4 Evaluating a Company’s Resources, Capabilities, and Competitiveness PDF

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CHAPTER 4

Evaluating a Company’s Resources, Capabilities, and Competitiveness

Learning Objectives

© Ikon Images/Alamy Stock Photo

THIS CHAPTER WILL HELP YOU UNDERSTAND:

LO 1

How to take stock of how well a company’s strategy is working.

LO 2

Why a company’s resources and capabilities are centrally important in giving the company a competitive edge over rivals.

LO 3

How to assess the company’s strengths and weaknesses in light of market opportunities and external threats.

LO 4

How a company’s value chain activities can affect the company’s cost structure and customer value proposition.

LO 5

How a comprehensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves.

Crucial, of course, is having a difference that matters in the industry. Cynthia Montgomery—Professor and author

If you don’t have a competitive advantage, don’t compete

Organizations succeed in a competitive marketplace over the long run because they can do certain things their customers value better than can their competitors. Robert Hayes, Gary Pisano, and David Upton— Professors and consultants

Jack Welch—Former CEO of General Electric

Chapter 3 described how to use the tools of industry and competitor analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situation. This chapter discusses techniques for evaluating a company’s internal situation, including its collection of resources and capabilities and the activities it performs along its value chain. Internal analysis enables managers to determine whether their strategy is likely to give the company a significant competitive edge over rival firms. Combined with external analysis, it facilitates an understanding of how to reposition a firm to take advantage of new opportunities and to cope with emerging competitive threats. The analytic spotlight will be trained on six questions: 1. How well is the company’s present strategy working? 2. What are the company’s most important resources and capabilities, and will they give the

company a lasting competitive advantage over rival companies? 3. What are the company’s strengths and weaknesses in relation to the market opportunities and external threats? 4. How do a company’s value chain activities impact its cost structure and customer value proposition? 5. Is the company competitively stronger or weaker than key rivals? 6. What strategic issues and problems merit frontburner managerial attention? In probing for answers to these questions, five analytic tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmarking, and competitive strength assessment—will be used. All five are valuable techniques for revealing a company’s competitiveness and for helping company managers match their strategy to the company’s particular circumstances.

QUESTION 1: HOW WELL IS THE COMPANY’S PRESENT STRATEGY WORKING? In evaluating how well a company’s present strategy is working, the best way to start is with a clear view of what the strategy entails. Figure 4.1 shows the key components of a single-business company’s strategy. The first thing to examine is the company’s competitive approach. What moves has the company made recently to attract customers and improve its market position—for instance, has it cut prices, improved the

LO 1 How to take stock of how well a company’s strategy is working.

Concepts and Techniques for Crafting and Executing Strategy

PART 1

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design of its product, added new features, stepped up advertising, entered a new geographic market, or merged with a competitor? Is it striving for a competitive advantage based on low costs or a better product offering? Is it concentrating on serving a broad spectrum of customers or a narrow market niche? The company’s functional strategies in R&D, production, marketing, finance, human resources, information technology, and so on further characterize company strategy, as do any efforts to establish alliances with other enterprises. The three best indicators of how well a company’s strategy is working are (1) whether the company is achieving its stated financial and strategic objectives, (2) whether its financial performance is above the industry average, and (3) whether it is gaining customers and gaining market share. Persistent shortfalls in meeting company performance targets and weak marketplace performance relative to rivals are reliable warning signs that the company has a weak strategy, suffers from poor strategy execution, or both. Specific indicators of how well a company’s strategy is working include: ∙ ∙ ∙ ∙

FIGURE 4.1

Trends in the company’s sales and earnings growth. Trends in the company’s stock price. The company’s overall financial strength. The company’s customer retention rate.

Identifying the Components of a Single-Business Company’s Strategy

Moves to attract customers and outcompete rivals via improved product design, better features, higher quality, wider selection, lower prices, and so on

Moves to respond to changing conditions in the macro-environment or in industry and competitive conditions Initiatives to build competitive advantage based on:

Efforts to expand or narrow geographic coverage

TIO

Sales, marketing, and distribution strategies

L NA

Production strategy

(The action plan for managing a single business)

C UN

Supply chain management strategy

BUSINESS STRATEGY

K EY F

R&D, technology, product design strategy

ST RA T

Information technology strategy

Lower costs relative to rivals? A better product offering? Superior ability to serve a market niche or specific group of buyers?

