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is the question of whether changes in market demand or the conditions of technology are likely to threaten how the firm creates value. Although this point seems transparent, firms can easily overlook it when they are in the throes of month-to-month battles for market share with their immediate rivals. Evaluating future prospects is also difficult due to the sheer complexity of predicting the future and the risks involved in acting on such predictions.
The history of an industry may also dull managers to the prospects for change. Threats to a firm’s ability to create value often come from outside its immediate group of rivals and may threaten not just the firm, but the whole industry. Honda’s foray into motorcycles in the early 1960s occurred within segments that the dominant producers at the time—Harley-Davidson and British Triumph—had concluded were unprofitable. The revolution in mass merchandising created by Wal-Mart occurred in out-of-the-way locations that companies such as Kmart and Sears had rejected as viable locations for large discount stores. The music recording industry warily eyed Apple’s iPod but was not fully upended until a start-up company called Napster offered users a way to easily (and, at the time, illegally) share music files over the Internet.
Value Creation and the Value Chain
Value is created as goods move along the vertical chain, which we first described in Chapter 3. The vertical chain is therefore sometimes referred to as the value chain.8 The value chain depicts the firm as a collection of value-creating activities, such as production operations, marketing and sales, and logistics, as Figure 9.7 shows. Each activity in the value chain can potentially add to the benefit B that consumers get from
FIGURE 9.7
Value Chain
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The value chain depicts the firm as a collection of value-creating activities. Porter distinguishes between five primary activities (inbound logistics, production operations, outbound logistics, marketing, and sales and service) and four support activities (firm infrastructure activities, such as finance and accounting, human resources management, technology development, and procurement).
Competitive Advantage and Value Creation: Conceptual Foundations • 305
the firm’s product, and each can add to the cost C that the firm incurs to produce and sell the product. Of course, the forces that influence the benefits created and cost incurred vary significantly across activities.
In practice, it is often difficult to isolate the impact that an activity has on the value that the firm creates. To do so usually requires estimating the incremental perceived benefit that an activity creates and the incremental cost associated with it. However, when different stages produce finished or semifinished goods that can be valued using market prices, we can estimate the incremental value that distinctive parts of the value chain create by using value-added analysis, which we described earlier in this chapter.
Value Creation, Resources, and Capabilities
Broadly speaking, there are two ways in which a firm can create more economic value than the other firms in its industry. First, it can configure its value chain differently from competitors. For example, in the car-rental market in the United States, Enterprise’s focus on the replacement-car segment has led it to operate with a fundamentally different value chain from the “Airport 7” (Hertz, Avis, National, Alamo, Budget, Dollar, and Thrifty), which are focused on the part of the market whose business originates at airports (primarily business and vacation travelers).9 By optimizing its activities to serve renters seeking to replace their vehicles for possibly prolonged periods of time, Enterprise creates more economic value for this segment of customers than do the Airport 7 (see Example 9.3).
Alternatively, a firm can create superior economic value by configuring its value chain in essentially the same way as its rivals, but within that value chain, performing activities more effectively than rivals do. To do this, the firm must possess resources and capabilities that its competitors lack; otherwise, the competitors could immediately copy any strategy for creating superior value.
Resources are firm-specific assets, such as patents and trademarks, brand-name reputation, installed base, organizational culture, and workers with firm-specific expertise. The brand recognition that Coca-Cola enjoys worldwide is an example of an economically powerful resource. As a testament to the power of Coke’s brand, the marketing consultancy InterBrand estimated that about half of Coca-Cola’s market capitalization in 2010 was due to the value of the Coke brand name alone.11 Unlike nonspecialized assets or factors of production, such as buildings, raw materials, or unskilled labor, resources cannot easily be duplicated or acquired by other firms in well-functioning markets. Resources can directly affect the ability of a firm to create more value than other firms. For example, a large installed base or an established reputation for quality may make the firm’s B higher than its rivals. Resources also indirectly impact value creation because they are the basis of the firm’s capabilities.
Capabilities are activities that a firm does especially well compared with other firms.12 Capabilities might reside within particular business functions (e.g., Virgin Group’s skills in brand promotion, American Airlines’ capabilities in yield management, or Nine West’s ability to manage its sourcing and procurement functions in the fashion shoe business). Alternatively, they may be linked to particular technologies or product designs (e.g., Facebook’s web design and programming skills, Nan Ya Plastics’ skills in working with polyester, or Honda’s legendary skill in working with small internal-combustion engines and power trains).13 Or they might reside in the firm’s ability to manage linkages between elements of the value chain or coordinate activities across it (e.g., the Geisinger Clinic in central Pennsylvania is famous for its use of
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EXAMPLE 9.3 CREATING VALUE AT ENTERPRISE RENT-A-CAR10
Can you name the largest rental car corporation in the United States? Hertz? Avis? You might be surprised to learn that it is Enterprise Rent-a-Car, a privately held company founded in 1957 by a St. Louis-based Cadillac dealer, Jack Taylor, who named the company for the USS Enterprise, the ship on which he served as a Navy pilot. Enterprise boasts the largest fleet size and number of locations in the United States. Enterprise is also widely believed to be the most profitable rental car firm in the United States. How has Enterprise maintained such profitability and growth in an industry widely believed to be very unattractive? The answer: Enterprise has carved out a unique position in the rental car industry by serving a market segment that historically was ignored by the airportbased rental car companies and by optimizing its value-chain activities to serve this segment.
