For https://courseworkhero.co.uk only ….

Write a 500-word (minimum) submission that responds to the questions posed below.

Read the Case 2-1: AirAsia X: Can the low Cost Model go Long Haul located in your textbook. Version: 2012 -02-17 ( LINK LOCATED BELOW)

Be sure to include your responses to the following questions:

How would you describe the AirAsia X model? What elements of its business model are the same or different from a traditional airline? What elements are the same or different from a traditional airline?
What is your assessment of the strengths and weaknesses of the X model?
What are the greatest threats to X? Where are its best opportunities?
What strategic recommendations would you make to X’s executive team?

Submission

The submission should be made in APA format and include in-text citations where necessary as well as a listing of reference citations at the end in APA format. 12pt font double spaced 500 words min. With references from academic journals and AirAsia website.

THE LINK IS (if you type in Page 180 the next page comes up as PC 2-1 )

http://rims.phe-randugunting.com/wordpress/wp-content/uploads/2017/10/EB00138HRM-Strategic-Management-and-Competitive-Advantage-Concepts-and-Cases-5e-Global-Edition-Barney-_-Hesterly

at SciVerse ScienceDirect

Journal of Air Transport Management 21 (2012) 24e35

Contents lists available

Journal of Air Transport Management

journal homepage: www.elsevier.com/locate/jairtraman

Strategies for managing risk in a changing aviation environment

Nicole Adler a,b,*, Aaron Gellman b

a School of Business Administration, Hebrew University of Jerusalem, Mount Scopus, Jerusalem 91905, Israel
b Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208, United States

Keywords:
Strategies towards risk
Aviation value chain
Aviation regulation
Airline competition
Airport commercialization

* Corresponding author. School of Business Adminis
Jerusalem, Mount Scopus, Jerusalem 91905, Israel. Te

E-mail address: msnic@huji.ac.il (N. Adler).

0969-6997/$ e see front matter � 2012 Elsevier Ltd.
doi:10.1016/j.jairtraman.2011.12.014

a b s t r a c t

Given the increasing volatility in the economic performance of airlines, partially reflecting the dynamics
of demand for air transport and the fixed costs associated with the industry, all stakeholders need to
consider appropriate strategies for better managing the risks. Many risks were identified in the literature
previously, some even decades ago, however most have yet to be satisfactorily addressed. Urgency is
growing. Removal of the remaining barriers to competition at all levels, congestion management, open
skies policies across continents, computer-centric air traffic management systems and increased research
and development into the processes and technology needed to reduce environmental externalities
remain among the top challenges for the next decade.

� 2012 Elsevier Ltd.

1. Introduction

The aviation industry is entering a new era in part due to two
major issues. The first issue involves the increasing interest in the
perceived environmental damage caused by transportation in
general and by aviation in particular. The second issue involves the
impact of multiple exogenous shocks such as the financial melt-
down of 2008 as a result of which the aggregate airline industry
profits of the past seventy years, which were admittedly marginal,
were completely wiped out. Fig.1 presents the data drawn from the
Air Transport Association (2010). The variability of the exogenous
shocks on airline demand levels has been increasing at a rapid pace
hence the need to develop strategies for all stakeholders in the
aviation sector. A major risk to the sustainability of the aviation
system is that legal principles rather than economic rationality will
prevail such that competition and good managerial leadership are
swamped by market distortions. Understanding the markets,
removing barriers to both entry and exit and encouraging compe-
tition on all links of the aviation sector leads to innovation and
internalization of the inherent risks of volatile demand, economic
cycles and climate change. Deregulation in the airline sector led to
the development of a new breed of carriers that has in turn
increased consumer surplus. Corporatization and privatization of
airports led to a substantial increase in alternative revenue streams
at airports which improved both producer and consumer surplus.

tration, Hebrew University of
l./fax: þ972 2 5883449.

On the other hand, distortionary subsidies given to airframe
manufacturers led to the development of aircraft that are not
financially viable, such as Concorde and the A380 (Gellman et al.,
2004).

In this article we discuss potentially fruitful strategies that may
aid the airlines, airports, airframe and engine manufacturers and
their first tier suppliers as well as those bodies governing the
industry. These strategies need to provide a cushion whereby
companies can reasonably handle the risk of fuel price instability,
the introduction of carbon cap and trade regulation, the need to
finance airport infrastructure, air traffic management systems,
aircraft and other assets, the competitive inequalities drawing from
subsidies across the globe at various levels of the supply chain and
the effects of increasing ad-hoc consumer protection laws. The
industry is dynamic and in 2010 returned to growth. Pro-active
strategies are needed to ensure that further growth is viable in an
economically, politically and environmentally sustainable manner
since the alternative will involve regulation and a reduction in
overall social welfare and mobility.

2. Airlines

Most airlines provide a scheduled service over which supply and
demand must be carefully balanced, especially in light of the
exogenous shocks that have substantially impacted demand in the
short to medium term such as the explosion of the dot-com bubble
in 2000, the security implications of September 11th 2001, the
Severe Acute Respiratory Syndrome outbreak in 2003 and the
United States housing price bubble of 2007 that led to the current
recession felt in many parts of the world. The effects of these

mailto:msnic@huji.ac.il

www.sciencedirect.com/science/journal/09696997

http://www.elsevier.com/locate/jairtraman

http://dx.doi.org/10.1016/j.jairtraman.2011.12.014

-40,00

-30,000

–

20,000

–

10,000

0
10,000
20,000

1940 1950 1960 1970 1980 1990 2000 2010

Net Profit in $ mill.

years

Fig. 1. World Airlines’ Net Profits 1947e2008 (Source: ATA, 2010).

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 25

downturns will continue to be felt at airlines that fail to adopt
a plan to replenish, upgrade and perhaps increase their fleet in
order to account for the longer term, underlying growth pattern
that is likely to transpire over time. Good management would
appear to be one of the most important elements of building and
maintaining a successful airline and prudent aircraft purchasing
decisions are at the epicenter of this approach (Tretheway and
Waters, 1998; Government Accountability Office, 2006). Further-
more, management must consider direct risks to the supply side,
including for example the future price of fuel as well as the pricing
and/or regulation of environmental externalities such as global
greenhouse gas emissions, local air pollutants and noise.

This section first discusses the issues of managing a heteroge-
neous customer base and the life cycle of the airline market in
section 2.1, the issues of achieving profitability in section 2.2, the
approaches to handling competition in section 2.3 and the
remaining supply side strategies in section 2.4.

2.1. Managing demand

Aviation is often treated as a discretionary service in comparison
to other forms of transport such as daily trips to work, which leads
to volatility and seasonality of demand. However airlines do
provide mobility which is unique in longer haul markets and spans
heavily business oriented destinations (e.g. Belgium and Shanghai),
almost purely touristic hotspots (e.g. Hawaii and Las Palmas) with
the majority of origin-destination pairs a mix of the two to varying
degrees. Overall growth in demand has been decidedly positive
over the longer term in line with the different stages of maturity of
the industry around the globe and the respective income levels.

Business travel demand appears to be shrinking which is
a process that began as far back as 1999 (Mason, 2005) and has
continued as a result of the current financial crisis, with companies
searching for alternative forms of communication or at the very
least, economy class tickets (Cobb, 2005). Consequently, airlines
need to encourage business passengers to move to the front of the
cabin by maintaining frequency where reasonable, improving
frequent flyer programs and attracting long term corporate travel
agent agreements. The standard scheduled carriers have lost some
business demand to the business jet market, although this is
obviously limited to the extremely time constrained with
a substantial willingness-to-pay (Mason, 2007). Private aircraft and
related traffic have so far avoided most of the security regulations
that the legacy and low cost carriers must handle, which contrib-
utes a reasonable amount of additional time to a trip particularly in
the shorter haul markets.

Leisure travelers choose holiday purchases given their discre-
tionary income levels which have been reduced since 2007. This
passenger type is the most price sensitive, which has encouraged
airlines to unbundle their product, providing the airlines with the
ability to further price discriminate whilst arguably allowing
passengers greater choice (Brons et al., 2002; Clemons et al., 2002;
Bilotkach, 2010). Airlines must utilize their existing staffing levels
and fleet of aircraft at least in the short term, which has led to
a heavy reliance on revenue management technology.

The heart of the airline business lies in attracting the two
consumer types, namely the business passenger interested in high
levels of frequency and less so the airfare as compared to the leisure
passenger who places much greater emphasis on fares
(Proussaloglou and Koppelman, 1995; Adler, 2005; Adler et al.,
2010c). Ignoring one type at the expense of the other would
appear to be extremely perilous. Despite the high margins on
business travel, a scheduled airline model catering specifically to
this type of consumer does not appear to be viable, see for example
Maxjet, Eos and Silverjet, pure business class airlines serving
transatlantic routes, all of which filed for bankruptcy in 2008. One
of their major issues were the problems of connectivity, as none of
the airlines developed a web of interline or codeshare services
which is so important to beyond or behind gateway travel
(Holloway, 2008). Charter carriers serving the pure leisure
market also appear to be a waning business model as the low cost
scheduled carriers take their place in maturing airline markets
(Gillen, 2006). For scheduled service, the high frequency demanded
by business consumers can only be served if the remainder of the
aircraft is filled with a sufficient number of passengers willing to at
least cover the marginal cost of the seats. Relatively high frequency
ensures a disproportionately higher market share (Swan, 2007;
Belobaba, 2009) which is only worthwhile if the yield at the very
least covers the average costs of the flight, including the cost of
capital. Airlines in the more mature, standardized markets achieve
competitive advantage through lower costs. It may also be true that
on longer flights (more than five hours), passengers are more
willing to pay for additional comfort which would permit the
differentiation strategy to survive and prosper.

Strategies also need to match the life cycle of the market in
which they exist. Until now, airlines have placed extreme emphasis
on maintaining or increasing market share rather than profit
potential and origin-destination yields. It would appear that the
American domestic market, currently the largest aviation market in
the world, has achieved a level of maturation such that market
growth is flattening out. Whilst the European Union is moving
towards saturation, the South American, Far East and

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e3526

intercontinental markets are all a long way from maturation.
Furthermore, the African and Middle Eastern markets have yet to
begin their exponential growth rates (Swelbar and Belobaba, 2009).
Consequently, low cost strategies in the United States and European
Union domestic markets appear to be the most profitable strategy
given the current market life cycle, whereas the differentiated
strategy would appear to be more profitable on the interconti-
nental routes and in regions that have yet to develop their markets
more fully.

2.2. Managing profits

It is extremely important for airlines to analyze the markets not
as short-run revenue maximizers rather as long-run profit
maximizers, in which case the reasonably substantial fixed costs
would be covered such that a normal return on capital could be
achieved. Gillen (2006) argues that the legacy carriers focus on
profitability at the network level rather than individual links which
has lead to managerial myopia, excessive network size and severe
price discounting. Tretheway (2004) argues that the low cost
carrier pricing policy differs subtly but importantly from that of the
legacy carrier revenue maximization procedure. Whilst the low
cost carriers require all flights to fully cover allocated costs thus
ignoring the issue of transfer passengers, the legacy carriers
separate the decision making apparatus such that in the first stage,
capacity choices are made and in the second stage, yield manage-
ment systems maximize revenue given the first stage decisions.
This separation in decision-making reduces the pricing policies to
short term decisions which has resulted in declining yields and
a failure to cover the capital costs needed to replenish a fleet.

Proussaloglou and Koppelman (1995) analyze air carrier
demand and demonstrate that new carriers with limited frequent
flyer programs must provide substantially lower airfares or
a superior level of service in order to compete effectively with
incumbents. However, the recent erosion of the gates required to
ensure successful revenue management models has left the legacy
carriers with a reduction in fare classes, for example as a result of
the disaggregation of return fares into single unidirectional tickets
that has occurred due to low cost carrier policies (Cobb, 2005).
Following Porter’s competitive strategy approach (1980), we argue
that the likely market outcome that would permit airlines to
achieve long run profitability suggests that low cost carriers should
serve the domestic or regional markets whereas legacy carriers
should continue with their differentiated approach on the inter-
continental, longer distance routes. This would permit the legacy
carriers to reduce the variety of aircraft currently required to serve
greatly differing stage lengths, in turn reducing maintenance and
training costs and increasing the productivity of the remaining
fleet. Codesharing across the two business models would be
a logical next step and although low cost carriers have not generally
participated in interlining or codesharing, examples do exist such
as Virgin Blue and United (2002e2008) then Delta (from 2008
onwards) and Westjet with Southwest for a short period and
Cathay Pacific (from May 2010).

2.3. Managing competition

Another important set of strategies available to airline managers
to better manage risk include choices with regard to interlining,
codesharing, joining an alliance or merging with complementary
partners or rivals, subject to government anti-trust regulation.
Interlining became a feature of the airline landscape as a result of
the Chicago Conference held in 1944 which permitted an airline to
sell a single ticket to a consumer despite the fact that the origin and
destination were not directly connected by the carrier, rather

passengers would need to change both planes and airlines on the
single itinerary. This was advantageous to the consumer who
would not need to carry baggage at the connection and was
organized between the airlines through the International Air
Transport Association (IATA). The IATA conferences organized the
airlines, enabling them to reach pricing decisions per region and to
subsequently share interline revenues according to the geograph-
ical distance each carrier provided per itinerary. Codesharing first
appeared in international markets in 1985 (Gellman Research
Associates, 1994). Collaboration between airlines was at first
designed in order to offer the international passenger a “seamless”
travel experience by minimizing some of the inconveniences of
traditional interline itineraries. Benefits to consumers of
codeshares over interline itineraries include agreements on stan-
dardized levels of service, access to airport lounges and frequent
flyer programs. For the suppliers, codeshares based on block space
or free sale agreements encourage the airlines to consider the issue
of double marginalization but also lead to closer associations and
a softening of competition, such that the agreements are a some-
what double edged sword. The Transportation Research Board
(1999) noted that 70% of global alliances include provisions for
codesharing, 50% include provisions relating to sharing of frequent
flyer programs and 15% also include agreements to share facilities
such as catering, training, maintenance and aircraft purchasing.

The web of codeshares that form the basis of an alliance help
airlines to better handle risk, permitting a reduction in capacity
during bear markets and faster response to unexpected short-term
changes in demand. Gillen (2006) argues that along with the
development of hub-and-spoke systems, domestic feeds have
contributed to the development of international alliances in which
one airline feeds another hence utilizing the capacity of both to
increase service and pricing. Codesharing began as a pure
marketing exercise but has now become an important element for
both suppliers and customers. The supplier offers a greater network
span and enjoys economies of scope and density. Consumers avoid
the issue of double marginalization that arises when required to
purchase two or more tickets from different vendors, enjoy
reductions in schedule delay and reduce complications arising from
delays particularly on the first leg of an itinerary. Adler and Hanany
(2010) demonstrate that consumer welfare on thin origin-
destination markets is higher with code-sharing airlines than
purely competing carriers. Consequently, codesharing increases the
level of service provided to the consumer.

Aviation should develop into an industry in which reasonable
levels of profit are achievable throughout the economic cycle.
Under the current regulatory regime, cross-border mergers are not
permitted since foreign ownership rights are curtailed to varying
degrees, except in the Australasian domestic markets. However, as
demonstrated in Adler and Smilowitz (2007), airlines would always
prefer to merge based on economic considerations, drawing from
improved cost efficiency and subsequently higher profits. Indeed
international gateway choice would change were mergers to be
permitted. Adler and Hanany (2010) also demonstrate this point
but purely from the demand side perspective whilst the cost
advantages are ignored. Consumer preferences for higher
frequencies and home carrier bias permit airlines to achieve their
highest profits under mergers although to some extent at the
expense of consumer surplus.

2.4. Managing supply side risks

Airline competition may not always be acting on a fair playing
ground which is a sign of supply side risk. Airlines in the Middle
East, including Emirates, Etihad and Qatar, have a growing presence
in the aviation markets and enjoy a business environment to which

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 27

other airlines do not have access. According to O’Connell (2006),
Emirates enjoys zero corporate tax under the United Arab Emirate’s
laws, extremely low airport charges at its Dubai hub since the
Chairman of the airline is also minister in charge of civil aviation
governing the airport, an uncongested hub that reduces fuel costs,
low labor costs and a labor force that is not permitted to join
a union or strike. Altogether, this contributes to an estimated 40%
cost advantage over British Airways and a 45% advantage over Air
France/KLM (O’Connell, 2006). Were the Middle East aviation
market to develop alongside regional stability and liberalization,
Adler and Hashai (2005) predict that Cairo and Tehran are likely to
develop regional hubs with Istanbul and Riyadh emerging along
with the prosperity of the region based on geographic and demo-
graphic considerations. Current transport investments also suggest
that the Dubai region is succeeding in its attempt to develop
a major hub system connecting the continents of North America,
Europe, Africa, the Far East and Australasia via the Middle East.

The growing lack of trained pilots is another issue of note to both
airlines and aircraft manufacturers. As the number of unmanned
aerial vehicles grows globally (The Economist, 2009), fewer fighter
pilots are being trained, leaving an insufficient number to subse-
quently enter the civilian industry once their military careers are
completed. Embraer has announced that within the coming decade
it plans to build a single pilot certified aircraft (Flightglobal, 2010)
and it is likely that pilotless cargo aircraft will be in use within this
timeframe as well. We predict that pilotless passenger aircraft are
likely to enter the skies within two decades, once the next gener-
ation of computer-centric air traffic management systems and
avionics enter the market. In the meantime, the burden to push for
increased funding of pilot training appears to lie on the shoulders of
the Pilots Association and trade associations, such as the Air
Transport Association and Regional Airline Association.

Finally the climate change debate is gradually pushing all
sectors of society to measure, manage and subsequently reduce
their carbon footprint. The aviation sector is slowly feeling this
pressure too with New Zealand and the European Union at the
vanguard of this process. The pressure on aviation has more to do
with the prominence of air travel in society today than with the real
contribution of aviation to global warming, since trucking and cars
are a far more important contributor. New Zealand introduced an
emissions trading scheme (ETS) in 2010 that extends only to
domestic flights and can be applied to either the petroleum
supplier or the airline. The New Zealand government intends to
reduce carbon emissions to 1990 levels. Scheelhaase et al. (2010)
discuss the likely impact of the European Union (E.U.) emissions
trading scheme currently expected to begin implementation in
January 2012, which is to be applied to both domestic and
international flights. Scheelhaase et al. argue that the E.U.-ETS will
probably provide a competitive advantage to non-E.U. carriers
whose short-haul, less environmentally efficient flights are not
within the E.U. jurisdiction. Forsyth (2008) argues the opposite by
suggesting that the free permits would provide a financial
advantage to those receiving them, although the impact is not
expected to be substantial.

The question then remains as to whether other regions of the
world will follow suit and set up emission trading schemes or
introduce carbon taxes in order to internalize the environmental
externalities. In addition, various individual airports have gradually
introduced night flight curfews and noise charges as well as local
air pollution charges covering both nitrogen oxide and hydro-
carbon (Scheelhaase, 2010) over the past decade. Governments
need to decide whether they are interested in dampening demand
to reduce global warming or push for innovation such that each
flight pollutes at lower levels hence permitting “green growth”. If
the latter has a greater priority, then subsidizing research and

development in this area is a necessary and currently under-
utilized component. Finally, it would probably be extremely
beneficial to the various players in the aviation supply chain were
the economic instruments chosen, whether restrictions, charges or
taxes, to be applied equally across the globe and in a harmonized
manner.

3. Airports

Airports have been changing as a result of privatization and
corporatization, the deregulation of airline markets regionally and
inter-continentally and the development of the low cost carrier
model which demands different services from the secondary
airports that they generally serve (deNeufville, 2008). Airports in
many parts of the world are no longer viewed as public utilities
rather as private enterprises aiming to maximize shareholder value
and profits from a fixed facility (Adler et al., 2010b). The trend to
privatize airports began in the United Kingdom in 1987 with the
flotation of the British Airports Authority, a company that owned
and managed seven airports, three of which were located in
London. The recent forced sale of Gatwick airport has the intended
aim of encouraging competition among the airports of London.
Within the London catchment area, BAA now owns and runs
Heathrow and Stansted, Global Infrastructure Partners owns and
runs Gatwick and London City whilst Luton is owned by the local
council and run by a private company.

As airports have required infrastructure investments beyond the
budgets of local and federal governments, the airports have
gradually been privatized in Europe, South America, South Africa,
Asia and Australasia. Perhaps surprisingly, airports in the United
States are owned either at the state or local authority level and are
operated by divisions of municipal governments or airport
authorities. However many of the sub-processes at American
airports are managed by private companies and a mere 10e20% of
the employees on the airport site are directly employed by the
government authority (deNeufville, 1999). Until the 1980s, much of
the investment in airport infrastructure drew from the Airport
Improvement Program, a Federal Aviation Authority based fund.
The fund has gradually reduced in importance, particularly at the
larger hub airports, and has been replaced with direct passenger
facility fees and the issuing of bonds often underwritten by the
relevant hubbing airline (Odoni, 2009).

Whilst many airports remain natural or locational monopolists,
for example in small countries with little to no domestic traffic,
others operate in competitive markets as a result of the deregula-
tion of both the airlines and airports (Starkie, 2002). Tretheway and
Kincaid (2010) define airport competition to include local demand
located in overlapping catchment areas e.g. multi-airport cities,
connecting traffic served by hubs, cargo traffic, alternative modes
and destinations. Barrett (2000) argues airport competition is
a new element of European aviation as a direct result of liber-
alization, whereby airports within one hour ground surface access
are in direct competition for their respective catchment area, as
occurs in multiple cases in France, Germany and the United
Kingdom. Hooper (2002) argues that governments in Asia may rely
on competition to impose a significant degree of discipline on
airport managerial behavior. Adler and Liebert (2010) demonstrate
that competition for connecting passengers and/or over catchment
areas appears to be sufficient to encourage cost efficiency inde-
pendent of ownership form or economic regulation. However, apart
from Australia and New Zealand, airports around the world remain
price regulated. According to Fu et al. (2011), the light handed
regulatory approach of Australasia in which price monitoring
replaced formal regulation has not been successful, mostly due to
the lack of competition inherent in a system with large distances

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e3528

between airports. Consequently, it would appear that competition
is sufficient to ensure that airports are cost efficient but without it,
independent of ownership form, some form of economic regulation
is necessary. Such regulation would reduce the likelihood of
litigation as has occurred on multiple occasions in Australia with
Virgin Blue, currently the second largest Australian airline. Adler
and Liebert (2010) also demonstrate that privatized airports
operating in a competitive environment may still require economic
regulation in order to avoid excessive pricing in comparison to their
unregulated, public counterparts operating in a similar
environment.

Strategies for airport managers therefore need to account for
ownership form. In section 3.1 we discuss strategies for the shorter
term timeframe and in section 3.2, we discuss size and pricing
policies relevant to the longer term issues identified.

3.1. Short term strategies

In the short term, airport managers may be interested in
maximizing variable factor productivity, given a fixed airport
capacity. This is particularly true for privatized airports and those
who are price capped under an inflationary less efficiency formu-
lation which permits the airport to retain productivity gains beyond
the minimum level required by the regulator. Variable factor
productivity includes labor, supplies and materials and outsourcing
costs and quantities, given passenger and cargo throughput, air
traffic movements and non-aeronautical revenues. Shorter term
decision making includes searching for a balance between in-house
production and outsourcing activities. Partial analyses of sub-
processes such as baggage handling and passenger flow through
terminals may also help managers to highlight bottlenecks in the
system. Benchmarking good practice is crucial to effective
management and public disclosure requirements, an approach
adopted in Britain and Australia (Hooper, 2002), is an important
missing link in encouraging productive efficiency. A uniform
system of airport accounts similar to that of the International Civil
Aviation Organization (ICAO) airline reporting practices would be
helpful to both airport managers and regulators alike. Indeed, there
are no generally accepted accounting practices even for airports
within a single country which means that the capital input mix
cannot be analyzed. The academic literature contains many
potentially useful methodologies for benchmarking processes, such
as stochastic frontier analysis (Oum et al., 2008; Martin et al., 2009)
and data envelopment analysis (Sarkis and Talluri, 2004; Adler
et al., 2010b) which could be applied were comparable data to be
made available. Transparency in data collection would also
encourage analyses of dynamic efficiency which is extremely
important in an industry with lumpy and large fixed costs.

In the medium term, uncongested airports with low capacity
utilization need to reduce their asset base and/or increase their
customer base. To attract greater output, either in terms of
passengers or cargo, may require offering lower charges for new
destinations served for the first couple of years of service or
unbundling the airport services, thus permitting airlines to choose
varying levels of service according to their desires. Congested
airports require different managerial policies including expanding
capacity at the margin wherever bottlenecks are identified and
incentivizing airlines to use off-peak slots through pricing. The
ICAO governs the rules for landing fees on all international flights
and requires that charges do not exceed the full cost including
a return on capital which is needed to provide the facilities and
services. A revenue neutral congestion pricing policy would remain
within the guidelines of the ICAO and may result in negative prices
for off-peak air traffic movements but this should improve capacity
utilization without being discriminatory. Alternatively, larger

planes could attract price reductions which again would provide
incentives for airlines to maximize capacity utilization in line with
social welfare optimization. Additional medium term strategies
include actively identifying ground access improvement opportu-
nities, such as high or higher speed train service, or improved road
access which may widen an airport’s catchment area.

3.2. Long term strategies

The longer term issues are the most difficult to solve since they
generally require capacity expansion or reduction, both of which
are very difficult to undertake. Barriers to expansion include
political interests, noise and environmental restrictions, the time
and expense involved in receiving planning permission, not in my
backyard syndrome and the lack of active management interest,
likely to be more relevant at public airport authorities. In addition,
there are sufficient examples of airports who undertook the risk
and expense of expansion only to be underutilized afterwards, such
as the City of Dayton that decided to build a hub at the behest of U.S.
Air which then drastically reduced its services. American Airlines
behaved similarly at Raleigh and Nashville and, after acquiring
Reno, left San Jose airport in the lurch to a large degree. In order for
an airport to be cost efficient, it is necessary to utilize resources
carefully, which generally leads to congestion and the need to deal
with this issue fairly with respect to passengers, airlines and the
environment. The toughest issue for airport managers is the lack of
signals inherent in a system whereby congestion and delay are not
priced. The lack of congestion pricing incentivizes airlines to
increase frequency and reduce aircraft size even during peak
periods. Indeed, the trend in airplane size in the United States has
been on the decline since 1985 because smaller aircraft achieve
shorter turn-around times hence higher utilization, consumers
value higher frequency which is reflected in airfares, smaller
aircraft produce marginally lower levels of noise which is relevant
at hub airports with aggregate noise constraints and congestion
pricing which is missing from the equation (Swan, 2007). Without
peak pricing in the United States or scarcity pricing in Europe under
the slot allocation system, from where do the signals come to
expand or define optimal capacity levels? As Levine wrote in 1969,
the existing pricing system fails to guide investment so as to ach-
ieve the appropriate mix and level of output with a minimum
investment of resources and the same could be said today.
Congestion pricing and the direct valuation of slots would appear to
be strictly preferable to the current system of rationing defined in
the form of slot allocation regulation in Europe and Department of
Transport brokerage in the United States (Johnson and Savage,
2006). One could argue that were congestion fees collected for
the transparent purpose of building or expanding specific bottle-
necks at an airport, such charges would indeed be in line with the
ICAO policy mandate.

Slot allocation policies exist to ensure that delays in air transport
are not excessive and appear to be effective when comparing
American and European delay outcomes (Forsyth, 2007). Indeed,
the lack of slot allocations at American airports has led to the
development of a ground delay program operated by air traffic
management through the Federal Aviation Administration (FAA).
However, the bartering involved with this system prevents new
entrants from entering congested airports hence provides an
economic advantage to legacy carriers. Adler et al. (2010a) discuss
the slot allocation issues in the greater Tokyo region which permit
the producers to extract surplus from consumers, to the extent that
an aggressive low cost carrier is not capable of increasing compe-
tition either domestically or regionally. Czerny et al. (2008)
summarize much research that promotes the use of auctions as
an alternative form of scarce resource allocation, however it is

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 29

rather unlikely that the incumbent airlines would readily agree (see
Sentance, 2003 for an incumbent airline’s response). The lack of
clear legal ownership with respect to landing rights is an issue that
needs to be solved in order to allow airports to efficiently match
supply with demand. Permitting slots to become a tradable asset
would substantially improve the capacity allocation issue although
regulation would still be necessary in order to ensure that airports
are not reregulating the airline sector. Whilst slot allocation is not
an issue in the United States where a first come, first served policy
exists, gate allocation acts as a barrier to entry instead (Dresner
et al., 2002). Gate allocations in the United States are often
accompanied by a 15e30 year lease contract in order to allow
airports to issue bonds that fund the expansion. Despite
deNeufville’s (1999) argument that the collaborative approach in
the United States has led to a better airport system than other areas
of the world, controlling access to busy airports acts as a barrier to
entry for airlines, which severely curtails competition and the
positive impacts of deregulation.

4. Airframe and engine manufacturers

Over time, many airframe manufacturers merged, exited or
failed to the point that two major markets remain; large airframe
and regional jet manufacturers. The large airframe market
currently consists of two firms, the European Airbus and American
Boeing companies. The duopolists have chosen to compete head-
on, with each firm producing a range of aircraft in direct compe-
tition, such as the A380 and Boeing 747-8, the A350 and B787and
later variants of the B777, and the smaller A320 with the B737. To
some extent the B787 is also in competition with the A380 over
certain routes. For example, in the American-Japanese market, the
A380 may well serve the JFK-Narita hub-to-hub market given the
level of congestion at both airports whereas the B787 may serve the
JFK-Nagoya or Newark-Nagoya market as a way of avoiding at least
one major hub and providing improved service to passengers
through a direct itinerary.

In the regional jet market, Brazilian Embraer and Canadian
Bombardier are the two major players but they may be competing
with manufacturers located in Russia, Japan and China shortly.
Small airframe development has benefitted from subsidies to
customers in the form of low interest loans from their respective
governments in order to support development of aircraft of up to
100 seats, despite 2000 and 2001 World Trade Organization (WTO)
rulings that this should not continue. Recently Bombardier, which
is subsidized by the Canadian government, announced the
development of their C series which will ultimately accommodate
150 seats. In an unusual move, Airbus and Boeing joined forces and
jointly argued before the WTO that such financial subsidies should
be limited to 100 seat capacities, if not stopped entirely. However,
both the Japanese and Chinese governments provide subsidies to
companies developing aircraft components within their respective
borders that encouraged outsourcing by both Airbus and Boeing.

Another form of subsidy occurs when new aircraft require
a change in the capabilities of airports and the cost is borne by the
airports rather than the relevant airframe manufacturer. In the
1960’s, McDonnell Douglas began producing the DC10-10 but the
conditions for sale were that the New York airports could accom-
modate the aircraft, which required strengthening the taxiways
and widening the runways. The New York Airport Authority argued
that the costs involved were prohibitive and the McDonnell
Douglas Company, after reducing the costs through a radical
redesign, paid for the changes necessary. Multiple airports are
currently under expansion in order to accommodate the A380, but
these costs are being borne by the airports, which represents
a distortion in the airframe market. Clearly, subsidies are unlikely to

disappear despite WTO rulings and it would appear that the more
appropriate policy would be to encourage discussions and reach
agreements across countries in order to limit the imbalance such
distortions create. An example of the results of such discussions
includes the 1992 E.U.-U.S. agreement that calls for a Critical Project
Appraisal before permitting any subsidization of the research and
development of airframes. The agreement called for the repayment
of direct government support over a period of 17 years beginning
from the date that the first state aid was received. However, as
argued in Gellman et al. (2004), such an appraisal of the A380 was
never undertaken and had this been the case, it is unlikely that the
aircraft would have been produced. Hence, it is insufficient to reach
such agreements unless a legal entity exists that can uphold the
clauses therein.

Other expensive inputs such as the engines and avionics are
manufactured by various companies located in Europe, South
America and North East Asia. In the parts market, under current
American regulation, the original equipment manufacturer controls
the supply of parts for aircraft still under production. Alternative
producers do not receive FAA approval and their parts are tagged
with the negative connotation of ‘bogus’ parts. A similar situation
occurs with engine parts but in this market, alternative producers
have tried to receive approval from the FAA on the basis of ‘func-
tional equivalence’. To date, functional equivalence has not been
approved and the spare parts market is limited, ensuring high
mark-ups which inflate airline input costs. Since the American
policy with respect to the parts approval process is emulated
globally, this issue crosses borders. We would argue that if
a comprehensive functional equivalence test can be developed and
the testing was undertaken by an independent agency, providing
approval for these parts would break the current stranglehold in
this first tier market.

Another major risk to the aviation sector is the continuing
fluctuations in the price of oil. It is unlikely that a battery powered
aircraft engine will be developed in the near future due to issues
with the weight and size of the batteries available under current
technological capabilities. Consequently, aviation is likely to
continue to be dependent on oil for the foreseeable future. Two
types of government action may be helpful in this regard. First, it
would appear to be important to begin regulating oil speculation in
order to prevent oil upside spikes that caused the massive changes
in the price of oil inputs mid 2008. Second, were the United States,
United Kingdom, France, Germany and Japan to agree, it would be
possible to break the stranglehold of the OPEC cartel on current oil
prices. The current price of jet fuel has little connection to the cost
of production. The relevant governments could restrict oil imports
if prices were deemed unacceptably high. Independently, these
governments could subsidize research and development into new,
cleaner technologies that would encourage universities and the
private sector to explore ways of reducing greenhouse gas emis-
sions. Current promising avenues include the use of lithium
aluminum or composite materials to reduce the weight of the
aircraft and the development of alternative fuels, such as bio-fuels
which reduce carbon dioxide based on the full life cycle approach.
Government funding, such as the European Union’s Clean Sky Joint
Technology Initiative, appears to be necessary at this point in time
due to the high risk involved in this research. It is not yet clear
whether Camelina or algae have the potential to be grown in
sufficient quantities to serve the market for bio-fuels without dis-
placing land needed for food production. Finally, operational
research and development could encourage air traffic management
systems to search for greener routings and manufacturers to
further improve aerodynamics and engine efficiency.

Noise remains a major issue, particularly in regions with high
density populations such as Europe and Asia but also at 29 out of

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e3530

the 50 busiest airports in the United States (Girvin, 2009). There are
examples of airports for whom capacity restrictions are defined by
noise regulation rather than their physical capabilities such as
Schiphol. Brueckner and Girvin (2008) argue that continuing to
limit cumulative noise at airports or equivalently, to charge a noise
tax, pressures stakeholders to attempt to mitigate the issue hence
maximize social welfare. Swan (2007) argues that the use of
smaller airplanes is preferable with respect to their noise output
than an equivalent number of seats on larger aircraft. Clarke (2003)
calls for automated air traffic management procedures which
would improve noise abatement measures beyond the impact of
improvements in individual aircraft. Clearly research and devel-
opment needs to consider all elements of the aviation sector. Two
initiatives are currently being funded including NASA’s ‘Quiet
Aircraft Technology’ program financed by the American govern-
ment and the Silent Aircraft Initiative undertaken at the
Cambridge-MIT Institute together with industrial partners, mainly
funded by the British government. Due to the trade-offs between
reductions in local air pollution, noise in the vicinity of the airport
catchment area and global greenhouse gas emissions affecting
climate change, one of the major tasks of the new decade will be to
strike the correct balance.

5. Regulators

In this section, we discuss the risks that exist within each of the
links of the aviation industry and the potential strategies available
to regulators to counteract the issues. We discuss the on-going
process of deregulation of the airline markets in section 5.1, the
conditions under which airport regulation continues to be
a necessity in a gradually privatized and corporatized airport
industry in section 5.2 and the issues arising as a result of the
changes in ownership form of the air traffic control sector in section
5.3.

5.1. Airline regulation

Over the history of the aviation industry, both airlines and
airports have been heavily regulated and subsidized. In the United
States, airlines have always been in private hands but until dereg-
ulation in 1978, the Civil Aeronautics Board chose the carriers to
serve specific markets and their respective airfares. After deregu-
lation, American carriers were free to fly wherever they chose in
domestic markets but international services remain regulated
according to reciprocal bi-lateral agreements. The American
government has gradually opened the skies by encouraging multi-
laterals which led to the horizontal Open Skies agreement with the
European Union in 2007, effective as of 2008. However, American
airlines are still protected through the standard Chapter 11 bank-
ruptcy proceedings under which airlines restructure their debt and
operations but continue to serve their markets (Button, 2009).
Whilst Chapter 11 proceedings are not specific to the aviation
sector, the impact of this law is to produce an effective barrier to
free exit from the market. In the European Union, most airlines
were defined as flag carriers up to deregulation in the Third
Package of 1998 in which airline subsidies, which had been quite
substantial up until that point, were no longer deemed acceptable.
Whilst there remain a few state owned airlines, such as Olympic
and TAP, the majority of carriers are now in private hands. The
European Union and individual countries have permitted airlines to
fail, for example Sabena and Swissair, however other airlines
continue to survive due to either protectionist international bi-
lateral agreements or subsidies, as has occurred in the cases of
Olympic and Alitalia. The domestic Chinese airline market has been
gradually deregulated with China Eastern Airlines listed on three

stock exchanges in 1997, marking the beginning of the process. In
2002 there was a wave of airline consolidations resulting in the
emergence of three large airline groups; Air China, China Eastern
and China Southern with major hubs in Beijing, Shanghai and
Guangzhou respectively (Zhang and Round, 2008). However, the
Chinese skies remain relatively closed as the government continues
to protect Chinese airlines from foreign competition. Southeast
Asian liberalization permitted a wave of new entrants in the early
1990’s although many did not survive the regional economic crisis
of 1997 (Hooper, 2005). The World Trade Organization has placed
on their website a geographical tool that demonstrates the level of
openness of bi-lateral agreements and awards each country
a weighted air liberalization index score based on the level of air
freedoms permitted, ownership restrictions, pricing and carrier
designations. New Zealand and Australia receive relatively high
scores, the United States is somewhat lower and China’s score is
close to the bottom of the scale currently.

In order to protect airlines on the grounds of security consid-
erations and potential job losses, the United States currently limits
all foreign ownership of American carriers to 25% of the voting
shares and at least two-thirds of the Board as well as the Chair must
be American nationals. The European Union limits foreign owner-
ship to 49% of the airline’s shares. A second open skies U.S.-E.U.
agreement, signed in June 2010 but still requiring ratification on
both sides of the Atlantic, aims to loosen airline ownership and
control restrictions reciprocally but as yet the details have not been
revealed. In 1994 the Chinese government began to permit foreign
investment in Chinese airlines of up to 35% of registered capital,
which has since been increased to 49%, although foreign owners
may not purchase more than 25% of the voting stock (Zhang and
Round, 2008). Similar restrictions exist in South America, Africa
and Asia. Tretheway (2004) calls for the elimination of foreign
ownership restrictions of air carriers and the permission for
mergers across borders, arguing that national security benefits do
not exceed the economic inefficiencies arising from the prevention
of cross-border consolidation. The failure to permit consolidation is
likely to result in either further bankruptcies or bailouts. New
Zealand was the first to remove foreign ownership restrictions on
domestic carriers and Australia followed suit in 1999. Indeed
a multilateral open skies agreement (MALIAT) was signed in 2001
between Brunei, Chile, Malaysia, New Zealand and the United
States in which the nationality clause was replaced with “the
principal place of business and effective control” (Hsu and Chang,
2005).

As a result of the existing ownership restrictions, airlines
currently unable to merge across borders have chosen to develop
strategic alliances through the development of a web of codeshares
which pools risk and increases network access. It would appear that
codeshares have positive benefits for both consumers and
producers alike even on parallel links and anti-trust immunity
should only be necessary on thin routes (Adler and Hanany, 2010).
Furthermore, bilateral agreements between two countries appear
to be the worst of all worlds, limiting frequency and hiking prices at
the expense of consumer surplus (Gillen et al., 2002; Adler and
Hanany, 2010). Therefore, the most important strategy from the
regulators perspective should be to open up the skies through
multi-laterals. Cabotage, defined as the eighth and ninth freedoms
of the air, would be another way to circumvent the archaic
ownership rules. Conservatism has ruled to date, for example the
Association of Southeast Asian Nations (ASEAN) have discussed
opening the skies regionally for over a decade but still appear to be
a long distance from achieving this goal (Tan, 2010), although the
MALIAT agreement has shown that this is a distinct possibility.

Deregulation of the airline industry has served to highlight the
importance of ongoing ex-post application of normal anti-trust

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 31

law. To protect the lower prices and higher frequencies that
strongly support the argument that the aviation market is better
off without regulation (Kahn, 1988), it is equally important to
protect the premise on which competitive markets develop. Free
entry and exit are the cornerstones of such a policy and prevent
market distortions and inefficiencies. However, it would appear
that both tenets are ignored in different geographical corners of
the world. Free entry only occurs if there are neither bi-laterals
protecting designated carriers nor restrictions on the freedom to
land and take-off at the airport level. Within the Far East and
European Union, almost all airports are slot controlled and many
are highly congested, both of which present serious barriers to
entry. Within the United States, slot controlled airports no longer
exist, however gate constraints due to high utilization or exclusive
use designations are proving to be real barriers to entry (Dresner
et al., 2002). In order to support revenue bond financing of facil-
ities, many of the larger airport operators have required airline
tenants to lease gates and counter space for a period of up to thirty
years and in some instances, dominant airline carriers have built
their own terminals and subsequently retain complete control
whether fully utilized or not (Cohen, 1983). Consequently, inde-
pendent investment in airport gates, restrictions on minimum
aircraft sizes during peaks and congestion or scarcity pricing are
important policies to be considered. Needless to say, the academic
literature has discussed replacing the weight based landing
charges with peak pricing for the last forty years but so far to no
avail. Levine (1969) and Carlin and Park (1970) were among the
first to discuss this issue. Daniel (1995) developed a bottleneck
model and applied it to Minneapolis-St. Paul airport, arguing that
by spreading the peak, the airport could increase air traffic
movements by as much as 30%. A series of papers by Brueckner
(2002, 2005) and Brueckner and Van Dender (2008) argued that
at least some of the congestion is internalized by hub airlines,
namely that which it imposes on itself, however this does not
remove the need for peak pricing nor the need to ensure access for
potential new entrants. Morrison and Winston (2007) argue that
second-best, atomistic congestion charges would improve social
welfare and significantly reduce delays at congested airports in
the United States even if internalized congestion is essentially
charged twice. Schank (2005) argued that peak pricing has so far
been unsuccessful, citing three attempts at Boston Logan, the Port
Authority of New York and New Jersey and the British Airports
Authority. His main line of reasoning suggests that implementa-
tion is only acceptable and likely to stand in subsequent litigation
if the airlines removed from the peak timeslots have the ability to
move to an alternative, efficient time, which the American carriers
flying into London in the early morning successfully argued was
not the case in the subsequent court proceedings, or to alternative
airports, which was not available in Boston. As Starkie (2008)
noted, most airports are not necessarily congested rather
demand is peaked over the course of a day which is currently not
managed efficiently through the weight-based charges but is the
current basis for deciding on the need to expand.

Free exit is the other single most important strategy for
governments to consider. Ensuring that no company is ‘too big to
fail’ is equally applicable to the airline industry. If Chapter 11 and
subsidies or bailouts permit airlines to survive rather than be
liquidated, the creativity and strong managerial skills that were
engendered in this market apparatus will fail. It is important to
permit failure and bankruptcy in order to ensure that the best
survive and profit with as few market distortions as possible.

Reregulating the airline industry is a perennial discussion that
has been highlighted once again at the initiative of Oberstar and
others in the United States congress recently (Lowy, 2010). A
Government Accountability Office report to Congress in 2006

argues that such a move would likely reverse consumer benefits
without saving airline pensions, such as those lost during the
bankruptcy proceedings at United and US Airways in 2004. The
report argues that the reduction in prices and increase in flight
frequency and competition which have benefited consumers to
varying degrees would be derailed by reregulation. Poole and
Butler (1999) argue that the serious problems remaining in the
aviation sector draw from the fact that although airlines were
deregulated in the United States, neither the airports nor the air
traffic management systems followed the same path which has led
to serious distortions in the market. Tretheway and Waters (1998)
argue that neither the Civil Aeronautics Board nor price cap regu-
lation would provide the stability that the political leadership is
attempting to encourage. If the main aim of the politicians is to
increase the levels of competition in an increasingly concentrated
market, Dresner et al. (2002) suggest that the construction of new
gates, alternative provisions that permit gate access to new
entrants during peak periods, specifying minimum aircraft size
provisions during peak periods and/or peak load pricing policies
may be sufficient to increase competition in congested corridors.
Winston (1993) argues that the use of reregulation to avoid
‘destructive’ competition draws from the traditional but flawed
theory of regulation which assumes that perfectly informed social
welfare maximizers are either managing the regulation or running
the regulated firms. It is argued that the airline industry appears to
oscillate between periods of excessive concentration and destruc-
tive competition. The regulator needs to help the industry to find
a happy medium in which neither extreme occurs. There is suffi-
cient anecdotal evidence that airlines use hubs, gate access and
frequent flyer programs as barriers to entrance, yet the hub-spoke
system allows airlines to be cost efficient and serve markets that
otherwise would not be served. Hubs are likely to continue for the
foreseeable future because half the origin-destination traffic in the
world is in markets too small to be served directly (Swan, 2007).
However, as opposed to the discussions of excessive concentration
being held in the United States Congress currently, Swan (2007)
points out that the United States airline industry has not consoli-
dated over the period of 1981 to 2001 according to the Herfindahl
index, despite numerous mergers and bankruptcies. Winston
(1993) argues that deregulation in multiple industries, including
that of airlines, has proven to be positive for consumers, labor and
producers, although not necessarily on an equal basis even within
a group. Consequently, the question remaining for the regulator is
how to protect the advantages of deregulation whilst maintaining
reasonable levels of competition in city pair markets. Removing the
remaining barriers to entry and exit, including the independent
investment in gates and pricing of slots, will help further the impact
so far achieved.

Finally, consumer protection rules need to be carefully balanced
in order to ensure reasonable levels of service and behavior only
where producers have been shown to be derelict. Examples of such
laws include the three hour tarmac rule that passed through
Congress in 2010. This rule has increased the likelihood of canceling
flights due to the maximal $27,500 fine per passenger were the
travelers to be forced to remain onboard the aircraft whilst waiting
on the tarmac for longer than the legal limit. In 2009, the European
Court of Justice ruled that passengers on flights delayed for more
than three hours are entitled to compensation from airlines as is
true for passengers on canceled flights. This begs the question as to
whether these consumer rights in fact protect or harm passengers
and whether there is a better way to handle congestion. We would
argue that the issue of congestion and delay is better served
through pricing appropriately rather than court cases or ad-hoc
government restrictions imposed after a public outcry through
the popular media.

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e3532

5.2. Airport regulation

The aim of airport regulation is to ensure that airports do not
abuse monopoly power, to incentivize airport managers to achieve
productive efficiency and to provide the correct signals in the
marketplace that would encourage appropriate utilization of the
fixed facility. It would appear that all of these issues have yet to be
resolved satisfactorily and will be discussed respectively. Niemeier
(2002) argues that ex-ante regulation should be limited to activities
with natural monopoly characteristics. Based on the premise that
airports enjoy locational monopoly power, economic regulation has
been undertaken in various forms ranging from cost based princi-
ples or rate of return regulation to incentive based structures. In
Europe, prices are capped by the relevant civil aviation authority or
Department of Transport, generally for a period of five years, after
which a new review is undertaken. The price caps are frequently
based on a value that changes according to inflation, for example
the retail or consumer price index, less a pre-specified level of
efficiency (RPI-X). An airport that achieves levels of efficiency
greater than X will reap the cost reductions at least until the next
review. Asymmetric information between the regulator and airport
owners ensures that the review process is both time-consuming
and relatively expensive but necessary where competition does
not exist. Furthermore, privatized airports working under
competitive conditions still may require regulation in order to
prevent excessive pricing relative to their public counterparts
serving under similar market conditions (Adler and Liebert, 2010).

An additional complication concerns the question of whether
the regulation is based on a single or dual till computation because
airports produce two revenue streams. On the aeronautical side
airlines are charged per landing, based on maximum take-off
weight, as well as a seat based fee. The non-aeronautical revenue
stream draws from the terminal side in the form of concessions, car
parking fees and rents from the development of airport land.
Niemeier (2002) argues that single till regulation, which constrains
overall airport profitability, may represent a first best solution for
unconstrained airports provided non-aviation rents are sufficiently
high. At the London airports price caps are set per airport and
specify the upper level the airports may charge for their aero-
nautical services, however within this calculation the British civil
aviation authority takes into account the revenues that the airport
realizes from the commercial side of the business, which represents
a single till approach. If the British government was concerned with
levels of congestion, this approach is clearly inappropriate (Jones
et al., 1994). According to Averch and Johnson (1962), if
a company is prevented from fully exploiting monopoly power,
there is a clear incentive to cross subsidize competitive offerings
from those that are regulated. According to Kahn (1987) this is
precisely what occurs at a single till, regulated airport and the
solution is to sever the link between the revenues and costs asso-
ciated with the airside from the revenues attainable on the
commercial side. In the United States, airports are viewed as not-
for-profit, public utilities and their pricing mechanism is based on
cost recovery using a residual, compensatory or hybrid cost pricing
approach. Consequently, this system does not require price regu-
lation which appears to be advantageous. However, airports who
do achieve profitability must then reinvest the revenues into the
airport whether necessary or not. The residual cost approach that is
more likely to arise at a hub in effect restricts airports to the
equivalent of a single-till regulatory system which appears to be
less appropriate for congested airports. Jones et al. (1994) argue
that all airport services should be regulated because the airports
enjoy monopoly presence in many markets including terminal side
car parking services as well as airline related services. Reductions in
the costs of services applicable to consumers directly, such as car

parking, would stop the cross subsidization from commercial to
airside activities and the consequent transfer of consumer surplus
to the producers. Fu et al. (2011) argue that airports enjoy
substantial market power due to low price elasticity on the aero-
nautical side which may be moderated by the vertical relationship
between the airport and hubbing airline. In summation, dual-till
regulation is preferable to the single till form at congested
airports both in terms of encouraging productive efficiency and
ensuring sufficient investment in infrastructure (Oum et al., 2004).
Starkie (2008) argues that RPI-X price cap regulation encourages
productive efficiency provided the airport acts as a profit maxi-
mizer rather than monopolist, however the same style of regulation
also encourages excessive investment as defined in the Averch
Johnson (1962) effect. Consequently, we would argue that dual
till economic regulation is preferable with separate price caps on
aviation and commercial services, restricted to only those activities
over which airports enjoy monopolistic rents.

Another important issue for regulators concerns the need to
ensure optimal capital investment in an industry with large fixed
costs. The current pricing policies at airports do not provide the
signals necessary to evaluate the need for capacity expansion or
reduction. Barrett (2000) argues that there is no reason to assume
that privatized airports are more likely to under-invest in infra-
structure rather that this is more likely to occur under monopo-
listic regulatory conditions that restrict output below competitive
levels, as indicated by the level of congestion that occurred under
the traditional organization of airports prior to liberalization.
However, Basso (2008) argues that social welfare maximizing
public airports subject to a budget constraint are strictly prefer-
able to unregulated profit maximizing private airports because the
latter would overcharge for congestion leading to excessive traffic
contractions. Martin and Socorro (2009) argue that a private,
congested airport does not require price regulation provided the
regulator ensures an appropriate capacity investment under
which private and public objectives coincide. Cost plus regulation
leads to over investment in either capacity or quality which leads
to an unnecessarily expensive airport due to the spiraling regu-
lated asset base cost issue. Since governments are frequently
interested in stimulating economic activity, incentives may exist
that encourage over investment (Forsyth, 2007). Whilst cost based
regulation may lead to over investment, incentive based regula-
tion may lead to under investment in which case the regulator
then needs to consider an investment incentive mechanism as
a counter balance.

Swelbar and Belobaba (2009) argue that the lack of infrastruc-
ture capacity at airports and air navigation service provision en-
route are two of the most critical issues facing international and
national air services today. Odoni (2009) argues that airport access
is becoming the new form of market regulation that distorts the
competitive outcome so sought after by many countries around the
world. One of the major issues with regulation and optimal
investment in airports lies in the mismatch between regulated
price caps which are normally set every five years and the lifetime
of an investment which may be closer to fifty. Privatized airports
will be willing to invest only if they are reasonably sure that they
will cover their investment costs. Carrier-served airports in the
United States are defined as not-for-profits which allows them to
receive infrastructure grants through the Airport Improvement
Program but as the funds are drying up, taxes on passengers, i.e. the
passenger facility charge added to airfares, and bond issues cover
the remaining costs. Consequently, irrespective of airport owner-
ship, the timing of capacity expansion will always be an issue unless
the pricing policies change, permitting the market to signal the
need for expansion through congestion and/or slot pricing
mechanisms.

Table 1
Inherent risks and potential strategies for the aviation sector.

Societal Risk Result Strategy

Airlines Excessive consolidation Bankruptcies/mergers lead to higher prices
and lower service levels

Profit maximize
Ongoing search for efficiency
Active management
Prudent fleet renewal/purchase schedule

Destructive competition Bailouts & subsidies if ‘too big to fail’ or
national pride prevents exit if inefficient

Airports Pricing
Too cheap Cross-subsidization between commercial and aviation

activities leads to transfer of consumer surplus to airlines
Small aircraft flown in peak periods

If competitive, apply ex-post anti-trust law
RPI-X price cap for locational monopolies
Dual till price cap separately on aviation
and commercial servicesToo expensive Stunt airline growth and reduce both economic

benefits of air transport and benefits of mobility
Capital:
Over-investment Wasted resources and unnecessarily expensive airports Congestion/scarcity pricing policy
Under-investment Excessive congestion and delays cause airports

to act as barriers to entry hence reregulating airlines

Regulator Political pressure to
reregulate airlines

Increased prices and lower service levels Stability of current system important for business environment
Actively look for predatory pricing behavior
Reduce barriers to entry/exit
Remove subsidy distortions
Separation of power of civil aviation authorities
from air traffic control service

Weak, expensive
bureaucracy

Inefficient resource utilization

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 33

5.3. Air traffic control regulation

Air traffic management is another link in the system that
requires change in order to prevent further restrictions on airline
service. Air traffic management is generally supplied by govern-
ment entities although there are a few notable exceptions such as
NavCanada, where this control is now in the hands of a not-for-
profit agency and NATS, a public-private partnership in the
United Kingdom. Weakly-led civil aviation authorities who prefer
a quiet life rather than ensuring an efficient, highly utilized system
have led to a mismatch between supply and demand. The dual role
leads to limitations in the system that ensures neither efficiency
nor productivity. Around the world, air traffic management needs
more rapid deployment of proven technologies and to become
computer-centric rather than human-centric as is currently true. It
is equally important that the individual links within the air traffic
management system are understood and their respective capacities
analyzed in order to set priorities for research and development to
be directed specifically at the bottlenecks. Prior to deregulation of
the airlines, many questioned whether profit oriented companies
would serve the public as safely as under the regulated era. The
same is true for air traffic management. There is a visible trend
towards privatization and corporatization of the air navigation
service providers around the world, however the ability to intro-
duce competition in this market is clearly suspect. Separate
companies, whether not-for-profit or economically regulated pri-
vatized concerns, appear to have reduced some of the inefficiency
that existed previously (McDougall and Roberts, 2009). The
departments of transport or civil aviation authorities could then
promote their rightful positions as safety regulators, at arms length
from the service providers.

6. Conclusions

Adam Smith’s (1776) treatise argues that competition enhances
economic welfare whereas monopoly power, for example in the
form of labor association restrictions or government regulation,
detracts from rational pricing. Multiple domestic airline markets
have been deregulated over the past 30 years, however interna-
tional routes are still associated with restrictive bi-laterals for the
most part, the MALIAT and U.S.-E.U. open skies pact being among

the first to remove such restrictions. There would appear to be
ample evidence of the success of deregulation in the form of
business model innovation and increased consumer surplus, hence
the global policy emulation. However, the volatility of demand
seriously impacts the airline industry pushing the players between
two extremes, excess concentration and destructive competition,
which requires regulators worldwide to continue their vigilance.
First, government oversight in the market should be restricted to
the protection of competition rather than the protection of
competitors such that no firm is too big to fail. Second, in order to
protect the positive impact of airline deregulation, it is necessary to
remove the remaining barriers to free entry and exit including bi-
lateral agreements between nations, restrictive slot and gate allo-
cations that grant preferred status to incumbent airlines and the
foreign ownership restrictions and controls that prevent mergers
across borders. In summation, the risks to society and possible
solutions are summarized in Table 1.

Consequently, pricing congestion or scarcity, noise and emis-
sions are far superior to the system of government restrictions that
are currently applied to solve the bottlenecks in the aviation supply
chain. Pricing provides the signals necessary to identify and
subsequently search for solutions to constraints based on demand
rather than ad-hoc short-term solutions. Specifically, one of the
major limitations to the prosperity of air travel today is the on-
going regulatory regime that restricts and controls the airport
and air traffic management capacities. Separation of powers is
necessary in both arenas in order to prevent either elements from
reregulating airlines. The airports, whether private corporations or
public entities, need to be separated from political pressures
defining slot or gate allocations and the civil aviation authorities,
who set the air traffic management levels, need to be separated
from the body that operates the system. Market distortions, limi-
tations and inefficiencies will thus be removed. These strategies
will enable the airlines, airframe and engine manufacturers and
airports to better respond to demand and reduce the risks inherent
in the existing system.

Acknowledgments

The authors would like to sincerely thank the organizers and
participants of the Hamburg Aviation Conference of February 2010

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e3534

for fruitful discussions that led to the development of this paper.
Nicole would also like to thank the Recanati Foundation for partial
support of this work.

References

Adler, N., 2005. The effect of competition on the choice of an optimal network in
a liberalized aviation market with an application to Western Europe. Trans-
portation Science 39 (1), 58e72.

Adler, N., Hanany, E., 2010. Trading capacity and capacity trade-offs. Working Paper
at the Center for Transportation Studies, Sauder School of Business, University
of British Columbia. http://www.sauder.ubc.ca/Faculty/Research_Centres/
Centre_for_Transportation_Studies.

Adler, N., Hashai, N., 2005. Effect of open skies in the Middle Eastern region.
Transportation Research Part A 39 (10), 878e894.

Adler, N., Liebert, V., 2010. The impact of ownership form, competition and regu-
lation on airport efficiency. Working Paper at the Center for Transportation
Studies, Sauder School of Business, University of British Columbia. http://www.
sauder.ubc.ca/Faculty/Research_Centres/Centre_for_Transportation_Studies.

Adler, N., Fu, X., Oum, T.-H., Yu, C., 2010a. Air transport liberalization and airport slot
allocation: the case of the Northeast Asian transport market. Working Paper at
the Center for Transportation Studies, Sauder School of Business, University of
British Columbia. http://www.sauder.ubc.ca/Faculty/Research_Centres/Centre_
for_Transportation_Studies.

Adler, N., Liebert, V., Yazhemsky, E., 2010b. Benchmarking airports from a manage-
rial perspective. Working Paper at the Center for Transportation Studies, Sauder
School of Business, University of British Columbia. http://www.sauder.ubc.ca/
Faculty/Research_Centres/Centre_for_Transportation_Studies.

Adler, N., Nash, C., Pels, E., 2010c. High-speed rail and air transport competition:
game engineering as tool for cost-benefit analysis. Transportation Research Part
B 44 (7), 812e833.

Adler, N., Smilowitz, K., 2007. Hub-and-spoke network alliances and mergers: price-
location competition in the airline industry. Transportation Research Part B 41,
394e409.

Air Transport Association, 2010. Annual results: world airlines. ATA website: http://
www.airlines.org/Economics/DataAnalysis (accessed 17.07.10).

Averch, H., Johnson, L.L., 1962. Behavior of the firm under regulatory constraint.
American Economic Review 52, 1052e1069.

Barrett, S.D., 2000. Airport competition in the deregulated European aviation
market. Journal of Air Transport Management 6, 13e27.

Basso, L., 2008. Airport deregulation: effects on pricing and capacity. International
Journal of Industrial Organization 26, 1015e1031.

Belobaba, P., 2009. Overview of airline economics, markets and demand. In:
Belobaba, P., Odoni, A., Barnhart, C. (Eds.), The Global Airline Industry. Wiley
Press, New York.

Bilotkach, V., 2010. Reputation, search cost and airfares. Journal of Air Transport
Management 16, 251e257.

Brons, M., Pels, E., Nijkamp, P., Rietveld, P., 2002. Price elasticities of demand for
passenger air travel: a meta-analysis. Journal of Air Transport Management 8,
165e175.

Brueckner, J.K., 2002. Airport congestion pricing when carriers have market power.
American Economic Review 92, 1357e1375.

Brueckner, J.K., 2005. Internalization of airport congestion: a network analysis.
International Journal of Industrial Organization 23, 599e614.

Brueckner, J.K., Girvin, R., 2008. Airport noise regulation, airline service quality and
social welfare. Transportation Research Part B 42, 19e37.

Brueckner, J.K., Van Dender, K., 2008. Atomistic congestion tolls at concentrated
airports? Seeking a unified view in the internalization debate. Journal of Urban
Economics 64, 288e295.

Button, K., 2009. Low cost airlines: a failed business model? GARS Workshop on
New Issues in Airline and Airport Economics, Hamburg, Germany.

Carlin, A., Park, R.E., 1970. Marginal cost pricing of airport runway capacity. Amer-
ican Economic Review 60, 310e319.

Clarke, J.-P., 2003. The role of advanced air traffic management in reducing the
impact of aircraft noise and enabling aviation growth. Journal of Air Transport
Management 9, 161e165.

Clemons, E.K., Hann, I.-L., Hitt, L.M., 2002. Price dispersion and differentiation in
online travel: an empirical investigation. Management Science 48 (4), 534e549.

Cobb, R., 2005. Today’s airlines should adopt a low-cost strategy: can this popular
idea be supported by the facts? Academy of Strategic Management Journal 4,
23e40.

Cohen, M., 1983. The antitrust implications of airline deregulation. The Antitrust
Bulletin 28, 131e158.

Czerny, A.I., Forsyth, P., Gillen, D., Niemeier, H.-M., 2008. Airport Slots: International
Experiences and Options for Reform. Ashgate Publishing, Aldershot.

Daniel, J.I., 1995. Congestion pricing and capacity of large hub airports: a bottleneck
model with stochastic queues. Econometrica 63 (2), 327e370.

deNeufville, R., 1999. Airport privatization: issues for the United States. Trans-
portation Research Record 1662, 24e31.

deNeufville, R., 2008. Low cost airports for low cost airlines: flexible design to
manage the risk. Transportation Planning and Technology 31, 35e68.

Dresner, M., Windle, R., Yao, Y., 2002. Airport barriers to entry in the U.S. Journal of
Transport Economics and Policy 36 (2), 389e405.

Flightglobal, 2010. Embraer reveals vision for single-pilot airliners. http://www.
flightglobal.com.

Forsyth, P., 2007. The impacts of emerging aviation trends on airport infrastructure.
Journal of Air Transport Management 13, 45e52.

Forsyth, P., 2008. The impact of climate change policy on competition in the air
transport industry. OECD/ITF Roundtable on Airline Competition, Systems of
Airports and Intermodal Connections.

Fu, X., Homsombat, W., Oum, T.H., 2011. Airport-airline vertical relationships, their
effects and regulatory policy implications. Journal of Air Transport Management
17, 347e353.

Government Accountability Office, 2006. Airline Deregulation. United States GAO
Report to Congressional Committees.

Gellman, A.J., Weber, H.J., Hamlin, G.W., Aboulafia, R.L., 2004. A shadow critical
project appraisal: the A380 program. Working paper at the Northwestern
University Transportation Center. http://transportation.northwestern.edu.

Gillen, D., 2006. Airline business models and networks: regulation, competition and
evolution in aviation markets. Review of Network Economics 5 (4), 366e385.

Gillen, D., Harris, R., Oum, T.H., 2002. Measuring the economic effects of bilateral
liberalization air transport. Transportation Research Part E 38, 155e174.

Girvin, R., 2009. Aircraft noise-abatement and mitigation strategies. Journal of Air
Transport Management 15, 14e22.

Gellman Research Associates, 1994. A Study of International Airline Code Sharing.
GRA, Jenkintown, United States.

Holloway, S., 2008. Straight and Level: Practical Airline Economics. Ashgate
Publishing Ltd, Aldershot.

Hooper, P., 2005. Privatization of airports in Asia. Journal of Air Transport
Management 8, 289e300.

Hooper, P., 2002. The environment for Southeast Asia’s new and evolving airlines.
Journal of Air Transport Management 11, 335e347.

Hsu, C.-J., Chang, Y.-C., 2005. The influences of airline ownership rules on aviation
policies and carriers’ strategies. Proceedings of the Eastern Asia Society for
Transportation Studies 5, 557e569.

Johnson, T., Savage, I., 2006. Departure delays, the pricing of congestion and
expansion proposals at Chicago O’Hare airport. Journal of Air Transport
Management 12, 182e190.

Jones, I., Viehoff, I., Marks, P., 1994. The economics of airport slots. Fiscal Studies 14
(4), 37e57.

Kahn,A.E.,1987.Deregulatoryschizophrenia.CaliforniaLawReview75(3),1059e1068.
Kahn, A.E., 1988. Airline deregulation: a mixed bag, but a clear success nevertheless.

Transportation Law Journal 16, 229e252.
Levine, M.E., 1969. Landing fees and the airport congestion problem. Journal of Law

and Economics 12 (1), 79e108.
Lowy, J., 2010. Reregulation of airlines being pondered. The Washington Times on

June 16th 2010.
McDougall, G., Roberts, A.S., 2009. Commercializing air traffic control: have the

reforms worked? Canadian Public Administration 51, 45e69.
Martin, J.C., Roman, C., Voltes-Dora, A., 2009. A stochastic frontier analysis to esti-

mate the relative efficiency of Spanish airports. Journal of Productivity Analysis
31, 163e176.

Martin, J.C., Socorro, M.P., 2009. A new era for airport regulators through capacity
investments. Transportation Research Part A 43, 618e625.

Mason, K.J., 2007. Airframe manufacturers: which has the better view of the future?
Journal of Air Transport Management 13, 9e15.

Mason, K.J., 2005. Observations of fundamental changes in the demand for aviation
services. Journal of Air Transport Management 11, 19e25.

Morrison, S.A., Winston, C., 2007. Another look at airport congestion pricing. The
American Economic Review 97 (5), 1970e1977.

Niemeier, H.-M., 2002. Regulation of airports: the case of Hamburg airport e a view
from the perspective of regional policy. Journal of Air Transport Management 8,
37e48.

O’Connell, J.F., 2006. The changing dynamics of the Arab Gulf based airlines and an
investigation into the strategies that are making Emirates into a global chal-
lenger. World Review of Intermodal Transportation Research 1 (1), 94e114.

Odoni, A., 2009. The international institutional and regulatory environment. In:
Belobaba, P., Odoni, A., Barnhart, C. (Eds.), The Global Airline Industry. Wiley
Press, New York.

Oum, T.H., Yan, J., Yu, C., 2008. Ownership forms matter for airport efficiency:
a stochastic frontier investigation of worldwide airports. Journal of Urban
Economics 64, 422e435.

Oum, T.H., Zhang, A., Zhang, Y., 2004. Alternative forms of economic regulation and
their efficiency implications for airports. Journal of Transport Economics and
Policy 38 (2), 217e246.

Poole, R.W., Butler, V., 1999. Airline deregulation: the unfinished revolution.
Regulation 22 (1) Policy Study No. 255.

Porter, M.E., 1980. Competitive Strategy: Techniques for Analyzing Industries and
Competitors. Free Press, New York.

Proussaloglou, K., Koppelman, F., 1995. Air carrier demand: an analysis of market
share determinants. Transportation 22, 371e388.

Sarkis, J., Talluri, S., 2004. Performance based clustering for benchmarking of US
airports. Transportation Research Part A 38, 329e346.

Schank, J.L., 2005. Solving airside airport congestion: why peak runway pricing is
not working. Journal of Air Transport Management 11, 417e425.

Scheelhaase, J., Grimme, W., Schaefer, M., 2010. The inclusion of aviation into the EU
emission trading scheme: impacts on competition between European and non-
European network airlines. Transportation Research Part D 15, 14e25.

http://www.sauder.ubc.ca/Faculty/Research_Centres/Centre_for_Transportation_Studies

http://www.airlines.org/Economics/DataAnalysis

http://www.flightglobal.com

http://transportation.northwestern.edu

N. Adler, A. Gellman / Journal of Air Transport Management 21 (2012) 24e35 35

Scheelhaase, J., 2010. Local emission charges e a new economic instrument at
German airports. Journal of Air Transport Management 16, 94e99.

Sentance, A., 2003. Airport slot auctions: desirable or feasible? Utilities Policy 11,
53e57.

Smith, A., 1776. The Wealth of Nations. J.M. Dent, London.
Starkie, D., 2002. Airport regulation and competition. Journal of Air Transport

Management 8 (1), 63e72.
Starkie, D., 2008. Aviation Markets: Studies in Competition and Regulatory Reform.

Ashgate Publishing Ltd, Aldershot.
Swan, W., 2007. Misunderstandings about airline growth. Journal of Air Transport

Management 13, 3e8.
Swelbar, W., Belobaba, P., 2009. Critical issues and prospects for the global airline

industry. In: Belobaba, P., Odoni, A., Barnhart, C. (Eds.), The Global Airline
Industry. Wiley Press, New York.

Tan, A.K.-J., 2010. The ASEAN multilateral agreement on air service: en route to
open skies? Journal of Air Transport Management 16, 289e294.

The Economist, 2009. Unmanned military aircraft: the attack of the drones.
September 3rd, 2009. http://www.economist.com.

Transportation Research Board, 1999. Entry and competition in the U.S. airline
industry: issues and opportunities. Special Report No. 255.

Tretheway, M.W., 2004. Distortions of airline revenues: why the network airline
business model is broken. Journal of Air Transport Management 10, 3e14.

Tretheway, M.W., Kincaid, I., 2010. Competition between airports: occurrence and
strategy. In: Forsyth, P., Gillen, D., Muller, J., Neimeier, H.-M. (Eds.), Airport
Competition: The European Experience. Ashgate Publishing Ltd, Aldershot.

Tretheway, M.W., Waters, W.G., 1998. Reregulation of the airline industry: could
price-cap regulation play a role? Journal of Air Transport Management 4, 47e53.

Winston, C., 1993. Economic deregulation: days of reckoning for microeconomists.
Journal of Economic Literature 31 (3), 1263e1289.

Zhang, Y., Round, D.K., 2008. China’s airline deregulation since 1997 and the driving
forces behind the 2002 airline consolidations. Journal of Air Transport
Management 14, 130e142.

http://www.economist.com

Strategic Management
and Competitive Advantage
Concepts and Cases
fifTH ediTion
Jay B. Barney • William S. Hesterly
This is a special edition of an established title widely
used by colleges and universities throughout the world.
Pearson published this exclusive edition for the benefit
of students outside the United States and Canada. If you
purchased this book within the United States or Canada
you should be aware that it has been imported without
the approval of the Publisher or Author.
Pearson Global Edition
GlobAl
ediTion
GlobAl
ediTion
For these Global Editions, the editorial team at Pearson has
collaborated with educators across the world to address a wide
range of subjects and requirements, equipping students with the best
possible learning tools. This Global Edition preserves the cutting-edge
approach and pedagogy of the original, but also features alterations,
customization, and adaptation from the North American version.
barney
H
esterly
fifT
H

ed
iT
io
n
Strategic M
anagem
ent and C
om
petitive A
dvantage
Concepts and Cases
G
lo
b
A
l
ed
iT
io
n

Whatever your course goals,
we’ve got you covered!
Use MyManagementLab® to
improve student results!
• Study Plan – Help students build a basic understanding of key concepts. Students
start by taking a pretest to gauge initial understanding of key concepts. Upon
completion, they receive a personalized path of study based on the areas where they
would benefit from additional study and practice.
• Business Today – Bring current events alive in your classroom with videos, discussion
questions, and author blogs. Be sure to check back often; this section changes daily.
• Decision-making Simulations – Place your students in the role of a key
decision-maker, where they are asked to make a series of decisions. The simulation
will change and branch based on the decisions students make, providing a variation
of scenario paths. Upon completion of each simulation, students receive a grade, as
well as a detailed report of the choices they made during the simulation and the
associated consequences of those decisions.
• Dynamic Study Modules – Through adaptive learning, students get personalized
guidance where and when they need it most, creating greater engagement, improving
knowledge retention, and supporting subject-matter mastery. Ultimately, students’
self-confidence increases and their results improve. Also available on mobile devices.
• Writing Space – Better writers make great learners—who perform better in
their courses. Providing a single location to develop and assess concept mastery and
critical thinking, the Writing Space offers assisted graded and create-your-own writing
assignments, enabling you to exchange personalized feedback with students, quickly
and easily.
Writing Space can also check students’ work for improper citation or plagiarism by
comparing it against the world’s most accurate text comparison database, available
from Turnitin.
http://www.pearsonmylabandmastering.com

What’s Out?
Models, concepts, and topics that don’t pass a simple test:
“Does this help students analyze cases and real business situations?”
What’s In?
“VRIO” – an integrative framework (see next page for details).
■ Broad enough to apply in analyzing a variety of cases and real business
settings.
■ Simple enough to understand and teach.
V R I O
V R I O
V R I O
V R I O
The Results?
Provides students with the tools they need to do strategic analysis.
Nothing more. Nothing less.
A01_BARN0088_05_GE_FM.INDD 1 13/09/14 3:08 PM

What Is It?
This book is not just a list of concepts, models, and theories. It is the first
undergraduate textbook to introduce a theory-based, multi-chapter organizing
framework to add additional structure to the field of strategic management.
“VRIO” is a mechanism that integrates two existing theoretical frameworks:
the positioning perspective and the resource-based view. It is the primary tool for
accomplishing internal analysis. It stands for four questions one must ask about a
resource or capability to determine its competitive potential:
1. The Question of Value: Does a resource enable a firm to exploit an
environmental opportunity, and/or neutralize an environmental threat?
2. The Question of Rarity: Is a resource currently controlled by only a small
number of competing firms?
3. The Question of Imitability: Do firms without a resource face a cost
disadvantage in obtaining or developing it?
4. The Question of Organization: Are a firm’s other policies and
procedures organized to support the exploitation of its valuable, rare, and
costly-to-imitate resources?
What’s the Benefit of the VRIO Framework?
The VRIO framework is the organizational foundation of the text. It creates a
decision-making framework for students to use in analyzing case and business
situations.
Students tend to view concepts, models, and theories (in all of their
coursework) as fragmented and disconnected. Strategy is no exception. This
view encourages rote memorization, not real understanding. VRIO, by serv-
ing as a consistent framework, connects ideas together. This encourages real
understanding, not memorization.
This understanding enables students to better analyze business cases and
situations—the goal of the course.
The VRIO framework makes it possible to discuss the formulation and
implementation of a strategy simultaneously, within each chapter.
Because the VRIO framework provides a simple integrative structure,
we are actually able to address issues in this book that are largely ignored
elsewhere—including discussions of vertical integration, outsourcing, real
options logic, and mergers and acquisitions, to name just a few.
“Value. Rarity. Imitability. Organization.”
A01_BARN0088_05_GE_FM.INDD 2 13/09/14 3:08 PM

5
E d i t i o n
Jay B. Barney
t he University of Utah
William S. Hesterly
t he University of Utah
Strategic Management and
Competitive Advantage
Concepts and Cases
Global Edition
Boston Columbus Hoboken Indianapolis New York San Francisco
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto
Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
A01_BARN0088_05_GE_FM.INDD 3 13/09/14 3:08 PM

Editor in Chief: Stephanie Wall
Head of Learning Asset Acquisition, Global
Editions: Laura Dent
Acquisitions Editor: Daniel Tylman
Program Management Lead: Ashley Santora
Program Manager: Sarah Holle
Editorial Assistant: Linda Albelli
Acquisitions Editor, Global Editions:
Vrinda Malik
Senior Project Editor, Global Editions: Vaijyanti
VP, Marketing: Maggie Moylan
Product Marketing Manager: Anne Fahlgren
Field Marketing Manager: Lenny Raper
Strategic Marketing Manager: Erin Gardner
Project Management Lead: Judy Leale
Project Manager: Karalyn Holland
Senior Manufacturing Production Controller,
Global Editions: Trudy Kimber
Media Production Manager, Global Editions:
M Vikram Kumar
Procurement Specialist: Michelle Klein
Cover Designer: Lumina Datamatics
Interior Illustrations: Gary Hovland
Cover Art: ©John T Takai/Shutterstock
Full-Service Project Management, Interior
Design, Composition: Integra
Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this
textbook appear on the appropriate page within text.
Pearson Education Limited
Edinburgh Gate Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the World Wide Web at:
www.pearsonglobaleditions.com
© Pearson Education Limited 2015
The rights of Jay B. Barney and William S. Hesterly to be identified as the authors of this work have
been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
Authorized adaptation from the United States edition, entitled Strategic Management and Competitive
Advantage: Concepts and Cases, 5th edition, ISBN 978-0-13-312740-9, by Jay B. Barney and William S.
Hesterly, published by Pearson Education © 2015.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without either the prior written permission of the publisher or a license permitting restricted copying in
the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street,
London EC1N 8TS.
All trademarks used herein are the property of their respective owners. The use of any trademark in this
text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor
does the use of such trademarks imply any affiliation with or endorsement of this book by such owners.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
10 9 8 7 6 5 4 3 2 1
15 14 13 12 11
ISBN 10: 1-292-06008-5
ISBN 13: 978-1-292-06008-8
Typeset in 10/12 Palatino LT Std Roman by Integra
Printed by Courier Kendallville in the United States of America
A01_BARN0088_05_GE_FM.INDD 4 13/09/14 3:08 PM

This book is dedicated to my family: my wife, Kim; our children,
Lindsay, Kristian, and Erin, and their spouses; and, most of all, our
nine grandchildren, Isaac, Dylanie, Audrey, Chloe, Lucas, Royal,
Lincoln, Nolan, and Theo. They all help me remember that no suc-
cess could compensate for failure in the home.
Jay B. Barney
Salt Lake City, Utah
This book is for my family who has taught me life’s greatest lessons
about what matters most. To my wife, Denise; my daughters, sons,
and their spouses: Lindsay, Matt, Jessica, John, Alex, Brittany, Austin,
Julia, Ian, and Drew.; and my grandchildren, Ellie, Owen, Emerson,
Cade, Elizabeth, Amelia, Eden, Asher, Lydia, and Scarlett.
William Hesterly
Salt Lake City, Utah
A01_BARN0088_05_GE_FM.INDD 5 13/09/14 3:08 PM

A01_BARN0088_05_GE_FM.INDD 6 13/09/14 3:08 PM

7
Brief Contents
Part 1: The ToolS of STrATegiC AnAlySiS
C H a p t E r 1 What Is Strategy and the Strategic Management Process? 24
C H a p t E r 2 Evaluating a Firm’s External Environment 48
C H a p t E r 3 Evaluating a Firm’s Internal Capabilities 84
End-of-Part 1 Cases PC 1–1
Part 2: BuSineSS-level STrATegieS
C H a p t E r 4 Cost Leadership 122
C H a p t E r 5 Product Differentiation 150
End-of-Part 2 Cases PC 2–1
Part 3: CorporATe STrATegieS
C H a p t E r 6 Vertical Integration 182
C H a p t E r 7 Corporate Diversification 208
C H a p t E r 8 Organizing to Implement Corporate Diversification 240
C H a p t E r 9 Strategic Alliances 268
C H a p t E r 1 0 Mergers and Acquisitions 296
C H a p t E r 1 1 International Strategies 328
End-of-Part 3 Cases PC 3–1
Appendix: Analyzing Cases and Preparing for Class Discussions 365
Glossary 369
Company Index 377
Name Index 380
Subject Index 385
A01_BARN0088_05_GE_FM.INDD 7 13/09/14 3:08 PM

A01_BARN0088_05_GE_FM.INDD 8 13/09/14 3:08 PM

9
Contents
Part 1: The ToolS of STrATegiC AnAlySiS
C H a p t E r 1 What Is Strategy and the Strategic Management Process? 24
Opening Case: Why Are These Birds So Angry? 24
Strategy and the Strategic Management process 26
Defining Strategy 26
The Strategic Management Process 26
What is Competitive a dvantage? 30
Research Made Relevant: How Sustainable Are
Competitive Advantages? 32
t he Strategic Management process, r evisited 32
Measuring Competitive a dvantage 33
Accounting Measures of Competitive Advantage 33
Strategy in Depth: The Business Model Canvas 34
Economic Measures of Competitive Advantage 38
The Relationship Between Economic and Accounting
Performance Measures 40
Emergent Versus intended Strategies 40
Ethics and Strategy: Stockholders Versus Stakeholders 42
Strategy in the Emerging Enterprise: Emergent Strategies
and Entrepreneurship 43
Why You need to Know a bout Strategy 44
Summary 44
Challenge Questions 45
Problem Set 46
End Notes 47
C H a p t E r 2 Evaluating a Firm’s External Environment 48
Opening Case: iTunes and the Streaming
Challenge 48
Understanding a Firm’s General Environment 50
t he Structure-Conduct-performance Model of Firm
performance 53
Ethics and Strategy: Is a Firm Gaining a Competitive
Advantage Good for Society? 54
a Model of Environmental t hreats 55
Threat from New Competition 56
Strategy in Depth: Environmental Threats
and the S-C-P Model 57
Threat from Existing Competitors 62
Threat of Substitute Products 63
Threat of Supplier Leverage 64
Threat from Buyers’ Influence 65
Environmental Threats and Average Industry
Performance 66
Another Environmental Force: Complementors 67
Research Made Relevant: The Impact of Industry and Firm
Characteristics on Firm Performance 69
industry Structure and Environmental
o pportunities 69
Opportunities in Fragmented Industries:
Consolidation 70
Opportunities in Emerging Industries: First-Mover
Advantages 71
Opportunities in Mature Industries: Product
Refinement, Service, and Process Innovation 73
Strategy in the Emerging Enterprise: Microsoft
Grows Up 75
Opportunities in Declining Industries: Leadership,
Niche, Harvest, and Divestment 76
Summary 78
Challenge Questions 80
Problem Set 80
End Notes 81
A01_BARN0088_05_GE_FM.INDD 9 13/09/14 3:08 PM

10 Contents
C H a p t E r 3 Evaluating a Firm’s Internal Capabilities 84
Opening Case: When a Noun Becomes a Verb 84
t he r esource-Based View of the Firm 86
What Are Resources and Capabilities? 86
Critical Assumptions of the Resource-Based View 87
Strategy in Depth: Ricardian Economics and the
Resource-Based View 88
t he Vrio Framework 88
The Question of Value 89
Strategy in the Emerging Enterprise: Are Business
Plans Good for Entrepreneurs? 91
Ethics and Strategy: Externalities and the Broader
Consequences of Profit Maximization 93
The Question of Rarity 94
The Question of Imitability 95
The Question of Organization 100
Research Made Relevant: Strategic Human Resource
Management Research 101
a pplying the Vrio Framework 103
Applying the VRIO Framework to Southwest
Airlines 104
imitation and Competitive d ynamics
in an industry 106
Not Responding to Another Firm’s Competitive
Advantage 107
Changing Tactics in Response to Another Firm’s
Competitive Advantage 108
Changing Strategies in Response to Another Firm’s
Competitive Advantage 110
implications of the r esource-Based View 110
Where Does the Responsibility for Competitive
Advantage in a Firm Reside? 110
Competitive Parity and Competitive Advantage 112
Difficult-to-Implement Strategies 112
Socially Complex Resources 113
The Role of Organization 114
Summary 114
Challenge Questions 116
Problem Set 116
End Notes 117
End-of-part 1 Cases
Case 1–1: You Say You Want a Revolution:
SodaStream International PC 1–1
Case 1–2: True Religion Jeans: Will Going
Private Help It Regain Its
Congregation? PC 1–11
Case 1–3: Wal-Mart Stores, Inc. PC 1–32
Case 1–4: Harlequin Enterprises: The Mira
Decision PC 1–46
Part 2: BuSineSS-level STrATegieS
C H a p t E r 4 Cost Leadership 122
Opening Case: The World’s Lowest-Cost Airline 122
What is Business-Level Strategy? 124
What is Cost Leadership? 124
Sources of Cost Advantages 124
Research Made Relevant: How Valuable Is Market
Share—Really? 131
Ethics and Strategy: The Race to the Bottom 133
t he Value of Cost Leadership 133
Cost Leadership and Environmental Threats 134
Strategy in Depth: The Economics of Cost Leadership 135
Cost Leadership and Sustained Competitive
a dvantage 136
The Rarity of Sources of Cost Advantage 136
The Imitability of Sources of Cost Advantage 137
A01_BARN0088_05_GE_FM.INDD 10 13/09/14 3:08 PM

Contents 11
o rganizing to implement Cost Leadership 141
Strategy in the Emerging Enterprise: The Oakland A’s:
Inventing a New Way to Play Competitive Baseball 142
Organizational Structure in Implementing Cost
Leadership 143
Management Controls in Implementing Cost
Leadership 145
Compensation Policies and Implementing Cost
Leadership Strategies 146
Summary 146
Challenge Questions 147
Problem Set 148
End Notes 149
C H a p t E r 5 Product Differentiation 150
Opening Case: Who Is Victoria, and What Is Her
Secret? 150
What is product d ifferentiation? 152
Bases of Product Differentiation 153
Research Made Relevant: Discovering the Bases of Product
Differentiation 155
Product Differentiation and Creativity 158
t he Value of product d ifferentiation 159
Product Differentiation and Environmental
Threats 159
Strategy in Depth: The Economics of Product
Differentiation 160
Product Differentiation and Environmental
Opportunities 161
product d ifferentiation and Sustained Competitive
a dvantage 162
Rare Bases for Product Differentiation 162
Ethics and Strategy: Product Claims and the Ethical
Dilemmas in Health Care 163
The Imitability of Product Differentiation 164
o rganizing to implement product differentiation 169
Organizational Structure and Implementing Product
Differentiation 170
Management Controls and Implementing Product
Differentiation 170
Strategy in the Emerging Enterprise: Going in Search
of Blue Oceans 171
Compensation Policies and Implementing Product
Differentiation Strategies 174
Can Firms implement product d ifferentiation
and Cost Leadership Simultaneously? 174
No: These Strategies Cannot Be Implemented
Simultaneously 175
Yes: These Strategies Can Be Implemented
Simultaneously 176
Summary 177
Challenge Questions 178
Problem Set 179
End Notes 180
End-of-part 2 Cases
Case 2–1: Airasia X: Can the Low Cost Model go
Long Haul? PC 2–1
Case 2–2: Ryanair—The Low Fares Airline:
Whither Now? PC 2–17
Case 2–3: The Levi’s Personal Pair Proposal PC 2–43
Case 2–4: Papa John’s International, Inc. PC 2–53
A01_BARN0088_05_GE_FM.INDD 11 13/09/14 3:08 PM

12 Contents
Part 3: CorporATe STrATegieS
C H a p t E r 6 Vertical Integration 182
Opening Case: Outsourcing Research 182
What is Corporate Strategy? 184
What is Vertical integration? 184
t he Value of Vertical integration 185
Strategy in Depth: Measuring Vertical Integration 186
Vertical Integration and the Threat of
Opportunism 187
Vertical Integration and Firm Capabilities 189
Vertical Integration and Flexibility 190
Applying the Theories to the Management of Call
Centers 192
Research Made Relevant: Empirical Tests of Theories
of Vertical Integration 192
Integrating Different Theories of Vertical
Integration 194
Vertical integration and Sustained Competitive
a dvantage 194
The Rarity of Vertical Integration 195
Ethics and Strategy: The Ethics of Outsourcing 195
The Imitability of Vertical Integration 197
o rganizing to implement Vertical integration 198
Organizational Structure and Implementing Vertical
Integration 198
Strategy in the Emerging Enterprise: Oprah, Inc. 199
Management Controls and Implementing Vertical
Integration 200
Compensation in Implementing Vertical Integration
Strategies 201
Summary 203
Challenge Questions 205
Problem Set 205
End Notes 206
C H a p t E r 7 Corporate Diversification 208
Opening Case: The Worldwide Leader 208
What is Corporate d iversification? 210
Types of Corporate Diversification 210
Limited Corporate Diversification 211
Related Corporate Diversification 212
Unrelated Corporate Diversification 213
t he Value of Corporate d iversification 213
What Are Valuable Economies of Scope? 213
Research Made Relevant: How Valuable Are Economies
of Scope, on Average? 214
Strategy in the Emerging Enterprise: Gore-Tex and Guitar
Strings 221
Can Equity Holders Realize These Economies of Scope
on Their Own? 229
Ethics and Strategy: Globalization and the Threat
of the Multinational Firm 230
Corporate d iversification and Sustained Competitive
a dvantage 231
Strategy in Depth: Risk-Reducing Diversification
and a Firm’s Other Stakeholders 232
The Rarity of Diversification 233
The Imitability of Diversification 234
Summary 235
Challenge Questions 236
Problem Set 236
End Notes 238
A01_BARN0088_05_GE_FM.INDD 12 13/09/14 3:08 PM

Contents 13
C H a p t E r 8 Organizing to Implement Corporate Diversification 240
Opening Case: And Then There Is Berkshire
Hathaway 240
o rganizational Structure and implementing Corporate
d iversification 242
The Board of Directors 243
Strategy in Depth: Agency Conflicts Between Managers
and Equity Holders 245
Research Made Relevant: The Effectiveness of Boards
of Directors 246
Institutional Owners 247
The Senior Executive 248
Corporate Staff 249
Division General Manager 251
Shared Activity Managers 252
Management Controls and implementing Corporate
d iversification 253
Evaluating Divisional Performance 254
Allocating Corporate Capital 257
Transferring Intermediate Products 258
Strategy in the Emerging Enterprise: Transforming Big
Business into Entrepreneurship 261
Compensation policies and implementing Corporate
d iversification 262
Ethics and Strategy: Do CEOs Get Paid Too Much? 262
Summary 264
Challenge Questions 264
Problem Set 265
End Notes 266
C H a p t E r 9 Strategic Alliances 268
Opening Case: Breaking Up Is Hard to Do:
Apple and Samsung 268
What is a Strategic a lliance? 270
How do Strategic a lliances Create Value? 271
Strategic Alliance Opportunities 271
Strategy in Depth: Winning Learning Races 274
Research Made Relevant: Do Strategic Alliances
Facilitate Tacit Collusion? 277
a lliance t hreats: incentives to Cheat on Strategic
a lliances 278
Adverse Selection 279
Moral Hazard 279
Holdup 280
Strategy in the Emerging Enterprise: Disney and Pixar 281
Strategic a lliances and Sustained Competitive
a dvantage 282
The Rarity of Strategic Alliances 282
The Imitability of Strategic Alliances 283
Ethics and Strategy: When It Comes to Alliances,
Do “Cheaters Never Prosper”? 284
o rganizing to implement Strategic
a lliances 287
Explicit Contracts and Legal Sanctions 288
Equity Investments 288
Firm Reputations 289
Joint Ventures 290
Trust 291
Summary 292
Challenge Questions 293
Problem Set 293
End Notes 294
A01_BARN0088_05_GE_FM.INDD 13 13/09/14 3:08 PM

14 Contents
C H a p t E r 1 0 Mergers and Acquisitions 296
Opening Case: The Google Acquisition Machine 296
What a re Mergers and a cquisitions? 298
t he Value of Mergers and a cquisitions 299
Mergers and Acquisitions: The Unrelated Case 299
Mergers and Acquisitions: The Related Case 300
What does r esearch Say a bout r eturns to Mergers
and a cquisitions? 304
Strategy in the Emerging Enterprise: Cashing Out 305
Why Are There So Many Mergers and Acquisitions? 306
Strategy in Depth: Evaluating the Performance Effects
of Acquisitions 308
Mergers and a cquisitions and Sustained Competitive
a dvantage 309
Valuable, Rare, and Private Economies of Scope 310
Valuable, Rare, and Costly-to-Imitate Economies
of Scope 311
Unexpected Valuable Economies of Scope Between
Bidding and Target Firms 312
Implications for Bidding Firm Managers 312
Implications for Target Firm Managers 317
o rganizing to implement a Merger or
a cquisition 318
Post-Merger Integration and Implementing a
Diversification Strategy 319
Special Challenges in Post-Merger Integration 319
Research Made Relevant: The Wealth Effects
of Management Responses to Takeover Attempts 320
Summary 324
Challenge Questions 325
Problem Set 325
End Notes 326
C H a p t E r 1 1 International Strategies 328
Opening Case: The Baby Formula Problem 328
Strategy in the Emerging Enterprise: International
Entrepreneurial Firms: The Case of Logitech 330
t he Value of international Strategies 331
to Gain a ccess to n ew Customers for Current
products or Services 332
Internationalization and Firm Revenues 332
Strategy in Depth: Countertrade 336
Internationalization and Product Life Cycles 337
Internationalization and Cost Reduction 338
to Gain a ccess to Low-Cost Factors of
production 338
Raw Materials 338
Labor 338
Ethics and Strategy: Manufacturing Tragedies and
International Business 339
Technology 340
to develop new Core Competencies 341
Learning from International Operations 341
Leveraging New Core Competencies in Additional
Markets 343
to Leverage Current Core Competencies in new
Ways 343
to Manage Corporate r isk 343
Research Made Relevant: Family Firms in the Global
Economy 344
t he Local r esponsiveness/international integration
t rade-o ff 345
t he t ransnational Strategy 347
Financial and political r isks in pursuing international
Strategies 347
Financial Risks: Currency Fluctuation and
Inflation 347
Political Risks 348
r esearch on the Value of international Strategies 350
international Strategies and Sustained Competitive
a dvantage 351
The Rarity of International Strategies 351
The Imitability of International Strategies 352
t he o rganization of international Strategies 354
Becoming International: Organizational Options 354
Summary 359
Challenge Questions 360
Problem Set 361
End Notes 362
A01_BARN0088_05_GE_FM.INDD 14 13/09/14 3:08 PM

Contents 15
End-of-part 3 Cases
Case 3–1: eBay’s Outsourcing Strategy PC 3–1
Case 3–2: National Hockey League Enterprises
Canada: A Retail Proposal PC 3–14
Case 3–3: Starbucks: An Alex Poole Strategy
Case PC 3–19
Case 3–4: Rayovac Corporation: International
Growth and Diversification Through
Acquisitions PC 3–32
Case 3–5: Aegis Analytical Corporation’s Strategic
Alliances PC 3–44
Case 3–6: McDonald’s and KFC: Recipes for Success
in China PC 3–54
a ppendix: a nalyzing Cases and preparing for Class d iscussions 365
Glossary 369
Company Index 377
Name Index 380
Subject Index 385
A01_BARN0088_05_GE_FM.INDD 15 13/09/14 3:08 PM

16
The first thing you will notice as you look through this edition of our book is that it con-
tinues to be much shorter than most textbooks on strategic management. There is not the
usual “later edition” increase in number of pages and bulk. We’re strong proponents of the
philosophy that, often, less is more. The general tendency is for textbooks to get longer and
longer as authors make sure that their books leave out nothing that is in other books. We
take a different approach. Our guiding principle in deciding what to include is: “Does this
concept help students analyze cases and real business situations?” For many concepts we
considered, the answer is no. But, where the answer is yes, the concept is in the book.
New to This Edition
This edition includes many new chapter-opening cases, including:
• Chapter 1: A case on the video app “Angry Birds”
• Chapter 2: A case on the music streaming industry
• Chapter 3: A case on how Google keeps going
• Chapter 8: A case on Berkshire-Hathaway’s corporate strategy
• Chapter 9: A case on the alliance between Apple and Samsung
• Chapter 10: A case on Google’s acquisition strategy
• Chapter 11: A case on the infant formula business in China
All the other opening cases have been reused and updated, along with all the examples
throughout the book.
Two newer topics in the field have also been included in this edition of the book: the
business model canvas (in Chapter 1) and blue ocean strategies (in Chapter 5).
This edition features several new and updated cases, including:
• You Say You Want a Revolution: Soda Stream International
• True Religion Jeans: Will Going Private Help It Regain Its Congregation?
• Walmart: Walmart Stores, Inc., in 2013
• Air Asia X: Can the Low Cost Model Go Long Haul?
• RyanAir—The Low Fares Airline: Whither Now?
• Papa John’s International, Inc.
• e-Bay’s Outsourcing Strategy
• National Hockey League Enterprises Canada: A Retail Proposal
• Starbucks: An Alex Poole Strategy Case
• Rayovac Corporation: International Growth and Diversification Through Acquisitions
VRIO Framework and Other Hallmark Features
One thing that has not changed in this edition is that we continue to have a point of view
about the field of strategic management. In planning for this book, we recalled our own
educational experience and the textbooks that did and didn’t work for us then. Those few
that stood out as the best did not merely cover all of the different topics in a field of study.
They provided a framework that we could carry around in our heads, and they helped us
preface
A01_BARN0088_05_GE_FM.INDD 16 13/09/14 3:08 PM

preface 17
to see what we were studying as an integrated whole rather than a disjointed sequence of
loosely related subjects. This text continues to be integrated around the VRIO framework.
As those of you familiar with the resource-based theory of strategy recognize, the VRIO
framework addresses the central questions around gaining and sustaining competitive
advantage. After it is introduced in Chapter 3, the VRIO logic of competitive advantage is
applied in every chapter. It is simple enough to understand and teach yet broad enough to
apply to a wide variety of cases and business settings.
Our consistent use of the VRIO framework does not mean that any of the concepts
fundamental to a strategy course are missing. We still have all of the core ideas and theories
that are essential to a strategy course. Ideas such as the study of environmental threats,
value chain analysis, generic strategies, and corporate strategy are all in the book. Because
the VRIO framework provides a single integrative structure, we are able to address issues
in this book that are largely ignored elsewhere—including discussions of vertical integra-
tion, outsourcing, real options logic, and mergers and acquisitions, to name just a few.
We also have designed flexibility into the book. Each chapter has four short sections
that present specific issues in more depth. These sections allow instructors to adapt the
book to the particular needs of their students. “Strategy in Depth” examines the intellectual
foundations that are behind the way managers think about and practice strategy today.
“Strategy in the Emerging Enterprise” presents examples of strategic challenges faced by
new and emerging enterprises. “Ethics and Strategy” delves into some of the ethical dilem-
mas that managers face as they confront strategic decisions. “Research Made Relevant”
includes recent research related to the topics in that chapter.
We have also included cases—including many new cases in this edition—that pro-
vide students an opportunity to apply the ideas they learn to business situations. The cases
include a variety of contexts, such as entrepreneurial, service, manufacturing, and interna-
tional settings. The power of the VRIO framework is that it applies across all of these set-
tings. Applying the VRIO framework to many topics and cases throughout the book leads
to real understanding instead of rote memorization. The end result is that students will find
that they have the tools they need to do strategic analysis. Nothing more. Nothing less.
Supplements
At the Instructor Resource Center, at www.pearsonglobaleditions.com/Barney, instructors
can download a variety of digital and presentation resources. Registration is simple and gives
you immediate access to all of the available supplements. In case you ever need assistance,
our dedicated technical support team is ready to help with the media supplements that
accompany this text. Visit http://247.pearsoned.custhelp.com for answers to frequently
asked questions and toll-free user support phone numbers.
The following supplements are available for download to adopting instructors:
• Instructor’s Manual
• Case Teaching Notes
• Test Item File
• TestGen® Computerized Test Bank
• PowerPoint Slides
Videos
Videos illustrating the most important subject topics are available in MyLab—available
for instructors and students, provides round-the-clock instant access to videos and cor-
responding assessment and simulations for Pearson textbooks. Contact your local Pearson
representative to request access.
A01_BARN0088_05_GE_FM.INDD 17 13/09/14 3:08 PM

18 preface
Other Benefits
Element Description Benefit Example
Chapter
Opening
Cases
We have chosen firms that are familiar to most stu-
dents. Opening cases focus on whether or not Rovio
Entertainment, Ltd.—maker of the popular video game
“Angry Birds”—can sustain its success, how Ryanair has
become the lowest cost airline in the world, how Victoria’s
Secret has differentiated its products, how ESPN has
diversified its operations, and so forth.
By having cases tightly
linked to the material,
students can develop
strategic analysis skills
by studying firms
familiar to them.
24–25
Full Length
Cases
This book contains selective, part-ending cases that
underscore the concepts in each part. This provides a tight
link to the chapter concepts to reinforce understanding of
recent research. These are 1) decision oriented, 2) recent,
3) student-recognized companies, and 4) cases where the
data are only partly analyzed.
Provides a tight link to
chapter concepts,
facilitating students’
ability to apply text
ideas to case analysis.
PC 1–1–
PC 1–10
Strategy in
Depth
For professors and students interested in understanding
the full intellectual underpinnings of the field, we have
included an optional Strategy in Depth feature in every
chapter. Knowledge in strategic management continues to
evolve rapidly, in ways that are well beyond what is
normally included in introductory texts.
Customize your course
as desired to provide
enrichment material for
advanced students.
245
Research
Made
Relevant
The Research Made Relevant feature highlights very
current research findings related to some of the strategic
topics discussed in that chapter.
Shows students the
evolving nature of
strategy.
69
Challenge
Questions
These might be of an ethical or moral nature, forcing
students to apply concepts across chapters, apply concepts
to themselves, or extend chapter ideas in creative ways.
Requires students to
think critically.
147
Problem
Set
Problem Set asks students to apply theories and tools from the
chapter. These often require calculations. They can be thought
of as homework assignments. If students struggle with these
problems they might have trouble with the more complex
cases. These problem sets are largely diagnostic in character.
Sharpens quantitative
skills and provides a
bridge between
chapter material and
case analysis.
179–180
Ethics and
Strategy
Highlights some of the most important dilemmas faced by
firms when creating and implementing strategies.
Helps students make
better ethical decisions
as managers.
230
Strategy in
the Emerging
Enterprise
A growing number of graduates work for small and
medium-sized firms. This feature presents an extended
example, in each chapter, of the unique strategic problems
facing those employed in small and medium-sized firms.
This feature highlights
the unique challenges of
doing strategic analysis
in emerging enterprises
and small and medium-
sized firms.
75
A01_BARN0088_05_GE_FM.INDD 18 13/09/14 3:08 PM

19
Obviously, a book like this is not written in isolation. We owe a debt of gratitude to all those
at Pearson who have supported its development. In particular, we want to thank Stephanie
Wall, Editor-in-Chief; Dan Tylman, Acquisitions Editor; Sarah Holle, Program Manager;
Erin Gardner, Marketing Manager; Judy Leale, Project Manager Team Lead; and Karalyn
Holland, Senior Project Manager.
Many people were involved in reviewing drafts of each edition’s manuscript. Their
efforts undoubtedly improved the manuscript dramatically. Their efforts are largely un-
sung but very much appreciated.
Thank you to these professors who participated in manuscript reviews:
Yusaf Akbar—Southern New Hampshire University
Joseph D. Botana II—Lakeland College
Pam Braden—West Virginia University at Parkersburg
Erick PC Chang—Arkansas State University
Mustafa Colak—Temple University
Ron Eggers—Barton College
Michael Frandsen—Albion College
Swapnil Garg—University of Florida
Michele Gee—University of Wisconsin, Parkside
Peter Goulet—University of Northern Iowa
Rebecca Guidice—University of Nevada Las Vegas
Laura Hart—Lynn University, College of Business & Management
Tom Hewett—Kaplan University
Phyllis Holland—Valdosta State University
Paul Howard—Penn State University
Richard Insinga—St. John Fisher College
Homer Johnson—Loyola University Chicago
Marilyn Kaplan—University of Texas at Dallas
Joseph Leonard—Miami University
Paul Maxwell—St. Thomas University, Miami
Stephen Mayer—Niagara University
Richard Nemanick—Saint Louis University
Hossein Noorian—Wentworth Institute of Technology
Ralph Parrish—University of Central Oklahoma
Raman Patel—Robert Morris College
Jiten Ruparel—Otterbein College
Acknowledgments
A01_BARN0088_05_GE_FM.INDD 19 13/09/14 3:08 PM

20 Acknowledgments
Roy Simerly—East Carolina University
Sally Sledge—Christopher Newport University
David Stahl—Montclair State University
David Stephens—Utah State University
Philip Stoeberl—Saint Louis University
Ram Subramanian—Grand Valley State University
William W. Topper—Curry College
Thomas Turk—Chapman University
Henry Ulrich—Central Connecticut State (soon to be UCONN)
Floyd Willoughby—Oakland University
Reviewers of the Fourth Edition
Terry Adler—New Mexico State University
Jorge Aravelo—William Patterson University
Asli M. Arikan—The Ohio State University
Scott Brown—Chapman University
Carlos Ferran—Governors State University
Samual Holloway—University of Portland
Paul Longenecker—Otterbein University
Shelly McCallum—Saint Mary’s University
Jeffrey Stone—CAL State–Channel Islands
Edward Taylor—Piedmont College
Les Thompson—Missouri Baptist University
Zhe Zhang—Eastern Kentucky University
All these people have given generously of their time and wisdom. But, truth be told,
everyone who knows us knows that this book would not have been possible without
Kathy Zwanziger and Rachel Snow.
Pearson would like to thank and acknowledge the following people for their work on the
Global Edition.
For their contribution:
Malay Krishna—S.P. Jain Institute of Management & Research
Thum Weng-Ho—Murdoch University
And for their reviews:
S Siengthai—Asian Institute of Technology
Kate Mottaram—Coventry University
Charles Chow—Lee Kong Chian School of Business
Dr.Pardeep Kumar—MGM Institute of Management
A01_BARN0088_05_GE_FM.INDD 20 13/09/14 3:08 PM

21
WiLLia M S. HESt Er LY
William Hesterly is the Associate
Dean for Faculty and Research
as well as the Dumke Family
Endowed Presidential Chair in
Management in the David Eccles
School of Business, University
of Utah. After studying at
Louisiana State University, he
received bachelors and masters
degrees from Brigham Young
University and a Ph.D. from the
University of California, Los Angeles. Professor Hesterly has
been recognized multiple times as the outstanding teacher
in the MBA Program at the David Eccles School of Business
and has also been the recipient of the Student’s Choice
Award. He has taught in a variety of executive programs
for both large and small companies. Professor Hesterly’s
research on organizational economics, vertical integration,
organizational forms, and entrepreneurial networks has ap-
peared in top journals including the Academy of Management
Review, Organization Science, Strategic Management Journal,
Journal of Management, and the Journal of Economic Behavior
and Organization. Currently, he is studying the sources of
value creation in firms and also the determinants of who
captures the value from a firm’s competitive advantage.
Recent papers in this area have appeared in the Academy of
Management Review and Managerial and Decision Economics.
Professor Hesterly’s research was recognized with the
Western Academy of Management’s Ascendant Scholar
Award in 1999. Dr. Hesterly has also received best paper
awards from the Western Academy of Management and the
Academy of Management. Dr. Hesterly currently serves as
the senior editor of Long Range Planning and has served on
the editorial boards of Strategic Organization, Organization
Science, and the Journal of Management. He has served as
Department Chair and also as Vice-President and President
of the faculty at the David Eccles School of Business at the
University of Utah.
JaY B. Barn EY
Jay Barney is a Presidential
Professor of strategic manage-
ment and the Lassonde Chair of
Social Entrepreneurship of the
Entrepreneurship and Strategy
Department in the David Eccles
Business School, The University
of Utah. He received his Ph.D.
from Yale and has held faculty
appointments at UCLA, Texas
A&M, and OSU [The Ohio State
University]. He joined the faculty at The University of Utah
in summer of 2013. Jay has published more than 100 journal
articles and books; has served on the editorial boards of
Academy of Management Review, Strategic Management
Journal, and Organization Science; has served as an associ-
ate editor of The Journal of Management and senior editor
at Organization Science; and currently serves as co-editor
at the Strategic Entrepreneurship Journal. He has received
Author Biographies
honorary doctorate degrees from the University of Lund
(Sweden), the Copenhagen Business School (Denmark),
and the Universidad Pontificia Comillas (Spain) and has
been elected to the Academy of Management Fellows and
Strategic Management Society Fellows. He has held hon-
orary visiting professor positions at Waikato University
(New Zealand), Sun Yat-Sen University (China), and Peking
University (China). He has also consulted for a wide vari-
ety of public and private organizations, including Hewlett-
Packard, Texas Instruments, Arco, Koch Industries Inc., and
Nationwide Insurance, focusing on implementing large-scale
organizational change and strategic analysis. He has received
teaching awards at UCLA, Texas A&M, and Ohio State. Jay
served as assistant program chair and program chair, chair
elect, and chair of the Business Policy and Strategy Division.
In 2005, he received the Irwin Outstanding Educator Award
for the BPS Division of the Academy of Management, and
in 2010, he won the Academy of Management’s Scholarly
Contribution to Management Award. In 2008, he was elected
as the President-elect of the Strategic Management Society,
where he currently serves as past-president.
A01_BARN0088_05_GE_FM.INDD 21 13/09/14 3:08 PM

A01_BARN0088_05_GE_FM.INDD 22 13/09/14 3:08 PM

The Tools of
sTraTegic analysis
1
P a r t
M01_BARN0088_05_GE_C01.INDD 23 17/09/14 4:15 PM

24
1. Define strategy.
2. Describe the strategic management process.
3. Define competitive advantage and explain its relation-
ship to economic value creation.
4. Describe two different measures of competitive
advantage.
Why a re t hese Birds So a ngry?
Rarely can the beg inning on an en tire industry be traced to a single ev ent on a specific da y. But
this is the case with the smart phone applications industry.
On June 29, 2007, A pple first introduced the iPhone. A central feature of the iP hone was
that it would be able t o run a wide v ariety of applications, or “apps.” And, most impor tantly for
the evolution of the apps industr y, Apple decided tha t while it w ould evaluate and distr ibute
these applications—through the online Apple App Store—it would not develop them. Instead,
Apple would “crowd source” most applications from outside developers.
And, thus, the smart phone applications industry began. By April 24, 2009, iP hone users had
downloaded more than 1 billion apps from the Apple App Store. During 2012, more than 45.6 billion
smart phone apps w ere downloaded from all sources, generating revenues in excess of $25 billion.
Projections suggest double-digit growth in this industry for at least another five years.
Of c ourse, much has changed sinc e 2007. F or e xample, A pple no w has six c ompetitors
for its A pple App Store, including A mazon App Store, Google Play Store, BlackBerry World, and
Windows Phone Store. Some of these stores distribute apps for non-Apple phone operating sys-
tems developed by Google (Android), BlackBerry, and Windows. But all of these distributors have
adopted Apple’s original model for developing applications: mostly outsource it to independent
development companies.
These development companies fall into four categories: (1) Internet companies— including
Google—who ha ve dev eloped smar t phone v ersions of popular I nternet sit es—including, f or
5. Explain the difference between emergent and intended
strategies.
6. Discuss the importance of understanding a firm’s
strategy even if you are not a senior manager in a
firm.
L e a r n i n g O B j e c t i v e S After reading this chapter, you should be able to:
MyManagementLab®
improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
1
c h a P t e r What is strategy
and the strategic
Management Process?
M01_BARN0088_05_GE_C01.INDD 24 17/09/14 4:15 PM

