separating the CEO and chairman
of the board,”Journal of Corporate Finance
3: 189–220; Daily, C.M., and D.R. Dalton
(1997), “CEO and board chair roles held
jointly or separately,”Academy of Management
Executive 3: 11–20; “GE governance prin-
ciples,” at: http://www.ge.com/pdf/company/
governance/principles/ge_governance_
principles ; Irving, J. (1972), Victims of
Groupthink. A Psychological Study of Foreign-
Policy Decisions and Fiascoes (Boston, MA:
Houghton Mifflin); Jensen, M.C. (1993),
“The modern industrial revolution, exit, and
the failure of internal control systems,” Jour-
nal of Corporate Finance 48: 831–880; “On
Apple’s board, fewer independent voices,”
The Wall Street Journal, March 24, 2010;
“Strings attached to options grant for GE’s
Immelt,” The Wall Street Journal, April 20,
2011; Westphal, J.D., and E.J. Zajac (1995),
“Who shall govern? CEO board power, demo-
graphic similarity and new director selection,”
Administrative Science Quarterly 40: 60–83;
and Westphal, J.D., and I. Stern (2007), “Flat-
tery will get you everywhere (especially if
you are male Caucasian): How ingratiation,
boardroom behavior, and demographic minor-
ity status affect additional board appointments
at U.S. companies,” Academy of Management
Journals 50: 267–288.
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CHAPTER 12 Corporate Governance and Business Ethics 445
36. See www.faireconomy.org/the_story,
accessed May 31, 2017.
37. The data presented here are drawn from:
Lublin, J. (2015, June 25), “How much the
best-performing and worst-performing CEOs
got paid,” The Wall Street Journal.
38. Lightner, R., and T. Francis (2017, Mar.
17), “How much do top CEOs make? Com-
pensation for the chief executives of compa-
nies listed in the S&P 500 index,” The Wall
Street Journal (http://graphics.wsj.com/ceo-
salary-vs-company-performance/ ).
39. Lublin, J. (2015, June 25), “How much
the best-performing and worst-performing
CEOs got paid,” The Wall Street Journal.
40. Ariely, D. (2010), The Upside of Irrational-
ity: The Unexpected Benefits of Defying Logic at
Work and at Home (New York: HarperCollins).
41. The Dell LBO battle is described in:
“Dell buyout pushed to brink,” The Wall
Street Journal, July 18, 2013; and “Monarchs
versus managers. The battle over Dell raises
the question of whether tech firms’ founders
make the best long-term leaders of their cre-
ations,” The Economist, July 27, 2013.
42. www.fasb.org: “The term ‘generally
accepted accounting principles’ has a specific
meaning for accountants and auditors. The
AICPA Code of Professional Conduct prohibits
members from expressing an opinion or stating
affirmatively that financial statements or other
financial data ‘present fairly . . . in conformity
with generally accepted accounting principles,’
if such information contains any departures
from accounting principles promulgated by
a body designated by the AICPA Council to
establish such principles. The AICPA Council
designated FASAB as the body that establishes
generally accepted accounting principles
(GAAP) for federal reporting entities.”
43. www.secfilings.com.
44. Lowenstein, R. (2010), The End of Wall
Street (New York: Penguin Press).
45. Hayward, M.L.A., and W. Boeker (1998),
“Power and conflicts of interest in professional
firms: Evidence from investment banking,”
Administrative Science Quarterly 43: 1–22.
46. www2.gmiratings.com/.
47. This section draws on and the definition is
from: Treviño, L.K., and K.A. Nelson (2011),
Managing Business Ethics: Straight Talk
About How to Do It Right, 5th ed. (Hoboken,
NJ: John Wiley & Sons).
48. Several such studies, such as the “ulti-
matum game,” are described in: Ariely, D.
(2008), Predictably Irrational: The Hidden
Forces That Shape Our Decisions (New York:
HarperCollins); and Ariely, D. (2010), The
Upside of Irrationality: The Unexpected Ben-
efits of Defying Logic at Work and at Home
(New York: HarperCollins).
49. Lowenstein, R. (2010), The End of Wall
Street (New York: Penguin Press).
50. Smith, G. (2012), Why I Left Goldman
Sachs. A Wall Street Story (New York: Grand
Central Publishing).
51. Smith, G. (2012), Why I Left Goldman
Sachs. A Wall Street Story (New York: Grand
Central Publishing).
52. Treviño, L.K., and K.A. Nelson (2011),
Managing Business Ethics: Straight Talk
About How to Do It Right, 5th ed. (Hoboken,
NJ: John Wiley & Sons).
53. Treviño, L., and A. Youngblood (1990),
“Bad apples in bad barrels: A causal analysis
of ethical-decision behavior,” Journal of
Applied Psychology 75: 378–385.
54. Treviño, L., and A. Youngblood (1990),
“Bad apples in bad barrels: A causal analysis
of ethical-decision behavior,” Journal of
Applied Psychology 75: 378–385. Also, for a
superb review and discussion of this issue, see
Treviño, L.K., and K.A. Nelson (2011), Man-
aging Business Ethics: Straight Talk About
How to Do It Right, 5th ed. (Hoboken, NJ:
John Wiley & Sons).
55. McLean, B., and P. Elkind (2004), The
Smartest Guys in the Room: The Amazing Rise
and Scandalous Fall of Enron (New York:
Portfolio).
56. Quoted in: “‘Fab’ trader liable in fraud,”
The Wall Street Journal, August 2, 2013.
57. Specifically see: “Disclaimer” on
Tourre’s personal website at https://fabrice-
tourre.com/disclaimer/, accessed June 1, 2017.
58. This Strategy Highlight is based on: Eis-
inger, J. (2017), The Chickenshit Club: Why the
Justice Department Fails to Prosecute Execu-
tives (New York: Simon & Schuster); Eisinger,
J. (2016), “Why the SEC Didn’t Hit Goldman
Sachs Harder,” The New Yorker, April 21; Bel-
kin, D., and R. Copeland (2015), “Hedge-fund
manager Paulson to donate $400 million to Har-
vard,” The Wall Street Journal, June 3; “‘Fab’
trader liable in fraud,” The Wall Street Journal,
August 2, 2013; “The Abacus trial. No longer
fabulous,” The Economist, August 2, 2013; “The
trial of Fabrice Tourre. Not so fabulous,” The
Economist, July 20, 2013; and Smith, G. (2012),
Why I Left Goldman Sachs. A Wall Street Story
(New York: Grand Central Publishing).
59. “‘Fab’ trader liable in fraud,” The
Wall Street Journal, August 2, 2013; “The
Abacus trial. No longer fabulous,” The
Economist, August 2, 2013; “The trial
of Fabrice Tourre. Not so fabulous,” The
Economist, July 20, 2013.
60. Khurana, R. (2007), From Higher Aims
to Hired Hands: The Social Transformation
of American Business Schools and the Unful-
filled Promise of Management as a Profession
(Princeton, NJ: Princeton University Press).
61. Khurana, R., and N. Nohria (2008), “It’s
time to make management a true profession,”
Harvard Business Review, October: 70–77.
62. For a history of the MBA oath and other
information, see: www.mbaoath.org. See also:
Anderson, M. (2010), The MBA Oath: Setting
a Higher Standard for Business Leaders (New
York: Portfolio).
63. www.mbaoath.org.
64. Austin, S., and D. MacMillan (2014, Nov.
18), “Is Uber’s biggest rival itself? A collec-
tion of controversy,” The Wall Street Journal.
65. As quoted in Austin, S., and D. MacMil-
lan (2014, Nov. 18), “Is Uber’s biggest rival
itself? A collection of controversy,” The Wall
Street Journal.
66. “I don’t subscribe to the idea that
the company has an image problem,”
Plouffe said. “I actually think when you
are a disrupter you are going to have a lot
of people throwing arrows.” As quoted
in: Swisher, K. (2014), “Man and Uber
man,” Vanity Fair, December: 1–11.
67. As quoted in: “Uber is facing the biggest
crisis in its short history,” The Economist,
March 25, 2017.
68. In addition to the above sources and
those cited earlier in the chapter, see:
O’Brien, S.A. (2017, June 9), “Arianna
Huffington’s role helping Uber try to
clean up its mess,” CNN, http://money.
cnn.com/2017/06/09/technology/business/
arianna-huffington-uber/index.html; LaF-
rance, A. (2017, Apr. 24), “Uber did what?
A field guide to the company’s ongoing
PR nightmare,” The Atlantic; Neidig, H.
(2017, Apr, 12), “Uber loses public rela-
tions chief,” The Hill, http://thehill.com/
policy/technology/328442-uber-loses-pr-
chief; “PR suicide: Uber’s good intentions,
bad press & the ugly mess,” Business.
com, February 22, 2017, https://www.
business.com/articles/what-to-learn-from-
ubers-public-relations-missteps/; Raman,
M. (2017, Jan. 31), “Why public relations
matter: Uber vs. Lyft,” Benzinga, https://
www.benzinga.com/news/17/01/8973412/
why-public-relations-matter-uber-vs-lyft;
and Hook, L., and H. Kuchler (2017,
Jan. 10), “David Plouffe quits Uber to
join Chan Zuckerberg Initiative,” Finan-
cial Times, https://www.ft.com/content/
b0422bb0-d771-11e6-944b-e7eb37a6aa8e.
69. This myStrategy module is based on:
“The ‘trophy kids’ go to work,” The Wall
Street Journal, October 21, 2008; and
Alsop, R. (2008), The Trophy Kids Grow
Up: How the Millennial Generation Is
Shaking Up the Workplace (Hoboken, NJ:
Jossey-Bass).
70. Survey by CareerBuilder.com.
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447
rot27628_minicase01_447-449.indd 447 12/12/17 03:22 PM
1 / Michael Phelps: The Role of Strategy in
Olympics and Business 448
2 / PepsiCo’s Indra Nooyi: Performance
with Purpose 450
3 / Yahoo: From Internet Darling to
Fire Sale 453
4 / How the Strategy Process Killed
Innovation at Microsoft 456
5 / Apple: The iPhone Turns 10, so
What’s Next? 459
6 / Nike’s Core Competency: The Risky
Business of Creating Heroes 463
7 / Dynamic Capabilities at IBM 466
8 / Starbucks after Schultz: How to Sustain
a Competitive Advantage? 470
9 / Business Model Innovation:
How Dollar Shave Club Disrupted
Gillette 474
10 / Competing on Business Models:
Google vs. Microsoft 476
11 / Can Amazon Trim the Fat at
Whole Foods? 481
MiniCases*
12 / LEGO’s Turnaround: Brick by
Brick 484
13 / Cirque du Soleil: Searching for a
New Blue Ocean 488
14 / Wikipedia: Disrupting the
Encyclopedia Business 491
15 / Disney: Building Billion-Dollar
Franchises 494
16 / Hollywood Goes Global 498
17 / Samsung Electronics: Burned
by Success? 503
18 / Does GM’s Future Lie in China? 509
19 / Flipkart vs. Amazon in India:
Who’s Winning? 512
20 / Alibaba—China’s Ecommerce Giant:
Challenging Amazon? 516
21 / HP’s Boardroom Drama and
Divorce 520
22 / UBS: A Pattern of Ethics
Scandals 524
How to Conduct a Case Analysis
PART 4
*Assignable case analyses for each of these MiniCases are available on Connect.
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MiniCase 1
Michael Phelps: The Role of Strategy in Olympics and Business
MICHAEL PHELPS, nicknamed MP, is the most deco-
rated Olympian of all time. Competing in five Olympic
Games,1 the American swimmer won 28 Olympic med-
als, including 23 gold! In 2000 at the Sydney Olympics,
Phelps at the age of 15 was the youngest U.S. athlete
in almost seven decades. In 2008 at the Beijing Olym-
pics, he won an unprecedented eight gold medals, and
while doing so set seven world records. Eight short days
changed Olympic history and Phelps’ life forever, mak-
ing him one of the greatest athletes of all time. Imme-
diately after the event, The Wall Street Journal reported
that Phelps would be likely to turn the eight gold med-
als into a cash-flow stream of more than $100 million
through several product and service endorsements.
He did not rest on his laurels, however. In subse-
quent Summer Olympics, Phelps added another four
gold and two silver medals in London (2012), and five
gold medals and one silver in Rio de Janeiro (2016).
He became an Olympic superhero against long odds.
Who would have predicted this level of success?
In his youth, Phelps was diagnosed with attention
deficit hyperactivity disorder (ADHD). Doctors pre-
scribed swimming to help him release his energy. It
worked! He excelled at swimming, and the focus may
have helped him succeed in academics too. Between
2004 and 2008, he attended the University of Michigan,
studying marketing and management.
Strategy Formulation
Strategy entered his life at a crucial point. He had
already competed successfully in the 2004 Athens Sum-
mer Olympics, where he won eight medals: six gold
and two bronze. Right after the Athens Games, the then
19-year-old sat down with his manager, Peter Carlisle,
and his long-time swim coach, Bob Bowman, to map out
a detailed strategy for the next four years. The explicit
goal was to win nothing less than a gold medal in each of
the events in which he would compete in Beijing.
Bowman was responsible for training Phelps, getting
him into the necessary physical shape for Beijing and
nurturing the mental toughness required to break Mark
Spitz’s 36-year-old record of seven gold medals won in
the 1972 Munich Olympic Games. Carlisle, meanwhile,
conceived of a detailed strategy to launch MP as a world
superstar during the Beijing Games. While Phelps spent
six hours a day in the pool, Carlisle focused on expos-
ing him to the Asian market, the largest consumer mar-
ket in the world, with a special emphasis on the Chinese
consumer. Phelps’ wide-ranging presence in the real
world was combined with a huge exposure in the virtual
world. Phelps posts and maintains his own Facebook
page, with some 9 million “phans.” He is also a favorite
on Twitter (2.2 million followers), YouTube, and online
blogs, garnering worldwide exposure to an extent never
before achieved by an Olympian. The gradual buildup
of Phelps over a number of years enabled manager
Carlisle to launch him as a superstar right after he won
his eighth gold medal at the Beijing Games. By then,
Phelps had become a worldwide brand.
You might attribute Phelps’ success to his unique
physical endowments: his long thin torso, which reduces
drag; his arm span of 6 feet 7 inches (204 cm), which is
disproportionate to his 6-foot-4-inch (193 cm) height;
Michael Phelps, the most decorated Olympian, turned into an entrepreneur.
©SVEN HOPPE/dpa/Alamy Stock Photo
Frank T. Rothaermel prepared this MiniCase from public sources. This MiniCase
is developed for the purpose of class discussion. It is not intended to be used for
any kind of endorsement, source of data, or depiction of efficient or inefficient
management. All opinions expressed, all errors and omissions are entirely the
author’s. Revised and updated: July 29, 2017. © Frank T. Rothaermel.
448
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his relatively short legs for a person of his height; and
his size 14 feet, which work like flippers due to hyper-
mobile ankles. After all, a successful strategy can be
based on leveraging unique resources and capabilities.
While MP’s physical attributes are a necessary con-
dition for winning, they are not sufficient. Other swim-
mers, like the Australian Ian Thorpe (with size-17 feet)
or the German “albatross” Michael Gross (with an arm
span of 7 feet or 213 cm), also brought extraordinary
resource endowments to the swim meet. Yet neither of
them (or any other person for that matter) won eight
gold medals in a single Olympics or 28 medals overall.
Strategy Implementation
Although Phelps was very disciplined in executing his
meticulously formulated strategy to win Olympic gold
medals, he stumbled in his efforts to monetize his star-
dom outside the pool. Image matters. In 2004, Phelps was
arrested for driving under the influence (DUI). Following
the 2008 Beijing Olympics, a British tabloid published
a photo that showed Phelps using a bong, apparently
smoking marijuana, at a party in South Carolina. After
this incident, Kellogg’s immediately withdrew Phelps’
endorsement contract. After the London 2012 Olympics,
Phelps (then 25) announced his retirement from swim-
ming. After 20 months, he announced he would come out
of retirement. However, just a few months later, in Sep-
tember 2014, Phelps was again arrested for DUI. After
this second arrest, he received a one-year suspended jail
sentence and 18 months of supervised probation. Phelps
also spent 45 days in an in-patient rehab center for alco-
hol abuse in Arizona. USA Swimming, the national gov-
ernance body of his sport, suspended him for six months
from all competitions and from representing the United
States at the 2015 world championships.
Yet Phelps persevered. He promised he had changed
his ways. In the spring of 2015, he announced his
intention to compete at the 2016 Rio Olympics. Subse-
quently, he won five gold medals and one silver there,
making him the most decorated athlete in Olympic his-
tory! There are persistent rumors that Phelps may even
compete at the 2020 Summer Olympics in Tokyo.
Of course, sponsors want to know whether the prom-
ised personal change is real, given that Phelps has made
such promises after his first DUI and then again when
photographed smoking a bong. Phelps assures the pub-
lic that he has been intrinsically motivated to personally
change after the London Olympics. He credits becom-
ing a father (to a boy named Boomer) and spending
time with his fiancée, Nicole Johnson, as the reasons
for becoming at peace with himself and who he is as a
person (rather than living large as a celebrity).
Endorsements and Entrepreneurship
Phelps has shown he has even more reason to keep
his public image clean. He launched his own line of
swimwear, MP, trademarking his nickname as an offi-
cial brand. The line was designed with Aqua Sphere,
a swimming equipment manufacturer. Having grown
up idolizing NBA star Michael Jordan, Phelps hopes
he can do for the public image and marketing of swim-
ming what Jordan, with his Nike sponsorship, did for in
basketball. So while his swim line purrs along, Phelps
continues to sign lucrative endorsement and advertise-
ment deals, including a series of commercials for chip-
maker Intel following the Rio Olympics.
DISCUSSION QUESTIONS
1. Olympians generally do not turn into global phe-
nomena. One reason is that they are highlighted
only every four years; e.g., not too many people
follow competitive swimming or downhill skiing
outside the Olympics. How did Michael Phelps
turn into a global brand?
2. What role did strategy play in Phelps achieving
success in and out of the pool? What general les-
sons can be learned?
3. Which approach to the strategy process did
Phelps, his coach, and manager use? Why was this
approach successful?
4. Phelps was embroiled in a number of controver-
sies outside the pool. What impact did these short-
comings have on his brand value? What do these
incidents tell you about maintaining and increas-
ing brand value over time?
5. What does Phelps need to do if he wants to play
a similar transformative role in the marketing
and sponsoring of swimming as Michael Jordan
achieved in basketball?
Endnote
1. Sydney in 2000; Athens in 2004; Beijing in 2008; London in 2012;
and Rio de Janeiro in 2016.
Sources: “Mark Spitz: Michael Phelps could compete at Tokyo Olympics
in 2020,” Eurosport, July 27, 2017; Jaramillo, C. (2016, Oct. 12), “Michael
Phelps garners marketing opportunities following Rio games,” The Wall Street
Journal, “Michael Phelps confirms he’s aiming to swim at 2016 Olympics,”
The Baltimore Sun, April 15, 2015; “Profile: Michael Phelps—A normal guy
from another planet,” The Telegraph, August 15, 2008; “Now, Phelps chases
gold on land,” The Wall Street Journal, August 18, 2008; and “Michael
Phelps’ agent has been crafting the swimmer’s image for years,” Associated
Press, September 14, 2008.
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1. Human sustainability. PepsiCo’s strategic intent is
to make its product portfolio healthier to combat
obesity by reducing sugar, sodium, and saturated
fat content in certain key brands. It wants to reduce
the salt and fat in its “fun foods” such as Frito-Lay
and Doritos brands, and to include healthy choices
such as Quaker Oats products and Tropicana fruit
juices in its lineup. Nooyi is convinced that if food
and beverage companies do not make their prod-
ucts healthier, they will face stricter regulation and
lawsuits, as tobacco companies did. Nooyi’s goal
is to increase PepsiCo’s revenues from nutritious
foods, substantially as detailed in her 2025 Perfor-
mance with Purpose agenda.3
2. Environmental sustainability. PepsiCo has insti-
tuted various initiatives to ensure that its opera-
tions don’t harm the natural environment. The
“Performance with Purpose is not how we spend the
money we make, it’s how we make the money,” says
PepsiCo CEO Indra Nooyi.1
AS CHIEF EXECUTIVE officer of PepsiCo, Indra
Nooyi is one of the world’s most powerful business
leaders. A native of Chennai, India, Nooyi holds mul-
tiple degrees: a bachelor’s degree in physics, chemis-
try, and mathematics from Madras Christian College;
an MBA from the Indian Institute of Management;
and a master’s degree in public and private manage-
ment from Yale University. Before joining PepsiCo in
1994, Nooyi worked for Johnson & Johnson, Boston
Consulting Group, Motorola, and ABB. Indra Nooyi
has been a regular in Forbes’ Top 20 most powerful
women for the past several years. However, she is not
your typical Fortune 500 CEO: She is known for walk-
ing around the office barefoot and singing—a remnant
from her days in an all-girls rock band in high school.
It should come as no surprise, therefore, that Nooyi
has been shaking things up at PepsiCo, a company with
roughly $63 billion in annual revenues, $165 billion
in stock market valuation, some 264,000 employ-
ees worldwide, and business interests in more than
100 countries. She took the lead role in spinning off
Taco Bell, Pizza Hut, and KFC in 1997. Later, she
masterminded the acquisitions of Tropicana in 1998
and Quaker Oats, including Gatorade, in 2001. When
becoming CEO in 2006, Nooyi declared PepsiCo’s
vision to be Performance with Purpose:
Performance with Purpose means delivering sus-
tainable growth by investing in a healthier future for
people and our planet…. We will continue to build
a portfolio of enjoyable and healthier foods and
beverages, find innovative ways to reduce the use
of energy, water and packaging, and provide a great
workplace for our associates…. Because a healthier
future for all people and our planet means a more
successful future for PepsiCo. This is our promise.2
In particular, Performance with Purpose has three
dimensions:
PepsiCo’s Indra Nooyi: Performance with Purpose
MiniCase 2
Indra Nooyi, chief executive officer of PepsiCo, captures her
strategic leadership with the mantra “Performance with Purpose.”
©Jin Lee/Bloomberg/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended
to be used for any kind of endorsement, source of data, or depiction of
efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: July 1, 2017.
©Frank T. Rothaermel.
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companies. One would focus on beverages (Pepsi,
Gatorade, Tropicana); the other would focus on snack
foods, several of which such as Lay’s and Doritos have
become multibillion-dollar brands. This move would
unlock additional profit potential, the argument goes,
because the well-performing snack food business
would no longer need to subsidize underperforming
beverages. For the time being, Nooyi has decided that
PepsiCo creates more value when the beverage and
snack foods divisions are together in one corporation,
rather than split into two companies.
Although PepsiCo’s revenues have remained more
or less flat over the past few years, investors see sig-
nificant growth potential. Over a five-year period
between 2012 and 2017, PepsiCo has outperformed
Coca-Cola by a relatively wide margin. During this
period, PepsiCo’s normalized stock appreciation was
almost 50 percentage points higher than that of Coca-
Cola (see Exhibit MC2.1). Albeit down from 90 percent
in 2000, soda drinks still accounted for 70 percent of
Coca-Cola’s total revenues, while PepsiCo has been
much more diversified. With better than expected
financial results, Nooyi stands vindicated after years
of criticism. Despite opposition, she stuck by her
strategic mantra for PepsiCo—Performance with
Purpose—and appears to be reaping the rewards.
DISCUSSION QUESTIONS
1. What grade would you give PepsiCo CEO Indra
Nooyi for her job performance as a strategic
leader? What are her strengths and weaknesses?
Where would you place Nooyi on the Level-5 pyr-
amid of strategic leadership (see Exhibit 2.2), and
why? Support your answers.
2. The first few years after Indra Nooyi took over as
PepsiCo’s CEO and implemented Performance
with Purpose, the company underperformed
archrival Coca-Cola Co. by a wide margin. What
should a strategic leader do if his or her vision
does not seem to lead to an immediate (financial)
competitive advantage? What would be your top
three recommendations? Support your arguments.
3. Do you agree with Indra Nooyi’s philosophy that
“performance and purpose are intimately linked
and you can’t do one without the other”? Support
your arguments. Apply the people, planet and prof-
its model of sustainable strategy (see Exhibit 5.9).
4. PepsiCo’s investors require the company to grow
about 5 percent or $3.5 billion a year. PepsiCo’s
company has programs in place to reduce water
and energy use, increase recycling, and promote
sustainable agriculture. The goal is to transform
PepsiCo into a company with a net-zero impact
on the environment. Nooyi believes that young
people today will not patronize or want to work for
a company that does not have a strategy that also
addresses ecological sustainability.
3. The whole person at work. PepsiCo wants to cre-
ate a corporate culture in which employees do not
“just make a living, but also have a life.” Nooyi
argues that this type of culture allows employees to
unleash both their mental and emotional energies.
PepsiCo’s vision of Performance with Purpose
acknowledges more than the importance of the cor-
porate social responsibility and stakeholder strategy.
Nooyi is convinced that companies have a duty to soci-
ety to “do better by doing better.” She subscribes to a
triple-bottom-line approach to competitive advantage,
which considers not only economic but also social and
environmental performance. Nooyi declares that the
true profits of an enterprise are not just “revenues minus
costs” but “revenues minus costs minus costs to soci-
ety.” Problems such as pollution or the increased cost of
health care to combat obesity impose costs on society
that companies typically do not bear (externalities). As
Nooyi sees it, the time when corporations can just pass
on their externalities to society is nearing an end.
The external environment in the soft drink industry,
however, has become much more challenging. Since
their peak in the late 1990s, sales of carbonated soft
drinks dropped some 25 percent. Consumption of bot-
tled water, in contrast, surpassed the consumption of
carbonated soft drinks in 2016. Energy drinks such as
Monster or Red Bull are continuing to grow by double
digits in the United States and overseas, making such
products one of the hottest categories in the soft drink
industry. Moreover, a wide range of governments, from
municipalities such as Berkeley or Philadelphia in the
United States to entire nation states such as France and
Norway, now levy sugar taxes on soda drinks, making
them much more expensive for consumers.
PepsiCo’s archrival Coca-Cola Co. continues to
concentrate on its core business in soda and other non-
alcoholic beverages. The full-calorie Coke remains
America’s most popular soda, as more and more peo-
ple abandon artificially sweetened sodas (number two
is PepsiCo’s full-calorie cola and number three is Diet
Coke). To enhance PepsiCo’s strategic focus, critics of
Nooyi propose splitting PepsiCo into two standalone
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rot27628_minicase02_450-452.indd 452 11/22/17 08:43 PM
3. “Performance with Purpose: 2025 Agenda,” https://www.pepsico.
com/docs/album/sustainability-reporting/pepsico_sustainability_
report_2015_and_-2025_agenda , accessed July 1, 2017.
Sources: “Performance with Purpose: 2025 Agenda,” https://www.
pepsico.com/docs/album/sustainability-reporting/pepsico_sustainability_
report_2015_and_-2025_agenda , accessed July 1, 2017; “Coca-Cola’s
new boss tries to move beyond its core product,” The Economist, March 18,
2017; Safian, R. (2017, Jan. 9), “How PepsiCo’s Indra Nooyi is steering
the company toward a purpose-driven future,” Fast Company; Esterl, M.
(2015, July 9), “PepsiCo’s outlook for year brightens,” The Wall Street
Journal; Esterl, M. (2015, Mar. 6), “Soft drinks hit 10th year of decline,”
The Wall Street Journal; Esterl, M. (2015, Feb. 27), “Monster Beverage
shares hit high on strong overseas growth,” The Wall Street Journal, Safian,
K. (2014, Oct. 14), “It’s got to be a passion, it’s gotta be your calling: Indra
Nooyi,” Fast Company, October 14; “As Pepsi struggles to regain market
share, Indra Nooyi’s job is on the line,” The Economist, May 17, 2012;
“Should Pepsi break up?” The Economist, October 11, 2011; “PepsiCo
wakes up and smells the cola,” The Wall Street Journal, June 28, 2011;
“Pepsi gets a makeover,” The Economist, March 25, 2010; “Keeping cool
in hot water,” BusinessWeek, June 11, 2007; “The Pepsi challenge,” The
Economist, August 17, 2006; and “PepsiCo shakes it up,” BusinessWeek,
August 14, 2006.
top line, however, remained flat for the past few
years. Where would future growth for PepsiCo
come from?
5. Some activist investors are putting pressure on
Indra Nooyi to split PepsiCo into two standalone
companies, with one focusing on beverages (Pepsi,
Gatorade, Tropicana); the other would focus on
snack foods (such as the Frito-Lay brand). What is
the idea behind this corporate strategy? Do you think
this move would add value for shareholders? For
consumers? Other stakeholders? Why or why not?
Endnotes
1. As quoted in Safian, K. (2014, Oct. 14), “It’s got to be a passion, it’s
gotta be your calling: Indra Nooyi,” Fast Company.
2. www.pepsico.com/Purpose/Overview.html.
EXHIBIT MC2.1 / Normalized Stock Performance of PepsiCo and Coca-Cola Co., June 2012 to June 2017
2013 2014 2015 2016 2017
–5%
5%
15% 14.72%
25%
35%
45%
55%
65% 63.44%
PepsiCo Price % Change Jul 30 ’17 63.44%
Coca-Cola Price % Change Jul 30 ’17 14.72%
SOURCE: Depiction of publicly available data.
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MiniCase 3
Marissa Mayer, CEO Yahoo, 2012–2017.
©ROBYN BECK/AFP/Getty Images
WHEN SHE WAS APPOINTED CEO OF YAHOO IN
2012, Marissa Mayer had just one job: Turn the com-
pany around. Yahoo was once the go-to internet leader,
a web portal with e-mail and finance, sports, social
media, and video sharing services. Advertisers loved
it. At the height of the dot-com bubble in the spring
of 2000, Yahoo was valued at more than $125 billion!
In 2017, Yahoo’s core internet business was sold to
Verizon for a mere $4.5 billion. What had happened?
By the time Marissa Mayer got the CEO job,
Yahoo’s market cap stood at $19 billion. The once lead-
ing internet company had lost some 85 percent of its
market value. Yahoo was in deep trouble as indicated
by a high CEO turnover: Mayer was the seventh CEO
in less than five years. By the time she sold Yahoo to
Verizon five years later, Yahoo’s market cap stood at
$53 billion. How did she almost triple the firm’s mar-
ket cap? And what explains the difference between
the over $50 billion market cap in 2017 and the sale
price of less than $5 billion to Verizon? Let’s answer
these questions one at a time. We begin by looking at
Marissa Mayer’s background and how she attempted to
turn Yahoo around.
Pre-Yahoo
Mayer grew up in Wausau, Wisconsin, but took her
higher education and built her career in California’s
Silicon Valley. She entered Stanford University in
1993, majoring in symbolic systems, a discipline that
combines cognitive sciences, artificial intelligence,
and human–computer interaction. Still at Stanford,
Mayer earned a master’s degree in computer science.
On graduation in 1999, she declined over a dozen job
offers, ranging from prestigious consulting firms to
top-tier universities. Instead she went to a garage that
housed a handful of employees for a small startup just
a few months old. It was called Google.
Google’s 20th hire and its first female engineer,
Mayer became a star. With a superior skill set and
strong work ethic, she rose quickly to the rank of vice
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended
to be used for any kind of endorsement, source of data, or depiction of
efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: June 1, 2017.
©Frank T. Rothaermel.
president. She helped develop many of Google’s best
known features: Gmail, images, news, and maps. In
particular, she designed the functionality and unclut-
tered look and feel of Google’s iconic search site.
Mayer is known for her attention to detail, her com-
mitment of time, and her desire to provide the very
best user experience possible, putting products before
profits. She maintains that if you build the best prod-
ucts possible, profits will come. No doubt Mayer’s
pedigree at Google appealed to the Yahoo board. She
was deeply involved in everything that Google had
done right. And she was ready.
At Yahoo
Mayer’s first acts at Yahoo revolved around mission,
culture, and cash. She developed a new mission for
Yahoo: From Internet Darling to Fire Sale
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rot27628_minicase03_453-455.indd 454 11/22/17 08:43 PM
another in the same team. Managers cynically traded
team members to fill their quotas. Political infighting
increased.
To raise cash, Mayer sold part of Yahoo’s owner-
ship stake in Alibaba, the Chinese ecommerce com-
pany, for more than $6 billion. She then spent about
$2 billion acquiring more than three dozen tech
ventures, including paying a bit over $1 billion for
microblogging and social networking site Tumblr and
$640 million for video ad company BrightRoll. The
acquisitions filled gaps in product line and brought in
new engineering talent (so-called “aqui-hires”).
To turn around Yahoo, Mayer identified four stra-
tegic growth areas for investing significant resources
and attention: mobile advertising, video, native adver-
tising, and social media.1 Mayer came up with the
catchy phrase for the four areas: MaVeNS (= mobile
advertising, video, native advertising, and social
media), which she enjoyed using during investor pre-
sentations and earnings calls.
Failed Turnaround at Yahoo
After five years on the job, it became apparent that
Yahoo would no longer be able to compete against
Google and Facebook in online advertising. Once a
leader in online advertising in the Web 1.0 portal world,
Yahoo had fallen to third place well before Mayer took
charge. Yahoo once owned the user experience in the
early days of the internet for desktop users. But much
has changed. In the early days, the internet was cum-
bersome to use. Yahoo provided a web portal that
solved this problem for millions of users worldwide. It
was their first stop once they logged in. With success-
ful Yahoo products like Yahoo Mail, Yahoo Finance,
and Yahoo Sports, many users spent their entire time
online at Yahoo. In the first decade of the internet, this
made Yahoo extremely attractive for online advertisers.
By 2012, however, the internet had undergone a
dramatic shift from the Web 1.0 on personal comput-
ers to a Web 2.0 on mobile devices. The mobile experi-
ence, and with it mobile advertising, had become the
new frontier. The difficulty that Mayer encountered as
the new Yahoo CEO was that Google and Facebook
had moved much faster and more successfully into the
mobile space and thus captured the lion share of adver-
tising. Google had long been the undisputed leader in
online search due to its superior page rank algorithm
technology over Yahoo’s older and less effective key-
word-based searches. Since 2009, Yahoo’s searches
Yahoo—to make the world’s daily habits more inspir-
ing and entertaining—to help reinvigorate Yahoo’s
employees and get its customers excited again. Mayer’s
mission attempted to inspire Yahoo’s employees to
resume leadership in online advertising. To retain
existing talent and restore morale, she also had to
sell her workers on the new mission. She did so by
sharing this mantra with them via tweets and other
means: People then products then traffic then rev-
enue. Employees understood they were the start of
the transformation. To put Yahoo’s new mission into
action, she also worked to rejuvenate Yahoo’s bureau-
cratic culture and engaged in more open and frequent
communication, with weekly FYI town-hall meet-
ings where she and other executives provided updates
and fielded questions. All employees were expected
to attend and encouraged to participate in the Q&A.
Questions were submitted online during the week, and
the employees voted for which questions executives
should address.
Mayer also took on Yahoo’s organizational culture.
Yahoo had become overly bureaucratic and lost the
zeal characteristic of high-tech startups. Many Yahoo
employees worked from home. For those who worked
in the office, weekends began Thursday afternoons,
leaving empty parking garages at Yahoo’s campus in
Sunnyvale, California. In response, Mayer withdrew
the option to work remotely. All of Yahoo’s 12,000
employees would have to come to the office. Her
rationale was that working in the same shared space
encourages collaboration, teamwork, and the creative
spark to foster innovation. She moved out of her cor-
ner office and instead worked in a cubicle among other
Yahoo rank-and-file employees. To ease the transition
into now being required to work on the Yahoo campus
in Sunnyvale, California, Mayer ordered a renovation
and upgrade to Yahoo’s cafeteria, making gourmet
meals—breakfast, lunch, and dinner—available free
for all Yahoos.
Mayer also implemented other less-than-popular
changes. Where before Yahoos enjoyed a casual work
culture, now they faced a stacked ranking system of
employee performance. Managers had to grade their
direct reports along a bell curve, with a fixed percent-
age as “underperforming.” Team leaders were now to
rank their employees in defined groups: 10 percent in
“greatly exceeds,” 25 percent in “exceeds,” 50 percent
in “achieves,” 10 percent in “occasionally misses,”
and 5 percent in “misses.” Unintended consequences
ensued. High performers refused to work with one
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DISCUSSION QUESTIONS
1. In an attempt to turn around Yahoo, Marissa Mayer
defined a new mission for the internet company.
How do strategic leaders such as Mayer develop
and implement a mission for their company to
achieve strategic goals? Why is an inspiring mis-
sion important?
2. What were some of the major changes Mayer
implemented to turn Yahoo around? How do you
evaluate them? In hindsight, what should Mayer
have done differently, if anything? Explain.
3. What grade would you give Mayer for her job
performance as strategic leader? What were her
strengths and her weaknesses?
4. Where would you place her on the Level-5 pyra-
mid of strategic leaders (see Exhibit 2.2) and why?
Support your answers.
5. Do you believe the $230 million in total compen-
sation was justified for Mayer’s efforts? Why or
why not? Explain.
Endnote
1. Native advertising is online advertising that attempts to present itself
as naturally occurring editorial content rather than a search-driven paid
placement.
Sources: Detailed background on Yahoo, Marissa Mayer, Google, and
the online advertising and search industry is presented in the following
books: Carlson, N. (2015), Marissa Mayer and the Fight to Save Yahoo!
(New York: Hachette Book Group); Thiel, P. (2014), Zero to One. Notes on
Startups or How to Build the Future (New York: Crown Business); Edwards,
D. (2012), I’m Feeling Lucky: The Confessions of Google Employee Number
59 (New York: Houghton Mifflin Harcourt); and Levy, S. (2011), In the
Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon
& Schuster). Other sources include: Seetharaman, D. (2017, Apr. 25),
“Yahoo’s Marissa Mayer to reap $187 million after Verizon deal,” The Wall
Street Journal, Knutson, R. (2017, Feb. 21), “Why Verizon decided to stick
with Yahoo deal after big data breaches,” The Wall Street Journal, Goel,
V., and M.J. de la Merced (2016, July 24), “Yahoo’s sale to Verizon ends an
era for a web pioneer,” The New York Times, “Yahoo to spin off remaining
Alibaba stake,” The Wall Street Journal, January 28, 2015; “Yahoo sales,
profit gains may allay Mayer critics,” The Wall Street Journal, October 22,
2014; Jackson, E. (2014, Oct. 19), “Yahoo CEO set to refresh turnaround
plan,” The Wall Street Journal, “Alibaba IPO to give Yahoo windfall,”
The Wall Street Journal, September 19, 2014; “How do you solve a problem
like Marissa?” Forbes, July 29, 2014; “Is Alibaba or SoftBank about to
buy Yahoo?” Forbes, July 23, 2014; “Mayer culpa,” The Economist, March
2, 2013; “A makeover made in Google’s image,” The Wall Street Journal,
August 9, 2012; “Google’s Marissa Mayer,” Vogue, March 28, 2012; and
“Yahoo Annual Reports” (various years), www.sec.gov.
were powered by Microsoft’s Bing. In addition,
newer social media platforms such as Facebook cap-
tured online users’ attention and activities. With these
changes, Google and Facebook started to dominate dig-
ital advertising. In 2016, Google captured 43 percent of
all ad dollars spent, and Facebook captured 15 percent.
In online advertising, Yahoo only had 3 percent market
share, which had been declining consistently over time.
To complicate matters for CEO Mayer, Yahoo
experienced two major data hacks under her watch. In
2013, data for more than 1 billion accounts were sto-
len, the largest corporate hack on record. A year later,
Yahoo disclosed a second hack, this time affecting
some 500 million users. As a result, Yahoo required
all of its users to reset their passwords; many did not
return. In the end, Verizon acquired Yahoo’s core
internet business for $4.5 billion.
Why did Verizon acquire Yahoo’s core internet
business? Verizon’s core business as a wireless ser-
vice provider is maturing, and the company has ambi-
tious plans to compete with Google and Facebook
in online advertising. Verizon is adding the Yahoo
acquisition to its prior purchase of the online media
company AOL in 2015 for $4.4 billion. Verizon has
more than 110 million wireless subscribers. It hopes
to build a portfolio of internet properties by merging
AOL and Yahoo to offer news, sports, and finance
against which to sell better targeted digital advertis-
ing. After the sale of Yahoo’s core business to Verizon,
Yahoo’s shareholders continue to own the investments
made earlier by Yahoo in the Chinese ecommerce
company Alibaba as well as in Yahoo Japan, valued
jointly at more than $40 billion. Verizon retained the
name Yahoo for its web properties, while the “origi-
nal Yahoo” renamed itself Altaba (a portmanteau of
“Alternate” and “Alibaba”).
Although Marissa Mayer failed to turn Yahoo
around, she did create shareholder value when com-
pared to the dire situation Yahoo was in when she took
the helm. Indeed, by the time Yahoo sold its core busi-
ness to Verizon, the internet company’s market value
had almost tripled. Mayer also did well for herself:
She departed Yahoo with some $230 million in total
compensation for the five years as CEO.
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How the Strategy Process Killed Innovation at Microsoft
to match that of other tech companies such as Google,
Apple, and Amazon because they created entirely
new areas of computing from scratch, and as a con-
sequence, their stock prices have soared. One reason
Microsoft’s fell and flattened in the 2000s was that
it saw its mission differently. Protecting its existing
portfolio, Microsoft largely failed to commercialize
any category-defining products or services. Why? The
answer: Microsoft’s strategy process killed innovation!
Top-Down Strategy Process Killed
Bottom-Up Strategic Initiatives at Microsoft
Microsoft actually came up with some major break-
throughs, but failed to successfully commercialize
them. The root of the problem seemed to lie with
Microsoft’s top-down strategy process. Once Win-
dows became the industry standard in 1990, Micro-
soft’s strategy was defensive: Any new product or
extension had to strengthen the existing Windows-
Office franchise; if not, it would be “killed.” Here
are some great products and services that Microsoft
invented, but never commercialized.
SINCE MICROSOFT LAUNCHED Windows 3.0 in
1990, it has dominated the industry for PC operating
system (OS) software with a 90 percent market share.
Microsoft’s huge installed base of Windows operating
systems on PCs and its long-term relationships with
original equipment manufacturers (OEMs), such as
Dell, HP, and Lenovo, create tremendous entry bar-
riers for newcomers. Intel’s semiconductor chips are
the perfect complement to Microsoft’s operating sys-
tem. Every time Microsoft releases a new operating
system, demand for Intel’s latest microprocessor goes
up, because new operating systems require more com-
puting power. Because of the complementary nature
of their products, Microsoft’s and Intel’s alternating
advances have created a virtuous cycle, benefiting
from network effects. The successful combination of
Microsoft’s Windows and Intel’s processors has pro-
duced the Wintel (a portmanteau of Windows and
Intel) standard in the PC industry. By 1999, Microsoft
was the most valuable company on the planet.
Fast-forward to 2017, two years after Microsoft
released Windows 10, its latest version of the ubiqui-
tous operating system. For the past quarter century,
Microsoft’s business model was to establish and main-
tain the dominance of the Wintel standard in the PC
industry. With this standard, Microsoft made money
off consumer and business application software such as
its Office Suite. Microsoft remains hugely profitable:
With some $85 billion in annual revenues in 2016, it
generated over $20 billion in profits! Windows and
Office still generate about 40 percent of Microsoft’s
total revenues and 75 percent of profits. The gross margin
of “classic” Office is 90 percent, while the new cloud-
based Office 365 only has a 50 percent profit margin.
Although Microsoft is highly profitable, its stock
price was flat through the 2000s, trailing the tech-
heavy NASDAQ-100 by a wide margin. This started
to change even before Satya Nadella became CEO in
2014, but under Nadella’s strategic focus of “mobile
first, cloud first,” Microsoft’s stock market valuation
has appreciated rapidly in recent years, in fact, more
than doubling over a recent five-year period. Yet
Microsoft is having to work hard for its performance
MiniCase 4
Zune, Microsoft’s (failed) digital media player.
©David Howells/Corbis/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended to
be used for any kind of endorsement, source of data, or depiction of efficient or
inefficient management. All opinions expressed, all errors and omissions are
entirely the author’s. Revised and updated: July 22, 2017.©Frank T. Rothaermel.
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rot27628_minicase04_456-458.indd 457 12/06/17 03:19 PM
ecosystem tightly integrating software, hardware, and
services. In 2005, during an employee meeting, one
Microsoft engineer asked Steve Ballmer whether
Microsoft should compete with Apple’s iPod and
iTunes. In a sarcastic tone, Ballmer asked the room
for a show of hands, “How many people think Micro-
soft is in the business of selling music?”1 Not surpris-
ingly, none of the intimidated Microsoft employees
raised their hands. More than a year later, Microsoft
introduced its own digital music player, the Zune (see
photo above), which flopped.
TABLET COMPUTERS. Long before Apple launched the
iPad in early 2010, the inventor of Microsoft’s highly
successful Xbox gaming console had developed a tablet
computer called the Courier. The Courier was a fully
functioning tablet that folded like a book and allowed
users to draw on a touchscreen, among other features.
Rather than compete against Apple, Ballmer informed
the Courier team that he was pulling the plug on the tab-
let to redirect resources to the next version of Windows,
the launch for which was more than two years away. To
add insult to injury, it was Windows 8, Microsoft’s failed
attempt to straddle desktop and mobile computing.
In the meantime, Apple had sold more than
250 million iPads, which have been instrumental in
strengthening Apple’s ecosystem. This ecosystem
allows Apple to be the world’s leader in mobile com-
puting. (One other mobile computing invention that
Microsoft killed was wearable devices such as smart
watches.)
OFFICE FOR IPHONE. As soon as Apple released
the iPhone in 2007, Microsoft engineers tweaked the
company’s PC-based Office Suite to run on the Apple
mobile device. Ballmer shut the project down—he had
a visceral disdain for Apple, once stomping on an
iPhone in an all-employee meeting when he saw a sub-
ordinate using the popular Apple device—telling the
group that Microsoft needed to focus its resources on
Windows 8.
In the meantime, Apple has garnered over
$1.2 billion in iPhone sales since it was launched in
2007, making it one of the most successful products
ever. In 2017, the average price for an iPhone was
close to $700. Apple’s 10th anniversary phone, the
iPhone X, is the first smartphone to cross the $1,000
price threshold. Although Apple holds some 15 percent
market share in the smartphone industry, it captures
more than 90 percent of the profits. A whopping two-
thirds of Apple’s annual revenues of some $220 billion
is from iPhone sales, surely sufficient to have paid a
handsome licensing fee for a Microsoft Office Suite
for the iPhone.
ONLINE SEARCH. Google is now the leading search and
online advertising company, with close to $100 billion
in annual revenues and a market capitalization of
some $700 billion in 2017, making it one of the most
valuable companies globally. What haunts former
Microsoft CEO Steve Ballmer is that Microsoft had its
own working prototype of a Google forerunner, called
Keywords, long before Google’s ascent.
Scott Banister, then a student at the University of Illi-
nois at Urbana-Champaign, had come up with the idea
of adding paid advertisements to internet searches. He
quit college and drove his Geo hatchback to the San
Francisco Bay Area to start Keywords, later joining an
online ad company called LinkExchange. In 1998, inci-
dentally the year Google was founded, Microsoft bought
LinkExchange for some $265 million. The newly formed
Microsoft online search team urged top managers to con-
tinue to invest in the burgeoning online search technol-
ogy. Instead, Microsoft executives shut down the project
in 2000 because they did not see a viable business model
in it. One team member actually approached Ballmer
and explained that he thought Microsoft was making a
huge mistake. But Ballmer said he wanted to manage
through delegation and would not reverse a decision
made by managers three levels below him. This decision
put an end to Microsoft’s first online advertising venture.
In 2003, Microsoft got a second chance to enter the
online advertising business when some mid-level engi-
neers proposed buying Overture Services, an innovator
in combining internet searches with advertisements.
This time, Ballmer, joined by Microsoft co-founder
Bill Gates, decided not to pursue the idea because
they thought Overture was overpriced. Shortly there-
after, Yahoo bought Overture for $1.6 billion. In 2008,
Ballmer offered to buy Yahoo for close to $50 billion
to help his company gain a foothold in the paid-search
business where Google rules. Fortunately for Micro-
soft, the offer was turned down by Yahoo, which was
sold for $4.5 billion to Verizon in 2017.
