Strengths, Weaknesses, and Competitive Advantage

LEARNING OBJECTIVES

Studying this chapter should provide you with the knowledge to:

1. Identify the steps in the value chain a firm uses to create competitive advantage.
2. Distinguish among the core concepts of strengths, weaknesses, resources, capabilities, and priorities.
3. Evaluate the strength and sustainability of internally generated competitive advantages using the VRIO model.
4. Analyze a company and identify its strengths or weaknesses, resources, capabilities, and priorities using the competitive advantage pyramid tool.

When most of us think about the Disney Company, we think of Mickey Mouse, Disney’s oldest and most important in a long line of memorable characters. As the company’s spokesman, Mickey appears prominently on the Walt Disney Company’s home page

(http://thewaltdisneycompany.com/about-disney.)1 Everyone knows Mickey, but few know the story about how Mickey’s arrival in 1928 set off a chain of events that continues to drive profits for Disney more than 85 years later.
In 1923, Walt Disney and his brother Roy settled in Burbank, California. They created the Disney Brothers Cartoon Studio to cap- italize on a series of Laugh-O-Gram animations Walt had produced in their hometown of Kansas City, Missouri. Later that year, movie distributor Margaret Winkler contracted with the new studio to produce a series of single-reel cartoons based on a character from Walt’s first movie, Alice’s Wonderland.2 After 56 successful episodes of the Alice Comedies, Winkler’s husband, Charles Mintz, contracted with the Disneys in 1927 to produce a new character, Oswald the Lucky Rabbit.
Oswald quickly gained popularity, in large part because of the Disneys’ insistence on quality drawing and animation sequences that came to be described as the “illusion of life,” which enabled characters to move smoothly, like real humans.3 In 1928, Walt and his wife, Lilly, headed east to negotiate with Mintz for more money to expand the successful series. The negotiations did not go well for the Disneys. Not only would Mintz not pay more, he fired Walt!

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Mintz held the rights to the Oswald character, and he set out to produce Oswald without the Disney brothers.
Crushed at the loss of their main character and income source, Walt and Lilly boarded the cross-country train to return to Holly- wood. Lilly recalled, “Walt showed me some of his sketches on the train coming home. They were cute little things; they could do anything. I asked him what he was going to call the character. “Mortimer Mouse,” he said. I said, “That doesn’t sound very good, and then I came up with ‘Mickey Mouse.’”4 That mouse, conceived in adversity, would soon lead his creator to prosperity.
Mickey’s public debut in Steamboat Willie in late 1928 intro- duced not only a memorable mouse performing laughable antics, but also a company that incorporated the latest technology to bring its stories to life. Sound was just beginning to make inroads in Hollywood, and Steamboat Willie represented the first synchro- nous sound movie. Mickey’s motions and voice were perfectly timed with the music and audio in the cartoon, a major advance in motion pictures. The public, and critics, loved it, and the Disneys were on their way to lasting success.
Walt and Roy Disney learned well from Charles Mintz the importance of owning, not just creating, characters. Ownership of their most important resources allowed the brothers to control the use of characters by licensing the images to others. Walt entered his first licensing agreement in 1929 with a stationery company that produced Mickey Mouse emblazoned notecards. By 1942, when the United States was entering its first full year of World War II, Disney was earning 10 percent of its revenue from licensing.5
The cartoons featuring the lovable Mickey Mouse, and cutting- edge technology became a Disney hallmark. The company pio- neered a series of firsts:

• Technicolor was used for the first time in a film in 1938’s Snow White and the Seven Dwarfs.
• A multiplane camera enhanced the illusion-of-life artistry.
• In 1940, Fantasia introduced a precursor to modern surround- sound technology. This innovative technology would not spread industry-wide for another two decades.6
Walt’s capability to innovate continued throughout his career. He realized the potential of television in its infancy. The first Disney television broadcast in 1950 was One Hour in Wonder- land, a program Walt created to help promote his upcoming film Alice in Wonderland. And on October 27, 1954, the first episode of Disneyland aired. The show would later become Walt Disney’s Wonderful World of Color to capitalize on the potential of color tel- evision. And, it would last. In some version, new Disney program- ming, from the original Mickey Mouse Club to today’s popular Disney Channel, has been on weekly network television for more than 60 years.
Walt entered the world of television in order to fund his grand- est innovation of all: the country’s first destination theme park. Disneyland opened in July of 1955 on 270 acres of land in Orange County, California.7 Disneyland defied all skeptics and proved to be a huge success from the day it opened. The park combined the company’s skills in engineering and entertainment. Walt even called his designers “imagineers.” Walt’s focus on creating a clean setting also helped to set Disneyland apart from other amuse- ment parks. Ferris wheels and roller coasters were no substitute for Space Mountain or the Tea Cups, and the spotless and inviting atmosphere proved a huge draw for families across the country. Disneyland became one of America’s first destination resorts.

The Disney brothers chose to compete in a difficult industry. Their studio survived and eventually flourished in spite of a harsh industry environment and intense competition. The film industry featured several large studios such as Metro Goldwyn Mayer (MGM) and United Artists. These industry powerhouses had access to the best actors and writers, and they had distribution networks to ensure that their films played in theaters across the United States. Competition in the industry was fierce—the industry produced more than 800 films a year throughout the 1920s.8
The Disney story, from a strategic perspective, captures the essence and power of a firm’s internal abilities—the resources and capabilities that can create and sustain a com- petitive advantage. The concepts and tools in this chapter will help you to evaluate a firm’s internal abilities in order to answer the question: “How can a firm succeed, even in a very difficult industry environment?” The first section of the chapter explains how firms create competitive advantages over rivals, and the second section discusses the sustainability of those advantages over time. Internal analysis seeks to facilitate informed and meaningful judgments about a company’s ability to win in its market, both in time (during any year or product cycle) and over time (as long as a decade or longer).9 Winning in time means that a firm has a competitive advantage; winning over time requires that advantage to be sustain- able. We end the chapter by describing how to use a tool called the competitive advantage pyramid to create a helpful visual model of the internal attributes that are the basis for a firm’s competitive advantages.
As we’ve mentioned, strategists assume that firms differ. How can we describe those differ- ences in a clear way that highlights how they contribute to the overall strategy? The value chain provides a logical way to divide the firm into important strategic activities.