25
example, YouTube and Google Maps; (2) traditional video game
companies—including S ega—who ha ve dev eloped smar t
phone v ersions of popular video games—including , f or e x-
ample, Sonic Dash; (3) diversified media companies—including
Disney—who ha ve built apps f eaturing char acters and st ories
developed in their far -flung media oper ations—including, f or
example, M onster’s Univ ersity; and (4) c ompanies who ha ve
been formed to develop entirely new apps.
There ar e, of c ourse, lit erally thousands—ma ybe hun –
dreds of thousands—of this last type of app development firm.
The proliferation of these firms— sometimes no more than one
person with an idea—has led t o a pr oliferation of apps acr oss
all smart phone platforms. Currently, there are 1.5 million do wnloadable apps available on both
the Apple App Store and Google Play Store.
Among these thousands of independen t developers, a few have been unusually suc cess-
ful. None exemplifies this “rag to riches” dynamic more than Rovio, an app development com-
pany headquartered outside Helsinki, Finland. Rovio is best known for an amazingly simple game
involving enraged avians—yes, Angry Birds.
The challenge facing R ovio, and all these suc cessful independent app dev elopers, is: C an
they go beyond developing a single “killer app,” or will they be “one-hit wonders?” Rovio is trying
to avoid this fa te by leveraging the A ngry Birds franchise into a ser ies of r elated apps—Angry
Birds Star Wars, Bad P iggies; by developing apps tha t build on new char acters—The Croods; by
diversifying into related non-app businesses— Angry Birds Toons; and b y licensing Angry Birds
characters to toy manufactures—including Mattel.
Rovio has ev en begun cr owd sour cing new app ideas tha t it can br ing t o mar ket.
Independent developers can pitch games and apps to Rovio online. Whether this effort will lead
to the next generation of Rovio apps is not yet known.
What is k nown is tha t the smar t phone applica tions industr y—an industr y that was cre-
ated only in 2007—is likely to grow and evolve dramatically over the next few years. And firms as
diverse as Google, Apple, Disney, Sega—and even Rovio—will have to evolve with it.
Sources: www.rovio.com ac cessed A ugust 23, 2013; www.distimo.com ac cessed A ugust 23, 2013; www.newrelic.com
accessed August 23, 2013
©
K
ev
in
B
rit
la
nd
/A
la
m
y
M01_BARN0088_05_GE_C01.INDD 25 17/09/14 4:15 PM

26 Part 1: The Tools of strategic analysis
firms in the smart phone applications industry—whether they have entered this business from another media industry—like Google and Disney—or not—like Rovio—face classic strategic questions. How is this industry likely
to evolve? What actions can be taken to change this evolution? How can firms
gain advantages in this industry? How sustainable are these advantages?
The process by which these, and related, questions are answered is the
strategic management process, and the answers that firms develop for these ques-
tions help determine a firm’s strategy.
Strategy and the Strategic Management Process
Although most can agree that a firm’s ability to survive and prosper depends on
choosing and implementing a good strategy, there is less agreement about what
a strategy is and even less agreement about what constitutes a good strategy.
Indeed, there are almost as many different definitions of these concepts as there
are books written about them.
Defining Strategy
In this book, a firm’s strategy is defined as its theory about how to gain com-
petitive advantages.1 A good strategy is a strategy that actually generates such
advantages. Disney’s theory of how to gain a competitive advantage in the apps
industry is to leverage characters from its movie business. Rovio’s theory is to
develop entirely new content for its apps.
Each of these theories—like all theories—is based on a set of assumptions
and hypotheses about the way competition in this industry is likely to evolve
and how that evolution can be exploited to earn a profit. The greater the extent
to which these assumptions and hypotheses accurately reflect how competition
in this industry actually evolves, the more likely it is that a firm will gain a com-
petitive advantage from implementing its strategies. If these assumptions and
hypotheses turn out not to be accurate, then a firm’s strategies are not likely to be
a source of competitive advantage.
But here is the challenge. It is usually very difficult to predict how competi-
tion in an industry will evolve, and so it is rarely possible to know for sure that a
firm is choosing the right strategy. This is why a firm’s strategy is almost always
a theory: It’s a firm’s best bet about how competition is going to evolve and how
that evolution can be exploited for competitive advantage.
The Strategic Management Process
Although it is usually difficult to know for sure that a firm is pursuing the best
strategy, it is possible to reduce the likelihood that mistakes are being made. The
best way to do this is for a firm to choose its strategy carefully and systemati-
cally and to follow the strategic management process. The strategic management
process is a sequential set of analyses and choices that can increase the likeli-
hood that a firm will choose a good strategy; that is, a strategy that generates
competitive advantages. An example of the strategic management process is pre-
sented in Figure 1.1. Not surprisingly, this book is organized around this strategic
management process.
M01_BARN0088_05_GE_C01.INDD 26 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 27
a Firm’s Mission
The strategic management process begins when a firm defines its mission. A
firm’s mission is its long-term purpose. Missions define both what a firm aspires
to be in the long run and what it wants to avoid in the meantime. Missions are
often written down in the form of mission statements.
Some Missions May n ot a ffect Firm Performance. Most mission statements incorpo-
rate common elements. For example, many define the businesses within which
a firm will operate—medical products for Johnson and Johnson; adhesives and
substrates for 3M—or they can very simply state how a firm will compete in those
businesses. Many even define the core values that a firm espouses.
Indeed, mission statements often contain so many common elements that
some have questioned whether having a mission statement even creates value for
a firm.2 Moreover, even if a mission statement does say something unique about a
company, if that mission statement does not influence behavior throughout an or-
ganization, it is unlikely to have much impact on a firm’s actions. After all, while
Enron was engaging in wide ranging acts of fraud3, it had a mission statement
that emphasized the importance of honesty and integrity.4
Some Missions c an improve Firm Performance. Despite these caveats, research has
identified some firms whose sense of purpose and mission permeates all that
they do. These firms include, for example, 3M, IBM, Philip Morris, Wal-Mart,
and Disney. Some of these visionary firms, or firms whose mission is central to
all they do have enjoyed long periods of high performance.5 From 1926 through
1995, an investment of $1 in one of these firms would have increased in value to
$6,536. That same dollar invested in an average firm over this same time period
would have been worth $415 in 1995.
These visionary firms earned substantially higher returns than average firms
even though many of their mission statements suggest that profit maximizing,
although an important corporate objective, is not their primary reason for
existence. Rather, their primary reasons for existence are typically reflected in a
widely held set of values and beliefs that inform day-to-day decision making.
While, in other firms, managers may be tempted to sacrifice such values and be-
liefs to gain short-term advantages, in these special firms, the pressure for short-
term performance is balanced by widespread commitment to values and beliefs
that focus more on a firm’s long-term performance.6
Of course, that these firms had performed well for many decades does not
mean they will do so forever. Some previously identified visionary firms have
stumbled more recently, including American Express, Ford, Hewlett-Packard,
Motorola, and Sony. Some of these financial problems may be attributable to
the fact that these formally mission-driven companies have lost focus on their
mission.
Mission Objectives
External
Analysis
Internal
Analysis
Strategic
Choice
Strategy
Implementation
Competitive
Advantage
Figure 1.1 The Strategic
Management Process
M01_BARN0088_05_GE_C01.INDD 27 17/09/14 4:15 PM

28 Part 1: The Tools of strategic analysis
Some Missions c an hurt Firm Performance. Although some firms have used their mis-
sions to develop strategies that create significant competitive advantages, missions
can hurt a firm’s performance as well. For example, sometimes a firm’s mission will
be very inwardly focused and defined only with reference to the personal values
and priorities of its founders or top managers, independent of whether those values
and priorities are consistent with the economic realities facing a firm. Strategies
derived from such missions are not likely to be a source of competitive advantage.
For example, Ben & Jerry’s Ice Cream was founded in 1977 by Ben Cohen
and Jerry Greenfield, both as a way to produce super-premium ice cream and as a
way to create an organization based on the values of the 1960s’ counterculture. This
strong sense of mission led Ben & Jerry’s to adopt some very unusual human re-
source and other policies. Among these policies, the company adopted a compensa-
tion system whereby the highest-paid firm employee could earn no more than five
times the income of the lowest-paid firm employee. Later, this ratio was adjusted to
seven to one. However, even at this level, such a compensation policy made it very
difficult to acquire the senior management talent needed to ensure the growth and
profitability of the firm without grossly overpaying the lowest-paid employees in
the firm. When a new CEO was appointed to the firm in 1995, his $250,000 salary
violated this compensation policy.
Indeed, though the frozen dessert market rapidly consolidated through
the late 1990s, Ben & Jerry’s Ice Cream remained an independent firm, partly be-
cause of Cohen’s and Greenfield’s commitment to maintaining the social values
that their firm embodied. Lacking access to the broad distribution network and
managerial talent that would have been available if Ben & Jerry’s had merged
with another firm, the company’s growth and profitability lagged. Finally, in
April 2000, Ben & Jerry’s Ice Cream was acquired by Unilever. The 66 percent
premium finally earned by Ben & Jerry’s stockholders in April 2000 had been
delayed for several years. In this sense, Cohen’s and Greenfield’s commitment
to a set of personal values and priorities was at least partly inconsistent with the
economic realities of the frozen dessert market in the United States.7
Obviously, because a firm’s mission can help, hurt, or have no impact on its
performance, missions by themselves do not necessarily lead a firm to choose and
implement strategies that generate competitive advantages. Indeed, as suggested
in Figure 1.1, while defining a firm’s mission is an important step in the strategic
management process, it is only the first step in that process.
Objectives
Whereas a firm’s mission is a broad statement of its purpose and values, its
objectives are specific measurable targets a firm can use to evaluate the extent
to which it is realizing its mission. High-quality objectives are tightly connected
to elements of a firm’s mission and are relatively easy to measure and track over
time. Low-quality objectives either do not exist or are not connected to elements
of a firm’s mission, are not quantitative, or are difficult to measure or difficult to
track over time. Obviously, low-quality objectives cannot be used by management
to evaluate how well a mission is being realized. Indeed, one indication that a firm
is not that serious about realizing part of its mission statement is when there are no
objectives, or only low-quality objectives, associated with that part of the mission.
external and internal a nalysis
The next two phases of the strategic management process—external analysis
and internal analysis—occur more or less simultaneously. By conducting an
M01_BARN0088_05_GE_C01.INDD 28 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 29
external analysis, a firm identifies the critical threats and opportunities in its
competitive environment. It also examines how competition in this environment
is likely to evolve and what implications that evolution has for the threats and
opportunities a firm is facing. A considerable literature on techniques for and
approaches to conducting external analysis has evolved over the past several
years. This literature is the primary subject matter of Chapter 2 of this book.
Whereas external analysis focuses on the environmental threats and op-
portunities facing a firm, internal analysis helps a firm identify its organizational
strengths and weaknesses. It also helps a firm understand which of its resources
and capabilities are likely to be sources of competitive advantage and which are
less likely to be sources of such advantages. Finally, internal analysis can be used
by firms to identify those areas of its organization that require improvement and
change. As with external analysis, a considerable literature on techniques for and
approaches to conducting internal analysis has evolved over the past several
years. This literature is the primary subject matter of Chapter 3 of this book.
Strategic c hoice
Armed with a mission, objectives, and completed external and internal analyses,
a firm is ready to make its strategic choices. That is, a firm is ready to choose its
theory of how to gain competitive advantage.
The strategic choices available to firms fall into two large categories:
business-level strategies and corporate-level strategies. Business-level strategies
are actions firms take to gain competitive advantages in a single market or indus-
try. These strategies are the topic of Part 2 of this book. The two most common
business-level strategies are cost leadership (Chapter 4) and product differentia-
tion (Chapter 5).
Corporate-level strategies are actions firms take to gain competitive ad-
vantages by operating in multiple markets or industries simultaneously. These
strategies are the topic of Part 3 of this book. Common corporate-level strate-
gies include vertical integration strategies (Chapter 6), diversification strategies
(Chapters 7 and 8), strategic alliance strategies (Chapter 9), merger and acquisi-
tion strategies (Chapter 10), and global strategies (Chapter 11).
Obviously, the details of choosing specific strategies can be quite complex,
and a discussion of these details will be delayed until later in the book. However,
the underlying logic of strategic choice is not complex. Based on the strategic
management process, the objective when making a strategic choice is to choose a
strategy that (1) supports the firm’s mission, (2) is consistent with a firm’s objec-
tives, (3) exploits opportunities in a firm’s environment with a firm’s strengths,
and (4) neutralizes threats in a firm’s environment while avoiding a firm’s weak-
nesses. Assuming that this strategy is implemented—the last step of the strategic
management process—a strategy that meets these four criteria is very likely to be
a source of competitive advantage for a firm.
Strategy implementation
Of course, simply choosing a strategy means nothing if that strategy is not
implemented. Strategy implementation occurs when a firm adopts orga-
nizational policies and practices that are consistent with its strategy. Three
specific organizational policies and practices are particularly important in
implementing a strategy: a firm’s formal organizational structure, its formal
and informal management control systems, and its employee compensation
policies. A firm that adopts an organizational structure, management controls,
M01_BARN0088_05_GE_C01.INDD 29 17/09/14 4:15 PM

30 Part 1: The Tools of strategic analysis
and compensation policy that are consistent with and reinforce its strategies is
more likely to be able to implement those strategies than a firm that adopts an
organizational structure, management controls, and compensation policy that
are inconsistent with its strategies. Specific organizational structures, manage-
ment controls, and compensation policies used to implement the business-
level strategies of cost leadership and product differentiation are discussed in
Chapters 4 and 5. How organizational structure, management controls, and
compensation can be used to implement corporate-level strategies, includ-
ing vertical integration, strategic alliance, merger and acquisition, and global
strategies, is discussed in Chapters 6, 9, 10, and 11, respectively. However,
there is so much information about implementing diversification strategies
that an entire chapter, Chapter 8, is dedicated to the discussion of how this
corporate-level strategy is implemented.
What Is Competitive Advantage?
Of course, the ultimate objective of the strategic management process is to enable
a firm to choose and implement a strategy that generates a competitive advan-
tage. But what is a competitive advantage? In general, a firm has a competitive
advantage when it is able to create more economic value than rival firms.
Economic value is simply the difference between the perceived benefits gained
by a customer that purchases a firm’s products or services and the full economic
cost of these products or services. Thus, the size of a firm’s competitive advantage
is the difference between the economic value a firm is able to create and the eco-
nomic value its rivals are able to create.8
Consider the two firms presented in Figure 1.2. Both these firms compete
in the same market for the same customers. However, Firm I generates $180 of
economic value each time it sells a product or service, whereas Firm II generates
$150 of economic value each time it sells a product or service. Because Firm I
generates more economic value each time it sells a product or service, it has a
competitive advantage over Firm II. The size of this competitive advantage is
equal to the difference in the economic value these two firms create, in this case,
$301$180 – $150 = $302.
However, as shown in the figure, Firm I’s advantage may come from differ-
ent sources. For example, it might be the case that Firm I creates greater perceived
benefits for its customers than Firm II. In panel A of the figure, Firm I creates per-
ceived customer benefits worth $230, whereas Firm II creates perceived customer
benefits worth only $200. Thus, even though both firms’ costs are the same (equal
to $50 per unit sold), Firm I creates more economic value 1$230 – $50 = $1802
than Firm II 1$200 – $50 = $1502. Indeed, it is possible for Firm I, in this situa-
tion, to have higher costs than Firm II and still create more economic value than
Firm II if these higher costs are offset by Firm I’s ability to create greater perceived
benefits for its customers.
Alternatively, as shown in panel B of the figure, these two firms may cre-
ate the same level of perceived customer benefit (equal to $210 in this example)
but have different costs. If Firm I’s costs per unit are only $30, it will generate
$180 worth of economic value 1$210 – $30 = $1802. If Firm II’s costs are $60,
it will generate only $150 of economic value 1$210 – $60 = $1502. Indeed, it
might be possible for Firm I to create a lower level of perceived benefits for its
customers than Firm II and still create more economic value than Firm II, as long
M01_BARN0088_05_GE_C01.INDD 30 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 31
as its disadvantage in perceived customer benefits is more than offset by its cost
advantage.
A firm’s competitive advantage can be temporary or sustained. As summa-
rized in Figure 1.3, a temporary competitive advantage is a competitive advantage
that lasts for a very short period of time. A sustained competitive advantage, in
contrast, can last much longer. How long sustained competitive advantages can
last is discussed in the Research Made Relevant feature. Firms that create the same
economic value as their rivals experience competitive parity. Finally, firms that
generate less economic value than their rivals have a competitive disadvantage.
Not surprisingly, competitive disadvantages can be either temporary or sustained,
depending on the duration of the disadvantage.
Total
Perceived
Customer
Benefits =
$230
Economic
Value
Created =
$180
(A) Firm I’s Competitive Advantage
When It Creates More Perceived Customer Benefits
Total Cost
= $50
Total
Perceived
Customer
Benefits =
$200
Firm II
Firm II
Firm I
Firm I
Economic
Value
Created =
$150
Total Cost
= $50
Total
Perceived
Customer
Benefits =
$210
Economic
Value
Created =
$180
(B) Firm I’s Competitive Advantage
When It Has Lower Costs
Total Cost = $30
Total
Perceived
Customer
Benefits =
$210
Economic
Value
Created =
$150
Total Cost
= $60
Figure 1.2 The Sources of
a Firm’s Competitive Advantage
Competitive Advantage
When a firm creates
more economic value
than its rivals
Temporary
Competitive Advantages
Competitive advantages
that last a short time
Sustained
Competitive Advantages
Competitive advantages
that last a long time
Competitive Disadvantage
When a firm creates
less economic value
than its rivals
Competitive Parity
When a firm creates
the same economic
value as its rivals
Temporary
Competitive Disadvantages
Competitive disadvantages
that last a short time
Sustained
Competitive Disadvantages
Competitive disadvantages
that last a long time
Figure 1.3 Types of Competitive Advantage
M01_BARN0088_05_GE_C01.INDD 31 17/09/14 4:15 PM

32 Part 1: The Tools of strategic analysis

For some time, economists have been interested in how long firms are
able to sustain competitive advantages.
Traditional economic theory predicts
that such advantages should be short-
lived in highly competitive markets.
This theory suggests that any competi-
tive advantages gained by a particular
firm will quickly be identified and imi-
tated by other firms, ensuring competi-
tive parity in the long run. However, in
real life, competitive advantages often
last longer than traditional economic
theory predicts.
One of the first scholars to ex-
amine this issue was Dennis Mueller.
Mueller divided a sample of 472 firms
into eight categories, depending on their
level of performance in 1949. He then
examined the impact of a firm’s initial
performance on its subsequent perfor-
mance. The traditional economic hy-
pothesis was that all firms in the sample
would converge on an average level of
performance. This did not occur. Indeed,
firms that were performing well in an
earlier time period tended to perform
well in later time periods, and firms that
performed poorly in an earlier time pe-
riod tended to perform poorly in later
time periods as well.
Geoffrey Waring followed up
on Mueller’s work by explaining
why competitive advantages seem to
persist longer in some industries than
in others. Waring found that, among
other factors, firms that operate in in-
dustries that (1) are informationally
complex, (2) require customers to
know a great deal in order to use an
industry’s products, (3) require a great
deal of research and development,
and (4) have significant economies of
scale are more likely to have sustained
competitive advantages compared to
firms that operate in industries with-
out these attributes.
Peter Roberts studied the persis-
tence of profitability in one particular
industry: the U.S. pharmaceutical in-
dustry. Roberts found that not only can
firms sustain competitive advantages in
this industry, but that the ability to do
so is almost entirely attributable to the
firms’ capacity to innovate by bringing
out new and powerful drugs.
The most recent work in this
tradition was published by Anita
McGahan and Michael Porter. They
showed that both high and low per-
formance can persist for some time.
Persistent high performance is related
to attributes of the industry within
which a firm operates and the corpo-
ration within which a business unit
functions. In contrast, persistent low
performance was caused by attributes
of a business unit itself.
In many ways, the difference be-
tween traditional economics research
and strategic management research is
that the former attempts to explain why
competitive advantages should not
persist, whereas the latter attempts to
explain when they can. Thus far, most
empirical research suggests that firms,
in at least some settings, can sustain
competitive advantages.
Sources: D. C. Mueller (1977). “The persistence of
profits above the norm.” Economica, 44, pp. 369-380;
P. W. Roberts (1999). “Product innovation, product-
market competition, and persistent profitabil-
ity in the U.S. pharmaceutical industry.” Strategic
Management Journal, 20, pp. 655-670; G. F. Waring
(1996). “Industry differences in the persistence of
firm-specific returns.” The American Economic Review,
86, pp. 1253-1265; A. McGahan and M. Porter (2003).
“The emergence and sustainability of abnormal
profits.” Strategic Organization, 1(1), pp. 79-108.
How Sustainable Are Competitive
Advantages?
research Made relevant
The Strategic Management Process, Revisited
With this description of the strategic management process now complete, it is
possible to redraw the process, as depicted in Figure 1.1, to incorporate the vari-
ous options a firm faces as it chooses and implements its strategy. This is done in
Figure 1.4. Figure 1.4 is the organizing framework that will be used throughout this
book. An alternative way of characterizing the strategic management process—the
business model canvas—is described in the Strategy in Depth feature.
M01_BARN0088_05_GE_C01.INDD 32 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 33
Measuring Competitive Advantage
A firm has a competitive advantage when it creates more economic value than its
rivals. Economic value is the difference between the perceived customer benefits
associated with buying a firm’s products or services and the full cost of producing
and selling these products or services. These are deceptively simple definitions.
However, these concepts are not always easy to measure directly. For example,
the benefits of a firm’s products or services are always a matter of customer per-
ception, and perceptions are not easy to measure. Also, the total costs associated
with producing a particular product or service may not always be easy to identify
or associate with a particular product or service. Despite the very real challenges
associated with measuring a firm’s competitive advantage, two approaches have
emerged. The first estimates a firm’s competitive advantage by examining its ac-
counting performance; the second examines the firm’s economic performance.
These approaches are discussed in the following sections.
Accounting Measures of Competitive Advantage
A firm’s accounting performance is a measure of its competitive advantage cal-
culated by using information from a firm’s published profit and loss and balance
sheet statements. A firm’s profit and loss and balance sheet statements, in turn,
are typically created using widely accepted accounting standards and principles.
The application of these standards and principles makes it possible to compare
the accounting performance of one firm to the accounting performance of other
firms, even if those firms are not in the same industry. However, to the extent that
these standards and principles are not applied in generating a firm’s accounting
statements or to the extent that different firms use different accounting standards
and principles in generating their statements, it can be difficult to compare the ac-
counting performance of firms. These issues can be particularly challenging when
comparing the performance of firms in different countries around the world.
One way to use a firm’s accounting statements to measure its competi-
tive advantage is through the use of accounting ratios. Accounting ratios are
simply numbers taken from a firm’s financial statements that are manipulated
in ways that describe various aspects of a firm’s performance. Some of the most
Mission Objectives
External
Analysis
Internal
Analysis
Strategic Choice Strategy Implementation Competitive Advantage
Impact:
None
Positive
Negative
Measurable
Specific
Business Strategies
— Cost Leadership
— Product
Differentiation
Corporate Strategies
— Vertical Integration
— Strategic Alliances
— Diversification
— Mergers and
Acquisitions
Threats
Opportunities
Strengths
Weaknesses
Organizational Structure
Control Processes
Compensation Policy
Disadvantage
— Temporary
— Sustained
Parity
Advantage
— Temporary
— Sustained
Figure 1.4 Organizing Framework
M01_BARN0088_05_GE_C01.INDD 33 17/09/14 4:15 PM

34 Part 1: The Tools of strategic analysis
Recently, some strategic manage-ment scholars have developed
an alternative approach to character-
izing the strategic management pro-
cess. Rather than starting with mission
statements and objectives and then
proceeding through the different kinds
of analyses that need to be done to
choose and implement a strategy, this
approach starts by identifying activities
that have an impact on the ability of a
firm to create and appropriate economic
value and then specifying exactly how
a particular firm accomplishes these
activities. That set of activities that a
firm engages in to create and appropri-
ate economic value, in this approach, is
called a firm’s business model.
Probably the most influential
approach to identifying a firm’s busi-
ness model was developed by Alex
Osterwalder and Yves Pigneur in their
book Business Model Generator. In the
book, a generic business model—not
unrelated to the generic value chains
that will be introduced in Chapter 3 of
this book—is presented. Because this
approach enables managers to see the
entire landscape of their business in a
single page, this model is called the
business model canvas. This canvas is re-
produced in this feature.
The center of the canvas is
dominated by a box labeled Value
Propositions. A firm’s value propositions
are statements about how it will at-
tempt to create value for its customers,
customer problems it is trying to solve
through its business operations, which
customers it will focus on, and so forth.
Identifying a firm’s value propositions
is very close to identifying its strategy,
as presented in Figure 1.4.
Once a firm’s value propositions
are identified, they have important
implications for the Key Activities
a firm needs to engage in, the Key
Resources it needs to control to engage
in those activities, and the Key Partners
it needs to have to gain access to those
resources. The value propositions
also help determine critical Customer
Relationships, the Channels a firm needs
to use to reach those critical custom-
ers, and which Customer Segments a
firm will address with its products or
services.
If a firm’s key activities, resources,
and partners, on the one hand, and its
customer relationships, channels, and
segments, on the other hand, all support
the execution of its value propositions,
then these activities—collectively—will
improve a firm’s cost structure and rev-
enue streams. Consistent with the defi-
nitions presented in this chapter, the dif-
ference between a firm’s revenues and
costs is a measure of the economic value
created by a firm.
Different business models—as
summarized by the business model
canvas—have been given labels to
help distinguish them. For example,
a “bricks and clicks” business model
(where online retail is integrated
with off-line retail) implies a very
different set of business activities
than a “franchise” business model
(where quasi-independent entrepre-
neurs own and operate retail out-
lets), which are also different from
a “direct” retail model (where firms
eliminate in-process inventory by
having customers order each product
sold), and so forth.
Some scholars have objected
to the introduction of the canvas, ar-
guing that it does not add anything
fundamental to our understanding
of the strategic management process.
Others have suggested that some im-
portant components of that process—
including, for example, organizing
to implement a firm’s strategy—are
left out of the canvas. Others argue
that competition is not well repre-
sented in the canvas—if numbers of
competing firms all adopt the same
business model canvas, how is that
canvas supposed to enhance the com-
petitive position of any one of those
firms? On the other hand, the canvas
is a convenient way to summarize a
wide variety of firm activities, how
those activities are related to one an-
other, and how they ultimately affect
a firm’s costs and revenues. And while
the framework presented in Figure 1.4
will be used to organize the material in
the rest of this book, insights from the
canvas approach will be incorporated
throughout the book as appropriate.
Sources: A. Osterwalder and Y. Pigneur (2010).
Business Model Generator. NY: Wiley. G. George
and A. J. Bock (2011). The business model in prac-
tice and its implications for entrepreneurial re-
search. Entrepreneurship: Theory and Practice, 35(1),
83-111. C. Zott, R. Amit, and L. Massa. (2010).
The Business Model: Theoretical Roots, Recent
Development, and Future Research. Working
Paper 862, IESE, Barcelona, Spain.
The Business Model Canvas
strategy in Depth
M01_BARN0088_05_GE_C01.INDD 34 17/09/14 4:15 PM

35
M01_BARN0088_05_GE_C01.INDD 35 17/09/14 4:15 PM

36 Part 1: The Tools of strategic analysis
Ratio Calculation Interpretation
Profitability Ratios
1. ROA profit after taxes
total assets
A measure of return on total investment in a
firm. Larger is usually better.
2. ROE profit after taxes
total stockholder=s equity
A measure of return on total equity investment
in a firm. Larger is usually better.
3. Gross profit margin sales – cost of goods sold
sales
A measure of sales available to cover operating
expenses and still generate a profit. Larger is
usually better.
4. Earnings per share (EPS) profits 1after taxes2 –
preferred stock dividends
number of shares of common
stock outstanding
A measure of profit available to owners of com-
mon stock. Larger is usually better.
5. Price earnings ratio (p/e) current market price>share
after@tax earnings>share
A measure of anticipated firm performance—a
high p/e ratio tends to indicate that the stock
market anticipates strong future performance.
Larger is usually better.
6. Cash flow per share after@tax profit + depreciation
number of common shares
stock outstanding
A measure of funds available to fund activities
above current level of costs. Larger is usually
better.
Liquidity Ratios
1. Current ratio current assets
current liabilities
A measure of the ability of a firm to cover
its current liabilities with assets that can
be converted into cash in the short term.
Recommended in the range of 2 to 3.
2. Quick ratio current assets – inventory
current liabilities
A measure of the ability of a firm to meet its
short-term obligations without selling off its
current inventory. A ratio of 1 is thought to be
acceptable in many industries.
Leverage Ratios
1. Debt to assets total debt
total assets
A measure of the extent to which debt has
financed a firm’s business activities. The higher,
the greater the risk of bankruptcy.
2. Debt to equity total debt
total equity
A measure of the use of debt versus equity to
finance a firm’s business activities. Generally
recommended less than 1.
3. Times interest earned profit before interest
and taxes
total interest charges
A measure of how much a firm’s profits can
decline and still meet its interest obligations.
Should be well above 1.
TABle 1.1 Common Ratios to Measure a Firm’s Accounting Performance
M01_BARN0088_05_GE_C01.INDD 36 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 37
common accounting ratios that can be used to characterize a firm’s performance
are presented in Table 1.1. These measures of firm accounting performance can be
grouped into four categories: (1) profitability ratios, or ratios with some measure
of profit in the numerator and some measure of firm size or assets in the denomi-
nator; (2) liquidity ratios, or ratios that focus on the ability of a firm to meet its
short-term financial obligations; (3) leverage ratios, or ratios that focus on the
level of a firm’s financial flexibility, including its ability to obtain more debt; and
(4) activity ratios, or ratios that focus on the level of activity in a firm’s business.
Of course, these ratios, by themselves, say very little about a firm. To de-
termine how a firm is performing, its accounting ratios must be compared with
some standard. In general, that standard is the average of accounting ratios of
other firms in the same industry. Using ratio analysis, a firm earns above average
accounting performance when its performance is greater than the industry aver-
age. Such firms typically have competitive advantages, sustained or otherwise. A
firm earns average accounting performance when its performance is equal to the
industry average. These firms generally enjoy only competitive parity. A firm earns
below average accounting performance when its performance is less than the in-
dustry average. These firms generally experience competitive disadvantages.
Consider, for example, the performance of Apple Inc. Apple’s financial state-
ments for 2011 and 2012 are presented in Table 1.2. Losses in this table would be
presented in parentheses. Several ratio measures of accounting performance are
calculated for Apple in these two years in Table 1.2.
Apple’s sales increased dramatically from 2011 to 2012, from just over $108
billion to just over $156 billion. Profitability accounting ratios suggest its profit-
ability during this same time period, from a return on total assets (ROA) of 0.217
to 0.237 and from a return on equity (ROE) of 0.33 to 0.353. Much of this increase
may be attributable to Apple’s increase in its gross profit margin from 0.408
to 0.439. So its sales went up, its overall profitability up, as did its gross profit
margin. This pattern suggests that Apple was able to increase the prices of the
products it was selling in 2012 compared with 2011, either by introducing new
products or more expensive versions of its current products or both.
Apple’s liquidity and leverage ratios remained largely unchanged over
these two years. With current and quick ratios well over 1, it’s pretty clear that
Apple had enough cash on hand to respond to any short-term financial needs.
And its leverage ratios suggest that it still had some opportunities to borrow
money for long-term investments should the need arise.
Overall, the information in Tables 1.2 and 1.3 suggests that Apple Inc., in
2011 and 2012, was, financially speaking, very healthy.
Ratio Calculation Interpretation
Activity Ratios
1. Inventory turnover sales
inventory
A measure of the speed with which a firm’s
inventory is turning over.
2. Accounts receivable
turnover
annual credit sales
accounts receivable
A measure of the average time it takes a firm to
collect on credit sales.
3. Average collection period accounts receivable
average daily sales
A measure of the time it takes a firm to receive
payment after a sale has been made.
M01_BARN0088_05_GE_C01.INDD 37 17/09/14 4:15 PM

38 Part 1: The Tools of strategic analysis
economic Measures of Competitive Advantage
The great advantage of accounting measures of competitive advantage is that
they are relatively easy to compute. All publicly traded firms must make their ac-
counting statements available to the public. Even privately owned firms will typi-
cally release some information about their accounting performance. From these
statements, it is quite easy to calculate various accounting ratios. One can learn
a lot about a firm’s competitive position by comparing these ratios to industry
averages.
However, accounting measures of competitive advantage have at least one
significant limitation. Earlier, economic profit was defined as the difference be-
tween the perceived benefit associated with purchasing a firm’s products or ser-
vices and the cost of producing and selling that product or service. However, one
important component of cost typically is not included in most accounting mea-
sures of competitive advantage: the cost of the capital a firm employs to produce
and sell its products. The cost of capital is the rate of return that a firm promises
2011 2012
Net sales 108,249 156,508
Cost of goods sold 64,431 87,846
Gross margin 43,818 68,662
Selling, general, and administrative expenses 7,599 10,040
R & D expense 2,429 3,381
Total operating expenses 10,028 13,421
Operating income (loss) 33,790 55,241
Total income (loss), before taxes 33,375 55,763
Provision for taxes 8,076 14,052
Net income, after taxes 25,299 41,711
Inventories 776 791
Total current assets 44,988 57,653
Total assets 116,371 176,064
Total current liabilities 27,970 38,542
Total debt 39,756 57,756
Total shareholders’ equity 76,615 118,210
Retained earnings 62,841
TABle 1.2 Apple Inc.’s
Financial Statements for 2011
and 2012 (numbers in millions
of dollars)
2011 2012
ROA 25,299/116,371 = 0.217 41,711/176,064 = 0.237
ROE 25,299/76,615 = 0.353 41,711/118,210 = 0.353
Gross profit margin 108,249 – 64,431 = 0.405
108,249
156,508 – 87,846
= 0.439
156,508
Current ratio 44,988/27,976 = 1.61 57,653/653 = 1.50
Quick ratio 44,988 – 776
= 1.58
27,970
57,653 – 791
= 1.48
38,542
Debt to assets 39,756/116.371 = 0.341 057,756/176,064 = 0.323
Debt to equity 39,756/76,615 = 0.519 57,756/118,210 = 0.489
TABle 1.3 Some Accounting
Ratios for Apple Inc. in 2011 and
2012
M01_BARN0088_05_GE_C01.INDD 38 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 39
to pay its suppliers of capital to induce them to invest in the firm. Once these
investments are made, a firm can use this capital to produce and sell products
and services. However, a firm must provide the promised return to its sources
of capital if it expects to obtain more investment capital in the future. Economic
measures of competitive advantage compare a firm’s level of return to its cost of
capital instead of to the average level of return in the industry.
Generally, there are two broad categories of sources of capital: debt (capital
from banks and bondholders) and equity (capital from individuals and institu-
tions that purchase a firm’s stock). The cost of debt is equal to the interest that a
firm must pay its debt holders (adjusted for taxes) in order to induce those debt
holders to lend money to a firm. The cost of equity is equal to the rate of return a
firm must promise its equity holders in order to induce these individuals and in-
stitutions to invest in a firm. A firm’s weighted average cost of capital (WACC) is
simply the percentage of a firm’s total capital, which is debt times the cost of debt
plus the percentage of a firm’s total capital; that is, equity times the cost of equity.
Conceptually, a firm’s cost of capital is the level of performance a firm
must attain if it is to satisfy the economic objectives of two of its critical stake-
holders: debt holders and equity holders. A firm that earns above its cost of
capital is likely to be able to attract additional capital because debt holders and
equity holders will scramble to make additional funds available for this firm.
Such a firm is said to be earning above normal economic performance and
will be able to use its access to cheap capital to grow and expand its business. A
firm that earns its cost of capital is said to have normal economic performance.
This level of performance is said to be “normal” because this is the level of
performance that most of a firm’s equity and debt holders expect. Firms that
have normal economic performance are able to gain access to the capital they
need to survive, although they are not prospering. Growth opportunities may
be somewhat limited for these firms. In general, firms with competitive parity
usually have normal economic performance. A firm that earns less than its cost
of capital is in the process of liquidating. Below normal economic performance
implies that a firm’s debt and equity holders will be looking for alternative
ways to invest their money, someplace where they can earn at least what they
expect to earn; that is, normal economic performance. Unless a firm with below
normal performance changes, its long-term viability will come into question.
Obviously, firms that have a competitive disadvantage generally have below
normal economic performance.
Measuring a firm’s performance relative to its cost of capital has several
advantages for strategic analysis. Foremost among these is the notion that a firm
that earns at least its cost of capital is satisfying two of its most important stake-
holders: debt holders and equity holders. Despite the advantages of comparing a
firm’s performance to its cost of capital, this approach has some important limita-
tions as well. For example, it can sometimes be difficult to calculate a firm’s cost of
capital. This is especially true if a firm is privately held—that is, if it has stock that
is not traded on public stock markets or if it is a division of a larger company. In
these situations, it may be necessary to use accounting ratios to measure a firm’s
performance. Moreover, some have suggested that although accounting measures
of competitive advantage understate the importance of a firm’s equity and debt
holders in evaluating a firm’s performance, economic measures of competitive
advantage exaggerate the importance of these two particular stakeholders, often
to the disadvantage of other stakeholders in a firm. These issues are discussed in
more detail in the Ethics and Strategy feature.
M01_BARN0088_05_GE_C01.INDD 39 17/09/14 4:15 PM

40 Part 1: The Tools of strategic analysis
The Relationship Between economic and Accounting
Performance Measures
The correlation between economic and accounting measures of competitive
advantage is high. That is, firms that perform well using one of these measures
usually perform well using the other. Conversely, firms that do poorly using one
of these measures normally do poorly using the other. Thus, the relationships
among competitive advantage, accounting performance, and economic perfor-
mance depicted in Figure 1.5 generally hold.
However, it is possible for a firm to have above average accounting per-
formance and simultaneously have below normal economic performance. This
could happen, for example, when a firm is not earning its cost of capital but has
above industry average accounting performance. Also, it is possible for a firm to
have below average accounting performance and above normal economic perfor-
mance. This could happen when a firm has a very low cost of capital and is earn-
ing at a rate in excess of this cost, but still below the industry average.
Emergent Versus Intended Strategies
The simplest way of thinking about a firm’s strategy is to assume that firms
choose and implement their strategies exactly as described by the strategic man-
agement process in Figure 1.1. That is, they begin with a well-defined mission and
objectives, they engage in external and internal analyses, they make their strategic
choices, and then they implement their strategies. And there is no doubt that this
describes the process for choosing and implementing a strategy in many firms.
For example, FedEx, a world leader in the overnight delivery business,
entered this industry with a very well-developed theory about how to gain com-
petitive advantages in this business. Indeed, Fred Smith, the founder of FedEx
(originally known as Federal Express), first articulated this theory as a student in
a term paper for an undergraduate business class at Yale University. Legend has
it that he received only a “C” on the paper, but the company that was founded on
the theory of competitive advantage in the overnight delivery business developed
in that paper has done extremely well. Founded in 1971, FedEx had 2013 sales just
over $44 billion and profits of $2.5 billion.9
Other firms have also begun operations with a well-defined, well-formed
strategy but have found it necessary to modify this strategy so much once it is
actually implemented in the marketplace that it bears little resemblance to the
theory with which the firm started. Emergent strategies are theories of how to
gain competitive advantage in an industry that emerge over time or that have
been radically reshaped once they are initially implemented.10 The relationship
between a firm’s intended and emergent strategies is depicted in Figure 1.6.
Competitive
Advantage
Competitive
Parity
Competitive
Disadvantage
Above Average
Accounting Performance
Average Accounting
Performance
Below Average
Accounting Performance
Above Normal
Economic Performance
Normal Economic
Performance
Below Normal
Economic Performance
Figure 1.5 Competitive
Advantage and Firm
Performance
M01_BARN0088_05_GE_C01.INDD 40 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 41
Several well-known firms have strategies that are, at least partly, emergent.
For example, J&J was originally a supplier of antiseptic gauze and medical plasters.
It had no consumer business at all. Then, in response to complaints about irritation
caused by some of its medical plasters, J&J began enclosing a small packet of tal-
cum powder with each of the medical plasters it sold. Soon customers were asking
to purchase the talcum powder by itself, and the company introduced “Johnson’s
Toilet and Baby Powder.” Later, an employee invented a ready- to-use bandage for
his wife. It seems she often cut herself while using knives in the kitchen. When J&J
marketing managers learned of this invention, they decided to introduce it into
the marketplace. J&J’s Band-Aid products have since become the largest-selling
brand category at J&J. Overall, J&J’s intended strategy was to compete in the medi-
cal products market, but its emergent consumer products strategies now generate
more than 40 percent of total corporate sales.
Another firm with what turns out to be an emergent strategy is the Marriott
Corporation. Marriott was originally in the restaurant business. In the late 1930s,
Marriott owned and operated eight restaurants. However, one of these restaurants
was close to a Washington, D.C., airport. Managers at this restaurant noticed that
airline passengers would come into the restaurant to purchase food to eat on their
trip. J. Willard Marriott, the founder of the Marriott Corporation, noticed this trend
and negotiated a deal with Eastern Airlines whereby Marriott’s restaurant would
deliver prepackaged lunches directly to Eastern’s planes. This arrangement was
later extended to include American Airlines. Over time, providing food service to
airlines became a major business segment for Marriott. Although Marriott’s initial
intended strategy was to operate in the restaurant business, it became engaged
in the emergent food service business at more than 100 airports throughout the
world.11
Some firms have almost entirely emergent strategies. PEZ Candy, Inc.,
for example, manufactures and sells small plastic candy dispensers with car-
toon and movie character heads, along with candy refills. This privately held
firm has made few efforts to speed its growth, yet demand for current and
older PEZ products continues to grow. In the 1990s, PEZ doubled the size of
its manufacturing operation to keep up with demand. Old PEZ dispensers
have become something of a collector’s item. Several national conferences
on PEZ collecting have been held, and some rare PEZ dispensers were once
Intended strategy:
A strategy a firm thought
it was going to pursue.
Realized strategy:
The strategy a firm is
actually pursuing.
Deliberate strategy:
An intended strategy
a firm actually
implements.
Emergent strategy:
A strategy that emerges
over time or that has been
radically reshaped once
implemented.
Unrealized strategy:
An intended strategy a
firm does not actually
implement.
Figure 1.6 Mintzberg’s
Analysis of the Relationship
Between Intended and Realized
Strategies
Source: Reprinted from “Strategy
formation in an adhocracy,” by
H. Mintzberg and A. McHugh,
published in Administrative Science
Quarterly, 30, No. 2, June 1985,
by permission of Administrative
Science Quarterly. Copyright ©
1985 by Administrative Science
Quarterly.
M01_BARN0088_05_GE_C01.INDD 41 17/09/14 4:15 PM

42 Part 1: The Tools of strategic analysis
Considerable debate exists about the role of a firm’s equity and
debt holders versus its other stake-
holders in defining and measuring
a firm’s performance. These other
stakeholders include a firm’s suppli-
ers, its customers, its employees, and
the communities within which it does
business. Like equity and debt hold-
ers, these other stakeholders make in-
vestments in a firm. They, too, expect
some compensation for making these
investments.
On the one hand, some argue
that if a firm maximizes the wealth
of its equity holders, it will automati-
cally satisfy all of its other stakehold-
ers. This view of the firm depends on
what is called the residual claimants
view of equity holders. This view is
that equity holders only receive pay-
ment on their investment in a firm
after all legitimate claims by a firm’s
other stakeholders are satisfied. Thus,
a firm’s equity holders, in this view,
only receive payment on their invest-
ments after the firm’s employees are
compensated, its suppliers are paid, its
customers are satisfied, and its obliga-
tions to the communities within which
it does business have been met. By
maximizing returns to its equity hold-
ers, a firm is ensuring that its other
stakeholders are fully compensated for
investing in a firm.
On the other hand, some ar-
gue that the interests of equity hold-
ers and a firm’s other stakeholders
often collide and that a firm that maxi-
mizes the wealth of its equity holders
does not necessarily satisfy its other
stakeholders. For example, whereas
a firm’s customers may want it to
sell higher- quality products at lower
prices, a firm’s equity holders may
want it to sell low-quality products at
higher prices; this obviously would
increase the amount of money left
over to pay off a firm’s equity hold-
ers. Also, whereas a firm’s employees
may want it to adopt policies that lead
to steady performance over long pe-
riods of time—because this will lead
to stable employment—a firm’s equity
holders may be more interested in its
maximizing its short-term profitabil-
ity, even if this hurts employment sta-
bility. The interests of equity holders
and the broader community may also
clash, especially when it is very costly
for a firm to engage in environmen-
tally friendly behaviors that could re-
duce its short-term performance.
This debate manifests itself in a
variety of ways. For example, many
groups that oppose the globalization
of the U.S. economy do so on the ba-
sis that firms make production, mar-
keting, and other strategic choices
in ways that maximize profits for
equity holders, often to the detriment
of a firm’s other stakeholders. These
people are concerned about the ef-
fects of globalization on workers, on
the environment, and on the cultures
in the developing economies where
global firms sometimes locate their
manufacturing and other operations.
Managers in global firms respond by
saying that they have a responsibil-
ity to maximize the wealth of their
equity holders. Given the passions
that surround this debate, it is un-
likely that these issues will be re-
solved soon.
Sources: T. Copeland, T. Koller, and J. Murrin
(1995). Valuation: Measuring and managing the
value of companies. New York: Wiley; L. Donaldson
(1990). “The ethereal hand: Organizational eco-
nomics and management theory.” Academy of
Review, 15, pp. 369-381.
ethics and strategy
Stockholders Versus Stakeholders
auctioned at Christie’s. This demand has enabled PEZ to raise its prices with-
out increases in advertising, sales personnel, and movie tie-ins so typical in
the candy industry.12
Of course, one might argue that emergent strategies are only important
when a firm fails to implement the strategic management process effectively.
After all, if this process is implemented effectively, then would it ever be neces-
sary to fundamentally alter the strategies that a firm has chosen?
In reality, it will often be the case that at the time a firm chooses its strate-
gies, some of the information needed to complete the strategic management
M01_BARN0088_05_GE_C01.INDD 42 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 43
Every entrepreneur—and would-be entrepreneur—is familiar with the
drill: If you want to receive financial
support for your idea, you need to
write a business plan. Business plans
are typically 25 to 30 pages long. Most
begin with an Executive Summary;
then move quickly to describing an en-
trepreneur’s business idea, why cus-
tomers will be interested in this idea,
how much it will cost to realize this
idea; and usually end with a series of
charts that project a firm’s cash flows
over the next five years.
Of course, because these busi-
ness ideas are often new and un-
tried, no one—including the entre-
preneur—really knows if customers
will like the idea well enough to buy
from this firm. No one really knows
how much it will cost to build these
products or produce these services—
they’ve never been built or produced
before. And, certainly, no one really
knows what a firm’s cash flows will
look like over the next five years or
so. Indeed, it is not unusual for en-
trepreneurs to constantly revise their
business plan to reflect new informa-
tion they have obtained about their
business idea and its viability. It is
not even unusual for entrepreneurs
to fundamentally revise their central
business idea as they begin to pursue
it in earnest.
The truth is, most decisions
about whether to create an entrepre-
neurial firm take place under condi-
tions of high uncertainty and high
unpredictability. In this setting, the
ability to adjust on the fly, to be flex-
ible, and to recast a business idea in
ways that are more consistent with
customer interests may be a central de-
terminant of a firm’s ultimate success.
This, of course, suggests that emergent
strategies are likely to be very impor-
tant for entrepreneurial firms.
This view of entrepreneurship is
different from the popular stereotype.
In the popular view, entrepreneurs
are assumed to be hit by a “blinding
rush of insight” about a previously
unexploited market opportunity. In
reality, entrepreneurs are more likely
to experience a series of smaller in-
sights about market opportunities.
But, typically, these periods of insight
will be preceded by periods of disap-
pointment, as an entrepreneur dis-
covers that what he or she thought
was a new and complete business
model is, in fact, either not new or
not complete or both. In the popular
view, entrepreneurship is all about
creativity, about being able to see op-
portunities others cannot see. In re-
ality, entrepreneurship may be more
about tenacity than creativity because
entrepreneurs build their firms step
by step out of the uncertainty and
unpredictability that plague their de-
cision making. In the popular view,
entrepreneurs can envision their suc-
cess well before it occurs. In reality,
although entrepreneurs may dream
about financial and other forms of
success, they usually do not know the
exact path they will take, nor what
success will actually look like, until
after they have arrived.
Sources: S. Alvarez and J. Barney (2005). “How do
entrepreneurs organize firms under conditions
of uncertainty?” Journal of Management, 31(5),
pp. 776-793; S. Alvarez and J. Barney (2004).
“Organizing rent generation and appropriation:
Toward a theory of the entrepreneurial firm,”
Journal of Business Venturing, 19, pp. 621-636;
W. Gartner (1988). “Who is the entrepreneur? is
the wrong question.” American Journal of Small
Business, 12, pp. 11-32; S. Sarasvathy (2001).
“Causation and effectuation: Toward a theoretical
shift from economic inevitability to entrepreneur-
ial contingency.” Academy of Management Review,
26, pp. 243-264.
emergent Strategies and
entrepreneurship
strategy in the emerging enterprise
process may simply not be available. As suggested earlier, in this setting a
firm simply has to make its “best bet” about how competition in an industry
is likely to emerge. In such a situation, a firm’s ability to change its strategies
quickly to respond to emergent trends in an industry may be as important a
source of competitive advantage as the ability to complete the strategic man-
agement process. For all these reasons, emergent strategies may be particu-
larly important for entrepreneurial firms, as described in the Strategy in the
Emerging Enterprise feature.
M01_BARN0088_05_GE_C01.INDD 43 17/09/14 4:15 PM

44 Part 1: The Tools of strategic analysis
Why You Need to Know About Strategy
At first glance, it may not be obvious why students would need to know about
strategy and the strategic management process. After all, the process of choosing
and implementing a strategy is normally the responsibility of senior managers in a
firm, and most students are unlikely to be senior managers in large corporations un-
til many years after graduation. Why study strategy and the strategic management
process now?
In fact, there are at least three very compelling reasons why it is important
to study strategy and the strategic management process now. First, it can give
you the tools you need to evaluate the strategies of firms that may employ you.
We have already seen how a firm’s strategy can have a huge impact on its com-
petitive advantage. Your career opportunities in a firm are largely determined by
that firm’s competitive advantage. Thus, in choosing a place to begin or continue
your career, understanding a firm’s theory of how it is going to gain a competi-
tive advantage can be essential in evaluating the career opportunities in a firm.
Firms with strategies that are unlikely to be a source of competitive advantage
will rarely provide the same career opportunities as firms with strategies that do
generate such advantages. Being able to distinguish between these types of strate-
gies can be very important in your career choices.
Second, once you are working for a firm, understanding that firm’s strategies,
and your role in implementing those strategies, can be very important for your
personal success. It will often be the case that expectations of how you perform
your function in a firm will change, depending on the strategies a firm is pursuing.
For example, as we will see in Part 2 of this book, the accounting function plays a
very different role in a firm pursuing a cost leadership strategy versus a product
differentiation strategy. Marketing and manufacturing also play very different roles
in these two types of strategies. Your effectiveness in a firm can be reduced by do-
ing accounting, marketing, and manufacturing as if your firm were pursuing a cost
leadership strategy when it is actually pursuing a product differentiation strategy.
Finally, although it is true that strategic choices are generally limited to very
experienced senior managers in large organizations, in smaller and entrepreneur-
ial firms many employees end up being involved in the strategic management
process. If you choose to work for one of these smaller or entrepreneurial firms—
even if it is not right after graduation—you could very easily find yourself to be
part of the strategic management team, implementing the strategic management
process and choosing which strategies this firm should implement. In this setting,
a familiarity with the essential concepts that underlie the choice and implementa-
tion of a strategy may turn out to be very helpful.
Summary
A firm’s strategy is its theory of how to gain competitive advantages. These theories, like
all theories, are based on assumptions and hypotheses about how competition in an in-
dustry is likely to evolve. When those assumptions and hypotheses are consistent with the
actual evolution of competition in an industry, a firm’s strategy is more likely to be able to
generate a competitive advantage.
One way that a firm can choose its strategies is through the strategic management pro-
cess. This process is a set of analyses and decisions that increase the likelihood that a firm will
be able to choose a “good” strategy, that is, a strategy that will lead to a competitive advantage.
M01_BARN0088_05_GE_C01.INDD 44 17/09/14 4:15 PM

chapter 1: What is strategy and the strategic Management Process? 45
The strategic management process begins when a firm identifies its mission, or its long-
term purpose. This mission is often written down in the form of a mission statement. Mission
statements, by themselves, can have no impact on performance, enhance a firm’s performance,
or hurt a firm’s performance. Objectives are measurable milestones firms use to evaluate
whether they are accomplishing their missions. External and internal analyses are the processes
through which a firm identifies its environmental threats and opportunities and organizational
strengths and weaknesses. Armed with these analyses, it is possible for a firm to engage in stra-
tegic choice. Strategies can be classified into two categories: business-level strategies (including
cost leadership and product differentiation) and corporate-level strategies (including vertical
integration, strategic alliances, diversification, and mergers and acquisitions). Strategy imple-
mentation follows strategic choice and involves choosing organizational structures, manage-
ment control policies, and compensation schemes that support a firm’s strategies.
The ultimate objective of the strategic management process is the realization of
competitive advantage. A firm has a competitive advantage if it is creating more economic
value than its rivals. Economic value is defined as the difference between the perceived
customer benefits from purchasing a product or service from a firm and the total economic
cost of developing and selling that product or service. Competitive advantages can be
temporary or sustained. Competitive parity exists when a firm creates the same economic
value as its rivals. A competitive disadvantage exists when a firm creates less economic
value than its rivals, and it can be either temporary or sustained.
Two popular measures of a firm’s competitive advantage are accounting perfor-
mance and economic performance. Accounting performance measures competitive ad-
vantage using various ratios calculated from a firm’s profit and loss and balance sheet
statements. A firm’s accounting performance is compared with the average level of
accounting performance in a firm’s industry. Economic performance compares a firm’s
level of return with its cost of capital. A firm’s cost of capital is the rate of return it had
to promise to pay to its debt and equity investors to induce them to invest in the firm.
Although many firms use the strategic management process to choose and imple-
ment strategies, not all strategies are chosen this way. Some strategies emerge over time,
as firms respond to unanticipated changes in the structure of competition in an industry.
Students need to understand strategy and the strategic management process for at
least three reasons. First, it can help in deciding where to work. Second, once you have
a job it can help you to be successful in that job. Finally, if you have a job in a small or
entrepreneurial firm you may become involved in strategy and the strategic management
process from the very beginning.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
challenge Questions
1.1. Some firms publicize their corpo-
rate mission statements by including
them in annual reports, on company let-
terheads, and in corporate advertising.
What, if anything, does this practice say
about the ability of these mission state-
ments to be sources of sustained com-
petitive advantage for a firm?
1.2. Why would including a corpo-
rate mission statement on company
letterhead or in corporate advertising
be seen as a source of sustained com-
petitive advantage?
1.3. Little empirical evidence indi-
cates that having a formal, written
mission statement improves a firm’s
performance. Yet many firms spend
a great deal of time and money
developing mission statements. Why?
1.4. Firm 2 generates a perceived
customer benefit of $200 at a cost
of $50. Compare this with Firm 1’s
M01_BARN0088_05_GE_C01.INDD 45 17/09/14 4:15 PM

