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Internal Report

Complete an analysis of the key internal factors that have implications for successful implementation of your General Dynamics strategy and goals/objectives. Submit your work in your assignment folder in the form of a 2,000-word double-spaced APA-formatted paper. The title page, reference list, and any appendices are not included in this suggested word count. You do not need to include an abstract.

Your paper should address these topics:

Given the company’s Vision, Mission and Objectives (VMO), identify the company’s core competencies and assess which ones are rare, costly, or not easily imitated. Discuss how they are related to and critical to the VMO execution.
Present a summary of your organization’s strengths and weaknesses. Submit the SWOT format in Table form and add in some narrative to discuss the strengths and weaknesses in more detail. Explain in your discussion (not in the table) why you selected them and how they relate to the VMO and organization strategy. (Note: You will have an opportunity to complete a full SWOT analysis, including threats and opportunities, as part of your week 6 paper.).
Apply the Resource-Based View (RBV) to help you identify both the tangible and intangible assets your organization may be able to use to accomplish its intended strategies. You can list them in a table form and then follow with a discussion of the assets, why you selected them and how they relate to the VMO and strategy.
Consider and discuss the things that may make your organization’s resources and capabilities difficult for others to imitate. Use Value Chain Analysis to help you deepen your understanding of the relative value of the resources and capabilities you have identified. Seek objective and independently verifiable evidence of potential rarity of the resources and capabilities.IMPORTANT: Do not just use someone else’s SWOT or other analysis. We want you to think for yourself. Critically analyze your firm and write about your original conclusions. Imagine you have been asked by the organization’s CEO or top leader to offer an assessment of the organization and how well it is positioned (or not) to deliver on the VMO and strategy. This is a critical element, stand back and offer thoughtful criticism and recommendations.
Add in a strong conclusion that ensures the reader leaves your paper with a clear recap of your key points.

Introduction

This week, we’ll be looking at a company’s internal resources to see how well its current strategy is working. When deciding whether a strategy is working, we look at whether the company is recording gains in financial strength and profitability, and whether the company’s competitive strength and market standing are improving. Indicators of how well a company’s strategy is working include

· Trends in the company’s sales and earnings growth and stock price

· The company’s overall financial strength

· The company’s customer retention rate and the rate at which new customers are acquired

· Changes in the company’s image and reputation with customers

· Improvement in internal processes

Resource and Capability Analysis

The company’s business model and strategy must match its resources and capabilities. Therefore, any evaluation of the company’s internal factors must include resource and capability analysis. Such an analysis involves first identifying the available resources and capabilities (its core competencies) and then deciding whether they support a competitive advantage over rival firms (“Developing strategy through internal analysis,” 2010). A resource is “An economic or productive factor required to accomplish an activity, or as means to undertake an enterprise and achieve desired outcome” (“Resource,” 2016). A capability is the capacity of a firm to competently perform some internal activity. “A firm’s resources and capabilities include all of the financial, physical, human, and organizational assets used by a firm to develop, manufacture, and deliver products or services to its customers” (Barney, 1995, p. 50).

Tangible resources are assets that can be seen and quantified. Production equipment, manufacturing plants, and formal reporting structures are examples of tangible resources. Intangible resources typically include assets that are rooted deeply in the firm’s history and have accumulated over time. Because they are embedded in unique patterns of routines, intangible resources are relatively difficult for competitors to analyze and imitate. Knowledge, trust between managers and employees, ideas, the capacity for innovation, managerial capabilities, organizational routines (the unique ways people work together), scientific capabilities, and the firm’s reputation for its goods or services and how it interacts with people (such as employees, customers, and suppliers) are all examples of intangible resources. (“Developing strategy through internal analysis,” 2010)

Resource-Based View

The resource-based view (RBV) is a model that sees resources as key to superior firm performance. The RBV “of strategy holds company assets as the primary input for overall strategic planning, emphasizing the way in which competitive advantage can be derived via rare resource combinations” (“The resource-based view,” 2016). If a resource exhibits VRIO (valuable, rare, imitatable, organization) attributes, the resource enables the firm to gain and sustain competitive advantage. Use the VRIO test(Barney, 1995; Jurevicius, 2013) by asking these four questions:

1. “Do a firm’s resources and capabilities add value by enabling it to exploit opportunities and/or neutralize threats?” (Barney, 1995, p. 50).

2. “How many competing firms already possess these valuable resources and capabilities?” (Barney, 1995, p. 52), Or, how rare are they?

3. “Do firms without a resource or capability face a cost disadvantage in obtaining it compared to firms that already possess it?” (Barney, 1995, p. 53). Or, how easily is the resource imitated?

4. “Is a firm organized to exploit the full competitive potential of its resources and capabilities?” (Barney, 1995, p. 56).

SWOT ANALYSIS

One of the most effective way to assess a firm’s capabilities is to do a SWOT analysis—an analysis of a firm’s strengths, weaknesses, opportunities, and threats. “Executives using SWOT analysis compare these internal and external factors to generate ideas about how their firm might become more successful. In general, it is wise to focus on ideas that allow a firm to leverage its strengths, steer clear of or resolve its weaknesses, capitalize on opportunities, and protect itself against threats” (“SWOT analysis,” 2012). For this week, we’ll be concentrating on the internal aspects of the SWOT: the strengths and weaknesses. Internal factors include your resources and experiences (“SWOT analysis: strengths, weaknesses, opportunities, and threats,” 2016). Strengths are positive factors over which the company has control; weaknesses are negative factors over which the company has control. This table can help you figure out how to analyze your company:

VALUE CHAIN ANALYSIS

Value chain analysis is another strategy tool used to analyze internal firm activities. The value chain is “the activities within and around a firm that together create a product or service” (Seidl, 2008, p. 1600). Michael Porter distinguishes between primary and support activities. “While primary activities contribute directly to the creation of the final product or service, the support activities merely increase the effectiveness or efficiency of those primary activities” (Seidl, 2008, p. 1601).

There are two ways in which to conduct a value chain analysis, depending on what type of competitive advantage a company wants to create (cost or differentiation advantage).

“Value chain analysis is not easy to apply. The framework has extensive data requirements, many of which relate to parts of the firm in which data collection is likely to be minimal (e.g. outbound logistics” (Hergert & Morris, 1989, pp. 178-179). This is where accounting data can help. “While organizations capture and record accounting data once, it subsequently serves two entirely different purposes. One is to satisfy the requirements of legal entity accounting, the other is to provide management with the relevant data for decision making and control” (Hergert & Morris, 1989, p. 177). “By controlling and reconfiguring the value chain, successful firms gain sustainable competitive advantage for the future” (Hergert & Morris, 1989, p. 184).

Performing a complete analysis of the internal factors of a company is essential to the strategic management process.

English

Section 14. SWOT Analysis: Strengths, Weaknesses,Section 14. SWOT Analysis: Strengths, Weaknesses,
Opportunities, and ThreatsOpportunities, and Threats

Main Section

Checklist

Examples

Tools

PowerPoint

T O O L : P E R F O R M I N G A S W O T A N A L Y S I S

Here are some general questions in each SWOT category to prompt analysis of your organization,

community, or effort.

PositivesPositives NegativesNegatives

InternalInternal

Human resources

Physical resources

Financial resources

Activities and

processes

Past experiences

StrengthsStrengths

What are your own advantages, in

terms of people, physical

resources, finances?

What do you do well? What

activities or processes have met

with success?

WeaknessesWeaknesses

What could be improved in your

organization in terms of staffing,

physical resources, funding?

What activities and processes lack

effectiveness or are poorly done?

ExternalExternal

Future trends – in your

field or the culture

The economy

Funding sources

(foundations, donors,

legislatures)

Demographics

The physical

environment

Legislation

Local, national, or

international events

OpportunitiesOpportunities

What possibilities exist to support

or help your effort – in the

environment, the people you

serve, or the people who conduct

your work?

What local, national, or

international trends draw interest

to your program?

Is a social change or demographic

pattern favorable to your goal?

Is a new funding source available?

Have changes in policies made

something easier?

Do changes in technology hold

new promise?

ThreatsThreats

What obstacles do you face that

hinder the effort – in the

environment, the people you
serve, or the people who conduct
your work?
What local, national, or

international trends favor interest

in other or competing programs?

Is a social change or demographic

pattern harmful to your goal?

Is the financial situation of a funder

changing?

Have changes in policies made

something more difficult?

Is changing technology

threatening your effectiveness?

Download a Microsoft Word version of this table here.

Contributor Contributor

Val Renault

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Accounting Data for Value Chain Analysis

Author(s): Michael Hergert and Deigan Morris

Source: Strategic Management Journal , Mar. – Apr., 1989, Vol. 10, No. 2 (Mar. – Apr.,
1989), pp. 175-188

Published by: Wiley

Stable URL: https://www.jstor.org/stable/2486509

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Strategic Management Journal, Vol. 10, 175-188 (1989)

ACCOUNTING DATA FOR VALUE CHAIN ANALYSIS

MICHAEL HERGERT
College of Business Administration, San Diego State University, San Diego, Cali-
fornia, U.S.A.

DEIGAN MORRIS
INSEAD, Fontainebleau, France

Strategic planning frameworks provide a means of combining internal data about the firm’s
capabilities with external information about the competitive environment in a manner
designed to guide resource allocation. The value chain approach to strategic planning, as
described by Michael Porter in his book Competitive Advantage (1985), is a recent addition
to this family of planning frameworks. In this article, we address some of the difficulties
in using accounting data for value chaini analysis. These difficulties are divided into those
that are inherent, because of differences in methods of data accumulation, and those that
are avoidable.

INTRODUCTION

All corporations make decisions that affect their

long run competitive position and profitability.

Some, perhaps many, of these decisions turn out

to be mistaken. Strategic planning is an attempt to

formalize the process of making these important

decisions and so reduce the incidence of costly

mistakes. The purpose is to help the firm position

itself against its competitors in the pursuit of

competitive advantage. A variety of conceptual

frameworks have been proposed for guiding this

process. They combine information about the

environment with information about the internal

workings of the firm in order to determine

investment priorities. This article addresses two

issues. First, we discuss the different types of

accounting data and previous observations on
their relevance to strategic planning. Second, we

analyze the value chain framework of strategic

planning proposed by Michael Porter (1985), and

discuss some of the problems in obtaining the

necessary accounting data. We conclude with
suggestions about improving accounting systems

and data for the purpose of value chain analysis.

Most approaches to strategic planning make
use of accounting data in some form or another.

0143-2095/89/020175-14$07. 00

? 1989 by John Wiley & Sons, Ltd.

However, an article in Fortune (Keichel, 1981:
140) on the formulation of corporate strategy
states that 70% of the analyst’s time was devoted
not to obtaining external data (about the industry,
market shares, activities of competitors), but to
reworking internal accounting numbers.

