Module 9

 

In this module, we looked at technology-based industries and the management of innovation. For this week’s assignment, review Tesla: Disrupting the Auto Industry, Case 12 (in your textbook). Remember: A case study is a puzzle to be solved, so before reading and answering the specific case study questions, develop your proposed solution by following these five steps:

1. Read the case study to identify the key issues and underlying issues. These issues are the principles and concepts of the course area which apply to the situation described in the case study.
2. Record the facts from the case study which are relevant to the principles and concepts of the course area issues. The case may have extraneous information not relevant to the current course area. Your ability to differentiate between relevant and irrelevant information is an important aspect of case analysis, as it will inform the focus of your answers.
3. Describe in some detail the actions that would address or correct the situation.
4. Consider how you would support your solution with examples from experience or current real-life examples or cases from textbooks.
5. Complete this initial analysis and then read the discussion questions. Typically, you will already have the answers to the questions but with a broader consideration. At this point, you can add the details and/or analytical tools required to solve the case.

Case Study Questions:

1. How are the conventional (internal-combustion-powered) automobile industry and the electric-powered automobile industry similar and how are they different?
2. Was it a mistake for Tesla to open its patents? Why or why not?
3. What is Tesla’s strategy? What role does innovation play in this strategy?
4. How sustainable is Tesla’s competitive advantage? What changes in Tesla’s strategy or its management systems, if any, would you recommend?

Your well-written paper should meet the following requirements:

• Be 4 pages in length, which does not include the required title and reference pages, which are never a part of the content minimum requirements.

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ISBN: 978-1-119-49572-7 (PBK)
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Library of Congress Cataloging-in-Publication Data
Names: Grant, Robert M., 1948– author.
Title: Contemporary strategy analysis / Robert M. Grant.
Description: Tenth edition. | Hoboken, NJ : Wiley & Sons, 2018. | Includes
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To Liam, Ava, Finn, Evie, Max, Lucy, and Bobby

B R I E F C O N T E N T S
Author Biography xiv
Preface to Tenth Edition xv
PART I INTRODUCTION 1
1 The Concept of Strategy 3
PART II THE TOOLS OF STRATEGY ANALYSIS 31
2 Goals, Values, and Performance 33
3 Industry Analysis: The Fundamentals 59
4 Further Topics in Industry and Competitive Analysis 83
5 Analyzing Resources and Capabilities 107
6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation 131
PART III BUSINESS STRATEGY AND THE QUEST FOR
COMPETITIVE ADVANTAGE 153
7 The Sources and Dimensions of Competitive Advantage 155
8 Industry Evolution and Strategic Change 189
9 Technology-Based Industries and the
Management of Innovation 219
PART IV CORPORATE STRATEGY 249
10 Vertical Integration and the Scope of the Firm 251
11 Global Strategy and the Multinational Corporation 269
12 Diversification Strategy 297

viii BRIEF CONTENTS
13 Implementing Corporate Strategy: Managing
the Multibusiness Firm 315
14 External Growth Strategies: Mergers, Acquisitions,
and Alliances 340
15 Current Trends in Strategic Management 360
CASES TO ACCOMPANY CONTEMPORARY STRATEGY
ANALYSIS, TENTH EDITION
Glossary 637
Index 643

Author Biography xiv
Preface to Tenth Edition xv
PART I INTRODUCTION 1
1 The Concept of Strategy 3
Introduction and Objectives 4
The Role of Strategy in Success 4
The Basic Framework for Strategy Analysis 9
A Brief History of Business Strategy 11
Strategy Today 14
How is Strategy Made? The Strategy Process 20
Strategic Management of Not-For-Profit Organizations 24
Summary 26
Self-Study Questions 28
Notes 28
PART II THE TOOLS OF STRATEGY ANALYSIS 31
2 Goals, Values, and Performance 33
Introduction and Objectives 34
Strategy as a Quest for Value 35
Profit, Cash Flow, and Enterprise Value 39
Putting Performance Analysis into Practice 42
Beyond Profit: Values and Corporate Social Responsibility 49
Beyond Profit: Strategy and Real Options 53
Summary 56
Self-Study Questions 57
Notes 57
3 Industry Analysis: The Fundamentals 59
Introduction and Objectives 60
From Environmental Analysis to Industry Analysis 60
Analyzing Industry Attractiveness 62
Applying Industry Analysis to Forecasting Industry Profitability 71
Using Industry Analysis to Develop Strategy 74
Defining Industries: Where to Draw the Boundaries 75
From Industry Attractiveness to Competitive Advantage:
Identifying Key Success Factors 77
C O N T E N T S

x CONTENTS
Summary 80
Self-Study Questions 81
Notes 81
4 Further Topics in Industry and Competitive Analysis 83
Introduction and Objectives 84
The Limits of Industry Analysis 84
Beyond the Five Forces: Complements, Ecosystems, and Business Models 86
Competitive Interaction: Game Theory and Competitor Analysis 91
Segmentation and Strategic Groups 98
Summary 103
Self-Study Questions 103
Notes 104
5 Analyzing Resources and Capabilities 107
Introduction and Objectives 108
The Role of Resources and Capabilities in Strategy Formulation 108
Identifying Resources and Capabilities 112
Appraising Resources and Capabilities 119
Developing Strategy Implications 123
Summary 128
Self-Study Questions 129
Notes 130
6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation 131
Introduction and Objectives 132
Strategy Formulation and Strategy Implementation 133
The Fundamentals of Organizing: Specialization,
Cooperation, and Coordination 136
Developing Organizational Capability 139
Organization Design 142
Summary 150
Self-Study Questions 150
Notes 151
PART III BUSINESS STRATEGY AND THE QUEST
FOR COMPETITIVE ADVANTAGE 153
7 The Sources and Dimensions of Competitive Advantage 155
Introduction and Objectives 156
How Is Competitive Advantage Established? 156
How Is Competitive Advantage Sustained? 162
Cost Advantage 166
Differentiation Advantage 173
Can Firms Pursue Both Cost and Differentiation Advantage? 184

CONTENTS xi
Summary 185
Self-Study Questions 186
Notes 186
8 Industry Evolution and Strategic Change 189
Introduction and Objectives 190
The Industry Life Cycle 191
The Challenge of Organizational Adaptation and Strategic Change 198
Managing Strategic Change 204
Summary 215
Self-Study Questions 215
Notes 216
9 Technology-Based Industries and the
Management of Innovation 219
Introduction and Objectives 220
Competitive Advantage in Technology-Intensive Industries 221
Strategies to Exploit Innovation: How and When to Enter 227
Standards, Platforms, and Network Externalities 232
Implementing Technology Strategies: Internal and External
Sources of Innovation 238
Implementing Technology Strategies: Organizing for Innovation 242
Summary 245
Self-Study Questions 246
Notes 246
PART IV CORPORATE STRATEGY 249
10 Vertical Integration and the Scope of the Firm 251
Introduction and Objectives 252
Transaction Costs and the Scope of the Firm 252
The Benefits and Costs of Vertical Integration 256
Designing Vertical Relationships 263
Summary 266
Self-Study Questions 266
Notes 267
11 Global Strategy and the Multinational Corporation 269
Introduction and Objectives 270
Implications of International Competition for Industry Analysis 271
Analyzing Competitive Advantage in an International Context 273
Internationalization Decisions: Locating Production 276
Internationalization Decisions: Entering a Foreign Market 278
Multinational Strategies: Global Integration versus
National Differentiation 281
Implementing International Strategy: Organizing the
Multinational Corporation 287

xii CONTENTS
Summary 293
Self-Study Questions 294
Notes 295
12 Diversification Strategy 297
Introduction and Objectives 298
Motives for Diversification 299
Competitive Advantage from Diversification 303
Diversification and Performance 307
The Meaning of Relatedness in Diversification 309
Summary 311
Self-Study Questions 312
Notes 312
13 Implementing Corporate Strategy: Managing the Multibusiness
Firm 315
Introduction and Objectives 316
The Role of Corporate Management 316
Managing the Corporate Portfolio 317
Managing Linkages Across Businesses 319
Managing Individual Businesses 323
Managing Change in the Multibusiness Corporation 329
Governance of Multibusiness Corporations 333
Summary 337
Self-Study Questions 338
Notes 338
14 External Growth Strategies: Mergers, Acquisitions,
and Alliances 340
Introduction and Objectives 341
Mergers and Acquisitions 342
Strategic Alliances 351
Summary 357
Self-Study Questions 357
Notes 358
15 Current Trends in Strategic Management 360
Introduction 361
The New Environment of Business 361
New Directions in Strategic Thinking 365
Redesigning Organizations 369
The Changing Role of Managers 371
Summary 372
Notes 373

CONTENTS xiii
CASES TO ACCOMPANY CONTEMPORARY STRATEGY
ANALYSIS, TENTH EDITION
1 Tough Mudder Inc.: Building Leadership in Mud Runs 375
2 Kering SA: Probing the Performance Gap with LVMH 384
3 Pot of Gold? The US Legal Marijuana Industry 393
4 The US Airline Industry in 2018 403
5 The Lithium-Ion Battery Industry 415
6 Walmart Inc. in 2018: The World’s Biggest Retailer Faces
New Challenges 428
7 Harley-Davidson, Inc. in 2018 442
8 BP: Organizational Structure and Management Systems 455
9 Starbucks Corporation, March 2018 462
10 Eastman Kodak’s Quest for a Digital Future 475
11 The New York Times: Adapting to the Digital Revolution 492
12 Tesla: Disrupting the Auto Industry 503
13 Video Game Console Industry in 2018 515
14 Eni SpA: The Corporate Strategy of an International
Energy Major 527
15 Zara: Super-Fast Fashion 546
16 Manchester City: Building a Multinational Soccer Enterprise 554
17 Haier Group: Internationalization Strategy 566
18 The Virgin Group in 2018 577
19 Google Is Now Alphabet—But What’s the Corporate Strategy? 587
20 Restructuring General Electric 600
21 Walt Disney, 21st Century Fox, and the Challenge of New Media 617
22 W. L. Gore & Associates: Rethinking Management 629
Glossary 637
Index 643

AU T H O R B I O G R A P H Y
Robert M. Grant is Professor of Strategic Management at Bocconi University, Milan,
Italy and a Visiting Professor at Cass Business School, London. He was born in Bristol,
England and has taught at Georgetown University, London Business School, Univer-
sity of British Columbia, California Polytechnic, UCLA, Insead, and University of South
Africa. His business experience includes making tires (Firestone) and meat pies (Kraft
Foods) and strategy consulting at American Express, Eni, BP, and other companies.

Contemporary Strategy Analysis equips managers and students of management with
the concepts and frameworks needed to make better strategic decisions. My goal is
a strategy text that reflects the dynamism and intellectual rigor of this fast-developing
field of management and takes account of the strategy issues that companies face today.
Contemporary Strategy Analysis endeavors to be both rigorous and relevant. While
embodying the latest thinking in the strategy field, it aims to be accessible to students
from different backgrounds and with varying levels of experience. I achieve this acces-
sibility by combining clarity of exposition, concentration on the fundamentals of value
creation, and an emphasis on practicality.
This tenth edition maintains the book’s focus on the essential tasks of strategy: iden-
tifying the sources of superior business performance and formulating and implement-
ing a strategy that exploits these sources of superior performance. At the same time,
the content of the book has been revised to reflect recent developments in the business
environment and in strategy research.
Distinctive features of the tenth edition include:
● More explicit guidance on how to apply the tools of strategy to analyze strategic
situations and develop strategy recommendations. See, in particular: “Applying
Strategy Analysis” in Chapter 1, “Putting Performance Analysis into Practice”
in Chapter 2, “Using Industry Analysis to Develop Strategy” in Chapter 3, and
“Developing Strategy Implications” [from the analysis of resources and capabil-
ities] in Chapter 5.
● Increased emphasis on strategy making under conditions of technological
change—especially in digital markets where strategy analysis must take account
of complements, network externalities, platform-based competition, and the
application of innovative business models to complex business ecosystems (see
Chapters 4, 8, and 9).
● Integration of stakeholder interests and corporate social responsibility within a
view of the firm as an institution for creating value (Chapter 2).
● An updated approach to strategy implementation. While maintaining an
integrated approach to strategy formulation and strategy implementation,
Chapters 6, 8, and 13 offers a systematic approach to strategy execution that
the role of organizational capabilities and capability development in guid-
ing resource allocation, and the design of organizational structures and
management systems.
My thanks to my editorial and production team at Wiley, especially to Lise Johnson,
Judy Howarth, and S. Indirakumari; and to Mary Fogarty and Nitish Mohan for their
P R E FA C E T O
T E N T H E D I T I O N

xvi PREFACE TO TENTH EDITION
assistance. This tenth edition of Contemporary Strategy Analysis has benefitted hugely
from feedback and suggestions from users—both instructors and students. I thank you
and look forward to continuing my engagement with you. Please feel free to contact me at
grant@unibocconi.com.
Robert M. Grant

I
INTRODUCTION
1 The Concept of Strategy

1
Strategy is the great work of the organization. In situations of life or death, it is the Tao
of survival or extinction. Its study cannot be neglected.
—SUN TZU, THE ART OF WAR
To shoot a great score you need a clever strategy.
—RORY MCILROY, GOLF MONTHLY, MAY 19, 2011
Everybody has a plan until they get punched in the mouth.
—MIKE TYSON, FORMER WORLD HEAVYWEIGHT BOXING CHAMPION
The Concept of Strategy
◆ Introduction and Objectives
◆ The Role of Strategy in Success
◆ The Basic Framework for Strategy Analysis
● Strategic Fit
◆ A Brief History of Business Strategy
● Origins and Military Antecedents
● From Corporate Planning to Strategic Management
◆ Strategy Today
● What Is Strategy?
● Why Do Firms Need Strategy?
● Where Do We Find Strategy?
● Corporate and Business Strategy
● Describing Strategy
◆ How Is Strategy Made? The Strategy Process
● Design versus Emergence
● Applying Strategy Analysis
◆ Strategic Management of Not-For-Profit
Organizations
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

4 PART I INTRODUCTION
The Role of Strategy in Success
Strategy Capsules 1.1 and 1.2 describe the careers of two individuals, Queen Elizabeth
II and Lady Gaga, who have been outstandingly successful in leading their organiza-
tions. Although these two remarkable women operate within vastly different arenas,
can their success be attributed to any common factors?
For neither of them can success be attributed to overwhelmingly superior resources.
For all of Queen Elizabeth’s formal status as head of state, she has very little real power
and, in most respects, is a servant of the democratically elected British government.
Lady Gaga is clearly a creative and capable entertainer, but few would claim that
she entered the music business with outstanding talents as a vocalist, musician, or
songwriter.
Introduction and Objectives
Strategy is about achieving success. This chapter explains what strategy is and why it is important to
success, for both organizations and individuals. We will distinguish strategy from planning. Strategy is
not a detailed plan or program of instructions; it is a unifying theme that gives coherence and direction
to the actions and decisions of an individual or an organization.
The principal task of this chapter will be to introduce the basic framework for strategy analysis that
underlies this book. This framework comprises two components of strategy analysis: analysis of the
external environment of the firm (mainly industry analysis) and analysis of the internal environment
(primarily analysis of the firm’s resources and capabilities). We shall then examine what strategy is, how it
has developed over time, how to describe the strategy of a business enterprise, and how organizations
go about making strategy.
Since the purpose of strategy is to help us to win, we start by looking at the role of strategy in success.
By the time you have completed this chapter, you will be able to:
◆ Appreciate the contribution that strategy can make to successful performance and rec-
ognize the essential components of an effective strategy.
◆ Comprehend the basic framework of strategy analysis that underlies this book.
◆ Recognize how strategic management has evolved over the past 60 years.
◆ Identify and describe the strategy of a business enterprise.
◆ Understand how strategy is made within organizations.
◆ Recognize the distinctive features of strategic management among not-for-profit orga-
nizations.

CHAPTER 1 THE CONCEPT Of STRATEgy 5
Nor can their success be attributed either exclusively or primarily to luck. Both have
experienced difficulties and setbacks at different stages of their careers. Central to their
success, however, has been their ability to respond to events—whether positive or neg-
ative—with flexibility and clarity of direction.
My contention is that, common to both the 60-year successful reign of Queen Eliza-
beth II and the short but stellar career of Lady Gaga, is the presence of a soundly for-
mulated and effectively implemented strategy. While these strategies did not exist as
explicit plans, for both Queen Elizabeth and Lady Gaga we can discern a consistency
of direction based upon clear goals and an ability to bend circumstances toward their
desired outcomes.
Elizabeth Windsor’s strategy as queen of the UK and the Commonwealth countries
is apparent in the relationship she has created between herself and her people. As
queen she is figurehead for the nation, an embodiment of its stability and continuity, a
symbol of British family and cultural life, and an exemplar of service and professional
dedication.
Lady Gaga’s remarkable success during 2008–18 reflects a career strategy that uses
music as a gateway to celebrity status, which she has built by combining the generic
tools of star creation—shock value, fashion leadership, and media presence—with a
uniquely differentiated image that has captured the attention and loyalty of teenagers
and young adults throughout the world.
What do these two examples tell us about the characteristics of a strategy that are
conducive to success? In both stories, four common factors stand out (Figure 1.1):
● Goals that are consistent and long term: Both Queen Elizabeth and Lady
Gaga display a focused commitment to career goals that they have pursued
steadfastly.
● Profound understanding of the competitive environment: The ways in
which both Elizabeth II and Lady Gaga define their roles and pursue their
careers reveal a deep and insightful appreciation of the external environ-
ments in which they operate. Queen Elizabeth has been alert both to the
changing political environment in which the monarchy is situated and to the
mood and needs of the British people. Lady Gaga’s business model and stra-
tegic positioning show a keen awareness of the changing economics of the
music business, the marketing potential of social networking, and the needs
of Generation Y.
● Objective appraisal of resources: Both Queen Elizabeth and Lady Gaga have
been adept at recognizing and deploying the resources at their disposal, and
also building those resources—for the Queen, this has included her family, the
royal household, and the recipients of royal patronage; for Lady Gaga, it com-
prises the creative talents of her Haus of Gaga.
● Effective implementation: Without effective implementation, the best-laid strat-
egies are of little use. Critical to the success of Queen Elizabeth and Lady Gaga
has been their effectiveness coordinating and leading “ecosystems” of sup-
portive individuals and organizations.
These observations about the role of strategy in success can be made in relation
to most fields of human endeavor. Whether we look at warfare, chess, politics, sport,
or business, the success of individuals and organizations is seldom the outcome of a

6 PART I INTRODUCTION
purely random process. Nor is superiority in initial endowments of skills and resources
typically the determining factor. Strategies that build on these four elements almost
always play an influential role.
Look at the “high achievers” in any competitive area. Whether we review the
world’s political leaders, the CEOs of the Fortune 500, or our own circles of friends
and acquaintances, those who have achieved outstanding success in their careers
are seldom those who possessed the greatest innate abilities. Success has gone to
those who managed their careers most effectively, typically by combining these
four strategic factors. They are goal focused; their career goals have taken pri-
macy over the multitude of life’s other goals—friendship, love, leisure, knowledge,
spiritual fulfillment—which the majority of us spend most of our lives juggling and
reconciling. They know the environments within which they play and tend to be
fast learners in terms of recognizing the paths to advancement. They know them-
selves well in terms of both strengths and weaknesses. Finally, they implement
STRATEGY CAPSULE 1.1
Queen Elizabeth II and the House of Windsor
By late 2018, Elizabeth Windsor had been queen for 66
years—longer than any of her predecessors.
At her birth on April 21, 1926, 45 other countries were
hereditary monarchies. By 2018, the forces of democracy,
modernity, and reform had reduced these to 26—mostly
small autocracies such as Bahrain, Qatar, Oman, Kuwait,
Bhutan, and Lesotho. Monarchies had also survived in
Denmark, Sweden, Norway, the Netherlands, and Bel-
gium, but these royal families had lost most of their
wealth and privileges.
By contrast, the British royal family retains con-
siderable wealth—the Queen’s personal net worth
is about $500 million—not including the $10 billion
worth of palaces and other real estate owned by the
nation but used by her and her family. Queen Eliza-
beth’s formal status is head of state of the UK and 15
other Commonwealth countries (including Canada and
Australia), head of the Church of England, and head of
the British armed forces. Yet none of these positions
confers any decision-making power—her influence
comes from the informal role she has established for
herself. According to her website, she “has a less formal
role as Head of Nation” where she “acts as a focus for
national identity, unity and pride; gives a sense of sta-
bility and continuity; officially recognises success and
excellence; and supports the ideal of voluntary service”
(www.royal.gov.uk).
How has Queen Elizabeth been able to retain not
just the formal position of the monarchy but also its
status, influence, and wealth despite so many chal-
lenges? These include wrenching social and political
changes and the trials of leading such a famously
dysfunctional family—including the failed marriages
of most of her children and the controversy that sur-
rounded the life and death of her daughter-in-law,
Diana, Princess of Wales.
At the heart of Elizabeth’s sustaining of the British
monarchy has been her single-minded devotion to what
she regards as her duties to the monarchy and to the
nation. In cultivating her role as leader of her nation, she
has preserved her political neutrality—even when she
has disagreed with her prime ministers (notably with

CHAPTER 1 THE CONCEPT Of STRATEgy 7
their career strategies with commitment, consistency, and determination. As the
management guru Peter Drucker observed: “we must learn how to be the CEO of
our own career.”1
There is a downside, however. Focusing on a single goal may lead to outstanding
success but may be matched by dismal failure in other areas of life. Many people who
have reached the pinnacles of their careers have led lives scarred by poor relationships
with friends and families and stunted personal development. These include Howard
Hughes and Jean Paul Getty in business, Richard Nixon and Joseph Stalin in politics,
Elvis Presley and Marilyn Monroe in entertainment, Tiger Woods and Boris Becker
in sport, and Bobby Fischer in chess. For most of us, personal fulfillment is likely to
require broad-based rather than narrowly focused goals.2
These same ingredients of successful strategies—clear goals, understanding the
competitive environment, resource appraisal, and effective implementation—form the
key components of our analysis of business strategy.
Margaret Thatcher’s “socially divisive” policies and Tony
Blair’s sending troops to Iraq and Afghanistan).
Through her outreach activities she promotes British
influence, British culture, and British values within the
wider world. She has made multiple visits to each of the
54 Commonwealth nations, including 27 to Canada and
16 to Australia.
The growing unacceptability of hereditary privilege
and the traditional British class system has required her
to reposition the royal family from being the leader of
the ruling class to embodying the nation as a whole. To
make her and her family more inclusive and less socially
stereotyped she has cultivated involvement with
popular culture, with ordinary people engaged in social
service and charitable work, and she has endorsed the
marriage of her grandsons William and Harry—the first
members of the royal family to marry outside the ranks
of the aristocracy.
Elizabeth has been adept at exploiting new media
for communicating both with her subjects and with a
wider global audience: initially through television, more
recently using the web, Twitter, and Facebook. Her press
and public relations staff comprises top professionals
who report to her private secretary.
While respecting tradition and protocol, she adapts
in the face of pressing circumstances. The death of her
daughter-in-law, Diana, created difficult tensions bet-
ween her responsibilities as mother and grandmother
and her need to show leadership to a grieving nation.
In responding to this crisis she recognized the need to
depart from established traditions.
Elizabeth has made effective use of the resources
available to her—especially the underlying desire of
the British people for continuity and their inherent
distrust of their political leaders. By positioning
herself above the political fray and emphasizing her
lineage—including the prominent public roles of her
mother and her children and grandchildren—she
reinforces the legitimacy of herself, her family, and the
institution they represent. She has also exploited her
powers of patronage, using her formal position to cul-
tivate informal relationships with both political and
cultural leaders.
The success of Elizabeth’s 66-year reign is indicated
by the popular support for her personally and for the
institution of the monarchy. Outside of Northern Ireland
and Quebec, republicanism is weak throughout the
British Commonwealth.

8 PART I INTRODUCTION
STRATEGY CAPSULE 1.2
Lady gaga and the Haus of gaga
Stefani Joanne Angelina Germanotta, better known as
Lady Gaga, is one of the most successful popular enter-
tainers of the 21st century. Since her first album, The
Fame, in 2008, all four of her albums have topped the Bill-
board charts; she has also topped Forbes Celebrity 100 list,
and generated $560 million in ticket sales from her five
concert tours between 2009 and 2017.
Since dropping out of NYU’s Tisch School of the Arts
in 2005, Germanotta has shown total commitment to
advancing her musical career, first as a songwriter, and
then developing her Lady Gaga persona.
Gaga’s music is a catchy mix of pop and dance, well
suited to dance clubs and radio airplay. It features good
melodies, Gaga’s capable vocals, and her reflections on
society and life, but it is hardly exceptional or innovative:
music critic Simon Reynolds described it as: “ruthlessly
catchy, naughties pop glazed with Auto-Tune and under-
girded with R&B-ish beats.”
However, music is only one element in the Lady Gaga
phenomenon—her achievement is not so much as a
singer or songwriter as in establishing a persona which
transcends pop music. Like David Bowie and Madonna
before her, Lady Gaga is famous for being Lady Gaga.
To do this she has created a multimedia, multifaceted
offering that comprises multiple components including
music, visual appearance, newsworthy events, a distinc-
tive attitude and personality, and a set of values with
which fans can identify.
Key among these is visual impact and theatricality.
Her hit records are promoted by visually stunning music
videos that have won Grammy awards and broken
records for numbers of YouTube downloads. Most striking
of all has been Lady Gaga’s dress and overall appearance,
which have set new standards in eccentricity, innovation,
and impact. Individual outfits—her plastic bubble dress,
meat dress, and “decapitated-corpse dress”—together
with weird hair-dos, extravagant hats, and extreme foot-
wear—are as well-known as her hit songs. The range of
visual images she projects means that her every appear-
ance creates a buzz of anticipation.
Lady Gaga has developed a business model adapted
to the post-digital world of entertainment. Like Web 2.0
pioneers such as Facebook and Twitter, Gaga has fol-
lowed the model: first build market presence, and then
think about monetizing that presence. By 2012, her
YouTube views, Facebook likes, and Twitter followers
had made her the “most popular living musician online.”
Her networking with fans includes Gagaville, an interac-
tive game developed by Zynga, and The Backplane, a
music-based social network.
Her emphasis on visual imagery takes account of the
means through which media popularity is converted
into revenues. While music royalties are important, con-
certs are her primary revenue source. Other revenue
sources—endorsements, product placement in videos
and concerts, merchandizing deals, and media appear-
ances—also link closely with her visual presence.
A distinctive feature of Gaga’s market positioning
is her relationship with her fans. The devotion of her
fans—her “Little Monsters”—is based less on their desire
to emulate her look as upon empathy with her values
and attitudes: Gaga’s images are social statements of
non-conformity rather than fashion statements. In com-
municating her experiences of alienation and bullying at
school and her values of individuality, sexual freedom,
and acceptance of differences, she has built a global fan
base of unusual loyalty and commitment. The sense of
belonging is reinforced by gestures and symbols such as
the “Monster Claw” greeting and the “Manifesto of Little
Monsters.” As “Mother Monster,” Gaga is spokesperson
and guru for this community.
Lady Gaga’s showmanship and theatricality are sup-
ported by The Haus of Gaga, a creative workshop modeled
on Andy Warhol’s “Factory.” It comprises a creative director
who coordinates a team of choreographers, fashion
designers, hair stylists, photographers, set designers, song-
writers, musicians, and marketing professionals.
Sources: M. Sala, “The Strategy of Lady Gaga,” BSc thesis Boc-
coni University, Milan, June 2011; http://www.biography.com/
people/lady-gaga-481598, accessed August 24, 2017.

http://www.biography.com/people/lady-gaga-481598

CHAPTER 1 THE CONCEPT Of STRATEgy 9
The Basic Framework for Strategy Analysis
Figure 1.2 shows the basic framework for strategy analysis that we shall use throughout
the book. The four elements of a successful strategy shown in Figure  1.1 are recast
into two groups—the firm and the industry environment—with strategy forming a
link between the two. The firm embodies three of these elements: goals and values
(“simple, consistent, long-term goals”), resources and capabilities (“objective appraisal
of resources”), and structure and systems (“effective implementation”). The industry
environment embodies the fourth (“profound understanding of the competitive envi-
ronment”) and is defined by the firm’s relationships with competitors, customers, and
suppliers.
This view of strategy as a link between the firm and its industry environment has
close similarities with the widely used SWOT framework. However, as I explain in
Strategy Capsule 1.3, a two-way classification of internal and external forces is superior
to the four-way SWOT framework.
The task of business strategy, then, is to determine how the firm will deploy its
resources within its environment and so satisfy its long-term goals and how it will orga-
nize itself to implement that strategy.
Profound
understanding of the
competitive environment
Objective
appraisal
of resources
EFFECTIVE IMPLEMENTATION
Clear, consistent,
long-term
goals
Successful
strategy
FIGURE 1.1 Common elements in successful strategies
STRATEGY
THE FIRM
• Goals and Values
• Resources and
Capabilities
• Structure and
Systems
THE INDUSTRY
ENVIRONMENT
• Competitors
• Customers
• Suppliers
FIGURE 1.2 The basic framework: Strategy as a link between the firm and its environment

10 PART I INTRODUCTION
Strategic Fit
Fundamental to this view of strategy as a link between the firm and its external envi-
ronment is the notion of strategic fit. This refers to the consistency of a firm’s strategy,
first, with the firm’s external environment and, second, with its internal environment,
especially with its goals and values and resources and capabilities. A major reason for
companies’ decline and failure is a strategy that lacks consistency with either the internal
or the external environment. The woes of the Italian airline, Alitalia, may be attributed to
a strategy that failed to respond to competition from budget airlines such as Ryanair and
EasyJet. Other companies struggle to align their strategies to their internal resources and
capabilities. A critical issue for Nintendo will be whether it possesses the financial and
technological resources to continue to compete head-to-head with Sony and Microsoft
in the market for video game consoles.
The concept of strategic fit also relates to the internal consistency among the differ-
ent elements of a firm’s strategy. An effective strategy is one in which all the decisions
and actions that make up the strategy are aligned with one another to create a con-
sistent strategic position and direction of development. This notion of internal fit is
central to Michael Porter’s conceptualization of the firm as an activity system. Porter
STRATEGY CAPSULE 1.3
What’s Wrong with SWOT?
Distinguishing between the external and the internal
environment of the firm is common to most approaches
to strategy analysis. The best-known and most widely
used of these is the “SWOT” framework, which classifies
the various influences on a firm’s strategy into four cat-
egories: Strengths, Weaknesses, Opportunities, and
Threats. The first two—strengths and weaknesses—
relate to the internal environment of the firm, primarily its
resources and capabilities; the last two—opportunities
and threats—relate to the external environment.
Which is better, a two-way distinction between
internal and external influences or the four-way SWOT
taxonomy? The key issue is whether it is sensible and
worthwhile to classify internal factors into strengths
and weaknesses and external factors into opportu-
nities and threats. In practice, these distinctions are
problematic.
Was Zlatan Ibrahimovic a strength or a weakness for
Manchester United? As the team’s top scorer during the
2016–17 season and ranking among the world’s top-10
players, he was a strength. But as a player whose best
days were behind him and whose dominant presence
intimidated his younger team-mates, he was a weakness.
Is global warming a threat or an opportunity for the
world’s automobile producers? By encouraging higher
taxes on motor fuels and restrictions on car use, it is a threat.
By encouraging consumers to switch to fuel-efficient and
electric cars, it offers an opportunity for new sales.
The lesson here is that classifying external factors
into opportunities and threats, and internal factors into
strengths and weaknesses, is arbitrary. What is important
is to carefully identify the external and internal forces that
impact the firm, and then analyze their implications.
In this book, I will follow a simple two-way classification
of internal and external factors and avoid any premature
categorization into strengths or weaknesses, and oppor-
tunities or threats.
Note: For more on SWOT see: T. Hill and R. Westbrook, “SWOT
Analysis: It’s Time for a Product Recall,” Long Range Planning, 30
(February 1997): 46–52; and M. Venzin, “SWOT Analysis: Such
a Waste of Time?” (February 2015) http://ideas.sdabocconi.it/
strategy/archives/3405.

http://ideas.sdabocconi.it/strategy/archives/3405

CHAPTER 1 THE CONCEPT Of STRATEgy 11
states that “Strategy is the creation of a unique and differentiated position involving a
different set of activities.”3 The key is how these activities fit together to form a consis-
tent, mutually reinforcing system. Ryanair’s strategic position is as Europe’s lowest-cost
airline providing no-frills flights to budget-conscious travelers. This is achieved by a
set of activities that fit together to support that positioning (Figure 1.3).
The concept of strategic fit is one component of a set of ideas known as
contingency theory. Contingency theory postulates that there is no single best
way of organizing or managing. The best way to design, manage, and lead an orga-
nization depends upon circumstances—in particular, the characteristics of that orga-
nization’s environment.4
A Brief History of Business Strategy
Origins and Military Antecedents
Enterprises need business strategies for much the same reason that armies need mili-
tary strategies—to give direction and purpose, to deploy resources in the most effec-
tive manner, and to coordinate the decisions made by different individuals. Many
of the concepts and theories of business strategy have their antecedents in military
strategy. The term strategy derives from the Greek word strategia, meaning “general-
ship.” However, the concept of strategy predates the Greeks: Sun Tzu’s classic, The Art
of War, from about 500 BC is regarded as the first treatise on strategy.5
Military strategy and business strategy share a number of common concepts and
principles, the most basic being the distinction between strategy and tactics. Strategy
is the overall plan for deploying resources to establish a favorable position; a tactic
is a scheme for a specific action. Whereas tactics are concerned with the maneu-
vers necessary to win battles, strategy is concerned with winning the war. Strategic
decisions, whether in military or business spheres, share three common characteristics:
● They are important.
● They involve a significant commitment of resources.
● They are not easily reversible.
Low operating costs
Secondary
airports
Point-to-point routes
25-min
turnaround
High aircraft
utilization
No-frills product
offering
High labor
productivity
Low prices;
separate charging
for additional
services
Single class; no
reserved seating
No baggage
transfer
Internet-only
check-in
Job
f lexibility
Direct
sales
only
Boeing
737s only
FIGURE 1.3 Ryanair’s activity system

12 PART I INTRODUCTION
Many of the principles of military strategy have been applied to business situations.
These include the relative strengths of offensive and defensive strategies; the merits of
outflanking over frontal assault; the roles of graduated responses to aggressive initia-
tives; the benefits of surprise; and the benefits of deception, envelopment, escalation,
and attrition.6 At the same time, there are major differences between business compe-
tition and military conflict. The objective of war is (usually) to defeat the enemy. The
purpose of business rivalry is seldom so aggressive: most business enterprises seek to
coexist with their rivals rather than to destroy them.
Despite parallels between military and business strategy, we lack a general theory
of strategy. The publication of Von Neumann and Morgenstern’s Theory of Games in
1944 gave rise to the hope that a general theory of competitive behavior would emerge.
Since then, game theory has revolutionized the study of competitive interaction, not
just in business but in politics, military studies, and international relations as well.
Yet, as we shall see in Chapter 4, game theory has achieved only limited success as a
broadly applicable general theory of strategy.7
From Corporate Planning to Strategic Management
The evolution of business strategy has been driven more by the practical needs of
business than by the development of theory. During the 1950s and 1960s, senior exec-
utives experienced increasing difficulty in coordinating decisions and maintaining con-
trol in companies that were growing in size and complexity. While new techniques of
discounted cash flow analysis allowed more rational choices over individual investment
projects, firms lacked systematic approaches to their long-term development. Corpo-
rate planning (also known as long-term planning) was developed during the late-
1950s to serve this purpose. Macroeconomic forecasts provided the foundation for
the new corporate planning. The typical format was a five-year corporate planning
document that set goals and objectives, forecasted key economic trends (including
market demand, the company’s market share, revenue, costs, and margins), established
priorities for different products and business areas of the firm, and allocated capital
expenditures. The new techniques of corporate planning proved particularly useful for
guiding the diversification strategies that many large companies pursued during the
1960s.8 By the mid-1960s, most large US and European companies had set up corpo-
rate planning departments. Strategy Capsule 1.4 provides an example of this formalized
corporate planning.
By the early 1980s, confidence in corporate planning had been severely shaken. Not
only did diversification fail to deliver the anticipated synergies, but the oil shocks of
1974 and 1979 ushered in a new era of macroeconomic instability, while Western com-
panies came under increasing pressure from Japanese, Korean, and Southeast Asian
competitors. Companies could no longer plan their investments and actions five years
ahead—they couldn’t forecast that far.
The result was a shift in emphasis from planning a company’s growth path to
positioning the company so that it could best exploit available opportunities for
profit. This transition from corporate planning to what became called strategic
management involved a focus on competition as the central characteristic of the
business environment and on performance maximization as the primary goal of
strategy.
This emphasis on strategy as a quest for performance directed attention to the
sources of profitability. At the end of the 1970s, Michael Porter pioneered the applica-
tion of industrial organization economics to analyzing the profit potential of different

CHAPTER 1 THE CONCEPT Of STRATEgy 13
industries and markets.9 Other studies examined how strategic variables—notably
market share—determined how profits were distributed between the firms within an
industry.10
During the 1990s, the focus of strategy analysis shifted from the sources of profit in
the external environment to the sources of profit within the firm. The resource-based
view of the firm identified the resources and capabilities of the firm as its main
source of competitive advantage and the primary basis for formulating strategy.11 This
emphasis on internal resources and capabilities has encouraged firms to identify how
they are different from their competitors and to design strategies that exploit these
differences.
During the 21st century, new challenges have continued to shape the princi-
ples and practice of strategy. Digital technologies have had a massive impact on
the competitive dynamics of many industries, creating winner-take-all markets
and standards wars.12 Disruptive technologies13 and accelerating rates of change
have meant that strategy has become less and less about plans and more about
creating options of the future,14 fostering strategic innovation,15 and seeking the
“blue oceans” of uncontested market space.16 The complexity of these challenges
has meant that being self-sufficient is no longer viable for most firms—alliances and
other forms of collaboration are an increasingly common feature of firms’ strategies.
The 2008–2009 financial crisis triggered closer scrutiny of purpose of business. Dis-
illusion with the excesses and unfairness of market capitalism has renewed interest in
corporate social responsibility, ethics, sustainability, and the legitimacy of profit as the
dominant goal of business.17
Figure 1.4 summarizes the main developments in strategic management since the
mid-20th century.
STRATEGY CAPSULE 1.4
Corporate Planning in a Large US Steel Company, 1965
The first step in developing long-range plans was to
forecast the product demand for future years. After cal-
culating the tonnage needed in each sales district to pro-
vide the “target” fraction of the total forecast demand, the
optimal production level for each area was determined.
A computer program that incorporated the projected
demand, existing production capacity, freight costs, etc.
was used for this purpose.
When the optimum production rate in each area was
found, the additional facilities needed to produce the
desired tonnage were specified. Then, the capital costs
for the necessary equipment, buildings, and layout were
estimated by the chief engineer of the corporation and
various district engineers. Alternative plans for achiev-
ing company goals were also developed for some areas,
and investment proposals were formulated after consid-
ering the amount of available capital and the company
debt policy. The vice president who was responsible for
long-range planning recommended certain plans to the
president, and, after the top executives and the board
of directors reviewed alternative plans, they made the
necessary decisions about future activities.
Source: H. W. Henry, Long Range Planning Processes in 45
Industrial Companies (Englewood Cliffs, NJ: Prentice-Hall,
1967): 65.

14 PART I INTRODUCTION
1950
1960
• Operational budgeting
• DCF capital budgeting
Financial Budgeting:
1970
Corporate Planning:
• Corporate plans based on medium-term
economic forecasts
1980
Emergence of Strategic Management:
• Industry analysis and competitive positioning
1990
The Quest for Competitive Advantage:
• Emphasis on resources and capabilities
• Shareholder value maximization
2000
2018
• Refocusing, outsourcing, delayering, cost
cutting
Adapting to Turbulence:
• Adapting to and exploiting digital technology
• The quest for flexibility and strategic innovation
• Strategic alliances
• Social and environmental responsibility
FIGURE 1.4 Evolution of strategic management
Strategy Today
What Is Strategy?
In its broadest sense, strategy is the means by which individuals or organizations
achieve their objectives. Table  1.1 presents a number of definitions of the term
strategy. Common to most definitions is the notion that strategy involves setting goals,
allocating resources, and establishing consistency and coherence among decisions
and actions.
Yet, as we have seen, the conception of firm strategy has changed greatly over
the past half-century. As the business environment has become more unstable and
unpredictable, so strategy has become less concerned with detailed plans and more
about guidelines for success. This is consistent with the introductory examples to
this chapter. Neither Queen Elizabeth nor Lady Gaga appears to have articulated any
explicit strategic plan, but the consistency we discern in their actions suggests both
possessed clear ideas of what they wanted to achieve and how they would achieve
it. This shift in emphasis from strategy as plan to strategy as direction does not imply
any downgrading of the role of strategy. The more turbulent the environment, the
more strategy must embrace flexibility and responsiveness. But it is precisely under
these conditions that strategy becomes more, rather than less, important. When the
firm is buffeted by unforeseen threats and where new opportunities are constantly
appearing, then strategy becomes the compass that can navigate the firm through
stormy seas.

CHAPTER 1 THE CONCEPT Of STRATEgy 15
Why Do Firms Need Strategy?
This transition from strategy as plan to strategy as direction raises the question of
why firms (or other types of organization) need strategy. Strategy assists the effective
management of organizations, first, by enhancing the quality of decision-making, sec-
ond, by facilitating coordination, and, third, by focusing organizations on the pursuit
of long-term goals.
Strategy as Decision Support Strategy is a pattern or theme that gives coher-
ence to the decisions of an individual or organization. But why can’t individuals
or organizations make optimal decisions in the absence of such a unifying theme?
Consider the 1997 “man versus machine” chess epic in which Garry Kasparov was
defeated by IBM’s “Deep Blue” computer. Deep Blue did not need strategy. Its phe-
nomenal memory and computing power allowed it to identify its optimal moves
based on a huge decision tree.18 Kasparov—although the world’s greatest chess
player—was subject to bounded rationality: his decision analysis was subject to the
cognitive limitations that constrain all human beings.19 For him, a strategy offered
guidance that assisted positioning and helped create opportunities. Strategy improves
decision-making in several ways:
● It simplifies decision-making by constraining the range of decision alternatives
considered and acting as a heuristic—a rule of thumb that reduces the search
required to find an acceptable solution to a decision problem.
● The strategy-making process permits the knowledge of different individuals to
be pooled and integrated.
● It facilitates the use of analytic tools—the frameworks and techniques that we
will encounter in the ensuing chapters of this book.
Strategy as a Coordinating Device The central challenge of management is
coordinating the actions of multiple organizational members. Strategy acts as a com-
munication device to promote coordination. Statements of strategy are a means by
TABLE 1.1 Some definitions of strategy
● Strategy: a plan, method, or series of actions designed to achieve a specific goal or effect.
—Wordsmyth Dictionary (www.wordsmyth.net)
● The determination of the long-run goals and objectives of an enterprise, and the adoption of
courses of action and the allocation of resources necessary for carrying out these goals.
—Alfred Chandler, Strategy and Structure
(Cambridge, MA: MIT Press, 1962)
● Strategy: “a cohesive response to an important challenge.”
—Richard Rumelt, Good Strategy/Bad Strategy
(New York: Crown Business, 2011): 6.
● Lost Boy: “Injuns! Let’s go get ’em!”
John Darling: “Hold on a minute. First we must have a strategy.”
Lost Boy: “Uhh? What’s a strategy?”
John Darling: “It’s, er … it’s a plan of attack.”
—Walt Disney’s Peter Pan

16 PART I INTRODUCTION
which the CEO can communicate the identity, goals, and positioning of the company
to all organizational members. The strategic planning process provides a forum in
which views are exchanged and consensus developed; once formulated, strategy can
be translated into goals, commitments, and performance targets that ensure that the
organization moves forward in a consistent direction.
Strategy as Target Strategy is forward looking. It is concerned not only with how
the firm will compete now, but also with what the firm will become in the future.
A forward-looking strategy establishes direction for the firm’s development and sets
aspirations that can motivate and inspire members of the organization. Gary Hamel
and C. K. Prahalad use the term strategic intent to describe this desired strategic
position: “strategic intent creates an extreme misfit between resources and ambitions.
Top management then challenges the organization to close the gap by building new
competitive advantages.”20 The implication is that strategy should embrace stretch and
resource leverage and not be overly constrained by considerations of strategic fit.21
Jim Collins and Jerry Porras make a similar point: US companies that have been sector
leaders for 50 years or more have all generated commitment and drive through setting
“Big, Hairy, Ambitious Goals.”22 Striving, inspirational goals are found in most organiza-
tions’ statements of vision and mission. One of the best known is that set by President
Kennedy for NASA’s space program: “before this decade is out, to land a man on the
moon and return him safely to earth.” However, goals on their own do not constitute
a strategy. Unless an organization’s goals are backed by guidelines for their attainment,
they are likely to be either meaningless or delusional.23
Where Do We Find Strategy?
Strategy has its origins in the thought processes of organizational leaders. For the entre-
preneur, the starting point of strategy is the idea for a new business. Until the new
business needs to raise finance, there is little need for any explicit statement of strategy.
At that point, the entrepreneur articulates the strategy in a business plan. In large
companies, strategy formulation is an explicit management process and statements of
strategy are found in board minutes and strategic planning documents, which are inva-
riably confidential. However, most companies—public companies in particular—see
value in communicating their strategy to employees, customers, investors, and business
partners. Collis and Rukstad identify four types of statement through which companies
communicate their strategies:
● The mission statement describes organizational purpose; it addresses “Why
we exist.”
● A statement of principles or values outlines “What we believe in and how we
will behave.”
● The vision statement projects “What we want to be.”
● The strategy statement articulates the company’s competitive game plan, which
typically describes objectives, business scope, and advantage.24
These statements can be found on the corporate pages of companies’ websites. More
detailed statements of strategy—including qualitative and quantitative medium-term
targets—are often found in top management presentations to analysts, which are
typically included in the “for investors” pages of company websites. Strategy Capsule
1.5 shows statements of strategy by McDonalds and Twitter.

CHAPTER 1 THE CONCEPT Of STRATEgy 17
STRATEGY CAPSULE 1.5
Statements of Company Strategy: McDonald’s and Twitter
McDONALD’S CORPORATION
Our goal is to become customers’ favorite place and
way to eat and drink by serving core favorites such
as our World Famous Fries, Big Mac, Quarter Pounder
and Chicken McNuggets.
The strength of the alignment among the
Company, its franchisees and suppliers (collectively
referred to as the “System”) has been key to McDonald’s
success. By leveraging our System, we are able to iden-
tify, implement and scale ideas that meet customers’
changing needs and preferences.
McDonald’s customer-focused Plan to Win (“Plan”)
provides a common framework that aligns our global
business and allows for local adaptation. We con-
tinue to focus on our three global growth priorities
of optimizing our menu, modernizing the customer
experience, and broadening accessibility to Brand
McDonald’s within the framework of our Plan. Our
initiatives support these priorities, and are executed
with a focus on the Plan’s five pillars—People, Prod-
ucts, Place, Price and Promotion—to enhance our
customers’ experience and build shareholder value
over the long term. We believe these priorities align
with our customers’ evolving needs, and—combined
with our competitive advantages of convenience,
menu variety, geographic diversification and System
alignment—will drive long-term sustainable growth.
Source: www.mcdonalds.com.
TWITTER, INC.
We have aligned our growth strategy around the
three primary constituents of our platform:
Users. We believe that there is a significant oppor-
tunity to expand our user base…
◆ Geographic Expansion. We plan to develop a
broad set of partnerships globally to increase rele-
vant local content … and make Twitter more acces-
sible in new and emerging markets.
◆ Mobile Applications. We plan to continue to
develop and improve our mobile applications…
◆ Product Development. We plan to continue to
build and acquire new technologies to develop
and improve our products and services…
Platform Partners. We believe growth in our
platform partners is complementary to our user
growth strategy…
◆ Expand the Twitter Platform to Integrate More
Content. We plan to continue to build and acquire
new technologies to enable our platform partners
to distribute content of all forms.
◆ Partner with Traditional Media  …  to drive more
content distribution on our platform…
Advertisers… [I]ncrease the value of our platform
for our advertisers by enhancing our advertising
services and making our platform more accessible.
◆ Targeting. We plan to continue to improve the tar-
geting capabilities of our advertising services.
◆ Opening our Platform to Additional Advertisers.
We believe that advertisers outside of the United
States represent a substantial opportunity…
◆ New Advertising Formats.
Source: Twitter, Inc. Amendment no. 4 to Form S-1, Registration
Statement, SEC, November 4, 2013.

18 PART I INTRODUCTION
All these are intentions and, as we shall see, strategic intent is not necessarily real-
ized. Ultimately, strategy is realized as action. Hence, strategy is observable in where
and how a firm chooses to compete. For example, information on a firm’s business
scope (products and its markets) and how it competes within these markets can be
found in a company’s annual reports. For US corporations, the description of the
business that forms Item 1 of the 10-K annual report to the Securities and Exchange
Commission (SEC) is particularly informative about strategy.
Checking a company’s pronouncements about strategy against its decisions and
actions may reveal a gap between rhetoric and reality. As a reality check upon gran-
diose and platitudinous sentiments of vision and mission, it is useful to ask:
● Where is the company investing its money? Notes to financial statements
provide detailed breakdowns of capital expenditure by region and by
business segment.
● What technologies is the company developing? Identifying the patents that a
company has filed (using the online databases of the US and EU patent offices)
indicates the technological trajectory a firm is pursuing.
● What new products have been released, major investment projects initiated, and
top management hired? These strategic decisions are typically announced in
press releases and reported in trade journals.
To identify a firm’s strategy it is necessary to draw upon multiple sources of
information in order to build an overall picture of what the company says it is doing
matches what it is actually doing. We will return to this topic when we discuss compet-
itive intelligence in Chapter 4.
Corporate and Business Strategy
Strategic choices can be distilled into two basic questions:
● Where to compete?
● How to compete?
The answers to these questions define the two major areas of a firm’s strategy: cor-
porate strategy and business strategy.
Corporate strategy defines the scope of the firm in terms of the industries and mar-
kets in which it competes. Corporate strategy decisions include choices over diver-
sification, vertical integration, acquisitions, and new ventures, and the allocation of
resources between the different businesses of the firm.
Business strategy is concerned with how the firm competes within a particular
industry or market. If the firm is to prosper within an industry, it must establish a
competitive advantage over its rivals. Hence, this area of strategy is also referred to as
competitive strategy.
The distinction between corporate strategy and business strategy corresponds to the
organizational structure of most large companies. Corporate strategy is the responsi-
bility of corporate top management. Business strategy is primarily the responsibility of
the senior managers of divisions and subsidiaries.
This distinction between corporate and business strategy also corresponds to the pri-
mary sources of superior profit for a firm. To survive and prosper over the long term,

CHAPTER 1 THE CONCEPT Of STRATEgy 19
a firm must earn a rate of return on its capital that exceeds its cost of capital. There are
two possible ways of achieving this. First, by locating within industries that offer attrac-
tive rates of profit (corporate strategy). Second, by establishing a competitive advantage
over rivals within an industry (Figure 1.5). This distinction may be expressed even more
simply. The basic question facing the firm is “How do we make money?” This prompts
the two basic strategic choices we identified above: “Where to compete?” and “How
to compete?”
As an integrated approach to firm strategy, this book deals with both business and
corporate strategy. However, our primary emphasis will be on business strategy. This
is because the critical requirement for a company’s success is its ability to establish
competitive advantage. Hence, issues of business strategy precede those of corporate
strategy. At the same time, these two dimensions of strategy are intertwined: the scope
of a firm’s business has implications for the sources of competitive advantage, and the
nature of a firm’s competitive advantage determines the industries and markets it can
be successful in.
Describing Strategy
These same two questions—“Where is the firm competing?” and “How is it com-
peting?”—also provide the basis upon which we can describe the strategy that a firm
is pursuing. The where question has multiple dimensions. It relates to the products the
firm supplies, the customers it serves, the countries and localities where it operates,
and the vertical range of activities it undertakes. The how question relates to the nature
of the firm’s competitive advantage: Is it seeking a cost advantage or a differentiation
advantage? How is the firm using its distinctive resources and capabilities to establish
a competitive advantage?
However, strategy is not simply about “competing for today”; it is also concerned
with “competing for tomorrow.” This dynamic aspect of strategy involves establishing
objectives for the future and determining how they will be achieved. Future objectives
relate to the overall purpose of the firm (mission), what it seeks to become (vision),
and how it will meet specific performance targets.
These two dimensions of strategy—the static and the dynamic—are depicted
in Figure  1.6. As we shall see in Chapter  8, reconciling these two dimensions of
CORPORATE
STRATEGY
BUSINESS
STRATEGY
COMPETITIVE
ADVANTAGE
How to
compete?
INDUSTRY
ATTRACTIVENESS
Where to compete?RATE OF PROFIT
ABOVE THE COST
OF CAPITAL
How do we
make money?
FIGURE 1.5 The sources of superior profitability

20 PART I INTRODUCTION
strategy—what Derek Abell calls “competing with dual strategies”—is one of the central
dilemmas of strategic management.25
How is Strategy Made? The Strategy Process
How companies make strategy and how they should make strategy are among the most
hotly debated issues in strategic management. The corporate planning undertaken by
large companies during the 1960s was a highly formalized approach to strategy mak-
ing. Strategy may also be made informally: emerging through adaptation to circum-
stances. In our opening discussion of Queen Elizabeth and Lady Gaga, I discerned
a consistency and pattern to their career decisions that I identified as strategy, even
though there is no evidence that either of them engaged in any systematic process of
strategy formulation. Similarly, successful companies are seldom the products of grand
designs. The rise of Apple Inc. to become the world’s most valuable company (in terms
of stock market capitalization) has often been attributed to a brilliant strategy of inte-
grating hardware, software, and design aesthetics to create electronic products that
offered a unique consumer experience. Yet, there is little evidence that Apple’s incred-
ible success since 2004 was the result of an explicit strategy. Apple’s huge success with
its iPod, iPhone, and iPad was the outcome of a set of strategic decisions that combined
Steve Job’s penetrating insight into consumer preferences and technological trends with
Apple’s capabilities in design, marketing, the integration of hardware and software, and
the management of an ecosystem of partners.
So, what does this mean for strategy making by companies and other organizations?
Should managers seek to formulate strategy through a rational systematic process, or
is the best approach in a turbulent world to respond to events with opportunism and
creativity?
Design versus Emergence
Henry Mintzberg is a leading critic of rational, analytical approaches to strategy design.
He distinguishes intended, emergent, and realized strategies. Intended strategy is
COMPETING FOR THE
PRESENT
PREPARING FOR THE
FUTURE
Strategy as Direction
• What do we want to become?
-Vision statement
• What do we want to achieve?
-Mission statement
-Performance goals
• How will we get there?
-Guidelines for development
-Priorities for capital expenditure,
R & D
-Growth modes: organic growth,
M & A, alliances
Strategy as Positioning
• Where are we competing?
-Product market scope
-Geographical scope
-Vertical scope
• How are we competing?
-What is the basis of our
competitive advantage?
FIGURE 1.6 Describing firm strategy: Competing in the present, preparing for
the future

CHAPTER 1 THE CONCEPT Of STRATEgy 21
strategy as conceived of by the leader or top management team. Even here, intended
strategy may be less a product of rational deliberation and more an outcome of
inspiration, negotiation, bargaining, and compromise among those involved in the
strategy-making process. However, realized strategy—the actual strategy that is
implemented—is only partly related to that which was intended (Mintzberg suggests
only 10–30% of intended strategy is realized). The primary determinant of realized
strategy is what Mintzberg terms emergent strategy—the decisions that emerge from
the complex processes in which individual managers interpret the intended strategy
and adapt it to changing circumstances.26
According to Mintzberg, rational design is not only an inaccurate account of how
strategies are actually formulated but also a poor way of making strategy: “The notion
that strategy is something that should happen way up there, far removed from the
details of running an organization on a daily basis, is one of the great fallacies of
conventional strategic management.”27 The emergent approaches to strategy-making
permit adaptation and learning through a continuous interaction between strategy for-
mulation and strategy implementation in which strategy is constantly being adjusted
and revised in the light of experience.
The debate between those who view strategy-making as a rational, analytical pro-
cess of deliberate planning (the design school) and those who envisage strategy-making
as an emergent process (the process or learning school of strategy) has centered on the
case of Honda’s successful entry into the US motorcycle market during the early 1960s.28
The Boston Consulting Group lauded Honda for its single-minded pursuit of a global
strategy based on exploiting economies of scale and learning to establish unassailable
cost leadership.29 However, subsequent interviews with the Honda managers in charge
of its US market entry revealed a different story: a haphazard, experimental approach
with little analysis and no clear plan.30 As Mintzberg observes: “Brilliant as its strategy
may have looked after the fact, Honda’s managers made almost every conceivable mis-
take until the market finally hit them over the head with the right formula.”31
In practice, strategy-making involves both thought and action: “Strategy exists in the
cognition of managers but also is reified in what companies do.”32 Top-down rational
design is combined with decentralized adaptation:
● The design aspect of strategy comprises organizational processes through which
strategy is deliberated, discussed, and decided. These include board meet-
ings, a strategic planning process, and informal participative events, such as
strategy workshops. I will discuss processes of strategic planning more fully in
Chapter 6.
● The enactment of strategy through decisions and actions being taken throughout
the organization is a decentralized process where middle managers play a central
role. These emergent processes are typically viewed as occurring when formal
strategic plans are being implemented. However, these emergent processes may
come first. Intel’s historic decision to abandon memory chips and concentrate on
microprocessors was initiated in the operational decisions of business unit and
plant managers and subsequently adopted as strategy by top management.33
I refer to this process of strategy-making that combines design and emergence as
“planned emergence.”34 The balance between the two depends greatly upon the sta-
bility and predictability of the organization’s business environment. The Roman Catholic
Church and La Poste, the French postal service, inhabit relatively stable environments;
they can plan activities and resource allocations in some detail quite far into the future.

22 PART I INTRODUCTION
For WikiLeaks, the Somali Telecom Group, and Islamic State, strategic planning will
inevitably be restricted to a few guidelines; most strategic decisions must be responses
to unfolding circumstances.
As the business environment becomes more turbulent and less predictable, so
strategy-making becomes less about detailed decisions and more about guidelines
and general direction. Bain & Company advocates the use of strategic principles—
“pithy, memorable distillations of strategy that guide and empower employees”—to
combine consistent focus with adaptability and responsiveness.35 McDonald’s strategy
statement in Strategy Capsule 1.5 is an example of such strategic principles. Similarly,
Southwest Airlines encapsulates its strategy in a simple statement: “Meet customers’
short-haul travel needs at fares competitive with the cost of automobile travel.”
For fast-moving businesses, strategy may be reduced to a set of “simple rules.” For
example, Lego evaluates new product proposals by applying a checklist of rules:
“Does the product have the Lego look?” “Will children learn while having fun?” “Does
it stimulate creativity?”36
Applying Strategy Analysis
Despite the criticisms leveled at rational, analytical approaches to strategy formulation,
the emphasis of this book will be the application of analytical tools to strategy issues.
This is not because I wish to downplay the role of intuition, creativity, or spontaneity—
these qualities are essential ingredients of successful strategies. Nevertheless, whether
strategy formulation is formal or informal, deliberate or emergent, systematic analysis
leads to better decisions and helps protect strategic decision-making from power battles,
whims, fads, and wishful thinking. Concepts, theories, and analytic tools are comple-
ments to, and not substitutes for, intuition and creativity, and they provide a framework
for organizing discussion, processing information, and developing consensus.
We must also recognize limitations of strategy analysis. Unlike many of the analytical
techniques in accounting, finance, market research, or production management, strategy
analysis does not offer algorithms or formulae that tell us the optimal strategy to adopt.
The purpose of strategy analysis is not to provide answers but to help us to probe
the relevant issues. By providing a framework that allows us to examine the factors
that influence a strategic situation and organize relevant information, strategy analysis
places us in a superior position to a manager who relies exclusively on experience
and intuition. Finally, to the extent that our analytic tools are not specific to individual
businesses or situations, they can improve our flexibility as managers. The concepts
and frameworks we shall cover are not specific to particular industries, companies, or
situations. Hence, they can help increase our confidence and effectiveness in under-
standing and responding to new situations and new circumstances.
So, how do we go about applying our tools of strategy analysis in a systematic and
productive way that allows us to make sound strategy recommendations? Developing a
strategy for a business typically involves four main stages. These are shown in Figure 1.7.37
1. Setting the strategic agenda. Any strategy-making exercise must begin by iden-
tifying the important issues that the strategy must address. For an existing
company, this involves assessing whether the current strategy is working, which
requires that we:
● Identify the current strategy. A vital preliminary step is to establish consensus
around what the current strategy is. The above sections on Where Do We Find
Strategy? and Describing Strategy offer guidance in this.

CHAPTER 1 THE CONCEPT Of STRATEgy 23
● Appraise performance. How well is the current strategy performing? In
the next chapter, we shall how to apply financial analysis to assess firm
performance.
2. Analyzing the situation
● Diagnose performance. Having determined the level and trend of the firm’s
performance, the next challenge is diagnosis: In the case of poor performance,
what are the sources of unsatisfactory performance? In the case of good
performance, what are the factors driving this? Chapter 2 offers guidance on
performance. Dick Rumelt puts it even more succinctly: the core question in
most strategy situations is, “What’s going on here?”38
● Industry analysis. To determine whether the current strategy needs to be
changed, we need to look not just at how it is currently performing, but how
it will perform in the future. This requires looking at the likely changes in the
firm’s industry and their implications. Chapters 3 and 4 address industry
analysis.
● Analysis of resources and capabilities. Having established likely external
changes, what do these mean for the firm’s competitive position? This
requires analysis of the firm’s resources and capabilities—which we address
in Chapter 5.
3. Formulating strategy. Performance diagnosis, industry analysis, and resource
and capability analysis provide a basis for generating strategic options, the most
promising of which can be developed into a recommended strategy. Recom-
mended strategies tend to avoid precise specifications of what is to be done, they
are more likely to articulate the primary basis for a firm’s competitive advantage
and what this means for how it will compete. Chapter 7 discusses how the inter-
section of internal strengths and external success factors create the basis for a
firm’s competitive advantage.
4. Implement strategy. Without action, a strategy is merely an idea expressed
in words. Implementing strategy requires allocating resources and moti-
vating people. As we shall see in Chapter 6, this requires putting in place the
organizational structure and management systems within which action can
take place.
Setting the
strategic agenda
Analyzing the
situation
Formulating
strategy
Implementing
strategy
Identify the
current
strategy
Appraise
performance
Diagnose
performance
Industry
analysis
Analysis of
resources and
capabilities
Formulate
strategy
Implement
strategy
FIGURE 1.7 Applying strategy analysis

24 PART I INTRODUCTION
Strategic Management of Not-For-Profit Organizations
When strategic management meant top-down, long-range planning, there was little dis-
tinction between business corporations and not-for-profit organizations: the techniques
of forecast-based planning applied equally to both. As strategic management has become
increasingly oriented toward the identification and exploitation of sources of profit, it has
become more closely identified with for-profit organizations. So, can the concepts and
tools of corporate and business strategy be applied to not-for-profit organizations?
The short answer is yes. Strategy is as important in not-for-profit organizations as it is in
business firms. The benefits I have attributed to strategic management in terms of improved
decision-making, achieving coordination, and setting performance targets (see the section
“Why Do Firms Need Strategy?” above) may be even more important in the nonprofit sec-
tor. Moreover, many of the same concepts and tools of strategic analysis are readily appli-
cable to not-for-profits—albeit with some adaptation. However, the not-for-profit sector
encompasses a vast range of organizations. Both the nature of strategic planning and the
appropriate tools for strategy analysis differ among these organizations.
The basic distinction here is between those not-for-profits that operate in com-
petitive environments (most nongovernmental, nonprofit organizations) and those
that do not (most government departments and government agencies). Among the
not- for-profits that inhabit competitive environments, we may distinguish between
TABLE 1.2 The applicability of the concepts and tools of strategic analysis to
different types of not-for-profit organizations
Organizations
in competitive
environments that
charge users
Organizations
in competitive
environments that
provide free services
Organizations
sheltered from
competition
Examples Royal Opera House
Guggenheim Museum
Stanford University
Salvation Army
Habitat for Humanity
Greenpeace Linux
UK Ministry of Defence,
European Central
Bank, New York Police
Department, World
Health Organization
Analysis of goals
and performance
Identification of mission, goals, and performance indicators and establish-
ing consistency between them is a critical area of strategy analysis for all
not-for-profits
Analysis of the
competitive
environment
Main tools of competitive
analysis are the same as
for for-profit firms
Main arena for compe-
tition and competitive
strategy is the market
for funding
Not important.
However, there is
interagency competi-
tion for public funding
Analysis of
resources and
capabilities
Identifying and exploiting distinctive resources and
capabilities critical to designing strategies that confer
competitive advantage
Analysis of resources
and capabilities
essential for deter-
mining priorities and
designing strategies
Strategy
implementation
The basic principles of organizational design, performance management, and
leadership are common to all organizational types

CHAPTER 1 THE CONCEPT Of STRATEgy 25
those that charge for the services they provide (most private schools, non profit-making
private hospitals, social and sports clubs, etc.) and those that provide their services
free—most charities and NGOs (nongovernmental organizations). Table  1.2 summa-
rizes some key differences between each of these organizations with regard to the
applicability of the basic tools of strategy analysis.
Among the tools of strategy analysis that are applicable to all types of not-for-profit
organizations, those that relate to the role of strategy in specifying organizational goals
and linking goals to resource-allocation decisions are especially important. For busi-
nesses, profit is always a key goal since it ensures survival and fuels development. But
for not-for-profits, goals are typically complex. The mission of Harvard University is to
“create knowledge, to open the minds of students to that knowledge, and to enable
students to take best advantage of their educational opportunities.” But how are these
multiple objectives to be reconciled in practice? How should Harvard’s budget be
STRATEGY CAPSULE 1.6
The Strategic Plan of the International Red Cross
The International Federation of Red Cross and Red
Crescent Societies (IFRC) coordinates activities of 190
National Red Cross and Red Crescent Societies. “Strategy
2020 provides the basis for the strategic plans of National
Societies.” It included the following:
Fundamental
Principles
Humanity, Impartiality, Neutrality, Independence, Voluntary service, Unity, Universality
Vision To inspire, encourage, facilitate and promote at all times all forms of humanitarian
activities by National Societies, with a view to preventing and alleviating human
suffering, and thereby contributing to the maintenance and promotion of human
dignity and peace in the world.
Strategic
Aims
1. Save lives, protect
livelihoods, and strengthen
recovery from disasters
and crises
2. Enable healthy and
safe living
3. Promote social
inclusion and a culture
of non violence and
peace
Enabling Actions Build strong National Red
Cross and Red
Crescent Societies
Pursue humanitarian
diplomacy to prevent
and reduce vulnerability
in a globalized world
Function effectively
as the IFRC
Expected Impact Expanded sustainable
national and local capacities
of National Societies
A stronger culture of
voluntary service and
participation in National
Societies.
Scaled-up services for the
most vulnerable people
Greater access to help
people who are vulnerable
and earlier attention to
causes of vulnerability
Deeper public,
government,
and partner support
More resources to address
vulnerabilities
Stronger recognition of
community perspectives
Stronger cooperation,
coordination and support
arrangements
Improved accountability
for IFRC activities
Greater IFRC contribution
to meeting vulnerability
needs at global, national
and local levels
Source: International Federation of Red Cross and Red Crescent Societies, Strategy 2020 (Geneva, 2010).

26 PART I INTRODUCTION
allocated between research and financial aid for students? Is Harvard’s mission better
served by investing in graduate or undergraduate education? The strategic planning
process of not-for-profits needs to be designed so that mission, goals, resource allo-
cation, and performance targets are closely aligned. Strategy Capsule 1.6 shows the
10-year strategic planning framework for the International Red Cross.
Similarly, most of the principles and tools of strategy implementation—especially in
relation to organizational structure, management systems, techniques of performance
management, and choice of leadership styles—are common to both for-profit and
not-for-profit organizations.
In terms of the analysis of the external environment, there is little difference bet-
ween the techniques of industry analysis applied to business enterprises and those
relevant to not-for-profits that inhabit competitive environments and charge for their
services. In many markets (theaters, sports clubs, vocational training), for-profits and
not-for-profits may be in competition with one another. Indeed, for these types of
not-for-profit organizations, the pressing need to break even in order to survive may
mean that their strategies do not differ significantly from those of for-profit firms.
In the case of not-for-profits that do not charge users for the services they offer
(mostly charities), competition does not really exist at the final market level: differ-
ent homeless shelters in San Francisco cannot really be said to be competing for
the homeless. However, these organizations compete for funding—raising donations
from individuals, winning grants from foundations, or obtaining contracts from fund-
ing agencies. Competing in the market for funding is a key area of strategy for most
not-for-profits.
The analysis of resources and capabilities is important to all organizations that
inhabit competitive environments and, hence, must deploy their resources and capa-
bilities to establish a competitive advantage. However, even for those organizations
that are monopolists—such as government departments and other public agencies—
performance is enhanced by aligning strategy with internal strengths in resources and
capabilities.
Summary
This chapter has covered a great deal of ground—I hope that you are not suffering from indigestion. If
you are feeling a little overwhelmed, not to worry: we shall be returning to the themes and issues raised
in this chapter in the subsequent chapters of this book.
The key lessons from this chapter are:
◆ Strategy is a key ingredient of success both for individuals and organizations. A sound strategy
cannot guarantee success, but it can improve the odds. Successful strategies tend to embody four
elements: clear, long-term goals; profound understanding of the external environment; astute
appraisal of internal resources and capabilities; and effective implementation.
◆ The above four elements form the primary components of strategy analysis: determination of goals,
industry analysis, analysis of resources and capabilities, and strategy implementation.

CHAPTER 1 THE CONCEPT Of STRATEgy 27
◆ Strategy is no longer concerned with using forecasts as the basis for detailed planning; it is increas-
ingly about direction, identity, and exploiting the sources of superior profitability.
◆ To describe the strategy of a firm (or any other type of organization), we need to recognize where the
firm is competing, how it is competing, and the direction in which it is developing.
◆ Developing a strategy for an organization requires a combination of purpose-led planning (rational
design) and a flexible response to changing circumstances (emergence).
◆ The principles and tools of strategic management have been developed primarily for business enter-
prises; however, they are also applicable to the strategic management of not-for-profit organizations,
especially those that inhabit competitive environments.
Our next stage is to delve further into the basic strategy framework shown in Figure  1.2. The
elements of this framework—goals and values, the industry environment, resources and capabil-
ities, and structure and systems—are the subjects of the five chapters that form Part II of the book.
We then deploy these tools to analyze the quest for competitive advantages in different industry
contexts (Part III), and then in the development of corporate strategy (Part IV ). Figure 1.8 shows the
framework for the book.
I. INTRODUCTION
Ch. 1 The Concept of Strategy
III. BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Ch. 7 The Sources and Dimensions of Competitive Advantage
Ch. 8 Industry Evolution and Strategic Change
Ch. 9 Technology-based Industries and the Management of Innovation
IV. CORPORATE STRATEGY
Ch. 10 Vertical Integration and the Scope of the Firm
Ch. 11 Global Strategy and the Multinational Corporation
Ch. 12 Diversif ication Strategy
Ch. 13 Implementing Corporate Strategy: Managing the Multibusiness Firm
Ch. 14 External Growth Strategies: Mergers, Acquisitions, and Alliances
Ch. 15 Current Trends in Strategic Management
II. THE TOOLS OF STRATEGY ANALYSIS
Analysis of the Firm Analysis of Industry and Competition
Ch. 2 Goals, Values, and Performance Ch. 3 Industry Analysis:
The Fundamentals Ch. 5 Analyzing Resources and Capabilities
Ch. 6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation
Ch. 4 Further Topics in Industry and
Competitive Analysis
FIGURE 1.8 The structure of the book

28 PART I INTRODUCTION
Self-Study Questions
1. In relation to the four characteristics of successful strategies in Figure 1.1, assess the US gov-
ernment’s Middle East strategy since the invasion of Iraq in 2003.
2. What is your career strategy for the next five years? To what extent does your strategy fit with
your long-term goals, the characteristics of the external environment, and your own strengths
and weaknesses?
3. The discussion of the evolution of business strategy (see the section “From Corporate Planning
to Strategic Management”) established that the characteristics of a firm’s strategic plans and its
strategic planning process are strongly influenced by the volatility and unpredictability of its
external environment. On this basis, what differences would you expect in the strategic plans
and strategic planning processes of Coca-Cola Company and Spotify SA, the Swedish-based
music streaming service?
4. I have noted that a firm’s strategy can be described in terms of the answers to two questions:
“Where are we competing?” and “How are we competing?” Applying these two questions, pro-
vide a concise description of Lady Gaga’s career strategy (see Strategy Capsule 1.2).
5. Using the framework of Figure 1.6, describe the strategy of the university or school you attend.
6. Your business school is considering appointing as dean someone whose entire career has
been spent in business management. What challenges might the new dean face in applying
her strategic management skills to a business school?
Notes
1. P. F. Drucker, “Managing Oneself,” Harvard Business
Review (March/April 1999): 65–74.
2. Stephen Covey (in The Seven Habits of Highly Effective
People, New York: Simon & Schuster, 1989) recommends
that we develop lifetime goals based on the multiple roles
that we occupy: in relation to our career, partner, family,
friends, and spiritual quest.
3. M. E. Porter, “What Is Strategy?” Harvard Business Review
(November/December 1996): 61–78.
4. See A. H. Van De Ven and R. Drazin, “The Concept of
Fit in Contingency Theory,” Research in Organizational
Behavior 7 (1985): 333–365.
5. Sun Tzu, The Art of Strategy: A New Translation of Sun
Tzu’s Classic “The Art of War,” trans. R. L. Wing (New
York: Doubleday, 1988).
6. W, Pietersen, “Von Clausewitz on War: Six Lessons for
the Modern Strategist,” Columbia School of Business
(February 2016); and E. Clemons and J. Santamaria,
“Maneuver Warfare,” Harvard Business Review (April
2002): 46–53.
7. On the contribution of game theory to business strategy
analysis, see F. M. Fisher, “Games Economists Play: A Non-
cooperative View,” RAND Journal of Economics 20 (Spring
1989): 113–124; C. F. Camerer, “Does Strategy Research
Need Game Theory?” Strategic Management Journal 12
(Winter 1991): 137–152; A. K. Dixit and B. J. Nalebuff,
The Art of Strategy: A Game Theorist’s Guide to Success in
Business and Life (New York: W. W. Norton, 2008).
8. H. I. Ansoff, “Strategies for Diversification,” Harvard
Business Review (September/October, 1957): 113–124.
9. M. E. Porter, Competitive Strategy (New York: Free
Press, 1980).
10. See Boston Consulting Group, Perspectives on Experience
(Boston: Boston Consulting Group, 1978) and studies
using the PIMS (Profit Impact of Market Strategy) data-
base, for example R. D. Buzzell and B. T. Gale, The PIMS
Principles (New York: Free Press, 1987).
11. R. M. Grant, “The Resource-based Theory of Compet-
itive Advantage: Implications for Strategy Formula-
tion,” California Management Review 33 (Spring 1991):
114–135; D. J. Collis and C. Montgomery, “Competing
on Resources: Strategy in the 1990s,” Harvard Business
Review ( July/August 1995): 119–128.
12. E. Lee, J. Lee, and J. Lee, “Reconsideration of the Winner-
Take-All Hypothesis: Complex Networks and Local Bias,”
Management Science 52 (December 2006): 1838–1848;
C. Shapiro and H. R. Varian, Information Rules (Boston:
Harvard Business School Press, 1998).

CHAPTER 1 THE CONCEPT Of STRATEgy 29
13. C. Christensen, The Innovator’s Dilemma (Boston:
Harvard Business School Press, 1997).
14. P. J. Williamson, “Strategy as Options on the Future,”
Sloan Management Review 40 (March 1999): 117–126.
15. C. Markides, “Strategic Innovation in Established Com-
panies,” Sloan Management Review ( June 1998): 31–42.
16. W. C. Kim and R. Mauborgne, “Creating New Market
Space,” Harvard Business Review ( January/February
1999): 83–93.
17. See, for example, N. Koehn, “The Brain—and Soul—of
Capitalism,” Harvard Business Review (November 2013);
and T. Piketty, Capital in the Twenty-First Century (Cam-
bridge, MA: Harvard University Press, 2014).
18. “Strategic Intensity: A Conversation with Garry Kasparov,”
Harvard Business Review (April 2005): 105–113.
19. The concept of bounded rationality was developed by
Herbert Simon (“A Behavioral Model of Rational Choice,”
Quarterly Journal of Economics 69 (1955): 99–118.
20. G. Hamel and C. K. Prahalad, “Strategic Intent,” Harvard
Business Review (May/June 1989): 63–77.
21. G. Hamel and C. K. Prahalad, “Strategy as Stretch and
Leverage,” Harvard Business Review (March/April
1993): 75–84.
22. J. C. Collins and J. I. Porras, Built to Last: Successful Habits
of Visionary Companies (New York: HarperCollins, 1995).
23. R. Rumelt, Good Strategy/Bad Strategy: The Difference and
Why It Matters (New York: Crown Business, 2011): 5–6.
24. D. J. Collis and M. G. Rukstad, “Can You Say What Your
Strategy Is?” Harvard Business Review (April 2008): 63–73.
25. D. F. Abell, Managing with Dual Strategies (New York:
Free Press, 1993).
26. H. Mintzberg, “Patterns of Strategy Formulation,”
Management Science 24 (1978): 934–948; “Of Strategies:
Deliberate and Emergent,” Strategic Management Journal
6 (1985): 257–272.
27. H. Mintzberg, “The Fall and Rise of Strategic Planning,”
Harvard Business Review ( January/February
1994): 107–114.
28. The two views of Honda are captured in two Harvard
cases: Honda [A] and [B] (Boston: Harvard Business
School, Cases 384049 and 384050, 1989).
29. Boston Consulting Group, Strategy Alternatives for the
British Motorcycle Industry (London: Her Majesty’s Statio-
nery Office, 1975).
30. R. T. Pascale, “Perspective on Strategy: The Real Story
Behind Honda’s Success,” California Management Review
26, no. 3 (Spring 1984): 47–72.
31. H. Mintzberg, “Crafting Strategy,” Harvard Business Review
( July/August 1987): 70.
32. G. Gavetti and J. Rivkin, “On the Origin of Strategy: Action
and Cognition over Time,” Organization Science 18
(2007): 420–439.
33. R. A. Burgelman and A. Grove, “Strategic Dissonance,”
California Management Review 38 (Winter 1996):
8–28.
34. R. M. Grant, “Strategic Planning in a Turbulent
Environment: Evidence from the Oil and Gas Majors,”
Strategic Management Journal 14 ( June 2003):
491–517.
35. O. Gadiesh and J. Gilbert, “Transforming Corner-office
Strategy into Frontline Action,” Harvard Business Review
(May 2001): 73–80.
36. K. M. Eisenhardt and D. N. Sull, “Strategy as Simple
Rules,” Harvard Business Review ( January 2001):
107–116.
37. A similar, but more detailed, approach is proposed in
M. Venzin, C. Rasner, and V. Mahnke, The Strategy Process:
A Practical Handbook for Implementation in Business
(London: Cyan, 2005).
38. Rumelt, op cit., 79.

II
THE TOOLS
OF STRATEGY
ANALYSIS
2 Goals, Values, and Performance
3 Industry Analysis: The Fundamentals
4 Further Topics in Industry and Competitive Analysis
5 Analyzing Resources and Capabilities
6 Organization Structure and Management Systems: The
Fundamentals of Strategy Implementation

2
The strategic aim of a business is to earn a return on capital, and if in any particular case
the return in the long run is not satisfactory, then the deficiency should be corrected
or the activity abandoned for a more favorable one.
—ALFRED P. SLOAN JR., PRESIDENT AND THEN CHAIRMAN OF GENERAL MOTORS, 1923 TO 1956.
Profits are to business as breathing is to life. Breathing is essential to life, but is not the
purpose for living. Similarly, profits are essential for the existence of the corporation,
but they are not the reason for its existence.
—DENNIS BAKKE, FOUNDER AND FORMER CEO, AES CORPORATION
Goals, Values,
and Performance
◆ Introduction and Objectives
◆ Strategy as a Quest for Value
● Value Creation
● Value for Whom? Shareholders versus Stakeholders
◆ Profit, Cash Flow, and Enterprise Value
● Types of Profit
● Linking Profit to Enterprise Value
● Enterprise Value and Shareholder Value
◆ Putting Performance Analysis into Practice
● Appraising Current and Past Performance
● Performance Diagnosis
● Using Performance Diagnosis to Guide Strategy
Formulation
● Setting Performance Targets
◆ Beyond Profit: Values and Corporate Social
Responsibility
● Values and Principles
● Corporate Social Responsibility
◆ Beyond Profit: Strategy and Real Options
● Strategy as Options Management
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

34 PART II THE TOOLS OF STRATEGY ANALYSIS
Introduction and Objectives
Our framework for strategy analysis (Figure 1.3) comprises four components: the firm’s goals and
values, its resources and capabilities, its structure and management systems, and its industry environ-
ment. The chapters that form Part II of this book develop these four components of strategy analysis.
We begin with goals and values of the firm and, by extension, the performance of the firm in attaining
its goals.
As the opening quotations to this chapter indicate, there is fierce debate over the appropriate
goals for business enterprises. In this chapter, we will consider whether the firm should pursue the
interests of its owners only or of all its stakeholders, including society as a whole. Our approach will
be pragmatic. While acknowledging that firms pursue multiple goals and that each firm chooses
a particular purpose, we focus upon a single goal: the creation of value. This I interpret as the pur-
suit of profit over the lifetime of the firm. Hence, the focus of our strategy analysis is upon con-
cepts and techniques that are concerned with identifying and exploiting the sources of profitability
available to the firm. Our emphasis on profitability and value creation allows us to draw upon the
tools of financial analysis for the purposes of performance appraisal, performance diagnosis, and
target setting.
Although profitability is the most useful indicator of firm performance, we shall acknowledge that
firms are motivated by goals other than profit. Indeed, the pursuit of these alternative goals may be
conducive to a superior generation of profit. Profit may be the lifeblood of the enterprise, but it is not a
goal that inspires organizational members to outstanding achievement. Moreover, for a firm to survive
and generate profit over the long run requires responsiveness and adaptability to its social, political, and
natural environments.
By the time you have completed this chapter, you will be able to:
◆ Recognize that, while every firm has a distinct purpose, the common goal for all firms is
creating value, and appreciate how the debate over shareholder versus stakeholder goals
involves different definitions of value creation.
◆ Understand how profit, cash flow, and enterprise value relate to one another.
◆ Use the tools of financial analysis to appraise firm performance, diagnose the sources of
performance problems, and set performance targets.
◆ Appreciate how a firm’s values, principles, and pursuit of corporate social responsibility
can help define its strategy and support its creation of value.
◆ Understand how real options contribute to firm value and how options thinking can con-
tribute to strategy analysis.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 35
Strategy as a Quest for Value
There is more to business than making money. For the entrepreneurs who create
business enterprises, personal wealth appears to be a less important motivation than
the wish for autonomy, desire for achievement, and lust for excitement. Almost 90
years ago, the economist Joseph Schumpeter observed: “The entrepreneur–innovator’s
motivation includes such aspects as the dream to found a private kingdom, the will to
conquer and to succeed for the sake of success itself, and the joy of creating and get-
ting things done.”1 Business enterprises are creative organizations that offer individuals
unsurpassed opportunity to make a difference in the world. Certainly, making money
was not the goal that inspired Henry Ford to build a business that precipitated a social
revolution:
I will build a motor car for the great multitude . . . It will be so low in price that no
man making good wages will be unable to own one and to enjoy with his family
the blessing of hours of pleasure in God’s great open spaces . . . When I’m through,
everyone will be able to afford one, and everyone will have one.2
Each entrepreneur is inspired by a goal that is personal and unique—family cars
for the multitude (Henry Ford), bringing the power of personal computing to the
individual (Steve Jobs), reducing deaths from infection after surgery ( Johnson & John-
son), or revolutionizing vacuum cleaning ( James Dyson). A business purpose is a
feature of established companies as well as entrepreneurial start-ups: Cynthia Mont-
gomery argues that “forging a compelling organizational purpose” is the ongoing job
of company leaders and the “crowning responsibility of the CEO.”3 Organizational
purpose is articulated in companies’ mission statements:
● Twitter’s mission is “To give everyone the power to create and share ideas and
information instantly, without barriers.”
● Nike’s mission is “To bring inspiration and innovation to every athlete* in the
world. (*If you have a body, you are an athlete.)”
● The Lego Group’s mission is “To inspire and develop the builders of tomorrow.”
Value Creation
Within this multiplicity of organizational purposes, there is a common denominator: the
desire, and the need, to create value. Value is the monetary worth of a product or asset.
Hence, we can generalize by saying that the purpose of business is to create value for
customers. However, if the firm is to survive and prosper, it is essential that it is able to
appropriate some of this customer value in the form of profit.
Value can be created in two ways: by production and by commerce. Production cre-
ates value by physically transforming products that are less valued by consumers into
products that are more valued by consumers—turning coffee beans and milk into cap-
puccinos, for example. Commerce creates value not by physically transforming prod-
ucts but by repositioning them in space and time. Trade involves transferring products
from individuals and locations where they are less valued to individuals and locations
where they are more valued. Similarly, speculation involves transferring products from
a point in time where a product is valued less to a point in time where it is valued
more. Thus, commerce creates value through arbitrage across time and space.4

36 PART II THE TOOLS OF STRATEGY ANALYSIS
How do we measure the value created by a firm? It is the value of the firm’s output
that is received by customers in excess of the real cost of producing that output:
Value creation Total customer value Real costs of producti– oon
So, is value creation the same as profit (where Profit = Revenue − Cost)? No, because
the value received by customers is typically greater than the amount they pay. Total
customer value is measured by their willingness to pay, not what they actually pay. The
difference is called consumer surplus. Similarly, the real cost of production is usu-
ally less than the firm’s accounting costs, since the owners of productive inputs (par-
ticularly employees) typically receive more than the minimum they needed in order
to supply their inputs. Producer surplus is comprised of the profits that accrue to the
owners of the firm together with earnings by input owners in excess of the minimum
they require. (We can also include taxes paid to government as part of this producer
surplus.) Figure 2.1 shows these relationships.
Consider Google (now a subsidiary of Alphabet Inc.), the total customer value it
creates far exceeds its revenue since most of its output—notably its search engine,
Gmail, and YouTube videos—are offered free. Similarly, its accounting costs exceed its
real production costs to the extent that its employees (including its managers) receive
pay and benefits in excess of would be needed to keep them working at Google. For
example, its software engineers are paid an average of about $160,000 compared to a
US average of about $95,000.
Value for Whom? Shareholders versus Stakeholders
As Figure 1.5 shows, the value created by firms is distributed among different
parties: customers receive consumer surplus, owners receive profits, government
receives taxes, and employees and the owners of other factors of production receive
$
Units of output
A. Value created:
total customer
value less real
cost of
production
Value
created
Real cost
of
production
Real cost
of
production
Price paid by
customers
Consumer
surplus
Pro�t
Taxes
Surplus to
input providers
Producer
surplus
B. Value created:
consumer
surplus plus
producer
surplus
Units of output
Accounting
cost
FIGURE 2.1 Value creation

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 37
remuneration in excess of the minimum needed for them to supply their inputs. So,
whose interests should the firm consider when considering which component of
value to pursue?
There are two answers to this question:
● Stakeholder value maximization. Stakeholder theory proposes that the firm
should operate in the interests of all its constituent groups (including society
as a whole), which implies that the goal of the firm should be to maximize
total value creation (i.e., the sum of consumer and producer surplus, including
external benefits to society as well).5
● Shareholder value maximization. Shareholder capitalism is based
upon two principles, first, that firms should operate in the interests of their
owners (who wish to earn profit); second, that the effectiveness of the
market economy is dependent upon firms responding to profit incentives
(the so-called “invisible hand”). Hence, the interests of both shareholders
and society are best served by firms maximizing profits.
The idea that the corporation should balance the interests of multiple stakeholders
has a long tradition, especially in Asia and continental Europe. By contrast, most
English-speaking countries have endorsed shareholder capitalism, where companies’
overriding duty is to produce profits for owners. These differences are reflected in
international differences in companies’ legal obligations. In the United States, Canada,
the United Kingdom, and Australia, company boards are required to act in the inter-
ests of shareholders. In most continental European countries, companies are legally
required to take account of the interests of employees, the state, and the enterprise
as a whole.6
The debate as to whether companies should operate exclusively in the inter-
ests of their owners or should pursue the goals of all stakeholders has yet to be
resolved. During the late 20th century, “Anglo-Saxon” shareholder capitalism was
in the ascendant—many continental European and Asian companies changed their
strategies and corporate governance to give primacy to shareholder interests.
However, during the 21st century, shareholder value maximization has become
tainted by its association with short-termism, financial manipulation, excessive CEO
compensation, and the failures of risk management that precipitated the 2008–09
financial crisis.
Clearly, companies have legal and ethical responsibilities to employees, customers,
society, and the natural environment, but should companies go beyond these respon-
sibilities and manage their businesses in the interests of these diverse stakeholders?
Pursuing the interests of all stakeholders is inherently appealing, yet, in practice the
stakeholder approach encounters two serious difficulties:
1 Measuring performance. Pursuing stakeholder interests means maximizing
total value creation and ensuring its equitable distribution among stakeholders.
In practice, estimating the components of value creation—consumer surplus,
producer surplus, and social externalities—is near impossible.7 Alternatively,
it may be possible to establish distinct goals for each stakeholder group, but
establishing tradeoffs among them is exceptionally difficult. As Michael Jensen
observes: “multiple objectives is no objective.”8

38 PART II THE TOOLS OF STRATEGY ANALYSIS
2 Corporate governance. If top management is to pursue and balance the inter-
ests of different stakeholders, how can management’s performance be assessed
and by whom? Must boards of directors comprise the representatives of every
stakeholder group? The resulting conflicts, wrangling, and vagueness around
performance objectives would make it easy for top management to substitute its
own interests for those of stakeholders.
To provide simplicity and clarity to our analysis of firm strategy, I make the assump-
tion that the primary goal of strategy is to maximize the value of the enterprise through
seeking to maximize profits over the long term. Having extolled the virtues of business
enterprises as creative institutions, how can I rationalize this unedifying focus on
money-making? I have three justifications:
● Competition: Competition erodes profitability. As competition increases,
the interests of different stakeholders converge around the goal of survival.
To survive a firm must, over the long term, earn a rate of profit that
covers its cost of capital; otherwise, it will not be able to replace its assets.
When weak demand and fierce international competition depress return
on capital, few companies have the luxury of sacrificing profits for
other goals.
● Threat of acquisition: Management teams that fail to maximize the profits of
their companies tend to be replaced by teams that do. In the “market for corpo-
rate control,” companies that underperform financially suffer a depressed share
price. This attracts acquirers—both other public companies and private equity
funds. Despite the admirable record of British chocolate maker Cadbury in
relation to employees and local communities, its dismal return to shareholders
between 2004 and 2009 meant that it was unable to resist acquisition by Kraft
Foods. Subsequently, both Kraft and Heinz were acquired by private equity
firm, 3G Capital, which imposed an even more rigorous focus on profit genera-
tion.9 Even without acquisition, activist investors—both individuals and institu-
tions—can pressure boards of directors to dismiss CEOs who fail to create value
for shareholders.10
● Convergence of stakeholder interests: There is likely to be more community of
interests than conflict of interests among different stakeholders. Profitability over
the long term requires loyalty from employees, trusting relationships with sup-
pliers and customers, and support from governments and communities. Indeed,
the instrumental theory of stakeholder management argues that pursuit of stake-
holder interests is essential to creating competitive advantage, which in turn
leads to superior financial performance.11 Empirical evidence shows that firms
that take account of a broader set of interests, including that of society, achieve
superior financial performance.12
Hence, the issue of whether firms should operate in the interests of shareholders
or of all stakeholders matters more in principle than in practice. According to Jensen:
“enlightened shareholder value maximization … is identical to enlightened stakeholder
theory.” We shall return to this issue later in this chapter when we consider explicitly
the social and environmental responsibilities of firms.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 39
Profit, Cash Flow, and Enterprise Value
Thus far, I have referred to firms’ quest for profit in general terms. It is time to look
more carefully at what we mean by profit and how it relates to value creation.
Profit is the surplus of revenues over costs available for distribution to the owners
of the firm. But if profit maximization is to be a realistic goal, the firm must know
what profit is and how to measure it. What is the firm to maximize: total profit or rate
of profit? Over what period? With what kind of adjustment for risk? And what is profit
anyway—accounting profit, cash flow, or economic profit? These ambiguities become
apparent once we compare the profit performance of companies. Table  2.1 shows
that ranking companies by profitability depends critically on what profitability mea-
sure is used.
Types of Profit
Accounting Profit is measured at different levels:
● Gross profit is sales revenue less the cost of bought-in materials and
components.
● Operating profit (or operating income) is the gross profit less operating
expenses, before deduction of interest and taxes.
● Net profit (or net income) is profit after the deduction of all expenses
and charges.
TABLE 2.1 Profitability measures for some of the world’s largest companies, 2017
Company
Market
capitalizationa
($ billion)
Net income
($ billion)
ROSb
(%)
ROEc
(%)
ROAd
(%)
Return to
shareholderse
(%)
Apple 824 48.4 26.9 39.0 16.3 +46.8
Amazon 689 3.0 2.3 9.6 3.1 +27.4
Alibaba 480 6.2 29.8 21.9 9.1 +94.1
JPMorgan Chase 397 24.4 50.2 9.5 1.4 +24.6
ExxonMobil 358 19.7 5.2 11.8 5.7 −5.8
Wal mart 310 13.6 4.1 14.9 11.9 +45.2
Toyota 204 15.8 7.6 13.2 4.1 +5.8
Notes:
aShares outstanding × closing price of shares on February 02, 2018.
bReturn on sales = Operating profit as a percentage of sales revenues.
cReturn on equity = Net income as a percentage of year-end shareholder equity.
dReturn on assets = Operating income as a percentage of year-end total assets.
eDividend + share price appreciation during 2017.

40 PART II THE TOOLS OF STRATEGY ANALYSIS
STRATEGY CAPSULE 2.1
Economic Value Added (EVA) at diageo plc.
At Guinness-to-Johnny-Walker drinks giant Diageo, EVA
transformed the way in which Diageo measured its
performance, allocated its capital and advertising expen-
ditures, and evaluated its managers.
Taking account of the costs of the capital tied up
in slow-maturing, vintage drinks such as Talisker and
Lagavulin malt whisky, Hennessey cognac, and Dom
Perignon champagne showed that these high-margin
drinks were often not as profitable as the company
had believed. The result was that Diageo’s advertising
expenditures were reallocated toward Smirnoff vodka,
Gordon’s gin, Baileys, and other drinks that could be sold
within weeks of distillation.
Once managers had to report profits after deduc-
tion of the cost of the capital tied up in their businesses,
they took measures to reduce their capital bases and
make their assets work harder. At Diageo’s Pillsbury food
business, the economic profit of every product and every
major customer was scrutinized. The result was the elim-
ination of many products and efforts to make marginal
customers more profitable. Ultimately, EVA analysis
resulted in Diageo selling Pillsbury to General Foods. This
was followed by the sale of Diageo’s Burger King chain to
Texas Pacific, a private equity group.
Value-based management was extended throughout
the organization by making EVA the primary determinant
of the incentive pay earned by 1400 Diageo managers.
Sources: John McGrath, “Tracking Down Value,” Financial Times
Mastering Management Review (December 1998);
www.diageo.com.
Economic Profit is pure profit. A major problem of accounting profit is that it
combines two types of returns: the normal return to capital, which rewards investors
for the use of their capital, and economic profit, which is the surplus available after
all inputs (including capital) have been paid for. Economic profit is a purer mea-
sure of profit that measures more precisely the surplus value a firm generates. To
distinguish it from accounting profit, economic profit is often referred to as rent or
economic rent.
Economic profit is calculated by deducting the cost of capital from operating profit
(where the cost of capital is: capital employed multiplied by the weighted average cost
of capital).
Economic profit has two main advantages over accounting profit as a performance
measure. First, it is a more realistic performance indicator. At many capital-intensive
companies, seemingly healthy profits disappear once cost of capital is taken into
account. McKinsey & Company calculated that among the world’s top 3000 companies,
47% were earning negative economic profit.13 Second, it improves the allocation of
capital between the different businesses of the firm by taking account of the real costs
of more capital-intensive businesses. The consulting firm Stern Stewart has popularized
the use of a particular measure of economic profit, economic value added, for allo-
cating capital (see Strategy Capsule 2.1).
Cash Flow shows the firm’s flows of cash transactions: operating cash flow is the
cash generated by the firm’s operations; free cash flow is operating cash flow less capital
investment. As a performance indicator, cash flow has the merit of being relatively
immune from accounting manipulation. Its main usefulness is in discounted cash flow

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 41
(DCF) calculation of the value of a business. Earnings before interest, taxes, deprecia-
tion, and amortization (EBITDA) provide a proxy for operating cash flow.
Linking Profit to Enterprise Value
There is also the problem of time. Once we consider multiple periods of time, then
profit maximization means maximizing the net present value of the stream of profits
over the lifetime of the firm.
Hence, profit maximization translates into maximizing the value of the firm. The
value of the firm is calculated in the same way as any other asset: it is the net present
value (NPV) of the returns that the asset generates. The relevant returns are the cash
flows to the firm. Hence, firms are valued using the same discounted cash flow (DCF)
methodology that we apply to the valuation of investment projects. Thus, the value of
an enterprise ( )V is the sum of its free cash flows ( )C in each year t, discounted at the
enterprise’s cost of capital. The relevant cost of capital is the weighted average cost of
capital (WACC) that averages the cost of equity and the cost of debt:
V
t
t
t
C
1 WACC

In practice, valuing companies by discounting economic profit gives the same result
as by discounting net cash flows. The difference is in the treatment of the capital con-
sumed by the business. The cash flow approach deducts capital at the time when the
capital expenditure is made; the economic profit approach follows the accounting
convention of charging capital as it is consumed (depreciation).
The difficulties of forecasting cash flows far into the future have encouraged the
search for approximations to DCF valuation. One approach is to estimate cash flows
over a 5-to-10-year horizon, then estimate a terminal value for the firm.14 Another is
proposed by McKinsey consultants who show that cash flow can be disaggregated into
return on capital employed (ROCE) and growth of revenue, both of which are easier
to forecast than free cash flow.15
Enterprise Value and Shareholder Value
How does maximizing the value of the firm (enterprise value) relate to the much-lauded
and widely vilified goal of maximizing shareholder value? At the foundation of modern
financial theory is the principle that the net present value of a firm’s profit stream is
equal to the market value of its securities—both equity and debt.16 Hence:
Enterprise value Market capitalization of equity Market vallue of debt17
Therefore, for the equity financed firm, maximizing the present value of the firm’s
profits over its lifetime also means maximizing the firm’s current market capitalization.
If maximizing profits over the life of the firm also means maximizing the stock
market value of the firm, why is it that shareholder value maximization has attracted so
much criticism in recent years? The problems arise from the fact that the stock market
cannot see the future with much clarity; hence, its valuations of companies are strongly
influenced by short-term and psychological factors. The danger is that top management
focuses upon boosting their firm’s stock market value rather than increasing profits
over the lifetime of the firm. For example, if stock markets are myopic, management

42 PART II THE TOOLS OF STRATEGY ANALYSIS
may be encouraged to maximize short-term profits to the detriment of long-run profit-
ability. This in turn may tempt top management to boost short-term earnings through
financial manipulation rather than by growing the firm’s operating profits. Such manip-
ulation may include adjustments to financial structure, earnings smoothing, and asset
sales that lift reported profits.
To avoid some of the criticisms that shareholder value maximization has attracted,
my emphasis will be on maximizing enterprise value rather than on maximizing share-
holder value. This is partly for convenience: distinguishing debt from equity is not
always straightforward, due to the presence of preference stock, convertible debt, and
junk bonds. More importantly, focusing on the value of the enterprise as a whole helps
emphasize the fundamental drivers of firm value over the distractions and distortions
that result from a preoccupation with stock market value.
Putting Performance Analysis into Practice
Our discussion so far has established that every business enterprise has a distinct
purpose. Yet, for all businesses, the profit earned over the life of the business—
enterprise value—is a sound indicator of a business’s success in creating and capturing
value. Long-term profitability also offers a sound criterion for selecting the strategy
through which the firm achieves its business purpose.
So, how do we apply these principles to appraise and develop business strategies?
There are four key areas where our analysis of profit performance can guide strategy:
first, in appraising a firm’s (or business unit’s) performance; second, in diagnosing the
sources of poor performance; third, in selecting strategies on the basis of their profit
prospects; and, finally, setting performance targets.
Appraising Current and Past Performance
The first task of any strategy formulation exercise is to assess the current situation.
This means identifying the current strategy of the firm and assessing how well that
strategy is doing in terms of the performance of the firm. The next stage is diagnosis—
identifying the sources of unsatisfactory performance. Thus, good strategic practice
emulates good medical practice: first, assess the patient’s state of health, and then
determine the causes of any sickness.
Forward-Looking Performance Measures: Stock Market Value If our goal is
to maximize profit over the lifetime of the firm, then to evaluate the performance of
a firm we need to look at its stream of profit (or cash flows) over the rest of its life.
The problem, of course, is that we can only make reasonable estimates of these a
few years ahead. For public companies stock, market valuation represents the best
available estimate of the NPV of future cash flows (net of interest payments). Thus, to
evaluate the performance of a firm in value creation, we can compare the change in
the market value of the firm relative to that of competitors over a period (preferably
several years). In the market for package and freight delivery, United Parcel Services,
Inc. (UPS) had a market capitalization and enterprise value that exceeded that of its
rival FedEx Corp. (see Table  2.2). This indicates that UPS is expected to generate a
higher cash flow than FedEx in the future (principally, because of its greater size and

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 43
higher profitability). However, over the period 2012–17 the gap has closed: FedEx has
created more value than UPS–as indicated by UPS’s higher total shareholder return
over the five-year period. Clearly, stock market valuation is an imperfect performance
indicator—it is vulnerable to disequilibrium, swings in market psychology, and mis-
interpretation of new information—but, as an indicator of a company’s risk-adjusted
profit stream over its lifetime, it is the best we have.
Backward-Looking Performance Measures: Accounting Ratios Because of
the volatility of stock market values, assessments of firm performance for the pur-
poses of appraising the current strategy or evaluating management effectiveness tend
to use accounting measures of performance. These are inevitably historical: finan-
cial reports appear at least three weeks after the period to which they relate. That
said, many firms offer earnings guidance—forecasts of profit for the next 12 months
(or longer).
Return on capital employed (ROCE) or closely-related measures, such as return on
equity (ROE) and return on assets (ROA), are the most useful indicators of a firm’s
effectiveness in generating profits from its assets. Indeed (as we saw on page 41),
the McKinsey valuation framework uses projections of ROCE, together with growth
and cost of capital, to estimate enterprise value. However, it is important to be aware
of the limitations and biases inherent in any particular profitability measure. Multiple
measures of profitability can be used to build a more balanced picture of a company’s
performance. Table 2.3 lists some widely used profitability indicators.
Interpreting probability ratios requires benchmarks. Comparisons over time tell
us whether performance is improving or deteriorating. Interfirm comparisons tell us
how a firm is performing relative to a competitor, relative to its industry average, or
relative to firms in general (e.g., relative to the Fortune 500, S&P 500, or FT 500).
Another key benchmark is cost of capital. ROCE should be compared with WACC,
and ROE compared with the cost of equity capital. Table 2.2 shows that, during 2013–
17, UPS earned an operating margin, ROE, ROCE, and ROA that exceeded those of
FedEx. UPS’s greater market capitalization and enterprise value reflects expectations
that UPS’s superior profit performance will be sustained into the future.
TABLE 2.2 The comparative performance of UPS and Federal Express
Company
Market
capitalization,
end 2017
($ billion)
Enterprise
value,
end 2017a
($ billion)
Return to
shareholders,
2015–2017b
(%)
Operating
margin,
2015–2017c
(%)
ROE,
2013–
2017d
(%)
ROCE,
2015–
2017e
(%)
ROA,
2015–
2017f
(%)
UPS 102.7 117.0 12.1 11.2 237.6 47.2 16.7
FedEx 66.9 82.1 50.8 6.3 13.1 12.4 7.6
Notes:
aMarket capitalization + Book value of long-term debt.
bPercentage increase in share price + Dividend yield.
cOperating income/Sales revenue.
dNet income/Shareholders’ equity.
eOperating income/(Shareholders’ equity + long-term debt).
fOperating income/Total assets.

44 PART II THE TOOLS OF STRATEGY ANALYSIS
TABLE 2.3 Profitability ratios
Ratio Formula Comments
Return on capital
employed (ROCE)
Operating profit (or EBIT)
Total assets current liabilless iities
ROCE is also known as return on invested capital
(ROIC). The denominator can also be measured as
shareholders’ equity plus long-term debt.
Return on
equity (ROE)
Net income
Shareholders’ equity
ROE measures a firm’s ability to use equity capital
to generate profits that can be returned to share-
holders. Net income may be adjusted to exclude
discontinued operations and special items.
Return on
assets (ROA)
Operating profit (or EBIT or EBITDA)
Total assets
The numerator should correspond to the return on
all the firm’s assets—e.g., operating profit, EBIT (earn-
ings before interest and tax), or EBITDA.
Gross margin Sales Cost of bought-in goods and services
Sales
Gross margin measures the extent to which a firm
adds value to the goods and services it buys in.
Operating margin Operating profit
Sales
Operating margin and net margin measure a firm’s
ability to extract profit from its sales.
Net margin Net income
Sales
Margins are useful to compare the performance of
firms within the same industry, but are not useful for
comparing firms in different industries because mar-
gins depend on an industry’s capital intensity (see
Table 2.1).
Notes:
Few accounting ratios have standard definitions; hence, it is advisable to be explicit about how you have calculated the ratio you are using.
A general guideline for rate of return ratios is that the numerator should be the profits that are available to remunerate the owners of the
assets in the denominator.
Profits are measured over a period of time (typically over a year). Assets are valued at a point of time. Hence, in rate of return calculations,
assets, equity, and capital employed should to be averaged between the beginning and end of the period.
Performance Diagnosis
If profit performance is unsatisfactory, we need to identify the sources of poor
performance so that management can take corrective actions. The main tool of diagnosis
is disaggregation of return on assets (or return on capital employed) in order to iden-
tify the fundamental value drivers. A starting point is to disaggregate return on assets
into sales margin and asset turnover (i.e., profit/assets = profit/sales x sales/assets).
We can then further disaggregate both sales margin and asset turnover into their com-
ponent items (Figure  2.2). This points us toward the specific activities that are the
sources of poor performance.
Strategy Capsule 2.2 disaggregates the return on assets for UPS and FedEx so that we can
begin to pinpoint the sources of UPS’s superior profitability. If we supplement the financial
data with the qualitative data on the two companies’ business strategies, operations, and
organization together with information on conditions within the industry in which the two
companies compete, we can gain insight into why UPS has outperformed FedEx.
Using Performance Diagnosis to Guide Strategy Formulation
A probing diagnosis of a firm’s recent performance—as outlined in Strategy
Capsule 2.2—provides a useful input into strategy formulation. If we can establish why a
company has been performing badly, then we have a basis for corrective actions. These

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 45
corrective actions are likely to be both strategic (with a medium- to long-term focus)
and operational (focused on the short term). The worse a company’s performance the
greater the need to concentrate on the short term. For companies teetering on the brink
of bankruptcy, long-term strategy takes a back seat; survival is the dominant concern.
For companies that are performing well, financial analysis allows us to understand the
sources of superior performance so that strategy can protect and enhance these deter-
minants of success. For example, in the case of UPS (see Strategy Capsule 2.2), financial
analysis points to the efficiency benefits that arise from being market leader and having
an integrated system of collection and delivery that optimizes operational efficiency. The
superior profitability of UPS’s international business points to its ability to successfully
enter foreign markets and integrate overseas operations within its global system.
However, analyzing the past only takes us so far. The world of business is one of
constant change and the role of strategy is to help the firm to adapt to change. The
challenge is to look into the future and identify factors that threaten performance or
create new opportunities for profit. In making strategy recommendations to UPS, our
financial analysis can tell us some of the reasons why UPS has been doing well up until
now, but the key to sustaining UPS’s performance is to recognize how its industry envi-
ronment will be changing in terms of customer requirements, competition, technology,
and energy costs and to assess UPS’s capacity to adapt to these new conditions. While
financial analysis is inevitably backward-looking, strategic analysis allows us to look for-
ward and understand some of the critical factors impacting a firm’s success in the future.
COGS/Sales
Turnover of other items
of working capital
Creditor Turnover
(Sales/Accounts receivable)
Inventory Turnover
(Sales/Inventories)
Fixed Asset Turnover
(Sales/PPE)
SGA expense/Sales
Depreciation/Sales Sales Margin
Sales/Assets
ROA
FIGURE 2.2 Disaggregating return on assets
Notes:
ROA: Return on assets.
COGS: Cost of goods sold.
PPE: Property, plant, and equipment.
For further discussion, see T. Koller et al., Valuation, 5th edn (Chichester: John Wiley & Sons, Ltd., 2010).

46 PART II THE TOOLS OF STRATEGY ANALYSIS
STRATEGY CAPSULE 2.2
diagnosing Performance: uPS versus FedEx
Between 2013 and 2017, United Parcel Service (UPS)
has earned more than double the return on assets as its
closest rival, FedEx Corporation. What insights can finan-
cial analysis offer into the sources of this performance
differential?
Disaggregating the companies’ return on capital
employed into operating margin and capital turnover
shows that differences in ROCE are due to UPS’s superior
operating margin and higher capital turnover (See
Figure 2.3).
Probing UPS’s higher operating margin highlights
major differences in the cost structure of the two com-
panies: UPS is more labor intensive with a much higher
ratio of employee costs to sales (however, UPS’s average
compensation per employee is much lower than
FedEx’s). FedEx has higher costs of fuel, maintenance,
depreciation, and “other.” UPS’s higher capital turnover is
mainly due to its higher turnover of fixed assets (prop-
erty, plant, and equipment).
These differences reflect the different composition
of the two companies’ businesses. UPS is more heavily
involved in ground transportation (UPS has 103,000 vehi-
cles; FedEx has 55,000), which tends to be more labor
intensive. FedEx is more oriented toward air transporta-
tion (UPS has 620 aircraft; FedEx has 650). Express delivery
services tend to be less profitable than ground delivery.
However, the differences in business mix do not appear
to completely explain the wide discrepancy in fuel, main-
tenance, and other costs between FedEx and UPS. The
likelihood is that UPS has superior operational efficiency.
Cash turnover
U: 9.51 F: 15.5
Receivables turnover
U: 10.23 F: 6.8
Labor costs/Sales
U: 54.8% F: 36.3%
Fuel costs/Sales
U: 7.5% F: 5.8%
Maintenance/Sales
U: 2.3% F: 4.2%
Operating
margin
U: 11.2%
F: 6.3%
Sales/Assets
U: 1.49
F: 1.21
ROA
U: 16.7%
F: 7.6%
U = UPS
F = FedEx
Depreciation/Sales
U: 3.4% F: 5.2%
Other costs/Sales
U: 21.4% F: 42.5%
PPE turnover
U: 3.02 F: 2.03
FIGURE 2.3 Analyzing why UPS earns a higher return on assets (ROA) than FedEx

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 47
Setting Performance Targets
We noted in Chapter  1 that an important role for strategic planning systems is to
translate strategic goals into performance targets and then monitor the performance
achieved against these targets. To be effective, performance targets need to be con-
sistent with long-term goals, linked to strategy, and relevant to the tasks and respon-
sibilities of individual organizational members. Translating goals into actionable
performance targets presents major problems for the stakeholder-focused firm. Even
for the shareholder-focused firm, the goal of maximizing the value of the firm offers
little guidance to the managers entrusted with that goal. The three main approaches to
setting performance targets are as follows:
Financial Disaggregation If the goal of the firm is to maximize profitability, we
can use the same financial disaggregation in Figure 2.2 to cascade targets down the
organization. Thus, for the top management team, performance goals might include
maximizing ROCE on existing assets while investing in new projects whose return
on capital exceeds their cost of capital. For functional vice presidents, performance
targets might include maximizing sales and market shares (for marketing and sales),
minimizing raw material and component costs (for purchasing), minimizing produc-
tion costs (for operations), maximizing inventory turns (for logistics/supply chain),
and minimizing the cost of capital (for finance). These functional goals can be further
disaggregated to the department level (e.g., plant maintenance is required to minimize
machine downtime in order to increase capacity utilization, the customer accounts
department is required to minimize the number of days of outstanding receivables,
and so on).
The dilemma with any system of performance management is that the performance
goals are long term (e.g., maximizing profits over the lifetime of the company), but
to act as an effective control mechanism performance targets need to be monitored
over the short term. For financial targets, there is the ever-present danger that pursuing
short-term profitability undermines long-term profit maximization.
Balanced Scorecards One solution to this dilemma is to combine financial targets
with strategic and operational targets. The most widely used method for doing this is
the balanced scorecard developed by Robert Kaplan and David Norton.18 The bal-
anced scorecard methodology provides an integrated framework for balancing finan-
cial and strategic goals and cascading performance measures down the organization to
individual business units and departments. The performance measures included in the
balanced scorecard derive from the answers to four questions:
● How do we look to shareholders? The financial perspective is composed of
measures such as cash flow, sales and income growth, and return on equity.
● How do customers see us? The customer perspective comprises measures such
as goals for new products, on-time delivery, and defect and failure levels.
● What must we excel at? The internal business perspective relates to internal
business processes such as productivity, employee skills, cycle time, yield rates,
and quality and cost measures.
● Can we continue to improve and develop? The innovation and learning per-
spective includes measures related to new product development cycle times,
technological leadership, and rates of improvement.

48 PART II THE TOOLS OF STRATEGY ANALYSIS
By balancing a set of strategic and financial goals, the scorecard methodology
allows the strategy of the business to be linked with the creation of shareholder
value while providing measurable targets to guide this process. Moreover, because
the balanced scorecard allows explicit consideration of the goals of customers,
employees, and other interested parties, scorecards can also be used to implement
stakeholder-focused management. Figure 2.4 shows the balanced scorecard for a US
regional airline.
Strategic Profit Drivers Financial value drivers and balanced scorecards are
systematic techniques of performance management based upon the notion that, if
overall goals can be disaggregated into precise, quantitative, time-specific targets, each
member of the organization knows what is expected of him or her and can be incen-
tivized toward achieving the targets set. However, a mounting body of evidence points
to the unintended consequences of performance targets.
In relation to profit maximization, setting profit targets may induce behavior that
undermines that goal’s attainment. Thus, many of the firms that are most successful at
creating shareholder value are those that emphasize purpose over profit. Conversely,
many of the firms most committed to profit and maximizing shareholder value—Enron,
BP, and Lehman Brothers for example—have been spectacularly unsuccessful in real-
izing these goals.19 The experiences of Boeing illustrate this problem (see Strategy
Capsule 2.3).
The problem of translating goals into targets is vividly illustrated by performance
management in the public sector. In Soviet shoe factories, quantitative monthly targets
would be met by producing low-quality shoes of a single size.20 In the British National
Health Service, the target of eight-minute ambulance response times was achieved by
Increase
Profitability
Lower
Cost
On-time
Flights
More
Cust-
omers
Low
Prices
Improve
turnaround
time
Align
Ground
Crews
Increase
Revenue
Simplified Strategy
Map
Financial
Customer
Internal
Learning
Performance
Measures
• Market Value
• Seat Revenue
• Plane Lease Cost
• FAA on-time
arrival rating
• First in industry
• 98% satisfaction
• % change
• Quality management
• Customer loyalty
program• Customer ranking
• On Ground Time
• % Ground crew
stockholders
• <25 Minutes • Stock ownership plan • Cycle time optimization program • 25% per year • Optimize routes • Standardize planes• 20% per year • 5% per year Targets Initiatives • No. customers • On-Time Departure • % Ground crew trained • Year 1, 70% • Year 4, 90% • Year 6, 100% • 93% • Ground crew training FIGURE 2.4 Balanced scorecard for a regional airline Source: Reproduced from www.balancedscorecard.org with permission. CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 49 replacing regular ambulance crews with single paramedics (or volunteers) in cars—no progress was met in improving survival rates from heart attacks and strokes.21 The solution to this problem is what John Kay calls “obliquity”: pursuing goals indi- rectly.22 In the case of firm profitability, this implies establishing targets around the stra- tegic factors that drive profit, rather than profitability itself. This focus on the drivers of profit is the core theme of this book. Once we have identified the primary sources of profit available to the firm we have a basis, first, for formulating a strategy to exploit these sources of profit and, second, for implementing that strategy through performance guidelines and targets based upon those strategic variables. This approach can also bring clarity to the complex and contentious issue of the corporate social responsibility. Beyond Profit: Values and Corporate Social Responsibility At the beginning of this chapter, I argued that, while every company has a distinct organizational purpose, a common goal for every business enterprise is to create value, and the best indicator of value creation is profit over the lifetime of the company—or, equivalently, maximizing enterprise value. Although the corporate scandals of the 21st century have discredited the pursuit of profit and shareholder value maximization, I have justified long-run profit maximization as an appropriate and practical goal for the strategic management of firms. STRATEGY CAPSULE 2.3 The Pitfalls of Pursuing Shareholder Value: Boeing Boeing was one of the most financially successful mem- bers of the Dow Jones Industrial Index between 1960 and 1990. Yet Boeing gave little attention to financial management. CEO Bill Allen was interested in building great planes and leading the world market with them: “Boeing is always reaching out for tomorrow. This can only be accomplished by people who live, breathe, eat and sleep what they are doing.” At a board meeting to approve Boeing’s biggest ever investment, the 747, Allen was asked by non-executive director Crawford Greenwalt for Boeing’s financial projections on the project. In response to Allen’s vague reply, Greenwalt buried his head in his hands. “My God,” he muttered, “these guys don’t even know what the return on investment will be on this thing.” In 1997, Boeing acquired McDonnell Douglas and a new management team of Harry Stonecipher and Phil Condit took over. Mr Condit talked proudly of taking the company into “a value-based environment where unit cost, return on investment, and shareholder return are the measures by which you’ll be judged.” The result was lack of investment in major new civil aviation projects and diversification into defense and sat- ellites. Under Condit, Boeing relinquished market lead- ership in passenger aircraft to Airbus, while faltering as a defense contractor due partly to ethical lapses by key executives. When Condit resigned on December 1, 2003, Boeing’s stock price was 20% lower than when he was appointed. Sources: John Kay, “Forget How the Crow Flies,” Financial Times Magazine (January 17, 2004): 17–27; R. Perlstein, The Stock Ticker and the Superjumbo (Prickly Paradigm Press, 2005). 50 PART II THE TOOLS OF STRATEGY ANALYSIS This justification rests upon the overall alignment between profits and the interests of society as a whole (Adam Smith’s notion of the “invisible hand” of profit guiding firms to serve the needs of consumers) and the convergence of stakeholder and share- holder interests. But what about situations when the pursuit of profit conflicts with the social good or with widely held ethical principles? How are such inconsistencies and conflicts to be managed? Milton Friedman’s answer was clear: There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engage in open and free competition without deception or fraud.23 Under this doctrine, it is the role of government to intervene in the economy where the pursuit of profit conflicts with the interest of society, using taxes and regulations to align profit incentives with social goals and legislation to criminalize unethical behavior. Others have argued that business enterprises should take the initiative to establish principles and values that extend beyond the limits of the law, and pursue strategies that are explicitly oriented toward the interests of society. Let us discuss each of these areas in turn. Values and Principles A sense of purpose—as articulated in statements of mission and vision—is often complemented by beliefs about how this purpose should be achieved. These orga- nizational beliefs typically comprise a set of values—in the form of commitments to certain ethical precepts and to different stakeholder interests—and a set of principles to guide the decisions and actions of organizational members. Strategy Capsule 2.4 displays the values statement of Accenture plc, the world’s biggest con- sulting company. At one level, statements of values and principles may be regarded as instruments of companies’ external image management. Yet, to the extent that companies are con- sistent and sincere in their adherence to values and principles, these ideals can be a critical component of organizational identity and an important influence on employees’ commitment and behavior. When values are shared among organizational members, they form a central component of corporate culture. The evidence that commitment to values and principles influences organizational performance is overwhelming. McKinsey & Company places “shared values” at the center of its “7-S framework.”24 Jim Collins and Jerry Porras argue that “core values” and “core purpose” unite to form an organization’s “core ideology,” which “defines an orga- nization’s timeless character” and is “the glue that holds the organization together.”25 They argue that when core ideology is put together with an “envisioned future” for the enterprise the result is a powerful sense of strategic direction that provides the foundation for long-term success. Corporate Social Responsibility The debate over the social responsibilities of companies has been both contentious and confused. Underlying the debate are different ideas about what a company CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 51 is: “the property conception” views the company as a set of assets owned by the shareholders; the “social entity conception” views it as a community of individuals sustained and supported by its social, political, economic, and natural environ- ment.26 While the “firm as property” view implies that management’s sole responsi- bility is to operate in the interests of shareholders, the “firm as social entity” implies a responsibility to maintain the firm within its overall network of relationships and dependencies. Yet, from a practical viewpoint, both these conceptions are problematic. The view that the sole purpose of the business enterprise is to make profit fails to recognize that to survive and prosper, any organization must maintain social legitimacy. The near-elimination of investment banks during the financial crisis of 2008–09—including the transformation of Goldman Sachs and Morgan Stanley into commercial banks—was caused less by their commercial failure than by a collapse of legitimacy. The phone hacking scandal that caused the closure of a British newspaper owned by Rupert Mur- doch’s News Corporation represented less than 1% of News Corp’s revenues. However, in the five weeks after the scandal broke in July 2011, News Corp’s market capitaliza- tion declined by 25%—a loss of $11 billion. The argument that the primary responsibility of business enterprises should be the pursuit of social goals is similarly untenable. To extend Adam Smith’s observation STRATEGY CAPSULE 2.4 Accenture: Our Core Values Since its inception, Accenture has been governed by its core values. They shape the culture and define the character of our company. They guide how we behave and make decisions. ◆ Stewardship Fulfilling our obligation of building a better, stronger and more durable company for future generations, protecting the Accenture brand, meet- ing our commitments to stakeholders, acting with an owner mentality, developing our people and helping improve communities and the global environment. ◆ Best People Attracting, developing and retaining the best talent for our business, challenging our people, demonstrating a “can-do” attitude, and fostering a collaborative and mutually supportive environment. ◆ Client Value Creation Enabling clients to become high-performance businesses and creating long-term relationships by being responsive and relevant and by consistently delivering value. ◆ One Global Network Leveraging the power of global insight, relationships, collaboration and learning to deliver exceptional service to clients wherever they do business. ◆ Respect for the Individual Valuing diversity and unique contributions, fostering a trusting, open and inclusive environment and treating each person in a manner that reflects Accenture’s values. ◆ Integrity Being ethically unyielding and honest and inspiring trust by saying what we mean, matching our behaviors to our words and taking responsibility for our actions. Source: http://www.accenture.com/us-en/company/overview/ values/Pages/index.aspx, accessed July 20, 2015. http://www.accenture.com/us-en/company/overview/values/Pages/index.aspx 52 PART II THE TOOLS OF STRATEGY ANALYSIS that it “is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest,”27 it is likely that if the butcher becomes an animal rights activist, the brewer joins the Temperance League, and the baker signs up to Weight Watchers, none of us has much hope of getting dinner! Somewhere between these two conceptions lies a middle ground of viability where business enterprises are aligned with the needs of their social and natural environment, but remain committed to their business purpose and the generation of profit. Several contributions to the management literature offer guidance as to how firms can recon- cile their commercial and social responsibilities. The efficacy argument for corporate social responsibility (CSR) emphasizes the evolutionary fitness of the firm. The firm is embedded within natural and social eco- systems to which it must adapt and sustain. Thus, according to former Shell executive Arie de Geus, long-living companies are those that build strong communities, have a strong sense of identity, commit to learning, and are sensitive to the world around them. In short, they recognize they are living organisms whose life spans depend upon effective adaptation to a changing environment.28 This view of the firm jointly pursuing its own interests and those of its ecosystem has been developed by Michael Porter and Mark Kramer into a pragmatic approach to CSR.29 They offer three reasons why CSR might also be in the interests of a company: the sustainability argument—CSR is in firms’ interests due to a mutual interest in sustaining the ecosystem; the reputation argument—CSR enhances a firm’s reputation with consumers and other third parties; and the license-to-operate argument—to conduct their businesses firms need the support of the constitu- encies upon which they depend. The critical task in selecting which CSR initiatives firms should pursue is to identify specific intersections between the interests of the firm and those of society (i.e., projects and activities that create competitive advantage for the firm while generating positive social outcomes)—what they term strategic CSR. At the intersection between corporate and social interests is what Porter and Kramer refer to as shared value: “creating economic value in a way that also creates value for society.”30 It is not about redistributing value, but expanding the total pool of value. For example, fair trade redistributes value by paying farmers a higher price for their crops— in the case of Ivory Coast cocoa growers, it increases their incomes by 10–20%. By con- trast, efforts by cocoa buyers to improve the efficiency of cocoa growing can increase growers’ incomes by 300%, while lowering the cost of cocoa beans for chocolate manufacturers. Creating shared value involves reconceptualizing the firm’s boundaries and its relationship with its environment from a transactional to a co-dependency viewpoint. This offers three types of opportunity for shared value creation: reconceiv- ing products and markets, redefining productivity within the value chain, and building local clusters of suppliers, distributors, and related businesses at the places where the firm does business. Unilever’s Sustainable Growth Plan exemplifies this approach (see Strategy Capsule 2.5). This notion of shared value is embedded in bottom of the pyramid initiatives—the potential for multinational companies to simultaneously create profitable business and promote social and economic development.31 The key is a switch of perception: view- ing the poor as consumers, workers, and entrepreneurs rather than as victims or charity recipients. CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 53 Beyond Profit: Strategy and Real Options So far, we have identified the value of the firm with the net present value (NPV) of its profit earnings (or, equivalently, free cash flows). But conventional approaches to cal- culating NPV ignore an important feature of our uncertain world: the simple idea that an option—the choice of whether to do something or not—has value. In recent years, the principles of option pricing have been extended from valuing financial securities to valuing investment projects and companies. The resulting field of real option analysis has emerged as vitally important both for investment decisions and for strategy formu- lation. The technical details of valuing real options are complex. However, the under- lying principles are intuitive. Let me outline the basic ideas of real options theory and what they mean for strategy analysis. STRATEGY CAPSULE 2.5 unilever’s Sustainable Living Plan Since launching its Sustainable Living Plan in November 2010, Unilever—the Anglo-Dutch multinational supply- ing over 400 brands of food, personal care, and household products—has become a world leader in environment sustainability. According to the Economist, Unilever is “reck- oned to have the most comprehensive strategy of enlight- ened capitalism of any global firm.” The program—with its goals of reducing Unilever’s environmental footprint, increasing its positive social impact, doubling sales, and increasing long-term profitability—has been the cen- terpiece of CEO Paul Polman’s strategy for the company. Unilever has embedded its sustainability program within its strategic, operational, and human resource management: the plan is overseen by the board and incentive bonuses are linked to quantitative targets for emissions and waste reduction and energy and water conservation. While Polman emphasizes that Unilever’s commit- ment to sustainability is because it is “the right thing to do,” he is also clear that the primary motivation is the fact that the Sustainable Living Plan is in the long-term inter- ests of Unilever itself. In an interview with McKinsey and Company, Polman noted that the benefits to Unilever included improved access to raw materials, greater employee commitment, a stronger drive toward innova- tion throughout the company, greatly increased numbers of applications for jobs at Unilever, and improvement in efficiency in Unilever plants and throughout its supply chain. Shareholders appear to have benefitted as well: in the five years following the launch of the Sustainable Living Plan, Unilever’s share price rose by 40%, well ahead of rivals Procter & Gamble and Nestlé. However, when Polman announced, en route for the January 2015 Davos meetings, that he planned to “use the size and scale of Unilever” to lobby global leaders for a binding agreement on climate change and poverty erad- ication, some wondered whether he was putting global interests ahead of Unilever’s—especially given Unilever’s disappointing sales performance during 2014. When Uni- lever survived a hostile takeover bid from Kraft Heinz in 2017, Polman shifted his attention towards cost reduction and asset sales. Sources: McKinsey & Company, “Committing to sustainability: An interview with Unilever’s Paul Polman,” http://www.mckinsey.com/videos/video?vid=3564008886001& plyrid=2399849255001&Height=270&Width=480, accessed July 20, 2015; “Unilever: In search of the good business,” Economist, August 9, 2014. http://www.mckinsey.com/videos/video?vid=3564008886001&plyrid=2399849255001&Height=270&Width=480, 54 PART II THE TOOLS OF STRATEGY ANALYSIS Consider the investments that Royal Dutch Shell is making in joint-venture development projects to produce hydrogen for use in fuel cells. The large-scale use of fuel cells in transportation vehicles or for power generation seems unlikely within the foreseeable future. Shell’s expenditure on these projects is small, but almost certainly these funds would generate a higher return if they were used in Shell’s core oil and gas business. So, how can these investments—indeed, all of Shell’s investments in renew- able energy—be consistent with shareholder interests? The answer lies in the option value of these investments. Shell is not developing a full-scale fuel cell business, and nor is it developing commercial-scale hydrogen pro- duction plants: it is developing technologies that could be used to produce hydrogen if fuel cells become widely used. By building know-how and intellectual property in this technology, Shell has created an option. If economic, environmental, or political factors restrict hydrocarbon use and if fuel cells advance to the point of technical and commercial viability, then Shell could exercise that option by investing much larger amounts in commercial-scale hydrogen production. In a world of uncertainty, where investments, once made, are irreversible, flexibility is valuable. Instead of committing to an entire project, there is virtue in breaking the project into a number of phases, where the decision of whether and how to embark on the next phase can be made in the light of prevailing circumstances and the learning gained from the previous stage of the project. Most large companies have a “phases and gates” approach to product development in which the development process is split into distinct “phases,” at the end of which the project is reassessed before being allowed through the “gate.” Such a phased approach creates the options to continue the project, to abandon it, to amend it, or to wait. Venture capitalists clearly recognize the value of growth options. By August 2017, Hyperloop One had raised $160 million to develop commercial hyperloop transportation systems. Will these systems ever be completed, let alone make a profit? It is doubtful. Investors—which include General Electric, Dubai Ports, and SNCF, the French rail system, as well as several venture capital firms—are making small bets on the initial development of a technology that just might revolutionize transportation.32 The emphasis that venture capitalists place on scalability—the potential to scale up or replicate a business should the initial launch be successful—similarly acknowledges the value of growth options. Strategy Capsule 2.6 addresses the calculation of real option values. Strategy as Options Management For strategy formulation, our primary interest is how we can use the principles of option valuation to create enterprise value. There are two types of real option: growth options and flexibility options. Growth options allow a firm to make small initial investments in a number of future business opportunities but without committing to them. Flexibility options relate to the design of projects and plants that permit adaptation to different circumstances—flexible manufacturing systems allow different product models to be manufactured on a single production line. Individual projects can be designed to intro- duce both growth options and flexibility options. This means avoiding commitment to the complete project and introducing decision points at multiple stages, where the main options are to delay, modify, scale up, or abandon the project. Merck, an early adopter of option pricing, notes, “When you make an initial investment in a research project, you are paying an entry fee for a right, but you are not obligated to continue that research at a later stage.”33 CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 55 In developing strategy, our main concern is with growth options. These might include: ● Platform investments. These are investments in core products or technologies that create a stream of additional business opportunities.34 3M’s investment in nanotechnology offers the opportunity to create new products across a wide STRATEGY CAPSULE 2.6 Calculating Real Option Value Application of real option value to investment projects and strategies has been limited by the complexity of the valuation techniques. Yet, even without getting into the mathematics needed to quantify option values, we can use the basic principles involved to understand the factors that determine option values and to recognize how projects and strategies can be designed in order to maximize their option values.a The early work on real option valuation adapted the Black–Scholes option-pricing formula developed for val- uing financial options to the valuation of real investment projects. Black–Scholes comprises six determinants of option value, each of which has an analogy (~) in the val- uation of a real option: 1 Stock price ~ The NPV of the project: a higher NPV increases option value. 2 Exercise price ~ Investment cost: the higher the cost, the lower the option value. 3 Uncertainty ~ for both financial and real options, uncertainty increases option value. 4 Time to expiry ~ for both financial and real options, the longer the option lasts, the greater its value. 5 Dividends ~ Decrease in the value of the investment over the option period: lowers option value. 6 Interest rate ~ a higher interest rate increases option value by making deferral more valuable.b However, the dominant methodology used for real option valuation is the binomial options pricing model. By allowing the sources of uncertainty and key decision points in a project to be modeled explicitly, the tech- nique offers a more intuitive appreciation of the sources of option value. The analysis involves two main stages: 1 Create an event tree that shows the value of the project at each development period under two dif- ferent scenarios. 2 Convert the event tree into a decision tree by iden- tifying the key decision points on the event tree, typically the points where commitments of new funds to the project are required, or where there is the option to defer development. Incremental project values at each stage can then be calcu- lated for each decision point by working back from the final nodes of the decision tree (using a discount factor based upon the replicating port- folio technique). If the incremental project value at the initial stage exceeds the initial investment, proceed with the first phase, and similarly for each subsequent phase.c Notes: aSee: L. Trigeorgis and J. J. Reuer, “Real Options Theory in Strategic Management” Strategic Management Journal 38 (2017): 42–63. bSee: K. J. Leslie and M. P. Michaels, “The Real Power of Real Options,” McKinsey Quarterly Anthology: On Strategy (Boston: McKinsey & Company, 2000); A. Dixit and R. Pindyck, “The Options Approach to Capital Investment,” Harvard Business Review (May/ June 1995): 105–115. cThis approach is developed in T. Copeland and P. Tufano, “A Real-World Way to Manage Real Options,” Harvard Business Review (March 2004). See also T. Copeland, “Developing Strategy Using Real Options” (Monitor Company, October 2003). 56 PART II THE TOOLS OF STRATEGY ANALYSIS range of its businesses, from dental restoratives and drug-delivery systems to adhesives and protective coatings. Snapchat, the image messaging service, sup- ports a growing array of applications including news, payments, image augmen- tation, sponsored stories, collaborative stories, and original video entertainment.35 ● Strategic alliances and joint ventures are limited investments that provide a development stage for creating a new business or new strategy.36 Virgin Group has used joint ventures as the basis for creating a number of new businesses. A joint venture may be a preliminary to a full acquisition. In July 2017, Starbucks announced the acquisition of its partners’ shareholdings in its highly successful Chinese joint venture. ● Organizational capabilities can also be viewed as options that offer the potential to create competitive advantage across multiple products and businesses.37 Fuji- film’s thin-film coating capabilities developed in its photographic business have provided Fuji with the option to diversify into magnetic recording materials, cosmetics, and industrial coatings. Summary Chapter 1 introduced a framework for strategy analysis that provides the structure for Part II of this book. This chapter has explored the first component of that framework—the goals, values, and performance of the firm. We have explored in some depth the difficult, and still contentious, issue of the appropriate goals for the firm. While each firm has a specific business purpose, common to all firms is the desire, and the necessity, to create value. How that value is defined and measured distinguishes those who argue that the firms should operate primarily in the interests of owners (shareholders) from those who argue for a stakeholder approach. Our approach is pragmatic: shareholder and stakeholder interests tend to converge and, where they diverge, the pressure of competition limits the scope for pursuing stake- holder interests at the expense of profit; hence, my conclusion that long-run profit—or its equivalent, enterprise value—is appropriate both as an indicator of firm performance and as a guide to strategy for- mulation. We explored the relationships between value, profit, and cash flow and saw how the failings of shareholder value maximization resulted more from its misapplication than from any inherent flaw. The application of financial analysis to the assessment of firm performance is an essential component of strategic analysis. Financial analysis creates a basis for strategy formulation, first, by appraising overall firm performance and, second, by diagnosing the sources of unsatisfactory performance. Combining financial analysis and strategic analysis allows us to establish performance targets for companies and their business units. Finally, we looked beyond the limits of our useful, yet simplistic, profit-oriented approach to firm performance and business strategy. We looked, first, at how the principles of corporate social responsi- bility can be incorporated within a firm’s strategy to enhance its creation of both social and shareholder value. Second, we extended our analysis of value maximization to take account of the fact that strategy creates enterprise value not only by generating profit but also by creating real options. CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 57 Notes 1. J. A. Schumpeter, The Theory of Economic Development (Cambridge, MA: Harvard University Press 1934). 2. “Henry Ford: The Man Who Taught America to Drive,” Entrepreneur (October 8, 2008), www.entrepreneur.com/ article/197524, accessed July 20, 2015. 3. C. A. Montgomery, “Putting Leadership Back into Strategy,” Harvard Business Review ( January 2008): 54–60. 4. In this chapter, I use the term value in two distinct senses. Here I am referring to economic value, which is worth as measured in monetary units. I shall also be discussing values as moral principles or standards of behavior. 5. T. Donaldson and L. E. Preston, “The Stakeholder Theory of the Corporation,” Academy of Management Review 20 (1995): 65–91. 6. In several countries, company law has been amended to allow companies to pursue explicit social goals. In the US, these “benefit corporations” (or B-corporations) include the outdoor apparel company, Patagonia. See J. Surowiecki, “Companies with Benefits,” The New Yorker, August 4, 2014. 7. M. B. Lieberman, N. Balasubramanian, and R. García- Castro outline a method for estimating changes in value creation over time (“Measuring Value Creation and Appro- priation in Firms: The VCA Model,” Strategic Management Journal 38 ( June 2017): 1193–1211). 8. M. C. Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance 22 (Winter 2010): 34. 9. “The Lean and Mean Approach of 3G Capital,” Financial Times (May 7, 2017). 10. “Activist Investors Have a New Bloodlust: CEOs,” Wall Street Journal (May 16, 2017). 11. T. M. Jones, “Instrumental Stakeholder Theory: A Syn- thesis of Ethics and Economics,” Academy of Management Review 20 (1995): 404–437. Self-Study Questions 1. Since long-run profitability requires that a firm is sensitive to the interests of its customers, employees, suppliers, and society-at-large, whether a firm is run in the interests of its share- holders or its stakeholders makes no real difference. Do you agree? Are there situations where shareholder and stakeholder interests diverge? 2. Table 2.1 compares companies according to different profitability measures. a. Which two of the six performance measures do you think are the most useful indicators of how well a company is being managed? b. Is return on sales or return on equity a better basis on which to compare the performance of the companies listed? c. Several companies are highly profitable yet delivered very low returns to their share- holders during 2017. How is this possible? 3. With regard to Strategy Capsule 2.2, what additional data would you seek and what additional analysis would you undertake to investigate further the reasons for UPS’s superior profit- ability to FedEx? 4. The CEO of a chain of pizza restaurants wishes to initiate a program of CSR to be funded by a 5% levy on the company’s operating profit. The board of directors, fearing a negative share- holder reaction, is opposed to the plan. What arguments might the CEO use to persuade the board that CSR might be in the interests of shareholders, and what types of CSR initiatives might the program include to ensure that this was the case? 5. Nike, a supplier of sports footwear and apparel, is interested in the idea that it could increase its stock market value by creating options for itself. What actions might Nike take that might generate option value? www.entrepreneur.com/article/197524 58 PART II THE TOOLS OF STRATEGY ANALYSIS 12. M. Orlitzky, F. L. Schmidt, and S. L. Rynes, “Corporate Social and Financial Performance: A Meta-Analysis,” Orga- nization Studies 24 (Summer 2003): 403–441. 13. See www.sternstewart.com. See also J. L. Grant, Founda- tions of Economic Value Added, 2nd edn (New York: John Wiley & Sons, Ltd, 2003). 14. See: “Five Ways to Estimate Terminal Values,” http:// onlinelibrary.wiley.com/doi/10.1002/9781118273166. app13/pdf. Accessed August 27, 2017. 15. T. Koller, M. Goedhart, D. Wessels, Valuation: Measuring and Managing the Value of Companies, 5th edn (Hoboken, NJ: John Wiley & Sons, Inc., 2010). 16. F. Modigliani and M. H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investments,” American Economic Review 48 (1958): 261–297. 17. Some calculations of enterprise value deduct the balance sheet value of a firm’s cash and marketable securities from the market value of its equity and debt in order to value only the business itself. 18. R. S. Kaplan and D. P. Norton, “The Balanced Scorecard: Measures That Drive Performance,” Harvard Business Review ( January/February 1992): 71–79; R. S. Kaplan and D. P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” Harvard Business Review ( January/ February 1996): 75–85. 19. S. Chatterjee, “Enron’s Incremental Descent into Bank- ruptcy: A Strategic and Organizational Analysis,” Long Range Planning 36 (2003): 133–149. 20. P. C. Roberts and K. LaFollett Meltdown: Inside the Soviet Economy (Washington, DC: Cato Institute, 1990). 21. G. Bevan and C. Hood, “What’s Measured Is What Matters: Targets and Gaming in the English Public Health Care System,” Public Administration 84 (2006): 517–538. 22. J. Kay, Obliquity (London: Profile Books, 2010). 23. M. Friedman, Capitalism and Freedom (Chicago: Univer- sity of Chicago Press, 1963). 24. L. Bryan, “Enduring Ideas: The 7-S Framework,” McKinsey Quarterly (March 2008). 25. J. Collins and J. Porras, “Building Your Company’s Vision,” Harvard Business Review (September/October 1996): 65–77. 26. W. T. Allen, “Our Schizophrenic Conception of the Business Corporation,” Cardozo Law Review 14 (1992): 261–281. 27. A. Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 5th edn (London: Methuen & Co., 1905), Chapter 2. 28. A. de Geus, “The Living Company,” Harvard Business Review (March/April 1997): 51–59. 29. M. E. Porter and M. R. Kramer, “Strategy and Society: The Link between Competitive Advantage and Corporate Social Responsibility,” Harvard Business Review (Decem- ber 2006): 78–92. 30. M. E. Porter and M. R. Kramer, “Creating Shared Value,” Harvard Business Review ( January 2011): 62–77. 31. C. K. Prahalad and S. L. Hart, “The Fortune at the Bottom of the Pyramid,” strategy + business 26 (2002): 54–67; T. London and S. L. Hart, “Reinventing Strat- egies for Emerging Markets: Beyond the Transnational Model,” Journal of International Business Studies 35 (2004): 350–370. 32. “Hyperloop One hits 309km/h in latest test,” Wired (August 2, 2017). 33. N. Nichols, “Scientific Management at Merck: An Inter- view with CFO Judy Lewent,” Harvard Business Review ( January/February 1994): 89–105. 34. B. Kogut and N. Kulatilaka, “Options Thinking and Platform Investments: Investing in Opportunity,” California Management Review (Winter 1994): 52–69. 35. “Snapchat: An Abridged History,” Fortune (February 4, 2017). http://fortune.com/2017/02/04/snapchat- abridged-history/ 36. T. Chi, “Option to Acquire or Divest a Joint Venture,” Strategic Management Journal 21 (2000) 665–687. 37. B. Kogut and N. Kulatilaka, “Capabilities as Real Options,” Organization Science 12 (2001) 744–758. http://onlinelibrary.wiley.com/doi/10.1002/9781118273166.app13/pdf http://onlinelibrary.wiley.com/doi/10.1002/9781118273166.app13/pdf http://onlinelibrary.wiley.com/doi/10.1002/9781118273166.app13/pdf 3 When a management with a reputation for brilliance tackles a business with a rep- utation for poor fundamental economics, it is the reputation of the business that remains intact. —WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY The reinsurance business has the defect of being too attractive-looking to new entrants for its own good and will therefore always tend to be the opposite of, say, the old business of gathering and rendering dead horses that always tended to contain few and prosperous participants. —CHARLES T. MUNGER, CHAIRMAN, WESCO FINANCIAL CORP Industry Analysis: The Fundamentals ◆ Introduction and Objectives ◆ From Environmental Analysis to Industry Analysis ◆ Analyzing Industry Attractiveness ● Porter’s Five Forces of Competition Framework ● Competition from Substitutes ● Threat of Entry ● Rivalry between Established Competitors ● Bargaining Power of Buyers ● Bargaining Power of Suppliers ◆ Applying Industry Analysis to Forecasting Industry Profitability ● Identifying Industry Structure ● Forecasting Industry Profitability ◆ Using Industry Analysis to Develop Strategy ● Strategies to Alter Industry Structure ● Positioning the Company ◆ Defining Industries: Where to Draw the Boundaries ● Industries and Markets ● Defining Industries and Markets: Substitution in Demand and Supply ◆ From Industry Attractiveness to Competitive Advantage: Identifying Key Success Factors ◆ Summary ◆ Self-Study Questions ◆ Notes O U T L I N E 60 PART II THE TOOLS OF STRATEGY ANALYSIS From Environmental Analysis to Industry Analysis The business environment of the firm consists of all the external influences that impact its decisions and its performance. Given the vast number of external influences, how can managers hope to monitor, let  alone analyze, environmental conditions? The starting point is some kind of system or framework for organizing information. Environmental influences can be classified by source, for example, PEST analysis considers the political, economic, social, and technological factors that impact a firm. Introduction and Objectives In this chapter and the next, we explore the external environment of the firm. In Chapter 1, we observed that profound understanding of the competitive environment is a critical ingredient of a successful strategy. We also noted that business strategy is essentially a quest for profit. The primary task for this chapter is to identify the sources of profit in the external environment. The firm’s proximate environment is its industry; hence, industry analysis will be our focus. Industry analysis is relevant both to corporate-level and business-level strategies. ◆ Corporate strategy is concerned with deciding which industries the firm should be engaged in and how it should allocate its resources among them. Such decisions require assessment of the attrac- tiveness of different industries in terms of their profit potential. The main objective of this chapter is to understand how the competitive structure of an industry determines its profitability. ◆ Business strategy is concerned with establishing competitive advantage. By analyzing customer needs and preferences and the ways in which firms compete to serve customers, we identify the general sources of competitive advantage in an industry—what we call key success factors. By the time you have completed this chapter, you will be able to: ◆ Appreciate that the firm’s industry forms the core of its external environment and under- stand that its characteristics and dynamics are essential components of strategy analysis. ◆ Identify the main structural features of an industry and understand how they impact the intensity of competition and overall level of profitability in the industry. ◆ Apply industry analysis to explain the level of profitability in an industry and predict how profitability is likely to change in the future. ◆ Develop strategies that (a) position the firm most favorably in relation to competition and (b) influence industry structure in order to enhance industry attractiveness. ◆ Define the boundaries of the industry within which a firm is located. ◆ Identify opportunities for competitive advantage within an industry (key success factors). CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 61 PEST analysis and similar approaches to macrolevel environmental scanning can be useful in keeping a firm alert to what is happening in the world but may result in information overload. The prerequisite for effective environmental analysis is to distinguish the vital from the merely important. Hence, we need to establish what features of a firm’s external environment are critical to its decisions. For the firm to make a profit, it must create value for customers. Hence, it must understand its customers. Second, in creating value, the firm acquires inputs from suppliers. Hence, it must under- stand its suppliers and manage relationships with them. Third, the ability to gen- erate profitability depends on the intensity of competition among firms that vie for the same value-creating opportunities. Hence, the firm must understand competi- tion. Thus, the core of the firm’s business environment is formed by its relationships with three sets of players: customers, suppliers, and competitors. This is its industry environment. This is not to say that macrolevel factors such as general economic trends, changes in demographic structure, political events, and new technologies are unimportant for strategy analysis. They may be critical determinants of the threats and opportunities a company will face in the future. The key issue, however, is how these factors affect the firm’s industry environment (Figure 3.1). Consider the threat of global warming. For most companies, this is not a core strategic issue (at least, not within their normal planning horizons). However, for those businesses most directly affected by chang- ing weather patterns—farmers and ski resorts—and those subject to carbon taxes and environmental regulations—electricity generators and automobile producers—global warming is a vital issue. For these businesses, the key is to analyze the implications of global warming for customers, suppliers, and competition within their particular industry. For the auto makers, will consumers switch to electric cars? Will governments mandate zero-emission vehicles or increase spending on public transportation? Will there be new entrants into the auto industry? If strategy is about identifying and exploiting sources of profit, then the starting point for industry analysis is the simple question “What determines the level of profit in an industry?” In the last chapter, we learned that, for a firm to make profit, it must create value for the customer. Value is created when the price the customer is willing to pay for a THE INDUSTRY ENVIRONMENT • Suppliers • Competitors • Customers DemographicsTechnology Government and political forces The national/ international economy The natural environment Social forces FIGURE 3.1 From environmental analysis to industry analysis 62 PART II THE TOOLS OF STRATEGY ANALYSIS product exceeds the costs incurred by the firm. But creating customer value does not necessarily yield profit. The value created is distributed between customers and pro- ducers by the forces of competition. The stronger competition is among producers, the more value is received by customers as consumer surplus (the difference bet- ween the price they actually pay and the maximum price they would have been wil- ling to pay) and the less is received by producers (as producer surplus or economic rent). A single supplier of umbrellas outside the Gare de Lyon on a wet Parisian morning can charge a price that fully exploits commuters’ desire to keep dry. As more and more umbrella sellers arrive, so the price of umbrellas will be pushed closer to the wholesale cost. However, the profit earned by Parisian umbrella sellers, or any other industry, does not just depend on the competition between them. It also depends upon their sup- pliers. If an industry has a powerful supplier—a single wholesaler of cheap, imported umbrellas—that supplier may be able to capture a major part of the value created in the local umbrella market. Hence, the profits earned by the firms in an industry are determined by three factors: ● the value of the product to customers ● the intensity of competition ● the bargaining power of industry members relative to their suppliers and buyers. Industry analysis brings all three factors into a single analytic framework. Analyzing Industry Attractiveness Table 3.1 shows the profitability of different US industries. Some earn consistently high rates of profit; others fail to cover their cost of capital. The basic premise that under- lies industry analysis is that the level of industry profitability is neither random nor the result of entirely industry-specific influences: it is determined by the systematic influ- ences of the industry’s structure. The underlying theory of how industry structure drives competitive behavior and determines industry profitability is provided by industrial organization (IO) eco- nomics. The two reference points are the theory of monopoly and the theory of per- fect competition. In a monopoly, a single firm is protected by high barriers to entry. In perfect competition, many firms supply a homogeneous product and there are no entry barriers. Monopoly and perfect competition form end points of a spectrum of industry structures. While a monopolist can appropriate as profit the full amount of the value it creates, under perfect competition, the rate of profit falls to a level that just covers firms’ cost of capital. Some real-world industries are close to being monop- olies. During 1996–2002, Microsoft’s near monopoly of the market for PC operating systems allowed it to earn a return on equity of over 30%. Niche markets may be suf- ficiently small that they can be dominated by a single firm (see Strategy Capsule 3.1). Other industries are close to being perfectly competitive. The US farm sector earns a long-run return on equity of about 3%—well below its cost of capital. However, most industries are somewhere in between: most are oligopolies—industries domi- nated by a few major companies. CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 63 TABLE 3.1 The profitability of US industries, 2010–2016 Industry ROCE (%) Leading Companies Tobacco 59.9 Altria, Reynolds American, Philip Morris Int. Computer Software 29.8 Microsoft, Oracle, Salesforce Household, Personal Care Products 25.2 Procter & Gamble, Kimberley-Clark, Colgate-Palmolive Semiconductors 22.5 Intel, Qualcomm, Texas Instruments Pharmaceuticals 21.3 Pfizer, Johnson & Johnson, Merck Entertainment 20.7 Walt Disney, Time Warner, CBS Aerospace, Defense 19.9 Boeing, Lockheed Martin, United Technologies Beverages 19.2 Coca-Cola, Constellation Brands, Chemicals, Specialty 18.2 PPG Industries, Monsanto, Praxair Food Processing 18.0 Kraft Foods, General Mills, ConAgra Medical Products 17.5 Becton Dickinson, Stryker, Boston Scientific Engineering/Construction 16.8 Flour, AECOM, Jacobs Engineering Restaurants, Catering 16.6 McDonalds, Darden Restaurants, Starbucks Office Equipment & Services 15.3 Xerox, NCR, NetApp Apparel 14.8 VF, Hanesbrands, Ralph Lauren Furniture, Home Furnishings 13.9 Mohawk Industries, Masco, Herman Miller Chemicals, General 13.8 Dow Chemical, DuPont, Huntsman Electronic products 13.7 Apple, Honeywell Intl., Dell Technologies Packaging, Containers 13.5 WestRock, Ball, Crown Holdings Metals & Mining 12.7 Alcoa, Freeport-McMoRan, Newmont Mining Publishing, Newspapers 12.5 News Corp, R.R. Donnelley & Sons, Gannett Railroads 12.4 Union Pacific, CSX, Norfolk Southern Hospitals, Healthcare Services 12.1 UnitedHealth Group, HCA Holdings, Tenet Healthcare Paper, Forest Products 11.2 Weyerhaeuser, International Paper, Boise Cascade Steel 9.9 Nucor, US Steel, Steel Dynamics Investment, Asset Management 9.5 BlackRock, Charles Schwab, Franklin Resources Telecom Services 9.5 AT&T, Verizon Communications, Comcast Agricultural Processing 9.5 Archer Daniel Midland, Tyson Foods, CHS Petroleum 9.2 ExxonMobil, Chevron, Valero Insurance 9.1 State Farm Insurance, MetLife, Prudential Financial Food Retailing 9.1 Kroger, Albertsons, Publix Super Markets Trucking 9.1 XPO Logistics, C.H. Robinson Worldwide, J.B. Hunt Hotels, Casinos 9.0 Marriott International, Las Vegas Sands, MGM Resorts Motor Vehicle Parts 9.0 General Motors, Ford, Lear Electrical Power 6.9 Exelon, Duke Energy, PG&E Corp. Motor Vehicles 5.7 General Motors, Ford Motor, Paccar Airlines 5.1 American Airlines, Delta Air Lines, United Continental Notes: ROCE = Earnings before interest and tax / (Equity + Long-term debt) 64 PART II THE TOOLS OF STRATEGY ANALYSIS Porter’s Five Forces of Competition Framework Michael Porter’s five forces of competition framework is the most widely used tool for analyzing competition within industries.1 It regards the profitability of an industry (as indicated by its rate of return on capital relative to its cost of capital) as determined by five sources of competitive pressure. These five forces of compe- tition include three sources of “horizontal” competition: competition from substi- tutes, competition from entrants, and competition from established rivals; and two sources of “vertical” competition: the power of suppliers and the power of buyers (Figure 3.2). The strength of each of these competitive forces is determined by a number of key structural variables, as shown in Figure 3.3. Competition from Substitutes The price that customers are willing to pay for a product depends, in part, on the availability of substitute products. The absence of close substitutes for a product, as in the case of gasoline or cigarettes, means that consumers are comparatively insen- sitive to price (demand is inelastic with respect to price). The existence of close sub- stitutes means that customers will switch to substitutes in response to price increases for the product (demand is elastic with respect to price). The Internet has provided a new source of substitute competition that has proved devastating for a number of established industries. Travel agencies, newspapers, and telecommunication providers have all suffered severe competition from Internet-based substitutes. STRATEGY CAPSULE 3.1 Chewing Tobacco, Sausage Skins, and Sports Cards: The Joys of Niche markets US Smokeless Tobacco Company earned an operating margin of 62% during 2014–2017, making a major con- tribution to the 122% return on equity earned by its par- ent, Altria Inc., over the same period. What’s the secret of USSTC’s profitability? It accounts for 57% of the US market for smokeless tobacco, and its long-established brands (including Skoal, Copenhagen, and Red Seal), its distribution through thousands of small retail outlets, and government restrictions on advertising tobacco prod- ucts create formidable barriers to would-be competitors. Devro plc, based in the Scottish village of Moodiesburn, is the world’s leading supplier of collagen sausage skins (“casings”). “From the British Banger to the Chinese Lap Cheong, from the French Merguez to the South American Chorizo, Devro has a casing to suit all product types.” Its overall world market share is around 60%. During 2014–2017, Devro’s return on equity exceeded 20%—about three times its cost of equity. Panini Group, based in Modena, Italy, is the world leader in sports trading cards and collectable stickers. With an exclusive licence with FIFA, it domi- nates soccer cards and, with licences to supply NBA. NFL and NHL trading cards, it has become market leader in the US. It is believed to have earned an operating margin of over 20% on its 2016 revenues of $631 million. Sources: www.altria.com, www.devro.com, and www.paninigroup.com/corporate/ CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 65 FIGURE 3.2 Porter’s five forces of competition framework INDUSTRY COMPETITORS Rivalry among existing f irms Bargaining power of suppliers Threat of new entrants Bargaining power of buyers Threat of substitutes POTENTIAL ENTRANTS SUBSTITUTES SUPPLIERS BUYERS FIGURE 3.3 The structural determinants of the five forces of competition Bargaining power • Size and concentration of buyers relative to producers • Buyers’ switching costs • Buyers’ information • Buyers’ ability to backward integrate BUYER POWER Price sensitivity • Cost of product relative to total cost • Product dif ferentiation • Competition between buyers • Concentration • Diversity of competitors • Product dif ferentiation • Excess capacity and exit barriers • Cost conditions SUPPLIER POWER • Buyers’ price sensitivity • Capital requirements • Economies of scale • Absolute cost advantages • Product dif ferentiation • Access to distribution • Legal barriers • Retaliation SUBSTITUTE COMPETITION • Buyers’ propensity to substitute • Relative prices and performance of substitutes INDUSTRY RIVALRYTHREAT OF ENTRY • Relative bargaining power (See Buyer Power for detail) 66 PART II THE TOOLS OF STRATEGY ANALYSIS The extent to which substitutes depress prices and profits depends on the propen- sity of buyers to substitute between alternatives. This, in turn, depends on their price– performance characteristics. If city-center to city-center travel between Washington and New York is 50 minutes quicker by air than by train and the average traveler values time at $30 an hour, the implication is that the train will be competitive at fares of $25 below those charged by the airlines. The more complex a product and the more differentiated are buyers’ preferences, the lower the extent of substitution by customers on the basis of price differences. Threat of Entry If an industry earns a return on capital in excess of its cost of capital, it will attract entry from new firms and established firms diversifying from other industries. If entry is unrestricted, profitability will fall toward its competitive level. In some industries, it is easy to establish a new company. Beer brewing has seen a flood of new entrants in recent years. Between 1990 and 2017, the number of breweries increased from 284 to 4269 in the US and from 241 to 892 in the UK, despite declining beer consumption in both countries.2 Wage differences between occupations are also influenced by entry barriers. Why is it that my wife, a psychotherapist, earns much less than our niece, a recently qualified medical doctor? Psychotherapy, with its multiple accrediting bodies and less restrictive licensing. has much lower barriers to entry than medical practice. Threat of entry rather than actual entry may be sufficient to ensure competitive price levels. An industry where no barriers to entry or exit exist is contestable: prices and profits tend toward the competitive level, regardless of the number of firms within the industry.3 Contestability depends on the absence of sunk costs, hence making an industry is vulnerable to “hit and run” entry whenever established firms raise their prices above the competitive level. In most industries, however, new entrants must surmount barriers to entry: disad- vantages that new entrants face relative to established firms. The size of this disadvan- tage determines the height of a barrier to entry. The principal sources of barriers to entry are as follows: Capital Requirements Set-up costs can be so large as to discourage all but the larg- est companies. The duopoly of Boeing and Airbus in large passenger jets is protected by the huge investments needed to develop, build, and service big jet planes. In other industries, entry costs can be modest. Intense competition in the market for smart- phone apps reflects the low cost of developing most software applications. Across the service sector, start-up costs tend to be low: the cost of a franchised pizza outlet starts at $119,950 for Domino’s and $130,120 for Papa John’s.4 Economies of Scale Industries with high capital requirements for new entrants are also subject to economies of scale. If large, indivisible investments in production, product development, distribution or marketing are required, efficiency requires amor- tizing these costs over a large volume of output. According to Fiat Chrysler’s late-CEO, Sergio Marchionne, financial viability in automobiles requires producing at least six million vehicles a year. New automobile producers must either enter with suboptimal capacity or with scale-efficient capacity that is massively underutilized while the entrant builds market share. CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 67 Absolute Cost Advantages Established firms may have a cost advantage over entrants, irrespective of scale. Absolute cost advantages often result from the owner- ship of low-cost sources of raw materials. Established oil and gas producers, such as Saudi Aramco and Gazprom, which have access to the world’s biggest and most acces- sible reserves, have an unassailable cost advantage over more recent entrants such as Cairn Energy and EOG Resources. Absolute cost advantages also result from learning. Intel’s dominance of the market for advanced microprocessors arises in part from the benefits it derives from its wealth of experience. Product Differentiation In an industry where products are differentiated, established firms possess the advantages of brand recognition and customer loyalty.5 New entrants to such markets must spend disproportionately heavily on advertising and promotion to establish brand awareness. Access to Channels of Distribution For many new suppliers of consumer goods, the principal barrier to entry is gaining distribution. Limited shelf space, risk aversion, and the costs of carrying an additional product cause retailers to be reluc- tant to carry a new manufacturer’s product. “Slotting fees”, payments by suppliers to supermarkets to reserve shelf space, further disadvantage new entrants. An impor- tant consequence of the Internet has been allowing new businesses to circumvent barriers to distribution. Governmental and Legal Barriers Some of the most effective barriers to entry are those created by government. In taxicabs, banking, telecommunications, and broadcasting, entry usually requires a license from a public authority. Leg- islation concerning intellectual properties allows the creators of inventions, art, and brands to be protected from imitators by patents, copyrights, and trademarks. Environmental and safety regulations may also put new entrants at a disadvan- tage to established firms because compliance costs tend to weigh more heavily on newcomers. Retaliation Potential entrants may also be deterred by expectations of retaliation by established firms. Such retaliation may take the form of aggressive price-cutting, increased advertising, sales promotion, or litigation. The budget airlines frequently allege predatory price cuts by the major airlines designed to deter them from new routes.6 To avoid retaliation, new entrants may initiate small-scale entry into marginal market segments. Toyota, Nissan, and Honda’s first entry into the US auto market targeted small cars, a segment that had been written off by the Detroit Big Three as inherently unprofitable. The Effectiveness of Barriers to Entry Industries protected by entry barriers— particularly those where capital retirements and advertising are high—tend to earn above-average rates of profit.7 The effectiveness of barriers to entry depends on the resources and capabilities that potential entrants possess. Barriers that are effective against new companies may be ineffective against established firms that are diversi- fying from other industries.8 Google’s massive web presence allowed it to challenge the seemingly impregnable market positions of Microsoft in web browsers and Apple in smartphones. 68 PART II THE TOOLS OF STRATEGY ANALYSIS Rivalry between Established Competitors In most industries, the major determinant of the overall state of competition and the general level of profitability is rivalry among the firms within the industry. In some industries, firms compete aggressively—sometimes to the extent that prices are pushed below the level of costs and industry-wide losses are incurred. In other industries, price competition is muted and rivalry focuses on advertising, innova- tion, and other nonprice dimensions. The intensity of price competition between established firms is the result of interactions between six factors. Let us look at each of them. Concentration Seller concentration refers to the number and size distribu- tion of firms competing within a market. It is most commonly measured by the concentration ratio: the combined market share of the leading producers. For example, the four-firm concentration ratio (CR4) is the market share of the four larg- est producers. In markets dominated by a single firm (e.g., Gillette in razor blades, or FICO in consumer credit scoring), or by a small group of companies (Coca-Cola and Pepsi in soft drinks; Bloomberg and Reuters in financial intelligence), price competition tends to be restrained, and competition focuses on advertising, pro- motion, and new product development. As the number of firms supplying a market increases, coordination of prices becomes more difficult and the likelihood that one firm will initiate price-cutting increases. In wireless telecommunications, regulators in the United States and Europe have favored four operators in each market and opposed mergers in the belief that three competitors is too few for effective price competition.9 However, despite the frequent observation that the exit of a compet- itor reduces price competition, while new entry stimulates it, there is little systematic evidence that seller concentration increases profitability: “The relation, if any, bet- ween seller concentration and profitability is weak statistically and the estimated effect is usually small.”10 Diversity of Competitors The ability of rival firms to avoid price competition by coordinating their prices depends on how similar they are in their origins, objectives, costs, and strategies. The cozy atmosphere of the US auto industry prior to the advent of import competition was greatly assisted by the similarities of the companies in terms of cost structures, strategies, and top management mindsets. Conversely, the difficulties that OPEC experiences in agreeing and enforcing output quotas among its member countries are exacerbated by their differences in terms of objectives, production costs, politics, and religion.11 Product Differentiation The more similar the offerings among rival firms, the more willing are customers to switch between them and the greater is the induce- ment for firms to cut prices to boost sales. Where the products of rival firms are virtually indistinguishable, the product is a commodity and price is the sole basis for competition. By contrast, in industries where products are highly differentiated (perfumes, pharmaceuticals, restaurants, management consulting services), com- petition tends to focus on quality, brand promotion, and customer service rather than price. Excess Capacity and Exit Barriers Why, especially in commodity industries, does industry profitability tend to fall so drastically during periods of recession? The key is the balance between demand and capacity. Unused capacity encourages firms to offer CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 69 price cuts to attract new business. Excess capacity may be cyclical (e.g., the boom– bust cycle in the semiconductor industry); it may also be part of a structural problem resulting from overinvestment and declining demand. In this latter situation, the key issue is whether excess capacity will leave the industry. Barriers to exit are impedi- ments to capacity leaving an industry. Where assets are durable and specialized, and where employees are entitled to job protection, barriers to exit may be substantial.12 In the European auto industry, excess capacity together with high exit barriers have devastated industry profitability. Conversely, demand growth creates capacity short- ages that boost margins. Rising demand for lithium-ion batteries has caused shortages of production capacity for lithium and cobalt, increasing their prices and profitability. On average, companies in growing industries earn higher profits than companies in slow-growing or declining industries (Figure 3.4). Cost Conditions: Scale Economies and the Ratio of Fixed to Variable Costs When excess capacity causes price competition, how low will prices go? The key factor is cost structure. Where fixed costs are high relative to variable costs, firms will take on marginal business at any price that covers variable costs. The incredible volatility of bulk shipping rates reflects the fact that almost all the costs of operating bulk carriers are fixed. The daily charter rates for “capesize” bulk carriers fell from $233,998 on June 5, 2008 to $2773 six months later as world trade contracted. Similarly, in airlines, the low additional costs of filling empty seats mean that the emergence of excess capacity often leads to price wars and industry-wide losses. “Cyclical” industries are characterized both by cyclical demand and high fixed costs causing fluctuations in revenues to be amplified into much bigger fluctuations in profits. Scale economies may also induce aggressive price competition as companies seek the cost benefits of greater volume. Bargaining Power of Buyers The profit margin earned by the firms in an industry depends on the prices they can charge their customers. These customers will do all they can to exert downward FIGURE 3.4 The impact of growth on profitability Im p ac t o n ra te o f p ro f it (% ) –6% –4% –2% 0% Rate of market growth (in real terms) 12%10%8%6%4%2% 2.5 2 1.5 1 0.5 0 –1 –1.5 –0.5 Return on investment Return on sales Source: Based upon the PIMS multiple regression equation. See R. M. Grant Contemporary Strategy Analysis, 5th edition (Blackwell, 2005): 491. 70 PART II THE TOOLS OF STRATEGY ANALYSIS pressure on these prices. The ability of buyers to drive down the prices they pay depends upon two factors: their price sensitivity and their bargaining power relative to the firms within the industry. Buyers’ Price Sensitivity The extent to which buyers are sensitive to the prices they are charged depends on the following. ● The greater the importance of the product as a proportion of buyers’ total cost, the more sensitive buyers will be about the price they pay. Soft drink com- panies are highly sensitive to the costs of aluminum cans because this is one of their largest cost items. Conversely, most companies are not sensitive to the fees charged by their auditors, since auditing costs are a tiny fraction of total expenses. ● The less differentiated the products of the supplying industry, the more wil- ling are buyers to switch suppliers on the basis of price. The manufacturers of T-shirts and light bulbs have much more to fear from Walmart’s buying power than have the suppliers of cosmetics. ● The more intense the competition among buyers, the greater their eagerness to obtain preferential terms from their suppliers. Intense price competition among British supermarket chains has made them hypersensitive to the prices they pay their suppliers. ● The more critical an industry’s product to the quality of the buyer’s product or service, the less sensitive are buyers to the prices they are charged. Dentists tend not to negotiate over the prices they pay the manufacturers of titanium dental implants. Relative Bargaining Power Bargaining power rests, ultimately, on the refusal to deal with the other party. The balance of power between the two parties to a transac- tion depends on the credibility and effectiveness with which each makes this threat. The key issue is the relative cost that each party would incur in the event of a hold-out by the counterparty, together with the relative bargaining skills of each party. Several factors influence the bargaining power of buyers relative to that of sellers: ● Size and concentration of buyers relative to suppliers. If an industry faces few buyers, each with large purchases, firms will be very reluctant to lose a large buyer. Because of their size, health maintenance organizations can pur- chase health care from hospitals and doctors at much lower costs than can individual patients. ● Buyers’ information. The better informed are buyers about suppliers and their prices and costs, the better they are able to bargain. Doctors and lawyers do not normally display the prices they charge, nor do traders in the bazaars of Marrakech or Chennai. Keeping customers ignorant of market prices is an effec- tive constraint on their buying power. But knowing prices is of little value if the quality of the product is unknown. In the markets for dentistry, interior design, and management consulting, the ability of buyers to bargain over price is limited by uncertainty over the precise attributes of the product they are buying. ● Capacity for vertical integration. Backward integration is a means through which buyers reduce their dependence upon their suppliers. Large beer com- panies have reduced their dependence on the manufacturers of aluminum CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 71 cans by manufacturing their own. Large retail chains introduce their own label brands to compete with those of their suppliers. Backward integration need not necessarily occur—a credible threat may suffice. Bargaining Power of Suppliers Analysis of supplier power is precisely analogous to analysis of buyer power. The only difference is that it is now the firms in the industry that are the buyers and the pro- ducers of inputs that are the suppliers. Again, the relevant factors are the ease with which the firms in the industry can switch between different input suppliers and the relative bargaining power of each party. The suppliers of commodities tend to lack bargaining power relative to their customers; hence, they may use cartels to boost their influence over prices (e.g., OPEC, the International Coffee Organization, and farmers’ marketing cooperatives). Conversely, the suppliers of complex, technically sophisticated components may be able to exert considerable bargaining power. The dismal profitability of the personal computer industry during the past 30 years may be attributed to the power exer- cised by the suppliers of key components (processors, disk drives, LCD screens) and the dominant supplier of operating systems (Microsoft). Wireless telecom car- riers are pressured by monopoly suppliers of spectrum: auctions of 3G licenses raised $127 billion of governments in the OECD countries, while US 4G auctions raised $65 billion during 2014–2017.13 Labor unions possess significant supplier power: in automobiles, steel, and airlines, powerful unions depress industry prof- itability. Applying Industry Analysis to Forecasting Industry Profitability Once we understand how industry structure determines current levels of industry prof- itability, we can use this analysis to forecast industry profitability in the future. Identifying Industry Structure The first stage of any industry analysis is to identify the key elements of the industry’s structure. In principle, this is a simple task. It requires identifying who are the main players—the producers, the buyers, the suppliers of inputs, and the producers of sub- stitute goods—then distinguishing the key structural characteristics of each that will impact competition and bargaining power. In most manufacturing industries, identifying the main groups of players is straight- forward; in other industries, particularly in service industries, mapping the industry can be more difficult. Figure  3.5 depicts the increased complexity of the recorded music industry. Forecasting Industry Profitability We can use industry analysis to understand why profitability has been low in some industries and high in others but, ultimately, our interest is not to explain the past 72 PART II THE TOOLS OF STRATEGY ANALYSIS but to predict the future. Investment decisions made today will commit resources to an industry for years—often for a decade or more—hence, it is critical that we are able to predict what level of returns the industry is likely to offer in the future. Current profitability is a poor indicator of future profitability: industries such as news- papers, solar panels, and petroleum have suffered massive declines in profitability; in other industries, such as airlines and food processing, profitability has revived. However, if an industry’s profitability is determined by the structure of that industry, then we can use observations of the structural trends in an industry to forecast likely changes in competition and profitability. Changes in industry structure typically result from fundamental shifts in customer buying behavior, technology, and firm strat- egies which can be anticipated well in advance of their impacts on competition and profitability. To predict the future profitability of an industry, our analysis proceeds in three stages: 1 Examine how the industry’s current and recent levels of competition and profit- ability are a consequence of its present structure. 2 Identify the trends that are changing the industry’s structure. Is the industry consolidating? Are new players seeking to enter? Are the industry’s products becoming more differentiated or more commoditized? Will additions to industry capacity outstrip growth of demand? Is technological innovation causing new substitutes to appear? 3 Identify how these structural changes will affect the five forces of competition and resulting profitability of the industry. Will the changes in industry structure cause competition to intensify or to weaken? Rarely, do all the structural changes move competition in a consistent direction; typically some will exacerbate com- petitive intensity, others will cause it to abate. Hence, determining the overall impact on profitability tends to be a matter of judgment. Strategy Capsule 3.2 discusses the outlook for profitability in the world auto- mobile industry. FIGURE 3.5 Industries are becoming more complex: Recorded music 1990 2018 Recording artists, songwriters Recording artists, songwriters Record Companies EMI, CBS, BMG, Polygram Record Companies (Sony BMG, Universal Music, Warner Music) Wholesalers Retailers Consumers Consumers Retailers (Amazon, HMV, Shimamura) Download (Apple iTunes, Amazon MP3) Streaming (Spotify, Apple Music, Pandora, Google Play, Kugou Music) Platforms (Apple iOS, Android, MS Windows) Advertisers SUPPLIERS PRODUCERS DISTRIBUTORS CONSUMERS CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 73 STRATEGY CAPSULE 3.2 The Future of the World Automobile Industry During the current decade, the world automobile industry has recovered from the financial crisis of 2008–2009, but competition has been fierce and profitability low. During 2013–17, the top eight producers (Toyota, VW, General Motors, Ford, Nissan, Hyundai, Honda and Fiat Chrysler) have earned an average operating margin of 4.7% and an average return on capital employed of 6.1% (almost certainly below their weighted average cost of capital). Applying the five forces of competition framework to the industry allows us to understand why profitability has been low. We can then identify the current trends that are reshaping the industry—the switch to electric vehicles (EVs), autonomous driving, increased shared ownership and ride sharing, internationalization by Chinese auto producers—and show how these trends will impact the five forces of competition in the future. In the table below, the direction of the arrow shows the predicted impact of each competitive force on industry profitability. Competitive force Relevant structural features of the industry Impact on profitability 2013–2018 Changes in industry structure 2019–2028 Impact on profitability 2019–2028 Substitutes Alternative modes of transportation (bicycles, public transport). Also telecommuting. Weak Congestion and environmental concerns will increase substitute competition Increasing New entry ● Internationalization by domestic producers ● New producers of EVs Moderate Increased competition from both sources. Increasing Internal rivalry ● 22 companies with annual output of >1 million cars
● Massive excess capacity
(global capacity utiliza-
tion approx. 72%)
● High fixed costs and
large-scale economies
encourage quest for
market share
Strong
● M&A to reduce no.
of producers
● Continuing excess
capacity due to exit
barriers (especially
government support)
and falling demand due
to lower personal owner-
ship of cars
Positive impact
of M&A offset by
negative impact
of new entry
and of declining
demand
Buyer power Distribution through
franchised dealers
Weak No significant change
Supplier
power
● Consolidation among
component suppliers
● Suppliers control key
technologies
Moderate Emergence of powerful
new suppliers, especially
software companies and
suppliers of batteries
Increasing
Even with potential new revenue sources (e.g., the
supply of information, entertainment, and advertising to
car occupants), it would appear that structural changes
in the industry will depress the profitability of the car
manufacturers. This negative outlook is reflected in com-
panies’ stock market capitalization: the top eight auto
makers had an average P/E ratio of 7.2 in June 2018—
less than half the average P/E of the world’s stock markets.

74 PART II THE TOOLS OF STRATEGY ANALYSIS
Using Industry Analysis to Develop Strategy
Once we understand how industry structure influences competition, which in turn
determines industry profitability, we can use this knowledge to develop firm strat-
egies. First, we can develop strategies that influence industry structure in order to
moderate competition; second, we can position the firm to shelter it from the ravages
of competition.
Strategies to Alter Industry Structure
Understanding how the structural characteristics of an industry determine the inten-
sity of competition and the level of profitability provides a basis for identifying
opportunities for changing industry structure to alleviate competitive pressures.
The first issue is to identify the key structural features of an industry that are
responsible for depressing profitability. The second is to consider which of these
structural features are amenable to change through appropriate strategic initiatives.
For example:
● Between 2000 and 2006, a wave of mergers and acquisitions among the world’s
iron ore miners resulted in three companies—Vale, Rio Tinto, and BHP Billiton—
controlling 75% of global iron ore exports. The growing power of the iron ore
producers relative to their customers, the steel makers, contributed to the 400%
rise in iron ore prices between 2004 and 2010.14
● In chemicals, depressed profitability caused by new capacity from Asian
and Middle East producers encouraged a wave of mergers among US and
European producers during 2016–17 as they sought to gain market power and
shift from commodity to specialty products. Major deals included Dow and
DuPont, Bayer and Monsanto, Clariant and Huntsman, and Sherwin-Williams,
and Valspar.15
● US airlines have deployed several strategies to change an unfavorable industry
structure. In the absence of significant product differentiation, they have used
frequent-flyer schemes to build customer loyalty. Through hub-and-spoke
route systems, they have built dominant positions at major airports: American
at Miami and Dallas/Fort Worth, Delta at Atlanta, and Southwest at Baltimore.
Mergers and alliances have reduced the numbers of competitors on most routes.
As a result, the industry’s net margin which was −1.3% during 1990–2010,
increased to 2.8% during 2010–17.16
● Building entry barriers is a vital strategy for preserving high profitability. A
primary goal of the American Medical Association has been to maintain the
incomes of its members by controlling the numbers of doctors trained in the
United States and imposing barriers to the entry of doctors from overseas.
Once we look beyond the confines of industry to consider a firm’s entire ecosystem,
then additional opportunities arise for a firm to reconfigure the system of relationships
within which it operates. Michael Jacobides argues that industries are in a state of
continual evolution and that all firms, even small ones, have the potential to influence
changes in industry structure to suit their own interests.17 We shall consider the role of
business ecosystems in the next chapter.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 75
Positioning the Company
Recognizing and understanding the competitive forces that a firm faces within its
industry allows managers to position the firm where competitive forces are weakest.
● The recorded music industry, once reliant on sales of CDs, has been devastated by
substitute competition in the form of digital downloads, piracy, file sharing, and
streaming. Yet, not all segments of the recorded music business have been equally
affected. The old are less inclined to new technology than younger listeners are;
hence, classical music, country, and golden oldies have become comparatively more
attractive for the sale of CDs than pop and hip-hop genres. Prominent in the resur-
gence of vinyl have been albums by David Bowie, the Beatles, and Pink Floyd.
● US truck-maker Paccar has achieved superior profitability by focusing on the
preferences of independent owner-operators (e.g., by providing superior sleep-
ing cabins, higher-specification seats, a roadside assistance program) thereby
sheltering from the bargaining power of fleet buyers.18
Effective positioning requires the firm to anticipate changes in the competitive forces
likely to affect the industry. Department stores are being decimated by online retailing.
The survivors will be those able to transform the content and nature of their customers’
experiences. The British department store chain, John Lewis, is shifting floor space
from products to services—restaurants, spas, roof gardens, and shared-use office ser-
vices—and adopting new approaches to integrating “clicks-and-bricks.”19
Defining Industries: Where to Draw the Boundaries
A key challenge in industry analysis is defining the relevant industry. The Standard Industrial
Classification (SIC) is of limited use in identifying groups of firms that compete with one
another. Which industry is Ferrari a member of? Is it part of the “motor vehicles and equip-
ment” industry (SIC 371), the automobile industry (SIC 3712), or the performance car
industry? Should it see itself as part of the Italian, European, or global auto industry?
Industries and Markets
We must clarify what we mean by the term industry. Economists define an industry as
a group of firms that supplies a market. Hence, a close correspondence exists between
markets and industries. So is there any difference between analyzing industry structure
and analyzing market structure? One major difference is that industry analysis, notably
five forces analysis, looks at industry profitability being determined by competition in
two markets: product markets and input markets.
In everyday usage, the term industry tends to refer to a fairly broad sector, whereas
a market refers to the buyers and sellers of a specific product. Thus, the packaging
industry comprises several distinct product markets—glass containers, steel cans,
aluminum cans, paper cartons, plastic containers, and so on.
To define an industry, it makes sense to start by identifying the firms that compete
to supply a particular market. At the outset, this approach may lead us to question
conventional concepts of industry boundaries. For example, what is the industry com-
monly referred to as banking? Institutions called banks supply a number of different
products and services, each comprising different sets of competitors. A basic distinction

76 PART II THE TOOLS OF STRATEGY ANALYSIS
is between retail banking, corporate/wholesale banking, and investment banking. Each
of these can be disaggregated into several different product markets. Retail banking
comprises deposit taking, transaction services, credit cards, and mortgage lending.
Investment banking includes corporate finance and underwriting, trading, and advisory
services (such as mergers and acquisitions).
Defining Industries and Markets: Substitution in Demand
and Supply
The central issue in defining a firm’s industry is to establish who is competing with whom.
To do this, we need to draw upon the principle of substitutability. There are two dimen-
sions to this: substitutability on the demand side and substitutability on the supply side.
Let us consider once more the industry within which Ferrari competes. Starting with
the demand side, if customers are willing to substitute only between Ferraris and other
sports car brands on the basis of price differentials, then Ferrari is part of the performance
car industry. If, on the other hand, customers are willing to substitute Ferraris for other
mass-market brands, then Ferrari is part of the broader automobile industry.
But this fails to take account of substitutability on the supply side. If volume car pro-
ducers such as Ford and Hyundai are able to apply their production facilities and distri-
bution networks to supply sports cars, then, on the basis of supply-side substitutability,
we could regard Ferrari as part of the broader automobile industry. The same logic can
be used to define the major domestic appliances as an industry. Although consumers
are unwilling to substitute between refrigerators and dishwashers, manufacturers can
use the same plants and distribution channels for different appliances—hence we view
Electrolux, Whirlpool, and Haier as competing in the domestic appliance industry.
Similar considerations apply to geographical boundaries. Should Ferrari view itself
as competing in a single global market or in a series of separate national or regional
markets? The criterion here again is substitutability. If customers are willing and able to
substitute cars available on different national markets, or if manufacturers are willing
and able to divert their output among different countries to take account of differences
in margins, then a market is global. The key test of the geographical boundaries of a
market is price: if price differences (net of taxes) for the same product between dif-
ferent locations tend to be eroded by demand-side and supply-side substitution, then
these locations lie within a single market.
In practice, drawing the boundaries of markets and industries is a matter of judg-
ment that depends on the purposes and context of the analysis. Decisions regarding
pricing and market positioning require a microlevel approach. Decisions over invest-
ments in technology, new plants, and new products require a wider view of the rele-
vant market and industry.
The boundaries of a market or industry are seldom clear-cut. A firm’s competitive
environment is a continuum rather than a bounded space. Thus, we may view the com-
petitive market of Disneyland, Hong Kong as a set of concentric circles. The closest
competitors are nearby theme parks Ocean Park and Ma Wan Park. Slightly more dis-
tant are Shenzhen Happy Valley, Shenzhen Window of the World, and Splendid China.
Further still are Disneyland parks in Tokyo and Shanghai and alternative forms of enter-
tainment, for example, a trip to Macau or to a Lantau Island beach resort.
For the purposes of applying the five forces framework, industry definition is
seldom critical. Whether we define the “box” within which industry rivals compete
broadly or narrowly, a key merit of the five forces framework is that it takes account
of competitors outside the industry box—either as the suppliers of substitutes or as
potential entrants.20

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 77
From Industry Attractiveness to Competitive Advantage: Identifying
Key Success Factors
The five forces framework allows us to determine an industry’s potential for profit. But
how is industry profit shared between the different firms competing in that industry?
Let us look explicitly at the sources of competitive advantage within an industry. In
subsequent chapters I shall develop a more comprehensive analysis of competitive
advantage. My goal in this chapter is simply to identify an industry’s key success
factors: those factors within an industry that influence a firm’s ability to outperform
rivals.21 In Strategy Capsule 3.3, Kenichi Ohmae, former head of McKinsey’s Tokyo
office, discusses key success factors in forestry.
STRATEGY CAPSULE 3.3
Probing for Key Success Factors
As a consultant faced with an unfamiliar business or
industry, I make a point of first asking the specialists in the
business, “What is the secret of success in this industry?”
Needless to say, I seldom get an immediate answer and
so I pursue the inquiry by asking other questions from a
variety of angles in order to establish as quickly as possible
some reasonable hypotheses as to key factors for success.
In the course of these interviews, it usually becomes quite
obvious what analyses will be required in order to prove
or disprove these hypotheses. By first identifying the
probable key factors for success and then screening them
by proof or disproof, it is often possible for the strategist to
penetrate very quickly to the core of a problem.
Traveling in the United States last year, I found myself
on one occasion sitting in a plane next to a director of
one of the biggest lumber companies in the country.
Thinking I might learn something useful in the course of
the five-hour flight, I asked him, “What are the key factors
for success in the lumber industry?” To my surprise, his
reply was immediate: “Owning large forests and maxi-
mizing the yield from them.” The first of these key factors
is a relatively simple matter: purchase of forestland. But
his second point required further explanation. Accord-
ingly, my next question was: “What variable or variables
do you control in order to maximize the yield from a
given tract?”
He replied: “The rate of tree growth is the key var-
iable. As a rule, two factors promote growth: the
amount of sunshine and the amount of water. Our
company doesn’t have many forests with enough of
both. In Arizona and Utah, for example, we get more
than enough sunshine but too little water and so tree
growth is very low. Now, if we could give the trees in
those states enough water, they’d be ready in less than
15 years instead of the 30 it takes now. The most impor-
tant project we have in hand at the moment is aimed at
finding out how to do this.”
Impressed that this director knew how to work out
a key factor strategy for his business, I offered my own
contribution: “Then under the opposite conditions,
where there is plenty of water but too little sunshine—
for example, around the lower reaches of the Columbia
River—the key factors should be fertilizers to speed up
the growth and the choice of tree varieties that don’t
need so much sunshine.”
Having established in a few minutes the general
framework of what we were going to talk about, I spent
the rest of the long flight very profitably hearing from him
in detail how each of these factors was being applied.
Source: Kenichi Ohmae, The Mind of the Strategist (New York:
McGraw-Hill, 1982): 85 © The McGraw-Hill Companies Inc.,
reproduced with permission.

78 PART II THE TOOLS OF STRATEGY ANALYSIS
Like Ohmae, our approach to identifying key success factors is straightforward
and commonsense. To survive and prosper in an industry, a firm must meet two
criteria: first, it must attract customers; second, it must survive competition. Hence, we
may start by asking two questions:
● What do our customers want?
● What does the firm need to do to survive competition?
To answer the first question, we need to look more closely at the customers of the
industry and to view them, not as a source of buying power and a threat to profit-
ability, but as the raison dӐtre of the industry and its underlying source of profit. This
requires that we inquire the following: Who are our customers? What are their needs?
How do they choose between competing offerings? Once we recognize the basis
upon which customers choose between rival offerings, we can identify the factors that
confer success upon the individual firm. For example, if travelers choose airlines pri-
marily on price, then cost efficiency is the primary basis for competitive advantage in
the airline industry and the key success factors are the determinants of relative cost.
The second question requires that we examine the nature of competition in the
industry. How intense is competition and what are its key dimensions? Thus, in airlines,
it is not enough to offer low fares. To survive intense competition during recessionary
periods an airline requires financial strength; it may also require good relations with
regulators and suppliers.
A basic framework for identifying key success factors is presented in Figure  3.6.
Application of the framework to identify key success factors in three industries is out-
lined in Table 3.2.
Key success factors can also be identified through the direct modeling of profit-
ability, thereby identifying the drivers of a firm’s relative profitability within an industry.
Using the same approach as in Chapter  2 (Figure  2.2), we can disaggregate return
on capital employed into component ratios, which then point to the main drivers
of superior profitability. In some industries, there are well-known formulae that link
operating ratios to overall profitability. Strategy Capsule 3.4 disaggregates profit margin
in the airline industry to identify key success factors.
FIGURE 3.6 Identifying key success factors
What do customers
want?
KEY SUCCESS FACTORS
Prerequisites for success
How does the f irm
survive competition?
Analysis of competition
• What drives competition?
• What are the main
dimensions of competition?
• How intense is competition?
• How can we obtain a superior
competitive position?
Analysis of demand
• Who are our customers?
• What do they want?

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 79
TABLE 3.2 Identifying key success factors: Steel, fashion clothing, and supermarkets
What do customers want?
(Analysis of demand)
How do firms survive
competition? (Analysis
of competition) Key success factors
Steel Low price
Product consistency
Reliability of supply
Technical specifications
Intense price competition
results from undifferentiated
products, excess capacity,
and high fixed costs.
Survival requires cost efficiency
and financial strength
Cost efficiency requires: large-scale
plants, low-cost raw materials, rapid
capacity adjustment
Hi-tech small-scale plants viable with
flexibility and high productivity
Quality, and service can yield a
price premium
Fashion
clothing
Diversity of customer preferences
Customers will pay premium for
brand, style, exclusivity, and quality
Mass market is highly price
sensitive
Low barriers to entry and
many competitors imply
intense competition
Differentiation offers price
premium, but imitation
is rapid
Combining differentiation with low costs
Differentiation involves style,
brand appeal, quality, and market
responsiveness
Cost efficiency requires manufacture
where wages are low
Supermarkets Low prices
Convenient location
Wide product range
Quality produce, good service, ease
of parking, pleasant ambience
Intensely price competitive
Buying power essential
for low costs
Low costs require operational efficiency,
large-scale purchases, low wages
Differentiation requires large stores,
convenient location, meticulous
in-store management
STRATEGY CAPSULE 3.4
Identifying Key Success Factors by Profitability modeling: Airlines
Profitability, as measured by operating income per availa-
ble seat-mile (ASM), is determined by three factors: yield,
which is total operating revenues divided by the number
of revenue passenger miles (RPMs); load factor, which is
the ratio of RPMs to ASMs; and unit cost, which is total
operating expenses divided by ASMs. Thus:

Profit
ASMs
Revenue
RPMs
RPMs
ASMs
Expenses
ASMs
Some of the main determinants of each of these
component ratios are the following:
◆ Revenue/RPMs
● intensity of competition on routes flown
● effective yield management to permit quick price
adjustment to changing market conditions
● ability to attract business customers
● superior customer service.
◆ Load factor (RPMs/ASMs)
● competitiveness and flexibility of prices
● efficiency of route planning (e.g., through
hub-and-spoke systems)
● building customer loyalty through quality of ser-
vice, frequent-flier programs
● matching airplane size to demand for individual
flights.
◆ Expenses/ASMs
● wage rates and benefit levels
● fuel efficiency of aircraft
● productivity of employees (determined partly by
their job flexibility)
● load factors
● level of administrative cost.

80 PART II THE TOOLS OF STRATEGY ANALYSIS
The usefulness of industry-level success factors in formulating strategy has been
scorned by some strategy scholars. Pankaj Ghemawat observes that the “whole
idea of identifying a success factor and then chasing it seems to have something
in common with the ill-considered medieval hunt for the philosopher’s stone, a
substance that would transmute everything it touched into gold.”22 However, the
existence of common success factors in an industry does not imply that firms should
adopt similar strategies. In the fashion clothing business, we identified a number
of key success factors (Table  3.2), yet  all the leading companies—Inditex (Zara),
H&M, Diesel, and Mango—have adopted unique strategies to exploit these key suc-
cess factors.
Summary
In Chapter 1, we established that a profound understanding of the competitive environment is a criti-
cal ingredient of a successful strategy. Despite the vast number of external influences that affect every
business enterprise, our focus is the firm’s industry environment that we analyze in order to evaluate the
industry’s profit potential and to identify the sources of competitive advantage.
The centerpiece of our approach is Porter’s five forces of competition framework, which links the
structure of an industry to the competitive intensity within it and to the profitability that it realizes. The
Porter framework offers a simple yet powerful organizing framework for identifying the relevant features
of an industry’s structure and predicting their implications for competitive behavior.
The primary application for the Porter five forces framework is in predicting how changes in an
industry’s structure are likely to affect its profitability. Once we understand the drivers of industry profit-
ability, we can identify strategies through which a firm can improve industry attractiveness and position
itself in relation to these different competitive forces.
As with most of the tools for strategy analysis that we shall consider in this book, the Porter five forces
framework is easy to comprehend. However, real learning about industry analysis and about the Porter
framework in particular derives from its application. It is only when we apply the Porter framework to
analyzing competition and diagnosing the causes of high or low profitability in an industry that we are
forced to confront the complexities and subtleties of the model. A key issue is identifying the industry
within which a firm competes and recognizing its boundaries. By employing the principles of substitut-
ability and relevance, we can delineate meaningful industry boundaries.
Finally, our industry analysis allows us to make a first approach at identifying the sources of compet-
itive advantage through recognizing key success factors in an industry.
I urge you to put the tools of industry analysis to work—not just in your strategic management
coursework but also in interpreting everyday business events. The value of the Porter framework is as
a practical tool—it helps us to understand the disparities in profitability between industries, to predict
an industry will sustain its profitability into the future, and to recognize which strategies have the best
potential for making money. Through practical applications, you will also become aware of the lim-
itations of the Porter framework. In the next chapter, we will see how we can extend our analysis of
industry and competition.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 81
Self-Study Questions
1. From Table 3.1, select a high-profit industry and a low-profit industry. From what you know
of the structure of your selected industries, use the five forces framework to explain why prof-
itability has been high in one industry and low in the other.
2. With reference to Strategy Capsule 3.1, use the five forces framework to explain why profit-
ability has been so high in the US market for smokeless tobacco.
3. The major forces shaping the business environment of the fixed-line telecom industry are
technology and government policy. The industry has been influenced by fiber optics (greatly
increasing transmission capacity), new modes of telecommunication (wireless and internet
telephony), the convergence of telecom and cable TV, and regulatory change (including the
opening of fixed-line infrastructures to “virtual operators”). Using the five forces of compe-
tition framework, predict how each of these developments has influenced competition and
profitability in the fixed-line telecom industry.
4. By 2018, the online travel agency industry had consolidated around two leaders: Expedia
(which had acquired Travelocity, Lastminute.com, Hotels.com, Trivago, and Orbitz) and Price-
line (which owned booking.com, Kayak, Rentalcars.com, and OpenTable). These two market
leaders competed with numerous smaller online travel agents (e.g., TripAdvisor, Travelzoo,
Skyscanner, Ctrip), with traditional travel agencies (e.g., Carlson Wagonlit, TUI, American
Express—all of which had adopted a “bricks ‘n’ clicks” business model), and with direct online
sales by airlines, hotel chains, and car rental companies. Amazon and Google were both
potential entrants to the market. The online travel agents are dependent upon computerized
airline reservation systems such as Sabre, Amadeus, and Travelport. Use Porter’s five forces
framework to predict the likely profitability of the online travel agency industry over the next
ten years.
5. Walmart (like Carrefour, Ahold, and Tesco) competes in several countries of the world, yet
most shoppers choose between retailers within a radius of a few miles. For the purposes of
analyzing profitability and competitive strategy, should Walmart consider the discount retailing
industry to be global, national, or local?
6. What do you think are key success factors in:
a. the pizza delivery industry?
b. the credit card industry (where the world’s biggest issuers are: Bank of America, JPMorgan
Chase, Citibank, American Express, Capital One, HSBC, and ICBC)?
Notes
1. M. E. Porter, “The Five Competitive Forces that Shape
Strategy,” Harvard Business Review 57 ( January
2008): 57–71.
2. Brewers Association, “Historical U.S. Brewery Count,”
http://www.brewersassociation.org/statistics/number-
ofbreweries/; “Good Beer Guide 2015 Shows UK has Most
Breweries,” Guardian (September 11, 2014).
3. W. J. Baumol, J. C. Panzar, and R. D. Willig, Contestable
Markets and the Theory of Industry Structure (New York:
Harcourt Brace Jovanovich, 1982). See also M. Spence,
“Contestable Markets and the Theory of Industry Struc-
ture: A Review Article,” Journal of Economic Literature
21 (1983): 981–990.
4. “Annual Franchise 500,” Entrepreneur ( January
2017).
5. Products where brand loyalty is particularly strong
include: online search, online retailing, smartphones,
video streaming, coffee, cosmetics, and cars. See: https://
brandkeys.com/portfolio/customer-loyalty-engagement-
index/, accessed September 2, 2017.

http://Lastminute.com

http://Hotels.com

http://booking.com

http://Rentalcars.com

82 PART II THE TOOLS OF STRATEGY ANALYSIS
6. C. V. Oster and J. S. Strong Predatory Practices in the US
Airline Industry (Washington DC, 2001). https://ntl.bts.
gov/lib/17000/17600/17602/PB2001102478 , accessed
September 5, 2017.
7. J. L. Siegfried and L. B. Evans, “Empirical Studies of Entry
and Exit: A Survey of the Evidence,” Review of Industrial
Organization 9 (1994): 121–155; D. Heger and K. Kraft,
“Barriers to Entry and Profitability,” ZEW—Centre for
European Economic Research Discussion Paper No.
08-071 (2008).
8. G. S. Yip, “Gateways to Entry,” Harvard Business Review
60 (September/October 1982): 85–93.
9. “Four is a Magic Number,” Economist (March 15, 2014):
64; “Three’s a Crowd.” Economist (February 4, 2016).
10. “OPEC Has a Deal, But Will Its Members Cheat?” Wall
Street Journal (December 11, 2016).
11. R. Schmalensee, “Inter-Industry Studies of Structure
and Performance,” in R. Schmalensee and R. D. Willig
(eds), Handbook of Industrial Organization, 2nd edn
(Amsterdam: North Holland, 1988): 976.
12. C. Baden-Fuller (ed.), Strategic Management of Excess
Capacity (Oxford: Basil Blackwell, 1990).
13. “After the Telecommunications Bubble,” OECD Economics
Department Working Papers (2003); “America’s Latest
Spectrum Auction,” Economist (February 16, 2017).
14. “Iron Ore Companies Consolidated,” International
Resource Journal (October 2014).
15. “Hunt for Earnings Growth Reshapes Chemicals Sector,”
Financial Times (May 30, 2017).
16. “Airlines in America: No choice.” https://www.economist.
com/blogs/gulliver/2015/07/airlines-america, accessed
September 5, 2017.
17. M. G. Jacobides, “Strategy Bottlenecks: How TME
Players Can Shape and Win Control of Their Industry
Architecture,” Insights 9 (2011): 84–91; M. G. Jacobides
and J. P. MacDuffie, “How to Drive Value Your Way,” Har-
vard Business Review, 91 ( July/August 2013): 92–100.
18. M. E. Porter, “The Five Competitive Forces that Shape
Strategy,” Harvard Business Review 57 ( January
2008): 57–71.
19. “John Lewis’ Paula Nickolds on reinventing the business.”
Retail Week, March 30, 2017.
20. For a concise discussion of market definition see Office of
Fair Trading, Market Definition (London: December 2004),
especially pp. 7–17. https://www.gov.uk/government/
publications/market-definition. Accessed September 5,
2017.
21. The term was coined by Chuck Hofer and Dan Schendel
(Strategy Formulation: Analytical Concepts, St Paul: West
Publishing, 1977: 77).
22. P. Ghemawat, Commitment: The Dynamic of Strategy
(New York: Free Press, 1991): 11.

https://ntl.bts.gov/lib/17000/17600/17602/PB2001102478

https://www.economist.com/blogs/gulliver/2015/07/airlines-america

https://www.gov.uk/government/publications/market-definition

4
Economic progress, in capitalist society, means turmoil.
—JOSEPH A. SCHUMPETER, AUSTRIAN ECONOMIST, 1883–1950
◆ Introduction and Objectives
◆ The Limits of Industry Analysis
● Does Industry Matter?
● Hypercompetition
● Winner-Take-All Industries
◆ Beyond the Five-Forces: Complements, Ecosystems,
and Business Models
● Complements: A Missing Force in the Porter Model?
● Business Ecosystems: Managing Value Migration
● Using Business Models to Manage the Business
Ecosystem
● Business Ecosystems: The Value Capture Model
◆ Competitive Interaction: Game Theory
and Competitor Analysis
● Game Theory
● Competitor Analysis
◆ Segmentation and Strategic Groups
● Segmentation Analysis
● Strategic Groups
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E
4 Further Topics
in Industry and
Competitive Analysis

84 PART II THE TOOLS OF STRATEGY ANALYSIS
The Limits of Industry Analysis
Does Industry Matter?
Porter’s five forces of competition framework has been subject to two main attacks.
Some have criticized its theoretical foundations, arguing that the “structure–
conduct–performance” approach to industrial organization that underlies it lacks rigor
(especially when compared with the logical robustness of game theory). Others have
recognized its empirical weaknesses. A firm’s industry environment is a relatively minor
determinant of its profitability. Studies of the sources of interfirm differences in profit-
ability have produced diverse results, but all acknowledge that industry factors account
for less than 20% of the variation in return on assets among firms.1
Do these findings imply that industry doesn’t matter and we relegate the analysis of
industry and competition to a minor role in our strategic analysis? Certainly not!
It is true that profitability differences within industries are greater than profitability
differences between industries: McKinsey & Company provide clear evidence of this
for US industries.2
However, the usefulness of industry analysis is not conditional upon the relative
importance of inter-industry and intra-industry profitability differences. Industry analysis
is important because, without a deep understanding of their competitive environment,
firms cannot make sound strategic decisions. Industry analysis is not just about choos-
ing which industries to locate within, it is also important for identifying competitive
threats, attractive segments, and the sources of competitive advantage. Nevertheless, it
Introduction and Objectives
The previous chapter outlined Porter’s five forces framework and demonstrated its application to ana-
lyzing competition, predicting industry profitability, and developing strategy. The Porter framework is one
of the most useful and widely applied tools of strategic analysis. It also has its limitations. In this chapter,
we shall extend our analysis of industry and competition beyond the limits of the Porter framework.
By the time you have completed this chapter, you will be able to:
◆ Recognize the limits of the Porter five forces framework, especially when industry struc-
ture is unstable and in winner-take-all industries.
◆ Extend industry analysis to include the role of complements, business ecosystems, and
business models.
◆ Understand competitive interaction, applying insights from game theory and the tools of
competitor analysis.
◆ Apply segmentation analysis and strategic group analysis in order to analyze industries at
a more disaggregated level.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 85
is important that we acknowledge the limitations of the Porter framework and, where
possible, augment our industry analysis.
Hypercompetition
The Porter’s five forces framework is based upon the assumption that industry structure
determines competitive behavior, which in turn determines industry profitability. But
competition also unleashes the forces of innovation and entrepreneurship that trans-
form industry structures. Joseph Schumpeter viewed competition as a “perennial gale
of creative destruction” in which market-dominating incumbents are challenged, and
often unseated, by rivals’ innovations.3
Schumpeter’s view of competition as a dynamic process in which industry structure
is in constant change raises the issue of whether competitive behavior should be seen
as an outcome of industry structure or a determinant of industry structure.4 The issue
here is the speed of structural change in the industry: if structural transformation is
rapid, then the five forces framework does not offer a stable basis for predicting com-
petition and profitability.
In most industries, Schumpeter’s process of “creative destruction” tends to be more
of a breeze than a gale. In established industries, new entry tends to be infrequent and
changes in industrial concentration are slow.5 One survey observed: “the picture of the
competitive process . . . is, to say the least, sluggish in the extreme.”6 As a result, both
at firm and industry levels, profits tend to be highly persistent in the long run.7
However, this stability of industry structures is being eroded by the disruptive impact
of digital technologies and intensifying international competition. Rich D’Aveni argues
that a general feature of industries today is hypercompetition: “intense and rapid
competitive moves, in which competitors must move quickly to build [new] advantages
and erode the advantages of their rivals.”8 If industries are hypercompetitive, their
structures are unstable and competitive advantage is temporary.9 According to Rita
McGrath, “Transient advantage is the new normal.”10
Despite a lack of consistent empirical evidence of growing instability of industry
structure and accelerating erosion of competitive advantage,11 casual observation sug-
gest that the rapid structural change is not restricted to the hi-tech sector—financial
services, oil and gas, and taxi services have all experienced disruptive change in recent
years. Yet, hypercompetition does not necessarily obviate Porter’s five forces frame-
work. For example, in analyzing the dramatic structural changes that have occurred in
the solar panel industry, in pharmaceuticals, in retailing, and in telecom services, the
five forces framework allows us to forecast how changes in industry structure will affect
the forces of competition, and what their impact on profitability is likely to be.
Winner-Take-All Industries
In some industries, the disparities in profitability between firms are so great as to render
irrelevant the whole notion of industry attractiveness. In mobile devices, Apple earned
a return on equity of about 30% during 2015–2017; most its competitors made losses.
Throughout the history of the video game industry, the console maker with market
leadership—typically Nintendo or Sony—has accounted for almost all of the indus-
try’s profits. In these industries, market share confers massive competitive advantage.
Often, this advantage is the result, not of conventional scale economies, but of positive
feedback loops—the most important of which are network externalities. In online auc-
tions (dominated by eBay) and social media (dominated by Facebook), users gravitate

86 PART II THE TOOLS OF STRATEGY ANALYSIS
to the firm that has the greatest number of users. More generally, a firm with market
share leadership attracts resources away from competitors. In web search, once Google
established a lead over Yahoo!, Excite, Lycos, and AltaVista, the expectations it gener-
ated allowed it to attract resources that enabled it to accelerate quality and innovation.
In these industries, the market leader may well scoop the entire profit pool. Followers
may continue to endure losses for some time—what sustains them is the possibility of
gaining market leadership should the current leader stumble. During 2017, the woes
that engulfed ride-sharing giant, Uber, were eagerly exploited by its rival, Lyft. In these
“winner-take-all” industries, analyzing the dynamics of competitive advantage— network
externalities in particular—takes precedent over conventional industry analysis. As
we shall see shortly, complementary products play a central role in creating network
externalities.
Beyond the Five Forces: Complements, Ecosystems,
and Business Models
If our industry analysis is to fulfill its potential, it needs to go beyond the confines of
the Porter five forces framework. To understand competitive behavior and the deter-
minants of profitability, we need to look more broadly at industries to include comple-
ments, extended value chains, and other participants that form part of the “business
ecosystem.” We also need to look more narrowly: disaggregating broad industry sectors
to examine competition within particular segments and among particular groups of
firms. Let’s begin by considering extensions to the Porter framework.
Complements: A Missing Force in the Porter Model?
The Porter framework considers the suppliers of substitutes as one of the forces of
competition that reduces the profit available to firms within an industry. But what about
complements? While the presence of substitutes reduces the value of a product, com-
plements increase its value: without ink cartridges my printer is useless, as is my car
without gasoline. Given the importance of complements to most products, our analysis
of the competitive environment needs to take them into account. The simplest way is
to add a sixth force to Porter’s framework (Figure 4.1).12
If complements have the opposite effect to substitutes—they increase rather than
reduce the value of an industry’s product—the key question is: how is this value shared
between the producers of the different complementary products?
● During the 1990s, Nintendo earned huge profits from its video game consoles.
Although most of the revenue and consumer value was in the software, mostly
supplied by independent developers, Nintendo’s dominance over the games
developers, through its control over its operating system and over the manufac-
ture and distribution of games cartridges, allowed it to appropriate most of the
profits of the entire system.
● In personal computers there is similar complementarity between hardware and
software, but here power has lain with the software suppliers—Microsoft in
particular. IBM’s adoption of open architecture meant that Microsoft Windows
became a proprietary standard, while PCs were gradually reduced to commodity
status. This is a very different situation from video games, where hardware sup-
pliers keep proprietary control over their operating systems.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 87
Where two products complement one another, profit accrues to the supplier that
builds the stronger market position and reduces the value appropriated by the other.
How is this done? The key is to achieve monopolization, differentiation, and short
supply of one’s own product, while encouraging competition, commoditization, and
excess capacity in complementary products.13 Apple’s domination of its complemen-
tors—especially the suppliers of applications software—has made its iPhone one of
the lucrative proprietary products of all time. Such dominance requires power over
complementors that typically require ownership of intellectual property. Apple’s own-
ership of its iOS operating system allows it to choose which apps are offered for its
iPhone and to take 30% of the revenues these apps generate. Such control is essential
whether or not the complementary products are supplied in-house or by third parties.
Gillette’s monopolization of blades for its razors and printer manufacturers’ monopo-
lization of ink cartridges rests upon their control of the technology in both the equip-
ment and the consumable. Producing the consumables in-house facilitates control—but
is not enough on its own. Nestlé supplies its own coffee capsules for its Nespresso
coffee system, but once its patents became ineffective, it was unable to prevent a flood
of new suppliers of Nespresso-compatible capsules.14
As the above examples suggest, products based on digital technologies present fas-
cinating issues of competition and profit appropriation. Many digital markets involve
systems that comprise hardware, an operating system, application software, and Inter-
net connection. In these markets, competition tends to be among rival platforms—
the interfaces that link the component parts of the system. A platform attracts
complementors—in some cases in huge numbers: Android has over 2.8 million apps;
Amazon’s online retailing platform offers over 450 million different products in the US.
The availability of complements creates a powerful network externality: complemen-
tors favor the platform with the most users; users favor the platform with the greater
number of complements. As we have already observed, network externalities are the
main source of winner-take-all markets. We shall revisit network externalities and plat-
form-based competition in Chapter 9.
COMPLEMENTS
BUYERS
POTENTIAL
ENTRANTS
Threat of
new entrants
Bargaining power of suppliers
SUPPLIERS
Bargaining power of buyers
Rivalry among
existing f irms
substitutes
Threat of
INDUSTRY
COMPETITORS
The suppliers of
complements create
value for the industry
and can exercise
bargaining power
SUBSTITUTES
FIGURE 4.1 Five forces, or six?