46 Part 1: The Tools of strategic analysis
Problem set
1.13. Write objectives for each of the following mission statements.
(a) We will be a leader in pharmaceutical innovation.
(b) Customer satisfaction is our primary goal.
(c) We promise on-time delivery.
(d) Product quality is our first priority.
1.14. The following objectives need to inform a firm’s strategic planning. Can you modify
them to be more actionable?
(a) We will improve productivity
(b) Our product features will be enhanced every year
(c) The cost of raw materials will fall
(d) We will delight all our clients
1.15. Do firms with the following financial results have below normal, normal, or above
normal economic performance?
(a) ROA = 14.3%, WACC = 12.8%
(b) ROA = 4.3%, WACC = 6.7%
(c) ROA = 6.5%, WACC = 9.2%
(d) ROA = 8.3%, WACC = 8.3%
1.16. For each of the following cases, comment on the firm’s performance in relative and
absolute terms.
(a) WACC < ROA < Industry Avg. ROA (b) WACC > ROA > Industry Avg. ROA
(c) ROA > Industry Avg. ROA > WACC
(d) ROA < Industry Avg. ROA < WACC 1.17. Is it possible for a firm to simultaneously earn above normal economic returns and below average accounting returns? What about below normal economic returns and above average accounting returns? Why or why not? If this can occur, which measure of perfor- mance is more reliable: economic performance or accounting performance? Explain. customer benefit of $220 generated at a cost of $30. What is the source of Firm 1’s advantage? Provide real-life examples of firms that match Firm 1. 1.5. Both external and internal analyses are important in the strategic manage- ment process. Is the order in which these analyses are conducted important? 1.6. If the order of analyses is impor- tant, which should come first: external analysis or internal analysis? 1.7. Concerning external analysis and internal analysis, if the order of analyses is not important, why not? 1.8. Will a firm that has a sustained competitive disadvantage necessarily go out of business? 1.9. Will a firm with below average accounting performance over a long period of time necessarily go out of business? 1.10. Will a firm with below normal economic performance over a long period of time necessarily go out of business? 1.11. Can more than one firm have a competitive advantage in an industry at the same time? 1.12. Is it possible for a firm to simultaneously have a competitive advantage and a competitive disadvantage? M01_BARN0088_05_GE_C01.INDD 46 17/09/14 4:15 PM chapter 1: What is strategy and the strategic Management Process? 47 1.18. Examine the corporate Web sites of the following companies and determine if the strategies pursued by these firms were emergent, deliberate, or both emergent and deliber- ate. Justify your answer with facts from the Web sites. (a) Lenovo (b) Mercedes-Benz (c) Airtel 1.19. Using the information provided, calculate this firm’s ROA, ROE, gross profit mar- gin, and quick ratio. If this firm’s WACC is 6.6 percent and the average firm in its industry has an ROA of 8 percent, is this firm earning above or below normal economic perfor- mance and above or below average accounting performance? Net sales 6,134 Operating cash 3,226 Net other operating assets 916 Cost of goods sold (4,438) Accounts receivable 681 Total assets 5,161 Selling, general administrative expenses (996) Inventories 20 Net current liabilities 1,549 Other current assets 0 Long-term debt 300 Other expenses (341) Total current assets 3,927 Deferred income taxes 208 Interest income 72 Gross properties, plant, equipment 729 Preferred stock 0 Interest expense (47) Retained earnings 0 Provision for taxes (75) Accumulated depreciation (411) Common stock 3,104 Other income 245 Book value of fixed assets 318 Other liabilities 0 Net income 554 Goodwill 0 Total liabilities and equity 5,161 MyManagementLab® Go to mymanagementlab.com for the following Assisted-graded writing questions: 1.20. Describe what visionary firms may do to earn substantially higher returns than average firms. 1.21. What is the relationship between a firm’s business model and its value proposition? end notes 1. This approach to defining strategy was first suggested in Drucker, P. (1994). “The theory of business.” Harvard Business Review, 75, September-October, pp. 95-105. 2. This approach to defining strategy was first suggested in Drucker, P. (1994). “The theory of business.” Harvard Business Review, 75, September-October, pp. 95-105. 3. See www.enron.com. 4. See Emshwiller, J., D. Solomon, and R. Smith. (2004). “Lay is indicted for his role in Enron collapse.” The Wall Street Journal, July 8, pp. A1+; Gilmartin, R. (2005). “They fought the law.” BusinessWeek, January 10, pp. 82-83. 5. These performance results were presented originally in Collins, J. C., and J. I. Porras. (1997). Built to last: Successful habits of visionary compa- nies. New York: HarperCollins. 6. Collins, J. C., and J. I. Porras. (1997). Built to last: successful habits of visionary companies. New York: HarperCollins. 7. See Theroux, J., and J. Hurstak. (1993). “Ben & Jerry’s Homemade Ice Cream Inc.: Keeping the mission(s) alive.” Harvard Business School Case No. 9-392-025; Applebaum, A. (2000). “Smartmoney.com: Unilever feels hungry, buys Ben & Jerry’s.” The Wall Street Journal, April 13, pp. B1+. 8. This definition of competitive advantage has a long history in the field of strategic management. For example, it is closely related to the definitions provided in Barney (1986, 1991) and Porter (1985). It is also consistent with the value-based approach described in Peteraf (2001), Brandenburger and Stuart (1999), and Besanko, Dranove, and Shanley (2000). For more discussion on this definition, see Peteraf and Barney (2004). 9. FedEx’s history is described in Trimble, V. (1993). Overnight success: Federal Express and Frederick Smith, its renegade creator. New York: Crown. 10. Mintzberg, H. (1978). “Patterns in strategy formulation.” Management Science, 24(9), pp. 934-948; and Mintzberg, H. (1985). “Of strategies, deliberate and emergent.” Strategic Management Journal, 6(3), pp. 257-272. Mintzberg has been most influential in expanding the study of strategy to include emergent strategies. 11. The J&J and Marriott emergent strategy stories can be found in Collins, J. C., and J. I. Porras. (1997). Built to last: Successful habits of visionary companies. New York: HarperCollins. 12. See McCarthy, M. J. (1993). “The PEZ fancy is hard to explain, let alone justify.” The Wall Street Journal, March 10, p. A1, for a discussion of PEZ’s surprising emergent strategy. M01_BARN0088_05_GE_C01.INDD 47 17/09/14 4:15 PM 48 1. Describe the dimensions of the general environment facing a firm and how this environment can affect a firm’s opportunities and threats. 2. Describe how the structure-conduct-performance (S-C-P) model suggests that industry structure can influence a firm’s competitive choices. 3. Describe the five environmental threats and indicators of when each of these forces will improve or reduce the attractiveness of an industry. iTunes and the Streaming Challenge It w as a nor mal Wednesday, February 24, 2010. Seventy-one-year-old L ouie Sulc e, fr om Woodstock, G eorgia, had just finished do wnloading a song fr om one of his fa vorite c ountry artists—Johnny Cash’s “Guess Things Happen tha t Way”—from the iT unes store. Suddenly, the phone rang. It w as S teve Jobs , CEO of A pple calling t o c ongratulate M r. Sulc e f or do wnloading the 10 billionth song fr om the iTunes store. For being “Mr. 10 Billion,” Mr. Sulce received a $10,000 iTunes store gift card. This story is interesting on several dimensions. First, it signaled the remarkable growth of iTunes. Founded on A pril 28, 2003, iT unes grew steadily, reaching the 1 billion do wnload mark less than three years later, on February 23, 2006. But with the growing popularity of Apple’s iPod MP3 player and, later, its iPhone and iPad, iTunes downloads began to take off. It took less than a year to go from 1 billion to 2 billion downloads, less than six mon ths to get to 3 billion, and so forth. B y February 6, 2013, mor e than 25 billion songs had been do wnloaded from iTunes. B y September 12, 2006, iTunes had 88 percent of the legal download market in the United States. And this g rowth w asn’t limit ed t o just do wnloaded songs . O ver the y ears, the r ange of products sold by iTunes has expanded from songs to movies, television shows, video games, and other media products. 4. Describe how rivals and substitutes differ. 5. Discuss the role of complements in analyzing competition within an industry. 6. Describe four generic industry structures and specific strategic opportunities in those industries. 7. Describe the impact of tariffs, quotas, and other non- tariff barriers to entry on the cost of entry into new geographic markets. L e a r n i n g O b j e C T i v e S After reading this chapter, you should be able to: MyManagementLab® improve Your grade! Over 10 million students improved their results using the Pearson MyLabs. Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems. 2 C h a p T e r Evaluating a Firm’s External Environment M02_BARN0088_05_GE_C02.INDD 48 13/09/14 3:21 PM 49 Not surprisingly, iTunes revenues grew right along with the growth in iTunes downloads. With first-year revenues of $278 million, iTunes rev- enues had grown to $2.4 billion in the first quarter of 2013. But Mr. Sulce’s story is interesting in another way as well—a 71-year- old man was using iTunes to download music. By 2010, iTunes was no lon- ger a Web site for technologically sophisticated young people to buy their music; it was the place where everyone bought their music. By June 2013, iTunes had mor e than 575 million ac tive accounts supporting 315 million mobile devices in 119 countries. It has been the largest music vendor in the United States since April 2008 and the largest in the world since February 2010. But such success and growth were bound to attract competition. In 2007, Amazon became an important rival for iTunes as it began selling on - line music downloads at a price lower than iTunes. In 2013, Amazon’s share of the U .S. music do wnload market had r isen to 22 per cent—still smaller than iTunes’ share, but significant growth nevertheless. Perhaps ev en mor e impor tantly, some impor tant substitut es f or iTunes had begun t o emer ge. I n par ticular, music str eaming ser vices— where consumers listen to but do not buy music—were beginning to grow. In 2013, t wo v ersions of these str eaming ser vices e xisted: subscr iption services—including one Spotify service, Rdio, and Rhapsody—where consumers paid a monthly fee for unlimited music ac cess and adv ertising-supported services—including a sec ond Spotify service and Pandora—that provided unlimited access for free but required consumers to listen to commercials periodically. Streaming services had several perceived advantages over iTunes. For example, these ser- vices provided instant access to a much wider v ariety of music than in most people ’s purchased collections. Also, users of these services did not have to use so much of the memory in their de- vices storing music. By 2013, iTunes’ share of the music download business had dropped from 69 percent to 63 percent, mostly due to the increased popularity of music streaming services. Indeed, in 2013, iT unes announc ed tha t it w ould in troduce an adv ertising-supported streaming product on the iTunes store. Whether this will be enough to enable iTunes to retain its dominant position in the download industry remains to be seen. Sources: Andy Fixmer. April 25, 2013. “Apple’s 10-Year-Old iTunes Loses Ground to Streaming,” http://www.businessweek.com/ articles/2013-04-25/apples-10-year-old-itunes-loses-ground-to-streaming. Accessed July 3, 2013; Apple Press Release. “iTunes Serves Up 10 Billionth Song Download,” February 2010. Accessed July 3, 2013; E. Smith (2006) “Can Anybody Catch iTunes?” Wall Street Journal, November 27, pp. R1+ . © G al lo Im ag es /A la m y M02_BARN0088_05_GE_C02.INDD 49 13/09/14 3:21 PM 50 Part 1: The Tools of Strategic Analysis The strategic management process described in Chapter 1 suggested that one of the critical determinants of a firm’s strategies is the threats and opportu-nities in its competitive environment. If a firm understands these threats and opportunities, it is one step closer to being able to choose and implement a “good strategy”; that is, a strategy that leads to competitive advantage. iTunes is clearly in this position in the music download industry. Despite its dominant position, rivals—like Amazon—and substitutes—like Spotify and Pandora—have both emerged. Of course, it is not enough to recognize that it is important to understand the threats and opportunities in a firm’s competitive environment. A set of tools that managers can apply to systematically complete this external analysis as part of the strategic management process is also required. These tools must be rooted in a strong theoretical base, so that managers know that they have not been developed in an arbitrary way. Fortunately, such tools exist and will be described in this chapter. Understanding a Firm’s General Environment Any analysis of the threats and opportunities facing a firm must begin with an understanding of the general environment within which a firm operates. This general environment consists of broad trends in the context within which a firm operates that can have an impact on a firm’s strategic choices. As depicted in Figure 2.1, the general environment consists of six interrelated elements: techno- logical change, demographic trends, cultural trends, the economic climate, legal and political conditions, and specific international events. Each of these elements of the general environment is discussed in this section. In 1899, Charles H. Duell, commissioner of the U.S. patent office, said, “Everything that can be invented has been invented.”1 He was wrong. Technological changes over the past few years have had significant impacts on the ways firms do business and on the products and services they sell. Technological Change Specific International Events Cultural Trends Demographic Trends Legal and Political Conditions Economic Climate Firm Figure 2.1 The General Environment Facing Firms M02_BARN0088_05_GE_C02.INDD 50 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 51 These impacts have been most obvious for technologies that build on digital information— computers, the Internet, cell phones, and so forth. Many of us routinely use digital products or services that did not exist just a few years ago. However, rapid technological innovation has not been restricted to digital tech- nologies. Biotechnology has also made rapid progress over the past 10 years. New kinds of medicines are now being created. As important, biotechnology holds the promise of developing entirely new ways of both preventing and treating disease.2 Technological change creates both opportunity, as firms begin to explore how to use technology to create new products and services, and threats, as tech- nological change forces firms to rethink their technological strategies. A second element of the general environment facing firms is demographic trends. Demographics is the distribution of individuals in a society in terms of age, sex, marital status, income, ethnicity, and other personal attributes that may determine buying patterns. Understanding this basic information about a popu- lation can help a firm determine whether its products or services will appeal to customers and how many potential customers for these products or services it might have. Some demographic trends are very well known. For example, everyone has heard of the “baby boomers”—those who were born shortly after World War II. This large population has had an impact on the strategies of many firms, espe- cially as the boomers have grown older and have had more disposable income. However, other demographic groups have also had an impact on firm strategies. This is especially true in the automobile industry. For example, minivans were invented to meet the demands of “soccer moms”—women who live in the suburbs and have young children. The Nissan Xterra seems to have been designed for the so-called Generation Y—young men and women currently in their 20s and either just out of college or anticipating graduation shortly. In the United States, an important demographic trend over the past 20 years has been the growth of the Hispanic population. In 1990, the percentage of the U.S. population that was African American was greater than the percentage that was Hispanic. However, by 2000, people of Latin descent outnumbered African Americans. Currently, Hispanics constitute almost 15 percent of the U.S. popula- tion, whereas the percentage of African Americans remains constant at less than 8 percent. These trends are particularly notable in the South and Southwest. For example, more than 36 percent of children under 18 in Houston are Hispanic, 39 percent in Miami and San Diego, 53 percent in Los Angeles, and more than 61 percent in San Antonio.3 Of course, firms are aware of this growing population and its buying power. Indeed, Hispanic disposable income in the United States jumped 29 percent, to $652 billion, from 2001 to 2003. In response, firms have begun marketing directly to the U.S. Hispanic population. In one year, Procter & Gamble spent $90 million market- ing directly to Spanish-speaking customers. Procter & Gamble has also formed a 65-person bilingual team to manage the marketing of products to Hispanics. Indeed, Procter & Gamble expects that the Hispanic population will be the corner- stone of its sales growth in North America.4 Firms can try to exploit their understanding of a particular demographic seg- ment of the population to create a competitive advantage—as Procter & Gamble is doing with the U.S. Hispanic population—but focusing on too narrow a demo- graphic segment can limit demand for a firm’s products. The WB, the alternative television network created by Time Warner in 1995, faced this dilemma. Initially, the M02_BARN0088_05_GE_C02.INDD 51 13/09/14 3:21 PM 52 Part 1: The Tools of Strategic Analysis WB found success in producing shows for teens—classics such as Dawson’s Creek and Buffy the Vampire Slayer. However, in 2003, the WB saw an 11 percent drop in viewership and a $25 million drop in advertising revenues. Although it did not leave its traditional demographic behind, the WB began producing some programs intended to appeal to older viewers. Ultimately, the WB merged with UPN to form a new network, the CW network. CW is a joint venture between CBS (owner of UPN) and Time Warner (owner of the WB).5 A third element of a firm’s general environment is cultural trends. Culture is the values, beliefs, and norms that guide behavior in a society. These values, be- liefs, and norms define what is “right and wrong” in a society, what is acceptable and unacceptable, what is fashionable and unfashionable. Failure to understand changes in culture, or differences between cultures, can have a very large impact on the ability of a firm to gain a competitive advantage. This becomes most obvious when firms operate in multiple countries simultaneously. Even seemingly small differences in culture can have an im- pact. For example, advertisements in the United States that end with a person putting their index finger and thumb together mean that a product is “okay”; in Brazil, the same symbol is vulgar and offensive. Ads in the United States that have a bride dressed in white may be very confusing to the Chinese because, in China, white is the traditional color worn at funerals. In Germany, women typi- cally purchase their own engagement rings, whereas in the United States, men purchase engagement rings for their fiancées. And what might be appropriate ways to treat women colleagues in Japan or France would land most men in U.S. firms in serious trouble. Understanding the cultural context within which a firm operates is important in evaluating the ability of a firm to generate competitive advantages.6 A fourth element of a firm’s general environment is the current economic climate. The economic climate is the overall health of the economic systems within which a firm operates. The health of the economy varies over time in a distinct pattern: Periods of relative prosperity, when demand for goods and ser- vices is high and unemployment is low, are followed by periods of relatively low prosperity, when demand for goods and services is low and unemployment is high. When activity in an economy is relatively low, the economy is said to be in recession. A severe recession that lasts for several years is known as a depression. This alternating pattern of prosperity followed by recession, followed by prosper- ity, is called the business cycle. Throughout the 1990s, the world, and especially the United States, enjoyed a period of sustained economic growth. Some observers even speculated that the government had become so skilled at managing demand in the economy through adjusting interest rates that a period of recession did not necessarily have to fol- low a period of sustained economic growth. Of course, the business cycle has reared its ugly head twice since the 1990s—first with the technology bubble-burst around 2001 and, more recently, in the credit crunch in 2008. Most observers now agree that although government policy can have a significant impact on the frequency and size of economic downturns, these policies are unlikely to be able prevent these downturns altogether. A fifth element of a firm’s general environment is legal and political conditions. The legal and political dimensions of an organization’s general en- vironment are the laws and the legal system’s impact on business, together with the general nature of the relationship between government and business. These M02_BARN0088_05_GE_C02.INDD 52 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 53 laws and the relationship between business and government can vary signifi- cantly around the world. For example, in Japan, business and the government are generally seen as having a consistently close and cooperative relation- ship. Indeed, some have observed that one reason that the Japanese economy has been growing so slowly over the past decade has been the government’s reluctance to impose economic restructuring that would hurt the perfor- mance of some Japanese firms—especially the largest Japanese banks. In the United States, however, the quality of the relationship between business and the government tends to vary over time. In some administrations, rigorous antitrust regulation and tough environmental standards—both seen as inconsistent with the interests of business—dominate. In other administrations, antitrust regula- tion is less rigorous and the imposition of environmental standards is delayed, suggesting a more business-friendly perspective. A final attribute of a firm’s general environment is specific international events. These include events such as civil wars, political coups, terrorism, wars between countries, famines, and country or regional economic recessions. All of these specific events can have an enormous impact on the ability of a firm’s strate- gies to generate competitive advantage. Of course, one of the most important of these specific events to have oc- curred over the past several decades was the terrorist attacks on New York City and Washington, D.C., on September 11, 2001. Beyond the tragic loss of life, these attacks had important business implications as well. For example, it took more than five years for airline demand to return to pre–September 11 levels. Insurance companies had to pay out billions of dollars in unanticipated claims as a result of the attacks. Defense contractors saw demand for their products soar as the United States and some of its allies began waging war in Afghanistan and then Iraq. A firm’s general environment defines the broad contextual background within which it operates. Understanding this general environment can help a firm identify some of the threats and opportunities it faces. However, this general environment often has an impact on a firm’s threats and opportunities through its impact on a firm’s more local environment. Thus, while analyzing a firm’s general environment is an important step in any application of the strategic management process, this general analysis must be accompanied by an analysis of a firm’s more local environment if the threats and opportunities facing a firm are to be fully understood. The next section discusses specific tools for analyzing a firm’s local environment and the theoretical perspectives from which these tools have been derived. The Structure-Conduct-Performance Model of Firm Performance In the 1930s, a group of economists began developing an approach for understanding the relationship among a firm’s environment, behavior, and performance. The original objective of this work was to describe conditions under which competition in an industry would not develop. Understanding when competition was not developing in an industry assisted government regulators in identifying industries where competition-enhancing regulations should be implemented.7 M02_BARN0088_05_GE_C02.INDD 53 13/09/14 3:21 PM 54 Part 1: The Tools of Strategic Analysis One of the basic tenets of economic theory is that society is better off when industries are very competi- tive. Industries are very competitive when there are large numbers of firms operating in an industry, when the products and services that these firms sell are similar to each other, and when it is not very costly for firms to enter into or exit these industries. Indeed, as is described in more detail in the Strategy in Depth feature, these indus- tries are said to be perfectly competitive. The reasons that society is bet- ter off when industries are perfectly competitive are well known. In such industries, firms must constantly strive to keep their costs low, keep their quality high, and, when appro- priate, innovate if they are to even survive. Low costs, high quality, and appropriate innovation are generally consistent with the interests of a firm’s customers and, thus, consistent with society’s overall welfare. Indeed, concern for social wel- fare, or the overall good of society, is the primary reason the S-C-P model was developed. This model was to be used to identify industries where perfect competition was not occur- ring and, thus, where social welfare was not being maximized. With these industries identified, the government could then engage in activities to in- crease the competitiveness of these industries, thereby increasing social welfare. Strategic management scholars turned the S-C-P model upside down by using it to describe industries where firms could gain competitive advan- tages and attain above-average perfor- mance. However, some have asked that if strategic management is all about creating and exploiting competitive imperfections in industries, is strategic management also all about reducing the overall good of society for advan- tages to be gained by a few firms? It is not surprising that individuals who are more interested in improving society than improving the performance of a few firms question the moral legitimacy of the field of strategic management. However, there is another view about strategic management and so- cial welfare. The S-C-P model assumes that any competitive advantages a firm has in an industry must hurt society. The alternative view is that at least some of the competitive advan- tages exist because a firm addresses customer needs more effectively than its competitors. From this perspective, competitive advantages are not bad for social welfare; they are actually good for social welfare. Of course, both perspectives can be true. For example, a firm such as Microsoft has engaged in activities that at least some courts have concluded are inconsistent with social welfare. However, Microsoft also sells applica- tions software that is routinely ranked among the best in the industry, an ac- tion that is consistent with meeting customer needs in ways that maximize social welfare. Sources: J. B. Barney (1986). “Types of compe- tition and the theory of strategy.” Academy of Management Review, 11, pp. 791–800; H. Demsetz (1973). “Industry structure, market rivalry, and public policy.” Journal of Law and Economics, 16, pp. 1–9; M. Porter (1981). “The contribution of industrial organization to strategic management.” Academy of Management Review, 6, pp. 609–620. Ethics and Strategy Is a Firm Gaining a Competitive Advantage Good for Society? The theoretical framework that developed out of this effort became known as the structure-conduct-performance (S-C-P) model; it is summarized in Figure 2.2. The term structure in this model refers to industry structure, measured by such factors as the number of competitors in an industry, the heterogeneity of products in an industry, the cost of entry and exit in an industry, and so forth. Conduct refers to the strategies that firms in an industry implement. Performance in the S-C-P model has two meanings: (1) the performance of individual firms and (2) the performance of the economy as a whole. Although both definitions of perfor- mance in the S-C-P model are important, as suggested in Chapter 1, the strategic M02_BARN0088_05_GE_C02.INDD 54 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 55 management process is much more focused on the performance of individual firms than on the performance of the economy as a whole. That said, the relation- ship between these two types of performance can sometimes be complex, as de- scribed in the Ethics and Strategy feature. The logic that links industry structure to conduct and performance is well known. Attributes of the industry structure within which a firm operates define the range of options and constraints facing a firm. In some industries, firms have very few options and face many constraints. In general, firms in these industries can only gain competitive parity. In this setting, industry structure completely determines both firm conduct and long-run firm performance. However, in other, less competitive industries, firms face fewer constraints and a greater range of conduct options. Some of these options may enable them to obtain competitive advantages. However, even when firms have more conduct options, industry structure still constrains the range of options. Moreover, as will be shown in more detail later in this chapter, industry structure also has an impact on how long firms can expect to maintain their competitive advantages in the face of increased competition. A Model of Environmental Threats As a theoretical framework, the S-C-P model has proven to be very useful in informing both research and government policy. However, the model can sometimes be awkward to use to identify threats in a firm’s local environment. Fortunately, several scholars have developed models of environmental threats based on the S-C-P model that are highly applicable in identifying threats facing a particular firm.8 These models identify the five most common threats, presented in Figure 2.3, faced by firms in their local competitive environments and the Industry structure Number of competing firms Homogeneity of products Cost of entry and exit Firm conduct Strategies firms pursue to gain competitive advantage Performance Firm level: competitive disadvantage, parity, temporary or sustained competitive advantage Society: productive and allocative efficiency, level of employment, progress Figure 2.2 The Structure- Conduct-Performance Model M02_BARN0088_05_GE_C02.INDD 55 13/09/14 3:21 PM 56 Part 1: The Tools of Strategic Analysis conditions under which these threats are more or less likely to be present. The relationship between the S-C-P model and the framework presented in Figure 2.3 is discussed in the Strategy in Depth feature. To a firm seeking competitive advantages, an environmental threat is any individual, group, or organization outside a firm that seeks to reduce the level of that firm’s performance. Threats increase a firm’s costs, decrease a firm’s revenues, or in other ways reduce a firm’s performance. In S-C-P terms, environ- mental threats are forces that tend to increase the competitiveness of an industry and force firm performance to competitive parity level. The five common envi- ronmental threats identified in the literature are: (1) threat from new competition, (2) threat from competition among existing competitors, (3) threat from superior or low-cost substitutes, (4) threat of supplier leverage, and (5) threats from buyers’ influence. Threat from New Competition The first environmental threat identified in Figure 2.3 is the threat of new com- petitors. New competitors are firms that have either recently started operating in an industry or that threaten to begin operations in an industry soon. For the music download industry, Amazon is a new competitor. For televised sports, Fox Sports, NBC Sports Network, and CBS Sports Network are new competitors.9 According to the S-C-P model, new competitors are motivated to enter into an industry by the superior profits that some incumbent firms in that industry may be earning. Firms seeking these high profits enter the industry, thereby increasing the level of industry competition and reducing the performance of incumbent firms. With the absence of any barriers, entry will continue as long as any firms in the industry are earning competitive advantages, and entry will cease when all incumbent firms are earning competitive parity. The extent to which new competitors act as a threat to an incumbent firm’s performance depends on the cost of entry. If the cost of entry into an industry is greater than the potential profits a new competitor could obtain by entering, then entry will not be forthcoming, and new competitors are not a threat to incumbent firms. However, if the cost of entry is lower than the return from entry, entry will occur until the profits derived from entry are less than the costs of entry. 3. Threat from competition among existing companies 4. Threat from new competition 2. Threat from superior or lower-cost substitute products 1. Threat of supplier leverage 5. Threat from buyers’ influence Profit Potential of Industry Figure 2.3 Environmental Threats and the Profit Potential of Industries M02_BARN0088_05_GE_C02.INDD 56 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 57 The relationship between environ-mental threats and the S-C-P model turns on the relationship between the CE threats and the nature of competi- tion in an industry. When all five threats are very high, competition in an in- dustry begins to approach what econo- mists call perfect competition. When all five threats are very low, competition in an industry begins to approach what economists call a monopoly. Between perfect competition and monopoly, economists have identified two other types of competition in an industry— monopolistic competition and oligopoly— where the five threats identified in the literature are moderately high. These four types of competition, and the ex- pected performance of firms in these different industries, are summarized in the table below. Industries are perfectly compet- itive when there are large numbers of competing firms, the products being sold are homogeneous with respect to cost and product attributes, and entry and exit costs are very low. An exam- ple of a perfectly competitive industry is the spot market for crude oil. Firms in perfectly competitive industries can expect to earn only competitive parity. In monopolistically competitive industries, there are large numbers of competing firms and low-cost entry into and exit from the industry. However, unlike the case of perfect competition, products in these industries are not homogeneous with respect to costs or product attributes. Examples of mo- nopolistically competitive industries include toothpaste, shampoo, golf balls, and automobiles. Firms in such indus- tries can earn competitive advantages. Oligopolies are characterized by a small number of competing firms, by ho- mogeneous products, and by high entry and exit costs. Examples of oligopolistic industries include the U.S. automobile and steel industries in the 1950s and the U.S. breakfast cereal market today. Currently, the top four producers of breakfast cereal account for about 90 per- cent of the breakfast cereal sold in the United States. Firms in such industries can earn competitive advantages. Finally, monopolistic industries consist of only a single firm. Entry into this type of industry is very costly. There are few examples of purely mo- nopolistic industries. Historically, for example, the U.S. Post Office had a monopoly on home mail delivery. However, this monopoly has been chal- lenged in small-package delivery by FedEx, in larger-package delivery by UPS, and in mail delivery by e-mail. Monopolists can generate competitive advantages—although they are some- times managed very inefficiently. Source: J. Barney (2007). Gaining and sustaining competitive advantage, 3rd ed. Upper Saddle River, NJ: Pearson Higher Education. Environmental Threats and the S-C-P Model Strategy in Depth Types of Competition and Expected Firm Performance Type of Competition Attributes Examples Expected Firm Performance Perfect competition Large number of firms Homogeneous products Low-cost entry and exit Stock market Crude oil Competitive parity Monopolistic competition Large number of firms Heterogeneous products Low-cost entry and exit Toothpaste Shampoo Golf balls Automobiles Competitive advantage Oligopoly Small number of firms Homogenous products Costly entry and exit U.S. steel and autos in the 1950s U.S. breakfast cereal Competitive advantage Monopoly One firm Costly entry Home mail delivery Competitive advantage M02_BARN0088_05_GE_C02.INDD 57 13/09/14 3:21 PM 58 Part 1: The Tools of Strategic Analysis The threat of new competitors depends on the cost of entry, and the cost of entry, in turn, depends on the existence and “height” of barriers to entry. Barriers to entry are attributes of an industry’s structure that increase the cost of entry. The greater the cost of entry, the greater the height of these barriers. When there are significant barriers to entry, potential new competitors will not enter into an industry even if incumbent firms are earning competitive advantages. Four important barriers to entry have been identified in the S-C-P and strat- egy literatures. These four barriers, listed in Table 2.1, are (1) economies of scale, (2) product differentiation, (3) cost advantages independent of scale, and (4) gov- ernment regulation of entry.10 economies of Scale as a barrier to entry Economies of scale exist in an industry when a firm’s costs fall as a function of its volume of production. Diseconomies of scale exist when a firm’s costs rise as a function of its volume of production. The relationship among economies of scale, diseconomies of scale, and a firm’s volume of production is summarized in Figure 2.4. As a firm’s volume of production increases, its costs begin to fall. This is a manifestation of economies of scale. However, at some point a firm’s volume of production becomes too large and its costs begin to rise. This is a manifestation of diseconomies of scale. For economies of scale to act as a barrier to entry, the re- lationship between the volume of production and firm costs must have the shape of the line in Figure 2.4. This curve suggests that any deviation, positive or nega- tive, from an optimal level of production (point X in Figure 2.4) will lead a firm to experience much higher costs of production. 1. Economies of scale 2. Product differentiation 3. Cost advantages independent of scale 4. Government regulation of entry TAblE 2.1 Possible Barriers to Entry into an Industry Low Volume of Production $ Pe r U ni t C os t of P ro d uc tio n X High Figure 2.4 Economies of Scale and the Cost of Production M02_BARN0088_05_GE_C02.INDD 58 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 59 To see how economies of scale can act as a barrier to entry, consider the following scenario. Imagine an industry with the following attributes: The industry has five incumbent firms (each firm has only one plant); the optimal level of production in each of these plants is 4,000 units (X = 4,000 units); total demand for the output of this industry is fixed at 22,000 units; the economies- of-scale curve is as depicted in Figure 2.4; and products in this industry are very homogeneous. Total demand in this industry (22,000 units) is greater than total supply (5 * 4,000 units = 20,000). Everyone knows that when demand is greater than supply, prices go up. This means that the five incumbent firms in this industry will have high levels of profit. The S-C-P model suggests that, absent barriers, these superior profits should motivate entry. However, look at the entry decision from the point of view of potential new competitors. Certainly, incumbent firms are earning superior profits, but potential entrants face an unsavory choice. On the one hand, new competitors could enter the industry with an optimally efficient plant and produce 4,000 units. However, this form of entry will lead industry supply to rise to 24,000 units (20,000 + 4,000). Suddenly, supply will be greater than demand (24,000 7 22,000), and all the firms in the industry, including the new entrant, will earn negative profits. On the other hand, the new competitor might enter the industry with a plant of smaller- than- optimal size (e.g., 1,000 units). This kind of entry leaves total industry demand larger than industry supply (22,000 7 21,000). However, the new competitor faces a serious cost disadvantage in this case because it does not produce at the low-cost position on the economies-of-scale curve. Faced with these bleak alternatives, the potential entrant simply does not enter even though incumbent firms are earning positive profits. Of course, potential new competitors have other options besides entering at the efficient scale and losing money or entering at an inefficient scale and losing money. For example, potential entrants can attempt to expand the total size of the market (i.e., increase total demand from 22,000 to 24,000 units or more) and enter at the optimal size. Potential entrants can also attempt to develop new production technology, shift the economies-of-scale curve to the left (thereby reducing the optimal plant size), and enter. Or potential new competitors may try to make their products seem very special to their customers, enabling them to charge higher prices to offset higher production costs associated with a smaller-than-optimal plant.11 Any of these actions may enable a firm to enter an industry. However, these actions are costly. If the cost of engaging in these “barrier-busting” activities is greater than the return from entry, entry will not occur, even if incumbent firms are earning positive profits. Historically, economies of scale acted as a barrier to entry into the world- wide steel market. To fully exploit economies of scale, traditional steel plants had to be very large. If new entrants into the steel market had built these efficient and large steel-manufacturing plants, they would have had the effect of increasing the steel supply over the demand for steel, and the outcome would have been reduced profits for both new entrants and incumbent firms. This discouraged new entry. However, in the 1970s, the development of alternative mini-mill tech- nology shifted the economies-of-scale curve to the left by making smaller plants very efficient in addressing some segments of the steel market. This shift had the effect of decreasing barriers to entry into the steel industry. Recent entrants, including Nucor Steel and Chaparral Steel, now have significant cost advantages over firms still using outdated, less efficient production technology.12 M02_BARN0088_05_GE_C02.INDD 59 13/09/14 3:21 PM 60 Part 1: The Tools of Strategic Analysis product Differentiation as a barrier to entry Product differentiation means that incumbent firms possess brand identification and customer loyalty that potential new competitors do not. Brand identification and customer loyalty serve as entry barriers because new competitors not only have to absorb the standard costs associated with starting production in a new in- dustry; they also have to absorb the costs associated with overcoming incumbent firms’ differentiation advantages. If the cost of overcoming these advantages is greater than the potential return from entering an industry, entry will not occur, even if incumbent firms are earning positive profits. Numerous examples exist of industries in which product differentiation tends to act as a barrier to entry. In the brewing industry, for example, substantial investments by Budweiser, Miller, and Coors (among other incumbent firms) in advertising (will we ever forget the Budweiser frogs?) and brand recognition have made large-scale entry into the U.S. brewing industry very costly.13 Indeed, rather than attempting to enter the U.S. market, InBev, a large brewer headquartered in Belgium, decided to purchase Anheuser Busch.14 E. & J. Gallo Winery, a U.S. winemaker, faced product differentiation barri- ers to entry in its efforts to sell Gallo wine in the French market. The market for wine in France is huge—the French consume 16.1 gallons of wine per person per year, for a total consumption of more than 400 million cases of wine, whereas U.S. consumers drink only 1.8 gallons of wine per person per year, for a total consumption of less than 200 million cases. Despite this difference, intense loyal- ties to local French vineyards have made it very difficult for Gallo to break into the huge French market—a market where American wines are still given as “gag gifts” and only American theme restaurants carry U.S. wines on their menus. Gallo is attempting to overcome this product differentiation advantage of French wineries by emphasizing its California roots—roots that many French consider to be exotic—and downplaying the fact that it is a U.S. company; corporate origins that are less attractive to many French consumers.15 Cost a dvantages independent of Scale as barriers to entry In addition to the barriers that have been cited, incumbent firms may have a whole range of cost advantages, independent of economies of scale, compared to new competitors. These cost advantages can act to deter entry because new competitors will find themselves at a cost disadvantage vis-à-vis incumbent firms with these cost advantages. New competitors can engage in activities to overcome the cost advantages of incumbent firms, but as the cost of overcoming them increases, the economic profit potential from entry is reduced. In some set- tings, incumbent firms enjoying cost advantages, independent of scale, can earn superior profits and still not be threatened by new entry because the cost of over- coming those advantages can be prohibitive. Examples of these cost advantages, independent of scale, are presented in Table 2.2; they include (1) proprietary technology, (2) managerial know-how, (3) favorable access to raw materials, and (4) learning-curve cost advantages. proprietary Technology. In some industries, proprietary (i.e., secret or patented) technology gives incumbent firms important cost advantages over potential en- trants. To enter these industries, potential new competitors must develop their own substitute technologies or run the risks of copying another firm’s patented technologies. Both of these activities can be costly. Numerous firms in a wide variety of industries have discovered the sometimes substantial economic costs M02_BARN0088_05_GE_C02.INDD 60 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 61 associated with violating another firm’s patented proprietary technology. Indeed, the number of patent infringement suits continues to increase, especially in industries—such as consumer electronics—where products apply technologies developed by many different companies. In the past few years, Intertrust has sued Apple, Yahoo! has sued Facebook, Google has sued BT, Boston University has sued Apple, Nokia has sued HTC, Samsung has sued Apple, and Apple has sued Samsung.16 In 2012, a total of 5,778 patent infringement suits were filed in the United States.17 Managerial Know- h ow. Even more important than technology per se as a bar- rier to entry is the managerial know-how built up by incumbent firms over their history.18 Managerial know-how is the often-taken-for-granted knowledge and information that are needed to compete in an industry on a day-to-day basis.19 Know-how includes information that it has taken years, sometimes decades, for a firm to accumulate that enables it to interact with customers and suppliers, to be innovative and creative, to manufacture quality products, and so forth. Typically, new entrants will not have access to this know-how, and it will often be costly for them to build it quickly. One industry where this kind of know-how is a very important barrier to entry is the pharmaceutical industry. Success in this industry depends on having high-quality research and development skills. The development of world-class research and development skills—the know-how—takes decades to accumulate. New competitors face enormous cost disadvantages for decades as they attempt to develop these abilities, and thus entry into the pharmaceutical industry has been quite limited.20 Favorable a ccess to r aw Materials. Incumbent firms may also have cost advan- tages, compared to new entrants, based on favorable access to raw materials. If, for example, only a few sources of high-quality iron ore are available in a specific geographic region, steel firms that have access to these sources may have a cost advantage over those that must ship their ore in from distant sources.21 Learning-Curve Cost a dvantages. It has been shown that in certain industries (such as airplane manufacturing) the cost of production falls with the cumula- tive volume of production. Over time, as incumbent firms gain experience in manufacturing, their costs fall below those of potential entrants. Potential new Proprietary technology. When incumbent firms have secret or patented technology that reduces their costs below the costs of potential entrants, potential new com- petitors must develop substitute technologies to compete. The cost of developing this technology can act as a barrier to entry. Managerial know-how. When incumbent firms have taken-for-granted knowledge, skills, and information that take years to develop and that is not possessed by potential new competitors. The cost of developing this know-how can act as a barrier to entry. Favorable access to raw materials. When incumbent firms have low-cost access to critical raw materials not enjoyed by potential new competitors. The cost of gain- ing similar access can act as a barrier to entry. Learning-curve cost advantages. When the cumulative volume of production of incumbent firms gives them cost advantages not enjoyed by potential new com- petitors. These cost disadvantages of potential entrants can act as a barrier to entry. TAblE 2.2 Sources of Cost Advantage, Independent of Scale, That Can Act as Barriers to Entry M02_BARN0088_05_GE_C02.INDD 61 13/09/14 3:21 PM 62 Part 1: The Tools of Strategic Analysis competitors, in this context, must endure substantially higher costs while they gain experience, and thus they may not enter the industry despite the superior profits being earned by incumbent firms. These learning-curve economies are discussed in more detail in Chapter 4. g overnment policy as a barrier to entry Governments, for their own reasons, may decide to increase the cost of entry into an industry. This occurs most frequently when a firm operates as a government- regulated monopoly. In this setting, the government has concluded that it is in a better position to ensure that specific products or services are made available to the population at reasonable prices than competitive market forces. Industries such as electric power generation and elementary and secondary education have been (and, to some extent, continue to be) protected from new competitors by government restrictions on entry. Threat from Existing Competitors New competitors are an important threat to the ability of firms to maintain or im- prove their level of performance, but they are not the only threat in a firm’s envi- ronment. A second environmental threat comes from the intensity of competition among a firm’s current direct competitors. Amazon and iTunes are direct com- petitors. ESPN, CBS, NBC, Fox, USA Networks, and TNN—to name a few—are all direct competitors in televised sports. Direct competition threatens firms by reducing their economic profits. High levels of direct competition are indicated by such actions as frequent price cut- ting by firms in an industry (e.g., price discounts in the airline industry), frequent introduction of new products by firms in an industry (e.g., continuous product introductions in consumer electronics), intense advertising campaigns (e.g., Pepsi versus Coke advertising), and rapid competitive actions and reactions in an in- dustry (e.g., competing airlines quickly matching the discounts of other airlines). Some of the attributes of an industry that are likely to generate high levels of di- rect competition are listed in Table 2.3. First, direct competition tends to be high when there are numerous firms in an industry and these firms tend to be roughly the same size. Such is the case in the laptop personal computer industry. Worldwide, more than 120 firms have entered the laptop computer market, and no one firm dominates in market share. Since the early 1990s, prices in the laptop market have been declining 25 to 30 percent a year. Profit margins for laptop personal computer firms that used to be in the 10 to 13 percent range have rapidly fallen to 3 to 4 percent.22 Second, direct competition tends to be high when industry growth is slow. When industry growth is slow, firms seeking to increase their sales must often acquire market share from established competitors. This tends to increase compe- tition. Intense price rivalry emerged in the U.S. fast-food industry—with 99-cent Whoppers at Burger King and “dollar menus” at Wendy’s and McDonald’s— when the growth in this industry declined.23 1. Large number of competing firms that are roughly the same size 2. Slow industry growth 3. Lack of product differentiation 4. Capacity added in large increments TAblE 2.3 Attributes of an Industry That Increase the Threat of Direct Competition M02_BARN0088_05_GE_C02.INDD 62 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 63 Third, direct competition tends to be high when firms are unable to differ- entiate their products in an industry. When product differentiation is not a viable strategic option, firms are often forced to compete only on the basis of price. Intense price competition is typical of high-competition industries. In the airline industry, for example, intense competition on longer routes—such as between Los Angeles and New York and Los Angeles and Chicago—has kept prices on these routes down. These routes have relatively few product differentiation options. However, by creating hub-and-spoke systems, certain airlines (American, United, Delta) have been able to develop regions of the United States where they are the dominant carrier. These hub-and-spoke systems enable airlines to partially dif- ferentiate their products geographically, thus reducing the level of competition in segments of this industry.24 Finally, direct competition tends to be high when production capacity is added in large increments. If, in order to obtain economies of scale, production capacity must be added in large increments, an industry is likely to experience periods of oversupply after new capacity comes online. This overcapacity often leads to price cuts. Much of the growing rivalry in the commercial jet industry between Boeing and AirBus can be traced to the large manufacturing capacity ad- ditions made by AirBus when it entered the industry.25 Threat of Substitute Products A third environmental threat is the threat of substitute products. The products or services provided by a firm’s direct competitors meet approximately the same customer needs in the same ways as the products or services provided by the firm itself. Substitutes meet approximately the same customer needs, but do so in different ways. Substitutes for downloaded music include Spotify, Pandora, and other music-streaming firms. Substitutes for televised sports include sports magazines, sports pages in the newspapers, and actually attend- ing sporting events. Substitutes place a ceiling on the prices firms in an industry can charge and on the profits firms in an industry can earn. In the extreme, substitutes can ultimately replace an industry’s products and services. This happens when a substitute is clearly superior to previous products. Examples include electronic calculators as substitutes for slide rules and mechanical calculators, electronic watch movements as substitutes for pin–lever mechanical watch movements, and compact discs as substitutes for long-playing (LP) records (although some audio- philes continue to argue for the sonic superiority of LPs). Substitutes are playing an increasingly important role in reducing the profit potential in a variety of industries. For example, in the legal profession private mediation and arbitration services are becoming viable substitutes for lawyers. Computerized texts are becoming viable substitutes for printed books in the pub- lishing industry. Television news programs, especially services such as CNN and Fox News, are very threatening substitutes for weekly newsmagazines, including Time and Newsweek. In Europe, so-called superstores are threatening smaller food shops. Minor league baseball teams are partial substitutes for major league teams. Cable television is a substitute for broadcast television. Groups of “big box” retail- ers are substitutes for traditional shopping centers. Private mail delivery systems (such as those in the Netherlands and Australia) are substitutes for government postal services. Home financial planning software is a partial substitute for professional financial planners.26 M02_BARN0088_05_GE_C02.INDD 63 13/09/14 3:21 PM 64 Part 1: The Tools of Strategic Analysis Threat of Supplier leverage A fourth environmental threat is supplier leverage. Suppliers make a wide vari- ety of raw materials, labor, and other critical assets available to firms. Suppliers can threaten the performance of firms in an industry by increasing the price of their supplies or by reducing the quality of those supplies. Any profits that were being earned in an industry can be transferred to suppliers in this way. In music downloading, record labels and, to a lesser extent, artists are critical suppliers. In televised sports, critical suppliers include sports leagues—such as the NFL and the NHL—as well as TV personalities. Some supplier attributes that can lead to high levels of threat are listed in Table 2.4. First, suppliers are a greater threat if the suppliers’ industry is dominated by a small number of firms. In this setting, a firm has little choice but to purchase supplies from these firms. These few firms thus have enormous flexibility to charge high prices, to reduce quality, or in other ways to squeeze the profits of the firms in the industry to which they sell. Much of Microsoft’s power in the software industry reflects its dominance in the operating system market, where Windows remains the de facto standard for most personal computers. For now, at least, if a company wants to sell personal computers, it is going to need to interact with Microsoft. It will be interesting to see if Linux-based PCs become more pow- erful, thereby limiting some of Microsoft’s leverage as a supplier. Conversely, when a firm has the option of purchasing from a large number of suppliers, suppliers have less leverage to threaten a firm’s profits. For example, as the number of lawyers in the United States has increased over the years (up 40 percent since 1981, currently more than 1 million), lawyers and law firms have been forced to begin competing for work. Some corporate clients have forced law firms to reduce their hourly fees and to handle repetitive simple legal tasks for low flat fees.27 Second, suppliers are a greater threat when what they supply is unique or highly differentiated. There is only one LeBron James. As a basketball player, as a spokesperson, and as a celebrity, his unique status gives him enormous bargain- ing power as a supplier and enables him to extract some of the economic profit that would otherwise have been earned by the Miami Heat and Nike. In the same way, Intel’s unique ability to develop, manufacture, and sell microproces- sors gives it significant bargaining power as a supplier in the personal computer industry. The uniqueness of suppliers can operate in almost any industry. For ex- ample, in the highly competitive world of television talk shows, some guests, as suppliers, can gain surprising fame for their unique characteristics. For example, one woman was a guest on eight talk shows. Her claim to fame: She was the tenth wife of a gay, con-man bigamist. Third, suppliers are a greater threat to firms in an industry when suppliers are not threatened by substitutes. When there are no effective substitutes, suppliers can 1. Suppliers’ industry is dominated by small number of firms. 2. Suppliers sell unique or highly differentiated products. 3. Suppliers are not threatened by substitutes. 4. Suppliers threaten forward vertical integration. 5. Firms are not important customers for suppliers. TAblE 2.4 Indicators of the Threat of Supplier Leverage in an Industry M02_BARN0088_05_GE_C02.INDD 64 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 65 take advantage of their position to extract economic profits from firms they sup- ply. Both Intel (in microprocessors) and Microsoft (in PC operating systems) have been accused of exploiting their unique product positions to extract profits from customers. When there are substitutes for supplies, supplier power is checked. In the metal can industry, for example, steel cans are threatened by aluminum and plastic containers as substitutes. In order to continue to sell to can manufacturers, steel companies have had to keep their prices lower than would otherwise have been the case. In this way, the potential power of the steel companies is checked by the existence of substitute products.28 Fourth, suppliers are a greater threat to firms when they can credibly threaten to enter into and begin competing in a firm’s industry. This is called forward vertical integration; in this situation, suppliers cease to be suppliers only and become suppliers and rivals. The threat of forward vertical integration is partially a function of barriers to entry into an industry. When an industry has high barriers to entry, suppliers face significant costs of forward vertical integra- tion, and thus forward integration is not as serious a threat to the profits of incum- bent firms. (Vertical integration is discussed in detail in Chapter 6.) Finally, suppliers are a threat to firms when firms are not an important part of suppliers’ business. Steel companies, for example, are not too concerned with losing the business of a sculptor or of a small construction company. However, they are very concerned about losing the business of the major can manufacturers, major white-goods manufacturers (i.e., manufacturers of refrig- erators, washing machines, dryers, and so forth), and automobile companies. Steel companies, as suppliers, are likely to be very accommodating and willing to reduce prices and increase quality for can manufacturers, white-goods man- ufacturers, and auto companies. Smaller, “less important” customers, however, are likely to be subject to greater price increases, lower-quality service, and lower-quality products. Threat from buyers’ Influence The final environmental threat is buyers. Buyers purchase a firm’s products or services. Whereas powerful suppliers act to increase a firm’s costs, powerful buyers act to decrease a firm’s revenues. In music downloads, consumers are the ultimate buyer. In televised sports, buyers include all those who watch sports on television as well as those who purchase advertising space on networks. Some of the important indicators of the threat of buyers are listed in Table 2.5. First, if a firm has only one buyer or a small number of buyers, these buy- ers can be very threatening. Firms that sell a significant amount of their output to the U.S. Department of Defense recognize the influence of this buyer on their operations. Reductions in defense spending have forced defense companies to try even harder to reduce costs and increase quality to satisfy government 1. Number of buyers is small. 2. Products sold to buyers are undifferentiated and standard. 3. Products sold to buyers are a significant percentage of a buyer’s final costs. 4. Buyers are not earning significant economic profits. 5. Buyers threaten backward vertical integration. TAblE 2.5 Indicators of the Threat of Buyers’ Influence in an Industry M02_BARN0088_05_GE_C02.INDD 65 13/09/14 3:21 PM 66 Part 1: The Tools of Strategic Analysis demands. All these actions reduce the economic profits of these defense- oriented companies.29 Firms that sell to large retail chains have also found it difficult to maintain high levels of profitability. Powerful retail firms—such as Wal-Mart and Home Depot—can make significant and complex logistical and other demands on their suppliers, and if suppliers fail to meet these demands, buyers can “fire” their suppliers. These demands can have the effect of reducing the profits of suppliers. Second, if the products or services that are being sold to buyers are stan- dard and not differentiated, then the threat of buyers can be greater. For ex- ample, farmers sell a very standard product. It is very difficult to differentiate products such as wheat, corn, or tomatoes (although this can be done to some extent through the development of new strains of crops, the timing of harvests, pesticide-free crops, and so forth). In general, wholesale grocers and food brokers can always find alternative suppliers of basic food products. These numerous alternative suppliers increase the threat of buyers and force farmers to keep their prices and profits low. If any one farmer attempts to raise prices, wholesale grocers and food brokers simply purchase their supplies from some other farmer. Third, buyers are likely to be more of a threat when the supplies they pur- chase are a significant portion of the costs of their final products. In this con- text, buyers are likely to be very concerned about the costs of their supplies and constantly on the lookout for cheaper alternatives. For example, in the canned food industry, the cost of the can itself can constitute up to 40 percent of a product’s final price. Not surprisingly, firms such as Campbell Soup Company are very concerned about keeping the price of the cans they purchase as low as possible.30 Fourth, buyers are likely to be more of a threat when they are not earning significant economic profits. In these circumstances, buyers are likely to be very sensitive to costs and insist on the lowest possible cost and the highest possible quality from suppliers. This effect can be exacerbated when the profits suppliers earn are greater than the profits buyers earn. In this setting, a buyer would have a strong incentive to enter into its supplier’s business to capture some of the eco- nomic profits being earned by the supplier. This strategy of backward vertical integration is discussed in more detail in Chapter 6. Finally, buyers are more of a threat to firms in an industry when they have the ability to vertically integrate backward. In this case, buyers become both buy- ers and rivals and lock in a certain percentage of an industry’s sales. The extent to which buyers represent a threat to vertically integrate, in turn, depends on the barriers to entry that are not in place in an industry. If there are significant barriers to entry, buyers may not be able to engage in backward vertical integration, and their threat to firms is reduced. Environmental Threats and Average Industry Performance The five environmental threats have three important implications for managers seeking to choose and implement strategies. First, they describe the most com- mon sources of local environmental threat in industries. Second, they can be used to characterize the overall level of threat in an industry. Finally, because the over- all level of threat in an industry is, according to S-C-P logic, related to the average level of performance of a firm in an industry, they can also be used to anticipate the average level of performance of firms in an industry. M02_BARN0088_05_GE_C02.INDD 66 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 67 Of course, it will rarely be the case that all five threats in an industry will be equally threatening at the same time. This can sometimes complicate the anticipation of the average level of firm performance in an industry. Consider, for example, the four industries in Table 2.6. It is easy to anticipate the average level of performance of firms in the first two industries: In Industry I, this per- formance will be low; in Industry II, this performance will be high; however, in Industries III and IV it is somewhat more complicated. In these mixed situa- tions, the real question to ask in anticipating the average performance of firms in an industry is, “Are one or more threats in this industry powerful enough to appropriate most of the profits that firms in this industry might generate?” If the answer to this question is yes, then the anticipated average level of perfor- mance will be low. If the answer is no, then the anticipated performance will be high. Even more fundamentally, this type of analysis can be used only to anticipate the average level of firm performance in an industry. This is accept- able if a firm’s industry is the primary determinant of its overall performance. However, as described in the Research Made Relevant feature, research sug- gests that the industry a firm operates in is far from the only determinant of its performance. Another Environmental Force: Complementors Professors Adam Brandenburger and Barry Nalebuff have suggested that another force needs to be added to the analysis of the profit potential of industries.31 These authors distinguish between competitors and what they call a firm’s complementors. If you were the chief executive officer of a firm, the following is how you could tell the difference between your competitors and your comple- mentors: Another firm is a competitor if your customers value your product less when they have the other firm’s product than when they have your product alone. Direct competitors, new competitors, and substitutes are all examples of competitors. In contrast, another firm is a complementor if your customers value your product more when they have this other firm’s product than when they have your product alone. Consider, for example, the relationship between producers of television programming and cable television companies. The value of these firms’ prod- ucts partially depends on the existence of one another. Television producers need outlets for their programming. The growth in the number of channels on cable television provides more of these outlets and thus increases the value Industry I Industry II Industry III Industry IV Threat of new competitors High Low High Low Threat of direct competition High Low Low High Threat of superior or low cost product substitutes High Low High Low Threat of supplier leverage High Low Low High Threat of buyers; influence High Low High Low Expected average firm performance Low High Mixed Mixed TAblE 2.6 Estimating the Level of Average Performance in an Industry M02_BARN0088_05_GE_C02.INDD 67 13/09/14 3:21 PM 68 Part 1: The Tools of Strategic Analysis of these production firms. Cable television companies can continue to add channels, but those channels need content. So, the value of cable television companies depends partly on the existence of television production firms. Because the value of program-producing companies is greater when cable television firms exist and because the value of cable television companies is greater when program-producing companies exist, these types of firms are complements. Brandenburger and Nalebuff go on to argue that an important difference between complementors and competitors is that a firm’s complementors help to increase the size of a firm’s market, whereas a firm’s competitors divide this market among a set of firms. Based on this logic, these authors suggest that, although it is usually the case that a firm will want to discourage the entry of competitors into its market, it will usually want to encourage the entry of com- plementors. Returning to the television producers/cable television example, television producers will actually want cable television companies to grow and prosper and constantly add new channels, and cable television firms will want television show producers to grow and constantly create new and innovative programming. If the growth of either of these businesses slows, it hurts the growth of the other. Of course, the same firm can be a complementor for one firm and a com- petitor for another. For example, the invention of satellite television and in- creased popularity of DirecTV and the Dish Network represent a competitive challenge to cable television companies. That is, DirecTV and, say, Time Warner Cable are competitors. However, DirecTV and television production companies are complementors to each other. In deciding whether to encourage the entry of new complementors, a firm has to weigh the extra value these new comple- mentors will create against the competitive impact of this entry on a firm’s cur- rent complementors. It is also the case that a single firm can be both a competitor and a comple- mentor to the same firm. This is very common in industries where it is impor- tant to create technological standards. Without standards for, say, the size of a CD, how information on a CD will be stored, how this information will be read, and so forth, consumers will often be unwilling to purchase a CD player. With standards in place, however, sales of a particular technology can soar. To develop technology standards, firms must be willing to cooperate. This coop- eration means that, with respect to the technology standard, these firms are complementors. And, indeed, when these firms act as complementors, their actions have the effect of increasing the total size of the market. However, once these firms cooperate to establish standards, they begin to compete to try to ob- tain as much of the market they jointly created as possible. In this sense, these firms are also competitors. Understanding when firms in an industry should behave as complemen- tors and when they should behave as competitors is sometimes very difficult. It is even more difficult for a firm that has interacted with other firms in its industry as a competitor to change its organizational structure, formal and informal control systems, and compensation policy and start interacting with these firms as a complementor, at least for some purposes. Learning to man- age what Brandenburger and Nalebuff call the “Jekyll and Hyde” dilemma as- sociated with competitors and complementors can distinguish excellent from average firms. M02_BARN0088_05_GE_C02.INDD 68 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 69 For some time now, scholars have been interested in the relative impact of the attributes of the industry within which a firm operates and the attributes of the firm itself on its performance. The first work in this area was published by Richard Schmalansee. Using a single year’s worth of data, Schmalansee esti- mated the variance in the performance of firms that was attributable to the industries within which firms operated versus other sources of performance variance. Schmalansee’s conclusion was that approximately 20 percent of the variance in firm performance was ex- plained by the industry within which a firm operated—a conclusion consistent with the S-C-P model and its emphasis on industry as a primary determinant of a firm’s performance. Richard Rumelt identified some weaknesses in Schmalansee’s re- search. Most important of these was that Schmalansee had only one year’s worth of data with which to exam- ine the effects of industry and firm at- tributes on firm performance. Rumelt was able to use four years’ worth of data, which allowed him to distinguish between stable and transient industry and firm effects on firm performance. Rumelt’s results were consistent with Schmalansee’s in one sense: Rumelt also found that about 16 percent of the vari- ance in firm performance was due to industry effects, versus Schmalansee’s 20 percent. However, only about half of this industry effect was stable. The rest represented year-to-year fluctuations in the business conditions in an industry. This result is broadly inconsistent with the S-C-P model. Rumelt also examined the im- pact of firm attributes on firm per- formance and found that more than 80 percent of the variance in firm performance was due to these firm attributes, but that more than half of this 80 percent (46.38 percent) was due to stable firm effects. The importance of stable firm differences in explain- ing differences in firm performance is also inconsistent with the S-C-P frame- work. These results are consistent with another model of firm performance called the resource-based view, which will be described in Chapter 3. Since Rumelt’s research, efforts to identify the factors that explain variance in firm performance have accelerated. At least nine articles addressing this issue have been published in the lit- erature. One of the most recent of these suggests that, while the impact of the industry and the corporation on busi- ness unit performance can vary across industries and across corporations, overall, business unit effects are larger than either corporate or industry effects. Sources: R. P. Rumelt (1991). “How much does industry matter?” Strategic Management Journal, 12, pp. 167–185; R. Schmalansee (1985). “Do markets differ much?” American Economic Review, 75, pp. 341–351; V. F. Misangyi, H. Elms, T. Greckhamer, and J. A. Lepine (2006). “A new perspective on a fundamental debate: A multi- level approach to industry, corporate, and busi- ness unit effects.” Strategic Management Journal, 27(6), pp. 571–590. The Impact of Industry and Firm Characteristics on Firm Performance Research Made Relevant Industry Structure and Environmental Opportunities Identifying environmental threats is only half the task in accomplishing an exter- nal analysis. Such an analysis must also identify opportunities. Fortunately, the same S-C-P logic that made it possible to develop tools for the analysis of environ- mental threats can also be used to develop tools for the analysis of environmental opportunities. However, instead of identifying the threats that are common in most industries, opportunity analysis begins by identifying several generic indus- try structures and then describing the strategic opportunities that are available in each of these different kinds of industries.32 M02_BARN0088_05_GE_C02.INDD 69 13/09/14 3:21 PM 70 Part 1: The Tools of Strategic Analysis Of course, there are many different generic industry structures. However, four are very common and will be the focus of opportunity analysis in this book: (1) fragmented industries, (2) emerging industries, (3) mature industries, and (4) declining industries. A fifth industry structure—international industries—will be discussed later in the chapter. The kinds of opportunities typically associated with these industry structures are presented in Table 2.7. Opportunities in Fragmented Industries: Consolidation Fragmented industries are industries in which a large number of small or medium-sized firms operate and no small set of firms has dominant market share or creates dominant technologies. Most service industries, including retailing, fabrics, and commercial printing, to name just a few, are fragmented industries. Industries can be fragmented for a wide variety of reasons. For example, the fragmented industry may have few barriers to entry, thereby encouraging numerous small firms to enter. The industry may have few, if any, economies of scale, and even some important diseconomies of scale, thus encouraging firms to remain small. Also, close local control over enterprises in an industry may be necessary—for example, local movie houses and local restaurants—to ensure quality and to minimize losses from theft. The major opportunity facing firms in fragmented industries is the imple- mentation of strategies that begin to consolidate the industry into a smaller number of firms. Firms that are successful in implementing this consolidation strategy can become industry leaders and obtain benefits from this kind of effort, if they exist. Consolidation can occur in several ways. For example, an incumbent firm may discover new economies of scale in an industry. In the highly fragmented funeral home industry, Service Corporation International (SCI) found that the development of a chain of funeral homes gave it advantages in acquiring key sup- plies (coffins) and in the allocation of scarce resources (morticians and hearses). By acquiring numerous previously independent funeral homes, SCI was able to substantially reduce its costs and gain higher levels of economic performance.33 Incumbent firms sometimes adopt new ownership structures to help consolidate an industry. Kampgrounds of America (KOA) uses franchise agree- ments with local operators to provide camping facilities to travelers in the fragmented private campgrounds industry. KOA provides local operators with professional training, technical skills, and access to its brand-name reputation. Industry Structure Opportunities Fragmented industry Emerging industry Mature industry Consolidation First-mover advantages Product refinement Investment in service quality Process innovation Declining industry Leadership Niche Harvest Divestment TAblE 2.7 Industry Structure and Environmental Opportunities M02_BARN0088_05_GE_C02.INDD 70 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 71 Local operators, in return, provide KOA with local managers who are intensely interested in the financial and operational success of their campgrounds. Similar franchise agreements have been instrumental in the consolidation of other frag- mented industries, including fast food (McDonald’s), muffler repair (Midas), and motels (La Quinta, Holiday Inn, Howard Johnson’s).34 The benefits of implementing a consolidation strategy in a fragmented industry turn on the advantages larger firms in such industries gain from their larger market share. As will be discussed in Chapter 4, firms with large market share can have important cost advantages. Large market share can also help a firm differentiate its products. Opportunities in Emerging Industries: First-Mover Advantages Emerging industries are newly created or newly re-created industries formed by technological innovations, changes in demand, the emergence of new customer needs, and so forth. Over the past 30 years, the world economy has been flooded by emerging industries, including the microprocessor industry, the personal com- puter industry, the medical imaging industry, and the biotechnology industry, to name a few. Firms in emerging industries face a unique set of opportunities, the exploitation of which can be a source of superior performance for some time for some firms. The opportunities that face firms in emerging industries fall into the general category of first-mover advantages. First-mover advantages are advantages that come to firms that make important strategic and technological decisions early in the development of an industry. In emerging industries, many of the rules of the game and standard operating procedures for competing and succeeding have yet to be established. First-moving firms can sometimes help establish the rules of the game and create an industry’s structure in ways that are uniquely beneficial to them. In general, first-mover advantages can arise from three primary sources: (1) technolog- ical leadership, (2) preemption of strategically valuable assets, and (3) the creation of customer-switching costs.35 First-Mover a dvantages and Technological Leadership Firms that make early investments in particular technologies in an industry are implementing a technological leadership strategy. Such strategies can generate two advantages in emerging industries. First, firms that have implemented these strategies may obtain a low-cost position based on their greater cumulative vol- ume of production with a particular technology. These cost advantages have had important competitive implications in such diverse industries as the manufacture of titanium dioxide by DuPont and Procter & Gamble’s competitive advantage in disposable diapers.36 Second, firms that make early investments in a technology may obtain patent protections that enhance their performance.37 Xerox’s patents on the xe- rography process and General Electric’s patent on Edison’s original lightbulb design were important for these firms’ success when these two industries were emerging.38 However, although there are some exceptions (e.g., the pharmaceuti- cal industry and specialty chemicals), patents, per se, seem to provide relatively small profit opportunities for first-moving firms in most emerging industries. One group of researchers found that imitators can duplicate first movers’ patent-based advantages for about 65 percent of the first mover’s costs.39 These researchers also found that 60 percent of all patents are imitated within four M02_BARN0088_05_GE_C02.INDD 71 13/09/14 3:21 PM 72 Part 1: The Tools of Strategic Analysis years of being granted—without legally violating patent rights obtained by first movers. As we will discuss in detail in Chapter 3, patents are rarely a source of sustained competitive advantage for firms, even in emerging industries. First-Mover a dvantages and preemption of Strategically valuable a ssets First movers that invest only in technology usually do not obtain sustained competitive advantages. However, first movers that move to tie up strategically valuable resources in an industry before their full value is widely understood can gain sustained competitive advantages. Strategically valuable assets are resources required to successfully compete in an industry. Firms that are able to acquire these resources have, in effect, erected formidable barriers to imitation in an industry. Some strategically valuable assets that can be acquired in this way include access to raw materials, particularly favorable geographic locations, and particularly valuable product market positions. When an oil company such as Royal Dutch Shell (because of its superior exploration skills) acquires leases with greater development potential than was expected by its competition, the company is gaining access to raw materials in a way that is likely to generate sustained competitive advantages. When Wal-Mart opens stores in medium-sized cities before the arrival of its competition, Wal-Mart is making it difficult for the competition to enter into this market. And when breakfast cereal companies expand their product lines to include all possible com- binations of wheat, oats, bran, corn, and sugar, they, too, are using a first-mover advantage to deter entry.40 First-Mover a dvantages and Creating Customer-Switching Costs Firms can also gain first-mover advantages in an emerging industry by creating customer-switching costs. Customer-switching costs exist when customers make investments in order to use a firm’s particular products or services. These invest- ments tie customers to a particular firm and make it more difficult for customers to begin purchasing from other firms.41 Such switching costs are important factors in industries as diverse as applications software for personal computers, prescrip- tion pharmaceuticals, and groceries.42 In applications software for personal computers, users make significant investments to learn how to use a particular software package. Once computer us- ers have learned how to operate particular software, they are unlikely to switch to new software, even if that new software system is superior to what they currently use. Such a switch would require learning the new software and determining how it is similar to and different from the old software. For these reasons, some com- puter users will continue to use outdated software, even though new software performs much better. Similar switching costs can exist in some segments of the prescription phar- maceutical industry. Once medical doctors become familiar with a particular drug, its applications, and side effects, they are sometimes reluctant to change to a new drug, even if that new drug promises to be more effective than the older, more familiar one. Trying the new drug requires learning about its properties and side effects. Even if the new drug has received government approvals, its use requires doctors to be willing to “experiment” with the health of their patients. Given these issues, many physicians are unwilling to rapidly adopt new drug therapies. This is one reason that pharmaceutical firms spend so much time and money using their sales forces to educate their physician customers. This kind of education is neces- sary if a doctor is going to be willing to switch from an old drug to a new one. M02_BARN0088_05_GE_C02.INDD 72 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 73 Customer-switching costs can even play a role in the grocery store industry. Each grocery store has a particular layout of products. Once customers learn where different products in a particular store are located, they are not likely to change stores because they would then have to relearn the location of products. Many cus- tomers want to avoid the time and frustration associated with wandering around a new store looking for some obscure product. Indeed, the cost of switching stores may be large enough to enable some grocery stores to charge higher prices than would be the case without customer-switching costs. First-Mover Disadvantages Of course, the advantages of first moving in emerging industries must be bal- anced against the risks associated with exploiting this opportunity. Emerging in- dustries are characterized by a great deal of uncertainty. When first-moving firms are making critical strategic decisions, it may not be at all clear what the right decisions are. In such highly uncertain settings, a reasonable strategic alternative to first moving may be retaining flexibility. Where first-moving firms attempt to resolve the uncertainty they face by making decisions early and then trying to influence the evolution of an emerging industry, they use flexibility to resolve this uncertainty by delaying decisions until the economically correct path is clear and then moving quickly to take advantage of that path. Opportunities in Mature Industries: Product Refinement, Service, and Process Innovation Emerging industries are often formed by the creation of new products or technol- ogies that radically alter the rules of the game in an industry. However, over time, as these new ways of doing business become widely understood, as technologies diffuse through competitors, and as the rate of innovation in new products and technologies drops, an industry begins to enter the mature phase of its develop- ment. As described in the Strategy in the Emerging Enterprise feature, this change in the nature of a firm’s industry can be difficult to recognize and can create both strategic and operational problems for a firm. Common characteristics of mature industries include (1) slowing growth in total industry demand, (2) the development of experienced repeat customers, (3) a slowdown in increases in production capacity, (4) a slow- down in the introduction of new products or services, (5) an increase in the amount of international competition, and (6) an overall reduction in the prof- itability of firms in the industry.43 The fast-food industry in the United States has matured over the last sev- eral years. In the 1960s, the United States had only three large national fast-food chains: McDonald’s, Burger King, and Dairy Queen. Through the 1980s, all three of these chains grew rapidly, although the rate of growth at McDonald’s outstripped the growth rate of the other two firms. During this time period, however, other fast-food chains also entered the market. These included some national chains, such as Kentucky Fried Chicken, Wendy’s, and Taco Bell, and some strong regional chains, such as Jack in the Box and In and Out Burger. By the early 1990s, growth in this industry had slowed considerably. McDonald’s announced that it was having difficulty finding locations for new McDonald’s that did not impinge on the sales of already existing McDonald’s. Except for non–U.S. operations, where competition in the fast-food industry is not as ma- ture, the profitability of most U.S. fast-food companies did not grow as much in the 1990s as it did in the 1960s through the 1980s. Indeed, by 2002, all the major M02_BARN0088_05_GE_C02.INDD 73 13/09/14 3:21 PM 74 Part 1: The Tools of Strategic Analysis fast-food chains were either not making very much money or, like McDonald’s, actually losing money.44 Opportunities for firms in mature industries typically shift from the devel- opment of new technologies and products in an emerging industry to a greater emphasis on refining a firm’s current products, an emphasis on increasing the quality of service, and a focus on reducing manufacturing costs and increased quality through process innovations. r efining Current products In mature industries, such as home detergents, motor oil, and kitchen appli- ances, few, if any, major technological breakthroughs are likely. However, this does not mean that innovation is not occurring in these industries. Innovation in these industries focuses on extending and improving current products and technologies. In home detergents, innovation recently has focused on changes in packaging and on selling more highly concentrated detergents. In motor oil, pack- aging changes (from fiber foil cans to plastic containers), additives that keep oil cleaner longer, and oil formulated to operate in four-cylinder engines are recent examples of this kind of innovation. In kitchen appliances, recent improvements include the availability of refrigerators with crushed ice and water through the door, commercial-grade stoves for home use, and dishwashers that automatically adjust the cleaning cycle depending on how dirty the dishes are.45 In fast foods, firms like McDonald’s and Wendy’s have introduced healthy, more adult-oriented food to complement their kid-friendly hamburger-heavy menus. This movement has helped restore the profitability of these firms. emphasis on Service When firms in an industry have only limited ability to invest in radical new technologies and products, efforts to differentiate products often turn toward the quality of customer service. A firm that is able to develop a reputation for high- quality customer service may be able to obtain superior performance even though its products are not highly differentiated. This emphasis on service has become very important in a wide variety of industries. For example, in the convenience food industry, one of the major rea- sons for slower growth in the fast-food segment has been growth in the so-called “casual dining” segment. This segment includes restaurants such as Chili’s and Applebee’s. The food sold at fast-food restaurants and casual dining restaurants overlaps—they both sell burgers, soft drinks, salads, chicken, desserts, and so forth—although many consumers believe that the quality of food is superior in the casual dining restaurants. In addition to any perceived differences in the food, however, the level of service in the two kinds of establishments varies signifi- cantly. At fast-food restaurants, food is handed to consumers on a tray; in casual dining restaurants, waitstaff actually bring food to consumers on a plate. This level of service is one reason that casual dining is growing in popularity.46 On the other hand, the fastest-growing segment of the U.S. restaurant in- dustry is the “fast casual” segment—Panera Bread, Café Rio (a regional Mexican restaurant), and Chipotle. These restaurants deliver high-quality food but avoid the delays often associated with full-service restaurants. process innovation A firm’s processes are the activities it engages in to design, produce, and sell its products or services. Process innovation, then, is a firm’s effort to refine and M02_BARN0088_05_GE_C02.INDD 74 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 75 It began with a 5,000-word e-mail sent by Steve Balmer, CEO of Microsoft, to all 57,000 employees. Whereas previous e-mails from Microsoft founder Bill Gates—includ- ing one in 1995 calling on the firm to learn how to “ride the wave of the Internet”—inspired the firm to move on to conquer more technological challenges, Balmer’s e-mail focused on Microsoft’s current state and called on the firm to become more focused and efficient. Balmer also an- nounced that Microsoft would cut its costs by $1 billion during the next fis- cal year. One observer described it as the kind of e-mail you would expect to read at Procter & Gamble, not at Microsoft. Then the other shoe dropped. In a surprise move, Balmer announced that Microsoft would distribute a large portion of its $56 billion cash reserve in the form of a special dividend to stockholders. In what is believed to be the largest such cash dispersion ever, Microsoft distributed $32 billion to its stockholders and used an additional $30 billion to buy back stock. Bill Gates received a $3.2 billion cash dividend. These changes meant that Microsoft’s capital structure was more similar to, say, Procter & Gamble’s than to an entrepreneurial, high-flying software company. What happened at Microsoft? Did Microsoft’s management con- clude that the PC software industry was no longer emerging, but had matured to the point that Microsoft would have to alter some of its tra- ditional strategies? Most observers believe that Balmer’s e-mail, and the decision to reduce its cash reserves, signaled that Microsoft had come to this conclusion. In fact, although most of Microsoft’s core businesses—its Windows operating systems, its PC applications software, and its server software—are still growing at the rate of about $3 billion a year, if they were growing at historical rates these busi- nesses would be generating $7 billion in new revenues each year. Moreover, Microsoft’s new businesses—video games, Internet services, business software, and software for phones and handheld computers—are add- ing less than $1 billion in new rev- enues each year. That is, growth in Microsoft’s new businesses is not offsetting slower growth in its tradi- tional businesses. Other indicators of the growing maturity of the PC software indus- try, and Microsoft’s strategic changes, also exist. For example, during 2003 and 2004, Microsoft resolved most of the outstanding antitrust litigation it was facing, abandoned its employee stock option plan in favor of a stock- based compensation scheme popular with slower-growth firms, improved its systems for receiving and acting on feedback from customers, and im- proved the quality of its relationships with some of its major rivals, includ- ing Sun Microsystems, Inc. These are all the actions of a firm that recognizes that the rapid growth opportunities that existed in the software industry when Microsoft was a new company do not exist anymore. At this point, Microsoft has to choose whether it is going to jump- start its growth through a series of large acquisitions or accept the lower growth rates in its core markets. It has tried to jump-start its growth through acquisitions, a strong indicator that Microsoft, while acknowledging slower growth in its core, has not com- pletely abandoned the idea of growing quickly in some parts of its business. Sources: J. Greene (2004). “Microsoft’s midlife crisis.” BusinessWeek, April 19, 2004, pp. 88+ ; R. Guth and S. Thurm (2004). “Microsoft to dole out its cash hoard.” The Wall Street Journal, Wednesday, July 21, 2004, pp. A1+ ; S. Hamm (2004). “Microsoft’s worst enemy: Success.” BusinessWeek, July 19, 2004, p. 33; Accessed July 12, 2006. Microsoft Grows Up Strategy in the Emerging Enterprise improve its current processes. Several authors have studied the relationship be- tween process innovation, product innovation, and the maturity of an industry.47 This work suggests that, in the early stages of industry development, product innovation is very important. However, over time product innovation becomes less important, and process innovations designed to reduce manufacturing costs, increase product quality, and streamline management become more important. M02_BARN0088_05_GE_C02.INDD 75 13/09/14 3:21 PM 76 Part 1: The Tools of Strategic Analysis In mature industries, firms can often gain an advantage by manufacturing the same product as competitors, but at a lower cost. Alternatively, firms can manu- facture a product that is perceived to be of higher quality and do so at a com- petitive cost. Process innovations facilitate both the reduction of costs and the increase in quality. The role of process innovation in more mature industries is perhaps best exemplified by the improvement in quality in U.S. automobiles. In the 1980s, Japanese firms such as Nissan, Toyota, and Honda sold cars that were of sig- nificantly higher quality than those produced by U.S. firms General Motors, Ford, and Chrysler. In the face of that competitive disadvantage, the U.S. firms engaged in numerous process reforms to improve the quality of their cars. In the 1980s, U.S. manufacturers were cited for car body panels that did not fit well, bumpers that were hung crookedly on cars, and the wrong engines being placed in cars. Today, the differences in quality between newly manufactured U.S. and Japanese automobiles are very small. Indeed, one well-known judge of initial manufactur- ing quality—J. D. Powers—now focuses on items such as the quality of a car’s cup holders and the maximum distance at which a car’s keyless entry system still works to establish quality rankings. The really significant quality issues of the 1980s are virtually gone.48 Opportunities in Declining Industries: leadership, Niche, Harvest, and Divestment A declining industry is an industry that has experienced an absolute decline in unit sales over a sustained period of time.49 Obviously, firms in a declining indus- try face more threats than opportunities. Rivalry in a declining industry is likely to be very high, as is the threat of buyers, suppliers, and substitutes. However, even though threats are significant, firms do have opportunities they can exploit. The major strategic opportunities that firms in this kind of industry face are lead- ership, niche, harvest, and divestment. Market Leadership An industry in decline is often characterized by overcapacity in manufacturing, distribution, and so forth. Reduced demand often means that firms in a declin- ing industry will have to endure a significant shakeout period until overcapacity is reduced and capacity is brought in line with demand. After the shakeout, a smaller number of lean and focused firms may enjoy a relatively benign environ- ment with few threats and several opportunities. If the industry structure that is likely to exist after a shakeout is quite attractive, firms in an industry before the shakeout may have an incentive to weather the storm of decline—to survive until the situation improves to the point that they can begin to earn higher profits. If a firm has decided to wait out the storm of decline in hopes of better en- vironmental conditions in the future, it should consider various steps to increase its chances of survival. Most important of these is that a firm must establish itself as a market leader in the pre-shakeout industry, most typically by becoming the firm with the largest market share in that industry. The purpose of becoming a market leader is not to facilitate tacit collusion (see Chapter 9) or to obtain lower costs from economies of scale (see Chapter 6). Rather, in a declining industry the leader’s objective should be to try to facilitate the exit of firms that are not likely to survive a shakeout, thereby obtaining a more favorable competitive environ- ment as quickly as possible. M02_BARN0088_05_GE_C02.INDD 76 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 77 Market leaders in declining industries can facilitate exit in a variety of ways, including purchasing and then deemphasizing competitors’ product lines, pur- chasing and retiring competitors’ manufacturing capacity, manufacturing spare parts for competitors’ product lines, and sending unambiguous signals of their intention to stay in an industry and remain a dominant firm. For example, overca- pacity problems in the European petrochemical industry were partially resolved when Imperial Chemical Industries (ICI) traded its polyethylene plants to British Petroleum for BP’s polyvinylchloride (PVC) plants. In this case, both firms were able to close some excess capacity in specific markets (polyethylene and PVC), while sending clear signals of their intention to remain in these markets.50 Market n iche A firm in a declining industry following a leadership strategy attempts to fa- cilitate exit by other firms, but a firm following a niche strategy in a declining industry reduces its scope of operations and focuses on narrow segments of the declining industry. If only a few firms choose a particular niche, then these firms may have a favorable competitive setting, even though the industry as a whole is facing shrinking demand. Two firms that used the niche approach in a declining market are GTE Sylvania and General Electric (GE) in the vacuum tube industry. Yes, vacuum tubes! The invention of the transistor followed by the semiconductor just about destroyed demand for vacuum tubes in new products. GTE Sylvania and GE rapidly recognized that new product sales in vacuum tubes were drying up. In response, these firms began specializing in supplying replacement vacuum tubes to the consumer and military markets. To earn high profits, these firms had to re- focus their sales efforts and scale down their sales and manufacturing staffs. Over time, as fewer and fewer firms manufactured vacuum tubes, GTE Sylvania and GE were able to charge very high prices for replacement parts.51 h arvest Leadership and niche strategies, though differing along several dimensions, have one attribute in common: Firms that implement these strategies intend to remain in the industry despite its decline. Firms pursuing a harvest strategy in a declin- ing industry do not expect to remain in the industry over the long term. Instead, they engage in a long, systematic, phased withdrawal, extracting as much value as possible during the withdrawal period. The extraction of value during the implementation of a harvest strategy presumes that there is some value to harvest. Thus, firms that implement this strategy must ordinarily have enjoyed at least some profits at some time in their history, before the industry began declining. Firms can implement a harvest strat- egy by reducing the range of products they sell, reducing their distribution net- work, eliminating less profitable customers, reducing product quality, reducing service quality, deferring maintenance and equipment repair, and so forth. In the end, after a period of harvesting in a declining industry, firms can either sell their operations (to a market leader) or simply cease operations. In principle, the harvest opportunity sounds simple, but in practice it pres- ents some significant management challenges. The movement toward a harvest strategy often means that some of the characteristics of a business that have long been a source of pride to managers may have to be abandoned. Thus, where prior to harvest a firm may have specialized in high-quality service, quality products, and excellent customer value, during the harvest period service quality may fall, M02_BARN0088_05_GE_C02.INDD 77 13/09/14 3:21 PM 78 Part 1: The Tools of Strategic Analysis product quality may deteriorate, and prices may rise. These changes may be difficult for managers to accept, and higher turnover may be the result. It is also difficult to hire quality managers into a harvesting business because such indi- viduals are likely to seek greater opportunities elsewhere. For these reasons, few firms explicitly announce a harvest strategy. However, examples can be found. GE seems to be following a harvest strategy in the electric turbine business. Also, United States Steel and the International Steel Group seem to be following this strategy in certain segments of the steel market.52 Divestment The final opportunity facing firms in a declining industry is divestment. Like a harvest strategy, the objective of divestment is to extract a firm from a declining industry. However, unlike harvest, divestment occurs quickly, often soon after a pattern of decline has been established. Firms without established competitive advantages may find divestment a superior option to harvest because they have few competitive advantages they can exploit through harvesting. In the 1980s, GE used this rapid divestment approach to virtually abandon the consumer electronics business. Total demand in this business was more or less stable during the 1980s, but competition (mainly from Asian manufacturers) increased substantially. Rather than remain in this business, GE sold most of its consumer electronics operations and used the capital to enter into the medical imaging industry, where this firm has found an environment more conducive to superior performance.53 In the defense business, divestment is the stated strategy of General Dynamics, at least in some of its business segments. General Dynamics’ man- agers recognized early on that the changing defense industry could not sup- port all the incumbent firms. When General Dynamics concluded that it could not remain a leader in some of its businesses, it decided to divest those and concentrate on a few remaining businesses. Since 1991, General Dynamics has sold businesses worth more than $2.83 billion, including its missile systems business, its Cessna aircraft division, and its tactical aircraft division (maker of the very successful F-16 aircraft and partner in the development of the next generation of fighter aircraft, the F-22). These divestitures have left General Dynamics in just three businesses: armored tanks, nuclear submarines, and space launch vehicles. During this time, the market price of General Dynamics stock has returned almost $4.5 billion to its investors, has seen its stock go from $25 per share to a high of $110 per share and has provided a total return to stockholders of 555 percent.54 Of course, not all divestments are caused by industry decline. Sometimes firms divest certain operations to focus their efforts on remaining operations, sometimes they divest to raise capital, and sometimes they divest to simplify operations. These types of divestments reflect a firm’s diversification strategy and are explored in detail in Chapter 11. Summary The strategic management process requires that a firm engage in an analysis of threats and opportunities in its competitive environment before a strategic choice can be made. This analysis begins with an understanding of the firm’s general environment. This general environment has six components: technological change, demographic trends, cultural M02_BARN0088_05_GE_C02.INDD 78 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 79 trends, economic climate, legal and political conditions, and specific international events. Although some of these components of the general environment can affect a firm directly, more frequently they affect a firm through their impact on its local environment. The S-C-P model can be used to develop tools for analyzing threats in a firm’s com- petitive environment. The most influential of these tools focuses on five environmental threats to the profitability of firms in an industry. The five threats are: threat from new competitors, threat from existing direct competitors, threat from superior or low cost substitutes, threat of supplier leverage, and the threat from buyers’ influence. The threat of new competition depends on the existence and “height” of barriers to entry. Common barriers to entry include economies of scale, product differentiation, cost advantages inde- pendent of scale, and government regulation. The threat of current direct competitors de- pends on the number and competitiveness of firms in an industry. This threat is high in an industry when there are large numbers of competing firms, competing firms are roughly the same size and have the same influence, growth in an industry is slow, there is no prod- uct differentiation, and productive capacity is added in large increments. The threat of superior substitutes depends on how close substitute products and services are—in per- formance and cost—to products and services in an industry. Whereas direct competitors meet the same customer needs in approximately the same way, substitutes meet the same customer needs, but do so in very different ways. The threat of supplier leverage in an industry depends on the number and distinctiveness of the products suppliers provide to an industry. The threat of supplier leverage increases when a supplier’s industry is domi- nated by a few firms, when suppliers sell unique or highly differentiated products, when suppliers are not threatened by substitutes, when suppliers threaten forward vertical in- tegration, and when firms are not important customers for suppliers. Finally, the threat of buyers’ influence depends on the number and size of an industry’s customers. The threat of buyers’ influence is greater when the number of buyers is small, products sold to buy- ers are undifferentiated and standard, products sold to buyers are a significant percentage of a buyer’s final costs, buyers are not earning significant profits, and buyers threaten backward vertical integration. Taken together, the level of these threats in an industry can be used to determine the expected average performance of firms in an industry. One additional force in a firm’s environment is complementors. Where competitors compete with a firm to divide profits in a market, complementors increase the total size of the market. If you are a CEO of a firm, you know that another firm is a complementor when the value of your products to your customers is higher in combination with this other firm’s products than when customers use your products alone. Where firms have strong incentives to reduce the entry of competitors, they can sometimes have strong in- centives to increase the entry of complementors. The S-C-P model can also be used to develop tools for analyzing strategic oppor- tunities in an industry. This is done by identifying generic industry structures and the strategic opportunities available in these different kinds of industries. Four common industry structures are fragmented industries, emerging industries, mature industries, and declining industries. The primary opportunity in fragmented industries is consolida- tion. In emerging industries, the most important opportunity is first-mover advantages from technological leadership, preemption of strategically valuable assets, or creation of customer-switching costs. In mature industries, the primary opportunities are product refinement, service, and process innovation. In declining industries, opportunities in- clude market leadership, niche, harvest, and divestment. MyManagementLab® Go to mymanagementlab.com to complete the problems marked with this icon . M02_BARN0088_05_GE_C02.INDD 79 13/09/14 3:21 PM 80 Part 1: The Tools of Strategic Analysis Challenge Questions 2.1. Suppose you have to evaluate microfinance ventures. One of the proposals is for opening a hairdresser’s shop in Guatemala City. The proposal argues that there must be significant demand for hairdressing and other cosmetic services because the city has lots of such shops already and several new ones open each month. It predicts that the demand for such services will continue to increase, given the increasing number of convenience stores in Guatemala that sell hair coloring dyes and hair straightening solutions. What are the risks involved in this proposal? Would you advise investing in this venture? 2.2. One potential threat in an industry is buyers’ influence. Yet unless buyers are satisfied, they are likely to look for satisfaction elsewhere. Can the fact that buyers can be threats be recon- ciled with the need to satisfy buyers? 2.3. Government policies can have a significant impact on the average profitability of firms in an industry. Government, however, is not included as a potential threat. Why should the model be expanded to include gov- ernment? Why or why not? 2.4. In particular, if an industry has large numbers of complementors, does that make it more attractive or less attractive or does it have no im- pact on the industry’s attractiveness? Justify your answer. 2.5. Opportunities analysis seems to suggest that strategic opportunities are available in almost any industry, including declining ones. If that is true, is it fair to say that there is re- ally no such thing as an unattractive industry? 2.6. If there is really no such thing as an unattractive industry, what implications does this have for the applicability of environmental threat analysis? 2.7. Describe an industry that has opportunities for niche and product refinement. 2.8. Describe when the evolution of industry structure from an emerging industry to a mature industry to a de- clining industry is inevitable. Problem Set 2.9. Perform an analysis of the profit potential on the following two industries: The Pharmaceutical Industry The pharmaceutical industry consists of firms that develop, patent, and distribute drugs. Although this industry does not have significant production economies, it does have impor- tant economies in research and development. Product differentiation exists as well because firms often sell branded products. Firms compete in research and development. However, once a product is developed and patented, competition is significantly reduced. Recently, the increased availability of generic, nonbranded drugs has threatened the profitability of some drug lines. Once an effective drug is developed, few, if any, alternatives to that drug usually are available. Drugs are manufactured from commodity chemicals that are avail- able from numerous suppliers. Major customers include doctors and patients. Recently, in- creased costs have led the federal government and insurance companies to pressure drug companies to reduce their prices. The Textile Industry The textile industry consists of firms that manufacture and distribute fabrics for use in clothing, furniture, carpeting, and so forth. Several firms have invested heavily in sophis- ticated manufacturing technology, and many lower-cost firms located in Asia have begun fabric production. Textiles are not branded products. Recently, tariffs on some imported textiles have been implemented. The industry has numerous firms; the largest have less than 10 percent market share. Traditional fabric materials (such as cotton and wool) have M02_BARN0088_05_GE_C02.INDD 80 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 81 recently been threatened by the development of alternative chemical-based materials (such as nylon and rayon), although many textile companies have begun manufacturing with these new materials as well. Most raw materials are widely available, although some syn- thetic products periodically may be in short supply. There are numerous textile customers, but textile costs are usually a large percentage of their final product’s total costs. Many users shop around the world for the lowest textile prices. 2.10. Perform an opportunities analysis on the following industries: (a) The fast-food industry in Mexico (b) Wired telecommunication industry in Nigeria (c) Computer manufacturing industry in China (d) The worldwide LED manufacturing industry (e) The worldwide small-package overnight delivery industry 2.11. Identify two rivals and two complementors for each of the following companies. Rivals could include incumbent competitors, substitutes or potential new entrants. (a) Toyota (b) Microsoft (c) Lenovo (d) HSBC Bank (e) Apple MyManagementLab® Go to mymanagementlab.com for the following Assisted-graded writing questions: 2.12. Describe a case when a single firm can be both a competitor and a complementor to the same firm. 2.13. Under what constraints can firms also gain first-mover advantages in an emerg- ing industry? End Notes 1. See (2003). The big book of business quotations. New York: Basic Books, p. 209. 2. See Weintraub, A. (2004). “Repairing the engines of life.” BusinessWeek, May 24, 2004, pp. 99 + for a discussion of recent developments in biotechnology research and the business challenges they have created. 3. See Grow, B. (2004). “Hispanic nation.” BusinessWeek, March 15, 2004, pp. 59+ . 4. Ibid. 5. Barnes, B. (2004). “The WB grows up.” The Wall Street Journal, July 19, 2004, pp. B1+ ; money.cnn.com/2006/01/24/news/companies/ cbs_warner. Accessed February 2007. 6. These and other cultural differences are described in Rugman, A., and R. Hodgetts. (1995). International business. New York: McGraw-Hill. A discussion of the dimensions along which country cultures can vary is presented in a later chapter. 7. Early contributors to the structure-conduct-performance model include Mason, E. S. (1939). “Price and production policies of large scale enterprises.” American Economic Review, 29, pp. 61–74; and Bain, J. S. (1956). Barriers to new competition. Cambridge, MA: Harvard University Press. The major developments in this framework are summarized in Bain, J. S. (1968). Industrial organization. New York: John Wiley & Sons, Inc.; and Scherer, F. M. (1980). Industrial market structure and economic performance. Boston: Houghton Mifflin. The links between this framework and work in strategic management are discussed by Porter, M. E. (1981a). “The contribution of industrial or- ganization to strategic management.” Academy of Management Review, 6, pp. 609–620; and Barney, J. B. (1986c). “Types of competition and the theory of strategy: Toward an integrative framework.” Academy of Management Review, 1, pp. 791–800. 8. See, for example, Porter, M. E. (1979). “How competitive forces shape strategy.” Harvard Business Review, March–April, pp. 137–156; and Porter, M. E. (1980). Competitive strategy. New York: Free Press. 9. Sharma, A., and M. Fatterman. (2013). “Fox, latest underdog, takes on ESPN.” The Wall Street Journal, Friday, July 26, pp. B1+ . 10. These barriers were originally proposed by Bain, J. S. (1968). Industrial organization. New York: John Wiley & Sons, Inc. It is actually possible to estimate the “height” of barriers to entry in an industry by comparing the cost of entry into an industry with M02_BARN0088_05_GE_C02.INDD 81 13/09/14 3:21 PM 82 Part 1: The Tools of Strategic Analysis barriers and the cost of entry into that industry if barriers did not exist. The difference between these costs is the “height” of the barri- ers to entry. 11. Another alternative would be for a firm to own and operate more than one plant. If there are economies of scope in this industry, a firm might be able to enter and earn above-normal profits. An economy of scope exists when the value of operating in two businesses simultaneously is greater than the value of operating in these two businesses separately. The concept of economy of scope is explored in more detail in Part 3 of this book. 12. See Ghemawat, P., and H. J. Stander III. (1992). “Nucor at a cross- roads.” Harvard Business School Case No. 9-793-039. 13. See Montgomery, C. A., and B. Wernerfelt. (1991). “Sources of superior performance: Market share versus industry effects in the U.S. brewing industry.” Management Science, 37, pp. 954–959. 14. Sorkin, A. R., and M. Merced. (2008). “Brewer bids $46 billion for Anheuser-Busch.” New York Times, June 12. http://www.nytimes. com/2008/06/12/business/worldbusiness/12beer.html?_r=0 15. Stecklow, S. (1999). “Gallo woos French, but don’t expect Bordeaux by the jug.” The Wall Street Journal, March 26, pp. A1+ . 16. Wingfield, N. (2013). “Intertrust sues Apple over patent violations.” Bcts.blogs. NYTimes.com, March 20; Swisler, K. (2012). “Yahoo sues Facebook for patent infringement.” Allthings.com, March 12; Fingas, J. (2013). “Google countersues BT.” www.engadget.com, February 13; “Boston University sues Apple for patent infringement.” (2013). www.macworld.com, July 3; “Nokia taking HTC to court over pat- ent violations.” (2013). www.mobilemg.com, May 25;Dobie, A. (2013). “Apple looks to add Sony Galaxy 54 to patent infringement suit.”www.androidcentral.com, May 14; “Bad Apple.” (2013). www. catholic.org, June 5. 17. www.patstats.org. Accessed July 3, 2013. 18. See Kogut, B., and U. Zander. (1992). “Knowledge of the firm, com- binative capabilities, and the replication of technology.” Organization Science, 3, pp. 383–397; and Dierickx, I., and K. Cool. (1989). “Asset stock accumulation and sustainability of competitive advantage.” Management Science, 35, pp. 1504–1511. Both emphasize the importance of know-how as a barrier to entry into an industry. More generally, intangible resources are seen as particularly important sources of sus- tained competitive advantage. This will be discussed in more detail in Chapter 5. 19. See Polanyi, M. (1962). Personal knowledge: Towards a post-critical philosophy. London: Routledge & Kegan Paul; and Itami, H. (1987). Mobilizing invisible assets. Cambridge, MA: Harvard University Press. 20. See Henderson, R., and I. Cockburn. (1994). “Measuring compe- tence: Exploring firm effects in pharmaceutical research.” Strategic Management Journal, 15, pp. 361–374. 21. See Scherer, F. M. (1980). Industrial market structure and economic perfor- mance. Boston: Houghton Mifflin. 22. See Saporito, B. (1992). “Why the price wars never end.” Fortune, March 23, pp. 68–78; and Allen, M., and M. Siconolfi. (1993). “Dell Computer drops planned share offering.” The Wall Street Journal, February 25, p. A3. 23. Chartier, John. (2002). “Burger battles.” CNN/Money, http://money. cnn.com, December 11. 24. See Ghemawat, P., and A. McGahan. (1995). “The U.S. airline industry in 1995.” Harvard Business School Case No. 9-795-113. 25. Labich, K. (1992). “Airbus takes off.” Fortune, June 1, pp. 102–108. 26. See Pollock, E. J. (1993). “Mediation firms alter the legal landscape.” The Wall Street Journal, March 22, p. B1; Cox, M. (1993). “Electronic campus: Technology threatens to shatter the world of college text- books.” The Wall Street Journal, June 1, p. A1; Reilly, P. M. (1993). “At a crossroads: The instant-new age leaves Time magazine searching for a mission.” The Wall Street Journal, May 12, p. A1; Rohwedder, C. (1993). “Europe’s smaller food shops face finis.” The Wall Street Journal, May 12, p. B1; Fatsis, S. (1995). “Major leagues keep minors at a distance.” The Wall Street Journal, November 8, pp. B1+ ; Norton, E., and G. Stem. (1995). “Steel and aluminum vie over every ounce in a car’s construc- tion.” The Wall Street Journal, May 9, pp. A1+ ; Paré, T. P. (1995). “Why the banks lined up against Gates.” Fortune, May 29, p. 18; “Hitting the mail on the head.” The Economist, April 30, 1994, pp. 69–70; Pacelle, M. (1996). “‘Big Boxes’ by discounters are booming.” The Wall Street Journal, January 17, p. A2; and Pope, K., and L. Cauley. (1998). “In battle for TV ads, cable is now the enemy.” The Wall Street Journal, May 6, pp. B1+ . 27. Tully, S. (1992). “How to cut those #$%* legal costs.” Fortune, September 21, pp. 119–124. 28. See DeWitt, W. (1997). “Crown Cork & Seal/Carnaud Metalbox.” Harvard Business School Case No. 9-296-019. 29. Perry, N. J. (1993). “What’s next for the defense industry.” Fortune, February 22, pp. 94–100. 30. See “Crown Cork and Seal in 1989.” Harvard Business School Case No. 5-395-224. 31. See Brandenburger, A., and B. Nalebuff. (1996). Co-opetition. New York: Doubleday. 32. This approach to studying opportunities was also first suggested in Porter, M. E. (1980). Competitive strategy. New York: Free Press. 33. Jacob, R. (1992). “Service Corp. International: Acquisitions done the right way.” Fortune, November 16, p. 96. 34. Porter, M. E. (1980). Competitive strategy. New York: Free Press. 35. For the definitive discussion of first-mover advantages, see Lieberman, M., and C. Montgomery. (1988). “First-mover advantages.” Strategic Management Journal, 9, pp. 41–58. 36. See Ghemawat, P. (1991). Commitment. New York: Free Press. 37. See Gilbert, R. J., and D. M. Newbery. (1982). “Preemptive patenting and the persistence of monopoly.” American Economic Review, 72(3), pp. 514–526. 38. See Bresnahan, T. F. (1985). “Post-entry competition in the plain paper copier market.” American Economic Review, 85, pp. 15–19, for a discus- sion of Xerox’s patents; and Bright, A. A. (1949). The electric lamp indus- try. New York: Macmillan, for a discussion of General Electric’s patents. 39. See Mansfield, E., M. Schwartz, and S. Wagner. (1981). “Imitation costs and patents: An empirical study.” Economic Journal, 91, pp. 907–918. 40. See Main, O. W. (1955). The Canadian nickel industry. Toronto: University of Toronto Press, for a discussion of asset preemption in the oil and gas industry; Ghemawat, P. (1986). “Wal-Mart store’s discount operations.” Harvard Business School Case No. 9-387- 018, for Wal-Mart’s preemption strategy; Schmalansee, R. (1978). “Entry deterrence in the ready-to-eat breakfast cereal industry.” Bell Journal of Economics, 9(2), pp. 305–327; and Robinson, W. T., and C. Fornell. (1985). “Sources of market pioneer advantages in consumer goods industries.” Journal of Marketing Research, 22(3), pp. 305–307, for a discussion of preemption in the breakfast cereal industry. In this latter case, the preempted valuable asset is shelf space in grocery stores. 41. Klemperer, P. (1986). “Markets with consumer switching costs.” Doctoral thesis, Graduate School of Business, Stanford University; and Wernerfelt, B. (1986). “A special case of dynamic pricing policy.” Management Science, 32, pp. 1562–1566. 42. See Gross, N. (1995). “The technology paradox.” BusinessWeek, March 6, pp. 691–719; Bond, R. S., and D. F. Lean. (1977). Sales, promotion, and product differentiation in two prescription drug markets. Washington, D.C.: U.S. Federal Trade Commission; Montgomery, D. B. (1975). “New product distribution: An analysis of supermarket buyer decision.” Journal of Marketing Research, 12, pp. 255–264; Ries, A., and J. Trout. (1986). Marketing warfare. New York: McGraw-Hill; and Davidson, J. H. (1976). “Why most new consumer brands fail.” Harvard Business Review, 54, March–April, pp. 117–122, for a discussion of switching costs in these industries. 43. Porter, M. E. (1980). Competitive strategy. New York: Free Press. 44. Gibson, R. (1991). “McDonald’s insiders increase their sales of com- pany’s stock.” The Wall Street Journal, June 14, p. A1; and Chartier, J. (2002). “Burger battles.” CNN/Money, http://money.cnn.com, December 11. McDonald’s lost money for only one quarter. It has since repositioned itself with nice upscale fast foods and has re- turned to profitability. 45. Descriptions of these product refinements can be found in Demetrakakes, P. (1994). “Household-chemical makers concentrate on downsizing.” Packaging, 39(1), p. 41; Reda, S. (1995). “Motor oil: Hands-on approach.” Stores, 77(5), pp. 48–49; and Quinn, J. (1995). “KitchenAid.” Incentive, 169(5), pp. 46–47. M02_BARN0088_05_GE_C02.INDD 82 13/09/14 3:21 PM Chapter 2: Evaluating a Firm’s External Environment 83 46. Chartier, J. (2002). “Burger battles.” CNN/Money, http://money.cnn. com, December 11. 47. See Hayes, R. H., and S. G. Wheelwright. (1979). “The dynamics of process-product life cycles.” Harvard Business Review, March–April, p. 127. 48. See www.jdpowers.com. 49. See Porter, M. E. (1980). Competitive strategy. New York: Free Press; and Harrigan, K. R. (1980). Strategies for declining businesses. Lexington, MA: Lexington Books. 50. See Aguilar, F. J., J. L. Bower, and B. Gomes-Casseres. (1985). “Restructuring European petrochemicals: Imperial Chemical Industries, P.L.C.” Harvard Business School Case No. 9-385-203. 51. See Harrigan, K. R. (1980). Strategies for declining businesses. Lexington, MA: Lexington Books. 52. See Klebnikov, P. (1991). “The powerhouse.” Forbes, September 2, pp. 46–52; and Rosenbloom, R. S., and C. Christensen. (1990). “Continuous casting investments at USX corporation.” Harvard Business School Case No. 9-391-121. 53. Finn, E. A. (1987). “General Eclectic.” Forbes, March 23, pp. 74–80. 54. See Smith, L. (1993). “Can defense pain be turned to gain?” Fortune, February 8, pp. 84–96; Perry, N. J. (1993). “What’s next for the defense industry?” Fortune, February 22, pp. 94–100; and Dial, J., and K. J. Murphy. (1995). “Incentive, downsizing, and value creation at General Dynamics.” Journal of Financial Economics, 37, pp. 261–314. M02_BARN0088_05_GE_C02.INDD 83 13/09/14 3:21 PM 84 1. Describe the critical assumptions of the resource-based view. 2. Describe four types of resources and capabilities. 3. Apply the VRIO framework to identify the competi- tive implications of a firm’s resources and capabilities. 4. Apply value chain analysis to identify a firm’s valu- able resources and capabilities. When a Noun Becomes a Verb Google w asn’t the first I nternet sear ch eng ine. A t least 19 sear ch eng ines e xisted—including Lycos, Alta Vista, Excite, Yahoo!, and A sk Jeeves—before Google was introduced in 1998. Nor is Google the only Internet search engine currently operating. Currently, at least 32 Internet search engines exist, including Ask.com, Bing, Baidu, and DuckDuckGo. However, despite wha t appears to be an incr edibly competitive industr y, Google reigns supreme, with a U.S. and worldwide market share in excess of 60 percent of all Internet searches. Indeed, Google has been so successful that it has been “verbicized.” Now, to “google” some- thing means to look something up on the Internet. This is the case even if you don’t use Google to search the Web. Many ha ve w ondered wha t has made G oogle so suc cessful and whether it will be able to maintain—and even extend—its success. Three attributes of G oogle have been most widely cited. First, G oogle is t echnically v ery c ompetent. I n the mid-1990s , all other sear ch eng ines counted key w ords on Web pages and then r eported which Web sites had the most key w ords. Google conceptualized the search process differently and used the relationship among pages as a way to guide users to those Web sites that were most helpful to them. Most people agree that Google’s approach to Internet search was superior. This t echnical c ompetence has enabled G oogle t o buy the t echnologies of sev eral firms—including Keyhole and Global IP S olutions—and then t o lev erage those t echnologies 5. Describe the kinds of resources and capabilities that are likely to be costly to imitate. 6. Describe how a firm uses its structure, formal and informal control processes, and compensation policy to exploit its resources. 7. Discuss how the decision of whether to imitate a firm with a competitive advantage affects the competitive dynamics in an industry. L e a r N i N g O B j e c t i V e s After reading this chapter, you should be able to: MyManagementLab® improve Your grade! Over 10 million students improved their results using the Pearson MyLabs. Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems. 3 c h a p t e r Evaluating a Firm’s Internal Capabilities M03_BARN0088_05_GE_C03.INDD 84 13/09/14 3:13 PM 85 into successful Google products—including Google Earth and Google Hangout. Second, G oogle has been unusually suc cessful in mon - etizing its software—that is, finding ways to make the software it g ives t o cust omers f or fr ee gener ate r evenues f or G oogle. Perhaps the best e xample of this is G oogle’s A dWords pr o- gram—a sy stem tha t uses demand f or G oogle adv ertising t o precisely pr ice the v alue of click ing on to a Web sit e. I n 2012, Google advertising generated $10.42 billion in revenue. Finally, Google’s founders—Larry Page and Sergey Brin— are c onvinced tha t G oogle’s unique or ganizational cultur e is central t o their suc cess. G oogle has a pla yful y et demanding culture. Developers are held to the highest standards of performance but are also encouraged to spend at least 20 percent of their time working on their own personal projects—many of which have turned into great products for Google. Google expects to meet its product announcement dates, but when it issued some new shar es in 2005, it sold 14,159,265 shar es, e xactly. Why? Because those ar e the first eigh t numbers af ter the decimal poin t in pi (3.14159265). G oogle’s unofficial slogan—a not-very-subtle dig on M icrosoft—is “Don’t Do Evil.” So, Google doesn’t de- velop proprietary software that it then a ttempts to sell t o users for high pr ices. Instead, Google trusts its users, follows their lead in dev eloping new products, and adopts an open appr oach to developing software. Whether or not these thr ee a ttributes of G oogle ar e sour ces of sustained c ompetitive advantage is still up f or debate. On the one hand , Google has used all thr ee to develop an open source smart phone operating system—Android—that has emerged as a ser ious competitor for Apple’s operating system. Moreover, Google seems to have figured out how to begin to monetize the success of one of its best-known acquisitions, YouTube. On the other hand , G oogle’s ac quisition of M otorola M obile f or $12.5 billion seems t o have created new challenges f or the fir m. Justified based on the mobile phone pa tents owned by Motorola, Google must nev ertheless find a w ay to make money manufac turing cell phones. Motorola failed in this effort the last few years it owned Motorola Mobile. And Google has never before owned a business that actually made tangible products, like phones. There are, of c ourse, lots of diff erent opinions about G oogle, and it ’s easy t o find them— just “google” Google on the Web, and in less than half a sec ond, you will see mor e than 2 billion Web sites that are related to Google. Sources: www.Google.com; D . Vise and M. M alseed (2005). The G oogle S tory. N Y: Ban tam //Wikipedia/history-of-internet- search-engines. Accessed July 5, 2013. © F oc us D ig ita l/A la m y M03_BARN0088_05_GE_C03.INDD 85 13/09/14 3:13 PM 86 Part 1: The Tools of Strategic Analysis Google has been extremely successful, first in the Internet search engine market and later in related markets. What, if anything, about Google’s resources and capabilities make it likely that this firm will be able to con- tinue its success? The ideas presented in this chapter help answer this question. The Resource-Based View of the Firm In Chapter 2, we saw that it was possible to take some theoretical models developed in economics—specifically the structure-conduct-performance (S-C-P) model—and apply them to develop tools for analyzing a firm’s external threats and opportuni- ties. The same is true for analyzing a firm’s internal strengths and weaknesses. However, whereas the tools described in Chapter 2 were based on the S-C-P model, the tools described in this chapter are based on the resource-based view (RBV) of the firm. The RBV is a model of firm performance that focuses on the resources and capabilities controlled by a firm as sources of competitive advantage.1 What Are Resources and Capabilities? Resources in the RBV are defined as the tangible and intangible assets that a firm controls that it can use to conceive and implement its strategies. Examples of resources include a firm’s factories (a tangible asset), its products (a tangible asset), its reputation among customers (an intangible asset), and teamwork among its managers (an intangible asset). eBay’s tangible assets include its Web site and associ- ated software. Its intangible assets include its brand name in the auction business. Capabilities are a subset of a firm’s resources and are defined as the tangible and intangible assets that enable a firm to take full advantage of the other resources it controls. That is, capabilities alone do not enable a firm to conceive and implement its strategies, but they enable a firm to use other resources to conceive and implement such strategies. Examples of capabilities might include a firm’s marketing skills and teamwork and cooperation among its managers. At eBay, the cooperation among software developers and marketing people that made it possible for eBay to dominate the online action market is an example of a capability. A firm’s resources and capabilities can be classified into four broad categories: financial resources, physical resources, individual resources, and organizational resources. Financial resources include all the money, from what- ever source, that firms use to conceive and implement strategies. These financial resources include cash from entrepreneurs, equity holders, bondholders, and banks. Retained earnings, or the profit that a firm made earlier in its history and invests in itself, are also an important type of financial resource. Physical resources include all the physical technology used in a firm. This includes a firm’s plant and equipment, its geographic location, and its access to raw materials. Specific examples of plant and equipment that are part of a firm’s physical resources are a firm’s computer hardware and software technology, robots used in manufacturing, and automated warehouses. Geographic location, as a type of physical resource, is important for firms as diverse as Wal-Mart (with its operations in rural markets generating, on average, higher returns than its operations in more competitive urban markets) and L. L. Bean (a catalogue retail firm that believes that its rural Maine location helps its employees identify with the outdoor lifestyle of many of its customers).2 Human resources include the training, experience, judgment, intelligence, rela- tionships, and insight of individual managers and workers in a firm.3 The importance M03_BARN0088_05_GE_C03.INDD 86 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 87 of the human resources of well-known entrepreneurs such as Bill Gates (Microsoft) and Steve Jobs (formerly at Apple) is broadly understood. However, valuable human resources are not limited to just entrepreneurs or senior managers. Each employee at a firm like Southwest Airlines is seen as essential for the overall success of the firm. Whether it is the willingness of the gate agent to joke with the harried traveler, or a baggage handler hustling to get a passenger’s bag into a plane, or even a pilot’s decision to fly in a way that saves fuel—all of these human resources are part of the resource base that has enabled Southwest to gain competitive advantages in the very competitive U.S. airline industry.4 Whereas human resources are an attribute of single individuals, organiza- tional resources are an attribute of groups of individuals. Organizational resources include a firm’s formal reporting structure; its formal and informal planning, con- trolling, and coordinating systems; its culture and reputation; and informal rela- tions among groups within a firm and between a firm and those in its environment. At Southwest Airlines, relationships among individual resources are an important organizational resource. For example, it is not unusual to see the pilots at Southwest helping to load the bags on an airplane to ensure that the plane leaves on time. This kind of cooperation and dedication shows up in an intense loyalty between Southwest employees and the firm—a loyalty that manifests itself in low employee turnover and high employee productivity, even though more than 80 percent of Southwest’s workforce is unionized. Critical Assumptions of the Resource-Based View The RBV rests on two fundamental assumptions about the resources and capabili- ties that firms may control. First, different firms may possess different bundles of resources and capabilities, even if they are competing in the same industry. This is the assumption of firm resource heterogeneity. Resource heterogeneity implies that for a given business activity, some firms may be more skilled in accomplish- ing this activity than other firms. In manufacturing, for example, Toyota continues to be more skilled than, say, General Motors. In product design, Apple continues to be more skilled than, say, IBM. In motorcycles, Harley Davidson’s reputation for big, bad, and loud rides separates it from its competitors. Second, some of these resource and capability differences among firms may be long lasting because it may be very costly for firms without certain resources and capabilities to develop or acquire them. This is the assumption of resource immobility. For example, Toyota has had its advantage in manufacturing for at least 30 years. Apple has had product design advantages over IBM since Apple was founded in the 1980s. And eBay has been able to retain its brand reputation since the beginning of the online auction industry. It is not that GM, IBM, and eBay’s competitors are unaware of their disadvantages. Indeed, some of these firms—notably GM and IBM—have made progress in addressing their disadvan- tages. However, despite these efforts, Toyota, Apple, and, to a lesser extent, eBay continue to enjoy advantages over their competition. Taken together, these two assumptions make it possible to explain why some firms outperform other firms, even if these firms are all competing in the same in- dustry. If a firm possesses valuable resources and capabilities that few other firms possess and if these other firms find it too costly to imitate these resources and capabilities, the firm that possesses these tangible and intangible assets can gain a sustained competitive advantage. The economic logic that underlies the RBV is described in more detail in the Strategy in Depth feature. M03_BARN0088_05_GE_C03.INDD 87 13/09/14 3:13 PM 88 Part 1: The Tools of Strategic Analysis The theoretical roots of the resource-based view can be traced to research done by David Ricardo in 1817. Interestingly, Ricardo was not even studying the profitability of firms; he was interested in the eco- nomic consequences of owning more or less fertile farm land. Unlike many other inputs into the production process, the total supply of land is relatively fixed and cannot be significantly increased in response to higher demand and prices. Such inputs are said to be inelastic in supply be- cause their quantity of supply is fixed and does not respond to price increases. In these settings, it is possible for those who own higher-quality inputs to gain competitive advantages. Ricardo’s argument concerning land as a productive input is sum- marized in Figure 3.1. Imagine that there are many parcels of land suitable for growing wheat. Also, suppose that the fertility of these different parcels varies from high fertility (low costs of production) to low fertility (high costs of production). It seems obvious that when the market price for wheat is low, it will only pay farmers with the most fertile land to grow wheat. Only these farmers will have costs low enough to make money when the market price for wheat is low. As the market price for wheat increases, then farmers with progressively less fertile land will be able to use it to grow wheat. These observations lead to the market sup- ply curve in panel A of Figure 3.1: As prices (P) go up, supply (S) also goes up. At some point on this supply curve, supply will equal demand (D). This point determines the market price for wheat, given supply and demand. This price is called P* in the figure. Now consider the situation facing two different kinds of farmers. Ricardo assumed that both these farmers follow traditional economic logic by producing a quantity (q) such that their marginal cost (MC) equals their marginal revenue (MR); that is, they produce enough wheat so that the cost of producing the last bushel of wheat equals the rev- enue they will get from selling that last bushel. However, this decision for the farm with less fertile land (in panel B of the figure) generates revenues that ex- actly equal the average total cost (ATC) of the only capital this farmer is as- sumed to employ, the cost of his land. In contrast, the farmer with more fertile land (in panel C of the figure) has an average total cost (ATC) less than the market-determined price and thus is able to earn an above-normal economic profit. This is because at the market- determined price, P*, MC equals ATC for the farmer with less fertile land, whereas MC is greater than ATC for the farmer with more fertile land. In traditional economic analy- sis, the profit earned by the farmer with more fertile land should lead other farmers to enter into this mar- ket, that is, to obtain some land and produce wheat. However, all the land that can be used to produce wheat in a way that generates at least a normal return given the market price P* is already in production. In particular, no more very fertile land is avail- able, and fertile land (by assumption) cannot be created. This is what is Ricardian Economics and the Resource-Based View Strategy in Depth The VRio Framework Armed with the RBV, it is possible to develop a set of tools for analyzing all the different resources and capabilities a firm might possess and the potential of each of these to generate competitive advantages. In this way, it will be possible to identify a firm’s internal strengths and its internal weaknesses. The primary tool for accomplishing this internal analysis is called the VRIO framework.5 The acronym, VRIO, in VRIO framework stands for four questions one must ask about a resource or capability to determine its competitive potential: the question of Value, the question of Rarity, the question of Imitability, and the question of Organization. These four questions are summarized in Table 3.1. M03_BARN0088_05_GE_C03.INDD 88 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 89 meant by land being inelastic in sup- ply. Thus, the farmer with more fertile land and lower production costs has a sustained competitive advantage over those farmers with less fertile land and higher production costs. Therefore, the farmer with the more fertile land is able to earn an above- normal economic profit. Of course, at least two events can threaten this sustained competitive advantage. First, market demand may shift down and to the left. This would force farmers with less fertile land to cease production and would also re- duce the profit of those with more fer- tile land. If demand shifted far enough, this profit might disappear altogether. Second, farmers with less fertile land may discover low-cost ways of increasing their land’s fertility, thereby reducing the competitive advantage of farmers with more fertile land. For ex- ample, farmers with less fertile land may be able to use inexpensive fertil- izers to increase their land’s fertility. The existence of such low-cost fertiliz- ers suggests that, although land may be in fixed supply, fertility may not be. If enough farmers can increase the fertil- ity of their land, then the profits origi- nally earned by the farmers with the more fertile land will disappear. Of course, what the RBV does is recognize that land is not the only pro- ductive input that is inelastic in supply and that farmers are not the only firms that benefit from having such resources at their disposal. Source: D. Ricardo (1817). Principles of political economy and taxation. London: J. Murray. Q* Price S S D D P* q1 Price MC ATC q2 Price MC ATC Market supply and demand, market quantity (Q*) and market-determined price (P*) A. Performance of firm with less fertile land (higher average total cost – ATC) B. Performance of firm with more fertile land (lower average total cost – ATC) C. MC = marginal costs, ATC = average total costs, Q = aggregate quantity produced in the industry, q = quantity produced by each firm in the industry Figure 3.1 The Economics of Land with Different Levels of Fertility The Question of Value The question of value is: “Do resources and capabilities enable a firm to exploit an external opportunity or neutralize an external threat?” If a firm answers this question with a “yes,” then its resources and capabilities are valuable and can be considered strengths. If a firm answers this question with a “no,” its resources and capabilities are weaknesses. There is nothing inherently valuable about a firm’s resources and capabilities. Rather, they are only valuable to the extent that they enable a firm to enhance its competitive position. Sometimes, the same resources and capabilities can be strengths in one market and weaknesses in another. M03_BARN0088_05_GE_C03.INDD 89 13/09/14 3:13 PM 90 Part 1: The Tools of Strategic Analysis Valuable r esources and Firm performance Sometimes it is difficult to know for sure whether a firm’s resources and capabili- ties really enable it to exploit its external opportunities or neutralize its external threats. Sometimes this requires detailed operational information that may not be readily available. Other times, the full impact of a firm’s resources and capabili- ties on its external opportunities and threats may not be known for some time. One way to track the impact of a firm’s resources and capabilities on its opportunities and threats is to examine the impact of using these resources and capa- bilities on a firm’s revenues and costs. In general, firms that use their resources and capabilities to exploit opportunities or neutralize threats will see an increase in their net revenues, or a decrease in their net costs, or both, compared to the situation in which they were not using these resources and capabilities to exploit opportunities or neutralize threats. That is, the value of these resources and capabilities will gener- ally manifest itself in either higher revenues or lower costs or both, once a firm starts using them to exploit opportunities or neutralize threats. a pplying the Question of Value For many firms, the answer to the question of value has been “yes.” That is, many firms have resources and capabilities that are used to exploit opportunities and neu- tralize threats, and the use of these resources and capabilities enables these firms to increase their net revenues or decrease their net costs. For example, historically Sony had a great deal of experience in designing, manufacturing, and selling minia- turized electronic technology. Sony used these resources and capabilities to exploit opportunities, including video games, digital cameras, computers and peripherals, handheld computers, home video and audio, portable audio, and car audio. 3M has used its resources and capabilities in substrates, coatings, and adhesives, along with an organizational culture that rewards risk-taking and creativity, to exploit opportunities in office products, including invisible tape and Post-It notes. Sony’s and 3M’s resources and capabilities—including their specific technological skills and their creative organizational cultures—have made it possible for these firms to respond to, and even create, new opportunities.6 Unfortunately, for other firms the answer to the question of value appears to be “no.” The merger of AOL and Time Warner was supposed to create a new kind of entertainment and media company; it is now widely recognized that Time Warner has been unable to marshal the resources necessary to create economic value. Time Warner wrote off $90 billion in value in 2002; its stock price has been at record lows, and there have been rumors that it will be broken up. Ironically, many of the segments of this diverse media conglomerate continue to create value. However, the company as a whole has not realized the synergies that it was expected to generate when it was created. Put differently, these synergies—as resources and capabilities—are apparently not valuable.7 1. The Question of Value. Does a resource enable a firm to exploit an environmental opportunity and/or neutralize an environmental threat? 2. The Question of Rarity. Is a resource currently controlled by only a small number of competing firms? 3. The Question of Imitability. Do firms without a resource face a cost disadvantage in obtaining or developing it? 4. The Question of Organization. Are a firm’s other policies and procedures organized to support the exploitation of its valuable, rare, and costly-to-imitate resources? TABlE 3.1 Questions Needed to Conduct a Resource-Based Analysis of a Firm’s Internal Strengths and Weaknesses M03_BARN0088_05_GE_C03.INDD 90 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 91 Entrepreneurial firms, like all other firms, must be able to answer “yes” to the question of value. That is, decisions by entrepreneurs to organize a firm to exploit an opportunity must increase revenues or reduce costs be- yond what would be the case if they did not choose to organize a firm to exploit an opportunity. However, entrepreneurs often find it difficult to answer the question of value before they actually organize a firm and try to exploit an oppor- tunity. This is because the impact of exploiting an opportunity on a firm’s revenues and costs often cannot be known, with certainty, before that op- portunity is exploited. Despite these challenges, entre- preneurs often are required to not only estimate the value of any opportuni- ties they are thinking about exploiting, but to do so in some detail and in a written form. Projections about how organizing a firm to exploit an op- portunity will affect a firm’s revenues and costs are often the centerpiece of an entrepreneur’s business plan—a document that summarizes how an entrepreneur will organize a firm to exploit an opportunity, along with the economic implications of exploiting that opportunity. Two schools of thought ex- ist as to the value of entrepreneurs writing business plans. On the one hand, some authors argue that writ- ing a business plan is likely to be helpful for entrepreneurs because it forces them to be explicit about their assumptions, exposes those as- sumptions to others for critique and analysis, and helps entrepreneurs focus their efforts on building a new organization and exploiting an opportunity. On the other hand, other authors argue that writing a business plan may actually hurt an entrepre- neur’s performance because writing such a plan may divert an entrepre- neur’s attention from more important activities, may give entrepreneurs the illusion that they have more control of their business than they actually do, and may lead to decision-making errors. Research supports both points of view. Scott Shane and Frederic Delmar have shown that writing a business plan significantly enhances the prob- ability that an entrepreneurial firm will survive. In contrast, Amar Bhide shows that most entrepreneurs go through many different business plans before they land on one that describes a business opportunity that they actually support. For Bhide, writing the business plan is, at best, a means of helping to create a new opportu- nity. Because most business plans are abandoned soon after they are writ- ten, writing business plans has limited value. One way to resolve the con- flicts among these scholars is to ac- cept that writing a business plan may be very useful in some settings and not so useful in others. In particular, when it is possible for entrepreneurs to collect sufficient information about a potential market opportunity so as to be able to describe the probability of different outcomes associated with exploiting that opportunity—a setting described as risky in the entrepreneur- ship literature—business planning can be very helpful. However, when such information cannot be collected—a set- ting described as uncertain in the entre- preneurship literature—then writing a business plan would be of only limited value, and its disadvantages might outweigh any advantages it might create. Sources: S. Shane and F. Delmar (2004). “Planning for the market: Business planning before market- ing and the continuation of organizing efforts.” Journal of Business Venturing, 19, pp. 767–785; A. Bhide (2000). The origin and evolution of new businesses. New York: Oxford; F. H. Knight (1921). Risk, uncertainty, and profit. Chicago: University of Chicago Press; S. Alvarez and J. Barney (2006). “Discovery and creation: Alternative theories in the field of entrepreneurship.” Strategic Entrepreneurship Journal, 1(1), pp. 11–26. Are Business Plans Good for Entrepreneurs? Strategy in the Emerging Enterprise Using Value c hain a nalysis to identify potentially Valuable r esources and c apabilities One way to identify potentially valuable resources and capabilities controlled by a firm is to study that firm’s value chain. A firm’s value chain is the set of busi- ness activities in which it engages to develop, produce, and market its products or M03_BARN0088_05_GE_C03.INDD 91 13/09/14 3:13 PM 92 Part 1: The Tools of Strategic Analysis services. Each step in a firm’s value chain requires the application and integration of different resources and capabilities. Because different firms may make different choices about which value chain activities they will engage in, they can end up developing different sets of resources and capabilities. This can be the case even if these firms are all operating in the same industry. These choices can have implica- tions for a firm’s strategies, and, as described in the Ethics and Strategy feature, they can also have implications for society more generally. Consider, for example, the oil industry. Figure 3.2 provides a simplified list of all the business activities that must be completed if crude oil is to be turned into consumer products, such as gasoline. These activities include exploring for crude oil, drilling for crude oil, pumping crude oil, shipping crude oil, buying crude oil, refining crude oil, selling refined products to distributors, shipping refined prod- ucts, and selling refined products to final customers. Different firms may make different choices about which of these stages in the oil industry they want to operate. Thus, the firms in the oil industry may have very different resources and capabilities. For example, exploring for crude oil is very ex- pensive and requires substantial financial resources. It also requires access to land (a physical resource), the application of substantial scientific and technical knowl- edge (individual resources), and an organizational commitment to risk-taking and exploration (organizational resources). Firms that operate in this stage of the oil business are likely to have very different resources and capabilities than those that, for example, sell refined oil products to final customers. To be successful in the retail stage of this industry, a firm needs retail outlets (such as stores and gas stations), which are costly to build and require both financial and physical resources. These outlets, in turn, need to be staffed by salespeople—individual resources—and marketing these products to customers through advertisements and other means can require a commitment to creativity—an organizational resource. However, even firms that operate in the same set of value chain activities in an industry may approach these activities very differently and therefore may Exploring for crude oil Drilling for crude oil Pumping crude oil Shipping crude oil Buying crude oil Refining crude oil Selling refined products to distributors Shipping refined products Selling refined products to final customers Figure 3.2 A Simplified Value Chain of Activities of Oil-Based Refined Products such as Gasoline and Motor Oil M03_BARN0088_05_GE_C03.INDD 92 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 93 Strategic management adopts the perspective of a firm’s owners in discussing how to gain and sustain competitive advantages. Even when adopting a stakeholder perspective (see the Ethics and Strategy feature in Chapter 1), how a firm can improve its performance and increase the wealth of its owners still takes center stage. However, an exclusive focus on the performance of a firm and the wealth of its owners can sometimes have broader effects—on society and on the environment—that are not fully recognized. Economists call these broader effects “externalities” because they are external to the core issue in economics and strategic management of how firms can maximize their per- formance. They are external to this issue because firms generally do not bear the full costs of the externali- ties their profit-maximizing behavior creates. Externalities can take many forms. The most obvious of these has to do with pollution and the environ- ment. If, for example, in the process of maximizing its performance a firm engages in activities that pollute the environment, the impact of that pol- lution is an externality. Such pollution reduces our quality of life and hurts the environment, but the firm creating this pollution often does not bear the full costs of doing so. Other externalities have to do with a firm’s impact on the public’s health. For example, when tobacco companies maximize their profits by selling tobacco to children, they are also creating a public health external- ity. Getting children hooked on tobacco early on might be good for the bot- tom line of a tobacco company, but it increases the chances of these children developing lung cancer, emphysema, heart disease, and the other ailments associated with tobacco. Obviously, these individuals absorb most of the adverse consequences of these diseases, but society suffers as well from the high health care costs that are engendered. Put differently, while adopting a simple profit-maximizing perspective in choosing and implementing strategies can have positive impacts for a firm, its owners, and its stakeholders, it can also have negative consequences for society as a whole. Two broad solutions to this problem of externalities have been pro- posed. First, governments can take on the responsibility of directly monitoring and regulating the behavior of firms in areas where these kinds of externalities are likely to develop. Second, govern- ments can use lawsuits and regulations to ensure that firms directly bear more of the costs of any externalities their behavior might generate. Once these externalities are “internalized,” it is then a matter of self-interest for firms not to engage in activities that generate nega- tive externalities. Consumers can sometimes also help internalize the externalities gen- erated by a firm’s behavior by ad- justing their consumption patterns to buy products or services only from companies that do not generate nega- tive externalities. Consumers can even be more proactive and let firms know which of their strategies are particu- larly troubling. For example, many consumers united to boycott firms with operations in South Africa when South Africa was still implementing a policy of apartheid. Ultimately, this pressure not only changed the strat- egies of many firms; it also helped change South Africa’s domestic poli- cies. More recently, consumer pres- sures on pharmaceutical companies forced these firms to make their AIDS drugs more accessible in less devel- oped countries in Africa; similar pres- sures forced Nike to adjust the wages and working conditions of the individ- uals who manufacture Nike’s shoes. To the extent that sufficient demand for “socially responsible firms” exists in the marketplace, it may make profit- maximizing sense for a firm to engage in socially responsible behavior by re- ducing the extent to which its actions generate negative externalities. Sources: “AIDS in Africa.” British Medical Journal, June 1, p. 456; J. S. Friedman (2003). “Paying for apartheid.” Nation, June 6, pp. 7+; L. Lee (2000). “Can Nike still do it?” BusinessWeek, February 21, pp. 121+. Ethics and Strategy Externalities and the Broader Consequences of Profit Maximization M03_BARN0088_05_GE_C03.INDD 93 13/09/14 3:13 PM 94 Part 1: The Tools of Strategic Analysis develop very different resources and capabilities associated with these activities. For example, two firms may sell refined oil products to final customers. However, one of these firms may sell only through retail outlets it owns, whereas the second may sell only through retail outlets it does not own. The first firm’s financial and physical resources are likely to be very different from the second firm’s, although these two firms may have similar individual and organizational resources. Studying a firm’s value chain forces us to think about firm resources and capabilities in a disaggregated way. Although it is possible to characterize a firm’s resources and capabilities more broadly, it is usually more helpful to think about how each of the activities a firm engages in affects its financial, physical, individ- ual, and organizational resources. With this understanding, it is possible to begin to recognize potential sources of competitive advantage for a firm in a much more detailed way. Because this type of analysis can be so helpful in identifying the financial, physical, individual, and organizational resources and capabilities controlled by a firm, several generic value chains for identifying them have been developed. One of these, proposed by the management-consulting firm McKinsey and Company, is presented in Figure 3.3.8 This relatively simple model suggests that the creation of value almost always involves six distinct activities: technology development, product design, manufacturing, marketing, distribution, and ser- vice. Firms can develop distinctive capabilities in any one or any combination of these activities. The Question of Rarity Understanding the value of a firm’s resources and capabilities is an important first consideration in understanding a firm’s internal strengths and weaknesses. However, if a particular resource or capability is controlled by numerous compet- ing firms, then that resource is unlikely to be a source of competitive advantage for any one of them. Instead, valuable but common (i.e., not rare) resources and capabilities are sources of competitive parity. Only when a resource is not con- trolled by numerous other firms is it likely to be a source of competitive advan- tage. These observations lead to the question of rarity: “How many competing firms already possess particular valuable resources and capabilities?” Consider, for example, competition among television sports channels. All the major networks broadcast sports. In addition, several sports-only cable Source Sophistication Patents Product/process choices Technology development Function Physical characteristics Aesthetics Quality Product design Integration Raw materials Capacity Location Procurement Parts production Assembly Manufacturing Prices Advertising/ promotion Sales force Package Brand Marketing Channels Integration Inventory Warehousing Transport Distribution Warranty Speed Captive/independent Prices Service Figure 3.3 The Generic Value Chain Developed by McKinsey and Company M03_BARN0088_05_GE_C03.INDD 94 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 95 channels are available, including the best-known all-sports channel, ESPN. Several years ago, ESPN began televising what were then called alternative sports—skateboarding, snowboarding, mountain biking, and so forth. The surprising popularity of these programs led ESPN to package them into an an- nual competition called the “X-Games.” “X” stands for “extreme,” and ESPN has definitely gone to the extreme in including sports in the X-Games. The X-Games have included sports such as sky-surfing, competitive high diving, competitive bungee cord jumping, and so forth. ESPN broadcasts both a sum- mer X-Games and a winter X-Games. No other sports outlet has yet made such a commitment to so-called extreme sports, and it has paid handsome dividends for ESPN—extreme sports have very low-cost broadcast rights and draw a fairly large audience. This commitment to extreme sports—as an example of a valuable and rare capability—has been a source of at least a temporary com- petitive advantage for ESPN. Of course, not all of a firm’s resources and capabilities have to be valuable and rare. Indeed, most firms have a resource base that is composed primarily of valuable but common resources and capabilities. These resources cannot be sources of even temporary competitive advantage, but are essential if a firm is to gain competitive parity. Under conditions of competitive parity, although no one firm gains a competitive advantage, firms do increase their probability of survival. Consider, for example, a telephone system as a resource or capability. Because telephone systems are widely available and because virtually all orga- nizations have access to telephone systems, these systems are not rare and thus are not a source of competitive advantage. However, firms that do not possess a telephone system are likely to give their competitors an important advantage and place themselves at a competitive disadvantage. How rare a valuable resource or capability must be in order to have the potential for generating a competitive advantage varies from situation to situation. It is not difficult to see that, if a firm’s valuable resources and capabilities are abso- lutely unique among a set of current and potential competitors, they can generate a competitive advantage. However, it may be possible for a small number of firms in an industry to possess a particular valuable resource or capability and still obtain a competitive advantage. In general, as long as the number of firms that possess a particular valuable resource or capability is less than the number of firms needed to generate perfect competition dynamics in an industry, that resource or capabil- ity can be considered rare and a potential source of competitive advantage. The Question of Imitability Firms with valuable and rare resources are often strategic innovators because they are able to conceive and engage in strategies that other firms cannot because they lack the relevant resources and capabilities. These firms may gain the first-mover advantages discussed in Chapter 2. Valuable and rare organizational resources, however, can be sources of sustained competitive advantage only if firms that do not possess them face a cost disadvantage in obtaining or developing them, compared to firms that already possess them. These kinds of resources are imperfectly imitable.9 These observa- tions lead to the question of imitability: “Do firms without a resource or capabil- ity face a cost disadvantage in obtaining or developing it compared to firms that already possess it?” M03_BARN0088_05_GE_C03.INDD 95 13/09/14 3:13 PM 96 Part 1: The Tools of Strategic Analysis Imagine an industry with five essentially identical firms. Each of these firms manufactures the same products, uses the same raw materials, and sells the prod- ucts to the same customers through the same distribution channels. It is not hard to see that firms in this kind of industry will have normal economic performance. Now, suppose that one of these firms, for whatever reason, discovers or develops a heretofore unrecognized valuable resource and uses that resource either to ex- ploit an external opportunity or to neutralize an external threat. Obviously, this firm will gain a competitive advantage over the others. This firm’s competitors can respond to this competitive advantage in at least two ways. First, they can ignore the success of this one firm and continue as be- fore. This action, of course, will put them at a competitive disadvantage. Second, these firms can attempt to understand why this one firm is able to be successful and then duplicate its resources to implement a similar strategy. If competitors have no cost disadvantages in acquiring or developing the needed resources, then this imitative approach will generate competitive parity in the industry. Sometimes, however, for reasons that will be discussed later, competing firms may face an important cost disadvantage in duplicating a successful firm’s valuable resources. If this is the case, this one innovative firm may gain a sus- tained competitive advantage—an advantage that is not competed away through strategic imitation. Firms that possess and exploit costly-to-imitate, rare, and valuable resources in choosing and implementing their strategies may enjoy a period of sustained competitive advantage.10 For example, other sports networks have observed the success of ESPN’s X-Games and are beginning to broadcast similar competitions. NBC, for ex- ample, developed its own version of the X-Games, called the “Gravity Games,” and even the Olympics now include sports that were previously perceived as being “too extreme” for this mainline sports competition. Several Fox sports channels broadcast programs that feature extreme sports, and at least one new cable channel (Fuel) broadcasts only extreme sports. Fuel was recently acquired by Fox to provide another outlet for extreme sports on a Fox channel. Whether these efforts will be able to attract the competitors that the X-Games attract, whether winners at these other competitions will gain as much status in their sports as do winners of the X-Games, and whether these other competitions and programs will gain the reputation among viewers enjoyed by ESPN will go a long way to determining whether ESPN’s competitive advantage in extreme sports is temporary or sustained.11 Forms of imitation: Direct Duplication and s ubstitution In general, imitation occurs in one of two ways: direct duplication or substitution. Imitating firms can attempt to directly duplicate the resources possessed by the firm with a competitive advantage. Thus, NBC sponsoring an alternative ex- treme games competition can be thought of as an effort to directly duplicate the resources that enabled ESPN’s X-Games to be successful. If the cost of this direct duplication is too high, then a firm with these resources and capabilities may obtain a sustained competitive advantage. If this cost is not too high, then any competitive advantages in this setting will be temporary. Imitating firms can also attempt to substitute other resources for a costly- to-imitate resource possessed by a firm with a competitive advantage. Extreme sports shows and an extreme sports cable channel are potential substitutes for ESPN’s X-Games strategy. These shows appeal to much the same audience as the X-Games, but they do not require the same resources as an X-Games strategy M03_BARN0088_05_GE_C03.INDD 96 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 97 requires (i.e., because they are not competitions, they do not require the network to bring together a large number of athletes all at once). If substitute resources ex- ist and if imitating firms do not face a cost disadvantage in obtaining them, then the competitive advantage of other firms will be temporary. However, if these resources have no substitutes or if the cost of acquiring these substitutes is greater than the cost of obtaining the original resources, then competitive advantages can be sustained. Why Might it Be c ostly to imitate a nother Firm’s r esources or c apabilities? A number of authors have studied why it might be costly for one firm to imitate the resources and capabilities of another. Four sources of costly imitation have been noted.12 They are summarized in Table 3.2 and discussed in the following text. Unique h istorical c onditions. It may be the case that a firm was able to acquire or develop its resources and capabilities in a low-cost manner because of its unique historical conditions. The ability of firms to acquire, develop, and use resources often depends on their place in time and space. Once time and history pass, firms that do not have space-and-time-dependent resources face a significant cost dis- advantage in obtaining and developing them because doing so would require them to re-create history.13 ESPN’s early commitment to extreme sports is an example of these unique historical conditions. The status and reputation of the X-Games were created because ESPN happened to be the first major sports outlet that took these com- petitions seriously. The X-Games became the most important competition in many of these extreme sports. Indeed, for snowboarders, winning a gold medal in the X-Games is almost as important as—if not more important than—winning a gold medal in the Winter Olympics. Other sports outlets that hope to be able to compete with the X-Games will have to overcome both the status of ESPN as “the worldwide leader in sports” and its historical advantage in extreme sports. Overcoming these advantages is likely to be costly, making competitive threats from direct duplication, at least, less significant. Of course, firms can also act to increase the costliness of imitating the resources and capabilities they control. ESPN is doing this by expanding its Unique Historical Conditions. When a firm gains low-cost access to resources be- cause of its place in time and space, other firms may find these resources to be costly to imitate. Both first-mover advantages and path dependence can create unique historical conditions. Causal Ambiguity. When competitors cannot tell, for sure, what enables a firm to gain an advantage, that advantage may be costly to imitate. Sources of causal am- biguity include when competitive advantages are based on “taken-for-granted” resources and capabilities, when multiple non-testable hypotheses exist about why a firm has a competitive advantage, and when a firm’s advantages are based on complex sets of interrelated capabilities. Social Complexity. When the resources and capabilities a firm uses to gain a com- petitive advantage involve interpersonal relationships, trust, culture, and other social resources that are costly to imitate in the short term. Patents. Only a source of sustained competitive advantage in a few industries, including pharmaceuticals and specialty chemicals. TABlE 3.2 Sources of Costly Imitation M03_BARN0088_05_GE_C03.INDD 97 13/09/14 3:13 PM 98 Part 1: The Tools of Strategic Analysis coverage of extreme sports and by engaging in a “grassroots” marketing cam- paign that engages young “extreme athletes” in local competitions. The purpose of these efforts is clear: to keep ESPN’s status as the most important source of ex- treme sports competitions intact.14 Unique historical circumstances can give a firm a sustained competitive ad- vantage in at least two ways. First, it may be that a particular firm was the first in an industry to recognize and exploit an opportunity, and being first gave the firm one or more of the first-mover advantages discussed in Chapter 2. Thus, although in principle other firms in an industry could have exploited an opportunity, that only one firm did so makes it more costly for other firms to imitate the original firm. A second way that history can have an impact on a firm builds on the con- cept of path dependence.15 A process is said to be path dependent when events early in the evolution of a process have significant effects on subsequent events. In the evolution of competitive advantage, path dependence suggests that a firm may gain a competitive advantage in the current period based on the acquisition and development of resources in earlier periods. In these earlier periods, it is often not clear what the full future value of particular resources will be. Because of this uncertainty, firms are able to acquire or develop these resources for less than what will turn out to be their full value. However, once the full value of these resources is revealed, other firms seeking to acquire or develop these resources will need to pay their full known value, which (in general) will be greater than the costs incurred by the firm that acquired or developed these resources in some earlier period. The cost of acquiring both duplicate and substitute resources would rise once their full value became known. Consider, for example, a firm that purchased land for ranching some time ago and discovered a rich supply of oil on this land in the current period. The difference between the value of this land as a supplier of oil (high) and the value of this land for ranching (low) is a source of competitive advantage for this firm. Moreover, other firms attempting to acquire this or adjacent land will now have to pay for the full value of the land in its use as a supply of oil (high) and thus will be at a cost disadvantage compared to the firm that acquired it some time ago for ranching. c ausal a mbiguity. A second reason why a firm’s resources and capabilities may be costly to imitate is that imitating firms may not understand the relationship between the resources and capabilities controlled by a firm and that firm’s com- petitive advantage. In other words, the relationship between firm resources and capabilities and competitive advantage may be causally ambiguous. At first, it seems unlikely that causal ambiguity about the sources of compet- itive advantage for a firm would ever exist. Managers in a firm seem likely to un- derstand the sources of their own competitive advantage. If managers in one firm understand the relationship between resources and competitive advantage, then it seems likely that managers in other firms would also be able to discover these relationships and thus would have a clear understanding of which resources and capabilities they should duplicate or seek substitutes for. If there are no other sources of cost disadvantage for imitating firms, imitation should lead to competi- tive parity and normal economic performance.16 However, it is not always the case that managers in a particular firm will fully understand the relationship between the resources and capabilities they control and competitive advantage. This lack of understanding could occur for at least three reasons. First, it may be that the resources and capabilities that M03_BARN0088_05_GE_C03.INDD 98 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 99 generate competitive advantage are so taken for granted, so much a part of the day-to-day experience of managers in a firm, that these managers are unaware of them.17 Organizational resources and capabilities such as teamwork among top managers, organizational culture, relationships among other employees, and rela- tionships with customers and suppliers may be almost “invisible” to managers in a firm.18 If managers in firms that have such capabilities do not understand their relationship to competitive advantage, managers in other firms face significant challenges in understanding which resources they should imitate. Second, managers may have multiple hypotheses about which resources and capabilities enable their firm to gain a competitive advantage, but they may be unable to evaluate which of these resources and capabilities, alone or in combination, actually create the competitive advantage. For example, if one asks successful entrepreneurs what enabled them to be successful, they are likely to reply with several hypotheses, such as “hard work, willingness to take risks, and a high-quality top management team.” However, if one asks what happened to unsuccessful entrepreneurs, they, too, are likely to suggest that their firms were characterized by “hard work, willingness to take risks, and a high-quality top management team.” It may be the case that “hard work, willingness to take risks, and a high-quality top management team” are important resources and capa- bilities for entrepreneurial firm success, but other factors may also play a role. Without rigorous experiments, it is difficult to establish which of these resources have a causal relationship with competitive advantage and which do not. Finally, it may be that not just a few resources and capabilities enable a firm to gain a competitive advantage, but that literally thousands of these organizational attributes, bundled together, generate these advantages. When the resources and capabilities that generate competitive advantage are complex networks of relationships between individuals, groups, and technology, imitation can be costly. Whenever the sources of competitive advantage are widely diffused across people, locations, and processes in a firm, those sources will be costly to imitate. Perhaps the best example of such a resource is knowledge itself. To the extent that valuable knowledge about a firm’s products, processes, customers, and so on is widely diffused throughout an organization, competitors will have diffi- culty imitating that knowledge, and it can be a source of sustained competitive advantage.19 s ocial c omplexity. A third reason that a firm’s resources and capabilities may be costly to imitate is that they may be socially complex phenomena, beyond the ability of firms to systematically manage and influence. When competitive advantages are based on such complex social phenomena, the ability of other firms to imitate these resources and capabilities, either through direct duplication or substitution, is significantly constrained. Efforts to influence these kinds of phenomena are likely to be much more costly than they would be if these phe- nomena developed in a natural way over time in a firm.20 A wide variety of firm resources and capabilities may be socially complex. Examples include the interpersonal relations among managers in a firm, a firm’s culture, and a firm’s reputation among suppliers and customers.21 Notice that in most of these cases it is possible to specify how these socially complex resources add value to a firm. Thus, there is little or no causal ambiguity surrounding the link between these firm resources and capabilities and competitive advantage. However, understanding that an organizational culture with certain attributes or M03_BARN0088_05_GE_C03.INDD 99 13/09/14 3:13 PM 100 Part 1: The Tools of Strategic Analysis quality relations among managers can improve a firm’s efficiency and effective- ness does not necessarily imply that firms lacking these attributes can engage in systematic efforts to create them or that low-cost substitutes for them exist. For the time being, such social engineering may be beyond the abilities of most firms. At the very least, such social engineering is likely to be much more costly than it would be if socially complex resources evolved naturally within a firm.22 It is interesting to note that firms seeking to imitate complex physical technology often do not face the cost disadvantages of imitating complex social phenomena. A great deal of physical technology (machine tools, robots, and so forth) can be purchased in supply markets. Even when a firm develops its own unique physical technology, reverse engineering tends to diffuse this technology among competing firms in a low-cost manner. Indeed, the costs of imitating a successful physical technology are often lower than the costs of developing a new technology.23 Although physical technology is usually not costly to imitate, the appli- cation of this technology in a firm is likely to call for a wide variety of socially complex organizational resources and capabilities. These organizational resources may be costly to imitate, and if they are valuable and rare, the combination of physical and socially complex resources may be a source of sustained competitive advantage. The importance of socially complex resources and capabilities for firm performance has been studied in detail in the field of strategic human resource management, as described in the Research Made Relevant feature. patents. At first glance, it might appear that a firm’s patents would make it very costly for competitors to imitate its products.24 Patents do have this effect in some industries. For example, patents in the pharmaceutical and specialty chemical industry effectively foreclose other firms from marketing the same products until a firm’s patents expire. As suggested in Chapter 2, patents can raise the cost of imitation in a variety of other industries as well. However, from another point of view a firm’s patents may decrease, rather than increase, the costs of imitation. When a firm files for patent protec- tion, it is forced to reveal a significant amount of information about its product. Governments require this information to ensure that the technology in question is patentable. By obtaining a patent, a firm may provide important information to competitors about how to imitate its technology. Moreover, most technological developments in an industry are diffused throughout firms in that industry in a relatively brief period of time, even if the technology in question is patented, because patented technology is not immune from low-cost imitation. Patents may restrict direct duplication for a time, but they may actually increase the chances of substitution by functionally equivalent technologies.25 The Question of Organization A firm’s potential for competitive advantage depends on the value, rarity, and im- itability of its resources and capabilities. However, to fully realize this potential, a firm must be organized to exploit its resources and capabilities. These observa- tions lead to the question of organization: “Is a firm organized to exploit the full competitive potential of its resources and capabilities?” Numerous components of a firm’s organization are relevant to the question of organization, including its formal reporting structure, its formal and informal man- agement control systems, and its compensation policies. A firm’s formal reporting M03_BARN0088_05_GE_C03.INDD 100 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 101 Most empirical tests of the RBV have focused on the extent to which history, causal ambiguity, and social complexity have an im- pact on the ability of firms to gain and sustain competitive advantages. Among the most important of these tests has been research that examines the extent to which human resource practices that are likely to gener- ate socially complex resources and capabilities are related to firm per- formance. This area of research is known as strategic human resources management. The first of these tests was con- ducted as part of a larger study of efficient low-cost manufacturing in the worldwide automobile in- dustry. A group of researchers from Massachusetts Institute of Technology developed rigorous measures of the cost and quality of more than 70 manufacturing plants that assembled mid-size sedans around the world. They discovered that at the time of their study only six of these plants had simultaneous low costs and high-quality manufacturing—a posi- tion that obviously would give these plants a competitive advantage in the marketplace. In trying to understand what distinguished these six plants from the others in the sample, the research- ers found that, not surprisingly, these six plants had the most modern and up-to-date manufacturing technol- ogy. However, so did many of the less effective plants. What distin- guished these effective plants was not their manufacturing technology, per se, but their human resource (HR) practices. These six plants all implemented a bundle of such prac- tices that included participative deci- sion making, quality circles, and an emphasis on team production. One of the results of these efforts—and another distinguishing feature of these six plants—was a high level of employee loyalty and commitment to a plant, as well as the belief that plant managers would treat employ- ees fairly. These socially complex re- sources and capabilities are the types of resources that the RBV suggests should be sources of sustained com- petitive advantage. Later work has followed up on this approach and has examined the impact of HR practices on firm per- formance outside the manufacturing arena. Using a variety of measures of firm performance and several different measures of HR practices, the results of this research continue to be very consistent with RBV logic. That is, firms that are able to use HR practices to develop socially complex human and organizational resources are able to gain competitive advantages over firms that do not engage in such practices. Sources: J. P. Womack, D. I. Jones, and D. Roos (1990). The machine that changed the world. New York: Rawson; M. Huselid (1995). “The impact of human resource management practices on turn- over, productivity, and corporate financial per- formance.” Academy of Management Journal, 38, pp. 635–672; J. B. Barney and P. Wright (1998). “On becoming a strategic partner.” Human Resource Management, 37, pp. 31–46. Strategic Human Resource Management Research Research Made Relevant structure is a description of whom in the organization reports to whom; it is often embodied in a firm’s organizational chart. Management control systems include a range of formal and informal mechanisms to ensure that managers are behaving in ways consistent with a firm’s strategies. Formal management controls include a firm’s budgeting and reporting activities that keep people higher up in a firm’s organizational chart informed about the actions taken by people lower down in a firm’s organizational chart. Informal management controls might include a firm’s culture and the willingness of employees to monitor each other’s behavior. Compensation policies are the ways that firms pay employees. Such policies create incentives for employees to behave in certain ways. These components of a firm’s organization are often called complementary resources and capabilities because they have limited ability to generate competitive M03_BARN0088_05_GE_C03.INDD 101 13/09/14 3:13 PM 102 Part 1: The Tools of Strategic Analysis advantage in isolation. However, in combination with other resources and capabili- ties they can enable a firm to realize its full potential for competitive advantage.26 For example, it has already been suggested that ESPN may have a sus- tained competitive advantage in the extreme sports segment of the sports broadcasting industry. However, if ESPN’s management had not taken advan- tage of its opportunities in extreme sports by expanding coverage, ensuring that the best competitors come to ESPN competitions, adding additional competi- tions, and changing up older competitions, then its potential for competitive ad- vantage would not have been fully realized. Of course, the reason that ESPN has done all these things is because it has an appropriate organizational structure, management controls, and employee compensation policies. By themselves, these attributes of ESPN’s organization could not be a source of competitive advantage; however, they were essential for ESPN to realize its full competitive advantage potential. Having an appropriate organization in place has enabled ESPN to realize the full competitive advantage potential of its other resources and capabilities. Having an inappropriate organization in place prevented Sony from exploiting its valuable, rare, and costly-to-imitate resources and capabilities. Earlier in this chapter, it was suggested that Sony had unusual experience in designing and building a wide variety of consumer electronics products. In the process of building this giant consumer electronics company, managers at Sony developed and acquired two substantial businesses: Sony Consumer Electronics and Sony Records. Among the many products developed by the Consumer Electronics busi- ness was an early MP3 player (i.e., a portable device that played music and other digital media from a hard drive). The key to MP3 technology was compression— taking analog signals and storing them in a way that they did not take up dispro- portionate space on the hard drive. Without compression, you could only store a few songs on an MP3 player; with compression, you can store thousands. Sony was a leader in compression technology. Of course, to be effective, MP3 players must have content to play. Here, the Sony Records Division should have been very helpful to the Consumer Electronics Division: Records had recording contracts with many famous artists, and Consumer Products had the MP3 player (along with compression technol- ogy) to play that music. So, why does Apple—with iPods, iTunes, iPhones, and iPads—dominate the portable music listening market? Apple had no advantages. It was late to the MP3 market (although it did introduce an MP3 player with a particularly elegant inter- face), it did not own any content, and it had a limited online presence. One explanation of Apple’s success is Sony’s failure—despite having the potential to dominate this market, despite its history of dominating similar mar- kets in the past (e.g., the Sony Walkman portable tape player), Sony could not find a way for its two divisions—Consumer Electronics and Music—to cooperate. Put differently, Sony’s failure was a failure in organization. The engineers in the Consumer Electronics business could never find a way to work with the artists in the music business. Of course, Apple had to do a great deal more to take advantage of the op- portunity that Sony’s organization failure had created for them. Nevertheless, despite its potential, Sony failed to gain or sustain any significant competitive advantages in this lucrative MP3 market.27 M03_BARN0088_05_GE_C03.INDD 102 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 103 Applying the VRio Framework The questions of value, rarity, imitability, and organization can be brought together into a single framework to understand the return potential associated with exploiting any of a firm’s resources or capabilities. This is done in Table 3.3. The relationship of the VRIO framework to strengths and weaknesses is presented in Table 3.4. If a resource or capability controlled by a firm is not valuable, it will not enable a firm to choose or implement strategies that exploit environmental opportunities or neutralize environmental threats. Organizing to exploit this resource will increase a firm’s costs or decrease its revenues. These types of re- sources are weaknesses. Firms will either have to fix these weaknesses or avoid using them when choosing and implementing strategies. If firms do exploit these kinds of resources and capabilities, they can expect to put themselves at a competitive disadvantage compared to those that either do not possess these nonvaluable resources or do not use them in conceiving and implementing strategies. If a resource or capability is valuable but not rare, exploitation of this resource in conceiving and implementing strategies will generate competitive parity. Exploiting these types of resources will generally not create competitive advantages, but failure to exploit them can put a firm at a competitive disadvan- tage. In this sense, valuable-but-not-rare resources can be thought of as organiza- tional strengths. If a resource or capability is valuable and rare but not costly to imitate, exploiting this resource will generate a temporary competitive advantage for a firm. A firm that exploits this kind of resource is, in an important sense, gain- ing a first-mover advantage because it is the first firm that is able to exploit a particular resource. However, once competing firms observe this competitive advantage, they will be able to acquire or develop the resources needed to implement this strategy through direct duplication or substitution at no cost disadvantage, compared to the first-moving firm. Over time, any competitive advantage that the first mover obtained would be competed away as other firms imitate the resources needed to compete. Consequently, this type of re- source or capability can be thought of as an organizational strength and as a distinctive competence. If a resource or capability is valuable, rare, and costly to imitate, exploiting it will generate a sustained competitive advantage. In this case, competing firms Is a resource or capability: Valuable? Rare? Costly to imitate? Exploited by organization? Competitive implications No — — No Competitive disadvantage Yes No — Competitive parity Yes Yes No Temporary competitive advantage Yes Yes Yes Yes Sustained competitive advantage TABlE 3.3 The VRIO Framework M03_BARN0088_05_GE_C03.INDD 103 13/09/14 3:13 PM 104 Part 1: The Tools of Strategic Analysis face a significant cost disadvantage in imitating a successful firm’s resources and capabilities. As suggested earlier, this competitive advantage may reflect the unique history of the successful firm, causal ambiguity about which resources to imitate, the socially complex nature of these resources and capabilities, or any patent advantages a firm might possess. In any case, attempts to compete away the advantages of firms that exploit these resources will not generate competitive advantage, or even competitive parity, for imitating firms. Even if these firms are able to acquire or develop the resources or capabilities in question, the very high costs of doing so would put them at a competitive disadvantage. These kinds of resources and capabilities are organizational strengths and sustainable distinc- tive competencies. The question of organization operates as an adjustment factor in the VRIO framework. For example, if a firm has a valuable, rare, and costly-to-imitate re- source and capability but fails to organize itself to take full advantage of this re- source, some of its potential competitive advantage could be lost (this is the Sony example). Extremely poor organization, in this case, could actually lead a firm that has the potential for competitive advantage to gain only competitive parity or competitive disadvantages. Applying the VRIO Framework to Southwest Airlines To examine how the VRIO framework can be applied in analyzing real strategic situ- ations, consider the competitive position of Southwest Airlines. Southwest Airlines has been the only consistently profitable airline in the United States over the past 30 years. While many U.S. airlines have gone in and out of bankruptcy, Southwest has remained profitable. How has it been able to gain this competitive advantage? Potential sources of this competitive advantage fall into two big categories: operational choices Southwest has made and Southwest’s approach to managing its people. On the operational side, Southwest has chosen to fly only a single type of aircraft (Boeing 737), only flies into smaller airports, has avoided complicated hub-and-spoke route systems, and, instead, flies a point-to-point system. On the people-management side, despite being highly unionized, Southwest has been able to develop a sense of commitment and loyalty among its employees. It is not unusual to see Southwest employees go well beyond their narrowly defined job responsibilities, helping out in whatever way is necessary to get a plane off the ground safely and on time. Which of these—operational choices or Southwest’s approach to managing its people—is more likely to be a source of sustained com- petitive advantage? Is a resource or capability: Valuable? Rare? Costly to imitate? Exploited by organization? Strength or weakness No — — No Weakness Yes No — Strength Yes Yes No Strength and distinctive competence Yes Yes Yes Yes Strength and sustainable distinctive competence TABlE 3.4 The Relationship Between the VRIO Framework and Organizational Strengths and Weaknesses M03_BARN0088_05_GE_C03.INDD 104 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 105 s outhwest’s Operational c hoices and c ompetitive a dvantage Consider first Southwest’s operational choices. First, do these operational choices reduce Southwest’s costs or increase the willingness of its customers to pay—that is, are these operational choices valuable? It can be shown that most of Southwest’s operational choices have the effect of reducing its costs. For example, by fly- ing only one type of airliner, Southwest is able to reduce the cost of training its maintenance staff, reduce its spare parts inventory, and reduce the time its planes are being repaired. By flying into smaller airports, Southwest reduces the fees it would otherwise have to pay to land at larger airports. Its point-to-point system of routes avoids the costs associated with establishing large hub- and-spoke systems. Overall, these operational choices are valuable. Second, are these operational choices rare? For most of its history, Southwest’s operational choices have been rare. Only recently have large incum- bent airlines and smaller new entrants begun to implement similar operational choices. Third, are these operational choices costly to imitate? Several incumbent air- line firms have set up subsidiaries designed to emulate most of Southwest’s op- erational choices. For example, Continental created the Continental Lite division, United created the Ted division, and Delta created the Song division. All of these divisions chose a single type of airplane to fly, flew into smaller airports, adopted a point-to-point route structure, and so forth. In addition to these incumbent airlines, many new entrants into the airline industry—both in the United States and elsewhere—have adopted similar op- erational choices as Southwest. In the United States, these new entrants include AirTran Airlines (recently purchased by Southwest), Allegiant Airlines, JetBlue, Skybus Airlines (now bankrupt), Spirit Airlines, and Virgin American Airlines. Thus, while Southwest’s operational choices are valuable and have been rare, they are apparently not costly to imitate. This is not surprising because these operational choices have few of the attributes of resources or capabilities that are costly to imitate. They do not derive from a firm’s unique history, they are not path dependent, they are not causally ambiguous, and they are not socially complex. Finally, is Southwest organized to fully exploit its operational choices? Most observers agree that Southwest’s structure, management controls, and compensa- tion policies are consistent with its operational choices. Taken together, this analysis of Southwest’s operational choices suggests that they are valuable, have been rare, but are not costly to imitate. While Southwest is organized to exploit these opportunities, they are likely to be only a source of temporary competitive advantage for Southwest. s outhwest’s people-Management and c ompetitive a dvantage A similar VRIO analysis can be conducted for Southwest’s approach to people management. First, is this approach valuable; that is, does it reduce Southwest’s costs or increase the willingness of its customers to pay? Employee commitment and loyalty at Southwest is one explanation of why Southwest is able to get higher levels of employee productivity than most other U.S. airlines. This increased productivity shows up in numerous ways. For ex- ample, the average turnaround time for Southwest flights is around 18 minutes. The average turnaround time for the average U.S. airline is 45 minutes. Southwest Airline employees are simply more effective in unloading and loading luggage, fueling, and catering their airplanes than employees in other airlines. This means M03_BARN0088_05_GE_C03.INDD 105 13/09/14 3:13 PM 106 Part 1: The Tools of Strategic Analysis that Southwest Airlines airplanes are on the ground for less time and in the air more time than its competitors. Of course, an airplane is only making money if it is in the air. This seemingly simple idea is worth hundreds of millions of dollars in lower costs to Southwest. Have such loyalty and teamwork been rare in the U.S. airline industry? Over the past 15 years, the U.S. airline industry has been wracked by employment strife. Many airlines have had to cut employment, reduce wages, and in other ways strain their relationship with their employees. Overall, in comparison to incumbent airlines, the relationship that Southwest enjoys with its employees has been rare. Is this relationship costly to imitate? Certainly, relationships between an air- line and its employees have many of the attributes that should make them costly to imitate. They emerge over time; they are path dependent, causally ambiguous, and socially complex. It is reasonable to expect that incumbent airlines, airlines that already have strained relationships with their employees, would have dif- ficulty imitating the relationship Southwest enjoys with its employees. Thus, in comparison to incumbent airlines, Southwest’s approach to managing its people is probably valuable, rare, and costly to imitate. Assuming it is organized appro- priately (and this seems to be the case), this would mean that—relative to incum- bent airlines—Southwest has a sustained competitive advantage. The situation may be somewhat different for new entrants into the U.S. airline industry. These airlines may not have a history of strained employee rela- tionships. As new firms, they may be able to develop more valuable employee re- lationships from the very beginning. This suggests that, relative to new entrants, Southwest’s approach to people management may be valuable and rare, but not costly to imitate. Again, assuming Southwest is organized appropriately, relative to new entrants into the U.S. airline industry, Southwest’s people-management capabilities may be a source of only a temporary competitive advantage. imitation and Competitive Dynamics in an industry Suppose a firm in an industry has conducted an analysis of its resources and ca- pabilities, concludes that it possesses some valuable, rare, and costly-to-imitate resources and capabilities, and uses these to choose a strategy that it implements with the appropriate organizational structure, formal and informal management controls, and compensation policies. The RBV suggests that this firm will gain a competitive advantage even if it is operating in what an environmental threat analysis (see Chapter 2) would suggest is a very unattractive industry. Examples of firms that have competitive advantages in unattractive industries include Southwest Airlines, Nucor Steel, and Wal-Mart, to name a few. Given that a particular firm in an industry has a competitive advantage, how should other firms respond? Decisions made by other firms given the stra- tegic choices of a particular firm define the nature of the competitive dynamics that exist in an industry. In general, other firms in an industry can respond to the advantages of a competitor in one of three ways. First, they can choose to limit their response. For example, when Wal-Mart entered the discount grocery market with the creation of Super Walmarts, some competitors (e.g., Safeway) ignored Wal-Mart’s moves and continued on as before. Other competitors (e.g., Kroger) modified some of their tactics, including, for example, selling more prepared foods and more specialty foods than before. Finally, other firms fundamentally altered their strategies (e.g., Target began building stores that also sold discount groceries). M03_BARN0088_05_GE_C03.INDD 106 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 107 Not Responding to Another Firm’s Competitive Advantage A firm might not respond to another firm’s competitive advantage for at least three reasons. First, this firm might have its own competitive advantage. By re- sponding to another firm’s competitive advantage, it might destroy, or at least compromise, its own sources of competitive advantage. For example, digital time- keeping has made accurate watches available to most consumers at reasonable prices. A firm such as Casio has a competitive advantage in this market because of its miniaturization and electronic capabilities. Indeed, Casio’s market share and performance in the watch business continue to climb although demand for watches, overall, has gone down. How should Rolex—a manufacturer of very expensive, non-electronic watches—respond to Casio? Rolex’s decision has been: Not at all. Rolex appeals to a very different market segment than Casio. Should Rolex change its strategies—even if it replaced its mechanical self-winding design with the technologically superior digital design—it could easily compromise its competitive advantage in its own niche market.28 In general, when a firm already possesses its own sources of competitive advantage, it will not respond to differ- ent sources of competitive advantage controlled by another firm. Second, a firm may not respond to another firm’s competitive advantage because it does not have the resources and capabilities to do so. A firm with insuf- ficient or inappropriate resources and capabilities—be they physical, financial, human, or organizational—typically will not be able to imitate a successful firm’s resources either through direct duplication or substitution. This may very well be the case with US Airways and Southwest Airlines. It may simply be beyond the ability of US Airways to imitate Southwest’s managerial resources and capabili- ties. In this setting, US Airways is likely to find itself at a sustained competitive disadvantage.29 Finally, a firm may not respond to the advantages of a competitor because it is trying to reduce the level of rivalry in an industry. Any actions a firm takes that have the effect of reducing the level of rivalry in an industry and that also do not require firms in an industry to directly communicate or negotiate with each other can be thought of as tacit cooperation. Explicit cooperation, where firms do directly communicate and negotiate with each other, is discussed in detail in Chapter 9’s analysis of strategic alliances. Reducing the level of rivalry in an industry can benefit all firms operating in that industry. This decision can have the effect of reducing the quantity of goods and services provided in an industry to below the competitive level, actions that will have the effect of increasing the prices of these goods or services. When tacit cooperation has the effect of reducing supply and increasing prices, it is known as tacit collusion. Tacit collusion can be illegal in some settings. However, firms can also tacitly cooperate along other dimensions besides quantity and price. These actions can also benefit all the firms in an industry and typically are not illegal.30 For example, it may be that firms can tacitly agree not to invest in certain kinds of research and development. Some forms of research and development are very expensive, and although these investments might end up generating products or services that could benefit customers, firms might still prefer to avoid the expense and risk. Firms can also tacitly agree not to market their products in certain ways. For example, before regulations compelled them to do so, most tobacco companies had already decided not to put cigarette vending machines in locations usually frequented by children, even though these machines could have generated significant revenues. Also, firms can tacitly cooperate by agreeing not M03_BARN0088_05_GE_C03.INDD 107 13/09/14 3:13 PM 108 Part 1: The Tools of Strategic Analysis to engage in certain manufacturing practices, such as outsourcing to developing countries and engaging in environmentally unsound practices. All of these actions can have the effect of reducing the level of rivalry in an industry. And reducing the level of rivalry can have the effect of increasing the average level of performance for a firm in an industry. However, tacit coopera- tive relationships among firms are sometimes difficult to maintain. Typically, in order for tacit cooperation to work, an industry must have the structural attri- butes described in Table 3.5. First, the industry must have relatively few firms. Informally communicating and coordinating strategies among a few firms is dif- ficult enough; it is even more difficult when the industry has a large number of firms. For this reason, tacit cooperation is a viable strategy only when an industry is an oligopoly (see Chapter 2). Second, firms in this industry must be homogeneous with respect to the products they sell and their cost structure. Having heterogeneous products makes it too easy for a firm to “cheat” on its tacitly cooperative agreements by modifying its products, and heterogeneous cost means that the optimal level of output for a particular firm may be very different from the level agreed to through tacit coop- eration. In this setting, a firm might have a strong incentive to increase its output and upset cooperative agreements. Third, an industry typically has to have at least one strong market-share leader if firms are going to tacitly cooperate. This would be a relatively large firm that has established an example of the kind of behavior that will be mutually beneficial in the industry, and other firms in the industry sometimes fall into line with this example. Indeed, it is often the market-share leader that will choose not to respond to the competitive actions of another firm in the industry in order to maintain cooperative relations. Finally, the maintenance of tacit cooperation in an industry almost always requires the existence of high barriers to entry. If tacit cooperation is successful, the average performance of firms in an industry will improve. However, this higher level of performance can induce other firms to enter into this industry (see Chapter 2). Such entry will increase the number of firms in an industry and make it very difficult to maintain tacitly cooperative relationships. Thus, it must be very costly for new firms to enter into an industry for those in that industry to maintain their tacit cooperation. The higher these costs, the higher the barriers to entry. Changing Tactics in Response to Another Firm’s Competitive Advantage Tactics are the specific actions a firm takes to implement its strategies. Examples of tactics include decisions firms make about various attributes of their products— including size, shape, color, and price—specific advertising approaches adopted by a firm, and specific sales and marketing efforts. Generally, firms change their tactics much more frequently than they change their strategies.31 1. Small number of competing firms 2. Homogeneous products and costs 3. Market-share leader 4. High barriers to entry TABlE 3.5 Attributes of Industry Structure That Facilitate the Development of Tacit Cooperation M03_BARN0088_05_GE_C03.INDD 108 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 109 When competing firms are pursuing approximately the same strategies, the competitive advantages that any one firm might enjoy at a given point in time are most likely due to the tactics that that firm is pursuing. In this setting, it is not unusual for competing firms to change their tactics by imitating the tactics of the firm with an advantage in order to reduce that firm’s advantage. Although changing one’s tactics in this manner will only generate competitive parity, this is usually better than the competitive disadvantage these firms were experiencing. Several industries provide excellent examples of these kinds of tactical in- teractions. In consumer goods, for example, if one company increases its sales by adding a “lemon scent” to laundry detergent, then lemon scents start showing up in everyone’s laundry detergent. If Coke starts selling a soft drink with half the sugar and half the carbs of regular Coke, can Pepsi’s low-sugar/low-carb product be far behind? And when Delta Airlines cuts it airfares, can American and United be far behind? Not surprisingly, these kinds of tactical changes, because they ini- tially may be valuable and rare, are seldom costly to imitate and thus are typically only sources of temporary competitive advantage. Sometimes, rather than simply imitating the tactics of a firm with a com- petitive advantage, a firm at a disadvantage may “leapfrog” its competitors by developing an entirely new set of tactics. Procter & Gamble engaged in this strategy when it introduced its laundry detergent, Tide, in a new, concentrated formula. This new formulation required new manufacturing and packaging equipment—the smaller box could not be filled in the current manufacturing lines in the industry—which meant that Tide’s competitors had to take more time in imitating the concentrated laundry detergent tactic than other tactics pursued in this industry. Nevertheless, within just a few weeks other firms in this market were introducing their own versions of concentrated laundry detergent. Indeed, some firms can become so skilled at innovating new products and other tactics that this innovative capability can be a source of sustained competi- tive advantage. Consider, for example, Sony during its heydays. Most observers agree that Sony possessed some special management and innovation skills that enabled it to conceive, design, and manufacture high-quality miniaturized consumer electronics. However, virtually every time Sony brought out a new miniaturized product several of its competitors quickly duplicated that product through reverse engineering, thereby reducing Sony’s technological advantage. In what way can Sony’s socially complex miniaturization resources and capabilities be a source of sustained competitive advantage when most of Sony’s products were quickly imitated through direct duplication? After Sony introduced each new product, it experienced a rapid increase in profits attributable to the new product’s unique features. This increase, however, leads other firms to reverse-engineer the Sony product and introduce their own versions. Increased competition resulted in a reduction in the profits associated with a new product. Thus, at the level of individual products, Sony apparently enjoys only temporary competitive advantages. However, looking at the total returns earned by Sony across all of its new products over time makes clear the source of Sony’s sustained competitive advantage: By exploiting its resources and capabilities in miniaturization, Sony was able to constantly introduce new and exciting personal electronics products. No single product generated a sustained competitive advantage, but, over time, across several such product introduc- tions, Sony’s resource and capability advantages led to sustained competitive advantages.32 M03_BARN0088_05_GE_C03.INDD 109 13/09/14 3:13 PM 110 Part 1: The Tools of Strategic Analysis Changing Strategies in Response to Another Firm’s Competitive Advantage Finally, firms sometimes respond to another firm’s competitive advantage by changing their strategies. Obviously, this does not occur very often, and it typi- cally only occurs when another firm’s strategies usurp a firm’s competitive ad- vantage. In this setting, a firm will not be able to gain even competitive parity if it maintains its strategy, even if it implements that strategy very effectively. Changes in consumer tastes, in population demographics, and in the laws that govern a business can all have the effect of rendering what once was a valu- able strategy as valueless. However, the most frequent impact is changes in tech- nology. For example, no matter how well made a mechanical calculator is, it is simply inferior to an electronic calculator. No matter how efficient the telegraph was in its day, it is an inferior technology to the telephone. And no matter how quickly one’s fingers can move the beads on an abacus, an electronic cash register is a better way of keeping track of sales and making change in a store. When firms change their strategies, they must proceed through the entire strategic management process, as described in Chapter 1. However, these firms will often have difficulty abandoning their traditional strategies. For most firms, their strategy helps define what they do and who they are. Changing its strategy often requires a firm to change its identity and its purposes. These are difficult changes to make, and many firms wait to change their strategy until absolutely forced to do so by disastrous financial results. By then, these firms not only have to change their strategy—with all that implies—they have to do so in the face of significant financial pressures. The ability of virtually all strategies to generate competitive advantages typically expires, sooner or later. In general, it is much better for a firm to change its strategy before that strategy is no longer viable. In this way, a firm can make a planned move to a new strategy that maintains whatever resources and capabili- ties it still possesses while it develops the new resources and capabilities it will need to compete in the future. implications of the Resource-Based View The RBV and the VRIO framework can be applied to individual firms to under- stand whether these firms will gain competitive advantages, how sustainable these competitive advantages are likely to be, and what the sources of these com- petitive advantages are. In this way, the RBV and the VRIO framework can be understood as important complements to the threats and opportunities analyses described in Chapter 2. However, beyond what these frameworks can say about the competitive performance of a particular firm, the RBV has some broader implications for man- agers seeking to gain competitive advantages. Some of these broader implications are listed in Table 3.6 and discussed in the following section. Where Does the Responsibility for Competitive Advantage in a Firm Reside? First, the RBV suggests that competitive advantages can be found in several of the different resources and capabilities controlled by the firm. These resources and capabilities are not limited to those that are controlled directly by a firm’s M03_BARN0088_05_GE_C03.INDD 110 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 111 senior managers. Thus, the responsibility for creating, nurturing, and exploiting valuable, rare, and costly-to-imitate resources and capabilities for competitive ad- vantage is not restricted to senior managers, but falls on every employee in a firm. Therefore, employees should go beyond defining their jobs in functional terms and instead define their jobs in competitive and economic terms. Consider a simple example. In a recent visit to a very successful automobile manufacturing plant, the plant manager was asked to describe his job responsi- bilities. He said, “My job is to manage this plant in order to help the firm make and sell the best cars in the world.” In response to a similar question, the person in charge of the manufacturing line said, “My job is to manage this manufacturing line in order to help the firm make and sell the best cars in the world.” A janitor was also asked to describe his job responsibilities. Although he had not been pres- ent in the two earlier interviews, the janitor responded, “My job is to keep this facility clean in order to help the firm make and sell the best cars in the world.” Which of these three employees is most likely to be a source of sustained competitive advantage for this firm? Certainly, the plant manager and the manu- facturing line manager should define their jobs in terms of helping the firm make and sell the best cars in the world. However, it is unlikely that their responses to this question would be any different than the responses of other senior manag- ers at other manufacturing plants around the world. Put differently, although the definition of these two managers’ jobs in terms of enabling the firm to make and sell the best cars in the world is valuable, it is unlikely to be rare, and thus it is likely to be a source of competitive parity, not competitive advantage. However, a janitor who defines her job as helping the firm make and sell the best cars in the world instead of simply to clean the facility is, most would agree, quite un- usual. Because it is rare, it might be a source of at least a temporary competitive advantage.33 1. The responsibility for competitive advantage in a firm: Competitive advantage is every employee’s responsibility. 2. Competitive parity and competitive advantage: If all a firm does is what its competition does, it can gain only competitive parity. In gaining competitive advantage, it is better for a firm to exploit its own valuable, rare, and costly-to-imitate resources than to imitate the valuable and rare resources of a competitor. 3. Difficult to implement strategies: As long as the cost of strategy implementation is less than the value of strategy implementation, the relative cost of implementing a strategy is more important for competitive advantage than the absolute cost of implementing a strategy. Firms can systematically overestimate and underestimate their uniqueness. 4. Socially complex resources: Not only can employee empowerment, organizational culture, and teamwork be valuable, they can also be sources of sustained competitive advantage. 5. The role of the organization: Organization should support the use of valuable, rare, and costly-to-imitate resources. If conflicts between these attributes of a firm arise, change the organization. TABlE 3.6 Broader Implications of the Resource-Based View M03_BARN0088_05_GE_C03.INDD 111 13/09/14 3:13 PM 112 Part 1: The Tools of Strategic Analysis The value created by one janitor defining her job in competitive terms rather than functional terms is not huge, but suppose that all the employees in this plant defined their jobs in these terms. Suddenly, the value that might be created could be substantial. Moreover, the organizational culture and tradition in a firm that would lead employees to define their jobs in this way are likely to be costly for other firms to imitate. Thus, if this approach to defining job responsibilities is broadly diffused in a particular plant, it seems likely to be valuable, rare, and costly to imitate and thus a source of sustained competitive advantage, assuming the firm is organized to take advantage of this unusual resource. In the end, it is clear that competitive advantage is too important to remain the sole property of senior management. To the extent that employees throughout an organization are empowered to develop and exploit valuable, rare, and costly- to-imitate resources and capabilities in the accomplishment of their job responsi- bilities, a firm may actually be able to gain sustained competitive advantages. Competitive Parity and Competitive Advantage Second, the RBV suggests that, if all a firm does is create value in the same way as its competitors, the best performance it can ever expect to gain is competitive parity. To do better than competitive parity, firms must engage in valuable and rare activities. They must do things to create economic value that other firms have not even thought of, let alone implemented. This is especially critical for firms that find themselves at a competitive dis- advantage. Such a firm certainly should examine its more successful competition, understand what has made this competition so successful, and, where imitation is very low cost, imitate the successful actions of its competitors. In this sense, benchmarking a firm’s performance against the performance of its competitors can be extremely important. However, if this is all that a firm does, it can only expect to gain competi- tive parity. Gaining competitive advantage depends on a firm discovering its own unique resources and capabilities and how they can be used in choosing and implementing strategies. For a firm seeking competitive advantage, it is better to be excellent in how it develops and exploits its own unique resources and capa- bilities than it is to be excellent in how it imitates the resources and capabilities of other firms. This does not imply that firms must always be first movers to gain com- petitive advantages. Some firms develop valuable, rare, and costly-to-imitate resources and capabilities in being efficient second movers—that is, in rapidly imitating and improving on the product and technological innovations of other firms. Rather than suggesting that firms must always be first movers, the RBV suggests that, in order to gain competitive advantages, firms must implement strategies that rely on valuable, rare, and costly-to-imitate resources and capabili- ties, whatever those strategies or resources might be. Difficult-to-Implement Strategies Third, as firms contemplate different strategic options, they often ask how dif- ficult and costly it will be to implement different strategies. As long as the cost of implementing a strategy is less than the value that a strategy creates, the RBV suggests that the critical question facing firms is not “Is a strategy easy to imple- ment or not?” but rather “Is this strategy easier for us to implement than it is for M03_BARN0088_05_GE_C03.INDD 112 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 113 our competitors to implement?” Firms that already possess the valuable, rare, and costly-to-imitate resources needed to implement a strategy will, in general, find it easier (i.e., less costly) to implement a strategy than firms that first have to de- velop the required resources and then implement the proposed strategy. For firms that already possess a resource, strategy implementation can be natural and swift. In understanding the relative costs of implementing a strategy, firms can make two errors. First, they can overestimate the uniqueness of the resources they control. Although every firm’s history is unique and no two management teams are exactly the same, this does not always mean that a firm’s resources and capabilities will be rare. Firms with similar histories operating in similar indus- tries will often develop similar capabilities. If a firm overestimates the rarity of its resources and capabilities, it can overestimate its ability to generate competitive advantages. For example, when asked what their most critical sources of competitive advantage are, many firms will cite the quality of their top management team, the quality of their technology, and their commitment to excellence in all that they do. When pushed about their competitors, these same firms will admit that they too have high-quality top management teams, high-quality technology, and a commitment to excellence in all that they do. Although these three attri- butes can be sources of competitive parity, they cannot be sources of competitive advantage. Second, firms can sometimes underestimate their uniqueness and thus underestimate the extent to which the strategies they pursue can be sources of sustained competitive advantage. When firms possess valuable, rare, and costly- to-imitate resources, strategy implementation can be relatively easy. In this con- text, it seems reasonable to expect that other firms will be able to quickly imitate this “easy-to-implement” strategy. Of course, this is not the case if these resources controlled by a firm are, in fact, rare and costly to imitate. In general, firms must take great care not to overestimate or underestimate their uniqueness. An accurate assessment of the value, rarity, and imitability of a firm’s resources is necessary to develop an accurate understanding of the relative costs of implementing a firm’s strategies and, thus, the ability of those strategies to generate competitive advantages. Often, firms must employ outside assistance in helping them describe the rarity and imitability of their resources, even though managers in firms will generally be much more familiar with the resources con- trolled by a firm than outsiders. However, outsiders can provide a measure of objectivity in evaluating the uniqueness of a firm. Socially Complex Resources Over the past several decades, much has been written about the importance of employee empowerment, organizational culture, and teamwork for firm perfor- mance. Most of this work suggests that firms that empower employees, that have an enabling culture, and that encourage teamwork will, on average, make better strategic choices and implement them more efficiently than firms without these organizational attributes. Using the language of the RBV, most of this work has suggested that employee empowerment, organizational culture, and teamwork, at least in some settings, are economically valuable.34 Resource-based logic acknowledges the importance of the value of these organizational attributes. However, it also suggests that these socially complex re- sources and capabilities can be rare and costly to imitate—and it is these attributes M03_BARN0088_05_GE_C03.INDD 113 13/09/14 3:13 PM 114 Part 1: The Tools of Strategic Analysis that make it possible for socially complex resources and capabilities to be sources of sustained competitive advantage. Put differently, the RBV actually extends and broadens traditional analyses of the socially complex attributes of firms. Not only can these attributes be valuable, but they can also be rare and costly to imitate and, thus, sources of sustained competitive advantage. The Role of Organization Finally, resource-based logic suggests that an organization’s structure, control systems, and compensation policies should support and enable a firm’s efforts to fully exploit the valuable, rare, and costly-to-imitate resources and capabilities it controls. These attributes of organization, by themselves, are usually not sources of sustained competitive advantage. These observations suggest that if there is a conflict between the resources a firm controls and that firm’s organization, the organization should be changed. However, it is often the case that once a firm’s structure, control systems, and compensation policies are put in place they tend to remain, regardless of whether they are consistent with a firm’s underlying resources and capabilities. In such settings, a firm will not be able to realize the full competitive potential of its underlying resource base. To the extent that a firm’s resources and capabilities are continuously evolving, its organizational structure, control systems, and compensation policies must also evolve. For these attributes of organization to evolve, managers must be aware of their link with a firm’s resources and capa- bilities and of organizational alternatives. Summary The RBV is an economic theory that suggests that firm performance is a function of the types of resources and capabilities controlled by firms. Resources are the tangible and intangible assets a firm uses to conceive and implement its strategies. Capabilities are a subset of resources that enable a firm to take advantage of its other resources. Resources and capabilities can be categorized into financial, physical, human, and organizational resources categories. The RBV makes two assumptions about resources and capabilities: the assumption of resource heterogeneity (that some resources and capabilities may be heterogeneously distributed across competing firms) and the assumption of resource immobility (that this heterogeneity may be long lasting). These two assumptions can be used to describe conditions under which firms will gain competitive advantages by exploiting their resources. A tool for analyzing a firm’s internal strengths and weaknesses can be derived from the RBV. Called the VRIO framework, this tool asks four questions about a firm’s resources and capabilities in order to evaluate their competitive potential. These ques- tions are the question of value, the question of rarity, the question of imitability, and the question of organization. A firm’s resources and capabilities are valuable when they enable it to exploit ex- ternal opportunities or neutralize external threats. Such valuable resources and capabili- ties are a firm’s strengths. Resources and capabilities that are not valuable are a firm’s weaknesses. Using valuable resources to exploit external opportunities or neutralize external threats will have the effect of increasing a firm’s net revenues or decreasing its net costs. M03_BARN0088_05_GE_C03.INDD 114 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 115 One way to identify a firm’s valuable resources and capabilities is by examining its value chain. A firm’s value chain is the list of business activities it engages in to develop, produce, and sell its products or services. Different stages in this value chain require dif- ferent resources and capabilities, and differences in value chain choices across firms can lead to important differences among the resources and capabilities controlled by differ- ent companies. A generic value chain has been developed by McKinsey and Company. Valuable and common (i.e., not rare) resources and capabilities can be a source of competitive parity. Failure to invest in such resources can create a competitive disadvan- tage for a firm. Valuable and rare resources can be a source of at least a temporary com- petitive advantage. There are fewer firms able to control such a resource and still exploit it as a source of at least temporary competitive advantage than there are firms that will generate perfect competition dynamics in an industry. Valuable, rare, and costly-to-imitate resources and capabilities can be a source of sustained competitive advantage. Imitation can occur through direct duplication or through substitution. A firm’s resources and capabilities may be costly to imitate for at least four reasons: unique historical circumstances, causal ambiguity, socially complex resources and capabilities, and patents. To take full advantage of the potential of its resources and capabilities, a firm must be appropriately organized. A firm’s organization consists of its formal reporting struc- ture, its formal and informal control processes, and its compensation policy. These are complementary resources in that they are rarely sources of competitive advantage on their own. The VRIO framework can be used to identify the competitive implications of a firm’s resources and capabilities—whether they are a source of competitive disadvan- tage, competitive parity, temporary competitive advantage, or sustained competitive advantage—and the extent to which these resources and capabilities are strengths or weaknesses. When a firm faces a competitor that has a sustained competitive advantage, the firm’s options are to not respond, to change its tactics, or to change its strategies. A firm may choose not to respond in this setting for at least three reasons. First, a response might weaken its own sources of sustained competitive advantage. Second, a firm may not have the resources required to respond. Third, a firm may be trying to create or main- tain tacit cooperation within an industry. The RBV has a series of broader managerial implications as well. For example, resource-based logic suggests that competitive advantage is every employee’s responsi- bility. It also suggests that if all a firm does is what its competition does, it can gain only competitive parity, and that in gaining competitive advantage it is better for a firm to exploit its own valuable, rare, and costly-to-imitate resources than to imitate the valuable and rare resources of a competitor. Also, resource-based logic implies that as long as the cost of strategy implementation is less than the value of strategy implementation, the rel- ative cost of implementing a strategy is more important for competitive advantage than the absolute cost of implementing a strategy. It also implies that firms can systematically overestimate and underestimate their uniqueness. With regard to a firm’s resources and capabilities, resource-based logic suggests that not only can employee empowerment, organizational culture, and teamwork be valuable; they can also be sources of sustained competitive advantage. Also, if conflicts arise between a firm’s valuable, rare, and costly- to-imitate resources and its organization, the organization should be changed. MyManagementLab® Go to mymanagementlab.com to complete the problems marked with this icon . M03_BARN0088_05_GE_C03.INDD 115 13/09/14 3:13 PM 116 Part 1: The Tools of Strategic Analysis Challenge Questions 3.1. Explain which of the following approaches to strategy formulation is more likely to generate economic prof- its: (a) evaluating external opportuni- ties and threats and then developing resources and capabilities to exploit these opportunities and neutralize these threats or (b) evaluating internal resources and capabilities and then searching for industries where they can be exploited? 3.2. Resource immobility is a key assumption of the resource-based view (RBV) of strategy and hence, the VRIO tool. However, many companies with decades of competitive advan- tage have started to lose ground to new competitors. Is resource immobility fleeting? How can the RBV and VRIO tools explain such changes in advantage? 3.3. The latest blockbuster drug of a pharmaceutical company or its HR practices, which have evolved to generate a culture of high performance and innovation: which is more impor- tant for the company to maintain a sustained competitive advantage? 3.4. Why would a firm currently experiencing competitive parity be able to gain sustained competitive advantages by studying another firm that is currently experiencing sus- tained competitive advantages? 3.5. Your former college roommate calls you and asks to borrow $10,000 so that he can open a pizza restaurant in his hometown. He acknowledges that there is a high degree of direct competition in this market, that the cost of entry is low, and that there are numerous substitutes for pizza, but he believes that his pizza restaurant will have some sustained competitive advantages. For example, he is going to have sawdust on his floor, a variety of imported beers, and a late-night delivery service. What are the risks in lending him the money? 3.6. In the text, it is suggested that Boeing did not respond to Airbus’s announcement of the development of a super-jumbo aircraft. Assuming this aircraft will give Airbus a competitive advantage in the segment of the air- liner business that supplies airplanes for long international flights, why did Boeing not respond? 3.7. Boeing did not respond to Airbus’s announcement of the de- velopment of a super-jumbo aircraft. Does it have its own competitive advantage that it does not want to abandon? Explain. 3.8. Boeing did not respond to Airbus’s announcement of the development of a super-jumbo aircraft. Does it not have the resources and capabilities needed to respond? Explain. 3.9. List some of the indicators of a firm engaging in an international strategy to develop new resources and capabilities. 