Having missed two huge opportunities to pur-
sue promising strategic initiatives that emerged from
lower levels within the firm, Microsoft has been play-
ing catch-up in online search and advertising ever
since. In the summer of 2009, after spending billions
of dollars and being about a decade late, it launched its
own search engine, Bing. Industry pundits joked that
Bing is an acronym for “Because It’s Not Google.”
PORTABLE MUSIC PLAYER. In 2001, Apple launched
the iPod, a portable music player, with which the floun-
dering company’s resurgence began. This was fol-
lowed up in 2003 by the launch of iTunes Music Store
with 200,000 songs at 99 cents each. The iPod and
iTunes laid the foundation of Apple’s hugely successful
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rot27628_minicase04_456-458.indd 458 12/06/17 03:19 PM
is allowing Microsoft to offer competitively matched
experiences across consumers’ platform of choice.3
Moreover, Nadella has created a culture in which
the company manages a full stack of hardware,
software, and data centers, and where bottom-up innova-
tion appears to be embraced. In fact, failure is accepted
as part of that process. Microsoft has created prototype
labs so new ideas can be developed and tested, and
if necessary, “to fail faster.” In 2017, The Economist
proclaimed that Microsoft has indeed transformed its
culture for the better, but that getting cloud computing
right remains a hard thing to do.
DISCUSSION QUESTIONS
1. Describe the strategic management process at
Microsoft under CEO Steve Ballmer (2000–2014).
How were strategic decisions made? What were the
strengths and weaknesses of this approach? Explain
in detail.
2. Although Microsoft invented some promising com-
puting breakthroughs, and often before competitors,
why did Microsoft fail to successfully commercialize
them?
3. Why is it so difficult for CEOs of large and suc-
cessful companies such as Microsoft to balance
exploitation—applying current knowledge to
enhance firm performance in the short term—with
exploration—searching for new knowledge that
may enhance a firm’s future performance? What
are the trade-offs? How could they be reconciled?
4. In contrast, what can you infer from information
in the case about the current design of Micro-
soft’s strategy process under Microsoft CEO Satya
Nadella, who started in 2014?
5. What advice would you give Nadella in his current
efforts?
Endnotes
1. Quote drawn from: “Next CEO’s biggest job: Fixing Microsoft’s
culture,” The Wall Street Journal, August 25, 2013.
2. Quote drawn from: “Microsoft bid to beat Google builds on a his-
tory of misses,” The Wall Street Journal, January 16, 2009.
3. Welch, C. (2017), “The biggest announcements from Microsoft’s
Build event,” The Verge, May 11; Warren, T. (2017), “Microsoft’s next
mobile strategy is to make iOS and Android better,” The Verge, May
11; Lopez, M. (2016), “7 reasons to give Microsoft’s strategy another
look,” Forbes, April 16.
Sources: “Among the iPhone’s biggest transformations: Apple itself,” The
Wall Street Journal, June 20, 2017; “What Satya Nadella did at Microsoft,”
The Economist, March 16, 2017; “Opening Windows,” The Economist, April
4, 2015; “Next CEO’s biggest job: Fixing Microsoft’s culture,” The Wall
Street Journal, August 25, 2013; “Microsoft bid to beat Google builds on a
history of misses,” The Wall Street Journal, January 16, 2009; and Microsoft
annual reports (various years).
CLOUD-BASED OFFICE SOFTWARE. Long before cloud-
based computing took off, Microsoft in 2000 devel-
oped a fully functioning suite of software applications
for the web including an Office-type word-processing
software called NetDocs. This project was discontin-
ued in 2001 because Ballmer feared it would canni-
balize sales of the “classic” Office suite. This opened
the door for Google to offer cloud-based computing
applications such as Google Docs, Google Slides, and
Google Sheets, which with Google Drive and Gmail
make up the core of Google’s cloud-based computing
services. These in turn established Google Chrome as
the dominant web browser and helped Google’s Android
become the leading mobile operating system with some
80 percent market share. In contrast, Microsoft’s Win-
dows has less than 1 percent market share in mobile
computing.
CAR SOFTWARE. In the early 2000s, dozens of Micro-
soft engineers developed—on their own time—car
software that allowed drivers to use online maps, have
e-mails translated to voice and read to them, as well
as play digital music. Ballmer shut the project down,
arguing that Microsoft—one of the most cash-rich
companies on the planet—could not afford another
big bet at the moment.
Today, Tesla is as much a software and sustainable
energy company as it is a car company, with a market
cap of more than $60 billion. Both Tesla and Google
are proving that driverless cars (all based on software
and sensors) are viable within a few years and promise
to be a multibillion-dollar industry.
While still CEO, Ballmer admitted problems
in Microsoft’s strategic management process—to
a degree: “The biggest mistakes I claim I’ve been
involved with are where I was impatient—because
we didn’t have a business yet in something, we should
have stayed patient.”2 Ballmer, who became Micro-
soft’s CEO in 2000, was replaced in 2014 by Satya
Nadella. Under Nadella, Microsoft has made strides in
reinventing itself with a “mobile first, cloud first” strat-
egy. Can Microsoft once again innovate successfully?
Microsoft’s strategy often gets its most critical look
when it holds its developers’ conference and announces
new initiatives. Even though the jury may still be out
for the long term, in recent years Microsoft has been
getting much better press, even as its stock evalua-
tions rise. Pundits applaud how Microsoft is releas-
ing, fixing, and refining products like a modern cloud
company. The company has broken free of Windows
platforms and gone to universal availability, some-
times jumping from device to device. And it has even
found new ways to provide iOS and Android apps. In
short, it appears its cloud first, mobile first approach
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Apple: The iPhone Turns 10, so What’s Next?
Nokia, and BlackBerry, struggle or go out of business?
The short answer is: Apple had a better strategy. But this
raises the question: What is a good strategy? A good strat-
egy is more than a mere goal or a company slogan. A good
strategy defines the competitive challenges facing an orga-
nization through a critical and honest assessment of the
status quo. A good strategy also provides an overarching
approach (policy) on how to deal with the competitive
challenges identified. Last, a good strategy requires effec-
tive implementation through a coherent set of actions.
A good strategy, therefore, consists of three elements:2
1. A diagnosis of the competitive challenge.
2. A guiding policy to address the competitive challenge.
3. A set of coherent actions to implement the firm’s
guiding policy.
IN 2017, THE 10TH ANNIVERSARY of the iconic
iPhone, Apple became the first company whose stock
market valuation crossed the $800 billion threshold,
making it the most valuable company of all time.1
Many expect Apple to be also the first company that
reaches a stock market valuation of $1 trillion! Some
20 years earlier, Apple would likely have gone bankrupt
if archrival Microsoft (which enjoyed the same position
with a valuation of $615 billion in December 1999) had
not invested $150 million in Apple.
Apple got to where it is today by implementing a
potent competitive strategy. That strategy, conceptual-
ized by co-founder Steve Jobs, combines innovation in
products, services, and business models. From near-
bankruptcy in 1997, Apple’s revitalization really took
off in 2001 (see Exhibit MC5.1) when it introduced the
iPod, a portable digital music player, the same year it
opened its first retail stores. Apple’s stores earn the high-
est sales per square foot of any retail outlets, including
luxury stores such as jeweler Tiffany & Co. and LVMH,
purveyor of fine handbags and other luxury goods.
In 2003, Apple soared even higher when it opened
the online store iTunes. Apple didn’t stop there. In 2007,
the company revolutionized the smartphone market with
the introduction of the iPhone. Just three years later,
Apple created the tablet computer industry by intro-
ducing the iPad, thus beginning to reshape the publish-
ing and media industries. Further, for each of its iPod,
iPhone, and iPad lines of businesses, Apple followed up
with incremental product innovations that extended each
product category, culminating in the 10th anniversary
edition of the iPhone launched in 2017. By combining
tremendous brainpower, intellectual property, and iconic
brand value, Apple has enjoyed dramatic increases in
revenues, profits, and stock market valuation.
A Good Strategy
Why was Apple so successful? Why did Microsoft’s once
superior market valuation evaporate? Why did Apple’s
competitors, such as Sony, Dell, Hewlett-Packard (HP),
MiniCase 5
At Apple’s new headquarters in Cupertino, California, the futuris-
tic building emphasizes open spaces with plenty of natural light to
allow for random encounters among employees to foster creativ-
ity and innovation. The building, reminiscent of a sci-fi spaceship,
cost an estimated $5 billion, making it the most expensive office
space built. In front, Tim Cook, CEO Apple.
©JOSH EDELSON/AFP/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended
to be used for any kind of endorsement, source of data, or depiction of
efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: July 29, 2017.
©Frank T. Rothaermel.
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460 MINICASE 5 Apple: The iPhone Turns 10, so What’s Next?
rot27628_minicase05_459-462.indd 460 11/22/17 08:42 PM
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product and business-model innovations, executed at
planned intervals. These actions allowed Apple to cre-
ate a string of temporary competitive advantages (see
Exhibit MC5.1). Taken together, this allowed Apple
to sustain its superior performance for over a decade,
making it the most valuable company on the planet in
the process.
Past performance, however, is no guarantee of future
performance. Microsoft was once the most valuable
company in the world but has since struggled to keep
up with Apple. At the same time, Microsoft, as well as
Google, Samsung, Amazon, and others, are working
hard to neutralize Apple’s competitive advantage.
The trillion-dollar question is whether Apple can
continue to maintain a competitive advantage in the
face of increasingly strong competition and rapidly
changing industry environments. In both mobile pay-
ment systems (Apple Pay launched in 2014) and music
streaming (Apple Music launched in 2015), Apple was
a late mover. The Apple Watch, introduced in 2015, is
the first new product category Apple launched since
the iPad in 2010. Although Apple continues to capture
over 90 percent of profits in the smartphone industry,
more than 60 percent of Apple’s $220 billion revenue
comes from the iPhone. Moreover, China accounts for
more than 20 percent of Apple’s total revenues, a mar-
ket that is becoming more and more volatile for the
Cupertino, California, tech company. These are press-
ing issues that Apple CEO Tim Cook needs to address
in order to sustain Apple’s competitive advantage.
DISCUSSION QUESTIONS
1. Explain Apple’s success over the past decade rela-
tive to its main competitors. Think about which
industries it has disrupted and how.
2. Is Apple’s success attributable to industry effects,
firm effects, or a combination of both? Explain.
3. What are the greatest challenges Apple is facing?
Detail them by internal weaknesses and external
threats. How can Apple transform internal weak-
nesses into strengths, and external threats into
opportunities?
4. Apply the three-step process for developing a
good strategy outlined above (diagnose the com-
petitive challenge, derive a guiding policy, and
implement a set of coherent actions) to Apple’s
situation today. Which recommendations would
you have for Apple to outperform its competitors
in the future? Be specific.
THE COMPETITIVE CHALLENGE. First, consider the
diagnosis of the competitive challenge. Above, we
briefly traced Apple’s renewal from the year 2001,
when it hit upon the product and business-model inno-
vations of the iPod/iTunes combination. Before that,
Apple was merely a niche player in the desktop-com-
puting industry and struggling financially. Steve Jobs
turned the sinking company around by focusing on only
two computer models (one laptop and one desktop) in
each of two market segments (the professional mar-
ket and the consumer market) as opposed to dozens of
non-differentiated products within each segment. This
streamlining of its product lineup enhanced Apple’s
strategic focus. Even so, the outlook for Apple was
grim. Jobs believed that Apple, with less than 5 percent
market share, could not win in the personal computer
industry where desktops and laptops had become com-
moditized gray boxes. In that world, Microsoft, Intel,
and Dell were the star performers. Jobs knew that he
needed to create the “next big thing.”3
A GUIDING POLICY. Second, Apple shifted its com-
petitive focus away from personal computers to mobile
devices. In doing so, Apple disrupted several industries
through its product and business-model innovations.
Combining hardware (i.e., the iPod) with a comple-
mentary service product (i.e., the iTunes Store) enabled
Apple to devise a new business model. Users could now
download individual songs legally (at 99 cents) rather
than buying an entire CD or downloading the songs
illegally using Napster and other file-sharing services.
The availability of the iTunes Store drove sales of iPods.
Along with rising sales for the new iPod and iTunes
products, demand rose for iMacs. The new products
helped disrupt the existing personal computer market,
because people wanted to manage their music and pho-
tos on a computer that worked seamlessly with their
mobile devices. Apple then leveraged the success of
the iPod/iTunes business-model innovation, following
up with product-category-defining innovations when
launching the iPhone (in 2007) and the iPad (in 2010).
COHERENT ACTIONS. Third, Apple implemented its
guiding policy with a set of coherent actions. Apple’s
coherent actions took a two-pronged approach: It
drastically streamlined its product lineup through a
simple rule—“we will make only one laptop and one
desktop model for each of the two markets we serve,
professional and consumer.” It also disrupted the
industry status quo through a potent combination of
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heat from Spotify, to offer streaming music service,” The Wall Street Journal,
June 1, 2015; “Apple’s share of smartphone industry’s profits soars to 92%,”
The Wall Street Journal, July 12, 2015; “Apple’s market cap loses $60 billion
after iPhone sales disappoint,” The Wall Street Journal, July 22, 2015; Sull,
D., and K.E. Eisenhardt (2015), Simple Rules: How to Thrive in a Complex
World (New York: Houghton Mifflin Harcourt); “Apple plans web TV
service in fall,” The Wall Street Journal, March 17, 2015; Kane, I.Y. (2014),
Haunted Empire: Apple After Steve Jobs (New York: HarperCollins); “An
iPopping phenomenon,” The Economist, March 24, 2012; “From pipsqueak to
powerhouse,” The Economist, August 21, 2012; “iRational?” The Economist,
March 24, 2012; “Apple market value hits record high,” The Wall Street
Journal, August 20, 2012; “GiantApple,” The Economist, August 21, 2012;
Sull, D., and K.E. Eisenhardt (2012), “Simple rules for a complex world,”
Harvard Business Review, September; Isaacson, W. (2011), Steve Jobs
(New York: Simon & Schuster); and Rumelt, R. (2011), Good Strategy, Bad
Strategy (New York: Crown Business).
Endnotes
1. Apple’s valuation is in absolute dollars, not in real (inflation-
adjusted) dollars. When adjusted for inflation since 1999, Microsoft’s
record market valuation would be roughly $850 billion in 2017.
2. This discussion is based on Rumelt, R. (2011), Good Strategy,
Bad Strategy (New York: Crown Business).
3. Rumelt, R. (2011), Good Strategy, Bad Strategy (New York: Crown
Business), 14.
Sources: Mickle, T. (2017, June 20), “Among the iPhone’s biggest transformations:
Apple itself,” The Wall Street Journal, Mickle, T. (2017, June 1), “What’s driving
Apple’s epic valuation,” The Wall Street Journal, “Apple earnings surge 33%
on iPhone sales,” The Wall Street Journal, April 27, 2015; “Apple, feeling
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Nike’s Core Competency: The Risky Business of Creating Heroes
ENTER KNIGHT. After completing his undergraduate
degree at the University of Oregon and serving in the
U.S. Army, Phil Knight entered the MBA program at
Stanford. One entrepreneurship class required him to
come up with a business idea. He wrote a term paper on
how to disrupt the leading athletic shoemaker, adidas.
The research question he came up with was, “Can
Japanese sports shoes do to German sports shoes what
Japanese cameras have done to German cameras?”1
At that time, adidas athletic shoes were the gold
standard. They were also expensive and hard to find
in the United States. After several failed attempts to
interest Japanese sneaker makers, Knight struck a dis-
tribution agreement with Tiger Shoes. After his first
shipment arrived in the United States, Phil Knight sent
some of the running shoes to his former coach, Bill
Bowerman, hoping to make a sale. To his surprise,
DURING THE LAST DECADE, Nike’s annual revenues
doubled and by 2018 attained some $35 billion. With
its globally recognized brand, Nike is the undisputed
leader in the athletic shoe and apparel industry. Number-
two adidas has some $22 billion in sales, while recent
entrant Under Armour reports revenues of $5 billion.
Nike is tremendously successful, holding close to a
60 percent market share in running shoes and nearly
a 90 percent market share in basketball shoes and
apparel. Yet one of its greatest strengths can also
be seen as one of its greatest vulnerabilities. Before
we introduce that strength, it helps to know how Nike
started.
Nike Co-founders:
Bill Bowerman and Phil Knight
The Beaverton, Oregon, company has come a long way
from its humble beginnings. It was founded by Univer-
sity of Oregon track and field coach Bill Bowerman
and middle-distance runner Phil Knight in 1964 and
was first called Blue Ribbon Sports. In 1971, the com-
pany changed its name to Nike (Greek mythology’s
goddess of victory) with the now iconic “swoosh”
designed by a Portland State University student.
BOWERMAN’S ROLE. Coach Bowerman was a true
innovator because he constantly sought ways to give
his athletes a competitive edge. He experimented
with many factors affecting running performance,
from different track surfaces to rehydration drinks.
Bowerman’s biggest focus, however, was on providing
a better running shoe for his athletes. While sitting at
the breakfast table one Sunday morning and absent-
mindedly looking at his waffle iron, Bowerman had
an epiphany. He poured hot, liquid urethane into the
waffle iron—ruining it in the process but coming up
with the now famous waffle-type sole that not only
provided better traction but was also lighter than tradi-
tional running shoes.
MiniCase 6
Nike’s sponsorship agreement with Brazil’s national soccer team, seen here at
the World Cup 2014 in Brazil, began in 1996 and became embroiled in the FIFA
soccer scandal.
©ITAR-TASS Photo Agency/Alamy Stock Photo
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended
to be used for any kind of endorsement, source of data, or depiction of
efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: July 31, 2017.
©Frank T. Rothaermel.
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464 MINICASE 6 Nike’s Core Competency: The Risky Business of Creating Heroes
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dominate one sport after another, from running to ice
hockey. It spends more than $1 billion a year sponsor-
ing athletes. Nike picks athletes that succeeded against
the odds—cancer survivor Lance Armstrong, double
amputee “blade runner” Oscar Pistorius, and other
athletes hailing from disadvantaged backgrounds.
Nike astutely focuses on its core competency in
athlete sponsorship and design, while it outsources
noncore activities such as manufacturing and much
of retailing. To create heroes, Nike has to engage
in a number of activities: Find athletes that succeed
against the odds; identify them before they are well-
known superstars; sign the athletes; create products
that are closely linked with the athlete; promote the
athletes or teams and Nike products through TV ads
and social media to create the desired image; and so
on. Each activity contributes to the relative value of
the product and service offering in the eyes of poten-
tial customers and the firm’s relative cost position
vis-à-vis its rivals. Over time, Nike developed a deep
expertise in creating heroes. More importantly, having
consistently better expectations of the future value of
resources allows Nike not only to shape the desired
image of the athlete, but also to capture some of the
value these athletes create.
When Heroes Fall
Although this core competency made Nike highly suc-
cessful, it has not been without considerable risks. Repeat-
edly, Nike’s “heroes” have become unmasked as cheaters,
frauds, and criminals, some of whom have committed
serious felonies, such as (culpable) homicide. Long-time
CEO and Chairman Phil Knight long ago declared that
Bowerman replied that he was interested in becom-
ing a business partner and contributing his innovative
ideas on how to improve running shoes, including the
waffle design. With an investment of $500 each and a
handshake, the venture commenced.
Creating Heroes
Nike had already reached a level of success by the late
1970s. Based on a highly successful string of innova-
tions including Nike Air, by 1979 the company had
captured more than a 50 percent market share for run-
ning shoes in the United States. A year later, Nike
went public. Even so, the company had yet to establish
one of its most effective marketing tactics.
In 1984, Nike signed Michael Jordan—still early in
his career, before he was hailed by many as the greatest
basketball player of all time—with an unprecedented
multimillion-dollar endorsement deal. Rather than
spreading its marketing budget more widely as was
common in the sports industry at that time, Nike made
the unorthodox move to spend basically its entire bud-
get for a specific sport on a single star athlete. Nike
sought to sponsor future superstars that embodied an
unlikely success story. Michael Jordan did not make
the varsity team as a junior in high school, and yet
he became the greatest basketball player ever. Nike’s
Air Jordan basketball shoes are all-time classics that
remain popular to this day.
In the 1990s and 2000s, Nike continued to spon-
sor track and field stars such as Marion Jones as well
as Kobe Bryant in basketball. With the help of major
celebrity endorsements, Nike was also able to move on
to different sports and their superstars, including golf
with Tiger Woods, cycling with Lance Armstrong,
soccer with Wayne Rooney, and football with Michael
Vick. If some of those names trigger memories of
scandals as well as athletic achievements, you see the
problems that Nike risks with its endorsement pro-
gram. Before going into the negatives, let’s examine
the powerful message behind such endorsements.
Nike is less about running shoes or sports apparel
than about unlocking human potential. This is cap-
tured in Nike’s mission to bring inspiration and inno-
vation to every athlete in the world (and if you have a
body, you are an athlete).2 Nike uses its heroes to tell
a story whose moral is that through sheer will, tenac-
ity, and hard work, anyone can unlock the hero within
and achieve amazing things. Nike will help everyone
become a hero. Just Do It! This type of mythical brand
image has allowed Nike to not only enter but also often
Oscar Pistorius (left) and Lance Armstrong (right), some of Nike’s
past celebrity endorsements.
(left) ©Ian Walton/Getty Images; (right) ©Ragnar Singsaas/Getty Images
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of wrongdoing. Clearly, Nike’s approach in building its
core competency of creating heroes is not without risks.
Too many of these public relations disasters combined
with too severe shortcomings of some of Nike’s most
celebrated heroes could damage the company’s repu-
tation and lead to a loss of competitive advantage. As
Nike veers from one public relations disaster to the next,
disappointment with the brand and its promise may
eventually set in, causing customers to go elsewhere.
DISCUSSION QUESTIONS
1. The MiniCase indicates that Nike’s core compe-
tency is to create heroes. What does this mean?
How did Nike build its core competency? Does
it, for example, identify and leverage the potential
identified in a VRIO analysis (are its competencies
valuable, rare, inimitable, and organized to capture
value) in a resource-based view of the firm?
2. What would it take for Nike’s approach to turn
from a strength into a weakness? Did this tipping
point already occur? Why or why not?
3. What recommendations would you have for Nike?
Can you identify a way to reframe the compe-
tency of creating heroes? Or a new way to think
of heroes, teams, or sports that would continue to
build the brand?
4. If you are a competitor of Nike (such as adidas,
Under Armour, New Balance, or Li-Ning), how
could you exploit Nike’s apparent vulnerability?
Provide a set of concrete recommendations.
Endnotes
1. As quoted in: “Knight the king: The founding of Nike,” Harvard
Business School Case Study, 9-810-077, 2.
2. http://help-en-us.nike.com/app/answers/detail/a_id/113/p/3897.
3. According to Reuters, cited in: www.sportbusiness.com,
December 15, 2009.
Sources: Germano, S. (2017, June 15), “Nike to cut jobs as it combats
sneaker slump,” The Wall Street Journal, Stevens, L., and S. Germano
(2017, June 28), “Nike thought it didn’t need Amazon—then the ground
shifted,” The Wall Street Journal, “Nike’s bold push into soccer entangled
it in FIFA probe,” The Wall Street Journal, June 4, 2015; “The big business
of fairy tales,” The Wall Street Journal, February 14, 2013; Sachs, J. (2012),
Winning the Story Wars (Boston, MA: Harvard Business School Press);
Nike, Inc., History and Heritage, http://nikeinc.com/pages/history-heritage;
and Halberstam, D. (2000), Playing for Keeps: Michael Jordan and the
World (New York: Broadway Books).
scandals surrounding its superstar endorsement athletes
are “part of the game.”3 So Nike appears to be comfort-
able in tolerating those risks, at least in some cases.
Sometimes Nike continued to sponsor its athletes
involved in various scandals; other times it terminated its
lucrative endorsement contracts. Nike continued to spon-
sor NBA star Kobe Bryant who was cleared of alleged
rape charges. After Tiger Woods was engulfed in an infi-
delity scandal, Nike continued to sponsor the golf super-
star. In 2007, Nike ended its endorsement contract with
NFL quarterback Michael Vick after a public outcry and
his subsequent felony conviction of running a dog-fight-
ing ring and engaging in animal cruelty. In 2011, after
serving a prison sentence and restarting his career at the
Philadelphia Eagles, Nike signed a new endorsement deal
with Vick. In 2012, Nike terminated its long-term rela-
tionship with disgraced cyclist Lance Armstrong. Just
before Armstrong’s public admission to doping in an
interview with Oprah Winfrey, Knight answered, “Never
say never,” when asked if Nike would sponsor Armstrong
again in the future. In 2013, Nike removed its ads with
Oscar Pistorius and the unfortunate tagline “I am the bul-
let in the chamber,” after the South African track and field
athlete was charged with homicide.
In 2014, Nike got entangled in the FIFA (the world
governing body of soccer) bribery scandal. It began
20 years earlier when Nike decided to gain a stronger
presence in soccer after the 1994 World Cup was held
in the United States. In 1996, Nike signed a long-term
sponsorship agreement with the Brazilian national
team worth hundreds of millions of dollars. This was
a huge win for Nike because soccer has been the basis
of adidas’ success, much like running and basketball
has been for Nike. Moreover, Brazil won the tourna-
ment five times (more than any other nation) and is
the only team to have played in every tournament,
which is only held every four years.
Nike is now alleged to have paid some $30 million
to a middleman, who used that money for bribing
soccer officials and politicians in Brazil. This mid-
dleman—Jose Hawilla—has admitted a number of
crimes including fraud, money laundering, and extor-
tion related to the FIFA soccer investigation by U.S.
prosecutors.
Time and time again Nike’s heroes have fallen from
grace, and the company itself has fallen under suspicion
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466
rot27628_minicase07_466-469.indd 466 11/22/17 08:19 PM
business, IBM partnered with Apple to provide
business productivity apps on Apple devices.
3. Big data and analytics: IBM now offers smarter
analytics solutions that focus on how to acquire,
process, store, manage, analyze, and visualize
data arriving at high volume, velocity, and variety.
Prime applications are in finance, medicine, law,
and many other professional fields relying on
deep domain expertise within fast-moving envi-
ronments. IBM partnered with Twitter to provide
IBM’s business clients big data and analytics solu-
tions in real time based on the vast amount of data
produced on Twitter.
IBM’s Core Competency:
Providing Solutions
At its core, IBM is a solutions company. It solves data-
based problems for its business clients, but the technol-
ogy and problems both change over time. As an example,
“You make the right decision for the long run. You
manage for the long run, and you continue to move
to higher value. That’s what I think my job is.”1
LED BY CEO Virginia Rometty, the IBM of today is an
agile and nimble IT services company. Rometty was
promoted to CEO in 2012 from her position as senior
vice president of sales, marketing, and strategy. Rather
than facing just one technological transformation,
IBM and its clients are currently facing three disrup-
tions at once:
1. Cloud computing: By providing convenient, on-
demand network access to shared computing
resources such as networks, servers, storage, appli-
cations, and services, IBM attempts to put itself at
the front of a trend now readily apparent in services
that include Google Drive, Dropbox, or Microsoft
365. Increasingly, businesses are renting computer
services rather than owning hardware and soft-
ware and running their own networks. One of the
largest cloud-computing providers for businesses
is Amazon Web Services (AWS), which beat out
IBM in winning a high-profile CIA contract. This
was seen as a major embarrassment given IBM’s
long history of federal contracts. Microsoft with
its Azure cloud offering is another potent competi-
tor, especially after CEO Satya Nadella focused
Microsoft on a “cloud first, mobile first” strategy.
2. Systems of engagement: IBM now helps busi-
nesses with their systems of engagement, a term
the company uses broadly to cover the transition
from enterprise systems to decentralized systems
or mobility. IBM identifies the traditional enter-
prise system as a “system of record” that passively
provides information to the enterprise’s knowledge
workers. It contrasts that with systems of engage-
ment that provide mobile computing platforms,
often including social media apps such as Facebook
or Twitter, that promote rapid and active collabo-
ration. To drive adoption of mobile computing for
Dynamic Capabilities at IBM
MiniCase 7
Frank T. Rothaermel prepared this MiniCase from public sources. This
MiniCase is developed for the purpose of class discussion. It is not intended
to be used for any kind of endorsement, source of data, or depiction of
efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: July 31, 2017.
©Frank T. Rothaermel.
Virginia Rometty, IBM chief executive officer. ©JEWEL SAMAD/AFP/
Getty Images
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MINICASE 7 Dynamic Capabilities at IBM 467
rot27628_minicase07_466-469.indd 467 11/22/17 08:19 PM
to some $120 billion early in 2016. And revenues
for IBM have fallen for five straight years, from a
high of $107 billion when Rometty became CEO to
$78 billion in 2017. During the same period, IBM’s
(normalized) stock price fell by more than 30 percent,
while the tech-heavy NASDAQ-100 index rose by
over 110 percent during the same period. Thus, IBM
is clearly underperforming the wider market by a
huge margin and has done so for quite some time.
Some critics even go so far as to call for a replace-
ment of Rometty.
Rometty, however, stays committed to IBM’s new
strategic focus and argues that she is transforming
IBM for the long run. She views the most recent waves
of technology disruptions as creating major business
opportunities and has made sure that IBM invests
heavily to take advantage of them. IBM has trained all
of its consultants—over 100,000—in these three areas
to help its business clients with their own transforma-
tion. Moreover, Rometty ended the option of IBM
employees to work from home. In an attempt to fos-
ter innovation through co-location, she gave all IBM
employees a choice: Start working from a regional
office Monday through Friday, or leave the company.
This came as a shock to many IBM employees as it
has been a pioneer in providing telecommute options
for its employees for decades. Indeed, IBM’s strate-
gic initiative of “the anytime, anywhere workforce”
was extremely popular among its employees. Until
recently, IBM believed that a distributed workforce,
with many employees working from home, allowed
it to further perfect the technology solutions it was
providing for its customers with similarly distributed
workforces.
DISCUSSION QUESTIONS
1. Why has IBM been underperforming the broader
technology market for several years now? What
are the reasons for its sustained competitive
disadvantage?
2. Describe the three current transformations that
IBM is facing. What causes these transformations?
Who are the main competitors?
3. What are dynamic capabilities? Explain. Look-
ing at IBM’s track record of technological trans-
formation depicted in Exhibit MC7.1, which role
did dynamic capabilities play in these successful
transformations?
IBM helped kick-start the PC revolution in 1981 by set-
ting an open standard in the computer industry with the
introduction of the IBM PC running on an Intel 8088
chip and a Microsoft operating system (MS-DOS).
Ironically, in the years following, IBM nearly vanished
after experiencing the full force of that revolution,
because its executives believed that the future of com-
puting lay in mainframes and minicomputers that would
be produced by fully integrated companies. However,
with an open standard in personal computing, the entire
industry value chain disintegrated, and many new firms
entered its different stages. This led to a strategic misfit
for IBM, which resulted in a competitive disadvantage.
Rather than breaking up IBM into independent busi-
nesses, Lou Gerstner, installed as CEO in 1993, refo-
cused the company on satisfying market needs, which
demanded sophisticated IT services. Keeping IBM
together as one entity allowed Gerstner to integrate
hardware, software, and services to provide sophisti-
cated solutions to customers’ IT challenges. IBM was
quick to capitalize on the emergence of the internet to
add further value to its business solutions. The company
also moved quickly to sell its PC business to Lenovo, a
Chinese tech company, in 2005 when substitution from
tablet computers was just beginning to impact demand.
In 2014, IBM followed up on this transaction with the
sale of its server business also to Lenovo.
Exhibit MC7.1 shows IBM’s dynamic capabil-
ity to successfully transform itself multiple times
over its more than 100-year history—a history with
periods of major disruptions in the data information
industry, from mechanical calculators to the inter-
net. In contrast to IBM, note how at the bottom of
Exhibit MC7.1, strong competitors in one period
drop from significance when a new wave of technol-
ogy emerges.
Challenges Ahead
Critics of Rometty’s strategic approach, including the
activist investor Mark Cuban, point out that IBM was
slow to take advantage of these mega-opportunities,
and they continue to watch IBM’s stock performance
with skepticism. The critics grew louder when Rom-
etty received a pay increase and a $3.6 million bonus
for her 2014 performance, during which revenue
dropped about 6 percent and net income 27 percent.
Overall, IBM’s market cap plummeted by 50 percent:
from a high of $240 billion in the spring of 2013
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468 MINICASE 7 Dynamic Capabilities at IBM
rot27628_minicase07_466-469.indd 468 11/22/17 08:19 PM
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MINICASE 7 Dynamic Capabilities at IBM 469
rot27628_minicase07_466-469.indd 469 11/22/17 08:19 PM
Sources: Simons, J. (2017, May 18), “IBM, a pioneer of remote work,
calls workers back to the office,” The Wall Street Journal, McMillan, R. (2016,
Jan. 28), “IBM CEO Rometty getting $4.5 million bonus for 2015,”
The Wall Street Journal, Langley, M. (2015, Apr. 20), “Behind Ginni
Rometty’s plan to reboot IBM,” The Wall Street Journal, “Systems of
engagement and the enterprise,” IBM website; Hiltzik, M. (2015, Feb. 2),
“IBM redefines failure as ‘success,’ gives underachieving CEO huge
raise,” Los Angeles Times, February 2; Belvedere, M. (2014, Oct. 22),
“IBM no longer a tech company: Mark Cuban,” CNBC, Goldman, D.
(2011, Oct. 25), “IBM CEO Sam Palmisano to step down,” CNN
Money; Harreld, J.B., C.A. O’Reilly, and M. Tushman (2007),
“Dynamic capabilities at IBM: Driving strategy into action,” California
Management Review 49: 21–43; Gerstner, L.V. (2002), Who Says
Elephants Can’t Dance? (New York: HarperBusiness); Grove, A.S.
(1996), Only the Paranoid Survive: How to Exploit the Crisis Points
that Challenge Every Company and Every Career (New York: Currency
Doubleday); and various resources at ibm.com and IBM annual reports
(diverse years).
4. Do you believe that IBM is likely to master the
current three-pronged tech transformation as iden-
tified? Why or why not? Explain.
5. IBM’s decision to end greater work flexibility and
require co-location of employees in the office was
met with some consternation. How do you see
IBM’s decision, and what are likely positive and
negative consequences?
Endnote
1. As quoted in: Lohr, S. (2014, May 13), “IBM’s Virginia Rometty on
leadership and management,” The New York Times,
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470
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For example, baristas used to grind beans throughout
the day whenever a new pot of coffee had to be brewed
(which was at least every eight minutes). The grind-
ing sounds and fresh coffee aroma were trademarks
of Starbucks stores. Instead, to accommodate its fast
growth, many baristas began to grind all of the day’s
coffee beans early in the morning and store them for
the rest of the day. New espresso machines, designed
for efficiency, were so tall that they physically blocked
interaction between baristas and customers. Although
these and other operations changes allowed Star-
bucks to reduce costs and improve efficiency, they
undercut Starbucks’ primary reason for success—that
going to Starbucks was not simply a stop for caffeine;
it was a sensory experience. The negative impact of
INSPIRED BY ITALIAN coffee bars, Starbucks CEO
Howard Schultz set out to provide a completely new
consumer experience. The trademark of any Starbucks
is its ambience—where music and comfortable chairs
and sofas encourage customers to sit and enjoy their
beverages and, more recently, food and (at some loca-
tions) even wine. Customers can use the complimen-
tary wireless service or just visit with friends. The
barista seems to speak a foreign language as she rattles
off the offerings: Caffé Misto, Caramel Macchiato,
Cinnamon Dolce Latte, Espresso Con Panna, or Mint
Mocha Chip Frappuccino, among some 30 different
coffee blends. Dazzled and enchanted, customers pay
$4 or more for a venti-sized drink. Starbucks has been
so successful in creating its ambience that customers
keep coming back for more.
Starbucks’ core competency is to create a unique
consumer experience the world over. Schultz’ strate-
gic intent was to create a “third place,” between home
and work, where people wanted to visit, ideally daily.
Customers are paying for the unique experience and
ambience, not just for the cup of coffee. The consumer
experience that Starbucks created is a valuable, rare,
and costly to imitate intangible resource. This allowed
Starbucks to gain a competitive advantage. Since
2000, Starbucks’ revenues have grown almost 15-fold,
from less than $2 billion to some $27 billion in 2017.
While core competencies are often built through
learning from experience, they can atrophy through
forgetting. This is what happened to Starbucks.
Between 2004 and 2008, Starbucks expanded opera-
tions rapidly by doubling the number of stores from
8,500 to almost 17,000 stores (see Exhibit MC8.1).
It also branched out into ice cream, desserts, sand-
wiches, books, music, and other retail merchandise,
straying from its core business.
Trying to keep up with its explosive growth in both
number of stores and product offerings, Starbucks
began to forget what made it unique. It lost the appeal
that made it special, and its unique culture got diluted.
Starbucks after Schultz: How to Sustain a Competitive Advantage?
MiniCase 8
China represents a significant future growth opportunity for Starbucks, assuming
it can transfer its core competency successfully.
©Stephen Shaver/ZUMAPRESS.com/Alamy Stock Photo
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: August 3, 2017.
© Frank T. Rothaermel.
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MINICASE 8 Starbucks after Schultz: How to Sustain a Competitive Advantage? 471
rot27628_minicase08_470-473.indd 471 11/22/17 08:20 PM
how to create a unique Starbucks experience was key
to bringing back its corporate culture.
In 2009, Starbucks introduced Via, its new instant
coffee, a move that some worried might further dilute
the brand. In 2010, Schultz rolled out new customer
service guidelines: Baristas would no longer mul-
titask, making multiple drinks at the same time, but
would instead focus on no more than two drinks at a
time, starting a second one while finishing the first.
Schultz also focused on readjusting store managers’
goals. Before Schultz’ return, managers had been
given a mandate to focus on sales growth. Schultz,
however, knew that Starbucks’ main differentiator was
its special customer experience. The CEO instructed
managers to focus on what had made the Starbucks
brand successful in the first place.
Although its earlier attempt to diversify away from
its core business in the mid-2000s failed, under Schultz,
Starbucks was able to successfully introduce food items.
Attempting to drive more store traffic in other than the
morning hours where customers need their daily caf-
feine shot, the chain has added baked goods, sand-
wiches, and other food items to its menu. To get more
customers into its stores in the late afternoon and early
cost-reduction measures was underscored when Star-
bucks lost a blind taste-test to fast food giant McDon-
ald’s. Among six coffees tested, Starbucks came in
last. Even run-of-the-mill supermarket coffees sold
in huge cans were rated higher. Some customers don’t
like Starbucks coffee and gave the chain the nickname
“Charbucks”—because critics say that a lot of the cof-
fee has an overly roasted quality, a dark and bitter taste.
To make matters worse, the global financial crisis
(2008–2009) hit Starbucks hard. The first items con-
sumers go without during recession are luxury items
such as a $4 coffee at Starbucks (see revenue drop in
Exhibit MC8.1).
Coming out of an eight-year retirement, Howard
Schultz again took the reins as CEO in January 2008,
attempting to re-create what had made Starbucks
special. He immediately launched several strategic
initiatives to turn the company around. Just a month
after coming back, Schultz ordered more than 7,000
Starbucks stores across the United States to close for
one day so that baristas could learn the perfect way
to prepare coffee. The company lost over $6 million
in revenue on that one day. This exacerbated investor
jitters, but Schultz felt the importance of relearning
$0
$5
$10
$15
$25
$30
$20
0
5,000
10,000
15,000
20,000
25,000
30,000
Stores Revenues
1971 1996 1998 2000 2002 2004 2006 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
EXHIBIT MC8.1 / Total Number of Starbucks Stores and Revenues ($ billions), 1971–2017
SOURCE: Depiction of data drawn from various Starbucks annual reports.
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472 MINICASE 8 Starbucks after Schultz: How to Sustain a Competitive Advantage?
rot27628_minicase08_470-473.indd 472 11/22/17 08:20 PM
platforms Facebook and Twitter to communicate with
customers more or less in real time. Its highly suc-
cessful Starbucks loyalty program has over 12 million
regular users. Some 27 percent of all transactions in
U.S. stores are now made using mobile devices. The
Starbucks app allows customers to order and pay for
drinks and food ahead of time, so that they can bypass
standing in line and just need to pick up their order.
Finally, as the U.S. market appears to be saturated
with some 12,000 stores, Schultz believes that Star-
bucks has a great growth opportunity by opening more
cafés overseas. Starbucks is planning to have more than
3,000 stores in China by 2019, up from 1,500 in 2015.
Starbucks also plans to double its number of cafés else-
where in Asia to more than 4,000 in the next few years.
As the creator of Starbucks, however, Schultz
enjoyed a degree of freedom that an ordinary CEO
would not have had. Howard Schultz is to Starbucks
much like Steve Jobs was to Apple. Schultz has the
reputation and power of personality to implement a
change that reduces operational effectiveness in favor
of delighting customers. Schultz was able to orches-
trate a successful turnaround, and with it Starbucks
was able to gain and sustain a competitive advantage.
Exhibit MC8.2 shows that Starbucks outperformed the
wider stock market by a huge margin.
In April 2017, Howard Schultz stepped down
as Starbucks CEO, in a second attempt to retire.
evening—traditionally its slowest time—Starbucks
stores now offer items such as vegetables, flatbread
pizza, plates of cheese, and desserts. It even introduced
alcoholic beverages such as wine and beer, available
after 4 p.m., as part of an “Evenings” program.
Starbucks also continues its efforts to find new
levels of luxury offerings catering to higher end cus-
tomers within its existing customer base. Online and
in stores it produces limited-run exclusive batches of
varietal coffees for home use, at high price points.
Some stores also offer individually brewed cups of the
same higher-priced roasts. Since 2014 Starbucks has
created something called a Starbucks Reserve Roast-
ery and Tasting Room. The first of super high-end
stores appeared in Starbucks’ home, in Seattle, with
more planned domestically and around the world.
Most of these initiatives continue. It has retooled
its Evenings program of alcohol, for example, and in
2017 announced such offerings would be scaled back
to continue only at its Roastery locations. Otherwise
its ambitions continue. Starbucks’ goal is to double
its revenues from food over the next few years and to
be seen as an evening food-and-wine destination. To
symbolize its transition from a traditional coffeehouse,
Starbucks dropped the word coffee from its logo.
Schultz also pushed the adoption of new tech-
nology to engage with customers more intimately
and effectively. Starbucks now uses social media
18.75K%
16.75K%
13.75K%
11.25K%
8.75K%
6.25K%
3.75K%
1.25K%
–1.25K%
20172015201020001995
June 26, 1992
SBUX IPO
April 6, 2000
Howard Schultz,
1st retirement
January 8, 2008
Howard Schultz
returns
April 2, 2017
Howard Schultz,
2nd retirement
565.10%
15.97K%
Starbucks Price % Change Jul 28 ’17 15.97K%
Dow Jones Industrials Level % Change Jul 28 ’17 565.10%
EXHIBIT MC8.2 / Starbucks (SBUX) Normalized (% Change) Stock Appreciation from Initial Public Offering (IPO) on
June 26, 1992, to July 28, 2017. Comparison is Dow Jones Industrials.
SOURCE: Depiction of publicly available data.
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MINICASE 8 Starbucks after Schultz: How to Sustain a Competitive Advantage? 473
rot27628_minicase08_470-473.indd 473 11/22/17 08:20 PM
4. What is your assessment of Howard Schultz as a
strategic leader? Where on the Level-5 pyramid
of strategic leadership would you place Schultz?
Why? Explain.
5. How can new Starbucks CEO Kevin Johnson
sustain the company’s competitive advantage? What
are some growth opportunities he could pursue?
What recommendations would you give him?
Sources: Jargon, J. (2017, April 3), “New Starbucks CEO sees growth
in suburbs, Midwest and lunch,” The Wall Street Journal, Trefis Team
(2017, Jan. 13), “Starbucks is ending its ‘Evenings’ beer and wine
program,” Forbes, January 13; Lublin, J.S., and J. Jargon (2016, Dec. 7),
“At Starbucks, CEO transition plan includes vow not to hover,” The Wall
Street Journal, “Starbucks raises prices despite declining coffee costs,”
The Wall Street Journal, July 6, 2015; “Starbucks profit jumps, as revenue
surges 18%,” The Wall Street Journal, July 23, 2015; “Starbucks aims to
double U.S. food sales,” The Wall Street Journal, December 4, 2014; “Forty
years young: A history of Starbucks,” The Telegraph, May 11, 2011; Schultz,
H. (2011), Onward: How Starbucks Fought for Its Life without Losing
Its Soul (New York: Rodale Books); “At Starbucks, baristas told no more
than two drinks,” The Wall Street Journal, October 13, 2010; “Latest
Starbucks buzzword: ‘Lean’ Japanese techniques,” The Wall Street Journal,
August 4, 2009; Behar, H. (2007), It’s Not About the Coffee: Leadership
Principles from a Life at Starbucks (New York: Portfolio); Clark, T.
(2007), Starbucked: A Double Tall Tale of Caffeine, Commerce, and Culture.
(New York: Little, Brown, 2007); Schultz, H., and D.J. Yang (1999), Pour
Your Heart Into It: How Starbucks Built a Company One Cup at a Time
(New York: Hyperion); “Five things Starbucks won’t tell you,” The Wall
Street Journal video, http:// on.mktw.net/1UVStO6; and http://investor.
starbucks.com. See also “The Roastery experience: An unofficial guide to
the Starbucks Roastery,” http://www.thestarbucksroastery.com/, accessed
August 3, 2017.
Starbucks’ new CEO is Kevin Johnson, who served as
chief operating officer and second in command under
Schultz. Schultz came out of retirement in 2008 when
Starbucks was failing, and initiated a successful turn-
around. His struggles are captured well in the title of
his New York Times bestseller: Onward: How Star-
bucks Fought for Its Life without Losing Its Soul. After
his return, Starbucks’ market valuation appreciated
some five-fold! Although Schultz clearly engineered
a hugely successful turnaround of his beloved Star-
bucks, the question is whether the new CEO can sus-
tain Starbucks’ competitive advantage.
DISCUSSION QUESTIONS
1. How did Starbucks create its uniqueness in the first
place? Why was this uniqueness so successful?
2. To be a source of competitive advantage over time,
core competencies need to be continuously honed
and upgraded. Why and how did Starbucks lose its
uniqueness and struggle in the mid-2000s?
3. What strategic initiatives did Howard Schultz put
in place to re-create Starbucks’ uniqueness after his
return in 2008? Detail each strategic initiative, and
explain why each initiative was successful, if so.
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rot27628_minicase09_474-475.indd 474 12/06/17 03:12 PM
Business Model Innovation: How Dollar Shave
Club Disrupted Gillette
really need six blades on one razor or want to pay over
$10 for one cartridge?
Seeing the opening provided by Gillette’s focus on
the high-end, high-margin portion of the market, Dollar
Shave Club established a low-cost alternative to invade
Gillette’s market from the bottom up. With an $8,000
budget and the help of a hilarious promotional video
that went viral with 25 million views, entrepreneur
Michael Dubin launched Dollar Shave Club, an ecom-
merce startup that delivers razors by mail. After the
promotional video was uploaded on YouTube in March
2012, some 12,000 people signed up for Dollar Shave
WHILE MOST of our attention is captured by fancy high-
tech innovations such as the iPhone or Tesla’s sleek
electric vehicles, innovations need neither to be high-
tech nor radical to be successful. Until recently, Gil-
lette, the company that invented the safety razor and
the razor–razor-blade business model, dominated the
$3 billion U.S. market for wet shaving with some
75 percent market share. Yet Dollar Shave Club,
which began as a fledgling startup with an initial bud-
get of $8,000, disrupted the powerful Gillette with a
low-tech innovation and is gaining market share rap-
idly. How can the powerful Gillette, a unit of Procter
& Gamble with annual revenues of $65 billion, be
beaten by a brash startup? Gillette’s pattern of inno-
vation over time led to overshooting in the market,
resulting in a product that became overengineered and
too expensive.
