The fifth course of Strategic Leadership and Management Specialization from the University of Illinois on Coursera, Business Strategy, is taught by Deepak Somaya, Professor of Business Administration. This course is about how organizations can create, capture and maintain value and how it’s fundamental for sustainable competitive advantage.
In the third module of the course, we learned about internal analysis and competitive advantage. How to understand the origin and consequences of the unique internal strength of a firm, using the analytical viewpoint of activities, resources, and capabilities.
In my opinion, Business Strategy was one of the best courses in this specialization with real case study analysis as assignments after every module. Both the content, methodology and the professor were great and I could enjoy taking the classes. The assignment for this module I shared in another blog post.
Companies’ performance is a result of two distinctive drivers of performance: industrial effects and internal effects. Industrial effects mean the performance it’s a result of being within a more or less profitable industry as, for example, the pharmaceutical industry highly profitable and the airline industry almost always operating in the red. The internal effects, on the other hand, means the performance it’s a result of the firm’s unique attribute that can outperform other firms in the same industry by developing and sustaining a competitive advantage.
Which of these effects is more important?
According to the latest researches (Hawawini et al, 2003), the unique attributes of a company is the most explainable factor of a company’s performance. What it means is that companies can outperform others even in the same industry.
What is a Competitive Advantage?
Firms that perform better than their competition are said to have a competitive advantage.
How to define competition?
Competition is a set of rivals of the firm in the same industry. One way to evaluate how the firm is performing is to analyze how the average competitor in the industry is performing and compare it with the firm’s performance.
How to define better performance?
In strategic management, usually interested in for-profit organizations, better performance means a long-run profit performance. Besides that, the focus should also be on the Economic Value Added (EVA) as an important metric to capture the type of performance the firm’s interested in when thinking about competitive advantage.
How can we know whether a firm is performing better or worse?
There are different approaches that can be used to measure, which has pros and cons.
Comparing Accounting Profitability using metrics such as Return on Assets (ROA), Return on Equity (ROE) and Return on Capital Employed (ROCE).
The clear advantage is that accounting data are regularly available for many firms.
The disadvantage is that these performance data tend to be backward-looking and may not say as much about whether there’s a current competitive advantage and whether it will result in future better performance.
Comparing the Market Value with its Stock Price x Number of Shares.
The advantage is that in principle, the financial market should incorporate the future prospects of a company.
However, in practice, the stock market valuation might not incorporate tacit internal information about how the company is actually doing.
I may also be subject to irrational swings in the Stock Exchange.
Comparing the Long-run Profitability by the Net Present Value (NPV)
Usually, these projections represent a scenario for planning purposes and do not sufficiently incorporate the implications of competition or competitive advantage.
The advantage is that with the NPV of a company we can project out the future free cash flows or cash profits.
However, there are questions about how well a company or a manager can actually do that.
Finally, by the Economic Value Added (EVA)
EVA it’s the difference between the value generated and the cost incurred by the company for the average customer.
The advantage is that performance measures as EVA go directly to the cross-over whether or not a company has a competitive advantage.
The challenge is that it’s often difficult in practice to measure exactly how much value is being created for the customer by the company’s product.
What’s to be done?
The EVA is what is needed to be focused on, at least conceptually, when interested in competitive advantage. Although, it is not the only one since the other approaches also have advantages.
The best-case scenario would be to triangulate some of these measures to have different perspectives about the performance.
Sustained Competitive Advantage
A sustained competitive advantage is one where a firm’s performance advantage relative to its competition is sustained over time. There are two key factors to analyze the source of a firm’s sustained competitive advantage:
- Heterogeneity: where do the interfirm differences in performance come from? What are the reasons that make the firm unique, different, from the others? Rarity.
- Sustaining: how do performance advantages enjoyed by a firm become durable? How can it stay relevant?
Sources of competitive advantage
There are three main conceptual views to understand how companies perform better for their competition: activities (set of), resources and capabilities.
One of the factors that make a company perform better is related to the set of activities that were chosen to undertake or that were chosen to not undertake.
Besides, productive firm’s assets of a different kind, or resources, that one firm has and the others don’t. There are different types of sets of resources: tangibles and intangibles.
And finally, the things that are relevant to the firm performance that the firm is very good at doing it. One example is the capability to offer excellent customer service, product design and etc.