3.10. Between the following two firms, which one is more likely to be successful in exploiting its sources of sustained competitive advantage in its home market than in a highly compet- itive, nondomestic market: (a) a firm from a less competitive home country or (b) a firm from a more competitive home country? Why? Problem Set 3.11. Apply the VRIO framework in the following settings. Will the actions described be a source of competitive disadvantage, parity, temporary advantage, or sustained competitive advantage? Explain your answers. (a) The Japanese automaker Suzuki announces a recall of a 100,000 vehicles in India, where its subsidiary enjoys leading market share. (b) SAP, the enterprise resource planning software giant, announces the acquisition of Fieldglass, the leading technology provider for procuring and managing temporary workforces for clients. (c) US Bancorp, one of the top five banks in the US, with over 3000 branches, announced the acquisition of local rival BankEast, which has 10 branches. (d) Caterpillar, construction equipment manufacturer, patents a new muffler for its machines’ exhaust systems. (e) GlaxoSmithKline, the pharmaceutical company, patents a new, potentially “blockbuster” drug for Alzheimer’s disease. M03_BARN0088_05_GE_C03.INDD 116 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 117 (f) Computer maker Lenovo plans to sponsor a Formula 1 car racing team. (g) Mobil announces a 5 cent drop in petrol prices across its network of petrol stations in New Zealand. (h) Accenture deploys a new skills inventory and training system that seeks to develop and deploy consulting resources to relevant client projects. (i) Deloitte announces a new incentive plan that allows not only partners but also all consultants to share in the profits of the firm. (j) Red Bull, the energy drink company, launches a new, larger size packaging for its original product. 3.12. Identify three firms you might want to work for. Using the VRIO framework, evaluate the extent to which the resources and capabilities of these firms give them the potential to real- ize competitive disadvantages, parity, temporary advantages, or sustained advantages. What implications, if any, does this analysis have for the company you might want to work for? 3.13. You have been assigned to estimate the present value of a potential construction project for your company. How would you use the VRIO framework to construct the cash- flow analysis that is a part of any present-value calculation? MyManagementLab® Go to mymanagementlab.com for the following Assisted-graded writing questions: 3.14. Give an example of how you would apply value chain analysis to identify a firm’s valuable resources and capabilities. 3.15. What is required for a firm to gain a sustained competitive advantage from a resource considered rare? End Notes 1. The term the resource-based view was coined by Wernerfelt, B. (1984). “A resource-based view of the firm.” Strategic Management Journal, 5, pp. 171–180. Some important early contributors to this theory in- clude Rumelt, R. P. (1984). “Toward a strategic theory of the firm.” In R. Lamb (ed.), Competitive strategic management (pp. 556–570). Upper Saddle River, NJ: Prentice Hall; and Barney, J. B. (1986). “Strategic fac- tor markets: Expectations, luck and business strategy.” Management Science, 32, pp. 1512–1514. A second wave of important early resource- based theoretical work includes Barney, J. B. (1991). “Firm resources and sustained competitive advantage.” Journal of Management, 7, pp. 49–64; Dierickx, I., and K. Cool. (1989). “Asset stock accumulation and sustainability of competitive advantage.” Management Science, 35, pp. 1504–1511; Conner, K. R. (1991). “A historical comparison of resource-based theory and five schools of thought within industrial organization economics: Do we have a new theory of the firm?” Journal of Management, 17(1), pp. 121–154; and Peteraf, M. A. (1993). “The cornerstones of competitive advantage: A resource-based view.” Strategic Management Journal, 14, pp. 179–191. A review of much of this early theoretical literature can be found in Mahoney, J. T., and J. R. Pandian. (1992). “The resource-based view within the conversation of strategic management.” Strategic Management Journal, 13, pp. 363–380. The theoretical perspective has also spawned a growing body of em- pirical work, including Brush, T. H., and K. W. Artz. (1999). “Toward a contingent resource-based theory.” Strategic Management Journal, 20, pp. 223–250; Marcus, A., and D. Geffen. (1998). “The dialectics of com- petency acquisition.” Strategic Management Journal, 19, pp. 1145–1168; Brush, T. H., P. Bromiley, and M. Hendrickx. (1999). “The relative influ- ence of industry and corporation on business segment performance.” Strategic Management Journal, 20, pp. 519–547; Yeoh, P.-L., and K. Roth. (1999). “An empirical analysis of sustained advantage in the U.S. phar- maceutical industry.” Strategic Management Journal, 20, pp. 637–653; Roberts, P. (1999). “Product innovation, product-market competition and persistent profitability in the U.S. pharmaceutical industry.” Strategic Management Journal, 20, pp. 655–670; Gulati, R. (1999). “Network location and learning.” Strategic Management Journal, 20, pp. 397–420; Lorenzoni, G., and A. Lipparini. (1999). “The leveraging of interfirm relationships as a distinctive organizational capability.” Strategic Management Journal, 20, pp. 317–338; Majumdar, S. (1998). “On the utilization of resources.” Strategic Management Journal, 19(9), pp. 809–831; Makadok, R. (1997). “Do inter-firm differences in capabilities affect strategic pricing dynamics?” Academy of Management Proceedings ’97, pp. 30–34; Silverman, B. S., J. A. Nickerson, and J. Freeman. (1997). “Profitability, transactional alignment, and organizational mortal- ity in the U.S. trucking industry.” Strategic Management Journal, 18 (Summer special issue), pp. 31–52; Powell, T. C., and A. Dent-Micallef. (1997). “Information technology as competitive advantage.” Strategic Management Journal, 18(5), pp. 375–405; Miller, D., and J. Shamsie. (1996). “The Resource-based view of the firm in two environments.” Academy of Management Journal, 39(3), pp. 519–543; and Maijoor, S., and A. Van Witteloostuijn. (1996). “An empirical test of the resource-based theory.” Strategic Management Journal, 17, pp. 549–569; Barnett, W. P., H. R. Greve, and D. Y. Park. (1994). “An evolutionary model of organi- zational performance.” Strategic Management Journal, 15 (Winter special issue), pp. 11–28; Levinthal, D., and J. Myatt. (1994). “Co-evolution of capabilities and industry: The evolution of mutual fund process- ing.” Strategic Management Journal, 17, pp. 45–62; Henderson, R., and I. Cockburn. (1994). “Measuring competence? Exploring firm effects in pharmaceutical research.” Strategic Management Journal, 15, pp. 63–84; M03_BARN0088_05_GE_C03.INDD 117 13/09/14 3:13 PM 118 Part 1: The Tools of Strategic Analysis Pisano, G. P. (1994). “Knowledge, integration, and the locus of learning: An empirical analysis of process development.” Strategic Management Journal, 15, pp. 85–100; and Zajac, E. J., and J. D. Westphal. (1994). “The costs and benefits of managerial incentives and monitor- ing in large U.S. corporations: When is more not better?” Strategic Management Journal, 15, pp. 121–142. 2. Ghemawat, P. (1986). “Wal-Mart stores’ discount operations.” Harvard Business School Case No. 9-387-018, on Wal-Mart; Kupfer, A. (1991). “The champion of cheap clones.” Fortune, September 23, pp. 115–120; and Holder, D. (1989). “L. L. Bean, Inc.—1974.” Harvard Business School Case No. 9-676-014, on L. L. Bean. Some of Wal-Mart’s more recent moves, especially its international acquisitions, are described in Laing, J. R. (1999). “Blimey! Wal-Mart.” Barron’s, 79, p. 14. L. L. Bean’s lethargic performance in the 1990s, together with its turnaround plan, is described in Symonds, W. (1998). “Paddling harder at L. L. Bean.” BusinessWeek, December 7, p. 72. 3. For an early discussion of the importance of human capital in firms, see Becker, G. S. (1964). Human capital. New York: Columbia University Press. 4. Heskett, J. L., and R. H. Hallowell. (1993). “Southwest Airlines: 1993 (A).” Harvard Business School Case No. 9-695-023. 5. See Barney, J. (1991). “Firm resources and sustained competitive advantage.” Journal of Management, 17, pp. 99–120. 6. See Schlender, B. R. (1992). “How Sony keeps the magic going.” Fortune, February 24, pp. 75–84; and (1999). “The weakling kicks back.” The Economist, July 3, p. 46, for a discussion of Sony. See Krogh, L., J. Praeger, D. Sorenson, and J. Tomlinson. (1988). “How 3M evaluates its R&D programs.” Research Technology Management, 31, pp. 10–14. 7. Anders, G. (2002). “AOL’s true believers.” Fast Company, July pp. 96+. In a recent Wall Street Journal article, managers of AOL Time Warner admitted they are no longer seeking synergies across their businesses. See Karnitschnig, M. (2006). “That’s all, folks: After years of push- ing synergy, Time Warner, Inc. says enough.” The Wall Street Journal, June 2, A1+. 8. See Grant, R. M. (1991). Contemporary strategy analysis. Cambridge, MA: Basil Blackwell. 9. Lipman, S., and R. Rumelt. (1982). “Uncertain imitability: An analysis of interfirm differences in efficiency under competition.” Bell Journal of Economics, 13, pp. 418–438; Barney, J. B. (1986). “Strategic factor mar- kets: Expectations, luck and business strategy.” Management Science, 32, pp. 1512–1514; and Barney, J. B. (1986). “Organizational culture: Can it be a source of sustained competitive advantage?” Academy of Management Review, 11, pp. 656–665. 10. Note that the definition of sustained competitive advantage pre- sented here, though different, is consistent with the definition given in Chapter 1. In particular, a firm that enjoys a competitive advan- tage for a long period of time (the Chapter 1 definition) does not have its advantage competed away through imitation (the Chapter 3 definition). 11. See Breen, B. (2003). “What’s selling in America.” Fast Company, January, pp. 80+. 12. These explanations of costly imitation were first developed by Dierickx, I., and K. Cool. (1989). “Asset stock accumulation and sustainability of competitive advantage.” Management Science, 35, pp. 1504–1511; Barney, J. B. (1991). “Firm resources and sustained competitive advantage.” Journal of Management, 7, pp. 49–64; Mahoney, J. T., and J. R. Pandian. (1992). “The resource-based view within the con- versation of strategic management.” Strategic Management Journal, 13, pp. 363–380; and Peteraf, M. A. (1993). “The cornerstones of competi- tive advantage: A resource-based view.” Strategic Management Journal, 14, pp. 179–191. 13. Dierickx, I., and K. Cool. (1989). “Asset stock accumulation and sustainability of competitive advantage.” Management Science, 35, pp. 1504–1511. In economics, the role of history in determining competitive outcomes was first examined by Arthur, W. B. (1989). “Competing technologies, increasing returns, and lock-in by historical events.” Economic Journal, 99, pp. 116–131. 14. See Breen, B. (2003). “What’s selling in America.” Fast Company, January, pp. 80+. 15. This term was first suggested by Arthur, W. B. (1989). “Competing technologies, increasing returns, and lock-in by historical events.” Economic Journal, 99, pp. 116–131. A good example of path depen- dence is the development of Silicon Valley and the important role that Stanford University and a few early firms played in creating the net- work of organizations that has since become the center of much of the electronics business. See Alley, J. (1997). “The heart of Silicon Valley.” Fortune, July 7, pp. 86+. 16. Reed, R., and R. J. DeFillippi. (1990). “Causal ambiguity, barriers to imitation, and sustainable competitive advantage.” Academy of Management Review, 15(1), pp. 88–102, suggest that causal ambigu- ity about the sources of a firm’s competitive advantage need only exist among a firm’s competitors for it to be a source of sustained competitive advantage. Managers in a firm, they argue, may fully understand the sources of their advantage. However, in a world where employees freely and frequently move from firm to firm, such special insights into the sources of a firm’s competitive advantage would not remain proprietary for very long. For this reason, for causal ambiguity to be a source of sustained competi- tive advantage, both the firm trying to gain such an advantage and those trying to imitate it must face similar levels of causal ambigu- ity. Indeed, Wal-Mart sued Amazon for trying to steal some of its secrets by hiring employees away from Wal-Mart. See Nelson, E. (1998). “Wal-Mart accuses Amazon.com of stealing its secrets in lawsuit.” The Wall Street Journal, October 19, p. B10. For a discus- sion of how difficult it is to maintain secrets, especially in a world of the World Wide Web, see Farnham, A. (1997). “How safe are your secrets?” Fortune, September 8, pp. 114+. The international dimensions of the challenges associated with maintaining secrets are discussed in Robinson, E. (1998). “China spies target corporate America.” Fortune, March 30, pp. 118+. 17. Itami, H. (1987). Mobilizing invisible assets. Cambridge, MA: Harvard University Press. 18. See Barney, J. B., and B. Tyler. (1990). “The attributes of top manage- ment teams and sustained competitive advantage.” In M. Lawless and L. Gomez-Mejia (eds.), Managing the high technology firm (pp. 33–48). Greenwich, CT: JAI Press, on teamwork in top management teams; Barney, J. B. (1986). “Organizational culture: Can it be a source of sustained competitive advantage?” Academy of Management Review, 11, pp. 656–665, on organizational culture; Henderson, R. M., and I. Cockburn. (1994). “Measuring competence? Exploring firm effects in pharmaceutical research.” Strategic Management Journal, 15, pp. 63–84, on relationships among employees; and Dyer, J. H., and H. Singh. (1998). “The relational view: Cooperative strategy and sources of interorganizational competitive advantage.” Academy of Management Review, 23(4), pp. 660–679, on relationships with suppliers and customers. 19. For a discussion of knowledge as a source of competitive advantage in the popular business press, see Stewart, T. (1995). “Getting real about brain power.” Fortune, November 27, pp. 201+; Stewart, T. (1995). “Mapping corporate knowledge.” Fortune, October 30, pp. 209+. For the academic version of this same issue, see Simonin, B. L. (1999). “Ambiguity and the process of knowledge transfer in strategic alliances.” Strategic Management Journal, 20(7), pp. 595–623; Spender, J. C. (1996). “Making knowledge the basis of a dynamic theory of the firm.” Strategic Management Journal, 17 (Winter special issue), pp. 109–122; Hatfield, D. D., J. P. Liebeskind, and T. C. Opler. (1996). “The effects of corporate restructuring on aggregate industry specialization.” Strategic Management Journal, 17, pp. 55–72; and Grant, R. M. (1996). “Toward a knowledge- based theory of the firm.” Strategic Management Journal, 17 (Winter special issue), pp. 109–122. 20. Porras, J., and P. O. Berg. (1978). “The impact of organizational devel- opment.” Academy of Management Review, 3, pp. 249–266, have done one of the few empirical studies on whether systematic efforts to change socially complex resources are effective. They found that such efforts are usually not effective. Although this study is getting older, it is unlikely that current change methods will be any more effective than the methods examined by these authors. 21. See Hambrick, D. (1987). “Top management teams: Key to strate- gic success.” California Management Review, 30, pp. 88–108, on top management teams; Barney, J. B. (1986). “Organizational culture: Can it be a source of sustained competitive advantage?” Academy of Management Review, 11, pp. 656–665, on culture; Porter, M. E. (1980). Competitive strategy. New York: Free Press; and Klein, B., and K. Leffler. (1981). “The role of market forces in assuring contractual perfor- mance.” Journal of Political Economy, 89, pp. 615–641, on relations with customers. 22. See Harris, L. C., and E. Ogbonna. (1999). “Developing a market ori- ented culture: A critical evaluation.” Journal of Management Studies, 36(2), pp. 177–196. 23. Lieberman, M. B. (1987). “The learning curve, diffusion, and com- petitive strategy.” Strategic Management Journal, 8, pp. 441–452, M03_BARN0088_05_GE_C03.INDD 118 13/09/14 3:13 PM Chapter 3: Evaluating a Firm’s Internal Capabilities 119 has a very good analysis of the cost of imitation in the chemical industry. See also Lieberman, M. B., and D. B. Montgomery. (1988). “First-mover advantages.” Strategic Management Journal, 9, pp. 41–58. 24. Rumelt, R. P. (1984). “Toward a strategic theory of the firm.” In R. Lamb (ed.), Competitive strategic management (pp. 556–570). Upper Saddle River, NJ: Prentice Hall, among others, cites patents as a source of costly imitation. 25. Significant debate surrounds the patentability of different kinds of products. For example, although typefaces are not patentable (and cannot be copyrighted), the process for displaying typefaces may be. See Thurm, S. (1998). “Copy this typeface? Court ruling counsels caution.” The Wall Street Journal, July 15, pp. B1+. 26. For an insightful discussion of these complementary resources, see Amit, R., and P. J. H. Schoemaker. (1993). “Strategic assets and organi- zational rent.” Strategic Management Journal, 14(1), pp. 33–45. 27. See H. Tabuchi (2012) How the tech parade passed Sony by. April 15, 2012. New York Times. http://www.nytimes.com/2012/04/15/tech- nology/how-sony-fell-behind in the tech parade. Accessed January 27, 2014. 28. (2004). “Casio.” Marketing, May 6, p. 95; Weisul, K. (2003). “When time is money—and art.” BusinessWeek, July 21, p. 86. 29. That said, there have been some “cracks” in Southwest’s capabilities armor lately. Its CEO suddenly resigned, and its level of profitability dropped precipitously in 2004. Whether these are indicators that Southwest’s core strengths are being dissipated or there are short- term problems is not yet known. However, Southwest’s stumbling would give US Airways some hope. Trottman, M., S. McCartney, and J. Lublin. (2004). “Southwest’s CEO abruptly quits ‘draining job.’” The Wall Street Journal, July 16, pp. A1+. 30. One should consult a lawyer before getting involved in these forms of tacit cooperation. 31. This aspect of the competitive dynamics in an industry is discussed in Smith, K. G., C. M. Grimm, and M. J. Gannon. (1992). Dynamics of com- petitive strategy. Newberry Park, CA: Sage. 32. Schlender, B. R. (1992). “How Sony keeps the magic going.” Fortune, February 24, pp. 75–84. 33. Personal communication. 34. See, for example, Peters, T., and R. Waterman. (1982). In search of excellence. New York: Harper Collins; Collins, J., and J. Porras. (1994). Built to last. New York: Harper Business; Collins, J. (2001). Good to great. New York: Harper Collins; and Bennis, W. G., and R. Townsend. (2006). Reinventing leadership. New York: Harper Collins. M03_BARN0088_05_GE_C03.INDD 119 13/09/14 3:13 PM M03_BARN0088_05_GE_C03.INDD 120 13/09/14 3:13 PM p a r t 1 c a s e s Anna Claire Butler wet her brush, slicked her hair back, and checked her reflection in the mirror. “My first day on Wall Street!” she thought. Five minutes later, she walked briskly down Broadway Avenue to the 86th Street subway station to catch the downtown 1-2-3 train. After a hot and cramped 20-minute subway ride, Anna Claire stepped into the lobby of the bank that housed the midtown Manhattan offices of Keller & Assoc., her new employer. Later that day, Anna Claire pushed through the crowd waiting for a table to join her best friend, Beth. After the two friends exchanged hellos, Beth said, “What’s wrong with you? You look like you were hit by a bus.” “My feet are killing me. I’ve got a run in my brand-new stockings, and I’m starving. Worse yet, I have to figure out the soda market and do a presentation to my boss in two days.” “What do you mean, figure out the soda market? You just started. What do you know about it?” asked Beth. “All I know is that my favorite soda is Diet Coke. Unfortunately, that’s not gonna to be enough—not nearly enough—to keep old J. B. Parker happy,” said Anna Claire. “Who’s J. B. Parker?” asked Beth. “Only the man who controls my destiny—the boss- man. He’s looking into doing a deal in the carbonated soft drink market. I don’t know the details, but I am supposed to do all his legwork in the next 48 hours. He told me to ‘show him the money.’ By that he meant explain who makes all the money in the industry and how they do it.” “Hmm, that is interesting, very interesting,” mused Beth. “You know, SodaStream’s stock has been on a roller coaster ride in the past couple of weeks.” “What are you talking about?” asked Anna Claire. “I’m talking about SodaStream being in play.” “Huh?” “An Israeli financial newspaper printed a story about Pepsi being in talks to acquire SodaStream in early June.2 The stock popped almost 8 percent in pre-market trading the day the story came out, but that was before Pepsi nixed the story the same afternoon.3 I bet that’s the deal your boss is working on,” Beth said. “Isn’t that the end of it?” Anna Claire asked. “Apparently not. Pepsi said it wasn’t making any large acquisitions, but investors still bid up SodaStream stock in the hopes that Coca-Cola was interested. The stock hit a high of about 78 bucks on takeover rumors, but has now plunged to about $60—well under where it was before the Pepsi rumor hit the press. It didn’t help the stock that the New York Post ran a story last week that said SodaStream had been shopping itself quietly for the past three months4—but no one was interested in buying. I bet your boss is trying to figure out if he should buy the stock on the pullback in the price.” The next morning, Anna Claire arrived at the office at 6:00 and got to work downloading the annual reports for Coca-Cola, PepsiCo, Dr. Pepper Snapple Group, and SodaStream. “Yikes, this is going to be more complicated than I thought. I bet I don’t get a wink of sleep for the C a s e 1 – 1 : Y o u S a y Y o u W a n t a R e v o l u t i o n : S o d a S t r e a m I n t e r n a t i o n a l * “Transportation for carbonated drinks in the world utilizes 100 million barrels of oil every year. That is 20 times the BP disaster that hit the Gulf of Mexico.” “I think it is criminal that the industry, led by two big companies, will do anything to protect their antiquated business model. They are generating 35 million bottles and cans every single day in the U.K. alone. World-wide it is one billion bottles and cans, most of which just go to trash, landfill, the oceans or parks. It’s insane.” —Daniel Birnbaum, CEO of SodaStream International, in a November 2012 interview with The Wall Street Journal.1 *This case was prepared by Bonita Austin for the purposes of class discussion. It is reprinted with permission. M03A_BARN0088_05_GE_CASE1.INDD 1 13/09/14 3:24 PM PC 1–2 The Tools of Strategic Analysis along with commercial machines, followed by the intro- duction of a home carbonation machine in the 1950s.6 The modern SodaStream system is pictured below. Consumers purchased a SodaStream machine along with a specially designed, durable plastic bottle, flavor concentrate, and a CO2 gas cylinder. After filling the bottle with tap water, the user screwed the bottle into the SodaStream machine and depressed a button to add carbonation. The machine injected CO2 into the water each time the user pushed the button. Once the user had put in the desired amount of carbonation, he added either liquid flavor concentrate to the bottle to his taste or dumped in a pre-measured “cap” of flavor similar to the pre-measured Keurig coffee “caps” made by Green Mountain Coffee Roasters. U.S. Carbonated Soft Drink Market According to Beverage Digest, the top 10 carbonated soft drink (CSD) brands held just over 66 percent of the estimated $74 billion market in 2011. All of the top 10 brands belonged to Coca-Cola, PepsiCo, and Dr. Pepper Snapple Group. Table 1 shows the distribution of market shares by company in the United States in 2011 as well as a listing of their brands and place on the top 10 CSD brand list. next two days,” Anna Claire thought ruefully. As Anna Claire clicked on the file containing SodaStream’s 10K, her mind was full of questions. “Is SodaStream even in the same market as Coke and Pepsi? Why would investors think Coke or Pepsi might want to buy the company? Is SodaStream a disruptive innovator of the carbonated soft drink market? What do the bottlers have to do with Coke and Pepsi? I guess I’d better figure out what SodaStream does first and then think about the competition.” SodaStream International and the SodaStream System SodaStream manufactures home soda drinks maker ma- chines, flavor concentrates, and gas cylinders. Founded in 1903 as a subsidiary of W&A Gibley gin distillers, the original SodaStream machines were marketed to British upper-class customers. The machine, dubbed “apparatus for aerating liquids” by inventor Guy Gibley, allowed us- ers to convert ordinary tap water into carbonated water by injecting compressed carbon dioxide gas (CO2) into a container of water. Marketed to the upper class, the first SodaStream machine was installed at Buckingham Palace.5 The company introduced flavored syrups in the 1920s ginger ale s odastream safe pures odastream Flavors: • Full range of regular, diet, “All-Natural,” mixers, energy • 2/3 less sugar and carbs than leading brands; no high-fructose corn syrup CO2 cylinders: • 60 or 130 liters • Consumers exchange empty cylinders for full ones at retail locations or home delivery via internet/phone Carbonating bottles: • Reusable • Hermetically-sealing cap • BPA-free • Glass or plastic + + +Soda makers: • • Durable, easy to use Large variety of designs, price points • • Over 100 patents Carbonation, Design, Functionality, Safety Source: SodaStream International7 M03A_BARN0088_05_GE_CASE1.INDD 2 13/09/14 3:24 PM Case 1–1: You Say You Want a Revolution: SodaStream International PC 1–3 Pepsi responded aggressively to its critics with the 2012 launch of Pepsi Next, a mid-calorie cola. The new product was sweetened with high-fructose corn syrup and three artificial sweeteners. Pepsi’s advertising expendi- tures jumped more than 44 percent—suggesting the fight for market share wasn’t over yet (see Table 2). Note that Pepsi boosted advertising on the Pepsi brand by 39 percent and on Mountain Dew by 87 percent in 2012. Moreover, the company stated publicly that it was pouring its research efforts into developing new, natural sweeteners in order to develop healthier alternatives to artificial sweeteners and support its planned new product launches in the future. Dr Pepper Snapple Group (DPS) stayed on the side- lines of the so-called “cola wars” by staking a claim to the “flavor” segment of the CSD market. The company held two positions on the top 10 brands list in 2011. Its flagship brand, Dr Pepper, held the #5 position in the industry. Diet Dr Pepper was #9 on the list of the largest CSD brands. In 2011, Dr Pepper Snapple group launched a line of reduced- calorie products in 23 flavors accompanied by the slogan “It’s Not for Women.” Products such as Dr Pepper 10 and The carbonated soft drink market was famous for its market share battles between Coca-Cola and PepsiCo. Notably, PepsiCo aggressively targeted Coke’s position with the Pepsi Challenge marketing campaign that ran from 1975 to 1978. The campaign featured blind taste tests by ordinary consumers all over the United States. To their surprise, more than 50 percent of consumers preferred the taste of Pepsi in head-to-head blind taste tests. The innovative campaign allowed Pepsi to build upon market share gains in the early 1970s and challenge Coke’s dominant position in the United States for the first time. After 15 consecutive years of market share losses to Pepsi in the United States, Coca-Cola responded with the unsuccessful launch of “New Coke” in 1985. A firestorm of consumer protests resulted in the intro- duction of the “Coke Classic” line in its signature hourglass plastic bottle a few months later. Interestingly, “New Coke” used a high-fructose corn syrup–sweetened version of the Diet Coke formula (introduced in 1982). Capitalizing on the strength of the Coke consumer’s bond with the brand that became apparent after the launch of “New Coke,” Coca-Cola directed much of its efforts from the mid-1980s to 2012 to positioning its flagship brand as a “lifestyle” brand. PepsiCo famously launched a series of marketing campaigns over about a 40-year span featur- ing popular artists such as Michael Jackson, Ray Charles, Britney Spears, Christina Aguilera, Mariah Carey, Beyonce, and Nicki Minaj. Although advertising expenditures re- mained high, industry observers in 2010 began to question Pepsi’s determination to compete in the category, as Pepsi appeared to “concede” the category to Coke. Diet Coke overtook Pepsi for the first time to become the #2 brand in the CSD industry. Under CEO Indra Nooyi, Pepsi seemed focused on its highly profitable Frito-Lay snack business rather than on the U.S. carbonated soft drink market. Table 1 2011 U.S. Carbonated Soft Drink (CSD) Company Market Shares and Brands Company Market Share CSD Brands Coca-Cola Co. 41.9% Coke (#1), Diet Coke (#2), Sprite (#6), Fanta (#10), Fresca, Mr. Pibb, Barq’s PepsiCo 28.5% Pepsi (#3), Mountain Dew (#4), Diet Pepsi (#7), Diet Mountain Dew (#8), Sierra Mist Dr. Pepper Snapple Group 21.1% Dr Pepper (#5), Diet Dr Pepper (#9), Vernor’s, Crush, 7Up, Canada Dry, Stewart’s, A&W, Schwepp’s, Diet Rite, Squirt, Orangina, RC Cola, Sunkist Cott Corp. 5.2% Sam’s Choice National Beverage 2.8% Faygo, Shasta, Ritz, Big Shot Source: Business Insider, Dr Pepper Snapple Group 2011 10K, Stastica, Wall Street Journal, Beverage-Digest. Table 2 U.S. Carbonated Soft Drink Advertising Effectiveness ($ in millions) Company 2011 2012 Change 2011 Spending/Share Point Coca-Cola $241.4 $253.8 5.1% $5.76 PepsiCo $236.7 $341.9 44.4% $8.31 Dr Pepper Snapple Group $137.3 $148.1 7.9% $6.47 Source: Advertising Age: Top 100 Advertisers, author’s calculations. M03A_BARN0088_05_GE_CASE1.INDD 3 13/09/14 3:24 PM PC 1–4 The Tools of Strategic Analysis simple concoction consisting of flavoring concentrate, car- bonated water, and sweetener. Companies like Coca-Cola, PepsiCo, and Dr Pepper Snapple Group—the concentrate producers—manufactured flavoring concentrate and sold it to licensed bottlers. Bottlers converted concentrate into carbonated beverages by adding carbonated water and packaging the drinks in bottles and cans. The concentrate producers (CPs) added sweeteners such as sucralose or Stevia before selling diet concentrate to the bottlers, while the bottlers added high-fructose corn syrup or cane sugar to full calorie beverages. For much of the past 25 years, the concentrate producers did not purchase bottles, cans, sugar, or high- fructose corn syrup, as they did not manufacture finished carbonated soda products. They did negotiate supply agreements for their fragmented “bottling systems” in order to increase the buying power of their bottlers sys- temwide. The concentrate producers created marketing campaigns and promotions for their brands and shared in the considerable marketing costs for their brands with the bottlers. The bottlers were responsible for purchasing raw materials and packaging, manufacturing the finished bev- erages, distribution and warehousing, and customer ser- vice. They paid for promotions and bore some marketing costs, set local prices of the finished beverages, and sold directly to retail stores. Coca-Cola and Pepsi bottlers were prohibited by contractual agreements from making and selling “imitative” products that competed directly with Coca-Cola and PepsiCo beverage brands. For example, a Coca-Cola bottler could not sell Pepsi or Diet Pepsi. In return, the CPs granted the bottlers exclusive distribution rights in geographic areas. While the independent bottling system was firmly in place in international markets in 2013, both PepsiCo and Coca-Cola had purchased most of their respective bot- tling systems in the United States in 2010–2011. PepsiCo purchased its two largest bottlers in North America (Pepsi Bottling Group and PepsiAmericas) for a combined value of $7.8 billion in early 2010. The purchase gave Pepsi control of 80 percent of its distributors in North America. Coca- Cola purchased the North American bottling operations of its largest bottler, Coca-Cola Enterprises, in a deal valued at about $12.3 billion in October 2010. Coca-Cola owned 90 percent of its North American bottling system after the CCE deal closed. The three acquisitions marked a reversal in strat- egy for both Coca-Cola and PepsiCo. Coca-Cola spun off the bottlers it owned in 1987 as so-called “anchor bottlers.” Spinning off the bottlers allowed Coke to push large amounts of capital off of its balance sheet and focus on concentrate production. The capital-intensive bottling A&W 10 were targeted to young men who are “turned off” by zero-calorie sodas. Clearly, ad spending signaled that competition was heating up between the major CSD makers in the United States. Industry observers that called the end of the “cola wars” in 2011 may have celebrated Coke’s victory prematurely. Retail Distribution Sales of carbonated soft drinks to consumers went through two major distribution channels: retail stores and fountain ac- counts. Sales to retailers accounted for more than 75 percent of total CSD sales in the United States, while fountain drinks generated about 25 percent of industry sales. The largest portion of retail store sales was through supermarkets and discounters. The $1.2 trillion supermarket and discounter industry accounted for 50 percent of all carbonated soft drink sales in the United States in 2011. The top five retailers in the segment—Wal-Mart, Kroger, Target, Costco, and Safeway— generated about 49 percent of all retail sales in the channel. Wal-Mart alone accounted for about 27 percent of retail sales in the supermarket and discounter industry. While figures were not available for individual retailer sales of carbonated soft drinks, PepsiCo stated that Wal-Mart (including Sam’s Club) accounted for 11 percent of its sales worldwide in 2011 and 17 percent of its U.S. sales. Although Costco accounted for only about 6 percent of all retail sales in the channel, the company dealt a blow to Coca-Cola in 2012 by switching all of its food courts to Pepsi products. Convenience stores, gas stations, vending machines, and other retailers made up the remainder of CSD industry sales to retail stores.8 Sales to restaurants, movie theaters, stadiums, and other fountain drink outlets generated about 25 percent of CSD industry sales. Coca-Cola held an estimated 70 percent of the fountain drink market—dwarfing PepsiCo’s estimated 19 percent share and Dr. Pepper’s 11 percent share in the channel. McDonalds exclusively sold Coca- Cola products and accounted for half of all food sales in fast-food burger joints in 2011 and so was undoubtedly one of Coca-Cola U.S.’s most important customers. With the estimated 75 percent retail margins on fountain drink sales, McDonald’s relationship with Coca-Cola has proven to be a profitable one for the fast-food giant. Manufacturing and Distribution of Carbonated Soft Drinks Originally sold by druggists as a healthful tonic, the bub- bly potion has been enjoyed by Americans since the early 1800s. The carbonated soft drink itself was a relatively M03A_BARN0088_05_GE_CASE1.INDD 4 13/09/14 3:24 PM Case 1–1: You Say You Want a Revolution: SodaStream International PC 1–5 Waning Popularity of Carbonated Soft Drinks At the turn of the 19th century, there were more than 100 different carbonated soft drink brands (CSD) and 2,763 bot- tling plants.11 As the popularity of the beverage increased, the number of bottling plants exploded, peaking at about 6,500 in 1950. Demand for carbonated soft drinks was strong for many years, and the beverage became America’s favorite when it surpassed coffee in popularity in 1977. At the peak of its reign as the U.S. consumer’s favorite drink in the late 1990s, Americans drank nearly 55 gallons of CSD per year on average, and CSD were 30 percent of all liquid beverage consumption. Beer was the next largest drinks cat- egory but only accounted for 12 percent of liquid beverage consumption in the United States.12 During the 1990s, de- mand grew at about 3 percent per year on average. Demand for CSD as measured by case volume began to decline in 2005 and fell for seven consecutive years. Nevertheless, Americans still consumed a whopping 42.4 gallons13 of CSD per capita and the beverage category accounted for about 25 percent of daily beverage consumption. Changes in consumer preferences fueled by health concerns were the largest contributor to the decline in CSD consumption. Increasingly, U.S. consumers turned to bottled wa- ter, energy drinks, ready-to-drink teas, coffee beverages, sports drinks, and juice drinks to quench their thirst. Rising health concerns, especially regarding obesity, and interest in “natural” and “green” products helped fuel demand for al- ternatives to CSD in the 2000s. Campaigns against CSDs in schools and the 2013 proposed ban on fountain drink serv- ing sizes of more than 16 ounces for full-calorie CSD in New York City highlighted the changes in public opinion about the health effects of CSD consumption. New York Supreme Court Judge Milton Tingling overturned the ban on grounds that the New York Board of Health was established to pro- tect citizens against diseases, not to regulate the city’s food supply except when the city faced an imminent threat from disease.14 Nevertheless, the proposed ban worried beverage makers, as it was an indication the movement to reduce the public’s consumption of sugary drinks continued to gain momentum in the United States. Moreover, NYC’s attempt to limit CSD consumption was a chilling reminder of the anti-cigarette movement that resulted in the smoking ban in NYC restaurants and bars in 2003. Bottled water was the largest non-alcoholic alterna- tive drink category to CSD in the U.S. market. Of the esti- mated 180 gallons of beverages Americans consumed on average per year, bottled water accounted for 29 gallons per person in 2011—up from 18 gallons per capita in 2001. Bottled water sales generated about $11 billion in revenues business was far less profitable than the lucrative concen- trate business. To illustrate, Coca-Cola Enterprises (CCE) had an operating margin of 7.6 percent and a return on average assets of 5 percent in 2009 excluding restructuring charges. Coca-Cola’s operating margin was 26.6 percent, and return on average assets was 15.3 percent—more than three times larger than CCE’s return on average assets. Pepsi spun off its bottlers in 1999. Pepsi Bottling Group had an operating margin of 7.9 percent and a return on average assets of 4.6 percent in 2009. PepsiCo’s operating margin on the North American beverage business was 21.7 percent in 2009. Coca-Cola and PepsiCo expected the purchase of the majority of their bottling systems in North America to allow both companies to realize significant cost savings and better address the challenges of shifting consumer preferences in the United States. Increasing demand for alternative bev- erages had strained both companies’ bottling systems as bottlers struggled to make investments in equipment and logistics systems that would facilitate a shift away from a manufacturing and inventory management process that was designed for large volume sales of a relatively small number of stock-keeping units. Alternative beverages such as energy drinks and ready-to-drink teas used smaller pro- duction runs and had much more complicated and exten- sive product lines that featured many flavors and sizes of beverages than CSD. These investments were not paying off for the bottlers but were desperately needed by both Coke and Pepsi to remain competitive in the United States. Investors speculated that both companies would eventually spin off or re-franchise the captive bottlers in the future or separate manufacturing and distribution. Indeed, Coca-Cola announced in April 2013 it had reached an agreement with its major independent bottlers to ex- pand their distribution territories, but not to increase their production capacities. Muhar Kent, chairman and CEO of Coca-Cola, commented, “A strong franchise system had always been the competitive advantage of the Coca-Cola business globally, and today we are accelerating the trans- formation of our U.S. system in ways that will establish a clear path to achieve our 2020 vision.”9 A few days later, Kent told investors, “In the coming months, we will be collaborating with five of our bottling partners to imple- ment a plan which will include the granting of exclusive territory rights and the sale of distribution assets with cold drink equipment. In the near term, production assets will remain with Coca Cola Refreshments, which will facilitate future implementation of a national product supply sys- tem.”10 It appeared that Coca-Cola had begun to transform its traditional manufacturing and distribution model in the United States. M03A_BARN0088_05_GE_CASE1.INDD 5 13/09/14 3:24 PM PC 1–6 The Tools of Strategic Analysis each 1 percent increase in price.18 CSD manufacturers in- creased retail prices in 2011 and 2012 to offset higher prices for sweeteners, especially high-fructose corn syrup. Price hikes appeared to be a contributing factor to the decline in consumption of CSD in both years. SodaStream Business Model The home drinks system was quite popular in the United Kingdom in the 1970s and 1980s but languished in the 1990s and early 2000s as the company suffered through several changes in ownership. Close to bankruptcy, the firm received a cash infusion from Fortissimo Capital and new management in 2007. Daniel Birnbaum, installed as SodaStream’s CEO in 2007, was fresh off of a three-year stint as Nike Israel’s general manager and also had estab- lished Pillsbury’s business in Israel during the late 1990s. Under Birnbaum, the company modified its customer value proposition while retaining its tried-and-true profit model. In order to build the brand, Birnbaum employed three value drivers that took advantage of major societal trends: rising consumer interest in so-called “green” products; in- creasing consumer concerns over health and wellness, espe- cially obesity; and the apparent change in the zeitgeist away from conspicuous consumption and toward frugality. As a result, the management team began to posi- tion the SodaStream system as an environmentally sound and healthy alternative to prepared carbonated soft drinks. According to SodaStream’s corporate Web site, the company seeks to “revolutionize the beverage industry by reducing plastic bottle waste and being an environmentally friendly product…SodaStream’s vision is to create a world free from bottles. At SodaStream, we believe it is time to rethink how you make your soda and to understand the positive environmental impact when making soda at home. We are committed to continuously improving as an earth friendly brand and offering eco-friendly products that have a posi- tive impact on our environment.” Indeed, the company’s Web site prominently features a plastic bottle “counter” at the top of the page that displays management’s estimates of the number of plastic bottles that the company’s customers “have kept out of landfills” by using the SodaStream refill- able system rather than purchasing prepackaged soft drinks. As of July 2013, the count stood at roughly 3.2 billion bottles. Mindful of consumer concerns over obesity and well- ness as well as the broad shift in consumer tastes away from colas to “flavors” over the past few years, SodaStream em- phasized that its 100 flavors of syrup allow the consumer to control the amount of concentrate per serving and were avail- able in diet or sugar-free versions. The company’s product in 2011, according to a report by Beverage Marketing.15 Continuing its meteoric rise in popularity, energy drink sales leaped more than 14 percent in 2011 to about $8.9 bil- lion in retail sales. Energy drink leader Monster Inc.’s sales grew more than 16 percent and the company nabbed more than 36 percent of all energy drink sales in 2011. Sports drink sales, pushed up by new low-calorie and no-calorie product introductions, increased almost 9 percent to about $7 billion in 2011. Other alternatives to CSD such as ready- to-drink coffee also experienced strong sales growth in 2011. Coca-Cola, PepsiCo, and Dr Pepper Snapple Group all acquired significant assets in the non-carbonated soft drink market to satisfy consumer demands for alternative bever- ages. Investors expected all three companies to continue to explore acquisitions, strategic alliances such as licensing, and homegrown forays into new beverage categories. Coca- Cola was #1 in the non-carbonated soft drink market with a 34 percent share. PepsiCo came in #2 with a 26 percent share, followed by Dr Pepper Snapple Group with an 11 percent share of the non-carbonated soft drink segment in 2012. Coca-Cola’s U.S. brand portfolio included the #2 sports drink brand (Powerade) and #2 bottled water brand (Dasani). The company added Vitamin Water to its line up through the $4.2 billion acquisition of Glaceau—putting Coke in the lead in the fortified water segment. Other key brands included Minute Maid, Fuze, and Glaceau SmartWater. Although it trailed Coca-Cola, PepsiCo had a strong position in non-CSD categories thanks in large part to its $13.4 billion purchase of Quaker Oats in 2001. Quaker’s Gatorade brand gave Pepsi an 80 percent share of the fast-growing U.S. sports drink market. While Gatorade’s market share had slipped to about 73 per- cent in 2011, the brand still held a commanding lead in the category.16 At $3.3 billion in annual sales as of October 2012, Gatorade was one of PepsiCo’s most important brands.17 The company also held the lead in the U.S. bottled water segment with its Aquafina brand. Other key PepsiCo brands included Tropicana, SoBe, Propel, Amp Energy, and licensed brands Lipton Brisk and Starbucks. Dr Pepper Snapple Group was a distant #3 in the non-carbonated soft drink market but was still a strong competitor in several categories. The company’s non- carbonated brands included #1 ready-to-drink tea brand Snapple, along with Hawaiian Punch, Clamato, DejaBlue, Mott’s, and Nantucket Nectars. In addition to consumer concerns over health, de- mand for CSD proved to be very price elastic. In fact, 160 research studies on the elasticity of demand for food conducted between 1938 and 2007 showed that a 10 percent increase in soft drink prices results in an aver- age –8 percent drop in demand, with an even larger drop for carbonated soft drinks of –9 percent on average for M03A_BARN0088_05_GE_CASE1.INDD 6 13/09/14 3:24 PM Case 1–1: You Say You Want a Revolution: SodaStream International PC 1–7 management expected the company’s already high profit margins to increase as its product mix shifted from low- margin machines to high-margin CO2 refills and flavor concentrates. As part of its move to increase household penetration and encourage repeat purchases of consum- ables, SodaStream aggressively pursued licensing partner- ships with established beverage brands such as Country Time and Crystal Light. The company also formed a rela- tionship with Samsung to sell a line of refrigerators with built-in SodaStream machines. The refrigerator retailed for $3,900 in 2013. Third, SodaStream pursued relationships with competing home soda machine manufacturers in or- der to try to establish the SodaStream gas cylinder as the industry standard. As of summer 2013, SodaStream had no significant competitors in the U.S. market. Financial Results The company sold its products in 60,000 stores and 45 countries in 2012. A relative newcomer to the U.S. market, SodaStream’s U.S. sales were conducted through 15,000 stores, including Williams-Sonoma, Best Buy, Wal-Mart, and Target. As Table 3 shows, the company’s 2012 revenues in the Americas were about $158 million—up from about $41 million in 2010. The majority of the company’s revenues in the Americas were generated by sales in the U.S. market. Overall revenues had more than doubled from $208 million to $436 million in two years. At the same time, operating profits more than tripled and net income in 2012 skyrock- eted to nearly three and a half times net income in 2010. With $62 million in cash and no debt, SodaStream’s balance sheet was a strong one. Yet, the company was dwarfed by its larger CSD competitors (see Appendix 1). SodaStream’s Outlook Despite the company’s exceptional financial results, inves- tors worried that the SodaStream system would lose its appeal to consumers as it had in previous decades. With no line included syrups for traditional carbonated soft drinks, energy drinks, fruit drinks, iced teas, and flavored waters. Along with the boost to its customer value proposition afforded by a major improvement in both machine and con- centrate quality, SodaStream stressed consumer cost savings compared to canned or bottled soft drinks. Excluding the upfront costs for the SodaStream machine, SodaStream said consumers spent only $0.25 for 12 ounces of SodaStream soda (the size of a can of Coke or Pepsi) and $0.25 per liter of sparkling water made with a SodaStream machine. The machine ranged in price from $79 for the basic model to $199 for the company’s automated model in the United States. Flavorings cost $4.99, $6.99, and $9.99 per bottle. Each bottle of flavoring made between 25 and 33 eight-ounce servings of soda. A refill CO2 canister (with a returned canister) cost $15 with each canister making about 60 liters of soda. SodaStream planned to profit from its customer value proposition by sticking with its proven profit model. Like the famous Gillette “blade and razor” model, SodaStream’s profit model relied upon follow-up sales of flavor concen- trates and gas cylinder refills. SodaStream starter kits ac- counted for about 43 percent of sales, while consumables (flavor syrups, bottles, and CO2 refills) generated 57 percent of revenues in 2012. SodaStream machines were profitable but generated gross margins of only an estimated 30 to 32 percent—well below the corporate average gross margin of 54 percent in 2012. In contrast, the consumables business had gross margins of an estimated 72 percent. While the CO2 refill business produced significantly smaller revenues than sales of flavors and bottles, the refill canisters had astonishingly high gross margins of an estimated 85 to 90 percent.19 The relatively small plastic bottle segment had the next best gross margins—an estimated 60 to 62 percent. The flavor concentrate business also was a very profitable one with gross margins of an estimated 58 percent. The company’s profit model had several major parts. First, the company was vertically integrated into the man- ufacturing of gas cylinders, SodaStream machines, and flavor concentrates. The company counted on economies of scale in its Israeli gas cylinder production facility to keep margins high. Its patented fittings on gas cylinders and the SodaStream machines made it difficult for potential competitors to copy this critical element of the SodaStream system. Moreover, regulations on handling and storing hazardous materials—the CO2 canisters were pressur- ized—made retailers leery of selling competing cylinders. Second, SodaStream intended to increase both its geo- graphic reach and household penetration of SodaStream machines, which would allow the firm to benefit from the sale of higher-margin consumables to each household with a SodaStream machine in the future. Over time, Table 3 SodaStream 2010–2012 Revenue Company 2010 2012 Difference SodaStream $41 $158 $117 PepsiCo $236.7 $341.9 $8.31 Dr Pepper Snapple Group $137.3 $148.1 $6.47 Source: Business Insider, Dr Pepper Snapple Group 2011 10K, Stastica, Wall Street Journal, Beverage-Digest. M03A_BARN0088_05_GE_CASE1.INDD 7 13/09/14 3:24 PM PC 1–8 The Tools of Strategic Analysis the United Kingdom by television industry trade group Clearcast than it would have gotten through the ad. Still, the system did not yet operate as smoothly as it should because U.S. retailers were unfamiliar with the gas cylinder exchange program and frequently did not know how to give consumers a newly filled but used cylinder for $15 rather than selling them a new cylinder for $25. Information on cylinder exchange often was missing from store shelves, and many flavors frequently were out of stock. Moreover, SodaStream bears pointed to the lack of significant barriers to entry for a potential SodaStream competitor—should the market become large enough to at- tract large consumer products companies. A new gas cylin- der factory might only cost $100 million to build compared to billions to replicate the Coca-Cola or Pepsi bottling system in the United States alone. SodaStream’s product might be a convenient alternative to prepackaged drinks at home, but U.S. consumers were accustomed to being able to purchase a Coke or Pepsi nearly anywhere. The huge popularity of the Coca-Cola “Freestyle” drink-dispensing machine with its 125 different flavor options underlined the company’s efforts to respond to consumer demands for flavor variety suggested that SodaStream’s flavor variety might have some traction with customers. As Anna Claire pondered all she had learned about the CSD industry and SodaStream in the past few days, she thought about a quote from Birnbaum, SodaStream’s CEO, in response to the CBS Super Bowl ad ban: “Our ad con- fronts the beverage industry and its arguably outdated busi- ness model.” He went on to say, “One day we will look back on plastic soda bottles the way we now view cigarettes.”20 “Perhaps Birnbaum was right,” Anna Claire thought. buyout in sight, the company had to continue to perform on its own to keep the stock market happy. SodaStream’s own research showed that an estimated 5 million con- sumers worldwide used a SodaStream machine at least once every two weeks. The company sold more than 10 million machines from 2008 to 2012. Still, investors had shown they were willing to bet on companies with far less impressive conversion rates than SodaStream, such as Pandora. SodaStream bulls argued that the company was a “disruptive innovator” that would make canned and bottled soft drinks obsolete. The SodaStream system did not require a capital-intensive bottling system because con- sumers made the drinks at home with their own CO2 can- isters. SodaStream drinks were inexpensive and relatively healthy. Consumers could customize the product by alter- ing the amount of carbonation and flavor concentrate. The product was environmentally friendly, unlike every other prepackaged beverage on the market. The company’s more than 100 soda flavors gave consumers more variety than they could get from the large CSD brands. In addition, the company’s money-back satisfaction guarantee was an important signal of quality assurance to the consumer. SodaStream’s total marketing expenditures worldwide were substantial at $153 million in 2012. The company indicated brand building was a top priority by purchasing ad time from the U.S.’s most expen- sive ad venue: the Super Bowl. However, SodaStream’s ad featuring exploding Coke-like and Pepsi-like bottles was banned by CBS from the Super Bowl in the United States. The ad immediately “went viral” on YouTube, according to NewsMax. SodaStream arguably garnered more con- sumer attention due to the CBS ban and a similar one in End Notes 1. Zekaria, S. (2012). “SodaStream fizzes up global market for carbonated and flavored drinks.” The Wall Street Journal, November 13. 2. Reuters Tel Aviv. (2013). “PepsiCo in talks to buy SodaStream for $2 billion.” June 6, www.reuters.com/article/2013/06/06/sodastream-pepsi-idUSL5N0EI0NI20130606. 3. Reuters Tel Aviv. (2013). “PepsiCo denies in talks to buy SodaStream.” June 6, www. reuters.com/article/2013/06/06/us-sodastream-pepsi-idUSBRE9550AJ20130606. 4. Kosman, J. (2013). “SodaStream’s sale hopes going pffffffft.” New York Post, July 9, www.nypost.com/p/news/business/ sodastream_sale_hopes_going_pffffffft_jFn51VKX0OTiRVKNipLn3J. 5. Stevens, J. (2012). “Remember SodaStream? Now you can just twist ‘n sparkle with a clever bottle that even makes your own champagne.” Mail OnLine, May 11, www. dailymail.co.uk/femail/article-2142925/Remember-SodaStream-Now-just-Twist-n- Sparkle-clever-bottle-makes-Champagne.html. M03A_BARN0088_05_GE_CASE1.INDD 8 13/09/14 3:24 PM Case 1–1: You Say You Want a Revolution: SodaStream International PC 1–9 6. en.wikipedia.org/wiki/Sodastream, July 17, 2013. 7. “SodaStream international presentation: Company overview.” July 17, 2013, sodas- tream.investorroom.com/sodastreamoverview. 8. “Breaking down the chain: A guide to the soft drink industry.” National Policy and Legal Analysis Network to Prevent Childhood Obesity. Public Health Law and Policy. changelabsolutions.org/publications/breaking-down-chain. 9. (2013). “The Coca-Cola Company commences implementation of 21st Century Beverage Partnership Model in the United States.” Coca-Cola press release, April 16, www.coca-colacompany/press-center/press-releases. 10. (2013). “The Coca-Cola Company discusses 1Q 2013 results—earnings call transcript.” April 16, seekingalpha.com/article/1344791-the-coca-cola-company-s-ceo-discusses- q1-2013-results-earnings-call-transcript?page=3. 11. Saltzman, H., R. Levy, and J. Hilke. (1999). “Transformation and continuity: The U.S. carbonated soft drink bottling industry and antitrust policy since 1980.” Bureau of Economics Staff Report. Federal Trade Commission, November. 12. Ibid. Page 5. 13. Esterl, M. (2013). “Fizzy drinks revenue goes from flat to sour.” The Wall Street Journal, January 18. 14. Adams, B. (2013). “Judge overturns NYC’s soda ban.” TheBlaze.com, May 11, www. theblaze.com/stories/2013/03/11/report-judge-overturns-nycs-soda-ban/. 15. (2012). “Reinvigorated bottled water bounces back from recessionary years, new re- port from beverage marketing corporation shows. Press release, May. 16. Edwards, J. (2012). “In Gatorade war, Pepsi seems to have deliberately given up market share to Coke.” Business Insider, February 1, www.businessinsider.com/ why-gatorades-10-point-loss-of-share-to-cokes-powerade-is-not-a-total-disaster-2012-2. 17. (2012). “Apple tops the list of the world’s most powerful brands.” Forbes, October 22, www.forbes.com/sites/kurtbadenhausen/2012/10/02/ apple-tops-list-of-the-worlds-most-powerful-brands/. 18. Andreyava, T., M. W. Long, and K. D. Brownell. (2010). “The impact of food prices on consumption: A systematic review of research on the price elasticity of demand for food.” American Journal of Public Health, 100(2), pp. 216–222. 19. Author’s estimates. 20. Elsinger, D. (2013). “SodaStream ad: Banned by CBS from Super Bowl, video goes viral.” NewsMax.com, February 4, www.newsmax.com/TheWire/ sodastream-ad-super-bowl-cbs/2013/02/04/id/488766. Other References 1. (2013). “100 leading national advertisers 2013 edition.” Advertising Age, June 24. 2. (2012). “Special issue: U.S. beverage results for 2012.” Beverage-Digest, March 20. M03A_BARN0088_05_GE_CASE1.INDD 9 13/09/14 3:24 PM PC 1–10 The Tools of Strategic Analysis AppENDIx A Selected 2012 Financials—Branded Carbonated Soft Drink Companies ($ in Millions Except EpS and Beta) Coca-Cola Dr Pepper Snapple PepsiCo SodaStream Sales $48,017 $5,595 $65,492 $436 Gross Profit 28,964 3,495 34,201 236 Gross Margin 60.3% 62.5% 52.2% 54.0% Operating Profit 10,779 1,092 9,112 46 Operating Margin 22.4% 19.5% 13.9% 10.4% Interest Expense 397 125 899 0 Net Income 9,019 629 6,214 44 EPS (fully diluted) $2.00 $2.96 $3.92 $2.09 Shares Outstanding 4504 2123 1575 2 Cash $16,551 $366 $6,619 $62 Accounts Receivable 4,759 602 7,041 115 Inventory 3,264 197 3,581 113 Total Assets 86,174 8,929 74,638 412 Accounts Payable $8,680 $283 $11,903 $86 Total Debt 32,610 2,804 28,359 0 Shareholders Equity 33,168 2,280 22,399 274 Depreciation 1,982 240 2,689 10 Capital Expenditures 2,780 193 2,714 34 Beta (as of 7/18/13) 0.33 -0.04 0.30 1.43 Share Price (7/18/13) $40.81 $47.91 $86.80 $58.22 North American Sales 41%a 100% 57% 36% International Sales 59% 0% 43% 64% North American Beverages 41% 100% 33% 36%b a U.S. only. b Includes sales of SodaStream machines and gas cylinders. M03A_BARN0088_05_GE_CASE1.INDD 10 13/09/14 3:24 PM C a s e 1 – 2 : T r u e R e l i g i o n J e a n s : W i l l G o i n g P r i v a t e H e l p I t R e g a i n I t s C o n g r e g a t i o n ? * True Religion Board Accepts $835 Million Takeover Bid “It’s been more than half a year since the 10-year-old high-end-jeans seller, no longer the must-have brand, put itself up for sale. True Religion Apparel Inc., the Southern Cali- fornia purveyor of pricey designer denim, may have gotten too small for its britches. More than half a year after putting itself up for sale amid growth struggles and fluctuating stock, the high-end-jeans seller said its board unanimously accepted an $835-million takeover offer from investment firm TowerBrook Capital Partners.” —excerpt from The Los Angeles Times1 True Religion Brand Jeans Founded in 2002 by Jeff Lubell, True Religion had become one of the largest premium denim brands in the United States by 2012. Although True Religion made its debut in upscale department stores and trendy boutiques a decade earlier, the company owned 86 full-price retail stores and 36 outlet stores in the United States as well as 30 stores in international markets by the end of 2012. The company’s domestic retail store business accounted for about 60 per- cent of revenues and 64 percent of operating profit before unallocated corporate expenses in 2012. Just five years ear- lier, the U.S. retail store segment generated only 17 percent of sales and 25 percent of operating profit before unallo- cated corporate expenses (see Exhibit 1). The ultimate in product differentiation, many companies attempt to create so-called “lifestyle” brands that tran- scend product category and inspire deep consumer loyalty. Becoming a lifestyle brand was the key to insulating True Religion from the inevitable fluctuations in fashion trends. Moreover, True Religion’s sales had grown at an average annual rate of almost 22 percent from 2007 to 2012 (see Exhibit 2). The company’s return on invested capital was an impressive 27 percent, and its return on average assets was 12 percent in 2012. Despite these factors, press articles and analyst reports on True Religion described the company as “the struggling maker of premium denim.”2 A New York Post article titled “Escape from Hell for True Religion” described private equity firm TowerBrook as the company’s “savior.”3 What had gone wrong at True Religion? Was the change in ownership the answer to the company’s prob- lems? Could True Religion regain its status as the must- have premium denim brand in the United States? Would the company be forced to pull a “Rock & Republic” and re- position itself as a mid-priced brand? Was premium denim destined to go the way of Flash Dance legwarmers and Crocs as fast fashion from the likes of H&M became more mainstream? Private equity investors had snapped up stakes in both established and up-and-coming premium denim brands in the previous five years. With soon only one publicly traded premium jeans maker (Joe’s Jeans) left, should investors stay away from the industry? A Brief Recap of the Recent History of the U.S. Denim Market Calvin Klein popularized the concept of premium jeans in the late 1970s. The designer burst onto the jeans scene with shockingly high prices, a skin-tight fit, and a controver- sial advertising campaign featuring a very young Brooke Shields. As Brooke Shields confided to U.S. consumers that nothing came between her and her “Calvins,” the $35-per- pair jeans flew off store shelves. At the time, mainstream Lee and Wrangler blue jeans retailed for about $12 per pair on *This case was prepared by Bonita Austin for the purposes of class discussion. It is reprinted with permission. Lubell’s vision of the company had come true—at least partly. The company had transformed itself from a jeans designer into an apparel retailer with it own brand à la Buckle and Diesel. At the same time, True Religion had managed to shift its product mix so that sportswear accounted for almost 35 percent of sales in its company- owned stores. Lubell felt these two ingredients were criti- cal to establishing True Religion as a “lifestyle brand.” M03A_BARN0088_05_GE_CASE2.INDD 11 13/09/14 3:25 PM PC 1–12 The Tools of Strategic Analysis Exhibit 1 True Religion Brand Jeans Operating Segments ($ in thousands) Net Sales 2007 2008 2009 2010 2011 2012 U.S. Consumer Direct $29,268 $75,314 $129,030 $189,097 $251,334 $281,583 U.S. Wholesale 111,390 153,235 123,203 104,874 86,268 99,215 International 31,728 40,044 54,479 64,443 78,974 83,824 Core Servicesa 870 1,407 4,289 5,300 3,222 2,663 Total Company Net Sales $173,256 $270,000 $311,001 $363,714 $419,798 $467,285 Gross Profit U.S. Consumer Direct $22,380 $57,669 $95,276 $136,915 $178,341 $197,328 Gross Margin 76.5% 76.6% 73.8% 72.4% 71.0% 70.1% U.S. Wholesale 60,007 78,670 65,882 53,362 44,445 50,452 Gross Margin 53.9% 51.3% 53.5% 50.9% 51.5% 50.9% International 15,498 19,255 30,115 34,402 45,821 49,080 48.8% 48.1% 55.3% 53.4% 58.0% 58.6% Other 870 1,407 4,289 5,300 3,222 2,663 Total Company Gross Profit $98,757 $157,003 $195,564 $229,981 $271,831 $299,525 Total Company Gross Margin 57.0% 58.1% 62.9% 63.2% 64.8% 64.1% Restated Restated Operating Profit 2007 2008 2009 2010 2011 2012 U.S. Consumer Direct $11,875 $27,810 $44,766 $64,641 $88,453 $93,726 Operating Margin 40.6% 36.9% 34.7% 34.2% 35.2% 33.3% $0.252 U.S. Wholesale 36,405 71,884 60,107 46,265 37,116 44,333 Operating Margin 32.7% 46.9% 48.8% 44.1% 43.0% 44.7% International 14,718 16,761 25,167 17,487 15,927 7,895 Operating Margin 46.4% 41.9% 46.2% 27.1% 20.2% 9.4% Core Servicesb -15,856 -47,579 -52,443 -58,471 -66,885 -67,837 Total Company Operating Profit $47,143 $68,877 $77,598 $69,923 $74,612 $78,118 Total Company Operating Margin 27.2% 25.5% 25.0% 19.2% 17.8% 16.7% Assets 2007 2008 2009 2010 2011 2012 U.S. Consumer Direct $10,167 $36,603 $55,763 $68,418 $78,089 $90,654 U.S. Wholesale 41,248 43,030 31,159 35,001 26,182 27,584 International 6,519 8,362 16,897 24,940 41,700 54,764 Core Servicesc 55,324 78,457 125,987 167,525 214,182 232,714 Total Company Assets $113,258 $166,452 $229,806 $295,884 $360,153 $405,716 a Licensing revenues generated by royalty agreements. b Unallocated corporate expenses. c Unallocated corporate assets. Source: True Religion Apparel Inc. 10K - 2007, 2008, 2009, 2010, 2011, 2012. average. Suddenly, jeans were no longer functional ward- robe staples. They were sexy fashion statements. The jeans craze peaked in 1981 when retail sales jumped to a record $6 billion and 520 million pairs.4 As designer jeans fell out of fa- vor and the prime 14–24-year-old jeans-buying cohort aged, domestic annual jeans sales slid to 416 million pairs by 1985. Following a protracted decline in the 1980s, the mar- ket surpassed its earlier peak and hit annual sales of 511 million pairs in 1995. Denim jeans unit sales grew at a strong 7 to 10 percent per year from 1990 to 1996. Then, in 1997, the denim market experienced a sharp slowdown in growth that lasted until the end of 1999—rising just 3 percent per year on average. For some industry players the slowdown meant disaster. Levi Strauss saw its sales plunge more than 13 per- cent in 1998, almost 14 percent in 1999, and nearly 10 percent in 2000. U.S. textile giants Cone, Swift, and Burlington cut prices and idled production lines—all victims of a denim glut at retail caused by a shift in fashion trends. M03A_BARN0088_05_GE_CASE2.INDD 12 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–13 Exhibit 2 True Religion Brand Jeans Selected Financials ($ in thousands except per share amounts) 2007 2008 2009 2010 2011 2012 Revenues $173,256 $270,000 $311,001 $363,714 $419,798 $467,285 Cost of Goods Sold 74,429 112,999 115,439 133,735 147,969 167,762 Gross Profit $98,827 $157,001 $195,562 $229,979 $271,829 $299,523 Gross Margin 57.0% 58.1% 62.9% 63.2% 64.8% 64.1% Selling, General & Administrative Exp. 51,685 88,125 117,965 160,057 197,218 221,406 Operating Profit 47,142 68,876 77,597 69,922 74,611 78,117 Operating Margin 27.2% 25.5% 25.0% 19.2% 17.8% 16.7% Other Expense (Income) - 1803 - 1065 - 169 - 403 637 - 94 Pretax Profit 48,945 69,941 77,766 70,325 73,974 78,211 Taxes 21,100 25,570 30,434 26,690 28,197 31,513 Tax Rate 43.1% 36.6% 39.1% 38.0% 38.1% 40.3% Net Income $27,845 $44,371 $47,332 $43,635 $45,777 $46,698 Redeemable Noncontrolling Interest 0 0 0 139 810 683 Net Income Attributable to True Religion $27,845 $44,371 $47,332 $43,496 $44,967 $46,015 Net Margin 16.1% 16.4% 15.2% 12.0% 10.7% 9.8% Earnings Per Share (Diluted) $1.16 $1.83 $1.92 $1.75 $1.80 $1.82 Average Shares Outstanding (Diluted) 23,949 24,270 24,659 24,852 25,026 25,328 Selected Balance Sheet Figures 2007 2008 2009 2010 2011 2012 Cash & Short-Term Investments $34,031 $62,095 $110,479 $153,792 $200,366 $186,148 Accounts Receivable 27,898 33,103 27,217 27,856 23,959 31,647 Inventory 20,771 25,828 34,502 41,691 53,320 65,655 Propterty, Plant & Equipment 11,579 28,006 39,693 48,448 53,698 61,565 Total Assets 113,258 166,452 229,806 295,884 360,153 405,716 Accounts Payable $9,597 $10,633 $11,717 $17,234 $22,872 $30,868 Total Debt 0 0 0 0 0 0 Shareholders’ Equity 95,247 142,250 197,854 249,032 299,788 332,935 Total Liabilities & Rquity 229,806 166,452 229,806 295,884 360,153 405,716 Rent Expense $3,700 $9,300 $16,200 $24,100 $30,600 $37,600 Advertising Expense 1,200 3,900 5,400 8,000 7,900 11,700 Number of Company-Owned Stores 15 42 73 94 109 152 Source: True Religion 10Ks 2007–2012 The introduction of new stretch fabrics and wide- spread acceptance of “casual Friday” and other office “dress-down” days stimulated demand for khaki, carpen- ter, and cargo pants and cut into denim demand in the late ’90s. Casual wear for work became so socially acceptable during the “dot-com bubble” that even staid Wall Street firms permitted employees to wear “golf casual” rather than formal business attire to work on Fridays in spring and summer. Nevertheless, even as demand for basic five- pocket denim jeans suffered from the shift in consumer preferences in casual wear in the late 1990s, demand for women’s fashion jeans grew. Angelo La Grega, president of VF Corporation’s Mass Market Denim Division, noted in a 1997 interview with Women’s Wear Daily, “The business is moving from pure commodity to fashion basics.”5 The primary reason for the resurgence in demand for fashion jeans was the availability of denim jeans in exciting new washes and finishes. “Distressed” and “dirty” denim hit retail shelves in spring 2000. The new distressed jeans tapped into consum- ers’ taste for vintage denim. Distressed, dirty jeans were already “broken in,” wrinkled, and stained and looked as if the owner had worn them for years. The Italian jeans maker Diesel had pushed dirty denim for several seasons before it gained approval from other designers. A few de- signers like Kenneth Cole also experimented with the new stretch denim, a cotton denim that incorporated 2 percent Lycra spandex to improve wearing comfort.6 Against that backdrop, Jerome Dahan and Michael Glasser introduced their 7 For All Mankind premium denim line to a consumer market hungry for fashion in- novations. The new denim label would fuel the hottest M03A_BARN0088_05_GE_CASE2.INDD 13 13/09/14 3:25 PM PC 1–14 The Tools of Strategic Analysis growth for the industry as 7 was one of the largest premium denim brands in the United States. Many investors were worried about the so-called aspirational shopper. While the core luxury buyer had returned to high-end shopping as the recession ended, aspirational shoppers had largely stayed away. At the same time, enormous improvements in bargain-priced jeans’ fabric, fit, and styling encouraged consumers to “trade down” from expensive brands to stalwarts like Levi’s, Lee, and Gap jeans. Some analysts estimated that as much as 70 percent of luxury brand sales and 50 per- cent of the growth in the luxury market was derived from so-called “aspirational” shoppers prior to the recession.9 Aspirational shoppers—middle-class consumers with lux- ury tastes—had household incomes between $75,000 and $150,000. Easy credit and rising home prices fueled spend- ing and made the aspirational shopper the target of many brand marketing campaigns in the heady days before the housing bubble burst and unemployment surged to post– Great Depression highs. Prior to the recession, many premium denim labels defined themselves as “aspirational brands”: expensive but not as pricey as couture brands that charged thousands for each piece of clothing. Numerous press articles declared the death of the aspirational shopper and a new “bargain hunting is cool” zeitgeist that would survive after the econ- omy rebounded. A November 2012 consumer survey by Accenture showed nearly two-thirds of American shoppers did not intend to return to pre-recession spending patterns.10 While not everyone believed that the aspirational shopper was gone for good, Tiffany’s earnings disappoint- ments for holiday 2012 and in the first quarter of 2013 were attributed partly to weakness in aspirational shop- per spending on the brand along with increasing product prices. Without the aspirational shopper, new premium denim customers were likely to prove hard to come by in the U.S. market. Still, the Accenture study showed half of the consumers surveyed were likely to make a small luxury purchase in the next six months. Although more consum- ers were likely to purchase a luxury or gourmet food item, 48 percent of consumers surveyed said they were likely to purchase luxury apparel to mix into a wardrobe of more affordable items.11 Investors also were concerned about fashion trends and prices. Embroidered, embellished, and distressed jeans were all the rage from 2002 to 2005. In those days of sky- rocketing demand, premium denim designers had many ways to differentiate their products and cash in on current fashion trends. As the U.S. economy began to slow, flashy fashion jeans fell out of favor with consumers whose in- terest in “basics” increased as their incomes declined. On upscale denim market since the late 1970s and eventually would spark product improvements at every price point in the jeans spectrum. Aspiring as well as established de- signers would introduce literally hundreds of denim labels in the new decade as they answered the siren call of high growth and high profit margins. Retailers eagerly snapped up new offerings, as their customers demanded the latest hot jeans. The premium denim market, defined as jeans re- tailing for $100 or more, would jump from a dollar market share of about 1 percent in 2000 to about 10 percent of retail sales in 2012. U.S. Premium Denim Industry Many industry observers believed that the estimated $1.7 billion (retail) premium denim market had begun to mature in 2006. Overall U.S. denim jeans ownership peaked at 8.2 pairs of jeans per consumer that year. The appeal of denim was strong, but average jeans owner- ship had fallen to 6.7 pairs per consumer by the end of 2012.7 According to a 2012 Cotton Inc. consumer survey, 75 percent of women and 73 percent of men stated they “loved or enjoyed wearing denim.” Still, those figures were down 3 percentage points each from the same sur- vey in 2007. 8 With nearly seven pairs of jeans in the typical American woman’s closet and the move away from fash- ion jeans to basics, it had become increasingly difficult to persuade consumers to buy new pairs of jeans. At the same time, the premium market had shown it was not immune to economic downturns. After years of torrid sales growth, the premium jeans industry experienced its first slowdown in 2007 with sales down about –5 percent. Although the industry seemed to defy economic weakness with sales up an estimated 17 percent in 2008, premium denim revenues slumped an estimated –8 percent in 2009 and fell about –10 percent in 2010. Industry sales jumped about 11 percent in 2011 and rose an estimated 7 to 8 percent in 2012 to about $1.7 billion at retail as the U.S. economy improved (see Exhibit 3). Nevertheless, the outlook for the market was cloudy. True Religion and Joe’s Jeans reported good growth in sales to retail accounts in the first quarter of 2013, but True Religion’s company-owned store growth was fueled by sales to outlet stores. 7 For All Mankind brand reported disappointing sales results in the second quarter of 2013 (down –5 percent) due to softness in the upscale depart- ment store channel. Moreover, 7’s management forecasted implied domestic growth for the brand of only 2 percent per year on average from 2012 to 2017—suggesting tepid M03A_BARN0088_05_GE_CASE2.INDD 14 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–15 Exhibit 3 2012 Selected Financials—Jeans Companies ($ in thousands except per share amounts and betas) Buckle Guess Joe’s Levi’s Fifth and Pacifica True Religion VF Corp Revenues $1,124,007 $2,658,605 $118,642 $4,610,193 $1,505,094 $467,285 $10,879,855 Gross Profit 499,315 1,067,123 56,170 2,199,331 842,975 299,523 5,061,975 Gross Margin 44.4% 40.1% 47.3% 47.7% 56.0% 64.1% 46.5% Operating Profit $258,175 $274,525 $10,717 $333,979 -$34,451 $78,117 $1,465,267 Operating Margin 23.0% 10.3% 9.0% 7.2% -2.3% 16.7% 13.5% Interest Expense $0 $1,640 $376 $134,694 $51,684 $0 $93,605 Net Income 164,305 178,744 5,565 143,850 -74,505 46,015 1,086,138 EPS (fully diluted) $3.44 $2.05 $0.08 NA -$0.68 $1.83 $9.70 Shares Outstanding 48,059 86,540 66,849 NA 109,292 25,328 110,205 Cash $144,022 $335,927 $13,426 $406,134 $59,402 $186,148 $597,461 Accounts Receivable 3,470 324,971 812 500,672 121,591 31,647 1,222,345 Inventory 103,853 369,712 31,318 518,860 220,538 65,655 1,354,158 Total Assets 477,974 1,713,506 86,024 3,170,077 902,523 405,716 9,633,021 Accounts Payable $34,124 $191,143 $10,893 $225,726 $174,705 $30,868 $562,638 Total Debt 0 1,901 0 1,729,211 406,294 0 1,844,598 Shareholders Equity 289,649 1,100,868 71,739 -101,508 -126,930 332,935 5,125,625 Depreciation $33,834 $87,197 $1,456 $122,608 $74,411 $13,373 $196,898 Capital Expenditures 30,297 99,591 2,779 83,855 82,792 21,994 251,940 Company Owned Stores 440 1,118 28 511 213c 152 65e Licensed/Franchised Stores 0 985 0 1,800 11 0 0 Beta (as of 7/22/13) 1.04 1.71 1.30 NA 2.62 1.08 0.77 Share Price (7/22/13) $56.42 $31.78 $1.35 NA $23.17 $31.90 $194.86 Own Brand as % of Sales 34% 100% 100% 100% 100% 100% 100% U.S. Comparable Store Sales Change 2.1% -6.6% 10.0% NA 10.0%c 2.7% NA U.S. Sales 100% 50.8% 95.8% 50% 95%d 82.1% 60%e International Sales 0% 49.2% 4.2% 50% 5% 17.9% 40% a Formerly Liz Claiborne-owns Lucky Jeans. b Guess comparable store sales and sales mix for North America. c Lucky Brand Jeans stores only. d Estimated Lucky Jeans sales only. Does not include other FNP brands. e 7 for All Mankind only. the plus side, a good pair of dark jeans was considered a “must have” item for women. Glamour magazine put jeans at #7 on its list of “10 Wardrobe Items Every Woman Should Own.”12 On the negative side, Topher Gaylord, then-president of 7 For All Mankind, commented in a 2009 interview with the New York Daily News, “We really don’t believe consumers today understand the value of premium denim.”13 It was hard to differentiate a plain, dark blue pair of expensive jeans from less expensive basic jeans. In an interview with Reuters, industry analyst Eric Beder said, “Premium denim slows down when the trend goes basic. How do you recognize it’s premium? How much dif- ferentiation is there in that pair of $189 jeans compared to a $79 pair when they are just dark and straight?”14 Skinny jeans had played well with consumers over the past five years, but they were as difficult to differenti- ate as other types of basic jeans. Colored denim and jeg- gings (denim leggings) had attracted consumers back to the premium market in 2011 and 2012. In general, they did not command super premium prices and so gave consum- ers a more affordable entry-level price point during the recession. Those offerings continued to drive premium purchases in 2013, but premium jeans designers were scrambling to find the next big thing in jeans. Designers were experimenting with wax and rubber coatings as well as patterned denim. Thus far, nothing had taken off with consumers. Moreover, the dip in denim’s overall popularity from 2008 to 2012 had not gone unnoticed by M03A_BARN0088_05_GE_CASE2.INDD 15 13/09/14 3:25 PM PC 1–16 The Tools of Strategic Analysis was followed by an additional surge of 48 percent in 2011. Denim designers cheered as cotton prices plunged 43 percent in 2012. The price relief continued through March 2013. Drought conditions and lower acreage allotted to cot- ton production by farmers in the United States along with aggressive cotton stockpiling by the Chinese government pushed cotton prices up in April and May 2013. A cotton price spike was the last thing the premium denim makers needed, given consumers’ reluctance to pay up for jeans. Still, it appeared that Americans’ nearly 140-year old love affair with denim was still going strong in 2013. The question for the industry remained was the market still “Rich & Skinny”—like denim guru Glasser’s premium brand—or had it become more like Cheap Monday, the Swedish line of mid-priced jeans? Competitive Landscape Despite the exodus of weaker brands during the recession, the premium denim market remained crowded. The top four premium jeans brands held an estimated combined 70 percent share of the market in 2012—up from an estimated combined share of 65 to 68 percent in 2007, but down from an estimated 80 percent in 2009. Conventional wisdom held that the underlying slowing industry growth combined with the economic downturn would result in a shakeout that would leave the strongest premium denim makers in control of the market. That had not turned out to be the case. In fact, only three of the top five brands in 2010 remained in the top five in 2012; J Brand and Hudson had replaced Citizens of Humanity and Rock & Republic in the top five. True Religion and 7 For All Mankind were still the top brands in the seg- ment, but both had shown signs of losing some of their grip on the category in the past two years. The remaining 30 per- cent of the market was split between dozens of denim labels. A July 2013 Internet survey of the five major U.S. upscale department stores and two prominent denim bou- tiques revealed that each carried 66 different brands of women’s premium jeans on average. The same retailers carried only 28 brands on average in December 2010. However, some retailers sold many more brands. Notably, trendsetting California-based Revolve Clothing offered 86 different brands of premium women’s jeans—up from 55 in 2010. Similarly, Nordstrom sold 74 brands of women’s premium jeans compared with 45 brands in 2010. The explosion in brands highlighted several features of the pre- mium denim market. First, it remained relatively easy to launch a new brand and gain retail shelf space. Though this was long a major barrier to entry in consumer products categories, the retailers. Retailers cut denim jeans floor space allocation and increased floor space for women’s dresses and skirts and men’s athletic wear and non-denim pants in 2012–2013 compared with 2010–2011.15 Price points continued to be an issue for premium denim designers in 2013. Prior to the recession, consumers had been willing to pay sometimes as much as $600 for a pair of jeans that was “just right.” “It was all just a fad,” said Jeff Rudes, founder of fast-growing J Brand premium jeans.16 Even though the economy improved, many con- sumers remained reluctant to pay up for the “right” pair of jeans. The Wall Street Journal and The New York Times ran stories about the gulf between premium jeans prices at the cash register and the price the designers paid to make consumers’ favorite jeans. A 2011 Wall Street Journal article quoted Lubell as saying True Religion’s best-selling “Super T” jeans cost only about $50 to make, wholesaled for $152, and retailed at $335 per pair.17 The press coverage only served to reinforce consumers’ doubts about whether the most expensive jeans were “worth it.” Notably, only about 15 percent of 7 For All Mankind’s denim jeans were priced at $200 or more in 2013—up from 5 percent in 2009 but down sharply from 25 percent in 2008 and the pre-recession peak of 30 percent.18 A survey of the Internet shopping sites of the top five premium jeans brands revealed that on average four of the five had prices below $200 on 83 percent of their jeans. True Religion was the outlier with 56 percent of its product line priced at $200 or above. Interestingly, the company had chosen to buck the industry trend and had increased the amount of pricier jeans in its line, up from 45 percent in 2010. Industry insiders were concerned about a new tariff on U.S. exports of women’s jeans to the European Union that became effective on May 1, 2013. The 38 percent tar- iff was tough on the premium jeans industry as about 75 percent of all premium jeans were manufactured in Los Angeles. Lower-end jeans typically were produced out- side of the United States due to the relatively high U.S. labor costs. The tariff was three times larger than the old tariff on women’s jeans. “Made in the USA” carried cachet with consumers in the European premium jeans market. Lowering costs by relocating manufacturing to low–labor cost countries was likely to hurt the brand images of ex- pensive jeans as the brands risked losing their authenticity by moving out of the United States. Some premium denim makers were experimenting with less expensive fibers in order to lower costs, but consumers so far had not flocked to the cotton blends. Premium denim labels had already experienced cost pressures as cotton prices hit a post–Civil War high in 2010. The 68 percent jump in average cotton prices in 2010 M03A_BARN0088_05_GE_CASE2.INDD 16 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–17 jeans with premium features, consumers needed a reason to buy new jeans. In late 2010, Jeff Rudes gave consumers something new to purchase by testing and then launching a line of brightly colored jeans under his J Brand line. So far, nothing had emerged to take the place of the popular colored jeans or the ubiquitous skinny jean, and both were easily copied. Retailers constantly were on the lookout for the next hot brand as premium denim buyers were fickle. In a recent Cotton Inc. survey of premium denim consumers, 84 percent of those surveyed indicated they were willing to try a new brand.20 In fact, jeans designers launched new brands even in the depths of the recession and downturn in the market. Current/Elliott is “. . . the most refreshing denim line to come out of LA’s jeans scene in a long, long time,” according to a Vogue magazine article. Current/Elliott gained traction in upscale department stores as the new “it-jeans” following its 2008 launch. The brand looked as if it had staying power as upscale department store retailers devoted nearly 70 percent more “e-shelf space” or Internet shelf space to the line as to True Religion in 2013. Table 1 shows the top 11 women’s premium jeans brands by e-shelf space devoted to them by the five major upscale department stores, and two denim bou- tiques in July 2013, compared with e-space in the same Internet stores in December 2010. Upscale retailers cut physical shelf space devoted to premium jeans in their fickle nature of many premium denim consumers made getting retail distribution much less of a problem for an in- novative denim entrée. Fashion consumers were always on the lookout for the latest, most fashionable items. The shift from the fashion jean to the wardrobe staple had not di- minished the importance of innovation in style, fit, finish, and fabric to consumers. Brands that missed key fashion trends frequently were discarded in favor of upstarts, and retailers were happy to offer the products as with an aver- age retail mark up of 2.2 times wholesale; their premium denim margins were high. Second, upscale retailers continued to try to differ- entiate their stores from their rivals’ stores through prod- uct offerings and a fashion “point of view”. Established large brands had to fend off the advances of upstarts and smaller brands as jeans lines attempted to segment the premium market and carve out their own niches. The high margins and returns of the larger players along with low capital requirements enticed new “jeaners” or denim specialists to enter the segment. As denim designer Mik Serfontaine stated in a 2010 interview for the Sundance Channel documentary Dirty Denim, “Make up some sam- ples and take it to the trade show—you’re in business.”19 Moreover, established fashion designers such as Donna Karan and Helmut Lang could knock out a few jeans styles and get shelf space on the strength of their broad apparel lines. While these designers might not pose a serious threat to the big premium brands, if industry growth remained low after the economy rebounded, the premium denim labels would have to deal with them as every market share point would be important. Third, the success of a premium denim line de- pended heavily upon the market and fashion insights of the head designer. It was notoriously difficult for even the savviest designers to generate hit after hit in the fast- moving fashion world. Once a semiannual event, new style launches had become a monthly event in some mar- ket segments such as the popular fast fashion category. Retailers such as H&M, Forever 21, and Zara had begun to transform the fashion industry. H&M wanted to “surprise” its customers and always have something new in stock in order to generate repeat business. Zara could design and produce its own products and get them on the shelf within a month. The biannual fashion cycle had become a year- round fashion cycle. Premium denim was not immune to the nearly constant pressure to introduce new products to induce consumers to purchase—especially now that the underly- ing growth of the U.S. premium denim market appeared to have experienced a secular slowdown. With seemingly everyone wearing either premium jeans or less-expensive Table 1 July 2013 e-Shelf Space Survey Top Premium Denim Brands Selected Upscale Retailer Internet Sites Internet Shelf Space Designer (Women’s) 2010 2013 7 For All Mankind 13% 8% AG Jeans 3% 5% Citizens of Humanity 11% 5% Current/Elliott 4% 5% Genetic Denim 2% 2% Hudson 3% 4% J Brand 6% 10% Joe’s 7% 3% Paige Premium 7% 4% NYDJ 6% 4% Rag & Bone 1% 5% True Religion 6% 3% All Others 31% 42% Sources: Internet sites of Bergdorf Goodman, Bloomingdale’s Neiman- Marcus, Nordstrom, Revolve Clothing, Saks, and ShopBop.com M03A_BARN0088_05_GE_CASE2.INDD 17 13/09/14 3:25 PM PC 1–18 The Tools of Strategic Analysis 480-pound bales of cotton or 14 percent of the world sup- ply.22 China was the largest consumer of cotton in the world. The United States was the largest exporter of cot- ton in the world. Cotton prices had been in a long-term decline as worldwide production costs fell with farm technology and farming practice improvements. After hitting their lowest levels in more than 30 years in 2001, cotton prices rebounded in 2002 only to slump for another four years. Prices rose slightly over 10 percent in 2007 and about 14 percent in 2008.23 As a result of the “worst global consump- tion contraction in 65 years,” cotton prices fell 12 percent on average in 2009. Unusually low stockpiles, heavy rains and flooding in China and Pakistan, and export restric- tions in India reduced the cotton supply and pushed prices up to a 150-year high in 2010. Calendar year prices were up 68 percent on average to nearly $1.00 per pound. Prices surged an additional 48 percent on average in 2011 to about $1.05 per pound before easing back to $0.89 per pound in 2012.24 While cotton prices continued to ease in the first quarter of 2013, they picked up again in May and June. Cotton consumers were worried that the combina- tion of aggressive stockpiling by the Chinese government, drought conditions in much of the United States, and less acreage earmarked for U.S. cotton production would push prices back to 2011 levels. At $0.93 per pound, June’s cotton prices were well below cotton highs in 2011 but far above historic levels of around $0.66 per pound. U.S. denim producers dominated worldwide produc- tion and exports of the fabric for many years but had been surpassed by China due to favorable production costs. U.S. production had declined for years as manufacturers closed American mills and relocated capacity to lower-cost coun- tries. North Carolina–based Cone Mills, known as the “King of Denim,” was the world’s largest producer of denim fabric for most of its 120-year existence. While the company remained a major player in the industry, Cone struggled against low-cost international competition and the phaseout of U.S. denim fabric quotas. The company was known for its ability to produce high-quality denim and had been the sole supplier of denim to Levi’s for nearly 40 years. Established in 1891 by the Cone brothers, Cone Denim was a subsidiary of publicly traded International Textile Group in 2013. The division had found a profit- able niche in serving premium denim customers. Massive restructuring efforts and a focus on high-valued-added materials allowed the company’s denim division to turn a profit in 2009 and remain profitable for the next three years—despite high cotton prices. International Textile Group’s bottom-weight woven fabrics division generated $566 million in revenues and $29 million in operating brick-and-mortar stores but nearly tripled the amount of premium jeans on their Internet shopping sites between December 2010 and July 2013. While it was not possible to draw a direct line from e-shelf space to market shares, the Internet survey clearly showed smaller jeans brands had encroached upon the e-shelf space of the larger brands as retailers increased their efforts to satisfy the desires of their customers for hot fashion items and unique looks. J Brand, AG Jeans, and Rag & Bone were the big winners with the retailers surveyed. J Brand, now majority owned by Star Capital, had been an up-and-comer prior to the recession. The three early movers in the premium denim market—7 For All Mankind, True Religion, and Citizens of Humanity—each lost a substantial amount of e-shelf space between 2010 and 2013. Given True Religion’s aggressive push into the retail business it is not surprising that the company’s major retail accounts would choose to cut back their shelf space allocations. Still, the e-shelf space loss again raised the question of whether the older brands remained relevant a decade or more after their launches into the category. Had J Brand, AG Jeans, and Rag & Bone done a better job in creating fashion trends than the industry stalwarts? If so, would their design teams be able to keep their fingers on the pulse of the fickle fashionista? Manufacturing Process and Supply Chain One bale of cotton can be made into 215 pairs of men’s jeans or 250 pairs of women’s jeans, according to the National Cotton Council.21 At 480 pounds per bale and a 2012 average world cotton price of about $0.89 per pound, raw cotton accounted for an estimated $1.71 per pair of women’s jeans. How did less than $2 per pair of cotton re- sult in jeans that retailed for $100 to $350 per pair? Premium jeans ranged from traditional 100 percent cotton denim jeans to jeans made from stretch denim—a combination of cotton and spandex—to jeans made from denim fabric composed of cotton and small amounts of polyester. Nevertheless, cotton was the major raw mate- rial for premium jeans. The top five cotton-producing na- tions were China, India, the United States, Pakistan, and Brazil in 2012. The big five accounted for 79 percent of the world’s cotton supply, according to the U.S. Department of Agriculture. China alone produced 29 percent of the world supply of cotton. Number-two producer India sup- plied 22 percent of the world’s cotton. At number three in the world, the United States produced 17.3 million M03A_BARN0088_05_GE_CASE2.INDD 18 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–19 they used contract manufacturers to cut and sew the fabric into jeans. There were thousands of cut-and-sew opera- tions around the world, but the U.S. premium brands all used U.S. manufacturers. About 75 percent of all premium denim was made in Los Angeles in 2012. The premium denim companies liked the shorter lead times and lower shipping costs as well as high quality control they got by using domestic suppliers. In addition, they felt U.S. consumers wanted and expected their expensive jeans to be “made in America”—the inventor of blue jeans. Manufacturing costs came in at about $10 per pair with another $2 per pair spent on shipping. Garments went from the factory to denim laundries, which were responsible for the all-important finishing process. Many jeans designers hung their shingles out in Los Angeles due to the prevalence of laundries in the LA area. “Raw” jeans underwent a variety of labor-intensive finishing processes including special washes, sand blast- ing, painting, bleaching, ripping, tearing, the addition of whiskers, the application of resins, baking, and pocket embroidery. One popular process, stonewashing, literally involved putting jeans in huge washers full of pumice stones in order to break the denim fibers down and make them softer. One pair of jeans could undergo 15 different treat- ments before achieving the desired “look.” The finishing process added about $12 per pair to the cost of a pair of premium jeans.21 However, some washes could run to $16 per pair or even much higher. In the Sundance Channel documentary Dirty Denim, Chip Foster (co-founder of Chip N Pepper) points out a pair of jeans with a $25 wash made to give the appearance of having been worn extensively.26 According to the designer, it would take approximately six years of wear to get the same look provided by the expen- sive wash. Lubell dissected the manufacturing cost of a pair of $310 (retail) True Religion “Phantom” jeans for The Wall Street Journal in 2011.27 According to Lubell, raw Phantom jeans cost $56 to make. Wash expenses added $6 to $16 per pair to the cost of the jeans for a total manufacturing cost of $62 to $72 for a finished pair. True Religion marked up the jeans 2.2 to 2.5 times to $140 to $160 per pair and sold them to retailers. Retailers then tacked on an additional $150 to $170 per pair to arrive at the cash register price of $310 per pair. The retail markup on a pair of premium jeans aver- aged 2.2 times. Through this markup process, the design- ers and their retail partners captured the lion’s share of the profits in the industry. The contract manufacturing model had worked well for denim designers, even though it created an opportu- nity for jeans cut-and-sew operators to forward vertically profit in 2012. The division’s operating margin improved somewhat as its product mix shifted to more profitable lines. Nevertheless, sales declined slightly in 2012 as the company was forced to pass on the relief in cotton prices to its customers in the form of price cuts. Unfortunately, much of its inventory remained tied to the older, higher cotton costs. Management remained concerned about the outlook for cotton prices as customers were reluctant to ac- cept higher denim costs but demanded lower denim prices as soon as cotton prices eased. Most domestic premium jeans companies preferred to source denim fabric from U.S. suppliers like Cone’s fa- mous White Oak Mill. Their designers felt the fabric was superior in quality and gave their jeans “authenticity” as- sociated with being made in the United States. Premium denim jeans companies all demanded high quality, and many were willing to pay for Cone’s special vintage sel- vage denim made on narrow Draper fly-shuttle looms that went out of production in the 1970s. Highly prized by denim zealots for its durability and beauty, selvage denim was used only in the most expensive jeans. According to Kenneth Kunberger, International Textile Group’s chief operating officer, Cone’s White Oak Mill was the only mill in the world using the old fly-shuttle looms in 2012.25 Some premium jeans makers swore by Japanese and Italian denim fabric. At any rate, denim fabric makers like Cone and privately held Swift Denim had low margins and little bargaining power. As it had been for more than a decade, the issue for U.S. denim makers in 2013 was survival in the face of intense competition from foreign competitors. In jeans made of stretch denim, cotton content typi- cally ranged from 95 to 99 percent with spandex making up the rest of the fiber in the stretch denim fabric. The incor- poration of spandex into cotton denim allowed women’s jeans to be form fitting but comfortable due to the “give” of the spandex fibers. The use of “stretch” in premium jeans was limited by spandex’s inability to withstand harsher finishing treatments like bleaching as well as the lack of rigidity of high spandex content denim and its relative lack of durability. High cotton prices and the 38 percent tariff the European Union imposed on U.S. premium denim exports in 2013 had denim designers experimenting with less expensive alternative fibers such as Tencel. Premium denim consumers still demanded cotton garments and had not yet accepted alternatives. Each pair of jeans used about 1.5 yards of denim fabric. While basic denim went for $2 to $3 per yard, pre- mium denim typically sold for about $7 per yard but could wholesale for $15 or more per yard. The usual fabric cost per pair was around $11. Most upscale jeans companies did not own their own manufacturing capacity; rather, M03A_BARN0088_05_GE_CASE2.INDD 19 13/09/14 3:25 PM PC 1–20 The Tools of Strategic Analysis manufacturing process in-house “was like running 10 or 12 other businesses.”29 J Brand’s approach was to share its headquarters space with an independent but captive manufacturer. It was this relationship and proximity to the factory that allowed Jeff Rudes to observe the return of colors to the high-fashion runways in Europe in September 2010 and launch a test line of brightly colored denim jeans in Barney’s NY five months later. A short time later, J Brand rolled out its line of colored denim nationwide. While it was possible for the jeans companies to backward vertically integrate into the finishing end of production, very few U.S. designers had opted to do so as it generally fell out of the area of management expertise and required meaningful capital investment. Citizens of Humanity brand was an exception as the line reportedly produced 1,000,000 pairs of jeans per year in its own denim laundry in Los Angeles.30 Moreover, different laundries had developed distinctive skills with different types of fin- ishes. LA’s washhouses were known for their high levels of technical skill and for innovation. As industry growth slowed, more denim companies might opt for owner- ship of denim laundries despite the barriers to entry. The wash and other finishing treatments had become increas- ingly important differentiating features of premium denim lines—making keeping the finishing details proprietary critical to success. Washhouses typically did not work exclusively for one premium denim customer. While the designers endeavored to keep details about fit and finish secret, it was extremely difficult to do so given the nature of the denim laundries and their processes. Many denim designers had so far opted to stick with the traditional con- tract manufacturing model, but the model appeared to be changing in 2013. Lifestyle Brands and the Diesel Model As the ultimate in product differentiation, many com- panies attempt to create so-called “lifestyle” brands that transcend product category and inspire deep consumer loyalty. Three of the top five best-selling premium denim companies were attempting to transform their denim la- bels into lifestyle brands by emulating the Diesel model. Once thought to be the key to continued high growth, “life- style brand status” may have become critical to survival by 2013. In the 2007 Touchstone movie Wild Hogs, the charac- ter Dudley Frank (played by William H. Macy) proudly de- clares; “I got a tat.” He pulls down his black leather jacket to reveal a multicolored version of the Apple corporate integrate into jeans design and marketing. Drawing on its experience in manufacturing denim, Grupo Denim launched Vintage Revolution premium jeans in fall 2010. The Mexican company was vertically integrated into pat- tern design, manufacturing, and finishing. Grupo Denim hired premium denim veteran Michael Press as CEO. Vintage Revolution debuted in 400 major department and specialty stores in the United States. Vintage Revolution jeans retailed for $118 to $140 per pair as Grupo Denim had a significant cost advantage compared with other premium jeans marketers and chose to pass on some of its savings to consumers. Despite the company’s cost advantages, the line tumbled from the premium ranks to the low end of the mid-priced tier of the market—retailing for $35 to $40 per pair at Sears and other mid-priced department stores in 2013. Outsourcing was the norm in the U.S. premium denim market, but some prominent premium denim de- signers began to bring key aspects of the manufacturing process in-house from 2010 to 2013. Most notably, 7 For All Mankind started manufacturing operations in its Vernon, California, headquarters by bringing in-house denim cut- ting, embroidery and finishing. The company added sew- ing to the internal process in 2011. The company intended to make all of its own jeans without relying on outside contractors. “One [factor] was controlling our destiny, hav- ing more control of our process. There was some cost ad- vantage. The other was speed to market. In today’s world, we need to be quicker,” said Barry Miguel, president of 7 For All Mankind.28 7 For All Mankind was unusually well equipped to handle the challenge of backward vertical in- tegration as its parent company, VF Corporation, was the largest apparel company in the world and had been mak- ing Lee jeans since 1889 and Wrangler’s since the 1940s. VF Corporation hoped to bring its expertise in research and development as well as enormous purchasing power to 7 to hold down cost increases and develop innovative prod- ucts. VF Corporation CEO Steve Wiseman liked to say the company was the largest zipper buyer in the world. Retailers’ demand for quicker speed to market was a powerful motive for producing domestically. Peter Kim, president of Hudson Jeans, said that in 2010 he could take eight to 12 weeks to produce and ship a new style and be- tween six to eight weeks to fill a reorder. A year later, Kim said he needed to deliver new styles in six to eight weeks and fill reorders in two to six weeks. Hudson’s approach was to outsource most production tasks to companies in the LA area—all within a few miles of the firm’s headquar- ters. Bringing all of the production process in-house would reduce the turnaround time on new products even fur- ther. However, Hudson’s Kim noted that doing the entire M03A_BARN0088_05_GE_CASE2.INDD 20 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–21 (with distributor partners) retail stores around the world. It also operated a Web site that both promoted the Diesel lifestyle and sold products. The company’s motto, [Diesel] “For Successful Living,” and its Web site’s invitation to consumers to join “the cult” highlighted the strong linkage between the brand and its customers. Founded in 1978 by Renzo Rosso and Adriano Goldschmeid, the Italian denim company sold through 5,000 distribution points in 80 countries including 300 Diesel brand stores. With 50 stores in the United States in 2010, The Wall Street Journal put the privately held com- pany’s worldwide sales at $1.81 billion.33 Premium denim juggernaut 7 For All Mankind had taken its company-owned store count from 10 in the United States in 2008 to 65 worldwide by the end of 2012. In addition, there were 60 independently operated 7 For All Mankind partnership stores in international markets. Perhaps more importantly, 7 management recognized that the key to a suc- cessful lifestyle brand was its core brand identity. Successful luxury lifestyle brands such as Dior, Gucci, Armani, and Versace all embodied the lifestyle and values of iconic de- signers. In order to more clearly define its core brand identity to the consumer, 7 hired acclaimed actor and director James Franco in 2012. Franco added his fashion and directing sen- sibilities to 7’s 2012 and 2013 advertising campaigns. Franco directed a series of films, titled “The Beautiful Odyssey,” for 7 that appeared on the brand’s YouTube channel. True Religion had increased its U.S. store base from 89 in December 2010 to 86 full-priced stores and 36 out- lets. The company owned another 20 full-priced stores and 10 outlets in international markets. As True Religion transformed itself into an apparel retailer, it had been suc- cessful in gaining ground in non-denim categories with its most devoted consumers. By the end of 2012, sportswear generated 35 percent of sales in True Religion stores, up from 20 percent in 2008. Nevertheless, the company had been largely unsuccessful at persuading its influential wholesale accounts to take on its non-denim offerings. The company’s self-described California hippie–Bohemian chic with influence from the Wild West image appeared to have proven to be difficult to translate into a clear brand identity that could transfer to non-jeans product catego- ries in a way that resonated with retailers and consumers. Somehow True Religion management needed to persuade its less devoted consumers that the Buddha strumming a guitar and the horseshoe stitching on the back pockets of its jeans were timeless symbols of a desirable lifestyle. In a March 2008 interview with Women’s Wear Daily, Diesel’s Steve Birkhold said; “It will take these brands a long time to get to what Diesel already has, which is the full life- style. You can’t go from being a flat denim brand with a huge logo tattooed on his right shoulder.16 Dudley Frank, a com- puter programmer, identified so closely with the Apple brand and its core values, he chose to have it etched into his skin.31 Only a handful of companies had been able to estab- lish such a strong association with a particular way of liv- ing that their brands symbolized the core values embodied in that lifestyle: Ralph Lauren, Harley-Davidson, Nike, Apple, Abercrombie & Fitch, Diesel, and a few others. Examples of failed attempts to transform regular brands into lifestyle brands abounded, such as McDonald’s, Starbucks, Microsoft, and Uggs. The appeal of the lifestyle brand was threefold: poten- tial for sales growth, brand premiums (high margins), and protection from downturns in product cycles. Developing a strong emotional bond with consumers that went beyond product functionality could allow a company to go beyond using mere line extensions to generate growth. Lifestyle brands had the potential to move into a whole host of re- lated product categories. In some cases, a brand could be used as a growth platform even in product categories that were seemingly unrelated to its original market due to the strength of the brand’s identity with its associated lifestyle. Harley-Davidson, the motorcycle manufacturer, successfully extended its brand to a wide variety of product categories including clothing, footwear, eyewear, jewelry, Christmas ornaments, trucks, and wine bottle stoppers, among others. The creation of a strong sense of identity with a brand by consumers also had the potential to let a com- pany charge a premium for its products as relative prices could be less important than the consumer’s relationship with the brand. In addition, diversifying into related prod- uct categories such as footwear for an apparel label could help protect a brand from downturns related to changes in fashion trends—thus reducing risk in the volatile fashion business. The measure of success in creating a lifestyle brand was the degree to which revenues and profits were diversified away from the original product line. Within the domestic premium denim market, both of the top premium denim companies were attempting to do just that—create lifestyle brands that would allow them to move outside of the denim business. 7 For All Mankind and True Religion were attempting to emulate the Diesel brand model. Although the brand’s roots were in the denim market, only about 35 percent of Diesel’s revenues were derived from denim sales by 2010. Sales of products as diverse as wine, cars, fragrances, sunglasses, shoes, and watches as well as non-denim apparel generated the remaining 65 percent of revenues.32 In addition to prod- uct diversification, the company had forward vertically integrated into wholly company-owned and partly owned M03A_BARN0088_05_GE_CASE2.INDD 21 13/09/14 3:25 PM PC 1–22 The Tools of Strategic Analysis photographed wearing 7s in everyday life. The line’s pop- ularity exploded, and it generated an unprecedented $13 million in first-year sales accompanied by $2 million in net profits. Two years later in 2003, the brand did $80 million in sales before jumping to $130 million in revenues in 2004. The brand’s success did not go unnoticed. Los Angeles became the denim capital of the world despite the fact that North Carolina–based mega-brands Lee and Wrangler’s operations were far from the glitz of the City of Angels and brand leader Levi’s was headquartered in San Francisco. There was a veritable volcanic eruption in the number of premium denim brands between 2001 and 2003. According to STS Market Research, consumers purchased 297 denim brands in 2001. That number jumped to 350 in 2002 and 438 in 2003—a 47 percent increase in two years, accounting for a third of all apparel brands purchased in the United States.37 The new brands mimicked the 7 model of in-house design, outsourcing production and finishing, using the highest-quality denim, and selling to trendy up- scale boutiques and high-end department stores. Below the surface at 7 For All Mankind, things were not going well between the partners. Dahan and Glasser left 7 and filed a $20 million lawsuit against Peter Koral in 2002. The lawsuit accused Koral of using profits from 7 to prop up his knitwear business and failing to live up to the partners’ oral agreement to establish 7 as a separate entity once sales hit $12 million. Koral claimed he plowed all the profits back into the brand. Further, he maintained that his partners gave up their share of the company by leaving to start a competing product line. A judge awarded the two men $55.5 million in September 2004, $50 million for the combined 50 percent share of 7 and $5.5 million in profits from 2001 and 2002. With $20 million in net profits on $60 million in sales in their second year of business, it is no wonder that Dahan and Glasser immediately applied their expertise to creating another premium denim brand. The two started Citizens of Humanity in 2002 using the same general busi- ness model that had served them so well with 7 For All Mankind. Glasser focused his merchandising and market- ing efforts on the same accounts he did business with at 7 like Nordstrom, Barney’s, and Neiman Marcus. Dahan updated his designs and added new washes and detailing. Citizens had an even bigger first year than 7 due to soaring demand for high-priced denim. In 2003, the line generated $23 million in sales. Sales leaped to $80 million reportedly accompanied by a whopping $35 million in profits in 2005. The brand sold in 35 countries with about 90 percent of its revenues coming from the sale of women’s jeans. Dahan bought out his partner in 2005 and then sold 66 percent of Citizens to the Boston venture capital wholesale distribution to being a lifestyle denim brand with a niche retail distribution unless you have the product en- gine to fuel it. That’s where I think Diesel is differentiated.”34 7 For All Mankind and the Premium Denim Market The premium denim market was populated with fanciful brand names and was characterized by all the melodrama of the best television soap operas. Rich & Skinny, Citizens of Humanity, Earnest Sewn, True Religion, Joe’s Jeans, Rag & Bone, Paige Premium, and Not Your Daughter’s Jeans were some of the premium denim labels launched on the heels of 7 For All Mankind’s successful debut. “7,” as it was affectionately referred to in the fashion press, was the brainchild of LA designer Dahan and salesman Glasser. Dahan was the head designer for Lucky jeans and a former designer for Guess jeans. Glasser started the sports- wear brand Democracy in 1990. The two men approached Peter Koral, owner of California sportswear maker L’Koral, in 2000 with the idea of launching a new jeans line at the nearly unheard of price points of $100 to $160 per pair. In contrast, the average price paid for jeans in the U.S. market was just less than $21. More than half of the jeans sold in the United States that year retailed for less than $20 per pair. “Designer” denim had been all but dead for nearly 20 years. Nevertheless, Koral agreed to provide financial backing to the venture in return for a 50 percent ownership stake in the line. For the first time in denim’s history, designers turned their attention to creating a pair of jeans whose function was to flatter and enhance women’s figures rather than to serve as durable casual wear or a skintight spot to paste a designer name for those fortunate enough to both afford it and carry it off. Dahan deconstructed the basic five-pocket jean and reengineered it with an eye toward enhancing and flattering women’s bodies. He added a distinctive stitching design to the back pockets of 7s so consumers could easily identify the product and be identified with it. Dahan used a stylish bootcut coupled with a low-rise, slim-fit, high-quality denim and subtle detailing to cre- ate a one-of-a-kind silhouette. One 20-something woman commented in a 2003 Boston Herald industry article, “I remember when 7 jeans would pay for themselves because when you went out you’d look so good that guys would buy you drinks.”35 As Charles Lessor, the former CFO of competitor True Religion Brand Jeans, noted succinctly in the same article, “It’s all about the butt.”36 7s made a wom- an’s derriere look great, and women rushed to stores to buy them. Celebrity trendsetters like Cameron Diaz were M03A_BARN0088_05_GE_CASE2.INDD 22 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–23 in company-owned stores, and international expansion as keys to longer-term success. In particular, VF Corporation planned to double the number of company-owned stores and increase its product mix to 60 percent lifestyle brands by 2015. By the end of 2012, VF owned 1,129 stores around the world, including 1,049 single-brand stores. Direct-to-consumer sales accounted for 21 percent of global revenues. VF had massive global operation in which it man- aged 450 million units across 36 brands in nearly every country in the world in 2012. Unlike many of its competi- tors, VF used a mix of 29 company-owned-and-operated manufacturing facilities and 1,900 contract manufacturers. As is noted in VF’s 2012 10K filing, company-owned facili- ties in the western hemisphere generally delivered lower- cost product, but contractor-sourced goods offered more flexibility and shorter lead times. As a result, VF balanced the need for lower-cost manufacturing costs with the abil- ity to hold lower inventories resulting from the use of contractors. In addition to global sourcing of raw materials and manufacturing, the company used “best of class” tech- nology to manage its resources. Best of class technology extended to inventory management at the retail level. VF employed a point-of-sale inventory management system that allowed it to gather daily sales information down to the individual store and SKU level (size, style, color detail). The company believed this point-of-sale inventory system gave it an advantage over its less sophisticated competi- tors. Its five largest customers accounted for 16 percent of 2012 sales and were all located in the United States. The company’s single largest customer was Wal-Mart, which accounted for 8 percent of 2012. The company’s brands were organized into “coali- tions” including jeanswear, outdoor, imagewear, sports- wear, and contemporary. The jeanswear coalition was made up of the so-called “heritage brands” Lee, Wrangler, and Rustler. VF management felt the jeanswear and image- wear (licensed and work apparel) coalitions would likely generate strong profits and cash flow with low-single-digit growth longer term. The outdoor, sportswear, and con- temporary coalitions were to be the growth engines of VF in management’s view. These lifestyle brand groups were expected to grow at a mid-single-digit to low-double-digit rate in the long term. 7 For All Mankind was placed into the newly cre- ated contemporary group in August 2007, which also in- cluded the recently acquired lucyR brand. When acquired in August 2007, domestic sales accounted for 75 percent of 7’s total revenues. By the end of 2012, international rev- enues had jumped to 37 percent of brand sales. While some of the increase was due to VF Corporation’s aggressive firm Berkshire Partners in 2006. According to press ac- counts, the majority stake in the privately held firm fetched $250 million to $300 million or 3.8 to 4.5 times estimated 2006 sales of $100 million. With the backing of Berkshire Partners, Citizens purchased GoldSign jeans from Adriano Goldschmeid along with his denim laundry in 2007 for an undisclosed sum. In March 2005, Peter Koral sold 50 percent of 7 For All Mankind to the investment bank Bear Sterns. Although specific terms of the deal were not disclosed, Mr. Koral confirmed publicly that Bear Sterns paid $75 million to $100 million for its stake in the firm. The brand had sales of about $200 million in 2004 so the deal was valued at 0.75 times to 1.0 times sales. The buzz on Wall Street was that the line had the potential to morph into a large global lifestyle brand. Denim giant VF Corporation picked up all of 7 For All Mankind in mid-2007 for a cool $775 million. The maker of Lee, Wrangler, and Rustler jeans pegged 2007 sales of the #1 premium denim brand at about $300 million, valuing the brand at nearly 2.6 times sales. VF Corporation and 7 For All Mankind VF Corporation was the world’s largest apparel company with 2012 revenues of $10.8 billion. The company began in 1899 as a glove and mitten manufacturer but diversified into women’s silk lingerie in 1914. The company retained the initials “VF” after dropping the Vanity Fair moniker following the acquisition of Lee jeans in 1969. Lee was one of the oldest apparel brands in the United States, having been established in 1899 (about 25 years after Levi Strauss). VF went on to acquire Wrangler and Rustler as part of its friendly acquisition of Blue Bell in 1986. In 2007, VF Corporation acquired 7 For All Mankind, the leading pre- mium denim brand in the United States. VF Corporation adopted a new corporate strategy in 2004. Its vision was to “grow by building leading life- style brands that excite consumers around the world.”38 In other words, the company wanted to transform itself into a global lifestyle apparel company with 60 percent of revenues being derived from lifestyle brands by 2015. As part of that initiative, it sought to stay on top of the ap- parel market by combining design and science to create value-added products for consumers. According to com- pany statements, “innovation is about much more than delivering a new product, fabric, or style . . . Innovation is a holistic process, one that touches every aspect of our enterprise—branding, supply chain management, global expansion, even our corporate citizenship initiatives.”39 Management saw growth in lifestyle brands, an increase M03A_BARN0088_05_GE_CASE2.INDD 23 13/09/14 3:25 PM PC 1–24 The Tools of Strategic Analysis the relationship soured and was dissolved. Co-founded by Ball and Andrea Bernholtz in 2002, Rock & Republic retailed its premium denim jeans for $186 to $330 per pair. The privately held company had become something of a force in the premium denim market by appealing to the fickle tastes of the most fashion-forward, affluent young consumers. Rock & Republic was all about trendy and fast. Nevertheless, the company moved in sync with the rest of the premium denim segment away from em- bellished jeans to cleaner and less provocative styling and raised its waistlines in 2007. Company co-founder Bernholtz commented to Women’s Wear Daily, “It’s [the rise is] just not as low as it was before with everything hanging out. It’s that quarter of an inch between sexy and slutty.”42 Rock & Republic reportedly did $2.4 million in sales in 2002 and about $23 million in 2004. Ball claimed the company did more than $100 million in sales in 2006. The outspoken Ball said he had a plan that would allow Rock & Republic to “literally dominate our market in the next fifteen years.”43 Ball’s plan revolved around transforming Rock & Republic into a full-line lifestyle brand including shoes, eyewear, and retail store ownership. While it was easy to dismiss the outspoken Ball as an insignificant player in the denim market, Rock & Republic’s success with the fashion-forward consumer had other companies looking over their shoulders. The jeans featured a distinctive, stylized “R” on each back pocket, high-quality denim, and a flattering fit. The brand com- manded even higher price points than True Religion, and consumers appeared willing to pay them. As Ball told the Daily News Record in a 2006 interview, “If you want Rock, you have to pay top dollar—you have to pay to be in the VIP section.”44 Ball’s view of the brand’s cache may ulti- mately have been its downfall as the company was forced to file for bankruptcy in 2010. VF Corporation quickly moved to reposition the line and take advantage of its appeal to fashion-forward con- sumers. In April 2011, VF announced that Rock & Republic would be available exclusively in Kohl’s department stores. The line launched in Kohl’s 1,150 mid-priced family- oriented U.S. stores in spring 2012. According to the com- pany’s fact book, 52 percent of the company’s $4.2 billion in revenues were derived from exclusive brands like Rock & Republic. The retailer’s objective was to “continue to of- fer exceptional value, quality, and convenience.”45 Rock & Republic women’s jeans retailed for $88 on Kohl’s Web site but were regularly sale-priced at $49.99 or below. Details on Rock’s first year as a mass-market brand were not available, but Kohl’s management seemed pleased with the line’s performance. expansion in international markets, the U.S. business had suffered due to the recession and slumping premium denim industry sales. 7 For All Mankind’s large share of the premium segment made it difficult for the brand to outperform the category. Nevertheless, 7 appeared to be struggling to maintain its position in the market as it lost ground to the likes of True Religion and J Brand, and the premium denim category recovered. VF Corporation had taken a nearly $200 million impairment charge to the 7 brand in 2010—indicating that the asset was no longer worth the $775 million that the com- pany paid for it less than three years earlier. At VF’s June 2013 Investor Day, management stated that 7’s 2012 total revenues came in at $300 million40—putting the brand’s rev- enues at about the same level as estimated 2007 revenues. While management expected an average of 7 to 8 percent annual growth through 2017, first-half 2013 re- sults were discouraging. 7’s revenues fell in the second quarter reportedly due to softness in the high-end depart- ment store channel. Management revised its 2013 growth forecast to “low single digit growth” from “high single digit growth” as 7’s revenues fell 5 percent or more in the quarter.41 Recent results raised questions about the rel- evance of 7’s brand to premium denim consumers and the likelihood that the brand could make the jump to lifestyle status A strong competitor in all of its markets, the North Carolina–based VF Corporation spent $575 million on ad- vertising and promotions in 2012. The company possessed a formidable stable of brands including Timberland, North Face, Nautica, Vans, Reef, and Majestic. As of June 2013, the company had $320 million in cash and $1.9 billion in total debt. Shareholder’s equity stood at $5.2 billion. VF Corporation Acquires and Repositions Rock & Republic from Super Premium to Mid-Priced VF picked up the assets of rival premium denim label Rock & Republic out of bankruptcy in March 2011 for $58.1 mil- lion. Notably, VF did not retain the services of the brand’s flamboyant founder, Michael Ball. According to company press, Rock & Republic “transcends the denim world with its luxe yet edgy ap- proach to fashion.” Its first collection “mixed an edgy, re- bellious style with sophistication,” which “inspires music and fashion industries alike.” The company paired with Victoria Beckham (Posh Spice) to create signature jeans marketed under the Rock & Republic brand name, but M03A_BARN0088_05_GE_CASE2.INDD 24 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–25 growth.”48 Crossman went on to say that he expected to be able to leverage the company’s sourcing capabilities to realize cost savings and significantly reduce input costs. With the addition of Hudson, Joe’s became a more formi- dable competitor in the premium denim industry. True Religion Brand Jeans Lubell had struck out on two occasions previously in his attempt to shift from textile salesman to independent jeans designer. He and his wife launched two jeans labels in the late 1990s—Bella Dahl and Jeffri Jeans—and lost both after running out of cash. Events turned ugly when Bella Dahl Inc. couldn’t keep up with payments to its factory and had to file for bankruptcy in late 2000. Several lawsuits later, Lubell was on his own with no assets or ownership in his jeans creations. In 2002, the Lubells launched a new pre- mium denim line, True Religion Brand Jeans. Lubell reg- istered his new line’s trademarks in his name and formed a holding company that he owned and controlled called Guru Denim. Things would turn out differently this time for the 46-year-old Los Angeles resident. The brand hit store shelves in December 2002 with five styles of women’s jeans available in five different “washes” under the True Religion label. (7s were only available in two basic styles at the time.) The corporate logo appeared on every tag and featured a fat, smiling Buddha strumming a guitar. According to a November 2002 WWD article, “True Religion has an “evolutionary” mannish styl- ing.” WWD interviewed Lubell for the article and quoted him as saying “there are a lot of women who love to wear their boyfriend’s jeans or husband’s jeans. This plays off of that.” The jeans had one of the lowest rises on the market and some of the highest prices. Lubell created “buzz” for the line by sending celebrity trendsetters free pairs of jeans with the hope they would appear in photos in the popular press wearing jeans with True Religion’s signature horse- shoe-shaped back pocket stitching. The strategy worked, and the line’s sales took off. First-year sales came in at $2.4 million and jumped to $27.7 million in 2004. The popularity of “distressed,” “destroyed,” and “embellished” jeans helped drive growth in the premium denim segment for years. The Joey Destroyed model had been one of True Religion’s best-selling products. The jeans model featured pre-washed denim that had been artfully aged and ripped so that most of the front of the left thigh was made up of strings rather than solid fabric. The de- signers added in a ripped left knee and extensive tearing on the front of the right thigh to complete the destroyed look (an extreme version of distressing). Embellished jeans Joe’s Jeans Moroccan-born Joe Dahan (no relation to Jerome Dahan of 7 and Citizens fame) entered the fashion business with a line of men’s formal wear and dress shirts in 1986 that rang up $8 million in sales when Joe was just 17 years old.46 From 1996 to 2001, Dahan was the head designer for Azteca Productions, a private-label manufacturer of sportswear and denim. Dahan entered the premium denim market in 2001 with five styles of fashion jeans under the Joe’s Jeans brand. The products retailed for $124 to $155 per pair. In March 2001, Innovo Group purchased the rights to the Joe’s Jeans brand from Azteca and moved into the premium denim market. Innovo later changed its name to Joe’s Jeans and trades on the NASDAQ market under the JOEZ symbol. Joe’s Jeans emphasized fit rather than the hottest trend. As Dahan said in a 2005 interview, “We’ve always been about clean, even when the market was embellished. We’re not about fast or trendy.”47 Joe’s Jeans aficiona- dos sang the praises of the line, claiming the jeans had an “insanely good fit.” Dahan’s attention to fit paid off with first year sales coming in at $9.1 million. The line retailed at tony department stores like Barney’s New York, Nordstrom, Bloomingdale’s, and Macy’s as well as bou- tiques catering to affluent shoppers. The company’s 10 largest customers accounted for 61 percent of sales in 2012. Nordstrom, Bloomingdale’s, and Macy’s were Joe’s three largest customers. In 2009, the three together accounted for 47 percent of sales. Joe’s, like its larger competitors, had moved to open its own retail stores in order to boost margins and reduce its dependence on upscale department store retailers. By the end of 2012, Joe’s owned 11 full- priced retail stores and 19 outlet stores in the United States. Total sales rang up at more than $118 million in 2012 with about 95 percent of sales derived from the U.S. market. Joe’s took two major steps to improve its position in the U.S. market in 2012 and 2013. Hedging its bets on premium denim, the company launched an exclusive line else™ sold primarily by Macy’s. The new line was priced at $68—putting it squarely in the mid-priced segment of the jeans market. From February to December 2012, else™ generated about $7.5 million in sales. In July 2013, Joe’s announced it had reached an agreement to purchase pre- mium denim brand, Hudson for about $98 million. Marc Crossman, president and chief executive officer of Joe’s Jeans, stated, “We are extremely excited about joining forces with Hudson Jeans. Once the acquisition is com- plete, we expect to nearly double the size of our business, meaningfully increase our international and e-commerce penetration, and enhance our overall prospects for M03A_BARN0088_05_GE_CASE2.INDD 25 13/09/14 3:25 PM PC 1–26 The Tools of Strategic Analysis unobtrusive logo on the back pocket. True Religion con- sumers did not respond well to the line as part of the ap- peal of the brand lay in its garish oversized back-pocket stitching and instantly recognizable logo. Moreover, the jeans were priced at $230 compared with $150 for similar jeans from competing brands. The line was discontinued. True Religion planned to introduce a new “core denim” assortment in 2013 and increase the differentia- tion between its women’s and men’s jeans. While True Religion had struggled in the women’s denim segment, the company’s men’s line held its own from 2009 to 2012. The company made three other key changes in 2013. It shifted some design responsibilities for its European business to Europe from California and began a consumer preference study. The company expected the study to give it insights into consumer purchase behavior that would allow its designers a greater opportunity to spot promising fashion trends. Finally, Lubell stepped down as the company’s chief merchant and CEO in March 2013. Lubell would re- main a creative consultant to True Religion but would no longer be responsible for its designs and operations. In this way, True Religion’s board hoped to avoid the fate of Rock & Republic and reinvigorate the brand. True Religion’s Strategy The company’s initial strategy was to emphasize distribu- tion through upscale department stores and boutiques and outsource every function except design and marketing to third parties. By the end of 2005, True Religion jeans sold in about 600 specialty stores and boutique shops as well as about 200 upscale department stores. Its customer lineup was a “who’s who” of upscale retailers including Nordstrom, Neiman Marcus, Saks Fifth Avenue, Barney’s, Henri Bendel, Bergdorf Goodman, Bloomingdale’s, and Marshall Fields. By late 2006, True Religion’s focus had shifted away from selling products wholesale to selling its products through company-owned stores. True Religion management, under then-President Michael Buckley, had started to vertically integrate into retail for several reasons. First, the company had faced resistance from retailers when it tried to diversify away from denim jeans into adjacent clothing categories such as sportswear. Big retailers viewed True Religion as a denim label—not as an apparel brand. Owning its own stores allowed True Religion to introduce a broader range of apparel to its customers. Management hoped that the sell-through figures from company-owned stores on non- denim items would persuade its retail accounts to carry the full line of True Religion apparel. Diversifying into other also had been very popular for a number of years in the early part of the product lifecycle. So-called embellish- ments ranged from elaborate embroidery to the addition of sparkly crystals and metallic threads. True Religion mar- keted women’s jeans with intricate embroidery on the back pockets like the Miss Groovy, Buddha, Fairy Girl, Godiva, and Geisha Girl designs. All of these popular “looks” required a substantial amount of additional labor to pro- duce relative to basic denim looks. They all commanded a significant premium to the more basic models in the True Religion portfolio with prices starting well above $200 per pair. Some True Religion models went for more than $500 per pair at retail. In 2008, premium denim designers responded to the mood of the times and moved away from elaborate finishing details back to more basic styles as consumers became interested in styles that would stay fashionable for years rather than for a season. True Religion followed suit and emphasized the lower-priced, more basic items in its lineup. Nevertheless, the brand remained one of the highest priced on the market with an average selling point of $196 for women’s jeans and $192 for men’s jeans in 2009. In company-owned stores, True Religion’s price peaked at a staggering $272 per pair in the first quarter of 2009. The company had not been as successful histori- cally in the basic end of the premium market as had 7 and Citizens. Indeed, True Religion’s wholesale sales plum- meted 20 percent during 2009 and 15 percent in 2010, followed by an 18 percent drop in 2011. The company relied on Lubell’s fashion sense and ability to spot the right trends to sell the “hottest” jean styles. He occupied the unusual position of CEO and “chief merchant” at True Religion. Lubell had an impres- sive track record, but True Religion’s sales to the wholesale off-price channel had become worryingly large by 2009. The company used off-price retailers such as Nordstrom Rack as well as its own outlet stores to sell slow-moving and obsolete inventory. Moreover, the recession and a series of fashion missteps cost True Religion some of its followers. Lubell initially dismissed skinny jeans as a fad and was slow to introduce a True Religion version of the popular pants. Lubell considered True Religion to be a trendsetter rather than a follower. After all, he pioneered the incredibly popular oversized stitching on jeans as well as the ultra-destroyed look among others. According to Diana Katz, an analyst at Lazard Capital, “He thought they’d trend back to bell bottoms and wider bottoms, but it never happened.”49 Similarly, Lubell missed the colored denim trend and refused to lower prices on True Religion products. After a lot of sales pressure, Lubell rolled out a lower-priced line of simpler, cleaner jeans with a small, M03A_BARN0088_05_GE_CASE2.INDD 26 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–27 ended December 2012. Operating profit before unallocated corporate expenses grew at a slower rate but nonetheless averaged 51 percent per year growth over the period. At first glance, it was difficult to understand how the company could have been characterized as “struggling” and in need of a “savior.” Investors were focused on four issues: the sharp slowdown in growth in the U.S. direct- to-consumer business (company-owned stores) and the accompanying huge drop in gross profit margin for the segment, the persistent weakness in wholesale sales espe- cially in women’s jeans, and the collapse in profits from international markets that occurred despite strong sales growth in those markets. Some of the slowdown in the direct-to-consumer segment growth in the United States was attributable to the law of large numbers. As the business became larger, it took a greater and greater amount of incremental sales in absolute dollars to generate the same sales growth rate. In 2009, the direct-to-consumer business reported a 71 percent jump in revenues to $129 million or an increase of about $54 million. The same $54 million increase would have resulted in only 21 percent growth in 2012 as the business had nearly doubled to $251 million. Nevertheless, investors were concerned when the high-flying direct-to- consumer business reported a mere 12 percent increase in revenues despite almost a 12 percent increase in the total number of stores owned. The company’s same store sales (sales in stores open for 13 months or more) were up 2.7 percent for the year. At the beginning of the retail store expansion plan, then-company President Buckley estimated that retail store gross margin would come in at 75 percent and “four-wall contribution margin would be about 40 percent as the company captured the benefits of the typical retail markup on its products as well as existing wholesale margin. For the first few years of the expansion, management’s pre- diction turned out to be an accurate one as gross margin for the consumer direct segment (company-owned stores and e-commerce) leaped to a peak of nearly 77 percent in 2008 before dipping to 74 percent in 2009 and ending up at about 70 percent in 2012. Similarly, segment operat- ing profit margin before unallocated corporate expense plunged from a peak of 40.6 percent in 2007 to 33.3 percent in 2012. Some of the dropoff in profit margins was attribut- able to the costs of rolling out so many stores in a relatively short period of time. However, most of the decline in prof- itability was a result of two factors: an unfavorable mix shift toward sales in outlet stores and the overall decline in average denim prices paid in the company’s stores. Both factors suggested the underlying appeal of the brand was waning among the fashion-forward affluent crowd True apparel categories and related product lines was abso- lutely critical to achieving management’s goal of creating a lifestyle brand. In its full-priced company-owned stores, sales of non-denim items had increased from 10 percent of sales to 35 percent of sales in six years. However, non-denim items only accounted for an estimated 20 percent of the company’s total U.S. sales, as True Religion largely had been unable to persuade its retail accounts to carry its non-denim items. Moreover, the company’s licensing rev- enues were a puny $2.7 million in 2012—down from more than $5 million in 2010. Licensing was critical to establishing a lifestyle brand especially for a relatively small company with specialized management expertise. In order to expand into non-apparel categories, True Religion needed partners—partners that would manufacture and market True Religion–branded fragrances, sunglasses, jew- elry, watches, and any other products that fit with True Religion’s brand image. Second, the margins in the company-owned stores were even higher than True Religion’s very high denim margins as the company captured the retail markup as well as its traditional wholesale markup. Management estimated that retail store gross margin would come in at 75 percent and “four-wall contribution margin” would be about 40 percent as the company captured the benefits of the typical retail markup on its products as well as ex- isting wholesale margin. Third, company-owned outlet stores gave True Religion a place to sell seconds, irregu- lars, and slow-moving merchandise. Without these outlet stores, True Religion brand products could surface in any type of discount outlet—potentially damaging the brand’s premium positioning. Prior to 2007, True Religion jeans appeared in Filene’s Basement, Costco, Century 21, and similar outlets on occasion. Fourth, retail industry mergers and bankruptcies pe- riodically caused manufacturers to miss sales and earnings forecasts. Using company-owned stores helped reduce the firm’s dependence on retailers and reduced the risk of major disruptions in sales. Company-owned stores and e- commerce accounted for 60 percent of revenues in 2012 com- pared with 17 percent in 2007. In total, True Religion owned 122 stores in the United States and 30 international stores at year-end 2012. Over time, management planned to open 100 stores in the United States. Nordstrom and Nordstrom Rack remained True Religion’s most important retail account. While 2012 figures were unavailable, Nordstrom alone ac- counted for 15.2 percent of the company’s net sales in 2009. As True Religion expanded the number of company-owned stores, its retail business took off— growing 57 percent per year on average for the five years M03A_BARN0088_05_GE_CASE2.INDD 27 13/09/14 3:25 PM PC 1–28 The Tools of Strategic Analysis Japanese consumers paid top dollar for American icons like vintage Levis. True Religion capitalized on its American origins by purchasing its high-quality denim fabric from Cone Mills and using domestic contract manufacturers and LA washhouses to finish its jeans. Management felt the “authenticity” of an American-made jean was a critical aspect of the brand’s image—particularly in international markets. Eric Beder, an analyst with Brean Murray, told the Los Angeles Times in 2009, “In the U.S., people care that their jeans are manufactured here. To consumers outside the U.S., it’s crucial . . . In order to be considered a real pre- mium brand, you need to have the Made in the USA label on it.”50 True Religion offshored production of non-denim items such as hoodies and T-shirts, where country of origin was not important to consumers. An enormous disappointment in Japanese sales in 2006 prompted management to reconsider the distribu- tor model. Full-year sales to Japan plunged 50 percent from about $30 million to about $15 million. True Religion fought accusations from the financial press that it had “stuffed” the Japanese retail trade with product in the back half of 2005 in order to meet aggressive sales fore- casts. Management’s analysis of the retail distribution for the brand in Japan suggested that the company needed to pull back and eliminate marginal accounts in order to pre- serve the brand’s exclusive image. As a result of the les- sons it learned in Japan, management decided to switch from a distributor model to company-owned subsidiaries or joint ventures in order to better control the brand’s retail placement and image. While distributors still ac- counted for a large part of True Religion’s international sales in 2012, the company began to transition in 2008 from a wholesale business to a retail business following Religion had wooed so assiduously for the past decade. More shoppers looking for True Religion jeans in outlet stores was likely a result of fewer shoppers being willing to pay up for jeans priced above $200 per pair, in line with industry trends toward lower-priced jeans. The fashion missteps that had plagued the company over the past few years had forced True Religion to discount more of its product line to move the product. Exhibit 4 below shows the decline in average prices paid by consumers for True Religion Jeans (excluding sportswear) in company-owned stores from their peak in the first quarter of 2009 through the fourth quarter of 2012. At the same time, company-store growth appeared to be fueled mainly by store expansion and discount- ing, True Religion’s wholesale business had increasingly shifted away from full-line department stores toward off- price channels. In recent quarters, shoppers had gravitated to the most heavily discounted True Religion items in off-price stores. The combination of all of these factors had investors spooked as concerns about the underlying health of the brand came to the forefront. One bright spot for the brand suggested it had not yet lost its cache. Sales to the specialty boutique channel had increased for 11 straight quarters. Much of the brand’s success in its early days was due to the endorsement of specialty boutique own- ers. Improving sales trends with these savvy buyers could signal that the brand was regaining its momentum in the U.S. market. True Religion’s brand positioning as a “Made in the USA” product based upon a unique combination of a Wild West, cowboy heritage paired with a California-hippie- bohemian image had played well in international markets, especially in Japan during the brand’s early days. Affluent $190 $200 $210 $220 $230 $240 $250 $260 $270 $280 1Q :0 9 2Q :0 9 3Q :0 9 4Q :0 9 1Q :1 0 2Q :1 0 3Q :1 0 4Q :1 0 1Q :1 1 2Q :1 1 3Q :1 1 4Q :1 1 1Q :1 2 2Q :1 2 3Q :1 2 4Q :1 2 A ve ra g e Se ll in g P ri ce P er P ai r Exhibit 4 Average Price/Pair Company-Owned Stores Sources: True Religion quarterly manage- ment comments and author’s estimates. M03A_BARN0088_05_GE_CASE2.INDD 28 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–29 True Religion’s financial performance generally was strong between 2006 and the first quarter of 2009. The company was well on its way to establishing 100 company-owned stores in the United States. The True Religion brand appeared strong at the #2 position in the U.S. market. Then, in May 2010, Buckley abruptly re- signed from the company. Two days before his resignation, Buckley sold more than 193,000 shares of stock. The com- pany offered no explanation for Buckley’s resignation and promptly replaced him with Mike Egeck about two weeks later. Egeck had served as the CEO of 7 For All Mankind. Four months later, True Religion reported disappointing sales and earnings and lowered its full-year 2010 forecast. The timing of Buckley’s departure and the speed at which he was replaced suggested Lubell was aware that Buckley planned to leave—or had forced him out. As chairman and CEO, Lubell had an enormous amount of influence with the company’s board of directors. Egeck left True Religion to “pursue other opportunities” in August 2011. Egeck was reportedly “poached” by Hurley to become its CEO. True Religion promoted Koplin to replace Egeck. Koplin now succeeds Lubell as the company’s interim CEO. True Religion’s strategy and objectives had been clear under the guidance of Lubell and Buckley. The com- pany stuck to its approach of adding retail stores and transforming itself into an upscale purveyor of its own brand under Egeck and after his departure. Although nei- ther Lubell nor Koplin had publicly commented about the Lubell’s long-standing objective of reaching $1 billion in sales, the company’s actions demonstrated that it pursued “lifestyle” brand status for the denim label. It was not clear in July 2013 that the company’s sale to private equity firm TowerBrook would enhance its position in the premium denim industry. Always a strong cash generator, True Religion had not suffered from a lack of capital to fund its expansion plans. Nevertheless, the sale did afford the company an opportunity to bring in fresh management and design talent while giving Lubell a graceful and profit- able exit from the company. Would TowerBrook prove to be more patient than institutional investors? Would new ownership give the team at True Religion more freedom to experiment with design out of the public spotlight? Could True Religion regain its “must have brand” status in the important U.S. premium denim market, or would the brand be forced to reposition itself at lower price points to survive? Lubell’s tenure as chairman, CEO, and chief merchant had been an eventful and profitable one. What would Lubell do now with his $25 million golden para- chute from the sale of True Religion? the pattern it used in the U.S. market. True Religion oper- ated 20 full-priced stores and 10 outlets in international markets at the end of 2012. International sales growth came in at a strong 26 percent average annual rate for the five-year period ended December 2012. Operating profits were about $15 million in 2007 and rose to a peak of about $25 million in 2009. The company’s wholesale business struggled even as its retail business (company-owned stores) gained traction in key international markets. International operating profits declined sharply to about $7 million in 2012 as the com- pany rolled out its retail stores and established in-house sales forces in many international markets. Selling, gen- eral, and administrative expenses for the international division climbed 121 percent per year on average over the five-year period. SG&A jumped 38 percent in 2012 alone. Management asserted that the increased expenses were needed to establish its retail business in international mar- kets. Investors impatiently awaited improved international profits and margins. Management Changes and the Future of True Religion The company named denim industry veteran Buckley to the newly created post of president in April 2006. Buckley was president and CEO of Ben Sherman’s North American business from 2001 to 2005. Prior to 2001, Buckley served as a vice president of denim giant Diesel USA for four years. He was to be responsible for day-to-day operations, including retail expansion, licensing, sourcing, and pro- duction. Lubell would remain in his post of chairman and CEO but devote more of his time to product design. Lubell commented to WWD, “Now I feel like I have a true partner and associate to help build the company and realize my vi- sion of becoming a $1B brand.”51 In August 2006, the company tapped Levi Strauss Europe designer Ziahaad Wells to be its design director. The following March, True Religion named Peter Collins as CFO. Collins was the former corporate controller for Nordstrom. Collins managed a staff of 100 and was an expert on compliance with Sarbanes-Oxley require- ments. In addition, Collins had valuable accounting experience in international operations. He reported to Buckley in his new position at True Religion. In January 2010, True Religion added Lynn Koplin as COO. Koplin was formerly president of Tommy Bahama’s women’s division. M03A_BARN0088_05_GE_CASE2.INDD 29 13/09/14 3:25 PM PC 1–30 The Tools of Strategic Analysis End Notes 1. Hsu, T. (2013). “True Religion board accepts $835 million takeover bid.” Los Angeles Times, May 10, www.luxurydaily.com/64-pc-us-shoppers-reluctant-to-return-to-old- buying-habits-study. Accessed July 10, 2013. 2. De La Merced, M. J. (2012). “True Religion puts itself up for sale.” New York Times, October 1, dealbook.nytimes.com/2012/10/10/true-religion-puts-itself-up-for- sale/?ref=truereligionapparelinc&_r=0. Accessed July 26, 2013. 3. Covert, J. (2013). “Escape from hell for True Religion.” New York Post, May 11, www.nypost.com/p/news/business/escape_from_hell_for_true_religion_ irDO7jxZYTFFLz7Jt76DLJ. Accessed July 25, 2013. 4. (1991). “A comfortable fit: Levi Strauss has prospered by combining maverick mar- keting with gentle style of management (company profile).” The Economist (U.S.). Economist Newspaper Ltd., June 22. Retrieved from High Beam. 5. Ozzard, J. (1997). “Shortening the denim pipeline (inventory management).” Women’s Wear Daily, May 8. 6. Knight, M. (1999). “Hot new jeans will be down and dirty at MAGIC; for spring 2000, light washes are re-creating that old, friendly, worn blue denim look.” Daily News Record, May 23. 7. lifestylemonitor.cottoninc.com/how-many-denim-garments-do-men-and-women- own/. Accessed July 25, 2013. 8. lifestylemonitor.cottoninc.com/men-and-women-love-wearing-denim/. Accessed July 25, 2013. 9. Klara, R. (2010). “The ‘aspirational’ consumer: R.I.P.” Brandweek.com, November 7. Accessed December 31, 2010. 10. Carr, T. (2012). “64 pc US shoppers reluctant to return old buying habits: Study.” Luxury Daily, July 11, www.luxurydaily.com/64-pc-us-shoppers-reluctant-to-return- to-old-buying-habits-study. Accessed July 25, 2013. 11. (2012). “Luxury shopping survey: November 2012.” Accenture Management Consulting—Sales 7 Customer Services. 12. Pantin, L. (2012). “10 Wardrobe Essentials Every Woman Should Own.” Glamour, August 10, www.glamour.com/fashion/2012/08/10-wardrobe- essentials-every- woman-should-own#slide=replay. 13. Hazlett, A. (2009). “The death of $200 + jeans?!” New York Daily News, July 31, www. nydailynews.com/2.1353/death-200-jeans-article-1.176339. Accessed July 15, 2013. 14. Sage, A. (2010). “Analysis: Garmentos proclaim the end of denim dominance.” Reuters Business & Financial News, August 27. 15. Lifestyle Monitor: Cotton Inc. (2013). “Driving demand for denim jeans.” July 15. lifestylemonitor.cottoninc.com/driving-demand-for-denim-jeans. 16. Wilson, E. (2009). “Preshrunk prices.” New York Times, October 28, www.nytimes. com/2009/10/29/fashion/29JEANS.html?pagewanted=all. Accessed July 15, 2013. 17. Binkley, C. (2011). “How can jeans cost $300?” Wall Street Journal, July 7, online.wsj. com/article/SB10001424052702303365804576429730284498872.html?mg=id-wsj. Accessed July 25, 2013. 18. Hazlett, A. (2009). “The death of $200 + jeans?!” New York Daily News, July 31, www. nydailynews.com/2.1353/death-200-jeans-article-1.176339. Accessed July 15, 2013. 19. Keeve, D. “Dirty Denim introduction.” Sundance Channel Documentary. www. sundancechannel.com/digital-shorts/#/theme/64930111001/64683988001. Accessed December 30, 2010. 20. Cotton Inc. Press Release. (2005). “Premium denim: Fit to be tried.” September 12. 21. World Cotton Supply and Demand. National Cotton Council of America. www. cotton.org/econ/cropinfo/supply-demand.cfm. Accessed December 30, 2010. 22. USDA: Foreign Agricultural Service. (2013). “Table 04: Cotton area, yield and produc- tion.” July 11, www.fas.usda.gov/psdonline/psdreport.aspx?hidReportRetrievalNam e=BVS&hidReportRetrievalID=851&hidReportRetrievalTemplateID=1. Accessed July 26, 2013. M03A_BARN0088_05_GE_CASE2.INDD 30 13/09/14 3:25 PM Case 1–2: True Religion Jeans: Will Going Private Help It Regain Its Congregation? PC 1–31 23. National Cotton Council. “Monthly prices.” www.cotton.org/econ/prices/monthly. cfm. Accessed July 25, 2013. 24. Ibid. 25. (2012). “An old mill, back in fashion.” Bloomberg Business Week, May 21–27, www.conedenim.com/Bloomberg_May_2012.html. Accessed July 26, 2013. 26. Keeve, D. “Dirty Denim Episode 2: The wash.” Sundance Channel Documentary. www.sundancechannel.com/digital-shorts/#/theme/64930111001/64571005001. Accessed December 30, 2010. 27. Binkley, C. (2011). “How can jeans cost $300?” Wall Street Journal, July 7, online.wsj. com/article/SB10001424052702303365804576429730284498872.html?mg=id-wsj. Accessed July 25, 2013. 28. (2011). “L.A. jeans makers put premium on local production.” Khanh T.L. Tran WWD: Women’s Wear Daily, 202(97), p. 14b-1. 29. Ibid. 30. “AG Jeans exclusive interview.” blog.stylesight.com/denim/ag-jeans-exclusive- interview. Accessed July 25, 2013. 31. blog.wired.com/cultofmac/2007/03/William_h_macy.html. Accessed December 2008. 32. Passariello, C. (2010). “Ditching designers to sell clothes.” Wall Street Journal, March 5. 33. Ibid. 34. Tucker, R. (2013). “Birkhold readies Diesel USA for growth push.” Women’s Wear Daily, March 13. 35. Radsken, J. (2003). “Fashion: Jeans splicing; express knockoffs do a number on Seven’s fans.” Boston Herald, August 14. 36. Ibid. 37. Tuner, D. (2005). “Understanding the EPS/HVI advantage in a world without quota.” EPS Conference Presentation (Singapore), April 20. 38. www.vfc.com/about/vision-values. Accessed December 2008. 39. Ibid. 40. Kellogg, S. (2013). “Contemporary brands presentation.” VF Corporation, June 11, phx.corporate-ir.net/phoenix.zhtml?c=61559&p=irol-irhome. Accessed July 23, 2013. 41. VF Corporation. “CEO discusses Q2 2013 results—earnings call transcript.” seekingalpha.com/article/1558802-vf-corp-vfc-ceo-discusses-q2-2013-results- earnings-call-transcript. Accessed July 26, 2013. 42. McGuiness, D. (2006). “Predicting the denim fallout (trends and forecast).” Women’s Wear Daily, February 9. 43. (2006). Interview with Michael Ball. Daily News Record. 44. Ibid. 45. “Kohl’s fact book.” www.kohlscorporation.com/InvestorRelations/sec-filings.htm. Accessed July 26, 2013. Harmon, A. (2007) 46. “Blue blood: The Dahan brothers reflect on the highs and lows of developing their denim lines (occupation overview).” Daily News Record, October 15. 47. Ibid. 48. (2013). “Joe’s Jeans to acquire Hudson Clothing.” Joe’s Jeans company press release. July 15, phx.corporate-ir.net/phoenix.zhtml?c=84356&p=irol-newsArticle &ID= 1837779&highlight=. Accessed July 25, 2013. 49. Morrissey, J. (2012). “Looking for investor faith in True Religion.” Fortune, November 20, management.fortune.cnn.com/2012/11/20/true-religion-jeffrey-lubell. Accessed July 20, 2013. 50. White, R. (2009). “In L.A. pricey denim jumps off the racks.” Los Angeles Times, May 27. 51. Tschorn, A. (2006). “True Religion taps Michael Buckley; former head of Ben Sherman’s U.S. business appointed president of denim label (True Religion Apparel Inc.).” Daily News Record, April 17. M03A_BARN0088_05_GE_CASE2.INDD 31 13/09/14 3:25 PM C a s e 1 – 3 : W a l m a r t S t o r e s , I n c . , i n 2 0 1 3 In November of 2013 Doug McMillon had just been named the CEO of Walmart Stores, Inc. effective February 1, 2014. McMillon had unique preparation for the job. He had held senior executive positions in Walmart’s domestic opera- tions and had presided over both the company’s interna- tional operations and Sam’s Club, Walmart’s discount club chain. McMillon would likely need to draw upon his di- verse experiences to successfully lead the company in the face of mounting challenges. As recently as 1979, Walmart had been a regional retailer little known outside the South with 229 discount stores compared to the industry leader Kmart’s 1,891 stores. In less than 25 years, Walmart had risen to become the largest U.S. corporation in sales. With more than $469 billion in revenues (see Exhibits 1 and 2), Walmart had far eclipsed not only Kmart but all retail competitors. Yet another measure of Walmart’s dominance was that it ac- counted for approximately 45 percent of general merchan- dise, 30 percent of health and beauty aids, and 29 percent of non-food grocery sales1 in the United States. Forbes put Walmart’s success into perspective: . . . all that’s left for Walmart is mop-up. It already sells more toys than Toys “R” Us, more clothes than the Gap and Limited combined and more food than Kroger. If it were its own economy, Walmart Stores would rank 30th in the world, right behind Saudi Arabia. Growing at 11 percent a year, Walmart would hit half a trillion dollars in sales by early in the next decade.2 Despite its remarkable record of success, though, Walmart was not without challenges. Many observers be- lieved that the company would find it increasingly difficult Exhibit 1 Walmart Stores, Inc., Income Statement, 2009–2013 In millions of USD (except for per share items) 2013 2012 2011 2010 Revenue 469,162.00 446,950.00 421,849.00 408,085.00 Total Revenue 469,162.00 446,950.00 421,849.00 408,085.00 Cost of Revenue, Total 352,488.00 335,127.00 314,946.00 304,106.00 Gross Profit 116,674.00 111,823.00 106,903.00 103,979.00 Selling/General/Admin. Expenses, Total 88,873.00 85,265.00 81,361.00 79,717.00 Unusual Expense (Income) — — — 260 Total Operating Expense 441,361.00 420,392.00 396,307.00 384,083.00 Operating Income 27,801.00 26,558.00 25,542.00 24,002.00 Income Before Tax 25,737.00 24,398.00 23,538.00 22,118.00 Income After Tax 17,756.00 16,454.00 15,959.00 14,962.00 Minority Interest -757 -688 -604 -513 Net Income Before Extra Items 16,999.00 15,766.00 15,355.00 14,449.00 Net Income 16,999.00 15,699.00 16,389.00 14,370.00 Income Available to Common Excl. Extra Items 16,999.00 15,766.00 15,355.00 14,449.00 Income Available to Common Incl. Extra Items 16,999.00 15,699.00 16,389.00 14,370.00 Diluted Weighted Average Shares 3,389.00 3,474.00 3,670.00 3,877.00 Diluted EPS Excluding Extraordinary Items 5.02 4.54 4.18 3.73 Dividends per Share—Common Stock Primary Issue 1.59 1.46 1.21 1.09 Diluted Normalized EPS 5.02 4.54 4.18 3.77 M03A_BARN0088_05_GE_CASE3.INDD 32 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–33 with its stores. Supercenters had provided significant growth for Walmart, but it was not clear how long they could deliver the company’s customary growth rates. The company added new stores at a prodigious rate, but the new stores often cannibalized sales from nearby Walmart stores. Walmart faced problems in other business areas as to sustain its remarkable record of growth (see Exhibit 3). Walmart faced a maturing market in its core business that would not likely see the growth rates it had previ- ously enjoyed. Growth in same-store sales had declined in multiple quarters in the previous year. Many investors believed that Walmart had reached a point of saturation Exhibit 2 Walmart Stores, Inc., Balance Sheet In millions of USD (except for per share items) 2013 2012 2011 2010 Cash and Equivalents 7,066.00 6,003.00 6,891.00 7,907.00 Cash and Short-Term Investments 7,066.00 6,003.00 6,891.00 7,907.00 Accounts Receivable—Trade, Net 6,768.00 5,937.00 5,089.00 4,144.00 Total Receivables, Net 6,768.00 5,937.00 5,089.00 4,144.00 Total Inventory 43,803.00 40,714.00 36,437.00 32,713.00 Prepaid Expenses 1,588.00 1,774.00 2,960.00 3,128.00 Other Current Assets, Total 715 547 635 140 Total Current Assets 59,940.00 54,975.00 52,012.00 48,032.00 Property/Plant/Equipment, Total—Gross 171,724.00 160,938.00 154,489.00 143,517.00 Accumulated Depreciation, Total -55,043.00 -48,614.00 -46,611.00 -41,210.00 Goodwill, Net 20,497.00 20,651.00 16,763.00 16,126.00 Other Long-Term Assets, Total 5,987.00 5,456.00 4,129.00 3,942.00 Total Assets 203,105.00 193,406.00 180,782.00 170,407.00 Accounts Payable 38,080.00 36,608.00 33,676.00 30,451.00 Accrued Expenses 18,808.00 18,180.00 18,701.00 18,734.00 Notes Payable/Short-Term Debt 6,805.00 4,047.00 1,031.00 523 Current Port. of LT Debt/Capital Leases 5,914.00 2,301.00 4,991.00 4,396.00 Other Current Liabilities, Total 2,211.00 1,164.00 204 1,439.00 Total Current Liabilities 71,818.00 62,300.00 58,603.00 55,543.00 Long-Term Debt 38,394.00 44,070.00 40,692.00 33,231.00 Capital Lease Obligations 3,023.00 3,009.00 3,150.00 3,170.00 Total Long-Term Debt 41,417.00 47,079.00 43,842.00 36,401.00 Total Debt 54,136.00 53,427.00 49,864.00 41,320.00 Deferred Income Tax 7,613.00 7,862.00 6,682.00 5,508.00 Minority Interest 5,914.00 4,850.00 3,113.00 2,487.00 Total Liabilities 126,762.00 122,091.00 112,240.00 99,939.00 Common Stock, Total 332 342 352 378 Additional Paid-In Capital 3,620.00 3,692.00 3,577.00 3,803.00 Retained Earnings (Accumulated Deficit) 72,978.00 68,691.00 63,967.00 66,357.00 Other Equity, Total -587 -1,410.00 586 -147 Total Equity 76,343.00 71,315.00 68,542.00 70,468.00 Total Liabilities and Shareholders’ Equity 203,105.00 193,406.00 180,782.00 170,407.00 Total Common Shares Outstanding 3,314.00 3,418.00 3,516.00 3,786.00 M03A_BARN0088_05_GE_CASE3.INDD 33 13/09/14 3:26 PM PC 1–34 The Tools of Strategic Analysis Exhibit 3 Walmart Sales Growth by Segment, 2011–2013 (in millions USD) 2013 2012 2011 Net Sales Percent of Total Percent Change Net Sales Percent of Total Percent Change Net Sales Percent of Total Walmart U.S. $274,490 58.9% 3.9% $264,186 59.5% 1.5% $260,261 62.1% Walmart International $135,201 29.0% 7.4% $125,873 28.4% 15.2% $125,873 26.1% Sam’s Club $56,423 12.1% 4.9% $3,795 12.1% 8.8% $53,795 11.8% well. The Walmart–owned Sam’s Club warehouse stores had not measured up to Costco, their leading competi- tor. International operations were another challenge for Walmart. Faced with slowing growth domestically, it had tried to capitalize on international opportunities. These international efforts, however, had met with only mixed success at best. Walmart was also a target for critics who attacked its record on social issues.3 Walmart had been blamed for pushing production from the United States to low- wage overseas producers. Some claimed that Walmart had almost single-handedly depressed wage growth in the U.S. economy. For many, Walmart had become a symbol of capitalism that had run out of control. Indeed, Time magazine asked, “Will Walmart Steal Christmas?”4 Much of the criticism directed at Walmart did not go beyond angry rhetoric. In many cases, however, Walmart had faced stiff community opposition to building new stores. With such challenges, some investment analysts questioned whether it was even possible for a company like Walmart, with more than $469 billion in sales, to sus- tain its accustomed high growth rates. To do so, Walmart would have to address a number of challenges such as maturing markets, competition in discount retailing from both traditional competitors and specialty retailers, ag- gressive efforts by competitors to imitate Walmart’s prod- ucts and processes, international expansion and increasing competition from online retailers. Indeed, some believed that Walmart would need to find new business if it were to continue its historic success. The Discount Retail Industry General retailing in the United States evolved dramati- cally during the 20th century. Before 1950, general retailing most often took the form of Main Street department stores. These stores typically sold a wide variety of general mer- chandise. Department stores were also different from other retailers in that they emphasized service and credit. Before World War II, few stores allowed customers to take goods directly from shelves. Instead, sales clerks served custom- ers at store counters. Not until the 1950s did self-help department stores begin to spread. Discount retail stores also began to emerge in the late 1950s. Discount retailers emphasized low prices and generally offered less service, credit, and return privileges. Their growth was spawned by the repeal of fair trade laws in many states. Many states had passed such laws during the Depression to protect local grocers from chains such as the Atlantic & Pacific Company. The laws fixed prices so that local merchants could not be undercut on price. The repeal of these laws freed discounters to offer prices below the manufacturer’s suggested retail price. Among discount retailers, there were both gen- eral and specialty chains. General chains carried a wide assortment of hard and soft goods. Specialty retailers, on the other hand, focused on a fairly narrow range of goods such as office products or sporting goods. Specialty discount retailers such as Office Depot, Home Depot, Staples, Best Buy, and Lowe’s began to enjoy widespread success in the 1980s. One result of the emergence of both general and specialty discount retailers was the decline of some of the best-known traditional retailers. Moderate- priced general retailers such as Sears and JC Penney had seen their market share decline in response to the rise of discount stores. A number of factors explained why discount retail- ers had enjoyed such success at the expense of general old-line retailers. Consumers’ greater concern for value, broadly defined, was perhaps most central. Value in the industry was not precisely defined but involved price, ser- vice, quality, and convenience. One example of this value orientation was in apparel. Consumers who once shunned the private-label clothing lines found in discount stores as M03A_BARN0088_05_GE_CASE3.INDD 34 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–35 in sales such as Newell, Fruit of the Loom, Sunbeam, and Fieldcrest Cannon received more than 15 percent of their sales from Walmart. Many of these large manufacturers also sold a substantial proportion of their output to Kmart, Target, and other discount retailers. Walmart’s purchasing clout was considerable, though, even compared to other large retailers. For example, Walmart accounted for more than 28 percent of Dial’s sales, and it was estimated that it would have to double sales to its next seven largest cus- tomers to replace the sales made to Walmart.5 Frequently, smaller manufacturers were even more reliant on the large discount retailers such as Walmart. For example, Walmart accounted for as much as 50 percent of revenues for many smaller suppliers. Private-label goods offered by discount stores had become much more important in the recent years and pre- sented new challenges in supplier relationships. Managing private labels required a high level of coordination be- tween designers and manufacturers (who were often for- eign). Investment in systems that could track production and inventory was also necessary. Technology investments in sophisticated inventory management systems, state-of-the-art distribution centers, and other aspects of logistics were seen as critically im- portant for all discount retailers. Discount retailers were spending large sums of money on computer and telecom- munications technology in order to lower their costs in these areas. The widespread use of Universal Product Codes (UPC) allowed retailers to more accurately track inventories for shopkeeping units (SKUs) and better match a source of stigma were increasingly buying labels offered by Kmart, Target, and Walmart. According to one esti- mate, discount stores were enjoying double-digit growth in apparel while clothing sales in department stores had decreased since the 1990s. Another aspect of consumers’ concern for value in- volved price. Retail consumers were less reliant on estab- lished brand names in a wide variety of goods and showed a greater willingness to purchase the private-label brands of firms such as JC Penney, Sears, Kmart, and Walmart. Convenience had also taken on greater importance for cus- tomers. As demographics shifted to include more working mothers and longer workweeks, many American workers placed a greater emphasis on fast, efficient shopping trips. More consumers desired “one-stop shopping,” where a broad range of goods were available in one store to mini- mize the time they spent shopping. This trend accelerated in the previous decade with the spread of supercenters. Supercenters, which combined traditional discount retail stores with supermarkets under one roof, grew to more than $100 billion in sales by 2001 and blurred some of the traditional lines in retailing. Larger firms had an advantage in discount retail- ing. The proportion of retail sales that went to multi-store chains had risen dramatically since the 1970s. The number of retail business failures had risen markedly. Most of these failures were individual stores and small chains, but some discount chains such as Venture, Bradlee, and Caldor had filed for bankruptcy. Large size enabled firms to spread their overhead costs over more stores. Larger firms were also able to distribute their advertising costs over a broader base. Perhaps the greatest advantage of size, however, was in relationships with suppliers. Increased size led to savings in negotiating price reductions, but it also helped in other important ways. Suppliers were more likely to engage in arrangements with large store chains such as cooperative advertising and electronic data interchange (EDI) links. The Internet posed an increasing threat to discount retailers as more people became comfortable with shopping online. Internet shopping was appealing because of the convenience and selection available, but perhaps the most attractive aspect was the competitive pricing. Some Internet retailers were able to offer steep discounts because of lower overhead costs. Additionally, customers were able to quickly compare prices between different Internet retailers. Most, if not all, major retailers sold goods via the Internet. Large discount retailers such as Walmart derived considerable purchasing clout with suppliers because of their immense size. Even many of the company’s larg- est suppliers gained a high proportion of their sales from Walmart (see Exhibit 4). Suppliers with more than $1 billion Exhibit 4 Proportion of Sales That Suppliers Receive from Walmart Company Walmart Share of Sales Rayovac 26% Dial 24 Hasbro 17 Procter & Gamble 17 Newell Rubbermaid 15 Gillette 12 Fruit of the Loom 10 H.J. Heinz 10 Kimberly-Clark 10 Kraft 10 Source: Hopkins, J. (2003). “Wal-Mart’s influence grows.” USA Today, Jan. 21. M03A_BARN0088_05_GE_CASE3.INDD 35 13/09/14 3:26 PM PC 1–36 The Tools of Strategic Analysis Kmart. Kmart had approximately 10 times more sales than the next largest retailers Dollar General and ShopKo. The most formidable specialty discount retailers included office supply chains such as Office Depot with more than $10 billion in sales, Staples with approximately $24 billion, Toys “R” Us with more than $11 billion, and Best Buy in electronics with approximately $45 billion. In warehouse clubs, Costco and Sam’s Club dominated. Costco was the leader with more than $99 billion in sales, followed by Sam’s Warehouse Club with $56 billion in revenue. BJ’s Wholesale Club followed far behind with around 11 billion in sales before being acquired by a private equity firm in 2011. Once Walmart’s largest competitor, Kmart had ex- perienced a long slide in performance. Kmart operated approximately 1,300 stores, about the same number it had had three years previously. Traditionally, Kmart’s discount philosophy had differed from Walmart’s. Kmart discount centers sought to price close to, but not necessarily lower than, Walmart’s everyday low prices (EDLP). More em- phasis was placed on sale items at Kmart. Pricing strategy revolved around several key items that were advertised in Kmart’s 73 million advertising circulars distributed in newspapers each Sunday. These items were priced sharply lower than competitors’ prices. The effective implementa- tion of this strategy had been impeded by Kmart’s dif- ficulty in keeping shelves stocked with sale items and by Walmart’s willingness to match Kmart’s sale prices. An at- tempt to imitate Walmart’s everyday low pricing strategy failed to deliver sales growth; at the same time, it squeezed margins, so Kmart returned to its traditional pricing strat- egy in 2003. Kmart sought to follow Walmart’s pattern in many of its activities. The company expressed a commitment to building a strong culture that emphasized performance, teamwork, and respect for individuals who, borrowing from Walmart, were referred to as associates. Establishing such a culture was particularly challenging in the midst of workforce reductions that had taken Kmart from 373,000 employees in 1990 to 307,000 at the end of 1995, and then an even more precipitous drop to 158,000 in 2004. Kmart had also adopted Walmart departmental structure within stores. Another area in which Kmart emulated Walmart was in offering larger income potential to store managers. Each store manager’s bonus was linked to an index of cus- tomer satisfaction. Kmart had also sought to close the gap between it and Walmart in technology and distribution. Target, Walmart’s other large national competi- tor, was owned by Target Corporation, formerly Dayton Hudson Corporation, based in Minneapolis, Minnesota. In 2013, Target operated 1,763 stores, which was an increase inventory to demand. Discount retailers also used EDI to shorten the distribution cycle. EDI involved the electronic transmission of sales and inventory data from the registers and computers of discounters directly to suppliers’ com- puters. Often, replenishment of inventories was triggered without human intervention. Thus, EDI removed the need for several intermediate steps in procurement such as data entry by the discounter, ordering by purchasers, data entry by the supplier, and even some production schedul- ing by supplier managers. Walmart was also pushing the adoption of radio frequency identification (RFID), a new technology for tracking and identifying products. RFID promised to eliminate the need for employees to scan UPC codes and would also dramatically reduce shrink- age, another term for shoplifting and employee pilferage. Suppliers anticipated that RFID would be costly to imple- ment, but the benefits for Walmart were estimated to be as high as $8 billion in labor savings and $2 billion in reduc- ing shrinkage. The implementation of RFID had not mate- rialized in the way Walmart had envisioned and, by 2013, was still evolving in ways not forecasted by the company. Another important aspect of managing inventory was accurate forecasting. Having the right quantity of products in the correct stores was essential to success. Stories of retailers having an abundance of snow sleds in Florida stores while stores in other areas with heavy snow- fall had none were common examples of the challenges in managing inventory. Discounters used variables such as past store sales, the presence of competition, variation in seasonal demand, and year-to-year calendar changes to ar- rive at their forecasts. Point-of-sale (POS) scanning enabled retailers to gain information for any purchase on the dollar amount of the purchase, category of merchandise, color, vendor, and SKU number. POS scanning, while valuable in managing inventory, was also seen as a potentially significant mar- keting tool. Databases of such information offered retailers the potential to “micromarket” to their customers. Upscale department stores had used the POS database marketing more extensively than discounters. Walmart, however, had used such information extensively. For example, POS data showed that customers who purchased children’s videos typically bought more than one. Based on this finding, Walmart emphasized placing other children’s videos near displays of hot-selling videos. Competitors Competition in discount retailing came from both general and specialty discount stores. Among the general discount retailers, Walmart was the largest, followed by Target and M03A_BARN0088_05_GE_CASE3.INDD 36 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–37 products that could be purchased at the most specialized retailers. In the typical Amazon model, customers selected and purchased items online. Through technology, the com- pany then located the product in large warehouses known as fulfillment centers. The product was then processed and sent to the customer via a third party such as UPS or Fedex. Amazon had invested heavily in its fulfillment capability. By 2013, it had about 35 large fulfillment centers spread throughout the U.S. with another 25 in Europe and 13 in Asia. For a flat annual fee of $79, customers could receive free two-day shipping and discounted one-day shipping rates on eligible products. Additionally, the company had made very visible moves into technology with its own line of Kindle readers and tablets. Its Prime Instant Video, with over 38,000 movies and TV episodes, competed against online firms such as Netflix and Hulu in the online distri- bution of media content. Amazon also hosted a large number of third-party sellers. Customers could view products sold by these sell- ers, purchase the product through Amazon and then the seller would ship to the customer. Amazon had begun giving these third-party sellers the option of warehousing their inventory in Amazon’s fulfillment network. Amazon could claim multiple advantages over bricks and mortar retailers. The firm did not have to deal with the extensive overhead involved with traditional stores. Its selection of products was vastly wider than that available in any traditional store. Yet another advantage for Amazon was that customers did not have to pay a state sales tax on many products purchased. For many shoppers, the convenience of shopping online was ap- pealing. Like Walmart, Amazon employed an everyday low pricing strategy. There were some disadvantages to online shopping. Customers typically had to pay ship- ping costs and wait for products to be shipped. Amazon Prime negated the cost problem and limited the wait time as well. Online sales of consumer products were growing by as much as 20 percent a year. Brick and mortar stores such as Walmart, Best Buy, Macy’s and others were trying to close the online gap with Amazon by embracing what some described as omni-channel fulfillment or ship-from- store. In the omni-channel model, retailers would route the fulfillment of online orders through retail stores near the customer. Though promising, the omni-channel model required sophisticated technology to locate products and reliable execution from local stores in fulfilling orders, a capability generally found more in warehouses than retail outlets. Amazon’s performance offered some indication of the rapid growth in the online sale of consumer products. The company went from $24.5 billion in sales in 2009 to of only 11 stores from three years earlier. This accounted for $65.4 billion in sales and $2.5 billion in profits. Target was considered an “upscale discounter.” The median in- come of Target shoppers, at $64,000, was considerably higher than its two main competitors, and 50 percent of its customers had completed college.7 Target attracted a more affluent clientele through a more trendy and upscale product mix and through a store ambience that differed from most discounters in aspects such as wider aisles and brighter lighting. The company also emphasized design much more in its products and had partnered with a number of designers to develop products across a broad range of apparel and housewares. Target had also intro- duced a proprietary credit card, the Target Guest Card, to differentiate it from other discounters. The conventional wisdom in the industry suggested that pricing at Target was generally not as low as Walmart but was lower than middle-market department stores such as JC Penney and Mervyn’s. As with Walmart and Kmart, supercenters were also high on Target’s list of strategic priorities. The super- centers, named Super Targets, had opened in many cities, and the company planned to aggressively grow in this area. Promotions were an important part of Target’s mar- keting approach. Each week, more than 100 million Target advertising circulars were distributed in Sunday newspa- pers. Holiday promotions were also emphasized at Target. Like Kmart, Target had traditionally focused much of its ef- fort on metropolitan areas. Early in the decade, more than half of its stores were in 30 metropolitan markets. By 2012, Target estimated that about 10 percent of its stores were in urban areas. Enticed by the growth of large cities relative to suburbs, Target introduced a new downsized format in Chicago in 2012 and planned several other such stores dubbed City for San Francisco, Seattle, and other large cit- ies. Target’s philanthropic activities were well known. Each year, the company gave 5 percent of its pre-tax earnings to not-for-profit organizations—St. Jude Children’s Research Hospital and local schools were perhaps Target’s highest philanthropic priorities. While Target had been an increasingly formidable competitor, many believed that the greatest competitive threat to Walmart came from a firm with no bricks and mortar stores: Amazon.com. Amazon began in 1994 as an online bookseller. Before long, Amazon offered other me- dia products such as music CDs, movies (VHS and DVD), software, and video games. By 2013, with sales of $61 bil- lion (in contrast, Walmart’s online sales were $7.7 billion), Amazon emphasized price, selection, and convenience and sold a wide diversity of products including perhaps anything that could be purchased at a traditional discount retailer along with a seemingly inexhaustible array of M03A_BARN0088_05_GE_CASE3.INDD 37 13/09/14 3:26 PM PC 1–38 The Tools of Strategic Analysis the variety stores business. The central focus of Walmart, however, was on price. Walton sought to make Walmart the low-priced provider of any product it sold. As Walton said, What we were obsessed with was keeping our prices below everybody else’s. Our dedication to that idea was total. Everybody worked like crazy to keep the expenses down. We didn’t have systems. We didn’t have ordering programs. We didn’t have a basic merchandise assortment. We certainly didn’t have any sort of computers. In fact, when I look at it today, I realize that so much of what we did in the begin- ning was really poorly done. But we managed to sell our merchandise as low as we possibly could and that kept us right-side up for the first ten years…. The idea was simple: when customers thought of Walmart, they should think of low prices and satis- faction guaranteed. They could be pretty sure they wouldn’t find it any cheaper anywhere else, and if they didn’t like it, they could bring it back.9 By 1970, Walmart had expanded to 30 stores in the small towns of Arkansas, Missouri, and Oklahoma. Sam Walton, however, was personally several million dollars in debt. For Walmart to expand beyond its small region re- quired an infusion of capital beyond what the Walton fam- ily could provide. Walton thus decided to offer Walmart stock publicly. The initial public offering yielded nearly $5 million in capital. By the early 1990s, 100 shares of that initial stock offering would increase in value from $1,650 to more than $3,000,000. The other problem that plagued Walmart in its early years was finding a way to keep its costs down. Large vendors were reluctant to call on Walmart and, when they did do business with the company, they would dictate the price and quantity of what they sold. Walton described the situation, “I don’t mind saying that we were the victims of a good bit of arrogance from a lot of vendors in those days. They didn’t need us, and they acted that way.”10 Another problem that contributed to high costs was distribution. Distributors did not service Walmart with the same care that they did its larger competitors. Walton saw that “the only alternative was to build our own warehouse so we could buy in volume at attractive prices and store the merchandise.”11 Walmart increased from 32 stores in 1970 to 859 stores 15 years later. For much of that time, Walmart re- tained its small-town focus. More than half its stores were in towns with populations of less than 25,000. Because of its small-town operations, Walmart was not highly visible to many others in the retail industry. By 1985, though, that had changed. Forbes named Sam Walton the richest man 34.2 billion in 2010, to $48 billion in 2011, to $61 billion in 2012. Amazon was renowned for its long-term perspective. It had clearly traded short-term profits in favor of invest- ing in technology and infrastructure intended to help it achieve dominance in online retailing. Walmart had not been blind to the rise and importance of online retailing generally and, more specifically, the threat from Amazon. From the early days of online commerce, it had sought to build a strong position in online commerce yet lagged dra- matically behind Amazon in 2013. Walmart’s History Walmart was started in 1962 by Sam Walton. The discount retail industry was then in its infancy. A couple of regional firms had experimented with discount retailing, but that year three major retail firms joined Walmart in entering the discount industry. Kresge Corporation started Kmart, Dayton Hudson began Target, and the venerable F. W. Woolworth initiated Woolco. Sam Walton had been the most successful franchisee in the Ben Franklin variety store chain, but discount stores threatened the success of his 18 stores. Walton was convinced that discount retail- ing would have a bright future even though most in the industry were highly skeptical of the concept. Indeed, Walton was quickly rebuffed in his efforts to convince Ben Franklin and others to provide financial backing for his proposed venture into discounting. With no major chains willing to back him, Walton risked his home and all his property to secure financing for the first Walmart in Rogers, Arkansas. Of the four new ventures in discount retailing started that year, Walmart seemed the least likely to suc- ceed. Most Walmart stores were in northwestern Arkansas and adjacent areas of Oklahoma, Missouri, and Kansas. Walton had started his retailing career with Ben Franklin in small towns because his wife Helen did not want to live in any city with a population of more than 10,000 people. He had chosen northwestern Arkansas as a base because it allowed him to take advantage of the quail-hunting sea- son in four states. Walmart was, in Sam Walton’s words, “underfinanced and undercapitalized”8 in the beginning. Nevertheless, Walton sought to grow Walmart as fast as he could, because he feared new competitors would preempt growth opportunities if Walmart did not open stores in new towns. After five years, Walmart had 19 stores and sales of $9 million. In contrast, Kmart had 250 stores and $800 million in sales. Walton retained many of the practices regarding customer service and satisfaction that he had learned in M03A_BARN0088_05_GE_CASE3.INDD 38 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–39 Operations From its beginning, Walmart had focused on EDLP. EDLP saved on advertising costs and on labor costs because employees did not have to rearrange stock before and after sales. The company changed its traditional slogan, “Always the Lowest Price,” in the 1990s to “Always Low Prices. Always.” In late 2007, Walmart changed its tagline to “Save Money, Live Better.” Despite the changes in slo- gan, however, Walmart continued to price goods lower than its competitors (see Exhibit 5). When faced with a decline in profits in the late 1990s, Walmart considered raising margins.12 Instead of pricing 7 to 8 percent below competitors, some managers believed that pricing only about 6 percent below would raise gross margins without jeopardizing sales. Some managers and board members, however, were skeptical that price hikes would work at Walmart. They reasoned that Walmart’s culture and iden- tity were so closely attached to low prices that broad price increases would clash with the company’s bedrock beliefs. in America. Furthermore, Walmart had begun to expand from its small-town base in the South and had established a strong presence in several large cities. By the 1990s, it had spread throughout the United States in both large cities and small towns. Walmart in 2013 By the beginning of 2013, Walmart’s activities had spread beyond its historical roots in domestic discount centers. The number of domestic discount centers had declined to 561 from a high 1,995 in 1996. Many discount cen- ters had been converted to supercenters, which had in- creased to 3,158 stores. Walmart Supercenters combined full-line supermarkets and discount centers into one store. Walmart also operated 620 Sam’s Clubs, which were ware- house membership clubs. In 1999, Walmart opened its first Neighborhood Markets, which were supermarkets, and it expanded to 286 in operation by 2013. Exhibit 5 Comparison of Prices at Walmart, Kmart, and Target, Nov. 2008 Item Walmart Kmart Target Oral B Pulsar ProHealth Toothbrush 5.97 6.19 4.74 Crest ProHealth Toothpaste 6 oz. 3.62 3.99 3.79 Pantene Pro V 2-in-1 25.4 oz 5.88 7.79 5.29 Head & Shoulders Classic 14.2 oz 4.72 5.49 4.89 Edge Shave Gel 7 oz 2.27 2.79 1.89 Schick Extreme 3 8 pk 9.97 11.99 9.99 Gillette Mach 3 Disposable 3 pk 6.12 6.99 5.59 1-a-Day Women’s Vitamins 100 tab 6.87 8.49 6.89 1-a-Day Energy Vitamins 50 tab 7.87 8.49 6.89 Bausch & Lomb ReNu 6.97 8.29 6.19 Advil Liquigel 40 tablets 6.48 7.29 5.34 Prestone Extended Life Antifreeze 1 gal 14.49 9.04 Penzoil Motor Oil 5W-30 1 qt 3.57 3.49 3.29 Armour All Glass Wipes 25 4.24 4.29 4.24 TopFlite D2 Straight Golf Balls 15 14.95 15.99 14.99 Perfect Pullup 99.99 99.99 Colemand Quickbed Queen 19.88 24.99 24.99 Crayola Colored Pencils 12 ct 1.88 2.59 1.99 Scott Double-Sided Tape 2.97 3.19 2.99 Some prices are sale prices. M03A_BARN0088_05_GE_CASE3.INDD 39 13/09/14 3:26 PM PC 1–40 The Tools of Strategic Analysis had attributed performance problems to Walmart’s ac- tions. Rubbermaid, for example, experienced higher raw materials costs in the 1990s that Walmart did not allow it to pass along in the form of higher prices. At the same time, Walmart gave more shelf space to Rubbermaid’s lower-cost competitors. As a result, Rubbermaid’s profits dropped by 30 percent and it was forced to cut its work- force by more than 1,000 employees.18 Besides pushing for low prices, the large discounters also required suppliers to pick up an increasing amount of inventory and mer- chandising costs. Walmart required large suppliers such as Procter & Gamble to place large contingents of employees at its Bentonville, Arkansas, headquarters in order to ser- vice its account. Although several companies such as Rubbermaid and the pickle vendor Vlasic had experienced dramatic downfalls largely through being squeezed by Walmart, other companies suggested that their relationship with Walmart had made them much more efficient.19 Some critics suggested, however, that these extreme efficiency pressures had driven many suppliers to move production from the United States to nations such as China that had much lower wages. Walmart set standards for all of its sup- pliers in areas such as child labor and safety. A 2001 audit, however, revealed that as many as one-third of Walmart’s international suppliers were in “serious violation” of the standards.20 Walmart pursued steps to help suppliers ad- dress the violations, but it was unclear how successful these efforts were. A Fast Company article on Walmart interviewed sev- eral former suppliers of the company and concluded: “To a person, all those interviewed credit Walmart with a funda- mental integrity in its dealings that’s unusual in the world of consumer goods, retailing, and groceries. Walmart does not cheat its suppliers, it keeps its word, it pays its bills briskly. ‘They are tough people but very honest; they treat you honestly,’ says Peter Campanella, a former Corning manager.”21 At the heart of Walmart’s success was its distribu- tion system. To a large extent, it had been born out of the necessity of servicing so many stores in small towns while trying to maintain low prices. Walmart used distribution centers to achieve efficiencies in logistics. Initially, distri- bution centers were large facilities—the first were 72,000 square feet—that served 80 to 100 Walmart stores within a 250-mile radius. Newer distribution centers were consider- ably larger than the early ones and in some cases served a wider geographical radius. Walmart had far more distri- bution centers than any of its competitors. Cross-docking was a particularly important practice of these centers.22 In cross-docking, goods were delivered to distribution Another concern was that competitors might seize any opportunity to narrow the gap with Walmart. While the reason was unclear, it appeared that some narrowing on price was occurring by 2008. One study showed that the price gap between Walmart and Kroger had shrunk to 7.5 percent in 2007 from 15 percent a few years earlier.13 Some analysts worried that many shoppers would switch to other retailers as the gap narrowed. Walmart’s low prices were at least partly due to its aggressive use of technology. Walmart had pioneered the use of technology in retail operations for many years and still possessed significant advantages over its competi- tors. It was the leader in forging EDI links with suppliers. Its Retail Link technology gave over 3,200 vendors POS data and authorization to replace inventory for more than 3,000 stores.14 Competitors had responded to Walmart’s advantage in logistics and EDI by forming cooperative ex- changes, but despite their efforts, a large gap remained be- tween Walmart and its competitors.15 As a result, Walmart possessed a substantial advantage in information about supply and demand, which reduced both the number of items that were either overstocked or out of stock. November 2003 was also notable for another Walmart technological initiative. It announced plans to implement RFID to all products by January 2005, a goal that had still not been realized by 2010. RFID, as its name implies, involves the use of tags that transmit radio signals. It had the potential to track inventory more precisely than traditional methods and to eventually reduce much of the labor involved in activities such as manually scanning bar codes for incoming goods. Some analysts estimated that Walmart’s cost savings from RFID could run as high as $8 billion.16 Some information technology observers suggested that Walmart had only experienced lukewarm results from RFID as many suppliers struggled to comply with the company’s demands. Walmart focused its RFID implementation efforts on tagging pallets for Sam’s Club stores and promotional displays in Walmarts. Reportedly, some Sam’s Club suppliers were warned they would be assessed a stiff fine for every pallet that was not tagged with RFID, but by 2009 the fines had been reduced to just 12 cents a pallett. Technology was only one area where Walmart ex- ploited advantages through its relationships with suppli- ers. Walmart’s clout was clearly evident in the payment terms it had with its suppliers. Suppliers frequently of- fered 2 percent discounts to customers who paid their bills within 15 days. Walmart typically paid its bills at close to 30 days from the time of purchase but still usu- ally received a 2 percent discount on the gross amount of an invoice rather than the net amount.17 Several suppliers M03A_BARN0088_05_GE_CASE3.INDD 40 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–41 regional vice presidents and a few hundred other manag- ers and employees met with the firm’s top managers to discuss the previous week’s results and discuss different directions for the next week. Regional managers then con- veyed information from the meeting to managers in the field via the videoconferencing links that were present in each store. In 2006, Walmart shifted this policy by requir- ing many of its 27 regional managers to live in the areas they supervised. Aside from Walmart’s impact on suppliers, it was frequently criticized for its employment practices, which critics characterized as being low in both wages and benefits. Charles Fishman acknowledged that Walmart saved customers $30 billion on groceries alone and pos- sibly as much as $150 billion overall when its effect on competitor pricing was considered, but he estimated that while Walmart created 125,000 jobs in 2005, it destroyed 127,500.25 Others agreed that Walmart’s employment and supplier practices resulted in negative externalities on employees, communities, and taxpayers. Harvard profes- sor Pankaj Ghemawat responded to Fishman by calculat- ing that—based on Fishman’s numbers—Walmart created customer savings ranging from $12 million to $60 million for each job lost.26 He also argued that, because Walmart operated more heavily in lower-income areas of the poor- est one-third of the United States, low-income customers were much more likely to benefit from Walmart’s lower prices. Another criticism of Walmart was that it consis- tently drove small local retailers out of business when it introduced new stores in small towns and that employ- ees in such rural areas were increasingly at the mercy of Walmart, essentially redistributing wealth from these areas to Bentonville. Jack and Suzy Welch defended Walmart by pointing out that employees in these areas were better off after a Walmart opened: In most small towns the storeowner drove the best car, lived in the fanciest house, and belonged to the country club. Meanwhile, employees weren’t exactly sharing the wealth. They rarely had life insurance or health benefits and certainly did not receive much in the way of training or big salaries. And few of these storeown- ers had plans for growth or expansion. . . a killer for employees seeking life-changing careers.27 Sam’s Club A notable exception to Walmart’s dominance in discount retailing was in the warehouse club segment. Despite significant efforts by Walmart’s Sam’s Club, Costco was the established leader. Sam’s Club had almost exactly the same number of stores as Costco—620 to 622—yet, Costco centers and often simply loaded from one dock to another or even from one truck to another without ever sitting in inventory. Cross-docking reduced Walmart’s cost of sales by 2 to 3 percent compared to competitors. Cross-docking was receiving a great deal of attention among retailers with most attempting to implement it for a greater proportion of goods. It was extremely difficult to manage, however, because of the close coordination and timing required be- tween the store, manufacturer, and warehouse. As one sup- plier noted, “Everyone from the forklift driver on up to me, the CEO, knew we had to deliver on time. Not 10 minutes late. And not 45 minutes early, either …. The message came through clearly: You have this 30-second delivery window. Either you’re there or you’re out.”23 Because of the close coordination needed, cross-docking required an informa- tion system that effectively linked stores, warehouses, and manufacturers. Most major retailers were finding it diffi- cult to duplicate Walmart’s success at cross-docking. Walmart’s focus on logistics manifested itself in other ways. Before 2006, the company essentially employed two distribution networks, one for general merchandise and one for groceries. The company created High Velocity Distribution Centers in 2006 that distributed both grocery and general merchandise goods that needed more frequent replenishment. Walmart’s logistics system also included a fleet of more than 2,000 company-owned trucks. It was able to routinely ship goods from distribution centers to stores within 48 hours of receiving an order. Store shelves were replenished twice a week on average in contrast to the industry average of once every two weeks.24 Walmart stores typically included many departments in areas such as soft goods/domestics, hard goods, statio- nery and candy, pharmaceuticals, records and electronics, sporting goods, toys, shoes, and jewelry. The selection of products varied from one region to another. Department managers and in some cases associates (or employees) had the authority to change prices in response to competi- tors. This was in stark contrast to the traditional practice of many chains where prices were centrally set at a company’s headquarters. Walmart’s use of technology was particularly useful in determining the mix of goods in each store. The company used historical selling data and complex models that included many variables such as local demographics to decide what items should be placed in each store. Unlike many of its competitors, Walmart had no regional offices until 2006. Instead, regional vice presi- dents maintained their offices at company headquarters in Bentonville, Arkansas. The absence of regional offices was estimated to save Walmart as much as 1 percent of sales. Regional managers visited stores from Monday to Thursday of each week. Each Saturday at 7:30 a.m., M03A_BARN0088_05_GE_CASE3.INDD 41 13/09/14 3:26 PM PC 1–42 The Tools of Strategic Analysis Some analysts claimed that Sam’s Club’s lackluster performance was a result of a copycat strategy. Costco was the first of the two competitors to sell fresh meat, produce, and gasoline and to introduce a premium private label for many goods. In each case, Sam’s followed suit two to four years later. “By looking at what Costco did and trying to emulate it, Sam’s didn’t carve out its own unique strategy,” says Michael Clayman, editor of the trade newsletter Warehouse Club Focus. And at least one of the “me too” moves made things worse. Soon after Costco and Price Club merged in 1993, Sam’s bulked up by purchasing Pace warehouse clubs from Kmart. Many of the 91 stores were marginal operations in marginal locations. Analysts say that Sam’s Club management became distracted as it tried to integrate the Pace stores into its system.28 To close the gap against Costco, Walmart in 2003 started to integrate the activities of Sam’s Club and Walmart more. Buyers for the two coordinated their efforts to get better prices from suppliers. Culture Perhaps the most distinctive aspect of Walmart was its cul- ture. To a large extent, Walmart’s culture was an extension of Sam Walton’s philosophy and was rooted in the early experiences and practices of Walmart. The Walmart culture still reported almost twice the sales—$105 billion versus $54 billion for Sam’s. Costco stores averaged considerably more revenue per store than Sam’s Club (see Exhibit 6). To the casual observer, Costco and Sam’s Clubs ap- peared to be very similar. Both charged small membership fees, and both were “warehouse” stores that sold goods from pallets. The goods were often packaged or bundled into larger quantities than typical retailers offered. Beneath these similarities, however, were important differences. Costco focused on more upscale small business owners and consumers while Sam’s, following Walmart’s pattern, had positioned itself more to the mass middle market. Relative to Costco, Sam’s was also concentrated more in smaller cities. Consistent with its more upscale strategy, Costco stocked more luxury and premium-branded items than Sam’s Club had traditionally done. This changed some- what when Sam’s began to stock more high-end merchan- dise after the 1990s, but some questioned whether or not its typical customers demanded such items. A Costco execu- tive pointed to the differences between Costco and Sam’s customers by describing a scene where a Sam’s customer responded to a $39 price on a Ralph Lauren Polo shirt by saying, “Can you imagine? Who in their right mind would buy a T-shirt for $39?” Despite the focus on pricier goods, Costco still focused intensely on managing costs and keep- ing prices down. Costco set a goal of 10 percent margins and capped markups at 14 percent (compared with the usual 40 percent markup by department stores). Managers were discouraged from exceeding the margin goals. Exhibit 6 Costco Versus Sam’s Club Costco Sam’s Club Year founded 1983 1983 U.S. revenues $99.137 billion $56.4 billion Number of stores 622 620 Presidents (or equivalents, since founding) 2 12 Membership cardholders 70.2 million 47 million Members’ average salary $77,000/$74,000/$96,000 N.A. Annual membership fees $55 $40 Average sales per square foot $814 (2009) $586 (2009) Average sales per store $168.8 million $87.1 million Starting hourly wage $11.50 N.A. Employee turnover per year 17% (2006) 44% (Walmart, 2006) Private label (as % of sales) Approximately 20% Approximately 10% M03A_BARN0088_05_GE_CASE3.INDD 42 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–43 was only the third variety store in the United States to do so. Later, he was one of the first to see the potential of dis- count retailing. Walton also emphasized always looking for ways to improve. Walmart managers were encouraged to critique their own operations. Managers met regularly to discuss their store operations. Lessons learned in one store were quickly spread to other stores. Walmart managers also carefully analyzed the activities of their competitors and tried to borrow practices that worked well. Walton stressed the importance of observing what other firms did well rather than what they did wrong. Another way in which Walmart had focused on improvement from its earliest days was in information and measurement. Long before Walmart had any computers, Walton would personally enter measures on several variables for each store into a ledger he carried with him. Information technology en- abled Walmart to extend this emphasis on information and measurement. International Operations Walmart’s entry into the international retail arena had been somewhat recent. As late as 1992, Walmart’s entire interna- tional operations consisted of only 162,535 square feet of retail space in Mexico. By 2013, however, international sales contributed nearly 30 percent of the company’s sales. With growth rates of 7.4 percent in sales and 8.3 percent in operat- ing income, Walmart’s international growth exceeded that of its domestic operations. Although it was the company’s fastest-growing division—going from about $59 billion in sales in 2006 to more than $135 billion in 2013—Walmart’s performance in international markets had been mixed, or as Forbes put it, “Overseas, Walmart has won some—and lost a lot.”32 Only a few years earlier, more than 80 percent of Walmart’s international revenue came from only three coun- tries: Canada, Mexico, and the United Kingdom. Walmart had tried a variety of approaches and faced a diverse set of challenges in the different countries it en- tered. Entry into international markets had ranged from greenfield development to franchising, joint ventures, and acquisitions. Each country that Walmart had entered had presented new and unique challenges. In China, Walmart had to deal with a backward supply chain. In Japan, it had to negotiate an environment that was hostile to large chains and protective of its small retailers. Strong foreign competitors were the problem in Brazil and Argentina. Labor unions had plagued Walmart’s entry into Germany along with unforeseen difficulties in integrating acquisi- tions. Mistakes in choosing store locations had hampered the company in South Korea and Hong Kong. emphasized values such as thriftiness, hard work, innova- tion, and continuous improvement. As Walton wrote, Because wherever we’ve been, we’ve always tried to instill in our folks the idea that we at Walmart have our own way of doing things. It may be different and it may take some folks a while to adjust to it at first. But it’s straight and honest and basically pretty simple to figure it out if you want to. And whether or not other folks want to accommodate us, we pretty much stick to what we believe in because it’s proven to be very, very successful.29 Walmart’s thriftiness was consistent with its obses- sion with controlling costs. One observer joked that “the Walmart folks stay at Mo 3, where they don’t even leave the light on for you.”30 This was not, however, far from the truth. Walton told of early buying trips to New York where several Walmart managers shared the same hotel room and walked everywhere they went rather than use taxis. One of the early managers described how these early trips taught managers to work hard and keep costs low: From the very beginning, Sam was always trying to instill in us that you just didn’t go to New York and roll with the flow. We always walked everywhere. We never took cabs. And Sam had an equation for the trips: expenses should never exceed 1 percent of our purchases, so we would all crowd in these little hotel rooms some- where down around Madison Square Garden. . . . We never finished up until about twelve-thirty at night, and we’d all go out for a beer except Mr. Walton. He’d say, “I’ll meet you at breakfast at six o’clock.” And we’d say, “Mr. Walton, there’s no reason to meet that early. We can’t even get into the buildings that early.” And he’d just say, “We’ll find something to do.”31 The roots of Walmart’s emphasis on innovation and continuous improvement can also be seen in Walton’s ex- ample. Walton’s drive for achievement was evident early in life. He achieved the rank of Eagle Scout earlier than anyone previously had in the state of Missouri. Later, in high school, he quarterbacked the undefeated state cham- pion football team and played guard on the undefeated state champion basketball team while serving as student body president. This same drive was evident in Walton’s early retailing efforts. He studied other retailers by spend- ing time in their stores, asking endless questions, and tak- ing notes about various store practices. Walton was quick to borrow a new idea if he thought it would increase sales and profits. When, in his early days at Ben Franklin, Walton read about two variety stores in Minnesota that were using self-service, he immediately took an all-night bus ride to visit the stores. Upon his return from Minnesota, he con- verted one of his stores to self-service, which, at the time, M03A_BARN0088_05_GE_CASE3.INDD 43 13/09/14 3:26 PM PC 1–44 The Tools of Strategic Analysis Some analysts feared that the pace of expansion by these major retailers was faster than the rate of growth in the market and could result in a price war. Like Walmart, these competitors had also found difficulty in moving into international markets and adapting to local differences. Both Carrefour and Makro had experienced visible fail- ures in their international efforts. Folkert Schukken, chair- man of Makro, noted this challenge: “We have trouble selling the same toilet paper in Belgium and Holland.” The chairman of Carrefour, Daniel Bernard, agreed, “If people think that going international is a solution to their problems at home, they will learn by spilling their blood. Global retailing demands a huge investment and gives no guarantee of a return.”35 Walmart sought aggressive growth in its interna- tional operations. The company added 497 units during 2013. Walmart’s early activities in a country typically in- volved acquisitions, but it had emphasized organic growth more in recent years. Looking Ahead Walmart CEO Doug McMillon faced the daunting chal- lenge of achieving the company’s accustomed growth rates despite its enormous size. A 5 percent organic growth rate would require the firm to add the equivalent of a firm ranking 129th in the Fortune 500 each year. To put that into perspective, the company’s growth in revenues would need to nearly equal the total sales of Nike and exceed the sales of companies as large as Xerox and Kimberly Clark. What strategic priorities would allow Walmart to achieve that amount of growth? Or would the company need to adjust its aspirations? Walmart approached international operations with much the same philosophy it had used in the United States. “We’re still very young at this, we’re still learn- ing,”33 stated John Menzer, former chief executive of Walmart International. Menzer’s approach was to have country presidents make decisions. His thinking was that it would facilitate the faster implementation of decisions. Each country president made decisions regarding his or her own sourcing, merchandising, and real estate. Menzer concluded, “Over time all you really have is speed. I think that’s our most important asset.”34 In most countries, entrenched competitors re- sponded vigorously to Walmart’s entry. For example, Tesco, the United Kingdom’s biggest grocer, responded by opening supercenters. In China, Lianhua and Huilan, the two largest retailers, merged in 2003 into one state- owned entity named the Bailan Group. Walmart was also not alone among major international retailers in seeking new growth in South America and Asia. One international competitor, the French retailer Carrefour, was already the leading retailer in Brazil and Argentina. Carrefour expanded into China in the late 1990s with a hypermar- ket in Shanghai. In Asia, Makro, a Dutch wholesale club retailer, was the regional leader. Both of the European firms were viewed as able, experienced competitors. The Japanese retailer, Yaohan, moved its headquarters from Tokyo to Hong Kong with the aim of becoming the world’s largest retailer. Helped by the close relationship between Chairman Kazuo Wada and Mao’s successor Deng Xiaoping, Yaohan was the first foreign retail firm to receive a license to operate in China and planned to open more than 1,000 stores there. Like Walmart, these inter- national firms were motivated to expand internationally by slowing down growth in their own domestic markets. End Notes 1. Standard and Poor’s Industry Surveys. Retailing, February 1998. 2. Upbin, B. “Wall-to-wall Wal-Mart.” Forbes, April 12, 2004. 3. Nordlinger, J. (2004). “The new colossus: Wal-Mart is America’s store, and the world’s and its enemies are sadly behind.” National Review, April 19, 2004. 4. Ibid. 5. Fishman, C. (2003). “The Wal-Mart you don’t know.” Fast Company, December 2003. 6. Berner, R. (2004). “The next Warren Buffett?” BusinessWeek, November 22, 2004. 7. Standard and Poor’s Industry Surveys. (1998). Retailing: General, February 5, 1998. 8. Walton, S. (with J. Huey). (1993). Sam Walton: Made in America. New York: Doubleday, p. 63. 9. Ibid., pp. 64–65. 10. Ibid., p. 66. 10. Ibid., p. 66. M03A_BARN0088_05_GE_CASE3.INDD 44 13/09/14 3:26 PM Case 1–3: Walmart Stores, Inc. PC 1–45 11. (1982). Forbes, August 16, p. 43. 12. Pulliam, S. (1996). “Wal-Mart considers raising prices, drawing praise from analysts, but concern from board.” Wall Street Journal, March 8, 1996, p. C2. 13. Bianco, A. (2007). “Wal-Mart’s midlife crisis.” BusinessWeek, April 30, 2007. 14. Standard and Poor ‘s Industry Surveys. (1998). Retailing: General, February 5, 1998. 15. Useem, J. (2003). “America’s most admired companies.” Fortune, February 18, 2003. 16. Boyle, M. (2003). Fortune, November 10, 2003, p. 46. 17. Schifrin, M. (1996). “The big squeeze.” Forbes, March 11, 1996. 18. Ibid. 19. Fishman, C. (2003). “The Wal-Mart you don’t know.” Fast Company, December 2003. 20. Walmart Web site. 21. Fishman, C. (2003). “The Wal-Mart you don’t know.” Fast Company, December 2003, p. 73. 22. Stalk, G., P. Evans, and L. E. Schulman. (1992). “Competing on capabilities: The new rules of corporate strategy.” Harvard Business Review, March/April 1992, pp. 57–58. 23. Fishman, C. (2003). “The Wal-Mart you don’t know.” Fast Company, December 2003, p. 73. 24. Stalk G., P. Evans, and L. E. Schulman. (1992). “Competing on capabilities: The new rules of corporate strategy.” Harvard Business Review, March/April 1992, pp. 57–58. 25. Fishman, C. (2006). “Wal-Mart and the decent society: Who knew that shopping was so important.” Academy of Management Perspectives, August 2006. 26. Ghemawat, P. (2006). “Business, society, and the ‘Wal-Mart effect.” Academy of Management Perspectives, August 2006. 27. Welch, J., and S. Welch. (2006). “What’s right about Wal-Mart.” BusinessWeek, May 1, 2006, p. 112. 28. Helyar, J. (2003). “The only company Wal-Mart fears.” Fortune, November 24, 2003, p. 158. 29. Walton, S. (with J. Huey). (1993). Sam Walton: Made in America. New York: Doubleday, p. 85. 30. Loeb, M. (1994). “Editor’s desk: The secret of two successes.” Fortune, May 2, 1994. 31. Walton, S. (with J. Huey). (1993). Sam Walton: Made in America. New York: Doubleday, p. 84. 32. Upbin, B. (2004). “Wall-to-wall Wal-Mart.” Forbes, April 12, 2004. 33. Ibid. 34. Ibid. 35. Rapoport, C. (1995). “Retailers go global.” Fortune, February 20, 1995. M03A_BARN0088_05_GE_CASE3.INDD 45 13/09/14 3:26 PM Hayes, leader of the MIRA team, knew this was a significant decision for Harlequin. Several years ear- lier an attempt at single-title publishing—Worldwide Library—had failed. Before going to her executive group for approval, Hayes thought about the decisions the company faced if it wished to enter single-title women’s fiction publishing: What were the growth and profitabil- ity implications if Harlequin broadened its scope from series romance to single-title women’s fiction? What fun- damental changes would have to be made to Harlequin’s current business model? Did the company have the nec- essary resources and capabilities to succeed in this new arena? If the company proceeds, how should it go about launching MIRA? The Publishing Industry2 Apart from educational material, traditional single-title book publishing was typically a high-risk venture. Each book was a new product with all the risks attendant on any new product introduction. The risks varied with the author’s reputation, the subject matter, and thus the predictability of the market’s response. Among the numerous decisions facing the publisher were selecting manuscripts out of the thousands submitted each year, deciding how many copies to print, and deciding how to promote the book. Insiders judged one key to success in publish- ing was the creative genius needed to identify good young authors among the hundreds of would-be writ- ers, and then publish and develop them through their careers. Years ago, Sol Stein of Stein and Day Publishers had commented, “Most successful publishers are creative editors at heart and contribute more than risk capital and marketing expertise to the books they publish. If a publisher does not add value to what he publishes, he’s a printer, not a publisher.” Traditional single-title publishers allowed distribu- tors 50 percent margins (from which the retailer’s mar- gin would come).3 Some other typical costs included royalty payments of more than 12 percent, warehouse and handling costs of 4 percent, and selling expenses at 5.5 percent. Advertising generally required 6 percent and printing costs4 required another 12 percent. The remainder was earnings before indirect overhead. Typically, indirect During June 1993, Harlequin management was deciding whether or not to launch MIRA, a new line of single- title women’s fiction novels. With the increased popu- larity of single-title women’s fiction, Harlequin’s leading position as the world’s largest romance publisher was being threatened. While Harlequin was the dominant and very profitable producer of series romance novels, research indicated that many customers were reading as many single-title romance and women’s fiction books as series romances. Facing a steady loss of share in a growing total women’s fiction market, Harlequin convened a task force in December 1992 to study the possibility of relaunching a single-title women’s fiction program. Donna Hayes, vice- president of direct marketing, stated: Industry trends reveal that demand for single-title women’s fiction continues to grow while demand for series romance remains stable. Our strengths lie in series romance . . . by any account, launching MIRA (single- title) will still be a challenge for us. How do we success- fully launch a single-title women’s fiction program? Tentatively named “MIRA,” Harlequin’s proposed single-title program would focus exclusively on women’s fiction. Management hoped MIRA’s launch would provide the opportunity to continue Harlequin’s history of strong revenue growth. C a s e 1 – 4 : H a r l e q u i n E n t e r p r i s e s : T h e M i r a D e c i s i o n * 1 *Ken Mark prepared this case under the supervision of Professors Rod White and Mary Crossan solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This mate- rial is not covered under authorization from CanCopy or any reproduction rights organization. To order copies or request per- mission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ ivey.uwo.ca. One-time permission to reproduce granted by Ivey Management Services on March 31, 2014. Copyright © 2003, Ivey Management Services Version: (A) 2009-10-21 M03A_BARN0088_05_GE_CASE4.INDD 46 13/09/14 3:27 PM Case 1–4: Harlequin Enterprises: The Mira Decision PC 1–47 Harlequin’s Target Market and Products Harlequin books were sold in more than 100 international markets in more than 23 languages around the world. Along with romance fiction, Harlequin participated in the series mystery and male action-adventure markets under its Worldwide Library and Gold Eagle imprints. Harlequin had an estimated 20 million readers in North America and 50 million readers around the world. With a median age of 41, the Harlequin’s ro- mance series reader was likely to be married, well edu- cated, and working outside the home. More than half of Harlequin readers spent at least three hours reading per week. Harlequin series readers were brand loyal; a survey indicated four out of five readers would continue to buy Harlequin books in the next year. Larry Heisey, Harlequin’s former chief executive officer and chairman, expanded on the value of Harlequin’s products: “I think our books are so popular because they provide relaxation and escape…. We get many letters from people who tell us how much these books mean to them.” While Harlequin had advertised its series product on television, current marketing efforts centered on print media. Harlequin advertised in leading women’s maga- zines such as Cosmopolitan, Glamour, Redbook, and Good Housekeeping, and general interest magazines such as People. The print advertisement usually featured one of Harlequin’s series products and also promoted the company’s brands. Romance Series Product: Well Defined and Consistent Under the Harlequin and Silhouette brands, Harlequin published 13 different series with 64 titles each month. Each series was distinctly positioned, featuring a particular genre (e.g., historical romances) or level of explicitness. Isabel Swift, editorial director of Silhouette, described the different types of series books published by Harlequin: Our different lines deliver different promises to our readers. For example, Harlequin Temptation’s tagline is sassy, sexy, and seductive, promising that each overhead accounted for two percent of the retail price of a book. Because of author advances, pre-publication, pro- motion, and fixed costs of printing, break-even volumes were significant. And if the publisher failed to sell enough books, the losses could be substantial. Harlequin’s core business, series romance fiction, was significantly different from traditional single-title publishing. Harlequin Enterprises Limited The word romance and the name Harlequin had become synonymous over the last half-century. Founded in 1949, Harlequin began applying its revolutionary approach to publishing—a packaged, consumer-goods strategy—in 1968 shortly after acquiring the publishing business of U.K.-based Mills & Boon. Each book was part of an iden- tifiable product line, consistently delivering the expected benefit to the consumer. With a growth rate of 25 percent per year during the 1970s, Harlequin became the world’s largest publisher of women’s series romance fiction. It was during this time that Torstar, a newspaper publisher, ac- quired all of Harlequin Enterprises Ltd. Over the years, many book publishers had attempted to enter Harlequin’s segment of the industry. All had even- tually withdrawn. Only once had Harlequin’s dominance in series romance fiction been seriously challenged. The “romance wars” began in 1980 when Harlequin took over U.S. distribution of its series products from Simon & Schuster (S&S), a large single-title publisher with estab- lished paperback distribution. Subsequently, S&S began publishing series romance fiction under the Silhouette im- print. After several years, a truce was negotiated between Harlequin and S&S. Harlequin acquired Silhouette, S&S’s series romance business, and S&S got a 20-year deal as Harlequin’s sole U.S. distributor for series fiction. During the late 1980s and early 1990s, growth in the series market slowed. Harlequin was able to maintain revenues by publishing longer and more expensive series products and generally raising prices. However, as shown in Table 1, global unit volume was no longer growing. Table 1 Total Unit Sales (in $000s) Year 1988 1989 1990 1991 1992 1993 Operating Revenue 344,574 326,539 348,358 357,013 417,884 443,825 Operating Profit 48,142 56,217 57,769 52,385 61,842 62,589 Total Unit Sales 202 191 196 193 205 199 M03A_BARN0088_05_GE_CASE4.INDD 47 13/09/14 3:27 PM PC 1–48 The Tools of Strategic Analysis price for the typical single-title paperback novel, and much less than the $15 to $25 for longer, hardcover titles by best- selling authors. Harlequin’s series romance product was fundamen- tally different from that of traditional single-title publish- ers: content, length, artwork size, basic formats, and print were all well defined to ensure a consistent product. Each book was not a new product, but rather an addition to a clearly defined product line. Unlike single-title books, Harlequin’s series products had a common format. They story will deliver a sexy, fun, contemporary romance between one man and one woman, whereas the Sil- houette Romance title, in comparison, is a tender read within a framework of more traditional values. Overall, the product portfolio offered a wide variety of stories to capture readers’ interests. For the positioning of Harlequin’s series, see Exhibit 1. Sold in more than a dozen countries. Harlequin had the ability to publish series books worldwide. The average retail price of a Harlequin series novel was $4.40,5 significantly less than the $7 retail Level of Sensuality Highest Lowest Series Legend HA HH HI HL HP HR HS HT Harlequin American Romance Harlequin Historicals Harlequin Intrigue Harlequin Love and Laughter Harlequin Presents Harlequin Romance Harlequin Superomance Harlequin Temptation SD SE SI SR SY Silhouette Desire Silhouette Special Editions Silhouette Intimate Moments Silhouette Romance Silhouette Yours Truly HT SD SI HH HP SYHL SE HA HI HS SRHR Adventure, Suspense, Intrigue Highest Lowest HI SI HH HS HA SEHT HL SD SY HP SRHR Editorial Tone Humorous Dramatic HL SY HT SRHA SD HH HR SI SE HS HI HP Locale Mix of International Settings Primary American HP HR HH SI SE HT HI SD HL HS SR SYHA Page Length HH HS 304 PGS. SE SI HI HA 256 PGS. HT 224 PGS. SR SD SY HP HR HL 192 PGS. Exhibit 1 Harlequin/ Silhouette Series Positioning Scales Source: Company files. M03A_BARN0088_05_GE_CASE4.INDD 48 13/09/14 3:27 PM Case 1–4: Harlequin Enterprises: The Mira Decision PC 1–49 To ensure a consistent product emerged, Harlequin’s editors assessed many elements, including plot, story line, main character(s), setting, percentage of romance in the plot, level of realism, level of fantasy, sensuality, social and/or individual problems, happy ending, and reading impact. Even though many different authors contributed to series romance, Harlequin’s editors ensured a consistent finished product, satisfying the needs of their loyal series romance readers. The consequences of this uniformity were significant. The reader was buying a Harlequin novel, and advertising promoted the Harlequin brands rather than a particular book or author. Bookstores were not the primary channel for series romance novels. Most retail purchases were made at super- markets or drugstores and increasingly mass merchandis- ers like Wal-Mart. But many avid Harlequin readers got measured 105 millimeters by 168 millimeters and fit neatly into specially designed racks located primarily in super- markets and drugstores. Most product lines were 192 to 256 pages in length; some were up to 304 pages in length. Cover designs differed slightly by product line and coun- try, but the look and feel was similar (see Exhibit 2). Harlequin provided prospective series romance au- thors with plot, style, and book length guidelines. However, crafting the stories still demanded skill and work. As David Galloway, chief executive officer of Torstar, Harlequin’s par- ent company, and the former head of Harlequin observed: The books are quite simply good stories. If they weren’t, we wouldn’t be getting the repeat purchases we do. A lot of writers think they can dash off a Harlequin, but they can’t. We’ve had submissions from Ph.D.’s in English who can certainly write but they can’t tell a story. Exhibit 2 Typical Harlequin Series Romance Products Source: Company files. M03A_BARN0088_05_GE_CASE4.INDD 49 13/09/14 3:27 PM PC 1–50 The Tools of Strategic Analysis sales was that order regulation and returns could be more eas- ily optimized to maximize the contribution to profits. A comparison of Harlequin’s series business model and the operations of traditional “one-off” publishers is presented in Exhibit 3. With a consistent quality product, standing orders, predictable retail traffic patterns, and the ability to produce and deliver books at low costs, Harlequin had achieved great success. Harlequin’s series romance business had con- sistently earned a return on sales of 15 percent. As shown in Exhibit 4, this figure compared favorably with larger tradi- tional publishers. Loriana Sacilotto, director of retail marketing, ex- plained why Harlequin outperformed other traditional single-title publishers: There are a variety of reasons why other publishers do not achieve the same margins we enjoy. The main reason is that they are broad in their publishing focus whereas we focus on women’s fiction. They don’t have the same reader recognition, trust and relationships. We invest in it. Harlequin Business System The Global Author–Editor Team. Harlequin had es- tablished a strong level of reader trust and brand equity by consistently delivering quality content. Editors in three acquisition centers in Toronto, New York, and London were responsible for working closely with 1,300-plus authors to develop and publish more than 1,000 new titles annually. In the product delivered to their home every month through Harlequin’s direct mail service. The standardized size and format made warehousing and distribution more efficient. In addition, the product’s consistency enabled standing or- der distribution to retail. As Pam Laycock, director of new product development, explained: A major contributor to our success as a series publisher is our standing order distribution. Each series is distrib- uted to a retail location in a predetermined configura- tion—for example in a series where we publish four titles per month, a retailer may take six copies per title and this level of distribution is generally agreed upon and maintained for the entire year. This approach enables us to more accurately predict monthly print quantities and achieve significant print cost effectiveness. Orders (and sales) for conventional single-title books were not as predictable. Another significant difference was that series romance books were part of Harlequin’s standing order distribution plan. And more like maga- zines, they were displayed on retail shelves for four weeks. Harlequin’s distributors then removed and returned any unsold books, and replaced them with the next month’s offerings. By comparison, single-title books were typically displayed at retail from 6 to 12 months or more. Harlequin’s series romance business did not generate or even encourage best-sellers. “Best-sellers (in series romance) would ruin our system,” a Harlequin insider stated. “Our objective is consistency in volume. We have no winners and no losers.” Unsold books could be returned to the publisher for credit. A consequence of Harlequin’s even and predictable Exhibit 3 Comparing Harlequin’s Series Business Model and a Traditional Publisher’s Harlequin Series Single-Title Publisher Editorial Emphasizes consistency within established guidelines Requires separate judgment on potential consumer demand for each manuscript Rights Uses standardized contract Can be a complex process, involving subrights, hard/soft deals, advances, and tying up authors for future books Author Management Less dependent on specific authors Vulnerable to key authors changing publisher Production Uses consistent format with focus on efficiency Emphasizes package, size, and format—cost control secondary Marketing Builds the imprint/series Builds each title/author Distribution Supermarkets, drugstores, mass merchandisers, big-box bookstores. Bookstores (all types) Large direct mail Book clubs and mass merchandisers Selling Emphasizes servicing, rack placement, and order regulation Cover, in-store placement, critical reviews, special promotional tactics (e.g., author signings) Order Regulation/ Information Systems Utilizes very sophisticated shipping and returns handling procedures Historically has not received much attention, and hence, is not as sophisticated M03A_BARN0088_05_GE_CASE4.INDD 50 13/09/14 3:27 PM Case 1–4: Harlequin Enterprises: The Mira Decision PC 1–51 almost 50,000 of these were supermarkets and drugstores. Harlequin’s series products were in 70 percent of super- markets, but only 55 percent of bookstores. In Europe, ki- osks and tobacconists accounted for the largest proportion of retail outlets. The direct channel handled direct-to-reader book sales. Harlequin’s “Reader Service” book club was an im- portant source of sales and profits. Investing in advertising to acquire readers, this direct mail operation offered frequent Harlequin readers the possibility of purchasing every book the company published, delivered right to their doorstep. In the United States, six books were sold through the book club for every 10 sold at retail. Furthermore, a book sold through the book club yielded Harlequin the full cover price, whereas a book sold at retail netted the company approximately half the retail price, and required advertising, distribution costs, and the acceptance of returns from retailers. Rise of Single-Title Romance The proliferation of titles and authors during the “Romance Wars” had resulted in the emergence of single- titles as a significant factor in the women’s romance fic- tion market. Exhibit 5 provides the sales breakdown for romance novels. In an attempt to capitalize on readers’ growing ap- petite for single-titles, Harlequin launched Worldwide Library in 1986, its first single-title publishing program. This move also gave Harlequin’s more accomplished series authors another outlet. Laycock commented: Several authors who began their writing careers with Harlequin writing series romance wanted broader op- portunities—opportunities that they saw in the single- title women’s fiction publishing arena. Prior to the launch of Worldwide Library, Harlequin didn’t have publishing opportunities to meet the desires of these authors. As a result, authors would seek out competi- tive publishers to support their single-title works. addition to the work of its regular writers, Harlequin received approximately 30,000 unsolicited manuscripts per year. Typically, about 100 of these were accepted in any given year. Series authors received royalties of 13 percent of retail book price. Harlequin’s typical series authors had more than 100,000 of each of their books distributed worldwide. Harlequin’s series romance product focused solely on front-list sales. In the publishing world, front-list sales refers to the first print runs of a book supporting its ini- tial market launch. Back-list refers to books reprinted and reissued years after the book’s initial run (often to sup- port an author’s subsequent books). Harlequin’s series romance novels—unlike a traditional publisher’s single- title books—were not available on back-list. However, Harlequin retained these rights. Printing was a highly competitive business and Harlequin subcontracted its requirements. Costs per series book were typically $0.44 per book compared to the compet- itors’ average costs of $0.88 per single-title soft cover book. Distribution, Selling, and Promotion. With its stand- ing orders, Harlequin’s distribution costs per book were $0.18, with selling expenses at an average of $0.09 per book. Because it was the dominant player in series romance, Harlequin had relatively low advertising and promotion costs—about $0.22 per book. In Canada, Harlequin had its own distribution. Elsewhere in the world, independent distributors were employed. In the United States, Pocketbooks, the sales division of Simon & Schuster, a large traditional publisher, handled Harlequin’s series romance books. Supermarkets, drugstores, discount department stores, and mass mer- chandisers accounted for 70 percent of North American retail sales. Specialty big-box bookstores like Barnes and Noble and other chains and independent bookstores accounted for the remainder of retail sales. Globally, Harlequin’s products were in over 250,000 retail outlets. Eighty thousand of these outlets were in North America; Exhibit 4 Comparison of Harlequin’s Performance with Traditional Publishers—1993 (in millions of dollars) Harlequina Simon and Schusterb Harper/Avonc Sales Revenue 417.8 1,929.0 1,210.4 Operating Profit 61.8 218.4 160.8 Identifiable Assets 319.2 2,875.8 2,528.0 R.O.S. 14.8% 11.3% 13.2% R.O.I.A. 19.4% 7.6% 6.4% a Canadian dollars b U.S. dollars (Cdn$1.20 = US$1) c Australian dollars (Cdn$0.80 = AUD$1) M03A_BARN0088_05_GE_CASE4.INDD 51 13/09/14 3:27 PM PC 1–52 The Tools of Strategic Analysis By 1988, Worldwide was shut down as a result of several problems. “Worldwide could never decide if it was a romance program, a women’s fiction program, or a general fiction program,” a Harlequin insider commented. Exhibit 6 illustrates a list of typical titles published at Worldwide. With the shutdown of Worldwide Library, popular au- thors moved to other publishers. As shown in Exhibit 7, other publishers continued to exploit the popularity of single-title romance novels. Eager to find ways to grow its publishing busi- ness, Harlequin’s management reexamined the publish- ing market. A broader analysis revealed that although Harlequin’s series romance had captured well over 80 percent of the North American series romance market by 1990, Harlequin’s estimated share of the North American women’s fiction market was only about 5 percent. Table 2 provides a breakdown of the women’s fiction market. There was substantial overlap in the readership of series romance fiction and other fiction. Mark Mailman, vice president of market research and analysis, added: One compelling reason to get into single-title publish- ing is that when we look at our research on customers, they’re reading 20 Harlequin books and 20 single-title books from other publishers. We have an opportunity to take a greater share of that market. Exhibit 5 Romance Novel Sales in North America (millions of units) 1985 1986 1987 1988 1989 1990 Harlequin series romance 77 79 80 82 83 85 Other romance series publishers 12 12 13 13 14 14 Single-title romance books by other publishers 72 79 86 94 102 112 Total romance books 161 170 179 189 199 211 Exhibit 6 Range of Worldwide Titles (1987) Book Title Type/Genre Unit Sales Data Harlequin Series Author? Longest Pleasure Romance 304,000 Yes Quarantine Horror 62,000 No Eve of Regression Psychological Thriller 55,000 No War Moon Suspense 72,000 No Illusion Psychological Suspense 35,000 No Dream Escape Romance 297,000 Yes Alien Planet Science Fiction 71,000 No Exhibit 7 Monthly Single-Title Romance Output Analysis North American Market Single-Title Romance by Category 1985 1989 1991 Contemporary 2 6 12 Historical 22 37 43 Regency 6 8 17 Total 30 51 72 By Publisher Zebra (Kensington Publishing) 5 15 21 Bantam/Dell 2 2 8 Diamond 0 0 4 Harper Paperbacks 0 0 3 Avon 4 5 6 Jove 2 2 4 Leisure Books 3 3 5 NAL/Signet 6 7 8 Pocket Books (Simon and Schuster) 1 6 3 Ballantine/Fawcett, Onyx, SMP 4 7 7 Warner Books/Popular Library 3 4 3 Total 30 51 72 Source: Company files. M03A_BARN0088_05_GE_CASE4.INDD 52 13/09/14 3:27 PM Case 1–4: Harlequin Enterprises: The Mira Decision PC 1–53 Exhibit 8 General Industry Contract Terms for Fiction Category by Author Group Brand-New Author Mid-List Author Best-Selling Author Advance Royalties Overseas Publishing Schedule Overseas Publishing Markets Minimum Distribution Promotional Support per book $10,000 to $30,000 5% to 13% Within 18 months Major markets 30,000 to 80,000 Possibly some support (up to $50,000) $80,000 to $200,000 8% to 15% Within 12 months All markets 100,000 to 400,000 Support ($100,000) $1 million to $5 million 10% to 17% Simultaneous All markets >1 million
Very strong support
(more than $300,000)
Sources: Industry sources and casewriter estimates.
Table 2 North American Women’s Fiction Market Size Estimate, 1993 (as a percentage of overall segment sizes in US$ millions)
General
Fiction Romance Mystery Sci-Fi
Total
Fiction
Total Segment Size 2,222 1,220 353 476 4,271
Estimated Women’s Fiction
Share of Segment
60% 100% 60% 38% 69%
Harlequin’s Single-Title Task Force
Faced with slow or no growth in series romance, a
Harlequin task force convened in 1992 to study the fea-
sibility of launching a new women’s fiction single-title
program. To begin, they examined why Worldwide had
failed and concluded that overall lack of success was at-
tributable to: editorial parameters that were too broad; less
than optimal North American retail distribution; very few
Worldwide titles distributed through the direct-to-reader
channel; global support for the program was not timely
and universal; and the selection of authors and titles was
unsuccessful. The task force report stated:
In the past few years, sell-through efficiencies in the
supermarket channels are not as great as the sell-through
efficiencies in both mass merchandisers and bookstores.
The more efficient retailer knew that the consumer
was spending her discretionary reading dollar to buy
a diversity of romantic reads, including those that had
previously been thought of as mainstream.
Since a single-title strategy requires a single-
title solicitation from the sales force and more
expensive single-title packaging, two of Harlequin’s
strategic lynchpins of our earlier decades have to be re-
thought (for single-title): standing order program and
same format production. However, Harlequin can still
capitalize on its global base and its ability to distribute
widely to points of purchase that women visit on a
regular basis.
MIRA Launch Decision
The task force was preparing its recommendation for
MIRA, Harlequin’s proposed women’s fiction single-title
program. The addition of single titles would make a wel-
come contribution to overhead costs. Currently, indirect
overhead costs per series novel were $0.09 per book.
Because infrastructure was already in place, it was esti-
mated that MIRA novels would not incur additional in-
direct overhead costs. Printing costs for single-titles were
expected to be $0.71 per book (350 pages on average).
Estimated advertising and promotional costs for new
single-titles were 6 percent of (the higher) retail price.
Author Management
In the single-title market, authors were categorized into
three groups, based on their sales potential: brand new,
mid-list, and best-seller (see Exhibit 8). Depending on
the author group royalties, sales, and promotional sup-
port varied. Best-selling authors were expected to sell
more than a million books. Publishers were known to
sign established authors for up to a five-book contract
with large multimillion dollar advances. It had not
been determined whether MIRA should follow suit.
In addition to author advances, typical royalties per
MIRA-type book were estimated to be 13 percent of the
$6.75 retail price.
M03A_BARN0088_05_GE_CASE4.INDD 53 13/09/14 3:27 PM