The Value Chain

value chain A visual description of the steps required to turn raw materials into finished products and/or services. The value chain also describes key functions of the company linked to each stage and functions that span its productive activities.

Figure 3.1 displays the value chain, or the steps in the process it takes to transform raw inputs into finished outputs. Developed by Michael Porter, the value chain is a way to depict and eval- uate the activities a company performs. The horizontal elements in Figure 3.1 capture the pro- duction process that a firm uses to acquire and import raw materials, transform them into valuable outputs, and put them in the hands of customers. The vertical axis represents four administrative elements—firm infrastructure, human resource management, technology development, and procurement—that span all of the firm’s economic activities. Porter’s value chain not only provides a framework to describe the activities a company performs, it also can help to identify which activities represent the firm’s competitive strengths and weaknesses.
Walmart’s sophisticated information system shows how technology development adds value by creating critical firm infrastructure. Its information systems give Walmart an advantage in inbound logistics because it can find low-cost ways to move products from its suppliers to warehouses, and in outbound logistics, when it uses the same systems to move products at low cost to its retail stores. High-end retailer Nordstrom’s legendary return policy is part of its core activities in marketing and sales as well as after-sales service. The ability to return virtually any Nordstrom item with no receipt and no questions asked creates unique value for customers.
Apple’s dominance in its markets can be traced to its strengths in the support activities of technology development and procurement. For example, the original iPhone featured a unique raw material, Corning’s ultra-strong Gorilla Glass.10 Apple’s iTunes website and Apple Stores showcase its strengths in operations. The company is also well-known for its strong marketing and sales efforts, including its sleek logo and advertising campaigns that have made Apple products a “must have” product for billions of customers across the globe.
Disney’s early strength, as the opening case indicated, came in operations, by way of its illusion- of-life cartooning process and innovative film production, both of which were enabled by the compa- ny’s technological development. The company used its stable of memorable and unique characters such as Mickey Mouse, Snow White, and the Little Mermaid to create and sustain its brand identity in film and theme park entertainment. That identity contributes to Disney’s strength in marketing and sales, theaters, theme parks, and retail operations such as the Disney Store.

Support (Enabling) Activities

Firm Infrastructure
Human Resource Management
Technology Development

Procurement

Margin

Inbound Logistics

Operations Outbound
Logistics

Marketing and Sales

After-Sales Services

FIGURE 3.1 The Value Chain
Source: Adapted from Michael Porter, Competitive Advantage, 1985.

Primary (Core) Activities

The value chain helps managers identify areas in which a firm has an absolute strength but provides no guidance about strength relative to competitors. So, the value chain can be used to answer the important question, “What is a firm good at?” However, it can’t be used to answer the critical question, “What is the firm better at than relevant competitors?” The second question can be answered through two processes. First, we’ll define a set of concepts—resources, capabilities, and priorities—to help in understanding the sources of a firm’s strengths. Second, we will introduce VRIO thinking, a way of measuring the magnitude and durability of a firm’s strengths versus competitive rivals.

The Resource-Based View

Resources, capabilities, and priorities can be thought of as answers to basic questions that firms face. Resources are what a firm employs to create value and competitive advantage. Capabilities represent how firms do things—the processes they use. Priorities explain why firms allocate critical resources to achieve key objectives.11

Resources
Resources provide the answer to the question, “What creates the firm’s strengths?” One defini- tion states that “resources include all assets, capabilities, organizational processes, firm attrib- utes, information, knowledge, etc. controlled by a firm that enables the firm to conceive of and implement strategies that improve its efficiency and effectiveness.”12 This definition clearly identifies what could be a resource, but its breadth makes it difficult to identify and limit what types of things count as a resource. Resources are the “what” of competitive advantage.
Most resources are, or could be, counted and quantified on a firm’s balance sheet as assets. Accountants classify resources as tangible or intangible assets. Tangible resources are those with physical presence, such as land, factories, machinery, equipment, or cash. Intangible resources are economically valuable assets that “do not have physical presence,” and include brands, licenses patents, knowledge, and reputation.13
Four categories of resources are important contributors to competitive advantage:

1. Physical resources, such as plant or equipment
2. Financial resources, such as free cash flow
3. Human resources, including employee know-how, management skill, and talents
4. Intangible resources, such as brands and patents
   These four types of resources enable both the core operational and important support/ administrative activities in the value chain. Nordstrom could not operate without the physical resources of stores or a website for customers to visit, or without the financial resources of cash or credit to purchase inventory. Similarly, without the human resources of salespeople there would be no customer service, which gives Nordstrom its strength in marketing and sales. Finally, without the intangible resource of Nordstrom’s elite brand and culture and training programs, the shopping experience would provide little of the satisfaction that customers have come to expect.

Capabilities
Capabilities are processes that the firm has developed to coordinate human activity in order to achieve specific goals. Capabilities represent the “how” of competitive advantage. McDonald’s corporation holds a commanding 24 percent market share in the US fast-food industry, nearly four times as large as rival Wendy’s.14 McDonald’s operates more than 34,000 stores worldwide, many of them in highly accessible locations, such as freeway off-ramps, towns, and mall loca- tions. Although the stores themselves are resources, McDonald’s has also developed a set of operating capabilities, or processes, that are implemented in each of these stores. The process of filling customers’ orders at industry-leading speed is a capability at the heart of what makes

resources All assets, brands, land, information, knowledge, and so on, controlled by a firm that enable it to conceive of and
implement strategies that improve its efficiency and effectiveness.
capabilities The procedures, processes, and routines firms employ in their activities.
priorities A firm’s values and rankings of what is most important.
assets Tangible or intangible resources or factors of production that create economic value for the firm when employed. This chapter focuses on physical, financial, human, and intangible assets.

operating capabilities Procedures, processes, or routines for delivering value to customers, employees, suppliers, or investors.

dynamic capabilities
Procedures, processes, and routines that continuously expand existing resources or improve operating capabilities.