Each one of these factors is different in how aggregated concepts they represent with the firm.
Activities are small, usually, like inspecting the quality of material from a supplier. However, a company might have hundreds or even thousands of sets of activities. Resources, on the other hand, are more aggregated conceptually, and companies have it on a total of double-digits, maybe. Capabilities are the more aggregated concept and, sometimes, it’s a combination of a set of activities and resources – numbering in single-digits.
Football field example: how do a team perform better than others?
Let’s use Grêmio, a team from south Brazil as an example and try to find their sources of competitive advantage.
The activities of the team might be listed as separated between good and bad activities as below. The idea is that the combination of good activities and the avoidance of bad activities might produce great results.
Dribble the ball well; Pass accurately; Good at getting free and open space for a pass.
They are selfish with the ball.
The resources of a football team can also show a source of competitive advantage. We can consider the human capital, which means great coach, a great set of top players, the fan base, the team’s reputation and, the team’s brand. Team’s brand is an excellent resource, sometimes a great player might choose to play in one team than another because of a team name in history and what it represents.
Finally, the capabilities of a team are the aggregation of the resources and the sets of activities, as for example, the capability of keeping the ball and moving it around quickly, which depends on having a good player that can perform good pass and get free and open space for a pass. Besides, we should also consider how the team absolves pressure and defense, and how they mount fast counter-attacks.
As mentioned before, firms might have hundreds or even thousands of activities. The challenges are: 1) how to organize such a large set of activities into meaningful subsets? 2) How to illustrate the relationships between these (subsets of) activities? The solution relies on the Value Chain and Value Network models. The first more suitable for manufacturing firms, and the second for services.
The concept of value chain applies to typical manufacturing firms where raw materials or components come in at one end, through the inbound logistics, and are delivered to the customer at the other end, through a sequence of value-adding steps.
The primary activities in a value chain are related to each of those steps from inbound logistics to after-sales services. The support activities support the primary activities in areas as research and development, human resource management, procurement and corporate infrastructure, including financing and accounting.
The concept of a value network maps important sets of activities and their relationship with each other. In this case, activities are not arranged in any sequential value chain, but all of them are nonetheless related to each other in different degrees. We must treat these relationships through a value network by drawing connections between these sets of activities.
It’s more suitable for services industries, such as airlines, telephone services and consulting, for example.
Let’s get an example from the airline industry: one set of activities would be to lease or purchase and aircraft; another would be managing the plane with pilots and the crew; plus ground-crew operations, maintenance, and baggage handling; additionally: marketing; pricing and selling tickets through different channels; plans the route structure; purchasing fuel and so on;
All these activities are not arranged in a sequential, although they are all linked with each other to a lesser or greater degree.
Resources and Capabilities
Find below an inventory of resource types.
|Tangible Resources||Financial||Internally generated cash, cash on hand, borrowing capability, etc.|
|Physical||Machinery, buildings, computing and telecom, raw material, etc.|
|Intangible Resources||Technologic||Product innovations, creative products, prototypes and models, know-how, software and IT systems, etc.|
|Relational||Product reputation, brand loyalty, customer relationship, alliances, etc.|
|Human Capital||Skills and expertise, training, motivation, creativity and adaptability, coordination, etc.|
Which resource matter the most?
To answer this question, we need to consider different factors that raise two more questions: which resource can most improve the economic value added (EVA) – increase the price-cost edge? Is access to the resource “rare”?
In general, intangible resources play a bigger role. That’s because recent researches show that tangible assets explain a much fraction of firm value today, as they are usually no “rare” in a modern economic market. By being not rare, it means that firms have more access to it nowadays.
Of course, depends on the industry. A paper company or even a coffee roaster, for example, would have a competitive advantage as long as they have high-quality raw materials.
What is capability?
According to Helfat & Winter (2011), capability means the capacity to perform a particular activity in a reliable and at least minimally satisfactory manner.
- The capacity of the firm to actually doing something, to perform some important activity.
- The capability should be reliable and the company should be able to repeatedly perform that activity in a consistent way.
- The capability shouldn’t assume to perform that activity in a superlative manner. Obviously, it could be an advantage, but the minimum expectation should be a satisfactory level of execution.
What are the sources of competitive advantage?