PC 1–54 The Tools of Strategic Analysis
acquiring office, the collective clout of Harlequin could create
the likelihood of better-selling mainstream titles marketed by
all countries in the global enterprise.”
Harlequin’s author and editor relationships re-
mained strong, so much so that many series authors were
enthusiastic about maintaining a long-term relationship
with a trusted editor as they pursued their break-out main-
stream book. With MIRA, these authors could remain loyal
to Harlequin.
How Best to Proceed
There were many issues to be resolved prior to any launch
of MIRA. Most pressing was the question of whether
Harlequin had the resources and capabilities to succeed in
its new women’s fiction segment. Certainly there were ele-
ments of its series business model that could be transferred
to the broader women’s fiction market. But what were the
gaps? What else did Harlequin need?
Hayes had several options if MIRA was launched.
Several established best-selling authors had begun their
writing careers with Harlequin and had moved on to writ-
ing single-title books. These authors had established repu-
tations. Harlequin could approach one or more of these
authors to sign with MIRA/Harlequin. Such an arrange-
ment would involve a multi-book contract and substantial
advances. While risky, this approach would ensure that
MIRA’s launch attracted attention.
A different, seemingly less risky alternative was to tap
into Harlequin’s extensive back-list collection and reissue a
selection of novels by current best-selling authors currently
signed with rival single-title publishers. The physical size of
the book and page length could be extended to 250 pages
from 192 by adjusting format. In addition, a new, MIRA-
branded cover could be produced to repackage the books.
Coincident with the launch of this back-list, Harlequin’s
editors would cultivate and develop existing series authors,
encouraging them to write single-title books for MIRA.
Returning to the strategic dilemma that Harlequin
faced, Swift commented on the challenge of successfully
launching MIRA:
Our biggest challenge is the requirement to publish
on a title-by-title basis. Every new book will have to
stand on its own, with its own cover, a new marketing
plan and possibly even an author tour. Can we as a
company develop the flexibility to remain nimble? How
patient should we be in waiting for success? Given
Worldwide’s poor results, how should we approach this
challenge?
A Different Format
Women’s fiction books were expected to have many
differences from well-defined series romance books.
Unlike series romance, topics would cover a broader
range of segments including general fiction, science fic-
tion, and mystery. Women’s fiction books would be lon-
ger in length: 100,000 to 400,000 words compared with a
series romance book length of 75,000 words. Naturally,
book sizes would be bigger in terms of page length:
from 250 to 400 pages versus a norm of 192 to 304 pages
for series romance.
Distribution
Harlequin had a strong distribution network for its se-
ries romances through supermarkets, drugstores, and
discount department stores. Single-title women’s fiction
novels required more mainstream distribution focusing
on retail bookstores. In addition, standing order distribu-
tion, a hallmark of Harlequin’s series romance business
model, would have to be abandoned in favor of relying
on orders generated by the distributor’s sales force for
single-titles.
Success in the United States would be key for MIRA,
and in this market, Harlequin relied upon Simon and
Schuster’s sales force. Since S&S was a major single-title
publisher, Harlequin did not know how much support
MIRA would be afforded. Harlequin was considering
offering better margins to the distributors than those
it offered for series romance distribution. Expenses for
single-title distribution were expected to be $0.27 per book.
MIRA books would rely more heavily upon distri-
bution through bookstores when distributed through the
same channels as the series product. Retailers would be en-
couraged to shelve MIRA books separately from the series
offering. The more intensive selling effort for single titles
would require 4 percent of the single title retail price. The
new single-title program planned to offer $3.38 in margin
to the distribution channel for single-title books (50 percent
of the typical retail price of $6.75) versus $2.42 for series
books (45 percent of the $4.40 suggested retail price).
Acquiring Single-Title Rights
Harlequin subsidiaries in some countries were already buying
rights to publish single titles. By launching MIRA Harlequin
could negotiate better global-author deals. The task force re-
port added: “By acquiring mainstream titles through a central
M03A_BARN0088_05_GE_CASE4.INDD 54 13/09/14 3:27 PM

