Business Strategy

Deepak Somaya

Module 3: Internal Analysis and Competitive Advantage

Table of Contents
Lesson 3-0 Overview Lecture ..................................................................................................... 1
Lesson 3-0.1 Overview Lecture .............................................................................................. 1
Lesson 3-1 Competitive Advantage & Firm Performance ......................................................... 3
Lesson 3-1.1 Competitive Advantage & Firm Performance .................................................. 3
Lesson 3-2 Sources of Competitive Advantage ........................................................................ 11
Lesson 3-2.1 Activities of the Firm ...................................................................................... 11
Lesson 3-2.2 Resources and Capabilities.............................................................................. 19
Lesson 3-3 Sustained Competitive Advantage ......................................................................... 25
Lesson 3-3.1 Sustained Competitive Advantage .................................................................. 25
Interview: Executive Expertise-Competitive Advantage.......................................................... 31

Lesson 3-0 Overview Lecture

Lesson 3-0.1 Overview Lecture

Hello and welcome to this module on Internal Analysis and Competitive Advantage. As we
begin this module, I want to quickly remind you of the central idea of strategic fit. Because the
goal of strategic management is to align the firm's internal attributes with its external
 Business Strategy
Deepak Somaya
environment. It follows that internal analysis is a critical step in developing a strategy for a
business. Moreover, when thinking about how a company can have a competitive advantage, is
only natural to think that this must be because of something distinctive or unique about that
company. Thus, an analysis of the internal features of a company has the potential to directly
inform our understanding of its sources of competitive advantage

We will cover three main topics in this module. Each addressed in a separate lesson. First, you
will learn about what we mean by the term competitive advantage, and understand its intellectual
underpinnings in the heterogeneity we observe in firm performance, often even within the same
industry. Second, you will learn about three intellectual traditions in understanding where
competitive advantage comes from: Activities, resources and capabilities. We will then seek to
understand how activities in particular can be represented and analyzed by using either a value
chain or a value network. In the third lesson, you will learn about a key idea related to
competitive advantage. Whether it can be sustained in the long run or not. To understand
sustained competitive advantage, we need to understand the barriers to imitation and mobility if
any, as well as the durability and relevance of internal attributes that give rise to competitive
advantage in the first place. In addition to video lectures on these topics, you will also be able to
learn about these topics from my interviews with our executive experts. As always, we will also
visit the soccer field and develop a little intuition about some of these topics. Please work
through any small exercises or quiz questions built into this module, as they will help you learn
better. For the case analysis in this module, we'll look at the large coffee house companies,
Starbucks corporation. Starbucks is an amazing success story that started with a single Cafe in
Seattle in 1987, and has now spread to almost 25,000 outlets worldwide. Despite dominating the
coffeehouse business, the company faces constant challenges, and continues to innovate and
adapt to meet those challenges. I think you'll really enjoy learning about Starbucks, and
analyzing its sources of competitive advantage.
 Business Strategy
Deepak Somaya
Lesson 3-1 Competitive Advantage & Firm Performance
Lesson 3-1.1 Competitive Advantage & Firm Performance

To understand competitive advantage, we need to first come to grips with the factors that drive
company performance. One important line of research that investigates this question has sought
to disentangle whether there are durable features of industries, so-called industry effects, or
particular attributes of companies, company effects, that drive company financial performance
over the long run. Of course, it's impossible to predict performance perfectly with a statistical
model, but amazingly, industry and company effects together predict nearly 50% of profit
performance in the more recent research that has been done. And importantly, the company
effects are a much more important factor, predicting nearly 80% of the explained differences in
firm performance. What this means is that some companies consistently outperform others, even
in the same industry. And these consistent differences within the same industry are much bigger
than the observed inter-industry differences in performance.
 Business Strategy
Deepak Somaya

One fantastic representation of this idea is Southwest Airlines. As you may know, the airline
industry itself is a notoriously unprofitable industry, which over the last two and a half decades
has had frequent bouts of terrible losses. And yet, even in this dreadful industry, one company,
Southwest Airlines, has done amazingly well. Here you can see Southwest's net margins over the
same period, and using the same scale on this graph as the airline industry as a whole. Southwest
has not had a single year of negative net margins in this entire period that the airline industry has
been struggling. Southwest has not had a single year of negative net margins in this entire period
that the airline industry has been struggling. In fact, it has average net margins of 5.8%, while the
airline industry as a whole, including Southwest, had net margins of around negative 1%. Even
more amazingly, Southwest's stock has had cumulative returns of 4,000% between 1990 and
2014, which is about two times, double the return on the S&P 500 index over the same period. I
actually wanted to give you a comparison of Southwest stock returns relative to other airline
companies, but guess what? I could not find a single other major airline that had not declared
bankruptcy at least once during this time period. As you may know, a bankruptcy means that all
the shareholders get wiped out, and the company then issues new stock, so I had to give up trying
to compare Southwest's stock returns to one of its peers in the airline industry.
 Business Strategy
Deepak Somaya