Activities sets, resources or capabilities can create a competitive advantage only if:
Value Criterion: helps increase the economic value added (EVA). If an activity, resource or capability doesn’t add value, there’s no point discussing it.
Rarity Criterion: the ability to increase EVA is not commonly available to other firms.
If an activity, resource or capability adds value but it isn’t rare, it’s not a competitive advantage, but competitive parity – which is not bad either.
Common roots of Heterogeneity
Firms possess unique activity sets, resources, and capabilities due to:
History: The history of a company and its first experiences can be an important factor. For example, Apple products that are easy to use (just works) can be traced back to the early stages of the company.
Path dependence: means that small events at varies points in time may take a company down to different paths, and the results might be very different from others. It’s hard to give an example on this topic, though. I believe that the TV Show Friends and the Coffee house culture in the US were one of these events that helped Starbucks to take off.
Managerial foresight: strategic choices made with foresight by management which can have a major impact. For example, a decision of opening the iTunes Store through the Apple-compatible apps where music could be sold.
Luck: sometimes it might be just dumb luck.
Which conceptual lens to use while analyzing the sources of competitive advantage?
Ultimately it’s a matter of judgment, but can be analyzed through different advantages and drawbacks of its set of activities, resources, and capabilities linked to the value creation (EVA).
Sustained Competitive Advantage
An important goal of strategic management is to create a competitive advantage for the firm that can be sustained over time. To do so, there are four potential challenges that can be grouped by threats to rarity and threats to the value creation.
Both imitation and replication are threats to the rarity of a certain competitive advantage. And both (non) durability and (non) relevance are threats to the value creation. Regarding duration, it means that a company should be able to reproduce and keep the set of activities, resources, and capabilities in order to not lose its competitive advantage. The challenge of relevance, though, doesn’t fully depend on the company’s internal attributes. One example is Apple products. Can Apple guarantee that their design will still be relevant in the coming years?
Barriers to imitation and replication
A firm must protect its competitive advantages of being replicated via isolating mechanisms, as listed below.
Causal ambiguity is a barrier since it’s not clear from where a company’s performance comes from and, therefore, it’s hard to replicate.
Complexity means that even the firm’s competitors know how the firm works, the firm’s methods and processes are hard to reproduce.
Tacit knowledge is also a barrier when the knowledge and the experiences from the firm cannot be easily explained or transferred. For example, the way Apple thinks about user experience is a knowledge within the company already spread to its culture – dances by the music there.
Resource mobility barriers to avoid losing talents to competition, and, therefore, knowledge and experiences.
Property rights such as patents.
It’s important to say, though, that none of these barriers are perfect and the goal here it’s to raise the cost for the competition to imitate or replicate.
Imitation of Value Chains and Value Networks
Value chains and value networks are hard to replicate by competition as they must know which activities are; and how they are used; and how they are combined; Often, there are so many possible combinations of activities that makes imitation nearly impossible.
The VRI Framework gives a resource-based view about how valuable, rare and inimitable a resource or capability is. It doesn’t give an analysis of the durability and relevance of it. You’ll find below a comparative table.
What about durability and relevance?
To deal with the durability challenge, we can use the analogy of the leaky bucket, where the bucket represents the company and the water represents the sources of competitive advantage.
Just as in the leaky bucket, the company might see its internal strengths gettings diminished over time. Resources may degrade, key employees may leave the company and the processes may get lost. Therefore, capabilities may deteriorate. Again, same as in the leaky bucket, you have two alternatives: plug the leaks trying to preserve the resources, maintain the activity processes and so on, or top the bucket up. Trying to replace what has been lost. So, new hires, new training, and, news processes.
Finally, the challenge of relevance that can arguably be the biggest one faced by companies nowadays. Basically, it means that the sources of competitive advantages that are useful now might no be enough in the future. This is especially hard to fix when some of the core activities were the main reason for the company’s success, and they get in the way when trying to add new more valuable activities. Ultimately, the solution for the relevance problem is to use dynamic capabilities, which means that the company would be able to change their sources of competitive advantage.
A summary to conclude this topic:
- Competitive advantage it’s important because we know that firms’ effects are significant factors while explaining firms’ performance.
- Three key ways to analyze sources of competitive advantage are activities, resources, and capabilities.
- Also, that competitive advantage must create value and be rare.
- Challenges of sustaining competitive advantage are creating barriers to imitation and replication, durability and relevance.