McDonald’s successful. Speedy customer service involves several steps: procuring customer orders accurately and quickly, communicating the orders to the cooks, cooking the food, pack- aging it, and delivering it to the customer. This process is repeated hundreds of times a day at all 34,000 individual store locations, leading to high store-level capability for order turnaround.
Competitive advantage relies on a strong set of operating capabilities. A firm’s advantage becomes stronger if it develops dynamic capabilities, processes that are designed to continu- ously expand existing resources or to improve or modify operating capabilities.15 Dynamic capabilities are practiced and refined over time and through repetition. For example, Procter & Gamble (P&G) has many brand resources, such as Crest, Tide, Pampers, Pantene, and Febreeze. But it also has been through the process of creating a new brand many times. Through repeti- tion, P&G has refined its capability to create new brands to the point that it now has a dynamic capability that can help it expand its existing brand resources with new additions, such as the Olay Pro-X skin cleaning system.
Dynamic capabilities can help firms modify and evolve processes to keep pace with envi- ronmental changes such as new competitors, shifting demographics, or emerging technologies. They can also enable firms to incorporate learning into their processes. For example, Toyota follows a method of continuous improvement of its processes, known as kaizen, in which ideas from many different sources are used to eliminate waste of effort or materials.
Companies with strong dynamic capabilities have a more secure foundation for comp- etitive advantage than those without them, for two reasons. First, dynamic capabilities entail complex connections and coordination among different internal units within the firm. For example, finding the optimal site for a restaurant requires input from marketing about demo- graphic information and target customer segments; the corporate counsel about sales con- tracts and local regulations; and real estate professionals skilled at identifying, negotiating, and closing on properties. These strong coordination processes contribute to the competitive advantage of good restaurant locations.
Second, dynamic capabilities take time to develop and require significant learning. Processes or routines represent deeply engrained habits of behavior that take years for com- panies to perfect. As firms and their managers master the ongoing process of learning and adjusting in the face of competitor, customer, or market changes, they develop a formidable set of dynamic capabilities.16 Read more about one of Disney’s critical dynamic capabilities, the ability to protect its intellectual property, in the Strategy in Practice feature.

Strategy in Practice

Preserving Disney’s Capabilities: Don’t Mess YouTube and other technology providers, Disney General Coun- with the Mouse! sel Alan Braverman decided on a different strategy: Disney would agree not to sue UGC sites as long as those sites worked to remove
Walt and Roy Disney learned early on about the importance of copy- copyrighted content on their own.19 The negotiations were delicate righting characters, and over the years, his company developed a and took more than a year, but industry giants Disney, Microsoft, set of dynamic capabilities to protect those resources.17 Steamboat Viacom, Myspace, NBC, Dailymotion, and Chinese UGC site Youku Willie, also known as Mickey Mouse, debuted on the screen in 1928. .com agreed to a set of rules to protect content copyrights.
Under existing copyright law, Disney’s copyright protection on the Critics complain that Disney’s efforts to protect its copyrights fabled mouse would expire in 2003, 75 years after the character’s stifle creativity and innovation in film and entertainment, often origination. In 1988, Disney led a group of Hollywood studios, music at the expense of small, independent filmmakers or retailers. The labels, and other content owners in the entertainment business to company maintains its legal right to protect its brands and proper- successfully lobby Congress to extend the copyright protection on ties through copyright law. Its actions around UGC, however, have Mickey Mouse, and other characters created between 1923 and allowed sites such as YouTube, Pinterest, and Facebook to grow 1978, for another 20 years.18 without the threat of costly and continuous lawsuits from content
With so much riding on the mouse and his friends, Disney providers such as Disney.20
makes every effort to safeguard its property. The rise of YouTube and Disney has acquired a number of new copyrighted assets in other user-generated content (UGC) sites has presented yet another recent years, from its acquisition of the Marvel Universe in 2009 to challenge in the copyright wars. Users can upload content to these the Lucasfilm acquisition in 2012. These assets provide many rev- sites without rights or permission to the material. Disney recognized enue opportunities for the company. They also provide protection this threat early and realized the resulting legal battle would be against the expiration of copyright protections on Mickey Mouse global, long-running, and very, very expensive. Rather than threaten and other Disney favorites.

Strategy in Practice

Values and Priorities at Pixar Because Jobs was fanatic about these unplanned collab- orations, he envisioned a campus where these encounters
When Steve Jobs bought Pixar Animation Studios in 1986, he refo- could take place, and his design included a great atrium
cused the company away from its founding focus on high-tech hard- space that acts as a central hub for the campus.
ware, and toward creating computer-generated animated movies Brad Bird, director of The Incredibles and Ratatouille, said
that people would flock to. The refocus was critically, as well of the space, “The atrium initially might seem like a waste
as financially, successful and resulted in box-office hits such as Toy of space . . . But Steve realized that when people run into
Story 1, 2, and 3, A Bug’s Life, Monsters Inc., Finding Nemo, Cars, each other, when they make eye contact, things happen.”
and Up.22
Jobs valued innovation and creativity, and he felt they And did it work? “Steve’s theory worked from day one,” were the keys to Pixar’s success. Jobs also believed that inno- said John Lasseter, Pixar’s chief creative officer “. . . I’ve vation is sparked when creative individuals spontaneously never seen a building that promoted collaboration and get together and share ideas. Jobs oversaw the design of the creativity as well as this one.”23
Pixar Studios building and made sure that the architecture At Pixar, values favoring creative collaborations led to a design itself would reinforce his values, by making interaction among priority: interaction. Building a workspace that promoted these employees a design priority. As Jobs’s biographer Walter Isaacson interactions maintains and enhances Pixar’s rich capabilities for recounts: innovation in both technical design and storytelling.

Priorities
Resources and capabilities help firms create and deliver unique value. So what drives the choices into which resources and capabilities a firm should invest money and time? The answer is priorities, which are a firm’s rankings about what is most important. Priorities are driven by a company’s underlying values, its leaders’ beliefs about what is right and wrong, good and bad, desirable and undesirable.
Management guru Peter Drucker described values as the ultimate test for action.21 Drucker noted that corporate decisions about hiring from the inside or outside, a company’s stance about the importance of R&D, marketing, or any other functions look like technical questions of strategy; however, they are really questions about what companies and their leaders truly value.
Values lead to priorities that help executives, managers, and employees make decisions. Priorities drive the creation of resources and capabilities in two ways. First, priorities guide resource allocation processes such as capital investment, human capital acquisition and training, and brand development. Second, priorities maintain those allocations over time when things get tough. Read in the Strategy in Practice feature how priorities influenced the design of a new headquarters building for Pixar Studios, a Disney subsidiary.