You may recognize that the Southwest example is by no means unique. If you think about any
industry or even country, you'll be able to come up with the names of companies that are very
high performers within that industry or country. What I have here is merely a partial list that I
came up with, and I'm certain you could come up with others. And you may even quibble with
some of my names, that perhaps they're not the high performers they once were. But be patient
with me, we'll come back to that idea later. What these high performing company names
illustrate, however, is that the recipe for high performance may lie in doing better than other
companies in your industry, in other words, in having and sustaining a competitive advantage.
 Business Strategy
Deepak Somaya

Let's take a minute to go to the soccer field now. [SOUND] And yes again, I'm taking you to the
field of soccer, rather than an actual soccer playing field, at least for now. You probably know by
now that the most profitable soccer league in the world is the Premier League of England and
Wales. But which is the most successful soccer club? What I mean by that is not the best club
team in playing and winning matches, but the most successful club as a business. As it turns out,
Forbes Magazine produces an estimated valuation of all the major soccer clubs, and we can use
these data to answer our question. So which club has the highest valuation in your opinion?
Amazingly, the top two soccer clubs in the world in valuation are Real Madrid and Barcelona,
both in the Spanish La Liga, which as a league is far behind the Premier League in overall
revenues and profits.
 Business Strategy
Deepak Somaya

So here again, we see a similar phenomenon. Some businesses do really well, even when they're
in poorly performing industries. And the way they do this is by really outperforming most of
their closest competitors. In other words, they develop and sustain a competitive advantage.

So what do we mean by this term competitive advantage? Quite simply, a firm has a competitive
advantage if it is able to outperform its competition. And that seems simple enough, but we can
get a little bit more precise about this concept if we define what we mean by competition. One
useful definition is that it is some set of rivals of the firm operating in the same industry. A
 Business Strategy
Deepak Somaya
convenient operationalization of this set of rivals concept is to focus on the industry average
competitor, and compare the firm's performance to this average. Another important question is
how we should define better performance. In strategic management, generally because we are
usually interested in for-profit firms, it makes sense that we should be interested in long run
profit performance. And here again, the concept of economic value added is a useful metric to
capture the type of performance we're interested in when we think about competitive advantage.

Let us dig a little deeper into this idea of better performance and ask ourselves how we know if a
firm has better or worse performance. One approach might be to simply compare accounting
profits, using such metrics as return on assets or return on equity or return on capital employed.
The advantage of this approach is that accounting data are regularly collected and readily
available for many firms. Unfortunately, however, these performance data tend to backward-
looking, and may not say as much about whether there is a current competitive advantage, and
whether it will result in future better performance.
An alternative measure might be to use the company's stock market value. Now in principle, the
financial markets should incorporate the future prospects of a company in its valuation. But in
practice, stock market valuation might not incorporate tacit internal information about how the
company is actually doing, and may also be subject to irrational swings. One can also estimate
the net present value of a company by projecting out future free cash flows or cash profits of the
company. But again, there are questions about how well a company or a manager can actually do
that. Usually, such projections represent a scenario for planning purposes, and do not sufficiently
incorporate the implications of competition or competitive advantage.
Finally, a measure of performance that has a close connection with, and therefore some appeal
for the idea of competitive advantage, is the company's economic value added, or EVA. By
EVA, we mean the difference between the value generated and the cost incurred by the company
for the average customer. In this graph, you will see an illustration of a company that has greater
 Business Strategy
Deepak Somaya
EVA than the average for its industry. In this case, we can directly say that the company has a
competitive advantage.
One way to see this is to notice that even if its customers price their products at average cost, the
company will still be able to slightly undercut them and make a profit. While performance
measured as economic value added, this EVA, goes directly to the crux of whether or not a
company has a competitive advantage, a major challenge is that it is often difficult in practice to
measure exactly how much value is being created for consumers by the company's products.
What is observable is price, and that is one indicator, albeit an imperfect one. So what is to be
done? My general advice here is to know that EVA is what you need to focus on, at least
conceptually, if you're interested in competitive advantage. But also recognize that each of these
approaches to measuring performance have advantages and drawbacks. It is perhaps better to
triangulate by using different approaches and develop a holistic perspective of how a company's
fairing, rather than to put too much store by a single imperfect measure. However, when
conceptually discussing competitive advantage from here on, we will be focusing on this idea of
economic value added.

Related to the idea of competitive advantage is the concept of sustained competitive advantage,
which many regard as the holy grail of strategy. In this view, the goal of all strategy must be to
develop and sustain a competitive advantage over time. While I agree that sustained competitive
advantage is important, I do not feel that it's the only thing strategic management should be
about. That said, the concept of sustained competitive advantage is key, and raises two important
questions for any analysis of competitive advantage. First, it's the question of heterogeneity.
Where do these inter-firm differences in profitability come from? In other words, what are the
attributes that make firms different in their performance? And how can a company acquire or
develop these attributes? The second question is one of sustaining a competitive advantage. Once
a company acquires a competitive advantage, how can these performance advantages be made
 Business Strategy
Deepak Somaya
durable? How can they be made to last? These two core questions are exactly what animates this
particular module, and what we will address in the next two lessons of this module.