The general irrelevance of traditional account-
ing data for strategic decision making has
been commented on recently by a number of
academics. This article focuses on the accounting
data needed for value chain analysis and discusses
why they were not readily available and what
can be done about it; part of the reason can be
traced to the fact that the dimensions of
data accumulation for value chain analysis are
incompatible with those of accounting. Part is
due to the way in which accounting systems are

designed and implemented.

ACCOUNTING DATA AS AN INPUT TO
STRATEGIC PLANNING

The accounting literature distinguishes three types
of accounting: financial (e.g. Anthony and
Reece, 1983), cost (e.g. Shillinglaw, 1982) and
management (e.g. Horngren, 1981). Recently the

Received 10 March 1986
Revised 20 July 1987

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176 M. Hergert and D. Morris

distinction between the last two has become
blurred as more emphasis is put on the uses of
cost accounting data than on its preparation.

Financial Accounting

Financial accounting is the oldest of the three

(Solomons, 1968). Its primary purpose is to give
a true and fair view of the financial position
of the firm to an external constituency. The
accounting principles and their interpretation,
which govern the content and format of financial
reporting documents, render financial accounting
entirely inappropriate for strategic decision mak-

ing (Allen, 1985; Rappaport, 1981, 1983). The
latter summarizes his arguments thus:

The essential problem lies in the use of accrual
accounting numbers, developed for ex post
external reporting, for unintended, inappropriate
purposes such as strategic planning. After all,
in the final analysis, economic value is created
by cash flows not accounting convention (Rappa-
port, 1983: 58).

Cost Accounting

Cost accounting originally had two missions:
product costing for external reporting (Solomons,
1968) and responsibility accounting for internal
control (Kaplan, 1984).

Problems arose when executives used these

numbers for decision making in the belief that
they represented ‘true costs’. Horngren calls
this conviction that products had objectively
determined actual costs, the ‘absolute-truth
approach’ (Horngren, reprinted in Bell, 1983:
5-22). Neither accountant nor executive had
heeded Clark’s dictum, ‘different costs for differ-
ent purposes’ (quoted in Parker, 1969).

To remedy this situation a third mission was
added-providing cost information for decision
making. A modern example of the results of this
evolution is provided by Shillinglaw (1982: 3),
who says that the uses of cost accounting data
are:

1. Managerial planning and control.
2. Preparation of financial statements for distri-

bution to outsiders.
3. Preparation of business income tax returns.
4. Determination of the reimbursable amounts

under cost-based contracts or similar pricing
or funding arrangements.

Strategic planning is specifically mentioned as
one type of planning activity. However, careful
examination of this and other cost accounting
texts reveals little or no discussion of how cost
accounting data can be used for strategic planning.

In his review of the evolution of management
accounting, Kaplan (1984) says about traditional
cost accounting and management control systems:

Virtually all of the practices employed by firms
today and explicated in leading cost accounting
textbooks had been developed by 1925. During
the last 60 years there has been little innovation
in the design and implementation of cost
accounting and management control systems

(1984: 390).

Since the modern strategic planning frameworks
were not developed until the 1970s and 80s (see
for example Abell and Hammond, 1979; Porter,
1985), it is possible that the difficulties experi-
enced by analysts in using accounting data for
strategic planning are due to Kaplan’s ‘accounting
lag’ (Kaplan, 1986). The present paper argues
that the inappropriateness of traditional cost
accounting data for value chain analysis is due
in part to the incompatibility of their respective
approaches to cost accumulation. Instead of
trying to use a universal accounting system for
all purposes, strategic planning requires a system
designed specifically to facilitate strategic cost
analysis.

Management Accounting

How does management accounting differ from
cost accounting? The definition of the former
given by Horngren (1981: 5) is:

The distinguishing feature of management
accounting is its emphasis on the planning and
control purposes (of accounting systems).

There are two types of planning decision:
routine and strategic (including special decisions)
(Horngren, 1981: 5-6). An ‘effective accounting
system’ provides information for these purposes
and for ‘external reporting to. . .outside parties’
(Horngren, 1981: 5). In common with other
textbooks in this field, there is no explicit
discussion of strategic decisions and their data
requirements.

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Accounting Data for Value Chain Analysis 177

Commenting on the relationship between man-
agement accounting and cost accounting and on

the former’s inability to live up to its name,

Simmonds (1981) says:

Yet, despite management accounting’s name,
proclaiming its metamorphosis from cost account-
ing, the tendency to place analysis of recorded
costs to the fore still outweighs the embryonic and
generally abstruse efforts to analyse managerial
decision making and design accounting infor-
mation to improve managerial decisions

(1981: 1).

One reason why this metamorphosis is proving

so difficult could be that accounting information
for some popular strategic planning frameworks

(Haspeslagh, 1982) cannot be directly extracted
from systems designed for external reporting and
routine decision making. The fact that data

for strategic planning are different from those
required for other internal purposes is not

explicitly discussed by authors of texts on cost
and management accounting.

While accounting texts have been silent on this

issue, there have been warnings about the need
to manage the interface between short-range
budgets and long-range (strategic) plans (Shank et
al., 1973) and to identify the specific information
requirements of each phase of the strategic

decision making process (Gordon et al., 1978).
To these, the authors of the present article would

add the warning that traditional cost accounting
data are poorly adapted to strategic decision
making.

Summary

While organizations capture and record account-
ing data once, it subsequently serves two entirely
different purposes. One is to satisfy the require-
ments of legal entity accounting, the other is to
provide management with the relevant data for

decision making and control. Cost accounting
currently provides data for both of these purposes.

While financial accounting can be used for

expressing how the results of strategies will
appear to outsiders after the event, it is not an
appropriate vehicle either for assessing the
economic value of a given strategy or for choosing
between competing strategies.

Traditional cost accounting, initially developed
to measure ‘true costs’ and bereft of significant

innovation for the last 60 years, is not able to

furnish the data required by the modern strategic
planning frameworks of the 70s and 80s.

The growing number of management account-

ing textbooks testifies to the new emphasis on a

user orientation to accounting data. However,
none specifically discusses how accounting data

can be used to support the more recent approaches
to strategic planning.

Traditional accounting systems are not just

unhelpful for value chain analysis (Porter, 1985;
39 and 61), they can also get in the way of it
(Porter, 1985: 63).

THE VALUE CHAIN APPROACH TO
STRATEGIC PLANNING

The value chain approach to planning is explained

in Porter (1985). In this and subsequent sections
we are only concerned with those aspects that

affect the requirements for accounting data. The
approach is based on a number of propositions.

While the majority are not unique individually,
together they lead to a unique framework for
strategic planning.

Porter argues that firm profitability is a function

of industry attractiveness and the firm’s relative
position within it. Strong relative positions imply
that the firm has a competitive advantage that
can be sustained against attacks by competitors
and evolution of the industry. Competitive
advantage comes from creating value for buyers
that exceeds the costs of generating it. There are
three sources of competitive advantage, known
collectively as generic strategies. They are low
cost, differentiation and focus. Competitive
advantage is created by the performance of
discrete activities such as design, production,
marketing, and delivery. Each of these contributes

to the chosen generic strategy. Value chain
analysis is a method for decomposing the firm
into strategically important activities and under-
standing their impact on cost behavior and
differentiation.

The value chain is not a collection of indepen-

dent activities. Complex interdependencies pro-
vide opportunities for optimization and problems
of coordination between activities within the

chain, with the value chains of buyers and
suppliers, and with the value chains of other

strategic business units (SBUs) within the same
corporation.

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178 M. Hergert and D. Morris

As a framework for strategic planning, value

chain analysis has several distinctive character-

istics. These are (1) an emphasis on identifying

the source of sustainable competitive advantage;

(2) an insistence on the importance of complex

linkages and interrelationships; and (3) the

identification of generic strategies which must

be pursued consciously and coherently in the
different value creating activities. The following
paragraphs explain these characteristics.

The first difference between value chain plan-

ning and other approaches (e.g. portfolio models
and PIMS-see Abell and Hammond, 1979)
is the emphasis on identifying the source of
competitive advantage. The roots of this approach

are in microeconomics. The firm is viewed as a

collection of discrete but related production
functions (activities), where some of them are

not freely traded in external markets. These non-

traded activities will generate rents for the firms

able to perform them and also create entry

barriers or cost disadvantages for other firms.
Firms perform a variety of tasks in transforming

raw materials and primary goods into final
products. Although necessary, most of these
activities do not distinguish a firm from its rivals.
Competitive advantage must be based on those
activities in which a firm has proprietary access
to scarce resources (e.g. skills, patents, assets,
distribution networks, etc.). The first step in

strategy formulation is to identify which activities
are the actual or potential source of such rents.
This is the part of the firm which must be
managed most closely.

The second distinguishing characteristic is the
emphasis on complex linkages and interrelation-
ships. These are of several types: internal linkages
within the value chain (such as relationships
between sequential tasks in the flow of value

added), interrelationships between one business
unit and another (often referred to as synergies
in diversified firms), and vertical linkages between
a business unit and its suppliers and buyers
(similar to vertical integration). These linkages
and interrelationships are important for creating
competitive advantage as they provide opportun-
ities for joint optimization and problems of
coordination. These are explained and illustrated
in the following paragraphs.

Internal linkages reflect the impact of one
activity on another. For example, product devel-
opment can reduce the costs of production by

reducing the number of parts. Between 1977 and

1984 Japanese manufacturers halved the number
of parts in videocassette recorders and reduced
prices from $1300 to $298.

Interrelationships between SBUs of a firm
occur when a value creating activity is shared
by several business units. Sharing increases
throughput, reduces unit costs and can improve
the pattern of capacity utilization. For example,
Honda is a diversified firm operating in markets
such as automobiles, lawn mowers and motor-
cycles. An important strategic component in all
these markets is engine technology. Its skills in
engine technology have enabled Honda to attain
a leadership position in many of its markets. The
danger of applying a narrowly defined SBU
planning approach to a company such as Honda
is that no single SBU is likely to take responsibility
for the maintenance of Honda’s leadership in
engine technology. This technology is an impor-
tant interrelationship between SBUs for Honda.
By focusing on interrelationships, value chain
analysis is likely to signal this fact to management.
Other planning approaches tend to assume away
inter-business unit dependencies once the SBUs
have been determined.

Lastly, vertical linkages describe the way in
which a firm’s value chain is related to the value
chains of its suppliers and buyers. Firms producing
canned beer consume enormous quantities of
cans. These are too bulky to transport far or
stock in large numbers. Makers of cans have
built plants next to their major clients and deliver
the cans by overhead conveyor thus securing
considerable savings for themselves and their
customers.

The third distinctive characteristic is the formu-
lation of generic strategies: cost leadership,
differentiation and focus. Cost leadership requires
the firm to have lower costs than its rivals,
differentiation to add more to buyer value than
to its own costs and focus to pursue cost
leadership or differentiation on a relatively
narrow definition of the market. The choice of
generic strategy and its successful implementation
require a good knowledge of the cost structure
of the firm and of its rivals.