Creating a Sustainable Competitive Advantage: The VRIO Model of Sustainability
Walt Disney’s experiences with Oswald the Rabbit illustrate the difference between having a competitive advantage and sustaining that advantage through time. Although the first car- toons were both profitable and promising of a strong future, the Oswald advantage was unsus- tainable because Disney didn’t own the rights to the character. Charles Mintz proved unable to sustain the character Oswald because Mintz lacked the capability to keep Oswald “alive” the way Disney kept Mickey Mouse alive through products, TV shows, and theme park. Oswald’s life on film ended as Mintz’s team ran out of new ideas for the character in 1943, shortly after

value Worth or utility.
rarity To be uncommon, or not available to other competitors.
inimitability An attribute of a resource that describes the
degree of difficulty a competitor would face in copying, imitating, or mimicking the value of
that resource.

Disney created Bambi, Dumbo, and Pinocchio.24 Walt Disney lost a valuable competitive asset when Mintz enforced his ownership of the copyright on Walt’s fateful trip to New York, but Mintz lacked the capability to sustain the character he had captured.
Competitive advantages arise when resources or capabilities possess two attributes: Value and rarity. Two other principles determine the durability, or sustainability, of com- petitive advantage: Inimitability, the characteristics that make a resource or capability difficult to imitate, and an organization’s ability to exploit profit returns generated by its unique and valuable resources. Together, these four characteristics—value, rarity, inimitab- ility, and organization to exploit profits—are often abbreviated as VRIO. We’ll examine each one in turn.

Value
Mickey Mouse earned returns for Disney and allowed the company to grow because this char- acter created value for film distributors and viewers. Value denotes worth for customers. A resource creates value if its contributions allow a company to produce a product or service that is of worth to end users. Products or services have value when they create direct pleasure, satisfaction, or happiness for the end user, or when they create indirect opportunities for users to experience pleasure and satisfaction. Users won’t pay for products or services unless they create value in their lives. In fact, a fundamental premise of our economic system holds that the price someone will pay for a good depends on the value that good produces. The higher the value, the higher the price that buyers are willing to pay.
Although not an absolute rule, resources and capabilities that provide firms with the opportunity to produce and sell at lower costs than their rivals create value for customers. Low price itself may produce some direct pleasure for users, but its benefits are mostly indirect, because purchasing products and services at a low cost usually leave users with more money to spend on other things that provide them pleasure or satisfaction. Similarly, unique products or services often create direct pleasure or satisfaction for customers. Resources that help a firm bring such differentiated products and services to the market create value for customers. Of course, those resources also create economic value for the firm, defined as profits. Chapter 4 includes a discussion about how firms can create cost leadership strategies and Chapter 5 con- siders differentiation.

Rarity
To be rare is to be uncommon, or not available to other competitors. Unique is often used as a synonym for rare. McDonald’s tries to find unique locations for its restaurants, such as being the only restaurant at a freeway exit, or the closest to the on-ramp, or its presence as the sole din- ing option inside many Walmart stores. Rare or unique resources create competitive advantage through a basic principle of economics—scarcity. When products or services are scarce, users are often willing to pay a higher price for them than they would if the same products or services were more commonly available, leading to higher company profits.

Inimitability
Inimitability is the extent to which competitors cannot easily reproduce a product by employing equal, or equivalent, sources of value in their own products and services. Think about attend- ing a Major League Baseball, NBA, or NFL game. The histories of the teams, the star players, the amenities of professional stadiums, and the rules adopted by each league to govern play mean that other leagues simply can’t imitate the experience these leagues provide. In fact, the last successful rival competitive league was the American Basketball Association (ABA), and it merged with the NBA in 1976! Several factors drive inimitability, thereby acting as barriers to imitation. We’ll describe each one below.

Path Dependence Path dependence means that the process through which a resource or capability came into being may make it difficult for competitors to imitate. During World War II, British aerospace companies focused on building small fighter planes while Boeing, an American company, built large bombers and tankers. After the war, Boeing leveraged its learning and investments in large aircraft to introduce the first successful commercial jetliner, the 707, in late 1957.25 A British company, De Havilland, actually developed the first commercial jet aircraft, the Comet. However, the Comet failed because De Havilland wasn’t as far along the learning curve on designing or building large aircraft that could safely fly passengers. Path dependence helps to block imitation when resources or capabilities follow a sequen- tial development path—for example, when previous investments enable later ones, or when significant learning underlies the resource or capability.

Tacit Knowledge For many processes, such as cooking french fries at McDonald’s, the actions needed to imitate the sequence can be codified, or written down, and easily learned by others. Such easy-to-codify-and-learn knowledge is referred to as explicit knowledge. Tacit knowledge is just the opposite. Many valuable skills and processes, such as Walt Disney’s knack for choosing good stories or Steve Jobs’s ability to spot great design in a product, can’t be learned easily, if they can be learned at all.27 These skills are difficult, maybe even impossible, to learn, teach, or coach, because they are based on tacit knowledge. Tacit knowledge is sticky, or immobile, and difficult to imitate by competitors.