88 PART II THE TOOLS OF STRATEGY ANALYSIS
Business Ecosystems: Managing Value Migration
Incorporating the suppliers of complementary products is a first step in broadening
industry analysis beyond Porter’s five forces—but we can go further. Recognition that a
firm’s business environment extends beyond conventional industry boundaries has given
rise to the term business ecosystem to describe the “community of organizations, insti-
tutions, and individuals that impact the enterprise.”15 This notion of an ecosystem also
emphasizes the codependencies among its members and the continually evolution of
the system.
Michael Jacobides shows how, within business systems, value migrates between its
different parts.16 This migration is the result of external forces such as technology, reg-
ulation, and changing customer preferences, but it can also be influenced by individual
firms—even those that are not dominant players. The quest for value requires iden-
tifying potential “bottlenecks” within the ecosystems—activities that create significant
customer value and can be dominated by the firm. Jacobides and his co-authors offer
the following guidelines:
● Become the “guardian of quality.” Who controls a product’s reputation? In wine,
there is competition for control between growers grouped by location (cham-
pagne, chianti), wine makers (Krug, Chateau Margaux), importers/distributors
(Harveys of Bristol, Berry Bros. & Rudd), and critics (Wine Spectator, Decanter).
Control typically lies with players that are closest to the consumer—but not
always: Intel’s “Intel Inside” campaign showed the potential for component
suppliers to forge links with consumers.
● Become irreplaceable: The battle to capture value is won by those who can
make themselves irreplaceable. In many industries, these are the system inte-
grators. Conversely, those who contribute a tiny portion of the value chain are
easily substituted. Apple is a master of “supply chain atomization”—ensuring
that each of its suppliers occupy limited roles that can be substituted by other
companies.
● Take advantage of changing customer needs. Shifts in customer preferences
can shift value within an ecosystem. As consumers expand the range of online
payment options they are willing to use, there are growing opportunities for
payment service providers such as Adyen, Worldpay, and Square.
● Redefine the value chain. In addition to fragmenting and integrating value
chains, firms may redefine roles along it. IKEA’s building of a global value
chain for furniture has involved the transfer of furniture assembly from manu-
facturers to consumers.
Using Business Models to Manage the Business Ecosystem
Business model is a widely used but poorly understood concept—which is hardly
surprising given the variety of ways in which it has been used. A model is a simplified
description of a real thing. Hence, a business model is a simplified description of a
business—it specifies the “core logic for creating value”17 or, as David Teece explains:
“the manner by which the business enterprise delivers value to customers, entices cus-
tomers to pay for value, and converts those payments to profit.”18
There is a long-running debate over whether there is anything distinctive about the
concept of a business model, or whether business model is simply another name for a
business strategy. We will not resolve that debate here. Instead, let us focus on situa-
tions where the concept of a business model can extend our strategy analysis. One area

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 89
is in formulating strategies to exploit the opportunities within a firm’s business eco-
system. The other, which we shall address in Chapter 7, concerns strategic innovation.
The reason that business models are useful is because strategy is often viewed too
narrowly—business strategy in terms of cost or differentiation advantage, corporate
strategy in terms of selecting sectors then managing linkages between them. Business
models allow us to consider more complex business situations and envisage business
opportunities more widely.
Most approaches to the design and selection of business models identify the com-
ponents of business models and alternative ways to configure them. One widely used
framework, the Business Model Canvas, views the firm as an infrastructure (comprising
resources, activities, and partners) that is applied to customers (comprising segments,
channels, and relationships) through a value proposition that generates revenue at
a cost that permits a profit (see Figure  4.2). The firm’s business model represents
an integrated set of choices in relation to these components. By mapping the firm’s
business model on this canvas, it is possible to experiment with alternatives: How can
the firm change the components of its business model to create new configurations?19
Traditionally, most enterprises are operated with fairly simple business models. For
example, the typical business model for a consumer goods producer involves adding
value to bought-in materials and components, then supplying the finished product to
distributors. More elaborate business models involve complementary products (e.g.,
the “razors-and-blades” model favored by Gillette and suppliers of inkjet printers) or
supplying inputs rather than outputs (e.g., franchising).
Digital technologies have caused the emergence of more complex business ecosys-
tems that offer opportunities for more diverse business models. As established indus-
tries are disrupted by digital technologies, the challenge for traditional firms is to
find business models to replace those rendered obsolete by new competition. Travel
agents have transitioned from being commission-based retailers to providing custom-
ized, fee-based services to travelers; newspapers have experimented with different
online revenue models: free content/paid advertising, “freemium” (free access to basic
content; charges for premium content), metered access, or variants on these.
The more elaborate business models that exploit the opportunities available in more
complex digital ecosystems are illustrated by Google (see Strategy Capsule 4.1). How-
ever, as Strategy Capsule 4.1. shows in relation to Ryanair, many mature industries also
have complex business ecosystems that offer opportunities for business models that
exploit relationships among diverse partner organizations.
Infrastructure
Activities
Resources
Partners
Customer
Segments
Channels
Relationships
O�er
Value
Proposition
Financial viability
RevenuesCosts Pro�t
FIGURE 4.2 The Business Model Canvas

90 PART II THE TOOLS OF STRATEGY ANALYSIS
STRATEGY CAPSULE 4.1
Business Models for Complex Business
Ecosystems: Google and Ryanair
Google: At the heart of Google’s strategy is a business
model whereby free search supports paid adver-
tising—over two-thirds of the revenues of Google’s
parent, Alphabet, are generated by advertising placed
on Google’s own websites and applications. How-
ever, Google’s full business model is more extensive. It
includes the following:
◆ Using its advertising management capabilities
and relationships with advertisers to manage
advertising placements on other content pro-
viders’ websites (AdSense).
◆ Gathering huge quantities of user data that allow
more precise targeting of advertising.
◆ Protecting the availability and data-gathering
capabilities of Google’s search products by
providing its own web browser (Chrome) and
operating systems (Android, Chrome OS).
◆ Sustaining dominance of online advertising
through launching competing products against
rivals such as Apple, Facebook, and Microsoft.
Ryanair: At the core of Ryanair’s strategy is the low-cost
carrier business model developed by Southwest Air-
lines (see Figure 1.3 in Chapter 1). However, this model
has been extended by Ryanair to exploit multiple
sources of  revenue generated by a range of partners.
Elements of the Ryanair business model include the
following:
◆ Extreme unbundling. In addition to paying for
flight tickets, passengers are encouraged to pay
for services such as seat assignments, checked
baggage, priority boarding, credit card fees, and
inflight refreshments.
◆ Payments from airports and local government
authorities (incentives to Ryanair to initiate and
maintain specific routes).
◆ Commission on sales of partners’ complementary
products and services such as car hire, train and
bus services, insurance, hotels, theater, and sports
tickets—also ticket sales for other airlines (e.g.,
Air Europa).
◆ Advertising on Ryanair website, travel magazine,
and seat backs.
Sources: Allan Afuah, Business Model Innovation: Concepts, Anal-
ysis, and Cases (Routledge, 2014); Ryanair Holdings plc, Annual
Report, 2017.
Business Ecosystems: The Value Capture Model
In an approach, variously described as the “value capture model,” “value-based
strategy,” and “bi-form models,” initial work by Brandenburger and Stuart20 has been
developed into a strategy framework that combines both breadth and analytic rigor.
The framework envisages the firm within a broad network of transacting parties.
The approach then establishes boundaries for the amount of value that the firm can
appropriate. The upper limit is determined by the amount of value that the firm
creates within its current network—which is the amount by which the total value
created within the network would diminish if the firm left the network. The lower
limit is determined by the amount of value that the form could add to an alternative
business network.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 91
Within this framework, a firm’s strategic decisions are mainly about investments in
resources and capabilities that influence the value it can capture. These decisions relate
to two types of action. First, those that increase the value that is available to the firm
by increasing the maximum value the firm adds either to its existing network or to
an alternative network—these are investments with competitive intent. Second, actions
that determine how much value the members of the network are willing to give up to
the firm—these are actions with persuasive intent.21 Recent work on the value capture
model attempts to measure then value created and captured and explores strategies
through which value creation and capture occur.22
Competitive Interaction: Game Theory and Competitor Analysis
Game Theory
Central to the criticisms of Porter’s five forces framework is its failure to address
competitive interaction among firms. A fundamental feature of strategic situations is
interdependence—the decisions made by any one player are dependent on the actual
and anticipated decisions of the other players. By relegating competition to a medi-
ating variable that links industry structure with profitability, the five forces analysis
offers little insight into competition as a process of interactive decision-making by
rival firms. Game theory allows us to model this competitive interaction. In going so,
it permits:
● The framing of strategic interaction by providing a structure, a set of con-
cepts, and a terminology that allows us to characterize a competitive situation
in terms of:
○○ Who are the players?
○○ What are each player’s options?
○○ What are the payoffs from every combination of options?
○○ What is the sequence of decisions?
● Predicting the outcome of competitive situations and identifying optimal stra-
tegic choices in situations of rivalry and bargaining. In doing so, game theory
offers penetrating insights into central issues of strategy that go well beyond
pure intuition. Simple models (e.g., the prisoners’ dilemma) predict whether
outcomes will be competitive or cooperative, whereas more complex games
permit analysis of the effects of reputation,23 deterrence,24 information,25 and
commitment,26 especially within the context of multi-period games. Particu-
larly, important for practicing managers, game theory can indicate strategies for
improving the outcome of the game through manipulating the payoffs to the
different players.27
Game theory has been applied to a wide variety of competitive situations: the
Cuban missile crisis of 1962,28 rivalry between Boeing and Airbus,29 NASCAR race
tactics,30 auctions of airwave spectrum,31 the 2008 financial crisis,32 and the evolu-
tionary determinants of male bird plumage.33 In terms of business competition, game
theory points to five types of strategic behavior for influencing competitive out-
comes: cooperation, deterrence, commitment, changing the structure of the game,
and signaling.

92 PART II THE TOOLS OF STRATEGY ANALYSIS
Cooperation One of the key merits of game theory is its ability to encompass both
competition and cooperation. While the five forces framework emphasizes compet-
itive relations between firms, Adam Brandenburger and Barry Nalebuff’s concept of
co opetition recognizes the competitive/cooperative duality of business relationships.34
While some relationships are predominantly competitive (Coca-Cola and Pepsi)
and others are predominantly cooperative (Intel and Microsoft), there is no simple
dichotomy between competition and cooperation: all business relationships combine
elements of both. For all their intense rivalry, Coca-Cola and Pepsi cooperate on mul-
tiple fronts, including common policies on sales of soda drinks within schools, environ-
mental issues, and health concerns. They may also coordinate their pricing and product
introductions.35 Exxon and Shell have competed for leadership of the world’s petro-
leum industry for over a century; at the same time they cooperate in a number of joint
ventures. The desire of competitors to cluster together—antique dealers in London’s
Bermondsey Market or movie studios in Hollywood—points to the common interests
of competing firms in growing the size of their market and developing its infrastructure.
Although cooperation usually results in better outcomes for rival firms, the communi-
cation and trust needed to avoid competition are difficult to establish. The prisoners’
dilemma game not only analyzes this predicament and points to the strategic initiatives
through which a player can transform the game in order to reach a cooperative out-
come (Strategy Capsule 4.1).
Deterrence As we see in Strategy Capsule 4.1, one way of changing a game’s
equilibrium is through deterrence. The principle behind deterrence is to impose costs
on the other players for actions deemed to be undesirable. By establishing the certainty
that deserters would be shot, the British army provided a strong incentive to its troops to
participate in advances on heavily fortified German trenches during the First World War.
The key to the effectiveness of any deterrent is that it must be credible. If admin-
istering the deterrent is costly or unpleasant for the threatening party, it will lack
credibility. Threatening a potential new entrant with a price war usually lacks credibility
since it would inflict more damage on the incumbent than on the new entrant. Invest-
ing in excess capacity can be more effective in discouraging entry. Prior to the expira-
tion of its NutraSweet patents, Monsanto invested heavily in unneeded plant capacity
to deter manufacturers of generic aspartame.36
However, deterrence only works when the adversaries can be deterred. A central
weakness of President George W. Bush’s “war on terror” was that ideologically moti-
vated terrorists are not susceptible to deterrence.37
Commitment For deterrence to be credible, it must be backed by commitment. Com-
mitment involves the elimination of strategic options: “binding an organization to a
future course of action.”38 When Hernán Cortés destroyed his ships on arrival in Mexico
in 1519, he communicated, both to Montezuma and to his own troops, that there was
no alternative to the conquest of the Aztec empire. Once Airbus had decided to build its
A380 superjumbo, it was critical to signal its commitment to the project. During 2000–02,
Airbus spent heavily on advertising the plane, even before completing the design phase,
in order to encourage airlines to place orders and discourage Boeing from developing
a rival plane.
These commitments to aggressive competition can be described as hard commit-
ments. A company may also make commitments that moderate competition; these are
called soft commitments. For example, if a company commits to achieving certain target
profit levels in the coming year, this would be a soft commitment: it signals its desire
to avoid aggressive competition.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 93
STRATEGY CAPSULE 4.2
The Prisoners’ Dilemma
The classic prisoners’ dilemma game involves a pair of
crime suspects who are arrested and interrogated sep-
arately. The dilemma is that each will rat on the other
with the result that both end up in jail despite the fact
that, if both had remained silent, they would have been
released for lack of evidence.
The dilemma arises in most competitive situations—
everyone could be better off with collusion. Consider
competition between Coca-Cola and Pepsi in Ecuador,
where each has the choice of setting a big or small
advertising budget. Figure  4.3 shows the payoffs to
each firm.
Clearly, the best solution for both firms is for each
to restrain their advertising expenditure (the upper left
cell). However, in the absence of cooperation, both firms
adopt big budgets (the lower right cell). The reason is
that each fears that any restraint will be countered by
the rival seeking advantage by shifting to a big adver-
tising budget. The resulting “maxi-min” strategy (each
company chooses the strategy that maximizes the
minimum payoff ) is a “Nash equilibrium”: no player can
increase its payoff by a unilateral change in strategy. Even
if collusion can be achieved, it will be unstable because
of the incentives for cheating—a constant problem for
OPEC, where the member countries agree quotas but
then cheat on them.
How can a firm escape from such prisoners’ dilemmas?
One answer is to change a one-period game (single trans-
action) into a repeated game. In the above example of
competition in advertising, a multiperiod perspective
allows the companies to recognize the futility of adver-
tising campaigns that merely cancel one another out.
In the case of supplier–buyer relations, where the typical
equilibrium is a low-quality product at a low price, moving
from a spot-transaction to a long-term vendor relationship
gives the supplier the incentive to offer a better-quality
product and the buyer to offer a price that reflects the
preferred quality.
A second solution is to change the payoffs through
deterrence. In the classic prisoners’ dilemma, the Mafia
shifts the equilibrium: the threat of draconian repri-
sals encourages both suspects to maintain the “code of
silence.” Similarly, if both Coca-Cola and Pepsi were to
threaten one another with aggressive price cuts should
the other seek advantage through a big advertising
budget, this could shift the equilibrium to the top-left cell.
FIGURE 4.3 Coca-Cola’s and Pepsi’s advertising budget: The prisoners’ dilemma
COCA-COLA (Payof fs in $ millions)
PEPSI
Small Advertising
Budget
Big Advertising
Budget 15
15
4
4
10
10
−2
−2
Big Advertising
Budget
In each cell,
the lower-left
number is the
payof f to Pepsi;
the upper-right
the payof f to
Coke.
Small Advertising
Budget

94 PART II THE TOOLS OF STRATEGY ANALYSIS
Changing the Structure of the Game Creative strategies can change the structure
of the competitive game. A company may seek to change the structure of its industry to
increase the industry’s profit potential or to appropriate a greater share of the available
profit. Thus, establishing alliances and agreements with competitors can increase the
value of the game by increasing the size of the market and building combined strength
against possible entrants. There may be many opportunities for converting win–lose (or
even lose–lose) games into win–win games through cooperative strategies.
In some cases, it may be advantageous for a firm to assist its competitors. When
in June 2014, Tesla Motors offered to make available its patents to competitors, it was
betting that any loss in its own competitive advantage would be offset by the benefits
of expanding the market for electric vehicles and encouraging the wider adoption of
its own technologies with regard to battery design and battery recharging systems.39 As
we shall see in Chapter 9, standards battles often involve the deliberate sacrificing of
profit margins in order to build market leadership.
Signaling Competitive reactions depend on how the competitor perceives its
rival’s initiative. The term signaling is used to describe the selective communication
of information to competitors (or customers) designed to influence their perceptions
and hence provoke or suppress certain types of reaction.40 The use of misinfor-
mation is well developed in military intelligence. In 1943, British military intelli-
gence used a corpse dressed as a marine officer and carrying fake secret documents
to convince German high command that the Allied landings would be in Greece,
not Sicily.41
Threats are credible when backed by reputation.42 Although carrying out threats is
costly and depresses short-term profitability, exercising such threats can build a repu-
tation for aggressiveness that deters competitors in the future. The benefits of building
a reputation for aggressiveness may be particularly great for diversified companies
where reputation can be transferred from one market to another.43 Hence, Procter &
Gamble’s protracted market share wars in disposable diapers and household deter-
gents established a reputation for toughness that protects it from competitive attacks
in other markets.
Signaling may also be used to communicate a desire to cooperate: preannounced
price changes can facilitate collusive pricing among firms.44
How useful is game theory? The great virtue of game theory is its rigor: it bases the
analysis of competition on sound theoretical foundations.
However, the price of theoretical rigor is limited applicability to real-world situ-
ations. Game theory provides clear predictions in stylized situations involving few
external variables and restrictive assumptions. When applied to more complex (and
more realistic) situations, game theory frequently results in either no equilibrium or
multiple equilibria, and outcomes that are highly sensitive to small changes in initial
assumptions. Overall, game theory has made limited progress in modeling real business
situations in a way that can generate clear strategy recommendations.45
Game theory is better at explaining the past than predicting the future. In diagnosing
Nintendo’s domination of the video games industry in the 1980s, Monsanto’s efforts to
prolong NutraSweet’s market leadership beyond the expiration of its patents, or Air-
bus’s wresting of market leadership from Boeing, game theory provides penetrating
insight into the competitive situation and deep understanding of the rationale behind
the strategies deployed. However, in predicting outcomes and designing strategies,

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 95
game theory has been much less impressive. For example, the application of game
theory by US and European governments to design auctions for wireless spectrum has
produced some undesirable and unforeseen results.46
So, where can game theory assist us in designing successful strategies? As with all
our theories and frameworks, game theory is useful not because it gives us answers
but because it can help us understand business situations. Game theory provides a set
of tools that allows us to structure our view of competitive interaction. By identifying
the players in a game, the decision choices available to each, and the implications
of each combination of decisions, we have a systematic framework for exploring the
dynamics of competition. Most importantly, by describing the structure of the game we
are playing, we have a basis for suggesting ways of changing the game and thinking
through the likely outcomes of such changes.
Game theory continues its rapid development—in particular, the value capture model
we discussed above, and which has considerable potential for developing a general
framework for strategy analysis, has its basis in cooperative game theory. We shall draw
upon game theory in several places in this book, especially in exploring competitive
dynamics in highly concentrated markets. However, our emphasis in strategy formula-
tion will be less on achieving advantage through influencing the behavior of competi-
tors and much more on transforming competitive situations through building positions
of unilateral competitive advantage. Game theory typically deals with competitive situ-
ations where closely matched players have strategic options (typically relating to price
changes, advertising budgets, capacity decisions, and new product introductions) and
outcomes depend upon the order of moves, signals, bluffs, and threats. Our emphasis
will be less on managing competitive interactions and more on establishing competi-
tive advantage through exploiting uniqueness.
Competitor Analysis
In highly concentrated industries, the dominant feature of a company’s competitive
environment is likely to be the behavior of its closest rivals. In household detergents,
Unilever’s industry environment is dominated by the strategy of Procter & Gamble. The
same is true in soft drinks (Coca-Cola and Pepsi), jet engines (GE, United Technologies,
and Rolls-Royce), and financial information (Bloomberg and Reuters). Similarly, in local
markets: the competitive environment of my local Costa coffee shop is dominated by
the presence of Starbucks across the road. While game theory provides a theoretical
apparatus for analyzing competitive interaction between small numbers of rivals, for
most strategic decisions, a less formal and more empirically-based approach to predict-
ing competitors’ behavior may suffice. Let us examine how information about compet-
itors can be used to predict their behavior.
Competitive Intelligence Competitive intelligence involves the systematic collec-
tion and analysis of information about rivals for informing decision making. It has three
main purposes:
● to forecast competitors’ future strategies and decisions
● to predict competitors’ likely reactions to a firm’s strategic initiatives
● to determine how competitors’ behavior can be influenced to make it more
favorable.

96 PART II THE TOOLS OF STRATEGY ANALYSIS
For all three purposes, the key requirement is to understand competitors in order to
predict their responses to environmental changes and to our own competitive moves.
To understand competitors, it is important to be informed about them. Competitive
intelligence is a growth field, with specialist consulting firms, professional associations,
and a flood of recent books.47 About one-quarter of large US corporations have spe-
cialist competitive intelligence units.
The boundary between legitimate competitive intelligence and illegal industrial espi-
onage is not always clear. The distinction between public and private information is
uncertain and the law relating to trade secrets is much less precise than that which
covers patents and copyrights. In addition to several well-publicized cases of trade
secret theft,48 more general allegations of systematic industrial espionage have been
levied against Chinese enterprises and government agencies.49
A Framework for Predicting Competitor Behavior Competitive intelligence is
not simply about collecting information. The problem is likely to be too much rather
than too little information. The key is a systematic approach that makes it clear what
information is required and for what purposes it will be used. The objective is to under-
stand one’s rival. A characteristic of great generals from Hannibal to Patton has been
their ability to go beyond military intelligence and to “get inside the heads” of their
opposing commanders. Michael Porter proposes a four-part framework for predicting
competitor behavior (Figure 4.4).
● Competitor’s current strategy: To predict how a rival will behave in the
future, we must understand how that rival is competing at present. Identi-
fying a firm’s strategy requires looking at what the company says and what it
does (see “Where Do We Find Strategy?” in Chapter 1)—and then to recon-
cile the two.
PREDICTIONS
STRATEGY
OBJECTIVES
RESOURCES AND CAPABILITIES
ASSUMPTIONS
• What strategy changes
will the competitor
initiate?
• How will the competitor
respond to our strategic
initiatives?
How is the f irm competing?
What are competitor’s current goals?
Is performance meeting these goals?
How are its goals likely to change?
What assumptions does the competitor
hold about the industry and itself?
What are the competitor’s key
strengths and weaknesses?
FIGURE 4.4 A framework for competitor analysis

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 97
● Competitor’s objectives: To forecast how a competitor might change its
strategy, we must identify its goals. Is the company driven by financial goals or
market goals? A company whose primary goal is attaining market share is likely
to be much more aggressive a competitor than one that is mainly interested
in profitability. The most difficult competitors can be those that are not sub-
ject to profit disciplines at all—state-owned enterprises in particular. The level
of current performance in relation to the competitor’s objectives determines
the likelihood of strategy change. The more performance falls short of target,
the more likely is strategic change, possibly accompanied by a change in top
management.
● Competitor’s assumptions about the industry: A competitor’s strategic decisions
are conditioned by its perceptions of itself and its environment. These percep-
tions are guided by the beliefs that senior managers hold about their industry
and the success factors within it. These beliefs tend to be stable over time and
also converge among the firms within an industry: what J.-C. Spender refers to
as “industry recipes.”50 Industry recipes may engender “blindspots” that limit the
capacity of a firm—even an entire industry—to respond to an external threat.
The failure of British and US motorcycle manufacturers to respond to emerging
Japanese competition during the 1960s reflected a belief system that failed to
acknowledge the threat posed by high-performance, lightweight motorcycles.
(Strategy Capsule 4.2).
STRATEGY CAPSULE 4.3
Motorcycle Myopia
During the 1960s, lightweight Japanese motorcycles
began to flood Britain and North America. The chairman
of BSA, Eric Turner, was dismissive of this competitive
challenge to the dominant position of his Triumph and
BSA brands:
The success of Honda, Suzuki, and Yamaha
has been jolly good for us. People start out by
buying one of the low-priced Japanese jobs.
They get to enjoy the fun and exhilaration of
the open road and they frequently end up
buying one of our more powerful and expen-
sive machines.
(Advertising Age, December 27, 1965)
Similar complacency was expressed by William
Davidson, president of Harley-Davidson:
Basically, we do not believe in the lightweight
market. We believe that motorcycles are sports
vehicles, not transportation vehicles. Even if a
man says he bought a motorcycle for transporta-
tion, it’s generally for leisure time use. The light-
weight motorcycle is only supplemental. Back
around World War I, a number of companies came
out with lightweight bikes. We came out with one
ourselves. We came out with another in 1947 and
it just didn’t go anywhere. We have seen what
happens to these small sizes.
(American Motor Cycle, September 15, 1966)
By 1980, BSA and Triumph had ceased production
and Harley-Davidson was struggling for survival. The
world motorcycle industry, including the heavyweight
segment, was dominated by Japanese companies.

98 PART II THE TOOLS OF STRATEGY ANALYSIS
● Competitor’s resources and capabilities: Evaluating the likelihood and seri-
ousness of a competitor’s potential challenge requires assessing the strength
of that competitor’s resources and capabilities. If our rival has a massive cash
pile, we would be unwise to unleash a price war. Conversely, if we direct
our competitive initiatives toward our rivals’ weaknesses, it may be difficult
for them to respond. Richard Branson’s Virgin Group has entered into music,
airlines, financial services, and wireless telecommunications using innova-
tive forms of differentiation that are difficult for established incumbents to
respond to.
Segmentation and Strategic Groups
Segmentation Analysis51
In Chapter 3, we noted the difficulty of drawing industry boundaries and the need to
define industries both broadly and narrowly according to the types of question we are
seeking to answer. Initially, it may be convenient to define industries broadly, but for a
more detailed analysis we need to focus on more narrowly drawn markets. This pro-
cess of disaggregating industries we call segmentation.
Astute choices of segment positioning can allow a firm to outperform its rivals.
During 2007–11, Nintendo’s Wii became a surprise market share leader in video game
consoles by focusing on a large and underserved market segment: casual and older
video game players. In the brutally competitive tire industry, Pirelli has achieved
superior margins by emphasizing high-performance tires for sports and luxury cars.52
The purpose of segmentation analysis is to identify attractive segments, to select
strategies for different segments, and to determine how many segments to serve. The
analysis proceeds in five stages.
1 Identify key segmentation variables: Our starting point is to determine the
basis of segmentation. Segmentation decisions are essentially choices about
which customers to serve and what to offer them: hence segmentation variables
relate to the characteristics of customers and the product (Figure 4.5). Typically,
segmentation analysis generates far too many segmentation variables; we need to
reduce these to two or three. This requires that we (a) identify the most strategi-
cally significant segmentation variables and (b) combine segmentation variables
that are closely correlated. For example, in the restaurant industry, price level,
service level, cuisine, and alcohol license tend to be closely related. We could use
a single variable, restaurant type, with three categories—full-service restaurants,
cafés/casual dining, and fast-food outlets—as a proxy for all of these variables.
2 Construct a Segmentation Matrix: Once the segmentation variables have been
selected and discrete categories determined for each, the individual segments
may be identified using a two- or three-dimensional matrix. Strategy Capsule 4.3
shows a two-dimensional segmentation matrix for the world automobile industry.
Strategy Capsule 4.4 takes an alternative approach to industry segmentation,
using the industry value chain as the basis for segmentation.
3 Analyze segment attractiveness: Profitability within an industry segment is deter-
mined by the same structural forces that determine profitability within an industry
as a whole. As a result, Porter’s five forces of competition framework is equally

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 99
effective in relation to a segment as to an entire industry. There are, however, a
few differences. Substitute competition comes not only from other industries but
also from other segments within the same industry. Similarly, entry into a seg-
ment is most likely to be from producers established in other segments within
the same industry. The barriers that protect a segment from firms located in other
segments are called barriers to mobility to distinguish them from the barriers
to entry, which protect the industry as a whole.53 As in most segments within the
auto industry, the lack of barriers to mobility results in the superior returns of
high-profit segments being quickly eroded (see Strategy Capsule 4.3).
Segmentation analysis can help identify unexploited opportunities in an
industry. Companies that have built successful strategies by concentrating
on unoccupied segments include Walmart (discount stores in small towns),
Enterprise Rent-A-Car (suburban locations), and Edward Jones (full-service
brokerage for small investors in smaller cities). This identification of unoccu-
pied market segments is one aspect of what Kim and Mauborgne refer to as
“blue ocean strategy”: the quest for uncontested market space.54
4 Identify the segment’s key success factors (KSFs): By analyzing how buyers’ pur-
chasing criteria and the basis of competition varies between segments, we can
identify KSFs for individual segments. For example, in the bicycle industry, we
can distinguish high-price enthusiasts’ bikes sold through specialist bike stores
and economy bikes sold through discount stores. KSFs in the enthusiast segment
are technology, reputation, and dealer relations. In the economy segment, KSFs
are low-cost manufacture and a supply contract with a leading retail chain.
Opportunities for
Dif ferentiation
Characteristics
of the Product
Characteristics
of the Buyers
Industrial
buyers
Household
buyers
Distribution
channel
Geographical
location
• Physical size
• Price level
• Product features
• Technology design
• Inputs used (e.g., raw materials)
• Performance characteristics
• Presales and postsales services
• Size
• Technical
sophistication
• OEM/replacement
• Demographics
• Lifestyle
• Purchase occasion
• Size
• Distributor/broker
• Exclusive/nonexclusive
• General/specialist
FIGURE 4.5 The basis for segmentation: The characteristics of buyers
and products

100 PART II THE TOOLS OF STRATEGY ANALYSIS
STRATEGY CAPSULE 4.4
Segmenting the World Automobile Industry
1 Identify key segmentation variables and categories.
Possible segmentation variables include price, size,
engine power, body style, buyer type (retail versus
fleet), and geographical market. We can reduce the
number of segmentation variables—in particular,
price, size, and engine power tend to be closely
correlated. Other variables clearly define distinct
markets (e.g., geographical regions and individual
national markets).
2 Construct a segmentation matrix. The segmentation
matrix in Figure  4.6 shows geographical regions
(columns) and product types (rows). These product
types combine multiple segmentation variables:
price, size, design, and fuel type.
3 Analyze segment attractiveness. Applying five forces
analysis to individual segments points to the attrac-
tiveness of the growth markets of Asia and Latin
America (especially for luxury cars) as compared
with the saturated, excess capacity-laden markets
of Europe and North America. In these mature mar-
kets, the hybrid and electric car segments may be
attractive due to fewer competitors and lack of
excess capacity.
4 Identify KSFs in each segment. In sports cars, tech-
nology and design aesthetics are likely to be key
differentiators. In luxury cars, quality and interior
design are likely to be essential. In family compact
and mini cars, low cost is the primary basis for com-
petitive advantage.
5 Analyze attractions of broad versus narrow seg-
ment scope. Because of the potential to share tech-
nology, design, and components across models,
all product segments are dominated by full-range
mass-manufactures. In terms of geographical seg-
ments, only in the biggest markets (primarily China)
have nationally-focused producers survived.
P
R
O
D
U
C
T
S
Luxury cars
Full-size cars
Mid-size cars
Small cars
Station wagons
Minivans
Sports cars
Sport utility
Pickup trucks
Hybrids/Plug-ins
North
America
Western
Europe
Eastern
Europe
Asia Latin
America
Australia
& NZ
Africa
REGIONS
FIGURE 4.6 A segmentation matrix of the World Automobile Market

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 101
5 Select segment scope: Finally, a firm needs to decide whether it wishes to be a
segment specialist or to compete across multiple segments. The advantages of
a broad over a narrow segment focus depend on two main factors: similarity of
KSFs and the presence of shared costs. If KSFs are different across segments, a
firm will need to deploy distinct strategies which may require different capabil-
ities for different segments. Harley-Davidson has found it difficult to expand from
its core segments of heavyweight cruiser and touring bikes into other segments
of the motorcycle industry. Conversely, in automobiles, segment specialists have
found it difficult to survive competition from broad-scope, volume producers.
STRATEGY CAPSULE 4.5
Vertical Segmentation: Profitability along the Value Chain
Segmentation is usually horizontal: markets are disaggre-
gated according to products, geography, and customer
groups. We can also segment an industry vertically by
identifying different value chain activities. Bain & Com-
pany’s profit pool analysis maps profit differences bet-
ween different vertical activities. Figure  4.7 shows the
distribution of value in the electric vehicle sector. The
area of each segment’s rectangle corresponds to the
total profit for that activity. Alternatively, stock market
capitalization can be used to identify which groups of
firms within a sector are most successful at appropri-
ating value.
25
20
10
0
Batteries
Vehicle production
15
5
Financing
Servicing
& repair
Power
generation
Charging
points
Power
management
Value added services
(e.g. entertainment,
navigation,
information)
Revenue
EB
IT
/S
al
es
(%
)
Distribution
FIGURE 4.7 A profit pool mapping for electric vehicles
Source: Adapted from Bain & Company, “Is your electric vehicle strategy shock-proof?” (January 28, 2011).

102 PART II THE TOOLS OF STRATEGY ANALYSIS
Strategic Groups
Strategic group analysis segments industries on the basis of the strategies of member
firms. A strategic group is “the group of firms in an industry following the same or a
similar strategy along the strategic dimensions.”55 These strategic dimensions might
include product range, geographical breadth, choice of distribution channels, product
quality, degree of vertical integration, choice of technology, and so on. By selecting
the most important strategic dimensions and locating each firm in the industry along
them, we can identify groups of companies that have adopted similar approaches to
competing within the industry. In some industries strategic groups are readily observ-
able, for example, airlines fall into two broad strategic groups: “legacy carriers” (such
as American, JAL, and British Airways) and “low-cost carriers” (such as Ryanair, Easyjet,
and Southwest). Other industries are more complex: Figure 4.8 shows strategic groups
within the petroleum industry.
Most empirical research into strategic groups has investigated profitability differ-
ences between groups—on the basis that mobility barriers between strategic groups
preserve profitability differentials.56 However, there is limited evidence of sustained,
systematic profitability differences between strategic groups.57 This may reflect the fact
that the members of a strategic group, although pursuing similar strategies, are not
necessarily in competition with one another. For example, within the European airline
industry, the low-cost carriers pursue similar strategies, but do not, for the most part,
compete on the same routes. Hence, strategic group analysis is mainly useful for under-
standing strategic positioning and recognizing patterns of competition; it is less useful
for analyzing interfirm profitability differences.58
SUPER MAJORS
e.g., ExxonMobil, Shell,
BP, Chevron, Total
INTEGRATED
INTERNATIONAL
MAJORS
e.g., ENI, Repsol,
Petro-Canada
INTEGRATED
NATIONAL OIL COMPANIES
e.g., Petrobras, PDVSA, CNPC,
Indian Oil, Pemex
Geographical Scope
GlobalNational
In
te
g
ra
te
d
Ve
rt
ic
al
B
al
an
ce
D
o
w
n
st
re
am
U
p
st
re
am
NATIONAL
PRODUCTION
COMPANIES
e.g., Saudi Aramco, Kuwait
Petroleum, Qatar
Petroleum
DOMESTIC-FOCUSED
DOWNSTREAM
COMPANIES
e.g., Valero, Nippon Oil,
Phillips 66
INTERNATIONAL
EXPLORATION AND PRODUCTION
COMPANIES
e.g., Conoco, Apache, Occidental,
Marathon Oil
FIGURE 4.8 Strategic groups within the world petroleum industry

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 103
Summary
The purpose of this chapter has been to go beyond the basic analysis of industry structure, competition,
and profitability presented in Chapter 3 to consider the dynamics of competitive rivalry and the internal
complexities of industries.
In terms of industry and competitive analysis, we have extended our strategy toolkit in several
directions:
◆ We have recognized the limitations of conventional industry analysis. These include: the limited
impact of industry upon firm profitability, the role of competition in transforming industries through
a process of creative destruction, and the emergence of “winner-take-all” industries.
◆ We have extended our analysis of industry and competition to take account of complementary
products—especially in industries where these complementarities give rise to network externalities,
platform-based competition, and business ecosystems.
◆ We have become familiar with two approaches to analyzing competitive interactions between close
rivals: (a) game theory which, despite its technical rigor, offers penetrating insights into competition,
bargaining, and the design of winning strategies and (b) competitor analysis which provides a less
formal approach to understanding competitors and predicting their behavior.
◆ We have examined the microstructure of industries and markets using segmentation analysis and
strategic group analysis to understand industries at a more detailed level and to select advantageous
strategic positions.
Self-Study Questions
1. Among the industries listed in Table 3.1 in Chapter 3, which would you consider to be the
most “hypercompetitive” (i.e., ones in which competitive advantage and market leadership are
frequently overturned)?
2. During 2010, the Apple iPhone replaced RIM’s Blackberry as global market leader in smart-
phones. By 2017, the world market for smartphones was dominated by Apple and Google’s
Android; RIM and Microsoft each held market shares of less than 0.1%. Why did Google suc-
ceed in this market while Microsoft and RIM failed?
3. HP, Canon, Epson, and other manufacturers of inkjet printers make most of their profits from
their ink cartridges. Why are cartridges more profitable than printers? Would the situation be
different:
a. if cartridges were manufactured by different firms from those which make printers?
b. if cartridges were interchangeable between different printers?
c. if patent and copyright restrictions did not prevent other firms from supplying ink car-
tridges that could be used in the leading brands of printer?

104 PART II THE TOOLS OF STRATEGY ANALYSIS
4. In November 2005, six of Paris’s most luxurious hotels—including George V, Le Bristol, the
Ritz, and Hotel de Crillon—were fined for colluding on room rates. Regular guests showed
little concern—noting that, whatever the listed rack rate, it was always possible to negotiate
substantial discounts. Using the prisoners’ dilemma model, can you explain why the hotels
were able to collude over their listed rates but not over discounts?
5. During 2017, Amazon made its first major foray into bricks-and-mortar retailing with the acqui-
sition of Whole Foods Market, the up-market supermarket chain. The acquisition followed
Amazon’s entry into online food retailing with Amazon Fresh. The shares of Kroger, the big-
gest supermarket chain in the United States, fell by 11% on news of the deal. How might
Kroger use the competitor analysis framework outlined in Figure  4.4 to predict Amazon’s
competitive strategy in the US grocery market?
6. How would you segment the restaurant market in your hometown? How would you advise
someone thinking of starting a new restaurant which segments might be most attractive in
terms of profit potential?
7. Consider either the North American or European markets for air travel. Can these markets be
segmented? If so, by what variables and into which categories? Can an airline be financially
viable by specializing in certain segments or must airlines seek to compete across all (or
most) segments?
Notes
1. See: R. P. Rumelt,“How much does industry matter?” Strategic
Management Journal 12 (1991): 167–185; A. M. McGa-
han and M. E. Porter, “How much does industry matter,
really?” Strategic Management Journal 18 (1997): 15–30;
V. F. Misangyi, H. Elms, T. Greckhamer, and J. A. Lepine,
“A New Perspective on a Fundamental Debate: A Multi-
level Approach to Industry, Corporate and Business Unit
Effects,” Strategic Management Journal 27 (2006): 571–590.
2. The Strategic Yardstick You Can’t Afford to Ignore,”
McKinsey Quarterly (October 2013).
3. J. A. Schumpeter, The Theory of Economic Development
(Cambridge, MA: Harvard University Press, 1934).
4. See R. Jacobson, “The Austrian School of Strategy,”
Academy of Management Review 17 (1992): 782–807;
and G. Young, K. Smith, and C. Grimm, “Austrian and
Industrial Organization Perspectives on Firm-Level Com-
petitive Activity and Performance,” Organization Science
7 (May/June 1996): 243–254.
5. R. Caves and M. E. Porter, “The Dynamics of Changing
Seller Concentration,” Journal of Industrial Economics 19
(1980): 1–15; P. A. Geroski, “What Do We Know About
Entry? International Journal of Industrial Organization
13, (December 1995): 421–440.
6. P. A. Geroski and R. T. Masson, “Dynamic Market Models
in Industrial Organization,” International Journal of
Industrial Organization 5 (1987): 1–13.
7. D. C. Mueller, Profits in the Long Run (Cambridge: Cam-
bridge University Press, 1986).
8. R. D’Aveni, Hypercompetition: Managing the Dynamics
of Strategic Maneuvering (New York: Free Press,
1994): 217–218.
9. R. A. D’Aveni, G. B. Dagnino, and K. G. Smith, “The Age
of Temporary Advantage,” Strategic Management Journal
31 (2010): 1371–1385.
10. R. G. McGrath, “Transient Advantage,” Harvard Business
Review 91 ( June 2013).
11. G. McNamara, P. M. Vaaler, and C. Devers, “Same As
It Ever Was: The Search for Evidence of Increasing
Hypercompetition,” Strategic Management Journal 24
(2003): 261–278. See also: R. R. Wiggins and T. W. Ruefli,
“Schumpeter’s Ghost: Is Hypercompetition Making the
Best of Times Shorter?” Strategic Management Journal 26
(2005): 887–911.
12. An alternative approach is offered by A. Brandenburger
and B. Nalebuff (Co-opetition, New York: Doubleday,
1996). Their value net includes complementors (together
with customers, suppliers and competitors).
13. D.B. Yoffie and M. Kwak. “With Friends Like These: The
Art of Managing Complementors.” Harvard Business
Review 84 (September 2006): 89–98.
14. “Nespresso’s Bitter Taste of Defeat?” Financial Times
(April 26, 2013).

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 105
15. D. J. Teece, “Explicating Dynamic Capabilities: The
Nature and Microfoundations of (Sustainable) Enterprise
Performance. Strategic Management Journal 28
(2007): 1325.
16. M. G. Jacobides, “Strategy Bottlenecks: How TME
Players Can Shape and Win Control of Their Industry
Architecture,” Insights, 9 (2011): 84–91; M. G. Jacobides
and J. P. MacDuffie, “How to Drive Value Your Way,”
Harvard Business Review, 91 ( July/August 2013):
92–100.
17. J. Linder and S. Cantrell, “Changing Business Models: Sur-
veying the Landscape.” Accenture Institute for Strategic
Change, May 2000.
18. D. J. Teece, “Business Models, Business Strategy and Inno-
vation”, Long Range Planning, Vol. 43 (2010): 172–194.
19. A. Osterwalder and Y. Pigneur, Business Model Genera-
tion: A Handbook for Visionaries, Game Changers, and
Challengers (Wiley, 2010).
20. A. Brandenburger and J. H. W. Stuart “Value-Based
Business Strategy,” Journal of Economics and
Management Strategy 5 (1996): 5–24.
21. M. D. Ryall, “The New Dynamics of Competition,”
Harvard Business Review 91 ( June 2013): 80–87.
22. J. Gans and M. D. Ryall, “Value Capture Theory:
A Strategic Management Review,” Strategic Management
Journal 38 (2017): 17–41.
23. K. Weigelt and C. F. Camerer, “Reputation and Corporate
Strategy: A Review of Recent Theory and Applications,”
Strategic Management Journal 9 (1988): 137–142.
24. A. K. Dixit, “The Role of Investment in Entry Deterrence,”
Economic Journal 90 (1980): 95–106.
25. P. Milgrom and J. Roberts, “Informational Asymmetries,
Strategic Behavior and Industrial Organization,” American
Economic Review 77, no. 2 (May 1987): 184–189.
26. P. Ghemawat, Commitment: The Dynamic of Strategy
(New York: Free Press, 1991).
27. See, for example: A. K. Dixit and B. J. Nalebuff, Thinking
Strategically: The Competitive Edge in Business, Politics,
and Everyday Life (New York: W. W. Norton, 1991); and
J. McMillan, Games, Strategies, and Managers (New York:
Oxford University Press, 1992).
28. G. T. Allison and P. Zelikow, Essence of Decision: Explain-
ing the Cuban Missile Crisis, 2nd edn (Boston: Little,
Brown and Company, 1999).
29. B. C. Esty and P. Ghemawat, “Airbus vs. Boeing in Super-
jumbos: A Case of Failed Preemption,” Harvard Business
School Working Paper No. 02-061 (2002).
30. D. Ronfelt, “Social Science at 190 mph on NASCAR’s
Biggest Superspeedways,” First Monday 5 (February 7,
2000).
31. “Spectrum Auction Pits Google’s Game Theorists Against
the FCC’s,” Wired (November 11, 2007).
32. John Cassidy “Rational Irrationality,” New Yorker (Octo-
ber 5, 2009).
33. J. Maynard Smith, “Sexual Selection and the Hand-
icap Principle,” Journal of Theoretical Biology 57
(1976): 239–242.
34. A. Brandenburger and B. Nalebuff, Co-opetition (New
York: Doubleday, 1996).
35. T. Dhar, J.-P. Chatas, R. W. Collerill, and B. W. Gould,
“Strategic Pricing between Coca-Cola Company and Pep-
siCo,” Journal of Economics and Management Strategy 14
(2005): 905–931.
36. Bitter Competition: Holland Sweetener vs. NutraSweet (A)
(Harvard Business School Case No. 9-794-079, 1994).
37. D. K. Levine and R. A. Levine, “Deterrence in the Cold
War and the War on Terror,” Defence and Peace Eco-
nomics 17 (2006): 605–617.
38. D. N. Sull, “Managing by Commitments,” Harvard Business
Review ( June 2003): 82–91.
39. R. M. Grant, “Tesla Motors: Disrupting the Auto Industry,”
in Contemporary Strategy Analysis: Text and Cases, 10th
edn. (Wiley, 2019).
40. For a review of research on competitive signaling, see
O. Heil and T. S. Robertson, “Toward a Theory of Com-
petitive Market Signaling: A Research Agenda,” Strategic
Management Journal 12 (1991): 403–418.
41. B. Macintyre, Operation Mincemeat: The True Spy Story
that Changed the Course of World War II (London:
Bloomsbury, 2010).
42. K. Weigelt and C. Camerer, “Reputation and Corporate
Strategy: A Review of Recent Theory and Applications,”
Strategic Management Journal 9 (1988): 443–454.
43. P. Milgrom and J. Roberts, “Predation, Reputation, and Entry
Deterrence,” Journal of Economic Theory 27 (1982): 280–312.
44. L. Miller, “The Provocative Practice of Price Signaling:
Collusion versus Cooperation,” Business Horizons ( July/
August 1993).
45. On the ability of game theory to predict almost any
equilibrium solution (the Pandora’s Box Problem) see
C. F. Camerer, “Does Strategy Research Need Game
Theory?” Strategic Management Journal, Special Issue 12
(Winter 1991): 137–152; S. Postrel, “Burning Your Britches
behind You: Can Policy Scholars Bank on Game Theory?”
Strategic Management Journal, Special Issue 12 (Winter
1991): 153–155.
46. G. F. Rose and M. Lloyd, “The Failure of FCC Spectrum
Auctions,” (Washington DC: Center for American Progress,
May 2006); P. Klemperer, “How not to Run Auctions:
The European 3G Mobile Telecom Auctions. European
Economic Review 46 (2002): 829–845.
47. For example, J. D. Underwood, Competitive Intelligence
For Dummies (Chichester: John Wiley & Sons, Ltd, 2014).
48. http://www.therichest.com/rich-list/10-of-the-most-
infamous-cases-of-industrial-espionage. Accessed Septem-
ber 11, 2017.
49. C. Roper, Trade Secret Theft, Industrial Espionage, and the
China Threat (CRC Press Book, 2013).
50. J.-C. Spender, Industry Recipes: The Nature and Sources of
Managerial Judgment (Oxford: Blackwell, 1989).
51. This section draws heavily on M. E. Porter, Competitive
Advantage (New York: Free Press, 1985): Chapter 7.
52. “Pirelli’s Bet on High-performance Tires,” International
Herald Tribune (April 2, 2005).
53. R. E. Caves and M. E. Porter, “From Entry Barriers to
Mobility Barriers: Conjectural Decisions and Contrived
Deterrence to New Competition,” Quarterly Journal of
Economics 91 (1977): 241–262.

106 PART II THE TOOLS OF STRATEGY ANALYSIS
54. W. C. Kim and R. Mauborgne, “Blue Ocean Strategy: From
Theory to Practice,” California Management Review 47
(Spring 2005): 105–121.
55. M. E. Porter, Competitive Strategy (New York: Free Press,
1980): 129.
56. A. Feigenbaum and H. Thomas, “Strategic Groups and
Performance: The US Insurance Industry,” Strategic
Management Journal 11 (1990): 197–215.
57. K. Cool and I. Dierickx, “Rivalry, Strategic Groups, and
Firm Profitability,” Strategic Management Journal 14
(1993): 47–59.
58. K. Smith, C. Grimm, and S. Wally, “Strategic Groups and
Rivalrous Firm Behavior: Toward a Reconciliation,” Stra-
tegic Management Journal 18 (1997): 149–157.

5 Analyzing Resources
and Capabilities
One gets paid only for strengths; one does not get paid for weaknesses. The question,
therefore, is first: What are our specific strengths? And then: Are they the right
strengths? Are they the strengths that fit the opportunities of tomorrow, or are they
the strengths that fitted those of yesterday? Are we deploying our strengths where
the opportunities no longer are, or perhaps never were? And finally, what additional
strengths do we have to acquire?
— PETER DRUCKER1
You’ve gotta do what you do well.
—LUCINO NOTO, FORMER VICE CHAIRMAN, EXXONMOBIL
◆ Introduction and Objectives
◆ The Role of Resources and Capabilities in Strategy
Formulation
● Basing Strategy on Resources and Capabilities
● Resources and Capabilities as Sources of Profit
◆ Identifying Resources and Capabilities
● Identifying Resources
● Identifying Organizational Capabilities
◆ Appraising Resources and Capabilities
● Appraising the Strategic Importance of Resources
and Capabilities
● Appraising the Relative Strength of a Firm’s Resources
and Capabilities
◆ Developing Strategy Implications
● Exploiting Key Strengths
● Managing Key Weaknesses
● What about Superfluous Strengths?
● The Industry Context of Resource Analysis
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

108 PART II THE TOOLS OF STRATEGY ANALYSIS
The Role of Resources and Capabilities in Strategy Formulation
Strategy is concerned with matching a firm’s resources and capabilities to the opportu-
nities that arise in the external environment. So far, our emphasis has been on identi-
fying profit opportunities in the external environment of the firm. In this chapter, our
emphasis shifts to the internal environment of the firm—specifically, with the resources
and capabilities of the firm.
There is nothing new in the idea that strategy should exploit the resource and capa-
bility strengths of a person or an organization. The biblical tale of David and Goliath
can be interpreted from this perspective (Strategy Capsule  5.1). However, in recent
decades, two factors have focused increased attention on the role of resources and
capabilities as the basis for strategy. First, as firms’ industry environments have become
more unstable, so internal resources and capabilities rather than external markets offer
a more secure basis for strategy. Second, competitive advantage rather than industry
attractiveness has emerged as the primary source of superior profitability. Let us con-
sider each of these factors.
Basing Strategy on Resources and Capabilities
During the 1990s, ideas concerning the role of resources and capabilities in coalesced
into what has become known as the resource-based view of the firm—a conceptual-
ization of the firm as a collection of resources and capabilities that form the basis of
competitive advantage and the foundation for strategy.2
Introduction and Objectives
In Chapter 1, I noted that the focus of strategy thinking has been shifted from the external environment
of the firm toward its internal environment. In this chapter, we will make the same transition. Looking
within the firm, we will concentrate our attention on the resources and capabilities that firms possess.
This provides the internal foundations for our analysis of competitive advantage (which complements
Chapter 3’s discussion of key success factors—the external foundations of competitive advantage).
I begin by explaining why a company’s resources and capabilities are so important to its strategy.
By the time you have completed this chapter, you will be able to:
◆ Appreciate the role of a firm’s resources and capabilities as a basis for formulating strategy.
◆ Identify the resources and capabilities of a firm.
◆ Evaluate the potential for a firm’s resources and capabilities to confer sustainable compet-
itive advantage.
◆ Formulate strategies that exploit internal strengths while defending against internal
weaknesses.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 109
To understand why the resource-based view has had a major impact on strategy
thinking, let us go back to the starting point for strategy formulation: the underlying
purpose of the firm that can be answered by posing the question: “What is our business?”
Conventionally, this question has been answered in terms of the market being served:
“Who are our customers?” and “Which of their needs are we seeking to serve?” However,
in a world where customer preferences are volatile and the identity of customers and the
technologies for serving them are changing, a market-focused strategy may not provide
the stability and constancy of direction needed to guide strategy over the long term.
When the external environment is in a state of flux, the firm itself, in terms of the
bundle of resources and capabilities it possesses, may be a more stable basis on which
to define its identity.
This emphasis on resources and capabilities as the foundation of firm strategy was
popularized by C. K. Prahalad and Gary Hamel in their 1990 landmark paper “The Core
Competence of the Corporation.”3 The potential for capabilities to be the “roots of com-
petitiveness,” the sources of new products, and the foundation for strategy is exempli-
fied by Honda and 3M, among other companies (Strategy Capsule 5.2).
The greater the rate of change in a firm’s external environment, the more likely it is
that internal resources and capabilities, rather than external market focus, will provide
a secure foundation for long-term strategy. In fast-moving, technology-based industries,
basing strategy upon capabilities can help firms to outlive the life cycles of their initial
products. Microsoft’s initial success was the result of its MS-DOS operating system for
the IBM PC followed by Windows. However, its software development, marketing, and
partnering capabilities have allowed Microsoft to expand from operating systems in to
applications software (e.g., Office), Internet services (e.g., Xbox Live), and cloud-based
computing services. W. L. Gore and Associates’ distinctive capability is developing
STRATEGY CAPSULE 5.1
david and Goliath
In about 1000 bc, David, an Israeli shepherd boy, took
up the challenge of meeting Goliath, the champion of
the Philistines in single combat. Goliath’s “height was six
cubits and a span [three meters]. He had a bronze helmet
on his head and wore a coat of scale armor of bronze
weighing five thousand shekels [58 kg]; on his  legs he
wore bronze greaves, and a bronze javelin was slung on
his back.” King Saul of the Israelites offered David armor
and a helmet, but David discarded them: “‘I cannot
go in these,’ he said to Saul, ‘because I am not used to
them.’  … Then he took his staff in his hand, chose five
smooth stones from the stream, put them in the pouch
of his shepherd’s bag and, with his sling in his hand,
approached the Philistine… As the Philistine moved
closer to attack him, David ran quickly toward the battle
line to meet him. Reaching into his bag and taking out
a stone, he slung it and struck the Philistine on the fore-
head. The stone sank into his forehead, and he fell face-
down on the ground.”
David’s victory reflects a strategy based upon exploit-
ing his three core strengths: courage and self-confidence,
speed and mobility, and expertise with a sling. This
strategy allowed him to negate Goliath’s core strengths:
size, advanced offensive and defensive equipment, and
combat experience. Had he followed King Saul’s advice
and adopted a conventional strategy for armed single
combat, the outcome would almost certainly have been
very different.
Source: Holy Bible (New International Version): 1 Samuel
17: 39–49.

110 PART II THE TOOLS OF STRATEGY ANALYSIS
STRATEGY CAPSULE 5.2
basing Strategy upon Resources and Capabilities: Honda and 3M
Honda Motor Company has never defined itself either
as a motorcycle or an automobile company. As Figure 5.1
shows, since its founding in 1948, its development of
expertise in designing and manufacturing engines
(some of it honed on the race track) has taken it from
motorcycles to a wide range of products that embody
internal combustion engines.
3M Corporation (originally Minnesota Mining and
Manufacturing) has expanded from sandpaper into over
55,000 industrial, office, medical, and household prod-
ucts. Is it a conglomerate?
Certainly not, claims 3M. Its vast product range rests on
a cluster of technological capabilities that it has systemati-
cally developed for more than a century (Figure 5.2).
1946 1950 1960 1970 1980 1990 2000 2010 2017
Honda
Technical
Research
Institute
founded 405cc
motor-
cycle
Marine engines,
generators, pumps,
chainsaws, snow-
blowers, ground tillers
Model A
clip-on
bicycle
engine
N360
minicar
1000cc
Goldwing
motorcycle
Acura Car
division
Enters
motorcycle
racing
4-cylinder
750cc
motorcycle
Portable
generator
Enters
Formula 1
racing
Honda
Civic
Enters Indy
car racing
Civic
Hybrid
Home cogeneration
system
Production
of diesel
engines
Honda
business jet
GE Honda
turbofan
engine
Variable
Cylinder
Management
98cc,
2-stroke
Dream
motorcycle
50cc
Super-
cub
Fuel
cell car
FIGURE 5.1 Key initiatives at Honda Motor Company
FIGURE 5.2 The evolution of products and technical capabilities at 3M
Carborundum
mining
Sandpaper
Scotch-
tape
Road signs and
markings
Post-it notes
Audio tape
Surgical tapes
and dressings
Videotape
Acetate
f ilm
Floppy disks
and data storage
products
Pharmaceuticals
Homecare/kitchen products
Abrasives Adhesives
Coatings and thin-f ilm
technologies
PRODUCTS
TECHNICAL
CAPABILITIES
Materials sciences
Health sciences
Microreplication
Flexible
electronics
LED lighting
Drug delivery systems
Nanotechnology
Sensors
Surface modif ication
Insulation products
Display screens
Anticorrosion coatings
1902 2015

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 111
product applications for the polymer, PTFE. This has taken W. L. Gore from rainwear
fabric (Gore-Tex) to dental floss, guitar strings, cardiac implants, fiber optic cables, and
a host of other products.
Conversely, those companies that attempted to maintain their market focus in the
face of radical technological change have often experienced huge difficulties in building
the new capabilities needed to serve their customers.
The saga of Eastman Kodak is a classic example. Its dominance of the world market
for photographic products was threatened by digital imaging. Kodak invested billions
of dollars developing digital technologies and digital imaging products. Yet, in January
2012, Kodak was forced into bankruptcy. Might Kodak have been better off allowing its
photographic business to decline while developing applications of its chemical-based
capabilities to plastics, industrial coatings pharmaceuticals, and health care?4
Typewriter and office equipment makers Olivetti and Smith Corona offer similar
cautionary tales. Despite their investments in microelectronics, both failed as suppliers
of personal computers. Might Olivetti and Smith Corona have been better advised to
deploy their existing electrical and precision engineering know-how in other prod-
ucts?5 The inability of established firms to adjust to disruptive technological change
within their own industries has been examined by Harvard’s Clay Christensen.6
Resources and Capabilities as Sources of Profit
In Chapter  1, we identified two major sources of superior profitability: industry
attractiveness and competitive advantage. Of these, competitive advantage is the
more important. As we observed in the previous chapter (Figure 4.1), industry factors
account for only a small proportion of interfirm profit differentials. Hence, establish-
ing competitive advantage through the development and deployment of resources and
capabilities, rather than seeking shelter from the storm of competition, has become the
primary goal of strategy.
The distinction between industry attractiveness and competitive advantage (based
on superior resources) as sources of a firm’s profitability corresponds to economists’
distinction between two types of profit (or rent). The profits arising from market power
are referred to as monopoly rents; those arising from superior resources are Ricardian
rents, after the 19th century British economist David Ricardo. Ricardo showed that, in a
competitive wheat market, when land at the margin of cultivation earned a negligible
return, fertile land would yield high returns. Ricardian rent is the return earned by any
superior resource or capability whose supply is limited.7 Most of the $940 million of
royalties earned in 2017 by Dolby Laboratories from licensing its sound reduction tech-
nologies comprise Ricardian rents, as does most of the $125 million earned by Floyd
Mayweather for his fight with Conor McGregor in August 2017.
Distinguishing between profit arising from market power and profit arising from
resource superiority is less clear in practice than in principle. A closer look at Porter’s
five-forces framework suggests that industry attractiveness often derives from the own-
ership of strategic resources. Barriers to entry, for example, are typically the result of
patents, brands, know-how, or distribution channels, learning, or some other resource
possessed by incumbent firms. Monopoly is usually based on the ownership of a key
resource such as a technical standard or government license.
The resource-based approach has profound implications for companies’ strategy
formulation. When the primary concern of strategy was industry selection and posi-
tioning, companies tended to adopt similar strategies. The resource-based view, by

112 PART II THE TOOLS OF STRATEGY ANALYSIS
contrast, recognizes that each company possesses a unique collection of resources and
capabilities; the key to profitability is not doing the same as other firms but exploiting
differences. Establishing competitive advantage involves formulating and implementing
a strategy that exploits a firm’s unique strengths.
The remainder of this chapter outlines a resource-based approach to strategy for-
mulation. Fundamental to this approach is a thorough and profound understanding of
the resources and capabilities of a firm. This enables the firm to adopt a strategy that
exploits its resource and capability strengths, while protecting against its weaknesses.
The same principles can be applied to guiding our own careers. A sound career
strategy is one that, like David against Goliath, leverages one’s strengths while min-
imizing vulnerability to one’s weaknesses—see Strategy Capsule 5.3 for an example.
For both individuals and organizations the starting point is to identify the available
resources and capabilities.
Identifying Resources and Capabilities
Let us begin by distinguishing between the resources and the capabilities of the firm.
Resources are the productive assets owned by the firm; capabilities are what the firm
can do. On their own, individual resources do not confer competitive advantage; they
must work together to create organizational capability. Organizational capability, when
applied through an appropriate strategy, creates competitive advantage. Figure  5.3
shows the relationships between resources, capabilities, and competitive advantage.
STRATEGY CAPSULE 5.3
Capability-based Strategy: Lyor Cohen on Mariah Carey
The year 2001 was disastrous for Mariah Carey. Her first
movie, Glitter, was a flop, the soundtrack was Carey’s
worst selling album in years, she was dropped by EMI,
and suffered a nervous breakdown.
Lyor Cohen, the workaholic chief executive of Island
Def Jam records was quick to spot an opportunity: “I
cold-called her on the day of her release from EMI and I
said, I think you are an unbelievable artist and you should
hold your head up high. What I said stuck on her and she
ended up signing with us.“
His strategic analysis of Carey’s situation was con-
cise: “I said to her, what’s your competitive advantage?
A great voice, of course. And what else? You write every
one of your songs—you’re a great writer. So why did you
stray from your competitive advantage? If you have this
magnificent voice and you write such compelling songs,
why are you dressing like that, why are you using all these
collaborations [with other artists and other songwriters]?
Why? It’s like driving a Ferrari in first—you won’t see what
that Ferrari will do until you get into sixth gear.”
Cohen signed Carey in May 2002. Under Universal
Music’s Island Def Jam Records, Carey returned to her
versatile voice, song-writing talents, and ballad style.
Her next album, The Emancipation of Mimi, was the
biggest-selling album of 2005, and in 2006 she won a
Grammy award.
Sources: “Rap’s Unlikely Mogul,” Financial Times (August 5, 2002).
“A Superstar Returns with Another New Self,” New York Times
(April 12, 2005).

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 113
Identifying Resources
Drawing up an inventory of a firm’s resources can be surprisingly difficult. No such
document exists within the accounting or management information systems of most
organizations. The balance sheet provides only a partial view of a firm’s resources—
it comprises mainly financial and physical resources. Our broader view of a firm’s
resources encompasses three main types of resource: tangible, intangible, and human.
Tangible Resources Tangible resources are the easiest to identify and value:
financial resources and physical assets are valued in the firm’s balance sheet. Yet,
accounting conventions—especially historic cost valuation—typically result in tan-
gible resources being misvalued. The Walt Disney Company’s annual accounts for
2016 valued its entire movie library—based on production cost less amortization—at
a mere $1.7 billion and its total land assets (including its 28,000 acres in Florida) at a
paltry $1.2 billion.8
However, the primary goal of resource analysis is not to value a company’s tan-
gible resources but to understand their potential for generating profit. This requires
not just valuation but information on their composition and characteristics. With that
information, we can explore two main routes to create additional value from a firm’s
tangible resources:
● What opportunities exist for economizing on their use? Can we use fewer
resources to support the same level of business or use the existing resources to
support a larger volume of business?
● Can existing assets be redeployed more profitably?
Strategy Capsule 5.4 discusses how Michael Eisner’s turnaround of Walt Disney dur-
ing the mid-1980s used both these approaches.
RESOURCES
HUMAN
COMPETITIVE
ADVANTAGE
INDUSTRY KEY
SUCCESS FACTORS
TANGIBLE
• Financial (cash,
securities, borrowing
capacity)
• Physical (plant,
equipment, land,
mineral reserves)
INTANGIBLE
• Technology
(patents, copyrights,
trade secrets)
• Reputation (brands,
relationships)
• Culture
• Skills /know-how
• Capacity for
communication
and collaboration
• Motivation
ORGANIZATIONAL
CAPABILITIES
STRATEGY
FIGURE 5.3 The links between resources, capabilities, and competitive advantage

114 PART II THE TOOLS OF STRATEGY ANALYSIS
Intangible Resources For most companies, intangible resources are more valuable
than tangible resources. Yet, in companies’ balance sheets, intangible resources tend
to be either undervalued or omitted altogether. The exclusion or undervaluation of
intangible resources is a major reason for the large and growing divergence between
companies’ balance-sheet valuations (or book values) and their stock-market valua-
tions (Table 5.1). Among the most important of these undervalued or unvalued intan-
gible resources are brands. Table 5.2 values the Walt Disney brand at $52 billion; yet in
Disney’s balance sheet, its trademarks are valued at $1.2 billion.
Trademarks, together with patents, copyrights, and trade secrets, form the intellec-
tual property of the firm. The growing importance of intellectual property as a strategic
resource is evident from the legal efforts companies make to protect their patents,
copyrights, and trademarks from infringement.
A firm’s relationships can also be considered resources. They provide a firm with
access to information, know-how, inputs, and a wide range of other resources that lie
beyond the firm’s boundaries. Being embedded within an interfirm network also con-
veys legitimacy upon a firm, which can enhance its survival capacity. These interfirm
relationships have been referred to as “network resources.”9
Finally, organizational culture may also be considered an intangible resource. Orga-
nizational culture is “an amalgam of shared beliefs, values, assumptions, significant
meanings, myths, rituals, and symbols that are held to be distinctive.”10 Although diffi-
cult to identify and describe, it is clear that organizational culture is a critically important
resource in most firms: it exerts a strong influence on the capabilities an organization
develops and the effectiveness with which they are exercised.11
Human Resources Human resources comprise the skills and productive effort
offered by an organization’s employees. Human resources do not appear on the firm’s
balance sheet—the firm does not own its employees; it purchases their services under
STRATEGY CAPSULE 5.4
Resource utilization: Revival at Walt disney
In 1984, Michael Eisner became CEO of the Walt Disney
Company. Between 1984 and 1988, Disney’s net income
increased from $98 million to $570 million, and its stock
market valuation from $1.8 billion to $10.3 billion.
The key to the Disney turnaround was the mobili-
zation of Disney’s considerable resource base. With the
acquisition of Arvida, a real estate development company,
Disney’s land holdings in Florida were developed into
hotels, convention facilities, residential housing, and a
new theme park, the Disney-MGM Studio Tour.
To exploit its huge film library, Disney began selling
the Disney classics on videocassette and licensing
packages of movies to TV networks. To put Disney’s
underutilized movie studios to work, Eisner doubled the
number of movies in production and made Disney a
major producer of TV programs.
Supporting the exploitation of these tangible
resources was Disney’s critically important intangible
resource: the enduring affection of millions of people
across generations and throughout the world for Disney
and its characters. As a result, Disney’s new management
was able to boost theme park admission charges, launch
a chain of Disney Stores to push sales of Disney merchan-
dise, and replicate Disney theme parks in Europe and Asia.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 115
employment contacts. However, the stability of employment relationships allows us to
consider human resources as part of the resources of the firm. In the United States, the
average length of time an employee stays with an employer is 4.2 years, in Europe it
is longer—8.6 years in Great Britain, 11.4 in France and 11.0 in Germany; in Japan it
is 12.1 years.12
Pronouncements that “our people are our greatest asset,” are more than a
platitude: most companies devote considerable effort to analyzing their human
resources—in hiring new employees, appraising their performance, and planning
their development. Many organizations have established assessment centers to mea-
sure the skills and attributes of employees and prospective employees. Competency
TABLE 5.1 Large companies with the highest market-to-book ratios,
September 14, 2017
Company Nationality
Market
capitalization ($ bn.)
Market-
to-book ratio
Lockheed Martin Corp. US 88 40.8
Home Depot, Inc. US 189 27.8
Netflix, Inc. US 80 26.0
Amazon.com US 472 22.8
MasterCard, Inc. US 152 22.8
AbbVie, Inc. US 140 22.0
Glaxo Smith Kline UK 96 14.9
NVIDIA Corp. US 102 14.5
PepsiCo, Inc. US 164 13.4
Novo Nordisk A/S Denmark 95 13.1
Celgene Corp. US 111 12.8
Naspers Ltd. S. Africa 100 12.4
Starbucks Inc. US 77 12.2
Tencent Holdings China 408 12.0
Accenture plc UK 88 10.5
3M Company US 125 10.5
Alibaba China 449 10.4
Roche Switzerland 175 9.1
Coca-Cola Co. US 199 8.9
Altria Inc. US 120 8.8
Note:
The table shows companies with market capitalizations exceeding $75 billion with the highest ratios of market capi-
talization to balance-sheet net asset value.
Sources: Merrill Lynch, Financial Times.

http://Amazon.com

116 PART II THE TOOLS OF STRATEGY ANALYSIS
modeling involves identifying the set of skills, content knowledge, attitudes, and
values associated with superior performers within a particular job category, then
assessing each employee against that profile.13 The finding that psychological and
social aptitudes are critical determinants of superior work performance has fueled
interest in emotional and social intelligence14 Hence the growing trend to “hire for
attitude; train for skills.”
Identifying Organizational Capabilities
Resources are not productive on their own. A brain surgeon is close to useless
without a radiologist, anesthetist, nurses, surgical instruments, imaging equipment,
and a host of other resources. To perform a task, resources must work together.
TABLE 5.2 The world’s 20 most valuable brands, 2017
Rank Brand Value, 2017 ($ bn) Change from 2016
1 Google 246 +7.1
2 Apple 235 +2.7
3 Microsoft 143 +17.6
4 Amazon 139 +40.7
5 Facebook 130 +26.6
6 AT&T 115 +7.2
7 Visa 111 +10.1
8 Tencent 108 +27.5
9 IBM 102 +18.4
10 McDonald’s 98 +10.2
11 Verizon 89 −4.2
12 Marlboro 88 +4
13 Coca-Cola 78 −2.7
14 Alibaba 59 +19.9
15 Wells Fargo 58 −0.2
16 UPS 58 +17.0
17 China Mobile 57 +1.1
18 Disney 52 +5.7
19 General Electric 50 −7.2
20 Mastercard 50 +8.2
Note:
Brand values are calculated as the net present value of forecasted future earnings generated by the brand.
Source: BrandZ ranking of the world’s top brands, compiled by Kantar Millward Brown, Financial Times (June
29, 2017).

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 117
An organizational capability is a “firm’s capacity to deploy resources for a desired
end result.”15 Just as an individual may be capable of playing the violin, ice-skating,
and speaking Mandarin, so an organization may possess the capabilities needed
to manufacture widgets, distribute them globally, and hedge the resulting foreign-
exchange exposure.
The idea that organizations possess distinctive competences is long established,16 but
it was not until Prahalad and Hamel introduced the term core competences to describe
those capabilities fundamental to a firm’s strategy and performance that organizational
capability became a central concept in strategy analysis.17 The resulting flood of litera-
ture has created considerable confusion over terminology: I shall use the terms capa-
bility and competence interchangeably.18
Classifying Capabilities Before deciding which organizational capabilities are
“distinctive” or “core,” the firms need to take a systematic survey of its capabilities. For
this we need some basis for classifying and disaggregating the firm’s activities. Two
approaches are commonly used:
● A functional analysis identifies organizational capabilities within each of the
firm’s functional areas: A firm’s functions would typically include operations,
purchasing, logistics/supply chain management, design, engineering, new prod-
uct development, marketing, sales and distribution, customer service, finance,
human resource management, legal, information systems, government relations,
communication and public relations, and HSE (health, safety, and environment).
● A value chain analysis identifies a sequential chain of the main activities that
the firm undertakes. Michael Porter’s generic value chain distinguishes between
primary activities (those involved with the transformation of inputs and inter-
face with the customer) and support activities (Figure 5.4).19 Porter’s broadly
defined value chain activities can be disaggregated to provide a more detailed
identification of the firm’s activities (and the capabilities that correspond to each
activity). Thus, marketing might include market research, test marketing, adver-
tising, promotion, pricing, and dealer relations.
HUMAN RESOURCE MANAGEMENT
TECHNOLOGY DEVELOPMENT
PROCUREMENT
PRIMARY ACTIVITIES
SUPPORT
ACTIVITIES
SERVICEMARKETING
AND SALES
OUTBOUND
LOGISTICS
OPERATIONSINBOUND
LOGISTICS
FIRM INFRASTRUCTURE
FIGURE 5.4 Porter’s value chain

118 PART II THE TOOLS OF STRATEGY ANALYSIS
Exploration Capability
Geological
Capability
Seismic
Capability
Well Construction
Capability
Partnering
Capability
Directional
Drilling
Capability
Well
Logging
Capability
Hydraulic
Fracturing
Capability
Deepwater
Drilling
Capability
Well
Casing
Capability
Negotiating
Capability
Drilling
Capability
Procurement
Capability
FIGURE 5.5 Organization capabilities as a hierarchy of integration: The case of oil
and gas exploration
The problem of both approaches is that, despite providing a comprehensive view of
an organization’s capabilities, they may fail to identify those idiosyncratic capabilities that
are truly distinctive and critical to an organization’s competitive advantage. We observed
earlier that Apple’s remarkable ability to create products of unrivaled ease of use and cus-
tomer appeal results from its combining technical capabilities with design aesthetics and
penetrating market insight. This capability is not readily apparent from either a functional
or a value chain analysis. To look beyond generic capabilities to uncover those that are
unique requires insight and judgment. A careful examination of an organization’s history
can be revealing. In reviewing an organization’s successes and failures over time, do pat-
terns emerge and what do these patterns imply about the capabilities that underlie them?
The Hierarchy of Capabilities Organizational capability involves coordinated
behavior among organizational members. This is what distinguishes an organizational
capability from an individual skill. Routines and processes play a critical role in inte-
grating individual actions to create organizational capabilities (see Strategy Capsule 5.5).
Integration is also important among organizational capabilities. Hence, the capabilities
of an organization may be viewed as a hierarchical system in which lower-level capa-
bilities are integrated to form higher-level capabilities. For oil and gas companies, a key
requirement for success is the ability to find oil and gas. Figure 5.5 shows that explo-
ration capability comprises a number of component capabilities, which, in turn, can be
further disaggregated into even more specialized capabilities.
For most companies, it is these higher-level capabilities that constitute the “core compe-
tences” described by Prahalad and Hamel. Thus, Toyota’s “lean production” capability inte-
grates multiple capabilities that relate to just-in-time scheduling, total quality management,
statistical process control, flexible manufacturing, and continuous improvement.
These higher-level capabilities tend to be cross-functional. For example, new prod-
uct development capability is an upper-level capability that integrates technological
development, marketing, design, product engineering, process engineering, and finance.
Some writers have proposed that at the highest level of the capability hierarchy
are dynamic capabilities—capabilities that allow the modification and adaptation
of lower-level operational and functional capabilities.20 We shall look more closely at
dynamic capabilities in Chapter 8.
This notion of an organization’s capabilities forming a hierarchy of integration empha-
sizes their complementarity. For example, Walmart’s “everyday low prices” strategy rests
upon four mutually reinforcing capabilities: aggressive vendor management, point-of-
sale data analysis, superior logistics, and rigorous working capital management.21

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 119
Appraising Resources and Capabilities
Having identified the principle resources and capabilities of an organization, how do
we appraise their potential for value creation? There are two fundamental issues: first,
the strategic importance of the different resources and capabilities of the firm and,
second, their strength relative to those of competitors’.
Appraising the Strategic Importance
of Resources and Capabilities
Strategically important resources and capabilities are those with the potential to gen-
erate substantial streams of profit for the firm that owns them. This depends on three
STRATEGY CAPSULE 5.5
Routines and Processes: The Foundations of Organizational
Capability
Resources are combined to create organizational capa-
bilities; however, an organization’s capabilities are not
simply an outcome of the resources upon which they
are based.
In sport, resource-rich teams are often outplayed
by teams that create strong capabilities from modest
resources. In European soccer, star-studded teams (e.g.,
Chelsea, Real Madrid, and Manchester City) are frequently
humbled by those built from limited means (e.g., Borus-
sia Dortmund, Porto, and Atletico Madrid). In business
too, we see upstarts with modest resources outcom-
peting established giants: Dyson against Electrolux in
domestic appliances, Hyundai against Toyota in automo-
biles, Dollar Shave Club against Gillette in shaving prod-
ucts, ARM against Intel in microprocessors. Clearly, there
is more to organizational capability than just resources.
The academic literature views organizational capa-
bility as based upon organizational routines: “regular and
predictable behavioral patterns [comprising] repetitive
patterns of activity”a that determine what firms do, who
they are, and how they develop. Like individual skills,
organizational routines develop through learning by
doing—and, if not used, they wither. Hence, there is a
trade-off between efficiency and flexibility. A limited rep-
ertoire of routines can be performed highly efficiently
with near-perfect coordination. The same organization
may find it difficult to respond to novel situations.
Organizational capabilities do not simply emerge:
they must be created through management action:
hence in this book we shall focus on processes rather
than routines. Processes are coordinated sequences
of actions through which specific productive tasks
are performed. Not only is the term process well
understood by managers, the tools for designing,
mapping, and improving business processes are well
developed.b
However, creating and developing organizational
capabilities is not only about putting in place processes.
Processes need to be located within appropriately
designed organizational units, the individuals involved
need to be motivated, and the resources, processes,
structures, and management systems need to be aligned
with one another.c In the next chapter, we shall address
in greater detail the challenge that companies face in
developing organizational capabilities.
Notes:
aR. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic
Change (Cambridge, MA: Belknap, 1982).
bT. W. Malone, K. Crowston, J. Lee, and B. Pentland, “Tools for
Inventing Organizations: Toward a Handbook of Organizational
Processes,” Management Science 45 (1999): 425–443.
cT. Felin, N. J. Foss, K. H. Heimeriks, and T. L. Madsen, “Microfoun-
dations of Routines and Capabilities: Individuals, Processes,
and Structure,” Journal of Management Studies, 49 (2012):
1351–1374.

120 PART II THE TOOLS OF STRATEGY ANALYSIS
factors: their potential to establish a competitive advantage, to sustain that competitive
advantage, and to appropriate the returns from the competitive advantage. Each of
these is determined by a number of resource characteristics. Figure  5.6 summarizes
the key relationships. The criteria I identify for appraising the strategic importance of
resources and capabilities are similar to those included in Barney’s VRIO framework
(see Strategic Capsule 5.6).
Establishing Competitive Advantage For a resource or capability to establish a
competitive advantage, two conditions must be present:
● Relevance: A resource or capability must be relevant to the key success factors
in the market—in particular, it must be capable of creating value for customers.
British coal mines produced some wonderful brass bands, but these musical
capabilities did little to assist the mines in meeting competition from cheap
imported coal and North Sea gas. As retail banking shifts toward automated
teller machines and online transactions, so retail branches have become a less
relevant resource.
● Scarcity: If a resource or capability is widely available within the industry, it
may be essential but it will not provide a basis for competitive advantage. In oil
and gas exploration, technologies such as directional drilling and 3-D seismic
analysis are widely available—hence they are “needed to play” but they are not
“sufficient to win.”
Sustaining Competitive Advantage Once established, competitive advantage
tends to erode; three characteristics of resources and capabilities determine the sus-
tainability of the competitive advantage they offer:
THE PROFIT-EARNING
POTENTIAL
OF A RESOURCE OR
CAPABILITY
ESTABLISHING A
COMPETITIVE
ADVANTAGE
SUSTAINING A
COMPETITIVE
ADVANTAGE
APPROPRIATING A
COMPETITIVE
ADVANTAGE
Relevance
Scarcity
Durability
Transferability
Replicability
Property rights
Relative
bargaining power
Embeddedness
FIGURE 5.6 Appraising the strategic importance of resources and capabilities

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 121
● Durability: The more durable a resource, the greater its ability to support
a competitive advantage over the long term. For most resources, including
capital equipment and proprietary technology, the quickening pace of tech-
nological innovation is shortening their life spans. Brands, on the other
hand, can be remarkably resilient. Heinz sauces, Kellogg’s cereals, Guinness
stout, Burberry raincoats, and Coca-Cola have been market leaders for over
a century.
● Transferability: Competitive advantage is undermined by competitive imi-
tation. If resources and capabilities are transferable between firms—that
is, if they can be bought and sold—then any competitive advantage that is
based upon them will be eroded. Most resources—including most human
resources—are easily acquired. Other resources and most capabilities are not
easily transferred. Some resources are immobile. A competitive advantage of
the Laphroaig distillery and its 10-year-old, single malt whiskey is its spring
on the Isle of Islay, which supplies water flavored by peat and sea spray.
Capabilities, because they combine multiple resources and are embedded
in processes, are also difficult to move from one firm to another. Another
STRATEGY CAPSULE 5.6
Appraising Resources and Capabilities: Grant versus barney
The approach outlined in this chapter for apprais-
ing the strategic importance of resources is an
alternative to the more widely used VRIO framework
developed by Jay Barney. Let me compare the two
approaches so that their similarities and differences
are apparent.
GRANT: Strategic
Importance Framework
BARNEY:
VRIO Framework Comparison
Establishing competitive advantage
● Relevance ● Valuable Similar: both are concerned with
creating value for customers
● Scarcity ● Rare Identical: scarcity = rareness
Sustaining competitive advantage
● Durability — No equivalent criterion in VRIO
● Transferability ● Imitable Similar: imitating a resource or
capability requires either buying it
(i.e., transferring it) or replicating it
● Replicability
Appropriating competitive advantage
● Appropriability ● Organization Similar: being organized to
capture value implies the ability
to appropriate value
Sources: The VRIO Framework is found in J. B. Barney, “Looking Inside for Competitive Advantage,” Academy of
Management Executive 9 (1995): 49–61 and J. B. Barney and W. Hesterly, Strategic Management and Competitive
Advantage 5th edn (Pearson, 2014).

122 PART II THE TOOLS OF STRATEGY ANALYSIS
barrier to transferability is limited information regarding resource quality.
Sellers of resources are better informed about the performance character-
istics of resources than buyers—this is certainly true of human resources.
This creates a problem of adverse selection for buyers.22 Finally, resources
are complementary: they are less productive when detached from their
original home. Hence, when Chinese companies acquire European brands—
Aquascutum by YGM, Cerruti by Trinity Ltd., MG (the British sports car
marque) by SAIC, and Ferretti by Weichai Group—there is a risk that brand
equity is eroded.
● Replicability: If a firm cannot buy a resource or capability, it must build it. Tech-
nologies that are not protected by patents can be imitated easily by competitors.
Capabilities based on complex networks of interacting organizational routines
are less easy to copy. Federal Express’s national, next-day delivery service and
Singapore Airlines’ superior inflight services are complex capabilities based on
carefully-honed processes, well-developed HR practices, and unique corporate
cultures. Even when resources and capabilities can be copied, imitators are typi-
cally at a disadvantage to initiators.23
● Appropriating the returns to competitive advantage: Who gains the returns
generated by superior resources and capabilities? Typically the owner of that
STRATEGY CAPSULE 5.7
Appropriating Returns from Superior Capabilities: Employees
versus Owners
Investment banking provides a fascinating arena to
observe the struggle between employees and owners to
appropriate the returns to organizational capability. Gold-
man Sachs possesses outstanding capabilities in merger
and acquisition services, underwriting and proprietary
trading. These capabilities combine employee skills, IT
infrastructure, corporate reputation, and the company’s
systems and culture. All but the first of these are owned
by the company. However, the division of returns between
employees and owners suggests that employees have the
upper hand in appropriating rents. In 2016, total employee
compensation was $11.7 billion—an average of $338,576
per employee; net after-tax profit was $7.1 billion out of
which shareholders received $1.1 billion in dividends.
A similar situation exists in professional sport: star
players are able to exploit the full value of their contri-
bution to their teams’ performance. The $38.4 million
salary the Los Angeles Lakers will pay LeBron James for
the 2018/19 NBA season seems likely to fully exploit his
value to the Lakers.
So too CEOs: Expedia’s CEO, Dara Khosrowshahi, was
paid $94.6 million in 2014—an exceptional level of pay
when compared to Expedia’s net profit of $425 million
or to the average pay of Expedia’s 16,291 other US
employees.
The more organizational performance can be iden-
tified with the expertise of an individual employee, the
more mobile is that employee, and the more likely that
the employee’s skills can be deployed with another
firm, then the stronger is the bargaining position of
that employee.
Hence, the emphasis that many investment banks,
advertising agencies, and other professional service
firms give to team-based rather than individual skills. “We
believe our strength lies in… our unique team-based
approach,” declares audit firm Grant Thornton. However,
employees can reassert their bargaining power through
emphasizing team mobility: in August 2018, a team of
European equity analysts moved from Societe Generale
to Barclays plc.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 123
resource or capability. But ownership may not be clear-cut. Are organizational
capabilities owned by the employees who provide skills and effort or by the
firm which provides the processes and culture? In human-capital-intensive
firms, there is an ongoing struggle between employees and shareholders as
to the division of the rents arising from superior capabilities. As Strategy Cap-
sule 5.7 describes, bargaining between star employees and owners over the
sharing of spoils is a characteristic feature of both investment banking and
professional sports. This struggle is reminiscent of Karl Marx’s description of
the conflict between labor and capital to capture surplus value. The prevalence
of partnerships (rather than shareholder-owned companies) in law, accounting,
and consulting firms is one solution to the battle for rent appropriation: the star
workers are the owners.
Appraising the Relative Strength of a Firm’s
Resources and Capabilities
Having established which resources and capabilities are strategically most important,
we need to assess how a firm measures up relative to its competitors. Appraising a
company’s resources and capabilities relative to those of its competitors’ is difficult.
Organizations frequently fall victim to past glories, hopes for the future, and their
own wishful thinking. Executives within the same company often have quite different
perceptions of their own company’s strengths and weaknesses.24 Executives may also
mistake luck for capability, creating overconfidence in their company’s capabilities.25
Royal Bank of Scotland’s successful acquisition of NatWest Bank was followed by an
acquisition binge culminating in the disastrous takeover of ABN Amro in 2007.26
Benchmarking—the process of comparing one’s processes and performance to
those of other companies—offers an objective and quantitative way for a firm to assess
its resources and capabilities relative to its competitors.27 The results can be salu-
tary: Xerox Corporation’s pioneering use of benchmarking during the 1980s revealed
the massive superiority of its Japanese competitors in cost, quality, and new product
development, providing the impetus for company-wide transformation.28 The case for
benchmarking has been reinforced by recent evidence showing that the substantial
productivity differences between firms within the same industry are primarily the result
of differences in management practices.29
Benchmarking is most useful for assessing functional capabilities. To assess idio-
syncratic capabilities—Johnson & Johnson’s ability to infuse ethics into its business
practices; Lego’s ability to inspire children across countries, cultures and generations;
Nokia’s capacity for corporate reincarnation—benchmarking needs to be supplemented
by more reflective approaches to recognizing strengths and weaknesses. As I discussed
earlier (“Identifying Organizational Capabilities”), in-depth probing of a company’ his-
tory and traits can be highly instructive.
Developing Strategy Implications
Our analysis so far—identifying resources and capabilities and appraising them in
terms of strategic importance and relative strength—can be summarized diagrammati-
cally (Figure 5.7).

124 PART II THE TOOLS OF STRATEGY ANALYSIS
Our focus is the two right-hand quadrants of Figure 5.7. How do we exploit our key
strengths most effectively? How can we address our key weaknesses in terms of both
reducing our vulnerability to them and correcting them? Finally, what about our “super-
fluous strengths”: are these really inconsequential or are there ways in which we can
deploy them to greater effect? Let me offer a few suggestions.
Exploiting Key Strengths
The foremost task is to ensure that the firm’s critical strengths are deployed to the
greatest effect:
● If some of Walt Disney’s key strengths are the Disney brand, the worldwide
affection that children and their parents have for Disney characters, and the
company’s capabilities in the design and operation of theme parks, the impli-
cation is that Disney should not limit its theme park activities to six locations
(Anaheim, Orlando, Paris, Tokyo, Hong Kong, and Shanghai); it should open
theme parks in other locations which have the market potential for year-round
attendance.
● If a core competence of quality newspapers such as the New York Times, the
Guardian (United Kingdom), and Le Monde (France) is their ability to interpret
events and identify emerging trends, can this capability be used as a basis for
creating new revenue sources such as specialized business and financial intelli-
gence, individually customized news feeds, and political consulting services?
● If a company has few key strengths, this may suggest adopting a niche strategy.
Harley-Davidson’s key strength is its brand identity; its strategy has been
to focus upon traditionally styled, technologically backward, cruiser motor-
cycles. British semiconductor company ARM is a technology leader in RISC
architecture; its strategy is highly focused: it licenses its microprocessor designs
for mobile devices worldwide.30
Managing Key Weaknesses
What does a company do about its key weaknesses? It is tempting to counter weak-
nesses with plans to upgrade existing resources and capabilities. However, converting
weakness into strength is likely to be a long-term task for most companies. In the short
Superfluous Strengths Key Strengths
Zone of lrrelevance Key Weaknesses
H
ig
h
High
RE
LA
TI
VE
S
TR
EN
G
TH
Lo
w
Low
STRATEGIC IMPORTANCE
FIGURE 5.7 The framework for appraising resources and capabilities

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 125
to medium term, a company is likely to be stuck with the resources and capabilities
that it has inherited.
The most decisive, and often most successful, solution to weaknesses in key
functions is to outsource. Companies have become increasingly selective in the activ-
ities they perform internally: concentrating on their key strengths and outsourcing
other activities. Across a range of activities specialist suppliers have developed
high-level capabilities in contact manufacture (Hon Hai Precision/Foxconn, Flextron-
ics), IT (Accenture, IBM, Capgemini), logistics (Exel, Kuehne + Nagel, UPS), and food
service (Compass, Sodexo).
Some companies may be present in relatively few activities within their value chains.
In athletic shoes and clothing, Nike undertakes product design, marketing, and overall
“systems integration,” but most other functions are contracted out. We shall consider
the vertical scope of the firm in greater depth in Chapter 11.
Clever strategy formulation can allow a firm to negate its vulnerability to key
weaknesses. Harley-Davidson cannot compete with Honda, Yamaha, and BMW on
technology. The solution? It has made a virtue out of its outmoded technology and
traditional designs. Harley-Davidson’s old-fashioned, push-rod engines, and recycled
designs have become central to its retro-look authenticity.
What about Superfluous Strengths?
What about those resources and capabilities where a company has particular strengths
that don’t appear to be important sources of sustainable competitive advantage? One
response may be selective divestment. If a retail bank has a strong but increasingly
underutilized branch network, it may be time to prune its real-estate assets and invest
in web-based customer services.
However, in the same way that companies can turn apparent weaknesses into com-
petitive strengths, so it is possible to develop innovative strategies that turn apparently
inconsequential strengths into key strategy differentiators. Edward Jones’ network of
brokerage offices and 8000-strong sales force looked increasingly irrelevant in an era
when brokerage transactions were going online. However, by emphasizing personal
service, trustworthiness, and its traditional, conservative investment virtues, Edward
Jones has built a successful contrarian strategy based on its network of local offices.31
In the fiercely competitive MBA market, business schools can also differentiate on the
basis of idiosyncratic resources and capabilities. Georgetown’s Jesuit heritage is not an
obvious source of competitive advantage for its MBA programs. Yet, the Jesuit emphasis
on developing the whole person and cultivating ethics, integrity, and emotional intel-
ligence provide a strong foundation for developing successful business leaders. Simi-
larly, Dartmouth College’s location in the woods of New Hampshire far from any major
business center is not an obvious benefit to its business programs. However, Dartmouth’s
Tuck Business School has used the isolation and natural beauty of its locale to create
close-knit MBA classes that then join a loyal and supportive alumni network.
The Industry Context of Resource Analysis
The results of our resource and capability appraisal depend critically upon how
broadly or narrowly we define the industry within which the firm is located. If we are
appraising the resources and capabilities of Harley-Davidson, should we view Har-
ley as located in the motorcycle industry or in the heavyweight motorcycle segment?
Clearly, our appraisal of both the strategic importance of resources and Harley’s relative
strength will differ substantially. Initially at least, it is best to define industries fairly

126 PART II THE TOOLS OF STRATEGY ANALYSIS
If the key success factor in the airline business is
providing safe, reliable transportation between city pairs
at a competitive price, we can begin by identifying the
resources and capabilities needed to achieve that goal.
We can then use the value chain to fill out more system-
atically this list of resources and capabilities. Table  5.3
and Figure 5.8 show the major resources and capabilities
required in the airline business and assess Icelandair’s
position relative to a peer group of competitors.
In terms of strategy implications, a key resource that
distinguishes Icelandair is location: Iceland’s population
of 326,000 offers a passenger and freight market that Ice-
landair can easily dominate, but is too small to support
an international airline. Hence, to achieve efficient
scale, Icelandair must (a) collaborate with other firms
and the Icelandic government to develop Iceland as a
tourist destination and (b) compete on North Atlantic
routes between European and North American cities.
For (b) to be viable, Icelandair needs to make routes
that involve a stopover at its Reykjavik hub competitive
with the point-to-point routes offered by the major US
and European airlines. This requires (a) using Icelandair’s
operational efficiency to undercut other airlines on price
and (b) exploiting Icelandair’s operational and customer
service capabilities, its human resource strengths, and
the appeal of Reykjavik/Iceland as a stopover to estab-
lish a differentiation advantage. Icelandair’s strategy is
encapsulated in its vision statement: “To unlock Iceland’s
potential as a year-round destination, to strengthen Ice-
land’s position as a connecting hub, and to maintain our
focus on flexibility and experience.”
STRATEGY CAPSULE 5.8
Resource and Capability Analysis in Action: Icelandair Group
FIGURE 5.8 Icelandair’s resource and capability profile
Superf luous Strengths
Inconsequential Weaknesses
Maintenance
General management
Human resources
Financial resources
Flight
operations
Cabin services
Marketing
Key Strengths
Brand
Landing
slots Location
/route networkFleet
Key Weaknesses
H
ig
h
High
RE
LA
TI
VE
S
TR
EN
G
TH
Lo
w
Low
STRATEGIC IMPORTANCE
broadly; otherwise, there is a risk our analysis will be constrained by the focal firm’s
existing strategic positioning, Thus, in the case of Harley-Davidson, it is useful to view
the company within the context of the motorcycle industry as a whole. That way we
can address the question of which segments Harley should be located within. We can
then go on to a more focused analysis of Harley’s resources and capabilities for the
different industry segments.
As with all strategy frameworks, we need to be alert to the limitations of resource
and capability analysis. Not only are our criteria of strategic importance and relative
strength context-dependent but also individual resources and capabilities are themselves

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 127
multidimensional aggregations. For example, a firm’s manufacturing capability might
be assessed in relation to efficiency, quality, and flexibility. Hence, the resource and
capability analysis as outlined in this chapter is likely to be a fairly crude tool for
appraising a firm’s potential for competitive advantage. However, what it does offer is
a systematic approach to describe and assess an organization’s portfolio of resources
and capabilities that can be subsequently refined.
Strategy Capsule  5.8 illustrates how the approach outlined in this chapter can be
applied to identify and appraise the resources and capabilities of the Icelandair Group
and indicate its potential to establish a competitive advantage within the airline industry.
TABLE 5.3 The resources and capabilities of Icelandair Groupa
Strategic importance [1–10] Icelandair’s relative strength [1–10]b
Resources
Fleet Planes are transferrable; main differentiator is
age of fleet [2]
Above-average age of fleet until new planes are
delivered in 2018–21 [2]
Financial resources Critical for (a) buying other resources (b) sur-
viving downturns [7]
Strong balance sheet; positive cash flow [8]
Location and
route network
Critical to market access and exploiting network
economies [9]
Tiny domestic market and inferior North Atlantic
routes [3]
Landing slots Key determinant of access to congested
airports [6]
Limited presence at the key capacity-constrained
airports of Europe and North America [3]
Brand Important indicator of quality and reliability [5] Lacks international prominence and still tainted by
former image as a “hippy airline” [4]
Human resources Human resources critical to most capabilities [8] Well-educated, well-trained, and well-motivated
employees [8]
Capabilities
Flight operations Operational capabilities are critical to cost
efficiency and user satisfaction [9]
Strong record of operational efficiency, safety, and
flexibility; cost per average seat mile below that of
US and European legacy carriers [8]
Cabin services Critically important in business class; less impor-
tant in economy class [6]
Customer reviews suggest parity in business
class and superior quality/price combination in
economy [6]
Maintenance Relevant to reliability and safety, but easily out-
sourced [3]
Safety record and reliability performance suggest
superior capability [7]
Marketing Important for building brand awareness and
stimulating demand [5]
A key element in Icelandair’s success in expanding
tourist traffic and market share of North Atlantic
market [8]
General
management
Essential for developing and maintaining opera-
tional, customer service, marketing, and support
capabilities [8]
Icelandair has a dynamic, hands-on senior
management team that supports a flexible and
committed approach to management [9]
Notes:
aThis exercise is for illustrative purposes only. The assessments provided are based upon the author’s perceptions, not upon objective
measurement.
bCompared to peer group, comprising Norwegian, SAS, Lufthansa, British Airways, American, EasyJet, and WOW Air.

128 PART II THE TOOLS OF STRATEGY ANALYSIS
Summary
We have shifted the focus of our attention from the external environment of the firm to its internal
environment. We have observed that internal resources and capabilities offer a sound basis for building
strategy. Indeed, when a firm’s external environment is in a state of flux, internal strengths are likely to
provide the primary basis upon which it can define its identity and its strategy.
In this chapter, we have followed a systematic approach to identifying the resources and capabilities
that an organization has access to; we then have appraised these resources and capabilities in terms of
their potential to offer a sustainable competitive advantage and, ultimately, to generate profit.
Having built a picture of an organization’s key resources and capabilities and having identified areas
of strength and weakness, we can then devise strategies through which the organization can exploit
its strengths and minimize its vulnerability to its weaknesses. Figure 5.9 summarizes the main stages of
our analysis.
In the course of the chapter, we have encountered a number of theoretical concepts and relation-
ships; however, the basic issues of resource and capability analysis are intensely practical. At its core,
resource and capability analysis asks what is distinctive about a firm in terms of what it can do better
than its competitors and what it cannot. This involves not only analysis of balance sheets, employee
competencies, and benchmarking data, but also insight into the values, ambitions, and traditions of a
company that shape its priorities and identity.
FIGURE 5.9 Summary: A framework for analyzing resources and capabilities
STRATEGY
RESOURCES
3. Develop strategy implications:
(a) How can strengths be exploited most
ef fectively?
(b) In relation to weaknesses:
–Which activities can be outsourced?
– Can a strategy that minimizes the
impact of weaknesses be selected?
– Can resources/capabilities be
strengthened by investment?
2. Appraise the f irm’s resources and capabilities
in terms of:
(a) strategic importance
(b) relative strength
1. Identify the f irm’s resources and capabilities
POTENTIAL FOR
SUSTAINABLE
COMPETITIVE
ADVANTAGE
CAPABILITIES

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 129
Because the resources and capabilities of the firm form the foundation for building competitive
advantage, we shall return again and again to the concepts of this chapter. In the next chapter, we shall
consider the organizational structure and management systems through which resources and capa-
bilities are deployed. In Chapter 7, we shall look more closely at the competitive advantages that arise
when resource and capability strengths intersect with key success factors. In Chapter 8, we shall con-
sider how companies build the capabilities needed to deal with the challenges of the future.
Self-Study Questions
1. Since it was founded in 1994, Amazon has expanded its business from online book sales, to
online general retailing, to audio and video streaming, to e-readers and tablet computers, to
cloud computing. Is Amazon’s strategy based primarily upon serving a market need or pri-
marily on exploiting its resources and capabilities?
2. The world’s leading typewriter manufacturers in the 1970s included Olivetti, Underwood, IBM,
Olympia, Remington, Smith Corona, and Brother Industries. While IBM and Brother adapted
to the microelectronics revolution, most of the others failed. What strategies might these com-
panies have pursued as an alternative to producing personal computers and electronic word
processors market?
3. I have argued that the part of discrepancy between firms’ stock market value and their book
value reflects the fact that intangible resources are typically undervalued or not valued at all in
their balance sheets. For the companies listed in Table 5.1, which types of resource are likely
to be absent or undervalued in the firms’ balance sheets?
4. Many companies announce in their corporate communications: “Our people are our greatest
resource.” In terms of the criteria listed in Figure  5.7, can employees be considered of the
utmost strategic importance? For Walmart, McDonald’s, and McKinsey & Company, how impor-
tant are employees to their competitive advantages?
5. The chapter argues that Apple’s key capabilities are product design and product development
that combine hardware technology, software engineering, aesthetics, ergonomics, and
cognitive awareness to create products with a superior user interface and unrivalled market
appeal. How easy would it be for Samsung to replicate these capabilities of Apple?
6. Given the profile of Icelandair’s resources and capabilities outlined in Strategic Capsule 5.8,
how might Icelandair best exploit its resources and capabilities to (a) expand passenger num-
bers traveling to and from Iceland and (b) profitably grow its share of the North Atlantic market?
7. Apply resource and capability analysis to your own business school. Begin by identifying the
resources and capabilities relevant to success in the market for business education, appraise the
resources and capabilities of your school, and then make strategy recommendations regarding
such matters as the programs to be offered and the overall positioning and differentiation of
the school and its offerings.

130 PART II THE TOOLS OF STRATEGY ANALYSIS
Notes
1. P. F. Drucker, Managing in Turbulent Times (New York:
Harper & Row, 1990).
2. The resource-based view is described in J. B. Barney, “Firm
Resources and Sustained Competitive Advantage,” Journal
of Management 17 (1991): 99–120; and R. M. Grant,
“The Resource-based Theory of Competitive Advantage,”
California Management Review 33 (1991): 114–135.
3. C. K. Prahalad and G. Hamel, “The Core Competence of
the Corporation,” Harvard Business Review (May/June
1990): 79–91.
4. “Eastman Kodak: Failing to Meet the Digital Challenge,” in
R. M. Grant, Cases to Accompany Contemporary Strategy
Analysis 10th edn (Oxford: Blackwell, 2019).
5. E. Danneels, “Trying to Become a Different Type of
Company: Dynamic Capability at Smith Corona,” Strategic
Management Journal 32 (2011): 1–31; and E. Danneels, B.
Provera, and G. Verona, “(De-)Institutionalizing Organiza-
tional Competence: Olivetti’s Transition from Mechanical to
Electronic Technology,” Bocconi University, Milan, 2012.
6. C. M. Christensen, The Innovator’s Dilemma (New York:
Harper Business, 2000).
7. A. Madhok, S. Li, and R. L. Priem, “The Resource-Based
View Revisited: Comparative Firm Advantage, Willingness-
Based Isolating Mechanisms and Competitive Heteroge-
neity,” European Management Review 7 (2010): 91–100.
8. Walt Disney Company, 10-K report, 2014.
9. R. Gulati, “Network Location and Learning: The Influence
of Network Resources and Firm Capabilities on Alli-
ance Formation,” Strategic Management Journal 20
(1999): 397–420.
10. S. Green, “Understanding Corporate Culture and Its Rela-
tionship to Strategy,” International Studies of Management
and Organization 18 (Summer 1988): 6–28.
11. J. Barney, “Organizational Culture: Can It Be a Source
of Sustained Competitive Advantage?” Academy of
Management Review 11 1986): 656–665.
12. http://stats.oecd.org/Index.aspx?DatasetCode=TENURE_
AVE. Accessed September 13, 2017.
13. E. Lawler, “From Job-Based to Competency-Based Orga-
nizations,” Journal of Organizational Behavior 15 (1994):
3–15; L. Spencer and S. Spencer, Competence at Work:
Models for Superior Performance (New York: John Wiley &
Sons, Inc., 1993).
14. D. Goleman, Emotional Intelligence (New York: Bantam,
1995); D. Goleman, Social Intelligence (New York:
Bantam, 2006).
15. C. E. Helfat and M. Lieberman, “The Birth of Capabilities:
Market Entry and the Importance of Prehistory,” Industrial
and Corporate Change 12 (2002): 725–760.
16. P. Selznick, Leadership in Administration: A Sociological
Interpretation (New York: Harper & Row, 1957).
17. C. K. Prahalad and G. Hamel, “The Core Competence of
the Corporation,” Harvard Business Review (May/June
1990): 79–91.
18. G. Hamel and C. K. Prahalad state: “the distinction bet-
ween competencies and capabilities is purely semantic”
(letter, Harvard Business Review, May/June 1992: 164–165).
19. M. E. Porter, Competitive Advantage (New York: Free
Press, 1984).
20. D. J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities
and Strategic Management,” Strategic Management Journal
18 (1997): 509–533.
21. P. Leinwand and C. Mainardi, “The Coherence Premium,”
Harvard Business Review 88 ( June 2010): 86–92.
22. Adverse selection refers to the propensity for a market to
be dominated by low-quality or risky offerings as a result
of information asymmetry. This is also known as the
lemons problem. See G. Akerlof, “The Market for Lemons:
Qualitative Uncertainty and the Market Mechanism,”
Quarterly Journal of Economics 84 (1970): 488–500.
23. I. Dierickx and K. Cool (“Asset Stock Accumulation and
Sustainability of Competitive Advantage,” Management
Science 35 (1989): 1504–1513) point to two major disadvan-
tages of imitation (a) asset mass efficiencies: the incumbent’s
strong initial resource position facilitates the subsequent
accumulation of resources and (b) time compression dis-
economies: additional costs incurred by an imitator when
seeking to rapidly accumulate a resource or capability.
24. J. Denrell, N. Arvidsson, and U. Zander, “Managing
Knowledge in the Dark: An Empirical Study of the Reli-
ability of Capability Evaluations,” Management Science 50
(2004): 1491–1503.
25. D. Miller, The Icarus Paradox: How Exceptional Companies
Bring about Their Own Downfall (New York: Harper-
Business, 1990).
26. I. Martin, Making It Happen: Fred Goodwin, RBS and the
Men Who Blew Up the British Economy (London: Simon &
Schuster, 2013).
27. “What is Benchmarking?” Benchnet: The Benchmarking
Exchange, www.benchnet.com, accessed September 18,
2017.
28. G. Jacobson and J. Hillkirk, Xerox: American Samurai
(New York: Macmillan, 1986).
29. N. Bloom, J. Van Reenen, and E. Brynjolfsson, “Good
Management Predicts a Firm’s Success Better Than IT,
R&D, or Even Employee Skills,” Harvard Business Review
(April 2017); N. Bloom and J. Van Reenen, “Why Do
Management Practices Differ across Firms and Countries?”
Journal of Economic Perspectives 24 (2010): 203–224.
30. S. Ferriani, E. Garnsey, G. Lorenzoni, and L. Massa, “The
Intellectual Property Business Model: Lessons from ARM
Plc.” (CTM Working Paper, University of Cambridge,
June 2015).
31. C. Markides, All the Right Moves (Boston: Harvard Business
School Press, 1999).

http://stats.oecd.org/Index.aspx?DatasetCode=TENURE_AVE

6 Organization Structure
and Management
Systems: The
Fundamentals of
Strategy Implementation
Ultimately, there may be no long-term sustainable advantage other than the ability to
organize and manage.
—JAY GALBRAITH AND ED LAWLER
I’d rather have first-rate execution and second-rate strategy anytime than brilliant
ideas and mediocre management.
—JAMIE DIMON, CEO, JPMORGAN CHASE & CO.
Many people regard execution as detail work that’s beneath the dignity of a business
leader. That’s wrong. To the contrary, it’s a leader’s most important job.
—LARRY BOSSIDY, FORMER CEO, HONEYWELL
6
◆ Introduction and Objectives
◆ Strategy Formulation and Strategy Implementation
● The Strategic Planning System: Linking Strategy
to Action
◆ The Fundamentals of Organizing: Specialization,
Cooperation, and Coordination
● Specialization and Division of Labor
● The Cooperation Problem
● The Coordination Problem
◆ Developing Organizational Capability
● Processes
● Motivation
● Structure
◆ Organization Design
● The Role of Hierarchy
● Defining Organizational Units
● Alternative Structural Forms: Functional,
Multidivisional, Matrix
● Systems and Style: Mechanistic versus Organic
Organizational Forms
● Recent Trends in Organizational Design
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

132 PART II THE TOOLS OF STRATEGY ANALYSIS
Introduction and Objectives
We spend a lot of our time strategizing: pondering our next career move, making plans for a vaca-
tion; thinking about how to improve our marketability. Most of these strategies remain just wishful
thinking: if strategy is to yield results, it must be backed by commitment and translated into action.
The challenges of strategy implementation are even greater for organizations than for individuals.
Executing strategy requires the combined efforts of all the members of the organization, many of whom
will have played no role in its formulation; others will find that the strategy conflicts with their own
personal interests. Even without these impediments, implementation tends to be neglected because
it requires commitment, persistence, and hard work. “How many meetings have you attended where
people left without firm conclusions about who would do what and when?” asks super-consultant,
Ram Charan.1
In this chapter, we consider some of the fundamentals of strategy implementation. We begin by
clarifying the relationship between strategy formulation and strategy implementation. If strategy
involves translating intention into action, the basic organizational requirements are for coordination
and cooperation. We view organizational capability as the mechanism through which coordination
and cooperation effectuate action. We disaggregate organizational capability into four components:
resources, motivation, processes, and structure and go on to explore the role of each of these in strategy
implementation.
This chapter introduces only the fundamentals of strategy implementation. In subsequent chap-
ters, we shall consider strategy implementation in particular contexts, such as strategic change
(Chapter 8), innovation (Chapter 9), mature industries (Chapter 10), international business (Chapter 12),
multi business firms (Chapter  14), and mergers and acquisitions (Chapter  15). At the same time, our
consideration of strategy implementation is limited: ultimately strategy implementation embraces the
whole of management.
By the time you have completed this chapter, you will be able to:
◆◆ Understand the relationship between strategy formulation and strategy implementation
and the role of strategic planning systems in linking strategy to action.
◆◆ Recognize the role of cooperation and coordination as the basic requirements for organi-
zational effectiveness.
◆◆ Appreciate the role that resources, processes, motivation, and structure play in developing
organizational capabilities.
◆◆ Select the organizational structure best suited to a particular business context.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 133
Strategy Formulation and Strategy Implementation
The relationship between strategy formulation and strategy implementation has long
been a contentious issue. During the early years of corporate planning, strategy was
viewed as a two-stage process: first, formulation (mainly by top management), then
implementation (mainly by middle management). This conception was challenged by
Henry Mintzberg who envisaged strategy as emerging from the interaction between
the formulation and implementation (see the discussion of “How is Strategy Made? The
Strategy Process” in Chapter 1).2
From what we have learned about the nature of strategy, it is clear that we cannot
separate strategic management into self-contained formulation and implementation
stages. The intended strategy of any organization is inevitably incomplete: it com-
prises goals, directions, and priorities, but it can never be comprehensive. It is during
implementation that the gaps are filled in and, because circumstances change, the
strategy adapts. Equally, strategy formulation must take account of the conditions of
implementation. The observation “Great strategy; lousy implementation” is typically a
misdiagnosis of strategic failure: a strategy which has been formulated without taking
account of its ability to be implemented is a poorly formulated strategy. Clearly, strategy
formulation and implementation are interdependent. Nevertheless, the fact remains that
purposeful behavior requires that action must be preceded by intention, and intention
needs to be preceded by thought.
The Strategic Planning System: Linking Strategy to Action
Our outline of the development of strategic management in Chapter  1 (see “A Brief
History of Business Strategy”) indicated that companies adopted corporate planning,
not to formulate strategy but to facilitate coordination and control in increasingly large
and complex organizations.
Similarly with entrepreneurial start-ups, when Steve Jobs and Steve Wozniak founded
Apple Computer at the beginning of 1977, strategy was developed in their heads and
through their conversation. A written articulation of Apple’s strategy did not appear
until they needed to write a business plan in order to attract venture capital funding.3
However, Apple did not adopt a systematic strategic planning process until several
years later when it needed to establish capital expenditure budgets for its different
functions and product teams and link strategy to day-to-day decision-making.
Thus, Mintzberg’s claim that formalized strategic planning is a poor way to make
strategy, even if it is right, fails to recognize the real value purpose of strategic planning
systems. As we shall see, strategic planning systems provide a framework for the
strategy process which can assist in building consensus, communicating the strategy
and its rationale throughout the organization, allocating resources to support the
strategy, and establishing performance goals to guide and motivate the individuals and
groups responsible for carrying out the strategy.
The Strategic Planning Cycle Most large companies have a regular (normally
annual) strategic planning process that results in a document that is endorsed by the
board of directors and provides a development plan for the company for the next three
to five years. The strategic planning process is a systematized approach that assem-
bles information, shares perceptions, conducts analysis, reaches decisions, ensures

134 PART II THE TOOLS OF STRATEGY ANALYSIS
consistency among those decisions, and commits managers to courses of action and
performance targets.
Strategic planning processes vary between organizations. At some they are highly
centralized. Even after an entrepreneurial start-up has grown into a large company,
strategy making may remain the preserve of the chief executive. At MCI Communica-
tions, former CEO Orville Wright observed: “We do it strictly top-down at MCI.”4 How-
ever, at most large companies, the strategic planning process involves a combination of
top-down direction and bottom-up initiatives.5
Figure 6.1 shows a typical strategic planning cycle. The principal stages are:
1 Setting the context: guidelines, forecasts, assumptions. The CEO typically initiates
the process by indicating strategic priorities—these will be influenced by the
outcome of the previous performance reviews. In addition, the strategic planning
unit may provide assumptions or forecasts that offer a common basis for strategic
planning by different units within the organization. For example, the 2017–20
strategic plan of the Italian oil and gas company Eni was based upon (a) the
goal of increasing free cash flow by expanding petroleum production and selling
assets and (b) assumptions that the price of crude would rise to $60 per barrel
and the dollar/euro exchange rate would appreciate to 1.20 by 2020.6
2 Business plans. On the basis of these priorities and planning assumptions, the
different organizational units—product divisions, functional departments, and
geographical units—create strategic plans that are then presented for com-
ment and discussion to top management. This dialogue represents a critically
important feature of the strategy system: it provides a process for sharing
knowledge, communicating ideas, and reaching consensus. This process may
be more important than the strategic plans that are created. As General (later
President) Dwight Eisenhower observed: “Plans are worthless, but planning is
everything.”7
Corporate
Guidelines
Draft
Business
Plans
Discussions
with
Corporate
Revised
Business
Plans
Approval
by
Board
Corporate
Plan
Capex
Budget
Performance
Targets
Operating Plan/
Operating Budget
Performance
Review
Forecasts/
Scenarios/
Planning
Assumptions
FIGURE 6.1 The generic annual strategic planning cycle

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 135
3 The corporate plan. Once agreed, the business plans are then integrated
to create the corporate strategic plan that is then presented to the board
for approval.
4 Capital expenditure budgets. Capital expenditure budgets link strategy
to resource allocation. They are established through both top-down and
bottom-up initiatives. When organizational units prepare their business plans,
they will indicate the major projects they plan to undertake during the stra-
tegic planning period and the capital expenditures involved. When top
management aggregates business plans to create the corporate plan, it estab-
lishes capital expenditure budgets both for the company as a whole and for
the individual businesses. The businesses then submit capital expenditure
requests for specific projects that are evaluated through standard appraisal
methodologies, typically using discounted cash flow analysis. Capital expen-
diture approvals take place at different levels of a company according to
their size. Projects of up to $5 million might be approved by a business
unit head; projects of up to $25 million might be approved by divisional
top management; larger projects might need to be approved by the top
management committee; the biggest projects may require approval by the
board of directors.
5 Operational plans and performance targets. Implementing strategy requires
breaking down strategic plans into a series of shorter-term plans that pro-
vide a focus for action and a basis for performance monitoring. At the basis
of the annual operating plan are a set of performance targets derived from
the strategic plan. These performance targets are both financial (sales growth,
margins, return on capital) and operational (inventory turns, defect rates,
number of new outlets opened). In the section on “Setting Performance Tar-
gets” in Chapter 2, I outlined the basic cascading logic for goal setting: overall
goals of the organization are disaggregated into more specific performance
goals as we move down the organization. As Chapter 2 shows, this can use
either a simple financial disaggregation or the balanced scorecard method-
ology. There is nothing new about this approach: management by objectives
(the process of participative goal setting) was proposed by Peter Drucker in
1954.8 Performance targets can be built into the annual operating budget. The
operating budget is a pro forma profit-and-loss statement for the company as
a whole and for individual divisions and business units for the upcoming year.
It is usually divided into quarters and months to permit continual monitoring
and the early identification of variances. The operating budget is part fore-
cast and part target. Each business typically prepares an operating budget for
the following year that is then discussed with the top management committee
and, if acceptable, approved. In some organizations, the budgeting process
is part of the strategic planning system: the operating budget is the first year
of the strategic plans; in others, budgeting follows strategic planning. Opera-
tional planning is more than setting performance targets and agreeing budgets;
it also involves planning specific activities. As Bossidy and Charan explain:
“An operating plan includes the programs your business is going to complete
within one year … Among these programs are product launches; the marketing
plan; a sales plan that takes advantage of market opportunities; a manufac-
turing plan that stipulates production outputs; and a productivity plan that
improves efficiency.”9

136 PART II THE TOOLS OF STRATEGY ANALYSIS
The Fundamentals of Organizing: Specialization, Cooperation,
and Coordination
Translating intention into action requires organizing. To understand what organizing
involves, we must understand why firms exist.
Specialization and Division of Labor
Firms exist because of their efficiency advantages in producing goods and services that
results from the division of labor: each worker specializing in a specific task. Consider
Adam Smith’s description of pin manufacture:
One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a
fifth grinds it at the top for receiving the head; to make the head requires two or three
distinct operations; to put it on is a peculiar business, to whiten the pins is another; it
is even a trade by itself to put them into the papers.10
Smith’s pin makers produced about 4800 pins per person each day. “But if they had all
wrought separately and independently, and without any of them having been educated
to this peculiar business, they certainly could not each have made 20, perhaps not one
pin, in a day.”
However, specialization comes at a cost: dividing the production process requires
integrating the separate efforts. This involves two problems: first, the cooperation
problem, aligning the interests of individuals who have divergent goals; second, the
coordination problem, even in the absence of goal conflict, how do individuals harmo-
nize their separate efforts?
The Cooperation Problem
The economics literature analyzes cooperation problems arising from goal misalign-
ment as the agency problem.11 An agency relationship exists when one party (the
principal) contracts with another party (the agent) to act on behalf of the principal. The
problem is ensuring that the agent acts in the principal’s interest. Particular attention has
been given to agency problems arising between owners (shareholders) and managers.
The central issue of corporate governance is ensuring that managers act in the inter-
ests of shareholders. However, agency problems exist throughout the entire hierarchy:
employees tend to pursue their own interests rather than those of their organization.
Even organizational goals fragment as a result of specialization as each department
creates its own subgoals. The classic conflicts are between different functions: sales
wishes to please customers, production wishes to maximize output, R & D wants to
introduce mind-blowing new products, while finance worries about profit and loss.
Several mechanisms are available to management for achieving goal alignment
within organizations:
● Control mechanisms typically operate through hierarchical supervision: man-
agers supervise the behavior and performance of subordinates using positive
and negative incentives. The principal positive incentive is the oppor-
tunity for promotion up the hierarchy; negative incentives are dismissal
and demotion.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 137
● Performance incentives link rewards to output: they include piece rates for pro-
duction workers and profit bonuses for executives. Performance-related incen-
tives have the advantages of being “high powered”—rewards are directly related
to performance—and they avoid the need for costly monitoring and supervision
of employees. Pay-for-performance is less effective when employees work in
teams or where output is difficult to measure.
● Shared values. Some organizations achieve high levels of cooperation and
low levels of goal conflict without resorting to either punitive controls or
performance incentives. The members of churches, charities, and voluntary
organizations often share values that support common purpose. Similarly,
for business enterprises, as we saw in Chapter 2 (see pp. 52–53), shared values
among members encourage the convergence of interests and perceptions that
facilitate consensus and enhances performance.12 In doing so, shared values
can act as a control mechanism that is an alternative to bureaucratic control or
financial incentives. An organization’s values are one component of its culture.
Strategy Capsule 6.1 discusses the role of organizational culture in aligning
individual actions with company strategy.
● Persuasion. Implementing strategy requires leadership and at the heart of lead-
ership is persuasion. J.-C. Spender argues that, language is central, both to the
conceptualization of strategy and to its implementation.13 Leadership requires
influencing others, where rhetoric—the use of language for persuasion—is a
core skill. Management rhetoric is not simply about communicating strategy; it
involves changing the perceptions of organizational members, their relationships
with the organization, and, ultimately, guiding their actions to actualize the
strategy in the face of uncertainty and ambiguity.
The Coordination Problem
Willingness to cooperate is not enough to ensure that organizational members integrate
their efforts—it is not a lack of a common goal that causes Olympic relay teams to drop
the baton. Unless individuals can find ways of coordinating their efforts, production
does not happen. As we shall see in our discussion of organizational capabilities, the
exceptional performance of Disney theme parks, the Ferrari Formula 1 pit crew, and
the US Marine Corps band derives less from the skills of the individual members and
more from superb coordination among them.
Mechanisms for coordination include the following:
● Rules and directives: A basic feature of all firms is a general employment
contract under which individuals agree to perform a range of duties as required
by their employer. This allows managers to exercise authority by means of
general rules (“Secret agents on overseas missions will have essential expenses
reimbursed only on production of original receipts”) and specific directives
(“Miss Moneypenny, show Mr Bond his new toothbrush with 4G communica-
tion and a concealed death ray”).
● Mutual adjustment: The simplest form of coordination involves the mutual
adjustment of individuals engaged in related tasks. In soccer or doubles
tennis, players coordinate their actions spontaneously without direction or
established routines. Such mutual adjustment occurs in leaderless teams and
is especially suited to novel tasks where routinization is not feasible.

138 PART II THE TOOLS OF STRATEGY ANALYSIS
● Routines: Where activities are performed repeatedly, coordination becomes
routinized. As we shall see in more detail when we discuss processes,
organizational routines are “regular and predictable sequences of coordinated
actions by individuals” that provide the foundation of organizational capability.
If organizations are to perform complex activities efficiently and reliably, rules,
directives, and mutual adjustments are not enough—coordination must become
embedded in routines.
STRATEGY CAPSULE 6.1
Organizational Culture as an Integrating Device
Corporate culture comprises the beliefs, values, and
behavioral norms of the company, which influence
how employees think and behave.a It is manifest in
symbols, ceremonies, social practices, rites, vocabulary,
and dress. While shared values are effective in aligning
the goals of organizational members, culture exercises
a wider influence on an organization’s capacity for pur-
poseful action. Organizational culture is a complex
phenomenon. It is shaped by the national and ethnic
cultures within which the firm is embedded and the
social and professional cultures of organizational mem-
bers. Most of all, it is a product of the organization’s his-
tory, especially the founder’s personality and beliefs: the
corporate culture of Walt Disney Company continues to
reflect the values, aspirations, and personal style of Walt
Disney. A corporate culture is seldom homogeneous:
different cultures coexist within different functions and
departments.
Culture can facilitate both cooperation and
coordination through fostering social norms and a sense
of identity. Cultures can also be divisive and dysfunc-
tional. At the British bank NatWest during the 1990s, John
Weeks identified a “culture of complaining” which was a
barrier to top-down strategy initiatives.b A culture may
support some types of corporate action but handicap
others. Lehman Brothers (whose collapse in September
2008 triggered the global financial crisis) was renowned
for its individualistic, entrepreneurial culture whose
downside was ineffective risk management. The culture
of the British Broadcasting Corporation reflects internal
politicization, professional values, and dedication to the
public good, but a lack of customer focus.c
Cultures take a long time to develop and cannot
easily be changed. As the external environment changes,
a highly effective culture may become dysfunctional. The
police forces of some US cities have developed cultures
of professionalism and militarism, which increased their
effectiveness in fighting crime, but led to isolation and
unresponsiveness to community needs.d
Despite its power in determining how an orga-
nization behaves, culture is far from being a flexible
management tool at the disposal of chief executives. It
is a property of the organization as a whole, which is not
amenable to manipulation. CEOs inherit rather than cre-
ate the culture of their organizations. The key issue is to
recognize the culture of the organization and to ensure
that structure and systems work with the culture and not
against it. Where strategy is aligned with organizational
culture, it can act as a control device and a source of flex-
ibility: when individuals internalize the goals and princi-
ples of the organization, they can be allowed to use their
initiative and creativity in their work.
Notes:
aE. H. Schein, “Organizational Culture,” American Psychologist 45
(1990): 109–119.
bJ. Weeks, Unpopular Culture: The Ritual of Complaint in a British
Bank (Chicago: University of Chicago Press, 2004).
cT. Burns, The BBC: Public Institution and Private World (London:
Macmillan, 1977).
d“Policing: Don’t Shoot,” Economist (December 13, 2014): 37.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 139
The relative roles of these different coordination devices depend on the types of
activity being performed and the intensity of collaboration required. Rules are highly
efficient for activities where standardized outcomes are required—most quality- control
procedures involve the application of simple rules. Routines are essential for activ-
ities where close interdependence exists between individuals, be the activity a basic
production task (supplying customers at Starbucks) or more complex (performing
a heart bypass operation). Mutual adjustment works best for nonstandardized tasks
(such as problem-solving), where those involved are well informed of the actions of
their coworkers, either because they are in close visual contact (a chef de cuisine and
her sous chefs) or because of information exchange (a design team using interactive
CAD software).
Developing Organizational Capability
Translating strategy into action requires organizational capability. Hence, the develop-
ment and deployment of organizational capabilities lies at the core of strategy imple-
mentation. So far, we have said little about the determinants of organizational capability
beyond recognizing that capabilities involve combining resources to perform a task. Let
us look more closely at the structure of organizational capability in the light of our pre-
ceding discussion of the fundamentals of organizing.
Capabilities require resources, and the level of capability depends, to some degree,
upon the amount and quality of these resources. However, there is more to capa-
bility than resources alone. In sport, all-star teams can be beaten by teams that create
strong capabilities from modest resources. In 1992, the US men’s Olympic basketball
team—the “Dream Team” that included Charles Barkley, Larry Bird, Patrick Ewing,
Magic Johnson, Michael Jordan, Karl Malone, and Scottie Pippen—lost to a team of
college players in one of their practice games. In Euro 2016, the English soccer team,
with a market value of $810 million, was eliminated by Iceland, a team valued at
$30 million. Similarly, in business: upstarts with modest resources can outcompete
established giants—Dyson against Electrolux in domestic appliances, ARM against Intel
in microprocessors, Spotify against Apple in streamed music. Clearly, there is more to
organizational capability than just resources.
The effectiveness with which resources—people especially—are integrated to cre-
ate capabilities depends upon three major factors: processes, motivation, and structure.
These are depicted in Figure 6.2.
ORGANIZATIONAL
CAPABILITIES
RESOURCES
Motivation StructureProcesses
FIGURE 6.2 Integrating resources to build capability

140 PART II THE TOOLS OF STRATEGY ANALYSIS
Processes
The academic literature views organizational capability as based upon organizational
routines—“regular and predictable behavioral patterns [comprising] repetitive patterns
of activity” that determine what firms do, who they are, and how they develop.14 Like
individual skills, organizational routines develop through learning-by-doing—and, if
not used, they wither.
However, the academic literature’s emphasis on routines as an emergent phenomenon
ignores the role of management. In practice, patterns of coordination among organi-
zational members to undertake a productive task are planned by managers who use
learning-before-doing as a vital preliminary to learning-by-doing. For this reason, I
emphasize organizational processes over organizational routines, where a process is
a coordinated sequence of actions through which specific productive tasks are per-
formed. Not only is the term process well understood by managers, but there are
established tools for their design, mapping, and development.15
Motivation
Processes provide the basis for team members to coordinate their individual actions;
however, the effectiveness of the coordination depends upon the extent of their
motivation. We discussed motivation in relation to the challenge of aligning the goals
of individuals with those of the organization. Team motivation is more complex: it
depends not only on each individual’s willingness to strive in performing his/her
specific task but also on a willingness to subordinate individuals to team goals. Despite
decades of research, the determinant of exceptional team performance remains a
mystery—which is why outstandingly successful sports coaches—Alex Ferguson,
Joe Gibbs, John Wooden, Scotty Bowman—command huge fees on the corporate
lecture circuits.
Structure
The people and processes that contribute to an organizational capability need to
be located within the same organizational unit if they are to coordinate effectively.
Processes that span internal organizational boundaries rarely achieve high levels
of capability. Until the mid-1980s, European and US automakers used a sequential
system of new product development which began in marketing then went, in turn,
to styling, engineering, manufacturing, and finance. When they adopted the cross-
functional product development teams pioneered by Toyota and Honda, the time to
develop a new model of car was halved.16 As companies develop new capabilities,
so their organizational structures become more complex. Strategy Capsule 6.2 shows
the evolution of organizational structure at a management consulting company as it
developed specialist capabilities.
The design of organizational structure is a broad topic that cannot be reduced to
the simple principle of locating each organizational process within an organizational
unit. So let us consider more generally the basic issues that are involved in the design
of organizational structures.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 141
STRATEGY CAPSULE 6.2
Capability Development and Organizational Structure
at Booz & Company
During the 1990s, Booz Allen Hamilton (now Strategy&,
a subsidiary of PwC) transitioned from a “generalist” to a
“specialist” model of management consulting. Under the
generalist model, consultants were located in one of its
28 offices throughout the world and were then assigned
to one or more consulting projects. The expectation was
that they would develop, through experience, broad-
based consulting expertise that was not specific either
to a particular management function or particular sector.
Booz’s managing partner referred to the firm as “a colony
of artists” (see Figure 6.3a).
During the 1990s, Booz recognized the need to
develop specialist capabilities in relation to individual
management functions (such as strategy, operations,
information technology, and change management) and
specific sectors (e.g., energy, telecom, financial services,
and automobiles). To develop these specialist capabilities,
Booz adopted a matrix structure comprising functional
practices and sector practices (see Figure  6.3b). Hence,
a new consultant or associate joining Booz would be
located within a particular office and assigned to one or
more client teams, but training and career development
purposes would also be part of a functional practice and
a sector practice.
FIGURE 6.3 Booz Allen Hamilton (Worldwide commercial business)
b 1998: Organizing for capabilitya 1992: “A colony of artists”
FUNCTIONAL PRACTICES
P
R
A
C
T
I
C
E
S
I
N
D
U
S
T
R
Y
NY Tokyo London
Strategy Operations IT
Financial
services
Energy
Telecom
Consumer
Engineering
Chemicals
/Pharma
P r o j e c t Te a m sP r o j e c t Te a m s
NY
Tokyo
London
Project Teams
Project Teams
Project Teams
Project Teams
Project Teams
Project Teams

142 PART II THE TOOLS OF STRATEGY ANALYSIS
Organization Design
Designing structures that can reconcile efficiency through specialization with effective
integration is a major management challenge that is informed by a substantial body of
organizational theory. Let us restrict ourselves to four issues that are especially rele-
vant to implementing strategy. We begin by acknowledging the need for hierarchy—all
organizations are hierarchical to a greater or lesser degree. We go on to consider how
to define organizational units within these hierarchies. We then examine how these
organizational units are configured within the overall structure of the company. Finally,
we look at formality within organizations and the relative merits of mechanistic and
organic structures.
The Role of Hierarchy
Hierarchy is the fundamental feature of all but the simplest organizations and the
primary mechanism for achieving coordination and cooperation. Despite the nega-
tive images that hierarchy often conveys, there are no viable alternatives for complex
organizations—the critical issue is how hierarchy should be structured and how its var-
ious parts should be linked. Hierarchy is a solution both to the problem of cooperation
and the problem of coordination.
Hierarchy as Mechanism for Cooperation: Hierarchy is system of control
through authority: each member of the organization reports to a superior and has
subordinates to supervise and monitor. Hierarchy is a core feature of bureaucracy—
a formalized administrative system devised by the Qin emperor of China in about
220BC, and deployed ever since in public administration, the military, and commerce.
For the German sociologist, Max Weber, bureaucracy was the most efficient and
rational way to organize human activity. It involves “each lower office under the con-
trol and supervision of a higher one”; a “systematic division of labor”; formalization
in writing of “administrative acts, decisions, and rules”; and work governed by stan-
dardized rules and operating procedures. Authority is based on “belief in the legality
of enacted rules and the right of those elevated to authority under such rules to issue
commands.”17
Hierarchy as Coordination: Hierarchy is a feature not only of human organiza-
tions, but of all complex systems:
● The human body comprises subsystems such as the respiratory system, nervous
system, and digestive system, each of which consists of organs, each of which is
made up of individual cells.
● The physical universe is a hierarchy with galaxies at the top, solar systems below,
planets below that, and so on, all the way down to atoms and subatomic particles.
● A novel is organized by chapters, paragraphs, sentences, words, and letters.
The basic principle here is that of modularity: dividing complex systems into hierarchi-
cally organized components.18 Modular, hierarchical structures have two major advan-
tages in coordinating productive activities:

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 143
● Economizing on coordination: Hierarchy reduces the amount of communica-
tion needed to coordinate the activities of organizational members. Suppose
that the optimal span of control is five. In a group of six individuals, there
are 15 bilateral interactions, if one member is appointed coordinator, there
are five vertical interactions. Similarly, a group of 25 involves 250 bilateral
interactions; a hierarchical system with a span of control of five requires a
three-tier hierarchy and 24 interactions. The larger the number of organiza-
tional members, the greater the efficiency benefits from organizing hierar-
chically. Complex computer software can require large development teams:
Microsoft’s Windows 8 development team comprised about 3200 software
development engineers, test engineers, and program managers. These were
organized into 35 “feature teams,” each of which was divided into a number
of component teams. As a result, each engineer needed to coordinate only
with the members of his or her immediate team. The modular structure
of the Windows 8 development team mirrored the modular structure of
the product.
● Adaptability: Hierarchical, modular systems can evolve more rapidly than uni-
tary systems. This adaptability requires decomposability: the ability of each
component subsystem to operate with some measure of independence from
the other subsystems. Modular systems that allow significant independence for
each module are referred to as loosely coupled.19 The modular structure of Win-
dows enabled a single feature team to introduce innovative software features
without the need to coordinate with all 34 other teams. The key requirement is
that the different modules must fit together—this requires a standardized inter-
face. Entire companies may be viewed as loosely coupled modular structures. At
Procter & Gamble, decisions about developing new shampoos can be made by
the Beauty, Hair, and Personal Care sector without involving P&G’s other three
sectors (Baby, Feminine, and Family Care; Fabric and Home Care; and Health
and Grooming). A modular structure also makes it easier to add new businesses
and divest others—in 2015, P&G sold its cosmetics and fragrances business
to Coty.20
Organizational capabilities can also be viewed as being organized hierarchically. In
the petroleum sector, drilling capability is composed of several specialist capabilities;
then drilling capability links with other capabilities to form overall exploration capa-
bility (see Figure 6.4). Similarly with Apple’s new product development capability, this
Negotiating
Capability
Geological
Capability
Directional
Drilling
Capability
Well
Logging
Capability
Deepwater
Drilling
Capability
Well
Casing
Capability
Hydraulic
Fracturing
Capability
Seismic
Capability
Drilling
Capability
Well Construction
Capability
Partnering
Capability
Procurement
Capability
Exploration Capability
FIGURE 6.4 The hierarchical structure of organization capabilities: The case of oil
and gas exploration

144 PART II THE TOOLS OF STRATEGY ANALYSIS
too is a higher-level capability that combines an array of lower-level capabilities such as
market insight, microelectronic capability, software engineering, design aesthetics, and
partner relations management. Because these upper-level capabilities integrate such a
broad span of specialist know-how, they are difficult for others to imitate.
Defining Organizational Units
An organizational hierarchy is composed of organizational units—but how should we
define these units? The principle we have established so far is that organizational struc-
ture should be aligned with processes: those who perform a process should be located
within the same organizational unit. The fundamental issue is intensity of coordination
needs: those individuals who need to interact most closely should be located within
the same organizational unit. In the case of McDonald’s, the store managers and crew
members undertake food preparation, cooking, and cleaning: the individual store is the
basic organizational unit. At Infosys Consulting, a client engagement may involve con-
sultants and software engineers at different Infosys offices throughout the world as well
as those at the client site: the project team is the appropriate organizational unit—even
if it is temporary and spans multiple locations. However, individuals’ organizational
roles typically involve them in multiple processes—which should take precedence
when defining organizational units? James Thompson’s answer was “Where interdepen-
dence among organizational members is most intense.”21
Alternative Structural Forms: Functional,
Multidivisional, Matrix
The same principle of defining organizational units in the basis of the intensity of
interdependence also applies to the integration of lower-level organizational units
into higher-level units. On the basis of these alternative approaches to grouping tasks
and activities, we can identify three basic organizational forms for companies: the
functional structure, the multidivisional structure, and the matrix structure.
The Functional Structure Single-business firms tend to be organized by
function. Most airlines have functional structures (see Figure 6.5). Grouping together
functionally similar tasks is conducive to exploiting scale economies, promoting
learning and capability building, and deploying standardized control systems.
Since cross- functional integration occurs at the top of the organization, functional
Finance
Legal &
Regulatory Technology
Human
ResourcesMarketingOperations
Board of Directors
CEO
Michael O’Leary
FIGURE 6.5 Ryanair Holdings plc: Organizational structure

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 145
structures are conducive to a high degree of centralized control by the CEO and top
management team.
As functionally organized companies grow and diversify, so there are pressures to
decentralize through adopting a divisional structure (see below). However, as com-
panies and their industries mature, the advantages of efficiency, centralized control,
and well-developed functional capabilities can cause companies to revert to functional
structures. General Motors, a pioneer of the multidivisional structure, integrated its
product divisions and overseas subsidiaries into a more integrated functional structure
as scale economies became its dominant strategic priority.
The Multidivisional Structure In a multidivisional corporation, the divisions are
separate businesses, defined by product or geography. The key advantage of the multi-
divisional structure is the potential for decentralized decision-making. It is a loosely
coupled, modular organization where business-level strategies and operating decisions
can be made at the divisional level, while the corporate headquarters concentrate on
corporate planning, budgeting, and providing common services.
The effectiveness of the multidivisional form depends on the ability of the corporate
center to apply a common management system to the different businesses. At ITT, Harold
Geneen’s “managing by the numbers” allowed him to cope with over 50 divisional heads
reporting directly to him. At BP, a system of “performance contracts” allowed CEO John
Browne to oversee BP’s 24 businesses, each of which reported directly to him. Divi-
sional autonomy also fosters the development of leadership capability among divisional
heads—an important factor in grooming candidates for CEO succession.
The large, divisionalized corporation is typically organized into three levels: the
corporate center, the divisions, and the individual business units, each representing a
distinct business for which financial accounts can be drawn up and strategies formu-
lated. Figure 6.6 shows General Electric’s organizational structure at the corporate and
divisional levels. Chapter 14 will look in greater detail at the management of the multi-
divisional corporation.
Matrix Structure Whatever the primary basis for grouping, all companies that
embrace multiple products, multiple functions, and multiple locations must coordinate
across all three dimensions. Organizational structures that formalize coordination and
control across multiple dimensions are called matrix structures.
Corporate Executive O�ce
Chairman & CEO
Corporate Sta�
-Business Development
-Commercial & Public Relations
-Human Resources
-Legal
-Global Research
-Finance
GE
Power
GE
Digital
GE
Health care
GE
Capital
GE
Renewable
Energy
GE
Aviation
GE Trans-
portation
Current
powered
by GE
Baker
Hughes
FIGURE 6.6 General Electric: Organizational structure, January 2018

146 PART II THE TOOLS OF STRATEGY ANALYSIS
Figure  6.7 shows the Shell management matrix (prior to reorganization in 1996).
Within this structure, the general manager of Shell’s Berre refinery in France reported
to his country manager, the managing director of Shell France, but also to his business
sector head, the coordinator of Shell’s refining sector, as well as having a functional
relationship with Shell’s head of manufacturing.
Many diversified, multinational companies, including Philips, Nestlé, and Unilever,
adopted matrix structures during the 1960s and 1970s, although in all cases one
dimension of the matrix tended to be dominant in terms of authority. Thus, in the
old Shell matrix, the geographical dimension, as represented by country heads and
regional coordinators, had primary responsibility for budgetary control, personnel
appraisal, and strategy formulation.
Since the 1980s, the matrix structure has fallen out of favor and several large corpo-
rations have claimed to have dismantled their matrix organizations: “They led to conflict
and confusion; the proliferation of channels created informational logjams as a pro-
liferation of committees and reports bogged down the organization; and overlapping
responsibilities produced turf battles and a loss of accountability.”22 Yet, any company
that operates over multiple products, multiple functions, and multiple geographical
RE
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ON
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an
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ia
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Eu
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Marine
Trading
Manufacturing
Metals
Others
Coal
Chemicals
Downstream
Oil
Natural Gas
SECTOR
Upstream (Oil and Gas)
H
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an
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m
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PAN
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FIGURE 6.7 Royal Dutch Shell Group: Pre-1996 matrix structure

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 147
markets has to coordinate with each of these dimensions. So, all multifunctional, multi-
product, multinational companies are de facto matrix organizations. The problem is
over-formalization, resulting in a top-heavy corporate HQ and over-complex systems
that slow decision-making and dull entrepreneurial initiative. The trend has been for
companies to focus on formal systems of coordination and control on one dimension,
then allowing the other dimensions of coordination to be mainly informal. Thus, while
Shell claims to have dismantled its matrix and organized itself around four business sec-
tors, the reality is that it still has country heads, responsible for coordinating all Shell’s
activities in relation to legal, taxation, and government relations within each country,
and functional heads, responsible for technical matters and best-practice transfer within
their particular function.
Systems and Style: Mechanistic versus Organic
Organizational Forms
So far, we have looked just at structure—the architecture of organizations. Equally
important are the systems through which the structure operates and the management
styles through which these systems are manifest. During the first half of the 20th century,
management thought was dominated by Weber’s theory of bureaucracy and Frederick
Taylor’s rational approach to job design and employee incentives. During the 1950s, the
human relations school of management recognized the importance of social relation-
ships within organizations and adverse impact of inertia and alienation on employee
effort. “Theory X” had been challenged by “Theory Y.”23 The important issue here is
that different types of management suit different circumstances. Among Scottish engi-
neering companies, Burns and Stalker found that firms in stable environments had
mechanistic forms, characterized by formality and high degrees of job specialization;
those in less stable markets had organic forms that were less formal and more flex-
ible.24 Table 6.1 contrasts key characteristics of the two forms.
This principle that an organization’s structure, systems, and management style should
reflect the environment, in which it operates forms the basis of contingency theory—
there is no one best way to organize; it depends upon circumstances.25 Although
Alphabet (Google) and McDonald’s are both large international companies, their struc-
tures and systems are very different. McDonald’s is highly bureaucratized: high levels
TABLE 6.1 Mechanistic versus organic organizational forms
Feature Mechanistic forms Organic forms
Task definition Rigid and highly specialized Flexible and broadly defined
Coordination and control Rules and directives vertically
imposed
Mutual adjustment, common culture
Communication Vertical Vertical and horizontal
Knowledge Centralized Dispersed
Commitment and loyalty To immediate superior To the organization and its goals
Environmental context Stable with low technological
uncertainty
Dynamic with significant technological
uncertainty and ambiguity
Source: Adapted from Richard Butler, Designing Organizations: A Decision-Making Perspective (London: Routledge,
1991): 76, by permission of Cengage Learning.

148 PART II THE TOOLS OF STRATEGY ANALYSIS
of job specialization, formal systems, and a strong emphasis on rules and procedures.
Google emphasizes informality, low job specialization, horizontal communication, and
the importance of principles over rules. These differences reflect differences in strategy,
technology, human resources, and the dynamism of the business environments that
each firm occupies. In general, the more standardized are a firm’s products (beverage
cans, blood tests, or haircuts for army inductees) and the more stable its environ-
ment, the greater are the efficiency advantages of mechanistic approach with stan-
dard operating procedures and high levels of specialization. Once markets become
turbulent, or innovation becomes desirable, or buyers require customized products—
then the bureaucratic model breaks down.
Contingency also requires the functions within a company to be organized differ-
ently. At my university, admissions, student records, and accounting operate on bureau-
cratic principles; research, fund raising, and external relations are organized organically.
As the business environment has become increasingly turbulent, the trend has been
toward organic approaches to organizing, which have tended to displace more bureau-
cratic approaches. Since the mid-1980s, almost all large companies have made strenuous
efforts to restructure and reorganize to achieve greater flexibility and responsiveness.
Within their multidivisional structures, companies have decentralized decision-making,
reduced their number of hierarchical layers, shrunk headquarters staffs, emphasized
horizontal rather than vertical communication, and shifted the emphasis of control from
supervision to accountability.
However, the trend has not been one way. The financial crisis of 2008 and its after-
math have caused many companies to reimpose top-down control. Greater awareness
of the need to manage financial, environmental, and political risks in sectors such as
banking, petroleum, and mining have also reinforced centralized control and reliance on
rules. Many companies follow the cycles of centralization and decentralization that may
be a means by which they balance the trade-off between integration and flexibility.26
Developments in information and communication technology (ICT) have worked in
different directions. In some cases, the automation of processes has permitted their cen-
tralization and bureaucratization (think of the customer services at your bank or telecom
supplier). In other areas, ICT has encouraged informal approaches to coordination. The
huge leaps in the availability of information available to organizational members and
the ease with which they can communicate with one another have increased vastly the
capacity for mutual adjustment without the need for intensive hierarchical guidance
and leadership.
Recent Trends in Organizational Design
Consultants and management scholars have proclaimed the death of hierarchical struc-
tures and the emergence of new organizational forms. Two decades ago, two of Ameri-
ca’s most prominent scholars of organization identified a “new organizational revolution”
featuring “flatter hierarchies, decentralized decision-making, greater tolerance for ambi-
guity, permeable internal and external boundaries, empowerment of employees, capacity
for renewal, self-organizing units, and self-integrating coordination mechanisms.”27
In practice, there has been more organizational evolution than organizational revolu-
tion. Certainly, major changes have occurred in the structural features and management
systems of industrial enterprises, yet there is little that could be described as radical
organizational innovation or discontinuities with the past. Hierarchy remains the basic
structural form of almost all companies, and the familiar structural configurations—
functional, divisional, and matrix—are still evident. Nevertheless, within these familiar
structural features, change has occurred:

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 149
● Delayering: Companies have made their organizational hierarchies flatter. The
motive has been to reduce costs and to increase organizational responsiveness.
Wider spans of control have also changed the relationships between managers
and their subordinates, resulting in less supervision and greater decentralization
of initiative. At General Electric, Jack Welch reduced the number of hierarchical
levels from nine to five throughout most of the company. As a result, senior
executives had up to 25 subordinates directly reporting to them, forcing them to
decentralize decision-making.
● Adhocracy and team-based organization: Adhocracies, according to Henry
Mintzberg, are organizations that feature shared values, high levels of partic-
ipation, flexible communication, and spontaneous coordination. Hierarchy,
authority, and control mechanisms are largely absent.28 Adhocracies tend to exist
where problem-solving and other nonroutine activities predominate and where
expertise is prized. Team-based organizations engaged in research, consulting,
engineering, and entertainment tend to be adhocracies, as are some technology-
based startup companies.
● Project-based organizations: Consulting and construction companies are
organized around projects, the defining characteristic of which is that work
assignments have finite lives, hence the organization structure needs to be
dynamically flexible. Because every project is different and involves a sequence
of phases, each project needs to be undertaken by a closely interacting team
that is able to draw upon the know-how of previous and parallel project teams.
As cycle times become compressed across more and more activities, project-
based organization is becoming increasingly common across the business sector.
● Network structures: A major feature of the shift from formal to informal orga-
nizational structures is that coordination is determined less by hierarchical
structures and more by social networks—the patterns of interactions among
organizational members. The importance of social networks to the behavior
and performance of organizations has led several management thinkers to rec-
ommend that these informal social structures be the primary basis for orga-
nizational structure and supplant traditional, formal structures. Thus, Gunnar
Hedlund and Bartlett and Ghoshal have proposed network-based models of the
multinational corporation.29 Advances in information and communications tech-
nology have greatly enhanced the potential for coordination to occur spontane-
ously without the need for formal organizational structure.
● Permeable organizational boundaries: Network relationships are not limited by
company boundaries. As firms specialize around their core competencies and
products become increasingly complex, so these interfirm networks become
increasingly important. As we shall see when we look more closely at strategic
alliances (Chapter 15), localized networks of closely interdependent firms are
features not only of traditional industrial districts such as those of northern Italy,30
but also the high-tech clusters such as the concentration of Formula 1 construc-
tors in Britain’s “Motorsport Valley” and Israel’s medical electronics cluster.31
Common to these emerging organizational phenomena are:
● A focus on coordination rather than on control: In contrast to the command-
and-control hierarchy, these structures focus almost wholly on achieving
coordination. Financial incentives, culture, and social controls take the place of
hierarchical control.

150 PART II THE TOOLS OF STRATEGY ANALYSIS
● Reliance on informal coordination where mutual adjustment replaces rules
and directives: Central to all nonhierarchical structures is their dependence
on voluntary coordination through bilateral and multilateral adjustment. The
capacity for coordination through mutual adjustment has been greatly enhanced
by information technology.
● Individuals occupying multiple organizational roles thereby requiring informal
structures that facilitate flexibility and responsiveness.
Summary
Strategy formulation and strategy implementation are closely interdependent. The formulation of
strategy needs to take account of an organization’s capacity for implementation; at the same time, the
implementation process inevitably involves creating strategy. If an organization’s strategic management
process is to be effective then its strategic planning system must be linked to actions, commitments
and their monitoring, and the allocation of resources. Hence, operational plans and capital expenditure
budgets are critical components of a firm’s strategic management system.
Strategy implementation involves the entire design of the organization. By understanding the
need to reconcile specialization with cooperation and coordination, we are able to appreciate the
fundamental principles of organizational design.
Applying these principles, we can determine how best to allocate individuals to organizational units
and how to combine these organizational units into broader groupings—in particular, the choice bet-
ween basic organizational forms such as functional, divisional, or matrix organizations.
We have also seen how companies’ organizational structures have been changing in recent years,
influenced both by the demands of their external environments and the opportunities made available
by advances in information and communication technologies.
The chapters that follow will have more to say on the organizational structures and management sys-
tems appropriate to different strategies and different business contexts. In the final chapter (Chapter 16),
we shall explore some of the new trends and new ideas that are reshaping our thinking about organi-
zational design.
Self-Study Questions
1. Jack Dorsey, the CEO of Twitter, Inc., has asked for your help in designing a strategic planning
system for the company. Would you recommend a formal strategic planning system with an
annual cycle such as that outlined in “The Strategic Planning System: Linking Strategy to Action”
and Figure 6.1? (Note: Twitter’s strategy is summarized in Strategy Capsule 1.5 in Chapter 1.)
2. Select a persistently successful team in a professional sport with which you are familiar. To
what extent can the superior capabilities of this team be attributed to the role of processes,
motivation, and structure (as discussed in the section “Developing Organizational Capability”)?

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 151
3. Within your own organization (whether a university, company, or not-for-profit organization),
which departments or activities are organized mechanistically and which organically? To what
extent does the mode of organization fit the different environmental contexts and technol-
ogies of the different departments or activities?
4. In 2008, Citigroup announced that its Consumer business would be split into Consumer
Banking, which would continue to operate through individual national banks, and Global
Cards, which would form a single global business (similar to Citi’s Global Wealth Management
division). On the basis of the arguments relating to the “Defining Organizational Units” section
above, why should credit cards be organized as a global unit and all other consumer banking
services as national units?
5. The examples of Apple and General Motors (see “Functional Structure” section above) point
to the evolution of organizational structures over the industry life cycle. During the growth
phase, many companies adopt multidivisional structures; during maturity and decline, many
companies revert to functional structures. Why might this be? (Note: you may wish to refer to
Chapter 8, which outlines the main features of the life-cycle model.)
6. Draw an organizational chart for a business school that you are familiar with. Does the school
operate with a matrix structure (for instance, are there functional/discipline-based depart-
ments together with units managing individual programs)? Which dimension of the matrix is
more powerful, and how effectively do the two dimensions coordinate? How would you reor-
ganize the structure to make the school more efficient and effective?
Notes
1. L. Bossidy and R. Charan, Execution: The Discipline of Get-
ting Things Done (New York: Random House, 2002): 71.
2. H. Mintzberg, “Patterns of Strategy Formulation,”
Management Science 24 (1978): 934–948; “Of Strategies:
Deliberate and Emergent,” Strategic Management Journal
6 (1985): 257–272.
3. Apple Computer: Preliminary Confidential Offering Mem-
orandum, 1978. http://www.computerhistory.org/collec-
tions/catalog/102712693.
4. MCI Communications: Planning for the 1990s (Harvard
Business School Case No. 9-190-136, 1990): 1.
5. For a description of the strategic planning systems of
the world’s leading oil and gas majors, see R. M. Grant,
“Strategic Planning in a Turbulent Environment: Evidence
from the Oil Majors,” Strategic Management Journal 24
(2003): 491–518.
6. “Eni 2016 Results and 2017–2020 Strategic Plan” (Rome:
Eni, March 1, 2017).
7. D. W. Eisenhower, “Remarks at the National Defense
Executive Reserve Conference” (November 14, 1957).
8. P. F. Drucker, The Practice of Management (New York:
Harper, 1954).
9. L. Bossidy and R. Charan, Execution: The Discipline
of Getting Things Done (New York: Random House,
2002): 227.
10. A. Smith, The Wealth of Nations (London: Dent, 1910): 5.
11. K. Eisenhardt, “Agency Theory: An Assessment and Reviews,”
Academy of Management Review 14 (1989): 57–74.
12. T. Peters and R. Waterman, In Search of Excellence
(New York: Harper & Row, 1982).
13. J.-C. Spender, Business Strategy: Managing Uncertainty,
Opportunity, and Enterprise (Oxford: Oxford University
Press, 2014).
14. R. Nelson and S.G. Winter, An Evolutionary Theory of
Economic Change (Cambridge, MA: Belknap, 1982).
15. T. W. Malone, K. Crowston, J. Lee, and B. Pentland,
“Tools for Inventing Organizations: Toward a Handbook
of Organizational Processes,” Management Science 45
(1999): 425–43.
16. K. B. Clark and T. Fujimoto, Product Development
Performance (Boston: Harvard Business School Press,
1991): 29–30.
17. M. Weber, Economy and Society: An Outline of Interpretive
Sociology (Berkeley, CA: University of California Press, 1968).
18. H. A. Simon, “The Architecture of Complexity,”
Proceedings of the American Philosophical Society 106
(1962): 467–482.
19. J. D. Orton and K. E. Weick, “Loosely Coupled Systems: A
Reconceptualization,” Academy of Management Review 15
(1990): 203–223.

152 PART II THE TOOLS OF STRATEGY ANALYSIS
20. “P&G Faces Up to Mistakes in Beauty Business,” Wall Street
Journal (November 9, 2015).
21. J. D. Thompson, Organizations in Action (New York:
McGraw-Hill, 1967).
22. C. A. Bartlett and S. Ghoshal, “Matrix Management: Not
a Structure, a Frame of Mind,” Harvard Business Review
( July/August 1990): 138–145.
23. “Idea: Theories X and Y,” The Economist online extra
(October 6, 2008), www.economist.com/node/12370445,
accessed December 18, 2017.
24. T. Burns and G. M. Stalker, The Management of Innovation
(London: Tavistock, 1961).
25. L. Donaldson, “Contingency Theory (Structural),” in
R. Thorpe and R. Holt (eds.), The Sage Dictionary of
Qualitative Management Research (London: Sage, 2008).
26. J. Nickerson and T. Zenger refer to this as structural
modulation: “Being Efficiently Fickle: A Dynamic Theory
of Organizational Choice,” Organization Science 13
(2002): 547–567.
27. R. Daft and A. Lewin, “Where Are the Theories for the New
Organizational Forms?” Organization Science 3 (1993): 1–6.
28. H. Mintzberg, Structure in Fives: Designing Effective
Organizations (Englewood Cliffs, NJ: Prentice Hall, 1993):
Chapter 12.
29. G. Hedlund, “The Hypermodern MNC: A Heterarchy?”
Human Resource Management 25 (1986): 9–35; C. Bartlett
and S. Ghoshal, Managing across Borders: The Trans-
national Solution, 2nd edn (Boston, Harvard Business
School, 1998).
30. M. H. Lazerson and G. Lorenzoni, “The Firms That Feed
Industrial Districts: A Return to the Italian Source,”
Industrial and Corporate Change 8 (1999): 235–266; A.
Grandori, Interfirm Networks (London: Routledge, 1999).
31. “Motorsport Valley Looks Beyond Automotive Sectors,”
Financial Times ( July 4, 2014); “Israel’s Tech Startups Are
Giving Silicon Valley a Run for Its Money,” New York Post
(May 28, 2017).

III
BUSINESS
STRATEGY AND
THE QUEST FOR
COMPETITIVE
ADVANTAGE
7 The Sources and Dimensions of Competitive Advantage
8 Industry Evolution and Strategic Change
9 Technology-based Industries and the Management
of Innovation

7
If you don’t have a competitive advantage—don’t compete!
JACK WELCH, CEO, GENERAL ELECTRIC 1981–2001.
The Sources and
Dimensions of
Competitive Advantage
◆ Introduction and Objectives
◆ How Is Competitive Advantage Established?
● External Sources of Competitive Advantage
● Internal Sources of Competitive Advantage: Strategic
Innovation through Business Models and Blue Ocean
Strategy
◆ How Is Competitive Advantage Sustained?
◆ Cost Advantage
● The Sources of Cost Advantage
● Using the Value Chain to Analyze Costs
◆ Differentiation Advantage
● The Nature and Significance of Differentiation
● Analyzing Differentiation: The Demand Side
● Analyzing Differentiation: The Supply Side
● Bringing It All Together: The Value Chain in
Differentiation Analysis
◆ Can Firms Pursue Both Cost and Differentiation
Advantage?
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

156 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
How Is Competitive Advantage Established?
Competitive advantage refers to a firm’s ability to outperform its rivals. Most of us can
recognize competitive advantage when we see it: Walmart in discount retailing, Vestas
in wind turbines, Google in online search, and Embraer in regional jets. Yet, defining
competitive advantage is troublesome. Competitive advantage can be defined broadly
in terms of a firm’s superiority in creating value for its stakeholders, or more narrowly
in terms of profitability. Because of the difficulties in identifying and measuring total
value creation (see the section on “Strategy as a Quest for Value” in Chapter 2), I shall
Introduction and Objectives
In this chapter, we integrate and develop the elements of competitive advantage that we have analyzed
in previous chapters. Chapter 1 noted that a firm can earn superior profitability either by locating in an
attractive industry or by establishing a competitive advantage over its rivals. Of these two, competitive
advantage is the more important. As competition has intensified across almost all industries, very few
industry environments can guarantee secure returns; hence, the primary goal of a strategy is to build
competitive advantage for the firm.
Chapters 3 and 5 provided the two primary components of our analysis of competitive advantage.
The last part of Chapter  3 analyzed the external sources of competitive advantage: the determinants
of the key success factors within a market. Chapter  5 analyzed the internal sources of competitive
advantage: the potential for the firm’s resources and capabilities to establish and sustain competitive
advantage.
This chapter looks more deeply at competitive advantage. We first explore the dynamics of com-
petitive advantage, examining the processes through which competitive advantage is created and
destroyed. This gives us insight into how competitive advantage can be attained and sustained. We
then look at the two primary dimensions of competitive advantage: cost advantage and differentiation
advantage and develop systematic approaches to their analysis.
By the time you have completed this chapter, you will be able to:
◆ Identify how a firm can create competitive advantage—including the roles that anticipa-
tion, agility, business model innovation, and blue ocean strategies can play.
◆ Identify how a firm can sustain competitive advantage—including the use of different
types of isolating mechanism.
◆ Use cost analysis to identify the sources of cost advantage in an industry, assess a firm’s
relative cost position, and recommend strategies to enhance cost competitiveness.
◆ Use differentiation analysis to identify the sources of differentiation and formulate strat-
egies that create differentiation advantage.
◆ Appreciate the feasibility of pursuing both cost and differentiation advantage.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 157
take the simple approach and define competitive advantage as: a firm’s potential to
earn a higher rate of profit than its direct competitors. I emphasize the potential for
superior profitability rather than actual superior profitability to take account of the
fact that competitive advantage may not be revealed in higher profitability—a firm may
forgo current profit in favor of investing in market share, technology, customer loyalty,
or executive perks. For example, over the ten-year period, 1998–2007, Amazon earned
a net loss, despite its obvious competitive advantage in online retailing. Amazon had
foregone profit in favor of sales growth.
In viewing competitive advantage as the result of matching internal strengths to
external success factors, I may have conveyed the notion of competitive advantage
as something static and stable. In fact, as we observed in Chapter 4 when discussing
competition as a process of “creative destruction,” competitive advantage is a disequi-
librium phenomenon: it is created by change and, once established, it sets in motion
the competitive process that leads to its destruction.1 The changes that generate com-
petitive advantage can be either internal or external. Figure  7.1 depicts the basic
relationships.
External Sources of Competitive Advantage
External changes create competitive advantage when they have differential effects on
companies because of their different resources and capabilities or strategic positioning.
For example, by reducing subsidies for renewable energy, the tax bill passed by the
US Congress in December 2017, will enhance the competitive advantage of power pro-
ducers that use fossil fuels, such as Duke Energy and AEP, over wind and solar power
producers such as Terra-Gen and Caithness Energy.
The greater the magnitude of the external change and the greater the difference
in the strategic positioning of firms, the greater the propensity for external change
to generate competitive advantage, as indicated by the dispersion of profitability
among the firms within an industry. The world’s beer brewing industry has a
relatively stable external environment and the leading firms—AB Inbev, Carlson,
Heineken, and Molson Coors—pursue similar strategies with similar resources and
Resource heterogeneity
among f irms creates
winners and losers
Some f irms are faster
and more ef fective
in exploiting change
Some f irms capable of
strategic innovations (e.g.,
new business models or
locating “blue oceans”)
Internal sources
of change
How does competitive
advantage emerge?
External sources of change, e.g.,
• Changing customer demand
• Changing prices of inputs
• Technological change
FIGURE 7.1 The emergence of competitive advantage

158 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
capabilities: differences in profitability among this group tend to be small and stable.
The major toy companies (Mattel, Lego, Hasbro, Bandai Namco, and MGA Entertain-
ment), on the other hand, comprise a heterogeneous group that experience unpre-
dictable shifts in consumer preferences, resulting in wide and variable profitability
differences.
The competitive advantage that arises from external change also depends on firms’
ability to respond to change. Any external change creates entrepreneurial opportunities
that will accrue to the firms that exploit these opportunities most effectively. Entrepre-
neurial responsiveness involves one of two key capabilities:
● Anticipation. Over its 100-year history, IBM has demonstrated a remarkable
ability to renew its competitive advantage through anticipating, and then tak-
ing advantage of, many of the major shifts in the IT sector: the birth of the
mainframe, the rise of personal computing, advent of the internet, migration of
value from hardware to software and services, cloud computing, big data, and
quantum computing. Conversely, Hewlett-Packard has been less adept in recog-
nizing and responding to these changes.
● Agility. As markets become more turbulent and unpredictable, quick-response
capability has become increasingly important as a source of competitive advantage.
Quick responses require information. As conventional economic and market fore-
casting has become less effective, so companies rely increasingly on “early-warning
systems” through contact with customers, suppliers, and competitors, then com-
press their cycle times so that information can be acted upon speedily. Zara, the
retail fashion chain owned by the Spanish company Inditex, has built a vertically
integrated supply chain that cuts the time between a garment’s design and retail
delivery to under three weeks (against an industry norm of three to six months).2
This emphasis on speed as a source of competitive advantage was popularized
by the Boston Consulting Group’s concept of time-based competition3 and in the
surge of interest by consultants and academics in strategic agility.4
Internal Sources of Competitive Advantage:
Strategic Innovation through Business Models and
Blue Ocean Strategy
Competitive advantage may also be generated internally through innovation which cre-
ates competitive advantage for the innovator while undermining previously established
competitive advantages—the essence of Schumpeter’s “creative destruction.”5 Although
innovation is typically thought of as applications of new technology, our emphasis
here is strategic innovation—new approaches to serving customers and competing
with rivals.
Business Model Innovation Strategic innovation has long been recognized as an
important source of competitive advantage. Four decades ago, McKinsey & Co. drew
the distinction between “same game” strategies (“playing by the traditional rules”) and
“new game” strategies (“rewriting them completely”).6 More recently, the term business
model innovation has been used to describe the introduction of novel approaches to
creating and/or capturing value within an industry.7 Its importance in creating competi-
tive advantage is indicated by research showing business model innovation to be a more
potent profit generator than either product or process innovation.8 It has been argued that

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 159
most new companies entering the Fortune 500 between 1997 and 2007 owed their success
to innovative business models.9 While business model innovations continue to create new
corporate giants and transform entire sectors, very often these innovative business models
are a variation on a theme or the transfer of an existing business model from a different
sector (see Strategy Capsule 7.1).
Business model innovations can be classified in different ways, A study by IBM iden-
tified three generic types:
● New industry models—reconfigurations of the conventional industry value chain
such as Dell’s direct sales model for PCs or Zara’s vertically integrated fast-
fashion model.
● New revenue models—changing the value proposition, the target audience or
pricing strategy. In the 1980s, Rolls Royce introduced “Power by the Hour”:
instead of buying jet engines outright, airlines could pay usage based fees for
engines, maintenance, and spares and other support services. Virgin America
introduced a novel customer offering comprising low airfares and a differenti-
ated in-flight experience.
● New enterprise models—involve reconfiguring enterprise boundaries and
partner relationships. Apple’s iPhone with outsourced manufacture and
network of application providers created a new model of the smart-
phone business.
STRATEGY CAPSULE 7.1
Examples of Business Model Innovations
Business model innovations are typically associated with
e-commerce businesses such as Google, eBay, Facebook,
Amazon, and Spotify. Yet, many of these business models
are variants on business models established much ear-
lier. Significant business model innovations include the
following:
◆ Free content supported by paid advertising origi-
nated with US commercial radio at the beginning of
the 1920s.
◆ Platform business models. A platform is an inter-
face between two sets of platform users. The first
platform businesses were auction houses. Sotheby’s
was established in 1744, Christies in 1766.
◆ Shared-ownership models used by Airbnb, Zipcar,
Netjets, and the like have their origins in real estate
timeshares (pioneered by the Swiss company, Hapi-
mag, during the 1960s).
◆ Franchising. The system of local licensed distributors,
each with defined exclusive territories, is attributed
to the Singer Sewing Machine Company which
introduced its system in the 1880s.
◆ Consumer cooperatives. The Rochdale Society of Equi-
table Pioneers’ cooperative grocery store was not the
world’s first consumer cooperative, but created a
model for future cooperatives.
◆ Microfinance—small loans to low-income business
owners—was developed by Muhammad Yunus’s
Grameen Bank during the 1970s.
◆ Tied products (razor-and-blades) model involving
below-cost pricing of the durable item and premium
pricing of consumables, was introduced by Gillette’s
competitors during the 1910s, then copied by Gillette.
◆ Mail order. The first major mail order retailer was
Montgomery Ward, established in 1872.

160 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Conceiving of business model innovations is much easier than implementing them.
To the extent that most business model innovations are variations on existing themes,
then analogical reasoning is a powerful tool for revealing new possibilities.10 Office
products retailer, Staples, was established as the “Toys ‘R’ Us for office supplies”; can-
nabis infrastructure company, Diego Pellicer Worldwide, Inc., envisages itself as the
“Starbucks of marijuana.”
Implementing business model innovations comes up against the resistance cre-
ated by commitment to the prevailing business model. Established companies may
be reluctant to experiment with new business models because of their adherence to
current asset allocations or to senior executives ‘perceptions of the “dominant logic”
of their business.11 However, using the lexicon of business models may assist in over-
coming these barriers: business models offer a narrative that can be used, not only to
simplify cognition, but also as a communication device creating a sense of legitimacy
around the initiative.12 Moreover, adopting new business models does not necessarily
involve abandoning existing models—increasingly companies are getting used to
operating multiple models: Netflix offers both video streaming and DVDs by mail.
STRATEGY CAPSULE 7.2
Blue Ocean Strategy
Kim and Mauborgne argue that the best value-creating
opportunities for business lie not in existing industries
following conventional approaches to competing (what
they refer to as “red oceans”), but seeking uncontested
market space. These “blue oceans” may be entirely new
industries created by technological innovation (such as
artificial intelligence and nanotechnology), but are more
likely to be the creation of new market space within
existing industries using existing technologies. This
may involve:
◆ New customer segments for existing products, for
example, Tesla’s Powerwall battery for electrical
storage in the home.
◆ Reconceptualization of existing products, for
example, Mark Zuckerberg’s reconceptualization of
a printed Facebook of class members as an online,
interactive, and social platform.
◆ Novel recombinations of product attributes and
reconfigurations of established value chains that
establish new positions of competitive advantage, for
example, Dell’s integrated system for ordering, assem-
bling, and distributing PCs, which permitted unprec-
edented customer choice and speed of fulfillment.
The strategy canvas is a framework for developing
blue ocean strategies. The horizontal axis shows the differ-
ent product characteristics along which the firms in the
industry compete; the vertical axis shows the amount of
each characteristic a firm offers its customers. Starting with
the value line showing the industry’s existing offerings, the
challenge is to identify a strategy that can provide a novel
combination of attributes. This involves four types of choice:
◆ Raise: What factors should be raised well above the
industry’s standard?
◆ Eliminate: Which factors that the industry has long
competed on should be eliminated?
◆ Reduce: Which factors should be reduced well below
the industry’s standard?

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 161
Pursuing multiple business models can offer companies the benefits of both synergy
and risk spreading.13
Blue Ocean Strategy An alternative approach to identifying the potential for stra-
tegic innovation is that developed by Insead’s Kim Chan and Renee Mauborgne. Their
blue ocean strategy involves a quest for “uncontested market space.”14 Creating
untapped market space doesn’t necessarily require finding new market opportunities
well beyond existing industry boundaries, blue oceans can also be created within
existing markets. The challenge is “to create new rules of the game by breaking the
existing value/cost trade-off.”15 One approach is to combine performance attributes
that were previously viewed as conflicting. Thus, Virgin America offers the low fares
typical of budget airlines together with inflight services that are superior to those
of most legacy carriers. Indeed, common to many blue ocean strategies is offering
superior customer value through reconciling low price with differentiation. Strategy
Capsule  7.2 outlines how the concept of blue ocean strategy can help companies
pursue strategic innovation.
◆ Create: Which factors should be created that the
industry has never offered?
Figure  7.2 compares value lines for Cirque du Soleil
and a traditional circus.
Source: Based upon W. C. Kim and R. Mauborgne, Blue Ocean
Strategy: How to Create Uncontested Market Space and Make
the Competition Irrelevant (Boston: Harvard Business School
Press, 2005).
FIGURE 7.2 The strategy canvas: Value lines for Cirque du Soleil and the traditional circus
Low
High
Cirque du Soleil
Pr
ice
Pe
rfo
rm
ing
an
im
als
Hu
mo
r
Th
rill
s/d
an
ge
r
Ac
ro
ba
tic
s
Da
nc
e
Co
stu
me
s
Mu
sic
Vis
ua
l e
xp
eri
en
ce
Co
mf
or
t
At
tra
cti
ve
ve
nu
e
Ap
pe
al
to
ch
ild
ren
Ap
pe
al
to
ad
ult
s
Traditional circus

162 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Identif ication • Obscure superior performance
REQUIREMENT FOR IMITATION ISOLATING MECHANISM
Incentives for imitation
• Deterrence: signal aggressive intentions
• Preemption: exploit all available
opportunities
Diagnosis
• Use multiple sources of competitive
advantages to create causal ambiguity
Resource acquisition
• Base competitive advantage upon resources
and capabilities that are immobile and
dif f icult to replicate
FIGURE 7.3 Sustaining competitive advantage: Types of isolating mechanism
How Is Competitive Advantage Sustained?
Once established, competitive advantage is eroded by competition. The speed with
which competitive advantage is undermined depends on the ability of competitors to
challenge either by imitation or innovation. Imitation is the most direct form of compe-
tition; hence, for competitive advantage to be sustained over time, barriers to imitation
must exist. Rumelt uses the term isolating mechanisms to describe the barriers that
prevent the erosion of a business’s superior profitability.16 The tendency for profit dif-
ferences between competitors to persist for periods of a decade or more suggests that
isolating mechanisms can be very effective.17
To identify the sources of isolating mechanisms, let us examine the process of com-
petitive imitation. For one firm to successfully imitate the strategy of another, it must
meet four conditions: it must identify the competitive advantage of a rival, it must have
an incentive to imitate, it must be able to diagnose the sources of the rival’s competitive
advantage, and it must be able to acquire the resources and capabilities necessary for
imitation. At each stage, the incumbent can create isolating mechanisms to impede the
would-be imitator (Figure 7.3).
Obscuring Superior Performance A simple barrier to imitation is to obscure the
firm’s superior profitability. According to George Stalk, former managing director of the
Boston Consulting Group: “One way to throw competitors off balance is to mask high
performance so rivals fail to see your success until it’s too late.”18 One of the attractions
of private company status is avoiding disclosure of financial performance. Few food
processors realized the profitability of canned cat and dog food until the UK Monop-
olies Commission revealed that the leading firm, Pedigree Petfoods (a subsidiary of
Mars, Inc.), earned a return on capital employed of 47%.19

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 163
In order to discourage new competitors, companies may forgo maximizing their
short-term profits. The theory of limit pricing, in its simplest form, postulates that
a firm in a strong market position sets prices at a level that just fails to attract
entrants.20
Deterrence and Preemption A firm may avoid competition by persuading potential
rivals that imitation will be unprofitable. Deterrence (as we discussed in the section
on “Game Theory” in Chapter 4) involves making threats that competitive incursions
will be resisted vigorously.21 For deterrence to work, threats must be clearly signaled,
backed by commitment, and credible. Following the expiration of its NutraSweet pat-
ents in 1987, Monsanto fought an aggressive price war against the Holland Sweetener
Company. Although costly, this gave Monsanto a reputation for aggression that deterred
other would-be entrants into the aspartame market.22
A firm can also deter imitation by preemption—occupying existing and potential
strategic niches to reduce the range of investment opportunities open to the challenger.
Preemption may include:
● Proliferation of product varieties by market leaders leaving few niches for new
entrants and smaller rivals to occupy. Between 1950 and 1972, for example, the
six leading suppliers of breakfast cereals introduced 80 new brands into the
US market.23
● Investing in underutilized production capacity can be especially discouraging
to rivals and potential entrants. Part of Monsanto’s strategy to protect its NutraS-
weet business were heavy investments in aspartame plants.
● Patent proliferation can limit competitors’ innovation opportunities. In 1974,
Xerox’s dominant market position in plain-paper copiers was protected by a
wall of over 2000 patents, most of which were not used. When IBM introduced
its first copier, Xerox sued it for infringing 22 of these patents.24
Causal Ambiguity and Uncertain Imitability If a firm is to imitate the com-
petitive advantage of another, it must understand the basis of its rival’s success. For
Kmart or Target to imitate Walmart’s success in discount retailing, they must first
understand what makes Walmart so successful. Walmart does many things differ-
ently, but which of these differences are the critical determinants of superior prof-
itability?
Lippman and Rumelt identify this problem as causal ambiguity: when a firm’s com-
petitive advantage is multidimensional and is based on complex bundles of resources
and capabilities, it is difficult for rivals to diagnose the success of the leading firm. The
outcome of causal ambiguity is uncertain imitability: if the causes of a firm’s success
cannot be known for sure, successful imitation is uncertain.25
Recent research suggests that the problems of strategy imitation may run even deeper.
We observed in Chapter 5 that capabilities are the outcome of complex combinations
of resources and that multiple capabilities interact to confer competitive advantage.
Research into complementarity among an organization’s activities suggests that these
interactions extend across the whole range of management practices.26 Strategy
Capsule  7.3 describes Urban Outfitters as an example of a unique “activity system.”
Where activities are tightly linked, complexity theory—NK modeling in particular—
predicts that, within a particular competitive environment, a number of fitness peaks

164 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
will appear, each associated with a unique combination of strategic variables.27 The
implications for imitation is that to locate on the same fitness peak as another firm not
only requires recreating a complex configuration of strategy, structure, management
systems, leadership, and business processes, but also means that getting it just a little
bit wrong may result in the imitator missing the fitness peak and finding itself in an
adjacent valley.28
One of the challenges for the would-be imitator is deciding which management prac-
tices are generic best practices and which are contextual—they only work in combination
with other management practices. For example, if Sears Holdings is considering which
of Walmart’s management practices to imitate in its Kmart stores, some practices (e.g.,
employees required to smile at customers, point-of-sale data transferred direct to the cor-
porate database) are likely to be generically beneficial. Others, such as Walmart’s “everyday
low prices” pricing policy, low advertising sales ratio, and hub-and-spoke distribution are
likely to be beneficial only when combined with other practices that ensure low costs.
Acquiring Resources and Capabilities Having diagnosed the sources of an
incumbent’s competitive advantage, the imitator’s next challenge is to assemble the
necessary resources and capabilities for imitation. As we saw in Chapter  5, a firm
can acquire resources and capabilities either by buying them or by building them.
STRATEGY CAPSULE 7.3
Urban Outfitters
Urban Outfitters, Inc. was founded in Philadelphia in 1976.
By 2018, it operated 650 Urban Outfitters, Anthropologie,
and Free People stores in 14 countries. The company tar-
gets, “Well-educated, urban-minded, young adults aged
18—30 through its unique merchandise mix and compel-
ling store environment ‘creating’ a unified environment that
establishes an emotional bond with the customer. Every
element of the environment is tailored to the aesthetic pref-
erences of our target customers. Through creative design,
much of the existing retail space is modified to incorpo-
rate a mosaic of fixtures, finishes and revealed architec-
tural details. In our stores, merchandise is integrated into a
variety of creative vignettes and displays designed to offer
our customers an entire look at a distinct lifestyle.”
According to Michael Porter and Nicolaj Siggelkow,
these management practices are both distinctive and
highly interdependent. The urban-bohemian-styled
product mix, which includes clothing, furnishings, and
gift items, is displayed within bazaar-like stores, each
of which has a unique design. To encourage frequent
customer visits, the layout of each store is changed every
two weeks, creating a new shopping experience when-
ever customers return. Each practice makes little sense
on its own, but together they represent a distinctive,
integrated strategy. It may be possible to replicate
the individual elements of Urban Outfitters’ business
system; the real challenge for an imitator integrating
them into a cohesive whole.
Source: Urban Outfitters, Inc. 10-K Report to January 31, 2018;
M. E. Porter and N. Siggelkow, “Contextuality within Activity
Systems and Sustainable Competitive Advantage,” Academy of
Management Perspectives 22 (May 2008): 34–56.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 165
The imitation barriers here are limits to the transferability and replicability of resources
and capabilities (see Chapter  5, “Sustaining Competitive Advantage”). Strategy Cap-
sule 7.4 shows how the resource requirements for competitive advantage differ across
different market settings.
STRATEGY CAPSULE 7.4
Competitive Advantage in Different Market Settings
Competitive advantage arises where there are imper-
fections in the competitive process, which in turn result
from the conditions under which essential resources and
capabilities are available. Hence, by analyzing imper-
fections of competition, we can identify the sources of
competitive advantage in different types of market. We
distinguish between two types of value-creating activity:
trading and production.
In trading markets, the limiting case is efficient markets,
which correspond closely to perfectly competitive mar-
kets (e.g., the markets for securities, currencies, and com-
modity futures). If prices reflect all available information
and adjust instantaneously to new information, no
market trader can expect to earn more than any other.
It is not possible to beat the market on any consistent
basis—in other words competitive advantage is absent.
This reflects the conditions of resource availability. Both
of the resources needed to compete—finance and
information—are equally available to all traders.
Competitive advantage in trading markets requires
imperfections in the competitive process:
◆ Where there is an imperfect availability of information,
competitive advantage results from superior access
to information—hence the criminal penalties for
insider trading in most advanced economies.
◆ Where transaction costs are present, competitive
advantage accrues to the traders with the lowest
transaction costs, hence the superior returns to
low-cost index mutual funds over professionally
managed funds. Vanguard’s S&P 500 Index fund with
administrative costs of 0.07% annually has outper-
formed 90% of US equity mutual funds.
◆ If markets are subject to systematic behavioral trends
(e.g., the small firm effect or the January effect), compet-
itive advantage accrues to traders with superior knowl-
edge of market psychology or of systematic price
patterns (chart analysis). If markets are subject to band-
wagon effects, competitive advantage can be gained
in the short term by following the herd (momentum
trading) and longer term by a contrarian strategy.
Warren Buffett is a contrarian who is “fearful when
others are greedy, and greedy when others are fearful.”
In production markets, the potential for compet-
itive advantage is much greater because of the com-
plex combinations of the resources and capabilities
required, the highly differentiated nature of these
resources and capabilities, and the imperfections in their
supply. Within an industry, the more heterogeneous are
firms’ endowments of resources and capabilities, the
greater the potential for competitive advantage. In the
European electricity-generating industry, the growing
diversity of players—utilities (EDF, ENEL), gas distributors
(Gaz de France, Centrica), petroleum majors (Shell, ENI),
independent power producers (AES, E.ON), and wind
generators—has expanded opportunities for compet-
itive advantage and widened the profit differentials
between them.
Differences in resource endowments also influence the
erosion of competitive advantage: the more similar are com-
petitors’ resources and capabilities, the easier is imitation.

166 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
DIFFERENTIATION
ADVANTAGE
COST
ADVANTAGE
Sim
ilar p
rodu
ct
at lo
wer
cos
t
Price premium
from unique product
COMPETITIVE
ADVANTAGE
FIGURE 7.4 Sources of competitive advantage
Cost Advantage
A firm can achieve a higher rate of profit (or potential profit) over a rival in one of two
ways: either it can supply an identical product or service at a lower cost or it can supply
a product or service that is differentiated in such a way that the customer is willing to
pay a price premium that exceeds the additional cost of the differentiation. In the former
case, the firm possesses a cost advantage; in the latter, a differentiation advantage. In
pursuing cost advantage, the goal of the firm is to become the cost leader in its industry
or industry segment. Cost leadership requires the firm to “find and exploit all sources
of cost advantage [and] sell a standard, no-frills product.”29 Differentiation by a firm
from its competitors is achieved “when it provides something unique that is valuable to
buyers beyond simply offering a low price.”30 Figure 7.4 illustrates these two types of
advantage. By combining the two types of competitive advantage with the firm’s choice
of scope—broad market versus narrow segment—Michael Porter has defined three
generic strategies: cost leadership, differentiation, and focus (Figure 7.5).
Historically, strategic management has emphasized cost advantage as the primary
basis for competitive advantage in an industry. This focus on cost reflected the tradi-
tional emphasis by economists on price as the principal medium of competition. It also
reflected the quest by large industrial corporations during the last century to exploit
economies of scale and scope through investments in mass production and mass dis-
tribution. This preoccupation with cost advantage was reinforced during the 1970s and
1980s when the experience curve became a widely-used tool of strategy analysis (see
Strategy Capsule 7.5).
Since then, increasing low-cost competition from emerging market countries has
resulted in Western firms adopting a number of new approaches to cost reduction,
including outsourcing, offshoring, process re-engineering, lean production, and orga-
nizational delayering.
COST
LEADERSHIP
COMPETITIVE
SCOPE
Industry wide DIFFERENTIATION
FOCUSSingle segment
Low cost Dif ferentiation
SOURCE OF COMPETITIVE ADVANTAGE
FIGURE 7.5 Porter’s generic strategies

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 167
STRATEGY CAPSULE 7.5
BCG and the Experience Curve
The experience curve has its basis in the systematic
reduction in the time taken to build airplanes and
Liberty ships during World War II. In studies ranging
from bottle caps and refrigerators to long-distance calls
and insurance policies, the Boston Consulting Group
(BCG) observed a remarkable regularity in the reduc-
tions in unit costs with increased cumulative output. Its
law of experience states: the unit cost of value added to
a standard product declines by a constant percentage
(typically between 15% and 30%) each time cumulative
output doubles. (Where “unit cost of value added” is the
unit cost of production less the unit cost of bought-in
components and materials).a Figure 7.6 shows the expe-
rience curve for Ford’s Model T.
The experience curve has important implications for
strategy. If a firm can expand its output faster than its
competitors can, it can move down the experience curve
more rapidly and open up a widening cost differential.
BCG recommended that a firm’s primary strategic goal
should be driving volume growth through increasing its
market share. BCG identified Honda in motorcycles as
an exemplar of this strategy.b The benefits market share
were supported by studies showing a positive relation-
ship between profitability and market share.c However,
association does not imply causation—it is likely that
market share and profitability are both outcomes of
some other source of competitive advantage—product
innovation, or superior marketing.d
The weaknesses of the experience curve as a strategy
tool are, first, it fails to distinguish several sources of cost
reduction (learning, scale, process innovation); second,
it presumes that cost reductions from experience are
automatic—in reality they must be managed.
Notes:
a Boston Consulting Group, Perspectives on Experience (Boston:
BCG, 1970).
b Boston Consulting Group, Strategy Alternatives for the British
Motorcycle Industry (London: HMSO, 1975).
c R. Jacobsen and D. Aaker, “Is Market Share All That It’s Cracked
Up To Be?” Journal of Marketing 49 (Fall 1985): 11–22.
d R. Wensley, “PIMS and BCG: New Horizons or False Dawn?”
Strategic Management Journal 3 (1982): 147–58.
FIGURE 7.6 Experience curve for the Ford Model T, 1909–1920
0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8 4.0
$4000
$3500
$3000
$2500
$2000
$1500
$1000
$500
$0
Cumulative units of production (millions)
U
n
it
c
o
st
1909
1910
1911
1912
1913
19201918
1915
1914
Note: The figure shows an 85% experience curve, that is, unit costs declined by approximately 15% with
each doubling of cumulative volume.

168 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
The Sources of Cost Advantage
There are seven principal determinants of a firm’s unit costs (cost per unit of output)
relative to its competitors; we refer to these as cost drivers (Figure 7.7).
The relative importance of these different cost drivers varies across industries,
between firms within an industry, and across the different activities within a firm.
By examining each of these different cost drivers in relation to a particular firm, we
can analyze a firm’s cost position relative to its competitors’, diagnose the sources
of inefficiency, and make recommendations as to how a firm can improve its cost
efficiency.
Economies of Scale The predominance of large corporations in most manufacturing
and service industries is a consequence of economies of scale. Economies of scale exist
wherever proportionate increases in the amounts of inputs employed in a production
process result in lower unit costs. Economies of scale have been conventionally associ-
ated with manufacturing. Figure 7.8 shows a typical relationship between unit cost and
plant capacity. The point at which most scale economies are exploited is the minimum
efficient plant size (MEPS).
• Technical input–output relationships
• Indivisibilities
• Specialization
• Increased individual skills
• Improved organizational routines
• Process innovation
• Re-engineering of business processes
• Standardization of designs and components
• Design for manufacture
• Location advantages
• Ownership of low-cost inputs
• Non-union labor
• Bargaining power
• Ratio of f ixed to variable costs
• Fast and f lexible capacity adjustment
• Organizational slack/X-inef f iciency
• Motivation and organizational culture
• Managerial ef fectiveness
ECONOMIES OF LEARNING
PRODUCTION TECHNIQUES
PRODUCT DESIGN
INPUT COSTS
CAPACITY UTILIZATION
RESIDUAL EFFICIENCY
ECONOMIES OF SCALE
FIGURE 7.7 The drivers of cost advantage

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 169
Scale economies arise from three principal sources:
● Technical input–output relationships: In many activities, increases in output do
not require proportionate increases in input. A 10,000-barrel oil storage tank
does not cost five times as much as a 2000-barrel tank. Similar volume-related
economies exist in ships, trucks, and steel and petrochemical plants.
● Indivisibilities: Many resources and activities are “lumpy”—they are unavailable
in small sizes. Hence, they offer economies of scale as firms are able to spread
the costs of these items over larger volumes of output. In R&D, new product
development and advertising market leaders tend to have much lower costs as a
percentage of sales than their smaller rivals.
● Specialization: Increased scale permits greater task specialization. Mass pro-
duction involves breaking down the production process into separate tasks
performed by specialized workers using specialized equipment. Division of
labor promotes learning and assists automation. Economies of specialization are
especially important in knowledge-intensive industries: in investment banking,
management consulting, and legal services, large firms are able to offer a
broader array of specialized expertise.
Scale economies are a key determinant of an industry’s level of concentration.
In many consumer goods industries, scale economies in marketing have driven
industry consolidation. Figure 7.9 shows how soft drink brands with the greatest sales
volume tend to have the lowest unit advertising costs. In other industries—especially
aerospace, automobiles, software, and movie production—economies of scale arise
from the huge costs of new product development. The Boeing 747 was hugely prof-
itable because 1536 were built between 1970 and 2017. The challenge for the Airbus
A380 is whether there is sufficient worldwide demand to cover the plane’s $18 billion
development cost.
In industries where scale economies are important, small- and medium-sized com-
panies can avoid disadvantages of small scale by outsourcing activities where scale is
critical. For example, specialist car makers typically license technologies and designs
and buy in engines.
Cost per
unit of output
Units of output
per periodMinimum
Ef f icient
Plant Size
FIGURE 7.8 The long-run average cost curve for a plant

170 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Economies of Learning The experience curve has its basis in learning-by-doing. Rep-
etition develops both individual skills and organizational routines. In 1943, it took 40,000
labor-hours to build a B-24 Liberator bomber. By 1945, it took only 8000 hours.31 Intel’s
dominance of the world microprocessor market owes much to its accumulated learning
in the design and manufacture of these incredibly complex products. Learning occurs
both at the individual level through improvements in dexterity and problem solving and
at the group level through the development and refinement of organizational routines.32
Process Technology and Process Design Superior processes can be a source of
huge cost economies. Pilkington’s revolutionary float glass process gave it (and its
licensees) an unassailable cost advantage in producing flat glass. Ford’s moving assem-
bly line reduced the time taken to assemble a Model T from 106 hours in 1912 to six
hours in 1914. When process innovation is embodied in new capital equipment, diffu-
sion is likely to be rapid. However, the full benefits of new process technologies typi-
cally require system-wide changes in job design, employee incentives, product design,
organizational structure, and management controls. Between 1979 and 1986, General
Motors achieved few productivity gains from the $40 billion it spent on robotics and
other advanced manufacturing technologies. The problem was that Toyota’s system of
lean production, which GM sought to imitate, relies less on advanced automation than
on work practices such as just-in-time scheduling, total quality management, continuous
improvement (kaizen), teamwork, job flexibility, and supplier partnerships.33
Business process re-engineering (BPR) is an approach to redesigning operational
processes that became widely popular during the 1990s. “Re-engineering gurus”
Michael Hammer and James Champy define BPR as: “the fundamental rethinking and
radical redesign of business processes to achieve dramatic improvements in critical
contemporary measures of performance, such as cost, quality, service, and speed.”34
BPR recognizes that processes can evolve haphazardly, hence, BPR begins with the
question: “If we were starting afresh, how would we design this process?”
BPR can lead to major gains in efficiency, quality, and speed (Strategy Capsule 7.6),
but where business processes are complex and embedded in organizational routines,
“obliterating” existing processes and starting with a “clean sheet of paper” may endanger
organizational capabilities that have been nurtured over a long period. In recent years,
BPR has been partly superseded by business process management, where the emphasis
has shifted from workflow management to the broader application of information tech-
nology (web-based applications in particular) to the redesign and enhancement of
organizational processes.35
A
d
ve
rt
is
in
g
e
xp
en
d
it
u
re
($
p
er
c
as
e)
0.02
10
Annual sales volume (millions of cases)
0.05
0.10
0.15
0.20
20 50 100 200 500 1000
Schweppes
SF Dr. Pepper
Diet PepsiDiet 7-Up
Diet Rite
Fresca
Sprite Dr. Pepper
Seven-Up
Pepsi Coke
Tab
FIGURE 7.9 Economies of scale in advertising: US soft drinks

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 171
Product Design Design-for-manufacture—designing products for ease of pro-
duction rather than simply for functionality and esthetics—can offer substantial cost
savings, especially when linked to the introduction of new process technology. In 2014,
General Motors CEO Mary Barra announced the goal of reducing 26 global vehicle pro-
duction platforms to just four by 2015. Such a transition would offer major savings in
component and product development costs.36
Service offerings, too, can be designed for ease and efficiency of production. Motel
6, cost leader in US budget motels, carefully designs its product to keep operating costs
low. Its motels occupy low-cost, out-of-town locations; it uses standard motel designs;
it avoids facilities such as pools and restaurants; and it designs rooms to facilitate easy
cleaning and low maintenance. However, efficiency in service design is compromised
by the tendency of customers to request deviations from standard offerings (“I’d like
my hamburger with the bun toasted on one side only, please”). This requires a clear
strategy to manage variability either through accommodation or restriction.37
Capacity Utilization Over the short and medium terms, plant capacity is more or
less fixed and variations in output cause capacity utilization to rise or fall. Underutiliza-
tion raises unit costs because fixed costs must be spread over fewer units of production.
Pushing output beyond normal full capacity also creates inefficiencies. Boeing’s efforts
to boost output during 2006–2011 resulted in increased unit costs due to overtime pay,
premiums for night and weekend shifts, increased defects, and higher maintenance costs.
STRATEGY CAPSULE 7.6
Process Re-engineering at IBM Credit
Michel Hammer and James Champy describe how
business process re-engineering resulted in IBM
reducing the time taken to approve requests by sales
personnel for new customer credit approval from six
days to four  hours. Under the old system, five stages
were involved:
1 an IBM salesperson telephoned a request for financ-
ing, which was logged on a piece of paper;
2 the request was sent to the credit department,
which checked the customer’s creditworthiness;
3 the request and credit check were sent to the
business practices department where a loan cove-
nant was drawn up;
4 the paperwork was passed to a pricer, who deter-
mined the interest rate;
5 the clerical group prepared a quote letter that was
sent to the salesperson.
Frustrated by the delays and resulting lost sales,
two managers undertook an experiment. They took a
financing request and walked it through all five steps—it
took just 90 minutes!
The problem was that the process had been designed
for the most complex credit requests that IBM received,
yet, in most cases no specialist judgment was called for: all
that was needed was to check credit ratings and to plug
numbers into standard algorithms. The credit approval
process was redesigned by replacing the specialists
(credit checkers, pricers, and so on) with generalists who
undertook all five processes. Specialists were reserved for
nonstandard or unusually complex requests. Processing
time was cut by 94%, fewer employees were required,
and the volume of customer approvals increased.
Source: Adapted from M. Hammer and J. Champy, Re-engineering
the Corporation: A Manifesto for Business Revolution (New York:
Harper Business, 1993): 36–39.

172 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Input Costs There are several reasons why a firm may pay less for an input than its
competitors:
● Locational differences in input prices: The prices of inputs—wage rates espe-
cially—vary between locations. In the United States, software engineers earned
an average of $85,000 in 2017. In India, the average was $13,000. In auto assem-
bly, the hourly rate in Chinese plants was about $3.90 an hour in 2016, com-
pared with $30 in the United States (not including benefits).38
● Ownership of low-cost sources of supply: In raw-material-intensive industries,
ownership of low-cost sources of material can offer a massive cost advantage.
In petroleum, lifting costs for the three “supermajors” (ExxonMobil, Royal
Dutch Shell, and BP) were about $21 per barrel in 2016; for Saudi Aramco they
were about $5.
● Nonunion labor: Labor unions result in higher levels of pay and benefits and
work rules that can lower productivity. In the US airline industry, nonunion
Virgin America had average salary and benefit cost per employee of $79,161 in
2013 compared with $98,300 for United States (80% unionized).
● Bargaining power: The ability to negotiate preferential prices and discounts can
be a major source of cost advantage for industry leaders, especially in retailing.39
Amazon’s growing dominance of book retailing allows it to demand discounts
from publishers of up to 60%.40
Residual Efficiency Even after taking account of the basic cost drivers—scale, tech-
nology, product and process design, input costs, and capacity utilization—unexplained
cost differences between firms typically remain. These residual efficiencies relate to the
extent to which the firm approaches its efficiency frontier of optimal operation which
depends on the firm’s ability to eliminate “organizational slack”41 or “X-inefficiency.”42
These excess costs have a propensity to accumulate within corporate headquarters—
where they become targets for activist investors.43 Eliminating these excess costs often
requires a threat to a company’s survival—in his first year as CEO, Carlos Ghosn cut
Nissan Motor’s operating costs by 20%.44 At Walmart, Ryanair, and Amazon, high levels
of residual efficiency are the result of management systems and company values that
are intolerant of unnecessary costs and glorify frugality.
Using the Value Chain to Analyze Costs
To analyze an organization’s cost position and seek opportunities for cost reduction,
we need to look at individual activities. Chapter  5 introduced the value chain as a
framework for viewing the sequence of activities that a company or business unit per-
forms. Each activity tends to be subject to a different set of cost drivers, which give it a
distinct cost structure. A value chain analysis of a firm’s costs seeks to identify:
● the relative importance of each activity with respect to total cost;
● the cost drivers for each activity and the comparative efficiency with which the
firm performs each activity;
● how costs in one activity influence costs in another;
● which activities should be undertaken within the firm and which activities
should be outsourced.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 173
A value chain analysis of a firm’s cost position comprises the following stages:
1 Disaggregate the firm into separate activities: Identifying value chain activities is
a matter of judgment. It requires identifying which activities are separate from
one another, which are most important in terms of cost, and their dissimilarity in
terms of cost drivers.
2 Estimate the cost that each activity contributes to total costs. The goal is to
identify which activities are the most important sources of cost, since, even with
activity-based costing, detailed cost allocation can be a major exercise.45
3 Identify cost drivers: For each activity, what factors determine the level of unit
cost relative to other firms? For activities with large fixed costs such as new prod-
uct development or marketing, the principal cost driver is likely to be the ability
to amortize costs over a large volume of sales. For labor-intensive activities, key
cost drivers tend to be wage rates, process design, and defect rates.
4 Identify linkages: The costs of one activity may be determined, in part,
by the way in which other activities are performed. Xerox discovered that
its high service costs relative to competitors’ reflected the complexity of
design of its.
5 Identify opportunities for reducing costs: By identifying areas of compara-
tive inefficiency and the cost drivers for each, opportunities for cost reduction
become evident. If the sources of inefficiency cannot be resolved, can the activity
be outsourced?
Figure 7.10 shows how the application of the value chain to automobile manufac-
ture can identify possibilities for cost reductions.
Differentiation Advantage
A firm differentiates itself from its competitors “when it provides something unique that
is valuable to buyers beyond simply offering a lower price.”46 Differentiation advantage
occurs when the price premium that the firm earns from differentiation exceeds the
cost of providing the differentiation.
Every firm has opportunities to differentiate its offering, although the range of
differentiation opportunities depends on the characteristics of the product. An auto-
mobile or a restaurant offers greater potential for differentiation than cement, wheat,
or memory chips. These latter products are called commodities precisely because they
lack physical differentiation. Yet, according to Tom Peters, “Anything can be turned into
a value-added product or service.”47 Consider the following:
● Cement is the ultimate commodity product, yet Cemex, based in Mexico, has
become a leading worldwide supplier of cement and ready-mix concrete through
emphasizing “building solutions”—one aspect of which is ensuring that 98% of
its deliveries are on time (compared to 34% for the industry as a whole).48
● Online bookselling is inherently a commodity business—any online
bookseller has access to the same titles and same modes of distribution.
Yet, Amazon has exploited the information generated by its business to offer
a range of value-adding services: best-seller lists, reviews, and customized
recommendations.