Case 1–4: Harlequin Enterprises: The Mira Decision PC 1–55
End Notes
1. To protect confidentiality, all financial information within this case study has been
disguised.
2. This section is adapted from the Richard Ivey School of Business case # 9A87M002.
Harlequin Enterprises Limited—1979, Peter Killing.
3. All amounts are a percentage of the suggested retail price.
4. Numbers are for the typical paperback. Hardcover books cost more to produce,
but as a percentage of its higher retail price, printing costs were roughly the same
proportion.
5. All amounts in Canadian dollars unless otherwise specified.
M03A_BARN0088_05_GE_CASE4.INDD 55 13/09/14 3:27 PM

M03A_BARN0088_05_GE_CASE4.INDD 56 13/09/14 3:27 PM

Business-LeveL
strategies
2
P a r t
M04_BARN0088_05_GE_C04.INDD 121 17/09/14 4:45 PM

122
1. Define cost leadership.
2. Identify six reasons firms can differ in their costs.
3. Identify four reasons economies of scale can exist and
four reasons diseconomies of scale can exist.
4. Explain the relationship between cost advantages due
to learning-curve economies and a firm’s market share,
as well as the limitations of this logic.
5. Identify how cost leadership helps neutralize each of
the major threats in an industry.
t he World’s Lowest-Cost a irline
Everyone’s heard of lo w-cost airlines—Southwest, EasyJet, and JetBlue , for example. But ha ve you
heard of the w orld’s lowest-cost airline? This airline currently gives 25 per cent of its sea ts away for
free. Its goal is t o double tha t within a c ouple of y ears. And yet, in 2013, this air line announced re-
cord annual profits of €569 million, up 13 percent; an increase in passenger traffic of 5 percent (from
€75.8 million t o €79.3 million); and an incr ease in r evenues of 13 per cent (from €4325 million t o
€4884 million). And this in spite of continued increases in jet fuel prices during this same time period!
The name of this air line is R yanair. Headquartered in D ublin, Ireland, Ryanair flies shor t flights
throughout Western Europe. In 1985, R yanair’s founders started a small air line to fly between Ireland
and England. For six years, this airline barely broke even. Then, in 1991, Michael O’Leary—current CEO
at Ryanair—was brought on boar d. O’Leary traveled to the Unit ed States and studied the most suc –
cessful low-cost airline in the world at that time: Southwest Airlines. O’Leary became convinced that,
once European airspace was deregulated, an air line that adopted Southwest’s model of quick tur n-
arounds, no frills, no business class, flying into smaller regional airports, and using only a single kind of
aircraft could be extremely successful. Prices in the European air market were fully deregulated in 1997.
Since then, Ryanair has become an even lower-cost airline than Southwest. Indeed, it calls
itself the only “ultra-low cost carrier.”
For example, like S outhwest, Ryanair only flies a single t ype of air craft—a Boeing 737–800.
However, to save on the cost of its airplanes, Ryanair orders them without window shades and with
6. Identify the bases of cost leadership that are more
likely to be rare and costly to imitate.
7. Explain how firms use a functional organizational
structure to implement business-level strategies, such
as cost leadership.
8. Describe the formal and informal management
controls and compensation policies firms use to
implement cost leadership strategies.
L e a r n i n g O b j e C t i v e s After reading this chapter, you should be able to:
MyManagementLab®
improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
4
C h a P t e r
Cost Leadership
M04_BARN0088_05_GE_C04.INDD 122 17/09/14 4:45 PM

123
seats that do not r ecline. This saves several hundred thousand
dollars per plane and also r educes ongoing maintenance costs.
Both Southwest and R yanair try to make it easy f or consumers
to order tickets online, thereby avoiding the costs of call centers
and travel agents. However, just 59 percent of Southwest’s tick-
ets are sold online; 98 percent of Ryanair’s tickets are sold online.
This focus on low costs allows Ryanair to have the lowest
prices possible for a seat on its airplanes. The a verage fare on
Southwest is $92; the average fare on Ryanair is $53. But, even at
those low prices, Ryanair is still able to earn comfortable margins.
However, those net margins don’t come just from Ryanair’s
low costs. They also reflect the fact that the fare you pay Ryanair
includes only the seat and virtually no other services. If you want any other services, you have to pay
extra for them. For example, you want to check bags? It will cost $9.95 per bag. You want a snack on
the airplane? It will cost you $5.50. For that, you get a not-very-tasty hot dog. You want a bottle of
water? It will cost you $3.50. You want a blanket or pillow—they cost $2.50 each.
In addition, flight attendants will sell y ou all sor ts of extras to keep you occupied during your
flight. These include scratch-card games, perfume, digital cameras ($137.50), and MP3 players ($165).
During 2007, Ryanair began offering in-flight mobile telephone service. Not only did this enable pas –
sengers to call their friends and family, Ryanair also used this service to introduce mobile gambling on
its planes. Now, on your way from London to Paris, you can play blackjack, poker, and slot machines.
Finally, to further increase revenues, Ryanair sells space on its planes t o advertisers. When
your seat tray is up, you may see an ad for a cell phone from Vodaphone. When the tray is down,
you may see an ad from Hertz.
All of these ac tions enable R yanair to keep its pr ofits up while keeping its far es as lo w as
possible. And the results of this str ategy have been impressive—from near bank ruptcy in 1991,
Ryanair is now among the largest international airlines in the world.
Of course, this suc cess did not happen without some c ontroversy. For example, in O ctober
2006, Ryanair was chosen as the most disliked E uropean airline in a poll of some 4,000 r eaders of
TripAdvisor, a British Web site for frequent travelers. Ryanair’s response: These frequent travelers usu-
ally have their companies pay for their travel. If they had to pay for their own tickets, they would pre-
fer Ryanair. Also, Ryanair’s strong anti-union stance has caused it political pr oblems in many of the
union-dominated countries where it flies. Finally, Ryanair has been criticized for some of its lax secu-
rity and safety procedures, for how it treats disabled passengers, and for the cleanliness of its planes.
However, if you want to fly from London to Barcelona for $49 round trip, it’s hard to beat Ryanair.
Source: K. Capell (2006). “Wal-Mart with wings.” BusinessWeek, November 27, pp. 44–46; www//en.wikipedia.org/wiki/Ryanair;
and Peter Arnold, Inc. www.Ryanair.com
©
im
ag
eb
ro
ke
r/
Al
am
y
M04_BARN0088_05_GE_C04.INDD 123 17/09/14 4:45 PM

124 Part 2: Business-Level strategies
ryanair has been profitable in an industry—the airline industry—that has historically been populated by bankrupt firms. It does this by implementing an aggressive low-cost strategy.
What Is Business-Level Strategy?
Part 1 of this book introduced the basic tools required to conduct a strategic analy-
sis: tools for analyzing external threats and opportunities (in Chapter 2) and tools
for analyzing internal strengths and weaknesses (in Chapter 3). Once these two
analyses have been completed, it is possible to begin making strategic choices. As
explained in Chapter 1, strategic choices fall into two large categories: business
strategies and corporate strategies. Business-level strategies are actions firms
take to gain competitive advantages in a single market or industry. Corporate-
level strategies are actions firms take to gain competitive advantages by operat-
ing in multiple markets or industries simultaneously.
The two business-level strategies discussed in this book are cost leadership
(this chapter) and product differentiation (Chapter 5). The importance of these
two business-level strategies is so widely recognized that they are often called
generic business strategies.
What Is Cost Leadership?
A firm that chooses a cost leadership business strategy focuses on gaining
advantages by reducing its costs to below those of all its competitors. This does
not mean that this firm abandons other business or corporate strategies. Indeed,
a single-minded focus on just reducing costs can lead a firm to make low-cost
products that no one wants to buy. However, a firm pursuing a cost leadership
strategy focuses much of its effort on keeping its costs low.
Numerous firms have pursued cost leadership strategies. Ryanair clearly
follows this strategy in the airline industry, Timex and Casio in the watch indus-
try, and BIC in the disposable pen and razor market. All these firms advertise
their products. However, these advertisements tend to emphasize reliability and
low prices—the kinds of product attributes that are usually emphasized by firms
pursuing cost leadership strategies.
In automobiles, Fiat has implemented a cost leadership strategy with its
emphasis on low-priced cars for basic transportation. Like Ryanair, Timex, Casio,
and BIC, Fiat spends a significant amount of money advertising its products, but
its advertisements tend to emphasize its sporty sexy styling and low price. Fiat has
positioned its cars as fun and inexpensive, not a high-performance sports car or a
luxurious status symbol. Fiat’s ability to sell these fun and inexpensive automobiles
depends on its design choices (keep it simple) and its low manufacturing costs.1
Sources of Cost Advantages
An individual firm may have a cost advantage over its competitors for a number
of reasons. Cost advantages are possible even when competing firms produce
similar products. Some of the most important of these sources of cost advantage
are listed in Table 4.1 and discussed in this section.
M04_BARN0088_05_GE_C04.INDD 124 17/09/14 4:45 PM

Chapter 4: Cost Leadership 125
Low
Volume of Production
$
Pe
r
U
ni
t
C
os
t
of
P
ro
du
ct
io
n
X High
Figure 4.1 Economies
of Scale
s ize Differences and economies of s cale
One of the most widely cited sources of cost advantages for a firm is its size.
When there are significant economies of scale in manufacturing, marketing,
distribution, service, or other functions of a business, larger firms (up to some
point) have a cost advantage over smaller firms. The concept of economies of
scale was first defined in Chapter 2. Economies of scale are said to exist when
the increase in firm size (measured in terms of volume of production) is associ-
ated with lower costs (measured in terms of average costs per unit of produc-
tion), as depicted in Figure 4.1. As the volume of production in a firm increases,
the average cost per unit decreases until some optimal volume of production
(point X) is reached, after which the average costs per unit of production begins
to rise because of diseconomies of scale (a concept discussed in more detail
later in this chapter).
If the relationship between volume of production and average costs per
unit of production depicted in Figure 4.1 holds, and if a firm in an industry has
the largest volume of production (but not greater than the optimal level, X),
then that firm will have a cost advantage in that industry. Increasing the volume
of production can reduce a firm’s costs for several reasons. Some of the most
important of these reasons are summarized in Table 4.2 and discussed in the
following text.
v olume of Production and s pecialized Machines. When a firm has high levels of
production, it is often able to purchase and use specialized manufacturing tools
that cannot be kept in operation in small firms. Manufacturing managers at BIC
1. Size differences and economies of scale
2. Size differences and diseconomies of scale
3. Experience differences and learning-curve economies
4. Differential low-cost access to productive inputs
5. Technological advantages independent of scale
6. Policy choices
TAble 4.1 Important Sources
of Cost Advantages for Firms
M04_BARN0088_05_GE_C04.INDD 125 17/09/14 4:45 PM

126 Part 2: Business-Level strategies
Corporation, for example, have emphasized this important advantage of high
volumes of production. A former director of manufacturing at BIC once observed:
We are in the automation business. Because of our large volume, one tenth of 1 cent
in savings turns out to be enormous. . . . One advantage of the high-volume busi-
ness is that you can get the best equipment and amortize it entirely over a short
period of time (4 to 5 months). I’m always looking for new equipment. If I see a cost-
savings machine, I can buy it. I’m not constrained by money.2
Only firms with BIC’s level of production in the pen industry have the ability to
reduce their costs in this manner.
v olume of Production and the Cost of Plant and equipment. High volumes of produc-
tion may also enable a firm to build larger manufacturing operations. In some
industries, the cost of building these manufacturing operations per unit of pro-
duction is lower than the cost of building smaller manufacturing operations per
unit of production. Thus, large-volume firms, other factors being equal, will be
able to build lower-per-unit-cost manufacturing operations and will have lower
average costs of production.
The link between volume of production and the cost of building manufac-
turing operations is particularly important in industries characterized by process
manufacturing—chemical, oil refining, paper and pulp manufacturing, and so
forth. Because of the physical geometry of process manufacturing facilities, the
costs of constructing a processing plant with increased capacity can be expected
to rise as the two-thirds power of a plant’s capacity. This is because the area of the
surface of some three-dimensional containers (such as spheres and cylinders) in-
creases at a slower rate than the volume of these containers. Thus, larger contain-
ers hold greater volumes and require less material per unit volume for the outside
skins of these containers. Up to some point, increases in capacity come at a less-
than-proportionate rise in the cost of building this capacity.3
For example, it might cost a firm $100 to build a plant with a capacity of
1,000 units, for a per-unit average cost of $0.01. But, assuming that the “two-thirds
rule” applies, it might cost a firm $465 to build a plant with a capacity of 10,000 units
(465 = 10,0002/3), for a per-unit average cost of $0.0046. The difference between
$0.01 per unit and $0.0046 per unit represents a cost advantage for a large firm.
v olume of Production and employee s pecialization. High volumes of production are
also associated with high levels of employee specialization. As workers specialize
in accomplishing a narrow task, they can become more and more efficient at this
task, thereby reducing their firm’s costs. This reasoning applies both in special-
ized manufacturing tasks (such as the highly specialized manufacturing functions
in an assembly line) and in specialized management functions (such as the highly
specialized managerial functions of accounting, finance, and sales).
TAble 4.2 Why Higher
Volumes of Production in a Firm
Can Lead to Lower Costs
With higher production volume . . .
1. firms can use specialized machines . . .
2. firms can build larger plants . . .
3. firms can increase employee specialization . . .
4. firms can spread overhead costs across more units produced . . .
. . . which can lower per-unit production costs.
M04_BARN0088_05_GE_C04.INDD 126 17/09/14 4:45 PM

Chapter 4: Cost Leadership 127
Smaller firms often do not possess the volume of production needed to jus-
tify this level of employee specialization. With smaller volumes of production,
highly specialized employees may not have enough work to keep them busy an
entire workday. This low volume of production is one reason why smaller firms
often have employees that perform multiple business functions and often use out-
side contract employees and part-time workers to accomplish highly specialized
functions, such as accounting, taxes, and human resource management.
v olume of Production and Overhead Costs. A firm with high volumes of produc-
tion has the luxury of spreading its overhead costs over more units and thereby
reducing the overhead costs per unit. Suppose, in a particular industry, that the
operation of a variety of accounting, control, and research and development
functions, regardless of a firm’s size, is $100,000. Clearly, a firm that manufac-
tures 1,000 units is imposing a cost of $100 per unit to cover overhead expenses.
However, a firm that manufactures 10,000 units is imposing a cost of $10 per unit
to cover overhead. Again, the larger-volume firm’s average per-unit costs are
lower than the small-volume firm’s average per-unit cost.
s ize Differences and Diseconomies of s cale
Just as economies of scale can generate cost advantages for larger firms, impor-
tant diseconomies of scale can actually increase costs if firms grow too large. As
Figure 4.1 shows, if the volume of production rises beyond some optimal point
(point X in the figure), this can actually lead to an increase in per-unit costs. If
other firms in an industry have grown beyond the optimal firm size, a smaller
firm (with a level of production closer to the optimal) may obtain a cost advan-
tage even when all firms in the industry are producing very similar products.
Some important sources of diseconomies of scale for a firm are listed in Table 4.3
and discussed in this section.
Physical Limits to efficient s ize. Applying the two-thirds rule to the construc-
tion of manufacturing facilities seems to imply, for some industries at least, that
larger is always better. However, there are some important physical limitations
to the size of some manufacturing processes. Engineers have found, for example,
that cement kilns develop unstable internal aerodynamics at capacities of above
7 million barrels per year. Others have suggested that scaling up nuclear reactors
from small installations to huge facilities generates forces and physical processes
that, though undetectable in smaller facilities, can become significant in larger
operations. These physical limitations on manufacturing processes reflect the un-
derlying physics and engineering in a manufacturing process and suggest when
the cost curve in Figure 4.1 will begin to rise.4
Managerial Diseconomies. Although the underlying physics and engineering in
a manufacturing process have an important impact on a firm’s costs, managerial
diseconomies are perhaps an even more important cause of these cost increases.
When the volume of production gets too large . . .
1. physical limits to efficient size . . .
2. managerial diseconomies . . .
3. worker de-motivation . . .
4. distance to markets and suppliers . . .
. . . can increase per-unit costs.
TAble 4.3 Major Sources of
Diseconomies of Scale
M04_BARN0088_05_GE_C04.INDD 127 17/09/14 4:45 PM

128 Part 2: Business-Level strategies
As a firm increases in size, it often increases in complexity, and the ability of man-
agers to control and operate it efficiently becomes limited.
One well-known example of a manufacturing plant that grew too large
and thus became inefficient is Crown, Cork and Seal’s can-manufacturing plant
in Philadelphia. Through the early part of this century, this Philadelphia facil-
ity handled as many as 75 different can-manufacturing lines. The most efficient
plants in the industry, however, were running from 10 to 15 lines simultaneously.
The huge Philadelphia facility was simply too large to operate efficiently and was
characterized by large numbers of breakdowns, a high percentage of idle lines,
and poor-quality products.5
Worker De-Motivation. A third source of diseconomies of scale depends on the re-
lationship between firm size, employee specialization, and employee motivation.
It has already been suggested that one of the advantages of increased volumes of
production is that it allows workers to specialize in smaller and more narrowly
defined production tasks. With specialization, workers become more and more
efficient at the particular task facing them.
However, a significant stream of research suggests that these types of very
specialized jobs can be unmotivating for employees. Based on motivational theo-
ries taken from social psychology, this work suggests that as workers are removed
further from the complete product that is the end result of a manufacturing
process, the role that a worker’s job plays in the overall manufacturing process
becomes more and more obscure. As workers become mere “cogs in a manufac-
turing machine,” worker motivation wanes, and productivity and quality can
both suffer.6
Distance to Markets and s uppliers. A final source of diseconomies of scale can
be the distance between a large manufacturing facility and where the goods
in question are to be sold or where essential raw materials are purchased. Any
reductions in cost attributable to the exploitation of economies of scale in manu-
facturing may be more than offset by large transportation costs associated with
moving supplies and products to and from the manufacturing facility. Firms that
build highly efficient plants without recognizing these significant transportation
costs may put themselves at a competitive disadvantage compared to firms with
slightly less efficient plants that are located closer to suppliers and key markets.
experience Differences and Learning-Curve economies
A third possible source of cost advantages for firms in a particular business de-
pends on their different cumulative levels of production. In some circumstances,
firms with the greatest experience in manufacturing a product or service will have
the lowest costs in an industry and thus will have a cost-based advantage. The
link between cumulative volumes of production and cost has been formalized in
the concept of the learning curve. The relationship between cumulative volumes
of production and per-unit costs is graphically represented in Figure 4.2.
t he Learning Curve and economies of s cale. As depicted in Figure 4.2, the learning
curve is very similar to the concept of economies of scale. However, there are two
important differences. First, whereas economies of scale focus on the relationship
between the volume of production at a given point in time and average unit costs,
the learning curve focuses on the relationship between the cumulative volume of
production—that is, how much a firm has produced over time—and average unit
costs. Second, where diseconomies of scale are presumed to exist if a firm gets too
M04_BARN0088_05_GE_C04.INDD 128 17/09/14 4:45 PM

Chapter 4: Cost Leadership 129
large, there is no corresponding increase in costs in the learning-curve model as
the cumulative volume of production grows. Rather, costs continue to fall until
they approach the lowest technologically possible cost.
t he Learning Curve and Cost a dvantages. The learning-curve model is based
on the empirical observation that the costs of producing a unit of output fall
as the cumulative volume of output increases. This relationship was first
observed in the construction of aircraft before World War II. Research showed
that the labor costs per aircraft fell by 20 percent each time the cumulative
volume of production doubled.7 A similar pattern has been observed in nu-
merous industries, including the manufacture of ships, computers, spacecraft,
and semiconductors. In all these cases, increases in cumulative production
have been associated with detailed learning about how to make production as
efficient as possible.
However, learning-curve cost advantages are not restricted to manufactur-
ing. Learning can be associated with any business function, from purchasing
raw materials to distribution and service. Service industries can also experience
important learning effects. The learning curve applies whenever the cost of
accomplishing a business activity falls as a function of the cumulative number of
times a firm has engaged in that activity.8
t he Learning Curve and Competitive a dvantage. The learning-curve model sum-
marized in Figure 4.2 has been used to develop a model of cost-based competitive
advantage that links learning with market share and average production costs.9
The logic behind this application of the learning-curve model is straightfor-
ward: The first firm that successfully moves down the learning curve will obtain
a cost advantage over rivals. To move a production process down the learning
curve, a firm needs to have higher levels of cumulative volume of production.
Of course, firms successful at producing high volumes of output need to sell
that output to customers. In selling this output, firms are increasing their market
share. Thus, to drive down the learning curve and obtain a cost advantage, firms
must aggressively acquire market share.
This application of learning-curve logic has been criticized by a wide variety of
authors.10 Two criticisms are particularly salient. First, although the acquisition of
Cumulative Volume of Production (units)
P
er
U
ni
t
C
os
ts
(
$)

Figure 4.2 The Learning
Curve and the Cost of
Production
M04_BARN0088_05_GE_C04.INDD 129 17/09/14 4:45 PM

130 Part 2: Business-Level strategies
market share is likely to allow a firm to reduce its production costs, the acquisition
of share itself is expensive. Indeed, as described in the Research Made Relevant fea-
ture, sometimes the cost of acquiring share may rise to equal its value.
The second major criticism of this application of the learning-curve model
is that there is, in this logic, no room for any other business or corporate strate-
gies. In other words, this application of the learning curve implicitly assumes that
firms can compete only on the basis of their low costs and that other strategies are
not possible. Most industries, however, are characterized by opportunities for at
least some of these other strategies, and thus this strict application of the learning-
curve model can be misleading.11
These criticisms aside, it is still the case that in many industries firms
with larger cumulative levels of production, other things being equal, will have
lower average production costs. Thus, experience in all the facets of production
can be a source of cost advantage even if the single-minded pursuit of market
share to obtain these cost reductions may not give a firm above normal eco-
nomic returns.
Differential Low-Cost a ccess to Productive inputs
Besides economies of scale, diseconomies of scale, and learning-curve cost advan-
tages, differential low-cost access to productive inputs may create cost differences
among firms producing similar products in an industry. Productive inputs are
any supplies used by a firm in conducting its business activities; they include,
among other things, labor, capital, land, and raw materials. A firm that has dif-
ferential low-cost access to one or more of these factors is likely to have lower
economic costs compared to rivals.
Consider, for example, an oil company with fields in Saudi Arabia com-
pared to an oil company with fields in the North Sea. The cost of obtaining crude
oil for the first firm is considerably less than the cost of obtaining crude oil for
the second. North Sea drilling involves the construction of giant offshore drill-
ing platforms, housing workers on floating cities, and transporting oil across an
often-stormy sea. Drilling in Saudi Arabia requires only the simplest drilling tech-
nologies because the oil is found relatively close to the surface.
Of course, in order to create a cost advantage, the cost of acquiring low-cost
productive inputs must be less than the cost savings generated by these factors.
For example, even though it may be much less costly to drill for oil in Saudi
Arabia than in the North Sea, if it is very expensive to purchase the rights to
drill in Saudi Arabia compared to the costs of the rights to drill in the North Sea,
the potential cost advantages of drilling in Saudi Arabia can be lost. As with all
sources of cost advantages, firms must be careful to weigh the cost of acquiring
that advantage against the value of that advantage for the firm.
Differential access to raw materials such as oil, coal, and copper ore can be
important determinants of a cost advantage. However, differential access to other
productive inputs can be just as important. For example, it may be easier (i.e., less
costly) to recruit highly trained electronics engineers for firms located near where
these engineers receive their schooling than for firms located some distance
away. This lower cost of recruiting is a partial explanation of the development
of geographic technology centers such as Silicon Valley in California, Route 128
in Massachusetts, and the Research Triangle in North Carolina. In all three cases,
firms are located physically close to several universities that train the engineers
that are the lifeblood of high-technology companies. The search for low-cost labor
can create ethical dilemmas, as described in the Ethics and Strategy feature.
M04_BARN0088_05_GE_C04.INDD 130 17/09/14 4:45 PM

Chapter 4: Cost Leadership 131
Research on the relationship be-tween market share and firm per-
formance has continued over many
decades. Early work identified market
share as the primary determinant of
firm performance. Indeed, one par-
ticularly influential article identified
market share as being the key to firm
profitability.
This initial conclusion about the
relationship between market share
and firm performance was based on
the observed positive correlation be-
tween these two variables. That is,
firms with large market share tend to
be highly profitable; firms with low
market share tend to be less profitable.
The logical conclusion of this empiri-
cal finding seems to be that if a firm
wants to increase its profitability, it
should increase its market share.
Not so fast. It turns out that
the relationship between market share
and firm profits is not that simple.
Consider the following scenario:
Suppose that 10 companies all con-
clude that the key to their profitability
is gaining market share. To acquire
share from each other, each firm will
probably increase its advertising and
other marketing expenses as well as
reduce its prices. This has the effect
of putting a price on the market share
that a firm seeks to acquire—that is,
these competing firms are creating
what might be called a “market-for-
market share.” And because there
are 10 firms competing for share in
this market, this market is likely to be
highly competitive. Returns to acquir-
ing share in such competitive markets
for market share should fall to a nor-
mal economic level.
All this analysis suggests that al-
though there may be a cross-sectional
positive correlation between market
share and firm performance—that is,
at a given point in time, market share
and firm performance may be posi-
tively correlated—this correlation may
not be positive over time, as firms seek
to increase their market share. Several
papers have examined this hypothesis.
Two of the most influential of these
papers—by Dick Rumelt and Robin
Wensley and by Cynthia Montgomery
and Birger Wernerfelt—have shown
that markets for market share often do
emerge in industries, that these mar-
kets are often very competitive, and
that acquiring market share in these
competitive markets does not im-
prove a firm’s economic performance.
Indeed, in their study of the consolida-
tion of the beer industry Montgomery
and Wernerfelt showed that firms such
as Anheuser-Busch and Miller paid so
much for the market share they ac-
quired that it actually reduced their
profitability.
The general consensus in the lit-
erature now seems to be that large
market share is an outcome of a com-
petitive process within an industry, not
an appropriate objective of firm man-
agers, per se. Thus, firms with par-
ticularly valuable strategies will natu-
rally attract more customers, which, in
turn, suggests that they will often have
higher market share. That is, a firm’s
valuable strategies generate both high
levels of firm performance and large
market share. This, in turn, explains
the positive correlation between mar-
ket share and firm performance.
Sources: R. D. Buzzell, B. T. Gale, and R. M.
Sultan (1975). “Market share—the key to profit-
ability.” Harvard Business Review, 53, pp. 97–106;
R. Rumelt and R. Wensley (1981). “In search
of the market share effect.” Proceedings of the
Academy of Management Meetings, 1981, pp. 2–6; C.
Montgomery and B. Wernerfelt (1991). “Sources
of superior performance: Market share versus
industry effects in the U.S. brewing industry.”
Management Science, 37, pp. 954–959.
How Valuable Is
Market Share—Really?
research Made relevant
technological a dvantages independent of s cale
Another possible source of cost advantage in an industry may be the different
technologies that firms employ to manage their business. It has already been sug-
gested that larger firms may have technology-based cost advantages that reflect
their ability to exploit economies of scale (e.g., the two-thirds rule).
Traditionally, discussion of technology-based cost advantages has focused
on the machines, computers, and other physical tools that firms use to manage
M04_BARN0088_05_GE_C04.INDD 131 17/09/14 4:45 PM

132 Part 2: Business-Level strategies
their business. Clearly, in some industries, these physical technology differences
between firms can create important cost differences—even when the firms in
question are approximately the same size in terms of volume of production. In
the steel industry, for example, technological advances can substantially reduce
the cost of producing steel. Firms with the latest steel-manufacturing technol-
ogy will typically enjoy some cost advantage compared to similar-sized firms
that do not have the latest technology. The same applies in the manufacturing of
semiconductors, automobiles, consumer electronics, and a wide variety of other
products.12
These physical technology cost advantages apply in service firms as well as
in manufacturing firms. For example, early in its history Charles Schwab, a lead-
ing discount brokerage, purchased a computer system that enabled it to complete
customer transactions more rapidly and at a lower cost than its rivals.13 Kaiser-
Permanente, the largest HMO in the United States, has invested in information
technology that doctors can use to avoid incorrect diagnoses and procedures
that can adversely affect a patient’s health. By avoiding these medical mis-
takes, Kaiser-Permanente can substantially reduce its costs of providing medical
service.14
However, the concept of technology can be easily broadened to include not
just the physical tools that firms use to manage their business, but any processes
within a firm used in this way. This concept of firm technology includes not only
the technological hardware of companies—the machines and robots—but also
the technological software of firms—things such as the quality of relations be-
tween labor and management, an organization’s culture, and the quality of mana-
gerial controls. All these characteristics of a firm can have an impact on a firm’s
economic costs.15
Policy Choices
Thus far, this discussion has focused on reasons why a firm can gain a cost advan-
tage despite producing products that are similar to competing firms’ products.
When firms produce essentially the same outputs, differences in economies of
scale, learning-curve advantages, differential access to productive inputs, and
differences in technology can all create cost advantages (and disadvantages) for
them. However, firms can also make choices about the kinds of products and
services they will sell—choices that have an impact on their relative cost position.
These choices are called policy choices.
In general, firms that are attempting to implement a cost leadership strat-
egy will choose to produce relatively simple standardized products that sell for
relatively low prices compared to the products and prices firms pursuing other
business or corporate strategies choose. These kinds of products often tend to
have high volumes of sales, which (if significant economies of scale exist) tend to
reduce costs even further.
These kinds of choices in product and pricing tend to have a very broad
impact on a cost leader’s operations. In these firms, the task of reducing costs is
not delegated to a single function or a special task force within the firm, but is
the responsibility of every manager and employee. Cost reduction sometimes be-
comes the central objective of the firm. Indeed, in this setting management must
be constantly alert to cost-cutting efforts that reduce the ability of the firm to meet
customers’ needs. This kind of cost-cutting culture is central to Ryanair’s ability to
implement its cost leadership strategy.
M04_BARN0088_05_GE_C04.INDD 132 17/09/14 4:45 PM

Chapter 4: Cost Leadership 133
O ne of the most important produc-tive inputs in almost all compa-
nies is labor. Getting differential low-
cost access to labor can give a firm a
cost advantage.
This search for low labor costs
has led some firms to engage in an
international “race to the bottom.”
It is well known that the wage rates
of most U.S. and Western European
workers are much higher than the
wage rates of workers in other, less
developed parts of the world. While a
firm might have to pay its employees
$20 per hour (in wages and benefits) to
make sneakers and basketball shoes in
the United States, that same firm may
only have to pay an employee in the
Philippines or Malaysia or China $1.00
per day to make the same sneakers
and basketball shoes—shoes the firm
might be able to sell for $250 a pair in
the United States and Europe. Thus,
many firms look to overseas manu-
facturing as a way to keep their labor
cost low.
But this search for low labor cost
has some important unintended con-
sequences. First, the location of the
lowest cost labor rates in the world
changes over time. It used to be that
Mexico had the lowest labor rates,
then Korea and the Philippines, then
Malaysia, then China, now Vietnam.
As the infrastructures of each of these
countries evolve to the point that they
can support worldwide manufactur-
ing, firms abandon their relationships
with firms in prior countries in search
of still lower costs in new countries.
The only way former “low-cost cen-
ters” can compete is to drive their
costs even lower.
This sometimes leads to a sec-
ond unintended consequence of the
“race to the bottom”: horrendous
working conditions and low wages in
these low-cost manufacturing settings.
Employees earning $1 for working a
10-hour day, six days a week may
look good on the corporate bottom
line, but many observers are deeply
concerned about the moral and ethi-
cal issues associated with this strategy.
Indeed, several companies—including
Nike and Kmart—have been forced to
increase the wages and improve the
working conditions of many of their
overseas employees.
An even more horrific result of
this “race to the bottom” has been the
reemergence of what amounts to slav-
ery in some Western European coun-
tries and some parts of the United
States. In search of the promise of a
better life, illegal immigrants are some-
times brought to Western European
countries or the United States and
forced to work in illegal, underground
factories. These illegal immigrants are
sometimes forced to work as many as
20 hours a day, for little or no pay—
supposedly to “pay off” the price of
bringing them out of their less devel-
oped countries. And because of their
illegal status and language barriers,
they often do not feel empowered to
go to the local authorities.
Of course, the people who create
and manage these facilities are crimi-
nals and deserve contempt. But what
about the companies that purchase the
services of these illegal and immoral
manufacturing operations? Aren’t
they also culpable, both legally and
morally?
Sources: R. DeGeorge (2000). “Ethics in inter-
national business—A contradiction in terms?”
Business Credit, 102, pp. 50+; G. Edmondson,
K. Carlisle, I. Resch, K. Nickel Anhalt, and
H. Dawley (2000). “Workers in bondage.”
BusinessWeek, November 27, pp. 146+; D. Winter
(2000). “Facing globalization.” Ward’s Auto World,
36, pp. 7+.
ethics and strategy
The Race to the bottom
The Value of Cost Leadership
There is little doubt that cost differences can exist among firms, even when those
firms are selling very similar products. Policy choices about the kinds of products
firms in an industry choose to produce can also create important cost differences.
But under what conditions will these kinds of cost advantages actually create
value for a firm?
V R I O
M04_BARN0088_05_GE_C04.INDD 133 17/09/14 4:45 PM

134 Part 2: Business-Level strategies
Cost leadership and environmental Threats
It was suggested in Chapter 3 that one way to tell if a resource or capability—such
as the ability of a firm to have a cost advantage—actually creates value for a firm
is by whether that resource or capability enables a firm to neutralize its external
threats or exploit its external opportunities. The ability of a cost leadership posi-
tion to neutralize external threats will be examined here. The ability of such a
position to enable a firm to exploit opportunities will be left as an exercise. The
specific economic consequences of cost leadership are discussed in the Strategy in
Depth feature.
A cost leadership competitive strategy helps reduce the threat of new
entrants by creating cost-based barriers to entry. Recall that many of the barri-
ers to entry cited in Chapter 2, including economies of scale and cost advantages
independent of scale, assume that incumbent firms have lower costs than poten-
tial entrants. If an incumbent firm is a cost leader, for any of the reasons just listed,
then new entrants may have to invest heavily to reduce their costs prior to entry.
Often, new entrants will enter using another business strategy (e.g., product
differentiation) rather than attempting to compete on costs.
Firms with a low-cost position also reduce the threat of rivalry. The threat
of rivalry is reduced through pricing strategies that low-cost firms can engage in
and through their relative impact on the performance of a low-cost firm and its
higher-cost rivals.
As suggested in Chapter 2, substitutes become a threat to a firm when their
cost and performance, relative to a firm’s current products or services, become
more attractive to customers. Thus, when the price of crude oil goes up, substi-
tutes for crude oil become more attractive. When the cost and performance of elec-
tronic calculators improve, demand for mechanical adding machines disappears.
In this situation, cost leaders have the ability to keep their products and ser-
vices attractive relative to substitutes. While high-cost firms may have to charge
high prices to cover their costs, thus making substitutes more attractive, cost
leaders can keep their prices low and still earn normal or above-normal economic
profits.
Suppliers can become a threat to a firm by charging higher prices for the
goods or services they supply or by reducing the quality of those goods or ser-
vices. However, when a supplier sells to a cost leader, that firm has greater flex-
ibility in absorbing higher-cost supplies than does a high-cost firm. Higher supply
costs may destroy any above-normal profits for high-cost firms but still allow a
cost leader firm to earn an above-normal profit.
Cost leadership based on large volumes of production and economies of
scale can also reduce the threat of suppliers. Large volumes of production imply
large purchases of raw materials and other supplies. Suppliers are not likely to
jeopardize these sales by threatening their customers. Indeed, as was suggested
earlier, buyers are often able to use their purchasing volume to extract volume
discounts from suppliers.
Cost leadership can also reduce the threat of buyers. Powerful buyers are a
threat to firms when they insist on low prices or higher quality and service from
their suppliers. Lower prices threaten firm revenues; higher quality can increase
a firm’s costs. Cost leaders can have their revenues reduced by buyer threats and
still have normal or above-normal performance. These firms can also absorb the
greater costs of increased quality or service and still have a cost advantage over
their competition.
M04_BARN0088_05_GE_C04.INDD 134 17/09/14 4:45 PM

Chapter 4: Cost Leadership 135
Q2 Q1
Price
Quantity
P*
MC2 MC1 ATC2
ATC1
Figure 4.3 Cost Leadership
and Economic Performance
A nother way to demonstrate that cost leadership can be a source of
economic value is to directly examine
the economic profits generated by a
firm with a cost advantage operating
in an otherwise very competitive in-
dustry. This is done in Figure 4.3.
The firms depicted in this figure
are price takers—that is, the price
of the products or services they sell is
determined by market conditions and
not by individual decisions of firms.
This implies that there is effectively no
product differentiation in this market
and that no one firm’s sales constitute
a large percentage of this market.
The price of goods or services in
this type of market (P*) is determined
by aggregate industry supply and de-
mand. This industry price determines
the demand facing an individual firm
in this market. Because these firms
are price takers, the demand facing an
individual firm is horizontal—that is,
firm decisions about levels of output
have a negligible impact on overall
industry supply and thus a negligi-
ble impact on the market- determined
price. A firm in this setting maxi-
mizes its economic performance by
curve ATC1 and marginal-cost curve
MC1. Notice that ATC1 is less than
ATC2 at the performance-maximizing
quantities produced by these two
kinds of firms (Q1 and Q2, respec-
tively). In this particular example,
firms with common average-total-
cost curves are earning zero economic
profits, while the low-cost firm is
earning an economic profit (equal to
the shaded area in the figure). A va-
riety of other examples could also
be constructed: The cost leader firm
could be earning zero economic prof-
its, while other firms in the market
are incurring economic losses; the
cost leader firm could be earning sub-
stantial economic profits, while other
firms are earning smaller economic
profits; the cost leader firm could
be incurring small economic losses,
while the other firms are incurring
substantial economic losses; and so
forth. However, in all these examples
the cost leader’s economic perfor-
mance is greater than the economic
performance of other firms in the in-
dustry. Thus, cost leadership can have
an important impact on a firm’s eco-
nomic performance.
producing a quantity of output (Q)
so that marginal revenue equals mar-
ginal cost (MC). The ability of firms
to earn economic profits in this set-
ting depends upon the relationship
between the market-determined price
(P*) and the average total cost (ATC)
of a firm at the quantity it chooses to
produce.
Firms in the market depicted in
Figure 4.3 fall into two categories. All
but one firm have the average-total-
cost curve ATC2 and marginal-cost
curve MC2. However, one firm in this
industry has the average-total-cost
The economics of Cost leadership
strategy in Depth
M04_BARN0088_05_GE_C04.INDD 135 17/09/14 4:45 PM

136 Part 2: Business-Level strategies
Buyers can also be a threat through backward vertical integration. Being a
cost leader deters backward vertical integration by buyers because a buyer that
vertically integrates backward will often not have costs as low as an incumbent
cost leader. Rather than vertically integrating backward and increasing its cost of
supplies, powerful buyers usually prefer to continue purchasing from their low-
cost suppliers.
Finally, if cost leadership is based on large volumes of production, then the
threat of buyers may be reduced because buyers may depend on just a few firms
for the goods or services they purchase. This dependence reduces the willingness
of buyers to threaten a selling firm.
Cost Leadership and Sustained
Competitive Advantage
Given that cost leadership can be valuable, an important question becomes
“Under what conditions will firms implementing this business strategy be able
to maintain that leadership to obtain a sustained competitive advantage?” If cost
leadership strategies can be implemented by numerous firms in an industry or if
no firms face a cost disadvantage in imitating a cost leadership strategy, then be-
ing a cost leader will not generate a sustained competitive advantage for a firm.
As suggested in Chapter 3, the ability of a valuable cost leadership competitive
strategy to generate a sustained competitive advantage depends on that strategy
being rare and costly to imitate, either through direct duplication or substitution.
As suggested in Tables 4.4 and 4.5, the rarity and imitability of a cost leadership
strategy depend, at least in part, on the sources of that cost advantage.
The Rarity of Sources of Cost Advantage
Some of the sources of cost advantage listed in Table 4.4 are likely to be rare
among a set of competing firms; others are less likely to be rare. Sources of cost
advantage that are likely to be rare include learning-curve economies (at least in
emerging industries), differential low-cost access to productive inputs, and tech-
nological “software.” The remaining sources of cost advantage are less likely to
be rare.
V R I O
Likely-to-be-rare sources of cost
advantage
Less-likely-to-be-rare sources of cost
advantage
Learning-curve economies of scale
(especially in emerging businesses)
Economies of scale (except when effi-
cient plant size approximately equals
total industry demand)
Differential low-cost access to
productive inputs
Diseconomies of scale
Technological “software” Technological hardware (unless a
firm has proprietary hardware devel-
opment skills)
Policy choices
TAble 4.4 The Rarity of
Sources of Cost Advantage
M04_BARN0088_05_GE_C04.INDD 136 17/09/14 4:45 PM

Chapter 4: Cost Leadership 137
r are s ources of Cost a dvantage
Early in the evolution of an industry, substantial differences in the cumulative vol-
ume of production of different firms are not unusual. Indeed, this was one of the
major benefits associated with first-mover advantages, discussed in Chapter 2. These
differences in cumulative volume of production, in combination with substantial
learning-curve economies, suggest that, in some settings, learning-curve advantages
may be rare and thus a source of at least temporary competitive advantage.
The definition of differential access to productive inputs implies that this
access is often rare. Certainly, if large numbers of competing firms have this same
access, then it cannot be a source of competitive advantage.
Technological software is also likely to be rare among a set of competing
firms. These software attributes represent each firm’s path through history. If
these histories are unique, then the technological software they create may also be
rare. Of course, if several competing firms experience similar paths through his-
tory, the technological software in these firms is less likely to be rare.
Less r are s ources of Cost a dvantage
When the efficient size of a firm or plant is significantly smaller than the total size
of an industry, there will usually be numerous efficient firms or plants in that in-
dustry, and a cost leadership strategy based on economies of scale will not be rare.
For example, if the efficient firm or plant size in an industry is 500 units, and the
total size of the industry (measured in units produced) is 500,000 units, then there
are likely to be numerous efficient firms or plants in this industry, and economies
of scale are not likely to give any one firm a cost-based competitive advantage.
Cost advantages based on diseconomies of scale are also not likely to be
rare. It is unusual for numerous firms to adopt levels of production in excess of
optimal levels. If only a few firms are too large in this sense, then several compet-
ing firms in an industry that are not too large will have cost advantages over the
firms that are too large. However, because several firms will enjoy these cost ad-
vantages, they are not rare.
One important exception to this generalization may be when changes in
technology significantly reduce the most efficient scale of an operation. Given
such changes in technology, several firms may be inefficiently large. If a small
number of firms happen to be sized appropriately, then the cost advantages these
firms obtain in this way may be rare. Such changes in technology have made large
integrated steel producers “too big” relative to smaller mini-mills. Thus, mini-
mills have a cost advantage over larger integrated steel firms.
Technological hardware is also not likely to be rare, especially if it is devel-
oped by suppliers and sold on the open market. However, if a firm has propri-
etary technology development skills, it may possess rare technological hardware
that creates cost advantages.
Finally, policy choices by themselves are not likely to be a rare source of cost
advantage, particularly if the product or service attributes in question are easy to
observe and describe.
The Imitability of Sources of Cost Advantage
Even when a particular source of cost advantage is rare, it must be costly to imitate
in order to be a source of sustained competitive advantage. Both direct duplication
and substitution, as forms of imitation, are important. Again, the imitability of a
cost advantage depends, at least in part, on the source of that advantage.
M04_BARN0088_05_GE_C04.INDD 137 17/09/14 4:45 PM

138 Part 2: Business-Level strategies
easy-to-Duplicate s ources of Cost a dvantage
In general, economies of scale and diseconomies of scale are relatively easy-to-
duplicate bases of cost leadership. As can be seen in Table 4.5, these sources of
cost advantage do not build on history, uncertainty, or socially complex resources
and capabilities and thus are not protected from duplication for these reasons.
For example, if a small number of firms obtain a cost advantage based on
economies of scale and if the relationship between production scale and costs is
widely understood among competing firms, then firms at a cost disadvantage
will rapidly adjust their production to exploit these economies of scale. This can
be done by either growing a firm’s current operations to the point that the firm
exploits economies or by combining previously separate operations to obtain
these economies. Both actions enable a firm at a cost disadvantage to begin using
specialized machines, reduce the cost of plant and equipment, increase employee
specialization, and spread overhead costs more effectively.
Indeed, perhaps the only time economies of scale are not subject to low-cost
duplication is when the efficient size of operations is a significant percentage of total
demand in an industry. Of course, this is the situation described in Chapter 2’s dis-
cussion of economies of scale as a barrier to entry. For example, as suggested earlier,
BIC Corporation, with its dominant market share in the disposable pen market, has
apparently been able to gain and retain an important cost advantage in that market
based on economies of scale. BIC’s ability to retain this advantage reflects the fact
that the optimal plant size in the disposable pen market is a significant percentage of
the pen market, and thus economies of scale act as a barrier to entry in that market.
Like economies of scale, in many settings diseconomies of scale will not be
a source of sustained competitive advantage for firms that have not grown too
large. In the short run, firms experiencing significant diseconomies can shrink
the size of their operations to become more efficient. In the long run, firms that
fail to adjust their size will earn below-normal economic performance and cease
operations.
TAble 4.5 Direct Duplication
of Cost Leadership Basis for costly duplication

Source of Cost Advantage

History

Uncertainty
Social
Complexity
Low-cost
duplication
possible
1. Economies of scale — — —
2. Diseconomies of scale — — —
May be costly
to duplicate
3. Learning-curve
economies
* — —
4. Technological “hardware” — * *
5. Policy choices * — —
Usually costly
to duplicate
6. Differential low-cost access
to productive inputs
*** — **
7. Technological “software” *** ** ***
— = not a source of costly imitation, * = somewhat likely to be a source of costly
imitation, ** = likely to be a source of costly imitation, *** = very likely to be a source
of costly imitation
M04_BARN0088_05_GE_C04.INDD 138 17/09/14 4:45 PM

Chapter 4: Cost Leadership 139
Although in many ways reducing the size of operations to improve effi-
ciency seems like a simple problem for managers in firms or plants, in practice
it is often a difficult change to implement. Because of uncertainty, managers in
a firm or plant that is too large may not understand that diseconomies of scale
have increased their costs. Sometimes, managers conclude that the problem
is that employees are not working hard enough, that problems in production
can be fixed, and so forth. These firms or plants may continue their ineffi-
cient operations for some time, despite costs that are higher than the industry
average.16
Other psychological processes can also delay the abandonment of op-
erations that are too large. One of these phenomena is known as escalation of
commitment: Sometimes, managers committed to an incorrect (cost-increasing
or revenue-reducing) course of action increase their commitment to this action as
its limitations become manifest. For example, a manager who believes that the
optimal firm size in an industry is larger than the actual optimal size may remain
committed to large operations despite costs that are higher than the industry
average.17
For all these reasons, firms suffering from diseconomies of scale must often
turn to outside managers to assist in reducing costs. Outsiders bring a fresh view
to the organization’s problems and are not committed to the practices that gener-
ated the problems in the first place.18
bases of Cost Leadership t hat May be Costly to Duplicate
Although cost advantages based on learning-curve economies are rare (especially
in emerging industries), they are usually not costly to duplicate. As suggested in
Chapter 2, for learning-curve cost advantages to be a source of sustained competi-
tive advantage the learning obtained by a firm must be proprietary. Most recent
empirical work suggests that in most industries learning is not proprietary and
thus can be rapidly duplicated as competing firms move down the learning curve
by increasing their cumulative volume of production.19
However, the fact that learning is not costly to duplicate in most indus-
tries does not mean it is never costly to duplicate. In some industries, the ability
of firms to learn from their production experience may vary significantly. For
example, some firms treat production errors as failures and systematically pun-
ish employees who make those errors. These firms effectively reduce risk-taking
among their production employees and thus reduce the chances of learning how
to improve their production process. Alternatively, other firms treat production
errors as opportunities to learn how to improve their production process. These
firms are likely to move rapidly down the learning curve and retain cost advan-
tages, despite the cumulative volume of production of competing firms. These
different responses to production errors reflect the organizational cultures of
these different firms. Because organizational cultures are socially complex, they
can be very costly to duplicate.20
Because technological hardware can usually be purchased across supply
markets, it is also not likely to be difficult to duplicate. Sometimes, however,
technological hardware can be proprietary or closely bundled with other unique,
costly-to-duplicate resources controlled by a firm. In this case, technological hard-
ware can be costly to duplicate.
It is unusual, but not impossible, for policy choices, per se, to be a source
of sustained competitive cost advantages for a firm. As suggested earlier, if
the policies in question focus on easy to observe and easy to describe product
M04_BARN0088_05_GE_C04.INDD 139 17/09/14 4:45 PM

140 Part 2: Business-Level strategies
characteristics, then duplication is likely, and cost advantages based on policy
choices will be temporary. However, if policy choices reflect complex decision
processes within a firm, teamwork among different parts of the design and manu-
facturing process, or any of the software commitments discussed previously, then
policy choices can be a source of sustained competitive advantage, as long as only
a few firms have the ability to make these choices.
Indeed, most of the successful firms that operate in unattractive indus-
tries make policy choices that are costly to imitate because they reflect his-
torical, causally ambiguous, and socially complex firm processes. Thus, for
example, Wal-Mart’s supply chain management strategy—a policy with clear
low-cost implications—actually reflects Wal-Mart’s unique history, its socially
complex relations with suppliers, and its unique organizational culture. And
Ryanair’s low-price pricing strategy—a strategy that reflects its low-cost posi-
tion—is possible because of the kind of airplane fleet Ryanair has built over
time, the commitment of its employees to Ryanair’s success, a charismatic
founder, and its unique organizational culture. Because these policies reflect
costly-to-imitate attributes of these firms, they can be sources of sustained com-
petitive advantage.
However, for these and other firms, it is not these policy choices, per se, that
create sustainable cost leadership advantages. Rather, it is how these policies flow
from the historical, causally ambiguous, and socially complex processes within a
firm that makes them costly to duplicate. This has been the case for the Oakland
A’s baseball team, as described in the Strategy in the Emerging Enterprise feature.
Costly-to-Duplicate s ources of Cost a dvantage
Differential access to low-cost productive inputs and technological software
is usually a costly-to-duplicate basis of cost leadership. This is because these
inputs often build on historical, uncertain, and socially complex resources
and capabilities. As suggested earlier, differential access to productive inputs
often depends on the location of a firm. Moreover, to be a source of economic
profits, this valuable location must be obtained before its full value is widely
understood. Both these attributes of differential access to productive inputs
suggest that if, in fact, it is rare, it will often be costly to duplicate. First, some
locations are unique and cannot be duplicated. For example, most private golf
clubs would like to own courses with the spectacular beauty of Pebble Beach
in Monterey, California, but there is only one Pebble Beach—a course that runs
parallel to some of the most beautiful oceanfront scenery in the world. Although
“scenery” is an important factor of production in running and managing a golf
course, the re-creation of Pebble Beach’s scenery at some other location is sim-
ply beyond our technology.
Second, even if a location is not unique, once its value is revealed, acquisi-
tion of that location is not likely to generate economic profits. Thus, for example,
although being located in Silicon Valley provides access to some important low-cost
productive inputs for electronics firms, firms that moved to this location after its
value was revealed have substantially higher costs than firms that moved there be-
fore its full value was revealed. These higher costs effectively reduce the economic
profit that otherwise could have been generated. Referring to the discussion in
Chapter 3, these arguments suggest that gaining differential access to productive
inputs in a way that generates economic profits may reflect a firm’s unique path
through history.
M04_BARN0088_05_GE_C04.INDD 140 17/09/14 4:45 PM

Chapter 4: Cost Leadership 141
Technological software is also likely to be difficult to duplicate and often can
be a source of sustained competitive advantage. As suggested in Chapter 3, the
values, beliefs, culture, and teamwork that constitute this software are socially
complex and may be immune from competitive duplication. Firms with cost ad-
vantages rooted in these socially complex resources incorporate cost savings in
every aspect of their organization; they constantly focus on improving the quality
and cost of their operations, and they have employees who are firmly committed
to, and understand, what it takes to be a cost leader. Other firms may talk about
low costs; these firms live cost leadership. Ryanair, Dell, Wal-Mart, and Southwest
are all examples of such firms. If there are few firms in an industry with these
kinds of beliefs and commitments, then they can gain a sustained competitive
advantage from their cost advantage.
s ubstitutes for s ources of Cost a dvantage
In an important sense, all of the sources of cost advantage listed in this chapter are
at least partial substitutes for each other. Thus, for example, one firm may reduce
its cost through exploiting economies of scale in large-scale production, and a
competing firm may reduce its costs through exploiting learning-curve economies
and large cumulative volume of production. If these different activities have simi-
lar effects on a firm’s cost position and if they are equally costly to implement,
then they are strategic substitutes for each other.
Because of the substitute effects of different sources of cost advantage, it is
not unusual for firms pursuing cost leadership to simultaneously pursue all the
cost-reduction activities discussed in this chapter. Implemention of this bundle
of cost-reducing activities may have few substitutes. If duplicating this bundle
of activities is also rare and difficult, then a firm may be able to gain a sustained
competitive advantage from doing so.
Several of the other strategies discussed in later chapters can also have the
effect of reducing a firm’s costs and thus may be substitutes for the sources of
cost reduction discussed in this chapter. For example, one common motivation
for firms implementing strategic alliance strategies is to exploit economies of
scale in combination with other firms. Thus, a strategic alliance that reduces
a firm’s costs may be a substitute for a firm exploiting economies of scale on
its own to reduce its costs. As is discussed in more detail in Chapter 8, many
of the strategic alliances among aluminum mining and smelting companies
are motivated by realizing economies of scale and cost reduction. Also, corpo-
rate diversification strategies often enable firms to exploit economies of scale
across different businesses within which they operate. In this setting, each of
these businesses—treated separately—may have scale disadvantages, but col-
lectively their scale creates the same low-cost position as that of an individual
firm that fully exploits economies of scale to reduce costs in a single business
(see Chapter 9).
Organizing to Implement Cost Leadership
As with all strategies, firms seeking to implement cost leadership strategies must
adopt an organizational structure, management controls, and compensation poli-
cies that reinforce this strategy. Some key issues associated with using these orga-
nizing tools to implement cost leadership are summarized in Table 4.6.
V R I O
M04_BARN0088_05_GE_C04.INDD 141 17/09/14 4:45 PM

B aseball in the United States has a problem. Most observers agree that
it is better for fans if there is competi-
tive balance in the league—that is, if,
at the beginning of the year, the fans of
several teams believe that their team
has a chance to go to the World Series
and win it all. However, the economic
reality of competition in baseball is that
only a small number of financially suc-
cessful teams in large cities—the New
York Yankees, the Los Angeles Dodgers,
the Chicago Cubs, the Los Angeles
Angels—have the resources necessary
to compete for a spot in the World Series
year after year. So-called “small-market
teams,” such as the Pittsburgh Pirates or
the Milwaukee Brewers, may be able to
compete every once in a while, but these
exceptions prove the general rule—
teams from large markets usually win
the World Series.
And then there is Oakland and
the Oakland A’s. Oakland (with a popu-
lation of just over 400,000) is the small-
est— and least glamorous—of the three
cities in the San Francisco Bay Area,
the other two being San Francisco and
San Jose. The A’s play in an outdated
stadium to an average crowd of 25,586
fans—ranking twenty-fourth among
the 30 major league baseball teams in
the United States. In 2013, the A’s player
payroll was $65 million, about one-fifth
of the Yankees’ player payroll.
Despite these liabilities, from
1999 to 2012, the A’s either won their
division or placed second in all but four
years. This compares favorably to any
major league team during this time pe-
riod, including teams with much higher
payrolls. And the team made money!
What is the “secret” to the A’s suc-
cess? Their general manager, William
Lamar Beane, says that it has to do with
three factors: how players are evaluated,
making sure that every personnel deci-
sion in the organization is consistent
with this approach to evaluation, and
ensuring that all personnel decisions are
thought of as business decisions.
The criteria used by the A’s to
evaluate players are easy enough to
state. For batters, the A’s focus on on-
base percentage (i.e., how often a batter
reaches base) and total bases (a measure
of the ability of a batter to hit for power);
that is, they focus on the ability of play-
ers to get on base and score. For pitchers,
the A’s focus on the percentage of first
pitches that are strikes and the quality
of a pitcher’s fast ball. First-pitch strikes
and throwing a good fast ball are cor-
related with keeping runners off base.
Thus, not surprisingly, the A’s criteria
for evaluating pitchers are the reverse of
their criteria for evaluating hitters.
Although these evaluation crite-
ria are easy to state, getting the entire
organization to apply them consistently
in scouting, choosing, developing, and
managing players is much more dif-
ficult. Almost every baseball player and
fan has his or her own favorite way to
evaluate players. However, if you want
to work in the A’s organization, you
must be willing to let go of your per-
sonal favorite and evaluate players the
A’s way. The result is that players that
come through the A’s farm system—
the minor leagues where younger play-
ers are developed until they are ready
to play in the major leagues—learn a
single way of playing baseball instead
of learning a new approach to the game
every time they change managers or
coaches. One of the implications of this
consistency has been that the A’s farm
system has been among the most pro-
ductive in baseball.
This consistent farm system
enables the A’s to treat personnel de-
cisions—including decisions about
whether they should re-sign a star player
or let him go to another team—as busi-
ness decisions. The A’s simply do not
have the resources necessary to play the
personnel game the same way as the
Los Angeles Dodgers or the New York
Yankees. When these teams need a par-
ticular kind of player, they go and sign
one. Oakland has to rely more on its
farm system. But because its farm system
performs so well, the A’s can let so-called
“superstars” go to other teams, knowing
that they are likely to have a younger—
and cheaper—player in the minor
leagues, just waiting for the chance to
play in “the show”—the players’ nick-
name for the major leagues. This allows
the A’s to keep their payroll costs down
and remain profitable, despite relatively
small crowds, while still fielding a team
that competes virtually every year for
the right to play in the World Series.
Of course, an important ques-
tion becomes: How sustainable is the
A’s competitive advantage? The evalua-
tion criteria themselves are not a source
of sustained competitive advantage.
However, the socially complex nature
of how these criteria are consistently ap-
plied throughout the A’s organization
may be a source of sustained competitive
advantage in enabling the A’s to gain the
differential access to low-cost productive
inputs—in this case, baseball players.
Sources: K. Hammonds (2003). “How to play Beane
ball.” Fast Company, May, pp. 84+; M. Lewis (2003).
Moneyball. New York: Norton; A. McGahan, J. F.
McGuire, and J. Kou (1997). “The baseball strike.”
Harvard Business School Case No. 9-796-059;
www.cbssports.com/mlb/story/21989238/
baseball-payrolls-list. Accessed August 21, 2013;
espn.go.com/mlb/attendance/-/sort/Allavg.
Accessed August 21, 2013.
The Oakland A’s: Inventing a New
Way to Play Competitive baseball
strategy in the emerging enterprise
142
M04_BARN0088_05_GE_C04.INDD 142 17/09/14 4:45 PM

Chapter 4: Cost Leadership 143
Organizational Structure in Implementing Cost leadership
As suggested in Table 4.6, firms implementing cost leadership strategies will
generally adopt what is known as a functional organizational structure.21 An
example of a functional organization structure is presented in Figure 4.4. Indeed,
this functional organizational structure is the structure used to implement all
business-level strategies a firm might pursue, although this structure is modified
when used to implement these different strategies.
In a functional structure, each of the major business functions is managed
by a functional manager. For example, if manufacturing, marketing, finance,
accounting, and sales are all included within a functional organization, then a
manufacturing manager leads that function, a marketing manager leads that
function, a finance manager leads that function, and so forth. In a functional
organizational structure, all these functional managers report to one person.
This person has many different titles—including president, CEO, chair, or founder.
However, for purposes of this discussion, this person will be called the chief
executive officer (CEO).
The CEO in a functional organization has a unique status. Everyone else in
this company is a functional specialist. The manufacturing people manufacture,
the marketing people market, the finance people finance, and so forth. Indeed,
only one person in the functional organization has to have a multifunctional
perspective: the CEO. This role is so important that sometimes the functional
organization is called a U-form structure, where the “U” stands for “unitary”—
because there is only one person in this organization that has a broad, multifunc-
tional corporate perspective.
Organization structure: Functional structure with
1. Few layers in the reporting structure
2. Simple reporting relationships
3. Small corporate staff
4. Focus on narrow range of business functions
Management control systems
1. Tight cost control systems
2. Quantitative cost goals
3. Close supervision of labor, raw material, inventory, and other costs
4. A cost leadership philosophy
Compensation policies
1. Reward for cost reduction
2. Incentives for all employees to be involved in cost reduction
TAble 4.6 Organizing to
Realize the Full Potential of Cost
Leadership Strategies
Chief Executive Officer
(CEO)
Manufacturing Sales Research and
Development
Human
Resources
Legal
Figure 4.4 An Example
of the U-form Organizational
Structure
M04_BARN0088_05_GE_C04.INDD 143 17/09/14 4:45 PM

144 Part 2: Business-Level strategies
When used to implement a cost leadership strategy, this U-form structure
is kept as simple as possible. As suggested in Table 4.6, firms implementing
cost leadership strategies will have relatively few layers in their reporting
structure. Complicated reporting structures, including matrix structures where
one employee reports to two or more people, are usually avoided.22 Corporate
staff in these organizations is kept small. Such firms do not operate in a wide
range of business functions, but instead operate only in those few business
functions where they have valuable, rare, and costly-to-imitate resources and
capabilities.
One excellent example of a firm pursuing a cost leadership strategy is
Nucor Steel. A leader in the mini-mill industry, Nucor has only five layers in its
reporting structure, compared to 12 to 15 in its major higher-cost competitors.
Most operating decisions at Nucor are delegated to plant managers, who have
full profit-and-loss responsibility for their operations. Corporate staff at Nucor is
small and focuses its efforts on accounting for revenues and costs and on explor-
ing new manufacturing processes to further reduce Nucor’s operating expenses
and expand its business opportunities. Nucor’s former president Ken Iverson
believed that Nucor does only two things well: build plants efficiently and run
them effectively. Thus, Nucor focuses its efforts in these areas and subcontracts
many of its other business functions, including the purchase of its raw materials,
to outside vendors.23
r esponsibilities of the CeO in a Functional Organization
The CEO in a U-form organization has two basic responsibilities: (1) to formulate
the strategy of the firm and (2) to coordinate the activities of the functional spe-
cialists in the firm to facilitate the implementation of this strategy. In the special
case of a cost leadership strategy, the CEO must decide on which bases such a
strategy should be founded—including any of those listed in Table 4.1—and then
coordinate functions within a firm to make sure that the economic potential of
this strategy is fully realized.
strategy Formulation. The CEO in a U-form organization engages in strategy for-
mulation by applying the strategic management process described in Chapter 1.
A CEO establishes the firm’s mission and associated objectives, evaluates environ-
mental threats and opportunities, understands the firm’s strengths and weaknesses,
and then chooses one or more of the business and corporate strategies discussed
in this book. In the case of a cost leadership strategy, the application of the stra-
tegic management process must lead a CEO to conclude that the best chance for
achieving a firm’s mission is for that firm to adopt a cost leadership business-level
strategy.
Although the responsibility for strategy formulation in a U-form organiza-
tion ultimately rests with the CEO, this individual needs to draw on the insights,
analysis, and involvement of functional managers throughout the firm. CEOs
who fail to involve functional managers in strategy formulation run several risks.
First, strategic choices made in isolation from functional managers may be made
without complete information. Second, limiting the involvement of functional
managers in strategy formulation can limit their understanding of, and commit-
ment to, the chosen strategy. This can severely limit their ability, and willingness,
to implement any strategy—including cost leadership—that is chosen.24
Coordinating Functions for s trategy implementation. Even the best-formulated strat-
egy is competitively irrelevant if it is not implemented. And the only way that
M04_BARN0088_05_GE_C04.INDD 144 17/09/14 4:45 PM

Chapter 4: Cost Leadership 145

When Function Is Aligned with
Cost Leadership Strategies
When Function Is Misaligned
with Cost Leadership Strategies
Manufacturing Lean, low cost, good quality Inefficient, high cost, poor
quality
Marketing Emphasize value, reliability,
and price
Emphasize style and
performance
Research and
Development
Focus on product extensions
and process improvements
Focus on radical new
technologies and products
Finance Focus on low cost and stable
financial structure
Focus on nontraditional
financial instruments
Accounting Collect cost data and adopt
conservative accounting
principles
Collect no-cost data and adopt
very aggressive accounting
principles
Sales Focus on value, reliability, and
low price
Focus on style and performance
and high price
TAble 4.7 Common
Misalignments Between
Business Functions and a Cost
Leadership Strategy
strategies can be effectively implemented is if all the functions within a firm are
aligned in a way consistent with this strategy.
For example, compare two firms pursuing a cost leadership strategy. All
but one of the first firm’s functions—marketing—are aligned with this cost lead-
ership strategy. All of the second firm’s functions—including marketing—are
aligned with this cost leadership strategy. Because marketing is not aligned with
the first firm’s cost leadership strategy, this firm is likely to advertise products
that it does not sell. That is, this firm might advertise its products on the basis
of their style and performance, but sell products that are reliable (but not styl-
ish) and inexpensive (but not high performers). A firm that markets products it
does not actually sell is likely to disappoint its customers. In contrast, the second
firm that has all of its functions—including marketing—aligned with its chosen
strategy is more likely to advertise products it actually sells and thus is less likely
to disappoint its customers. In the long run, it seems reasonable to expect this
second firm to outperform the first, at least with respect to implementing a cost
leadership strategy.
Of course, alignment is required of all of a firm’s functional areas, not just
marketing. Also, misalignment can emerge in any of a firm’s functional areas.
Some common misalignments between a firm’s cost leadership strategy and its
functional activities are listed in Table 4.7.
Management Controls in Implementing Cost leadership
As suggested in Table 4.6, cost leadership firms are typically characterized by
very tight cost-control systems; frequent and detailed cost-control reports; an em-
phasis on quantitative cost goals and targets; and close supervision of labor, raw
materials, inventory, and other costs. Again, Nucor Steel is an example of a cost
leadership firm that has implemented these kinds of control systems. At Nucor,
groups of employees are given weekly cost and productivity improvement goals.
Groups that meet or exceed these goals receive extra compensation. Plant manag-
ers are held responsible for cost and profit performance. A plant manager who
does not meet corporate performance expectations cannot expect a long career
M04_BARN0088_05_GE_C04.INDD 145 17/09/14 4:45 PM

146 Part 2: Business-Level strategies
at Nucor. Similar group-oriented cost-reduction systems are in place at some of
Nucor’s major competitors, including Chaparral Steel.25
Less formal management control systems also drive a cost-reduction
philosophy at cost leadership firms. For example, although Wal-Mart is one of
the most successful retail operations in the world, its Arkansas headquarters is
plain and simple. Indeed, some have suggested that Wal-Mart’s headquarters
looks like a warehouse. Its style of interior decoration was once described as
“early bus station.” Wal-Mart even involves its customers in reducing costs by
asking them to “help keep your costs low” by returning shopping carts to the
designated areas in Wal-Mart’s parking lots.26
Compensation Policies and Implementing Cost leadership Strategies
As suggested in Table 4.6, compensation in cost leadership firms is usually tied
directly to cost-reducing efforts. Such firms often provide incentives for employ-
ees to work together to reduce costs and increase or maintain quality, and they ex-
pect every employee to take responsibility for both costs and quality. For example,
an important expense for retail stores like Wal-Mart is “shrinkage”—a nice way
of saying people steal stuff. About half the shrinkage in most stores comes from
employees stealing their own companies’ products.
Wal-Mart used to have a serious problem with shrinkage. Among other
solutions (including hiring “greeters” whose real job is to discourage shoplifters),
Wal-Mart developed a compensation scheme that took half the cost savings cre-
ated by reduced shrinkage and shared it with employees in the form of a bonus.
With this incentive in place, Wal-Mart’s shrinkage problems dropped significantly.
Summary
Firms producing essentially the same products can have different costs for several reasons.
Some of the most important of these are: (1) size differences and economies of scale, (2) size
differences and diseconomies of scale, (3) experience differences and learning-curve econo-
mies, (4) differential access to productive inputs, and (5) technological advantages indepen-
dent of scale. In addition, firms competing in the same industry can make policy choices about
the kinds of products and services to sell that can have an important impact on their relative
cost position. Cost leadership in an industry can be valuable by assisting a firm in reducing
the threat of each of the five environmental threats in an industry outlined in Chapter 2.
Each of the sources of cost advantage discussed in this chapter can be a source of
sustained competitive advantage if it is rare and costly to imitate. Overall, learning-curve
economies, differential access to productive inputs, and technological “software” are
more likely to be rare than other sources of cost advantage. Differential access to produc-
tive inputs and technological “software” is more likely to be costly to imitate—either
through direct duplication or through substitution—than the other sources of cost ad-
vantage. Thus, differential access to productive inputs and technological “software” will
often be more likely to be a source of sustained competitive advantage than cost advan-
tages based on other sources.
Of course, to realize the full potential of these competitive advantages, a firm must
be organized appropriately. Organizing to implement a strategy always involves a firm’s
M04_BARN0088_05_GE_C04.INDD 146 17/09/14 4:45 PM

Chapter 4: Cost Leadership 147
organizational structure, its management control systems, and its compensation poli-
cies. The organizational structure used to implement cost leadership—and other busi-
ness strategies—is called a functional, or U-form, structure. The CEO is the only person
in this structure who has a corporate perspective. The CEO has two responsibilities: to
formulate a firm’s strategy and to implement it by coordinating functions within a firm.
Ensuring that a firm’s functions are aligned with its strategy is essential to successful
strategy implementation.
When used to implement a cost leadership strategy, the U-form structure generally
has few layers, simple reporting relationships, and a small corporate staff. It focuses on
a narrow range of business functions. The management control systems used to imple-
ment these strategies generally include tight cost controls; quantitative cost goals; close
supervision of labor, raw materials, inventory, and other costs; and a cost leadership
culture and mentality. Finally, compensation policies in these firms typically reward cost
reduction and provide incentives for everyone in the organization to be part of the cost-
reduction effort.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
Challenge Questions
4.1. Ryanair, Wal-Mart, Timex, Casio,
and Hyundai are all cited as examples
of firms pursuing cost leadership
strategies, but these firms make
substantial investments in advertis-
ing, which seems more likely to be
associated with a product differentia-
tion strategy. Are these firms really
pursuing a cost leadership strategy, or
are they pursuing a product differen-
tiation strategy by emphasizing their
lower costs?
4.2. When economies of scale exist,
firms with large volumes of produc-
tion will have lower costs than those
with smaller volumes of production.
The realization of these economies of
scale, however, is far from automatic.
What actions can firms take to ensure
that they realize whatever economies
of scale are created by their volume of
production?
4.3. A firm may choose a strategy of
cost leadership in an industry where
customers are very price insensitive,
e.g., in luxury goods. Given that most
competitors will focus on differentiat-
ing their products in such an industry,
is cost leadership a poor choice? What
can a cost leadership strategy hope to
achieve in such an industry?
4.4. When firms do engage in
“forward pricing” what risks, if any,
do they face?
4.5. One way of thinking about orga-
nizing to implement cost leadership
strategies is that firms pursuing this
strategy should be highly centralized,
have high levels of direct supervi-
sion, and keep employee wages to an
absolute minimum. Another approach
is to decentralize decision-making
authority—to ensure that individuals
who know the most about reducing
costs make decisions about how to
reduce costs. This, in turn, would
imply less direct supervision and
somewhat higher levels of employee
wages. Why is this?
4.6. Economies of scale and differential
low-cost access to productive inputs are
two drivers of cost leadership. Are these
two factors related?
4.7. Often, the first step in determin-
ing if cost leadership is a feasible
strategy for a company is to analyze
the costs of key activities (e.g., using
the value chain tool) relative to com-
petitors. However, many companies
increasingly outsource some of their
value added activities to temporary
workforces. How would you modify
the value chain approach to support
this cost analysis?
M04_BARN0088_05_GE_C04.INDD 147 17/09/14 4:45 PM

148 Part 2: Business-Level strategies
Problem set
4.8. The economies of scale curve in Figure 4.1 can be represented algebraically in the
following equation:
Average costs = a + bQ + cQ2
where Q is the quantity produced by a firm and a, b, and c are coefficients that are esti-
mated from industry data. For example, it has been shown that the economies of scale
curve for U.S. savings and loans is:
Average costs = 2.38 – .615A + .54A2
where A is a savings and loan’s total assets. Using this equation, what is the optimal size
of a savings and loan? (Hint: Plug in different values of A and calculate average costs. The
lowest possible average cost is the optimal size for a savings and loan.)
4.9. The learning curve depicted in Figure 4.2 can be represented algebraically by the
following equation:
Average time to produce x units = ax-b
where x is the total number of units produced by a firm in its history, a is the amount of
time it took a firm to produce its first unit, and β is a coefficient that describes the rate of
learning in a firm.
Suppose it takes a team of workers 45 hours to assemble its first product 1a = 452 and
40.5 hours to assemble the second. When a firm doubles its production (in this case, from
one to two units) and cuts its production time (in this case, from 45 hours to 40.5 hours),
learning is said to have occurred (in this case, a 40.5/45, or 90 percent, learning curve). The
β for a 90 percent learning curve is 0.3219. Thus, this firm’s learning curve is:
Average time to produce x units = 45x-0.3219
What is the average amount of time it will take this firm to produce six products? (Hint:
Simply plug “6” in for x in the equation and solve.) What is the total time it took this firm
to produce these six products? (Hint: Simply multiply the number of units produced, 6,
by the average time it will take to produce these six products.) What is the average time it
will take this firm to produce five products? What is the total time it will take this firm to
produce five products? So, what is the total time it will take this firm to produce its sixth
product? (Hint: Subtract the total time needed to produce five products from the total time
needed to produce six products.)
Suppose a new firm is going to start producing these same products. Assuming this
new firm does not learn anything from established firms, what will its cost disadvantage
be when it assembles its first product? (Hint: Compare the costs of the experienced firm’s
sixth product with the cost of the new firm’s first product.)
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
4.10. What are the implications and considerations for a small business that chooses a
cost leadership business strategy?
4.11. Discuss the impact of a cost leadership strategy on environmental threats.
M04_BARN0088_05_GE_C04.INDD 148 17/09/14 4:45 PM

Chapter 4: Cost Leadership 149
end notes
1. Kiley, D. (2011). “Fiat headed back to U.S. after 27 years.”
http://autos.aol.com/article/fiat-500-coming-to-america/ Accessed
Aug 21, 2013.
2. Christensen, C. R., N. A. Berg, and M. S. Salter. (1980). Policy formula-
tion and administration: A casebook of senior management problems in
business, 8th ed. Homewood, IL: Irwin, p. 163.
3. Scherer, F. M. (1980). Industrial market structure and economic perfor-
mance. Boston: Houghton Mifflin; Moore, F. T. (1959). “Economies
of scale: Some statistical evidence.” Quarterly Journal of Economics,
73, pp. 232–245; and Lau, L. J., and S. Tamura. (1972). “Economies of
scale, technical progress, and the nonhomothetic leontief production
function.” Journal of Political Economy, 80, pp. 1167–1187.
4. Scherer, F. M. (1980). Industrial market structure and economic perfor-
mance. Boston: Houghton Mifflin; and Perrow, C. (1984). Normal
accidents: Living with high-risk technologies. New York: Basic Books.
5. Hamermesh, R. G., and R. S. Rosenbloom. (1989). “Crown Cork and
Seal Co., Inc.” Harvard Business School Case No. 9-388-096.
6. See Hackman, J. R., and G. R. Oldham. (1980). Work redesign. Reading,
MA: Addison-Wesley.
7. This relationship was first noticed in 1925 by the commander of
Wright-Patterson Air Force Base in Dayton, Ohio.
8. Learning curves have been estimated for numerous industries. Boston
Consulting Group. (1970). “Perspectives on experience.” Boston: BCG,
presents learning curves for over 20 industries while Lieberman,
M. (1984). “The learning curve and pricing in the chemical process-
ing industries.” Rand Journal of Economics, 15, pp. 213–228, estimates
learning curves for 37 chemical products.
9. See Henderson, B. (1974). The experience curve reviewed III—How does
it work? Boston: Boston Consulting Group; and Boston Consulting
Group. (1970). “Perspectives on experience.” Boston: BCG.
10. Hall, G., and S. Howell. (1985). “The experience curve from
the economist’s perspective.” Strategic Management Journal, 6,
pp. 197–212.
11. Hill, C. W. L. (1988). “Differentiation versus low-cost or differentia-
tion and low-cost: A contingency framework.” Academy of Management
Review, 13(3), pp. 401–412.
12. See Ghemawat, P., and H. J. Stander III. (1992). “Nucor at a cross-
roads.” Harvard Business School Case No. 9-793-039 on technology
in steel manufacturing and cost advantages; Shaffer, R. A. (1995).
“Intel as conquistador.” Forbes, February 27, p. 130 on technology
in semiconductor manufacturing and cost advantages; Monteverde,
K., and D. Teece. (1982). “Supplier switching costs and vertical
integration in the automobile industry.” Rand Journal of Economics,
13(1), pp. 206–213; and McCormick, J., and N. Stone. (1990).
“From national champion to global competitor: An interview with
Thomson’s Alain Gomez.” Harvard Business Review, May/June,
pp. 126–135 on technology in consumer electronic manufacturing
and cost advantages.
13. Schultz, E. (1989). “Climbing high with discount brokers.” Fortune, Fall
(special issue), pp. 219–223.
14. Schonfeld, E. (1998). “Can computers cure health care?” Fortune,
March 30, pp. 111+.
15. Ibid.
16. See Meyer, M. W., and L. B. Zucker. (1989). Permanently failing organiza-
tions. Newbury Park, CA: Sage.
17. Staw, B. M. (1981). “The escalation of commitment to a course of
action.” Academy of Management Review, 6, pp. 577–587.
18. Hesterly, W. S. (1989). Top management succession as a determinant of firm
performance and de-escalation: An agency problem. Unpublished doctoral
dissertation, University of California, Los Angeles.
19. Barney, J. B. (1986). “Organizational culture: Can it be a source of
sustained competitive advantage?” Academy of Management Review, 11,
pp. 656–665.
20. See Spence, A. M. (1981). “The learning curve and competition.”
Bell Journal of Economics, 12, pp. 49–70, on why learning needs to be pro-
prietary; Mansfield, E. (1985). “How rapidly does new industrial tech-
nology leak out?” Journal of Industrial Economics, 34(2), pp. 217–223;
Lieberman, M. B. (1982). The learning-curve, pricing and market structure
in the chemical processing industries. Unpublished doctoral dissertation,
Harvard University; Lieberman, M. B. (1987). “The learning curve,
diffusion, and competitive strategy.” Strategic Management Journal, 8,
pp. 441–452, on why it usually is not proprietary.
21. Williamson, O. (1975). Markets and hierarchies. New York: Free Press.
22. Davis, S. M., and P. R. Lawrence. (1977). Matrix. Reading, MA:
Addison-Wesley.
23. See Ghemawat, P., and H. J. Stander III. (1992). “Nucor at a
crossroads.” Harvard Business School Case No. 9-793-039.
24. See Floyd, S. W., and B. Woldridge. (1992). “Middle management
involvement in strategy and its association with strategic type: A
research note.” Strategic Management Journal, 13, pp. 153–167.
25. Ibid.
26. Walton, S. (1992). Sam Walton, Made in America: My story. New York:
Doubleday.
M04_BARN0088_05_GE_C04.INDD 149 17/09/14 4:45 PM

150
1. Define product differentiation.
2. Describe 11 bases of product differentiation and how
they can be grouped into three categories.
3. Describe how product differentiation is ultimately
limited only by managerial creativity.
4. Describe how product differentiation can be used to
neutralize environmental threats and exploit environ-
mental opportunities.
5. Describe those bases of product differentiation that are
not likely to be costly to duplicate, those that may be
Who Is Victoria, and What Is Her Secret?
Sexy. Glamorous. M ysterious. Victoria’s S ecret is the w orld’s leading specialt y retailer of linger ie
and beauty products. With 2012 sales of $6.12 billion and operating income of $1 billion, Victoria’s
Secret sells its mix of se xy lingerie, prestige fragrances, and fashion-inspir ed collections through
more than 1,000 retail stores and the almost 400 million catalogues it distributes each year.
But all this glamour and success leaves the t wo central questions about this firm unan –
swered: “Who is Victoria?” and “What is her secret?”
It turns out that Victoria is a retired fashion model who lives in an up-and-coming fashion-
able district in London. She has a committed relationship and is thinking about starting a family.
However, these ma ternal instinc ts ar e balanc ed b y Victoria’s adv enturous and se xy side . She
loves good food, classical music, and great wine. She travels frequently and is as much at home
in New York, Paris, and Los Angeles as she is in London. Her fashion tastes are edgy enough to
never be boring, but practical enough to never be extreme. Her lingerie is an essential part of her
wardrobe. Sexy and allur ing, but nev er cheap, trashy, or vulgar , Victoria’s lingerie is the per fect
complement to her o verall lifestyle. M ost impor tant, while Victoria k nows she is beautiful and
sexy, she also knows that it is her brains, not her looks, that have enabled her to succeed in life.
This is who Victoria is. This is the w oman that Victoria’s Secret’s designers design for, the
woman Victoria’s Secret marketers create advertising for, and the w oman to whom all Victoria’s
Secret sales associates are trained to sell.
costly to duplicate, and those that will often be costly
to duplicate.
6. Describe the main substitutes for product differentia-
tion strategies.
7. Describe how organizational structure, control pro-
cesses, and compensation policies can be used to
implement product differentiation strategies.
8. Discuss whether it is possible for a firm to implement
cost leadership and product differentiation strategies
simultaneously.
L e a r n I n g O b j e c t I V e S After reading this chapter, you should be able to:
MyManagementLab®
Improve Your grade!
More than 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
5
c H a p t e r
Product
Differentiation
M05_BARN0088_05_GE_C05.INDD 150 13/09/14 3:30 PM