Ethics and Strategy
Nondisclosure and Noncompete Agreements From the firm’s perspective, these contracts offer protection
against the leakage of its valuable knowledge, processes, and Many companies have competitive resources in the form of propri- skills. Managers, however, can write NDAs so tightly that those etary business practices. These proprietary resources, also known who sign them would be prohibited from using any knowledge, as trade secrets, may be a “formula, pattern, compilation, program, skill, or process that is even remotely related to the actual trade device, method, technique, or process”26 that has been devel- secret. Some entrepreneurs use the NDA as a weapon to keep oped within a firm for its own use. One common trade secret is the suppliers, customers, or investors from working on products or detailed information about the purchase preferences of customers projects that might be only loosely related to the trade secret. learned by salespeople over time. This leads to manufacturing NDAs that prohibit disclosure of particular lines of software code, companies, for example, customizing machines or tools to fit their or particular programming languages, for example, might stifle own unique production demands. Similarly, many firms develop competition instead of protecting intellectual property. Ironi- unique software code that adapts “off the shelf” software packages cally, many venture capitalists, suppliers, and large customers such as SAP or Microsoft Office to perform functions unique to the routinely refuse to sign NDAs in order to avoid any restrictions on firm. Trade secrets improve a firm’s ability to create a differentiated their ability to pursue their own interests. Managers must balance offering or to lower costs. These trade secrets do not qualify for their economic interests in protecting their trade secrets with legal protection through patents, copyrights, or trademarks, how- stakeholders’ ethical rights to pursue their own goals without vio- ever, and challenges arise when other organizations gain access to lating a contract.
these “secrets.” Similarly, noncompete agreements can be written so broadly
Trade secrets that create value for customers or other stake- that they unfairly penalize employees in their search for new holders and are unique to the firm can be a source of a sustained employment. First, noncompetes might be written in a way that advantage, as long as they do not “leak out” and become common extends far beyond direct competitors, suppliers, or customers knowledge available to competitors. Companies use two legal con- and includes firms only distantly affected by the firm’s trade tracts to protect trade secrets: nondisclosure agreements and non- secrets. Second, noncompetes might be of such a long duration compete agreements. Nondisclosure agreements, often referred to that even after a trade secret becomes obsolete it still prevents as NDAs, prohibit employees, suppliers, investors, or others who have employees from working for a competitor. Managers, in their knowledge about a trade secret from sharing it with others. Noncom- zeal to protect trade secrets, can create agreements that restrict pete agreements prohibit employees from leaving the company and employees from using even their generalized skills to find other taking a job with a firm that could exploit an employee’s knowledge employment.
about trade secrets. A noncompete agreement usually covers Managers must strike an appropriate balance between the
employee movement to firms that compete directly, but could also strategic need of the firm to protect its valuable trade-secret-based include key suppliers or customers as well. The use of NDAs and non- resources and the legitimate needs of other stakeholders to interact competes raises ethical issues for strategic managers. with the firm and still pursue their own interests.

positive network externalities When the value of a product increases with the number
of users.
virtuous circle When more sellers attract more buyers, who, in turn, attract more sellers.

Causal Ambiguity Causality refers to the notion that one thing causes another: A leads to B. Sometimes, however, the causal relationship is unclear or ambiguous, and the relation- ship between variable A and outcome B is difficult to disentangle.28 You might have learned in statistics courses that correlation does not equal causation, and just because A and B appear together does not mean that A causes B. One example is Steve Jobs, who studied calligraphy at Reed College and yogic meditation from gurus in India. Jobs credited these two experiences as highly influential in shaping his aesthetic sense, but most entrepreneurs will not find that calligraphy classes or meditation trips to India bestow upon them the same aesthetic eye that Jobs possessed. In similar fashion, General Motors tried to imitate Toyota’s production methods—the Toyota Production System—to produce cars at the same cost and quality. But even after its engineers spent weeks and months watching Toyota build cars in a joint-venture plant, GM still wasn’t able to achieve equal productivity. The cause of Toyota’s productivity was not easy to determine because it was spread throughout the organization, including hiring and training systems, the layout of its plants, and fundamental priorities and culture of the company.

Complexity Resources, capabilities, and priorities become difficult for competitors to imitate when they span the organization or contain many interrelated elements and exhibit substantial complexity. Creating synchronous sound for Steamboat Willie, for example, proved a complex task in 1927. Walt Disney learned that the key was to time the cartoon framing and motion with the beat of the music (12 frames and beats per minute). Today, much of Disney’s competitive advantage rests on the complex interplay between film production, distribution in theaters and television, branding, merchandising, and theme park management. NBC Universal has similar resources, but its profit rate is only about one-fourth of Disney’s. Disney mastered the complex art of managing multiple, interrelated businesses over several decades, while NBC Universal combined these resources through a merger and has yet to prove the same ability to manage a complex and interrelated set of business processes.

Time Compression Diseconomies Diseconomies happen when an action increases, rather than decreases, cost and inefficiency. Timing is crucial in the development or deployment of many resources, capabilities, or priorities and can become a diseconomy in many cases.29 If a project requires a $20 million investment per year for the next two years, time compression diseconomies mean that you can’t get the same results by spending $40 million in one year. Resources that come from natural or physical processes, such as biological growth limits in biotechnology, pharmaceutical research, or forestry, cannot be rushed. Similarly, resources that come from differences in individual or organizational abilities to learn require adequate time for lessons to be deciphered and processed.30

Network Effects and First-Mover Advantages Much of the reason eBay is so successful has to do with network effects, which economists call positive network externalities. eBay wins because of its network effect. If you want to sell your old stuff, where do you want to sell? Some place where there are lots of potential buyers. If you want to buy stuff, where would you look? In a place with lots of sellers! More sellers attract more buyers, who in turn attract more sellers. It’s a virtuous circle. As eBay grows in popularity, other online auction sites such as Yahoo! have a hard time competing because it’s difficult to attract buyers and sellers. Everyone wants to be where they have the greatest exposure or selection.
Network effects represent a specific form of a first-mover advantage.31 For example, eBay has been able to lock up the best sellers and most active buyers for its site because it was the first mover in the market. Being the second to enter is difficult, as eBay learned in Japan, where it exited the market because Yahoo!’s auction site had captured the first-mover advantage.32 First movers establish a number of advantages. In addition to customers, they can lock up other resources such as locations, patents, or scarce raw material inputs. They can also establish long-term contracts with customers and set industry standards that favor their products. These actions make it difficult for rivals to profitably imitate the first mover.