ACCOUNTING DATA FOR VALUE
CHAIN ANALYSIS

Value chain analysis is not easy to apply. The
framework has extensive data requirements,

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Accounting Data for Value Chain Analysis 179

many of which relate to parts of the firm in

which data collection is likely to be minimal (e.g.

outbound logistics). In this section, some of the

key concepts in value chain planning will be

described and problems in obtaining the relevant

accounting numbers discussed. We start by

considering structural issues; that is to say the
cost objectives for the accumulation of costs,

assets and revenues. Next we focus on the topic
of linkages and interrelationships and examine

the extent to which accounting systems model
these complex causal models of cost behavior.
Then we turn to traditional budgeting mechanisms

and compare them with the value chain concept

of the cost of performing different activities.
Porter’s enumeration of the structural determi-

nants of these costs (Porter, 1985, chap. 3) is
compared with the models of cost behavior
discussed in leading accounting texts. Finally we
point out some of the difficulties of performing
value chain analysis in the absence of privileged
access to internal data.

Structural Issues

The different dimensions in which it is necessary

to accumulate costs, assets and revenues are
shown in Figure 1.

Defining the Strategic Business Unit

The first step in applying value chain analysis is
to determine the boundaries of the segments of

STRATEGIC BUSINESS UNIT

l ~~~FIRM INFRASTRUCTURE _

SUPPORT HUMAN RESOURCE MANAGEMENT

ACTIVITIES
TECHNOLOGY DEVELOPMENT
II II

\ ~~~~PROCUREMENT

PRODUCTS INBOUND OPERATIONS OUTBOUND MARKETING SERVIC
\ LOGISTICS LOGISTICS & SALES

PRIMARY ACTIVITIES

Figure 1. Dimensions for data accumulation

the business to be analysed. This requires dividing
the firm into strategic business units in a manner
appropriate for strategic decision making. Once
the SBUs have been defined, the planner can
begin to divide the business into individual
activities for further study.

The justification for SBU analysis is that
different kinds of businesses have different
sources of competitive advantage and thus need
to be managed differently (Porter, 1985: 23).

The guiding principle in applying SBU planning
is to determine what subunits of the total firm
can be considered autonomous for strategic
decision making. Autonomy in this context means
that decisions about one SBU can be made in
relative isolation from decisions about other
SBUs. The planner is therefore seeking a vantage
point for decision making which will allow him
to manage the most critical shared resources. In
establishing SBUs, the planner will look inside
the firm for shared costs and technologies and
outside for shared markets, distribution, and
customers. These two perspectives may not lead
to the same definition of SBUs.

A great deal of judgement is required in
interpreting the information from these two
perspectives and, when they conflict, in choosing
which should dominate. Value chain planning
recognizes this dilemma by placing considerable
emphasis on understanding the interrelationships
that exist between business units because of
shared resources. Porter (1985) provides numer-
ous examples of how the existence of inter-

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180 M. Hergert and D. Morris

relationships can provide a competitive advantage
to the multi-product firm.

During the last 15 years, there has been a
growing awareness of the importance of business
relatedness within corporate portfolios. Rumelt
(1974) identified eight strategic profiles of firms,
ranging from single business to conglomerate
corporations. His findings indicate that horizon-
tally integrated firms were more profitable than
companies comprised of unrelated business units.
Other research indicates that pure conglomerates
often sell at a discount relative to the value which
would be placed on its subsidiaries if they were
traded as independent firms. This is consistent
with the fact that conglomerates seem to be valued
at consistently lower price/earnings multiples than
the stock market as a whole. Using the ideas of
value chain analysis, this implies that conglomer-
ates are unable to exploit potential linkages to
create competitive advantage. The diversity of
businesses in a conglomerate makes it difficult
to lower costs or enhance differentiation through
coordinated action across SBU boundaries. Gen-
eral Electric is a good example of a firm which
is redeploying its assets in order to exploit
potential linkages. Under the leadership of
Jack Welch, General Electric has divested 190
subsidiaries and made over 90 acquisitions, in
order to create a more complimentary set of
business units. Likewise, many conglomerates
(ITT, Borden, Fuqua, Scoville) are spinning off
business units unrelated to their core business.

Value chain analysis provides a framework for
establishing clusters of businesses (Heany and
Weiss, 1983) based on an underlying set of
skills. Porter (1985) provides a comprehensive
discussion of the sources of synergy through SBU
interrelationships as well as the managerial
impediments to achieving these synergies in
practice. Unfortunately, understanding such
interrelationships and implementing effective
strategies to exploit them is extremely complex.
Organizational boundaries tend to create impedi-
ments to coordination across business lines
(Lawrence and Lorsch, 1967; Kilmann, 1983).

While the problem of defining SBUs is not
unique to value chain analysis, it is more difficult
because of the need to achieve a high degree of
coordination across SBUs.

As the previous discussion suggests, it is
unlikely that the actual organization structure
of multi-product firms corresponds with the

definition of SBUs adopted by the strategic
planner. Kilmann (1983: 348) suggests that the
current organization structure is likely to be the
one most out of alignment with the desired state.
Dynamic environments, proactive stances to
strategy and a preference for only changing
structures in the last resort, all contribute to
misalignments.

Consequently the basic structural unit of
analysis required for value chain analysis often
has no clearly delineated organizational counter-
part and is therefore likely to cut across organi-
zational boundaries. Since accounting systems
accumulate costs around products and organi-
zational units (Garrison, 1982), there is no general
method for mapping accounting data built up
around these dimensions onto SBUs defined by
value chain analysis.

The first obstacle to using accounting data for
value chain analysis therefore occurs when
the firm is not organized around SBUs and
consequently the accounting system does not
recognize SBUs as a dimension for data accumu-
lation.

Identifying Critical Activities

Having defined the boundaries of the SBU, the
next step is to identify its component critical
activities. A starting point for this analysis will
be the generic value chain (see Porter, 1985: 37).
However, it will be necessary to go well beyond
the generic chain in order to apply the model.

Porter (1985: 39, 45) provides some guidance
on how to do this. Critical activities are technolog-
ically and strategically distinct and have one or
more of the following characteristics: (1) they
have different economics; (2) they have a high
potential impact on differentiation; and (3) they
represent a significant or growing proportion of
cost.

A critical activity is therefore one which has a
large impact on competitive advantage. This
means that an activity becomes key if it creates
a large potential for cost reduction or differen-
tiation. Chester Barnard (1938) defined the most
important competitive differences as ‘critical
factors’. The critical factors, as determined in
the market place, should translate into key
activities for creating value. The task facing the
planner is to identify the cost and effect of
changing the way an activity is performed.

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Accounting Data for Value Chain Analysis 181

There is no particular reason why the formal

grouping of responsibilities in the organization

structure should correspond to critical activities

as defined by Porter (1985). This should come

as no surprise. There is considerable diversity in

the prescriptions for organizational design (e.g.
Kilmann, 1983. proposes minimizing misdirected

conversion costs) and in the structures adopted

by firms (Lawrence and Lorsch, 1972). In
fact Porter specifically states that organizational

boundaries may not recognize and reflect critical

activities and advises that boundaries be redrawn

with this concept in mind (Porter, 1985: 55-61).
This lack of correspondence between critical

activities and organizational boundaries is another

source of potential difficulty for the analyst. The
organizational dimension of cost accumulation is

the responsibility center (Garrison, 1982: 438).
The accounting system attempts to measure the

resources committed to each of these and to

evaluate the performance of the manager. This
is accomplished through responsibility center
budgets and control reports.

If neither theoretical models of organization

design nor the actual structures of firms is

consciously built around critical activities, existing
cost accounting systems are unlikely to accumulate
costs, assets and revenues for them.

Four possible differences between cost centers

and critical activities exist in theory and are

found in practice: (i) Some critical activities may
not be recognized as such and their performance

is divided out among a number of functions. They
therefore have no organizational counterpart
(Porter, 1985; 41, 59). Examples would be
management education (properly part of human
resource management) and procurement (often
spread across most cost centers, except for very
conspicuous items). (ii) Critical activities are
not contained within individual functions and

therefore spill over into related parts of the
organization. (iii) A function contains more than
one critical activity, but the cost centers into
which the function has been subdivided do not

recognize this fact. (iv) The definitions of different
functions do not distinguish between primary and
support activities (Porter, 1985: 38-43).

The second obstacle to using cost accounting
data for value chain analysis is that there is no
obvious correspondence between critical activities
as defined in the value chain and responsibility
centers as defined in accounting systems.

Defining Products

The last structural dimension for the accumulation

of costs and revenues is the product. The costs

of each primary activity must be split down by
product (or product group). Three difficulties are

encountered.

The first is that it may not be the physical
product that creates value for buyers. An obvious

example would be IBM’s initial dominance of

the personal computer market. Its products were

outclassed by many competitors in terms of

performance, quality and price. Nevertheless
IBM’s products dominated their market segments

because of software, service, advertising and

because IBM was going to stay around. If the
physical product is not responsible for creating
buyer value, or does not account for a major part
of it, then the accounting system’s accumulation of
costs by product will be of little help.

The second is that traditional accounting

systems do not attempt to trace non-manufactur-
ing costs to products. Thus manufacturing costs

are classified as product costs and non-manufac-
turing as period costs (Garrison, 1982: 28-31,
62). The reason for this distinction is that the
former are used for valuing inventories and

determining income and the latter are not.
The value chain analyst must therefore con-

struct his own theoretical models of how resource

inputs to non-manufacturing primary activities
are related to products and find ways of expressing
this theoretical model in terms of data which are

available or can be obtained at an appropriate

cost. The experience of service industries, such
as banks, in applying cost accounting to determine

the profitability of services, products and cus-
tomers (Garrison, 1982: 30) shows that it can be
done.

The third difficulty concerns the use of standard
product cost data as an estimate of the value added

to the product by manufacturing operations. If
the plant contains several different manufacturing
processes and technologies, it will be necessary

to go back to the raw accounting data on

individual operations, times and costs to deter-
mine the value added by each of the distinct
activities within the plant. If the product is not

responsible for buyer value, then it will be
necessary to accumulate factory costs in another

dimension altogether, for example, average con-
figuration for a mainframe computer.

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182 M. Hergert and D. Morris

Reworking factory accounting data is probably

easier than developing product cost data for non-

manufacturing areas. There are several reasons.

(i) The definition of cost centers, reflecting

different technologies and operations within the

factory, are likely either to correspond to critical

activities or be simply related to them. (ii)
Factories are designed to cope with predeter-

mined patterns of work flow and all operations

are rigorously defined to reduce variability to

acceptable limits, thus making it easier to measure

where resources are going. (iii) Factories are

used to collecting shop floor data for production
control and cost accounting, and therefore should
be amenable to the collection of additional data

needed for value chain analysis.