174 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
The lesson is this: differentiation is not simply about offering different product fea-
tures; it is about identifying and understanding every possible interaction between the
firm and its customers and asking how these interactions can be enhanced or changed
in order to deliver additional value to the customer. This requires looking at both the
firm (the supply side) and its customers (the demand side). While supply-side analysis
1. IDENTIFY ACTIVITIES
Establish the basic framework of the value
chain by identifying the principal activities
of the firm.
2. ALLOCATE TOTAL COSTS
For a first-stage analysis, a rough estimate
of the breakdown of total cost by activity is
sufficient to indicate which activities offer
the greatest scope for cost reductions.
3. IDENTIFY COST DRIVERS
(See diagram.)
4. IDENTIFY LINKAGES
Examples include:
1. Consolidating purchase orders to
increase discounts increases inventories.
2. High-quality parts and materials reduce
costs of defects at later stages.
3. Reducing manufacturing defects cuts
warranty costs.
4. Designing different models around
common components and platforms
reduces manufacturing costs.
5. IDENTIFY OPPORTUNITIES
COST REDUCTION
For example:
Purchasing: Concentrate purchases on
fewer suppliers to maximize purchasing
economies. Institute just-in-time
component supply to reduce inventories.
R&D/Design/Engineering: Reduce
frequency of model changes. Reduce
number of different models (e.g., single
range of global models). Design for
commonality of components and platforms.
Component manufacture: Exploit
economies of scale through concentrating
production of each component on fewer
plants. Outsource wherever scale of
production or run lengths is suboptimal
or where outside suppliers have technology
advantages. For labor-intensive
components (e.g., seats, dashboards,
trim), relocate production in low-wage
countries. Improve capacity utilization
through plant rationalization or supplying
components to other manufacturers.
SEQUENCE OF ANALYSIS VALUE CHAIN COST DRIVER
PURCHASING
COMPONENTS
AND
MATERIALS
R&D, DESIGN,
AND
ENGINEERING
COMPONENT
MANUFACTURE
ASSEMBLY
TESTING AND
QUALITY
CONTROL
INVENTORIES
OF FINISHED
PRODUCTS
SALES AND
MARKETING
DISTRIBUTION
AND DEALER
SUPPORT
Prices of bought-in
components depend upon:
• Order sizes
• Average value of purchases
per supplier
• Location of suppliers
Size of R&D commitment
Productivity of R&D
Number and frequency of new
models
Sales per model
Scale of plants
Run length per component
Capacity utilization
Location of plants
Scale of plants
Number of models per plant
Degree of automation
Level of wages
Location of plants
Level of quality targets
Frequency of defects
Predictability of sales
Flexibility of production
Customers’ willingness to wait
Size of advertising budget
Strength of existing reputation
Sales volume
Number of dealers
Sales per dealer
Desired level of dealer support
Frequency of defects
repaired under warranty
FIGURE 7.10 Using the value chain in cost analysis: An automobile manufacturer

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 175
identifies the firm’s potential to create uniqueness, the critical issue is whether such
differentiation creates value for customers and whether the value created exceeds the cost
of the differentiation. Only by understanding what customers want, how they choose,
and what motivates them can we identify opportunities for profitable differentiation.
Thus, differentiation strategies are not about pursuing uniqueness for its own sake.
Differentiation is about understanding customers and how to best meet their needs.
To this extent, the quest for differentiation advantage takes us to the heart of business
strategy. The fundamental issues of differentiation are also the fundamental issues of
business strategy: Who are our customers? How do we create value for them? And how
do we do it more effectively and efficiently than anyone else?
Because differentiation is about uniqueness, establishing differentiation advantage
requires creativity: it cannot be achieved simply through applying standardized frame-
works and techniques, but it can be guided by systematic analysis. As we have observed,
there are two requirements for creating profitable differentiation. On the supply side,
the firm must be aware of the resources and capabilities through which it can create
uniqueness (and do it better than competitors). On the demand side, the key is insight
into customers and their needs and preferences. These two sides form the major com-
ponents of our analysis of differentiation.
The Nature and Significance of Differentiation
The potential for differentiating a product or service is partly determined by its
physical characteristics. For products that are technically simple (a pair of socks, a
brick), that satisfy uncomplicated needs (a corkscrew, a nail), or must meet rigorous
technical standards (a DRAM chip, a thermometer), differentiation opportunities are
constrained by technical and market factors. Products that are technically complex (an
airplane), that satisfy complex needs (an automobile, a vacation), or that do not need
to conform to particular technical standards (wine, toys) offer much greater scope for
differentiation.
Beyond these constraints, the potential in any product or service for differentiation
is limited only by the boundaries of the human imagination. For seemingly simple
products such as shampoo, toilet paper, and bottled water, the proliferation of brands
on any supermarket’s shelves is testimony both to the ingenuity of firms and the com-
plexity of customers’ preferences. Differentiation extends beyond the physical charac-
teristics of the product or service to encompass everything about the product or service
that influences the value that customers derive from it. Hence, differentiation requires
an understanding of every aspect of a company’s relationship with its customers. Star-
bucks’ ability to charge up to $5 for a cup of coffee (compared to $1 at Burger King)
reflects, not just the characteristics of the coffee, but also the overall “Starbucks Experi-
ence” which encompasses the retail environment, the community in which customers
participate, and the values that Starbucks projects.
Differentiation includes both tangible and intangible dimensions. Tangible differentiation
is concerned with the observable characteristics of a product or service that are relevant
to customers’ preferences and choice processes: for example, size, shape, color, weight,
design, material, and performance attributes such as reliability, consistency, taste, speed,
durability, and safety. Tangible differentiation also extends to products and services that
complement the product in question: delivery, after-sales services, and accessories.
Opportunities for intangible differentiation arise because the value that customers
perceive in a product is seldom determined solely by observable product features or
objective performance criteria. Social, emotional, psychological, and esthetic criteria
also guide customer choices. For consumer goods and services, the desire for status,

176 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
exclusivity, individuality, security, and community are powerful motivational forces.
These attributes are closely linked to the overall image of the firm and its offering.
Image is especially important for those products and services whose qualities and
performance are difficult to ascertain at the time of purchase (so-called experience
goods). These include cosmetics, medical services, and education.
Differentiation and Segmentation Differentiation is different from segmentation.
Differentiation is concerned with how a firm competes—the ways in which it can offer
uniqueness to customers. Such uniqueness might relate to consistency (McDonald’s),
reliability (Federal Express), status (American Express), quality (BMW), and innovation
(Apple). Segmentation is concerned with where a firm competes in terms of customer
groups, localities, and product types.
Whereas segmentation is a feature of market structure, differentiation is a strategic
choice made by a firm. Differentiation may lead to focusing upon particular market
segments, but not necessarily. IKEA, McDonald’s, Honda, and Starbucks all pursue
differentiation, but position themselves within the mass market spanning multiple
demographic and socioeconomic segments.49
The Sustainability of Differentiation Advantage Differentiation offers a more
secure basis for competitive advantage than low cost does. A position of cost advantage
is vulnerable to adverse movements in exchange rates and to new competitors taking
advantage of low input costs and new technologies. Differentiation advantage would
appear to be more sustainable. Large companies that consistently earn above-average
returns on capital—such as Colgate-Palmolive, Diageo, Johnson & Johnson, Kellogg’s,
Procter & Gamble, 3M, and Wyeth—tend to be those that have pursued differentiation
through quality, branding, and innovation.
Analyzing Differentiation: The Demand Side
Analyzing customer demand enables us to determine which product characteris-
tics have the potential to create value for customers, customers’ willingness to pay
for differentiation, and a company’s optimal competitive positioning in terms of
differentiation variables. Analyzing demand begins with understanding why customers
buy a product or service. Market research systematically explores customer prefer-
ences and customer perceptions of existing products. However, the key to successful
differentiation is to understand customers: a simple, direct inquiry into the purpose of
a product and the needs of its customers can often be far more illuminating than sta-
tistically validated market research (Strategy Capsule 7.7).
Understanding customer needs requires the analysis of customer preferences in rela-
tion to product attributes. Techniques include the following:
● Multidimensional scaling (MDS) compares competing products in terms of key
product attributes.50 Figure 7.11 shows consumer ratings of competing pain
relievers. Multidimensional scaling has also been used to classify 109 single-malt
Scotch whiskies according to their color, nose, palate, body, and finish.51
● Conjoint analysis measures the strength of customer preferences for
different products which then allows consumer preference for a hypothetical
new product to be predicted.52 Conjoint analysis was used by Marriott to design
its Courtyard hotel chain.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 177
● Hedonic price analysis views products as bundles of underlying attributes.53
It uses regression analysis to estimate the implicit market price for each
attribute. For example, price differences among European washing machines
can be related to differences in capacity, spin speed, energy consump-
tion, number of programs, and reliability.54 Similarly, price differences bet-
ween models of personal computer reflect differences in processor speed,
memory, and hard drive capacity. This analysis can be used to decide what
levels of each attribute to include within a new product and the price for
that product.
The Role of Social and Psychological Factors Analyzing product differentiation
in terms of measurable performance attributes fails to take account of customers’
underlying motivations. Few goods or services only satisfy physical needs: most buy-
ing is influenced by social and psychological motivations, such as the desire to find
STRATEGY CAPSULE 7.7
Understanding What a Product Is About
Kenichi Ohmae was the head of McKinsey &
Company’s Tokyo office (1972–1995). He is Japan’s
most renowned strategy guru. Product differentiation,
in his view, is about understanding customers and
their relationship to the product. He recounts the
efforts of a Japanese appliance maker to develop a
coffee percolator. The development team sought to
differentiate its coffee maker from those produced
by General Electric, Philips, and Faberware in terms of
size, speed, brewing system, and shape. Ohmae urged
the development team to ask a different question:
“Why do people drink coffee?” The answer: “For the
taste.” Yet, the company’s engineers knew nothing
about what determined the taste of good coffee.
After a few weeks they discovered that a superior
tasting cup of coffee required freshly-ground quality
beans, pure water, optimal water temperature, and
an even distribution of grains.
As a result, the essential design features for the
coffee  maker emerged: it had to have a built-in
grinder,  it  needed a water purifier to remove chlo-
rine, it  required precise control of water temperature,
and so on.
Ohmae emphasizes the need to ask the right ques-
tions when formulating strategy. It is vital to establish a
competitive advantage, but concentrating upon what
competitors are doing can lock a company into con-
ventional ways of thinking. The Japanese appliance
company risked becoming fixated on General Electric’s
new percolator that brewed coffee in 10 minutes—it
targeted a brewing time of eight minutes. Where does
this logic lead us? To the conclusion that instant coffee
is best! Ohmae encourages us to take a step back and
consider a product in relation to customers’ innate needs
and motives.
Nintendo’s success with its Wii and Switch video
games consoles confirms the potential of this approach.
Rather than a futile attempt to match Sony and Micro-
soft on computing power, graphics, or virtual reality,
Nintendo has concentrated on enhancing users’ gaming
experiences. This has allowed it to discover differentiation
opportunities that don’t depend upon advanced micro-
electronics.
Sources: K. Ohmae “Getting Back to Strategy,” Harvard Business
Review (November/December 1988); K. Ohmae, The Borderless
World, (New York: HarperCollins,1999).

178 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
community with others and to reinforce one’s own identity. Psychologist Abraham
Maslow proposed a hierarchy of human needs that progress from basic survival needs to
security needs, to belonging needs, to esteem needs, up to the desire for self-actual-
ization.55 For most goods, brand equity has more to do with higher-level needs such
as status and identity than with tangible product performance. The disastrous intro-
duction of “New Coke” in 1985 was the result of Coca-Cola giving precedence to tan-
gible differentiation (taste preferences) over intangible differentiation (authenticity).56
Harley-Davidson harbors no such illusions: it recognizes quite clearly that it is in the
business of selling lifestyle, not transportation.
If the main drivers of consumer behavior are identity and social affiliation, the
implications for differentiation are that we must analyze not only the product and its
characteristics but also customers, their lifestyles and aspirations, and the relation-
ship of the product to those lifestyles and aspirations. Market research that focuses
upon traditional demographic and socioeconomic factors may be less useful than a
deep understanding of consumers’ relationships with a product. As consumers become
increasingly sensitive to the activities of companies that supply their goods and ser-
vices, so companies are drawn toward corporate social responsibility as a means of
protecting and augmenting the value of their brands.57
Figure 7.12 summarizes the key points of this discussion by posing some basic ques-
tions that explore the potential for demand-side differentiation.
Analyzing Differentiation: The Supply Side
Creating differentiation advantage also depends on a firm’s ability to offer differentiation.
This requires us to pay attention to the activities that the firm undertakes and its capa-
bilities in performing them.
High
Tylenol
Buf ferin
Excedrin
Bayer
Anacin
Private-
label
aspirin
GENTLENESS
EFFECTIVENESS
Low
Low
High
FIGURE 7.11 Consumer perceptions of competing pain relievers: A
multidimensional scaling mapping

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 179
The Drivers of Uniqueness Differentiation is concerned with providing customers
with uniqueness. Michael Porter argues that the opportunities for providing uniqueness
are not limited to a particular function or activity but can arise in virtually everything
that the firm does, including:
● product features and product performance;
● complementary services (such as credit, delivery, repair);
● intensity of marketing activities (such as rate of advertising spending);
● technology embodied in design and manufacture;
● quality of purchased inputs;
● procedures that influence the customer experience (such as the rigor of quality
control, service procedures, frequency of sales visits);
● skill and experience of employees;
● location (e.g., proximity to the customer);
● degree of vertical integration (which influences a firm’s ability to control inputs
and intermediate processes).58
Differentiation can also occur through bundling—combining complementary
products and services in a single offering.59 Such bundling runs contrary to the
normal tendency for  products to unbundle as markets mature and complementary
services become provided by specialist suppliers. Electronic commerce has reinforced
unbundling: consumers increasingly create their own customized vacations in preference
to purchasing an all-inclusive vacation package. However, rebundling of products and
services has become especially important in business-to-business transactions through
“providing customer solutions”—combinations of goods and services that are tailored to
the needs of each client. This involves a radical rethink of the business models in many
companies.60
What needs
does it satisfy?
THE
PRODUCT
Relate patterns of
customer
preferences to
product attributes
What price
premiums do
product attributes
command?
What are the
demographic,
sociological, and
psychological
inf luences on
customer behavior?
• Select product
positioning in relation
to product attributes
• Ensure customer/
product compatibility
FORMULATE
DIFFERENTIATION
STRATEGY
By what criteria
do they
choose?
What are its key
attributes?
THE
CUSTOMER
What
motivates
them?
• Select target
customer group
• Evaluate costs and
benef its of
dif ferentiation
FIGURE 7.12 Identifying differentiation potential: The demand side

180 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Product Integrity Differentiation decisions cannot be made on a piecemeal
basis. Establishing a coherent and effective differentiation position requires the firm
to assemble a complementary package of differentiation attributes. If Burberry, the
British fashion house, wants to expand its range of clothing and accessories, it needs
to ensure that every new product offering is consistent with its overall image as a
quality-focused brand that combines traditional British style with contemporary edg-
iness. Product integrity refers to the consistency of a firm’s differentiation; it is the
extent to which a product achieves:
total balance of numerous product characteristics, including basic functions, esthetics,
semantics, reliability, and economy… Internal integrity refers to consistency between
the function and structure of the product… External integrity is a measure of how
well a product’s function, structure, and semantics fit the customer’s objectives, values,
production system, lifestyle, use pattern, and self-identity.61
Simultaneously achieving internal and external integrity is a complex organiza-
tional challenge: it requires close cross-functional collaboration and intimate customer
contact.62 This integration of internal and external product integrity is especially impor-
tant to those supplying “lifestyle” products, where differentiation is based on customers’
social and psychological needs. Here, the credibility of the image depends critically on
the consistency of the image presented. One element of this integration is a common
identity between customers and company employees. For instance:
● Harley-Davidson’s image of ruggedness, independence, individuality, and
community is supported by a top management team that dons biking leathers
and participates in owners’ group rides, and a management system that
empowers shop-floor workers and fosters quality, initiative, and responsibility.
● Central to the “Starbucks Experience” is the connection between customers and
employees, which is reinforced by Starbuck’s generous employee benefits and
employee involvement in Starbuck’s social and environmental initiatives.
Signaling and Reputation Differentiation is only effective if it is communicated
to customers. But information about the qualities and characteristics of products is
not always readily available to potential customers. The economics literature distin-
guishes between search goods, whose qualities and characteristics can be ascertained
by inspection, and experience goods, whose qualities and characteristics are only recog-
nized after consumption. This latter class of goods includes medical services, baldness
treatments, frozen TV dinners, and wine. Even after purchase, performance attributes
may be slow in revealing themselves. Bernie Madoff established Bernard L. Madoff
Investment Securities LLC in 1960—it took 48 years before the renowned investment
house was revealed as a “giant Ponzi scheme.”63
In the terminology of game theory (see Chapter  4), the market for experience
goods corresponds to a classic prisoners’ dilemma. A firm can offer a high-quality or
a low-quality product. The customer can pay either a high or a low price. If quality
cannot be detected, then equilibrium is established, with the customer offering a low
price and the supplier offering a low-quality product, even though both would be better
off with a high-quality product sold at a high price. The resolution of this dilemma is
for producers to find some credible means of signaling quality to the customer. The
most effective signals are those that change the payoffs in the prisoners’ dilemma.
Thus, an extended warranty is effective because providing such a warranty would be

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 181
more expensive for a low-quality producer than a high-quality producer. Brand names,
warranties, expensive packaging, money-back guarantees, sponsorship of sports and
cultural events, and a carefully designed retail environment for the product are all sig-
nals of quality. Their effectiveness stems from the fact that they represent significant
investments by the manufacturer that will be devalued if the product proves unsatis-
factory to customers.
The more difficult it is to ascertain performance prior to purchase, the more impor-
tant are these signals of quality.
● A perfume can be sampled prior to purchase and its fragrance assessed, but
its ability to augment the identity of the wearer and attract attention remains
uncertain. Hence, the key role of branding, packaging, advertising, and lav-
ish promotional events in establishing the perfume’s identity and performance
credentials.
● In financial services, the customer cannot easily assess the honesty, financial
soundness, or competence of the supplier. Hence, financial service companies
rely upon symbols of security and stability: imposing head offices, conserva-
tive office decor, smartly dressed employees, and trademarks such as Pruden-
tial’s rock and Travelers’ red umbrella. Bernie Madoff’s multibillion investment
swindle was sustained by his association with leading figures among New
York’s Jewish community, his prominent role in cultural and charitable organiza-
tions, and the aura of exclusivity around his investment firm.
Brands Brands fulfill multiple roles. At the most basic level, a brand provides an
implicit guarantee of quality simply by identifying the producer of a product, thereby
ensuring the producer is legally accountable for its products. Further, the brand rep-
resents an investment that provides an incentive to maintain quality and customer
satisfaction. It is a credible signal of quality because of the disincentive of its owner
to devalue it. As a result, a brand acts as a guarantee to the customer that reduces
uncertainty and search costs. The more difficult it is to discern quality on inspection,
and the greater the cost to the customer of purchasing a defective product, the greater
the value of a brand: a trusted brand name is more important to us when I purchase
mountaineering equipment than when I buy a pair of socks.
However, the value conferred by consumer brands such as Red Bull, Tesla,
Mercedes-Benz, Gucci, Virgin, and American Express is more about conferring
identity than guaranteeing reliability and quality. As brand building focuses increas-
ingly on “brand experience,” “tribal identity,” “shared values,” and “emotional dialogue,”
traditional mass-market advertising is taking a back seat to word-of-mouth promotional
initiatives using social and the other digital marketing tools of viral marketing.64
The Costs of Differentiation Differentiation adds cost: higher-quality inputs,
better-trained employees, higher advertising costs, and better after-sales service. If
differentiation narrows a breadth of appeal, it also limits the potential for exploiting
scale economies.
One means of reconciling differentiation with cost efficiency is to postpone
differentiation to later stages of the firm’s value chain. Modular design with common
components permits scale economies while permitting product variety. All the major
automakers have standardized platforms, engine types, and components, while
offering customers multiple models and innumerable combinations of colors, trim,
and accessories.

182 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
FIRM INFRASTRUCTURE
HUMAN RESOURCE MANAGEMENT
TECHNOLOGY DEVELOPMENT
OPERATIONS OUTBOUND
LOGISTICS
MARKETING
AND SALES
SERVICEINBOUND
LOGISTICS
Quality of
components
and materials
Defect-free
products.
Wide variety
Fast delivery.
E�cient order
processing
Building
brand
reputation
Customer technical
support. Consumer
credit. Availability
of spares
IT that supports
fast response
capabilities
Unique product features.
Fast new product
development
Training to support
customer service
excellence
FIGURE 7.13 Using the value chain to identify differentiation potential on the
supply side
Bringing It All Together: The Value Chain in
Differentiation Analysis
Demand side and supply side analyses of differentiation potential is only useful once
they are brought together. The key to successful differentiation is matching the firm’s
capacity for creating differentiation to the attributes that customers value most. For this,
the value chain provides a particularly useful framework. Let’s begin with the case of a
producer good, that is, one that is supplied by one firm to another.
Value Chain Analysis of Producer Goods Using the value chain to identify oppor-
tunities for differentiation advantage involves three principal stages:
1 Construct a value chain for the firm and its customer. It may be useful to consider
not just the immediate customer but also firms further downstream in the value
chain. If the firm supplies different types of customers, it’s useful to draw sepa-
rate value chains for each major category of customer.
2 Identify the drivers of uniqueness in each activity of the firm’s value chain.
Figure 7.13 identifies some possible sources of differentiation within Porter’s
generic value chain.
3 Locate linkages between the value chain of the firm and that of the buyer. What
can the firm do with its own value chain activities that can reduce the cost or
enhance the differentiation potential of the customer’s value chain activities?
The amount of additional value that the firm creates for its customers through
exploiting these linkages represents the potential price premium the firm can
charge for its differentiation. Strategy Capsule 7.8 demonstrates the identification
of differentiation opportunities by lining the value chains of a firm and its
customers.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 183
Value Chain Analysis of Consumer Goods Value chain analysis of differentiation
opportunities can also be applied to consumer goods. Few consumer goods are con-
sumed directly: typically, consumers engage in a chain of activities that involve search,
acquisition, and use of the product. In the case of consumer durables, the value chain
may include search, purchase, financing, acquisition of complementary products and
services, operation, service and repair, and eventual disposal. Such complex consumer
value chains offer many potential linkages with the manufacturer’s value chain, with
rich opportunities for innovative differentiation. Harley-Davidson has built its strategy
around the notion that it is not supplying motorcycles; it is supplying a customer
experience. This has encouraged it to expand the scope of its contact with its cus-
tomers to provide a wider range of services than any other motorcycle company.
Even nondurables involve the consumer in a chain of activities. Consider a frozen TV
STRATEGY CAPSULE 7.8
Using the Value Chain to Identify Differentiation
Opportunities for a Manufacturer of Metal Containers
The metal container industry is a highly competitive,
low-growth, low-profit industry. Cans lack potential for
differentiation, and buyers (especially beverage and food
canning companies) are very powerful. Cost efficiency is
essential, but can we also identify opportunities for prof-
itable differentiation? Following the procedure outlined
above, we can construct a value chain for a firm and its
customers, and then identify linkages between the two.
Figure 7.14 identifies five such linkages:
1 Distinctive can designs (e.g., Sapporo’s beer can)
can support the customer’s efforts to differentiate
its product.
2 Manufacturing cans to high tolerances can mini-
mize breakdowns on customers’ canning lines.
3 Reliable, punctual can deliveries allow canners to
economize on their can inventories.
4 An efficient order-processing system reduces can-
ners’ ordering costs.
5 Speedy, proficient technical support allows customers
to operate their canning lines with high-capacity
utilization and low downtime.
FIGURE 7.14 Identifying differentiation opportunities by linking the firm’s value chain to
that of the customer
Su
p
p
lies o
f steel
an
d
alu
m
in
u
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184 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
TABLE 7.1 Features of cost leadership and differentiation strategies
Generic strategy Key strategy elements Organizational requirements
Cost leadership Scale-efficient plants
Maximizing labor productivity
Design for manufacture
Control of overheads
Process innovation
Outsourcing
Avoid marginal
customering accounts
Access to capital
Division of labor with incentives linked
to quantitative performance targets
Product design coordinated with
manufacture
Tight cost controls
Process engineering skills
Benchmarking
Measuring profit per customer
Differentiation Emphasis on branding, advertising,
design, customer service, quality,
and new product development
Marketing abilities
Product engineering skills
Cross-functional coordination
Creativity
Research capability
Incentives linked to qualitative
performance targets
dinner: it must be purchased, taken home, removed from the package, heated, and
served before it is consumed. After eating, the consumer must clean any used dishes,
cutlery, or other utensils. A value chain analysis by a frozen foods producer would
identify ways in which the product could be formulated, packaged, and distributed to
assist the consumer in performing this chain of activities.
Can Firms Pursue Both Cost and Differentiation Advantage?
The two primary sources of competitive advantage require fundamentally different
approaches to business strategy. A firm that is competing on low cost is distinguish-
able from a firm that competes through differentiation in terms of market positioning,
resources and capabilities, and organizational characteristics. Table 7.1 outlines some
of the principal features of cost and differentiation strategies.
Porter views cost leadership and differentiation as mutually exclusive strategies. A
firm that attempts to pursue both is “stuck in the middle”:
The firm stuck in the middle is almost guaranteed low profitability. It either loses
the high-volume customers who demand low prices or must bid away its profits to
get this business from the low-cost firms. Yet, it also loses high-margin business—
the cream—to the firms who are focused on high-margin targets or have achieved
differentiation overall. The firm that is stuck in the middle also probably suffers from
a blurred corporate culture and a conflicting set of organizational arrangements and
motivation system.65
In practice, few firms are faced with such stark alternatives. Differentiation is not
simply an issue of “to differentiate or not to differentiate.” All firms must make decisions
as to which customer requirements to focus on and where to position their product or
service in the market. A cost leadership strategy typically implies limited-feature, stan-
dardized offerings, but this does not necessarily imply that the product or service is an

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 185
undifferentiated commodity. Southwest Airlines and AirAsia are budget airlines with a
no-frills offering yet have clear market positions with unique brand images. The VW
Beetle shows that a utilitarian, mass-market product can achieve cult status.
In most industries, market leadership is held by a firm that maximizes customer
appeal by reconciling effective differentiation with low cost—Toyota in cars, McDon-
ald’s in fast food, Nike in athletic shoes. The huge global success of Japanese suppliers
of cars, motorcycles, consumer electronics, and musical instruments during the 1980s
and 1990s was the result of simultaneously pursuing cost efficiency, quality, innovation,
and brand building. The management techniques pioneered by Japanese companies—
notably total quality management—reconciling cost efficiency with differentiation has
been facilitated by new management techniques: total quality management repudiated
the conventional trade-off between quality and cost; flexible manufacturing systems
have reconciled scale economies with variety. In many industries, the cost leader is not
the market leader but a smaller competitor with minimal overheads, nonunion labor
and cheaply acquired assets.
Summary
Making money in business requires establishing and sustaining competitive advantage. Identifying
opportunities for competitive advantage requires insight into the nature and process of competition
within a market. Our analysis of the imperfections of the competitive process takes us back to the
resources and capabilities needed to compete in a particular market and conditions under which these
are available. Similarly, the isolating mechanisms that sustain competitive advantage are dependent pri-
marily upon the ability of rivals to access the resources and capabilities needed for imitation.
Competitive advantage has two primary dimensions: cost advantage and differentiation advantage.
The first of these, cost advantage, is the outcome of seven primary cost drivers. We showed that by
applying these cost drivers and by disaggregating the firm into a value chain of linked activities, we can
appraise a firm’s cost position relative to competitors and identify opportunities for cost reduction. The
principal message of this section is the need to look behind cost accounting data and beyond simplistic
approaches to cost efficiency, and to analyze the factors that drive relative unit costs in each of the firm’s
activities in a systematic and comprehensive manner.
The appeal of differentiation is that it offers multiple opportunities for competitive advantage with a
greater potential for sustainability than does cost advantage. The vast realm of differentiation opportu-
nity extends beyond marketing and design to encompass all aspects of a firm’s interactions with its cus-
tomers. Achieving a differentiation advantage requires the firm to match its own capacity for creating
uniqueness to the requirements and preferences of customers. The value chain offers firms a useful
framework for identifying how they can create value for their customers by combining demand-side
and supply-side sources of differentiation.
Finally, the basis of a firm’s competitive advantage has important implications not just for the design
of its strategy but for the design of its organizational structure and systems. Typically, companies that are
focused on cost leadership design their organizations differently from those that pursue differentiation.
However, the implications of competitive strategy for organizational design are complicated by the fact
that, for most firms, cost efficiency and differentiation are not mutually exclusive—in today’s intensely
competitive markets, firms have little choice but to pursue both.

186 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Notes
1. The dynamic relationship between competitive advantage
and profitability is emphasized by Richard Rumelt: when
competitive advantage increases profit increases (and
vice versa). See Good Strategy Bad Strategy (New York:
Crown Business, 2011): 163–177.
2. K. Ferdows, M. A. Lewis, and J. Machuca, “Rapid-Fire
Fulfillment,” Harvard Business Review (November
2004): 104–110.
3. G. Stalk, Jr., “Time: The Next Source of Competitive
Advantage,” Harvard Business Review ( July/August,
1988): 41–51.
4. See, for example, Y. Doz and M. Kosonen, “Embedding
Strategic Agility: A Leadership Agenda for Accelerating
Business Model Renewal,” Long Range Planning 43 (April
2010): 370–382; and S. Fourné, J. Jansen, and T. Mom,
“Strategic Agility in MNEs: Managing Tensions to Capture
Self-Study Questions
1. Figure 7.1 implies that stable industries, where firms have similar resources and capabilities,
offer less opportunity for competitive advantage than industries where change is rapid and
firms are heterogeneous. On the basis of these considerations, among the following industries,
in which do you predict that interfirm differences in profitability will be small and in which
will they be wide: retail banking, video games, wireless handsets, insurance, supermarkets,
and semiconductors?
2. Since 2009, Apple has been the world’s most profitable supplier of wireless handsets by a large
margin. Can Apple sustain its competitive advantage in this market?
3. Illy, the Italian-based supplier of quality coffee and coffee-making equipment, is launching an
international chain of gourmet coffee shops. What advice would you offer Illy for how it can
best build competitive advantage in the face of Starbucks’ market leadership?
4. Which drivers of cost advantage (Figure  7.7) do low-cost carriers such as Southwest Air-
lines and Ryanair exploit in order to undercut legacy carriers such as United Airlines and
British Airways?
5. Target (the US discount retailer), H&M (the Swedish fashion clothing chain), and Primark (the
UK discount clothing chain) have pioneered cheap chic—combining discount store prices
with fashion appeal. What are the principal challenges of designing and implementing a
cheap chic strategy? Design a “cheap chic” strategy for a company entering another market,
for example, restaurants, sports shoes, cosmetics, or office furniture.
6. To what extent are the seven cost drivers shown in Figure 7.7 relevant in analyzing the costs
per student at your business school or educational institution? What recommendations would
you make to your dean for improving the cost efficiency of your school?
7. Bottled water sells at least 200 times the price of tap water, with substantial price differentials
between different brands. What are the key differentiation variables that determine the price
premium that can be obtained for bottled water?
8. Advise a chain of movie theaters on a differentiation strategy to restore its flagging profit-
ability. Use the value chain framework outlined in Strategy Capsule 7.8 to identify potential
linkages between the company’s value chain and that of its customers in order to identify
differentiation opportunities.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 187
Opportunities across Emerging and Established Markets,”
California Management Review 56 (Spring 2014).
5. J. A. Schumpeter, Capitalism, Socialism and Democracy
(London: Routledge, 1994, first published 1942): 82–83.
6. R. Buaron, “New Game Strategies,” McKinsey Quarterly
Anthology (2000): 34–36.
7. However, a review of the literature on business model
innovation (BMI) revealed: “deep ambiguity with respect
to what a BMI is” (N. J. Foss and T. Saebi, “Fifteen Years
of Research on Business Model Innovation: How Far
Have We Come, and Where Should We Go?” Journal of
Management 43 ( January 2017): 200–227.)
8. IBM Global Technology Services “Business Model
Innovation—The New Route to Competitive Advantage.”
(IBM UK Ltd., September 2006).
9. L. L. Martins, V. P. Rindova, and B. E. Greenbaum,
“Unlocking the Hidden Value of Concepts: A Cognitive
Approach to Business Model Innovation,” Strategic Entre-
preneurship Journal 9 (2015): 99–117.
10. G. Gavetti, D. A. Levinthal, and J. W. Rivkin, “Strategy
Making in Novel and Complex Worlds: The Power
of Analogy,” Strategic Management Journal 26
(2005): 691–712.
11. H. Chesbrough, “Business Model Innovation: Oppor-
tunities and Barriers,” Long Range Planning 43
(2010): 354–363.
12. L. Massa, C. L. Tucci, and A. Afuah, “A Critical Assessment
of Business Model Research,” Academy of Management
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13. P. Aversa, S. Haefliger, and D. G. Reza, “Building a Win-
ning Business Model Portfolio,” MIT Sloan Management
Review 58 (Summer 2017): 49–54.
14. C. Kim and R. Mauborgne, “Blue Ocean Strategy,”
Harvard Business Review (October 2004).
15. C. Kim and R. Mauborgne, “Blue Ocean Strategy: From
Theory to Practice,” California Management Review 47
(Spring 2005): 105–121.
16. R. P. Rumelt, “Toward a Strategic Theory of the Firm,” in
R. Lamb (ed.), Competitive Strategic Management (Engle-
wood Cliffs, NJ: Prentice Hall, 1984): 556–570.
17. R. Jacobsen, “The Persistence of Abnormal Returns,”
Strategic Management Journal 9 (1988): 415–430; R. R.
Wiggins and T. W. Ruefli, “Schumpeter’s Ghost: Is Hyper-
competition Making the Best of Times Shorter?” Strategic
Management Journal 26 (2005): 887–911.
18. G. Stalk, “Curveball: Strategies to Fool the Competition,”
Harvard Business Review (September 2006): 114–122.
19. Monopolies and Mergers Commission, Cat and Dog Foods
(London: Her Majesty’s Stationery Office, 1977).
20. D. Besanko, D. Dranove, S. Schaefer, and M. Shanley,
Economics of Strategy, 6th edn (Hoboken, NJ: John
Wiley & Sons, Inc., 2013): section on “Limit Pricing,”
pp. 207–211.
21. T. C. Schelling, The Strategy of Conflict, 2nd edn (Cam-
bridge, MA: Harvard University Press, 1980): 35–41.
22. A. Brandenburger and B. Nalebuff, Co-opetition (New
York: Doubleday, 1996): 72–80.
23. R. Schmalensee, “Entry Deterrence in the Ready-to-Eat
Breakfast Cereal Industry,” Bell Journal of Economics 9
(1978): 305–327.
24. Monopolies and Mergers Commission, Indirect
Electrostatic Reprographic Equipment (London: Her Maj-
esty’s Stationery Office, 1976): 37, 56.
25. S. A. Lippman and R. P. Rumelt, “Uncertain Imitability:
An Analysis of Interfirm Differences in Efficiency under
Competition,” Bell Journal of Economics 13 (1982):
418–438. See also R. Reed and R. DeFillippi, “Causal
Ambiguity, Barriers to Imitation, and Sustainable Com-
petitive Advantage,” Academy of Management Review 15
(1990): 88–102.
26. P. R. Milgrom and J. Roberts, “Complementarities and Fit:
Strategy, Structure, and Organizational Change in Man-
ufacturing,” Journal of Accounting and Economics 19
(1995): 179–208.
27. J. W. Rivkin, “Imitation of Complex Strategies,”
Management Science 46 (2000): 824–844.
28. M. E. Porter and N. Siggelkow, “Contextuality within
Activity Systems and Sustainable Competitive Advantage,”
Academy of Management Perspectives 22 (May
2008): 34–56.
29. M. E. Porter, Competitive Advantage (New York: Free
Press, 1985): 13.
30. Ibid.: 120.
31. L. Rapping, “Learning and World War II Production
Functions,” Review of Economics and Statistics (February
1965): 81–86.
32. L. Argote, S. L. Beckman, and D. Epple, “The Persis-
tence and Transfer of Learning in Industrial Settings,”
Management Science 36 (1990): 140–154; M. Zollo and S. G.
Winter, “Deliberate Learning and the Evolution of Dynamic
Capabilities,” Organization Science 13 (2002): 339–351.
33. J. Womack and D. T. Jones, “From Lean Production to
Lean Enterprise,” Harvard Business Review (March/April
1994); J. Womack and D. T. Jones, “Beyond Toyota: How
to Root Out Waste and Pursue Perfection,” Harvard
Business Review (September/October, 1996).
34. M. Hammer and J. Champy, Re-engineering the Corpo-
ration: A Manifesto for Business Revolution (New York:
HarperBusiness, 1993): 32.
35. V. Glover and M. L. Marcus, “Business Process Transfor-
mation,” Advances in Management Information Systems
9 (M. E. Sharpe, March 2008); R. Merrifield, J. Calhoun,
and D. Stevens, “The Next Revolution in Productivity,”
Harvard Business Review (November 2006): 72–79.
36. www.autoevolution.com/news/gm-to-cut-costs-by-
using-only-4-platforms-by-2025-87460.html. Accessed
December 19, 2017.
37. F. X. Frei, “Breaking the Tradeoff between Efficiency
and Service,” Harvard Business Review (November
2006): 92–103.
38. Bureau of Labor Statistics, http://www.bls.gov/iag/tgs/iag-
auto.htm, accessed July 20, 2015.
39. “Buying Power of Multiproduct Retailers,” OECD Journal
of Competition Law and Policy 2 (March, 2000).
40. P. Krugman, “Amazon’s Monopsony Is Not O.K.,” New
York Times (October 19, 2014).
41. R. Cyert and J. March, A Behavioral Theory of the Firm
(Englewood Cliffs, NJ: Prentice Hall, 1963).
42. H. Leibenstein, “Allocative Efficiency versus X-Efficiency,”
American Economic Review 54 ( June 1966): 392–415.

188 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
43. “Fighting the Flab,” Economist (March 22, 2014).
44. K. Kase, F. J. Saez, and H. Riquelme, The New Sam-
urais of Japanese Industry (Cheltenham: Edward
Elgar, 2006).
45. M. E. Porter, Competitive Advantage (New York: Free
Press, 1985): 87; and R. S. Kaplan and S. R. Ander-
son, “Time-Driven Activity-based Costing,” Harvard
Business Review (November 2004): 131–138.
46. M. E. Porter, Competitive Advantage (New York: Free
Press, 1985): 120.
47. T. Peters, Thriving on Chaos (New York: Knopf,
1987): 56.
48. “Cemex: Cementing a Global Strategy,” Insead Case
No. 307-233-1 (2007).
49. The distinction between segmentation and
differentiation is discussed in P. R. Dickson
and J. L. Ginter, “Market Segmentation, Product
Differentiation, and Marketing Strategy,” Journal of
Marketing 51 (April 1987): 1–10.
50. S. Schiffman, M. Reynolds, and F. Young, Introduction
to Multidimensional Scaling: Theory, Methods, and
Applications (Cambridge, MA: Academic Press, 1981).
51. F.-J. Lapointe and P. Legendre, “A Classification
of Pure Malt Scotch Whiskies,” Applied Statistics
43 (1994): 237–257. On the principles of MDS,
see I. Borg and P. Groenen, Modern Multidimen-
sional Scaling: Theory and Application (New York:
Springer-Verlag, 1997).
52. P. Cattin and D. R. Wittink, “Commercial Use of
Conjoint Analysis: A Survey,” Journal of Marketing
46 (Summer 1982): 44–53.
53. K. Lancaster, Consumer Demand: A New Approach
(New York: Columbia University Press, 1971).
54. P. Nicolaides and C. Baden-Fuller, Price
Discrimination and Product Differentiation in the
European Domestic Appliance Market (London:
Center for Business Strategy, London Business
School, 1987).
55. A. Maslow, “A Theory of Human Motivation,”
Psychological Review 50 (1943): 370–396.
56. “Coke Lore: The Real Story of New Coke,” www.the-
cocacolacompany.com/heritage/cokelore_newcoke.
html, accessed July 20, 2015.
57. S. Zadek, “The Path to Corporate Responsi-
bility,” Harvard Business Review 82 (December,
2004): 125–129.
58. Porter, Competitive Advantage, op. cit., 124–125.
59. S. Mathur, “Competitive Industrial Marketing Strat-
egies,” Long Range Planning 17 (1984): 102–109.
60. K. R. Tuli, A. K. Kohli, and S. G. Bharadwaj,
“Rethinking Customer Solutions: From Product Bun-
dles to Relational Processes,” Journal of Marketing
71 (2007): 1–17.
61. K. Clark and T. Fujimoto, Product Development
Performance (Boston: Harvard Business School
Press, 1991): 29–30.
62. K. B. Clark and T. Fujimoto, “The Power of Product
Integrity,” Harvard Business Review (November/
December, 1990): 107–118.
63. “The Madoff Affair: Going Down Quietly,” Economist
(March 14, 2009).
64. D. J. Watts and J. Peretti, “Viral Marketing for
the Real World,” Harvard Business Review (May
2007): 22–23.
65. M. E. Porter, Competitive Strategy (New York: Free
Press, 1980): 42.

www.thecocacolacompany.com/heritage/cokelore_newcoke.html

8
No company ever stops changing . . . Each new generation must meet changes—in
the automotive market, in the general administration of the enterprise, and in the
involvement of the corporation in a changing world. The work of creating goes on.
—ALFRED P. SLOAN JR., PRESIDENT OF GENERAL MOTORS 1923–37, CHAIRMAN 1937–56
It is not the strongest of the species that survive, nor the most intelligent, but the one
that is most responsive to change.
—CHARLES DARWIN
You keep same-ing when you ought to be changing.
—LEE HAZLEWOOD, THESE BOOTS ARE MADE FOR WALKING, RECORDED BY NANCY SINATRA, 1966
Industry Evolution and
Strategic Change
◆ Introduction and Objectives
◆ The Industry Life Cycle
● Demand Growth
● Creation and Diffusion of Knowledge
● How General is the Life-Cycle Pattern?
● Implications of the Life Cycle for Competition and
Strategy
◆ The Challenge of Organizational Adaptation and
Strategic Change
● Why is Change So Difficult? The Sources of Organiza-
tional Inertia
● Organizational Adaptation and Industry Evolution
● Coping with Technological Change
◆ Managing Strategic Change
● Dual Strategies and Organizational Ambidexterity
● Combatting Organizational Inertia
● Developing New Capabilities
● Dynamic Capabilities
● Using Knowledge Management to Develop
Organizational Capability
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

190 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Introduction and Objectives
Everything is in a state of constant change—the business environment especially. One of the greatest
challenges of strategic management is to ensure that the firm keeps pace with changes occurring
within its environment.
Change in the industry environment is driven by technology, consumer needs, politics, economic
conditions, and a host of other influences. Some industries have been transformed by these forces. In
the 1980s, telecommunications were dominated by monopolies such as British Telecom, Deutsche Tele-
kom, and AT&T. Now, diverse providers—Vodafone, SoftBank, Comcast, Twitter and WhatsApp (owned
by Facebook)—compete with multiple communications technologies. In other industries—food
processing, railroads, and car rental—change is more gradual and more predictable.
The purpose of this chapter is to help us to understand and manage change. To do this we shall
explore the forces that drive change and look for patterns that can help us to predict how industries are
likely to evolve over time. While each industry follows a unique development path, there are common
drivers of change that give rise to similar patterns of change, thereby allowing us to identify opportu-
nities for competitive advantage.
Understanding, even predicting, change in an industry’s environment is difficult. Adapting to
change is even more so. For individuals, change is disruptive, costly, and uncomfortable. For orga-
nizations, the forces of inertia are even stronger. As a result, the life cycles of firms tend to be much
shorter than the life cycles of industries: changes at the industry level tend to occur through the
death of existing firms and the birth of new firms rather than through continuous adaptation by
a constant population of firms. We need to understand these sources of inertia in organizations
in order to overcome them. We shall look, not only at firms’ adaptation to change, but also at the
potential for firms to initiate change. What determines the ability of some firms to become game-
changers in their industries?
Whether adapting to or initiating change, competing in a changing world requires the development
of new capabilities. Building upon our analysis of organizational capability in Chapters  5 and  6, we
address the challenges firms face in building new capabilities.
By the time you have completed this chapter, you will be able to:
◆ Recognize the different stages of industry development; understand the factors that drive
industry evolution; and recommend strategies appropriate to the different stages of the
industry life cycle.
◆ Understand the sources of organizational inertia, the process of organizational evolution,
and the challenges of technological change.
◆ Become familiar with the different tools to manage strategic change including: organi-
zational ambidexterity, scenarios, crisis management, capability development, dynamic
capabilities, and knowledge management.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 191
The Industry Life Cycle
One of the best-known and most enduring marketing concepts is the product life
cycle.1 Products are born, their sales grow, they reach maturity, they go into decline,
and they ultimately die. If products have life cycles, so the industries that produce them
experience an industry life cycle. To the extent that an industry produces multiple
generations of a product, the industry life cycle is likely to be of longer duration than
that of a single product.
The life cycle comprises four phases: introduction (or emergence), growth, matu-
rity, and decline (Figure 8.1). Let us first examine the forces that drive industry evolu-
tion, and then look at the features of each of these stages. Two forces are fundamental:
demand growth and the production and diffusion of knowledge.
Demand Growth
The life cycle and the stages within it are defined primarily by changes in an industry’s
growth rate over time. The characteristic profile is an S-shaped growth curve.
● In the introduction stage, sales are small and the rate of market penetration is
low because the industry’s products are little known and customers are few.
The novelty of the technology, small scale of production, and lack of experi-
ence mean high costs and low quality. Customers for new products tend to be
affluent, tech-savvy, and risk-tolerant.
● The growth stage is characterized by accelerating market penetration as
technical improvements and increased efficiency open up the mass market.
● Increasing market saturation causes the onset of the maturity stage. Once satu-
ration is reached, demand is wholly for replacement.
● Finally, as new substitute products appear, the industry enters its
decline stage.
INTRODUCTION
GROWTH
MATURITY
DECLINE
In
du
st
ry
S
al
es
Time
FIGURE 8.1 The industry life cycle

192 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Creation and Diffusion of Knowledge
The second driver of the industry life cycle is knowledge. New knowledge is responsible
for an industry’s birth, and the dual processes of knowledge creation and knowledge
diffusion exert a major influence on industry evolution.
In the introduction stage, product technology advances rapidly. There is no domi-
nant product technology, and rival technologies compete for attention. Competition is
primarily between alternative technologies and design configurations:
● The first 30 years of steam ships featured competition between paddles and
propellers, wooden hulls and iron hulls, and, eventually, between coal and oil.
● The beginnings of the personal computer industry during 1978–82 saw compe-
tition between different data storage systems (audiotapes vs. floppy disks), dif-
ferent visual displays (TV receivers vs. dedicated monitors), different operating
systems (CPM vs. DOS vs. Apple II), and different microprocessor architectures.
Dominant Designs and Technical Standards The outcome of competition bet-
ween rival designs and technologies is usually convergence by the industry around
a dominant design—a product architecture that defines the look, functionality, and
production method for the product and becomes accepted by the industry as a whole.
Dominant designs have included:
● The Underwood Model 5 introduced in 1899 established the basic architecture
and main features of typewriters for the 20th century: a moving carriage, the
ability to see the characters being typed, a shift function for upper-case charac-
ters, and a replaceable inked ribbon.2
● Leica’s Ur-Leica camera launched in Germany in 1924 established key features
of the 35 mm camera, though it was not until Canon began mass-producing
cameras based on the Leica original that this design of 35 mm camera came to
dominate still photography.
● When Ray Kroc opened his first McDonald’s hamburger restaurant in Illinois
in 1955, he established what would soon become a dominant design for the
fast-food restaurant industry: a limited menu, no waiter service, eat-in and
take-out options, roadside locations for motorized customers, and a franchising
model for licensing the entire business system.
The concepts of dominant design and technical standard are related but distinct.
Dominant design refers to the overall configuration of a product or system. A technical
standard is a technology or specification that allows compatibility. While technical stan-
dards typically embody intellectual property in the form of patents or copyright, dom-
inant designs usually do not. A dominant design may or may not embody a technical
standard. IBM’s PC established both a dominant design for personal computers and
the “Wintel” standard. Conversely, the Boeing 707 was a dominant design for large
passenger jets, but did not set industry standards in aerospace technology. Technical
standards arise where there are network effects—the need for users to connect with
one another. Network effects cause each customer to choose the same technology as
everyone else to avoid being stranded. Unlike a proprietary technical standard, which is
typically embodied in patents or copyrights, a firm that sets a dominant design does not
normally own intellectual property in that design. Hence, except for some early-mover
advantage, there is not necessarily any profit advantage from setting a dominant design.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 193
Dominant designs also exist in processes. In the flat glass industry, there has been
a succession of dominant process designs from glass cylinder blowing to continuous
ribbon drawing to float glass.3 Dominant designs are present, too, in business models.
In many new markets, competition is between rival business models. In home gro-
cery delivery, e-commerce start-ups such as Webvan and Peapod soon succumbed to
competition from “bricks and clicks” retailers such as Giant, and Walmart (and Tesco
in the UK).
From Product to Process Innovation The emergence of a dominant design marks
a critical juncture in an industry’s evolution. Once the industry coalesces around a
leading product design, there’s a shift from radical to incremental product innovation.
Greater certainty over product design and its trajectory reduces risks to customers and
firms, triggering the industry’s growth phase. The emphasis on efficiency and prod-
uct reliability causes process innovation to take precedence over product innovation
(Figure  8.2). The combination of process improvements, design modifications, and
scale economies results in falling costs, which drive rapidly increasing market pene-
tration. Strategy Capsule 8.1 uses the automobile industry to illustrate this pattern of
development.
Consumer also benefit from knowledge diffusion. As they become increasingly
knowledgeable about the performance attributes of rival manufacturers’ products,
so they are better able to judge value for money and become more price sensitive.
How General is the Life-Cycle Pattern?
To what extent do industries conform to this life-cycle pattern and how variable is the
duration of the life cycle?
● The hotel industry had its origins over two millennia ago. In year 1 AD, the
baby Jesus was born in a stable in Bethlehem because, according to Luke’s
Gospel, “there was no room at the inn.” In the US, hotels (as distinct from inns)
were established in the late 18th century. During the 21st century, the industry
has continued to expand. However, home sharing services such as Airbnb pre-
sent a threat to continued growth.
Time
Product Innovation
Process Innovation
Ra
te
o
f I
nn
ov
at
io
n
FIGURE 8.2 Product and process innovation over time

194 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
● The introduction phase of the US railroad industry extended from the building
of the first railroad, the Baltimore and Ohio in 1827, to the growth phase of the
1870s. With the growth of road transport, the industry entered its decline phase
during the late 1950s.
● Digital audio players (MP3 players) were first introduced by Seehan Information
Systems and Diamond Multimedia in 1997. With the launch of Apple’s iPod
in 2001, the industry entered its growth phase. After reaching a peak in 2009,
global sales of MP3 players, including the iPod, went into steep decline. By
2017, dedicated MP3 players were widely viewed as obsolete.
Over time, industry life cycles have become increasingly compressed—especially
in e-commerce. The implication is that “competing on internet time” requires a radical
rethink of strategies and management processes.4
Patterns of evolution also differ. Industries supplying basic necessities such as res-
idential construction, food processing, and clothing may never enter a decline phase
STRATEGY CAPSULE 8.1
Evolution of the Automobile Industry
The period 1890–1912 was one of rapid product inno-
vation in the auto industry. Karl Benz’s introduction of
a  three-wheel motor carriage in 1886 was followed
by  a  flurry of technical advances which occurred in
Germany, France, the US, and the UK. Developments
included
◆ the first four-cylinder four-stroke engine (by Karl
Benz in 1890);
◆ the honeycomb radiator (by Daimler in 1890);
◆ the manual gearbox (Panhard and Levassor in 1895);
◆ automatic transmission (by Packard in 1904);
◆ electric headlamps (by General Motors in 1908);
◆ the all-steel body (adopted by General Motors
in 1912).
Ford’s Model T, introduced in 1908, with its
front-mounted, water-cooled engine and transmis-
sion with a gearbox, wet clutch, and rear-wheel drive,
became a dominant design for the industry. During the
remainder of the 20th century, alternative technologies
and designs were eliminated. Volkswagen’s Beetle
was the last mass-produced car with a rear-mounted,
air-cooled engine. Citroen abandoned its distinctive
suspension and braking systems. Four-stroke engines
with four or six inline cylinders became dominant. Dis-
tinctive national differences eroded as American cars
became smaller and Japanese and Italian cars became
bigger. The fall of the Iron Curtain extinguished the
last outposts of nonconformity: by the mid-1990s, East
German two-stroke Wartburgs and Trabants were col-
lectors’ items.
As product innovation slowed, so process innova-
tion took off. In 1913, Ford’s Highland Park Assembly
Plant with its revolutionary moving assembly line began
production. The price of the Model T fell from $628 in
1908 to $260 in 1924. By 1927, 15 million Model Ts had
been produced.
Then came Toyota’s system of lean production,
involving a tightly integrated “pull” system of produc-
tion embodying just-in-time scheduling, team-based
production, flexible manufacturing, and total quality
management. By the end of the 20th century, lean produc-
tion had diffused throughout the world’s vehicle industry.
However, by 2018, a new era was dawning: electric
propulsion and autonomous driving threatened to trans-
form the world automobile industry.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 195
because obsolescence is unlikely for essential needs. Some industries may experience
a rejuvenation of their life cycle. The market for TV receivers has experienced multiple
revivals: color TVs, portable TVs, flat-screen TVs, and HDTVs. Similar waves of innova-
tion have revitalized retailing (Figure 8.3).
An industry is likely to be at different stages of its life cycle in different countries.
Although the automobile markets of the EU, Japan, and the US are in their decline
phase, those of Asia and Latin America are in their growth phase. Multinational com-
panies can exploit such differences: developing new products and introducing them
into the advanced industrial countries, then shifting attention to emerging markets once
maturity sets in.
A further feature of industry evolution is shifting industry boundaries—some indus-
tries converge (cell phones, portable game players, cameras, and calculators); other
industries (banking and medical services) fragment.5
Implications of the Life Cycle for Competition and Strategy
Changes in demand growth and technology over the cycle have implications for industry
structure, the population of firms, and competition. Table 8.1 summarizes them.
Product Differentiation The introduction stage typically features a variety of prod-
uct types that incorporate diverse technologies and designs. Convergence around a
dominant design is often followed by commoditization during the mature phase unless
producers develop new dimensions for differentiation. Personal computers, credit
cards, online financial services, wireless communication services, and Internet access
have all become commodity items, which buyers select primarily on price. However,
the trend toward commoditization also creates incentives for firms to create novel
approaches to differentiation.
Organizational Demographics and Industry Structure The number of firms
in an industry changes substantially over the life cycle. The field of organizational
ecology, founded by Michael Hannan, John Freeman, and Glen Carroll, analyzes the
Mail Order,
Catalogue
Retailers
e.g., Sears
Roebuck,
Montgomery
Ward
Chain
Stores
e.g., A&P,
Woolworth’s,
WHSmith
Warehouse
Clubs
e.g., Price Club
Sam’s Club
Department
Stores
e.g., Le Bon
Marché,
Macy’s,
Harrods
Discount
Stores
e.g., Kmart
Walmart
Category
Killers
e.g., Toys “R”
Us, Home
Depot
Internet
Retailers
e.g., Amazon,
Alibaba
Pop-Up
Stores
2000 1980196019401920190018801840
FIGURE 8.3 Innovation and renewal in the industry life cycle: Retailing

196 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
population of firms within an industry and the processes of founding and selection that
determine entry and exit.6 Some of the main findings of the organizational ecologists in
relation to industry evolution are:
● The number of firms in an industry increases rapidly during the early stages of
an industry’s life. As an industry gains legitimacy, failure rates decline and the
rate of new firm foundings increases. The US automobile industry comprised
272 manufacturers in 1909,7 while in TV receivers there were 92 companies in
1951.8 New entrants include both start-up companies (de novo entrants) and
established firms diversifying from other industries (de alio entrants).
● With the onset of maturity, the number of firms begins to fall—often involving
a shakeout phase during which the rate of firm failure increases sharply. After
this point, rates of entry and exit decline and the survival rate for incumbents
increases substantially.9 In the US tire industry, the number of firms grew from
one (Goodrich) in 1896 to 274 in 1922 before shakeout reduced the industry to
49 firms in 1936.10 By 2018, subsequent waves of consolidation resulted in the
TABLE 8.1 The evolution of industry structure and competition over the life cycle
Introduction Growth Maturity Decline
Demand Limited to early adopters:
high income,
avant garde
Rapidly increasing
market penetration
Mass market, replacement/
repeat buying. Cus-
tomers knowledgeable
and price sensitive
Obsolescence
Technology Competing technol-
ogies, rapid product
innovation
Standardization around
dominant tech-
nology, rapid process
innovation
Well-diffused technical
know-how: quest
for technological
improvements
Little product
or process
innovation
Products Poor quality, wide variety
of features and tech-
nologies, frequent
design changes
Design and quality
improve, emergence
of dominant design
Trend to commoditization.
Attempts to differentiate
by branding, quality,
and bundling
Limited scope for
differentiation
Manufacturing
and distribution
Short production runs,
high-skilled labor
content, specialized
distribution channels
Capacity shortages, mass
production, competi-
tion for distribution
Emergence of overcapacity,
deskilling of produc-
tion, long production
runs, distributors carry
fewer lines
Chronic over-
capacity,
reemergence of
specialty channels
Trade Producers and
consumers in
advanced countries
Exports from advanced
countries to
rest of world
Production shifts to newly
industrializing then
developing countries
Exports from coun-
tries with lowest
labor costs
Competition Few companies Entry, mergers, and exits Shakeout, price
competition increases
Price wars, exits
Key success factors Product innovation,
establishing cred-
ible image of firm
and product
Design for manufacture,
access to distribution,
brand building, fast
product development,
process innovation
Cost efficiency through
capital intensity, scale
efficiency, and low
input costs
Low overheads,
buyer selection,
signaling com-
mitment, ratio-
nalizing capacity

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 197
world tire industry being dominated by seven companies: Bridgestone, Michelin,
Continental, Goodyear, Pirelli, Hankook, and Sumitomo.
● Consolidation may be accompanied by a new phase of entry as new firms seek
niche positions in the industry—a process referred to as resource partitioning.
For example, as the world beer industry has become dominated by a few global
giants—AB Inbev, Carlsberg, and Heineken—so a wave of craft brewers have
entered the industry.11
Location and International Trade Industries migrate internationally during their
life cycles. New industries begin in the advanced industrial countries because of the
presence of affluent consumers and the availability of technical and scientific resources.
As demand grows in other countries, they are serviced initially by exports, but with
deskilling of production processes, production shifts first to newly industrializing coun-
tries and eventually to developing countries.
In 1975, the world’s leading producers of television receivers were Japan, US,
Germany, Taiwan, and UK. By 2014, the leading producers were China, Mexico, South
Korea, and India.
The Nature and Intensity of Competition These changes in industry structure
over the life cycle—commoditization, new entry, and international diffusion of pro-
duction—have implications for competition: first, a shift from nonprice competition to
price competition; second, margins shrink as the intensity of competition grows.
During the introduction stage, the battle for technological leadership means that
price competition may be weak, but heavy investments in innovation and market
development depress profitability. The growth phase is more conducive to profitability
as market demand outstrips industry capacity, especially if incumbents are protected
by barriers to entry. With the onset of maturity, increased product standardization and
excess capacity stimulate price competition, especially during shakeout. How intense
this is depends a great deal on the balance between capacity and demand and the
extent of international competition. In food retailing, airlines, motor vehicles, metals,
and insurance, maturity was accompanied by strong price competition and slender
profitability. In household detergents, breakfast cereals, cosmetics, and cigarettes, con-
solidation and strong brands have limited price rivalry and supported high margins.
The decline phase usually involves strong price competition (often degenerating into
destructive price wars) and dismal profit performance.
Key Success Factors and Industry Evolution These same changes in structure
together with changes in demand and technology over the industry life cycle also
have important implications for the sources of competitive advantage at each stage of
industry evolution:
1 During the introductory stage, product innovation is the basis for initial entry and
for subsequent success. Soon, other requirements for success emerge: growing
investment requirements necessitate increased financial resources; product
development needs to be supported by capabilities in manufacturing, marketing,
and distribution.
2 Once the growth stage is reached, the key challenge is scaling up. As the
market expands, product design and manufacturing must adapt to the needs

198 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
of large-scale production. As Figure 8.4 shows, investment in R&D, plant and
equipment, and sales tends to be high during the growth phase. Increased
manufacturing must be matched by widening distribution.
3 With maturity, competitive advantage is increasingly a quest for efficiency, par-
ticularly in industries that tend toward commoditization. Cost efficiency through
scale economies, low wages, and low overheads becomes the key success factor.
Figure 8.4 shows that R&D, capital investment, and marketing are lower in
maturity than during the growth phase.
4 The transition to decline intensifies pressures for cost cutting. It also requires
maintaining stability by encouraging the orderly exit of industry capacity and
capturing residual market demand.
The Challenge of Organizational Adaptation and Strategic Change
We have established that industries change. But what about the companies within
them? Let us turn our attention to business enterprises and consider both the impedi-
ments to change and the means by which change takes place.
12
10
8
6
4
2
0
RO
I
V
al
u
e
A
d
d
ed
/R
ev
en
u
e
Te
ch
n
ic
al
C
h
an
g
e
N
ew
P
ro
d
u
ct
s
%
S
al
es
fr
o
m
N
ew
Pr
o
d
u
ct
s
Pr
o
d
u
ct
R
&
D
/S
al
es
A
g
e
o
f P
la
n
t
an
d
Eq
u
ip
m
en
t
In
ve
st
m
en
t/
Sa
le
s
A
d
ve
rt
is
in
g
/S
al
es
Growth
Maturity
Decline
FIGURE 8.4 Differences in strategy and performance between businesses at
different stages of the industry life cycle
Note: The figure shows standardized means for each variable for businesses at each stage of the life cycle.
Source: C. Anderson and C. Zeithaml, “Stage of the Product Life Cycle, Business Strategy and Business
Performance,” Academy of Management Journal 27 (1984): 5–24.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 199
Why is Change so Difficult? The Sources of
Organizational Inertia
At the heart of all approaches to change management is the recognition that organi-
zations find change difficult. Why is this so? Different theories of organizational and
industrial change emphasize different barriers to change:
● Organizational routines: Evolutionary economists emphasize the fact that
capabilities are based on organizational routines—patterns of coordinated
interaction among organizational members that develop through continual
repetition. The more highly developed are an organization’s routines, the
more difficult it is to develop new routines. Hence, organizations get caught in
competency traps12 where “core capabilities become core rigidities.”13
● Social and political structures: Organizations are both social systems and
political systems. As social systems, organizations develop patterns of interaction
that make organizational change stressful and disruptive.14 As political systems,
organizations develop stable distributions of power; change represents a threat
to the power of those in positions of authority. Hence, both as social systems
and political systems, organizations tend to resist change.
● Conformity: Institutional sociologists emphasize the propensity of firms to
imitate one another in order to gain legitimacy. The process of institutional
isomorphism locks organizations into common structures and strategies that
make it difficult for them to adapt to change.15 The pressures for conformity can
be external—governments, investment analysts, banks, and other resource pro-
viders encourage the adoption of similar strategies and structures. Isomorphism
also results from voluntary imitation—risk aversion encourages companies to
adopt similar strategies and structures to their peers.16
● Limited search: The Carnegie School of organizational theory (associated with
Herbert Simon, Jim March, and Richard Cyert) views search as the primary
source of organizational change. Organizations tend to limit search to areas
close to their existing activities—they prefer exploitation of existing knowledge
over exploration for new opportunities.17 Limited search is reinforced, first, by
bounded rationality—human beings have limited information processing
capacity, which constrains the set of choices they can consider and, second, by
satisficing—the propensity for individuals (and organizations) to terminate the
search for better solutions when they reach a satisfactory level of performance
rather than to pursue optimal performance. The implication is that organizations
are only willing to accept major changes when they are faced with a dramatic
decline in performance.
● Complementarities between strategy, structure, and systems: We encountered
the notion of strategic fit in Chapter 1. A firm’s strategy must fit its external envi-
ronment and its internal resources and capabilities. Moreover, all the compo-
nents of a firm’s strategy must fit together: we observed that strategy is manifest
as an activity system. Ultimately, all the features of an organization—strategy,
structure, systems, culture, goals, and employee skills—are complemen-
tary.18 Organizations establish combinations of strategy, processes, structures,
and management styles during their early phases of development that are
shaped by the circumstances that they encounter. However, once established,

200 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
this configuration becomes a barrier to change. For the firm to adapt to new
circumstances, it is not enough to make incremental changes in a few dimen-
sions of strategy—it is likely that the firm will need to find a new configura-
tion that involves a comprehensive set of changes (Strategy Capsule 8.2).19
As a result, organizations tend to evolve through a process of punctuated
equilibrium, involving long periods of stability during which the widening mis-
alignment between the organization and its environment ultimately forces rad-
ical and comprehensive change on the company.20
Organizational Adaptation and Industry Evolution
Thinking about industrial and organizational change has been strongly influenced by
ideas from evolutionary biology. Evolutionary change is viewed as an adaptive process
STRATEGY CAPSULE 8.2
A Tight-Fitting Business System Makes Change Perilous:
The liz Claiborne Story
During the 1980s, Liz Claiborne became a highly suc-
cessful designer, manufacturer, and retailer of clothes for
professional women. Liz Claiborne’s success was based
upon a strategy that combined a number of closely
linked choices concerning functions and activities.
◆ Design was based around a “color by numbers”
approach involving “concept groups” of different gar-
ments that could be mixed and matched.
◆ Department stores were encouraged to provide
dedicated space to present Liz Claiborne’s con-
cept collections. Liz Claiborne consultants visited
department stores to train their sales staff and to
ensure that the collections were being displayed
correctly.
◆ Retailers could not purchase individual garment
lines; they were required to purchase the entire con-
cept group and had to submit a single order for each
season—they could not reorder.
◆ Most manufacturing was contracted out to garment
makers in SE Asia.
◆ To create close contact with customers, Liz Clai-
borne offered fashion shows at department stores,
“breakfast clinics” where potential customers could
see the latest collection, and tracked customer pref-
erences through point-of-sale data collection.
◆ Rather than the conventional four-season product
cycle, Liz Claiborne operated a six-season cycle.
During the 1990s, Liz Claiborne’s performance went
into a sharp decline. The key problem was the trend
toward more casual clothes in the workplace. Moreover,
financial pressures on department stores made them
less willing to buy complete collections. As a result, Liz
Claiborne allowed reordering by retailers. However,
once retailers could split orders into smaller, more fre-
quent orders, the entire Liz Claiborne system began to
break down: it could not adapt to the quick-response,
fast-cycle model that was increasingly dominant within
the garment trade. In 1994, Liz Claiborne appointed a
new CEO who systematically rebuilt the business around
a more casual look, more flexibility within its collec-
tions (although still with a common “color card”), and a
shorter supply chain, with most production in North and
Central America.
Source: N. Siggelkow, “Change in the Presence of Fit: The Rise,
the Fall, and the Renaissance of Liz Claiborne,” Academy of
Management Journal 44 (2001): 838–857.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 201
that involves variation, selection, and retention.21 Different research traditions focus on
different levels at which these evolutionary processes occur:
● Organizational ecology has been discussed in relation to changes in the number
of firms in an industry over time. However, organizational ecology is a broader
theory of economic change that assumes organizational inertia. As a result,
industry evolution occurs through changes in the population of firms rather
than by adaptation of firms themselves. Industries develop and grow through
new entry spurred by the imitation of initial successful entrants. The competitive
process is a selection mechanism, in which organizations whose characteristics
match the requirements of their environment can attract resources; those that do
not are eliminated.22
● Evolutionary economics emphasizes change within individual firms. The
processes of variation, selection, and retention take place at the level of the
organizational routine—unsuccessful routines are abandoned; successful rou-
tines are retained and replicated within the organization.23 As we discussed in
Chapter 5, these patterns of coordinated activity are the basis for organizational
capability. Firms evolve through searching for new routines, replicating success-
ful routines, and abandoning unsuccessful routines.
While the membership of most industries changes dramatically over time, some
firms show a remarkable capacity for adaptation. BASF has been one of the world’s
leading chemical companies since it was founded in 1865 to produce synthetic dyes.
Exxon and Shell have led the world’s petroleum industry since the late 19th century.24
Mitsui Group, a Japanese conglomerate, is even older—its first business, a retail store,
was established in 1673.
Yet these companies are exceptions. Among the companies forming the original
Dow Jones Industrial Average in 1896, only General Electric remained in the index
until it was dropped in July 2018. Of the world’s 12 biggest companies in 1912, none
remained in the top 12 by 2018 (Table 8.2). And life spans are shortening: the average
period in which companies remained in the S&P 500 was 90 years in 1935; in 1958 it
was 61 years; by 2011 it was down to 18 years.
The demise of great companies partly reflects the rise of new industries—notably
the information and communications technology (ICT) sector, but also the failure of
established firms to adapt successfully to the life cycles of their own industries.
Even if the pattern of industry evolution can be predicted, different stages of the life
cycle require different resources and capabilities. The innovators that pioneer the
creation of a new industry are typically different companies from the “consolidators”
that develop it:
The skills, mind-sets, and competences needed for discovery and invention are not
only different from those needed for commercialization; they conflict with the needed
characteristics. This means that the firms good at invention are unlikely to be good at
commercialization and vice versa.25
The typical pattern is that technology-based start-ups that pioneer new areas of
business are acquired by companies that are well established in closely related indus-
tries, and these established incumbents offer the financial resources and functional
capabilities needed to grow start-ups. In plant biotechnology, the pioneers were start-
ups such as Calgene, Cetus Corporation, DNA Plant Technologies, and Mycogen;

202 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
by 2018, the leading suppliers of genetically modified seeds were Bayer (which
acquired Monsanto), ChemChina (which acquired Syngenta), and DowDuPont—all
long-established chemical firms. Of course, some start-ups do survive industry shake-
outs and acquisition to become industry leaders: Google, Cisco Systems, and Face-
book are examples. Geoffrey Moore describes the transition from a start-up serving
early adopters to an established business serving mainstream customers as “crossing
the chasm.”26
In most new industries, we find a mixture of start-up companies (de novo entrants)
and established companies that have diversified from other sectors (de alio entrants).
Which is more successful depends upon whether the flexibility and entrepreneurial
advantages of start-ups outweigh the superior resources and capabilities of established
firms. This further depends upon whether the resources and capabilities required in the
new industry are similar to those present in an existing industry. Where these linkages
are close, de alio entrants are at an advantage: in automobiles, former bicycle, carriage,
and engine manufacturers tended to be the best performers;27 television production
was dominated by former producers of radios.28
Many start-up ventures also draw resources and capabilities from established firms.
A high proportion of new ventures are established by former employees of existing
firms within that sector. In Silicon Valley, most of the leading semiconductor firms,
including Intel, trace their origins to Shockley Semiconductor Laboratories, the pioneer
of integrated circuits.29 Established companies are often important investors in new
ventures. Investors in Uber include the Chinese Internet giant Baidu and the founders
of Amazon, Napster, and Yelp.
TABLE 8.2 World’s biggest companies in terms of market capitalization,
1912 and 2018
1912 $billion 2018 $billion
US Steel 0.74 Apple 876
Standard Oil NJ (Exxon) 0.39 Alphabet 737
J&P Coates 0.29 Microsoft 658
Pullman 0.20 Amazon 567
Royal Dutch Shell 0.19 Facebook 511
Anaconda 0.18 Tencent 496
General Electric 0.17 Berkshire Hathaway 488
Singer 0.17 Alibaba 441
American Brands 0.17 Johnson & Johnson 376
Navistar 0.16 JP Morgan Chase 371
British American Tobacco 0.16
De Beers 0.16
Sources: L. Hannah “Marshall’s ‘Trees’ and the Global ‘Forest’: Were ‘Giant Redwoods’ Different?” in N. Lamoreaux, D.
Raff, and P. Temin (eds), Learning by Doing in Markets, Firms and Nations, Chicago: University of Chicago Press, 1999:
253–94; Financial Times (January 3, 2018).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 203
Coping with Technological Change
Competition between new start-ups and established firms is not restricted to the early
phases of an industry’s life cycle: it is ongoing. The threat that newcomers pose to
established firms is greatest during periods of technological change—especially when
the new technology is “competence destroying,” “architectural,” or “disruptive.”
Competence Enhancing and Competence Destroying Technological Change
Some technological changes undermine the resources and capabilities of established
firms—according to Tushman and Anderson, they are “competence destroying.” Other
changes are “competence enhancing”—they preserve, even strengthen, the resources
and capabilities of incumbent firms.30 The quartz watch radically undermined the compe-
tence base of mechanical watchmakers. Conversely, the turbofan, a major advance in jet
engine technology, reinforced the capability base of existing aero engine manufacturers.
Architectural and Component Innovation The ease with which established firms
adapt to technological change depends upon whether the innovation occurs at the
component or the architectural level. Innovations that change the overall architecture
of a product create great difficulties for established firms because an architectural inno-
vation requires a major reconfiguration of a company’s strategy and activity system.31
In automobiles, the hybrid engine was an important innovation but did not require
a major reconfiguration of car design and engineering. The battery-powered electric
motor is an architectural innovation—it requires redesign of the entire car and involves
carmakers in creating systems for recharging. In many sectors of e-commerce—online
grocery purchases and online banking—the internet involved innovation at the com-
ponent level (it provided a new channel of distribution for existing products). Hence,
existing supermarket chains and established retail banks with their clicks and bricks
business models have dominated online groceries and online financial services. The
rise of Boeing during the 1960s to become the world’s leading producer of passenger
aircraft was primarily because of its recognition that the jet engine was an architectural
innovation that necessitated a major redesign of airplanes.32
Disruptive Technologies Clay Christiansen distinguishes between new technology
that is sustaining—it augments existing performance attributes—and new technology
that is disruptive—it incorporates different performance attributes than the existing
technology.33
Steam-powered ships were initially slower, more expensive, and less reliable than
sailing ships. The leading shipbuilders failed to make the transition to steam power
because their leading customers, the transoceanic shipping companies, remained loyal
to sail until the closing decades of the 19th century. Steam power was used mainly
for inland waters, which lacked constant winds. After several decades of gradual
development for these niche markets, stream-powered ships were able to outperform
sailing ships on ocean routes.
In the disk-drive industry, some technological innovations—such as thin-film heads
and more finely dispersed ferrous oxide coatings—enhanced the dominant performance
criterion—recording density—reinforcing the market positions of established industry
leaders. Other disk-drive technologies, notably new product generations with smaller
diameters, were disruptive: established companies lagged behind newcomers in
launching the new disk sizes and typically lost their industry leadership.34 They stored
less data and were resisted by major customers. Thus, the 3.5-inch disk was introduced

204 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
by Connor Peripherals (mainly for use in laptop computers), but was initially rejected
by industry leader, Seagate. Within three years, the rapid development of the 3.5-inch
disk had rendered the 5.25-inch disk obsolete.35
Managing Strategic Change
Given the many barriers to organizational change and the difficulties that companies
experience in coping with disruptive technologies and architectural innovation, how
can companies adapt to changes in their environment?
Just as the sources of organizational inertia are many, so too are the theories and
methods of organizational change. Until the 1980s, most approaches to organizational
change were based upon the behavioral sciences and emphasized bottom-up, decen-
tralized initiatives. Socio-technical systems emphasized the need for social systems to
adapt to the requirements of new technologies,36 while organizational development
(OD) emphasized group dynamics and the role of “change agents.”37
More recently, managing change has become a central topic within strategic
management practice and research. In this section, we review four approaches to
managing strategic change. We begin with the challenge of managing for today while
preparing for tomorrow and discuss the potential for organizational ambidexterity.
Second, we examine management tools for counteracting organizational inertia. Third,
we explore the means by which companies develop new capabilities. Fourth, we
address the role and nature of dynamic capabilities. Finally, we examine the contri-
bution of knowledge management.
Dual Strategies and Organizational Ambidexterity
In Chapter 1, we learned that strategy has two major dimensions: positioning for the
present and adapting to the future. Reconciling the two is difficult. Derek Abell argued
that “managing with dual strategies”—in terms of “lavishing attention on those factors
that are critical to short-term success” while “changing a business in anticipation of the
future”—is the most challenging dilemma that senior managers face.38
Abell argues that dual strategies require dual planning systems: short-term planning
that focuses on strategic fit and performance over a one- or two-year period; and
longer-term planning to develop vision, reshape the corporate portfolio, redefine and
reposition individual businesses, develop new capabilities, and redesign organizational
structures over periods of five years or more. This challenge of reconciling “competing
for today” with “preparing for tomorrow” is closely related to the tradeoff between
exploitation and exploration that we discussed in relation to organizational inertia.
Charles O’Reilly and Michael Tushman use the term “organizational ambidexterity”
to refer to the capacity to reconcile exploration with exploitation. The ambidextrous
firm is “capable of simultaneously exploiting existing competences and exploring new
opportunities.”39 There are two approaches to creating organizational ambidexterity:
structural and contextual.
Structural Ambidexterity involves creating organizational units for exploration
activities that are separate from the core operational activities of the company.40 For
example:
● IBM developed its PC in a separate unit in Florida—far from IBM’s corporate
headquarters in New York. Its leader, Bill Lowe, claimed that this separation was

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 205
critical to creating a business system that was radically different from IBM’s ver-
tically integrated mainframe business.41
● Shell’s GameChanger program was established to develop new avenues for
future growth by exploiting innovations and entrepreneurial initiatives that
would otherwise be stifled by Shell’s financial system and organizational
structure.42
The key challenge is whether the initiatives fostered within the “exploration” unit will
lead change within the organization as a whole. Xerox’s Palo Alto Research Center
developed many of the innovations that drove the microcomputer revolution of the
1980s and 1990s, but few of these innovations were exploited by Xerox itself. Similarly,
the innovative business system established by General Motors’ Saturn division did little
to turn GM into “a new kind of car company.”43
Contextual ambidexterity involves the same organizational units and the same
organizational members pursuing both exploratory and exploitative activities. At Oticon,
the Danish hearing aid company, employees were encouraged to sustain existing prod-
ucts while pursuing innovation and creativity.44 Under the slogan “Innovation from
Everyone, Everywhere,” Whirlpool sought to embed innovation throughout its existing
organization.45 The problem of contextual ambidexterity is that the management sys-
tems and the individual behaviors required for exploitation are incompatible with those
needed for exploration.
Combatting Organizational Inertia
If organizational change follows a process of punctuated equilibrium in which periods
of stability are interspersed by periods of intense upheaval, what precipitates these
episodes of transformational change? Corporate restructuring, involving simultaneous
changes in strategy, structure, management systems, and top management personnel,
typically follows declining performance. For example, the oil and gas majors under-
went far-reaching restructuring during 1986–92 following the oil price decline of 1986.46
During 2017, consumer goods giants Unilever, Procter & Gamble, and Nestle all initi-
ated major restructuring programs in response to sluggish sales, declining profitability,
and takeover threats. A challenge for top management is to undertake large-scale
change before being pressured by declining performance. This may require managers
to let go of the beliefs that wed them to the prevailing strategy. Polaroid’s failure to
adapt to digital imaging despite developing leading-edge digital-imaging capabilities
can be attributed to top management’s entrenched beliefs about the company and its
strategy.47
Creating Perceptions of Crisis Crises create the conditions for strategic change
by loosening the organization’s attachment to the status quo. The problem is that
by the time the organization is engulfed in crisis it may already be too late. Hence,
leaders may foster the perception of impending crisis so that necessary changes can
be implemented well before a real crisis emerges. At General Electric, even when the
company was reporting record profits, Jack Welch was able to convince employees
of the need for change in order to defend against emerging threats. Andy Grove’s
dictum “Only the paranoid survive” helped Intel to maintain a continual striving for
improvement and development despite its dominance of the market for PC micro-
processors.

206 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Establishing Stretch Targets Another approach to counteracting organizational
inertia is to continually pressure the organizations by setting ambitious performance
targets. Stretch goals can motivate creativity and initiative while attacking compla-
cency. Stretch goals are usually quantitative and short term; however, they also relate to
long-term strategic goals. A key role of vision statements and ambitious strategic intent
is to create a sustained sense of ambition and organizational purpose. These ideas are
exemplified by Collins and Porras’ notion of “Big Hairy Ambitious Goals” that I dis-
cussed in Chapter 1. Apple’s success in introducing “insanely great” new products owes
much to Steve Jobs imposing seemingly impossible goals on his product development
teams. For the iPod he insisted that it should store thousands of songs, have a battery
life exceeding four hours, and be smaller and thinner than any existing MP3 player.48
Corporate-Wide Initiatives as Catalysts of Change Chief executives are limited
in their ability to initiate and implement organization-wide change. However, by a
combination of authoritative and charismatic leadership, they may be able to pioneer
specific initiatives with a surprisingly extensive impact. Corporate initiatives sponsored by
the CEO are effective for disseminating strategic changes, best practices, and management
innovations. At General Electric, Jack Welch was an especially effective exponent of using
corporate initiatives to drive organizational change. These were built around communi-
cable and compelling slogans such as “Be number 1 or number 2 in your industry,” “GE’s
growth engine,” “boundarylessness,” “six-sigma quality,” and “destroy-your-business-dot-
com.” Leaders can also have a profound impact through symbolic actions. A key incident
in the transformation of the Qingdao Refrigerator Plant into Haier, one of the world’s
biggest appliance companies, was when the CEO, Zhang Ruimin, took a sledgehammer
to defective refrigerators in front of the assembled workforce.49
Reorganizing Company Structure By reorganizing the structure, top management
can redistribute power, reshuffle top management, and introduce new blood. One
of the last major actions of CEO Steve Ballmer before retiring in August 2013 was to
reorganize Microsoft’s divisional structure in order to break down established power
centers and facilitate the transition to a more integrated company. Activist investor,
Nelson Peltz, has urged Procter & Gamble to reorganize around three operating units
as a means of reducing corporate power and stimulating innovation and efficiency.50
Periodic changes in organizational structure can stimulate decentralized search and
local initiatives while encouraging more effective exploitation of the outcomes of such
search.51 Reconciling the benefits of integration and flexibility may require organiza-
tions to oscillate between periods of decentralization and periods of centralization.52
New Leadership If strategic change is hampered by management’s adherence to
outmoded beliefs or if the existing team lacks the diversity of opinion and outlook for
new strategic thinking, then an outsider may be needed to lead change. Evidence of
the relative performance of internal and external CEOs is mixed. However, if an orga-
nization is performing poorly, an external CEO tends to be more effective at leading
change than an internal appointment.53 Certainly, the crisis that engulfed Uber Tech-
nologies in 2017 made it essential to appoint a new CEO from outside the company.
Scenario Analysis Adapting to change requires anticipating change. Yet predicting
the future is hazardous, if not impossible. “Only a fool would make predictions espe-
cially about the future,” remarked movie mogul Samuel Goldwyn. But the inability to
predict does not preclude preparing for change. Scenario analysis is a systematic way
of thinking about how the future might unfold. Scenario analysis is not a forecasting

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 207
technique, but a process for thinking about and analyzing the future by drawing upon
a broad range of information and expertise.
Herman Kahn, who pioneered their use first at the Rand Corporation, defined sce-
narios as “hypothetical sequences of events constructed for the purpose of focusing
attention on causal process and decision points.”54 The multiple-scenario approach
constructs several distinct, internally consistent views of how the future may look
5–50 years ahead. Its key value is in combining the interrelated impacts of a wide
range of economic, technological, demographic, and political factors into a few dis-
tinct alternative stories of how the future might unfold. Scenario analysis can be either
qualitative or quantitative or a combination of the two. Quantitative scenario analysis
builds simulation models to identify likely outcomes. Qualitative scenarios typically
take the form of narratives and can be particularly useful in engaging the insight and
imagination of decision makers.
Scenario analysis is used to explore paths of industry evolution, the development
of particular countries, and the impact of new technology. However, as with most
strategy techniques, the value of scenario analysis is not in the results but in the
process. Scenario analysis is a powerful tool for communicating different ideas and
insights, surfacing deeply held beliefs and assumptions, identifying possible threats
and opportunities, generating and evaluating alternative strategies, encouraging more
flexible thinking, and building consensus. Evaluating different strategies under differ-
ent scenarios can help identify which strategies are most robust and force managers to
address “what if?” questions. Strategy Capsule 8.3 outlines the use of scenarios at Shell.
Developing New Capabilities
Ultimately, adapting to a changing world requires developing the capabilities needed
to renew competitive advantage. In Chapter 6, we saw that developing organizational
capability is an essential task for strategy implementation. Yet, for established organiza-
tions—both for-profit and not-for-profit—creating new capabilities represents a formi-
dable challenge. To understand why, let us consider where do capabilities come from?
The Origins of Organizational Capability: Early Experiences and Path Depen-
dency As Table 8.3 illustrates, a company’s distinctive capabilities can often be traced
back to the circumstances which prevailed during its founding and early development.
They are subject to path dependency—a company’s capabilities today are the result
of its history.55
The examples in Table 8.3 are troubling for managers in established companies: if a
firm’s capabilities are determined during the early stages of its life, is it really possible
to develop the new capabilities needed to adapt to changes? Established capabilities
embedded within organizational structure and culture present formidable barriers to
building new capabilities. Indeed, the more highly developed a firm’s organizational
capabilities, the greater the barrier they create. Because Dell Computer’s direct sales
model was so highly developed, Dell found it difficult to adapt to selling through retail
outlets as well. Hence the argument that core capabilities are simultaneously core
rigidities.56
Developing Capabilities Sequentially In Chapter 6, we saw that developing capa-
bilities requires putting in place processes, organizational structure, and motivation.
However, identifying the essential components of organizational capability provides
limited guidance to managers seeking to create a new capability. The key challenge is

208 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
not obtaining the necessary resources: it is integrating them through establishing and
developing processes through routinization and learning, building structure, motivating
the people involved, and aligning the new capability with other aspects of the organi-
zation, the demands upon management are considerable. Hence, an organization must
limit the number and scope of the capabilities that it is attempting to create at any point
in time. This implies that capabilities need to be developed sequentially rather than all
at once.
The task is further complicated by the fact that we have limited knowledge about
how to manage capability development. Hence, it may be helpful to focus not on
the organizational capabilities themselves but on developing and supplying the prod-
ucts that use those capabilities. A trajectory through time of related, increasingly
STRATEGY CAPSULE 8.3
Multiple-Scenario Development at Shell
Royal Dutch Shell has used scenarios as a basis for
long-term strategic planning since 1967. Mike Pocock,
Shell’s former chairman, observed: “We believe in basing
planning not on single forecasts, but on deep thought
that identifies a coherent pattern of economic, political,
and social development.”
Shell’s scenarios are critical to the transition of its
planning function from producing plans to leading a
process of dialogue and learning, the outcome of which
is improved decision making by managers. This involves
continually challenging current thinking within the
group, encouraging a wider look at external influences
on the business, and forging coordination among Shell’s
200+ subsidiaries.
Shell’s global scenarios are prepared every four or
five years by a team comprising corporate planning
staff, executives, and outside experts. Economic, political,
technological, and demographic trends are analyzed up
to 50 years into the future. In 2014, Shell identified two
global scenarios for the period to 2060:
◆ Mountains: A world where current elites retain
their power, manage for stability, and “unlock
resources steadily and cautiously, not solely dictated
by immediate market forces. The resulting rigidity
within the system dampens economic dynamism
and stifles social mobility.”
◆ Oceans: A world of devolved power where “com-
peting interests are accommodated and compro-
mise is king. Economic productivity surges on a huge
wave of reforms, yet social cohesion is sometimes
eroded and politics destabilized . . . giving immediate
market forces greater prominence.”
Once approved by top management, the scenarios
are disseminated by reports, presentations, and work-
shops, where they form the basis for long-term strategy
discussion by business sectors and operating companies.
Shell is adamant that its scenarios are not forecasts. They
represent carefully thought-out stories of how the various
forces shaping the global energy environment of the future
might play out. Their value is in stimulating the social and
cognitive processes through which managers envisage
the future: “They are designed to stretch management to
consider even events that may be only remotely possible.”
According to former CEO Jeroen van der Veer: “the impera-
tive is to use this tool to gain deeper insights into our global
business environment and to achieve the cultural change
that is at the heart of our group strategy.”
Sources: A. de Geus, “Planning as Learning,” Harvard Business
Review (March/April 1988): 70–4; P. Schoemacher, “Multiple Sce-
nario Development: Its Conceptual and Behavioral Foundation,”
Strategic Management Journal 14 (1993): 193–214; Royal Dutch
Shell, New Lens Scenarios: A Shift in Perspective for a World in
Transition (2014).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 209
sophisticated products allows a firm to develop the “integrative knowledge” that is at
the heart of organizational capability.57 Consider Panasonic’s approach to developing
manufacturing capabilities in emerging markets:
In every country batteries are a necessity, so they sell well. As long as we bring a
few advanced automated pieces of equipment for the processes vital to final product
quality, even unskilled labor can produce good products. As they work on this rather
simple product, the workers get trained, and this increased skill level then permits us
to gradually expand production to items with increasingly higher technology levels,
first radios, then televisions.58
TABLE 8.3 Childhood experiences shape distinctive capabilities
Company Distinctive capability Early history
Walmart Stores Inc. Supply chain management Walmart stores were initially located in
small towns in Arkansas and Oklahoma.
With vendors unable to provide reli-
able distribution, Walmart built its own
warehouses and designed its own
hub-and-spoke distribution system
Exxon Mobil Inc. Financial management (espe-
cially capital budgeting)
Exxon and Mobil were both members of
Rockefeller’s Standard Oil Trust. Exxon’s
predecessor was Standard Oil New Jer-
sey, the holding company for the group
with primary responsibility for financial
management
Royal Dutch Shell Adaptability to local conditions
in over 120 countries
The original parents were established
with headquarters in Europe to man-
age operations thousands of miles
away: Royal Dutch Petroleum had oil-
fields in Indonesia; Shell Transport and
Trading bought oil products in Russia
for sale in the Far East. Both developed
highly decentralized, locally adaptable
organizations
Eni SpA Host country relations As a newcomer in the industry where the
established majors controlled most of
the world’s known reserves, Eni’s initial
internationalization involved innovative
partnership agreements with producer
governments
Toyota Motor Corp. Lean production “Lean production”—a combination of
kaizen (continuous improvement),
just-in-time supply chain management,
and total quality management
developed in the aftermath of World War
II when acute shortages of materials and
finance forced Toyota to be fastidious
in avoiding waste and minimizing
work-in-progress

210 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
The key to such a sequential approach is for each stage of development to be linked
not just to a specific product (or part of a product) but also to a clearly defined set of
capabilities. Strategy Capsule 8.4 outlines Hyundai’s sequential approach to capability
development.
STRATEGY CAPSULE 8.4
Hyundai Motor: Developing Capabilities through Product
Sequencing
Hyundai’s emergence as a world-class automo-
bile producer is a remarkable example of capability
development over a sequence of compressed phases
(Figure  8.5). Each phase of the development process
was characterized by a clear objective in terms of prod-
uct outcome, a tight time deadline, an empowered
development team, a clear recognition of the capabil-
ities that needed to be developed in each phase, and
an atmosphere of impending crisis should the project
not succeed. The first phase was the construction of
an assembly plant in the unprecedented time of 18
months in order to build Hyundai’s first car—a Ford
Cortina imported in semi-knocked down (SKD) form.
Subsequent phases involved products of increasing
sophistication and the development of more advanced
capabilities.
FIGURE 8.5 Phased development at Hyundai Motor, 1968–95
Source: Draws upon L. Kim, “Crisis construction and organizational learning: Capability building and catching
up at Hyundai Motor,” Organizational Science 9 (1998): 506–521.
1970 1974 1985 1994–95
• Large-scale design
integration
• Global logistics
• Life-cycle engineering
• Assembly
• Production
engineering
• Local
marketing
• Hydrodynamics
• Thermodynamics
• Fuel engineering
• Emission control
• Lubrication
• Kinetics and vibration
• Ceramics
• Electronic control
systems
CAPABILITIES
PRODUCTS
Accent
Avante
Sonata
• Auto styling
and design
• Casting and
forging
• Chassis
design
• Tooling
• Body
production
• Export
marketing
• FWD
engineering
• CAD/CAM
• Assembly
control
systems
• Advanced
component
handling
1968
SKD/CKD
Ford Cortina
Pony
”Alpha”
engine
Excel

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 211
Dynamic Capabilities
The ability of some firms (e.g., IBM, General Electric, 3M, Toyota, and Tata Group) to
repeatedly adapt to new circumstances while others stagnate and die, suggests that the
capacity for change is itself an organizational capability. David Teece and his colleagues
introduced the term dynamic capabilities to refer to a “firm’s ability to integrate, build,
and reconfigure internal and external competences to address rapidly changing envi-
ronments.”59
Despite a lack of consensus over definition, common to most conceptions of dynamic
capabilities is that they are “higher-order” capabilities that orchestrate change among
lower-level “ordinary” or “operational” capabilities. Teece proposes that “dynamic capa-
bilities can be disaggregated into the capacity (1) to sense and shape opportunities
and threats, (2) to seize opportunities, and (3) to maintain competitiveness through
enhancing, combining, protecting, and, when necessary, reconfiguring the business
enterprise’s intangible and tangible assets.”60 However, this does not help us much when
trying to identify the dynamic capabilities a company possesses, or in distinguishing
dynamic from ordinary capabilities. To facilitate the identification of dynamic capa-
bilities, it is therefore useful to equate dynamic capabilities with “specific and iden-
tifiable processes”61 and “patterned and routine”62 behavior (as opposed to ad hoc
problem solving).
IBM offers an example of how management processes can build higher-level dynamic
capabilities. Under the leadership of three CEOs—Lou Gerstner, Sam Palmisano, and
Ginni Rometty—IBM’s Strategic Leadership Model comprised a number of processes
designed to sense new business opportunities and then fund their development into
new business initiatives. Strategy Capsule 14.3 in Chapter 14 outlines IBM’s strategic
management system.63
Using Knowledge Management to Develop
Organizational Capability
Since the early 1990s, the development of capabilities by organizations has been
profoundly influenced by a set of concepts and practices referred to as knowledge
management. Knowledge management comprises a range of management organi-
zational processes and practices whose common feature is their goal of generating
value from knowledge.64 Knowledge management includes many long-established orga-
nizational functions such as R&D, management information systems, employee training,
and managing intellectual property, even strategic planning; however, at its core it
comprises:
● The application of information technology to management processes—espe-
cially the use of databases, intranets, expert systems, and groupware for storing,
analyzing, and disseminating information.
● The promotion of organizational learning—including best practices
transfer, “lessons learned” from ongoing activities, and processes for
sharing know-how.

212 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
These two areas of knowledge management correspond to the two principal types
of knowledge—knowing about and knowing how65:
● Knowing about is explicit: it comprises facts, theories, and sets of instructions.
Explicit knowledge can be communicated at negligible marginal cost between
individuals and across space and time. This ability to disseminate knowledge
such that any one person’s use does not limit anyone else’s access to the same
knowledge means that explicit knowledge has the characteristic of a public
good: once created, it can be replicated among innumerable users at low cost.
Information and communication technologies play a major role in storing, ana-
lyzing, and disseminating explicit knowledge.
● Know-how is tacit in nature: it involves skills that are expressed through their
performance (riding a bicycle, playing the piano). Such tacit knowledge cannot
be directly articulated or codified. It can only be observed through its applica-
tion and acquired through practice. Its management requires socially embedded
person-to-person processes.
If explicit knowledge can be transferred so easily, it is seldom the foundation
of sustainable competitive advantage. It is only secure from rivals when it is pro-
tected, either by intellectual property rights (patents, copyrights, trade secrets) or by
secrecy (“The formula for Coca-Cola will be kept in a safe in the vault of our Atlanta
headquarters guarded by heavily-armed Coca-Cola personnel.”). The challenge of
tacit knowledge is the opposite. The Roca brothers’ Catalan restaurant, El Celler
de Can Roca, has been declared the world’s best restaurant. If their culinary skills
have been acquired through intuition and learning-by-doing, how do they transfer
this know-how to the chefs and managers of their new restaurant in Barcelona’s
Hotel Omm?
To build organizational capability, individual know-how must be shared within the
organization. Replicating knowledge in a new location requires making know-how
explicit. This systematization is the basis of McDonald’s incredible growth, but is
more difficult for a Michelin three-starred restaurant. For consulting companies,
the distinction between tacit (personalized) and explicit (systematized) knowledge
defines their business model and is a central determinant of their strategy.66 More-
over, while systematization permits internal replication, it also facilitates imitation by
rivals. The result is a “paradox of replication.” In order to utilize knowledge to build
organizational capability, we need to replicate it; and replication is much easier if the
knowledge is in explicit form.67
Knowledge Management Activities That Contribute to Capability Development
Knowledge management can be represented as a series of activities that contribute to
capability development by building, retaining, accessing, transferring, and integrating
knowledge. Table 8.4 lists several knowledge management practices.
However, the contribution of knowledge management to capability development
in organizations may be less about specific techniques and more about the

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 213
TABLE 8.4 Knowledge management practices
Knowledge process Contributing activities Explanation and examples
Knowledge identification Intellectual property
management
Corporate yellow pages
Firms are devoting increased effort to identifying and
protecting their intellectual property, and patents
especially
BP’s Connect comprises personnel data that allows each
employee to identify the skills and experience of other
employees in the organization
Knowledge measurement Intellectual capital accounting Skandia’s intellectual capital accounting system pio-
neered the measurement and valuation of a firm’s
stock of knowledge. Dow Chemical uses intellectual
capital metrics to link its patent portfolio to share-
holder value
Knowledge retention Lessons learned The US Army’s Center for Lessons Learned distils the
results of maneuvers, simulated battles, and actual
operations into tactical guidelines and recommended
procedures. Most consulting firms have post project
reviews to capture the knowledge gained from
each project
Knowledge transfer
and sharing
Databases Project-based organizations typically store knowledge
generated by client assignments in search-
able databases
Communities-of-practice Communities of practice are informal, self-
organizing networks for transferring experiential
knowledge among employees who share the same
professional interests
Best practice transfer Where operations are geographically dispersed, differ-
ent units are likely to develop local innovations and
improvements. Best practice methodology aims to iden-
tify then transfer superior practices
Data analysis Big data “Big data” refers to the collation and analysis of huge data
sets such as Walmart’s more than one million customer
transactions each hour and UPS’s tracking of its 16.3
million packages per day and telematic data for its
46,000 vehicles
insight that the knowledge-based view of the firm has given to organizational
performance and the role of management. For example, Ikujiro Nonaka’s model of
knowledge creation offers penetrating insights into the organizational processes
through which knowledge is created and value is created from knowledge (Strategy
Capsule 8.5).

214 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Source: Based upon I. Nonaka, “A Dynamic Theory of Organizational Knowledge Creation,”
Organization Science 5 (1994): 14–37.
FIGURE 8.6 Knowledge conversion
Individual Organization
Explicit
Tacit
Skills,
Know-how
Organizational
routines
Ty
p
es
o
f K
n
o
w
le
d
g
e
Levels of knowledge
Facts, Information,
Scientif ic kn.
Databases, Rules,
Systems, IP
Internalization
Externalization
CRAFT
ENTERPRISES
INDUSTRIAL
ENTERPRISES
Combination
Socialization
Routinization
Sys
tem
ati
zat
ion
STRATEGY CAPSULE 8.5
Knowledge Conversion and Knowledge Replication
Ikujiro Nonaka’s theory of knowledge creation argues
that knowledge conversion between tacit and explicit
forms and between individual and organizational levels
produces a “knowledge spiral” in which the organization’s
stock of knowledge broadens and deepens. For example,
explicit knowledge is internalized into tacit knowledge
in the form of intuition, know-how, and routines, while
tacit knowledge is externalized into explicit knowledge
through articulation and codification. Knowledge
also moves between levels: individual knowledge is
combined into organizational knowledge; individual
knowledge is socialized into organizational knowledge.
Knowledge conversion lies at the heart of a key stage
of business development: the transition from the craft
enterprise based upon individual, tacit knowledge, to the
industrial enterprise based upon explicit, organizational
knowledge. This transition is depicted in Figure  8.6 and
is illustrated by the following examples:
◆ Henry Ford’s Model T was initially produced on a
small scale by skilled workers. Ford’s assembly line
mass-production technology systematized that
individual, tacit knowledge and built it into machines
and processes. Ford’s industrial system was no longer
dependent upon skilled craftsmen: the assembly
lines could be operated by former farm workers and
new immigrants.
◆ When Ray Kroc discovered the McDonald brothers’
hamburger stand in Riversdale, California, he recog-
nized the potential for systematizing and replicating
their process. McDonald’s business model was rep-
licated through operating manuals and training
programs. Now 400,000 employees, most of whom
lack the most rudimentary culinary skills, serve 68
million customers daily. The relevant knowledge is
embedded within McDonald’s business system.
This systematization of knowledge offers massive
potential for value creation through replication and
deskilling. This systematization has transformed the
service sector: with the replacement of individual pro-
prietorships by international chains in hotels (Marriott),
car rental (Hertz), coffee shops (Starbucks), and tax
preparation (H&R Block).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 215
Summary
A vital task of strategic management is to navigate the crosscurrents of change. But predicting and
adapting to change are huge challenges for businesses and their leaders.
The life-cycle model allows us to understand the forces driving industry evolution and to anticipate
their impact on industry structure and the basis of competitive advantage.
But, identifying regularities in the patterns of industry evolution is of little use if firms are unable to
adapt to these changes. The challenge of adaptation is huge: the presence of organizational inertia
means that industry evolution occurs more through the birth of new firms and the death of old ones
rather than through adaptation by established firms. Even flexible, innovative companies experi-
ence problems in coping with new technologies—especially those that are “competence destroying,”
“ disruptive,” or embody “architectural innovation.”
Managing change requires managers to operate in two time zones: they must optimize for today
while preparing the organization for the future. The concept of the ambidextrous organization is an
approach to resolving this dilemma. Other tools for managing strategic change include: creating per-
ceptions of crisis, establishing stretch targets, corporate-wide initiatives, recruiting external managerial
talent, dynamic capabilities, and scenario planning.
Whatever approach or tools are adopted to manage change, strategic change requires building new
capabilities. To the extent that an organization’s capabilities are a product of its entire history, building
new capabilities is a formidable challenge. To understand how organizations build capability, we need
to understand how resources are integrated into capability—in particular, the role of processes, struc-
ture, motivation, and alignment. The complexities of capability development and our limited under-
standing of how capabilities are built point to the advantages of sequential approaches to developing
capabilities.
Ultimately, capability building is about harnessing the knowledge which exists within the organiza-
tion. For this purpose, knowledge management offers considerable potential for increasing the effec-
tiveness of capability development. In addition to specific techniques for identifying, retaining, sharing,
and replicating knowledge, the knowledge-based view of the firm offers penetrating insights into the
challenges of—and potential for—the creation and exploitation of knowledge by firms.
In the next two chapters, we discuss strategy formulation and strategy implementation in industries
at different stages of their development: emerging industries, which are characterized by rapid change
and technology-based competition, and mature industries.
Self-Study Questions
1. Consider the changes that have occurred in a comparatively new industry (e.g., wireless tele-
communications, smartphones, video game consoles, online brokerage services, and fitness
clubs). To what extent has the evolution of the industry followed the pattern predicted by the
industry life-cycle model? What are the features of the industry that have influenced its pattern
of evolution? At what stage of development is the industry today? How is the industry likely to
evolve in the future?

216 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Notes
1. T. Levitt, “Exploit the Product Life Cycle,” Harvard
Business Review (November/December 1965): 81–94; G.
Day, “The Product Life Cycle: Analysis and Applications,”
Journal of Marketing 45 (Autumn 1981): 60–67.
2. F. F. Suárez and J. M. Utterback, “Dominant Designs and
the Survival of Firms,” Strategic Management Journal 16
(1995): 415–430.
3. P. Anderson and M. L. Tushman, “Technological Discon-
tinuities and Dominant Designs,” Administrative Science
Quarterly 35 (1990): 604–633.
4. M. A. Cusumano and D. B. Yoffie, Competing on Internet
Time: Lessons from Netscape and Its Battle with Microsoft
(New York: Free Press, 1998).
5. M. G. Jacobides, “Industry Change through Vertical Dis-
integration: How and Why Markets Emerged in Mort-
gage Banking,” Academy of Management Journal 48
(2005): 465–498.
6. G. Carroll and M. Hannan, The Demography of Corpora-
tions and Industries (Princeton, MA: Princeton University
Press, 2000). For a survey, see J. Baum, “Organizational
Ecology,” in S. R. Clegg, C. Hardy, and W. R. Nord (eds),
The SAGE Handbook of Organizational Studies (Thousand
Oaks, CA: SAGE Publications, 1996); and D. Barron, “Evo-
lutionary Theory,” in D. O. Faulkner and A. Campbell
(eds), The Oxford Handbook of Strategy (Oxford: Oxford
University Press, 2003), vol. 1: 74–97.
7. G. R. Carroll, L. S. Bigelow, M.-D. Seidel, and B. Tsai, “The
Fates of de novo and de alio Producers in the American
Automobile Industry, 1885–1981,” Strategic Management
Journal 17 (Summer 1996): 117–137.
8. S. Klepper and K. L. Simons, “Dominance by Birthright:
Entry of Prior Radio Producers and Competitive Ramifi-
cations in the US Television Receiver Industry,” Strategic
Management Journal 21 (2000): 997–1016.
2. Select a product that has become a dominant design for its industry (e.g., the IBM PC in
personal computers, McDonald’s in fast food, Harvard Business School in MBA education, and
Southwest in budget airlines). What factors caused one firm’s product architecture to become
dominant? Why did other firms imitate this dominant design? How did the emergence of the
dominant design influence the evolution of the industry?
3. The resource partitioning model argues that, as industries become dominated by a few major
companies with similar strategies and products, so opportunities open for new entrants to
build specialist niches. Identify an opportunity for establishing a specialist new business in an
industry currently dominated by mass-market giants.
4. Choose an industry that faces significant change over the next 10 years. Identify the main
drivers of change and construct two scenarios of how these changes might play out. In relation
to one of the leading firms in the industry, what are the implications of the two scenarios, and
what strategy options should the firm consider?
5. Identify two sports teams: one that is rich in resources (such as talented players) but whose
capabilities (as indicated by performance) have been poor; one that is resource-poor but has
displayed strong team capabilities. What clues can you offer as to the determinants of capabil-
ities among sports teams?
6. The market leaders in video games for mobile devices during 2012–17 were start-up com-
panies such as DeNA, GungHo Online, Supercell, King, and Rovio. Why have start-ups outper-
formed established video game giants such as Electronic Arts, Rock Star Games, and Activision
Blizzard in this market?
7. The dean of your business school wishes to upgrade the school’s educational capabilities in
order to better equip its graduates for success in their careers and in their lives. Advise your
dean on what tools and systems of knowledge management might be deployed in order to
support these goals.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 217
9. High rates of entry and exit may continue well into
maturity. See T. Dunne, M. J. Roberts, and L. Samu-
elson, “Patterns of Firm Entry and Exit in US Manu-
facturing Industries,” Rand Journal of Economics 19
(1988): 495–515.
10. S. Klepper and K. Simons, “The Making of an Oligopoly:
Firm Survival and Technological Change in the Evolution
of the US Tire Industry,” Journal of Political Economy 108
(2000): 728–760.
11. G. Carroll and A. Swaminathan, “Why the Microbrewery
Movement? Organizational Dynamics of Resource Par-
titioning in the American Brewing Industry,” American
Journal of Sociology 106 (2000): 715–762.
12. B. Levitt and J. G. March, “Organizational Learning,”
Annual Review of Sociology 14 (1988): 319–340.
13. D. Leonard-Barton, “Core Capabilities and Core Rigidities:
A Paradox in Managing New Product Development,” Stra-
tegic Management Journal 13 (Summer 1992): 111–125.
14. M. T. Hannan, L. Polos, and G. R. Carroll, “Structural
Inertia and Organizational Change Revisited III: The Evo-
lution of Organizational Inertia,” Stanford GSB Research
Paper 1734 (April 2002).
15. P. J. DiMaggio and W. Powell, “The Iron Cage Revisited:
Institutional Isomorphism and Collective Rationality in
Organizational Fields,” American Sociological Review 48
(1983): 147–160.
16. J.-C. Spender, Industry Recipes (Oxford: Blackwell Pub-
lishing, 1989).
17. J. G. March, “Exploration and Exploitation in Organiza-
tional Learning,” Organizational Science 2 (1991): 71–87.
18. The concept of fit is common to several disciplines within
management including: organizational economics (e.g.,
P. R. Milgrom and J. Roberts, “Complementarities and Fit:
Strategy, Structure, and Organizational Change in Man-
ufacturing,” Journal of Accounting and Economics 19
(1995): 179–208); sociotechnical systems (e.g., E. Trist,
“The Sociotechnical Perspective,” in A. H. Van de Ven
and W. H. Joyce (eds), Perspectives on Organization
Design and Behavior (New York: John Wiley & Sons, Inc.,
1984); and complexity theory (e.g., J. W. Rivkin, “Imi-
tation of Complex Strategies,” Management Science 46
(2000): 824–844).
19. M. E. Porter and N. Siggelkow, “Contextual Interactions
within Activity Systems,” Academy of Management Per-
spectives 22 (May 2008): 34–56.
20. E. Romanelli and M. L. Tushman, “Organizational Trans-
formation as Punctuated Equilibrium: An Empirical Test,”
Academy of Management Journal 37 (1994): 1141–1166.
21. H. E. Aldrich, Organizations and Environments (Stanford,
CA: Stanford University Press, 2007).
22. For an introduction to organizational ecology, see M. T.
Hannan and G. R. Carroll, “An Introduction to Organiza-
tional Ecology,” in G. R. Carroll and M. T. Hannan (eds),
Organizations in Industry (Oxford: Oxford University
Press, 1995): 17–31.
23. For a survey of evolutionary approaches, see R. R.
Nelson, “Recent Evolutionary Theorizing about Economic
Change,” Journal of Economic Literature 33 (March
1995): 48–90.
24. R. Foster, “Creative Destruction Whips through Corporate
America,” Innosight Executive Briefing (Winter 2012).
25. C. Markides and P. Geroski, “Colonizers and Consolida-
tors: The Two Cultures of Corporate Strategy,” Strategy
and Business 32 (Fall 2003).
26. G. A. Moore, Crossing the Chasm (New York: HarperCol-
lins, 1991).
27. S. Klepper, “The Capabilities of New Firms and the Evolu-
tion of the US Automobile Industry,” Industrial and Cor-
porate Change 11 (2002): 645–666.
28. S. Klepper and K. L. Simons, “Dominance by Birthright:
Entry of Prior Radio Producers and Competitive Ramifi-
cations in the US Television Receiver Industry,” Strategic
Management Journal 21 (2000): 997–1016.
29. D. A. Kaplan, The Silicon Boys and Their Valley of Dreams
(New York: Morrow, 1999).
30. M. L. Tushman and P. Anderson, “Technological Disconti-
nuities and Organizational Environments,” Administrative
Science Quarterly 31 (1986): 439–465.
31. R. M. Henderson and K. B. Clark, “Architectural Innova-
tion: The Reconfiguration of Existing Systems and the
Failure of Established Firms,” Administrative Science
Quarterly (1990): 9–30.
32. Ibid: 17.
33. J. Bower and C. M. Christensen, “Disruptive Technologies:
Catching the Wave,” Harvard Business Review ( January/
February 1995): 43–53.
34. C. M. Christensen, The Innovator’s Dilemma (Boston: Har-
vard Business School Press, 1997).
35. Ibid.
36. W. A. Pasmore, Designing Effective Organizations: The
Sociotechnical Systems Perspective (New York: John Wiley
& Sons, Inc., 1988).
37. W. G. Bennis, Organization Development: Its Nature, Ori-
gins, and Prospects (New York: Addison-Wesley, 1969).
38. D. F. Abell, Managing with Dual Strategies (New York:
Free Press, 1993): 3.
39. C. A. O’Reilly and M. L. Tushman, “The Ambidex-
trous Organization,” Harvard Business Review (April
2004): 74–81.
40. C. M. Christensen and M. Overdorf, “Meeting the
Challenge of Disruptive Change,” Harvard Business
Review (March/April 2000): 66–76.
41. T. Elder, “Lessons from Xerox and IBM,” Harvard Business
Review ( July/August 1989): 66–71.
42. “Shell GameChanger: A Safe Place to Get Crazy Ideas
Started,” http://www.managementexchange.com,
Management Innovation eXchange ( January 7, 2013),
www.managementexchange.com/story/shell-game-
changer, accessed July 20, 2015.
43. See “Lab Inventors: Xerox PARC and Its Innovation
Machine,” in A. Rao and P. Scaruffi, A History of Silicon
Valley, 2nd edn (Omniware, 2013); and “Saturn: Why One
of Detroit’s Brightest Hopes Failed,” Christian Science
Monitor (October 1, 2009).
44. G. Verona and D. Ravasi, “Unbundling Dynamic Capa-
bilities: An Exploratory Study of Continuous Product
Innovation,” Industrial and Corporate Change 12
(2002): 577–606.
45. Interview with Nancy Snyder, Whirlpool’s vice-president
of leadership and strategic competency development,
Business Week (March 6, 2006), http://www.businessweek.
com/innovate/content/mar2006/id20060306_287425.htm?.

http://www.businessweek.com/innovate/content/mar2006/id20060306_287425.htm?

218 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
46. R. Cibin and R. M. Grant, “Restructuring among the
World’s Leading Oil Companies,” British Journal of
Management 7 (1996): 283–308.
47. M. Tripsas and G. Gavetti, “Capabilities, Cognition
and Inertia: Evidence from Digital Imaging,” Strategic
Management Journal 21 (2000): 1147–1161.
48. H. Y. Howard, “Decoding Leadership: How Steve Jobs
Transformed Apple to Spearhead a Technological
Informal Economy,” Journal of Business and Management
19 (2013): 33–44.
49. “Haier: Taking a Chinese Company Global in 2011,” Harvard
Business School Case No. 712408-PDF-ENG (August 2011).
50. “P&G vs. Nelson Peltz,” Wall Street Journal (Octo-
ber 8, 2017).
51. N. Siggelkow and D. A. Levinthal, “Escaping Real (Non-
benign) Competency Traps: Linking the Dynamics of
Organizational Structure to the Dynamics of Search,” Stra-
tegic Organization 3 (2005): 85–115.
52. J. Nickerson and T. Zenger, “Being Efficiently Fickle: A
Dynamic Theory of Organizational Choice,” Organization
Science 13 (September/October 2002): 547–567.
53. A. Karaevli and E. Zajac, “When Is an Outsider CEO a
Good Choice?” MIT Sloan Management Review (Summer
2013); A. Falato and D. Kadyrzhanova, “CEO Succes-
sions and Firm Performance in the US Financial Industry,”
Finance and Economics Discussion Series (Federal
Reserve Board, 2012).
54. H. Kahn, The Next 200 Years: A Scenario for America and
the World (New York: William Morrow, 1976). For a guide
to the use of scenarios in strategy making, see K. van
der Heijden, Scenarios: The Art of Strategic Conversation
(Chichester: John Wiley & Sons, Ltd, 2005).
55. B. Wernerfelt, “Why Do Firms Tend to Become Different?”
in C. E. Helfat (ed), Handbook of Organizational Capabil-
ities (Oxford: Blackwell, 2006): 121–133.
56. D. Leonard-Barton, “Core Capabilities and Core
Rigidities,” Strategic Management Journal 13
(Summer 1992): 111–126.
57. C. E. Helfat and R. S. Raubitschek, “Product Sequencing:
Co-evolution of Knowledge, Capabilities and Products,”
Strategic Management Journal 21 (2000): 961–979. The
parallel development of capabilities and products has also
been referred to as “dynamic resource fit.” See: H. Itami,
Mobilizing Invisible Assets (Boston: Harvard University
Press, 1987): 125.
58. A. Takahashi, What I Learned from Konosuke Matsushita
(Tokyo: Jitsugyo no Nihonsha, 1980); in Japanese, quoted
by H. Itami, Mobilizing Invisible Assets (Boston: Harvard
University Press, 1987): 25.
59. D. J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabil-
ities and Strategic Management,” Strategic Management
Journal 18 (1997): 509–533.
60. D. J. Teece, “Explicating Dynamic Capabilities: The
Nature and Microfoundations of (Sustainable) Enterprise
Performance,” Strategic Management Journal 28
(2007): 1319.
61. K. M. Eisenhardt and J. Martin, “Dynamic Capabilities:
What Are They?” Strategic Management Journal 21 (2000):
1105–1121.
62. S. G. Winter, “Understanding Dynamic Capabilities,” Stra-
tegic Management Journal 24 (2003): 991–995.
63. J. B. Harreld, C. A. O’Reilly, and M. L. Tushman,
“Dynamic Capabilities at IBM: Driving Strategy
into Action,” California Management Review 49
(2007): 21–43.
64. K. Dalkir, Knowledge Management in Theory and Prac-
tice, 2nd edn (Cambridge, MA: MIT Press, 2011).
65. R. M. Grant, “Toward a Knowledge-Based Theory of the
Firm,” Strategic Management Journal 17 (Winter Special
Issue, 1996): 109–122.
66. M. Hansen, N. Nohria, and T. Tierney, “What’s Your
Strategy for Managing Knowledge?” Harvard Business
Review (March 1999): 106–116.
67. J. Rivkin, “Reproducing Knowledge: Replication without
Imitation at Moderate Complexity,” Organization Science
12 (2001): 274–293.

9 Technology-Based
Industries and the
Management of Innovation
Whereas a calculator on the ENIAC is equipped with 18,000 vacuum tubes and weighs
30 tons, computers in the future may have only 1000 vacuum tubes and perhaps
weigh only 1.5 tons.
—POPULAR MECHANICS, MARCH 1949
There’s no chance that the iPhone is going to get any significant market share.
—STEVE BALLMER, CEO, MICROSOFT, APRIL 30, 2007
◆ Introduction and Objectives
◆ Competitive Advantage in Technology-Intensive
Industries
● The Innovation Process
● Capturing Value from Innovation
● Which Mechanisms Are Effective at Protecting
Innovation?
◆ Strategies to Exploit Innovation: How and
When to Enter
● Alternative Strategies to Exploit Innovation
● Timing Innovation: To Lead or to Follow?
● Managing Risks
◆ Standards, Platforms, and Network Externalities
● Types of Standard
● The Role of Network Externalities
● Competing for Standards
◆ Implementing Technology Strategies: Internal and
External Sources of Innovation
● Internal Sources of Innovation: Fostering Creativity
● Sourcing Innovation from Customers and Partners
◆ Implementing Technology Strategies: Organizing
for Innovation
● Aligning Innovation with Business Strategy
● Reconciling Creativity with Commercial Discipline
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

220 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Introduction and Objectives
In the previous chapter, we saw that technology is the primary force that creates new industries and
transforms existing ones. New technology-based industries include: biotechnology, photovoltaic power,
cloud computing, robotics, and social networking. Industries transformed by new technologies include
photography, recorded music, telecommunications, and securities trading. New technology is a source
of opportunity, especially for new businesses but, as we saw in the previous chapter, it presents major
problems for many established companies.
This chapter focuses on businesses where technology is a key driver of change and an important
source of competitive advantage. Technology-intensive industries include both emerging industries
(those in the introductory and growth phases of their life cycle) and established industries where tech-
nology continues to drive competition. The issues we examine, however, are also relevant to all indus-
tries where technology has the potential to create competitive advantage including those which may
be revolutionized by new technology, such as healthcare, banking services, automotive transportation,
and education.
In the last chapter, we viewed technology as an external driver of industrial change. In this chapter,
our primary concern will be the use of technology as a tool of competitive strategy. How can an
enterprise best exploit technology to establish a competitive advantage?
The chapter is organized around four topics in technology management. First, we examine the
potential for innovation to establish sustainable competitive advantage. Second, we discuss the design
of innovation strategies, including alternative business models for exploiting an innovation, timing,
and managing risk. Third, we discuss network externalities and setting industry standards. Fourth, we
look at how firms are extending their innovation processes beyond their organizational boundaries.
Finally, we examine how technology-based strategies can best be implemented.
By the time you have completed this chapter, you will be able to:
◆ Identify the factors that determine the returns to innovation, and evaluate the potential
for an innovation to establish competitive advantage.
◆ Formulate strategies for exploiting innovation including: assessing alternative approaches
to commercializing innovation, comparing the relative merits of being a leader or a fol-
lower, and managing risk.
◆ Formulate strategies that exploit network effects, create successful platforms, and win
standards wars.
◆ Understand that innovation may be generated internally and also sourced externally
(“open innovation”).
◆ Design organizational structures and systems that foster innovation and new product
development.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 221
Competitive Advantage in Technology-Intensive Industries
Innovation forms the key link between technology and competitive advantage. The
quest for competitive advantage stimulates the search for innovation and successful
innovations allow some firms to dominate their industries. To explore the conditions
under which innovation creates competitive advantage, let us begin by examining the
innovation process.
The Innovation Process
Invention is the creation of new products and processes through the development
of new knowledge or from new combinations of existing knowledge. Most inventions
are the result of novel applications of existing knowledge. Samuel Morse’s telegraph,
patented in 1840, was based on several decades of research into electromagnetism
from Ben Franklin to Ørsted, Ampère, and Sturgeon. The compact disk embodies
knowledge about lasers developed several decades previously.
Innovation is the initial commercialization of an invention or an idea in the form
of a new product or process. Once introduced, innovation diffuses: on the demand
side, through customers purchasing the product; on the supply side, through imitation
by competitors. An innovation may be the result of a single invention (most product
innovations in chemicals and pharmaceuticals involve discoveries of new chemical com-
pounds) or it may combine many inventions. The first automobile, introduced by Karl
Benz in 1885, embodied a multitude of inventions, from the wheel, invented some 5000
years previously, to the internal combustion engine, invented nine years earlier. Not all
invention progresses into innovation: among the patent portfolios of most technology-
intensive firms are inventions that have yet to find a viable commercial application. Con-
versely, innovations may involve little or no new technology: the personal computer was
a new configuration of existing technologies; most new types of packaging, including
the vast array of tamper-proof packages, involve novel designs but no new technology.
Figure 9.1 shows the pattern of development from knowledge creation to invention
and innovation. Historically, the lags between knowledge creation and innovation have
been long. For example, the jet engine, patented by Frank Whittle in 1930, uses Isaac
Invention Innovation Dif fusion
ADOPTION
IMITATION
Supply side
Demand side
Basic
Knowledge
FIGURE 9.1 The development of technology: From knowledge creation to diffusion

222 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Newton’s laws of motion discovered in the 17th century. Its first commercial use was in
the De Havilland Comet in 1957 and, two years later, the Boeing 707.
Recently, the innovation cycle has speeded up:
● The use of satellite radio signals for global positioning was developed by phys-
icists at Johns Hopkins University in late 1950s. An experimental GPS satellite
was launched by the US Air Force in 1978 and the GPS system was fully oper-
ational by 1995. Commercial applications began in the 1990s: Garmin launched
its car sat-nav system in 1998 followed by TomTom in 2002.
● First developed at MIT in the 1980s, the first patent for instant messaging was
issued to AOL in 2002. The world’s most popular instant messaging applica-
tions, Whatsapp, Facebook Messenger, and WeChat, were introduced between
2008 and 2011.
The speed with which new research findings are applied commercially depends upon
the motivation of the research. Research motivated by practical need, such as Louis
Pasteur’s study of micro-organisms, has more immediate application than research
motivated by pure science, such as Neils Bohr’s study of atomic physics.1 The huge,
and rapid, commercial impact of the research undertaken by the US Department of
Defense’s Advanced Research Projects Agency—GPS satellites, the internet, RISC com-
puting, motion-sensing devices—underlines the potential of basic research inspired by
practical needs.2
Capturing Value from Innovation
“If a man can … make a better mousetrap than his neighbor, though he build his house
in the woods, the world will make a beaten path to his door,” claimed Emerson. Yet
the inventors of new mousetraps, and other gadgets too, are more likely to be found at
the bankruptcy courts than in the millionaires’ playgrounds of the Caribbean. The weak
linkage between innovation and prosperity is also true for companies. There is no con-
sistent evidence that either R&D intensity or frequency of new-product introductions is
positively associated with profitability.3
The profitability of an innovation to the innovator depends on the value cre-
ated by the innovation and the share of that value that the innovator is able to
capture. As Strategy Capsule 9.1 shows, different innovations result in very different
distributions of value.
The term regime of appropriability describes the conditions that influence the
distribution of the value created by innovation. In a strong regime of appropriability,
the innovator is able to capture a substantial share of that value: Pilkington’s float glass
process, Pfizer’s Viagra, and Dyson’s dual-cyclone vacuum cleaner—like Searle’s NutraS-
weet—all generated huge profits for their owners. In a weak regime of appropriability,
other parties derive most of the value. E-book readers, music streaming and online
brokerage services are similar to personal computers: a lack of proprietary technology
results in fierce price competition and most of the value created goes to consumers.
Four factors determine the innovator’s ability to profit from innovation: property rights,
the tacitness and complexity of the technology, lead time, and complementary resources.
Property Rights in Innovation Capturing the returns to innovation depends, to
a great extent, on the ability to establish property rights in the innovation. It was the
desire to protect the returns to inventors that prompted the English Parliament to pass

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 223
the 1623 Statute of Monopolies, which established the basis of patent law. Since then,
the law has been extended to several areas of intellectual property, including:
● Patents: Exclusive rights to a new and useful product, process, substance, or
design. Obtaining a patent requires that the invention is novel, useful, and
not excessively obvious. Patent law varies from country to country. In the
United States, a patent is valid for 17 years (14 for a design).
STRATEGY CAPSULE 9.1
How the Returns on Innovation are Shared
The value created by an innovation is distributed among
a number of different parties (Figure 9.2).
◆ Aspartame: Aspartame, the artificial sweetener, was
discovered in 1965 by the drug company G. D. Searle
& Co. (later acquired by Monsanto) and launched
in 1981 as NutraSweet. The patent on aspartame
expired in 1992, after which competition grew. How-
ever, Searle/Monsanto, successfully appropriated a
major part of the value created.
◆ Personal computers: The innovators—MITS, Tandy,
Apple, and Xerox—earned modest profits from
their innovation. The followers—IBM, Dell, Compaq,
Acer, Toshiba, and a host of later entrants—
did somewhat better, but their returns were
overshadowed by the huge profits earned by the
suppliers to the industry, especially: Intel in micro-
processors and Microsoft in operating systems.
Complementors, notably the suppliers of applica-
tions software, also did well. However, intense price
competition meant that the primary beneficiaries
from the PC were consumers, who typically paid
prices for their PCs that were a fraction of the value
they derived.
◆ Smartphones: The first were the IBM Simon (1993)
and the Nokia 9000 series (1996). Followers—notably
RIM, Apple, and Samsung—have earned huge profits
from smartphones. Several suppliers have also been
big winners (e.g., microprocessor supplier, ARM); also
complementors, notably app suppliers.
FIGURE 9.2 Appropriating of value: Who gets the benefits from innovation?
Customers Customers
Followers
Followers
Complementors Complementors
Suppliers
Suppliers
Innovator Innovator
ASPARTAME
Customers
Followers
Suppliers
Innovator
SMARTPHONESPERSONAL COMPUTERS

224 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
● Copyrights: Exclusive production, publication, or sales rights to the creators of
artistic, literary, dramatic, or musical works. Examples include articles, books,
drawings, maps, photographs, and musical compositions.
● Trademarks: Words, symbols, or other marks used to distinguish the goods or
services supplied by a firm. In the United States and the United Kingdom, they
are registered with the Patent Office. Trademarks provide the basis for brand
identification.
● Trade secrets: Offer a modest degree of legal protection for recipes, formulae,
industrial processes, customer lists, and other knowledge acquired in the course
of business.
The effectiveness of intellectual property law depends on the type of innovation
being protected. Where the invention is the new product—as in the case of a new drug
or a new synthetic fiber—patents can provide effective protection. For products that
reconfigure existing components, patents may fail to prevent rivals from innovating
around them. The scope of the patent law has been extended to include computer
software, business methods, and genetically engineered life forms. While patents and
copyright establish property rights, their disadvantage (from the inventor’s viewpoint)
is that they make information public. Hence, companies often prefer secrecy to patent-
ing as a means of protecting innovations.
In recent decades, companies have increasingly recognized the economic value of
their intellectual property. This has involved monetizing patents through licensing and
an upsurge in patenting to convert ideas and know-how into intellectual property.
Between 2010 and 2017, the US Patent and Trademark Office issued an average of
about 300,000 patents annually—three times as many as during the final two decades
of the 20th century.
However, the management of intellectual property is not all about protecting one’s
proprietary technology. In certain circumstances, it may be advantageous for a firm to
make its technology freely accessible to other firms. These circumstances include:
● Winning standards wars. In battling to set the standard for next-generation,
high-definition DVDs, Sony and Toshiba both made their technology freely
available to manufacturers and film studios.
● Growing the market. Telsa opened its patent portfolio to competitors in 2014 in
the belief that any loss in competitive advantage was outweighed by the bene-
fits of growing the market for electric vehicles.
● Counteracting the power of suppliers. In 2011, Facebook initiated the Open
Compute Project, an open-source, collaborative effort to improve hardware
design. The goal of the project was to lower the costs of servers purchased by
Facebook and other project partners.4
Tacitness and Complexity of the Technology In the absence of effective legal
protection, a competitor’s ability to imitate an innovation depends on the ease with
which the technology can be comprehended and replicated. The more an innovation
is based upon tacit rather than codified knowledge, the more difficult it is to copy.
Financial innovations such as mortgage-backed securities and credit default swaps
embody readily codifiable knowledge that can be copied very quickly. Intel’s designs
for advanced microprocessors are codified and can be copied; however, manufacturing
them requires deeply tacit knowledge.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 225
The second key factor is complexity. Every new fashion, from the Mary Quant
miniskirt of 1962 to Gucci’s 2017 Marmot bag, involves simple, easy-to-copy ideas.
Conversely, Airbus’s A380 and Intel’s Core i9 microprocessor present entirely different
challenges for the would-be imitator.
Lead Time Tacitness and complexity do not provide lasting barriers to imitation, but
they do offer the innovator time. Innovation creates a temporary competitive advantage
that offers a window of opportunity for the innovator to build on the initial advantage.
The challenge for the innovator is to use initial lead-time advantages to build the capa-
bilities and market position to entrench industry leadership. Intel in microprocessors,
Cisco Systems in routers, and Nvidia in graphics chips were brilliant at exploiting lead
time to build advantages in efficient manufacture, quality, and market presence.
Complementary Resources Bringing new products and processes to market requires
not just invention; it also requires the diverse resources and capabilities needed to finance,
produce, and market the innovation. These are referred to as complementary resources
(Figure  9.3). Chester Carlson invented xerography but was unable for many years to
bring his product to market because he lacked the complementary resources needed to
develop, manufacture, market, distribute, and service his invention. Conversely, Searle
(and its later parent, Monsanto) was able to provide almost all the development, manufac-
turing, marketing, and distribution resources needed to exploit its NutraSweet innovation.
Carlson was able to appropriate only a tiny part of the value created by his Xerox copier;
Searle/Monsanto was much more successful in profiting from its new artificial sweetener.
Complementary resources may be accessed through alliances with other firms, for
example biotech firms ally with large pharmaceutical companies for clinical trials,
manufacture, and marketing.5 When an innovation and the complementary resources
that support it are supplied by different firms, the division of value between them
depends on their relative power. A key determinant of this is whether the complemen-
tary resources are specialized or unspecialized. Suppose that Alphabet’s autonomous
vehicle subsidiary, Waymo is first to market with a government-approved self-driving
software platform. How much profit might Waymo earn? A key factor will be whether
Distribution
Customer service
capability
Marketing
capability
Financial
resources
Complementary
technologies
Supplier
relationships
Brand
Manufacturing
capability
Innovation
and core
technological
know-how
FIGURE 9.3 Complementary resources

226 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
TABLE 9.1 The effectiveness of different mechanisms for protecting innovation
Secrecy
(%)
Patents
(%)
Lead-time
(%)
Sales/service
(%)
Manufacturing
(%)
Product innovations
Food 59 18 53 40 51
Drugs 54 50 50 33 49
Electronic components 34 21 46 50 51
Telecom equipment 47 26 66 42 41
Medical equipment 51 55 58 52 49
All industries 51 35 53 43 46
Process innovations
Food 56 16 42 30 47
Drugs 68 36 36 25 44
Electronic components 47 15 43 42 56
Telecom equipment 35 15 43 34 41
Medical equipment 49 34 45 32 50
All industries 51 23 38 31 43
Note:
These data show the percentage of companies reporting that the particular mechanism, their sales and service, and their manufacturing
capabilities were effective in protecting their innovations.
Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions and Why US Manufacturing
Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000. Reprinted by permission of the authors.
the complementary resources that the software requires are specialized or not. If devel-
opments in vehicle design allow Waymo’s software to be installed in all new cars, the
profit potential is likely to be considerable. If, on the other hand, using Waymo’s soft-
ware requires extensive adaptations by other firms—design changes by auto makers,
specialized graphics processing units from Nvidia, radar sensors from Bosch—then
Waymo’s profit potential will be more limited.
Which Mechanisms are Effective at Protecting Innovation?
How effective are these different mechanisms in protecting innovations? Table  9.1
shows that, despite considerable variation across industries, patent protection is of
limited effectiveness as compared with lead time, secrecy, and complementary manu-
facturing and sales/service resources. Indeed, since the late 1980s, the effectiveness of
patents appeared to have declined despite the strengthening of patent law. Although
patents are effective in increasing the lead time before competitors are able to bring
imitative products to market, these gains tend to be small. The great majority of pat-
ented products and processes are duplicated within three years.6
Given the limited effectiveness of patents, why do firms continue to engage in pat-
enting? Figure 9.4 shows that, while protection from imitation is the principal motive,
several others are also very important. In particular, much patenting activity appears to
be strategic: it is directed toward blocking the innovation efforts of other companies and
building patent portfolios that can be used to bargain with other companies for access
to their patents. In microelectronics and software, such cross-licensing arrangements

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 227
are critical in permitting “freedom to design”: the ability to design products that draw
on technologies owned by different companies.7
Strategies to Exploit Innovation: How and When to Enter
Having established some of the key factors that determine the returns to innovation,
let us consider some of the main questions concerning the formulation of strategies to
manage technology and exploit innovation.
Alternative Strategies to Exploit Innovation
How should a firm maximize the returns to its innovation? A number of alternative
strategies are available. Figure  9.5 orders them according to the size of the com-
mitment of resources that each requires. Thus, licensing requires little involvement
by the innovator in subsequent commercialization, hence is a limited investment.
Internal commercialization, possibly through creating a new enterprise or business
unit, involves a much greater investment of resources and capabilities. In between
there are various opportunities for collaboration with other companies—joint ven-
tures, strategic alliances, and outsourcing that allow resource sharing between
companies.
A firm’s choice of exploitation mode depends on two sets of factors: the character-
istics of the innovation and the resources and capabilities of the firm.
Characteristics of the Innovation The extent to which a firm can establish clear
property rights in an innovation is a critical determinant of its innovation strategy.
Licensing is only viable where ownership in the innovation is protected by patent
or copyrights. Thus, in pharmaceuticals, licensing is widespread because patents
are clear and defensible. Many biotech companies engage only in R&D and license
0 10 20 30 40 50 60 70 80 90 100
To prevent copying
For licensing revenue
To prevent lawsuits
To block others
For use in negotiations
To enhance reputation
To measure performance Process innovations
Product innovations
FIGURE 9.4 Why do companies patent? (Responses by 674 US companies)
Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions
and Why US Manufacturing Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000.
Reprinted by permission of the authors.

228 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
their drug discoveries to large pharmaceutical companies that possess the necessary
complementary resources. Royalties from licensing its sound-reduction technologies
accounted for 90% of Dolby Laboratories’ 2017 revenues. Conversely, when Mark
Zuckerberg launched Facebook in his Harvard dorm, he had little option other than
to develop the business himself: the absence of proprietary technology ruled out
licensing as an option.
The advantages of licensing are relieving a company of the need to acquire comple-
mentary resources and capabilities and speed of commercialization: multiple licensing
can allow for a fast global rollout. The problem, however, is that the success of the
innovation is dependent on the commitment and effectiveness of the licensees. James
Dyson, the British inventor of the dual cyclone vacuum cleaner, created his own
company to manufacture and market his vacuum cleaners after failing to interest any
major appliance company in licensing his technology.
Resources and Capabilities of the Firm As Figure 9.5 shows, different strategies
require very different resources and capabilities. Hence, the choice of how to exploit
an innovation depends critically upon the resources and capabilities that the inno-
vator brings to the party. Start-up firms possess few of the complementary resources
and capabilities needed to commercialize their innovations. Inevitably, they will be
attracted to licensing or to accessing the resources of larger firms through outsourcing,
alliances, or joint ventures. As we noted in the previous chapter, new industries often
follow a two-stage evolution where “innovators” do the pioneering and “consolidators”
with their complementary resources do the developing.
Certain large, established corporations such as DuPont, Corning, Siemens, Hitachi,
and IBM have strong traditions of pursuing basic research, then internally devel-
oping the innovations that arise. However, even these companies have expanded their
technological collaborations with other companies. Innovation increasingly requires
Licensing
Outsourcing
certain
functions
Strategic
alliance
Joint
venture
Internal
commercialization
Little investment risk
but returns also
limited. Risk that the
licensee either lacks
motivation or steals
the innovation
Risk and
return
Limits capital
investment, but may
create dependence
on suppliers/partners
Benef its of
f lexibility. Risks of
informal structure
Shares investment
and risk. Risk of
partner
disagreement
and culture clash
Biggest investment
requirement and
corresponding risks.
Benef its of control
Legal protection Capability in managing
outsourced activities
Pooling of the resources and capabilities
of multiple f irms requires collaborative
capability
Full set of
complementary
resources and
capabilities
ARM licenses its
microprocessor
technology to over
200 semiconductor
companies; Stanford
University earns over
$100m annually from
licensing its inventions
Apple designs its iPhones
and Nvidia designs its
graphics processing units,
but both outsource
manufacturing
Spotify’s data-
sharing alliance
with WPP, the
world’s largest
advertising and
marketing
company, allows
Spotify to better
monetize its
160-million user
base
Panasonic and Tesla
Motors formed a
joint venture in 2014
to develop a
gigafactory to
produce lithium ion
batteries
Larry Page and
Sergey Brin
established Google
Inc. to develop and
market their internet
search technology
Resource
requirements
Examples
FIGURE 9.5 Alternative strategies for exploiting innovation

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 229
coordinated responses by multiple companies. Hence, innovating firms need to iden-
tify and map their innovation ecosystem, then manage the interdependencies within
it. The delayed introduction of HDTV can be attributed to inadequate coordination
among TV manufacturers, production studios, and broadcasters.8 We shall return to
the challenges of managing innovation ecosystems when we look more closely at
platform-based competition.
Timing Innovation: To Lead or to Follow?
To gain competitive advantage in emerging and technologically intensive industries, is
it better to be a leader or a follower in innovation? As Table 9.2 shows, the evidence is
mixed: in some products the leader has been the first to grab the prize; in others, the
leader has succumbed to the risks and costs of pioneering. Optimal timing of entry into
an emerging industry and the introduction of new technology are complex issues. The
advantage of being an early mover depends on the following factors:
● The extent to which innovation can be protected by property rights or lead-time
advantages: If an innovation is appropriable through a patent, copyright, or
lead-time advantage, there is advantage in being an early mover. This is espe-
cially the case where patent protection is important, as in pharmaceuticals.
Notable patent races include that between Alexander Bell and Elisha Gray to
patent the telephone (Bell got to the Patent Office a few hours before Gray),9
and between Celera Inc. and the National Institutes of Health to sequence the
human genome (although Celera won the race, President Clinton ruled that the
human genome could not be patented).10
TABLE 9.2 Leaders, followers, and success in emerging industries
Product Innovator Follower The winner
Jet airliner De Havilland (Comet) Boeing (707) Follower
Float glass Pilkington Corning Leader
X-ray scanner EMI General Electric Follower
Airline reservation system Sabre Amadeus, Apollo Leader
VCRs Ampex/Sony Matsushita Follower
Instant camera Polaroid Kodak Leader
Microwave oven Raytheon Samsung Follower
Video games player Atari Nintendo/Sony Followers
Disposable diaper Procter & Gamble Kimberley-Clark Leader
Compact disk Sony/Philips Matsushita, Pioneer Leader
Web browser Netscape Microsoft Follower
Web search engine Lycos Google Follower
MP3 music players Diamond Multimedia Apple (iPod) Follower
Operating systems for
mobile devices
Symbian, Palm OS Apple, Google Followers
Cryptocurrencies Bitcoin Etherium, Ripple Leader
Flash memory Toshiba Samsung, Intel Followers
E-book reader Sony (Digital Reader) Amazon (Kindle) Follower
Social networking SixDegrees.com Facebook Follower

http://SixDegrees.com

230 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
● The importance of complementary resources: The more important complemen-
tary resources are in exploiting an innovation, the greater the costs and risks
of pioneering. Tesla Motors’ pioneering of the all-electric car reveals the huge
development costs that arise from the need to orchestrate multiple technol-
ogies and create an entire infrastructure for distribution, service, and recharg-
ing. Where the need for complementary resources is great, followers are also
favored by the fact that, as an industry develops, specialist firms emerge to
supply complements.
● The potential to establish a standard: As we shall see later in this chapter, some
markets converge toward a technical standard. The greater the importance of
technical standards, the greater the advantages of being an early mover in order
to influence those standards and gain the market momentum needed to estab-
lish leadership. Once a standard has been set, displacing it becomes excep-
tionally difficult. IBM was responsible for establishing Microsoft’s MS-DOS as
the dominant operating system for personal computers. However, when in
1987 IBM launched its OS/2 operating system, it had little success against the
entrenched position of Microsoft. Only by offering their operating systems for
free have Linux and Google’s Chrome been able to take market share from
Microsoft’s Windows.
The implication is that optimal timing depends on the resources and capabil-
ities that a firm has at its disposal. Hence, different firms have different strategic
windows—periods in time when their resources and capabilities are aligned with the
opportunities available in the market. A small, technology-based firm may have no
choice but to pioneer innovation: its opportunity is to grab first-mover advantage
and then develop the necessary complementary resources before more powerful
rivals appear. For the large, established firm with financial resources and strong
production, marketing, and distribution capabilities, the strategic window is likely
to be both longer and later. The risks of pioneering are greater for an established
firm with a reputation and brands to protect, while to exploit its complementary
resources effectively typically requires a more developed market. Consider the fol-
lowing examples:
● In the early days of personal computers, Apple was a pioneer, IBM a follower.
The timing of entry was probably optimal for each. Apple’s resources com-
prised the vision of Steve Jobs and the technical genius of Steve Wozniak; only
by pioneering could it hope to be successful. IBM had enormous strengths in
manufacturing, distribution, and reputation. The key for IBM was to delay its
entry until the time when the market had developed to the point where IBM’s
strengths could have their maximum impact.
● In the browser war between Netscape and Microsoft, Microsoft had the luxury
of being able to follow the pioneer, Netscape. Microsoft’s huge product
development, marketing, and distribution capabilities, and, most important,
its vast installed base of the Windows operating system allowed it to overhaul
Netscape’s initial lead.
● EMI, the British music and electronics company, introduced the world’s first CT
scanner in 1972. Despite a four-year lead, General Electric’s vast technological
and commercial capabilities within medical electronics allowed it to drive EMI
out of the market.11

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 231
While first movers launch innovative new products that embody new technology
and new functionality, fast followers are especially effective in initiating a new prod-
uct’s transition from niche market to mass market by lowering cost and increasing
quality.12 Timing is critical. Don Sull argues that a successful follower strategy requires
“active waiting”: a company needs to monitor market developments and assemble
resources and capabilities while it prepares for large-scale market entry.13
Managing Risks
Emerging industries are risky. There are two main sources of uncertainty:
● Technological uncertainty arises from the unpredictability of technological evo-
lution and the complex dynamics through which technical standards and domi-
nant designs are selected. Hindsight is always 20/20, but ex ante it is difficult to
predict how technologies and the industries that deploy them will evolve.
● Market uncertainty relates to the size and growth rates of the markets for new
products. When Xerox introduced its first plain-paper copier in 1959, Apple its
first personal computer in 1977, or Sony its Walkman in 1979, none had any idea
of the size of the potential market. When Brian Chesky and Joe Gebbia began
renting the use of an air mattress in their San Francisco apartment to help pay the
rent, they had little idea that the outcome would be Airbnb (valued at $31 billion
in 2017). Forecasting demand for new products is hazardous—most forecasting
techniques are based on past data. Demand forecasts for new products tend to
rely either on analogies14 or expert opinion, for example, the Delphi technique.15
If managers are unable to forecast technology and demand, then to manage risk they
must be alert to emerging trends while limiting their exposure to risk through avoiding
large-scale commitments. Useful strategies for limiting risk include:
● Cooperating with lead users: During the early phases of industry development,
careful monitoring of and response to market trends and customer requirements
are essential in order to avoid major errors in technology and design. Von Hip-
pel argues that lead users provide a source of leading market indicators, can
assist in developing new products and processes, and offer an early cash flow
to fund development expenditures.16 In computer software, beta versions are
released to computer enthusiasts for testing. Nike has two sets of lead users:
professional athletes who are trendsetters for athletic footwear and hip-hop
artists who are at the leading edge of urban fashion trends. In communications
and aerospace, government defense contracts play a crucial role in developing
new technologies.17
● Limiting risk exposure: The financial risks of emerging industries can be miti-
gated by financial and operational practices that minimize a firm’s exposure to
adversity. By avoiding debt and keeping fixed costs low, a firm can lower its
financial and operational gearing. Outsourcing and strategic alliance can also
hold down capital investment and fixed costs.
● Flexibility: Uncertainty necessitates rapid responses to unpredicted events.
Achieving such flexibility means keeping options open and delaying com-
mitment to a specific technology until its potential becomes clear. Twitter—
originally Odeo—was founded to develop a podcasting platform. Once Apple

232 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
added a podcasting facility to iTunes, Odeo redirected itself toward a platform
for internet-hosted text messages.
● Multiple strategic options: Faced with technological uncertainty, well-resourced
companies—such as IBM, Microsoft, and Google—have the luxury of simul-
taneously investing in multiple technologies—what Eric Beinhocker refers to
as “robust, adaptive strategies.”18 For Microsoft, this portfolio of options has
included a number of prominent failures—MP3 players (Zune), smartphones
(Nokia), and social networking (Yammer)—but also leadership positions in
several new fields, including online gaming and cloud computing.
Standards, Platforms, and Network Externalities
In the previous chapter, we noted that the establishment of a standard can be a key
event in an industry’s development and growth. In the digital, networked economy,
more and more markets are subject to standards which play a vital role in ensuring
compatibility between users. For companies, owning a standard can be an important
source of competitive advantage with the potential to offer returns that are unmatched
by any other type of competitive advantage. Table 9.3 lists several companies which
own key technical standards within a particular product category. A characteristic of
most of these companies is the fact that these standards have generated considerable
profits and shareholder value.
Types of Standard
A standard is a format, an interface, or a system that allows interoperability. Adhering
to standards allows us to browse millions of different web pages, ensures the light
TABLE 9.3 Examples of companies that own de facto industry standards
Company Product category Standard
Microsoft PC operating systems Windows
Intel PC microprocessors x86 series
Sony/Philips Compact disks CD-ROM format
ARM (Holdings) Microprocessors for mobile devices ARM architecture
Oracle Corporation Programming language for web apps Java
Qualcomm Digital cellular wireless communication CDMA
Adobe Systems Common file format for creating and view-
ing documents
Acrobat Portable
Document Format
Adobe Systems Web page animation Adobe Flash
Adobe Systems Page description language for document printing Post Script
Bosch Antilock braking systems ABS and TCS (Traction
Control System)
IMAX Corporation Motion picture filming and projection system IMAX
Apple Music downloading system iTunes/iPod
Sony High definition DVD Blu-ray
Nissan, Toyota, PSA Electric vehicle charging CHAdeMO

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 233
bulbs made by any manufacturer will fit any manufacturer’s lamps, and keeps the traffic
moving in Los Angeles (most of the time). Standards can be public or private.
● Public (or open) standards are those that are available to all users. They include
mandatory standards set by government and backed by the force of law (these
relate mainly to safety, environmental, and consumer protection standards) and
consensus standards set by standards bodies such as the International Organiza-
tion for Standardization (ISO) or by industry or professional associations such as
Institute of Electrical and Electronics Engineers (IEEE).19 Although most public
standards are free, they may utilize privately owned intellectual property—3G
wireless communication standards rely heavily on Qualcomm’s CDMA patents
(from which Qualcomm earns most of its profits).
● Private (proprietary) standards are owned by companies or individuals. If I
own the technology that becomes a standard, I can embody the technology in
a product that others buy or license the technology to others who wish to use
it. Thus, in smartphones the major rival standards are Apple’s iOS and Google’s
Android. Apple’s iOS is used only in Apple’s mobile devices; Android is licensed
widely. Android also represents another variant on technical standards: it is
open source; it is freely available; and it can be used, adapted, and developed
by anyone. Most private standards are de facto standards: they emerge through
voluntary adoption by producers and consumers. Table 9.3 gives examples.
A problem with de facto standards is that they may take a long time to emerge, result-
ing in a duplication of investments and delaying the development of the market. It was
40 years before a standard railroad gauge was agreed in the United States.20 A mandated,
public standard can avoid much of this uncertainty. Europe’s mandating of standards for
wireless telephony as compared with the United States’ market-based approach resulted
in Europe making the transition to 2G much quicker than the United States. In establish-
ing 3G, 4G, and 5G wireless standards, the 3rd Generation Partnership Project (3GPP), a
worldwide grouping of telecommunications associations, has played a lead role.
The Role of Network Externalities
Standards that permit connectivity tend to emerge in markets that are subject to net-
work externalities. A network externality exists whenever the value of a product
to an individual customer depends on the number of other users of that product.
The classic example of network externality is the telephone. Since there is little sat-
isfaction to be gained from talking to oneself, the value of a telephone to each user
depends on the number of other users connected to the same network. This is dif-
ferent from most products. When I pour myself a glass of Glenlivet after a couple of
exhausting MBA classes, my enjoyment is independent of how many other people
in the world are drinking whiskey. Indeed, some products may have negative net-
work externalities—the value of the product is less if many other people purchase
the same product. If I spend $3000 on an Armani silver lamé tuxedo and find that
half my colleagues at the faculty Christmas party are wearing the same jacket, my
satisfaction is lessened.
Networks require technical standards to ensure connection to the network. This
does not require everyone to use the same product or even the same technology, but
rather that the different products are compatible with one another through a common
interface. In the case of wireless telephone service, it doesn’t matter (as far as network

234 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
access is concerned) whether I purchase service from AT&T, Verizon, or T-Mobile:
technical standards ensure compatibility between each network which allows connec-
tivity. Similarly with railroads: if I am transporting coal from Wyoming to Boston, my
choice of railroad company is not critical. Unlike in the 1870s, every railroad company
now uses a standard gauge and is required to give “common carrier” access to other
companies’ rolling stock.
Network externalities arise from several sources:
● Products where users are linked to a network: Telephones, railroad systems,
and email instant messaging groups are networks where users are linked
together. Applications software, whether spreadsheet programs or video games,
also links users—they can share files and play games interactively. User-level
externalities may also arise through social identification. I watch Game of
Thrones and the Hollywood Oscar presentations on TV not because I enjoy
them but so that I have something to talk to my colleagues about in the faculty
common room.21
● Availability of complementary products and services: Where products are con-
sumed as systems, the availability of complementary products and services
depends on the number of customers for that system. By 2015, Microsoft and
Blackberry were doomed as suppliers of smartphone operating systems. With
less than 2% of the market, they could no longer attract support from third-party
application developers. Similarly, I choose to own a Ford Focus rather than a
Ferrari Testarossa, not only because I’m a lousy driver but also because I know
that, should I break down in northern Saskatchewan, spare parts and a repair
service will be more readily available.
● Economizing on switching costs: By purchasing the product or system that is
most widely used, there is less chance that I shall have to bear the costs of
switching. By using Microsoft PowerPoint rather than an alternative presentation
software such as WPS Presentation or Prezi, it is more likely that I will avoid
the costs of retraining and file conversion when I become a visiting professor at
another university.
Network externalities create positive feedback. Once a technology or system gains
market leadership, it attracts more and more users. Conversely, once market lead-
ership is lost, a downward spiral is likely. This process is called tipping: once a
certain threshold is reached, cumulative forces become unstoppable—the result
is  a  winner-takes-all market, a phenomenon particularly associated with digital
technologies.22
Once established, technical and design standards tend to be highly resilient.
Standards are difficult to displace due to learning effects and collective lock-
in. Learning effects cause the dominant technology and design to be continually
improved and refined. Even where the existing standard is inherently inferior, switch-
ing to a superior technology may not occur because of collective lock-in. A classic
case is the QWERTY typewriter layout. Its 1873 design was based on the need to slow
the speed of typing to prevent typewriter keys from jamming. Although the jamming
problem was soon solved, the QWERTY layout has persisted.23 Technical standards
are especially important in relation to digital technologies where connectivity and
compatibility are vital. Strategy Capsule 9.2 discusses the strategic aspects of digital
innovation—particularly the role of platforms and new business models.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 235
Competing for Standards
In markets subject to network externalities, control over standards is the primary basis
for competitive advantage. Owning a proprietary standard—especially when it is incor-
porated into a platform—can be the basis for market domination and a source of mas-
sive profits. What do we know about designing winning strategies in markets subject
to network externalities?
STRATEGY CAPSULE 9.2
Digital Innovation: Platforms and Ecommerce Business Models
Innovation during the past four decades has been domi-
nated by applications of digital technology. Digital innova-
tion has distinctive characteristics to the extent that digital
technology is generic: it reduces a vast range of artifacts—
information, images, sounds—to binary code. It creates
new products—websites, mobile communication, video
games—and transforms existing ones—retailing, travel
reservations, payments, and recorded music.
The wealth-creating potential of digital innovation
is remarkable. McKinsey & Co. show that the “economic
profit generated by TMT [technology, media, and tel-
ecom] companies grew 100-fold, or by $200 billion from
2000 to 2014.” However, most of this value creation was
concentrated among a few giant companies. As a result,
by 2018, the world’s seven most valuable companies—
Apple, Alphabet, Microsoft, Amazon, Tencent, Facebook,
and Alibaba—were all based on digital technologies.
Common to all seven of these companies—as well
as other digital startups that have established multi
billion dollar valuations, such as Netflix, Uber, Airbnb, and
Pinterest—is their platform-based businesses.
Digital technologies, together with Internet or wireless
connectivity, have created markets where network exter-
nalities arise both from user connections and from the
availability of complements. These platform-based mar-
kets are also referred to as two-sided (or even multi-sided)
markets because they form an interface between two
groups of users: customers and the suppliers of comple-
mentary products.
Operating systems are the quintessential platforms:
Microsoft’s Windows, Apple’s iOS, and Google’s Android
create network externalities among users (direct
externalities) and among the suppliers of applica-
tions (indirect externalities). Each of these platforms
is central to an ecosystem comprising thousands of
interdependent companies that co-evolve. Thus, the
Android ecosystem comprises over 100 smartphone
manufacturers, thousands of app developers, suppliers
of hardware components, accessory providers, and
many other types of player. As Strategy Capsule  4.1 in
Chapter  4 describes in relation to smartphones, com-
petition between rival platforms for market dominance
is often intense.
However, platforms are not restricted to digital
markets, and nor do the networks necessarily require
technical standards. A shopping mall is a platform: the
mall developer creates a two-sided market comprising
the retailers who lease the individual stores and the cus-
tomers who do the shopping—network externalities
operate on both sides.
Deciding whether to pursue a product strategy or
a platform strategy is a key strategic issue. Google and
Facebook both began with product strategies but soon
recognized the potential for their products—Google’s
search engine and Facebook’s social network—to
become platforms. Many department stores have under-
taken a similar transition: abandoning retailing in favor
of managing an infrastructure that hosts multiple con-
cession stores. The success of the Apple Macintosh bet-
ween 1984 and 2004 was limited by Apple’s pursuit of a
product rather than a platform strategy. We look further
at platform strategies in Strategy Capsule 9.3.

236 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
STRATEGY CAPSULE 9.3
Winning Standards Wars
Past competitive battles between rival platforms
embodying different technical standards have exercised a
powerful influence over current thinking about designing
strategies for markets subject to network externalities.
None has been more influential than the competitive bat-
tles of the late 1970 and 1980s in videocassette recorders
(VCRs) and personal computers (PCs).
In neither case was technical superiority the key—
indeed, in both instances it could be argued that the
superior technology lost. The key factor was managing
the dynamics of market penetration in order to build
market leadership:
◆ In VCRs, Sony kept tight proprietary control of its
Betamax system; JVC licensed its VHS system to
Sharp, Philips, GE, RCA, and others, fueling market
penetration.
◆ In computers, IBM’s PC platform became dominant
because access to its product specifications and
the availability of the core technologies—notably
Microsoft’s operating system and Intel’s micropro-
cessors—allowed a multitude of “clone makers” to
enter the market. The problem for IBM was that it
established the dominant “Wintel” standard but Intel
and Microsoft appropriated most of the value. For
Apple, the situation was the reverse: by keeping tight
control over its Macintosh operating system and
product architecture, it earned high margins, but it
forfeited the opportunity for market dominance.
This trade-off between penetrating the market and
appropriating the returns to platform ownership is shown
in Figure  9.6. Learning from these two epic contests,
platform owners have relinquished more and more value
to complementors, competitors, and customers in order
to build a bigger bandwagon than their rivals. In some
cases this has meant foregoing all possible profits. In the
browser war of 1995–1998, both Netscape (Navigator) and
Microsoft (Explorer) ended up giving away their products.
Finding a better balance between market penetra-
tion and value appropriation has resulted in new pricing
The first key issue is to determine whether we are competing in a market that will
converge around a single technical standard. This requires a careful analysis of the
presence and sources of network externalities.
The second strategic issue in standards setting is recognizing the role of positive
feedback: the technology that can establish early leadership will rapidly gain
momentum. Building a “bigger bandwagon” according to Shapiro and Varian24 requires
the following:
● Before you go to war, assemble allies: You’ll need the support of consumers,
suppliers of complements, even your competitors. Not even the strongest com-
panies can afford to go it alone in a standards war.
● Preempt the market: Enter early, achieve fast-cycle product development, make
early deals with key customers, and adopt penetration pricing.
● Manage expectations: The key to managing positive feedback is to convince
customers, suppliers, and the producers of complementary goods that you will
emerge as the victor. These expectations become a self-fulfilling prophecy.
Sony’s massive pre-launch promotion and publicity campaign prior to the

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 237
launch of PlayStation 4 in November 2013 was an effort to convince consumers, retailers, and
game developers that the product would dominate the new generation of video game consoles,
thereby stymieing efforts by Nintendo and Microsoft to establish their rival systems.25
A great deal has been learned from the past, especially two high-profile standards wars of the 1980s—see
Strategy Capsule 9.3. If a company attempts to appropriate too great a share of the value created, it may
well fail to build a big enough bandwagon to gain market leadership. Thus, recent standards battles have
involved broad alliances, which comprise multiple ecosystem members. In the 2006–2008 struggle between
Sony (Blu-ray) and Toshiba (HD-DVD), each camp recruited movie studios, software firms, and producers
of computers and consumer electronics using various inducements, including direct cash payments. The
defection of Warner Brothers to the Sony camp was critical to the market tipping suddenly in Sony’s favor.
However, it appears that all the financial gains from owning the winning standard were dissipated by the
costs of the war.26
Achieving compatibility with existing products is a critical issue in standards battles. An evolutionary
strategy (that offers backward compatibility) is usually superior to a revolutionary strategy.27 Because the
Apple Mac, launched in 1984, was incompatible with the Apple II, it was unable to take advantage of the
Apple II’s vast installed base.
models. Adobe (and many other software suppliers)
follows a “freemium” model—Acrobat Reader is avail-
able free of charge, but to create or convert PDF files,
the necessary Acrobat software must be purchased.
Other standards show that winning is not solely
about building the biggest bandwagon of users and
complementors. Users buy a system, not a platform, and
their choices depend on the overall quality of the system.
Apple’s dominant share of the profits from the global
smartphone industry, despite having a smaller market
share than Google’s Android, derives from the overall
quality of the iPhone system, which depends to a great
extent on Apple’s exercise of tight control over applica-
tion developers, including quality standards and overall
system integration.
Sources: A. Gawer and M. A. Cusumano, “How Companies
Become Platform Leaders,” MIT Sloan Management Review 49
(2008): 28–35; C. Cennamo and J. Santal, “Platform Competition:
Strategic Trade-offs in Platform Markets,” Strategic Management
Journal 34 (2013): 133–150.
FIGURE 9.6 Standards wars in videocassette recorders and personal
computers
Maximizing
market
penetration
Maximizing
value
appropriation
VHS Betamax
IBM PC
Personal computers
Apple Mac
VCRs

238 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
What are the key resources needed to win a standards war? Shapiro and Varian
emphasize the following:
● control over an installed base of customers;
● owning intellectual property rights in the new technology;
● the ability to innovate in order to extend and adapt the initial technolog-
ical advance;
● early-mover advantage;
● strength in complements (e.g., Intel has preserved its standard in microproces-
sors by promoting standards in buses, chipsets, graphics controllers, and inter-
faces between motherboards and CPUs);
● reputation and brand name.28
However, the dynamics of standards wars are complex and we are far from being
able to propose general strategy principles. As Strategy Capsule  9.3 shows, it is not
always the case that “the biggest bandwagon wins”—issues of quality and brand
differentiation are also important. Nor does market leadership necessarily translate into
a platform owner’s ability to capture value. Finally, it is often unclear whether a market
will converge around a single platform (e.g., eBay in online auctions) or multiple plat-
forms (e.g., video game consoles and smartphones).29
Implementing Technology Strategies: Internal and External
Sources of Innovation
As we have noted previously, strategy formulation cannot be separated from its imple-
mentation. Nowhere is this more evident than in technology-intensive businesses.
Our analysis so far has taught us about the potential for generating competitive
advantage from innovation and about the design of technology-based strategies, but has
said little about the conditions under which innovation is achieved. Incisive strategic anal-
ysis of how to make money out of innovation is of little use if we cannot generate inno-
vation in the first place. We know that innovation requires certain resources— people,
facilities, information, and time—but, like other capabilities, the relationship between
R&D input and innovation output is weak—indeed lack of resources may act as a spur to
innovation.30 The productivity of R&D depends critically on the organizational conditions
that foster innovation. What are these conditions and how do we create them?
Let’s begin with the critical distinction between invention and innovation. While
these activities are complementary, they require different resources and different orga-
nizational conditions. While invention depends on creativity, innovation requires col-
laboration and cross-functional integration.
Internal Sources of Innovation: Fostering Creativity
The Conditions for Creativity Invention is an act of creativity requiring knowledge
and imagination. The creativity that drives invention is typically an individual act that
establishes a meaningful relationship between concepts or objects that had not previ-
ously been related. This reconceptualization can be triggered by accidents: an apple
falling on Isaac Newton’s head or James Watt observing a kettle boiling. Creativity is asso-
ciated with particular personality traits. Creative people tend to be curious, imaginative,
adventurous, assertive, playful, self-confident, risk-taking, reflective, and uninhibited.31

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 239
Individuals’ creativity also depends on the organizational environment in which
they work—this is as true for the researchers and engineers at Amgen and Google as
it was for the painters and sculptors of the Florentine and Venetian schools. Few great
works of art or outstanding inventions are the products of solitary geniuses. Creativity
is stimulated by human interaction: the productivity of R&D laboratories depends crit-
ically on the communication networks that the engineers and scientists establish.32 An
important catalyst of interaction is play, which creates an environment of inquiry, lib-
erates thought from conventional constraints, and provides the opportunity to establish
new relationships by rearranging ideas and structures at a safe distance from reality.
The essence of play is that it permits unconstrained forms of experimentation.33 The
potential for low-cost experimentation has expanded vastly, thanks to advances in
computer modeling and simulation that permit prototyping and market research to be
undertaken speedily and virtually.34
Organizing for Creativity Creativity requires management systems that are quite
different from those that are appropriate for efficiency. We observed in Chapter  8,
when discussing the challenge of ambidexterity, that exploration needs to be managed
very differently from exploitation. In particular, creatively oriented people tend to be
responsive to distinctive types of incentive. They want to work in an egalitarian culture
with enough space and resources to provide the opportunity to be spontaneous, expe-
rience freedom, and have fun in the performance of a task that, they feel, makes a
difference to the performance of their organization (and, possibly, to the world as a
whole). Praise, recognition, and opportunities for education and professional growth
are also more important than assuming managerial responsibilities.35 Evidence from
open-source projects shows that people will devote time and effort to creative activities
even in the absence of financial rewards.36 Nurturing the drive to create may require a
degree of freedom and flexibility that conflicts with conventional HR practices. At many
technology-based companies, including Google and W. L. Gore & Associates, engineers
choose which projects they wish to join.
Organizational environments conducive to creativity tend to be both nurturing and
competitive. Creativity requires a work context that is secure but not cozy. Dorothy
Leonard points to the merits of creative abrasion within innovative teams—fostering
innovation through the interaction of different personalities and perspectives. Man-
agers must resist the temptation to clone in favor of embracing diversity of cognitive
and behavioral characteristics within work groups—creating whole brain teams.37 Jeff
and Staney DeGraff make a similar point: they extol the merits of combining different
innovation archetypes: artists, engineers, athletes, and sages.38 The constructive conflict
they advocate is an established feature of new product development in Silicon Valley
where development team meetings are renowned for open criticism and intense dis-
agreement. Such conflict can spur progress toward better solutions.
Table  9.4 contrasts some characteristics of innovative organizations with those
designed for operational efficiency.
Sourcing Innovation from Customers and Partners
Internal creativity is not the sole source of innovation: innovation can be accessed
beyond an organization’s boundaries. A major trend in innovation management has
been a shift in focus away from firms’ internal R&D toward accessing ideas and
knowledge from the wider world. New tools of information and communications tech-
nology have reinforced this trend.

240 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Customers as Sources of Innovation We observed earlier in this chapter that
research directed toward practical needs is more likely to lead to innovation than that
motivated toward scientific discovery. Few important inventions have been spontaneous
creations by scientists—most have resulted from grappling with practical problems.
Chester Carlson was a patent attorney. His invention of the Xerox copying process was
inspired by his frustration with the tedious task of making multiple copies of patent
applications. Joseph Lister, a British surgeon, developed sterile surgery in response to
the appalling fatality rate from surgery in the Victorian era.
The old adage that “necessity is the mother of invention” explains why customers are
such fertile sources of innovation—they are most acutely involved with matching exist-
ing products and services to their needs. However, listening to customers is typically
a weak inspiration and guide for innovation. As Henry Ford remarked: “If I had asked
people what they wanted, they would have said faster horses!” Moreover, as studies of
disruptive innovation have shown, customers tend not to embrace radical innovation.
According to management thinker, Adrian Slywotzky, the key is “Creating What
People Love Before They Know They Want It.” This requires focusing not on what
customers want but on their sources of dissatisfaction. He advocates creating a “hassle
map”: a sequence of customers’ frustrations and negative emotions that can guide new
approaches to creating customer value.39
Eric von Hippel advocates making customers part of the innovation process.40 Com-
panies can induce and exploit customer-initiated innovation by identifying leading-
edge customers, supplying them with easy-to-use design tools, and ensuring flexibility
in production processes so that customers’ innovations can be effectively exploited.41
Lego has an online community, Lego Ideas, where members share creative ideas and
submit their own designs for new Lego products. In February 2018, Lego released its
20th new customer-designed product: Ship-In-A-Bottle.42
TABLE 9.4 The characteristics of “operating” and “innovating” organizations
Operating organization Innovating organization
Structure Bureaucratic
Specialization and division of labor
Hierarchical control
Defined organizational boundaries
Flat organization without
hierarchical control
Task-oriented project teams
Fuzzy organizational boundaries
Processes Emphasis on eliminating variation
(e.g., six-sigma)
Top-down control
Tight financial controls
Emphasis on enhancing variation
Loose controls to foster idea generation
Flexible strategic planning and finan-
cial control
Reward systems Financial compensation
Promotion up the hierarchy
Power and status symbols
Autonomy
Recognition
Equity participation in new ventures
People Recruitment and selection based
on the needs of the organization
structure for specific skills: functional
and staff specialists, general
managers, and operatives
Key need is for idea generators
who combine required technical
knowledge with creative person-
ality traits
Managers must act as sponsors and
orchestrators.
Source: Adapted from J. K. Galbraith and R. K. Kazanjian, Strategy Implementation: Structure, Systems and Processes,
2nd edn (St. Paul, MN: West, 1986).

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 241
Open Innovation Involving customers in innovation is one step in opening the
innovation processes. As innovation increasingly integrates multiple technologies and
becomes pressured by time, so companies are forced to look outside their own bound-
aries for ideas and expertise. The evidence that boundary spanning stimulates inno-
vation is overwhelming. This is true whether we are considering R&D teams within
organizations, inter-firm alliances, interpersonal networks, or clusters of firms concen-
trated within industrial districts.43 Building on the principle that the gains to collaborative
knowledge sharing outweigh the risks of one’s proprietary knowledge being expropri-
ated, an increasing number of firms are adopting open innovation—an approach to
innovation that seeks, exploits, and applies knowledge both from inside and outside
the organization. According to Henry Chesbrough: “Open innovation is fundamentally
about operating in a world of abundant knowledge, where not all the smart people
work for you, so you’d better go find them, connect to them, and build upon what they
can do.”44 Open innovation takes many forms. Most extensive are open-source software
communities, such as Linux where thousands of independent developers contribute to
the Linux operating system. Increasingly, open innovation has been embraced by large,
established companies—see Strategy Capsule 9.4.
Buying Innovation Despite the success of the internal innovation efforts of large,
established companies such as Samsung Electronics, Siemens, IBM, and Alphabet, the
fact remains that small, technology-intensive start-ups have advantages over large cor-
porations in the early stages of the innovation process. Hence, the major source of inno-
vation for many large companies is to buy it. This may involve licensing or purchasing
STRATEGY CAPSULE 9.4
Open Innovation at IBM
IBM’s Innovation Jam is one element of IBM’s extensive col-
laborative innovation network. It is a massive online brain-
storming process to generate, select, and develop new
business ideas. The 2006 Jam was based upon an initial
identification of 25 technology clusters grouped into six
broad categories. Websites were built for each technology
cluster and, for a 72-hour period, IBM employees, their
families and friends, suppliers, customers, and individual
scientists and engineers from all around the world were
invited to contribute ideas for innovations based on these
technologies. The 150,000 participants generated vast
and diverse suggestions that were subject to text mining
software and review by 50 senior executives and technical
specialists who worked in nine separate teams to identify
promising ideas. The next phase of the Jam subjected
the selected innovation ideas to comments and review
by the online community. This was followed by a further
review process in which the ten best proposals were
selected and a budget of $100 million was allocated to
their development. The selected business ideas included
a real-time foreign language translation service, smart
healthcare payment systems, IT applications to environ-
mental projects, and 3-D Internet. The new businesses
were begun as incubator projects and were then trans-
ferred to one or other of IBM’s business groups. As well
as divisional links, the new ventures were also subject to
monthly review by IBM’s corporate top management. IBM
has since extended its jam methodology to address a
widening array of issues.
Sources: O. M. Bjelland and R. C. Wood, “An Inside View of IBM’s
Innovation Jam,” MIT Sloan Management Review (Fall 2008):
32–43.

242 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
patents, or acquiring young, technology-based companies. Between 2014 and 2017,
the world’s four biggest pharmaceutical companies ( Johnson & Johnson, Pfizer, Roche,
and Novartis) acquired 45 companies; the world’s four biggest ecommerce companies
(Amazon. Google, Facebook, and Tencent) acquired 94 companies. We shall look more
closely at mergers, acquisitions, and alliances in Chapter 14.
Implementing Technology Strategies: Organizing for Innovation
Aligning Innovation with Business Strategy
For a firm’s innovation efforts to be effective, they must be aligned with its overall
strategy. Gary Pisano of Harvard Business School observes that, for many firms, inno-
vation strategy is no more than a grab-bag of best-practices: crowdsourcing, lead-
customer collaboration, corporate ventures, rapid-prototyping, and so on.
Companies need an innovation system: “a coherent set of interdependent processes
and structures that dictates how the company searches for novel problems and solu-
tions, synthesizes ideas into a business concept and product designs, and selects which
projects get funded.”45 Designing an innovation system that creates value for a firm
requires a clear understanding of how innovation fits with business strategy. A firm
needs to consider how its innovation can create value for its customers and how it will
capture value from these innovations.
In assessing the implementation challenges of innovation, it is important to recog-
nize the implications of innovation for a firm’s capabilities and its business model. On
these two dimensions, Pisano identifies four innovation archetypes (see Figure  9.7).
Established companies are likely to require a combination of different innovation
types—e.g. Alphabet uses all four innovation modes, including routine innovation in
relation to its Google search engine, and architectural innovation in relation to its
Waymo (autonomous driving) and Calico (extending human longevity) projects.
Requires
new
business
model
DISRUPTIVE
For example,
Google’s Android is an
open-source operating
system, but draws upon
Google’s expertise in
software development
ARCHITECTURAL
For example,
Kodak’s entry into
digital imaging required
new capabilities and a
di�erent business model
Leverages
current
business
model
ROUTINE
For example, Intel’s new
microprocessors deploy
its existing design and
fabrication capabilities
and require no change in
Intel’s business model
RADICAL
For example, The major
pharmaceutical firms’
entry into biotechnology
required new genetic
capabilities, but no change
in their existing business
models
Uses existing
technical capabilities
Requires new
technical capabilities
FIGURE 9.7 Innovation modes
Source: Adapted from Gary Pisano, “You Need an Innovation Strategy,” Harvard
Business Review (June 2015): 44–54.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 243
Reconciling Creativity with Commercial Discipline
For innovation to create value, it must be directed to customer need and harnessed to
commercial discipline. Reconciling creativity with financial performance is a challenge
not just for technology-based companies but for all businesses whose products derive
from the human imagination, including fashion and media companies: “The two
cultures—of the ponytail and the suit—are a world apart, and combustible together.”46
Many innovative companies have been formed by frustrated inventors leaving established
companies. The success of Google in Internet-based software, Apple in digital mobile
devices, Disney in animated movies, and HBO with its succession of award-winning TV
series reveals a remarkable ability to mesh creativity with commercial acuity.
Reconciling creativity with commercial effectiveness is a major challenge for orga-
nizational design—as Table 9.4 shows, the organizational requirements of the two are
very different. This is a special case of the challenge of organizational ambidexterity
that we encountered in the previous chapter. Innovation is concerned with exploring
new opportunities, while the operational side of the business is all about exploit-
ing existing capabilities. Yet, ultimately, the key to successful innovation is integrating
creativity and technological expertise with operational capabilities in production,
marketing, finance, distribution, and customer support. Achieving such integration is
difficult. Tension between the operating and the innovating parts of organizations is
inevitable. Innovation upsets established routines and threatens the status quo. The
more stable the operating and administrative side of the organization, the greater its
propensity to resist innovation.
As innovation has become an increasing priority for established corporations, so
chief executives have sought to emulate the flexibility, creativity, and entrepreneurial
spirit of technology-based start-ups. Organizational initiatives aimed at stimulating
new product development and the exploitation of new technologies include the
following:
● Cross-functional product development teams: These have proven highly effective
mechanisms for integrating creativity with functional effectiveness. Conventional
approaches to new product development involved a sequential process that
began in the corporate research lab, then went “over the wall” to engineering,
manufacturing, finance, and so on. Japanese companies pioneered autono-
mous product development teams staffed by specialists seconded from different
departments with leadership from a “heavyweight” team manager who was able
to protect the team from undue corporate influence.47 Such teams have proven
effective in deploying a broad range of specialist knowledge and, most impor-
tantly, integrating that knowledge flexibility and quickly—for example, through
rapid prototyping and concurrent engineering.48
● Product champions allow individual creativity to be embedded within organiza-
tional processes and to link invention to its subsequent commercialization. The
key is to permit the individuals who generate creative ideas to lead the teams,
which develop those ideas—and to allow this leadership to continue into the
commercialization phases. Companies that are consistently successful in inno-
vation typically have organizational processes that capture and exploit individ-
uals’ drive for achievement and their commitment to their innovations. These
committed individuals can overcome resistance to change within their organi-
zations and infect others with their enthusiasm. A study of 15 major inventions
of the 20th century concluded: “a new idea either finds a champion or dies.”49

244 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
A British study of 43 matched pairs of successful and unsuccessful innovations
found that successful innovations were distinguished by entrepreneurial leader-
ship from a “business innovator.”50 3M Corporation has a long tradition of using
product champions to develop new product ideas and grow them into new
businesses (Strategy Capsule 9.5).
● Corporate incubators are business development units that fund and nurture
new businesses based upon technologies that have been developed inter-
nally but have limited applications within a company’s established businesses.
Despite their popularity as a means by which established companies could
participate in the tech-boom of the late 1990s, few of these incubators have
achieved sustained success.51 Among the successful ones, many have been sold
to venture capital firms. A key problem, according to Hamel and Prahalad, is
that: “Many corporate incubators became orphanages for unloved ideas that
had no internal support or in-house sponsorship.”52 Among the more successful
STRATEGY CAPSULE 9.5
The Role of the Product Champion at 3M: Scotchlite
We don’t look to the president or the vice-president for
R&D to say, all right, on Monday morning 3M is going to
get into such-and-such a business. Rather, we prefer
to see someone in one of our laboratories, or marketing,
or manufacturing units bring forward a new idea that
he’s been thinking about. Then, when he can convince
people around him, including his supervisor, that he’s
got something interesting, we’ll make him what we call
a “project manager” with a small budget of money and
talent, and let him run with it.
Someone asked the question, “Why didn’t 3M make
glass beads, because glass beads were going to find
increasing use on the highways?” . . . I had done a little work
on trying to color glass beads and had learned a little about
their reflecting properties. And, as a little extra-curricular
activity, I’d been trying to make luminous house numbers.
From there, it was only natural for us to conclude that,
since we were a coating company, and probably knew
more than anyone else about putting particles onto a
web, we ought to be able to coat glass beads very accu-
rately on a piece of paper.
So, that’s what we did. The first reflective tape we
made was simply a double-coated tape—glass beads
sprinkled on one side and an adhesive on the other.
We took some out here in St. Paul and, with the cooper-
ation of the highway department, put some down. After
the first frost came, and then a thaw, we found we didn’t
know as much about adhesives under all weather condi-
tions as we thought . . .
We looked around inside the company for skills in
related areas. We tapped knowledge that existed in our
sandpaper business on how to make waterproof sand-
paper. We drew on the expertise of our roofing people
who knew something about exposure. We reached into
our adhesive and tape division to see how we could
make the tape stick to the highway better.
The resulting product became known as “Scotchlite.”
Its principal application was in reflective signs; only later
did 3M develop the market for highway marking. The
originator of the product, Harry Heltzer, interested the
head of the New Products Division in the product, and
he encouraged Heltzer to go out and sell it. Scotchlite
was a success and Heltzer became the general manager
of the division set up to produce and market it.
Source: “The Technical Strategy of 3M: Start More Little
Businesses,” Innovation 5 (1969).

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 245
incubators, Cisco System’ Emerging Markets Technology Group was established
in 2006 to detect emerging market trends, conceive of opportunities to exploit
them, and organically grow new ventures inside the company. Within the
first two years, over 2,000 ideas for new businesses had been posted on the
Cisco wiki and several were under development. A key feature of Cisco’s incu-
bator is its close linkage with the rest of the company—especially with senior
management.53
Summary
In emerging and technology-based industries, nurturing and exploiting innovation is the fundamental
source of competitive advantage and the focus of strategy formulation. Yet the fundamental strategic
issues in these industries—the dynamics of competition, the role of the resources and capabilities in
establishing competitive advantage, and the design of structures and systems to implement strategy—
are ones we have already encountered and require us to apply our basic strategy toolkit.
However, the unpredictability and instability of these industries mean that strategic decisions in
technology-driven industries have a very special character. The remarkable dynamics of these industries
mean that the difference between massive value creation and total failure may be the result of small
differences in timing or technological choices.
The speed and unpredictability of change in these markets means that sound strategic
decision-making can never guarantee success. Yet, managing effectively amidst such uncertainty is
only possible with a strategy based upon understanding technological change and its implications for
competitive advantage.
In this chapter I have distilled what we have learned in recent decades—about strategies to success-
fully manage innovation and technological change. The key lessons learned relate to:
◆ how the value created by innovation is shared among the different players in a market, including
the roles of intellectual property, tacitness and complexity of the technology, lead time, and com-
plementary resources;
◆ the design of innovation strategies, including whether to be an early mover or a follower; whether
to exploit an innovation through licensing, an alliance, a joint venture, or internal development; and
how to manage risk;
◆ competing for standards and platform leadership in markets subject to network externalities;
◆ how to implement strategies for innovation, including organizing to stimulate creativity, access inno-
vation from outside, and developing new products.
Many of the themes we have dealt with—such as appropriating value from innovation and recon-
ciling creativity with commercial discipline—are general issues in the strategic management of tech-
nology. Ultimately, however, the design and implementation of strategies in industries where innovation
is a key success factor requires strategy to be closely tailored to the characteristics of technology, market
demand, and industry structure. BCG’s list of the world’s most innovative companies includes among its
top ten Apple, Samsung, Amazon, Toyota, and Facebook. While all these companies have been highly
successful in using innovation to build competitive advantage, the strategies each has deployed have
been closely tailored to their individual circumstances.

246 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Notes
1. D. Stokes, Pasteur’s Quadrant: Basic Science and Techno-
logical Innovation (Washington, DC: Brookings Institution
Press, 1997).
2. R. E. Dugan and K. J. Gabriel, “Special Forces Innovation:
How DARPA Attacks Problems,” Harvard Business Review
(October 2013).
3. In the United States, the return on R&D spending was
estimated at between 3.7% and 5.5%. See M. Warusawitha-
rana, “Research and Development, Profits and Firm Value:
A Structural Estimation,” Discussion Paper (Washington,
DC: Federal Reserve Board, September, 2008). See also: K.
W. Artz, P. M. Norman, D. E. Hatfield, and L. B. Cardinal,
“A Longitudinal Study of the Impact of R&D, Patents, and
Product Innovation on Firm Performance,” Journal of
Product Innovation Management 27 (2010): 725–740.
4. A. Gambardella and E. von Hippel, “Open Inputs as a
Profit-Maximizing Strategy by Customers” (October 2,
2017). https://ssrn.com/abstract=3046727; accessed
January 11, 2018.
5. F. T. Rothermael, “Incumbent Advantage through Exploit-
ing Complementary Assets via Interfirm Cooperation,”
Strategic Management Journal 22 (2001): 687–699.
6. R. C. Levin, A. K. Klevorick, R. R. Nelson, and S. G. Winter,
“Appropriating the Returns from Industrial Research and
Development,” Brookings Papers on Economic Activity 18,
no. 3 (1987): 783–832.
Self-Study Questions
1. Trevor Baylis, a British inventor, submitted a patent application in November 1992 for a wind-
up radio for use in Africa in areas where there was no electricity supply and people were too
poor to afford batteries. He was excited by the prospects for radio broadcasts as a means of
disseminating health education in areas of Africa devastated by AIDS. After appearances on
British and South African TV, Baylis attracted a number of entrepreneurs and companies inter-
ested in manufacturing and marketing his clockwork radio. However, Baylis was concerned
by the fact that his patent provided only limited protection for his invention: most of the main
components—a clockwork generator and transistor radio—were long-established technol-
ogies. What advice would you offer Baylis as to how he can best exploit his invention?
2. Table 9.1 shows that:
a. patents have been more effective in protecting product innovations in drugs and medical
equipment than in food or electronic components;
b. patents are more effective in protecting product innovations than process innovations.
Can you suggest reasons why?
3. Page 228 refers to James Dyson’s difficulties in licensing his innovative vacuum cleaner (see
http://www.cdf.org/issue_journal/dyson_fills_a_vacuum.html for further information). What
lessons would you draw from Dyson’s experience concerning the use of licensing by small
firms to exploit innovation?
4. From the evidence presented in Table  9.2, what conclusions can you draw regarding the
factors that determine whether leaders or followers win out in the markets for new products?
5. In the market for ride sharing services, Uber is the market leader, followed by Lyft, Curb, and
Sidecar. In each overseas country where Uber operates, it faces local competitors: UK rivals
include BlaBlaCar, Carpooling.com, and Hailo. What are the sources of network externalities
in this market? Do they operate at the city, national, or global level? Does the strength of these
network effects mean that Uber’s competitors are doomed to failure?

http://www.cdf.org/issue_journal/dyson_fills_a_vacuum.html

http://Carpooling.com

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 247
7. P. Grindley and D. J. Teece, “Managing Intellectual Capital:
Licensing and Cross-Licensing in Semiconductors and
Electronics,” California Management Review 39 (Winter
1997): 8–41.
8. R. Adner, “Match your Innovation Strategy to your Inno-
vation Ecosystem,” Harvard Business Review (April
2006): 17–37.
9. S. Shulman, The Telephone Gambit (New York:
Norton, 2008).
10. “The Human Genome Race,” Scientific American (April
24, 2000).
11. “EMI and the CT Scanner,” Harvard Business School Case
No. 383-194 ( June 1983).
12. C. Markides and P. A. Geroski, Fast Second (San Francisco:
Jossey-Bass, 2005).
13. D. Sull, “Strategy as Active Waiting,” Harvard Business
Review (September 2005): 120–129.
14. For example, data on penetration rates for electric tooth-
brushes and CD players were used to forecast the market
demand for HDTVs in the United States (B. L. Bayus,
“High-Definition Television: Assessing Demand Forecasts
for the Next Generation Consumer Durable,” Management
Science 39 (1993): 1319–1333).
15. G. Rowe and G. Wright, “The Delphi Technique as a Fore-
casting Tool: Issues and Analysis,” International Journal
of Forecasting 15 (1999) 353–375.
16. E. Von Hippel, “Lead Users: A Source of Novel Product
Concepts,” Management Science 32 ( July, 1986).
17. In electronic instruments, customers’ ideas initiated most
of the successful new products introduced by manufac-
turers. See E. Von Hippel, “Users as Innovators,” Tech-
nology Review 5 (1976): 212–239.
18. E. D. Beinhocker, “Robust Adaptive Strategies,” Sloan
Management Review (Spring 1999): 95–106; E. D.
Beinhocker, “Strategy at the Edge of Chaos,” McKinsey
Quarterly (Winter 1997).
19. For a discussion on the role of standards see: European
Patent Office, “The importance of industry standards”
(April 2017); https://www.epo.org/news-issues/issues/
standards.html (accessed January 9, 2018).
20. A. Friedlander, The Growth of Railroads (Arlington, VA:
CNRI, 1995).
21. S. J. Liebowitz and S. E. Margolis, “Network Externality: An
Uncommon Tragedy,” Journal of Economic Perspectives 8
(Spring 1994): 133–150 refer to these user-to-user exter-
nalities as direct externalities.
22. M. Gladwell, The Tipping Point (Boston: Little, Brown and
Company, 2000).
23. P. David, “Clio and the Economics of QWERTY,” American
Economic Review 75 (May 1985): 332–337; S. J. Gould,
“The Panda’s Thumb of Technology,” Natural History
96, no. 1 (1986): 14–23. For an alternative view see
S. J. Liebowitz and S. Margolis, “The Fable of the Keys,”
Journal of Law and Economics 33 (1990): 1–26.
24. C. Shapiro and H. R. Varian, “The Art of Standards Wars,”
California Management Review 41 (Winter 1999): 8–32.
25. “Competition in Video Game Consoles, 2018.” In R.M.
Grant, Contemporary Strategy Analysis: Text and Cases
(Hoboken, NJ: Wiley, 2019).
26. R. M. Grant, “The DVD War of 2006–8: Blu-Ray vs. HD-
DVD.” Available from the author.
27. C. Shapiro and H. R. Varian, “The Art of Standards Wars,”
California Management Review 41 (Winter 1999): 15–16.
28. Ibid: 16–18.
29. For recent research into network effects see: and
platform-based competition, see: D.P. McIntyre and A.
Srinivasan, “Networks, Platforms, and Strategy: Emerging
Views and Next Steps,” Strategic Management Journal 38
(2017): 141–160; P. C. Evans and A. Gawer, The Rise of
the Platform Enterprise: A Global Survey, (New York: The
Center for Global Enterprise, January 2016); and A. Hagiu
and S. Rothman, “Network Effects Aren’t Enough,” Har-
vard Business Review 94 (April 2016): 64–71.
30. R. Katila and S. Shane, “When Does Lack of Resources
Make New Firms Innovative?” Academy of Management
Journal 48 (2005): 814–829.
31. J. M. George, “Creativity in Organizations,” Academy of
Management Annals 1 (2007): 439–477.
32. M. L. Tushman, “Managing Communication Networks in
R&D Laboratories,” Sloan Management Review 20 (Winter
1979): 37–49.
33. D. Dougherty and C. H. Takacs, “Team Play: Heedful
Interrelating as the Boundary for Innovation,” Long Range
Planning 37 (December 2004): 569–590.
34. S. Thomke, “Enlightened Experimentation: The New
Imperative for Innovation,” Harvard Business Review
(February 2001): 66–75.
35. R. Florida and J. Goodnight, “Managing for Creativity,”
Harvard Business Review ( July/August 2005): 124–131.
36. G. von Krogh, S. Haefliger, S. Spaeth, and M. W. Wallin,
“Carrots and Rainbows: Motivation and Social Practice in
Open Source Software Development,” MIS Quarterly 36
(2012): 649–676.
37. D. Leonard and S. Straus, “Putting Your Company’s Whole
Brain to Work,” Harvard Business Review (August 1997):
111–121; D. Leonard and P. Swap, When Sparks Fly:
Igniting Creativity in Groups (Boston: Harvard Business
School Press, 1999).
38. J. and S. DeGraff, The Innovation Code: The Creative
Power of Constructive Conflict (Oakland CA: Berrett-
Koehler, 2017).
39. A. J. Slywotzky, Demand: Creating What People Love
Before They Know They Want It (Paris: Hachette, 2012).
40. E. Von Hippel, The Sources of Innovation (New York:
Oxford University Press, 1988).
41. S. Thomke and E. Von Hippel, “Customers as Innovators:
A New Way to Create Value,” Harvard Business Review
(April 2002).
42. https://shop.lego.com/en-US/Ship-in-a-Bottle-21313;
accessed January 11, 2018.
43. M. Dodgson, “Technological Collaboration and
Innovation,” in M. Dodgson and R. Rothwell (eds.), The
Handbook of Industrial Innovation (Cheltenham: Edward
Elgar, 1994); A. Arora, A. Fosfur, and A. Gambardella,
Markets for Technology (Cambridge, MA: MIT Press,
2001); S.  Breschi and F. Malerba, Clusters, Networks and
Innovation (Oxford: Oxford University Press, 2005).
44. H. Chesbrough, Open Innovation: The New Imperative for
Creating and Profiting from Technology (Boston: Harvard
Business School Press, 2003). See also, B. Cassiman and
G. Valentini, “What is Open Innovation, Really?” Bocconi
University working paper (2014).

https://www.epo.org/news-issues/issues/standards.html

248 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
45. G.P. Pisano, “You Need an Innovation Strategy,” Harvard
Business Review ( June 2015): 44–54.
46. “How to Manage a Dream Factory,” Economist ( January
16, 2003).
47. K. Clark and T. Fujimoto, Product Development
Performance: Strategy, Organization, and Management
in the World Auto Industry (Boston: Harvard Business
School Press, 1991).
48. K. Imai, I. Nonaka, and H. Takeuchi, “Managing the New
Product Development Process: How Japanese Companies
Learn and Unlearn,” in K. Clark, R. Hayes, and C. Lorenz
(eds.), The Uneasy Alliance (Boston: Harvard Business
School Press, 1985).
49. D. A. Schön, “Champions for Radical New Inventions,”
Harvard Business Review (March/April, 1963): 84.
50. R. Rothwell, C. Freeman, A. Horlsey, V. T. Jervis, A. B.
Robertson, and J. Townsend, “SAPPHO Updated: Project
SAPPHO Phase II,” Research Policy 3 (1974): 258–291.
51. A. Campbell and J. Birkinshaw, “Know the Limits of
Corporate Venturing,” Financial Times (August 8, 2004).
52. G. Hamel and C. K. Prahalad, “Nurturing Creativity:
Putting Passions to Work,” Shell World (Royal Dutch Shell,
September 14, 2007): 1–12.
53. R.C. Wolcott and M.J. Lippitz, Grow From Within:
Mastering Corporate Entrepreneurship and Innovation
(McGraw Hill, 2010).

10 Vertical Integration and the Scope of the Firm
11 Global Strategy and the Multinational Corporation
12 Diversification Strategy
13 Implementing Corporate Strategy: Managing the Multi-
business Firm
14 External Growth Strategies: Mergers, Acquisitions,
and Alliances
15 Current Trends in Strategic Management
IV
CORPORATE
STRATEGY

10
Do what you do best and outsource the rest!
—PETER DRUCKER, MANAGEMENT GURU, 1909–2005
Bath Fitter has control of the product from raw material to installation. This control
allows them to better guarantee the quality by knowing exactly how it is made,
not outsourcing it to someone that could take shortcuts …. Also, they control the
measuring, installation, and customer facing representative. By doing this, Bath Fitter
would be able to get accurate and fast feedback about how the product is being used,
quality issues, or the ease of installation.
—“BATH FITTER HAS VERTICAL INTEGRATION,” HTTP://BEYONDLEAN.WORDPRESS.COM/2011/08/29/
Vertical Integration and
the Scope of the Firm
◆ Introduction and Objectives
◆ Transaction Costs and the Scope of the Firm
◆ The Benefits and Costs of Vertical Integration
● The Benefits from Vertical Integration
● The Costs of Vertical Integration
● Applying the Criteria: Deciding Whether to Make
or Buy
◆ Designing Vertical Relationships
● Different Types of Vertical Relationship
● Choosing Among Alternative Vertical Relationships
● Recent Trends
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

252 PART IV CORPORATE STRATEGY
Transaction Costs and the Scope of the Firm
Although the capitalist economy is frequently referred to as a “market economy,” it
actually comprises two forms of economic organization. One is the market mechanism,
where individuals and firms, guided by market prices, make independent decisions to
buy and sell goods and services. The other is the administrative mechanism of firms,
where decisions concerning production and resource allocation are made by man-
agers and carried out through hierarchies. The market mechanism was characterized
by Adam Smith as the “invisible hand” because its coordinating role does not require
Introduction and Objectives
Chapter  1 introduced the distinction between corporate strategy and business strategy. Corporate
strategy is concerned with where a firm competes; business strategy is concerned with how a firm com-
petes within a particular area of business.1 So far, the primary focus of the book has been business
strategy. In this final part, we shift our attention to corporate strategy: decisions that define the scope
of the firm, including:
◆ Product scope: How specialized should the firm be in terms of the range of products it supplies?
Coca-Cola (soft drinks) and H&M (fashion retailing) are engaged in a single industry sector; Amazon
and Tata Group are diversified across multiple industries.
◆ Geographical scope: What is the optimal geographical spread of activities for the firm? In the chocolate
industry, Hershey is heavily focused on North America; Nestlé operates globally.
◆ Vertical scope: What range of vertically linked activities should the firm encompass? In electric cars,
Tesla is highly integrated—about 80% of the value of its cars are produced internally. Ford’s Focus
Electric is heavily outsourced—its entire drive train is supplied by Magna and its batteries by LG.
In this chapter, we begin by considering the overall scope of the firm. We then focus specifically on
vertical integration. In the next two chapters, we shall consider geographical scope (multinationality)
and product scope (diversification). However, as we shall discover, our analysis of all three dimensions of
scope will draw upon several common concepts: economies of scope, transaction costs, and the costs
of corporate complexity.
By the time you have completed this chapter, you will be able to:
◆ Recognize the role of firms and markets in organizing economic activity and apply trans-
action cost analysis to explain the boundaries between the two.
◆ Understand the benefits and costs of vertical integration and make decisions over whether
a particular activity should be undertaken internally or outsourced.
◆ Identify alternative ways of organizing vertical transactions and, given the characteristics
and circumstances of a transaction, recommend the most suitable transaction mode.

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 253
conscious planning. Alfred Chandler referred to the administrative mechanism of firms
as the “visible hand” because it involves active planning and direction.2
Firms and markets may be viewed as alternative institutions for organizing produc-
tion. Firms are distinguished by the fact they comprise a number of individuals bound
by employment contracts with a central contracting authority. However, production
can also be organized through market transactions. When I remodeled my basement,
I contracted a self-employed builder to undertake the work. He in turn subcontracted
parts of the work to a plumber, an electrician, a joiner, a drywall installer, and a painter.
Although the job involved the coordinated activity of several individuals, these self-
employed specialists were not linked by employment relations but by market contracts
(“$4,000 to install wiring, lights, and power outlets”).
The relative roles of firms and markets vary between countries, industries, and seg-
ments within an industry. Some countries are dominated by a few diversified business
groups: Samsung and LG in South Korea; Koc and Sabanci in Turkey. In the US computer
industry, the production of mainframes is organized very differently from that of PCs.
IBM’s System z mainframe computers are assembled by IBM using IBM microprocessors
and IBM’s z/OS operating system, and run IBM applications software. IBM also under-
takes distribution, marketing, and customer support. HP’s laptop computers are manu-
factured by Flextronics, Quanta, and other companies using components produced by
firms such as Intel, Seagate, Nvidia, and Samsung. Customer support is also outsourced.
What determines the relative roles of firms and markets? Ronald Coase’s answer was
the relative cost of organizing within firms as compared to organizing within markets.3
Markets are not costless: the transaction costs of markets include the costs of search,
negotiation, drawing up contracts, and monitoring and enforcing contracts (including
the costs of litigation should a dispute arise). Conversely, if an activity is internalized
within a firm, then the firm incurs certain administrative costs. If the transaction costs
of organizing an activity through the market are more than the administrative costs of
organizing it within a firm, we can expect that activity to be encompassed within a firm.
Consider the examples shown in Figure 10.1. With regard to vertical scope, which
is a more efficient way to produce electric cars: three separate companies, one
Specialized �rms Single integrated �rm
Vertical
scope:
Electric
cars
Product
scope:
Entertainment
Geographical
scope:
Banking
LG (Battery)
Ford (Final assembly)
Magna (Drivetrain)
S Video games
O Consumer
N electronics
Y Movies
Wells Fargo (US)
Banco Bradesco (Brazil)
Lloyds Banking Group (UK)
T Battery
E
S Drivetrain
L
A Assembly
Nintendo (Video games)
MGM (Movies)
Panasonic (Consumer electronics)
Ford
Focus
Electric
H US
S UK
B Brazil
C +other countries
FIGURE 10.1 The scope of the firm: Specialization versus integration

254 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 10.1
The Rise of the modern Corporation
ORIGInS OF THE mOdERn
CORPORATIOn
The large corporation, the dominant feature of advanced
capitalist economies, is of recent origin. At the beginning
of the 19th century, most production, even in Britain, the
most industrially advanced economy of that time, was by
individuals and families working in their own homes. Even
by the mid-19th century, the biggest business organiza-
tions in the US were family-owned farms, notably the large
plantations of the South. The business corporation resulted
from two key developments during the 19th century:
1 Technology. Mechanization caused the shift of
manufacturer from the home to the factory, while
developments in transportation—canals and rail-
ways—expanded the size of markets.
2 Limited liability. A corporation is an enterprise that
has a separate legal identity from its owners: it can
own property, enter into contracts, sue, and be
sued. The earliest business corporations were colo-
nial trading companies created by royal decree: the
British East India Company (1600), the Dutch East
India Company (1602), and Hudson’s Bay Company
(1670). The introduction of limited liability during
the mid-19th century, insulated the shareholders
from the debts of the companies they owned,
encouraging large-scale equity financing of railroad
and manufacturing corporations.
Emergence of giant industrial companies was a feature
of the “second industrial revolution,” which occurred in
the United States in the late 19th and early 20th centuries.
Its drivers were technological innovations—electricity,
the telephone, and the automobile—and organizational
and management innovations. Management innovations
included Winslow Taylor’s scientific management—a
systematic, empirically based approach to job design and
production management; Ford’s assembly line system of
mass production; techniques of mass marketing; and sys-
tems of cost and management accounting.
Organizational innovations included:
◆ Line-and-staff structure: Most companies comprised
a single establishment. The railroad companies were
the first to create geographically separate operating
units managed by an administrative headquar-
ters. This structure—“line” employees in operating
units coordinated by a head office “staff ” of admin-
istrators and functional specialists—developed into
more complex functional structures. Sears Roebuck
& Co. and Shell Transport and Trading comprised
numerous operating units and headquarters made
up of specialized functional departments.
◆ The holding company: The biggest companies at
the beginning of the 20th century were holding
companies built through mergers and acquisitions
(e.g., American Tobacco, US Steel, and Standard Oil).
In a holding company, the parent company owns
controlling equity stakes in a number of subsidiary
companies allowing the parent to appoint the
boards of the subsidiaries and receive dividends, but
with limited managerial control.
THE 20TH CEnTURY: EXPAndInG
SCAlE And SCOPE
Large holding companies and functionally organized
companies increasingly adopted multidivisional struc-
tures. At DuPont, increasing size and a widening product
range strained its functional structure and overloaded
top management. Pierre Du Pont’s solution was to
decentralize: 10 product divisions were created, each
with its own R&D, production, and sales; a corporate
supplying batteries, another producing drivetrains, a third undertaking assembly (as
in the case of the Ford Focus Electric), or a single company undertaking all three
stages (as in the case of Tesla)? In relation to product scope, is it more efficient for
video games, consumer electronic products, and movies to be produced by a single
firm (such as Sony), or for each product to be produced by a separate company?

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 255
head office led by an executive committee undertook
coordination, strategy, and resource allocation. Shortly
after, in 1924, General Motors, a holding company built
by acquisition, also adopted a multidivisional structure to
solve its problems of weak financial control and a con-
fused product line. During the next 50 years, the multi-
divisional structure became the dominant organizational
form for large corporations.
During the first half of the 20th century, large com-
panies grew mainly through vertical integration and
horizontal integration (i.e., increasing market share within
existing markets). After World War II, diversification and
international expansion were the main sources of corpo-
rate growth. By the 1960s, the increasing dominance of
giant corporations pointed to the replacement of market
capitalism by a system of managerial capitalism.
However, by the 1980s, this trend went into reverse.
Increasing emphasis on shareholder value and core com-
petences resulted in a shift from vertical integration to
outsourcing and from diversification to “core business
focus.” Increasingly, companies used collaborative rela-
tionships with other companies to achieve the bene-
fits of vertical, horizontal, and cross-border integration.
Figure 10.2 illustrates the trends.
Sources: A. D. Chandler, The Visible Hand: The Managerial Rev-
olution in American Business (Cambridge, MA: MIT Press, 1977).
J.  Micklethwait and A. Wooldridge, The Company: A Short His-
tory of a Revolutionary Idea (New York: Modern Library, 2005).
A. D.  Chandler, Strategy and Structure (Cambridge: MIT Press, 1962).
In the case of geographical scope, is it better to have banking services provided by
separate banks in each country, or by a single multinational bank (such as HSBC) that
operates across multiple countries?
The answers to these question have changed over the past 200 years. As Strategy
Capsule 10.1 explains, these shifts can be linked to the factors that have influenced the
0
2
4
6
8
10
12
14
16
First Industrial
Revolution:
Mechanization
and the factory
system
Expanding Scale and Scope
• scale economies from new
technologies
• new management tools
• multidivisional structure
• computers
• international expansion
Restructuring, Refocusing, and
Downsizing:
• Quest for shareholder value:
focus on core competences
and core businesses
• Turbulent business
environment: in�exibility of
large, complex hierarchies
• Digital revolution
Top 100
companies’
share of
total
employment
(%)
Consolidation
through mergers
and acquisitions
Quest for scale
and market
dominance in
both mature and
hi-tech sectors
Second Industrial
Revolution: Growth of
industrial giants
assisted by electricity,
the telephone,
innovations in
management and
organization
Railways,
canals, and
telegraph
expand �rms
geographical
reach
18
00
18
20
18
40
18
60
18
80
19
00
19
20
19
40
19
60
19
80
20
00
20
20
FIGURE 10.2 The widening scale and scope of large US companies
Sources: Author’s estimates based upon various sources including: A. Chandler Jr., The Visible Hand (Cambridge, MA: MIT
Press, 1977); L. J. White and J. Yang, “What Has Been Happening to Aggregate Concentration in the U.S. Economy in the
21st Century?”Stern School of Business, New York University, 2017. S. Kim “The Growth of Modern Business Enterprises in
the Twentieth Century,” Research in Economic History 19 (1999): 75–110.

256 PART IV CORPORATE STRATEGY
relative efficiencies of firms relative to markets. For most of the 19th and 20th centuries,
new technologies—including innovations in management and organization—have
favored large firms. Around the mid-1970s, this trend went into reverse: a more turbulent
business environment and new information and communications technologies favored
more focused enterprises coordinated through markets.
The Benefits and Costs of Vertical Integration
So far, we have considered the overall scope of the firm. Let us focus now on just one
dimension of corporate scope: vertical integration. The question we seek to answer
is this: Is it better to be vertically integrated or vertically specialized? With regard to a
specific activity, this translates into: To make or to buy? First, we must be clear what we
mean by vertical integration.
Vertical integration is a firm’s ownership and control of multiple vertical stages in
the supply of a product. The extent of a firm’s vertical integration is indicated by the
number of stages of the industry’s value chain that it spans, and can be measured by
the ratio of its value added to sales revenue.4
Vertical integration can be either backward (or upstream) into its suppliers’ activ-
ities or forward (or downstream) into its customers’ activities. Vertical integration
may also be full or partial. Some California wineries are fully integrated: they pro-
duce wine only from the grapes they grow, and sell it all through direct distribution.
Most are partially integrated: their homegrown grapes are supplemented with pur-
chased grapes; they sell some wine through their own tasting rooms but most through
independent distributors.
Strategies toward vertical integration have been subject to shifting fashions. For most
of the 20th century, the prevailing wisdom was that vertical integration was beneficial
because it allowed superior coordination and reduced risk. Yet, by the 1990s, opinions
had changed. In 1992, management guru Tom Peters observed: “The idea of vertical
integration is anathema to an increasing number of companies.”5 Outsourcing could
reduce cost, enhance flexibility and allow firms to concentrate on those activities that
they performed best. Moreover, many of the benefits of vertical integration could be
achieved through collaboration with suppliers and buyers.
Inevitably, the truth is more nuanced. Even within the same industry, companies
make different choices over vertical integration and outsourcing. Strategy Capsule 10.2
compares Disney’s vertical integration between content production and distribution
with the system of licensing contracts with which J. K. Rowling’s Harry Potter is com-
mercialized through multiple channels.
Our task is to identify the factors that determine whether vertical integration or out-
sourcing is the better strategy for a particular company in a particular situation.
The Benefits from Vertical Integration
Technical Economies from the Physical Integration of Processes Proponents
of vertical integration have often emphasized the technical economies it offers: cost
savings that arise from the physical integration of processes. Thus, most steel sheet is
produced by integrated producers in plants that first produce steel and then roll hot
steel into sheet. Linking the two stages of production at a single location reduces trans-
portation and energy costs. Similar technical economies arise in integrating pulp and
paper production and from linking oil refining with petrochemical production.