Organized to Exploit
A firm may employ valuable, rare, and difficult-to-imitate resources and yet still lack a sustain- able competitive advantage because the firm may not be organized to exploit or have the contracts and systems in place to capture the profits that resources create.33 Consider National Football League (NFL) players. Revenues paid to the NFL from television networks for the exclusive right to broadcast NFL games have grown from $47 million per year in 1970 to just over $4 billion each year in 2012, a compound annual growth rate of an impressive 12 percent. Over that same period, the players’ share of revenue has jumped from 35 percent in 1970 to 57 percent in 2011.34 How were players able to increase their share of the pie by more than 60 percent?
Before 1970, the NFL Players Association (NFLPA) had been a weak collection of player representatives. During the 1970s, however, the NFLPA emerged as a true, well-organized union, capable of engaging owners in meaningful contract negotiations backed up by credible threats of strikes and legal action. The contracts that the NFLPA negotiated for its members have garnered an increasing percentage of the NFL’s growing revenue. The NFLPA’s stronger organization enhanced its legal standing and administrative abilities, allowing players to capture the value from their rare and inimitable resources.

Assessing Competitive Advantage with VRIO
Figure 3.2 shows the relationships between VRIO attributes of resources or capabilities and competitive advantage. You can assess the strength and durability of a company’s position by answering a yes or no question for each element in the matrix. Both resources and capabilities should be subjected to the VRIO questions to determine the strength of a company’s competitive advantage., in the real world, firms that can’t create value for their stakeholders don’t survive. These businesses experience competitive failure. Many companies, especially new start-ups, introduce valuable products that are also unique and rare and enjoy a period of competitive advantage. The combination of value and uniqueness creates a short-run competitive advantage in time for a firm. Over time, however, competitors can imitate these resources and create competitive parity in the industry. Parity means that a company survives but has no real competitive advantage over rivals.

organized to exploit The degree to which the legal, administrative, and operating structure of the firm allows it to capture the rents generated by resources.

competitive failure When firms can’t create value for their stakeholders, they don’t survive.
competitive parity When a company survives but has no real competitive advantage over rivals.

Is the resource Valuable? Is the resource Rare? Is the resource Inimitable? Is the company Organized to exploit?
No No No No Competitive Failure
Yes No No No Competitive Parity
Yes Yes No No Competitive Advantage
Yes Yes Yes No Durable Competitive Advantage
Yes Yes Yes Yes Sustained Competitive Advantage
FIGURE 3.2 Resources and Competitive Advantage
Source: Adapted from Jay Barnery, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17, no. 1 (March 1, 1991): 99–120 and Jay Barney and Bill Hesterly, Strategic Management and Competitive Advantage, 4e, Pearson.

Strategy in Practice
Disney Responds to a Competitive Threat later peg Lasseter as “the next Walt Disney.”37 Disney had used CGA
since the production of Tron in 1982, but only as a complement to, Disney’s initial competitive advantage arose from the company’s never a substitute for, hand-drawn animation.
ability to combine illusion-of-life animation and the latest techno- Disney lacked the in-house skill or software to compete with
logical advances with classic stories in the 1920s. Steamboat Willie, Pixar. The company also found itself boxed in strategically. Mickey which pioneered synchronous-sound, Fantasia, which debuted Mouse turned 60 in 1987, and the Disney brand evoked images of Technicolor, and Snow White, the first full-length animated feature family-oriented entertainment but not cutting-edge technology. film, all still stand as classics. Modern classics, including The Little Furthermore, the look and feel of its animated character family Mermaid, The Lion King, and Beauty and the Beast, built on and rein- appealed more to children than to teenagers or adults. CGA posed forced Disney’s valuable, rare, and difficult-to-imitate brand and a threat to Disney’s brand, character resources, and illusion-of-life character resources, as well as its storytelling capabilities. and storytelling capabilities.
Eventually, however, a leapfrog technological innovation How did Disney respond? At first, the company partnered
threatened Disney’s core source of competitive advantage. In 1986, with Pixar and provided distribution for Pixar films, as well as Pixar Animation Studios secured its first Oscar nomination for its financial resources for production and marketing. In return, Disney animated short film Luxo, Jr. The wonderful, family-friendly story of received a percentage of the films’ profits. The partnership pros- a small lamp signaled that computer-generated animation (CGA), pered through six movies, including Ratatouille, Up, Toy Story 3, and coupled with a great story line, could prove a viable competitor to Monsters University.
Disney’s illusion-of-life capability. During the time it partnered with Pixar, Disney’s own films,
With the development of its RenderMan software in 1987,35 built around its illusion-of-life animation, such as Treasure Planet, Pixar “could produce settings that looked absolutely real,” said were mostly unsuccessful. Eventually, Disney decided it needed to Pixar director John Lasseter.36 Pixar used this new technology to own Pixar’s cutting-edge CGA capabilities. In 2006, Disney bought produce a series of blockbuster hits, including Toy Story, Toy Story 2, Pixar for $7.5 billion, adding Pixar’s capabilities to its own pool of Monsters Inc., The Incredibles, and Wall-E. Wired magazine would Disney capabilities.

sustained competitive advantage When firms combine the legal elements, intellectual property rights, administrative elements, and cultural elements, allowing them to capture high profits
that come from their valuable, rare, and inimitable resources, capabilities, or priorities.

To create competitive advantage in the long run—an advantage that endures over several years—a firm must create barriers to imitation. Barriers make it difficult for competitors to offer similar products or services, drive prices down, and dissipate the firm’s superior profits. Barriers to imitation provide a durable competitive advantage, one a company is able to sustain. Durable advantages dissipate over time, and moving from durable to sustainable potential advantage into an actual one requires an organizational structure and design that captures the value from resources and capabilities. Companies that realize sustained competitive advantage combine the legal elements, such as contracts or intellectual property rights; administrative elements, including organizational structure; and cultural elements, such as norms regarding rewards and what constitutes equity, that allow them to capture high profits that come from their valuable, rare and inimitable resources, capabilities, or priorities.
Managers may work hard to create resources and capabilities that are VRIO, only to then witness changes in technology, consumer tastes and preferences, government regulations, or other forces that imperil their source of competitive advantage. The Strategy in Practice feature describes how Disney responded when a new technology for cartooning presented a threat to its sources of competitive advantage.