The third obstacle to using cost accounting

data for value chain analysis concerns identifying

the constituents of buyer value and then accumu-

lating costs, revenues and assets around these

cost objectives. If the physical product does not
create buyer value, traditional cost accounting

systems are very little help. Even if the physical
product is important, since cost accounting

systems distinguish between product costs and
period costs, the analyst will have to build a
product costing system for the latter. Moreover,
factory product costs, classified by direct labor,
direct material and manufacturing overhead

(Garrison, 1982: 31, 35) do not distinguish
between different value creating activities in the

plant. It will be necessary to work with raw
disaggregated data in order to develop the costs
of the different manufacturing activities.

SUB 1

INTERRELATIONSHIP

tSUPPIER_ __B e izttz

VERTICAL LINKAGE INTERNAL LINKAGE

Figure 2. Linkages and interrelationships

Linkages and Interrelationships

The cost of performing one activity will often be

influenced by the way in which others are

performed. Other activities within the same SBU,
activities of buyers and suppliers and activities

performed by sister SBUs provide the potential

for joint optimization and problems of coordi-

nation. These relationships are shown in Figure

The value chain approach to linkages has a

clear predecessor in the literature on vertical
integration. Harrigan (1984, 1985) provides an
excellent summary of the literature and theoretical

underpinnings of vertical integration strategies,

as well as an empirical application of a new

framework for the analysis of vertical integration.

Her work builds on the traditional view of vertical

integration as a means of avoiding transaction

costs (Williamson, 1971, 1975). Within the value

chain context, a vertical integration strategy

becomes appropriate if the benefits of extending
the chain of activities for a firm (avoiding the

costs of using the market, enhanced value
creation, improved security of throughput, better
coordination of activities) are greater than the
costs (reduced strategic flexibility, added over-
heads, out-of-pocket costs).

The importance and difficulty of modelling

these different types of interdependency can be
illustrated with an example of an internal linkage.
A quality drive in a component factory may
result in a substantial reduction in costs of

the field service organization and a substantial

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Accounting Data for Value Chain Analysis 183

increase in buyer value. While it is unreasonable

to expect an accounting system to quantify the

costs and benefits of this type of decision as a

matter of routine, it is legitimate to demand that

the system makes it relatively easy to extract the

data for these ad hoc strategic decisions.

Most accounting theories and methods assume

that organization subunits are independent (Kil-
mann, 1983). They therefore do not attempt to
capture and model the data necessary for jointly

optimizing the performance of two or more
activities.

When interdependencies between activities of
the same corporation are recognized, their effects

are mediated through allocations (for services)
and transfer prices (for components or products).
Apart from these crude tools, the analyst will

either have to turn to model building and
statistical analysis to capture the effects of
interdependencies, or to use an approach such

as Kilmann’s (1983) for estimating misdirected
conversion costs and generating optimal organi-

zational relationships.

The fourth obstacle to using accounting data
for value chain analysis is that accounting systems
assume independence of subunits, rarely collect
the information for coordinating and optimizing
different activities (Porter, 1985: 61) and when
this is not the case, use rudimentary tools for
modelling interdependencies.

Determining the Value of an Activity

Having defined SBUs, activities and products,
the final step is to determine the value created

for buyers by the performance of each activity.
If there are no markets for intermediate products,
cost has to be used as a surrogate for value. The

process of estimating the cost of each activity
has two parts. First it is necessary to understand
the behavior of the different cost components
that make up the total cost of)each activity. From
an understanding of behavior the analyst then
estimates what the total cost of the’ activity will
be under different circumstances.

This section starts with a discussion of the
concept of value creation, then examines the
determinants of cost behavior and finally con-
siders to what extent budgets reflect the value
of an activity.

Value Creation

A fundamental notion in value chain analysis is

that a product gains value (and costs) as it passes

through the vertical stream of production within

the firm (design, production, marketing, delivery,

service). When created value exceeds costs, a

profit is generated. This notion of value creation

derives from the economics of demand. Products

are viewed as a bundle of attributes (Lancaster,

1975) which can be configured in multiple ways

to appeal to segments of consumers having

diverse demand functions. This creates the

potential for differentiating a firm’s product and

charging price premiums. As a result, a given

configuration of product attributes will uniquely
appeal to a set of consumers (a market segment).

The necessary condition for supernormal profits

is that not all firms will be able to offer certain

combinations of product attributes which are
highly valued by consumers, or that some firms

will be disadvantaged in their ability to offer

those combinations. The assumption behind this
approach is that firms are unique on the supply
side of markets. This means that the cost

structures of firms within the same markets are

not homogeneous.

A firm must therefore know which of its

activities is responsible for its competitive advan-

tage. It can do this only if it knows both the

cost and the perceived value of each activity.

Unfortunately, severe problems exist in trying to
make these calculations. Apart from the problems

of determining costs, it will be difficult for a firm
to know the value to the consumer of intermediate

activities. Value is defined as the willingness of

consumers to pay for the product at each stage
of processing. If intermediate products are traded
on external markets, it is possible for the firm
to observe a market price for the goods at different

stages of processing. However, intermediate

markets for the outputs of each activity may not
exist. The willingness to pay for activities internal
to the firm will remain unobservable, and this
will contribute to the uncertainty about where a
firm’s competitive advantage truly lies.

Cost Behavior

Each activity that a firm performs will have an
underlying cost structure and behavior. Porter

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184 M. Hergert and D. Morris

calls the determinants of activity cost ‘cost drivers’

and identifies ten categories (Porter, 1985:

62-118). Analysis of these drivers is important
irrespective of which generic strategy the firm

has chosen as the source of its competitive

advantage. These drivers are summarized in

Table 1.

Of the ten cost drivers described by Porter,
scale economies and learning are probably the

easiest to quantify. Nonetheless, economists have

tackled this problem with mixed success. Data

on scale economies and learning are not generally
collected by a firm for its own operations and

are difficult to estimate for competitors (obvious

exceptions would be the aircraft and automobile
industries). However, one motive for employing
the value chain approach is the light it sheds

on achieving competitive advantage through
performing activities better than competitors.
Thus knowledge of the firm’s cost drivers and

those of its competitors is important to using the

method successfully.

Table 1. Cost drivers. The following ten cost drivers determine the cost of an activity and its evolution through
time

Cost drivers Definition

1. Economies and diseconomies Impact of scale on the costs of performing an activity.
of scale Increasing complexity can lead to diseconomies.

2. Learning and spillover Reduction in cost of performing an activity due to experience.
Learning from the experience of others is called spillover.

3. Pattern of capacity utilization High fixed costs and high change over costs provide
opportunities for joint optimization of production, logistics and
marketing.

4. Linkages The cost of an activity is related to how other activities are
performed within the same value chain and in the chains of
suppliers and buyers.

5. Interrelationships An SBU may be able to benefit from sharing scarce resources
with another SBU within the same firm.

6. Integration Vertical integration may reduce transaction costs, but at the
expense of flexibility and scale. Buying goods or services that

were sourced in-house is particularly difficult.

7. Timing There are circumstances in which it pays to be the first-mover.
In others it is better to be a follower.

8. Discretionary policies Decisions by the firm, not related to the other cost drivers,
influence the cost of an activity e.g. product specification,
technology, etc.

9. Location The skills of the labor force, access to transportation, etc., all
affect costs.

10. Institutional Government incentives, union power, regulations of all sorts,
have a major impact on costs.

Modern cost and managerial accounting texts

discuss the learning curve and methods of

estimating it (e.g. Dopuch et al., 1974). They

also explain different ways of modelling cost

behavior (e.g. Kaplan, 1982; Shillinglaw, 1982).
Typically these consist of time study, account

classification, high-low, multiple regression, and

visual estimation. Apart from time study, they

are essentially backward looking. They attempt
to model past behavior. This is an important first
step. However, value chain analysis suggests that

besides understanding cost structure and behavior
in the past, management should use cost drivers

as a competitive weapon. By controlling and
reconfiguring the value chain, successful firms

gain sustainable competitive advantage for the

future (Porter, 1985: 100-118). The distinction
between modelling the past and mastering the

future can be illustrated by recent experiences
of the American automobile industry. In response
to the threat from Japanese automobiles, they
have reconfigured their value chains and secured

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Accounting Data for Value Chain Analysis 185

substantial reductions in their break-even vol-

umes. This reconfiguration has changed the
economics of their businesses and consequently
made obsolete any statistical models they had
developed.

As far as the ten cost drivers are concerned,

none can be easily estimated from routinely

available cost accounting data. Moreover, their

estimation is hindered by changes in organization
structure, chart of accounts and accounting
conventions.

Budgets and Value

The cost accounting equivalent to measuring the

value of an activity is the responsibility center

budget. It is unlikely that responsibility center
budgets correctly measure the value (cost) of
performing the related activities. There are two

main reasons: the first concerns the categories
of expense charged to the budget; the second
concerns the items of expense included in each
category.

There has been considerable debate in the

literature over cost allocations (see for example
Bodnar and Lusk, 1977; Zimmerman, 1979;
Swieringa and Weick, 1981). Problems of not
allocating costs include: excessive consumption
by users, measurement of the efficiency of service
departments, the choice between providing the
service in-house or purchasing it, evaluating the

trade-off between quality and price (Kaplan,
1982: 353-356). Some of these problems are
concerned with the measurement of expenses,
others with providing management control data
and motivating appropriate behavior. They may
not be compatible (Bodnar and Lusk, 1977: 857).

Cost centers can be charged with three types
of cost: those directly consumed by the center
(e.g. salaries), those supplied by a support group
(e.g. office space, computing facilities) and those
related to being part of a wider organization
(e.g. head office, central personnel).

In the experience of the authors, there is little
uniformity of practice among firms as regards
the treatment of indirect support and indirect
general overhead. Determining the cost of an
activity will therefore require substantial rework-
ing of company figures.

The first set of adjustments makes sure that
the responsibility center is charged for the

resources it consumes. These should be long run

average estimates, not short run marginal ones.

It will be necessary to exclude charges that do

not really belong, but have been included because

the proper critical activity has not been defined

for the purposes of cost accumulation (human
resource management, for example). It will also

be necessary to replace the marginal cost of
consuming a service (e.g. telex), by an estimate

of the long run average cost of providing it. There
is also the ‘charge in/charge out’ problem. Work
is frequently performed by one responsibility
center for another. While a record may be kept

of the value of this work for the responsibility
center as a whole, it is unusual to identify the
precise activities within the centers rendering and
receiving the service. Consequently the spending

report for the responsibility center can be correct,
and that of its component activities wrong.

The general rule is that the entire costs of an

SBU should be charged to its primary and support
activities if a shutdown or major expansion is
being contemplated. If the organization chart

defines a responsibility center which is not
important to the creation of sustainable competi-
tive advantage, its costs will have to be distributed
among the critical activities.

Having made sure that the budgets are charged
with the right categories of expense, it is also
necessary to examine the contents of each

category. The categories are defined in the chart
of accounts. Each is an accumulation of a number

of elements. While these groups may be legitimate
and useful for the purposes of cost accounting,
they may lack the necessary degree of homogen-
eity when viewed from the perspective of value
chain analysis. The analyst should therefore check
that the definitions contained in the chart of

accounts are appropriate.
This is not a major obstacle, but it may cause

a great deal of tedious work if the chart of

accounts has not been defined correctly for value
chain analysis.