So in conclusion, what have you learned so far in this lesson? First, we learned that company
effects, that is differences between firms in the same industry, are the major contributor to
explaining firm performance. And this implies that we need to understand how firms are
different in their internal attributes, and how these differences help them develop a competitive
advantage. We also learned what we mean by competitive advantage and sustained competitive
advantage, and examined some ways in which we might measure firm performance, as well as
firm competitive advantage.
 Business Strategy
Deepak Somaya
Lesson 3-2 Sources of Competitive Advantage
Lesson 3-2.1 Activities of the Firm

In this lesson, we will attempt to understand the main conceptual perspectives on how firms
obtain a competitive advantage, quite simply how are they able to perform better than the
competition. Let us take the example of Apple Incorporated. Why has Apple performed so well
over a period of several years to become the most valuable public company in the world? Is it
because the company does specific things in its business that others don't, and combines them in
unique ways such as the steps in its product development process? Or is it perhaps because of the
great technologies the company has developed, and in many cases owns? Is it because the
company has very unique human capital, whether we're thinking of special talents like Steve
Wozniak and Andy Hertzfeld shown here, or a culture of employee empowerment and
motivation? Is it because the company has great marketing capabilities, making it so effective in
selling its products through multiple channels including his iconic Apple stores? Or has the
company been uniquely capable in blending technology and fashion, creating products that are
[inaudible] , and must-have accessories? Or is Apple mostly a story of amazing leadership? Is
Apple successful because of great leaders like Steve Jobs and Tim Cook? Of course, Apple
success can be attributed to all of these things, but it might be stimulating to think about which
one of them is most responsible for Apple's success.
 Business Strategy
Deepak Somaya

When thinking about why companies might outperform their competitors, three main conceptual
points of view have been developed over time. The first approach developed primarily by
Michael Porter treats activities as the focus of analysis. What differentiates one firm from
another then, is the set of activities that it chooses to undertake, activities that it chooses not to
undertake, how it executes each activity so that it is more or less effective, and ultimately how
the activities are linked up and their synergies are exploited. In the second approach, the focus is
on resources, by which we mean productive firm-specific assets of different kinds that one firm
owns and another one doesn't, thus a well-known brand name is a resource, or know-how for
improving production processes, or real estate, or even cash can be thought of as a resource. The
third conceptual lens emphasizes capabilities. Things that are relevant for the company's
performance that it is very good at doing, say something like great customer service, or
innovative product design, or low-cost inventory management. Again, if a company has unique
capabilities that other firms don't, then this will set it apart from its competitors. Now it is
important to recognize that each of these ideas, activities, resources, and capabilities, are
different in how aggregate a concept they represent within the firm. An activity is typically quite
small. For example, we inspect raw material at our supplier site before they ship it to us, that
might be an activity. Within the company, the number of activities undertaken can easily number
in the hundreds, or even in the thousands. Resources, on the other hand, are a more aggregate
concept. You might expect companies to have important resources numbering in the double
digits perhaps. Capabilities, however, are an even more aggregate concept. With key capabilities
in the firm often numbering in the single digits. In many cases, a capability may result from a
combination of a few resources and a set of activities or processes that weaves them all together.
 Business Strategy
Deepak Somaya

I think we can look to the soccer field to help make these ideas a little more concrete. So you
might ask yourself, how is it that some soccer teams perform better? Look to each of these
concepts activities, resources, and capabilities for answers. Starting with activities, we might say
for example that good soccer teams dribble the ball well, or they pass the ball accurately, or that
they're good at getting free and open space for a pass. We might even focus on several activities
that good teams don't do, for example, they aren't too selfish with the ball. But most importantly,
we would recognize that it's not simply these activities by themselves but how they are combined
that produces great performance.
So some good dribbling combined with not being selfish and making an accurate pass to a team
member who happens to be in open space ready for that pass, all of this working together in
synergy might produce a great result. We could also use the conceptual lens of resources to
explain how soccer teams perform better than others. Many of the key resources for soccer teams
are of course human capital base such as a great manager or a set of star players. But you might
also look to other resources such as the fanbase, and reputation, and brand of the team. Being
Real Madrid or Manchester United, for example, is a huge advantage even before these teams
have signed up a single-player or manager.
Last but not least, we could look at a soccer teams unique capabilities to understand its
performance. For example, some people attribute the success of FC Barcelona and even the
Spanish national team to their capability to keep possession of the ball and move it around
quickly using the tiki-taka style of play. In other teams, the capability to absorb pressure in
defense and mount fast counterattacks is considered important. One can also look outside the
field of play and look to good coaching and management capabilities as another source of
advantage for some soccer teams. Notice how these capabilities are essentially aggregations of a
set of resources and activities. Tiki-taka, for example, needs talented players, and knowledgeable
coaches, the resources combined with a set of activities like quick passing, effective
communication, lots of practice, etc.
 Business Strategy
Deepak Somaya
I hope these soccer examples have given you some intuition for what activities, resources, and
capabilities are. We will now turn towards understanding each of these concepts within
companies.