The Competitive Advantage Pyramid: A Tool for Assessing Competitive Advantage
We’ve introduced some important concepts to help you understand how a company’s internal resources and capabilities may allow it to deliver unique value and achieve superior performance. Internal analysis depends on more than concepts, however, and so now we present an analytical process and tool that allow you to identify and catalog a firm’s potential for sustained competitive advantage. The competitive advantage pyramid tool will help you in the academic work of this course, but it will prove even more valuable as you decide whether to invest in or work for a particular company. You can also use the pyramid after you take a job, when you work on teams assigned to create strategy for your company or to understand the strategic strengths of your competitors. This tool will prove particularly helpful should you want to start your own company.
The pyramid also invokes a powerful metaphor about internal sources of competitive advantage. The stability and beauty of the top of the pyramid depends on the solidness of the base below. Just as each brick of a pyramid relies on the one below it for strength, support, and orientation, each level of competitive advantage depends on the one below. A company’s value- creating activities will only be as strong as the resources and capabilities that support them. The strength of those resources and capabilities, in turn, relies on a company’s core values and priorities to sustain the investments over time that build VRIO resources and capabilities.
Figure 3.3 illustrates the competitive advantage pyramid. The shape helps you to integrate the different internal elements that create layers of competitive advantage.38 In the top layer are the activities that create strengths and weaknesses. Resources and capabilities lie below, in the center layer, because they lay the foundation for and fuel the activities in the top layer. The bottom of the pyramid—the deepest driver of competitive advantage—captures the values and priorities that guide the development of resources and capabilities.
The numbered questions can be answered in order to help you move down the pyramid to discover the different sources of competitive advantage for a company. When you are finished gathering and analyzing data to answer them, you should be able to draw a pyramid or create a table for the company that provides a robust and detailed picture of the company’s strategic advantages.

Gathering Data for the Competitive Advantage Pyramid Analysis
Data to complete a pyramid come from a number of sources. You can use three main types of data:

1. Archival data: Written or numeric information can be found in the library or on the Internet.
2. Interviews: Interviews can range from personal questions to impersonal surveys.
3. Observation: Your own experiences, such as visits or use of products or services, are also valuable.
4. What is the company good at? What activities create value for customers?
5. What resources and capabilities drive those activities? How rare are they? How difficult to imitate?
6. In what ways is the organization designed to capture the value created?
7. What priorities and values support and sustain resources and capabilities? How committed is the company to these priorities and values?

Activities

Resources, Capabilities, and Organization

Values and Priorities

FIGURE 3.3 The Competitive Advantage Pyramid

Strategy and Your Career
The competitive advantage pyramid provides a way for you to for yourself, or You, Inc. There is an end-of-chapter exercise quickly document and understand a company’s sources of com- that describes how you can create a personal pyramid. Take petitive advantage, and it allows you to make some judgment the time to collect data on your own activities, strengths, and about how durable and sustainable that advantage might be. As weaknesses. You may get some uncomfortable feedback, but you approach decisions about where to work, you would be wise to it will help you identify where you can add value. Catalog your invest the time and effort into creating a pyramid for each company resources and capabilities and think deeply about your core you might like to work for. If you use the rigorous research meth- values and priorities. This deep level of the pyramid should ods described earlier in the chapter, you should be able to create an help you clarify what you care about most, in your work and accurate and useful picture of the company. If you can do interviews throughout your career.
or site visits, you may be able to create personal relationships that With a thoughtful personal pyramid, you can compare will give you good information and some positive recommenders yours with those of target companies. You can identify areas, and within the company. The pyramid can help you prepare for inter- jobs, where you may be able to create value for a company, and views as well, as you’ll be able to couch your answers in terms the see where you can add to their resource base as well as grow your company will value, and the pyramid tells you where to focus your own. Finally, and most importantly, you can make sure that poten- research so you learn more about the company. tial employers share your priorities and align with your values.
The real value of the competitive advantage pyramid These pyramids, both company and personal, can help you make model in your job search, however, comes when you create one better choices about where to work.

If you want to create a pyramid profile for a private company, you might find very little archival data, but you may identify people willing to grant interviews or to directly observe the company’s operations. For public companies, the reverse often proves true. Abundant archival data exist, but companies often create barriers, or firewalls, that make interviews difficult. The size of the company means that observations provide only a limited view of the company. The appendix helps you know what to look for as you perform a pyramid analysis and describes in detail different data sources you can use to do the analysis.
As you gather data and use the questions to sort and categorize the information you find, remember the GIGO principle from computer programming: garbage in, garbage out. Stated more elegantly, the more attention you pay to gathering, verifying, and comparing the data, the richer, more robust, and more insightful your finished product will be. You should always rely on at least two types of data (e.g., archival records and interviews) and use multiple sources of data within each type. For each strength, weakness, resource, capability, value, or priority that you identify, include the source from which you drew your data. If your data all come from a single source such as a website or a Bloomberg Businessweek, Fortune, or Wall Street Journal article, then your pyramid will be weaker than if the information is drawn from multiple sources. Tapping other data sources, such as doing an interview or scheduling a plant visit, may seem daunting, but doing so will pay great dividends in creating a richer, more complete profile of the company.
Be very careful to balance your data sources. Don’t rely exclusively on data provided by the company or solely on data that come from the company’s detractors. Both have a point of view that differs from the real company. If you are thinking about accepting a job with a company, or one of its competitors, you’ll want to dedicate significant time and energy to developing the most accurate pyramid you can.

Using the Competitive Advantage Pyramid
You can use the pyramid to focus on a company’s strengths or its weaknesses. It is often simpler to create a separate analysis for strengths and weaknesses as a first step.
Table 3.1 shows the results of a simple pyramid analysis to compare the strengths of two national retailers: Walmart and Nordstrom. As you can see from the table, both Walmart and Nordstrom have clearly identifiable strengths that customers, suppliers, and others can readily see.

TABLE 3 . 1 Using the Pyramid Model to Identify Strengths

Questions Company
Walmart Nordstrom
What is company good at? Low prices Customer service
What activities create value for customers? Low prices enable customers to purchase more total items Pleasure and satisfaction through the shopping experience and the goods purchased
What resources and capabilities drive those activities? Rural locations
Large number of stores Logistics/planning
Huge distribution centers Sophisticated IT systems
Pricing policies Posh stores Upscale locations Talented staff
In-store merchandizing Compensation system for staff
How rare are these resources and capabilities? Rare due to size and scale Rare due to brand and reputation
How difficult are they to imitate? Organizational complexity makes resources difficult to imitate Causal ambiguity and path dependence make resources difficult to imitate
In what ways is the company organized to capture value? Centralized decision authority ensures consis- tency across stores Decentralized structure allows each store to customize to meet customer needs
What priorities support and sustain those resources and capabilities? Frugality
Striving for excellence Outstanding service Empowered employees
Sources: Author interviews with selected organizational members, store visits and tours, various articles in popular press such as The New York Times, Wall Street Journal, Business Week, Fortune, and Forbes.