151
And this is her secr et—Victoria doesn ’t really exist. Or ,
more precisely, the number of r eal women in the en tire world
who are like Victoria is very small—no more than a handful. So
why w ould a c ompany like Victoria’s S ecret or ganize all of its
design, marketing, and sales eff orts around meeting the linge –
rie needs of a w oman who, for all pr actical purposes, doesn’t
really exist?
Victoria’s S ecret k nows ho w f ew of its ac tual cust om-
ers ar e like Victoria. Ho wever, it is c onvinced tha t man y of its
customers would like to be treated as if they were Victoria, if
only for a time , when they c ome into a Victoria’s S ecret store.
Victoria’s S ecret is not just selling linger ie; it is selling an
opportunity, almost a fantasy, to be like Victoria—to live in an exciting and sexy city, to travel the
world, to have refined, yet edgy, tastes. To buy and wear Victoria’s Secret lingerie is—if only for a
moment or two—an opportunity to experience life as Victoria experiences it.
Practically speaking, building an entire company around meeting the needs of a customer
who does not ac tually e xist cr eates some in teresting pr oblems. You can ’t just call Victoria on
the phone and ask her about trends in her lifestyle; you can’t form a focus group of people like
Victoria and ask them t o evaluate new lines of linger ie. In a sense , not only has Victoria’s Secret
invented Victoria; it also had t o invent Victoria’s lifestyle—and the linger ie, fragrances, and ac –
cessories that go along with that lifestyle. And as long as the lifestyle that it invents for Victoria is
desirable to, but just bey ond the reach of, its ac tual customers, Victoria’s Secret will continue to
be able to sell a romantic fantasy—along with its bras and panties.
Sources: www.limitedbrands.com accessed August 24, 2013; www.victoriassecret.com accessed August 24, 2013.
Im
ag
e
So
ur
ce
/G
et
ty
M05_BARN0088_05_GE_C05.INDD 151 13/09/14 3:30 PM

152 Part 2: Business-Level Strategies
Victoria’s Secret uses the fictional character “Victoria” to help implement its product differentiation strategy. As successful as this effort is, however, this is only one of many ways that firms can try to differentiate their products.
What Is Product Differentiation?
Whereas RyanAir exemplifies a firm pursuing a cost leadership strategy, Victoria’s
Secret exemplifies a firm pursuing a product differentiation strategy. Product dif-
ferentiation is a business strategy where firms attempt to gain a competitive
advantage by increasing the perceived value of their products or services relative
to the perceived value of other firms’ products or services. These other firms can
be rivals or firms that provide substitute products or services. By increasing the
perceived value of its products or services, a firm will be able to charge a higher
price than it would otherwise. This higher price can increase a firm’s revenues
and generate competitive advantages.
A firm’s attempts to create differences in the relative perceived value of its
products or services often are made by altering the objective properties of those
products or services. Rolex attempts to differentiate its watches from Timex and
Casio watches by manufacturing them with solid gold cases. Mercedes attempts
to differentiate its cars from Fiat’s cars through sophisticated engineering and
high performance. Victoria’s Secret attempts to differentiate its shopping experi-
ence from Wal-Mart, and other retailers, through the merchandise it sells and the
way it sells it.
Although firms often alter the objective properties of their products or
services in order to implement a product differentiation strategy, the existence
of product differentiation, in the end, is always a matter of customer perception.
Products sold by two different firms may be very similar, but if customers believe
the first is more valuable than the second, then the first product has a differentia-
tion advantage.
In the world of “craft” or “microbrewery” beers, for example, the con-
sumers’ image of how a beer is brewed may be very different from how it is
actually brewed. Boston Beer Company, for example, sells Samuel Adams Beer.
Customers can tour the Boston Beer Company, where they will see a small row of
fermenting tanks and two 10-barrel kettles being tended by a brewmaster wear-
ing rubber boots. However, Samuel Adams Beer was not actually brewed in this
small factory. Instead, it was, for much of its history, brewed—in 200-barrel steel
tanks—in Cincinnati, Ohio, by the Hudepohl-Schoenling Brewing Company, a
contract brewing firm that also manufactured Hudy Bold Beer and Little Kings
Cream Ale. Maui Beer Company’s Aloha Lager brand was brewed in Portland,
Oregon, and Pete’s Wicked Ale (a craft beer that claims it is brewed “one batch at
a time. Carefully.”) was brewed in batches of 400 barrels each by Stroh Brewery
Company, makers of Old Milwaukee Beer. However, the more consumers believe
there are important differences between these “craft” beers and more traditional
brews—despite many of their common manufacturing methods—the more will-
ing they will be to pay more for a craft beer. This willingness to pay more suggests
that an important “perceptual” basis of product differentiation exists for these
craft beers.1 If products or services are perceived as being different in a way that is
valued by consumers, then product differentiation exists.
Just as perceptions can create product differentiation between products that
are essentially identical, the lack of perceived differences between products with
M05_BARN0088_05_GE_C05.INDD 152 13/09/14 3:30 PM

Chapter 5: Product Differentiation 153
very different characteristics can prevent product differentiation. For example,
consumers with an untrained palate may not be able to distinguish between two
different wines, even though expert wine tasters would be very much aware of
their differences. Those who are not aware of these differences, even if they exist,
will not be willing to pay more for one wine over the other. In this sense, for these
consumers at least, these two wines, though different, are not differentiated.
Product differentiation is always a matter of customer perceptions, but firms
can take a variety of actions to influence these perceptions. These actions can be
thought of as different bases of product differentiation.
Bases of Product Differentiation
A large number of authors, drawing on both theory and empirical research, have
developed lists of ways firms can differentiate their products or services.2 Some
of these are listed in Table 5.1. Although the purpose of all these bases of product
differentiation is to create the perception that a firm’s products or services are un-
usually valuable, different bases of product differentiation attempt to accomplish
this objective in different ways. For example, the first four bases of product differ-
entiation listed in Table 5.1 attempt to create this perception by focusing directly
on the attributes of the products or services a firm sells. The second three attempt
to create this perception by developing a relationship between a firm and its cus-
tomers. The last five attempt to create this perception through linkages within
and between firms. Of course, these bases of product differentiation are not mu-
tually exclusive. Indeed, firms will often attempt to differentiate their products
or services along multiple dimensions simultaneously. An empirical method for
identifying ways that firms have differentiated their products is discussed in the
Research Made Relevant feature.
Focusing on the a ttributes of a Firm’s products or Services
The first group of bases of product differentiation identified in Table 5.1 focuses
on the attributes of a firm’s products or services.
To differentiate its products, a firm can focus directly on the attributes of
its products or services:
1. Product features
2. Product complexity
3. Timing of product introduction
4. Location
or on relationships between itself and its customers:
5. Product customization
6. Consumer marketing
7. Product reputation
or on linkages within or between firms:
8. Linkages among functions within a firm
9. Linkages with other firms
10. Product mix
11. Distribution channels
12. Service and support
Sources: M. E. Porter (1980). Competitive strategy. New York: Free Press; R. E. Caves and P. Williamson
(1985). “What is product differentiation, really?” Journal of Industrial Economics, 34, pp. 113–132.
TaBle 5.1 Ways Firms Can
Differentiate Their Products
M05_BARN0088_05_GE_C05.INDD 153 13/09/14 3:30 PM

154 Part 2: Business-Level Strategies
product Features. The most obvious way that firms can try to differentiate their
products is by altering the features of the products they sell. One industry in
which firms are constantly modifying product features to attempt to differentiate
their products is the automobile industry. Chrysler, for example, introduced the
“cab forward” design to try to give its cars a distinctive look, whereas Audi went
with a more radical flowing and curved design to differentiate its cars. For emer-
gency situations, General Motors (GM) introduced the “On Star” system, which
instantly connects drivers to GM operators 24 hours a day, while Mercedes-Benz
continued to develop its “crumple zone” system to ensure passenger safety in a
crash. In body construction, General Motors continues to develop its “uni-body”
construction system where different parts of a car are welded to each other rather
than built on a single frame—while Jaguar introduced a 100 percent alumi-
num body to help differentiate its top-of-the-line model from other luxury cars.
Mazda continues to tinker with the motor and suspension of its sporty Miata,
while Nissan introduced the 370Z—a continuation of the famous 240Z line—and
Porsche changed from air-cooled to water-cooled engines in its 911 series of sports
cars. All these—and many more—changes in the attributes of automobiles are ex-
amples of firms trying to differentiate their products by altering product features.
product c omplexity. Product complexity can be thought of as a special case of
altering a product’s features to create product differentiation. In a given industry,
product complexity can vary significantly. The BIC “crystal pen,” for example,
has only a handful of parts, whereas a Cross or a Mont Blanc pen has many more
parts. To the extent that these differences in product complexity convince con-
sumers that the products of some firms are more valuable than the products of
other firms, product complexity can be a basis of product differentiation.
t iming of product Introduction. Introducing a product at the right time can also
help create product differentiation. As suggested in Chapter 2, in some industry
settings (e.g., in emerging industries) the critical issue is to be a first mover—to
introduce a new product before all other firms. Being first in emerging industries
can enable a firm to set important technological standards, preempt strategically
valuable assets, and develop customer-switching costs. These first-mover advan-
tages can create a perception among customers that the products or services of
the first-moving firm are somehow more valuable than the products or services of
other firms.3
Timing-based product differentiation, however, does not depend only on
being a first mover. Sometimes, a firm can be a later mover in an industry but
introduce products or services at just the right time and thereby gain a competi-
tive advantage. This can happen when the ultimate success of a product or service
depends on the availability of complementary products or technologies. For exam-
ple, the domination of Microsoft’s MS-DOS operating system, and thus ultimately
the domination of Windows, was only possible because IBM introduced its version
of the personal computer. Without the IBM PC, it would have been difficult for any
operating system—including MS-DOS—to have such a large market presence.4
Location. The physical location of a firm can also be a source of product differen-
tiation.5 Consider, for example, Disney’s operations in Orlando, Florida. Beginning
with The Magic Kingdom and EPCOT Center, Disney built a world-class destina-
tion resort in Orlando. Over the years, Disney has added numerous attractions to its
core entertainment activities, including Disney Studios, more than 11,000 Disney-
owned hotel rooms, a $100 million sports center, an automobile racing track, an
after-hours entertainment district, and, most recently, a $1 billion theme park called
M05_BARN0088_05_GE_C05.INDD 154 13/09/14 3:30 PM

Chapter 5: Product Differentiation 155
“The Animal Kingdom”—all in and around Orlando. Now, families can travel from
around the world to Orlando, knowing that in a single location they can enjoy a full
range of Disney adventures.6
Focusing on the r elationship between a Firm and Its c ustomers
The second group of bases of product differentiation identified in Table 5.1 fo-
cuses on relationships between a firm and its customers.
product c ustomization. Products can also be differentiated by the extent to which
they are customized for particular customer applications. Product customization
is an important basis for product differentiation in a wide variety of industries,
from enterprise software to bicycles.
Of all the possible bases of prod-uct differentiation that might exist
in a particular market, how does one
pinpoint those that have actually been
used? Research in strategic manage-
ment and marketing has shown that
the bases of product differentiation can
be identified using multiple regression
analysis to estimate what are called
hedonic prices. A hedonic price is that
part of the price of a product or service
that is attributable to a particular char-
acteristic of that product or service.
The logic behind hedonic prices
is straightforward. If customers are
willing to spend more for a product
with a particular attribute than they
are willing to spend for that same
product without that attribute, then
that attribute differentiates the first
product from the second. That is, this
attribute is a basis of product differen-
tiation in this market.
Consider, for example, the price
of used cars. The market price of a
used car can be determined through
the use of a variety of used car buying
guides. These guides typically estab-
lish the base price of a used car. This
base price typically includes product
features that are common to almost
all cars—a radio, a standard engine,
a heater/defroster. Because these
product attributes are common to vir-
tually all cars, they are not a basis for
product differentiation.
However, in addition to these
common features, the base price of
an automobile is adjusted based on
some less common features—a high-
end stereo system, a larger engine,
air-conditioning. How much the base
price of the car is adjusted when these
features are added—$300 for a high-
end stereo, $500 for a larger engine,
$200 for air-conditioning—are the
hedonic prices of these product at-
tributes. These product attributes dif-
ferentiate well-equipped cars from
less-well-equipped cars and, because
consumers are willing to pay more for
well-equipped cars, can be thought of
as bases of product differentiation in
this market.
Multiple regression techniques
are used to estimate these hedonic
prices in the following way. For our
simple car example, the following re-
gression equation is estimated:
Price = a1 + b11Stereo2 + b21Engine2
+ b31AC2
where Price is the retail price of cars, Ste-
reo is a variable describing whether a car
has a high-end stereo, Engine is a vari-
able describing whether a car has a large
engine, and AC is a variable describ-
ing whether a car has air-conditioning.
If the hedonic prices for these features
are those suggested earlier, the results
of running this regression analysis
would be:
Price = +7,800 + +3001Stereo2
+ +5001Engine2 + +2001AC2
where $7,800 is the base price of this
type of used car.
Sources: D. Hay and D. Morris (1979). Industrial
economics: Theory and evidence. Oxford: Oxford
University Press; K. Cowling and J. Cubbin
(1971). “Price, quality, and advertising competi-
tion.” Economica, 38, pp. 378–394.
Discovering the Bases of Product
Differentiation
Research Made Relevant
M05_BARN0088_05_GE_C05.INDD 155 13/09/14 3:30 PM

156 Part 2: Business-Level Strategies
Enterprise software is software that is designed to support all of a firm’s
critical business functions, including human resources, payroll, customer service,
sales, quality control, and so forth. Major competitors in this industry include
Oracle and SAP. However, although these firms sell basic software packages,
most firms find it necessary to customize these basic packages to meet their spe-
cific business needs. The ability to build complex software packages that can also
be customized to meet the specific needs of a particular customer is an important
basis of product differentiation in this marketplace.
In the bicycle industry, consumers can spend as little as $50 on a bicycle,
and as much as—well, almost as much as they want on a bicycle, easily in excess
of $10,000. High-end bicycles use, of course, the very best components, such as
brakes and gears. But what really distinguishes these bicycles is their feel when
they are ridden. Once a serious rider becomes accustomed to a particular bicycle,
it is very difficult for that rider to switch to alternative suppliers.
c onsumer Marketing. Differential emphasis on consumer marketing has been a
basis for product differentiation in a wide variety of industries. Through advertis-
ing and other consumer marketing efforts, firms attempt to alter the perceptions
of current and potential customers, whether or not specific attributes of a firm’s
products or services are actually altered.
For example, in the soft drink industry, Mountain Dew—a product of
PepsiCo—was originally marketed as a fruity, lightly carbonated drink that
tasted “as light as a morning dew in the mountains.” However, beginning in the
late 1990s Mountain Dew’s marketing efforts changed dramatically. “As light as
a morning dew in the mountains” became “Do the Dew,” and Mountain Dew
focused its marketing efforts on young, mostly male, extreme-sports–oriented
consumers. Young men riding snowboards, roller blades, mountain bikes, and
skateboards—mostly upside down—became central to most Mountain Dew com-
mercials. Mountain Dew became a sponsor of a wide variety of extreme sports
contests and an important sponsor of the X Games on ESPN. Note that this radical
repositioning of Mountain Dew depended entirely on changes in consumer mar-
keting. The features of the underlying product were not changed.
r eputation. Perhaps the most important relationship between a firm and its cus-
tomers depends on a firm’s reputation in its marketplace. Indeed, a firm’s reputa-
tion is really no more than a socially complex relationship between a firm and its
customers. Once developed, a firm’s reputation can last a long time, even if the
basis for that reputation no longer exists.7
A firm that has tried to exploit its reputation for cutting-edge entertainment
is MTV, a division of Viacom, Inc. Although several well-known video artists—
including Madonna—have had their videos banned from MTV, it has still been
able to develop a reputation for risk-taking on television. MTV believes that its
viewers have come to expect the unexpected in MTV programming. One of the
first efforts to exploit, and reinforce, this reputation for risk-taking was Beavis and
Butthead, an animated series starring two teenage boys with serious social and
emotional development problems. More recently, MTV exploited its reputation
by inventing an entirely new genre of television—“reality TV”—through its Real
World and Road Rules programs. Not only are these shows cheap to produce, they
build on the reputation that MTV has for providing entertainment that is a little
risky, a little sexy, and a little controversial. Indeed, MTV has been so successful
in providing this kind of entertainment that it had to form an entirely new cable
station—MTV 2—to actually show music videos.8
M05_BARN0088_05_GE_C05.INDD 156 13/09/14 3:30 PM

Chapter 5: Product Differentiation 157
Focusing on Links Within and between Firms
The third group of bases of product differentiation identified in Table 5.1 focuses
on links within and between firms.
Linkages between Functions. A less obvious but still important way in which a
firm can attempt to differentiate its products is through linking different functions
within the firm. For example, research in the pharmaceutical industry suggests
that firms vary in the extent to which they are able to integrate different scientific
specialties—such as genetics, biology, chemistry, and pharmacology—to develop
new drugs. Firms that are able to form effective multidisciplinary teams to explore
new drug categories have what some have called an architectural competence,
that is, the ability to use organizational structure to facilitate coordination among
scientific disciplines to conduct research. Firms that have this competence are able
to more effectively pursue product differentiation strategies—by introducing new
and powerful drugs—than those that do not have this competence. And in the
pharmaceutical industry, where firms that introduce such drugs can experience
very large positive returns, the ability to coordinate across functions is an impor-
tant source of competitive advantage.9
Links with Other Firms. Another basis of product differentiation is linkages with
other firms. Here, instead of differentiating products or services on the basis of
linkages between functions within a single firm or linkages between different
products, differentiation is based on explicit linkages between one firm’s products
and the products or services of other firms.
This form of product differentiation has increased in popularity over the
past several years. For example, with the growth in popularity of stock car rac-
ing in the United States, more and more corporations are looking to link their
products or services with famous names and cars in NASCAR. Firms such as
Burger King, McDonald’s Target, Taco Bell, GEICO, Farmers Insurance, Lowe’s,
FedEx, 5-Hour Energy, and Miller Lite have all been major sponsors of NASCAR
teams. In one year, the Coca-Cola Corporation filled orders for more than 200,000
NASCAR-themed vending machines. Visa struggled to keep up with demand for
its NASCAR affinity cards, and more than 1 million NASCAR Barbies were sold by
Mattel—generating revenues of about $50 million. Notice that none of these firms,
except GEICO and Farmers, sells products for automobiles. Rather, these firms seek
to associate themselves with NASCAR because of the sport’s popularity.10
In general, linkages between firms that differentiate their products are ex-
amples of cooperative strategic alliance strategies. The conditions under which
cooperative strategic alliances create value and are sources of sustained competi-
tive advantage are discussed in detail in Chapter 9.
product Mix. One of the outcomes of links among functions within a firm and
links between firms can be changes in the mix of products a firm brings to the
market. This mix of products or services can be a source of product differentiation,
especially when (1) those products or services are technologically linked or (2)
when a single set of customers purchases several of a firm’s products or services.
For example, technological interconnectivity is an extremely important sell-
ing point in the information technology business and, thus, an important basis of
potential product differentiation. However, seamless interconnectivity—where
Company A’s computers talk to Company B’s computers across Company C’s
data line merging a database created by Company D’s software with a database
created by Company E’s software to be used in a calling center that operates with
M05_BARN0088_05_GE_C05.INDD 157 13/09/14 3:30 PM

158 Part 2: Business-Level Strategies
Company F’s technology—has been extremely difficult to realize. For this
reason, some information technology firms try to realize the goal of intercon-
nectivity by adjusting their product mix, that is, by selling a bundle of products
whose interconnectivity they can control and guarantee to customers. This
goal of selling a bundle of interconnected technologies can influence a firm’s
research and development, strategic alliance, and merger and acquisition strat-
egies because all these activities can influence the set of products a firm brings
to market.
Shopping malls are an example of the second kind of linkage among a mix
of products—where products have a common set of customers. Many customers
prefer to go to one location, to shop at several stores at once, rather than travel to
a series of locations to shop. This one-stop shopping reduces travel time and helps
turn shopping into a social experience. Mall development companies have recog-
nized that the value of several stores brought together in a particular location is
greater than the value of those stores if they were isolated, and they have invested
to help create this mix of retail shopping opportunities.11
Distribution c hannels. Linkages within and between firms can also have an impact
on how a firm chooses to distribute its products, and distribution channels can be a
basis of product differentiation. For example, in the soft drink industry, Coca-Cola,
PepsiCo, and 7-Up all distribute their drinks through a network of independent
and company-owned bottlers. These firms manufacture key ingredients for their
soft drinks and ship these ingredients to local bottlers, who add carbonated water,
package the drinks in bottles or cans, and distribute the final product to soft drink
outlets in a given geographic area. Each local bottler has exclusive rights to distrib-
ute a particular brand in a geographic location.
Canada Dry has adopted a completely different distribution network.
Instead of relying on local bottlers, Canada Dry packages its soft drinks in several
locations and then ships them directly to wholesale grocers, who distribute the
product to local grocery stores, convenience stores, and other retail outlets.
One of the consequences of these alternative distribution strategies is that
Canada Dry has a relatively strong presence in grocery stores but a relatively
small presence in soft drink vending machines. The vending machine market is
dominated by Coca-Cola and PepsiCo. These two firms have local distributors that
maintain and stock vending machines. Canada Dry has no local distributors and
is able to get its products into vending machines only when they are purchased
by local Coca-Cola or Pepsi distributors. These local distributors are likely to pur-
chase and stock Canada Dry products such as Canada Dry ginger ale, but they are
contractually prohibited from purchasing Canada Dry’s various cola products.12
Service and Support. Finally, products have been differentiated by the level of
service and support associated with them. For example, some personal computer
firms have very low levels of service provided by independent service dealers.
Others have outsourced service and support functions to overseas companies, of-
ten in India. On the other hand, some firms continue to staff support centers with
highly qualified individuals, thereby providing a high level of support.13
Product Differentiation and Creativity
The bases of product differentiation listed in Table 5.1 indicate a broad range
of ways in which firms can differentiate their products and services. In the
end, however, any effort to list all possible ways to differentiate products and
M05_BARN0088_05_GE_C05.INDD 158 13/09/14 3:30 PM

Chapter 5: Product Differentiation 159
services is doomed to failure. Product differentiation is ultimately an expression
of the creativity of individuals and groups within firms. It is limited only by the
opportunities that exist, or that can be created, in a particular industry and by the
willingness and ability of firms to creatively explore ways to take advantage of
those opportunities. It is not unreasonable to expect that the day some academic
researcher claims to have developed the definitive list of bases of product differ-
entiation, some creative engineer, marketing specialist, or manager will think of
yet another way to differentiate his or her product.
The Value of Product Differentiation
In order to have the potential for generating competitive advantages, the bases of
product differentiation upon which a firm competes must be valuable. The mar-
ket conditions under which product differentiation can be valuable are discussed
in the Strategy in Depth feature. More generally, in order to be valuable, bases of
product differentiation must enable a firm to neutralize its threats and/or exploit
its opportunities.
Product Differentiation and environmental Threats
Successful product differentiation helps a firm respond to each of the environ-
mental threats identified. For example, product differentiation helps reduce the
threat of new entry by forcing potential entrants to an industry to absorb not
only the standard costs of beginning business, but also the additional costs as-
sociated with overcoming incumbent firms’ product differentiation advantages.
The relationship between product differentiation and new entry has already been
discussed in Chapter 2.
Product differentiation reduces the threat of rivalry because each firm in
an industry attempts to carve out its own unique product niche. Rivalry is not
reduced to zero because these products still compete with one another for a
common set of customers, but it is somewhat attenuated because the custom-
ers each firm seeks are different. For example, both a Rolls-Royce and a Fiat
satisfy the same basic consumer need—transportation—but it is unlikely that
potential customers of Rolls-Royce will also be interested in purchasing a Fiat
or vice versa.
Product differentiation also helps firms reduce the threat of substitutes by
making a firm’s current products appear more attractive than substitute prod-
ucts. For example, fresh food can be thought of as a substitute for frozen pro-
cessed foods. In order to make its frozen processed foods more attractive than
fresh foods, products such as Stouffer’s and Swanson are marketed heavily
through television advertisements, newspaper ads, point-of-purchase displays,
and coupons.
Product differentiation can also reduce the threat of powerful suppliers.
Powerful suppliers can raise the prices of the products or services they provide.
Often, these increased supply costs must be passed on to a firm’s customers in
the form of higher prices if a firm’s profit margin is not to deteriorate. A firm
without a highly differentiated product may find it difficult to pass its increased
costs on to customers because these customers will have numerous other ways to
purchase similar products or services from a firm’s competitors. However, a firm
with a highly differentiated product may have loyal customers or customers who
V R I O
M05_BARN0088_05_GE_C05.INDD 159 13/09/14 3:30 PM

160 Part 2: Business-Level Strategies
The two classic treatments of the relationship between product dif-
ferentiation and firm value, developed
independently and published at approx-
imately the same time, are by Edward
Chamberlin and Joan Robinson.
Both Chamberlin and Robinson
examine product differentiation and
firm performance relative to perfect
competition. As explained in Chapter 2,
under perfect competition, it is assumed
that there are numerous firms in an in-
dustry, each controlling a small propor-
tion of the market, and the products or
services sold by these firms are assumed
to be identical. Under these conditions,
firms face a horizontal demand curve
(because they have no control over the
price of the products they sell), and they
maximize their economic performance
by producing and selling output such
that marginal revenue equals marginal
costs. The maximum economic perfor-
mance a firm in a perfectly competitive
market can obtain, assuming no cost
differences across firms, is normal eco-
nomic performance.
When firms sell differentiated
products, they gain some ability to
adjust their prices. A firm can sell its
output at very high prices and pro-
duce relatively smaller amounts of
output, or it can sell its output at very
low prices and produce relatively
greater amounts of output. These
trade-offs between price and quantity
produced suggest that firms selling
differentiated products face a down-
ward-sloping demand curve, rather
than the horizontal demand curve for
firms in a perfectly competitive mar-
ket. Firms selling differentiated prod-
ucts and facing a downward-sloping
demand curve are in an industry
structure described by Chamberlin as
monopolistic competition. It is as if,
within the market niche defined by a
firm’s differentiated product, a firm
possesses a monopoly.
Firms in monopolistically
competitive markets still maximize
their economic profit by producing
and selling a quantity of products
such that marginal revenue equals
marginal cost. The price that firms can
charge at this optimal point depends
on the demand they face for their
differentiated product. If demand
is large, then the price that can be
charged is greater; if demand is low,
then the price that can be charged is
lower. However, if a firm’s average to-
tal cost is below the price it can charge
(i.e., if average total cost is less than
the demand-determined price), then
a firm selling a differentiated product
can earn an above-normal economic
profit.
Consider the example pre-
sented in Figure 5.1. Several curves
are relevant in this figure. First, note
that a firm in this industry faces
downward-sloping demand (D). This
means that the industry is not per-
fectly competitive and that a firm
has some control over the prices it
will charge for its products. Also,
the marginal-revenue curve (MR)
is downward sloping and every-
where lower than the demand curve.
Marginal revenue is downward slop-
ing because in order to sell additional
levels of output of a single product, a
firm must be willing to lower its
price. The marginal-revenue curve is
lower than the demand curve be-
cause this lower price applies to all
the products sold by a firm, not just
to any additional products the firm
The economics of Product
Differentiation
Strategy in Depth
are unable to purchase similar products or services from other firms. These types
of customers are more likely to accept increased prices. Thus, a powerful supplier
may be able to raise its prices, but, up to some point, these increases will not re-
duce the profitability of a firm selling a highly differentiated product.
Finally, product differentiation can reduce the threat of powerful buyers.
When a firm sells a highly differentiated product, it enjoys a “quasi-monopoly” in
that segment of the market. Buyers interested in purchasing this particular prod-
uct must buy it from a particular firm. Any potential buyer power is reduced by
the ability of a firm to withhold highly valued products or services from a buyer.
M05_BARN0088_05_GE_C05.INDD 160 13/09/14 3:30 PM

Chapter 5: Product Differentiation 161
Qe
P
Q
Pe
MC
MR
ATC
ATC
D
Figure 5.1 Product
Differentiation and Firm
Performance: The Analysis of
Monopolistic Competition
sells. The marginal-cost curve (MC)
is upward sloping, indicating that in
order to produce additional outputs
a firm must accept additional costs.
The average-total-cost curve (ATC)
can have a variety of shapes, de-
pending on the economies of scale,
the cost of productive inputs, and
other cost phenomena described in
Chapter 4.
These four curves (demand,
marginal revenue, marginal cost, and
average total cost) can be used to de-
termine the level of economic profit
for a firm under monopolistic com-
petition. To maximize profit, the firm
produces an amount (Qe) such that
marginal costs equal marginal reve-
nues. To determine the price of a firm’s
output at this level
of production, a ver-
tical line is drawn
from the point
where marginal
costs equal marginal
revenues. This line
will intersect with
the demand curve.
Where this vertical
line intersects de-
mand, a horizon-
tal line is drawn to
the vertical (price)
axis to determine
the price a firm can
in Chapter 2, a basic assumption of
S-C-P models is that the existence of
above-normal economic performance
motivates entry into an industry or
into a market niche within an indus-
try. In monopolistically competitive
industries, such entry means that the
demand curve facing incumbent firms
shifts downward and to the left. This
implies that an incumbent firm’s cus-
tomers will buy less of its output if it
maintains its prices or (equivalently)
that a firm will have to lower its prices
to maintain its current volume of sales.
In the long run, entry into this market
niche can lead to a situation where the
price of goods or services sold when a
firm produces output such that mar-
ginal cost equals marginal revenue is
exactly equal to that firm’s
average total cost. At this
point, a firm earns zero eco-
nomic profits even if it still
sells a differentiated product.
Sources: E. H. Chamberlin (1933).
The economics of monopolistic compe-
tition. Cambridge, MA: MIT Press;
J. Robinson (1934). “What is perfect
competition?” Quarterly Journal of
Economics, 49, pp. 104–120.
charge. In the figure, this price is Pe.
At the point Pe, average total cost is
less than the price. The total revenue
obtained by the firm in this situation
(price × quantity) is indicated by the
shaded area in the figure. The eco-
nomic profit portion of this total rev-
enue is indicated by the crosshatched
section of the shaded portion of the
figure. Because this crosshatched sec-
tion is above average total costs in
the figure, it represents a competitive
advantage. If this section was below
average total costs, it would represent
a competitive disadvantage.
Chamberlin and Robinson go
on to discuss the impact of entry into
the market niche defined by a firm’s
differentiated product. As discussed
Product Differentiation and environmental Opportunities
Product differentiation can also help a firm take advantage of environmental
opportunities. For example, in fragmented industries firms can use product dif-
ferentiation strategies to help consolidate a market. In the office-paper industry,
Xerox has used its brand name to become the leading seller of paper for office
copy machines and printers. Arguing that its paper is specially manufactured to
avoid jamming in its own copy machines, Xerox was able to brand what had been
a commodity product and facilitate the consolidation of what had been a very
fragmented industry.14
M05_BARN0088_05_GE_C05.INDD 161 13/09/14 3:30 PM

162 Part 2: Business-Level Strategies
The role of product differentiation in emerging industries was discussed in
Chapter 2. By being a first mover in these industries, firms can gain product dif-
ferentiation advantages based on perceived technological leadership, preemption
of strategically valuable assets, and buyer loyalty due to high switching costs.
In mature industries, product differentiation efforts often switch from at-
tempts to introduce radically new technologies to product refinement as a basis
of product differentiation. For example, in the mature retail gasoline market
firms attempt to differentiate their products by selling slightly modified gasoline
(cleaner-burning gasoline, gasoline that cleans fuel injectors, and so forth) and by
altering the product mix (linking gasoline sales with convenience stores). In ma-
ture markets, it is sometimes difficult to find ways to actually refine a product or
service. In such settings, firms can sometimes be tempted to exaggerate the extent
to which they have refined and improved their products or services. The implica-
tions of these exaggerations are discussed in the Ethics and Strategy feature.
Product differentiation can also be an important strategic option in a declin-
ing industry. Product-differentiating firms may be able to become leaders in this
kind of industry (based on their reputation, unique product attributes, or some
other product differentiation basis). Alternatively, highly differentiated firms may
be able to discover a viable market niche that will enable them to survive despite
the overall decline in the market.
Finally, the decision to implement a product differentiation strategy can
have a significant impact on how a firm acts in a global industry. For example,
several firms in the retail clothing industry with important product differentiation
advantages in their home markets are beginning to enter into the U.S. retail cloth-
ing market. These firms include Sweden’s H & M Hennes & Mauritz AB, with its
emphasis on “cheap chic”; the Dutch firm Mexx; the Spanish company Zara; and
the French sportswear company Lacoste.15
Product Differentiation and Sustained
Competitive Advantage
Product differentiation strategies add value by enabling firms to charge prices for
their products or services that are greater than their average total cost. Firms that
implement this strategy successfully can reduce a variety of environmental threats
and exploit a variety of environmental opportunities. However, as discussed in
Chapter 3, the ability of a strategy to add value to a firm must be linked with rare
and costly-to-imitate organizational strengths in order to generate a sustained
competitive advantage. Each of the bases of product differentiation listed earlier in
this chapter varies with respect to how likely it is to be rare and costly to imitate.
Rare Bases for Product Differentiation
The concept of product differentiation generally assumes that the number of firms
that have been able to differentiate their products in a particular way is, at some
point in time, smaller than the number of firms needed to generate perfect competi-
tion dynamics. Indeed, the reason that highly differentiated firms can charge a price
for their product that is greater than average total cost is because these firms are us-
ing a basis for product differentiation that few competing firms are also using.
Ultimately, the rarity of a product differentiation strategy depends on the
ability of individual firms to be creative in finding new ways to differentiate their
V R I O
M05_BARN0088_05_GE_C05.INDD 162 13/09/14 3:30 PM

Chapter 5: Product Differentiation 163
products. As suggested earlier, highly creative firms will be able to discover or
create new ways to do this. These kinds of firms will always be one step ahead of
the competition because rival firms will often be trying to imitate these firms’ last
product differentiation moves while creative firms are working on their next one.
One of the most common ways to try to differentiate a product is to
make claims about that product’s per-
formance. In general, high- performance
products command a price premium
over low-performance products.
However, the potential price advan-
tages enjoyed by high- performance
products can sometimes lead firms to
make claims about their products that,
at the least, strain credibility and, at the
most, simply lie about what their prod-
ucts can do.
Some of these claims are eas-
ily dismissed as harmless exaggera-
tions. Few people actually believe that
using a particular type of whitening
toothpaste is going to make your in-
laws like you or that not wearing a
particular type of deodorant is going
to cause patrons in a bar to collapse
when you lift your arms in victory
after a foosball game. These exaggera-
tions are harmless and present few
ethical challenges.
However, in the field of health
care, exaggerated product perfor-
mance claims can have serious con-
sequences. This can happen when a
patient takes a medication with exag-
gerated performance claims instead
of a medication with more mod-
est, although accurate, performance
claims. A history of false medical per-
formance claims in the United States
led to the formation of the Food and
Drug Administration (FDA), a federal
regulatory agency charged with eval-
uating the efficacy of drugs before
they are marketed. Historically, the
FDA has adopted the “gold standard”
of drug approval—not only must a
drug demonstrate that it does what
it claims, it must also demonstrate
that it does not do any significant
harm to the patient. Patients can be
confident that drugs that pass the
FDA approval process meet the high-
est standards in the world.
However, this “gold standard”
of approval creates important ethical
dilemmas—mostly stemming from the
time it takes a drug to pass the FDA
approval process. This process can take
between five and seven years. During
FDA trials, patients who might other-
wise benefit from a drug are not allowed
to use it because it has not yet received
FDA approval. Thus, although the FDA
approval process may work very well
for people who may need a drug some-
time in the future, it works less well for
those who need a drug right now.
A growing suspicion among
some consumers that the FDA pro-
cess may prevent effective drugs from
being marketed has helped feed the
growth of alternative treatments—
usually based on some herbal or more
natural formula. Such treatments are
careful to note that their claims—
everything from regrowing hair to
losing weight to enhancing athletic
performance to quitting smoking—
have not been tested by the FDA. And
yet these claims are still made.
Some of these performance
claims seem at least reasonable. For ex-
ample, it is now widely accepted that
ephedra does behave as an amphet-
amine and thus is likely to enhance
strength and athletic performance.
Others—including those that claim
that a mixture of herbs can actually
increase the size of male genitals—
seem far-fetched, at best. Indeed, a
recent analysis of herbal treatments
making this claim found no ingredi-
ents that could have this effect, but did
find an unacceptably high concentra-
tion of bacteria from animal feces that
can cause serious stomach disorders.
Firms that sell products on the basis
of exaggerated and unsubstantiated
claims face their own ethical dilem-
mas. And, without the FDA to ensure
product safety and efficacy, the adage
caveat emptor—let the buyer beware—
seems like good advice.
Sources: J. Angwin (2003). “Some ‘enlargement
pills’ pack impurities.” The Wall Street Journal,
April 8, p. B1; G. Pisano (1991). “Nucleon, Inc.”
Harvard Business School Case No. 9-692-041.
Ethics and Strategy
Product Claims and the ethical
Dilemmas in Health Care
M05_BARN0088_05_GE_C05.INDD 163 13/09/14 3:30 PM

164 Part 2: Business-Level Strategies
The Imitability of Product Differentiation
Valuable and rare bases of product differentiation must be costly to imitate if they
are to be sources of sustained competitive advantage. Both direct duplication and
substitution, as approaches to imitation, are important in understanding the abil-
ity of product differentiation to generate competitive advantages.
Direct Duplication of product Differentiation
As discussed in Chapter 4, firms that successfully implement a cost leadership
strategy can choose whether they want to reveal this strategic choice to their com-
petition by adjusting their prices. If they keep their prices high—despite their cost
advantages—the existence of those cost advantages may not be revealed to com-
petitors. Of course, other firms—such as Wal-Mart—that are confident that their
cost advantages cannot be duplicated at low cost are willing to reveal their cost
advantage through charging lower prices for their products or services.
Firms pursuing product differentiation strategies usually do not have this
option. More often than not, the act of selling a highly differentiated product or
service reveals the basis upon which a firm is trying to differentiate its prod-
ucts. In fact, most firms go to great lengths to let their customers know how
they are differentiating their products, and in the process of informing poten-
tial customers they also inform their competitors. Indeed, if competitors are not
sure how a firm is differentiating its product, all they need to do is purchase
that product themselves. Their own experience with the product—its features
and other attributes—will tell them all they need to know about this firm’s
product differentiation strategy.
Knowing how a firm is differentiating its products, however, does not
necessarily mean that competitors will be able to duplicate the strategy at low
cost. The ability to duplicate a valuable and rare product differentiation strategy
depends on the basis upon which a firm is differentiating its products. As sug-
gested in Table 5.2, some bases of product differentiation—including the use of
product features—are almost always easy to duplicate. Others—including prod-
uct mix, links with other firms, product customization, product complexity, and
consumer marketing—can sometimes be costly to duplicate. Finally, still other
bases of product differentiation—including links between functions, timing, lo-
cation, reputation, distribution channels, and service and support—are usually
costly to duplicate.
How costly it is to duplicate a particular basis of product differentiation
depends on the kinds of resources and capabilities that basis uses. When those
resources and capabilities are acquired in unique historical settings, when there
is some uncertainty about how to build these resources and capabilities, or when
these resources and capabilities are socially complex in nature, then product dif-
ferentiation strategies that exploit these kinds of resources and capabilities will
be costly to imitate. These strategies can be a source of sustained competitive
advantage for a firm. However, when a product differentiation strategy exploits
resources and capabilities that do not possess these attributes, then those strate-
gies are likely to be less costly to duplicate and, even if they are valuable and rare,
will only be sources of temporary competitive advantage.
bases of product Differentiation t hat a re easy to Duplicate. The one basis of product
differentiation in Table 5.2 that is identified as almost always being easy to du-
plicate is product features. The irony is that product features are by far the most
popular way for firms to try to differentiate their products. Rarely do product
M05_BARN0088_05_GE_C05.INDD 164 13/09/14 3:30 PM

Chapter 5: Product Differentiation 165
features, by themselves, enable a firm to gain sustained competitive advantages
from a product differentiation strategy.
For example, virtually every one of the product features used in the auto-
mobile industry to differentiate the products of different automobile companies
has been duplicated. Chrysler’s “cab forward” design has been incorporated into
the design of many manufacturers. The curved, sporty styling of the Audi has
surfaced in cars manufactured by Lexus and General Motors. GM’s “On Star”
system has been duplicated by Mercedes. Mercedes’ crumple-zone technology
has become the industry standard, as has GM’s uni-body construction method.
Indeed, only the Mazda Miata, Nissan 370Z, and Porsche 911 have remained
unduplicated—and this has little to do with the product features of these cars and
much more to do with their reputation.
The only time product features, per se, can be a source of sustained com-
petitive advantage for a firm is when those features are protected by patents.
However, as was discussed in Chapters 2 and 3, even patents provide only lim-
ited protection from direct duplication, except in very unusual settings.
Although product features, by themselves, are usually not a source of sus-
tained competitive advantage, they can be a source of a temporary competitive
advantage. During the period of time when a firm has a temporary competitive
advantage from implementing a product differentiation strategy based on product
features, it may be able to attract new customers. Once these customers try the
product, they may discover other features of a firm’s products that make them at-
tractive. If these other features are costly to duplicate, then they can be a source of
sustained competitive advantage, even though the features that originally attracted
a customer to a firm’s products will often be rapidly duplicated by competitors.
bases of product Differentiation t hat May be c ostly to Duplicate. Some bases of prod-
uct differentiation may be costly to duplicate, at least in some circumstances. The
first of these, listed in Table 5.2, is product mix.
History Uncertainty Social Complexity
Low-cost duplication usually possible
1. Product features — — —
May be costly to duplicate
2. Product mix * * *
3. Links with other firms * — **
4. Product customization * — **
5. Product complexity * — *
6. Consumer marketing — ** —
Usually costly to duplicate
7. Links between functions * * **
8. Timing *** * —
9. Location *** — —
10. Reputation *** ** ***
11. Distribution channels ** * **
12. Service and support * * **
— = Not likely to be a source of costly duplication, * = Somewhat likely to be a source of costly duplication,
** = Likely to be a source of costly duplication, *** = Very likely to be a source of costly duplication
TaBle 5.2 Bases of Product
Differentiation and the Cost of
Duplication
M05_BARN0088_05_GE_C05.INDD 165 13/09/14 3:30 PM

166 Part 2: Business-Level Strategies
Duplicating the features of another firm’s products is usually not diffi-
cult. However, if that firm brings a series of products to market, if each of these
products has unique features, and most important, if the products are highly
integrated with each other, then this mix of products may be costly to duplicate.
Certainly, the technological integration of the mix of information technology
products sold by IBM and other firms has been relatively difficult to duplicate for
firms that do not manufacture all these products themselves.
However, when this basis of a product mix advantage is a common cus-
tomer, then duplication is often less difficult. Thus, although having a mall that
brings several stores together in a single place is a source of competitive advan-
tage over stand-alone stores, it is not a competitive advantage over other malls
that provide the same service. Because there continue to be opportunities to build
such malls, the fact that malls make it easier for a common set of customers to
shop does not give any one mall a sustained competitive advantage.
Links with other firms may also be costly to duplicate, especially when
those links depend on socially complex relationships. The extent to which inter-
firm links can provide sources of sustained competitive advantage is discussed in
more detail in Chapter 9.
In the same way, product customization and product complexity are often easy-
to-duplicate bases of product differentiation. However, sometimes the ability of a firm
to customize its products for one of its customers depends on the close relationships
it has developed with those customers. Product customization of this sort depends
on the willingness of a firm to share often-proprietary details about its operations,
products, research and development, or other characteristics with a supplying firm.
Willingness to share this kind of information, in turn, depends on the ability of each
firm to trust and rely on the other. The firm opening its operations to a supplier must
trust that that supplier will not make this information broadly available to competing
firms. The firm supplying customized products must trust that its customer will not
take unfair advantage of it. If two firms have developed these kinds of socially com-
plex relationships, and few other firms have them, then links with other firms will be
costly to duplicate and a source of sustained competitive advantage.
The product customization seen in both enterprise software and in high-end
customized bicycles has these socially complex features. In a real sense, when
these products are purchased, a relationship with a supplier is being established—
a relationship that is likely to last a long period of time. Once this relationship is
established, partners are likely to be unwilling to abandon it, unless, of course, a
party to the exchange tries to take unfair advantage of another party to that ex-
change. This possibility is discussed in detail in Chapter 9.
Finally, consumer marketing, though a very common form of product differ-
entiation, is often easy to duplicate. Thus, whereas Mountain Dew has established
itself as the “extreme games” drink, other drinks, including Gatorade, have also
begun to tap into this market segment. Of course, every once in a while an advertis-
ing campaign or slogan, a point-of-purchase display, or some other attribute of a
consumer marketing campaign will unexpectedly catch on and create greater-than-
expected product awareness. In beer, marketing campaigns such as “Tastes great,
less filling,” “Why ask why?,” the “Budweiser Frogs,” and “What’s Up?” have had
these unusual effects. If a firm, in relation with its various consumer marketing
agencies, is systematically able to develop these superior consumer marketing cam-
paigns, then it may be able to obtain a sustained competitive advantage. However,
if such campaigns are unpredictable and largely a matter of a firm’s good luck, they
cannot be expected to be a source of sustained competitive advantage.
M05_BARN0088_05_GE_C05.INDD 166 13/09/14 3:30 PM

Chapter 5: Product Differentiation 167
bases of product Differentiation t hat a re Usually c ostly to Duplicate. The remaining
bases of product differentiation listed in Table 5.2 are usually costly to duplicate.
Firms that differentiate their products on these bases may be able to obtain sus-
tained competitive advantages.
Linkages across functions within a single firm are usually a costly-to-duplicate
basis of product differentiation. Whereas linkages with other firms can be either
easy or costly to duplicate, depending on the nature of the relationship that exists
between firms, linkages across functions within a single firm usually require socially
complex, trusting relations. There are numerous built-in conflicts between functions
and divisions within a single firm. Organizations that have a history and culture that
support cooperative relations among conflicting divisions may be able to set aside
functional and divisional conflicts to cooperate in delivering a differentiated product
to the market. However, firms with a history of conflict across functional and divi-
sional boundaries face a significant, and costly, challenge in altering these socially
complex, historical patterns.
Indeed, the research on architectural competence in pharmaceutical firms
suggests that not only do some firms possess this competence, but that other firms
do not. Moreover, despite the significant advantages that accrue to firms with this
competence, firms without this competence have, on average, been unable to de-
velop it. All this suggests that such a competence, if it is also rare, is likely to be
costly to duplicate and thus a source of sustained competitive advantage.
Timing is also a difficult-to-duplicate basis of product differentiation. As
suggested in Chapter 3, it is difficult (if not impossible) to re-create a firm’s
unique history. If that history endows a firm with special resources and capa-
bilities it can use to differentiate its products, this product differentiation strategy
can be a source of sustained competitive advantage. Rivals of a firm with such
a timing-based product differentiation advantage may need to seek alternative
ways to differentiate their products. Thus, it is not surprising that universities that
compete with the oldest universities in the country find alternative ways to dif-
ferentiate themselves—through their size, the quality of their extramural sports,
their diversity—rather than relying on their age.
Location is often a difficult-to-duplicate basis of product differentiation. This
is especially the case when a firm’s location is unique. For example, research on the
hotel preferences of business travelers suggests that location is a major determinant
of the decision to stay in a hotel. Hotels that are convenient to both major transpor-
tation and commercial centers in a city are preferred, other things being equal, to
hotels in other types of locations. Indeed, location has been shown to be a more im-
portant decision criterion for business travelers than price. If only a few hotels in a
city have these prime locations and if no further hotel development is possible, then
hotels with these locations can gain sustained competitive advantages.
Of all the bases of product differentiation listed in this chapter, perhaps none
is more difficult to duplicate than a firm’s reputation. As suggested earlier, a firm’s
reputation is actually a socially complex relationship between a firm and its custom-
ers, based on years of experience, commitment, and trust. Reputations are not built
quickly, nor can they be bought and sold. Rather, they can only be developed over
time by consistent investment in the relationship between a firm and its customers.
A firm with a positive reputation can enjoy a significant competitive advantage,
whereas a firm with a negative reputation, or no reputation, may have to invest sig-
nificant amounts over long periods of time to match the differentiated firm.
Distribution channels can also be a costly-to-duplicate basis of product
differentiation, for at least two reasons. First, relations between a firm and its
M05_BARN0088_05_GE_C05.INDD 167 13/09/14 3:30 PM

168 Part 2: Business-Level Strategies
distribution channels are often socially complex and thus costly to duplicate.
Second, the supply of distribution channels may be limited. Firms that already
have access to these channels may be able to use them, but firms that do not have
such access may be forced to create their own or develop new channels. Creating
new channels or developing entirely new means of distribution can be difficult
and costly undertakings.16 These costs are one of the primary motivations under-
lying many international joint ventures (see Chapter 9).
Finally, level of service and support can be a costly-to-duplicate basis of
product differentiation. In most industries, it is usually not too costly to provide
a minimum level of service and support. In home electronics, this minimum level
of service can be provided by a network of independent electronic repair shops. In
automobiles, this level of service can be provided by service facilities associated
with dealerships. In fast foods, this level of service can be provided by a mini-
mum level of employee training.
However, moving beyond this minimum level of service and support can be
difficult for at least two reasons. First, increasing the quality of service and sup-
port may involve substantial amounts of costly training. McDonald’s has created
a sophisticated training facility (Hamburger University) to maintain its unusually
high level of service in fast foods. General Electric has invested heavily in training
for service and support over the past several years. Many Japanese automakers
spent millions on training employees to help support auto dealerships before they
opened U.S. manufacturing facilities.17
More important than the direct costs of the training needed to provide
high-quality service and support, these bases of product differentiation often
reflect the attitude of a firm and its employees toward customers. In many
firms throughout the world, the customer has become “the bad guy.” This is, in
many ways, understandable. Employees tend to interact with their customers
less frequently than they interact with other employees. When they do interact
with customers, they are often the recipients of complaints directed at the firm.
In these settings, hostility toward the customer can develop. Such hostility is,
of course, inconsistent with a product differentiation strategy based on cus-
tomer service and support.
In the end, high levels of customer service and support are based on socially
complex relations between firms and customers. Firms that have conflicts with
their customers may face some difficulty duplicating the high levels of service
and support provided by competing firms.
Substitutes for product Differentiation
The bases of product differentiation outlined in this chapter vary in how rare they
are likely to be and in how difficult they are to duplicate. However, the ability of
the bases of product differentiation to generate a sustained competitive advantage
also depends on whether low-cost substitutes exist.
Substitutes for bases of product differentiation can take two forms. First,
many of the bases of product differentiation listed in Table 5.1 can be partial
substitutes for each other. For example, product features, product customiza-
tion, and product complexity are all very similar bases of product differentia-
tion and thus can act as substitutes for each other. A particular firm may try to
develop a competitive advantage by differentiating its products on the basis
of product customization only to find that its customization advantages are
reduced as another firm alters the features of its products. In a similar way, link-
ages between functions, linkages between firms, and product mix, as bases of
M05_BARN0088_05_GE_C05.INDD 168 13/09/14 3:30 PM

Chapter 5: Product Differentiation 169
product differentiation, can also be substitutes for each other. IBM links its sales,
service, and consulting functions to differentiate itself in the computer market.
Other computer firms, however, may develop close relationships with computer
service companies and consulting firms to close this product differentiation
advantage. Given that different bases of product differentiation are often partial
substitutes for each other, it is not surprising that firms pursue these multiple
bases of product differentiation simultaneously.
Second, other strategies discussed throughout this book can be substi-
tutes for many of the bases of product differentiation listed in Table 5.1. One
firm may try to gain a competitive advantage through adjusting its product
mix, and another firm may substitute strategic alliances to create the same
type of product differentiation. For example, Southwest Airlines’ continued
emphasis on friendly, on-time, low-cost service and United Airlines’ empha-
sis on its links to Lufthansa and other worldwide airlines through the Star
Alliance can both be seen as product differentiation efforts that are at least
partial substitutes.18
In contrast, some of the other bases of product differentiation discussed in
this chapter have few obvious close substitutes. These include timing, location,
distribution channels, and service and support. To the extent that these bases of
product differentiation are also valuable, rare, and difficult to duplicate, they may
be sources of sustained competitive advantage.
Organizing to Implement Product Differentiation
As was suggested in Chapter 3, the ability to implement a strategy depends
on the adjustment of a firm’s structure, its management controls, and its
compensation policies to be consistent with that strategy. Whereas strategy
implementation for firms adopting a cost leadership strategy focuses on re-
ducing a firm’s costs and increasing its efficiency, strategy implementation
for a firm adopting a product differentiation strategy must focus on innova-
tion, creativity, and product performance. Whereas cost-leading firms are all
about customer value, product-differentiating firms are all about style. How
the need for style is reflected in a firm’s structure, controls, and compensation
policies is summarized in Table 5.3.
Organizational Structure:
1. Cross-divisional/cross-functional product development teams
2. Complex matrix structures
3. Isolated pockets of intense creative efforts: Skunk works
Management Control Systems:
1. Broad decision-making guidelines
2. Managerial freedom within guidelines
3. A policy of experimentation
Compensation Policies:
1. Rewards for risk-taking, not punishment for failures
2. Rewards for creative flair
3. Multidimensional performance measurement
TaBle 5.3 Organizing
to Implement Product
Differentiation Strategies
V R I O
M05_BARN0088_05_GE_C05.INDD 169 13/09/14 3:30 PM

170 Part 2: Business-Level Strategies
Organizational Structure and Implementing Product Differentiation
Both cost leadership and product differentiation strategies are implemented
through the use of a functional, or U-form, organizational structure. However,
whereas the U-form structure used to implement a cost leadership strategy has few
layers, simple reporting relationships, a small corporate staff, and a focus on only
a few business functions, the U-form structure for a firm implementing a product
differentiation strategy can be somewhat more complex. For example, these firms
often use temporary cross-divisional and cross-functional teams to manage the
development and implementation of new, innovative, and highly differentiated
products. These teams bring individuals from different businesses and different
functional areas together to cooperate on a particular new product or service.
One firm that has used these cross-divisional and cross-functional teams
effectively is the British advertising agency WPP. WPP owns several very large
advertising agencies, several public relations firms, several market research com-
panies, and so forth. Each of these businesses operates relatively independently in
most areas. However, the corporation has identified a few markets where cross-
divisional and cross-functional collaboration is important. One of these is the
health care market. To exploit opportunities in the health care market, WPP, the
corporation, forms teams of advertising specialists, market research specialists,
public relations specialists, and so on, drawn from each of the businesses it owns.
The resulting cross-divisional teams are given the responsibility of developing
new and highly differentiated approaches to developing marketing strategies for
their clients in the health care industry.19
The creation of cross-divisional or cross-functional teams often implies
that a firm has implemented some form of matrix structure. As suggested in
Chapter 4, a matrix structure exists when individuals in a firm have two or
more “bosses” simultaneously. Thus, for example, if a person from one of WPP’s
advertising agencies is assigned temporarily to a cross-divisional team, that
person has two bosses: the head of the temporary team and the boss back in
the advertising agency. Managing two bosses simultaneously can be very chal-
lenging, especially when they have conflicting interests. And as we will see in
Chapter 8, the interests of these multiple bosses will often conflict.
A particularly important form of the cross-divisional or cross-functional
team exists when this team is relieved of all other responsibilities in the firm and
focuses all its attention on developing a new innovative product or service. The
best-known example of this approach to developing a differentiated product
occurred at the Lockheed Corporation during the 1950s and 1960s when small
groups of engineers were put on very focused teams to develop sophisticated and
top-secret military aircraft. These teams would have a section of the Lockheed
facility dedicated to their efforts and designated as off-limits to almost all other
employees. The joke was that these intensive creative efforts were so engaging
that members of these teams actually would forget to shower—hence the name
“skunk works.” Skunk works have been used by numerous firms to focus the cre-
ative energy required to develop and introduce highly differentiated products.20
Management Controls and Implementing Product Differentiation
The first two management controls helpful for implementing product differen-
tiation listed in Table 5.3—broad decision-making guidelines and managerial
freedom within those guidelines—often go together. How some firms have used
M05_BARN0088_05_GE_C05.INDD 170 13/09/14 3:30 PM

Chapter 5: Product Differentiation 171
these kinds of controls to build entirely new markets is described in the Strategy
in the Emerging Enterprise feature.
Broad decision-making guidelines help bring order to what otherwise might
be a chaotic decision-making process. When managers have no constraints in
their decision making, they can make decisions that are disconnected from each
other and inconsistent with a firm’s overall mission and objectives. This results in
decisions that are either not implemented or not implemented well.
So much innovation in both small and large organizations focuses on
repositioning a firm’s products along
established bases of competition—
a more fuel-efficient car, a better-
cleaning shampoo, a less expensive
insurance policy. While these efforts
can, for a time, be a source of product
differentiation, for reasons discussed
in Chapter 3, they are usually not
sustainable.
For this reason, two scholars—
W. Chan Kim and Renee Mauborgne—
began studying firms that did not
just reposition their products in well-
established competitive markets but,
instead, transcended their competition
to identify entirely new markets. They
called these markets “blue oceans”
because they are not crowded with
competitors seeking to improve their
positions but instead are empty of
competitors and give firms the op-
portunity to grow quickly. For these
authors, blue oceans emerge when
managers discover that the only way
to beat the competition is to stop trying
to beat the competition.
Examples of companies that
have created blue oceans include
Cirque du Soleil—a firm that redefined
what a circus was to become an inter-
national entertainment sensation—and
Casella Wines—a firm whose [yellow
tail] brand made drinking wine a sim-
ple alternative to drinking beer. Both
these companies did not try to compete
with established firms; they created
a new competitive space where these
firms were irrelevant.
So, how can a firm create a blue
ocean? Kim and Mauborgne suggest
that firms begin by understanding
the bases of competition that exist
within an industry already. In the U.S.
wine industry, for example, Casella
identified seven bases of competition:
price, an elite image in packaging,
consumer marketing, aging quality of
wine, vineyard prestige, taste com-
plexity, and a diverse range of wines.
With these bases of product differen-
tiation identified, firms should then
ask four questions about competition
in their industry:
1. Which factors that the industry
currently competes on should be
eliminated?
2. Which factors that the industry
currently competes on should be
reduced well below the industry’s
standard?
3. Which factors should be raised well
above the industry’s standard?
4. Which factors should be
created that the industry has
never offered?
By applying these four ques-
tions to the bases of competition
identified by Casella, this firm de-
cided that elite packaging, aging
quality wine, vineyard prestige, and
taste complexity all complicated the
wine drinking experience and could
be eliminated. They also created new
bases for competition: easy drinking,
ease of selection, and fun and adven-
ture. The result was a wine brand—
[yellow tail]—that has grown faster
than any other wine over the past
10 years.
Some firms have found it dif-
ficult to apply these principles to de-
velop blue oceans for their businesses.
Nevertheless, by systematically seek-
ing ways to redefine the bases of com-
petition in an industry, some firms
have been able to create entirely new
markets where competition does
not exist.
Source: W. Chan Kim and Renee Mauborgne
(2005). Blue ocean strategy. Cambridge: Harvard
Business School Press.
Going in Search of Blue Oceans
Strategy in the Emerging Enterprise
M05_BARN0088_05_GE_C05.INDD 171 13/09/14 3:30 PM

172 Part 2: Business-Level Strategies
However, if these decision-making guidelines become too narrow, they can
stifle creativity within a firm. As was suggested earlier, a firm’s ability to dif-
ferentiate its products is limited only by its creativity. Thus, decision guidelines
must be narrow enough to ensure that the decisions made are consistent with a
firm’s mission and objectives. Yet these guidelines also must be broad enough so
that managerial creativity is not destroyed. In well-managed firms implementing
product differentiation strategies, as long as managerial decisions fall within the
broad decision-making guidelines in a firm, managers have the right—in fact, are
expected—to make creative decisions.
A firm that has worked hard to reach this balance between chaos and control
is 3M. In an effort to provide guiding principles that define the range of acceptable
decisions at 3M, its senior managers have developed a set of innovating principles.
These are presented in Table 5.4 and define the boundaries of innovative chaos at
3M. Within these boundaries, managers and engineers are expected to be creative
and innovative in developing highly differentiated products and services.21
Another firm that has managed this tension well is British Airways (BA).
BA has extensive training programs to teach its flight attendants how to pro-
vide world-class service, especially for its business-class customers. This train-
ing constitutes standard operating procedures that give purpose and structure
to BA’s efforts to provide a differentiated service in the highly competitive
airline industry. Interestingly, however, BA also trains its flight attendants in
when to violate these standard policies and procedures. By recognizing that no
set of management controls can ever anticipate all the special situations that
can occur when providing service to customers, BA empowers its employees
to meet specific customer needs. This enables BA to have both a clearly defined
product differentiation strategy and the flexibility to adjust this strategy as the
situation dictates.22
Firms can also facilitate the implementation of a product differentiation
strategy by adopting a policy of experimentation. Such a policy exists when
firms are committed to engaging in several related product differentiation efforts
simultaneously. That these product differentiation efforts are related suggests
that a firm has some vision about how a particular market is likely to unfold
over time. However, that there are several of these product differentiation efforts
occurring simultaneously suggests that a firm is not overly committed to a par-
ticular narrow vision about how a market is going to evolve. Rather, several dif-
ferent experiments facilitate the exploration of different futures in a marketplace.
Indeed, successful experiments can actually help define the future evolution of a
marketplace.
Consider, for example, Charles Schwab, the innovative discount broker. In
the face of increased competition from full-service and Internet-based brokerage
firms, Schwab engaged in a series of experiments to discover the next generation
of products it could offer to its customers and the different ways it could dif-
ferentiate those products. Schwab investigated software for simplifying online
mutual fund selection, online futures trading, and online company research. It
also formed an exploratory alliance with Goldman Sachs to evaluate the possibil-
ity of enabling Schwab customers to trade in initial public offerings. Not all of
Schwab’s experiments led to the introduction of highly differentiated products.
For example, based on some experimental investments, Schwab decided not to
enter the credit card market. However, by experimenting with a range of possible
product differentiation moves, it was able to develop a range of new products for
the fast-changing financial services industry.23
M05_BARN0088_05_GE_C05.INDD 172 13/09/14 3:30 PM

Chapter 5: Product Differentiation 173
TaBle 5.4 Guiding Innovative Principles at 3M*
1. Vision. Declare the importance of innovation; make
it part of the company’s self-image.
“Our efforts to encourage and support innovation are
proof that we really do intend to achieve our vision of
ourselves … that we intend to become what we want
to be … as a business and as creative individuals.”
2. Foresight. Find out where technologies and mar-
kets are going. Identify articulated and unarticulated
needs of customers.
“If you are working on a next-generation medical
imaging device, you’ll probably talk to radiologists,
but you might also sit down with people who en-
hance images from interplanetary space probes.”
3. Stretch goals. Set goals that will make you and
the organization stretch to make quantum improve-
ments. Although many projects are pursued, place
your biggest bets on those that change the basis of
competition and redefine the industry.
“We have a number of stretch goals at 3M. The first
states that we will drive 30 percent of all sales from
products introduced in the past 4 years .… To estab-
lish a sense of urgency, we’ve recently added another
goal, which is that we want 10 percent of our sales
to come from products that have been in the market
for just 1 year .… Innovation is time sensitive … you
need to move quickly.”
4. Empowerment. Hire good people and trust them,
delegate responsibilities, provide slack resources, and
get out of the way. Be tolerant of initiative and the
mistakes that occur because of that initiative.
“William McKnight [a former chairman of 3M]
came up with one way to institutionalize a tolerance
of individual effort. He said that all technical employ-
ees could devote 15 percent of their time to a project
of their own invention. In other words, they could
manage themselves for 15 percent of the time .… The
number is not so important as the message, which
is this: The system has some slack in it. If you have
a good idea, and the commitment to squirrel away
time to work on it and the raw nerve to skirt your lab
manager’s expressed desires, then go for it.
“Put another way, we want to institutionalize
a bit of rebellion in our labs. We can’t have all our
people off totally on their own … we do believe in
discipline … but at the same time 3M management
encourages a healthy disrespect for 3M management.
This is not the sort of thing we publicize in our an-
nual report, but the stories we tell—with relish—are
frequently about 3Mers who have circumvented their
supervisors and succeeded.
“We also recognize that when you let people fol-
low their own lead … everyone doesn’t wind up at the
same place. You can’t ask people to have unique visions
and march in lockstep. Some people are very precise,
detail-oriented people … and others are fuzzy thinkers
and visionaries … and this is exactly what we want.”
5. Communications. Open, extensive exchanges ac-
cording to ground rules in forums that are present
for sharing ideas and where networking is each indi-
vidual’s responsibility. Multiple methods for sharing
information are necessary.
“When innovators communicate with each other,
you can leverage their discoveries. This is critically
important because it allows companies to get the
maximum return on their substantial investments
in new technologies. It also acts as a stimulus to fur-
ther innovation. Indeed, we believe that the ability to
combine and transfer technologies is as important as
the original discovery of a technology.”
6. Rewards and recognition. Emphasize individual
recognition more than monetary rewards through peer
recognition and by choice of managerial or technical
promotion routes. “Innovation is an intensely human
activity.”
“I’ve laid out six elements of 3M’s corporate culture
that contribute to a tradition of innovation: vision,
foresight, stretch goals, empowerment, communica-
tion, and recognition .… The list is … too orderly.
Innovation at 3M is anything but orderly. It is sen-
sible, in that our efforts are directed at reaching our
goals, but the organization … and the process … and
sometimes the people can be chaotic. We are manag-
ing in chaos, and this is the right way to manage if
you want innovation. It’s been said that the competi-
tion never knows what we are going to come up with
next. The fact is, neither do we.”
*As expressed by W. Coyne (1996). Building a tradition of innovation. The Fifth U.K. Innovation Lecture, Department of Trade and Industry, London.
Cited in Van de Ven et al. (1999), pp. 198–200.
M05_BARN0088_05_GE_C05.INDD 173 13/09/14 3:30 PM

174 Part 2: Business-Level Strategies
Compensation Policies and Implementing Product Differentiation
Strategies
The compensation policies used to implement product differentiation listed in
Table 5.3 very much complement the organizational structure and managerial
controls listed in that table. For example, a policy of experimentation has little
impact on the ability of a firm to implement product differentiation strategies
if every time an innovative experiment fails individuals are punished for tak-
ing risks. Thus, compensation policies that reward risk-taking and celebrate
a creative flair help to enable a firm to implement its product differentiation
strategy.
Consider, for example, Nordstrom. Nordstrom is a department store that
celebrates the risk-taking and creative flair of its associates as they try to satisfy
their customers’ needs. The story is often told of a Nordstrom sales associate
who allowed a customer to return a set of tires to the store because she wasn’t
satisfied with them. What makes this story interesting—whether or not it is
true—is that Nordstrom doesn’t sell tires. But this sales associate felt empow-
ered to make what was obviously a risky decision, and this decision is cele-
brated within Nordstrom as an example of the kind of service that Nordstrom’s
customers should expect.
The last compensation policy listed in Table 5.3 is multidimensional
performance measurement. In implementing a cost leadership strategy, com-
pensation should focus on providing appropriate incentives for managers and
employees to reduce costs. Various forms of cash payments, stock, and stock
options can all be tied to the attainment of specific cost goals and thus can
be used to create incentives for realizing cost advantages. Similar techniques
can be used to create incentives for helping a firm implement its product dif-
ferentiation advantage. However, because the implementation of a product
differentiation strategy generally involves the integration of multiple business
functions, often through the use of product development teams, compensation
schemes designed to help implement this strategy must generally recognize its
multifunctional character.
Thus, rather than focusing only on a single dimension of performance, these
firms often examine employee performance along multiple dimensions simul-
taneously. Examples of such dimensions include not only a product’s sales and
profitability, but customer satisfaction, an employee’s willingness to cooperate
with other businesses and functions within a firm, an employee’s ability to ef-
fectively facilitate cross-divisional and cross-functional teams, and an employee’s
ability to engage in creative decision making.
Can Firms Implement Product Differentiation and
Cost Leadership Simultaneously?
The arguments developed in Chapter 4 and in this chapter suggest that cost lead-
ership and product differentiation business strategies, under certain conditions,
can both create sustained competitive advantages. Given the beneficial impact of
both strategies on a firm’s competitive position, an important question becomes:
Can a single firm simultaneously implement both strategies? After all, if each
separately can improve a firm’s performance, wouldn’t it be better for a firm to
implement both?
M05_BARN0088_05_GE_C05.INDD 174 13/09/14 3:30 PM

Chapter 5: Product Differentiation 175
No: These Strategies Cannot Be Implemented Simultaneously
A quick comparison of the organizational requirements for the successful
implementation of cost leadership strategies and product differentiation strat-
egies presented in Table 5.5 summarizes one perspective on the question of
whether these strategies can be implemented simultaneously. In this view,
the organizational requirements of these strategies are essentially contradic-
tory. Cost leadership requires simple reporting relationships, whereas prod-
uct differentiation requires cross-divisional/cross-functional linkages. Cost
leadership requires intense labor supervision, whereas product differentia-
tion requires less intense supervision of creative employees. Cost leadership
requires rewards for cost reduction, whereas product differentiation requires
rewards for creative flair. It is reasonable to ask “Can a single firm combine
these multiple contradictory skills and abilities?”
Some have argued that firms attempting to implement both strategies will
end up doing neither well. This logic suggests that there are often only two
ways to earn superior economic performance within a single industry: (1) by
selling high-priced products and gaining small market share (product differ-
entiation) or (2) by selling low-priced products and gaining large market share
(cost leadership). Firms that do not make this choice of strategies (medium
price, medium market share) or that attempt to implement both strategies will
fail. These firms are said to be “stuck in the middle.”24
Cost leadership Organizational structure
Product differentiation Organizational structure
1. Few layers in the reporting structure 1. Cross-divisional/cross-functional product
development teams
2. Simple reporting relationships 2. Willingness to explore new structures to exploit
new opportunities
3. Small corporate staff 3. Isolated pockets of intense creative efforts
4. Focus on narrow range of business functions
Management control systems Management control systems
1. Tight cost-control systems 1. Broad decision-making guidelines
2. Quantitative cost goals 2. Managerial freedom within guidelines
3. Close supervision of labor, raw material,
inventory, and other costs
3. Policy of experimentation
4. A cost leadership philosophy
Compensation policies Compensation policies
1. Reward for cost reduction 1. Rewards for risk-taking, not punishment for failures
2. Incentives for all employees to be involved in
cost reduction
2. Rewards for creative flair
3. Multidimensional performance measurement
TaBle 5.5 The Organizational Requirements for Implementing Cost Leadership and Product Differentiation Strategies
M05_BARN0088_05_GE_C05.INDD 175 13/09/14 3:30 PM

176 Part 2: Business-Level Strategies
Yes: These Strategies Can Be Implemented Simultaneously
More recent work contradicts assertions about being “stuck in the middle.” This
work suggests that firms that are successful in both cost leadership and product
differentiation can often expect to gain a sustained competitive advantage. This
advantage reflects at least two processes.
Differentiation, Market Share, and Low-c ost Leadership
Firms able to successfully differentiate their products and services are likely to
see an increase in their volume of sales. This is especially the case if the basis of
product differentiation is attractive to a large number of potential customers.
Thus, product differentiation can lead to increased volumes of sales. It has al-
ready been established (in Chapter 4) that an increased volume of sales can lead
to economies of scale, learning, and other forms of cost reduction. So, successful
product differentiation can, in turn, lead to cost reductions and a cost leadership
position.25
This is the situation that best describes McDonald’s. McDonald’s has tra-
ditionally followed a product differentiation strategy, emphasizing cleanliness,
consistency, and fun in its fast-food outlets. Over time, McDonald’s has used its
differentiated product to become the market share leader in the fast-food indus-
try. This market position has enabled it to reduce its costs, so that it is now the
cost leader in fast foods as well. Thus, McDonald’s level of profitability depends
both on its product differentiation strategy and its low-cost strategy. Either one of
these two strategies by itself would be difficult to overcome; together they give
McDonald’s a very costly-to-imitate competitive advantage.26
Managing Organizational c ontradictions
Product differentiation can lead to high market share and low costs. It may also
be the case that some firms develop special skills in managing the contradictions
that are part of simultaneously implementing low-cost and product differentia-
tion strategies. Some recent research on automobile manufacturing helps describe
these special skills.27 Traditional thinking in automotive manufacturing was that
plants could either reduce manufacturing costs by speeding up the assembly line
or increase the quality of the cars they made by slowing the line, emphasizing
team-based production, and so forth. In general, it was thought that plants could
not simultaneously build low-cost/high-quality (i.e., low-cost and highly differen-
tiated) automobiles.
Several researchers have examined this traditional wisdom. They began by
developing rigorous measures of the cost and quality performance of automobile
plants and then applied these measures to more than 70 auto plants throughout
the world that assembled mid-size sedans. What they discovered was six plants
in the entire world that had, at the time this research was done, very low costs and
very high quality.28
M05_BARN0088_05_GE_C05.INDD 176 13/09/14 3:30 PM

Chapter 5: Product Differentiation 177
In examining what made these six plants different from other auto plants,
the researchers focused on a broad range of manufacturing policies, management
practices, and cultural variables. Three important findings emerged. First, these
six plants had the best manufacturing technology hardware available—robots,
laser-guided paint machines, and so forth. However, because many of the plants
in the study had these same technologies, manufacturing technology by itself was
not enough to make these six plants special. In addition, policies and procedures
at these plants implemented a range of highly participative, group-oriented man-
agement techniques, including participative management, team production, and
total quality management. As important, employees in these plants had a sense
of loyalty and commitment toward the plant they worked for—a belief that they
would be treated fairly by their plant managers.
What this research shows is that firms can simultaneously implement cost
leadership and product differentiation strategies if they learn how to manage
the contradictions inherent in these two strategies. The management of these
contradictions, in turn, depends on socially complex relations among employees,
between employees and the technology they use, and between employees and
the firm for which they work. These relations are not only valuable (because they
enable a firm to implement cost leadership and differentiation strategies) but also
socially complex and thus likely to be costly to imitate and a source of sustained
competitive advantage.
Recently, many scholars have backed away from the original “stuck in the
middle” arguments and now suggest that low-cost firms must have competitive
levels of product differentiation to survive and that product differentiation firms
must have competitive levels of cost to survive.29 For example, the fashion design
company Versace—the ultimate product differentiating firm—has hired a new
CEO and controller to help control its costs.30
Summary
Product differentiation exists when customers perceive a particular firm’s products to be
more valuable than other firms’ products. Although differentiation can have several bases,
it is, in the end, always a matter of customer perception. Bases of product differentiation
include: (1) attributes of the products or services a firm sells (including product features,
product complexity, the timing of product introduction, and location); (2) relations be-
tween a firm and its customers (including product customization, consumer marketing,
and reputation); and (3) links within and between firms (including links between func-
tions, links with other firms, a firm’s product mix, its distribution system, and its level of
service and support). However, in the end, product differentiation is limited only by the
creativity of a firm’s managers.
M05_BARN0088_05_GE_C05.INDD 177 13/09/14 3:30 PM

178 Part 2: Business-Level Strategies
Product differentiation is valuable to the extent that it enables a firm to set its
prices higher than what it would otherwise be able to. Each of the bases of product differ-
entiation identified can be used to neutralize environmental threats and exploit environ-
mental opportunities. The rarity and imitability of bases of product differentiation vary.
Highly imitable bases of product differentiation include product features. Somewhat
imitable bases include product mix, links with other firms, product customization, and
consumer marketing. Costly-to-imitate bases of product differentiation include linking
business functions, timing, location, reputation, and service and support.
The implementation of a product differentiation strategy involves management of
organizational structure, management controls, and compensation policies. Structurally,
it is not unusual for firms implementing product differentiation strategies to use cross-
divisional and cross-functional teams, together with teams that are focused exclusively
on a particular product differentiation effort, so-called “skunk works.” Managerial con-
trols that provide free managerial decision making within broad decision-making guide-
lines can be helpful in implementing product differentiation strategies, as is a policy of
experimentation. Finally, compensation policies that tolerate risk-taking and a creative
flair and that measure employee performance along multiple dimensions simultaneously
can also be helpful in implementing product differentiation strategies.
A variety of organizational attributes is required to successfully implement a
product differentiation strategy. Some have argued that contradictions between these
organizational characteristics and those required to implement a cost leadership strategy
mean that firms that attempt to do both will perform poorly. More recent research has
noted the relationship between product differentiation, market share, and low costs and
has observed that some firms have learned to manage the contradictions between cost
leadership and product differentiation.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
Challenge Questions
5.1. Should a firm pursue differen-
tiation strategy in an industry where
customers are very price sensitive? As
low prices are often supported by low
costs, in such a market, what can a dif-
ferentiation strategy hope to achieve?
5.2. Product features are often the
focus of product differentiation ef-
forts. Yet product features are among
the easiest-to-imitate bases of product
differentiation and thus among the
least likely bases of product differ-
entiation to be a source of sustained
competitive advantage. This appears
paradoxical. How can you resolve
this paradox?
5.3. What are the strengths and
weaknesses of using regression
analysis and hedonic prices to
describe the bases of product
differentiation?
5.4. Some researchers believe that
a firm pursuing differentiation can
sustain its advantage, despite the
threat of imitation, by constant up-
grades to product/service features.
With the help of examples, discuss
the feasibility of deterring imitation
using this approach.
5.5. Implementing a product
differentiation strategy seems to
require just the right mix of control
and creativity. How do you know if
a firm has the right mix?
5.6. Is it possible to evaluate the
mix of control and creativity when
implementing a product differentiation
strategy before problems associated
with being out of balance manifest
themselves? If yes, how? If no, why not?

M05_BARN0088_05_GE_C05.INDD 178 13/09/14 3:30 PM

Chapter 5: Product Differentiation 179
5.7. Think of two examples of a
company that pursued a differentia-
tion strategy and whose sustainability
was threatened by substitutes (not
imitators). How should the companies
respond? What are the implications
for sustaining differentiation
advantage, in general?
Problem Set
5-8. In what ways do the following products pursue a strategy of differentiation?
(a) Louis Vuitton bags
(b) Samsung smartphones
(c) BBC television series
(d) Marlboro cigarettes
(e) Tencent
(f) Apple iPod
5-9. Which, if any, of the bases of product differentiation in the previous question are
likely to be sources of sustained competitive advantage? Why?
5-10. Suppose you obtained the following regression results, where the starred (*) coef-
ficients are statistically significant. What could you say about the bases of product differen-
tiation in this market? (Hint: A regression coefficient is statistically significant when it is so
large that its effect is very unlikely to have emerged by chance.)
House Price = 125,000* + 15,000*1More than three bedrooms2
+ +18,000*1More than 3,500 square feet2
+ +1501Has plumbing2 + +1801Has lawn2
+ 17,000*1Lot larger than 1/2 acre2
How much would you expect to pay for a four-bedroom, 3,800-square-foot house on a
one-acre lot? How much for a four-bedroom, 2,700-square-foot house on a quarter-acre
lot? Do these results say anything about the sustainability of competitive advantages in
this market?
5-11. Which of the following management controls and compensation policies is con-
sistent with implementing cost leadership? With product differentiation? With both
cost leadership and product differentiation? With neither cost leadership nor product
differentiation?
(a) Firm-wide stock options
(b) Compensation that rewards each function separately for meeting its own objectives
(c) A detailed financial budget plan
(d) A document that describes, in detail, how the innovation process will unfold in a firm
(e) A policy that reduces the compensation of a manager who introduces a product that
fails in the market
(f) A policy that reduces the compensation of a manager who introduces several products
that fail in the market
(g) The creation of a purchasing council to discuss how different business units can
reduce their costs
M05_BARN0088_05_GE_C05.INDD 179 13/09/14 3:30 PM

180 Part 2: Business-Level Strategies
5-12. Identify three industries or markets where it is unlikely that firms will be able to
simultaneously implement cost leadership and product differentiation. Which firms in this
industry are implementing cost leadership strategies? Which are implementing product
differentiation strategies? Are any firms “stuck in the middle”? If yes, which ones? If no,
why not? Are any firms implementing both cost leadership and product differentiation
strategies? If yes, which ones? If no, why not?
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
5.13. How can product differentiation be used to neutralize environmental threats and
exploit environmental opportunities?
5.14. How can organizational structure be used to implement product differentiation
strategies?
End Notes
1. See Ono, Y. (1996). “Who really makes that cute little beer? You’d be sur-
prised.” The Wall Street Journal, April 15, pp. A1+. Since this 1996 article,
some of these craft beer companies have changed the way they manu-
facture the beers to be more consistent with the image they are trying to
project.
2. See Porter, M. E. (1980). Competitive strategy. New York: Free Press;
and Caves, R. E., and P. Williamson. (1985). “What is product dif-
ferentiation, really?” Journal of Industrial Organization Economics, 34,
pp. 113–132.
3. Lieberman, M. B., and D. B. Montgomery. (1988). “First-mover advan-
tages.” Strategic Management Journal, 9, pp. 41–58.
4. Carroll, P. (1993). Big blues: The unmaking of IBM. New York: Crown
Publishers.
5. These ideas were first developed in Hotelling, H. (1929). “Stability in
competition.” Economic Journal, 39, pp. 41–57; and Ricardo, D. (1817).
Principles of political economy and taxation. London: J. Murray.
6. See Gunther, M. (1998). “Disney’s call of the wild.” Fortune, April 13,
pp. 120–124.
7. The idea of reputation is explained in Klein, B., and K. Leffler. (1981).
“The role of market forces in assuring contractual performance.”
Journal of Political Economy, 89, pp. 615–641.
8. See Robichaux M. (1995). “It’s a book! A T-shirt! A toy! No, just MTV
trying to be Disney.” The Wall Street Journal, February 8, pp. A1+.
9. See Henderson, R., and I. Cockburn. (1994). “Measuring compe-
tence? Exploring firm effects in pharmaceutical research.” Strategic
Management Journal, 15, pp. 63–84.
10. See Johnson, R. (1999). “Speed sells.” Fortune, April 12, pp. 56–70.
In the last few years, NASCAR’s popularity has begun to wane.
For example, NASCAR television ratings have been consis-
tently down since 2005. www.jayski.com/news/pages/story/
NASCAR-television-ratings
11. Kotler, P. (1986). Principles of marketing. Upper Saddle River, NJ:
Prentice Hall.
12. Porter, M. E., and R. Wayland. (1991). “Coca-Cola vs. Pepsi-Cola and
the soft drink industry.” Harvard Business School Case No. 9-391-179.
13. Ghemawat, P. (1993). “Sears, Roebuck and Company: The merchan-
dise group.” Harvard Business School Case No. 9-794-039.
14. Welsh, J. (1998). “Office-paper firms pursue elusive goal: Brand loy-
alty.” The Wall Street Journal, September 21, p. B6.
15. See White, E., and K. Palmer. (2003). “U.S. retailing 101.” The Wall Street
Journal, August 12, pp. B1+.
16. See Hennart, J. F. (1988). “A transaction cost theory of equity joint ven-
tures.” Strategic Management Journal, 9, pp. 361–374.
17. Deutsch, C. H. (1991). “How is it done? For a small fee…” New York
Times, October 27, p. 25; and Armstrong, L. (1991). “Services: The cus-
tomer as ‘Honored Guest.’” BusinessWeek, October 25, p. 104.
18. See Yoffie, D. (1994). “Swissair’s alliances (A).” Harvard Business
School Case No. 9-794-152.
19. “WPP—Integrating icons.” Harvard Business School Case No.
9-396-249.
20. Orosz, J. J. (2002). “Big funds need a ‘Skunk Works’ to stir ideas.”
Chronicle of Philanthropy, June 27, p. 47.
21. Van de Ven, A., D. Polley, R. Garud, and S. Venkatraman. (1999). The
innovation journey. New York: Oxford, pp. 198–200.
22. Prokesch, S. (1995). “Competing on customer service: An interview
with British Airways’ Sir Colin Marshall.” Harvard Business Review,
November–December, p. 101. Now if they wouldn’t lose our luggage
at Heathrow, they would be a great airline.
23. Position, L. L. (1999). “David S. Pottruck.” BusinessWeek, September 27,
EB 51.
24. Porter, M. E. (1980). Competitive strategy. New York: Free Press.
25. Hill, C. W. L. (1988). “Differentiation versus low cost or differentia-
tion and low cost: A contingency framework.” Academy of Management
Review, 13(3), pp. 401–412.
26. Gibson, R. (1995). “Food: At McDonald’s, new recipes for buns, eggs.”
The Wall Street Journal, June 13, p. B1.
27. Originally discussed in the Research Made Relevant feature in
Chapter 3.
28. Womack, J. P., D. I. Jones, and D. Roos. (1990). The machine that changed
the world. New York: Rawson.
29. Porter, M. E. (1985). Competitive advantage. New York: Free Press.
30. Agins, T., and A. Galloni. (2003). “Facing a squeeze, Versace
struggles to trim the fat.” The Wall Street Journal, September 30,
pp. A1+.
M05_BARN0088_05_GE_C05.INDD 180 13/09/14 3:30 PM

C a s e 2 – 1 : A i r a s i a X : C a n t h e L o w C o s t
M o d e l g o L o n g H a u l ?
Ben Forrey, Professor Andreas Schotter, Professor Jon-
athan Doh and Professor Thomas Lawton wrote this
case solely to provide material for class discussion. The
authors do not intend to illustrate either effective or
ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying
information to protect confidentiality.
Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without
its written permission. Reproduction of this material is not covered under authorization by any reproduction rights
organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey
School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519)
661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. One time permission to reproduce granted by Richard Ivey
School of Business Foundation on March 31, 2014.
Copyright © 2012, Richard Ivey School of Business Foundation Version: 2012-02-17
p a r t 2 c a s e s
On March 11, 2011, after a busy week in Kuala Lumpur at
AirAsia X’s global headquarters, Darren Wright, head of
commercial operations, sat in seat 44C on a late night flight
back home to Australia. Wright, who had only recently been
appointed to this position, was responsible for managing the
airline’s direct revenue generating activities including ticket
sales, ancillary onboard sales, and all global marketing and
advertising activities. In addition, he served as the company’s
country manager for Australia. While Wright observed the
cabin crew selling duty-free merchandise to passengers, he
reflected on five of his most pressing challenges: First, how
best to leverage the extensive network of the regional sister
company AirAsia in selecting new and profitable destinations
for AirAsia X, the long haul1 venture of the group? Second,
how to increase revenues without raising ticket prices? Third,
how best to globally position the airline’s brand in non-Asian
markets? Fourth, how to shift his marketing team’s mentality
away from a start-up mindset? And finally, how to prepare
for a global initial public offering within the next 12 months?
The Beginning: Airasia and the
Budget Model
In 2001, just a few days prior to the World Trade Center ter-
rorist attacks in the United States, former music executive and
entrepreneur Tony Fernandes launched AirAsia. Fernandes’
idea was to bring a low cost airline model to Malaysia similar
to what Ryanair in Europe and Southwest Airlines in the U.S.
offered. From the outset, Fernandes contemplated adapting a
global, long haul element to the typically regional budget air-
line model. He believed he could provide affordable long dis-
tance intercontinental air travel for the rapidly growing new
middle class throughout Asia, something that had not been
done in that region and had been attempted with only mixed
success in other geographic regions. AirAsia’s initial business
plan included a route between Fernandes’ current home in
Kuala Lumpur and his boyhood home in London, England.
However, several of Fernandes’ closest advisors con-
vinced him to initially focus on building a strong intra-
Asian flight network instead of dealing with the difficulties
of getting passengers to Europe. They argued a low cost
network in Asia would one day attract European tourists
and budget conscious business travellers, which would
then support the launch of an ultra-competitive intercon-
tinental airline. Consequently, Fernandes put his plans to
fly to non-Asian destinations on hold. Within the following
six years, starting with only two planes, he grew the airline
into Southeast Asia’s largest and most comprehensive flight
network. In 2007, AirAsia operated nearly 30 aircraft and
several regional subsidiary companies including Malaysia
AirAsia, Thai AirAsia, Indonesia AirAsia, Vietnam AirAsia
and AirAsia X2 (from now on referred to as X). The corpo-
rate slogan of AirAsia became: “Now Everyone Can Fly!”
M05A_BARN0088_05_GE_CASE1.INDD 1 13/09/14 3:32 PM

PC 2–2 Business-Level Strategies
time zones and cultural arenas all played a factor. However,
establishing a new airline was much more complicated
than starting any other type of business. The process of get-
ting the necessary approvals and certifications could take
years. Coincidentally during this time, Malaysian Airlines
expressed interest in taking over the routes of a small local
Malaysian commuter airline Fernandes and a group of
Malaysian investors also owned. He swiftly transferred the
routes to Malaysian Airlines and used these freed up airline
certifications to launch the new long haul carrier.
Fernandes wanted an appropriate name addition to
AirAsia that would, on the one hand, take advantage of the
strong brand and, on the other, reflect the new, expanded
services. Without much thought, he called the new airline
AirAsia X. At the same time, Fernandes recruited a young
CEO from outside the airline industry to launch the new
airline (see Exhibit 1). Both, the selection of then 36-year
old Azran Osman-Rani along with the unconventional new
To prove the point, AirAsia routinely offered one-way fares
as low as US$3.00. In 2008 and 2009, AirAsia won the pres-
tigious Skytrax3 “World’s Best Low Cost Airline Award.”
The Launch of X
In early 2007, Fernandes finally felt the timing and the exist-
ing infrastructure of AirAsia’s route network provided the
right conditions for entering the intercontinental air travel
market. Despite constant claims from industry insiders that
low cost, long haul flights would never be profitable,4
Fernandes pushed forward with the expansion. After a
few months of strategizing, he realized, due to the substan-
tial differences between long haul and short haul airline
operations, the new business had to be—at least legally—
separated from the regional AirAsia entity. Different levels
of financial risk, legal issues with landing rights, and the
substantial complexities in operating across very different
Darren Wright, a native of Australia, had been with X since its first flight in November 2007. A
lifelong surfer, Darren spent his summers during university as a surf guide in Bali, Indonesia. After
graduating, Darren joined a local government department focused on agribusiness marketing.
Seizing an opportunity to expand his management skills, he joined Australia’s largest travel
agency, Flight Centre, where he oversaw the sales of all airline tickets around the world. After
five years of building the Flight Centre brand, Darren joined the start-up Australian airline Virgin
Blue as the Director of Marketing in 2002. Seeking a new challenge, Darren was introduced to
X in 2007 by a mutual friend of X’s CEO, Azran Osman-Rani, and he accepted the opportunity
to become the country manager for Australia. Darren assumed responsibility for all operational
and marketing activities for three destinations within Australia. Happy in his role as country
manager, Darren was asked to serve as the Head of Commercial Operations for the airline in
June 2010 with direct responsibility for all activities that generated revenue including marketing
and public relations, ticket sales, onboard sales, revenue management and all fee programs. His
intimate knowledge of surfing had helped the airline achieve a leading brand position among
the surf community in Australia and worldwide. Darren relocated to Kuala Lumpur in 2011 after
spending six months splitting his time between headquarters and Australia.
Azran Osman-Rani was the son of two university educators. As a young child, both of
Azran’s parents had foreign teaching assignments outside of Malaysia, and several years
of Azran’s youth were spent in the United States and the Philippines. When he reached
university age, Azran attended Stanford University in the United States and received a
bachelor’s degree in electrical engineering and graduate degree in economics. Upon grad-
uation, Azran became a consultant and spent time at Booz Allen Hamilton and then at
McKinsey & Company in Asia, and held posts in Thailand, Indonesia, Singapore and South
Korea. Azran was asked to return to Malaysia to help the Kuala Lumpur Stock Exchange
automate its trading activities and transform it from a private into a publicly traded entity.
Happy being back home in Malaysia, Azran joined Astro all Asia Networks, Malaysia’s top
cable TV provider as Director of Business Development. It was while in this capacity that
Azran was approached by AirAsia founder Tony Fernandes and asked to become the CEO
of X. He accepted after Fernandes told him that: “ . . . everyone is saying it can’t be done.”
Osman-Rani became the CEO of X at only 36 years of age.
Azran Osman-Rani, CEO

Darren Wright, Head of Commercial Operations and Australia Country Manager
Exhibit 1 Key Management BIOS
Source: Company files
M05A_BARN0088_05_GE_CASE1.INDD 2 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–3
features—the long haul budget airline model developed
by X was considered an innovation. Conventional avia-
tion wisdom assumed an airline could not sustain prof-
itable operations by charging low fares for long haul
flights.5 The basic operating costs per flight were deemed
too high and average flight bookings were either too low
or too seasonal to make money. It appeared the cost lead-
ership model based on scale simply might not work for
long haul flights.
Historically, long haul operations targeted either
business travelers or affluent individual travelers, com-
peting on service differentiation and route network in-
tegration. Most, if not all, airline executives around the
globe believed passengers would never choose to fly long
distances if amenities such as checked baggage, food and
beverages, and onboard entertainment were not included
in the ticket price. Furthermore, the assumption that a pre-
mium class cabin was a necessity6 was unquestionable. In
fact, many of the leading global long haul airlines operated
business class only flights between, for example, Singapore
and Los Angeles or London and New York City. Fernandes
did not agree. He was certain his largely Asian clientele
would embrace the opportunity to travel to distant loca-
tions if the price was right, despite the fact that some of the
comfort features associated with other airlines would be
lacking. Fernandes, together with Osman-Rani, built upon
the belief that many of their Asian clients would jump at
the chance to fly farther if it were more affordable.
While X maintained its laser-like focus on low cost,
it also built on AirAsia’s experience in using low costs to
attract new customer segments in new ways. In this sense,
AirAsia was effectively differentiating around low cost,
and building that distinct approach into its branding and
customer engagement.
Targeting the Base
Instead of focusing on the upper levels of the wealth pyra-
mid, X targeted a much larger potential passenger pool
that would not ordinarily consider flying to intercontinen-
tal destinations, but was characterized by substantially
lower but rapidly growing disposable income. In order to
attract these new customers, X’s published fares included
the seat and all departure/landing taxes but explicitly
excluded all frills. The inclusion of the taxes and fees in
the advertised ticket price made the calculation of out of
pocket costs very simple to understand. Optional items
such as seat assignments, checked baggage, onboard food
and beverages, inflight entertainment, flight transfers or
changes, pillows and blankets, and the like were all avail-
able for purchase separately based on a fixed price list.
airline name were typical of Fernandes—the polar opposite
of how most traditional airline industry executives would
proceed. In an interview, Osman-Rani stated:
People always ask us what the significance of the X in
AirAsia X is, and I just have to tell them that it has
no special story behind it. It is just what we called the
airline at the beginning in order to get the business
started. It then kind of stuck. Now we believe that the
name fits us really well. We like to think that we are
the ‘X-factor’ to the success of the AirAsia Group.
From an operating standpoint, long haul required a larger
type of airplane compared to the model AirAsia was cur-
rently flying. In keeping with AirAsia’s low cost approach,
the aircraft choice fell ultimately on Airbus Industry’s A330
type aircraft. AirAsia not only had a large fleet of Airbus air-
planes already, but also knew Airbus would provide more
favorable financing terms than its main competitor, Boeing.
The AirAsia group became one of the world’s largest opera-
tors of Airbus aircraft.
While legally a separate corporate entity, X was
launched as a franchise of AirAsia, allowing it to leverage
some existing infrastructure resources. For example, ini-
tially some of AirAsia’s pilots, engineers, and cabin crews
were cross-trained to operate both aircraft types and all
ticket sales were integrated into a single website and book-
ing system. All maintenance, training, customer service,
and back office activities were performed jointly, including
all marketing and administrative functions. The ability of
AirAsia to financially and operationally support X during
its start-up period proved key to the successful launch.
Australia’s Gold Coast became X’s first destination.
X’s inaugural flight to Australia took place on November 2,
2007. Three years later, in the summer of 2010, X received
its eleventh aircraft and flew to 15 destinations on three
continents. The substantial differences between long haul
and short haul operating requirements became more and
more apparent, so management decided to formally sepa-
rate X from AirAsia. With this separation, 100 per cent
of all maintenance, administration, flight operations and
marketing activities were now managed by X indepen-
dently with its own resources. The decision to separate the
two companies was also made in preparation for a global
IPO anticipated in late 2011 or early 2012.
The Airasia X Business Model:
Differentiating Around Low Cost
While the AirAsia model closely followed what Southwest
Airlines and Ryanair practiced in Europe and the
United States—albeit with some unique and distinctive
M05A_BARN0088_05_GE_CASE1.INDD 3 13/09/14 3:32 PM

PC 2–4 Business-Level Strategies
when other regional competitors such as Hong Kong-based
Oasis and Zoom Airlines ceased operations at the height of
the global financial crisis. Wright stated:
It sometimes surprises passengers that when they land
in Kuala Lumpur, they get off the airplane directly
onto the airport tarmac and not into a gate area at a
terminal. Why should we build gates, or pay expen-
sive gate lease fees if it will only add costs to the ticket
price? When people wonder ‘what are we going to do’
when they land and it is raining outside, we just smile
and hand them an umbrella.
Besides being the low cost leader, other significant
aspects of X’s business model included aircraft selection,
higher utilization of space by maximizing seating capacity,
aircraft utilization, customer focused paid a la carte inflight
experience, including premium seats, operational simplic-
ity and other unique intangibles.
Aircraft Selection and Seat Configuration
By flying Airbus A330s and later adding four engine A340
aircraft to the fleet, X was able to leverage the strong re-
lationship with Airbus Industries previously initiated by
AirAsia. A large pool of Airbus trained mechanics was
available to meet the maintenance needs of both airlines
at the Kuala Lumpur home base. Tremendous time and
cost savings were achieved by utilizing cross training ini-
tiatives. The young age of X’s fleet also helped the airline
achieve the highest possible fuel efficiencies. The airline
was one of the first to order the yet to be built A350 model
which some heralded as the most fuel-efficient airliner ever.
As of February 2011, X operated a fleet of eleven air-
craft; nine Airbus A330s with 377 total seats (12 premium
and 365 economy) and two Airbus A340s with 327 seats (18
premium and 309 economy). A comparison of its competi-
tors operating the same A330 indicated that X generally
had approximately 20 per cent higher seating capacity on
the same airplane than most other carriers (see Exhibit 2).
This 20 per cent higher capacity allowed for X to charge
This clarity reduced the hurdle for the lower income cli-
entele to decide on a flight compared to the confusion and
hassle traditional carriers create with their hidden fees and
brokerage-like variation in real out of pocket costs. It was
not uncommon for established international carriers to add
up to 30 per cent in surcharges to the posted ticket price.
Similar to most airlines around the world, X’s op-
erations focused strongly on flight safety. However, this was
where operating similarities ended. As a point of reference,
the average U.S. budget airline’s cost per seat mile in 2009
was approximately US$0.09 per mile. X’s cost per seat mile
was just over US$0.02 per mile in 2009, less than one quar-
ter of the cost of the traditional low budget airlines. Given
the drastic disparity between X’s operating costs and those
of other airlines, many experts wondered how this was
achieved, especially considering a significant portion of the
operating costs of the airline (e.g. fuel and aircraft pricing)
was driven by global forces out of individual carriers’ control.
The reason was surprisingly simple. From the be-
ginning, X operated as an ultra-lean company, with the
bare minimum number of staff hired to achieve safety and
effectively complete only the basic transportation tasks.
Additionally, labor costs in Malaysia, and the absence of
unionization, helped keep human resource costs low. Until
it reached the necessary scale, X shared resources with
AirAsia, focused on avoiding duplicate processes. X did
not invest in terminal or other non-airplane related infra-
structure that would increase fixed asset overheads.
Many factors contributed to the development of an
extreme low cost seeking culture within every activity of the
company. These factors included the company’s emerging
market heritage, the struggles to overcome the depressed
economic environment during AirAsia’s launch, the nega-
tive effects of 9/11 on the airline industry and diligent
benchmarking against the successful models Ryanair and
Southwest Airlines operated. Osman-Rani made it his mis-
sion to create an airline that would withstand any kind of
major external environmental shocks, including pandemic
disease, terrorist attacks, natural disasters, economic crises,
or oil price spikes. Consequently, X survived and expanded
Exhibit 2 Comparison of Typical A330 Aircraft Seating Versus X’S Seating
Airline A330 Premium Seats A330 Economy Seats Total Seats
Delta Airlines 34 264 298
Cathay Pacific Airlines 44 267 311
Jetstar Airlines 38 265 303
AirAsia X Airlines 12 365 377
Source: Company files
M05A_BARN0088_05_GE_CASE1.INDD 4 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–5
and sleep, so it was an easy decision. In fact, these
seats are so popular almost every one is sold on every
flight. We are currently looking at what it will mean
to double the number of flat bed seats available on
our flights. The decision to introduce the world’s
most affordable flat bed seat was one of the best
decisions we ever made, and I believe it really sets
us apart from anyone else. It provides extreme value
for money.
Aircraft Utilization
Since the X model focused on achieving scale instead
of a differentiated mix between premium and economy,
a higher than typical aircraft utilization was required
to break even.7 In 2010, on average, each of X’s aircraft
was in the air for 16 hours every day versus the industry
average of 11 hours per day.8 In order to achieve this
kind of utilization, the airline had to deviate from fixed
flight departure and arrival times. These times changed
from day to day—an absolute novelty in the industry.
For example, if on Mondays the departure time for a
specific destination was 2:00 p.m. it could be 11:00 a.m.
on Tuesdays and then 9:00 p.m. on Wednesdays. While
this was considered contrary to industry norms, there
was evidence many passengers only cared about their in-
dividual flight timings, and not a regular daily schedule.
X’s model proved if the price was low enough, even very
early morning or late night departures would be popular
with passengers.
This utilization model also helped X reduce its oper-
ating and capital costs. In airline finance, interest payments
are allocated on a per flight basis and with more flights per
up to 20 per cent lower fees and earn the same revenue as
its competitors without even considering the lower labor
costs, terminal costs and general operating expenses.
To achieve the extra capacity, X used a 3-3-3 seating
configuration throughout the airplane in one large single
economy class. This seating configuration was not favored
by other airlines because of the perceived inconvenience
to the passengers seated by the windows. They had to get
by two other passengers in order to access or exit their
seats. The most common configuration was 2-4-2, which
allowed for only eight seats per row. To address passenger
comfort despite the higher than typical capacity, X reduced
the width of the seats but provided more legroom instead.
According to an internal company survey, this was what
long haul travelers really preferred. The company also
designed an innovative new headrest better suited for
sleeping during longer flights.
Luxury for the Masses: Flat Bed Seats
Another unique option on X’s flights was introduced in
2010—a limited number of premium seats in a small sec-
tion of the airplane (between three and five per cent of
available seats only). These seats reclined to a fully flat
position for sleeping, a first in the world of budget airlines.
On a traditional full service airline, these seats would be the
business class or first class seats (see Exhibit 3). However,
on X, these seats did not automatically come with all the
premium complimentary amenity offerings. These addi-
tional offerings had to be paid for just like standard seats.
Wright commented:
We realized the most sought after premium feature
when flying long distance is the ability to lie flat
Exhibit 3 Typical Business Class Seat Versus Airasia X Premium Seat
Korean Airlines–Prestige Business Class AirAsia X–Premium Flat Bed Seat
Source: Company files
M05A_BARN0088_05_GE_CASE1.INDD 5 13/09/14 3:32 PM

PC 2–6 Business-Level Strategies
low frills frequent flyer program, was launched. In January
2011, the AirAsia Group launched a new option to accept
flight bookings up to just four hours prior to departure.
Company Culture
From the very beginning, X aimed to avoid the emer-
gence of corporate hierarchy based on rank, age, gender, or
seniority. At the airline’s headquarters, all senior executives
and department heads worked in one large open office
space without any partition walls or closed meeting rooms.
This created the same unpretentious and casual atmosphere
one could experience when flying on one of X’s aircrafts.
Everybody was addressed by first name, even the CEO. All
employees were referred to officially as “All Stars.”
Azran Osman-Rani explained: “We are probably the
only airline in the world where the chief pilot sits right
next to the chief engineer, and the head of marketing.”
It was Osman-Rani’s vision to foster a corporate culture
where any member of the company could openly see and
approach any colleague. He also instilled a healthy “work
hard—play harder” mentality that appeared to encour-
age each employee to show up extremely dedicated every
day. “For us at X, culture eats strategy for lunch,” stated
Osman-Rani. These approaches were previously unheard
of in Malaysia, a country where the business culture is
based on old traditions.
Early Success: Why X Survived When
Others Failed
The global financial crisis of 2008 caused a real shakeout
in the airline industry generally, including among low cost
carriers. But throughout this period, X thrived relative to
the industry. X enjoyed a significant advantage over other
low cost long haul carriers because it could draw on the
resources of its parent company, AirAsia. Senthil Balan,
director of route and network planning at X, explained:
Our website was up and running from day one. Right
from the beginning we had cockpit, cabin, and mainte-
nance crews with considerable budget airline experience
in place. Operationally, we could go to the well and draw
upon resources to provide catering, fuel, and legal advice
without the usual inefficiencies that start-ups have to
battle with. When I first joined, there was already a team
of people doing what I was going to be doing, so it made
things easier during the first few months.
day for the same aircraft than its competitors would fly,
X was able to decrease the overall interest and financing
period. Debt was deferred or spread out over more flights,
which significantly reduced the fixed operating costs of X.
A La Carte In-Flight Experience
“Try ordering more than one meal the next time you fly
Singapore Airlines. You can’t,” explained Wright. “On any
AirAsia X flight you can eat as much as you want—that
is until we have nothing left to sell to you.” To lower
costs while generating additional revenue from onboard
services, X’s management decided all food and beverages
were to be booked separately from the ticket. A reduced
price pre-booking option was implemented to encourage
sales. However, nearly 50 per cent of all food was pur-
chased inflight despite the pre-booking option.
Additionally, a large selection of AirAsia branded
merchandise and duty free goods were carried on board
for sale. Traditionally on most budget airlines, inflight en-
tertainment was not offered. X decided to offer individual
inflight entertainment for a fee in all seat backs on all
flights. The seatback option later evolved into a portable
media player offered on selected flights. Cabin crews dou-
bled as product sales people, and despite having signifi-
cantly fewer flight attendants per flight compared to full
service carriers, surveys showed X’s cabin crews provided
some of the swiftest and friendliest service in the industry.
X put special emphasis on training flight crews to be client
focused and skilled in selling services and products.
Keep it Simple, Stupid
Initially, the only ticket option available on X was a one-
way point-to-point fare. The goal was reduced purchasing
complexity. Passengers always knew they would either
reach their final destination directly or that they had
to handle connections to other flights independently. In
December 2010, X launched a limited flight transfer option
between a handful of selected X and AirAsia destinations
at its hub in Kuala Lumpur. The selection of the routes was
strategic and based on a combination of passenger demand
and connecting times no greater than six hours.
Another early decision was to postpone the imple-
mentation of a reward program in order to keep the book-
ing process and pricing model simple and transparent
to the clients. X never charged any online, telephone or
personal booking fees. X did not provide refunds after
tickets were purchased except under very exceptional cir-
cumstances. It was not until December 2010 that “BIG,” a
M05A_BARN0088_05_GE_CASE1.INDD 6 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–7
accumulated at other airlines, most members of the cabin
crews were new to the airline industry. X benefited from
the existing infrastructure and the operating model align-
ment already put in place by AirAsia.
Sales Outlets
Together with AirAsia, X sold its tickets primarily through
its website, AirAsia.com. To reduce costs, X strived for
100 per cent online sales. However, the operating regions
with the most promising potential had low but steadily
growing Internet penetrations. The company was also
exploring the sales of tickets by cell phone. Despite the
additional costs, AirAsia Group operated ticket offices,
ticket kiosk machines, and sales counters at each airport.
The group also operated several call centers throughout
the world. Additionally, particularly in countries such
as Australia, where travel agents were still the preferred
choice for ticketing, X had agreements with many local
travel agencies.
Traditional and Nontraditional Marketing
Most global companies used social media to varying
degrees and for different purposes. AirAsia was so com-
mitted to social media that, in June, 2010, they acquired
KoolRed, their own social networking platform. KoolRed12
was essentially the Asian equivalent of Facebook but with
a greater focus on travel related content. Other airlines
mainly used social media sites as customer feedback tools
and disgruntled passengers overly frequented these sites.
Often these sites were heavily moderated, creating an even
more hostile reaction. This was no exception for AirAsia.
However, AirAsia allowed all content, no matter its view-
point. As a result, within the global airline industry, only
U.S. based Southwest Airlines had more friends following
an airline. With the exception of Australia, all social media
activities were managed centrally from Malaysia. In late
2010, the company decided the U.K., France, India, South
Korea, Japan and New Zealand would begin managing
social media platforms locally in order to achieve closer
and more effective customer communication. X India for
example was working to penetrate the massive mobile
phone messaging platform.
AirAsia.com had approximately one million indi-
vidual visitors every day. In addition, management was
well aware of the growing e-commerce acceptance rate
among Asian consumers. In 2011, AirAsia.com had evolved
into a huge portal for online business in Asia. In addition to
Maintaining Low Costs at KL
At its home base in Kuala Lumpur, AirAsia faced a di-
lemma. Kuala Lumpur International Airport (KLIA) had
one of the most modern and beautiful terminals in the
world, but it also had high gate fees compared to other
regional airports. AirAsia, with strong local political sup-
port, was allowed to construct AirAsia’s own low cost
carrier terminal (LCCT). The building housed the group’s
headquarters and handled all of its flight operations.9 The
LCCT was designed to handle 10 million passengers a
year. However, for 2011, the projections were an estimated
18 million passengers, more than the entire yearly airport
traffic of Honolulu, Hawaii, United States, Auckland, New
Zealand or Vienna, Austria.10
Leveraging the Feeder Network and
Scaling the Model
X benefitted from the connectivity and passenger feed
of the AirAsia network to fill its larger aircraft. Unlike
its Hong Kong based low cost competitor Oasis, which
only served the Hong Kong to London and Hong Kong
to Vancouver routes, X had access to hundreds of feeder
flights to and from 78 destinations. Due to the global finan-
cial crisis, Oasis ceased operations in April 2008.11
AirAsia targeted a customer demographic over-
looked by traditional airlines and even by other budget
carriers. Competitors, including MaxJet and EOS Airlines
from the United States and Oasis from Hong Kong, fought
for budget travelers from the middle and upper middle
class. X deliberately targeted new travelers with less dis-
posable income from the economic base of the pyramid
instead. Those new customers previously either chose
other means of transportation, including busses and trains,
or they did not travel at all. Osman-Rani commented:
“Obviously flying is still a luxury for many people, but our
mission is bringing down the fares so low, that hopefully
more people than ever before can experience the freedom
of long distance travel.”
Training and Development
AirAsia was very focused on the low cost model and
to differentiate itself from the traditional airline model
it established its own training academy for new pilots,
engineers and cabin crews. The goal was to develop a
specific AirAsia mindset. Although many pilots joined
the company with thousands of hours of flight experience
M05A_BARN0088_05_GE_CASE1.INDD 7 13/09/14 3:32 PM