Let us begin first with activities. Because any company will have such a large number of
activities within it. There are two challenges we must overcome to usefully analyze these
activities. First, we need a way to divide these activities into groups or subsets so that analysis
becomes more manageable and organized. Second, we need to figure out ways to illustrate the
relationships between these activities so that we can understand where the synergies are
generated, and where coordination might be unnecessary and costly. Two solutions have been
devised to address these challenges, the value chain, and the value network. Let us begin first
with the value chain.
 Business Strategy
Deepak Somaya

Activities being performed in a company can usefully be thought of as being a longer value
chain. The concept of a value chain applies to typical manufacturing firms, where raw materials
or components come in at one end through inbound logistics and are delivered to customers at
the other end through a sequence of value-adding steps. Raw materials or components are
processed in one or more production steps to manufacture the company's products, which are
then sent out for distribution and sales through outbound logistics. Most companies also engage
in marketing, and after-sales services related to their finished products. Activities related to each
of these steps from inbound logistics to after-sale service are called primary activities. These
primary activities are in turn supported by a set of support activities in such areas as research and
development, human resource management, procurement, and corporate infrastructure, which
includes finance and accounting.
 Business Strategy
Deepak Somaya

The value chain is not a good way to characterize the relationships between activities in service
industries. For example, airlines, telephone services, financial services, healthcare, or consulting.
For these types of industries, we use the concept of a value network, which maps important sets
of activities and their relationships with each other.

So the value network for an airline company would look something like this. One set of activities
would relate to purchasing or leasing aircrafts. Of course, an airline company must also operate
its planes which requires managing pilots and crew, as well as ground crew operations to do
maintenance and baggage handling. Additionally, an airline must market its services including
 Business Strategy
Deepak Somaya
figuring out how to price and sell tickets through various marketing channels. An airline must
also plan its root structure and acquire the necessary permissions and gate space to operate
flights from and to specific airports. Two other important sets of activities for an airline are
purchasing fuel in such a way as to minimize cost, and Managing labor relations with its
workforce. The important thing about all of these activities is that they are not arranged in any
sequential value chain, but all of them are nonetheless related to each other to a lesser or a
greater degree. We illustrate these relationships through a value network by drawing connections
between these sets of activities.

So to recap, how do each of these approaches, value chain, and value network help to organize
activities and illustrate their interrelationships? Let us consider the value chain. Remember that
the value chain framework is primarily used for manufacturing companies. In a value chain, the
company's activities are first organized along a set of primary activities that lie along the value-
adding flow of material in the company. So activities would be grouped into say, in-bound
supplier logistics, intermediate and final production operations, distribution logistics, marketing
and post-sales customer service. In addition, companies may also have several subsets of support
activities like research and development, information systems, accounting and finance, human
resources and procurement, which are typically illustrated alongside the primary activities. Keep
in mind that this figure only shows some tentative categories of value chain activities, and within
each category, there are typically many different activities that the company performs. For
example, human resources alone may include many tons of activities related to the recruitment,
motivation, training, career development, and retention of employees. A value chain
representation of activities suggests that primary activities are related to and must be coordinated
with neighboring stages of the value chain. Thus it would make sense to explore synergies
between marketing activities, for example, and activities, in both distribution logistics, and
customer service. However, the value chain approach is unclear about the relationships among
the various support activities, and between those activities and the primary activities. This is
largely left up to us as strategic analysts to figure out and analyze as the context suggests.
 Business Strategy
Deepak Somaya

Here, you can see an illustration of a value network. The more prominent network nodes in blue
are meant to illustrate more important sets of activities, and the white network nodes are less
important ones. You may take a minute to pause the video here and look more closely at the
value network shown. Right away, you might notice that unlike the value chain, a value network
is less generic in the subcategories of activities used and how they're connected with each other.
In this case, we're examining an airline company, and the major groups of activities used such as
aircraft operation, passenger amenities, route structure, and scheduling are quite specific to
airlines. Moreover, the linkages between these activities are identified as a conscious choice and
are highly specific perhaps even to the airline company being analyzed. Thus building a value
network is an exercise that's very customized to accompany, and typically no two networks
would or indeed should look alike. Moreover, with a value network, both the categories of
activities and their relationships must be discerned and illustrated by the strategist. Once they're
illustrated in the value network, these interactivity relationships become quite clear and explicit.
 Business Strategy
Deepak Somaya
Lesson 3-2.2 Resources and Capabilities

Let us now turn our attention to resources and try to understand the different types of resources
that companies could have. A checklist such as this one is useful to develop an inventory of the
company's most important resources. One can broadly categorize resources into tangible and
intangible ones, further tangible resources can be separated into financial resources such as cash
at hand and borrowing capacity, and physical resources like buildings, machinery, and real
estate. Intangible resources may be categorized in many ways. But one taxonomy that I find
especially useful is to think about resources related to technology, relationships, and human
capital. Within technology, we include a range of resources from product innovation, prototypes,
and designs to know how processes and organizational routines in systems. Among relational
resources, reputation and relationships with customers and clients are clearly very important. But
alliances and relationships with suppliers and distributors and even with other stakeholders can
also matter in specific instances. Human capital resources relate not only to the raw talent and
skills of employees, but also how they're trained, motivated, and organized to perform in a
cohesive and coordinated manner. Given the set of resources, ask yourself which resources
matter more in business today. Is it financial capital that's more important, or human capital, or
relational capital perhaps, or maybe technology, or physical resources? So which resources
matter most in today's business environment? Firstly, the answer depends on which resources
have the greatest potential to create economic value.
 Business Strategy
Deepak Somaya

That is, they can significantly increase customer value and/or reduce cost in the business and
thus increase the price cost wedge. Secondly, it depends on which resources are more difficult
for firms to own or access exclusively. Remember that for a company to have competitive
advantage, it must have something that its rivals don't. Otherwise, it may achieve competitive
parity but it will not enjoy a competitive advantage. We will come back to these ideas of value,
rarity, and competitive parity again soon.