The fifth obstacle to using cost accounting data

for value chain analysis is that the cost center
budgets are likely to be a poor reflection of the
economics of performing an activity. This is
compounded by the inability of the cost accounts
to quantify the cost drivers, and the likelihood
that the accounting conventions used for internal

purposes have been mandated by external report-
ing authorities (Kaplan, 1984: 409).

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186 M. Hergert and D. Morris

To remedy this situation, the choice of an

appropriate internal accounting system should
depend not only on the choice of corporate
strategy (Kaplan, 1986), but also on the choice
of strategic planning framework.

Understanding Competitive Advantage

One of the motives for value chain analysis is to
discover the firm’s relative competitive position.
This involves comparing the value chain of a firm

with those of its competitors.
We have described some of the difficulties that

will be encountered in trying to develop the value
chain of a firm, given access to internal data.
Since a great deal of data will be inappropriate
or missing, extensive interviews will be necessary
both to interpret what is available and to fill the
gaps. Developing value chains for competitors
from external data and without the possibility of
interviews is going to be even more difficult.

Table 2. Value chain concepts and their management accounting counterparts

Value chain Management accounting

1. Structure
Strategic business unit If the firm is not organized into SBUs, then the accounting

system will not accumulate data in this dimension.

Activities If the organization structure of the firm does not correspond to
critical activities, accounting data will not be accumulated for
activities.

Products A product costing system will have to be built for period costs.
Summary product cost data for the plants must be abandoned in
favor of raw disaggregated data. If the physical product does not
create buyer value, costing systems will have to be built for
plants and for non-manufacturing areas.

2. Relationships
Linkages Accounting systems assume independence of subunits. Transfers

within of goods and services are modelled by transfer prices and
vertical allocations. Neither are capable of serving as an appropriate

Interrelationships mechanism for joint optimization of two or more activities
within the same SBU, between SBUs of the same firm, or
between an SBU and its suppliers and buyers.

3. Budgets and value
Cost drivers Accounting systems do not collect data on cost drivers, because

they are not part of either product or period costs. Deriving
estimates of them from intertemporal studies is complicated by
changes in structure, responsibilities and accounting systems.

Budgets Responsibility center budgets are unlikely to correspond to the
cost of performing an activity. The categories of expense and
the chart of accounts are likely to be wrong.

A certain amount of useful information about

competitors can be gleaned from trade journals,
customers, suppliers and inferences drawn from
the firm’s own value chain. However, difficulties
in making judgments about competitors’ value
chains should not be underestimated.

While making these competitive comparisons

will not be easy, value chain analysis is a
considerable help. The concepts guide the search
for data and provide a model for linking cause
and effect.

SUMMARY AND CONCLUSIONS

The key concepts in value chain analysis and
their management accounting counterparts are

shown in Table 2. Difficulties in using accounting
data for value chain analysis arise from a lack of
equivalence between them.

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Accounting Data for Value Chain Analysis 187

The degree to which management accounting

concepts correspond to the requirements of value
chain analysis may appear disappointing. In this
regard, Porter (1985: 63) comments:

While accounting systems do contain useful data
for cost analysis, they often get in the way of
strategic cost analysis.

Despite problems in obtaining accounting data
for value chain analysis, the approach does
provide insights into creating competitive advan-
tage that are unlikely to emerge from other
frameworks. Moreover, once the causes of the
problems have been identified, much can be done
to make strategic cost analysis easier. This section
discusses the benefits of value chain analysis,
suggests ways of improving the availability of
accounting data and offers some general con-
clusions.

Some of the benefits of value chain analysis
will arise even if the firm is unable to estimate
the precise value of the variables analyzed in the
model. Even if the boundaries of SBUs, linkages
between activities, cost drivers and value creation
cannot be measured exactly, there may be
considerable benefit to the firm in simply asking
the right questions. Thus, it is the process of
performing value chain analysis and not the exact
numerical output which provides useful insights.

One of the strengths of value chain analysis is
that it forces managers to think about which
activities create profits, to choose a generic
strategy for each product and to ask of each item
of expenditure ‘how does this add value to
buyers?’.

The value chain approach is also attractive as

a planning model because of its intuitive appeal
to operating managers. In our experience, they
are keen to know whether the tasks they perform
contribute to building sustainable competitive
advantage.

Another benefit of the value chain approach
is the emphasis it places on managing resources
which cut across SBUs. These broadly defined
resources are key technologies or skills which

affect the ability of the firm to compete in many
different markets.

Against these benefits must be weighed the
difficulties in using traditional cost and manage-
ment accounting data for value chain analysis.
Difficulties arise because of the dimensions

chosen for accumulating accounting data, because

of the inability of accounting systems to model

complex cost behavior and because of the failure

of responsibility center budgets either to identify

the factors driving costs or to measure all the

resources required in the long run for the

performance of particular activities. With the

exception of building a product costing system
for period costs, there is little that can be done

to resolve either the structural difficulties of data

accumulation or the way cost behavior is reflected

in accounting systems. These obstacles to using
traditional accounting data for value chain analysis

are inherent.

However, it is possible to make sure that the
chart of accounts and cost center budgets are

compatible with the needs of value chain analysis.

At the very least this will involve giving more

visibility to those categories of expense which

require different treatment.

While performing value chain analysis obviously
becomes easier with practice, the inherent prob-

lems of using traditional accounting data remain.

Firms intending to reappraise their strategic

plans on a regular basis, may wish to create

an accounting system for this purpose. While

transaction data would be captured once, it would

subsequently be used by three separate systems:

legal entity accounting, management accounting

and strategic cost analysis. There would be

different systems for different purposes.

This solution would serve two purposes: it
would prevent management accounting data
from being contaminated by external reporting

requirements; and it would also make value chain

analysis possible without recruiting an army of

analysts to rework the management accounting
data.

REFERENCES

Abell, D. F. and J. S. Hammond. Strategic Market
Planning, Prentice-Hall, Englewood Cliffs, NJ,
1979.

Allen, D. ‘Strategic management accounting’, Manage-
ment Accounting, March 1985, pp. 25-27.

Anthony, R. N. and J. S. Reece. Accounting Principles,
Irwin, Homewood, IL, 1983.

Barnard, C. The Functions of the Executive, Harvard
University Press, Cambridge, MA, 1938.

Bodnar, G. and H. J. Lusk. ‘Motivational consider-
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Contents

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Issue Table of Contents

Strategic Management Journal, Vol. 10, No. 2, Mar. – Apr., 1989
Front Matter
Diversification Strategy and Internationalization: Implications for MNE Performance [pp. 109 – 119]
Chief Executive Compensation: A Study of the Intersection of Markets and Political Processes [pp. 121 – 134]
Flexibility: The Next Competitive Battle the Manufacturing Futures Survey [pp. 135 – 144]
Selecting Tactics to Implement Strategic Plans [pp. 145 – 161]
ZBB, MBO, PPB and Their Effectiveness Within the Planning/Marketing Process [pp. 163 – 173]
Accounting Data for Value Chain Analysis [pp. 175 – 188]
Research Notes and Communications
Strategy Content and the Research Process: A Critique and Commentary [pp. 189 – 197]
Back Matter

Looking inside for competitive advantage.

Home Read Sign in

CONTENTS PRINCIPLES OF MANAGEMENT

Search in book …

5.6 Developing Strategy Through

Internal Analysis

Learning Objectives

1. Learn about internal analysis.

2. Understand resources, capabilities, and core competencies.

. See how to evaluate resources, capabilities, and core competencies using VRIO
analysis.

In this section, you will learn about some of the basic internal inputs for strategy formulation—
starting with the organization’s strengths and weaknesses. We will focus on three aspects of
internal analysis here, though you recognize that these should be complemented by external
analysis as well. There is no correct order in which to do internal and external analyses, and the
process is likely to be iterative. That is, you might do some internal analysis that suggests the
need for other external analysis, or vice versa. For the internal environment, it is best to start
with an assessment of resources and capabilities and then work your way into the identification
of core competences using VRIO analysis.

Internal Analysis

By exploiting internal resources and capabilities and meeting the demanding standards of
global competition, firms create value for customers (McEvily & Chakravarthy, 2002; Buckley
& Carter, 2000). Value is measured by a product’s performance characteristics and by its
attributes for which customers are willing to pay. Those particular bundles of resources and
capabilities that provide unique advantages to the firm are considered core competencies
(Prahalad & Hamel, 1990). Core competencies are resources and capabilities that serve as a
source of a firm’s competitive advantage over rivals. Core competencies distinguish a company
competitively and reflect its personality. Core competencies emerge over time through an
organizational process of accumulating and learning how to deploy different resources and
capabilities. As the capacity to take action, core competencies are “crown jewels of a
company,” the activities the company performs especially well compared with competitors and
through which the firm adds unique value to its goods or services over a long period of time
(Hafeez, et. al., 2002; Prahalad & Hamel, 1990).

Sometimes consistency and predictability provide value to customers, such as the type of value
Walgreens drugstores provides. As a Fortune magazine writer noted, “Do you realize that from
1975 to today, Walgreens beat Intel? It beat Intel nearly two to one, GE almost five to one. It
beat 3M, Coke, Boeing, Motorola (Useem, 2001).” Walgreens was able to do this by using its
core competencies to offer value desired by its target customer group. Instead of responding to
the trends of the day, “During the Internet scare of 1998 and 1999, when slogans of ‘Change or
Die!’ were all but graffitied on the subway, Walgreens obstinately stuck to its corporate credo
of ‘Crawl, walk, run.’ Its refusal to act until it thoroughly understood the implications of e-
commerce was deeply unfashionable, but…Walgreens is the epitome of the inner-directed
company (Useem, 2001).” Thus, Walgreens creates value by focusing on the unique
capabilities it has built, nurtured, and continues to improve across time.
Figure 5.14

Internal analysis tells the strategist what is inside the organization—helps answer the question, “what strengths can we
leverage?”
Dave Dugdale – Analyzing Financial Data – CC BY-SA 2.0.

During the past several decades, the strategic management process was concerned largely with
understanding the characteristics of the industry in which the firm competed and, in light of
those characteristics, determining how the firm should position itself relative to competitors.
This emphasis on industry characteristics and competitive strategy may have understated the
role of the firm’s resources and capabilities in developing competitive advantage. In the current
competitive landscape, core competencies, in combination with product-market positions, are
the firm’s most important sources of competitive advantage (Hitt, et. al., 1999). The core
competencies of a firm, in addition to its analysis of its general, industry, and competitor
environments, should drive its selection of strategies. As Clayton Christensen noted,
“Successful strategists need to cultivate a deep understanding of the processes of competition
and progress and of the factors that undergird each advantage. Only thus will they be able to
see when old advantages are poised to disappear and how new advantages can be built in their
stead (Christensen, 2001).” By drawing on internal analysis and emphasizing core
competencies when formulating strategies, companies learn to compete primarily on the basis
of firm-specific differences, but they must be aware of how things are changing as well.