The entrepreneur King Gillette invented the safety
razor some 115 years ago and also came up with the
highly profitable business model of selling the razor
for a low price and charging a premium for replacement
razor blades. This razor–razor-blade business model,
so named to commemorate its origins, has now been
widely adopted. When introduced, the safety razor was
a radical innovation, allowing Gillette a temporary
competitive advantage. To sustain this advantage, Gil-
lette followed up with incremental innovations, mainly
by adding more blades to its razor until there were not
one but six! As a result of this innovation pattern, Gil-
lette’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!
This pricing exposed Gillette to low-cost disrup-
tion. The high-end, highly priced offering of the mar-
ket leader is not only overshooting what the market
demands, but also often priced too high. Does anyone
MiniCase 9
The entrepreneur Michael Dubin founded Dollar Shave Club using a business
model innovation by providing an online subscription-based mail-order alterna-
tive to in-store retail purchases of razor blades. Many customers were not only
turned off by Gillette’s premium prices, but also by the inconveniences that
in-store purchases entail. Given that packs of razor blades are a prime target
for shoplifters, many stores lock them in glass vitrines, much to the dismay of
customers who have to hunt down an employee with a key to access razor blades.
©Dan Krauss
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors
and omissions are entirely the author’s. Revised and updated: July 3, 2017.
© Frank T. Rothaermel.
Final PDF to printer
MINICASE 9 Business Model Innovation: How Dollar Shave Club Disrupted Gillette 475
rot27628_minicase09_474-475.indd 475 12/06/17 03:12 PM
A mere two years after Dollar Shave Club started, two
entrepreneurs founded Harry’s, another online, sub-
scription-based mail-order business for shaving equip-
ment. After Target invited Harry’s to put flashy displays
in all of its stores in 2016, its business took off. This was
a smart move on Target’s part, because it allowed it to
put some competitive pressure on Gillette, which has
historically held a near-monopoly position as a sup-
plier with its 75 percent market share. Similar to Dollar
Shave Club, Harry’s business is growing rapidly. As a
consequence of increased competition, Gillette’s mar-
ket share in the $3 billion market for razors and razor
blades has declined from some 75 percent (in 2010)
to below 60 percent (by 2017), and continues to slide.
DISCUSSION QUESTIONS
1. If you buy shaving equipment, do you purchase it
in a retail store or online? Explain your choice.
2. Apply the four I’s framework: idea, invention, inno-
vation, and imitation to describe the wet shaving
industry in the United States over the past 100 years.
3. How was Gillette initially able to gain a competi-
tive advantage? Was Gillette able to sustain its
competitive advantage? If so, how?
4. What market opening did entrepreneurs, such as
Michael Dubin with Dollar Shave Club, use to enter
the industry? How did they enter the industry?
What type of innovation did they use, and why
were they successful?
5. Why did Unilever offer $1 billion (in cash!) for
Dollar Shave Club?
6. Do you think online startups such as Dollar Shave
Club and Harry’s will continue to steal market
share from Gillette? Why or why not?
Sources: Terlap, S. (2017, Apr. 4), “Gillette, bleeding market share, cuts
prices of razors,” The Wall Street Journal, Terlep, S., and K. Safdar (2016,
Nov. 9), “Online upstart Harry’s razor jumps into Gillette’s turf,” The Wall
Street Journal, Terlep, S. (2016, July 20), “Unilever buys Dollar Shave
Club,” The Wall Street Journal, Ng, S., and P. Ziobro (2015, June 23),
“Razor sales move online, away from Gillette,” The Wall Street Journal,
Luna, T. (2014, Apr. 29), “The new Gillette Fusion Pro-Glide Flexball razor,
to be available in stores June 9,” The Boston Globe, Glazer, E. (2012, Apr. 12),
“A David and Gillette story,” The Wall Street Journal, and Dollar Shave
Club promotional video, https://www.youtube.com/dollarshaveclub.
membership within the first 48 hours! The company
also raised more than $20 million in venture capital
funding from prominent firms such as Kleiner Perkins
Caufield & Byers and Andreessen Horowitz, among
others. Dollar Shave Club followed up with advertising
on regular television in addition to its online campaigns
and has expanded its product lines with the introduc-
tion of additional personal grooming products.
Dollar Shave Club is an ecommerce company that
uses a subscription-based business model. As the com-
pany’s name suggests, its entry-level membership plan
delivers a razor and five cartridges a month for just $1
(plus $2 shipping). The member selects an appropri-
ate plan, pays a monthly fee, and receives razors every
month in the mail. Dollar Shave Club is using a busi-
ness model innovation to disrupt an existing market.
Technology is defined as the methods and materials
used to achieve a commercial objective. The technology
or method here is the business model innovation, a
potent competitive weapon. The entrepreneur identified
the market need for those who don’t like to go shopping
for razors and certainly don’t like to pay the high prices
commanded by market leaders such as Gillette.
Procter & Gamble’s competition also took notice.
Unilever, P&G’s European rival, has long stayed away
from the U.S. wet shaving market because Gillette
was so dominant. But noting how Dollar Shave Club
disrupted the market, resulting in Gillette’s rapid mar-
ket share decline, Unilever saw its opening into the
U.S. market. The Anglo-Dutch multinational consumer
products company, with some $61 billion in annual rev-
enues and thus roughly the same size as P&G, offered
a whopping $1 billion in cash in 2016 to buy Dollar
Shave Club. Not too bad of an offer for a five-year-
old startup! Dubin happily accepted the offer and sold
Dollar Shave Club to Unilever.
With sales of razors and razor blades moving rap-
idly online, Unilever is hoping to leverage this business
model innovation to unseat Gillette’s dominance in the
U.S. market. Gillette is not sitting by idle: It responded
swiftly by offering its own subscription-based service
(Gillette Shave Club) and by lowering prices up to
20 percent, a move that was unimaginable in the past few
decades. Successful innovations also lead to imitations.
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Competing on Business Models: Google vs. Microsoft
as an online search and advertising company, it now
offers software applications (Google Docs, word pro-
cessing, spreadsheet, e-mail, interactive calendar, and
presentation software) hosted on the cloud (Google
Drive), and also operating systems (Chrome OS for
RIVALS OFTEN USE different business models to com-
pete with one another. Because of competitive dynam-
ics and industry convergence, Google (since 2015 a
subsidiary of Alphabet) and Microsoft progressively
move on to the other’s turf. In many areas, Google and
Microsoft are now direct competitors. This represents
multipoint competition, as Google and Microsoft are
rivals in many different markets. Both companies are
about the same size in terms of revenues. In 2016,
Microsoft had $87 billion in revenues and Google
$89.5 billion.
In an attempt to manage its high degree of unrelated
diversification more effectively, Google put in place a
multidivisional structure overseen by Alphabet, a cor-
porate holding company. Alphabet’s 10 business units
start with Google’s core businesses (search, ads, apps,
YouTube, Android, Chrome, and Google maps) in a
single unit joined by Google X (artificial intelligence,
high-altitude balloons providing global internet con-
nectivity), Waymo (self-driving cars), Nest (smart
homes), Access & Energy (broadband fiber services),
Verily (life sciences, smart contact lenses), Calico (lon-
gevity research), Side Walk Labs (urban innovation),
Google Ventures (venture capital investments in early
phase startups), and Google Capital (venture capital
investments in later-stage startups, similar to corporate
venture capital investments). (See Exhibit MC10.1.)
This sweeping restructuring allows the sprawling
conglomerate to separate its highly profitable search
and advertising business from its “moon shots,” such
as providing wireless internet connectivity via high-
altitude balloons or developing contact lenses that
double as a computer monitor and provide real-time
information to the wearer.
Google continues to dominate the revenue streams
for Alphabet—accounting for more than 99 percent
of total revenues (see Exhibit MC10.2). Google is a
standalone strategic business unit within Alphabet and
has its own profit and loss responsibility. Google is
run by CEO Sundar Pichai. Although Google started
MiniCase 10
Sundar Pichai, Google CEO (top), and Satya Nadella, Microsoft CEO (bottom)
(top): ©AP Images/Tsering Topgyal; (bottom): ©Justin Sullivan/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges research assistance by Amey Sahasrabuddhe.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: June 1, 2017.
©Frank T. Rothaermel.
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MINICASE 10 Competing on Business Models: Google vs. Microsoft 477
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gaming with Xbox One. Both also compete in mobile
devices (with Microsoft being focused more on the
business market). Since 2014, Microsoft has been run
by CEO Satya Nadella.
Given the companies’ size combined with increas-
ing multipoint competition, the stage is set for a clash
the web and Android for mobile applications), among
many other online products and services. In contrast,
Microsoft began its life by offering an operating sys-
tem (since 1985, called Windows), then moved into
software applications with its Office Suite, and later
into online search and advertising with Bing as well as
ALPHABET
GOOGLE
GOOGLE X
WAYMO
NEXT
ACCESS &
ENERGY
VERILY
CALICO
SIDE WALK
LABS
GOOGLE
VENTURES
GOOGLE
CAPITAL
Search Ads Apps YouTube Android Chrome Google Maps
Artificial intelligence High-altitude balloons providing
global internet connectivity
Venture capital investments
in later-stage startups
Corporate venture
capital (CVC) investments
Life sciences Smart contact lenses
Self-driving cars
Smart homes
Longevity research
Urban innovation
Venture capital investments in early phase startups
Broadband fiber services
EXHIBIT MC10.1 / Alphabet’s Multidivisional Structure (M-form) with Its Strategic Business Units,
including Google’s Businesses
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478 MINICASE 10 Competing on Business Models: Google vs. Microsoft
rot27628_minicase10_476-480.indd 478 12/06/17 03:14 PM
In competing with each other, Google and Micro-
soft pursue very different business models, as detailed
in Exhibit MC10.3. Google offers its applications soft-
ware Google Docs and hosting service Google Drive for
free to entice and retain as many users as possible for its
search engine. Google Drive follows a freemium pric-
ing model, that is, a limited amount of data storage is
free (15GB), while Google charges for additional stor-
age space.
Although Google’s flagship search engine is free for
the end user, it makes money from sponsored links by
advertisers. The advertisers pay for the placement of
their ad on the results page, and they pay each time a user
clicks through an ad (which Google calls a “sponsored
link”). Many billions of these mini-transactions add up
to a substantial business. Google uses part of the profits
earned from its lucrative online advertising business to
subsidize Google Docs and other service offerings (see
Exhibit MC10.2 and Exhibit MC10.3). Giving away
products and services to induce widespread use allows
Google to benefit from network effects—the increase in
the value of a product or service as more people use it.
Google can charge advertisers for highly targeted and
effective ads, allowing it to subsidize other product
offerings that compete directly with Microsoft.
of the technology titans. In spring 2017, Alphabet was
the second most valuable technology company glob-
ally, just behind Apple, but ahead of Microsoft, Ama-
zon, and Facebook (in that order).
EXHIBIT MC10.3 / Competing Business Models: Google vs. Microsoft
Revenues 2014 2015 2016
Google Properties $45,085 $52,357 $63,785
Google Network
Members Websites
14,539 15,033 15,598
Total Advertising
Revenues
59,624 67,390 79,383
Total Google
Revenues
65,674 74,544 89,463
Other Business
Unit Revenues
327 445 809
Total Revenues 66,001 74,989 90,272
SOURCE: Tabulation of data from Alphabet annual reports (various years).
EXHIBIT MC10.2 /
Breakdown of Google’s Revenues by Business
Segment, ($ millions) 2014–2016
Microsoft
Google
Medium
Cost for
OEMs
Windows
High
Cost for
Users
Office Suite
Free for User
(Loss Leader)
Bing
Free for User Free for User Free for User,
High Cost for
Advertisers
Chrome OS
& Android
Google
Docs
Google
Operating
Systems
Software
Apps
Online
Search
SOURCE: Depiction of publicly available data.
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MINICASE 10 Competing on Business Models: Google vs. Microsoft 479
rot27628_minicase10_476-480.indd 479 12/06/17 03:14 PM
mobile devices. The second is the increasing use of
cloud-based rather than standalone PC-based comput-
ing. The demand for Microsoft Office is driven by its
installed base of Windows. The gross margin for the
“classic” Office sitting on your computer is 90 percent,
while that for the cloud-hosted Office 365 is only
some 50 percent. To maximize the number of users
that will upgrade from Windows 7 and the disappoint-
ing Windows 8 to Windows 10 launched in summer
2015, users of current versions of the operating sys-
tem will get a free upgrade. (Microsoft did not offer
a Windows 9 version.) On top of the aforementioned
problems, Microsoft wrote off almost $8 billion of its
ill-fated $9.4 billion acquisition of smartphone maker
Nokia, along with cutting some 8,000 jobs.
As shown in Exhibit MC10.3, Microsoft uses the
profits from its application software business to sub-
sidize its search engine Bing, which—just like Google
Docs— is a free product for the end user. Given Bing’s
relatively small market share, however, and the tremen-
dous cost of developing the search engine, Microsoft,
unlike Google, does not make any money from its
online search offering; rather, it is a big money loser.
The logic behind Bing is to provide a countervailing
power to Google’s dominant position in online
search.1 The logic behind Google Docs is to create
a threat to Microsoft’s dominant position in applica-
tion software. The computing industry is undergoing a
shift away from personal computers to mobile devices
and cloud-based computing. Google holds more than
80 percent market share in mobile operating systems
software with Android, while Microsoft’s market
share has shrunk to less than 1 percent.
Taken together, Google and Microsoft compete
with one another for market share in several product
categories through quite different business models.
As shown in MC10.5, the stock market has valued
Google’s business model much more highly over the
past decade (over 300 percent appreciation, com-
pared to Microsoft’s 130 percent appreciation). Also
noteworthy is that Google has outperformed the tech-
heavy NASDAQ-100 stock market index by a fairly
wide margin, while Microsoft has underperformed
it. Google was able to gain and sustain a competitive
advantage over Microsoft.
Under CEO Satya Nadella, Microsoft is attempt-
ing to reinvent itself with a new “mobile first, cloud
first” strategy. Microsoft is shifting quickly from
being a Windows-only firm to a company offering
diversified online services to its customers via the
Revenues 2014 2015 2016
Productivity
and Business
Processes
$26,976 $26,430 $26,487
Intelligent Cloud 21,735 23,715 25,042
More Personal
Computing
38,460 43,160 40,460
Corporate and
Other
(338) 275 (6,669)
Total Revenues 86,833 93,580 85,320
SOURCE: Tabulation of data from Microsoft annual reports (various
years).
EXHIBIT MC10.4 /
Breakdown of Microsoft’s Revenues by Business
Segment, ($ millions) 2014–2016
Microsoft’s business model, however, is almost
the reverse of Google’s (see the opposing arrows in
Exhibit MC10.3). Initially, Microsoft focused on cre-
ating a large installed base of users for its PC oper-
ating system, Windows. It holds some 90 percent
market share in operating system software for personal
computers worldwide, although the PC has become
less important as mobile devices have become more
important in recent years. Yet, by 2017, the Windows
and Office combination still generated about 40 per-
cent of Microsoft’s total revenues and 75 percent of its
profits. Moreover, PC users are locked into a Micro-
soft operating system that generally comes preloaded
with the computer they purchase; they then want to
buy applications that run seamlessly with the oper-
ating system. The obvious choice for most users is
Microsoft’s Office Suite containing Word, Excel,
PowerPoint, Outlook, and Access. Microsoft is work-
ing hard to transition the Office revenues from the old
business model of standalone software licenses ($150
for Office Home & Student) to repeat business via
cloud-based subscriptions such as Office 365 Home
& Student (which is $70 per year). Exhibit MC10.4
details Microsoft’s revenues by business segment.
Microsoft faces two immediate problems. The first
is that people and businesses are buying fewer and
fewer PCs (including both desktops and laptops) as
personal and business computing move increasingly to
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480 MINICASE 10 Competing on Business Models: Google vs. Microsoft
rot27628_minicase10_476-480.indd 480 12/06/17 03:14 PM
5. What recommendations would you give to Satya
Nadella, CEO of Microsoft, to compete more
effectively against Google?
6. What recommendations would you give to Sundar
Pichai, CEO of Google, to compete more effec-
tively against Microsoft?
Endnote
1. According to Microsoft lore, the name “Bing” actually is an
acronym and stands for “Because It’s Not Google.”
Sources: “What Satya Nadella did at Microsoft,” The Economist, March 16,
2017; Nicas, J. (2017, Jan. 26), “Google parent Alphabet finds new growth
beyond search,” The Wall Street Journal, “Microsoft at middle age:
Opening windows,” The Economist, April 4, 2015; Ovide, S. (2015, July 8),
“Microsoft to cut 7,800 jobs on Nokia woes,” The Wall Street Journal, Barr, A.
(2015, July 13), “Google takes stricter approach to costs,” The Wall Street
Journal, Barr, A. (2015, July 17), “Google’s share price hits all-time high,”
The Wall Street Journal, Gryta, T., and Y. Kim (2013, May 6), “The quest
for a third mobile platform,” The Wall Street Journal, Adner, R. (2012), The
Wide Lens. A New Strategy for Innovation (New York: Portfolio); Levy, S.
(2011), In the Plex: How Google Thinks, Works, and Shapes Our Lives
(New York: Simon & Schuster); Anderson, C. (2009), Free: The Future of
a Radical Price (New York: Hyperion); Gimeno, J. (1999), “Reciprocal
threats in multimarket rivalry: Staking out ‘spheres of influence’ in the U.S.
airline industry,” Strategic Management Journal 20: 101–128; Gimeno, J.,
and C.Y. Woo (1999), “Multimarket competition, economies of scale, and
firm performance,” Academy of Management Journal 42: 239–259; Chen,
M.J. (1996), “Competitor analysis and interfirm rivalry: Toward a theoretical
integration,” Academy of Management Review 21:100–134; and various
Google and Microsoft annual reports.
2008 2009 20112010 2012 2013 2014 2015 2016 2017
-75%
-25%
25%
75%
175%
125%
225%
275%
325%
Alphabet Price % Change Jul 28 ’17 310.8%
NASDAQ 100 Level % Change Jul 28 ’17 206.4%
Microsoft Price % Change Jul 28 ’17 129.5%
310.8%
206.4%
129.5%
EXHIBIT MC10.5 / Stock Performance Comparison (normalized percentage change) of Alphabet,
Microsoft, and NASDAQ-100 Index, 2007–2017
SOURCE: Depiction of publicly available data.
cloud, supported by its strong network of data centers.
Nadella realizes that as more computing moves toward
the cloud, Microsoft’s tried-and-tested model of
tightly integrating standalone software with hardware
is no longer working. The absence of a sole focus on
Windows in Microsoft’s new mantra is evidence
of where the new CEO sees the future of comput-
ing. Whether Nadella can engineer a turnaround at
Microsoft, which is entering its fifth decade, remains
to be seen.
DISCUSSION QUESTIONS
1. How is a strategy different from a business model?
How is it similar?
2. Apply the why, what, who, and how of business
models framework (as shown in Exhibit 5.10 ) to
describe Google’s and Microsoft’s respective busi-
ness models. What conclusions do you draw?
3. Why are Microsoft and Google becoming increas-
ingly direct competitors?
4. Identify other examples of companies that were
not competing in the past but are becoming com-
petitors. Why are we seeing such a trend?
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Can Amazon Trim the Fat at Whole Foods?
chains and other retailers now offer organic food. As
a result, sales performance of existing Whole Foods
stores (“same-store sales,” an important performance
metric in the grocery business) has been declining
since 2013. Overall, Whole Foods Market has sus-
tained a competitive disadvantage, underperforming
not only its competitors, but also the broader market
by a wide margin. Over five years, Whole Foods Mar-
ket underperformed the broader stock market by some
200 percentage points!
To revitalize Whole Foods, co-founder and CEO
John Mackey decided to “trim fat” on two fronts: First,
the supermarket chain refocused on its mission to
offer wholesome and healthy food options. In Mack-
ey’s words, Whole Foods’ offerings had included “a
bunch of junk,” including candy. Mackey is passion-
ate about helping U.S. consumers overcome obesity
WHEN FOUR YOUNG entrepreneurs opened a small
natural-foods store in Austin, Texas, in 1980, they never
imagined it would one day turn into an international
supermarket chain with stores in the United States,
Canada, and the United Kingdom. Some 35 years later,
Whole Foods has about 450 stores, employs 85,000
people, and earned $16 billion in revenue in 2016.
Whole Foods’ mission is to offer the finest natu-
ral and organic foods available, maintain the highest
quality standards in the grocery industry, and remain
firmly committed to sustainable agriculture. The gro-
cery chain differentiates itself from competitors by
offering top-quality foods obtained through sustain-
able agriculture. This business strategy implies that
Whole Foods focuses on increasing the perceived
value created for customers, which allows it to charge
a premium price. In addition to natural and organic
foods, it also offers a wide variety of prepared foods
and luxury food items, such as $400 bottles of wine.
The decision to sell high-ticket items incurs greater
costs for the company because such products require
more expensive in-store displays and more highly
skilled workers, and many items are perishable and
require high turnover. Moreover, sourcing natural and
organic food is generally done locally, limiting any
scale advantages. Taken together, these actions reduce
efficiency and drive up costs. The rising cost structure
erodes Whole Foods’ margin.
Whole Foods Market:
Stuck in the Middle
Given its unique strategic position as an upscale gro-
cer offering natural, organic, and luxury food items,
Whole Foods enjoyed a competitive advantage during
the economic boom through early 2008. But as con-
sumers became more budget-conscious in the wake
of the deep recession in 2008–2009, the company’s
performance deteriorated. Competitive intensity also
increased markedly because basically all supermarket
MiniCase 11
Amazon acquired Whole Foods Market in 2017 for close to $14 billion. Many
industry observers expect that Amazon will drastically reduce the organic
grocer’s notoriously high cost structure.
©Simon Hayter/Toronto Star/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors
and omissions are entirely the author’s. Revised and updated: July 31, 2017.
©Frank T. Rothaermel.
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482 MINICASE 11 Can Amazon Trim the Fat at Whole Foods?
rot27628_minicase11_481-483.indd 482 12/06/17 03:20 PM
the market, Whole Foods Market was outperformed
in urban centers by more specialized grocery stores
focusing on specific segments such as seafood, meats,
breads, cheese, or wines.
Amazon Acquires Whole Foods
Mackey’s turnaround initiative failed. This became
more apparent as activist investors honed in on Whole
Foods’ poor performance and highlighted the strate-
gic shortcomings of the organic grocery chain. Even
though Whole Foods Market attempted to strengthen
its strategic position and also changed its board of
directors, bringing in more large-chain retail expe-
rience, it was too little, too late. In 2017, Amazon
acquired Whole Foods Market for close to $14 billion.
With the acquisition of Whole Foods, Amazon con-
tinues its vertical integration along the value chain into
physical retail spaces. Two aspects about this acquisi-
tion are particularly noteworthy. First, the Whole Foods
acquisition is 10 times larger than any other acquisi-
tion the Seattle-based technology firm has undertaken
(its second-largest acquisition, Twitch, a live-video
streaming site was acquired for less than $1 billion
in 2014). Second, Amazon chose to make an acquisi-
tion in the grocery business and not in any other retail
space. Why?
Amazon already dominates categories such as con-
sumer electronics; therefore, it has no need to acquire
a retail outlet such as Best Buy. The Whole Foods
acquisition also offers Amazon a slew of new benefits:
The organic grocery has a national footprint, which
allows the ecommerce firm to test its latest technol-
ogy on a much larger scale. For example, it has experi-
mented with AmazonGo, a grocery concept without
checkout counters. Shoppers fill their carts, and soft-
ware automatically tallies the bill and deducts it from
the person’s account. This technology could be rolled
out at Whole Foods Market. Amazon will also be in
a position to gather more data about shopping behav-
ior. Grocery shopping is a particularly important need
for consumers, and Amazon reasons if shoppers start
associating groceries with Amazon, they will want to
buy other items online also. In addition, Amazon is
notoriously cost conscious. Bringing down the cost
structure of Whole Foods by applying Amazon’s
world-leading logistics technology could significantly
strengthen the grocer’s strategic position.
to help reduce heart disease and diabetes. Given that,
the new strategic intent at Whole Foods is to become
the champion of healthy living not only by offering
natural and organic food choices, but also by educat-
ing consumers with its new Healthy Eating initiative.
Whole Foods Market now has “Take Action Centers”
in every store to educate customers on many food-
related topics such as genetic engineering, organic
foods, pesticides, and sustainable agriculture.
Yet, a 2015 mislabeling scandal in New York—in
which city officials found that Whole Foods had misla-
beled weights of several freshly packaged foods such as
chicken tenders and vegetable platters, leading to over-
charges of up to $15 an item—reinforced the public’s
image of Whole Foods as overpriced. Mackey made
a video apology and said this was an unfortunate but
isolated incident caused by inadvertent errors of local
employees. He also emphasized that the problems were
found in only nine out of 425 stores (at that time).
Second, Whole Foods is trimming fat by reducing
costs. To attract more customers who buy groceries
for an entire family or group, it now offers volume
discounts to compete with Costco, the most success-
ful membership chain in the United States. Whole
Foods also expanded its private-label product line,
which now includes thousands of products at lower
prices. The company also launched a new store for-
mat, “365 by Whole Foods Market,” based on its “365
Everyday Value” private label. The 365 stores focus
exclusively on Whole Foods’ discount private labels,
primarily to address the rise of discount competitor
Trader Joe’s. The risk, however, is that this strategic
initiative will cannibalize demand from the higher-
end Whole Foods Markets, rather than taking away
customers from Trader Joe’s. To offer its private-
label line and volume-discount packages, Whole
Foods is beginning to rely more on low-cost suppliers
and is improving its logistics system to cover larger
geographic areas more efficiently.
Mackey indicated that he planned to grow threefold
in the future and believes the United States can prof-
itably support some 1,200 Whole Foods stores. Larger
scale and more efficient logistics and operations should
allow the company to drive down its cost structure.
Whole Foods got stuck in the middle. It was out-
flanked on the low end by national grocery chains
such as Publix or Kroger that offer a wide variety of
organic foods at lower prices. At the higher end of
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DISCUSSION QUESTIONS
1. Why was Whole Foods successful initially? Why
did it lose its competitive advantage and underper-
formed its competitors?
2. Why did Whole Foods end up being “stuck in the
middle”?
3. What changes do you expect at Whole Foods
following the integration with Amazon?
4. Why did Amazon acquire Whole Foods? What are
some operational and strategic reasons for this deci-
sion? Do you think the Whole Foods acquisition was a
good move for Amazon? Why, or why not? Explain.
Sources: “Amazon’s big, fresh deal with Whole Foods,” The Economist,
June 24, 2017; “An industry shudders as Amazon buys Whole Foods for
$13.7bn,” The Economist, June 16, 2017; Stevens, L., and A. Gasparro
(2017), “Amazon to buy Whole Foods for $13.7 billion,” The Wall Street
Journal, June 16, 2017; “Whole Foods 365 takes on Trader Joe’s,” Forbes,
June 22, 2015; “Whole Foods sales sour after price scandal,” The Wall Street
Journal, July 29, 2015; “Walter Robb: Whole Foods’ other CEO on organic
growth,” Fortune, May 6, 2013; “Whole Foods profits by cutting ‘whole
paycheck’ reputation,” Bloomberg Businessweek, May 8, 2013; “Walter
Robb on Whole Foods’ recession lessons,” Bloomberg Businessweek, August
9, 2012; “Frank talk from Whole Foods’ John Mackey,” The Wall Street
Journal, August 4, 2009; “As sales slip, Whole Foods tries to push health,”
The Wall Street Journal, August 5, 2009; “The conscience of a capitalist,”
The Wall Street Journal, October 3, 2009; and www.wholefoodsmarket.com.
Finally, Amazon bought Whole Foods to compete
more effectively with Walmart. The largest physi-
cal retailer in the world is the largest U.S. grocery
chain, accounting for some 15 percent market share.
In addition, the grocery business is Walmart’s most
profitable, and is the strongest draw for customers
to the big-box stores. In recent years, Walmart has
been more aggressively moving to combat Amazon’s
dominance in ecommerce. The Bentonville, Arkansas,
retail chain purchased Jet.com for more than $3 billion
in 2016, just one year after the site was launched. Jet.
com offered lower prices than other retailers, expect-
ing that many consumers would be willing to wait a
bit longer for their shipments. The entrepreneurs were
correct in making this assumption. In addition, Jet.
com’s strategic approach was tailor-made to enhance
Walmart’s online presence. Walmart.com has become
a star performer as the site’s user-friendliness has
improved. Walmart has also been at the forefront of
implementing a hybrid retail concept where consum-
ers order goods online and pick them up in stores.
The stage is set for a battle of the retail giants, with the
number-one old-line physical retailer in one corner of the
ring and the ecommerce leader in the other. Stay tuned!
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LEGO’s Turnaround: Brick by Brick
no background in the toy industry. To make matters
worse, the new executive decided that LEGO’s home-
town of Billund, Denmark, with 6,000 people, was
too provincial. He continued to live in Paris and either
commute or run the company remotely.
Things at LEGO went from bad to worse. It started
hyperinnovating and diversified into too many areas,
too quickly, and too far away from its core. Among a
whole slew of other innovation failures, the company
created a Saturday morning cartoon called “Galidor,”
which flopped. During this time period, it also decided
to become a lifestyle company and to offer LEGO-
branded clothing and accessories.
LEGO’S TURNAROUND. By 2003, LEGO was on the
verge of bankruptcy. To avoid this fate, the closely
held private company, owned by the Kristiansen family
IN THE DECADE between 2006 and 2016, LEGO—the
famous Danish toy company—grew fivefold from a bit
over $1 billion in revenues to $6 billion (see Exhibit
MC12.1). In 2016 LEGO delivered its best results in
terms of top-line revenues and bottom-line profits in
its 85-year history. It beat out long-time rivals Mattel
and Hasbro to become the world’s largest and most
profitable toy company. How did this privately held
toy company from an obscure town in Denmark beat
the well-funded and publicly traded U.S. companies
Hasbro and Mattel?
Rediscovering, leveraging, and extending its core
competency allowed a successful revival for a com-
pany that was floundering in the early 2000s. How did
LEGO construct a successful turnaround? To answer
this question, we first need to understand a bit of the
history of this Danish wonder company.
LEGO’s Humble Beginnings
The company was founded in 1932 by Ole Kirk Kris-
tiansen. The name is a contraction of the Danish words
Leg godt, which means “play well.” Only later did
LEGO executives realize that le go in Latin also means
“I assemble.” Throughout its history, LEGO has had
numerous formidable competitors, but it has outper-
formed all of them. Tinkertoys were more complex;
Lincoln Logs were limited in what could be constructed;
traditional blocks had nothing to hold them together and
were too large to show much detail. LEGO bricks were
the right balance of simplicity, versatility, and durability.
LEGO competes for the attention of children and
their parents, who buy the product. Plus, there is also
a sizable group of adult LEGO fans. In the wake of
the personal computer revolution in the 1990s, the
popularity of LEGO began to wane because of attrac-
tive alternatives for children such as gaming consoles
and computer games. By 1998, LEGO was in trouble.
The Danish toymaker hired a highly touted turnaround
expert to change its fortune. Unfortunately, he had
MiniCase 12
The LEGO Movie was a huge hit: The 3D computer-animated film had a budget of
$60 million, but grossed some $500 million at the box office, making it one of the top
five movies in 2014. Similarly, the 2017 The LEGO Batman Movie was almost as suc-
cessful. With a budget of $80 million, it grossed over $310 million at the box office.
©Mim Friday/Alamy Stock Photo
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: August 1, 2017.
©Frank T. Rothaermel.
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rot27628_minicase12_484-487.indd 485 12/06/17 03:20 PM
encourage user innovation and creativity. To drive
innovation, LEGO has brought its adult fans into the
product development process to leverage crowdsourc-
ing—obtaining ideas from a large fan base using
online forums and other internet-based technologies.
To drive future growth, LEGO has been much more
careful with its product extensions. In the past LEGO
licensed its brand freely to other brands, including
Star Wars, Indiana Jones, Harry Potter, the Lord of
the Rings, Batman, the Simpsons, and Iron Man. But
the benefits from these licensing agreements accrued
mainly to the existing brands, because LEGO did not
own the more critical intellectual property.
Knudstorp instead focused on owning and leverag-
ing the core intellectual property. The LEGO Movie
in 2014 was a particular high for the company, gross-
ing $500 million in the first year of its release on a
$60 million budget. Unlike in previous movie tie-ins,
LEGO owned the intellectual property, which meant
LEGO did not need to split profits with existing
brands. In 2017, the company repeated this feat with
The LEGO Batman Movie, also a computer-animated
superhero comedy film that was almost as success-
ful: With a budget of $80 million, it grossed over
$310 million, making it one of the top-10 box office
hits in 2017.
since its inception, needed to do something drastic and
quickly. Almost out of desperation, it hired Jørgen Vig
Knudstorp as CEO. His résumé was quite unusual to
say the least: He was only 35 years old (in comparison,
the average age for a Fortune 500 CEO is 55 years),
held a doctorate in economics, and was a former aca-
demic. Knudstorp had transitioned to McKinsey, one
of the world’s premier strategy consulting firms.
Knudstorp decreed that LEGO must “go back to
the brick” and focus on core products. As a result of
the strategic refocusing, LEGO divested a number of
assets including its theme parks. It also drastically
culled its product portfolio by almost 50 percent,
from some 13,000 pieces to 7,000. At the same time
as Knudstorp focused LEGO again on its fundamen-
tal strengths, he was also careful to balance exploita-
tion—applying current knowledge to enhance firm
performance in the short term—with exploration—
searching for new knowledge that may enhance a
firm’s future performance. This allowed LEGO to
improve the performance of traditional product lines,
while at the same time to innovate, but this time in a
much more disciplined manner.
In particular, LEGO increased sales of its well-
known existing products by strengthening the interop-
erability of various LEGO pieces with other sets to
$7
$6
$5
$4
$3
$2
$1
$0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Mattel Hasbro Lego
EXHIBIT MC12.1 / Revenues of Mattel, Hasbro, and LEGO (in $ billion), 2002–2016
SOURCE: Depiction of publicly available data.
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creative children will grow up to drive innovation
in firms, something many critics say Chinese com-
panies lack. In addition, Chinese parents and grand-
parents are eager to spend money on things that are
perceived to help their offspring to excel academi-
cally. In general, parents around the globe are more
than happy to spend money on games that get their
children away from mobile devices, computers, and
game consoles.
To take advantage of the growth opportunity in
China and other Asian countries such as India and
Indonesia, LEGO opened offices in Shanghai and
Singapore as well as a factory in Jiaxing, China. To
address the globalization challenge more generally,
LEGO also needs to internationalize its management.
At this point, it is a local, small-town company that
happened to be successful globally, especially in the
West. LEGO hopes to become a global company that
happens to have its headquarters in Billund, Denmark.
LEGO is also experiencing a change in leader-
ship. After a widely successful turnaround, Jørgen Vig
Knudstorp stepped down as CEO in 2017. His succes-
sor was Bali Padda, who had been LEGO’s chief oper-
ating officer (COO), and thus second in command.
The Indian-born British Padda was the first non-Dan-
ish CEO to run the company in its 85-year history. Just
eight months into his tenure, Padda was replaced as
LEGO CEO by Niels Christiansen, a Dane who comes
from outside the toy industry. Christiansen headed the
industrial group Danfoss and was hailed for moving
it into the digital age. LEGO is hoping that he will do
the same for the Danish toymaker.
DISCUSSION QUESTIONS
1. Why did LEGO face bankruptcy in the early
2000s? In your reasoning, focus on both external
and internal factors.
2. What is LEGO’s core competency? Explain.
3. Apply the core competence–market matrix to show
how LEGO leveraged its core competence into
existing and new markets over the past decade.
4. In terms of revenue growth, LEGO experienced a
competitive advantage over both Hasbro and Mat-
tel since 2007 because it grew much faster. What
explains LEGO’s competitive advantage?
5. What must LEGO do to sustain its competitive
advantage in the future? One avenue to tackle
this question is to think about diversification,
both along products but also geography. Another
CHALLENGES. Although LEGO grew more than
fivefold after Knudstorp took over, it faces a number
of challenges. LEGO needs to strengthen its triple-
bottom-line performance along economic, social,
and ecological dimensions, and address globalization
challenges.
LEGO must address ecological concerns in the face
of growing consumer criticism: Its signature bricks are
made from petroleum-based plastic. The company is
searching for an environmentally friendly material to
replace its bricks, which that date to 1963. To reduce
its relatively large carbon footprint, the company is
spending millions on a 15-year R&D project in hope
of finding an eco-friendly alternative. The goal is to
invent and then manufacture bricks cost-effectively
from a new bio-friendly material that will be virtu-
ally indistinguishable from the current blocks. It is a
difficult problem to solve because LEGO bricks are
precisely engineered to four-thousandths of a millime-
ter, hold a large range of colors well, and even make a
sound when two pieces are snapped together.
To continue to grow, LEGO must become stronger
in emerging growth markets such as China. LEGO is
a comparatively new entry into China because of the
fear that knockoff bricks have sufficiently damaged
its brand. Knockoffs, which are rampant in China,
are of inferior quality and even have injured some
consumers. Yet, with growth in Western markets pla-
teauing and a larger number of Chinese entering the
middle class, this market opportunity is critical to
LEGO’s future success. Moreover, Chinese govern-
ment officials endorse LEGO as a “mind toy,” which
helps children to develop creativity. The hope is that
In 2017, Bali Padda was appointed CEO of LEGO, but served in that position
for only eight months. Does this sudden change in leadership spell trouble
for LEGO ahead?
©NIKOLAI LINARES/AFP/Getty Images
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Mar. 9), “Lego reports highest revenue in 85-year history,” The Telegraph,
“LEGO tries to build a better brick,” The Wall Street Journal, July 12, 2015;
“How LEGO became the Apple of toys,” Fast Company, January 8, 2015;
“LEGO bucks industry trend with profit growth,” The Wall Street Journal,
February 25, 2015; “Unpacking LEGO,” The Economist, March 8, 2014;
“Empire building,” The Economist, February 13, 2014; “Oh, snap! LEGO’s
sales surpass Mattel,” The Wall Street Journal, September 4, 2014; and “How
LEGO built up from innovation rubble,” Forbes, September 23, 2013.
avenue is partnerships such as strategic alliances
or even acquisitions. What lessons from LEGO’s
past should guide its future diversification?
Sources: Schmidt, G., and B. Barnes (2017, July 23), “For Warner Bros., a
cinematic universe’ built of Lego bricks,” The New York Times, Bury, R. (2017,
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Cirque du Soleil: Searching for a New Blue Ocean
rivals compete on. Perceived buyer value is increased
by raising existing key success factors and by creating
new elements that the industry has not offered previ-
ously. To initiate a strategic move that allows a firm
to open new and uncontested market space through
value innovation, managers must answer the four key
questions below when formulating a blue ocean busi-
ness strategy. In terms of achieving successful value
innovation, note that the first two questions focus on
lowering costs, while the other two questions focus on
increasing perceived consumer benefits.
Value Innovation: Lower Costs
1. Eliminate. Which of the factors that the industry
takes for granted should be eliminated?
2. Reduce. Which of the factors should be reduced
well below the industry’s standard?
FOUNDED IN 1984 by two street performers, Guy
Laliberté and Gilles Ste-Croix, in an inner-city area of
Montreal, Canada, Cirque du Soleil today is the largest
theatrical producer in the world. With its spectacularly
sophisticated shows, Cirque’s mission is to “evoke
the imagination, invoke the senses, and provoke the
emotions of people around the world.”1 Employing
some 5,000 people (one-third of them artists) and with
annual revenues of about $1 billion, Cirque is hugely
successful. Since its founding, some 200 million people
worldwide have been dazzled by its high-quality
artistic shows, with some 15 million viewers per year
recently. How did Cirque become so successful while
most circuses either shut down or barely survive?
Cirque’s Blue Ocean Strategy
and Value Innovation
Using a blue ocean strategy based on value innova-
tion, Cirque du Soleil created a new and thus uncon-
tested market space in the entertainment industry. A
blue ocean strategy attempts to make the competition
irrelevant by creating new, uncontested market spaces.
For a blue ocean strategy to succeed, managers must
resolve trade-offs between the two generic strategic
positions—low cost and differentiation. This is done
through value innovation, aligning innovation with
total perceived consumer benefits, price, and cost.
Instead of focusing to compete directly with rivals,
attempting to outcompete them by offering better
features or lower costs, successful value innovation
makes competition more or less irrelevant by provid-
ing a leap in value creation, thereby opening new and
uncontested market spaces.
Successful value innovation requires that a firm’s
strategic moves lower its costs and at the same time
increase the perceived value for buyers. Lowering a
firm’s costs is primarily achieved by eliminating and
reducing the taken-for-granted factors that the firm’s
MiniCase 13
©AP Images/Jonathan Short
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: August 1, 2017.
©Frank T. Rothaermel.
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MINICASE 13 Cirque du Soleil: Searching for a New Blue Ocean 489
rot27628_minicase13_488-490.indd 489 11/22/17 08:36 PM
attracted consumers who were used to paying much
higher ticket prices for live performances at the the-
ater and ballet than what the traveling circus charged,
it raised ticket prices (starting at $75 up to $200). This
was also possible because Cirque attracted an adult
audience rather than several children coming with one
adult to the circus.
CREATE. Cirque du Soleil created an entire new enter-
tainment experience. Cirque did this by combining the
fun and thrill elements of the traditional circus with
the sophistication and high-quality choreographed
performances of the theater. Cirque combined a num-
ber of unique entertainment features in novel ways.
Each show follows a storyline characterized by intel-
lectual, sophisticated, highly choreographed dance
performances and artistic music. In this sense, Cirque
shows are more akin to theater and ballet produc-
tions than traditional circuses, which deliver a lineup
of unrelated acts. Akin to Broadway shows, Cirque
offers multiple productions, playing at all the major
venues across the world. In summary, Cirque has cre-
ated much more sophisticated shows and dramatically
increased demand, even at high ticket prices. With
multiple productions and changing global venues,
visitors now also go to the “circus” more frequently.
A Perfect Storm
Although Cirque du Soleil’s venues are still glamor-
ous, the company has fallen on hard times in recent
years. A combination of external and internal factors
led to a significant decline in performance. Cirque du
Soleil was hit hard by the economic downturn dur-
ing the 2008–2010 global financial crisis. Cirque’s
management made the situation worse through poor
strategic decisions, including offering too many shows
that were too little differentiated (at least in the mind
of the consumer). As a consequence, Cirque lost its
rarity appeal, and its payroll and costs also ballooned.
Demand for its European shows dropped as much as
40 percent.
Misfortune also struck: In 2013 Cirque du Soleil
experienced its first fatality as one of its perform-
ers fell 95 feet to her death during a live show in Las
Vegas. The U.S. Occupational Safety and Health
Administration (OSHA) has issued citations and fines;
an in-depth investigation of safety practices at Cirque
revealed a very high injury rate. Some Cirque perform-
ers claim that the pressure to perform at a high level
created a culture where it is difficult to raise concerns
Value Innovation: Increase Perceived
Consumer Benefits
3. Raise. Which of the factors should be raised well
above the industry’s standard?
4. Create. Which factors should be created that the
industry has never offered?
Let’s take a closer look at how Cirque used the
eliminate-reduce-raise-create framework to reinvent
the circus and to create a blue ocean of uncontested
market space where competition is less of a concern.
ELIMINATE. In redefining the circus, Cirque du Soleil
eliminated several taken-for-granted elements. First,
Cirque did away with all animal shows. In recent
years, the public has grown much more concerned
about the humane treatment of animals. In addition,
animals were the most expensive items for a circus
because of their needed care, transportation, medical
attention, insurance, and food consumption (a grown
male lion can devour some 90 pounds of meat a day).
Second, Cirque did away with star performers. They
were also expensive; moreover, their name recognition
in comparison to movie or sports stars is trivial. Third,
it also abolished the standard three-ring venues. They
were also expensive since so many performers had
to be on stage at the same time, and they frequently
created anxiety among circus-goers as they switched
their attention rapidly from venue to venue. Finally,
it did away with aisle concession sales. They annoyed
most circus visitors not only because of the frequent
interruptions and interference with the viewing expe-
rience, but also because visitors felt taken advantage
of because of the vendors’ high prices.
REDUCE. Cirque kept the clowns, but reduced their
importance in the shows. Moreover, it shifted the
clown humor from slapstick and low-brow to a more
sophisticated and intellectually stimulating style.
RAISE. Cirque significantly raised the quality of
the live performance with its signature acrobatic and
aerial stunts to levels never seen before. While many
other circuses did away with the luxurious circus
tents of old in favor of generic low-cost venues that
they rented, Cirque, in contrast, glamorized the cir-
cus tent. Using the tent as a unique venue capturing
the magic of the circus, Cirque built tents with mag-
nificent exteriors, which attracted the attention of the
public, combined with a much higher level of comfort
and amenities in the tent’s interiors. Given that Cirque
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that required medical attention. One investigation
found that Cirque’s signature show had 56 injuries
per 100 workers, which is four times the injury
rate for professional sports teams, according to
the Bureau of Labor Statistics. What can Cirque’s
management do to address the safety concerns of
its performers? With more safety measures and
less risky shows, do you think Cirque du Soleil
will lose its differentiated appeal to audiences?
Why or why not?
4. In the search for a new blue ocean, Cirque is now
pursuing a strategy of diversification. What kind
of diversification opportunities could Cirque pur-
sue with its most recent acquisition of the Blue
Man Group? Cirque’s CEO evaluated the Blue
Man Productions acquisition as follows: “It’s a
big, big shift, and it has been supported by the
Blue Man Group. What it means is that now, we’re
no longer only a circus company, but now, we’re
going to become a global leader of entertainment.
That’s the goal we are pursuing.”2 Do you think
Cirque can become a “global leader of entertain-
ment.” Hint: Fosun, one of Cirque’s owners, is
keen to see a stronger presence of Cirque in China.
5. Assume that Cirque du Soleil’s new owner has
retained you (or your study group) as consultants.
First deduce Cirque’s current strategy from its
goals and actions. Then recommend changes in
that strategy formation and implementation, with
special attention to external threats and internal
weaknesses. How can Cirque once again gain and
sustain a competitive advantage? How can it best
implement your suggested changes? Be specific.
Endnotes
1. Cirque du Soleil at a Glance, www.cirquedusoleil.com/en/home/
about-us/at-a-glance.aspx.
2. Picker, L. (2017, July 6), “Private equity-backed Cirque du Soleil
inks deal for Blue Man Group as it looks to expand beyond circus,”
CNBC.
Sources: Picker, L. (2017, July 6), “Private equity-backed Cirque du Soleil inks
deal for Blue Man Group as it looks to expand beyond circus,” CNBC, July 6;
“Son of a Cirque du Soleil founder killed on set,” The Wall Street Journal /
Associated Press, November 30, 2016; Kim, W.C., and Mauborgne, R.
(2005), Blue Ocean Strategy: How to Create Uncontested Market Space
and Make the Competition Irrelevant (Boston, MA: Harvard Business
Review Press); “Cirque du Soleil’s next act: Rebalancing the business,”
The Wall Street Journal, December 1, 2014; “Cirque du Soleil tour
revenue tumbles to £40m,” The Telegraph, February 22, 2015; “Cirque
du Soleil being sold to private-equity group,” The Wall Street Journal,
April 20, 2015; “Injuries put safety in spotlight at Cirque du Soleil,”
The Wall Street Journal, April 22, 2015; “The perils of workers’ comp
for injured Cirque du Soleil performers,” The Wall Street Journal, April
24, 2015; and WSJ video on Cirque du Soleil, www.wsj.com/articles/
injuries-put-safety-in-spotlight-at-cirque-du-soleil-1429723558.
about acrobat safety. In 2016, the Cirque technician
Olivier Rochette died during a San Francisco show
after being hit in the head with an aerial lift. He was
the son of Cirque founder, Gilles Ste-Croix.
As a consequence of external threats combined
with internal weaknesses, Cirque du Soleil’s revenues
dropped from $1 billion in 2012 to $850 million in
2013. Cirque du Soleil is now in search of a new blue
ocean. It is attempting to diversify away from its trade-
mark live shows, characterized by creating theatrical
spectacles combining high-suspense acrobat stunts.
