Chapter 2: Business Strategy

1 Temporary vs. Sustainable Competitive Advantage

a Firms ability to resist competitors attempt to imitate/improve on source of its competitive advantage

2 Relative Performance

Competitive Advantage

Able to perform value activities at lower cost or perform them in a way that lead to differentiation and premium
price (more value)

Possess resources and capabilities, which are valuable, rare and costly to imitate, and they are able to exploit
these resources and capabilities in order to develop and implement sustainable competitive advantage and
positive economic profit

a If rare and valuable, but easy to imitate, then temporary competitive advantage

Competitive Parity

Valuable, but not rare

Competitive Disadvantage

No firm will want to invest in resources and capabilities that are not valuable increase

cost and not revenue 3 Business vs. Corporate Strategy

Neutralize (cope best with its industry) and/or exploit opportunities (influence environment in company's
favour) by leveraging resources and capabilities in order to gain competitive advantage within PARTICULAR
(business) or ACROSS SEVERAL (corporate)

markets/industries
4 Firm Performance Measures

Normal vs. Economic Profit

Minimum level of profit owner would consider necessary in order to make it worthwhile to run business (covers
cost of inputs and opportunity cost competitive parity)

Generates revenue above opportunity cost and cost of inputs (competitive advantage)

In a perfectly competitive market, economic profit is zero!

Measure of Efficiency (Ability To Leverage Assets)

Operating Income to Asset/Sales/Employee (profit generated per dollar or or per employee)

Fixed Asset/Total Asset Turnover (Sales/FA or TA - sales generated per dollar of )

Inventory Turnover (COGS/Average Inventory)

Measure of Cost (Management)

COGS to Sales (widen its gross margin?)

SGA to Sales (control expenses?)

Operating Expense to Sales (efficiency of cost structure - measures total overhead employed per dollar of
revenue)

Measure of Profitability

ROA = NI/TA (net profit generated per dollar of TA)

ROE = NI/Equity (net profit generated for every unit of SHQ)

ROI = (gains-investments)/investments (profitability of investment for every dollar invested)

ROS or Operating Profit Margin = OI/Sales (profit generated per dollar of sales)

Growth in Net Sales = [sales (t=0) - sales (t=1)]/sales (t=0) (year to year basis)

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Gross Profit Margin = (Sales - COGS)/COGS (proportion of money in excess of revenues after accounting
for COGS)

Net Profit Margin = NI/Sales (amount of profit generated for each dollar of sales, after

accounting for other expenses)

Alternative: Economic Profit Per $ of Capital Employed (EP) i EP/CE = (NOPAT/CE) - WACC

ROIC

NOPAT = Net Operating Profit After Tax

WACC = Weighted Average Cost of Capital)

CE (Capital Employed) = Sum of Equity and Debt Capital

If ROIC is greater than WACC, then EP/CE is positive and firm creates value

Therefore, ability to add, regardless of size, depends on its ability to earn positive return spread

Used to examine if strategies create value for SH

Reflects concept of residual income and economic performance

Not bound by accounting conventions

5 Business Model

Defines how firm delivers value to its customers, entices customers to pay for value and convert these
payments into profits
Defines how an enterprise interacts with its environment to define an unique strategy, attract resources and
build capabilities to execute it and in the process, create value for all SH

Successful business models aligns organization with its environment

Function:

Articulate value proposition

Select appropriate tech. and features

Identify target market segments

Define structure of value chain

Estimate cost structures and profit potential

Walmarts Business Model

Locate in small/relatively isolated towns (can match or beat prices that is offered in metropolitan areas
shop locally, too small to support more than 1 large retailer, superstore logic to sales of general
merchandise willing to give up service for lower price)

Everyday Low Prices (made efficiency and cost reduction through innovation in purchasing, logistics and
information management)

Business Model = Discount Retailing (offer branded goods for less to carefully targeted customer base)

Increase Change of Designing Successful Business Model

Analyze multiple alternatives

Deep understanding of user needs

Analyze value chain - deliver wants in cost effective and timely fashion

Adopt neutrality or relative efficiency perspective to outsourcing desicisons

Development of business model requires an exercise in due diligence

(resources/capabilities/knowledge + understanding of industry and position in market) 6 Porters Five