Resources and

Capabilities

Resources

Broad in scope, resources cover a spectrum of individual, social, and organizational
phenomena (Eisenhardt & Martin, 2000; Michalisin, et. al., 2000). Typically, resources alone
do not yield a competitive advantage (West & DeCastro, 2001; Deeds, et. al., 2000; Chi, 1994).
In fact, the core competencies that yield a competitive advantage are created through the
unique bundling of several resources (Berman, et. al., 2002). For example, Amazon.com has
combined service and distribution resources to develop its competitive advantages. The firm
started as an online bookseller, directly shipping orders to customers. It quickly grew large and
established a distribution network through which it could ship “millions of different items to
millions of different customers.” Compared with Amazon’s use of combined resources,
traditional bricks-and-mortar companies, such as Toys “R” Us and Borders, found it hard to
establish an effective online presence. These difficulties led them to develop partnerships with
Amazon. Through these arrangements, Amazon now handles online presence and the shipping
of goods for several firms, including Toys “R” Us and Borders, which now can focus on sales
in their stores. Arrangements such as these are useful to the bricks-and-mortar companies
because they are not accustomed to shipping so much diverse merchandise directly to
individuals (Shepard, 2001).

Some of a firm’s resources are tangible while others are intangible. Tangible resources are
assets that can be seen and quantified. Production equipment, manufacturing plants, and formal
reporting structures are examples of tangible resources. Intangible resources typically include
assets that are rooted deeply in the firm’s history and have accumulated over time. Because
they are embedded in unique patterns of routines, intangible resources are relatively difficult
for competitors to analyze and imitate. Knowledge, trust between managers and employees,
ideas, the capacity for innovation, managerial capabilities, organizational routines (the unique
ways people work together), scientific capabilities, and the firm’s reputation for its goods or
services and how it interacts with people (such as employees, customers, and suppliers) are all
examples of intangible resources (Feldman, 2000; Knott & McKelvey, 1999). The four types of
tangible resources are financial, organizational, physical, and technological. The three types of
intangible resources are human, innovation, and reputational.

As a manager or entrepreneur, you will be challenged to understand fully the strategic value of
your firm’s tangible and intangible resources. The strategic value of resources is indicated by
the degree to which they can contribute to the development of core competencies, and,
ultimately, competitive advantage. For example, as a tangible resource, a distribution facility is
assigned a monetary value on the firm’s balance sheet. The real value of the facility, however,
is grounded in a variety of factors, such as its proximity to raw materials and customers, but
also in intangible factors such as the manner in which workers integrate their actions internally
and with other stakeholders, such as suppliers and customers (Gavetti & Levinthal, 2000; Coff,
1999; Marsh & Ranft, 1999).

Capabilities

Capabilities are the firm’s capacity to deploy resources that have been purposely integrated to
achieve a desired end state (Helfat & Raubitschek, 2000). The glue that holds an organization
together, capabilities emerge over time through complex interactions among tangible and
intangible resources. Capabilities can be tangible, like a business process that is automated, but
most of them tend to be tacit and intangible. Critical to forming competitive advantages,
capabilities are often based on developing, carrying, and exchanging information and
knowledge through the firm’s human capital (Hitt, et. al., 2001; Hitt, et. al., 2000; Hoopes &
Postrel, 1999). Because a knowledge base is grounded in organizational actions that may not
be explicitly understood by all employees, repetition and practice increase the value of a firm’s
capabilities.

The foundation of many capabilities lies in the skills and knowledge of a firm’s employees and,
often, their functional expertise. Hence, the value of human capital in developing and using
capabilities and, ultimately, core competencies cannot be overstated. Firms committed to
continuously developing their people’s capabilities seem to accept the adage that “the person
who knows how will always have a job. The person who knows why will always be his boss.”

Global business leaders increasingly support the view that the knowledge possessed by human
capital is among the most significant of an organization’s capabilities and may ultimately be at
the root of all competitive advantages. But firms must also be able to use the knowledge that
they have and transfer it among their operating businesses (Argote & Ingram, 2000). For
example, researchers have suggested that “in the information age, things are ancillary,
knowledge is central. A company’s value derives not from things, but from knowledge, know-
how, intellectual assets, competencies—all of it embedded in people (Dess & Picken 1999).”
Given this reality, the firm’s challenge is to create an environment that allows people to fit their
individual pieces of knowledge together so that, collectively, employees possess as much
organizational knowledge as possible (Coy, 2002).

To help them develop an environment in which knowledge is widely spread across all
employees, some organizations have created the new upper-level managerial position of chief
learning officer (CLO). Establishing a CLO position highlights a firm’s belief that “future
success will depend on competencies that traditionally have not been actively managed or
measured—including creativity and the speed with which new ideas are learned and shared
(Baldwin & Danielson, 2000).” In general, the firm should manage knowledge in ways that
will support its efforts to create value for customers (Kuratko, et. al., 2001; Hansen, et. al.,
1999).
Figure 5.15 The Value Chain

Adapted from Porter, M. (1985). Competitive Advantage. New York: Free Press. Exhibit is creative
commons licensed at http://en.wikipedia.org/wiki/Image:ValueChain.PNG.

Capabilities are often developed in specific functional areas (such as manufacturing, R&D, and
marketing) or in a part of a functional area (for example, advertising). The value chain,
popularized by Michael Porter’s book Competitive Advantage, is a useful tool for taking stock
of organizational capabilities. A value chain is a chain of activities. In the value chain, some of
the activities are deemed to be primary, in the sense that these activities add direct value. In the
preceding figure, primary activities are logistics (inbound and outbound), marketing, and
service. Support activities include how the firm is organized (infrastructure), human resources,
technology, and procurement. Products pass through all activities of the chain in order, and at
each activity, the product gains some value. A firm is effective to the extent that the chain of
activities gives the products more added value than the sum of added values of all activities.

It is important not to mix the concept of the value chain with the costs occurring throughout the
activities. A diamond cutter can be used as an example of the difference. The cutting activity
may have a low cost, but the activity adds to much of the value of the end product, since a
rough diamond is significantly less valuable than a cut, polished diamond. Research suggests a
relationship between capabilities developed in particular functional areas and the firm’s
financial performance at both the corporate and business-unit levels (Hitt & Ireland, 1986; Hitt
& Ireland, 1985; Hitt, et. al., 1982; Hitt;et. al., 1982; Snow & Hrebiniak, 1980), suggesting the
need to develop capabilities at both levels.

VRIO Analysis

Given that almost anything a firm possesses can be considered a resource or capability, how
should you attempt to narrow down the ones that are core competencies, and explain why firm
performance differs? To lead to a sustainable competitive advantage, a resource or capability
should be valuable, rare, inimitable (including nonsubstitutable), and organized. This VRIO
framework is the foundation for internal analysis (Wernerfelt, 1984). VRIO is an acronym for
valuable, rare, inimitable, and organization.

If you ask managers why their firms do well while others do poorly, a common answer is likely
to be “our people.” But this is really not an answer. It may be the start of an answer, but you
need to probe more deeply—what is it about “our people” that is especially valuable? Why
don’t competitors have similar people? Can’t competitors hire our people away? Or is it that
there something special about the organization that brings out the best in people? These kinds
of questions form the basis of VRIO and get to the heart of why some resources help firms
more than others.
Figure 5.16 VRIO and Relative Firm Performance

Moreover, your ability to identify whether an organization has VRIO resources will also likely
explain their competitive position. In the figure, you can see that a firm’s performance relative
to industry peers is likely to vary according to the level to which resources, capabilities, and
ultimately core competences satisfy VRIO criteria. The four criteria are explored next.

Valuable

A resource or capability is said to be valuable if it allows the firm to exploit opportunities or
negate threats in the environment. Union Pacific’s extensive network of rail-line property and
equipment in the Gulf Coast of the United States is valuable because it allows the company to
provide a cost-effective way to transport chemicals. Because the Gulf Coast is the gateway for
the majority of chemical production in the United States, the rail network allows the firm to
exploit a market opportunity. Delta’s control of the majority of gates at the Cincinnati /
Northern Kentucky International Airport (CVG) gives it a significant advantage in many
markets. Travelers worldwide have rated CVG one of the best airports for service and
convenience 10 years running. The possession of this resource allows Delta to minimize the
threat of competition in this city. Delta controls air travel in this desirable hub city, which
means that this asset (resource) has significant value. If a resource does not allow a firm to
minimize threats or exploit opportunities, it does not enhance the competitive position of the
firm. In fact, some scholars suggest that owning resources that do not meet the VRIO test of
value actually puts the firm at a competitive disadvantage (Barney, 1991).

Rare

A resource is rare simply if it is not widely possessed by other competitors. Of the criteria this
is probably the easiest to judge. For example, Coke’s brand name is valuable but most of
Coke’s competitors (Pepsi, 7Up, RC) also have widely recognized brand names, making it not
that rare. Of course, Coke’s brand may be the most recognized, but that makes it more
valuable, not more rare, in this case.

A firm that possesses valuable resources that are not rare is not in a position of advantage
relative to competitors. Rather, valuable resources that are commonly held by many
competitors simply allow firms to be at par with competitors. However, when a firm maintains
possession of valuable resources that are rare in the industry they are in a position of
competitive advantage over firms that do not possess the resource. They may be able to exploit
opportunities or negate threats in ways that those lacking the resource will not be able to do.
Delta’s virtual control of air traffic through Cincinnati gives it a valuable and rare resource in
that market.

How rare do the resources need to be for a firm to have a competitive advantage? In practice,
this is a difficult question to answer unequivocally. At the two extremes (i.e., one firm
possesses the resource or all firms possess it), the concept is intuitive. If only one firm
possesses the resource, it has significant advantage over all other competitors. For instance,
Monsanto had such an advantage for many years because they owned the patent to aspartame,
the chemical compound in NutraSweet, they had a valuable and extremely rare resource.
Because during the lifetime of the patent they were the only firm that could sell aspartame,
they had an advantage in the artificial sweetener market. However, meeting the condition of
rarity does not always require exclusive ownership. When only a few firms possess the
resource, they will have an advantage over the remaining competitors. For instance, Toyota and
Honda both have the capabilities to build cars of high quality at relatively low cost (Dyer, et.
al., 2004). Their products regularly beat rival firms’ products in both short-term and long-term
quality ratings (Dyer & Hatch, 2004). Thus, the criterion of rarity requires that the resource not
be widely possessed in the industry. It also suggests that the more exclusive a firm’s access to a
particularly valuable resource, the greater the benefit for having it.