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 257
STRATEGY CAPSULE 10.2
Vertical Integration in the Entertainment Industry: Frozen versus
Harry Potter
Over the past two decades, integration between content
producers (film studios, music publishing) and distribu-
tion companies (theaters, TV broadcasting, cable com-
panies, satellite TV, digital streaming) has reshaped the
entertainment industry.
Content producers such as Walt Disney Company,
Time Warner, and News Corporation have forward
integrated into distribution (TV broadcasting, cable,
satellite TV, and movie distribution). Cable companies
and broadcasters (such as Comcast and Viacom) have
backward integrated into movie and TV production.
The mergers creating these integrated production
and distribution companies have not all been successful:
AOL’s 2000 merger with Time Warner and the acquisition
spree that transformed Compagnie Générale des Eaux
into Vivendi Universal were disasters.
Yet, the urge for vertical integration continues: the
leading providers of video streaming services, Netflix
and Amazon, are both investing heavily in content pro-
duction, while communications giant AT&T has acquired
Time Warner.
To illustrate the relative merits of vertical integration
and market-based contracts, consider the commercial
exploitation of the fictional characters from Harry Potter
with those of Frozen.
HARRY POTTER
◆ Seven Harry Potter novels written by J. K. Rowling were
published by Bloomsbury in the United Kingdom and
Scholastic Press in the United States between 1997
and 2007 with total sales of 400 million (to 2017).
◆ Film rights were acquired by Warner Bros., which pro-
duced eight movies generating $7.7 billion in box
office receipts.
◆ 11 Harry Potter video games were produced by
Electronic Arts.
◆ A Harry Potter attraction opened at Comcast’s
Universal Orlando Resort in 2010, while a Warner
Bros. Harry Potter studio tour opened in the
UK in 2012.
◆ Harry Potter copyrights and trademarks were
licensed to Mattel, Coca-Cola, Lego, Hasbro, John-
son & Johnson, Lochaven of Scotland, and other
companies for the production of toys, clothing, and
other products.
FROZEn
Frozen is a computer-animated film inspired by Hans
Christian Andersen’s The Snow Queen, produced by Walt
Disney Animation Studios, and released by Walt Disney
Pictures in 2013. It generated $1.3  billion in worldwide
box office revenue. Prior to release, Frozen was pro-
moted heavily at Disney theme parks. Commercial spi-
noffs from the movie and its lead characters, Elsa and
Anna, include:
◆ a range of merchandise including dolls, cos-
tumes and “home décor, bath, textile, footwear,
sporting goods, consumer electronics, and pool
and summer toys” developed by Disney Consumer
Products and sold through Disney Stores and
independent channels;
◆ DVD and Blu-ray releases by Walt Disney Studios
Home Entertainment;
◆ a video game launched by Disney Mobile for hand-
held devices;
◆ a Disney-On-Ice touring Frozen show and a Broadway
stage musical adaptation by Disney Theatrical;
◆ Frozen Ever After ride at Walt Disney World, Florida.

258 PART IV CORPORATE STRATEGY
However, although these considerations explain the need for the co-location of
plants, they do not explain why vertical integration in terms of common ownership is
necessary. Why can’t steel and steel strip production or pulp and paper production be
undertaken by separate firms that own facilities which are physically integrated with
one another? To answer this question, we must look beyond technical economies and
consider the implications of linked processes for transaction costs.6
Avoiding Transaction Costs in Vertical Exchanges Consider the value chain for
steel cans that extends from mining iron ore to the use of cans by food-processing com-
panies (Figure 10.3). There is vertical integration between some stages; other stages are
linked by market contracts between specialist firms. In the final linkage—between can
producing and canning—most cans are produced by specialist packaging companies
(such as Crown Holdings and Ball Corporation).7 An analysis of transaction costs can
explain these different arrangements.
The predominance of market contracts between the producers of steel strip and the
producers of cans reflects low transaction costs in the market for steel strip: there are
many buyers and sellers, information is readily available, and the switching costs for
buyers and suppliers are low. The same is true for many other commodity products: few
jewelry companies own gold mines; flour-milling companies seldom own wheat farms.
To understand why vertical integration predominates across steel production and
steel strip production, let us see what would happen if the two stages were owned by
separate companies. Because there are technical economies from hot-rolling steel as
soon as it is poured from the furnace, steel makers and strip producers must invest in
integrated facilities. A competitive market between the two stages is impossible; each
steel strip producer is tied to its adjacent steel producer. In other words, the market
becomes a set of bilateral monopolies.
The reason these relationships between steel producers and strip producers are
problematic is that each steel supplier must negotiate with a single buyer; there is no
market price: it all depends on relative bargaining power. Such bargaining is costly: the
mutual dependency of the two parties encourages opportunism and strategic misrep-
resentation as each company seeks to enhance and exploit its bargaining power at the
expense of the other. Thus, once we move from a competitive market situation to one
where individual buyers and sellers are locked together in close bilateral relationships,
the efficiencies of competitive markets are lost.
The culprits in this situation are transaction-specific investments. When the steel
producer and the strip producer build adjoining plants, each plant is totally dependent
Steel strip
production
Can-
making
Steel
production
Iron ore
mining
Canning of
food, drink,
oil, etc.
MARKET
CONTRACTS
VERTICAL
INTEGRATION
MARKET
CONTRACTS
VERTICAL
INTEGRATION
AND MARKET
CONTRACTS
FIGURE 10.3 The value chain for steel cans

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 259
on the continuing business of the other party—each party has the potential to hold
up the other (i.e., each party can threaten the other with withholding business). Con-
versely, when a steel strip producer supplies a can maker, neither needs to invest in
equipment nor technology that is specific to the needs of the other party.
If the future were predictable, these issues could be resolved in advance. However,
in an uncertain world, it is impossible to write a complete contract that covers every
possible eventuality over the entire life span of the capital investments being made.
Empirical research confirms the tendency for transaction-specific investments to
encourage vertical integration.8 Among automakers, specialized components are more
likely to be manufactured in-house than commodity items such as tires and spark
plugs.9 Similarly, in aerospace, company-specific components are more likely to be
produced in-house rather than purchased externally.10
Coordination Benefits The tendency for changing circumstances to impose
transaction costs points to the coordination benefits of vertical integration, Consider
Tesla’s development and production of its electric cars. As noted in Figure  10.1,
Tesla makes its own batteries and powertrains—indeed it produces in-house about
80% of its components and sub-assemblies (including seats). The reason is that
Tesla cars are revolutionary designs that require specially-designed components.
In-house production relieves Tesla’s engineers and managers of the need for con-
tinuous, time-consuming communication and coordination with suppliers. Similar
considerations explain relationships between semiconductor designers and fabri-
cators. Companies that produce highly complex chips that require close technical
collaboration between designer and fabricator tend to be vertically integrated (e.g.,
Intel and STMicroelectronics).11
The Costs of Vertical Integration
Market contracts incur transaction costs, but vertical integration imposes administrative
costs. The extent of these costs depends on several factors.
Differences in Optimal Scale between Different Stages of Production UPS’s
delivery vans are manufactured to its own specifications by Morgan Olson (which also
supplies walk-in vans to FedEx, Amazon, US Postal Service, and other customers).
Should UPS build its own vans and trucks? Almost certainly not: the transaction costs
avoided by UPS will be trivial compared with the inefficiencies incurred in manu-
facturing its own vans: the 20,000 vans UPS purchases each year are well below the
minimum efficient scale of an assembly plant. Similarly, specialist brewers such as
Anchor Brewing of San Francisco or Adnams of Suffolk, England do not make their
own containers (as does Anheuser-Busch InBev). Small brewers lack the scale to man-
ufacture cans and bottles efficiently.
The Need to Develop Distinctive Capabilities Another reason for UPS not mak-
ing its own vans is that it is likely to be a poor vehicle manufacturer. A key advantage
of a company specializing in a few activities is its ability to develop distinctive capa-
bilities in those activities. Even large, technology-based companies such as Boeing,
Intel, and Philips cannot maintain IT capabilities that match those of IT services
specialists such as IBM, TCS, and Accenture. A major advantage of these IT spe-
cialists is the learning they gain from working with multiple clients. If Boeing’s IT
department only serves the in-house needs of Boeing, this limits the development of
its IT capabilities.

260 PART IV CORPORATE STRATEGY
However, this assumes that capabilities in different vertical activities are independent
of one another and that the required capabilities are generic rather than highly cus-
tomized. Where one capability is closely integrated with capabilities in adjacent activ-
ities, vertical integration may help develop these integrated, system-wide capabilities.
Thus, Walmart keeps most of its IT in-house. The reason is that real-time information
is central to Walmart’s supply chain management, in-store operations, and upper-level
managerial decision-making. Walmart’s tightly integrated IT services are customized to
meet the needs of its unique business system.
Problems of Managing Strategically Different Businesses These problems of
differences in optimal scale and developing distinctive capabilities are part of a wider
set of problems—that of managing vertically-related businesses that are strategically
very different. A major disadvantage of UPS owning a truck-manufacturing company is
that the management systems and organizational capabilities required for truck man-
ufacturing are very different from those required for express delivery. These consid-
erations explain the lack of vertical integration between manufacturing and retailing.
Firms that are integrated across manufacturing, and retailing, such as Zara (Inditex S.A.)
and Gucci (Kering S.A.), are unusual. Most of the world’s leading retailers—Walmart,
Gap, Carrefour—do not manufacture. Similarly, few manufacturing companies retail
their own products. Not only do manufacturing and retailing require very different
organizational capabilities, but they also require different strategic planning systems,
different approaches to control and human resource management, and different top-
management styles and skills.
These strategic dissimilarities are a key factor in the trend to vertically de-integrate.
Marriott’s split into two separate companies, Marriott International and Host Marriott,
was influenced by the belief that owning hotels is a strategically different business
from operating hotels. Similarly, the Coca-Cola Company spun off its bottling activities
as Coca-Cola Enterprises Inc. partly because managing local bottling and distribution
operations is very different from managing the global Coca-Cola brand and producing
and distributing concentrates.
Incentive Problems Vertical integration changes the incentives between vertically-
related businesses. Where a market interface exists between a buyer and a seller, profit
incentives ensure that the buyer is motivated to secure the best possible deal and the
seller is motivated to pursue efficiency and service in order to attract and retain the
buyer—these are termed high-powered incentives. With vertical integration, internal
supplier–customer relationships are subject to low-powered incentives. When my office
computer malfunctions, I call the university’s IT department. The incentives for the
in-house technicians to respond promptly to my email and voice messages are weak.
If I were free to use an outside IT specialist, that specialist would only get the business
if they were able to offer same-day service and would only get paid once the problem
was resolved.
One approach to creating stronger performance incentives within vertically-
integrated companies is to open internal divisions to external competition. As we shall
examine more fully in Chapter 13, many large corporations have created shared-service
organizations, where internal suppliers of corporate services—such as IT, training, and
engineering—compete with external suppliers of the same services to serve internal
operating divisions.
Competitive Effects For a monopolist, one of the supposed benefits of vertical
integration is to extend a monopoly position at one stage of an industry’s value chain to
adjacent stages. Classic cases of this are Standard Oil and Alcoa. However, economists

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 261
have shown that there is no additional monopoly profit to be extracted by extending a
monopoly to adjacent stages of the value chain.12
For a firm that is not monopolist, vertical integration risks damaging its competi-
tive position in its core business. If it forward integrates, it becomes a competitor of
its customers (or, if it backwards integrates, a competitor of its suppliers), potentially
damaging its attractiveness as a business partner. When Google acquired cell phone
maker, Motorola, a major risk was that other handset makers that were customers for its
Android operating system (Samsung in particular) might regard Google more as a com-
petitor and less as a reliable supplier and be inclined to find an alternative operating
system to Android.13
Flexibility Both vertical integration and market transactions can claim advantage
with regard to different types of flexibility. Where the required flexibility is rapid
responsiveness to uncertain demand, there may be advantages in market transactions.
The lack of vertical integration in the construction industry allows flexibility in adjust-
ing both to fluctuations of demand and to the different requirements of each project.14
Vertical integration may also be disadvantageous in responding quickly to new prod-
uct development opportunities that require new combinations of technical capabil-
ities. Some of the most successful new electronic products of recent years—Apple’s
iPod, Microsoft’s Xbox, Amazon’s Echo—have been produced by contract manufac-
turers. Extensive outsourcing has been a key feature of fast-cycle product development
throughout the electronics sector.
Yet, where system-wide flexibility is required, vertical integration may allow for speed
and coordination in achieving simultaneous adjustment throughout the value chain.
Inditex, owner of Zara, has pioneered the fast-fashion model of vertical integration to
achieve unprecedented flexibility and speed to market. Zara feeds market information
from its directly owned and managed retail stores to its designers, and in-house pro-
duction and distribution to supply products twice-weekly to its retail stores. The time
period from initial design to retail shelf is about three weeks, compared to four to six
months for fashion clothing companies that outsource production.
Investing in an Unattractive Business Finally, one of the biggest disadvantages of
vertical integration is that it may involve investing in an inherently unattractive industry.
Irrespective of transaction costs and coordination benefits, McDonald’s chooses not to
backward integrate into cattle ranching and potato growing, because agriculture is a
low-margin industry.
Compounding Risk To the extent that it ties a company to its internal suppliers and
internal customers, vertical integration represents a compounding of risk: problems at
any one stage of production threaten production and profitability at all other stages.
When union workers at a General Motors brake plant went on strike in 1998, GM’s 24
US assembly plants were soon brought to a halt. Disney’s animation studios produce
blockbuster movies—Lion King, Frozen, Cars—that feed DVD sales, Disney Channel
TV shows, live performances, theme park rides, and merchandise sales. If the studios
produce a series of flops, the entire Disney system suffers.
Applying the Criteria: Deciding Whether to Make or Buy
Vertical integration is neither good nor bad. As with most questions of strategy, it all
depends upon the specific context. The value of our analysis is that we can identify the
factors that determine the relative advantages of the market transactions versus inter-
nalization. Figure 10.4 summarizes some of the key criteria.

262 PART IV CORPORATE STRATEGY
The greater the number of f irms, the less advantageous is VI
How many f irms are in the
vertically adjacent activity?
The greater the need for transaction-specif ic investments, the
greater the advantages of VI
Do transaction-specif ic investments
need to be made by either party?
The greater is the need for coordination, the greater the
advantages of VI
How great is the need for coordination
between the two stages?
How great is uncertainty over the period
of the relationship?
The greater the uncertainty, the more incomplete is the contract
and the greater the advantages of VI
How critical is the continual upgrading
of capabilities in the adjacent activity?
The greater the need for capability development, the greater the
disadvantages of VI
How important are prof it incentives to
performance in the adjacent activity?
The greater the need for high-powered incentives, the greater
the disadvantages of VI
How uncertain is market demand? The more unpredictable is demand, the less advantageous is VI
How great is the risk that each stage
is an unreliable supplier to (or buyer
from) adjacent stages?
The greater the risks at each stage, the more VI compounds the
�rm’s overall risk
How similar are two stages in terms of
the optimal scale of the operation?
The greater the dissimilarity, the less advantageous is VI
How strategically similar are the
stages?
Characteristics of the
vertical relationship
Implication
FIGURE 10.4 Vertical integration (VI) versus outsourcing: Key considerations

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 263
However, our analysis is not yet complete; we must consider some additional factors
that influence the choice of vertical strategy, and in particular the fact that vertical rela-
tionships are not limited to the binary choice of make or buy.
Designing Vertical Relationships
Our discussion so far has compared vertical integration with arm’s-length market
contracts. In practice, the adjacent stages in a value chain can be linked through a
variety of relationships. Figure 10.5 shows a number of different types of relationship
between buyers and sellers. These relationships may be classified in relation to two
characteristics. First, the extent to which the buyer and seller commit resources to the
relationship: arm’s-length, spot contracts involve no resource commitment beyond the
single deal; vertical integration typically involves a substantial investment. Second,
the formality of the relationship: long-term contracts and franchises are formalized by
the complex written agreements they entail; spot contracts typically involve little or no
documentation and are governed by common law; collaborative agreements between
buyers and sellers are usually informal—they are trust-based; vertical integration allows
management discretion to replace legal formality.
Different Types of Vertical Relationship
Different vertical relationships offer different combinations of advantages and disad-
vantages. For example:
● Long-term contracts: Market transactions can be either spot contracts—Shell
buying a cargo of crude oil on the Rotterdam petroleum market—or long-term
contracts—Shell contracting to buy specific quantities of crude oil from Saudi
Aramco over a five-year period. Spot transactions work well under competi-
tive conditions (many buyers and sellers and a standard product) where there
is no need for transaction-specific investments by either party. Where closer
supplier–customer ties are needed, particularly when one or both parties need
High
Fo
rm
al
iz
at
io
n
Low
Spot sales/
purchases
Low
HighDegree of Commitment
Long-term
contracts
Agency
agreements
Franchises
Joint
ventures
Vertical
integration
Informal
supplier/
customer
relationships
Value
adding
vertical
partnerships
FIGURE 10.5 Different types of vertical relationship

264 PART IV CORPORATE STRATEGY
to make transaction-specific investments, a longer-term contract can help
avoid opportunism and provide the security needed to make the necessary
investment. However, long-term contracts face the problem of anticipating the
circumstances that may arise during the life of the contract: either they are too
restrictive or so loose that they give rise to opportunism and conflicting inter-
pretation. Long-term contracts often include provisions for the arbitration of
contract disputes.
● Vertical partnerships: The greater the difficulties of specifying complete con-
tracts for long-term supplier–customer deals, the greater the advantage of
vertical relationships based on trust and mutual understanding. Such relation-
ships can provide the security needed to support transaction-specific invest-
ments, the flexibility to meet changing circumstances, and the incentives to
avoid opportunism. Such arrangements may be entirely relational contracts,
with no written contract at all. The model for vendor partnerships has been
the close collaborative relationships that many Japanese companies have with
their suppliers. Japanese automakers have been much less backward integrated
than their US or European counterparts but have also achieved close collabo-
ration with component makers in technology, design, quality, and production
scheduling.15
● Franchising: A franchise is a contractual agreement between the owner of a
business system and trademark (the franchiser) that permits the franchisee
to produce and market the franchiser’s product or service in a specified area.
Franchising brings together the brand, marketing capabilities, and business sys-
tems of the large corporation with the entrepreneurship and local knowledge
of small firms. The franchising systems of companies such as McDonald’s,
Century 21 real estate, Hilton Hotels, and 7-Eleven convenience stores combine
the advantages of vertical integration in terms of coordination and investment
in transaction-specific assets with advantages of market contracts in terms of
high-powered incentives, flexibility, and separate ownership of strategically dis-
similar businesses.
Choosing Among Alternative Vertical Relationships
The criteria listed in Figure 10.4 establish the basic features of the vertical relation that
favor either market transactions or vertical integration. However, the availability of
other types of vertical relationships, such as franchises and vendor partnerships, mean
that vertical integration is not the sole solution to problems of transaction costs. More-
over, many of these relational contracts and hybrid arrangements can combine the
advantages of both vertical integration and market contracts.
Choosing the optimal vertical relationships needs to take account of additional
factors to those listed in Figure 10.4. In particular:
● Resources, capabilities, and strategy: Within the same industry, different com-
panies will choose different vertical arrangements according to their relative
resource and capability strengths and the strategies they pursue. Thus, in
fashion clothing, Zara’s high level of vertical integration compared to H&M’s
or Gap’s reflects strategy based upon fast-cycle new-product development and
tight integration between its retail stores, designers, and manufacturers. While
most fast-food chains have expanded through franchising, Chipotle Mexican
Grill and California-based In-N-Out Burger seek to maintain their unique

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 265
culture and distinctive business practices by directly owning and managing
their restaurants. While most banks outsource IT to companies such as IBM
and EDS, credit card group Capital One sees IT as a key source of competitive
advantage: “IT is our central nervous system … if we outsourced tomorrow we
might save a dollar or two on each account, but we would lose flexibility and
value and service levels.”16
● Allocation of risk: Any arrangement beyond a spot contract must cope with
uncertainties over the course of the contract. A key feature of any contract is
that its terms allocate (often implicitly) risks between the parties. How risk is
shared is dependent partly on bargaining power and partly on efficiency con-
siderations. In franchise agreements, the franchisee (as the weaker partner)
bears most of the risk—it is the franchisee’s capital that is at risk and the fran-
chisee pays the franchiser a flat royalty based on sale revenues. In oil explora-
tion, outsourcing agreements between the national oil companies (e.g., Kuwait
Petroleum, Petronas, and Statoil) and drilling companies (e.g., Schlumberger and
Halliburton) have moved from fee-for-service contracts to risk service contracts
where the drilling company bears much more of the risk.
● Incentive structures: Incentives are central to the design of vertical relation-
ships. Market contracts provide powerful motivations to the parties involved,
but may also induce opportunistic behavior. Weak performance incentives are
a key problem of vertical integration. Hence, hybrid and intermediate gover-
nance modes may offer the best solutions to the design of incentives. Toyota,
Benetton, Boeing, and Starbucks have relationships with their vendors that
may involve formal contracts, but their essence is that they are long-term and
trust-based. The key to these relationships is that the promise of a long-term,
mutually-beneficial relationship trumps short-term opportunism.
Recent Trends
The main feature of recent years has been a growing diversity of hybrid vertical rela-
tionships that have attempted to combine the flexibility and incentives of market
transactions with the close collaboration provided by vertical integration. These col-
laborative vertical arrangements we have described as “vertical partnerships” have also
been denoted “virtual vertical integration” and “value-adding partnerships.” Leading
models have included Toyota’s supply chain with its three tiers of suppliers17 and Dell’s
build-to-order, direct sales model involving close coordination among a small group
of suppliers. In Apple’s “ecosystem,” Apple leads product development and tightly
controls its intellectual property but integrates the capabilities and innovations of a
broad network of firms that include component suppliers and contract assemblers and
a developer community responsible for over one million applications for the macOS
and iOS platforms.
Although these collaborative vertical relationships are viewed as a recent
phenomenon—associated with microelectronics, biotechnology, and other hi-tech
sectors—local clusters of vertically collaborating firms have long been a feature of
European industries—in northern Italy, the localized firm networks in traditional indus-
tries such as clothing, footwear, and furniture are also apparent in newer sectors such
as packaging equipment18 and motorcycles.19
Collaborative vertical partnerships have allowed the scope of outsourcing to extend
from raw materials and basic components to more complex products and business
services that represent whole chunks of the value chain. In electronics, contract

266 PART IV CORPORATE STRATEGY
manufacturers, such as Flextronics and Foxconn (a subsidiary of Hon Hai Precision
Industry Co.), design and manufacture entire products. Business services and corpo-
rate functions such as payroll, IT, training, customer service and support, and external
communications are often outsourced to specialist providers.
However, there seem to be limits to the extent to which a firm can outsource activ-
ities while still retaining the capabilities needed to develop and evolve. The virtual
corporation, a firm whose sole function is to coordinate the activities of a network of
partners, remains an abstract concept rather than a tangible reality.20 Companies such
as Boeing, Toyota, Amazon, Hewlett Packard, and McDonalds have the role of systems
integrators—they orchestrate the activities and components of many suppliers and
partners. However, empirical research shows that sustaining that role requires, not
only that these companies continue to develop their systems know-how (“architec-
tural capabilities”), but that they also need to keep abreast of the technologies being
deployed by their suppliers and partners (“component capabilities”).21 The complex-
ities of managing a network of suppliers during a period of rapid technological change
is indicated by Boeing’s difficulties in developing its 787 Dreamliner.22
Summary
The size and scope of firms reflects the relative efficiencies of markets and firms in organizing produc-
tion. Over the past 200 years, the trend has been for firms to grow in size and scope as a result of tech-
nology and advances in management, causing the administrative costs of firms to fall relative to the
transaction costs of markets.
In relation to vertical scope, there is no universal best solution. A firm must compare benefits of
vertical integration in avoiding transaction costs and permitting superior coordination against the ben-
efits of outsourcing in allowing the firm to focus on what it does best.
The dominant trend of the past three decades is for firms to concentrate on fewer stages of their
value chains and outsource the rest. However, this involves replacing vertical integration, not with arm’s-
length market contracts but with collaborative arrangements which combine the specialization bene-
fits of outsourcing with the coordination and knowledge-sharing benefits of vertical integration.
In subsequent chapters, we shall return to issues of vertical integration. In the next chapter, we shall
consider offshoring firms locating different value chain activities in different countries. In Chapter 14, we
shall look more closely at alliances—including the vertical partnering that characterizes modern supply
chains.
Self-Study Questions
1. Can the expanding scale and scope of large companies between the late 19th century and the
1970s be explained by factors which reduced the administrative costs of firms relative to the
transaction costs of markets?
2. Figure  10.2 shows that during 1980–2000 large US companies accounted for a smaller
percentage of total employment—a development that is attributed to “a more turbulent business

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 267
Notes
1. In practice, there is no clear boundary between business
strategy and corporate strategy: it depends on where we
draw the boundaries of industries and markets.
2. A. Chandler Jr., The Visible Hand: The Managerial Rev-
olution in American Business (Cambridge, MA: MIT
Press, 1977).
3. R. H. Coase, “The Nature of the Firm,” Economica 4
(1937): 386–405.
4. The more of its inputs a firm makes rather than buys, the
greater is its value added relative to its sales revenue. See
Ruth Maddigan, “The Measurement of Vertical Integration,”
Review of Economics and Statistics 63 (August, 1981).
5. Tom Peters, Liberation Management (New York:
Knopf, 1992).
6. O. E. Williamson, Markets and Hierarchies: Analysis and
Antitrust Implications (New York: Free Press, 1975); O. E.
Williamson, The Economic Institutions of Capitalism:
Firms, Markets and Relational Contracting (New York:
Free Press, 1985).
7. Some large food processors, such as Campbell Soup
and H. J. Heinz, have backward integrated into can
production.
8. For a review of empirical evidence on transaction costs
and vertical integration see J. T. Macher and B. D. Rich-
man, “Transaction Cost Economics: An Assessment of
Empirical Research in the Social Sciences,” Business
and Politics 10 (2008): Article 1; and M. D, Whinston,
“On the Transaction Cost Determinants of Vertical
Integration,” Journal of Law, Economics & Organization
19 (2003): 1–23.
9. K. Monteverde and J. J. Teece, “Supplier Switching Costs
and Vertical Integration in the Automobile Industry,” Bell
Journal of Economics 13 (Spring 1982): 206–213.
10. S. Masten, “The Organization of Production: Evidence
from the Aerospace Industry,” Journal of Law and Eco-
nomics 27 (October 1984): 403–417.
11. J. T. Macher, “Technological Development and the Bound-
aries of the Firm: A Knowledge-based Examination in
Semiconductor Manufacturing,” Management Science 52
(2006): 826–843; K. Monteverde, “Technical Dialogue as
an Incentive for Vertical Integration in the Semiconductor
Industry,” Management Science 41 (1995): 1624–1638.
12. R. Rey and J. Tirole, “A Primer on Foreclosure,” Chapter 33
in M. Armstrong and R. H. Porter (eds), Handbook of
Industrial Organization: Vol. 3 (Amsterdam: Elsevier, 2007).
13. “Would Samsung ever leave Android? New CEO drops
hints,” CNET ( June 16, 2012), http://www.cnet.com/uk/
news/would-samsung-ever-leave-android-new-ceo-drops-
hints/, accessed July 20, 2015.
14. However, E. Cacciatori and M. G. Jacobides (“The
Dynamic Limits of Specialization: Vertical Integration
Reconsidered,” Organization Studies 26 (2005): 1851–
1883) point to changes in construction that are causing
reintegration.
15. J. H. Dyer, “Effective Interfirm Collaboration: How Firms
Minimize Transaction Costs and Maximize Transaction
Value,” Strategic Management Journal 18 (1997): 535–556;
J. H. Dyer, “Specialized Supplier Networks as a Source of
Competitive Advantage: Evidence from the Auto Industry,”
Strategic Management Journal 17 (1996): 271–292.
environment and new information and communications technologies” (p. 256). Explain why
these factors might cause large corporations to reduce their size and scope.
3. A large proportion of major corporations outsource their IT functions to specialist suppliers
of IT services, such as IBM, HP, Accenture, and Capgemini. What benefits do corporations
derive from outsourcing their IT requirements? What transaction costs might arise from these
arrangements?
4. Strategy Capsule 10.2 compares alternative strategies for exploiting children’s characters. Hello
Kitty is owned by the Japanese company Sanrio Co. Ltd. and is exploited throughout the world
through licensing contracts with toy makers, jewelry companies, fashion companies, restau-
rants, theme parks, retail stores, and many other types of businesses. Could Hello Kitty be
exploited more effectively by a vertically-integrated entertainment company, such as Disney?
5. For its Zara brand, Inditex manufactures the majority of the garments it sells and undertakes
all of its own distribution from manufacturing plants to its directly managed retail outlets.
The Gap outsources its production and focuses upon design, marketing, and retail distribu-
tion. Applying the considerations listed in Figure 10.4, should Gap backward integrate into
manufacture?

http://www.cnet.com/uk/news/would-samsung-ever-leave-android-new-ceo-dropshints/

268 PART IV CORPORATE STRATEGY
16. L. Willcocks and C. Sauer, “High Risks and Hidden Costs
in IT Outsourcing,” Financial Times (May 23, 2000): 3.
17. J. H. Dyer and K. Nobeoka, “Creating and Managing
a High-performance Knowledge-sharing Network:
The Toyota Case,” Strategic Management Journal 21
(2000): 345–368.
18. G. Lorenzoni and A. Lipparini, “The Leveraging of Inter-
firm Relationships as Distinctive Organizational Capabil-
ities: A Longitudinal Study,” Strategic Management Journal
20 (1999): 317–338.
19. A. Lipparini, G. Lorenzoni, and S. Ferriani, “From Core to
Periphery and Back: A Study on the Deliberate Shaping of
Knowledge Flows in Interfirm Dyads and Networks,” Stra-
tegic Management Journal 35 (2014): 578–595.
20. H. W. Chesborough and D. J. Teece, “When is Virtual
Virtuous? Organizing for Innovation,” Harvard Business
Review (May/June 1996): 68–79.
21. S. Brusoni, A. Prencipe, and K. Pavitt, “Knowledge
Specialization, Organizational Coupling and the Bound-
aries of the Firm: Why Do Firms Know More than
They Make?” Administrative Science Quarterly 46
(2001): 597–621.
22. “Boeing 787’s Problems Blamed on Outsourcing, Lack of
Oversight,” Seattle Times (February 3, 2013).

11
Shenzhen: World Hub for Electronics. When the Chinese government made
Shenzhen a Special Economic Zone in 1980, it was a small town with 94,100 inhabitants
located close to China’s border with Hong Kong. By 2017, it was among the world’s top
20 most populous cities with over 18 million inhabitants (including migrants) and the
highest GDP per head of any city in China. Shenzhen’s remarkable growth is a result of
it becoming the world’s leading hub for the manufacturing of electronic products and
home to Huawei, Tencent, ZTE, BYD, Skyworth, TP-Link, and OnePlus. It makes 60% of
the world’s computer magnetic heads. 60% of its laser pickups, 45% of its clocks and
watches, 38% of its shipping containers, and 10% of its hard drives.
Global Strategy and
the Multinational
Corporation
O U T L I N E
◆ Introduction and Objectives
◆ Implications of International Competition for
Industry Analysis
● Patterns of Internationalization
● Implications for Competition
◆ Analyzing Competitive Advantage in an
International Context
● National Influences on Competitiveness: Comparative
Advantage
● Porter’s National Diamond
● Consistency between Strategy and National
Conditions
◆ Internationalization Decisions: Locating
Production
● Determinants of Geographical Location
● Location and the Value Chain
◆ Internationalization Decisions: Entering a Foreign
Market
◆ Multinational Strategies: Global Integration versus
National Differentiation
● The Benefits of a Global Strategy
● The Need for National Differentiation
● Reconciling Global Integration with National
Differentiation
◆ Implementing International Strategy: Organizing
the Multinational Corporation
● The Evolution of Multinational Strategies and
Structures
● Recent Trends in Multinational Management
◆ Summary
◆ Self-Study Questions
◆ Notes

270 PART IV CORPORATE STRATEGY
Introduction and Objectives
Internationalization—the extension of business of across national borders—is a source of both
opportunities and problems. International expansion permits companies to grow beyond the limits
of their national markets. Embraer, once a struggling, state-owned Brazilian aircraft manufacturer, now
generates 85% of its revenues outside of Brazil and is the world’s third-biggest plane maker (after Boeing
and Airbus) and market leader in 70- to 130-seater commercial jets.
Internationalization is also a potent destroyer. For centuries, Sheffield, England, was the world’s
leading center of cutlery manufacture. By 2015, the industry employed only a few hundred people
there— production had shifted to China and other low-cost locations. Nor is it just the industries in the
mature industrial nations that have been ravaged by imports. Bulk imports of second-hand clothing
from Europe and North America (much of it from charities and churches) have been ruinous for East
Africa’s textile and apparel sector.
Internationalization occurs through two mechanisms: trade and direct investment. Both are driven
by firms seeking to exploit either market opportunities or resources and capabilities beyond their
own borders.
In this chapter, we shall consider the implications of internationalization for our strategic analysis. As
we shall see, once firms are no longer limited by national boundaries, the analysis of competition and
competitive advantage becomes much more complex. We shall examine two major aspects of firms’
internationalization strategies—where to locate production and how to enter foreign markets. Finally,
we shall consider the formulation and implementation of strategy within the multinational corporation.
We begin by exploring the implications of international competition, first for industry analysis and
then for the analysis of competitive advantage.
By the time you have completed this chapter, you will be able to:
◆ Use the tools of industry analysis to examine the impact of internationalization on industry
structure and competition.
◆ Analyze the implications of a firm’s geographical location for its competitive advantage.
◆ Select the optimal geographical location for a firm’s productive activity.
◆ Formulate strategies for exploiting overseas market opportunities.
◆ Formulate international strategies that achieve an optimal balance between global
integration and national differentiation.
◆ Design organizational structures and management systems appropriate to the pursuit of
international strategies.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 271
Implications of International Competition for Industry Analysis
Patterns of Internationalization
Internationalization occurs through trade—supplying goods and services from one
country to another—and direct investment—building or acquiring productive assets in
another country.1 On this basis, we can classify industries according to the extent and
mode of their internationalization (Figure 11.1):
● Sheltered industries are shielded from both imports and inward direct
investment by regulation and trade barriers, or because of the localized nature
of the goods and services they offer. Hence, they are served by indigenous
firms. Growing internationalization has made this category progressively smaller
over time. The remaining sheltered industries tend to be fragmented service
industries (dry cleaning, hairdressing, auto repair), some small-scale production
industries (handicrafts, residential construction), and industries producing prod-
ucts that are non-tradable because they are perishable (fresh milk, bread) or dif-
ficult to move (beds, garden sheds).
● Trading industries are those where internationalization occurs primarily through
imports and exports. Exporting from a single location is the most efficient
means to exploit overseas markets for products that are transportable, subject
to substantial scale economies, and are not nationally differentiated. Examples
include commercial aircraft, shipbuilding, and defense equipment. Trading
industries also include products whose inputs are available only in a few
locations (rare earths from China, caviar from Iran and Azerbaijan).
● Multidomestic industries are those that internationalize through direct
investment—either because trade is not feasible (e.g., service industries such as
banking, consulting, hotels) or because products are nationally differentiated
(e.g., frozen ready-meals, book publishing).
• house building
• laundries/dry cleaning
• hairdressing
• fresh milk
• frozen foods
• retail banking
• hotels
• wireless telephony
• shipbuilding
• military hardware
• diamond mining
• agriculture
TRADING
INDUSTRIES
SHELTERED
INDUSTRIES
• automobiles
• petroleum
• semiconductors
• alcoholic beverages
Foreign Direct Investment
HighLow
In
te
rn
at
io
na
l T
ra
de
Lo
w
H
ig
h GLOBAL
INDUSTRIES
MULTIDOMESTIC
INDUSTRIES
FIGURE 11.1 Patterns of industry internationalization

272 PART IV CORPORATE STRATEGY
● Global industries are those that feature high levels of both trade and direct
investment. These include most major manufacturing and extractive industries
that are populated by multinational corporations.
By which route does internationalization typically occur? The Uppsala Model pre-
dicts that firms internationalize in a sequential pattern, first exporting to countries with
the least “psychic distance” from their home markets (i.e., geographically or culturally
close), then broadening and deepening their engagement, and eventually establish-
ing manufacturing subsidiaries in foreign markets.2 However, different industries and
different firms follow different patterns. In service industries, exporting is not usu-
ally feasible, hence internationalization involves either direct investment (“greenfield
entry,” acquisition, or joint venture) or licensing (including franchising). Firms based
upon digital technologies are often “born global”—from the outset, PayPal, Spotify, and
Dropbox viewed their markets as worldwide.
Implications for Competition
Internationalization widens the market available to firms, increasing both the number
of potential customers and the diversity of their preferences. It also means more com-
petition, usually leading to lower industry profit margins. In 1976, the US automobile
market was dominated by GM, Ford, and Chrysler, with 84% of the market. By 2017,
there were 13 companies with auto plants within the United States; of these, the sole
indigenous producers were GM and Ford, with a combined market share of 32%.
Applying Porter’s five forces of competition framework, internationalization inten-
sifies competition from three sources:
● Potential entrants: Internationalization is both a cause and a consequence of
falling barriers to entry. Trade liberalization, falling transportation costs, and
converging customer preferences make it much easier for producers in one
country to supply customers in another. Entry barriers that are effective against
domestic entrants may be ineffective against established producers in other
countries.
● Rivalry among existing firms: Internationalization increases the number of firms
competing within each national market—it lowers seller concentration. The
western European market for motor scooters was once dominated by Piaggio
(Vespa) and Innocenti (Lambretta). There are now over 25 suppliers of scooters
to the European market, including BMW from Germany; Honda, Yamaha, and
Suzuki from Japan; Kwang Yang Motor Co (KYMCO) from Taiwan; Baotian,
Qingqi, and Znen from China; Bajaj from India; and Tomos from Slovenia.
Although internationalization typically triggers a wave of mergers and acqui-
sitions that reduce the global population of firms in an industry, the number
of competitors in each national market often increases.3 In addition, interna-
tionalization stimulates competition by increasing investments in capacity and
increasing the diversity of competitors within each national market.
● Increasing the bargaining power of buyers: The option of sourcing from over-
seas greatly enhances the power of industrial buyers. It also allows distributors
to engage in international arbitrage: pharmaceutical distributors have become
adept at searching the world for low-price pharmaceuticals for importation to
their domestic markets.
Figure 11.2 shows how internationalization affects the basic strategy model (from
Chapter 1). The right-hand arrow shows the impact on industry environment.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 273
Analyzing Competitive Advantage in an International Context
Growing international competition has been associated with some stunning rever-
sals in the competitive positions of different companies. In 1989, US Steel was the
world’s biggest steel company; in 2017, ArcelorMittal based in Luxemburg and India
was the new leader. In 2000, four of the world’s top five cell phone suppliers were
US or European based (Nokia, Motorola, Ericsson, and Siemens). By 2017, four of the
top five (Samsung, Huawei, Oppo, and Xiaomi) were based in East Asia, though a US
firm (Apple) was still global market share leader (even though it did not manufacture
any phones).
To understand how internationalization impacts a firm’s competitive position, we
need to extend our framework for analyzing competitive advantage to include the
influence of firms’ national environments. Competitive advantage, we have noted, is
achieved when a firm matches its internal strengths in resources and capabilities to
the key success factors within its industry. When competing firms are based in differ-
ent countries, competitive advantage depends not just on their internal resources and
capabilities but on the availability of resources within those countries. This impact of
national resource availability on a firm’s resources and capabilities is indicated by the
left-hand arrow of Figure 11.2.
National Influences on Competitiveness:
Comparative Advantage
The effect of national resource availability on international competitiveness is the
subject of the theory of comparative advantage. The theory states that a country
has a comparative advantage in those products which make intensive use of
those resources available in abundance within that country. Thus, Bangladesh has
an abundant supply of unskilled labor. Its comparative advantage lies in labor-
intensive products such as clothing, handicrafts, leather goods, and assembly of
consumer electronic products. The United States has an abundant supply of tech-
nological resources: trained scientists and engineers, research facilities, and uni-
versities. Its comparative advantage lies in technology-intensive products such as
THE FIRM
• Resources &
Capabilities
THE
INDUSTRY
ENVIRONMENT
STRATEGY
INTERNATIONALIZATION
• Wider market, more
diverse customer preferences
• More competitors
• Lower-entry barriers
• Increased buyer power
• National resource availability
(theory of comparative advantage)
• Impact of national context on
resource development
(Porter‘s national diamond)
FIGURE 11.2 How internationalization affects the basic strategy framework

274 PART IV CORPORATE STRATEGY
TABLE 11.1 Indexes of revealed comparative advantage for selected product categories, 2013
US UK Japan Switzerland Germany Australia China India
Cereals 2.1 0.4 0.0 0.0 0.3 4.3 0.3 3.5
Beverages 0.8 3.5 0.2 1.0 0.3 1.6 0.2 0.1
Mineral fuels 0.7 0.4 0.2 0.0 0.2 4.3 0.0 1.1
Pharmaceuticals 1.0 2.5 0.2 6.9 1.8 0.4 0.1 3.5
Vehicles 1.0 1.5 2.6 0.1 2.2 0.1 0.3 0.7
Aerospace 4.5 1.2 0.4 0.3 1.7 0.4 0.05 0.6
Electrical and electronic equipment 0.8 0.4 1.1 0.3 0.7 0.1 2.6 0.2
Optical, medical, and
scientific equipment
1.7 1.2 1.7 1.5 1.5 0.4 0.9 0.2
Clocks and watches 0.3 0.8 0.6 21.1 0.5 0.2 2.2 0.2
Apparel (knitted) 0.1 0.6 0.1 0.1 0.4 0.1 2.8 2.3
Note:
Country X’s revealed comparative advantage within product category A is measured as: Country X’s share of world exports in product
category A / Country X’s share of world exports in all products. A number greater than 1 indicates a comparative advantage in that prod-
uct category.
Source: International Trade Center.
microprocessors, computer software, pharmaceuticals, medical diagnostic equip-
ment, and management consulting services.
The term comparative advantage refers to the relative efficiencies of producing differ-
ent products. So long as exchange rates are well behaved (i.e., they do not deviate far from
their purchasing power parity levels), then comparative advantage translates into competitive
advantage. Comparative advantages are revealed in trade performance. Table 11.1 shows
revealed comparative advantages for several product categories and several countries.4
Trade theory initially looked to natural resource endowments, labor supply, and
capital stock as the main determinants of comparative advantage. Emphasis has shifted
to the central role of knowledge (including technology, human skills, and management
capability) and the resources needed to commercialize that knowledge (capital mar-
kets, communications facilities, and legal systems).5 For industries where scale econ-
omies are important, a large home market is an additional source of comparative
advantage (e.g., the United States in aerospace).6
Porter’s National Diamond
Michael Porter has extended the traditional theory of comparative advantage by pro-
posing that the key role of the national environment upon a firm’s potential for interna-
tional competitive advantage is its impact upon the dynamics through which resources
and capabilities are developed.7 Porter’s national diamond framework identifies four
key factors that determine whether firms from a particular country can establish com-
petitive advantage within their industry sector (Figure 11.3).8
1 Factor conditions: Whereas the conventional analysis of comparative advantage
focuses on endowments of broad categories of resource, Porter emphasizes the
role of highly specialized resources, many of which are “home grown” rather

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 275
than “endowed.” For example, the United States’ pre-eminence in producing
movies and TV shows is based upon the concentration in Los Angeles of highly
skilled labor and supporting institutions including financiers and film schools.
2 Related and supporting industries: National competitive strengths tend to
be associated with “clusters” of industries. Silicon Valley’s cluster comprises
semiconductor, computer, software, and venture capital firms. For each industry,
closely related industries are sources of critical resources and capabilities. Denmark’s
global leadership in wind power is based upon a cluster comprising wind turbine
manufacturers, offshore wind farm developers and operators, and utilities.
3 Demand conditions: In the domestic market these provide the primary driver of
innovation and quality improvement. For example:
● Switzerland’s pre-eminence in watches is supported by the obsessive punctu-
ality of the Swiss.
● Japan’s dominant share of the world market for cameras by companies owes
much to the Japanese enthusiasm for amateur photography and customers’
eager adoption of innovation in cameras.
● German dominance of high-performance automobiles (Daimler, BMW,
Porsche, VW-Audi) reflects German motorists’ love of quality engineering and
their irrepressible urge to drive on autobahns at terrifying speeds.
4 Strategy, structure, and rivalry: International competitive advantage depends
upon how firms within a particular sector interact within their domestic markets.
Porter observes that intense competition within the domestic market drives inno-
vation, quality, and efficiency. The global success of Japanese companies in cars,
cameras, consumer electronics, and office equipment during the last two decades
of the 20th century was based upon domestic industries where five or more
major producers competed strongly with one another. Conversely, European
failure in many hi-tech industries may be a result of European governments’ pro-
pensity to kill domestic competition by creating national champions.
Consistency between Strategy and National Conditions
Establishing competitive advantage in global industries requires congruence bet-
ween business strategy and the pattern of the country’s comparative advantage. In
DEMAND
CONDITIONS
RELATED AND
SUPPORTING
INDUSTRIES
FACTOR CONDITIONS
STRATEGY, STRUCTURE,
AND RIVALRY
FIGURE 11.3 Porter’s national diamond framework

276 PART IV CORPORATE STRATEGY
semiconductors, US companies such as Intel, Texas Instruments, Nvidia, and Qualcomm
tend to focus upon sophisticated microprocessors, digital signal processing chips,
graphics chips, and application-specific integrated circuits, and emphasize design
rather than manufacture. Chinese semiconductor producers tend to focus upon less
sophisticated memory and logic chips, on older generations of analog integrated cir-
cuits and microcontrollers, and emphasize fabrication rather than design.
Similarly in footwear. The world’s three leading exporters, after China, are Italy, Viet-
nam, and Germany. Each country’s shoe producers exploit the resource strengths of
their home country. Italian shoe producers such as Tod’s, Fratelli Rosetti, and Santoni
emphasize style and craftsmanship; Germany’s shoe companies such as Adidas, Puma,
and Brütting emphasize technology; and Vietnam’s shoe industry uses low-cost labor
to produce vast numbers of cheap casual shoes.
Among national resources, national culture can be an especially potent source of
a firm’s international competitive advantage. The success of US companies in many
areas of high technology, including computer software and biotechnology, owes
much to a system of entrepreneurial capitalism that embodies a national culture that
emphasizes individuality, opportunity, and wealth acquisition. The global success of
Korean corporate giants such as Samsung and LG reflects organizational structures
and management systems that embody Korean cultural characteristics such as loyalty,
respect for authority, conformity to group norms, commitment to organizational goals,
and a strong work ethic.9
Internationalization Decisions: Locating Production
To examine how national resource conditions influence company strategies, we will
look at two types of strategic decision-making in international business: first, where to
locate production activities and, second, how to enter a foreign market. Let us begin
with the first of these.
Firms move beyond their national borders not only to seek foreign markets but
also to access the resources and capabilities available in other countries. Tradition-
ally, multinationals established plants to serve local markets. Increasingly, decisions
concerning where to produce are being separated from decisions over where to sell.
For example, ST Microelectronics, the world leader in application-specific integrated
circuits (ASICs), is headquartered in Switzerland; production is mainly in France, Italy,
and Singapore; R&D is conducted mainly in France, Italy, and the United States; and
the biggest markets are the United States, Japan, the Netherlands, and Singapore.
Determinants of Geographical Location
Figure 11.2 shows that a firm’s resources and capabilities may be located either within
the firm, or may be available from the national environment(s) where it does business.
The sources of a firm’s resources and capabilities have important implications for where
the firm locates its production:
● Country-based resources: If a firm’s competitive advantage is based upon
resources and capabilities available within the national environment, it needs
to locate where these resources and capabilities can be accessed. For oil and
gas companies, this means exploring where petroleum reserves are located. For
software companies, it means locating where software engineers can be recruited.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 277
● Firm-based resources and capabilities: For firms whose competitive advantage is
based on internal resources and capabilities, optimal location depends on where
those resources and capabilities are situated and how mobile they are. Walmart has
experienced difficulty replicating its US-based logistics and merchandising capabil-
ities outside of North America. Conversely, Toyota and IKEA have been highly suc-
cessful in transferring their operational capabilities beyond their home bases.
However, these considerations presume that the firm has the flexibility to choose
where it locates its production. Most services—hairdressing, restaurant meals, banking,
and management consulting—are not tradable: they need to be produced in close
proximity to where they are consumed.
Location and the Value Chain
The production of most goods and services comprises a vertical chain of activities
where the input requirements of each stage vary considerably. Hence, different coun-
tries offer advantages at different stages of the value chain. Table 11.2 shows the pattern
of international specialization for the different stages of production for knitted clothing
(T-shirts, sweaters, etc.). Similarly with consumer electronics: component production
is research- and capital-intensive, the main production centers are the United States,
Japan, Korea, and Taiwan; assembly is labor-intensive and is concentrated in South-East
Asia and Latin America. China is the world leader in both.
A key feature of internationalization has been the international fragmentation of
value chains as firms seek to locate each activity where the resources required are
cheapest and most available.10 Table  11.3 shows the international composition of
Apple’s iPhone.
As the iPhone indicates, for technologically advanced goods and services, global
sourcing is determined more by the location of sophisticated know-how than by access-
ing low cost labor. Increasingly Western companies look to China, Taiwan, Korea,
Malaysia, and India for technical and engineering talent rather than for low cost pro-
duction. Chinese companies are increasingly world leaders in advanced manufacturing
processes while most leading Indian IT service companies operate at level 5 (the high-
est level of expertise) of the Capability Maturity Model.11
TABLE 11.2 Comparative advantages along the value chain for knitted apparel
Raw cotton Spun cotton yarn Knitted fabric Knitted apparel
United States +0.68 +0.85 +0.03 −0.89
Germany −1.00 −0.18 +0.30 −0.18
Korea −1.00 −0.28 +0.94 −0.34
China −0.99 −0.54 +0.70 +0.97
Bangladesh −0.98 −0.95 −0.96 +0.98
Note:
A country’s revealed comparative advantage in particular product is measured as (exports – imports)/(exports +
imports). The scale ranges from −1 to +1. (Note: This is a different measure of revealed comparative advantage from
that used in Table 11.1.)
Source: International Trade Commission.

278 PART IV CORPORATE STRATEGY
The benefits from fragmenting the value chain must be traded off against the
added costs of coordinating globally dispersed activities—the biggest of which is time.
Just-in-time scheduling often requires production activities to be carried out in close
proximity to one another. Companies that compete on speed and flexibility (e.g.,
Inditex) often forsake the cost advantages of a globally dispersed value chain in favor
of co-located activities. The trend toward US corporations “reshoring” manufacturing
activities is partly a result of the narrowing cost gap between the United States and
China, but also because of the flexibility benefits of shorter supply chains.12
Figure 11.4 summarizes the relevant criteria in location decisions.
Internationalization Decisions: Entering a Foreign Market
Firms enter foreign markets in pursuit of revenue and, ultimately, profitability. A firm’s
success in generating sales and profits in a foreign market depends on its ability
to establish a competitive advantage. How a firm can best establish a competitive
advantage will determine how it enters a foreign market.
There are two basic modes of entry into a foreign market: transactions or direct
investment. Figure  11.5 further divides these into a spectrum of market entry types
TABLE 11.3 Where does the iPhone X come from?
Item Supplier Location
Design and operating system Apple US
Flash memory Toshiba Japan
DRAM memory TSMC
SK Hynix
Taiwan
S. Korea
Chip sets and Processors Apple
Qualcomm
US
US
Baseband Qualcomm US
Cameras Sony
Genius Electronic Optical
Japan
Taiwan
Mixed signal chips NXP Neth.
Power management Dialog Semiconductor Germany/UK
Batteries Sunwoda Electronics China
Audio Cirrus Logic US
Touchscreen control Nissha Japan
Sensors STMicroelectronics
Bosch
Italy
Germany
E-compass Alps Electric Japan
Assembly Foxconn China
Source: various websites.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 279
involving progressively higher degrees of resource commitment. Thus, at one extreme,
a firm can export through individual sales transactions; at the other, it can establish a
wholly owned, fully integrated subsidiary.
How does a firm weigh the merits of different market entry modes? Five key factors
are relevant:
● Is the firm’s competitive advantage based on firm-specific or country-specific
resources? If the firm’s competitive advantage is country-based, the firm must
exploit an overseas market by exporting. If Shanghai Auto’s competitive
advantage in Western car markets is its low domestic cost base, it must produce
Where is the optimal location of X in terms
of the cost and availability of inputs?
The optimal location
of activity X considered
independently
The importance of links
between activity X and
other activities of the f irm
What government incentives/penalties
af fect the location decision?
What internal
resources and capabilities does the f irm
possess in particular locations?
What is the f irm’s business strategy
(e.g., cost vs. dif ferentiation advantage)?
How great are the coordination
benef its from colocating activities?
WHERE TO LOCATE
ACTIVITY X?
FIGURE 11.4 Determining the optimal location of value chain activities
Licensing
patents and
other IP
Franchising
TRANSACTIONS
Spot
sales
Foreign
agent/
distributor
Long-term
contract
Wholly-owned
subsidiary
Marketing and
distribution
only
Fully
integrated
HighResource commitmentLow
DIRECT INVESTMENT
Joint venture
Fully
integrated
Marketing and
distribution
only
Exporting Licensing
FIGURE 11.5 Alternative modes of overseas market entry

280 PART IV CORPORATE STRATEGY
in China and export to foreign markets. If Toyota’s competitive advantage is
its production and management capabilities then, as long as it can transfer
these capabilities, it can exploit foreign markets either by exports or by direct
investment.13
● Is the product tradable? If the product cannot be exported because of trans-
portation constraints or import restrictions, then accessing the foreign market
requires either direct investment or licensing the use of key resources to a
local company.
● Does the firm possess the full range of resources and capabilities needed for
success in the overseas market? Competing in an overseas market is likely to
require resources and capabilities that the firm does not possess, necessi-
tating collaboration with a local firm. The form of the collaboration depends,
in part, on the resources and capabilities required. If a firm needs marketing
and distribution capabilities, it might appoint a distributor or agent with
exclusive territorial rights. The Italian brewer, Menabrea, appoints exclusive
distributors in each of the 36 countries to which it exports. If a wider range
of capabilities is needed, the firm might license its product and/or its tech-
nology to a local manufacturer. Thailand’s Boon Rawd Brewery licenses its
Singha beer trademarks and recipes to Denmark’s Carlsberg Group. Alterna-
tively, a joint venture might be sought with a local manufacturing company.
Cobra beer is brewed in the United Kingdom by a joint venture between
Cobra India and Molson Coors.
● Can the firm directly appropriate the returns to its resources? The viability of
licensing in exploiting a foreign market depends on appropriability consider-
ations. In chemicals and pharmaceuticals, the patents protecting product inno-
vations tend to offer strong legal protection; in which case, offering licenses to
local producers can be an effective means of appropriating their returns. For
electronic hardware and medical devices, the protection offered by patents
and copyrights is looser, which encourages exporting rather than licensing
as a means of exploiting overseas markets. With all licensing arrangements,
the key considerations are the capabilities and reliability of the local licensee.
This is particularly important in licensing brand names, where the licenser
must carefully protect the brand’s reputation. Starbucks’ formation of a joint
venture with Tata Group to develop Starbucks outlets in India, was facilitated
by the two companies’ shared commitment to ethics and corporate social
responsibility.
● What transaction costs are involved? Transaction costs are fundamental to
the choice between alternative market entry modes. Barriers to exports
in the form of transport costs and tariffs constitute transaction costs that
may encourage direct investment. The choice between licensing and
direct investment also depends upon the transaction costs of negotiating,
monitoring, and enforcing licensing agreements. In the United Kingdom,
Starbucks owns and operates most of its coffee shops, while McDonald’s fran-
chises its burger restaurants. The McDonald’s business system can be specified
and enforced through a franchise agreement. The “ Starbucks experience,” by
contrast, is as much about intangibles such as ambiance and values as it is
about coffee. These are difficult to specify in a franchise contract. More gen-
erally, the presence of transaction costs both in product markets and in the
markets for resources and capabilities, are a major reason why multinational
enterprises predominate in many industries.14

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 281
Multinational Strategies: Global Integration versus National
Differentiation
So far, we have looked only at individual international strategic decisions concerning
locating production and entering foreign markets. However, international strategy
involves managing a firm’s overall geographical scope. What is the potential for such
“global strategies” to create competitive advantage over nationally focused rivals? In
what types of industry are they likely to be most effective? And how should they be
designed and deployed in order to maximize their potential?
The Benefits of a Global Strategy15
A global strategy is one that views the world as a single, if segmented, market. There
are five major sources of value from operating internationally.
Cost Benefits of Scale and Replication The primary advantage of companies
that compete globally over their local rivals is their access to scale economies in
purchasing, manufacturing, marketing, and new product development.16 Pankaj Ghe-
mawat refers to these as benefits from cross-border aggregation.17 Exploiting these
scale economies has been facilitated by the growing convergence of customer pref-
erences: “Everywhere everything gets more and more like everything else as the
world’s preference structure is relentlessly homogenized,” observed Ted Levitt.18 In
many industries—commercial aircraft, semiconductors, consumer electronics, video
games—firms have no choice: they must market globally to amortize the huge costs
of product development. In service industries, the cost efficiencies from multinational
operation derive primarily from economies of replication. Once a company has cre-
ated a knowledge-based asset or product—be it a recipe, a piece of software, or an
organizational system—it can be replicated in additional national markets at a fraction
of the cost of creating the original.19 Disneyland theme parks in Tokyo, Paris, Hong
Kong, and Shanghai replicate the rides and management systems that Disney develops
for its parks in Anaheim and Orlando. This is the appeal of franchising: if I create
a brilliantly innovative facial massage system that allows elderly people to maintain
the complexion of a 20-year-old, why limit myself to a single outlet in Beverly Hills,
California? Why not try to emulate Domino’s Pizza with its 14,000 outlets across 71
countries of the world?
Serving Global Customers In several industries (e.g., investment banking, audit
services, and advertising), the primary driver of globalization has been the need to ser-
vice global customers.20 Hence, auto-parts manufacturers have internationalized as they
follow the global spread of the major automobile producers. Law firms such as Baker
& McKenzie, Clifford Chance, and Linklaters have internationalized to better serve their
multinational clients.
Exploiting National Resources: Arbitrage Benefits As we have already seen,
firms internationalize not only to expand into new markets but also to access resources
outside their home countries.
Traditionally, this has meant a quest for raw materials and low-cost labor. Stan-
dard Oil’s initial internationalization during 1917–1923 followed its quest for crude

282 PART IV CORPORATE STRATEGY
oil reserves in Mexico, Colombia, Venezuela, and the Dutch East Indies. Nike’s
pursuit of low-cost manufacturing facilities has taken it from Japan, to Taiwan and
South Korea, to China, and, most recently, to Vietnam, Indonesia, and Bangladesh.
Ghemawat refers to this exploitation of differences in resource availability bet-
ween countries as arbitrage.21 Arbitrage strategies are conventionally associated
with exploiting wage differentials by offshoring production to low-wage locations;
increasingly arbitrage is about exploiting the distinctive knowledge available in dif-
ferent locations. Most of the world’s leading semiconductor firms have established
R&D facilities in California’s Silicon Valley.22
Arbitrage opportunities may arise not only from national resource conditions, but
from any distinctive advantages that a country possesses. Apple, Google, Amazon, and
Starbucks have been adept at ensuring that their profits accrue in countries which levy
the lowest corporate tax rates.23
Learning Benefits The learning benefits of multinational companies are not
simply accessing the knowledge available in different locations but also transferring
and integrating that knowledge and using the exposure to different national envi-
ronments to create new knowledge. IKEA’s success is based, not only on replicating
its unique business system, but also on its ability to learn from each country where
it does business and then transfer that learning to its global network. In Japan, IKEA
had to adjust to Japanese design preferences, modes of living, and consumers’ acute
quality- consciousness. IKEA was then able to transfer the quality and design capa-
bilities it developed in Japan to its global activities. According to the CEO of IKEA
Japan, “One reason for us to enter the Japanese market, apart from hopefully doing
very good business, is to expose ourselves to the toughest competition in the world.
By doing so, we feel that we are expanding the quality issues for IKEA all over
the world.”24
Recent contributions to the international business literature suggest that this
ability of multinational corporations to develop knowledge in multiple locations, to
synthesize that knowledge, and to transfer it across national borders may be their
greatest advantage over nationally focused companies.25 To exploit these learning
benefits a company must possess global infrastructure for managing knowledge
that permits new experiences, new ideas, and new practices to be integrated
and diffused.
Competing Strategically A major advantage of Julius Caesar and the Romans
over Asterix and the Gauls was the Romans’ ability to draw upon the military and
economic resources of the Roman Empire to suppress rebellious tribes. Similarly, mul-
tinational companies possess a key strategic advantage over their nationally-focused
rivals when engaging in competitive battles in individual national markets: they can
use resources from other national markets. In the battle for leadership of the Indian
online retail market, a key advantage of Amazon over its local rival, Flipkart, was
Amazon’s ability to use its US cash flow to finance losses in India. By selling a majority
stake to Walmart in 2018, Flipcart has leveled the field. Cross-subsidization of compet-
itive initiatives in one market using profits from other markets may involve predatory
pricing—cutting prices to a level that drives competitors out of business. More usually,
cross-subsidization involves using cash flows from other markets to finance aggres-
sive sales and marketing campaigns.26 Strategic competition between multinational
corporations can result in complex patterns of attack, retaliation, and containment.27

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 283
As the US and Chinese ecommerce giants, Amazon and Alibaba, internationalize each
is making forays into the other’s home market as well as battling in third countries
such as India.28
The Need for National Differentiation
For all the advantages of global strategy, national differences still frustrate firms’
attempts to design “global products” to meet the needs of the “global customer.” Even
globally standardized products such as the iPhoneX and the Big Mac vary from country
to country.29
In some industries, efforts toward globalization have met with little success. In
domestic appliances, national preferences have shown remarkable resilience. The
design and features of washing machines and cookers vary between the regions of
the world.30 Similarly in retail banking, despite some examples of successful inter-
nationalization (Banco Santander, HSBC), customer preferences and regulations vary
between countries and there are few economies from cross-border integration. As a
result, Citibank, HSBC, Barclays, and Deutsche Bank radically reduced their interna-
tional presence during 2010 to 2018.31
To identify and assess the extent of strategic differences between countries,
Ghemawat’s “CAGE’ framework identifies four dimensions of distance between
countries: cultural, administrative and political, geographical, and economic (see
Table 11.4).
These broad categories are only a starting point for navigating the national
idiosyncrasies that make international expansion such a minefield. Consumer prod-
uct firms must, not only adapt to differences in consumer preferences between
TABLE 11.4 Ghemawat’s CAGE framework for assessing country differences
Cultural distance
Administrative and
political distance Geographical distance
Economic
differences
Distance
between two
countries
increases with:
Different languages,
ethnicities, religions,
social norms
Lack of connective
ethnic or
social networks
Absence of shared
political or monetary
association
Political hostility.
Weak legal and
financial institutions
Lack of common border,
water-way access, adequate
transportation or communi-
cation links
Physical remoteness
Different
consumer incomes
Different costs and
quality of natural,
financial, and
human resources
Different information
or knowledge
Industries
most affected
by source
of distance:
Industries with high
linguistic content
(TV, publishing) and
cultural content (food,
wine, music)
Industries viewed
by government
as strategically
important
(e.g., energy,
defense, telecoms)
Products with low
value-to-weight (cement),
are fragile or perishable
(glass, milk), or dependent
upon communications
(financial services)
Products whose
demand is sensitive to
consumer income
levels (luxury goods)
Labor-intensive
products (clothing)
Sources: Based upon: P. Ghemawat, “Distance Still Matters: The Hard Reality of Global Expansion,” September 2001, pp. 137–47
and P. Ghemawat, “Differences and the CAGE Distance Framework.” https://www.ghemawat.com/wordpress/wp-content/
uploads/2016/10/DifferencesAndTheCAGEFramework .

https://www.ghemawat.com/wordpress/wp-content/uploads/2016/10/DifferencesAndTheCAGEFramework

284 PART IV CORPORATE STRATEGY
countries, they must also adapt to differences in distribution channels. Procter &
Gamble adapts its marketing and distribution of its toiletries and household prod-
ucts to take account of the fact that, in the United States, a few chains account for
a major share of its US sales; in southern Europe, most sales are through small,
independent retailers, while in Japan, it must sell through a multi-tiered hierarchy
of distributors. The closer an industry is to the final consumer, the more important
cultural factors are likely to be. Strategy Capsule 11.1 considers some dimensions
of national culture. These cultural differences explain why so few retailers have
been successful outside their home markets. Walmart, IKEA, H&M, and Gap are
among the few retailers that are truly global.
Reconciling Global Integration with National Differentiation
Formulating an international strategy involves trading off the benefits of global
integration with those of national adaptation. Figure  11.6 shows that this trade-off
STRATEGY CAPSULE 11.1
How do national Cultures differ?
How people differ between countries with regard to
beliefs, norms, and value systems has been the subject of
a number of research studies.
The best-known study of national cultural differ-
ences is by Geert Hofstede. The principal dimensions of
national values he identified were:
◆ Power distance: The extent to which inequality, and
decision-making power in particular, is accepted
within organizations and within society was high in
Malaysia, and most Latin American and Arab coun-
tries; low in Austria and Scandinavia.
◆ Uncertainty avoidance: Preference for certainty
and established norms was high in most southern
European and Latin American countries; tolerance
for uncertainty and ambiguity was high in Singa-
pore, Sweden, the United Kingdom, the United
States, and India.
◆ Individualism: Concern for individual over group
interests was highest in the United States, the United
Kingdom, Canada, and Australia. Identification with
groups and the collective interest was strongest in
Latin America and Asia (especially Indonesia, Paki-
stan, Taiwan, and South Korea).
◆ Masculinity/femininity: Hofstede identifies emphasis
on work and material goals and demarcation of
gender roles as masculine; emphasis on personal
relationships rather than efficiency and belief in
gender equality he viewed as feminine. Japan, Austria,
Venezuela, and Italy scored high on masculinity;
Scandinavia and the Netherlands scored very low.
Other scholars emphasize different dimensions of
national cultures. Fons Trompenaars (another Dutchman)
identifies the United States, Australia, Germany, Sweden
and the United Kingdom as universalist societies—rela-
tionships are governed by standard rules; Brazil, Italy,
Japan, and Mexico are particularist societies—social
relationships are strongly influenced by contextual and
personal factors. In affective cultures, such as Mexico and
the Netherlands, people display their emotions; in neutral
cultures, such as Japan and the United Kingdom, people
hide their emotions.
Sources: G. Hofstede, Culture’s Consequences: International Differ-
ences in Work-related Values (Thousand Oaks, CA: SAGE Publica-
tions, 1984); F. Trompenaars, Riding the Waves of Culture (London:
Economist Books, 1993).

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 285
varies greatly between industries. Jet engines and semiconductors are industries where
scale economies are huge and customer preferences vary little from country to country.
Firms in these industries can view the world as a single, global market. Conversely,
in industries such as retail banking and frozen foods, national preferences are pro-
nounced and meeting them does not impose prohibitive costs. This favors multidomestic
strategies involving distinct strategies for each national market. Indeed, in industries
where there are few benefits from global integration, multinational firms may be absent
(as in funeral services and laundries). Some of the most interesting and complex indus-
tries from an international strategy viewpoint are those that combine substantial ben-
efits from operating globally with the need to adapt to the requirements of individual
national markets, such industries include domestic appliances, military hardware, cos-
metics, and insurance.
Reconciling conflicting forces for global efficiency and national differentiation
represents one of the greatest strategic challenges facing multinational corporations.
The typical solution is to globally standardize product features and company activities
where scale economies are substantial, and locally differentiate where national prefer-
ences are strongest and where achieving them is not overly costly. The world’s leading
automobile companies design their cars around a few global platforms and common
components, then differentiate to meet national safety and environmental standards
and also local preferences for legroom, seat specifications, accessories, color, and trim.
McDonald’s, too, standardizes its core business system, then adapts to local cultural and
culinary preferences (Strategy Capsule 11.2).
Reconciling global efficiency with national adaptation requires disaggregating the
company by product and function. In retail banking, different products and services
have different potential for globalization. Credit cards and basic savings products
Jet engines
Autos
Cement
Consumer
electronics
Telecom
equipment
Investment
banking
Retail
banking
Benef its of national dif ferentiation
Benef its of
global
integration
Funeral
services
Auto
repair
FIGURE 11.6 Benefits of global integration versus national differentiation

286 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 11.2
Mcdonald’s Goes “Glocal”
McDonald’s has long been demonized by anti-
globalization activists. They allege that it crushes national
cuisines and independent, family-run restaurants with
the juggernaut of US fast-food, corporate imperialism. In
reality, its global strategy is a careful blend of global stan-
dardization and local adaptation.
McDonald’s menus feature an increasing number of
locally-developed items. These include:
◆ Australia: Gourmet Angus Truffle & Cheese, English
Brekkie Wrap, and Frozen Coke;
◆ France: Croque McDo, Le Blue Cheese and Bacon
Burger;
◆ Hong Kong: Mixed Veggies & Egg, Mini Twisty Pasta,
Mango Layer Cake;
◆ India: McSpicy Paneer and McAloo Wrap;
◆ Saudi Arabia: McArabia Kofta, McArabia Chicken;
◆ Switzerland: Quinoa Curry, Ovomaltine;
◆ UK: So Simple Apple and Cherry Porridge, Fish
Fingers,  Peri Peri Snack Wrap, Cadbury Crunchie
McFlurry;
◆ US: Sausage Burrito, Maple Bacon Dijon with Artisan
Grilled Chicken, Fruit and Yogurt Parfait.
There are differences too in restaurant decor, ser-
vice offerings (e.g., home delivery in India), and market
positioning (outside the United States McDonald’s is
more upmarket). In Israel, most McDonald’s are kosher:
there are no dairy products and it is closed on Satur-
days. In India, neither beef nor pork is served. In Ger-
many, France, and Spain, McDonald’s serves beer. A
key reason that most non-US outlets are franchised is
to facilitate adaptation to national environments and
access to local know-how.
Yet, the core features of the McDonald’s strategy
are identical throughout the world. McDonald’s
values and business principles are seen as universal
and invariant. Its emphasis on families and children is
intended to identify McDonald’s with fun and family
life wherever it does business. Community involve-
ment and the Ronald McDonald children’s charity are
also worldwide. Corporate trademarks and brands are
mostly globally uniform, including the golden arches
logo and “I’m lovin’ it” tag line. The business system
itself—franchising arrangements, training, restau-
rant operations, and supplier relations—is also highly
standardized.
McDonald’s international strategy has changed from
adapting its US model to local conditions to seeking and
encouraging local innovation everywhere, then using
its global network to transfer promising concepts more
widely. McCafés, gourmet coffeehouses within McDon-
ald’s restaurants, were first developed in Australia in
1993. By 2013, McCafés were operating in 30 countries.
Growing concern over nutrition and obesity has accel-
erated McDonalds’ reliance upon country initiatives to
drive global learning.
Has McDonald’s got the balance right between
global standardization and local adaptation? Simon
Anholt, a British marketing expert, argues: “By putting
local food on the menu, all you are doing is removing
the logic of the brand, because this is an American
brand. If McDonald’s serves what you think is a poor
imitation of your local cuisine, it’s going to be an insult.”
But according to McDonald’s CEO Jim Skinner: “We don’t
run our business from Oak Brook. We are a local business
with a local face in each country we operate in.” Chief
marketing officer, Mary Dillon, adds: “Globally we think
of ourselves as the custodian of the brand, but it’s all
about local relevance.”
Source: www.mcdonalds.com.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 287
such as certificates of deposit tend to be globally standardized; checking accounts
and mortgage lending are much more nationally differentiated. Similarly with business
functions: R&D, purchasing, IT, and manufacturing have strong globalization potential;
sales, marketing, customer service, and human resource management need to be much
more nationally differentiated. These differences have important implications for how
the multinational corporation is organized.
Implementing International Strategy: Organizing the
Multinational Corporation
These same forces that determine international strategies—exploiting global integration
while adapting to national conditions—also have critical implications for the design of
organizational structures and management systems to implement these strategies. As
we shall see, one of the greatest challenges facing the senior managers of multinational
corporations is aligning organizational structures and management systems to fit with
the strategies being pursued.
The Evolution of Multinational Strategies and Structures
Choices over international strategy have implications for firms’ organizational
structures. Christopher Bartlett and Sumantra Ghoshal describe the strategy-structure
configurations of multinational corporations as their administrative heritage and, once
established, this heritage creates a barrier to strategic and organizational change.32
They identify three eras in the development of the multinational corporation
(Figure 11.7):
● The early 20th century: era of the European multinationals. Companies such
as Unilever, Shell, ICI, and Philips were pioneers of multinational expan-
sion. Because of the conditions at the time of internationalization—poor
The Europeans:
Decentralized
Federations
The Japanese:
Centralized
Hubs
The Americans:
Coordinated
Federations
FIGURE 11.7 The development of the multinational corporation: Alternative
parent–subsidiaries relations
Note:
The density of shading indicates the concentration of decision making.
Source: C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business
School Press, 1998). Copyright © 1989 by the Harvard Business School Publishing Corporation, all rights reserved.

288 PART IV CORPORATE STRATEGY
transportation and communications, highly differentiated national
markets—the companies created multinational federations: each
national subsidiary was operationally autonomous and undertook the full
range of functions, including product development, manufacturing, and
marketing.
● Post-Second World War: era of the American multinationals. US dominance
of the world economy was reflected in the pre-eminence of US multina-
tionals, such as GM, Ford, IBM, Coca-Cola, Caterpillar, and Procter & Gamble.
While their overseas subsidiaries were allowed considerable autonomy,
this was within the context of the dominant position of their US parent in
terms of finance, technology, and management. These US-based resources
and capabilities provided the foundation for their international competitive
advantages.
● The 1970s and 1980s: the Japanese challenge. Honda, Toyota, Matsushita, NEC,
and YKK pursued global strategies from centralized domestic bases. R&D and
manufacturing were concentrated in Japan; overseas subsidiaries undertook
sales and distribution. Globally standardized products manufactured in
large-scale plants provided the basis for unrivalled cost and quality advantages.
Over time, manufacturing and R&D were dispersed, initially because of trade
protection by consumer countries and the rising value of the yen against other
currencies.
These different administrative heritages have continued to set the strategic agendas
of these different groups of multinational corporations. The strength of European
multinationals is their ability to adapt to the requirements of individual national
markets. Their challenge has been to achieve greater integration of their sprawling
international empires. For Shell and Philips this has involved periodic reorganization
over the past three decades. The strength of the US multinationals is their ability to
transfer technology and proven new products from their domestic strongholds to their
national subsidiaries. The challenge for companies such as Ford, IBM, and Procter
& Gamble has been dispersing technology, design, and product development while
achieving a high level of global integration. During the 1980s, Japanese multinational
corporations exemplified the efficiency benefits of global standardization. Since then,
Japanese multinational corporations such as Sony, Panasonic, Nomura, Hitachi, and
NEC have taken major strides to becoming true insiders in the many countries where
they do business, yet have struggled to sustain leadership in product and process
innovation.
Recent Trends in Multinational Management
Despite the different heritages of the different groups of multinationals, all have
faced the same strategic and organizational challenge during recent decades: rec-
onciling global integration with national differentiation. Escalating costs of research
and new product development have made global strategies with global product plat-
forms essential. At the same time, meeting consumer needs in each national market
and responding swiftly to changing local circumstances requires greater decentral-
ization. Accelerating technological change further exacerbates these contradictory
forces: innovation needs to take place at multiple locations rather than at a centralized
R&D facility.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 289
Bartlett and Ghoshal argue that reconciling these conflicting performance goals
has caused multinationals to adopt a new configuration of strategy and structure:
the transnational corporation. In the transnational corporation, the corporate
center is responsible for coordinating a global network where each national unit
is responsible for managing local affairs but also fulfils a global role based upon
its own distinctive capabilities (see Figure  11.8). Bartlett notes that the transna-
tional requires “a very different kind of internal management process than existed
in simpler multinational organizations… it’s the corporate equivalent of being able
to walk, chew gum, and whistle at the same time.”33 Ford Motor Company’s global
strategy and organization corresponds closely to this transnational model (see
Strategy Capsule 11.3).
Ghemawat recognizes that the challenge for multinationals in reconciling the
conflicting strategic goals is even more complex. He makes an important extension
to the Bartlett-Ghoshal framework.34 In addition to exploiting scale economies
from global integration through aggregation and meeting local demands through
adaptation, multinationals also need to exploit country-based advantages through
arbitrage. As we discussed earlier (pp. 281–282), opportunities for arbitrage arise not
only from the availability of different resources and capabilities in different countries,
but also from other national characteristics—including taxation systems, environ-
mental policies, and financial regulations. Strategy Capsule 11.4 outlines Ghemawat’s
“Triple-A” framework.
Over recent decades, the pressure of competition has required multinational
corporations to exploit multiple sources of value. For North American and
European multinational corporations, this has required a shift from a multidomes-
tic approach organized around national subsidiaries and regional groupings to
increased global integration involving the creation of worldwide product divisions.
However, designing organizational structures and management systems that can
achieve an optimal balance between the three dimensions of Ghemawat’s AAA tri-
angle is complex. Aggregation favors global product divisions, adaptation is best
achieved through semi-autonomous national subsidiaries, while arbitrage requires
the concentration of particular functions and activities in specific locations. More-
over, the trade-offs among these factors varies between products, functions, and
geographical markets.
For example, Procter & Gamble adopts global standardization for some of its prod-
ucts (e.g., Gillette razor blades and high-end fragrances); for others (e.g., hair care
Tight complex controls
and coordination and
a shared strategic
decision process
Heavy f lows of
technology, f inances,
people, and materials
between interdependent
units
FIGURE 11.8 Bartlett and Ghoshal’s transnational corporation

290 PART IV CORPORATE STRATEGY
products and laundry detergent), it allows significant national differentiation. Across
countries, P&G organizes global product divisions to serve most of the industrialized
world because of the similarities between their markets, while for emerging-market
countries (such as China and India) it operates through country subsidiaries in order
to adapt to the distinctive features of these markets. Among functions, R&D is globally
integrated, while sales are organized by national units that are differentiated to meet
local market characteristics.
STRATEGY CAPSULE 11.3
Ford Motor Company: A Transnational Corporation
Between 1970 and 2017, the Ford Motor Company
evolved from a “coordinated federation” with a dominant
US core and fairly autonomous overseas subsidiaries into
a globally integrated network. In the early 1970s, the
US parent exercised financial control over the overseas
subsidiaries and appointed their chief executives—but
product policy, operations, and marketing were mostly
in the hands of the country managers. In the United
Kingdom, the leading Ford models were the Cortina
and the Escort—both designed and manufactured by
Ford of Britain. Ford Germany’s leading model was the
Ford Taunus—again, designed and manufactured in
Germany. Ford Brazil’s leading models were the Concel
and the Aero.
Global integration began with the creation of
Ford of Europe in 1969 and continued with Ford’s
efforts to introduce global models. The 1992 Mondeo
(Contour in North America) was the first global model.
Under Alan Mullaly (CEO 2006–2014), Ford intensi-
fied its quest for global integration. Mullaly’s “One
Ford” strategy involved standardizing components,
reducing the number of platforms from 27 in 2007 to
8 in 2017, and developing global models for manu-
facture at multiple plants throughout the world. For
example, the 2017 (4th generation) Ford Focus was
developed by Ford’s design studios and technical cen-
ters in Europe and the United States and manufac-
tured at plants in Mexico, Germany, China, Thailand,
Russia, and Argentina.
At the same time, individual national subsidiaries
continue to introduce variations on these global
models. The Ford Mustang and its F-series pick-up
trucks are designed and manufactured in the United
States for sale primarily to North American customers.
Ford’s Chinese joint venture with Changan Auto
manufactures the Ford Escort, a long wheelbase ver-
sion of the 3rd generation Focus. The Ford Ka, sold
mainly in Europe, was originally manufactured by Fiat.
It is now built by Ford Brazil for sale in Latin America
and Europe.
This globally integrated strategy encouraged Ford
to reorganize around global functions—such as Global
Product Development, Global Manufacturing, Quality
and New Model Launch and Global Marketing—together
with regional divisions (The Americas; Europe, Middle
East, and Africa; and Asia Pacific). However, the key to the
One Ford strategy was for people to collaborate, share,
and innovate across organizational and geographical
boundaries.
Within this structure, Ford’s national units have both
local and global responsibility. Ford of Britain no longer
assembles Ford cars, but is responsible for marketing,
distribution, and customer support within the United
Kingdom, as well having global responsibilities for the
manufacture of 1.6-liter gasoline engines (at Bridgend)
and EcoBlue diesel engines (at Dagenham), transmis-
sions (at Halewood), and engine design (at Dunton
Technical Center).

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 291
The quest to exploit arbitrage opportunities has resulted in MNCs reallocating activ-
ities outside their home countries. When Philips adopted a product division structure,
it located responsibility for medical electronics in its US subsidiary and leadership in
consumer electronics in Japan. During 2017, Nomura, Morgan Stanley, and Goldman
STRATEGY CAPSULE 11.4
Ghemawat’s “AAA Triangle”
Ghemawat proposes that a multinational corpora-
tion’s strategy may be represented by its positioning
along the three dimensions of aggregation, adaptation,
and arbitrage—his “AAA triangle” (Figure  11.9). A firm
can be positioned by using proxy variables. Each stra-
tegic direction has different organizational implications:
aggregation requires strong cross-border integration, for
example, global product divisions and global functions;
adaptation requires country-based units with high levels
of autonomy; arbitrage requires activities to be located
according to the availability of resources and capabil-
ities. However, the managerial challenge of reconciling
these different organizational requirements means that
most firms are able to able to pursue two out the three
As.35 For example, among Indian IT service companies,
Tata Consultancy Services (TCS) has emphasized arbi-
trage and aggregation, while Cognizant is oriented
toward arbitrage and adaptation. In medical diagnos-
tics, General Electric Healthcare is unusual in terms of its
ability to achieve high levels along all three dimensions:
it achieves aggregation economies through the highest
R&D budget in the industry, arbitrage through locating
global production centers in low cost countries, and
adaptation by developing country-focused marketing
units and offering customer-focused solutions that com-
bine hardware with a range of services.
FIGURE 11.9 Ghemawat’s AAA Triangle
ADAPTATION
Cognizant
TCS
Proxy: Advertising-
to-sales ratio relative
to rivals
Proxy: R&D-to-sales
ratio relative to rivals
ARBITRAGE
Proxy: Labor cost to sales
ratio relative to rivals
AGGREGATION
Source: P. Ghemawat, “Managing Differences: The Central Challenge of Global Strategy,” Harvard Business
Review 85 (March 2007).

292 PART IV CORPORATE STRATEGY
Sachs shifted staff and activities from London to Frankfurt in anticipation of Brexit,
while other banks chose Dublin or Paris for their European Union bases. Exploiting
arbitrage opportunities of particular national locations may even require shifting corpo-
rate domicile.36 Burger King’s $11 billion acquisition of the Canadian chain Tim Hortons
was motivated in part by the tax advantages of shifting Burger King’s headquarters
to Canada.37
The tendency for MNCs to disperse previously centralized functions is particu-
larly evident in R&D. P&G operates 26 innovation centers throughout the world.
In Japan, it seeks to capitalize on Japanese obsessiveness over cleanliness, through
developing new household cleaning products such as Swiffer. Its Singapore innova-
tion center emphasizes biomedical research, while Cincinnati is its base for developing
new beauty products. A survey by McKinsey & Company found that 80% of executives
believed that R&D goals were best served by establishing satellite units that collabo-
rated as a network.38
To what extent are the benefits that MNCs derive from aggregation, adaptation,
and arbitrage outweighed by the administrative costs imposed by administrative com-
plexity? McKinsey found that successful MNCs underperformed successful “national
champions.” They pointed to a “globalization penalty” that reflected difficulties in
gaining consensus around a shared vision, encouraging innovation, and building
government and community relationships. Reconciling national differentiation with
local differentiation was an ongoing challenge:
Almost everyone we interviewed seemed to struggle with this tension, which often
plays out in heated internal debates. Which organizational elements should be
standardized? To what extent does managing high-potential emerging markets on a
country-by-country basis make sense? When is it better, in those markets, to leverage
scale and synergies across business units in managing governments, regulators, part-
ners, and talent?39
–5
0
5
10
15
20
25
MNC
Local �rm
Te
ch
no
lo
gy
Ot
he
r c
on
su
m
er
In
du
str
ial
Cy
cli
ca
l c
on
su
m
er
Ut
ilit
ies
Fin
an
cia
l
Di
ve
rsi
�e
d
Ba
sic
m
at
er
ial
s
M
ed
ia
&
co
m
m
un
ica
tio
ns
En
er
gy
FIGURE 11.10 The return on equity of MNCs and their local competitors, 2016
Source: Bloomberg; The Economist

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 293
Further evidence of deteriorating profitability of MNCs is indicated by a decline in
the rate of return on foreign direct investment by US and UK companies during 1988
to 2016 and the tendency for MNCs to be outperformed by their local rivals in most
sectors (see Figure 11.10).40
Sectors where scale economies mandate global scale—jet engines, semiconductors,
and telecom equipment—will inevitably be dominated by MNCs. Elsewhere the trend
is for MNCs to reduce their global scope—this is particularly evident in sectors where
the aggregation benefits of cross-border operation are small: banking, retailing, tel-
ecom services.
Summary
Moving from a national to an international business environment represents a quantum leap in
complexity. In an international environment, a firm’s potential for competitive advantage is deter-
mined not just by its own resources and capabilities, but also by the conditions of the national envi-
ronments in which it operates: including input prices, exchange rates, and institutional and cultural
factors.
International strategic decisions utilize the same basic tools of strategy analysis that we developed
in earlier chapters. For example, to determine whether a firm should enter an overseas market, we must
examine the profit implications of such an entry. This requires an analysis of (a) the attractiveness of the
overseas market using the familiar tools of industry analysis and (b) the potential of the firm to establish
competitive advantage in that overseas market.
However, establishing the potential for a firm to create value from internationalization is only a
beginning. Subsequent analysis needs to design an international strategy: do we enter an overseas market
by exporting, licensing, or direct investment? If the latter, should we set up a wholly owned subsidiary or
a joint venture? Once the strategy has been established, a suitable organizational structure needs to be
designed.
That so many companies that have been outstandingly successful in their home market have failed
so miserably in their overseas expansion demonstrates the complexity of international management. In
some cases, companies have failed to recognize that the resources and capabilities that underpinned
their competitive advantage in their home market could not be readily transferred or replicated in over-
seas markets. In others, the problems were in designing the structures and systems that could effec-
tively implement the international strategy.
As the lessons of success and failure from international business become recognized and dis-
tilled into better theories and analytical frameworks, so we advance our understanding of how to
design and implement strategies for competing globally. We are at the stage where we recognize
the issues and the key determinants of competitive advantage in an international environment.
However, there is much that we do not fully understand. Designing strategies and organizational
structures that can reconcile critical trade-offs between global scale economies versus local
differentiation, decentralized learning and innovation versus worldwide diffusion and replication,
and localized flexibilities versus international standardization remains a key challenge for senior
managers.

294 PART IV CORPORATE STRATEGY
Self-Study Questions
1. With reference to Figure  11.1, choose a sheltered industry—one that
has been subject to little penetration either by imports or foreign direct
investment. Explain why the industry has escaped internationalization. Are
there opportunities for profitable internationalization for firms within the
industry? If so, what strategy would offer the best chance of success?
2. With reference to Table  11.1, what characteristics of national resources
explain the different patterns of comparative advantage for the United States
and Japan?
3. According to Michael Porter’s Competitive Advantage of Nations, some of
the industries where British companies have an international advantage are:
advertising, auctioneering of antiques and artwork, distilled alcoholic bever-
ages, hand tools, and chemical preparations for gardening and horticulture.
Some of the industries where US companies have an international competi-
tive advantage are: aircraft and helicopters, computer software, oilfield ser-
vices, management consulting, cinema films and TV programs, healthcare
products and services, and financial services. For either the United Kingdom
or the United States, use Porter’s national diamond framework (Figure 11.3)
to explain the observed pattern of international competitive advantage.
4. When Porsche decided to enter the SUV market with its luxury Cayenne
model, it surprised the auto industry by locating its new assembly plant in
Leipzig in eastern Germany. Many observers believed that Porsche should
have located the plant either in central or eastern Europe where labor costs
were very low or (like Mercedes and BMW) in the United States where it
would be close to its major market. Using the criteria outlined in Figure 11.4,
can you explain Porsche’s decision?
5. British expatriates living in the United States frequently ask friends and
relatives visiting from the United Kingdom to bring with them bars of Cad-
bury chocolate on the basis that the Cadbury chocolate available in the
United States (manufactured under license by Hershey’s) is inferior to “the
real thing.” Should Mondelēz International (formerly Kraft Foods, which
acquired Cadbury in 2010) continue Cadbury’s licensing agreement with
Hershey or should it seek to supply the US market itself, either by export
from the United Kingdom or by establishing manufacturing facilities in the
United States?
6. Since 2013, McDonald’s sales have been falling. Has it got the balance
right between global standardization and national differentiation (Strategy
Capsule  11.2)? How much flexibility should it offer its overseas franchi-
sees with regard to new menu items, store layout, operating practices, and
marketing? Which aspects of the McDonald’s system should McDonald’s top
management insist on keeping globally standardized?

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 295
Notes
1. For the OECD countries (the developed, industrialized
nations) the ratio of total trade (imports + exports) to
GDP grew from 11% in 1960 to 58% in 2014 (OECD Fact-
book, 2017).
2. J. Johanson and J.-E. Vahlne, “The Uppsala Internationali-
zation Process Model Revisited: From Liability of Foreign-
ness to Liability of Outsidership,” Journal of International
Business Studies 40 (2009): 1411–1431.
3. P. Ghemawat and F. Ghadar, “Global Integration: Global
Concentration,” Industrial and Corporate Change 15
(2006): 595–624.
4. As Tables 11.1 and 11.3 show, revealed comparative
advantage can be measured in different ways.
5. E. E. Learner, Sources of International Comparative
Advantage: Theory and Evidence (Cambridge MA:
MIT Press).
6. P. Krugman, “Increasing Returns, Monopolistic Competi-
tion, and International Trade,” Journal of International
Economics (November 1979): 469–79.
7. M. E. Porter, The Competitive Advantage of Nations (New
York: Free Press, 1990).
8. For a review of the Porter analysis, see R. M. Grant, “Por-
ter’s Competitive Advantage of Nations: An Assessment,”
Strategic Management Journal 12 (1991): 535–548.
9. Korean business culture has been described as “dynamic
collectivism.” See: Y.-H. Cho and J. Yoon, “The Origin
and Function of Dynamic Collectivism: An Analysis of
Korean Corporate Culture,” Asia Pacific Business Review 7
(2001): 70–88.
10. See B. Kogut, “Designing Global Strategies and Compet-
itive Value-Added Chains,” Sloan Management Review
(Summer 1985): 15–38.
11. A. Y. Lewin, S. Massini, and C. Peeters, “Why Are Com-
panies Offshoring Innovation? The Emerging Global Race
for Talent,” Journal of International Business Studies 40
(2009): 901–925.
12. Willy C. Shih, “What It Takes to Reshore Manufacturing
Successfully,” MIT Sloan Management Review 56 (Fall
2014): 55–62.
13. The role of firm-specific assets in explaining the multina-
tional expansion is analyzed in R. Caves, “International
Corporations: The Industrial Economics of Foreign
Investment,” Economica 38 (1971): 127.
14. D. J. Teece, “Transactions Cost Economics and Multina-
tional Enterprise,” Journal of Economic Behavior and
Organization 7 (1986): 21–45.
15. This section draws heavily upon G. S. Yip and G. T. M.
Hult, Total Global Strategy, 3rd edn. (Upper Saddle River,
NJ: Prentice Hall, 2012).
16. T. Levitt, “The Globalization of Markets,” Harvard Business
Review (May/June 1983): 92–102.
17. P. Ghemawat, Redefining Global Strategy: Crossing Bor-
ders in a World Where Differences Still Matter (Boston:
Harvard Business School, 2007).
18. Levitt, op. cit., 94.
19. S. G. Winter and G. Szulanski, “Replication as Strategy,”
Organization Science 12 (2001): 730–743.
20. G. S. Yip and A. Bink, “Managing Global Accounts,” Har-
vard Business Review 85 (September 2007): 102–111.
21. P. Ghemawat, “The Forgotten Strategy,” Harvard Business
Review (November 2003): 76–84.
22. P. Almeida, “Knowledge Sourcing by Foreign Multina-
tionals: Patent Citation Analysis in the US Semiconductor
Industry,” Strategic Management Journal 17 (Winter
1996): 155–165.
23. See, for example, “Apple’s Tax Affairs Spark Transatlantic
Face-off,” Financial Times April 4, 2016.
24. Comments by Tommy Kullberg (IKEA Japan) in “The
Japan Paradox,” conference organized by the European
Commission, Director General for External Affairs
(December 2003): 62–3, http://www.deljpn.ec.europa.
eu/data/current/japan-paradox , accessed July 20,
2015. See also: A. Jonsson and N. J. Foss, “International
Expansion through Flexible Replication: Learning from
the Internationalization Experience of IKEA,” Journal of
International Business Studies 42 (2011): 1079–1102.
25. A. K. Gupta and P. Govindarajan, “Knowledge Flows
within Multinational Corporations,” Strategic Management
Journal 21 (April 2000): 473–496; P. Almeida, J. Song, and
R. M. Grant, “Are Firms Superior to Alliances and Markets?
An Empirical Test of Cross-Border Knowledge Building,”
Organization Science 13 (March/April 2002): 147–161.
26. G. Hamel and C. K. Prahalad, “Do You Really Have a
Global Strategy?” Harvard Business Review ( July/August
1985): 139–148.
27. I. C. Macmillan, A. van Ritten, and R. G. McGrath,
“Global Gamesmanship,” Harvard Business Review (May
2003): 62–71.
28. Amazon vs. Alibaba: Which Will Dominate Global Online
Retail? Internet Retailer, March 31, 2017. https://www.
digitalcommerce360.com/2017/03/31/amazon-vs-alibaba-
which-will-dominate-global-online-retail/https://www.
ft.com/content/625e7980-45fe-3bd7-b431-148727959ecc.
29. The iPhone7 is configured differently for network com-
patibility and its operating software is adapted to different
national languages. The Big Mac varies between countries
in size, ingredients, and calorie content.
30. C. Baden-Fuller and J. Stopford, “Globalization Frustrated,”
Strategic Management Journal 12 (1991): 493–507.
31. R. M. Grant and M. Venzin, “Strategic and Organizational
Challenges of Internationalization in Financial Services,”
Long Range Planning 42 (October 2009). “Big Banks
Giving Up on their Global Ambitions.” Financial Times,
October 20, 2014.
32. C. A. Bartlett and S. Ghoshal, Managing across Borders:
The Transnational Solution, 2nd edn (Boston: Harvard
Business School Press, 1998): 34.
33. C. Bartlett, “Building and Managing the Transnational:
The New Organizational Challenge,” in M. E. Porter
(ed.), Competition in Global Industries (Boston: Harvard
Business School Press, 1986): 377.
34. P. Ghemawat—“Managing Differences: The Central
Challenge of Global Strategy,” Harvard Business Review
85 (March 2007)—proposes a three-way rather than

http://www.deljpn.ec.europa.eu/data/current/japan-paradox

https://www.ft.com/content/625e7980-45fe-3bd7-b431-148727959ecc

https://www.digitalcommerce360.com/2017/03/31/amazon-vs-alibabawhich-will-dominate-global-online-retail/

296 PART IV CORPORATE STRATEGY
a two-way analysis. In his Adaptation–Aggregation–
Arbitrage (AAA) Triangle he divides integration into
aggregation and arbitrage.
35. Adaptation to local business environments is a matter,
only for MNC subsidiaries, but for headquarters too. See
P. C. Nell and B. Ambos, “Parenting Advantage in the
MNC: An Embeddedness Perspective on the Value Added
by Headquarters,” Strategic Management Journal 34
(2013): 1086–1103.
36. J. Birkinshaw, P. Braunerhjelm, U. Holm, and S. Terjesen,
“Why Do Some Multinational Corporations Relocate Their
Headquarters Overseas?” Strategic Management Journal
27 (2006): 681–700.
37. A similar “tax inversion” deal in 2016 involving US-based
Pfizer acquiring Irish-based Allergen, resulted in the US
government closing the tax loophole through which US
companies could shift their tax domicile by acquiring a
foreign company.
38. M.M. Capozzi, P. Van Biljon, and J. Williams, “Organizing
R&D for the Future,” MIT Sloan Management Review
(Spring 2013).
39. M. Dewhurst, J. Harris, and S. Heywood, “Under-
standing Your Globalization Penalty,” McKinsey Quarterly
( June 2011).
40. “The Retreat of the Global Company,” Economist,
January 27, 2017.

12
Telephones, hotels, insurance—it’s all the same. If you know the numbers inside out,
you know the company inside out.
—HAROLD SYDNEY GENEEN, CHAIRMAN OF ITT, 1959–1978, AND INSTIGATOR OF 275 CORPORATE ACQUISITIONS
Creating three independent, public companies is the next logical step for Tyco … the
new standalone companies will have greater flexibility to pursue their own focused
strategies for growth than they would under Tyco’s current corporate structure. This
will allow all three companies to create significant value for shareholders.
—ED BREEN, CHAIRMAN AND CEO, TYCO INTERNATIONAL LTD, ANNOUNCING THE COMPANY’S BREAKUP,
SEPTEMBER 19, 2011
Diversification Strategy
◆ Introduction and Objectives
◆ Motives for Diversification
● Growth
● Risk Reduction
● Value Creation: Porter’s “Essential Tests”
◆ Competitive Advantage from Diversification
● Economies of Scope
● Economies from Internalizing Transactions
● Parenting Advantage
● The Diversified Firm as an Internal Market
◆ Diversification and Performance
● The Findings of Empirical Research
◆ The Meaning of Relatedness in Diversification
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

298 PART IV CORPORATE STRATEGY
Introduction and Objectives
Answering What business are we in? is the starting point of strategy. Some companies define their busi-
nesses broadly: Nestle’s objective is “to be the leader in Nutrition, Health and Wellness.” Other companies
define themselves in terms of a particular sector or product: McDonald’s vision is “to be the world’s best
quick-service restaurant chain.”
Firms’ choices over their product scope change over time. The dominant trend of the past two decades
has been “refocusing on core businesses.” In 2000, Philips (based in the Netherlands) was engaged in
lighting, domestic appliances, consumer electronics, cell phones, semiconductors, and medical systems.
By 2018, Philips was specialized in medical systems. Similar refocusing had taken place at other highly
diversified companies such as Siemens, British American Tobacco, and General Mills. Other diversified
companies have split into multiple specialist companies. Hanson the UK–US conglomerate split into five
separate companies; Tyco International split into three companies; during 2018, General Electric was in
the process of spinning off four of its seven divisions.
Yet, diversification continues among leading technology companies, such as Amazon, Alphabet,
and  Tencent, while the economies of several Asian and Latin America countries are dominated by
highly-diversified business groups.
Diversification remains a conundrum. It liberates firms from the constraints of a single industry, yet it
has caused more value destruction than almost any other type of strategic initiative.
Our goal in this chapter is to resolve this conundrum. Is it better to be specialized or diversified?
Under what conditions does diversification create rather than destroy value? Is there an optimal degree
of diversification? What types of diversification are most likely to create value?
We make diversification decisions every day in our personal lives. If my car doesn’t start in the morning,
should I try to fix it myself or have it towed directly to the garage? There are two considerations. First, is
repairing a car an attractive activity to undertake? If the garage charges $85 an hour but I can earn $500
an hour consulting, then car repair is not attractive to me. Second, am I any good at car repair? If I am
likely to take twice as long as a skilled mechanic then I possess no competitive advantage in car repair.
Diversification decisions by firms involve the same two issues:
◆ How attractive is the industry to be entered?
◆ Can the firm establish a competitive advantage?
These are the very same factors we identified in Chapter 1 (Figure 1.5) as determining a firm’s profit
potential. Hence, no new analytic framework is needed for appraising diversification decisions: we can
draw upon the industry analysis developed in Chapter 3 and the analysis of competitive advantage
developed in Chapters 5 and 7.
Our primary focus will be the latter question: under what conditions does operating multiple busi-
nesses assist a firm in gaining a competitive advantage in each? This leads into exploring linkages bet-
ween different businesses within the diversified firm—a phenomenon often referred to as synergy.
By the time you have completed this chapter, you will be able to:
◆ Recognize the corporate goals that have motivated diversification and their impact on
diversification trends since the late 20th century.
◆ Assess the potential for diversification to create value for shareholders from economies of
scope, internalizing transactions, and corporate parenting.
◆ Comprehend the empirical evidence on the performance outcomes of diversification.
◆ Identify the implications of different types of business relatedness for the success of diver-
sification and the management of diversification.

CHAPTER 12 DIVERSIfICATIOn STRATEGY 299
Motives for Diversification
Changing corporate goals has been the primary driver of trends in diversification.
Strategy Capsule 12.1 provides a brief summary of the history of diversification. Diver-
sification by large companies during most of the 20th century was driven by two objec-
tives: growth and risk reduction. The shift from diversification to refocusing during the
last two decades of the 20th century was an outcome of the growing commitment of
corporate managers to the goal of creating shareholder value.
Growth
In the absence of diversification, firms are prisoners of their industry. For firms in stag-
nant or declining industries this is a daunting prospect. The urge to achieve corporate
growth that outstrips that of a firm’s primary industry is especially appealing to senior
executives. Companies in low-growth, cash flow-rich industries such as tobacco and
oil have been especially susceptible to the temptations of diversification. During the
1980s, Exxon diversified into copper and coal mining, electric motors, and computers
and office equipment; RJR Nabisco transformed itself from a tobacco company into a
diversified consumer products company. In both cases diversification destroyed share-
holder value. Exxon returned to its core oil and gas businesses, while the leveraged
buyout of RJR Nabisco by Kohlberg Kravis Roberts was followed by its breakup. Reyn-
olds American, Inc. is now a specialist tobacco company.
Diversification is typically very successful in generating revenue growth—especially
when it is achieved through acquisition. But what about profitability? If diversification
efforts become a cash drain for companies in declining industries—as they did for East-
man Kodak and Blockbuster—then diversification may well hasten rather than stave
off bankruptcy.
Risk Reduction
The notion that risk spreading is a legitimate goal for the value-creating firm has become
a casualty of modern financial theory. If the cash flows of two different businesses are
imperfectly correlated then bringing them together under common ownership certainly
reduces the variance of the combined cash flow. But, does a more stable cash flow benefit
shareholders? Shareholders can diversify risk by holding diversified portfolios. Hence,
what advantage can there be in companies diversifying for them? The only possible
advantage could be if firms can diversify at a lower cost than individual investors. In fact,
the reverse is true: the transaction costs to shareholders of diversifying their portfolios
are far less than the transaction costs to firms diversifying through acquisition. Not only
do acquiring firms incur the heavy costs of using investment banks and legal advisers,
they must also pay an acquisition premium to gain control of an independent company.
The capital asset pricing model (CAPM) formalizes this argument. The theory
states that the risk that is relevant to determining the price of a security is not the
overall risk (variance) of the security’s return but the systematic risk—that part of
the variance of the return that is correlated with overall stock market returns. This is
measured by the security’s beta coefficient. Corporate diversification does not reduce
systematic risk: if two separate companies are brought under common ownership,
and their individual cash flow streams are unchanged—the beta coefficient of the
combined company is simply the weighted average of the beta coefficients of the
constituent companies. Hence, the simple act of bringing different businesses under
common ownership does not create shareholder value through risk reduction.1

300 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 12.1
Trends in Corporate Diversification Over Time
Diversification has followed the same trend as that of cor-
porate scope more generally (see Chapter  10, Strategy
Capsule 10.1). For most of the 20th century—and espe-
cially during the 1960s and 1970s—large companies in
all the advanced industrial nations diversified beyond
their core business.2 The 1960s also saw the emergence
of a new type of company—the conglomerate: a highly
diversified company assembled from multiple, unre-
lated acquisitions. These included ITT, Textron, and Allied
Signal in the United States and Hanson, Slater Walker, and
BTR in the United Kingdom. Their existence reflected the
belief that top management no longer needed industry-
specific experience: the new techniques of financial and
strategic management could be applied to any business.3
Figure 12.1 shows the growing number of highly diversi-
fied US and UK firms (both “related business” and “unre-
lated business”) during the latter part of the 20th century.
After 1980, the diversification trend went into reverse
as companies divested their “noncore” businesses. Bet-
ween 1980 and 1990, the average index of diversification
for Fortune 500 companies declined from 1.00 to 0.67.4
The main driver of this trend was a shift of corporate
goals from growth to profitability—typically companies’
diversified businesses were less profitable than their core
businesses. Evidence of a “conglomerate discount”—that
the stock market was valuing diversified companies at
less than the sum of their parts—resulted in diversifica-
tion in general becoming viewed as the enemy of share-
holder interests.5 CEOs came under increasing pressure
from both institutional shareholders, including pension
funds such as California’s Public Employees’ Retirement
System, and hostile takeovers launched by private
equity groups. Kohlberg Kravis Roberts’ $31 billion take-
over of the tobacco and food giant RJR Nabisco in 1989
0
10
20
30
40
50
60
70
1949 1964 1974 1950 1970 1993
Single business
Dominant business
Related business
Unrelated business
United States United Kingdom
%
FIGURE 12.1 Diversification strategies of large US and UK companies during the late 20th century
Sources: R. P. Rumelt, “Diversification strategy and profitability,” Strategic Management Journal 3 (1982): 359–370; R. Whittington,
M. Mayer, and F. Curto, “Chandlerism in Post-war Europe: Strategic and Structural Change in France, Germany and the
United Kingdom, 1950–1993,” Industrial and Corporate Change 8 (1999): 519–550; D. Channon, The Strategy and Structure of British
Enterprise (Cambridge: Harvard University Press, 1973).

CHAPTER 12 DIVERSIfICATIOn STRATEGY 301
demonstrated that even the largest US companies
were vulnerable to attack from corporate raiders.6
In Chapter  10, we observed that volatile, uncer-
tain conditions increase the decision-making burden
on top management, making large, complex com-
panies less agile than specialized companies. At the
same time, the growing availability of private capital
encouraged many diversified companies to spin off
their growth businesses in order to tap funding from
external capital markets.
However, many companies still view diversi-
fication as an opportunity for value creation. The
tendency for digital technologies to erode market
boundaries and create hardware/software com-
plementarities has encouraged technology leaders
such as Alphabet, Amazon, Alibaba, Baidu, and
Rocket Internet to continuously expand their prod-
uct ranges. In more mature sectors, an emphasis
on providing “customer solutions” is similarly
encouraging firms to offer bundles of complemen-
tary products and services. In many instances, these
diversification initiatives are occurring through
collaboration with other companies rather than
through conventional diversification.
In the emerging markets of Asia and Latin
America, the leading companies tend to be highly
diversified—and often family controlled. These
include Tata and Reliance in India, Charoen Pokphand
(CP) in Thailand, Astra International in Indonesia,
Sime Darby in Malaysia, and Grupo Alfa and Grupo
Carso in Mexico.7 We shall consider the reasons for
these differences in diversification patterns between
mature and emerging countries later in the chapter.
Figure  12.2 summarizes the trends in diversifi-
cation strategy since the middle of the last century
and points to the influence of corporate goals and
developments in strategic management concepts
and tools on these trends.
MANAGEMENT
GOALS
Growth
• Core business
focus
• Divestments,
and spin-of fs
• Leveraged
buyouts
• Emphasis on
related
diversif ication
• Quest for synergy
• Diversif ication by
established f irms
• Emergence of
conglomerates
• Boom in M&A
STRATEGY TOOLS
AND CONCEPTS
1960 1970 1980 1990 20182000
Creating
shareholder
value
Corporate
advantage
Making
diversif ication
prof itable
IMPLICATIONS FOR
DIVERSIFICATION
STRATEGY
• Financial analysis
• Corporate planning
• M-form structures
• Economies of
scope
• Portfolio
planning models
• Modern f inancial
theory
• Shareholder value
• Transaction cost
analysis
• Core competence
• Dominant logic
• Parenting
advantage
• Real options
• Demand-side
economies of scope
• Technology
platforms
• Product bundling
and customer
solutions
• Alliances
• Creating growth
options
FIGURE 12.2 The evolution of diversification strategies, 1960–2018

302 PART IV CORPORATE STRATEGY
Empirical studies are generally supportive of the absence of shareholder benefit
from diversification that simply combines independent businesses under a single cor-
porate umbrella.8 Diversification may even fail to lower unsystematic risk (risk that is
specific to a company and is uncorrelated with overall stock market fluctuations).9
Special issues arise once we consider credit risk. Diversification that reduces cyclical
fluctuations in cash flows reduces the risk of default on the firm’s debt. This may permit
the firm to carry a higher level of debt which can create shareholder value because of
the tax advantages of debt (i.e., interest is paid before tax; dividends are paid out of
post-tax profit).10
Are there other circumstances in which reductions in unsystematic risk can create
shareholder value? If it is cheaper to finance investments internally rather than resort to
external capital markets, the stability in the firm’s cash flow that results from diversifi-
cation may reinforce independence from external capital markets. During the financial
crisis of 2008–2009, when access to capital markets became highly restricted for many
firms, diversified companies benefitted from their ability to rely on funding from their
internally generated funds.11
Value Creation: Porter’s “Essential Tests”
If corporate strategy is to be directed toward value creation, what are the implica-
tions for diversification strategy? At the beginning of the chapter, we revisited our two
sources of superior profitability: industry attractiveness and competitive advantage. In
establishing the conditions for profitable diversification, Michael Porter refines these
into “three essential tests” that determine whether diversification will truly create share-
holder value:
● The attractiveness test: The industries chosen for diversification must be structur-
ally attractive or capable of being made attractive.
● The cost-of-entry test: The cost of entry must not capitalize all the future profits.
● The better-off test: Either the new unit must gain competitive advantage from its
link with the corporation or vice versa.12
The Attractiveness and Cost-of-Entry Tests A critical realization in Porter’s
“essential tests” is that industry attractiveness on its own is insufficient to justify
diversification. Diversification may allow a firm access to more attractive investment
opportunities than are available in its own industry, yet it faces the challenge of
entering a new industry. The second test, cost of entry, recognizes that, for outsiders,
the cost of entry may counteract the attractiveness of the industry. Pharmaceuticals,
corporate legal services, and defense contracting offer above-average profitability
precisely because they are protected by barriers to entry. Firms seeking to enter these
industries may either acquire an established player—in which case the acquisition
cost is likely to fully capitalize the target firm’s profit prospects (not to mention the
need to pay an acquisition premium)13—or establish a new corporate venture—in
which case the diversifying firm must directly confront the barriers to entry to that
industry.14
Hewlett-Packard offers a salutary example. It diversified into IT services because of
its greater attractiveness than IT hardware. However, its $13.9 billion acquisition of EDS
in 2008 was at a 30% premium over EDS’s market value and its $10.3 billion acquisition
of Autonomy in 2011 involved a 60% premium. HP subsequently took write-offs of $16
billion against the balance sheet values of these two companies.

CHAPTER 12 DIVERSIfICATIOn STRATEGY 303
The Better-Off Test Porter’s third criterion for value creation from diversification—
the better-off test—addresses the issue of competitive advantage. If two different busi-
nesses are brought together under the ownership and control of a single enterprise, is
there any reason why they should become any more profitable? The issue here is one
of synergy: what is the potential for interactions between the two businesses that can
enhance the competitive advantage of either business?
In most diversification decisions, it is the better-off test that takes center stage. In the
first place, industry attractiveness is rarely a source of value from diversification—in
most cases, cost-of-entry cancels out the advantages of industry attractiveness. Second,
the better-off test can often counteract the disadvantages is an unattractive industry. If
a diversifying company can establish a strong competitive advantage in an industry, the
low profitability of the industry as a whole may be immaterial. Most of Virgin Group’s
diversification has been into industries where average profitability has been low (or
non-existent): airlines, wireless telecommunications, gym clubs, passenger rail services
and retail banking. Yet, Virgin has created competitive advantage through transferring its
brand and customer service capabilities. Sony’s acquisition of CBS Records, BMG, and
EMI Records took it into the spectacularly unattractive recorded music industry—how-
ever, for Sony, music forms an integral component of its home entertainment business.
Let us now explore how the better-off test can be applied through analyzing the
relationship between diversification and competitive advantage.
Competitive Advantage from Diversification
If the primary source of value creation from diversification is exploiting linkages bet-
ween different businesses, what are these linkages and how are they exploited? The
key linkages are those that permit the sharing of resources and capabilities across dif-
ferent businesses.
Economies of Scope
The most general argument concerning the benefits of diversification focuses on the
presence of economies of scope in common resources: “Economies of scope exist
when using a resource across multiple activities uses less of that resource than when
the activities are carried out independently.”15
Economies of scope exist for similar reasons as economies of scale. The key
difference is that economies of scale relate to cost economies from increasing output of
a single product; economies of scope are cost economies from increasing the output
of multiple products. The nature of economies of scope varies between different types
of resources and capabilities.
Tangible Resources Tangible resources—such as distribution networks, information
technology systems, sales forces, and research laboratories—confer economies of scope
by eliminating duplication—a single facility can be shared among several businesses.
The greater the fixed costs of these items, the greater the associated economies of
scope are likely to be. Diversification by cable TV companies into telecoms and broad-
band and by telephone companies into TV, broadband, and music streaming are moti-
vated by the desire to spread the costs of networks and billing systems over as many
services as possible. Common resources such as customer databases, customer service
centers, and billing systems have encouraged Centrica, Britain’s biggest gas utility, to

304 PART IV CORPORATE STRATEGY
diversify into supplying electricity, fixed-line and mobile telephony, broadband access,
home security, insurance, and home-appliance repair.
Economies of scope also arise from the centralized provision of administrative and
support services to the different businesses of the corporation. Accounting, legal ser-
vices, government relations, and information technology tend to be centralized at the
corporate headquarters (or through a shared service organization).
Intangible Resources Intangible resources—such as brands, corporate reputation,
and technology—offer economies of scope from the ability to extend them to addi-
tional businesses at a low marginal cost. Exploiting a strong brand across additional
products is called brand extension. Starbucks has extended its brand to ice cream,
packaged cold drinks, home espresso machines, audio CDs, and books. Similarly with
technology: Fujifilm has extended its proprietary coatings technology from photo-
graphic film to cosmetics, pharmaceuticals, and industrial coatings.
Organizational Capabilities Organizational capabilities can also be transferred
within a diversified company. For example:
● LVMH is the world’s biggest and most diversified supplier of branded luxury
goods. Its capabilities in design, market analysis, advertising and promo-
tion, retail management, and craftsmanship are deployed across Louis Vuitton
(accessories and leather goods); Hennessey (cognac); Moët & Chandon, Dom
Pérignon, Veuve Clicquot, and Krug (champagne); Céline, Givenchy, Kenzo,
Christian Dior, Guerlain, and Donna Karan (designer clothing); TAG Heuer and
Chaumet (watches); Sephora (retailing); Bulgari (jewelry); and some 25 other
branded businesses.
● Apple’s distinctive capability is in new product development where it combines
its expertise in microelectronics, software engineering, and design aesthetics to
create products of outstanding functionality, ease of use, and consumer appeal.
This capability has taken Apple from laptop computers, to MP3 players, smart-
phones, tablet computers, TV set-top boxes, and watches and other wearable
technology.
Some of the most important capabilities in influencing the performance of diver-
sified corporations are general management capabilities. For over a century, General
Electric was one of the world’s most diversified and successful companies. Its core
capabilities were its ability to motivate and develop its managers; its strategic and finan-
cial management, which reconciles decentralized decision making with strong central-
ized control; and its international management.16 GE’s dismal performance since 2001
raised doubts over the effectiveness of these corporate-level capabilities to the extent
that, in June 2018, the company announced a far-reaching divestment plan.
The success of Danaher Corporation, the technology-based conglomerate head-
quartered in Washington, DC, also rests upon its general management capabilities. Its
effectiveness in selecting acquisition targets then applying its system of performance
management and human resource development have allowed it to triple its market val-
uation between 2008 and 2018.17
Demand-side Economies of Scope So far, we have looked only at supply-side econ-
omies of scope: cost savings that supplying firms derive from sharing resources and
capabilities across different businesses. Economies of scope also arise for customers
when they buy multiple products. Walmart’s vast array of products offers consumers

CHAPTER 12 DIVERSIfICATIOn STRATEGY 305
the convenience of one-stop shopping. Similarly with online shopping: consumers
gravitate toward Amazon because of the ease and time saving of funneling their online
purchases through a single website. Suppliers of products and services to business
have also diversified in order to provide “integrated solutions.” ISS, based in Demark,
is the world’s biggest supplier of facilities management services with half a million
employees in 47 countries. It offers its industrial and commercial clients cleaning, main-
tenance, security, air conditioning, and catering services.18
Economies from Internalizing Transactions
Economies of scope provide cost savings from sharing and transferring resources and
capabilities among different businesses, but does a firm have to own these businesses
to exploit economies of scope? The answer is no. Economies of scope in resources
and capabilities can be exploited simply by selling or licensing the use of the resource
or capability to another company. In Chapter 9, we observed that a firm can exploit
proprietary technology by licensing it to other firms. In Chapter  12, we noted how
technology and trademarks are licensed across national frontiers as an alternative to
direct investment. Similarly across industries: Starbucks’ diversification into the grocery
trade was initially through licensing: Unilever and PepsiCo produced Tazo tea bever-
ages, Nestlé produced Starbucks’ ice cream, and Kraft distributed Starbucks’ packaged
coffee. Walt Disney exploits its trademarks, copyrights, and characters directly through
diversification into theme parks, live theater, cruise ships, and hotels; but it also earned
$2.4 billion in 2013 from licensing its intellectual property to producers of clothing,
toys, music, comics, food and drink, and other products.
In industries based upon digital technologies, the owners of digital platforms can
reap the benefits of diversification simply by charging third-party suppliers for access
to their platforms. Thus, Apple earns substantial revenues from the suppliers of games,
rideshare services, air travel, fitness services, and thousands of other goods and ser-
vices who sell through its app stores.
Even tangible resources can be shared across different businesses through market
transactions. Airport and railroad station operators exploit economies of scope in their
facilities not by diversifying into catering and retailing but by leasing space to specialist
retailers and restaurants.
Is it better to exploit economies of scope in resources and capabilities internally
within the firm through diversification or externally through contracts with independent
companies? There are two major issues here:
● Can licensing exploit the full value of the resource or capability? This depends,
to a great extent, on the transaction costs involved. The transaction costs of
licensing include the costs incurred in drafting, negotiating, monitoring, and
enforcing a contract. Where property rights are clearly defined—as with trade-
marks and many types of patents—licensing may be highly effective; for orga-
nizational capabilities and know-how more generally, writing and enforcing
licensing contracts is problematic. Fujifilm’s diversification into cosmetics, phar-
maceuticals, and industrial coatings reflects the fact that, despite owning pat-
ents, the commercial exploitation of its coatings technology depends critically
upon the capabilities of Fujifilm in applying this technology.19
● Does the firm have the other resources and capabilities required for success-
ful diversification? For fragrances, Dolce & Gabbana, the Italian fashion house,
licenses its brand to Procter & Gamble, which produces and markets Dolce &

306 PART IV CORPORATE STRATEGY
Gabbana fragrances (along with other licensed brands such as Gucci, Hugo
Boss, Rochas, and Dunhill). Dolce & Gabbana lacks the resources and capabil-
ities needed to design, produce, and globally distribute fragrances. Conversely,
Starbucks’ decision to terminate its licensing agreement with Kraft reflected Star-
bucks’ belief that it could build the resources and capabilities needed to market
and distribute packaged coffee to supermarkets.
Parenting Advantage
So far, our case for diversification has rested upon its potential to create value for the
firm.20 Michael Goold, Andrew Campbell, and colleagues argue that this is an insuffi-
cient justification for diversification. If a parent company is to own a particular business,
not only must it be able to add value to that business but also it should be capable of
adding more value than any other potential parent. Otherwise, it would be better off
selling the business to the company that can add the most value. Consider General
Electric’s sale of NBC Universal to Comcast in 2011. Irrespective of GE’s capacity to add
value to NBC Universal, the sale was justified because Comcast (as a result of its other
media interests) could add more value to NBC Universal than could GE.
The concept of parenting value offers a different perspective on diversification
from Porter’s better-off test. Parenting value comes from applying the management
capabilities of the parent company to a business. While Porter’s better-off test focuses
on the potential to share resources across businesses, parenting advantage emphasizes
on the value-adding role of the corporate center. Successful diversification is more
about the relationship between corporate management and the new business rather
than about the fit between the different businesses within the diversified firm. We shall
return to this concept of the parenting advantage in the next chapter.
The Diversified Firm as an Internal Market
We have seen that economies of scope on their own do not provide an adequate
rationale for diversification: there needs to be transaction costs which make diversifica-
tion preferable to licensing contracts. Indeed, the presence of transaction costs in the
markets for resources offers a rationale for diversification even when no economies of
scope are present.
Internal Capital Markets Consider the case of financial capital. The diversified
firm possesses an internal capital market in which the different businesses compete for
investment funds. Which is more efficient, the internal capital market of diversified com-
panies or the external capital market? Diversified companies have two key advantages:
● By maintaining a balanced portfolio of cash-generating and cash-using busi-
nesses, diversified firms can avoid the costs of using the external capital market,
including the margin between borrowing and lending rates and the heavy costs
of issuing new debt and equity.
● Diversified companies have better access to information on the financial prospects
of their different businesses than that typically available to external financiers.21
Against these advantages is the critical disadvantage that investment allocation
within the diversified company is a politicized process in which strategic and financial
considerations are subordinated to turf battles and ego building. Evidence suggests
that diversified firms’ internal capital markets tend to cross-subsidize poorly performing

CHAPTER 12 DIVERSIfICATIOn STRATEGY 307
divisions and are reluctant to transfer cash flows to the divisions with the best pros-
pects.22 According to McKinsey & Company, high-performing conglomerates—including
Berkshire Hathaway and Danaher of the United States, Hutchison Whampoa of Hong
Kong, Bouygues and Lagardère of France, Wesfarmers of Australia, ITC of India, and
Grupo Carso of Mexico—are those with strict financial discipline, a refusal to overpay
for acquisitions, rigorous and flexible capital allocation, lean corporate centers, and a
willingness to close or sell underperforming businesses.23
Private equity firms also operate efficient internal capital markets that avoid the
transaction costs of external capital markets. Firms such as the Blackstone Group,
Carlyle Group, and Kohlberg Kravis Roberts each manage multiple funds. Each fund
is created with finance from individual and institutional investors and is then used to
acquire equity in companies. Funds typically have lives of 10–15 years. Acquisitions
by private equity companies include both private and public companies and typically
involve creating value through increasing financial leverage, cost cutting, divesting
poorly performing assets, and replacing and incentivizing top management.24
Internal Labor Markets Efficiencies also arise from the ability of diversified
companies to transfer employees, especially managers and technical specialists, bet-
ween their businesses, and to rely less on hiring and firing. The costs associated with
hiring include advertising, time spent in interviewing and selection, and the costs of
head-hunting agencies. The costs of dismissing employees can be very high where
severance payments must be offered. A diversified corporation has a pool of employees
and can respond to the specific needs of any one business through transfer from else-
where within the corporation.
The broader set of career opportunities available in the diversified corporation may
also attract a higher caliber of employee. Graduating students compete intensely for
entry-level positions in diversified corporations such as Alphabet, Samsung Electronics,
Unilever, and Nestlé in the belief that these companies can offer richer career
development than more specialized companies.
Most important are informational advantages of diversified firms in relation to
internal labor markets. A key problem of hiring from the external labor market is
limited information. A résumé, references, and a day of interviews are poor indicators
of how a new hire will perform in a particular job. The diversified firm that is engaged
in transferring employees between different positions and different internal units can
build detailed information on the competencies and characteristics of its employees.
These advantages of internal markets for capital and labor may explain the continued suc-
cess of highly diversified business groups in emerging economies (Strategy Capsule 12.2).
Diversification and Performance
Where diversification exploits economies of scope in resources and capabilities in
the presence of transaction costs, it has the potential to create value for shareholders.
Diversification that seeks only growth or risk reduction is likely to destroy value. How
do these predictions work in practice?
The Findings of Empirical Research
Empirical research into diversification has concentrated on two major issues: first, how
do diversified firms perform relative to specialized firms and, second, does related
diversification outperform unrelated diversification?

308 PART IV CORPORATE STRATEGY
The Performance of Diversified and Specialized Firms Hundreds of empirical
studies over the past 50 years have failed to establish a systematic relationship bet-
ween diversification and either accounting-based or stock market-based measures of
performance. Even the widely observed “conglomerate discount”—the stock market’s
undervaluation of diversified firms—appears to be the result of measurement and sam-
pling errors.25
Several studies have detected an inverted-U relationship between diversification and
profitability: diversification enhances profitability up to a point, after which further
diversification reduces profitability due to increasing costs of complexity.26 McKinsey &
Company also point to the benefits of moderate diversification—“a strategic sweet spot
between focus and broader diversification”—which is beneficial when a company has
exhausted growth opportunities in its existing markets and can match its existing capa-
bilities to emerging external opportunities.27
More consistent evidence concerns the performance results of refocusing initiatives
by North American and European companies: when companies divest diversified busi-
nesses and concentrate more on their core businesses, the result is, typically, increased
profitability and higher stock-market valuation.28
Related and Unrelated Diversification Given the importance of economies of
scope in shared resources and capabilities, it seems likely that diversification into
STRATEGY CAPSULE 12.2
Emerging-market Conglomerates
Highly diversified groups of closely connected
companies—chaebols in South Korea, business houses in
India, holding companies in Turkey, grupos económicos in
Latin America, the Hong Kong trading companies that
developed from the original British hongs—dominate the
economies of many Asian and Latin American countries.
The conventional argument for the success of these
conglomerates—in contrast to the near disappearance of
US and European conglomerates—has been the advan-
tages of this corporate form in countries with poorly
developed capital and labor markets. Inefficient capital
markets offer a huge advantage to groups, such as Tata
of India and Koç of Turkey, in using internally generated
cash flows to fund growing businesses and establish
new ventures. Similarly with managerial resources, where
managerial talent is rare, companies such as Koç or LG of
Korea are able to attract exceptionally talented graduates
then develop them into highly capable managers.
However, the performance advantages of emerg-
ing market conglomerates show no sign of abating,
despite increasingly efficient capital and labor markets
in their home countries. South Korean conglomerates
have been growing their revenues by 11% a year; Indian
business groups by 23% a year.
It seems likely that, especially in growing econ-
omies, the management model of the emerging market
business groups may offer some advantages over the
more integrated multidivisional corporations typical
of North America, Europe, and Japan. Business groups
such as Tata, Sabancı Holding (Turkey), and SK (Korea)
are able to combine high levels of autonomy for their
member companies with strong parental leadership
that emphasizes identity and values, and also provides
strategic guidance.
Sources: “From Dodo to Phoenix,” The Economist
( January 11, 2014): 58; C. Stadler, “3 Reasons Why Con-
glomerates Are Back In Fashion,” https://www.forbes.com/
sites/ christianstadler/2015/11/05/three-reasons-why-
conglomerates-are-back-in-fashion/#4390e0693be6, Accessed
July 28, 2017.

https://www.forbes.com/sites/christianstadler/2015/11/05/three-reasons-why-conglomerates-are-back-in-fashion/#4390e0693be6

CHAPTER 12 DIVERSIfICATIOn STRATEGY 309
related industries should be more profitable than diversification into unrelated indus-
tries. Empirical research initially supported this prediction. By 1982, Tom Peters and
Robert Waterman were able to conclude: “virtually every academic study has con-
cluded that unchanneled diversification is a losing proposition.”29 This observation
supported one of their “golden rules of excellence”:
Stick to the Knitting. Our principal finding is clear and simple. Organizations that do
branch out but stick very close to their knitting outperform the others. The most suc-
cessful are those diversified around a single skill, the coating and bonding technology
at 3M for example. The second group in descending order, comprise those companies
that branch out into related fields, the leap from electric power generation turbines to
jet engines from GE for example. Least successful are those companies that diversify
into a wide variety of fields. Acquisitions especially among this group tend to wither
on the vine.30
Subsequent studies have clouded the picture: once risk and industry influences are
taken into account, the superiority of related diversification is less apparent31; some
studies even point to unrelated diversification outperforming related diversification.32
This confusing body of evidence points to the complex relationship between diver-
sification and firm performance. Diversification is motivated by different goals; there
are different sources of benefit from diversification, each of which depends upon the
context in which the diversification takes place; and diversification is managed with
different degrees of effectiveness. Also, the performance outcomes of diversifica-
tion depend not only on the benefits of diversification but also on the management
costs that diversification imposes. These costs arise from the greater complexity and
coordination needs of diversified companies and are likely to be especially great for
related diversification—especially when resources are shared across businesses.33
Even if a relationship between diversification and performance is observed, there is
the problem of distinguishing association from causation. Not only does diversifica-
tion impact profitability, but profitability also influences diversification: for example,
highly profitable firms may seek to channel their cash flows into diversification.
Given this complexity, Gautam Ahuja and Elena Novelli argue that the relation-
ship between diversification and performance needs to be studied at a much more
micro-level. This should focus, first, on the individual sources of synergy and (and
“antisynergy”) and, second, upon specific contexts in terms of industries, countries, and
time periods. With regard to time they note that, during the 20th century, supply-side
economies of scope were principal driver of diversification. During the 21st century,
demand-side economies of scope (“consumption synergies”), such as those exploited
by Amazon, have become more important.34
The Meaning of Relatedness in Diversification
The most surprising feature of empirical research into the impact of diversification
on performance is the failure to find clear support for the superiority of related
over unrelated diversification. This points to the difficulty in distinguishing between
the two.  Related businesses are those with the potential for sharing resources and
capabilities—but this depends on the company undertaking the diversification. Empirical
studies have defined relatedness in terms of similarities between industries in technol-
ogies and markets. These similarities emphasize relatedness at the operational level—in

310 PART IV CORPORATE STRATEGY
manufacturing, marketing, and distribution—typically activities where economies from
resource sharing are small and achieving them is costly in management terms. Con-
versely, one of the most important sources of value creation within the diversified firm
is the ability to apply common general management capabilities, strategic management
systems, and resource allocation processes to different businesses. Such economies
depend on the existence of strategic rather than operational similarities among different
businesses within the diversified corporation.35
● Berkshire Hathaway is involved in insurance, candy stores, furniture, kitchen
knives, jewelry, and footwear. Despite this diversity, all these businesses have
been selected on the basis of their ability to benefit from the unique style of
corporate management established by its chairman and CEO, Warren Buffett,
and vice-chairman, Charles Munger.
● Clothing, leather products, wine, watches, and cosmetics are not obviously
related products, but LVMH applies similar design and brand management capa-
bilities to them all.
● Richard Branson’s Virgin Group covers a huge array of businesses from air-
lines to health clubs. Yet, they share certain strategic similarities: almost all are
start-up companies that benefit from Branson’s entrepreneurial zeal and exper-
tise; almost all sell to final consumers and are in sectors that offer the potential
for innovative approaches to differentiation.
The essence of such strategic-level linkages is the ability to apply similar strategies
and management systems across the different businesses within the corporate port-
folio.36 Table 12.1 lists some of the strategic factors that determine similarities among
businesses in relation to corporate management activities.
Unlike operational relatedness, where the opportunities for exploiting economies
of scope in joint inputs are comparatively easy to identify—even to quantify— strategic
relatedness is more elusive. It necessitates an understanding of the overall strategic
approach of the company and recognition of its corporate-level management capabilities.
TABLE 12.1 The determinants of strategic relatedness between businesses
Corporate Management Tasks Determinants of Strategic Similarity
Resource allocation Similar sizes of capital investment projects
Similar time spans of investment projects
Similar sources of risk
Similar general management skills required for business
unit managers
Strategy formulation Similar key success factors
Similar stages of the industry life cycle
Similar competitive positions occupied by each business
within its industry
Performance management and
control variables
Similar indicators for performance targets
Similar time horizons for performance targets
Source: R. M. Grant, “On Dominant Logic, Relatedness, and the Link between Diversity and Performance,” Strategic
Management Journal 9 (1988): 641. Reused by permission of John Wiley & Sons, Ltd.

CHAPTER 12 DivERsifiCATion sTRATEgy 311
Ultimately, the linkage between the different businesses within a company may
depend upon the strategic rationale of the company—what Prahalad and Bettis
refer to as the dominant logic of the company.37 Such a common view of a com-
pany’s identity and raison d’être is a critical precondition for effective integration
across its different businesses. For example, Richard Branson’s Virgin group of
companies is based upon a logic that asserts that start-up companies in mature,
consumer industries can provide innovative differentiation and a commitment to
enthusiasm, fun, and fairness the allows them to establish competitive advantage
over bigger, established rivals.38
Summary
Diversification: it’s attractions are obvious, yet the experience is often disappointing. For top
management, it is a minefield. The diversification experiences of large corporations are littered with
expensive mistakes: Exxon’s attempt to build Exxon Office Systems as a rival to Xerox and IBM; Vivendi’s
diversification from water and environmental services into media, entertainment, and telecoms; Royal
Bank of Scotland’s quest to transform itself from a retail bank into a financial services giant. Despite so
many costly failures, the urge to diversify continues to captivate senior managers. Part of the problem
is the divergence between managerial and shareholder goals. While diversification has offered meager
rewards to shareholders, it is the fastest route to building vast corporate empires. A further problem
is hubris. A company’s success in one line of business tends to result in the top management team
becoming overly confident of its ability to achieve similar success in other businesses.
Nevertheless, for companies to survive and prosper over the long term, they must change; inevitably,
this involves redefining the businesses in which they operate. Without diversification, BMW would still
be a manufacturer of aircraft engines and Du Pont a bleach producer. For most companies that have
survived for more than half a century, diversification has played a key role in their evolution. In most
cases, this diversification was not a major discontinuity but an initial incremental step in which existing
resources and capabilities were deployed to exploit a perceived opportunity.
If companies are to use diversification as part of their long-term adaptation and avoid the many
errors that corporate executives have made in the past then better strategic analysis of diversification
decisions is essential. The objectives of diversification need to be clear and explicit. Value creation pro-
vides a demanding and illuminating criterion with which to appraise investment in new business oppor-
tunities. Rigorous analysis also counters the tendency for diversification to be a diversion— corporate
escapism resulting from the unwillingness of top management to come to terms with difficult condi-
tions within the core business.
Our tools for evaluating diversification decisions have developed greatly in recent years. Vague
notions of synergy that have been displaced by more precise analysis of the sources of economies of
scope both on the supply side and demand side, the role of transaction costs, and the administrative
costs that can offset diversification synergies. The inconclusive empirical research into the impact of
diversification on performance has illuminated the basic truth about diversification strategy. There are
no generally valid rights or wrongs; decisions about diversification need to take careful account of the
characteristics of the firm, the specific diversification opportunity being considered, and the overall
business context.

312 PART IV CORPORATE STRATEGY
Notes
1. See any standard corporate finance text, for example,
R. A. Brealey and S. Myers, Principles of Corporate
Finance, 12th edn (New York: McGraw-Hill, 2016):
Chapter 8.
2. A. D. Chandler Jr., Strategy and Structure: Chapters
in the History of the Industrial Enterprise (Cambridge,
MA: MIT Press, 1962); R. P. Rumelt, Strategy, Structure
and Economic Performance (Cambridge, MA: Harvard
University Press, 1974); H. Itami, T. Kagono,
H. Yoshihara, and S. Sakuma, “Diversification Strategies
and Economic Performance,” Japanese Economic Studies
11 (1982): 78–110.
3. M. Goold and K. Luchs, “Why Diversify? Four Decades of
Management Thinking,” Academy of Management Execu-
tive 7 (August 1993): 7–25.
4. G. F. Davis, K. A. Diekman, and C. F. Tinsley, “The Decline
and Fall of the Conglomerate Firm in the 1980s: A Study
in the De-Institutionalization of an Organizational Form,”
American Sociological Review 49 (1994): 547–570.
5. L. Laeven and R. Levine, “Is there a Diversification Dis-
count in Financial Conglomerates?” Journal of Financial
Economics 82 (2006): 331–367.
6. B. Burrough, Barbarians at the Gate: The Fall of RJR
Nabisco (New York: Harper & Row, 1990).
7. T. Khanna and K. Palepu, “Why Focused Strategies May
Be Wrong for Emerging Markets,” Harvard Business
Review ( July/August, 1997): 41–51; J. Ramachandran, K. S.
Manikandan, and A. Pant, “Why Conglomerates Thrive
(Outside the U.S.),” Harvard Business Review 91 (Decem-
ber 2013): 110–117.
Self-Study Questions
1. An ice-cream manufacturer is proposing to acquire a soup manufacturer on the basis that, first,
its sales and profits will be more seasonally balanced and, second, from year to year, sales and
profits will be less affected by variations in weather. Will this risk spreading create value for
shareholders? Under what circumstances could this acquisition create value for shareholders?
2. Tata Group is one of the India’s largest companies, employing 424,000 people in many differ-
ent industries, including steel, motor vehicles, watches and jewelry, telecommunications, finan-
cial services, management consulting, food products, tea, chemicals and fertilizers, satellite TV,
hotels, motor vehicles, energy, IT, and construction. Such diversity far exceeds that of any
North American or Western European company. What are the conditions in India that might
make such broad-based diversification both feasible and profitable?
3. Giorgio Armani SpA is an Italian private company owned mainly by the Armani family. Most of
its clothing and accessories are produced and marketed by the company (some are manufac-
tured by outside contractors). For other products, notably fragrances, cosmetics, and eyewear,
Armani licenses its brand names to other companies. Armani is considering expanding into
athletic clothing, hotels, and bridal shops. Advise Armani on whether these new businesses
should be developed in-house, by joint ventures, or by licensing the Armani brands to spe-
cialist companies already within these fields.
4. General Electric, Berkshire Hathaway, and Richard Branson’s Virgin Group each comprise a
wide range of different businesses that appear to have few close technical or customer link-
ages? Are these examples of unrelated diversification? For each of the three companies, can
you identify linkages among their businesses such that bringing them under common owner-
ship creates value?
5. Amazon has diversified from online retailing into cloud computing services (Amazon Web Ser-
vices), tablet computers (Amazon Fire), and the production of movies and TV shows (Amazon
Studios). What synergies might justify these diversifications?

CHAPTER 12 DIVERSIfICATIOn STRATEGY 313
8. J. D. Martin and A. Sayrak (“Corporate Diversification and
Shareholder Value: A Survey of Recent Literature,” Journal
of Corporate Finance, 9 (2003): 37–57) note that: “Finan-
cial economists have spent much of the last two decades
amassing evidence that corporate diversification destroys
shareholder value” but, because of methodological prob-
lems “much remains to be done.”
9. M. Lubatkin and S. Chatterjee, “Extending Modern Port-
folio Theory into the Domain of Corporate Strategy:
Does It Apply?” Academy of Management Journal 37
(1994): 109–136.
10. The reduction in risk that bondholders derive from diver-
sification is termed the coinsurance effect. See L. W. Lee,
“Coinsurance and the Conglomerate Merger,” Journal of
Finance 32 (1977): 1527–1537; and F. Franco, O. Urcan,
and F. P. Vasvari, “Debt Market Benefits of Corporate
Diversification and Segment Disclosures,” Accounting
Review, 91 (2016): 1139–1165.
11. V. Kuppuswamy and B. Villalonga, “Does Diversification
Create Value in the Presence of External Financing Con-
straints? Evidence from the 2007–2009 Financial Crisis,”
Management Science 62 (2016): 905–923.
12. M. E. Porter, “From Competitive Advantage to Corpo-
rate Strategy,” Harvard Business Review 65 (May/June
1987): 43–59.
13. M. Hayward and D. C. Hambrick, “Explaining the Pre-
miums Paid for Large Acquisitions,” Administrative
Science Quarterly 42 (1997): 103–127.
14. On average, new, diversifying ventures make losses for
their first six years of life; see R. Biggadike, “The Risky
Business of Diversification,” Harvard Business Review
(May/June 1979): 103–111.
15. The formal definition of economies of scope is in terms
of “subadditivity.” Economies of scope exist in the pro-
duction of goods x x xn1 2, , ,… , if C X C xi i i( ) ( ), where
X xi i( ) C X( ) is the cost of producing all n goods
within a single firm i i iC x( ) is the cost of producing the
goods in n specialized firms. See W. J. Baumol, J. C. Pan-
zar, and R. D. Willig, Contestable Markets and the Theory
of Industry Structure (New York: Harcourt Brace Jovanov-
ich, 1982): 71–72.
16. “Our true core competency today is not manufacturing
or services, but the global recruiting and nurturing of the
world’s best people and the cultivation in them of an insa-
tiable desire to learn, to stretch and to do things better
every day.” Letter to Shareholders, General Electric Annual
Report, 2000.
17. The role of capabilities in diversification is discussed
in C. C. Markides and P. J. Williamson, “Related
Diversification, Core Competencies and Corporate
Performance,” Strategic Management Journal 15 (Special
Issue, 1994): 149–165.
18. https://www.issworld.com/our-services/facility-
management. For more on demand side synergies, see:
J. Schmidt, R. Makadok, and T. Keil, “ Customer-specific
Synergies and Market Convergence,” Strategic
Management Journal 37 (2016): 870–895.
19. This issue is examined more fully in D. J. Teece,
“Towards an Economic Theory of the Multiproduct
Firm,” Journal of Economic Behavior and Organization
3 (1982): 39–63.
20. A. Campbell, J. Whitehead, M. Alexander, and M. Goold,
Strategy for the Corporate-Level: Where to Invest, What to
Cut Back and How to Grow Organisations with Multiple
Divisions (New York: John Wiley & Sons, Inc., 2014).
21. J. P. Liebeskind, “Internal Capital Markets: Benefits, Costs
and Organizational Arrangements,” Organization Science
11 (2000): 58–76.
22. D. Scharfstein and J. Stein, “The Dark Side of Internal
Capital Markets: Divisional Rent Seeking and Inefficient
Investment,” Journal of Finance 55 (2000): 2537–2564; D.
Bardolet, C. Fox, and D. Lovallo, “Corporate Capital Allo-
cation: A Behavioral Perspective,” Strategic Management
Journal 32 (2011): 1465–1483.
23. C. Kaye and J. Yuwono, “Conglomerate Discount or
Premium? How Some Diversified Companies Create
Exceptional Value,” Marakon Associates (2003), http://
www.nd.edu/∼cba/cc/pdf/Doyle_Portfolio%20decision%
20making , accessed July 20, 2015.
24. J. Kelly The New Tycoons: Inside the Trillion Dollar Private
Equity Industry that Owns Everything (Hoboken, NJ: John
Wiley & Sons, Inc., 2012).
25. S. Erdorf, T. Hartmann-Wendels, N. Heinrichs, and
M. Matz, “Corporate Diversification and Firm Value:
A Survey of Recent Literature,” Financial Markets and
Portfolio Management 27 (2013): 187–215.
26. L. E. Palich, L. B. Cardinal, and C. C. Miller, “Curvilinearity
in the Diversification–Performance Linkage: An Exam-
ination of over Three Decades of Research,” Strategic
Management Journal 22 (2000): 155–174.
27. N. Harper and S. P. Viguerie, “Are You Too Focused?”
McKinsey Quarterly (Special Edition, 2002): 29–37;
J. Cyriac, T. Koller, and J. Thomsen, “Testing the Limits of
Diversification,” McKinsey Quarterly (February 2012).
28. C. C. Markides, “Consequences of Corporate Refocusing:
Ex Ante Evidence,” Academy of Management Journal 35
(1992): 398–412; C. C. Markides, “Diversification, Restruc-
turing and Economic Performance,” Strategic Management
Journal 16 (1995): 101–118.
29. T. Peters and R. Waterman, In Search of Excellence (New
York: Harper & Row, 1982).
30. Ibid., 294.
31. H. K. Christensen and C. A. Montgomery, “Corporate
Economic Performance: Diversification Strategy versus
Market Structure,” Strategic Management Journal 2 (1981):
327–343; R. A. Bettis, “Performance Differences in Related
and Unrelated Diversified Firms,” Strategic Management
Journal 2 (1981): 379–383.
32. See, for example, A. Michel and I. Shaked, “Does
Business Diversification Affect Performance?” Financial
Management 13 (1984): 18–24; G. A. Luffman and
R. Reed, The Strategy and Performance of British Industry:
1970–1980 (London: Macmillan, 1984).
33. Y. M. Zhou, “Synergy, Coordination Costs, and Diver-
sification Choices,” Strategic Management Journal 32
(2011): 624–639.
34. G. Ahuja and E. Novelli, “Redirecting Research Efforts
on the Diversification-Performance Linkage: The Search
for Synergy,” Academy of Management Annals 11
(2017): 342–390.
35. For a discussion of relatedness in diversification, see
J. Robins and M. F. Wiersema, “A Resource-Based

http://www.nd.edu/%E2%88%BCcba/cc/pdf/Doyle_Portfolio%20decision%20making

https://www.issworld.com/our-services/facility-management

314 PART IV CORPORATE STRATEGY
Approach to the Multibusiness Firm: Empirical Analysis
of Portfolio Interrelationships and Corporate Financial
Performance,” Strategic Management Journal 16 (1995):
277–300; and J. Robins and M. F. Wiersema, “The
Measurement of Corporate Portfolio Strategy: Analysis of
the Content Validity of Related Diversification Indexes,”
Strategic Management Journal 24 (2002): 39–59.
36. R. M. Grant, “On Dominant Logic, Relatedness, and the
Link between Diversity and Performance,” Strategic
Management Journal 9 (1988): 639–642.
37. C. K. Prahalad and R. A. Bettis, “The Dominant Logic:
A New Linkage between Diversity and Performance,”
Strategic Management Journal 7 (1986): 485–502.
38. “The Virgin Group in 2018,” In Contemporary Strategy
Analysis: Text and Cases, 10th edn (2019).

13
Some have argued that single-product businesses have a focus that gives them an
advantage over multibusiness companies like our own—and perhaps they would
have, but only if we neglect our own overriding advantage: the ability to share the
ideas that are the result of wide and rich input from a multitude of global sources.
GE businesses share technology, design, compensation and personnel evaluation sys-
tems, manufacturing practices, and customer and country knowledge.
—JACK WELCH, CHAIRMAN AND CEO, GENERAL ELECTRIC COMPANY, 1981–2001
Implementing Corporate
Strategy: Managing the
Multibusiness Firm
◆ Introduction and Objectives
◆ The Role of Corporate Management
◆ Managing the Corporate Portfolio
◆ Managing Linkages Across Businesses
● Common Corporate Services
● Transferring and Sharing Resources and Capability
among Businesses
● Implications for the Corporate Headquarters
◆ Managing Individual Businesses
● Direct Corporate Involvement in Business-level
Management
● The Strategic Planning System
● Performance Management and Financial Control
● Strategic Planning and Performance Control:
Alternative Approaches to Corporate Management
◆ Managing Change in the Multibusiness Corporation
◆ Governance of Multibusiness Corporations
● The Rights of Shareholders
● The Responsibilities of Boards of Directors
● Governance Implications of Multibusiness
Structures
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

316 PART IV CORPORATE STRATEGY
Introduction and Objectives
The key feature of the multibusiness firm is that—whether organized as business units, divisions, or
subsidiaries—they comprise a number of separate businesses that are coordinated and controlled by a
corporate headquarters. These businesses may be organized around different products (e.g., Samsung
Electronics), different geographical markets (e.g., McDonald’s), or different vertical stages (e.g., Royal
Dutch Shell). While the individual businesses are responsible for most business-level decisions, both
strategic and operational, the headquarters is responsible for corporate strategy and issues that affect
the company as a whole.
The three previous chapters have addressed the three key dimensions of corporate scope: vertical
integration, international expansion, and diversification. In relation to all three, the critical issue has
been whether the diversified company can create value by operating across multiple businesses.
However, value is only realized if the benefits from exploiting these linkages are not outweighed by
the additional costs of managing the multibusiness company. This raises several issues. How should
corporate strategy be formulated and linked to resource allocation? How should the corporate head-
quarters coordinate and control the businesses? What roles and leadership styles should corporate
managers adopt? Under what kind of governance structure should corporate managers operate? To
answer these questions, we must look closely at the activities of the corporate headquarters and its
relationships with the businesses.
By the time you have completed this chapter, you will be able to:
◆ Comprehend the primary strategic role of corporate managers: creating value within the
businesses owned by the company.
◆ Apply the techniques of portfolio analysis to corporate strategy decisions.
◆ Understand how the corporate headquarters manages the linkages among the different
business units within the company.
◆ Appreciate the tools and processes by which the corporate headquarters influences the
performance of its individual businesses.
◆ Understand how corporate managers can stimulate and guide strategic change.
◆ Recognize the governance issues that impact the work of managers within the multibusi-
ness corporation.
The Role of Corporate Management
Common to decisions over vertical integration, international expansion, and diversi-
fication is the basic condition that the benefits from extending the scope of the firm
should exceed the administrative costs of a larger, more complex corporate entity. This

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 317
implies that the formulation and implementation of corporate strategy are inseparable:
decisions over corporate scope must take account of both the benefits and the costs
that arise from extending (or reducing) corporate scope which depend upon how
corporate strategy is implemented. To investigate these benefits and cost, we need to
direct our attention to the mechanisms through which multibusiness corporations cre-
ate value for the businesses they own.
In this chapter we shall focus on four activities through which corporate management
adds value to its businesses:
● managing the corporate portfolio
● managing linkages across businesses
● managing individual businesses
● managing change in the multibusiness corporation.
The four sections that follow consider each of these activities, establish the condi-
tions under which they create value, and specify what this implies for the role of the
corporate headquarters.
Managing the Corporate Portfolio
The simplest form of multibusiness company is one that assembles independent busi-
nesses under common ownership and neither intervenes in their management nor
exploits linkages between them. The corporate executives in this type of company are
engaged in portfolio management: buying and selling businesses and managing the
allocation of capital among them. Can such portfolio management add value to a set
of businesses in excess of the cost of the corporate headquarters and transaction costs
of acquiring and disposing of businesses? Ask Warren Buffett, the foremost exponent
of portfolio management who has built Berkshire Hathaway out of 65 mostly unrelated
acquisitions (see Strategy Capsule 13.1).
For portfolio planning to create value, the essential requirement is for corporate
management to be adept at spotting undervalued companies (that is, to be better
than the stock market in recognizing the long-term profit potential of certain com-
panies) and to be better than capital markets at allocating capital among different
businesses. The more efficient are the financial markets, the less scope there is for
portfolio management wizards such as Warren Buffett.
Even if it is not their primary source of value creation, portfolio management—
determining which businesses the company should be in and managing resource
allocation among them—is an important corporate management function for all mul-
tibusiness companies. For this purpose, portfolio planning matrices are a widely used
strategy tool among multibusiness firms. By showing the strategic positioning of a
firm’s different businesses, they can be used to analyze their value-creating prospects
(see Strategy Capsule 13.2).

318 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 13.1
berkshire Hathaway, Inc.
Berkshire Hathaway comprises 63 operating sub-
sidiaries (some of which are shown in Figure  13.1)
and a headquarters in Omaha, NE, that comprises
25 employees. It is America’s third biggest company by
revenue with profits second only to Apple. It follows a
simple portfolio management strategy that has been
executed since 1970 by its 86-year-old chairman and
CEO, Warren Buffett. That strategy involves selecting com-
panies that possess a “wide moat” (=sustainable compet-
itive advantages), that compete in industries with sound
long-term prospects, and whose stock market valuation
is sufficiently low to permit a sizable upside potential. Buf-
fett’s stock picking ability is reinforced by rigorous capital
allocation: “We move huge sums from businesses that
have limited opportunities for incremental investment
to other sectors with greater promise. Moreover, we are
free of historical biases created by lifelong association
with a given industry and are not subject to pressures
from colleagues having a vested interest in maintaining
the status quo.”
Manufacturing
Lubrizoil
IMC
Fruit of the Loom
Clayton Homes
CTB International
Media and
Services
NetJets
Business Wire
Store Capital BH Media
Home Services of America
Main Portfolio
Investments
• Heinz Kraft
• Apple
• Coca-Cola
• Wells Fargo
• American Express
• Phillips 66
• Goldman Sachs
• Delta Airlines
Insurance
GEICO General Re
BHRGBH Primary
Energy
Mid American Energy
Paci�cCorp
NV Energy
Northern Powergrid
Retail
See’s Candy
Nebraska Furniture Mart
RC Willey Home Furnishings
BorsheimsPampered Chef
Dairy Queen
BERKSHIRE
HATHAWAY
INC.
FIGURE 13.1 The Warren Buffett portfolio: Some of Berkshire Hathaway’s businesses

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 319
Managing Linkages Across Businesses
In relation to vertical integration, international strategy, and diversification (Chapters 10, 11,
and 12), we established that the main opportunities to create value arise from exploiting
the linkages between businesses. These include the benefits from sharing and transferring
resources and capabilities and avoiding the transaction costs of markets. Most multibusi-
ness firms are organized to exploit resource and capability linkages in two areas: first,
through the centralization of common services at the corporate level and, second, through
managing direct linkages among the businesses.
Common Corporate Services
The simplest form of resource sharing in the multidivisional company is the central-
ized provision of corporate functions and common services. These include corpo-
rate management functions such as strategic planning, financial control, treasury, risk
management, internal audit, taxation, government relations, and shareholder relations.
They also include business services that are more efficiently provided on a centralized
basis, such as research, engineering, human resources management, legal services,
management development, purchasing, and any other administrative services subject
to economies of scale or learning.4
In practice, the benefits of the centralized provision of common services and
functions may be disappointingly small. Cost savings from eliminating duplications
may be offset, first, by the propensity for corporate staffs to grow under their own
momentum and, second, by the weak incentives for corporate staffs to meet the needs
of the businesses. Part of the problem is that the corporate headquarters serves two
distinct purposes: providing the businesses with leadership and control and providing
them with support services. Hence, a growing trend has been for companies to sepa-
rate their corporate headquarters into a corporate management unit—responsible for
supporting top management in strategic planning, finance, and communication—and
a shared services organization—responsible for supplying common services such as
research, recruitment, training, and information technology to the businesses.
By 2017, the majority of large multibusiness corporations in North America and
Europe had established shared service organizations. Most of these comprised three
or more functions the most common of which were information technology, human
resource management, real estate and facilities management, and legal services.
Increasingly, shared service organizations offer services that span national borders. The
location of these global shared service centers is influenced by the cost and skills of
local human resources.5
Procter & Gamble’s Global Business Services organization employs 7,000 people
in six “global hubs”: Cincinnati (US), San Jose (Puerto Rico), Newcastle (UK), Brussels
(Belgium), Singapore, and Manila (Philippines). Through scale economies and stan-
dardizing systems, it has reduced the cost of business services by over $800 million.
In addition to traditional support services, Global Business Services improves decision
making in P&G’s businesses through innovations such as virtualization (e.g., replacing
physical product mock-ups with virtual reality applications), internal collaboration and
decision support tools, and real-time digital capabilities.6

320 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 13.2
Portfolio Planning Matrices
Portfolio planning techniques were developed by Boston
Consulting Group, McKinsey & Company, and Arthur D.
Little when addressing the challenges faced by General
Electric at the end of the 1960s in managing its 46 divi-
sions and 190 businesses.
The basic idea of a portfolio planning matrix is to
position graphically the different businesses of a multi-
business company in relation to the key strategic vari-
ables that determine their profit potential.
The GE/McKinsey Matrix uses the two primary
drivers of profitability that we identified in Chapter  1
(see Figure  1.5): market attractiveness and competitive
advantage. The GE/McKinsey matrix measures industry
attractiveness by combining market size, market growth
rate, return on sales, potential for margin growth, and
international potential. A business unit’s competitive
advantage combines market share, return on sales relative
to competitors, and relative position in terms of quality,
technology, manufacturing, distribution, marketing, and
cost.1 Figure  13.2 shows the basic strategy implications
concerning the allocation of capital to each business.
The Boston Consulting Group Growth–Share
Matrix is a simplified version of the GE/McKinsey matrix.
It uses rate of market growth as proxy for industry attrac-
tiveness and relative market share (the business unit’s
market share relative to that of its largest competitor) as
an indicator of competitive advantage. The four quadrants
of the BCG matrix predict patterns of profits and cash flow
and indicate strategies to be adopted (Figure 13.3).2
The Ashridge Portfolio Display is based upon
the concept of parenting advantage.3 It recognizes that the
value-creating potential of a business not just dependent
upon the characteristics of the business, but also on the
characteristics of the parent. Hence, the focus is on the
fit between a business and its parent company. The posi-
tioning of a business along the horizontal axis of Figure 13.4
depends upon the parent’s potential to create profit for
the business by, for example, applying its corporate-level
management capabilities, sharing resources and capabil-
ities with other businesses, or economizing on transaction
costs. The vertical axis measures the parent’s potential for
value destruction by the costs of corporate overhead or a
mismatch between the management needs of the business
and the management systems and style of the parent.
These different portfolio planning matrices each have
their advantages and disadvantages as well as generic
limitations:
◆ The McKinsey and BCG matrices are both intended
to indicate the future profit potential for the business,
yet they utilize data drawn from the past.
◆ The McKinsey and BCG matrices ignore linkages bet-
ween businesses, yet such synergies between busi-
nesses tend to be major sources of multibusiness
companies’ value creation.
In
du
st
ry
A
tt
ra
ct
iv
en
es
s
Low
Low
Medium
Medium
High
High
Business Unit Competitive Advantage
B U I L D
H A R V E S T
H O L D
FIGURE 13.2 The GE/McKinsey portfolio planning matrix

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 321
Re
al
R
at
e
of
M
ar
ke
t G
ro
w
th
(%
)
LO
W
H
IG
H
Earnings:
Cash f low:
Strategy:
low, unstable, growing
negative
analyze potential
?
Earnings:
Cash f low:
Strategy: Strategy:
low, unstable
neutral or negative
divest
Earnings:
Cash f low:
Strategy:
high, stable, growing
high, stable
high, stable
neutral
invest for growth
Earnings:
Cash f low:
milk
LOW
Relative Market Share
HIGH
FIGURE 13.3 The BCG growth–share matrix
◆ All the matrices encounter problems of market def-
inition—for example, in the BCG matrix, is BMW’s
auto business a “dog” because it holds less than 2%
of the world auto market or a “cash cow” because it is
the market leader in the luxury car segment?
◆ The Ashridge matrix recognizes the role of strategic
fit and synergy, but encounters problems of com-
plexity and subjectivity—neither of the dimensions
lend themselves to quantification.
LOW
HEARTLANDBALLAST
• businesses with
high potential
for adding value
• typical legacy
business:
good �t; limited
potential to add
value
EDGE OF
HEARTLAND
Potential for value
destruction from
misf it between
needs of the
business and
parent’s corporate
management style
• less value-adding
potential or higher risk
of value destruction
VALUE TRAPALIEN TERRITORY
• lack of management �t limits
potential to add value
• exit: no potential for
value creation
HIGH
LOW HIGH
Potential for the parent to add value to the business
FIGURE 13.4 Ashridge portfolio display: The potential for parenting advantage
Source: Ashridge Strategic Management Centre.

322 PART IV CORPORATE STRATEGY
Transferring and Sharing Resources and Capabilities
among Businesses
Exploiting economies of scope doesn’t necessarily mean centralizing resources and
capabilities at the corporate level. In most multibusiness companies, the major source
of synergy is from sharing resources and transferring capabilities between businesses.
To identify the potential for sharing and resources and capabilities, Michael Porter
advocates comparing the value chains for different businesses to see where there are
similarities both between individual activities or in the overall configuration of the dif-
ferent value chains.7 Such similarities can be exploited in two ways:
● Transferring resources and capabilities: In the previous chapter we observed
that organizational capabilities can be transferred between businesses: LVMH
transfers its design and brand management capabilities among its luxury busi-
nesses, General Electric transfers its turbine expertise between jet engines and
electrical generators. Similarly with intangible resources: Virgin transfers the
use of its brand name among its many businesses; W.L. Gore transfers its pro-
prietary technology relating to expanded PTFE polymer across its business
units. Michael Porter notes that sharing skills and know-how is “an active
process … that does not happen by accident or by osmosis … support of
high-level management is essential.”8 The main impediments to the transfer of
best-practices within companies appear to lie in deficiencies in the relationships
across intra-organizational boundaries.9
● Sharing activities: When different business units have activities that use similar
tangible and human resources, there may be major economies from combining
them. Samsung Electronics has global design centers in Seoul, Tokyo, Bei-
jing, Delhi, London, San Francisco, and Sao Paulo which serve all Samsung’s
business units.10 Ford Motor Company’s transition from a geographical to a
more functional organizational structure (see Chapter 11, Strategy Capsule 11.3)
reflects its desire for cost savings through consolidating design, purchasing and
manufacturing.
Implications for the Corporate Headquarters
The more closely related are a company’s businesses, the greater are potential gains
from managing the linkages among those businesses and the greater the need for an
active role by the corporate center. Thus, in vertically integrated petroleum companies
(such as Royal Dutch Shell or Eni) or companies with close market or technological
links (such as IBM, Procter & Gamble, and Sony), corporate staffs tend to be much
larger than at companies with few linkages among their businesses. Berkshire Hatha-
way, which has almost no linkages among its businesses, has a corporate staff of about
25. Prior to its 2015 split, Hewlett-Packard, with about the same sales but much closer
linkages between its divisions, had over 2000 employees at its Palo Alto head office.
When business units share common resources or capabilities, the corporate headquar-
ters is likely to be closely involved in developing and deploying those resources and
capabilities. For example, both Pfizer and Corning each have strong corporate R&D
departments, while Virgin Group’s corporate team is heavily involved in managing the
Virgin brand.
Developing and sharing organizational capabilities implies an important role for
knowledge management. In industries such as beer, cement, food processing, and
telecommunication services, internationalization offers few economies of scope in

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 323
shared resources, but does offer important opportunities for transferring innovation
and know-how among national subsidiaries.
Exploiting linkages between businesses imposes costs which can easily outweigh
the benefits generated. Even straightforward collaborations, such as cross-selling
between different businesses, have yielded disappointing results, especially in financial
services.11 A comparison between conglomerate companies and vertically-integrated
paper companies found that the heavier coordination requirements of the paper com-
panies resulted in greater involvement of head office staff in divisional operations, larger
head office staffs, more complex planning and control devices, and a lower respon-
siveness to change in the external environment. By contrast, conglomerate companies
made little attempt to exploit operating synergies, even if they were present.12
Managing Individual Businesses
In the portfolio management approach to corporate strategy, the corporate headquar-
ters’ primary role is as an investor: making acquisitions and divestments and allocating
investment funds among the different businesses. In managing linkages among the
businesses the essential role of the corporate headquarters is as a coordinator and
orchestrator of synergies between businesses. However, the corporate headquarters may
be involved more directly in adding value to its individual businesses by improving
their management. Andrew Campbell and his associates refer to this direct influence of
corporate headquarters on the individual businesses as “vertical value-added” achieved
through “stand-alone influence” (i.e., it is not dependent upon exploiting synergies
among the businesses). There are many types of intervention through which corporate
management can improve the performance of the businesses they own: replacing busi-
ness-level managers, controlling budgets, guiding strategy, setting performance targets,
facilitating external relationships (e.g., with governments and investors), providing
advice and guidance, and managing the corporate culture.13
We focus upon just three of these mechanisms: direct corporate involvement in
business level management, strategic planning, and performance management and
financial control.
Direct Corporate Involvement in Business-level Management
There is overwhelming evidence that performance differences between companies are
vast and are caused primarily by differences in the quality of management.14 Hence,
there is scope to create value by improving the management practices of poorly
managed companies. A restructuring strategy is one in which a parent company
intervenes to install new managers, change strategy, sell off surplus assets, and pos-
sibly make further acquisitions in order to achieve scale and market presence. For
the strategy to create value requires that management is able to spot companies that
are undervalued or offer turnaround potential to then make strategic and operational
interventions to boost their performance. A further requirement, observes Michael
Porter, is the willingness to recognize when the work has been done and then dispose
of the restructured business.15
Restructuring was once associated with the strategies of conglomerate companies,
most of which have disappeared from the corporate sectors of North America and
Europe. Their role as restructurers has passed to private equity groups. Firms such as
Carlyle Group, Kohlberg Kravis Roberts, Blackstone, and Apollo Global Management

324 PART IV CORPORATE STRATEGY
in the United States and CVC Capital Partners and BC Partners in the United Kingdom
create investment funds organized as limited partnerships that acquire full or partial
ownership of private and public companies. Value is created through financial restruc-
turing (primarily increasing leverage), management changes, and making strategic and
operational changes. Private equity firms have also been involved in acquiring very
large public companies. 3G Capital’s acquisitions of Heinz and Kraft points to the
potential for restructuring interventions to radically boost profit margins (see Strategy
Capsule  13.3). On average, private equity funds have generated returns that exceed
those of the stock market, although the gap has narrowed.16 Whether private equity
firms create value on a more broadly defined basis is less clear; it is likely that the gains
to investors have been financed by employees, taxpayers, and communities.
Restructuring may also involve not just individual companies, but entire industries.
The merging of Heinz and Kraft by 3G Capital and its subsequent attempt to acquire
Unilever, suggests intent to consolidate the entire processed foods sector. 3G’s role in
consolidating the global beer industry around Anheuser-Busch InBev—with its 21%
share of the world beer market—offers a precedent.
For most multibusiness companies, involvement by corporate-level management in
the strategic and operational decisions at the business level is less intrusive than that
implied by a restructuring approach. Multibusiness companies with superior financial
performance over the long term tend to have close communication and collaboration
between the business and corporate management. For example:
● Exxon Mobil Corporation has been the most profitable of the world’s petroleum
majors for the past 50 years. At the core of ExxonMobil’s renowned financial
STRATEGY CAPSULE 13.3
3G Capital’s Restructuring of Heinz-Kraft
3G Capital is a Brazil-based private equity firm founded
in 2004. In 2013, it partnered with Berkshire Hathaway
to acquire the US food processing company. Heinz, then
two years later merged Heinz into Kraft Foods. Between
2013 and 2017, Heinz-Kraft has undergone massive orga-
nizational and operational changes.
3G’s initial interventions were replacements of
management. At Heinz, 3G fired 11 of the top 12 exec-
utives in a single day; at Kraft, 10 top executives were
quickly dismissed. Cost cutting measures at Kraft
ranged from the symbolic—eliminating office refriger-
ators, selling corporate jets, requiring all employees to
fly coach—to the substantial—closing seven plants in
North America, eliminating some 2,600 jobs, and selling
the Chicago corporate campus. Plant closures and lay-
offs induced favors from governments and unions: cities
and states offering Heinz-Kraft incentives to keep plants
open and unions offering concessions on pay and con-
ditions. 3G’s management processes include “zero-based
budgeting,” every expense item must be justified in each
accounting period; measurable, transparent annual goals
for each employee; and rapid advancement for high-
performing young talent.
The impact on profitability has been remarkable: in
2017, Heinz-Kraft’s operating margin was 30%—double
what it was in 2012—and far ahead of rivals General Mills,
Campbell Soup, Kellogg, Unilever, and Nestle.
3G’s attempt to acquire Unilever in 2017 has made
Heinz-Kraft’s rivals increasingly wary of their vulnerability—
most boosting their cost cutting efforts to support their
share prices.
Sources: “The Lean and Mean Approach of 3G Capital,” Financial
Times, May 7, 2017; “Kraft’s Heinz Recipe – Buy, Squeeze, Repeat,”
Fortune (February 1, 2017).

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 325
discipline, strategic acuity, and operational effectiveness is a management
system that combines rigorous implementation of company-wide financial and
operational procedures, a close relationship between the president of each
of the 10 global businesses and a member of the five-person management
committee, and a powerful corporate culture that has been described as “relent-
less,” “ruthless,” “Texan,” and “cult-like.”17
● Danaher Corporation adds value to its 27 companies in life sciences, dental
care, and environmental systems through applying its Danaher Business
System which “guides what we do, measures how well we execute, and cre-
ates options for doing even better” and “drives every aspect of our culture
and performance.”18 The system comprises Toyota’s principles of lean pro-
duction and continuous improvement, the extensive use of closely-monitored
performance metrics, and a company-wide commitment to using innovation to
solve customers problems.19
● Kering, the Paris-based luxury and lifestyle group that includes Gucci, Bot-
tega Veneto, Yves St. Laurent, Puma, and other fashion brands, has a corporate
center that nurtures creativity, diffuses corporate values such as environmental
sustainability, women’s empowerment, and developing diverse talent, while
closely monitoring performance and replacing subsidiary CEOs and creative
directors when it deems necessary.20
The downside of direct corporate involvement in business-level decisions is its
potential to undermine the autonomy and motivation of the general managers of those
businesses. Authoritarian, highly-interventionist CEOs can be very successful (as in
the case of Steve Jobs at Apple) or very unsuccessful (as in the case of Carly Fio-
rina at Hewlett-Packard). Universally true, however, is that centralization of initiative
and decision-making authority adversely affects the responsiveness and adaptability
of the organization as a whole. A key challenge of managing the multibusiness firm is
to design a management system that allows business-level managers to benefit from
the expertise and perspective of corporate managers while sustaining their initiative
and motivation and exploiting their superior knowledge of their own businesses. Two
management systems can assist in this task: strategic planning systems and performance
management systems.
The Strategic Planning System
In most multibusiness companies, the corporate center establishes overall corporate
goals and priorities, then within this framework, the business units develop their
business strategies. It is then the role of corporate managers to appraise, amend,
approve, and then integrate these business-level strategies. The challenge is to
design a strategy-making process that reconciles the decentralized decision making
that is essential to fostering flexibility, responsiveness, and a sense of ownership at
the business level with corporate management’s ability to apply its knowledge, per-
spective, and responsibility for the interests of shareholders and other stakeholders.
Common to the success of ExxonMobil, Siemens, and Unilever is a strategic planning
system that supports a high level of decision-making autonomy at the business level,
motivates business leaders toward high performance, shares knowledge between
corporate and business levels, and reconciles business initiative with overall cor-
porate control. The typical strategic planning cycle is outlined in Chapter 6 (“The
Strategic Planning System: Linking Strategy to Action”).

326 PART IV CORPORATE STRATEGY
Criticisms of Strategic Planning Since the early 1980s, the strategic planning sys-
tems of large firms have been bombarded by criticism. We observed in Chapter 1 that
Henry Mintzberg claimed top-down, formalized strategic planning to be ineffective
since it separated strategy formulation from strategy implementation and failed to take
account of uncertainty or the need for flexibility and creativity. These deficiencies may
explain the observation that, for many large companies, strategy is formulated outside
the strategic planning system. Marakon consultants Mankins and Steele observe that the
rigidities of formal planning cycles mean that “senior executives … make the decisions
that really shape their companies’ strategies … outside the planning process typically
in an ad hoc fashion without rigorous analysis or productive debate.”21 Mintzberg’s criti-
cism of the divorce of strategy formulation from strategy implementation is reinforced
by surveys that show that deficiencies in strategy execution processes are the biggest
challenge that senior executives face.22
Improving Strategic Planning Systems Proposals to increase the effectiveness
of the strategic planning processes of large, multibusiness companies have focused on
three types of initiative.
Emphasize critical strategic issues. Richard Rumelt observes that:
“A strategy is a way through a difficulty, an approach to overcoming an obstacle, a
response to a challenge. If the challenge is not defined, it is difficult or impossible to
assess the quality of the strategy… if you fail to identify and analyze the obstacles,
you don’t have a strategy. Instead, you have a stretch goal or a budget or a list of
things you wish would happen.”23
McKinsey consultants point to the need to begin the strategy process by “deliberately,
thoughtfully identifying the strategy issues that will have the biggest impact on future
business performance.”24 A key problem, according to a study by Bain & Company,
is that strategic issues are obscured by an emphasis placed on financial targets. Com-
panies that separated strategy development from budgetary planning reported bolder,
more inspiring ambitions and clearer choices over where to play and how to win.25
Adapt strategic planning to meet a company’s specific needs. Different companies
face different strategic decisions and decision contexts which require different strategic
planning processes. Companies in slow moving, mature industries such as processed
foods, earth-moving equipment, and airlines can utilize traditional strategic planning sys-
tems that emphasize incremental change and utilize performance targets. Companies in
e-commerce and information technology need strategic planning systems that foster alert-
ness to technologies and business models that may disrupt their businesses. Companies’
strategic planning cycles should match the needs of their businesses. According to McK-
insey & Company, business units whose performance is satisfactory and face a stable
business environment do not need to undertake a full-blown strategy review each year.
Conversely, businesses in fast moving sectors need to review their strategies continuously.26
Systematize strategy execution. Effectiveness in executing strategy must go beyond
budget setting. To link strategic planning more closely to operational management,
Larry Bossidy and Ram Charan recommend using milestones—specific actions or
intermediate performance goals to be achieved at specified dates. These can “bring
reality to a strategic plan.”27 As we noted in Chapter 2, the balanced scorecard offers a
means of cascading high-level strategic plans into specific functional and operational
targets for different organizational units. Building this approach, Kaplan and Norton
propose the use of strategy maps to plot the linkages between strategic actions and
overall goals.28 To be effective, performance targets must be embedded into human

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 327
resource management so that appraisal metrics and compensation incentives reflect
strategic goals. Connecting strategic planning to its implementation may require a
broader role for strategic planning units. Kaplan and Norton recommend upgrading
strategic planning units into offices of strategy management that, not only manage the
annual strategic planning cycle, but also oversee the execution of strategic plans.29
Performance Management and Financial Control
Most multibusiness companies have a dual planning process: strategic planning is
concerned with the medium and long term; financial planning and control typically
concentrate upon a two-year horizon. The first year of the strategic plan normally
includes the performance plan for the upcoming year comprising an operating budget
and strategy targets that relate to market share, output growth, new product introductions,
and employment levels which are often expressed as specific strategic milestones. Annual
performance plans are agreed between senior business-level managers and corporate-
level managers. Targets are monitored on a monthly and quarterly basis to provide early
detection of deviations from targeted performance. At the end of each financial year, they
are probed and evaluated in performance review meetings held between business and
corporate management. Capital expenditure budgets tend to be longer term—usually
extending over the entire three to five year strategic planning period.
Companies whose management systems are heavily orientated towards demanding
financial and operating targets typically use powerful individual incentives to create
an intensely motivating environment for divisional managers. Creating a performance-
driven culture requires unremitting focus on a few quantitative performance targets that
can be monitored on a short-term basis. PepsiCo CEO Indra Nooyi observed: “We are a
very objective-driven company. We spend a lot of time up front setting objectives and
our guys rise to the challenge of meeting those objectives. When they don’t meet the
objectives, we don’t have to flog them because they do it themselves.”30
In industries in which investment horizons and the lag between strategic decisions
and their outcomes are longer, the challenges of reconciling short- and medium-term
targets with longer-term company performance is more difficult. The performance
management system of BP, the UK-based petroleum company, was identified as a con-
tributory factor in the tragic accidents at its Texas City refinery and Deepwater Horizon
drilling platform (see Strategy Capsule 13.4).
Strategic Planning and Performance Control: Alternative
Approaches to Corporate Management
Although many companies implement their strategic plans through setting performance
targets, ultimately, strategic plans and performance targets represent alternative mech-
anisms of corporate control. Strategic planning involves exerting corporate control
over the strategic decisions made by the businesses. Performance management, on the
other hand, involves establishing performance targets for the businesses, then allowing
the managers of the business the freedom to make the decisions needed to attain the
required performance.
The distinction between these two approaches is between input and output con-
trol. A company can control the inputs into strategy (the decisions) or the output from
strategy (the performance). Although most companies use a combination of input
and output controls, there is a tradeoff between the two: more of one implies less
of the other. If the corporate HQ micromanages divisional decisions, it must accept

328 PART IV CORPORATE STRATEGY
the performance outcomes that will result from this. Conversely, if the corporate HQ
imposes rigorous performance targets, it must give divisional managers the decision-
making freedom for their attainment.
This implies that, in designing their corporate control systems, companies must
emphasize either strategic planning or financial control. This distinction was observed
by Goold and Campbell in their study of the corporate management systems of British
multibusiness companies.31 Strategic planning companies emphasized the longer-term
development of their businesses and had corporate HQs that were heavily involved in
business-level planning. Financial control companies had corporate HQs that empha-
sized short-term budgetary control and rigorously monitored financial performance
against ambitious targets, but had limited involvement in business strategy formula-
tion—this was left to divisional and business unit managers. Table 13.1 summarizes the
key features of the two styles.
Over time, the trend has been for companies to make increasing use of financial
control in managing their businesses. This has occurred even in capital-intensive sec-
tors with long time horizons, such as petroleum, where strategic planning has become
increasingly oriented toward short- and medium-term financial targets.32 However, since
the financial crisis of 2008–2009, increasing criticism has been levied against short-term
shareholder value maximization. Whether this will lead to an increasing emphasis on
longer-term strategic planning remains to be seen.
STRATEGY CAPSULE 13.4
Performance Management at bP
Under the leadership of John Browne (CEO 1995–2007),
BP became the most decentralized, entrepreneurial, and
performance focused of the petroleum majors. Brown’s
management philosophy emphasized three principles:
◆ BP operates in a decentralized manner, with individual
business unit leaders (such as refinery managers)
given broad latitude for running the business and
direct responsibility for delivering performance.
◆ The corporate organization provides support and
assistance to the business units through a variety of
functions, networks, and peer groups.
◆ BP relies upon individual performance contracts to
motivate people.
The CEO was responsible for presenting the five-year
and annual corporate plans to the board for approval.
The goals, metrics, and milestones in corporate plans
were cascaded down in the plans for each segment,
function, and region. These same goals and metrics
were reflected in individual performance contracts.
A performance contract outlined the key results and mile-
stones an employee was expected to achieve that year.
Progress against targets and milestones in an employee’s
performance contract were a key determinant of annual
bonuses. Performance contracts were the key mecha-
nism for delegating annual plans into commitments by
individual leaders. The performance contracts set goals
for financial, operational, strategic, and HSSE (health,
safety, security, and environmental) performance that
were high, but not so high that they couldn’t be achieved.
Source: Adapted from The Report of the BP US Refineries
Independent Safety Review Panel, January 2007, with permission
from BP International.

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 329
Managing Change in the Multibusiness Corporation
The shifting priorities of corporate managers have had important implications for the stra-
tegic management of multibusiness companies. During the last two decades of the 20th
century, the priority shifted from growth to the creation of shareholder value. This
resulted in the restructuring of diversified corporate empires through outsourcing and
refocusing. During the present century, especially since the financial crisis of 2008–2009,
the greatest challenge has been enhancing responsiveness to external change and accel-
erating the pace of organizational evolution.
Disillusion with the shareholder value maximization model, diminishing returns to
cost cutting, and the need to create new sources of value have resulted in profound
shifts in the corporate strategies of multibusiness companies. Increasingly, large mul-
tibusiness companies have sought to identify opportunities for innovation, for new
product development, and for exploiting linkages—both internally between their busi-
nesses and externally with other companies. Corporate headquarters are concerned
less with the problem of control and more with the challenges of creating value within
and between their individual businesses. The parenting concept reflects this growing
emphasis on business development and the quest for new sources of value. One of the
greatest challenges for the corporate management is to facilitate adaptation to change
TABLE 13.1 Characteristics of different corporate management styles
Strategic planning Financial control
Business strategy
formulation
Businesses and corporate HQ jointly
formulate strategy
The HQ coordinates strategies of
businesses
Strategy formulated at business
unit level
Corporate HQ largely reactive, offering
little coordination
Controlling
performance
Primarily strategic goals with medium-
to long-term horizons
Financial budgets set annual targets for
ROI and other financial variables with
monthly and quarterly monitoring
Advantages Effective for exploiting (a) linkages
among businesses, (b) innovation,
(c) long-term competitive positioning
Business unit autonomy sup-
ports initiative, responsiveness,
efficiency, and development of
business leaders
Disadvantages Loss of divisional autonomy and
initiative
Conducive to unitary strategic view
Tendency to persist with failing
strategies
Short-term focus discourages innova-
tion and long-term development
Limited sharing of resources and
capabilities among businesses
Style suited to Companies with few closely related
businesses
Works best in highly competitive,
technology-intensive sectors where
investment projects are large
and long term
Highly diversified companies with low
relatedness among businesses
Works best in mature, low-tech sec-
tors where investment projects are
relatively small and short term
Source: Based on M. Goold and A. Campbell, Strategies and Styles (Oxford: Blackwell Publishing, 1987) with permis-
sion of John Wiley & Sons, Ltd.

330 PART IV CORPORATE STRATEGY
by large, multibusiness companies. (Strategy Capsules 13.5 and 13.6 illustrate how the
corporate centers of IBM and Samsung Electronics have built adaptive capability. These
companies, together with other exemplars of responsiveness to changing business con-
ditions—such as Microsoft Siemens, Philips, Haier, and Johnson & Johnson—point to
three ways of facilitating corporate adaptation:
● Counteracting inertia: As we noted in Chapter 8 (“The Challenge of Organiza-
tional Adaptation and Strategic Change”), organizations resist change. Multibusi-
ness corporations, because of their greater complexity, are especially subject to
STRATEGY CAPSULE 13.5
Reformulating Strategic Planning at IbM
IBM is an evolutionary wonder. It has successfully tran-
sitioned from tabulating machines to mainframe com-
puters, to personal computers, to networked information
technology, to cloud computing. During the past two
decades, it has also changed from a hardware to a soft-
ware and services company. Under its past three CEOs,
IBM’s pace of evolution accelerated, assisted by IBM’s
processes for making and implementing strategy.
Under transformational CEO’s Lou Gerstner and Sam
Palmisano, IBM recreated its strategic planning system
around processes for identifying and responding to
emerging opportunities and threats. This IBM Strategic
Leadership Model includes systems for sensing new
opportunities:
◆ The technology team meets monthly to assess
emerging technologies and their market potential.
◆ The strategy team comprising a cross section of gen-
eral managers, strategy executives, and functional
managers meets monthly to review business unit
strategies and recommend new initiatives.
◆ The integration and values team comprises 300 key
leaders selected by top management. The team is
responsible for companywide initiatives called “win-
ning plays” that cut across IBM’s divisional boundaries.
◆ “Deep dives” are conducted by ad hoc teams to
explore specific opportunities or issues and may
result in recommendations to enter a new area of
business or to exit from a particular technology or
product market.
The initiatives arising from these processes are then
acted on by the three main executing vehicles:
◆ Emerging business opportunities (EBOs) are business
development processes that protect new business
initiatives from the financial rigor applied to more
conventional projects. EBOs were established to
develop Linux applications, autonomic computing,
blade servers, digital media, network processing, and
life sciences.
◆ Strategic leadership forums are three- to five-day
workshops facilitated by IBM’s Global Executive and
Organizational Capability Group. Their purpose is to
transform strategic initiatives into action plans and
to address pressing strategic issues, such as poor
performance, in specific business areas. They are
initiated by a senior manager and overseen by the
strategy team.
◆ The Corporate Investment Fund finances new initia-
tives identified by the integration and values team
or by EBOs.
Source: J. B. Harreld, C. A. O’Reilly, and M. L. Tushman, “Dynamic
Capabilities at IBM: Driving Strategy into Action,” California
Management Review49 (Summer 2007): 21–43.

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 331
organizational inertia. One aspect of this is the difficulty that companies expe-
rience in reallocating resources among their existing businesses in response to
external change and internal performance differences. Not only do multibusi-
ness companies tend to maintain the same allocation of capital expenditures
to their individual businesses from year to year, but there is also a bias toward
equalizing capital expenditures to each business.33 This is despite the fact that
STRATEGY CAPSULE 13.6
Samsung Electronics: Top-down Initiatives that Drive
Corporate Development
Samsung is the biggest of South Korea’s chaebols—
groups of companies linked by cross-shareholdings and
controlled by a founding family. The Samsung group
comprises 83 companies. The biggest company is Sam-
sung Electronics, the world’s largest electronics company
in terms of sales. The head of the Samsung group, and
chairman of Samsung Electronics, is Lee Kun-hee, son
of the founder Lee Byung-chull and father of Jay Y. Lee,
president of Samsung Electronics.
The rise of Samsung Electronics is the result of a series
of corporate initiatives that were ambitious, focused,
long-term, and driven by intense top-down commit-
ment—and capital investment. In 1982, Samsung Elec-
tronics resolved to become world leader in memory
devices—it achieved this in DRAM chips in 1992. In
2004, its semiconductor investments began focusing on
flash memories, where it also established global leader-
ship. Between 2000 and 2009, it established itself as the
world’s biggest producer of batteries for mobile digital
devices, similarly with flat-panel televisions.
These successes involved massive commitments of
resources to technology (Samsung receives more US
patents than any other company except IBM), manufac-
turing (for semiconductor production Samsung built the
world’s biggest fabrication complex), design (design cen-
ters in five cities of the world), and the Samsung brand.
Its resource deployments have been supported by a
culture and working practices that support high levels
of coordination and commitment. Samsung’s culture is
nourished by tales of outstanding endeavor, including
constructing a four-kilometer paved road in a single day
to ensure that Samsung’s first integrated circuit plant
could open on time.
Central to Samsung’s success is a new product
development process supported by a knowledge
management process that allows development teams
to exploit the expertise of the entire company. In April
2009, the Visual Display Division of Samsung Elec-
tronics’ Digital Media Business had just completed
work on a high-resolution LED TV when it was required
to roll out a high-definition, 3-D television within a
year. Within a week, the two task forces assigned to
the project scoured Samsung Electronics’ Test and
Error Management System ( TEMS) of information on
every product development project undertaken at the
company to identify know-how within Samsung that
might assist the new project.
Samsung Electronics’ top-down drive contines.
In 2010–2011, CEO Lee Kun-hee announced 10-year
plans to build major new businesses in solar panels,
LED lighting, electric vehicle batteries, biotechnology,
and medical devices. During 2014 to 2018, the strategic
priorities were to transition Samsung from hardware to
software and services and build strength in automo-
tive systems, digital health, and industrial automation.
By acquiring Harman International in December 2017,
Samsung indicated its willingness to use acquisitions to
build new areas of business.
Sources: “Samsung: The Next Big Bet,” Economist (October 1,
2011); Samsung Electronics, HBS Case 9–705–508 (revised 2009);
“Samsung Electronics’ Knowledge Management System,” Korea
Times (October 6, 2010).

332 PART IV CORPORATE STRATEGY
those companies that did achieve higher levels of capital reallocation outper-
formed those which did not.34
● Adaptive tension: At General Electric, Jack Welch, CEO from 1981 until 2001,
created a corporate management system that decentralized decision making to
business-level managers but created a level of internal stress that counteracted
complacency and fostered responsiveness to external change and a constant
striving for performance improvement. The role of the CEO as a catalyst for
change and driver of outstanding performance is also evident in the leadership
styles of Steve Jobs at Apple and Jeff Bezos at Amazon.
● Institutionalizing strategic change: As we have already noted, companies’
strategic planning systems are seldom sources of major strategic initiatives:
the impetus for major strategy redirection usually comes from outside formal
strategy processes. The IBM case example shows that strategic planning systems
can be redesigned as systems for sensing external changes and responding to
the opportunities these changes offer—in other words, building dynamic capa-
bility at the corporate level.
● New business development: The compression of industry lifecycles means that
multibusiness companies are under increasing pressure to revamp their business
portfolios. The barriers to releasing mature and declining businesses lie princi-
pally in management psychological and organizational politics: once a company
has decided to exit a sector, the divestment is typically applauded by the stock
market (e.g., GE’s sale of its domestic appliance business or HP’s decision to
spin off its PC and printer business). Developing new businesses represents a
bigger challenge. A few companies are able to build whole new businesses on
internally developed new products (e.g., 3M), new technology (e.g., Google,
Amazon), or new entrepreneurial initiatives (e.g., the Virgin Group). Some com-
panies have established corporate incubators for nurturing new startups: Royal
Dutch Shell’s GameChanger and Google’s Area 120 are examples.35
● Top-down, large-scale development initiatives: Throughout this book, we have
pointed to the key role of strategic intent—top-down strategic goals—in uni-
fying and motivating organizational members. In some companies, linking
such strategic intent to specific projects and programs has been an especially
powerful vehicle for corporate development. The rise of Samsung Electronics
to become the world’s largest electronics company has been on the basis of
a small number of hugely ambitious development projects that have involved
massive commitments of finance, human ingenuity, and effort.
Adaptation to changing circumstances also requires timing. Intel’s former CEO,
Andy Grove, emphasizes the importance of CEOs identifying strategic inflection
points—instances where seismic shifts in a firm’s competitive environment require a
fundamental redirection of strategy. For Intel, key inflection points included: transition
from DRAM chips to microprocessors as its core business, its choice of its x86 micro-
processor architecture, and its 1994 decision to replace its faulty Pentium chips at a
cost of $475m.36
Finally, managing change in large organizations also requires providing people
with the security and certainty to allow them to leap into the unknown. Some of
the companies that have been most effective in adapting to change—IBM, Philips,
3, and HSBC—have done so while emphasizing the continuity of their heritage and
identity.  Creating a sense of identity is more challenging for a company that spans
several businesses than for one whose identity is determined by the products it offers

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 333
(e.g., McDonald’s or De Beers). It goes beyond “strategic relatedness” and “dominant
logic” and embraces vision, mission, values, and principles. For example, the French-
based multinational Danone has undergone multiple transformations before emerging
as a dairy products and baby foods company, yet has provided continuity through its
commitment to a set of enduring business principles that have emphasized employee
welfare and corporate social responsibility.37
Governance of Multibusiness Corporations
So far, our discussion of the multibusiness corporation has focused on the means by
which the corporate headquarters can create value. What we have not discussed is:
value for whom? This takes us to the issue of corporate governance—the system by
which companies are directed and controlled—or more formally:
Procedures and processes according to which an organization is directed and con-
trolled. The corporate governance structure specifies the distribution of rights and
responsibilities among the different participants in the organization—such as the
board, managers, shareholders and other stakeholders—and lays down the rules and
procedures for decision-making.38
The reason corporate governance is an important issue is because of the separation
of ownership from control in large companies, which gives rise to the agency problem:
the propensity for managers (the agents) to operate companies in their own interests
rather than in the interests of the owners (see the discussion of “The Cooperation
Problem” in Chapter 6). Although corporate governance is an issue for all companies
whose owners are not directly engaged in managing the company, it is especially acute
in large public corporations, almost all of which comprise multiple businesses. Indeed,
in the multibusiness company the problem of agency is compounded by the separa-
tion not only of the shareholders from corporate management but also of corporate
management from business-level management.
Let us examine three key issues of corporate governance in relation to large, mul-
tibusiness firms: the rights of shareholders, the responsibilities of boards of directors,
and the role of corporate management.
The Rights of Shareholders
The tendency for companies to be operating in the interests of their senior managers—
whose personal goals tend to be the aggrandizement of their wealth, power, influence,
and status—rather than in the interests of their owners is primarily a problem for public
companies where, typically, ownership is dispersed among thousands of shareholders.
Hence, in most countries company law seeks to protect shareholders’ interests through
establishing their rights to elect and remove members of the board of directors, to share
in the profits of the company, to receive company information (including audited finan-
cial statements), and to sell their shares.
However, even with these protections, shareholders’ incentives to exercise their gov-
ernance rights are weak: if each shareholder owns only a small fraction of a company
and these shares only account for a small fraction of the shareholder’s total wealth then
the costs of active engagement are high relative to the likely returns. Disgruntled share-
holders typically sell their shares rather than oppose the incumbent management team.

334 PART IV CORPORATE STRATEGY
The short-term orientation of most shareholders further discourages activism: over the
past 40 years the average holding period for US equities has fallen from seven years to
seven months.39 At the time of Kraft’s highly contentious takeover of British chocolate
maker Cadbury, about 30% of Cadbury’s shares were owned by hedge funds.40
Mechanisms to limit shareholder power include issuing shares with differential
voting rights. This allows the founders of companies and their families to exercise
effective control despite owning a minority of shares. At News International, Rupert
Murdoch and family owned 12% of the company but controlled 40% of the votes. After
Facebook’s IPO, Mark Zuckerberg owned 18% of the company but controlled 57% of
the votes. Shares with differential voting rights are primarily a defense against hos-
tile takeover. Managers as well as founders tend to oppose takeovers, since they are
likely to lose their jobs. Hence the use of “poison pill” defenses that penalize hostile
takeovers.
The Responsibilities of Boards of Directors
The board of directors, according to OECD Principles of Corporate Governance, has
the responsibility to “ensure the strategic guidance of the company, the effective moni-
toring of management by the board, and the board’s accountability to the company and
the shareholders.”41 This requires that:
● board members act in good faith, with due diligence and care, in the best
interest of the company and its shareholders;
● board members review and guide corporate strategy, major plans of action,
risk policy, annual budgets, and business plans; set and monitor performance
objectives; oversee major capital expenditures; select, monitor, and compen-
sate key executives; ensure the integrity of the corporation’s accounting and
financial reporting systems; and oversee the process of disclosure and com-
munication.
However, there are several impediments to the effectiveness of boards of directors in
exercising oversight and strategic guidance:
● The dominance of the board by executive directors. Among many companies
(including many US and UK corporations), the top management team are also
board members, hence limiting the board’s role in providing independent over-
sight of management. Such overlap also occurs when the roles of board chair
and CEO are held by a single person—a feature of one-half of Fortune 500 cor-
porations in the United States, though less common in Europe. The weight of
evidence points to the advantages of splitting the roles; however, in general it is
the competence of the individuals who do the job that is more important than
the structural arrangements.42
● Boards have become increasingly preoccupied with compliance issues with the
result that their role in guiding corporate strategy has shrunk.
Dominic Barton, global managing director of McKinsey & Company, argues that, if
boards are to become effective agents of long-term value creation, they must devote
much more time to their roles, need to have relevant industry experience, and should
have a small analytical staff to support their work.43
The harshest criticisms of board oversight have been in relation to management
compensation. From 1978 to 2013, the compensation of US CEOs, inflation-adjusted,

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 335
increased 937% compared to 10.2% for the average worker compensation over the
same period.44 The paradox is that the massive payouts to CEOs have been the result of
compensation systems designed to align management goals with those of shareholders’,
especially through the grant of stock options and emphasis on performance-related
bonuses. As Table  13.2 shows, the highest-paid CEOs were not always those who
delivered exceptional returns to their shareholders. Poor alignment between executive
compensation and shareholder value is often the result of linking bonuses to short-term
performance, failing to correct for overall stock market movements, and incentives for
creating shareholder value not being matched by penalties for its destruction.45
Governance Implications of Multibusiness Structures
In the multibusiness corporation, decision-making responsibilities are divided between
a corporate headquarters and the individual businesses—typically through a multidi-
visional structure. As we saw in Chapter 6 (Strategy Capsule 6.1), the multidivisional
form was a key development in the emergence of the modern corporation. What are
the implications of this structure for corporate governance?
For organizational economist Oliver Williamson, the widespread adoption of the
multidivisional structure (or “M-form”) was a result of its advantages both in combining
centralized direction and localized adaptation and in overcoming the problems of cor-
porate governance that affect large public companies.46 The multidivisional form facil-
itates corporate governance in two ways:
● Allocation of resources: Resource allocation within any administrative structure
is a political process in which power, status, and influence can triumph over
purely commercial considerations.47 To the extent that the multidivisional
company can create a competitive internal capital market in which capital is
allocated according to past and projected divisional profitability and projects
are subjected to a standardized appraisal process, it can avoid much of this
politicization.
TABLE 13.2 The highest-paid CEOs of 2016
Rank CEO Company Direct compensation 2016 ($m)
1 Thomas Rutledge Charter Communications 98
2 Leslie Moonves CBS 69
3 Robert A. Iger Walt Disney 41
4 David Zaslav Discovery Communications 37
5 Robert Kotick Activision Blizzard 33
6 Brian Roberts Comcast Corp. 33
7 Jeffrey L. Bewkes Time Warner 33
8 Virginia Rometty IBM 32
9 Leonard Schleifer Regeneron Pharmaceuticals 28
10 Stephen Wynn Wynn Resorts Ltd. 28
Source: Equilar

336 PART IV CORPORATE STRATEGY
STRATEGY CAPSULE 13.7
Governance in Holding Companies
A holding company owns a controlling interest in a
number of subsidiary companies. The term holding
company is used to refer both to the parent company
and to the group as a whole. Holding companies are
common in Japan (notably the traditional zaibatsu such
as Mitsubishi and Mitsui), in Korea (chaebols such as LG,
Hyundai, and SK) and the Hong Kong trading houses
(Swire, Jardine Matheson, and Hutchison Whampoa). In
the United States, holding companies own the majority
of US banking assets.
Within holding companies, the parent exercises con-
trol over the subsidiary through appointing its board of
directors. The individual subsidiaries typically retain high
levels of strategic and operational autonomy. Unlike the
multidivisional corporation, the holding company lacks
financial integration: there is no centralized treasury,
profits accrue to the individual operating companies,
and there is no centralized budgeting function—each
subsidiary is a separate financial entity. The parent
company provides equity and debt capital and receives
dividends from the subsidiary.
Although the potential for exploiting synergies bet-
ween businesses is more limited in the holding company
than in the divisionalized corporation, the holding
company structure has important advantages for large
family-owned companies. The attractiveness of holding
companies is that they allow family dynasties to retain
ownership and control of business empires that diversify
family wealth across multiple sectors. At the same time,
their decentralization allows effective management of
the group without the need for the parent company to
develop a tremendous depth of management capability.
Thus, the Tata Group, India’s biggest business concern
with over $60 billion in revenue and 424,000 employees,
is controlled by the Tata family through Tata Sons Ltd, par-
ent company of the group. Among the many hundreds
of subsidiaries, several are leading companies within
their industries, including Tata Steel, Tata Motors (owner
of Jaguar and Land Rover), Tata Tea (owner of the Tetley
brand), and Tata Consulting Services. Twenty-seven Tata
companies are publicly listed.
In contrast to the public corporations where the key
governance problem is the conflicting interests of owners
and managers, the governance problems of holding
companies relate to the conflicting interests of different
shareholders: especially between the founding family and
other shareholders. Through its investment company Exor,
the Agnelli family controls a business empire that com-
prises Fiat Chrysler, Ferrari, CNH Industrial, and Juventus
Football Club, despite minority ownership of these enter-
prises. Similarly with the Tata family: cross- shareholdings
and shares with differential voting rights allow family con-
trol despite minority ownership.
Sources: M. Granovetter, “Business Groups and Social Organi-
zation,” in N. J. Smelser and R. Swedberg, Handbook of Economic
Sociology (Princeton: Princeton University Press, 2005): 429–450;
F. Amatori and A. Colli, “Corporate Governance: The Italian Story,”
Bocconi University, Milan (December 2000).
● Agency problems: Given the limited power of shareholders to discipline and
replace managers and the weakness of boards to control management, the cor-
porate head office of a multidivisional firm can act as an interface between
shareholders and the divisional managers and enforce adherence to profit goals.
With divisions designated as profit centers, financial performance can readily be
monitored by the head office and divisional managers can be held responsible
for performance failures. Hence, multibusiness companies can be more effective
profit maximizers than specialist companies.

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 337
There is not much support for Williamson’s “theory of the M-form.” At some multi-
business companies—such as ExxonMobil, Danaher, Berkshire Hathaway—corporate
management is highly effective at pursuing long-term shareholder value maximiza-
tion. Other multibusiness companies—Enron, WorldCom, Royal Bank of Scotland, and
Kaupthing Bank of Iceland—have become vehicles for CEO ambition resulting in the
destruction of shareholder value on a massive scale.
Multidivisional companies may also lack the flexibility and responsiveness that their
modular structures should, in principle, be capable of. Henry Mintzberg points to two
key rigidities: first, highly centralized decision making within each division as a result of
divisional presidents’ personal accountability to the corporate head office; second, stan-
dardization of management systems and styles across the different businesses of the mul-
tidivisional corporation.48 As already noted, the rigidities of multidivisional companies’
allocation of their capital expenditures is indicative of a lack of performance orientation.49
The governance issues that multibusiness companies face are highly dependent
upon their structures and ownership patterns. As Strategy Capsule  13.7 shows, the
other major type of multibusiness company—the holding company—gives rise to dif-
ferent governance issues from the multidivisional corporation.
Summary
While corporate strategies in the form of vertical integration, multinational expansion, and diversifica-
tion have the potential to create value, ultimately, their success in doing so depends upon the effective-
ness with which corporate strategy is implemented. This in turn depends upon the role of the corporate
headquarters in managing companies that comprise multiple business units. We have identified four
principal types of activity through which corporate management creates value within these companies:
◆ Managing the business portfolio: deciding which businesses and geographical markets the company
should serve and allocating resources among these different businesses and markets.
◆ Managing linkages among businesses: exploiting opportunities for sharing resources and transferring
capabilities comprises multiple activities ranging from the centralized provision of functions to best
practices transfer. The key is to ensure that the potential gains from exploiting such economies of
scope are not outweighed by the costs of managing the added complexity.
◆ Managing individual businesses: increasing the performance of individual businesses by enhancing
the quality of their decision making, installing better managers, and creating incentives that drive
superior performance.
◆ Managing change and development: although multibusinesses have the key advantage of not being
captives of a single industry, exploiting this advantage means the processes, structures, and attitudes
that foster new initiatives and create a willingness to let go of the past.
Finally, there is the contentious and perplexing issue of corporate governance. While broad
agreement exists over the goal of corporate governance—ensuring that companies pursue long-term
value maximization while taking account of the interest of multiple stakeholders—putting in place a
system that achieves this goal remains elusive. Establishing corporate systems that are invulnerable to
self-serving managers, short-term orientated shareholders, human greed and stupidity, and bureau-
cratic inertia represents a design challenge that is unlikely to be realized.