Given its poor safety record, it also revamped its shows
to reduce the risk to its performers. Cirque-branded
shows now deliver roughly 85 percent of the compa-
ny’s revenues; the company hopes to lower this to no
more than 60 percent in five to 10 years as it contin-
ues to diversify into TV programs, special events, and
auxiliary services such as ticketing. To increase its
appeal to high-growth markets outside North Amer-
ica, it is infusing Russian and Chinese influences as
well as improv comedy.
In 2015, Cirque du Soleil founder Guy Laliberté sold
his controlling ownership stake to an investor group led
by U.S. private-equity firm TPG. Other investors in
Cirque include Fosun, a Chinese investment firm, and
a Canadian pension fund. This deal valued Cirque at
$1.5 billion, down from a onetime $3 billion valuation.
Once flying high, Cirque du Soleil’s valuation had
dropped by 50 percent.
In searching for a new blue ocean, Cirque turned
to acquisitions. In 2017, it bought Blue Man Produc-
tions, the New York performance art company. Cirque
CEO Daniel Lamarre stated that with the acquisition
of Blue Man Group, Cirque is able to develop new
forms of entertainment, to reach new audiences, and
to expand its repertoire of creative capabilities. The
acquisition was part of broader strategy of diversifica-
tion, the CEO indicated.
DISCUSSION QUESTIONS
1. Cirque du Soleil was able to gain and sustain a
competitive advantage for many years. Why was
Cirque du Soleil successful in the first place (while
most other circuses barely survive)?
2. Which factors contributed to Cirque du Soleil
losing its competitive advantage, and as a conse-
quence led to a 50 percent drop in its valuation?
Look at both external and internal factors.
3. A recent report by OSHA concludes that Cirque
performers suffered a high number of injuries
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Wikipedia: Disrupting the Encyclopedia Business
encyclopedia. In Hawaiian, wiki means quick, refer-
ring to the instant do-it-yourself editing capabilities of
the site. Jimmy Wales identifies September 11, 2001,
as a “Eureka moment” for Wikipedia. Before 9/11,
Wikipedia was a small niche site. Immediately follow-
ing the terrorist attacks, millions of people visited the
site to learn more about what they had seen and heard
on the news. Massive numbers of queries for search
terms such as Al-Qaeda, the World Trade Center, the
Pentagon, the different airlines and airports involved,
etc., made Wales realize that Wikipedia “could be
big.” Some 17 years later, Wikipedia is visited about
200 times a second, or 500 million times a month! It
is ranked number five on the list of the world’s most
visited websites, just behind Google, Facebook, You-
Tube (also owned by Google/Alphabet), and Baidu, but
before well-known sites such as Yahoo, Amazon, Reddit,
and others. Wikipedia has more than 40 million articles
in nearly 300 languages, including some 5 million
WIKIPEDIA IS OFTEN the first source consulted for infor-
mation about an unfamiliar topic, but this was not
always the case. For almost 250 years, Encyclopaedia
Britannica was the gold standard for authoritative refer-
ence works, delving into more than 65,000 topics with
articles by some 4,000 scholarly contributors, including
many by Nobel laureates. The beautiful leather-bound,
multivolume set of books made a decorative item in
many homes. In the early 1990s, when total sales for
encyclopedias were over $1.2 billion annually, Ency-
clopaedia Britannica was the undisputed market leader,
holding more than 50 percent market share and earn-
ing some $650 million in revenues. Not surprisingly, its
superior differentiated appeal was highly correlated with
cost, reflected in its steep sticker price of up to $2,000.
Two innovation waves disrupted the encyclo-
pedia business and over time drove Encyclopædia
Britannica, Inc., the publisher of its namesake ref-
erence, to abandon its print version. Innovation—
the successful introduction of a new product, process,
or business model—is a powerful driver in the com-
petitive process.
The first wave was initiated by the introduction
of Encarta. Banking on the widespread diffusion of
the personal computer, Microsoft launched its elec-
tronic encyclopedia Encarta in 1993 at a price of $99.
Although some viewed it as merely a CD version of the
lower-cost and lower-quality Funk & Wagnalls ency-
clopedia sold in supermarkets, Encarta still took a big
bite out of Britannica’s market. Within only three years,
the market for printed encyclopedias had shrunk by
half, along with Britannica’s revenues, while Microsoft
sold over $100 million worth of Encarta CDs. This level
of disruption was compounded by a later development
that overtook both Encarta and printed encyclopedias.
The second wave of disruption through innova-
tion ultimately played the major role in driving the
Encyclopaedia Britannica out of printed media. In
January 2001, internet entrepreneur Jimmy Wales
launched Wikipedia, the free online multi-language
MiniCase 14
©BORIS ROESSLER/EPA/Newscom
Frank T. Rothaermel prepared this MiniCase from public sources.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: August 1, 2017.
© Frank T. Rothaermel.
Final PDF to printer
492 MINICASE 14 Wikipedia: Disrupting the Encyclopedia Business
rot27628_minicase14_491-493.indd 492 11/22/17 08:34 PM
The Upside How accurate is the result? What quality
is the information? Although Wikipedia’s volume of
English entries is more than 500 times greater than
that of the Britannica, the site is not as error-prone
as you might think. Wikipedia relies on the wisdom
of the crowds, which assumes “the many” often
know more than “the expert.” Moreover, user-gener-
ated content needs to be verifiable by made reliable
sources such as links to reputable websites. A peer-
reviewed study by Nature of selected science topics
found that the error rates of Wikipedia and Britannica
were roughly the same.
The Downside Wikipedia’s crowdsourcing approach
to user-generated content is not without criticism. The
most serious criticisms are that the content may be
unreliable and not authoritative, that it could exhibit
systematic bias, and that group dynamics might pre-
vent objective and factual reporting. Therefore many
users approach Wikipedia with caution; ideally, care-
ful researchers go to and review the sources of Wiki-
pedia articles for verification.
EASY. Despite real or perceived drawbacks, most
users will verify that Wikipedia remains easy to use,
especially free of the time-consuming apparatus found
on sites that use a marketing-based business model.
What Next for Wikipedia?
Every year or so articles come out questioning the
ability of Wikipedia to survive, given its uncertain
funding and amorphous (and possibly shrinking) body
of active volunteer editors.3 Others note that with
expanding use, the demands on its servers and infra-
structure threaten to bring the enterprise down.
In the meanwhile, social entrepreneur and founder
Jimmy Wales keeps going. In 2017 he proposed a new
and parallel effort, Wikitribune, aimed at fixing “bro-
ken” journalism.4 His goal? Evidence-based journalism
following a model very similar to Wikipedia.
DISCUSSION QUESTIONS
1. The MiniCase provides an example of how
advancements in technology can render traditional
business models obsolete. With the introduction
of its CD-based Encarta, Microsoft destroyed
about half the value created by Britannica. In
turn, Wikipedia moved away from Britannica’s
entries in English. Roughly 12,000 new pages spring
up each day.
The combined effect of these two innovations dev-
astated the business of printed encyclopedias. Sales
of the beautiful leather-bound Encyclopaedia Britan-
nica volumes declined from a peak of 120,000 sets in
1990 to a mere 12,000 sets in 2010. As a consequence,
Encyclopaedia Britannica Inc. announced in 2012 that
it no longer would print its namesake books. Its content
is now accessible via a paid subscription through its
website and apps for mobile devices. Encarta, which
began the disruptive cycle and had developed its own
online models to supplement delivery via CD, also
fell. Microsoft ceased all Encarta versions in 2009.
The Power of Free, Open, and Easy
Wikipedia is a nonprofit, advertising-free, social
entrepreneurship venture that owes its success to
being free to all users, open to improvement by all,
and easy to use, with no registration requirements and
no advertisements to suffer through.
WHO PAYS FOR FREE?. Wikipedia is exclusively
financed by donations. The site runs regular calls for
donations using slogans such as: “Please help us feed
the servers,” “We make the Internet not suck. Help us
out,” and “We are free, our bandwidth isn’t!”1 Calls for
donations also come in the form of personal appeals by
co-founder Wales. These appeals are effective. In 2015,
people donated more than $50 million in 70 currencies,
mostly via a large number of small donations through
its website. When asked why Wales wouldn’t want to
monetize one of the world’s most successful websites
by placing targeted ads for example, Wales responded
that running Wikipedia as a charity “just felt right,
knowledge should be free for everyone.”2 The ques-
tion arises whether the donation model is sustainable
given not only the increasing demand for Wikipedia’s
services, but also the emergence of competitors.
OPEN SOURCE SUPPORTS QUALITY. Wikipedia’s
slogan is the free encyclopedia that anyone can edit.
Since it is open source, any person, expert or novice, can
contribute content and edit pages using the handy “edit
this page” button. Although Wikipedia has 70 million
registered accounts, and any of these people can edit
content, some 100,000 Wikipedians represent the core.
They volunteer as editors and authors, representing
a global community of widely diverse views.
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3. How can Wikipedia maintain and grow its ability
to harness the crowdsourcing of its “Wikipedians”
to maintain high-quality and quickly updatable
content?
4. As Wikipedia keeps growing, do you think it can
continue to rely exclusively on time and money
donations? Why or why not? What other business
models could be considered? Would any of those
“violate the spirit of Wikipedia”? Why or why not?
5. What, if anything, should Wikipedia do to ensure
that its articles present a “neutral point of view”?
Shouldn’t the crowdsourcing approach ensure
objectivity? Does a “neutral point of view” matter
to Wikipedia’s sustainability? Why or why not?
6. Qualify Wales’ efforts around Wikitribune as to
the degree to which it has the same disruptive and
innovative benefits as Wikipedia.
Endnotes
1. http://en.wikipedia.org/wiki/Wikipedia:Donation_appeal_ideas,
accessed August 4, 2017.
2. CBS, 60 Minutes video “Wikimania,” www.cbsnews.com/news/
wikipedia-jimmy-wales-morley-safer-60-minutes/, April 5, 2015.
3. See, for example, Simonite, T. (2013, Oct. 22), “The Decline of
Wikipedia,” MIT Technology Review.
4. See interview by Smits, L., (2017, June 8), “Wikipedia Founder:
The Future of News ,” Finfeed.
Sources: Greenstein, S. (2017), “The reference wars: Encyclopædia
Britannica’s decline and Encarta’s emergence,” Strategic Management
Journal 38: 995–1017; CBS, 60 Minutes video, “Wikimania,”
www.cbsnews.com/news/wikipedia-jimmy-wales-morley-safer-60-minutes/,
April 5, 2015; “How Jimmy Wales’ Wikipedia harnessed the web as a force
for good,” Wired, March 19, 2013; Greenstein, S., and F. Zhu (2012),
“Is Wikipedia biased?” American Economic Review 102: 343–348; “End of
era for Encyclopaedia Britannica,” The Wall Street Journal, March 14,
2012; Greenstein, S., and F. Zhu (2012), “Is Wikipedia biased?” American
Economic Review 102: 343–348; www.encyclopediacenter.com;
www.alexa.com/topsites; “Wikipedia’s old-fashioned revolution,” The Wall
Street Journal, April 6, 2009; Anderson, C. (2009), Free. The Future of a
Radical Price (New York: Hyperion); “Internet encyclopedias go head-to-
head,” Nature, December 15, 2005; Anderson, C. (2006), The Long Tail.
Why the Future of Business Is Selling Less of More (New York: Hyperion);
Surowiecki, J. (2004), The Wisdom of Crowds (New York: Bantam Dell);
and, of course, various Wikipedia sources.
and Microsoft’s proprietary business models to
an open-source model powered by user-gener-
ated content and made available to anyone on the
internet. In doing so, it destroyed Encarta’s busi-
ness, which Microsoft shut down in 2009. At the
same time, Wikipedia created substantial benefits
for users by shifting to the open-source model
for content. Because Wikipedia was able to cre-
ate value for consumers by driving the price for
the end user to zero and making the information
instantly accessible on the internet, there is no
future for printed or CD-based encyclopedias.
a. What are the general take-aways in regard to
innovation as a driver of competition?
b. How can existing firms respond to disruptions
in their industry?
2. The founder of Wikipedia, Jimmy Wales, is a
social entrepreneur. 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. 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.
a. If you were the founder of Wikipedia, would
you want to monetize the business? Why or
why not?
b. What are the pros and cons of for-profit ver-
sus nonprofit business? Where do you come
down?
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Disney: Building Billion-Dollar Franchises
as Time Warner, Sony’s Columbia Pictures, and 21st
Century Fox.
Disney and Pixar: “Try Before You Buy”
To understand Disney’s corporate strategy of growing
through acquisition, let’s look at one of the most suc-
cessful deals in recent history: Disney acquired Pixar,
and then built a number of billion-dollar franchises
around it. It all started with a strategic alliance. Pixar
started as a computer hardware company producing
high-end graphic display systems. One of its custom-
ers was Disney. To demonstrate the graphic display
systems’ capabilities, Pixar produced short, computer-
animated movies. Despite being sophisticated, Pixar’s
computer hardware was not selling well, and the new
venture was hemorrhaging money. To the rescue rode
WITH $55 BILLION in annual revenues in 2017, Dis-
ney is the world’s largest media company and is
renowned for its Walt Disney Studios and the popular
Walt Disney Parks and Resorts. Over the past decade,
Disney has grown through a number of high-profile
acquisitions, including Pixar (2006), Marvel (2009),
and Lucasfilm (2012), the creator of Star Wars. All
this was done with the goal of building billion-dollar
franchises based on movie sequels, park rides, and
merchandise. In 2017, Disney revealed even bigger
ambitions.
Disney’s Corporate Strategy
As a diversified media company, Disney is active in a
wide array of business activities—movies, amusement
parks, cable and broadcast television networks (ABC,
ESPN, and others), cruises, and retailing. It became
the world’s leading media company to a large extent
by pursuing a corporate strategy of related-linked
diversification. That is, some, but not all, of Disney’s
business activities share common resources, capabili-
ties, and competencies.
Disney executes its corporate strategy by entering
alliances and acquiring other media businesses to create
theme-based franchises. The corporate strategy of cre-
ating billion-dollar franchises through diversification is
Disney’s main focus. CEO Bob Iger leads a group of
about 20 executives whose sole responsibility is to hunt
for new billion-dollar franchises. This group of senior
leaders decides top-down which projects are a go and
which are not. They also allocate resources to particu-
lar projects. Disney has even organized its employees in
the consumer products group around franchises such as
Frozen, Toy Story, Star Wars, and other cash cows.
The corporate strategy around building billion-dollar
franchises is certainly paying off: Disney has seen a steady
growth to its top line, and it earned some $10 billion in
profits in 2016. Its stock rose more than 350 percent
between 2010 and 2017, outperforming rivals such
MiniCase 15
Star Wars: The Force Awakens is part of the global Star Wars franchise. This
sequel alone is estimated to turn into a $10 billion franchise for Disney.
©Mim Friday/Alamy Stock Photo
Frank T. Rothaermel prepared this MiniCase for the purpose of class
discussion. He gratefully acknowledges research assistance by Amey
Sahasrabuddhe. This MiniCase is not intended to be used for any kind
of endorsement, source of data, or depiction of efficient or inefficient
management. All opinions expressed, all errors and omissions are entirely
the author’s. Revised and updated: August 1, 2017. © Frank T. Rothaermel.
Final PDF to printer
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providing some 60,000 YouTube creators with sup-
port by promoting their channels and selling ads.
Rather, Maker now the marching orders to focus on
no more than the top 250 YouTube content creators
with large followings. The goal is to build billion-
dollar franchises in the new on-demand TV space. One
Maker Studios early success story was YouTube mega-
star PewDiePie, who at one point had the most success-
ful YouTube channel and for many years was one of the
highest-profile stars on YouTube. In 2017, however,
Disney cut ties with PewDiePie following his posting
of videos in which he made inflammatory remarks, not
in line with Disney’s values.
Building Billion-Dollar Franchises
After taking the reins, CEO Iger transformed a lackluster
Disney following a decade or so of inferior performance
by refocusing it around what he calls franchises, which
generally begin with a big movie hit and are followed
up with derivative TV shows, theme park rides, video
games, toys, clothing such as T-shirts and PJs, among
many other spin-offs. Rather than churning out some
30 movies per year as it did before Iger, Disney now
produces about 10 movies per year, focusing on cre-
ating box-office hits. Disney’s annual movie lineup is
dominated by such franchises as Stars Wars and Marvel
superhero movies and also by live-action versions of
animated classics such as Cinderella and Beauty and the
Beast. The biggest Disney franchises that started with
a movie hit include the Pirates of the Caribbean (with
the franchise grossing more than $4 billion), Toy Story
(over $2 billion), Monsters Inc. (close to $2 billion),
Cars (over $1 billion), and, of course, Frozen.
The 2013 animated movie Frozen (made by Walt
Disney Animation Studios run by Pixar execs Catmull
and Lasseter) has grossed over $1.5 billion, making
it the most successful animated movie ever. To fur-
ther build its Frozen franchise, Disney is working on
a sequel of its animated movie hit for release in late
2019, and in the meanwhile it has spun off several
shorter films, much merchandise, and a dreamlike
ride through the fictional world of Arendelle at Disney
World’s Epcot Center, replacing a previous attraction
that had grown stale.
The Star Wars franchise, however, is clearly the
crown jewel in Disney’s lineup of billion-dollar
franchises. The 2015 Star Wars sequel The Force
Awakens grossed over $2 billion on the big screen,
making it the third-best-selling movie ever after Avatar
and Titanic.
not Buzz Lightyear, but Steve Jobs. Shortly after being
ousted from Apple in 1986, Jobs bought the struggling
hardware company for $5 million and founded Pixar
Animation Studios, investing another $5 million into
it. The Pixar team, led by Edwin Catmull and John
Lasseter, then transformed the company into a computer-
animation film studio.
To finance and distribute its newly created computer-
animated movies, Pixar entered a strategic alliance with
Disney. Disney’s distribution network and its stellar
reputation in animated movies were critical comple-
mentary assets that Pixar needed to commercialize its
new type of films. In turn, Disney was able to rejuve-
nate its floundering product lineup, retaining the rights
to the newly created Pixar characters and to any sequels.
Pixar became successful beyond imagination as
it rolled out one blockbuster after another: Toy Story
(1, 2, and 3), A Bug’s Life, Monsters Inc., Finding Nemo,
The Incredibles, and Cars, grossing several billion
dollars. Given Pixar’s huge success and Disney’s
abysmal performance with its own releases during
this time, the bargaining power in the alliance shifted
dramatically. Renegotiations of the Pixar–Disney
alliance broke down in 2004, reportedly because of
personality conflicts between Steve Jobs and then-
Disney Chairman and CEO Michael Eisner.
After Robert Iger was appointed CEO, Disney
acquired Pixar for $7.4 billion in 2006. The success
of the alliance demonstrated that the two entities’
complementary assets matched, and it gave Disney an
inside perspective on the value of Pixar’s core compe-
tencies in the creation of computer-animated features.
Integrating Pixar allowed Disney to transfer and apply
some of its unique competencies including marketing,
brand building, product extensions.
Acquisitions Ever After . . .
In 2009, Disney turned to acquisitions again. The
acquisition of Marvel Entertainment for $4 billion
added Spider-Man, Iron Man, The Incredible Hulk,
and Captain America to its lineup of characters.
Marvel’s superheroes grossed a cumulative $15 billion
at the box office, with The Avengers bringing in some
$2 billion. In 2012, Mickey Mouse’s extended family
was joined by Darth Vader, Obi-Wan Kenobi, Prin-
cess Leia, and Luke Skywalker when Disney acquired
Lucasfilm for more than $4 billion.
In 2014, Disney acquired Maker Studios, a YouTube-
based multichannel network, for $675 million. Under
Disney, Maker Studies is no longer focused on
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1. Risks of Relying on a Few Big Franchises. Dis-
ney’s approach is risky. What if the pipeline dries
up? That is, how sustainable is an acquisition-led
growth strategy? Not many media companies remain
of the same caliber as Pixar, Marvel, or Lucasfilm.
2. Losing Originality. Critics worry that focusing
on billion-dollar franchises hampers Disney’s
originality. Moviegoers could write off Disney’s
offerings as too predictable.
3. Problems on the TV Side. Roughly half of Dis-
ney’s profits come from its TV networks ESPN,
ABC, and others. Yet that industry is in disrup-
tion. People spend more time and sometimes
money watching content online via YouTube, Net-
flix, Hulu, and other streaming services, and they
watch less TV. This means the numbers of TV
viewers and cable subscribers are in decline.
4. Underperforming Acquisitions. Disney’s acqui-
sitions have not been uniformly successful. While
Disney won big with franchise-based studios Pixar
and Lucasfilm, it has also lost money and focus
with the acquisition of technology companies.
Examples include online video producer Maker
Studios (2014) and social gaming company Play-
dom Inc. (2010).
5. Issues of Succession. Who will succeed Robert Iger
as CEO? He was the architect of Disney’s corpo-
rate strategy of building billion-dollar franchises
and implemented it to achieve new levels of growth.
Appointed in 2005, he originally planned to step
down in 2015. Most recently he extended his ten-
ure until 2019. With no clear internal candidates to
take over the mantle as CEO, Disney has no heir
apparent.
These challenges were suddenly cast in a new light
when Iger announced a strategic shift, significantly
changing the complexity of several of these challenges.
Iger Joins the Disruption
In 2017 Iger announced that Disney would launch
two streaming services similar to Netflix. One service
would focus on ESPN’s audience and start in 2018,
the other on Disney’s huge catalog of original content
and start in 2019.
AN ESPN STREAMING SERVICE. While the ESPN
service will focus on ESPN’s audience, it will not
cannibalize the existing ESPN stations. The ESPN
Intergalactic Finance: The Star Wars
Franchise Is Worth $10 Billion
The numbers generated around the Star Wars fran-
chise do seem fantastic. First, just consider the grosses
of the movies. Although The Force Awakens grossed
over $2 billion in box-office receipts on a budget of
about $260 million, NYU finance professor Aswath
Damodaran estimates the final gross receipts of the
2015 Star Wars sequel to be $10 billion.
HOW ONE MOVIE GROSSES $10 BILLION. Profes-
sor Damodaran extrapolated add-on revenue by using
historical data, so he could project anticipated reve-
nues not just from The Force Awakens but also from
other announced sequels in the pipeline. Here is how
a simple version of his model plays out, based on
the reported box-office receipts the 2015 for sequel
of roughly $10 million. Note that add-on revenue is
computed using a multiplier (shown in parentheses) of
box-office receipts.1
∙ Box-office receipts: $2 billion.
∙ Streaming revenue (1.2): $2.4 billion.
∙ Toys and merchandise (1.8): $ 3.6 billion
∙ Books and e-books (0.2): $ 0.4 billion.
∙ Gaming (0.5): $ 1 billion.
∙ TV shows and other (0.5): $ 1 billion.
Thus the total gross receipts for The Force Awakens
are $10.4 billion.
VALUATION OF A FRANCHISE. By coincidence, Damo-
daran ultimately values the entire Star Wars franchise
at the same amount—around $10 billion. He therefore
concludes that Disney’s $4 billion price tag for Lucas-
film was a good investment. Again, the astonishing
valuation of the franchise—or the reveal of the likely
true gross receipts of a new film in the franchise—is
explained by Disney’s ability to build revenue on top
of billion-dollar franchises through product extensions
and add-ons. The Star Wars empire has a far reach in
many corners of commerce, let alone in the galaxy.
Clouds on Disney’s Horizon
While things have been sunny in Southern California,
where Disney is headquartered, there are clouds on
the horizon, which is to say Disney has been facing a
number of potential challenges.
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DISCUSSION QUESTIONS
1. Before announcing its streaming services, what
type of corporate strategy was Disney pursuing?
Which core competencies were shared and how?
2. Why do you think Disney’s acquisitions of Pixar,
Marvel, and Lucasfilm were so successful, while
other media interactions such as Sony’s acquisi-
tion of Columbia Pictures and News Corp.’s acqui-
sition of Myspace were much less successful?
3. Do you think focusing on billion-dollar franchises
has been a good corporate strategy for Disney?
What are pros and cons of this strategy?
4. Given the build-borrow-or-buy framework, do you
think Disney should pursue alternatives to acquisi-
tions? Why or why not?
5. Given Disney’s focus on creating and monetizing
billion-dollar franchises, some industry observers
now view Disney more as a global consumer prod-
ucts company like Nike rather than a media com-
pany. Do you agree with this perspective? Why or
why not? What strategic implications would it have
if Disney is truly a global consumer products com-
pany rather than a media and marketing company?
6. What type of corporate strategy is evidenced in
Disney’s announced streaming services? What are
the potential benefits and risks of such strategies?
Endnote
1. This assessment uses the simple and generic model taken from
Aswath Damodaran’s 2015 blog posting that generated the 2016 Forbes
article. Specifically this computation uses the multipliers to apply to
box-office receipts of movies in the pipeline. Compare: Damodaran,
A. (2015), “Intergalactic finance: Valuating the Star Wars franchise,”
Musings on Markets [blog], December 28, at http://aswathdamodaran.
blogspot.com/2015/12/intergalactic-finance-valuing-star-wars.html, and
Damodaran, A. (2016), “Intergalactic finance: Why the Star Wars franchise
is worth nearly $10 billion to Disney,” Forbes, January 6.
Sources: Barnes, B. (2017, Aug. 9), “With Disney’s move to streaming,
a new era begins,” The New York Times, Schwartzel, E., J. Lublin, and D.
Cimilluca (2016, Sept. 26), “Disney considers offer for Twitter,” The Wall
Street Journal, Fritz, B. (2017, Feb. 7), “Walt Disney pressured by sagging
ESPN performance,” The Wall Street Journal, Fritz, B. (2017, Mar. 23),
“Disney extends CEO Robert Iger’s tenure to 2019,” The Wall Street Journal,
Fritz, B. (2017, May 16), “Disney’s Iger isn’t about to let go as CEO,” The
Wall Street Journal, “ESPN is losing subscribers but it is still Disney’s
cash machine,” The Economist, May 6, 2017; Fitz, B. (2015, June 8),
“How Disney milks its hits for profits ever after,” The Wall Street Journal,
Damodaran, A. (2016, Jan. 6), “Intergalactic finance: Why the Star Wars
franchise is worth nearly $10 billion to Disney,” Forbes, Catmull, E., and A.
Wallace (2014), Creativity, Inc.: Overcoming the Unseen Forces That Stand
in the Way of True Inspiration (New York: Random House); “Superman v
Spider-Man,” The Economist, January 15, 2013; “Disney buys out George
Lucas, the creator of ‘Star Wars,’” The Economist, November 3, 2012;
Isaacson, W. (2011), Steve Jobs (New York: Simon & Schuster); “Marvel
superheroes join the Disney family,” The Wall Street Journal, August 31,
2009; Paik, K. (2007), To Infinity and Beyond!: The Story of Pixar Animation
Studios (New York: Chronicle Books); and various Disney annual reports.
streaming service will carry new sports content that
extends the ESPN cable content—if you already sub-
scribe to ESPN on cable, you would be able to also
watch the cable events over the streaming service.
This decision may reflect the importance that cable
companies place on the ESPN sports channels as their
single biggest draw overall, their “must-have” compo-
nent of the cable offering. But the cable companies
were increasingly frustrated by rising costs, especially
as the costs affected viewership. ESPN, often the most
expensive part of the cable bundle, accounts for over
$8 per month of cable charges even when distributed
across all subscribers, by some estimates.
Cable companies wanted Disney to rein in fees
because subscribers were growing more restive and
some had already jumped ship. ESPN at its peak had
100 million subscribers, but has lost close to 12 million
subscribers in the past five years. And cable companies
feared such a loss was just the beginning of a subscriber
revolt, with subscribers demanding ESPN become
unbundled from cable packages.
A FRANCHISE STREAMING SERVICE. While the pro-
posed ESPN streaming service may not adversely impact
ESPN channels, the decision to create a streaming ser-
vice for many of Disney’s blue-chip franchises has much
greater potential, with special impact on Netflix.
Iger has announced that Disney will be pulling
most of its movies from Netflix over the next two
years. Some analysts see this move as reducing the
value of Netflix to subscribers. Others see the con-
tent being pulled as relatively minor. First, Disney
has not yet decided if it would pull its Marvel or Star
Wars movies from Netflix, and second, none of the
Marvel series (think the Marvel Defenders, Jessica
Jones, and Luke Cage) will go because they are copro-
ductions with Netflix.
TECHNOLOGY IS KEY. To make this streaming happen,
Disney is making one highly focused technology
acquisition. Last year it acquired a third of BamTech—
which supplies streaming services for HBO and many
sports events—and has an option to buy a controlling
interest.
EARLY DAYS. It is too early yet to tell how this shift
in corporate strategy will play out. But what is clear
now is that in the face of various issues noted above,
Disney under Iger has decided to increase its indepen-
dence in unsettled media markets. Instead of fighting
the disruption, Disney is joining it.
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Hollywood Goes Global
BLOCKBUSTER MOVIES have always been a quintes-
sentially American product. Globalization, however,
has changed the economics of the movie industry.
Foreign ticket sales for Hollywood blockbusters made
up 50 percent of worldwide totals in 2000. By 2016,
they made up more than 70 percent, with some mov-
ies (e.g., Transformers: Age of Extinction) grossing
80 percent of total box-office receipts overseas. Of
the total $38.6 billion that Hollywood movies grossed
in 2016, more than $27.2 billion came from outside
North America. Today, largely because of the collapse
of DVD/Blu-ray sales, Hollywood would be unable to
continue producing big-budget movies without for-
eign revenues. Foreign sales now make or break the
success of newly released big-budget movies.
Avatar is the highest-grossing movie to date, earn-
ing almost $3 billion since its release in 2009. Non-
U.S. box-office sales account for close to 75 percent
of that number. Avatar was hugely popular in Asia,
especially in China, where the government gave per-
mission to increase the number of movie theaters
showing the film from 5,000 to 35,000. Another of
James Cameron’s popular films, Titanic, grossed
almost 70 percent of its close to $2 billion earnings in
overseas markets. Exhibit MC16.1 depicts the lifetime
revenues of Hollywood’s all-time blockbuster movies,
broken down into domestic and foreign.
“We Need Movies That Break Out
Internationally”
Given the increasing importance of non-U.S. box-
office sales, Hollywood studios are changing their
business models. Rob Moore, vice chairman of Para-
mount Pictures, explains: “We need to make mov-
ies that have the ability to break out internationally.
That’s the only way to make the economic puzzle
of film production work today.”1 For instance, in
2014, only one film grossed more than $300 million
in the U.S. home market (Guardians of the Galaxy).
MiniCase 16
With a budget of $150 million, and starring Matt Damon and Jing Tian, The Great
Wall is the most ambitious coproduced movie between Hollywood and Chinese
film studies to date. The Great Wall is also the most expensive movie ever shot
exclusively in China.
©LEGENDARY EAST/ATLAS ENTERTAINMENTKAVA PROD/LE VISION
PICTUR/Album/Newscom
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges research assistance by Amey Sahasrabuddhe.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors
and omissions are entirely the author’s. Revised and updated: July 4, 2017.
©Frank T. Rothaermel.
Thanks to international releases, however, 2014 was
one of the most profitable for Hollywood. As a result,
movie studios have changed a number of tactics.
Some mega-releases such as Disney’s Monsters Uni-
versity (the prequel to Monsters, Inc.) premiered first
in foreign markets before being shown in the United
States. Avengers: Age of Ultron set the record in 2015
for the biggest overseas opening, surpassing a record
set weeks earlier by Furious 7, in The Fast and the
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faced by U.S. films when selling internationally.
Besides potential government interference with con-
tent, there are numerous piracy concerns. Even in the
European Union (EU), where some countries impose
fines on producers and buyers of pirated content, other
countries, such as Spain, have long been havens for
the distribution of illegal movies and music. In 2011,
Spain passed a law to provide better protection of
copyrighted material, but enforcement is notoriously
difficult in a country where nearly 50 percent of all
internet users admit to illegally downloading copy-
righted content (twice the EU average).
Movie studios are moving to simultaneous world-
wide releases of expected blockbusters in part to try
to cut down on the revenues lost to piracy. Yet growth
in China (and elsewhere) is not as profitable as tra-
ditional releases in the United States. For example,
film distributors typically earn 50 to 55 percent of
box-office revenues in America. The average in many
other countries is closer to 40 percent (the rest goes to
the cinema owner). But in China, a typical Hollywood
film distributor gets only 15 percent of the box-office
ticket revenue. Moreover, stringent regulations by
the Chinese government mean that only a select few
Furious film series. Unsurprisingly, the record passed
back to the eighth movie in The Fast and the Furi-
ous film series when it hauled in $44.3 million in the
opening weekend, with a whopping 80 percent of its
total opening weekend sales coming from screens out-
side the United States.
Hollywood is also adapting scripts to appeal to
global audiences, casting foreign actors in leading
roles, and pulling the plug on projects that seem too
U.S.-centric. For example, the film G.I. Joe: The Rise
of Cobra prominently featured South Korean movie
star Byung-hun Lee and South African actor Arnold
Vosloo. Although Hollywood has had to release ver-
sions of films edited to meet local censorship rules for
many years, a recent phenomenon has been the record-
ing of special scenes to cater to audiences in specific
markets. Other challenges also loom. In 2014, hack-
ers famously penetrated Sony Pictures and publicly
posted damaging internal e-mails as retaliation for the
comedy film The Interview, about the assassination of
North Korean leader Kim Jong-un.
The fact that Hollywood now garners roughly
seven out of 10 dollars of its revenues internation-
ally is somewhat surprising, given several constraints
Avatar (2009)
$0 $500 $1,000 $1,500 $2,000 $2,500 $3,000
Non-U.S. sales, ($ mn)
Life Time Box Office Total
Titanic (1997)
Star Wars: The Force Awakens (2015)
Jurassic World (2015)
Marvel’s The Avengers (2012)
Furious 7 (2015)
Avengers: Age of Ultron (2015)
Harry Potter and the Deathly Hallows 2 (2011)
Frozen (2013)
Beauty and the Beast (2017)
The Fate of the Furious (2017)
Iron Man 3 (2013)
Minions (2015)
Captain America: Civil War (2016)
Transformers: Dark of the Moon (2011)
The Lord of the Rings: The Return of the King (2003)
Skyfall (2012)
Transformers: Age of Extinction (2014)
The Dark Knight Rises (2012)
Toy Story 3 (2010)
U.S. sales, ($ mn)
EXHIBIT MC16.1 / Lifetime Revenues of Top 20 Hollywood Blockbuster Movies (release year in parentheses)
SOURCE: Depiction of data from Box Office Mojo, http://boxofficemojo.com for years 2010–2017.
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For instance, Disney’s Marvel Studios produced two
versions of the 2013 box office hit Iron Man 3. One
version was produced for general release, and another
version was specifically targeted for Chinese movie-
goers. This version included bonus footage in Beijing
and guest appearances by Chinese movie stars. In
addition, the hits Mission Impossible III and Skyfall
were edited for the Chinese market to cut scenes that
Chinese censors thought portrayed China in a negative
light, even though several key scenes from these films
were set in China.
Some critics assert that Hollywood’s accommo-
dating of Chinese preferences is going too far, and
amounts to pandering. For instance, in The Martian,
released in 2015, NASA had to accept help from its
counterpart, the China National Space Administration,
to provide a classified booster rocket that would carry
payload to Mars and thus allow NASA (which did not
have such an advanced rocket at its disposal) to rescue
its stranded astronaut.
The Great Wall (released in China in December
2016 and in the United States in February 2017)
marked a new level of U.S.-China collaboration in
Hollywood movies can make it to Chinese theaters. As
of 2017, China allows only 34 foreign movie imports
a year. The state-backed distributor China Film Group
also restricts most Chinese theaters to Chinese films
during national holidays, further reducing revenue for
Hollywood studios.
China: The Largest Movie
Market by 2020
That the economics of the movie industry have funda-
mentally changed is further demonstrated by the fact
that in 2016 China was the second-largest contribu-
tor to Hollywood’s top line, with close to $7 billion in
annual revenues. China’s overall box-office revenues
have tripled between 2013 and 2016. Most impressive,
China is poised to exceed the United States in terms
of total box-office sales in a few short years, making
it the largest movie market globally. Exhibit MC16.2
depicts overall box-office revenues for the United
States and China.
Given China’s importance as a movie market, it is
no wonder that Hollywood executives aim to please.
EXHIBIT MC16.2 / Box Office Revenue in the United States and China, 2000–2020
$12,000
Revenue (mns)
$9,000
$6,000
$3,000
$0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
U.S. China
SOURCE: Depiction of data from IHS Markit (with projections for U.S. beginning in 2016 and China in 2017).
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Chinese consumer (and government officials approv-
ing the screening of foreign movies).
China is also infamous for rampant infringement of
copyright, resulting in a flourishing market for bootleg
content. In 2010, a Chinese government report found
that the market for pirated DVDs was $6 billion. As
a comparison, the total box-office revenues in China
in 2010 were a mere $1.5 billion. One reason is that
ticket prices for movies in China are steep and movies
are still considered luxury entertainment that few are
willing to pay for. Another reason that black-market
sales in China are so high is that legitimate sales often
are not allowed. As mentioned, China allows only a
few dozen new non-Chinese movies into its theaters
each year. Additionally, it has strict licensing rules
on the sale of home-entertainment goods. As a result,
there is often no legitimate product competing with
the bootleg offerings available via DVD and the inter-
net in China.
With the move from physical media such as DVDs
and Blu-ray discs to online streaming, Chinese stream-
ing and video-on-demand services are growing rapidly.
In 2016, PPTV, a Chinese online streaming website,
secured the post-theater rights to Warcraft for $24 mil-
lion, indicating a potentially new source of revenues
for Hollywood. While Netflix does not yet do business
directly in China, and the government blocks computers
in China from accessing Netflix’s service, it is estimated
that 20 million Chinese access Netflix using proxy serv-
ers that mask the actual location of the user’s machine.
Netflix’s original series House of Cards has been a huge
success not only in the United States but also in China.
In 2017, Netflix came one step closer to directly access-
ing the China market. It signed a licensing agreement
with video platform IQiyi, owned by Chinese internet
search company Baidu, which will stream its original
content. Netflix content, however, could give Chinese
regulators pause. The House of Cards plotline, for exam-
ple, involves a corrupt Chinese businessman operating at
the highest level of politics.
Enter Bollywood
The huge opportunities in the global movie market
have also attracted new entrants. Besides wanting to
cater to international audiences, Hollywood film stu-
dios are also feeling squeezed by low-cost foreign
competition. While certainly not number one in terms
of revenue, India’s Bollywood films have long been
movie production. Directed by Zhang Yimou, who
rose to fame when he choreographed the opening
and closing ceremonies of the 2008 Beijing Summer
Olympic Games, the movie co-stars Damon and Jing
Tian. Damon plays a European mercenary who joins
forces with a Chinese commander, played by Jing
Tian, to fight mysterious invaders at the Great Wall.
With a mega-budget of $150 million, The Great Wall
is the most ambitious coproduction between Holly-
wood and Chinese film studies to date. It is also the
most expensive movie ever shot exclusively in China.
As an official coproduction between U.S. and Chinese
companies, The Great Wall combines cast and effects
from both countries and could offer a template for
future American-Chinese movies.
Although the hope was that The Great Wall would
appeal to both Chinese and U.S. audiences, the movie
flopped in the United States. Critics highlight the
difficulties of creating movies that blend Eastern
and Western stories and characters. To produce The
Great Wall, the companies had to retain more than
100 interpreters to deal with conflicts among cast and
crew members based on different cultural understand-
ings. In the United States, The Great Wall made only
some $35 million, against a total estimated loss of
$75 million. Yet movie studios are undeterred. They
admit that although The Great Wall was a commercial
failure, they blame that in part on negative reviews.
Movie executives continue to highlight the huge mar-
ket opportunities in China and emphasize that they
will soon find the right formula to make movies that
are attractive to both U.S. and Chinese audiences.
Challenges with the Chinese Market
Although the Chinese market clearly provides a poten-
tially huge upside for Hollywood, this opportunity does
not come without its challenges. One serious chal-
lenge is content editing by government officials before
screening. The Oscar-winning film Django Unchained
saw its release in China temporarily canceled due to
“technical reasons,” which were interpreted to mean
excessive violent and sexual content. By the time the
film was recut and released, it performed poorly, in
part driven by the fact that many Chinese filmgoers
had already seen the film unedited on pirated DVDs.
The remake of the film Red Dawn was digitally edited
in postproduction to change the invading Chinese army
to an army from North Korea to avoid offending the
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strategy would that entail? What are some benefits
of this type of global positioning? What are some
of its risks? Why is this type of global positioning
so hard to achieve?
5. What can movie producers do to ensure that future
Chinese-U.S. co-productions are more successful?
Explain.
Endnote
1. “Plot change: Foreign forces transform Hollywood films,” The Wall
Street Journal, August 2, 2010.
Sources: Faughnder, R. (2017, Apr. 25), “Netflix finds a path into China
through Baidu streaming service,” The Los Angeles Times; McClintock,
P., and S. Galloway (2017, Mar. 2), “Matt Damon’s ‘The Great Wall’ to
lose $75 million; future U.S.-China productions in doubt,” The Hollywood
Reporter, http://www.hollywoodreporter.com/news/what-great-
walls-box-office-flop-will-cost-studios-981602, accessed July 4, 2017;
Schwartzel, E. (2016, Aug. 18), “’Warcraft’ deal sets record for streaming
video in China,” The Wall Street Journal; Lin, L., and W. Ma (2017, July 1),
“Hollywood seeks better deal as China’s box office growth slows,” The Wall
Street Journal; Langfitt, F. (2015, May 18), “How China’s censors influence
Hollywood,” NPR, www.npr.org/sections/parallels/2015/05/18/407619652/
how-chinas-censors-influence-hollywood, accessed July 5, 2015; Lin,
L. (2015, May 15), “Netflix in talks to take content to China,” The Wall
Street Journal; Editorial Board (2015, Jan. 31), “China’s losing battle with
Internet censorship,” Chicago Tribune; Brook, T. (2014, Oct. 21), “How the
global box office is changing Hollywood,” BBC; Kuo, L. (2014, Mar. 27),
“China’s film market is going gangbusters, but it may not help Hollywood
much,” Quartz; Miller, D. (2014, June 14), “After the controversy, ‘Django
Unchained’ flops in China,” The Los Angeles Times; McCarthy, N. (2014,
Sept. 3), “Bollywood: India’s film industry by the numbers,” Forbes;
Takada, K. (2013, Apr. 11), “China debut of Django Unchained suddenly
cancelled for technical reasons,” Reuters; MacSlarrow, J. (2013, June 7 ),
“Is Bollywood India’s next greatest export?” Global Intellectual Property
Center; ‘Hobbit’ to break $1 billion,” Daily Variety, January 22, 2013;
“China gets its own version of Iron Man 3 after Disney allows the
country’s film censors onto the set,” MailOnline, April 14, 2012; Levin,
D., and J. Horn (2011, Mar. 22), “DVD pirates running rampant in China,”
Los Angeles Times; “Ending the open season on artists,” The Economist,
February 17, 2011; “Bigger abroad,” The Economist, February 17, 2011;
Schuker, L. (2010, Aug. 2), “Plot change: Foreign forces transform
Hollywood films,” The Wall Street Journal; Schuker, L. (2009, Apr. 2)
“Hollywood squeezes stars’ pay in slump,” The Wall Street Journal;
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and D. Carr (2009, Feb. 23), ”A ‘Slumdog’ kind of the night at the Oscar
ceremony,” The New York Times.
king in terms of total ticket sales. Although generally
smaller-budget productions than Hollywood, the Hindi
film industry in Bollywood produces four times as
many films per year. Moreover, Bollywood brings in
low-cost but high-impact actors such as Freida Pinto
and Dev Patel, who played the lead roles in the mega-
success Slumdog Millionaire. Slumdog’s budget was
merely $14 million, but the movie grossed almost
$400 million and won eight Oscars. By comparison,
Hollywood’s budget for Home Alone, a similar success
in terms of revenues, was nearly five times as large.
Globalization also puts pressure on the pay of Hol-
lywood stars. Given the importance of international
audiences and the availability of foreign stars and mov-
ies, the days are over when stars such as Tom Hanks,
Angelina Jolie, Denzel Washington, or Julia Roberts
could demand 20 percent royalties on total ticket sales.
DISCUSSION QUESTIONS
1. How has the global environment changed for U.S.
(Hollywood) movie studies since 2000? Explain.
2. Apply the integration-responsiveness framework to
describe which global strategy Hollywood studios
followed originally, and how their strategic position-
ing has changed over time. Explain how and why.
3. When commenting on the disappointing perfor-
mance of The Great Wall, movie executives con-
tinue to highlight the huge market opportunities in
China, and emphasize that they will soon find the
right formula to make movies that are attractive to
both U.S. and Chinese audiences. Do you agree
with this assessment? Why or why not?
4. Assuming that movie studios will be able to create
breakthrough hits that are attractive for both East-
ern and Western audiences, what type of global
Final PDF to printer
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges research assistance by Rahul Singh. This
MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or
depiction of efficient or inefficient management. All opinions expressed,
all errors and omissions are entirely the author’s. Revised and updated:
August 25, 2017. © Frank T. Rothaermel.
503
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Samsung Electronics: Burned by Success?
Humble Beginnings
In 1938, when the Western world was still recover-
ing from the Great Depression and World War II was
about to break out, Lee Byung-chul started a small
trading company in Korea (at that time still under
Japanese occupation). He named the trading company
Samsung, which means three stars in Korean, symbol-
izing big, powerful, and numerous. Samsung started
with just 40 employees and sold noodles and dried sea-
food. It has since diversified into various industries,
including electronics, chemicals, pharmaceuticals,
shipbuilding, financial services, and construction. As
a result, Samsung today is a widely diversified con-
glomerate with over 80 standalone subsidiaries. The
sprawling chaebol has 490,000 employees more than
Apple, Google, and Microsoft combined. Not surpris-
ingly, the huge enterprise exerts a powerful influence
WITH $176 BILLION in revenues in 2017, Samsung
Electronics is the crown jewel of Samsung Group, with
its mobile division contributing some 75 percent of the
conglomerate’s overall profits. The Samsung Group is
one of the biggest conglomerates globally. In compari-
son, the U.S. conglomerate General Electric had some
$150 billion in revenues, while the Tata group of India
registered $104 billion in the same year. Indeed, Sam-
sung is the largest chaebol in South Korea, making up
one-third of the entire stock market domestically, and it
is the country’s biggest exporter. Chaebols are family-
owned multinational companies typical of South
Korea, whose economy is dominated by a small num-
ber of chaebols (including LG, Hyundai, Kia Motors,
SK Group, and others).
As impressive as the achievements of the largest
chaebol in South Korea may sound, Samsung Elec-
tronics is facing a host of challenges, creating a per-
fect storm that calls into question Samsung’s future
viability. In recent years, the Korean conglomerate has
been beset with crises, including:
∙ Leadership. Lee Kun-hee, Samsung’s iconic
chairman and long-time leader, remains incapaci-
tated after a heart attack in 2014. This situation is
creating a leadership vacuum.
∙ Product recall. In 2016, Samsung’s flagship
phone, the Galaxy Note 7, was withdrawn from
the market after some of the new phones spontane-
ously exploded and caught on fire.
∙ Political scandal. In 2017, Lee Jae-yong, the de-facto
leader of Samsung (and son of Lee Kun-hee), was
arrested and charged with bribery, embezzlement,
and perjury in the wake of the scandal surrounding
former South Korean President Park Geun-hye.
Before taking a closer look at the current chal-
lenges, we need first to understand a bit of Sam-
sung’s storied history and its role in the South Korean
economy.
MiniCase 17
An exploded Samsung Galaxy Note 7.
©AP Images/Shawn L. Minter
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504 MINICASE 17 Samsung Electronics: Burned by Success?