Inimitable

An inimitable (the opposite of imitable) resource is difficult to imitate or to create ready
substitutes for. A resource is inimitable and nonsubstitutable if it is difficult for another firm to
acquire it or to substitute something else in its place. A valuable and rare resource or capability
will grant a competitive advantage as long as other firms do not gain subsequently possession
of the resource or a close substitute. If a resource is valuable and rare and responsible for a
market leader’s competitive advantage, it is likely that competitors lacking the resource or
capability will do all that they can to obtain the resource or capability themselves. This leads us
to the third criterion—inimitability. The concept of imitation includes any form of acquiring
the lacking resource or substituting a similar resource that provides equivalent benefits. The
criterion important to be addressed is whether competitors face a cost disadvantage in
acquiring or substituting the resource that is lacking. There are numerous ways that firms may
acquire resources or capabilities that they lack.

As strategy researcher Scott Gallagher notes:

“This is probably the toughest criterion to examine because given enough time and money almost any

resource can be imitated. Even patents only last 17 years and can be invented around in even less time.

Therefore, one way to think about this is to compare how long you think it will take for competitors to

imitate or substitute something else for that resource and compare it to the useful life of the product.

Another way to help determine if a resource is inimitable is why/how it came about. Inimitable resources

are often a result of historical, ambiguous, or socially complex causes. For example, the U.S. Army paid

for Coke to build bottling plants around the world during World War II. This is an example of history

creating an inimitable asset. Generally, intangible (also called tacit) resources or capabilities, like corporate

culture or reputation, are very hard to imitate and therefore inimitable (Falcon, 2009).”

Organized

The fourth and final VRIO criterion that determines whether a resource or capability is the
source of competitive advantage recognizes that mere possession or control is necessary but
not sufficient to gain an advantage. The firm must likewise have the organizational capability
to exploit the resources. The question of organization is broad and encompasses many facets of
a firm but essentially means that the firm is able to capture any value that the resource or
capability might generate. Organization, essentially the same form as that taken in the P-O-L-C
framework, spans such firm characteristics as control systems, reporting relationships,
compensation policies, and management interface with both customers and value-adding
functions in the firm. Although listed as the last criterion in the VRIO tool, the question of
organization is a necessary condition to be satisfied if a firm is to reap the benefits of any of the
three preceding conditions. Thus, a valuable but widely held resource only leads to competitive
parity for a firm if they also possess the capabilities to exploit the resource. Likewise, a firm
that possesses a valuable and rare resource will not gain a competitive advantage unless it can
actually put that resource to effective use.

Many firms have valuable and rare resources that they fail to exploit (the question of imitation
is not relevant until the firm exploits valuable and rare resources). For instance, for many years
Novell had a significant competitive advantage in computer networking based on its core
NetWare product. In high-technology industries, remaining at the top requires continuous
innovation. Novell’s decline during the mid- to late 1990s led many to speculate that Novell
was unable to innovate in the face of changing markets and technology. However, shortly after
new CEO Eric Schmidt arrived from Sun Microsystems to attempt to turnaround the firm, he
arrived at a different conclusion. Schmidt commented: “I walk down Novell hallways and
marvel at the incredible potential of innovation here. But, Novell has had a difficult time in the
past turning innovation into products in the marketplace (Haddox, 2003).” He later commented
to a few key executives that it appeared the company was suffering from “organizational
constipation.” Novell appeared to still have innovative resources and capabilities, but they
lacked the organizational capability (e.g., product development and marketing) to get those
new products to market in a timely manner.

Likewise, Xerox proved unable to exploit its innovative resources. Xerox created a successful
research team housed in a dedicated facility in Palo Alto, California, known as Xerox PARC.
Scientists in this group invented an impressive list of innovative products, including laser
printers, Ethernet, graphical interface software, computers, and the computer mouse. History
has demonstrated that these technologies were commercially successful. Unfortunately, for
Xerox shareholders, these commercially successful innovations were exploited by other firms.
Xerox’s organization was not structured in a way that information about these innovations
flowed to the right people in a timely fashion. Bureaucracy was also suffocating ideas once
they were disseminated. Compensation policies did not reward managers for adopting these
new innovations but rather rewarded current profits over long-term success. Thus, Xerox was
never able exploit the innovative resources and capabilities embodied in their off-site Xerox
PARC research center (Kearns & Nadler, 1992; Barney, 1995).

SWOT and VRIO

As you already know, many scholars refer to core competencies. A core competency is simply
a resource, capability, or bundle of resources and capabilities that is VRIO. While VRIO
resources are the best, they are quite rare, and it is not uncommon for successful firms to
simply be combinations of a large number of VR _ O or even V _ _ O resources and
capabilities. Recall that even a V _ _ O resource can be considered a strength under a
traditional SWOT analysis.

Key Takeaway

Internal analysis begins with the identification of resources and capabilities. Resources
can be tangible and intangible; capabilities may have such characteristics as well. VRIO
analysis is a way to distinguish resources and capabilities from core competencies.
Specifically, VRIO analysis should show you the importance of value, rarity, inimitability,
and organization as building blocks of competitive advantage.

Exercises

1. What is the objective of internal analysis?

2. What is the difference between a resource and a capability?

3. What is the difference between a tangible and an intangible resource or capability?

4. What is a core competency?

5. What framework helps you identify those resources, capabilities, or core
competencies that provide competitive advantage?

6. Why might competitive advantage for a firm be fleeting?

Pocket Strategy. (1998). Value (p. 165). London: The Economist Books.

Thoughts on the business of life. (1999, May 17). Forbes, p. 352.

Personal communication with former executives.

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Previous: 5.5 Strategy as Trade-Offs, Discipline, and Focus Next: 5.7 Developing Strategy Through External Analysis

5.5 Strategy as Trade-Offs, Discipline, and Focus

5.7 Developing Strategy Through External Analysis

Strategic Management Search

Porter’s competitive strategies: Porter’s three strategies
can be defined along two dimensions: strategic scope and
strategic strength.

SWOT ANALYSIS
Helpful

to achieving the objective

Strengths Weaknesses

Opportunities Threats

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SWOT analysis: The SWOT analysis matrix illustrates
where the company’s strengths and weaknesses lie
relative to factors in the market. Strengths and
opportunities (the S and O of SWOT) are both helpful
toward achieving company objectives, but strengths
originate internally while opportunities originate externally.
Similarly, weaknesses and threats (the W and T of SWOT)
are harmful toward achieving objectives, but weaknesses
originate internally and threats originate externally.
Assessing all four points of the SWOT acronym ensures a
thorough evaluation.

Previous Next

Internal Analysis Inputs to Strategy

The Mission Statement

A mission statement defines the fundamental purpose of an organization or enterprise.

LEARNING OBJECTIVES

Outline the appropriate content necessary to construct a comprehensive mission statement

KEY TAKEAWAYS

Key Points

A mission statement is generated to retain consistency in overall strategy and to
communicate core organizational goals to all stakeholders.

The business’s owners and upper managers develop the mission statement and
uphold it as a standard across the organization. It provides a strategic framework by
which the organization is expected to abide.

In a best-case scenario, an organization conducts internal and external assessments
relative to the mission statement to ensure it is being upheld.

A mission statement informs the key market, contribution, and distinction of an
organization. It describes what the organization does, why it does so, and how it
excels.

Key Terms

mission: A set of tasks that fulfills a purpose or duty; an assignment set by an
employer.

stakeholder: A person or organization with a legitimate interest in a given situation,
action, or enterprise.

A mission statement defines the purpose of a company or organization. The mission statement
guides the organization’s actions, spells out overall goals, and guides decision making. The mission
statement is generated to retain consistency in overall strategy and to communicate core
organizational goals to all stakeholders. The business’s owners and upper managers develop the
mission statement and uphold it as a standard across the organization. It provides a strategic
framework by which the organization is expected to abide.

Mission statement: An example of a mission statement, which includes the
organization’s aims and stakeholders and how it provides value to these stakeholders.

In a best-case scenario, an organization conducts internal and external assessments relative to the
mission statement. The internal assessment should focus on how members inside the organization
interpret the mission statement. The external assessment, which includes the business’s
stakeholders, is valuable since it offers a different perspective. Discrepancies between these two
assessments can provide insight into the effectiveness of the organization’s mission statement.

Contents

Effective mission statements start by articulating the organization’s purpose. Mission statements
often include the following information:

Aim(s) of the organization

The organization’s primary stakeholders, including clients/customers, shareholders,
congregation, etc.

How the organization provides value to these stakeholders, that is, by offering specific types of
products or services

A declaration of an organization’s core purpose

According to business professor Christopher Bart, the commercial mission statement consists of
three essential components:

1. Key market – Who is your target client/customer? ( generalize if necessary)

2. Contribution – What product or service do you provide to that client?

3. Distinction – What makes your product or service so unique that the client would choose you?

Assimilation

To be truly effective, an organizational mission statement must be assimilated into the organization’s
culture (as the theory states). Leaders have the responsibility of communicating the vision regularly,
creating narratives that illustrate the vision, acting as role-models by embodying the vision, creating
short-term objectives compatible with the vision, and encouraging employees to craft their own
personal vision that is compatible with the organization’s overall vision.

Porter’s Competitive Strategies

Michael Porter classifies competitive strategies as cost leadership, differentiation, or market
segmentation.

LEARNING OBJECTIVES

Discuss the value of using Porter’s competitive strategies of cost leadership, differentiation,
and market segmentation

KEY TAKEAWAYS
Key Points

Michael Porter defines three strategy types that can attain competitive advantage.
These strategies are cost leadership, differentiation, and market segmentation (or
focus).

Cost leadership is about achieving scale economies and utilizing them to produce
high volume at a low cost. Margins may be narrower, but quantity is larger, enabling
high revenue streams.

Differentiation is creating a unique service or product offering, either through good
branding or strong internal skills. This strategy aims at offering something difficult to
copy and is strongly associated with an organization ‘s brand.

Market segmentation strategy is narrower in scope. Both cost leadership and
differentiation are relatively broad in market scope and can encompass both strategic
advantages on a smaller scale.

Porter warns that companies who try to accomplish both cost leadership and
differentiation may fall into the “hole in the middle”; he notes that specializing is the
ideal strategic approach.

Key Terms

competitive advantage: Something that places a company or a person above the
competition.

Market Share: Percentage of a specific market held by a company.

Michael Porter described a category scheme consisting of three general types of strategies
commonly used by businesses to achieve and maintain competitive advantage. These three
strategies are defined along two dimensions: strategic scope and strategic strength. Strategic scope
is a demand-side dimension and considers the size and composition of the market the business
intends to target. Strategic strength is a supply-side dimension and looks at the strength or core
competency of the firm.

Porter identifies two competencies as most important: product differentiation and product cost
(efficiency). He originally ranked each of the three dimensions (level of differentiation, relative
product cost, and scope of target market) as either low, medium, or high and juxtaposed them in a
three-dimensional matrix. That is, the category scheme was displayed as a 3x3x3 cube; however,
most of the twenty-seven combinations were not viable.