338 PART IV CORPORATE STRATEGY
Notes
1. For a fuller discussion of the GE/McKinsey matrix, see
“Enduring Ideas: The GE–McKinsey Nine-box Matrix,”
McKinsey Quarterly (September 2008).
2. For a fuller discussion of the BCG matrix, see B. Hen-
derson, The Experience Curve Reviewed: IV: The Growth
Share Matrix or Product Portfolio (Boston: Boston Con-
sulting Group, 1973).
3. A. Campbell, M. Goold, and M. Alexander. “Corporate
Strategy: The Quest for Parenting Advantage,” Harvard
Business Review (April–May 1995): 120–132.
4. M. Goold, D. Pettifer, and D. Young, “Redesigning the
Corporate Center,” European Management Review 19
(2001): 83–91.
5. Roland Berger Strategy Consultants, Corporate Head-
quarters: Developing Value Adding Capabilities to
Overcome the Parenting Advantage Paradox (Munich,
April 2013); Deloitte, 2017 Shared Services Survey
Results. https://www2.deloitte.com/us/en/pages/oper-
ations/articles/shared-services-survey.html. Accessed
August 1, 2017.
6. P&G’s Global Business Services: Transforming the
Way Business Is Done, http://www.pg.com/en_US/
downloads/company/PG_GBS_Factsheet , accessed
August 1, 2017.
7. M. E. Porter, “From Competitive Advantage to Corporate
Strategy,” Harvard Business Review (May/June 1987):
43–59. A more detailed value chain analysis of synergy is
found in P. Puranam and B. Vanneste, Corporate Strategy:
Tools for Analysis and Decision Making (Cambridge Uni-
versity Press, 2016), Chapter 2.
8. Porter, “From Competitive Advantage to Corporate
Strategy,” op. cit.
9. G. Szulanski, “Exploring Internal Stickiness: Impediments
to the Transfer of Best Practice Within the Firm,” Strategic
Management Journal 17 (1996): 27–43.
10. “Introducing Samsung Design Global Office.” http://
design.samsung.com/global/m/contents/global_office/.
Accessed August 2, 2017.
11. D. Shah and V. Kumar, “The Dark Side of Cross-Selling,”
Harvard Business Review (December 2012).
Self-Study Questions
1. Unilever—one of the world’s leading consumer goods companies—is reviewing its business
portfolio in order to address the problems of unsatisfactory growth and profitability. The head
of group planning has asked for your advice on the use of portfolio matrices as an initial
screen of Unilever’s portfolio of businesses. Should Unilever use portfolio analysis and, if so,
which portfolio matrix would you recommend: the McKinsey, BCG, or Ashridge matrix?
2. Apply the BCG matrix to the different programs that your institution offers. (You will need to
make some informed guesses about market growth rates and relative market share.) Does this
analysis offer useful implications for strategy and resource allocation?
3. The discussion of “performance management and financial control” identified two companies
where the corporate HQ imposes a strong performance management system on its business
units, PepsiCo and BP. To which company do you think a performance management system
using financial targets is better suited?
4. Amazon.com, Inc. is under pressure to improve its profitability (between 2015 and 2017 it
earned a net margin of 1.4%). Amazon is a highly diversified company engaged in online
retailing in 14 different countries, audio and video streaming, the production and sale of
mobile electronic devices, web hosting and other cloud computing services, and numerous
other activities. Of the four main corporate management roles discussed in this chapter—
managing the corporate portfolio, managing linkages among businesses, managing individual
businesses, and managing change and development—which offers the greatest opportunities
for Amazon’s corporate headquarters to create value?
5. Would holding companies (such as Tata Group, Samsung Group, the Virgin Group, and Berk-
shire Hathaway) be more successful if they were converted into multidivisional corporations
(such as General Electric, Philips, and Unilever)?

http://www.pg.com/en_US/downloads/company/PG_GBS_Factsheet

http://Amazon.com

CHAPTER 13 IMPlEMEnTInG CORPORATE STRATEGY: MAnAGInG THE MulTIbuSInESS FIRM 339
12. J. W. Lorsch and S. A. Allen III, Managing Diversity and
Interdependence: An Organizational Study of Multi-
divisional Firms (Boston: Harvard Business School
Press, 1973).
13. A. Campbell, J. Whitehead, M. Alexander, and M. Goold,
Strategy for the Corporate-level (San Francisco: Jossey-
Bass, 2014).
14. See, for example, N. Bloom, J. Van Reenen, and
E.  Brynjolfsson, “Good Management Predicts a Firm’s
Success Better Than IT, R&D, or Even Employee Skills,”
Harvard Business Review (April 19, 2017); J. Dowdy and
J. Van Reenen, “Why Management Matters for Produc-
tivity,” McKinsey Quarterly (September 2014): 147–150.
15. Porter, “From Competitive Advantage to Corporate
Strategy,” op. cit.
16. Bain & Company, Global Private Equity Report 2017.
17. S. Coll, Private Empire: ExxonMobil and American Power
(New York: Penguin, 2012).
18. http://www.danaher.com/how-we-work/danaher-busi-
ness-system. Accessed August 3, 2017.
19. “What Makes Danaher Corp. Such a Star?” Bloomberg
View (May 19, 2015, https://www.bloomberg.com/view/
articles/2015-05-19/what-makes-danaher-corp-such-a-
stock-market-star. Accessed August 03, 2017.
20. A. Shipilov, and F. Godart, “Luxury’s Talent Factories: How
Companies like LVMH, Kering, and Richemont Groom
Designers and Managers,” Harvard Business Review 93
( June 2015): 98–104.
21. M. C. Mankins and R. Steele, “Stop Making Plans; Start
Making Decisions,” Harvard Business Review ( January
2006): 76–84.
22. D. Sull, R. Homkes, and C. Sull, “Why Strategy Execution
Unravels – and What to Do About It,” Harvard Business
Review 93 (March 2015): 58–66.
23. R. Rumelt, “The Perils of Bad Strategy,” McKinsey
Quarterly ( June 2011).
24. R. Dye and O. Sibony, “How to Improve Strategic
Planning,” McKinsey Quarterly ( January 2007).
25. M. Judah, D. O’Keeffe, D. Zehner, and L. Cummings,
Strategic Planning that Produces Real Strategy (Bain &
Co., February 2016).
26. Dye and Sibony, “How to Improve Strategic
Planning,” op. cit.
27. L. Bossidy and R. Charan, Execution: The Discipline
of Getting Things Done (New York: Crown Business,
2002): 197–201.
28. R. S. Kaplan and D. P. Norton, “Having Trouble with Your
Strategy? Then Map It,” Harvard Business Review (Septem-
ber/October 2000): 67–76.
29. R. S. Kaplan and D. P. Norton, “The Office of Strategy
Management,” Harvard Business Review (October
2005): 72–80.
30. Tuck School of Business, CEO Speaker Series,
September 23, 2002.
31. M. Goold and A. Campbell, Strategies and Styles (Oxford:
Blackwell Publishing, 1987).
32. R. M. Grant, “Strategic Planning in a Turbulent Environ-
ment: Evidence from the Oil and Gas Majors,” Strategic
Management Journal 24 (2003): 491–518.
33. D. Bardolet, C. R. Fox, and D. Lovallo, “Corporate
Capital Allocation: A Behavioral Perspective,” Strategic
Management Journal 32 (2011): 1465–1483.
34. S. Hall, D. Lovallo, and R. Musters, “How to Put Your
Money Where Your Strategy Is,” McKinsey Quarterly
(March 2012).
35. http://www.shell.com/energy-and-innovation/innovating-
together/shell-gamechanger.html; https://techcrunch.com/
tag/area-120/;
36. R. A. Burgelman and A. Grove, “Strategic Dissonance,”
California Management Review 38 (Winter 1996): 8–28.
37. R. M. Grant and A. Amodio, “Danone: Strategy Imple-
mentation in an International Food and Beverage
Company,” in R. M. Grant (ed.), Contemporary Strategy
Analysis: Text and Cases, 8th edn (Chichester: John
Wiley & Sons Ltd, 2013).
38. OECD, Glossary of Statistical Terms (Paris: OECD, 2012).
39. D. Barton, “Capitalism for the Long Term,” Harvard
Business Review (March/April 2011): 84–92.
40. D. Cadbury, Chocolate Wars (New York: Public Affairs,
2010): 304.
41. OECD Principles of Corporate Governance (Paris:
OECD, 2004).
42. “Should the Chairman be the CEO?” Fortune (October
21, 2014).
43. D. Barton, “Capitalism for the Long Term,” Harvard
Business Review (March/April 2011): 84–92.
44. L. Mishel and A. Davis, “CEO Pay Continues to Rise
as Typical Workers Are Paid Less” (Washington, DC:
Economic Policy Institute, June 12, 2014).
45. P. Bolton, J. Scheinkman, and W. Xiong, “Pay for
Short-term Performance: Executive Compensation
in Speculative Markets,” NBER Working Paper 12107
(March 2006).
46. O. E. Williamson, Markets and Hierarchies: Analysis and
Antitrust Implications (New York: Free Press, 1975); and
O. E. Williamson, “The Modern Corporation: Origins,
Evolution, Attributes,” Journal of Economic Literature 19
(1981): 1537–1568.
47. J. L. Bower, Managing the Resource Allocation Process
(Boston: Harvard Business School Press, 1986).
48. H. Mintzberg, Structure in Fives: Designing Effective
Organizations (Englewood Cliffs, NJ: Prentice Hall, 1983):
Chapter 11.
49. See notes 32 and 33 above.

https://www.bloomberg.com/view/articles/2015-05-19/what-makes-danaher-corp-such-astock-market-star

https://techcrunch.com/tag/area-120/

https://techcrunch.com/tag/area-120/

14
When it comes to mergers, hope triumphs over experience.
—IRWIN STELZER, US ECONOMIST AND COLUMNIST
External Growth
Strategies: Mergers,
Acquisitions, and Alliances
◆ Introduction and Objectives
◆ Mergers and Acquisitions
● The Pattern of M&A Activity
● Are Mergers Successful?
● Motives for Mergers and Acquisitions
● Managing Mergers and Acquisitions: Pre-merger
Planning
● Managing Mergers and Acquisitions: Post-merger
Integration
◆ Strategic Alliances
● Motives for Alliances
● Managing Strategic Alliances
◆ Summary
◆ Self-Study Questions
◆ Notes
O U T L I N E

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 341
Introduction and Objectives
Mergers, acquisitions, and alliances are important instruments of corporate strategy. They are the
principal means by which firms achieve major extensions in the size and scope of their activities—often
within a remarkably short period of time. Mergers and acquisitions have created many of the world’s
leading enterprises:
◆ In 1993, Interbrew was a Belgian brewer with annual sales of $1.4 million. A sequence of acquisi-
tions that included Labatt (Canada), Bass (UK), Beck’s (Germany), AmBev (Brazil), Anheuser-Busch
(US), Modelo (Mexico), and SAB Miller (UK) created Anheuser-Busch Inbev—the world’s largest beer
company with 319 breweries and annual sales of $46 billion.
◆ Cable provider Comcast became the biggest US media company through acquiring Metrome-
dia (1992), QVC (1995), AT&T Broadband (2002), Adelphia Communication and MGM (2005), NBC
Universal (2011), and DreamWorks Animation (2016). In 2018 it was vying with Walt Disney to acquire
Twentyfirst Century Fox.
◆ EssilorLuxottica has grown to be the world’s dominant eyewear company as a result of Luxottica’s
acquisitions of Ray-Ban, Lenscrafters, PearleVision, Sunglass Hut and Oakley, and, finally, its 2017
merger with Essilor.
Mergers and acquisitions can also have disastrous consequences:
◆ Royal Bank of Scotland’s 2007 acquisition of ABN AMRO was a key factor in the bank’s near collapse
and subsequent rescue by the British government the following year.
◆ The 2006 merger of Alcatel-Lucent created a telecom hardware giant with sales of $25 billion and a
market capitalization of $36 billion. By 2016, it had accumulated losses of $5 billion, sales had fallen
by 40%, and the company was acquired by Nokia for $17 billion.
◆ Daimler-Benz’s merger with Chrysler is widely regarded as one of the most disastrous merger of all
time. The losses arising from Daimler’s ownership Chrysler from 1998 to 2007 amounted to about
$48 billion.
Alliances provide a means to access the resources and capabilities of other firms without the costs
and risks of a full merger. However, they do bear risks: Danone’s disastrous relationship with its Chinese
partner Wahaha and VW’s failed alliance with Suzuki dented both companies’ Asian strategies.
If mergers, acquisitions, and alliances are to contribute to firms’ strategic objectives, we must recog-
nize that they are not strategies in themselves: they are tools of strategy—the means by which a firm
implements its strategy. Hence, in previous chapters, we have already considered the role of acquisitions
and alliances in relation to capability building, technology strategy, international expansion, and diver-
sification. In this chapter we draw together these separate strands and consider what we know about
managing these modes of external growth.
Given the diversity in their motives, contexts, and outcomes, decisions concerning mergers, acqui-
sitions, and alliances need to be take account of their specific strategic goals, the characteristics of the
partner firms, and their industry and national environments. We shall develop a structured approach to
analyzing the value-creating potential and risks of these arrangements and consider how they can be
managed to best achieve a positive outcome.

342 PART iV CoRPoRATE STRATEGY
Mergers and Acquisitions
The Pattern of M&A Activity
An acquisition (or takeover) is the purchase of one company by another. This involves
the acquiring company (the acquirer) making an offer for the common stock of the
other company (the acquiree or target company). Acquisitions can be “friendly,” that
is when they are supported by the board of the target company, or “unfriendly,” when
they are opposed. In the latter case they are known as hostile takeovers.
A merger is the amalgamation of two companies to form a new company. This
requires agreement by the shareholders of the two companies, who then exchange
their shares for shares in the new company. Mergers typically involve companies of sim-
ilar size (Daimler and Chrysler; Exxon and Mobil), although, as in these two examples,
one firm is usually the dominant partner. Although are less frequent than acquisitions,
mergers are often preferred because of their tax advantages and (for the dominant
partner) they avoid having to pay an acquisition premium. For cross-border combina-
tions, mergers may be more politically acceptable than acquisitions because they avoid
“foreign domination” (e.g., Alcatel and Lucent, Mittal Steel and Arcelor).
The term merger is sometimes used to denote both mergers and acquisitions—I shall
follow this popular convention.
Mergers first became prominent in the United States during the late 19th century. To
avoid competition, rival companies assigned their shares to a board of trustees which
determined their prices and marketing policies. John D. Rockefeller’s Standard Oil
was the most prominent of these trusts. Following the Sherman Antitrust Act of 1890,
holding companies displaced trusts as the preferred means of consolidating industries.
Thus, in 1899, Standard Oil of New Jersey became the owner of controlling stakes in
the 40 member companies of the Standard Oil Trust, while General Motors became
the holding company for 23 automotive companies acquired between 1908 and 1918.1
Since the mid-20th century, mergers and acquisitions (M&A) have increased in fre-
quency and have become a generally accepted mode of corporate development—even
in Japan, South Korea, and China. M&A activity follows a cyclical pattern, usually cor-
related with stock market cycles. However, the types of mergers and acquisitions have
changed over time. During the 1960s and 1970s, most mergers and acquisitions were
directed toward diversification—with conglomerate companies especially active. Dur-
ing 1998–2000, TMT (technology, media, and telecoms) accounted for one-half of all
By the time you have completed this chapter, you will be able to:
◆ Understand the factors that motivate mergers and acquisitions and assess their potential
to create value in the light of the challenges of post-merger integration.
◆ Recognize the different motives for strategic alliances and the circumstances in which
they can create value for the partners.

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 343
M&A. During 2000–2008, the boom in financial services and natural resources stimu-
lated a surge of M&A activity in these sectors. Since the financial crisis of 2008, the big-
gest M&A deals have been horizontal mergers consolidating sectors such as chemicals,
beer, food, media and communications, and pharmaceuticals. Figure 14.1 shows the
cycles in M&A activity since 1998 and some of the biggest deals.
Are Mergers Successful?
The chief attraction of mergers and acquisitions is the speed at which they can achieve
major strategic transformations. We have seen how M&A has allowed Anheuser-Busch
InBev and EssilorLuxottica to dominate their industries. For other companies, acquisi-
tions have allowed them to redefine their businesses. For Nokia, the sale of its handset
division to Microsoft and takeover of Alcatel-Lucent transformed it from a supplier of
mobile devices into a network infrastructure provider. The Chinese car producer, Geely,
has used its acquisitions of Volvo, Proton/Lotus, and London taxi maker, Manganese
Bronze to launch it on to the world stage.
Yet, these strategic attractions can obscure the risks inherent in mergers and acquisi-
tions. Research into the performance consequences of mergers and acquisitions points
to their generally disappointing outcomes. Empirical studies focus upon two main
performance measures: shareholder returns and accounting profits.
0
1000
2000
3000
4000
5000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Value of M&A deals ($ millions)
Vodafone—Mannesman $183bn.
Aol—Time Warner $165bn.
P�zer—Warner Lambert $90bn.
Glaxo—Smith Kline Beecham $76bn.
SBC—Ameritech $70bn.
Exxon—Mobil $85bn.
Citicorp—Travelers $70bn.
Dow Chemical—DuPont $130bn.
Royal Dutch Shell—BG $81bn.
Charter Communication—
Time Warner Cable $78bn.
Dell—EMC $67bn.
H.J. Heinz—Kraft Foods $54bn.
“CVS—Aetna $70bn.
Cigna—Express Scripts $67bn.
AT&T—Time Warner $109bn.
Walt Disney—21st Century Fox $85bn.”
RBS/Santander/Fortis—ABN AMBRO $81bn.
Enel—Endesa $60bn.
Procter & Gamble—Gillette $57bn.
Royal Dutch Petroleum—Shell
Transport & Trading $75bn.
Sano�—Aventis $60bn.
JPMorgan Chase—BancOne $59bn.
Gaz de France—Suez $75bn.
P�zer—Wyeth $68bn.
Novartis—Alcom $52bn.
AT&T—BellSouth $73bn.
Comcast—AT&T
Broadband $72bn.
Bell Atlantic—GTE $71bn.
P�zer—Pharmacia $60bn.
InBev—Anheuser-Busch $52bn.
Bank of America—Merrill Lynch $50bn.
Verizon Communication—
Verizon Wireless $130bn.
Actavis—Allergan $71bn.
AT&T—Time Warner $85bn.
Bayer—Monsanto $66bn.
BAT—Reynolds $58bn.
FIGURE 14.1 Worldwide mergers and acquisitions 1998–2018
Sources: Dealogic; Reuters; media reports.

344 PART iV CoRPoRATE STRATEGY
Evidence from Shareholder Returns Studies of the impact of M&A announce-
ments on the share prices of bidding and acquired companies have found that:
● The overall effect is a small gain in stock market value: typically around 2% of
the combined market value of the merging companies.2 The trend over time
has been for the returns from mergers and acquisitions improve. Mergers and
acquisitions occurring during 2000–2009 reduced the combined value of the
companies involved by about 2%; those occurring during 2010–2014 generated
average returns of 12%.3
● The gains from acquisition accrue almost exclusively to the shareholders of the
acquired firms. This reflects the acquisition premium paid by acquiring firms.
Between 2000 and 2014 the average acquisition premium was 27%. As a result,
the overall returns to the shareholders of acquiring firms averaged −4% between
2000 and 2014.4
However, these findings relate only to short-term stock market responses to merger
announcements and reflect investors’ expectations rather than actual outcomes—which
inevitably require several years to materialize.
Evidence from Accounting Profits To trace the actual outcomes of mergers and
acquisitions we need to observe post-merger performance over several years and com-
pare it to the companies’ performance prior to merging. The problem here is sep-
arating the effects of the merger from the multitude of other factors that influence
companies’ performance over time. Hence, it is hardly surprising that the many studies
that use accounting data to compare post-merger profitability with pre-merger profit-
ability show little consistency in their findings: “the results from these accounting-based
studies are all over the map.”5
The Diversity of Mergers and Acquisitions The lack of consistent findings
regarding the outcomes of mergers and acquisitions is hardly surprising given their
diversity. They are motivated by different goals, take place under different circum-
stances, involve highly complex interactions between the companies involved, and
are conducted by management teams of differing competencies. Yet, even when
mergers and acquisitions are grouped into different categories, the performance
outcomes remain unclear. For example, one might expect that horizontal mergers
(which increase market share and offer gains from scale economies) would be
more successful than diversifying mergers; among diversifying mergers, it would
be expected that the acquisition of firms in related businesses would outperform
unrelated acquisitions. Yet both these highly plausible predictions fail to find robust
empirical support.
Even in the case of individual mergers and acquisitions, the outcomes are seldom
predictable. Table  14.1 lists mergers and acquisitions from recent decades that the
financial press has identified as either successes or failures. Yet, in few cases were the
predictions—either of the stock market or by expert commentators—accurate about
the consequences. The disastrous mergers between Daimler and Chrysler and between
AOL and Time Warner were much lauded initially. Conversely, the highly successful
Exxon–Mobil and Tata–Jaguar Land Rover combinations were greeted with widespread
skepticism at the time.
In the absence of clear general findings about the outcomes of mergers, we need
to recognize that each combination of companies is a unique event that must be

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 345
considered on its own merits. This means we must subject M&A decisions to careful
strategic appraisal. Let us start by considering the different goals that motivate mergers
and acquisitions.
Motives for Mergers and Acquisitions
Managerial motives A major reason why shareholders should view acquisitions
with extreme skepticism is because they are so appealing to CEOs. Managerial incen-
tives, both financial and psychological, tend to be associated more with a company’s
size than with its profitability. Acquisition offers the fastest route to corporate growth.
Even more dangerous is CEOs’ quest for celebrity status; again, large-scale acquisitions
are the surest way a CEO can gain media coverage while projecting an image of power
and influence.
The tendency for acquisitions to be led by male business leaders points to the role
of biological and psychological forces. Corporate empire builders may be subject to
the same sexual urges that drive bulls and stags to amass herds of females.6 Once they
have embarked on acquisitive growth, business leaders such as Jean-Marie Messier
at Vivendi Universal, Fred Goodwin at Royal Bank of Scotland, and Bernie Ebbers at
WorldCom appear to be victims of hubris: exaggerated self-confidence that leads to
distorted judgment and an ever-growing gap between perception and reality.7
The stock market may collude with such behavior. Overvalued equity encourages
companies to make equity-financed acquisitions that can help support their share
price.8 AOL’s merger with Time Warner was motivated, in part, by AOL’s inflated stock
market valuation.
A further factor encouraging imprudent mergers and acquisitions is imitation among
companies. We have seen that M&A activity is highly cyclical, with a heavy clustering
in specific sectors: the petroleum mergers of 1998–2002; the telecoms merger waves
of 1998–2005 and 2013–2015; and the global consolidation in beer, pharmaceuticals,
and media since 2010.9 This sectoral clustering reflects firms’ propensity to follow the
leader: if firms resist the urge to merge, they risk being left at the fringes of the dance
floor with only unattractive dancing partners left.
TABLE 14.1 Success and failure among prominent mergers and acquisitions
Successes Failures
Exxon–Mobil Daimler–Chrysler
Procter & Gamble–Gillette AOL–Time Warner
Walt Disney Co.–Pixar Royal Bank of Scotland–ABN AMRO
Tata Motor–Jaguar Land Rover Hewlett Packard–Autonomy
Sirius–XM Radio Bank of America–Countrywide
Cemex–RMC Alcatel–Lucent
Bank of America–Merrill Lynch Sprint–Nextel
Heinz–Kraft Foods Sears–K Mart
Geely–Volvo Microsoft–Nokia
Dell–EMC News Corp.–MySpace
Sources: Based upon lists of “best” and “worst” mergers published by Forbes, Fortune, CNBC, and Bloomberg.

346 PART iV CoRPoRATE STRATEGY
Let us ignore for the moment the interests of managers and consider the interests
of shareholders. If mergers and acquisitions are directed toward creating shareholder
value, we can distinguish two sources of value creation: financial and strategic.
Financially Motivated Mergers Mergers and acquisitions can generate share-
holder value simply as a result of stock market inefficiencies or through tax benefits or
financial engineering.
● Stock market valuations are determined by expectations of future profit streams
and risks which are conditioned by psychological factors. As a result, privileged
information, or superior analysis of generally available information, can provide
the basis for identifying and acquiring under-valued companies. Warren Buffett’s
genius for spotting well-managed, strategically well-positioned companies
whose potential the stock market has not fully recognized, is the basis for Berk-
shire Hathaway’s history of successful acquisition.
● Acquisitions can allow a company to reduce its tax bill. For example, a poorly
performing company may be an attractive takeover target simply because of the
value of its tax credits to the acquirer. Acquisition also provides a mechanism
for a company to relocate to a lower-tax jurisdiction. In 2016, Pfizer abandoned
its $150 billion tax-inversion merger with Irish-domiciled Allergen when the US
government amended its tax regulations to eliminate the tax savings from “tax-
inversion takeovers.”10
● By changing the capital structure of an acquired company an acquirer may
reduce its cost of capital, thereby creating value. Leveraged buyouts (LBOs) are
acquisitions of companies (or divisions of companies) that are financed mainly
by debt. Such acquisitions can create value as a result of debt being cheaper
than equity. A study of 701 private equity deals is completed between 1990
and 2013 found that 31% of the value created resulted from increasing financial
leverage.11
Strategically Motivated Mergers For the most part, value creation from mergers
and acquisitions is the result of their potential to increase the underlying profits of the
firms involved. On the basis of the major sources of such value creation, we can iden-
tify several categories of mergers and acquisitions:
● Horizontal mergers can increase profitability by means of cost economies and
enhanced market power resulting from combining firms that compete within
the same market. US airline mergers—including United and Continental Airlines,
American and US Airways, and Delta and Northwest—have played a major role
in eliminating excess capacity, exploiting scale economies, and moderating price
competition in the industry. Similarly, the $145 billion merger between Dow
Chemical and Du Pont was motivated by the potential both for cost savings and
increased pricing power.12
● Geographical extension mergers are the principal means through which com-
panies enter foreign markets. Between 1980 and 2003, HSBC transformed itself
from a local Hong Kong bank into one of the world’s leading global banks
through acquiring 17 different banks across 12 different countries. For many
Chinese companies—Lenovo, ChemChina, Haier, and Tencent, to mention but a
few—foreign acquisitions offer the quickest route to build global presence and

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 347
to overcome the “liabilities of foreignness”—especially lack of brand recogni-
tion, lack of local knowledge, and barriers to distribution. Spurred by the trend
toward globalization, cross-border mergers as a proportion of all mergers grew
from 19% in 1996 to 31% in 2016.13
● Vertical mergers involve the acquisition of either a supplier or a customer. In
2013, the world’s fourth-biggest mining company, Xstrata, merged with the
world’s biggest commodities trader, Glencore International, to form a ver-
tically integrated metals supplier. As discussed in Chapter 10 (see Strategy
Capsule 10.2), mergers between content producers and distributors have been a
major theme in the restructuring of the media sector in recent years.
● Diversifying mergers. Acquisition is the predominant mode of diversification for
firms. The alternative—diversification by means of a new business start-up—is
too slow for most companies. While internal “business incubators” can success-
fully develop new business ventures, such start-ups seldom provide the basis
for major diversifications. Established technology giants may diversify through
one or two major acquisitions—Dell’s takeover of EMC or Nokia’s purchase of
Alcatel-Lucent—or through multiple smaller acquisitions. IBM’s transition from
a hardware to a software and services company involved the acquisition of
115 companies between 2000 and 2011. Microsoft’s entry into video games with
the launch of Xbox in November 2001 was preceded by the acquisition of sev-
eral small companies that supplied 3D graphics hardware, video game control-
lers, and video games.
Among all these M&A categories, the primary goal may be less to acquire the
business of the target company than to acquire its resources and capabilities. We dis-
covered in Chapter 5 that the most valuable resources and capabilities are those that
are not transferable and not easily replicated. Obtaining such resources and capabilities
may require acquisition. UK-based Reckitt Benckiser has used acquisition to build a
large portfolio of brands: Clearasil skin products, Dettol disinfectant, Durex contra-
ceptives, Finish dishwashing products, Nurofen analgesics, Scholl footcare products,
Woolite laundry products, French’s mustard, and many more. US-based Fortune Brands
has followed a similar strategy.
In technology-based industries, established companies regularly acquire small,
start-up firms in order to access their technology. During 2010–2017, Google acquired
166 companies to grow its technical capabilities in robotics, imaging, internet security,
artificial intelligence, facial recognition, virtual reality, and cloud computing. Each year,
Microsoft hosts its VC Summit, where venture capitalists from all over the world are
invited to market their companies. Walt Disney’s 2006 acquisition of Pixar, the animated
movie studio founded by John Lasseter and Steve Jobs, is a classic example of a large
established company acquiring a small start-up in order to obtain technical and creative
capabilities.
Acquisition can short circuit the tortuous process of developing internally a new
organizational capability, but it poses major risks. To begin with, acquisitions are
expensive. In addition to the acquisition premium that must be paid, the targeted
capability comes with a mass of additional resources and capabilities that are surplus
to requirements. Most importantly, once the acquisition has been made, the acquiring
company must find a way to integrate the acquiree’s capabilities with its own. All too
often, culture clashes, personal frictions between senior managers, or incompatible
management systems can result in the degradation or destruction of the very capabil-
ities the acquiring company was seeking.

348 PART iV CoRPoRATE STRATEGY
Managing Mergers and Acquisitions: Pre-merger Planning
The unsatisfactory performance outcomes of most mergers and acquisitions suggest
that M&A decisions need to be based upon a clear understanding by the companies
involved of what their strategies are and how the proposed merger or acquisition
will contribute to that strategy. This needs to be followed by a detailed and real-
istic assessment of the likely outcomes of the merger or acquisition. This is easier
with some types of mergers and acquisitions than it is with others. In the case of
horizontal acquisitions, it is usually possible, not just to identify the sources of cost
savings from integrating the companies, but also to quantify those savings. Other
sources of synergy—in particular benefits from revenue enhancement and inno-
vation—are more elusive. In general, acquiring companies overestimate the gains
from mergers.
In relation to costs, McKinsey & Company found that 60% of mergers achieved
their cost targets, but a quarter of mergers overestimated cost savings by at least 25%.
Forecasts of revenue synergies tended to be widely inaccurate: 70% of mergers over-
estimated revenue synergies. McKinsey suggests that acquiring companies are espe-
cially blind to revenue dis-synergies—a major source of which is the tendency for the
customers of the acquired firm to defect.14 In mergers between retail banks, the cost
savings from closing overlapping branches can easily be offset by the consequent
loss of customers. In the case of many diversifying mergers within financial services,
the potential for cross-selling and customers’ desire for one-stop shopping have been
wildly optimistic. The risk is that acquirers fall victim to their own propaganda: in seek-
ing to persuade the stock market about the benefits of an acquisition, they believe their
own inflated estimates of potential synergies.
Sound M&A decisions require objective, quantitative analysis. One approach uses a
discounted cash flow approach to determine the value of a potential acquisition of to
the buyer, and hence the maximum bid price:
1 Start with the target company’s current market capitalization. Given the target
company’s cost of equity capital, what does this imply about the future net cash
flows that the market expects?
2 How reasonable are these cash flow expectations? Is there any reason to
believe that the stock market may be underestimating these future cash
flows? For example, the market may be undervaluing either the profit
prospects for the industry or the target company’s potential for competitive
advantage.
3 What is restructuring potential? First, can the net cash flows of the target
company be improved by increasing profit margins (by reducing costs, raising
prices, or disposing of unprofitable lines of business) or by reducing capital
investment? Second, can the cost of capital be lowered by increasing financial
leverage? The excess of the restructured NPV over the as-is NPV (calculated
above) shows the potential for adding value through restructuring.
4 What is the potential for synergy? If the target company is merged into the
acquiring company, what sources of synergy can be exploited? In the short-term,
these will include cost savings from combining headquarters services, consoli-
dating plants, and merging operations. Longer term, they will include the more
speculative benefits of transferring capabilities and exploiting new business
opportunities. Synergies may accrue both to the acquiring and the acquired com-
panies. As we have already observed, it is important to recognize the costs of
exploiting synergies and not just their benefits.

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 349
A key impediment to assessing the potential for a merger or acquisition to add
value, is what Carliss Baldwin refers to as “fragility risk”: the risk that the implementa-
tion phase will go awry such that the potential benefits of the merger are never real-
ized and the underlying businesses of the partnering firms are damaged.15 Evaluating
fragility risk is very difficult, however it is likely to be correlated with the number of
changes that the acquirer will need to make in the target company’s business opera-
tions (and in its own operations) following the deal. A further problem in estimating
the potential value added from acquisition is the acquirer’s limited knowledge of the
target company. Even friendly takeovers are still prone to information asymmetry—the
seller knows much more about the acquisition target than the buyer, so the acquirer
can be hoodwinked into overpaying (the so-called lemons problem). Hewlett-Packard’s
disastrous $11 billion takeover of British software firm Autonomy in 2011 is exemplifies
this problem.16
Better pre-merger planning requires not only improved information, but also better
analysis. Concerns over confidentiality can result in an M&A team being too small to
provide the expertise needed to adequately appraise a potential acquisition.17
Managing Mergers and Acquisitions: Post-merger Integration
The risks inherent in mergers and acquisitions is revealed by the numbers that fail—
including some which were meticulously planned. The combination of Daimler-Benz
and Chrysler was exemplary in its pre-merger planning; yet, the outcome was disap-
pointing. Not only did Chrysler’s problems appear to be intractable but also Chrysler’s
demands on the group’s top management negatively impacted Daimler-Benz’s core
business.18
Consistent with the observation that M&A risks depend upon the number of post-
merger changes that must be managed, it appears that, where the potential benefits of
mergers and acquisitions are great, so too are the costs and risks of integration. Thus,
Capron and Anand argue that cross-border acquisitions typically have the strongest
strategic logic.19 Yet the evidence of DaimlerChrysler, BMW-Rover, and Alcatel-Lucent
suggests that the complexities of cross-border integration—accentuated by differences
in both corporate and national cultures—makes post-merger assimilation espe-
cially fraught.
It is increasingly being recognized that managing acquisition is a rare and com-
plex organizational capability that needs to be developed through explicit, experience-
based learning. Acquisition performance improves with experience—though not at
first. There appears to be a learning threshold, after which subsequent acquisitions add
value.20 However, the learning from acquisitions needs to be explicitly managed, for
example, the codifying of acquisition processes appears to be conducive to acquisition
success.21
Ultimately, successful mergers and acquisition require combining pre-acquisition
planning with post-acquisition integration. Most case studies of failed mergers iden-
tify poor post-acquisition management as the key problem. Yet, in many instances,
these integration problems could have been anticipated. Hence, the critical failure was
going ahead with the acquisition without adequate assessment of the challenges of
post-merger management. In Quaker Oats’ acquisition of Snapple (“the billion-dollar
blunder”), the critical problem—the impediments to integrating Snapple’s distribution
system with that of Quaker’s Gatorade—was evident to the marketing managers and
the franchised distributors of the two companies prior to the takeover.22 Conversely,
Walt Disney’s acquisition of Pixar was preceded by an anticipation of the problems that

350 PART iV CoRPoRATE STRATEGY
might arise, followed by a careful and sensitive approach to planning, and then imple-
menting, the integration of Pixar (Strategy Capsule 14.1).
Clay Christensen and colleagues argue that acquisition targets need to be care-
fully selected to match the strategic objective of the acquisition.23 They distinguish
between acquisitions which leverage a firm’s existing business model from those
STRATEGY CAPSULE 14.1
walt disney Company and Pixar
Most industry observers were pessimistic about Dis-
ney’s $7.4 billion acquisition of rival animated movie
producer Pixar in 2006. Most acquisitions of movie
studios had experienced major difficulties: General
Electric’s NBC acquisition of Universal Studios and
Viacom’s of DreamWorks. The worries were that Disney’s
corporate systems would suppress Pixar’s creativity and
that Pixar’s animators would leave. Although the two
companies had allied for several years (Disney distrib-
uted Pixar movies), the relationship had not been a
smoothone.
Yet the acquisition is generally regarded as being
highly successful. Since the acquisition, several Disney/
Pixar animated movies, including Toy Story 3 and Frozen,
have been massive box office successes and have gen-
erated huge revenues from DVDs, video streaming, and
licensing. Disney’s CEO, Bob Iger, claims that, compared
with the earlier alliance between the two companies,
ownership of Pixar has facilitated the closer coordination
needed to exploit the synergies between the two
companies.
Factors contributing to the success of the merger
included:
◆ A high level of personal and professional respect
among the key personnel at Pixar and Disney. In
announcing the acquisition, CEO Iger commented:
“We also fully recognize that Pixar’s extraordinary
record of achievement is in large measure due to
its vibrant creative culture, which is something we
respect and admire and are committed to support-
ing and fostering in every way possible.”
◆ Rapid and honest communication to Pixar employees
about the merger and its implications.
◆ Careful pre-acquisition planning specifying which
elements of Pixar would remain unchanged and
which would be adapted to and integrated with Dis-
ney’s existing activities and practices.
◆ Appointing Pixar’s president, Edwin Catmull, as head
of Walt Disney Animation Studios.
◆ Bob Iger’s personal experience of working for com-
panies that were the subject of takeovers.
◆ Explicit guidelines designed to protect Pixar’s
creative culture, including a continuation of Pixar
employees’ generous fringe benefits and loosely
defined employment conditions.
◆ Honoring commitments: according to Edwin Cat-
mull: “Everything they’ve said they would do, they
have lived up to.”
In one respect, the Disney–Pixar merger flouted con-
ventional wisdom. According to Bob Iger: “There is an
assumption in the corporate world that you need to inte-
grate swiftly. My philosophy is exactly the opposite. You
need to be respectful and patient.”
Sources: The Walt Disney Company Press Release, “Disney Com-
pletes Pixar Acquisition,” (Burbank, CA, May 5, 2006); “Disney:
Magic Restored,” The Economist (April 17, 2008); “Disney and
Pixar: The Power of the Prenup,” www.nytimes.com/2008/06/01/
business/media/01pixar.html?pagewanted+all.

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 351
intended to  re-invent its business model. Acquisitions that leverage the existing
model need to carefully specify how the proposed acquisition will augment the
existing business model. For example, if the goal is to reduce cost, basic questions
need to be asked:
● Will the acquisition’s products fit into our product catalogue?
● Do its customers buy products like ours, and vice versa?
● Will the acquired company’s products fit into our existing supply chain, produc-
tion facilities, and distribution?
● Can our people readily service the customers of the acquired company?
The answers to these questions will indicate what needs to be done when
integrating the acquisition within the acquirer’s existing business. However, if
the purpose of the acquisition is to re-invent the firm through acquiring a disrup-
tive business model, integration should be avoided to allow the acquired business
model to flourish. Thus, when EMC acquired VMware—with its disruptive business
model that allowed customers to substitute software for hardware in their server
businesses—EMC chose to operate VMware as a separate company (as did Dell
when it acquired EMC.)24
Strategic Alliances
A strategic alliance is a collaborative arrangement between two or more firms to
pursue agreed common goals. Strategic alliances take many different forms:
● A strategic alliance may or may not involve equity participation. Most alliances
are agreements to pursue particular activities and do not involve any own-
ership links. The alliance between IBM and Apple announced in July 2014
involves the two companies jointly developing enterprise apps and IBM dis-
tributing Apple products to its corporate customers. The idea behind the tie-up
is to combine Apple’s hardware expertise and leadership in mobile devices
with IBM’s big data, analytics, and cloud computing capabilities to develop
enterprise mobility applications.25 In other strategic alliances, equity stakes
can reinforce the alliance agreement. General Motors’ alliance with ride-share
provider, Lyft, to develop self-driving cars involved GM taking a $500m equity
stake in Lyft.26
● A joint venture is a particular form of equity alliance where the partners
form a new company that they jointly own. CFM International, one of the
world’s leading suppliers of jet engines, is a 50/50 joint venture between
General Electric of the US and Snecma of France. Volkswagen is China’s
leading automobile brand through its joint ventures with SAIC Motor and
FAW Group.
● Alliances are created to fulfill a wide variety of purposes:
○○ Star Alliance is an agreement among 25 airlines (including United,
Lufthansa, and Air Canada) to code share flights and link frequent-
flier programs.

352 PART iV CoRPoRATE STRATEGY
○○ Automobili Lamborghini and Callaway Golf Company formed an R&D
alliance in 2010 to develop advanced composite materials.
○○ GlaxoSmithKline and Dr Reddy’s Laboratories (a leading Indian pharma
company) formed an alliance in 2009 to market Dr Reddy’s products in
emerging-market countries through GSK’s sales and marketing network.
○○ The Rumaila Field Operating Organization is a joint venture comprising
China National Petroleum Company, BP, and South Oil Company to operate
Iraq’s biggest oilfield.
● Alliances may be purely bilateral arrangements or they may be a part of a
network of inter-firm relationships. Most companies that assemble complex
manufactured products are supported by a supplier network comprising
hundreds of enterprises. Toyota’s supplier network comprises first-level,
second-level, and tertiary suppliers bound by long-term relationships with
Toyota and supported by a set of routines that permit knowledge sharing
and continuous improvement.27 Another type of alliance network is the local-
ized industry cluster that characterizes the industrial districts of Italy (e.g.,
Prato woolen knitwear cluster, Carrara stonecutting cluster, and Sassuolo
ceramic tile cluster). The Hollywood film industry represents another such
cluster. Relationships within these localized networks are based upon his-
tory and proximity; they are informal rather than formal; and they involve
both cooperation and intense rivalry.28 In sectors affected by technological
changes from multiple sources, alliances can play a vital role in innovation
and adaptability. Figure 14.2 shows Samsung Electronics’ extensive network
of alliances.
Bglobal PLC
Sala Enterprises
Uni-Pixel Inc
Kia Motors Corp
Ube Industries Ltd
Robert Bosch Stiftung GmbH
SiRF Technology Holdings Inc
Reactrix Systems Inc
Juniper Networks Inc
Inf ineon Technologies AG
Quintiles Transnational Corp
Sumitomo Chemical Co Ltd
Huawei Technologies Co Ltd SIP State Property Holding
Singapore
Telstra Corp Ltd
Nanosys Inc
Hynix Semiconductor Inc
Intel Corp
DreamWorks Animation SKG Inc
KT Corp
Thomson SA
NEC Corp
Fujitsu Ltd
Panasonic Corp
Universal Display Corp
IBM Corp
SAP AG
ARM Holdings PLC
Global Foundries Singapore
NTT
Russia
TLC
Corp
Samsung Electronics
FIGURE 14.2 The strategic alliances of Samsung Electronics, 2014
Source: Professor Andrew Shipilov, Insead.

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 353
Motives for Alliances
Most inter-firm alliances are created to exploit complementarities between the resources
and capabilities owned by different companies:
● Bulgari Hotels and Resorts is a joint venture that combines Bulgari’s reputation
for luxury and quality with Marriott International’s capabilities in developing
and operating hotels.
● Uber and Volvo Cars established a project to develop fully-autonomous cars
using Uber’s software capability with Volvo’s vehicle design and manufacturing
capability.
● The Oneworld airline alliance—comprising American Airlines, British Airways,
Cathay Pacific, Japan Airlines, Qantas, Qatar Airways, and nine other airlines—
allows member airlines to offer through-ticketing on one-anothers’ routes,
coordinate their schedules, and link their frequent flier schemes.
● The alliance between Panasonic and Tesla combines Panasonic’s battery capa-
bilities with Tesla’s automotive and photovoltaic capabilities. The main activity
of the alliance is the two companies’ joint production of battery packs within
Tesla’s Gigafactory in Nevada.
There has been a debate in the literature as to whether the primary aim of stra-
tegic alliances is to access the partner’s resources and capabilities or to acquire them
through learning.29 The strategic alliance between Marriott International and Alibaba
announced in August 2017 allows Marriott to access the millions of Chinese tour-
ists who make hotel reservations through Alibaba and payments through Alipay,
while expanding Alibaba’s presence outside of China.30 Conversely, the South China
Locomotive & Rolling Stock Corp.’s alliances with Bombadier and Siemens were moti-
vated primarily by the desire to acquire their technology.31 In most instances alliances
are about accessing rather than acquiring capabilities: for most firms the basic ratio-
nale of alliances is that they allow the firm to specialize in a limited range of capa-
bilities while enabling the exploitation of specific opportunities that require a wider
range of capabilities.32
A major advantage of such alliances is the flexibility they offer: they can be cre-
ated and dissolved fairly easily, their scope and purpose can change according to the
changing requirements of the parties, and (for non-equity alliances) they typically
involve modest investments. This flexibility and low cost is especially advantageous
for making option-type investments.33 Alphabet’s technology-based new ventures
make extensive use of alliances. Its Waymo autonomous driving unit has alliances
with Robert Bosch, Nvidia, FiatChrysler, and Lyft. Google’s Calico subsidiary, whose
goal is to extend human life, has alliances with AbbVie, The Broad Institute, and
C4 Therapeutics.
Alliances also permit risk sharing. In petroleum, most upstream projects are joint
ventures. Kazakhstan’s Kashagan field, the world’s biggest oil discovery of the past
40 years, has required investment of $105 billion, which is spread among a consortium
of seven companies including Eni, Shell, and ExxonMobil.

354 PART iV CoRPoRATE STRATEGY
Managing Strategic Alliances
It is tempting to view a strategic alliance as a quick and low-cost means to extend
the resources and capabilities available to a firm. However, managing alliance
relationships is itself a critically important organizational capability. Relational capa-
bility comprises building trust, developing inter-firm knowledge sharing routines,
and establishing mechanisms for coordination.34 The more a company outsources its
value chain activities to a network of alliance partners, the more it needs to develop
the systems integration capability to coordinate and integrate the dispersed activ-
ities.35 The delays that plagued the launch of the Boeing 787 Dreamliner are one
indicator of the challenges of managing a network of alliances in developing a com-
plex, technologically-advanced product.36
There is a lack of comprehensive evidence relating to the overall success of strategic
alliances. Alliance formations tend to be met with favorable stock market responses,37 but
longer-term data on alliance performance is conspicuously absent. McKinsey observes
that even alliance participants lack knowledge of the costs and benefits of their alli-
ances. McKinsey recommends establishing a system to track alliance performance as a
vital component of effective alliance management.38
Cross-border alliances play a particularly important role in internationalization
strategy, where they can also pose acute management problems. When entering an
overseas market, the internationalizing firm will typically lack the local knowledge,
political connections, and access to distribution channels that a local firm will
possess. At the same time, acquiring a local firm may not be an attractive option,
either because local regulations or ownership patterns make acquisition difficult or
because of the large and irreversible financial commitment involved. In such circum-
stances, alliances—either with or without equity—can be an attractive entry mode.
By sharing resources and capabilities, alliances economize on the investment needed
for major international initiatives. The FreeMove Alliance formed by Telefonica
(Spain), TIM (Italy), T-Mobile (Germany), and Orange (France) created a seamless
third-generation, wireless communication network across Europe at a fraction of the
cost incurred by Vodafone, allowing each firm access to the mobile network of the
leading operator in at least five major European markets.39
Some firms have made extensive use of strategic alliances to build their international
presence. Figure 14.3 shows General Motors’ network of strategic alliances. Some of
these generated few benefits for GM (e.g., the alliances with Fiat, Isuzu, and Suzuki);
others led to full acquisition of the alliance partner (Daewoo, Saab).
For the local partner, an alliance with a foreign firm can also be an attractive means
of accessing resources and capabilities. In many emerging-market countries—notably
China and India before their accession to the World Trade Organization—governments
often oblige foreign companies to take a local partner in order to encourage the flow
of technology and management capabilities to the host country.
However, for all their attractions, international alliances are difficult to manage:
the usual problems that alliances present—those of communication, agreement, and
trust—are exacerbated by differences in language, culture, and greater geographical
distance. Danone’s joint venture with Wahaha created the largest beverage company
in China; however, misunderstanding and misaligned incentives resulted in the joint
venture collapsing in 2011.40
It is tempting to conclude that international alliances are most difficult where
national cultural differences are wide (e.g., between Western and Asian companies).

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 355
However, some alliances between Western and Asian companies have been highly
successful (e.g., Fuji/Xerox and Renault/Nissan). Conversely, many alliances bet-
ween Western companies have been failures: BT and AT&T’s Concert alliance, the
GM/Fiat alliance, and Swissair’s network of airline alliances. Disagreements over
the sharing of the contributions to and returns from an alliance are a frequent
source of friction, particularly in alliances between firms that are also competitors.
When each partner seeks to access the other’s capabilities, “competition for com-
petence” results.41 During the 1980s, Western companies fretted about losing their
technological know-how to Japanese alliance partners. In recent years, Western
companies have been dismayed by the speed at which their Chinese partners have
absorbed their technology and emerged as international competitors. In rail infra-
structure, China’s state-owned companies have used their partnerships with Ger-
many’s Siemens, France’s Alstom, Japan’s Kawasaki Heavy Industries, and Canada’s
Bombardier to build homegrown capabilities that are now being exported.42 The
complaints made by Western companies against their Chinese joint-venture part-
ners in 2012 are almost identical to those made against Japanese joint-venture part-
ners in the 1980s.43
Firms must also choose which growth mode to follow. Typically, companies have a
bias toward either internal or external growth and between either acquisition or alli-
ance without considering fully the relative merits of each. Within the telecom sector,
firms that used a combination of growth modes—internal development, alliances, and
acquisitions—were more successful than those that stuck to a single mode.44 Strategy
Capsule 14.2 considers the issues involved.
AVTOVAZ
HINDUSTAN MOTORS
SUZUKI
ISUZU
NISSAN
TOYOTA
PEUGEOT
SAAB
FIAT
FAW
SAIC
DAEWOO
GM
Jo
in
t
d
ev
el
o
p
m
en
t
an
d
p
u
rc
h
as
in
gJV produces
cars in Russia
Production JV in India, 1994−1999
Production JV; 10% ownership
40% owned
Produ
ct sour
cing
50% owned
50%
owned
50
%
ow
ne
d
19
89
−2
00
0
60%
owned
IBC (built
vans in the
UK, 1989−1998)
NUMMI
(produced cars in
the US, 1984−2009)
50.9%
ow
ned; technical and
production collaboration
Production JVs in China,
Indonesia, India
JV producing light trucks in China
Technical collaboration, joint
purchasing and 20% ownership,
2000−2006
FIGURE 14.3 General Motors’ network of international alliances

356 PART iV CoRPoRATE STRATEGY
STRATEGY CAPSULE 14.2
Choosing the Right Growth Path: internal development vs.
Contracts, vs. Alliances, vs. Acquisitions
Choosing the best way to grow requires a careful con-
sideration of a firm’s resource gap: the resources needed for
its strategy relative to the resources it already possesses.
Capron and Mitchell outline a three-step approach to
deciding a firm’s growth mode (Figure 14.4).
1 The resources a firm needs for its future
development are usually different from those it cur-
rently possesses. But how different? The greater the
gap, the greater the likelihood it will need to seek
these externally rather than develop them internally.
2 If resources are needed from outside the firm, typ-
ically the easiest way to obtain them is through a
contractual agreement (e.g., licensing a specific
technology). But such contracts require agreement
over the value of the resources concerned; in
the absence of such consensus, a contractual
agreement may be impossible.
3 How deeply involved does the firm need to be
with its partner in order to effectively transfer and
integrate the resources required? If the depth and
complexity of involvement is low then an alli-
ance will suffice. However, if closer involvement
is needed, then the fuller integration potential
offered by acquisition is preferable. Researchers at
the Wharton School reached a similar conclusion:
systemic linkages between the firms—“reciprocal
synergies”—favor acquisition; “modular” and
“sequential” linkages are better managed through
alliances. They also note that choosing whether to
ally or acquire depends upon the type of resources
involved. Tangible resources such as manufacturing
plants or mineral resources are better integrated
through mergers and acquisitions; “soft resources”
such as people and knowledge can be linked via
alliances.
FIGURE 14.4 Choosing the right growth path
Do the f irm’s resources and
capabilities f it the needs of
the current strategy?
• Parties’ level of agreement over the
value of the required resources
Contract or inter-f irm
Combination?
• Desired closeness with resource provider
Alliance or acquisition?
ACQUISITION
INTERNAL DEVELOPMENT
CONTRACT
No
Yes
High
Low
ALLIANCE
Low
High
Sources: L. Capron and W. Mitchell, “Finding the Right Path,” Harvard Business Review,
( September–October 2010): 102–110; J. Dyer, P. Kale, and H. Singh, “When to Ally and When to
Acquire?” Harvard Business Review (July–Aug 2004): 109–115.

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 357
Summary
Mergers and acquisitions can be useful tools of several types of strategy: for acquiring particular
resources and capabilities, for reinforcing a firm’s position within an industry, and for achieving diversifi-
cation or horizontal expansion.
However, despite the plausibility of most of the stated goals that underlie mergers and acquisitions,
most fail to achieve these goals. Empirical research shows that the gains flow primarily to the share-
holders of the acquired companies.
These disappointing outcomes may reflect the tendency for mergers and acquisitions to be moti-
vated by the desire for growth rather than for profitability. The pursuit of growth through merger is
sometimes reinforced by CEO hubris, producing a succession of acquisitions that will ultimately lead to
the company failing or restructuring.
A second factor in the poor performance consequences of many mergers are the unforeseen diffi-
culties of post-merger integration. However, the diversity of mergers and their outcomes makes it very
difficult to generalize about the types of merger or the approaches to integration that are associated
with success.
Strategic alliances take many forms. In common is the desire to exploit complementarities between
the resources and capabilities of different companies. Like mergers and acquisitions, and like relation-
ships between individuals, they have varying degrees of success. Unlike mergers and acquisitions, the
consequences of failure are usually less costly. As the business environment becomes more complex
and more turbulent, the advantages of strategic alliances both in offering flexibility and in reconciling
specialization with the ability to integrate a broad array of resources and capabilities become increas-
ingly apparent.
Self-Study Questions
1. Most of the mergers and acquisitions shown in Figure 14.1 are horizontal (i.e., they are bet-
ween companies within the same sector). Some of these horizontal mergers and acquisitions
are between companies in the same country; some cross national borders. Are there any
reasons why horizontal mergers and acquisitions are likely to be more beneficial than other
types of mergers and acquisitions (diversifying and vertical) and involve less risk? Among
these horizontal mergers and acquisitions, which do you think will be more successful: those
between companies in the same country or those that cross borders?
2. A large number of studies examining the success of M&A have examined their impact on
shareholder returns. Most of these studies measure changes in the market value of the merg-
ing companies from before the merger announcement to several months after. What do these
studies tell us about the effects of mergers and acquisitions?
3. Commenting on the Pixar acquisition (Strategy Capsule 14.1), Disney’s CEO stated: “You can
accomplish a lot more as one company than you can as part of a joint venture.” Do you agree?

358 PART iV CoRPoRATE STRATEGY
Notes
1. J. Micklethwait and A. Wooldridge, The Company (New
York: Random House, 2003); A. P. Sloan, My Years with
General Motors (Garden City, NY: Doubleday, 1964).
2. S. N. Kaplan, “Mergers and Acquisitions: A Financial Eco-
nomics Perspective,” University of Chicago, Graduate
School of Business Working Paper (February, 2006); P. A.
Pautler, Evidence on Mergers and Acquisitions, Bureau
of Economics, Federal Trade Commission (September
25, 2001).
3. “Mergers and Acquisitions: The New Rules of Attraction,”
Economist (November 15, 2014).
4. Ibid.
5. Kaplan, “Mergers and Acquisitions: A Financial Economics
Perspective,” op. cit., 8.
6. J. M. Townsend, What Women Want—What Men Want
(New York: Oxford University Press, 1998).
7. R. Roll, “The Hubris Hypothesis of Corporate Takeovers,”
Journal of Business 59 (April 1986): 197–216.
8. M. C. Jensen, “Agency Costs of Overvalued Equity,” Har-
vard Business School (May 2004).
9. J. Harford, “What Drives Merger Waves?” Journal of Finan-
cial Economics 77 (2005): 529–560.
10. “Pfizer Walks Away From Allergan Deal,” Wall Street
Journal (April 7, 2016).
11. Center for Entrepreneurial and Financial Studies, Value
Creation in Private Equity (Capital Dynamics, June
2014).
12. “DuPont, Dow Chemical Agree to Merge, Then Break Up
Into Three Companies,” Wall Street Journal (December
11, 2015).
13. Deloitte M&A Institute, Cross-border M&A: Springboard to
Global Growth (Deloitte, 2017).
14. “Where Mergers Go Wrong,” McKinsey Quarterly (Summer
2004): 92–99.
15. C. Baldwin, “Evaluating M&A Deals: Introduction to Deal
NPV” (Harvard Business School, February 2008).
16. “Hewlett-Packard v Autonomy: Bombshell that Shocked
Corporate World,” Financial Times (August 12, 2014).
17. “The Artful Synergist, or How to Get More Value from
Mergers and Acquisitions,” McKinsey Quarterly (Feb-
ruary 2017).
18. “DaimlerChrysler: Stalled,” Business Week (September
10, 2003).
19. L. Capron and J. Anand, “Acquisition-based Dynamic
Capabilities,” in C. E. Helfat, S. Finkelstein, W. Mitchell,
M. A. Peteraf, H. Singh, D. J. Teece, and S. G. Winter
(eds), Dynamic Capabilities (Malden, MA: Blackwell,
2007): 80–99.
20. S. Finkelstein and J. Haleblian, “Understanding Acquisition
Performance: The Role of Transfer Effects,” Organization
Science 13 (2002): 36–47.
21. M. Zollo and H. Singh, “Deliberate Learning in Corporate
Acquisitions: Post-acquisition Strategies and Integration
Capabilities in US Bank Mergers,” Strategic Management
Journal 24 (2004): 1233–1256.
22. J. Deighton, “How Snapple Got Its Juice Back,” Harvard
Business Review ( January 2002).
23. C. M. Christensen, R. Alton, C. Rising, and A. Waldeck,
A. “The New M&A Playbook,” Harvard Business Review
(March 2011): 48–57.
24. Ibid., 56.
25. “Apple and IBM Take On Corporate Market Together,”
Financial Times ( July 15, 2014).
26. “GM invests $500 million in Lyft, sets out self-driving
car partnership,” http://www.reuters.com/article/us-
gm-lyft-investment-idUSKBN0UI1A820160104, Accessed
August 11, 2017.
27. J. H. Dyer and K. Nobeoka, “Creating and Managing
a High-Performance Knowledge-Sharing Network:
The Toyota Case,” Strategic Management Journal 21
(2000): 345–367.
28. “Local Partnership, Clusters and SME Globalization,” Work-
shop Paper on Enhancing the Competitiveness of SMEs
(OECD, June 2000).
29. D. C. Mowery, J. E. Oxley, and B. S. Silverman, “Strategic
Alliances and Interfirm Knowledge Transfer,” Strategic
Management Journal 17 (Winter 1996): 77–93.
30. “Alibaba, Marriott Team Up to Serve Chinese Tourists
Abroad,” Wall Street Journal (August 7, 2017).
31. “How China built a Global Rail Behemoth That’s Leav-
ing Western Train Makers Behind,” The Globe and Mail
( June 9, 2017).
Illustrate your answer by referring to some of the joint ventures (or alliances) referred to in
this chapter. Would these have been more successful as mergers?
4. In the motor industry, companies have followed different internationalization paths. Toyota
expanded organically, establishing subsidiaries in overseas markets. Ford went on an acquisi-
tion spree, buying Volvo, Jaguar, Land Rover, and Mazda. General Motors has made extensive
use of strategic alliances (Figure 14.3). Which strategy is best? Which strategy would you rec-
ommend to Chinese automobile manufacturers such as SAIC and Dongfeng?

CHAPTER 14 ExTERnAl GRowTH STRATEGiES: MERGERS, ACquiSiTionS, And AlliAnCES 359
32. R. M. Grant and C. Baden-Fuller, “A Knowledge Accessing
Theory of Strategic Alliances,” Journal of Management
Studies 41 (2004): 61–84.
33. R. S. Vassolo, J. Anand, and T. B Folta, “Non-additivity in
Portfolios of Exploration Activities: A Real Options-based
Analysis of Equity Alliances in Biotechnology,” Strategic
Management Journal 25 (2004): 1045–1061.
34. P. Kale, J. H. Dyer, and H. Singh, “Alliance Capability,
Stock Market Response and Long Term Alliance Success,”
Strategic Management Journal 23 (2002): 747–767.
35. A. Prencipe, “Corporate Strategy and Systems Integration
Capabilities,” in A. Prencipe, A. Davies, and M. Hobday
(eds), The Business of Systems Integration (Oxford: Oxford
University Press, 2003): 114–132.
36. “Dreamliner Becomes a Nightmare for Boeing,” Der Spiegel
(March 3, 2011), http://www.spiegel.de/international/
business/0,1518,753891,00.html, Accessed 20 July, 2015.
37. S. H. Chana, J. W. Kensinger, A. J. Keown, and J. D.
Martine, “Do strategic alliances create value?” Journal of
Financial Economics 46 (November 1997): 199–221.
38. J. Bamford and D. Ernst, “Measuring Alliance
Performance,” McKinsey Quarterly, Perspectives on
Corporate Finance and Strategy (Autumn 2002): 6–10.
39. Freemove: Creating Value through Strategic Alliance
in the Mobile Telecommunications Industry, IESE Case
0-305-013 (2004).
40. S. M. Dickinson, “Danone v. Wahaha: Lessons for
Joint Ventures in China,” www.chinalawblog.com/
DanoneWahahaLessons , Accessed July 20, 2015.
41. G. Hamel, “Competition for Competence and Inter-partner
Learning within International Strategic Alliances,” Strategic
Management Journal 12 (1991): 83–103.
42. “China: A Future on Track,” Financial Times (September
24, 2010).
43. R. Reich and E. Mankin, “Joint Ventures with Japan Give
Away Our Future,” Harvard Business Review (March/
April 1986).
44. L. Capron and W. Mitchell, “Finding the Right Path,”
Harvard Business Review (September/October
2010): 102–110.

http://www.spiegel.de/international/business/0,1518,753891,00.html

15
In any field of human endeavor you reach a point where you can’t solve new problems
using the old principles. We’ve reached that point in the evolution of management.
When you go back to the principles upon which our modern companies are built—
standardization, specialization, hierarchy, and so on—you realize that they are not bad
principles, but they are inadequate for the challenges that lie ahead.1
—GARY HAMEL, MANAGEMENT THINKER
The truth is you don’t know what is going to happen tomorrow. Life is a crazy ride, and
nothing is guaranteed.
—EMINEM, MUSICIAN AND SONGWRITER
The future ain’t what it used to be.
—YOGI BERRA, BASEBALL PLAYER AND COACH
Current Trends in
Strategic Management
◆ Introduction
◆ The New Environment of Business
● Technology
● Competition
● Systemic Risk
● Social Forces and the Crisis of Capitalism
◆ New Directions in Strategic Thinking
● Reorienting Corporate Objectives
● Seeking More Complex Sources of Competitive
Advantage
● Strategy in a Digital World
● Managing Options
● Understanding Strategic Fit
◆ Redesigning Organizations
● MultiDimensional Structures
● Coping with Complexity: Making Organizations
Informal, Self-Organizing, and Permeable
◆ The Changing Role of Managers
◆ Summary
◆ Notes
O U T L I N E

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 361
The New Environment of Business
In terms of the forces reshaping business, the first two decades of the 21st century are
similar to the first two decades of the 20th century. During both periods, the devel-
oped world was transformed by technological innovation. In the 20th century, it was
electricity, the automobile and the telephone; in the 21st century, digital technologies
are transforming production, commerce, and social interaction. Both periods also saw
massive political changes: in the early 20th century it was the rise of the nation state,
the collapse of colonial empires, and the birth of Marxist-Leninism; in the early 21st
century, the rise of religious extremism, the decline of liberalism, and disillusion with
political leaders and political systems. During both periods popular disaffection with
big business was a common theme. Let us focus upon four key drivers of change in
the 21st century.
Technology
The invention of the integrated circuit in 1958 marked the beginning of the digital
era. However, it was not until the advent of the microprocessor (1971), RFID and the
subsequent “Internet of Things” (1989), and wireless broadband (2001) that the digital
revolution became a truly disruptive force.
In the US, “FAANG” companies (Facebook, Amazon, Apple, Netscape, and Google)
accounted for 14% of the market capitalization of the S&P 500 at the end of July 2018.
The most valuable Chinese companies were Tencent Holdings and Alibaba Group. Yet,
according to Brian Arthur, a pioneer of complexity economics, the full impact of the
digital revolution has yet to be felt. The combination of sensors, big data, and artificial
intelligence (AI) produces an “external intelligence in business—one not housed
internally in human workers but externally in the virtual economy’s algorithms and
machines. Business and engineering and financial processes can now draw on huge
libraries of intelligent functions and bit by bit render human activities obsolete.”2 For in-
stance, the advent of autonomous vehicles will likely eliminate not only millions of jobs
in commercial and personal transportation but also the need for individuals to own
Introduction
In 2018, the business world was being reshaped by unpredictable forces: the widespread adoption of
artificial intelligence, the rise of nationalism and decline of international institutions, and challenges to
social and political norms. Our challenge in this chapter is to identify the forces that are reshaping the
business environment, to assess their implications for strategic management, and to consider what new
ideas and tools managers can draw upon to meet the challenges ahead.
We are in poorly charted waters and, unlike the other chapters of this book, this chapter will not
equip you with proven tools and frameworks that you can deploy directly in case analysis or in your own
companies. Our approach is exploratory. We begin by reviewing the forces that are reshaping the envi-
ronment of business. We will then draw upon concepts and ideas that are influencing current thinking
about strategy and the lessons offered from leading-edge companies about strategies, organizational
forms, and management styles that can help us to meet the challenges of this demanding era.

362 PART iV CORPORATE STRATEgY
cars. In retailing, check-out-free Amazon Go stores, together with the development of
shelf-filling robots, point the potential for fully-automated retail stores.3
Technology is also shifting the boundaries between firms and markets in fundamental
ways. Wireless technologies have slashed transaction costs, facilitating the growth of
the “sharing economy” involving both peer-to-peer sharing (Airbnb, Blablacar, Lending
Club) and “gig economy” freelance services (Uber, freelancer.com, TaskRabbit).4 By
the end of 2017, Airbnb’s listings exceeded the hotel rooms offered by the world’s five
biggest hotel chains, while Uber, with 16,000 employees, had 1.6m drivers worldwide.
Competition
As we observed in Chapter 11 (“Implications of International Competition for Industry
Analysis”), the entry into world markets by companies from emerging-market countries
has added considerably to competitive pressures in many manufacturing industries. In
wireless hand-sets, 67 new companies entered the industry between 2000 and 2009, 34
of them from China and Taiwan. Many of these new suppliers began as OEM suppliers
and then went on to develop their own brands, thereby competing with their former
customers.5
The wave of digital innovation described in the previous section is also a source of
new competition. Across a broad range of industries, established market leaders are
threatened by digital upstarts deploying disruptive technologies: TV broadcasting and
cable companies by video streaming companies such as Netflix, banks by fintech com-
panies offering new payment systems such as Ant Financial and Adyen, home security
companies such as ADT by Nest Labs (owned by Alphabet).
Increased competition from low-cost, emerging-market competitors, or from new
entrants with innovative business models, means that competitive advantage has
become increasingly fleeting. As we shall see later, one consequence of this is that
firms must develop multiple sources of competitive advantage.
However, these sources of new competition have been counteracted by the efforts
of established companies to consolidate their positions of market leadership. The
merger wave of 2014–18 was dominated horizontal mergers among market leaders,
which turned more and more of the world’s industries into concentrated oligop-
olies. For example: Anheuser-Busch’s acquisition of SAB Miller created a global giant
with 25% of the world’s beer market; in metals mining mergers have resulted in
five leading global players—Glencore, Rio Tinto, BHP-Billiton, and Vale; four com-
panies dominate the world tobacco industry—Philip Morris, Japan Tobacco, BAT, and
Imperial Tobacco.
These monopolistic tendencies are not just a feature of mature industries. The most
startling feature of the digital revolution has been the growing dominance of a few
diversified digital giants, of which Apple, Alphabet, Amazon, Facebook, Alibaba and
Tencent are the most prominent. Each of these companies has quasi-monopoly posi-
tions in one or more markets (e.g., Alphabet has a 70% share of web search and 84%
share of smartphone operating systems; Amazon has a 48% share of all book sales). Of
greater concern is these companies’ ability to extend dominance from one market to
another and accumulate vast stores of data on individuals.6
Systemic Risk
The financial crisis of 2008–09 demonstrated the vulnerability of the global finan-
cial system to turbulence arising from a single source (in this instance, US real estate

http://freelancer.com

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 363
financing). However, the decade since has been one of low volatility in most of the
world’s financial markets.
This apparent tranquility may be a delusion. As Nicholas Taleb observes, most of
the key turning points in world history are “black swan events”: rare occurrences with
extreme impact that are unpredictable.7 Yet, we can also point to the types of systems
that give rise to such events.
A feature of the global economy, and human society in general, is increasing inter-
connectedness through trade, financial flows, markets, and communication. Systems
theory predicts that increasing levels of interconnectedness within a complex, non-
linear system increase the tendency for small initial movements to be amplified in
unpredictable ways. Regional and global political and social phenomena—such as
the “Arab Spring” the rise of radical populism in the US and Europe, and the “me too”
movement—point to the role of systematic forces.
In 2018, the World Economic Forum pointed to three “complex risks in the
interconnected systems that underpin our world”: environmental risks (caused by
climate change), cybersecurity risks (caused by the vulnerability of computer systems
and electronic data), and geopolitical risks (caused by the erosion of multilateral rules-
based approaches to international relations).8 In all three areas, the transition from
a unipolar world led by the US and international organizations (such as the United
Nations, World Bank, IMF, and OECD) to a multipolar world where China, Russia, and
Iran challenge prevailing orthodoxies has increased the vulnerability of the global
system.9
Social Forces and the Crisis of Capitalism
For organizations to survive and prosper requires that they adapt to the values and
expectations of society—what organizational sociologists refer to as legitimacy.10 One
fall-out from the 2008–09 financial crisis was the loss of legitimacy that many busi-
nesses suffered—banks in particular. This negatively affected their reputations among
consumers, the morale of their employees, the willingness of investors and financiers
to provide funding, and the government policies toward them. The 2017 allegations of
sexual abuse against Hollywood mogul, Harvey Weinstein, led to the bankruptcy of his
movie production company in March 2018.
The notion that the business enterprise is a social institution that must identify with
the goals and aspirations of society has been endorsed by many management thinkers,
including Peter Drucker, Charles Handy, and Sumantra Ghoshal.11 The implication is
that, when the values and attitudes of society are changing, so must the strategies
and behaviors of companies. During the past two decades antibusiness sentiment has
moved from the fringes of the political spectrum—neo-Marxists, environmentalists, and
antiglobalization activists—into mainstream public opinion.
The fraying legitimacy of market capitalism can be traced to the 2008–09 finan-
cial crisis; the corporate scandals that have engulfed Volkswagen (diesel emmissions
fraud), Kobe Steel (bogus quality data), and BP (safety violations); and the rising tide
of inequality.12 Figure 15.1 offers one indication of the growing income disparities gen-
erated by the modern economy.
The rise of China has reinforced doubts about the efficacy of market capitalism.
Between 2000 and 2017, the number of Chinese companies among the Global Fortune
500 grew from 10 to 109—most of them state-owned enterprises. By 2017, the Chinese
economy was about 25% bigger than the US economy (on the basis of GDP measured
at purchasing power parity exchange rates).

364 PART iV CORPORATE STRATEgY
State-owned enterprises are one alternative to traditional shareholder-owned
companies; other alternative forms of business enterprise have also attracted interest
in recent years.
● Cooperatives—businesses that are mutually owned by consumers (e.g., credit
unions), employees (e.g., the British retailing giant John Lewis Partnership), or
by independent producers (e.g., agricultural marketing cooperatives)—have
captured particular attention. Cooperatives account for 21% of total produc-
tion in Finland, 17.5% in New Zealand, and 16.4% in Switzerland. In most
East African countries, cooperatives are the dominant organizational form in
agriculture.13
● Social enterprises are business enterprises that pursue social goals. Social enter-
prises may be for-profit or not-for-profit companies (and may include both
charities and cooperatives). Muhammad Yunus’ Grameeen Bank is a for-profit
company that encourages business development among poor people through
microcredit. Most US states have amended their corporate laws to permit benefit
corporations: companies with explicit goals to pursue social and environmental
goals as well as profit.14
Adapting to society’s growing demands for fairness, ethics, and sustainability presents
challenges for business leaders that extend beyond the problems of reconciling soci-
etal demands with shareholder interests. Should a company determine unilaterally the
values that will govern its behavior or does it seek to reflect those of the society in
which it operates? Companies that embrace the values espoused by their founders are
secure in their own sense of mission and can ensure a long-term consistency in their
strategy and corporate identity (e.g., Walt Disney Company and Walmart with respect
to founders Walt Disney and Sam Walton). However, being continually responsive to
stakeholder interests and views and staying alert to social issues, can also be diversion
of time and effort for senior managers. In 1989, Michael Jensen of Harvard Business
School predicted that the advantages of private companies over public companies
would cause the “Eclipse of the Public Corporation.”15 Thirty years later, his prediction
0
50
100
150
200
250
300
350
400
450
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2016
FIGURE 15.1 Ratio of average CEO compensation to that of average worker,
USA, 1965–2016
Source: Institute for Economic Policy.

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 365
is being realized: between 1997 and 2017 the number of companies listed on US stock
markets has halved.16 More and more companies are avoiding the scrutiny to which
public corporations are subject, either by going private, or—as in the case of ecom-
merce startups such as Airbnb, Uber, and Didi Chuxing—by avoiding IPOs.
New Directions in Strategic Thinking
These features of the 21st century business environment have created challenging con-
ditions under which to formulate and implement business strategy. The result has been
a reconsideration of corporate objectives, new approaches to competitive advantage
and the management of uncertainty, and new thinking about strategic fit.
Reorienting Corporate Objectives
The issue of whether companies should be operated in the interests of their owners,
in the interests of their stake-holders, or in the interests of society as a whole remains
unresolved. Recent efforts to reconcile a broader societal role for firms with share-
holder value maximization have emphasized either the need for companies to main-
tain social legitimacy or the potential for such a broadening of goals to open up new
avenues for value creation—the central theme of Porter and Kramer’s shared value
concept.17
The doctrine of shareholder value creation has also evolved away from its 1990s
preoccupation with stock market valuation toward a refocusing of top management
priorities upon the fundamental drivers of enterprise value. This reflects a recognition
that management cannot create stock market value: its focus should be the strategic
factors that drive profits: operational efficiency, customer satisfaction, innovation, and
new product development.
There is a danger that we get sidetracked by the debate over the appropriate goals
for a company. Richard Rumelt views strategy as a response to a problem—whether
it is President Cyril Ramaphosa’s challenge of reviving the South African economy or
Coca-Cola’s challenge of maintaining its revenues and profits as worldwide sales of
soda drinks decline. Hence, for Rumelt the kernel of a good strategy begins with “an
explanation of the nature of the challenge.”18
Seeking More Complex Sources of Competitive Advantage
Addressing such strategy fundamentals does not necessarily lead to simple strategies.
As we have already observed, both in this chapter and in Chapter 7, in today’s dynamic
business environment competitive advantages are difficult to sustain. According to Rita
McGrath, firms need to “constantly start new strategic initiatives, building and exploit-
ing many transient competitive advantages at once.”19 Complex competitive advan-
tages are more sustainable than simple advantages. A key feature of companies that
have maintained both profitability and market share over many years—for example,
Toyota, Walmart, 3M, Robert Bosch, and Samsung Electronics—is their development
of multiple layers of competitive advantage, including cost efficiency, differentiation,
innovation, responsiveness, and adaptability. As we shall see, reconciling the different
requirements of different performance dimensions imposes complex organizational
challenges that are pushing companies to fundamentally rethink their structures and
management systems.

366 PART iV CORPORATE STRATEgY
This pursuit of multiple capabilities in contrast to building a single core capability
recalls Isaiah Berlin’s classification of intellectuals into foxes and hedgehogs: “The fox
knows many things; the hedgehog knows one big thing.”20 Despite Jim Collins’ praise
for companies that exploit a single penetrating insight into the sources of value in their
chosen sectors, the fate of companies such as Toys “R” Us with big-box retailing, Dell
with its direct sales model, and Nokia’s consumer-oriented market segmentation, points
to the weakness of a single dominant logic in a complex, changing world.21
The quest for more complex sources of competitive advantage also involves strat-
egies that look beyond industry boundaries to exploit linkages across sectors. As we
shall explore below, the competitive advantages built by Apple, Google, and Amazon
are the result of business models that exploit sources of value across entire ecosystems
of linked businesses.22
Strategy in a Digital World
Of all the forces that have transformed the business sector over the past three decades,
digital technologies have been the most potent and the most ubiquitous. What does
this mean for strategy—both for the types of strategies appropriate to digital sectors
and the types of analytical tools we apply in order to formulate digital strategies?
In the course of this book, we have seen identified some of the major features of
firms and industries that are based upon digital technologies. Beginning with industry
structures, we noted in Chapter  4 that industries supplying goods and services tend
to be complex ecosystems comprising different suppliers of complementary products.
For example, the smartphone industry comprises the suppliers of handsets, operating
systems, applications, components, and contact manufacturing services. Such industries
offer potential for complex business models—especially for platform owners. Although,
as we observed in Chapter 7 (pp. 158 and 170), despite the emphasis given to business
model innovation, most digital business models are variants of more traditional models.
Among industries based upon digital technologies, a key differentiator is whether
the industry is subject to network externalities—a critical factor that explains the mas-
sive value appropriation of companies that dominate one or more digital market such
as Apple, Alphabet, Amazon, Facebook, Microsoft, eBay, and Baidu. In the absence of
network externalities, digital industries are subject to fragmentation and intense price
competition—for example, the markets for Android smartphones, digital cameras, and
cloud storage.
Because digital technologies are ultimately based upon binary codes, digital
resources tend to be fungible: a software development team can develop software for
a wide variety of applications. For Alphabet, the different businesses providing web
search (Google), autonomous vehicles (Waymo), home automation (Nest), and human
longevity (Calico) are all engaged in developing algorithms. Fungibility also character-
izes digital process technology: 3D printing is a generic technology with the potential
to transform much of manufacturing industry.
These strategic characteristics of digital industries are summarized in Figure  15.2.
As digital technologies continue to transform more and more established industries, so
these features will become increasingly general.
Managing Options
As we observed in the last section of Chapter 2 (“Strategy as Options Management”),
the value of the firm derives not only from the present value of its profit stream (cash

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 367
flows) but also from the value of its options. During turbulent times, real options—
growth options, abandonment options, and flexibility options—become increasingly
important as sources of value.
Viewing strategy as the management of a portfolio of options shifts the emphasis of
strategy formulation from making resource commitments to the creation of opportu-
nities. Strategic alliances are especially useful in creating growth options while allowing
firms to focus on a narrow set of capabilities.
The adoption of options thinking also has far-reaching implications for our tools and
frameworks of strategy analysis. For example:
● Industry analysis has taken the view that decisions about industry attractive-
ness depend on profit potential. However, as industry structure become less
stable, industry attractiveness will depend more on option value. From this
perspective, an industry that is rich in options is one that produces differ-
ent products, comprises multiple segments, has many strategic groups, and
utilizes different technologies—such as computer software, packaging, and
investment banking. These offer more strategic options than airlines or steel
or car rental.
● Similarly with the analysis of resources and capabilities. In terms of option
value, an attractive resource is one that has multiple applications. A technolog-
ical breakthrough in nanotechnology is likely to offer greater option value than
a new process that increases the energy efficiency of blast furnaces. A rela-
tionship with a rising politician is a resource that has more option value than
a coalmine. Similarly with capabilities: a highly specialized capability, such as
expertise in the design of petrochemical plants, offers fewer options than exper-
tise in the marketing of fast-moving consumer goods. Dynamic capabilities are
especially important because they “are the organizational and strategic routines
by which firms achieve new resource combinations as markets emerge, collide,
split, evolve, and die.”23
However, applying real options thinking goes beyond making modest adaptations
to our strategic analysis. Lenos Trigeorgis and Jeff Reuer view real options theory as
Industry
structure
Importance of
complementary products
Network externalities
Complex industry
structures (“ecosystems”)
Potential for complex and innovative
business models
Competitive
advantage
Fast cycle innovation and
product development
Swift erosion of competitive
advantage (unless supported by
network dominance)—hence need
for speed
Ease of imitation of
successful strategies
Critical importance of timing:
strategic windows of short duration
Opportunities for market dominance
(in winner-take-all markets)
Strategic characteristics Strategy implications
Fungibility of IT resources Ease of diversi�cation between
technology-based industries
FIGURE 15.2 The strategic characteristics of digital industries

368 PART iV CORPORATE STRATEgY
a comprehensive approach to analyzing the firm’s strategic decision-making under
uncertainty whose potential has yet to be realized.24
Understanding Strategic Fit
A central theme throughout this book is the notion of strategic fit. The basic framework
for strategy analysis presented in Chapter 1 (Figure 1.2) emphasized how strategy must
fit with the business environment and with the firm’s resources and capabilities. We
subsequently viewed the firm as an activity system where all the activities of the firm
fit together (Figure 1.3). In Chapter 6, we introduced contingency approaches to orga-
nizational design: the idea that the structure and management systems of the firm must
fit with its strategy and its business environment. In Chapter  8, we saw how this fit
between strategy, structure, and management systems can act as a barrier to change. In
recent years our understanding of fit (or contingency) has progressed substantially as
a result of two major concepts: complementarity and complexity. These concepts offer
new insights into linkages within organizations.
Complementarity Complementarity among management practices implies that
management must be viewed as a system: the successful adoption of lean manu-
facturing requires that human resource practices are adapted to meet the needs of
new production processes.25 Similarly, the effectiveness of six-sigma quality programs
are dependent upon changes in incentives, recruitment policies, product strategy, and
capital budgeting practices.
This complementarity makes it difficult to generalize about the effectiveness of
particular strategies every firm is unique and must create a unique configuration of
strategic variables and management practices. However, strategic choices tend to con-
verge around a limited number of configurations. Thus, successful adaptation among
large European companies was associated with a few configurations of organizational
structure, processes, and boundaries.26
Complexity Theory Organizations—like the weather, flocks of birds, and human
crowds—are complex systems whose behavioral characteristics have important implica-
tions for their management:
● Unpredictability: agents interact to produce unpredictable outcomes; small
disturbances typically have minor consequences but may also trigger major
movements.27
● Self-organization: is a feature of most biological and social systems. If
bee colonies and shoals of fish display sophisticated coordination without
anyone giving orders, presumably human organizations have the same
capacity.28
● Inertia, chaos, and evolutionary adaptation: Complex systems can stagnate
into inertia (stasis) or become disorderly (chaos). In between is an intermediate
region where the most rapid evolutionary adaptation occurs. Positioning at this
edge of chaos results in both small, localized adaptations and occasional evolu-
tionary leaps that allow the system to attain a higher fitness peak.29 Kaufman’s
NK model, which allows the behavior of complex systems to be simulated, has
been widely applied to the study of organizations.30
The Contextuality of Linkages within the Firm The implications of comple-
mentarity and complexity for management depend upon contextuality of the link-
ages among activities.31 There are two dimensions to this contextuality. First, the

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 369
contextuality of activities: whether the performance effects of an activity are dependent
or independent of the other activities that a firm undertakes. Second, contextuality of
interactions: whether the interactions between activities are the same for all firms, or
whether they are specific to individual contexts.32 Understanding contextuality can help
us to understand whether or not it is desirable to transfer a “best practice” from another
firm or even from another part of the same firm and the extent to which change in any
activity will have wider repercussions.
Redesigning Organizations
A more complex, more competitive business environment requires that companies
perform at higher levels with broader repertoires of capabilities. Building multiple
capabilities and pursuing multiple performance dimensions presents dilemmas: pro-
ducing at low cost while also innovating, deploying the massed resources of a large
corporation while showing the entrepreneurial flair of a small start-up, achieving reli-
ability and consistency while also adapting to individual circumstances. In Chapter 8,
we addressed one of these dilemmas: the challenge of ambidexterity—optimizing
efficiency and effectiveness for today while adapting to the needs of tomorrow. In
reality, the problem of reconciling incompatible strategic goals is much broader: recon-
ciling multiple dilemmas requires multidexterity.
Implementing complex strategies with conflicting performance objectives takes us
to the frontiers of organizational design. We know how to devise structures and sys-
tems that drive cost efficiency; we know the organizational conditions conducive to
innovation; we can recognize the characteristics of high-reliability organizations; we
are familiar with the sources of entrepreneurship. But how on earth do we achieve all
of these simultaneously?
Multidimensional Structures
Organizational capabilities, we have learned (Chapter  5), need to be embodied in
processes and housed within organizational units that provide the basis for coordination
between the individuals involved. The traditional matrix organization allows capabil-
ities to be developed in relation to products, geographical markets, and functions. And
the more capabilities an organization develops, the more complex its organizational
structure becomes.
Coping with Complexity: Making Organizations Informal,
Self-Organizing, and Permeable
How can firms avoid the costs, rigidities, and loss of dynamism that result from
increasing organizational complexity? In Chapter 6, we observed that traditional matrix
structures which combined product, geographical, and functional organizations proved
unwieldy for many corporations. Yet, developing additional capabilities has involved
adding further organizational dimensions!
Informal Organization The key to increasing organizational complexity while
maintaining agility and efficiency is to shift from formal to informal structures and
systems. The organizational requirements for coordination are different from those
required for compliance and control. Traditional hierarchies with bureaucratic systems
are based upon the need for control. Coordination requires modular structures. But

370 PART iV CORPORATE STRATEgY
each module can be organized as an informal, team-based structure, while coordination
between modules does not necessarily need to be managed in a directive sense—it can
be achieved by means of standardized interfaces, mutual adjustment, and horizontal
collaboration (see discussion of “The Coordination Problem” in Chapter 6).
The scope for team-based structures to reconcile complex patterns of coordination
with flexibility and responsiveness is enhanced by the move toward project-based organi-
zations. While construction companies and consulting firms have always been structured
around projects, a wide range of companies are finding that project-based structures fea-
turing cross-functional teams charged with clear objectives and a specified time horizon
are more able to achieve innovation, adaptability, and rapid learning than more tradi-
tional structures. W. L. Gore, the supplier of Gore-tex and other hi-tech fabric products,
is an example of a team-based, project-focused structure that integrates a broad range of
highly sophisticated capabilities despite an organizational structure that is almost wholly
informal: there are no formal job titles and leaders are selected by peers. Employees
(“associates”) may apply to join particular teams, and it is up to the team members to
choose new members. The teams are self-managed and team goals are self-determined.33
Reducing complexity at the formal level can foster greater variety and sophisticated
coordination at the informal level. In general, the greater the potential for reorder-
ing existing resources and capabilities in complex new combinations, the greater the
advantages of consensus-based hierarchies, which emphasize horizontal communica-
tion, over authority-based hierarchies, which emphasize vertical communication.34
Self-Organization The above-mentioned attributes of complex systems that are
conducive to self-organization—identity, information, and relationships—can substitute
for formal management processes.
● Organizational identity: A collective view of what is distinctive and enduring
about the character of an organization can offer organizational members a
stable bearing in navigating the cross-currents of the 21st century business envi-
ronment.35 Coherence at the core allows an organization to face the world with
greater confidence.36 Of course, organizational identity, because of its perma-
nence, can impede rather than facilitate change. The challenge for organiza-
tional leaders is to reinterpret organizational identity in a way that can support
and legitimate change. Michael Eisner at Disney, Lou Gerstner at IBM, and
Franck Riboud at Danone all initiated major strategic changes, but within the
constancy of their companies’ identities.
● Information: The information and communication revolution of the past two
decades has transformed society’s capacity for self-organization, as evident from
the role of social media in political movements ranging from the “Arab Spring”
to “MeToo” of 2017–18. Within companies, information and communication net-
works support spontaneous patterns of complex coordination with little or no
hierarchical direction.
● Relationships: According to Wheatley and Kellner-Rogers: “Relationships are the
pathways to the intelligence of the system. Through relationships, information
is created and transformed, the organization’s identity expands to include more
stakeholders, and the enterprise becomes wiser. The more access people have
to one another, the more possibilities there are. Without connections, nothing
happens… In self-organizing systems, people need access to everyone; they
need to be free to reach anywhere in the organization to accomplish work.”37
There is increasing evidence that a major part of the work of organizations is
achieved through informal social networks.38

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 371
For organizations to respond spontaneously to the changes occurring around them,
they require mechanisms that facilitate automated, real-time organizational responses
to new data—without requiring human decisions. BCG consultants, Martin Reeves and
colleagues, envisage a “self-tuning enterprise” where adaptation is guided by organi-
zational algorithms. They view the Chinese ecommerce giant, Alibaba, as exemplifying
many of these self-tuning characteristics.39
Permeable Corporate Boundaries Even with informal coordination mech-
anisms, modular structures, and sophisticated knowledge management systems,
there are limits to the range of capabilities that any company can develop inter-
nally. Hence, in order to expand the range of capabilities that they can deploy,
firms collaborate in order to access the capabilities of other firms. This implies less
distinction between what happens within the firm and what happens outside it.
Strategic alliances, as we have already seen, permit stable yet flexible patterns for
integrating the capabilities of different firms while also sharing risks. While local-
ized networks of firms—such as those that characterize Italy’s clothing, furniture,
and industrial machinery industries—offer potential for building trust and interfirm
routines, web-based technologies permit much wider networks of collaboration.
The open innovation efforts, such as IBM’s “Innovation Jam,” and open-source
product development communities, such as Linux and Wikipedia, illustrate the
power of technologies to support the accessing and integration of knowledge from
across the globe.40
The Changing Role of Managers
Changing external conditions, new strategic priorities, and different types of organi-
zation call for new approaches to management and leadership. In the emerging 21st
century organization, the traditional role of the CEO as peak decision-maker may no
longer be feasible, let alone desirable. As organizations and their environments become
increasingly complex, the CEO is no longer able to access or synthesize the information
necessary to be effective as a peak decision-maker. Recent contributions to the liter-
ature on leadership have placed less emphasis on the role of executives as decision-
makers and more on their role in guiding organizational evolution. Gary Hamel is
emphatic about the need to redefine the work of leadership:
The notion of the leader as a heroic decision maker is untenable. Leaders must
be recast as social-systems architects who enable innovation… In Management 2.0,
leaders will no longer be seen as grand visionaries, all-wise decision-makers, and iron-
fisted disciplinarians. Instead, they will need to become social architects, constitution
writers, and entrepreneurs of meaning. In this new model, the leader’s job is to cre-
ate an environment where every employee has the chance to collaborate, innovate,
and excel.41
Jim Collins and Jerry Porras also emphasize that leadership is less about decision-
making and more about cultivating identity and purpose:
If strategy is founded in organizational identity and common purpose, and if orga-
nizational culture is the bedrock of capability, then a key role of top management
is to clarify, nurture and communicate the company’s purpose, heritage, personality,

372 PART iV CORPORATE STRATEgY
values, and norms. To unify and inspire the efforts of organizational members, leader-
ship requires providing meaning to people’s own aspirations. Ultimately this requires
attention to the emotional climate of the organization.42
These views are supported by empirical research by McKinsey & Company into
the characteristics of effective leaders. They identify four attributes that “explained 89
percent of the variance between strong and weak organizations in terms of leadership
effectiveness”: solving problems effectively, operating with a strong results orientation,
seeking different perspectives, and supporting others.43
This changing role also implies that senior managers require different knowledge
and skills. Research into the psychological and demographic characteristics of success-
ful leaders has identified few consistent or robust relationships—successful leaders
come in all shapes, sizes, and personality types. However, research using competency
modeling methodology points to the key role of personality attributes that have been
referred to by Daniel Goleman as emotional intelligence.44 These attributes comprise:
self-awareness, the ability to understand oneself and one’s emotions; self-management,
control, integrity, conscientiousness, and initiative; social awareness, particularly the
capacity to sense others’ emotions (empathy); and social skills, communication, collab-
oration, and relationship building. Personal qualities are also the focus of Jim Collins’
concept of “Level 5 Leadership,” which combines personal humility with an intense
resolve.45
A similar transformation is likely to be required throughout the hierarchy. Informal
structures and self-organization have also transformed the role of middle managers from
being administrators and controllers into entrepreneurs, coaches, and team leaders.
Summary
The dynamism and unpredictability of today’s business environment presents difficult challenges for
business leaders responsible for formulating and implementing their companies’ strategies. Not least,
because businesses need to compete at a higher level along a broader front.
In responding to these challenges, business leaders are supported by two developments. The first
comprises emerging concepts and theories that offer both insight and the basis for new management
tools. Key developments include complexity theory, the principles of self-organization, real option anal-
ysis, organizational identity, network analysis, and new thinking concerning innovation, knowledge
management, and leadership.
A second area is the innovation and learning that results from adaptation and experimentation
by companies. Long-established companies such as IBM and P&G have embraced open innovation;
technology-based companies such as Google, W. L. Gore, Microsoft, and Facebook have introduced
radically new approaches to project management, human resource management, and strategy for-
mulation. In emerging-market countries we observe novel approaches to government involvement
in business (China), new initiatives in managing integration in multibusiness corporations (Samsung),
new approaches to managing ambidexterity (Infosys), and new forms of employee engagement (Haier).
At the same time, it is important not to overemphasize either the obsolescence of existing princi-
ples or the need for radically new approaches to strategic management. Many of the features of today’s

CHAPTER 15 CuRREnT TREndS in STRATEgiC MAnAgEMEnT 373
Notes
1. “A Conversation with Gary Hamel and Lowell Bryan,”
McKinsey Quarterly (Winter 2008).
2. W. B. Arthur, “Where is Technology Taking the Economy?”
McKinsey Quarterly (October 2017).
3. “Amazon’s New Supermarket Could Be Grim News for
Human Workers,” The New Yorker ( January 26, 2018).
4. “The Future of Work,” Economist ( January 3, 2015): 17–20.
5. J. Alceler and J. Oxley, “Learning by Supplying,” Strategic
Management Journal 35 (2014): 204–223.
6. See “The Antitrust Case Against Facebook, Google and
Amazon,” Wall Street Journal ( January 16, 2018); and
F. Foer, World Without Mind: The Existential Threat of Big
Tech (New York: Penguin, 2017).
7. N. N. Taleb, The Black Swan: The Impact of the Highly
Improbable (New York: Random House, 2007).
8. http://reports.weforum.org/global-risks-2018/executive-
summary/. Accessed February 5, 2018.
9. E. A. Cohen, “How Trump Is Ending the American Era,”
The Atlantic (October 2017).
10. A. Y. Lewin, C. B. Weigelt, and J. D. Emery, “Adaptation
and Selection in Strategy and Change,” in M. S. Poole and
A. H. van de Ven (eds.), Handbook of Organizational
Change and Innovation (New York: Oxford University
Press, 2004): 108–160.
11. P. F. Drucker, Managing in the Next Society (London:
St. Martin’s Press, 2003); S. Ghoshal, C. A. Bartlett, and
P. Moran, “A New Manifesto for Management,” Sloan
Management Review (Spring 1999): 9–20; C. Handy, The
Age of Paradox (Boston: Harvard University Press, 1995).
12. Rising inequality is analyzed in T. Piketty, Capital in
the 21st Century (Cambridge, MA: Harvard University
Press, 2014).
13. “Background Paper on Cooperatives.” http://www.un.org/
esa/socdev/social/cooperatives/documents/survey/
background , accessed July 20, 2015.
14. J. Moizer and P. Tracey, “Strategy Making in Social
Enterprise: The Role of Resource Allocation and its effects
on Organizational Sustainability,” Systems Research and
Behavioral Science 27 (2010): 252–266.
15. M. C. Jensen, “Eclipse of the Public Corporation,” Harvard
Business Review (Sept.–Oct. 1989).
16. M. Jensen, “The Eclipse of the Public Corporation,” Har-
vard Business Review (September–October, 1989).
17. R. L. Martin, “The Public Corporation is Finally in Eclipse,”
Harvard Business Review (October 2014); “Why the
Decline in the Number of Listed American Firms Matters.”
Economist (April 22, 2017).
18. R. P. Rumelt, “The Perils of Bad Strategy,” McKinsey
Quarterly ( June 2011).
19. R. G. McGrath, “Transient Advantage,” Harvard Business
Review ( June/July 2013): 62–70.
20. I. Berlin, The Hedgehog and the Fox (New York: Simon &
Schuster, 1953).
21. J. Collins, Good to Great (New York: HarperCollins,
2001).
22. See: N. J. Foss and T. Saebi (eds.) Business Model
Innovation: The Organizational Dimension (Oxford:
Oxford University Press, 2015).
23. K. M. Eisenhardt and J. A. Martin, “Dynamic Capabilities:
What Are They?” Strategic Management Journal 21 (2000):
1105–1121.
24. L. Trigeorgis and J.J. Reuer, “Real Options Theory in
Strategic Management,” Strategic Management Journal 38
(2017): 42–63.
25. K. Laursen and N. J. Foss, “New Human Resource
Management Practices, Complementarities and the Impact
on Innovation Performance,” Cambridge Journal of
Economics 27 (2003): 243–263.
26. R. Whittington, A. Pettigrew, S. Peck, E. Fenton, and
M. Conyon, “Change and Complementarities in the
New Competitive Landscape,” Organization Science 10
(1999): 583–600.
27. P. Bak, How Nature Works: The Science of Self-organized
Criticality (New York: Copernicus, 1996).
28. M. J. Wheatley and M. Kellner Rogers, A Simpler Way (San
Francisco: Berrett-Koehler, 1996).
29. P. Anderson, “Complexity Theory and Organizational
Science,” Organization Science 10 (1999): 216–232.
business environment are extensions of well-established trends rather than fundamental discontinu-
ities. Certainly, our strategy analysis will need to be adapted and augmented in order to take account
of new circumstances; however, the basic tools of analysis—industry analysis, resource and capability
analysis, the applications of economies of scope to corporate strategy decisions—remain relevant and
robust. One of the most important lessons to draw from the major corporate failures that have scarred
the 21st century—from Enron and WorldCom to Royal Bank of Scotland and Eastman Kodak—has been
the realization that the rigorous application of the tools of strategy analysis outlined in this book might
have helped these firms to avoid their misdirected odysseys.

http://www.un.org/esa/socdev/social/cooperatives/documents/survey/background

http://reports.weforum.org/global-risks-2018/executivesummary/

374 PART iV CORPORATE STRATEgY
30. S. McGuire, B. McKelvey, L. Mirabeau, and N. Oztas,
“Complexity Science and Organization Studies,” in S. Clegg
(ed.), The SAGE Handbook of Organizational Studies
(Thousand Oaks, CA: SAGE Publications, 2006): 165–214.
31. M. E. Porter and N. Siggelkow, “Contextuality within Activity
Systems and Sustainable Competitive Advantage,” Academy
of Management Perspectives 22 (May 2008): 34–56.
32. These issues are discussed in greater depth in Porter and
Siggelkow op. cit.
33. G. Hamel, The Future of Management (Boston: HBS Press,
2007): 84–99.
34. J. A. Nickerson and T. R. Zenger, “The Knowledge-based
Theory of the Firm: A Problem-solving Perspective,” Orga-
nization Science 15 (2004): 617–632.
35. D. A. Gioia, M. Schultz, and K. G. Corley, “Organiza-
tional Identity, Image and Adaptive Instability,” Academy
of Management Review 25 (2000): 63–81; D. Ravasi,
“Organizational Identity, Culture, and Image.” In M Schultz
et al (eds.), The Oxford Handbook of Organizational
Identity (Oxford University Press, 2016): 65–78.
36. M. J. Wheatley and M. Kellner-Rogers, “The Irresist-
ible Future of Organizing,” ( July/August 1996), http://
margaretwheatley.com/articles/irresistiblefuture.html,
accessed July 2015.
37. Wheatley and Kellner-Rogers, op. cit.
38. L. L. Bryan, E. Matson, and L. M. Weiss, “Harnessing
the Power of Informal Employee Networks,” McKinsey
Quarterly (November 2007).
39. M. Reeves, M. Zeng and A. Venjara, “The Self Tuning
Enterprise,” Harvard Business Review ( June 2015).
40. R. D. Steele, The Open-Source Everything Manifesto
(Berkeley CA: North Atlantic Books, 2012).
41. G. Hamel, “Moon Shots for Management?” Harvard
Business Review (February 2009): 91–98.
42. J. C. Collins and J. I. Porras, Built to Last (New York:
Harper Business, 1996).
43. C. Feser, F. Mayol, and R. Srinivasan, “Decoding
Leadership: What Really Matters,” McKinsey Quarterly
( January 2015).
44. D. Goleman, “What Makes a Leader?” Harvard Business
Review (November/December 1998): 93–102.
45. J. Collins, “Level 5 Leadership: The Triumph of Humility
and Fierce Resolve,“ Harvard Business Review ( January
2001): 67–76.

Case 1 Tough Mudder Inc.:
Building Leadership
in Mud Runs
Tough Mudder has its origins in a business plan written by Harvard MBA student, Will
Dean, for entry in the school’s annual business plan competition. The business concept
was inspired by Tough Guy, an annual obstacle course race based on British special
forces training.
On graduating from Harvard, Dean and his friend, Guy Livingstone, launched their
first Tough Mudder event. On May 21, 2010, at Bear Creek ski resort, Pennsylvania,
4500 participants battled through a grueling 10-mile course.
By 2018, Tough Mudder Inc. had hosted about 200 events involving over two
million participants, it employed over 200 people, and had revenues of about $100
million a year. During 2018, Tough Mudder would host 55 two-day events involving
up to half a million participants. The challenges include wading through a dump-
ster filled with ice (the “Arctic Enema”), climbing a vertical tube through a cascade
of water (“Augustus Gloop”), and dashing through live wires carrying up to 10,000
volts (“Electroshock Therapy”). Tough Mudder’s website described the experience
as follows:
Tough Mudder events are team-based obstacle course challenges designed to test your
all-around strength, stamina and mental grit, while encouraging teamwork and cama-
raderie. With the most innovative courses and obstacles, over two million inspiring
participants worldwide to date, and more than $8.7 million raised for the Wounded
Warrior Project by US participants, Tough Mudder is the premier adventure challenge
series in the world. But Tough Mudder is more than an event; it’s a way of thinking.
By running a Tough Mudder challenge, you’ll unlock a true sense of accomplishment,
have a great time and discover a camaraderie with your fellow participants that’s
experienced all too rarely these days.1
Really tough. But really fun. When I got back to the office on Monday morning, I looked at my
colleagues and thought: “And what did you do over the weekend?”
—Tough Mudder parTicipanT
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

376 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
The Market for Endurance Sports
The origins of endurance sports can be traced to the introduction of the modern mar-
athon race in 1896, the triathlon in the 1920s, orienteering in the 1930s, and the first
Ironman triathlon in 1974. In recent years, a number of new endurance sports have
appeared, including
● adventure races—off-road, triathlon-based events, which typically include
trekking/orienteering, mountain biking, and paddling;
● obstacle course races (OCRs)—cross-country running events with a variety of
challenging obstacles;
● novelty events—fun events such as 5K races in which competitors are doused
in paint (Color Run), running with real bulls (Great Bull Run), and food fights
(Tomato Royale).
Obstacle mud runs were initiated in the UK in 1987 with the annual Tough Guy
race organized by ex-British soldier Billy Wilson (“Mr. Mouse”) on his farm in Staf-
fordshire, England. In the US, Warrior Dash launched in July 2009, followed by Tough
Mudder and Spartan Races in May 2010. A flood of new entrants followed, many of
which survived for only a short time. In January 2018, Mud Run Guide listed 881
“active race series and organizers of mud runs, obstacle races, and adventure runs”
and 204 inactive raced series and organizers. A large number of these were charity
events organized by not-for-profit organizations. By 2013, there were 3.4 million
participants in US OCRs paying a total of $290.1 million.2 By comparison, triathlons
attracted about two million participants in 2013. However, by 2014, participation
appears to have peaked. Running USA pointed to a decline in the numbers of par-
ticipants in OCRs and other “nontraditional” running sports during 2015 and 2016.3
Despite this fading of the initial boom, efforts were afoot to establish OCRs as a
legitimate sport. The developing infrastructure of the industry included specialist
magazines and websites and national and international associations (e.g., United
States Obstacle Course Racing and International Obstacle Sports Federation). During
2017, the possibility of making obstacle course racing an Olympic sport was being
discussed.
The psychology of mud runs (and other endurance sports) is complex. The satis-
faction participants derive from overcoming their perceived physical and mental limits
combines with identification with warrior role models and the nourishing of camara-
derie. The New York Times referred to the “Walter Mitty weekend-warrior complex,”
noting that, while the events draw endurance athletes and military veterans, “the mud-
diest, most avid, most agro participants hail from Wall Street.”4 A psychologist pointed
to the potential for “misattributed arousal”: the tendency among couples participating
in endurance events to attribute increased blood pressure, heart rate, and sensory alert-
ness to their emotional relationship with their partner. Bottom line: “Want your boy-
friend or girlfriend to feel intense feelings of love and desire for you? Put yourselves
through a grueling, 12-mile obstacle course!”5
During 2013–17, the mud run industry experienced a shake-out as many smaller
organizers were unable to attract sufficient participants to cover the high fixed costs of
producing and publicizing their events. Among the casualties was BattleFrog, which
closed down two-thirds of the way through its 30-event program for 2016. By 2017,
the industry leaders were Tough Mudder, Spartan Races, and Warrior Dash (Table 1).

CASE 1 TOuGh MuddER INC.: BuILdING LEAdERShIP IN Mud RuNS 377
Growing the Company, Building the Brand
After a successful inaugural event at Bear Creek ski resort in Pennsylvania in June
2010 and subsequent events that year in California and New Jersey, Tough Mudder’s
strategic priority was to establish leadership within the emerging market for obstacle
course races. How to position Tough Mudder in relation both to other endurance
sports and to other obstacle runs was the critical strategic issue for CEO Will Dean.
Dean believed that compared to traditional endurance sports—such as marathons
and triathlons—the key attributes of obstacle course races were: first, their opportu-
nities for personal fulfillment through confronting the risks of injury, hypothermia,
TABLE 1 The big three of obstacle course events
Spartan Races Warrior Dash Tough Mudder
Founding: Started by Joe De
Sena in 2010
Expanded overseas
through franchising
Red Frog Events LLC
launched Great Urban
Race in 2007 and
Warrior Dash in 2009
First mud run in May 2010. 14
weekend events in 2011.
2012 first international
events in Australia and UK
2018 events: Mostly 1-day events,
55 in US, 9 in Canada,
41 in 19 other
countries
US: 27 one-day events 55 two-day events: 31 in the
US, 2 in Canada, 15 in the
UK, 1 in Ireland, 5 in Ger-
many, and 1 in Australia
The product: 3 types of race: Sprint
(3 miles, 20+ obsta-
cles); Super (8 miles,
25+ obstacles); Beast
(12 miles, 30+ obsta-
cles); Ultra Beast
(26 miles, 60+ obsta-
cles). Also: Spartan Sta-
dium Series (3+ miles,
18+ obstacles, held
in baseball stadiums,
prize pool of $20,000);
Hurricane Heat (endur-
ance event over 4, 12,
or 24 hours); and Spar-
tan World Champion-
ship (annual event)
3- to 4-mile race with
12 obstacles followed
by postrace party
(beer, bbq, live music)
Challenge Series: Tough
Mudder 5K (5 km, 10
obstacles); Tough Mudder
Half (5 miles; 13 obstacles);
Tough Mudder Full (10
miles; 20+ obstacles).
Competitive series:
Tougher Mudder (10 miles,
20+ obstacles); Toughest
Mudder (8 hours from mid-
night on Saturday); World’s
Toughest Mudder (24-hours,
prizes for the man, woman,
and team that complete the
most course laps).
Elite sport series: Tough
Mudder X Open and
Tough Mudder X World
Championship.
Sponsors: Reebok (2013–17),
Clif Bar, Yokohama tires,
GTS (organic health
drinks), Eat the Bear
Dogfish Head (beer),
Core power (protein
drinks), Grunt Style
(fitness programs),
Tomer Kosher (beef
sticks). Vibram, Any-
time Fitness, Gold
Bond, Rockin’ Refuel
Merrell (shoes), Trek (health
foods), P&G Head &
Shoulders, Guinness,
Aflac (insurance),
Kill Cliff (endurance
drinks), Amazon, Celsius
(fitness drinks)
Entry fees: $114–$194 $65–$104 $55–$204

378 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
and extreme exhaustion; second, they could be collaborative rather than competitive
events; and third, they were more engaging by allowing a variety of experiences and
challenges. Figure 1 outlines Tough Mudder’s conceptualization of the market and its
positioning within it.
However, combining the various attributes of the mud run experience—exhaustion,
camaraderie, fun, and fear—was challenging in terms of product design. In trading
off individual achievement against collaboration, Dean emphasized the collabora-
tive dimension—Tough Mudder would be untimed and team-based; the individual
challenge would be to complete the course. A more complex challenge was the need
for Tough Mudder to present itself as formidable (“Probably the Toughest Event on the
Planet”) while attracting a wide range of participants. Making it a team-based event
and giving participants the option to bypass individual obstacles helped reconcile
these conflicting objectives. Appealing to military-style principles of esprit de corps
(“No Mudder left behind”) also helped reconcile this dilemma. This combination of
personal challenge and team-based collaboration also encouraged participation from
business enterprises and other organizations seeking to build trust, morale, and moti-
vation among teams of employees. To encourage corporate participation, Tough Mud-
der offered customized corporate packages that could include a private tent, catering,
and other services.
The principle of collaboration was not only within teams but extended across all
participants. Before each Tough Mudder event, participants gather at the start line to
recite the Tough Mudder pledge:
●● I understand that Tough Mudder is not a race but a challenge.
●● I put teamwork and camaraderie before my course time.
●● I do not whine—kids whine.
●● I help my fellow Mudders complete the course.
●● And I overcome all my fears.
Tough Mudder
Color Run
Tough Mudder
Spartan Races
Warrior Dash
Ironman
Marathons
Color Run
Marathons
Ironman
Warrior Dash
Spartan Races
Collaborative Unconventional
TraditionalCompetitive
Low risk High risk Activity-led
event
Brand-led
event
FIGURE 1 The market for endurance sports
Source: Adapted from a presentation by Nick Horbaczewski to Strategic Planning Innovation Summit, New York, December 2013.

CASE 1 TOuGh MuddER INC.: BuILdING LEAdERShIP IN Mud RuNS 379
As psychologist Melanie Tannenbaum observes: “this pledge is setting a very pow-
erful descriptive norm  .  .  .  there’s a little part of our brains that hasn’t quite left the
‘Peer Pressure’ halls of high school. We want to fit in, and we want to do what others
are doing.”6
The spirit of unity and collaboration provides a central element of Tough Mud-
der’s marketing strategy. Tough Mudder has relied almost exclusively on Facebook
for building its profile, encouraging participation, and building community among its
participants. Its Facebook ads target specific locations, demographics, and “likes” such
as ice hockey and other physical sports. Tough Mudder also makes heavy use of “spon-
sored stories,” which appear on users’ Facebook “news feeds” when their friends “like”
Tough Mudder. Most important, Facebook is the ideal media for Tough Mudder to
exploit its greatest appeal to participants: the ability for them to proclaim their courage,
endurance, and fighting spirit. As the New York magazine observes: “the experience is
perfect for bragging about on social media, and from the outset Tough Mudder has
marketed to the boastful.”7 By March 2015, Tough Mudder had four million Facebook
“likes.” Will Dean observed that: “We spend a lot of money on Facebook advertising,
but these platforms are amplified many times over by this network of users them-
selves.” This amplification includes: “. . . uploading photographs to Facebook, posting
statuses about events, linking YouTube videos, Snapchatting, Instagramming, Tweeting,
blogging, and all the rest.”8
By 2018, Tough Mudder’s marketing efforts had become strongly orientated toward
video. Most Tough Mudder events are video streamed on Facebook and the Tough
Mudder website. In addition, Tough Mudder made increased use of training videos
and video interviews. In 2016, CBS began televising Tough Mudder competitive events.
Establishing leadership within the obstacle mud run market was a key strategic goal
for the company. The tendency for the market to coalesce around a few leading firms
would be reinforced by the ability of the market leader to set industry standards—to
establish norms of the key attributes of an authentic mud run. Hence, Dean envisaged
Tough Mudder playing a similar role to the World Triathlon Corporation and its Iron-
man brand in triathlon racing.
The problem, however, was that Spartan Races was also committed to market leader-
ship. The result was a fierce rivalry between the two companies and their CEOs, which
manifested itself in espionage, efforts to poach one another’s customers, and flying arial
banners over their rival’s events. At the same time, Will Dean liked to emphasize the
differences between the two companies: “Spartan Race is based on the philosophy that
success is earned through punishment and self-denial . . . anyone who fails to get over
Spartan obstacles is punished by having to perform multiple numbers of burpees. . .
We wanted to show that a tribal spirit of cooperation would prove more attractive than
a message of ‘win ar all costs’”9
Early-mover advantage combined with a rapidly growing program of events (Figure 2)
gave Tough Mudder joint market leadership in North America together with Spartan
Races. In the UK, Tough Mudder was the clear market leader. In other countries—notably
Germany, Australia, and New Zealand—Tough Mudder licensed its trademarks, designs,
and know-how to local event organizers. However, sustaining growth and staying ahead
of the competition required delivering an experience that people would want to come
back for, time and time again. This involved three major activities at Tough Mudder:
● Meticulous attention to customer feedback was achieved through customer
surveys, on-site observations (including employee participation in mud runs),
and close attention to social media. Tough Mudder continually sought clues as
to how it might make improvements that would allow it to satisfy the energy,
determination, and gung-ho spirit of the participants.

380 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
●● Continuous development of obstacles and course design involved continuous
new product development and learning from participant experiences. As Will
Dean explained: “the process starts with ideation—essentially brainstorming,
having lots of ideas out there—not worrying about whether they’re practical or
feasible. . . And then we go through a very rapid iteration process of building
prototypes, trying to understand what the economics of this might look like.
And then we go to actual testing. We have an obstacle innovation lab out in
Pennsylvania, where we have five mad scientists. And then we bring people in
to try them. . . And then we have a big unveil once a year.”10
Partnering
Partnering with other organizations has been a central feature of Tough Mudder’s
growth. Its partnerships have been important for building market momentum, providing
resources and capabilities that Tough Mudder lacked, and generating additional sources
of revenue.
Since its inaugural run in 2010, Tough Mudder has been an official sponsor of the
Wounded Warriors Project, a charity that supports wounded veterans. The relation-
ship reinforces Tough Mudder’s military associations and helps legitimize Tough Mud-
der’s image of toughness, bravery, and compassion. Military connections were further
reinforced by sponsorship from the US Army Reserve, which viewed Tough Mudder
events as an opportunity for promotion and recruitment.
Commercial sponsors include the suppliers of athletic apparel, beer, energy drinks,
and food supplements—plus a few large consumer goods companies such as Diageo
(Guinness), P&G (Head & Shoulders shampoo), and Suntory (Lucozade).
Expanding the Product Range
The principal means by which Tough Mudder sought to broaden the base of partic-
ipation and encourage repeat business was through broadening the product range.
No. of events (mostly two-day) Participants (tens of thousands)
0
10
20
30
40
50
60
70
2010 2011 2012 2013 2014 2015 2016 2017 2018
Note: Participant numbers are casewriter’s estimates. Data for 2018 are projections.
FIGURE 2 Tough Mudder: Growth 2010–2018

CASE 1 TOuGh MuddER INC.: BuILdING LEAdERShIP IN Mud RuNS 381
Between 2013 and 2017, Tough Mudder introduced a number of new events. Some of
these, such as Mudderella, a five to seven mile obstacle course for women and Urban
Mudder, a five to six mile city-based obstacle course, were soon withdrawn. Others
became part of Tough Mudder’s regular program. By 2018, Tough Mudder was offering
its “Challenge Series” of Full, Half and 5-kilometer Tough Mudders and its “Competi-
tive Series”: a hierarchy of timed events for individuals and teams that culminated in
the World’s Toughest Mudder, which was introduced in 2011 to reinforce the brand’s
reputation for toughness. The annual run featured individuals and teams competing to
complete the greatest number of course laps during a 24-hour period. The Financial
Times described the event: “Le Mans on foot, through a Somme-like landscape with
Marquis de Sade-inspired flourishes.”11 In addition, the “Mini-Mudder” was a 1-mile-
obstacle course for children from 7 to 12.
Tough Mudder has also sought to diversify its sources of revenue. In addition to
deals with CBS and Sky Sports to televise its Toughest Mudder events, in 2017, it
launched a chain of franchised gyms. Tough Mudder Bootcamp offers functional fit-
ness and teamwork training through 45-minute workout classes. Tough Mudder also
provides franchise packages to gym operators and owners of work and office spaces
suitable for its Bootcamp program.
Management
In an interview with Inc. magazine, CEO Will Dean outlined his management philosophy:
“There are only two things a leader should worry about: strategy and culture . . . We
aspire to become a household brand name, so mapping out a long-term strategy is cru-
cial. I speak with Cristina DeVito, our chief strategy officer, every day, and I meet with
the entire five-person strategy team once a week . . . We go on retreats every quarter to
a house in the Catskill Mountains.”12
At the core of Tough Mudder’s strategy is its sense of identity, which is reinforced
through the culture of the company: “Since Day 1, we’ve had a clear brand and mission:
to create life-changing experiences. That clear focus means that every employee is
aligned on the same vision and knows what they’re working toward.”13 “We know who
we are and what we stand for,” he added. To sustain the culture, Tough Mudder has
established a list of core values to guide the actions and behavior of the management
team. The emphasis on building the corporate culture is reflected in a meticulous
approach to hiring new employees who combine professional achievement with the
pursuit of adventure and share Dean’s passion and values. One indicator of Tough
Mudder’s distinctiveness is its reliance on internal financing: Tough Mudder has grown
without venture capital financing and has no plans to go public.
Tough Mudder in 2018
During 2018, Tough Mudder continued to adapt its strategy to the challenges of a
maturing market. Dean showed little concern over the industry’s shakeout: consoli-
dation around a few leading players was a normal feature of market evolution. At the
same time, Tough Mudder’s future depended upon it growing beyond mud runs:
I think to be successful today, you must really have an integrated business. You have
to, of course, be good at the events, but you also have to be good at marketing, you
have to be good at media partnerships. You have to have ancillary businesses, such

382 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Notes
1. http://toughmudder.com/about/, accessed July 20, 2015.
2. An acrimonious legal dispute between Will Dean and
Tough Guy Challenge founder Billy Wilson over the
alleged theft of trade secrets was resolved by Dean paying
$725,000 to Wilson in an out-of-court settlement.
3. “Obstacle Race World: The State of the Mud Run
Business” ( June 2014), http://www.obstacleusa.com/
obstacle-race-world-the-state-of-the-mud-run-business-
details-the-size-and-reach-of-the-ocr-market-as-the-sports-
first-ever-industry-report/, accessed July 20, 2015.
4. “The Running Bubble has Popped,” New York Times
(November 5, 2017).
5. M. Tannenbaum, “The Making of a Tough Mudder”
( January 15, 2015), http://blogs.scientificamerican.
com/psysociety/2015/01/15/mud-running/, accessed
July 20, 2015.
6. Ibid.
7. “Tough Mudder: There Are Riches in This Mud Pit,” New
York Magazine (September 29, 2013), http://nymag.com/
news/business/boom-brands/tough-mudder-2013-10,
accessed July 20, 2015.
8. Will Dean, It Takes a Tribe: Building the Tough Mudder
Movement (New York: Penguin, 2017): 95.
9. Ibid: 49.
as the training business, to support that. Events companies are very much becoming
sports media entertainment and lifestyle brands.14
In expanding its presence in sport and fitness, Dean regarded Tough Mudder as
pioneering change in the endurance sport and fitness markets:
Well, I think when we first got started, we really were disrupting the mass participa-
tion events business. . . I wanted to create an event that was much more about team
inclusiveness, less about a race. I think we changed the way people think about mass
participation events.
Then if you look at the business today, I think we’re really in two or three differ-
ent areas. So of course we have the events business. We also have media business.
I do think that what we’re doing with CBS and Sky Sports in the UK has started to
challenge some of the conventional norms within the sports media space.
And then I think one area where we’re definitely challenging assumptions is in the
gym and the training space. We launched the Tough Mudder Bootcamp this year.
In certain markets, like in New York or in L.A. or London, of course there are thou-
sands of fitness studios to choose from. But in most parts of the United States, that’s
simply not true. We’re definitely trying to disrupt what the fitness market looks like
outside of those tier 1 markets, with what we believe is a very compelling fitness
concept.15
However, these additional legs to Tough Mudder’s business model depended upon
the continued appeal of its mud runs. Here Tough Mudder faced uncertainties. Was
the decline in obstacle course participation a feature of market maturity, or did it
indicate long-term decline? Would Tough Mudder’s broadening of its product port-
folio encourage wider participation and would this detract from the appeal of its
core 10-mile mud run? Would Tough Mudder’s investments in community building,
product development, and continuous improvement of the participant experience
encourage repeat business? And would Tough Mudder’s emphasis on camaraderie
and team work win out over Spartan Run’s commitment to individual achievement
and competitiveness?

http://www.obstacleusa.com/obstacle-race-world-the-state-of-the-mud-run-businessdetails-the-size-and-reach-of-the-ocr-market-as-the-sportsfirst-ever-industry-report/

http://blogs.scientificamerican.com/psysociety/2015/01/15/mud-running/

http://nymag.com/news/business/boom-brands/tough-mudder-2013-10

CASE 1 TOuGh MuddER INC.: BuILdING LEAdERShIP IN Mud RuNS 383
10. “CEO of Tough Mudder Talks About the Future of Adven-
ture Racing,” http://fortune.com/2017/09/26/tough-
mudder-bootcamp-will-dean, accessed January 18, 2018.
11. “Tough Mudder,” Financial Times online edition ( January
18, 2013), http://www.ft.com/cms/s/2/7a80e610-603d-
11e2-b657-00144feab49a.html#ixzz2nFzd1Xx4, accessed
July 20, 2015.
12. “The Way I Work: Will Dean, Tough Mudder,” Inc.,
Magazine, http://www.inc.com/magazine/201302/
issie-lapowsky/the-way-i-work-will-dean-tough-mudder.
html, accessed July 20, 2015.
13. “On the Streets of SoHo. Will Dean, Tough Mudder,” http://
accordionpartners.com/wp-content/uploads/2013/02/QA-
Will-Dean , accessed July 20, 2015.
14. “CEO of Tough Mudder Talks About the Future of Adven-
ture Racing,” op cit.
15. Ibid.

http://www.inc.com/magazine/201302/issie-lapowsky/the-way-i-work-will-dean-tough-mudder.html

http://fortune.com/2017/09/26/tough-mudder-bootcamp-will-dean

http://www.ft.com/cms/s/2/7a80e610-603d-11e2-b657-00144feab49a.html#ixzz2nFzd1Xx4

http://accordionpartners.com/wp-content/uploads/2013/02/QAWill-Dean

Case 2 Kering SA: Probing
the Performance
Gap with LVMH
From PPR to Kering
In March 2013, the French fashion and retail giant, Pinault-Printemps-Redoute (PPR),
changed its name to Kering. According to CEO François-Henri Pinault: “Kering is a
name with meaning, a name that expresses both our purpose and our corporate vision.
Strengthened by this new identity, we shall continue to serve our brands to liberate
their potential for growth.” The change in name followed the transformation in the
business of the company.
PPR was primarily a retailing company: it owned the department store chain Au
Printemps, the mail-order retailer La Redoute, and the music and electronics chain
Fnac. However, the acquisition of a controlling stake in the Gucci Group in 1999
marked the beginning of a transformation into a fashion and luxury goods company.
Table 1 shows the main acquisitions and divestments of PPR/Kering.
This was not the first transformation that the company had undergone. PPR/ Kering
was the creation of the French entrepreneur Francois Pinault who had established
Pinault SA as a timber trading company before acquiring retailers Au Printemps
and La Redoute in 1992. In March 2005, Francois Pinault was succeeded by his son
François-Henri Pinault as chairman and CEO of Kering. The Pinaults’ dominance of
Kering is ensured through the role of the Pinault family’s holding company, Groupe
Artémis, which owns 40.9% of Kering. (Artemis also owns Christie’s, the auction house,
and the Château Latour vineyards.)
In recreating itself as a diversified fashion and luxury goods company, Kering has
been widely viewed as modeling itself on LVMH—the world’s leading purveyor of
luxury goods. However, despite the close parallels between the two companies—and
their leading families, the Pinaults and the Arnaults—Kering has struggled to match
LVMH’s financial performance. During the period of François-Henri Pinault’s leadership
(2005–17), Kering’s revenues and operating profits have grown more slowly than LVMH’s.
This differential was reflected in Kering’s share price growth, which, until early 2016,
lagged that of LVMH. (121% compared to 271% for LVMH during the 10 years to the end
of 2015.) However, during 2016 and 2017, Kering’s prospects were upwardly revised
by the stock market—mainly due to the surging performance of Gucci. As a result, for
the 10 years to February 21, 2018, Kering’s share price growth (315%) outstripped that
of LVMH (247%).
However, despite the upturn, Kering’s profit performance—including its operating
margin, return on assets (ROA), and return on equity (ROE)—continued to lag behind
that of LVMH. If Kering was to close the gap, it needed to understand the sources of
this performance differential.
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

CASE 2 KErinG SA: ProbinG tHE PErforMAnCE GAP witH LVMH 385
500.00
400.00
300.00
200.00
100.00
0.00
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
FIGURE 1 Kering share price (in euros), January 2000 to March 2018
TABLE 1 Kering’s principal acquisitions, divestments, and new business
launches, 1999–2017
Year Business
1999 Acquisition of 42% of Gucci Group (later increased to 100%)
Acquisition of Yves St. Laurent
2000 Acquisition of Boucheron (jewelry and perfumes)
2001 Acquisition of Bottega Veneta and Balenciaga
Launch of Stella McCartney and Alexander McQueen brands
2004 Ownership of Gucci Group increased to 99.4%
Sale of Facet (financial services), Rexel (distributors of electrical equipment)
2006 Sale of Printemps
2007 Acquisition of 62% of Puma
2009 Acquisitions of Dobotex (manufacturer of Puma socks and apparel) and Brandon
(corporate merchandising)
2010–11 Acquisitions of Cobra and Volcom (sports equipment suppliers) and luxury menswear
supplier, Brioni
2012 Divestment of Fnac
Sale of Redcats online businesses
Joint venture formed with Yoox for online sales of luxury brands
2013 Acquisition of Christopher Kane (fashion clothing), Pomellato (jewelry), and France Croco
(processor of crocodile skins)
Sale of La Redoute and Relais Colis (parcel delivery)
2014 Acquisition of Ulysse Nardin (watches)
2015 Sale Sergio Rossi (shoes)
Launch of Kering Eyewear
2016 Kering Luxury Logistics and Industrial Operations established as a new division
Sale of Electric (sports apparel and accessories)
Source: Tables 1, 2, 3, A1, and A2 are based upon information in Kering Financial Documents 2016 and 2017.

386 CASES to ACCoMPAnY ContEMPorArY StrAtEGY AnALYSiS
Kering in 2018
In February 2018, Kering SA operated in two segments:
● Luxury: Kering designs, manufactures, and markets ready-to-wear clothing,
leather goods, shoes, watches, jewelry, fragrances, and cosmetic products
through Gucci, Bottega Veneta, Yves Saint Laurent, and several other high-
profile brands.
● Sport & Lifestyle: Kering designs and develops footwear, apparel, and acces-
sories under the Puma, Volcom brands.
Figure 2 shows Kering’s organizational structure. Table 2 shows the performance of
its major brands. Table 3 shows revenue by geographical region. Appendices 1 and 2
show financial data for Kering and LVMH.
Kering description of its group strategy is shown in Table 4. This strategy was revealed
in several of the strategic decisions that Kering made during 2016–18. Close corporate
supervision of the individual businesses was evident from the fact that, during 2015–17,
Kering appointed new CEOs to every one of its subsidiaries with the exception of Puma,
YSL, and Stella McCartney. New creative directors were also appointed to most subsidi-
aries. Kering’s efforts to provide greater integration and efficiency included the creation
of a single purchasing and supply chain organization to serve the luxury division.
However, by far the biggest strategic move was Kering’s announcement in January
2018 that it would spin off the major part of its shareholding in Puma by distrib-
uting Puma shares to Kering’s shareholders. The announcement had been widely
anticipated and had been a factor in Kering’s rising share price during late 2017 and
early 2018. Kering’s CFO observed that: “We found ourselves in a sort of imbalance,
linked to the outperformance of the luxury sector,” and the spinoff offered “a simple,
KERING
Kering Americas Kering Asia PacificKering Corporate*
Sport & Lifestyle ActivitiesLuxury Activities
Gucci
Bottega Veneta
Puma (86%)
Volcom
YSL
Alexander McQueen
Boucheron
Balenciaga
Brioni
Christopher Kane (51%)
Pomellato (75%)
Qeelin 78%
Stella McCartney (50%)
Ulysse Nardin
Sowind
*Comprises:
1. Kering’s corporate departments and HQ teams
2. Shared Services
3. Kering Sustainability Department
4. Kering’s Sourcing Department
FIGURE 2 Kering: Divisional structure and main brands, January 2018

CASE 2 KErinG SA: ProbinG tHE PErforMAnCE GAP witH LVMH 387
TABLE 3 Kering Group: Sales revenue by geographical region
2017
(€m)
2016
(€m)
Reported
change (%)
Comparable
change (%)a
Western Europe 5077 3886 +30.7 +32.3
North America 3306 2741 +20.6 +22.9
Japan 1291 1226 +5.3 +10.9
Eastern Europe, Middle East, and Africa 1024 814 +25.7 +24.9
South America 595 514 +15.6 +19.1
Asia-Pacific (excluding Japan) 4185 3304 +30.6 +32.7
Total revenue 15,478 12,385 +25.0 +27.2
Note:
a Change in revenue after adjusting for changes in exchange rates.
Source: Kering Financial Document, 2017.
rapid way of creating value for our investors.” The divestment marked the end of
Kering’s ambitions to integrate luxury fashion with a sports lifestyle brand—efforts
that had included the appointment of singer and hip-hop artist Rihanna as Puma’s
creative director.
TABLE 2 Kering Group: Performance of the major brands (€ millions)
Revenue Op. incomea Op. margin Net assets
2017 2016 2017 2016 2017 2016 2017 2016
Gucci 6211 4378 2124 1256 34.2% 28.7% 6482 6633
Bottega Veneta 1176 1173 294 297 25.0% 25.3% 618 619
Yves Saint Laurent 1501 1220 377 269 28.1% 22.0% 1136 1102
Other luxury brands 1907 1698 116 114 6.1% 6.7% 2267 2353
Total Luxury Division 10,796 8469 2911 1936 27.0% 22.9% 10,504 10,508
Puma 4152 3642 244 127 5.9% 3.5% 4427 4430
Other sport/lifestyle
brands
230 242 0 (3) 0.0% (1.2%) 220 265
Total Sport & Lifestyle
Division
4382 3884 244 123 5.6% 3.2% 4646 4695
Note:
a Recurrent operating income. Excludes impairment of goodwill, restructuring costs, etc.
Source: Kering Financial Document, 2017.

388 CASES to ACCoMPAnY ContEMPorArY StrAtEGY AnALYSiS
Appendix 1: Kering SA: Financial Data
TABLE 4 Kering: Extracts from “Kering in 2017—Group Strategy”
VISION: Embracing creativity for a modern, bold vision of luxury
Our ambition is to be the world’s most influential Luxury group in terms of creativity, sustainability,
and economic performance. Boldness is an essential source of inspiration and creativity. . . . Our
values are closely tied to a powerful, creative content imbued with modernity, and are comple-
mented by the entrepreneurial spirit that permeates each of our brands and creative teams.
BUSINESS MODEL: A multi-brand model built on a long-term approach and creative autonomy of
our Houses
Our multi-brand approach is built on a long-term vision and combines agility, balance, and
responsibility.
Agility: Kering helps its Houses realize their full growth potential . . . they benefit from the Group’s solid
integrated value chain and pooled support functions. By encouraging imagination in all its forms, our
organization fosters performance while enabling our Houses to unleash the best of their talents and
creativity.
Balance: We use our strength as a Group to help forge a distinctive identity for each House . . . The
Group supports the brands by providing its expertise, reliable supply chain and access to distribution
networks, as well as enhancing customer experience—especially in digital channels.
Responsibility: All our operations are founded on a responsible economic model. Our comprehensive,
sustainable approach is a structural competitive advantage.
STRATEGY: Harnessing the full potential of Luxury to grow faster than our markets
● Promoting organic growth: product innovation, sales efficiency, customer experience
● Enhancing synergies and integration: resource pooling, cross-business expertise, vertical
Integration, talent excellence
Source: Kering Financial Document, 2017: 8–12.
TABLE A1 Kering Group: Selected data from financial statements
Year to 31 December (in € millions) 2017 2016 2015 2014
INCOME STATEMENT
Total sales 15,478 12,385 11,584 10,038
Cost of sales 5345 4595 4510 3742
Gross margin 10,133 7790 7074 6296
Payroll expenses 2444 1984 1821 1545
Other recurring operating costs 4741 3920 3607 3087
Recurring operating income 2948 1886 1747 1664
Nonrecurring expensesa 242 506 394 112
Operating income 2706 1382 1253 1552
Finance costs (interest) 243 202 249 197
(continues)

CASE 2 KErinG SA: ProbinG tHE PErforMAnCE GAP witH LVMH 389
Year to 31 December (in € millions) 2017 2016 2015 2014
Income before tax 2464 1178 1004 1355
Net income of discontinued operations (6) (12) 41 (479)
Net income (“total comprehensive income”) 1685 931 892 477
BALANCE SHEET (at 31 December (in €m))
Assets
Cash and cash equivalents 2137 1050 1146 1196
Total receivables 1445 1302 1261 1168
Inventories 2699 2432 2192 2235
Total current assets 7317 5640 5365 5273
Property, plant, & equipment 2268 2207 2073 1887
Goodwill, netb 3421 3534 3759 4040
Brands and Intangible assetsc 11,159 11,273 11,286 10,748
Total assets 25,577 24,139 23,851 23,254
Trade payables 1241 1099 940 983
Current borrowings 940 1235 1786 2284
Other current financial liabilities 368 286 239 347
Total current liabilities 5763 4899 5099 5780
Total long-term debt 4246 4206 4054 3195
Total debt (long-term and current) 5554 5727 6069 5696
Total liabilities (except shareholders’ equity) 12,951 12,175 12,228 12,620
Total shareholders’ equity 12,626 11,964 11,623 10,634
CASH FLOWS
Total cash from operations 2459 1792 1296 1261
Total cash from investing (725) (670) (759) (903)
of which, capital expenditures on fixed assets (752) (611) (672) (551)
Notes:
a Mainly writedown of brand values and restructuring costs.
b Arising from acquisitions.
c At cost less amortization and impairment.
Source: Tables A1, A2, and A3 are based upon Kering Financial Document, 2017.
TABLE A1 Kering Group: Selected data from financial statements (Continued )

390 CASES to ACCoMPAnY ContEMPorArY StrAtEGY AnALYSiS
TABLE A2 Kering Group: Divisional information
Luxury Sport & Lifestyle
2017 2016 2017 2016
Brand value (€m) 6813 6887 3813 3920
Goodwill (€m) 2439 2551 977 978
Number of stores 1388 1305 789 734
Number of production units 114 97 3 4
Number of logistic units 82 80 46 4
Number of employees (full-time equivalents)a 23,423 21,559 12,144 11,873
Divisional revenue by product (total €m) 10,796 8469 4382 3884
of which Apparel (%) 16 16 38 37
Footwear (%) 17 14 45 45
Leather goods (%) 52 52 – –
Watches & jewelry (%) 8 9 – –
Other (%) 7 9 17 18
Divisional revenue by region
W. Europe (%) 34 32 30 29
N. America (%) 19 19 27 26
Asia Pacific (%) 31 31 17 16
Japan (%) 9 10 7 9
Other (%) 7 8 19 20
Note:
a In addition, there were 3029 “corporate & other” employees (2445 in 2016; 1349 in 2015).
TABLE A3 Performance of leading suppliers of sports and lifestyle products, 2017
Revenue Operating margin ROE
Nike Inc. $34.4 bn 12.8% 32.1%
Adidas AG €19.3 bn 9.4% 21.4%
Puma SE €4.1 bn 5.9% 8.2%
Under Armour Inc. $5.0 bn 0.6%a (2.38%)a
Note:
a Under Armour’s profit was reduced in 2017 by a rise in operating costs. In 2016, operating margin was 8.6% and
ROE 12.5%.

CASE 2 KErinG SA: ProbinG tHE PErforMAnCE GAP witH LVMH 391
Appendix 2: LVMH: Selected Financial Data
LVMH Moet Hennessy Louis Vuitton SA (LVMH) is a Paris-based luxury goods company.
Tables A4–A6 show financial data for the company and its main businesses.
TABLE A4 LVMH’s product segments and brandsa
Revenue
(€m)
Op. profit
(€m)
Operating
margin (%)
Assets
(€m) ROA (%)
Division 2017 2016 2017 2016 2017 2016 2017 2016 2017 2016
Wines and spiritsa 5084 4835 1558 1504 30.6 31.1 15,581 14,137 10.0 10.6
Fashion and leather goodsb 15,472 12,775 4905 3873 31.7 30.3 18,781 11,239 26.1 34.4
Perfumes and cosmeticsc 5560 4953 600 551 10.8 11.1 3629 3419 16.5 16.1
Watches and jewelryd 3805 3468 512 458 13.5 13.2 8239 8531 6.2 5.4
Selective retailinge 13,311 11,973 1075 919 8.1 7.7 6921 8549 15.5 10.7
Notes:
a Major brands are: Moët & Chandon, Dom Pérignon, Veuve Clicquot, Krug, Ruinart, Mercier, Château d’Yquem, Château Cheval Blanc,
Hennessy, Glenmorangie, Ardbeg, Wen Jun, Belvedere, Chandon, Cloudy Bay.
b Major brands are: Louis Vuitton, Céline, Loewe, Kenzo, Givenchy, Thomas Pink, Fendi, Emilio Pucci, Donna Karan, Marc Jacobs, Berluti,
Nicholas Kirkwood, Loro Piana.
c Major brands are: Christian Dior, Guerlain, Parfums Givenchy, Parfums Kenzo, Loewe Perfumes, Benefit Cosmetics, Make Up For Ever,
Acqua di Parma.
d Major brands are: Bulgari, TAG Heuer, Chaumet, Dior Watches, Zenith, Fred, Hublot, De Beers Diamond Jewellers Ltd (a joint venture).
e Major brands are: DFS, Sephora, Le Bon Marché, la Samaritaine, Royal Van Lent.
Source: Tables A4, A5, and A6 are based upon LVMH Financial Documents, 2017.
TABLE A5 LVMH’s revenues by geographical region, 2016 and 2017
2017 2016
€ millions % € millions %
France 4172 10 3745 10
Europe (excluding France) 8000 19 6825 18
Asia (excluding Japan) 11,877 28 9922 26
Japan 2957 7 2696 7
United States 10,691 25 10,004 27
Other countries 4939 11 4408 12

392 CASES to ACCoMPAnY ContEMPorArY StrAtEGY AnALYSiS
TABLE A6 LVMH: Selected items from financial documents 2014–17
2017 2016 2015 2014
INCOME STATEMENT ITEMS
Total revenue 42,636 37,600 35,644 30,638
Cost of sales 14,783 13,039 12,553 10,801
Gross margin 27,783 24,561 23,111 19,837
Selling, general, and admin. expenses 19,557 17,538 16,493 14,117
Profit from recurring operations 8293 7026 6605 5431
Nonrecurring net expenses 180 122 221 284
Operating profit 8113 6904 6384 5431
Cost of debt 62 83 78 115
Net income 5129 3981 3573 5648
BALANCE SHEET ITEMS
Cash and short-term investments 3738 3544 3594 4091
Trade accounts receivable 2737 2685 2521 2274
Inventory 10,908 10,546 10,096 9475
Total current assets 21,028 19,398 18,950 18,110
Property, plant, and equipment 13,206 12,139 11,157 10,387
Goodwill 16,514 10,401 10,122 8810
Brands and other intangibles 13,714 13,335 13,572 13,031
Total assets 68,550 59,622 57,601 53,362
Trade accounts payable 4540 4184 3960 3606
Short-term borrowings 4530 3447 3769 4189
Total current liabilities 15,003 12,810 12,699 12,175
Long-term debt 7046 3932 4511 5054
Total debt 11,586 7379 8280 9243
Total liabilities (less equity) 38,290 31,733 30,002 31,599
Shareholders’ equity 30,260 27,903 27,599 23,003
CASH FLOWS
Net cash from operating activities 7030 6751 6063 4607
Total cash from investing (8607) (2347) (2466) (2007)
of which, capital expenditures (2276) (2265) (1995) (1775)
OPERATIONAL DATA
Number of employees 138,449 134,476 125,346 121,289
Number of stores 4374 3948 3860 3544

Case 3 Pot of Gold? The US
Legal Marijuana
Industry
By 2018, the legal marijuana industry had established itself as a significant compo-
nent of both the US agribusiness and medical sectors. Retail sales of legal marijuana in
2017 were estimated at $9 billion by BDS Analytics—most of it for medically-approved
use. The 2017 US marijuana crop was valued (at wholesale prices) at $5.7 billion by
Cannabis Benchmarks—as compared to the US wheat crop of $7.4 billion. For the
states in which marijuana was legally cultivated and distributed, the benefits included
121,000 direct jobs and $1.2 billion in tax revenues.1
Medium-term projections for the industry pointed to continued strong growth.
ArcView—a marijuana information, consulting, and investment firm—forecast that,
by 2021, US consumer spending on legal cannabis would total $20.8 billion, and
that the industry would generate 414,000 jobs and more than $4 billion in tax
revenue.2
Like most growth industries, the industry has attracted considerable financial
interest. Some of the venture capital and private equity funds investing in the industry
are listed in Table 1. Investment in the marijuana sector was also facilitated by ArcView
Group’s intermediating role in linking investors with marijuana entrepreneurs had
generated a buzz of excitement about this “new gold rush.” By October 2017, its net-
work of angel investors had invested $125 million in 157 cannabis-sector companies.
The transformation of the marijuana business from one controlled by criminal
gangs to a legitimate business activity supported by an infrastructure of consultants,
information providers and investment funds had generated a buzz of excitement about
this “new gold rush.” However, there remained perplexing questions over the indus-
try’s potential to generate attractive profits. Would the industry offer the sustained
high profitability associated with the two other heavily regulated industries supplying
recreational drugs—alcohol and tobacco—or would it suffer the squeezed margins and
low returns typical of the agricultural sector?
Legalization
In 1996, California became the first state to legalize the sale of marijuana for medical
use. Then, in 2014, Colorado and Washington became the first states to legalize the
production, sale, and consumption of marijuana for recreational use. At the beginning
of 2018, the sale of marijuana the sale of was legal in 30 states and, for recreational
This case was prepared by Robert M. Grant. © 2019 Robert M. Grant.

394 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
use by adults, in nine states (Colorado, Washington, Oregon, California, Nevada, Mas-
sachusetts, Maine, Alaska, and Vermont).
Yet, amidst continuing concerns over the physical and psychological dangers of mar-
ijuana consumption, the impetus to change federal law was weak. Continuing illegality
of the production, sale, and possession of marijuana under federal law was a major
handicap for the industry. In particular, firms engaged in producing and selling mar-
ijuana had limited access to the US financial system. Banks were fearful that involve-
ment with the industry might contravene drug-racketeering or money-laundering rules.
In the United States as a whole, law enforcement against consumers and suppliers of
marijuana continued to be active. In 2016, there were 653,249 arrests throughout the
United States on marijuana-related charges, down from 693,481 in 2013. Close to 90%
of these arrests were for possession.
Moreover, the approach to enforcing Federal laws against marijuana had shifted
considerably in the transition from the Obama to the Trump administration. In
January 2018, US Attorney General Jeff Sessions rescinded the Obama-era guide-
lines, known as the “Cole Memo,” which discouraged federal prosecutors from tak-
ing action against state-licensed marijuana businesses. As a result, banks and credit
TABLE 1 Private equity and venture capital funds investing in the marijuana sector
Fund Founded Size Notes
Privateer
Holdings
2010 $129m. Backed by PayPal cofounder Peter Thiel. Investments
include Tilray (medical marijuana, The Goodship,
(marijuana-infused candies and cookies), Marley
Natural, and Leafly
Tuatara Capital 2014 $93m. Investments include Willie’s Reserve (owned by
Willie Nelson), TeeWinot Life Sciences (cannabis-
based pharmaceuticals), GreenDot Labs (cannabis
extracts).
MedMen
Opportunity
Fund
2016 $130m. The investment arm of MedMen Inc., a chain of 11
dispensaries in CA, NY, and NV. Has raised $176m in
private equity funding, with an implied valuation of
$1 billion.
Poseidon Asset
Management
2013 $8m. Invests in agricultural technology, SaaS solutions and
data analytics for the marijuana industry.
Salveo Capital 2017 $2m. Chicago-based venture capital fund. Initial investments:
company Headset (cannabis data analytics) and
Front Range Biosciences (biotech)
Casa Verde 2015 $33m. Investments include Eaze Solutions Inc. (CA-based
medical marijuana home delivery service), Trelis,
Green Bits, and FunkSac (marijuana packaging)
Phyto Partners 2015 $10m. Investments include: New Frontier (data analytics),
firm Grownetics (growing solutions), Leaf (cannabis
growing), and Flowhub (business management
platform for marijuana businesses).
Source: https://www.investopedia.com/news/top-marijuana-private-equity-and-venture-capital-funds/

CASE 3 POT Of GOLd? ThE US LEGAL MARIjUANA INdUSTRY 395
unions became increasingly wary of transactions involving companies engaged in
marijuana businesses.
The Market for Marijuana
The US market for marijuana can be segmented between legal and illegal sectors and
between medical and recreational use. Table 2 provides some data.
Marijuana consumption in the United States has been widespread since the mid-
1960s, although estimates of its prevalence are imprecise. According to the National
Institute on Drug Abuse:
Marijuana is the most commonly used illicit drug (22.2 million people have used it
in the past month), according to the 2015 National Survey on Drug Use and Health.
Its use is more prevalent among men than women—a gender gap that widened in
the years from 2007 to 2014. Marijuana use is widespread among adolescents and
young adults. . . Among the nation’s middle and high school students, most measures
of marijuana use by 8th, 10th, and 12th graders peaked in the mid-to-late 1990s and
then began a period of gradual decline through the mid-2000s before levelling off.
Most measures showed some decline again in the past five years. . . In 2016, 9.4%
of 8th graders reported marijuana use in the past year and 5.4% in the past month
(current use). Among 10th graders, 23.9% had used marijuana in the past year and
14.0% in the past month. Rates of use among 12th graders were higher still: 35.6%
had used marijuana during the year prior to the survey and 22.5% used in the past
month; 6.0% said they used marijuana daily or near-daily.3
Among adults, marijuana consumption was most prevalent among young males bet-
ween the ages of 18 and 34; however, the fastest growth in marijuana use was among
older Americans—especially those over 55.4
TABLE 2 Estimates of the US market for marijuana
Market feature Data
Numbers of users, 2017 Total users: 33mn. (Gallup poll); 55mn. (Marist poll)
Medical marijuana users: 1.7mn. (Marijuana Business Daily).
Marijuana sales, 2017 Total legal sales: $9 bn. (BDS Analytics), $5.1–6.1 bn.
(Marijuana Business Daily).
Medical sales: 60% of total; recreational 40% of total
Total illegal sales: $64.7 bn. (ArcView).
Leading states for legal
marijuana sales, 2017
California $1.45bn.; Washington $7.8bn. Colorado $0.44bn.;
Arizona $0.35bn.; Michigan $0.13bn.; Illinois $0.08bn.;
Oregon $0.07bn. (Marijuana Business Daily).
Number of legal marijuana
businesses, 2017
Growers: 2500–3500; Retail dispensaries 3300–4300;
Infused product manufacturers: 1600–2000; Testing labs:
100–150 (Marijuana Business Daily)
Note: The sources of the estimates are shown in brackets.

396 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Development of Legal Marijuana Industry
The two lead states in legalizing recreational marijuana were Colorado and Washington;
hence, the industry’s development in these two states offers pointers as to how the
legal marijuana industry might develop elsewhere—even though the structure and
conduct of the industry will depend greatly upon how each state frames its regulations.
In the future, California—because of the size of its market and extent of both legal
and illegal cultivation—will have the biggest impact on the fortunes of the marijuana
industry at the national level.
At present, entry into the industry depends critically upon the allocation of licenses.
The availability of licenses depends upon the restrictiveness of eligibility criteria and
whether the state imposes a limit on the number of licenses. In Colorado, eligibility
criteria are strict: licensees must be US citizens, state residents, have clean criminal
records, and meet other standards, but there is no quantitative limit on licenses issued.
In Washington, a fixed number of licenses are available, and their allocation is by lot-
tery. In California, eligibility criteria are relaxed and there is no quota on the number
of licenses that can be issued. As a result, Cannabiz Media predicts that, by the end of
2018, California could grant as many as 10,000 licenses for marijuana businesses.5
However, in all states, receiving a state license is dependent upon local authorization—
in Colorado, Washington, and California—many counties and cities have decided
against permitting marijuana businesses. As a result, most businesses are concentrated
in relatively few locations. In Colorado, over one-third of the state’s 500+ dispensaries
are in the Denver metropolitan area. In California, four cities—Oakland, San Jose, Sac-
ramento, and San Francisco—accounted for 30% of all licenses in April 2018.6
In addition to the conditions for obtaining a license, the industry is subject to a
vast array of regulatory requirements. All marijuana facilities have to have elabo-
rate security equipment installed, including surveillance cameras and precautions
against theft. In addition, every marijuana plant is subject to an elaborate system
of tracking that includes RFID tagging. The physical movement of marijuana is also
highly regulated—including specifications for the vehicles that can be used to trans-
port marijuana.
The issuing of separate licenses for different types of marijuana businesses—
growers, distributors/transporters, manufacturers, retailers, and testing labs—tends
to reinforce fragmentation along the industry’s value chain. Most states encourage
small businesses—including social enterprises—in the development of their mar-
ijuana industries. However, the evidence in Colorado, Washington, and California
shows an increasing role of large enterprises. In Colorado, dispensary chains include
Native Roots (21 stores), LivWell (14 stores plus growing and processing opera-
tions), The Green Solution (11 stores), Green Dragon (11 stores), and Starbuds (10
stores). In California, multiple license holders include Honeydew Farms LLC (29
licenses), Harborside (12 licenses), KindPeoples (12 licenses), and CA Systematize (8
licenses).7 Vertical integration from seed to retail dispensary is a feature of several of
the larger players.
The development of the industry has been accompanied by the development of
an infrastructure of support services. For example, MJ Freeway offers “seed-to-sale”
tracking software that meets states’ regulatory requirements and assisted operations
management; Advanced Cannabis Solutions lease real estate to large commercial
growers; Waste Farmers supply soils for cannabis growing; and ArcView Group is a
hub for data, investment, media, and consulting. Table 3 shows some of the main fea-
tures of the legal marijuana industries of Colorado, Washington, and California.

CASE 3 POT Of GOLd? ThE US LEGAL MARIjUANA INdUSTRY 397
TABLE 3 Some features of the legal marijuana sector in Colorado, Washington, and
California
Colorado Washington California
Date of
legalization
Medical 2000
Recreational 2012
Medical 1998
Recreational 2012
Medical 1996
Recreational 2018
Home
cultivation
Yes (max. 6 plants) No Yes (max. 6 plants)
Licensing Separate licenses for
cultivation, manufacture
and retailing, and for
medical and recreational
marijuana. State licenses
only issued when allowed
by local jurisdictions
Single licensing
system for medical and
recreational. Separate
licenses for producers,
processors, and retailers
Separate licenses for
cultivation, manufacture,
and distribution. License
applicants must first
have approval from local
government.
Licensing fees Application fees: dispen-
sary $6000–$14,000;
cultivation $1000.
Licenses: dispensary
$3000–$8000; cultivation:
$1500–$1800
Application: $266
License fee: 1062
$1000 application fee.
Licenses on sliding
scale based on business
throughput: e.g., retailers
$4000–$72,000; distribu-
tors $1200–$125,000.
Taxes 2.9% sales tax 37% excise tax;
9.6% sales tax
15% excise tax plus
$9.25 tax per pound
on flower and $2.74
per pound on trim (in
addition to sales and
use taxes)
Operational
regulation
State-wide tracking system for all plants and processed products
Licenses
issued
(early 2018)
Medical: 503 dispensaries;
751 cultivators
Recreational: 518 stores
722 cultivators
486 retail stores
1147 cultivators.
No more licenses
being issued
1273 licenses issued:
cultivator 322,
dispensary/retailer
322, manufacturer 302,
distributor 176, micro-
business 57,
Delivery 52, testing 15.
Notes:
aBy 2018, Colorado has highly developed marijuana industry with extensive infrastructure. Marijuana generated over
$200m. in taxes and licensing fees for the state.
bThe state has had a highly developed illegal marijuana market for decades with substantial production in the east of
the state and imports from British Columbia.
cTotal production approx.13.5 million pounds per year; consumption approx. 2.5 million pounds—hence massive
(illegal) exports to other states.

398 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
The Economics of the Marijuana Business
Cultivation
Growing marijuana, whether for the medical or the recreational market, requires, first,
a license, and then the acquisition of a growing facility. Marijuana is grown primarily
in indoor, climate-controlled buildings under artificial light, but also in greenhouses
and outdoors. Although greenhouse and outdoor cultivation offers economies both
in set-up and operating costs, these advantages are mitigated by the need for exten-
sive security equipment for all marijuana-growing facilities. More importantly, the key
advantage of indoor cultivation is the ability to have multiple growing cycles each year.
The average size of an indoor facility is 18,300 square feet; that of a greenhouse is
39,000 square feet.8
The growing process involves the following stages:
1 Establishing stage: cloning new plants from existing female plants and allowing
the new plants 7–12 days to become established.
2 “Veg” (or growing) stage: two months under constant light.
3 Flowering stage: about two months with a daily cycle of 12 hours of light fol-
lowed by 12 hours of darkness.
4 Processing stage: hanging the plants upside-down, then harvesting their buds
and leaves.
5 Curing stage: drying the buds and leaves.
Figure 1 shows the layout of a typical growing facility.
Early estimates of revenues and costs suggested that marijuana is a highly profitable
crop. For example, Motley Fool estimated that a 10,000-square-foot growing facility
with five annual growing cycles could produce 1250 pounds a year, with a wholesale
value of $2.75 million. With production costs of $1.25 million (i.e., $1000/lb.), this
implies a margin of 55%.9 However, estimates of production costs are highly variable:
one study estimates a range of $70–$400/lb10, while another study puts them as high
as $1606/lb.11
Veg State Veg State
Veg State
Flowering State
Flowing State
Processing Facility
Cloning & CuringO�ce
FIGURE 1 Layout of a typical marijuana indoor cultivation facility
Source: J. Maxfield, “More Legalized Drug Dealing: An Inside Look at Colorado’s Massive Marijuana
Industry,” Motley Fool (January 5, 2014).

CASE 3 POT Of GOLd? ThE US LEGAL MARIjUANA INdUSTRY 399
As the industry develops and spreads to more and more states, more reliable esti-
mates of revenues and costs have become available. Table 4 provides estimates based
on data available during the first half of 2017.
Over time, production costs change. While increased productivity from technolog-
ical advances and greater operational efficiencies reduce production costs, these are
offset by rising real estate costs due to a shortage of suitable facilities and increasing
wage rates for marijuana workers—these wage rates tend to be above those for
workers in similar horticultural and retail sectors. In Colorado, Oregon, Alaska, and
some other states, employees in marijuana businesses are required to have state
occupational licenses.
Most estimates of the profit margins on marijuana growing have failed to take
account of the many risks affect the industry. These include: diseases, natural disasters
(California’s wild fires of 2017 and 2018 wiped out many producers), and other sources
of crop failure. In addition, there is the ever-present risk of crime that affects all cash-
based businesses and the risk of closure or loss of license resulting from failure to
comply with state or local regulations.
The greatest uncertainty in projecting future profitability relates to prices. In the
wholesale market, prices are determined by supply and demand. Prices vary over
times due to spikes in demand (demand peaks during summer and holidays) and
seasonal variations in supply (supply from outdoor and greenhouse cultivation
increases during the fall). Longer term, there has been an overall downward trend in
prices as growth in supply has outpaced growth in demand. Figure 2 shows prices
between 2015 and the end of 2017. This downward trend has continued during the
first half of 2018. During mid-August 2018, the average US spot wholesale price was
$1130 per pound compared to $1486 at the beginning of the year. These averages
masked considerable price variation both between quality grades and localities. Dur-
ing the first half of 2018, wholesale prices in Oregon were approximately 55% higher
than those in Colorado.12
TABLE 4 Estimates of the costs, revenues and profitability of legal marijuana
production, 2017
Indoor Greenhouse
Start-up cost (per sq. ft.)a $75 $50
Annual operating cost (per sq. ft.)b $81 $8
Revenue (per sq. ft.) c $151 $26
Average profit margind 30% 40%
Percentage of business that is profitable 67% 55%
Percentage of business that breaks even 28% 22%
Percentage of business that is loss making 30% 44%
Notes:
a Equipment and real estate accounted for 60% of start-up costs, licensing, and security for a further 20%.
b Wages accounted for 30% of operating costs, rent/mortgage for 18%, utilities for 16%.
c Because of quality and consistency, indoor grown marijuana sells at a price premium.
d After-tax, net margin.
Source: Marijuana Business Daily, Marijuana Business Factbook 2017.

400 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
TABLE 5 Average revenues costs, and profitability of licensed marijuana
retailers, 2017
Medical Recreationala
Average outlet size (square feet) 2566 2100
Start-up cost (per outlet) $0.775m. $0.193m.
Annual operating cost (per outlet) $1.920m. $1.140m.
Revenue (per outlet) $3.000m. $1.800m.
Average profit marginb 15% 21%
Percentage of business that are profitable 65% 68%
Percentage of business that breakeven 29% 29%
Percentage of business that are loss-making 6% 3%
Notes:
a Includes combined medical and recreational stores.
b After-tax, net margin.
Source: Marijuana Business Daily, Marijuana Business Factbook 2017.
Retailing
There is a huge diversity in the retail outlets supplying marijuana and marijuana
processed products. There is a distinction between medical and recreational outlets,
with the latter present in only nine states, compared to 30 for medical. Variations in
regulations among states mean differences in size, operating practices, costs, and
competitive conditions. In addition, some retailers are stand-alone, other backward-
integrated into cultivation. Some indications of average revenues and costs are shown
in Table 5.
$2200
2016 Avg = $1789
$2100
$2000
$1900
$1800
$1700
$1600
$1500
$1400
$1300
4/
24
/2
01
5
5/
24
/2
01
5
6/
24
/2
01
5
7/
24
/2
01
5
8/
24
/2
01
5
9/
24
/2
01
5
10
/2
4/
20
15
11
/2
4/
20
15
12
/2
4/
20
15
1/
24
/2
01
6
2/
24
/2
01
6
3/
24
/2
01
6
4/
24
/2
01
6
5/
24
/2
01
6
6/
24
/2
01
6
7/
24
/2
01
6
8/
24
/2
01
6
9/
24
/2
01
6
10
/2
4/
20
16
11
/2
4/
20
16
12
/2
4/
20
16
1/
24
/2
01
7
2/
24
/2
01
7
3/
24
/2
01
7
4/
24
/2
01
7
5/
24
/2
01
7
6/
24
/2
01
7
7/
24
/2
01
7
8/
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/2
01
7
9/
24
/2
01
7
10
/2
4/
20
17
11
/2
4/
20
17
12
/2
4/
20
17
2017
2015
2016
2017 Avg = $1562
FIGURE 2 Average spot wholesale price of marijuana in the US ($ per pound)
Source: Cannabis Benchmarks.

CASE 3 POT Of GOLd? ThE US LEGAL MARIjUANA INdUSTRY 401
Competition
Competition in the legal market for marijuana is highly dependent on the ease with
which licenses are available. Typically, because of the visibility of marijuana retailers
and the often-hostile attitude of local residents, states are more restrictive over retail
licenses than cultivation licenses. Indeed the steady decline in Colorado wholesale
marijuana prices during 2016 and 2017 was attributed by many observers to the large
number of cultivation licenses that had been issued.
Like most agricultural products, marijuana is essentially a commodity product at
the wholesale level, although there are many different types. Marijuana comprises two
species: Cannabis indica and Cannabis sativa, each with distinctive characteristics and
each comprising many different strains. Leafly.com (“The World’s Cannabis Information
Resource”) has listed and reviewed some 800 strains. There are also quality differen-
tials: in general, indoor-grown marijuana commands a price premium of about 25%
over outdoor-grown marijuana.
Growers have had limited success in establishing their own brands—not least
because of the inability to register trademarks for marijuana-based products with the
US Patent and Trademark Office. At the retail level differentiation has been greater—in
addition to differentiation by geographical location, individual dispensaries can use
quality and customer service to build customer loyalty.
Competition extends beyond the boundaries of the legal market for marijuana. Con-
sumers, both medical and recreational, have the legal option of growing their own (in
Colorado and Washington, adults can cultivate up to six plants). In addition, there is
illegal marijuana. Illegal marijuana is produced domestically and imported from Mexico,
Canada, and other countries. Mexico and British Columbia are major foreign sources. In
the case of Mexico, outdoor production and low-cost labor gives producers a huge cost
advantage that is only partly offset by the costs of clandestine, high-risk transportation
and distribution. Nevertheless, the supply chains and distribution networks for illegal
marijuana are well established and the lack of sales tax and regulatory compliance
more than compensates for their inefficiencies. However, domestically grown illegal
marijuana is a bigger threat than imported marijuana. A report in January 2018 by the
California Growers Association estimated that, of the state’s estimated 68,150 cannabis
growers, only 534 were licensed to cultivate cannabis.13
According to data from Price of Weed, marijuana prices in states where recreational
marijuana is illegal, but laws are lightly enforced, are similar to those in Colorado and
Washington with a well-developed legal marijuana industry. However, in states where
marijuana laws are strongly enforced (e.g., Alabama, Louisiana, North Dakota, and
Iowa), prices are about 50% higher than states with light enforcement.14
Marijuana also competes with a host of other recreational drugs. These include
cocaine, amphetamine, methamphetamine, ecstasy, and a number of other organic and
synthetic drugs.
The Future
The major determinant of the development of the US marijuana industry in the coming
years will be government policy. In 2018, there was a clear divergence between policy
at the state level and at the federal level, where there was a renewed commitment to
enforcing the existing legislation against marijuana. What happens at the federal level
is critical to the industry’s future development. So long as marijuana remains classified
as an illegal drug, the industry will have limited access to the banking system and intel-
lectual property protection, and businesses will find it difficult to expand across state
boundaries.

http://Leafly.com

402 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
However, even under the uncertain situation existing in early 2018, some trends
were clear; although the industry remained fragmented in all states where legalization
had occurred, there was a trend towards consolidation both in retail and production.
This was partly the result of competition—i.e., expansion among the better-managed
businesses—and partly the result of the flood of investment funds into the industry,
resulting in individual venture capital funds controlling more marijuana businesses.
Should the federal government drop its opposition to marijuana, then Canada offers
some pointers as to how the marijuana industry might evolve within the United States.
During 2017 and 2018, the Canadian marijuana industry appeared to be consolidating at
a rapid rate. The biggest producer, Canopy Growth, was planning to increase its output
from 31 metric tons in 2017 to over 90 metric tons in 2018 as it expands from medical into
recreational marijuana. It was already the world’s biggest exporter of medical marijuana.15 In
January 2018, Canada’s second biggest marijuana company, Aurora Cannabis Corp., acquired
CanniMed for $1 billion.16 In August 2018, there were 22 marijuana supplying companies
listed on the Toronto stock exchange and three on US stock exchanges: Tilray Inc. (valued
at $13bn.), Canopy Growth (valued at $11bn.), and Cronos Group (valued at $2bn.).
Another feature of the Canadian marijuana industry has been the interest shown
by tobacco and alcohol companies in the business. Tobacco and alcoholic beverages
are the most developed industries offering intoxicating and addictive products that
are harmful to health and highly regulated. In the case of tobacco, it is interesting
that—despite falling consumption, tight regulation, litigation, and heavy taxation—it
remains one of the world’s most profitable industries: the leading companies (Altria/
Philip Morris, BAT, Japan Tobacco, and Imperial Tobacco) earned an average return on
equity of 52% during 2014–17. In October 2017, US beer and wine giant, Constellation
Brands, acquired a 10% stake in Canopy Growth, with a view to developing marijuana-
infused beverages.17 Big tobacco has kept a watchful eye on the marijuana market
for decades. In 2017, tobacco company, Imperial Brands, added a medical marijuana
executive to its board.18
Notes
1. Cannabis Benchmarks, Annual Review and Outlook 2017-
18 (New Leaf Data Services, 2017).
2. ArcView
3. https://www.drugabuse.gov/publications/research-
reports/marijuana/what-scope-marijuana-use-in-united-
states. Accessed March 1, 2018.
4. B. Kaskie, et al. “The Increasing Use of Cannabis
Among Older Americans: A Public Health Crisis or
Viable Policy Alternative?” Gerontologist 57 (November,
2017):1166-1172; “Middle-aged Parents More Likely to
Smoke Weed than their Teenage Kids,” Washington Post
( September 2, 2016).
5. “Trends and Surprises From California’s First 1,000
Cannabis Licenses.” https://cannabiz.media/learnings-from-
californias-first-1000-licenses/. Accessed March 2, 2018.
6. Marijuana Business Daily, Marijuana Business
Factbook 2017.
7. “Trends and Surprises From California’s First 1,000
Cannabis Licenses.” Op cit.
8. “Trends and Surprises from California’s First 1,000
Cannabis Licenses.”
9. “More Legalized Drug Dealing: An Inside Look at
Colorado’s Massive Marijuana Industry,” Motley Fool
( January 5, 2014), http:/fwww.fool.com/investing/
general/2014/01/05/legalized-drug-dealing-an-inside-look-
at-colorados.aspx, accessed July 20, 2015.
10. J. P. Caulkins, “Estimated Cost of Production for Legalized
Cannabis,” RAND Corporation ( July 2010), http://www.
rand.org/pubs/working_papers/WR764.html, accessed
July 20, 2015.
11. PBS Frontline, “Marijuana Economics 101,” http://www.
pbs.org/wgbh/pages/frontline/the-pot-republic/marijuana-
economics/, accessed July 20, 2015.
12. Cannabis Benchmarks Weekly Report, March 2, 2018.
13. https://www.greenmarketreport.com/californias-cannabis-
market-verge-crisis. Accessed March 2, 2018.
14. http://www.priceofweed.com/prices/United-States/.html.
Accessed March 3, 2018.
15. https://seekingalpha.com/article/4136511-future-holds-
canopy-growth-corp. Accessed March 3, 2018.
16. https://www.bloomberg.com/news/articles/2018-01-24/
marijuana-growers-aurora-cannimed-said-to-reach-deal-
on-merger. Accessed March 3, 2018.
17. “Big Brewer Makes a Play for Marijuana Beverages,” Wall
Street Journal (October 29, 2017).
18. “Imperial Brands Adds Cannabis Company Chairman to
its Board,” Financial Times ( June 13, 2017).

http:/fwww.fool.com/investing/general/2014/01/05/legalized-drug-dealing-an-inside-lookat-colorados.aspx

https://cannabiz.media/learnings-fromcalifornias-first-1000-licenses/

http://www.rand.org/pubs/working_papers/WR764.html

http://www.pbs.org/wgbh/pages/frontline/the-pot-republic/marijuanaeconomics/

https://www.greenmarketreport.com/californias-cannabismarket-verge-crisis

http://www.priceofweed.com/prices/United-States/.html

https://seekingalpha.com/article/4136511-future-holdscanopy-growth-corp

https://www.bloomberg.com/news/articles/2018-01-24/marijuana-growers-aurora-cannimed-said-to-reach-dealon-merger

https://www.drugabuse.gov/publications/researchreports/marijuana/what-scope-marijuana-use-in-unitedstates

Case 4 The US Airline
Industry in 2018
During the first quarter of 2018, it was unclear whether the strong upswing in the
profitability of US airlines that had begun in 2012 would continue. The announcement
by United Continental Holdings on January 24 that it planned to expand capacity by
between 4% and 6% annually raised fears that the recent upswing would end the same
way as previous booms—in excessive capacity additions leading to price wars.1 These
fears were reflected in the prices of airline shares: during the two weeks after the
announcement, the Dow Jones Airlines Index declined by 17% (see Figure 1).
From Regulation to Competition
The first scheduled airline services began in the 1920s. Between 1938 and 1978, the
industry was regulated by the Civil Aeronautics Board which awarded routes, approved
mergers and acquisitions, and set fares.
Deregulation, combined with rapidly growing demand for air travel, transformed
the industry. Despite barriers to entry into the industry arising from the need to set up
a complex system comprising airline and aircraft certifications, airport facilities, bag-
gage handling services, and ticketing, 20 new carriers—including People Express, Air
Florida, Spirit Airlines, and Midway—began operating soon after deregulation. Since
then, new entry into the industry has continued. Although most new airlines failed,
successful entrants include Frontier Airlines (1994), Allegiant (1998), JetBlue (2000),
Virgin America (2007).
300
250
200
150
100
50
2002 2004 2006 2008 2010 2012 2014 2016 2018
FIGURE 1 Dow Jones Airlines Index, 2000–2018
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

404 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Since deregulation, the industry has been subject to turbulence caused by external
shocks and internal competition. During 1979–83, high oil prices, recession, and strong
competition triggered bankruptcies (over 100 carriers went bust) and a wave of mergers.
Further profit slumps occurred in 1990–94, 2001–03, and 2008–11. Since 1990, all the
leading US airlines (with the exception of Southwest) entered Chapter 11 bankruptcy:
Continental (1990), United (2002), US Airways (2002, 2004), Delta (2005), Northwest
(2005), and American (2011). Each re-emerged a few years later, reorganized and with
new equity.
Table 1 shows the financial performance of the four leading airlines and Figure 2
shows industry profitability since deregulation. Profitability is acutely sensitive to the
balance of demand and capacity: because of high fixed costs, dips in load factors or
increases in cost result in industry-wide losses (Figure 3). The role of competition in
driving efficiency is evident from the near-continuous decline in real prices over the
period (Figure 4).
Dismal profit performance is not limited to the US airline industry: the propensity
for the industry to earn a return on capital less than its cost of capital is a feature of
the worldwide industry (Figure  5). During the first decade of the 21st century, the
only major airlines to cover their cost of capital were Ryanair, Emirates, Singapore Air-
lines, and Southwest.2 The industry’s woes caused legendary investor, Warren Buffett,
to observe:
The worst sort of business is one that grows rapidly, requires significant capital to
engender the growth, and then earns little or no money. Think airlines. Here a durable
competitive advantage has proven elusive ever since the days of the Wright Brothers.
Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done
his successors a huge favor by shooting Orville down.3
However, the 2013–17 upswing in airline financial performance was stronger and
more sustained than previous interludes of profitability. The revival in economic
growth after the financial crisis and a sharp decline in oil prices during 2015 and 2016
were contributory factors, but it was likely that rising profitability reflected a more
fundamental transformation in the industry. Increased cost efficiency had resulted from
union concessions on pay, benefits, and working practices, as well as from benefits
from outsourcing, IT, and new, fuel-efficient planes. The consolidation in the industry
as a result of mergers and acquisitions had created the conditions for a more restrained
price competition. Moreover, the major airlines were showing unusual discipline by
allowing increased demand to fill existing capacity rather than rushing to add new
capacity. Even arch-skeptic Warren Buffett had begun to invest in airline stocks.4
However, despite the Financial Times’ observation that, “In recent years, passenger
numbers grew faster than capacity.  .  . [and] there are some signs that the boom-
to-bust capacity cycle has finally been broken,”5 uncertainty remained—especially
in relation to capacity. The low cost carriers (LCCs) continued to lead in capacity
additions: during 2017 Spirit Airlines had increased capacity by 16%, Allegiant by
9%, and Southwest by 4%. Following United’s announcement of capacity additions,
there was anxiety that the major airlines might return to their old game of adding
capacity in order to protect market share—a game that invariably led to intense price
competition.

CASE 4 ThE US AIRLINE INdUSTRY IN 2018 405
–15
–10
–5
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
20
14
20
16
0
5
10
15
20
Operating margin (%) Net margin (%) Index of inflation-adjusted crude oil prices
FIGURE 2 Profitability of the US airline industry, 1978–2017
Source: Bureau of Transportation Statistics.
TABLE 1 Revenues and profitability of the largest US airlines, 2009–2017
2017 2016 2015 2014 2013 2012 2011 2010 2009
Revenue ($bn.)
Uniteda 37.7 36.6 37.9 38.3 38.9 37.2 37.1 23.3 16.3
Delta 41.2 39.6 40.7 40.4 37.8 36.2 35.1 31.8 28.1
Americanb 42.2 40.2 41.0 42.6 26.7 24.9 24.0 22.2 19.9
Southwest 21.2 20.4 19.8 18.6 17.7 17.1 15.7 12.1 10.4
Net margin (%)
Uniteda 5.1 6.3 19.4 2.9 1.5 (1.9) 2.7 1.1 (4.0)
Delta 9.0 11.0 11.1 1.6 6.7d 2.7 2.4 1.9 (4.4)
Americanb 9.6 6.7 18.6 10.0 (4.7) (8.3) (8.2) (2.1) (7.4)
Southwest 16.6 11.1 11.0 6.1 4.2 2.5 1.1 3.8 1.0
ROA (%)c
Uniteda 8.7 10.6 14.1 3.0 1.6 (1.9) 2.2 0.6 (3.5)
Delta 11.5 12.1 14.7 1.2 4.8d 2.3 2.0 1.4 (2.8)
Americanb 8.0 10.3 12.8 9.7 (3.0) (8.8) (8.3) (2.1) (5.8)
Southwest 12.9 15.2 16.3 9.2 6.3 2.3 1.0 3.0 0.7
Notes:
a AMR until 2014, American Airlines Group after 2014.
b UAL Corp. until 2010, United Continental Holdings after 2014.
c Net income/End of period total assets.
d Based upon pre-tax net income.

406 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
50.0
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
20
09
20
11
20
13
20
15
20
17
55.0
60.0
65.0
70.0
75.0
80.0
85.0
90.0
95.0
Load factor
Breakeven
load factor
FIGURE 3 Load factor in the US airline industry, 1978–2017
Source: Air Transport Association, annual economic reports (various years); Bureau of Transportation Statistics.
0
5
10
15
20
25
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2017
Current prices
Constant 1984 prices
FIGURE 4 Average fares in the US airline industry (cents per revenue passenger
mile), 1960–2015
Source: Bureau of Transportation Statistics.

CASE 4 ThE US AIRLINE INdUSTRY IN 2018 407
Firm Strategy
Changes in the structure of the airline industry during the past three decades were pri-
marily an outcome of the strategies of the airlines as they sought to adjust to the con-
ditions of competition in the industry and to gain competitive advantage.
Route Strategies: The Hub-and-Spoke System
During the l980s, the major airlines reorganized their route networks. Systems of
point-to-point routes were replaced by hub-and-spoke systems, whereby each airline
concentrated its routes on a few major airports. These hubs were linked by frequent
services using large aircraft. Smaller cities were connected to these hubs by shorter
routes using smaller aircraft. The hub-and-spoke system allowed greater efficiency
through reducing the total number of routes needed to link the airports served, con-
centrating traveler and maintenance facilities into fewer locations, and permitting larger,
more cost-efficient aircraft to be used for inter-hub travel. The system also allowed each
major carrier to establish dominance in a particular regional market. Table 2 shows air-
ports where a single airline held a dominant market share in 2017. The hub-and-spoke
system also created a barrier to the entry of new carriers, who often found it difficult
to obtain gates and landing slots at the major hubs. These hub-and-spoke networks of
the major airlines also involved alliances with local commuter airlines. American Eagle,
United Express, and Delta Shuttle were franchise systems established by American,
United, and Delta, respectively.
Mergers
Mergers and acquisitions between airlines have been frequent (see Figure 6)—in many
cases, acquisition was an alternative to bankruptcy for failing airlines. Since 2007, a more
permissive attitude from the Department of Justice resulted in the pace of consolidation
10
%
Return on capital
(ROIC)
8
6
4
2
0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Cost of capital
(WACC)
FIGURE 5 Return on invested capital (ROIC) and weighted average cost of capital
(WACC) for the world airline industry, 1993–2014
Source: IATA.

408 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
TABLE 2 Share of passenger numbers by largest airline at selected US
airports, 2017
City Airline Share of passengers (%)
Atlanta Delta 73.0
Baltimore Southwest 69.9
Miami International American 68.6
Dallas/Fort Worth American 68.5
Charlotte American 60.3
Houston Intercontinental United 52.8
Minneapolis–St. Paul United 52.8
Newark United 49.9
Detroit Delta 47.1
Philadelphia American 44.8
Seattle Alaska 40.9
San Francisco United 32.2
Source: Bureau of Transportation Statistics.
American
TWA
Ozark
America West
Allegheny
Piedmont
United
Pan American
Continental
People Express
Texas International
Eastern Airlines
Delta
Western
Comair
Northwest
Republic
Southwest
Morris Air
ValuJet
American
United
Delta
Southwest
Acquired by
American 2001
Acquired by
TWA 1986
Bankrupt 1991
Continental and Eastern
acquired by Texas Air 1986
which renamed itself
Continental
Allegheny became US Air;
Acquires Piedmont 1987.
Merges with America
West 2005
Acquired 1993
Airtran
Becomes AirTran in 1997
Acquired 1986
Acquired by Delta 1999
Acquired by
Northwest 1986
Merges with Delta 2009
Continental
merges with
United 2010
Acquired by Southwest 2010.
US Airways
Merge 2014
Acquired 1987
FIGURE 6 Mergers and acquisitions among major US passenger airlines, 1981–2018

CASE 4 ThE US AIRLINE INdUSTRY IN 2018 409
accelerating, with several mergers among leading airlines—Delta acquiring Northwest,
United merging with Continental, and American merging with US Airways (Figure 7).
Yet, despite these combinations, industry concentration declined after 2000—a result
of capacity reduction by the major airlines and market share gains by smaller carriers.
A report by the US General Accounting Office concluded that despite several major air-
line mergers, on most major routes there were between 4 and 5 competitors.6 However,
various alliance arrangements limited competition among airlines. These included
franchise arrangements between major airlines and commuter airlines and codeshare
agreements such as Alaska Airlines with American.7
Pricing
Price competition was typically initiated by the LCCs, which used their efficient cost
structures and a bare-bones service to undercut the “legacy airlines”—the major,
long-distance carriers that were established before deregulation. The majors then
responded with price cuts that were selective by route and by customer segment—a
major objective was to separate price-sensitive leisure customers from price-inelastic
business travelers.
The ability of the major airlines to compete against the budget airlines was limited
by their cost structures, which reflected their extensive infrastructure, restrictive labor
agreements, and older planes. To meet competition from the LCCs, most of the major
airlines set up new subsidiaries to replicate the strategies and cost structures of the
20
30
40
50
60
70
80
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2017
FIGURE 7 Concentration in the US Airline Industry (four-firm concentration
ratio) 1970–2017
Note:
The four-firm concentration ratio (CR4) measures the share of the industry’s passenger miles accounted for by the
four largest companies. During 1970–81, the four biggest companies were United, American, TWA, and Eastern. Dur-
ing 1982–2005, the four biggest companies were American, United, Delta, and Northwest. During 2006–15, the four
biggest were American, United, Delta, and Southwest.
Source: US Department of Transportation.

410 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
budget airlines. These included Delta’s Song (1993), and United’s Ted (1994), and Con-
tinental’s Continental Lite (1994)—all were failures.
During the past two decades, the quest to be price-competitive has resulted in the
legacy airlines adopting many of the operational practices of the LCCs. These have
included charging separately for baggage, seat reservations, and refreshments. Baggage
and reservation change fees collected by US airlines increased from $1.4 billion in 2007
to $7.6 billion in 2017. They also renegotiated union contracts, terminated inefficient
working practices, abandoned unprofitable routes, and reduced staffing levels. In many
instances, radical cost cutting was achieved during Chapter 11 bankruptcy.
The Quest for Differentiation
Under price regulation, airlines competed through branding, customer service, and
in-flight food and entertainment. Deregulation exposed the myth of customer loyalty:
most travelers found little discernible difference among the offerings of different major
airlines—their choice of airline was determined mainly by price and convenience. As
amenities for economy-class travelers were cut, differentiation efforts became focused
upon first and business-class travelers.
The most successful loyalty-building initiative was the introduction of frequent-flyer
schemes during the 1980s. These schemes encouraged customers to concentrate their
air travel on a single airline. Unredeemed frequent-flyer miles represented a substantial
financial liability for the airlines. American’s liability from its AAdvantage program in
2015 was estimated at $1.8 billion.8
The dominance of cost leadership strategies in airlines was challenged by several
recent entrants, which sought to combine low operating costs with a superior service
offering. Jet Blue and Virgin America achieved high passenger satisfaction ratings as a
result of superior cabin ambience, in-seat entertainment, and catering.
The Industry in 2018
The Airlines
At the beginning of 2018, the US airline industry (excluding charter and cargo airlines)
comprised 12 “mainline” airlines, 21 “regional” airlines, and 32 “commuter” airlines.
Table 3 shows operating data for the 14 biggest airlines. The industry was dominated
by four major airlines: American, Delta, United, and Southwest. The market presence
of the legacy carriers—American, Delta, and United—was augmented by their alliances
with smaller airlines. These three were also core members of international airline alli-
ances: American with Oneworld, Delta with SkyTeam, and United with Star Alliance.
Market for Air Travel
Airlines were the dominant mode of long-distance travel in the United States. For
shorter journeys, cars provided the major alternative. Alternative forms of public
transportation—bus and rail—accounted for a small proportion of journeys in excess
of a hundred miles.
The Federal Aviation Administration System forecast the US airline market (in terms
of RPMs) to grow at an annual rate of 2.4% between 2017 and 2037, with domestic
RPMs growing at 2.0% a year and international RPMs at 3.4% a year.

CASE 4 ThE US AIRLINE INdUSTRY IN 2018 411
Changes were occurring within the structure of demand. Of concern to the airlines
was the erosion of the segmentation between business and leisure customers. Conven-
tional wisdom dictated that the demand for air tickets among leisure travelers was fairly
price-elastic, whereas that of business travelers was highly inelastic. Hence, airlines
could cross-subsidize low fares for leisure travelers with expensive first and business
class seats and full-price, flexible economy class tickets for business travelers. However,
the number of organizations providing premium-class air travel to their employees was
shrinking.9
Changes in the distribution of airline tickets contributed to increased price compe-
tition. Traditional travel agencies had been replaced by online retailers—most prom-
inently Expedia and Priceline—and by direct online sales by the airlines. Although
airlines had benefited from a sharp reduction in travel agents’ commission rates, the
new price transparency greatly increased travelers’ responsiveness to fare differentials.
Cost Conditions
The structure of operating costs is shown in Table 4. Most of the industry’s costs were
fixed in the short term: they varied little with fluctuations in demand. For example,
with union contracts, it was difficult to reduce employment and hours worked during
seasonal and cyclical slack periods. The need to maintain flight schedules meant that
TABLE 3 Operating statistics for US airlines, 2014 and 2017 (domestic flights only)
Airline
Market share
(%)a
Passenger numbers
(millions)
Load factor
(%)
2017 2014 2017 2014 2017 2014
Southwest 18.4 16.9 154.2 126.7 84.1 82.8
Delta 16.5 16.8 120.9 106.2 87.1 86.8
American 18.2 12.4 116.3 66.4 85.1 85.0
United 14.7 15.1 80.5 64.7 86.0 86.1
JetBlue 5.5 5.1 32.4 26.4 84.8 84.7
Alaska 4.7 4.3 24.0 19.2 85.6 85.6
Spirit 3.4 2.1 22.0 12.6 83.6 86.8
SkyWest 2.7 2.3 34.2 26.0 84.1 83.5
Frontier 2.5 1.7 15.9 11.3 86.6 89.8
Virgin America 1.9 1.6 8.2 6.3 84.3 82.4
Allegiant 1.6 1.3 12.1 8.1 84.2 89.3
Hawaiian 1.5 1.6 10.0 9.1 88.6 85.0
ExpressJet 1.1 2.3 14.2 28.0 77.9 81.4
Envoy 0.8 1.2 10.7 14.7 77.2 77.5
Notes:
a Based upon available passenger miles.
Source: Bureau of Transportation Statistics.

412 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
planes flew even when occupancy was very low. An implication of this cost structure
was that, during times of excess capacity, the marginal costs of filling empty seats on
scheduled flights was extremely low. Major cost items included:
● Labor Average pay in the industry was 58% above the average for US
industry as a whole. Pension and other benefits were also more generous than
in most other industries. Labor costs for the legacy airlines were boosted by low
labor productivity resulting from rigid working practices that were part of the
employment contracts agreed with unions. At the three legacy carriers, average
pilot flying time was 42.8 hours a month, compared to 55.3 at the LCCs. One
outcome of the Chapter 11 bankruptcies of the legacy airlines was the negotia-
tion of reduced benefits and more flexible working practices.
● Fuel was the industry’s most volatile cost item. As a result, most airlines used
forward contracts, options, and other derivatives to hedge against fluctuating
oil prices. Delta went even further and acquired a refinery in 2011.10 The fuel
efficiency of modern planes was a major factor in conferring a cost advantage
on airlines with the youngest fleets.
TABLE 4 Operating costs in the US airline industry
% of total operating expenses
Cost item
Increase in cost
2000–17 (%) 2017 2014
Labora 188.4 23.8 24.7
Fuelb 283.7 25.5 28.0
Cost of aircraftc 93.3 7.0 n.a.
Professional servicesc 120.8 8.6 7.5
Food and beveragesd 73.8 2.0 1.5
Landing feese 142.0 2.1 1.9
Maintenance materialf 81.6 1.5 1.9
Insuranceg 52.4 0.2 0.3
Passenger commissionsh 23.1 1.0 0.9
Communicationi 70.5 0.9 0.8
Advertising and promotionj 59.4 0.7 0.6
Notes:
a Compensation per employee;
b cost per gallon;
c per available seat mile;
d per revenue seat mile;
e per ton landed;
f per aircraft block hour;
g aircraft and nonaircraft;
h as % of passenger revenue;
i per enplanement;
j per revenue passenger mile.
Source: Airlines for America, “Passenger Airline Cost Index: US. Passenger Airlines.”

CASE 4 ThE US AIRLINE INdUSTRY IN 2018 413
● Equipment Aircraft were the biggest capital expenditure item for the air-
lines, in 2018, with list prices for commercial jetliners ranging from $68 mil-
lion for a Boeing 737 to $440 million for an Airbus A380. Although Boeing and
Airbus competed through discounts and generous financing terms, the extent
of price competition during 2016–18 was limited by the size of their bulging
order books. Moreover, their major source of profits was aftermarket sales.
Boeing’s return on equity during 2010–17 averaged 54%; Airbus’s was 9%. For
smaller planes, competition was stronger: the smallest jets supplied by Boeing
and Airbus overlapped with the largest planes of Bombardier and Embraer. The
airlines’ weak finances and high borrowing costs meant a preference for leas-
ing rather than purchasing planes. The world’s two biggest aircraft owners were
both leasing companies: GECAS (a subsidiary of General Electric) and ILFC (a
subsidiary of AIG).
● Airport facilities Airports are key players in US aviation. Only the larg-
est cities are served by more than one airport and, despite the growth in air
transport, Denver International Airport is the only major new airport to have
been built since 1978. Most airports are owned by municipalities and generate
substantial revenue flows for their owners. In 2017, the airlines paid over $3
billion to US airports in landing fees and a further $3.6 billion in passenger
facility charges. Landing fees were based on aircraft weight. New York’s La
Guardia airport has the highest landing fees in the US, charging about $7500
for a Boeing 777 to land. Four US airports—JFK and La Guardia in New York,
Newark, and Washington’s Reagan National—are officially “congested” and
take-offs and landings in those airports are regulated by the government.
At these airports, slots have been allocated to individual airlines, who have
subsequently assumed de facto ownership.11
Cost differences between airlines were primarily related to the two dominant business
models in the industry. The major carriers, with their hub-and-spoke route configura-
tions, extensive international connections and multiclass traveler segmentation, had
higher costs than the LCCs with their point-to-point connections, single aircraft type,
and minimal traveler services. The other factor accounting for the LCCs’ cost advantage
was their youth: the legacy airlines were burdened by their inherited structures and
the costs of retirees’ pensions and health care benefits. Economies of scale in airlines
are relatively minor; economies of network density are of greater significance: the
greater the number of routes within a region, the easier it is for an airline to gain fuller
utilization of aircraft and crews, as well as passenger and maintenance facilities. In
practice, cost differences between airlines are determined more by managerial, institu-
tional, and historical factors than by economies of scale, scope, or density. The indus-
try’s traditional cost leader, Southwest, created the LCC business model comprising:
point-to-point service from minor airports, single-class planes, limited customer ser-
vice, a single type of aircraft, and job flexibility by employees. Southwest, JetBlue, and
Spirit Airlines continue to have the industry’s lowest operating costs per available seat
mile (ASM), despite flying relatively short routes. However, as shown in Table 5, the
cost gap between the legacy carriers and the LCCs has narrowed.
Managing costs requires meticulous attention to capacity utilization—the principle
source of losses is load factors falling below breakeven level. Moreover, excess capacity
creates incentives to cut prices in order to fill empty seats. Adjusting fares to optimize
load factors and maximize the revenue for each flight is the goal of the airlines’ yield
management systems—sophisticated computer models that combine capacity, sales
data, and demand forecasts to adjust pricing continually.

414 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Notes
1. “Airline Shares Drop on Capacity Expansion Plans,” Wall
Street Journal ( January 24, 2018).
2. International Air Transport Association, Vision 2050
(Singapore: IATA, February 2011).
3. Berkshire Hathaway 2007 Annual Report.
4. “Airline Stocks Lifted By Buffett’s Buys,” Wall Street
Journal (February 15, 2017).
5. “Airline capacity: plane sailing,” Financial Times
(February 18, 2018).
6. United States Government Accountability Office,
Report to Congressional Requestors: Airline Competition
( June 2014).
7. As a condition of its acquisition of Virgin America in 2016,
Alaska was required to limit its codeshare arrangement
with American.
8. https://www.traveldatadaily.com/american-ffp-analysis.
Accessed February 23, 2018.
9. “CEOs Fly Coach? Business Travel Turns Frugal,” Wall
Street Journal (February 12, 2013).
10. “Delta Buys Refinery to Combat Fuel Costs,” Financial
Times (April 30, 2012).
11. “Airport Heist: The Rules on Allocating Take-off and Landing
Slots Favor Incumbents,” Economist (November 15, 2017).
12. Lex, op. cit.
TABLE 5 Operating data for the larger airlines, 2006, 2014, and 2017
Airline ASMs (billion) Load factor (%)
Operating
revenue per Operating expense
per ASM (cents)ASM (cents)
2006 2014 2017 2006 2014 2017 2006 2014 2017 2006 2014 2017
American 175.9 157.4 243.4 80.2 82.1 83.1 12.5 17.3 17.1 12.5 15.8 15.4
United 139.5 212.0 232.2 82.1 83.8 83.2 13.1 18.2 16.1 13.1 17.3 14.5
Delta 124.0 207.2 228.0 79.0 85.6 86.0 13.0 19.0 17.9 13.6 16.8 15.3
Southwest 92.7 122.6 152.2 73.0 82.5 84.1 9.5 13.0 13.7 8.5 12.4 11.4
JetBlue 28.5 45.0 55.1 81.6 84.0 84.9 7.6 12.9 12.5 7.5 11.9 10.5
Alaska 23.2 32.4 42.0 76.6 85.7 85.0 11.3 16.6 15.2 11.5 14.0 11.8
Note: The data relate to both domestic and international operations.
Source: Bureau of Transportation Statistics.

Case 5 The Lithium-Ion
Battery Industry*
During the early part of 2018, the Tesla Gigafactory near Reno, Nevada, was ramping
up its production of lithium-ion batteries (LIBs) as it sought to be “the highest-
volume and lowest-cost source of lithium-ion batteries in the world.”1 Within the
plant, the cells were produced by Panasonic Corporation and then assembled into
battery packs by Tesla. At full capacity, the plant would produce 35 gigawatt hours
(GWh) of lithium-ion cells—equivalent to about one-third of the world’s total
output in 2017.2
The project was part of a surge of investment in production capacity for LIBs in antic-
ipation of the growing demand for electric vehicles (EVs) and for stationary storage of
electricity. Tesla’s projected annual output of 500,000 cars by 2019 would alone require
the entire battery output of the gigafactory. However, while the Tesla/Panasonic giga-
factory had attracted massive media attention, the main center of activity was China.
In mid-2017, planned additions to lithium-ion battery capacity in the United States
amounted to 36.6 GWh; in China, planned new capacity was 320.9 GWh.3
Given the pace at which auto makers were introducing new models of plug-in EVs,
and governments were planning the phasing out of petroleum-fueled vehicles, there
seemed little doubt about the likelihood of a massive growth in the demand for LIBs.
Indeed, a key concern among auto manufacturers was the ability of the battery industry
to meet the anticipated growth in output of EVs.
Profitability was a different matter. During 2017, it appeared that most manufacturers
were earning thin margins on their production of LIBs, and some were making losses.
Future profitability would depend critically on the balance between demand and pro-
duction capacity. It would also depend on the costs of raw materials and components.
Major uncertainties related to the adequacy of supplies of lithium and cobalt and key
components such as cathodes and separators.
Lithium-Ion Batteries
Research into lithium batteries began in 1912, but it was not until the early 1970s when
the first nonrechargeable LIBs became commercially available. Sony first introduced
rechargeable LIBs in 1991 to power its CCD-TR1 camcorder. Since then, LIBs have
become the dominant means of power storage for mobile electronic devices.
Lithium is the lightest of all metals, has the greatest electrochemical potential, and
provides the largest energy density for weight. The energy density of an LIB is about
twice that of a nickel–cadmium battery. The cell voltage of 3.6 volts (three times that
* This case was prepared by Robert Grant assisted by Nitish Mohan.

416 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
of nickel–cadmium batteries) allows single-cell battery packs—as used in most mobile
phones. Other advantages include low maintenance (no scheduled cycling is required
to prolong battery life), self-discharge is less than half that of nickel–cadmium, they are
long-lasting (battery life extends to more than 1000 recharging cycles), and present few
hazards when disposed of.
Their major disadvantage is safety. Lithium is a highly reactive metal, and while the
lithium compounds used in batteries are less volatile than lithium metal, they are still
flammable. Each battery pack requires a protection circuit to control voltage during
charge and discharge and to monitor cell temperature. Spontaneous combustion of
LIBs affected Sony’s laptop computers (2006), the Boeing 787 (2013), and Samsung’s
Galaxy Note 7 (2016).
The industry’s product standard is the 18650: a cylindrical cell 65 millimeters long
and 18 millimeters diameter. It powers most of the world’s mobile devices. While
most automakers were developing larger cells for use with their EVs, Tesla chose the
standard 18650 for its battery packs (although it later switched to the slightly larger
2170 cell, developed jointly with Panasonic, for its Model 3).
Manufacturers are constantly improving lithium-ion batteries. Changes in design
and electrochemistry allow continual increases in the energy density of batteries.
However, technological development involves a host of minor improvements,
not major breakthroughs. The rate of technical improvement tends to be around
5% each year. Moreover, many technical developments involve improvements in
some performance dimensions at the expense of others. For example, lithium–
polymer batteries use a solid or gel polymer electrolyte, which offer much greater
design flexibility (including ultrathin batteries) but with lower energy density and
higher cost.
The Market for LIBs
Until 2011, LIBs were used almost exclusively for portable electronic and electrical appli-
ances: laptop computers, phones, power tools, and the like. The growing demand for
EVs and switch from nickel–metal hydride (NiMH) to LIBs has meant that EVs will soon
become the biggest users of lithium-ion batteries. Even if the switch over from internal
combustion engines to EVs is slow, the size of electric vehicle battery packs (the Tesla
85 kWh battery pack has 7104 cells) means that EVs will dominate the demand for
lithium-ion batteries. The rate at which EVs will displace fuel-burning vehicles is highly
uncertain (in 2017 plug-in EVs accounted for 1.2% of world production of automobiles
and light trucks): forecasts of EV sales in 2040 range from 12 million (ExxonMobil)
to 65 million (Bloomberg). At the beginning of 2018, most forecasts of EV sales were
being revised upward: UBS raised its forecasts for global EV sales from 14% to 16%
of total cars produced by 2025; components maker, Valeo, raised its “base scenario”
forecast from 5% to 6% to “over 10%.”4 Figures  1 and  2 show projections of future
demand for LIBs.5
A further source of demand uncertainty relates to the use of LIBs for stationary
electrical storage in individual buildings (“behind-the-meter” electrical storage) and for
grid storage by electric utilities. The successful completion by Tesla of a 129 megawatt-
hour storage facility for South Australia—the world’s biggest battery—in December
2017 had led to a surge of interest by electrical grid operators in the potential for such
batteries to bridge the imbalance in the supply and demand for solar and wind gener-
ated electricity.

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 417
The rate of demand growth for lithium-ion batteries—especially the stationary storage
demand—is sensitive to the rate at which LIB costs continue to fall. Between 2010 and
2017, prices declined by an average of 18% a year—a result of technical improvements
and scale economies and squeezed profit margins. This trend is expected to continue
(see Figure 3).
0
50
100
150
200
250
300
350
2016 2017 2018 2019 2020 2021 2022 2023 2024
Personal electronics EVs Home & grid storage
FIGURE 1 The demand for lithium-ion batteries, 2016–2024 (in gigawatt hours)
0
200
400
600
800
1000
1200
1400
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
GWh
FIGURE 2 Demand for automotive lithium-ion batteries 2015–2030 (in gigawatt hours)
Source: Bloomerg new energy finance.
Source: Bloomerg.

418 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
$1000
900
800
700
600
500
400
300
200
100
0
2010 2013 2016 2019 2022 2025 2028 2030
Per Kilowatt Hour
FIGURE 3 Cost of lithium-ion battery packs, 2010–2016 with forecasts for
2017–2030 ($/kWh)
The Manufacture of Lithium-ion Batteries
The leading producers of LIBs are Japanese, South Korean, and Chinese companies.
Estimates of market shares by company vary considerably according to whether
market shares are measured by sales or production and whether the units are quantity
or value. However, the industry big-five are Panasonic, LG Chem, BYD, Samsung
SDI, and CATL (see Figure 4). In addition to the big, global players, there are many
smaller manufacturers—especially in China where more than 140 companies pro-
duce LIBs or components for them. Exhibit 1 provides information on the leading
suppliers of LIBs.
During 2012–16 a slower-than-expected growth in sales of EVs worldwide meant
that battery manufacturers expanded capacity ahead of demand. The resulting excess
capacity caused intense price competition to the point where several battery manufac-
turers were making losses on sales of LIBs.
0
0.5
1
1.5
2
2.5
3
3.5
4
BYD Panasonic LG
Chemical
Samsung
SDI
CATL Lishen GS Yuasa ATL
Sales ($ billions)
FIGURE 4 Sales of lithium-ion batteries by manufacturer, 2016

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 419
EXHIBIT 1
Major Suppliers of Lithium-Ion Batteries
PANASONIC established itself as industry leader in LIBs
through its strong position in consumer electronics.
Panasonic’s technical innovations have made the bat-
teries thinner and lighter for use in mobile devices. Its
partnership with Tesla has allowed it helped to extend
its technological and market leadership into automotive
and stationary storage batteries.
LG CHEM, a member of the LG Group, is the largest
Korean chemical company. It began mass production
of LIBs in 1999 and by 2011 had an annual production
capacity of 1 billion cells. LG Chem’s US subsidiary in
Holland, Michigan, began manufacturing battery packs
for General Motors and Ford in 2013; it also has supply
agreements with Volkswagen, Daimler, Volvo, and Hyundai.
BYD was China’s biggest producers of LIBs, in 2016
mostly for its own EVs. BYD produces the world’s cheap-
est battery packs, although their energy density is lower
than those produced by Tesla/Panasonic. It is also highly
vertically integrated: during 2016 it backward integrated
into lithium mining by acquiring 18% of Zhabuye
Lithium, a lithium and boron mining company in Tibet,
for $31 million; it is seeking secure supplies of lithium in
other parts of the world.
CATL, Contemporary Amperex Technology Ltd., is
based in Ningde, China. It was spun off from Amperex
Technology Limited in 2011. It supplies batteries for
iPhones and other Apple products and battery packs for
neighborhood electric vehicles (NEVs), passenger cars,
and buses. With more than 3700 R&D personnel, CATL is
a technological leader in LIBs. An IPO in June 2018 valued
CATL at $12.3 bn. and will allow capacity expansion from
17 GWh in 2017 to over 50 GWh by 2021.
SAMSUNG SDI is a separately quoted battery and
electronic component supplier within the Samsung
group. It supplies small LIBs for mobile devices (mainly to
Samsung Electronics) and large LIB packs for automotive
applications. Its 2015 acquisition of Magna’s automotive
battery business allowed it to become a full-system
supplier of battery packs for EVs.
LISHEN. Tianjin Lishen Battery Co., Ltd. supplies
LIBs for consumer electronic products, power tools, EVs,
electric bicycles, and energy storage systems. It is con-
trolled by state-owned China Electronics Technology
Group. To support the Chinese government’s EV strategy,
Lishen built new EV battery plants in Tianjin, Suzhou, and
Qingdao in 2016 to triple its output to 10 gigawatts by
early 2018.
GS YUASA CORP. is one of the world’s biggest sup-
pliers of vehicle batteries. It acquired the lead-acid bat-
tery businesses of Exide and Lucas, then diversified into
LIBs for automotive and aviation applications. It pro-
duces LIBs at five plants including a joint-venture with
Bosch in Germany. During 2017, it announced that it was
developing a new LIB that would double the range of its
battery packs. During 2018, it was building a new plant
in Hungary.
AUTOMOTIVE ENERGY SUPPLY CORPORA-
TION (AESC) was formed in 2007 as a joint venture
between NEC Corp. and Nissan to supply batteries to
Renault- Nissan. Its main plant is at Zama City, Japan,
close to Nissan’s main production complex. Dur-
ing 2017, it was acquired by GSR Capital, a Chinese
private equity firm.
ATL is a Hong-Kong-based international company
specializing in design, manufacture, sales, and
marketing of rechargeable lithium ion/polymer bat-
tery cells, battery packs and systems. Its lithium bat-
tery products are widely used mainly in consumer
electronics products and cordless tools; it is expand-
ing its sales of battery packs for electrical vehicles and
electrical energy storage.
WANXIANG GROUP is China’s biggest supplier of
automotive parts. It began producing LIBs in 2000, ini-
tially for electric buses. In 2012, Wanxiang acquired A123
Systems, the bankrupt US producer of lithium batteries,
which uses a proprietary nanophosphate technology
initially developed at MIT.

420 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
During 2017 and 2018, the major LIB producers were in a race to add capacity in
anticipation of the upsurge in demand from the automakers. While Tesla had taken the
lead and captured most of the publicity with its Nevada gigafactory, most of the new
investment was in China. Among the priorities for China’s 13th Five-Year Plan for 2016–20
was growing the auto industry and curbing emissions—hence a major focus on the
development of EVs. This meant that expanding the production of LIBs was a key com-
ponent of industrial strategy.6 In response, Japanese and South Korean manufacturers
were expanding their production capacities in order to maintain their market posi-
tions. Figure 5 shows some of the main LIB plants currently under construction, while
Figure 6 shows projections of capacity for the leading manufacturers.
0 5 10 15 20 25 30 35
Tesla/Panasonic, Reno NV
CATL, Huxi, China
Guoxuan, Nanjing, China
BYD, Kengzi Plant 3, China
Lishen, Hangzhou Plant 2, China
LG Chem, Nanjing, China
Microvast, Huzhou, China
LG Chem, Ochang
CATL, Liyang, China
Optimum Battery, Weinan, China
Plant capacity (GWh)
FIGURE 5 Major lithium-ion battery plants under construction at the
beginning of 2018
0
LG
C
he
m
Pa
na
so
ni
c
BY
D
CA
TL
Lis
he
n
GS
Yu
as
a
M
icr
ov
as
t
Gu
ox
ua
n
Hi
gh
-T
ec
h
AE
SC
Op
tim
um
Ba
tte
ry
Sa
m
un
g
SD
I
10
20
30
40
50
60
2017 2021
FIGURE 6 Lithium-ion battery manufacturing capacity, 2017 and 2021
Source: Cairn ERA, CATL, Bloomberg, company websites.

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 421
The sheer scale of Chinese investment in production capacity ensures that China
will be the world’s dominant manufacturing center for LIBs for the foreseeable future.
Table 1 shows implications of current investment plans for the LIB production capacity
by country.
Technology
Differences in technical know-how among manufacturers were indicated by differ-
ences in energy density (see Figure 7).
These differences reflected both differences in experiential learning and differences
in proprietary technology. During 2000–04, US patent applications relating to LIBs
TABLE 1 Lithium-ion battery production capacity by country
at the end of 2017 (including announced capacity additions)
Country Capacity (GWh)
China 217.2
United States 46.9
South Korea 23.1
Japan 14.0
Poland 5.0
Hungary 1.7
United Kingdom 1.4
France 1.1
Russia 1.0
Germany 0.7
250
200
150
100
50
0
Panasonic LG Chem AESC Li-Tec Samsung Guoxuan Lishen
Tianjin
Li Energy Toshiba
FIGURE 7 Energy density of lithium-ion batteries by manufacturer (watt-hour
per kilogram)

422 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
were about 170 annually; by 2010–14, they had risen to 450 annually. Of the total
patent applications, 48% relate to electrodes, 35% to the manufacture of secondary
cells, and 8% to the construction or manufacturing processes of nonactive parts.
The companies conducting research into LIBs include battery manufacturers, users
of batteries (automobile producers in particular), and the suppliers of materials and
components to the industry. Table 2 shows the most active patenting companies.
New Battery Technologies
In the same way that LIBs have displaced lead-acid, nickel–cadmium, and nickel–metal
hydride batteries, the demise of the LIBs has been long anticipated. Alternative bat-
tery technologies offer attractions in energy density in terms of power output per unit
of volume (size efficiency) and power output per unit of weight (weight efficiency),
but none has yet been commercialized to the extent that it emerged as a realistic
TABLE 2 Leading assignees for worldwide patents relating
to lithium-ion batteries, 2016
Company No. of patents
1. Samsung 1258
2. Panasonic 1224
3. Toyota 1127
4. Hitachi 790
5. LG Chem 632
6. Sony 493
7. Mitsubishi 474
8. NEC 325
9. Nissan Motor 309
10. Sumitomo 245
11. Shin-Kobe Electric 190
12. Toshiba 162
13. Robert Bosch 153
14. NOK Insulators 148
15. TDK 133
16. AIST * 128
17. Ube Industries 107
18. Mitsui 101
19. Zeon 95
20. GS Yuasa 91
Note:
*AIST is National Institute of Advanced Industrial Science and Technology, Japan.