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and mobile phones. During a 1993 trip, Lee Kun-
hee saw firsthand how poorly Samsung’s electronics
were perceived in the United States and Europe, and
he vowed to change that. Back in Korea, to show his
disappointment and determination alike, he destroyed
150,000 new Samsung cell phones in a large bonfire
in front of all 2,000 employees of Samsung’s Gami
factory. Many employees credit this as the pivotal
moment in redefining Samsung Electronics’ strategic
focus and initiating a successful turnaround. Under
Lee Kun-hee’s leadership, Samsung Electronics sig-
nificantly increased spending on research and devel-
opment (R&D) as well as on marketing and design.
Once economies of scale due to a larger market share
could be reaped, he moved Samsung to the high end
of the market, offering premium consumer electronics
such as flat-screen TVs, appliances, semiconductors,
and mobile devices, including its famous Galaxy line
of smartphones.
In 2007, Apple introduced the iPhone, redefining
the entire category of mobile phones and setting the
standard for the way smartphones looked and felt.
Samsung played catch-up again, ratcheting up spend-
ing on R&D and marketing. In particular, the company
applied its time-tested “follow first, innovate second”
rule. As a key component vendor to other leading tech-
nology companies including Apple, Samsung Elec-
tronics saw early on what directions other companies
were taking. Within a short time, it had overtaken
Motorola, HTC, BlackBerry, Nokia, and even Apple to
become the number-one vendor of smartphones in the
world and the largest technology company globally by
revenues, and held the largest market share by units
(see Exhibit MC17.1). By 2012, with the release of
its Galaxy S III phone, Samsung had successfully
imitated the look and feel of the Apple iPhone. Apple
and Samsung, however, have been locked in ongoing
court battles over infringement among the various
smartphone models. Samsung lost a high-profile case
against Apple in a California court in 2015, where
damages were later reduced to some $500 million.
Despite the temporary competitive advantage
Samsung achieved in 2012, within several years it stum-
bled, with revenues and profits down sharply from its
peak in 2013 (see Exhibit MC17.2). Although it sells
fewer phones than Samsung, Apple’s profit margin
per phone is much higher. With the introduction of the
iPhone 6 in 2014, Apple again pulled away from Sam-
sung. With the larger screen on the iPhone 6 Plus, Apple
on South Korea’s economy, but also on its politics,
media, and culture.
The rise of Samsung Electronics began in 1970
when it introduced its first consumer electronics prod-
uct, a 12-inch black-and-white television. Although it
was a latecomer, Samsung made a breathtaking ascent
in consumer electronics. It is now leading a number of
key electronics industries globally. For instance, since
1993, Samsung Electronics has been the world’s larg-
est producer of memory chips. The original iPhone
even ran on chips made by Samsung. The company is
also the largest television manufacturer in the world, as
well as the largest manufacturer of LCD panels. Today,
Samsung Electronics produces some 98 percent of all
AMOLED screens (unlike LCD screens, AMOLED
screens do not need backlight), used in computer moni-
tors, TVs, phones, cars, and elsewhere. Since 2012,
Samsung has also been the world’s largest phone man-
ufacturer, replacing Nokia at the top spot. Its mobile
devices contribute some 75 percent of the conglomer-
ate’s overall profits. In 2017, Samsung also overtook
Intel as the largest chipmaker in the world.
The person credited for this tremendous ascent to
world leadership in consumer electronics is Lee Kun-hee,
the youngest son of the founder, who took over as
chair of the conglomerate in 1987. Lee Kun-hee was
trained in Western management principles, earning an
MBA from George Washington University. To a cul-
ture that deeply values seniority, he introduced merit-
based pay and promotion. His strategic intent was to
make Samsung a world leader in high-tech industries,
including consumer electronics. To execute his strat-
egy, Lee Kun-hee focused first on gaining market
share by invading markets from the bottom up with
lower-priced products at acceptable value. He hired
Western managers and designers into leading posi-
tions and sent homegrown talent to learn best busi-
ness practices from other firms wherever they could
be found. Lee Kun-hee also set up the Global Strate-
gic Group to assist non-Korean MBAs and PhDs with
a smooth transition into their positions in a largely
homogenous cadre of Korean executives.
Positioning Samsung Electronics
for Global Leadership
In the 1990s, Samsung’s image, however, was still
overshadowed by those of Sony, Motorola, and Nokia,
the undisputed world leaders in consumer electronics
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number-one seller of smartphones in China by units.
Similarly, by launching new smartphones quickly,
almost like fashion accessories, India’s Micromax had
become the number-one seller in its home market.
Samsung Electronics is being squeezed in the middle.
On the high end, it has fallen behind Apple, which con-
tinues to pull away with its innovation and design setting
new standards for the most profitable segment of the mar-
ket. On the low end, upstarts from China and India are
capturing leading positions in markets with huge growth
potential. Within the company, the soul-searching about
Samsung’s future has begun. In 2010, Lee Kun-hee set
the strategic intent that Samsung should quadruple its rev-
enues from $100 billion to $400 billion by 2020 (which
would be more than the revenues of Apple, Google, Micro-
soft, and Amazon combined).
By 2016, the situation for Samsung Electronics was
getting worse. From selling well over 30 percent of all
mobile phones globally, its market share had fallen to
18 percent by the end of the year.
also negated Samsung’s lead with its successful Galaxy
Note phablets. Apple followed up with the iPhone 7 in
2016 and its 10th anniversary model in 2017. With a
string of incremental innovations, Apple has continued
to capture a greater share of the high end of the mar-
ket. Although Apple’s market share in terms of units in
the global smartphone industry is less than 20 percent, it
captures a whopping 92 percent of all the profits gener-
ated in the industry!
Struggles at Samsung Electronics
Samsung Electronics not only lost market share on the
high end of the mobile phone market, but also on the
low end. Chinese technology companies Oppo, Huawei,
and Xiaomi are becoming more and more popular. In
particular, the Chinese startup Oppo has challenged
Samsung and Apple in consumer markets with huge
growth potential such as China. By 2017, Oppo,
often described as China’s Apple, had become the
EXHIBIT MC17.1 / Samsung vs. Apple: Global Smartphone Market Share by Units (in %), 2010–2017
40%
35%
30%
25%
20%
15%
10%
5%
0%
2010 2011 2012 2013 2014 2015 2016 2017
AppleSamsung
SOURCE: Depiction of publicly available data. Data for 2017 is based on Q1.
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506 MINICASE 17 Samsung Electronics: Burned by Success?
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mobile, and consumer electronics). The involvement
of the Lee family in Samsung is persistent through-
out the conglomerate, however, with descendants of
the company’s founder serving in multiple leadership
positions.
Lee Jae-yong holds a relative small stake in Sam-
sung Electronics, which is key to running the entire
conglomerate. At the same time, activist shareholders
such as Elliott Management of the United States are
pushing to restructure the Samsung conglomerate to
provide more transparency in its governance structure,
and to break open the tight grip that some Korean
families have over the chaebols, despite fairly small
share holdings. The younger Lee also faces billions in
inheritance taxes when his father dies.
PRODUCT RECALL. Samsung Electronics was already
dealing with shrinking margin share, when it encoun-
tered the Galaxy Note 7 debacle. The Note line of
mobile devices are Samsung’s phones with larger
screens, in which the South Korean company had been
leading Apple. The new Note 7 was introduced in the
summer of 2016 to great fanfare and raving reviews
(e.g., “best phone ever”).
Three Crises in Four Years
During the struggles identified above, which may
seem part of the rough and tumble of high-stakes com-
petition, Samsung had to face three separate crises
that rocked the company further: leadership struggles,
product recalls, and political scandal.
LEADERSHIP STRUGGLES. Although the business
situation for Samsung Electronics seems to be improv-
ing, its downward spiral for the past few years coin-
cided with Lee Kun-hee’s heart attack in 2014, which
left him incapacitated. The 75-year-old had ruled
Samsung with an iron fist: No strategic or personnel
decisions were made without his approval. With the
leadership vacuum, the turf battle for Samsung’s top
job began, with many observers convinced that Lee
Kun-hee’s only son, Lee Jae-yong (who goes by Jay
Lee), was the heir apparent. Prior to his arrest and
charge in 2017, the younger Lee held the position of
vice chairman within the Samsung Group. At the same
time, Samsung Electronics currently has an unusual
leadership structure, with three co-CEOs each acting
as the leader of his respective division (components,
$250
$200
$150
$100
$50
$0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
$0
$5
$10
$15
$20
$25
$30
Revenue Net Income
SOURCE: Depiction of publicly available data.
EXHIBIT MC17.2 / Samsung Electronics Revenues (left vertical axis) and Net Income (right vertical axis) in
$ billions, 2000–2016
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Pension Service to cast the deciding vote in favor of the
proposed merger within the Samsung conglomerate.
The National Pension Service obliged, even though it
was losing money in the transaction.
To ensure continuation of the cozy relationship
between politics and business in South Korea, Sam-
sung made a $38 million “donation” to foundations
held by a close friend of the president, Choi Soon-
sil. She is one of the key figures in the scandal rock-
ing South Korea because prosecutors allege that Choi
Soon-sil had a huge influence on the president’s deci-
sions and access to confidential government papers,
despite not holding any formal position. Park Geun-hye
is the first Korean president to be impeached. Charges
against her include abuse of power, bribery, and leak-
ing of government secrets. Caught up in the presiden-
tial scandal, Lee Jae-yong, Samsung’s de-facto leader
and figurehead, was convicted of bribery in the summer
of 2017, and sentenced to five years in jail. His attor-
neys immediately appealed the ruling. In the meantime,
Samsung’s leadership vacuum continues.
DISCUSSION QUESTIONS
Corporate Strategy and Governance
1. What makes Samsung a conglomerate? What type
of diversification does Samsung pursue? Identify
possible factors such as core competencies, econo-
mies of scale, and economies of scope that were
the basis of its past success as a widely diversified
conglomerate. Why is Samsung as a conglomerate
struggling today?
2. Despite being a widely diversified conglomer-
ate, Samsung prefers vertical integration: in-house
design and development teams, manufacturing in
large company-owned factories, and coordinating
a sprawling global supply chain. In contrast, Apple
concentrates on the design (and retail sales) of high-
end mobile devices, while it outsources its produc-
tion to Foxconn and others. Do you think Samsung’s
high degree of vertical integration contributed to its
recent problems? Why or why not? Explain.
3. What is a chaebol? What are some of the corpo-
rate governance challenges that chaebols such as
Samsung face? What are some of the advantages
and disadvantages of chaebols? What changes
to a chaebol’s governance structure are Ameri-
can activist investors such as Elliott Management
pushing for, and why?
But just a few days after its launch, reports of spon-
taneous explosions and fires that the new smartphone
was experiencing started to circulate in the media.
Rushing to contain the looming problem, Samsung
Electronics blamed a faulty battery from a specific
supplier. It decided to no longer use this particular
supplier and exchange all the phones already sold
with new Note 7 phones that contained batteries from
a different supplier. Alas, this did not solve the prob-
lem. The media storm was gathering strength as more
and more reports of spontaneous phone explosions
and resulting fires came in. In the United States, the
Federal Aviation Administration acted swiftly by ban-
ning all Samsung Galaxy Note 7 phones from flights.
Flight crews made announcements before every flight,
reminding each traveler of the problems Samsung was
facing with its Note 7 at about the same time as Apple
was introducing the new iPhone 7, which turned out
to be a bestseller. After recalling millions of Note 7
phones globally, Samsung announced in October 2016
that it would permanently end production and sale of
the tarnished smartphone.
In the spring of 2017, Samsung launched its new
Galaxy S8 (a smaller version, not related to its Note
line of phone) with considerable success. In the same
year, Samsung Electronics also reported record prof-
its as demand for the Galaxy S8 and the company’s
microchips was strong.
POLITICAL SCANDAL. The leadership challenges
facing Lee Jae-yong may have also led to events that
embroiled him in a political scandal. In 2017, prosecu-
tors accused him of bribery, embezzlement, and perjury.
He was subsequently arrested, becoming the first Sam-
sung leader to land in jail. (His father, Lee Kun-hee, was
convicted in 2008 for embezzlement and tax evasion,
but later received a presidential pardon.)
In the case of the younger Lee, prosecutors allege
that he sought South Korean President Park Geun-hye’s
support and influence in a controversial merger of two
Samsung affiliates. Lee Jae-yong, who holds only a
0.6 percent share in Samsung Electronics, needed the
merger to go through to generate much-needed cash,
and more importantly to strengthen his hold on Sam-
sung Electronics, ensuring a smooth leadership transi-
tion along the Lee family lines. And one reason he may
have needed that cash was to deal with the inheritance
taxes relative to his share of Samsung Group. To achieve
his goal, Lee Jae-yong turned to President Park, pros-
ecutors allege, who in turn influenced Korea’s National
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508 MINICASE 17 Samsung Electronics: Burned by Success?
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Samsung will be making a comeback with its Gal-
axy line of phones? Why or why not?
Endnote
1. Cheng, J., and Lee, M. J. (2015, May 11), “After Galaxy smartphone
debacle, Samsung questions game plan,” The Wall Street Journal.
Sources: Jeong, E.-Y. (2017, Aug. 25), “Samsung Heir Lee Jae-yong
Convicted of Bribery, Gets Five Years in Jail,” The Wall Street Journal;
Tsang, A. (2017, July 7), “Samsung, seeking to move past scandals,
forecasts record profit,” The New York Times; Fowler, G. (2017, Apr. 18),
“Samsung Galaxy S8 review: Great phone, but that’s not all that matters,”
The Wall Street Journal; Jeong, E-Y., and T. W. Martin (2017, Apr. 7),
“Samsung heir takes center stage in South Korea’s ‘trial of the century,’”
The Wall Street Journal; Mozur, P. (2017, Jan. 22), “Galaxy Note 7
fires caused by battery and design flaws, Samsung says,” The New York
Times; Song, J., K. Lee, and T. Khanna (2016), “Dynamic capabilities
at Samsung: Optimizing internal co-opetition,” California Management
Review 58 (4): 118–140; “Charred chaebol,” The Economist, October 15,
2016; Bellman, E., and R.J. Krishna (2015, June 4), “India’s Micromax
churns out phones like fast fashion,” The Wall Street Journal; “Samsung:
The soft succession,” The Economist, May 23, 2015; Cheng, J., and M.-J.
Lee (2015, May 11), “After Galaxy smartphone debacle, Samsung questions
game plan,” The Wall Street Journal; Cheng, J. (2015, May 11), “What to
know about Samsung,” The Wall Street Journal; Cheng, J. (2015, Mar. 1),
“Samsung unveils Galaxy S6 to answer iPhone 6,” The Wall Street Journal;
Cheng, J. (2014, Oct. 27), “Samsung’s primacy is tested in China,” The
Wall Street Journal; Lee, M.-J. (2014, Oct. 7), “Samsung girds for cost cuts
after downbeat guidance,” The Wall Street Journal; “Samsung: Waiting
in the wings,” The Economist, September 27, 2014; “How Samsung got
big,” TechCrunch, June 1, 2013; “The rise of Samsung and how it is the
mobile reshaping ecosystem,” Business Insider, March 14, 2013; “Faster,
higher, stronger: The rise and rise of Samsung,” The Sydney Morning
Herald, August 13, 2012; “Samsung: the next big bet,” The Economist,
October 1, 2011; “Samsung and its attractions: Asia’s new model
company,” The Economist, October 1, 2011; Khanna, T., J. Song, and K.
Lee (2011), “The paradox of Samsung’s rise,” Harvard Business Review,
July–August; and various Samsung Annual Reports.
4. With South Korea being rocked by the presi-
dential scandal exposing a deep-running and
long- standing nexus of bribery and chummy rela-
tionships between industry and politicians, and
by the call for more transparency and governance
changes in the chaebols, do you think reform and
changes will happen, or will things return to busi-
ness as usual? What is your opinion? Explain.
Business Strategy
5. Lee Jae-yong, the 50-year-old grandson of the
Samsung founder, was educated at Seoul National
University, Keio University (in Japan), and Har-
vard Business School. He wrote a master’s thesis
at Keio University on Japan’s struggle to retain
its world leadership in manufacturing in the mid-
1990s when the country’s fast-growing period
was ending. He concluded, “Japan’s troubles were
worsened by its manufacturers’ pursuit of scale
and market share.”1 Is Samsung Electronics’ pur-
suit of scale and market share to blame for its los-
ing its competitive advantage?
6. Why is Samsung Electronics encountering prob-
lems selling its flagship line of smartphones, the
Galaxy? How should it compete against premium
phone makers such as Apple and low-cost lead-
ers such as Oppo and Micromax? Do you think
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rot27628_minicase18_509-511.indd 509 11/23/17 02:38 PM
Does GM’s Future Lie in China?
GM’s China operation has been cost-competitive
from day one. The company operates about the same
number of assembly plants in China as in the United
States, but sells more vehicles while employing about
half the number of employees. Chinese workers cost
GIVEN THE SHEER SIZE OF THE U.S. automotive market,
the “old” GM concentrated mainly on its domestic mar-
ket. GM once held more than 50 percent market share
in the United States and was the leader in global car
sales (by units) between 1931 and 2007, before filing
for bankruptcy in 2009.1 In its heyday, GM employed
350,000 U.S. workers and was an American icon.
The future for the “new” GM may lie overseas, most
notably in China. Some 65 percent of GM’s revenues
are now from outside the United States. This is quite a
high level of globalization for a company that once was
focused more or less on the domestic market only. The
Chinese market is becoming more and more important
to GM’s performance. In 2016, GM sold 3.9 million
vehicles in China alone, which is 39 percent of total
GM cars sold. As shown in Exhibit MC18.1, China’s
share of GM’s total sales is on a steady climb, reaching
40 percent of total revenues in 2017 (Q1).
With a population of 1.4 billion and currently only
11 vehicles per 100 people—compared with a vehicle
density of 81 per 100 in the United States—China
offers tremendous growth opportunities for the auto-
motive industry. Since China joined the World Trade
Organization (WTO) in 2001, its domestic auto mar-
ket has been growing rapidly and has now overtaken
the United States as the largest in the world. Although
the growth of the Chinese auto market has slowed in
recent years because of the economy’s downturn, GM
CEO Mary Barra remains convinced that China offers
significant long-term growth opportunities.
Unlike some of its main rivals, GM entered the Chi-
nese market early. In 1997, GM formed a joint venture
with Shanghai Automotive Industrial Corp. (SAIC),
one of the “big four” Chinese carmakers. SAIC is one
of the largest companies worldwide and included in the
Fortune Global 100 list (ranked 46th, just behind Ama-
zon.com and before Hewlett-Packard).2 Over 30 years,
GM was able to develop guanxi—social networks and
relationships that facilitate business dealings—with its
Chinese business partners and government officials.
MiniCase 18
Mary Barra, CEO General Motors, is refocusing GM on the U.S. home
market and China, among other developing economies, while exiting
Europe.
©Tomohiro Ohsumi/Bloomberg/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges research assistance by Rahul Singh. This MiniCase
is developed for the purpose of class discussion. It is not intended to be used for
any kind of endorsement, source of data or depiction of efficient or inefficient
management. All opinions expressed, all errors and omissions are entirely the
author’s. Revised and updated: July 3, 2017. ©Frank T. Rothaermel.
Final PDF to printer
510 MINICASE 18 Does GM’s Future Lie in China?
rot27628_minicase18_509-511.indd 510 11/23/17 02:38 PM
well). Since 2013, Buick’s sales in China have risen by
almost 50 percent; in 2016 alone, GM sold more than
1 million Buick vehicles. However, sales of Chevy,
another GM brand, have fallen by some 16 percent.
Despite being offered at a higher price point, GM sold
twice as many Buicks as Chevrolets in China.
Taken together, China and other emerging economies
in Asia, Latin America, and the Middle East are becom-
ing more and more critical to GM’s future performance
as it strives to become a lean and low-cost manufacturer
of profitable small cars (at least for its non-U.S. markets).
To back up its strategic intent, GM has quadrupled its
engineering and design personnel in China and is invest-
ing $250 million to build a cutting-edge R&D center on
its Shanghai campus, home of its international headquar-
ters. Also, GM is spending an estimated $14 billion to
build five additional manufacturing plants to support
anticipated annual sales of 5 million vehicles.
At the same time that GM is doubling down on
China, it has exited Europe. In 2015, GM stopped
manufacturing cars in Russia, citing unstable business
conditions as the main reason. After years of losing
only a fraction of what U.S. workers do, and GM is not
weighed down by additional health care and pension
obligations.
Although struggling in the United States, GM’s
Cadillac luxury brand is in high demand in China,
where owning a Cadillac is considered a status symbol.
GM’s best-selling model in China, however, is the Wul-
ing Sunshine, a small, boxy, purely functional micro
van priced between $5,000 and $10,000 depending
on what options the customer chooses. The SAIC-GM
joint venture sold almost 2 million Wuling vehicles in
China in 2014. The Wuling Sunshine may help GM
further penetrate the Chinese market; it also may be an
introductory car for other emerging markets. GM’s low-
cost strategy with this vehicle has been so successful
that the firm is planning to expand the Wuling product
line and offer the vehicle globally. GM already sells the
Wuling Sunshine in Brazil under the Buick nameplate.
Among GM’s most profitable vehicles sold in China
are such popular SUVs as the Baojun 560 and the Buick
Envision (the latter of which is made in China and then
imported to the United States, where it is also selling
2014
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
2015 2016
China North America Europe South America
EXHIBIT MC18.1 / GM’s Number of Vehicles Sold by Geographical Location (in thousands), 2014–2016.
SOURCE: Depiction of data from 2016 GM Annual Report.
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DISCUSSION QUESTIONS
1. How important are non-U.S. sales to GM? What impli-
cations does this have for GM’s global and business
strategy? Think about the integration- responsiveness
framework to inform global strategy and different
strategic positions to inform business strategy.
2. In 2016, GM held almost 15 percent market share
in China, while Ford held only 3 percent. Why
was GM so successful in China, while some of its
rivals, including Ford, struggled to gain a stronger
position in the world’s largest automobile market?
3. What are the challenges GM is currently facing
in the Chinese automobile market? How should
GM’s CEO address them? Be specific.
Endnotes
1. Keep in mind that selling a large volume of cars doesn’t make a
company profitable, if the cars are sold at a low margin or even at a
loss. In contrast, Ferrari sells only some 7,500 vehicles a year, but is
highly profitable (not surprising because the sticker price of the entry-
level Ferrari is $200,000).
2. Fortune’s Global 500 (2016), http://fortune.com/global500/
saic-motor/, accessed July 3, 2017.
Sources: GM Annual Reports, various years; and Colias, M. (2017, May 18),
“General Motors will stop selling cars in India,” The Wall Street Journal;
Bensinger, G., and J. Nicas (2017, May 15), “Alphabet’s Waymo, Lyft to
collaborate on self-driving cars,” The Wall Street Journal; Colias, M., and
J.D. Stoll (2017, Mar. 6), “GM’s Opel exit is rare no-confidence vote in
European market,” The Wall Street Journal; Nagesh, G. (2016, Jan. 21),
“GM sells record 9.8 million vehicles in 2015,” The Wall Street Journal;
“GM, SAIC plan to jointly design new cars,” The Wall Street Journal,
July 28, 2015; “GM, Ford flourish out of the limelight,” The Wall Street
Journal, July 28, 2015; “Big vehicles power surge in GM’s profit,” The
Wall Street Journal, July 23, 2015; “China stocks take GM, Ford on rough
ride,” The Wall Street Journal, July 10, 2015; “GM hopes to shift gears
after recalls,” The Wall Street Journal, September 29, 2014; and “Can
China save GM?” Forbes, May 10, 2010.
money and acrimonious parent–subsidiary relation-
ship, GM sold its Opel (Germany) and Vauxhall (United
Kingdom) divisions to Peugeot of France in 2017. In
the same year, Barra also announced that the U.S. auto-
maker will discontinue selling cars in India. This further
retrenchment will allow GM to focus more on China
and Brazil overseas, and to fend off tech startups such
as Tesla and Uber in the United States, where it made an
equity investment in Lyft, which in turn partnered with
Waymo, Alphabet’s self-driving car unit.
For Mary Barra, unfortunately, not everything in
China will be smooth sailing. Given the slowdown in
the Chinese economy, combined with continual deval-
uation of the Chinese currency (the yuan) since 2014,
the competitive intensity in the world’s largest auto-
mobile market is becoming more intense. Moreover,
several government-supported domestic car manu-
facturers in China are initiating a cutthroat price war
to gain market share and, with it, scale. For instance,
GM’s own joint venture partner SAIC as well as other
domestic companies such as Great Wall Motor Co. are
increasingly competing with GM for market share. As
the quality and technology expertise is rapidly increas-
ing at domestic car manufacturers, many Chinese con-
sumers are increasingly turning to local brands instead
of the pricey foreign models from the United States
and Europe. At the premium end of the Chinese mar-
ket, brands such as Porsche or Audi (both are Volk-
swagen brands) remain the most popular choices. In
contrast, low gas prices in the United States in recent
years have fueled high demand for sport utility vehi-
cles (SUVs) and trucks—an area where GM and Ford
hold strong positions. These types of vehicles are also
the most profitable for the U.S. automakers to sell.
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Flipkart vs. Amazon in India: Who’s Winning?
FLIPKART’S MANTRA IS “Ab Har Wish Hogi Poori” or
“Every wish fulfilled.” For the time being, the Indian
ecommerce company has fulfilled its own wish. With
a valuation of close to $12 billion in 2017, Flipkart
(www.flipkart.com) is one of the 10 most valuable
privately held startups. It is in fine unicorn company
along with Uber, Didi Chuxing, Airbnb, and SpaceX,
all privately held startups valued between $12 billion
and $70 billion. The stated goal of the co-founders,
Sachin Bansal and Binny Bansal is to make Flipkart
India’s first $100 billion ecommerce company.1
With $11 billion in sales in 2015, India’s ecommerce
market is still in its infancy. In comparison, China’s ecom-
merce sales in 2016 were a whopping $900 billion.
With rising internet penetration in India (see Exhibit
MC19.1) and a rising middle class of young, well-
educated urban professionals, India’s ecommerce is
expected to reach $130 billion by 2025.
How Flipkart Took an Early Lead
The leading ecommerce company in India is not one of
the global giants such as Amazon or Alibaba, but the
homegrown Flipkart. Founded in 2007 by Sachin Bansal
and Binny Bansal (same last name, but unrelated),
Flipkart began its life just like Amazon.com: selling
books online at discounted prices. To many observers,
this was not surprising because the co-founders met
while working at Amazon.com. They are also both grad-
uates of India’s most prestigious university system: the
Indian Institute of Technology (IIT). Flipkart continues
to recruit the best and the brightest engineers from IIT.
Flipkart had humble beginnings, as Bansal and
Bansal set up the company from their two-bedroom
apartment in Bangalore with an initial investment of
$8,000. What began as selling books is now disrupt-
ing retailing in India. In this land of over 1.2 billion
people, more than 50 percent of its population is age
25 or younger and more than 65 percent is below
the age of 35. In 2020, the average Indian will be
29 years old, while the average Chinese will be 37;
MiniCase 19
TOP: Sachin Bansal (left) and Binny Bansal (right; no relation)
are the co-founders of Flipkart. Valued at close to $12 billion, it
is India’s most valuable retail company. BOTTOM: Jeff Bezos is
making a major push into India, with Amazon investing billions. In
2013, Amazon did not exist in India. In the meantime, Bezos lost
out to Alibaba in China. He promised not to repeat this outcome
in India where Amazon now takes on Flipkart, the early leader in
Indian ecommerce.
(top): ©Mint/Hindustan Times/Getty Images; (bottom): ©MANJUNATH
KIRAN/AFP/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges research assistance by Amey Sahasrabuddhe.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors and
omissions are entirely the author’s. Revised and updated: August 7, 2017.
©Frank T. Rothaermel.
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Even with the availability of plastic money options, many
Indians are wary about the security of online transactions
using credit or debit cards. Compounding this problem
is that most Indians lack access to credit. To overcome
these challenges, Flipkart became one of the first major
ecommerce players in India to offer a cash-on-delivery
(COD) service to online customers in 2010. This went a
long way to build credibility and brand value for Flipkart.
Some estimates peg the number of COD transactions in
Indian ecommerce as high as 80 percent of all sales.
A second and related problem Flipkart addressed is
the custom in India for shoppers to buy goods only after
a thorough physical inspection of the product at a brick-
and-mortar store, often by multiple family members if
a larger purchase is being considered. To overcome this
challenge, Flipkart introduced a hassle-free return-and-
exchange policy. This tactic allowed Flipkart to attract
many first-time online buyers, who now make up a sig-
nificant portion of the company’s revenues, which were
$2.3 billion in 2015, up from only $10 million in 2011.
Flipkart’s explosive growth in revenues equates to a
compound annual growth rate of almost 300 percent!
Third, Flipkart also introduced an option to pur-
chase expensive items with its EMI (easy monthly
the average American, 42; and the average Japanese, 48.
In addition, English is the country’s official language,
and most younger Indians are well educated and moving
rapidly into the middle class. As their disposable income
increases, their time to battle the chaotic Indian traffic and
inclination to haggle with obstinate vendors decreases.
Instead, they are using the internet in ever larger numbers
and are conducting more and more transactions online
(see Exhibit MC19.1 for growth in internet users).
While Flipkart is certainly benefiting from a first-
mover advantage combined with the explosive growth
in Indian ecommerce, it was unique tweaks to its busi-
ness model that set it apart from other online retailers,
including American online giants such as Amazon and
eBay or the Chinese internet firm Alibaba. In a coun-
try like India where fraud is rampant and trust among
vendors and customers is low, Flipkart had to first trans-
form the way Indians shopped. It achieved this by tai-
loring its offerings to the idiosyncrasies of its domestic
retail market. Unlike in the United States or Europe,
retail transactions in India are mostly cash-based, so
credit card penetration is very low (about 1 percent).
However, as more of the population relies on the main-
stream banking system, so grows its debit card usage.
2000
0
50
100
150
200
250
300
350
400
450
500 40%
35%
30%
25%
20%
15%
10%
5%
0%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Internet Users % of Population
EXHIBIT MC19.1 / India’s Internet Population (in million) and Penetration Rates (in percent), 2000–2016
SOURCE: Depiction of data from “India Internet Users,” http://www.internetlivestats.com/internet-users/india/.
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It makes money by taking a fee on every transaction
occurring on its site.
Amazon Comes to India:
The Empire Strikes Back
After Amazon lost out to Alibaba in China, it entered
India in 2013 to sell books, DVDs, electronic goods,
and fashion accessories (www.amazon.in). This made
Amazon.com a latecomer to the Indian ecommerce
party. Indian ecommerce companies Flipkart and runner-
up Snapdeal (www.snapdeal.com) enjoyed early-mover
advantages over Amazon. Both domestic startups were
able to leverage deep understanding of the Indian retail
market and ecommerce into a competitive advantage
(see Exhibit MC19.2). In the summer of 2017, Flipkart
offered close to $1 billion to acquire Snapdeal. Snapdeal’s
largest shareholder, Japan’s SoftBank Group, supported
Flipkart’s bid to merge both homegrown Indian
ecommerce companies in an effort to compete more
effectively against Amazon.com. Just a month later,
Snapdeal terminated merger talks with Flipkart, and
decided to continue going it alone.
installments) program. It accomplished this through
associations with all major banks. In 10 urban areas
Flipkart offers same-day delivery, and it guarantees
next-day delivery in more than 65 metropolitan areas.
While its business model provided solutions to
unique Indian ecommerce challenges, Flipkart diver-
sified quickly into many different product categories.
Starting as just an online bookseller, Flipkart now hosts
75 product categories on its platform. Its major product
categories include books, electronics and accessories,
lifestyle and fashion, home decor, and do-it-yourself
products. While books and electronics continue to be its
strongholds, lifestyle and fashion are the fastest-growing
segments. Because the Indian government continues to
bar foreign direct investment in retail companies, Flip-
kart (which is financed by non-Indian venture capitalists
from the United States, the United Kingdom, Russia,
and Singapore) had to change its business model. It
moved away from Amazon’s model of shipping mainly
merchandise it owns and that requires storage in its own
warehouses to now be more akin to Alibaba, hosting
third-party sellers. Flipkart morphed into an online plat-
form that enables other merchants to sell on its website.
2015 20162014
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Flipkart Snapdeal Amazon Others
SOURCE: Depiction of data compiled and constructed from various newspaper articles in The Economic Times, Mint, and Business Standard, and Purnell, N. (2016),
“Jeff Bezos invests billions to make Amazon a top e-commerce player in India,” The Wall Street Journal, November 18.
EXHIBIT MC19.2 / Market Share of Indian E-tailers, 2014–2016
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Jeff Bezos, Amazon’s founder and CEO, himself
visited Bangalore in 2014. In a Bollywood-like PR
stunt, he stepped out of a colorfully decorated Indian
truck, dressed in traditional white Nehru jacket, and
hand-delivered a surfboard-sized check of $2 billion to
Amit Agarwal, Amazon’s India head. Bezos’ march-
ing order to Agarwal: Do what it takes to succeed in
India and don’t worry about the cost. We cannot allow
another failure like in China to happen. Amazon has
added another $3 billion of investments in India since.
Although Flipkart innovated with features to match
the unique Indian retail environment, the features
were easily imitated by Amazon. Indeed, it quickly
matched many of Flipkart’s tactics such as cash on
delivery, installment payment plans, and same-day and
next-day deliveries. Like Flipkart, Amazon also offers
some 80 million products on its site, while runner-up
Snapdeal offered some 50 million. Amazon also offers
services that Flipkart cannot yet match, such as the
“fulfilled by Amazon” service (in which items offered
by a third-party seller on Amazon’s site are shipped
from an Amazon fulfillment center and all Amazon
standard shipping rates and policies apply).
Amazon also brings to bear several advantages that
Flipkart cannot match. In particular, Amazon is using
its sophisticated U.S. technology now in India, with a
powerful search engine based on artificial intelligence
that predicts what customers are looking for and what
they might buy next. Besides its $5 billion invest-
ments, Amazon has a huge war chest of cash it brings
to bear, being valued at $475 billion in 2017, mak-
ing it one of the most valuable tech companies glob-
ally. Amazon quickly built a network of warehouses in
India, especially near large urban areas, which helps
with speedy and reliable deliveries. It is building rela-
tionships of trust with its customers, delivering prod-
ucts they want such as smartphones at low prices.
As an indication of how fast Amazon is catching
up: It reached sales of $1 billion just one year after it
entered India. The same milestone took Snapdeal four
years and Flipkart, as the first major entrant, seven
years to accomplish. By 2016, Amazon had reached
almost 30 percent market share, making it number two
in the Indian ecommerce market, closing the gap with
Flipkart (see Exhibit MC19.2). It is too early to count
out the deep-pocketed and relentless Amazon and its
CEO quite yet.
On the other hand, there are some indications that
Walmart, Amazon’s biggest rival in the United States,
is interested in investing or acquiring Flipkart. So the
ecommerce battle for supremacy in India is far from
over. In the meantime, India’s consumers can benefit
from more choice, lower prices, and better service.
DISCUSSION QUESTIONS
1. Why was Flipkart able to achieve an early com-
petitive advantage in India? What is the basis of
Flipkart’s competitive advantage? Focus on external
and internal factors. Separate factors unique to India
from more generic factors (fast growth, for example)
that may also hold true in other countries.
2. Will Flipkart be able to sustain its early lead over
Amazon, given the deep pockets of the U.S. ecom-
merce giant and its intentions to invest further in
India? What are some key advantages that Flipkart
has over Amazon? What are some of Flipkart’s
disadvantages? What would Flipkart need to do to
sustain its competitive advantage?
3. Should Flipkart leverage its core competencies
outside India to “go global”? If so, which coun-
tries do you think would provide the best oppor-
tunities for Flipkart, and why? If Flipkart were to
go global, what kind of global strategy should it
pursue, and where?
4. What kind of global strategy is Amazon pursuing in
India? Why is India so important for Amazon? Do you
think Amazon will win in India? Why or why not?
5. What will the future look like for Flipkart? Why
would Walmart want to acquire Flipkart?
Endnote
1. A unicorn is a privately held startup valued at $1 billion or more.
Sources: “Flipkart acquisition of Snapdeal collapses as latter decides to
go ahead alone,” The Economic Times of India, August 7, 2017; “Flipkart
raises bid for Snapdeal to up to $950 million,” Reuters, July 18, 2017;
Purnell, N. (2016, Nov. 18), “Jeff Bezos invests billions to make Amazon
a top e-commerce player in India,” The Wall Street Journal; Das, G.
(2015, May 24), “The battle of the big boys—Flipkart vs. Snapdeal vs.
Amazon,” Business Standard; “Online retailing in India: The great race,”
The Economist, March 5, 2016; Thoppil, D.A. (2015, May 19), “Flipkart
valued at $15 billion after latest funding,” The Wall Street Journal; McLain, S.
(2015, Feb. 19), “Flipkart is worth more than Airbnb,” The Wall Street
Journal; Austin, S., C. Canipe, and S. Slobin (2015, Feb. 18), “The billion
dollar startup club,” The Wall Street Journal; Sood, V. (2015, Jan. 20),
“Amazon India may emerge as fastest e-tailer to touch $2-bn sales mark,”
The Economic Times; Bhagavatula, S. (2015), “Creative Disruptions—The
story of Indian entrepreneurship,” YouTube, NSRCEL, Indian Institute of
Management Bangalore (IIMB), www.youtube.com/watch?v=vAFlO9-
I5rg (2:53 min); Thoppil, D.A. (2014, July 29), “India’s Flipkart raises
$1 billion in fresh funding,” The Wall Street Journal; Fatima, F. (2014),
“Flipkart-Myntra; From a merger to an acquisition,” International Journal
of Management and International Business Studies 4: 71–84; Kakroo,
U. (2012, July ), “E-commerce in India: Early birds, expensive worms,”
McKinsey & Co.; and various pages at www.flipkart.com.
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Alibaba—China’s Ecommerce Giant: Challenging Amazon?
year on Singles Day (11/11), the biggest annual online
sales event in China, Alibaba alone achieved close to
$18 billion in sales, 20 percent of the total!
Initially, Alibaba’s website was a business-to-
business (B2B) platform where China’s small and
medium-sized businesses could showcase their prod-
ucts to buyers around the world. Alibaba was not the
first company to explore opportunities in introducing
China’s manufacturing to global demand, but it was
the first to do so online. In its first year of opera-
tion, Alibaba signed up new members at a rate of
1,200 per day. By 2002, the young startup was
TODAY, ALIBABA GROUP is the largest Chinese ecommerce
company. In the original Arabic tale of Ali Baba and the
Forty Thieves, Ali Baba, the poor woodcutter, opened
the cave with hidden treasure by calling out the magic
words “Open Sesame.” Alibaba’s founder selected the
name to open up opportunities for small Chinese man-
ufacturers to sell their goods around the world, with
the hope of finding treasures for Alibaba’s users and
shareholders. Today, Alibaba is a family of ecommerce
businesses, which The Wall Street Journal described as
“comparable to eBay, Amazon, and PayPal all rolled
into one, with a stake in Twitter-like Weibo thrown
in to boot.”1 The Alibaba Group comprises four pri-
mary portals: Taobao, Tmall, Alibaba.com, and Aliyun
(now AliCloud). Hundreds of millions of users access
the sites, and millions of businesses rely on the por-
tals to connect them with potential buyers. Taobao is
Alibaba’s flagship online marketplace, a consumer-to-
consumer retail platform with 7 million sellers offering
more than 800 million items.
Just like Ali Baba in the folk tale, Alibaba had humble
beginnings. In 1999, a former English teacher named
Jack Ma started the company with a team of 18 in his
apartment in Hangzhou, a city some 100 miles southwest
of Shanghai. His timing couldn’t have been better, as the
internet was just beginning to take hold in China. Since
then, China has experienced explosive growth in inter-
net users (see Exhibit MC20.1). By 2017, China’s inter-
net users had grown to more than 720 million. Alibaba
rode this wave of exponential growth to major success.
In comparison, the United States has some 286 million
internet users (less than 40 percent of China’s total).
The internet penetration rate, shown in the dotted
line in Exhibit MC20.1, follows a typical S-shaped
growth function, indicating that internet usage in China
seems to be maturing. Nonetheless, given the still rela-
tively low volume of online transactions in comparison
to China’s total commerce, significant growth in per
capita spending online is expected. In 2016, China’s
ecommerce totaled about $900 billion in sales. That
MiniCase 20
Jack Ma, a Hangzhou, China, native, is the founder and executive
chairman of Alibaba Group. Alibaba had the most successful initial
public offering (IPO) ever (listed on NYSE), surpassing a valuation
of over $230 billion on its first day of trading, September 19, 2014.
By fall 2017, Alibaba’s market cap was some $437 billion, making
it one of the largest tech firms globally (and almost double its IPO
valuation).
©Tomohiro Ohsumi/Bloomberg/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges the contribution of Ling Yang on an earlier
version, and research assistance by Amey Sahasrabuddhe for this version.
This MiniCase is developed for the purpose of class discussion. It is not
intended to be used for any kind of endorsement, source of data, or depiction
of efficient or inefficient management. All opinions expressed, all errors
and omissions are entirely the author’s. Revised and updated: September 30,
2017. ©Frank T. Rothaermel.
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Amazon’s market cap was some $465 billion at the
same time.
Yet, Alibaba’s market presence is still predomi-
nantly in China. In 2017, Alibaba employed around
50,000 people, had $23 billion in revenues, and
remained highly profitable, capturing more than
50 percent of its revenues as profits. In the same year,
Alibaba’s Chinese marketplaces reported sales of
some $550 billion.
In a survey of U.S. internet shoppers, almost 9 out
of 10 had never heard of Alibaba. Jack Ma, however,
intends to change this perception. After meeting with
President Donald J. Trump in early 2017, Ma prom-
ised that Alibaba would help lead at least 1 million
small- and medium-sized businesses in the United
States to its various online platforms, as well as offer
global logistics expertise to help sell these businesses’
goods in China.
Alibaba vs. U.S. Ecommerce Giants
To grow its business in China, Alibaba followed a
strategy of related diversification by opening the C2C
(consumer-to-consumer) website Taobao and later its
already profitable. By 2012, Alibaba facilitated trans-
actions in nearly every country around the world.
Alibaba’s Business Model and IPO
Exclusively a trading platform for third-party ven-
dors, Alibaba, unlike Amazon, does not hold or own
any inventory. Alibaba’s main source of revenue is the
transaction fees, listing fees, and ad revenues it gener-
ates from more than 10 million active sellers across
its marketplaces. This asset-light model means
the company has more room to push down prices
on its platform by reducing transaction costs for
its sellers. While both Alibaba and Amazon focus
on a cost-leadership strategy, its asset-light model
could thus turn out to be a competitive advantage
for the Chinese firm.
On September 19, 2014, Alibaba went public on
the New York Stock Exchange (NYSE). It had the
most successful initial public offering ever, surpass-
ing a stock market valuation of over $230 billion on its
first day of trading. By fall 2017, its market cap stood
at a record high of $437 billion, making it one of the
most valuable tech companies globally. In comparison,
0
100
200
300
400
500
600
700
800
0%
10%
20%
30%
40%
50%
60%
Millions
20
00
20
0220
01
20
04
20
03
20
06
20
07
20
05
20
08
20
09 20
10 20
11
20
12
20
13
20
14
20
15
20
16
20
17E
20
18
E
Internet Population Internet Penetration
EXHIBIT MC20.1 / China’s Internet Users (millions) and Internet Penetration Rate (in percent), 2000–2018E
SOURCE: Depiction of data from “China Internet Users,” http://www.internetlivestats.com/internet-users/china/ (data for years 2017e and 2018e are estimates).
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held an abysmal 1 percent market share in China (see
Exhibit MC20.2). In what appeared to be a surrender,
Amazon set up an online store on Alibaba’s Tmall!
Challenges for Alibaba Going Forward
Looking ahead, Jack Ma and Alibaba are facing sev-
eral internal and external challenges. Alibaba deliv-
ered slower than anticipated growth. The company
also reorganized its operation by folding its consumer
sites Taobao and Tmall into one business unit with
group-buying site Juhuasuan. Alibaba also continues
to heavily invest in expanding beyond the Chinese
market to become a truly global player.
Alibaba invests heavily in cloud computing to
compete more effectively with Amazon’s AWS, the
world’s leader in cloud computing. Alibaba also spent
almost $5 billion to buy a 20 percent stake in Suning,
China’s largest electronics retailer. This should allow
Alibaba to compete more effectively with its domestic
rival JD.com, which is especially strong in electronics.
JD.com, China’s number-two ecommerce company,
recently made waves by deploying drones for deliveries
of online purchases, especially in remote areas. JD.com
also plans to deploy larger drones that can carry up to
1 ton of payload in the near future, which it already
tested successfully. To keep JD.com at bay, Alibaba
is creating a retail presence throughout China—much
more popular B2C (business-to-consumer) website Tmall,
and a host of other services such as Alipay, Alisoft, and
cloud services. The other players in global ecommerce
that were big during the 1990s, mainly the U.S. companies
eBay and Amazon, decided to enter China via acquisitions.
Started in 1995, eBay entered the Chinese market
in 2003 by acquiring EachNet for $180 million. Each-
Net was started in Shanghai in 1999 by two Chinese
entrepreneurs who had MBA training in the United
States. It was designed as an auctioning platform to
function very much like eBay. Early on, EachNet was
the dominant force in China’s online C2C market with
close to 85 percent market share and 2 million users.
Even when Alibaba launched its C2C website Taobao,
completely free for sellers, the dominant position of
EachNet, which charged a listing and transaction fee,
did not erode. Problems mounted in 2004, however,
when eBay decided to shut down EachNet’s home-
grown technology platform and move it to eBay’s
global platform. As EachNet’s Chinese users migrated
to the global platform, EachNet started losing mar-
ket share in China. Its web pages loaded more slowly
than those of its rivals because they now had to pass
through the Chinese government’s (internet) firewall
(censoring software and other controls). Moreover,
eBay’s website features and user experience made it
difficult for most of its Chinese users to navigate.
Alibaba was quick to react to this lapse by eBay; it
launched features designed for a native Chinese audi-
ence. The instant messaging application Aliwangwang
and Alipay, the escrow management services to facili-
tate online transactions, were instant hits with both
sellers and buyers. By 2005, Alibaba’s Taobao had
60 percent market share, while EachNet had fallen to
a mere 30 percent (from 85 percent a few years prior).
By 2006, eBay decided to shut down EachNet. Com-
menting on Alibaba’s competition with eBay, founder
Ma noted, “eBay may be a shark in the ocean, but
I am a crocodile in the Yangtze River. If we fight in the
ocean, we lose, but if we fight in the river, we win.”2
Although Amazon is by far the leading ecommerce
company in the United States (50 cents of every dol-
lar spent online is spent there), its entry strategy into
China parallels eBay’s attempts. Amazon also entered
China via acquisition. It bought Joyo.com, then the larg-
est online bookstore in China, for $75 million. It soon
expanded Joyo.com (now Amazon.cn) product offer-
ings. However, local players in China quickly labeled
Amazon.cn as an expensive Western choice in com-
parison to low-cost local alternatives. By 2016, Amazon
Others (18.10%)
Amazon.cn
(0.90%)
Tmall (58.10%)JD.com (22.90%)
EXHIBIT MC20.2 /
Market Share of B2C Companies in China, 2016
SOURCE: Depiction of data from Statista.com.
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3. Apply a SWOT analysis to Alibaba. Use the results
to make some recommendations to Alibaba’s CEO.
4. Apply the integration-responsiveness framework
to determine:
a. Which global strategy position you would
recommend Alibaba to pursue when attempt-
ing to create a stronger foothold in the United
States. Explain why.
b. Which global strategy positions you would
recommend U.S. ecommerce companies such
as eBay, Amazon, and others to pursue when
competing in China. Explain why.
Endnotes
1. “China changes won’t face Alibaba,” The Wall Street Journal,
July 5, 2013.