EG

Efforts to build competitively valuable partnerships and strategic alliances with other enterprises within its industry

IE S

Human resource strategy

Finance strategy

CHAPTER 4

Evaluating a Company’s Resources, Capabilities, and Competitiveness

∙ The rate at which new customers are acquired. ∙ Evidence of improvement in internal processes such as defect rate, order fulfillment, delivery times, days of inventory, and employee productivity. The stronger a company’s current overall performance, the more likely it has a well-conceived, well-executed strategy. The weaker a company’s financial performance and market standing, the more its current strategy must be questioned and the more likely the need for radical changes. Table 4.1 provides a compilation of the financial ratios most commonly used to evaluate a company’s financial performance and balance sheet strength.

TABLE 4.1

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Sluggish financial performance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both.

Key Financial Ratios: How to Calculate Them and What They Mean

Ratio

How Calculated

What It Shows

Profitability ratios 1. Gross profit margin

Salesrevenues – Costofgoodssold ________________________

Shows the percentage of revenues available to cover operating expenses and yield a profit.

2. Operating profit margin (or return on sales)

Salesrevenues – Operatingexpenses _________________________

Shows the profitability of current operations without regard to interest charges and income taxes. Earnings before interest and taxes is known as EBIT in financial and business accounting.

3. Net profit margin (or net return on sales)

Profitsaftertaxes _____________

4. Total return on assets

Profitsaftertaxes +Interest ____________________ Totalassets

5. Net return on total assets (ROA) 6. Return on stockholders’ equity (ROE) 7. Return on invested capital (ROIC)— sometimes referred to as return on capital employed (ROCE)

Salesrevenues

Salesrevenues or Operatingincome _____________ Salesrevenues

Shows after-tax profits per dollar of sales.

Salesrevenues

Profitsaftertaxes _____________ Totalassets

Profitsaftertaxes ___________________

Totalstockholders’equity

A measure of the return on total investment in the enterprise. Interest is added to after-tax profits to form the numerator, since total assets are financed by creditors as well as by stockholders. A measure of the return earned by stockholders on the firm’s total assets. The return stockholders are earning on their capital investment in the enterprise. A return in the 12%–15% range is average.

Profitsaftertaxes _______________________________

A measure of the return that shareholders are Long-termdebt+Totalstockholders’equity earning on the monetary capital invested in the enterprise. A higher return reflects greater bottom-line effectiveness in the use of long-term capital.

Liquidity ratios 1. Current ratio

Currentassets _____________ Currentliabilities

Shows a firm’s ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should be higher than 1.0. (continued)

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TABLE 4.1

Concepts and Techniques for Crafting and Executing Strategy

(continued)

Ratio 2. Working capital

How Calculated

What It Shows

Currentassets–Currentliabilities

The cash available for a firm’s day-to-day operations. Larger amounts mean the company has more internal funds to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital.

Totaldebt _________

Measures the extent to which borrowed funds (both short-term loans and long-term debt) have been used to finance the firm’s operations. A low ratio is better—a high fraction indicates overuse of debt and greater risk of bankruptcy.

Leverage ratios 1. Total debt-toassets ratio

2. Long-term debtto-capital ratio

Totalassets

Long-termdebt _______________________________

A measure of creditworthiness and balance sheet Long-termdebt+Totalstockholders’equity strength. It indicates the percentage of capital investment that has been financed by both longterm lenders and stockholders. A ratio below 0.25 is preferable since the lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 indicate an excessive reliance on long-term borrowing, lower creditworthiness, and weak balance sheet strength.

3. Debt-to-equity ratio

Totaldebt ___________________

Shows the balance between debt (funds borrowed both short term and long term) and the amount that stockholders have invested in the enterprise. The further the ratio is below 1.0, the greater the firm’s ability to borrow additional funds. Ratios above 1.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings.

4. Long-term debtto-equity ratio

Long-termdebt ___________________

Shows the balance between long-term debt and stockholders’ equity in the firm’s long-term capital structure. Low ratios indicate a greater capacity to borrow additional funds if needed.

5. Times-interestearned (or coverage) ratio

Operatingincome _____________ Interestexpenses

Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios above 3.0 signal progressively better creditworthiness.

Totalstockholders’equity

Totalstockholders’equity

Activity ratios 1. Days of inventory

Inventory __________________

2. Inventory turnover

Costofgoodssold _____________ Inventory

Measures the number of inventory turns per year. Higher is better.

3. Average collection period

Accountsreceivable _______________ Totalsales÷365 or Accountsreceivable _______________ Averagedailysales

Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better.

Costofgoodssold÷365

Measures inventory management efficiency. Fewer days of inventory are better.