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 423
challenge to the dominance of the LIBs, which continue to benefit from decades of
development involving thousands of incremental improvements and the accumulation
of deep manufacturing expertise.
Alternative battery technologies include variants on lithium-ion technology and
batteries using distinctly different chemistries:
● Solid-state lithium-ion batteries use a solid electrolyte, which offer
improved safety and ease of assembly and greater energy density. These batteries
are being developed by the UK appliance manufacturer Dyson (which is also
developing a plug-in electric car), BMW (in collaboration with Solid State), and
by Toyota—which intends commercial production by the early 2020s.
● Lithium metal batteries use lithium metal for their negative electrode.
They offer energy density of 350 or 400 watt-hours per kilogram, as compared
to 150 watt-hours per kilogram for LIBs—but are about 10 years away from
commercialization.
● Lithium air batteries Building upon research at MIT, research teams at
Tesla’s Gigafactory, Argonne National Laboratory and Peking University are
working on prototypes of lithium air batteries, which offer greater durability,
and faster recharging than conventional LIBs. Development being undertaken
by Polypus Battery Company envisages a battery will allow EVs to travel
500 miles on a single charge.
● Lithium sulfur batteries are cheaper, lighter, and have double the energy
density of LIBs; however, commercialization has been hampered by their
tendency to become unstable over time hence, limiting widespread adoption.
● Zinc–bromine flow batteries offer faster charging, lower lifetime cost,
but lower energy density than LIBs. They may offer an alternative to LIBs for
stationary electrical storage.
In addition, fuel cells offer a distinctive alternative to battery-powered EVs. Fuel cells
offer exceptional energy generation, but their dependence on liquid hydrogen has so
far prevented commercialization.
The Supply Chain for LIBs
The value chain for LIBs is shown in Figure 8. During 2017 and early 2018, the rapid
expansion of demand for LIBs was placing considerable strain on the supplies of
materials and components for LIBs.
Raw Materials
Among raw materials there were emerging shortages of both lithium and cobalt.
Lithium was mined in the form of lithium brine, which accounted for about half the
world’s supply, and spodumene, a crystalline ore, which accounted for most of the
remainder. While lithium is plentiful within the earth’s crust—with large deposits in
Australia, Bolivia, Chile, and Argentina—its production is concentrated into a small
number of locations. In South America, production is almost wholly through extracting
lithium brine; elsewhere lithium is extracted through hard-rock mining. Table 3 shows
the leading producer countries.

424 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Battery
packs
Processed
materials:
lithium
carbonate,
lithium
hydroxide
Raw materials:
lithium brine
spodumene,
cobalt, graphite
Components:
cathodes,
electrodes,
separators
Cells
Main lithium
producers:
Australia, Chile,
Argentina, China
CR4 = 86%
Lithium
processing
mainly in
China
CR4 = 75%
Production mainly in
China, and to a
lesser degree in Japan
and South Korea.
CR4 in cathodes =
42%
CR4 in electrolyte =
50%
Big-3 producers
in 2017 were
China, Japan
and South Korea.
CR4 = 65%
Small battery packs
produced by LIB
manufacturers and
mobile device makers.
Large battery packs
produced by LIB
manufacturers, auto
components suppliers
and auto assemblers.
FIGURE 8 The value chain for lithium-ion batteries
TABLE 3 Lithium-producing countries
Country
Production
(tonnes, 2017)
Reserves
(tonnes) Notes
Australia 18,700 1.5m Greenbushes, jointly owned by
China’s Tianqi Group and US-based
Albemarle, is the world’s largest
hard-rock lithium mine. Other mines
operated by Pilbara Minerals and
Galaxy Resources.
Chile 14,100 16.4m The leading producer, SQM, produces
lithium salts from the brine deposits
found beneath the Atacama Desert.
Argentina 5700 18.9m The main production area is the Salar del
Hombre Muerto salt flat.
China 3000 3.5m Production—mainly in western Tibet—
covers only a small portion of China’s
lithium consumption. Sichuan Tianqi
Lithium and Jiangxi Ganfeng Lithium
are major producers.
Zimbabwe 1000 0.2m Bikita Minerals is the main producer.
Portugal 400 0.6m Production is located mainly in the
Goncalo aplite-pegmatite field.
Brazil 200 0.5m Production is mainly in the north,
including Minas Gerais and Ceara.
United States n.a. 0.4m Rockwood Holdings owns the sole
production site in Nevada, which was
acquired by Albemarle in 2015. Other
companies (e.g., Darin Resources
and Pure Energy Minerals) conduct
exploration.

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 425
The industry was also highly concentrated with the top five producers accounting for
about 75% of world lithium output. The growing demand for LIBs encouraged a surge of
acquisitions in the lithium mining sector including Albemarle’s acquisition of the world’s
largest lithium producer, Rockwood Holdings, in July 2014 and Tianqi Lithium (China)
acquiring a stake in SQM (Chile) in September 2016. Fear of a shortage of lithium has
encouraged both battery makers and automobile producers to establish alliances, supply
agreements, and partnerships with lithium miners. In January 2018, Toyota took a 15%
equity stake in Orocobre. Table 4 shows the major producers of lithium.
TABLE 4 Leading lithium-producing companies
Company
World market
share, 2016 Notes
Albemarle 22% A US-based specialty chemicals business with lithium sales of
$1.02bn. in 2017. With the takeover of Rockwood, Albemarle
acquired lithium mining operations in Nevada, Chile, and Australia.
its plan to expand lithium production in Chile, Albemarle’s
lithium production would increase from 55,000 tonnes in 2016 to
165,000 tonnes in 2021.
SQM 21% Revenues from lithium were $645m in 2017 on which it earned an
operating margin of 21%. Problems with the Chilean government
included a dispute over its mining leases and bribery and tax
evasion allegations that resulted in the resignation of its CEO.
In 2017, SQM sold $49,700 tonnes of lithium cambonate and
derivative products. By 2021, its annual production capacity
would expand to 180,000 tonnes.
FMC 10% Operates lithium production in the Salar del Hombre Muerto in
Argentina. Lithium sales were $347m in 2017 with operating
profits of $41m.
Tianqi
Lithium
Industries
10% Formerly Sichuan Tianqi Lithium. A subsidiary of Chengdu Tianqi
Group, headquartered in Chengdu, China. A backward integrated
producer of the lithium battery market. The world’s largest hard-
rock lithium miner. Acquired 49% of Talison Lithium owner of the
Greenbushes mine in Australia, in 2012; subsequently sold its stake
to Rockwood.
Jiangxi
Ganfeng
Lithium
12% China’s #2 lithium producer based in Xinyu. Interests outside of China
include 14.7% of International Lithium and an offtake agreement
with Australia’s Reed Industrial Minerals.
Other producers include the following:
● Orocobre, based in Brisbane, Australia, mines lithium and borax in Argentina. It rapidly expanded
its lithium production during 2016–17.
● Galaxy Resources. The Australian-based company has lithium extraction projects under
development in Western Australia (Mt Cattlin), Argentina (Sal de Vida), and Quebec, Canada.
● Bacanora Minerals is a Canadian-based company developing the Sonora Lithium Project in
Mexico, with projected output of 35,000 tonnes per annum of battery-grade lithium carbonate.
● Pure Energy Minerals Ltd. is one of several mining companies developing lithium brine projects in
Clayton Valley, Nevada.
● Rare Earth Minerals is developing lithium mining projects in Mexico and the Czech Republic.

426 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
During 2016 and 2017, growing demand for LIBs had caused a rapid rise in the
price of lithium carbonate (Figure 9). Because of the long development lags for new
mines—between 5 and 8 years—supply was price inelastic in the short and medium
term. Although price increases had encouraged new entry, most of these were engaged
in exploration and project development—few had begun production. In February
2018, Mining Feeds listed 22 lithium mining companies quoted on US, Canadian, and
Australian stock markets.7 The requirement for substantial investment over this long
period meant that several recent entrants had gone bankrupt.8
During 2017, attention shifted from lithium to cobalt, a metal used in the production
of electrodes and another potential bottleneck in the LIB supply chain. The world’s
production of cobalt was about 100,000 tonnes in 2016. Glencore estimated that growth
in battery production would increase the demand for cobalt to about 360,000 tonnes.9
During the two years to March 2018, the price of cobalt increased by 280%. How-
ever, because cobalt is produced as a by-product of copper and nickel mining, even
a large rise in the price of cobalt will not necessarily induce expansion in its supply.
Compounding the problem, 60% of the world’s cobalt supply is from the Democratic
Republic of Congo—most of it from the Chinese-owned Tenke Fungurume mine whose
development is hampered by “the lack of rail links, the horrific poverty, violence and
corruption of the country, and the necessity for big power developments.”10 Evidence
of widespread use of child labor in cobalt mining presented ethical challenges for LIB
producers and their customers.
Components
Bottlenecks also existed in the supply of components. In a July 2017 report, Bloomberg
New Energy Finance concluded: “Without the supply chain in place, the battery industry
will not be able to meet future demand. The supply chain for battery components
(cathodes, anodes, electrolyte, and separators) is a complex business. There’s a looming
production capacity shortage for components, particularly the separator. EV sales
growth in China, in particular, is creating separator supply bottlenecks.”11 Figure 10
shows the contribution of different components to the cost of LIBs.
Jul 2016 Jul 2017Jan 2017 Jan 2018
60
80
100
120
140
160
FIGURE 9 The price of lithium carbonate ($ per kilogram), February
2016–February 2018

CASE 5 ThE LIThIuM-ION BATTERY INduSTRY 427
Notes
1. Tesla, Inc. 10K Report for 2017: 9
2. A kilowatt hour (kWh) is a measure of energy, which
represents one thousand watts supplied over one hour. A
megawatt is a million watts. A gigawatt is a billion watts.
3. https://www.bloomberg.com/news/articles/2017-06-28/
china-is-about-to-bury-elon-musk-in-batteries, accessed
October 11, 2017.
4. “Valeo Doubles Forecast for Electric Car Sales,” Financial
Times (February 26, 2018).
5. All forecasts are highly sensitive to the speed of transition
from petroleum to electric propulsion. With world
production of cars and light trucks at around 94 million
annually and an average battery size of 30 kWh, if EVs
account for 25% of total production, battery demand is
225.6 GWh; if EVs account for 25% of total production,
battery demand is 705 GWh. This ignores the potential for
battery-powered large trucks, where battery sizes would
be between 400 and 1200 kWh.
6. “The Breakneck Rise of China’s Colossus of Electric-Car
Batteries,” Bloomberg Business Week ( January 31, 2018).
7. http://www.miningfeeds.com/lithium-mining-report-all-
countries, accessed February 27, 2018.
8. Albemarle, “Global Lithium Market Outlook,” Goldman
Sachs HCID Conference (March 2016).
9. “Glencore Sees Rich Benefits in Battery Growth as Debt
Falls,” Financial Times (August 10, 2017).
10. “Lack of Ethical Cobalt Undermines Tesla Debt Issue,”
Financial Times (August 11, 2017).
11. “Lithium-ion Battery Costs and Market,” Bloomberg New
Energy Finance ( July 17, 2017).
Cathode 26%
Manufacturing 21%
Anode 9%
Module
components 21%
Separator 6%
Electrolyte 4%
Other
materials
13%
FIGURE 10 Cost composition of lithium-ion batteries
Source: Argonne National Laboratories, industry experts.

https://www.bloomberg.com/news/articles/2017-06-28/china-is-about-to-bury-elon-musk-in-batteries

Walmart, Inc. in 2018:
The World’s Biggest
Retailer Faces New
Challenges
In 2018, Walmart was not only the world’s biggest retailer, it was also the world’s big-
gest company in terms of revenue—a position it had first attained in 2000 and had held
for most of the intervening years.
Since going public in 1972, Walmart’s record of growth and profitability was remark-
able. Between 1972 and 2009, its average annual sales growth was 22% and its return
on equity had not fallen below 20%.
Yet, sustaining Walmart’s phenomenal record of growth and profitability was
proving to be an ever more daunting challenge. As Walmart continued to expand
its range of goods and services—into groceries, fashion clothing, music downloads,
online prescription drugs, financial services, and health clinics—it was forced to com-
pete on a broader front. While Walmart could seldom be beaten on price, it faced
competitors that were more stylish (T.J.Maxx), more quality-focused (Whole Foods),
more service-oriented (Lowe’s, Best Buy), and more focused in terms of product
range. In its traditional area of discount retailing, Target was an increasingly for-
midable competitor, while in warehouse clubs, its Sam’s Clubs ran a poor second
to Costco.
However, all these competitive threats were trivial compared to that posed by
online retailing—and, specifically that posed by the world’s emerging retail colossus:
Amazon. During 2017, the turf battle between the two became increasingly acute:
while Walmart expanded its online operations, Amazon shocked the retail world with
its acquisition of Whole Food Markets. In December 2017, the company announced
that it was changing its name from Wal-Mart Stores Inc. to Walmart Inc. reflecting
“the company’s growing emphasis on serving customers seamlessly however they
want to shop: in stores, online, on their mobile device, or through pickup and
delivery.”1
Competition was not the only external threat that Walmart had to deal with. Its
growth had made “The Beast of Bentonville” a bigger target for environmentalists,
antiglobalization activists, women’s and children’s rights advocates, small-business rep-
resentatives, and organized labor, which had long sought to unionize Walmart’s 2.2 mil-
lion employees. In response, Walmart had become increasingly engaged in social and
environmental responsibility, corporate ethics, and government relations—all of which
meant greater involvement of top management with government agencies, external
interest groups, and the media.
These headwinds were reflected in Walmart’s financial performance. During its five
most recent financial years (2014–18), annual sales growth had averaged just 1.3% and
return on equity had dipped below 20% (see Table 1).
Case 6
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 429
Walmart’s success had rested heavily upon its ability to combine huge scale with
speed and responsiveness. Walmart’s increasing size and complexity—including its
presence in 29 countries of the world—threatened this agility. One component of this
agility was its short chain of command and close relationship between top management
TABLE 1 Walmart Inc.: Financial data 2005–18 year ended January 31 ($billion unless
otherwise stated)
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Net sales 285 312 345 375 401 405 419 444 469 476 486 478 481 495
Net sales increase (%) 11.3 9.5 11.7 8.6 7.2 1.0 4.4 5.9 5.0 1.6 2.0 −1.6 0.6 2.9
Gross margin (%) 22.8 23.1 23.5 24.1 24.3 24.9 24.8 24.5 24.3 24.3 24.3 32.8 33.2 32.7
SG&Aa expense as
% of sales
18.0 18.2 18.5 19.1 19.4 19.7 19.4 19.2 19.0 19.3 19.4 20.3 21.0 21.4
Interest, net 0.9 1.2 1.6 1.8 1.9 1.9 2.0 2.1 2.1 2.2 2.3 2.4 2.2 2.1
Income taxes 5.6 5.8 6.2 6.9 7.1 7.4 7.5 7.9 8.8 8.1 8.0 6.5 6.2 4.6
Operating income 17.3 18.7 20.5 22 22.8 24 25.5 26.5 27.7 26.9 27.1 24.1 22.7 22.1
Net income 10.3 11.2 11.3 12.7 13.4 14.4 16.9 16.3 17.0 16.0 16.4 15.0 14.2 10.5
Current assets 38.9 43.8 47.6 47.6 48.8 48.8 52.0 54.9 58.8 61.2 63.3 54.3 57.6 59.6
Inventories 29.8 32.2 33.7 35.2 34.5 32.7 36.4 40.7 43.8 44.9 45.1 44.4 43.0 43.7
Property and
equipment
68.1 79.3 88.4 97.0 95.7 102 105 110 113.0 117.9 116.7 116.5 114.1 114.8
Total assets 119.8 138.0 152.2 164.3 163.0 170.0 181.0 193.6 200.1 204.5 203.5 199.6 199.9 204.5
Current liabilities 43.2 48.8 52.2 58.5 55.3 56.8 58.6 62.3 67.2 69.3 65.3 66.0 66.9 78.5
Long-term debtb 23.3 30.1 30.7 33.4 34.5 39.5 43.7 47.0 41.4 44.6 43.7 40.3 36.0 30.0
Shareholders’ equity 49.4 53.2 61.6 64.6 65.3 70.5 68.5 71.3 76.3 76.3 81.4 80.2 87.0 77.0
Current ratio 0.9 0.9 0.9 0.8 0.9 0.8 0.9 0.9 0.9 0.9 1.0 0.8 0.9 0.8
Return on assetsc (%) 9.3 8.9 8.8 8.5 8.4 8.7 9.3 8.4 9.1 8.2 8.4 12.6 7.2 5.1
Return on equityd (%) 22.6 22.5 22.0 21.0 21.2 21.2 24.6 22.8 23.0 21.0 20.8 18.8 16.3 13.6
Other data (units)
US storese 3702 3856 4022 4141 4258 4314 4418 4479 4625 4835 5163 5229 5332 5358
International storesf 1587 2285 2757 3121 3615 4099 4587 5287 5783 6107 6290 6299 6363 6360
Employees (millions) 1.6 1.8 2.1 1.9 2.1 2.1 2.1 2.2 2.2 2.2 2.2 2.2 2.3 2.3
Notes:
aSG&A: sales, general, and administrative.
bIncluding long-term lease obligations.
cNet income before minority interest/average assets.
dNet income/average shareholders’ equity.
eIncludes US Sam’s Club outlets.
fIncludes overseas Sam’s Club outlets.
Source: Walmart Inc. 10-K reports.

430 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
and individual store managers. Walmart’s Saturday-morning meeting at its Bentonville
HQ, once described as “the pulse of our culture,” was progressively downgraded bet-
ween 2008 and 2015.2
Given these challenges, could Walmart’s outstanding retailing capabilities sustain its
outstanding performance in a retail sector that had always been brutally competitive,
but was now being torn apart by online giants such as Amazon and Alibaba?
History of Walmart
Discount stores—large retail outlets offering a broad range of products—began appear-
ing in the United States after World War II. Conventional wisdom held that cities with at
least 100,000 inhabitants were needed to support a discount store. Sam Walton believed
that, with low enough prices, discount stores could be viable in smaller communities:
“Our strategy was to put good-sized stores into little one-horse towns that everyone
else was ignoring.”3 His first Walmart opened in 1962; by 1970, there were 30 Walmarts
across Arkansas, Oklahoma, and Missouri.
Distribution was a problem for Walmart:
Here we were in the boondocks, so we didn’t have distributors falling over themselves
to serve us like our competitors in larger towns. Our only alternative was to build our
own distribution centers so that we could buy in volume at attractive prices and store
the merchandise.4
Walmart’s expansion strategy involved entering new areas by building a few stores
that were served initially from a nearby distribution center. Once a critical mass of
stores had been established, Walmart would build a new distribution center. By 1995,
Walmart was in all 50 states and was competing in major conurbations as well as in
smaller towns.5
Different Store Formats
Sam Walton experimented continually with alternative retail formats—this continued
under subsequent CEOs:
● Sam’s warehouse clubs were wholesale outlets which required membership:
they offered products in multipacks and catering-size packs with minimal
customer service.
● Supercenters were large-format stores (averaging a floor space of 178,000
square feet, compared with 105,000 square feet for a Walmart discount store
and 129,000 square feet for a Sam’s Club). They combined a discount store with
a grocery supermarket, plus other specialty units such as an eyeglass store,
hair salon, dry cleaners, and photo lab. They were open 24 hours a day, seven
days a week.
● Neighborhood Markets were supermarkets with an average floor space of
42,000 square feet.
● Walmart Express convenience stores of about 12,000 square feet were
launched in 2013; however, in January 2016, Walmart closed all 102 of its
Express stores.

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 431
● Walmart also built a substantial online business through its websites www.
walmart.com and www.samsclub.com. A key feature of Walmart’s online
strategy was its integration of web-based transactions with its physical store
network. In 2016–17, Walmart acquired additional e-commerce companies
namely: Jet.com (general merchandise), Hayneedle.com (home furnishings),
Shoes.com, Moosejaw (outdoor apparel and gear), ModCloth (women’s
apparel), and Bonobos (men’s apparel).
International Expansion
Walmart’s international expansion began in 1991 with a joint venture with Mexico’s
largest retailer, Cifra SA, to open discount stores and Sam’s Clubs. By 2000, Walmart had
entered six overseas countries. Table 2 summarizes Walmart’s international development.
Walmart’s overseas expansion followed no standard pattern: it might enter through
greenfield entry, through joint venture, or by acquisition. Unlike the globally standard-
ized approach of retailers such as IKEA and H&M, Walmart adapted its strategy to
each country’s consumer habits, infrastructure, competitive situation, and regulatory
environment. Its overseas operations have met with varying degrees of success. In
the adjacent countries of Mexico and Canada, Walmart was highly successful. Walmart
withdrew from Germany and South Korea after sustaining heavy losses and, in March
2018, it was negotiating the sale of its Brazilian stores. Walmart’s subsidiaries in UK and
Japan, Asda and Seiyu, have each found profitability elusive.6
China represents Walmart’s greatest international success outside of North America.
In 2018, China accounted for 20% of Walmart’s retail square footage outside the
United States. It was also the lead country for Walmart’s online operations. Through
an alliance with JD.com, Walmart offers a guaranteed one-hour fresh grocery delivery
service through a network of mini-warehouses.7
TABLE 2 Walmart stores by country, January 2015 and January 2018
Country
No of stores
Notes2018 2015
US 5358 5163 In 2018 these comprised 3,561 Supercenters, 400 discount
stores, 597 Sam’s Clubs, 800 Neighborhood Markets, and
other small formats
Canada 410 394 Entered in 1994 by acquiring 120 Woolco stores from
Woolworth and converting them into Walmart discount stores
Mexico 2358 2290 In 1991 formed JVa with Cifra. Chains include Walmart,
Bodegas, Suburbia, VIPS, and Mercamas. In 2000, Walmart
acquired 51% of Cifra and took control of the JV. Walmart
Mexico is the country’s biggest retailer
Central America 778 690 Acquired CARHCO, a subsidiary of Royal Ahold in 2005 with
stores throughout Central America
Argentina 106 105 Entered 1995: greenfield venture
Brazil 465 557 Entered 1995: JV with Lojas Americana, includes Todo Dia,
Bompreço, and Sonae stores
(Continues)

http://Jet.com

http://Hayneedle.com

http://Shoes.com

http://JD.com

432 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
Sam Walton and His Legacy
Walmart’s strategy and management style was inseparable from the philosophy and
values of its founder. After his death in 1992, Sam Walton’s beliefs and business princi-
ples continued to guide Walmart’s identity and development.
For Walton, thrift and value for money were a religion. Undercutting competitors’
prices was an obsession that drove his unending quest for cost economies. Walton
established a culture in which every item of expenditure was questioned. Was it
necessary? Could it be done cheaper? He set an example that few of his senior
colleagues could match: he walked rather than took taxis, shared rooms at budget
motels while on business trips, and avoided any corporate trappings or manifes-
tations of opulence or success. For Walton, wealth was a threat and an embarrass-
ment rather than a reward and a privilege. His own lifestyle gave little indication
that he was America’s richest person (before being eclipsed by Bill Gates). He
was equally disdainful of the display of wealth by colleagues: “We’ve had lots of
millionaires in our ranks. And it drives me crazy when they flaunt it  .  .  .  I don’t
think that big mansions and flashy cars is what the Walmart culture is supposed to
be about.”8
His attention to detail was legendary. As chairman and CEO, his priorities lay with
his “associates” (as Walmart employees are known), customers, and the operational
details through which the former created value for the latter. Much of his life was
Country
No of stores
Notes2018 2015
Chile 378 404 Entered January 2009 by acquiring Distribución y Servicio SA
China 443 411 Entered 1996, mainly organic growth, but in 2006 acquired
Trust-Mart with 102 stores. Average store size was
166,000 sq. ft.—three times the average for Walmart
International
Japan 336 431 Entered 2002: acquired 38% of Seiyu; 2008, Seiyu became a
wholly owned subsidiary of Walmart. Mainly small stores,
some superstores
India 20 20 Entered May 2009; JV with Bharti Enterprises
Africa 424 396 Entered 2011, acquiring 51% of Massmart Holdings Ltd; 382
stores in South Africa, also stores in Botswana, Ghana,
Lesotho, Malawi, Mozambique, Namibia, Nigeria, Swaziland,
Tanzania, Uganda, and Zambia
UK 642 592 Entered 1999 by acquiring Asda. Operates Walmart super-
stores, and Asda supermarkets and discount stores
Total 11,718 11,453
Note:
a JV = joint venture.
Source: Walmart Inc. 10K reports.
TABLE 2 Walmart stores by country, January 2015 and January 2018 (Continued)

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 433
spent on the road (or in the air, piloting his own plane) making impromptu visits
to stores and distribution centers. He collected information on which products were
selling well in Tuscaloosa, why margins were down in Santa Maria, how a new display
system for children’s clothing in Carbondale had boosted sales by 15%. His passion for
detail extended to competitors’ stores: he visited their stores and counted cars in their
parking lots.
Central to his leadership role was his relationship with his employees, the
Walmart associates. In an industry known for low pay and poor working condi-
tions, Walton created a spirit of motivation and involvement. He believed fervently
in giving people responsibility, trusting them, but also continually monitoring their
performance.
After his death in 1992, Sam Walton’s habits and utterances became enshrined in
Walmart’s operating principles. The “10-foot attitude” pledge embodied Sam Wal-
ton’s request to an employee that: “I want you to promise that whenever you come
within 10 feet of a customer, you will look him in the eye, greet him and ask
if you can help him.”9 The “Sundown Rule”—that every request, no matter how
big or small, gets same-day service—became the basis for Walmart’s fast-response
management system. “Three Basic Beliefs” formed the foundation for Walmart’s
corporate culture:
● Service to our customers: “Every associate—from our CEO to our hourly asso-
ciates in local stores—is reminded daily that our customers are why we’re here.
We do our best every day to provide the greatest possible level of service to
everyone we come in contact with.”
● Respect for the individual: Walmart’s emphasis on “respect for every associate,
every customer, and every member of the community” involves valuing and rec-
ognizing the contributions of every associate, owning “what we do with a sense
of urgency” and empowering “each other to do the same,” and “listening to all
associates and sharing ideas and information.”
● Striving for excellence: this comprised innovating by continuous improvement
and trying new ways of doing things, pursuing high expectations, and working
as a team by “helping each other and asking for help.”10
Sam Walton’s iconic status owed much to his ability to generate excitement and fun
within the seemingly sterile world of discount retailing. Walmart’s replacement of its
mission slogan—“Everyday Low Prices” by “Save Money, Live Better”—was intended to
reflect Walton’s insistence that Walmart play a vital role in the happiness and well-being
of ordinary people.
Walmart in 2018
The Business
Walmart described its business as follows:
Walmart Inc. . . . helps people around the world save money and live better— anytime
and anywhere—in retail stores and through e-commerce and mobile capabilities.
Through innovation, we are striving to create a customer-centric experience that
seamlessly integrates our e-commerce and retail stores in an omni-channel offering

434 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
that saves time for our customers. Each week, we serve nearly 270 million customers
who visit our over 11,700 stores and numerous e-commerce websites under 65 ban-
ners in 28 countries.
Our strategy is to lead on price, invest to differentiate on access, be competitive on
assortment and deliver a great experience. Leading on price is designed to earn the
trust of our customers every day by providing a broad assortment of quality merchan-
dise and services at everyday low prices (“EDLP”). EDLP is our pricing philosophy
under which we price items at a low price every day so our customers trust that our
prices will not change under frequent promotional activity. Price leadership is core to
who we are. Everyday low cost (“EDLC”) is our commitment to control expenses so
those cost savings can be passed along to our customers. Our omni-channel presence
provides customers access to our broad assortment anytime and anywhere. We strive
to give our customers and members a great digital and physical shopping experience.11
Walmart divides its sales into three product groups: grocery (56%), health and well-
ness (11%), and general merchandise (33%). Grocery provided most of Walmart’s sales
growth over the past decade. By 2017, Walmart’s held 26% of the US grocery market—
Kroger, America’s biggest supermarket chain, had 10%.
Walmart reports its operations and financial results in three business segments—
Walmart US, Walmart International, and Sam’s Club. Table 3 shows sales and profits
for these segments. Although Walmart’s Sam Club underperformed Costco, Walmart’s
overall corporate performance outshone all of its leading competitors (see Table 4).
TABLE 3 Walmart: Performance by segment (year ending January 31)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Sales ($billion)
Walmart US 239.5 255.7 259.9 260.3 264.2 274.4 279.4 288 298.4 307.8 318.5
Sam’s Clubs 44.4 46.9 47.8 49.4 53.7 56.4 57.2 58.0 56.8 57.4 59.2
International 90.6 98.6 97.4 109.2 125.9 134.7 136.5 136.2 123.4 116.1 118.1
Change in sales (%)
Walmart US 5.8 6.8 1.6 0.1 1.5 3.9 1.8 3.1 3.6 3.2 3.5
Sam’s Clubs 6.7 5.6 1.9 3.5 8.8 4.9 1.3 1.5 −2.1 1.1 3.1
International 17.5 9.1 −1.2 12.1 15.2 7.4 1.3 0.3 −9.4 −5.9 1.7
Operating income ($billion)
Walmart US 17.5 18.8 19.3 19.9 20.3 21.1 21.8 21.3 19.1 17.7 17.8
Sam’s Clubs 1.6 1.6 1.5 1.7 1.8 1.9 1.8 2.0 1.8 1.6 1.0
International 4.8 4.9 4.9 5.6 6.2 6.4 5.1 6.2 5.3 5.7 5.3
Operating margin (%)
Walmart US 7.3 7.3 7.4 7.6 7.7 7.7 7.8 7.4 6.4 5.8 5.6
Sam’s Clubs 3.6 3.4 3.1 3.4 3.4 3.3 3.2 3.4 3.2 2.8 1.7
International 5.2 5.0 4.5 5.1 4.9 4.7 3.8 4.5 4.3 4.9 4.5
Source: Walmart Inc. 10-K reports.

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 435
Walmarts’ Operations and Activities
Purchasing and Vendor Relationships
The size of Walmart’s purchases and its negotiating ability made it both desired and
feared by suppliers. As a Walmart vendor, a manufacturer gained unparalleled access
to the US retail market. At the same time, Walmart’s buying power and cost-cutting
fervor means razor-thin margins for most suppliers. Purchasing is centralized. All deal-
ings with US suppliers take place at Walmart’s Bentonville headquarters. Would-be
suppliers were escorted to one of the spartan cubicles on “Vendor Row” where they
prepared themselves for an intimidating and grueling encounter: “Expect a steely eye
across the table and be prepared to cut your price,” counseled one supplier.12 To avoid
dependence on individual suppliers, Walmart limited the total purchases it obtained
TABLE 4 Walmart and its competitors: Performance comparisons ($billion unless
otherwise stated)
Walmarta Targeta
Dollar
Generalb Costcoc
2017 2018 2016 2017 2017 2018 2016 2017
Net sales 481.3 495.8 69.4 71.8 21.9 23.4 116 126.1
Operating income 22.7 22.1 4.9 4.3 2 2 3.6 4.1
Net income 14.2 10.5 2.7 2.9 1.2 1.5 2.3 2.6
Current assets 57.6 59.6 11.9 12.5 3.6 4.2 15 17
Inventories 43 43.7 8.3 8.6 3.2 3.6 8.9 9.8
Total assets 198.8 204.5 37 38 11 12 33 36
Current liabilities 66.9 78.5 12 13 2.6 2.9 15.5 17.4
Long-term debt 36 30 12.7 11.5 3.2 3 4 6.5
Shareholders’ equity 87 77 10 11 5.4 6.1 12 10
Financial ratios
Operating income/assets ratio 11.5 10.8 13.2 11.3 18.2 16.7 10.9 11.4
Current ratio 0.9 0.8 1 1 1.4 1.4 1 1
Return on assets (%) 7.2 5.1 7.3 7.6 10.9 12.5 7 7.2
Return on equity (%) 16 14 27 26 22 25 19 26
Inventory turnover 11.2 11.3 8.4 8.3 6.8 6.5 13 12.9
Total assets turnover 2.4 2.4 1.9 1.9 2 2 3.5 3.5
SG&A expense as % of sales 21 21.4 19.2 19.8 21.5 22.2 10.2 10.4
operating margin 4.7 4.5 7.1 6 9.1 8.5 3.1 3.3
Notes:
a 12 months to January 31 the following year
b 12 months to February 28 the following year
c 12 months to September 30
Sources: Company 10-K reports.

436 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
from any one supplier. The result was an asymmetry of bargaining power: Walmart’s
biggest supplier, Procter & Gamble, accounted for about 3% of Walmart’s sales, but this
represented 18% of P&G’s revenues.
However, Walmart’s relationships with its suppliers are anything but arm’s-length.
Walmart’s Standards for Suppliers Manual is a 38-page document that covers sup-
pliers’ hiring and employment practices, environmental policies, health and safety,
provision of canteen facilities for workers, and financial integrity.13 Collaboration
involves a constant quest for efficiencies through enhanced cooperation—though
Walmart receives a disproportionate share of the resulting cost savings. Walmart’s
arrangements with P&G were a model for these relationships. Electronic data inter-
change (EDI) began in the early 1990s and within two years there were 70 P&G
employees based at Bentonville to manage sales and deliveries to Walmart.14 EDI was
extended to almost all Walmart’s US vendors. Through Walmart’s “Retail Link,” sup-
pliers could log onto the Walmart database for real-time store-by-store information on
sales and inventory for their products. This collaboration allows suppliers and man-
ufacturers within the supply chain to synchronize their demand projections under a
collaborative planning, forecasting, and replenishment scheme, resulting in Walmart
achieving faster replenishment, lower inventory, and a product mix more closely
tuned to local customer needs.
In 2017, Walmart increased its synchronization with suppliers through its “on-time,
in-full” initiative. From January 2018, suppliers were obliged to deliver full orders within
a specified one- or two-day window 85% of the time or be fined 3% of the cost of the
delayed goods.15
Warehousing and Distribution
Walmart’s world leadership in distribution logistics is a central component of its cost
advantage. While most discount retailers relied heavily on their suppliers and third-
party distributors for distribution to their individual stores, about 85% of Walmart’s
purchases are shipped to Walmart’s own distribution centers, then distributed to
Walmart stores in Walmart trucks. Walmart’s hub-and-spoke configuration, where each
distribution center serves between 75 and 110 stores within a 200-mile radius, permits
control over the scheduling of deliveries, larger drop sizes, fuller utilization of trucks,
and greater flexibility. On backhauls, Walmart trucks bring returned merchandise
from stores and pick up from local vendors, allowing trucks to be over 60% full on
backhauls.
Walmart continuously adapts its logistics system to increase speed and efficiency:
● Cross-docking allows goods arriving on inbound trucks to be unloaded and
reloaded on outbound trucks without entering warehouse inventory.
● “Remix” adds an additional tier to Walmart’s distribution system: third-party
logistic companies made small frequent pick-ups from suppliers allowing
Walmart a five-day rather than a four-day week ordering cycle from
suppliers.
● The international extension of Walmart’s procurement system involves direct
purchases from overseas suppliers, rather than through importers, giving
Walmart direct control of import logistics. In China it has global purchasing
centers in Shenzhen and Shanghai. Imports are funneled through its huge
import distribution center in Baytown, Texas.16

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 437
● Walmart pioneered the use of radio frequency identification (RFID) for logistics
management and inventory control.
● In 2008, Walmart introduced a new system of packing trucks—allowing a better
use of their capacity.
In-store Operations
Walmart’s management of its retail stores is based upon satisfying customers by
combining low prices, a wide range of quality products carefully tailored to customer
needs, and a pleasing shopping experience. Walmart’s store management was distin-
guished by the following characteristics:
● Merchandising: Walmart offers a wide range of nationally-branded prod-
ucts. Between 2006 and 2009, it had expanded its range of brands, focusing
in particular on upscale brands. Traditionally, Walmart had placed less
emphasis on own-brand products than other mass retailers; however, after
2008, Walmart greatly increased its range of private-label products. Its “Store
of the Community” philosophy involves tailoring its range of merchandise
to local market needs on a store-by-store basis—a goal that is facilitated by
Walmart’s meticulous analysis of point-of-sale data for individual stores (see
Information Technology below).
● Decentralization of store management: Individual store managers are given
greater decision-making authority in relation to merchandise, product posi-
tioning within stores, and pricing than is typical in discount retailing where
such decisions are concentrated at head office or at regional offices. Sim-
ilarly, decentralized decision-making is apparent within stores, where the
department managers (e.g., toys, health and beauty, consumer electronics) are
expected to develop and implement their own ideas for increasing sales and
reducing costs.
● Customer service: Most Walmart stores in the United States are either 24 hours
or 6 am to midnight (sometimes with shorter hours on Sundays). Despite the
primacy of “Everday Low Prices”, Walmart seeks to engage with its customers
at a personal level. Within stores, employees are expected to look customers
in the eye, smile at them, and offer a verbal greeting. Walmart’s “Satisfaction
Guaranteed” program assures customers that Walmart would accept returned
merchandise on a no-questions-asked basis.
Marketing and External Relations
At the core of Walmart’s strategy is Sam Walton’s credo that “There is only one
boss: the customer” and the belief that value for customers equated to low prices.
Hence, Walmart’s marketing strategy is built upon its slogan “Everyday Low
Prices.” Unlike other discount chains, Walmart does not engage in promotional
price-cutting.
“Everyday Low Prices” also permitted Walmart to spend less on advertising and
other forms of promotion than its main rivals. Its advertising/sales ratio in 2017 was
0.6%—less than half that of its main rivals (Target’s was 2.0%). Nevertheless, Walmart
advertising budget of $3 billion exceeded that of any other retailer.

438 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
The image that Walmart communicates is grounded in traditional American virtues
of hard work, thrift, individualism, opportunity, and community. This identification
with core American values is reinforced by a strong emphasis on patriotism and
national causes.
However, as Walmart became a target for pressure from politicians, NGOs, and
labor unions, it was increasingly forced to adapt its image and its business practices.
In 2005, Walmart committed itself to a program of environmental sustainability and set
targets for renewable energy, waste reduction, and the introduction of environmentally
friendly products.17 Two years later, Walmart published the first of its annual sustain-
ability reports.
Commitment to social and environmental responsibility forms part of a wider corpo-
rate makeover to upgrade Walmart’s image and broaden its consumer appeal.18
Human Resource Management
Walmart’s approach to human resource management reflects Sam Walton’s beliefs
about relations between the company and its employees and between employees and
customers. All employees, from corporate executives to checkout clerks, are known as
“associates.” Walmart claims that its relations with its associates are based on respect,
high expectations, close communication, and clear incentives.
In common with other discount retailers, Walmart’s employees receive low pay. In
2015, full-time employees earned an average of $13.58 an hour; part-time employees,
$10.28. Benefits included a company health plan that covered almost all employees
and a retirement scheme for employees with a year or more of service. Performance
bonuses were paid to hourly as well as salaried employees and a stock purchase plan
was also available.
Walmart is under continuous pressure to increase rates of pay—particularly from
labor unions that have long sought to recruit Walmart employees. In January 2018,
Walmart increased its minimum starting rate from $9 to $11 and improved maternity
and parental leave benefits. Walmart has resisted unionization in the belief that union
membership create a barrier between the management and the employees in furthering
the success of the company and its members. However, at several of its overseas sub-
sidiaries Walmart works closely with local unions.19
Orchestrating employee enthusiasm and involvement is a central feature of Walmart’s
management style. Opportunity for advancement provides a key incentive: 75% of
Walmart managers (including CEO Doug McMillon) had started as hourly employees.
Top management believes that close collaboration between managers and front-line
employees infuses every aspect of Walmart’s operations. Employees are encouraged to
show initiative and flexibility, especially in relation to serving customers and identifying
opportunities for cost saving.
Walmart’s human resource practices are an ongoing paradox. Its dedication to
training, internal promotion, and employee involvement can generate levels of com-
mitment among Walmart shop-floor employees that is unusual in the brutally com-
petitive discount retailing sector. Yet, the intense pressure for cost reduction and
sales growth frequently results in cases of employee abuse. In several adverse court
decisions, Walmart has been forced to compensate current and former employees for
unpaid overtime work and for failure to ensure that workers received legally man-
dated rest breaks.

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 439
Information Technology
Walmart has long been a pioneer in applying information and communications
technology to support decision making and promote efficiency and customer
responsiveness. Walmart was among the first retailers to use computers for inventory
control, to initiate EDI with its vendors, and to introduce bar code scanning for point-
of-sale and inventory control. To link stores and cash register sales with supply chain
management and inventory control, Walmart invested $24 million in its own satellite
in 1984. By 1990, Walmart’s satellite system was the largest integrated private satellite
network in the world, providing two-way interactive voice and video capability, data
transmission for inventory control, credit card authorization, and enhanced EDI. During
the 1990s, Walmart pioneered the use of data mining for retail merchandising,
The result, by now, is an enormous database of purchasing information that enables
us to place the right item in the right store at the right price. Our computer system
receives 8.4 million updates every minute on the items that customers take home—
and the relationship between the items in each basket.
Data analysis allows Walmart to forecast, replenish, and merchandise on a
product-by-product, store-by-store level. For example, with years of sales data and
information on weather, school schedules and other pertinent variables, Walmart
can predict daily sales of Gatorade at a specific store and automatically adjust store
deliveries accordingly.20
Analyzing purchasing patterns also led to continual adjustments in store layout (e.g.,
creating “baby aisles that include infant clothes and children’s medicine alongside dia-
pers, baby food and formula—but at the same time plac[ing] higher-margin products
among the staples.”21
Even before the onset of web-based computing, IT had played a central role in inte-
grating Walmart’s entire value chain with point-of-sale data forming the basis for inventory
replenishment, deliveries from suppliers, and top management decision making:
Combine these information systems with our logistics—our hub-and-spoke system
in which distribution centers are placed within a day’s truck run of the stores—and
all the pieces fall into place for the ability to respond to the needs of our customers,
before they are even in the store. In today’s retailing world, speed is a crucial compet-
itive advantage. And when it comes to turning information into improved merchandis-
ing and service to the customer, Walmart is out in front.22
Unlike most retailers, Walmart outsourced little of its IT requirements. In 2018,
Walmart’s IT function was split between two groups: Walmart Technology, at the cor-
porate headquarters in Bentonville, developed and managed technology for the stores
and logistical systems, while Global eCommerce, employing over 2000 developers
and engineers in Silicon Valley, developed customer-focused technologies and ran
Walmart websites.
As Walmart increased its commitment to building an online presence, so too did its
investments in information technology and e-commerce. In the United States, these
rose from $2.54 billion in 2013 (29% of total US capital expenditure) to $4.52 in 2017
(61% of the total). They included a number of acquisitions of hi-tech companies. The
most important being Jet.com. bought in 2016 for $3.3 billion. Jet.com’s founder and
CEO, Marc Lore, was also put in charge of walmart.com.

http://Jet.com.

http://Jet.com

http://walmart.com

440 Cases To aCComPaNY CoNTemPoRaRY sTRaTegY aNalYsIs
In order to compete with Amazon, walmart.com is imitating some elements of Ama-
zon’s approach, for example, it now offers free two-day shipping on orders greater
than $35. In other areas it is exploiting Walmart’s distinctive presence—most notably its
4700 stores, hundreds of distribution centers, and 6200 trucks. By early 2018, walmart.
com customers could pick up their grocery orders from grocery pickup from 1125 US
locations.23 Walmart was also testing “associate delivery” using employees to deliver
packages for extra pay on their way home from work in their personal cars.
Walmart’s other online initiatives included partnering with Google Express, and
using Google’s data analytics and artificial intelligence capabilities. Walmart customers
can link their Walmart and Google accounts providing Walmart with additional data to
forecast customer demand. Walmart also established a Silicon-Valley-based incubator—
Store No. 8—to develop and launch innovative retailing startups. In May 2018, Walmart
opened a new front in its rivalry with Amazon: it acquired a controlling interest in
Flipkart, Amazon’s leading online retailing competitor in India.
Organization and Management Style
Walmart’s management structure and management style reflects Sam Walton’s princi-
ples and values—especially his belief that all managers, including the CEO, needed
to be closely in touch with customers and store operations. The result was a structure
in which communication between individual stores and the Bentonville headquarters
are both close and personal. Traditionally, Walmart US’s regional vice presidents were
each responsible for supervising between ten and 15 district managers (later designated
“market managers”) who, in turn, were in charge of 8 to 12 stores. The key to Walmart’s
fast-response management system was the close linkages in this system which ensured
speed of communication and decision making between the corporate headquarters and
the individual stores and warehouses. The critical links in this system were the regional
vice presidents. Most large retailers had regional offices; Walmart’s regional VPs had no
offices. Their time was spent visiting stores and warehouses in their regions Monday
to Thursday, then returning to Bentonville on Thursday night for Friday and Saturday
meetings. On Friday, the 7 a.m. management meeting was followed by the merchandis-
ing meeting, which dealt with stockouts, excess inventory, new product introductions,
and various merchandising errors. At the Saturday meeting, weekly sales data would be
reviewed and the regional VPs would contact their district managers about actions for
the coming week. According to former CEO David Glass: “By noon on Saturday we had
all our corrections in place. Our competitors, for the most part, got their sales results on
Monday for the week prior. Now, they’re already ten days behind.”
The two-and-a-half-hour Saturday morning meetings beginning at 7 a.m. were a
manifestation of Walmart’s unique management style—“part evangelical revival, part
Oscars, part Broadway show.”24 Their downgrading to monthly with optional attendance
are seen by many as indicating the erosion of Walmart’s fast-paced, high-commitment,
highly personalized, management culture.
Notes
1. https://news.walmart.com/2017/12/05/walmart-changes-
its-legal-name-to-reflect-how-customers-want-to-shop,
accessed April 11, 2018.
2. “Wal-Mart Alters Regular Saturday Meeting,” Northwest
Arkansas Democrat Gazette ( January 14, 2008); “Walmart’s
new CEO has made its iconic Saturday morning meeting
optional,” http://qz.com/272018/walmarts-new-ceo-has-
made-its-iconic-saturday-morning-meeting-optional/,
accessed April 11, 2018.
3. S. Walton, Sam Walton: Made in America (New York:
Bantam Books, 1992).
4. “How Sam Walton Does It,” Forbes (August 16, 1982): 42.

http://walmart.com

http://walmart.com

Case 6 WalmaRT, INC. IN 2018: The WoRld’s BIggesT ReTaIleR FaCes NeW ChalleNges 441
5. Wal-Mart Stores, Inc., Harvard Business School Case No.
9–974–024 (1994).
6. Asda Stores Ltd. earned a small operating profit in 2015
and 2016. In Japan, Asda reduced the number of its stores
from 434 in 2014 to 336 in 2018.
7. “Wal-Mart Already Has a Thriving Online Grocery
Business—in China,” Bloomberg Businessweek
(November 30, 2017).
8. S. Walton, op. cit.
9. http://www.wal-martchina.com/english/walmart/rule/10.
htm, accessed August 7, 2018.
10. “Three Basic Beliefs & Values in Walmart.” https://lisparc.
wordpress.com/2010/09/07/3-basic-beliefs-values-
in-walmart/, accessed August 7, 2018.
11. Wal-Mart Inc., 2018 10-K report: 7.
12. These percentages were stable between 2016 and 2018.
“Grocery” comprises food and beverages, personal care
products, and household cleaning products.
13. https://www.forbes.com/sites/greatspeculations/2017/
11/30/a-closer-look-at-wal-marts-online-grocery-
ambitions/#2df2aa8215cf, accessed April 12, 2018.
14. “A Week Aboard the Wal-Mart Express,” Fortune
(August 24, 1992): 79.
15. Wal-Mart Stores Inc., Standards for Suppliers Manual
(Bentonville, April 2014).
16. “Lou Pritchett: Negotiating the P&G Relationship with
Wal-Mart,” Harvard Business School Case No. 9-907-
011 (2007).
17. “Wal-Mart Tightens Delivery Windows for Suppliers,”
Wall Street Journal ( January 30, 2018).
18. “Inside the World’s Biggest Store,” Time Europe ( January
20, 2003).
19. “The Green Machine,” Fortune ( July 31, 2006).
20. “Wal-Mart Moves Upmarket,” Business Week
( June 3, 2009).
21. “Wal-Mart Works with Unions Abroad, but not at Home,”
Washington Post ( June 7, 2011).
22. Wal-Mart Stores, Annual Report, 1999: 9.
23. Ibid.: 9.
24. Ibid.: 11.
25. “Can Wal-Mart’s Expensive New E-Commerce Opera-
tion Compete With Amazon?” Bloomberg Businessweek
(May 8, 2017).
26. “Wal-Mart’s Weekly Meeting: Saturday Morning Fever,”
Economist (December 6, 2001).

http://www.wal-martchina.com/english/walmart/rule/10.htm

https://lisparc.wordpress.com/2010/09/07/3-basic-beliefs-valuesin-walmart/

https://www.forbes.com/sites/greatspeculations/2017/11/30/a-closer-look-at-wal-marts-online-groceryambitions/#2df2aa8215cf

Case 7
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.
Harley-Davidson,
Inc. in 2018
Harley-Davidson, Inc. was far from being the world’s biggest motorcycle manufacturer.
In 2017, it sold 241,498 bikes; Honda sold 11.2 million. In relation to the world market
for motorcycles of about 132 million bikes—of which Asia accounted for over 80%—
Harley’s market share was about 0.25%.
Yet, Harley-Davidson was also one of the world’s most famous motorcycle com-
panies. On Interbrand’s ranking of the world’s most valuable brands, it placed #77 in
2017 with a brand value of $5.7 billion. In 2018, the company would celebrate its 115th
birthday. On Labor Day weekend, tens of thousands of Harley riders would descend
on Milwaukee WI for five days of festivities. As one enthusiast explained: “It ain’t a
motorcycle—It’s a way of life!”
Harley-Davidson was also the world’s most financially successful motorcycle company.
Since its listing on the NYSE in 1986, its revenues had grown 11-fold, it had earned an
average return on equity of 27%, and average annual return to shareholders was 12.8%.
However, since 2008, Harley had experienced headwinds. The financial crisis of
2008–09 had hit it hard and, despite a strong recovery, sales revenues and profits had
declined after 2014. The decline in sales continued in 2018—exacerbated by the trade
war initiated by the Trump administration. The European Union had targeted Harley-
Davidson with 25% additional tariff on imports of US-made motorcycles. However, CEO
Matt Levatich’s biggest concern was the longer term outlook for the market for its bikes.
Was America’s long-running love affair with Harley-Davidson’s heavyweight motorcycles
cooling? And, if it was, would international markets take up the slack? These concerns
were fueled by demographic trends. Harley’s core market was the baby-boomer genera-
tion—and this cohort was moving toward retirement homes rather than outdoor sports.
Would the next cohorts—Generation X, Y, and the millennials—have the same affinity
for the motorcycles and the cultural values that Harley-Davidson represented? The evi-
dence pointed to worrying problems for the entire US motorcycle market. Among the
youngest age group—the under-18s—motorcycle ownership was declining sharply.
For us and for our loyal customers, the motorcycles we build aren’t just motorcycles. They are
living pieces of American history, mystique on two wheels. They are the vehicle with which
our riders discover the power, the passion, and the people that define the Harley-Davidson
Experience.
—HARLEY-DAVIDSON, INC.1

CASE 7 HArlEy-DAvIDSon, InC. In 2018 443
The History of Harley-Davidson
From Birth to Maturity, 1903–81
Harley-Davidson, Inc. was founded in 1903 by William Harley and the three Davidson
brothers: William, Arthur, and Walter. In 1909, Harley introduced its two-cylinder, V-twin
engine with its deep, rumbling sound: this engine type would be the characteristic fea-
ture of Harley-Davidson motorcycles for the next 110 years. At that time, there were
about 150 US motorcycle producers in the United States; by 1953, Harley-Davidson was
the sole survivor.
After the Second World War, the demand for motorcycles boomed. This encouraged
a flood of imports: first the British (BSA, Triumph, and Norton) and then the Japanese
(led by Honda). Following Harley’s acquisition by the leisure conglomerate AMF in
1969, sales declined and financial losses mounted.
Rebirth, 1981–2008
In 1981, Harley’s senior managers led a leveraged buyout of the company. Despite a
perilous financial condition, the management team embarked upon rebuilding pro-
duction methods and working practices. Managers visited Japanese automobile plants
and introduced their own version of Toyota’s just-in-time ( JIT) system called “MAN”
(materials-as-needed). Harley’s manufacturing plants adopted collaborative processes
of quality management.
The 1986 initial public offering of Harley-Davidson’s shares fueled investment in
new models, plants, and dealerships. Harley’s share of the market for heavyweight
motorcycles (over 500cc) grew steadily. Harley’s biggest challenge was satisfying the
surging demand for its products. Between 1996 and 2003, it dramatically increased its
production capacity. In 2006, Harley’s sales reached a peak of 362,000 motorcycles, a
10-fold increase on 1986. Figure 1 shows Harley’s growth in output.
FIGURE 1 Annual shipments of motorcycles by Harley-Davidson
400.0
Th
o
u
sa
n
d
s
o
f u
n
it
s
350.0
300.0
250.0
200.0
150.0
100.0
50.0
0.0
1900 1920 1940 1960
Year
1980 2000 2020
Source: Harley Davidson annual reports and Harley-Davidson archives.

444 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
Downturn and Readjustment, 2008–14
The financial crisis of 2008 put an abrupt end to growth. After decades of customer
waiting lists and a shortage of production capacity, Harley faced plummeting sales,
excess inventory, and bad debts as customers defaulted on their loan repayments. In
the shrinking motorcycle markets of North America and Europe, Harley—with the
highest average retail price of any major manufacturer—suffered disproportionately.
The credit crunch prevented Harley-Davidson Financial Services (HDFS) from securi-
tizing its customer loans—it was obliged to retain them on its own books.
When Keith Wandell took over as Harley’s CEO in May 2009, his priorities were to
restore funding for Harley’s consumer lending, align production and employment with
lower demand, and refocus on the core Harley-Davidson brand—which involved closing
Buell Motorcycles and selling Italian subsidiary MV Agusta.2 With its financial position sta-
bilized, Wandell then sought to return Harley to its previous growth path. This involved:
● Restructuring manufacturing operations including reducing capacity and
increasing flexibility to allow a wider range of models to be produced and to
match production to seasonal fluctuations in demand.
● Expanding international sales—especially in the emerging markets of Asia and
Latin America. In 2011, Harley opened an Asia-Pacific regional headquarters in
Singapore, and an assembly plant in India.3
● Expanding the customer base. To reestablish growth in North America, Harley
needed to broaden its customer base from its core demographic of white males
of 45 years or more. Targeted groups included: women riders, “Harlistas” (Latino
riders), “Iron Elite” (African-American riders), “Harley’s Heroes” (military and
veteran riders), and, most of all, younger riders through new models. During
2013, Harley launched its “Project Rushmore” motorcycles: a restyled range of
touring motorcycles. They were followed by its “Street” models—lighter, sports
motorcycles featuring new, liquid-cooled 500cc and 750cc engines.
Matt Levatich and Harley’s Ten-Year Strategy
In May 2015, when Matt Levatich succeeded Keith Wandell as CEO, Harley was facing
declining revenues as it faced a shrinking US motorcycle market, intensifying inter-
national competition, and a rising US dollar. Of particular concern was a decline in
motorcycle ownership among younger Americans. To address these challenges, in Feb-
ruary 2017, Levatich and his team announced a 10-year development strategy for the
company. The key theme of the strategy was “Building the Next Generation of Harley-
Davidson Riders Globally.” Table 1 summarizes the key components of the strategy.
The Heavyweight Motorcycle Market
Until the financial crisis of 2008–09, the heavyweight segment had been the most rap-
idly growing part of the world motorcycle market: sales trebled between 1990 and
2008. However, during 2008–10, sales dropped sharply in North America and Europe.
Despite a subsequent recovery, the US market continued to contract during 2015–17.
In North America, Harley was the leader in heavyweight bikes, with over half the
market (Table  2). Overseas, Harley had been unable to replicate this market dom-
inance, despite strong sales in a few markets: it was heavyweight market leader in
Japan, Australia, and Brazil. In Europe, Harley’s market share lagged those of Honda,
BMW, Suzuki, and Triumph.

CASE 7 HArlEy-DAvIDSon, InC. In 2018 445
TABLE 1 Harley-Davidson’s 10-year strategy, 2017–27
10-Year objectives Actions
Build 2 million new HDa riders in
the United States
To convert “customer opportunities” into HD customers, HD would use its dealer net-
work to provide more instruction in m-cb riding, expand m-c rental, assure quality
of local events, and expand HD presence in used m-c market.
Grow international business to
50% of annual volume
Add 150–200 dealer points between 2016 and 2020. Increase brand awareness and
loyalty through test rides and dealer events, including “Battle of the Kings” dealer
customization competition.
Launch 100 new high-impact
H-D motorcycles
Annual expenditure on product development to be doubled. New models intended
to expand HD’s customer base while building on HD’s “Key Differentiators”:
Look, Sound, Feel, Personalization, and Connected Riding Experience.
Deliver superior
return on invested
capital for HDMCc
(S&P 500 top 25%)
HD’s initiatives to grow demand and increase the appeal of HD m-cs would help
revenue growth while improvements in operational efficiency would support mar-
gins. HD Financial Services would become increasingly important source of compet-
itive advantage.
Grow our business
without growing
our environmental impact
Sustainability initiatives related mainly to waste reduction and improvements in fuel
economy. The launch of an all-electric m-c announced January 2018.
Notes:
aHD = Harley-Davidson;
bm-c = motorcycle;
cHDMC = Harley-Davidson Motor Company, the main subsidiary of Harley-Davidson, Inc.
Source: Harley-Davidson, Inc. Investor Meeting, February 28, 2017.
TABLE 2 Retail sales (registrations) of heavyweight motorcycles (601+ cc), 2008–17 (thousands of units)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
United Statesa
Total market 477 304 260 271 299 306 316 328 311 289
Harley-Davidson 235 174 154 152 161 168 167 165 160 147
Market share (%) 49.3 53.2 54.9 55.7 53.8 54.9 52.8 50.2 51.2 50.7
Europe
Total market 384 314 301 293 300 282 320 352 392 391
Harley-Davidsonb 45 40 41 44 36 36 39 37 42 38
Market share (%) 11.7 12 12.7 13.7 12.1 12.8 12 10.5 10.8 9.8
Asia-Pacific
Harley-Davidson 25 23 21 21c 25c 27c 30c 32 33 30
Latin America
Harley-Davidson 8 6 6 7 9 11 12 11 10 9
Canada
Harley-Davidson n.a. n.a. n.a. 10 11 11 10 10 10 10
Notes:
aIncludes Canada for 2008–10.
bIncludes Middle East and Africa a 2005–11.
cIn 2011–17, sales in Japan were between 9,500 and 11,000 each year.
n.a. = not available.
Source: Harley-Davidson 10-K reports.

446 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
The heavyweight motorcycle market comprised three segments:
● Cruiser motorcycles: These were “big, noisy, low riding, unapologetically
macho cycles,”4 typically with V-twin, large displacement engines and an
upright riding position. Their design reflected the dominance of styling over
either comfort or speed. For the urban males (and some females), the cruiser
motorcycle, while a practical mode of transportation, was primarily a statement
of style. The cruiser segment was dominated by Harley and most of its com-
petitors in this segment had imitated the main features of the traditional Har-
ley design.
● Touring motorcycles: These included cruisers especially equipped for
longer-distance riding and bikes especially designed for comfort over
long distances (including the Honda Goldwing and the bigger BMWs).
These tourers featured luxuries such as audio systems, two-way inter-
coms, and heaters. While Harley was segment leader, Honda and BMW
had engineered their motorcycles for greater smoothness and comfort over
long distances through the use of multi-cylinder, shaft-drive engines and
advanced suspension systems.
● Performance motorcycles: These were based on racing bikes, with high-
technology, high-revving engines offering speed, acceleration, race-track styling,
and minimal concessions to rider comfort. The segment was the most important
in the European and Asia-Pacific markets, representing 62% and 65% of total
heavyweight bike sales, respectively. It was dominated by Japanese motorcycle
companies, with a strong representation of European specialists, such as Ducati
and Triumph. Harley had competed in this segment during 1993–2010 through
Buell Motorcycles.
Unlike its Japanese competitors, Harley was highly market focused: its Harley’s
models were concentrated on the “super-heavyweight” segment (over 850cc) and
within this on cruiser and touring motorcycles.
Harley-Davidson in 2018
The Brand
Harley-Davidson’s image and the loyalty the company engendered among its cus-
tomers were seen as its greatest assets. The famed spread eagle signified not just
the brand of one of the world’s oldest motorcycle companies but also an entire
lifestyle with which it was associated. Harley has been described as “the ultimate
biker status symbol . . . a quasi religion, an institution, a way of life.”5 Harley had
a unique relationship with American culture. The values that Harley represented—
individuality, freedom, and adventure—could be traced back to the cowboy and
frontiersman of yesteryear, and before that to the quest that brought people to
America in the first place. As the sole surviving indigenous motorcycle company,
Harley-Davidson represented a once-great tradition of American engineering and
manufacturing.
The Harley brand was central not just to the company’s marketing but also to its
strategy as a whole. The central thrust of the strategy was reinforcing and extending
the relationship between the company and its consumers. Harley-Davidson had long

CASE 7 HArlEy-DAvIDSon, InC. In 2018 447
recognized that it was not selling motorcycles: it was selling the Harley Experience,
which formed the central theme in almost all its external communications:
A chill sweeps through your body, created by a spontaneous outburst of pure, unadul-
terated joy. You are surrounded by people from all walks of life and every corner of
the globe. They are complete strangers, but you know them like your own family.
They were drawn to this place by the same passion—the same dream. And they came
here on the same machine. This is one place you can truly be yourself. Because you
don’t just fit in. You belong.6
Customers and Customer Relations
If the appeal of the Harley motorcycle was the image it conveyed and the lifestyle
it represented, the company’s challenge was to ensure that the experience matched
the image. Harley’s involvement in its consumers’ riding experience was through
the Harley Owners’ Group (HOG), which organized social and charity events.
Employees, from the CEO down, were encouraged to take an active role in attending
HOG shows, rallies, and rides. “The feeling of being out there on a Harley-Davidson
motorcycle links us like no other experience can. It’s made HOG like no other orga-
nization in the world . . . more family reunion than organized meeting.”7 Customer
loyalty led to their continuing reinvesting in Harley products: Harley-branded acces-
sories and apparel, customizing their bikes, and eventually trading them in for a new
(typically more expensive) model. About half of bike sales were to repeat customers.
Financial success involved Harley’s repositioning from blue-collar youngsters to
middle-aged and upper-income buyers, many of whom had never ridden a motorcycle
before. Harley’s core demographic was Caucasian males aged 35 and over. The average
age of Harley’s customers was about 50.
Harley’s core customer base was narrow and it was aging, hence the priority given to
widening the brands appeal. In his final letter to shareholders, retiring CEO Keith Wan-
dell reported success in expanding Harley’s customer base. Between 2012 and 2014,
Harley had grown its sales to “outreach customers”: young adults, women, African
Americans, and Hispanics. In addition, its international sales had grown to 36% of total
retail sales.8
The Products
Broadening Harley’s market appeal had major implications for product policy and
design. Ever since its disastrous foray into small bikes during the AMF years, Harley had
recognized that its competitive advantage lay with super-heavyweight bikes. Here it
stuck resolutely to the classic styling that had characterized Harleys since the company’s
early years. At the heart of the Harley motorcycle was the air-cooled V-twin engine that
had been Harley’s distinctive feature since 1909. Harley’s frames, handlebars, fuel tanks,
and seats also reflected traditional designs.
Harley’s commitment to traditional design features may be seen as making a virtue
out of necessity. Its smaller corporate size and inability to share R & D across cars and
bikes (unlike Honda and BMW) limited its ability to invest in technology and new
products. As a result, Harley lagged far behind its competitors in the development
and application of automotive technologies: not only did its motorcycles look old-style,
much of their technology was old-style. Among the 238 US patents awarded to Harley
during 2000–2016, a large proportion related to the design of peripheral items: saddlebag

448 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
mounting systems, footpegs, seats, backrests, electrical assemblies, and motorcycle music
systems. Over the same period Honda was awarded 12,228 US patents, Kawasaki 2146,
and Suzuki 740.
Long after other manufacturers had moved to multiple valves per cylinder, overhead
camshafts, liquid cooling, and electronic ignition, most Harley bikes featured air-cooled
push-rod engines with two valves per cylinder. Hence, the launch of the Milwaukee
Eight engine in 2016 was a major event for Harley. Throughout Harley’s entire history
there had been just nine engines powering its heavyweight V-twins. The Milwaukee
Eight’s predecessor was the Twin-Cam introduced in 1999.
Nevertheless, Harley was engaged in constant upgrading—principally incremental
refinements to its engines, frames, and gearboxes—aimed at improving power delivery
and reliability, increasing braking power, and reducing vibration. Harley’s automotive
technology alliance partners included Porsche, Ford, and Gemini Racing.
Harley’s new product development was driven by design rather than by technology.
By 2018, Harley offered 47 different models. Its Product Development Center and
Prototyping Lab were among the most important units within the company. Most of
Harley’s product development efforts were limited to style changes, new paint designs,
and engineering improvements. However, after 2000, Harley accelerated technological
development. Milestones included the liquid-cooled engines, fuel injection, electronic
ignition, a six-speed gearbox, and electric propulsion.
At the heart of the Levatich’s “Ten Year Strategy” for “Building the Next Generation of
Harley-Davidson Riders Globally” was a new range of motorcycles that were radically
different from Harley’s traditional designs. The Street 500cc and 750cc models, introduced
in 2015, were the first of series of lighter-weight, more technologically-advanced motor-
cycles. In 2019 they would be joined by the LiveWire, Harley’s first all-electric motorcycle.
Additional electric models will follow. Harley will also introduce the Pan-American–an
adventure bike designed for on and off-road use.
Central to Harley’s product strategy was the belief that every Harley rider should
own a unique, personalized motorcycle—hence the offer of a wide range of presale
and postsale customization opportunities. New bikes offered multiple options for seats,
bars, pegs, controls, and paint jobs, with over 7000 accessories, and special services
such as “Chrome Consulting.”
Reconciling product differentiation with scale economies was a continuing
challenge for Harley. The solution was to offer a wide range of customization options
while standardizing key components. Thus, Harley’s broad model range involved
“permutations of four”: four engine types, four basic frames, four styles of gas tank,
and so on.
The Harley product line also covered a wide price range. The Street 500 model was
priced as an entry-level bike, beginning at $6799, less than one-fifth of the price of the
CVO Limited, at $39,349. Table 3 shows Harley’s motorcycle output by product type.
Distribution
Upgrading Harley’s distribution network was central to its resurgence during the 1980s
and 1990s. At the time of the buyout, many of Harley’s 620 US dealerships were oper-
ated by enthusiasts, with erratic opening hours, a poor stock of bikes and spares, and
indifferent customer service. If Harley was in the business of selling a lifestyle and an
experience, then dealers played a pivotal role in delivering that experience. Moreover,
if Harley’s target market had shifted toward mature, upper-income individuals, Harley
needed to provide a retail experience commensurate with the expectations of this group.
Harley’s dealer development program provided increased support for dealers, while
imposing higher standards of pre- and after-sales service and requiring improved

CASE 7 HArlEy-DAvIDSon, InC. In 2018 449
facilities. Dealers were obliged to carry a full line of Harley products and accessories
and to offer services that extended beyond service, repair and financing to include
test ride facilities, rider instruction classes, motorcycle rental, consulting for customiza-
tion, insurance services, and vacation packages. Over 90% of Harley dealerships in the
United States were exclusive: most other motorcycle manufacturers sold through multi-
brand dealerships.
Dealer services were a continuing strategic priority for Harley. Its Retail Environ-
ments Group established a meticulous set of performance standards and guidelines
for dealers that covered every aspect of managing the showroom and interacting
with actual and potential customers. Harley-Davidson University was established to
“enhance dealer competencies in every area, from customer satisfaction to inventory
management, service proficiency, and front-line sales.”9
Expanding international sales required Harley to extend its dealer network into
countries where it had little or no distribution presence. Yet, as Table 4 shows, Harley’s
dealership network outside of North America was still sparse even in 2018.
Other Products and Services
Sales of parts, accessories, “general merchandise” (clothing and collectibles), and
financial services represented 32% of Harley’s total revenue in 2017 (Table 5)—much
higher than for other motorcycle companies. Clothing sales included not just tra-
ditional riding apparel but also a wide range of men’s, women’s, and children’s
leisure apparel.
TABLE 3 Harley-Davidson shipments of motorcycles, 2006–17
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Unit shipments (thousands of motorcycles)
United States 273.2 241.5 206.3 144.4 131.6 152.2 160.5 167 174 170 161.8 144.8
International 76.0 89.1 97.2 78.5 78.8 80.9 87.1 93.4 96.7 95.6 100.3 96.6
Buell 12.5 11.5 13.1 9.5 2.6 0.2 — — — — — —
Company total 361.6 342.1 316.4 232.4 213 233.2 247.6 260.5 270.7 266.3 262.2 241.7
Product mix (%)
Sportster and Street 18.5 21.8 20 21.4 19.5 21.3 20.5 19.3 21.0 23.4 23.4 22.5
Cruiser 46.2 43.7 46.4 40.9 41.4 39.2 39.1 39.5 33.8 33.5 35.6 36.2
Touring 35.4 34.5 33.6 37.7 39.0 39.5 40.4 41.2 45.2 43.1 41.0 41.3
Source: Harley-Davidson 10-K reports.
TABLE 4 Harley-Davidson’s dealership network, 2008–17
US Canada EMEA Asia-Pacific Latin America
2008 686 71 383 201 32
2014 669 69 369 273 55
2017 698 68 398 276 58
Source: Harley Davidson 10-K reports.

450 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
The “general merchandising” business included licensing of the Harley-Davidson
name and trademarks to third-party manufacturers of clothing, giftware, jewelry,
toys, and other products. Licensing revenues were $35.5 million in 2017, down from
$46.5 million in 2015. To expand sales of licensed products, Harley opened “nontra-
ditional” dealerships: retail outlets selling clothing, accessories, and giftware but not
motorcycles.
Manufacturing
Since the 1981 buyout, Harley-Davidson had been upgrading its manufacturing
operations through new plant and equipment, automation, enterprise resource
planning, total quality management, JIT scheduling, CAD/CAM, and participative
decision-making.
Despite the constant development of its manufacturing facilities and operational
capabilities, Harley’s low production volume relative to Honda and the other Japanese
manufacturers imposed significant cost disadvantages, especially in the purchase of
components.
Harley’s capacity for efficiency was also limited by its dispersed manufacturing
operations: engine manufacture in Milwaukee, Wisconsin and assembly in York,
Pennsylvania, and Kansas City, Missouri. During 2009–14, Harley reorganized its manu-
facturing operations, combining the two Milwaukee-area powertrain plants into a single
facility and merging the separate paint and frame operations at York, Pennsylvania. Job
losses and the introduction of more flexible employment arrangements and working
practices created frictions with Harley’s labor unions.
Competition
Despite Harley’s insistence that it was supplying a unique Harley experience, its success
inevitably attracted competitors. The clearest indication of direct competition was imi-
tation: Honda, Suzuki, Yamaha, and Kawasaki had long been offering V-twin cruisers
styled closely along the lines of the classic Harleys, but at lower prices and with more
advanced technologies (Table 6). In competing against Harley, the Japanese manufac-
turers’ key advantage was the scale economies that derived from vastly greater volume.
However, despite their price premium, Harley-Davidson motorcycles benefitted from a
lower rate of depreciation than other brands.
Almost all of Harley’s competitors were, compared to Harley, highly diversified.
Honda, BMW, and Suzuki were important producers of automobiles, and more than
TABLE 5 Harley-Davidson’s nonmotorcycle sales, 2005–14 ($million)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Parts and accessories 858.7 767.2 749.2 816.5 836.7 873.1 875 862.6 842.6 804.3
General merchandise 313.8 282.2 259.1 274.1 282.5 295.9 284.8 292.3 284.5 262.7
Financial services 377.0 494.7 682.7 649.4 650.1 641.6 660.8 686.6 725.0 732.1
Source: Harley Davidson 10-K reports.

CASE 7 HArlEy-DAvIDSon, InC. In 2018 451
one-third of Yamaha’s turnover came from boats and snowmobiles. These companies
could share technologies, engineering capabilities, distribution, and brand awareness
across their different vehicle divisions. Moreover, sheer size conferred purchasing power.
Imitators of Harley’s retro-styled, V-twin cruisers were not only the Japanese motor-
cycle companies but also domestic competitors—notably Polaris which produced Vic-
tory and Indian motorcycles.
Appendix Table  A2 compares the financial performance of leading motorcycle
companies.
TABLE 6 Recommended retail prices for V-twin, cruiser motorcycles, 2018
Model Specifications Price ($)
Harley-Davidson
Street 750 Liquid-cooled, OHC, 8-valve, 750cc engine 7599*
Sportster Superlow Air-cooled, 4-valve, 883cc engine 8699*
Softail Slim Air/liquid cooled, 8-valve 1746 cc engine
Air/liquid cooled, 8-valve 1746 cc engine
15,899
Fat Boy 17,699
Honda
Shadow Phantom Liquid-cooled, 6-valve, OHC, 745cc 7799
Fury Liquid-cooled, 6-valve, OHC, 1312cc 10,449
Suzuki
Boulevard M50 Liquid-cooled, OHC, 805cc 8649
Boulevard C90T Liquid-cooled, OHC, 1462cc 12,949
Kawasaki
Vulcan 900 Classic Liquid-cooled, 8-valve, OHC, 903cc, belt drive
Liquid-cooled, 8-valve, OHC, 903cc, belt drive
7999
Vulcan 900 Custom 8499
Yamaha
Bolt V-twin, OHC, 4-valve, air-cooled, 942cc 7999
Stryker OHC, 8-valve, liquid-cooled, 1304cc 11,899
Polaris
Victory Octane 4-valve, OHC, liquid cooled, 1200cc 9999
Victory Vegas 8-Ball 8-valve, air-cooled, 1731cc 12,999
Indian Scout Sixty Liquid cooled, 655ccs 8999
Indian Chief Liquid cooled, 1644ccs 18,499
Note:
*Price is for the base model which is black, other colors extra.

452 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
The Future
During the first half of 2018, Harley’s revenues, net income, and margins continued to
decline. Its problems were principally in the US where sale volume was 8.7% lower
than the first half of 2017; international sales volume grew by 0.5%.10 Overseas, Harley
sought to expand sales through adding new dealerships and building an assembly
plant in Thailand. At home, Harley continued its quest to broaden its rider base. Among
its new models, the most radical was the electric motorcycle, to be introduced in the
latter part of 2019. Moreover, Harley planned to “increase its investment in electric
motorcycle technology, products and infrastructure in 2018 and beyond. . . [which] will
help accelerate the development of this market and assure its leadership in electric
motorcycles.”11 In March 2018, it invested in Alta Motors, a California-based developer
of electric vehicles.12
In the face of challenging market conditions, Harley announced the closure of its
Kansas City plant. Production would be transferred to the York, PA plant, and the
company would incur a $54 million restructuring charge. However, Harley remained
committed to its strategy to “build the next generation of Harley-Davidson riders
globally.” On July 30, 2018, Harley announced accelerated measures to develop new
models, broaden market reach with “a multichannel retail experience,” and strengthen
its dealer network.
Exploiting the potential offered by emerging markets was particularly challenging.
A major dilemma for Harley was the extent to which it should seek to replicate the
same brand image and the same Harley Experience that had been so successful in the
United States, or whether it should adapt to the physical and cultural differences of
each national market?
A Milwaukee blogger summarized Harley’s dilemma:
So what does Harley do? One tack would be to stay focused on what it does best: big
bikes. While that strategy may make sense on some fronts (focus on what you know,
stay loyal to the brand identity, etc.), that approach will mean greatly reduced growth
prospects and could doom it if the current consumer spending environment holds out
long term. And meanwhile its core audience just gets older.
Or it could do what people have been saying what it should do for years: Make
smaller, more affordable bikes. That’s harder than it sounds, as it would force Harley
to compete against the Japanese manufacturers on their own turf. But if the market is
moving away from Harley, does it have a choice?13
As for Harley’s venture into electric motorcycles, this too attracted skepticism:
“Investment in the tech will be funded by a dying business, and they are basically
starting from scratch. Either they shrink to demand and be what they’ve always been
or they sell out and pursue some weird future-mobility business model that doesn’t
promise anything—even if they were capable of pulling it off.”14 Bloomberg Business-
week summed up HD’s dilemma as follows: “It’s searching for a middle ground, one
that will let it reach into the future without letting go of the past. If there is such a path,
it must be pretty narrow.” 15

CASE 7 HArlEy-DAvIDSon, InC. In 2018 453
Appendix: Financial Data
TABLE A1 Selected Items from Harley-Davidson financial statements, 2005–14 ($million)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Income statement items
Net sales 5594 4781 4859 5311 5581 5900 6229 5995 5996 5647
R & D 164 143 136 145 137 152 138 161 172 175
Selling, administrative, and
engineering expense
985 979 1020 1061 1111 1127 1160 916 866 907
Operating income 1029 197 559 829 1000 1154 1281 1155 1048 891
—of which:
Financial services 83 (117) 181 268 259 283 278 280 275 275
Interest income/(expense) 9 (22) (90) (45) (46) (45) (4) 12 29 31
Income before taxes 1034 178 390 792 961 1114 1283 1150 1023 863
Net income 655 (55) 146 599 624 734 845 752 692 521
Balance sheet items
Cash 594 1630 1021 1526 1327 1067 907 722 759 687
Finance receivables 1378 1436 1080 1168 1344 1774 1917 2053 2076 2105
Accounts receivable, net 296 269 262 219 255 261 248 247 285 329
Inventories 401 323 326 418 428 425 449 585 499 538
Total current assets 5378 4341 4066 4542 4216 3989 3948 3977 3853 3884
Property, plant, and
equipment, net
1094 906 815 809 819 842 883 942 981 967
Total assets 7829 9155 9430 9674 9513 9405 9528 9972 9890 9972
Current portion of
long-term debt
0 1332 0 399 682 1176 1011 838 1084 1127
Accounts payable 324 162 225 255 248 240 197 235 235 227
Total current liabilities 2604 2268 2013 2698 0 2510 2389 2747 2862 3158
Long-term debt 2176 4144 2516 2396 2936 3417 3762 4832 4666 4587
Post-retirement
healthcare liability
274 264 254 268 258 216 203 193 173 118
Stockholders’ equity 2116 2108 2207 2420 2558 3009 2909 1839 1920 1844
Cash flow items
Operating activities 2685 609 1163 885 801 977 1147 1100 1174 1005
Capital expenditures (2232) (116) (170) (189) (189) (208) (232) (259) (256) (206)
Total investing activities (2393) (863) 145 (63) (261) (569) (745) (915) (392) (562)

454 CASES To ACCoMPAny ConTEMPorAry STrATEGy AnAlySIS
Notes
1. “The Company,” http://www.harley-davidson.com/
content/h-d/en_GB/company/becoming-a-dealer/the-
company.html, accessed March 19, 2018.
2. Harley produced sports motorcycles under the Buell brand
between 1990 and 2009. Harley acquired MV Agusta, an
Italian manufacturer of premium, high-performance motor-
cycles in July 2008. On August 6, 2010, Harley sold it back
to its previous owner for €3 ($3.90).
3. The Indian plant was its second overseas assembly plant;
the first was established in Brazil in 1999.
4. G. Strauss, “Born to be Bikers,” USA Today (Novem-
ber 5, 1997).
5. M. Ballon, “Born to be Wild,” Inc. (November, 1997): 42.
6. Harley-Davidson, Inc., annual report (2000).
7. “Welcome Letter,” Blackstone Valley HOG Chapter, http://
www.blackstonevalleyhog.com/HTML/Welcome.php,
accessed July 20, 2015.
8. “Letter to Shareholders,” Harley-Davidson 2014
annual review.
9. Harley-Davidson, Inc., “Knowledge is Horsepower,”
annual report (2003).
10. Harley-Davidson, Inc. Second Quarter Update (July
24, 2018).
11. Harley-Davidson, Inc. 10K Report for 2017: 24.
12. https://www.bloomberg.com/news/articles/2018-01-30/
harley-davidson-is-making-an-electric-motorcycle-after-
livewire, accessed March 18, 2018.
13. brewcitybrawler.typepad.com/brew_city_brawler/2009/01/
screw-it-lets-ride-is-not-a-strategy.html, accessed March 18, 2018.
14. https://www.bloomberg.com/news/articles/2018-01-30/
harley-davidson-is-making-an-electric-motorcycle-after-
livewire. Accessed May 20, 2018.
15. “Harley-Davidson Needs a New Generation of Riders,”
Bloomberg Businessweek, August 27, 2018.
TABLE A2 Comparative financial data for Honda, Yamaha, and Harley-Davidsona
Honda Motor Co. Yamaha Motor Co. Harley-Davidson Triumph Motorcycles
2017 2016 2017 2016 2017 2016 2017 2016
Revenue ($bn) 119.97 131.3 14.31 13.28 5.65 6.00 0.54 0.43
—of which
motorcycles ($bn)
14.7 15.23 8.95 8.02 4.92 5.27 0.54 0.43
Operating income ($bn) 7.5 5.9 1.29 0.96 0.89 1.05 0.01 0.01
Net income
after tax ($bn)
5.8 4.1 0.87 0.56 0.52 0.69 0.01 0.01
Gross margin (%) 22.4 22.3 27.5 26.8 42.3 43.0 12.0 13.9
Operating margin (%) 5.94 4.45 8.93 7.22 15.75 17.5 1.43 2.17
Net margin (%) 4.85 2.78 6.08 4.21 9.2 11.5 1.22 2.44
Operating income/
total assets
4.43 2.76 10.57 8.19 8.92 10.62 2.31 2.97
Return on equity (%) 8.97 5.77 17.59 12.31 28.20 35.93 11.3 19.3
Inventory turnover 10.26 11.12 5.42 5.09 10.50 12.0 5.25 4.51
Debt/equity ratio 0.53 0.53 0.27 0.27 2.49 2.43 0.64 0.73
Capital
expenditure ($bn)
5.04 5.89 0.42 0.45 0.21 0.26 n.a. n.a.
—of which
motorcycles ($bn)
0.57 0.65 n.a. n.a.b n.a n.a n.a. n.a.
R&D expenditure ($bn) 5.71 6.39 n.a. n.a. 0.18 0.17 n.a n.a.
Motorcycles shipped
(units ,000s)
11,237 10,529 5400 5200 241 262 63 56
Notes:
a Honda’s financial year is to March 31; Triumph’s is to June 30. Yamaha and Harley-Davidson have financial years that end on December 31.
b n.a. = not available.
Sources: Company annual reports.

http://www.harley-davidson.com/content/h-d/en_GB/company/becoming-a-dealer/thecompany.html

https://www.bloomberg.com/news/articles/2018-01-30/harley-davidson-is-making-an-electric-motorcycle-afterlivewire

https://www.bloomberg.com/news/articles/2018-01-30/harley-davidson-is-making-an-electric-motorcycle-afterlivewire

This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.
Case 8 BP: Organizational
Structure and
Management Systems
When John Browne stepped down as CEO at BP plc in January 2007, he was credited
with having transformed an inefficient, bureaucratic, state-owned oil company into
the world’s most dynamic, entrepreneurial, performance-focused, and environmentally
aware oil and gas major. Since taking up the job in 1995, BP’s market capitalization had
increased fivefold and its earnings per share by 600%.
Even before Browne’s departure, BP’s fall from grace had already commenced.
Concerns over BP’s HSE (health, safety, and environmental) management had been
circulating for years. However, in March 2005 disaster struck: an explosion at BP’s Texas
City refinery killed 15 employees. This was the first of a series of catastrophes that
destroyed the company’s reputation and threatened its very survival.
In 2006, a corroded pipeline from BP’s huge Alaskan oilfield leaked 4800 barrels
of oil. Then in March 2009, BP was fined for safety violations at its Toledo refinery.
The next month, an explosion on Transocean’s Deepwater Horizon oilrig drilling BP’s
Macondo oil well in the Gulf of Mexico killed 11 workers and caused one of the worst
environmental disasters in US history. The company took an accounting charge of
$37.2 billion to cover the likely costs of the cleanup, compensation, and legal penalties,
but by 2018 these costs had reached $65 billion.
BP’s troubles extended beyond its safety and environmental mishaps. Between 2003
and 2013, BP’s trading activities in the crude oil, gasoline, propane, and natural gas
markets were investigated by US regulators, resulting in a series of fines. In Russia,
BP was hit, first, by a dispute with its joint venture partner, TNK, and then from the
declining value of its 20% stake in Rosneft following Western sanctions on Russia.
In the recriminations that followed the Texas City and Gulf of Mexico disasters,
attention increasingly focused upon the organizational structure, management systems,
and corporate culture that had developed at BP during John Browne’s tenure. The
management system developed by Browne had produced what the Financial Times
described as “the most swashbuckling, the most entrepreneurial, the most creative” of
the world’s biggest oil companies.1 Was it also the most accident prone and, more gen-
erally, was it suited to the circumstances and needs of the petroleum industry?
A Brief History of BP
BP began as the Anglo-Persian Oil Company, which had been founded in 1909 to
exploit a huge oilfield that had been discovered in Iran. At the outbreak of the First
World War, the British government acquired a controlling interest in the company,

456 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
which it held until the company (by then renamed British Petroleum) was privatized
by Margaret Thatcher’s government in 1979.
Under a series of chief executives—Peter Walters, Bob Horton, and David Simon—
BP went from being a highly centralized, bureaucratic organization to becoming less
hierarchical and more financially oriented. However, it was under John Browne that
BP’s transformation gathered pace. Browne initiated the acquisitions of Amoco, Atlantic
Richfield, and Burmah Castrol not only made BP the world’s third biggest petroleum
major after Exxon and Shell, but also precipitated an industry-wide wave of consolida-
tion. Browne refocused BP’s exploration efforts around frontier regions including deep
waters (the Gulf of Mexico in particular), Angola, Siberia, and the Arctic. Browne also
broke away from industry convention by acknowledging climate change, supporting
the Kyoto Protocol, and rebranding BP as “Beyond Petroleum.” This strategic transfor-
mation was accompanied by radical changes to BP’s structure, systems, and culture.
The Atomic Structure
In 1997, the Harvard Business Review commented upon the changes occurring at BP:
Organizationally, BP is much smaller and simpler than it was a decade ago. It now
has 53,000 employees–down from 129,000. Before, the company was mired in proce-
dures; now it has processes that foster learning and tie people’s jobs to creating value.
Before, it had a multitude of baronies; now it has an abundance of teams and informal
networks or communities in which people eagerly share knowledge.2
At the heart of Browne’s transformation of BP were high aspirations. According to
Nick Butler, former head of strategy at BP:
When Browne stepped in as CEO in 1995, we knew we had to create something
different. We looked at the ROACE [return on average capital employed]: we were
all operating within a limited space. We realized that to break out we had to rede-
fine ourself. It was not about beating Exxon, it was about how to beat the ROACE
of Microsoft. We wanted to create [a] company with sufficient scale to take regional
knocks with enough reach to survive in almost any circumstances.3
Through a series of mergers and acquisitions, Browne created a company with the
scale he believed was essential to become a leader in the petroleum industry. But it also
created the challenge of how to organize such a huge company—by 2000, BP was the
world’s seventh biggest company in terms of revenues. Browne’s approach was built
upon three principles:
● BP operates in a decentralized manner, with individual business unit leaders
(such as refinery plant managers) given broad latitude for running the business
and direct responsibility for delivering performance.
● The corporate organization provides support and assistance to the business
units (such as individual refineries) through a variety of functions, networks,
and peer groups.
● BP relies upon individual performance contracts to motivate people.4
At the time, most of the oil majors had a corporate head office that coordinated
and controlled a few major divisions. This divisional structure typically comprised:
upstream (exploration and production), downstream (refining and marketing), and

CASE 8 BP: ORGANIZATIONAL STRUCTURE AND MANAGEMENT SYSTEMS 457
petrochemicals. BP had been similar; its divisional structure had been described as a
“collection of fiefdoms.”
Browne was keen to break away from the management conventions of the oil industry.
His inspirations were the management styles of Silicon Valley and the corporate trans-
formation that had been unleased by Jack welch at General Electric. The structure cre-
ated by Browne was radically different: the divisions were dismantled and the company
was organized around 150 business units each headed by a business unit leader who
reported directly to the corporate center. According to the deputy CEO, this was “an
extraordinarily flat, dispersed, decentralized process of delivery” that reflected a divi-
sion of responsibility between the business unit heads who were responsible for opera-
tional performance and senior management who were responsible for strategic direction
and managing external relations—especially with governments. The 150 business units
were organized into 15 “peer groups”—networks of similar businesses that could share
knowledge, cooperate on matters of common interest, and challenge one another.
The Performance Management System
A basic principle of BP’s management system was decentralized, personalized
responsibility:
Under the Management Framework, authority is delegated, but accountability is not.
Delegations of authority flow from the shareholders to the Board of Directors to the
Group Chief Executive and down throughout BP. BP’s philosophy is to delegate authority
to the lowest appropriate point in the organization—a single point of accountability.
The single point of accountability is always a person, as opposed to an organization,
committee, or other group of people, who manages performance through monitoring
and intervention. Those higher in the chain of delegation monitor this performance and
report up the line of delegation to meet their accountabilities. This structure reflects BP’s
philosophy that leadership monitors but does not supervise the business; leadership
only supervises the people who report directly to them. BP’s Management Framework
is evident at every level of the organization. Its concepts of delegation and account-
ability begin with the shareholders and extend through each level of the organization.5
The relationship between top management and the business units was governed
by a “performance contract”: an agreement between the head of the business unit
and the corporate center over the performance that the business would deliver in the
year ahead. While the performance targets included strategic and operational goals—
including HSE objectives—the primary emphasis was on four financial targets: profit
before tax, cash flow, investment, and return on invested capital.
Performance goals for the year were proposed by the business unit head after dis-
cussions, first with his/her own management team and, second, with the other business
unit heads within the peer group. BP encouraged the business unit heads within each
peer group to support and encourage one another. There was a particular responsibility
for the top three units in each peer group to assist the performance of the bottom three.
Each business unit then discussed its performance targets with top management. The
outcome was a performance contract. Once a performance contract was agreed, the
business unit leader was free to pursue them in whatever way he or she found appro-
priate. The monitoring of performance targets involved a quarterly meeting between
top management and the business unit leader. “There is an understanding here . . . that
this is a performance culture and either you deliver or you don’t,” explained one senior

458 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
executive. Failure to achieve performance targets often meant reassignment to another
job or termination.
Performance contracts were given to all managers within BP from the CEO down
and were a key determinant of a manager’s annual bonus.
BP as a Learning Organization
At the same time as driving financial and operational performance, Browne was deter-
mined to recreate BP as a “learning organization.” According to Browne:
In order to generate extraordinary value for shareholders, a company has to learn
better than its competitors and apply that knowledge throughout its business faster
and more widely than they do. Any organization that thinks it does everything the
best and that it need not learn from others is incredibly arrogant and foolish.6
Turning BP into a learning organization involved redefining the role of top management.
The primary role of top management was strategic thinking, which involved a quest for
knowledge and a commitment to analysis and sharing ideas. Browne espoused an intel-
lectualism that was foreign to the senior executives of most oil companies:
This company is founded on a deep belief in intellectual rigor. In my experience, unless
you can lay out rational arguments as the foundation of what you do, nothing happens.
Rigor implies that you understand the assumptions you have made: assumptions about
the state of the world, of what you can do, and how your competitors will interact with
it, and how the policy of the world will or will not allow you to do something.7
This openness involved BP’s executives fostering links outside their own company
and outside the petroleum business. Browne was a board member of both Intel and
Goldman Sachs.
The same culture of interaction and communication was encouraged among peer
groups and supported by a number of intranet-based knowledge management and
groupware tools. It also involved increased emphasis on career development within BP
through training and mentoring.
Social and Environmental Responsiveness
Browne sought to distance BP from the common perception of oil companies as being
powerful, secretive organizations complicit with the corrupt, autocratic practices of
many leaders of oil-producing countries. Browne envisaged the “new BP” as being
more open and responsive to the interests of its employees and the needs of society:
To build the reputation, we picked four areas. First, safety: when you invite someone
to come and work, you should send them home in the same shape as when they
arrived—that is a minimum requirement for respect of a person, and you have to take
that terribly seriously. Second, you have to take care of the natural environment. It is
important because people do not want companies to make a mess and leave them
behind. Third, everyone wants a place in the ideal which is free of all discrimination;
it doesn’t matter what you stand for in terms of your race, gender, sexual orientation,
or religious beliefs. All that matters is merit. Fourth, the company has to invest in the

CASE 8 BP: ORGANIZATIONAL STRUCTURE AND MANAGEMENT SYSTEMS 459
community from which the people have come, so as to narrow the gap between life
within the company and life outside the company.
The key initiative was Browne’s endorsing of the link between greenhouse gases
and climate change and his commitment to a path of environmental responsibility for
BP. The resulting effort to reposition BP in the minds of consumers, governments, and
NGOs involved a host of initiatives, including renaming British Petroleum as simply
“BP” and replacing its shield logo with a sunburst. The effectiveness of BP’s newfound
environmentalism was indicated by references to BP and Exxon as “beauty and the
beast”8 and the Oil & Gas Journal’s lauding of the company:
Among the top 10 [oil and gas companies] there is one striking example of a company
driven by a different vision. BP has designated corporate citizenship and being
forward-thinking about the environment, human rights and dealing with people and
ethics as the new fulcrum of competition between the oil companies.9
Adapting the Management Model, 2001–08
In 2001 and again in 2003, BP’s organizational structure underwent significant revisions
designed to address excessive decentralization and to improve coordination and control.
Instead of the individual business units reporting directly to top management, the
peer groups were replaced by “strategic performance units,” which were more for-
malized organizational units with their own budgets and with responsibility for the
business units beneath them.
The strategic performance units were organized within three business segments:
exploration and production; refining and marketing; and gas, power, and renew-
ables. Thus, while BP’s individual refineries remained as separate business units, they
reported to refining, which itself was one of the three strategic performance units that
comprised the refining and marketing segment.
In addition to the business structure, there was a regional structure. BP had four broad
geographic areas: (1) Europe; (2) the Americas; (3) Africa, the Middle East, Russia, and
the Caspian; and (4) Asia, the Indian subcontinent, and Australasia. The head of each
region was responsible for ensuring regional consistency of the businesses within that
region, managing BP’s relations with governments and other external parties, and con-
ducting certain administrative functions relating to tax and compliance with local laws.
Further changes took place when Tony Hayward took over from John Browne in
2007. A consulting report from Bain and Co. declared that BP was the most complicated
organization that the consultants had ever encountered. Bain identified more than
10,000 organizational interfaces. Hayward’s “forward agenda” emphasized cost cutting
and simplification. Regional structures were eliminated, functional structures stream-
lined, and the number of senior executives was reduced from 650 to 500.
Findings of the Baker Panel
An independent investigation by a panel led by former Secretary of State James Baker
into the Texas City refinery explosion offered penetrating insights into the role that BP’s
culture and management system had played in the events leading up to the disaster.
Among the findings of the Panel were the following:

460 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
● From board level downwards, “BP has not provided effective process safety
leadership and has not adequately established process safety as a core value
across all its five US refineries.”10
● Inappropriate performance metrics. Establishing and monitoring performance
targets can reconcile individual decision-making with overall coordination—but
only if the targets encourage the right decisions. In safety, BP’s key performance
metric was the number of days lost through injury. While conducive to improve-
ments in personal safety, this metric did not help BP in improving its process
safety. According to the Panel: “BP’s corporate process safety management
system does not effectively translate corporate expectations into measur-
able criteria for management of process risk or define the appropriate role of
qualitative and quantitative risk management criteria.”11
● Inadequate resources. The Panel reached no conclusion as to whether BP’s
emphasis on cost reduction and profit performance had impeded safety.
However, it did observe that: “the company did not always ensure that ade-
quate resources were effectively allocated to support or sustain a high level of
process safety performance. In addition, BP’s corporate management mandated
numerous initiatives that applied to the US refineries and that, while well-inten-
tioned, had overloaded personnel at BP’s US refineries. This “initiative overload”
may have undermined process safety performance.”12
● Failure of board oversight: “BP’s Board of Directors has been monitoring pro-
cess safety performance of BP’s operations based on information that BP’s cor-
porate management presented to it. A substantial gulf appears to have existed,
however, between the actual performance of BP’s process safety management
systems and the company’s perception of that performance . . . [T]he Panel
believes that BP’s Board can and should do more to improve its oversight of
process safety at BP’s five US refineries.”13
Similar allegations surfaced following the Deepwater Horizon tragedy. A study by
the Center for Catastrophic Risk Management observed that BP lacked a “functional
safety culture”; there were “gross imbalances between the system’s provisions for pro-
duction and those for protection”; a potent driving force was “BP management’s desire
to “close the competitive gap” and “improve bottom-line performance.” In addition to
“incentives that provided increases in productivity without commensurate increases
in protection” and “inappropriate cost and corner cutting,” the study pointed to BP’s
emphasis on “worker safety” and its failure to address “system safety.”14
However, these inquiries into the Texas City and Deepwater Horizon disasters
focused entirely on BP’s performance in relation to safety. A broader issue concerned
the appropriateness of BP’s organization structure and management systems to overall
corporate performance. It was notable that BP’s organizational delayering and system
of performance management had not been imitated by other oil and gas majors. Exxon
Mobil, for example, remained organized around 10 global businesses, and maintained
a management system that was dominated by its emphasis on disciplined processes.
Its management style had been described as “no-nonsense,” “conservative,” “detail-
oriented,” “engineering-based,” and “military.” Yet, Exxon Mobil had maintained the
best financial performance in the industry and was widely admired for its operational
excellence—including its safety record: it had not suffered any major incident since the
Exxon Valdez oil spill in 1989.

CASE 8 BP: ORGANIZATIONAL STRUCTURE AND MANAGEMENT SYSTEMS 461
Notes
1. “BP: The Inside Story,” Financial Times ( July 3, 2010).
2. “Unleashing the Power of Learning: An Interview with
British Petroleum’s John Browne,” Harvard Business
Review (September–October 1997).
3. The Transformation of BP, London Business School
(March 2002): 2–3.
4. See The Report of the BP U.S. Refineries Independent Safety
Review Panel ( January 2007).
5. Ibid.: 27. Note that the “Management Framework” refers
to the company’s description of its management system,
produced in 2003.
6. The Transformation of BP, London Business School
(March 2002): 5.
7. Ibid.: 7.
8. I. H. Rowlands, “Beauty and the Beast? BP’s and Exxon’s
Positions on Global Climate Change” Environment and
Planning: Government and Policy 18 (2000): 339–54.
9. “Common Financial Strategies Found among Top-10 Oil
and Gas Firms,” Oil & Gas Journal (April 20, 1998).
10. The Report of the BP U.S. Refineries Independent Safety
Review Panel ( January 2007): xii.
11. Ibid.: xv.
12. Ibid.: iii.
13. Ibid.: xv.
14. Deepwater Horizon Study Group, Final Report on the
Investigation of the Macondo Well Blowout (Center for
Catastrophic Risk Management, March 1, 2011).

Case 9 Starbucks Corporation,
March 2018
Starbucks Corporation’s annual shareholders’ meeting on March 22, 2017 marked
Starbucks’ 25th anniversary as a public company. It also marked a changing of the
guard: Howard Schultz, Starbucks founder, CEO, and chairman announced his retire-
ment as CEO and handed over the key of the first Starbucks store to his succes-
sor, Starbucks’ president and chief operating officer, Kevin Johnson. Johnson was
a 16-year Microsoft veteran who had been CEO of Juniper Networks before joining
Starbucks.
Stepping in Schulz’s “venti-sized” shoes presented a massive challenge to Johnson
and for his first year as CEO, he kept a low profile. When Starbucks hit turbulence—as
in April when two African-American men were arrested at a Starbucks in Philadelphia—
it was Schultz who was the public face of the company. However, in June 2018, Schulz
also announced his retirement as executive chairman of Starbucks—fueling specula-
tion that he was planning to run for president of the United States of America as a
Democratic candidate.
Johnson was now the official and de facto leader of Starbucks Corporation. As he
acknowledged: “The most difficult transition any company will ever go through is
from founder-led to founder-inspired.”1 Moreover, Starbucks was facing significant stra-
tegic and operational challenges. Some of Starbucks’ diversification—into tea shops for
example—had been unsuccessful, and in the United States, same-store sales growth
had declined, causing the company to announce in June 2018 the closure of 150 stores.
But to put these challenges in context, Starbucks’ financial health continued to be
robust: in the first quarter of 2018, Starbucks’ revenues grew by 7% (year-on-year), its
operating margin was 12.8%, and it earned a return on equity of 14.0%.
Starbucks’ rise from a single Seattle coffee store to a global chain of over 27,000
coffee shops employing almost 280,000 people and generating revenues of $22.4 billion
in 2017 was one of the wonders of American entrepreneurial capitalism. Howard
Schultz was a legend among US business leaders. During 2017/18, Starbucks’ profits
and share price had set new records (Table 1 and Figure 1).
For many observers, including the owners of the Milanese cafés that had provided
the inspiration for Schultz, the Starbucks story was little short of miraculous. America’s
first coffeehouse had opened in Boston in 1676. How could brewing a better cup of
coffee in the 1980s produce a company with a market value of $78 billion? Given the
ubiquity of good coffee, could Starbucks possibly sustain its success?
Any sense of trepidation that Johnson might have felt would have been heightened
by the memory of Schultz’s previous retirement as CEO in 2000: Starbucks’ faltering
performance forced Schultz to return as CEO in 2008.
This case was prepared by Robert M. Grant ©2019 Robert M. Grant.

CASE 9 StArbuCkS CorporAtion, MArCh 2018 463
The Starbucks Story
Starbucks Coffee, Tea, and Spice had been founded in Seattle by college buddies
Gerald Baldwin and Gordon Bowker. In 1981, Howard Schultz, a coffee filter salesman,
visited their store. The coffee he sampled was a revelation: “I realized the coffee I had
been drinking was swill.” Captivated by the business potential that Starbucks offered,
Schultz encouraged the founders to hire him as head of marketing. Shortly afterward,
Schultz experienced a second revelation. On a trip to Italy, he discovered the joys of the
Milanese coffee houses, which offered a combination of good coffee, ambiance, social
interaction, and the artistry of the barista. After failing to persuade the founders to trans-
form Starbucks into a chain of coffee bars, Schultz left to open his own Italian-styled
coffee bar, Il Giornale. However, in 1987, Schultz acquired the Starbucks chain of six
stores, merged it with his three Il Giornale bars, and adopted the Starbucks name for
the enlarged company.2
TABLE 1 Starbucks Corporation: Financial data for 2010–18 ($million)
12 months to end-Sept. ($m) 2018a 2017 2016 2015 2014 2013 2012 2011 2010
Total net revenues of which: 16,448 22,387 21,316 19,163 16,448 14,892 13,300 11,700 10,707
—company-operated stores 12,978 17,651 16,844 15,197 12,978 11,793 10,534 9632 8964
—licensed stores 1589 2355 2318 2104 1589 1360 1210 1007 801
—CPGb, foodservice, other 1881 2.381 2318 2104 1881 1739 1555 1061 1744
Cost of sales 6859 9038 8511 7788 6859 6382 5813 4916 4459
Store operating expenses 4638 6493 6064 5411 4638 4286 3918 3595 3551
Other operating expenses 450 554 545 522 450 457 430 393 293
Depreciation and amortization 710 1011 981 894 710 621 550 523 510
General and
administrative expenses
991 1393 1361 1197 991 938 801 636 570
Special chargesc — — — — — 2784 — — 53
Total operating expenses 13,635 18,643 17,462 15,812 13,635 15,469 11,513 10,176 9436
Operating income 3081 4135 4172 3601 3081 (325) 1997 1729 1419
Net earnings 2068 2885 2818 2757 2068 8 1384 1246 946
Net cash from operations 608 4174 4575 3749 608d 2908 1750 1612 1705
Capital expenditures (net) 818 1519 1440 1304 1161 1411 974 1019 441
Working capital 450 1063 211 719 690 94 1990 1719 977
Total assets 14,752 14,366 14,313 12,404 10,752 11,516 8219 7360 6386
Long-term debt 3648 3933 3585 2335 2048 1299 550 549 549
Shareholders’ equity 5610 5450 5884 5818 5272 4482 5115 4385 3675
Notes:
a First 9 months of financial year only.
b Consumer Products Group.
c The special charge in 2013 comprised a payment to Kraft Foods arising from litigation. Special charge in 2010 was restructuring cost.
d Operating cash flow was reduced by the $2.8 billion payment made to Kraft.

464 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
Schultz’s original idea of replicating Italian coffee bars (where customers mostly
stand to drink coffee) was adapted to “the American equivalent of the English pub, the
German beer garden, and the French café.” With the addition of wi-fi, Starbucks’ stores
became a place to work as well as to socialize. An IPO in 1992 funded accelerated
growth. Expansion followed a cluster pattern: opening multiple stores in a single metro
area increased local brand awareness and helped customers make a Starbucks’ visit part
of their daily routine. International expansion began with Japan in 1996 and the UK
in 1998. Starbucks relied mainly on organic growth, but with occasional acquisitions.
The Starbucks Experience
Starbucks’ mission “to inspire and nurture the human spirit” required not just serv-
ing excellent coffee but also engaging customers at an emotional level. As Schultz
explained: “We’re not in the coffee business serving people, we are in the people
business serving coffee.”
Central to Starbucks’ strategy was Schultz’s concept of the “Starbucks Experience,”
which centered on the creation of a “third place”—somewhere other than home and
work where people could engage socially while enjoying the shared experience of
drinking good coffee. The Starbucks Experience combined several elements:
● Coffee beans of a high, consistent quality and the careful management of a chain
of activities that resulted in their transformation into the best possible espresso
coffee: “We’re passionate about ethically sourcing the finest coffee beans, roast-
ing them with great care, and improving the lives of the people who grow them.”
● Employee involvement. Starbucks’ counter staff—the baristas—played a central
role in delivering the Starbucks Experience. Their role was not only to brew
and serve coffee but also to engage customers in the ambiance of the Starbucks
coffee shop. This was supported by human resource practices based upon a
FIGURE 1 Starbucks’ share price ($), January 1998 to January 2018 (adjusted
for splits)
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
60
55
50
45
40
35
30
25
20
15
10
5

CASE 9 StArbuCkS CorporAtion, MArCh 2018 465
distinctive view about the company’s relationship with its employees: “we had
to exceed the expectations of our people, so that they could exceed the expec-
tations of our customers.”3 This required, first, attracting and recruiting people
whose attitudes and personalities were consistent with the company’s values
and, second, fostering trust and loyalty that facilitated their engagement with
the Starbucks experience. Starbucks’ employee training extended beyond basic
operational and customer-service skills to educate employees about coffee; it
provided health insurance for all regular employees, including most part-timers;
its College Achievement Plan provided tuition reimbursement for employees
taking online degree programs.
● Community relations and social purpose. Schultz viewed Starbucks as redefin-
ing the role of business in society: “I wanted to build the kind of company
my father never had the chance to work for, where you would be valued and
respected wherever you came from, whatever the color of your skin, whatever
your level of education . . . We wanted to build a company that linked share-
holder value to the cultural values that we want to create with our people.”4
Schultz’s vision was of a company that would earn good profits but would also
do good in the world. This began at the local level: “Every store is part of a
community, and we take our responsibility to be good neighbors seriously. We
want to be invited in wherever we do business. We can be a force for positive
action—bringing together our partners, customers, and the community to con-
tribute every day.”5 It extended to Starbucks’ global role: “we have the oppor-
tunity to be a different type of global company. One that makes a profit but
at the same time demonstrates a social conscience.” Starbucks’ sponsoring of
social causes was not without controversy: its 2015 “Race Together” campaign to
promote discussion of racism was poorly received by customers and was soon
abandoned.6
● The layout and design of Starbucks’ stores were critical elements of the experi-
ence. Like everything else at Starbucks, store design was subject to meticulous
planning, following Schultz’s dictum that “retail is detail.” While every Starbucks
store is adapted to its unique neighborhood, all stores reflect some common
themes. “The design of a Starbucks store is intended to provide both unhurried
sociability and efficiency on-the-run, an appreciation for the natural goodness
of coffee and the artistry that grabs you even before the aroma. This approach
is reflected in the designers’ generous employment of natural woods and richly
layered, earthy colors along with judicious high-tech accessorizing . . . No matter
how individual the store, overall store design seems to correspond closely to the
company’s first and evolving influences: the clean, unadulterated crispness of the
Pacific Northwest combined with the urban suavity of an espresso bar in Milan.”7
● Starbucks’ location strategy—its clustering of 20 or more stores in each
urban hub—helped create a local “Starbucks buzz” and facilitated customer
loyalty. To expand sales of coffee-to-go, Starbucks began adding drive-
through windows to some of its stores and building new stores adjacent to
major highways.
Broadening the Experience
Delivering the Starbucks Experience encouraged Starbucks to broaden its product
offerings. This involved adding food, music, books, and videos. Schulz was initially
skeptical about Starbucks’ “Artists Choice” CDs, “But then I began to understand that
our customers looked to Starbucks as a kind of editor. It was like, ‘We trust you. Help
us choose.!’”

466 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
Starbucks also diversified its business model to include other ownership and
management formats, additional products, and different channels of distribution.
These included:
● Licensed coffee shops and kiosks. The desire to reach customers in a variety
of locations eventually caused Starbucks to abandon its policy of only selling
through company-owned outlets. Its first licensing deal was with Host Marriot,
which owned food and beverage concessions in several US airports. This was
followed by licensing arrangements with Safeway and Barnes & Noble for open-
ing Starbucks coffee shops in their stores. Overseas, Starbucks increasingly
relied upon licensing arrangements with local companies.
● Distribution of Starbucks retail packs of Starbucks coffee through supermarkets
and other retail food stores.
● Licensing of Starbucks brands to PepsiCo and Unilever for the supply of
Starbucks bottled drinks (such as Frappuccino and Tazo Tea).
● Starbucks’ involvement in financial services began with its Starbucks prepaid
store card, which was later combined with a Visa credit card (the Starbucks/Bank
One Duetto card). The Starbucks card allowed entry to the Starbucks reward
program, which offered free drinks and other benefits to regular customers.
The Crisis of 2007–09
Starbucks’ growth trajectory came to a shuddering halt in 2007–09 when slowing same-
store sales growth and declining operating profits were exacerbated by the finan-
cial crisis. In response to growing concerns over Starbucks’ strategy and management
effectiveness, Howard Schultz, who had relinquished the CEO role and continued as
chairman, returned as CEO in early 2008.
Schultz’s turnaround strategy comprised two initiatives. First, retrenchment: Schultz
cancelled new store openings, closed 600 US stores and most Australian stores, elim-
inated 6000 jobs in the stores and 700 corporate and support positions. Savings in
operating costs of $500 million in 2009 included Schultz cutting his own salary from
$1.2 million to $10,000 and selling two of Starbucks’ three corporate jets.8
Second, Schultz worked to reaffirm Starbucks’ values and business principles, revitalize
the “Starbucks Experience,” and reconnect with customers. Reinvigorating Starbucks’
social commitment played a central role in the rediscovery process. A company-wide
reconsideration of Starbucks’ purpose and principles resulted in a revised mission state-
ment and a stronger commitment to social responsibility, environmental sustainability,
and community service programs. To promote these initiatives, Schultz traveled exten-
sively meeting with employees (“partners”) in concert halls and other venues, reigniting
their drive and reinforcing Starbucks’ values with inspiring tales of the “humanity of
Starbucks” and the values that made Starbucks a special place.9
Broadening Corporate Scope: Diversification, Internationalization,
and Technology
Diversification
By 2010, Starbucks had restabilized and resumed its growth path. In the US market,
the primary emphasis was on exploiting new revenue opportunities. Overseas, it was
building Starbucks’ presence in emerging markets.

CASE 9 StArbuCkS CorporAtion, MArCh 2018 467
In its US stores, Starbucks expanded its menu of drinks and food. A stream of new
coffee drinks included Cascara Latte, Smoked Butterscotch Latte, Nitro Cold Brew,
barrel-aged Starbucks Reserve coffee, and “Black & White” mocha beverages. Starbucks
also expanded beyond coffee drinks.
In November 2011, Starbucks acquired premium juice maker Evolution Fresh Inc.,
with a view to expanding the retail distribution of fruit juices both within its own stores
and to the grocery trade.
A year later, Starbucks acquired Teavana Holdings, Inc. for $620 million with the
intention of creating over 1000 Teavana stores on the basis that “the tea category is
ripe for reinvention and rapid growth.”10 However, following disappointing sales and
a reassessment of market potential, Starbucks decided in 2017 to close its 379 Teavana
outlets and sell Teavana drinks only through its Starbucks outlets. Fizzio “handcrafted
soda” was another initiative that had little market impact.
Starbucks also introduced new formats for its coffee outlets, Starbucks Reserve
began as a brand of ultra-premium coffees served in selected Starbucks stores. In
2014, Starbucks began creating separate Starbucks Reserve cafes and its flagship
Starbucks Reserve Roastery and Tasting Room chain where coffee drinks ranged from
$3.50 to $12.
Starbucks viewed food as the greatest opportunity for growing revenue at its US stores.
In 2012, Starbucks acquired San Francisco bakery, La Boulange, to provide pastries and
baked goods to its stores. To build traffic during quiet periods, Starbucks launched a
dinner menu accompanied, in selected stores, by beer and wine. Starbucks ended its
“Evenings” program in 2016 and shifted attention to growing its lunchtime food sales.
However, despite continued efforts “to grow food business through customer-driven
innovation,” food continued to account for just 20% of sales at company-operated stores
during 2017.
Starbucks’ most successful diversification was in expanding sales to the grocery sector.
Under Schultz’s leadership, Starbucks’ Channel Development (previously the Consumer
Products Group) became the fastest-growing part of the company. The strategy was
to exploit complementarities between Starbucks’ coffeehouses and the grocery trade:
first, introducing Starbucks branded products (such as Via instant coffee) in its own
stores, then supplying them to supermarkets and other grocery outlets. Initially,
Starbucks packaged coffee and other products were distributed to the grocery trade by
Kraft Foods. In 2010, Starbucks terminated the arrangement and took over distribution
itself. In 2013, Starbucks was required to pay Kraft $2.8 billion in compensation.
International Expansion
Starbucks’ international expansion had initially focused upon Canada, Western
Europe, Japan, and Latin America. After 2010, its emphasis shifted to Asia–China in
particular. By 2017, China was Starbucks’ biggest market after the United States. By
2021, Starbucks aimed to have 5000 stores in China. Other initiatives in Asia included
an Indian joint venture with Tata Group and the buyout of its Japanese joint venture
partner in 2014.
In a few countries, notably Canada, China, and Japan, Starbucks stores were mostly
company managed; however, in most overseas markets, Starbucks increasingly favored
licensing to local operators.
In September 2018, Starbucks’ licensee, Percassi, would open the first Starbucks
coffee house in Italy.
Tables  2 and  3 show Starbucks’ store information and financial performance by
region. The appendix shows Starbucks’ stores by country.

468 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
TABLE 2 Starbucks Corporation: Store information, 2010–2017
2017 2016 2015 2014 2013 2012 2011 2010
Percentage change in same store sales
Americas 3 6 5 6 7 8 8 7
EMEAa 1 0 4 5 0 0 3 5
Pacific 3 3 9 7 9 15 22 11
Consolidated 3 5 7 6 7 7 8 7
Stores opened during the year (net of closures)
Americas
Company-operated stores 394 348 276 317 276 228 32 32
Licensed stores 558 465 336 381 404 280 215 101
EMEA
Company-operated stores (21) (214) (80) (9) (29) 10 25 (64)
Licensed stores 353 494 302 180 129 101 79 100
China/Asia-Pacific
Company-operated stores 259 359 1320 250 240 154 73 30
Licensed stores 777 622 (482) 492 348 294 193 79
All other segments
Company-operated stores (68) (17) 6 12 343 0 6 (1)
Licensed stores 2 (6) (1) (24) (10) (4) (478) 10
Total stores opened 2254 2042 1677 1599 1701 1063 145 223
Total number of stores at year-end
Americas
Company-operated stores 9413 9019 8671 8395 8078 7802 7574 7542
Licensed stores 7146 6588 6132 5796 5415 5011 4731 4516
EMEA
Company-operated stores 502 523 737 817 853 882 872 847
Licensed stores 4409 3632 3010 1323 1116 987 886 807
China/Asia-Pacific
Company-operated stores 3070 2811 2452 1132 906 666 512 439
Licensed stores 4409 3632 3010 3492 2976 2628 2334 2141
All other segments
Company-operated stores 290 358 375 369 357 14 14 8
Licensed stores 37 35 41 42 66 76 80 558
Total number of stores 27,399 25,085 23,043 21,366 19,767 18,066 17,003 16,858
Note:
a Europe, Middle East and Africa.
Source: Starbucks Corporation, 10-K reports.

CASE 9 StArbuCkS CorporAtion, MArCh 2018 469
Technology
The appointment of Kevin Johnson as CEO was indicative of the central role that tech-
nology played in Starbucks strategy. Johnson’s prior experience was exclusively in
the digital technology sector. Technology was a critical component of the Starbucks
Experience: Starbucks was an early leader in using social media (particularly Facebook
and Twitter) to connect with customers, it was a pioneer of mobile payment systems,
and the Starbucks app for iPhone and Android provided customers with an integrated
set of services—including placing orders. The Starbucks loyalty card, an in-store debit
card, was launched in 2002 and was linked to “My Starbucks Rewards” loyalty program,
providing rewards for cumulative purchases. These three components—loyalty
rewards, remote ordering, and mobile payments—were three components of Starbucks’
“Digital Flywheel.” The fourth was personalization: “Offers, communications, and ser-
vice tailored to individual customers.” According to Starbucks’ head of strategy, “Our
TABLE 3 Starbucks Corporation: Segment results, 2015–2017
($ millions ) Americas
China/
Asia Pacific EMEA
Channel
development
Fiscal 2017
Total net revenues 15,652.7 3240.2 1013.7 2008.6*
Company- operated stores 13,996.4 2906.0 551.0 —
Licensed stores 1617.3 327.4 407.7 —
Foodservice and other 39.0 6.8 55.0 —
Operating income/(loss) 3663.2 765.0 116.1 893.4
Total assets 3327.2 2770.9 273.8 114.0
Fiscal 2016
Total net revenues 14,795.4 2938.8 1124.9 1932.5*
Company-operated stores 13,247.4 2640.4 732.0 —
Licensed stores 1518.5 292.3 339.5 —
Foodservice and other 29.5 6.1 53.4 —
Operating income/(loss) 3742.0 631.6 151.6 807.3
Total assets 3424.6 2740.2 552.1 67.1
Fiscal 2015
Total net revenues 13,293.4 2395.9 1216.7 1730.9*
Company-operated stores 11,925.6 2127.3 911.2 —
Licensed stores 1334.4 264.4 257.2 —
Foodservice and other 33.4 4.2 48.3 —
Operating income/(loss) 3223.3 500.5 168.2 653.9
Total assets 2726.7 2230.5 749.1 87.3
Note:
* During 2015 to 2017, Channel Development’s revenues comprised 77% consumer packaged goods and 23%
foodservice.

470 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
personalization engine will help us deepen engagement with customers and would
allow our baristas to recognize customers that deserve differentiated treatment, perhaps
customers celebrating birthdays or regular customers from one store who show up at a
different store.”11 Yahoo Finance went as far as to claim that Starbucks had become “a
technology company that also sells coffee.”12
The Market for Coffee
Coffee was the most popular beverage of North America and Europe, with Northern
Europeans the heaviest consumers (Table 4).
The United States was the world’s biggest market for coffee, with expenditure (for
consumption at home, at work, and at catering establishments) of $68 billion in 2017.
In terms of expenditure, the market was split roughly equally between sales of the
home-brewed coffee and sales of ready-brewed coffee. However, in terms of quantity,
80% of the coffee consumed in the United States was at home. Sales of home-brewed
coffee had recently reversed their long-term decline due to the popularity of single-
serve coffee makers.
The US market could also be segmented between “ordinary” coffee and “specialty”
coffee (also known as “premium” or “gourmet” coffee). Although specialty coffee-
houses had existed for many decades, especially on the east and west coasts of the
United States, Starbucks’ achievement had been to bring quality coffee to the mass
market. Sales of premium brewed coffee were estimated to have grown from about $3.5
billion in 2000 to about $23.4 billion in 2017, with the number of coffee shops roughly
doubling over the same period to reach 32,500.13
Although Starbucks had been the primary driver of this growth, its success had
spawned many imitators. These included both independent coffeehouses and chains,
most of which were local or regional, although some aspired to grow into national
chains (Table 5).
In addition to specialty coffeehouses, most catering establishments in the United
States, whether restaurants or fast-food chains, served coffee as part of a broader
TABLE 4 Coffee consumption per head of population, 2014
Source: Euromonitor (www.caffeineinformer.com/caffeine-what-the-world-drinks).
Rank Country Kilograms
11 Bosnia-Herzegovina 4.3
12 Estonia 4.2
13 Switzerland 3.9
14 Croatia 3.8
15 Dominican Republic 3.7
16 Costa Rica 3.7
17 Macedonia 3.6
18 Italy 3.4
19 Canada 3.4
20 Lithuania 3.3
Rank Country Kilograms
1 Finland 9.6
2 Norway 7.2
3 Netherlands 6.7
4 Slovenia 6.1
5 Austria 5.5
6 Serbia 5.4
7 Denmark 5.3
8 Germany 5.2
9 Belgium 4.9
10 Brazil 4.8

CASE 9 StArbuCkS CorporAtion, MArCh 2018 471
menu of food and beverages. Increasingly, these outlets were seeking to compete more
directly with Starbucks by adding premium coffee drinks to their menus. McDonald’s
had introduced a premium coffee to its menu and had also reconfigured its outlets
to include McCafés, which highlighted its premium coffee drinks. Burger King and
Dunkin’ Donuts had also moved upmarket in their coffee offerings. Both McDonald’s
and Dunkin’ Donuts had targeted Starbucks in their advertising, characterizing Starbucks
as overpriced and snobbish.
Outside of the United States, Starbucks’ competitive situation varied by country. In some,
competition was even more intense than in the United States. For example, Starbucks’
withdrawal from Australia was a consequence of a highly sophisticated coffee market
developed by southern European and Middle Eastern immigrants. Throughout continental
Europe, Starbucks had to deal with well-developed markets with high standards of coffee
preparation and strong local preferences. In the United Kingdom, where Starbucks was
second to Costa in terms of outlets, it earned a net margin of just 1.7% in 2016.
As well as competition from the bottom (McDonald’s, Dunkin’ Donuts), Starbucks
faced competition from the top. The upmarket Italian coffee roaster Illycaffè SpA was
expanding in the United States through franchise arrangements with independent
coffee houses. Some observers believed that once Starbucks had educated North Amer-
icans about the joy of good coffee, consumers of gourmet coffee would go on to seek
superior alternatives to Starbucks.
The home-brewed coffee market was also being revolutionized. Sales of Italian-style
espresso coffee makers, which used highly pressurized hot water to make coffee, had
grown rapidly since 2000. The key stimulus had been the popularity of single-serve
coffee pod systems pioneered by Nestlé’s Nespresso subsidiary. In the United States,
Keurig Green Mountain with its K-Cup system dominated the market. In March 2012,
Starbucks joined the fray by launching its own single-serve, home coffee makers under
its Verismo brand. Starbucks also supplied K-Cups for Keurig coffee makers. By 2017,
Starbucks was one of the leading suppliers of both premium packaged coffee and
single-cup capsules to the US retail market (Table 6).
TABLE 5 Leading chains of coffee shops in the US, 2017
Company No. of outlets Headquarters
Starbucks 13,172 Seattle, WA
Tim Hortons 580 Oakville, Ontario
Caribou Coffee 402 Brooklyn Center, MN
Coffee Bean and Tea Leaf 378 Los Angeles, CA
Peet’s Coffee & Tea 193 Emeryville, CA
Coffee Beanery 131 Flushing, MI
Gloria Jean’s 110 Castle Hill, Australia
Dunn Bros. Coffee 77 St. Paul, MN
Tully’s Coffee Shops 76 Seattle, WA
PJ’s Coffee 76 New Orleans, LA
It’s a Grind Coffee House 17 Long Beach, CA
Source: Multiple company web sources.

472 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
Looking Ahead
In the early months of 2018, Starbucks was looking forward to continued growth of
revenue and earnings. Despite several quarters of disappointing revenue growth, Star-
bucks predicted net revenue growth in the upper single digits, and earnings-per-share
growth of 12% or more in the coming years. Among the 35 analysts following Star-
bucks, 34 rated Starbucks a buy, an outperform, or a hold. At the same time, Starbucks
acknowledged the risks to its continued prosperity:
● Growing competition in Starbucks’ markets: “In the US, the ongoing focus
by large competitors in the quick-service restaurant sector on selling high-
quality specialty coffee beverages could lead to decreases in customer traffic to
Starbucks . . . Similarly, continued competition from well-established competi-
tors in our international markets could hinder growth.”14
● Starbucks recognized that its core US market was close to saturation: “because
the Americas segment is relatively mature and produces the large majority of
our operating cash flows, such a slowdown or decline could result in reduced
cash flows. . .”15
● In international markets, Starbucks’ future growth was heavily dependent
upon China and Asia Pacific. Here, risk factors included political and
regulatory uncertainties, difficulties of protecting intellectual property and
enforcing contracts, reliance upon foreign partners, and the challenge of
adapting to differences in consumer tastes and business and employment
practices.
Starbucks’ growing diversification also presented risks. Its widening range of food
and beverage products, and entry into the grocery trade, raised issues as to whether
Starbucks had the capabilities necessary to succeed in these areas, and the possible
erosion of the Starbucks Experience and Starbucks’ identity as it extended into tea,
soda drinks, hot food, instant coffee, and drive-through stores.
TABLE 6 Brand market shares of packaged coffee in the US, 2017
Packaged ground and whole-bean coffee Single cup servings
Brand Market share (%) Brand Market share (%)
Folgers 29 Keurig Green Mountain 24
Kraft 17 Private label 16
Starbucks 10 Starbucks 15
Private label 9 Kraft 10
J.M. Smuckler 8 Folgers 8
Source: Multiple web sources.

CASE 9 StArbuCkS CorporAtion, MArCh 2018 473
Appendix: Starbucks’ Stores by Country
TABLE A2 Starbucks’ licensed stores
2017 2012
US 5708 4189
Mexico 632 356
Canada 377 300
Other Americas 429 166
UK 606 168
Turkey 387 171
United Arab Emirates 164 99
Germany 156 —
Spain 96 78
Kuwait 118 65
Saudi Arabia 124 64
Russia 115 60
Other EMEAa 689 282
Japan — 965
TABLE A1 Starbucks’ company operated stores
2017 2012
US 8222 6875
Canada 1083 874
Brazil 108 53
UK 345 593
Other EMEA 157 289
China 1540 408
Japan 1218 —
Thailand 312 155
Singapore — 80
All othera 290 14
Total 13,275 9327
Note:
aIncludes Seattle’s Best Coffee, Teavana, Evolution Fresh, and Siren Retail.
Source: Starbucks Corporation 10-K reports.
(Continues)

474 CASES to ACCoMpAnY ContEMporArY StrAtEGY AnALYSiS
Notes
1. “The CEO of Starbucks Isn’t Leaving. Only Howard Schultz
Is,” New York Times ( June 17, 2018).
2. Howard Schultz, Pour Your Heart Into It: How Starbucks
Built a Company One Cup at a Time (New York:
Hyperion, 1997).
3. https://hbr.org/2010/07/the-hbr-interview-we-had-to-
own-the-mistakes; accessed January 19, 2018.
4. Ibid.
5. http://en.starbucks.at/about-us/company-information/
mission-statement; accessed July 20, 2018.
6. “Starbucks Ends Conversation Starters on Race,” New York
Times (March 22, 2015).
7. “Starbucks: A Visual Cup o’ Joe,” @Issue: Journal of
Business and Design 1, (2006): 18–25.
8. Starbucks Corporation, press release, Starbucks Reports
First Quarter Fiscal 2009 Results ( January 28, 2009).
9. A meeting at London’s Barbican Center is described in
J. Wiggins, “When the Coffee Goes Cold,” Financial Times
(December 13, 2008).
10. “Starbucks’ Quest for Healthy Growth: An Interview with
Howard Schultz,” McKinsey Quarterly (March 2011).
11. https://www.geekwire.com/2017/starbucks-tech-company-
coffee-giant-investing-heavily-digital-innovation/; accessed
January 20, 2018.
12. https://finance.yahoo.com/news/starbucks-becoming-
tech-company-sells-coffee-202605767.html; accessed Janu-
ary 20, 2018.
13. http://www.scanews.coffee/2016/12/06/specialty-coffee-
shops-market-size-in-the-u-s/; accessed January 21,
2018.
14. Starbucks Corporation 10-K report for 2017: 14.
15. Ibid.: 14.
2017 2012
China 1396 292
South Korea 1108 467
Taiwan 420 271
Philippines 324 201
Other Asia Pacific 844 432
Other licensed 37 76
Total licensed 14,064 8702
Note:
aEMEA: Europe, Middle East, and Africa.
Source: Starbucks Corporation 10-K reports.
TABLE A2 Starbucks’ licensed stores (continued)

http://en.starbucks.at/about-us/company-information/mission-statement

Case 10 Eastman Kodak’s
Quest for a
Digital Future
On January 19, 2012, the Eastman Kodak Company declared bankruptcy—it entered
“voluntary Chapter  11 business reorganization.” Its two-decade journey of transition
from traditional photography into digital imaging was effectively over. In 1990, Kodak
had launched its Photo CD system for storing photographic images; in 1991, it had intro-
duced its first digital camera and, in 1994, its new CEO, George Fisher, had declared:
“We are not in the photographic business . . . we are in the picture business.”
With senior executives recruited from Motorola, Apple, General Electric, Silicon
Graphics, and Hewlett-Packard, Kodak’s digital imaging efforts had established some
notable successes. In digital cameras, Kodak was US market leader for most of 2004–10;
globally, it ranked third after Canon and Sony. It was a technological leader in mega-
pixel image sensors. It was global leader in retail printing kiosks and digital minilabs.
Financial performance was a different story. In 1991, Eastman Kodak was America’s
18th-biggest company by revenues; by 2011, it had fallen to 334th: over the same period
its employment had shrunk from 133,200 to 17,100. During 2000–11, its operating
losses totaled $5.2 billion.
As Antonio Perez prepared for his new role under the supervision of Kodak’s chief
restructuring officer, James Mesterharm, he reflected on Kodak’s two decades of decline.
How could a company that had been a pioneer of digital imaging and had invested so
heavily in building digital capabilities and launching new digital imaging products have
failed so miserably to profit from its efforts? And what could he have done differently
to have avoided this fate?
These same questions haunted the CEOs of other companies: if one of America’s
most successful companies could be destroyed by new technology, what did the future
hold for their own businesses?
Kodak’s History, 1901–93
George Eastman transformed photography from a professional, studio-based activity
into an everyday consumer hobby. His key innovations were silver halide roll film and
the first fully portable camera. The Eastman Kodak Company established in Roches-
ter, New York, in 1901 offered a full range of products and services for the amateur
photographer: “You push the button, we do the rest” was its first advertising slogan.
By the time George Eastman died in 1932, Eastman Kodak was one of the world’s
leading multinational corporations with production, distribution, and processing facil-
ities throughout the world and with one of the world’s most recognizable brand names.
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

476 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
After the Second World War, Kodak entered a new growth phase with an expand-
ing core business and diversification into chemicals (its subsidiary, Eastman Chemical,
exploited its polymer technology) and healthcare (Eastman Pharmaceutical was
established in 1986). Kodak also faced major competitive challenges. In cameras,
Japanese companies came to dominate the world market; in film, Fuji Photo Film
Company embarked on an aggressive international expansion. In addition, new
imaging technologies were emerging: Polaroid pioneered instant photography; Xerox
led the new field of electrostatic plain-paper copying; while the advent of the personal
computer ushered in new image management and printing technologies.
Kodak was alert to the emergence of digital technology and introduced several
products that embodied new imaging technologies:
● The world’s first megapixel electronic image sensor (1986), followed by a
number of new products for scanning and electronic image capture.
● Computer-assisted image storage and retrieval systems for storing, retrieving,
and editing graphical and microfilm images.
● Data storage products included floppy disks (Verbatim was acquired in 1985)
and 14-inch optical disks (1986).
● Plain-paper office copiers (Kodak acquired IBM’s copier business in 1988).
● The Photo CD system (1990) allowed digitized photographic images to be
stored on a compact disk, which could then be viewed and manipulated on a
personal computer.
● Kodak’s first digital camera, the 1.3 megapixel DCS-100, priced at $13,000
launched in 1991.
Committing to a Digital Future
Kodak’s commitment to a digital imaging strategy was sealed with the appointment
of George Fisher as CEO. Fisher had a doctorate in applied mathematics, 10 years of
R & D experience at Bell Labs, and had led strategic transformation at Motorola. To
focus Kodak’s efforts on the digital challenge, Fisher’s first moves were to divest East-
man Chemical Company and most of Kodak’s healthcare businesses (other than med-
ical imaging) and to create a single digital imaging division headed by newly hired Carl
Gustin (previously with Apple and Digital Equipment).
Kodak’s Digital Strategy
Under three successive CEOs—George Fisher (1993–99), Dan Carp (2000–05), and
Antonio Perez (2005–12)—Kodak developed a digital strategy intended to transform
Kodak from a traditional photographic company to a leader in the emerging field of
digital imaging. The scale and scope of this transformation was outlined by Antonio
Perez in terms of the “fundamental challenges” that Kodak was engaged in (Figure 1).
During 1993–2011, Kodak’s strategy embodied four major themes:
● an incremental approach to managing the transition to digital imaging;
● different strategies for the consumer market and for the professional and
commercial markets;

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 477
● external sourcing of knowledge through hiring, alliances, and acquisitions;
● an emphasis on printed images;
● harvesting the traditional photography business.
An Incremental Approach
“The future is not some harebrained scheme of the digital information highway or
something. It is a step-by-step progression of enhancing photography using digital
technology,” declared Fisher in 1995.2 This recognition that digital imaging was an evo-
lutionary rather than a revolutionary change would be the key to Kodak’s ability to
build a strong position in digital technology. If photography was to switch rapidly from
the traditional chemical-based technology to a wholly digital technology where cus-
tomers took digital pictures, downloaded them onto their computers, edited them, and
transmitted them through the Internet to be viewed electronically, Kodak would face an
extremely difficult time. Not only would the new digital value chain make redundant
most of Kodak’s core competitive advantages (its silver halide technology and its global
network of retail outlets and processing facilities): most of this digital value chain was
already in the hands of computer hardware and software companies.
Fortunately for Kodak, during the 1990s, digital technology made only selective
incursions into traditional photographic imaging. As late as 2000, digital cameras had
achieved limited market penetration; the vast majority of photographic images were
still captured on traditional film.
Hence, central to Kodak’s strategy, was a hybrid approach where Kodak introduced
those aspects of digital imaging that could offer truly enhanced functionality for users.
Thus, in the consumer market, Kodak recognized that image capture would continue
to be dominated by traditional film for some time (digital cameras offered inferior res-
olution compared with conventional photography). However, digital imaging offered
immediate potential for image manipulation and transmission.
If consumers continued to use conventional film while seeking the advantages of
digitization for editing and emailing their pictures, this offered a valuable opportunity
The Scope of Transformation
FROM
Analogue technology
Long design cycle
Industrial manufacturing processes
Value based on physical products
Mass-produced, large inventories
High margins, heavy infrastructure
Rapid prototyping
Flexible manufacturing processes
Value based on solutions (product +
consumables + services)
Just-in-time, just-in-place, customized
Lower margins, lean organization
Digital technology
TO
FIGURE 1 Eastman Kodak’s “fundamental challenges”
Source: Based upon Bob Brust, “Completing the Kodak Transformation,” Presentation, Eastman Kodak Company,
September 2005. © Kodak. Used with permission.

478 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
for Kodak’s vast retail network. Kodak had installed its first self-service facility for
digitizing, editing, and printing images from conventional photographs in 1988. In
1994, Kodak launched its Picture Maker, a self-service kiosk located in retail stores
where customers could edit and print digital images from a variety of digital inputs,
or from digital scans of conventional photo prints. Picture Maker allowed customers
to edit their images (zoom, crop, eliminate red-eye, and add text) and print them in a
variety of formats. George Fisher emphasized the central role of retail kiosks in Kodak’s
digital strategy:
Four years ago, when we talked about the possibilities of digital photography, people
laughed. Today, the high-tech world is stampeding to get a piece of the action, calling
digital imaging perhaps the greatest growth opportunity in the computer world. And
it may be. We surely see it as the greatest future enabler for people to truly “Take
Pictures. Further.” We start at retail, our distribution stronghold  …  We believe the
widespread photo-retailing infrastructure will continue to be the principal avenue by
which people obtain their pictures. Our strategy is to build on and extend this existing
market strength which is available to us, and at the same time be prepared to serve
the rapidly growing, but relatively small, pure digital market that is developing. Kodak
will network its rapidly expanding installed base of Image Magic stations and kiosks,
essentially turning these into nodes on a massive, global network. The company will
allow retailers to use these workstations to bring digital capability to the average snap-
shooter, extending the value of these images for the consumers and retailers alike,
while creating a lucrative consumable business for Kodak.3
Despite growing ownership of inkjet printers, a very large proportion of consumers
continued to use photo-print facilities in retail stores. By the beginning of 2004, Kodak
was the clear leader in self-service digital printing kiosks, with 24,000 installed Kodak
Picture Makers in the United States and over 55,000 worldwide.
Kodak also used digital technology to enhance the services offered by photofin-
ishers. Thus, the Kodak I.Lab system offered a digital infrastructure to photofinishers
that digitized every film negative and offered better pictures by fixing common prob-
lems in consumer photographs.
Despite the inferior resolution of digital cameras, Fisher recognized their potential
and pushed Kodak to establish itself in this highly competitive market. In addition to
high-priced digital single reflex lens cameras for professional use, Kodak developed
the QuickTake camera for Apple: at $75 it was the cheapest digital camera available in
1994. In March 1995, Kodak introduced the first full-featured digital camera priced at
under $1000.
The Consumer Market: Emphasizing Simplicity and
Ease of Use
Kodak pursued different approaches to consumer and professional/commercial
markets. While the commercial and professional market offered the test-bed for Kodak’s
advanced digital technologies, the emphasis in the consumer segment was to main-
tain Kodak’s position as mass-market leader by providing simplicity, quality, and value.
Kodak’s incremental strategy was most evident in the consumer market, providing
an easy pathway for customers to transition to digital photography while exploit-
ing Kodak’s core brand and distribution strengths. This transition path was guided by
Kodak’s original vision of “You push the button, we do the rest.” Kodak envisaged itself

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 479
as the mass-market leader in digital imaging, providing security, reliability, and sim-
plicity for customers bewildered by the pace of technological change.
Simplicity and mass-market leadership implied that Kodak provided the fully
integrated set of products and services needed for digital photography. “For Kodak,
digital photography is all about ease of use and helping people get prints—in other
words, getting the same experience they’re used to from their film cameras,” noted
Martin Coyne, head of Kodak’s Photographic Group.4 A systems approach recognized
that most consumers had neither the time nor the patience to read instructions and to
integrate different devices and software. Kodak believed that its integrated system
approach would have particular appeal to women, who made up the major part of the
consumer market.
The result was Kodak’s EasyShare system, launched in 2001. According to Willy Shih,
head of digital and applied imaging, EasyShare’s intention was to:
provide consumers with the first easy-to-use digital photography experience … Digital
photography is just the first step … People need to get their pictures to their PCs and
then want to share by printing or e-mail. So we developed a system that made the full
experience as easy as possible.5
Figure 2 shows Kodak’s conceptualization of its EasyShare system.
By 2005, most of the main elements of the EasyShare system were in place:
● Kodak’s range of EasyShare digital cameras had carved out a strong position in
a crowded market.
● EasyShare software allowed the downloading, organization, editing, and email-
ing of images and the ordering of online prints. EasyShare software was bun-
dled with Kodak’s cameras as well as being available for downloading for free
from Kodak’s website.
● The EasyShare printer dock introduced in 2003 was the first printer that incor-
porated a camera dock allowing the “one touch simple” thermal-dye printing
direct from a camera. Antonio Perez’s arrival in 2003 reinforced Kodak’s push
FIGURE 2 Kodak’s easyShare network: “Your pictures—anytime, anywhere”
Source: Based upon Bob Brust, “Completing the Kodak Transformation,” Presentation, Eastman Kodak Company,
September 2005. © Kodak. Used with permission.
Phone cam
Consumer mediaDigital still camera
Mobile services
PC-based, online
services
Home printingRetail kiosk printing
Professional
printing
Kodak
EasyShare
Gallery

480 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
into printers: “If a company wants to be a leader in digital imaging, it neces-
sarily has to participate in digital output.”6
● Online digital imaging services: Kodak had been quick to recognize the poten-
tial of the Internet for allowing consumers to transmit and store their photo-
graphs and order prints. Kodak’s Picture Network, launched in 1997, allowed
consumers to have their conventional photographs digitized by a retail photo
store, then uploaded to a personal Internet account on Kodak’s Picture Net-
work. In 1998, Kodak launched its online printing service, PhotoNet, enabling
consumers to upload their digital images and order prints. Kodak also part-
nered with AOL to offer You’ve Got Pictures. By acquiring Ofoto in 2001,
Kodak became the leader in online photofinishing and online image storage. In
January 2005, Kodak renamed Ofoto “Kodak EasyShare Gallery.”
By 2005, therefore, Kodak was present across the entire digital value chain—this
integrated presence was underpinned by proprietary technology at each of these stages
(Figure 3).
Professional, Commercial, and Healthcare Markets
The commercial and professional markets were important to Kodak for two reasons.
First, they were lead customers for many of Kodak’s cutting-edge digital technologies:
news photographers were early adopters of digital cameras; the US Department of
Defense pioneered digital imaging for satellite imaging, weather forecasting, and sur-
veillance activities; NASA used Kodak cameras and imaging equipment for its space
missions and satellites. For commercial applications ranging from real estate brokerage
to security systems, digital imaging offered image transmission and linkage with IT
management systems for image storage and retrieval. The huge price premium of
commercial consumer products made it attractive to focus R & D on these leading-edge
users in the anticipation of trickle-down to the consumer market.
FIGURE 3 Kodak’s technological position within the digital imaging chain
Image capture
Image storage
Image
manipulation
Image
transmission
Image
printing
Document
and image
management
In commercial sector, Kodak o�ered systems to store, retrieve, edit, and print text and
graphics. In consumer sector, Kodak had built a strong online presence through
Ofoto/Kodak Gallery allowing users to archive and organize digital images.
• Technological strengths in thermal and ink-jet printing and color science.
• Kodak had algorithms for compressing image �les while minimizing image loss.
They were used in proprietary systems but had not become industry standards.
• Kodak had developed algorithms for processing and manipulating digital images that
were used by its proprietary software for both commercial and consumer markets.
• Established presence through �oppy disks, 14-inch optical disks, compact disks
(Photo-CD), and most recently �ash memories.
• Pioneer in both CCD and CMOS image sensors for digital cameras.
• Technical and market leadership in OLED (organic light emitting diode) screens
which were displacing liquid crystal displays (LCDs).
• World leadership in photographic paper and other print media.

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 481
In commercial printing and publishing (which became the Graphic Communica-
tions Group in 2005), Kodak assembled a strong position in commercial scanning,
formatting, and printing systems for the publishing, packaging, and data processing
industries. Kodak’s opportunity was to exploit the transition from traditional offset
printing to digital, full-color, variable printing. This opportunity built on two key
strengths: first, Kodak’s proprietary inkjet technology (including its technically superior
inks) and, second, its leadership in variable-data printing—printing that permitted
individually customized output (as in personalized sales catalogues or bills). Kodak
built its commercial printing business on both internally developed technologies and
acquisitions—notably Heidelberg’s Nexpress and Digimaster businesses, and Scitex,
supplier of Versamark high-speed inkjet printers. Kodak also built a presence in pre-
press and workflow systems used by commercial printers.
In medical imaging, Kodak also faced the decline of its sales of X-ray film and in
related chemicals and accessories. Through a series of acquisitions and internal devel-
opments, Kodak established a portfolio of products for digital X-rays, laser imaging,
picture archiving and communications systems—including systems for digitizing and
storing conventional X-rays. Kodak also built up a strong position in dental imaging
systems comprising hardware, software, and consumables. Kodak sold its Health Group
to Onex Healthcare Holdings in 2007 for $2.55 billion.
Kodak’s capability in creating integrated imaging and information solutions was of
particular value in certain public sector projects. Kodak’s digital scanning and docu-
ment management systems were used in national censuses in the United States, the
United Kingdom, France, Australia, and Brazil. At the German post office, a Kodak team
achieved a world record, creating digitized copies of 1.7 million documents in 24 hours.
Hiring, Alliances, and Acquisitions
Kodak’s business system had been based upon vertical integration and self-sufficiency:
at its Rochester base, Kodak developed its own technology, produced its own prod-
ucts, and supplied them worldwide through its vast global network. In digital imaging,
not only did Kodak lack much of the expertise needed to build a digital imaging
business but also the pace of technological change was too rapid to rely on in-house
development. Hence, as Kodak transformed its capability base from chemical to digital
imaging, it looked outside for the knowledge it required.
Kodak recruited executives and technical specialists it needed for its new digital
strategy. Key executives who relocated from a variety of technology-intensive com-
panies including Silicon Graphics, IBM, Xerox, Hewlett-Packard, Lexmark, Apple, GE
Medical Electronics, Olympus Optical, and Lockheed Martin. Table 1 shows the back-
grounds of Kodak’s top management team.
Kodak acknowledged that the digital imaging chain already included companies
that were well established, sometimes dominant, in particular activities. For example,
Adobe Systems dominated image-formatting software; Hewlett-Packard, Epson, and
Canon were leaders in inkjet printers; and Microsoft dominated PC operating systems.
Willy Shih, head of Kodak’s digital imaging products from 1997 to 2003, observed: “We
have to pick where we add value and commoditize where we can’t.”7
In many cases, this meant partnering with companies that were already leaders in
digital technologies. Kodak forged alliances with Canon, AOL, Intel, Hewlett-Packard,
Olympus, and IBM.
Kodak made acquisitions where it believed that a strong proprietary position was
essential to its strategy and in technologies where it needed to complement its own
expertise. Its major acquisitions over the period are shown in Table 2.

482 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Emphasis on Printed Images
A consistent feature of Kodak’s digital strategy from 1993 to 2012 was the belief that
digital technology would not eliminate printed images. Kodak’s emphasis on printed
images was reinforced by its own capabilities: the printing of photographic and other
images onto paper and other media lay at the heart of Kodak’s traditional chemical
and chromatic know-how. Under Perez, the impetus behind photographic printers for
the consumer market intensified, reflecting Perez’s own background as former head of
Hewlett-Packard’s printer division.
This effort to build Kodak’s presence in the market for consumer inkjet printers
has been the most widely criticized of all Kodak’s digital imaging initiatives. Even
with Kodak’s “treasure trove” of inkjet technologies and its tweaking of the traditional
“razors-and-blades” model by charging low prices for ink and higher prices for printers,
establishing Kodak in such a mature, intensely competitive market would be a struggle.
By 2011, Kodak held just 6% of the US market, compared to 60% for Hewlett-Packard.
TABLE 1 Eastman Kodak’s senior management team, April 2012
Name Position Joined Kodak Prior company experience
Robert L. Berman Senior Vice President 1982 Kodak veteran
Philip J. Faraci President and COO 2004 Phogenix Imaging, Gemplus
Stephen Green Director, Business
Development, Asia-Pacific
2005 Creo Inc.
Pradeep Jotwani President, Consumer Business 2010 Hewlett-Packard
Brad W. Kruchten President Film and Photo-
finishing Systems Group
1982 Kodak veteran
Antoinette
McCorvey
CFO and Senior Vice President 1999 Monsanto/Solutia
Gustavo Oviedo Chief Customer Officer 2006 Schneider Electric
Antonio M. Perez Chairman and CEO 2003 Hewlett-Packard
Laura G. Quatela General Counsel and Chief
Intellectual Property Officer
1999 Clover Capital Management,
Inc., SASIB Railway GRS, and
Bausch & Lomb Inc.
Isidre Rosello General Manager, Digital
Printing Solutions
2005 Hewlett-Packard
Eric H. Samuels Chief Accounting Officer and
Corporate Controller
2004 KPMG, Ernst & Young
Patrick M. Sheller Chief Administrative
Officer, General Counsel
and Secretary
1993 McKenna, Long & Aldridge,
Federal Trade Commission
Terry R. Taber Vice President 1980 Kodak veteran
Note:
Includes corporate officers, senior vice presidents, and division heads.
Source: www.kodak.com. © Kodak. Used with permission.

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 483
TABLE 2 Kodak’s major acquisitions, 1994–2011
Date Company Description
1994 Qualex, Inc. Provider of photo-finishing services; acquired to
complement Kodak’s online photofinishing service
1997 Wang Laboratories Acquisition of Wang’s software unit
1997 Chinon Industries Japanese camera producer; majority stake acquired; out-
standing shares purchased in 2004
1998 PictureVision, Inc. Provider of PhotoNet online digital imaging services and
retail solutions; complement to Kodak’s Picture Net-
work business
1998 Shantou Era Photo Material,
Xiamen Fuda Photo-
graphic Materials
Strengthened Kodak’s position in photographic film in China
1999 Imation Supplier of medical imaging products and services
2000 Lumisys, Inc. Provider of desktop computed radiography systems and
X-ray film digitizers
2001 Bell & Howell Imaging businesses only acquired
2001 Ofoto, Inc. Leading US online photofinisher
2001 Encad, Inc. Wide-format commercial inkjet printers
2003 PracticeWorks Digital dental imaging and dental practice
management software
2003 Algotec Systems Ltd. Developer of picture archiving systems
2003 Lucky Film Co., Ltd. Acquisition of 20% of China’s leading photographic
film supplier
2003 LaserPacific Media
Corporation
Provider of postproduction services for filmmakers
2004 NexPress Acquired Heidelberg’s 50% of this joint venture, which sup-
plied high-end, on-demand color printing systems and
black-and-white variable-data printing systems
2004 Scitex Digital Printing A leader in high-speed variable data inkjet printing (renamed
Kodak Versamark, Inc.)
2004 National Semiconductor Acquisition of National’s imaging sensor business
2005 Kodak Polychrome
Graphics LLC
Kodak acquires Sun Chemical’s 50% stake in the joint
venture, which is a leader in graphic communication
2005 Creo Inc. Leading supplier of prepress and workflow systems used by
commercial printers
2008 Design2Launch Developer of collaborative end-to-end digital workflow solu-
tions for transactional printing
2008 Intermate A/S Danish supplier of Intelligent Print Data Stream software for
managing high speed printers
2009 Böwe Bell & Howell Acquisition of document scanner division
2011 Tokyo Ohka Kogyo Co., Ltd. Acquisition of TOK’s relief printing plates business
Source: Eastman Kodak 10-K reports, various years.

484 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Harvesting the Traditional Photography Business
On the basis that the transition to digital photography would be gradual, Kodak
believed that the transition period would give it the opportunity to generate cash flows
from its legacy film business while investing in digital imaging technologies and prod-
ucts. Kodak’s prediction was initally correct. Through the 1990s, film sales continued
to grow in the United States, reaching a peak of 800 million rolls in 1999. However, by
2004, sales had halved to under 400 million and by 2011 were below 100,000.
Kodak’s forecasts proved wrong in relation to emerging market demand. Kodak’s
acquisitions of Chinese photographic film producers were based on the assumption
that sales of roll film would continue to increase into the 21st century. In reality, the
transition to digital imaging occurred at much the same pace in emerging markets as in
the mature industrialized countries.
During 2011 and 2012, Kodak withdrew several film products, including film for
slides. It also withdrew from other unprofitable markets (including cameras) and sold
other businesses, including its Kodak EasyShare Gallery to rival Shutterfly.
Eastman Kodak in 2012
Eastman Kodak’s business was organized around three business segments. Exhibit  1
describes each of these segments.
EXHIBIT 1
Eastman Kodak’s business segments
CONSuMER DIGITAL IMAGING
GROuP (“CDG”) SEGMENT
CDG’s mission is to enhance people’s lives and social
interactions through the capabilities of digital imaging
and printing technology. CDG’s strategy is to drive prof-
itable revenue growth by leveraging a powerful brand, a
deep knowledge of the consumer, and extensive digital
imaging and materials science intellectual property.
◆ Digital Capture and Devices includes digital still
and pocket video cameras, digital picture frames,
accessories, and branded licensed products. These
products are sold directly to retailers or distributors,
and are also available to customers through the
Internet  .  .  .  As announced on February 9, 2012, the
company plans to phase out its dedicated capture
devices business. . .
◆ Retail Systems Solutions’ product and service
offerings to retailers include kiosks and consum-
ables, Adaptive Picture Exchange (“APEX”) drylab
systems and consumables, and after sale service and
support  .  .  .  Kodak has the largest installed base of
retail photo kiosks in the world.
◆ Consumer Inkjet Systems encompasses Kodak All-
in-One desktop inkjet printers, ink cartridges, and
media . . .
◆ Consumer Imaging Services: Kodak Gallery is a
leading online merchandise and photo sharing
service . . .

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 485
Competition
In most of the markets where it competed, Kodak was subject to intense competition.
In digital cameras, phones incorporating cameras had decimated all but the quality seg-
ment of the market. Online photographic services were also ferociously competitive:
Kodak’s Gallery was the market leader, but it competed with a host of other online
competitors, including: Shutterfly, Snapfish, Walmart.com’s Photo Center, Fujifilmnet.
com, Yahoo Photos, and Sears.com.
Kodak’s highest margins were earned on consumables, notably photographic paper.
However, Kodak faced strong competition, mainly from Xerox, Hewlett-Packard, 3M,
and Oji, as well as from many minor brands. Its attempts to differentiate itself through
superior technology, particularly in inkjet printing paper, were only partially successful
GRAPHIC COMMuNICATIONS
GROuP (“GCG”) SEGMENT
GCG’s strategy is to transform large graphics markets with
revolutionary technologies and customized services that
grow our customers’ businesses and Kodak’s business
with them.
◆ Prepress Solutions is comprised of digital and tra-
ditional consumables, including plates, chemistry,
and media, prepress output device equipment and
related services, and proofing solutions. Prepress
solutions also include flexographic packaging solu-
tions, which is one of Kodak’s four digital growth
initiative businesses.
◆ Digital Printing Solutions includes high-speed,
high-volume commercial inkjet printing equipment,
consumables, and related services, as well as color
and black-and-white electrophotographic printing
equipment . . .
◆ The Business Services and Solutions group’s prod-
uct and service offerings are composed of high-speed
production and workgroup document scanners,
related services, and digital controllers for driving
digital output devices, and workflow software and
solutions. Workflow software and solutions, which
includes consulting and professional business pro-
cess services, can enable new opportunities for our
customers to transform from a print service provider
to a marketing service provider . . .
FILM, PHOTOFINISHING AND
ENTERTAINMENT GROuP
(“FPEG”) SEGMENT
FPEG provides consumers, professionals, and the entertain-
ment industry with film and paper for imaging and pho-
tography. Although the markets . . . are in decline . . . due to
digital substitution, FPEG maintains leading market posi-
tions for these products. The strategy of FPEG is to provide
sustainable cash generation by extending our materials
science assets in traditional and new markets.
◆ Entertaining Imaging includes origination, inter-
mediate, and color print motion picture films, special
effects services, and other digital products and ser-
vices for the entertainment industry.
◆ Traditional Photofinishing includes color negative
photographic paper, photochemicals, professional
output systems, and event imaging services.
◆ Industrial Materials encompasses aerial and
industrial film products, film for the production
of printed circuit boards, and specialty chemicals,
and represents a key component of FPEG’s strategy
of extending and repurposing our materials sci-
ence assets.
◆ Film Capture includes consumer and professional
photographic film and one-time-use cameras.
Source: Eastman Kodak 10-K report, 2011: pp. 5–8.
Reproduced by permission of Eastman Kodak Company.

http://walmart.com

http://Fujifilmnet.com

http://Fujifilmnet.com

http://Sears.com

486 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
in resisting the tide of commoditization and, across all markets, Kodak was suffered
the growing trend for consumers to view their photographs on screens rather than in
printed form.
In commercial markets, competitive price pressures were less severe than in
the consumer sector, in particular the opportunity for Kodak to differentiate its
offering through packaging hardware, software, and services into customized “user
solutions.”
Kodak’s Resources and Capabilities
Digital imaging was a classic “disruptive technology.”8 For traditional photographic
companies, it was “competence destroying”9—digital technology undermined the use-
fulness of many of their resources and capabilities Yet, as late as 2011, Kodak still pos-
sessed some potentially valuable resources and capabilities.
● Brand and distribution: Kodak’s traditional resource strengths had been its
brand and its global distribution presence. Two decades of decline and wrench-
ing technological changes had weakened both. Despite Kodak’s brand recog-
nition, it was unclear whether it added value and market appeal to Kodak’s
consumer and commercial products.
● Technology: For two decades Kodak had maintained one of the world’s big-
gest research efforts in imaging. During 2000–05, its research labs in the United
States, the United Kingdom, France, Japan, China, and Australia had employed
more than 5000 engineers and scientists, including more than 600 PhDs. Bet-
ween 1975 and 2011, Kodak had been issued 16,760 patents. Table 3 identifies
some of Kodak’s principal areas of technological strength.
● New Product Development: Despite Kodak’s strengths in basic and applied
research and its long history of successful new product launches, the company
had struggled to move away from its traditional long and meticulous product
development process to embrace the fast-cycle world of electronics.
Table 4 shows financial data for Eastman Kodak, while Table 5 shows data for its
business segments.
Reflections
As Perez reflected upon Kodak’s two decades of digital transformation, he was struck
by the paradox of Kodak’s progress. In terms of adapting to a highly disruptive tech-
nological revolution, Kodak had been surprisingly successful. For a company that had
dominated its traditional market for so long and so thoroughly as Kodak had, to survive
the annihilation of its core technology, and to build the capabilities needed to become a
significant player in a radically different area of technology was unusual. Yet, in terms of
financial performance, Kodak had failed: for all of Kodak’s technical and market achieve-
ments, Perez and his two predecessors, Dan Carp and George Fisher, had been unable
to build a financially viable digital imaging business. Where had they gone wrong?
● It was difficult to argue that Kodak had been too slow or that it had failed to
recognize the digital threat—as early as 1979 Kodak produced a remarkably

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 487
TABLE 3 Kodak’s technical capabilities
Area of
technology Kodak capabilities
Color science Kodak is a leader in the production, control, measurement, specification, and visual
perception of color, essential to predicting the performance of image-capture
devices and imaging systems. Kodak has pioneered colorimetry—measuring and
quantifying visual response to a stimulus of light.
Image
processing
Includes technologies to control image sharpness, noise, and color reproduction.
It is used to maximize the information content of images and to compress data for
economical storage and rapid transmission. Kodak is a leader in image processing
algorithms for automatic color balancing, object and text recognition, and image
enhancement and manipulation. These are especially important in digital photo-
finishing for image enhancement, including adjustments for scene reflectance,
lighting conditions, sharpness, and a host of other conditions.
Imaging sys-
tems analysis
Provides techniques to measure the characteristics of imaging systems and com-
ponents. Predictive system modeling is especially important in Kodak’s new prod-
uct development, where it can predict the impact of individual components on
the performance of the entire system.
Sensors A world leader in image sensor technology, with 30 years’ experience in the design
and manufacture of both CCD and CMOS electronic image sensors used in cam-
eras, machine vision products, and satellite and medical imaging.
Ink technology A world leader in dyes and pigments for color printing. Pioneer of micro-milling
technology (originally invented for drug delivery systems). It has advanced
knowledge of humectants (which keep print-head nozzles from clogging), and
surface tension and viscosity modifiers (which control ink flows).
Inkjet
technology
Innovations in the electronic and thermal control of inkjet heads coupled with
innovation in inks have given Kodak technological advantages in inkjet printing. In
commercial printing, Kodak’s continuous inkjet technology has permitted the flex-
ibility of inkjet printing to be matched with substantial improvements in resolution
and color fidelity.
Microfluidics Microfluidics, the study of miniature devices that handle very small quantities of
liquids, is relevant to film coating, fluid mixing, chemical sensing, and liquid ink-
jet printing.
Print media A leader in applying polymer science and chemical engineering to ink-receiving
materials. Expertise in specially constructed inkjet media in which layers of organic/
inorganic polymers are coated onto paper or clear film and multilayer coated struc-
tures of hydrogels and inorganic oxides.
Electronic
display
technology
Through its joint venture with Sanyo, Kodak pioneered organic light-emitting
diode (OLED) technology for self-luminous flat panel displays. Kodak’s OLED display
panels extended from small-screen devices to larger displays.
Software EasyShare software focused on ease of image manipulation, printing, and storage
(even without a computer). Commercial software leads in workflow solutions
(Kodak EMS Business Software), scanning software (Perfect Page), and printing
software (Kodak Professional Digital Print Production Software); strengths in con-
trol software and printing algorithms that overcome technical limitations of inkjet
printing and optimize color and tone reproduction (e.g., the Kodak One Touch
Printing System).
Source: www.kodak.com.

488 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
TABLE 4 Eastman Kodak: Selected financial data, 2006–2011 ($million)
2011 2010 2009 2008 2007 2006
From income statement
Sales 6022 7167 7609 9416 10,301 10,568
Cost of goods sold 5135 5221 5850 7247 7757 8159
Selling, general, and admin. 1159 1275 1298 1606 1802 1950
R & D costs 274 318 351 478 525 578
Operating earnings (600) (336) (28) (821) (230) (476)
Interest expense 156 149 119 108 113 172
Other income (charges) (2) 26 30 55 86 65
Restructuring costs 121 70 226 140 543 416
Income taxes 9 114 115 (147) (51) 221
Net earnings (764) (687) (210) (442) 676 (601)
From balance sheet
Total current assets including 2703 3786 4303 5004 6053 5557
Cash 861 1624 2024 2154 2947 1496
Receivables 1103 1196 1395 1716 1939 2072
Inventories 607 746 679 948 943 1001
Property, plant, and equipment 895 1037 1254 1551 1811 2602
Other long-term assets 803 1109 1227 1728 4138 3509
Total assets 4678 6226 7691 9179 13,659 14,320
Total current liabilities including 2150 2820 2896 3438 4446 4554
Payables 706 959 2811 3267 3794 3712
Short-term borrowings other liabilities 152 50 62 51 308 64
Long-term borrowings 1363 1195 1129 1252 1289 2714
Postemployment liabilities 3053 2661 2694 2382 3444 3934
Other long-term liabilities 462 625 1005 1119 1451 1690
Total liabilities 7028 7301 7724 8191 10,630 12,932
Shareholders’ equity (2350) (1075) (33) 988 3029 1388
From cash flow statement
Net cash from operating activities (998) (219) (136) 168 328 956
Net cash used in investing activities (25) (112) (22) (188) 2408 (225)
Net cash flows from financing activities 246 (74) 33 (746) (1294) (947)
Number of employees 17,100 18,800 20,250 24,400 26,900 40,900
Source: Eastman Kodak annual reports.

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 489
accurate forecast of the evolution of digital imaging and it had been a pioneer
of digital cameras.10
● It was also difficult to argue that Kodak had failed in implementing its digital
strategy in terms of being a laggard in developing the capabilities needed
to compete in digital imaging. Kodak’s market leadership in digital cameras
pointed to its ability to build technological know-how, apply that know-how to
develop attractive new products, and market those products in fiercely competi-
tive digital markets.
● Perhaps Kodak’s emphasis had been on the wrong markets and wrong prod-
ucts? Kodak’s biggest losses had been in the consumer market, Kodak’s tradi-
tional stronghold. Was this market simply too unattractive because of intense
competition? Had Perez’s emphasis on printing been misplaced? Might Kodak’s
scarce resources been better spent on other parts of the digital value chain
(such as image capture through cameras and sensors and displays)?
● A further possibility was that Kodak’s vision of establishing itself as a leader
in digital imaging was misconceived. In 2000, Kodak had announced its inten-
tion to be at the center of the $225 billion “infoimaging” industry. But did this
TABLE 5 Eastman Kodak: Results by business segments, 2007–2011 ($million)
2011 2010 2009 2008 2007
Net sales from continuing operations
Consumer Digital Imaging Group 1739 2731 2626 3088 3247
Film, Photofinishing, and Entertainment Group 1547 1762 2262 2987 3632
Graphic Communications Group 2736 2674 2718 3334 3413
All other — — 3 7 9
Consolidated total 6022 7167 7609 9416 10,301
Earnings (losses) from continuing operations
before interest and taxes
Consumer Digital Imaging Group (349) 278 (10) (177) (17)
Graphic Communications Group (191) (95) (107) 31 104
Film, Photofinishing, and Entertainment Group 34 91 187 196 281
All other — (1) (16) (17) (25)
Total of segments (506) 273 54 33 343
Segment total assets:
Consumer Digital Imaging Group 929 1126 1198 1647 2442
Graphic Communications Group 1459 1566 1734 2190 3723
Film, Photofinishing, and Entertainment Group 913 1090 1991 2563 3778
All other — 1 — 8 17
Total of segments 3301 3782 4923 6408 9960
Source: Eastman Kodak 10-K reports.

490 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
“infoimaging” industry really exist? Or was digital imaging part of the overall
computing and communication sector?
Finally, Perez wondered as to what lessons could be drawn from the comparative
success of Fujifilm. For all of Fuji’s similarities to Kodak, its performance had been rad-
ically different: its revenues had grown (in terms of US dollars), and it had been con-
sistently profitable (Exhibit 2).
EXHIBIT 2
Fujifilm Holdings Corporation
1992 2011
Sales
($million)
Net income
($million) Employees
Sales
($million)
Net income
($million) Employees
Fujifilm Holdingsa 9126 593 24,868 27,440 1412 35,274
Eastman Kodakb 20,577 1146 132,600 6022 (764) 17,100
Notes:
a2011 data are for financial year to March 31, 2012.
b2011 data are for year ended December 31, 2011.
Despite the strong similarities between Fujifilm and
Kodak—both companies were heavily dependent on
film during the early 1990s and both had diversified into
other imaging technologies (Fujifilm had a major posi-
tion in plain-paper copiers through its Fuji/Xerox joint
venture)—the two companies responded to the digital
revolution with different strategies which led to very dif-
ferent financial results.
Like Kodak, Fujifilm recognized the implications of
digital imaging for its core business and struggled to
adapt its strategy. However, a key difference was Fuji’s
recognition that digital imaging alone would be unlikely
to support the business of a large company, hence its
emphasis on diversification. Under its chief executive,
Shigetaka Komori, Fujifilm underwent a major restructur-
ing between 2000 and 2010 (especially during 2005/6
and 2009/10) involving business closures, employee lay-
offs, and financial write-downs.
Comparing Fujifilm and Kodak in 2012, the most
obvious difference is Fujifilm’s business diversity. Its
three business segments comprise a variety of different
businesses:
Imaging solutions (14.8% of total sales) included tra-
ditional photo imaging products (photographic paper,
film, and supplies) and electronic imaging (mainly
digital cameras).
Information solutions (40.5% of total sales) included
medical systems, pharmaceuticals, cosmetics, flat panel
display materials, graphic arts materials, data storage
tapes, industrial X-rays, and optical devices.
Document solutions (44.8% of total sales) comprised
office supplies, office printers, and document prod-
uct services.
Fujifilm’s diversification has combined selective
acquisitions (since 2000, $9 billion has been spent on
40 acquisitions) and internal development based upon

CASE 10 EASTMAN KODAK’S QuEST FOR A DIGITAL FuTuRE 491
Fujifilm’s existing technical capabilities. In particular, it has
built upon its chemical and coatings expertise to diver-
sify into cosmetics, pharmaceuticals (especially drug
delivery systems), components for LCD panels, and a
variety of plastics products. The quest to exploit technical
capabilities in “functional compound molecular design,
chemical reaction control, and organic synthesis tech-
nologies” resulted in several discoveries. For example,
human skin was observed to be similar to photographic
film: it contained collagen and was about the same thick-
ness. Fujifilm discovered that many of the antioxidants
used to preserve photographic film could be used for
skin care products.
Sources: www.fujifilm.com; “The last Kodak moment?”
Economist, January 14, 2012; Stefan Kohn, “Disruptive innova-
tions applied: A review of the imaging industry,” http://www
.iande.info/wp-content/uploads/2011/03/StefanKohn
DisruptiveInnovationsFujifilm , accessed September 20, 2012.
Notes
1. “Eastman Kodak Company and its U.S. Subsidiaries Com-
mence Voluntary Chapter 11 Business Reorganization,”
Press Release ( January 19, 2012).
2. “Kodak’s New Focus,” Business Week ( January 30,
1995): 62–68.
3. Eastman Kodak Company, “Kodak Leaders Outline Road
Ahead to get Kodak ‘Back on Track’,” press release
(November 11, 1997).
4. Eastman Kodak Company, “The Big Picture: Kodak and
Digital Photography,” www.Kodak.com/US/en/corp/
presscenter/presentations/020520mediaforum3.shtml.
Website no longer available.
5. See www.Kodak.com/US/en/corp/presscenter/
presentations/020520mediaforum3.shtml, accessed October
29, 2009. Website no longer available.
6. Interview with Antonio Perez, President and COO, Kodak,
PMA Magazine (February 2004).
7. “Why Kodak Still Isn’t Fixed,” Fortune (May 11, 1998).
8. J. L. Bower and C. M. Christensen, “Disruptive Technol-
ogies: Catching the Wave,” Harvard Business Review
( January/February 1995).
9. M. Tushman, and P. Anderson, “Technological Disconti-
nuities and Organizational Environments,” Administrative
Science Quarterly 31 (1986): 439–465.
10. Andrew Hill of the Financial Times observed: “In 1979,
the company put together a graphic timeline laying
out roughly when Kodak’s customers would make the
transition to digital imaging, starting with government
clients, moving through graphic businesses and ending,
in about 2010, with retail consumers. In 1991, the group
drew up a digital strategy … Even the potential threat from
camera-enabled mobile phones was ‘war-gamed’ by Kodak
executives in the early 2000s.” (“A Victim of Its Own Suc-
cess,” Financial Times, April 2, 2012.)

http://www.iande.info/wp-content/uploads/2011/03/StefanKohnDisruptiveInnovationsFujifilm

Case 11
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.
The New York Times:
Adapting to the
Digital Revolution
On January 1, 2018, 37-year-old A.G. Sulzberger succeeded his father, Arthur Ochs Sul-
zberger, as chairman of the New York Times Company (NYT). He is the sixth member
of the Ochs/Sulzberger family to lead the newspaper since it was purchased by Adolph
Ochs in 1896.
Yet, this apparent reverence for family tradition was not matched by conservatism in
the company’s strategy and operational management. Indeed, A.G. Sulzberger was the
primary architect of the digital strategy that had shaken the “Gray Lady”—as the Times
was affectionately known—to her very foundations.
In 2012, the prospects for the New York Times Company (NYT) were bleak. In
common with most of the world’s newspaper companies, revenues were in steep
decline and the company was losing money. Most commentators were pessimistic
about the company’s future. Henry Blodget of Business Insider predicted a continuing
decline in the company’s revenues as news readership and advertising moved online.1
Eric Jackson of Ironfire Capital LLC predicted that declining advertising revenues, rising
pension costs, and limits on further cuts in operating costs, would mean that the NYT
would be unable to continue as a standalone business.2
For over a decade, the NYT had been experimenting with different online business
models, while at the same time selling assets and cutting costs. However, growth in
revenues from digital advertising had failed to cover the shrinking revenues from print
advertising, while cost cutting was limited by NYT’s commitment to comprehensive,
high-quality journalism.
The appointment of Mark Thompson, formerly director-general of the British Broad-
casting Corporation, as CEO at the end of 2012 marked the beginning of a profound
strategic shift. In May 2014, a working party chaired by A.G. Sulzberger issued a report
titled “Innovation,” which provided a searing and penetrating analysis of the NYT’s
weaknesses in adapting to the new world of digital media.3 The report created a fire-
storm both within the NYT and in the newspaper industry more widely and was the
trigger for a total overhaul of the company’s strategy.
In 2017, the NYT had its “best revenue growth in many years, driven by strong digital
subscription revenues, which increased by over $100 million year-over-year.”4 The turn-
around was reflected in the NYT’s share price, which more than doubled in the two
years leading up to March 2018 (see Figure 1).
However, as A.G. Sulzberger prepared for his first annual shareholders’ meeting
as board chairman, he wondered about the sustainability of the NYT’s upturn in
performance. Had the NYT finally cracked the problem of how to reconcile its tradi-
tional commitment to quality journalism with the requirements of the digital age, or
did the massive rise in the number of digital subscriptions simple reflect the “Trump

CASE 11 THE NEW YORK TIMES: ADAPTING TO THE DIGITAL REVOLUTION 493
bump”—the quest for unbiased, authoritative journalism in a time when the current US
President was challenging the norms of objectivity and truth?
The US Newspaper Industry
The US newspaper industry—like that of most other countries—had been in decline
for over two decades. The reason was competition from online media, both for news
readership and for advertising. Although print newspapers had diversified into online
news provision, they had encountered powerful competition in this field from other
suppliers of digital news content—including online newspapers such as the Huffington
Post, Daily Beast, and BuzzFeed—as well as TV news suppliers with their own websites
(ABC, CNN, and Fox), and online news aggregators such as Google News and Lexis-
Nexis. Table 1 shows the leading US news websites. The ability of all news websites to
generate advertising revenues was constrained by the dominance of Google and Face-
book over online advertising and by the powerful mobile platform owners—notably
Apple and Google (Android). As a result, the decline in print readership (Figure  2)
translated into an even steeper decline in advertising revenues for printed newspapers
(Figure  3), which was only partly compensated for by the shift from print to digital
advertising (Figure 4).
The shift from print to online readership favored both national and international
newspapers at the expense of the vast majority of US newspapers, which served local
markets—individual cities and metropolitan regions. Only three newspapers could
claim to be national (or even international) in their distribution: USA Today, the Wall
Street Journal, and the New York Times. Table 2 shows the print circulations of the larg-
est US newspapers.
For newspapers to survive, they needed to reduce costs to match their shrinking
revenues. Independent news gathering had been the major casualty—newsroom staffs
had been cut drastically and most newspapers relied upon agencies such as Reuters,
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
5
10
15
20
25
30
35
40
45
50
FIGURE 1 New York Times Company share price January 2000–March 2018
Source: Macrotrends.

494 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Associated Press, and Agence France-Presse for their news content. Alternatively, news-
papers could seek out a billionaire “sugar daddy”: following Jeff Bezos’s purchase of
the Washington Post, Warren Buffet bought the Omaha World-Herald, and Patrick Soon
acquired the Los Angeles Times.
Decline and Refocusing
Between 1996 and the end of 2017, strategic leadership of the NYT was exercised by
its chairman, Arthur Sulzberger Jr. At the heart of his strategy was a commitment to
TABLE 1 Leading US news websites by number of unique visitors for 2017
(in millions)
Website 2017 2015
Yahoo News 128 128
Google News 102 82
Huffington Post 110 84
CNN Network 101 102
USA Today 78 79
BuzzFeed 73 78
The New York Times 70 57
Fox News 65 57
NBC News 63 101
Mail Online 53 51
Washington Post 47 40
Guardian 42 36
0
10,000,000
20,000,000
30,000,000
40,000,000
50,000,000
60,000,000
70,000,000
19
40
19
47
19
50
19
53
19
56
19
59
19
62
19
65
19
68
19
71
19
74
19
77
19
80
19
83
19
86
19
89
19
92
19
95
19
98
20
01
20
04
20
07
20
10
20
13
20
16
Weekday Sunday
FIGURE 2 Average daily circulation of newspapers in the US, 1940–2017
Source: Pew Research Center and industry sources.

CASE 11 THE NEW YORK TIMES: ADAPTING TO THE DIGITAL REVOLUTION 495
delivering the highest standards of journalism, while recognizing that the Times could
not restrict itself to print:
“[A] decade from now and a century from now, the New York Times will still be the
leader in its field of quality journalism, regardless of how it is distributed. These plans
entail our moving from a strategy focused on the specific products we produce to
one built around our audience—a quality audience strategy. Our goal is to know
our audience better than anyone else; to meet their informational and transactional
needs—by ourselves where we can; in partnership with others when necessary; and
to serve them in print and digitally, continuously and on-demand.”5
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
TOTAL
ADVERTISING
SALES OF NEWSPAPERS (PRINT AND DIGITAL)
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
20
09
20
11
20
13
20
15
20
17
FIGURE 3 Annual revenues of US newspapers, 1970–2017 ($ millions)
0
5
10
15
20
25
30
35
2009 2010 2011 2012 2013 2014 2015 2016 2017
FIGURE 4 Digital advertising revenue as a percentage of total US newspaper
advertising, 2009–2017
Source: Pew Research Center and company accounts.
Source: Pew Research Center and industry sources.

496 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
This strategy required focusing upon a single title: the New York Times. Between
2007 and 2013, NYT sold nine local television stations, its WQXR radio station, the
Regional Media Group of 16 local newspapers, and the Boston Globe, which was sold
for 93% less than the $1.1 billion the NYT had paid for it in 1993. The Paris-published
International Herald Tribune became the global edition of the New York Times.
This focusing upon the Times reflected the unique status of the newspaper in terms
of its national and international distribution and unrivalled reputation for journalism.
Times’ journalists had earned more than twice as many Pulitzer prizes as any other
newspaper. Its columnists, including Nicholas Kristof, Thomas Friedman, Maureen
Dowd, and Nobel-Prize-winning economist Paul Krugman, were leading commenta-
tors on current issues.
Meanwhile, the NYT’s revenues continued the decline that had commenced in 2005
when revenues had peaked at $3.4 billion. Reduced print sales of newspapers were one
factor, but a much bigger one was the collapse of advertising revenues. Table 3 shows
the NYT’s revenues. Cost economies were sought through eliminating duplication (e.g.,
moving to a single printing plant), closing loss-making businesses, outsourcing a wide
range of functions, and eliminating jobs. Table 4 shows overall financial performance.
TABLE 2 Print circulation of leading US newspapers
2015 2013
Wall Street Journal 1064 1481
New York Times 528 731
Los Angeles Times 328 433
Washington Post 330 431
USA Today 299 1424
Chicago Tribune 266 368
New York Post 245 300
New York Daily News 228 360
Newsday 217 266
Minneapolis Star Tribune 184 228
Houston Chronicle 169 231
Arizona Republic 164 286
Denver Post 156 214
Cleveland Plain Dealer 153 216
Newark Star-Ledger 144 180
Tampa Bay Times 141 241
Boston Globe 140 172
Philadelphia Inquirer 138 185
Chicago Sun-Times 118 185
Source: Alliance for Audited Media.

CASE 11 THE NEW YORK TIMES: ADAPTING TO THE DIGITAL REVOLUTION 497
TABLE 3 The New York Times Company’s revenues, 2009–2017
2017 2016 2015 2014 2013 2012 2011 2010 2009
Total revenues 1676 1555 1579 1589 1577 1595 2323 2394 2440
of which
—Advertisinga 559 581 639 662 667 712 1222 1300 1336
—Subscriptionb 1008 881 852 837 824 795 942 932 937
of which
—Digital only 340 233 199 169 149 n.a. n.a. n.a. n.a
—Otherc 109 94 89 89 86 88 160 162 168
Notes:
a Advertising revenues were 57% print and 43% digital in 2017. In 2014, the corresponding proportions were 73% and 27%.
b Company renamed as “subscription revenues.” Subscription revenues (previously called “circulation revenues”) are revenues from subscriptions to print
and digital products and single-copy and bulk sales of print products (which represent approximately 10% of these revenues).
c Principally syndication revenues.
TABLE 4 New York Times Company, Inc.: Selected financial data for 2010–2017
2017 2016 2015 2014 2013 2012 2011 2010
Revenues 1676 1555 1579 1589 1577 1595 2323 2393
Operating costs 1488 1411 1393 1484 1412 1441 2093 2137
Operating profit 112 102 137 92 156 104 57 23
Interest expense, net 20 35 36 54 58 63 85 85
Post-tax income from continuing operations 7 26 63 33 57 164 (40.2) 109
Post-tax income from discontinued operations (1) (2) — (1.1) 7.9 (27.9) — —
Net income 4 29 63 33 65 136 (40) 109
Property, plant, and equipment 640 597 632 666 713 773 1085 1157
Total assets 2100 2185 2418 2566 2573 2807 2883 3286
Total debt and lease obligations 250 247 431 650 683 697 698 996
Stockholders’ equity 897 848 827 726 843 662 506 656
ROE (%) 0.5 3.5 8.1 4.2 8.6 23.2 (6.9) 17.3
Debt/equity ratio 0.22 0.23 0.34 0.89 0.81 1.05 1.38 1.52
Operating margin (%) 8.7 6.5 8.6 5.8 9.9 6.5 2.4 1.0
Current assets to current liabilities 1.80 2.00 1.53 1.90 3.36 2.45 1.46 1.7
Employees (full-time equivalent) 3789 3710 3560 3588 3529 5363 7273 7414
Source: New York Times Company, Inc. 10-K reports.

498 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Searching for an Online Business Model
The NYT was quick to recognize the potential—and the threat—of the Internet. The
NYTimes.com website launched in 1996 focused upon adapting content from the print
edition for Web display. It was free to access and aimed to attract paid advertising.
In 1999, New York Times Digital was established to manage the websites of the
Times, Globe, and International Herald Tribune and to launch other online initiatives.
It was an independent business unit within NYT in the belief that, if NYT was to be a
serious player in cyberspace, it needed to have the people, systems, and culture of a
dot.com start-up rather than of a century-old newspaper.
Despite success in attracting online visitors, digital advertising revenues were disap-
pointing, and executives increasingly recognized the need to charge users. The first
online subscription, launched in 2005, was Times Select, which charged an annual
$49.95 fee for premium content and access to online archives. It generated a mere
$10 million a year and was discontinued in 2007. Then in March 2011, NYT introduced
its “metered access” model, which allowed Web visitors free access to a limited number
of articles each month, after which a paid subscription was required. By the end of
2011, there were 390,000 paid digital subscribers to subscription packages and, by the
end of 2014, there were 910,000 digital-only subscribers.
Although digital advertising revenues grew—by 2014, digital accounted for 27% of
NYT’s advertising revenues—this growth failed to offset declining revenues from print
advertising. Moreover, despite huge improvements in the content and accessibility of
NYTimes.com, it was the digital-only upstarts that were leaders in innovation and
user features.
Some industry observers saw the hybrid model—print and digital editions—as
doomed to failure. Rick Wartzman, Director of the Drucker Institute, argued: “Dead-
tree editions must immediately yield to all-internet operations. The presses need to
stop forever, with the delivery trucks shunted off to the scrapyard.” He pointed to the
Huffington Post (owned by AOL) as the model for an online newspaper.6 Eric Schmidt,
chairman of Google, suggested that users would only be willing to pay for unique
content, as most news was available from multiple online sources. For online news-
papers to generate adequate advertising revenues, they needed to offer targeted adver-
tising linked to customized content—for this, Google was an essential partner for the
newspaper companies.7
The 2014 Innovation Report
One of the main initiatives of the incoming CEO, Mark Thompson, was to initiate a
fundamental rethink of NYT’s digital strategy. In May 2014, a committee headed by A.G.
Sulzberger delivered a report entitled “Innovation” that provided a wrenching diagnosis
of NYT’s weaknesses in “the art and science of getting our journalism to readers.”
Among the many challenges the report identified were as follows:
● Creating a fully digital newsroom. With Jeff Bezos funding advanced technolog-
ical development at the Washington Post, BuzzFeed and Yahoo increasing their
investments in news gathering and delivery, and new entrants such as Flipboard
and First Look Media entering the business—NYT was being left behind. The
report noted: “The newsroom has historically reacted defensively by watering

http://NYTimes.com

http://dot.com

http://NYTimes.com

CASE 11 THE NEW YORK TIMES: ADAPTING TO THE DIGITAL REVOLUTION 499
down or blocking changes, prompting a phrase that echoes almost daily around
the business side: ‘The newsroom would never allow that.’”8
● Fewer and fewer readers were accessing the Times through the NYTimes.com
home page. The NYT needed to take its journalism to the reader: at NYT “the
story is done when you hit publish. At the Huffington Post, the article begins
its life when you hit publish.”9 Taking NYT journalism to readers’ “digital door-
steps” would require eliminating the NYT’s traditional division between the
news side and the business side of the newspaper.
● Exploiting the archive: “We have an archive of 14,723,933 articles extending back
to 1851 that can be resurfaced in useful or timely ways. Yet we rarely think to
mine our archive, largely because we are so focused on news and new features.”10
● Experimentation—especially in finding new ways of packaging existing content
that would be conducive to sharing on social networks.
● Personalization: “using technology to ensure that the right stories are reaching
the right readers in the right places and the right times. For example, letting you
know when you are walking past a restaurant we have just reviewed.”11
● User-generated content. The Times’ audience is its “most underutilized resource.
We can count the world’s best-informed and most influential people among our
readers. And we have a platform to which many of them would be willing and
honored to contribute.”12
The report was intended for a handful of senior managers; however, the leak of the
report to BuzzFeed triggered an explosion of anguish and debate within the company.
Harvard’s Nieman Lab reported: “One [NYT employee] admitted crying while reading
it because it surfaced so many issues about Times culture that digital types have been
struggling to overcome for years.”13 For A.G. Sulzberger the leak was “. . . a moment
of panic . . . suddenly it felt like our dirty laundry was being aired.” Yet, within days,
the report had become a rallying cry: “You couldn’t read that report and think that the
status quo was an option.”14
The Innovation Report was a prelude to a flurry of top management and orga-
nizational changes. A week after the distribution of the report, the executive editor
of the Times, Jill Abramson, was fired. She was replaced by the Times’ managing
editor Dean Baquet. One factor in her dismissal was her perceived opposition to the
greater integration of the news and business sides of the NYT—a key objective of
CEO Thompson, but contrary to the long tradition of the independence of the Times’
journalism. As A.G. Sulzberger later explained: “. . . the most important thing is to have
real strong protections around the editorial independence of our newsroom,” but the
separation of the news and the business sides of the newspaper had created a barrier
to change. “We regarded the members of our technology team and product team as
being on the business side . . . the folks who were building our website weren’t able
to talk to the people who were filling the website with great journalism each day.”15
Jill Abramson’s dismissal was followed by the elimination of about 100 positions
in the company’s newsroom: “the most extraordinary collection of talent, of human
knowledge, that has ever left the New York Times in a single day,” according to reporter
David Dunlap.16 Under Dean Baquet, the newsroom leadership was reorganized around
four deputy editors. The major emphasis was on promoting and bringing in talent
that could propel the Times’ digital efforts—especially within mobile communication.
Essential to this effort was the integration of journalism and technology. According
to Clifford Levy, who won two Pulitzers at the Times before being promoted to the
assistant managing editor overseeing digital platforms: “Working hour by hour, day by

http://NYTimes.com

500 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
day, with software developers and designers and product managers—to me that was a
real revolution, a kind of epiphany. . . This is standard operating procedure in Silicon
Valley, but it was radical here.”17
Our Path Forward
Having established a consensus around the imperative of a digital future for the Times,
it was easier to articulate a longer-term strategy for the company. In October 2015,
the top management team released “Our Path Forward,” a public document intended
“to share our challenges, our progress and our plans for moving forward.”18 At the
foundation of the NYT’s strategy was the principle of “offering content and products
worth paying for,” which put quality journalism at the heart of NYT’s strategy and
established that NYT’s basic revenue model was user fees. If producing quality content
was the dominant priority, it needed to be financed. To do this, the company set the
goal of doubling its digital revenues over the next five years to more than $800 mil-
lion—which in turn meant more than doubling the number of digital readers, most of
whom would be accessing news content on their phones and mobile devices.
Expanding the number of users and building a revenue-generating relationship with
users required the following:
● “We will continue to lead the industry in creating the best original journalism
and storytelling.” This involved not only maintaining NYT’s corps of journalists
but also infusing them with the technical and design skills needed to deploy
new storytelling tools. Initiatives included increased emphasis on visuals,
including videos, and increased customization to allow fully personalized
content delivery.
● “We will continue to develop new audiences and grow the Times as an interna-
tional institution.” The international expansion offered a huge potential for sub-
scriber growth: this strategy required both greater global integration and greater
customization to meet the needs of specific audiences in different countries.
● “We will improve the customer experience for our readers, making it easier to
form and deepen a relationship with the Times.” The goal was to make the
Times an essential part of its readers’ lives. This required that: “Every moment
in the reader’s journey, from visiting for the first time to registering as a user to
becoming a lifelong subscriber, must be frictionless, intuitive, and responsive.
To support this goal, we will improve each stage of the experience.”
● “We will continue to grow digital advertising by creating compelling, integrated
ad experiences that match the quality and innovation of the Times.”
● “We will continue providing the best newspaper experience for our print readers
and advertisers, while carefully shifting time and energy to our digital platforms.”
Digital Initiatives
These aspirations were reflected in a host of digitally based new initiatives launched
between 2014 and 2017. Behind these initiatives was the Beta Group—an in-house
digital development group housed on the 9th floor of the NYT’s building. Most of the
new products were apps for mobile platforms. These included NYT Now, a mobile app

CASE 11 THE NEW YORK TIMES: ADAPTING TO THE DIGITAL REVOLUTION 501
aimed at younger readers, and NYT Cooking, a hugely successful mobile app allow-
ing access to the Times’ library of over 17,000 recipes, which became the model for
additional apps covering real estate, crosswords, health and fitness, and TV and movie
reviews. In 2015, NYT launched a virtual reality app. Emailed newsletters were another
means by which NYT communicated with users. By mid-2017, it had 50 different news-
letters with 13 million subscribers. Wirecutter, acquired in 2016, was another website
and mobile app providing reviews of consumer products.
T Brand Studio, was established in 2014 to create “native advertising”—stories
appearing on NYT websites and apps that were sponsored by advertisers. One of the
first of these paid posts was an article on women prison inmates, accompanied by
video interviews with several of them, designed to generate interest in Netflix’s Orange
is the New Black series. T Brand Studio developed into a fully-fledged marketing and
creative services agency—partly through acquiring Hello Society, a leader in influencer
marketing, and Fake Love, an experiential design studio with a focus on virtual reality
and augmented reality.
Looking to the Future
By 2018, the NYT had made substantial progress in implementing a clearly articulated
strategy based upon an intelligible vision for the future and a realistic understanding of
the challenges it faced. The decline in its revenues had been halted and its presence in
digital media transformed.
Yet still doubts remained. The dominance in digital media of Google and Facebook
and the power exerted by the other digital giants—Apple, Amazon, Microsoft, and
Netflix—placed all digital media companies in a subservient position, while the pace of
technological change gave born-digital upstarts an advantage over the former giants of
print media. This was especially apparent in digital advertising revenues whose growth
since 2014 had been modest.
A report by a NYT newsroom working party in early 2017, “Journalism that Stands
Apart,” made it clear that NYT still had far to go: “For all the progress we have made,
we still have not built a digital business large enough on its own to support a news-
room that can fulfill our ambitions,” the report’s authors wrote, and “too often, digital
progress has been accomplished through workarounds . . . our work too often reflects
conventions built up over many decades, when we spoke to readers once a day.”19
Among the report’s criticisms were:
● Too many stories that “lack significant impact or audience” or were “little differ-
ent from what can be found in the freely available competition.”
● Stories “dominated by long strings of text” because reporters “lack the proper
training to embed visuals contextually.”
● The need for greater engagement by readers through “email newsletters, alerts,
FAQs, scoreboards, audio, video, and forms yet to be invented.”
● The success of NYT’s Cooking and Watching (TV and movie reviews) apps
needs to be extended with “more big digital bets” in features—especially fea-
tures that are designed to provide useful guidance to readers (as The Wirecutter
and Smarter Living).
● The need for better organization around themes of reader interest: “High-
priority coverage areas are spread across multiple desks . . . Our health care
coverage, for example, spans five departments and multiple print sections.”

502 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
● The needs to improve hiring and training processes to ensure “the right mix of
skills in the newsroom to carry about the ambitious plan for change.”
● “Lack of clarity over who are we writing for”. The success of sections like
Cooking and Well is because they were designed with specific audiences and
story forms in mind. Other parts of the Times are unclear who their target audi-
ence is. Every section should specify what the team will cover, the target audi-
ence, how that audience will experience the section’s reporting, and what kinds
of skills the group will need.
Even if the NYT could achieve the same level of comfort and flexibility with the world
of digital media as its “digitally native” competitors such as BuzzFeed, Vox, Mashable
and Vice Media, the financial performance of these companies gave cause for concern.
During 2017, all the on-line news providers struggled to grow revenues.20 Although
the NYT’s user subscription-based business model provided insulation from the slim
returns to content providers from digital advertising, this placed even greater weight on
the imperative of generating new subscriptions.
If NYT were to be unable to generate the revenues needed to finance the high
costs of high-quality, global journalism, would it need to explore alternative business
models? One possibility was that NYT could become a social enterprise: either explic-
itly, through enlisting charitable support or establishing an endowment that could
support news gathering and analysis, or implicitly, through seeking a wealthy backer
(as in the case of the Washington Post with Jeff Bezos).21 Alternatively, should NYT
view itself less in the news business and more in the intelligence business, using its
news gathering and analytical capabilities to supply customized intelligence to corpo-
rations and government agencies?
Notes
1. “The Incredible Shrinking New York Times,” Business
Insider (February 4, 2012).
2. “End Game of the New York Times,” Ironfire Capital LLC
(April 5, 2012).
3. http://www.niemanlab.org/2014/05/the-leaked-new-york-
times-innovation-report-is-one-of-the-key-documents-of-
this-media-age/. Accessed March 11, 2018.
4. Press Release: 2017 Fourth-Quarter and Full-Year Results,
The New York Times Company (February 8, 2018).
5. New York Times Company, Inc., annual meeting of stock-
holders (April 23, 2009).
6. “Out with the Dead Wood for Newspapers,” Business
Week (March 10, 2009).
7. “View from the Top: Eric Schmidt of Google,” Financial
Times (May 21, 2009).
8. New York Times Innovation Report (May 2014): 78
9. Ibid: 24.
10. Ibid.: 28.
11. Ibid.: 37.
12. Ibid.: 49.
13. http://www.niemanlab.org/2014/05/the-leaked-new-york-
times-innovation-report-is-one-of-the-key-documents-of-
this-media-age/. Accessed March 10, 2018.
14. https://www.wired.com/2017/02/new-york-times-digital-
journalism/. Accessed March 10, 2018.
15. A Conversation with A. G. Sulzberger, the New
Leader of the New York Times,” The New Yorker
(December 2017).
16. “In One Day, The Times Lost a World of Knowledge” Times
Insider (December 16, 2014), http://www.nytimes.com/
times-insider/2014/12/16/1925-in-one-day-the-times-lost-a-
world-of-knowledge/?_r=1. Accessed July 20, 2015.
17. https://www.wired.com/2017/02/new-york-times-digital-
journalism/. Accessed March 10, 2018.
18. https://www.nytco.com/wp-content/uploads/Our-Path-
Forward . Accessed March 10, 2018.
19. “Journalism that Stands Apart: The Report of the 2020
Group” (New York Times Company, January 2017).
20. “Digital News Organizations: Buzz Kill,” Economist
(December 2, 2017).
21. See, for example, P. M. Abernathy, “A Nonprofit Model
for the New York Times?” Duke Conference on Nonprofit
Media (May 4–5, 2009).

http://www.nytimes.com/times-insider/2014/12/16/1925-in-one-day-the-times-lost-aworld-of-knowledge/?_r=1

https://www.wired.com/2017/02/new-york-times-digitaljournalism/

https://www.wired.com/2017/02/new-york-times-digitaljournalism/

Case 12 Tesla: Disrupting
the Auto Industry
Tesla’s strategy was no secret: in 2006, chairman and CEO, Elon Musk, had announced:
“So, in short, the master plan is:
● Build a sports car
● Use that money to build an affordable car
● Use that money to build an even more affordable car
● While doing above, also provide zero emission electric power genera-
tion options
● Don’t tell anyone.”1
By July 2017, Tesla had implemented its master plan. Phase 1 (“Build a sports car”)
was realized with the launch of its Roadster in 2007. Phase 2 (“Use that money to build
an affordable car”) began in 2013 with the launch of Model S. Phase 3 (“Use that money
to build an even more affordable car”) was realized with the launch of Model 3 in July
2017. Providing “zero emission electric power generation options” involved, first, estab-
lishing SolarCity, which installed solar power systems; then, merging SolarCity with
Tesla in 2016. The only deviation from Musk’s original plan had been the introduction
of Model X—an SUV derivative of Model S—in 2015.
Tesla’s “Master Plan, Part Deux,” which would take Tesla into integrating solar energy
generation with storage, expanding to “cover the major forms of terrestrial transport”
(including heavy-duty trucks), fully autonomous driving, and vehicle sharing, was out-
lined by Elon Musk on July 20, 2016:
“So, in short, Master Plan, Part Deux is:
● Create stunning solar roofs with seamlessly integrated battery storage
● Expand the electric vehicle product line to address all major segments
● Develop a self-driving capability that is 10X safer than manual via massive
fleet learning
● Enable your car to make money for you when you aren’t using it.”2
The success of Tesla’s strategy was reflected in the company’s stock market
performance. Despite incurring huge losses, Tesla’s stock market capitalization was
$55 billion on August 2, 2018. By comparison, Ford Motor Company—which in 2017
had produced 6.6 million vehicles compared to Tesla’s 103,184—was valued at $39
billion. General Motors, which sold 9.6 vehicles in 2017, had a market valuation of $53
billion. The optimism that supported Tesla’s valuation reflected the company’s remark-
able achievements during its short history—including the acclaim that has greeted its
first four models of car—and investors’ faith in the ability of Elon Musk to realize his
mission “to accelerate the advent of sustainable transport by bringing compelling mass
market electric cars to market as soon as possible.”3
This case was prepared by Robert M. Grant assisted by Nitish Mohan. ©2019 Robert M. Grant.