2. As quoted in: “Standing up to a giant,” Forbes, April 25, 2005.
Sources: A detailed and in-depth overview of Alibaba, its genesis and
growth, is the insightful book by Clark, D. (2016), Alibaba: The House
That Jack Ma Built (Ecco: New York). Other sources: Purnell, N. (2016,
Nov. 18), “Jeff Bezos invests billions to make Amazon a top e-commerce
player in India,” The Wall Street Journal; Baskin, B., and L. Lin (2017,
May 23), “Chinese online retailer JD.com is developing heavy-duty delivery
drones,” The Wall Street Journal; “China’s internet giants go global,”
The Economist, April 20, 2017; Knutson, R., and L. Stevens (2017, Jan. 9),
“Alibaba’s Jack Ma: China-U.S. relationship should be ‘more friendly,’”
The Wall Street Journal; Tan, H. (2016, Dec. 21), “US puts Alibaba’s Taobao
website back in its list of ‘notorious marketplaces,’” CNBC; Dou, E. (2016,
Nov. 11), “Swinging singles day: Alibaba holiday drives shoppers in China,”
The Wall Street Journal; Osawa, J., and E. Dou (2015, June 23), “Alibaba
stumbles in U.S. market,” The Wall Street Journal; “Alibaba Group FY 2016-17
results,” http://www.alibabagroup.com/en/news/press_pdf/p170518.
pdf; company overview, news on Alibaba.com; Chu, K., and G. Wong
(2015, Aug. 17), “Alibaba faces fresh threat from rivals,” The Wall Street
Journal; Wong, G., and C. Dulaney (2015, Aug. 2), “Reality hits Alibaba’s
results,” The Wall Street Journal; “Clicks to bricks,” The Economist, August
15, 2015; Mishkin, S. (2014, Oct. 29) “Amazon’s ventures in China are
raising concerns at home,” The Financial Times; Demos, T., and J. Osawa
(2014, Sept. 19), “Alibaba debut makes a splash,” The Wall Street Journal;
“Alibaba: The world’s greatest bazaar,” The Economist, March 23, 2013;
“E-commerce in China: The Alibaba phenomenon,” The Economist,
March 23, 2013; “Microsoft considered building e-commerce market,” Fox
Business, June 2013; “Yahoo’s Marissa Mayer hits one-year mark,” The
Wall Street Journal, July 15, 2013; “Yahoo’s ad struggles persist,” The
Wall Street Journal, April 16, 2013; “How Taobao bested eBay in China,”
Financial Times, March 12, 2012; “How eBay failed in China,” Forbes,
September 12, 2010; “How eBay lost the China market,” Global Times,
August 10, 2009; “E-commerce with Chinese characteristics,” The
Economist, November 15, 2007; and “The Jack who would be king,”
The Economist, August 24, 2000.
as Amazon is doing in the United States—to facilitate
pick up and return of merchandise.
Since Alibaba is still mainly focused on the Chinese
market, facilitating ecommerce transactions to consum-
ers, it was hit hard by China’s slowing economy. More-
over, the Chinese government decided to devalue its
currency (the yuan), which made international products
such as Nike running shoes and Procter & Gamble con-
sumer products such as Tide much more expensive for
Chinese consumers. This, in turn, is hurting Alibaba’s
sales. Moreover, some of Alibaba’s domestic rivals,
including JD.com, Tencent, Baidu, and WeChat, are
getting much stronger, especially on mobile platforms.
With its instant messaging app and mobile payment
options, WeChat (owned by Tencent), in particular, is
outperforming Alibaba on mobile platforms. WeChat
has aspirations to morph into a global mobile platform.
With 1 billion users worldwide, it is one of the most
popular mobile apps in China and also globally.
Offering and facilitating the sales of counterfeit prod-
ucts is another big problem for Alibaba. Being an open
online marketplace, it allows anyone to use its platform.
The continued problem of counterfeits has led to Alibaba’s
being put on the United States Trade Representative
(USTR) blacklist of notorious marketplaces (again),
because the company has failed to keep counterfeiting
and piracy levels in check. Alibaba is also in the middle
of an investigation by the U.S. Securities and Exchange
Commission about its accounting practices. As Alibaba
looks to expand its services outside of ecommerce and
China, Jack Ma needs to gear up to face new challenges.
DISCUSSION QUESTIONS
1. Why did eBay lose out to Alibaba in China? What
lessons can be learned for non-Chinese internet
(technology) companies?
2. How was Alibaba able to become the most suc-
cessful ecommerce company in China? Think
about standards, network effects, and the crossing-
the-chasm framework to inform your reasoning.
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HP’s Boardroom Drama and Divorce
The HP Way guided the company since its incep-
tion in 1938, when it was founded with some $500 of
initial investment in Dave Packard’s garage in Palo
Alto, California. As one of the world’s most successful
technology companies (think laser printing), HP initi-
ated the famous technology cluster now known as Sili-
con Valley. Over the past decade, however, HP’s board
of directors—a group of individuals that is supposed
to represent the interests of the firm’s shareholders and
oversee the CEO—seemed to forget the HP Way as it
violated its core values time and time again. In the pro-
cess, HP’s board of directors acted out a drama rival-
ing House of Cards, with the season finale not yet in
sight.
The first season of the drama “aired” in 2006. The
online technology site CNET published an article
IN RECENT YEARS, Hewlett-Packard (HP) lost its rank
among the largest technology companies in the world.
It started the 2010s as one of the largest, with revenues
north of $127 billion at its peak in 2011. In 2014 (with
revenues of some $111 billion), HP was still in the
top five in size. Late in 2015 it became harder to keep
score, because the company split into two companies,
each going their own way. However, if you combine
the 2016 revenues of HP and HPE, you are now south
of $100 billion.
Decline in revenue was not HP’s most difficult
problem during this period. Worse was the huge ero-
sion in shareholder value, which was much more dra-
matic and which we will discuss soon. The company’s
decline is in sharp contrast to most of its history.
Indeed, HP was once so successful that it was featured
as one of a handful of visionary companies in the busi-
ness bestseller Built to Last (published in 1994). These
select companies outperformed the stock market by a
wide margin over several decades. Built to Last opens
with a quote by HP’s co-founder Bill Hewlett:
Hewlett passed away in 2001. Much has changed at
HP since then. Within the 18 months from April 2010
to November 2012, HP’s market value dropped by
almost 80 percent, wiping out $82 billion in shareholder
wealth. Over the longer term, from early 2010 until
summer 2015, HP’s stock price declined by 42 percent,
while the tech-heavy NASDAQ-100, containing many
firms that compete with HP, rose by 143 percent. This
marks a whopping 185 percentage points difference in
performance! It turns out that a perfect storm of corpo-
rate governance problems, combined with repeated eth-
ical shortcomings, had been brewing at HP for a decade.
The result: a sustained competitive disadvantage.
This development is even more astonishing given
that, at one point, HP was much admired for its corporate
culture—known as “the HP Way.” The core values of
the HP Way include business conducted with “uncom-
promising integrity,” as well as “trust and respect for
individuals,” among others (see Exhibit MC21.1)
MiniCase 21
Meg Whitman, CEO of Hewlett Packard Enterprise. At the end of 2017, Whitman
announced that she will be stepping down as CEO in early 2018.
©Kyodo News/NEW YORK/Newscom
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges the contribution of Ling Yang on an earlier
version. This MiniCase is developed for the purpose of class discussion. It
is not intended to be used for any kind of endorsement, source of data, or
depiction of efficient or inefficient management. All opinions expressed, all
errors and omissions are entirely the author’s. Revised and updated: August
1, 2017. ©Frank T. Rothaermel.
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HP board members and employees. The firm also con-
ducted physical surveillance of the suspected leaker—
board member George Keyworth—and his spouse, as
well as two other directors.
In a May 2006 board meeting, Dunn presented
the evidence gathered, implicating Keyworth as the
source of the leak. Dunn’s disclosure of the investiga-
tion infuriated HP director Thomas Perkins, a promi-
nent venture capitalist, so much that he resigned on the
spot. Perkins called the HP-initiated surveillance “ille-
gal, unethical, and a misplaced corporate priority.”2
Perkins also forced HP to disclose the spying cam-
paign to the Securities and Exchange Commission
(and thus the public) as his reason for resigning.
Dunn and Keyworth were dismissed from the board
along with six senior HP managers. Despite the
boardroom drama, HP came out unscathed finan-
cially, largely due to the superior performance of
then-CEO Mark Hurd.
on HP’s strategy. Quoting an anonymous source, the
article disclosed sensitive details that could have come
only from one of the directors or senior executives at
HP. Eager to discover the identity of the leaker, Patricia
Dunn, then chair of the board, launched a covert inves-
tigation. She hired an outside security firm to conduct
surveillance on HP’s board members, select employ-
ees, and even some journalists. Although it is common
for companies to monitor phone and computer use of
their employees, HP’s investigation went above and
beyond. The private investigators used an illegal spy-
ing technique called “pretexting” (impersonating the
targets) to obtain phone records by contacting telecom
service providers. The security firm obtained some
300 telephone records covering mobile, home, and
office phones of all directors (including Dunn), nine
journalists, and several HP employees. Not to leave
anything to chance, the security firm also obtained
phone records of the spouses and even the children of
EXHIBIT MC21.1 / The HP Way
We have trust and respect for individuals.
We approach each situation with the belief that people want to do a good job and will do so, given the proper tools and support.
We attract highly capable, diverse, innovative people and recognize their efforts and contributions to the company. HP people
contribute enthusiastically and share in the success that they make possible.
We focus on a high level of achievement and contribution.
Our customers expect HP products and services to be of the highest quality and to provide lasting value. To achieve this, all HP
people, especially managers, must be leaders who generate enthusiasm and respond with extra effort to meet customer needs.
Techniques and management practices which are effective today may be outdated in the future. For us to remain at the forefront
in all our activities, people should always be looking for new and better ways to do their work.
We conduct our business with uncompromising integrity.
We expect HP people to be open and honest in their dealings to earn the trust and loyalty of others. People at every level
are expected to adhere to the highest standards of business ethics and must understand that anything less is unacceptable.
As a practical matter, ethical conduct cannot be assured by written HP policies and codes; it must be an integral part of the
organization, a deeply ingrained tradition that is passed from one generation of employees to another.
We achieve our common objectives through teamwork.
We recognize that it is only through effective cooperation within and among organizations that we can achieve our goals. Our
commitment is to work as a worldwide team to fulfill the expectations of our customers, shareholders and others who depend
upon us. The benefits and obligations of doing business are shared among all HP people.
We encourage flexibility and innovation.
We create an inclusive work environment which supports the diversity of our people and stimulates innovation. We strive for
overall objectives which are clearly stated and agreed upon, and allow people flexibility in working toward goals in ways that they
help determine are best for the organization. HP people should personally accept responsibility and be encouraged to upgrade
their skills and capabilities through ongoing training and development. This is especially important in a technical business where
the rate of progress is rapid and where people are expected to adapt to change.
SOURCE: Hewlett-Packard Alumni Association, www.hpalumni.org/hp_way.htm
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HP also exited the mobile device industry, most nota-
bly tablet computers. Many viewed this move as capit-
ulating to Apple’s dominance.
As part of his new corporate strategy, Apotheker
was eager to make a high-impact acquisition to put his
strategic vision of HP as a software and service company
into action. He ended up acquiring the British software
company Autonomy for $11 billion, which analysts saw as
grossly overvalued. Shortly thereafter, HP took an almost
$9 billion writedown due to alleged “accounting inaccura-
cies” at Autonomy. HP’s stock went into free fall. During
Apotheker’s short 11 months at the helm of HP, the share
price dropped by almost 50 percent. HP’s due diligence
process by the board was clearly flawed when acquiring
Autonomy. The process itself had been truncated. More-
over, the HP board did not heed the red flags thrown up by
Deloitte, Autonomy’s auditor. Indeed, a few days before
the Autonomy acquisition was finalized, Deloitte audi-
tors asked to meet with the board to inform them about
a former Autonomy executive who accused the company
of accounting irregularities. Deloitte also added that had it
investigated the claim and did not find any irregularities.
Perhaps most problematic, the board fell victim to
groupthink, rallying around Apotheker as CEO and
Ray Lane, the board chair, who strongly supported
him. In the wake of the Hurd ethics scandal, an outside
recruiting firm had proposed Apotheker as CEO and
Lane as the new chair of HP’s board of directors. The
full board never met either of the men before hiring
them into key strategic positions! The HP board of
directors experienced a major shakeup after the Hurd
ethics scandal and then again after the departure of
Apotheker. Lane stepped down as chair of HP’s board
in the spring of 2013 but remains a director.
After Apotheker was let go, HP did not conduct a
search for its next CEO. Instead, in the fall of 2011,
the board appointed one of its directors, Meg Whit-
man, as CEO because the board members were “too
exhausted by the fighting.”3 Whitman had been the
CEO at eBay, was appointed to HP’s board of direc-
tors in 2011, and was a director when the Autonomy
acquisition was approved. In an effort to regain com-
petitiveness Whitman cut 55,000 jobs.
As noted above, in 2015 HP split into two firms, one
focusing on consumer hardware (PCs and printers) and
called HP Inc. ($48 billion in 2016 revenues), and the
other on business equipment and services called Hewlett
Packard Enterprise ($50 billion in 2016 revenues).
This corporate strategy move is very similar to what
Apotheker had suggested three years earlier and similar
Hurd was appointed Hewlett-Packard’s CEO in
the spring of 2005. He began his business career 25
years earlier as an entry-level salesperson with NCR, a
U.S. technology company best known for its bar code
scanners in retail outlets and automatic teller machines
(ATMs). By the time Hurd worked his way up to the
role of CEO at NCR, he had earned a reputation as a
low-profile, no-nonsense manager focused on flawless
strategy execution. When he was appointed HP’s CEO,
industry analysts praised its board of directors for its
decision. Investors hoped that Hurd would run an effi-
cient and lean operation at HP and return the company
to its former greatness and, above all, profitability.
Hurd did not disappoint. By all indications, he was
highly successful at the helm of HP. The company
became number one in desktop computer sales and
increased its lead in inkjet and laser printers to more
than 50 percent market share. Through significant cost-
cutting and streamlining measures, Hurd turned HP
into a lean operation. For example, he oversaw large-
scale layoffs and a pay cut for all remaining employees
as he reorganized the company. Wall Street rewarded
HP shareholders with an almost 90 percent stock price
appreciation during Hurd’s tenure, outperforming
broader stock market indices by a wide margin.
Yet, in the summer of 2010, HP aired the second sea-
son of its boardroom soap opera. The HP board found
itself caught between a rock and a hard place, with
no easy options in sight. Jodie Fisher, a former adult-
movie actor, filed a lawsuit against Hurd alleging sexual
harassment. As an independent contractor, Fisher had
worked as a hostess at HP-sponsored events. In this
function, she had screened attending HP customers and
personally ensured that Hurd spent time with the most
important ones. With another ethics scandal looming
despite Hurd’s stellar financial results for the company,
HP’s board of directors forced him to resign. He left HP
in August 2010 with an exit package worth $35 million.
The third season of HP’s boardroom drama began in
the fall of 2010 when HP announced Leo Apotheker as
its new CEO. Apotheker, who came to HP after being
let go from the German enterprise software company
SAP, proposed a new corporate strategy for HP. He
suggested that the company focus on enterprise soft-
ware solutions and spin off its low-margin consumer
hardware business. HP’s consumer hardware business
resulted from the $25 billion acquisition of Compaq
during the tumultuous tenure of CEO Carly Fiorina,
prior to Mark Hurd. The hardware business had grown
to 40 percent of HP’s total revenues. Under Apotheker,
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3. You are brought in as a corporate governance con-
sultant or a business ethics consultant by the board
of directors (of either HP or HPE). What recom-
mendations would you give the board? How would
you go about implementing them? Be specific.
4. Discuss the general lessons in terms of corporate
governance and business ethics that can be drawn
from this MiniCase.
Endnotes
1. “Suspicions and spies in Silicon Valley,” Newsweek, September 17,
2006.
2. “How Hewlett-Packard lost its way,” CNN Money, May 8, 2012.
Sources: King, R. (2017, Feb. 22), “HP revenue grows again on PC
rebound,” The Wall Street Journal; King, R. (2016, July 24), “Dell, HP take
opposite tacks amid roiling tech market,” The Wall Street Journal; “As H-P
split nears, bosses tick off a surgery checklist,” The Wall Street Journal, June
30, 2015; “Split today, merge tomorrow,” The Economist, October 7, 2014;
“Inside HP’s missed chance to avoid a disastrous deal,”
The Wall Street Journal, January 21, 2013; “The HP Way out,” The
Economist, April 5, 2013; “How Hewlett-Packard lost its way,” CNN
Money, May 8, 2012; “HP shakes up board in scandal’s wake,” The Wall
Street Journal, January 21, 2011; “HP CEO Mark Hurd resigns after sexual
harassment probe,” The Huffington Post, August 6, 2010; “The curse of
HP,” The Economist, August 12, 2010; “Corporate governance: Spying
and leaking are wrong,” The Economist, September 14, 2006; “Corporate
governance: Pretext in context,” The Economist, September 14, 2006;
Packard, D. (1995), HP Way: How Bill Hewlett and I Built Our Company
(New York: Collins); and Collins, J.C., and J.I. Porras (1994), Built to Last:
Successful Habits of Visionary Companies (New York: HarperCollins).
to what IBM, one of HP’s main rivals, had undertaken
a decade earlier. Whitman remained CEO of the new
Hewlett Packard Enterprise, which is considered to
have higher growth potential than the low-margin
computer hardware business. By 2017, both stand-
alone companies—Hewlett Packard Enterprise and
HP—were performing decently. Indeed, Hewlett Pack-
ard Enterprise outperformed the tech-heavy NAS-
DAQ-100 index over the past few years, while old-line
HP Inc. performed roughly at the same level as the
broader technology market. Both companies have
avoided major boardroom drama in recent years.
DISCUSSION QUESTIONS
1. Who is to blame for HP’s shareholder-value
destruction—the CEO, the board of directors, or
both? What recourse, if any, do shareholders have?
2. Why did HP split itself into two firms, a move that
was rejected just three years earlier? Do you think
the corporate strategy move of splitting the “old”
HP into two companies (HP Inc. and Hewlett Pack-
ard Enterprise, HPE) will create shareholder value?
Why or why not? Which of the two companies
would you expect to be the higher performer? Why?
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UBS: A Pattern of Ethics Scandals
IRS. In addition, UBS aggressively marketed its “tax-
saving” schemes by sending its Swiss bankers to the
United States to develop clientele, even though those
bankers never acquired proper licenses from the U.S.
Securities and Exchange Commission (SEC) to do so.
The U.S. prosecutors pressed charges on UBS for
conspiring to defraud the United States by impeding the
IRS. In a separate suit, the U.S. government requested
that UBS to reveal the names of 52,000 U.S. clients
who were believed to be tax evaders. In February 2009,
UBS paid $780 million in fines to settle the charges.
Although it initially resisted the pressure to turn over
clients’ information, citing Swiss bank privacy laws,
UBS eventually agreed to disclose some 5,000 account
details, including individual names, after intense nego-
tiations involving officials from both countries. Clients
left UBS in droves: Operating profit from the bank’s
wealth management division declined by 60 percent,
UBS WAS FORMED in 1997 when Swiss Bank Corp.
merged with Union Bank of Switzerland. After acquir-
ing Paine Webber, a 120-year-old U.S. wealth man-
agement firm, in 2000, and aggressively hiring for its
investment banking business, UBS soon became one
of the top financial services companies in the world
and the biggest bank in Switzerland. Between 2008
and 2015, however, its reputation was severely tar-
nished by a series of ethics scandals. These scandals
cost the bank billions of dollars in fines and lost prof-
its, not to mention a severely diminished reputation.
Even more important, they seem not to be isolated
instances, but rather to suggest a troubling pattern.
Ethics Scandal No. 1: U.S. Tax Evasion
Swiss banks have long enjoyed a competitive advantage
conferred by Swiss banking privacy laws that make it a
criminal offense to share clients’ information with any
third parties. The exceptions are cases of criminal acts
such as accounts being linked to terrorists or tax fraud.
Merely not declaring assets to tax authorities (tax eva-
sion), however, is not considered tax fraud. After the
acquisition of Paine Webber, UBS entered into a quali-
fied intermediary (QI) agreement with the Internal
Revenue Service (IRS), the federal tax agency of the
U.S. government. Like other foreign financial institu-
tions under a QI agreement, UBS agreed to report and
withhold taxes on accounts receiving U.S.-sourced
income. This reporting is done on an aggregate basis
to protect the identity of the non-U.S. account holders.
In mid-2008, it came to light that since 2000, UBS
had actively participated in helping its U.S. clients
evade taxes. To avoid QI reporting requirements,
UBS’ Switzerland-based bankers had assisted the
U.S. clients to structure their accounts by divesting
U.S. securities and setting up sham entities offshore
to acquire non-U.S. account holder status. Aided by
Swiss bank privacy laws, UBS successfully helped
its U.S. clients conceal billions of dollars from the
MiniCase 22
©SEBASTIAN DERUNGS/AFP/Getty Images
Frank T. Rothaermel prepared this MiniCase from public sources.
He gratefully acknowledges the contribution of Ling Yang on an earlier
version. This MiniCase is developed for the purpose of class discussion. It
is not intended to be used for any kind of endorsement, source of data, or
depiction of efficient or inefficient management. All opinions expressed, all
errors and omissions are entirely the author’s. Revised and updated: May 27,
2017. ©Frank T. Rothaermel.
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Bankers’ Association based on their perceived unse-
cured borrowing cost; the rate is then calculated using
a “trimmed” average, which excludes the highest and
lowest 25 percent of the submissions. LIBOR is the
most frequently used benchmark reference rate world-
wide, setting prices on financial instruments worth
about $800 trillion, including mortgage rates, term
loans, and many others.
UBS, as one of the panel banks, was fined $1.5
billion in December 2012 by U.S., UK, and Swiss
regulators for manipulating LIBOR submissions
from 2005 to 2010. Besides accepting the fine, UBS
pleaded guilty to U.S. prosecutors for committing wire
fraud. During the stated period, UBS acted on its own
or colluded with other panel banks to adjust LIBOR
submissions to benefit UBS’s own trading positions.
In addition, during the second half of 2008, UBS
instructed its LIBOR submitters to keep submissions
low to make the bank look stronger. At least 40 peo-
ple, including several senior managers at UBS, were
involved in the manipulation. One major conviction
was handed down.
In particular, 35-year-old Tom Hayes, a former
UBS (and Citibank) trader, was sentenced to 14 years
in prison for rigging the LIBOR. The jail sentence
was much longer than what was expected. The judge
presiding over the case stated that the court wanted to
send a powerful message to banks around the world
that financial crime will be severely punished and will
no longer be settled with just a fine (paid by the bank).
Hayes argues that he is the scapegoat for senior man-
agement failings: “I refute that my actions constituted
any wrong doing. . . I wish to reiterate that my actions
were consistent with those of others at senior levels. . .
senior management was aware of my actions and at no
point was I told that my actions could or would consti-
tute any wrongdoing.”3
In contrast, prosecutors maintained that Hayes was
the mastermind behind a corrupt ring of traders and
brokers globally, motivated by a desire to make his
performance look stronger. Just a few years earlier,
Hayes had been considered one of the most talented
traders in the banking industry, whom Goldman Sachs
tried to poach from UBS with the promise of a $3 million
signing bonus.
Following an appeal, in 2015, Hayes’ sentence was
reduced to 11 years. In his letters from prison, Tom
Hayes states that he is being held basically in solitary
confinement away from other inmates. Authorities
indicate that this is done for his protection.
or $4.4 billion, in 2008 alone; it declined by another
17 percent, or $504 million, in 2009.
The UBS case has far-reaching implications for the
bank’s wealth management business and the Swiss
banking industry as a whole, especially its cherished
bank secrecy. To close loopholes in the QI program and
crack down on tax evasion in countries with strict bank
secrecy traditions, President Obama signed into law
the Foreign Account Tax Compliance Act (FATCA)
in 2010. The law requires all foreign financial institu-
tions to report offshore accounts and activities of their
U.S. clients with assets over $50,000, and to impose
a 30 percent withholding tax on U.S. investments or
to exit the U.S. business. Switzerland has agreed to
implement the FATCA. The annual compliance cost
for each Swiss bank is estimated to be $100 million.
Ethics Scandal No. 2: Rogue Trader
On September 15, 2011, UBS announced that a rogue
trader named Kweku Adoboli at its London branch
had racked up an unauthorized trading loss of $2.3
billion over three years. Nine days later, UBS CEO
Oswald Grübel resigned “to assume responsibility
for the recent unauthorized trading incident.”1 After
more than a year of joint investigation by the U.K. and
Swiss regulators, the case was concluded with find-
ings that systems and controls at UBS were “seriously
defective.”2 As a result, Adoboli, a relatively junior
trader, had been able to take highly risky positions
with vast amounts of money. More alarmingly, all
three of Adoboli’s desk colleagues admitted that they
knew of his unauthorized trades. Moreover, Adoboli’s
two bosses had shown a relaxed attitude toward his
breaching of daily trading limits.
UBS was fined $47.6 million in late 2012. Adoboli
was sentenced to seven years in prison, of which he
served about half before being released in 2015.
By summer 2017, he was still fighting his deporta-
tion order from Britain, where he had arrived at age 12
from his native Ghana to attend boarding school.
Ethics Scandal No. 3:
LIBOR Manipulation
LIBOR, or the London Interbank Offered Rate,
is the interest rate at which international banks
based in London lend to each other. LIBOR is set
daily: A panel of banks submits rates to the British
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Ethics Scandal No. 4:
UBS “Did It Again”
In 2015, in the wake of the LIBOR rigging scandal,
the U.S. Department of Justice voided the $1.5 billion
settlement from 2012 with UBS, adding another
$200 million in fines. Perhaps more damaging, UBS
pleaded guilty to allegations that its UBS traders
(including Hayes) manipulated LIBOR. UBS had
avoided prosecution in 2012 by agreeing to cooperate
with authorities and promising not to engage in rate
rigging and other illegal activities in the future. The
Department of Justice now alleges that UBS violated
the terms of the agreement and “did it again.” This
time, prosecutors say that UBS manipulated foreign-
exchange rates. In particular, UBS and other banks
are accused of having colluded in moving foreign-
exchange rates for their own benefit and to the detri-
ment of their clients. The Justice Department views
UBS as a “repeat offender,” especially in light of a
2011 settlement related to antitrust violations in the
municipal-bond investments market.
DISCUSSION QUESTIONS
1. This MiniCase details several ethics scandals that
occurred at UBS in recent years. What does that
tell you about UBS?
2. Given repeated ethics failures at UBS, who is to
blame? The CEO? The board of directors? The
supervising managers? The individuals directly
involved? Who should be held accountable? Is it
sufficient just to fine the bank?
3. Given the information provided in this MiniCase,
do you think that the 11-year jail sentence for Tom
Hayes was too harsh? Did he serve as a scapegoat?
Note: The average jail sentence served for a person
convicted of murder is 17 years in England and
Wales.
4. What can UBS do to avoid ethics failures in the
future and to repair its damaged reputation?
Endnotes
1. Bill Hewlett, HP co-founder, as quoted in Collins, J.C., and Porras,
J.I., Built to Last: Successful Habits of Visionary Companies,
New York: HarperCollins, 1994, 1.
2. “Suspicions and spies in Silicon Valley,” Newsweek, September 17,
2006.
3. “How Hewlett-Packard lost its way,” CNN Money, May 8, 2012.
Sources: Raghavan, A. (2017, Mar. 24), “A rogue trader blames the system,
but not all are persuaded,” The New York Times; UBS annual reports, various
years; “How long do murderers serve in prison?” Data at: https://fullfact.
org/crime/how-long-do-murderers-serve-prison/, accessed May 27, 2017;
Topham, G. (2016, Jan. 3), “Libor fraudster Tom Hayes describes prison
life in series of letters,” The Guardian, January 3; Bray, C. (2015, Dec. 21),
“Court reduces ex-trader’s sentence in Libor case,” The New York Times;
“Former trader Tom Hayes sentenced to 14 years for LIBOR rigging,”
The Wall Street Journal, August 3, 2015; “Justice Department to tear up
past UBS settlement,” The Wall Street Journal, May 14, 2015; “Goldman
Sachs offered Tom Hayes $3 million bonus to quit UBS,” Bloomberg
Businessweek, May 28, 2015; “Demise of Swiss banking secrecy heralds
new era,” Financial Times, May 19, 2013; “UBS ex-official gets 18 months
in muni bond-rigging case,” The Wall Street Journal, July 24, 2013; “LIBOR
rate-probe spotlight shines on higher-ups at Citigroup, other banks,” The
Wall Street Journal, August 28, 2013; “Swiss and U.S. move forward on tax
compliance,” Swissinfo.ch, June 21, 2012; “The LIBOR scandal: The rotten
heart of finance,” The Economist, July 7, 2012; “UBS fined £30m over rogue
trader,” The Guardian, November 26, 2012; “UBS fined £29.7m over rogue
trader,” Financial Times, November 26, 2012; “Final notice to UBS AG,”
Financial Services Authority, December 19, 2012; Cantley, B.G. (2011),
“The U.B.S. case: The U.S. attack on Swiss banking sovereignty,” Brigham
Young University International Law & Management Review 7 (Spring),
available at SSRN: http://ssrn. com/abstract=1554827; “Rogue trader causes
$2 billion loss at UBS,” Associated Press, September 15, 2011; “Ending an
era of Swiss banking secrecy: The facts behind FATCA,” American Criminal
Law Review, September 18, 2011; “UBS enters into Deferred Prosecution
Agreement,” The United States Department of Justice Release, February 18,
2009; “UBS to give 4,450 names to U.S.,” The Wall Street Journal, August
20, 2009; and “Tax haven banks and U.S. tax compliance,” United States
Senate, July 17, 2008.
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How to Conduct a Case Analysis
making mistakes. The companies in these cases will
not lose profits or fire you if you miscalculate a finan-
cial ratio, misinterpret someone’s intentions, or make
an incorrect prediction about environmental trends.
Cases also invite you to “walk in” and explore many
more kinds of companies in a wider array of industries
than you will ever be able to work at in your lifetime.
With this strategy content, you will find MiniCases
(i.e., shorter cases) about athletes (Michael Phelps),
mass media and entertainment (Disney), technology
(Apple), and entertainment (Cirque du Soleil), among
others, as well as longer cases with complete finan-
cial data about companies such as Facebook, Tesla,
McDonald’s, to name just a few. Your personal orga-
nizational experiences are usually much more limited,
defined by the jobs held by your family members or
by your own forays into the working world. Learning
about companies involved in so many different types
of products and services may open up new employ-
ment possibilities for you. Diversity also forces us to
think about the ways in which industries (as well as
people) are both similar and yet distinct, and to criti-
cally examine the degree to which lessons learned
in one forum transfer to other settings (i.e., to what
degree are they “generalizable”). In short, cases are a
great training tool, and they are fun to study.
You will find that many of our cases are written
from the perspective of the CEO or general manager
responsible for strategic decision making in the organ-
ization. While you do not need to be a member of a top
management team to utilize the strategic management
process, these senior leaders are usually responsible
for determining strategy in most of the organizations
we study. Importantly, cases allow us to put ourselves
“in the shoes” of strategic leaders and invite us to
view the issues from their perspective. Having respon-
sibility for the performance of an entire organiza-
tion is quite different from managing a single project
team, department, or functional area. Cases can help
THE CASE STUDY is a fundamental learning tool in stra-
tegic management. We carefully wrote and chose the
cases in this book to expose you to a wide variety of
key concepts, industries, protagonists, and strategic
problems.
In simple terms, cases tell the story of a company
facing a strategic dilemma. The firms may be real or
fictional in nature, and the problem may be current
or one that the firm faced in the past. Although the
details of the cases vary, in general they start with a
description of the challenge(s) to be addressed, fol-
lowed by the history of the firm up until the decision
point, and then additional information to help you
with your analysis. The strategic dilemma is often
faced by a specific manager, who wonders what he or
she should do. To address the strategic dilemma, you
will use the AFI framework to conduct a case analy-
sis as well as the strategic management tools and con-
cepts provided in this textbook. After careful analysis,
you will be able to formulate a strategic response and
make recommendations about how to implement it.
Why Do We Use Cases?
Strategy is something that people learn by doing; it
cannot be learned simply by reading a book or lis-
tening carefully in class. While those activities will
help you become more familiar with the concepts and
models used in strategic management, the only way
to improve your skills in analyzing, formulating, and
implementing strategy is to practice.
We encourage you to take advantage of the cases
in this text as a “laboratory” in which to experiment
with the strategic management tools you have been
given, so that you can learn more about how, when,
and where they might work in the “real world.” Cases
are valuable because they expose you to a number
and variety of situations in which you can refine your
strategic management skills without worrying about
Case Analysis /
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to analyze the facts carefully, fighting the temptation
to jump right to proposing a solution.
The third step, continuing the medical analogy, is
to determine which analytical tools will help you to
most accurately diagnose the problem(s). Doctors may
choose to run blood tests or take an X-ray. In doing
case analysis, we follow the steps of the strategic man-
agement process. You have any and all of the follow-
ing models and frameworks at your disposal:
1. Perform an external environmental analysis of
the:
■ Macro-level environment (PESTEL analysis).
■ Industry environment (e.g., Porter’s five forces).
■ Competitive environment.
2. Perform an internal analysis of the firm using the
resource-based view:
■ What are the firm’s resources, capabilities, and
competencies?
■ Does the firm possess valuable, rare, costly to
imitate resources, and is it organized to capture
value from those resources (VRIO analysis)?
■ What is the firm’s value chain?
3. Analyze the firm’s current business-level and
corporate-level strategies:
■ Business-level strategy (product market
positioning).
■ Corporate-level strategy (diversification).
■ International strategy (geographic scope and
mode of entry).
■ How are these strategies being implemented?
4. Analyze the firm’s performance:
■ Use both financial and market-based measures.
■ How does the firm compare to its competitors
as well as the industry average?
■ What trends are evident over the past three to
five years?
■ Consider the perspectives of multiple stake-
holders (internal and external).
■ Does the firm possess a competitive advan-
tage? If so, can it be sustained?
CALCULATING FINANCIAL RATIOS. Financial ratio
analysis is an important tool for assessing the out-
comes of a firm’s strategy. Although financial per-
formance is not the only relevant outcome measure,
long-term profitability is a necessary precondition for
you see the big picture in a way that most of us are
not accustomed to in our daily, organizational lives.
We recognize that most undergraduate students and
even MBAs do not land immediately in the corporate
boardroom. Yet having a basic understanding of the
types of conversations going on in the boardroom not
only increases your current value as an employee, but
also improves your chances of getting there someday,
should you so desire.
Finally, cases help give us a long-term view of the
firms they depict. Corporate history is immensely
helpful in understanding how a firm got to its present
position and why people within that organization think
the way they do. Our case authors (both the author of
this book and authors of cases from respected third-
party sources) have spent many hours poring over his-
torical documents and news reports in order to recreate
each company’s heritage for you, a luxury that most
of us do not have when we are bombarded on a daily
basis with homework, tests, and papers or project team
meetings, deadlines, and reports. We invite you not
just to learn from but also to savor reading each com-
pany’s story.
STRATEGIC CASE ANALYSIS. The first step in ana-
lyzing a case is to skim it for the basic facts. As you
read, jot down your notes regarding the following
basic questions:
■ What company or companies is the case about?
■ Who are the principal actors?
■ What are the key events? When and where do they
happen (in other words, what is the timeline)?
Second, go back and reread the case in greater
detail, this time with a focus on defining the problem.
Which facts are relevant and why? Just as a doctor
begins by interviewing the patient (“What hurts?”),
you likewise gather information and then piece the
clues together in order to figure out what is wrong.
Your goal at this stage is to identify the “symptoms”
in order to figure out which “tests” to run in order to
make a definitive “diagnosis” of the main “disease.”
Only then can you prescribe a “treatment” with con-
fidence that it will actually help the situation. Rush-
ing too quickly through this stage often results in
“malpractice” (that is, giving a patient with an upset
stomach an antacid when she really has the flu), with
effects that range from unhelpful to downright danger-
ous. The best way to ensure that you “do no harm” is
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Formulation: Proposing Feasible
Solutions
When you have the problem figured out (your diag-
nosis), the next step is to propose a “treatment plan”
or solution. There are two parts to the treatment plan:
the what and the why. Using our medical analogy:
The what for a patient with the flu might be antiviral
medication, rest, and lots of fluids. The why: antivirals
attack the virus directly, shortening the duration of ill-
ness; rest enables the body to recuperate naturally; and
fluids are necessary to help the body fight fever and
dehydration. The ultimate goal is to restore the patient
to wellness. Similarly, when you are doing case analy-
sis, your task is to figure out what the leaders of the
company should do and why this is an appropriate
course of action. Each part of your proposal should be
justifiable based on your analyses.
One word of caution about the formulation stage:
By nature, humans are predisposed to engage in
“local” and “simplistic” searches for solutions to the
problems they face.1 On the one hand, this can be
an efficient approach to problem solving, because
relying on past experiences (what worked before)
does not waste time reinventing the wheel. The
purpose of doing case analysis, however, is to look
past the easy answers and to help us figure out not
just what works (satisficing) but what might be the
best answer (optimizing). In other words, do not just
take the first idea that comes to your mind and run
with it. Instead, write down that idea for subsequent
consideration but then think about what other solu-
tions might achieve the same (or even better) results.
Some of the most successful companies engage in sce-
nario planning, in which they develop several possible
outcomes and estimate the likelihood that each will
happen. If their first prediction turns out to be incor-
rect, then they have a Plan B ready and waiting to be
executed.
Plan for Implementation
The final step in the AFI framework is to develop a
plan for implementation. Under formulation, you came
up with a proposal, tested it against alternatives, and
used your research to support why it provides the best
solution to the problem at hand. To demonstrate its
feasibility, however, you must be able to explain how
to put it into action. Consider the following questions:
firms to remain in business and to be able to serve the
needs of all of their stakeholders. Accordingly, at the
end of this introductory module, we have provided a
table of financial measures that can be used to assess
firm performance (see Table 1).
All of the following aspects of performance should
be considered, because each provides a different type
of information about the financial health of the firm:
■ Profitability ratios—how efficiently a company
utilizes its resources.
■ Activity ratios—how effectively a firm manages
its assets.
■ Leverage ratios—the degree to which a firm relies
on debt versus equity (capital structure).
■ Liquidity ratios—a firm’s ability to pay off its
short-term obligations.
■ Market ratios—returns earned by shareholders
who hold company stock.
MAKING THE DIAGNOSIS. With all of this informa-
tion in hand, you are finally ready to make a “diag-
nosis.” Describe the problem(s) or opportunity(ies)
facing the firm at this time and/or in the near future.
How are they interrelated? (For example, a runny
nose, fever, stomach upset, and body aches are all
indicative of the flu.) Support your conclusions with
data generated from your analyses.
The following general themes may be helpful to
consider as you try to pull all the pieces together into
a cohesive summary:
■ Are the firm’s value chain (primary and support)
activities mutually reinforcing?
■ Do the firm’s resources and capabilities fit with
the demands of the external environment?
■ Does the firm have a clearly defined strategy that
will create a competitive advantage?
■ Is the firm making good use of its strengths and
taking full advantage of its opportunities?
■ Does the firm have serious weaknesses or face sig-
nificant threats that need to be mitigated?
Keep in mind that “problems” can be positive (how
to manage increased demand) as well as negative
(declining stock price) in nature. Even firms that are
currently performing well need to figure out how to
maintain their success in an ever-changing and highly
competitive global business environment.
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1. What activities need to be performed? The value
chain is a very useful tool when you need to
figure out how different parts of the company are
likely to be affected. What are the implications
of your plan with respect to both primary activi-
ties (e.g., operations and sales/marketing/service)
and support activities (e.g., human resources and
infrastructure)?
2. What is the timeline? What steps must be taken
first and why? Which ones are most critical?
Which activities can proceed simultaneously, and
which ones are sequential in nature? How long is
your plan going to take?
3. How are you going to finance your proposal?
Does the company have adequate cash on hand, or
does it need to consider debt and/or equity finan-
cing? How long until your proposal breaks even
and pays for itself?
4. What outcomes is your plan likely to achieve? Pro-
vide goals that are “SMART”: specific, measur-
able, achievable, realistic, and timely in nature.
Make a case for how your plan will help the firm
to achieve a strategic competitive advantage.
In-Class Discussion
Discussing your ideas in class is often the most valu-
able part of a case study. Your professor will moderate
the class discussion, guiding the AFI process and ask-
ing probing questions when necessary. Case discussion
classes are most effective and interesting when every-
body comes prepared and participates in the exchange.
Actively listen to your fellow students; mutual
respect is necessary in order to create an open and
inviting environment in which people feel comfortable
sharing their thoughts with one another. This does not
mean you need to agree with what everyone else is say-
ing, however. Everyone has unique perspectives and
biases based on differences in life experiences, educa-
tion and training, values, and goals. As a result, no two
people will interpret the same information in exactly
the same way. Be prepared to be challenged, as well as
to challenge others, to consider the case from another
vantage point. Conflict is natural and even beneficial
as long as it is managed in constructive ways.
Throughout the discussion, you should be pre-
pared to support your ideas based on the analyses you
conducted. Even students who agree with you on the
general steps to be taken may disagree on the order of
importance. Alternatively, they may like your plan in
principle but argue that it is not feasible for the com-
pany to accomplish. You should not be surprised if
others come up with an altogether different diagno-
sis and prescription. For better or worse, a good idea
does not stand on its own merit—you must be able to
convince your peers of its value by backing it up with
sound logic and support.
Things to Keep in Mind while
Doing Case Analysis
While some solutions are clearly better than others,
it is important to remember that there is no single
correct answer to any case. Unlike an optimization
equation or accounting spreadsheet, cases cannot be
reduced to a mathematical formula. Formulating and
implementing strategy involves people, and working
with people is inherently messy. Thus, the best way to
get the maximum value from case analysis is to main-
tain an open mind and carefully consider the strengths
and weaknesses of all of the options. Strategy is an
iterative process, and it is important not to rush to a
premature conclusion.
For some cases, your instructor may be able to
share with you what the company actually did, but that
does not necessarily mean it was the best course of
action. Too often students find out what happened in
the “real world” and their creative juices stop flow-
ing. Whether due to lack of information, experience,
or time, companies quite often make the most expedi-
ent decision. With your access to additional data and
time to conduct more detailed analyses, you may very
well arrive at a different (and better) conclusion. Stand
by your findings as long as you can support them
with solid research data. Even Fortune 500 companies
make mistakes.
Unfortunately, to their own detriment, students
sometimes discount the value of cases based on fic-
tional scenarios or set some time in the past. One sig-
nificant advantage of fictional cases is that everybody
has access to the same information. Not only does
this level the playing field, but it also prevents you
from being unduly biased by actual events, thus cut-
ting short your own learning process. Similarly, just
because a case occurred in the past does not mean it
is no longer relevant. The players and technology may
change over time, but many questions that businesses
face are timeless in nature: how to adapt to a changing
environment, the best way to compete against other
firms, and whether and how to expand.
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Case Limitations
As powerful a learning tool as case analysis can be,
it does come with some limitations. One of the most
important for you to be aware of is that case analy-
sis relies on a process known as inductive reasoning,
in which you study specific business cases in order to
derive general principles of management. Intuitively,
we rely on inductive reasoning across almost every
aspect of our lives. We know that we need oxygen to
survive, so we assume that all living organisms need
oxygen. Similarly, if all the swans we have ever seen
are white, we extrapolate this to mean that all swans
are white. While such relationships are often built
upon a high degree of probability, it is important to
remember that they are not empirically proven. We
have in fact discovered life forms (microorganisms)
that rely on sulfur instead of oxygen. Likewise, just
because all the swans you have seen have been white,
black swans do exist.
What does this caution mean with respect to case
analysis? First and foremost, do not assume that just
because one company utilized a joint venture to com-
mercialize a new innovation, another company will
be successful employing the same strategy. The first
company’s success may not be due to the particu-
lar organizational form it selected; it might instead
be a function of its competencies in managing inter-
firm relationships or the particularities of the exter-
nal environment. Practically speaking, this is why the
analysis step is so fundamental to good strategic man-
agement. Careful research helps us to figure out all
of the potential contributing factors and to formulate
hypotheses about which ones are most likely critical
to success. Put another way, what happens at one firm
does not necessarily generalize to others. However,
solid analytical skills go a long way toward enabling
you to make informed, educated guesses about when
and where insights gained from one company have
broader applications.
In addition, we have a business culture that tends
to put on a pedestal high-performance firms and their
leaders. Critical analysis is absolutely essential in
order to discern the reasons for such firms’ success.
Upon closer inspection, we have sometimes found that
their image is more a mirage than a direct reflection
of sound business practices. Many business analysts
have been taken in by the likes of Enron, WorldCom,
and Bernie Madoff, only to humbly retract their praise
when the company’s shaky foundation crumbles. We
selected many of the firms in these cases because of
their unique stories and positive performance, but we
would be remiss if we let students interpret their pres-
ence in this book as a wholehearted endorsement of
all of their business activities.
Finally, our business culture also places a high pre-
mium on benchmarking and best practices. Although
we present you with a sample of firms that we believe
are worthy of in-depth study, we would again caution
you against uncritical adoption of their activities in
the hope of emulating their achievements. Even when
a management practice has broad applications, strat-
egy involves far more than merely copying the indus-
try leader. The company that invents a best practice
is already far ahead of its competitors on the learning
curve, and even if other firms do catch up, the best
they can usually hope for is to match (but not exceed)
the original firm’s success. By all means, learn as
much as you can from whomever you can, but use
that information to strengthen your organization’s own
strategic identity.
Frequently Asked Questions
about Case Analysis
1. Is it OK to utilize outside materials?
Ask your professor. Some instructors utilize cases
as a springboard for analysis and will want you to look
up more recent financial and other data. Others may
want you to base your analysis on the information
from the case only, so that you are not influenced by
the actions actually taken by the company.
2. Can I talk about the case with other students?
Again, you should check with your professor,
but many will strongly encourage you to meet and
talk about the case with other students as part of
your preparation process. The goal is not to come to
a group consensus, but to test your ideas in a small
group setting and revise them based on the feedback
you receive.
3. Is it OK to contact the company for more
information?
If your professor permits you to gather outside
information, you may want to consider contacting the
company directly. If you do so, it is imperative that
you represent yourself and your school in the most
professional and ethical manner possible. Explain
to them that you are a student studying the firm and
that you are seeking additional information, with your
instructor’s permission. Our experience is that some
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to remember is not to waste precious space repeating
facts from the case. You can assume that your profes-
sor has read the case carefully. What he or she is most
interested in is your analysis of the situation and your
rationale for choosing a particular solution.
ENDNOTE
1. Cyert, R.M., and J.G. March (2001), A Behavioral Theory of the
Firm, 2nd ed. (Malden, MA: Blackwell Publishers Inc.).
companies are quite receptive to student inquiries;
others are not. You cannot know how a particular
company will respond unless you try.
4. What should I include in my case analysis report?
Instructors generally provide their own guidelines
regarding content and format, but a general outline
for a case analysis report is as follows: (1) analysis
of the problem; (2) proposal of one or more alterna-
tive solutions; and (3) justification for which solution
you believe is best and why. The most important thing
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be
tw
ee
n
sa
le
s
an
d
th
e
co
st
s
to
s
up
po
rt
th
os
e
sa
le
s
(e
.g.
, m
an
uf
ac
tu
rin
g,
pr
oc
ur
em
en
t,
ad
ve
rt
is
in
g,
pa
yr
ol
l,
et
c.
)
Re
tu
rn
o
n
as
se
ts
(R
OA
)
Ne
t i
nc
om
e
/ T
ot
al
a
ss
et
s
M
ea
su
re
s
th
e
fir
m
’s
ef
fic
ie
nc
y
in
u
si
ng
a
ss
et
s
to
g
en
er
at
e
ea
rn
in
gs
Re
tu
rn
o
n
eq
ui
ty
(R
OE
)
Ne
t i
nc
om
e
/ T
ot
al
s
to
ck
ho
ld
er
s’
eq
ui
ty
M
ea
su
re
s
ea
rn
in
gs
to
o
wn
er
s
as
m
ea
su
re
d
by
n
et
a
ss
et
s
Re
tu
rn
o
n
in
ve
st
ed
c
ap
ita
l (
RO
IC
)
Ne
t p
ro
fit
s
/ I
nv
es
te
d
ca
pi
ta
l
M
ea
su
re
s
ho
w
ef
fe
ct
iv
el
y
a
co
m
pa
ny
u
se
s
its
to
ta
l i
nv
es
te
d
ca
pi
ta
l,
wh
ic
h
co
ns
is
ts
o
f t
wo
c
om
po
ne
nt
s:
(1)
s
ha
re
ho
ld
er
s’
eq
ui
ty
th
ro
ug
h
th
e
se
lli
ng
o
f s
ha
re
s
to
th
e
pu
bl
ic
, a
nd
(2
) i
nt
er
es
t-b
ea
rin
g
de
bt
th
ro
ug
h
bo
rr
ow
in
g
fr
om
fi
na
nc
ia
l i
ns
tit
ut
io
ns
a
nd
b
on
dh
ol
de
rs
.
