5.6: Developing Strategy Through Internal Analysis

Learning Objectives

1. Learn about internal analysis.
2. Understand resources, capabilities, and core competencies.
3. See how to evaluate resources, capabilities, and core competencies using VRIO analysis.

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

Internal Analysis

By exploiting internal resources and capabilities and meeting the demanding standards of global competition, firms create value for customers (McEvily & Chakravarthy, 2002; Buckley & Carter, 2000). Value is measured by a product’s performance characteristics and by its attributes for which customers are willing to pay.¹ Those particular bundles of resources and capabilities that provide unique advantages to the firm are considered core competencies (Prahalad & Hamel, 1990). Core competencies are resources and capabilities that serve as a source of a firm’s competitive advantage over rivals. Core competencies distinguish a company competitively and reflect its personality. Core competencies emerge over time through an organizational process of accumulating and learning how to deploy different resources and capabilities. As the capacity to take action, core competencies are “crown jewels of a company,” the activities the company performs especially well compared with competitors and through which the firm adds unique value to its goods or services over a long period of time (Hafeez, et. al., 2002; Prahalad & Hamel, 1990).

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

Figure 5.14

Internal analysis tells the strategist what is inside the organization—helps answer the question, “what strengths can we leverage?”

Dave Dugdale – Analyzing Financial Data – CC BY-SA 2.0.

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

Resources and Capabilities

Resources

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

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

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

Capabilities

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

The foundation of many capabilities lies in the skills and knowledge of a firm’s employees and, often, their functional expertise. Hence, the value of human capital in developing and using capabilities and, ultimately, core competencies cannot be overstated. Firms committed to continuously developing their people’s capabilities seem to accept the adage that “the person who knows how will always have a job. The person who knows why will always be his boss.”²

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

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

Figure 5.15 The Value Chain

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

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

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