Cost Leadership, Differentiation, and Market Segmentation

Porter simplified the scheme by reducing it to the three most effective strategies: cost leadership,
differentiation, and market segmentation (or focus). He characterizes each as the following:

Cost leadership pertains to a firm’s ability to create economies of scale though extremely
efficient operations that produce a large volume. Cost leaders include organizations like
Procter & Gamble, Walmart, McDonald’s and other large firms generating a high volume of
goods that are distributed at a relatively low cost (compared to the competition).

Differentiation is less tangible and easily defined, yet still represents an extremely effective
strategy when properly executed. Differentiation refers to a firm’s ability to create a good that is
difficult to replicate, thereby fulfilling niche needs. This strategy can include creating a powerful
brand image, which allows the organization to sell its products or services at a premium. Coach
handbags are a good example of differentiation; the company’s margins are high due to the
markup on each bag (which mostly covers marketing costs, not production).

Market segmentation is narrow in scope (both cost leadership and differentiation are relatively
broad in scope) and is a cross between the two strategies. Segmentation targets finding
specific segments of the market which are not otherwise tapped by larger firms.

Avoiding the “Hole in the Middle”

Empirical research on the profit impact of
marketing strategy indicates that firms with a
high market share are often quite profitable, but
so are many firms with low market share. The
least profitable firms are those with moderate
market share. This is sometimes referred to as
the “hole-in-the-middle” problem. Porter
explains that firms with high market share are
successful because they pursue a cost-
leadership strategy, and firms with low market
share are successful because they employ
market segmentation or differentiation to focus
on a small but profitable market niche. Firms in
the middle are less profitable because of the

lack of a viable generic strategy.

SWOT Analysis

A SWOT analysis allows businesses to assess internal strengths and weaknesses in relation to
external opportunities and threats.

LEARNING OBJECTIVES

Explain how a SWOT analysis can be used as a tool in strategic decision making

KEY TAKEAWAYS
Key Points

SWOT analysis is a strategic planning method used to evaluate a business’s
strengths, weaknesses, opportunities, and threats.

The goal of a SWOT analysis is to analyze the business environment to develop a
strategic plan of action that captures opportunities using internal strengths (and
avoids threats while addressing weaknesses).

Businesses set objectives after the SWOT analysis has been performed, which allows
the organization to define achievable goals.

Key Terms

environment: The surroundings of, and influences on, a particular item of interest.

A method of analyzing the environment in which businesses operate is referred to as a context
analysis. One of the most recognized of these is the SWOT (strengths, weaknesses, opportunities,
and threats) analysis. Performing a SWOT analysis allows a business to gain insights into its internal
strengths and weaknesses and to relate these insights to the external opportunities and threats
posed by the marketplace in which the business operates. The main goal of a context analysis,
SWOT or otherwise, is to analyze the business environment in order to develop a strategic plan.

SWOT and Strategy

A SWOT analysis is a strategic planning method
used to evaluate the strengths, weaknesses,
opportunities, and threats related to a project or
business venture. A SWOT assessment involves
specifying the business’s objective and then
identifying the internal and external factors that
are favorable and unfavorable toward the
business’s ability to achieve its objective.
Setting the objective, in terms of moving from
strategy planning to strategy implementation,
should be done after the SWOT analysis has
been performed. Doing so allows the
organization to set achievable goals and
objectives.

Components of SWOT

Strengths: internal characteristics of the
business that give it an advantage over
competitors

Weaknesses: internal characteristics that
place the business at a disadvantage
against competitors

Opportunities: external chances to
improve performance in the overall
business environment

Threats: external elements in the environment that could cause trouble for the business

Identifying SWOTs is essential, as subsequent stages of planning can be derived from the analysis.
Decision makers first determine whether an objective is attainable, given the SWOTs. If the objective
is not attainable, a different objective must be selected, and then the process can be repeated.
Users of SWOT analysis must ask and answer questions that generate meaningful information for
each category to maximize the benefits of the evaluation and identify the organization’s competitive
advantages.

Forecasting

Forecasting is the process of making statements about expected future events, based upon
evidence, research, and experience.

LEARNING OBJECTIVES

Demonstrate the value and role of effective forecasting in the development of successful
strategies

KEY TAKEAWAYS
Key Points

An important aspect of forecasting is the relationship it holds with planning.
Forecasting can be described as predicting what the future will look like, whereas
planning predicts what the future should look like.

As part of the implementation of policies and strategies, the forecasting method
develops a reliable picture of the company’s expected future environment.

Quantitative forecasting generally employs statistical confidence intervals and
historical data to project potential future trends that are based upon the criteria being
analyzed.

Qualitative approaches are the opposite: they rely on logical premises, expertise, or
past experience to generate estimates of future circumstances.

Forecasting enables a manager to look at the current environment and identify likely
scenarios, each of which may require a deviation from the overall strategy.

Key Terms

forecast: An estimation of a future condition.

scenario: An outline or model of an expected or supposed sequence of events.

planning: The act of formulating a course of action or of drawing up plans.

Forecasting is the process of making statements about expected future events based upon
evidence, research, and experience. For example, a business might estimate the exchange rate
between the U.S. and the EU one year from now to determine the real financial cost of a project.

An important and often overlooked aspect of forecasting is the relationship it holds with planning.
Forecasting can be described as predicting what the future will look like, whereas planning predicts
what the future should look like. While both are managerial functions, forecasting is rife with external
uncertainty while planning is hindered by internal uncertainty.

Forecasting Methods

Forecasting can be accomplished in a variety of different ways, some more statistically reliable than
others. Following are a few critical points of differentiation and specific strategies to keep in mind
when forecasting.

Quantitative vs. Qualitative

One of the simplest points of differentiation between methods is the reliance on numbers for
accuracy. Quantitative forecasting generally uses statistical confidence intervals and historical data
to project potential future trends that are based upon the criteria being analyzed. In this format,
results are expressed in certainty intervals (i.e., how confident can we be that this will be the case?)
and often rely on financial data (exchange rates, industry growth, etc.).

Qualitative approaches are the opposite; they rely on logical premises or past experience to
generate estimates about future circumstances. The inherent problem with the qualitative approach
is simple: subjectivity. While quantitative measure use data to express objective results, qualitative
approaches do not have this luxury. Generally this type of forecast will include the opinions of
experts, upper management, and market research.

Quantitative vs. qualitative forecasting: This flow chart compares quantitative and qualitative
forecasting methods. Qualitative forecasting relies more on opinions than data and can employ market
research, sales-force input, or a jury of executives. In contrast, quantitative forecasting relies more on
objective, numerical data, and can look at chronological trends and statistical regression to infer cause-
and-effect.

Causal Forecasting

Another method of forecasting, which is likely to be both quantitative and qualitative, is the
causal/econometric approach. This strategy tasks managers with identifying cause and effect
relationships of past instances by defining a series of if/then statements that express the likelihood of
the outcome which follows. For example, if consumer spending is down in Q2, then it is likely that
gross domestic product (GDP) growth will be down in Q3. Whether or not this is true would have to
be supported with data, but the forecast is that Q2 consumer spending results could forecast Q3
GDP growth.

Implications of Forecasting

Keeping these methods in mind, it is important to understand how management uses these forecasts
to draw conclusions. Forecasting plays a role in the implementation of policies and strategies. The
practice helps businesses create plans for different situations, in addition to contingency plans for
adapting if and when necessary.

Forecasting enables a manager to look at the current environment and identify likely scenarios, each
of which may require a deviation from the overall strategy. As the management team implements the
broader strategy, it must continuously monitor the current environment for deviations and use
forecasting to adapt both the primary strategy and contingency plans for potential shifts.

To summarize, forecasts enable businesses to prepare new strategies or reinforce the existing
strategy, based upon the projections made.

The Resource-Based View

In the resource-based view (RBV), strategic planning uses organizational resources to generate a
viable strategy.

LEARNING OBJECTIVES

Describe the intrinsic competitive advantage defined by the resource-based view strategy

KEY TAKEAWAYS
Key Points

Strategic approaches are wide and varied, and the resource-based view is a
commonly cited strategic approach to attaining competitive advantage.

To transform a short-run competitive advantage into a sustained competitive
advantage requires that these resources be varied in nature and not perfectly mobile.
They also must not be easily imitated or substituted without great effort.

The RBV theory involves first identifying the firm’s potential key resources and
deriving a strategy to apply them to create synergy.

If key resources are valuable, rare, inimitable, and non-substitutable (VRIN), they may
enable a strategy for achieving competitive advantage.

Key Terms

heterogeneous: Diverse in kind or nature; composed of diverse parts.

imitable: Capable of being copied.

substitutable: Capable of being replaced.

The resource-based view (RBV) of strategy holds company assets as the primary input for overall
strategic planning, emphasizing the way in which competitive advantage can be derived via rare
resource combinations. To transform a short-run competitive advantage into a sustained competitive
advantage requires that these resources are heterogeneous in nature and not perfectly mobile.
Effectively, this principle translates into valuable resources that are cannot be either imitated or
substituted without great effort. If the firm’s strategy emphasizes and accomplishes this goal, its
resources can help it sustain above-average returns.

Applicability to Strategy

In many ways, business strategy aims to achieve competitive advantage through the proper use of
organizational resources. As a result, the resource-based view offers some insight as to what defines
strategic resources and furthermore what enables them to generate above-average returns (profit).
Upper management must carefully consider what resources are at the company’s disposal and how
these assets may equate to operational value through strategic processes.

The VRIN Characteristics

In achieving a competitive advantage, the resource-based view defines characteristics which make a
competitive process sustainable. These characteristics are described as valuable, rare, inimitable,
and non-substitutable, referred to as VRIN:

Valuable – A resource must enable a firm to employ a value-creating strategy by either
outperforming its competitors or reducing its own weaknesses. The value factor requires that
the costs invested in the resource remain lower than the future rents demanded by the value-
creating strategy.

Rare – To be of value, a resource must be rare by definition. In a perfectly competitive strategic
factor market for a resource, the price of the resource will reflect expected future above-
average returns.

Inimitable – If a valuable resource is controlled by only one firm, it can be a source of
competitive advantage. This advantage can be sustained if competitors are not able to
duplicate this strategic asset perfectly. Knowledge-based resources are “the essence of the
resource-based perspective.”

Non-substitutable – Even if a resource is rare, potentially value-creating and imperfectly
imitable, of equal importance is a lack of substitutability. If competitors are able to counter the
firm’s value-creating strategy with a substitute, prices are driven down to the point that the
price equals the discounted future rents, resulting in zero economic profits.

A company should care for and protect resources that possess these characteristics, because doing
so can improve organizational performance. The VRIN characteristics mentioned are individually
necessary, but each is insufficient on its own to sustain competitive advantage. Within the framework
of the RBV, the chain is as strong as its weakest link, and therefore requires the resource to display
each of the four characteristics to be a viable strategy for competitive advantage.

Example of VRIN resources: Rare earth elements satisfy the requirements of being VRIN, in that they are
valuable, rare, largely inimitable due to few extraction sites, and difficult to substitute.

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