Re
tu
rn
o
n
re
ve
nu
e
(R
OR
)
Ne
t p
ro
fit
s
/ R
ev
en
ue
M
ea
su
re
s
th
e
pr
of
it
ea
rn
ed
p
er
d
ol
la
r o
f r
ev
en
ue
Di
vi
de
nd
p
ay
ou
t
Co
m
m
on
d
iv
id
en
ds
/
Ne
t i
nc
om
e
M
ea
su
re
s
th
e
pe
rc
en
t o
f e
ar
ni
ng
s
pa
id
o
ut
to
c
om
m
on
st
oc
kh
ol
de
rs
Li
m
it
at
io
ns
1.
St
at
ic
s
na
ps
ho
t o
f b
al
an
ce
s
he
et
.
2.
M
an
y
im
po
rt
an
t i
nt
an
gi
bl
es
n
ot
a
cc
ou
nt
ed
fo
r.
3.
A
ffe
ct
ed
b
y
ac
co
un
tin
g
ru
le
s
on
a
cc
ru
al
s
an
d
tim
in
g.
O
ne
-ti
m
e
no
no
pe
ra
tin
g
in
co
m
e/
ex
pe
ns
e.
4.
D
oe
s
no
t t
ak
e
in
to
a
cc
ou
nt
c
os
t o
f c
ap
ita
l.
5.
A
ffe
ct
ed
b
y
tim
in
g
an
d
ac
co
un
tin
g
tr
ea
tm
en
t o
f o
pe
ra
tin
g
re
su
lts
.
TA
BL
E
1 /
W
he
n
an
d
H
ow
to
U
se
F
in
an
ci
al
M
ea
su
re
s
to
A
ss
es
s
Fi
rm
P
er
fo
rm
an
ce
Final PDF to printer
How to Conduct a Case Analysis 535
rot27628_caseanalysis_528-538.indd 535 11/23/17 03:48 PM
TA
BL
E
1 /
W
he
n
an
d
H
ow
to
U
se
F
in
an
ci
al
M
ea
su
re
s
to
A
ss
es
s
Fi
rm
P
er
fo
rm
an
ce
(c
on
tin
ue
d)
Ta
bl
e
1b
: A
ct
iv
ity
R
at
io
s
Fo
rm
ul
a
Ch
ar
ac
te
ri
st
ic
s
In
ve
nt
or
y
tu
rn
ov
er
CO
GS
/
in
ve
nt
or
y
M
ea
su
re
s
in
ve
nt
or
y
m
an
ag
em
en
t
Re
ce
iv
ab
le
s
tu
rn
ov
er
Re
ve
nu
e
/ a
cc
ou
nt
s
re
ce
iv
ab
le
M
ea
su
re
s
th
e
ef
fe
ct
iv
en
es
s
of
c
re
di
t p
ol
ic
ie
s
an
d
th
e
ne
ed
ed
le
ve
l
of
re
ce
iv
ab
le
s
in
ve
st
m
en
t f
or
s
al
es
Pa
ya
bl
es
tu
rn
ov
er
Re
ve
nu
e
/ a
cc
ou
nt
s
pa
ya
bl
e
M
ea
su
re
s
th
e
ra
te
a
t w
hi
ch
a
fi
rm
p
ay
s
its
s
up
pl
ie
rs
W
or
ki
ng
c
ap
ita
l t
ur
no
ve
r
Re
ve
nu
e
/ w
or
ki
ng
c
ap
ita
l
M
ea
su
re
s
ho
w
m
uc
h
wo
rk
in
g
(o
pe
ra
tin
g)
c
ap
ita
l i
s
ne
ed
ed
fo
r
sa
le
s
Fi
xe
d
as
se
t t
ur
no
ve
r
Re
ve
nu
e
/ f
ix
ed
a
ss
et
s
M
ea
su
re
s
th
e
ef
fic
ie
nc
y
of
in
ve
st
m
en
ts
in
n
et
fi
xe
d
as
se
ts
(p
ro
pe
rt
y,
pl
an
t,
an
d
eq
ui
pm
en
t a
fte
r a
cc
um
ul
at
ed
d
ep
re
ci
at
io
n)
To
ta
l a
ss
et
tu
rn
ov
er
Re
ve
nu
e
/ t
ot
al
a
ss
et
s
Re
pr
es
en
ts
th
e
ov
er
al
l (
co
m
pr
eh
en
si
ve
) e
ffi
ci
en
cy
o
f a
ss
et
s
to
sa
le
s
Ca
sh
tu
rn
ov
er
Re
ve
nu
e
/ c
as
h
(w
hi
ch
u
su
al
ly
in
cl
ud
es
m
ar
ke
ta
bl
e
se
cu
rit
ie
s)
M
ea
su
re
s
a
fir
m
’s
ef
fic
ie
nc
y
in
it
s
us
e
of
c
as
h
to
g
en
er
at
e
sa
le
s
Li
m
it
at
io
ns
Go
od
m
ea
su
re
s
of
c
as
h
flo
w
ef
fic
ie
nc
y,
bu
t w
ith
th
e
fo
llo
wi
ng
li
m
ita
tio
ns
:
1.
Li
m
ite
d
by
a
cc
ou
nt
in
g
tr
ea
tm
en
t a
nd
ti
m
in
g
(e
.g.
, m
on
th
ly/
qu
ar
te
rly
c
lo
se
)
2.
L
im
ita
tio
ns
o
f a
cc
ru
al
v
s.
c
as
h
ac
co
un
tin
g
Final PDF to printer
536 How to Conduct a Case Analysis
rot27628_caseanalysis_528-538.indd 536 11/23/17 03:48 PM
TA
BL
E
1 /
W
he
n
an
d
H
ow
to
U
se
F
in
an
ci
al
M
ea
su
re
s
to
A
ss
es
s
Fi
rm
P
er
fo
rm
an
ce
(c
on
tin
ue
d)
Ta
bl
e
1c
: L
ev
er
ag
e
Ra
tio
s
Fo
rm
ul
a
Ch
ar
ac
te
ri
st
ic
s
De
bt
to
e
qu
ity
To
ta
l l
ia
bi
lit
ie
s
/ t
ot
al
s
to
ck
ho
ld
er
s’
eq
ui
ty
Di
re
ct
c
om
pa
ris
on
o
f d
eb
t t
o
eq
ui
ty
s
ta
ke
ho
ld
er
s
an
d
th
e
m
os
t
co
m
m
on
m
ea
su
re
o
f c
ap
ita
l s
tr
uc
tu
re
De
bt
to
a
ss
et
s
To
ta
l l
ia
bi
lit
ie
s
/ t
ot
al
a
ss
et
s
De
bt
a
s
a
pe
rc
en
t o
f a
ss
et
s
In
te
re
st
c
ov
er
ag
e
(ti
m
es
in
te
re
st
ea
rn
ed
)
(N
et
in
co
m
e
+
In
te
re
st
e
xp
en
se
+
T
ax
e
xp
en
se
) /
in
te
re
st
ex
pe
ns
e
Di
re
ct
m
ea
su
re
o
f t
he
fi
rm
’s
ab
ili
ty
to
m
ee
t i
nt
er
es
t p
ay
m
en
ts
,
in
di
ca
tin
g
th
e
pr
ot
ec
tio
n
pr
ov
id
ed
fr
om
c
ur
re
nt
o
pe
ra
tio
ns
Lo
ng
-te
rm
d
eb
t t
o
eq
ui
ty
Lo
ng
-te
rm
li
ab
ili
tie
s
/ t
ot
al
s
to
ck
ho
ld
er
s’
eq
ui
ty
A
lo
ng
-te
rm
p
er
sp
ec
tiv
e
of
d
eb
t a
nd
e
qu
ity
p
os
iti
on
s
of
st
ak
eh
ol
de
rs
De
bt
to
m
ar
ke
t e
qu
ity
To
ta
l l
ia
bi
lit
ie
s
at
b
oo
k
va
lu
e
/ t
ot
al
e
qu
ity
a
t m
ar
ke
t v
al
ue
M
ar
ke
t v
al
ua
tio
n
m
ay
re
pr
es
en
t a
b
et
te
r m
ea
su
re
o
f e
qu
ity
th
an
bo
ok
v
al
ue
. M
os
t f
irm
s
ha
ve
a
m
ar
ke
t p
re
m
iu
m
re
la
tiv
e
to
b
oo
k
va
lu
e.
Bo
nd
ed
d
eb
t t
o
eq
ui
ty
Bo
nd
ed
d
eb
t /
s
to
ck
ho
ld
er
s’
eq
ui
ty
M
ea
su
re
s
a
fir
m
’s
le
ve
ra
ge
in
te
rm
s
of
s
to
ck
ho
ld
er
s’
eq
ui
ty
De
bt
to
ta
ng
ib
le
n
et
w
or
th
To
ta
l l
ia
bi
lit
ie
s
/ (
co
m
m
on
e
qu
ity
–
in
ta
ng
ib
le
a
ss
et
s)
M
ea
su
re
s
a
fir
m
’s
le
ve
ra
ge
in
te
rm
s
of
ta
ng
ib
le
(h
ar
d)
a
ss
et
s
ca
pt
ur
ed
in
b
oo
k
va
lu
e
Fi
na
nc
ia
l l
ev
er
ag
e
in
de
x
Re
tu
rn
o
n
eq
ui
ty
/
re
tu
rn
o
n
as
se
ts
M
ea
su
re
s
ho
w
we
ll
a
co
m
pa
ny
is
u
si
ng
it
s
de
bt
Li
m
it
at
io
ns
Ov
er
al
l g
oo
d
m
ea
su
re
s
of
a
fi
rm
’s
fin
an
ci
ng
s
tr
at
eg
y;
ne
ed
s
to
b
e
lo
ok
ed
a
t i
n
co
nc
er
t w
ith
o
pe
ra
tin
g
re
su
lts
b
ec
au
se
1.
Th
es
e
m
ea
su
re
s
ca
n
be
m
is
le
ad
in
g
if
lo
ok
ed
a
t i
n
is
ol
at
io
n.
2.
T
he
y
ca
n
al
so
b
e
m
is
le
ad
in
g
if
us
in
g
bo
ok
v
al
ue
s
as
o
pp
os
ed
to
m
ar
ke
t v
al
ue
s
of
d
eb
t a
nd
e
qu
ity
.
Final PDF to printer
How to Conduct a Case Analysis 537
rot27628_caseanalysis_528-538.indd 537 11/23/17 03:48 PM
Ta
bl
e
1d
: L
iq
ui
di
ty
R
at
io
s
Fo
rm
ul
a
Ch
ar
ac
te
ri
st
ic
s
Cu
rr
en
t
Cu
rr
en
t a
ss
et
s
/ c
ur
re
nt
li
ab
ili
tie
s
M
ea
su
re
s
sh
or
t-t
er
m
li
qu
id
ity
. C
ur
re
nt
a
ss
et
s
ar
e
al
l a
ss
et
s
th
at
a
fi
rm
c
an
re
ad
ily
c
on
ve
rt
to
c
as
h
to
p
ay
o
ut
st
an
di
ng
d
eb
ts
an
d
co
ve
r l
ia
bi
lit
ie
s
wi
th
ou
t h
av
in
g
to
s
el
l h
ar
d
as
se
ts
. C
ur
re
nt
lia
bi
lit
ie
s
ar
e
a
fir
m
’s
de
bt
a
nd
o
th
er
o
bl
ig
at
io
ns
th
at
a
re
d
ue
wi
th
in
a
y
ea
r.
Qu
ic
k
(a
ci
d-
te
st
)
(C
as
h
+
M
ar
ke
ta
bl
e
se
cu
rit
ie
s
+
N
et
re
ce
iv
ab
le
s)
/
cu
rr
en
t l
ia
bi
lit
ie
s
El
im
in
at
es
in
ve
nt
or
y
fr
om
th
e
nu
m
er
at
or
, f
oc
us
in
g
on
c
as
h,
m
ar
ke
ta
bl
e
se
cu
rit
ie
s,
an
d
re
ce
iv
ab
le
s.
Ca
sh
(C
as
h
+
M
ar
ke
ta
bl
e
se
cu
rit
ie
s)
/
cu
rr
en
t l
ia
bi
lit
ie
s
Co
ns
id
er
s
on
ly
c
as
h
an
d
m
ar
ke
ta
bl
e
se
cu
rit
ie
s
fo
r p
ay
m
en
t o
f
cu
rr
en
t l
ia
bi
lit
ie
s.
Op
er
at
in
g
ca
sh
fl
ow
Ca
sh
fl
ow
fr
om
o
pe
ra
tio
ns
/
cu
rr
en
t l
ia
bi
lit
ie
s
Ev
al
ua
te
s
ca
sh
-re
la
te
d
pe
rf
or
m
an
ce
(a
s
m
ea
su
re
d
fr
om
th
e
st
at
em
en
t o
f c
as
h
flo
ws
) r
el
at
iv
e
to
c
ur
re
nt
li
ab
ili
tie
s
Ca
sh
to
c
ur
re
nt
a
ss
et
s
(C
as
h
+
M
ar
ke
ta
bl
e
se
cu
rit
ie
s)
/
cu
rr
en
t a
ss
et
s
In
di
ca
te
s
th
e
pa
rt
o
f c
ur
re
nt
a
ss
et
s
th
at
a
re
a
m
on
g
th
e
m
os
t
fu
ng
ib
le
(i
.e
.,
ca
sh
a
nd
m
ar
ke
ta
bl
e
se
cu
rit
ie
s)
.
Ca
sh
p
os
iti
on
(C
as
h
+
M
ar
ke
ta
bl
e
se
cu
rit
ie
s)
/
to
ta
l a
ss
et
s
In
di
ca
te
s
th
e
pe
rc
en
t o
f t
ot
al
a
ss
et
s
th
at
a
re
m
os
t f
un
gi
bl
e
(i.
e.
,
ca
sh
).
Cu
rr
en
t l
ia
bi
lit
y
po
si
tio
n
Cu
rr
en
t l
ia
bi
lit
ie
s
/ t
ot
al
a
ss
et
s
In
di
ca
te
s
wh
at
p
er
ce
nt
o
f t
ot
al
a
ss
et
s
th
e
fir
m
’s
cu
rr
en
t l
ia
bi
lit
ie
s
re
pr
es
en
t.
Li
m
it
at
io
ns
Li
qu
id
ity
m
ea
su
re
s
ar
e
im
po
rt
an
t,
es
pe
ci
al
ly
in
ti
m
es
o
f e
co
no
m
ic
in
st
ab
ili
ty
, b
ut
th
ey
a
ls
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538 How to Conduct a Case Analysis
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Final PDF to printer
rot27628_cidx_539-544 539 11/23/17 02:57 PM
539
COMPANY INDEX
Note: Page numbers followed by n
indicate material in chapter end
notes. Page numbers beginning with
C indicate material in case studies.
A
Abacus, 434–436
ABB, 321, 344, 359
ABC Television Group, 70, 221, 224,
C494
Accenture, 349, C468
Acer, 348
Acura, 246
Adelphia, 48
Adidas, 267, 297, 298, 328
Adobe, 153
AirAsia, 169
Airbnb, 42, 47, C65–C66, 68, C97–C98,
158, 251, 422, C512
Airbus, 75, 80, 85, 87, 96, C183–C184,
194–196, C211, 243, 342, 348, 356
Airtel, 279
AirTran, 92, 324
Alaska Airlines, 75, 93, 114, C184
Albertson’s, 70
Aldi, 351
Alibaba Group, 15, 24, 33, 42, 47, 56,
249, 250, C265, 286, C298, 341,
355, C367, C454, C455, C512,
C513, C516–C519
Allegiant Air, 188
Alphabet, C31, 45, 47, 48, 50, 51, 56,
72, 88, 113, 152, 154, C173, 249,
C267, 281, C298, C309, C309–
C310, C330, 427, 431, C511
Alstom, 352
Alta Velocidad Española (AVE), 82
Altek, 279
Amazon, 15, 33, 42, 43, 50, 56, 72, 91,
111–114, 117, 124, 127, 158, 168,
170, 173, 191, 203, 221, 224, 225,
227, 247–249, 254, C265–C267,
267, 270, 272, 289, 291, 324, 342,
355, C379, 391, C410, C438, C468,
C505, C512–C515
Amazon Prime, 10
Amazon Prime Air, 43
Amazon Web Services, 111, 158,
C265
Amdahl, C468
América Móvil, 279
American Airlines, 46, 75, 80, 87, 88,
92–94, 104n42, C183, C184, 188,
194, 234, 324, 347, 348
American College of Cardiology, 200
American Eagle, 166
American Eagle Outfitters, 130
American Red Cross, 11
Ameritrade, 92
Amgen, 47, 244–245
Anheuser-Busch InBev, 270, 295
AOL, 313, 332
Apple, 8, C31, 33, 39, 50, 52, C65, 71,
72, 85, 88, 90, C107, C107–C108,
108, 111, 114, 116–118, 122,
124, 127, 129, C135–136, C145,
147–155, 158, 166–168, 170–171,
C172–C173, 192, 203, 208, C220,
224–226, 228–229, 233, 237, 247,
249, 254, C265, C267, 272, 279–
281, 284, C298, 327, 341, 345, 349,
352, 374–375n79, 399–401, 403,
C456–C457, C460–C464, C495,
C504, C505
ArcelorMittal, 341
Areva, 46, 56
ARM Holdings, 247, 279
Arthur Andersen, 48
Arvind, Ltd., 424
AstraZeneca, 349
ASUS, 85
AT&T, 79, 81, 91, 114, 170, 192, 249,
C255, 279, 282, 398
Audi, 365, 366
Audio-Technica, 108
AutoNation, 24
Autonomy, 313
AWS, 299
B
Baidu, 139, 355, C491
Bain & Company, 175
Bank of America, 292, 306n66, 313, 426
Bank of Italy, 292
BankSouth, 292
Barnes & Noble, 24, 175, 203
Barnett Bank, 292
BASF, 279
Beats Electronics, C107–C108, 108,
111, 116, 129, C135–C136, 225
Berkshire Hathaway, 50, 289, 291,
326, 431
Bertelsmann, 359, 361
Best Buy, 42, 91, 112, 124, 175, 203
Bethlehem Steel, 283
Better World Books, 15, 226
BIC, 188
Bing, C455, C477, C479
Biogen, 47
BlackBerry, 8, 71, 127, 240, 249, C504
Black Biz Hookup, 119
Blackstone Group, 431–432
Blockbuster, 10, C219, 247
Bloomberg Businessweek, 433
BlueTooth, 290
BMW, 69, 164, 230–231, 341, 365, 366
Boeing, 40, 51, 69, 75, 80, 85, 87,
194–195, 243, 342, 348, 356
Bombardier of Canada, 80, 243
Bose, 107, 108
Boston Consulting Group (BCG), 295
Bowmar, 284
BP (British Petroleum), 40, 54, 55,
63n70, 72, 385
Bridgestone, 359
BrightRoll, C454
Bristol-Myers Squibb, 322
British Airways, C184, 347
British Petroleum. See BP (British
Petroleum)
Brother, 235
Burberry, 136
Burger King, 70, 87, 275
Burroughs Adding Machine, C468
BYD, 230, 279
C
Cadbury PLC, 326, 432
Calico, 393
Canon, 245
Caribou Coffee, 76
CarMax, 24, 91
Carnegie Mellon University, C420
Carrefour, 352
Casella Wines, 348
Caterpillar, 341, 342
CBS, 70, 221, 400
CEMEX, 82, 341
Chaparral, 283
Charge-Point, 230
Charter Communications, 431
Chevrolet, 231
Chick-fil-A, 87, 286
Final PDF to printer
rot27628_cidx_539-544 540 11/23/17 02:57 PM
540 COMPANY INDEX
China Mobile, 279
Chipotle, 70, 87
Chrysler, 6, 8, 33, 88, 323
Circuit City, 34, 42, 91, 112, 124
Cirque du Soleil, C488–C490
Cisco, 315, 323, 349
Citigroup, 33
CNBC, 433
CNN, 244
Coca-Cola, 51, 85, 91, 111, 114, 189,
223, 276, 284, 286, 291, 342, 358,
C450
Colgate-Palmolive, 126
Columbia Pictures, 400, C494
Comcast, 79, 158, 221, C255
Compaq, 16, 221, 226, C468
Computer Associates, C468
Computing-Tabulating-Recording
Company (IBM), C468
Conejo Deals, 119
ConocoPhillips, 282
Consumer Reports, 237
Continental, 80, 92, 104n41, 104n42,
114, 234, 324
Continental Lite, 114
Control Data, C468
Corning, 277
Costco, C482
CountryWide Mortgages, 292
Coursera, 246
Crocs, 117, 141n15
CSX Railroad, 15
D
Daily Pride, 119
Daimler, 313, 315, 323, 341, 365, 366
Danone, 189
Darden Restaurants, 24
Data General, C468
DEC, C468
DeepMind, 327
de Havilland, 243
Dell Computer, 16, 52, 85, 155, 221,
247, 285, 403, 432, C468
Delphi, 284
Delta Air Lines, 75, 80, 87, 88, 92,
94–95, 104n41, 114, C183, C184,
188, 194, 209, 210, 234, 282, 324,
347, 348
DePuy, 86
Didi Chuxing, 421, C512
DirecTV, C183
Disney, 50, 93, 224, 291, 323, 325, 329,
403, 431, C494–C497, C498
Disney-ABC, 277, 318, 320
Dole Foods, 24
Dollar Shave Club, 125, 244, C474–C475
Domino’s Pizza, 175
Dow Chemical, 277
Dow Corning, 277
DreamWorks, 315
DreamWorks Animation SKG, 314
Dropbox, C65
Dr Pepper Snapple Group, 328
DuPont, 279
E
EachNet, C518
eBay, 24, 226, 227, 249, 394,
C518–C519
Eckert-Mauchly Computer, C468
Economist, 284
EDS, 285, C468
E&J Gallo, 279–280
Eli Lilly, 275, 313, 319, 321–323
Embraer of Brazil, 80, 243, 341
EMC, C468
Emirates, 95, 194, 347
Encarta, C491
Encyclopaedia Britannica, C491
Engineering Research Associates, C468
Enron, 33, 44, 48, 434, 436
Enron Wind, 44
Equate, 82
ESPN, C496
ESPN Deportes, 70
Estee Lauder, 24, 431
Etihad Airways, 95, 194, 347
E*Trade, 92
European Commission, 324
Excel, 170
ExxonMobil, 111, 249, 279, 288, 291,
342, 435
F
Facebook, 15, 24, C31–C32, 32–33, 36,
37, 47, 51, 56, C56–C57, 72, 77, 82,
92, 111, 119, 152, 226, 227, 229,
236, 249, 250, 253, C265, C267,
272, 291, 327, 342, 355, 382, C419,
422, 427, C438, C454–C455, C468
Fannie Mae, 34
Fast Company, 254
Federal Aviation Administration, C507
Federal Trade Commission (FTC), 283,
324
FedEx, 15, 46, 85, 161, C438
Felt & Tarrant Manufacturing, C468
Ferrari, 5
Ferrero, 223
Fiat, 323
Fisker Automotive, 238
Fitch, 433, 435
FleetBank, 292
Flextronics, 279, 280
Flipkart, C512–C515
FMC Corporation, 163
Food and Drug Administration (FDA),
319
Forbes, 176, 433
Ford Motor Company, 16, 78, 88, 197,
275, 283–284, 315, 358
Fortune, 386, C410, 417n84, 433
Fortune 100, 245, 384, 430
Fortune 500, 349, 430
Fortune 1000, 314, 430
Foursquare, 158
Fox, 70, 224, 244, 277, 318, 320
Foxconn, 150, 279, 281, 345, 350
Friendster, 236
Frito-Lay, 45, 52
Frontier Airlines, 93, 188, 347
Fujitsu, C468
G
Galleon Group, 426
Gap, 175, 352
Gatorade, 293, 328
Gazelle, 233
Gazprom, 341
GE, 13, 15, 36, 44–45, 75, 96, 111,
160, 164, 200, 247, 269, 291, 294,
321, 323, 342–344, 349, 398, 430,
443n31, C468
GE Capital, 294, 297
Genentech, 47, 275, 316, 318, 319
Genentech-Lilly, 318
Genzyme, 47
Georgia Power, 46, 86
Gilead Sciences, 47
Gillette, 125, 169, 244, C474–C475
GM, 33, 78, 88, 121, 122, 152,
187, 192, 197, 275, 277–278,
C309–C310, 315, 317, C330, 405,
C509–C511
Goldman Sachs, 426, 434–436
Goodrich, 75
Google, 15, C31, 45, 47, 57, C57, 72,
86, 88, 90, 92, 111, 113, 114, 118,
119, 127, 135, 140n6, 152, 153, 168,
192, 203, C220, 221, 223, 224, 227,
229, 236–237, 244, 246–247, 252,
254, 262n75, C265, 272, 279–282,
291, C309–C310, 327, 349, 355,
381–382, 393, 404, C420, 426,
C453, C454–C455, C456,
C457–C458, C476–C480, C505
Final PDF to printer
rot27628_cidx_539-544 541 11/23/17 02:57 PM
COMPANY INDEX 541
Google Fiber, 393
Google Plus, 77
Google Ventures, 319, 393, 427
Google X, 393
Gore Associates, 196
GovernanceMetrics International (GMI
Ratings), 433
Grameen Bank, 424
Great Wall Motor Co., C511
Greenpeace, 424
Greyhound Lines, 160, 347
Groupe Bull, C468
Groupe Danone, 322
Groupon, 119, 120
H
Habitat for Humanity, 424
Haier, 341
Halo Collaboration Studio, 314
Handspring, 240
Hangzhou Wahaha Group, 322
Harley-Davidson, 40, 291, 359
Harpo Productions, 403
Harry’s, 125
Harvard Business School, 436
Harvard Graphics, 170
Hasbro, 85
Heinz, 326
Hershey Company, 326
Hertz, C419
Hewlett Packard (HP), 16, 47, 85, 157,
169, 221, 226, 240, 247, 285,
313–315, 321, 436, C468, C520–C523
Hilton, 251
Hitachi, C468
H&M, 352
Home Depot, 33, 42, 74, 85, 168, 195,
203, 208
Honda, 110, 111, 121, 162, 230–231,
341, 344
Honeywell, C468
HP. See Hewlett Packard (HP)
H&R Block, 82, 275
HTC, 247, 280, 281–282, C504
Huawei, 8, 279, 281, C505
Hulu, 10, C220, 224, 277, 318, 320
Hyundai, 246, 344
I
IBM, 16, 36, 114, 127, 145, 149, 221,
235, C265, 321, 341, 342, 344, 348,
361, 398, 426, C466–C469
Icos, 322
IKEA, 79, 111, 205–207, C339–C340,
341, 348, 358, C367–C368
ImClone, 322–323
Infinity, 246
Infosys, 341, 349, 359
Instagram, 92, 325
Institute of Electrical and Electronics
Engineers, 230
Intel Corporation, 16, 45–46, 69, 130,
153, 247, 262n75, 279, 341, 426,
C456, C468
Interface Inc., 165
Intuit, 82
J
J. Crew, 210
Jabil Circuit, 279
Jaguar, 289
JBL, 107, 108
JCPenney, 33, 42, 207, 208, 210
Jdeal, 120
JetBlue, 93–95, C183–C184, 190
John Deere, 40, 69, 342
Johnson Controls, 431
Johnson & Johnson, 200, 291, 435
Johnson & Johnson Development
Corporation, 319
K
Kaiser Permanente Ventures, 319
Kawasaki Heavy Industries, 352
Kayak, 75
KFC, 24, 286, C450
Kia, 192, 193, 246, 344
Kimberly-Clark, 34, 126
Kleiner Perkins Caulfield & Byers, 114
Kmart, 42, 193
Kraft Foods, 326, 432
KraftHeinz Company, 326–327
Kroger, 70
Kyocera, 279
L
Land Rover, 289
LaSalle Bank, 292
Lay’s, 286
LegalZoom, 82
LEGO, C484–C487
Lehman Brothers, 33, 153
Lenovo, 85, 88, 157, 221, 247, 282, 341,
359, 361
Levi Strauss, 345, 358, 424
Lexus, 246
LG (LG Display), 279, 341
Lidl, 351–352
Life Sciences, 393
LinkedIn, 92, 151, 229, 422, C468
Live Nation, 323
Lockheed Martin, 36, 123
Logitech, 344
Lotus 1-2-3, 170
Louis Vuitton S.A., C497-C500. See
also LVMH
Lowe’s, 74, 85
Lucasfilm, 325, 329, C494–C497
Lufthansa, 347
LVMH, 69
Lyft, 42, C309–C310, C330, C420,
C439, C511
M
Maidenform, 233
Mannesmann, 323
Manpower, 24
Marlboro, 114
Marriott, C66, 75, 190, 251
Mars, 326
Martha Stewart Living Omnimedia, 403
Marvel Comics, 325, 329, C494–C497
Marvel Entertainment, C495
Match, 235
Mattel, 85
McDonald’s, 24, 52, 68, 70, 87, 114,
275, 358, 386, 387, 408
McKinsey, 111, 426
McKinsey & Co., 284
Medtronic, 46
Merck, 18, 74, 398–399
Merrill Lynch, 92, 292, 306n66, 313,
426
Metro, 351
Micromax, C505
Microsoft, 8, 33, 51, 72, 114, 118, 123,
C145, 147–151, 153, 154, 168–170,
C172–C173, 195, 224, 236, 246–
247, 249, 262n75, C265, C267, 272,
313, 323, 400, 435, C455, C456–
C458, C476–C480, C505
Microsoft-IBM, 318
Mohawk Industries, 121
Mondelez International, 326
Monster Beverage Corporation, 276
Monster Cable Products, 129
Monster.com, 25
MontBlanc, 188
Moody’s, 433, 435
Morgan Stanley, 92
Morris Air, C183
Motorola, 88, 239–240, 282, 327, 358,
C504
MTV, 361, 362, 369
MundoFox, 70
MySpace, C31, 253, 2335
Final PDF to printer
rot27628_cidx_539-544 542 11/23/17 02:57 PM
542 COMPANY INDEX
N
Nakjima, 235
Napster, 124
Narayana Health, 200, 201, 348
NASA, 158
NASDAQ, C220, 422, 443n8
National Cash Register, C468
NationsBank, 292
NBC, 70, 221, 224, C255, 277,
318, 320
NBC Universal, 79, 221, 224, 277
Nest, 393
Nestlé, 52, 189, 291, 326, 348, 359, 360
Netflix, 10, 82, 107, 108, 111, 169,
C219–C220, 223–226, 229, 244,
247, 252–253, C254–C255, C265
News Corp., C31, 93
New York Stock Exchange, 249, 422
New York Times, The, 169
Nike, 15, 74, 107, 116, 267, 284, 291,
297, 298, 328, 345, 431, C463–C465
Nissan, 122, 230–231, 341, 344
Nokia, 282, 313, 365, 374–375n79, C504
Nordstrom, 9, 13, 175, 214
North Carolina National Bank (NCNB),
292
Northwest, 80, 92, 104n41, 234
Northwest Airlines, 324
Novartis, 316, 324
Nucor, 196, 283
NUMMI, 317, 319
O
Oculus, 327
Office 365, 172
Office Depot, 324
Office Max, 324
Oi, 279
Old Navy, 166
Olivetti, 235
Ol’Roy, 82
Opel, 277–278
Oppo Electronics, 279, 281
Oracle, 153, 285, C468
Orange, 279
Orbitz, 75
Otto, 427
Overture, C457
OWN (the Oprah Winfrey Network), 403
OXO, 191
Ozon, 355
P
Palantir Technologies, C420, 422
Panasonic, 8, 78, 315
PandoDaily, C420
Pandora, 108, 229
Paramount Pictures, C498
Parent’s Choice, 82
Paulson & Co., 435
PayPal, 226, 394, C420
Peet’s Coffee & Tea, 76
Pegatron, 352
PeopleSoft, 285
PepsiCo, 33, 45, 52, 85, 91, 164, 189,
276, 284, 286, 293, 326, 328, 358,
C450–C452
Perot Systems, 285
Pershing Square Capital Management,
431–432
PETA, 52
PetCo, 84
PetSmart, 84
Peugeot, 277–278
PewDiePie, 224
Pfizer, 45, 74, 123, 124, 316, 325
Philadelphia Gas Works, 86
Philco, C468
Philip Morris, 235
Philips, 321, 348, 359
Pinkerton Tobacco Company, 235
Pinterest, 92
Pixar, 323, 325, 329, C494–C495
Pizza Hut, 286, C450
Polo Ralph Lauren, 404
Porsche, 5, 365, 366
Powerade, 293
PowerPoint, 170
Pratt & Whitney, 96
Procter & Gamble (P&G), 13, 85,
124–127, 162, 224, 226, 244, 321,
342, 359, 426
Q
Qatar Airways, 95, 194, 347
Quaker Oats Company, 286, 293, 328,
C450
R
RadioShack, 42
Random House Publishing, 362
RCA, C468
Redbox, 10, 82
Reddit, C491
Red Hat, 170
Reebok, 328
Reliance Group, 341
Reliance Industries, 36
Remington Rand, C468
Remington Typewriter, C468
Renault-Nissan, 318
Research in Motion (RIM), 240
Revlon, 358
RIM (Canada), 374–375n79
Roche, 316, 318
Roku, C220
Rolex, 359
Rolls-Royce, 75, 96
RTL Group, 362
Rubbermaid, 81
Ryanair, 169
S
Salesforce, 229, 293
Salesforce.com, C468
Sam’s Club, 37
Samsung, 8, 88, 118, 123, 127, 203,
221, 228, 247, 279–281, 341, 348,
374–375n79, C503–C508
SAP, C468
Scottrade, 92
Sears, 42
Securities and Exchange Commission
(SEC), 147, 153, 433
Sennheiser, 107, 108
Sequoia Capital, C65, 114
7-Eleven, 275
Shanghai Automotive Industrial Corp.,
C509–C511
Sharp, 281
Shaw Industries, 121
Siemens, 321, 341, 344, 352
Siemens Energy, 359
Siemens Nixdorf, C468
Siemens Venture Capital, 319
Silverlake Partners, 432
Skechers, 406
Skullcandy, 108
Skype, 82, 91, 172, 229
Smith Corona, 221
Smith & Nephew, 85
Snap, 254
Snapchat, 92, 422
Snapdeal, C514–C515
Snapple, 328
SolarCity, C6, 17, C21–C22, 226
Song Airline, 114
Sony Corp., 52, 108, 127, 329, 358,
400–401, C494, C504
Southwest Airlines (SWA), 51, 92–96,
114, C183, C184, 188, 209, 210,
324, 347, 404–406
SpaceX, 11, 15, 33, 226, C512
Spanx, 9, 24, 233
Spar Handels AG, 351
Sperry Rand, C468
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COMPANY INDEX 543
Spirit Airlines, 91–93, 169, 188, 347
Spotify, 108
Sprint, 81, 108, 279, 282
Standard & Poor’s, 433, 435
Staples, 324
Starbucks, 33, 44, 51, 54, 68, 76, 203,
355, 359, C470–C473
Sterlite, 81
Stokely-Van Camp, 293
Strategic Management Society, 62n52
Stripe, C65
Stryker, 86
Subway, 70, 87
Sun Microsystems, C468
Svalbardi, 189
SWA, 209
T
Taco Bell, 286, C450
Taobao, C516–C518
Target Corporation, 324, 367
Tata Group, 160, 289–290, 294, 424
TCS, 289, 349
Teach for America (TFA), 11, 12–13,
226
Telemundo, 70
Tesla, Inc., C5–C6, 6–8, 11, 14–17,
C21–C22, 33, 70, 72, 77–79, 111,
162, 187, 195, 197–198, 216n27,
225–226, 230–231, 238, C265, 315,
319, C330, C458
Teva Pharmaceutical Industries, 124
Texas Instruments, 284
Threadless, 166, 175
3G Capital, 326
3M, 13, 45, 162, 409
Ticketmaster, 323
Tidal, 108
Tiffany & Co., 116
Time Warner, 93, C220, 247, 313
Tmall, C518
T-Mobile, 81, 279, 282
TOMS Shoes, 226
Toyota, 78, 121, 122, 196, 210, 230–
231, 275, 290, 315, 317, 319, 341,
344, 358, 365, 366
Trader Joe’s, 191, 204–205
Travelocity, 75
TripAdvisor, 252
Tumblr, C454
Turner, 318
21st Century Fox, 224
Twitch.tv, C65
Twitter, 10, 24, 47, C65, 92, 229, 237,
312, 422, C468
Tyco, 48, 426
U
Uber, 42, 47, 56, 72, 111, 229, 249,
250, 253, 254, C309–C310,
C419–C420, 421, 426–427,
C438–C439, C512
UBS, C524–C526
Udacity, 246
Under Armour, 74, 328
Underwood, 221
Unilever, 85, 126, 326–327, 349
United Airlines, 46, 75, 80, 87, 92, 94,
104n41, C183, C184, 188, 194, 234,
324, 347, 348
Univision, 70
UPS, 15, 41, 46, 85, 161, 291, C438
Urban Outfitters, 166
U.S. Airways, 80, 92, 234, 324
U.S. Food and Drug Administration, 276
U.S. Patent and Trademark Office,
222–223, 226
U.S. Steel, 283
V
Vanguard Group, 131–133
Vauxhall, 277–278
Verizon, 52, 81, 170, C255, 279, 282,
332, C455
Virgin America, 75
Virgin Atlantic, 75
Virgin Group, 75
Visa, 114
Vivo, 281
Vodafone, 279, 323
Volkswagen (VW), 341, 365, C511
Volvo, 230
W
Walgreens, 34
Wall Street Journal, The, 169, 211,
C420, 431, 433, 438
Walmart, 9–10, 13, 15, 37, 42, 51, 79,
81, 201, 203, 210, 221, 227, C265,
324, C339, 342, 350–352, 356, 358,
C367, 404
Wang Laboratories, 221
Wanxiang, 238
Waymo, C330, 420, 427, C511
Waze, 327
Wendy’s, 87
Wertkauf, 351
WhatsApp, C56, 327
Whole Foods, 70, 158, 205, C481–C483
Wikipedia, 226–227, C491–C493
WileyPLUS, 102
Wintel, 262n75, C456
Wipro, 349
W.L. Gore & Associates, 386–387, 390,
391, 395, 412
WorldCom, 33, 48
Wyeth, 325
X
Xerox, 36, 118, 245
Xiaomi, 8, 221, 228, 281, 341, 422,
C505
XM Satellite Radio, C183
XTO Energy, 288
Y
Yahoo, C31–C32, 52, 227, C265, 332,
381–382, 405, C453–C455, C491
Yahoo Japan, C455
Yamaha Group, 289, 291
Yandex, 355
Y Combinator, C65–66
YouTube, 221, 224, 252, 279, 327, 393
Yum Brands, 286
Z
Zappos, 123, 175, 191, 229,
C379–C380, 380–382, 385, 387,
391, 397, 406–409, C410, 412
Zara, 348
Zimmer Biomet, 86
Zip2, 226
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545
NAME INDEX
Note: Page numbers followed by n indi-
cate material in chapter end notes.
Page numbers beginning with C
indicate material in case studies.
A
Ackman, Bill, 52
Adoboli, Kweku, C525
Aftermath Entertainment, 225
Ahrendts, Angela, 33, 136
Akerlof, George, 274
Ambani, Mukesh, 36
Anderson, Ray, 165
Apotheker, Leo, C521–C522
B
Ballmer, Steve, 149, 313, C457, C458
Balsillie, Jim, 71
Bansal, Binny, C512
Bansal, Sachin, C512
Barney, Jay, 115
Barra, Mary, 33, 278, 404, C509, C511
Beard, Elisa Villanueva, 12
Behar, Howard, 44, 409
Bernanke, Ben, 306n66
Bewkes, Jeff, C220
Bezos, Jeff, 33, 117, 159, 225, 259,
C265, 267, 269, 270, 299, C379,
C512, C515
Blakely, Sara, 9, 233
Blecharczyk, Nathan, C65
Bowerman, Bill, C463–C464
Branson, Richard, 75
Brewer, Rosalind, 37
Brin, Sergey, 47, 117, 403
Brodin, Jesper, C367
Brown, Dan, 170
Bryant, Kobe, 107, 129
Buffett, Warren, 50, 326, 426, 431
Burns, Ursula, 36
Byung-chul, Lee, C503
C
Camp, Garrett, C438
Capron, Laurence, 310
Carlisle, Peter, C448
Catmull, Edwin, C495
Chandler, Alfred, 382
Chesky, Brian, C65
Choi Soon-sil, C507
Christensen, Clayton, 14, 16, 246, 247
Coase, Ronald, 271
Collins, Jim, 34, 165
Cook, Tim, 39, 52, 122, 135, 150, 237,
350
Crum, George, 45
D
Damon, Matt, 117
Death Row Records, 225
DeHart, Jacob, 166
Dell, Michael, 52, 403, 432
Disney, Walt, 403
Dr. Dre, 107–108, 116, 117, 124, 129,
135–136, 225
Dubin, Michael, C474
Dudley, Bob, 55
Dunn, Patricia, C521
E
Eazy-E, 225
Ebbers, Bernard, 33
Einstein, Albert, 222
Eisner, Michael, C495
Ellison, Larry, 404
Eminem, 225
F
50 Cent, 225
Fincher, David, C255
Finkelstein, S., 415n14
Fiorina, Carly, C521
Fisker, Henrik, 238
Flannery, John, 36
Ford, Henry, 16
Frazier, Kenneth, 18
Freda, Fabrizio, 431
Friedman, Milton, 53, 422
Friedman, Thomas, 404
Fuld, Richard, 33
G
Gates, Bill, C145, 404, C457
Gebbia, Joe, C65
Gerstner, Lou, C467
Ghemawat, Pankaj, 345, 353, 369,
372n6, 372n20
Ghosn, Carlos, 230
Gillette, King C., 244
Gilmartin, Raymond, 18
Gore, Bill, 386, 388, 390
Grande, Ariana, 135
Graves, Ryan, 438
Greenspan, Alan, 155
Gretzky, Wayne, 71
Gross, Michael, C449
Grübel, Oswald, C525
Gupta, Rajat, 426
H
Hamel, Gary, 292, 293, 306n48
Harker, Susan, 215
Hastings, Reed, C219–C220, 225–226,
C255
Hayes, Robin, C211
Hayes, Tom, C525–C526
Hayward, Tony, 55
Hewlett, Bill, C520
Hewson, Marillyn, 36, 123
Hofstede, Geert, 354, 355
Holder, Eric, 420
Hsieh, Tony, 123, 365, C379, 382,
402–404, 406, C410
Hurd, Mark, 436, C521–C522
I
Icahn, Carl, 52, 431–432
Ice Cube, 225
Idei, Nobuyuki, 401
Iger, Robert, 431, C495, C496
Immelt, Jeffrey, 44–45, 164, 247, 294,
424, 430
Iovine, Jimmy, 107, 116, 135–136
Ive, Jonathan, 122
J
Jacobs, Marc, 108
James, LeBron, 107
Jennings, Ken, 128
Jobs, Steve, 39, 71, 107, 108, 122,
135–136, C145, 259, 403, C460,
C461, C495
Johnson, Ron, 33, 208
Jones, Jeff, 439
Jordan, Michael, 107
Julius Caesar, 15
K
Kalanick, Travis, 419, 420, 438–439
Kamprad, Ingvar, C339, 367, C367
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546 NAME INDEX
Kasparov, Garry, 127
Kelleher, Herb, 403
Keyworth, George, C521
Khosrowshahi, Dara, 438
Kim, W. Chan, 204, 205
Klum, Heidi, 117
Knight, Phil, C463–C465
Knudstorp, Jørgen Vig, C485–C486
Koestler, Arthur, C379, 414n3
Kopp, Wendy, 11, 12–13
Kozlowski, Dennis, 426
Kristiansen, Ole Kirk, C484
Kryscynski, David, 216n27
Kwon Oh-Hyun, C506
L
Lacy, Sarah, 420
Lady Gaga, 107
Lafley, A. G., 125, 126, 226
Laliberté, Guy, C488, C490
Lane, Ray, C522
Lasseter, John, C495
Lauren, Ralph, 403
Lay, Ken, 33
Lee Jae-yong, C503, C507
Lee Kun-hee, C503, C505, C507
Levandowski, Anthony, 420, 427
Levitt, Theodore, 358
Lewis, Ken, 306n66
Lil Wayne, 107
Lincoln, Abraham, 15
Lombardi, Vince, 412–413
M
Ma, Jack, 33, C516–C518
Mackey, John, C481–C482
Martin, Roger, 125
Mason, Andrew, 119
Mauborgne, Renée, 204, 205
Mayer, Marissa, 381, 405, C453–C455
McDonald, Robert, 126
McGrath, Rita, 284
McMillon, Douglas C., 37
Merck, George W., 18
Michael, Emil, 419–420
Middleton, Kate (Duchess of Cam-
bridge), 117
Minaj, Nicki, 107
Mintzberg, Henry, 42
Mitchell, Will, 310
Molinaroli, Alex, 431
Moore, Geoffrey, 235
Moore, Rob, C498
Mother Teresa, 200
Müller, Matthias, C484
Musk, Elon, C5–C6, 6–8, 11, 21, 33, 77,
225–226, 238, 319
N
Nadella, Satya, 33, 149, 151, 154,
168, 313, 349, C456, C458, C466,
C476–C477
Nardelli, Robert, 33
Neeleman, David, C183
Neymar Jr., 107
Nickell, Jake, 166
Nooyi, Indra, 33, 164, 286, C450–C452
N.W.A, 225
P
Packard, Dave, C520
Page, Larry, 47, 403, 431
Parker, Mark, 431
Park Geun-hye, C507
Patrick, Danica, 110
Paulson, John, 435
Perkins, Thomas, C521
Phelps, Michael, C448–C449
Pichai, Sundar, 349, C476
Pickens, T. Boone, 52, 431–432
Plouffe, David, 439
Polman, Paul, 327
Porras, Jerry I., 165
Porter, Michael E., 74, 324, 364, 366,
422, 424
Prahalad, C. K., 292, 294, 306n48
Prince Charles, 33
R
Rajaratnam, Raj, 426
Rihanna, 135
Robertson, Brian, C379–C380
Rogers, E. M., 261n46
Rometty, Virginia, 36, C466–C467
Ronaldo, Christiano, 107
Roosevelt, Franklin Delano, 15
Rumelt, Richard, 287
Rutledge, Thomas, 431
S
Sandberg, Sheryl, C31–C32, 32, 35–37,
C56–C57
Sandler, Adam, 117
Schmidt, Eric, C31
Schramm, C. J., 260n14
Schultz, Howard, 33, 44,
C470–C473
Schumpeter, Joseph, 221
Sculley, John, 33
Shetty, Devi, 199–200, 348
Shin, J. K., C506
Sloan, Alfred P., 187
Smith, Greg, 434, 436
Spacey, Kevin, C219, C254–C255
St. George, Marty, C211
Ste-Croix, Gilles, C488
Stewart, Martha, 404
T
Tata, Jamsetji Nusserwanji, 289
Tata, Ratan, 290
Taylor, David, 126
Tesla, Nikola, 226
Thain, John, 426
Thiel, Peter, 420, 439
Thorpe, Ian, C449
Tourre, Fabrice, 435, 436
Toyoda, Akio, 319
Trump, Donald, 346
V
Vagelos, Ray, 18
W
Wagoner, Richard, 33
Wales, Jimmy, 227, C491
Walton, Sam, 9, 367, C367, 404
Whetstone, Rachel, 439
Whitman, Meg, C521–C522
will.i.am, 107
Williams, Serena, 107
Winfrey, Oprah, 33, 233, 403
Winterkorn, Martin, 33
Wright, Robin, C219, C254
Y
Yang, Jerry, 381
Yoon, B. K., C506
Young, Andre. See Dr. Dre
Yunus, Muhammad, 424
Z
Zuckerberg, Mark, C31–C32, 32–33, 35,
37, C56–C57, 226, 259, 388
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SUBJECT INDEX
rot27628_sidx_547-560 547 11/23/17 04:11 PM
547
Note: Page numbers followed by n
indicate material in chapter end
notes. Page numbers beginning with
C indicate material in case studies.