504 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Indeed, Musk’s vision for Tesla extended beyond revolutionizing the automobile
industry: Tesla’s battery technology would also provide an energy storage system that
would change “the fundamental energy infrastructure of the world.” The installation of
the world’s biggest lithium-ion battery at a South Australian wind farm on December 1,
2017 was a landmark in this ambition.4
For a technology-based, start-up company, Tesla’s strategy was unorthodox. This
was most clearly manifest in the scale of its ambition: not only did Musk wish to estab-
lish Tesla as one of the world’s leading car companies, he also wanted to “accelerate
the world’s transition to sustainable energy” and, if this wasn’t enough to save Planet
Earth, to develop pace travel in order to make homo sapiens an interplanetary species.5
Rather than minimizing risk and investment requirements by outsourcing to other com-
panies, Tesla was the world’s most vertically integrated automobile supplier. Instead
of keeping tight control over its proprietary technology, Tesla had opened its patent
portfolio to its competitors.
During the first half of 2018, Tesla’s strategy was facing some major challenges.
Operational difficulties in ramping up the production at its both Fremont CA auto plant
and Nevada battery plant, the “Gigafactory,” had prevented Tesla from reaching its
target production of 5000 Model 3s per week until the final week of June—six months
behind schedule. With capital expenditures in 2018 expected to reach $2.5 billion
spent in 2018, cash burn remained a problem, despite Tesla’s forecast that it would
achieve a positive free cash flow in the second half of 2018. Meanwhile, competition
in electric vehicles (EVs) was intensifying: the main feature of the March 2018 Geneva
Motor Show was the number of new EVs being launched by the world’s leading auto-
makers.6 Was Tesla’s strategy consistent with its capability and the emerging situation
in the world vehicle market and with the resources and capabilities available to Tesla?
Electric Cars
The 21st century saw the “second coming” of electric cars. Electric motors were widely
used in cars and buses during the 1890s and 1900s, but by the 1920s they had lost out
to the internal combustion engine.
However, most of the world’s leading automobile companies had been undertaking
research into electric cars since the 1960s, including developing electric “concept cars,”
and, in the early 1990s, several had introduced EVs to California in response to pressure
from the state. The first commercially successful electric cars were hybrid electric vehi-
cles (HEVs), the most successful of which was the Toyota Prius, 10 million of which
had been sold by January 2017. The first all-electric, battery-powered cars (BEVs) were
the Tesla Roadster (2008), the Mitsubishi i-MiEV (2009), the Nissan Leaf (2010), and the
BYD e6 (launched in China in 2010), In addition, there were plug-in hybrid electric
vehicles (PHEVs), which were fitted with an internal combustion engine to extend their
range. General Motors’ Chevrolet Volt, introduced in 2009, was a PHEV.
Other types of BEVs included highway-capable, low-speed, all-electric cars such
as the Renault Twizy and the city cars produced by the Reva Electric Car of Ban-
galore, India. Others were for off-highway use. These “neighborhood electric vehi-
cles” (NEVs) included golf carts and vehicles for university campuses, military bases,
industrial plants, and other facilities. Global Electric Motorcars, a subsidiary of Polaris,
was the US market leader in NEVs. Most NEVs used heavier, but cheaper, lead–acid
batteries.
Electric motors had very different properties from internal combustion engines—in
particular, they delivered strong torque over a wide range of engine speeds, thereby

CASE 12 TESLA: DISRuPTING ThE AuTO INDuSTRY 505
dispensing with the need for a gearbox. This range of torque also gave them rapid
acceleration. Although electric motors were much lighter than internal combustion
engines, the weight advantages were offset by the need for heavy batteries, which were
also the most expensive part of an electric car, costing from $10,000 to $25,000.
Electric cars were either redesigns of existing gasoline-powered models (e.g., the
Ford Focus Electric and Volkswagen’s e-Golf) or newly designed electric cars (e.g., the
Tesla Roadster and Nissan’s Leaf). Complete redesign had major technical advantages:
the battery pack formed part of the floor of the passenger cabin, which saved on space
and improved stability and handling due to a lower center of gravity.
Predictions that electric cars would rapidly displace conventionally powered cars
proved false. In 2017, global registrations of plug-in EVs totaled 1,223,600. Although
this was a 58% increase on 2016, this still represented just 1.3% of total sales of cars and
light trucks, with China the world’s largest market. Forecasts of the growth in demand
varied substantially—most predicted that the market share of EVs would be between
7% and 20% by 2025. Much depended on government policy: by March 2018, eight
countries had announced their intention to ban the sale of new gasoline and diesel-
powered vehicles at some date between 2020 and 2040. The countries where EVs
had gained the highest market shares were those with the most generous government
incentives. Thus, in Norway, where plug-in EVs had a 39% market share in 2017, incen-
tives included exemption from purchase taxes on cars (including VAT), road tax, and
fees in public car parks, and the right to use bus lanes. In the US, federal government
incentives included development grants to the manufacturers of EVs and batteries, and
tax credits for purchases of EVs. Several countries had announced a phasing out or
scaling back of subsidies. The US federal government’s $7,500 tax credit to buyers of
Tesla cars would be halved In January 2019 and phased out a year later. The impact of
lower fiscal incentives would be offset, in part, by EVs falling prices relative to conven-
tional vehicles—in addition to lower battery prices, EVs benefitted from fewer compo-
nents than conventional vehicles.
“Range anxiety”—the threat of running out of battery charge—was seen as a major
obstacle to the market penetration of battery-powered EVs. However, by 2018, these
concerns were dissipating. Improved battery technology had doubled the average
range of EVs between 2015 and 2018. Secondly, the density of charging stations was
increasing rapidly. By the end of 2017, there were 210,000 publicly available charging
points in China, 43,000 in the US, 33,000 in Netherlands, and 24,000 in Germany.
Although battery-powered electric propulsion was the leading zero-emission tech-
nology available to automakers, it was not the only one: fuel cells offered an alternative.
Several automakers had developed prototypes of fuel-cell cars, but in 2018 only Toyota
was producing cars powered by fuel cells. The dependence of fuel cell vehicles on a
network of hydrogen fueling stations was the main disadvantage of this technology.
Figure 1 shows the leading suppliers of EVs in 2017.
Tesla Motors, 2003–2018
Elon Musk is a South-African-born, serial entrepreneur, who moved to Canada at the
age of 17. He cofounded Zip2, a developer of Web-based publishing software, and then
PayPal, which earned him $165 million when it was acquired by eBay. His next start-
ups were SpaceX, which became the world’s leading satellite launch company, and
SolarCity, which aimed to become “the Walmart of solar panel installations.”
Tesla Motors Inc., founded in 2003, was named after Nikola Tesla, a pioneer of
electric motors and electrical power systems. In 2004, Musk became its lead shareholder

506 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
and chairman, and then took over as CEO in 2008. Two years later, Tesla Motors’ shares
began trading on the NASDAQ market.
The Tesla Roadster, launched in 2007, was a sensation. Priced at $109,000, it was a
luxury sports car that could accelerate from 0 to 60 miles per hour in less than four sec-
onds and had a range of 260 miles on a single charge. It immediately became a favorite
among Hollywood celebrities and Silicon Valley entrepreneurs. The battery pack was
built by Tesla from Panasonic lithium-ion cells, car assembly was by Lotus in the UK,
and the car was delivered direct to the final customer without using dealers. Although
only 2500 Roadsters were produced between 2007 and 2012, the huge publicity the car
attracted is credited with changing public perceptions of electric cars.
Model S was the first car Tesla built at the GM-Toyota joint-venture plant in Fre-
mont, California, a plant that Tesla acquired from Toyota for $42 million. It was a
four-door, five-seater sedan, with an additional seat to accommodate two children. It
offered different battery sizes (up to 85 KWh). It’s launch price was between $52,400
and $72,400. The car’s electronics featured a touchscreen that controlled almost all the
car’s functions, eliminating the need for most knobs and other controls. Its software
allowed the driver to adjust the car’s suspension and steering behavior and allowed
Tesla to remotely monitor performance, diagnose problems, and provide updates to
expand functionality. In order to control its interface with customers, Tesla rejected the
traditional franchised dealer model, and set up its own directly managed retail show-
rooms, mainly in downtown locations. This direct sales model conflicted with the laws
of several US states. These laws required retail sales of automobiles to be undertaken
BYD
0 20 40 60 80 100 120
BAIC
Tesla
BMW Group
VW Group
Geely
SAIC
GM
Nissan
TMC
Renault
Hyundai-Kia
Daimler
Zotye
Chery
JAC
JMC
Changan
Mitsubishi
Ford
Volvo
Dongfeng
Kandi
Hawtai
FCA
BEV PHEV
FIGURE 1 World’s leading suppliers of plug-in electric vehicles, 2017 (thousands of units)

CASE 12 TESLA: DISRuPTING ThE AuTO INDuSTRY 507
through independent dealers. As a result, Tesla was unable to open retail outlets in six
states, including Texas.
The Tesla S was launched in 2013 to a torrent of rave reviews. It won Motor Trend’s
Car of the Year for 2013, Consumer Reports gave it the highest customer satisfaction
score for any car it had tested, and it was awarded the National Highway Traffic Safety
Administration’s highest safety rating.7
Model X, a sedan/SUV crossover built upon the same platform as Model S, was
launched in September 2015 with a base price of $79,500. Like the Model S, it received
superlative reviews; however, the difficulties that Tesla encountered in its manufacture,
including problems with its falcon-wing doors, were warning signs of the much bigger
manufacturing problems that would plague the Model 3.
Model 3 would take Tesla from being a niche producer of luxury cars to a volume
manufacturer. However, this transition tested Tesla—and its leader—to the limit. Intro-
duced in July 2017, problems at the Gigafactory in ramping up the production of battery
packs and assembly difficulties at Fremont resulted in Tesla’s target of producing 10,000
vehicles a week being deferred to December 2018. During the latter half of 2017, just
2686 Model 3s were produced; during the first half of 2018, this increased to 28,215. By
the middle of 2018, very few of the more than 400,000 people who has each paid $1,000
for a place on the waiting list for a Model 3 had received their car.
In addition to EVs, Tesla has two other lines of business:
● Energy Storage. Tesla’s Powerwall was a 7 kWh battery pack for home storage
of electrical power. In 2016, this was superseded by the 13.5 kWh Powerwall
2. During 2017, Tesla’s Powerwall accounted for almost 80% of power storage
installations under California’s Self-Generation Incentive Program.8 Tesla also
produced large-scale battery storage for grid storage. Tesla’s power storage bat-
teries are particularly useful for bridging asymmetries in the demand and supply
of power from solar and wind generation.
● Solar Energy Systems. SolarCity installs solar energy systems in residential and
commercial properties. Most of the residential systems are supplied on 20-year
leases that allow customers to take advantage of federal tax credits. In October
2016, Tesla introduced its Solar Roof—photovoltaic glass roofing tiles produced
at Tesla’s Gigafactory 2 in Buffalo, New York.
During the first half of 2018, energy generation and storage revenues were $784m
compared to $6092m from automotive.
Tesla’s Technology
Tesla regards itself as a technological leader within EVs:
Our core competencies are powertrain engineering, vehicle engineering, innovative
manufacturing and energy storage. Our core intellectual property includes our electric
powertrain, our ability to design a vehicle that utilizes the unique advantages of an
electric powertrain and our development of self-driving technologies. Our powertrain
consists of our battery pack, power electronics, motor, gearbox and control software.
We offer several powertrain variants for our vehicles that incorporate years of research
and development. In addition, we have designed our vehicles to incorporate the lat-
est advances in consumer technologies, such as mobile computing, sensing, displays,
and connectivity.9

508 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
However, for the most part, Tesla’s cars combined existing automotive, electric motor,
and battery technologies with few radically new innovations. In electric motors, for
example, the technology was mature and Tesla’s advances (including several of its pat-
ents) related to refinements in design (e.g., a liquid-cooled rotor). However, the critical
technical advantages of Tesla’s electric motors related to their overall integration within
the electrical powertrain and the software that managed that system.
Batteries
Electrical storage was the most formidable challenge facing electrical vehicle manufac-
turers. The lithium-ion battery was first introduced in 1991 and became the dominant
type of battery for rechargeable mobile devices. By 2005, all the automakers devel-
oping EVs had adopted lithium-ion batteries because of their superior power density.
To power electric cars, lithium-ion cells are combined into modules, which are then
assembled into battery packs. Battery packs are controlled by software that monitors
and manages their charging, usage, balancing, and temperature.
Each of the leading automakers partnered with a battery producer to develop and
supply batteries for their electric cars: Renault–Nissan with NEC, General Motors with
LG Chemical, BMW with Samsung SDI. With the exception of Chinese EV giant, BYD,
the automakers were unwilling to backward integrate into lithium-ion batteries.
Although most of the automakers sought to develop customized lithium-ion cells
for their battery packs, Tesla used the standard 18650 lithium-ion cell, which it bought
from Panasonic. This off-the-shelf lithium-ion cell is used in laptop computers and
many other portable devices. Because of their small size, a large number were required.
The Tesla S with an 85 kWh battery pack uses 7104 lithium-ion battery cells in 16 mod-
ules wired in series and weighs 1200 lb (540 kg). By contrast, the Nissan Leaf uses
a much bigger cell: its 24 kWh battery pack comprises 192 cells in 48 modules and
weighs 403 lb (182 kg).10
The paradox of Tesla’s battery technology is that in using standard lithium cells,
it has achieved superior performance from its battery packs. The key to this lies in
Tesla’s configuration of its cells and modules and the software for managing battery
performance.
In July 2014, Tesla announced an agreement with Panasonic to build the world’s big-
gest manufacturing plant for lithium-ion batteries. The “Gigafactory,” built near Reno,
Nevada, has the capacity to manufacture 35 gigawatt-hours of battery cells and 50
gigawatt-hours of battery packs. The $5 billion cost was shared between Tesla and
Panasonic, with the state of Nevada providing $1.25 billion in grants and tax breaks.
Tesla’s goal was to ensure sufficient supply of battery packs for its cars and to reduce
the cost of batteries from about $260 per kilowatt-hour in 2015 to $120 by 2020.
During 2017, the Gigafactory began producing a new cell, the “2170,” which referred
to the cell’s size: 21 mm in diameter and 70 mm long, compared to the 18650 with its
18 mm diameter and 65 mm length. The new cell was used in the Model 3 whose 50 kWh
battery pack comprises 2976 of these cells. Shortly afterward, Samsung SDI launched
its own battery pack using the larger 2170 cell.
At the end of 2012, one third of Tesla’s patents and patent applications related
to batteries and another 28% to battery charging.11 Tesla’s battery patents were
mainly concerned with the configuration of batteries, their cooling and temperature
management, and systems for their monitoring and management. Although Tesla
closely monitored developments in battery chemistry, very few of its patents related
to the design or chemistry of lithium-ion cells. Hence, amidst excitement over Tesla’s

CASE 12 TESLA: DISRuPTING ThE AuTO INDuSTRY 509
prospects in supplying battery packs for stationary power storage, Scientific American
noted that, first, Tesla possessed no breakthrough technology in batteries and, secondly,
it was doubtful whether Tesla’s cost advantage in battery packs was sustainable.12
Battery Charging
In battery charging, Tesla’s Supercharger stations offered—until recently—the world’s fastest
recharging of EV batteries: delivering up to 120 kWh of direct current directly to the battery,
a 30-minute Supercharger permitted about 170 miles’ driving, whereas a 30-minute charge
from a standard public charging station would allow about 10 miles’ driving. The speed of
the Supercharger is a result of the architecture of Tesla’s car battery packs, the high-voltage
cables that feed the battery, and the computer system that managed the charging process. In
June 2015, Tesla had 64 patents relating to its charging system.
At the beginning of March 2018, Tesla had 480 Supercharger stations in the US and
698 elsewhere. The total number of public charging stations in the US was about 21,000.
There were two competing technical standards for fast charging: the CHAdeMO
standard, supported by Nissan, Mitsubishi, and Toyota and the SAE J1772 standard,
supported by GM, Ford, Volkswagen, and BMW. Tesla’s proprietary system was not
compatible with either: hence, to use the large number of CHAdeMO and SAE charg-
ing stations, Tesla owners needed special adapters. In the US in January 2018, the
Tesla’s 390 Supercharger stations were outnumbered by 1651 CHAdeMO and 1438 SAE
charging stations—though Tesla possessed the greatest number of charging points.
The different networks of charging stations had different systems of payment. In the
US, the biggest network of fast-charging stations was owned by ChargePoint, which
required users to purchase an annual subscription. Networks of charging stations
were also operated by electricity providers: in China, the leading provider of charg-
ing stations was the State Grid. In Europe, the Ionity network was backed by BMW,
Mercedes, Ford, and Volkswagen. In 2018, several European charging networks were
introducing ultra-fast 350 kW chargers.
Self-Driving Cars
Tesla’s first version of Autopilot, its semi-autonomous driving system, was offered as
an option for the Tesla S in October 2013. Then from October 2016, all Tesla vehicles
were equipped with the sensing and computing hardware for future fully-autonomous
operation, with the software becoming available as it developed. Tesla was a latecomer
to autonomous driving: other car manufacturers began testing driverless systems sev-
eral years earlier: Ford and BMW since 2005, VW since 2010, GM since 2011. By 2018,
at least 30 companies were developing their own driverless car systems. While Tesla’s
rivals were experimenting with fully autonomous driving systems, Tesla’s emphasis
was on gaining experience through collecting and analyzing the vast quantities of data
generated by its Autopilot system on its entire fleet of cars: “The aggregate of such data
and learnings, which we refer to as our ‘neural net,’ is able to collect and analyze more
high-quality data than ever before, enabling us to roll out a series of new autopilot
features in 2018 and beyond.”13 As a result of its distinctive approach, assessments of
different companies’ progress in bringing fully autonomous driving to market viewed
Tesla as lagging behind its rivals: Navigant Research placed Ford, GM, Renault-Nissan,
and Daimler as leaders, with Tesla a distant 12th.14 Investor’s Business Daily observed
that: “Tesla largely has eschewed self-driving alliances and acquisitions in favor of
developing its Autopilot feature, which has some autonomous capabilities. Although

510 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
the company has amassed a vast trove of data from Autopilot usage that could improve
performance, Tesla is now seen at risk of falling behind other carmakers on rolling
out full autonomy.”15 Tesla’s preference for radar over lidar sensors was viewed as a
particular weakness of its self-driving technology.
Tesla Opens Its Patents
Early on, Tesla had rigorously protected its intellectual property. Its 2012 Annual
Report stated:
Our success depends, at least in part, on our ability to protect our core technology
and intellectual property. To accomplish this, we rely on a combination of patents,
patent applications, trade secrets – including know-how employee and third party
non-disclosure agreements, copyright laws, trademarks, intellectual property licenses
and other contractual rights to establish and protect our proprietary rights in our
technology.16
Hence the amazement when, on June 12, 2014, Elon announced:
Tesla Motors was created to accelerate the advent of sustainable transport. If we clear
a path to the creation of compelling electric vehicles, but then lay intellectual prop-
erty landmines behind us to inhibit others, we are acting in a manner contrary to that
goal. Tesla will not initiate patent lawsuits against anyone who, in good faith, wants
to use our technology.17
The announcement was followed by a flurry of speculation as to the reasons why
Tesla would want to relinquish its most important source of competitive advantage
in the intensifying battle for leadership in EVs. Tesla’s motivation was unclear. Was
it Elon Musk’s personal commitment to saving the plant from fossil-fueled vehicles,
or a calculated judgment that Tesla’s interest would be better served by speeding
the development of an EV infrastructure rather than by holding on to its proprietary
technologies? Certainly, diffusing its technology would help Tesla influence technical
standards and dominant designs with regard to batteries, charging technology, electric
powertrains, and control systems. Writing in the Harvard Business Review, Paul Nunes
and Joshua Bellin emphasized Tesla’s strategic position as an innovator within its eco-
system; by adopting an open-source approach to its technology, Tesla could strengthen
its centrality within its ecosystem.18
Professor Karl Ulrich of Wharton Business School emphasized the limits of Tesla’s
patent portfolio: “I don’t believe Tesla is giving up much of substance here. Their pat-
ents most likely did not actually protect against others creating similar vehicles.”19 This
observation was reinforced by the recognition that Tesla’s patent portfolio was smaller
than those of most major auto companies (Table 1). Tesla’s strengths were much more
in the know-how needed to combine existing technologies in order to optimize vehicle
performance, design, add-on features, and the overall user experience. Figure 2 shows
the annual numbers of patents received by Tesla.
Tesla’s Future
During the first half of 2018, Tesla’s dominant priority was resolving its operational
difficulties. At its Nevada Gigafactory and Fremont auto plant, employees worked

CASE 12 TESLA: DISRuPTING ThE AuTO INDuSTRY 511
desperately to boost the output of its battery packs and Model 3 cars. During most of
June, Elon Musk was sleeping at the factory amidst “production hell” as the company
struggled to achieve its weekly production target of 5000 Model 3s. Unless Tesla
could deliver cars to its waiting list of about 360,000 customers, there was a risk they
might request refunds on their $1000 deposits and defect to the other major auto-
makers that were launching new models of BEVs. Table 2 shows just a few of some
of the BEVs available early in 2018. Competition in the sector would continue to
0
10
20
30
40
50
60
70
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
FIGURE 2 Patents awarded to Tesla Motors Inc. and Tesla Inc., 2008–2017
TABLE 1 Automobile companies’ numbers of patents relating to electric vehicles,
2012 and 2014
Company 2012a 2014b
General Motors 686 370
Toyota 663 201
Honda 662 255
Ford 446 459
Nissan 238 102
Daimler 194 48
Tesla Motors 172 84
Hyundai 109 n.a.
BMW 41 n.a.
Notes:
a M. Rimmer, “Tesla Motors: Intellectual Property, Open Innovation, and the Carbon Crisis,” Australian National Univer-
sity College of Law (September 2014).
b Includes only patents that specifically mention “electric vehicles.” http://www.ipwatchdog.com/2015/09/02/electric-
vehicle-innovation-america-tops-japan/id=61178/, accessed March 8, 2018.

512 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
increase—all the world’s major automakers were committed to increasing the number
of BEV models they offered. Moreover, several of the world’s leading producers
of BEVs—BYD, BAIC, and ZD, in particular—had yet to establish themselves in
Western markets.
Given these short-term priorities and the financial constraints that Tesla faced, the
company might have been expected to limit the scope of its longer term projects.
However, during summer 2018, Tesla showed little sign of moderating its ambitions.
Internationally, it sought to broaden its presence in Europe and Asia. It was expected
to announce a European Gigafactory to manufacture battery packs and assemble Tesla
cars. In China, where Tesla has 15 retail outlets, it planned to open an assembly plant
by 2020. Tesla’s vertical integration strategy makes international expansion especially
challenging—it has to develop its own retail network and charging network and, if it is
to produce within its overseas markets, it also needs to develop battery plants. At the
end of June 2018, it had just 347 retail stores worldwide.
Tesla was also committed to introducing a heavy-duty truck. The Tesla Semi, with a
hauling capacity of 40 tons and range of 500 miles, will begin production in 2019. By
January 2018 preorders had been received from Walmart, PepsiCo, Anheuser-Busch,
Sysco, UPS, DHL, and several other companies.
However, Elon Musk’s ambitions were not limited to Tesla. His other major venture,
SpaceX, is world market leader in commercial space launches. The successful launch
of its massive Falcon Heavy rocket on February 6, 2018 reinforced its leadership.
Other ventures include the Boring Company, which develops innovative solutions to
tunneling in order to relieve urban congestion, the “hyperloop” project to develop
ultra-high-speed intercity travel, and Neuralink, which seeks to combine human and
artificial intelligence.
Conventional business wisdom dictates that sustaining diverse and grandiose
long-term ambitious while grappling with short-term operational difficulties is a recipe
TABLE 2 Tesla’s rivals: Some of the battery-electric cars available in March 2018
Model (base model) Type Base price Range
Tesla 3 5-seat compact sedan $35,000 220 miles
Tesla X90D Crossover SUV $93,500 257 miles
Tesla S70 5-seat +2 compact sedan $72,700 234 miles
Nissan Leaf 5-seat compact sedan $29,990 150 miles
GM Chevrolet Bolt 5-seat compact sedan $36,620 238 miles
Kia Soul EVi subcompact, crossover SUV $32,250 90 miles
Smart Fortwo (Daimler) 2-seat city car $25,750 80 miles
Mitsubishi i-MiEV 4-seat sub-compact sedan $23,845 80 miles
BMW i3 5-seat compact sedan $42,400 114 miles
Ford Focus Electric 5-seat compact sedan $29,120 73 miles
FIAT 500e 5-seat compact sedan $32,995 84 miles
Jaguar I-PACE Crossover SUV $69,500 240 miles
BYD e6 5-seat compact sedan $35,000 250 miles

CASE 12 TESLA: DISRuPTING ThE AuTO INDuSTRY 513
for disaster. However, Elon Musk had the capacity to deploy his long-term vision to
inspire faith in Tesla that dwarfed short-term fears. For example, the impact of Tesla’s
dismal 4th quarter results announced on February 7, 2018 was dwarfed by the publicity
arising from SpaceX’s launch of a Tesla Roadster into space just the day before. For-
tunately, the quarterly financial data released on August 1, 2018 did not require such
gimmickry: despite a net loss of $718m, Tesla’s smaller-than-expected cash outflow and
projections of profitable upcoming quarters reinforced hopes that Tesla could become
a profitable volume manufacturer of cars.
Appendix
TABLE A1 Tesla Inc.: Selected financial data
($ millions) 2017 2016 2015 2014 2013 2012 2011 2010
Revenues 11,758 7000 4046 3198 2013 413 204 117
Gross profit 2222 1599 923 882 456 30 62 31
SG&A expenses 2477 1432 922 603 286 97 52 46
Research & development 1378 834 718 465 232 274 209 93
Operating profit (1632) (667) (717) (187) (61) (394) (251) (147)
Net profit (1961) (674) (889) (294) (74) (396) (254) (154)
Cash 3368 3393 2286 1906 846 458 255 100
Total assets 28,655 22,664 8067 5849 2417 1114 713 386
Total long-term obligations 15,348 10,923 4145 2772 1075 450 298 93
Cash flow from operating
activities
(61) (124) (525) (57) 265 (264) (114) (128)
Cash flow from investment
activities
(4419) (1416) (1674) (990) (249) (207) (176) (180)
TABLE A2 Extracts from Tesla’s income statements: Years 2015, 2016, and 2017; and
first six months of 2018
($ millions) 2018 (to June 30) 2017 2016 2015
Revenues
Automotive sales 5680 8535 5589 3432
Automotive leasing 413 1107 762 309
Total automotive revenues 6093 9641 6351 3741
Energy generation and storage 784 1116 181 14
Services and other 534 1001 468 291
Total revenues 7411 11,759 7000 4046
(Continues)

514 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
TABLE A2 Extracts from Tesla’s income statements: Years 2015, 2016, and 2017; and
first six months of 2018 (continued)
($ millions) 2018 (to June 30) 2017 2016 2015
Cost of revenues
Automotive sales 4621 6724 4268 2640
Automotive leasing 241 708 482 183
Total automotive cost of revenues 4863 7433 4750 2823
Energy generation and storage 706 875 178 12
Services and other 767 1229 472 287
Total cost of revenues 6336 9536 5401 3123
Gross profit 1075 2222 1599 924
Operating expenses 2294 3855 2267 1640
Loss from operations (1218) (1632) (667) (717)
Interest income 10 20 9 2
Interest expense (313) (471) (199) (119)
Other (expense) income, net 13 (125) 111 (42)
Loss before income taxes (1508) (2209) (746) (876)
Net loss (1527) (2241) (773) (889)
Notes
1. https://www.tesla.com/blog/secret-tesla-motors-master-
plan-just-between-you-and-me?redirect=no, accessed
March 6, 2018.
2. https://www.tesla.com/blog/master-plan-part-deux
3. “The Mission of Tesla,” (November 18, 2013), http://www.
teslamotors.com/en_GB/blog/mission-tesla, accessed
July 20, 2015.
4. The 100 megawatt-hour battery was Musk’s response to
the power crisis that had gripped South Australia early
in 2017. Musk promised to have the battery farm up and
running within 100 days or supply it free of charge. The
project was completed in 62 days. See: “Tesla Delivers
the World’s Biggest Battery—and Wins a Bet,” Wall Street
Journal (November 23, 2017).
5. “How Elon Musk Does It,” Economist (February 10, 2018).
6. http://www.autoexpress.co.uk/motor-shows/geneva-motor-
show/102380/geneva-motor-show-2018-live, accessed
March 6, 2018.
7. Tesla Motors, Inc. 10-K report for 2014: 4.
8. https://electrek.co/2017/09/27/tesla-powerwall-2-
installations-swell/
9. Tesla, Inc. 10-K report for 2017: 3.
10. https://qnovo.com/inside-the-battery-of-a-nissan-leaf/
11. “How to Build a Tesla, According to Tesla,” Washington
Post ( June 23, 2014). https://www.washingtonpost.com/
news/the-switch/wp/2014/06/23/how-to-build-a-tesla-
according-to-tesla/?utm_term=.5e49a24eec38, accessed
March 7, 2018.
12. “Will Tesla’s Battery for Homes Change the Energy
Market?” Scientific American (May 4, 2015).
13. Tesla, Inc. 10-K report for 2017: 40.
14. http://www.businessinsider.com/the-companies-most-
likely-to-get-driverless-cars-on-the-road-first-2017-4,
accessed March 7, 2018.
15. https://www.investors.com/research/ibd-industry-themes/
self-driving-cars-tesla-general-motors-google-waymo-
eye-2018-milestones/, accessed March 7, 2018
16. Tesla Motors, Inc. 10-K report for 2012.
17. “All Our Patent Are Belong to You,” https://www.tesla
.com/blog/all-our-patent-are-belong-you, accessed
March 7, 2018.
18. https://hbr.org/2014/07/elon-musks-patent-decision-
reflects-three-strategic-truths, accessed March 7, 2018.
19. “What’s Driving Tesla’s Open Source Gambit?” Knowledge@
Wharton ( June 25, 2014), http://knowledge.wharton.
upenn.edu/article/whats-driving-teslas-open-source-
gambit/, accessed July 20, 2015.

http://www.teslamotors.com/en_GB/blog/mission-tesla

https://www.washingtonpost.com/news/the-switch/wp/2014/06/23/how-to-build-a-teslaaccording-to-tesla/?utm_term=.5e49a24eec38

http://www.businessinsider.com/the-companies-mostlikely-to-get-driverless-cars-on-the-road-first-2017-4

https://www.investors.com/research/ibd-industry-themes/self-driving-cars-tesla-general-motors-google-waymoeye-2018-milestones/

https://www.tesla.com/blog/all-our-patent-are-belong-you

https://hbr.org/2014/07/elon-musks-patent-decisionreflects-three-strategic-truths

What’s Driving Tesla’s Open Source Gambit?

https://www.washingtonpost.com/news/the-switch/wp/2014/06/23/how-to-build-a-teslaaccording-to-tesla/?utm_term=.5e49a24eec38

https://www.washingtonpost.com/news/the-switch/wp/2014/06/23/how-to-build-a-teslaaccording-to-tesla/?utm_term=.5e49a24eec38

Case 13 Video Game Console
Industry in 2018
In 2018, the video games consoles—dedicated hardware devices for playing video
games in the home—were in their eighth generation. Yet, although this generation
had begun six years previously with the launch of the Nintendo Wii U followed by
Sony’s PlayStation 4 and Microsoft’s Xbox One, uncertainty remained over the future
direction of their industry and the strategies to pursue.
The first six generations of consoles had established a clear consensus as to key suc-
cess factors in this industry. The strategies of all the leading players were focused upon
establishing market leadership that would then generate network effects in gaining
support both from users and game developers. To establish early market leadership,
the key was to target early adopters—the “hardcore gamers,” who were primarily males
aged between 12 and 35.
However, the conventional wisdom had been upset by the outcome of the last
round of competition. Among seventh-generation consoles, the winner had been Nin-
tendo. Its Wii was a technologically unsophisticated, easy-to-use console targeted at
the casual user. It had outsold the more technologically-advanced machines from Sony
and Microsoft. Moreover, while Sony and Microsoft had focused upon turning their
consoles into multifunctional home entertainment devices, the Wii was a dedicated
games console.
At the same time, the home video game console was under threat. Increasingly
game playing was shifting to mobile, multifunctional devices, such as smartphones
and tablet computers.1 Not only were the console makers facing competition from
alternative hardware platforms, they were grappling with the rising power of video
games publishers. The inability of the console makers to enforce restrictive licensing
conditions on the games publishers had greatly weakened the network effects that
had caused consumers and developers to converge toward the market-leading
console platform.
History of the Video Game Industry, 1972–2018
The history of the video game console comprised a series of product generations, each
lasting between five and seven years and each defined primarily by the power of the
microprocessors used by the consoles (Figure 1).
This case was prepared by Robert M. Grant assisted by Nitish Mohan. ©2019 Robert M. Grant.

516 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
The First and Second Generations, 1972–85: The Atari Era
The home video game market emerged during the 1970s as an extension of arcade
video games. The first generation of home video consoles were dedicated to a single
game. The second generation of players featured interchangeable cartridges. Industry
pioneer Atari with its Atari 2600 unleashed a craze for video games driven by Space
Invaders (released in 1979) and Pac-Man (1981). Atari failed to protect its proprietary
technology and was overwhelmed by competition from suppliers of Atari-compatible
consoles and a flood of unauthorized games from independent software developers.
The Third Generation, 1985–90: The Nintendo Era
Nintendo, the leading Japanese supplier of arcade video games, released its Nintendo
Entertainment System (NES) home video console system in Japan in 1983 and two years
later in the United States. By 1988, Nintendo held 80% the US market, due to hugely
popular games such as Donkey Kong, Legend of Zelda, and Super Mario Brothers cre-
ated by its legendary games developer, Shigeru Miyamota.
Nintendo’s market dominance and huge profits rested upon its tight control over
the development, manufacture, and distribution of games. Cartridges incorporated a
security chip that ensured that only cartridges manufactured by Nintendo could run on
the NES. Nintendo charged game publishers a 20% royalty and a manufacturing fee of
$14 per cartridge. The minimum order—10,000 cartridges for the Japanese market and
50,000 for the US market—had to be paid in advance. Any game developed for the NES
could not be released on a competing system for two years.
By 1991, Nintendo’s sales exceeded $4.4 billion, its stock market value exceeded that
of Sony, and about one-third of US and Japanese households owned an NES.
The Fourth Generation, 1991–95: Sega versus Nintendo
Sega, like Atari and Nintendo, began in arcade games. In October 1988, it launched its
16-bit Genesis home video system in Japan and next year in the United States. With the
introduction of Sonic the Hedgehog in 1991 and, with strong support from independent
games developers, sales of Genesis took off.
FIGURE 1 Global sales of video game consoles by product generation (millions of units)
0
50
100
150
200
250
300
2G (1978–85) 3G (1985–90) 4G (1991–95) 5G (1995–98) 6G (1999–2005) 7G (2006–13) 8G (2013–17)
Nintendo Sony Microsoft Atari Sega Other
Xbox One
PS4
Wii U +
Switch
Xbox 360
PS3
Xbox
Wii
N64
PS2
Dreamcast
Play
Station
GameCube
Genesis
Saturn
Atari 260
Super NES
Master Sys.
NES

CASE 13 VIdEO GAME CONSOLE INduSTRY IN 2018 517
Nintendo countered with its 16-bit Super-NES, in September 1991. Sega’s bigger
library of 16-bit titles (by 1993 it offered 320 games, compared to 130 for Nintendo)
allowed it to take a small lead in the European and US markets; however, Nintendo
continued to dominate in Japan.
The Fifth Generation, 1995–98: Sony PlayStation
The launch of Sega’s 32-bit Saturn console in November 1994, was quickly followed
by Sony’s introduction of its PlayStation console, the result of a six-year development
effort led by Ken Kutaragi, Sony’s video game guru. Like Saturn, PlayStation used
CD-ROMs rather than cartridges. Sony’s advantages included its strong brand, global
distribution capability, and content from its movie division. It was able to offer a suite
of high-quality games, the result of close technical, creative, and marketing collabora-
tion with leading games developers. Sega’s ill-coordinated Saturn introduction paled
beside PlayStation’s well-orchestrated, big budget launch, which was preceded by pre-
launch promotion that fueled a buzz of anticipation within the gamer community.
Meanwhile, Nintendo attempted to recapture market leadership by leapfrogging Sony
in technology. Its 64-bit N-64 console was released in June 1996 at a low price ($199
compared to $299 for a PlayStation), but its cartridge system was more costly and less
flexible than Sony’s use of CD-ROMS, allowing Sony to offer a much bigger library of
games, many of which targeted niche markets segments.2 By 1998, PlayStation was the
undisputed market leader.
The Sixth Generation, 1999–2005: Sony versus Microsoft
With the sixth generation of consoles, was led by Sega with its Dreamcast console in
November 1998, followed by Sony’s PlayStation 2 (PS2) two years later. With massive
processing power, cinematic-style graphics, a DVD player, and the potential for internet
connectivity, the PS2 was a huge advance over the orogonal PlayStation, and aspired
to be a multifunctional entertainment device. However, its technical complexity created
problems both for the supply of key components and the development of new games.
As a result, the launch of the PS2 was marred by a shortage of consoles and a lack of
new games.
A few months later, Microsoft entered the market with its Xbox, which featured an
internal hard disk, a 733 MHz processor, 64 MB of memory, a DVD player, an ethernet
port, and the hit game Halo. In 2002, Microsoft launched Xbox Live, which allowed
online interactive gaming and the direct downloading of games.
Nintendo, with its GameCube console, was the last to join the new generation of consoles.
By 2004, Sony was the clear market leader, with Microsoft a strong second in the
United States and Europe, and Nintendo a strong second in Japan. Saga withdrew from
the console market in 2002, in order to focus on game development.
The Seventh Generation, 2006–12: Nintendo’s Renaissance
Microsoft’s Xbox 360 released on November 25, 2005 represented a shift in market
positioning: while the original Xbox emphasized processing power and focused on
hardcore gamers, Xbox 360 emphasized versatility, design, and a multiplicity of enter-
tainment and online capabilities.
Sony’s PS3 was launched on November 11, 2006 after a long delay, caused by Sony’s
technological ambitiousness—notably its decision to make the PS3 the flagship for the

518 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Blu-ray DVD drive and its adoption of an advanced microprocessor developed jointly
with IBM and Toshiba. The huge development and high component cost of the PS3
resulted in Sony incurring a loss on every unit sold.3 In addition, the complexity and
high cost of developing games for the PS3 meant that there were few games that fully
exploited its technical capabilities.
Nintendo’s Wii console, also in November 2006, was a game changer. Despite its
technological modesty—it lacked the speed and graphical capabilities of the PS3 and
Xbox 360 as well as a hard drive, DVD player, and ethernet port—it featured a remote,
wand-like controller that was sensitive to a range of hand movements. This allowed
Wii to be used for a variety of new sport and exercise applications—Wii Fit was one
of the biggest-selling titles of 2008–10. The accessibility, ease of use, and cheapness of
the Wii (it retailed at $250, compared to $499 for the PS3) appealed to a very broad
demographic group, including older people.4
The Eighth Generation, 2012–18
Nintendo’s Wii U, launched in November 2012, was essentially an upgraded Wii. It’s
most innovative feature was a touchscreen controller that could also be used as the
main screen itself, enabling games to be played without the need of a television. It was
the first Nintendo console to support high-definition graphics, but compared with the
rival offerings from Sony and Microsoft, it was a low-powered console. For example, it
possessed 2 GB of memory compared to its rivals’ 8 GB. By the end of 2015, 12.6 mil-
lion Wii Us were sold worldwide, after which sales fell off sharply. . .
Sony’s PS4 and Microsoft’s Xbox One were launched in November 2013. In terms of
technology, they were surprising similar: both used an AMD Octa-Core microprocessor,
an AMD Radeon graphics processor, and BluRay disk reader. Yet their positioning was
different. With the PS4, Sony returned to the industry’s traditional focus on hardcore
gamers—its tagline “4 the players” emphasized its focus on technical capabilities—
notably in graphics, upgraded online services, and remote playing capability, which
allowed a smartphone to be used both as a controller and as a display screen. Sony also
envisaged a continual upgrading of PS4 over its intended 10-year lifespan—this would
include virtual reality capability.
Microsoft’s Xbox One reflected the company’s “One Microsoft” strategy, which
sought greater integration across the company’s products and divisions. According to
Microsoft’s VP for hardware: “It’s more than a gaming platform. We’re thinking about
our devices as a stage for all of Microsoft.”5 Xbox One was envisaged as a platform for
a broad array of Microsoft’s streaming and cloud services.
Between 2014 and 2017, Sony established a clear market lead: its PS4 outsold the
Xbox One by more than two-to-one. Targeting hardcore games players gave Sony’s PS4
a focus that Microsoft’s Xbox lacked:
The PlayStation 4 is a game console that was more powerful than the Xbox One at
launch while also selling at a lower price. The focus was always on the games, and the
ability to trade or loan your games to a friend at a time when Microsoft was pushing an
innovative but poorly communicated system of digital rights and limitations. . . Micro-
soft wanted to sell a box that connected all aspects of your entertainment center while
pulling everyone into a digital future while also ushering in a new era of motion con-
trols with the Kinect. Raw power was less important than voice commands, and Micro-
soft believed that players would be willing to pay for this strange mixture of features.6

CASE 13 VIdEO GAME CONSOLE INduSTRY IN 2018 519
This difference in focus was also apparent in the two firms approach to virtual reality
(VR). While Sony’s Playstation VR focused on game playing, Microsoft has pursued
“mixed reality” that has involved partnering with different companies in developing
various VR headsets.
The big surprise of the eighth generation was Nintendo’s Switch console, which
was introduced in February 2017 to replace the Wii U. Switch was a hybrid device that
could be used as a console linked to a TV or as a handheld, portable games player.
Between February 2017 and the end of March 2018, Switch was the world’s leading
console selling 17.8 million units—four million more than the Wii U over its entire
lifetime. Driving the Switch’s sales were new games in Nintendo’s Super Mario, Mario
Kart, Zelda, and Splatoon franchises.
The Video Game Industry in 2018
The Market for Video Games
In 2018, video games continued to be a growth industry. Worldwide sales of video
game software, dedicated hardware (both consoles and handheld game players) and
online content and subscription, were expected to reach $165 billion in 2018, and were
likely to grow to $230 billion by 2022.7 China was the world’s biggest market, and
would account for much of the growth. The United States and Japan were the other
biggest markets, but would show much slower growth.
However, the industry was becoming increasingly fragmented. Video games were
played on an increasingly wide variety of hardware: home video consoles, personal
computers, and various mobile devices. All the recent growth had been in gaming
on mobile devices—smartphones in particular. In mature markets, notably in the
United States, sales of video game consoles had been in decline for several years
(Figure  2). Nevertheless, video game consoles faced little prospect of total displace-
ment. User experience had been continually enhanced by graphical realism, multiplayer
online gaming, the personalization of games, 3-D visual displays, and virtual reality.
The shift in the distribution of games from boxed DVDs to downloads, subscrip-
tions, and cloud access fostered the emergence of new business models. The online
FIGURE 2 US sales of home video game consoles and associated software ($billion)
Source: Author’s estimates based upon multiple sources.
30
25
20
15
10
5
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Hardware & software Hardware

520 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
distribution of video games through console makers’ websites had facilitated the sale
of add-ons and accessories. In-game advertising also offered additional sources of
revenue. Most video games for mobile devices were offered free and supported by
advertising. Increasingly, the developers of mobile games adopted “freemium” models:
the games could be downloaded for free, but additional features and enhancements
had to be purchased.
E-sports, organized, multiplayer video game tournaments and competitive leagues,
usually with prize money and professional players, have been a rapidly growing fea-
ture of video gaming over the past decade. Types of e-sports include first-person
shooter games, multiplayer online battle arena (MOBA) games, and sports such as FIFA
soccer and NBA basketball. Spectators view competitions as live audience at tourna-
ment arenas, televised tournaments, online streaming and through Twitch, and through
dedicated modes for certain games. By the end of 2017, e-sports was believed to have
an audience of 320 million and annual revenues of $1 billion.8
In terms of demographics, a major development has been the broadening user
base of video game players. Once the preserve of teenage boys and young adult
men, by 2017 the majority of the US population aged 18–49 played video games;
even among 55- to 65-year-olds 38%, played video games. Female participation had
increased strongly—especially in mobile gaming. However, gaming on dedicated con-
soles remained concentrated among males aged between 12 and 35. The broadening
of the market had also led to its segmentation—both demographically and in terms of
game genres.9
Software
Each video game console supplier (“platform provider”) licensed third-party software
companies to develop and distribute games for its system. Two types of company were
involved in video game software: video game publishers, which were responsible for
financing, manufacturing, and marketing video games; and video game developers,
which developed the software. Publishing was increasingly dominated by a few large
companies (Table 1). Typically, the software publisher submitted a proposal or a pro-
totype to the console maker for evaluation and approval. The licensing agreement
between the software company and the hardware provider gave the console maker
the right to approve game content and control of the release date, and provided for
a royalty payment from the software company. Game developers were paid a royalty,
typically between 5% and 15%, based on the publisher’s revenues from the game. The
console makers also developed and published their own games, including some of the
most popular titles (Table 2).
Escalating game development costs were a result of the demand for multi-featured,
3-D, cinematic-quality games that could utilize the potential of increasingly powerful
consoles. Atari’s Pac-Man released in 1982 was created by a single developer and cost
about $100,000. Rockstar Games’ Grand Theft Auto V cost an estimated $137 million to
develop and was supported by a $125 million marketing budget.10 Like movies, video
games incurred substantial upfront costs and a mere few became money-spinning
blockbusters. Like movies, they increasingly featured Hollywood actors and many
of the most successful new releases were sequels to earlier games—this created
valuable brand franchises such as Super Mario Brothers, Grand Theft Auto, Call of
Duty, and Halo.
Over time, there has been a major shift in the balance of power from console
makers to game publishers. In earlier generations, the console makers were dominant,

CASE 13 VIdEO GAME CONSOLE INduSTRY IN 2018 521
TABLE 2 Top-10 console games in the United States, 2014 and 2017 (ranked by units sold)
2017 2014
Rank Title/platform* Publisher Title/platform* Publisher
1 Call of Duty: WII (PS, Xbox) Activision Blizzard Call of Duty: Advanced Warfare (PS, Xbox) Activision Blizzard
2 Destiny 2 (PS, Xbox) Activision Blizzard Madden NFL 15 (PS, Xbox) Electronic Arts
3 NBA 2K18 (PS, Xbox) Take 2 Interactive Destiny (PS, Xbox) Activision Blizzard
4 Madden NFL 18 (PS, Xbox) Electronic Arts Grand Theft Auto V (PS, Xbox) Take 2 Interactive
5 Tom Clancy’s Ghost Recon:
Wildlands (PS, Xbox)
Ubisoft Minecraft (PS, Xbox) Mojang
6 The Legend of Zelda: Breath
of the Wild (Switch, Wii)
Nintendo Super Smash Bros. (Wii) Nintendo
7 Grand Theft Auto V
(PS, Xbox)
Take 2 Interactive NBA 2K15 (PS, Xbox) Take 2 Interactive
8 For Honor (PS, Xbox) Ubisoft Watch Dogs (PS, Xbox) Ubisoft
9 Injustice 2 (PS, Xbox) Warner Bros. FIFA 15 (PS, Xbox, Wii) Electronic Arts
10 Horizon Zero Dawn (PS) Sony Call of Duty: Ghosts (PS, Xbox, Wii) Activision Blizzard
Note:
*No distinction is made between the different models of PS (e.g., PS3, PS4), Xbox (e.g., Xbox 360, Xbox One) or Wii (e.g., Wii, Wii U).
TABLE 1 Leading suppliers of video games ranked by sales of game software ($million)
Company 2017 (Q1–Q3) 2016 2014
Tencent 12,701 12,009 7211
Sony* 6642 7837 6040
Activision Blizzard 4975 6607 4409
Microsoft* 4854 6477 5023
Apple* 4764 5864 3199
NetEase 4072 4177 1586
Electronic Arts 3935 4626 4453
Google* 3039 4065 2623
Nintendo 1879 1831 2092
Bandai Namco 1737 1991 –
Nexon 1557 1564 1446
Net Marble 1553 1247 –
TakeTwo Interactive 1433 1585 978
Square Enix 1323 1666 949
Ubisoft 1245 1602 1806
Warner Brothers 1223 1606 883
Note:
*estimated.
Source: New Zoo.

522 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
enforcing exclusivity and imposing heavy royalty payments on the publishers. Consoli-
dation among publishers (caused by rising development costs) and more intense com-
petition among the different hardware platforms have changed all that. Exclusivity ties
have disappeared from most licensing contracts—by 2018, most leading games titles
were cross-platform—and were often launched simultaneously on both PlayStation
and Xbox. The only popular games exclusive to a single platform were typically those
developed in-house by the console makers (e.g., Microsoft’s Halo).
At the same time, game publishers were also facing new pressures. The licensing fees
paid by software publishers for exclusive rights to the intellectual property of media
companies and sports organizations grew substantially over the past two decades. The
rights to a game based on a hit movie (e.g., Harry Potter) could cost several million
dollars. For sports games, the major leagues (NFL, NHL, MLB, NBA, and FIFA) required
an upfront payment, plus a royalty of 5–15% of the publisher’s revenue from the game.
The licensing fee paid by EA Sports to FIFA is undisclosed, but EA Sport’s payments to
the English Premier League alone amount to $85 million over 3 years.
Not only did software sales exceed hardware sales; software was responsible
for virtually all of the industry’s profit. The console makers followed a “razors and
blades” business model: the consoles were sold at a loss; profits were recouped on
software sales (both games developed internally and royalties received from third-
party game publishers). The result was strongly cyclical earnings for the platform
providers: the launch of a new console would result in massive cash outflows; only
with a substantial installed base would the platform provider begin to recoup the
investment made.
The Console Makers
For the console suppliers, the past two generations (2008–18) had been a difficult
period. Their razors-and-blades model worked less well when the games were no
longer exclusive to specific platforms. The loss of software exclusivity also undermined
network effects: the incentives for consumers and software developers to gravitate
toward the market-leading platform were weaker, and consumers had less loyalty to a
particular platform.
The console makers also faced increasing competition from alternative games plat-
forms notably smartphones and competition also came from new console platforms,
notable Android consoles such as the Nvidia Shield, Mojo Micro, and Amazon’s Fire
TV console.
The competitive pressures were evident from the financial performance of the com-
panies (see the Appendix). Despite being the industry leader, Sony’s games division
earned an overall loss during the 10-year period 2008–17. Nintendo was also unprofit-
able during the most recent six-year period. Although Microsoft’s financial results for
the Xbox were buried in the aggregated financial data it published, it appears that
Microsoft’s video game business accumulated billions of dollars of losses between
2001 and 2017.
One consequence of deteriorating profitability was the desire to extend product
cycles. Reluctance to incur the costs of developing new models was the major moti-
vation behind Sony and Microsoft’s desire to extend the lives of their current models.
Thus, rather than following Nintendo in developing an entirely new games console,
both Sony and Microsoft chose to release upgrades of their existing models. In 2017,
Sony released its PS4 Pro and Microsoft its Xbox One X, while continuing to market
their base PS4 and Xbox One models.

CASE 13 VIdEO GAME CONSOLE INduSTRY IN 2018 523
Xbox One X was viewed as an attempt by Microsoft to gain technological leadership
over Sony: its new machine featured superior graphics processing and ultra-high def-
inition 4k resolution. It also committed itself to backward compatibility: both its Xbox
One and Xbox One X were adapted to play games from any generation of Xbox.
However, competition among the three focused more on software than on hardware.
The primary draw of the Nintendo Switch was new games in the Mario, Legend of
Zelda, and Splatoon franchises—all developed by Nintendo. For Sony and Microsoft
too, their exclusive., in-house games were critically important in driving demand for
their upgraded models—Uncharted 4 and Horizon Zero Dawn for the PS4 Pro, and
new versions of Halo, Gears of War, and Forza Motorsport titles for Xbox One X.
During 2018, each of the three major console suppliers was pursuing different
strategies in their quest to establish competitive advantage and enhance financial
performance:
● Sony’s key challenge was sustaining the global market leadership that it had
held for most of the period since 1995. Its focus on the gaming community had
given its strategy a clarity and focus that engendered loyalty within its two target
communities: consumers and developers. Its strategy of technological leader-
ship for its PlayStation was reinforced by complementary products and services.
The PlayStation Network included PlayStation Plus, providing game patches,
betas, and online multiplayer gaming; the PlayStation Store, from which games,
music, and movies could be downloaded; and PlayStation Vue, which allowed
TV streaming. At the end of 2017, there were 31.5 million PlayStation Plus sub-
scribers each paying about $60 annually. The PlayStation VR headset launched
in 2016 established Sony’s leadership in virtual reality. Over 2 million units had
been sold by the end of 2017.
● Microsoft’s primary focus in 2018 was on closing the gap between itself and
Sony. Its bid for technological leadership with its Xbox One X was one element
of its strategy. Even more significant was its convergence of the Xbox and
the PC as games platforms. During 2017 and 2018, updates to Windows 10
operating system enhanced the PC’s game-playing capabilities. Simultaneously,
all new and updated Microsoft-released games could be run on both Xbox and
PCs. A game bought on Xbox would automatically add it to the user’s Windows
10 library, and vice versa. While this upgrading of the gaming experience of
the PC relative to the Xbox might reduce the incentive for PC owners to also
own an Xbox, the fact remained that in March 2018 there were about 1.3 billion
personal computers in the world of which almost 89% ran Windows and 37%
of these ran Windows 10. Encouraging third-party developers to develop games
simultaneously for Xbox and the PC could also help Microsoft overcome the
Xbox’s disadvantage to the PC in terms of developer support (see Table 3).
● Nintendo had demonstrated that its Wii was no one-hit-wonder: its Switch was
destined to be the world’s best-selling console during the early months of 2018.
Like Microsoft, Nintendo was drawing upon its firm-specific strengths to offset
the weaknesses of its small corporate size and limited technological resources.
Nintendo’s strength is its creativity that is founded upon a unique culture that
combines Japanese traditions of craftsmanship with a love of fun, fantasy, and
the transcendent. This culture is expressed most fully in Nintendo’s highly
successful games. In hardware, Nintendo’s primary strength was its handheld
devises: Gameboy, DS, and 3DS By creating a hybrid console/mobile device,

524 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Switch could tap a bigger market and—assuming eventual discontinuation of
the 3DS—offer internal and third-party developers a single platform for game
development. However, this still raised the issue of whether Nintendo needed
its own hardware platform. If Nintendo’s core capability was its in software—as
demonstrate by the enduring appeal of Mario, Pokémon, and Legend of Zelda—
should it exploit the opportunity to offer its games for the biggest available
platforms—namely Android, Windows, and iOS?
Looking to the Future
The evolution of the video game industry had greatly impacted the distribution of profit
among the different participants. During the 1980s and 1990s, the console makers’ con-
trol over software, and the power of network effects, ensured massive profits for the
market leader (first, Nintendo, then Sony).
The shift in power from the suppliers of hardware to the suppliers of soft-
ware had greatly undermined network effects had meant that video games were
no longer a winner-takes-all industry with a single dominant strategy for all the
console makers.
The competitive dynamics of the sectors were also complicated by, the expand-
ing number and variety of platforms for playing video games. One implication was
increased market segmentation with casual games players using mobile devices such as
smartphones and tablets, and consoles being the platform of choice for more intensive
and sophisticated games players. Such segmentation was also apparent within dedi-
cated home consoles: Nintendo’s Wii and Switch appealed to different users than the
Xbox and PlayStation.
By 2018, it seemed that attempts to position video games console as multifunctional
platforms for home entertainment, communication, and home automation had made
little headway.
Hence, the strategic challenge for the console makers was twofold. First, they
needed to protect their position in the video games ecosystem against other par-
ticipants—notably the games developers and owners of alternative platforms (such
as Google, Apple, and Amazon). Here, their online, subscription-based models for
distributing games and supporting multiplayer game play, were proving useful.
Second, they needed to build competitive advantage vis-a-vis one another. This
resulted in a quest for differentiated strategies that could deploy each company’s
idiosyncratic strengths.
TABLE 3 Developer support for different gaming platforms, January 2018
PC PS4 Switch Xbox One
Smartphones
/Tablets Mac
Developers currently
developing for
59% 39% 36% 28% 30% 14%
Most interested in developing for 60% 30% 12% 26% 36% 20%
Note: Based on a survey of 4000 video game developers. Percentages aggregate to more than 100 because many
developers work on multiple platforms.
Source: UBM, State of the Game Industry, January 2018.

CASE 13 VIdEO GAME CONSOLE INduSTRY IN 2018 525
Appendix: Financial Data for the Leading Console Makers
TABLE A1 Nintendo (year ending March 31; ¥billion)
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Sales 966 1672 1838 1434 1014 648 635 572 550 504 489 1056
Operating income 226 487 555 357 171 (37) (36) (46) 25 33 29 178
Net income 174 257 279 229 78 (43) 7 (23) 42 17 103 140
Operating income/
average total assets (%)
19.5 27.0 31.7 21.0 10.1 (2.4) (2.2) (3.1) 1.8 2.5 1.9 11.5
Return on equity (%) 16.8 11.0 19.9 16.8 5.7 (4.2) 0.6 (2.0) 3.7 1.4 8.5 10.9
Source: The financial data in Tables A1, A2, and A3 is derived from the companies’ annual reports.
TABLE A2 Sony corporation (year ended March 31; ¥billion)
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Sales 8296 8871 7729 7214 7181 6403 5691 6682 7036 8160 7603 8544
—of which, Games 974 1219 1685 1512 1493 3137 750 1044 1388 1552 1650 1944
Operating income 150 475 (227) 32 200 (67) 227 26 40 294 289 735
—of which, Games (232) (124) (87) (83) 36 (230) (4) (19) 48 89 136 177
Net income 126 369 (98) (41) (259) (457) 42 (128) (126) 148 73 491
Operating income/average
total assets (%)
0.6 2.9 (1.8) 0.3 1.6 (0.5) 1.6 0.0 0.3 1.8 1.7 4.0
Return on equity (%) 3.9 10.8 (3.1) (1.4) (9.4) (15.6) 0.3 (4.6) (4.1) 6.2 2.9 18.0
TABLE A3 Microsoft (year ending June 30; $billion)
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sales 44.3 51.1 60.4 58.4 62.5 69.9 73.7 77.8 86.8 93.6 85.3 90.0
—of which,
Entertainment
and devicesa
4.29 6.07 8.14 6.42 6.22 8.16 32.44 32.10 37.67 23.7 25.0 27.4
Operating income 16.5 18.5 22.5 20.4 24.1 27.2 21.8 21.9 22.1 18.2 20.0 22.3
—of which,
Entertainment
and devicesa
(1.28) 0.43 (1.97) 0.29 0.57 1.14 6.05 9.42 8.71 5.1 6.2 8.3
Net income 12.6 14.1 17.7 14.6 18.8 23.2 17.0 21.9 22.1 12.2 16.8 21.2
Operating
income/average
total assets (%)
23.6 29.3 30.9 27.2 27.8 27.9 18.0 18.8 16.0 10.6 11.0 17.6
Return on equity (%) 28.6 16.45 42.47 38.5 43.7 44.8 25.6 27.8 24.7 14.4 22.1 29.4
Note:
a The segment data for 2012–14 relate to “Devices and Consumer,” of which “Computing and Gaming Hardware” comprises less than 25%.
Segment data for 2015–17 relate to “More Personal Computing.”

526 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Notes
1. The rise of smartphones for playing video games was
revealed by the success of Angry Birds. Launched in 2009
for the Apple iPhone, over 3 billion copies of Angry Birds
had been downloaded by the end of 2015.
2. In 1997, the average PlayStation game sold 69,000 copies;
the average N-64 title sold over 400,000 copies.
3. “Delays Likely for Sony’s PlayStation 3,” Financial Times
(February 20, 2006).
4. Prof. Clayton Christensen discusses Nintendo’s Wii strategy
and its implications in: http://www.easy-strategy.com/
sony-strategy.html. Accessed April 5, 2018.
5. “Xbox Is a Test for the One Microsoft Strategy,” Bloomberg
Business Week (November 21, 2013).
6. https://www.polygon.com/2017/12/8/16751740/
playstation-vs-xbox. Accessed April 4, 2018.
7. https://venturebeat.com/2018/01/19/digi-capital-game-
software-hardware-could-hit-170-billion-in-2018-230-
billion-by-2023/. Accessed April 4, 2018.
8. “How the Owner of Esports.com Is Using the
Valuable Domain He Purchased for 7 Figures,” Inc
( November 5, 2017).
9. Genres included: action games, shooter games, adventure
games, role-playing games, simulation games, strategy
games, and sports games.
10. Rockstar Games is a subsidiary of Take-Two Interactive
Software, Inc.

http://www.easy-strategy.com/sony-strategy.html

http://Esports.com

Case 14 Eni SpA: The
Corporate Strategy
of an International
Energy Major
Between 1992 and 2018, Eni had been transformed from a widely diversified, loss-making,
state-owned company into an international oil and gas major with the highest market
capitalization of any Italian company. Over this period, Eni had pursued a consistent,
focused strategy that concentrated heavily on oil and gas exploration and production.
This strategy has involved an emphasis on Africa (which accounted for more than half
of Eni’s oil and gas production), collaborating closely with producer countries (and
their national oil companies), a vertically integrated natural gas strategy linking Eni’s
gas fields to its downstream markets in Europe with pipelines and liquefied natural gas
(LNG) facilities (This included partnering with Gazprom, the Russian gas giant, partic-
ularly in international pipeline projects).
The strategy brought Eni considerable success—including a series of spectacular
oil and gas field discoveries. These included the Kashagan oilfield in the Caspian Sea
(2000), the Mamba gas fields off Mozambique (2011), and Zohr gas field in the eastern
Mediterranean (2015).
However, changing circumstances had upturned many of the assumptions that had
underpinned Eni’s strategy. Most serious was the fall in crude oil prices during the
latter half of 2014. Eni’s strategy of concentrating capital investment on E&P was pred-
icated on the belief that upstream was inherently more profitable than downstream.
For over half century this had been true—but not when crude oil prices were below
$50 a barrel. Eni’s upstream operations were also threatened by political developments.
The Arab Spring had unleashed chaos across much of North Africa and the Middle
East, with Eni’s two most important sources of hydrocarbons, Libya and Egypt, par-
ticularly affected. Further problems ensued from increased tensions between Europe
and Russia. In December 2014, Vladimir Putin announced the cancelation of the South
Stream gas pipeline from Russia to Western Europe, which was to have been built by
Eni’s associate Saipem.
Meanwhile, Eni’s strategy of vertical integration in natural gas conflicted with the
European Union’s goal of creating a competitive market for gas in Europe. As a result,
Eni was forced to divest most of its gas storage and pipeline businesses into a separate
company, SNAM Rete.
These developments impacted Eni’s top and bottom lines. Between 2012 and 2017,
despite increased production of oil and gas, revenues contracted by 44% while net
profits fell by 56%.
For CEO, Claudio Descalzi, Eni’s difficulties presented a personal threat. Eni had
long regarded itself as a pioneer of corporate social responsibility, especially in its deal-
ings with host governments. However, allegations from the Nigerian government that
This case was prepared by Robert M. Grant. ©2019 Robert M. Grant.

528 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
that and Shell had paid huge bribes to Nigeria’s former president and attorney-general
substantial bribes to secure exploration licenses had resulted in Italian prosecutors
indicting both companies and 13 of their executives—including Descalzi—in a trial that
began in June 2018.1
The History of Eni
Mattei and State Ownership, 1953–92
In 1926, Italian Prime Minister Benito Mussolini established Azienda Generali Italiana
Petroli (Agip) as a state-owned oil company. At the end of the Second World War,
Enrico Mattei, a former partisan, was appointed head of Agip and instructed to dis-
mantle this relic of fascist economic intervention. Instead, Mattei renewed Agip’s explo-
ration and, in 1948, discovered a substantial gas field in Italy’s Po Valley. In 1953, the
government merged Agip, Snam (gas distribution), and other state-owned enterprises
to form Ente Nazionale Idrocarburi (Eni) with the task of “promoting and undertaking
initiatives of national interest in the fields of hydrocarbons and natural gases.” Mattei
was its first chairman and chief executive.
Mattei’s vision was for Eni to become an integrated, international oil and gas
company that would ensure the independence of Italy’s energy supplies and con-
tribute to Italy’s postwar regeneration. In doing so he became a national hero: “He
embodied great visions for postwar Italy—antifascism, the resurrection and rebuilding
of the nation, and the emergence of the ‘new man’ who had made it himself, without
the old boy network.”2
Eni’s international growth reflected Mattei’s daring and resourcefulness. The inter-
national oil majors, which Mattei referred to as the “Seven Sisters,” controlled most oil
reserves in the Middle East and Latin America. The production-sharing agreement that
Mattei signed with the Shah of Iran in 1957 marked the beginning of a fundamental
shift of power from the oil majors to producer governments and established Eni as the
enfant terrible of the oil business. The agreement created a jointly owned explora-
tion and production company headed by an Iranian chairman and with the proceeds
shared between Eni and the Iranian National Oil Company. This “Mattei formula” was
replicated in Libya, Egypt, Tunisia, and Algeria. Mattei also concluded a barter deal to
import crude oil from the Soviet Union.
At home, Mattei built political support within Italy, principally by rescuing struggling
companies to gain favor with government ministers and politicians. By 1962, Eni was
“engaged in motels, highways, chemicals, soap, fertilizers, synthetic rubber, machinery,
instruments, textiles, electrical generation and distribution, contract research, engi-
neering and construction, publishing, nuclear power, steel pipes, cement, investment
banking, and even education, to mention only a few.”3
Mattei died in a plane crash on October 27, 1962 aged 56. He left a sprawling corpo-
rate empire whose strategy had been Mattei’s own vision and whose integrating force
had been Mattei’s charisma and personal authority. Without his leadership, Eni became
an instrument of government economic, industrial, and employment policies, with
the boards and chief executives of Eni’s subsidiaries appointed by government.4 Eni
continued to expand its oil and gas interests, but its financial performance was weak.
Privatization and Transformation, 1992–98
In 1992, under pressure to cut the public-sector deficit and reduce state intervention,
prime minister Giuliano Amato appointed Franco Bernabè, a 44-year-old economist

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 529
with no line management experience, as CEO. Though lacking operational experience,
Bernabè possessed a clear vision of Eni as a privatized, international oil and gas major.
The corruption scandal that swept Italy in 1993 resulting in the arrest of Eni’s chairman and
many senior executives gave Bernabè the opportunity to implement his vision.5 Bernabè’s
transformation of “Eni from being a loose conglomerate to concentrate on its core activity
of energy”6 involved divesting businesses, cutting employment, and eliminating losses.7
Eni’s initial public offering on the Milan, London, and New York stock exchanges
in November 1995 marked the beginning of a new era. The new creed of shareholder
value creation encouraged further refocusing: “Eni’s strategy is to focus on businesses
and geographical areas where, through size, technology, or cost structure, it has a
leading market position. To this end, Eni intends to implement dynamic management
of its portfolio through acquisitions, joint ventures, and divestments. Eni also intends
to outsource non-strategic activities.”8 The results were striking (see Figure 1). Between
1992 and 1998, Eni halved its debt, turned a loss into a substantial profit, and reduced
employment by 46,000. In 1998, Bernabè departed to lead another newly-privatized
giant: Telecom Italia.
Focused Development 1998–2017
During the next 19 years, Eni was led by three different chief executives: Vittorio
Mincato, a veteran line manager (1998–2005); Paolo Scaroni (2005–14), former CEO of
British glassmaker Pilkington and Enel, Italy’s leading electricity supplier; and Claudio
Descalzi (2014–), an Eni’s insider with extensive upstream experience in Africa. Yet,
despite their differences, all three followed a consistent long-term strategy for Eni. The
strategy resulted in steadily increasing petroleum production, an upward trend in rev-
enues and profits, and a shrinking employee base (see Figure 1).
Upstream Strategy: “Disciplined Growth” Eni’s dominant strategic goal was to
grow its production of oil and gas. This was achieved primarily by organic growth—
finding new oil and gas fields and more effectively exploiting existing reserves. All three
CEOs were eschewed large-scale mergers and acquisitions and made only small acqui-
sitions that could be integrated within Eni’s existing upstream activities. These included
British Borneo (2000, €1.3 billion), LASMO (2000, €4.1 billion), Fortum’s Norwegian oil
and gas assets (2002, $1.1 billion), and Dominion Exploration and Production’s Gulf of
Mexico oilfields (2007, $4.8 billion), Maurel & Prom’s Congo oilfields (2007, $1.4 billion),
and Burren Energy (2008, €2.36 billion).
Between 1998 and 2012, Eni’s capital expenditure more than tripled before being cut
back during 2013–16. Most went upstream where major projects included:
● Kazakhstan: Eni held 16.8% of the Kashagan oilfield—the world’s biggest oil
find of the past three decades and the most expensive and difficult to develop.
Eni had endured huge cost overruns, an eight-year start-up delay, and fierce dis-
putes with the Kazakh government.
● Russia: Eni built upon its status as a major, long-term customer for Soviet oil
and gas to broaden its relationship with Gazprom (including joint ventures to
build the Blue Stream and South Stream gas pipelines) and exploration ventures
with Rosneft.
● Republic of Congo: Eni’s activities in Congo were widely viewed as a model for
its relationships with other with host governments. In addition to E&P projects,
Eni built power plants using associated gas to provide the majority of Congo’s
electricity supply, a biofuel plant, and health clinics, and a vaccination program.

530 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
● Libya: Eni built on its status as Libya’s oldest and biggest petroleum partner by
maintaining production despite the chaos that followed the overthrow of the
Gaddafi regime.
● Two huge gas discoveries: off Mozambique, the Coral and Mamba gas fields
hold about 2250 billion cubic meters (or 85 trillion cubic feet) of gas; Eni’s Zohr
field off Egypt holds about 850 billion cubic meters (30 trillion cubic feet) of
gas. Overall, Eni replaced 150% of its reserves during 2014–16, compared to
50% for the other majors.
● Eni extended its E&P activities into Asia—including Australia, East Timor, Indo-
nesia, and Pakistan.
A further feature of Eni’s upstream strategy was its preference to take the role
of operator in oil and gas fields in which it held a major stake. This allowed Eni
greater control over development and costs and helped it to build its production
capabilities.
In March 2018, Eni sold 10% of its giant Zohr gas field and acquired oil and gas
assets in the United Arab Emirates. As it extended the geographical extent of its gas
fields beyond its core Mediterranean region, it looked increasingly to LNG as a means
FIGURE 1 The development of Eni, 1985–2017
180,000 15,000
10,000
5,000
0
–5,000
–10,000
–15,000
2000
1800
1600
1400
1200
1000
800
600
400
200
0
Sales ($m.)
Employees (,000s) Oil and gas production, (,000s boe/day)*
Net income ($m.)
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
160
140
120
100
80
60
40
20
0
19
85
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87
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91
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11
20
13
20
15
20
17
*barrels of oil equivalent
Note: BOE = barrels of oil-equivalent.
Source: Eni annual reports for various years.

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 531
of monetizing these reserves. LNG allowed Eni to develop gas production far from its
core European market and to expand its sales of gas to Asia. By 2018, Eni held equity
interests in LNG trains in Egypt, Libya, Nigeria, Angola, Oman, Trinidad, Indonesia, and
Australia.
Table 1 shows the geographical distribution of Eni’s production and reserves. This
distribution contrasted sharply with that of most other petroleum majors. Their major
sources of hydrocarbons were North America and the Middle East. Eni’s focus on Africa
and the former Soviet Union reflected, first, its comparative youth and, second, its
capacity to build cordial relations in countries that were viewed as difficult places to
do business. Energy commentator Steve LeVine observed: “Italy’s Eni continues to pio-
neer a successful path to survival in Big Oil’s treacherous new world—get in bed, don’t
compete with the world’s state-owned oil companies. . . Where its brethren bicker with
Hugo Chavez and Vladimir Putin, Eni has found a comfortable embrace.”9 At the root
of Eni’s flexible approach to host government relationships was its recognition that the
balance of power had shifted in favor of the producer countries. As former CEO Scaroni
commented: “The fact is, the oil is theirs . . . If you are looked at as a partner, you are
allowed to exploit their oil; if not, you are pushed aside.”10 Electricity supply formed
one component of Eni’s engagement with host countries. In Nigeria, Eni’s power pro-
duction supplied 10.5 million customers.
Downstream: Building the European Gas Business Eni’s possession of a large
downstream gas business made it was unique among the majors—few of which pos-
sessed a substantial downstream presence in gas. In Europe, distribution had histori-
cally been in the hands of regulated monopolies (e.g., British Gas and Gaz de France;
in the US it was in the hands of regulated local utilities).
TABLE 1 Eni’s petroleum production and reserves by region, 2017a
Hydrocarbon
productionb
Liquids
productionc
Gas
productiond Reservese
Italy 134 53 442 354
Rest of Europe 189 102 476 495
North Africa 713 233 2620 2446
Sub-Saharan Africa 347 250 533 1399
Kazakhstan 132 83 264 1221
Rest of Asia 119 54 357 290
Americas 160 75 264 1006
Australia and Oceania 22 2 105 145
TOTAL 1816 852 5261 6990
Notes:
aProduction/reserves data include both consolidated subsidiaries and equity-accounted entities.
bThousands of barrels of oil-equivalent per day.
cThousands of barrels per day.
dMillions of cubic feet per day.
eMillions of barrels of oil-equivalent (includes both developed and undeveloped reserves).
Source: Eni 20-F report for 2017.

532 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
Eni’s downstream gas and power business was a consequence of Eni’s historical
roots in natural gas and its belief that its integrated gas chain was a key competitive
advantage. As Paolo Scaroni observed:
Eni has a very distinctive way of dealing with the gas in Europe. We are both upstream
with our E&P division, and downstream in distribution, transport and sales. Just to
give you an idea of how integrated these two divisions are, 35% of our equity gas is
sold through our Gas and Power division, so we are already where most of our com-
petitors in the midstream and downstream business of gas would like to be: integrated
upstream, and generating our sales from our own equity gas . . . Then of course we
have a wide portfolio of sourcing of gas, which goes from Algeria to Libya, Poland,
Norway, and of course, Russia . . . There is no other player that has such a privileged
position in the European market.11
Marco Alvera, in charge of gas supplies, explained further:
Our gas, be it equity or contracted, comes from ten different countries. This gives us
considerable diversity and security of supply. Second, we can leverage on a growing
integrated LNG business. Third, we have attractive contractual structures and terms.
Fourth, we have access to a very large set of transportation and storage assets across
Europe from north to south and east to west. Finally, we have significant commercial
flexibility that allows us to vary, on a daily basis, the amounts of gas produced or
drawn from each of our contracts. Summing up, I would say that no other operator in
the European gas market can claim to have the same scale and asset-backed flexibility
as Eni’s Gas and Power division.12
International pipelines linked Eni’s gas supplies with its Italian distribution net-
work. The Trans Austria Pipeline (TAP) brought Russian gas from Slovakia; the Trans
Europa Naturgas Pipeline (TENP) carried North Sea gas from the Netherlands; the
Trans- Mediterranean pipeline brought Algerian gas; the Green stream pipeline car-
ried gas from Libya; the Blue stream pipeline, owned jointly with Gazprom, linked
Russia and Turkey across the Black Sea. Saipem, an oilfield services, engineering, and
construction company, 43% owned by Eni, built its subsea pipelines.
To further its goal of a competitive European gas market, the European Commission
required Eni it reduce its share of the Italian downstream gas market to 50% and divest
gas transmission, storage, and distribution. Eni’s ownership and operation of interna-
tional gas pipelines were also targeted by the European Commission: Eni was forced to
sell its stakes in the TAP and TENP pipelines.
At the same time, Eni broadened its European presence by acquiring equity stakes in
downstream gas companies in Spain, Germany, Portugal, Belgium, Hungary, and Croatia.
Refining, Marketing, and Chemicals In oil, Eni’s downstream presence was small:
the refining, marketing, and chemicals accounted for just 10% of Eni’s capital employed
compared to 85% for E&P. The business was based almost wholly in Italy, where Eni
held 31% of the market for fuels. Yet, despite shrinking refining capacity, fewer retail
outlets, and exiting downstream markets outside of Italy, the sector was a consistent
loss maker and only turned an operating profit in 2015 and 2016. In chemicals, Eni
lacked scale and distinctive technological advantages. After failing to find a buyer for
the business, in 2012, Eni renamed its chemicals division Versalis and refocused on spe-
cialty chemicals, bio-chemicals, and collaborative arrangements with other companies.
Eni’s vertical chains for oil and gas are shown in Figure 2.

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 533
Organizational Changes All three CEOs sought to make Eni a more integrated
corporation in order to strengthen financial control, implement more rigorous internal
auditing and risk management procedures, establishing a corporate-wide code of ethics
and sustainability reporting system, and give Eni a clearer corporate identity. The first
stage of this was transforming Eni from a holding company into a multidivisional cor-
poration with three key divisions—exploration and production, gas and power, and
FIGURE 2 Eni’s vertical chains for oil and gas
OIL AND REFINED PRODUCTS (millions of tonnes)
Crude oil
purchases 35.6
Eni’s crude oil
production 27.6
Crude oil
trading 32.1
Re�ning in
Italy 27.0
Re�ning
overseas 2.0
Wholesalers
in Italy 9.4
Retailers
outside Italy 2.0
Other sales
(including petro
-chemicals) 9.0
Exports 1.4
Retailers
in Italy 8.4
Wholesalers
outside Italy 1.4
NATURAL GAS (billion cubic meters)
Wholesalers 5.2
Industry 8.1
Gas produced by Eni
15.9
Sales elsewhere in
Europe 53.0
Sales in Italy
28.5
Spot markets 5.2
Gas purchases
79.2
Sales outside
Europe 6.2
Power generators 4.3
Eni’s power
generation 5.1
Residential 5.7
Source: Eni Fact Book.

534 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
refining and marketing—and stronger corporate-level functions, especially finance and
human resources.
Under Descalzi, further integration involved breaking up the divisional structure and
reorganizing around activities and businesses (see Figure 3).
The Petroleum Industry in 2018
The petroleum sector comprises two major segments: upstream and downstream.
Upstream undertakes the exploration and production of oil and gas; in downstream,
gas and oil have separate value chains. In oil, the primary activities are refining
and marketing (where marketing includes both wholesale and retail distribution
of fuels). In gas, the primary downstream activities are distribution and marketing.
Linking upstream and downstream are mid-stream activities: transportation, storage,
and trading.
Exploration and Production
The rise in the price of crude from around $22 in 2002 to over $100 during 2010–14
resulted from rising world demand (especially from India and China) and limits on
oil production—not because of declining reserves—but because of political insta-
bility in Libya, Egypt, Iraq, and Nigeria and underinvestment in Venezuela, Rus-
sia, and Mexico. During 2006–13, the majors earned a return on capital employed
in E&P at least double what they earned in refining and marketing, reinforcing
the conventional wisdom that industry’s primary source of profit was oil and gas
production. Hence, all the majors channeled their capital investment increasingly
toward E&P.
Board of Directors
Chairman: Emma Marcegaglia
CEO
Claudio Descalzi
O�ce of the CEO
Chief Financial & Risk
Management O�cer
Chief Services & Stakeholder
Relations O�cer
Assistant to the Chairman
Board secretary & corporate
governance counsel
Internal
Audit
Chief
Exploration
O�cer
Chief
Upstream
O�cer
Chief
Development,
Operations &
Technology
O�cer
Exec. VP
Energy
Solutions
Chief
Re�ning &
Marketing
O�cer
Chief
Gas, LNG
Marketing
& Power
O�cer
Corporate A�airs &
Governance
Legal
A�airs
Integrated
Compliance
External
Communication
International
A�airs
Integrated
Risk
Management
FIGURE 3 Eni’s organizational structure, March 2018
Source: https://www.eni.com/en_IT/company/our-management/organizational-chart.page.

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 535
During June 2014 to January 2016, crude declined from $115 to $28 per barrel from
before recovering during 2017 (Figure 4). The main cause of falling prices was growing
US production of “tight” oil as a result of horizontal drilling and hydraulic fracturing.
United States 2018, the US was poised to displace Saudi Arabia as the world’s biggest
oil producer (Table 2).
The impact of lower oil prices on the finances of the oil majors was severe. During
2015 and 2016, the pretax profits of the majors were between 40% and 70% lower than
below the average for the previous three years.
Upstream margins were also pressured by rising costs. In response, the oil and gas
companies had outsourced more and more of their E&P activities. Drilling, seismic
surveys, rig design, platform construction, and oilfield maintenance were increasingly
undertaken by oilfield service companies. As these companies developed their exper-
tise and their proprietary technologies, and grew through mergers and acquisitions, sec-
tor leaders such as Schlumberger, Baker Hughes, Halliburton, and Diamond Offshore
Drilling emerged as powerful players within the petroleum industry.
Refining and Marketing
The main refined products in order of importance were gasoline, diesel fuel, aviation
fuel, heating oil, liquefied petroleum gas (LPG), and petrochemical feedstock (e.g.,
naphtha). Historically, downstream was less profitable than upstream: in their refining
and marketing businesses, the majors typically earned rates of return that barely covered
their costs of capital. As a result, all the majors had divested refining and marketing
assets to concentrate increasingly on their upstream businesses (Table 3).
The main problem in refining was excess capacity. Demand for refined products was
declining in Europe and North America and new refining capacity was coming on stream
in the Middle East and Asia as a result of downstream investments by the national oil com-
panies (NOCs). Excess capacity and thin margins were also the norm in gasoline retailing.
0
M
ay
-1
98
7
M
ay
-1
98
9
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ay
-1
99
1
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ay
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ay
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99
5
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ay
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ay
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ay
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ay
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ay
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ay
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ay
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ay
-2
01
5
M
ay
-2
01
7
20
40
60
80
100
120
140
FIGURE 4 Europe Brent Spot Price ($ per barrel)
Source: IEA.

536 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
TABLE 2 Oil and gas production and reserves by country
Oil production
(mn barrels/day)
Gas production
(bn cubic meters)
Oil reserves
(bn barrels)
Gas reserves
(tn cubic meters)
2016 2007 1991 2016 2007 1991 2016 2016
Saudi Arabia 11.5 10.4 8.8 103 76 35 266 8.2
Russia 10.8 10.0 9.3 605 607 600 93 31.3
US 10.0 6.9 9.1 688 546 510 44 9.3
China 4.2 3.7 2.8 117 69 15 18 3.3
Canada 3.9 3.3 2.0 155 184 105 174 2.0
Iran 3.6 4.4 3.5 167 112 26 157 33.8
UAE 3.6 2.9 2.6 56 49 24 98 6.1
Kuwait 3.1 2.6 0.2 16 13 1 102 1.8
Iraq 3.1 2.1 0.3 1 1 n.a. 150 3.6
Mexico 2.9 3.5 3.1 57 46 28 11 0.3
Venezuela 2.6 2.6 2.5 28 29 22 298 5.6
Norway 2.1 2.6 1.9 109 90 27 9 2.0
Nigeria 1.8 2.4 1.9 36 28 4 37 5.1
Brazil 2.1 1.8 0.8 21 14 6 16 0.5
Qatar 2.0 1.3 0.5 159 63 12 25 24.7
Kazakhstan 1.8 1.5 0.5 19 15 4 30 1.5
Angola 1.8 1.7 0.2 — — — 13 —
Algeria 1.6 2.0 1.4 79 83 53 12 4.5
Notes:
mn = million; bn = billion; tn = trillion.
n.a. = not available.
Source: BP Statistical Review of World Energy, 2008 and 2017.
Downstream Gas and Power
Unlike Eni, whose origins lay in gas rather than oil, the other petroleum majors were
relative newcomers to natural gas. The rising demand for natural gas caused all the
majors to reorient their upstream activities toward gas, while the privatization and
liberalization of downstream gas and power markets offered opportunities to market
gas to end users and to become generators of electricity. However, the downstream
gas and power did not offer the petroleum majors rates of return comparable to those
earned upstream.
Chemicals
Petrochemicals have similar structural features to oil refining: capital-intensive
processes producing commodity products, many competitors, and a tendency toward

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 537
excess capacity (mainly resulting from new investment by Asian and Middle Eastern
producers). Competitive advantage in chemicals depended upon scale economies,
technological advantages (such as patented products and processes), and low costs
of feedstock. Low feedstock costs give Middle Eastern and North American producers
a big advantage over European producers. Among the oil and gas majors, there were
two distinct views about chemicals. Some, such as Eni and BP, saw chemicals as a fun-
damentally unattractive industry and believed that chemical plants were better run by
chemical companies. Others (including ExxonMobil, Shell, and Total) viewed chemicals
as part of their core business and believed that integration between refining and petro-
chemicals offered them significant advantages.
The Companies
The petroleum sector featured three main types of company:
● The oil and gas majors were characterized by their age, size, international
scope, and vertical integration. Between 1998 and 2002, a wave of mergers and
acquisitions resulted in the emergence of an elite group of “super majors” com-
prising ExxonMobil, BP, Royal Dutch Shell, Chevron, ConocoPhillips, and Total
(Table 4). The extent of economic benefits from these mergers and acquisitions
remains unclear. The costs of developing oil and gas fields and building LNG
facilities were huge, but typically these were undertaken as joint ventures, not
by single firms. The main benefits of a large portfolio of upstream projects were
spreading risks and infrastructure costs and accelerating learning. However,
there was little evidence that scale economies continued up to the size of com-
panies such as ExxonMobil or Shell. The majors differed in the geographical
and sector balance of their businesses. Although all the majors had shifted their
capital expenditure upstream, only ConocoPhillips had gone as far as spinning
off its downstream businesses entirely.
● The national oil companies were state-owned enterprises created by producer
governments to manage their countries’ petroleum reserves. In terms of
TABLE 3 Capital expenditures among the majors, 2003–2017
Average annual capex ($ bn) Capex on E&P as % of total
2003–2007 2008–2012 2013–2017 2003–2007 2008–2012 2013–2017
ExxonMobil 17.0 31.5 25.4 78.2 82.6 78.5
Royal Dutch/Shell 16.4 28.6 26.2 68 78.2 81.6a
BP 17.9 24.6 18.8 69.3 79.1 81.3
Total 12.2 24.1 23.5 72.3 65.2 69.4
Chevron 10.8 23.0 27.6 77.0 90.2 89.5
Conoco Phillips 11.4 12.1 10.5 57.9 86.7 98.7
Eni 9.6 16.0 13.7 65.7 69.8 90.2
Note:
aIncludes upstream and integrated gas.
Source: Company annual reports.

538 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
production and reserves, they dominated the industry (Table 5). Most had been
created between 1965 and 1982 by nationalizing the assets of the majors. During
2000–17, the relationship between the majors and the NOCs shifted substan-
tially. High crude prices and growing nationalism among oil-producing coun-
tries resulted in the desire for greater control over their countries’ hydrocarbon
resources and bigger shares of production and revenues. In Venezuela, Bolivia,
and Russia, foreign oil companies were forced to transfer upstream assets to
the national government or to NOCs. Elsewhere higher taxes were imposed
and participation agreements renegotiated. Different NOCs followed different
strategies. Petróleo Brasileiro SA (Petrobras), Statoil, PetroChina, and CNOOC
became important international players. Others, such as Saudi Aramco, Kuwait
Petroleum, and Petróleos de Venezuela SA (PDVSA), invested heavily in refining
and petrochemical businesses. With the help of oil service companies, many
NOCs became less dependent upon the majors for technology and know-how.
● Independents: At each vertical stage, specialist companies played an impor-
tant role. In exploration and production, companies such as Devon Energy,
Anadarko Petroleum, Cairn Energy, and Woodside Petroleum were important
TABLE 4 Mergers and acquisitions among the petroleum majors, 1998–2017a
Major oil
companies, 1995
Revenues,
1995 ($bn.)
Date
merged
Major oil
companies, 2017
Revenues,
2017 ($bn.)
Royal Dutch Petroleum
Shell Transport & Trading
Enterprise Oil
BG Group plc
66
44
1
14
2004
2002
2015
Royal Dutch Shell 257
Exxon
Mobil
124
75
1999 Exxon Mobil Corp. 233
British Petroleum
Amoco
Arco
56
28
16
1998
2000
BP 200
Total
Petrofina
Elf Aquitaine
28
18
37
1999
2000
Total 137
Chevron
Texaco
31
36 2001
Chevron 119
Eni 36 Eni 68
Repsol
YPF
21
5
1999 (de-
merged 2012)
Repsol 44
Conoco
Philips Petroleum
Tosco
15
13
14
2002
2001
ConocoPhillips 33
Note:
aOnly includes acquisitions of companies with revenues exceeding $1 billion.
Source: Reports in the financial press.

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 539
players, some concentrated on exploring frontier regions, others on onshore
production. Their operational and financial success contradicted the argu-
ments of the majors that huge size was an essential requirement in the
petroleum industry. In refining, independent refiners such as Valero in
TABLE 5 The world’s top-30 petroleum companies by size of reserves
Company State ownership Reserves (BOE bn)
National Iranian Oil Company (Iran) 100% 300
Saudi Arabian Oil Company (Saudi Arabia) 100% 303
Petróleos de Venezuela SA (Venezuela) 100% 129
Qatar General Petroleum Corporation (Qatar) 100% 170
Iraq National Oil Company (Iraq) 100% 134
Abu Dhabi National Oil Company (UAE) 100% 126
Petróleos Mexicanos (Mexico) 100% 111
Kuwait Petroleum Corporation (Kuwait) 100% 95
Nigerian National Petroleum Corporation (Nigeria) 100% 68
National Oil Company (Libya) 100% 51
Sonatrach (Algeria) 100% 39
OAO Gazprom (Russia) 50% 29
OAO Rosneft (Russia) 75% 23
PetroChina Co. Ltd. (China) 87% 22
BP Corporation (United Kingdom) 0% 18
Egyptian General Petroleum Corporation (Egypt) 100% 18
Exxon Mobil Corporation (US) 0% 21
OAO Lukoil (Russia) 0% 13
Royal Dutch/Shell (Netherlands) 0% 13
Petróleo Brasileiro SA (Brazil) 37% 13
Sonangol (Angola) 100% 11
Chevron Corporation (US) 0% 11
Petroleum Development Oman LLC (Oman) 100% 11
Total (France) 5% 19
ConocoPhillips (US) 0% 7
Eni (Italy) 30% 7
Petróleos de Ecuador (Ecuador) 90% 7
Petronas (Malaysia) 100% 6
Statoil (Norway) 67% 5
Suncor Energy Inc. (Canada) 0% 5
Note:
BOE: barrels of oil-equivalent.

540 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS
the US, grew as the majors sold off downstream assets. (Table A4 lists the
world’s largest publicly listed oil and gas companies.)
Vertical Integration Strategies
Vertical integration throughout the value chain from exploration through to retailing
refined products was a key feature of the strategies of majors. The rationale for vertical
integration had been to secure supply and market outlets. However, in the case of oil,
the development of a global infrastructure of transportation and storage, competitive
markets for both crude and refined products, and the presence of specialist companies
at every stage of the value chain had reduced (if not eliminated) the advantages of
vertical integration. Most majors remained vertically integrated, but few had close oper-
ational linkages between their oilfields and refineries, and all had withdrawn from
some stages of the value chain (e.g., outsourcing oilfield services and marine trans-
portation). When ConocoPhillips spun off its downstream businesses into a separate
company, Phillips 66, in 2011, CEO Jim Mulva stated:
Looking forward over time, we believe that pure play companies will deliver greater
value because the complex, integrated business model is no longer a strategic
advantage in gaining resource and market acc… repositioning into two separate
companies will be the best way to compete and grow and to attract, retain and
develop talent.13
In gas, the situation was different. The physical difficulties of transporting and stor-
ing gas meant that monetizing gas reserves required dedicated investments in trans-
portation, liquefaction, and storage to link production to consumption. The lack of an
integrated global market in gas was indicated by the wide geographical price differ-
ences—prices in Asia were often five times those in the US. The desire to exploit their
upstream gas resulted in all the majors making substantial investment in LNG.
The Outlook for Eni in 2018
Despite the profound challenges that the political and economic environment pre-
sented for Eni’s long-term strategy, Claudio Descalzi’s presentation of Eni’s strategy
for 2018–21 on March 16, 2017 was marked by confidence and optimism in Eni’s
future. Upstream, Eni would continue to capitalize on its strength in exploration with a
target of adding 2 billion barrels of oil-equivalent within four years. Upstream expan-
sion would be combined with strong cash generation through Eni’s “dual exploration
model”: aggressively exploring for hydrocarbons, then making early sales of minority
stakes in newly-discovered fields. Eni’s upstream cash flows would be boosted by its
speed in developing new fields: the company claimed that its “time-to-market” (bet-
ween discovery and start-up) was 4.5 years, compared to the 9 years that was typical
in the industry. During 2018–21, E&P would account for about 82% of Eni’s capital
expenditures.
In Gas and Power, a key theme was increased integration with upstream—especially
through Eni’s increased commitment to LNG. By 2012, Eni would rely heavily on its
equity gas for its LNG, the principal market for which would be Asia. It’s target for LNG
sales was 14 million tonnes per annum by 2015.

CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 541
Across the company as a whole, two strategic themes would be prominent:
● Environmental sustainability. Initiatives included reducing emissions from
upstream operations, increasing the output of biofuels, expanding Versalis’s
efforts in biochemicals, and increasing solar and wind generation—including
the use of derelict industrial sites for solar power.
● Digitization would be the basis for process improvement increasing efficiency,
speed, and reliability in projects that extended from enhanced seismic imaging
in exploration to applications of blockchain in trading, to developing a car-
sharing scheme.
Underlying Eni’s strategy for 2018–21 were several assumptions. Explicit assump-
tions concerned key external variables, the price of Brent crude was assumed to rise
from $60 in 2018 to $72 in 2021, a US$/Euro exchange rate rising from 1.17 to 1.25 over
the same period, and a refining margin of $5 per barrel. There were assumptions about
Eni’s own internal strengths, these are summarized in Exhibit 1.
In view of the uncertain geopolitical situation, continuing growth in the production
of tight oil and gas, especially in the US, and the depressed state of Eni’s home market,
were these forecasts unduly optimistic, and did Eni need to reconsider the fundamen-
tals of its strategic direction?
EXHIBIT 1
Eni’s strengths
1 Exploration: an unbeatable success
● Eni is the unrivalled sector leader in exploration:
13 bn boe discovered since 2008 at a unit cost of
about $1.2/boe.
● 2017–20 plan targets: 2–3 bn boe of new resources
with 120 wells in more than 20 countries.
2 An integrated development model
● Quick time-to-market and low operating & pro-
duction costs thanks to organic discoveries.
● High operatorship allowing for timing framework
and development costs optimization.
3 An attractive upstream project portfolio
● +3% per year of organic production growth. New
project start-ups will account for +850 kboe/day
by 2020. 2019–20 cash flow at $29/boe.
● Eni’s “dual exploration mobn”: $9bln of resources
sold since 2013.
4 The relaunch of the G&P business
● G&P: structural breakeven in 2017; 2017–20
cumulative operating cash flow at € 2.6 b.
● Growing LNG portfolio player integrated with
upstream: 10 MTPA by 2025.
5 A value-creating downstream business
● Refining margin breakeven at $3/bbl in 2018.
● Versalis: €1.3 b of cumulative operating cash flow
in 2017–20.
6 A robust but flexible financial strategy
● Low leverage (net debt/equity) at <20% pro- forma Zohr and Mozambique deals by end of 2016. ● CAPEX and dividend coverage at $60/bbl by 2018. 7 A competitive and transparent distribution policy ● Progressive distribution policy in line with under- lying earnings growth and scenario. ● For 2017, we confirm our commitment to pay a full cash dividend of €0.8 per share. Source: https://www.eni.com/en_IT/investors/strategy/enis- strengths.page (Accessed May 8, 2017). 542 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Appendix TABLE A1 Eni’s financial highlights, 2009–2016 (€billions unless otherwise indicated) 2009 2010 2011 2012 2013 2014 2015 2016 2017 Exchange rate ($/€) 1.394 1.326 1.393 1.285 1.328 1.329 1.11 1.107 1.13 Net sales from operations 83.2 98.5 109.6 127.1 114.7 109.8 72.3 55.8 71 Operating profit 12.1 16.1 17.4 15.2 8.9 7.9 (3.1) 2.2 8.0 Adjusted operating profit 13 17.5 17.9 20.7 12.6 11.6 1.1 (0.2) 5.8 Net profit 4.4 6.3 6.9 7.8 5.1 1.3 (8.8) (1.5) 3.4 Adjusted net profit 5.2 6.9 7.0 7.3 4.4 3.7 0.8 (0.3) 2.4 Net cash from operating activities 11.1 14.7 14.4 12.4 11.0 15.1 11.6 7.7 10.1 Capital expenditures 13.7 13.9 13.4 13.5 12.8 12.2 11.3 9.2 9.0 R&D expenditure 0.29 0.29 0.27 0.2 0.18 0.17 0.18 0.16 0.19 Total assets at year-end 117.5 131.9 142.9 140.2 138.3 146.2 139 124.5 115 Shareholders’ equity (including minority interests) 46.1 51.2 55.5 62.4 61.0 62.2 57.4 53.1 48.1 Short- and long-term debt 24.8 27.8 29.6 24.2 25.6 25.9 27.8 27.2 24.7 Leverage 0.46 0.47 0.46 0.24 0.25 0.22 0.29 0.28 0.23 Net capital employed 73.1 81.8 88.4 78.2 76.6 75.9 74.2 67.9 59.1 Average share price (€) 16.6 16.4 16.0 17.2 17.6 17.8 15.5 13.4 13.9 Adjusted ROACE (%) 12.3 16.0 17.2 17.6 13.5 12.7 0.6 0.2 4.7 TABLE A2 Eni’s operating data, 2009–2017 2009 2010 2011 2012 2013 2014 2015 2016 2017 Employees 71,461 73,768 72,574 77,838 82,289 84,405 34,196 33,536 33,126 Proved hydrocarbon reserves (million BOE) 6571 6843 7086 7166 6535 6602 6890 7490 6990 Reserve life index (years) 10.2 10.3 12.3 11.5 11.1 11.3 10.7 11.6 10.5 Hydrocarbon production (thousand BOE/day) 1769 1815 1581 1701 1619 1598 1760 1759 1816 Worldwide gas sales (bn m3) 103.7 97.1 96.8 95.3 93.2 89.2 90.9 88.9 80.8 Finding and development cost per BOE ($) 28.9 19.3 18.8 17.4 19.2 21.5 19.3 13.2 13.8 Electricity sold (TWH) 34.0 39.5 40.3 42.6 35.1 33.6 34.9 37.1 35.3 Refinery throughput (mn tonnes) 34.6 34.8 32.0 30.1 27.4 25.0 26.4 24.5 24.0 Refinery capacity (m barrels/day) 747 757 767 767 787 617 548 488 480 (continues) CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 543 TABLE A3 Eni’s financial performance by business segment, 2012–17 2012 2013 2014 2015 2016 2017 Sales (€bn.) E&P 35.9 31.3 28.5 21.5 16.1 19.5 Gas & Power 36.2 32.2 73.4 52.1 41 50.6 Refining & Marketing and Chemicals 62.5 57.2 29.0 22.6 18.7 22.7 Corporate and other 6.4 5.9 1.4 1.5 1.3 1.5 Operating profit (€bn.) E&P 18.5 14.6 11.6 (1.0) 2.6 5.1 Gas & Power (3.1) (3.0) 0.2 (1.3) (0.4) 0.2 Refining & Marketing and Chemicals (1.9) (2.2) (2.8) (1.6) 0.7 1.0 Corporate and other n.a. n.a. 1.5 1.2 (0.1) (0.5) Operating margin (%) E&P 51.5 46.8 40.5 (4.5) 16 26.2 Gas & Power (8.6) (9.2) 0.6 (2.4) (1) 0.4 Refining & Marketing and Chemicals (2) (2.6) (4) (6.9) 3.9 4.4 Net capital employed (€bn.) E&P 42.4 45.7 51 54 57.9 49.8 Gas & Power 10.6 9.2 9 5.8 4.1 3.4 Refining & Marketing and Chemicals 8.9 11.4 9.7 7 7 7.4 Operating profit/Capital employed (%) E&P 43.6 32 24.2 (1.8) 4.4 10.2 Gas & Power (29.5) (32.3) 2.4 (21.7) (9.5) 5.9 Refining & Marketing and Chemicals (14.2) (18.6) 27.9 (22.4) 10.4 13.5 2009 2010 2011 2012 2013 2014 2015 2016 2017 Retail sales of petroleum products (mn. tonnes) 12.0 11.7 11.4 10.9 9.7 9.2 8.9 8.5 8.4 Number of service stations 5986 6167 6287 6384 6386 6220 5846 5622 5450 Av. service station throughput (mn. liters/year) 2477 2353 2206 2064 1828 1725 1754 1742 1698 TABLE A2 Eni’s operating data, 2009–2017 (continued ) 544 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS TABLE A4 World’s leading publicly traded oil and gas companies, 2017 (ranked by stock market capitalization on March 2, 2018) Company Country Market value ($bn) Sales ($bn) Operating margin (%) ExxonMobil US 320 237 5.1 Royal Dutch Shell Netherlands 261 305 5.4 PetroChina China 218 240 3.6 Chevron US 213 135 3.9 Total France 119 174 7.1 Sinopec China 116 246 3.5 BP UK 115 249 2.6 Reliance Industries India 93 58 4.4 Petrobras Brazil 90 88 18.0 Statoil Norway 74 61 22.6 ConocoPhillips US 65 30 (7.7) Eni Italy 60 82 12.0 Rosneft Russia 61 85 10.0 CNOOC China 63 23 17.7 Gazprom Russia 59 100 13.3 EOG Resources US 59 11 8.2 Lukoil Russia 57 86 8.0 Suncor Energy Inc. Canada 52 24 14.2 PTT PCL Thailand 51 60 11.8 Occidental Petroleum US 50 13 5.6 Phillips 66 US 46 103 1.9 Valero US 40 94 3.8 Oil & Natural Gas Corp. India 36 22 13.0 Anadarko Petroleum US 31 11 (6.1) Indian Oil India 28 57 2.6 Source: Financial Times/Thomson Reuters. CASE 14 ENI SPA: ThE CORPORATE STRATEGY Of AN INTERNATIONAL ENERGY MAjOR 545 Notes 1. “The OPL245 Affair: Drillers in the Dock,” Economist (March 3, 2018). 2. D. Yergin, The Prize (Simon & Shuster, New York, 1992): 23. 3. Ibid. 4. D. Votaw, The Six-Legged Dog: Mattei and ENI: A Study in Power (University of California Press, Berkeley, CA, 1964): 71. 5. Franco Bernabè at Eni, Harvard Business School Case 9-498-034 (April 7, 1998). 6. “Eni Savors the Taste of Freedom,” Financial Times ( June 9, 1994). 7. Eni SpA, Securities and Exchange Commission, Form 20F (1996). 8. Ibid.: 3. 9. S. LeVine, The Oil and the Glory: The Pursuit of Empire and Fortune on the Caspian Sea (New York: Random House, 2007). 10. “How Italy’s ENI Vastly Boosted Oil Output,” Business Week (April 20, 2009). 11. Eni SpA Gas seminar conference call (December 1, 2006). 12. Ibid. 13. “Creating Two Leading Energy Companies,” Spirit Maga- zine (ConocoPhillips, 3rd quarter, 2011): 6. Case 15 Zara: Super-Fast Fashion With sales of €25.3 billion in the 12 months to January 31, 2018, Inditex, based in Arteixo, Galicia, in the north-west corner of Spain, was the world’s biggest apparel supplier. Its founder and controlling shareholder, Amancio Ortego, was estimated by Forbes to be the world’s sixth richest person (after Jeff Bezos, Bill Gates, Warren Buffett, Bernard Arnault, and Mark Zuckerberg). Inditex is famous mainly for its biggest business, Zara, which accounted for 66% of the Group’s sales in 2017. In January 2018, there were 2251 Zara stores—the great majority company-owned and operated—in 96 different countries. The Group’s other businesses (ranked by sales) were Pull & Bear, Massimo Dutti, Bershka, Stradivarius, Zara Home, and Oysho. Except for Zara Home (furnishings and tableware), all the businesses are engaged in the design, manufacture, and retailing of fashion clothing (together with footwear and accessories), although each operates independently with a distinctive brand personality and a different target customer segment. As well as being the core business of Inditex Group, Zara is also the primary expo- nent of Amancio Ortega’s unique approach to the fashion clothing business. Zara’s strategy defies most of the fashion world’s conventional wisdom: it spends almost nothing on advertising, employs no super-star designers, seeks no celebrity endorse- ments, and undertakes most of its manufacture in Spain rather than offshoring it to low-wage locations. Instead, Zara has created a unique business system that is quick to recognize and exploit emerging fashion trends through a vertically-integrated supply chain that supports unparalleled speed and market responsiveness. A Brief History1 Amancio Ortego was born in Galicia in 1936. He left school at the age of 11 and by the age of 13 was working for a local shirt-maker. In his early 20s, he began producing copies of popular designer garments using inexpensive fabrics; at age 29, he opened his first Zara store selling modestly-priced, fashionable women’s clothing. Here, Ortego introduced the novel idea of a continuously changing collection of garments, in contrast to the two-season per year collections that were traditional in the clothing business. As Ortego opened additional stores, he developed his “instant fashion” model involving designers replicating emerging trends, then using close integration of factories, distri- bution centers, and retail stores to compress the design-to-store cycle. The first Zara store outside Spain was in Portugal in 1988, and in 1989, Zara entered the United States. By 2000, Zara had created a business system unlike that of any other fashion brand. Zara’s designers, based at Inditex’s Arteixo headquarters, sourced design ideas from fashion shows, celebrities, streetwear, and—most of all—feedback from the stores. Fab- rics for Inditex brands were purchased by its subsidiary, Comditel, which also under- took most dying and printing of the fabric. This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. CaSe 15 Zara: Super-FaSt FaShion 547 Zara in 20183 Zara’s strategy is based upon supplying cutting-edge fashion at reasonable prices—or, as the New York Times explained: “. . . trendy and decently made but inexpensive prod- ucts sold in beautiful, high end-looking stores. Zara’s prices are similar to those of the Gap: coats for $200, sweaters for $70, T-shirts for $30.”4 The success of the strategy is indicated by its financial performance (see Table 1). Initially, most of Zara’s garments were produced in-house. As its product range and volume grew, the proportion of Zara’s sales produced by third-party manufacturers increased to about half. Zara’s distribution center, at Arteixo, served Zara stores throughout the world with twice-weekly deliveries, each taking a maximum of three days. Garments were shipped with price-tags attached, on rails, ready for immediate display within the stores. Each store’s shipment would comprise only 3–5 units of each size and each design. Zara’s stores featured a uniform design and product presentation. Store managers oversaw ordering and providing weekly feedback. Prices were determined centrally and varied between countries according to transport costs and what the market would bear. Compared to Spain, Zara’s prices were 70% higher in North America and 100% higher in Japan. Zara’s international expansion involved setting up new stores in prime locations. Zara’s initial entry was often through joint venture—in Italy and Japan, joint ventures helped gain access to prime real estate; in Germany and India, joint ventures gave access to local market knowledge. However, joint venture partners were usually bought out at a later stage—according to Inditex’s head of corporate development: “We don’t mind investing in joint ventures to learn but prefer to go alone.”2 The time from a product’s design to its arrival in a retail store could be as little as two weeks. Figure 1 shows Inditex and Zara’s growth from 1996 to 2017. 0 5 10 15 20 25 30 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 No. of stores (,000s)Inditex sales (€bn.) Zara sales (€bn.) FIGURE 1 Growth of Inditex and Zara’s sales and store numbers, 1996–2017 Source: Inditex. 548 CaSeS to aCCoMpanY ConteMporarY StrateGY anaLYSiS Design Designers form part of Zara headquarters’ “commercial team,” together with country managers and buyers. Designers tend to be young—mostly in their late 20s and early 30s and work collaboratively in an egalitarian environment. Designers are organized into three groups—women’s wear, men’s wear, and children’s wear—each group occu- pying a large, open-plan hall, within which there are separate areas for different product groups. Buyers and county managers sit around a long table in the middle of each hall. Design is a collaborative process involving numerous meetings. A product group head explains: “For new collections we meet to decide which trends we are going to follow, then how to put the collection together, then select which items to prototype, which items to produce, and in what quantity . . . the design team may come up with 500 design ideas . . . we may arrive at 40 designs to move forward, and we may actually choose to go ahead with only a few of them.”5 In common with the rest of the fashion industry, Zara designers create collections for both fall/winter and spring/summer seasons—but typically these items cover only about 15% to 20% of Zara’s sales (compared to 80% to 100% for most branded fashion companies). The pre-planned collections are continuously augmented and adapted— mainly on the basis of feedback from store managers. The country managers play an important role in linking the stores within their country with design and production decisions. Based mainly at headquarters, they are in constant communications with their store managers. TABLE 1 Financial performance of Zara and Inditex 2017 2016 2015 2014 2013 2012 2011 Sales (€bn.) Zara 16.6 15.4 13.6 11.6 10.8 10.5 9.0 Inditex 25.3 23.3 20.9 18.1 16.7 15.9 13.8 EBIT (€bn.)a Zara 3.02 2.76 2.45 2.12 2.09 2.23 1.73 Inditex 4.31 4.02 3.68 3.20 3.07 3.12 2.52 EBIT/Sales (%) Zara 18 18 18 18 19 21 19 Inditex 17 17 18 18 18 20 18 ROCE (%)b Zara 30 30 30 29 31 37 32 Inditex 33 33 34 33 35 39 37 ROE% Inditex 26 26 26 25 27 30 28 Notes: aEarnings Before Interest and Tax. bEBIT/Average capital employed. Source: Inditex Annual Accounts. CaSe 15 Zara: Super-FaSt FaShion 549 The buyers manage sourcing, procurement, and the allocation of production to dif- ferent plants and to third-party suppliers. Production Zara had historically concentrated its production in its own production plants close to its Arteixo base. However, as its sales have grown and its international scope widened, it has relied increasingly on a global network of about 1600 third-party suppliers— located mainly in Eastern Europe (including Turkey) and Asia. Zara’s own manufacturing plants concentrate upon products that are most sensitive to time to market. Basic items which are designed pre-season and whose sales are predict- able are typically outsourced to Asia. For in-house production, Zara’s plants concentrate on fabric cutting; sewing is mostly undertaken by about 200 contractors located mainly around La Coruña and elsewhere in north-west Spain. Sewn garments are then returned to Zara for quality inspection, labeling, and transfer to the main distribution center. Distribution By 2018, Zara had three major distribution centers: its original distribution center at Arteixo, plus its centers at Zaragoza, for women’s garments, and at Meco, near Madrid, mainly for children’s wear. The distribution centers are highly automated. The introduc- tion of RFID (radio frequency identification) technology in 2014 has enabled tracking of every garment from factory to point of sale. For European stores, each store’s shipment is consolidated at the Zaragoza center, and then shipped within a 24-hour window by trucks (third-party carriers, but in Zara liveried trucks). Stores outside outside Europe? have their shipments airfreighted, usually by scheduled air service, with 48- to 72-hour shipment time. As soon as shipments arrive, they are put on display at the stores—retail stores have no back inventory. Retailing Stores place orders and receive shipments twice-weekly at specified times. Because of the constant stream of new products, a large proportion of orders are for new items— hence the need for frequent discussion between the store manager and country head. Typically, each item spends less than two weeks in a retail store. If an item is still in a store after two or three weeks, it is removed and sent to a store within the same country where that particular item is selling faster—or even sent back to Spain for relabeling for a store in a different country. Zara’s retail stores play a critical role in Zara’s brand identity. Zara targets premier retail locations: Fifth Avenue in New York, Regent Street in London, the Champs- Élysées in Paris. According to one fashion journalist: The high street is really divided according to brand value. Prada wants to be next to Gucci, Gucci wants to be next to Prada. The retail strategy for luxury brands is to try to keep as far away from the likes of Zara. Zara’s strategy is to get as close to them as possible.6 Zara’s merchandising is designed to create a unique retail dynamic for the brand. Because Zara ships limited quantities of each product and is continually changing its 550 CaSeS to aCCoMpanY ConteMporarY StrateGY anaLYSiS collection, it has incentivized impulse buying—buy it now or there may not be another chance! Equally, the fast-revolving collection encourages frequency of store visits. The retail stores are important listening posts for Zara designers. Retail staff are encouraged to elicit and note customer reactions concerning what they like and dis- like about specific products. Store managers report this information to their country heads so that it can be incorporated within headquarters, where it is then transmitted to designers. The Fashion Clothing Business The quest for cost efficiency has resulted in the value chain of the world clothing industry becoming globally distributed. The leading producing countries for fabric and components (buttons, zippers, trim, etc.) are China, the European Union, India, the United States, Turkey, and South Korea. Garment manufacture is concentrated in coun- tries where labor costs are low, notably China, Bangladesh, Vietnam, and India. Table 2 shows the leading exporters and importers of clothing. The complexities of managing across borders and the strategic differences bet- ween the different stages of the value chain result in different companies specializing in different stages of the chain (see Figure 2). Fabrics, both woven and knitted, are almost entirely produced by specialized textile companies. Most garment production is undertaken by cut-and-sew specialists, mainly contract manufacturers whose products are sold under their customers’ brand names. Although some clothing manufacturers design clothes for sale under their own brands (e.g. VF and Hanesbrands), the biggest retailers of clothing—e.g., Walmart, Target, Macy’s and TJX Companies—are mainly just retailers, with limited backward integration into previous stages of the value chain. In the case of fashion clothing, however, the importance of branding means that there are advantages in coordination between design and retailing—not least to ensure consistency between the garments and the retail environment within which they are Retail distribution Wholesale distribution Brand marketing Garment manufacture Garment design Manufacture of fabric and components D E S I G N E R F A S H I O N H O U S E S (e.g., Dior, Armani, Burberry) B R A N D E D M A N U F A C T U R E R - W H O L E S A L E R S (e.g., VF, Hannesbrands) T R A D I N G C O M P A N I E S P R O V I D I N G S O U R C I N G & S U P P L Y C H A I N M A N A G E M E N T (e.g., Li & Fung) O W N - B R A N D G L O B A L R E T A I L E R S (e.g., H&M, Gap, Abercrombie & Fitch) Z A R A D E S I G N & M A R K E T I N G C O M P A N I E S [ W I T H F R A N C H I S E D R E T A I L E R S ] (e.g., Forever 21) FIGURE 2 Positioning along the fashion clothing value chain CaSe 15 Zara: Super-FaSt FaShion 551 TABLE 2 Major exporting and importing countries of clothing, 2015 Exports $bn. Imports $bn. China 175 European Union 96 European Union 28 US 96 Bangladesh 26 Japan 29 Vietnam 22 Hong Kong (mainly from China) 15 Hong Kong (re-exports) 18 Canada 10 India 18 South Korea 9 Turkey 15 Australia 7 Indonesia 7 China 7 Cambodia 6 Switzerland 6 US 6 Russia 6 Source: World Bank. presented. Thus, mass market fashion retailers such as the Gap, H&M, Next, and Fast Retailing (Uniqlo) are primarily retailers, but also undertake design and brand marketing. Some of these companies limit their involvement in retailing to franchising (e.g., Forever 21). Table 3 shows the world’s leading suppliers of branded apparel. TABLE 3 The world’s leading apparel companies, 2017a Company Country Sales ($bn.) Total assets ($bn.) Operating margin (%) ROEb (%) Inventoryc turnover Market value ($bn.) Christian Dior France 49.4 87.3 18.8 18.2 4.0 77.1 Inditex Spain 28.6 24.2 17.0 25.7 9.7 94.9 H&M Sweden 23.4 13.1 9.4 23.5 6.1 23.7 Gap US 15.9 8.0 9.3 29.2 8.3 11.7 Fast Retailing Japan 14.6 10.3 10.7 16.5 6.7 46.2 VF Corp. US 11.8 10.3 12.7 27.4 7.4 30.6 PVH Corp. US 8.9 11.9 7.1 7.0 6.1 12.2 Hanesbrands US 6.5 6.9 11.2 54.6 3.5 6.5 Michael Kors Holdings UK 4.7 4.1 15.9 34.0 8.2 10.0 Burberry Group UK 3.5 3.1 14.6 20.9 4.7 9.5 Notes: aExcludes diversified companies such as LVMH and Kering. bNet income/Shareholder’s average equity. cSales/Average inventory. Source: Companies’ financial statements. 552 CaSeS to aCCoMpanY ConteMporarY StrateGY anaLYSiS The situation is different for the up-market designer houses such as Dior, Prada, Gucci, Chanel, Yves Saint Laurent, Versace, and Armani. The importance of quality and image there requires much closer control of their value chains; hence they tend to be highly vertically integrated, undertaking much of their production in-house and directly owning and managing their retail outlets. However, their product development cycles are very long compared to the fast fashion companies. The February/March fashion shows held in New York, London, Milan, and Paris show fall and winter collections; in September, the spring and summer collections are showcased. This implies a period of about nine months from initial design sketch to retail store. Attempts to shorten cycle time include Burberry’s pioneering of “see-now, buy-now” system of immediate online availability of garments from its catwalk shows. Hence, Zara is an outlier. Its vertical integration is reminiscent of the luxury fashion houses, yet it is competing in the mass market with the likes of Gap, H&M, and Next, whose affordable pricing favor outsourcing production to contract manufacturers in southern Asia and other low-cost locations. Meeting current and future challenges Zara’s ability to defy the conventional wisdom of the mass-market, fashion clothing business is the result of a business system whose components complement one another and are closely aligned to the company’s capabilities. Zara’s production of short runs of a large number of products in its own Spanish plants appear to be a recipe for high costs. However, these cost disadvantages are offset by efficiencies elsewhere in the Zara system. Zara’s compressed cycles and short runs also mean that markdowns (price reductions for slow-moving products) are a fraction of those typical in fashion retailing. Small runs and frequent new changes in the collection also increase the frequency of customer visits and boost sales. A short design-to-store cycle and responsiveness to customer demand result in Inditex turning over its inventory much faster than its com- petitors—despite being more vertically integrated, which typically means higher levels of inventory and work in progress. Finally, the system only works because of Zara’s management systems as well as its culture, which allows good communication and supports responsiveness across geographical and functional boundaries. The effectiveness of Zara’s internal communications is indicated by an incident reported by the Financial Times. A week before her wedding to Prince William in April 2011, a Zara store manager informed Zara headquarters that Kate Middleton had been trying on a £49.99 blue dress at the manager’s London store. Eight days later, when Miss Middleton was spotted leaving Buckingham Palace in Zara dress, Zara was ready to rush additional copies of the dress to its stores worldwide.7 In the following year, a visiting New York Times reporter observed the continuous interaction at Zara’s headquarters between country managers, designers, and produc- tion heads. As country managers received calls from their store managers that the same item was selling well in multiple stores in different countries, they could readily identify the emergence of a global trend and alert their designers and production managers. Similarly, if an item was not selling well, they could get feedback from customers and retail staff as to how the design might be revamped.8 However, as Zara grew in size, geographical scope, and product range, so its closely integrated business system and collaborative management style was threatened by the increasing complexity of the business. Consider, for example, Zara’s supply chain. CaSe 15 Zara: Super-FaSt FaShion 553 Notes 1. This section draws heavily upon “Inditex: 2000” ( Harvard Business School, Case No. 9-713-538, revised March 5, 2014). 2. K. Ferdows, J, Machuda, M.A. Lewis, “Zara: The World’s Largest Fashion Retailer” (The Case Centre, Case No. 615-059-1, 2015): 3. 3. This section draws upon two previous cases: Ferdows et al, op cit and “Zara: Fast Fashion,” (Harvard Business School, Case No. 9-704-497, December 21, 2006). 4. “How Zara Grew Into the World’s Largest Fashion Retailer,” New York Times (November 10, 2012). 5. Ferdows et al, op cit: 8. 6. “How Zara Grew Into the World’s Largest Fashion Retailer,” op cit. 7. “Inditex keeps its finger on the pulse,” Financial Times (May 23 2011). 8. “How Zara Grew Into the World’s Largest Fashion Retailer,” op cit. Three distribution centers in Spain rather than one require that products must be shipped from the Arteixo and Meco distribution centers for consolidation at the Zara- goza center. With increased sourcing from suppliers in Asia, Zara’s supply chains are increasingly stretched—most outsourced production is air freighted or shipped to the Zaragoza distribution center. The development of online retailing further complicates Zara’s business model— by 2017, Zara was offering online sales in most of the countries in which it operated stores. In January 2018, it opened its first click n’ collect store. Inditex’s commitment to environmental sustainability and corporate social responsibility also created additional complexity. In 2017, Zara rolled out a clothes recycling service providing collection bins in its stores. In Spain, it also provided a home collection service for used clothing. Finally, there was the issue of whether increasing numbers of employees—par- ticularly at headquarters—would reduce the effectiveness of Zara’s informal, collab- orative, non-hierarchical management model. By January 2018, Inditex had 171,839 employees representing 87 different nationalities and speaking 54 languages. Advances in information and communication technology could augment Zara’s alertness to changing circumstances, but it was not clear that it could substitute for the qualitative judgments, subjective insights, and alertness to weak signals that were vital compo- nents of the Zara’s management capability. Case 16 Manchester City: Building a Multinational Soccer Enterprise In August 2008, Manchester City Football Club (MCFC) was acquired for £210 million (€262m) by Sheikh Mansour bin Zayed Al Nahyan, a businessman and member of Abu Dhabi’s ruling family. The change in ownership marked the beginning of a new era for Manchester City and its long-suffering fans. Between August 2008 and January 2018, Manchester City spent £1,350 million on acquiring new players and £250 million on new facilities—a level of investment unmatched by any other European club. In 2012, MCFC was crowned champion of the English Premier League—the first time in 44 years—and from 2012 to 2018, it was the most successful club in British soccer. However, the rise of Manchester City has not simply a story of a super-star team built on Middle Eastern wealth. Between 2008 and 2018, Manchester City’s owners created an organizational structure and management system that was unlike that of any other soccer club. City Football Group Ltd. (CFG) was formed in May 2013, initially to take ownership of MCFC, but also to act as a holding company for a global portfolio of football investments. By 2018, CFG had equity stakes in six football clubs on five con- tinents, alliances with seven other football clubs, and a management system for lever- aging these relationships. The key question, both for CFG and for those football clubs that lacked such scope, was: could such a global portfolio, backed by an international management system, really enhance the competitiveness of the individual soccer clubs? Manchester City Football Club MCFC was founded in 1894, but for most of its history lived in the shadow of its neigh- bors, Manchester United. In 2007, former prime minister of Thailand, Thaksin Shinawa- tra, purchased the club but, amidst intensifying legal difficulties, he sold the club to Sheikh Mansour in 2008. Mansour, who had been considering the purchase of an English Premier League club for several years, was attracted to Manchester City because of its location, its his- tory, its new stadium (built with government finance to host the Commonwealth Games in 2004), and the real estate potential of the derelict land surrounding the stadium. In addition, Abu Dhabi’s national airline, Etihad, had started flying to Manchester in 2006 and was considering expanding its presence there. From the outset, it was clear that Mansour was a hard-headed investor rather than an indulgent football enthusiast. At the same time, Mansour’s vision for MCFC was not limited to financial return—he was inspired by FC Barcelona whose emphasis on This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 555 values, youth development, and community involvement, as well as its artistic, attack- ing football, had conferred upon it a unique status as a club. With Mansour’s business partner, Haldon Al Mubarak, installed as chairman of MCFC, the initial stages of a turnaround program were implemented: ● New players. Beginning with the purchase of Robinho for £32.5 million, MCFC invested £188 million in players and other assets during the first year under the new ownership. By the end of the 2011–12 season, £452 million ($695 million) had been spent on acquiring 22 new players (at an average price of £22 million). ● New coaches. In seeking a coaching staff capable of integrating MCFC’s star-studded squad into one of Europe’s most successful teams, Mansour and Al Mubarak employed a succession of internationally experienced coaches with successful track records: Mark Hughes ( June 2008–December 2009), Roberto Mancini (December 2009–May 2013), Manuel Pellegrini ( June 2013–June 2016), and Pep Guardiola (from July 2016). ● Facilities. Soon after buying MCFC, Mansour and Al Mubarak began planning a fully integrated training, entertainment, and administrative complex alongside the stadium. Brian Marwood, a former Arsenal player and Nike executive, designed the new training facilities by adopting the best features of other clubs’ facilities and drawing, in particular, on AC Milan’s Milanello training complex. The Etihad Campus was opened in 2014. It housed training facilities for all the club’s teams, from age-group sides to men’s and women’s senior squads. It included 16 football pitches, a 7000-seat stadium for academy and women’s teams, a 50-seat auditorium for reviewing video, 4-star accommodation for players and their families, retail stores, and CFG’s administrative headquarters. The first-team’s facilities feature a hypoxic chamber where players can run at altitude or in extreme temperatures, a hydrotherapy area for treating injuries, and a hydro treadmill with underwater cameras. The complex also accommo- dates the Beswick Community Hub whose facilities include a leisure center for local residents, a sixth form college, and the Manchester Institute of Health and Performance. The addition of a third tier to the South and North stands of the main stadium increased its capacity to 61,000. City Football Group Ltd. The Abu Dhabi United Group, which Mansour created as a vehicle for acquiring MCFC, became its parent company. However, Mansour’s interests in football were not limited to Manchester City. By 2012, he was already looking elsewhere for investment and development opportunities. To manage these interests, City Football Group Ltd. (CFG) was created as a holding company, headquartered at Manchester City’s Etihad campus, to manage Abu Dhabi United Group’s worldwide footballing investments. Internationalization began in 2013 with in the creation of a new US Major League Soccer franchise—New York City FC. Manchester City executives pioneered the initiative and CFG took an 80% equity stake. In 2014, CFG acquired the Australian A-League club, Melbourne Heart (which was renamed Melbourne City FC), a 20% stake in Japan’s Yokohama F. Marinos, and Club Atlético Torque in Montevideo, Uru- guay. In 2017, Girona FC in Spain’s La Liga was acquired. Table 1 shows the football clubs owned by CFG and those with which the CFG has co-operation agreements. 556 CASES to ACCoMpAny ContEMporAry StrAtEgy AnAlySiS Strategy In creating a multiteam, multinational enterprise, CFG is unusual in football (and in most other professional sports). Historically, football clubs—like most sports clubs— were local in their fan base, their players, and their sources of finance. When Glasgow Celtic won the European Cup in 1967, all the players and the manager had been born within 30 miles of the stadium, and the club’s owners were also from Glasgow. But since then, the teams, their fans, and their financing have internationalized. In English football, the new owners came from Russia (Roman Abramovitch and Chelsea, Maxim Demin and Bournemouth), the United States (Malcolm Glazer and Manchester United, John Henry and Liverpool, Steve Kaplan and Swansea), and China (Gao Jisheng and Southampton, Guochuan Lai and West Bromwich Albion). CFG was not the first sports enterprise to own clubs in different countries: Stan Kroenke is majority owner of Arsenal and the Colorado Rapids; Vichai Srivaddhanaprabha owns both Leicester City and OK Leuven. The soft drinks company Red Bull owns football TABLE 1 Clubs owned by or allied with City Football Group Manchester City FC (England) Acquired in 2004. Average home attendance 53,600 (women’s team 2300) Three-time winners of Premier League since 2010. New York City FC (US) Founded in 2014 with CFG holding 80% equity. Finished 2nd In Eastern Conference In 2017. Average attendance 23,000. Melbourne City FC (Australia) Acquired in 2014, became wholly owned in 2015. Has finished in top 5 of A-league during past 3 seasons ((2015–17). Average attendance 10,700. Yokohama F.  Marinos (Japan) 20% equity stake acquired in May 2014. The remaining 80% owned by Nissan Motor Co. Plays in Japan’s J1 league. Average attendance 24,000. Club Atlético Torque (Uruguay) Acquired by CFG in March 2017. Promoted to Uruguay Primera Division in 2017. Girona FC (Spain) 44.3% acquired by CFG in August 2017. Another 44.3% held by Girona Football Group, led by Pere Guardiola, the brother of Pep Guardiola. Promoted to La Liga in 2017. ALLIANCES NAC Breda (Netherlands) Agreement to loan youth players—primarily to gain EU citizenship Long Island Rough Riders (US) Agreement with New York City FC to assist in player development San Antonio FC (US) Agreement with New York City FC to co-operate on training, scouting, and player loans Atletico Venezuela Agreement with CFG to share scouting data and provide coaching support. Atletico midfielder Yandel Herrera signed for Man City and was loaned to New York City FC CF Pearled Feeder club for Girona FC Ghana Football Association Training collaboration. Also, CFG has agreement with the Right to Dream Academy in Accra, Ghana, for recruiting its graduates CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 557 clubs in the United States, Brazil, Germany, and Austria. However, CFG is unique in creating a multinational operating company to run its football clubs, the principal activity of which is “the operation of professional football clubs as well as providing football and commercial services to other organizations.”1 In operating different clubs in different countries, CFG has sought to create a common identity for its clubs. This is evident in the naming of its three principle clubs as “City Football Club” and its choice of sky blue for its teams’ strip. This common identity extends beyond a unified brand presence. CFG has also promoted the “City Way,” a concept whereby all the City teams adopt a style of foot- ball based on passing, possession and a commitment to attack. This style of play was developed at Barcelona and then transferred to MCFC by its team manager Pep Guar- diola and CEO Ferran Soriano. The same style of football is practiced not only in the various CFG first teams but also women’s and academy teams right down to the youn- gest age groups. In April 2015, Soriano outlined the City approach: There is a core of values, a core of beliefs that we all have. We win and we lose, but we never leave these values. We always play attacking football, we try to keep the ball, we play with a high defensive line and we apply pressure to recover the ball. These are very simple things that all our teams do and, hopefully, when you see our teams in Melbourne and Manchester play and you will see the same kind of football. This doesn’t mean we’ll win. At the weekend, Manchester City had 73 per cent pos- session in a game we lost. But we never, ever renounce our values of the way we play football … because all organizations need some set of basic values that people believe in.2 The Management Team Although Mansour is the majority owner of CFG (through his ownership of its parent company, Abu Dhabi United Group), he has no formal role in the management of CFG or its member clubs. The key executives within the group are shown in Table 2. CFG’s business model has been shaped primarily by the vision of Soriano. While at FC Barcelona, he developed the concept of a football organization with the capability to build a highly successful team while also creating shareholder value. Central to this concept was a global brand and a global system for sourcing and developing players. At a presentation at Birkbeck College, London, in February 2006, Soriano outlined his vision for turning FC Barcelona into a “global entertainment brand” through product management, human resource development, cost control and value chain management, revenue growth, and globalization.3 However, it was CFG that was to give Soriano the opportunity to realize that vision. Player Sourcing, Assessment, and Development At the heart of CFG’s approach to combining team success with financial success is its global system for finding and nurturing world-class players. Early on, Soriano rec- ognized that UEFA’s new financial fair play rules (introduced in 2009) meant that the old “benefactor model” of clubs being bankrolled by billionaire owners was no longer viable. A major implication of the new rules was that clubs could no longer rely on recruiting superstar players at vast expense—they would have to grow their own talent. 558 CASES to ACCoMpAny ContEMporAry StrAtEgy AnAlySiS For CFG, one of the key drivers of globalization was the priority given to locating young talent, wherever it might be in the world. By owning multiple clubs and hav- ing collaborations with other clubs across the world, CFG is reckoned to have the world’s biggest and most effective talent-spotting network. Its international spread alleviates some of the problems of work permits and immigration restrictions that bedevil professional football. This international scope also increases CFG’s appeal to young talent: “The fact that the CFG’s tentacles stretch so far makes it easier to attract young players particularly, because recruitment staff can make the case that if life does not work out for them in Manchester, they might later find their level in other appealing cities.”4 In terms of scouting, CFG’s global network represents a massive extension in the talent-finding capability of the individual clubs. In 2014, CFG employed 36 scouts, of TABLE 2 Key members of CFG board and executive team Khaldoon Khalifa Al Mubarak, Chairman and CEO, CFG; Chairman of MCFC (also CEO of Mubadala Development Co., an Abu Dhabi state-owned investment company) Born in Abu Dhabi 1976. Educated at Tufts University. Appointed to Abu Dhabi Executive Council. Trusted adviser to the Abu Dhabi royal family. Li Ruigang, CFG Board Member; Chairman of China Media Capital Born in China, 1969. Created China’s most global media company, China Media Capital, which owns 16% of CFG. Regarded as “China’s most connected media mogul.” Martin Edelman, CFG Board Member, vice- chairman NY City FC US lawyer specializing in international law and real estate development. Simon Pearce, CFG Board Member, Vice Chairman Melbourne City FC Business associate of Mansour and Al Mubarak, who worked for Abu Dhabi government to build the Abu Dhabi brand, develop tourism, and attract business partners Ferran Soriano, CEO of CFG, also CEO of MCFC Born in 1967 in Barcelona, Spain. After a career in consumer goods management consulting, elected vice president and CFO of Barcelona FC in 2003, then resigned in 2008. CEO of MCFC from August 2012. Pep Guardiola, Team Manager, MCFC Born in 1971 in Catalonia, Spain. Played as midfielder for Barcelona FC and Spain. Coach at Barcelona (2007–12) and Bayern Munich (2012–16). Patrick Vieira, Football Development Executive 2012–15; Head Coach New York City FC 2016–18 Born in Senegal, 1976. Playing career spanned Arsenal, Inter Milan, MCFC. At MCFC respon- sible for youth development and Community involvement. Brian Marwood, Managing Director, City Football Services (since October 2015) Born in 1960 in Durham, England. Played for Sheffield Wednesday and Arsenal. Marketing Manager for Nike, then Director of Football at MCFC (2008–12) and in charge of developing its academy. CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 559 whom 14 were based in South America. Announcing CFG’s acquisition of Club Atlético Torque and agreement with Atletico Venezuela, Soriano observed: The investment in CA Torque enables our organization to build on existing connec- tivity in Uruguay and helps to expand the options for identifying and developing local and South American talent. This move also provides us with an administrative hub for our pre-existing scouting operations in the region and provides a footprint for City Football Group in South America. I am also delighted to start a working partnership with Atletico Venezuela to the benefit of both clubs. The collaboration agreement allows us to share knowledge, insights and hard data, all of which enables us to further complement and increase our scouting and recruitment operations on the continent.5 Two players exemplify the merits of CFG’S global approach to player assessment and deployment. ● Yangel Herrera was signed by MCFC from its affiliate, Atlético Venezuela, in January 2017 for about £1.7 million and immediately loaned to New York City FC, where he became one of the stars of the team. During 2018, CFG will assess Herrera’s performance and prospects and determine whether he stays at New York City, joins MCFC, or is sold to another club.6 ● Bruno Fornaroli captains Melbourne City FC. Despite his early promise in Uruguay’s top youth team, his subsequent performance in both Italian and Greek leagues was disappointing. However, back in Uruguay and aged 27, a report from one of CFG’s scouts recommended a fuller analysis of Fornaroli. On the basis of additional analysis, CFG acquired Fornaroli’s registration for Melbourne City FC. At Melbourne, Fornaroli became the club’s leading goal scorer and has also won most of the A League’s individual awards.7 Having different teams in different countries helps player development. Soriano refers to a “development gap” that is especially problematic for English clubs. “If the player is top quality, he needs to play competitive football to develop. It’s not only for the technical aspect of the game, but also for the pressure. The under-21 or under-19 competitions in England don’t provide this, because games aren’t in front of a lot of fans and there isn’t enough competitive tension.”8 However, in Europe, clubs such as Barcelona, Real Madrid, and Bayern Munich all have reserve teams that play in their countries’ second or third division against other professional clubs—not in a separate league, as English youth teams do. Hence, according to Academy chief, Brian Mar- wood, the importance to MCFC of loaning its young players to other clubs: “We did some research last year and discovered that in the last 10 years, 83% of players who featured in the quarter-final stage of the Champions League had played first team foot- ball at 17 … That’s why you’ll find more than 30 Blues on loan …”9 CFG’s investment in its academies has centered on its Manchester campus, where its training and youth development facilities are reckoned to be among the best in the world. However, in 2015, a new academy was unveiled at Melbourne City FC, and in 2018 New York City FC opened its new academy. The features of both were based on those of the Manchester academy and both were designed by the same architect, Rafael Viñoly. Inspired by the tradition of FC Barcelona and its renowned La Masia academy, CFG placed a massive emphasis on youth development. According to Academy director, Mark Allen: Our focus remains on style of play. Every single side, from the under-nines right up to the elite development squad team, play the game in the same way … Coaches 560 CASES to ACCoMpAny ContEMporAry StrAtEgy AnAlySiS focus on the technical and tactical side of the game as soon as a youngster joins the academy, with the physical development seen as secondary … Last season saw suc- cess at almost every level. The under-10s became national champions … The under- 13s are national champions. The under-15s are the Floodlit Cup national winners. And the under-18s reached the FA Youth Cup for the second consecutive season.10 CFG’s commitment to youth development is apparent from the Group’s investment in facilities for its younger teams at the Manchester Academy: “Two-thirds of the 16. pitches on site are primarily used for youth football, and the wider development of the young players is supported by tailored coaching and education facilities, medical and sports science services, sleeping accommodation and parents’ facilities.”11A common style of football (“The City Way”) assists young players to rise up the hierarchy. In addition, youth development takes a holistic approach: City’s academy collaborates with a local independent school, St. Bede’s, which allows City’s youth players to enroll on an integrated football and education program designed by the club and the school. CFG’s involvement in developing young players is also apparent in the residential soccer camps offered by its member clubs (including MCFC’s intensive football and language immersion program) and its joint venture with Goals Soccer Centres PLC to develop a chain of dedicated, five-a-side pitches and training facilities across North America. The sites will be jointly City and Goals branded, with the new identity to be launched later this year. Technology Information technology has had a huge impact on football management over the past decade. Although statistical analysis has long been applied in training, team selection, and recruiting in US professional sports,12 its application to soccer was delayed by the intensely interactive nature of the game. In English football, Bolton Wanderers FC was an early convert to data analytics—it was there that Gavin Fleig, who would become head of performance analysis at MCFC, gained early experience. Following the Mansour takeover, data analysis has played a growing role in team performance at MCFC. Initial applications included postgame analysis using the detailed player tracking data supplied by Opta and Prozone and player recruitment. Under Brian Marwood (MCFC Director of Football, 2008–12), player recruitment relied increasingly on quantitative data. For youth recruits, 30-page, color-coded reports were the norm, while for major signings, the dossiers would run to 40 or 50 pages.13 In 2015, CFG signed a partnership agreement with SAP to use SAP’s cloud and ana- lytics technology across its backroom operations and on-field activities, and replaced CFG’s paper-based systems with SAP’s cloud-based system. The SAP platform includes components for team management, training, player fitness, and performance analysis, all of which can be used to customize training, create tactics, and create individual player development plans. SAP’s software for postmatch analysis integrates Opta and Prozone data. In monitoring youth squads, the system integrates videoed coaching sessions, GPS data, biometrics including heart rate, and sleep data.14 Digital technology also plays a growing role both in deepening the City clubs’ rela- tionships with their fans and in expanding the fan base. CityTV creates video content for all the City clubs, which is then distributed via the Web, mobile apps, and differ- ent social media platforms. In addition, CFG has been a leader in launching enhanced game-viewing through providing real-time analytics, chat bots, hackathons, and virtual reality—including participation in eSports.15 CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 561 Marketing In terms of generating commercial revenues—licensing, sponsorship, and retail sales— MCFC has lagged far behind its cross-town rival, Manchester United, long regarded as football’s most commercially successful club. In 2006/7, MCFC’s commercial revenues were £14.1 million; Manchester United’s were £56.1 million. Building MCFC’s commercial revenues initially involved other Abu Dhabi businesses. In July 2011, MCFC announced a £400 million sponsorship deal with Etihad Airways that covered 10-year naming rights for the stadium and financial support for MCFC’s Etihad Campus. This was followed in 2013 by a six-year kit sponsorship deal with Nike worth £72 million ($109 million). With the creation of CFG, marketing was established as a global unit—City Football Marketing—based in its own London offices in order to allow the different clubs to access the same marketing assets. Omar Berrada (Commercial Director of City Football Marketing, 2015–16) emphasized the benefits to clients from the global approach CFG’s family of clubs offered: “It allows brands to have the best of both worlds: a consistent global marketing platform in terms of the assets and inventory they can use to engage with our fans, as well as the ability to deliver messages that are very specific to the local markets of our clubs around the world.”16 In 2014, Nissan entered into a global marketing relationship with CFG when it became the official automotive partner of all four City clubs. Similarly, Etihad Airways extended its kit sponsorship of Manchester City to include both New York City and Melbourne City. Community Involvement and Corporate Social Responsibility Despite the efforts to create a unified, global, brand presence for the City clubs and to agree with global sponsorship and licensing deals, Tom Glick, President of New York City FC (previously Chief Commercial and Operating Officer for MCFC), stressed that it was vital to sustain and build the individual character of each club, in a way which respects the tribal loyalties of each fanbase: “… the most important thing is that each one of our clubs is connected to its local city and the fans of that city.” To build engagement, the CFG clubs have sought to involve fans in club decisions. In both New York and Melbourne, fans participated in the design of the new club badges. In Melbourne, this resulted in the inclusion of the city’s municipal flag in the design.17 CFG’s emphasis on developing and exploiting its global reach has been balanced with close attention to the cultivation of the local fan base of its clubs and responsibility to the local communities within which its clubs are located. As a result, CFG has been able to avoid the hostility directed by the fans of Manchester United, Liverpool, and Hull City toward the foreign acquirers of their clubs. At MCFC, CFG has worked closely with Manchester City Council in its development strategy for the club. This was mandated by the City Council’s ownership of the stadium and the need for CFG to obtain planning permits for developing the Etihad complex and other real estate developments adjacent to the stadium. More generally, however, CFG and the City Council have viewed themselves as partners in developing an eco- nomically depressed area of Manchester, while also providing opportunities for addi- tional investment by Abu Dhabi in the city (e.g., increased flights by Etihad Airways from Manchester Airport). 562 CASES to ACCoMpAny ContEMporAry StrAtEgy AnAlySiS As one fan observed: “The other major benefit [of CFG’s ownership of MCFC] is the vast improvement in the area around the stadium. This was largely a toxic, deprived and neglected post-industrial area prior to the arrival of the Abu Dhabi owners and much money and work has gone into transforming it, with a lot more regeneration still on the cards. This is all being done within the framework of a strategic partnership with the city council.”18 Organizational Structure Fundamental to CFG’s strategy has been the notion that competitive advantage in professional football can be achieved simply through the application of standard business principles to the often-chaotic and personalized world of football club management. Following the acquisition of MCFC, Al Mubarak remarked: “One of the big surprises was how amateurish it was … I found it shocking in the famous Premier League, to be without such basic functions.”19 A key feature of CFG’s introduction of professional management to MCFC was creating an organizational structure that was consistent with its corporate strategy. The structure of CFG embodies two distinctive characteristics. First, there is a con- sistent organization structure for all the member clubs. At each of the City clubs, there is a CEO (or President), a Director of Football, a Technical Director, and a Head Coach (or Team Manager at MCFC), and then there are directors for communication, opera- tions, community relations, and other areas; Al Mubarak is Board Chairman. Second, CFG is organized around different functional areas that provide support for the different clubs. CFG’s academies and technical services to its members’ clubs are provided by a subsidiary of CFG, City Football Services Ltd., headed by Brian Marwood. In May 2016, City Football Services had 63 employees. Marketing services are provided by City Foot- ball Marketing Ltd., whose “services include partnership sales and activation, content production and distribution, retail and licensing and fan relationship management for all of CFG’s clubs.”20 In May 2016, City Football Marketing had 92 employees. Figure 1 shows the ownership structure of the CFG. Figure 2 shows its management structure. Abu Dhabi United Group China Media Capital/CITIC Capital (13%) City Football Group Ltd. Chairman: Al Mubarak CEO: Ferran Soriano City Football Services Ltd. CEO: Brian M City Football Marketing Ltd. CEO: Tom Glick 13%87% Manchester City FC Ltd. CEO: Ferran Soriano COO: Omar Berrada New York City FC LLC CEO: Jon Patricof Melbourne City FC Ltd. CEO: Scott Munn Yokohama F. Marinos Club Atlético Torque Girona FC City Football Japan City Football Singapore City Football China 80% 20% 44% FIGURE 1 City Football Group Ltd.: Group structure CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 563 Finance The finance to MCFC and CFG made available by Mansour through his Abu Dhabi United Group has allowed both companies to rack up massive losses while not taking on any debt. Table 3 shows CFG’s financial results. Table 4 and Figure 3 shows MCFC’s financial performance. Board of Directors Chairman: Al Mubarak CEO: Ferran Soriano Managing Director Emerging Clubs Diego Gigliani Chief Commercial O�cer Tom Glick CFO Andy Young General Counsel Simon Cli� Chief Communications O�cer Vicky Kloss Director of Operations Development Don Drans�eld Chief Marketing O�cer Nuria Tarre Managing Director City Football Services Brian Marwood Senior VP Partnerships Damian Willoughby FIGURE 2 City Football Group Ltd.: Corporate management team TABLE 3 City Football Group Ltd.: Financial Data 2017a 2016 2015 2014 Revenue 514.3 423.2 368.7 347.1 —Matchday 68.5 64.7 50.1 48.2 —Broadcasting: UEFA 47.9 61.2 32.9 31.3 —Broadcasting: other 160.7 103.2 104.1 101.9 —Other commercial activities 237.1 194.1 181.7 165.6 Operating profit (loss) (70.1)b (33.7) (28.9) (57.9) Net profit (loss) (74.7) (38.4) (34.9) (63.4) Property, plant, equipment 431.2 410.2 403.3 343.9 Intangibles and other noncurrent assets 427.3 349.9 287.5 298.4 Current assets 442.4 414.7 244.0 186.8 Total assets 1300.9 1175.8 937.8 832.1 Current liabilities 335.5 193.5 142.6 156.9 Noncurrent liabilities 116.9 131.9 119.9 109.1 Shareholders’ equity 848.5 850.4 675.3 566.1 Cash flow from operating activities 91.9 25.8 56.0 (13.2) (Continues) 564 CASES to ACCoMpAny ContEMporAry StrAtEgy AnAlySiS The only external financing used by CFG $40 (£265 million) in December 2015 from the sale of 13% of CFG to a consortium of Chinese investors led by Chinese media giant China Media Capital and its chairman, Ruigang Li. This valued CFG at $3 billion. The deal was seen as an opportunity for CFG to partner with China Media Group in exploiting the huge potential market for football in China. TABLE 4 Manchester City Football Club.: Financial Data (£ millions) 2017a 2016 Revenue 473.4 398.8 —Matchday 51.9 52.5 —Broadcasting: UEFA 47.9 61.2 —Broadcasting: other 155.6 100.1 —Other commercial activities 218.0 177.9 Operating profit (loss) (121.7)b (33.7) Net profit (loss) 1.1c 20.5 Tangible fixed assets 412.6 268.6 Intangibles and other noncurrent assets 335.5 268.6 Current assets 312.7 271.9 Total assets 1060.7 939.1 Current liabilities 294.4 160.7 Noncurrent liabilities 88.2 101.2 Shareholders’ equity 678.2 677.1 Total number of employees 325 320 —of which, football staff (including players) 153 (72.3) Source: City Football Group Limited: Directors’ Report and Financial Statements. Notes: a 13 months to end-June 2017. b Operating profit before loss on disposal of player registrations was £91.6. c If the loss on disposal of players is excluded, net profit would have been £88.3. 2017a 2016 2015 2014 Cash flow from investing activities (186.6) (92.8) (140.8) (199.6) —of which, transfer fees less receipts (146.9) (72.3) (13.9) n.a. Source: City Football Group Limited: Directors’ Report and Financial Statements. Notes: a 13 months to end-June 2017. b Operating loss before profit on disposal of player registrations was £105.7. TABLE 3 (Continued) CASE 16 MAnChEStEr City: Building A MultinAtionAl SoCCEr EntErpriSE 565 Although chairman Al Mubarak has claimed that CFG’s global model has been a means of reconciling world-class team performance with sound financial performance, other European clubs have complained that the international structure of CFG is a means by which MCFC can circumvent UEFA financial fair play rules. –300 –200 –100 0 100 200 300 400 500 600 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Revenue (£m.) Net pro�t (£m.) FIGURE 3 Manchester City Football Club Ltd.: Revenue and profit (financial years ending May 31) Notes 1. City Football Group Limited: Directors’ Report and Finan- cial Statements for the Year Ended 31 May 2016: p. 4. 2. “Manchester City will not Sacrifice their Attacking Philos- ophy Despite Recent Defeats, Insists Ferran Soriano,” The Telegraph (London: April 9, 2015). 3. http://www.sportbusinesscentre.com/news/fc-barcelona- faces-the-challenges-of-going-global-february-2006/. Accessed January 27, 2018. 4. “An Inside Look at the City Football Group,” The Independent (September 8, 2017). 5. https://www.manchestereveningnews.co.uk/sport/ football/ football-news/man-city-news-south-america-12851638. Accessed January 29, 2018. 6. “Manchester City and the Disneyfication of Football,” Financial Times (December 7, 2017). 7. “An Inside Look at the City Football Group,” op cit. 8. www.theguardian.com/news/2017/dec/15/manchester-city- football-group-ferran-soriano. Accessed January 29, 2018. 9. https://www.mancity.com/news/academy/academy%20 news/2017/october/brian%20marwood%20man%20city%20 academy%20interview. Accessed July 20, 2018. 10. http://bleacherreport.com/articles/2650491-are- manchester- citys-ambitious-academy-plans-on-track. Accessed January 28, 2018. 11. https://www.cityfootballgroup.com/Our-Business/City- Football-Academies. Accessed January 29, 2018. 12. The use of statistical analysis by the Oakland Athletics baseball team was popularized in Michael Lewis’s book Moneyball (W. W. Norton & Co., 2003). 13. David Conn, “Manchester City: A Tale of Love and Money,” The Guardian (May 18, 2012). 14. www.mancity.com/fans%20and%20community/club/ partners/global/sap; http://www.silicon.co.uk/data- storage/bigdata/man-city-digital-tech-football-201114. Accessed January 28, 2018. 15. http://www.thedrum.com/news/2017/12/22/manchester- city-doubles-down-esports-with-signing-marcus- expectsporting-jorgensen. Accessed January 30, 2018. 16. https://www.marketingweek.com/2015/08/05/footballs- most-innovative-business-model/?ct_5a6f622106449=5a6f62 21064ed. Accessed January 29, 2018. 17. Ibid. 18. “Manchester City and the Disneyfication of Football,” Financial Times (December 8, 2017). 19. “Manchester City: A Tale of Love and Money,” op. cit. 20. https://www.cityfootballgroup.com/Our-Business/ Leadership-Team, Accessed January 30, 2018. https://www.marketingweek.com/2015/08/05/footballsmost-innovative-business-model/?ct_5a6f622106449=5a6f6221064ed https://www.mancity.com/news/academy/academy%20news/2017/october/brian%20marwood%20man%20city%20academy%20interview Case 17 Haier Group: Internationalization Strategy The transformation of the bankrupt Qingdao General Refrigerator Factory into the Haier Group, the world’s biggest supplier of household appliances, is an epic tale that symbolizes China’s rise to become the world’s dominant manufacturing economy. In the process, Haier’s CEO, Zhang Ruimin, has become a national hero and internationally-renowned business leader who has been ranked among the world’s top-50 management thinkers.1 Since 2012, Euromonitor has recognized Haier as the world’s leading white goods producer in terms of units sold. In terms of revenues, the ranking is less clear (see Table 1). This is due to the complex legal structure of the Haier Group: financial data is only available for Haier’s listed subsidiaries, Qingdao Haier and Haier Electronics. However, with Haier’s acquisition of General Electric’s appliance division in 2016, it appears that Haier has become the world’s biggest domestic appliance company in terms of both output and revenues. Yet, Haier’s rise to global leadership, while inspiring, has also been baffling. Its inter- nationalization has flouted almost all conventional thinking concerning strategies for building global competitive advantage. Indeed, the whole history of Haier has involved unusual—even quirky—management principles and practices. To what extent does Haier’s unconventional approach to strategy and management also offer lessons for the leaders of Western multinational corporations? And what about the future of Haier? Its global presence has been built upon a combination of opportunism, ambition, and determination. As it consolidates its posi- tion as a leading multinational corporation, does Haier need a more orderly and integrated approach to global strategy? Building Leadership in the Home Market When Zhang Ruimin was appointed general manager of the Qingdao General Refriger- ator Factory in 1984, it was a cooperative enterprise with about 800 workers operating under the control of the Qingdao city government. Zhang’s early efforts involved eliminating the obvious sources of inefficiency and poor quality and collaborating with foreign appliance makers—including Liebherr of Germany, Merloni of Italy, and Mitsubishi and Sanyo of Japan—to improve product design and process technology. In 1985, Qingdao Refrigerator formed a joint venture with Liebherr for producing refrig- erators for the Chinese market. Zhang Ruimin has viewed Haier’s development as a sequential process with each phase lasting about seven years (see Figure 1). In the first phase, the key challenge was This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. CASE 17 HAIEr Group: IntErnAtIonAlIzAtIon StrAtEGy 567 changing employees’ attitudes to product quality. In one—now famous— intervention, Zhang ordered defective refrigerators to be removed from the production line and smashed to pieces.2 Haier’s quest for quality improvement was driven, first, by Zhang’s constant emphasis on the consumer’s experience and the decision in 1992 to apply for ISO9001 authentication, which provided a major impetus for the reformulation and upgrading of processes.3 Between 1984 and 1989, revenues climbed from 3.5 mn. to 410 mn. yuan and in 1992, a new factory complex and head office were built on the outskirts of Qingdao. In 1995, its refrigerator division was listed on the Shanghai Stock Exchange and in 2005 its subsidiary, Haier Electronics Group, was listed on the Hong Kong Stock Exchange. Haier’s successful turnaround resulted in government pressure for it to acquire other failing state enterprises. During the 1990s, Haier acquired 16 other Chinese companies broadening its range of domestic appliances and diversifying its product range into televisions, telecom equipment, and pharmaceuticals. TABLE 1 The world’s leading domestic appliance companies, 2018 Ranka Company Country Sales ($bn.) Profits ($bn.) Assets ($bn.) Market Value ($bn.) Employeesb #245 Midea Group China 37.8 2.7 40.1 55.7 96,418 #294 Gree Electric Appliances China 23.9 3.6 34.7 45.1 71,610 #565 Qingdao Haierc China 24.6 1.1 24.6 17.3 74,570 #748 LG Corp South Korea 9.1 2.1 20.2 13.3 16,096 #1042 Whirlpool US 21.4 0.3 20.3 11.0 93,000 #1254 Electrolux Group Sweden 14.5 0.6 10.7 7.6 53,889 #1631 SEB SA France 7.3 0.4 8.0 9.5 24,927 Notes: aRanking on Forbes 2000 listing of the world’s largest public companies. bEmployment data is for 2016. cNot including Haier Electronics or other parts of the Haier Group. Source: Forbes Global 2000, 2018. FIGURE 1 Haier Group: Strategy phases, 1984–2015 Source: www.haier.net/en/about_haier/haier_strategy/, accessed July 20, 2015. Brand Building Strategy Haier builds presence within the Chinese market though quality and customer service Diversification Strategy Haier acquires other Chinese enterprises to expand product range Internationalization Strategy Haier enters 19 other national markets and becomes the world’s biggest domestic appliance company in terms of units of output Networking Strategy Haier’s networked enterprise strategy embodies: a border-free enterprise, manager- free management, and a scale-free supply chain Global Brand Strategy Transformation from a product-driven to a user-driven “on- demand” mode. Globalization uses global resources to create localized mainstream brands. 1984 1991 1998 2005 2012 568 CASES to ACCoMpAny ContEMporAry StrAtEGy AnAlySIS Haier’s Management System Governance Formally, Haier was a collective under the supervision of Qingdao municipal government. In practice, the ownership, organizational structure, and governance of the Haier Group Corporation were unclear.4 Financial information was available only for the group’s two listed subsidiaries, Qingdao Haier Company Ltd listed in Shanghai and Haier Electronics Group Company Ltd listed in Hong Kong. No consolidated finan- cial statements were available for the group. The Haier website gave the group’s rev- enues as 242 bn. yuan in 2017 (202 bn. yuan in 2016). Haier’s two listed subsidiaries, Qingdao Haier and Haier Electronic, accounted for about 90% of the group total.5 Table  2 shows financial data for Haier’s two listed subsidiaries; Table  3 shows their major shareholders. Zhang Ruimin Despite its opaque governance structure—or perhaps because of it—power within the Haier Group was concentrated in the hands of Zhang Ruimin. This power derived partly from his formal position as chairman and CEO, partly from his reputation as the architect of Haier’s remarkable development, and partly from his political ties. In addition to being the secretary of the Communist Party Committee of the Haier Group, he was also a member of the party’s Central Committee. His political connections gave TABLE 2 Selected financial data for Qingdao Haier and Haier Electronics 2010 2011 2012 2013 2014 2015 2016 2017 Qingdao Haier Revenue ($million) 9743 11,638 12,628 14,102 14,422 13,838 17,230 20,709 Operating margin (%) 4.90 5.50 6.60 7.08 8.72 7.19 5.98 6.42 Net margin (%) 3.36 3.65 4.09 4.82 5.62 6.68 5.58 5.71 ROE (%) 28.45 32.26 29.38 20.85 27.5 12.94 14.23 23.1 Return on capital employed (%) 17.93 18.35 17.23 16.94 29.34 16.22 20.41 19.4 Employees 53,412 59,814 57,977 55,726 54,286 57,447 74,570 76,878 Haier Electronics Group Revenues ($billion) 5802 7893 8819 9659 10.5 9681 9241 10328 Operating margin (%) 4.01 3.75 4.18 4.36 4.89 4.23 4.23 5.53 Net margin (%) 2.69 2.82 3.05 3.27 3.74 4.35 4.36 4.47 ROE (%) 48.30 42.80 35.48 30.72 25.47 24.62 15.17 17.50 Return on capital employed (%) 47.58 39.07 31.74 28.11 23.05 23.17 18.72 20.85 Employees 18,204 18,406 17,304 16,506 15,637 15,491 15,476 15,240 Sources: Annual reports of Qingdao Haier Company Ltd. and Haier Electronics Group Co., Ltd. CASE 17 HAIEr Group: IntErnAtIonAlIzAtIon StrAtEGy 569 Haier independence from municipal interference and valuable support from central and provincial governments and state banks. Zhang was born in Qingdao in 1949. Despite a lack of formal education, he was an avid reader. His ideas about management developed during his career at Haier, where he began as deputy plant manager at the age of 33. His management philosophy draws upon Chinese traditions from Confucius and Sun Tzu to Mao Zedong and Western ideas derived from Joseph Schumpeter, Peter Drucker, and contemporary management thinkers.6 At the same time, Zhang is dismissive of the management practices of many Western multinationals. Zhang’s management thinking developed in parallel with his strategy for Haier. His early focus was on building Haier’s capabilities in relation to quality management, customer focus, brand building, and new product development. Gradually, Zhang’s priorities shifted toward fundamentally rethinking Haier’s structure and management systems. For example, customer orientation became the principle of “market chains” around which Haier’s internal relationships were reformulated. The idea behind “market chains” was that, in the same way that Haier’s fundamental purpose was to serve its final customers, all interactions within the company could be redefined around supplier–customer relationships: Every unit, every operation and everyone was linked to a customer and every unit/ operation/body was someone else’s customer. In this way everyone within the enterprise, no matter how deeply inside the firm, felt market pressure directly.7 Developments in information and communications technology, especially the Inter- net, greatly influenced Zhang’s thinking about internal organization. Increasingly, he TABLE 3 Biggest shareholders of Qingdao Haier Co. Ltd. and Haier Electronics Group Co. Ltd., December 31, 2016 Name of shareholder Number of shares held (millions) Percentage (%) Qingdao Haier Co. Ltd. Haier Electric Appliances International Co., Ltd. 1259 20.64 Haier Group Corporation 1073 17.59 KKR Home Investment S.A R.L. 606 9.94 Hong Kong Securities Clearing Co., Ltd. 430 7.05 China Securities Finance Corporation Limited 168 2.76 Qingdao Haier Venture & Investment Information Co., Ltd 161 2.63 Haier Electronics Group Co. Ltd. Qingdao Haier Co. Ltd. 1562 55.95 Haier Shareholdings (Hong Kong) Ltd. 832 29.79 HCH (HK) Investment Management Co. Ltd. 337 12.06 JP Morgan Chase & Co. 140 5.02 Sources: Annual reports of Qingdao Haier Company Ltd. and Haier Electronics Group Co., Ltd. 570 CASES to ACCoMpAny ContEMporAry StrAtEGy AnAlySIS devoted himself to moving Haier from a hierarchy to a decentralized, team-based struc- ture. For example, Haier’s sales organization for China was completely restructured: We used to have a pyramid-style structure for our sales in China. The people in charge of sales had to manage business at the national, provincial, and city level. After the arrival of the Internet age, we realized that under this triangular hierarchical structure, people had a difficult time adapting to the requirements of the times. So we reorga- nized ourselves as an entrepreneurial platform. We flattened everything out, taking out all the middle management… We are using digital technology to connect everyone…  there is no “inside” the company versus “outside” anymore. As a Haier executive, my goal is no longer to be a maker of home appliances, but to be an agent of interaction and networking among people who might be anywhere. I want to turn the company into an Internet-based company, a company unrestricted by borders. Whoever is capable, come and work with us… In the long run, there won’t be any company employees to speak of—only the Haier platform.8 Zhang’s interest in communicating his management thinking and willingness to engage with western consultants and business schools established him as a management guru and visionary. He has lectured at Harvard and Stanford universities, received Yale School of Management’s “Legend in Leadership Award,” and been interviewed in Harvard Business Review, McKinsey Quarterly, and MIT Sloan Management Review. Performance Management A central feature of Haier’s management system is rigorous performance management based upon accountability and individual incentives. In the early years of this century, Haier introduced its “OEC” system. According to Haier’s head of human resources, Wang Yingmin: “O stands for Overall; E stands for Everyone, Everything, and Everyday; C stands for Control and Clear. OEC means that every employee has to accomplish the target work every day. The OEC management- control system aims at overall control of everything that every employee finishes on his or her job every day with a 1% increase over what was done the previous day.”9 OEC became part of a performance management system that began each December with performance targets set by corporate headquarters for every division. Each divi- sion submits a divisional action program that monitors actual performance against target performance on a month-by-month basis. Monthly divisional targets were disaggregated into daily targets for each employee. Each day began with team leaders briefing team members and ended with workers completing a self-checking assessment against OEC criteria. Assessments were linked to compensation through bonuses and penalties. With decentralization, the basis for performance measurement and compensation shifted to the notion of creating value for users. According to Zhang: Now, compensation is determined by how much value is created for the user. When employees create value, they get paid. If they don’t create measurable value, they don’t get paid. Ultimately, if they don’t create value, they have to leave.10 Innovation and New Product Development Haier’s product development was driven primarily by responding to customer needs Haier required its engineers to visit customers to learn of their experiences at first CASE 17 HAIEr Group: IntErnAtIonAlIzAtIon StrAtEGy 571 hand. In rural China, Haier engineers discovered that washing machines breakdowns often resulted from their being used to clean vegetables. Haier adapted its design and provided advice on using washing machines to clean vegetables and peanuts.11 To meet the preferences of specific customer groups, Haier adopted flexible modular designs. According to Zhang Ruimin, “Our products are based on modules and sub- systems, and on basic platforms that we can vary. Periodically we will add some new features, but the basic model is there.”12 Haier was an industry leader in providing Internet connectively for its appliances. In 2014, it launched its “Smart Living” appliances with embedded wireless connectivity allowing customers to monitor and control their appliances remotely. In the same year, it became the first home appliance maker to join Apple’s Homekit platform. In 2018, Haier launched its “Smart Home Solution” system which provided: “com- prehensive solutions for air, water, clothes care, security, voice control, health and information … [and] allows users to customize the smart home experience to best suit their needs.”13 Smart Home Solution uses Haier’s COSMOPlat cloud-based Internet platform that links with users to permit large-scale customization. “It means that every user can par- ticipate in the process of the product design, developing, manufacturing, logistics and distribution. It’s done through the creation of the ‘internet factory’ that is visual and transparent for every consumer. Every user would also have a chance to customize Haier’s products and, thus, exercise one’s own creative vision.”14 In 2017, COSMOPlat won Gartner’s “Supply Chainnovator Award” for supply chain innovation. Building the Networked Enterprise Zhang Ruimin’s ideas about market responsiveness, entrepreneurial initiative, and team- based organization eventually became crystallized in his concept of the networked enterprise. Central to the transformation of Haier into a new type of organization was the creation of some 2000 self-managed teams called “ZZJYTs”—an acronym for Zi Zhuu Jing Ying Ti, meaning “autonomous business unit.” Professor Bill Fischer and col- leagues described the ZZJYTs as follows: Each comprises a team of 10 to 20 people—sometimes located in one place, other times virtual—who come from various functional roles and are brought together for a specific mission, and who are given profit and loss responsibility and accountability. They have their own independent accounting systems and complete autonomy in hiring and firing employees, setting internal rules about expenses and determining bonus distribution, and making almost any operational decision that typically would be made by an independent functional organization  … Everyone, whatever their function, is expected to talk to consumers regularly.15 These principles of autonomy, individual and team responsibility, and customer focus eventually led to Haier’s transformation into a network of microenterprises, each responsible for its own success. Zhang Ruimin called this management model rendanheyi: Rendanheyi has three main attributes: 1 The enterprise is transformed from a closed system to an open system, a net- work of self-governing microenterprises with free-flowing communication among them and mutually creative connections with outside contributors. 572 CASES to ACCoMpAny ContEMporAry StrAtEGy AnAlySIS 2 Employees are transformed from executors of top-down directions to self- motivated contributors, in many cases choosing or electing the leaders and members of their teams. 3 Purchasers of our offerings are transformed from customers to lifetime users of products and services designed to solve their problems and increase their satisfaction. In effect, implementing the rendanheyi model meant tearing apart the walls of our enterprise and changing our structure into a collection of entrepreneurial ventures. The Haier platform now connects more than 2000 microenterprises in various loca- tions around the world. The leaders of each microenterprise have the type of power that would ordinarily accrue to the CEO of a company, not to a division leader … The microenterprises are part of global Haier organizations, which maintain common functions for research and development, production, and sales. Each Haier branch is thus grounded in local markets. Rather than trying to compete with homo- geneous products, we design our businesses to respect the differences between customers in different markets. We try to assimilate into each local culture, while maintaining a global approach that fosters human dignity and aspiration … We have deployed this business model not just in our home country, China, but everywhere else we do business. For example, in 2016, Haier acquired GE Appli- ances (GEA). In the beginning, the rendanheyi model was not understood in GEA, and it was difficult to change the long-standing bureaucracy and linear management mind-set. But we persevered. GEA first tried out the rendanheyi model in the water heater department, and found that … it stimulated employees’ enthusiasm and cre- ativity. GEA has since been split into seven microenterprises representing its seven appliance groups… In 2017, GEA began to select its microenterprise leaders through open elections, forming a management committee of three executives elected by their colleagues.16 Internationalization International Strategies in Domestic Appliances Internationalization in the domestic appliance industry has attracted considerable interest from business school scholars. In an influential article, Harvard professor Ted Levitt argued that the success of Italian appliance manufacturers such as Indesit and Merloni was the result of the economies of scale they were able to exploit through pro- ducing large volumes of standardized models for world markets.17 Subsequent research, however, showed not only that scale economies were modest in appliance manufacture but also that the most profitable producers were typically those that differentiated their products and their marketing strategies to meet the preferences of individual national markets.18 By the beginning of the 21st century, the domestic appliance industry was domi- nated by multinational firms whose operations spanned most continents of the world: Electrolux (of Sweden), Whirlpool (of the US), LG and Samsung (of South Korea), and Bosch-Siemens (of Germany). However, there were also major players whose size was the result of huge domestic sales-these included the main Chinese appliance firms Midea, Haier, and Gree electric appliances, China). All the world’s leading appliance firms have grown through acquisition. Whirlpool led the consolidation trend. Its acqui- sitions included, in 2005, Maytag (US) for $1.7 bn. and, in 2014, Hefei Sanyo (China) for $552 mn. and Indesit (Italy) for $1.0 bn. CASE 17 HAIEr Group: IntErnAtIonAlIzAtIon StrAtEGy 573 Haier’s Initial Internationalization Haier began its internationalization in a seemingly haphazard fashion. Between 1992 and 1997, Haier entered a number of overseas markets: ● In South-East Asia, initially Indonesia, Philippines, and Malaysia, Haier established joint ventures with local companies to manufacture and sell refriger- ators and air conditioners. ● In the United States, Haier began supplying compact refrigerators to an importer, Welbilt Appliances, initially for sale under a retailer’s brand, subse- quently under the Haier brand. Compact refrigerators were followed by wine coolers. Sales were concentrated on large chains—notably Walmart. ● In 1997, Haier began exporting appliances to Germany, the Netherlands, and Italy for sale by importers mainly under the Haier brand name. Haier achieved significant sales in Germany, where its joint-venture partner, Liebherr, was its sales agent. From the outset, Zhang was clear that Haier’s goal in expanding overseas was not to seek export revenues through exploiting Haier’s low manufacturing costs but to build a global brand: “making Haier the most respected brand in the world is the most important goal in the global strategy.”19 In doing so, Haier would be forced to raise its standards of product development, manufacturing, marketing, and customer service to world-class levels. Yet, building a global brand would be achieved through focusing on local markets: “All success relies on one thing in overseas markets— creating a localized brand name,” noted Mr. Zhang. “We have to make Americans feel that Haier is a localized US brand rather than an imported Chinese brand. The same goes for the European market.”20 Haier’s “locally designed, locally made, locally sold” approach involved three stages: first, using local distributors to break into an overseas market; second, establishing manufacturing plants and building market share; and finally, establishing research and product development activities. Rather than following conventional wisdom and focusing on entering nearby markets, which were at a similar (or lower) stage of economic development than China, Haier chose to tackle developed markets with sophisticated consumers—North American, Europe, and Japan. As Mr. Zhang remarked: “If one wants to improve one’s chess skills, then one must play with the top players.”21 Success in these markets required hiring experienced local managers to head Haier’s overseas subsidiaries. “We want to use local people and local thinking to satisfy the needs of the customer,” explained Yang Mianmian. Haier typically targeted experienced executives who had worked with leading appliance companies to head up its foreign operations. Chinese expatriates were primarily technical staff sent from headquarters. Haier America Haier America was established at the initiative of Michael Jemal, part-owner of Haier’s US distributor, Wellbilt Appliances. Under Jemal’s leadership Haier penetrated niche markets—notably small refrigerators for offices and students’ dorm rooms and wine coolers—before expanding into window air conditioners and full-size appliances. In 2000, it opened a manufacturing plant in South Carolina and in 2001 moved into its New York headquarters on Broadway. Haier’s main focus was refrigerators, which it sold at similar price points as the market leaders but sought differentiation advantage through innovative design features targeted at specific customer needs. 574 CASES to ACCoMpAny ContEMporAry StrAtEGy AnAlySIS In 2006, Haier introduced its upmarket range of Italian-designed appliances under the Casarte brand name. The Casarte line was subsequently introduced into other mar- kets, including China. In 2012, Haier America established its own research and product development center and, in 2014, appointed Adrian Micu, formerly head of engineering with Whirlpool, as its CEO. Despite Haier’s success in small fridges, it made limited progress in major appliances. One estimate put Haier’s share of the total US home appliance market at a mere 1.1%.22 The Acquisition of GE Appliances In January 2016, Haier’s international presence was transformed by its acquisition of General Electric’s home appliances division for $5.6 bn. With GE Appliance’s 14% US market share, Haier’s US market share would at least quadruple.23 In 2015, GE Appli- ances had revenues of $5.9 bn. and earned an operating margin of about 6%. Haier was licensed to use the GE brand name for 40 years. The deal also included a “long-term strategic partnership” between Haier and General Electric to collaborate in high-tech manufacturing areas such as healthcare and the industrial internet. on technologies relating to healthcare, the Internet, and advanced manufacturing systems. Given that both companies were positioning them- selves as leaders in the internet-of-things, Haier attached great strategic importance to the agreement.24 Haier Europe In 2000, Haier established a European sales office in Varese in the north of Italy. In the following year, it acquired Meneghetti Equipment, which owned a refrigerator plant in Padua and a distribution network. Qingdao Haier Co. Ltd. Haier Electronics Group Co. Small household electrical appliance business • Refrigerator business • Ice bar business • Freezer business Washing machine business • Pulsator washing machine business • Drum washing machine business Water heater business • Electric water heater business • Gas water heater business • Solar power water heater business Channel integration services business • Distribution business • Logistics business • After sales service business • Other auxiliary services business Note: Other companies within the Haier Group are not shown. These include: Haier Electric Appliances International Co., Ltd., Haier Finance Co., Ltd., Qingdao Haier Logistics Co., Ltd., Qingdao Haier Venture & Investment Information Co., Ltd., and many other companies. (56% ownership) Haier Group Corporation (42% ownership) (42% indirect ownership) Refrigerator and freezer business • Refrigerator business • Ice bar business • Freezer business Equipment components business • Mold business • Special steel business • Robotics business Air conditioner business • Cabinet air conditioner business • Wall-mounted air conditioner business FIGURE 2 Haier corporate structure Source: http://www.haier.net/en/invester_relations/haier/gc/. Accessed April 6, 2018. CASE 17 HAIEr Group: IntErnAtIonAlIzAtIon StrAtEGy 575 Over time, Haier repositioned itself from the lower price band to the middle of the market, where it sought to capture market share through aesthetics and design—drawing upon its Italian design center (in Varese) and German R & D center (in Frankfurt). In refrigerators, Haier Europe put a special emphasis on three-door models and novel color options. In 2010, Haier Europe moved its headquarters to Paris and, in 2015, Yan- nick Fierling, another recruit from Whirlpool, was named CEO of Haier Europe. Haier in Asia-Pacific Haier established joint ventures with local companies to enter most Asian markets. Its most important collaboration was with Sanyo Electric Company of Japan. In 2012, Haier acquired Sanyo’s domestic appliance business from its parent, Panasonic, for $132 mn. However, Sanyo’s traditions of collective responsibility and deference to seniority conflicted with Haier’s emphasis on individual performance targets backed by individual incentives.25 Later in 2012, Haier acquired New Zealand-based Fisher & Paykel, an upmarket appliance maker specializing in dishwashers, washing machines, and cookers, for $751 mn. Fisher & Paykel had plants in New Zealand, Australia, United States, Thailand, Mexico and Italy. Haier’s Future as a Global Company For all Haier’s remarkable success under Zhang Ruimin’s leadership, the effectiveness of its international strategy remained in question. Much of Haier’s success can be attrib- uted to the phenomenal opportunity provided by the rapid rise in the living standards of the Chinese since Zhang Ruimin’s arrival at the Qingdao Refrigerator Factory in 1984. Indeed, China continued to account for the overwhelming majority of Haier’s sales and profits. Haier’s international performance remained patchy. Despite pockets of success— for example, compact refrigerators and wine coolers in the US—Haier has strug- gled to achieve organic growth in overseas market. International growth has been achieved primarily through its acquisitions of Sanyo, Fisher & Paykel, and GE Appliances. This raises the issue of whether Haier’s radically decentralized, consumer-focused management model is appropriate to a multinational home appliances company. Despite Haier’s emphasis on customer service and brand building, anecdotal evidence suggests that Haier’s brand awareness and brand reputation outside of China are low. Haier is not listed among the world’s top-500 brands.26 In 2016, Haier Japan changed its name to Aqua (one of Sanyo’s former brands) to distance itself from its Chinese own- ership, has reverted to Sanyo’s. The mixed performance of Haier, especially outside China, raised questions as to the suitability of the company’s radically decentralized, rendanheyi management model for an international supplier of home appliances. Yet, given that so much of Haier’s actions, policies, and performance are cloaked secrecy, the reality of Haier’s strategy and management system is difficult to discern. Almost all that is known about Haier has come from the company itself—especially the writings and speeches of the chairman and CEO, Zhang Riumim. It is unclear how far his aspirations and radical management ideas are translated into reality at Haier. As one academic study concluded: “The rhetoric here implies considerable employee autonomy, which does not appear evident in some of its proclaimed HRM policies and practices.”27 576 CASES to ACCoMpAny ContEMporAry StrAtEGy AnAlySIS Notes 1. See: http://thinkers50.com/biographies/zhang-ruimin/. Accessed April 6, 2018. 2. The early history of Haier is outlined in the Harvard Business School case “Haier: Taking a Chinese Company Global,” Case No. 9-706-401 (2006). 3. See “Yang Mianmian: President of Haier,” CEIBS Case No. 307-015 (2007): 5. 4. Haier’s corporate governance is discussed in N. Kumar and J.-B. E. M. Steenkamp, Haier: The Quest to Become the First Chinese Global Consumer Brand (University of North Carolina, Kenan-Flagler Business School, December 2013): 4–5. 5. In 2016, revenues for Qingdao Haier were 119.1 bn. yuan and for Haier Electronics Group 63.8 bn. yuan. 6. Zhang’s intellectual influences are discussed in Kumar and Steenkamp, ibid.: 5–6. 7. IMD/CEIBS, “Building Market Chains at Haier,” IMD Case No. 3-0939 (August 2003). 8. A. Kleiner, “China’s Philosopher: CEO Zhang Ruimin,” strategy+business, Issue 77, (Winter 2014). 9. T. W. Lin, “OEC Management-Control System Helps China Haier Group Achieve Competitive Advantage,” Management Accounting Quarterly (Spring 2005). 10. Zhang Ruimin and Paul Michelman, “Leading to Become Obsolete,” MIT Sloan Management Review (Fall 2017). 11. “Haier: Taking a Chinese Company Global,” HBS Case No. 9-706-401 (2006): 6. 12. Ibid. 13. https://www.prnewswire.com/news-releases/haier-to- launch-all-scenario-smart-home-solution-at-2018-awe- with-20-percent-annual-growth-by-2017-300611401.html. Accessed April 8, 2018. 14. https://www.huffingtonpost.com/entry/haier- cosmoplat-provides-world-class-originality-for_ us_59300115e4b00afe556b0b47. Accessed April 8, 2018. 15. B. Fischer, U. Lago, and F. Liu, “The Haier Road to Growth,” strategy+business (April 27, 2015). 16. Z. Ruimin “Why Haier Is Reorganizing Itself around the Internet of Things,” strategy+business (February 26, 2018). 17. T. Levitt, “The Globalization of Markets,” Harvard Business Review (May/June 1983). 18. C. Baden-Fuller and J. Stopford, Rejuvenating the Mature Business, revised edition (Boston: Harvard Business School Press, 1994). 19. J.-B. Steenkamp, “Haier: The Quest to Become the First Chinese Global Consumer Brand,” (Kenan-Flagler Business School, University of North Carolina, December 2013). 20. Ibid.: 14. 21. “Haier’s Aim: Develop Our Brand Overseas,” Bloomberg Business Week (March 30, 2003), http://www.bloomberg .com/bw/stories/2003-03-30/online-extra-haiers-aim- develop-our-brand-overseas, accessed July 20, 2015. 22. Estimates of Haier’s share of the US appliance market prior to its acquiring GE Appliances varied greatly. CNET put it at 1.1%; Euromonitor at 5.6%. 23. https://www.cnet.com/news/its-official-ge-appliances- belongs-to-haier/ 24. “Higher Ambitions: China Haier’s Gambit to Invade American Homes,” Bloomberg Businessweek ( January 25, 2016). 25. “Case Studies: How Haier Handled Foreign Traditions,” Financial Times (April 1, 2013): 3. 26. The only home appliance brand appearing in the top- 500 was Haier’s Chinese rival, Medea at #405. See: http:// brandirectory.com/league_tables/table/global-500-2017. Accessed April 8, 2018. 27. M. Warner and A. Nankervis, “HRM Practices in Chinese MNCs: Rhetoric and Reality,” Journal of General Management 37 (March 2012): 67. https://www.huffingtonpost.com/entry/haiercosmoplat-provides-world-class-originality-for_us_59300115e4b00afe556b0b47 http://www.bloomberg.com/bw/stories/2003-03-30/online-extra-haiers-aimdevelop-our-brand-overseas The Virgin Group in 2018 On July 18, 2018, Sir Richard Branson celebrated his 68th birthday. Yet, 52 years after starting his first business, Branson’s entrepreneurial vigor seemed little dimmed. His recent ventures included the launch of a Virgin cruise line, a US chain of Virgin hotels, the startup of Virgin Orbit providing launch services for small satellites, and Virgin Sport, which held its “first mass participation sports events” in London, Oxford, and San Francisco in 2017. However, the Virgin Group as a whole was no longer a collection of young, entre- preneurial businesses—increasingly it was a portfolio of long-established businesses in mature sectors such as airlines, train services, banking, and healthcare. Moreover, in recent years, Virgin’s investments in new businesses had been dwarfed by its divest- ments. Increasingly, the Virgin Group had only minority stakes or even no ownership in the companies operating under the Virgin brand name. The changing character of the Virgin Group and the maturing of its founder and leader, Richard Branson—who was increasingly committed to charitable rather than business ventures—raised troubling questions for the identity and future direction of the group. Was Virgin still an incubator of new businesses, or had it transitioned to a more conventional financially-based holding company along the lines of Warren Buffet’s Berkshire Hathaway or the Wallenberg family’s Investor AB group? As it divested busi- nesses, while retaining control of the Virgin brand, perhaps it was primarily a brand licensing company? Development of the Virgin Group, 1968–2017 Richard Branson dropped out of boarding school at the age of 16 and started a maga- zine, Student, which was first published on January 26, 1968. The magazine displayed features that would characterize many of Branson’s subsequent entrepreneurial initia- tives. It targeted the baby-boomer generation; embodied the optimism, irreverence, and anti-authoritarianism; combined fashion, popular music, and avant-garde culture; and filled a “gaping hole in the market.” Virgin Records Branson’s next venture, mail-order record sales, saw the birth of the Virgin brand name. In 1971, Virgin Records opened its first retail store, on London’s busy Oxford Street and, in 1973, Virgin created its own record label. Its first release, Tubular Bells, by an This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. Case 18 578 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS unknown musician, Mike Oldfield, was a huge hit, eventually selling over five million copies. Virgin Records went on to sign up a series of new artists: Phil Collins, Human League, Simple Minds, and Boy George’s Culture Club—including several that had been shunned by the major record companies, notably the Sex Pistols. Virgin Atlantic Airways Virgin Atlantic began with a phone call from Randolph Fields, a Californian lawyer, suggesting a transatlantic, budget airline. To the horror of his colleagues at Virgin Records, Branson was enthralled with the idea. On June 24, 1984, Branson appeared in a First World War flying outfit to celebrate the inaugural flight of Virgin Atlantic in a second-hand 747 bought from Aereolíneas Argentinas. Unlike Branson’s other busi- nesses, the airline business was capital-intensive, heavily regulated, and required col- laboration with governments, banks, and aircraft manufacturers. Virgin Atlantic’s financing needs pushed Branson to the stock market. In 1985, 35% of Virgin Group PLC was listed on the London and NASDAQ stock markets and Branson became the chairman of a public corporation—a role that ill-fitted his personality and leadership style. Following the October 1987 stock market crash, Branson took the opportunity to raise £200 million to buy out external shareholders. Virgin Everywhere Between 1988 and 2004, Virgin launched a near-continuous stream of new businesses. These were concentrated around a few main areas of opportunity: ● Travel. The success of Virgin Atlantic encouraged Branson to launch other air- lines. The Virgin approach was to mesh the business model of the low-cost carriers with Virgin’s distinctive approach to enhancing customers’ experience in novel ways. New airlines included the Brussels-based Virgin Express, Virgin Australia (originally Virgin Blue and Pacific Blue), and Virgin America. Other aviation ventures included Vintage Air Tours, Virgin Lightships (blimp advertise- ments), Virgin Galactic, and Virgin Balloons. Virgin Rail was established in 1997 to operate two passenger rail franchises awarded in the privatization of Britain’s rail system. ● Holidays. Linked to Virgin’s airline interests were investments in hotels and vacation services, including a lodge and wildlife park in South Africa and Branson’s own Necker Island resort in the Caribbean. ● Retailing. Virgin’s record stores provided a platform for internationally expand- ing retail interests. The Our Price chain of UK record stores was a joint venture between Virgin and WHSmith. Virgin Megastores pioneered “experience-based retailing”—not just in the United Kingdom but also in Japan, the United States, Australia, and Europe. Virgin Bride was a UK chain of bridal stores. ● E-commerce. The Internet provided opportunities for Virgin to expand into online retailing of cars, motorcycles, wine, and music downloads. ● Telecom. In wireless communication, Virgin Mobile, a joint venture with Deutsche Telecom, was an early virtual network operator: buying network access from other providers to offer cellular service. Virgin.net, a joint venture with cable operator NTL, was an Internet service provider that became absorbed into Virgin Media. CASE 18 ThE VIRGIN GROuP IN 2018 579 ● Financial services. Virgin Money (originally Virgin Direct) began as a joint venture with Norwich Union offering credit cards and personal financial prod- ucts. It expanded greatly in 2012 when it acquired Northern Rock, the failed British bank. ● Leisure and entertainment. From its origins in music and magazine pub- lishing, Virgin entered video games (Virgin Games, 1991), book publishing (Virgin  Publishing, 1991), radio broadcasting (Virgin Radio, 1992), cinemas (Virgin Cinemas, 1995), and health clubs (Virgin Active, 1998). ● International expansion: Virgin’s expansion outside the United Kingdom began with its Megastores. After 2000, Virgin replicated several of its suc- cessful UK businesses overseas, including Virgin Mobile, Virgin Active, and Virgin Money. In most of these international ventures, Virgin Group was a minority partner, and in some, Virgin owned no equity and simply licensed its brand. Other new ventures defied categorization; they were the result of opportunism and Branson’s whims. These included biofuels (Virgin Fuels, Virgin Bioverda), video games (Virgin Interactive), beverages (Virgin Drinks, Virgin Cola), clothing (Victory Corporation), cosmetics (Virgin Vie), and Virgin Health Bank, where parents could store the stem cells from their newly born babies. Other new ventures reflected Branson’s growing commitment to environmental and charitable causes. Virgin Unite, Branson’s charitable foundation, was established in 2004 to provide opportu- nities and support for Virgin Group employees to partner with different charitable organizations. Focusing and Divestment Throughout its history, Virgin has divested businesses, either wholly or partially, in order to release equity for other business ventures or simply to cash in the value it had created. In 1992, it sold its music business to EMI; in 1998 it sold 49% of Virgin Rail to Stagecoach, a UK travel operator; and, in 1999, sold 49% of Virgin Atlantic to Singapore Airlines. From 2005, the pace of divestment increased with the sale or closure of financially unsuccessful businesses—such as Virgin Vie, Virgin Cosmetics, Virgin Cars, Virgin Bikes, Virgin Brides, Virgin Cola, Virgin Drinks, and Virgin Money USA—and the sale or floatation of some of its most successful businesses. Virgin Mo- bile and Virgin.net (an Internet service provider) were sold to the UK cable company, NTL, which, in 2007, changed its name to Virgin Media. In 2013, US cable company, Liberty Media acquired Virgin Media for $23.3 billion. Virgin America launched its initial public offering of shares in 2014, seven years after its inaugural flight. In 2016 it was acquired by Alaska Airlines for $4 billion (including debt and aircraft leases). Virgin Money—a full-fledged bank with the acquisition of Northern Rock—floated its shares on the London Stock Exchange in 2014, then in 2018 was acquired by the Clydesdale Yorkshire Banking Group. The Virgin Group of Companies in 2018 The Virgin website lists 58 “Virgin companies” which it groups into seven cate- gories. These are shown in Figure 1. By 2018, few of these companies were wholly or even majority owned by Virgin Group. The group’s biggest shareholdings were 580 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS 51% of Virgin Rail Group (the owner of Virgin Trains), 34% of Virgin Money Hold- ings plc, 20% of Virgin Atlantic, and 20% of Virgin Active. Virgin Media, Virgin Mobile, and Virgin Wines had been sold off entirely, licensing the brand to the new owners. Ownership Structure and Financial Performance In March 2018, there were 306 Virgin companies registered at Britain’s Companies House (113 of which had been identified as “converted/closed” or “recently dissolved”). In addition, there were Virgin companies registered in about 28 other countries. The Virgin companies were linked through a complex network of parent–subsidiary relations—many of the Virgin companies listed at Companies House were identified as “investment companies” or “holding companies.” For example, West Coast Trains Ltd., Virgin’s main UK rail franchise, was owned by Virgin Rail Group, which was owned by Virgin Rail Group Holdings Ltd., the majority of which was owned by Virgin Holdings Ltd., which was a subsidiary of Virgin Group Holdings Ltd. For most of the Virgin-owned companies, the ultimate parent was Virgin Group Holdings Ltd., a private company registered in the British Virgin Islands and owned by a series of family trusts, the beneficiaries of which were Richard Branson and his family. FIGURE 1 Virgin’s business portfolioa Virgin Casino Virgin Games Virgin Megastore Virgin Produced Virgin Radio Virgin Red Entertainment Virgin Active (separate companies in Australia, Italy, Singapore, South Africa, UK) Virgin Care Virgin Health Bank Virgin Pulse Virgin Pure Virgin Sport Virgin Balloon Flights Virgin Experience Days Virgin Gift Cards Virgin Megastore Virgin Racing Virgin Wines (separate companies in UK, US, Australia) Virgin Books Virgin Incentives Virgin America Virgin Atlantic Virgin Australia Virgin Holidays Virgin Hotels Virgin Limited Edition Virgin Trains Virgin Trains East Coast Virgin Vacations Virgin Money (separate companies in UK, Australia, and South Africa) Virgin Money Giving Virgin Start-up Virgin Earth Challenge Virgin Green Fund Virgin Unite Health and Wellness People and Planet Money Leisure Travel Virgin Connect Virgin Media Virgin Media Business Virgin Mobile (separate companies in Australia, Canada, Chile, Columbia, Peru, UAE, Mexico, Poland, South Africa, UK, US, Saudi Arabia) Telecom and Tech Space Virgin Galactic Virgin Orbit Note: a Includes only those companies listed on the Virgin website. Sources: http://www.virgin.com/company CASE 18 ThE VIRGIN GROuP IN 2018 581 Given this complexity, it was inevitable that financial reporting by the Virgin com- panies was fragmented, hard to locate, and difficult to interpret. The Virgin website claimed that Virgin businesses earned £16.7 billion ($21.7) and employed 69,000 peo- ple.1 However, companies owned and controlled by the Virgin Group accounted for only a small fraction of these totals. No consolidated accounts were available for the group as a whole, and tracking financial results for individual companies was compli- cated by Virgin’s tendency to transfer its investments in operating companies between its holding companies. Among the Virgin companies filing their financial statements with the UK’s Companies House, those filed by Virgin Holdings Ltd. cover rail trans- port, hotels, healthcare, and brand licensing (see Tables 1 and 2). Doubts had frequently been expressed about the overall financial health of the group.2 Branson was dismissive of such speculation, claiming that analysts and jour- nalists misunderstood his business empire, emphasizing that the financial performance goals of a private company are different from those of a public corporation: “Short-term taxable profits with good dividends are a prerequisite of public life. Avoiding short-term taxable profits and seeking long-term capital growth is the best approach to growing private companies.”3 It appears that, since 2005 most of the Virgin’s group’s profits have come from the sale and flotation of its businesses rather than from operating profits. Also, the accounts for UK companies did not take account of the cash drain from Virgin Galactic. Galactic had absorbed over $600 million by November 2014, $380 million of which was provided by Abu Dhabi’s state investment agency.4 The Virgin Brand The Virgin brand was the group’s greatest single asset. Compared to most other consumer brands, it was unusual in the range of products it encompassed. Could a TABLE 1 Financial data for Virgin Holdings Ltd. (£million) 2016 2015 Revenue 1553 1449 Operating profit 115 602 Profit (loss) on disposal of businesses (7) 439 Pretax profit 117 608 Net profit 60 626 Fixed assets 880 853 Cash and cash equivalents 650 671 Total assets 1226 1040 Long-term debt 103 164 Net assets (liabilities) 272 186 Shareholders’ equity 272 186 Source: Virgin Holdings Ltd. and Subsidiary Companies: Annual Report and Financial Statements (December 31, 2016). 582 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS brand that extended from rail travel to streamed music have any meaningful identity? The Virgin website offered the following explanation: All the markets in which Virgin operates tend to have features in common: they are typically markets where the customer has been ripped off or under-served, where there is confusion and/or where the competition is complacent. In these markets, Virgin is able to break into the market and shake it up. Our role is to be the consumer champion, and we do this by delivering to our brand values, which are: ● Value for Money. ● Good Quality. ● Brilliant Customer Service. ● Innovative. ● Competitively Challenging. ● Fun.5 These attributes were conveyed to customers through Virgin’s distinctive approach to differentiation. For example, Virgin Atlantic pioneered a range of innovative customer services (principally for its business class passengers). These included inflight massages, hair stylists, aromatherapists, and limousine and motorcycle transportation to and from the airport—even a speedboat service along the Thames from Heathrow to the Lon- don financial center. British Airways provided the ideal adversary against which Virgin Atlantic could position itself as the plucky upstart with customers’ interests at heart. Some of Branson’s ventures seemed to be inspired more by a sense of fun and eagerness to “stick it to the big boys” than by commercial logic. When Virgin Cola was introduced in 1994, the goal, according to Branson, was to “drive Coke out of the States.”6 By 1997, Virgin Cola was losing £5 million on revenues of £30 million. The Virgin brand was inseparable from Richard Branson’s persona as entrepre- neur, joker, and the “acceptable face of capitalism.” The affection of the British public for Branson, and the appeal of the Virgin brand, reflected the alignment between TABLE 2 Segment financial data for Virgin Holdings Ltd. (£million) Revenue Net profit 2016 2015 2016 2015 Air travela – 1570 – n.a. Rail 1109 1090 45 62 Hotels 44 46 (7) (14) Healthcare 262 230 (7) (4) Other trading 22 30 8 10 Brand licensing n.a. n.a. 66 45 Other trading and management services 58 55 3 0 Note: a Virgin’s airline interests were transferred to another Virgin holding company at the end of 2015. Source: Virgin Holdings Ltd. and Subsidiary Companies: Annual Report and Financial Statements (December 31, 2016). CASE 18 ThE VIRGIN GROuP IN 2018 583 Branson’s values and sense of fair play with some of the traditional values that defined the British character. In battling huge, anonymous corporations, Branson recalled the legendary heroes of yesteryear who fought tyranny and evil: King Arthur, Robin Hood, and St. George. His willingness to appear in outlandish attire reflected a British pro- pensity for eccentric dressing-up. Though it also raised issues as to whether Branson and the Virgin brand could achieve a similar rapport with consumers outside of Britain. Virgin’s diversity presented several risks to the Virgin brand. In some markets, Virgin was unable to offer distinctive differentiation. In others, Virgin had limited control over its licensees use of the Virgin brand. And there was the ever-present danger that cus- tomer dissatisfaction in a single business might contaminate the entire brand. Moreover, Branson’s popular appeal appeared to be waning. A critical biography highlighted some of the contradictions in Branson’s image and behavior: flying his private jet to climate change summits, lecturing on transparency and accountability while presiding over an impenetrably opaque business empire, promoting the interests of the underprivileged while protecting his own wealth in offshore family trusts.7 The Virgin Business Development Model Most of Virgin businesses were start-ups. From the founding of Student magazine through to the formation of Virgin Galactic, Branson’s strength as a businessman was in conceiving and implementing new business ideas—even if the ideas behind most of Virgin’s new business ventures came from other people. Branson acted as a magnet for would-be entrepreneurs from both inside and outside the Virgin Group. Virgin’s website encouraged the submission of new business ideas to its corporate development office. Virgin’s approach to business start-ups reflected Branson’s attributes of innocence, innovation, and irreverence for authority. His business ventures, just like his sporting exploits, reflected a “just live life” attitude and a “bigger the challenge, greater the fun” belief. He was particularly drawn to markets where stodgy, incumbent firms resulted in underserved customers and Virgin could offer a better alternative. On its website, Virgin explained its purpose as: “Virgin is known for challenging the status quo—taking on industry giants and championing people and the planet. Disruption is in our DNA and we’ve made sure this is captured in our purpose, the reason Virgin exists. Virgin Group’s purpose is changing business for good.” Over time, Virgin’s approach to business development had become more systematized: When we start a new venture, we base it on hard research and analysis. Typically, we review the industry and put ourselves in the customer’s shoes to see what could make it better. We ask fundamental questions: Is the customer confused or badly served? Is this an opportunity for restructuring a market and creating competitive advantage? What are the competitors doing? Is this an opportunity for building the Virgin brand? Can we add value? Will it interact with our other businesses? Is there an appropriate trade-off between risk and reward? We are also able to draw on talented people from throughout the Group. New ven- tures are often steered by people seconded from other parts of Virgin, who bring with them the trademark management style, skills and experience. We frequently create partnerships with others to combine industry specific skills, knowledge, and opera- tional expertise ...8 Typically, Virgin was able to use the Virgin brand and Branson’s celebrity status to obtain 51% or more of the equity of new ventures while contributing a minority of the equity capital. 584 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS The Virgin Group’s Management Style Branson’s approach to management reflected his values and personality. Informality and disrespect for convention were central to Branson’s way of business. He resisted any separation among work, family, and leisure, reflecting a view of business as part of life, which, like life, should involve excitement, creativity, and fun. Equally he was happy to involve cousins, aunts, childhood friends, and dinner-party acquaintances in business relationships. His hands-off approach to his business empire was based upon giving autonomy and incentives to managers he trusted. Once a new Virgin business was up and running, it was handed over to a trusted managing director and financial controller. The top management team were rewarded with equity stakes or options and expected to develop the company. Much of Virgin’s entrepreneurial success can be traced to Branson’s ability to embody the spirit of the “New Britain”—a country which, at the end of the 20th century, was identified more by its vibrant culture than by its colonial heritage and rigid class system. In a country where business leaders were conventionally part of “the establishment,” Branson was the “people’s capitalist.” Branson’s antipathy toward authority and convention was also reflected in his dis- respect for conventional business principles. He argued that Virgin’s network of small companies combined “small is beautiful” with “strength through unity.” Claiming to have never read a management book, he developed his own principles of management. His business maxims have included: “Staff first, then customers and shareholders,” “Shape the business around the people,” “Be best, not biggest,” “Pioneer, don’t follow the leader,” “Capture every fleeting idea,” and “Drive for change.” Increasingly, Branson’s freewheeling management philosophy was at odds with the growing formalization of the Virgin Group’s management structure. This included: ● Establishing Virgin Management Ltd. as the center for the group’s management capability. As the Virgin website explained: At the center, Virgin Management Ltd. (VML) provides advisory and managerial support to all of the different Virgin companies and our specialist Sector teams around the world. Our people in London, New York and Sydney offer regional support and between us and the Sector teams we manage Virgin’s interests across the whole of the Virgin Group. VML’s fastidious number-crunchers get to manage Virgin’s financial assets in the group, our witty marketeers and intelligent communicators get to protect and max- imise the value of the Virgin brand and our touchy-feely people teams ensure Virgin is an employer of choice.9 ● Sector teams, each headed by a managing partner, provided oversight to com- panies within a particular area of business: “The specialists keep our companies on their toes and ensure we keep developing better experiences and world beating products.”10 ● Centralizing ownership and control of the Virgin brand within Virgin Enterprises Ltd. Neil Hobbs, intellectual property lawyer for Virgin Enterprises, explained: “Our role is both to optimize and enhance the value of the brand and to pro- tect that by ensuring that value is not diminished through infringement by third parties.”11 During 2016, royalties from licensing the Virgin brand to members of the group and to other companies amounted to £95 million yielding a net, after tax profit of £66 million. CASE 18 ThE VIRGIN GROuP IN 2018 585 ● Establishing a top-management team. The appointment of Peter Norris as non-executive chairman of Virgin Group Holdings in 2009 was followed, in July 2011, with the appointment of Josh Bayliss, formerly Virgin’s general counsel, as CEO. Yet, despite this formalization, the critical components of the Virgin management system remained its entrepreneurial culture and personal relationships. The group’s senior management team is shown in Table 3. Richard Branson’s only formal role was as president of Virgin Atlantic. Looking to the Future By 2018, it was clear that the identity and the strategic direction of the Virgin Group had shifted. While Sir Richard continued to espouse—and pioneer—bold entrepre- neurial ventures, the businesses owned and controlled by the Virgin Group were pri- marily established ventures in regulated industries: airlines, trains, and healthcare. The group’s profit was increasingly dependent not on its own business operations but on brand royalties, dividends from associated companies, and capital gains from disposals. This raised the issue of the appropriate business model for Virgin Group. For much of its history, Virgin had been primarily a business incubator, initiating and developing entrepreneurial new ventures. Virgin had previously described itself as a “branded venture capital organization”; however, the typical venture capital firm invested in other entrepreneurs’ start-ups: Virgin created its own businesses, typically using other people’s money. As the company established a number of major businesses in the travel, entertain- ment, and retail sectors, Virgin increasingly became a diversified holding company— along the lines of Berkshire Hathaway, Koch Industries, or the Tata Group. Branson himself had likened Virgin to a Japanese keiretsu—like Mitsubishi or Mitsui, the Virgin TABLE 3 Virgin’s senior executives, 2018 Executive Role at Virgin Prior career Josh Bayliss CEO since 2011, previously Virgin’s General Counsel Lawyer (Slaughter & May) Peter Norris Group Chairman since 2009 Investment banker (Goldman Sachs, Barings) Patrick McCall Senior Managing Director with responsibilities for Virgin Active, Virgin Money, Virgin Galactic, and Virgin Trains, previously with Virgin Rail and Virgin Active Investment banker (S.G. Warburg) Evan Lovell Managing Director of Investments, responsible for Virgin’s North American investment portfolio Private equity (TPG) Amy Stirling Chief Financial Officer of the Virgin Group CFO The Prince’s Trust, CFO TalkTalk Lisa Thomas Managing Director of Virgin Enterprises M&C Saatchi Group Ian Woods Partner, General Counsel and COO Lawyer (Slaughter & May) Source: www.virgin.com/virgingroup/content/our-senior-team. 586 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Group featured equity linkages, interlocking directorships, collaboration between member companies, and a focus on long-term development. However, as Virgin increasingly sold off or floated majority equity stakes in its core businesses, so it increasingly looked more like a private equity fund. Certainly, the preponderance of investment bankers and lawyers among Virgin’s top executive team was reminiscent of private equity firms. The group’s transition from being an entrepre- neurial and operating company into an investment company was acknowledged in its own “About us” description: “We are a family-owned growth capital investor, with a globally recognised and respected brand.”12 Yet, what distinguished Virgin from the typical private equity firm was the central role of the Virgin brand. In markets where brand differentiation has proved elusive— airlines, rail travel, wireless communication, and healthcare—the Virgin brand was widely viewed as conferring substantial value. So, perhaps Virgin should conceive of itself as a brand licensing company. Yet, this too was problematic: the Virgin brand, because it was linked to an individual rather than to a particular product or business enterprise, was vulnerable. “Every day that Richard gets older the issue of the Virgin brand becomes a bigger one because so much of it is tied to him,” noted Jez Frampton, chief executive of Interbrand, the brand consultancy.13 Using high-profile new ven- tures to expand Virgin’s brand awareness had proved problematic. Virgin Galactic was intended as a vehicle for boosting Virgin’s US brand awareness. However, the crash of Galactic’s SpaceShipTwo in October 2014 had wide repercussions. According to the Financial Times: “Sir Richard had hoped Galactic would have a ‘halo effect’ on the rest of the company. The risk is that it will have the opposite impact and threaten the value of the brand upon which the whole edifice depends.”14 Whichever strategic model Virgin followed, it seemed likely that it would need to continue to make changes to its structure and management system. The informal, col- laborative approach that had allowed the Virgin Group to survive and develop despite a turbulent economic environment had depended greatly upon Richard Branson and his personal leadership. Inevitably, his role within the group would diminish over time. Notes 1. https://www.virgin.com/virgingroup/content/about-us, accessed March 28, 2018. 2. “The future for Virgin,” Financial Times (August 13, 1998): 24–25; M. Wells, “Red Baron,” Fortune magazine ( July 3, 2000). 3. R. Branson, letter to the Economist (March 7, 1998): 6. 4. Virgin Group Funds Tapped for Delayed Space Venture,” Financial Times (November 2, 2014). 5. “Virgin Group: Brand it like Branson,” Financial Times (November 5, 2014). 6. P. Robison, “Briton Hopes Beverage Will Conquer Coke’s Monopoly,” Bloomberg News (December 14, 1997). 7. T. Bower, Branson: Behind the Mask (London: Faber & Faber, 2014). 8. “The Virgin Brand,” http://www.virgin.com/about- us, accessed September 27, 2012. Reproduced with permission. 9. “The Virgin Brand,” http://www.virgin.com/about- us, accessed September 27, 2012. Reproduced with permission. 10. Ibid. 11. “Consolidating and Protecting the Licensed Virgin Brand,” http://www.chrispatmore.com/wp-content/ uploads/2011/12/virgin_case_study , accessed July 20, 2015. 12. https://www.virgin.com/virgingroup/content/about-us. Accessed March 28, 2018. 13. “Virgin Group: Brand it like Branson,” Financial Times (November 5, 2014). 14. Ibid. http://www.chrispatmore.com/wp-content/uploads/2011/12/virgin_case_study Case 19 Google Is Now Alphabet—But What’s the Corporate Strategy? On August 10, 2015, Google’s CEO, Larry Page, announced that Google Inc. would become Alphabet Inc., a holding company of which Google (comprising the compa- ny’s search and Internet businesses) would be the biggest operating company. Extracts of the announcement are reproduced in Exhibit  1. The organizational structure of Alphabet is shown in Figure 1. The creation of Alphabet was widely viewed as Google’s top management finally conceding to investors’ demands for greater transparency by separating Google’s pri- mary source of profits, its search business, from Google’s other businesses. It was also a confirmation by Google’s founders, Larry Page and Sergey Brin, that their company was no longer simply a search company. The announcement was a reaffirmation of the company’s commitment to developing and commercialization of revolutionary tech- nologies. This quest had already led Google beyond search, beyond the provision of information, and beyond software into mobile devices, home appliances, life sciences, self-driving cars, broadband services, digital eyewear, and a host of other ventures. Soon after its founding, Google had proclaimed “Ten Things We Know To Be True”— a set of business principles that would guide the company’s development. Second on the list was, “It’s best to do one thing really, really well,” to which the response was: “We do search.”1 Google—now Alphabet—was no longer a search company. But what was it? Founders Brin and Page had consistently emphasized that the essence of their company was applying technology to improving the lives of people. Page had declared, “The societal goal is our primary goal,” the challenge being to: “... use all these resources ... and have a much more positive impact on the world?”2 If Alphabet was to be described by technology—then which technologies? From the beginning Google/Alphabet has been about algorithms. Initially, its PageRank algorithm, but increasingly artificial intelligence algorithms that model the functioning of the human brain. By combining machine learning and artificial intelligence, Alphabet is identifying areas where machine intelligence can be superior to human intelligence. The scope of these applications—from autonomous driving to medical diagnosis, to facial recognition, to education—seems limitless. The diversity of Alphabet’s business and technological initiatives also fueled suspi- cions about the motivations of the founders, Brin and Page. Despite their proclama- tions to pursue the good of society and to “do no evil,” it seemed to some that Google was locked in battle with Apple, Amazon, Facebook, and Microsoft for the control of cyberspace. This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. 588 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Alphabet Inc. Google Waymo Calico VerilyAccess CapitalG GV XNest* * Nest was transferred to become part of Google in February 2018 “OTHER BETS” FIGURE 1 Alphabet Inc.: Organization structure, March 2018 Yet, in terms of its revenue model, Google is an advertising company. In 2017, adver- tising accounted for 86% of Alphabet’s revenues. Common to almost all Alphabet’s businesses is that they are either vehicles for carrying advertising or they are sources of information that could be utilized to better target advertising. EXHIBIT 1 Google Announces Plans for New Operating Structure August 10, 2015 As Sergey and I wrote in the original founders’ letter 11 years ago, “Google is not a conventional company. We do not intend to become one.” ... From the start, we’ve always strived to do more, and to do important and meaningful things with the resources we have. We did a lot of things that seemed crazy at the time. Many of those crazy things now have over a billion users, like Google Maps, YouTube, Chrome, and Android. And we haven’t stopped there. We are still trying to do things other people think are crazy but we are super excited about. We’ve long believed that over time companies tend to get comfortable doing the same thing, just making incremental changes. But in the technology industry, where revolutionary ideas drive the next big growth areas, you need to be a bit uncomfortable to stay relevant. Our company is operating well today, but we think we can make it cleaner and more accountable. So we are creating a new company, called Alphabet. I am really excited to be running Alphabet as CEO with help from my capable partner, Sergey, as President. What is Alphabet? Alphabet is mostly a collection of companies. The largest of which, of course, is Google. This newer Google is a bit slimmed down, with the com- panies that are pretty far afield of our main internet prod- ucts contained in Alphabet instead. What do we mean by far afield? Good examples are our health efforts: Life Sciences (that works on the glucose-sensing contact lens), and Calico (focused on longevity). Fundamentally, we believe this allows us more management scale, as we can run things independently that aren’t very related. Alphabet is about businesses prospering through strong leaders and independence. In general, our model is to have a strong CEO who runs each business, with Sergey and me in service to them as needed. We will rig- orously handle capital allocation and work to make sure each business is executing well. We’ll also make sure we have a great CEO for each business ... Larry Page, CEO, Alphabet Source: https://abc.xyz/investor/news/releases/2015/ 0810.html, accessed March 21, 2018. https://abc.xyz/investor/news/releases/2015/0810.html CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 589 The confusion over Alphabet’s corporate strategy was no recent phenomenon. In 2009, the Mercury News reported: Google increasingly feels like a company running in a thousand different directions at once ... The problem is that in expanding into so many different areas, the iden- tity of Google itself has become muddled ... it’s getting harder every day to articulate what Google is. Is it a Web company? A software company? Something else entirely?3 Although comparisons have been made with other diversified giants—the Economist proclaimed Alphabet to be “the new General Electric” and Alphabet’s Chairman Eric Schmidt drew parallels with Berkshire Hathaway—ultimately, it seemed that Alphabet truly was “a different kind of company.”4 Hence, the creation of Alphabet had done little to answer the question that had tormented Google-watchers for years: What was the corporate strategy of the company formerly known as Google? The History of Google, 1996–2018 The Google Search Engine Larry Page and Sergey Brin met as PhD students at Stanford University. Their investi- gation of the linkage structure of the World Wide Web led them to develop a page- ranking algorithm that used backlink data (references by a Web page to other Web pages) to measure the importance of any Web page. They called their search engine “Google” and in September 1998 incorporated Google Inc. in Menlo Park, California. Google’s “PageRank” algorithm received a patent on September 4, 2001. Search engines met the need of the growing number of people who were turning to the World Wide Web for information and commercial transactions. As the number of web- sites grew, locating relevant content became essential. Early Web search engines included WebCrawler, Lycos, Excite, Infoseek, Inktomi, Northern Light, and AltaVista. Several of them became portal sites—websites that offered users their first port of entry to the web. Other portals, such as Yahoo! and AOL, soon recognized the need to offer a search facility. The Google search engine attracted a rapidly growing following because of its superior page ranking and simple design. In 2000, Google began selling advertise- ments—paid Web links associated with search keywords. Its Adwords placed “spon- sored links”—brief, plain text ads with a click-on URL—which appeared alongside Web search results for specific keywords. Advertisers bid for keywords; it was these “cost-per-click” bids weighted by an ad’s click-through rate (CTR) that determined the order in which the paid listings would appear. By 2004, Google became the US market leader in Web search; by 2009 its share had reached 65.6%. Google became a public company on August 19, 2004: an IPO of about 7% of Google’s shares raised $1.67 bn., valuing Google at $23 bn. Organizing the World’s Information Google’s expansion beyond Web search was a reflection of its mission “to organize the world’s information and make it universally accessible and useful.” Google’s IPO pro- spectus elaborated this intent: We serve our users by developing products that enable people to more quickly and easily find, create and organize information. We place a premium on products that 590 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS TABLE 1 Alphabet’s revenue sources, 2008–2017 ($billion) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Google advertising revenues (total) 21.1 22.9 28.2 36.5 46.0 51.1 59.6 67.4 79.4 95.4 —Google properties 14.4 15.7 19.4 26.1 31.2 37.4 45.1 52.4 63.8 77.8 —Google network members’ properties 6.7 7.2 8.8 10.4 12.5 13.1 14.0 15.0 15.6 17.6 Google other revenues 0.7 0.8 1.1 1.4 2.4 5.0 6.9 7.2 10.1 14.3 Google total revenues 21.8 23.7 29.3 37.9 46.0 55.5 66.0 74.5 89.5 109.7 Other Bets revenuesa – – – – – – – 0.4 0.8 1.2 Total revenues 21.8 23.7 29.3 37.9 46.0 55.5 66.0 75.0 90.3 110.9 Notes: a Revenues from Other Bets businesses were included in “Google total revenues” prior to 2015. Source: Google Inc. and Alphabet Inc 10-K reports. matter to many people and have the potential to improve their lives, especially in areas in which our expertise enables us to excel. Search is one such area. People use search frequently and the results are often of great importance to them. Delivering quality search results requires significant computing power, advanced software and complex processes—areas in which we have expertise and a high level of focus. The result was a series of new products that allowed access to information from diverse sources. These sources of information included images (Google Image Search), maps (Google Maps), academic articles (Google Scholar), books (Google Book Search), satellite imagery (Google Earth), panoramic street photographs of most of the world’s cities (Google StreetView), news (Google News), patents (Google Patent Search), video (YouTube), finance (Google Finance), Web logs (Google Blog Search), and many more. However, Google’s entrepreneurial and technological dynamism led it well beyond the accessing and organizing of information. Beginning with Gmail in 2004, Google introduced a widening array of software and services for communicating, creating and manipulating images, producing documents, creating Web pages, managing time, and social networking. These new products expanded Google’s advertising revenues by providing addi- tional opportunities for carrying ads and improving Google’s targeting of ads. Google’s primary source of advertising revenue was AdWords, launched in 2000. Advertisers specify the keywords that should trigger their ads and the maximum amount they are willing to pay per click. When a user searches google.com, short text advertisements appear on the screen. The rank ordering of ads is determined by advertiser’s cost- per-click bid and the “ad quality” (its relevance to the user). The advertiser then pays Google according to the number of clicks on the advertisement. AdSense uses an advertisement placement technology developed by Applied Seman- tics (acquired in 2003) that allows Google to place ads on third-party websites. Table 1 shows Alphabet’s revenues from advertising and other sources. In 2007 and 2008, Google’s diversification efforts took a dramatic new turn with Google’s entry into mobile telephony and Web browsers. http://google.com CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 591 Android and Mobile Telephony Google acquired Android Inc. in 2005 and in November 2007 launched the development of its Android software platform, a Linux-based operating system for mobile devices. According to Google: “Android is being developed ... with the goal of providing consumers a less expen- sive, richer and more powerful mobile experience.”5 Most observers thought that Google’s primary concern was the threat that the shift from desktop to mobile devices posed to Google’s advertising revenues. Android was a spectacular success: in establishing market leadership (Table  2), it prevented Apple from dominating the smartphone and tablet market. By offering Android as a free, open-source, mobile operating system, it was able to attract a large number of handset manufacturers (the most important being Samsung) and an army of application developers—by 2018, there 1.76 million Android apps. Chrome Google’s Chrome Web browser announced on September 2, 2008 generated huge publicity, but little surprise. Google’s then head of product development (later CEO of Google within Alphabet), Sundar Pichai, explained: “Google’s entire business is people using a browser to access us and the web.” Google’s website added: “Google Chrome is a browser that combines a minimal design with sophisticated technology to make the web faster, safer, and easier.” By contrast, Microsoft’s Internet Explorer (IE) was constrained by the legacy of its 15-year history. Google’s goal for Chrome was not simply a superior user experience. Version 8 of Microsoft’s IE launched in 2008 allowed an “InPrivate” protection mode that would delete cookies, making it more difficult to track users’ browsing habits. This would limit Google’s ability to use such information to target consumers with advertising. Others saw Google’s primary intention as not so much to protect its search engine but more to attack Microsoft’s dominance of personal computing and to speed the TABLE 2 Shipments of smartphones: Market share by operating system 2018a (%) 2015a (%) 2013a (%) 2011a (%) Android (Google) 86.1 78.0 75.5 36.1 iOS (Apple) 13.7 18.3 15.9 18.3 Blackberry OS (RIM) – 0.3 2.9 13.6 Windows (Microsoft) – 2.7 3.2 2.6 Other 0.2b 0.7 1.5 29.4c TOTAL 100.0 100.0 100.0 100.0 Notes: a The data are for the first quarter of each year. b Includes Blackberry and Windows. c In 2011, “Other” comprised Symbian with 26.0%, Linux with 3.1% and other systems 0.3%. Source: IDC. 592 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS transition of computing to a new online environment. Wired magazine viewed it as: “an aggressive move destined to put the company even more squarely in the crosshairs of its rival Microsoft.6 The announcement ten months later that Google would add an operating system to its Chrome browser was seen as confirmation of Google’s aggressive intent toward Microsoft. Google in Hardware As Internet access transitioned toward mobile devices, Google sought to reinforce its proprietary technology in that sphere. Its acquisition of the struggling handset maker Motorola Mobility in 2012 for $12.5 bn., was primarily to acquire its rich portfolio of patents relating to wireless communication. Owning Motorola would also permit Google closer integration of hardware and software development in smartphones and tablet computers, thereby enhancing the user experience. However, becoming a handset maker put Google into competition with some of its major customers, notably Samsung, which was already developing its own operating system. In 2012, Google sold Motorola to Lenovo, but continued to develop and market mobile devices, including the Nexus brand of smartphones (build by HTC) and a range of notebook and tablet computers based upon its Chrome operating system. In January 2018, Google deepened its relationship with HTC when it paid HTC $1.1 bn. for patent licenses and an engineering unit. Subsequent diversifications also increased Google’s involvement in hardware: ● Google Glass, an Internet-enabled, optical head-mounted display controlled by natural language voice commands, was marketed on an experimental basis bet- ween April 2013 and January 2015. ● With the acquisition of Nest in January 2014, Google became a supplier of home security and control devices—including thermostats and smoke detec- tors. The goal was to build Google’s position as a central player in the “smart home.” In May 2015, Google announced Project Brillo, an operating system to link home devices, such as door locks, light bulbs, and security cameras, while Project Weave would allow these devices to communicate with other products and web services.7 ● Google Home, launched in October 2016, and the Home Mini, launched 12 months later, were Google’s entrants to the fast-growing market for voice- activated, smart speakers. Despite selling about 2 million smart speakers per month in the closing months of 2017, Google remained a distant second to Amazon in this market. ● Google’s involvement in smart TV has included its Google TV and Android TV software programs and its Chromecast plug-in devices, first launched in 2013, which allow video streaming on TV receivers. Google+ Google’s foray into social networking began with Orkut in January 2004 and continued with Google Friend Connect and Google Buzz. However, all were eclipsed by Face- book. When, in March 2010, Facebook overtook Google as the most visited website CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 593 within the United States, Google became fully aware of the threat posed by Facebook to its online advertising revenue: If you were an advertiser, who would you rather place your ads with? On the one hand, you have a company that will attempt to gear ads to things like the search his- tory of users. On the other hand, you have a company that knows where its users went to college, where they work, who they are friends with, what they’re reading and sharing, and their favorite bands, books, foods, and colors. Advertisers want to target their ads to the people most likely to be receptive to them, and information is the key to targeting. The more information available, the better the targeting.8 Launched in June 2011, Google+, the company’s fourth venture into online social networking, had 540 million users by October 2013. However, by the end of 2017, it was clear that, yet again, Google had failed to build a viable competitor to Facebook— although YouTube was widely viewed as a social media platform. Waymo Google began developing autonomous driving systems in 2009 with applications both to existing production cars and its own prototype cars, which lacked all driver con- trols. By 2017, Waymo had a fleet of self-driving vehicles in Phoenix, AZ, being driven without a person behind the wheel. However, it was competing with at least 12 other companies in developing self-driving systems and any commercial revenues within the next five years seemed unlikely. In February 2018, Alphabet received $244 million in Uber equity, settling a legal suit over Uber’s alleged theft of Waymo’s technology. Life Sciences Alphabet’s research activities in life sciences were organized into two businesses. Calico’s mission is “to harness advanced technologies to increase our understanding of the biology that controls lifespan.” In 2014, Calico formed an R&D alliance with AbbVie to develop new therapies for age-related diseases, including neurodegeneration and cancer. Verily’s mission to make the world’s health data useful so that people enjoy healthier lives. It makes a smart contact lens that measures blood sugar. In January 2017, Temasek, a Singapore-based investment company, paid $800 million for a non- controlling equity stake in Verily. Broadband Alphabet’s Access subsidiary combines several broadband projects whose goal is to expand access to the Internet. The major component of Access is Google Fiber, which offers broadband and TV service in several locations with in the United States. It also includes Webpass, a gigabit Internet provider acquired in 2016. Venture Capital Google Capital was established in 2013 to make late-stage venture capital investments in technology companies. In 2016, it was renamed CapitalG. In addition to finance, CapitalG provides companies within its portfolio access to technological and strategic 594 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS advice from Google’s executives. Its investments include Survey Monkey, Lending Club, Airbnb, Snap Inc., Stripe, Looker, and Lyft. GV, formerly Google Ventures, is Alphabet’s other venture capital subsidiary. It invests in life sciences, artificial intelligence, robotics, and cybersecurity companies, mainly in the early stages of their development. X X, formerly Google X, is a corporate lab for developing experimental technologies known as “moonshots.” According to The Atlantic magazine: “X is perhaps the only enterprise on the planet where regular investigation into the absurd is not just permitted but encouraged, and even required.”10 Because of the secrecy surrounding X, only a few of the projects being undertaken are known. During early 2018, these included: ● Project Loon—high altitude balloons providing internet connectivity in areas lacking broadband infrastructure; ● Project Wing—package delivery via airborne drones; ● Makani Power—generating electrical power through wind turbines mounted on tethered kites; ● development of a revolutionary, miniature battery for powering mobile devices; ● various robotics projects. Alphabet’s Management and Capabilities Google—now Alphabet—had created a management system that was unique, even by the unorthodox standards of Silicon Valley. Some of the key features of this system included: ● Hiring policy: From its earliest days, Google committed itself to hiring only the “brightest of the bright.” Google’s targets were not simply the highly intelli- gent. They were “smart creatives”—people who were “not confined to specific tasks ... not adverse to taking risks ... not hemmed in by role definitions ... don’t keep quiet when they disagree ... get bored easily and shift jobs a lot ... com- bine technical depth with business savvy and creative flair.”9 As founders Page and Brin explained: “Our employees, who have named themselves Googlers, are everything. Google is organized around the ability to attract and leverage the talent of exceptional technologists and business people ... Because of our employee talent, Google is doing exciting work in nearly every area of com- puter science ... Talented people are attracted to Google because we empower them to change the world.”11 ● A “dramatically flat, radically decentralized” organization: Google structure and systems were designed around the simple notion of “What do smart cre- atives need in order to be productive?” The answer was primarily about the aspects of traditionally managed organizations that should be avoided: authority, rules, formality, defined job roles, and hierarchical privileges. Google was a flat organization because its smart creatives needed easy access to key decisions in order to get things done. To minimize hierarchy, Google used a “rule of seven”: each manager must have at least seven direct reports. ● Small, self-managing teams: The majority of Google’s employees, including all those involved in product development, worked in small teams. Most engineers CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 595 were in teams of three or four. Team size was limited by the “two-pizza rule”— teams should be small enough to be fed by two pizzas. Teams appointed their own leaders, and engineers could switch teams without the need for permission from the HR department. ● An environment that fosters creativity: For employees to be productive required a working environment that stimulated and fostered their interac- tion. Google’s workplaces were designed to minimize separation among col- leagues. Google’s opulent eating and sports facilities were similarly designed to increase human interaction. Creativity and innovation were institutionalized through Google’s “70–20–10” rule, which stipulated that Google would devote 70% of its engineering resources to developing the core business, 20% to extend that core into related areas, and 10% allocated to fringe ideas. As a result, Google employees were able to spend time working on pet projects of their own choosing. ● Rapid, low-cost experimentation: According to Gary Hamel: “Evolutionary adaptation isn’t the product of a grand plan, but of relentless experimenta- tion ... Google’s ‘just-try-it’ philosophy is applied to even the company’s most daunting projects, like digitizing the world’s libraries ... That kind of step-wise, learn-as-you-go approach has repeatedly helped Google to test critical assump- tions and avoid making bet-the-farm mistakes.”12 Underlying Alphabet’s capacity for innovation and the effective implementation of new initiatives was a set of resources that few other technology-based companies could match. With an operating cash flow of $37 bn. in 2017 and a cash pile of $103 bn., Alphabet was a financial powerhouse that could buy its way into almost any market or area of technology. (Table 3 shows financial data for Alphabet.) However, most of TABLE 3 Alphabet Inc.: Selected financial data, 2008–2017 ($ bn.) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Revenues 21.8 23.7 29.3 37.9 43.7 50.5 59.1 75.0 90.3 110.9 Cost of revenues 8.6 8.8 10.4 13.2 17.2 22 25.7 28.2 35.1 45.6 R & D 2.8 2.8 3.8 5.2 6.1 7.1 9.8 12.3 13.9 16.6 Sales and marketing expense 1.9 2.0 2.8 4.6 5.5 6.6 8.1 9.0 10.5 12.9 General and admin. expense 1.8 1.7 2.0 2.7 3.5 4.4 5.9 6.1 7.0 6.9 Income from operations 6.6 8.3 10.4 11.7 13.8 15.4 16.5 19.4 23.7 26.1a Other income 0.3 0.1 0.4 0.6 0.6 0.5 0.8 0.3 0.4 1.0 Income before income taxes 5.9 7.1 10.8 12.3 14.5 15.9 17.3 19.7 24.2 27.2 Net income 4.2 6.5 8.5 9.7 10.7 12.9 14.4 16.3 19.5 12.7 Cash and marketable securities 28.4 24.5 35.0 44.6 48.1 58.7 64.4 73.1 86.3 101.9 Long-term liabilities 1.2 1.7 1.6 5.5 7.7 7.7 9.8 7.8 11.7 20.6 Total stockholders’ equity 28.2 36.0 46.2 58.1 71.7 87.3 104.5 120.3 139.0 152.5 Notes: a Operating income was reduced in 2017 by a European Union fine of $2.7 bn. Source: Alphabet Inc. and Google Inc. 10K reports. 596 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS the time it was content to make small acquisitions. Owning one of the world’s most valuable brands (Google) and the world’s two most visited websites (google.com and youtube.com), Alphabet commanded attention in any market it chose to enter. The holding company structure of Alphabet would allow greater autonomy and flex- ibility for the individual subsidiaries, but would the loss of integration undermine the organizational capabilities that had made the company so successful? Commenting on the transition from Google to Alphabet, the Financial Times observed: “Further down the organization, life gets more compartmentalized. It is not obvious that working in a silo at Company XYZ, ‘an Alphabet subsidiary’, is as attrac- tive as working on complex issues across today’s Google.”13 Two years later, Fortune confirmed these fears, noting that the creation of Alphabet has “changed what it means to work for Google. Some grumble that their role now is to subsidize innovation at their sister companies, rather than to innovate themselves. ...That’s a striking shift, especially for high-performing employees accustomed to moving about the company almost at will.”14 The Future of Alphabet Soon after Google’s reincarnation as Alphabet, Forbes contributor, Ken Favaro, argued that Alphabet had failed to address the fundamental question of corporate strategy: “How does the company itself add value to its particular businesses and ventures?” As a result, Alphabet’s “strategy remains as opaque as ever.” In terms of the managerial effectiveness, lack of strategic clarity may translate into loss of “coherence, insight, and resilience” such that corporate development will “inevitably amount to a random walk that can only be rationalized ex post.”15 These issues were especially pertinent in relation to Alphabet’s “Other Bets.” Business Insider’s Steve Kovach noted: The hope was that one of these Other Bets would become the next multibillion-dollar tech company and help diversify parent company Alphabet’s revenue sources beyond Google’s digital ads business. But this grand vision was always laden with some unan- swered and uncomfortable questions: What does a successful Other Bet look like? When will one of those companies graduate from a mere “bet” to a winner that can stand on its own? Are they supposed to reach a point where they’re big enough to spin out into a separate company outside Alphabet?16 Revealing the dire financial performance of Alphabet’s Other Bets (see Table 4) had increased the tensions between Alphabet’s technological ambitions and responsibilities to investors. These tensions appear to have been a factor in the high turnover of senior managers in the Other Bet companies: [T]he heads of some of Alphabet’s Other Bets, or of divisions that were on track to become Other Bets, were frustrated by the Alphabet structure... They signed up with the promise of being CEOs running their own startups, but were instead constrained from the top by Alphabet’s CFO Ruth Porat, who controlled funding, as well as by the whims of Google cofounders Larry Page and Sergey Brin...The vision of Alphabet was to create nimble startups, but many of the entrepreneurs tasked with leading these startups concluded that they had better prospects of accomplishing their goals outside Alphabet than within.17 http://google.com http://youtube.com CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 597 In principle, the holding company structure had conferred greater autonomy to the businesses, giving them greater freedom to develop and grow. This would resolve many of the problems arising from Google’s increasing size and complexity. By 2018, Google had 88,110 employees, up from 16,805 ten years earlier—inevitably this strained Google’s famously informal management processes. Yet, the impact of the decentraliza- tion in taking pressure off top management would be offset by the increasing external pressures that Alphabet faced in 2018. Concerns over Google’s market power had resulted in antitrust investigations in the European Union, India, South Korea, Brazil, and Argentina. In 2017, the European Commission imposed a fine of €2.42 bn. for anticompetitive practices regarding Google’s display and ranking of shopping search results. It was also investigating Android distri- bution practices and Google’s syndication of AdSense. Privacy issues were another area where Alphabet faced regulatory and legal threats. Pri- vacy advocates and political activists have long expressed concern that Google’s ability to track individuals’ search and browsing behavior, the content of their Gmail messages, and, through Android, their cell phone usage and locations, represented a threat to individual privacy. Initiatives to restrict Alphabet’s use of individuals’ data included the European Court’s “right to be forgotten” judgement in 2014, which allowed individuals to require that Google removed search results about them, the European General Data Protection Reg- ulation to protect personal data, and a similar measure under consideration in California. Alphabet’s vulnerability to concerns over privacy was highlighted by the crisis that engulfed Facebook in March 2018 over its release of personal data to Cambridge Analytica.18 One indication of growing regulatory and political pressures that Alphabet faced was its growing presence in Washington, DC. In 2017, Alphabet spent more on lobby- ing than any other company. Competition provided another dimension of Alphabet’s increasingly complex external environment. As the company diversified from search into an ever-increasing range of activities, so it came into competition with a widening range of rivals. In advertising, Facebook was its closest competitor; in mobile platforms and online payment systems, it was Apple; in browsers, computer operating systems, and office software, Microsoft; in home automation, Amazon and Honeywell; in autonomous driving, Tesla, Uber, Ford, and General Motors; in cloud computing, all the major IT companies. Competing with multiple companies on multiple fronts meant that Alphabet could not operate as a set of quasi-autonomous companies. TABLE 4 Alphabet Inc.: Financial results of business segments, 2015–2017 2015 2016 2017 Google Revenues 74,544 89,463 109,652 Operating income 23,319 27,892 32,908 Capital expenditures 8868 9417 12,605 Other Bets Revenues 445 809 1203 Operating income (3456) (3578) (3355) Capital expenditures 850 1385 507 Source: Alphabet Inc. 10K report for 2017. 598 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Notes 1. https://www.google.com/about/philosophy.html, accessed March 22, 2018. 2. “FT Interview with Google Co-founder and CEO Larry Page,” Financial Times (October 31, 2014). 3. “Google’s Growing Identity Crisis,” ( July 19, 2009), http:// www.mercurynews.com/ci_12853656?IADID, accessed July 20, 2015. 4. “The New GE: Google, Everywhere,” Economist ( January 18, 2014). 5. Google Inc. 10K Report for 2008: 4. 6. “Inside Chrome: The Secret Project to Crush IE and Remake the Web,” Wired (October 16, 2008). 7. “Google Reveals Project Brillo and Weave to Power Inter- net of Things,” Fast Company (May 28, 2015). 8. “Why Facebook Is a Threat to Google’s Earnings,” (April 12, 2012), http://www.cnbc.com/id/47030496, accessed July 20, 2015. 9. E. Schmidt and J. Rosenberg, How Google Works (London: J. Murray, 2014): 17. The new structure would also facilitate adding new businesses—either by acqui- sition or internal development—thereby setting the scene for further diversification. This raised concerns among investors as to whether the new company would provide greater opportunity for Page and Brin to pursue their ambitions of using technology to change the world. In an interview with the Financial Times in October 2014, Larry Page declared, “The societal goal is our primary goal,” and outlined the main challenge as: “How do we use all these resources ... and have a much more positive impact on the world?” The answer seemed to be to use the money generated by Google’s search advertising business to make bets on technologies that offered long-term solutions to some of the world’s most pressing problems. Many of these initiatives grew out of the curiosity and personal interests of the two founders. For example, the inspiration for Calico came from the interests of Larry Page’s wife, Lucy, in bioinformatics and the dis- eases of old age. Beyond the notion of creating a “21st century, technology-based conglomerate,” there was little indication of the boundaries that would be established around Alpha- bet’s ambitions or its activities. Forbes contributor Dan Diamond pointed to healthcare as a major area of future growth for Alphabet. The implications of the new company for Google’s core search and advertising business were far from clear. While investors hoped the holding company structure would allow greater transparency and bottom-line focus for management, there was limited evidence to support this optimism. The new Google subsidiary would include YouTube and Android; there was no indication that financial data would be available for the individual lines of businesses within Google. Nor was it clear what the new structure would mean for the company’s ability to address the challenges it faced from competitors and regulators. One regulatory challenge was antitrust: Google’s dominant share of Internet search and Android’s share of mobile operating systems meant it was a monopoly in terms of the compe- tition laws of many countries of the world. The other was privacy: concerns included the scanning of emails sent through Gmail, the use of cookies to track an individual’s search history, the aggregation of an individual’s data across Google’s various services, the depiction of private residences on Google’s StreetView, and the release of user data to national government agencies. Given the breadth of the challenges Google faced, had the time come for Google’s leading trio—CEO and founder Larry Page, founder and director Sergey Brin, and exec- utive chairman Eric Schmidt—to scale back Google’s ambitions and draw boundaries around Google’s corporate strategy? CASE 19 GOOGLE IS NOW ALPhABET—BuT WhAT’S ThE CORPORATE STRATEGY? 599 10. “Google X and the Science of Radical Creativity,” The Atlantic (November 2017). 11. Letter from the Founders, “An Owner’s Manual,” for Google’s Shareholders, http://investor.google.com/ipo_ letter.html, accessed July 20, 2015. Reproduced with per- mission from Google Inc. 12. G. Hamel, The Future of Management (Boston: Harvard Business School Press, 2007). 13. “Google: hacking the structure,” Financial Times (August 11, 2015). 14. http://fortune.com/2017/06/27/google-alphabet-corporate- structure/, accessed March 23, 2018. 15. https://www.forbes.com/sites/kenfavaro/2015/09/07/ still-searching-for-the-strategy-in-alphabet-nee- google/#16a0a49b6601, accessed March 23, 2018. 16. http://www.businessinsider.com/is-alphabet-other-bets- strategy-doomed-to-fail-2018-2, accessed March 23, 2018. 17. Ibid. 18. “Facebook and Democracy: The Anti-social Network,” Economist (March 24, 2018). http://investor.google.com/ipo_letter.html https://www.forbes.com/sites/kenfavaro/2015/09/07/still-searching-for-the-strategy-in-alphabet-neegoogle/#16a0a49b6601 Case 20 Restructuring General Electric The appointment of Larry Culp as the chairman and CEO of the General Electric Company (GE) on October 1st, 2018 was a clear indication of the seriousness of the problems that had engulfed the company. Culp, the former CEO of the highly-successful conglomerate, Danaher Corporation, had been appointed a GE director only six months previously and was the first outsider to lead GE—every one of GE’s previous CEOs had been a career manager at the company. On the same day as Culp’s appointment, GE abandoned its earning guidance for the year and announced a $23 billion accounting charge arising from a write-down of goodwill at its troubled electrical power division.1 Culp’s predecessor, John Flannery had been CEO for a mere 14 months—a sharp contrast to GE’s two previous CEOs: Jeff Immelt (16 years) and Jack Welch (20 years). Flannery’s tenure at GE has coincided with of the company’s most difficult periods in its entire 126-year history. In November 2017, amidst deteriorating financial performance, Flannery announced a halving of GE’s quarterly dividend, the proposed sale of its lighting and locomotive units—two of GE’s oldest businesses—and the elimination of 12,000 jobs in the power division. In 2018, the situation worsened. In January, GE announced that it would be paying $15 bn. to cover liabilities at insurance companies it had sold 12 years previously. In February, GE confirmed suspicions over its dubious accounting practices by restating its revenues and earnings for the previous two years, while also announcing the likelihood of legal claims arising from its its subprime mortgage lending over a decade earlier. The outcome was a precipitous fall in GE’s share price (see Figure 1) that culminated in GE’s dismissal from the Dow Jones Industrial Average (DJIA). Until June 2018, GE was the sole surviving member of the DJIA when it was created in 1896. The crisis at GE presented the board with two central questions. First, should GE be broken up? Second, if GE was to continue as a widely-diversified company, how should it be managed? As a diversified corporation that extended from jet engines, to oil and gas equipment, to healthcare products, to financial services, GE was an anomaly. For three decades, con- glomerates—diversified companies comprising unrelated or loosely related businesses— had been deeply unfashionable. CEOs, Jack Welch and Jeff Immelt, had claimed that, by virtue of its integrated management system and knowledge sharing among its busi- nesses, GE was not a conglomerate. The stock market seemed to agree—for decades GE was able to defy the “conglomerate discount” that had been the trigger for many widely-diversified companies to unbundle. GE’s ability to flout conventional wisdom rested on its status as one of the world’s best-managed companies. In the first 10 years of Fortune’s ranking of the world’s most admired companies (1998–2007), GE topped the list seven times. By 2018, GE’s dismal financial performance (see Table 1), poor top-level decision-making, and dubious financial practices have reduced that reputation to tatters. During summer 2018, Flannery provided a partial answer to the question of whether the company should be broken up: GE would spin off its Transportation and Healthcare divisions and its oilfield services business, Baker Hughes, A GE Company (BHGE). This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 601 TABLE 1 General Electric: Selected financial data, 2010–2017 ($bn unless otherwise indicated) 2017a 2016a 2015a 2014b 2013b 2012b 2011b 2010b GE consolidated Revenues 122.1 123.7 117.4 148.6 146.0 146.7 147.3 150.2 Net earnings (7.8) 8.8 (6.1) 15.3 15.2 14.6 14.2 11.6 R & D expenditurea 4.8 4.8 4.2 4.2 4.6 4.5 5.4 4.9 Cash flow from operating activities 10.4 (0.2) 19.9 27.5 29.0 31.0 33.4 36.1 Cash from (used in) investing activities 2.3 49.2 59.5 (5.0) 29.1 11.3 19.9 32.4 Return on average equity (8.7%) 10.9% 1.6% 11.6% 12.2% 12.1% 11.9% 12.1% Stock price range ($) 17.25–31.84 27.10–33.00 19.37–31.49 27.94–23.69 28.09–20.68 23.18–18.02 21.65–14.02 19.70–13.75 Total assets 377.9 365.2 493.1 648.3 656.6 681.7 717.2 747.8 Long-term borrowings 108.6 105.1 144.7 200.4 221.7 236.1 243.5 293.3 Total employees (thousands) 313 295 333 305 307 305 301 287 GE data (industrial businesses) Short-term borrowings 14.5 20.5 19.8 3.9 1.8 6.0 2.2 0.5 Long-term borrowings 67.0 58.8 83.3 12.5 11.5 11.4 9.4 9.6 Shareowners’ equity 64.3 75.8 98.3 128.2 130.6 123.0 116.4 118.9 Total capital invested 166.8 159.5 205.7 145.3 144.8 141.3 129.0 133.1 Return on average capital invested 2.7% 25.4% 16.9% 10.6% 11.3% 11.7% 11.6% 11.8% (Continues) 60 55 50 45 40 35 30 25 20 15 10 2000 2005 2010 2015 FIGURE 1 General Electric share price, March 1998 to March 2018 ($) Sources: General Electric Shareowners Meeting, April 25, 2012 and Annual Letter to GE Shareholders: 2014. 602 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS Although Culp had endorsed this restructuring of GE’s business portfolio, the board’s decision to fire Flannery and appoint him CEO was a clear indication that these mea- sures were not enough. Culp would need to answer the fundamental questions relating to the identity and strategic rationale of GE. If GE really did add value to its constituent businesses, why divest these major divisions? If the synergies among GE’s businesses really were illusory, then why not break up GE entirely? The History of GE GE was created in 1892 from the merger of Thomas Edison’s Electric Light Company with the Thomas Houston Company. Its business was based upon exploiting Edison’s patents relating to electricity generation and distribution, light bulbs, and electric motors. Throughout the 20th century, GE was not only one of the world’s biggest industrial corporations but also “a model of management—a laboratory studied by business schools and raided by other companies seeking skilled executives.”2 Each of GE’s chairmen contributed to the development of GE’s management system, and these contributions diffused well beyond GE’s corporate boundaries: ● Charles Coffin (1892–1922) married Edison’s industrial R&D laboratory to a business system capable of turning scientific discovery into marketable products. ● Ralph Cordiner (1950–63), assisted by Peter Drucker, established GE’s  Crotonville management development institute and decentralized GE’s operational management to 120 departmental general managers. ● Fred Borsch (1963–72), devised GE’s corporate planning system based on stra- tegic business units and guided by portfolio management techniques, which became a model for most diversified corporations. ● Reg Jones (1972–81) integrated strategic planning with financial control to create a comprehensive system for the corporate headquarters to manage its businesses. 2017a 2016a 2015a 2014b 2013b 2012b 2011b 2010b Borrowings as % of capital invested 48.9% 49.7% 50.1% 11.2% 9.2% 12.4% 9.0% 7.6% GE capital data (financial services) Revenues 9.1 10.9 10.8 42.7 44.1 45.4 49.1 49.9 Net earnings (7.1) (2.2) (15.8) 7.2 6.2 6.2 16.5 2.2 Shareowner’s equity 13.5 24.7 46.2 87.5 82.7 81.9 77.1 69.0 Total borrowings 95.2 117.3 180.2 349.5 371.1 397.0 443.1 470.5 Ratio of debt to equity 7.06:1 4.75:1 3.90:1 3.99:1 4.49:1 4.85:18 5.75:1 6.82:1 Total assets 156.7 183.0 316.0 500.2 516.8 539.4 584.5 605.3 Notes: a As reported in 2017 financial statements. b As reported in 2014 financial statements. TABLE 1 (Continued) CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 603 ● Jack Welch (1982–2001) had energized GE by stripping out layers of hierarchy, introducing a rigorous, and demanding performance management system based on stretch targets and powerful incentives for their achievement, and spear- headed a series of initiatives designed to root out complacency and to drive change.3 Welch reformulated GE’s business portfolio through exiting low-growth extractive and manufacturing businesses and by expanding services—financial services in particular. By the time he retired, GE was “a bank disguised as an industrial conglomerate.”4 ● Jeff Immelt (2001–17) returned GE to its manufacturing roots through divesting its financial service and entertainment businesses, and increasing integration among the industrial businesses through sharing technology, increasing global presence, and exploiting synergies in sales and marketing. GE’s Business Portfolio In a world of turbulence, GE had always viewed its diversified portfolio of businesses as a source of stability over the business cycle. In 2015, Jeff Immelt stated: “Diversity provides strength through disruptive events and commodity cycles,” thereby consti- tuting a key “source of value from a multibusiness company.”5 The guiding theme of Immelt’s restructuring of GE’s portfolio of businesses was exploitation of profitable opportunities for long-term growth. Immelt identified four global trends of key importance to GE: ● Demography: The aging of the world’s population would create opportunities for goods and services required by older people—healthcare especially. ● Infrastructure: GE anticipated massive investments in infrastructure including energy, water, and transportation. ● Emerging markets would offer rates of GDP growth around three times those of the world as a whole. ● Environment: The problems of global warming, water scarcity, and conservation required new technologies and innovative business responses. The outcome was to recreate GE as an infrastructure company—a diversified cor- poration directed toward global needs for aviation, rail transportation, power genera- tion and distribution, oil and gas production, and medical hardware. Figure 2 shows Capital Finance 25% Infrastructure 75% Plastics, Media 20% Infrastructure 41% Capital Finance 24% Capital Finance 43% Infrastructure 34% Plastics, Media 15% 2001 2005 2016 Insurance 15% Insurance 8% FIGURE 2 The changing balance of General Electric’s business portfolio 604 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS Immelt’s depiction of GE’s changing business composition. During his 16-year tenure, Immelt reconfigured GE through the acquisition of infrastructure-related companies and the divestment of consumer and financial service businesses. Table 2 shows GE’s principal acquisitions and divestitures during 2004–17. TABLE 2 General Electric’s principal acquisitions and disposals, 2004–17 Year Acquisitions Disposals 2004 Acquires entertainment assets of Vivendi Universal for $12 bn. to form NBC Universal (80% owned by GE). GE Healthcare buys Amersham PLC for $9.5 bn. GE Capital acquires Dillard’s credit card unit for $1.25 bn. GE Security acquires InVision Technologies (airport security equipment). Life and mortgage insurance spun off as Genworth Financial. 2005 GE Commercial Finance acquires the financial service business of Bombardier for $1.4 bn. 2006 GE Healthcare acquires IDX Systems, a medical software firm, for $1.2 bn. GE Water & Process Technologies acquires Zenon Environmental Systems for $758 mn. GE Advanced Materials sold for $3.8 bn. GE Insurance Solutions and GE Life sold for $6.5 bn. 2007 GE Aviation acquires Smiths Aerospace for $4.6 bn. GE Oil & Gas acquires VetcoGray for $1.4 bn. GE Plastics is sold to Saudi Arabia Basic Industries for $11.7 bn. 2008 NBC Universal buys Weather Channel for $3 bn. GE Capital acquires Merrill Lynch Capital, CitiCapital, and Bank BPH. 2010 GE Healthcare acquires Clarient for $0.6 bn. 2011 GE Oil and Gas acquires Dresser Inc. ($3 bn.), Wellstream PLC ($1.3 bn.), and the well support division of John Wood Group PLC ($2.9 bn.). 51% of NBC Universal sold to Comcast for $13.8 bn. GE Capital sells Mexican assets to Santander. 2012 GE Capital acquires $7 bn. bank deposits from MetLife. 2013 Buys oilfield pump maker, Lufkin Industries, for $3.1 bn. Remaining 49% of NBC Universal sold to Comcast for $16.7 bn. 2015 Acquires Alstom S.A.’s power business for $13.1 bn. GE Antares Capital (private equity) $12.0 bn. GE Capital (vehicle services) $6.9 bn. GE Capital (transport finance) $8.9 bn. GE Capital (lending & leasing) to Wells Fargo for $26.5 bn. Synchrony (credit cards) for $21.6 bn. 2016 Sale of GE Appliances to Qingdao Haier for $5.4 bn. 2017 Acquires 62.5% of Baker Hughes (for $32.4 bn.), merges it with GE Oil and Gas. GE Water & Process Technologies sold to Suez for $3.4 bn. Sources: General Electric press releases and Wall Street Journal. CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 605 Shrinking GE Capital was a massive challenge given its size and contribution to GE’s profitability. Despite Immelt’s commitment to downsizing GE Capital, it continued to grow during 2001–07. In 2006 and 2007, GE Capital accounted for almost half of GE’s total net profit (up from 25% in 2001). Only after the financial crisis of 2008–09 did GE take drastic action to divest financial services. The designa- tion of GE Capital as a “systemically important financial institution” in 2013, which raised its capital reserve requirements, eliminated any competitive advantages it had derived from being a nonbank supplier of financial services.6 The only businesses that GE Capital retained were “vertical financial businesses”—those linked to GE’s core industrial businesses. At the beginning of 2018, GE comprised eight major sectors. Table 3 shows these sectors’ financial performance. Exhibit 1 describes their business activities. TABLE 3 General Electric segment financial results, 2013–2017 2017 2016 2015 2014 2013 Revenues ($mn.) Power 35,990 36,795 28,903 27,746 26,770 Renewable Energy 10,280 9033 6273 6399 4824 Oil & Gas 17,231 12,898 16,450 19,085 17,341 Aviation 27,375 26,261 24,660 23,990 21,911 Healthcare 19,116 18,291 17,639 18,299 18,200 Transportation 4178 4713 5933 5650 5885 Lighting(a) 1987 4823 8751 8404 8338 Total industrial segment revenues 116,157 112,814 108,609 109,574 103,269 GE Capital 9070 10,905 10,801 11,320 11,267 Total segment revenues 125,227 123,719 119,410 120,894 114,536 Segment profit Power 2786 5091 4772 4731 4437 Renewable Energy 727 576 431 694 485 Oil & Gas 220 1392 2427 2758 2357 Aviation 6642 6115 5507 4973 4345 Healthcare 3448 3161 2882 3047 3048 Transportation 824 1064 1273 1130 1166 Lighting 93 199 674 431 381 Total industrial segment profit 14,740 17,598 17,966 17,764 16,220 GE Capital (6765) (1251) (7983) 1209 401 Total segment profit 7975 16,347 9983 18,973 16,621 (Continues) 606 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS TABLE 3 (Continued) 2017 2016 2015 2014 2013 Operating Margins (%) Power 7.74 13.84 16.51 17.05 16.57 Renewable Energy 7.07 6.38 6.87 10.85 10.05 Oil & Gas 1.28 10.79 14.75 14.45 13.59 Aviation 24.26 23.29 22.33 20.73 19.83 Healthcare 18.04 17.28 16.34 16.65 16.75 Transportation 19.72 22.58 21.46 20.00 19.81 Lighting(a) 4.68 4.13 7.70 5.13 4.57 Total industrial segment 12.69 15.60 16.54 16.21 15.71 GE Capital –74.59 –11.47 –73.91 10.68 3.56 Total 6.37 13.21 8.36 15.69 14.51 Note: (a)  Lighting includes Appliances before 2017. Source: General Electric, 10K report for 2017. EXHIBIT 1 General Electric’s business segments, January 2018 GE Power. The acquisition of Alstom had made GE the world’s biggest supplier of equipment for generating and distributing electricity. GE Power was also GE’s big- gest division with 83,500 employees in 2017. It supplied gas turbines, steam power systems, power plants, main- tenance and service solutions for power generation, industrial gas engines for power generation, nuclear reactors and fuel (GE Hitachi Nuclear), electricity trans- mission and distribution systems, and electric motors. During 2017, GE Power was hit by a decline in world- wide demand and made a loss of $0.9 bn. arising from a write-down of inventory. GE Renewable Energy employed 24,000 people in 2017 and was one of the world’s top-five suppliers to the wind power industry, supplying wind turbines and related hardware, software, and services for both onshore and offshore generation. GE was a world-leader in wind generation technology: its Haliade-X wind turbine, launched in March 2018, is 260-m tall and can generate 12MW. GE Renewable Energy also supplies products and services to the hydropower industry. GE Oil and Gas, with 64,000 employees in 2017, had been built by multiple acquisitions between 2007 and 2016. By merging with Baker Hughes, it created Baker Hughes, A GE Company (BHGE), the world’s second biggest oilfield services supplier after Schlumberger. Its products include drilling equipment, oilfield fluids and chemicals, pumps, pressure control equipment, subsea production systems, flexible pipeline systems, equip- ment for production platforms, and products for refining and petrochemicals. Oilfield services include well eval- uation, drilling, downhole completion, wellbore inter- vention, wireline services, and decommissioning. Profits declined in 2017 due to reduced capital expenditure by oil and gas companies and restructuring costs arising from the acquisition. CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 607 Planning for a New General Electric During his 14 months as CEO, John Flannery had taken a systematic approach to GE’s restructuring, making it clear that a wide range of strategic options for GE were under consideration: “That assessment is continuing and focuses on maximizing value, all options on the table, no sacred cows.” The corporate review “could result in many, many different permutations, including separately traded assets really in any one of our units, if that’s what made sense.”7 Any restructuring of GE would need to address two major questions: What were the sources of GE’s current problems? and, did GE add value to its constituent businesses or destroy it? The Sources of GE’s Problems Analyses of what had gone wrong at GE were plentiful. Most of these focused on the role of Flannery’s predecessor, Jeff Immelt, and some traced the problems further back to the Welch era. GE Aviation, with 44,500 employees in 2017, was the world’s leading supplier of jet engines (together with avionics systems and after-market services). GE Aviation’s 40-year-old joint venture with Safran of France, CFM International, supplies its highly successful LEAP engine for which there was an order backlog of 12,550 at the beginning of 2018. GE’s GE9X engine, built using light- weight carbon fiber and 3-D printing, which is to be launched in 2018, is the world’s biggest turbofan engine. GE Healthcare, with 52,000 employees, is the world’s leading supplier of diagnostic imaging systems using X-rays, digital mammography, computed tomography, magnetic resonance, molecular imaging, and ultrasound. It also provides systems for patient monitoring, infant incubation, respiratory care, anesthesia, and cellular and gene therapy. GE Transportation, with 8000 employees in 2017, supplies diesel-electric locomotives together with support services, parts, software solutions, and data analytics. It also supplies diesel engines and drive sys- tems to the shipping and mining industries. Despite GE’s technical leadership in locomotives, the world market was dominated by CNR and CSR of China. Following them was CLW of India and Bombardier of Canada. In May 2018, the merger of GE Transportation with US rail equip- ment manufacturer, Wabtec Corp, was announced. The combined company would be owned 49.9% by Wabtec shareholders, 40.2% by GE shareholders, and 9.9% by GE. GE Lighting, with 7500 employees in 2017, is com- prised of a consumer lighting business focused on LED lighting; and Current, which provided lighting solutions for commercial, industrial, and municipal customers. At the end of 2017, the business was put up for sale and a management buyout had been agreed upon for GE Lighting’s business in Europe, Middle East, and Africa. GE Capital, with 4000 employees in 2017, had been reduced to financial services that were closely aligned with GE’s industrial businesses. These included Industrial Finance, providing equipment financing for the health- care and additive businesses; Energy Financial Services, which offers financial solutions and underwriting for Power, Renewable Energy, and Oil & Gas; and GE Capital Aviation Services, the world’s biggest aircraft leasing company. During 2018, its Industrial Finance and Energy Financial Services would be shrunk considerably. How- ever, it continued to be haunted by its past—during 2008–14, it would pay $15 billion to top-up the reserves deficiencies of previously-owned insurance companies. 608 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS It was clear that Immelt was guilty of decision-making errors—particularly with regard to timing. Criticisms focused in particular on the following: ● Ill-judged acquisitions. Several commentators pointed to GE overpaying for the companies it acquired. The principal evidence of this related to Alstom. During the long delay in gaining approval for the acquisition, the market for power-generating equipment took a downturn, and GE was forced to offer more concessions to Alstom and the French government. Hence, by the time the acquisition closed, Alstom was worth considerably less than the price GE was paying. Timing was also amiss for several of GE’s acquisitions in oilfield services: Dresser, Wellstream, John Wood, and Lufkin were all bought when oil prices were booming. Scott Davis of Melius Research estimated that GE’s total return on Immelt’s acquisitions were less than half of what GE would have earned by simply investing in stock index mutual funds.8 The Economist esti- mated that GE was paying much more for the businesses it bought than what it received for those it sold.9 ● Poor cash flow management. During the 21st century, GE lost its reputation for financial conservatism along with its triple-A credit rating. At the core of con- cerns over its financial management has been an erratic approach to cash-flow management. The financial crisis was, of course, unexpected, but the fact that GE was forced to obtain $3 bn. in emergency funding from Warren Buffett’s Berkshire Hathaway Inc. and $139 bn. in loan guarantees from the federal government appears not to have alerted GE to the risks inherent in GE Capital. Particular criticism has been directed at GE’s stock buyback program: in the three years prior to the dividend cut in 2017, GE spent $49 bn. on buying its own stock.10 According to the Financial Times, GE’s free cash flows from its industrial businesses failed to cover its dividend during 2015–17.11 ● Over-optimism. GE’s failure to guard itself against risk and pay adequate attention to early warning signs have been interpreted by some GE-watchers as symptoms of top-management’s overconfidence and reckless optimism. According to some current and former GE executives, Immelt and his top dep- uties engaged in “success theater”—they “projected an optimism about GE’s businesses and its future that didn’t always match the reality of its operations or its markets.”12 In particular, during 2017, when signs of flagging sales and mounting inventory were emerging at GE Power, Immelt was slow in acknowl- edging the problems. ● Problems with GE’s financial accounting. If GE had been slow to recognize and react to emerging problems, one factor might have been its accounting prac- tices, which for decades had been designed to impress Wall Street, but may also have insulated management from the reality of business performance. Under Jack Welch’s leadership, GE Capital became a valuable tool for managing GE’s quarterly earnings: “Unlike a factory, GE Capital’s highly liquid assets could be bought or sold at the ends of quarters to ensure the smoothly-rising earn- ings that investors loved.”13 Dubious accounting practices also surfaced in GE’s industrial businesses. At GE Power, sales of upgrades to make existing gas tur- bines run more efficiently were booked as current revenues, without taking into account the effects of these sales would have on reducing future service revenues.14 CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 609 Does GE Add Value to Its Businesses? Ultimately, the question of whether or not GE should be broken up rested on the issue of whether GE’s corporate umbrella added or subtracted value from the businesses. At the time Culp was appointed CEO, with its share price depressed and facing a slew of legal and regulatory problems, it was likely that GE would be worth more if it was broken up and its constituent businesses either sold or floated as independent com- panies. In January 2018, the Financial Times valued GE’s constituent businesses as: Aviation at $85 bn., Healthcare at $56 bn., and Power at $36 bn. Adding other smaller businesses and subtracting debt and other liabilities (including pensions) gave a sum- of-the-parts valuation of costs, the result was something close to $158 bn. Although this was greater than GE’s market capitalization, the Financial Times cautioned that: “It does not look as though there is a pot of gold there waiting to be uncovered.”15 Previous CEOs, Immelt and Welch, had argued that GE created value for its busi- nesses through several mechanisms. These were: 1 Reducing risk. According to Immelt: “The GE portfolio was put together for a purpose—to deliver earnings growth through every economic cycle. We’re con- stantly managing these cycles in a business where the sum exceeds the parts.”16 To the extent that GE’s business diversity did smooth its overall cash flows, then it seemed that the major benefit of this was giving GE greater independence from external financing. 2 Portfolio management. Both Welch and Immelt had radically changed and reconstituted GE’s business portfolio. Welch had built a huge financial services business; Immelt had re-created GE as an industrial corporation heavily focused on infrastructure. The rationale was to exit slow-growing, low-margin sectors to exploit the growth and profit opportunities of more attractive industries. In building GE’s presence in jet engines, medical equipment, and systems for gener- ating and distributing electricity, Immelt was widely perceived as having aligned GE’s businesses with long-term global growth trends. However, The Economist’s Schumpeter column doubted the effectiveness of portfolio management in cre- ating value: “The cost of churning capital in predictable ways can be significant ... GE has paid a multiple of 13 times gross operating profits for the businesses it has bought and got 9 times for those it sold. Some nine-tenths of its industrial capital is now comprised of goodwill, or the premium that a firm paid above book value for its acquisitions.”17 For portfolio management to work well, corporate management must be willing to exit businesses whose long-term prospects are deteriorating. This is easier for a private equity firm than for a diversified industrial corporation where long- established businesses are likely to be protected by sentimental attachment and entrenched political power. A feature of Immelt’s leadership was the long length of time it took to exit from financial services and domestic appliances. 3 Exploiting synergies. A central theme of Immelt’s 16-year tenure as CEO was building and exploiting linkages among GE’s different businesses. While Welch had been a passionate advocate of knowledge sharing within GE, Immelt’s emphasis was on putting in place the systems for such sharing to take place. Sharing technology was the priority. Under Immelt’s leadership, GE built a net- work of eight Global Research Centers. By 2015, GE had 37,000 technologists 610 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS engaged in R & D within its businesses and its corporate research centers. Corpo- rate-level research programs addressed technologies with applications to multiple businesses. These included molecular imaging and diagnostics, nanotechnology, energy conversion, advanced propulsion, sustainable energy, and security tech- nologies. The greatest importance was attached to establishing GE’s leadership in “the Internet of things”—the “interface of the physical and digital worlds ... through combining data and physics.” This involved the use of the continuous data from embedded sensors on jet engines, locomotives, oil and gas equipment, medical diagnostic, electricity generators, and so on, as an input to the software that managed maintenance schedules, fuel optimization, accident prevention, factory automation, and enterprise management. In 2011, GE opened a new software center in San Ramon, CA to develop applications of big data and artificial intelligence that would lead GE’s digital transformation. The new software center formed the centerpiece of GE Digital, a new business division created in September 2015 that “brings together all of the digital capabilities from across the company into one organization.”18 GE Digi- tal’s efforts focused on the development of its Predix platform, a cloud-based operating system for industrial applications that uses sensor-generated data within a next-generation industrial automation system. However, during 2016 and 2017, problems with the Predix platform had increased its development costs and slowed its rollout to third-party customers. As a result, in February 2018, Flannery announced narrowing the focus of GE’s digital business and targeting existing customers with its Predix operating system.19 Sales and marketing provided another rich area for cross-business synergies. Increasingly, GE bundled products and support services to offer customized “customer solutions.” In the case of a new hospital development, for example, there might be opportunities not just for medical equipment but also for lighting, turbines, and financing. Such opportunities were particularly impor- tant internationally. In 2009, GE launched its “Company-to-Country” strategy to build relationships with host governments across multiple infrastructure development projects. This strategy involved looking beyond China, India, and Brazil; in 2012, GE announced that “Nigeria should be our next billion-dollar country.”20 4 The GE management system. The management system that Larry Culp inherited was—despite its restructuring by Jack Welch and reformulation by Jeff Immelt—a product of 120 years of continuous development. Many of its processes were so deeply embedded within GE’s culture that they were inte- gral to its identity and world view. At the core of GE’s management system were management development—its “talent machine”—and its system of performance management. GE’s commitment to leadership development was indicated by its reli- ance on internally developed senior executives. Its effectiveness in devel- oping leaders had given it the status of a “CEO factory”—former GE managers are chief executives of companies throughout the world. Key components of its management development system were its corporate university at Crotonville, New York, and its “Session C” system for tracking managers’ performance, planning their careers, and formulating succession plans for every management position at GE from department heads upward. Did Culp’s appointment as CEO imply that GE had lost faith in its management development capability? CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 611 GE’s performance management system was based heavily on objective, quantitative performance measures: “Nothing happens in this company without an output metric,” observed Immelt. Managers were set demanding performance targets, then given strong incentives for their attainment. However, while many performance variables—revenue, profits, quality, safety—where conducive to quantification, many of the performance variables that had been emphasized by Immelt—innovation, cross-selling, knowledge sharing—were much more difficult to quantify and monitor. If, as Immelt had claimed, GE’s performance depended upon integration—“Our managers have to work cross-function, cross-region, cross-company”21—then its performance management system needed to provide the right incentives for such collaboration. Which Corporate Model for GE? As Larry Culp considered the restructuring initiatives that were currently underway—the merger of GE’s Transportation division with US railroad equipment producer, Wabtech Corporation to create a jointly-owned company and the spin off of GE Heathcare and BHGE (Baker Hughes) as separately quoted companies with their shares distributed to GE shareholders—he pondered the type of company that GE should become. The obvious model was that of Danaher. Danaher was a widely-diversified, technology- based company built through acquisition. Its strong performance was the result of the application of a common set of management principles and processes based upon lean production and continuous improvement (kaisen)—the “Danaher Business System”— to carefully selected acquisitions. Although Danaher’s portfolio of over 100 businesses were clustered in four main areas: life sciences, diagnostics, dental, water quality, and product identification, Danaher did not attempt to create the huge integrated divisions that GE possessed.22 An alternative model was the business system created by Siemens AG. The German giant had a similar background and profile to GE: it was founded in the late 19th century and its biggest businesses were power generation systems (including wind power), medical equipment, and industrial automation. However, unlike GE, Siemens had moved toward greater decentralization rather than GE’s path of closer integration. Siemens’ CEO, Joe Kaeser, described the Siemens model as a “fleet of ships” with divi- sions becoming semiautonomous and separately listed. Siemens’ medical equipment unit, Healthineers, was listed in March 2018. Like GE, Siemens’ had suffered from the sharp reduction in world demand for gas turbines—however, the fall in revenues and profits in its power division was much less than that experienced by GE. During the three years to June 2018, Siemens share price increased by 22%; that of GE’s fell by 48%. APPENDIX: Extracts from General Electric Company Update, June 26, 2018 As you know, we have been working to determine the appropriate longer term stra- tegic focus for GE. There are three essential elements of this strategy: one is focusing our portfolio for growth and shareholder value creation; the second is strengthening our balance sheet; and the third is a market shift in how we run the company. With respect to our portfolio, our Aviation, Power and Renewables businesses will be the core of GE going forward. These are three formidable franchises where we’ve 612 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS built leadership positions over many decades. These businesses also have significant strategic linkages. They share technologies, digital and additive strategies, and business models. While our core Aviation, Power and Renewable businesses can thrive inside of the current GE framework, we think substantial value can be created by moving other businesses outside of GE. To implement that strategy, we are creating a separate stand-alone Healthcare company and we also intend to fully separate BHGE. These are two strong and competitive businesses with leading positions and strong growth pros- pects but they both have various constraints operating inside the current GE construct. We believe these businesses can achieve greater results for employees, customers, and our owners as stand-alone companies. The pending merger of our Transportation business with Wabtec was driven by the same strategic approach. We will begin the process of separating our Healthcare business immediately. We will monetize approx- imately 20% and approximately 80% of Healthcare will be distributed tax free to our shareholders through a spin or split ... Oil & Gas was separated from GE in July of 2017 when we made the strategic decision to combine it with Baker Hughes. There’s strong industrial logic for the transaction, the companies are much stronger together and shareholders are getting the benefit of significant synergies both on the revenue and cost side as well as benefiting from substantial combined technology. We expect to pursue an orderly separation of the company within 2–3 years with a focus on max- imizing value for BHGE and GE. Strengthening the balance sheet of the company is a top priority for us. This will allow us the flexibility and capacity to invest in growing our core businesses going forward. We will reduce our net debt by about $25 billion, and this will bring our net debt-to-EBITDA below 2.5 times by 2020. We will run the company with a substantially higher cash balance and reduce our use of commercial paper. Our strategy with regard to GE Capital is clear, we’re making it smaller and more focused. We are reducing assets by $25 billion, and we’ll bring our debt to equity to less than 4 times by 2020. We are aggressively working on actions and alternatives to mitigate, reduce or eliminate our exposure to long-term care insurance. As I outlined at EPG, we will run GE Company in a fundamentally different way going forward. Our businesses will be the center of gravity and will run on a new operating system that we believe will improve our operations and cash performance. These changes will reduce corporate costs by at least $500 million by 2020. We expect this number to grow over time as this velocity is applied across all levels of the company. This is in addition to cost actions already announced in 2017 and 2018. In conjunction with previous actions, today’s announcement marks the emergence of a new GE, a high-tech industrial GE. A simpler, stronger and more focused company at the core, a strengthened balance sheet, a new operating system and a bright future for our Healthcare and BHGE businesses. This is a GE that is equipped to fight for the future. ... As I’ve said previously, the steps we’re taking are really a means to an end, the end being a simpler, stronger and more focused company where our quality assets can reach their true potential and flourish in the decades ahead. We sought to posi- tion the businesses in an environment guided by 4 basic principles: the maximum ability to pursue their organic and inorganic investment strategies; strong alignment for management incentives linking performance and reward; reducing complexity and cost, while improving decision-making speed; and making sure any central essential services are subject to a market test by the business units. We are fundamentally invert- ing the company to make the business units the center of gravity. I want to focus the businesses externally into the market. CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 613 We’ll have a much smaller corporate focused on strategy and execution, capital allo- cation, talent development and governance. The entire fabric of the company will be one of continuous improvement driven by operating leaders using well-proven tools, like Lean and Six Sigma. Digital and Additive strategies will continue to drive customer value and performance. We believe that these changes will yield substantial improve- ments in performance over time. There will be improved focus, better accountability, clear capital allocation decisions, more strategic optionality and better alignment of compensation. Our plan will create a strong, exciting and growing GE built on oper- ational execution and robust industrial logic. Going forward, GE will be comprised of Aviation, Power and Renewables, supported by Digital, Additive and the financing expertise of GE Capital. These are leading businesses solving the world’s toughest problems for our customers. By combining these strong franchises with a healthy balance sheet, we see numerous avenues to invest for growth. We see sustained strength and growth in Aviation going forward. We see growth in the overall Renewables market and in our expansion of market share into new areas, like offshore wind and storage. We see earnings growth in the turnaround of our Power business with 1/3 of the world’s electricity from our installed base and 2 of every 3 flights on our engines, GE is a high-tech industrial company that forms the backbone of a connected and electrifying world in every sense of those words. In addition to the strength of GE going forward, we’re also unlocking substantial value for our shareholders. GE Healthcare is a leader in the drive to more effective and more efficient health-care outcomes. BHGE is uniquely positioned across the value chain as a full stream, oil & gas company. Our merger with Wabtec creates a global leader in the rail industry. As focused pure plays, they’ll have greater strategic flexibility and more resources to pursue strategies dedicated to their industries. I want to spend a minute touching on each of these franchises. Our Aviation business is a market-leading business with industry firsts spanning back decades and our tech- nology stack has never been stronger. Both the commercial and military businesses are strong. Our fleet is young, with 61% of our engines not yet at their second shop visit. That bodes well for our service business. We’re managing well through the LEAP ramp. Despite the LEAP growth, we’re maintaining 20%-plus margins through the launch. Our military portfolio is broad and we see opportunities for growth with our next-gen technologies both in the US and internationally. We were encouraged by the strong first quarter performance, especially in services. And finally, across the whole business, we’re leveraging the strength of Additive, which is a game-changer for high-tech com- ponent manufacturing. Additive is allowing us to reset our supply chain cost entitle- ment and we’re seeing proof points across parts, systems and products. Aviation is a premier asset with over $200 billion in backlog and good visibility to long-term growth. We want to continue to invest and grow this franchise. Next is Power. While our results here have been unacceptable, this is a fundamen- tally strong franchise with leading technology, a valuable installed base and expansive global reach. GE generates about 1/3 of the world’s electricity and has about 1600 gigawatts of installed capacity. Gas, which is our largest segment, remains a key part of the world’s long-term power generation mix. GE has approximately 7000 gas turbines in our installed base and we have a 20-year plus track record that demonstrates we can improve output, reliability and performance of those assets when we service them. We are a big player in grid, equipping 90% of transmission utilities worldwide. There are certainly macro and secular challenges to this business, but we are taking actions to remediate the issues that we saw in 2017 and to right-size our cost structure for a lower heavy-duty gas turbine market in the near term. This is a turnaround story, and we are confident in our ability to improve the future operating performance. We have 614 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS a well-thought-out and detailed plan to reach the 10%-plus margins outlined at EPG. Overall, this is valuable franchise that will be run better moving forward. Our Renewables business is an important part of the energy mix. Sixty-seven percent of 2017 global power capacity additions were from renewable sources, with some sources estimating 70% of 2018–21 additions from renewable sources. We are a leading player in onshore wind, gaining market share in 2017. We are making inroads into off- shore wind and have a strong hydro business. Renewables is a competitive and evolv- ing industry but one, we think, we’re positioned well in going forward. Aviation, Power and Renewables are businesses that we feel are best positioned together to deliver results and drive shareholder value. These are all businesses marked by deep and complementary technology investment and differentiation and using that investment to grow our installed base and build high-value service stream annuities. Whether generating electricity on land or thrust in propulsion in the skies, the machines from these segments share a common core set of technologies, service platforms and global markets that make them stronger together than they would be if innovated in isolation. In fact, the first US jet engine created by GE evolved from the industrial gas turbine. While one is for power and one for flight, they both share a common architecture and operating environment that allow them to naturally have a common set of technology needs. Wind turbines, too, share many common traits. They are large spinning machines that generate megawatts of torque and power. That’s very familiar to GE. I’ll give you two examples of technology synergies. First, edge controls. For decades, we’ve devel- oped industrial controls for gas turbines, jet engines and more recently, wind turbines to ensure each operates safely and at the highest levels of performance and efficiency possible. With the exponential growth of computing power in the past decade, we’re now combining controls with digital technologies in a very powerful way to further optimize the way we operate and maintain these machines. At our global research center, we developed a common industrial operating system called [Edge OS], which works in a wind turbine, jet engine or gas turbine. A second example is material science. The LEAP engine was the first to have a rev- olutionary new material called ceramic matrix composites, or CMCs. It’s a lightweight ceramic material engineered to be as strong as metal but able to withstand much hotter temperatures. It has been a real difference maker in our LEAP product offering. The development of CMCs actually started as a project in our gas turbine business. In fact, it was because the material performed so well in the field testing with gas turbines that led us to discover it could work in jet engines as well. With polymer matrix composites, or PMCs, GE Aviation first introduced lightweight composite fan blades in the GE90 engine, and we took that knowledge and quickly adapted it for Renewable Energy’s wind blades. On the services side, we had a massive installed base across all three businesses with 65,000 aircraft engines, 7000 gas turbines, and 35,000 wind turbines. These prod- ucts all have long lives and our services business model provides a very profitable recurring revenue stream. We realized many common synergies around how to execute and manage these long-term service contracts. The markets are similar, they’re global and this is where we can tap into GE’s deep global network and experience. Digital and Additive are substantial opportunities across all 3 segments that provide benefits to enhance growth and lower cost. We are certain that with focus and a strong balance sheet, GE will be a technology- driven growth story again in the coming years. CASE 20 REStRuCtuRinG GEnERAl ElECtRiC 615 As I said before, we’ve been methodically reviewing the portfolio and looking at the best structure or structures to maximize value and position our businesses for suc- cess. We are excited about the future of GE Transportation, Baker Hughes GE, and GE Healthcare. We announced the merger of Wabtec and GE Transportation last month. We are contributing Transportation at an attractive multiple and realizing $2.9 billion of cash proceeds, while our shareholders will benefit from the compelling long-term prospects and synergies of the combined platform. The industrial logic of this deal is strong and there are good growth opportunities with GE’s installed base and services offering combining with Wabtec’s portfolio. We are beginning the process of separating Healthcare immediately and expect to complete it in the next 12–18 months. We plan to monetize approximately 20%. We expect it to have a capital structure and capital allocation aligned to its peers. As part of the transaction, we will transfer approximately $18 billion of debt and pension obligations to Healthcare. With respect to the impact this will have on future divi- dends, it’s our intention to maintain the current $0.48 dividend until the time Health- care is established as a stand-alone entity. At that time, both GE and GE Healthcare will determine their future dividends with an intended payout ratio in line with their respective industry peers. Given the typically lower payout ratios in the health-care industry, this will likely lead to a reduction in the aggregate GE dividend at that time. We like the BHGE combination. Customer reception has been positive and we’re gaining traction across product lines. The realization of synergies, both top and bot- tom line, was premised upon GE’s sharing of significant technology and expertise with BHGE. This was contracted for at the time of the merger and is going well. BHGE is well positioned to thrive as an independent company. As I said earlier, we expect to substantially exit our direct ownership of this business within 2–3 years. Running the businesses as the center of gravity is the third major point of our announcement today. We’re implementing a new way to run the company. We will focus all of our activity in the company around our businesses with a much smaller cor- porate headquarters. Corporate will focus on strategy, capital allocation, talent and gov- ernance, and we will reduce the size of corporate significantly with at least $500 million of additional corporate cost-out by 2020. As we apply the same principle to our busi- nesses, we expect incremental cost savings in the businesses during this period of time. As you know, we have historically run several organizations centrally. This will change. Centrally, run activities in shared services will be placed back in the hands of the businesses. Our business leaders will have full accountability for and ownership of their operations, and everything we do will be subject to a market test. There will be no central residual cost. Global research will now align under David Joyce. Our Global Growth Organization will be significantly smaller and focused on government relations and developing markets where we need strong resources to play its scale and manage risk. And GE Ventures will be refocused. It’ll be focused on only the most urgent mar- kets and new technologies as determined and paid for by our business leaders. Our digital strategy continues to focus on our core industries in our installed base, and we expect no cost drag from digital by 2020. We believe these actions will result in better execution, increased speed and additional cost reductions of at least $500 million. This is incremental to the more than $2 billion of cost-out we’re actioning in 2018. Source: https://www.ge.com/investor-relations/sites/default/files/ge_webcast_ transcript_06262018_0 616 CASES tO ACCOMPAnY COntEMPORARY StRAtEGY AnAlYSiS Notes 1. “GE Ousts CEO John Flannery in Surprise Move After Missed Targets,” Wall Street Journal (October 2, 2018); Lex column, “General Electric: Culp-able,” Financial Times (October 2, 2018). 2. “What Makes GE Great?” Fortune (March 6, 2006): 90–96. 3. Welch’s initiatives included: the requirement that every GE business should be #1 or #2 in its global industry; “Work-out,” a process where managers allowed their sub- ordinates to initiate organizational changes; “Six Sigma,” a total quality management program; and “Destroy your business dot.com,” an initiative to drive the adoption of ecommerce. 4. htts://seekingalpha.com/article/106445-general-electric- genuine-risk-of-collapse. Accessed March 13, 2018. 5. General Electric, 10-K report for 2014: 7. 6. “GE to Cash Out of Banking Business,” Wall Street Journal (April 11, 2015). 7. “GE Puts a Breakup on the Table,” Wall Street Journal ( January 17, 2018). 8. “How GE Went From American Icon to Astonishing Mess,” Bloomberg Businessweek (February 5, 2018). 9. “General Eclectic,” Economist (May 27, 2017). 10. “How GE Went from American Icon to Astonishing Mess,” op cit. 11. “GE’s new leader faces big call on behemoth’s dividend,” Financial Times (October 15, 2017). 12. “Success Theater Masked Rot at GE,” Wall Street Journal (February 21, 2018). 13. “How GE Went from American Icon to Astonishing Mess,” op cit. 14. “Success Theater Masked Rot at GE,” Wall Street Journal (February 21, 2018). 15. https://www.ft.com/content/eaf94308-fb4f-11e7-9b32- d7d59aace167. Accessed March 15, 2018. 16. Annual Report to Share Owners, 2002: 4–5. 17. “General Eclectic,” op cit. 18. https://www.genewsroom.com/press-rrepoirt, 2017.eleases/creation-ge-digital-281706. Accessed March 16, 2018. 19. CEO’s Letter, General Electric Annual Report, 2017. 20. “Growth as a Process: An Interview with Jeff Immelt,” Harvard Business Review ( June 2006): 63. 21. Ibid: 69. 22. For a discussion of the Danaher Business System see: https://rctom.hbs.org/author/benfehrtomchallengetheda- naherway/. Accessed October 3, 2018. https://www.genewsroom.com/press-rrepoirt,2017.eleases/creation-ge-digital-281706 https://rctom.hbs.org/author/benfehrtomchallengethedanaherway/ http://dot.com Case 21Case 21 Walt Disney, 21st Century Fox, and the Challenge of New Media On July 19th, 2018, Comcast Inc. withdrew from the battle to acquire Rupert Murdoch’s 21st Century Fox, leaving the field clear for the Walt Disney Company. Disney’s initial bid of $54 bn. (plus the assumption of Fox’s debt of $14 bn.) had been accepted by 21st Century Fox on December 14, 2017. However, a higher bid from Comcast had thrown the deal into doubt and was only resolved when Disney raised its bid to $71 bn., mak- ing the deal worth $85 bn. For Disney’s CEO, Bob Iger, the acquisition would reinforce Disney’s position as America’s leading entertainment provider. For 87-year-old Rupert Murdoch—Fox’s controlling shareholder—it signaled his intention to dissolve the multimedia empire that had been his life’s work. For both companies, it was an acknowledgement of the technological changes that were sweeping the media sector, in particular, the potential for video streaming to undermine existing channels for distributing video entertain- ment: these included cinemas, broadcast TV, cable TV, satellite TV, and DVDs. These changes had been highlighted by the rise of Netflix and the entry of technology giants such as Amazon, Alphabet, Apple, Facebook, and Microsoft into the market for video- based entertainment. A major motivation for the deal—according to Disney’s CEO, Bob Iger—was to bolster Disney’s efforts to adapt to these changes occurring in video enter- tainment. During 2018–19, Disney intended to rapidly build its presence in OTT (“over-the-top”) video streaming: the direct provision of video content to consumers via Internet connection. Yet, Fox’s businesses were more “old media” than “new media”: its main involvement in OTT was its 30% stake in Hulu; its Internet stream- ing service, Hotstar; and Sky’s OTT service in Europe (Fox held a 39% controlling stake in Sky). For the most part, therefore, the acquisition would augment Disney’s existing businesses in movie and TV production, cable channels, and broadcasting, while also adding Sky’s European satellite broadcasting network (another distribu- tion channel threatened by video streaming). Figure 1 shows the main businesses of the two companies. The Appendix shows their financial performance. Given the size of the acquisitions—far bigger than any other of Disney’s many acqui- sitions in recent decades—and the sustained top management efforts that would be required to integrate Fox into Disney’s vast entertainment empire—industry observers were divided over the wisdom of the deal for Disney. Would the acquisition reinforce Disney’s efforts to address the technological and competitive challenges of the new era, or would it hamper Disney’s efforts to transition to new modes of entertainment distribution? This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. 618 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Walt Disney Company Walt Disney began making cartoon movies in 1920. His breakthrough came in 1928 with Steamboat Willie, which launched Mickey Mouse. Disney’s transition from cartoon shorts to full-length animated movies produced a string of international hits: Snow White (1937), Cinderella (1950), Sleeping Beauty (1959), 101 Dalmatians (1961), and Jungle Book (1967). These provided the basis for diversification into live action movies (Davy Crockett, 1955; Mary Poppins, 1964; The Love Bug, 1968), TV production, film distribution, theme parks (Disneyland, 1955; Walt Disney World, 1967), and a lucrative licensing business. Under the leadership of Michael Eisner (CEO 1984–2005), Disney became America’s biggest studio in terms of movie releases, expanded its productions for TV, and revi- talized animation—its animated movies included Little Mermaid (1989), Beauty and the Beast (1991), and Lion King (1998). Disney also grew internationally with the opening of Disneyland theme parks in Tokyo (1983), Paris (1992), and Hong Kong (2005)— Disneyland Shanghai followed in 2016. Walt’s preference for control and self-sufficiency was reflected in his company’s vertically-integrated approach to building the business. Early on, Disney had taken control over the distribution of its films to cinemas. As new distribution channels for video content emerged, Disney forward integrated into them. These included video cassettes and DVDs, TV syndication, and cable TV (the Disney Channel). Disney also sought to exploit its characters and movie themes through books, video games, live theaters, and retail stores. Much of Disney’s vertical integration was through acquisition. The takeover of ABC in 1995 gave Disney ownership of one of America’s big-3 TV networks as well as estab- lishing Disney as America’s leading cable provider of sports through ESPN. In building the intellectual property to support its animated productions, Disney acquired the Star WALT DISNEY COMPANY STUDIOS TV BROADCAST NETWORKS CHARACTERS CABLE NETWORKS SATELLITE TV LOCAL TV STATIONS OTT VIDEO OTHER Walt Disney Studios, Pixar, Disney Animation Studios ABC Network Disney movie characters, Marvel, Star Wars, Muppets, Winnie the Pooh, ESPN, Disney Channel, A&E, ABC Cable 8 ABC local stations ESPN Plus and Disney Over-the-Top under development, Hulu (30%) Disney Theatrical Productions, Disney Music, Disney Publishing 21ST CENTURY FOX 20th Century Fox, 20th Century Fox TV Endemol Shine (TV production in Europe) [Fox Broadcasting Company not included in the acquisition] Simpsons, Fantastic Four, X-Men FX, Fox Life, Baby TV, National Geographic, Star India [Fox News and Fox Sports not included in acquisition] 39% Sky plc (21m. subscribers in Europe) 17 Fox local stations Hulu (30%), Hotstar (India), Now TV (owned by Sky) Fox Music, Fox Next (video games) Note: Non-media businesses such as theme parks and retail stores are not shown in this figure. FIGURE 1 The media businesses of Walt Disney and 21st Century Fox CASE 21 WALT DISNEY, 21ST CENTuRY FOx, AND ThE ChALLENGE OF NEW MEDIA 619 Wars and Marvel characters, and the Muppets. Other acquisitions extended Disney’s technical capabilities into computer-generated animation (Pixar), video games (Play- dom, Rocket Pack, and Tapulous), and video streaming (BAMTECH, Maker Studios). Table 1 shows Disney’s biggest acquisitions. Disney’s acquisitions attracted mixed reviews. Prior to its bid for Fox, Disney’s big- gest acquisition was ABC—one of America’s leading TV networks and the owner of several cable TV channels and local TV stations. The acquisition was criticized over the dubious benefits of vertical integration between studio production and TV broad- casting, and the declining audience for network broadcasting. Four years after the takeover, the Economist declared it “a disaster”1—while acknowledging that the sports channel ESPN had proved to be an unexpected goldmine for Disney. In addition, some smaller acquisitions failed to prosper—for example, after making several acqui- sitions, Disney had abandoned video game development. However, for its other major acquisitions, Disney has demonstrated sound judgment in assessing its potential to add value to its target companies and effectiveness in integrating them within its organization and infusing them with the Disney culture. In the case of Pixar, Marvel, and Lucasfilm, Disney was perceived as having overpaid for its acquisitions—yet, its subsequent success with these characters and movie franchises, both in developing new blockbuster movies and generating further revenue streams from its theme parks, stores, and licensing—points to its effectiveness in using its diversified business model to exploit synergies. Figure 2 shows the Disney’s organizational structure and span of its businesses. The acquisition of Marvel in 2009 had a massive impact on Disney’s revenues and profits. According to the Financial Times, Marvel’s 5000 characters, ranging from The Incredible Hulk to Ant-Man, “gave Disney access to a demographic that had previously been hard to reach—teenage boys—and a library of storylines and characters that lent themselves to sequels and spin-offs. They all had “franchise” potential and, so far, each release ... has hit the mark.”2 TABLE 1 Walt Disney Company main acquisitions 1995–2017 Acquired company Activities Consideration Year ABC TV broadcast and cable networks $19.0bn. 1995 Fox Family Worldwide Cable TV channels $5.3bn. 2001 Muppets Acquired from Jim Henshaw Company Not known 2004 Pixar Animation Studios Animated productions $7.4bn. 2006 Marvel Entertainment Characters and film production $3.8bn. 2009 Playdom Video games $0.8 bn. 2010 Lucasfilm Studios and movie library $4.1B 2012 A&E Television Network (50%) Cable channels $3.0bn. 2013 Maker Studios YouTube video content $0.5bn. 2014 BAMTECH Media Video streaming technology $1.6bn. 2017 21st Century Fox Movie and TV production and distribution $66.1bn. 2018a Note: a In July 2018 the acquisition was awaiting approval from the Dept. of Justice. 620 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Studio Entertainment Media Networks Parks, Experiences and Consumer Products Direct-to- Consumer and International Legal Finance HR Global Security Communications O�ce of the Chief Executive • Walt Disney Studios • Walt Disney Animation Studios • Pixar Animation • Disney Music Group • Disney Theatrical Gp. • Disney Nature • Lucas�lm • Marvel Studios • Disney / ABC Television • ESPN • Disney Parks and Resorts (CA, FL, Tokyo, Paris, Hong Kong, Shanghai) • Disney Cruise Line • Disney Vacation Club • Disney Publishing • Disney Store • Walt Disney Imagineering • Disney’s international media businesses • Disney Digital Network • BAMTECH Media FIGURE 2 Walt Disney Company: Organizational structure, April 2018 A key part of Disney’s acquisition effectiveness results from an astute assessment of the resources and capabilities that its acquired companies possess and their value-adding potential. This has required careful nurturing of the acquired resources—especially, the human ones. With Pixar, Disney appointed the Pixar management team to run its entire animation business and replaced its existing development process with that used by Pixar. Sustaining the capabilities of acquired companies requires respecting the people and the culture of the acquired companies. At Pixar, the acquisition was preceded by a premerger agreement protecting the rights of Pixar employees and the creative culture of Pixar—commitments that were honored once the acquisition had been completed. Disney was also willing to ignore conventional wisdom on mergers and acquisitions. Bob Iger stated: “There is an assumption in the corporate world that you need to integrate swiftly. My philosophy is exactly the opposite. You need to be respectful and patient.”3 Under its successive CEOs, Michael Eisner and Bob Iger, Disney honed a systema- tized and integrated approach to exploit its creative content. At the heart of this system were movies. In the case of Frozen, Disney’s blockbuster hit of 2013, the $1.8 bn. in box office revenues were only the starting point for a cascade of revenue- generating activities including music, DVDs, streaming, sequels (Frozen II will be released in 2019), theme park attractions, theatrical performances (Frozen on Ice, Frozen the Musical), and consumer product licensing. Bob Iger is reported to have told the Disney board: “As animation goes, so goes our company. A hit animated film is a big wave, and the ripples go down to every part of our business—from characters in a parade, to music, to parks, to video games, TV, internet, consumer products. If I don’t have wave makers, the company is not going to succeed.”4 21st Century Fox 21st Century Fox, based in New York City, was established in 2013 when Rupert Murdoch’s News Corporation decided to separate its newspapers from its other media CASE 21 WALT DISNEY, 21ST CENTuRY FOx, AND ThE ChALLENGE OF NEW MEDIA 621 interests following the phone-hacking scandal in the UK, which had severely damaged the reputation of News Corp. At the core of the 21st Century Fox group was 20th Century Fox, the movie produc- tion company that Rupert Murdoch had acquired in 1984 and became the foundation for creating Fox Broadcasting Network, the Fox News channel, and other US-based entertainment and media businesses. When 21st Century Fox was spun off from News Corp., it included News Corp’s non-newspaper businesses outside the US, notably its Star TV group in Asia and Endemol Shine in Europe. Fox’s successful movie franchises include Avatar, Wolverine, Deadpool, Alien, and Planet of the Apes—each of which has generated a series of sequels. Its most successful TV productions are X-Files and The Simpsons.5 Fox’s assets also included a 39% stake in Sky plc—a European operator of satellite television providers and pay channels in the UK and Ireland, Austria, Germany, and Italy. Sky was one of Murdoch’s most successful and profitable start-up ventures that used its sports channel, Sky Sports, as its key weapon to penetrate TV markets in sev- eral European countries. Changes within the Media and Entertainment Sector The market for video entertainment had traditionally been segmented into home and out-of-home viewing: the home segment traditionally comprised television, while the out-of-home, cinema. In both segments, the Hollywood studios play a central role. The big-6 Hollywood studios—Disney, Warner Brothers, Universal, 20th Century Fox, Columbia Pictures, and Paramount—accounted for an average of 77% of US box office takings since 2000, and they lead the world movie-making industry. In addition, they are major producers of shows for television. Despite changes in their ownership and the entry of new pro- duction companies, the big-6 have dominated Hollywood for the past four decades. Table 2 shows their US market shares. Ever since the advent of television, the demise of the cinema had been predicted. Yet, despite declining cinema attendance, box office revenues had been relatively stable in America and growing worldwide (see Figure 3). However, the economics of movie production had changed: all the industry’s profits were generated by a few blockbusters. By 2017, 27% of box office revenues were gen- erated by the top-grossing 1% of movies, double what it had been 20 years earlier. TABLE 2 Market shares of US box office takings by studio (%) 2017 2016 2015 2014 2013 2012 Disney 21.8 26.3 19.8 14.9 14.9 13.9 Warner Brothers 18.4 16.7 13.9 14.4 16.2 14.9 Universal 13.8 12.4 21.3 10.3 12.4 11.9 20th Century Fox 12.0 12.9 11.3 16.5 9.2 9.2 Sony/Columbia 9.6 8.0 8.4 11.6 9.9 16.1 Paramount 4.8 7.7 5.9 9.7 8.4 8.2 Lionsgate 8.0 5.8 5.9 6.8 9.3 11.1 Source: www.boxofficemojo.com. 622 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS If movie production and distribution were havens for stability, technology had made home entertainment an arena of perpetual turbulence. The once-dominant major networks—ABC, CBS, and NBC (joined in 1986 by the Fox Broadcast Net- work)—had been disrupted by cable TV, satellite TV, video cassette recorders, and DVDs, and—most recently—the Internet. Each technological wave brought new com- petitors. Cable TV saw the rise of Comcast, Liberty Media, and Viacom, while the advent of the Internet allowed telecom providers such as AT&T and Verizon to offer online video. The potential for Internet distribution of video entertainment also encouraged the entry of digital technology companies into the sector. These included giants such as Apple, Alphabet, Microsoft, and Amazon, as well start-up enterprises. Most prominent has been Netflix, which began a mail order service for DVDs and then became a world leader in subscription-based video streaming. At the end of March 2018, it had 125 million subscribers worldwide. Netflix is a major distributor of both Disney and Fox movies and TV shows, and in April 2018 had a market capitalization $142 bn., com- pared to Disney’s $151 bn. Figure 4 shows the rise of subscription-based video stream- ing relative to both cable TV and satellite TV. Initially, it appeared that the Internet would lead to the end of “mass entertain- ment”: the ability to serve niche market segments and specialist tastes would cause broadcasting to be replaced by “narrowcasting.” However, the “blockbuster effect”— the propensity for audiences to converge around the same products—appears to dominate specialist preferences. For example, Spotify and YouTube each offer many millions of products, yet user interest concentrates on a tiny fraction. Netflix has about 6000 movies and TV series available to US subscribers, but viewing has con- centrated around a few wildly popular series: House of Cards, The Crown, Orange is the New Black.6 Although Netflix is the global leader in OTT, the field is becoming increasingly crowded. In the US and in some Europe countries, Amazon’s Prime service is second in terms of subscriptions, followed by Hulu, HBO Go and Now, and Sony’s PlayStation 0 5 10 15 20 25 30 35 40 45 2010 2011 2012 2013 2014 2015 2016 2017 US & Canada International Notes: The biggest international markets in 2017, ranked by box office revenues were: 1. China, 2. Japan, 3. UK, 4. India, 5. South Korea, 6. France, 7. Germany, 8. Russia, 9. Australia, 10. Mexico. FIGURE 3 Global box office revenues ($ bn.) Source: MPAA Annual Reports. CASE 21 WALT DISNEY, 21ST CENTuRY FOx, AND ThE ChALLENGE OF NEW MEDIA 623 Vue. In addition, there are a number of nonsubscription services including Alphabet’s YouTube and Google Play, mainly targeting mobile devices. During 2018, Apple was developing original content in anticipation of the launch of its streaming service. The arrival of new players into video distribution was accompanied by a surge of mergers and acquisitions. Some of these were horizontal—notably the merging of cable providers into just three dominant providers: Comcast, Charter, and AT&T. Others were vertical between production companies and distribution companies: the Disney-ABC and AOL-Time Warner mergers were among the first of these, the most recent was that between AT&T and Time Warner. These vertical mergers raise important issues for antitrust authorities—including the reduced opportunities for specialist production companies to distribute their own content, and the reduced access to content for spe- cialized distribution companies.7 Table 3 shows the biggest mergers and acquisitions in the media and entertainment sector. The main beneficiaries of these mergers and acquisitions appear to be the share- holders of the acquired companies. Media acquisitions tend to be motivated less by TABLE 3 Biggest media mergers and acquisitions in the US Acquirer Acquired company Consideration Year AOL Time Warner $162 bn. 2000 AT&T Time Warner $108.7 bn. 2016a Walt Disney Co. 21st Century Fox $85 bn. 2017 Comcast AT&T Broadband $72 bn. 2011 Charter Communications Time Warner Cable $65.5 bn. 2016 Viacom CBS $35.6 bn. 1999 Walt Disney Co. ABC $19.0 bn. 1995 Clear Channel AMFM $16.0 bn. 1999 Note: a In July 2018, the acquisition was awaiting court approval. 0 100 200 300 400 500 600 700 2013 2014 2015 2016 2017 Cable TV Online subscription video Satellite TV Internet protocol TV (IPTV) FIGURE 4 Global pay TV and online video subscriptions (millions) Source: MPAA 624 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS TABLE 4 Leading companies in the US telecommunication services, broadcasting, and cable industries Company Sales ($bn.) Profits ($bn.) Assets ($bn.) Market value ($bn.) AT&T 163.8 13.0 403.8 249.3 Verizon Communications 126.0 13.1 244.2 198.4 Comcast 80.4 8.7 180.5 193.5 Walt Disney 54.9 9.0 91.6 178 Time Warner 29.3 3.9 66 76.2 Charter Communications 29.0 3.5 153.2 101.6 21st Century Fox 28.1 3.1 49.2 57.5 Liberty Global 20.0 1.7 68.7 31.2 CenturyLink 17.5 0.6 47.0 13.4 DISH Network 15.1 1.4 28.2 29.1 CBS 13.2 1.3 24.2 29.5 Viacom 12.7 1.4 23.3 18.0 Live Nation Entertainment 8.4 (0.1) 6.8 6.4 Level 3 Communications 8.2 0.7 24.9 21.1 Discovery Communications 6.5 1.2 15.8 16.8 Source: Forbes “The World’s Biggest Public Companies” (2017). strategic logic, and more by the empire-building urges of media moguls such as John Malone (Liberty Media), Sumner Redstone (Viacom), and Brian Roberts (Comcast). For the owners of telecom and cable companies—essentially utility businesses—there is also the glamour of owning movie studios. The inflated acquisition prices for media companies has resulted in intensive acquirers accumulating large amounts of goodwill on their balance sheets, thereby depressing their rates of return. For example, during 2015–17, the average return on capital employed was 3.6% for AT&T, 4.2% for Liberty Media, 9.2% for Comcast, and 12.9% for Viacom.8 Table 4 shows the leading companies in the US media and telecom sector. Rationale for the Merger Fox’s Motives For 21st Century Fox, the decision to sell to Disney seemed straightforward: “old media” companies were threatened by “new media” companies. “From a strategic point of view this is the right [time to sell],” Mr. Murdoch said in an interview with the Financial Times. “We are living in an age of enormous disruption.”9 Although content would be in demand, whatever changes occurred within distribution, the general opinion of industry experts was that, unlike Disney, Fox lacked the size, scope, and bargaining power needed to adapt to the changes reshaping the sector. According to one banker: “Companies in the CASE 21 WALT DISNEY, 21ST CENTuRY FOx, AND ThE ChALLENGE OF NEW MEDIA 625 middle risk getting squeezed in their economics by the very large guys unless they can figure out their comparative advantage.”10 There was also the issue of family succession. It had been widely assumed that Rupert Murdoch’s empire building had been driven by the goal of creating a media dynasty. His four marriages yielded six children, but his relationships with his adult children had been fraught. His two sons led 21st Century Fox—Lachlan as co-chairman (with Rupert) and James as CEO ( James was also chairman of Sky plc). In April 2018, it appeared that Lachlan would manage Fox’s remaining news and sports businesses, while James might take up an executive position with Disney. Rupert Murdoch was ambivalent about his future business activities: “Are we retreat- ing? Absolutely not,” he said. “We are pivoting at a pivotal moment.” Rupert and Lachlan Murdoch would continue to run the remaining Fox assets—including the Fox News channel—which will be spun off to Fox shareholders as a new company. The spin-off would be “a growth company” centered on live news and sport. “Those of you who know me know that I am a news man with a competitive spirit,” said Murdoch.11 Press spec- ulation suggested that that new company might be a vehicle for renewed acquisitions. Disney’s Motives For Disney, the acquisition was viewed as being entirely consistent with the company’s strategic trajectory. At a Morgan Stanley conference in February 2018, Bob Iger outlined three strategic objectives for Disney and pointed to how the acquisition of Fox would contribute to each: We’ve been a company that has emphasized ... the value of high-quality, branded entertainment. And the acquisitions of Pixar, Marvel, and Lucasfilm/Star Wars, obvi- ously were a reflection of that core strategy. [Fox] gives us a larger portfolio of high- quality branded content. When you think about FX, ... about National Geographic, about a number of the franchises that Fox has created, including their Marvel fran- chises and Avatar, and other product, we believe that this fits beautifully into a strategy to continue to invest in entertainment, particularly in a world that seems to be growing in terms of its appetite to consume entertainment. Secondly, we’ve been talking a lot about using technology to reach consumers in more modern, more efficient, and effective ways. That certainly has changed signif- icantly. When I talk about a dynamic marketplace, I think it’s most evident in how people access entertainment, how they consume entertainment, and this acquisition gives us the ability not only to have essentially more product, more intellectual prop- erty, but to bring it to the consumer in more compelling ways and ways we think the consumer wants their entertainment more and more. The Star and Sky assets and the Hulu assets give us an opportunity to do that. And then lastly, we’ve talked a lot about wanting to grow our company globally. ... This gives us the ability to have a far more global footprint and to diversify the com- pany’s interest from a geographic perspective.12 Iger also emphasized that the acquisition was not just about adding Fox’s existing businesses: [I]t comes with the people that operate those businesses and the experience that they have. ... If you look at what they’ve done, as for instance, in India, ... they have exper- tise that our company will take full advantage of. And our intention ... is creating a structure of the company that is aimed at basically being more modern and aimed at 626 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS integrating these assets in a far more effective way—one of the things we want to do is we want to look across our company and share best practices. Many—particularly as it relates to distribution—of those best practices will come from the people and the assets that we are acquiring here.13 Iger acknowledged that many of the businesses that Disney was acquiring were cable channels, but he looked beyond their existing distribution modes: [W]e’ve looked at channels less as channels and more as brands ... what’s more impor- tant to us is the quality of the brand and intellectual property that fits under that brand umbrella. And our intention is to—as the world shifts in terms of distribution and con- sumption we talked about earlier—is to migrate those brands and those products in the more modern direction from a distribution and consumption perspective ... What we’ve tried to do is design a company that is capable of thriving in a fully disrupted world, or a world that doesn’t look anything like the media world that we currently live in.14 During the early months of 2018, Disney’s initiatives to establish itself in OTT moved into a higher gear. In March, Disney created a new division to house direct-to-consumer and international businesses. The new division would comprise its forthcoming stream- ing services in the US and abroad, global advertising sales for ESPN, ABC, and other Disney-owned channels and, once the Fox merger was consummated, Fox’s streaming services and Hulu. The division would be led by Kevin Mayer, Disney’s much-admired chief strategy officer and architect of the acquisitions of Pixar, Lucasfilm, and Marvel. In April 2018, Disney launched its ESPN+ subscription streaming service offering a vast array of live sports events and a range of add-on, interactive services. However, its major effort was developing the streaming service it will launch in 2019, which will carry the full range of Disney content. Once this service is launched, Disney will no longer offer its content to Netflix and other third-party streaming services. Among the design parameters that Iger outlined for Disney’s new streaming ser- vice were the following: it would be tailored for viewing on mobile devices, it would permit binge viewing, and it would offer the flexibility of short subscription periods. It would be launched, first, in the US, then rolled out internationally. In terms of content, it would allow exclusive access to Disney’s new movies, access to Disney and Fox’s vast studio libraries, some 5000 episodes of Disney TV series, and several specially created TV series. In terms of Disney’s position vis-à-vis Netflix, Disney would empha- size quality over variety: “We are going to be in the business of less volume but more branded product—so Marvel, Star Wars, Pixar, Disney as part of that. Those brands are in enough demand and will have enough quality that we believe it will enable us to take a product to market with less volume.”15 The Debate over the Merger Commentary on the acquisition revealed one area of consensus: for Rupert Murdoch, the sale of 21st Century Fox to Disney was a sound decision. However, in relation to Disney, opinions were divided. The majority of investment analysts and investment bloggers were positive on the benefits of the merger to Disney citing the following: ● Disney’s potential for an increased flow of “tentpole” movie releases with the themes and characters obtained from Fox; CASE 21 WALT DISNEY, 21ST CENTuRY FOx, AND ThE ChALLENGE OF NEW MEDIA 627 ● Cost savings from Disney’s increased scale; ● The boost to Disney’s proposed streaming service that would result from Fox’s back catalog and Fox’s ability to contribute to the creation of new content; and ● The benefit of Fox and Sky’s international presence—especially, in Asia and Europe. The stock market  was generally supportive of Disney’s move. Between November 4, 2017, when talks between Disney and Fox were first reported, and December 19, three business days after the merger announcement, Disney’s share rose from $98.37 to $111.80. Others were critical, pointing to the following: ● Disney was acquiring businesses that were in their initial phases of long-term decline. According to one investment analyst: “Buying Fox and Sky cements Disney in the past, because it adds networks that are tied to the legacy eco- system.”16 In the past, bundling multiple cable channels in a package to sell to cable operators improved bargaining power, but as users are increasingly “cutting the cable,” that strategy will yield diminishing returns. ● Netflix and Amazon’s early-mover advantage in video streaming, their buzz- generating content, and superb technology makes it difficult for Disney to make inroads into their user base. ● The merger’s greatest potential for value creation would probably be from combining the two companies’ studios. However, their combined market share of about 34% might well alarm the Department of Justice, causing it to mandate divestments. Summer 2018 In June 2018, Comcast Corp.—America’s biggest cable company and owner of TV and movie giant, NBC Universal—joined the fray with a $65 bn. bid for 21st Century Fox. In the following week, Disney responded by upping its bid for Fox’s assets from $52 bn. to $71 bn.—with the assumption of Fox’s debt, Disney would be paying $85 bn. It also received confirmation from the Department of Justice that the US government would not challenge the merger. Comcast’s decision on July 19 to walk away was widely attributed to its weaker balance sheet—if Comcast sought to outbid Disney, it risked losing its investment-grade rating for its debt. However, Comcast was not giving up on its growth ambitions—just shifting the focus of its attention. One of 21st Century Fox’s “crown jewels” was its ownership of 39% of the equity of Sky, the UK-based satellite broadcaster and broadband pro- vider. For several years, 21st Century Fox had attempted to acquire the remaining 61% of Sky. However, in April 2018, Comcast announced a $22 bn. bid for Sky, about 16% higher than Fox’s bid. The bidding war between Fox and Comcast was resolved on September 22, 2018 when Comcast’s offer of $40 bn. for Sky was accepted by the British regulator. It was widely assumed l that Disney and Comcast would then do a deal in which Disney traded Fox’s 39% stake in Sky for Comcast’s 30% stake in Hulu (together with a cash transfer to make up for different values of the two shareholdings).17 628 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Notes 1. “Two Sharks in a Fishbowl,” Economist (November 18, 2017). 2. “Disney: Let It Grow,” Financial Times (May 22, 2015). 3. M. Reeves, J. Harnoss, and R. Bergman, “Using M&A to Increase Your Capacity for Growth,” Harvard Business Review ( July 13, 2016). 4. W. Isaacson, Steve Jobs (Simon & Schuster, 2011): 239. 5. Although Disney had acquired Marvel Entertain- ment and its portfolio of characters, Fox had licensing agreements for 6. “Winner Takes All,” Economist (February 11, 2017). 7. “AT&T and Time Warner: Dropped Connection,” Economist (November 11, 2017). 8. “A Deal That Donald Dislikes,” Economist (November 18, 2017). 9. “Rupert Murdoch and the Disruption of a Dynasty,” Finan- cial Times (December 15, 2017). 10. https://www.ft.com/content/efa4c728-0a50-11e8-839d- 41ca06376bf2, accessed April 19, 2018. 11. “Disney to Buy 21st Century Fox Assets in $66bn Deal,” Financial Times (December 14, 2017). 12. The Walt Disney Company at the Morgan Stanley Tech- nology, Media & Telecom Conference (Walt Disney Co., February 26, 2018). [Transcript]: 3–4. 13. Ibid: 4–5. 14. Ibid: 5. 15. Ibid: 8. 16. https://www.bloomberg.com/view/articles/2017-12-14/dis- ney-will-rue-its-merger-with-fox, accessed April 22, 2018. 17. “Comcast carries off Sky,” Economist (September 28, 2018) APPENDIX TABLE A1 Walt Disney Company: Financial data, $ millions (Year ended September 30) 2017 2016 2015 2014 2013 Revenues 55,137 55,632 52,465 48,813 45,041 Net income 9366 9790 8852 8004 6636 Total assets 95,789 92,033 88,182 84,141 81,197 Long-term obligations 26,710 24,189 19,142 18,573 17,293 Disney shareholders’ equity 41,315 43,265 44,525 44,958 45,429 Net cash from operating activities 12,343 13,136 11,385 10,148 9,495 Net cash from investing activities (4111) (5758) (4245) (3345) (4676) TABLE A2 21st Century Fox: Financial data, $ millions (Year ended June 30) 2017 2016 2015 2014 2013 Revenues 28,500 27,326 28,987 31,867 27,675 Net income 2952 2755 8306 4514 7097 Total assets 50,724 48,193 49,868 54,628 50,785 Debt 19,913 19,553 18,868 18,893 16,299 Shareholders’ equity 15,722 13,661 17,220 17,418 16,998 Net cash from operating activities 3785 3048 3617 2964 3002 Net cash from investing activities (752) (1638) 6736 (935) 86 Case 22 If a man could flow with the stream, grow with the way of nature, he’d accomplish more and he’d be happier doing it than bucking the flow of the water. —W. L. GORE W. L. Gore & Associates: Rethinking Management Malcolm Gladwell (author of The Tipping Point and Outliers) described his visit to W. L. Gore & Associates (Gore) as follows: When I visited a Gore associate named Bob Hen at one of the company’s plants in Delaware, I tried, unsuccessfully, to get him to tell me what his position was. I  suspected, from the fact that he had been recommended to me, that he was one of the top executives. But his office wasn’t any bigger than anyone else’s. His card just called him an “associate.” He didn’t seem to have a secretary, one that I could see anyway. He wasn’t dressed any differently from anyone else, and when I kept asking the question again and again, all he finally said, with a big grin, was, “I’m a meddler.”1 The absence of job titles and the lack of the normal symbols of hierarchy are not the only things that are different about Gore. Since its founding in 1958, Gore has deliberately adopted a system of management that contrasts sharply with that of other established corporations. While the styles of management of all start-up companies reflect the personality and values of their founders, the remarkable thing about Gore is that, as a $3.2 billion company with 9500 employees (“associates”) in 25 countries of the world, its organizational structure and management systems continue to defy the principles under which corporations of similar size and complexity are managed. The Founding of Gore Wilbert L. (Bill) Gore left DuPont in 1958 after 17 years as a research scientist. At DuPont, Gore had been working on a new synthetic material called polytetrafluoro- ethylene (PTFE), which it had branded “Teflon.” Gore was convinced that DuPont’s commitment to supplying large industrial markets with basic chemical products had This case was prepared by Robert M. Grant. ©2019 Robert M. Grant. 630 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS caused it to overlook new applications for PTFE. When Bill Gore and his wife, Vieve, formed their own business in 1958, they were keen, not only to explore these novel applications, but also to create the energy and passion that he had experienced when working in small research teams at DuPont on those occasions when they were given the freedom to pursue innovation. Working out of their home in Newark, Delaware, and with the help of their son, Bob, the Gores’ first product was Teflon-insulated cable. However, their break- through was Bob Gore’s discovery of the potential of Teflon to be stretched and laced with microscopic holes. The resulting fabric shed water droplets but was also breathable. Gore-Tex received a US patent in 1976. Not only did it have a wide range of applications for outdoor clothing, the fact that Gore-Tex was chemically inert and resistant to infection made it an excellent material for medical applications such as artificial arteries and intravenous bags. The potential to vary the size of the microscopic holes in Gore-Tex also made it ideal for a wide range of filtration applications. Since then, continuous innovation has resulted in a growing array of consumer prod- ucts (such as guitar strings, dental floss, footwear components, and vacuum cleaner bags), industrial products (such as fuel cell components, electronic components, fire safety fabrics, and rope fibers), and medical products (such as implantable medical devices, pharmaceutical tubing products, and sealants). Origins of the Gore Management Philosophy FundingUniverse.com describes the development of Bill Gore’s management ideas as follows: From their basement office, the Gores expanded into a separate production facility in their hometown of Newark, Delaware. Sales were brisk after initial product introduc- tions. By 1965, just seven years after the business had started, Gore & Associates was employing about 200 people. It was about that time that Gore began to develop and implement the unique management system and philosophy for which his company would become recognized. Gore noticed that as his company had grown, efficiency and productivity had started to decline. He needed a new management structure, but he feared that the popular pyramid management structure that was in vogue at the time suppressed the creativity and innovation that he valued so greatly. Instead of adopting the pyramid structure, Gore decided to create his own system. During World War II, while on a task force at DuPont, Gore had learned of another type of organizational structure called the lattice system, which was developed to enhance the ingenuity and overall performance of a group working toward a goal. It emphasized communication and cooperation rather than hierarchy of authority. Under the system that Gore developed, any person was allowed to make a decision as long as it was fair, encouraged others, and made a commitment to the company. Consultation was required only for decisions that could potentially cause serious damage to the enterprise. Furthermore, new associates joined the company on the same effective authority level as all the other workers, including Bill and Vieve. There were no titles or bosses, with only a few exceptions, all commands were replaced by personal commitments. New employees started out working in an area best suited to their talents, under the guidance of a sponsor. As the employee progressed there came more responsibility, www.FundingUniverse.com CASE 22 W. L. GORE & ASSOCIATES: REThINkING MANAGEMENT 631 and workers were paid according to their individual contribution. “Team members know who is producing,” Bill explained in a February 1986 issue of the Phoenix Business Journal. “They won’t put up with poor performance. There is tremendous peer pressure. You promote yourself by gaining knowledge and working hard, every day. There is no competition, except with yourself.” The effect of the system was to encourage workers to be creative, take risks, and perform at their highest level.2 Bill Gore’s ideas about management were influenced by Douglas McGregor’s The Human Side of Enterprise, published when Gore was starting up his own company. In it, McGregor identifies two models of management: the conventional model of management, rooted in Taylor’s scientific management, and Weber’s principles of bureaucracy, which McGregor termed “Theory X.” At its core is the assumption that work is unpleasant, that employees are motivated only by money, and that manage- ment’s principal role is to prevent shirking. “Theory Y” was McGregor’s alternative theory rooted in the work of the human relations school of management, which assumes that individuals are self-motivated, anxious to solve problems, and capable of working harmoniously on joint tasks. Bill Gore’s dominant concern was the limits to organizational size. He believed that the need for interpersonal trust would result in organizations declining in effective- ness once they reached about 200 members. Hence, in 1967, rather than expand their Delaware facility, Bill and Vieve decided to build a second manufacturing facility in Flagstaff, Arizona. From then on, Gore built a new facility each time an existing unit reached 200 associates. According to Malcolm Gladwell, Gore’s insistence upon small organizational units is an application of a principle developed by anthropologist Robin Dunbar. According to Dunbar, social groups are limited by individuals’ capacity to manage complex social relationships. Among primates, the size of the typical social group for a species is cor- related with the size of the neocortex of that species’ brain. For humans, Dunbar esti- mates that 148 is the maximum number of individuals that a person can comfortably have social relations with. Across a range of different societies, Dunbar found that 150 was the typical maximum size of tribes, religious groups, and army units.3 Organization Structure and Management Principles The Gore organization does include elements of hierarchy. For example, as a corpo- ration, it is legally required to have a board of directors—this is chaired by Bob Gore. There is also a CEO, Terri Kelly. The company is organized into four divisions (fabrics, medical, industrial, and electronic products), each with a recognized “leader.” Within these divisions there are specific business units, each based upon a group of products. There are also specialized, company-wide functions such as human resources and information technology. What is lacking is a codified set of ranks and positions. Gore associates are expected to adapt their roles to match their skills and aptitudes. The basic organizational units are small, self-managing teams. Relationships within teams and between teams are based upon the concept of a lattice rather than a conventional hierarchy. The idea of a lattice is that every orga- nizational member is connected to every other organizational member within the particular facility. In the lattice, communication is peer to peer, not superior to sub- ordinate. For Bill Gore, this was a more natural way to organize. He observed that in 632 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS most formal organizations it was through informal connections that things actually got done: “Most of us delight in going around the formal procedures and doing things the straightforward and easy way.”4 New associates are assigned to a “sponsor” whose job is to introduce the new hire to the company and guide him or her through the lattice. The new hire is likely to spend time with several teams during the first few months of employment. It is up to the new associate and a team to find a good match. An associate is free to find EXHIBIT 1 What we believe Founder Bill Gore built the company on a set of beliefs and principles that guide us in the decisions we make, in the work we do, and in our behavior toward others. What we believe is the basis for our strong culture, which connects Gore associates worldwide in a common bond. FUNDAMENTAL BELIEFS Belief in the individual: If you trust individuals and believe in them, they will be motivated to do what’s right for the company. Power of small teams: Our lattice organization harnesses the fast decision-making, diverse perspectives, and col- laboration of small teams. All in the same boat: All Gore associates are part owners of the company through the associate stock plan. Not only does this allow us to share in the risks and rewards of the company, it gives us an added incentive to stay com- mitted to its long-term success. As a result, we feel that we are all in this effort together and believe we should always consider what’s best for the company as a whole when making decisions. Long-term view: Our investment decisions are based on long-term payoff and our fundamental beliefs are not sacrificed for short-term gain. GUIDING PRINCIPLES ◆ Freedom: the company was designed to be an orga- nization in which associates can achieve their own goals best by directing their efforts toward the suc- cess of the corporation; action is prized; ideas are encouraged; and making mistakes is viewed as part of the creative process. We define freedom as being empowered to encourage each other to grow in knowledge, skill, scope of responsibility, and range of activities. We believe that associates will exceed expectations when given the freedom to do so. ◆ Fairness: everyone at Gore sincerely tries to be fair with each other, our suppliers, our customers, and anyone else with whom we do business. ◆ Commitment: we are not assigned tasks; rather, we each make our own commitments and keep them. ◆ Waterline: everyone at Gore consults with other associates before taking actions that might be “below the waterline”—causing serious damage to the company. Working in Our Unique Culture Our founder Bill Gore once said, “The objective of the Enterprise is to make money and have fun doing so.” And we still believe that, more than 50 years later. Because we are all part owners of the company through the associate stock plan, Gore associates expect a lot from each other. Innovation and creativity; high ethics and integrity; making commitments and standing behind them. We work hard at living up to these expec- tations as we strive for business success. But we also trust CASE 22 W. L. GORE & ASSOCIATES: REThINkING MANAGEMENT 633 a new sponsor if desired. Typically, each associate works on two or three different project teams. Annual reviews are peer based. Information is collected from at least 20 other asso- ciates. Each associate is then ranked against every other associate within the unit in terms of overall contribution. This ranking determines compensation. The company’s beliefs, management principles, and work culture are articulated on its website (Exhibit 1). and respect each other and believe it’s important to cele- brate success. Gore is much less formal than most workplaces. Our relationships with other associates are open and informal and we strive to treat everyone respectfully and fairly. This type of environment naturally promotes social interac- tion and many associates have made lifelong friends with those they met working at Gore. Do Something You’re Passionate About At Gore, we believe it’s important to have passion for what you do. If you’re passionate about your work, you are natu- rally going to be highly self-motivated and focused. If you feel pride and ownership, you will want to do whatever it takes to be successful and have an impact. So when you apply for an opportunity at Gore, be sure you’re going to be passionate about the work you’ll be doing. The Lattice Structure and Individual Accountability Gore’s unique “lattice” management structure, which illus- trates a nonhierarchical system based on interconnec- tion among associates, is free from traditional bosses and managers. There is no assigned authority, and we become leaders based on our ability to gain the respect of our peers and to attract followers. You will be responsible for managing your own work- load and will be accountable to others on your team. More importantly, only you can make a commitment to do something (e.g., a task, a project, or a new role)—but once you make a commitment, you will be expected to meet it. A “core commitment” is your primary area of concentration. You may take on additional commitments depending on your interests, the company’s needs, and your availability. Relationships and Direct Communication Relationships are everything at Gore—relationships with each other, with customers, with vendors and suppliers, and with our surrounding communities. We encourage people to build and maintain long-term relationships by communicating directly. Of course, we all use e-mail, but we find that face-to-face meetings and phone calls work best when collaborating with others. Sponsors Everyone at Gore has a sponsor, who is committed to helping you succeed. Sponsors are responsible for sup- porting your growth, for providing good feedback on your strengths and areas that offer opportunities for development and for helping you connect with others in the organization. Source: www.gore.com/en_xx/careers/whoweare/about-gore. html, W. L. Gore & Associates: Beliefs, Principles and Culture. Reproduced by permission of W. L. Gore & Associates. 634 CASES TO ACCOMPANY CONTEMPORARY STRATEGY ANALYSIS Leadership Leadership is important at Gore, but the basic principle is that of natural leadership: “If you call a meeting and people show up—you’re a leader.”5 Teams can appoint team leaders; they can also replace their team leaders. As a result, every team leader’s accountability is to the team. “Someone who is accustomed to snapping their fingers and having people respond will be frustrated,” says John McMillan, a Gore associate. “I snap my fingers and nobody will do anything. My job is to acquire followership, artic- ulate a goal and get there … and hope the rest of the people think that makes sense.”6 CEO Terri Kelly compares the conventional approach to leadership with Gore’s “ distributed leadership model”: The model of the single powerful leader who operates through command and control is attractive in its simplicity … In reality, it is impractical to expect the single leader to have all the answers, and history has shown that relying upon rigid control mecha- nisms will not prevent catastrophic outcomes. It’s far better to rely upon a broad base of individuals and leaders who share a common set of values and feel personal own- ership for the overall success of the organization. And as organizations grow in size and complexity, it becomes even more critical to distribute the leadership load … The capacity of the organization increases when it distributes the leadership load to com- petent leaders on the ground who can make the best knowledge-based decisions.7 She argues that talented newcomers to the workforce adapt much more easily to the distributed leadership than to traditional modes of management. Young people recog- nize that they have choices, are not wedded to a single organization, and will move to where they perceive the best opportunities. As a result, companies that persevere with traditional management models will find it difficult to retain the best talent. At the same time, warns Kelly, making the shift to a distributed leadership model is a challenge to top management. It requires a fundamental change in the values, attitudes, and reward systems that are deeply embedded in most organizations: It will require a shift within the organization from valuing a key few to valuing the unique contributions of many. Individuals will need to feel they have a voice and can be heard. Leaders will need to recognize that their primary role is to empower others versus build their own power. They will no longer stand behind a title with assumed authority to tell people what to do. Leaders’ focus will shift to creating the right environment and instilling the right values that can enable capable leaders to emerge. They will recognize that they are only leaders if they have willing followers, and that this needs to be earned every day. Ultimately, their contributions will be judged by the people they lead. Most rewards systems depend upon higher level management to assess the effec- tiveness of the leader. This view can be somewhat limited and biased by the fact the managers were often the ones who put the leader in the role in the first place. Those who know their leaders best are typically the individuals they lead. If you want indi- viduals to have a voice in the organization, they must also have a voice in selecting and evaluating their leaders. CASE 22 W. L. GORE & ASSOCIATES: REThINkING MANAGEMENT 635 In our company, we have found it very useful to adopt a peer ranking system. All associates get the opportunity to rank members of their team, including their leaders. They are asked to create a contribution list in rank order based on who they believe is making the greatest contribution to the success of the enterprise. This approach serves as an excellent form of “checks and balances” when it comes to who is truly recognized for their contributions as well as for overall leadership.8 Innovation The success of Gore’s unusual management system is its capacity for innovation. Between 1976 and 2017, Gore received 1428 US patents; in each year between 2012 and 2018 it was awarded between 70 and 108 patents. Even more remarkable has been its ability to extend its existing technological breakthroughs to a wide variety of new applications. Central to Gore’s ability to innovate is its willingness to allow individuals the freedom to pursue their own projects: each associate is allowed a half day each week of “dabble time.” New product ideas typically originate with customers or individual employees and are then developed by a self-directed team. Gore’s Elixir guitar strings began when several amateur guitarists in the research department began experimenting with differ- ent coatings for guitar strings, then sent samples to musicians to try. The source of Gore’s innovations is not so much its brilliant technologists and engi- neers as a management system that attracts top talent and provides an environment that inspires creativity and collaboration. Gary Hamel closes his discussion of Gore with the following challenge: Bill Gore was a 40-something chemical engineer when he laid the foundations for his innovation democracy. I don’t know about you, but a middle-aged polytetrafluoro- ethylene-loving chemist isn’t my mental image of a wild-eyed management innovator. Yet, think about how radical Gore’s vision must have seemed back in 1958. Fifty years later, postmodern management hipsters throw around terms like complex adaptive systems and self-organizing teams. Well, they’re only a half century behind the curve. So ask yourself, am I dreaming big enough yet? Would my management innovation agenda make Bill Gore proud?9 Notes 1. M. Gladwell, The Tipping Point (Little, Brown & Co., London, 2000). 2. “W. L. Gore & Associates, Inc. History,” http://www.fundin- guniverse.com/company-histories/WL-Gore-amp;-Associ- ates-Inc-Company-History.html, accessed July 20, 2015. 3. Gladwell, op. cit.: 177–181. 4. Quoted by G. Hamel with B. Breen, The Future of Management (Harvard Business School Press, Boston, MA, 2007, p. 87). 5. Reprinted by permission of Harvard Business School Press from The Future of Management by Gary Hamel. Boston, MA, 2007, p. 100 Copyright © 2007 by the Harvard Business School Publishing Corporation; all rights reserved. 6. “W. L. Gore & Associates, Inc.: Quality’s Different Drum- mer,” IMPO Magazine, January 14, 2002, http://www. impomag.com/articles/2002/01/wl-gore-associates-inc- qualitys-different-drummer, accessed July 20, 2015. 7. Terri Kelly, “No More Heroes: Distributed Leadership,” Management Innovation eXchange (April 8, 2010), http:// www.managementexchange.com/blog/no-more-heroes, accessed July 20, 2015. 8. Ibid. 9. Reprinted by permission of Harvard Business School Press from The Future of Management by Gary Hamel. Boston, MA, 2007, p. 100. Copyright © 2007 by the Harvard Business School Publishing Corporation; all rights reserved. http://www.impomag.com/articles/2002/01/wl-gore-associates-incqualitys-different-drummer G L O S S A R Y acquisition (or takeover) The purchase of one company by another. activity system A conceptualization of the firm as a set of interrelated activities. agency problem An agency relationship exists when one party (the principal) contracts with another party (the agent) to act on behalf of the principal. The agency problem is the difficulty of ensuring that the agent acts in the principal’s interest. alliance See strategic alliance. ambidextrous organization An organization that can simultaneously exploit existing competences while exploring new opportunities for future development. balanced scorecard A tool for linking strategic goals to performance indicators. These performance indicators combine performance indicators relating to financial performance, consumer satisfaction, internal efficiency, and learning and innovation. barriers to entry Disadvantages that new entrants to an industry face in relation to established firms. barriers to exit Costs and other impediments that prevent capacity from leaving an industry. benchmarking A systematic process for comparing the practices, processes, resources, and capabilities of other organizations with one’s own. blue-ocean strategy The discovery or creation of uncontested market space. bottom of the pyramid This refers to the poorest people in the world: typically the 3 billion people who live on less than $2 per day. bounded rationality The principle that the rationality of human beings is con- strained (“bounded”) by the limits of their cognition and capacity to process information. business ecosystem The network of organizations with which a business enterprise interacts. business model The overall logic of a business and the basis on which it gener- ates revenues and profits. 638 GLOSSARY business strategy (aka competitive strategy) This refers to how a firm com- petes within a particular industry or market. capability More precisely referred to as organizational capability, is an organiza- tion’s capacity to perform a particular task or function. causal ambiguity The difficulty facing any observer of diagnosing the sources of the competitive advantage of a firm with superior performance. It means that poten- tial rivals face the problem of uncertain imitability. comparative advantage A country’s ability to produce a particular product at a lower relative cost than other countries. competency trap The barrier to change that results from an organization devel- oping high levels of capability in particular activities. competitive advantage A firm possesses a competitive advantage over its direct competitors when it earns (or has the potential to earn) a persistently higher rate of profit. consumer surplus The value that a consumer receives from a good or service minus the price that he or she paid. contingency theory Postulates that there is no single best way to design and manage an organization. The optimal structure and management systems for any organization are contingent upon its context—in particular, the features of its business environment and the technologies it utilizes. corporate governance The system by which companies are directed and controlled. corporate planning A systematic approach to resource allocation and strategic decisions within a company over the medium to long-term (typically 4–10 years). corporate restructuring Radical strategic and organizational change designed to improve performance through cost reduction, employment reduction, divestment of assets, and internal reorganization. corporate social responsibility (CSR) The social responsibilities of a business organization. corporate strategy A firm’s decisions and intentions with regard to the scope of its activities (its choices in relation to the industries, national markets, and vertical activities within which it participates) and the resource allocation among these. customer relationship management (CRM) A set of tools, techniques, and methodologies for understanding the needs and characteristics of customers in order to better serve them. dominant design A product architecture that defines the look, functionality, and production method for the product and becomes accepted by the industry as a whole. GLOSSARY 639 dynamic capabilities Organizational capabilities that allow an organization to recon- figure its resources and modify its operating capabilities in order to adapt and change. economic profit Pure profit: it is the surplus of revenues over all the costs of pro- ducing that revenue inputs (including the costs of capital). economic value added (EVA) A measure of economic profit. It is the excess of net operating profit after tax over the cost of the capital used in the business. economies of scale These exist when increases in the scale of a firm or plant result in reductions in costs per unit of output. economies of scope These exist when using a resource across multiple products or multiple markets uses less of that resource than when the activities are carried out independently. ecosystem See business ecosystem. emergent strategy The strategy that results from the actions and decisions of dif- ferent organizational members as they deal with the forces that impinge upon the organization. experience curve The relationship between unit costs and accumulated produc- tion. Typically unit costs decline by 15–30% every time cumulative output doubles. first-mover advantage The competitive advantage that accrues to the firm that is first to occupy a new market or strategic niche, or to exploit a new technology. First- mover advantage is a special case of early-mover advantage. functional structure Organization around specialized business functions such as accounting, finance marketing, operations, and so on. game theory A body of theory that analyzes and predicts the outcomes of com- petitive (and cooperative) situations where each player’s choice of action depends on the choices made by the other players in the game. Game theory has applications to business, economics, politics, international relations, biology, and social relations. global strategy A strategy that treats the world as a single, if segmented, market. globalization The process through which differences between countries diminish and the world becomes increasingly integrated. hypercompetition Competition that is characterized by rapid and intensive com- petitive moves where competitive advantage is quickly eroded and firms are contin- ually seeking new sources of competitive advantage. industry life cycle The pattern of industry evolution from introduction to growth to maturity to decline. innovation The initial commercialization of invention by producing and marketing a new good or service, or by using a new method of production. 640 GLOSSARY institutional isomorphism The tendency for organizations that are subject to common social norms and pressures for legitimacy to develop similar organizational characteristics. intellectual property Intangible goods that have no physical presence and that are “creations of the mind.” It includes ideas, names, symbols, designs, artwork, and writings. intended strategy The strategy conceived by top management with the intention of implementing it within the organization. invention The creation of new products and processes through the development of new knowledge or from new combinations of existing knowledge. isolating mechanisms Barriers that protect the competitive advantage of firms from imitative competition. key success factors Sources of competitive advantage within an industry. knowledge-based view of the firm This regards the firm as a pool of knowledge assets where the primary challenge for management is to integrate the specialized knowledge of organizational members into the production of goods and services. matrix structures Hierarchies that comprise multiple dimensions; these typically include product (or business) units, geographical units, and functions. merger The amalgamation of two or more companies to form a new company. In a merger, the owners of the merging companies exchange their shares for shares in the new company. multidivisional structure A company structure comprising separate business units, each with significant operational independence, coordinated by a corporate head office that exerts strategic and financial control. network effects (or network externalities) Linkages between the users of a product or technology that result in the value of that product or technology being positively related to the number of users. open innovation An approach to innovation where a firm seeks solutions from organizations and individuals outside the firm and shares its technologies with other organizations. organizational ambidexterity see ambidextrous organization. organizational culture An organization’s values, traditions, behavioral norms, symbols, and social characteristics. organizational ecology (aka organizational demography and the population ecology of organizations) This studies the organizational population of industries and the processes of founding and selection that determine entry and exit. GLOSSARY 641 organizational routines Patterns of coordinated activity through which an orga- nization is able to perform tasks regularly and predictably. parenting advantage A parent company’s ability to create more value from own- ing a particular business than could any other parent company. path dependency The simple fact that history matters; more specifically, it implies that an organization’s strategy and structure and management’s options for the future are determined by it’s past decisions and actions. platform A product, technology, or system that provides a foundation for a number of complementary products (or applications). In business, platforms that form an interface between two-sided markets (comprising application suppliers and final users) occupy an especially important role in several technology-based sectors. prisoner’s dilemma A simple game theory model that shows how lack of coop- eration results in an outcome that is inferior to that which could have been achieved with cooperation. profit The surplus of revenues over costs available for distribution to the owners of the firm. real option analysis This identifies and values possibilities for investment in uncertain opportunities. The two major types of real option are investments in flex- ibility and investment in growth opportunities. realized strategy The actual strategy that the organization pursues; it is the out- come of the interaction of intended strategy with emergent strategy. regime of appropriability The conditions that determine the extent to which a firm is able to capture profits from its innovations. resources The assets of the firm including tangible assets (such as plant, equip- ment, land, and natural resources), intangible resources (such as technology, brands, and other forms of intellectual property) and human resources. resource-based view of the firm A conceptualization of the firm as a collection of resources and capabilities that form the basis of competitive advantage and the foundation for strategy. scenario analysis A technique for integrating information and ideas on current trends and future developments into a small number of distinctly different future outcomes. segmentation The process of disaggregating industries and markets into more narrowly defined submarkets on the basis of product characteristics, customer char- acteristics, or geography. self-organization The tendency for complex systems, both natural and biological, to spontaneously achieve order and adaptation though decentralized interactions without any centralized direction or control. 642 GLOSSARY seller concentration This measures the extent to which a market is dominated by a small number of firms. The concentration ratio measures the market share of the largest firms; for example the four-firm concentration ratio (CR4) is the combined market share of the four biggest firms. stakeholder value maximization This proposes that the firm should maximize the value created by all its stakeholders (owners, employees, customers, suppliers, and society). Top management has the task of balancing and integrating these dif- ferent interests. state capitalism A market-based economy where a large proportion of leading enterprises are owned by the government. strategic alliance A collaborative arrangement between two or more firms involving their pursuit of certain common goals. strategic fit The consistency of a firm’s strategy with its external environment and with its internal environment, especially with its goals and values, resources, and capabilities, and structure and systems. strategic group A group of firms within an industry that follow similar strategies. strategic intent The goal of an organization in terms of a desired future stra- tegic position. SWOT framework The SWOT framework classifies the factors relevant for a firm’s strategic decision making into four categories: strengths, weaknesses, opportunities, and threats. technical standard A specification or requirement or technical characteristic that becomes a norm for a product or process thereby ensuring compatibility. transaction costs The costs incurred in researching, negotiating, monitoring, and enforcing market contracts. value Within management terminology, value is used to refer to two very different concepts. In its plural form, values typically refer to ethical precepts and principles. In its singular form it typically refers to economic value: the monetary worth of a product or asset. value added Sales revenue minus the cost of bought-in goods and services; it is equal to all the firm’s payments to factors of production (i.e., wages and salaries + interest + rent + royalties and license fees + taxes + dividends + retained profit). value chain A sequence of vertically related activities undertaken by a single firm or by a number of vertically related firms in order to produce a product or service. vertical integration A firm’s ownership of adjacent vertical activities. winner-takes-all markets Markets where a single firm is able to capture the great majority of sales and/or profits. I N D E X Note: Page numbers in italics refer to illustrations and tables. A Aaker, D., 167 AbbVie, Inc., 115 Abell, D. F., 20, 29, 204, 217 absolute cost advantage, 67 Accenture plc, 51, 115 accounting profit, 39–40 accounting ratios, 43, 45 see also return on invested capital acquisitions see mergers and acquisitions activity system, 163 firm as, 368 adaptability, organizing for, 143 see also flexibility Adaptation–Aggregation–Arbitrage (AAA) framework, 291, 291, 296 adhocracies, 149 administrative costs, 253, 259 administrative distance, 283, 283 Adner, R., 247 Adobe Systems, 232 adverse selection, 121, 130 advertising, 169, 170, 181 Afuah, A., 90, 187 agency problems, 136, 333, 336 agility, competitive advantage, 158 Air Canada, 351 AirAsia, 185 Airbnb, 36 Airbus, 66, 92, 94, 169 airline industry business models, 159 industry analysis, 66, 67, 94 input costs, 172 profitability, 75 strategic group analysis, 102 structure, 71 see also Air Canada; Airbnb; Airbus; Boeing; Icelandair; South- west Airlines Akerlof, G., 130 Alcatel-Lucent, 342 Alceler, J., 373 Aldrich, H. E., 217 Alexander, M., 313, 338, 339 Alibaba, 115, 202, 235, 361, 362 Allen, Bill, 49 Allen, S. A., III, 339 Allen, W. T., 58 alliances see strategic alliances Allison, G. T., 105 Almeida, P., 295 Alphabet, 147, 202, 235, 362 diversification, 298 Alstom, 355 Alton, R., 358 Altria Inc., 64, 115 Amatori, F., 336 Amazon.com, 115, 202, 235, 362 brand value, 116 competitive advantage, 172, 366 differentiation, 173–174 diversification, 298 exploiting innovation, 229 property rights, 222 valuation ratio, 115 ambidexterity, 369 ambidextrous organization, 204–205 Ambos, B., 296 American Airlines, 346, 353 American Airways, 102 American Brands, 202 American Express, 176 American Medical Association, 74 Amodio, A., 339 Anaconda, 202 Anand, J., 349, 358, 359 Anderson, P., 203, 216, 217, 373 Anderson, S. R., 188 Anheuser-Busch, 343 Anolt, S., 286 Ansoff, H. I., 28 antibusiness sentiment, 363 anticipation, competitive advantage, 158 AOL, 257, 344 Apollo Global Management, 323 Apple Inc., 20, 67, 133, 151, 202, 235, 243, 304, 362 competitive advantage, 120, 176, 366 industry life cycle, 194 industry standards, 232, 232, 236 innovation, 222, 223, 228, 229, 230, 231 internationalization, 273, 277, 278 iPhone, 159, 277 iPod, 194 market capitalization, 202 organizational capabilities, 56 organizational change, 206 organizational structure, 144–145 platform-based markets, 235 profitability, 39 resources and capabilities, 109, 116–117 strategic alliances, 351–352 value, 116 vertical integration, 265 appropriability, regime, 222 Aquascutum, 121 arbitrage, national resources, 281–282 Arcelor, 342 ArcelorMittal, 273 architectural innovation, 203 Argote, L., 187 ARM, 124, 139, 223 arm’s-length contracts, 263 Arora, A., 247 Arthur, D. Little, 320 Arthur, W. B., 361, 373 Artz, K. W., 246 Ashridge Portfolio Display, 320–321, 321 assets mass efficiencies, 130 tangible resources, 112 Astra, 301 Atari, 229 AT&T, 355 attractiveness, industry, 19, 19, 62–71, 111, 302 authority-based hierarchies, 370 auto industry barriers to exit, 69 comparative advantage, 273–276, 274, 275 competitor analysis, 95–98, 96 development, 207–208, 210 exploiting innovation, 229 industry life cycle, 196, 197 national differentiation, 283, 285 resources and capabilities, 110, 117 segmentation analysis, 98 strategic group analysis, 101 substitutability, 76 technological change, 203 threat of entry, 66 value-chain analysis, 174 see also Ford Motor Company; General Motors; Honda; Nissan; Toyota; Volkswagen AG Automobili Lamborghini, 352 Autonomy, 302, 349 Aversa, P., 187 B Baden-Fuller, C., 82, 188, 295, 359 Bain & Company, 22, 101 Bak, P., 373 Bakke, D., 33 balanced scorecard, 47–48, 48, 326 Balasubramanian, N., 57 Baldwin, C. Y., 349, 358 Ballmer, Steve, 206, 319 Bamford, J., 329 www.Amazon.com 644 INDEX banking industry see financial services industry bankruptcy, 363 risk, 299 Bardolet, D., 312, 339 bargaining power, 65 bilateral monopolies, 258 of buyers, 69–71 complementary products, 86 cost advantage, 172 employees, 122 relative, 70–71 of suppliers, 71 Barney, J. B., 120, 123, 130 barriers to entry, 66–67, 272, 302 barriers to exit, 69 barriers to mobility, 99 Barron, D., 216 Bartlett, C. A., 149, 152, 287, 289, 295, 373 Barton, D., 334, 339 BASF, 201 Bath Fitter, 251 Baum, J., 216 Baumol, W. J., 81, 313 Bayus, B. L., 247 BC Partners, 324 Beckman, S. L., 187 beer industry see brewing industry Beinhocker, E. D., 232, 247 belief systems, competitors, 97 beliefs (values) see values (beliefs) benchmarking, 122–123 benefit corporations, 364 Bennis, W. G., 217 Berkshire Hathaway, 202, 307, 310, 317, 318, 322, 324, 346 Berlin, Isaiah, 366, 373 Besanko, D., 187 best practices, 369 beta coefficient, 299 better-off test, 303, 306 Bettis, R. A., 311, 313 Bevan, G., 58 Bharadwaj, S. G., 188 BHP-Billiton, 362 Bigelow, L. S., 216 Biggadike, R., 313 bilateral monopolies, 258 Bink, A. J. M., 295 binomial options pricing model, 55 Birkinshaw, J. M., 248 Black, F., 55 black swan events, 363 Black–Scholes option-pricing formula, 55 Blackstone, 307, 323 Blockbuster, 261, 299 Bloom, N., 339 blue ocean strategy, 160–161, 161 BMW, 321 boards of directors, 334–335 Boeing, 171 capital requirements, 66 cost advantage, 168, 172 global strategies, 277 industry analysis, 66, 67, 94 industry life cycle, 192 innovation, 221, 229 profit maximization pitfalls, 49 strategic alliances, 354 system integrators, 266 technological change, 203 Bolton, P., 339 Bombardier, 355 Booz & Company, 141 Borg, I., 188 Bosch, 232 Bossidy, L., 132, 135, 151, 326, 339 Boston Consulting Group (BCG), 29, 167, 320, 321 competitive advantage, 158, 162 experience curve, 167, 167 growth-share matrix, 320–321, 321 portfolio planning, 320–321, 320–321 strategic management, 28 strategy making, 20 bottom of the pyramid, 52 bottom-up organizational change, 204–205 boundaries permeable, 149, 371 bounded rationality, 29, 199 Bower, J. L., 217, 339 BP see British Petroleum brainstorming, massive online, 241 Brandenburger, A., 90, 92, 104, 105, 187 brands and brand names diversification, 303, 304, 306 national differentiation, 286 overseas markets, 279, 280 product differentiation, 177, 182–183 property rights, 221–222 value, 114, 115, 121 BrandZ, 116 Branson, R., 310 Braunerhjelm, P., 296 Brealey, R. A., 312 Breen, Ed, 297 Breschi, S., 247 brewing industry, 157, 217 British Airways, 102 British American Tobacco, 202, 298 British Broadcasting Corporation (BBC), 138 British Petroleum (BP), 145, 172, 213, 327, 328, 338, 352 Browne, John, 145 Brusoni, S., 268 Bryan, L. L., 58, 374 Brynjolfsson, E., 339 BSA Ltd., competitor analysis, 97 BT, 355 Buaron, R., 187 budgets, 135, 327 Buffett, Warren, 59, 165, 310, 317, 318, 346 Bulgari Hotels, 353 Burberry, 180 bureaucracy, 142 bureaucratic organizations, 137, 148 Burgelman, R. A., 29, 339 Burger King, 175, 292 Burns, T., 138, 147, 152 Burrough, B., 312 Bush, George W., 92 business ecosystem, 88–91 business model, 88–90, 89 innovation, 158–161 business process management, 170 business process re-engineering (BPR), 170, 171 business schools, 126 business strategy, corporate com- pared, 18–19 see also strategy analysis business-to-business transactions, 179 Butler, R., 147 buyer power, 65, 71, 73, 273 Buzzell, R. D., 28 C Cacciatori, E., 267 Cadbury, 38, 286, 294, 334 Cadbury, D., 339 CAGE framework, 283, 283 Cairn Energy, 67 Calhoun, J., 187 Calico, 366 Callaway Golf Company, 352 Camerer, C. F., 28, 105 Campbell, A., 216, 248, 306, 313, 323, 329, 338, 339 Campbell Soup, 324 Canon Inc., 192 cans see metal container industry Cantrell, S., 105 capabilities, organizational, 108–112, 116–118, 128, 369–371 acquiring, 164 adapting to change, 200–202 appraising, 118–122, 120, 121, 125 comparative advantage, 273–276, 274 diversification, 304 exploiting innovation, 228–230 firm boundaries and, 371 identifying, 116–118, 117, 119 internationalization, 273–276, 279, 282 link with resources, 112, 207–210 options approach, 367 sources of profit, 111–112 strategy analysis framework, 13 strength of, 122–123 capacity excess, 68–69, 172, 197, 346 utilization, 168, 172 capital asset pricing model (CAPM), 299 capital costs, barrier to entry, 66 capital expenditure budgets, 135 capital markets, diversification, 301, 306–307 Capital One, 265 capitalism, crisis of, 363–365 Capozzi, M. M., 296 Capron, L., 349, 356, 358, 359 car industry see auto industry Cardinal, L. B., 246, 313 Carey, Mariah, 112 Carlson, C., 225, 240 Carlyle Group, 307, 323 Carnegie School, 199 Carrara, 352 Carrefour, 260 Carroll, G. R., 195, 216, 217 cash flows firm value, 41 performance, 42 portfolio planning, 320 strategy value, 42 Cassidy, John, 105 Cassiman, B., 247 Caterpillar, 288 Catmull, Edwin, 350 INDEX 645 Cattin, P., 188 causal ambiguity, 163–164 Caves, R., 104, 105, 295 Celera Inc., 229 Celgene Corporation, 115 Cemex, 173 Cennamo, C. 94, 237 Centrica, 303 CEOs, 325, 327, 328, 330–332, 334, 335, 335, 337, 364, 371 Cerruti, 121 CFM International, 351 Champy, J., 170, 171, 187 Chana, S. H., 359 Chandler, A. D., Jr., 15, 253, 255, 267, 312 change, 189, 190 competitive advantage, 157–161 complexity theory, 368 external sources, 157–158 industry life cycle, 191–198, 200–202 internal sources, 158–161 in multibusiness firms, 329–333 organizational adaptation to, 190, 198 see also innovation Charan, R., 132, 135, 151, 326, 339 Charoen Pokphand, 301 Chatas, J.-P., 105 Chatterjee, S., 58, 313 chemical industry, overseas markets, 280 see also Dow Chemical; DuPont Chesbrough, H., 187, 241, 247, 268 Chi, T., 58 chief executive officers (CEOs), 325, 327, 328, 330–332, 334, 335, 335, 337, 364, 371 China National Petroleum Company, 352 Cho, Y.-H., 295 Christensen, C. M., 29, 130, 217, 358 Christensen, H. K., 313 Chrysler, 341, 342, 344, 349 Cibin, R., 218 Cirque de Soleil, 161, 161 Cisco Systems, 24, 116, 202, 225 CitiGroup, 151 Citroen, 194 Clark, K. B., 151, 188, 217, 248 Clemons, E., 28 clusters of industries, 275 Coase, R. H., 253, 267 Coca-Cola Co., 93 brand value, 116 cooperation, 92, 93 differentiation advantage, 178 internationalization, 288 market-to-book ratios, 115 vertical deintegration, 260 codifiable knowledge, 224 cognitive factors, change, 208 Cohen, E. A., 373 Cohen, Lyor, 112 Cohen, W. M., 226–227 coinsurance effect, 313 Colgate-Palmolive, 63, 176 Coll, S., 339 collaborative arrangements, 265, 351 Collerill, R. W., 105 Colli, A., 336 Collins, James C., 16, 29, 50, 58, 206, 366, 371–374 Collis, D. J., 16, 28, 29 Comcast, 335 commitment, game theory, 92 commodity products, 173 communication, strategy as device for, 15–16 communications equipment industry see network and communications equipment industry Compagnie Générale des Eaux, 257 companies see firm-level strategy analysis; firms comparative advantage, 273–276, 274, 275 compensation systems, 334, 335, 335 competencies human, 114–116 modeling, 372 organizational see capabilities, organizational traps, 199 competition, 362 for competence, 355 competitor analysis, 95–98, 96 five forces model see five forces of competition game theory, 91–95 global strategies, 282 hypercompetition, 85 industry analysis, 61, 62, 64–66, 65, 66–71 industry boundaries, 75–76, 98–101 industry structure, 75–76 internationalization, 272 key success factors, 77–80, 100 segmentation analysis, 98–101 strategic group analysis, 100–101, 102 industry life cycle, 196, 197 profitability and, 38 stakeholder vs. shareholder interests, 38 from substitutes, 64, 66 vertical integration effects, 260 see also competitive advantage; competitors competitive advantage, 155–188 causal ambiguity, 163 contextuality, 368–369 cost, 166, 166, 176, 303 differentiation, 166, 166, 168– 169, 173–175 diversification, 303–307 establishing, 120 external sources of, 157, 157–158 identifying key success factors, 77–80 industry life cycle, 197 innovation, 221–222 internal sources of, 158–161 internationalization comparative advantage, 273, 273–276 entry into foreign markets, 278–280 global strategies, 281–287 location of production, 276–277 resources and capabilities, 111–112, 113, 118–123 acquiring, 164–165 internationalization, 273–276 seeking complex sources of, 365–366 sustaining, 120–121, 162–165, 176, 226, 226–227, 365 technology-based industries, 221–227, 229–231 uncertain imitability, 163 competitive intelligence, 95–96 competitive strategy, 18 competitor analysis, 95–98, 96 competitor, industry analysis, 61, 64, 65, 68, 91–98, 96, 272 complementarity, 368 competitive imitation, 163–164 contextuality, 368–369 network externalities, 233–234 organizational change, 198–200 product, 86–87, 87, 179 resources, 121, 225, 225–226, 230 complexity, of technology, 224–225 complexity theory, 163, 368 computer industry (hardware) adapting to technological change, 203–204 conditions for innovation, 241 exploiting innovation, 229 industry analysis, 70, 71 industry standards, 232, 236, 237 internationalization, 285 life cycle, 193–195 profitability, 223 segmentation analysis, 98 vertical scope, 252–253 see also Apple Computer Inc.; Dell Computer; Hewlett-Packard; IBM computer industry (software) bargaining power, 87 conditions for innovation, 240 exploiting innovation, 229, 230, 231 industry standards, 232, 232–234, 236 profitability of innovation, 225 value chain, 172 see also Apple Computer Inc.; Google; Microsoft concentration industry, 169 seller, 68, 372 concentration ratio, 68 configurations, 368 conformity, 199 conglomerates, emergence, 308 conjoint analysis, 176 Connor Peripherals, 204 consensus-based hierarchies, 370 consolidators, 201 consumer goods, 183, 283–284 consumer surplus, 36, 62 contemporary strategy analysis see strategy analysis contestable industries, 66 contextuality, 368–369 Continental Airlines, 346 contingency approaches, 368 contingency theory, 11, 147 contracts employment, 137, 253 performance, 145 in vertical relationships, 252–256, 259–261, 263–265 control mechanisms, management, 136, 145 Conyon, M. J., 373 Cool, K., 106, 130 cooperation, 92, 93, 136–137, 150 cooperatives, 364 coordination 646 INDEX for exploiting innovation, 229 hierarchical structures, 142–144, 143, 369 mechanisms mutual adjustment, 137 routines, 138–139 rules and directives, 137 for organizational capability, 119, 207 organizational structure, 136–139, 144 strategy as support for, 15–16 Copeland, T., 55 copyright, 224, 305 see also intellectual property Corley, K. G., 374 Corning, 229, 323 corporate, 333–337 corporate control, market for, 38 corporate culture see organizational culture corporate economy, 252 corporate incubators of innovation, 244 corporate management, role of, 316–317 corporate management units, 322 corporate objectives, 365 corporate planning (long-term), 12–13, 14 corporate portfolio, 317 corporate restructuring, 205, 323–325 corporate social responsibility (CSR), 50–52 corporate strategy, 18–19, 20 current trends, 360–374 diversification, 297–314 industry analysis, 59–82 internationalization, 270–296 multibusiness firms, 315–339 scope of the firm, 251–268 vertical integration, 251–268 corporation, culture of, 138 cost advantage, 166, 166 absolute, 67 costs of differentiation, 181 drivers of, 166–173, 303–305 mature industries, 215 sustainability, 176 value-chain analysis, 172–173, 174 cost conditions, industry analysis, 69 cost differentiation strategies, 184, 184 cost drivers, 168, 168 cost leadership, 184, 184 cost-of-entry test, 302 Covey, Stephen, 28 creative abrasion, 239 creative destruction, 85 creativity, 238–239 credit crisis see financial crisis cross-border aggregation, 281 cross-functional teams, 243 cross-subsidies, 282 Crowston, K., 119, 151 cultural distance, 283, 283 customers demand analysis, 176–178, 178 differentiation, 181 global strategies, 281, 285 industry analysis, 61–62 buyer power, 65, 70, 71, 73, 78, 79 defining markets, 76 internationalization, 272 key success factors, 77, 78, 78, 100 innovation, 240, 241 national differentiation, 283, 285 segmentation analysis, 98–101, 176 value-chain analysis of, 183–184 Cusumano, M. A., 216, 237 CVC Capital Partners, 324 Cyert, R., 187, 199 Cyriac, J., 313 D Daft, R., 152 Dagnino, G. B., 104 Daimler, 342, 344 Daimler-Benz, 341, 349 DaimlerChrysler, 349 Dalkir, K., 218 Danneels, E., 130 Danone, 333, 341, 354, 370 Darwin, Charles, 189 D’Aveni, R. A., 85, 104 David, P., 247 Davidson, William, 97 Davies, A., 359 Davis, A., 339 Davis, G. F., 312 Day, G., 216 De Beers, 202 de facto standards, 232, 232 de Geus, A., 52, 58, 208 De Havilland, 222, 229 debt, shareholder value, 41 decentralization, 148, 149, 206, 288, 336 decision making competitive intelligence for, 95 M-form theory, 337 national differences, 284 strategy as support for, 15 declining industries, 69, 299 decomposability, 143 DeFillippi, R., 187 Deighton, J., 358 delayering, 149 Dell Computer, 160, 207, 223, 265, 347, 366 Delphi technique, 231 Delta, 346 demand growth, 191, 196 demand-side analysis comparative advantage, 274 differentiation, 175–178, 179 emerging industries, 231 demand, substitution in, 76 design dominant, 192–193 organizational see organizational structure product/service, 168, 171 deterrence competitive advantage, 163 game theory, 91–93 Devers, C., 104 Devro plc, 64 Dewhurst, M., 296 Dhar, T., 105 Diageo plc, 40 Diamond Multimedia, 194, 229 Dickinson, S. M., 359 Dickson, P. R., 188 Diekman, K. A., 312 Dierickx, I., 106, 130 differentiation, 173–184 advantage, 166 conditions for innovation, 242 demand-side analysis, 174, 176–178, 179 industry analysis, 67, 68, 70, 74 industry life cycle, 195 national, 281–287 segmentation distinguished, 176 supply-side analysis, 174, 178–181 sustainability of advantage, 176 value-chain analysis, 182, 182–184 variables, 176 digital industries, 366–367 digital innovation, 235 digital technologies, 361–362 digital world, 366 Dillon, M., 286 DiMaggio, P. J., 317 Dimon, Jamie, 131 direct investment, 271–272, 278, 279 directors, responsibilities, 334–335 discounted cash flow (DCF), 41 Disney, 243 see also Walt Disney disruptive technologies, 203–204 distribution channels access to, 67 industry life cycle, 196 overseas markets, 280 diversification, 297–314 competitive advantage from, 303–307 motives for, 299, 302 performance, 307–309 trends over time, 300, 300–301, 301 diversity, competitor, 68 division of labor, 136, 169 Dixit, A. K., 28, 55, 105 Dodgson, M., 247 Dolby Laboratories, 111, 228 Dolce & Gabbana, 305, 306 domestic appliances, 283 dominant design, 192–193 dominant logic, 311, 333 Domino’s Pizza, 66, 281 Donaldson, I., 152 Donaldson, L., 152 Donaldson, T., 57 dot.coms see e-commerce Dougherty, D., 247 Dow Chemical, 346 Dowdy, J., 339 Doz, Y., 186 Dr Reddy’s Laboratories, 352 Dranove, D., 187 Drazin, R., 28 DreamWorks Animation, 341, 353 Drucker, P. F., 7, 28, 107, 130, 135, 151, 251, 363, 373 dual strategies, 204–205 Dugan, R. E., 246 Dunne, T., 217 DuPont, 228, 254 DuPont Formula, 54 Dye, R., 339 Dyer, J. H., 267, 268, 356, 358 dynamic capabilities, 211, 367 dynamic collectivism, 295 dynamic dimension of strategy, 19 Dyson, J., 35, 228, 246 E e-commerce, 194, 203 Eastman Kodak, 111, 229, 373 INDEX 647 Ebbers, Bernie, 345 ecology, organizational, 195, 201 ecommerce business models, 235 economic distance, 283, 283 economic profit, 40–41, 111–112 economic rent see economic profit economic value added (EVA), 40 economies of learning, 168, 170 economies of scale, 65, 66, 145 cost advantage, 168, 168–172 differentiation advantage, 182 economies of scope compared, 303 global strategies, 281, 285 knowledge replication, 281 organizational structure, 145 vertical integration, 260 economies of scope, 303–308, 313 ecosystem see business ecosystem EDS, 302 Edward Jones, 125 Eisenhardt, K. M., 29, 151, 218, 373 Eisenhower, D. W., 151 Eisner, Michael, 114, 370 Elder, T., 217 Electrolux, 76 electronics industry, 277, 281, 291, 304 see also network and communications equipment industry Elizabeth II, Queen, 4–7 Elms, H., 104 Embraer, 270 emergent strategy, 21 emerging industries, risk, 229–231 see also new entrants Emery, J. D., 373 EMI, 229, 230 Eminem, 360 emotional climate, 372 emotional intelligence, 116, 372 employment contracts, 137, 253 ENI, 134, 353 Eni SpA, 209 Enron, 48, 337, 373 Enterprise Rent-A-Car, 99 enterprises see firm-level strategy analysis; firms entertainment industry, 63, 74–76, 113, 257 see also Time Warner; Walt Disney entrepreneurship, 158 entry cost of, 302 threat of, 66–67 environment of firms see industry environment environmental analysis, 60–62 EOG Resources, 67 Epple, D., 187 Erdorf, S., 313 Ericsson, 273 Ernst, D., 359 Esty, B. C., 105 ethics, 50 Evans, L. B., 82 evolutionary economics, 201 evolutionary processes, 368 evolutionary strategies, 237 evolutionary theory, 201 Ewing, D. W., 139 excess capacity, 68–69, 172 exit barriers, 68–69 Expedia, 122 experience curve, 166, 167 experience goods, 180 experimentation, 239 explicit knowledge, 212 exploitation, 199 external industry environment change see change diversification, 308–309 industry analysis, 60–62 strategic fit, 10–11, 368–369 Exxon Mobil, 324–325, 344, 353 cooperation, 92 diversification, 304 market capitalization, 202 organizational adaptation, 200–202 organizational capabilities, 209 profitability, 39 strategic planning system, 325 Exxon Mobil Inc., 209 F Facebook, 7, 8, 85, 90, 116, 159, 160, 190, 202, 222, 224, 228, 229, 235, 242, 245, 334, 361, 362, 366, 372 family-owned companies, 336 FAW Group, 351 Federal Express, 43, 121, 176 feedback, positive, 85, 234, 236 Feigenbaum, A., 106 Felin, T., 119 femininity, 284 Fenton, E., 373 Ferdows, K., 186 Ferrari, 75, 76, 112, 137, 234, 336 Ferretti, 121 Ferriani, S., 130, 268 Feser, C., 374 Fiat, 66, 73, 336, 353–355 financial crisis (2008–9), 13, 37, 302, 362, 363 financial management systems, multibusiness firms, 7, 327–329 financial performance analysis see performance analysis financial scandals, 363 see also Enron; WorldCom financial services industry, 76 see also Capital One Finkelstein, S., 358 Fiorina, Carly, 325 firm-level strategy analysis contextuality, 368–369 goals, values, and performance, 33–58 key drivers of profitability, 77–80 resources and capabilities, 107–130 strategic fit, 10–11 firm-specific competitive advantage, 276 firms scope of, 252–256 see also firm-level strategy analysis first-mover advantage, 230, 231 Fisher, F. M., 28 fitness peak, 368 five forces of competition, 64, 65 extending the model, 86–91 internationalization, 272–273 fixed costs, 69 fixed:variable cost ratio, 69 flexibility corporate culture, 138 efficiency and, 119 managing risk, 231 organizational structure, 142–150 risk limitation, 231 vertical integration, 256–266 Flextronics, 125, 253, 266 Florida, R., 113, 114, 204 focusing, capability development, 211 followers in innovation, 229, 229–231 Folta, T. B., 359 Ford Motor Company cost advantage, 168, 170 industry life cycle, 194 industry standards, 233 internationalization, 287, 288 knowledge creation, 214 national differentiation, 283–284 specialization, 136 Fortune Brands, 347 Fosfur, A., 247 Foss, N. J., 119, 187, 295, 373 Foster, R., 217 Fourné, S., 186 Fox, C. F., 313, 339 Foxconn, 125, 266, 278 franchising, 263, 264, 280, 286 Franco, F., 313 Freeman, C., 248 Freeman, J., 195 FreeMove, 354 Frei, F. X., 187 Friedlander, A., 247 Friedman, M., 50, 58 Fujifilm, 56, 304, 305 Fujimoto, T., 151, 188, 248 functional classification, capabilities, 117–118 G Gabriel, K. J., 246 Gadiesh, O., 29 Galbraith, J. K., 131, 240 Gale, B. T., 28 Gambardella, A., 246 game theory, 12, 28, 91–95, 105, 180 Gans, J., 105 Gap, 260 García-Castro, R., 57 Garmin, 222 Garnsey, E., 130 Gavetti, G., 29, 187, 218 Gawer, A., 237, 247 Gazprom, 67 GE see General Electric GE/McKinsey matrix, 320, 320 Geely, 121 Geneen, H. S., 145, 297 General Electric (GE), 202, 320 acquisitions, 350 brand value, 116 business linkages, 322 corporate strategy, 316–318, 320, 322 diversification, 304, 306–308 exploiting innovation, 229, 230 GE/McKinsey portfolio planning matrix, 320, 320 joint ventures, 351 market capitalization, 202 organizational change, 200, 206 organizational structure, 145 profitability, 39 648 INDEX General Mills, 298, 324 General Motors (GM), 73, 145, 145, 151, 170, 171, 194, 205, 255, 261, 342, 351, 354, 355, 358 acquisitions, 342, 351, 354, 355 competitive advantage, 171 international alliances, 354–356, 355 internationalization, 287 organizational change, 205 profitability, 170 vertical integration, 261 geographical boundaries, markets, 76 see also segmentation geographical distance, 283, 283 geographical location competitive advantage from, 156 geographical scope, 252–256 industry life cycle, 197 international strategies, 276–278 see also internationalization George, J. M., 247 Geroski, P. A., 104, 247 Gerstner, Lou, 211, 330, 370 Ghadar, F., 295 Ghemawat, P., 80, 82, 105, 281–283, 283, 289, 291, 295 Ghoshal, S., 149, 152, 287, 289, 295, 363, 373 Ghosn, Carlos, 172 Gilbert, J., 29 Gillette, 68, 87, 89, 119, 159, 289, 345 Ginter, J. L., 188 Gioia, D. A., 374 Gladwell, M., 247 GlaxoSmithKline, 115, 352 Glencore International, 347, 362 global industries, 271, 272 global localization, 286 globalization see internationalization Glover, V., 187 GM see General Motors goals, 5, 34 identifying competitors, 94 setting, 47–49 short-term monitoring, 45, 47 strategy as, 15–16, 35, 48 value maximization, 38, 49–53, 365 Godart, F., 339 Goedhart, M., 58 Goldman Sachs, 51, 122 Goldwyn, Samuel, 206 Goleman, D., 130, 372, 374 Goodnight, J., 247 Goodwin, Fred, 345 Google, 67, 90, 243, 366, 372 acquisitions, 347 Android, 90 brand value, 116 competitive advantage, 365–366 diversification, 298 industry standards, 232 industry structure, 74 innovation, 229, 230, 239 mission, 35 organizational design, 148 platform-based markets, 235 platform investments, 55–56 strategic alliances, 351–356 vertical integration, 260 Goold, M., 306, 312, 313, 328, 329, 338, 339 Gould, B. W., 105 Gould, S. J., 247 government barriers to entry, 67 standards, 232, 233 governmental barriers, 67 Govindarajan, P., 295 GPS systems, 222 Grameen Bank, 159 Grandori, A., 152 Granovetter, M., 336 Grant, J. L., 58 Grant, R. M., 69, 105 concept of strategy, 27 diversification, 314 GEM system, 359 globalization, 295 mature industries, 270 organizational change, 218 signaling, 105 standards wars, 247 strategic planning systems, 151 strategic relatedness, 310 Grant Thornton, 122 Greckhamer, T., 104 Green, S., 130 Greenbaum, B. E., 187 Grimm, C., 104, 106 Grindley, P., 247 Groenen, P., 188 gross margin, 44 Grove, A., 29, 205, 332, 339 growth demand, 191, 196 diversification for, 299 growth–share matrix, 320, 321 Grupo Alfa, 301 Grupo Carso, 301, 307 Gucci, 181, 225, 260, 306, 325 Gulati, R., 130 Gupta, A. K., 295 H Haefliger, S., 187, 247 Haier, 76, 206 Haleblian, J., 358 Hall, S., 339 Hambrick, D. C., 313 Hamel, G., 16, 29, 109, 130, 248, 295, 359, 360, 371, 373, 374 core competences, 109, 117 corporate incubators, 244 globalization, 295 leadership, 371 strategic innovation, 161 strategic intent, 16 Hammer, M., 170, 171, 187 Handy, C., 363, 373 Hannah, L., 202 Hannan, M. T., 195, 216, 217 Harford., J., 358 Harley-Davidson, 97 competitor analysis, 97 differentiation advantage, 178, 180, 183 resources and capabilities, 124, 125 segmentation analysis, 97 Harper, N., 313 Harreld, J. B., 218, 330 Harris, J., 296 Hart, S. L., 58 Hartmann-Wendels, T., 313 Harvard University, 25 Hatfield, D. E., 246 Hayward, M., 313 Hazlewood, Lee, 189 HBO, 243 Hedlund, G., 149, 152 hedonic price analysis, 177 Heger, D., 82 Heil, O., 105 Heimeriks, K. H., 119 Heinrichs, N., 313 Heinz-Kraft, 324 Helfat, C. E., 130, 218 Henderson, B., 338 Henderson, R. M., 217, 338 Henry, H. W., 13 Hershey, 294 Hesterly, W., 123 Hewlett-Packard, 158, 302, 322, 325, 349 acquisitions, 342, 349 brand value, 116 business linkages, 322 competitive advantage, 158 diversification, 302 Heywood, S., 296 hierarchical decomposition principle, 143 hierarchical structures, 142–144, 148, 369, 370, 372 high-reliability organizations, 369 Hillkirk, J., 130 Hitachi, 228, 288 H&M, 80, 186, 252, 264, 284 Hobday, M., 359 Hofer, Chuck, 82 Hofstede, G., 284 holding companies, 254, 336 Holland Sweetener Company, 163 Hollywood, 352 Holm, U., 296 Home Depot, Inc., 115 Homkes, R., 339 Honda, 97, 125, 167 brand value, 116 competitive advantage, 176 global strategies, 285 industry analysis, 67, 97 internationalization, 293 resources and capabilities, 110, 110 strategy making, 20 Hood, C., 58 Horlsey, A., 248 hostile takeovers, 334, 342 Howard, H. Y., 218 HSBC, 81, 283, 332, 346 Hult, G. T. M., 295 human resources, 114–116, 121 internal labor markets, 307 managing creativity, 238–239 hypercompetition, 85 Hyundai Motor, 210 I IBM, 159, 370, 372 acquisitions, 347, 351 brand value, 116 change within, 330 competitive advantage, 158 exploiting innovation, 228 industry life cycle, 192 INDEX 649 industry standards, 236 “Innovation Jam,” 241, 371 internationalization, 287, 293 open innovation, 241 organizational capabilities, 211 organizational change, 205, 207, 330 patent infringement, 163 process re-engineering, 171 product design, 171 profitability of innovation, 223 strategic alliances, 351 valuation ratio, 115 vertical integration, 264 Icelandair, 126, 126, 127, 127 ICI, 287 identity, organizational, 370–372 Iger, Robert, 335 IKEA, 88, 176, 277, 282, 284, 295 Imai, K., 248 IMAX Corporation, 232 IMF, 363 imitation, competitive, 162–164, 225, 226 Imperial Tobacco, 362 In-N-Out Burger, 264 incentives see performance incentives Inditex, 80, 158, 260, 261, 267, 278 Zara see Zara individualism, 284 indivisibilities, 169 Industrial & Commercial Bank of China, profitability, 39 industrial espionage, 96 industry analysis, 60–62, 61 industry attractiveness, 62–71, 111, 302–303 industry environment change see change defining industry boundaries, 75–76, 98–102 external, 59–82 internal, 108 options management, 367 strategic fit, 10, 368–369 industry life cycle, 191–198 industry recipes, 97 industry structure company positioning, 75 forecasting profitability, 71–73 game theory, 92, 94–95 identifying, 71 industry life cycle, 195–198, 196 strategies to alter, 74 inertia, 199–200, 368 information and communication revo- lution, 370 information and communication technology (ICT), 201 current trends, 361–362 networks of collaboration, 371 vertical integration, 364 see also Internet Infosys, 144 innovation, 219–248 aligning with business strategy, 242 competitive advantage, 158–161, 221–227, 229–231 conditions for, 238–239 ecosystem, 229, 235–237 exploiting, 227–232 industry life cycle, 193, 197 internal creativity, 239–242 modes, 242 multibusiness firms, 329 multinational corporations, 287, 288 profitability, 222 protecting, 222, 224, 226–227, 229–231 innovative organizations, 239 innovators, 201 input costs, cost advantage, 168, 172 institutional isomorphism, 199 intangible differentiation, 175 intangible resources, 114, 304 integration, vertical, 251–268 Intel, 67, 170, 202 brand value, 116 exploiting innovation, 229 industry standards, 232, 237 knowledge replication, 224 organizational change, 206, 332 profitability of innovation, 224 intellectual property, 67, 223 diversification, 305 protecting, 224, 226, 226–227, 229–231 value of brand names, 115 intelligence, competitive, 95–96 intended strategy, 20, 133 internal commercialization, innovations, 228 internal industry environment, 108, 109, 128 internal markets, diversified firms, 306–307 internalization, administrative costs, 261 internalizing transactions, 305–306 International Federation of Red Cross (IFRC), 25 internationalization, 269–296 comparative advantage, 273–274 competition and, 272–273 entry into foreign markets, 278–280 global strategies, 281–287 industry life cycle, 197 location of production, 276–278 national differentiation, 281–287 organizational structures, 281–287 patterns of, 271, 271–272 Internet differentiation advantage, 181, 182 industry standards, 232 of things, 361–362 see also e-commerce inventions, 221, 238 commercialization see innovation iron ore industry, 74 isolating mechanism, 162, 162 Itami, H., 312 J Jacobides, M. G., 74, 82, 105 Jacobson, G., 130 Jacobson, R., 104 Jaguar, 336, 344, 345, 358 JAL Airways, 102 Jansen, J., 186 Japan Tobacco, 362 Jensen, M. C., 37, 57, 358, 364, 373 Jervis, V. T., 248 Jobs, Steve, 35, 133, 206, 230, 325 Johanson, J., 295 John Lewis Partnership, 364 Johnson & Johnson, 35, 63, 123, 176, 202, 242, 257, 330 joint ventures, 351 cooperation, 92 to exploit innovation, 228, 228 international, 280 Jones, D. T., 187 Jones, T. M., 57 Jonsson, A., 295 J&P Coates, 202 JPMorgan Chase, 39, 202 Judah, M., 339 K Kagono, T., 312 Kahn, Herman, 207, 218 Kale, P., 356, 359 Kaplan, D. A., 217 Kaplan, R. S., 47, 58, 188, 227, 339 Kaplan, S. N., 358 Karaevli, A., 218 Kase, K., 44 Kasparov, G., 15 Katila, R., 247 Kaufman, S. A., 368 Kawasaki Heavy Industries, 355 Kay, J., 49, 58 Kaye, C., 313 Keil, T., 313 Kellner-Rogers, M., 370, 374 Kellogg, 324 Kelly, J., 313 Kennedy, J. F., 16 Kensinger, J. W., 359 Keown, A. J., 359 key success factors identifying, 77–80, 100 industry life cycle, 196, 197 Khanna, T., 312 Khosrowshahi, Dara, 122 Kim, C., 161, 187 Kim, L., 210 Kim, S., 255 Kim, W. C., 29, 99, 106, 160 Klemperer, P., 105 Klepper, S., 216, 217 Klevorick, A. K., 246 know-how, 212 knowledge, 211–214, 213 codifiable, 224 creation and diffusion, 192–193, 221 global strategies, 281 industry life cycle, 191–193 organizational structure, 369 knowledge conversion, 214, 214 knowledge creation, 214 knowledge identification, 213 knowledge management systems, 211–214 knowledge measurement, 213 knowledge replication, 214 knowledge retention, 213 knowledge transfer and sharing, 213 Kodak see Eastman Kodak Koehn, N., 29 Kogut, B., 58, 295 Kohlberg Kravis Roberts, 299, 300, 307, 323 Kohli, A. K., 188 Koller, T., 58, 313 Kosonen, M., 186 Kraft, K., 82 Kraft Foods, 38, 63, 294, 324 Kramer, M. R., 52, 58, 365 Kroc, R., 192, 214 650 INDEX Krugman, P., 187, 295 Kulatilaka, N., 58 Kullberg, Tommy, 295 Kumar, V., 338 Kuppuswamy, V., 313 Kwak, M., 104 L labor comparative advantage, 273, 276 division of, 136, 169 internal markets, 307 labor unions see unionization Lady Gaga, 4–5, 8 Laeven, L., 312 LaFollett, K., 58 Lancaster, K., 188 Land Rover, 336, 344 Lapointe, F.-J., 188 Lasseter, John, 347 Laursen, K., 373 Lawler, E., 130, 131 Lazerson, M. H., 152 lead time advantages, 225, 226, 229 lead users, 231 leaders, in innovation, 229, 229–231 leadership, 371–372 lean manufacturing, 368 lean production, 194 learning economies of, 168, 170 global strategies, 282 organizational, 207, 370 organizational structure for, 144 Lee, E., 28 Lee, J., 28, 119, 151 Lee, L. W., 313 legal barriers to entry, 67 Legendre, P., 188 legitimacy, 363 Lego, 22, 35, 257 Lehman Brothers, 48 Leibenstein, H., 187 Leica, 192 Leinwand, P., 130 lemons problem, 130, 349 Lending Club, 362 LensCrafters, 341 Leonard-Barton, D., 218 Leonard, D., 239, 247 Lepine, J. A., 104 Leslie, K. J., 55 Level 5 Leadership, 372 leveraged buyouts (LBOs), 346 Levin, R. C., 246 Levine, D. K., 105 Levine, R. A., 105, 312 Levinthal, D. A., 187, 218 Levitt, B., 217 Levitt, T., 216, 281, 295 Lewin, A. Y., 152, 295, 373 Lewis, M. A., 186 LG Electronics, 276 Li, S., 130 licensing, 227–228, 228, 280, 305 Lieberman, M. B., 57, 130 Liebeskind, J. P., 313 Liebowitz, S. J., 247 life cycle, industry, 191, 191–198, 195, 196, 198, 200–202 lifestyle products, 180 limit pricing theory, 163 Linder, J., 105 line-and-staff organizational structure, 254 Linux, 230, 241, 371 Lippitz, M. J., 248 Lippman, S. A., 163, 187 Liz Claiborne, 200 Lloyd, M., 105 location see geographical location Lockheed Martin Corp., 115 London, T., 58 long-term contracts, 263–264 long-term (corporate) planning, 12–14, 14 loosely coupled systems, 143, 151 Lorenzoni, G., 130, 152, 268 Lorsch, J. W., 339 Louis Vuitton, 304 Lovallo, D., 313, 339 Lowe, Bill, 204 Lubatkin, M., 313 Lucent, 341 Luchs, K., 312 Luffman, G. A., 313 Luxottica, 343 LVMH, 304, 310, 322 Lycos, 229 M M-form theory, 335 MacDuffie, J. P., 82 Macher, J. T., 267 machine bureaucracies, 142 Machuca, J., 186 Macintyre, B., 105 Macmillan, I. C., 295 Maddigan, R., 267 Madhok, A., 130 Madoff, B., 180, 181 Madsen, T. L., 119 Mainardi, C., 130 Makadok, R., 313 Malerba, F., 247 Malone, T. W., 119, 151 management systems complexity theory, 368 for creativity, 238, 239 multibusiness firms, 329–333 multinational firms, 287–293 managers, changing role, 371–372 mandatory standards, 233 Manikandan, K. S., 312 Mankin, E., 359 Mankins, M. C., 326, 339 manufacture design for, 171 industry life cycle, 196 Marakon Associates, 326 March, J. G., 187, 199, 217 Marchionne, Sergio, 66 Marcus, M. L., 187 Margolis, S. E., 247 market economy, 252 market for corporate control, 38 market needs, creativity and, 240 market research, product attributes, 176 market share, profitability and, 167 marketing economies of scale, 168–169 overseas markets, 280, 281 quality signaling, 181 markets defining industry boundaries, 75–76, 97 diversification, 306–307 entry into foreign, 278–280, 281 global strategies, 281–283 transaction costs, 252–256 uncertainty about, 231 winner-takes-all, 234 Markides, C., 29, 130, 217, 247, 313 Marriott Hotels, 260 Marriott International, 353 Mars Inc., 162 Martin, I., 130 Martin, J. A., 218, 373 Martin, J. D., 313 Martin, R. L., 373 Martine, J. D., 359 Martins, L. L., 187 Marx, Karl, 121 masculinity, 284 Maslow, A., 188 Massa, L., 130, 187 Massini, S., 295 Masson, R. T., 104 Masten, S., 267 MasterCard, Inc., 115 Mathur, S., 188 matrix organizations, 145–147, 146, 369 Matson, E., 374 Matsushita, 229, 288 mature industries, 326 Matz, M., 313 Mauborgne, R., 29, 99, 106, 160, 161, 187 Maynard Smith, J., 105 Mayol, F., 374 McDonald’s, 17, 144, 316 brand value, 116 business model, 159 competitive advantage, 176, 185 franchising, 264, 280, 286 industry life cycle, 192 internationalization, 280, 285, 286 knowledge creation, 214 national differentiation, 286 organizational structure, 144 vertical integration, 261 vision statement, 298 McGahan, A. M., 104 McGrath, J., 40 McGrath, R. G., 104, 295, 365, 373 McGuire, S., 374 McIntyre, D. P., 247 McKelvey, B., 374 McKinsey & Company, 41, 43, 50, 235, 320 corporate restructuring, 326 diversification, 307 key success factors, 77 McMillan, J., 105 McNamara, G., 104 mechanistic bureaucracies, 142 mechanistic organizational forms, 147, 147–148 mechanistic vs. organic organizational forms, 147, 147–148 media sector, vertical integration, 347 see also entertainment industry Mercedes-Benz, 181 Merck, 54 INDEX 651 mergers and acquisitions, 341–351, 343, 345 definitions, 342 diversification, 302, 307, 309 diversity of, 344–345 hostile takeovers, 334, 342 lemons problem, 349 motives for, 345–347 post-merger integration, 349–351 pre-merger planning, 348–349 shareholders’ rights, 333–334 success and failure, 343–345, 345 Merrifield, R., 187 Merrill Lynch, 115 Messier, Jean-Marie, 345 metal container industry, 183, 183 Michaels, M. P., 55 Michel, A., 313 Micklethwait, J., 255, 358 Microsoft, 67, 86, 202, 235, 372 acquisitions, 347, 366 brand value, 116 exploiting innovation, 229, 230, 232 industry standards, 232, 234, 236 internal environment, 109 market capitalization, 202 organizational change, 206 organizational structure, 144 profitability of innovation, 222, 230 return on equity, 62 Xbox, 109, 347 milestones, 326 Milgrom, P., 105, 187, 217 Miller, C. C., 313 Miller, D., 130 Miller, L., 105 Miller, M. H., 58 minimum efficient plant size (MEPS), 168, 170 Mintzberg, H., 20–21, 29, 133, 149, 151, 152, 326, 337, 339 Mirabeau, L., 374 Misangyi, V. F., 104 Mishel, L., 339 mission statements, 16, 18, 35 Mitchell, W., 356, 358, 359 Mitsui Group, 201 Mittal Steel, 342 Mobil Corporation, 342 see also Exxon Mobil mobile phone suppliers see network and communications equipment industry mobility, barriers to, 99 Modigliani, F., 58 modularity, 142, 145 Moizer, J., 373 Mom, T., 186 monopolies, vertical integration, 258, 260 monopoly rents, 111 monopoly theory, 62 Monsanto, 92, 94, 163, 223, 225 Monteverde, K., 267 Montgomery, C. A., 28, 35, 57, 313 Moore, G. A., 202, 217 Moran, P., 373 Motel 6, service design, 171 motor industry see auto industry Motorola, 261, 273 Mowery, D. C., 358 MP3 players, 194, 232 Mueller, D. C., 104 multibusiness firms, 316–339 change within, 317, 329–333 corporate portfolio, 317 evolution, 254 external strategy, 342–351 governance, 333–337 individual businesses within, 323–329 linkages between businesses, 319–323 structure, 144–147 multidexterity, 369 multidimensional scaling (MDS), 176 multidimensional structures, 369 multidomestic industries, 271, 272 multinational firms see internationalization Munger, Charles T., 59, 310 Murdoch, Rupert, 51, 334 music industry, 75, 112 see also entertainment industry Musters, R., 339 Myers, S., 312 N Nalebuff, B. J., 28, 92, 104, 105, 187 nanotechnology, 367 Naspers Ltd., 115 national diamond framework, 274–275, 274–275 national differentiation, 281–284, 288 national resources, 273 exploiting, 281 foreign entry strategies, 278–280 location of production, 276–278 NatWest Bank, 122 Navistar, 202 NBC Universal, 306 NEC, 288 Nelson, R. R., 119, 151, 217, 226, 246 Nest, 366 Nest Labs, 362 Nestlé, 146, 205, 324 net margin, 44 net present value (NPV), 41, 42, 53 Netflix, Inc., 115, 362 Netscape, 229, 230, 236 network analysis, 372 network and communications equip- ment industry future profitability, 73 industry standards, 232–238 innovation, 229, 233 platform-based competition, 87 profitability of innovation, 222 see also Cisco Systems; Motorola; Nokia; Qualcomm; Sony network effects, technical standards, 192 network externalities, 87, 233–234 network structures, 149 networked organization, 372 new business models, 234 new enterprise models, 159 new entrants, threat of, 66–67 see also emerging industries new game strategies, 187 new industry models, 159 new revenue models, 159 News Corporation, 51, 345 News International, 334 niche markets, 64 niches, declining industries, 163 Nichols, N., 58 Nickerson, J. A., 152, 218, 374 Nicolaides, P., 188 Nike, 35, 125, 185, 231, 282 Nintendo, 10, 86, 94, 98, 229, 237 Nissan, 67, 172, 355 NK model, 163 Nobeoka, K., 268, 358 Nohria, N., 218 Nokia, 223 Nomura, 288 Nonaka, I., 214, 248 Nooyi, I., 327 Norman, P. M., 246 norms, national differences, 284 Northwest, 346 Norton, D. P., 47, 58, 326, 339 not-for-profit organizations, 24, 24–26 Noto, L., 107 Novartis, 242 Novo Nordisk A/S, 115 Nucor, 63 NUMMI, 355 NutraSweet, 163, 223, 225 NVIDIA Corp., 115 O Oakley, 341 OECD, 363 offices of strategy management, 327 Ohmae, K., 77, 177 oil and petroleum industry competitive advantage, 67, 172, 185 competitor diversity, 68 cost advantages, 67, 172 exploration capability, 118, 119 location of production, 276 strategic group analysis, 102 structure, 74 vertical integration, 256, 265 see also British Petroleum; Eni; Exxon Mobil; Royal Dutch Shell O’Keeffe, D., 339 oligopolies, 62 Olivetti, 111 open innovation, 241, 243, 371 open (public) standards, 233 operating budgets, 135 operating margin, 44 operating organizations, 240 operational relatedness, 310 opportunism, 258, 264, 265 options, 53–56, 366–368 Oracle, 232 Orange, 354 O’Reilly, C. A., 204, 218, 330 organic organizational forms, 147, 147–148 organization capability development, 139, 141 motivation, 140 processes, 140 structure, 140 culture as integrating device, 138 fundamentals cooperation problem, 136–137 coordination problem, 137–139 specialization and division of labor, 136 structure, 141 Ryanair Holdings plc, 144 652 INDEX organizational ambidexterity, 204–205 organizational capabilities, 143, 143 see also capabilities, organizational organizational change, 199–200, 329–333 organizational complexity, coping with, 369–371 corporate boundaries, breaking, 371 informal organization, 369–370 organizational culture as control mechanism, 136 human resources, 114–116 as integrating device, 138 values, 50 self-organization, 370–371 identity, 370 information, 370 relationships, 370 organizational culture, 138 organizational design hierarchy roles as coordination, 142–144 mechanism for cooperation, 142 trends in, 148–150 organizational development (OD), 204 organizational ecology, 195, 201 organizational identity, 370–372 organizational inertia, 199–200 organizational learning, 208, 370 organizational processes, 119 inertia and, 199–200 product champions, 243–244 organizational routines, 140, 170, 199, 208 organizational slack, 172 organizational structure for adaptability, 370 complexity theory, 368 cooperation problem, 136–137 coordination, 136–139 evolution of the corporation, 254 functional, 144–145, 254 hierarchical decomposition principle, 143 hierarchies, 142–144, 143, 147–148, 370, 372 for innovation, 242–245 matrix, 145–147, 146, 369 multibusiness firms, 145, 146, 329, 329–333 multidivisional, 145 multinational strategies, 287–288 nonhierarchical, 150 Orlitzky, M., 58 Orton, J. D., 151 Oster, C. V., 82 Osterwalder, A., 105 Oticon, 205 outsourcing, 125 to exploit innovation, 228, 228 or vertical integration, 261, 262, 265 see also internationalization Overdorf, M., 217 ownership, resources and capabilities, 121 see also property rights Oxley, J. E., 358, 373 Oztas, N., 374 P Paccar, 75 Palepu, K., 312 Palich, L. E., 313 Palmisano, Sam, 211, 330 Panasonic, 209, 288 Pandora’s Box Problem, 105 Panini Group, 64 Pant, A., 312 Panzar, J. C., 81, 313 Papa John’s, 66 paradox of replication, 212 parenting, 329 advantage, 306, 320, 321 particularism, 284 Pascale, R. T., 29 Pasmore, W. A., 217 patents, 67, 163, 223, 224, 226, 226, 229, 280 path dependency, 207 Pautler, P. A., 358 Pavitt, K., 268 Peck, S. I., 373 Pedigree Petfoods, 162 Peeters, C., 295 Pentland, B., 119, 151 PepsiCo, 92, 93, 115, 305, 327, 338 Peretti, J., 188 perfect competition, 62 performance analysis, 42–49 appraising current and past performance, 42–44 balanced scorecard, 47–48, 48, 326 diversified firms, 307–309 multibusiness firms, 327–329 performance incentives, 137, 239 CEO compensation systems, 334–335, 335 multibusiness firms, 327 vertical integration, 260, 265 performance targets see goals Perlstein, R., 49 permeable organizational boundaries, 149 personal computer industry see computer industry (hardware); computer industry (software) personality, leaders, 372 persuasion, 137 PEST analysis, 60–61 Peters, T., 151, 173, 188, 267, 309, 313 petroleum industry see oil and petro- leum industry Pettifer, D., 338 Pettigrew, A., 373 Pfizer, 222, 346 pharmaceutical industry, 227, 280, 302 see also Johnson & Johnson; Merck; Pfizer Philip Morris Companies Inc., 362 see also Altria Philips, 229, 232, 287, 288, 298 photographic sector, 275 see also Eastman Kodak; Polaroid Pietersen, W., 28 Pigneur, Y., 105 Piketty, T., 29, 373 Pilkington, 170, 222, 229 PIMS (Profit Impact of Market Strategy), 28 Pindyck, R., 55 Pioneer, 229 Pirelli, 98 Pisano, G. P., 130, 218, 242, 248 Pixar, 347, 349, 357 planning, corporate (long-term), 12–14, 14 plant biotechnology, 201 platform investments, as growth options, 55–56 platforms, 87, 234–238 play, 238 Pocock, M., 208 poison pill defenses, 334 Polaroid, 205, 229 political distance, 283, 283 political factors, diversification, 306 Polman, Paul, 53 Polos, L., 217 Porras, J., 16, 29, 50, 58, 206, 374 Porter, M. E., 10–12, 28, 58, 64, 81, 82, 98, 104–106, 130, 313, 323, 365, 374 competitive advantage, 164, 166, 166, 173, 179, 182, 184, 187, 188, 217 competitor analysis, 96 corporate social responsibility, 50–52 corporate strategy types, 322, 338 diversification, 302–303, 306 leadership and differentiation, 184 national diamond, 274–275, 274–275, 294, 295 value chain, 117, 117, 182, 295 see also five forces of competition portfolio management, 323 portfolio planning matrices, 320 portfolio planning models, 317–318 positive feedback, 234 Postrel, S., 105 Powell, W., 217 power distance, 283 Prahalad, C. K., 16, 29, 58, 109, 117, 130, 244, 248, 295, 311, 314 Prato, 352 predatory pricing, 282 preemption, competitive advantage, 163–164 Prencipe, A., 268, 359 Preston, L. E., 57 price analysis, hedonic, 177 price competition, 68–70 game theory, 180 global strategies, 282–283 industry life cycle, 197 key success factors, 77, 79, 99 substitutability, 76 price sensitivity, buyers, 70 price setting, limit pricing theory, 163 Priem, R. L., 130 principles, 50 see also values (beliefs) prisoners’ dilemma game, 93, 180 private equity firms, 307, 323, 346 private (proprietary) standards, 233 process innovation, 193, 193 process technologies, 170 dominant designs, 193 Procter & Gamble, 143 business linkages, 319 exploiting innovation, 229 internationalization, 288, 289 national differentiation, 284 open innovation, 371 organizational structure, 143 reputation, 94 INDEX 653 producer surplus, 62 product champions, 243–244 product design, cost advantage, 171 product development costs, 281 product development teams, 241 product differentiation, 67, 68 product innovation, industry life cycle, 193, 193, 196, 201 product integrity, 180 product scope, 252, 298 see also diversification production design for, 171 drivers, cost advantage, 168, 171 for value creation, 35–36 profit pools, 101 profit/profitability basic analytic framework, 35 capabilities as source of, 111–112 competitive advantage, 157–158 corporate social responsibility, 50–52 definition, 39 diversification, 302, 309 forecasting, 71–72 foreign markets, 278 impact of growth on, 69 industry analysis, 60–62 competitor analysis, 97 internationalization, 272 segmentation analysis, 98, 101 strategic group analysis, 102 innovation, 222–226 key drivers of firm-level, 77–80 market share, 167 measures of, 39, 39 mergers and acquisitions, 344 multibusiness firms, 333 obscuring, 162–163 resources as source of, 111–112 stock market value and, 42–43, 365 US industries, 63 profitability ratios, 43, 44 see also return on invested capital project-based organizations, 149, 370 property rights in innovation, 222–224, 226, 227, 229 overseas markets, 280 resources and capabilities, 122–123 see also intellectual property proprietary (private) standards, 233 Provera, B., 130 psychological factors, product differentiation, 177–178 public (open) standards, 233 Pullman, 202 punctuated equilibrium, 205 Puranam, P., 338 purpose, sense of, 50 Q Quaker Oats, 349 Qualcomm, 232 quality signaling, 180–181 R Ramachandran, J., 312 Rand Corporation, 207 Rapping, L., 187 Raubitschek, R. S., 218 Ravasi, D., 217, 374 Ray-Ban, 341 Raytheon, 229 real option analysis, 53, 372 real options, 53–56, 367 realized strategy, 21 Reckitt Benckiser, 347 Reed, R., 187, 313 Reeves, M., 374 regime of appropriability, 222–226 Reich, R., 359 relatedness, in diversification, 309–311, 310 relational capability, 54 relational contracts, 264 relative efficiency, 306 Reliance, 301 Renault, 355 rent see economic profit replication, paradox of, 212–213 reputation brand value, 280 causal ambiguity, 163 competitive advantage, 180–181 threat to credibility, 94, 163 research and development (R&D), 238–245 residual efficiency, 168, 172 resource allocation, 335 resource-based view of firms, 13, 108–112 resources, 108–112 acquiring, 164–165 appraising, 114–116, 120, 122–123, 124, 125, 127 comparative advantage, 273–276 complementary, 121, 225, 225–226, 230 diversification, 303, 305 exploiting innovation, 228–230 human see human resources identifying, 114 intangible, 114, 115, 116, 304 internationalization, 273–276 link with capabilities, 113, 207–209 options approach, 367–368 organizational change, 201–202 sharing in multibusiness firms, 322 sources of profit, 111–112 strategic intent, 16 strength of, 122–123 tangible, 113, 303–305 restructuring, corporate, 323–325 retail sector causal ambiguity, 163 competitive advantage, 158, 172 diversification, 304 industry life cycle, 195 internationalization, 284 key success factors, 79, 80 resources and capabilities, 122–123 strategic innovation, 158 see also IKEA; Wal-Mart Inc.; Zara retaliation, as barrier to entry, 67 return on assets (ROA), 43, 44 return on capital employed (ROCE) see return on invested capital return on equity (ROE), 43, 44 return on invested capital (ROIC, return on capital employed (ROCE)), 41, 43, 44 key success factors, 79 performance diagnosis, 46, 46 performance target setting, 47 returns on innovation, 223 Reuer, J. J., 373 revolutionary strategies, 237 Rey, R., 267 Reynolds, M., 188 Reynolds American, Inc., 299 Reza, D. G., 187 Riboud, Franck, 370 Ricardian rents, 111 Ricardo, David, 111 Richman, B. D., 267 rigidity, organizational, 207 RIM, 103, 223 Rindova, V. P., 187 Rio Tinto, 362 Riquelme, H., 188 Rising, C., 358 risk diversification, 299–302, 309 emerging industries, 231–232 systemic, 362–363 vertical integration, 228, 265 rivalry, competitors, 65, 68–69 internationalization, 272 Rivkin, J. W., 29, 187, 217, 218 RJR Nabisco, 299, 300, 312 Robert Bosch, 365 Roberts, J., 105, 187, 217 Roberts, M. J., 217 Roberts, P. C., 58 Robertson, A. B., 248 Robertson, T. S., 105 Robins, J., 313, 314 Roche, 115, 242 Rockefeller, John D., 342 Roll, R., 358 Rolls Royce, 159 Romanelli, E., 217 Rometty, Ginni, 211 Ronfelt, D., 105 Roper, C., 105 Rose, G. F., 105 Rothermael, F. T., 246 Rothwell, R., 247, 248 routinization, 119, 208 for coordination, 137 economies of learning, 170 organizational inertia, 199 Rover, 349 Rowe, G., 247 Rowling, J. K., 257 Royal Bank of Scotland, 122, 345, 373 Royal Dutch Shell, 202, 209, 316 internationalization, 287, 288 joint ventures, 56, 92 market capitalization, 202 objective, 298 option value, 53–54 organizational adaptation, 201 organizational change, 205 organizational structure, 145–146, 146 scenario analysis, 208 Ruefli, T. W., 104, 187 Ruimin, Zhang, 206 Rukstad, M. G., 16, 29 rules, for coordination, 137 Rumaila Field Operating Organization, 352 654 INDEX Rumelt, R. P., 15, 23, 29, 104, 162, 163, 186, 187, 300, 312, 326, 339, 365, 373 Ryall, M. D., 105 Ryanair, 10, 11, 89, 90, 102, 144, 144, 172, 186 Rynes, S. L., 58 S SAB Miller, 362 Saebi, T., 187, 373 Saez, F. J., 188 SAIC Motor, 351 Sakuma, S., 312 Samsung, 276, 316, 330–332, 365, 372 business linkages, 322 exploiting innovation, 229 strategic alliances, 352 Samuelson, L., 217 Santal, J., 237 Santamaria, J., 28 sat-nav systems, 222 satisficing, 199 Saudi Aramco, 67, 172, 263 Sauer, C., 268 Sayrak, A., 313 scalability, 54 scale economies see economies of scale scandals, 49, 363 see also Enron; WorldCom scenario analysis, 206–207 Schaefer, S., 187 Scharfstein, D., 313 Schein, E. H., 138 Scheinkman, J., 339 Schelling, T. C., 187 Schendel, Dan, 82 Schiffman, S., 188 Schmalensee, R., 82, 187 Schmidt, F. L., 58 Schmidt, J., 313 Schoemacher, P., 208 Schön, D. A., 248 Schultz, M., 374 Schumpeter, J. A., 35, 57, 83, 85, 104, 158, 187 scope, economies of see economies of scope scope of the firm, 252–256 see also diversification; internationalization; vertical integration Scotchlite, 244 search goods, 180 Searle, G. D., & Co., 222, 223, 225 Sears Holdings, 164 segmentation, 98–101, 176 Seidel, M.-D., 216 self-awareness, 372 self-management, 372 self-organization, 368, 372 seller concentration, 68, 272 Selznick, P., 130 Sephora, 304 service design, 171 services, shared, 304, 322 Shah, D., 338 Shaked, I., 313 Shane, S., 247 Shanley, M., 187 Shapiro, C., 28, 236, 238, 247 share value see stock market value shared corporate services, 322 shared service organizations, 304, 319 shared values, 50, 52, 137 concept, 365 shareholder returns, mergers and acquisitions, 344 shareholder value, 36–38 diversification and, 299, 307 maximization, 37 maximization as dominant goal, 41–42, 365 multibusiness firms, 329–333 options management, 366–368 pitfalls of pursuing, 49 shareholders’ rights, 333–334 Shell see Royal Dutch Shell sheltered industries, 271, 271 Shipilov, A., 339 Shockley Semiconductor Laboratories, 202 Shuen, A., 130, 218 Shulman, S., 247 Sibony, O., 339 Siegfried, J. L., 82 Siemens, 228, 241, 273, 298, 325, 330, 353, 355 Siggelkow, N., 164, 187, 200, 217, 218, 374 signaling, 94 differentiation advantage, 180–181 game theory, 94, 180–181 Silverman, B. S., 358 Sime Darby, 301 Simon, Herbert A., 29, 151, 199 Simons, K. L., 216, 217 Singapore Airlines, 121 Singer, 159, 202 six-sigma program, 368 SixDegrees.com, 229 Skandia, 213 slack, organizational, 172 Sloan, A. P., Jr., 33, 189, 358 Slywotzky, A. J., 240, 247 Smith, A., 50, 51, 58, 136, 151, 252 Smith, J. M., 105 Smith, K. G., 104, 106 Smith Corona, 111, 129 Snapple, 349 Snecma, 351 Snyder, N. T., 217 social awareness, 372 social enterprises, 364 social factors current trends, 363–365 organizational change, 199 product differentiation, 176–178 social pressures, 363–365 social responsibility, 49–52 social skills, 372 social systems, self-organization, 368 Song, J., 295 Sony diversification, 303 industry standards, 232, 235–236 innovation, 229, 231, 236 internationalization, 288 South Oil Company, 352 Southwest Airlines, 22, 90, 185, 186 Spaeth, S., 247 specialization cost advantage, 166 diversification compared, 308 scope of the firm, 253, 253 see also diversification; internationaliza- tion; vertical integration specialized complementary resources, 226 Spence, M., 81 Spencer, L., 130 Spencer, S., 130 Spender, J.-C., 97, 105, 137, 151, 217 spot contracts, 263, 265 Srinivasan, A., 247 Srinivasan, R., 374 stakeholder approach to the firm, 36–38 stakeholder value maximization, 37 Stalk, G., Jr., 147, 152, 162, 186, 187 Stalker, G. M., 147, 152 stand-alone influence, 323 Standard Oil, 202, 281, 342 standardization divisional management, 335–336 multinational firms, 285, 288 standards (technical), 232, 233 exploiting innovation, 230 industry life cycle, 192–193 Staples, 160 Star Alliance, 351 Starbucks differentiation advantage, 176, 180 diversification, 304, 305 internationalization, 280 market-to-book ratios, 115 valuation ratio, 115 static dimension of strategy, 19 steel cans see metal container industry steel industry, 13, 79 Steele, R., 326, 339, 374 Stein, J., 313 Stelzer, Irwin, 340 Stern Stewart & Co., 40 Stevens, D., 187 stewardship, 51 stock market value as performance indicator, 42–43, 43 shareholder value maximization, 365 Stokes, D., 246 Stopford, J., 295 strategic alliances, 351–356, 367 to exploit innovation, 228, 231 international alliances, 354–358 managing, 354–358 motives for, 353 strategic corporate social responsibility, 53 strategic fit, 10–11, 368–369 strategic group analysis, 101–102, 102 strategic inflection points, 332 strategic innovation, 158 strategic intent, 16, 206, 331 strategic management capabilities, 304 complexity theory, 368 design vs. emergent strategy, 20–22 evolution, 12–13, 14 of innovation, 238–245 multibusiness firms, 315–339 organizational change, 204–213, 329–333 strategic planning systems, 133–135, 134, 151 INDEX 655 annual cycle, 134 criticisms of, 326 improvement, 326–327 multibusiness firms, 325–327, 329 planning cycle, 133–135 strategic relatedness, 310, 310 strategic windows, 230 strategy analysis, 9, 9–1, 23 change, 189–218 competitive advantage see competitive advantage corporate strategy see corporate strategy external environment, 59–82 firm elements, 9 goals, values, and performance, 34–58 resources and capabilities, 107–130 technology-based industries, 219–248 strategy, concept of, 3–29 analytical framework, 9, 9–11 see also strategy analysis corporate–business strategy distinction, 18–19 see also corporate strategy definitions, 14, 15 describing, 19–20, 20 game theory as general theory of, 12, 94 history, 12–14 identifying a company’s, 16, 18 process, 20–23 statements of, 16, 18 success and, 4–9, 9, 19 strategy formulation, 151, 367 planning system, 133–135 strategic planning cycle, 133, 133–135 strategic planning systems, 133–135, 134 strategy implementation, 131–152 multibusiness firms, 315–339 strategy maps, 326 Straus, S., 247 strengths assessing, 122–123 exploiting key, 124 superfluous, 125 SWOT framework, 10 Strong, J. S., 82 structural ambidexterity, 204–205 structural modulation, 152 structure see industry structure; organizational structure structured network, 149 Stuart, J. H. W., 105 Suárez, F. F., 216 substitutability, 76, 80 substitutes competition from, 64–66, 71, 74, 86, 100 in demand and supply, 76 segmentation analysis, 100 success, 9, 19 identifying key factors, 77–80 strategy and, 4–9, 9, 19 Sull, C., 339 Sull, D. N., 29, 105, 231, 247, 339 Sun Tzu, 3, 11, 28 Sunglass Hut, 341 sunk costs, 66 supermarkets, key success factors, 79 see also retail sector suppliers industry analysis, 9, 61, 62, 64, 67, 69–71 concentration, 68 internationalization, 272 vertical relationships, 265 supply-side differentiation, 178–181 supply-side substitutability, 76 supply sources, ownership, 172 supply, substitution in, 76 Surowiecki, J., 57 Suzuki, competitor analysis, 97 Swaminathan, A., 217 Swap, P., 247 Swissair, 355 switching costs, 234 SWOT framework, 9, 10 Symbian, 229 systematic risk, 299 systemic risk, 362–363 systems see management systems systems integrators, 266 Szulanski, G., 295, 338 T T-Mobile, 234, 354 tacit knowledge, 212, 224 Takacs, C. H., 247 Takahashi, A., 218 takeovers see mergers and acquisitions Takeuchi, H., 248 Taleb, N. N., 363, 373 tangible differentiation, 175 tangible resources, 113, 303–305 targets see goals Tata Consultancy Services, 291 Tata Group, 211, 252, 280, 312, 336, 338 team-based organizations, 149, 370 team leadership, 372 technical economies, 256 technical standards, 192–193, 230–238 technology, 361–362 as competitive strategy tool see technology-based industries driving change, 192, 196, 203 history of strategy, 13 uncertainty about, 255 technology-based industries, 219–248 comparative advantage, 274 competitive advantage, 221– 227, 229–231 conditions for innovation, 238–245 exploiting innovation, 227–229 overseas markets, 280 profitability of innovation, 222–226 protecting innovation, 224, 226, 226–227, 280 standards, 230–238 Teece, D. J., 88, 105, 130, 211, 218, 247, 267, 268, 295, 313, 358 telecommunications industry, 73 see also network and communications equipment industry Telefonica, 354 television manufacture, 195, 229 Telsa, patent portfolio, 224 Tencent Holdings, 116, 202, 235, 242, 298, 361, 362 diversification, 298 market-to-book ratios, 115 Terjesen, S., 296 Tesla, 94, 230 textile industry, 277 theory of limit pricing, 163 Thomas, H., 106 Thomke, S., 247 Thompson, J. D., 144, 152 Thomsen, J., 313 threat credibility, 94, 163 threat of entry, 66–67 3G Capital, 324 3M Corporation competitive advantage, 365 diversification, 308–309 market-to-book ratios, 115 organizational change, 207 platform investments, 55–56 product champions, 243–244 resources and capabilities, 110, 110 3rd Generation Partnership Project (3GPP), 233 Tierney, T., 218 TIM, 354 Tim Hortons, 292 time compression diseconomies, 130 Time Warner, 257, 344, 345 Tinsley, C. F., 312 tipping points, 234 tire industry, 196 Tirole, J., 267 tobacco industry, 64 see also Altria TomTom, 222 Toshiba, 223, 224, 229, 237 Townsend, J. M., 248, 358 Toyota, 118, 209, 352 competitive advantage, 170, 185, 365 industry analysis, 67 industry life cycle, 194 internationalization, 277–280, 288 lean production, 118, 170, 211 resources and capabilities, 211 vertical integration, 265 Toys “R” Us, 366 Tracey, P., 373 trade comparative advantage, 274 industry life cycle, 196, 197 internationalization, 271–272, 274, 277 for value creation, 35–36 trade secrets, 224, 226 see also intellectual property trade unions see unionization trademarks, 224, 280, 305 see also brands and brand names trading industries, 271, 271 transaction costs, 252–256 diversification, 299, 305 internationalization, 280 vertical integration, 258–259, 264 transaction-specific investments, 258, 264 transactions, foreign market entry, 278, 279 transnational corporations, 288–293, 289 Trigeorgis, L., 373 Trinity Ltd, 121 Tripsas, M., 218 Trist, E., 217 Tsai, B., 216 Tucci, C. L., 187 Tufano, P., 55 656 INDEX Tuli, K. R., 188 Tushman, M. L., 203, 204, 216–218, 247, 330 Twitter, 17, 35 Tyco International, 297, 298 U Uber, 86, 202, 206, 235, 246, 353, 362, 365 uncertain imitability, 163–164 Underwood, J. D., 105 Underwood, 128, 192 Unilever, 52, 53, 287, 305, 324 unionization, 71, 172 uniqueness, 179, 182 United, 346, 351 United Nations, 363 Universal Studios, 350 universalism, 284 UPS, 42, 43, 43, 45, 46, 46, 259 Urban Outfitters Inc., 164 Urcan, O., 313 US Airways, 346 US economy, shifting roles of firms and markets in the, 255 US food processing industry, 324 US industries, 62, 63, 84 US Smokeless Tobacco Company (USSTC), 64 US Steel, 13, 202, 254, 273 Utterback, J. M., 216 V Vaaler, P. M., 104 Vahlne, J.-E., 295 Vale, 362 Valentini, G., 247 value definition, 35 value added, 36–38 corporate management, 317 parenting, 306, 320 value chain cost analysis, 172–173, 174 differentiation analysis, 182, 182–184 international location, 277, 277–278, 279 new game strategies, 159 organizational capabilities, 116–118, 117 vertical exchanges, 258, 258, 265 value net, 104 value, strategy as quest for, 35–38, 365 see also profit/profitability values (beliefs, principles), 50–53, 363–365 corporate social responsibility, 50 national, 284 shared, 137 Van Biljon, P., 296 Van de Ven, A. H., 28 van der Heijden, K., 218 van der Veer, J., 208 Van Reenen, J., 130, 339 van Ritten, A., 295 Vanneste, B., 338 variable costs, 69 fixed:variable cost ratio, 69 Varian, H. R., 28, 238, 247 Vassolo, R. S., 359 Vasvari, F. P., 313 vendor partnerships, 264 Venjara, A., 374 Venzin, M., 10, 29, 295 Verona, G., 130, 217 vertical integration, 251–268 administrative costs, 259–261 choice of, 264–265 recent trends, 265–266 transaction costs, 258–259 types of vertical relationships, 263, 263–264 vertical scope, 252, 253 see also vertical integration Viacom, 257, 350 Viguerie, S. P., 313 Villalonga, B., 313 viral marketing, 181 Virgin Group, 56, 98, 303, 310–312, 322, 332 virtual corporation, 266 vision statements, 16 business identity in, 298 sense of purpose, 50 Vivendi, 257, 311, 345 Vodafone, 354 Volkswagen AG, 194, 351, 363 Volvo, 343, 353, 358 Von Hippel, E., 231, 240, 246, 247 von Krogh, G., 247 VRIO framework, 120, 123 W W. L. Gore & Associates, 239, 370, 372 Wahaha, 341, 354 Wal-Mart Inc. causal ambiguity, 163, 164 competitive advantage, 118, 172, 364, 365 internationalization, 277 profitability, 39 vertical integration, 260 Waldeck, A., 358 Wallin, M. W., 247 Wally, S., 106 Walmart Stores Inc., 163–164, 209 Walsh, J. P., 226–227 Walt Disney, 370 acquisitions, 347, 349, 350 diversification, 305 global strategies, 281 key strengths, 124 resource utilization, 114 values, 364 vertical integration, 252, 257, 261 Walton, Sam, 364 Warusawitharana, M., 246 watch industry, 275 Waterman, R., 151, 309, 313 Watts, D. J., 188 Waymo, 366 weaknesses, key, 124–125 Web-based technologies, 371 see also Internet Weber, M., 142, 147, 151 Weber’s theory, 147 Weeks, J., 138 Weichai Group, 121 Weick, K. E., 151 Weigelt, C. B., 373 Weigelt, K., 105 weighted average cost of capital (WACC), 40, 41, 73 Weiss, L. M., 374 Welch, J., 149, 155, 205, 206, 315, 332 Wells Fargo, 116 Wensley, R., 167 Wernerfelt, B., 218 Wesfarmers, 307 Wessels, D., 58 Wheatley, M. J., 370, 373, 374 Whinston, M. D., 267 Whirlpool, 76, 205 White, L. J., 255 Whitehead, J., 313, 339 Whittington, R., 300, 373 Whittle, Frank, 221 Wiersema, M. F., 313, 314 Wiggins, R. R., 104, 187 Wikipedia, 371 Willcocks, L., 268 Williams, J., 296 Williamson, O. E., 267, 335, 337, 339 Williamson, P. J., 29, 313 Willig, R. D., 81, 82, 313 winner-takes-all markets, 234 Winter, S. G., 119, 151, 187, 218, 246, 295 Wittink, D. R., 188 Wolcott, R. C., 248 Womack, J., 187 Wooldridge, A., 255, 358 world automobile industry, 73 World Bank, 363 World Trade Organization, 354 WorldCom, 337, 345, 373 Wozniak, Steve, 133, 230 Wright, G., 247 Wright, O., 134 X X-inefficiency, 172 Xerox Corporation, 122, 163, 173, 205, 355 innovation, 221, 223, 231, 240 Xiong, W., 339 Xstrata, 347 Y Yahoo!, 86 Yamaha, 97, 125, 272 YGM, 121 Yip, G. S., 82, 295 YKK, 288 Yoffie, D. B., 104, 216 Yoon, J., 295 Yoshihara, H., 312 Young, D., 338 Young, F., 188 Young, G., 104 Yunus, Muhammad, 159, 364 Yuwono, J., 313 Z Zadek, S., 188 Zajac, E., 218 Zara, 80, 158, 159, 260, 261, 264, 267 Zelikow, P., 105 Zeng, M., 374 Zenger, T. R., 152, 218, 374 Zhou, Y. M., 313 Zollo, M., 187, 358 Zuckerberg, Mark, 160, 228, 334 WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA. http://www.wiley.com/go/eula Cover Title Page Copyright Contents Author Biography Part I Introduction 1 The Concept of Strategy Introduction and Objectives The Role of Strategy in Success The Basic Framework for Strategy Analysis A Brief History of Business Strategy Strategy Today How is Strategy Made? The Strategy Process Strategic Management of Not-For-Profit Organizations Summary Self-Study Questions Notes Part II The Tools of Strategy Analysis 2 Goals, Values, and Performance Introduction and Objectives Strategy as a Quest for Value Profit, Cash Flow, and Enterprise Value Putting Performance Analysis into Practice Beyond Profit: Values and Corporate Social Responsibility Beyond Profit: Strategy and Real Options Summary Self-Study Questions Notes 3 Industry Analysis: The Fundamentals Introduction and Objectives From Environmental Analysis to Industry Analysis Analyzing Industry Attractiveness Applying Industry Analysis to Forecasting Industry Profitability Using Industry Analysis to Develop Strategy Defining Industries: Where to Draw the Boundaries From Industry Attractiveness to Competitive Advantage: Identifying Key Success Factors Summary Self-Study Questions Notes 4 Further Topics in Industry and Competitive Analysis Introduction and Objectives The Limits of Industry Analysis Beyond the Five Forces: Complements, Ecosystems, and Business Models Competitive Interaction: Game Theory and Competitor Analysis Segmentation and Strategic Groups Summary Self-Study Questions Notes 5 Analyzing Resources and Capabilities Introduction and Objectives The Role of Resources and Capabilities in Strategy Formulation Identifying Resources and Capabilities Appraising Resources and Capabilities Developing Strategy Implications Summary Self-Study Questions Notes 6 Organization Structure and Management Systems: The Fundamentals of Strategy Implementation Introduction and Objectives Strategy Formulation and Strategy Implementation The Fundamentals of Organizing: Specialization, Cooperation, and Coordination Developing Organizational Capability Organization Design Summary Self-Study Questions Notes Part III Business Strategy and the Quest for Competitive Advantage 7 The Sources and Dimensions of Competitive Advantage Introduction and Objectives How Is Competitive Advantage Established? How Is Competitive Advantage Sustained? Cost Advantage Differentiation Advantage Can Firms Pursue Both Cost and Differentiation Advantage? Summary Self-Study Questions Notes 8 Industry Evolution and Strategic Change Introduction and Objectives The Industry Life Cycle The Challenge of Organizational Adaptation and Strategic Change Managing Strategic Change Summary Self-Study Questions Notes 9 Technology-Based Industries and the Management of Innovation Introduction and Objectives Competitive Advantage in Technology-Intensive Industries Strategies to Exploit Innovation: How and When to Enter Standards, Platforms, and Network Externalities Implementing Technology Strategies: Internal and External Sources of Innovation Implementing Technology Strategies: Organizing for Innovation Summary Self-Study Questions Notes Part IV Corporate Strategy 10 Vertical Integration and the Scope of the Firm Introduction and Objectives Transaction Costs and the Scope of the Firm The Benefits and Costs of Vertical Integration Designing Vertical Relationships Summary Self-Study Questions Notes 11 Global Strategy and the Multinational Corporation Introduction and Objectives Implications of International Competition for Industry Analysis Analyzing Competitive Advantage in an International Context Internationalization Decisions: Locating Production Internationalization Decisions: Entering a Foreign Market Multinational Strategies: Global Integration versus National Differentiation Implementing International Strategy: Organizing the Multinational Corporation Summary Self-Study Questions Notes 12 Diversification Strategy Introduction and Objectives Motives for Diversification Competitive Advantage from Diversification Diversification and Performance The Meaning of Relatedness in Diversification Summary Self-Study Questions Notes 13 Implementing Corporate Strategy: Managing the Multibusiness Firm Introduction and Objectives The Role of Corporate Management Managing the Corporate Portfolio Managing Linkages Across Businesses Managing Individual Businesses Managing Change in the Multibusiness Corporation Governance of Multibusiness Corporations Summary Self-Study Questions Notes 14 External Growth Strategies: Mergers, Acquisitions, and Alliances Introduction and Objectives Mergers and Acquisitions Strategic Alliances Summary Self-Study Questions Notes 15 Current Trends in Strategic Management Introduction The New Environment of Business New Directions in Strategic Thinking Redesigning Organizations The Changing Role of Managers Summary Notes Cases to Accompany Contemporary Strategy Analysis, Tenth Edition Case 1 Tough Mudder Inc.: Building Leadership in Mud Runs Case 2 Kering SA: Probing the Performance Gap with LVMH Case 3 Pot of Gold? The US Legal Marijuana Industry Case 4 The US Airline Industry in 2018 Case 5 The Lithium-Ion Battery Industry Case 6 Walmart, Inc. in 2018: The World’s Biggest Retailer Faces New Challenges Case 7 Harley-Davidson, Inc. in 2018 Case 8 BP: Organizational Structure and Management Systems Case 9 Starbucks Corporation, March 2018 Case 10 Eastman Kodak’s Quest for a Digital Future Case 11 The New York Times: Adapting to the Digital Revolution Case 12 Tesla: Disrupting the Auto Industry Case 13 Video Game Console Industry in 2018 Case 14 Eni SpA: The Corporate Strategy of an International Energy Major Case 15 Zara: Super-FastFashion Case 16 Manchester City:Building a MultinationalSoccer Enterprise Case 17 Haier Group:Internationalization Strategy Case 18 The Virgin Group in 2018 Case 19 Google Is Now Alphabet—ButWhat’s the Corporate Strategy? Case 20 Restructuring General Electric Case 21 Walt Disney, 21st Century Fox, and the Challenge of New Media Case 22 W. L. Gore & Associates: Rethinking Management Glossary Index EULA