In general, across the economy as a whole, intangibles are becoming relatively more important
for companies. As seen in research, the documents extent to which different types of assets
 Business Strategy
Deepak Somaya
explain the market value of publicly listed companies. For example, in this particular graph, you
can clearly see that tangible assets shown in purple had been decreasing as a proportion in
explaining the market value of companies included in the S&P 500 index. In other words,
intangible resources are playing a much bigger role in determining firm value. The reasons for
this ongoing change are twofold. Firstly, intangibles are much more important nowadays for
creating economic value. Secondly, firms have greater access to financial and physical resources
in the modern market-based economy. So intangible resources have a greater potential to
differentiate firms from their rivals. However, it is important to note that which resources are
more valuable and rare can vary quite a bit by industry and even company. So for instance in
industries like paper and mineral refining, access to cheap and high-quality raw material can be
both valuable for economic value added and even rare. Therefore, tangible physical resources
like good forest land or mining rights can be quite important for competitive advantage in these
industries. Nonetheless, research has shown that even in these types of industries, the relative
importance of intangibles has been on the rise in recent years.

What then are capabilities? Here's a useful definition taken from the research literature. A
capability is the capacity to perform a particular activity in a reliable and at least minimally
satisfactory manner. Three aspects of this definition are worth reflecting on because they help
clarify what we mean by capabilities. First, capabilities are the capacity of the firm to actually do
something, that is to perform some important activity. So you can have a product development
capability or a viral marketing capability and so on. By contrast, talented product designers or
marketing managers are merely resources. Second, a capability must be reliable and that the
company should be able to repeatedly perform that activity in a consistent way. Finally, note that
having a capability doesn't necessarily assume that the activity will be performed in a superlative
manner. That could be an advantage, but the minimum expectation is merely a satisfactory level
of execution. Let us now understand capabilities better by looking at some of their properties and
by using examples from the company Apple Incorporated. First, many definitions of capabilities
emphasized that they involve the deployment combination and linking of resources. Apple is
 Business Strategy
Deepak Somaya
known to have a great marketing capability, which, for example, deploys and combines resources
like its brand and reputation, its talented marketing managers, its uniquely designed retail stores,
its web developers, and it's viral marketers. Second, capability development requires learning
and the embedding of this learning in organizational routines and processes. Apple is known for
its capability to make customer-friendly, easy-to-use products, but developing this capability is
involved years of learning how to design such products which is now pretty much built into the
DNA of Apple's product design teams. While many of our examples have involved capabilities
relating to specific functional areas, say marketing or developing products, that may not always
be the case. For example, Apple is known for introducing very cool innovative products, and this
capability is definitely cross-functional, involving resources and activities in marketing, product
development, supplier management and more.

When we analyze companies internally with their sets of activities, their resources or their
capabilities, we ultimately come down to asking how these internal attributes can result in a
competitive advantage. There are two important criteria here. First, the set of activities, or the
resource, or capability must help the company perceptibly increase economic value added. That
is, it must create value in the business. Otherwise, there's little point talking about it. Second, we
look at how rare it is. Is our company unique in its access to such a source of value? If activity
sets resources or capabilities are merely valuable but not rare, they can help a company achieve
competitive parity, which is certainly better than not having them and being at a competitive
disadvantage. But to have competitive advantage, you do need rarity. The firm needs to have
exclusive access to some internal attribute that helps create business value.
 Business Strategy
Deepak Somaya

Because competitive advantage depends on having access to a rare source of business value, it is
important to understand how such heterogeneity among firms comes about. Why do some
companies end up with particular activity sets, or particular resources, or capabilities whereas
others don't? Here are some important factors, and again I will illustrate with a few examples
from Apple. First, the history of a company and its early experiences can be an important factor.
So for example, Apple's capability to develop simple to use products that often work straight out
of the box can be traced back to its early years and the influence of its founders. A second factor
is path dependence, which means the small events at various points in time may take a company
down different paths and result in it becoming quite different from others. It is hard to say which
small events have shaped the Apple of today. But there certainly would have been many as long
history that are now manifested in the activities of its value network. Of course, there might also
be certain strategic choices made with foresight by management, which can have a major impact.
So for example, the decision to open the iTunes Store through which Apple compatible apps and
music could be sold was a key turning point that created a phenomenal resource for Apple today.
Finally, sometimes it might just be dumb luck. For example, some say that Steve Jobs was lucky
that he came across inventions like the graphical user interface and the computer mouse at
Xerox's famous Palo Alto Research Center, which he then developed and built into Apple
products. Of course, you might also say that it was Jobs' foresight that recognized the value of
these inventions and that's okay too. Ultimately, so long as companies have unique internal
attributes that others don't, there's the possibility that they could create a competitive advantage
for the company.
 Business Strategy
Deepak Somaya