A
Absorptive capacity, 399
Accounting profit, 160
Accounting profitability, 146–151, 161
Apple vs. Microsoft,
C145, 147–151
data limitations, 150
intangible assets and, 150–151
Acquisitions, 323. See also Mergers and
acquisitions (M&A)
Activities, 110, 111, 132
Activity ratios, 530
Administrative distance, 355–356
Adverse selection, 427
Affordable Care Act (ACA), 53
AFI strategy framework, 3, 19–20, 181,
183, 377
in case analysis, 528
definition of, 19
scenario planning with, 39–41
Agency business model, 169–170
Agency theory, 426–428, 440
adverse selection, 427
moral hazard, 427–428
Aircraft manufacturing, 196, 197
Airline industry
five forces model in, 75, 80, 87
industry dynamics and, 88
JetBlue business strategy,
C183–C184, 186, C211
legacy carriers, 209–210
mergers in, 324
mobility barriers and, 95–96
strategic commitments in, 87
in strategic group model, 93–95
supplier power in, 80
Ambidexterity, 390
Ambidextrous organization, 390
Architectural innovation, 245
Artifacts, 402
Assets, intangible, 150–151
Athletic shoe industry, C463–C465
Auditors, 432–433
Australia, 355
Automotive market, 5–8,
C509–C511
Automotive technology, 230–231
Autonomous actions, 43–45
Autonomous behavior, 409
B
Backward vertical integration, 280
Balanced scorecard, 161–164, 171, 407
advantages, 162–163
definition of, 161
disadvantages, 163–164
framework, 161
Barriers to entry, 95, 104n27
Benchmarks, 8
BlackRock, 133
Black swan events, 40–42, 48, 345–346,
422
Blue ocean strategy, 204–212, 389–391
Cirque du Soleil case study,
C488–C490
difficulty in implementing, 207–210
value innovation, 205–207
Board of directors, 428–430, 440
board independence, 429
CEO/chairperson duality, 429
inside and outside directors, 428
Boston Consulting Group (BCG)
growth-share matrix, 295, 301
Bottom-up emergent strategy, 43
Brazil, 341
Budgets, and input controls, 408
Build-borrow-or-buy framework,
310–313, 330
Bundling business model, 170
Business ethics, 433–437
bad apples vs. bad barrels, 434–437
codes of conduct, 434, 436
definition of, 433
implications for the strategist, 437
and law compared, 433–434
MBA oath, 436–437
strategic leaders and, 33
strategy and, 433
Uber case study, C419–C420,
C438–C439
Business-level strategies, 212
blue ocean strategy, 204–210, 389,
391
case analysis of, 529
competing for advantage, 185–188
cost-leadership, 184, 187, 192–201,
389, 391
definition of, 185
differentiation strategy, 184,
186–192, 201–203, 389, 391
five forces and, 201–203
functional structure and, 389–390
implications for the strategist, 210
JetBlue case study,
C183–C184, C211
scope of competition and, 187
Business models, 165–172
definition of, 165
dynamic nature of, 170–171
legal conflicts, 171
popular business models, 169–170
Business process outsourcing (BPO), 349
Business strategy, 36–37, 268. See also
Corporate strategy
Buyer power, 79–80, 95, 201–202
C
CAGE distance framework, 353–357,
366, 368, 372n6
administrative and political distance,
355–356
cultural distance, 354–355
economic distance, 356
geographic distance, 356
Canada, 355
Capabilities, 110–111, 125–126, 135
Capital requirements, 78
Carrot-and-stick approach, 408
Case analysis, 528–538
assessing performance using
financial measures, 534–538
diagnosing problems/opportunities,
530
feasible solutions, formulating, 530
financial ratios, calculating,
529–530
frequently asked questions about,
532–533
implementation plan, 530–531
in-class discussion, 531
limitations of, 532
reasons for use of, 528–530
strategic, 529
things to keep in mind during, 531
Case studies
Airbnb, C65–C66
Airbnb case study, C97–C98
Alibaba, C516–C519
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548 SUBJECT INDEX
Case studies—Cont.
Amazon.com, C265–C267,
C298–C299, C512–C515
Apple, future of, C460–C464
Apple vs. Microsoft, C145,
C172–C173
Beats Electronics, C107–C108,
C135–C136
Cirque du Soleil, C488–C490
Disney, C494–C497
Dollar Shave Club, C474–C475
Flipkart, C512–C515
globalization of movie industry,
C498–C502
GM and China, C509–C511
Google vs. Microsoft, C476–C480
Hewlett Packard (HP), C520–C523
IBM, C466–C469
IKEA, C339–C340, C367–C368
JetBlue, C183–C184, C211
LEGO, C484–C487
Microsoft, strategy process at,
C456–C458
Netflix, C219–C220, C254–C255
Nike, C463–C465
PepsiCo, C450–C452
Phelps, Michael, C448–C449
purpose of, 528
Samsung, C503–C508
Starbucks, C470–C473
Tesla Motors case study, C97–C98
Tesla’s secret strategy, C5–C6,
C21–C22
Uber, C419–C420, C438–C439
Whole Foods, C481–C483
Wikipedia, C491–C493
Yahoo, C453–C455
Zappos, C379–C380, C410
Cash cows (SBUs), 295–296
Cash turnover, 535
Causal ambiguity, 122, 406
Caveat emptor, 274
Celeron chip, 247
Centralization, 385
CEO/chairperson duality, 429, 443n35
China, 104n33, C255, 345–346, 348,
355
Alibaba Group and, C516–C519
automotive market case study,
C509–C511
Facebook in, C57
movie industry, C498, C500–C501
smartphone makers in, 8
Class discussions, of case analysis, 531
Closed innovation, 398–400
Cloud-based office software, C458
Codes of conduct, 434, 436
Coherent actions, 7–8
Collateralized debt obligation (CDO), 435
Combination business model, 170
Command-and-control decisions, 273
Communities of learning, 349
Communities of practice, 395
Community feedback, 251–253
Community of knowledge, 273
Compensation, executive, 430–431
Competition
competitive intensity in a focal
industry, 365
exit barriers and, 87–88
in five forces model, 74–76
Google vs. Microsoft case study,
C476–C480
industry competitive structures, 83–84
industry growth and, 86–87
innovation and, 221–224
monopolistic, 85
monopoly, 86
multipoint, C476–C478
oligopoly, 85, 104n30
perfect competition, 84–85
price competition, 79
rivalry among existing competitors,
83–88, 201–202
Competitive advantage, 6–10, 14, 22,
135, 144–179
accountability profitability, 146–151
Apple vs. Microsoft case study,
C145, C172–C173
balanced scorecard, 161–164
business-level strategy, 185–188
business models, 165–172
as determined by industry and firm
effects, 185–186
economic value creation, 155–161
generic business strategies, 186–188
implications for the strategist, 171–172
isolating mechanisms and, 120–124
measuring and assessing, 171
mergers and acquisitions and,
327–329, 331
multidimensional perspective for
assessing, 146
nature of strategy and, 6–10
organizational culture and, 405–407
relational view of, 314
shareholder value creation,
153–155, 171
stakeholders and, 47–55
strategic position, 186, 188
sustainable, 8
triple bottom line, 164–165
Competitive challenge, C460–C464
Competitive disadvantage, 8–9, 22, 328
Competitive industry structure, 83–84
Competitive parity, 9, 22
Complementor, 88, 365–366
Complements, 88, 99, 104n25, 191–192
Conglomerate, 289
Consolidated industry, 83–84
Consolidate strategy, 235
Consumer surplus, 157
Contract enforcement, 274
Co-opetition, 88, 316, 394
Coordination costs, 297
Copyright infringement, C499
Core competence-market matrix,
292, 301
Core competencies, 108–113, 135,
162, 270
leveraging for corporate
diversification, 291–293
Nike case study, C463–C465
Starbucks case study, C470–C473
Core rigidity, 124, 404
Core values, 17, 386
Core values statement, 17
Corporate citizenship, 54
Corporate culture (Hewlett Packard case
study), C520–C523
Corporate diversification, 267, 285–287,
392–393
Amazon.com case study, C265–
C267, C298–C299
dominant business, 392, 393
firm performance and, 293–297
geographic diversification strategy,
286–287
implications for the strategist,
297–298
leveraging core competencies for,
291–293
product diversification strategy,
286–287
product-market diversification
strategy, 287
related diversification, 392, 393
restructuring and, 295–296
single business, 392, 393
types of, 287–291, 300
unrelated diversification, 392, 393
Corporate entrepreneurship, 226
Corporate governance, 425–433
agency theory, 426–428
board of directors, 428–430
definition of, 425
implications for the strategist, 437
shareholders and, 52
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SUBJECT INDEX 549
Corporate-level strategies, case analysis
of, 529
Corporate raiders, 431–432
Corporate social responsibility (CSR),
52, 352, 422–423
global survey of attitudes toward, 423
Corporate strategy, 36, 254, 267–271,
299
boundaries of the firm, 271–278
case analysis of, 529
dimensions of, 269–271, 299
Disney case study, C494–C497
diversification (See Corporate
diversification)
implications for the strategist,
297–298
matching, to structure, 393
multidivisional structure and,
392–394
need for growth, 268–269
related diversification, 288–289, 295
unrelated diversification, 289, 291,
295
vertical integration (See Vertical
integration)
Corporate venture capital (CVC), 319
Cost drivers, 193–194, 212
Cost leader, 192
Cost-leadership strategy, 184, 192–201,
212, 233, 389, 391. See also Blue
ocean strategy
benefits and risks, 201–204
cost of input factors, 194
definition of, 187
economies of scale, 194–196
experience curve, 199–201
focused, 188
JetBlue case study, C183–C184,
C211
learning curve, 196–199
process innovation, 200, 201
Costly-to-imitate resource, 116–117
Cost of capital, 147
Cost of goods sold (COGS), 149
Cost parity, 189
Cost reductions, diversification and, 295
Cost reductions in global-standardization
strategy, 358
Credible commitment, 277
Credible threat of retaliation, 79
Cross-elasticity of demand, 104n25
Cross-functional teams, 390, 395
Crossing-the-chasm framework,
235–242, 254
definition of, 235–236
early adopters, 237
early majority, 237–238
laggards, 239
late majority, 238–239
mobile phone industry application,
239–242
technology enthusiasts, 236–237
Crowdsourcing, 166
Cube-square rule, 195
Cultural distance, 354–355, 374n56
Cumulative learning and experience, 79
Currency exchange rates, 69
Customer-oriented vision statements, 14,
15–16, 23
companies with, 15
moving from product-oriented to,
16–17
Customer perspective, 161
Customer service, 191
D
Death-of-distance hypothesis, 362
Decline stage, of industry life cycle,
234–235, 241
Dedicated alliance function, 322
Deflation, 69
Demand conditions, 365
Demographic trends, 70
Deregulation, 79
Diagnosis, of competitive challenge, 7
Differentiation parity, 193
Differentiation strategy, 184, 188–192,
212, 233, 389, 391. See also Blue
ocean strategy
benefits and risks, 201–203
complements, 191–192
customer service, 191
definition of, 186–187
focused, 188
JetBlue case study, C183–C184,
C211
product features, 191
Whole Foods case study,
C481–C483
Digital monopoly, 86
Direct imitation (of resource), 117, 118
Diseconomies of scale, 196
Disruption business model, 170–171
Wikipedia case study, C491–C493
Disruptive innovation, 245–248
definition of, 245
at GE, 248
responding to, 247–248
Distribution agreements, 318
Diversification. See Corporate
diversification
Diversification discount, 294
Diversification premium, 294
Division of labor, 384
Dogs (SBUs), 295–296
Dominant business diversification,
392, 393
Dominant business firm, 287, 291
Dominant strategic plan, 41
Duopoly, 104n30
Dynamic capabilities, 124, 126–127, 133
Dynamic capabilities perspective, 109,
124–128
E
Early adopters, 237
Early majority, 237–238
Ecological factors, in PESTEL model,
70–72
Ecomagination, 424
Ecommerce. See specific companies
Economic arbitrage, 356
Economic contribution, 9
Economic factors, in PESTEL model,
68–70
Economic incentives, 244
Economic responsibilities, in CSR, 53,
54
Economic value, 74, 146
Economic value creation, 155–161, 171,
204, 405
Economies of experience, 356
Economies of learning, 199
Economies of scale, 8, 77, 190–191,
194–196, 269, 270, 295, 346–348,
356
certain physical properties and,
195–196
specialized systems/equipment, 195
spreading fixed costs over larger
output, 195
Economies of scope, 191, 270, 295,
346–348, 356
Economies of standardization, 356
EDGAR database, 433
Efficient-market hypothesis, 153
Emergent strategy, 43, 45
Employee stock ownership plans
(ESOPs), 51
Employment levels, 69
Enterprise resource planning (ERP), 195
Entrepreneurs, 225–226
Entrepreneurship, 225–227, 256
definition of, 226
social, 226–227
strategic, 226
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550 SUBJECT INDEX
Entry barriers, 76–77, 95
Environmental sustainability, 164
Equity alliances, 276–277, 319–320
Ethical responsibilities, in CSR, 53–54
Ethics. See Business ethics
Euro, 373n50
European Union, 345–346
Evolution business model, 170
Exchange relationships, 49
Executive compensation, 430–431, 440
Exit barriers, 87–88
Exit strategy, 235
Experience curve, 199–201
Experience-curve effect, 201
Explicit knowledge, 319
Exploitation, 390
Exploration, 390
Exporting, 360
Express-delivery industry, 85
External analysis, 64–105
Airbnb case study, C65–C66,
C97–C98
five forces model (See Five forces
model)
implications for the strategist, 96–97
industry dynamics, 92–93
PESTEL model (See PESTEL
model)
strategic groups, 93–96
SWOT analysis and, 134–135
External environment, 66–67, 94–96
External environmental analysis, 529
External stakeholders, 48–49
External transaction costs, 271
F
Factor conditions, 364–365
FASB (Financial Accounting Standards
Board), 147
Feedback loop, 253
Fiduciary responsibility, 428, 435
Financial Accounting Standards Board
(FASB), 147
Financial ratios, calculating, 529–530
Firm effects, 10, 73, 98, 108–109, 185
Firms vs. markets, 272–274
First-mover advantages, 224
First-mover disadvantages, 228
Five forces model, 73–90, 95, 96,
104n27, 104n33, 212, 324
in airline industry, 75, 80, 87
business-level strategy and, 201–203
competition in, 74–76
competitive analysis checklist, 89
definition of, 73
power of buyers, 79–80
power of suppliers, 80
rivalry among competitors, 83–90
strategic role of complements and,
88–90
threat of entry, 76–79, 104n27
threat of substitutes, 82–83
Fixed asset turnover, 535
Fixed costs, 159
Focal industry, competitive intensity in,
365
Focused cost-leadership strategy, 188
Focused differentiation strategy, 188
Foreign Account Tax Compliance Act
(FATCA), C525
Foreign direct investment (FDI), 342,
368
Formalization, 384–385
Forward vertical integration, 281
Founder imprinting, 403
Fragmented industry, 83
Franchising, 275, C494–C497
Freemium business model, 169
Functional manager, 37
Functional strategy, 36
Functional structure, 388–390
business strategy and, 389–390
disadvantages of, 390
G
GAAP (generally accepted accounting
principles), 147, 433, 445n42
Game theory, 85
Gatekeepers, 250
Gender diversity, in Fortune 1000, 430,
443nn31–33
General environment, of firm, 67
Generally accepted accounting principles
(GAAP), 147, 433, 445n42
Generic business strategies, 186–188.
See also Cost-leadership strategy;
Differentiation strategy
Geographic diversification strategy, 286
Germany, 342, 356
Globalization, 368. See also Global
strategy
advantages of, 346–349, 368
automotive market and, C509–C511
deciding where and how, 353–357
definition and nature of, 342–343
disadvantages of, 350–353, 368
LEGO and, C484–C487
movie industry case study,
C498–C502
retrenchment, 345–346
stages, 343–344
state of, 344–346
strategic alliances and, 313, 314, 357
Globalization hypothesis, 358
Global standardization, 372n10, 396
Global-standardization strategy, 360–361
Global strategy, 338–375. See also
Globalization
CAGE distance framework, 353–357
definition of, 342, 372n10
IKEA case study, C339–C340,
C367–C368
implications for the strategist, 366
integration-responsiveness
framework, 358–362
matching, to structure, 396
matrix structure and, 395–396
national competitive advantage,
362–366
Good strategy, 7
Governance, 319–320, 331, 440
Government policy, 79
Government regulators, 432–433
Greenfield operations, 317, 357
Groupthink, 404, 430
Growth, 299–300
achieving, 310–313
build-borrow-or-buy framework,
310–313
strategic alliances, 313
Growth rate, 68
Growth stage, of industry life cycle,
230–233, 241
Guiding policy, 7–8
H
Harvest strategy, 235
Health care costs, process innovation
and, 200
Hedge funds, 431
Herding effect, 238
Hierarchy, 385
Holacracy, C379–C380, 380
Hong Kong, 342
Horizontal integration, 323, 331
Hostile takeover, 323, 431–432
Human-asset specificity, 282
I
Illusion of control, 42
Implementation plan, 530–531
Incomplete contracting, 274
Incremental innovation, 243–245
India, 342, 343, 348, C501–C502
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SUBJECT INDEX 551
Individualism (dimension of national
culture), 355, 373n54
Inductive reasoning, 532
Indulgence (dimension of national
culture), 355
Industry, 72
Industry analysis, 72
Industry analysts, 432–433
Industry consolidation, 324
Industry convergence, 92
Industry dynamics, 92–93
Industry effects, 10, 108–109, 185
Industry growth, 86–87
Industry life cycle, 227–242, 254
decline stage, 234–235, 241
features/strategic implications of,
241
growth stage, 230–233, 241
introduction stage, 228–229, 241
maturity stage, 234, 241
shakeout stage, 233–234, 241
smartphone industry and, 227–228
transitions (crossing the chasm),
235–242
Industry value chain, 269–270, 278–279
Inertia, 382–384
Inflation, 69
Influence costs, 297
Information asymmetry, 274, 300,
425–426
Innovation, 220–224
architectural vs. disruptive, 245–248
competition driven, 221–224
imitation and, 224
implications for the strategist, 254
incremental vs. radical, 243–245
industry life cycle and (See Industry
life cycle)
Microsoft case study, C456–C458
Netflix case study, C219–C220,
C254–C255
platform strategy, 249–253
process, 222–224, 256
reverse innovation, 247
types of, 242–248, 256
users and, 220
Innovation ecosystem, 245
Input controls, 408
Input factors, 194
Inside directors, 428
Insider information, 426
Institutional arrangements, 271
Intangible assets
stock market evaluation and, 152
value of firms and, 152
working capital, 150–151
Intangible resources, 113, 127, 202
Integration-responsiveness framework,
358–362, 368–369
definition of, 358
global-standardization strategy,
360–361, 363
international strategy, 359–360, 363,
396
multidomestic strategy, 360, 363,
366
transnational strategy, 361–362, 396
Intellectual property (IP)
patents, 223
protection, 123–124
Intended strategy, 42–43
Interest-bearing debt, 147
Interest rates, 68
Interfirm trust, 321
Internal analysis
of cases, 529
core competencies, 109, 110–113
dynamic capabilities perspective,
109, 124–128
implications for the strategist, 133
resource-based view (See Resource-
based view)
SWOT analysis and, 110, 134–135
value chain analysis, 110, 128–130
Internal capital markets, 295–296
Internal champions, 44
Internal stakeholders, 48–49
Internal transaction costs, 271–272
International strategy, 359–360
Interorganizational trust, 321
Intrapreneurs, 226
Introduction stage, of industry life cycle,
228–229, 241
Invention, 222–223
Inventory turnover, 535
Ireland, 353, 355
ISO 9000, 123
Isolating mechanisms, 120–124
causal ambiguity, 122
expectations of future resource
value, 120–121
intellectual property (IP) protection,
123–124
path dependence, 121–122
social complexity, 123
J
Japan, 342
Joint ventures, 277, 320
Just-in-time (JIT) operations
management, 232
K
Kenya, 344
L
Laggards, 239
Large cap, 177n16
Late majority, 238–239
Law, as minimum acceptable standard,
433
Learning curve, 196–199, 216n28
Learning races, 316–317
Legal factors, in PESTEL model, 72
Legal responsibilities, in CSR, 53
Legitimacy of stakeholders, 50
Lemons problem, 274
Level-5 leadership pyramid, 34–35
Leveraged buyout (LBO), 431–432
Leverage ratios, 530, 536
Liability of foreignness, 350
LIBOR (London Interbank Offered
Rate), C525–C526
Licensing, 275
Licensing agreements, 318
Liquidity ratios, 530
Local responsiveness, 358
Location economies, 349
Location of business, as advantage, 79
Long tail business model, 220, 260n3
Long-term contracts, 275
Long-term orientation (dimension of
national culture), 355
Low-cost leader, 203
M
Maintain strategy, 235
Make or buy
alternatives, 274–278
firms vs. markets, 272–274
Managerial hubris, 328
Market capitalization, 153, 177n16
Market for corporate control, 431–432
Market power, 269
Market ratios, 530
Markets-and-technology framework,
243, 256
Market segmentation techniques, 215n6
Masculinity-femininity (dimension of
national culture), 355, 373–374n55
Massive open online courses (MOOCs),
246
Matrix structure, 394–397
disadvantages, 396–397
global strategy and, 395–396
SBUs in, 394
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552 SUBJECT INDEX
Maturity stage, of industry life cycle,
234, 241
MBA oath, 436–437
Mechanistic organizations, 385–386,
389, 411
Media industry, 92–93
Mergers and acquisitions (M&A),
323–329, 331, 336n53
competitive advantage and,
327–329, 331
definition of, 323
implications for the strategist, 329
Kraft Foods hostile takeover of
Cadbury, 326
purpose of acquisitions, 325–327
purpose of mergers, 323–325
Mexico, 354
Microcredit, 424
Mid cap, 177n16
Minimum acceptable standard, 433
Minimum efficient scale (MES), 195
Mission, 11, 13–14
Mobile phone industry, 239–242
Mobility barriers, 95–96
Monopolies, 86
Monopolistic competition, 85
Moral hazard, 427–428
Movie industry, C498–C502
Multidivisional structure (M-form),
390–394
corporate strategy and, 392–394
Multidomestic strategy, 360, 363, 366,
369, 396
Multinational enterprises (MNEs), 342,
368–369, 396
modes of foreign market entry,
357–358
Multipoint competition, C476–C478
Multi-sided markets, 250
N
NAFTA, 354
National competitive advantage, 362–366
Porter’s Diamond framework,
364–366
National culture, 354
Natural monopolies, 86
Natural resources, 364
Near monopolies, 86
Net neutrality, C255
Net operating profit after taxes
(NOPAT), 177n5
Network effects, 77, 229, 252–253, C309
Network structure, 395
New Zealand, 355
NGOs (nongovernmental
organizations), 424
Niche in existing industry, 91
Non-equity alliances, 318–319
Nongovernmental organizations
(NGOs), 424
Nonmarket strategies, 68
Non-price competition, 85
Not-invented-here syndrome, 398
O
Obamacare, 53
Offshoring (offshore outsourcing), 285
Oligopoly, 85, 104n30
Online retailing, 42
Online search engines, C456–C458
On-the-job consumption, 426
Open innovation, 226, 398
and closed innovation compared,
399–400
example of, 399
Opportunism, 274, 282
Opportunities, diagnosing, 530
Opportunity costs, 160
Organic organizations, 386–387, 389, 411
Organizational core values, 17
Organizational culture, 401–407, 411
change in, 404–405
competitive advantage and, 405–407
employee behavior and, 406
origins of, 403–404
Organizational design, 376–417
competitive advantage and, 381–382
implications for the strategist, 409
mechanistic vs. organic
organizations, 385–387
organizational culture, 401–407
organizational inertia, 382–384
organizational structure, 384–385
strategic control-and-reward
systems, 407–409
strategy and structure, 387–397
traditional vs. holacracy, 380
Zappos case study, C381
Organizational inertia, 245, 410
Organizational structure, 384–385, 411
Organized to capture value, 118
Output controls, 408–409
Outside directors, 428
Outsourcing, 285
P
Parent-subsidiary relationship, 277
Partner commitment, 321
Partner compatibility, 321
Patents, 223
Path dependence, 121–122
Patient Protection and Affordable Care
Act (PPACA), 53
Payables turnover, 535
Pay-as-you-go business model, 169
Perfect competition, 84–85, 115
Performance, case analysis of, 529
Performance with Purpose (PepsiCo),
C450–C452
PESTEL model, 67–72, 96, 97, 104n33,
109, 134, 241
ecological factors, 70–72
economic factors, 68–70
legal factors, 72
political factors, 68
sociocultural factors, 70
technological factors, 70
Philanthropic responsibilities, in
CSR, 54
Physical-asset specificity, 282
Pipeline business model, 249
Planned emergence, 46–47
Plant, Property, and Equipment (PPE),
150–151
Platform as a service (PaaS), 293
Platform businesses, 249
Platform ecosystem, 250–253
Platform strategy, 249–253, 257
platform ecosystem, 250–253
Point-to-point business model, 183
Poison pill, 432
Political distance, 355–356
Political factors, in PESTEL model, 68
Polycentric innovation strategy, 349
Portable music players, C456
Porter’s diamond framework, 364–366,
369
competitive intensity in focal
industry, 365
demand conditions, 365
related and supporting industries and
complementors, 365–366
Portugal, 353
Positive-sum co-opetition, 99, 104n36
Power
defined, 32
of stakeholders, 50
Power distance (dimension of national
culture), 355, 373n54
PPE (Plant, Property, and Equipment),
150–151
Preferential access to materials and
distribution channels, 78
Price stability, 69
Primary activities, 130
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SUBJECT INDEX 553
Principal-agent problem, 269, 273, 300,
327–328, 425–427, 437
Private companies, 431–432
Private equity firms, 431–432
Private information, 426
Problems, diagnosing, 530
Process innovations, 200, 201, 231–233
Producer surplus, 157
Product diversification strategy, 286–287
Product features, 191
Product innovations, 231–232
Product-market diversification strategy,
287
Product-oriented vision statements,
14–15, 23
moving to customer-oriented from,
16–17
Profit, 157, 268–269
Profit ratios, 530
Proprietary technology, 78
Public stock companies, 421–423
auditors, government regulators, and
industry analysts, 432–433
board of directors, 428–430
characteristics of, 422
executive compensation, 430–431
leveraged buyouts and, 431–432
market for corporate control,
431–432
other governance mechanisms,
430–433
Public utilities, 86
Q
Qualitative performance dimensions,
172
Quantitative performance dimensions,
172
Question marks (SBUs), 295–296
R
Radical innovation, 243–245
Rare resource, 116
Razor-razor-blade business
model, 169, 224
Real growth rate, 68
Realized strategy, 43
Real options perspective, 316
Receivables turnover, 535
Red oceans, 204
Regional clusters, 425
Related-constrained diversification
strategy, 288–289, 291
Related diversification, 301, 392, 393
Related diversification strategy, 288–289
Related-linked diversification strategy,
289, 291
Relational view of competitive
advantage, 314
Reputation, loss of, 350–351
Requests for proposals (RFPs), 274
Research & development, 149
Reservation price, 155–161
Resource-allocation process (RAP),
45–46
Resource-based view, 109, 113–124, 136
critical assumptions, 114–115
isolating mechanisms, 120–124
VRIO framework, 115–120
Resource flows, 127
Resource gap, 311–313
Resource heterogeneity, 114
Resource immobility, 114
Resources, 110, 135. See also Resource-
based view
intangible, 113
isolating mechanisms for
competitive advantage, 120–124
tangible, 113
VRIO framework, 115–120
Resource stocks, 127
Response to disruption business model,
171
Restructuring, 295–296
Results-only work environments
(ROWEs), 409
Retaliation, 79
Return on assets (ROA), 147
Return on equity (ROE), 147
Return on invested capital (ROIC), 147,
148–150
Return on revenue (ROR), 147, 148–149
Reverse innovation, 247, 372n17
Risk capital, 153
Risk reduction, 269
Rivalry, nature of, 75
ROA (return on assets), 147
ROE (return on equity), 147
ROIC (return on invested capital), 147,
148
ROR (return on revenue), 147, 148
Russia, 342, 346
S
Scale economies, 196
Scenario planning, 39–41, 46–47, 58
Scope of competition, 187
Search costs, 273
Selling, general & administrative, 149
Serendipity, 45
70-20-10 rule, 45
SG&A/Revenue, 149
Shakeout stage, of industry life cycle,
233–234, 241
Shared value creation framework,
421–425, 439
creating shared value, 423–424
definition of, 422
public stock companies, 421–423
shareholder capitalism, 422
Shareholder activists, 52
Shareholder capitalism, 422
Shareholder perspective, 162
Shareholders, 153
Shareholder’s equity, 147
Shareholder value creation, 146, 152,
153–155, 161
Sharing economy, C22, 42
Short-term contracts, 274–275, 305n19
Simple structure, 388
Singapore, 342
Single business diversification,
392, 393
Single business firm, 288, 291
Site specificity, 282
Six Sigma, 123
Size, advantages independent of, 78–79
Small cap, 177n16
Smartphone industry, 227–229, 278–
279, 374–375n79
Smartphone market, 239–240
Social complexity, 123, 406
Social entrepreneurship, 225–227, 269
Socialization, 402
Social market economies, 423
Sociocultural factors, in PESTEL model,
70
Soft drink industry, C450–C452
Software as a service (SaaS), 293
Solutions, proposing, 530
South Korea, 342
Span of control, 385
Specialization, 384
Specialized assets, 282
Stage model, 357
Stakeholder impact analysis, 50–54
addressing stakeholder concerns, 54
definition of, 50
identifying opportunities and threats,
52
identifying social responsibilities,
52–54
identifying stakeholder interests,
51–52
identifying stakeholders, 50–51
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554 SUBJECT INDEX
Stakeholders
attributes of, 50
competitive advantage and, 47–55
definition of, 48
stakeholder strategy, 48–50
Stakeholder strategy, 48–50, 56,
62n52, 423
Stakeholder theory, 425. See also
Stakeholder strategy
Standard, 230
Standard operating procedures, 408
Stars (SBUs), 295–296
Stock market evaluation, intangible
assets and, 152
Stock options, 431
Strategic alliances, 275–277, 313–323,
331
accessing critical complementary
assets, 316
alliance management capability,
320–323, 331
entry to new markets, 314–315
globalization and, 313
governing, 317–320
hedging against uncertainty,
315–316
implications for the strategist, 329
learning new capabilities, 316–317
long-term contracts, 275
post-formation management of,
321–322
reasons for, 314–317
strengthen competitive position, 314
of Tesla, 315
trust and, 321
Strategic business units (SBUs),
37, 163
in matrix structure, 394–395
in multidivisional structure, 390–394
Strategic commitments, 7, 14, 87
Strategic control-and-reward systems,
407–409, 411
input controls, 408
output controls, 408–409
Strategic entrepreneurship, 225–226
Strategic equivalence, 117
Strategic fit, 109, 126, 133
Strategic groups, 93–96, 99
mobility barriers, 95–96
strategic group map, 94
strategic group model, 93–95
Strategic initiative, 43, 56
Strategic intent, 11
Strategic leadership, 32–33
characteristics of strategic leaders,
33–35
definition, 11, 32
ethics and, 33
Facebook case study, C31–C32,
C56–C57
formulating strategy across levels,
36–37
implications for, 55
mission, 11, 13–17
top-down and bottom-up, 38–39,
41–47
values, 17–18
vision, 11–13
Strategic management, 6, 256
competitive advantage as defining
goal, 147–148
emergent strategy, 41–47
process, 38–47
process map, 28–29
realized strategy, 45–46
scenario planning, 39–41
top-down strategic planning, 38–39,
45–46
transaction cost economics, 271
Strategic management process, 38–47,
55, 529
Strategic outsourcing, 285
Strategic position, 73, 188
Strategic positioning, 9
Strategic trade-offs, 186
Strategists, 55–56
Strategy, 4–28. See also specific
strategies
AFI framework for (See AFI strategy
framework)
at business level (See Business-level
strategies)
competitive advantage and, 6–10
at corporate level (See Corporate
strategy)
definition, 6
elements of, 6–8, C460
growing a user base (case study),
C5–C6
implications for strategist, 20–21,
55–56
industry vs. firm effects, 10
literature, 216n10
scenario planning, 39–41
secret (case study), C5–C6
stakeholders and, 47–55
Tesla case study, C5–C6, C22–C23
Strategy and Structure (Chandler),
382
Strategy canvas, 209
Strategy formulation, 36, 58, 184, 409
Phelps case study, C448–C449
Strategy implementation, 36, 58,
163–164, 381, 409
Phelps case study, C449
Structure-Conduct-Performance (SCP)
model, 104n27
Subscription business model, 169
Substitution (of resource), 117–118
Supplier power, 75, 80, 95, 201–202
Supply agreements, 318
Support activities, 130
Surge-pricing payment model, 407, 419,
439
Sustainable competitive advantage, 8,
38, 58
Sustainable strategy, 164
Switching costs, 78, 81, 82
SWOT analysis, 110, 134–135
T
Tablet computers, C457
Tacit knowledge, 319
Taiwan, 342
Tangible resources, 113, 137
Taper integration, 284–285
Technological factors, in PESTEL
model, 70
Technology enthusiasts, 236–237,
261n46
Textile industry, 352
Thailand, 360
Threat of entry, 76–79, 201–202
Threat of substitutes, 82–83, 95,
201–202
Top-down strategic planning, 38–39,
46–47, 58
Total asset turnover, 535
Total invested capital, 147
Total perceived consumer benefits,
155–160
Total return to shareholders, 153
Trade-offs, 9
Trade secrets, 223
Transaction cost economics, 271, 300,
304n10
firms vs. markets, 272–274
Transaction costs, 270–272
Transaction-specific investments, 273
Transnational strategy, 361–362, 396
global matrix structure and, 395, 396
Travel industry, 82–83. See also Airline
industry
Treatment plan, proposing, 530
Triple-bottom-line, 164–165, 171, 226
Turkey, 346
Turner Broadcast System (TBS), 320
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SUBJECT INDEX 555
U
Uncertainty avoidance (dimension of
national culture), 355, 374n55
Unicorns, 421–422
Unique strategic position, 10
United Kingdom, 355
Unrealized strategy, 42
Unrelated diversification, 301, 392, 393
Unrelated diversification strategy, 289,
291, 295
Upper-echelons theory, 33
Urgency of stakeholders, 50
V
Valuable resource, 116
Value, 157
Value chain analysis, 110, 128–130
platform ecosystem and, 250
primary activities, 130
support activities, 130
Value creation, 162
Value curve, 209
Value drivers, 191, 212
Value innovation, 205–207
create, 206
eliminate, 206
raise, 206
reduce, 206
Values, 11, 17–18
organizational core values, 17
Variable costs, 160
Vertical integration, 267, 272, 278–285,
295, 300
alternatives to, 284–285
benefits of, 281–282, 300
definition of, 278
risks of, 282–283, 300
types of, 279–280
Vertically disintegrated firms, 278–279
Vertical market failure, 284
Vertical value chains, 278–279
Vision/vision statements, 11, 14–17, 23
customer-oriented, 15–17
Merck’s reconfirmation of core
values in, 18
product-oriented, 14–15
VRIO framework, 115–120, 134, 406,
407
applying (Groupon), 119–120
costly-to-imitate resource, 116–117
definition of, 115
organized to capture value, 118
rare resource, 116
valuable resource, 116
W
Wholesale business model, 169
Winner’s curse, 327, 432
Winner-take-all markets, 244
Working capital turnover, 148, 150, 535
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FINANCIAL RATIOS USED IN CASE ANALYSIS
Formula
Profitability Ratios: “How profitable is the company?”
Gross Margin (or EBITDA, EBIT, etc.) (Sales – COGS) / Sales
Return on Assets (ROA) Net Income / Total Assets
Return on Equity (ROE) Net Income / Total Stockholders’ Equity
Return on Invested Capital (ROIC) Net Operating Profit After Taxes / (Total Stockholders’ Equity + Total Debt –
Value of Preferred Stock)
Return on Revenue (ROR) Net Profits / Revenue
Dividend Payout Common Dividends / Net Income
Activity Ratios: “How efficient are the operations of the company?”
Inventory Turnover COGS / Inventory
Receivables Turnover Revenue / Accounts Receivable
Payables Turnover Revenue / Accounts Payable
Working Capital Turnover Revenue / Working Capital
Fixed Asset Turnover Revenue / Fixed Assets
Total Asset Turnover Revenue / Total Assets
Cash Turnover Revenue / Cash (which usually includes marketable securities)
Leverage Ratios: “How effectively is the company financed in terms of debt and equity?”
Debt to Equity Total Liabilities / Total Stockholders’ Equity
Financial Leverage Index Return on Equity / Return on Assets
Debt Ratio Total Liabilities / Total Assets
Interest Coverage (Times Interest Earned) (Net Income + Interest Expense + Tax Expense) / Interest Expense
Long-Term Debt to Equity Long-Term Liabilities / Total Stockholders’ Equity
Debt to Market Equity Total Liabilities at Book Value / Total Equity at Market Value
Bonded Debt to Equity Bonded Debt / Stockholders’ Equity
Debt to tangible net worth Total Liabilities / (Common Equity – Intangible Assets)
Liquidity Ratios: “How capable is the company of meeting its short-term obligations?”
Current Current Assets / Current Liabilities
Quick (Acid-Test) (Cash + Marketable Securities + Net Receivables) / Current Liabilities
Cash (Cash + Marketable Securities) / Current Liabilities
Operating Cash Flow Cash Flow from Operations / Current Liabilities
Cash to Current Assets (Cash + Marketable Securities) / Current Assets
Cash Position Cash / Total Assets
Current Liability Position Current Liabilities / Total Assets
Market Ratios: “How does the company’s performance compare to other companies?”
Book Value per Share Total Stockholders’ Equity / Number of Shares Outstanding
Earnings-Based Growth Models P = kE / (r – g), where E = Earnings, k = Dividend Payout Rate,
r = Discount Rate, and g = Earnings Growth Rate
Market-to-Book (Stock Price × Number of Shares Outstanding) / Total Stockholders’ Equity
Price-Earnings (PE) Ratio Stock Price / EPS
Price-Earnings Growth (PEG) Ratio PE / Earnings Growth Rate
Sales-to-Market Value Sales / (Stock Price × Number of Shares Outstanding)
Dividend Yield Dividends per Share / Stock Price
Total Return to Shareholders Stock Price Appreciation + Dividends
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Cover
Strategic Management
Dedication
Contents in Brief
Minicases & Full-Length Cases
Chapter Cases & Strategy Highlights
Contents
About the Author
Preface
Acknowledgments
PART ONE: Analysis
CHAPTER 1: What Is Strategy?
CHAPTERCASE 1 / Tesla’s Secret Strategy
1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage
What Is Competitive Advantage?
1.2 Vision, Mission, and Values
Vision
Mission
Values
1.3 The AFI Strategy Framework
1.4 Implications for Strategic Leaders
CHAPTERCASE 1 / Consider This…
CHAPTER 2: Strategic Leadership: Managing the Strategy Process
CHAPTERCASE 2 / Sheryl Sandberg: Leaning in at Facebook
2.1 Strategic Leadership
What Do Strategic Leaders Do?
How Do You Become a Strategic Leader?
The Strategy Process Across Levels: Corporate, Business, and Functional Managers
2.2 The Strategic Management Process
Top-Down Strategic Planning
Scenario Planning
Strategy as Planned Emergence: Top-Down and Bottom-Up
2.3 Stakeholders and Competitive Advantage
Stakeholder Strategy
Stakeholder Impact Analysis
2.4 Implications for Strategic Leaders
CHAPTERCASE 2 / Consider This…
CHAPTER 3: External Analysis: Industry Structure, Competitive Forces, and Strategic Groups
CHAPTERCASE 3 / Airbnb: Disrupting the Hotel Industry
3.1 The PESTEL Framework
Political Factors
Economic Factors
Sociocultural Factors
Technological Factors
Ecological Factors
Legal Factors
3.2 Industry Structure and Firm Strategy: The Five Forces Model
Industry vs. Firm Effects In Determining Firm Performance
Competition In the Five Forces Model
The Threat of Entry
The Power of Suppliers
The Power of Buyers
The Threat of Substitutes
Rivalry Among Existing Competitors
A Sixth Force: The Strategic Role of Complements
3.3 Changes over Time: Entry Choices and Industry Dynamics
Entry Choices
Industry Dynamics
3.4 Performance Differences within the Same Industry: Strategic Groups
The Strategic Group Model
Mobility Barriers
3.5 Implications for Strategic Leaders
CHAPTERCASE 3 / Consider This…
CHAPTER 4: Internal Analysis: Resources, Capabilities, and Core Competencies
CHAPTERCASE 4 / Dr. Dre’s Core Competency: Coolness Factor
4.1 Core Competencies
4.2 The Resource-Based View
Two Critical Assumptions
The Vrio Framework
Isolating Mechanisms: How to Sustain A Competitive Advantage
4.3 The Dynamic Capabilities Perspective
4.4 The Value Chain and Strategic Activity Systems
The Value Chain
Strategic Activity Systems
4.5 Implications for Strategic Leaders
Using Swot Analysis to Generate Insights From External and Internal Analysis
CHAPTERCASE 4 / Consider This…
CHAPTER 5: Competitive Advantage, Firm Performance, and Business Models
CHAPTERCASE 5/ The Quest for Competitive Advantage: Apple vs. Microsoft
5.1 Competitive Advantage and Firm Performance
Accounting Profitability
Shareholder Value Creation
Economic Value Creation
The Balanced Scorecard
The Triple Bottom Line
5.2 Business Models: Putting Strategy into Action
The Why, What, Who, and How of Business Models Framework
Popular Business Models
Dynamic Nature of Business Models
5.3 Implications for Strategic Leaders
CHAPTERCASE 5 / Consider This…
PART TWO: Formulation
CHAPTER 6: Business Strategy: Differentiation, Cost Leadership, and Blue Oceans
CHAPTERCASE 6 / JetBlue Airways: Finding a New Blue Ocean?
6.1 Business-Level Strategy: How to Compete for Advantage
Strategic Position
Generic Business Strategies
6.2 Differentiation Strategy: Understanding Value Drivers
Product Features
Customer Service
Complements
6.3 Cost-Leadership Strategy: Understanding Cost Drivers
Cost of Input Factors
Economies of Scale
Learning Curve
Experience Curve
6.4 Business-Level Strategy and the Five Forces: Benefits and Risks
Differentiation Strategy: Benefits and Risks
Cost-Leadership Strategy: Benefits and Risks
6.5 Blue Ocean Strategy: Combining Differentiation and Cost Leadership
Value Innovation
Blue Ocean Strategy Gone Bad: “Stuck In the Middle”
6.6 Implications for Strategic Leaders
CHAPTERCASE 6 / Consider This…
CHAPTER 7: Business Strategy: Innovation, Entrepreneurship, and Platforms
CHAPTERCASE 7 / Netflix: Disrupting the TV Industry
7.1 Competition Driven by Innovation
The Innovation Process
7.2 Strategic and Social Entrepreneurship
7.3 Innovation and the Industry Life Cycle
Introduction Stage
Growth Stage
Shakeout Stage
Maturity Stage
Decline Stage
Crossing the Chasm
7.4 Types of Innovation
Incremental vs. Radical Innovation
Architectural vs. Disruptive Innovation
7.5 Platform Strategy
The Platform vs. Pipeline Business Models
The Platform Ecosystem
7.6 Implications for Strategic Leaders
CHAPTERCASE 7 / Consider This…
CHAPTER 8: Corporate Strategy: Vertical Integration and Diversification
CHAPTERCASE 8 / Amazon.com: To Infinity and Beyond
8.1 What Is Corporate Strategy?
Why Firms Need to Grow
Three Dimensions of Corporate Strategy
8.2 The Boundaries of the Firm
Firms vs. Markets: Make or Buy?
Alternatives on the Make-or-Buy Continuum
8.3 Vertical Integration along the Industry Value Chain
Types of Vertical Integration
Benefits and Risks of Vertical Integration
When Does Vertical Integration Make Sense?
Alternatives to Vertical Integration
8.4 Corporate Diversification: Expanding Beyond a Single Market
Types of Corporate Diversification
Leveraging Core Competencies for Corporate Diversification
Corporate Diversification and Firm Performance
8.5 Implications for Strategic Leaders
CHAPTERCASE 8 / Consider This…
CHAPTER 9: Corporate Strategy: Strategic Alliances, Mergers, and Acquisitions
CHAPTERCASE 9 / Little Lyft Gets Big Alliance Partners
9.1 How Firms Achieve Growth
The Build-Borrow-Buy Framework
9.2 Strategic Alliances
Why Do Firms Enter Strategic Alliances?
Governing Strategic Alliances
Alliance Management Capability
9.3 Mergers and Acquisitions
Why Do Firms Merge With Competitors?
Why Do Firms Acquire Other Firms?
M&A and Competitive Advantage
9.4 Implications for Strategic Leaders
CHAPTERCASE 9 / Consider This…
CHAPTER 10: Global Strategy: Competing Around the World
CHAPTERCASE 10 / Sweden’s IKEA: The World’s Most Profitable Retailer
10.1 What Is Globalization?
Stages of Globalization
State of Globalization
10.2 Going Global: Why?
Advantages of Going Global
Disadvantages of Going Global
10.3 Going Global: Where and How?
Where In the World to Compete? The Cage Distance Framework
How Do Mnes Enter Foreign Markets?
10.4 Cost Reductions vs. Local Responsiveness: The Integration-Responsiveness Framework
International Strategy
Multidomestic Strategy
Global-Standardization Strategy
Transnational Strategy
10.5 National Competitive Advantage: World Leadership in Specific Industries
Porter’s Diamond Framework
10.6 Implications for Strategic Leaders
CHAPTERCASE 10 / Consider This…
PART THREE: Implementation
CHAPTER 11: Organizational Design: Structure, Culture, and Control
CHAPTERCASE 11 / Zappos: Of Happiness and Holacracy
11.1 Organizational Design and Competitive Advantage
Organizational Inertia: The Failure of Established Firms
Organizational Structure
Mechanistic vs. Organic Organizations
11.2 Strategy and Structure
Simple Structure
Functional Structure
Multidivisional Structure
Matrix Structure
11.3 Organizing for Innovation
11.4 Organizational Culture: Values, Norms, and Artifacts
Where Do Organizational Cultures Come From?
How Does Organizational Culture Change?
Organizational Culture and Competitive Advantage
11.5 Strategic Control-and-Reward Systems
Input Controls
Output Controls
11.6 Implications for Strategic Leaders
CHAPTERCASE 11 / Consider This…
CHAPTER 12: Corporate Governance and Business Ethics
CHAPTERCASE 12 / Uber: Most Ethically Challenged Tech Company?
12.1 The Shared Value Creation Framework
Public Stock Companies and Shareholder Capitalism
Creating Shared Value
12.2 Corporate Governance
Agency Theory
The Board of Directors
Other Governance Mechanisms
12.3 Strategy and Business Ethics
Bad Apples vs. Bad Barrels
12.4 Implications for Strategic Leaders
CHAPTERCASE 12 / Consider This…
PART FOUR: MiniCases
Company Index
Name Index
Subject Index
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Preflight Ticket Signature