TABLE 3 . 2 Using the Pyramid Model to Identify Weaknesses
Questions Sears Holdings
What is company good at? Limited selection of goods; Sears sold off many valuable brands such as Craftsman Tools and Lands End
What activities fail to create value for customers? Outmoded stores Poor merchandizing
Unmotivated employees
What resources and capabilities are lacking and contribute to those weaknesses? Lack of financial resources for reinvestment
Lack of strategic consistency to support training, merchandizing
How rare are these resources and capabilities? Diminishing through asset sales, most valuable real estate sold off and stores closed
How difficult are they to imitate? Not difficult: Specialty retailers offer better products, services; low-cost retailers offer better prices
In what ways is the company organized to capture value? 2018 bankruptcy means all profits go to creditors; shareholders lost all value
What values support/sustain those resources and capabilities? Survival. As the bankruptcy proceeds, the only value will be maximizing liquidation value

What if you wanted to create a pyramid to describe a company’s weaknesses? Consider Sears Holdings, the company created by the 2004 merger of Sears and Kmart. Kmart began operations in the late nineteenth century and was a competitor of Walmart until Walmart drove them into bankruptcy. Sears opened its first retail store in 1925 and enjoyed a run as America’s largest retailer through most of the twentieth century. Sears filed for Chapter 11 bankruptcy on October 15, 2018. Whether Sears will survive as a retailer will depend on the company’s ability to turn its weaknesses into strengths. A pyramid analysis for Sears reveals how difficult that will be.
A visit to a Sears store would allow you to observe both the company’s strengths and weak- nesses. Sears stores now carry a limited line of major national brands and some of their own branded merchandise, offered at multiple price points.39 However, while you would see a broad selection, you would also likely see a store with outmoded lighting, worn carpeting or tile, and a merchandising and product mix that lacks excitement. Articles in the popular press indicate that the company’s strategy centers on store closings and layoffs, rather than on investing in new capabilities.40 Table 3.2 details this analysis.

Summary
• Strategy tools can be used to better understand how companies cre- ate and sustain competitive advantages through their own efforts, as opposed to merely relying on the industry’s structure.
• The value chain provides a broad and comprehensive roadmap for identifying the sources of a firm’s strengths and weaknesses among its different value-creating functions and infrastructure elements.
• The factors of production that a firm uses to create competitive advan- tages can be divided into three categories: resources, capabilities, and priorities. Priorities support the development of capabilities, and they enable the creation and deployment of unique and valuable resources.

• Valuable and rare resources and capabilities create competi- tive advantages for firms. The durability or sustainability of those resources depends on inimitability—how difficult it would be for a competitor to imitate the resource. Finally, the firm must be orga- nized in legal and administrative ways that capture the returns cre- ated by those resources.
• The competitive advantage pyramid is a tool to help identify, cat- egorize, and assess the overall strategic advantages of a firm. The diamond allows depth of analysis and understanding about the root causes of a firm’s competitive advantages.

Key Terms
assets 47
capabilities 47
competitive failure 53
competitive parity 53
dynamic capabilities 48
inimitability 50

operating capabilities 47 organized to exploit 53
positive network externalities 52 priorities 47
rarity 50
resources 47

sustained competitive advantage 54 value 50
value chain 46
virtuous circle 52

Review Questions

1. Identify and describe the two major elements of the value chain. How can the value chain help you do internal analysis?
2. What is a resource? What types of resources can firms employ in their search for competitive advantage?
3. What is a capability? How do capabilities work together with resources to enable companies to create value?
4. How is a resource different from a capability? How are the two sim- ilar? How do different types of resources work together to create com- petitive advantage?
5. Under what conditions will resources lead to competitive advan- tages? When will those advantages be sustainable?
6. Identify three situations in which a competitive advantage pyramid analysis would be useful to you. What two rules about data collecting should you remember when you do a pyramid analysis?

Application Exercises
Exercise 1: Identifying the value chain.

1. Go to your local grocery store and walk down the cereal aisle, the soda and snack foods aisle, and the meat aisle. How many different brands do you see on each aisle? Which companies produce those brands? Research two companies from your search and use the value chain to describe each company. As you compare them, what key dif- ferences do you see in their value chain strengths and weaknesses? How do their financial results differ?
   Exercise 2: Understanding and using the competitive advantage pyramid.
2. Choose a company you would like to work for. Using the com- petitive advantage pyramid, analyze the strength (or weakness) of competitive advantage for your target company and for the two rival firms. Begin your research by looking at news reports, company fil- ings, and press releases to create a working model of the competi- tive advantage pyramid. Then, identify and interview someone who works at that company. Find out what elements they would include in the pyramid. How did the pyramid differ when you included “inside”

References
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3J. P. Telotte, The Mouse Machine Disney and Technology (Urbana: University of Illinois Press, 2008). p. 27.
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information? How would you evaluate the company’s prospects for future performance?

2. Identify two companies in the same industry. Using their 10-K fil- ing or other available data, determine the operating performance (market share, customer satisfaction, new product introductions, etc.) and financial performance (return on sales, return on assets or equity, free cash flow) of both companies. Using the data in the 10-K or annual report, create a list of resources and capabilities for each company. How do the differences in the strength of competitive advantages cor- relate with firm performance?
   Exercise 3: Personalizing the competitive advantage pyramid.
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34Data compiled from P. Ghemawat, Commitment: The Dynamic of Strategy (New York: Free Press, 2001), pp. 96–98, and J. Vrooman, “The Economic Structure of the NFL,” in The Economics of the National Football League: The State of the Art, ed. K. G. Quinn (New York: Springer Science + Business, 2012), p. 335.
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