Forces/Industry Structure

Determine competitive intensity and attractiveness of market (overall, profitability)

Threat of New Entry (Increase Threat/Barrier = Decrease Attractiveness)

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Economies of Scale

Demand Side Benefits of Scale (Networking Effect)

Customer Switching Cost

Capital Requirement

Incumbent Advantage Independent of Size

Access to Distribution Channel

Government Policy

Implicit Barrier: entry to past reaction of incumbents to new entrants or expected reaction of
incumbent to new entrants the more aggressive the retaliation = higher the barrier to entry,
reaction depends on market growth and capital structure

Proxies For Competition From Potential Entrants: IND-PPE, IND-R&D, IND-CPX

(Capital Expenditure) necessary investments that must be made by new entrant to compete
against average existing firm in the industry (IND is Calculated by taking

weighted average of of all firms in the industry)

Power of Suppliers (Decrease Profit = Increase Price or Decrease Quality)

Suppliers are an oligopoly

Their products are unique or differentiated and/or there is no substitute for the product they offer

Can credibly threaten to integrate forward

Industry is not an important customer in terms of revenue generated for suppliers

Industry participants face substantial switching costs

Power of Buyers (Able to negotiate price/quality that they buy from industry - Higher Power =
Stronger Downward Pressure On Level Of Profits)

Small number of buyers (oligopsony) which buy in large volumes

Products that industry produces (what customers buy) is not differentiated

Buyers face no switching costs

Buyers can credibly threaten to integrate backward

Industry product is not significant to quality of buyers product/service

Threat of Substitutes (product/service that performs the same or similar function as industrys
product/service but through different means)

Price to performance trade off that the substitute offers relative to product of industry

Buyers cost of switching to a substitute product/service

Rivalry Among Existing Competitors (Competitive Actions: Advertising, Price Discounts, New
Products, New Features on Existing Products/Service Higher Rivalry Intensity = Lower

Overall Profitability)

Number of existing competitors

Industry growth

Exit barriers
Rivals commitment to the business

Competitive Reaction: price competition is the most destructive to industry profit (likely to engage in
price based competition if the product are commodity-like, firm have high fixed costs and products
are perishable)

Proxies For Competition Among Existing Rivals:

Herfindahl-Hirschman Index (IND-HHI) - sum of squared market shares of all firms in an industry

Four Firm Concentration Ratio (IND-CON4) - sum of market shares of four largest firms in the
industry

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IND-NUM (total number of firms in industry)

IND-MKTS (product market size, measured as natural log of industry aggregate sales)

Aggregate sales are positively associated with number of firms in markets and large market demand attract
more entrants!

Implications of Five Forces

Unattractive Industry = severe price wares, heavy advertising, diverse product alternatives, and added
services

a firm can either neutralize competitor's strength through imitation

(reduce high cost of product innovation, can mimic behaviour and copy technology used - reduce tech
based innovation) OR by identifying new segment and serving new customers who have different
value system (market based innovation to target new or underserved market)

b In highly competitive markets, should pay attention to cost because of greater pressure that price wars
cause

c Competitive intensity is conducive to market based innovations (which can outperform technological
advances leading to invading existing market and replacing existing product)

Porters ROIC = EBIT/Average Invested Capital - Excess Cash

Better measure of profitability for strategy formation because other measures fail to account for capital
required to compete in industry and ROIC controls for unique differences in capital structure and tax rates
across companies and industries

Criticisms to Five Forces

Implicitly views market structure as exogenous, when in fact, it is endogenous (result of innovation and
learning - changes in science and technology create opportunities for innovation)
Relevant factors ignored or underplayed include technological opportunities, path dependencies,
appropriability conditions, supporting institutions, installed based effects, learning, certain switching costs,
regulation in regimes of rapid tech. changes with well developed markets for goods/services, five forces
framework is compromised

Insufficient appreciation for importance of and nature of innovation and other factors that changes the rules
of the game, for factors inside business enterprise that constrain choices, for factors that impact imitation
and appropriability issues, for the role of

supporting institutions, complementary assets, co-specialization and network externalities, or for blurred
nature of industry boundaries