(continued)

CHAPTER 4

TABLE 4.1

Evaluating a Company’s Resources, Capabilities, and Competitiveness

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(continued)

Ratio

How Calculated

What It Shows

Other important measures of financial performance 1. Dividend yield on common stock

Annualdividendspershare _____________________

A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2%–3%. The dividend yield for fast-growth companies is often below 1%; the dividend yield for slow-growth companies can run 4%–5%.

2. Price-toearnings (P/E) ratio

Currentmarketpricepershare _____________________

P/E ratios above 20 indicate strong investor confidence in a firm’s outlook and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12.

Annualdividendspershare ___________________

Indicates the percentage of after-tax profits paid out as dividends.

3. Dividend payout ratio 4. Internal cash flow

5. Free cash flow

Currentmarketpricepershare

Earningspershare

Earningspershare

After-taxprofits+Depreciation

After-taxprofits+Depreciation–Capital expenditures–Dividends

A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures. A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, taxes, dividends, and desirable reinvestments in the business. The larger a company’s free cash flow, the greater its ability to internally fund new strategic initiatives, repay debt, make new acquisitions, repurchase shares of stock, or increase dividend payments.

QUESTION 2: WHAT ARE THE COMPANY’S MOST IMPORTANT RESOURCES AND CAPABILITIES, AND WILL THEY GIVE THE COMPANY A LASTING COMPETITIVE ADVANTAGE OVER RIVAL COMPANIES? An essential element of deciding whether a company’s overall situation is fundamentally healthy or unhealthy entails examining the attractiveness of its resources and capabilities. A company’s resources and capabilities are its competitive assets and determine whether its competitive power in the marketplace will be impressively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry. Resource and capability analysis provides managers with a powerful tool for sizing up the company’s competitive assets and determining whether they can provide the foundation necessary for competitive success in the marketplace. This is a two-step process. The first step is to identify the company’s resources and

CORE CONCEPT A company’s resources and capabilities represent its competitive assets and are determinants of its competitiveness and ability to succeed in the marketplace.

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Resource and capability analysis is a powerful tool for sizing up a company’s competitive assets and determining whether the assets can support a sustainable competitive advantage over market rivals.

PART 1

Concepts and Techniques for Crafting and Executing Strategy

capabilities. The second step is to examine them more closely to ascertain which are the most competitively important and whether they can support a sustainable competitive advantage over rival firms.1 This second step involves applying the four tests of a resource’s competitive power.

Identifying the Company’s Resources and Capabilities

A firm’s resources and capabilities are the fundamental building blocks of its competitive strategy. In crafting strategy, it is essential for managers to know how to take stock of the company’s full complement of resources and capabilities. But LO 2 before they can do so, managers and strategists need a more precise definition of these terms. Why a company’s In brief, a resource is a productive input or competitive asset that is owned or conresources and capabilities are trolled by the firm. Firms have many different types of resources at their disposal that centrally important in vary not only in kind but in quality as well. Some are of a higher quality than others, giving the company and some are more competitively valuable, having greater potential to give a firm a a competitive edge competitive advantage over its rivals. For example, a company’s brand is a resource, as over rivals. is an R&D team—yet some brands such as Coca-Cola and Xerox are well known, with enduring value, while others have little more name recognition than generic products. In similar fashion, some R&D teams are far more innovative and productive than others due to the outstanding talents of the individual team members, the team’s composition, its experience, and its chemistry. A capability (or competence) is the capacity of a firm to perform some internal activity competently. Capabilities or competences also vary in form, quality, and competitive importance, with some being more competitively valuable than others. American Express displays superior capabilities in brand management and marketing; Starbucks’s employee management, training, and real estate capabilities are the drivers behind its rapid growth; LinkedIn relies on superior software innovation capabilities to increase new user memberships. Organizational capabilities CORE CONCEPT are developed and enabled through the deployment of a company’s resources.2 A resource is a competitive For example, Nestlé’s brand management capabilities for its 2,000+ food, beverasset that is owned or age, and pet care brands draw on the knowledge of the company’s brand managers, controlled by a company; a the expertise of its marketing department, and the company’s relationships with capability(or competence) retailers in nearly 200 countries. W. L. Gore’s product innovation capabilities in is the capacity of a firm its fabrics and medical and industrial product businesses result from the personal to perform some internal initiative, creative talents, and technological expertise of its associates and the comactivity competently. pany’s culture that encourages accountability and creative thinking. Capabilities are developed and enabled through the deployment of a company’s resources.

Types of Company Resources

A useful way to identify a company’s resources is to look for them within categories, as shown in Table 4.2. Broadly speaking, resources can be divided into two main categories: tangible and intangible resources. Although human resources make up one of the most important parts of a company’s resource base, we include them in the intangible category to emphasize the role played by the ski...