The “Airport 7” car rental companies— Hertz, Avis, National, Budget, Alamo, Thrifty, and Dollar—cater primarily to the business traveler. While the Airport 7 firms operate out of large, fully stocked parking lots at airports, Enterprise maintains smaller-sized lots in towns and cities across America, which are more accessible to the general population. Moreover, Enterprise will pick customers up at home. The company saves money by not relying on travel agents. Instead, it cultivates relationships with body shops, insurance agents, and auto dealers who, in turn, direct business toward Enterprise. To this end, Enterprise benefited from a legal ruling in 1969 that required insurance companies
to pay for loss of transportation. Enterprise has extended its reach to weekend users, for whom it provides extremely low weekend rates. While almost nonexistent when Enterprise was founded, the replacement-car market now comprises nearly half of the rental car market, of which Enterprise has, by far, the largest share.
In 1999, Enterprise entered the airport market. However, it did so to cater not to the business traveler but to another relatively underserved segment—the infrequent leisure traveler. It offers inexpensive rates while providing valueadded services that an infrequent leisure traveler could appreciate, such as providing directions, restaurant recommendations, and help with luggage. Enterprise now has rental counters at over 200 airports. In a surprise move, Enterprise purchased National and Alamo car rentals in 2007. Taken together, Enterprise/National/Alamo’s airport market share is about equal to erstwhile segment leader Hertz.
The Airport 7 retaliated by dramatically increasing their off-airport sites. Hertz has been particularly aggressive, with over 200 off-airport locations in the United States. Hertz and Avis have even targeted repair shops, but have a long way to go to match the relationships that Enterprise has built in this sector. With its unique mix of activities, it seems likely that Enterprise will sustain its competitive advantage.
As of this writing, Hertz is attempting to acquire Dollar/Thrifty. If successful, the “Airport 7” plus Enterprise will be reduced to the “Everywhere 4.”
health information technology to reinvent how it delivers medical care across the spectrum from primary care through surgery and recovery.)
Whatever their basis, capabilities have several key common characteristics:
1.They are typically valuable across multiple products or markets.
2.They are embedded in what Richard Nelson and Sidney Winter call organi-
zational routines—well-honed patterns of performing activities inside an organization.15 This implies that capabilities can persist even though individuals leave the organization.
3.They are tacit; that is, they are difficult to reduce to simple algorithms or procedure guides.
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EXAMPLE 9.4 MEASURING CAPABILITIES IN THE PHARMACEUTICAL INDUSTRY
Drawing on detailed quantitative and qualitative data from 10 major firms, Rebecca Henderson and Iain Cockburn attempted to measure resources and capabilities associated with new drug research in the pharmaceutical industry.14 Although drug discovery is not the only skill that pharmaceutical firms must possess to compete effectively, it is extremely important. Henderson and Cockburn hypothesize that research productivity (measured as the number of patents obtained per research dollar invested) depends on three classes of factors: the composition of a firm’s research portfolio; firm-specific scientific and medical know-how; and a firm’s distinctive capabilities. The composition of the research portfolio is important because it is easier to achieve patentable discoveries in some areas than in others. For example, in the 20 years prior to Henderson and Cockburn’s study, investments in cardiovascular drug discovery were consistently more productive than investments in cancer research. Firm-specific knowhow is critical because modern drug research requires highly skilled scientists from disciplines such as biology, biochemistry, and physiology. Henderson and Cockburn use measures such as the firm’s existing stock of patents as proxies for idiosyncratic firm know-how.
Henderson and Cockburn also hypothesize that two capabilities are likely to be especially significant in new drug research. The first is skill at encouraging and maintaining an extensive flow of scientific information from the external environment to the firm. In pharmaceuticals, much of the fundamental science that lays the groundwork for new discoveries is created outside the firm. A firm’s ability to take advantage of this information is important for its success in making new drug discoveries. Henderson and Cockburn measure the extent of this capability through variables such as the firm’s reliance on publication records in making promotion decisions, its proximity to major research universities, and
its involvement in joint research projects with major universities.
The second capability they focus on is skill at encouraging and maintaining flow of information across disciplinary boundaries inside the firm. Successful new drug discoveries require this type of integration. For example, the commercial development of HMG CoA reductase inhibitors (drugs that inhibit cholesterol synthesis in the liver) depended on pathbreaking work at Merck on three disciplinary fronts: pharmacology, physiology, and biostatistics. Henderson and Cockburn measure this capability with variables such as the extent to which the research in the firm was coordinated through cross-disciplinary teams and giving one person authority to allocate resources for research. The team-based method would facilitate the flow of information across disciplines; the one-person approach would inhibit it.
Henderson and Cockburn’s study indicates that differences in firms’ capabilities explain much variability in firms’ research productivity. For example, a firm that rewards research publications is about 40 percent more productive than one that does not. A firm that organizes by cross-disciplinary research teams is about 25 percent more productive than one that does not. Does this mean that a firm that switches to a team-based research organization will immediately increase its output of patents per dollar by 40 percent? Probably not. This and other measures Henderson and Cockburn used were proxies for deeper resource-creation or integrative capabilities. For example, a firm that rewards publications may have an advantage at recruiting the brightest scientists. A firm that organizes by teams may have a collegial atmosphere that encourages team-based organizations. A team-based organization inside a firm that lacks collegiality may generate far less research productivity. These observations go back to our earlier point. It is often far easier to identify distinctive capabilities once they exist than for management to create them.