7 Porters Value Chain: System of Interdependent Activities

Value a company creates is measured by the amount buyers are willing to pay for service/product

Firms ability to coordinate its value activities is a power source of competitive advantage (activities can
affect the cost or effectiveness of another activity)

Success rest in ability to manage compete process - taking individual functional units and working together

Primary Activities: physical creation of product, its marketing and delivery to buyers, and its support and
service after the sale (i.e. inbound logistics, operations/productions, outbound logistics, marketing and
sales, after sales service and support)

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Support Activities: provide inputs and infrastructure that allows the value activities to take place (i.e. HR
management, firms infrastructure (accounting, legal, general management), information technology, R&D,
procurement)

8 Resource Based View (RBV)

Firms possess different resources (physical capital, human capital, organizational capital owned or
controlled by firm) and capabilities (ability to combine resources to promote superior performance) that
can be leveraged to implement valuable strategies

Competitors may have difficulty obtaining or mimicking same resources capabilities, thus, sustainable
competitive advantage

Durable vs. Nondurable Resource Heterogeneity

Initial number of firms that possess specific resource/capability is small (heterogeneity), but it approaches
number need to quickly generate perfectly competitive equilibrium (nondurable heterogeneity) specific
resource/capability becomes a commodity!

Valuable? Accessible (Rare)? Costly to imitate/acquire/substitute?

Isolating Mechanisms: Barriers to Imitation

Casual Ambiguity

Relationship between input (cause) and output (effect) - more opaque the association, the more difficult to
understand and copy

Understanding source of success

Path Dependence

Choice made during early stages of project

Must take same pathway as competitor and no short cuts - the stronger the path dependence, the more
difficult it is for competitors to replicate

source of advantage iii Role of History

Resource and capability may depend on its position at a certain time in history or geographical loaction
i Other firms cannot achieve at the same cost

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ii Cost disadvantage due to time compression diseconomies 9 Porters Generic Business Strategy

Cost Leadership

Gain competitive advantage by reducing cost below that of its competitor (SUCCESS = Economic Profit)

ex. Wal-Mart, SouthWest Airlines, Hyundai and Charles Schwab

Reduce cost by economies of scale (average cost per unit decreases as number of units produced
increases) or access to technology

Achieve Economies of Scale:

Specialized equipment that is only available and feasible with a min. level of production

Building larger facilities or factories

Using specialized employees

Spread overhead cost in a higher number of units produced and sold

Have more bargining power against suppliers

Access to New Technology:

Achieve lower cost per unit even at lower levels of production

Leverage technological innovations to reduce their cost and support their

cost leadership strategy

vi Able to:
Fend of various threats (industry structure)

Afford to operate at lower cost in order to deter threat of new entrants

Afford to enter into price war in other to defend against rivals

Price its products competitive in order to avoid threat of substitute products

Afford to absorb higher cost of inputs imposed by suppliers

Leverage its size when negotiating with customers

Product Differentiation

Develop and sell product/service with features that customers find valuable (real - superior
design/engineering or perceived - image, prestige)

Try to increase perceived value compared to competitors

Obtained through leveraging leading edge R&D OR superior customer service

SUCCESS = Able to charge premium on its price, sell more at given price or achieve higher customer
loyalty

Ways to Differentiate

Changing properties or features of product/service

Linkages between functions within firm provide the firm with unique advantage

Introducing product/service at the right iem

Physical location of firm

Mix of product/service

Explicit links between product/service of a firm with the product/service of another firm

Reputation of firm and its product/service

Focused: Specific Geographic Market or Segment of Market

Return on Asset (Dupont Analysis)

i Driven by higher profit margin (product differentiator) or asset turnover (cost leader)?

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Asset Turnover

Higher for cost leader

Achieve lowest average cost per unit by leveraging economies of scale, operational efficiencies
(lean operations) and technologies

Quantifiable Measures cost and time reduction

Gross Profit Margin

Higher for product differentiator (performance metric)

Due to product innovation and customer satisfaction - able to charge higher price due to brand
reputation etc.
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