As you can imagine, using either activities, or resources, or capabilities as our conceptual lens
for analyzing a firm's internal sources of competitive advantage entail some trade-offs. At one
end with activities, we get a more fine-grained application for what a firm is doing differently
from other firms. At the other end with capabilities, we get a better grasp of substantive
differentiators that really set the company apart. In other words, analysis is easier because we
don't get lost in the widths of all the thousands of little things that the company might be doing
differently. Moreover, it's easier to link a particular capability with the environment and see why
it might matter for creating economic value added. So for example, if consumers are becoming
more environmentally conscious, you can see that a capability to design and market
environmentally friendly or green products might help with company performance. Resources
typically lies somewhere in-between these two extremes represented by activities and
capabilities. Ultimately, how you approach your internal analysis whether it is by focusing on
activities, or resources, or on capabilities is a matter of judgment. If there's more of a need to
connect with the details of how the company is generating a competitive advantage, a focus on
activities may be appropriate. If the need is to more quickly summarize the company's key
differentiators and to show why it might have a performance advantage, a focus on capabilities
or resources might work better. In practice, I think it's often valuable to use a blended approach
to both understand what some major capabilities of the firm might be, as well as to articulate the
resources and activities that might underlie some of these capabilities.
 Business Strategy
Deepak Somaya

We first learned about three different ways of analyzing the sources of competitive advantage,
activities which can be organize as a value chain or a value network, resources and capabilities.
Second, irrespective of the approach to internal analysis, we learned that the internal attributes
need to be valuable and rare to create a competitive advantage.
Lesson 3-3 Sustained Competitive Advantage
Lesson 3-3.1 Sustained Competitive Advantage

As we have noted earlier an important goal of strategic management is to create a competitive

advantage for a company that can be sustained over time. Conceptually, we can see the problem
 Business Strategy
Deepak Somaya
of sustaining a competitive advantage as one of overcoming four potential challenges. The first
two challenges are imitation and replication, which are essentially threats to the rarity of the
firm's internal attributes. Taking the example of Apple's capability to develop cool new products,
the threat of imitation implies that other firms will figure out and implement Apple's product
development processes and routines. By contrast, the threat from replication is one where other
firms use different product development processes but achieve similar results. The threats of non
durability or non-relevant, are essentially threats to the firm's ability to continue to produce
economic value added. To sustain a competitive advantage, firms need their internal attributes
like their activity sets, resources, and capabilities to be durable, and to not degrade or erode over
time. So for example, Apple's reputation and brand image could be lost over time. Its talented
employees may leave or stop working well together, or key activities may fade from his value
network and so on. At the same time, it is also possible that the environment might change, and
activity sets, resources, and capabilities that were once very valuable are no longer so. In other
words, they lose their relevance. Thus for example, Apple's strengths in designing fashionable
sleek products, they become less relevant as the company pivots away from products that are
accessories like the iPhone and iWatch, and more towards products such as the Apple TV or
electric cars. Therefore, in order to sustain their competitive advantage, firms need ways to
prevent imitation and replication, and to ensure the durability and relevance of their internal
strengths.

Much of the academic literature on sustained competitive advantage focuses on so-called

isolating mechanisms, which are barriers to imitation and replication of a firm's competitive
advantage. Some prominent examples of such isolating mechanisms include causal ambiguity,
complexity, tacit knowledge, resource mobility barriers, and property rights. I will illustrate each
of these mechanisms again with examples from Apple. By causal ambiguity, we mean that it is
unclear where exactly a company's performance advantages come from. So for example, it may
be unclear to other companies whether Apple's success is due to its product development, or its
marketing, or it's innovative culture, or is leadership and so on. If other firms don't know how
 Business Strategy
Deepak Somaya
Apple has become successful, it is very hard for them to reproduce that success. Complexity
implies that even if the individual elements of the company success are known, these elements
can be combined in many different ways, and success depends on a very precise combination of
these different elements. Small mistakes in the combinations used to replicate a company's
success can have major consequences. So that for example, Apple's imitators can and often do
fall significantly short if they don't get every element of Apple's activity system exactly right.
Tacit knowledge is another potential isolating mechanism. Knowledge that is tacit as opposed to
explicit or codified, is knowledge that cannot be easily explained and transferred to another. It's
like riding a bike. Thus, Apple's tacit knowledge about say, designing products, or writing user-
friendly software may be things that can only be learned by doing under the guidance and
supervision of Apple's senior managers.
Naturally, this will make it hard for other companies to learn and acquire this tacit knowledge.
One of the possible ways in which imitation or replication may happen, is not by trying to
recreate a company's competitive advantages but by luring away key resources, specifically
resources that have agency, and can choose where they want to be. So for example, competitors
may try to hire away key Apple employees, or draw away their suppliers or partner application
developers. Barriers that limit such resource mobility are therefore also important for sustaining
competitive advantage. Last but not least, property rights over resources can be an effective
barrier to imitation and replication. In some industries, there might be property rights or physical
resources, such as a mining lease or exclusive real estate, which might be very important. In
Apple's case, the property rights that matter are mostly over intangibles, trademarks that covered
it's brands and logos, copyrights over software and other creative content, and patents on its
various technologies. As you might know, Apple has been very aggressive in seeking to enforce
its smartphone patents against a number of other companies, notably Samsung and HTC, as a
strategy to retain some of its competitive advantage. Of Course, intellectual property is not
perfect in preventing imitation of a company's resources, as Apple has been finding out. But then
none of these imitation and replication barriers are perfect. Rather, the idea is to identify and
deploy isolating mechanisms that just raise the cost for rivals to mimic your competitive
advantage.
 Business Strategy
Deepak Somaya

We've learned about imitation and replication barriers so far, in a somewhat general way. With
respect to activity systems in a value chain or a value network however, strategies have
highlighted a specific built-in barrier to imitation. That's important to understand. In Michael
Porter's description of such activity systems, he emphasized that they are inherently difficult for
other firms to replicate, because it is often difficult for these rivals to know exactly which
activities are used, and how they're implemented, and more importantly how they are combined.
Put differently, because there are so many choices among activities, and so many potential
combinations among them, imitation becomes difficult.
 Business Strategy
Deepak Somaya
The Analysis of resources as the basis of competitive advantage has given rise to a literature that
is called the Resource Based View or RBV for short. A popular framework in this literature for
analyzing competitive advantage is the V-R-I framework which is developed by Professor Jay
Barney, along with contributions from a number of other scholars. The V-R-I framework
explains the link between a firm's resources or capabilities and its ability to realize a sustained
competitive advantage. The acronym VRI refers to whether the resource or capability is
valuable, rare, and inimitable, ideas that you're already familiar with from this module. If a
resource or capability is merely valuable but not rare as shown in the first blue column here, then
it can only help a firm achieve competitive parity with other firms that have the same resource.
To have a temporary competitive advantage, the firm must possess a resource or capability that's
both valuable and rare. Finally, to enjoy a sustained competitive advantage, the firm's resource or
capability must be all three, valuable, rare, and difficult to imitate. Thus the V-R-I framework
gives you a nice summary of many of the ideas we have looked at in this module. One thing you
might notice is that this framework says very little about the durability or relevance of the
sources of competitive advantage. But this focus on imitation barriers is not unique to the V-R-I
framework. Indeed, most of the field of strategic management tends to emphasize isolating
mechanisms when thinking about the sustainability of competitive advantage.

In practice however, managers are nowadays far more concerned about durability and relevance
when they think about sustaining the competitive advantage of their companies. Possibly, this is
a reflection of how much more dynamic and challenging the environment of business has
become. Let us start with the durability of activity systems, resources, and capabilities. A useful
metaphor for thinking about durability is a leaky bucket, where the bucket represents a company,
and the water its sources of competitive advantage. Just as this leaky bucket constantly faces the
prospect of losing water, any company also faces the prospect that it's internal strengths may
steadily diminish over time. Resources may degrade, routines and activities may be lost, key
employees and partners may leave and go elsewhere, capabilities might deteriorate. Like with a
leaky bucket, there may be two solutions to solve the durability challenge. The first would be to
 Business Strategy
Deepak Somaya
attempt to plug the leaks. Try to preserve your resources, maintain your activity system, retain
your people and so on. In addition, a company may try to continuously top-up and add to the
bucket to replace what is being lost. So new hires can replace lost talent. Training and
managerial intervention can strengthen the firm's activity systems and capabilities etc.
Last but not least, we turn to the challenge of relevance, which is arguably the biggest one faced
by companies today. Typically, the problem is that within a dynamic and constantly changing
business environment, the company's existing sources of competitive advantage may not be as
useful in the future. The situation may actually be worse, because certain core competencies help
the company succeed in the past, it may be difficult to abandon them and these core
competencies become core rigidities, something that is no longer valuable but gets in the way of
acquiring or building new relevant competencies. Ultimately, responding to the challenge of
relevance means that companies need to be capable of changing their sources of competitive
advantage through so-called dynamic capabilities, an idea that we will return to later in this
course.

In concluding this module, let me point to the key ideas that I hope you will take away from it.
First, competitive advantage is important, because we know that firm effects are a significant
factor in explaining company performance. Second, we learned about three key ways of
analyzing sources of competitive advantage, activities, resources, and capabilities. We also
understood that to have a competitive advantage, these sources must both create economic value
and they must be rare. Finally, we learned that there were four potential challenges to overcome
in sustaining competitive advantage. Challenges to maintaining the rarity of the sources of
competitive advantage, which requires barriers to imitation and replication, and the challenges to
the continued creation of economic value mean that companies need to ensure that their
activities, resources and capabilities remain durable and relevant.
 Business Strategy
Deepak Somaya
Interview: Executive Expertise-Competitive Advantage

I also asked our executive experts about the key sources of competitive advantage for their
business and how they sustain their competitive advantage. All three executives listed a number
of traditional barriers to imitation that may provide some sustainability to their competitive
advantage. What was remarkable however was how each of them emphasized the need for
constant change and improvement and staying ahead of the competition and disruption. Quite
simply, the key to sustaining competitive advantage in today's business environment is
innovation. Thereby staying relevant to customers.
I very much believe in the idea of building sustainable competitive advantage and I think that's
difficult to accomplish, especially in a world where barriers to entry are decreasing. I think
things that really are sustainable are difficult. For volunteers I think about it. I think we have a
number of competitor, then one is scale. We've gotten to scale fairly quickly and it's very
difficult for someone that's brand new to compete with us. From the standpoint, the amount of
capital we raised, the people and personnel we have, the skill level we have. Technology and
Analytics can be a competitive advantage for us. The analytical capability that we've developed,
is in fact I believe a competitive advantage because we are 5-10 years ahead of what our
competitors are doing. Really we've spent two and a half years developing different deployment
architecture for reverse analytical models. The analytical models themselves are out of academia.
We're not developing them, but the architecture to actually deploy them is something that just is
not off the shelf. You have to be able to build. To clarify, you need the analytical models if I
understand correctly to basically be able to price risk. Because you are lending at the end of the
day and you need to be able to price risk. Now, for us, it's a really simple proposition. The better
we can price an individual's risk and ideally perfectly.
That we know that this person will default and this person will not. Therefore the person that
won't default will not have to subsidize a person that will. So the better we can price risk, the
lower the rate and can offer to an individual consumer. So I think those are real competitive
 Business Strategy
Deepak Somaya
advantages in operational capability. We have a 550 percent servicing center today we built from
scratch. We own it, we own all of the technology that CRM systems all the data required. So
somebody's starting from scratch, we have to just be able to rebuild all of that. Brand is really
important. I think if you could provide value to your consumers and really build a brand, brand
can be a sustainable competitive advantage over long periods. I think it's very challenging. The
Innovator's Dilemma I think is a great book. Twenty years ago that outline this whole paradox of
why is it the companies that seemingly are on top of the world miss the next boat, or miss the
change in the stock, or the change in the vertical. There are very few companies that over time
had been able to continuously build organically and evolve. Maybe Apple is one. I just think you
have to constantly question every decision every known answer.

So we never thought our product was amazing. We always felt like we could do so much more to
improve our product. Even if it was better than everyone else's, that didn't matter to us. Our Bar
was always some sort of internal barometer, some sort of internal metric that we can never hit.
Every time we did something, we would ratchet it up and say we need to do more. So that I think
was really important. We never said, hey, at least we're number one, we're ahead of all these
other guys, so we can take a break. Or at least we're better than these other guys. We always
looked out at our our our competitive field and more importantly we looked at what our
customers wanted. Customers being as demanding as they are, always want a lot more than you
can deliver. Anything you deliver, they're going to come up with new things and new ideas. So
that was really ultimately the way we judged ourselves. The other thing that we did that became
both a short-term but a mid-term competitive advantages, we figured out our channel
relationships really well.
A lot of that had to do with understanding the exact dynamics and the roles that we should play
relative to the roles that our channel should play. When we first started really exploring the
channel relationships it was really mingled and it was really hard to pull apart as a result. There
were a lot of it. It felt more like coopetition at that point. But once we were able to tease that
apart and say these are the things that we will do, and we agree we will never do those things that
 Business Strategy
Deepak Somaya
you do and, you do your things and agree that you're not going to do the things that we do. Then
it became very cooperative. Figuring that out and unlocking that early became a huge
competitive advantage for us relative to our competitors who took a lot longer. Some of them
wanted to compete with the channel. That ultimately hurt them. So when you look at their glass
today it is the prevailing model. So all other players who are like those last have adopted
essentially that same model. I think long-run competitive advantage really does have to come
from the people. It sounds trite but it's true. Because over a long period of time, you have to have
a culture where you're never satisfied with your current status quo. I think company after
company become satisfied with their status quo after they become the top player. If they don't
have a culture that forces them to eat their young and to innovate, despite the fact that they're on
top or to take brats however small they may appear seriously, you're gonna get unseated. So
long-term competitive advantage has to come from having the right people and the right culture
in place to do that.

Certainly in ensuring that we've got a very strong and capable channel which aren't really a
financial representatives. We spend a lot of money on recruiting and retaining financial
representatives, it's key to us to have really strong financial advisers. So to do everything from
right to simple all the way to sit down with the company and talk about their 401K plan. There is
no insurance company today that is not changing its systems.

We're no different we're in Bloomington, Illinois right next to State Farm. So we are absolutely
no different. Different scale but no different in our own issues. On top of that though, the
technology that got company used to the position we are 9 years of life, we're based on a
mainframe. We did all our programming ourselves. These are our programs. They're
tremendously precise and mainly flexible in. They do not respond to customer needs quickly. So
we are changing out our property casualty platform, our life platform. But on top of that though,
you're seeing us move and the industry move from, mainframe cobol based, very precise to very
flexible, configurable systems. That interact well with a customer that are very well and enabled,
 Business Strategy
Deepak Somaya
etc. It's a tremendously difficult transition for us as well as for others, but I would just say us.
Because the talents that you needed to do all those things just talked about acquire customers,
settle claims, make sure that you build them correctly, etc. We are touching all those. It is the
third rail of our of our business technology is.