PC 2–8 Business-Level Strategies
extremely high yield factors and lower load factor break-
even points. Full service airlines relied on higher yields
rather than higher load factors to generate profits.13
Budget airlines, however, did not typically empha-
size profit margins per seat (yield factor), instead they
concentrated on seats sold (load factor). The conventional
assumption in the airline industry was that the only way to
generate higher loads would be to sell seats at a lower price
point. A strong strategic focus was put on cost savings. In
order to avoid the cost trap, full service airlines would com-
pete based on differentiation along yield factor generating
value added activities. This naturally put the focus on the
more affluent customer segments. The challenge for budget
airlines, however, was that direct costs were largely depen-
dent on external factors including fuel prices, maintenance
costs, airport landing and terminal fees. These direct costs
were extremely difficult to influence and created a much
higher vulnerability for budget airlines since those addi-
tional costs could often not easily be transferred to custom-
ers. If ticket prices were too high, leisure travelers would
simply not fly or migrate to full service airlines since price
gaps would be lower during these periods.
Similar to other budget airlines, X modeled the
break-even point for each flight on a combined fixed cost-
direct cost mix and then established the relevant break-even
fare. During the active sales process, a dynamic model was
used following a complicated demand estimation model.
This dynamic model was critical especially considering
the low margins approach. Budget airlines often cut prices
just to fill seats believing some revenue was better than no
revenue. This tactic was also at the core of X’s sales strat-
egy. Using this approach since its inception, X experienced
some months when routes had high load factors, but cre-
ated in less than the budgeted revenues due to low yields.
Since X flew long distances competing head to head
with full service airlines, the adoption of the pure low cost
model was considered insufficient. Sensing this alignment
issue, Wright, as the manager for revenue management,
convinced Osman-Rani to recruit a seasoned executive
with extensive airline industry revenue management
experience in order to close this expertise gap. The newly
established revenue management team began operating in
December 2010. Wright requested a thorough analysis of
X’s revenue model, passenger profile and passenger needs
as the team’s first deliverable.
X’s Passenger Profile
At the end of 2010, approximately 60 per cent of X’s pas-
sengers were Malaysian nationals. The remaining 40 per
cent were a combination of customers either originating
airline tickets, AirAsia sold concert tickets, travel insurance,
hotel rooms, vacation packages, and even everyday mer-
chandise such as shoes and handbags. Osman-Rani hoped
X would be able to capture the trickle down effect and
increase ancillary sales. One important tactic in achieving
these goals was the localization of the website. AirAsia.com
was designed for 24 countries in nine languages although X
served only 10 different countries at the time. In compari-
son, the website for the world’s largest airline, U.S. based
United Airlines, was designed for 30 countries utilizing 11
different languages.
Traditional and Non-traditional marketing
Even though Internet penetration and e-commerce were
growing rapidly throughout Asia, print media were still
important for raising brand awareness and for communi-
cating deals in all of X’s markets. Hence, X spent approxi-
mately 30 per cent of its communication budget on ads in
prominent daily and weekly newspapers. In addition, X
organized dozens of free journalist familiarization trips ev-
ery year. The goal of these trips was to generate favorable
reviews from the participants to be published in specific
travel journals for budget backpackers, students, surfers,
outdoor and shopping enthusiasts.
Full Service Airlines do it Differently =
Yield Factor Versus Load Factor
Budget airlines typically used revenue management differ-
ently than full service airlines. A full service airline would
seek to create a proprietary mix of profit margin per seat
(yield factor) in combination with a utilization factor fol-
lowing the numbers of seats sold (load factor) that would be
calculated based on complicated algorithms and real time
ticket price adjustments for each individual flight. Prices
for the different seating categories would vary based on
the targeted passenger mix per destination and the current
demand. For example, Singapore Airlines offered a tradi-
tional three-tier service consisting of a mix of first, business,
and economy class on a single airplane. Singapore Airlines
over the years had developed strong capabilities around the
full service concept, which resulted in consistent rankings
among the top airlines in this category in the world. The
airline also structured all its activities and resources around
this differentiation model. Singapore Airlines developed
even more differentiated offerings including a business
class only service to Los Angeles. This passenger segment
was underserved on this particular route and provided
M05A_BARN0088_05_GE_CASE1.INDD 8 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–9
sale, AirAsia.com had issues processing credit cards from
the EU for the first six hours, although over 30,000 tickets
were sold within the first 36 hours.
No-shows lead to onboard wastage
When fares were at their lowest, X’s customers— particularly
those in Malaysia—would purchase a ticket for travel even
when the trip was several months away. They would then
work harder and save on other expenditures to earn enough
money to cover the other trip related expenses. The frenzy
to secure cheap tickets temporarily made some travelers
ignore the realities of foreign travel. The biggest problem
was securing a visa for the destination country. Especially
for Malaysian nationals, it can be difficult or very costly
to obtain a visa for countries in Europe, North America or
even Japan. When Malaysian passengers could not secure
a visa by the date of departure, they could not fly. Unaware
of this, X would purchase and upload meals and merchan-
dise for sale to these passengers. Additionally, the weight
and balance of the airplane and loading calculations of the
cargo could be altered when a significant number of pas-
sengers were not seated as planned. X was successfully
fulfilling its mission statement—to allow “everyone to fly.”
Unfortunately X also experienced challenges when serving
passengers who had never flown before. Wright explained:
We have seen it most when a passenger arrives at
check-in a few hours prior to departure and they don’t
have a visa to enter the country they are flying to. We
serve passengers from countries where passport pen-
etration can be very low, and sometimes they are not
aware of the existence of visas. We try our best to edu-
cate our passengers the best we can before they pur-
chase their tickets, but it can be difficult, and we are in
no way involved with issuing visas for any country.
Our policy is clearly stated that we do not provide
refunds, but unfortunately some of our passengers
expect that and this has become one of the challenges
of serving a historically underserved market.
Where is AirAsia X . . . . in Asia!
During one of the first meetings of X managers in 2007, a
map of the world was placed on a table. A circle that repre-
sented the operationally optimal flying time of eight hours
from Kuala Lumpur was drawn on the map, and it became
clear X would only be limited by the number of planes in its
fleet, and not by a lack of attractive and viable destinations.
After 2008, with much of the developed world deal-
ing with the global financial crisis, most of Asia was enjoy-
ing strong economic growth. The middle classes of highly
from an X destination or transferring to or from an AirAsia
or other airline’s flight in Kuala Lumpur. One of the initial
motivations behind launching X was to provide an ex-
tremely affordable intercontinental air travel alternative for
less affluent Malaysian residents. As X grew, it became in-
creasingly more important to cater to a broader passenger
segment across different needs categories. The challenge
was to make these adjustments without negatively affect-
ing the less affluent Malaysian passenger base. The special
attention paid to the latter passenger base continued to
drive operational initiatives such as food menus, merchan-
dise offerings and the marketing and sales tools, including
the way technology was utilized.
A Big Sale = Website Crash and Hours
on Hold
X was known for launching new routes at very low
fares. For example, the Kuala Lumpur to Delhi route was
launched for only US$53, London, U.K. to Kuala Lumpur
for US$157, and Tokyo to Kuala Lumpur for US$58. These
were all-inclusive fares, a hallmark of X. These low fares
resulted in huge sales during the initial 24 to 72 hours of
ticketing. When AirAsia or X had a massive fare sale, it
was always designed to surprise consumers and influ-
ence them to purchase the low priced fares immediately.
However, AirAsia.com did not have the bandwidth and
server infrastructure to handle the sudden spike in web
traffic on promotional sales days. Peak website traffic
could easily top one million visitors per hour and the
online booking system occasionally crashed. This led cus-
tomers to then contact an AirAsia callcenter, which was
equally overloaded.
While X believed the massive web traffic generated
by AirAsia’s sales was great for the company, it did prevent
significant numbers of customers booking tickets from
receiving services for already booked flights. Once, during
a massive sales period for AirAsia, an already ticketed X
passenger in Australia calling to confirm some unrelated
travel details sat on hold, at the expense of X, for nearly
seven hours before he could reach a customer service
representative. The risk was more affluent travelers in par-
ticular, or those who could also fly on full service airlines,
would eventually not return for future travels because of
the hassle. To help mitigate the problem, X established
its own dedicated call centre in August of 2010. This new
X call centre could handle Korean, Japanese and French
language inquiries, something AirAsia’s other call center
could not handle. However, X still had to rely on the cur-
rent capabilities and limitations of the general AirAsia.com
website. In November 2010, when tickets to Paris went on
M05A_BARN0088_05_GE_CASE1.INDD 9 13/09/14 3:32 PM

PC 2–10 Business-Level Strategies
and fourth, what is the commitment of support, both
economic incentives and marketing contribution, that
will be provided by the destination’s tourism organiza-
tion and airport authority?
Wright added: “For example in less than one week, X
sold over 80,000 seats between Kuala Lumpur and Seoul—
all this for a route that was only anticipated to generate
100,000 seats annually.”
X also pursued alternative opportunities. For ex-
ample, in November 2010, X dedicated one of its planes to
a charter operation used to ferry religious pilgrims from
different Asian countries and the Middle East to and from
Saudi Arabia before, during and after the annual pilgrim-
age to Mecca. While this charter evolved into an excellent
and unplanned source of revenue, it was only temporary.
On the other hand, it also served as an excellent exploratory
trial for some new routes. In November 2010, X’s eleventh
aircraft—a brand new Airbus A330—was to be delivered to
help launch the upcoming Seoul, South Korea and Tokyo,
Japan routes scheduled for a December 2010 launch. Balan
knew after the charter ended and all of the routine yearly
maintenance checks were completed, he would have es-
sentially one spare aircraft available to launch a new route.
Balan and his staff analyzed numerous destinations includ-
ing Saudi Arabia, Nepal, Japan, Australia, and Europe
against the four factors previously outlined. Due to the
lack of approval by the Malaysian government, none of
these destinations could be realized. At this point, facing a
deadline to launch the new route in order to avoid aircraft
underutilization, Balan began to explore more deeply a
hunch he had been having for some time.
Growing up in New Zealand, Balan was very famil-
iar with the many tourist attractions New Zealand could
offer to Asian travelers. He was keenly aware of the recent
success Singapore Airlines enjoyed by flying non-stop
from nearby Singapore to both Auckland on the north is-
land, and Christchurch on the south Island.
Balan approached Wright and floated the idea of
launching a service to Christchurch. Wright suspected the
route would do well given the allure of the south island’s nat-
ural beauty, and the fact Singapore Airlines sold out most of
its flights between Singapore and Christchurch at a price close
to two to three times what X would charge. Wright offered
to make a few phone calls to his tourism contacts in New
Zealand, and scheduled a meeting in Kuala Lumpur with the
Christchurch Airport Authority. Balan easily matched Kuala
Lumpur and Christchurch against all of his criteria, while his
team found ways to make the break-even fare and the utiliza-
tion of the aircraft fit into the overall route network.
Balan and his team had to then convince X’s majority
shareholder—Tony Fernandes—Christchurch was the best
populated countries such as China, India, Indonesia,
Vietnam, the Philippines and Thailand were now more
and more able to afford air travel. In addition, traveling
to foreign countries was one of the most desired items on
the wish list of these demographics. The explosive growth
of the entire AirAsia Group could be partly attributed to
the fact that Kuala Lumpur was in a very central location
in relation to the world’s most populated and fastest de-
veloping economies. Malaysia was a very popular tourist
destination for travelers from Iran, Saudi Arabia and much
of the Middle East due to a shared Islamic heritage and the
lack of visa requirements for travelers from these countries.
Constraints of Expansion
For X, network expansion was no small task. Two essential
elements were required to serve new destinations—first,
an airplane, and second, bi-lateral landing and operating
rights. The list price for a new Airbus A330 aircraft was
US$200 million. By leveraging the successful track record
of AirAsia, and finding investors who believed in the
potential of the low cost long haul model, X was able to
steadily expand its fleet of wide body aircraft from only
one in 2007 to 11 in 2011. In addition to the capital expendi-
ture, overcoming the regulatory hurdles for bilateral land-
ing rights was even more difficult. All local governments
would try to protect their own home country airlines first,
before allowing outside competition, and Malaysia was no
exception. X’s expansion, however, was limited at times
primarily by the Malaysian government, which was reluc-
tant to approve routes that would provide stiff competition
to the state owned Malaysian Airlines.
Viability of New Destinations
To fit the competitive model of high load factors, it was
critically important for X to select the destinations provid-
ing the highest probability of sustained success. Director of
route and network planning Senthil Balan explained:
There are a hundred different things we look at, how-
ever, there are four basic criteria that must be satisfied;
first, is the destination appealing both from a Malay-
sian traveler perspective as well as from the entire
AirAsia network perspective; second, what are the
historical passenger numbers between the two areas
as well as the traffic breakdown by direction of travel?
Either must be large enough fro us to enter the market.
Third, the propensity to travel, both on the route in
question as well as the overall propensity to travel
by the local population at either end of the flight;
M05A_BARN0088_05_GE_CASE1.INDD 10 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–11
and movies were marketed aggressively. Cabin crews were
trained in customer service and incentivized to push sales.
In addition to the usual duty-free items like alcohol, tobacco,
chocolate and fashion products, X also sold travel related
merchandise such as travel adapters, train and bus tickets,
prepaid phone cards, scarves and hats and scale models of
their aircraft. X’s onboard sales per passenger were more
than three times the amount Singapore Airlines generated.
Fees and Meals
A survey of the global airline industry in early 2011 pointed to
the widespread adoption of fees for checked baggage. X was
no exception to the trend. In 2010, approximately 8 per cent of
overall revenue came from checked baggage fees. X provided
a discount for prepaid baggage compared to at check-in fees.
Approximately 95 per cent of all checked bags were pre-paid.
Passengers had the option of pre-booking a hot meal
that came with a small bottle of mineral water. The only
other pre-booked option was a comfort kit, which included
an inflatable travel pillow, an eye mask and a blanket. In
September 2010, X began to manage the flight cabin more
strategically as a retail space and started to analyze on-
board product offerings. Wright stated:
If we are going to pay a cost to procure and upload
items to sell on each flight, we need to make sure we
are only loading those items that really do sell and sell
well. Unlike full service airlines where there is one meal
item for each passenger on board, we need to be very
conscious of our wastage and unsold inventory. We
think the retail mindset of viewing the cabin more like
shelf space, and what sells best and where and when do
we place it applies to us. We have to break away from
the traditional industry norms. Ideally we are aiming
to strike a better balance between offering more pre-
booked options and drilling down to what really sells
best onboard to maximize our ancillary revenue.
next destination. During the following two weeks, Balan
met periodically with Fernandes to keep him briefed while
the Christchurch Airport Authority officials traveled to
Kuala Lumpur and offered their plan to ensure sustainable
success of the route. The airport partnered with local and
national tourism and economic development entities to
present a package of incentives, commitments, and contri-
butions for an initial five-year period to demonstrate their
faith in the viability of the route.14
Fernandes gave Balan approval. The Kuala Lumpur
to Christchurch flight was approximately 11 hours in dura-
tion and the initial launch fare was set at NZ$99 (US$75).
The route was announced on December 1, 2010, with the
typical X splashy advertising burst (see Exhibit 4), and the
first flight was scheduled for April 1, 2011. On December 8,
2010, one week after tickets went on sale, Wright excitedly
stated, “Within six hours 17,000 tickets had been sold for
Christchurch, and nearly 44,000 within the first three days.
That is the equivalent of every seat on every flight for more
than seven months. It feels great when everything comes
together like this.”
Growing Revenue, Maintaining Low Ticket
Price
The challenge for X and other low cost airlines was increas-
ing revenues while still maintaining a lower priced ticket
than its competitors. Unlike full service airlines such as
American Airlines or Lufthansa Airlines, with packaged ser-
vice offerings included in their ticket prices, AirAsia X did
not believe the best or only time to generate revenue from
a passenger was at the time of booking. X built its revenue
model on the notion that passengers were willing to spend
money throughout the entire travel experience. Onboard
food and beverages, cabin amenities such as pillows and
blankets, and digital media players with music, games
Exhibit 4 Airasia X Advertisements
Source: Company files
M05A_BARN0088_05_GE_CASE1.INDD 11 13/09/14 3:32 PM

PC 2–12 Business-Level Strategies
Building the Global Brand
In a far-sighted move to improve brand recognition, X
chose high profile sport sponsoring as a marketing tool.
Osman-Rani stated:
X’s sponsorship of Manchester United started years
before the brand flew to and from the UK. It drip-
fed into peoples’ consciousness to such a degree that
when the inaugural service came to London in March
2009 the first plane-load was made up of 28 per cent
British citizens, 18 per cent from other EU countries
and 7 per cent from Australia. Normally, more than
70 per cent of passengers on a maiden flight are
from an airline’s home country.16 Look at the United
States. We currently have no tangible plans to launch
a flight, but it is definitely one of our long-term target
destinations. This was the reason behind the decision
to establish a sponsoring agreement with the Oakland
Raiders National Football League team in 2009. The
idea is that by the time we start a service we have
already established solid brand awareness. You’ve got
to think ahead and not follow the crowd.
X also currently sponsored the Lotus Formula One
Racing Team as well as the Asian Basketball League.
When X prepared to launch, the decision was made
to emphasize a single brand identity among all AirAsia
Group companies despite the differing customer demo-
graphics for short haul versus long haul flights. This deci-
sion created a singular AirAsia brand that was very recog-
nizable and strong in Malaysia and throughout Southeast
Asia, but only marginally known in other parts of the
world. All but one of X’s aircraft were painted with the
large AirAsia.com logo.
To the casual observer, it was difficult to distinguish
AirAsia from X with the exception of X’s much larger air-
planes. The decision to create a public perception as one
seamless airline brought both its share of advantages and
challenges to X,17 The AirAsia brand was positioned as
fun, hip and affordable, and considered to be one of the
most recognizable brands in Southeast Asia. The distinc-
tive celebrity personalities of both AirAsia CEO Tony
Fernandes and X CEO Azran Osman-Rani added signifi-
cant value to each brand.
For passengers outside of Southeast Asia, however,
it could be confusing to visit AirAsia.com and to see
the many promotional ads for cheap flights from Kuala
Lumpur to Phuket, while trying to find their own depar-
ture airports. On the other hand, some passengers that
specifically sought out the ultra low fares for intra-Asia
flights were surprised to learn that X flew to destinations
outside of Asia.
Game Changers
When X introduced the world’s first flat bed seat on a bud-
get airline in 2009, the conventional airline industry was
bewildered.15 Wright explained:
Our competitors use the exact same seat in business class
as we use, and it costs us a fraction of their costs to fill it
and fly it. The concept behind the bold move is actually
quite basic. All we are doing is going back to giving long
haul travelers what they really want and that is a place
to lie down and sleep comfortably without the caviar
and champagne. We are always looking to be the first
to do things. We consider ourselves game changers. At
the beginning, this was strictly prudence and driven
by survival instincts. Today it is this spirit driving our
strategy. Whether it be to provide entertainment on USB
thumb drives to passengers for a fraction of the cur-
rent costs, or to simply rent them a long lasting battery
source to use for their own laptop and media devices, it
just makes great business sense to stretch the boundaries.
Flight Transfers
Until December 2010, all X flights were sold as point to
point only, and all passengers had to collect their bags,
clear customs, and self connect to other flights indepen-
dently, even within the AirAsia Group’s network. This
worked well for vacationers, yet it frustrated some travel-
ers accustomed to automatic baggage transfers from their
first departure point to their final destination.
With a network that could support several transfer
choices in December 2010, X began to sell the option of
booking tickets to destinations beyond just their point-
to-point hub in Kuala Lumpur. The flight transfer option
was priced at the nominal fee of US$3. However the added
value of convenience attracted more and more flyers to
book tickets on X flights. Wright explained:
This change was really the first step to add to our original
value proposition externally. As our network contin-
ues to grow, we envision the day when all passenger
segments from backpackers, to families on vacation, to
business executives will seek out ways to connect through
Kuala Lumpur because of the affordable fares and high
frequency of flights offered on our network every day.
The new connecting option was particularly popu-
lar on the highly traveled segments between the UK and
Australia. While the connecting concept was originally
intended to be between different X flights only, AirAsia
quickly realized the powerful marketing potential of the
idea. In January 2011, the entire AirAsia group network
rolled out flight transfers—marketed as “Fly-Thru”—but
only on select routes.
M05A_BARN0088_05_GE_CASE1.INDD 12 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–13
but there is a lot of that in all we do. We recently made
three television commercials for CNN targeting seasoned
business travelers. Our most effective spot showcased
a guy drenched by his water bottle because he forgot he
was seated in one of our flat bed seats when he sat back.
Long Haul versus Short Haul and the
Challenge of a Single Brand
With only a handful of exceptions, all of the world’s low
cost airlines flew what was known as short haul routes no
longer than five hours in duration. Five hours, however,
is long enough to travel between Los Angeles and New
York City, London to Tel Aviv, Sydney to Perth, or Lima to
São Paulo. X’s position as a long haul carrier meant all its
flights were at least five hours in duration with the longest
non-stop routes being more than 13 hours. On the surface,
one might assume simply doubling the distance of a flight
would not alter passenger psychographics or demograph-
ics, however, that was not the case.
Traditionally, airlines focused on elevating their
brand by providing a super premium level of comfort,
more amenities and better service on their longest flights.
Over the decades, long haul travelers had come to expect
this when flying longer distances. At its inception, X’s
long haul flying experience did not include a first or busi-
ness class cabin, complimentary inflight entertainment,
or complimentary food and beverage, or even reclining
seats. Reclining seats were added later mainly for health
and minimal comfort related reasons and with no impact
on loads. However, X also tried to target the more comfort-
seeking passengers as well. According to Wright:
Unfortunately, there are business travelers out there
that could potentially fly with us on our international
trunk routes and book our flat bed seats, but they only
know us as AirAsia. They don’t understand that X is
a separate airline, and they don’t know that we offer a
more comfortable flying experience. Our unified mar-
keting approach does not really help us in this regard.
For shorter flights, seasoned fliers were more willing
to do without amenities if the price was right, but the same
customer demographic expected a different comfort level
on long haul flights. Income disparity between passengers
was not as much a factor on short haul as on long haul.
Osman-Rani stated:
When Southwest in the United States flies between
Houston and Dallas for US$49, you will have young and
old, rich and poor on every flight. Not so with the longer
flights. And that is where we fit into the marketplace, we
are the brand that is literally turning dreams into reality
for so many people and opening up the skies to everyone.
A pointed example of the complexities that ex-
ist in maintaining one singular brand, but two different
operational models was the shared e-mail database of
each company’s best customers. Open for anyone to join,
a large database of tens of thousands of e-mail addresses
was shared between AirAsia and X to publicize new items
and special fare sales. Since the sister company AirAsia re-
lied on filling as many seats as possible on a much shorter
turnaround basis, they routinely—as often as three times a
week—sent blast e-mails with new fare promotions.
X employees observed their friends telling others:
“Don’t worry, they are always going to have a sale, so
there is no rush to buy.” From the X point of view, this
constant barrage of ‘buy now’ e-mails diluted the urgency
of the promotional long haul fares and actually worked
to gradually alienate the existing X customer base. In the
two-month period of September through October 2010, the
rate at which these e-mails were even opened by recipients
dropped from 25 per cent to 15 per cent.
Distinctive Advertising
Similar to AirAsia, X’s advertising was very explicit and of-
ten sarcastic or humorous in nature18. Wright commented:
We were brainstorming how best to market our flat bed
seats in Australia, where sarcastic ads are just part of
the culture when one of our team members came up with
“Our Premium seats are a Flat – Out – Lie. Trust Us.”
I instantly loved it. It’s true, but also slightly edgy—
just enough for the message to stick. For us, attracting
attention is usually best accomplished by doing what
everyone else won’t. There are so many professional surf
tours now around the globe, so we decided to do the ex-
act opposite. We came up with the “No-Pro Tour.” Now
any amateur surfers can post videos of themselves to our
site and if the video is voted most popular by the website
audience, they’ll win flights on X to some of the world’s
best surf destinations. This has been a great way to get a
viral response to a customer segment that fits perfectly
with our business model.
Wright continued:
Most companies only joke about some of the things that
we seriously consider and often times do. When we were
planning the launch party for our Christchurch route,
we considered releasing 99 New Zealand sheep, painted
red and with an X logo shaved into the wool into the city
square to powerfully signify the NZ$99 fare. We began
making plans for our founder, Tony Fernandes, to travel
to Antarctica and plant an X flag at the pole. With so
many old and boring airline messages out there today,
we have to find more and more creative ways to get our
message around. Not every message is fun and games,
M05A_BARN0088_05_GE_CASE1.INDD 13 13/09/14 3:32 PM

PC 2–14 Business-Level Strategies
the global marketing expenditures. He commented: “We are
great at being nimble and addressing each local market’s
needs, but we can do a much better job if we integrate our
adverting activities globally. We could be more cost-effective
and reduce the potential risk of misalignments.”
Revenue Management: Plan Versus React
One of the greatest challenges for X was matching their ad-
vertising activities to their revenue management activities.
Wright explained:
There have been times in our history that the day the
advertisement came out the fare advertised had already
been sold out. While that’s not perfect, it’s much better
than where we find ourselves often, and that is to al-
ways be reacting to this week’s unsold ticket numbers.
We are reaching a scale now that to sell off any seat
at a ridiculous fare just to fill it will not enhance our
brand value in the long term. We need to start lever-
aging our brand a little more than our fares.
In November 2010, while profitable for the year and
with 85 per cent of all remaining seats already sold, X was
50 million Malaysian ringgit or US$15 million short of its
projected revenue for the year. Wright met with his revenue
management team to devise a strategy to meet the year-
end target. Meeting the target was extremely important to
Osman-Rani as well; he wanted to confidently stand in front
of the board of directors and demonstrate the airline was
ready for an IPO. “Without proving we can meet our bud-
gets, it will become difficult to convince investors we know
what we are doing and that we are a promising investment,”
explained Wright. X met their 2010 budgeted revenues.
From its inception, all major items acquired by the
company were expensed. At the time of the operational
split from AirAsia in August, 2010, Osman-Rani recruited
a new CFO and gave her authority to overhaul anything
and everything to get set for the future IPO.19 One of the
first initiatives she undertook was to establish an inven-
tory system that utilized amortization and depreciation
in order to improve financial ratios. At the same time,
Osman-Rani decided that quality control of in-flight meals
and merchandise could best be managed by taking the
procurement duties away from AirAsia and external sup-
pliers. He created an in-house position dedicated to quality
management. From a technology perspective, X began to
investigate a new handheld inventory tracking system to
be used in flight by cabin crews. The new tool would allow
X to be more like a retailer and digitally track inventories
and wastage real time. They could also find merchandise
more easily across different carts on one aircraft. This
In addition to the differences in perceived in-flight
comfort, X deviated from the short haul models because
it was not as easy to capture the last minute passenger.
Particularly due to the Internet and social media, last min-
ute fares had become an extremely viable tool to fill airline
seats. According to Wright:
The reality is that the decision process to buy a one-hour
long domestic flight and the decision process to buy an
eight-hour intercontinental flight requiring passports
and visas are drastically different. Most people sitting
in our seats have been thinking about and planning
their trip for weeks if not months in advance. I think
eventually, the strength of the X brand needs to be more
about our network and frequency and value for money,
than it needs to be about the occasional ridiculously low
promotional fare.
Can a Glocal Focus Work: Being Global
and Malaysian
X was a company of just over 1,000 employees, 99 per cent of
which were Malaysian nationals. CEO Azran Osman-Rani
and his upper management team all had foreign education,
work, or living experiences. However, much of the rest of
the team had never been exposed to international business
practices. In early 2011, 60 per cent of X’s passengers were
Malaysians, though this ratio was about to shift with the
addition of new routes. Balan commented: “We have never
really had people with an outsider’s viewpoint, and I think
that will be a huge asset for us as we become more diverse
and grow.” Supporting this position, Osman-Rani stated:
We expect to have to make alterations to our busi-
ness model as we expand to serve new and different
markets, and that includes our workforce. At the same
time, it is critical to remain disciplined in keeping our
costs low, so we can adapt and change. We can’t afford
to hire seasoned highly paid airline executives. It will
disturb our culture.
Looking Ahead: A Global IPO and
Other Priorities
As of early 2011, all advertising and media purchases were
placed through local media service agencies located in the
target markets. X headquarters staff coordinated the adver-
tising activities for 12 countries and 15 cities, while remote
teams in Australia and the United Kingdom managed their
respective country’s advertising independently. The problem
was Wright did not have one consolidated report outlining
M05A_BARN0088_05_GE_CASE1.INDD 14 13/09/14 3:32 PM

Case 2–1: Airasia X: Can the Low Cost Model go Long Haul? PC 2–15
Conclusions
With more than 1,000 employees of its own, a core chal-
lenge for X was to maintain its entrepreneurial and flexible
culture that had attracted some of Malaysia’s best and
brightest. Since its inception, X deliberately maintained a
bold culture, using adjectives that began with X such as
“Xcited, Xcellence, X-Rated, Xtc.” Compared with AirAsia,
X was a more relaxed and open environment, and enjoyed
a much lower employee attrition rate. There were concerns
that, with the planned growth and internationalization of
the organization, this culture could get lost. In a corporate
video made for new hires, Osman-Rani invited all of his
team members to focus on maintaining the “X-factor” as
their top priority in whatever they did while the company
moved towards the IPO. This emphasis on culture might
prove a key differentiator as the market became more
crowded. Projected growth figures of 56 per cent by 2014
for air travel in the wider Asian market were stimulating
fleet and route expansion across the region.20 Challenges
to both AirAsia and AirAsia X were multiplying, both
from rival low cost operators such as the Philippines’ Cebu
Pacific and Indonesia’s Lion Air, as well as from estab-
lished full service carriers like Thai Airways and Japan’s
All Nippon Airlines (ANA).
In May 2011, X’s IPO plans appeared to receive a
boost when Singapore Airlines announced their intention
to launch a long haul budget carrier. This move by one of
the industry’s preeminent players gave credibility to X’s
business model and growth targets. As X’s CEO Azran
Osman-Rani commented, “The plans will definitely help
us with our IPO and give us credibility—there is a market
for running a long haul low cost airline.”21
Even so, challenges and questions remained in the
run up to an IPO and beyond. Despite Osman-Rani’s
upbeat assessment, the market entry of an operation-
ally efficient, globally respected airline like Singapore
Airlines put increased pressure on X to list quickly and
expand rapidly. Would X’s first move advantage suffice
in the next phase of competition? Could X make money,
particularly as the market became more contested? Would
their brand and customer value proposition succeed be-
yond Southeast Asia? In the long term, how viable was
a long haul, global cost leadership strategy in the airline
industry?
These questions played on the mind of Wright as he
eased into his seat and tried to get some sleep on his red
eye flight to Australia. The answers would not come easily
but they needed to come swiftly if he was to prepare for
a successful IPO and build on X’s head start in the global
long haul, low cost market.
system helped to stock up on merchandise at the airport
more quickly and effectively.
Making Nice: Balancing Domestic Political
Relationships
Shortly after the inception of AirAsia X, the Malaysian
Transport Ministry was forced into a love-hate rela-
tionship with the airline. The success of X helped the
Malaysian economy, but some within the government
believed this happened at the expense of the national
airline—Malaysian Airlines (MAS). The relationship strug-
gles between X and the Malaysian government could
be best illustrated by the clash over the rights to fly be-
tween Kuala Lumpur and Sydney, Australia. Although the
Australian government indicated it would allow X to fly to
Sydney, the Malaysian government steadfastly defended
state owned Malaysian Airlines’ monopoly on the route
and did not grant X permission to fly. X pushed back pub-
lically in September 2010 by painting one of their airplanes
with a message asking to open up the skies to Sydney. In
October 2010, sister company AirAsia overtook Malaysian
Airlines’ market capitalization for the first time and be-
came the country’s largest airline. Within a week, X’s
management was summoned to meet with the Ministry of
Transport and flatly told X would not be flying to Sydney
in the foreseeable future.
For X, potentially the single most limiting factor
to growth of their business was the Malaysian govern-
ment’s protectionist stance in favor of Malaysian Airlines.
While X was granted permission to launch many new
routes from Kuala Lumpur, Malaysian Airlines did not
serve any of those routes. In early 2011, the Ministry of
Transport worked with X to establish the twenty most
vital air routes for the Malaysian economy, and once that
list was finalized, hopefully a plan to share equal rights
along with Malaysian Airlines to serve those routes could
be established.
There was a significant amount of public and gov-
ernment pressure to list X on the Kuala Lumpur Stock
Exchange (KLSE) for its upcoming IPO. However, from
X’s perspective there were concerns the company could
be caught in a no-win situation if they listed on the KLSE.
There was fear that the success of the IPO could be greatly
reduced due to the little value it possessed for those
Malaysian investors already holding shares of AirAsia.
If X chose to list in Hong Kong or New York instead, the
Malaysian government could further slow down some of
X’s expansion plans, including continuing to prohibit X
from getting the approvals to fly to certain foreign destina-
tions. X’s IPO was scheduled for late 2011 or early 2012.
M05A_BARN0088_05_GE_CASE1.INDD 15 13/09/14 3:32 PM

PC 2–16 Business-Level Strategies
End Notes
1. Within the airline industry flights greater than five hours in duration are referred to
as “long haul” flying.
2. www.airasia.com/my/en/flightinfo/routemap.page?, accessed July 10, 2011.
3. www.skytraxresearch.com/General/ranking.htm, accessed July 10, 2011.
4. www.centreforaviation.com/news/2009/11/18/lcc-challenges-hybridisation-long-
haul-low-cost-being-stuck-in-the-middle-and-consolidation/page1, accessed July 10,
2011.
5. www.flightglobal.com/articles/2010/04/21/340855/interview-air-arabia-chief-executive-
adel-ali.html, accessed May 13, 2011.
6. http://boardingarea.com/blogs/onemileatatime/2010/12/27/a-note-about-premium-
cabins-and-becoming-jaded/, accessed July 15, 2011.
7. http://web.mit.edu/airlinedata/www/Res_Glossary.html, accessed July 10, 2011.
8. Jens Flottau, “Airline Profits Will Get Pinched In 2011,” Aviation Week, December 17,
2010.
9. http://lcct.klia.com.my/, accessed July 10, 2011.
10. Airport Council International rankings 2009, accessed July 10, 2011.
11. www.oasishongkong.com/, accessed May 31, 2011.
12. www.koolred.com/, accessed July 10, 2011.
13. www.airlearn.net/images/UVa-Pricing-Jan09 , accessed July 10, 2011.
14. www.travelio.net/airasia-x-deal.html.
15. www.centreforaviation.com/news/2010/06/24/airasia-x-becomes-first-lcc-offer-
low-cost-flatbed-seats-as-expansion-rolls-on/page1, accessed July 10, 2011.
16. Pip Brooking, “AirAsia X: Using Sponsorship to Build a Brand/Interview/M&M,”
M&M Global-International Media & Marketing News & Analysis, October 11, 2010, www.
mandmglobal.com/global-accounts/activity/11-10-10/airasia-x-using-sponsorship-
to-build-a-brand.aspx, accessed January 20, 2011.
17. http://blog.airasia.com/index.php/surfing, accessed July 10, 2011.
18. http://adsoftheworld.com/media/print/air_asia_x_phuket_ill_go?size=_original,
accessed July 10, 2011.
19. www.businessweek.com/ap/financialnews/D9G6V0QG0.htm, accessed July 10,
2011.
20. Eric Bellman, “Competition takes off in Asia’s budget airline market,” The Wall Street
Journal, July 22, 2011.
21. Cited in Jeeva Arulampalam, “AirAsia X IPO gets a boost,” The Star Online, May 30,
2011.
M05A_BARN0088_05_GE_CASE1.INDD 16 13/09/14 3:32 PM

*This case was written by Eleanor O’Higgins, University College
Dublin. It is intended to be used as a basis for class discussion
rather than to illustrate effective or ineffective handling of a
management situation.
© Eleanor O’Higgins, 2011. All rights reserved.
fleet of 256 new Boeing 737-800 aircraft with firm orders
for a further 64 aircraft to be delivered over the following
two years. It employed 8,100-plus people and had carried
almost 67 million passengers in 2010, expecting to carry
approximately 73.5 million passengers for fiscal 2011.
Ryanair was founded in 1985 by the Tony Ryan
family to provide scheduled passenger services between
Ireland and the United Kingdom, as an alternative to then-
state monopoly airline Aer Lingus. Initially, Ryanair was a
full-service conventional airline, with two classes of seat-
ing, leasing three different types of aircraft. Despite growth
in passenger volumes, by the end of 1990, the company had
flown through much turbulence, disposing of five chief ex-
ecutives and accumulating losses of IR£20 million. Its fight
to survive in the early 1990s saw the airline transform itself
to become Europe’s first low-fare, no-frills carrier, built
on the model of Southwest Airlines, the successful Texas-
based operator. A new management team, led by Michael
O’Leary, then a reluctant recruit, was appointed. Ryanair,
floated on the Dublin Stock Exchange in 1997, is quoted on
the Dublin and London Stock exchanges and on NASDAQ,
where it was admitted to the NASDAQ-100 in 2002.
Mixed Fortunes
Mixed Results
Ryanair designated itself as the “World’s Favourite Airline”
on the basis that, in 2010, IATA ranked it as the world’s
largest international airline by passenger numbers—
despite the fact that it had already been calling itself the
world’s favorite airline for a number of years. It was now
the eighth-largest airline in the world (when the large U.S.
carriers’ domestic traffic is included). Over the following
five years, Ryanair intended to grow to become the second-
largest airline in the world, ranked only behind its mentor
Southwest.
Releasing Ryanair’s 2010 results in June 2010, O’Leary
announced, “We can be proud of delivering a 200 percent in-
crease in profits and traffic growth during a global recession
when many of our competitors have announced losses or
cutbacks, while more have gone bankrupt.” Revenues had
risen 2 percent to €2,988 million, as fares fell 13 percent to
€34.95. Unit costs fell 19 percent due to lower fuel costs and
rigorous cost control. Fuel costs declined 29 percent as oil
prices fell from $104 to $62 per barrel. Fuel hedging was ex-
tended to 90 percent for full year 2011, 50 percent for quarter 1
C a s e 2 – 2 : R y a n a i r — T h e L o w F a r e s
A i r l i n e : W h i t h e r N o w ? *
“There is only one thing in the world worse than being talked
about, and that is not being talked about,” declared Lord
Charles in Oscar Wilde’s novel, The Picture of Dorian Gray.
This could have been the mantra of budget airline Ryanair,
Europe’s largest carrier by passenger numbers and market
capitalization in 2010. The airline was given to making contro-
versial news, whether it was annoying the Queen of Spain by
using her picture without permission in marketing material
or announcing plans to charge passengers to use toilets on its
flights or engaging in high-profile battles with the European
Commission. Ryanair also made news with its achievements,
such as winning international awards, like Best Managed
Airline, or receiving a 2009 FT-ArcelorMittal Boldness in
Business Award in the Drivers of Change category. This
award announcement said that Ryanair had “changed the
airline business outside North America—driving the way the
industry operates through its pricing, the destinations it flies
to and the passenger numbers it carries.”1 Ryanair had been
the budget airline pioneer in Europe, rigorously following a
low-cost strategy. It had enjoyed remarkable growth and in
the five years to 2009, was the most profitable airline in the
world, according to Air Transport magazine.
Despite this apparent success, Ryanair faced issues.
The most pressing, shared by all airlines, was an industry
that was “structurally sick” and “in intensive care,”2 with
plunging demand in the global economic recession and un-
certainty about oil prices. What strategy should Ryanair use
to weather this storm? Would the crisis produce a long-term
change in industry structure? Could Ryanair take advan-
tage of the situation as it had in the past, by growing when
others were cutting back? A predicament of its own making
was Ryanair’s 29.8 percent shareholding in Aer Lingus, the
Irish national carrier, following an abortive takeover at-
tempt. Aer Lingus’s flagging share price had necessitated
drastic write-downs, which had dragged Ryanair’s results
into losses in 2009, the first since its flotation 12 years earlier.
Overview of Ryanair
In 2010, Ryanair had 44 bases and 1,200-plus routes across
27 countries, connecting 160 destinations. It operated a
M05A_BARN0088_05_GE_CASE2.INDD 17 15/09/14 7:43 PM

PC 2–18 Business-Level Strategies
depreciation charge. Excluding these exceptional charges,
underlying profits fell 78 percent from €480.9 million to
€105 million. This was due largely to a surge in fuel prices
in the first half of fiscal 2009, as Ryanair failed to hedge
when oil prices rose to $147 a barrel in July 2008. Then,
bowing to shareholder pressure to cover against rocketing
prices, it locked in fuel costs at $124 a barrel for 80 percent
of its consumption during the third quarter—just as oil
prices crashed to a low of $33 a barrel during that period.
Passenger numbers rose 15 percent from 50.9 million to
58.5 million. Average fares fell 8 percent to €40. (Ryanair’s
financial data are given in Exhibits 1a and 1b, and operat-
ing data are given in Exhibit 1c.)
and 20 percent of quarter 2 of 2012. Airport and handling
costs declined by 9 percent, despite price increases at Dublin
and Stansted, two of Ryanair’s busiest bases. Ancillary sales
grew 11 percent to €664 million, slightly lower than traffic
growth and constituting 22 percent of total revenues. The
balance sheet had strengthened with a cash rise of €535 mil-
lion to €2.8 billion. According to the airline, currency hedg-
ing had locked in the cost of aircraft purchases in 2010–2011.
The full-year 2010 improvement in profit had fol-
lowed a particularly miserable 2009, when Ryanair
plunged to a €180 million loss, as its €144 million operat-
ing profit was eradicated by a €222 million write-down
of its Aer Lingus shares and an accelerated €51.6 million
Exhibit 1a Ryanair Consolidated Income Statement
Year end
March 31,
2010
Year end
March 31,
2009
Year end
March 31,
2008
€M €M €000
Operating revenues
Scheduled revenues ……………………………………………………… 2,324.5 2,343.9 2,225.7
Ancillary revenues ……………………………………………………… 663.6 598.1 488.1
Total operating revenues—continuing operations ………………… 2,988.1 2,942.0 2,713.8
Operating expenses
Staff costs ……………………………………………………………… (335.0) (309.3) (285.3)
Depreciation …………………………………………………………… (235.4) (256.1) (176.0)
Fuel and oil ……………………………………………………………. (893.9) (1,257.1) (791.3)
Maintenance, materials, and repairs ……………………………….. (86.0) (66.8) (56.7)
Marketing and distribution costs …………………………………… (144.8) (12.8) (17.2)
Aircraft rentals ………………………………………………………… (95.5) (78.2) (72.7)
Route charges …………………………………………………………. (336.3) (286.6) (259.3)
Airport and handling charges ……………………………………….. (459.1) (443.4) (396.3)
Other ………………………………………………………………….… —* (139.1) (122.0)
Total operating expenses ……………………………………………… (2,586.0) (2,849.3) (2,176.8)
Operating profit—continuing operations……………………………. 402.1 92.6 537.1
Other income / (expenses)
Finance income ……………………………………………………….. 23.5 75.5 83.9
Finance expense ……………………………………………………… (72.1) (130.5) (97.1)
Foreign exchange gain / (losses) …………………………………… (1.0) 4.4 (5.6)
Loss on impairment of available-for-sale financial asset …………. (13.5) (222.5) (91.6)
Gain on disposal of property, plant and equipment ……………… 2.0 — 12.2
Total other income / (expenses) ……………………………………… (61.1) (273.1) (98.2)
Profit / (Loss) / before tax ……………………………………………… 341.0 (180.5) 438.9
Tax on profit / (loss) on ordinary activities ……………………….. (35.7) 11.3 (48.2)
Profit / (Loss) for the year — all attributable to
equity holders of parent …………………………………………….. 305.3 (169.2) 390.7
Basic earnings per ordinary share (eurocents) ………………………. 20.68 (11.44) 25.84
Diluted earnings per ordinary share (eurocents) ……………………. 20.60 (11.44) 25.62
Number of ordinary shares (in 000s) ………………………………….. 1,476.4 1,478.5 1,512.0
Number of diluted shares (in 000s) …………………………………… 1,481.7 1,478.5 1,524.9
*Consolidated with Marketing & Distribution in 2010
Source: Ryanair Annual Report 2010.
M05A_BARN0088_05_GE_CASE2.INDD 18 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–19
Exhibit 1b Ryanair Consolidated Balance Sheet
March 31,
2010
March 31,
2009
€M €M
Non-current assets
Property, plant, and equipment ……………………………. 4,314.2 3,644.8
Intangible assets …………………………………………….. 46.8 46.8
Available for sale financial assets ………………………….. 116.2 93.2
Derivative financial instruments …………………………… 22.8 60.0
Total non-current assets ………………………………………. 4,500.0 3,844.8
Current assets
Inventories ……………………………………………………. 2.5 2.1
Other assets …………………………………………………… 80.6 91.0
Current tax …………………………………………………… — —
Trade receivables ……………………………………………. 44.3 41.8
Derivative financial instruments …………………………… 122.6 130.0
Restricted cash ………………………………………………. 67.8 291.6
Financial assets: cash > 3 months …………………………. 1,267.7 403.4
Cash and cash equivalents …………………………….…… 1,477.9 1,583.2
Total current assets ……………………………………….…… 3,063.4 2,543.1
Total assets……………………………………………………… 7,563.4 6,387.9
Current liabilities
Trade payables ………………………………………………. 154.0 132.7
Accrued expenses and other liabilities …………………… 1,088.2 905.8
Current maturities of debt ……………………………….… 265.5 202.9
Current tax …………………………………………………… 0.9 0.4
Derivative financial instruments …………………………… 41.0 137.4
Total current liabilities …………………………………….… 1,549.6 1,379.2
Non-current liabilities
Provisions…………………………………………………….. 102.9 72.0
Derivative financial instruments …………………….……. 35.4 54.1
Deferred tax ………………………………………………….. 199.6 155.5
Other creditors ………………………………………………. 136.6 106.5
Non-current maturities of debt ………………………….… 2,690.7 2,195.5
Total non-current liabilities …………………………….…… 3,165.2 2,583.6
Shareholders’ equity
Issued share capital ……………………………………….… 9.4 9.4
Share premium account …………………………………….. 631.9 617.4
Capital redemption reserve ………………………………… 0.5 0.5
Retained earnings …………………………………………… 2,083.5 1,777.7
Other reserves ……………………………………………….. 123.3 20.1
Shareholders’ equity ………………………………………….. 2,848.6 2,425.1
Total liabilities and shareholders’ equity ………………….. 7,563.4 6,387.9
Source: Ryanair Annual Report 2010.
Ancillary Revenues
Ryanair provides various ancillary services connected with
its airline service, including in-flight beverage, food, and
merchandise sales and Internet-related services. Ryanair
also distributes accommodation, travel insurance, and
car rentals through its Web site. Providing these services
through the Internet enables Ryanair to increase sales
while reducing unit costs. In 2010, Ryanair’s Web site
ranked 12th by number of visits for e-tailers in the United
Kingdom (behind EasyJet, which ranked 10th). Ancillary
M05A_BARN0088_05_GE_CASE2.INDD 19 15/09/14 7:43 PM

PC 2–20 Business-Level Strategies
Exhibit 1c Ryanair Selected Operating Data
2010 2009 2008 2007
Average Yield per Revenue Passenger
Mile (“RPM”) (€) ……………………….. 0.052 0.060 0.065 0.070
Average Yield per Available
Seat Miles (“ASM”) (€)……………….…. 0.043 0.050 0.054 0.059
Average Fuel Cost per U.S.
Gallon (€) ……………………………….. 1.515 2.351 1.674 1.826
Cost per ASM (CASM) (€) ………………. 0.047 0.058 0.051 0.054
Breakeven Load Factor …………………… 73% 79% 79% 77%
Operating Margin ………………………… 13% 5% 20% 21%
Average Booked Passenger
Fare (€) …………………………………… 34.95 40.02 43.70 44.10
Ancillary Revenue per
Booked Passenger (€) ………………….. 9.98 10.21 9.58 8.52
Other Data
2010 2009 2008 2007
Revenue Passengers
Booked …………………………………… 66,503,999 58,565,663 50,931,723 42,509,112
Revenue Passenger Miles ………………… 44,841 39,202 34,452 26,943
Available Seat Miles ……………………… 53,470 47,102 41,342 32,043
Booked Passenger Load
Factor ……………………………………. 82% 81% 82% 82%
Average Length of Passenger
Haul (miles) …………………………….. 661 654 662 621
Sectors Flown ……………………………… 427,900 380,915 330,598 272,889
Number of Airports Served ……………… 153 143 147 123
Average Daily Flight Hour
Utilization (hours) ……………………… 8.89 9.59 9.87 9.77
Employees at Period End ………………… 7,168 6,616 5,920 4,462
Employees per Aircraft …………………… 31 36 36 34
Booked Passengers
per Employee……………………………. 9,253 8,852 8,603 9,527
Source: Ryanair Annual Report 2010
services accounted for 22 percent of Ryanair’s total op-
erating revenues, compared with 20.3 percent in 2009.
However, it might be that ancillary revenue generation
could have its limits, as they had, in fact, dropped from
€10.20 in 2009 to €9.98 per passenger in 2010.
Ancillary revenue initiatives were constantly being
introduced by Ryanair, such as onboard and online gam-
bling and a trial in-flight mobile phone service in 2009. A
poll of Financial Times’ readers had produced a 72 percent
negative response to the question, “Should mobile phones
be allowed on aircraft?” Among the comments was “Just
another reason not to fly Ryanair.”5 However, O’Leary
declared, “If you want a quiet flight, use another airline.
Ryanair is noisy, full, and we are always trying to sell you
something.”6 In March 2010, despite a promising trial on
50 aircraft, Ryanair announced the suspension of its on-
board telephone service due to a failure to reach an agree-
ment with the Swiss provider, OnAir, on a plan to roll out
the service to Ryanair’s entire fleet.
Ryanair was the first airline to introduce charges
for check-in luggage. Virtually all budget airlines have
followed suit, as they have with other Ryanair initiatives.
It has continued to find ways of charging passengers
for services once considered intrinsic to an airline ticket.
M05A_BARN0088_05_GE_CASE2.INDD 20 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–21
peers on its PE ratio. However, this offered an upside
potential for capital gains, according to Davy, the com-
pany’s stockbrokers.
Ryanair’s Operations
O’Leary said, “Any fool can sell low airfares and lose
money. The difficult bit is to sell the lowest airfares and
make profits. If you don’t make profits, you can’t lower
your airfares or reward your people or invest in new
aircraft or take on the really big airlines like BA (British
Airways) and Lufthansa.”7 Certainly, Ryanair had stuck
closely to the low-cost/low-fares model. Ever-decreasing
costs was its theme, as it constantly adapted its model to
the European arena and changing conditions. In this re-
spect, Ryanair differed in its application of the Southwest
Airlines budget airline prototype and its main European ri-
val, EasyJet, as they were not as frill-cutting. One observer
described the difference between EasyJet and Ryanair:
“EasyJet, you understand is classy cheap, rather than just
plain cheap.”8
The Ryanair Fleet
Ryanair continued its fleet commonality policy, using
Boeing 737 planes, to maintain staff training and aircraft
maintenance costs as low as possible. Over the years, it
purchased new, more environmentally friendly aircraft,
reducing the average age of its aircraft to 3.3 years, among
the youngest fleets in Europe. The newer aircraft produced
50 percent less emissions, 45 percent less fuel burn, and 45
percent lower noise emissions per seat. Winglet modifica-
tion provided better performance and a 2 percent reduction
in fleet fuel consumption, a saving the company believed
could be improved. Despite larger seat capacity, new air-
craft did not require more crew. In 2009, in aircraft buying
mode, Ryanair sought to repeat its 2002 coup when it placed
aircraft orders at the bottom of the market. However, in late
2009, talks with Boeing for the purchase of 200 aircraft be-
tween 2013 and 2015 broke down. Notwithstanding strict
adherence to Boeing 737 planes, in an attempt to extract
ever greater discounts from Boeing, Ryanair invited Airbus,
the European aircraft manufacturer, to enter into prelimi-
nary bidding for a multimillion-dollar order for 200-plus
short-haul aircraft. However, Airbus rebuffed the Ryanair
invitation, declaring this sales campaign would be too
expensive and time consuming. Yet Ryanair hinted that it
had an interest in Airbus’s new generation of fuel-efficient
aircraft and, moreover, that it had the economies of scale to
run a mixed fleet between Boeing and Airbus models.
Passengers were charged extra for checking in at the
airport rather than online (which also incurs a charge), al-
though those with hold luggage did not have the option of
checking in online. While avoiding pre-assigned seats, an
extra charge procures “priority boarding.” Interestingly,
Aer Lingus took up a similar idea by enabling passengers
to book seats online for a charge of €5.
Some of Ryanair’s revenue-generating ideas have
provoked controversy—and publicity. One of the most
talked about was its intention to charge passengers a £1
charge to use the lavatory by installing a coin slot on its
aircraft. While it has not implemented this concept, (it may
contravene security rules), the idea generated much pub-
licity. Another idea mooted by Ryanair was a “fat tax” for
overweight passengers. (In fact, several U.S. airlines already
require obese passengers who spill over into neighboring
seats to buy a second seat.) In an online poll of more than
30,000 respondents, the fat tax idea was approved by one
in three. However, the airline later announced that it would
not implement the surcharge because it could not collect it
without disrupting its 25-minute turnarounds and online
check-in process. The same online poll, supposedly to gen-
erate ideas for additional revenue, also gained 25 percent
approval for a €1 levy to use onboard toilet paper with
O’Leary’s face on it.
Investor Perspectives
Since its flotation in 1996, Ryanair had never declared or
paid dividends on its shares. Instead, Ryanair retained
its earnings to fund its business operations, including
the acquisition of additional aircraft required for entry
into new markets, expansion of its existing services,
and routine replacements of its fleet. However, thanks
to a healthy balance sheet and the suspension of its
aircraft-buying program when negotiations with Boeing
broke down, the no-dividend policy changed in 2010.
The company declared a special €500 million dividend
with the possibility of a further similar dividend in 2013.
Previously, its healthy cash position had caused the com-
pany to seek alternative ways of improving the liquidity
and marketability of its stock through a series of share
buy-backs of the equivalent of about 1.2 percent of the is-
sued share capital between 2006 and 2009. Ryanair shares
reached a high of €6.30 in April 2007 and plummeted to
€1.97 in October 2008 as global equity markets were reel-
ing. By mid-2009, the shares were trading in the €3.20
to €3.40 range, with an expected medium term target of
€4.20, based on expected earnings and a PE ratio of 13.
In mid-2009, its rival EasyJet shares had a PE ratio of 29.
Ryanair had often underperformed other budget airline
M05A_BARN0088_05_GE_CASE2.INDD 21 15/09/14 7:43 PM

PC 2–22 Business-Level Strategies
Airport Charges and Route Policy
Consistent with the budget airline model, Ryanair’s routes
were point-to-point only. This reduced airport charges
by avoiding congested main airports, choosing second-
ary and regional destinations, eager to increase passen-
ger throughput. Usually these airports were significantly
further from the city centers they served than the main
airports, “from nowhere to nowhere” in the words of Sir
Stelios Haji-Ioannou, founder of EasyJet, Ryanair’s biggest
competitor.11 Ryanair uses Frankfurt Hahn, 123 kilome-
ters from Frankfurt; Torp, 100 kilometers from Oslo; and
Charleroi, 60 kilometers from Brussels. In December 2003,
the Advertising Standards Authority rebuked Ryanair and
upheld a misleading advertising complaint against it for
attaching “Lyon” to its advertisements for flights to St
Etienne. A passenger had turned up at Lyon Airport, only
to discover that her flight was leaving from St Etienne,
75 kilometers away.
Ryanair continued to protest at charges and condi-
tions at some airports, especially Stansted and Dublin, two
of its main hubs. The airline was “deeply concerned by
continued understaffing of security at Stansted which led
to repeated passenger and flight delays . . . management
of Stansted security is inept, and BAA has again proven
that it is incapable of providing adequate or appropri-
ate security services at Stansted. This shambles again
highlights that BAA is an inefficient, incompetent airport
monopoly.”12 When BAA appealed its break-up, ordered
by the UK Competition Commission in 2009, Ryanair se-
cured the right to intervene in the appeal in support of the
Commission and later applauded the loss of the appeal by
BAA. Meanwhile, Ryanair bemoaned a €10 tourist tax be-
ing levied in Ireland, along with a 40 percent price increase
at Dublin Airport, largely to pay for a second terminal
costing €1.2 billion, initially commissioned in the heyday
of the Irish Celtic Tiger and derided by Ryanair as a white
elephant. Ryanair acted against Dublin and various UK
airports by cutting its capacity and shifting its aircraft to
countries, such as Spain, with cheaper airports and lower
or nonexistent passenger taxes.
Marketing Strategy
Following the introduction of its Internet-based reserva-
tions and ticketing service, enabling passengers to make
reservations and purchase tickets directly through the Web
site, Ryanair’s reliance on travel agents had been elimi-
nated. It had promoted its Web site heavily through news-
paper, radio, and television advertising. As a result, Internet
bookings accounted for 99 percent of all reservations.
Staff Costs and Productivity
Ryanair refuses to recognize trade unions and negotiates
with Employee Representative Committees (ERCs). Its 2010
employee count of 7,032 people, composed of more than
25 different nationalities, had doubled over the previous
three years. This was accounted for almost entirely by flight
and cabin crew to service expansion. Ryanair’s employees
earned productivity-based incentive payments, consisting
of 39 percent and 37 percent of total pay for cabin crew and
pilots respectively. By tailoring rosters, the carrier maxi-
mized productivity and time off for crew members, com-
plying with EU regulations that impose a ceiling on pilot
flying hours to prevent dangerous fatigue. Its passenger-
per-employee ratio of 9,457 was the highest in the industry.
After a series of pay increases for cabin staff and pilots, in
late 2009, staff agreed to a one-year pay freeze.
Passenger Service Costs
Ryanair pioneered cost-cutting/yield-enhancing measures
for passenger check-in and luggage handling. One was pri-
ority boarding and Web-based check-in. More than half of
its passengers availed of this, thus saving on check-in staff,
airport facilities, and time. Charging for check-in bags en-
couraged passengers to travel with fewer and, if possible,
zero check-in luggage, thus saving on costs and enhancing
speed. Before Ryanair began to charge for checked-in bags,
80 percent of passengers were traveling with checked-in
luggage; two years later this had fallen to 30 percent of
passengers. From October 2009, it adopted a 100 percent
Web check-in policy, enabling a reduction in staff numbers,
calculated to save €50 million per year. Ryanair claims that
“passengers love Web checkin. Never again will they have
to arrive early at an airport to waste time in a useless check-
in queue. As more passengers travel with carry-on luggage
only, they are delighted to discover that they will never
again waste valuable time at arrival baggage carousels
either. These measures allow Ryanair to save our passen-
gers valuable time, as well as lots of.”9 A natural next step
announced by Ryanair was a move to 100 percent carry-on
luggage. Additional bags would be brought by passengers
to the boarding gate, where they would be placed it in the
hold and returned as passengers deplane on arrival. These
efficiencies would allow more efficient airport terminals
to be developed without expensive check-in desks, bag-
gage halls, or computerized baggage systems “and enable
Ryanair to make flying even cheaper, easier and much
more fun again,” claimed the company.10 The feasibility of
the proposals to require passengers to carry hold baggage
through security to the aircraft was yet to be tested.
M05A_BARN0088_05_GE_CASE2.INDD 22 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–23
Ryanair approach, stating that it had acted in “a hostile,
anti competitive manner designed to eliminate a rival at a
derisory price.” A combined Ryanair–Aer Lingus operation
would account for 80 percent of all flights between Ireland
and other European countries. Affirming that his company
was fundamentally opposed to a merger with Ryanair,
even if it raised its price, then-Aer Lingus Chief Executive
Dermot Mannion stated, “I cannot conceive of the circum-
stances where the Aer Lingus management and Ryanair
would be able to work harmoniously together . . . this is
simply a reflection of the fact that these organisations have
been competing head to head, without fear or favour, for
20 years. It would be like merging Manchester United and
Liverpool football clubs.”16
In fact, the bid was opposed by a loose alliance
representing almost 47 percent of Aer Lingus shares.
This included the Irish government, which still retained
a 25.4 percent holding, two investment funds operated
on behalf of Aer Lingus pilots accounting for about
4 percent of shares, and Irish telecom tycoon Denis
O’Brien, who bought 2.1 percent of shares explicitly
to complicate Ryanair’s move. A critical 12.6 percent
of the shareholding was controlled by the Aer Lingus
employee share ownership trust (ESOT), which had the
right to appoint two directors and a stake in future prof-
its. Its members rejected the Ryanair offer by a 97 percent
majority vote, dismissing Ryanair’s claim that each ESOT
member stood to receive an average of €60,000 from the
transaction. They asserted that its members would receive
only €32,000 after borrowing costs.
Having abandoned this bid due to the shareholder
opposition and a blocking decision by the European
Commission on competition grounds, Ryanair came back
in December 2008 with an offer of €1.40 per share, a pre-
mium of approximately 25 percent over the closing price.
It proposed to keep Aer Lingus as a separate company,
maintaining the Aer Lingus brand, to double Aer Lingus’
short-haul fleet from 33 to 66 aircraft, and to create 1,000 as-
sociated new jobs over a five-year period. It claimed that if
the offer was accepted, the Irish government would receive
more than €180 million and the ESOT members and other
employees who owned 18 percent of Aer Lingus would re-
ceive more than €137 million in cash. However, in January
2009, when the offer was rejected by Aer Lingus manage-
ment and by the ESOT and other parties, Ryanair decided
to withdraw it.
Aer Lingus’ fortunes continued to deteriorate, with
the company announcing losses for 2008 and project-
ing even worse for 2009. In July of that year, its shares
were trading at less than €0.50. In April, its CEO, Dermot
Mannion, resigned after controversy over a potential
Ryanair minimized its marketing and advertising
costs, relying on free publicity, by its own admission,
“through controversial and topical advertising, press con-
ferences and publicity stunts.” Other marketing activities
include distribution of advertising and promotional ma-
terial and cooperative advertising campaigns with other
travel-related entities and local tourist boards.
As referred to earlier, one of Ryanair’s public-
ity stunts was its unauthorized use of a photograph of
Spanish Queen Sofia after she took a £13 flight from
Santander Northern Spain to London. When it incurred
the Queen’s displeasure, Ryanair apologized and prom-
ised to donate €5000 to a charity of her choice. In another
instance of controversy over using pictures of the rich
and famous, in 2008, Ryanair was forced to pay a fine
of €60,000 to President Sarkozy of France and his Italian
bride, Carla Bruni, for using their images with the slogan,
“With Ryanair, all my family can come to my wedding.” It
also used the face of Spanish Prime Minister Zapatero in
an advertisement depicting him supposedly musing over
its offers.
So, What About Aer Lingus?
According to a commentator in the Financial Times,
“Ryanair’s bid for Aer Lingus was a folie de grandeur.”13
Even O’Leary admitted it was “a stupid investment. At
the time, it was the right strategy to go for one combined
airline but it has now proven to be a disaster.”14 During
2007, in a shock bid, Ryanair had acquired a 25.2 percent
stake in Aer Lingus, only a week after the flotation of the
national carrier. It subsequently increased its interest to
29.8 percent, at a total aggregate cost of €407.2 million.
By July 2009, the investment had been written down to
€79.7 million. At the time of the initial bid, Ryanair de-
clared its intention to retain the Aer Lingus brand and
“up-grade their dated long-haul product, and reduce
their short-haul fares by 2.5 percent per year for a mini-
mum of 4 years . . . one strong Irish airline group will be
rewarding for consumers and will enable both to vigor-
ously compete with the mega carriers in Europe . . . there
are significant opportunities, by combining the purchas-
ing power of Ryanair and Aer Lingus, to substantially
reduce its operating costs, increase efficiencies, and pass
these savings on in the form of lower fares to Aer Lingus’
consumers.”15
It had been an achievement for the Irish government
finally to have floated Aer Lingus after several false starts
over a number of years. Once they recovered their collec-
tive breaths, Aer Lingus and its board firmly rejected the
M05A_BARN0088_05_GE_CASE2.INDD 23 15/09/14 7:43 PM

PC 2–24 Business-Level Strategies
Input Costs
Fuel. Perhaps the greatest concern in input costs is fuel.
Jet fuel prices are subject to wide fluctuations, increases in
demand, and disruptions in supply, factors that Ryanair
can neither predict nor control. In such unpredictable cir-
cumstances, even hedging is only palliative. The situation
is compounded by exchange rate uncertainties, although
declines of the U.S. dollar against the euro and sterling
worked in Ryanair’s favor, as fuel prices are denominated
in dollars. Ryanair’s declaration of “no fuel surcharges
ever” and its reliance on low fares limit its capacity to pass
on increased fuel costs.
Airport Charges and Government Taxes. Ryanair
is especially sensitive to airports that raise charges, like
Stansted and Dublin. Indirectly, it is also vulnerable to ex-
tra taxes and charges, such as a €10 tourist tax imposed by
the Irish government.
Passenger Compensation. On February 17, 2005, a new
EU regulation (EU 261) came into effect, providing for stan-
dardized and immediate assistance for air passengers at EU
airports for delays, cancellations, and denied boarding. It
was initially expected that the compensation costs would
amount to a sector-wide bill of €200 million annually.
Passengers affected by cancellations must be offered a
refund or rerouting and free care and assistance while wait-
ing for their rerouted flight—specifically, meals, refresh-
ments, and hotel accommodation where an overnight stay
is necessary. Financial compensation is payable, unless the
airline can prove unavoidable exceptional circumstances,
like political instability, weather conditions, security and
safety risks, or strikes. For Ryanair, the typical compensa-
tion cost would likely fall into the €250 category, based on
the average distance of its flights. Passengers subject to long
delays would also be entitled to similar assistance. Until
April 2010, the new regulation was largely ignored and had
no material impact on Ryanair, despite the emergence of
online “advisors” to help passengers make claims against
airlines when their flights have been canceled or delayed.
Volcanic Ash Repercussions and Further
Threats
However, the situation with respect to compensation was
highlighted dramatically with the eruption of Iceland’s
Eyjafjallajokull volcano, causing volcanic ash that closed
airspace in Europe for six days in April 2010, with further
sporadic disruptions in May. The losses to Europe’s air sec-
tor resulting from flight cancellations and compensation
secret payoff deal in the event of a hostile takeover. While
Ryanair did not have a seat on the board, it continued to
denigrate Aer Lingus, forecasting “a bleak future as a loss
making, subscale, regional airline, which has a high cost
base and declining traffic numbers.”17 Meanwhile, the two
airlines continued to compete vigorously, especially within
the Irish market.
In July 2009, Aer Lingus appointed a CEO to re-
place Dermot Mannion. This was Christoph Mueller,
known as “axe man,” former CEO of Sabena Airlines
before it went bust in 2001. Mueller had already crossed
swords with Ryanair when it compared its own fares to
those of Sabena in advertisements that were alleged to
be misleading, offensive, and defamatory. When Ryanair
lost a court case over the matter and was ordered to pub-
lish an apology in Belgian newspapers and on its Web
site, it used the apology to continue its publicity about its
relatively lower fares.
In July 2010, the European General Court upheld the
European Commission’s decision, as well as a verdict in a
case brought by Aer Lingus, to block the takeover of Aer
Lingus by Ryanair. However, it did not go as far as forc-
ing Ryanair to sell its stake in Aer Lingus, an action that
Aer Lingus wanted the Court to impose. Upon hearing
the Court decision, O’Leary declared that he had not ruled
out making a third bid for Aer Lingus at some future date.
Despite the European level judgment, later in 2010, the UK
Office of Fair Trade (OFT) announced that it would conduct
a preliminary competition investigation into Ryanair’s 29.8
percent holding in Aer Lingus. Ryanair, of course, rejected
the investigation, arguing that the UK OFT had no juris-
diction in the matter and a four-month time limit after the
European ruling for the case to be brought had elapsed.
Risks and Challenges
Apart from its foray into Aer Lingus, Ryanair faced various
challenges in 2009, some specific to itself and some general
to the aviation industry.
Sharp Economic Downturn
The global recession commencing in 2008 created unfavor-
able economic conditions such as high unemployment
rates and constrained credit markets, with reduced spend-
ing by leisure and business passengers alike. This con-
strained Ryanair’s scope to raise fares, putting downward
pressure on yields. Continued recession could restrict the
company’s passenger volume growth.
M05A_BARN0088_05_GE_CASE2.INDD 24 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–25
Growth and Reducing Yields
Growth plans by Ryanair entailed investment in new air-
craft and routes. If growth in passenger traffic did not keep
pace with its planned fleet expansion, overcapacity could
result. Related pressures were additional marketing costs
and reduced yields from lower fares to promote added
routes, especially to airports new to the Ryanair system.
In its drive for growth, Ryanair was likely to encounter
increased competition, putting even more downward pres-
sure on yields, as airlines struggled to fill vacant seats to
cover fixed costs.
Industrial Relations
In light of the recession and financial losses, Ryanair nego-
tiated with all employee groups and secured a pay freeze
for fiscal 2009 and 2010. It also planned to make 250 people
redundant at Dublin Airport.
Ryanair came under fire for refusing to recognize
unions and allegedly providing poor working conditions
(for example, staff are banned from charging their own
mobile phones at work to reduce the company’s electricity
bill). It conducted collective bargaining with employees on
pay, work practices, and conditions of employment through
internal elected Employee Representation Committees.
However, the British Airline Pilots Association (BALPA)
was constantly attempting to organize Ryanair pilots in
the United Kingdom and legal action was pending in this
regard in 2011.
In July 2006, the Irish High Court ruled that Ryanair
had bullied pilots to accept new contracts, where pilots
would have to pay €15,000 for retraining on new aircraft
if they left the airline or if the company were forced to
negotiate with unions during the following five years.
Some Ryanair managers were judged to have given false
evidence in court. Meanwhile, Ryanair was contesting
the claims of some pilots for victimization under the new
contracts. By 2009, only 11 of the 64 pilots who had lodged
the claim remained with the company and still had claims.
Ryanair was ordered to pay “well in excess” of €1
million in legal costs after a court refused the airline access
to the names and addresses of pilots who posted criti-
cal comments about the company, on a site hosted by the
British and Irish pilots’ unions. O’Leary claimed anony-
mous pilots were using a Web site to intimidate and harass
foreign-based pilots to dissuade them from working for
the company. The pilots involved used code names such
as “ihateryanair” and “cant-fly-wontfly.” Nonetheless, in
effect, Ryanair appeared to have no problems recruiting
cabin staff, including pilots, to meet its needs.
were estimated at €2.5 billion. These closures resulted in
the cancellation of 9,490 Ryanair flights for 1.5 million
passengers. Many airlines were demanding government
aid to make up for lost revenue and the cost of feeding
and lodging stranded passengers. The airlines contended
that flawed computer models used by member states were
partly to blame for grounding planes even after it was safe
to resume services. The EU Commission noted that fis-
cal conditions prevented cash-strapped governments from
offering aid to airlines, even if the rules could be bent to
allow such aid. Ryanair argued strongly against offering
aid to airlines, as did EasyJet, on grounds that it could be
used as a back door to prop up ailing airlines, especially
national carriers.
Initially Ryanair declared that it would not compen-
sate passengers for food and accommodation expenses in-
curred as a result of canceled flights, although it would
offer refunds. It argued strenuously about how ludicrous it
was that passengers could charge airlines unlimited sums
to cover their expenses, no matter how cheap had been
the cost of their ticket. Furthermore, Ryanair claimed that
the compensation regulations were discriminatory because
competitor ferry, coach, and train operators were obliged to
reimburse passengers only to a maximum of the ticket price
paid. Such a situation was not sustainable for the airlines,
especially because the disruption to air traffic from ash cloud
from the erupting volcano could continue sporadically and
indefinitely, depending on the strength of the volcano and
weather conditions. However, several days into the crisis,
Ryanair did an about-turn, saying it would comply with the
EU compensation regulation, but it would continue to work
alongside other low-fare airlines to alter the regulation to
put a reasonable limit on compensation. O’Leary said that
Ryanair would reimburse “reasonable costs” to passengers
caught up in the chaos in April. Asked if Ryanair would
make it difficult to make claims, O’Leary responded, “Perish
the thought.”18 Ryanair expected to refund these monies
and reimburse passengers reasonable expenses, although
it would take a substantial period of time to complete this
and management estimated that the approximate costs of
this and the non-recoverable fiscal costs incurred during the
cancellations would be in the order of €50 million.
At the end of May 2010, it was announced that the
Eyjafjallajokull volcano had subsided and was unlikely to
cause any further problems in the short to medium term.
However, later in 2010, Ryanair was obliged to cancel
flights to and from Spain during wildcat strikes by Spanish
air traffic controllers in August and then in December
when unusually severe winter weather forced the closure
of a number of airports for several days. Again, this en-
tailed not only lost revenue but issues of compensation.
M05A_BARN0088_05_GE_CASE2.INDD 25 15/09/14 7:43 PM

PC 2–26 Business-Level Strategies
publicly owned airports and confined to the fewer pri-
vately owned airports across Europe.
On another front, Ryanair was being sued by three
airport authorities over alleged delays in paying airport
charges. After the company applied for the judge hearing
the case to withdraw on grounds of bias toward Ryanair
in previous proceedings, the judge did indeed withdraw,
not because he admitted Ryanair’s charges but to avoid
delay in the case. However, when pulling out, Justice Peter
Kelly of the Irish High Court stood by his previous com-
ments that “Ryanair told untruths to and about the court
and . . . that the airline and the truth made uncomfortable
bedfellows.”19
In 2009, Ryanair took a successful legal action against
TUI, a screen scraper, to prevent it from selling Ryanair
flights on grounds that it had no agreement to do so and
accusing it of charging a fictitious £40 “fuel surcharge”
and falsely inflating airfares to consumers buying Ryanair
tickets. (Screen scrapers are Web sites that compare costs
from different airlines and can also book flights.) Having
secured its legal victory for “Ryanair and consumers,”
the carrier declared its intention to “pursue unlawful and
misleading tickettouts in the courts in the interest of our
passengers.”20
Customer Services and Perceptions
In 2003, Ryanair published a Passenger Charter, which
includes doctrines on low fares, redress, and punctuality.
Its annual report offers figures to show its superiority over
competitors with respect to punctuality, completed flights,
and fewest bags lost per thousand passengers.
However, its Skytrax two-star rating is among the
worst for budget airlines. In Europe, only bmibaby and
Wizzair achieve as low a rating. There have been sugges-
tions that Ryanair’s “obsessive focus on the bottom line
may have dented its public image. In an infamous inci-
dent, it charged a disabled man £18 (€25) to use a wheel-
chair.”21 In response to protests over the charge, Ryanair
imposed a 50-cent wheelchair levy on every passenger
ticket. Campaigners for the disabled accused Ryanair of
profiteering, declaring that the levy should be no more
than 3 cents. It was the only major airline in Europe to im-
pose such wheelchair charges.
There was growing attention to extra charges con-
tinually being imposed by Ryanair on passengers, many on
unavoidable services such as check-in. In some instances,
these extra charges made Ryanair more expensive than
BA.22 Examples were a family of four traveling to Ibiza
from London with three bags for a two-week holiday cost-
ing £1157 with Ryanair versus £913 with BA and £634 with
Environmental Concerns
Aviation fuel had been exempt from carbon taxes, but
the EU had established an Emissions Trading Scheme to
encompass the aviation industry commencing in 2012.
Ryanair was predicted to be the fourth-most adversely af-
fected airline in the world with a shortfall of 2.8 tonnes in
CO2 allowances, equivalent to €40 million in extra costs.
This is despite its young fleet of fuel-efficient, minimal pol-
lution aircraft. Therefore, Ryanair has contended that any
environmental taxation scheme should be to the benefit
of more efficient carriers, so airlines with low load factors
that generate high fuel consumption and emissions per
passenger and those offering connecting rather than point-
to-point flights should be penalized.
Sundry Legal Actions
Ryanair has been in litigation with the EU about alleged
receipt of state aid at certain airports. An EU ruling in 2004
held that Ryanair had received illegal state aid from pub-
licly owned Charleroi Airport, its Brussels base. Ryanair
was ordered to repay €4 million. The Belgian authori-
ties were claiming back a further €2.3 million in the Irish
courts for the reimbursement to Ryanair of startup costs
at Charleroi. On appeal, the original EU decision was
overturned in December 2008, Ryanair was refunded its €4
million, and the Belgian authorities withdrew their claim.
Nonetheless, the EU launched further investigations into
allegations of illegal aid, purportedly subsidizing Ryanair
at publicly owned airports, such as Lubeck and Frankfurt
Hahn in Germany and Shannon in Ireland. Other legal
challenges were launched against Ryanair by competi-
tors. On another front Ryanair was vigorously opposing
French government attempts to protect Air France-KLM
by forcing EasyJet and Ryanair to move their French-based
staff from British employment contracts to more expensive
French ones.
Often, Ryanair took the initiative on alleged illegal
aid to rivals. For example, it filed a complaint with the
EU Commission accusing Air France-KLM of attempting
to block competition after the French airline filed a case,
alleging that Marseille was acting illegally by offering dis-
count airlines cut-price fees at its second, no-frills terminal.
That complaint came a month after Ryanair called on the
Commission to investigate allegations that Air France had
received almost €1 billion in illegal state aid, benefiting
unfairly from up to 50 percent discounted landing and
passenger charges on flights within France. Adverse rul-
ings on these airport cases could curtail Ryanair’s growth,
if it was prevented from striking advantageous deals with
M05A_BARN0088_05_GE_CASE2.INDD 26 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–27
■ dependence on key personnel (especially
O’Leary);
■ dependence on external service providers;
■ dependence on its Web site; and
■ the continued acceptance of budget carriers with re-
spect to safety. Tied in with the latter are potential rises
in insurance costs.
Ryanair’s Competitive Space
Globally, airlines were hit hard during the economic down-
turn with a $9.9 billion loss in 2009 and $16 billion in 2008,
but in 2010 it was believed that the cyclical movement of the
airline industry had begun to improve as the International
Air Transport Association (IATA) had actually predicted
a $2.5 billion airline industry profit forecast for 2010.
However, European carriers were still expected to generate
losses of $2.8 billion, aggravated by the disruption from the
volcanic ash in April and May. In 2009, of the mainstream
European carriers, only Lufthansa made a net profit. BA,
Air France-KLM, and Scandinavian Air Systems (SAS) all
made severe losses, due to declining traffic from long-haul
business-class passengers. The woes of these legacy carriers
were compounded by huge pension fund deficits.
Some industry analysts considered the possibility
that the economic recession could offer an opportunity
for budget carriers, as passengers who continued to travel
were expected to trade down. By mid-2009, budget air-
lines accounted for more than 35 percent of scheduled
intra- European traffic. Ryanair was the clear market share
leader, with EasyJet another dominant force. (Exhibit 2).
The two were often compared and contrasted because both
operated mainly out of the United Kingdom and served
the same markets. However, it was a matter for debate
as to whether EasyJet’s use of primary airports would be
better than Ryanair’s at capturing the traffic trading down
from network carriers.
Other budget carriers of diverse size and growth
ambitions, trajectories, and regional emphases varied in
different levels of services to passengers and use of main
versus secondary airports. The comparison with the U.S.
budget airline market in Exhibit 2 indicates that pen-
etration in Europe is less than in the United States, which
suggests scope for growth in the sector in Europe. It also
raises the question as to whether the extent of dominance
enjoyed by Southwest offers a model for Ryanair to assert
itself further. Another possible development trajectory for
Ryanair was to follow up on its announcement in 2007
to offer €10 transatlantic flights, an idea that had not yet
taken off and appeared to have been shelved as of 2009.
EasyJet. A single passenger traveling to Venice from London
for a week at Christmas with one bag would pay a total £139
on Ryanair compared to £89 on BA and £121 on EasyJet.
Ryanair features on many consumer complaint in-
teractive Web sites and some blogs have been established
specifically to disparage the airline. In a blog titled “20 rea-
sons never to fly Ryanair,” extra charges for booking fees,
baggage overweight and low weight limits, premium rate
helplines, and the fact that “you are always being flogged
stuff” were enumerated.23 Claiming that the service is pro-
vided by a third party, Ryanair even charges passengers a
€10 service fee to collect lost property. When the Irish Times
put Ryanair customers’ gripes on the Pricewatch blog to
its head of communications, Stephen McNamara, his re-
sponse was to dismiss them as “subjective and inaccurate
rubbish” and even implied Pricewatch had made them
up to further some class of anti-Ryanair agenda.24 Among
the complaints were, “Customers want to be treated like a
human being, to get to their desired destination (not 50/60
miles away) . . . to be allowed to bring luggage without
persecution . . . a complete and utter lack of communication
when flights run late . . . I’m sick of that miserable booking
charge/service charge/admin charge system.”
So, why are so many people willing to put up with
an airline that, in the words of The Economist, “has be-
come a byword for appalling customer service, misleading
advertising claims and jeering rudeness?”25 Ryanair has
responded to such comments, declaring that, in effect,
customers vote with their feet by choosing Ryanair for
its four tenets of customer service: low fares, a good on-
time record, few cancellations, and few lost bags. “If you
want anything more—go away,” admonishes O’Leary.26
The Financial Times aerospace correspondent observed that
Ryanair still offered relative value compared with rail al-
ternatives, at least on a journey from London to Scotland,
even when Ryanair extras are factored in.
Other Risks and Challenges
As listed in its own report, Ryanair faced other risks, some
particular to itself and some generic to the industry:
■ risks associated with growth in uncertain highly com-
petitive markets, such as downward pressure on fares
and margins;
■ prices and availability of new aircraft;
■ potential impairments from Ryanair’s 29.8 percent
stake in Aer Lingus;
■ threats of terrorist attacks;
■ potential outbreak of airborne diseases, such as
swine flu;
M05A_BARN0088_05_GE_CASE2.INDD 27 15/09/14 7:43 PM

PC 2–28 Business-Level Strategies
cancellations, so it is not possible to check out the verac-
ity of Ryanair’s claims to superiority on these factors. See
Exhibits 5 and 6 for financial and operational comparisons
with competitors and benchmark airline operators, includ-
ing Southwest Airlines.
EasyJet
EasyJet, the second-largest budget airline in Europe, was
Ryanair’s greatest rival. As of the end of 2009, EasyJet
served 114 airports in 27 countries on 422 routes with
Competitors and Comparators
The following section describes Ryanair’s budget airline
competitors and some selected other carriers. Exhibits 3
and 4 show comparative fare levels and punctuality sta-
tistics, as well as airport distances for Ryanair versus other
airlines. This is in addition to the Skytrax star ratings in
Exhibit 2, based on the perception of delivered front-line
product and service quality for Ryanair and other bud-
get airlines. There are no externally verified published
data on customer complaints, lost baggage, and flight
Exhibit 2 Budget Airlines Sundry Data: Europe and United States (2008–09)
European Market Position U.S. Market Position
Airline Pax (m)> Rating* Airports# Airline Pax (m)< Aigle Azur 1.46 26 AirTran 24.6 Air Berlin 28.6 4 126 Allegiant Air 3.9 Belle Air 0.46 24 American Trans Air (ATA) 0.4 Bmibaby 3.87 2 32 Frontier Airlines 10.1 Brussels Airlines 5.4 3 62 GoJet Airlines 1.5 Clickair^ 6.3 3 40 Horizon Airlines (Alaska Air) 6.5 EasyJet 44.6 3 110 Island Air Hawaii 0.5 FlyBe 7.5 3 65 JetBlue Airways 20.5 Germanwings 7.6 3 70 Midwest Airline Inc. 3.0 Jet2.com 3.5 3 51 Shuttle America Corp. 3.5 Meridiana 1.9 3 30 Southwest Airlines 101.9 Monarch Airlines 3.9 21 Spirit Airlines 5.5 Myair.com^ 1.5 27 Sun County Airlines 1.3 Niki Airline 2.1 3 33 USA 3000 Airlines 0.8 Norwegian 9.1 3 85 Virgin America 2.5 Ryanair 57.7 2 140 Sky Europe^ 3.6 3 30 Sterling^ 3.8 39 Sverigeflyg 0.5 15 transavia.com 5.5 3 88 TUIfly 10.5 75 Vueling Airlines 5.9 3 45 Windjet 2.7 28 Wizz Air 5.9 3 58 > Sources: European Low Fares Airlines Association (ELFAA), company reports.
< Sources: CIA, Bureau of Transportation Statistics. * Skytrax star rating from 1 to 5 (not all airlines rated) # Number of airports served; Sources: European Low Fares Airlines Association (ELFAA), company reports. ^ These airlines have ceased operations. Total Passengers (Pax) European Budget Airlines 223.9 Total Pax U.S. Budget Airlines 186.4 Ryanair as % of Total: 26% Southwest as % of Total: 55% Key Population Data Key Population Data Population EU 27 (m) 500 Population U.S. (m) 307 Key Population Ratios Key Population Ratios Budget ratio to EU 27 population 0.45 Budget ratio to U.S. population 0.61 M05A_BARN0088_05_GE_CASE2.INDD 28 15/09/14 7:43 PM Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–29 Exhibit 3 Comparative Fare Levels (same booking dates and approximate departure times, includes one piece of luggage) Route: Dublin–London: Weekend Return (2 Nights) Airline From To Total Price € Aer Lingus Dublin Heathrow 108.98 Bmi British Midland Dublin Heathrow 103.59 Ryanair Dublin Gatwick 166.00 Ryanair Dublin Stansted 74.98 Ryanair Dublin Luton 81.98 Route: Dublin–London: Weekday Return (3 Nights) Airline From To Total Price € Aer Lingus Dublin Heathrow 97.99 Bmi British Midland Dublin Heathrow 85.59 Ryanair Dublin Gatwick 113.35 Ryanair Dublin Stansted 69.98 Ryanair Dublin Luton 67.98 Route: Rome–London: Weekend Return (2 Nights) Airline From To Total Price € Alitalia Rome (Fiumicino) Heathrow 200.15 British Airways Rome (Fiumicino) Gatwick 275.61 British Airways Rome (Fiumicino) Heathrow 308.04 Easyjet Rome (Fiumicino) Gatwick 220.15 Ryanair Rome (Ciampino) Stansted 187.88 Route: Rome–London: Weekday Return (3 Nights) Airline From To Total Price € Alitalia Rome (Fiumicino) Heathrow 244.68 British Airways Rome (Fiumicino) Gatwick 571.16 British Airways Rome (Fiumicino) Heathrow 542.04 Easyjet Rome (Fiumicino) Gatwick 396.15 Ryanair Rome (Ciampino) Stansted 218.78 Route: Berlin–London: Weekend Return (2 Nights) Airline From To Total Price € Air Berlin Berlin (Tegel) Stansted 285.00 British Airways Berlin (Tegel) Heathrow 152.62 Easyjet Berlin (Schonefeld) Gatwick 123.15 Easyjet Berlin (Schonefeld) Luton 154.69 Lufthansa Berlin Tegel Heathrow 218.00 Ryanair Berlin (Schonefeld) Stansted 113.67 Route: Berlin–London: Weekday Return (3 Nights) Airline From To Total Price € Air Berlin Berlin (Tegel) Stansted 193.00 British Airways Berlin (Tegel) Heathrow 126.62 Easyjet Berlin (Schonefeld) Gatwick 150.15 Easyjet Berlin (Schonefeld) Luton 146.69 Lufthansa Berlin (Tegel) Heathrow 261.00 Ryanair Berlin (Schonefeld) Stansted 149.19 Route: London–Oslo: Weekend Return (2 Nights) Airline From To Total Price € British Airways Heathrow Oslo Gardermoen 279.00 Bmi British Midland Heathrow Oslo Gardermoen 316.00 Norwegian Gatwick Oslo Gardermoen 304.20 Ryanair Stansted Rygge 166.00 Ryanair Stansted Torp 74.98 Sas Heathrow Oslo Gardermoen 262.73 (continued) M05A_BARN0088_05_GE_CASE2.INDD 29 15/09/14 7:43 PM PC 2–30 Business-Level Strategies Exhibit 3 Comparative Fare Levels (continued) Route: London–Oslo: Weekday Return (3 Nights) Airline From To Total Price € British Airways Heathrow Oslo Gardermoen 309.40 Bmi British Midland Heathrow Oslo Gardermoen 320.00 Norwegian Gatwick Oslo Gardermoen 196.00 Ryanair Stansted Rygge 110.00 Ryanair Stansted Torp 121.50 Sas Heathrow Oslo Gardermoen 324.36 Airports Distance To City Center (point 0) Airports Distance (kms): Stansted 61 Heathrow 25 Luton 55 Gatwick 45 Dublin 12 Rome (Fiumicino) 32 Rome (Ciampino) 15 Berlin (Tegel) 8 Berlin (Schonefeld) 18 Oslo Gardermoen 47 Rygge (Oslo) 66 Stockholm Arlanda 40 Stockholm Skvasta 100 Stockholm Vasteras 87 Torp (Oslo) 110 Airbus aircraft. Ryanair and EasyJet frequently attacked each other as part of their “public relations.” When ac- cused by EasyJet of introducing stealth charges, Ryanair retaliated by pointing out that, even with taxes included, its average fare was well below EasyJet’s. Ryanair said that EasyJet had charged each passenger £14 (€20) more per ticket than Ryanair, thereby overcharging their passengers by £413 (€600) million in a year. In fact, eventually, EasyJet had followed many of Ryanair’s extra charge initiatives, such as a fee for check-in baggage. Based at London Luton Airport, EasyJet was founded by Greek Cypriot EasyGroup entrepreneur Sir Stelios Haji-Ioannou in 1995. Although it was listed on the London Stock Exchange, members of the Haji-Ioannou family still owned almost 40 percent of the company in 2010. The business model of EasyJet is somewhat different to Ryanair in that it uses more centrally located airports, thus incurring higher airport charges, but more actively courts the business traveler. For example, Schiphol in Amsterdam and Orly Airport in Paris are hubs, while the airline also uses Charles de Gaulle Airport in the French capital. In 2009, EasyJet grew the number of business passengers in spite of an overall decline in the business travel market. EasyJet won a number of industry awards in 2009, including Best European Budget Airline (World Traveler Awards), Best Airline Website (Travolution), and the Condé Nast Traveler Best Low Cost Airline award (for the sixth consecutive year). In March 2008, EasyJet purchased GB Airways, a franchise of British Airways, headquartered at London Gatwick, in a deal worth £103.5 million. The takeover was used to expand EasyJet operations at Gatwick and start op- erations at Manchester. While all GB aircraft (fortuitously Airbus) were transferred to EasyJet, slots used by GB Airways at London Heathrow Airport were not included in the sale. Compared with Ryanair, EasyJet traditionally strug- gled on the profit front, as it strove to bring down its costs. However, from the mid-2000s, its results moved into profit. In contrast to airline industry peers, the airline traded resiliently in 2009 during the recession, as it was one of the few airlines globally to make a profit, with an underly- ing pretax profit of £43.7 million. Revenue grew by 12.9 percent to £2,666.8 million, partially offsetting the £86.1 million increase in unit fuel costs (equivalent to £1.63 per seat). The carrier claimed to have given itself a platform M05A_BARN0088_05_GE_CASE2.INDD 30 15/09/14 7:43 PM Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–31 Exhibit 4 Punctuality Statistics (a) Comparative Punctuality on Selected Routes for 2009 London -> Dublin
Operating from London Airports Avg. Delay
(mins)
OTP
Within 15
1 hr+
late (%)
3 hrs+
late (%)
Total
FlightsRank Airline LHR LGW LCY STN LTN
1 British Airways * ✓ 6.86 87.88 1.81 0.54 553
2 City Jet ✓ 7.5 86.62 2.56 0.34 2,967
3 bmi British Midland ✓ 9.27 82.21 3 0.23 4,402
4 BA CityFlyer ** ✓ 11.22 82.69 6.73 0.48 208
5 Aer Lingus ✓ ✓ 12.32 76.98 4.22 0.42 11,146
6 Ryanair ✓ ✓ 12.71 76.43 3.38 0.64 11,839
AVERAGE ALL 6 AIRLINES > > > 11.47 78.66 3.54 0.47 31,115
* – British Airways discontinued LGW-DUB during March 2009
** – BA CityFlyer discontinued LCY-DUB during March 2009
London -> Rome
Data relate to flights to and from Fiumicino and Ciampino airports.
Operating from London Airports Avg. Delay
(mins)
OTP
Within 15
1 hr+
late (%)
3 hrs+
late (%)
Total
FlightsRank Airline LHR LGW LCY STN LTN
1 British Airways ✓ ✓ 11.1 78.88 3.64 0.46 5,408
2 Ryanair ✓ 14.44 75.07 3.61 0.95 2,411
3 Alitalia ✓ 18.29 63.61 6.63 0.56 3,226
4 EasyJet ✓ 21.2 57.61 7.77 0.76 1,840
AVERAGE ALL 4 AIRLINES > > > 14.97 71.31 4.97 0.62 12,885
London -> Dusseldorf
Data relate to flights to and from Dusseldorf and Niederrhein airports.
Operating from London Airports Avg. Delay
(mins)
OTP
Within 15
1 hr+
late (%)
3 hrs+
late (%)
Total
FlightsRank Airline LHR LGW LCY STN LTN
1 Eurowings * ✓ 3.53 94.71 1.76 0.25 397
2 Lufthansa City
Line ^
✓ 6.51 86.97 2.08 0 913
3 Lufthansa ✓ 7.01 86.49 2.31 0.1 2,858
4 British Airways ✓ 7.37 85.64 2.59 0.19 3,704
5 Air Berlin ✓ 11.34 81.54 3.59 1.09 2,199
6 Ryanair ** ✓ ✓ 11.98 81.75 3.91 0.98 1,737
7 Flybe ^^ ✓ 15.68 71.65 4.43 0.44 903
AVERAGE ALL 7 AIRLINES> > > 9.02 83.97 2.95 0.44 12,711
^ – Lufthansa City Line commenced LCY DUS during May 2009
^^ – Flybe commenced LGW DUS during June 2009
* – Eurowings discontinued LCY DUS during April 2009
** – Ryanair discontinued LGW NRN during March 2009
(continued)
M05A_BARN0088_05_GE_CASE2.INDD 31 15/09/14 7:43 PM

PC 2–32 Business-Level Strategies
Exhibit 4 Punctuality Statistics
(a) Comparative Punctuality on Selected Routes for 2009 (continued)
London -> Barcelona
Data relate to flights to and from Barcelona, Gerona and Reus airports.
Operating from London Airports Avg. Delay
(mins)
OTP
Within 15
1 hr+
late (%)
3 hrs+
late (%)
Total
FlightsRank Airline LHR LGW LCY STN LTN
1 Ryanair ✓ ✓ ✓ 9.7 82.73 2.39 0.5 3,979
2 British Airways * ✓ ✓ 12.32 76.27 4.14 0.44 4,542
3 EasyJet ✓ ✓ ✓ 14.27 73.88 5.18 0.42 4,981
4 Iberia ** ✓ 15.75 69.35 5.76 0.65 2,013
5 BA CityFlyer *** ✓ 25.22 54.59 11.91 0.25 403
AVERAGE ALL 5 AIRLINES> > > 13.04 75.71 4.43 0.47 15,918
* – British Airways discontinued LGW BCN during October 2009
** – Iberia discontinued LHR BCN during October 2009
*** – BA CityFlyer discontinued LCY BCN during October 2009
London -> Oslo
Data relate to flights to and from Gardermoen and Torp airports.
Operating from London Airports Avg. Delay
(mins)
OTP
Within 15
1 hr+
late (%)
3 hrs+
late (%)
Total
FlightsRank Airline LHR LGW LCY STN LTN
1 Scandinavian SAS ✓ 7.36 86.84 2.19 0.32 3,420
2 British Airways ✓ 8.28 85.59 2.79 0.28 2,831
3 Ryanair ✓ 8.38 83.81 2.19 0.18 2,742
4 Transwede Airlines* ✓ 14.57 74.34 3.98 0.88 226
5 Norwegian Air Shuttle** ✓ ✓ 14.93 71.01 5.11 0.35 1,721
AVERAGE ALL 5 AIRLINES > > > 9.19 83.01 2.84 0.29 10,940
* – Transwede Airlines discontinued LCY-OSL during March 2009
** – Norwegian Air Shuttle discontinued STN-OSL during March 2009
for profitable growth in the medium term from which to
achieve a 15 percent return on equity through improve-
ments in network quality by taking advantage of capac-
ity cuts by other carriers to advance its position, gaining
share in important markets such as Milan, Paris, Madrid,
and London Gatwick, and increasing its slot portfolio at
congested airports by more than 10 percent. Other mea-
sures taken to improve performance were lower-cost deals
with key suppliers and enhancements to its Web site. The
board agreed to a fleet plan that would deliver about a 7.5
percent growth per annum in seats flown over the next five
years, enabling EasyJet to grow its share of the European
short-haul market from about 7 percent to 10 percent.
However, all was not well in the EasyJet board-
room. In May 2010, Sir Stelios and another nonexecutive
board member he had nominated, Robert Rothenberg, de-
clared open warfare on EasyJet by resigning from its board
to become “shareholder activists” against its expansion
plans. Sir Stelios was continuing his campaign started in
2008, objecting to “the management’s strategy of relentless
growth in aircraft numbers and lack of focus on profit mar-
gin increase,” notwithstanding that the dispute had earlier
appeared to be resolved with a compromise that would see
the airline keep expanding by 7.5 percent a year.
The resignation of Sir Stelios came just three days
after he delivered a blast at departing chief executive Andy
Harrison, declaring he was “over-rated and had increased
nothing but the size of his bonus since joining the airline
in late 2005.” These comments were seen as a parting shot
at the chief executive after a 2008 boardroom row over
EasyJet’s growth strategy that preceded the announced de-
partures of Harrison and the airline’s finance director and
chairman.27 EasyJet’s incoming chief executive was to be
Carolyn McCall, the head of the Guardian Media Group.
Sir Stelios added that he “feels sorry for the outgoing chief
executive’s new employers,” Whitbread, owner of Premier
Inn and Costa Coffee. Sir Stelios continued, “Over the past
five years Andy Harrison developed a love affair with
M05A_BARN0088_05_GE_CASE2.INDD 32 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–33
Exhibit 4(b) Punctuality Performance of Scheduled Airlines
Average Delay (mins.) Within 15 mins (%) > 1 hour late (%)
2009
Rank
2008 2009 2008 2009 2008 2009
bmi regional 1st 5.6 4.8 89.9 93.3 1.8 2.0
KLM 2nd 11.4 5.8 78.6 90.6 3.6 1.6
VLM Airlines 3rd 12.5 6.0 75.7 90.5 3.6 2.2
City Jet / Scot Airways 4th 13.4 7.0 71.8 88.4 4.0 2.4
Brussels Airlines 5th 10.2 7.7 79.3 85.7 2.6 2.0
Eastern Airways 6th 6.6 7.9 88.8 88.9 2.0 3.0
Scandinavian SAS 7th 15.0 8.1 70.2 86.0 4.9 2.6
Swiss Airlines 8th 13.3 8.7 72.0 83.1 3.4 2.5
Air Berlin 9th 8.8 9.0 83.0 85.7 2.2 3.5
Loganair 10th 8.7 9.0 86.9 87.9 3.5 3.6
bmi British Midland 11th 15.3 9.3 69.8 83.4 5.5 3.2
Aer Arann 12th 11.2 9.4 83.8 87.5 5.2 3.9
TAP Air Portugal 13th 17.0 9.7 65.6 81.8 5.8 3.5
Lufthansa 14th 12.3 10.0 75.4 80.9 3.8 3.2
Air France 15th 15.4 10.5 66.5 79.5 4.4 3.2
British Airways 16th 17.6 11.0 66.8 81.1 6.3 3.6
BA Cityflyer 17th 20.3 11.0 62.3 80.5 9.5 4.3
bmi baby 18th 15.8 11.0 76.8 83.4 7.4 4.3
Ryanair 19th 12.3 11.0 76.4 79.9 2.9 2.9
Flybe 20th 13.0 11.2 79.0 83.3 5.4 4.5
Air Southwest 21st 10.2 11.6 80.7 82.0 3.8 5.2
Aer Lingus 22nd 17.8 12.0 65.0 79.2 6.7 4.4
United Airlines 23rd 18.6 13.0 68.3 80.1 7.7 5.0
EasyJet 24th 16.1 13.7 71.2 77.0 6.1 5.2
Alitalia 25th 16.2 13.9 66.7 73.6 5.8 5.2
American Airlines 26th 18.1 15.1 68.7 74.2 7.1 5.8
Monarch Scheduled 27th 18.4 15.8 72.8 78.0 7.2 5.8
Wizz Air 28th 22.4 16.7 66.1 73.1 7.5 5.6
Iberia 29th 20.1 17.2 62.6 68.9 8.2 6.3
Emirates 30th 22.1 17.6 53.7 61.9 7.1 4.3
Air Canada 31st 21.2 17.6 66.1 72.1 7.2 6.0
Continental Airlines 32nd 23.0 18.9 65.4 71.7 10.4 7.9
Virgin Atlantic 33rd 27.9 19.4 56.8 68.4 12.3 8.2
Jet2 34th 16.4 21.5 73.3 65.7 6.5 7.6
flyglobespan 35th 16.1 25.0 76.3 69.6 6.8 7.8
2009 Ranking by January–December average delay (ascending). Analysis includes arrivals and departures at UK reporting airports.
Source: www.flightontime.info
M05A_BARN0088_05_GE_CASE2.INDD 33 15/09/14 7:43 PM

E
xh
ib
it
5

C
om
p
ar
at
iv
e
A
ir
li
n
e
Fi
n
an
ci
al
S
ta
ti
st
ic
s
A
ir
B
er
li
n

20
09

(€
m
il
li
on
s)
A
er
L
in
gu
s
20
09

(€
m
il
li
on
s)
N
or
w
eg
ia
n

20
09

(N
O
K
m
il
li
on
s)
B
ri
ti
sh
A
ir
w
ay
s
20
09

(£
G
B
P
m
il
li
on
s)
E
as
yJ
et

20
09

(£
G
B
P
m
il
li
on
s)
L
u
ft
h
an
sa

20
05

(€
m
il
li
on
s)
S
ou
th
w
es
t

20
09

($
U
S
D
m
il
li
on
s)
T
ot
al
R
ev
en
u
e
3,
28
2.
79
1,
20
5.
70
7,
30
9.
00
8,
99
2.
00
2,
66
6.
80
22
,2
83
.0
0
10
,3
50
.0
0
O
pe
ra
ti
ng
C
os
ts
:
E
m
pl
oy
ee
C
os
ts
44
0.
70
31
2.
20
1,
30
3.
00
2,
19
3.
00
34
2.
90
5,
99
6.
00
3,
46
8.
00
Sa
le
s/
M
ar
ke
ti
ng
D
is
tr
ib
ut
io
n
71
.9
0
45
.5
0
14
9.
00
36
9.
00
83
.5
0
74
8.
00
A
ir
po
rt
C
ha
rg
es
69
7.
10
25
2.
00
1,
03
8.
00
60
3.
00
48
1.
50
3,
76
2.
00
71
8.
00
G
ro
un
d
H
an
d
lin
g
10
1.
70
72
3.
00
1,
02
1.
00
25
5.
90
Fu
el
71
5.
40
33
1.
70
1,
42
3.
00
2,
96
9.
00
80
7.
20
3,
64
5.
00
3,
04
4.
00
M
ai
nt
en
an
ce
18
7.
30
70
.5
0
66
0.
00
51
0.
00
16
1.
60
71
7.
00
71
9.
00
L
ea
se
C
ha
rg
es
36
6.
00
55
.8
0
62
0.
00
73
.0
0
11
6.
20
33
8.
00
18
6.
00
D
ep
re
ci
at
io
n
10
9.
10
82
.7
0
14
9.
00
69
4.
00
55
.4
0
1,
47
5.
00
61
6.
00
O
p
er
at
in
g
P
ro
fi
t (
L
os
s)
28
.5
0
(8
1.
02
)
57
1.
90
(2
20
.0
0)
60
.1
0
27
1.
00
26
2.
00
N
et
P
ro
fi
t (
L
os
s)
(9
.5
0)
(1
30
.0
8)
62
3.
00
(3
58
.0
0)
71
.2
0
(1
12
.0
0)
99
.0
0
O
p
er
at
in
g
M
ar
gi
n
(%
)
0.
86
(6
.7
0)
7.
80
(2
.4
0)
2.
30
1.
20
2.
50
N
et
M
ar
gi
n
(%
)
(0
.2
9)
(1
0.
80
)
8.
50
(3
.9
0)
2.
70
0.
50
0.
96
So
ur
ce
s:
A
nn
ua
l R
ep
or
ts
fo
r
A
ir
B
er
lin
(2
01
0)
, A
er
L
in
gu
s
(2
01
0)
, N
or
w
eg
ia
n
(2
01
0)
, B
ri
ti
sh
A
ir
w
ay
s
(2
01
0)
, E
as
yJ
et
(2
01
0)
, L
uf
th
an
sa
(2
00
6)
, S
ou
th
w
es
t A
ir
lin
es
(2
01
0)
PC 2–34
M05A_BARN0088_05_GE_CASE2.INDD 34 15/09/14 7:43 PM

E
xh
ib
it
6

C
om
p
ar
at
iv
e
A
ir
li
n
e
O
p
er
at
io
n
al
S
ta
ti
st
ic
s
A
er
L
in
gu
s
20
09
€
a
B
ri
ti
sh
A
ir
w
ay
s
20
09
£
G
B
P
E
as
yJ
et

20
09
£
G
B
P
L
u
ft
h
an
sa

20
05
€
S
ou
th
w
es
t
20
09
$
U
S
D
W
iz
z
20
09
A
ir
B
er
li
n

20
09
€
N
or
w
eg
ia
n

20
09
N
O
K
Fl
ee
t
35
24
5
18
1
72
2
44
5
26
15
2
46
A
ve
ra
ge
D
ai
ly
A
ir
cr
af
t H
ou
rs
10
.2
10
.6
8
11
11
.7
10
.3
C
ap
ac
it
y
(b
ill
io
ns
)b
13
.2
2
14
8.
5
58
.2
20
6.
3
98
50
.7
13
.5
Pa
ss
en
ge
rs
(m
ill
io
ns
)
9.
31
33
.1
45
.2
76
.5
86
.3
7.
8
27
.9
10
.8
R
ev
en
ue
P
as
se
ng
er
D
is
ta
nc
e
U
ni
ts
(m
ill
io
ns
)c
9.
97
11
4.
3
50
.6
16
0.
6
74
.5
39
.2
10
.6
A
ve
ra
ge
L
en
gt
h
of
H
au
l
10
48
k
m
64
4
km
11
01
km
11
77
.9
77
5
m
ile
s
14
02
k
m
R
ev
en
ue
p
er
P
as
se
ng
er
€7
7.
10
42
.4
3
93
.6
8
10
6.
28
R
ev
en
ue
p
er
R
ev
en
ue
P
as
se
ng
er
D
is
ta
nc
e
U
ni
t
7.
4
ce
nt
.0
68
5/
R
PK
.1
32
9/
R
PM
7.
57
c
en
t.
C
os
t p
er
R
ev
en
ue
P
as
se
ng
er
U
ni
t
5.
41
c
en
t
R
ev
en
ue
p
er
C
ap
ac
it
y
U
ni
t
.0
52
8/
A
SK
4.
58
p
en
ce
.1
05
6/
A
SM
5.
86
c
en
t.
O
pe
ra
ti
ng
C
os
t p
er
C
ap
ac
it
y
U
ni
t
4.
51
p
en
ce
.1
02
9/
A
SM
0.
49
L
oa
d
F
ac
to
r
(%
)
75
.4
72
85
.5
77
.9
76
83
77
.3
78
A
ve
ra
ge
S
ta
ff
38
44
41
47
3
64
78
11
23
20
31
,7
29
94
5
82
78
16
84
D
es
ti
na
ti
on
s
73
15
0
11
4
12
0d
68
50
13
4
93
a
sh
or
t h
au
l e
xc
ep
t f
or
s
ta
ff
, =
to
ta
l f
or
c
om
pa
ny
b
av
ai
la
bl
e
se
at
k
ilo
m
et
re
s
(A
SK
) e
xc
ep
t S
ou
th
w
es
t a
va
ila
bl
e
se
at
m
ile
s
(A
SM
)
c r
ev
en
ue
p
er
k
ilo
m
et
er
(R
PK
) e
xc
ep
t f
or
S
ou
th
w
es
t r
ev
en
ue
p
er
m
ile
(R
PM
)
d
s
ho
rt
h
au
l
So
ur
ce
s:
A
nn
ua
l r
ep
or
ts
. W
iz
z
A
ir
(2
01
0)
.
PC 2–35
M05A_BARN0088_05_GE_CASE2.INDD 35 15/09/14 7:43 PM

PC 2–36 Business-Level Strategies
the Airbus A330-200, a dedicated business class section
was offered. Air Berlin also ran a frequent flyer program,
“topbonus,” in collaboration with hotel and car rental
partners as well as sundry marginal airlines. Air Berlin had
won numerous awards every year, including being desig-
nated as the best low-cost carrier in Europe from Skytrax
and, in 2010, a best business travel award for short-haul
airlines.
The airline first floated on the stock exchange in May
2006, with its initial share-price range reduced from €15.0
to €17.5 before finally opening at €12 due to rising fuel
costs and other market pressures at that time. As a result
of the IPO, the company claimed to have more than €400
million in the bank to be used to fund further expansion,
including aircraft purchases. Since its announcement as a
low cost airline in the mid-2000s, it had only made a profit
once, in 2006.
From 2009 onward, Air Berlin announced measures to
strengthen its efficiency and profitability, through a “Jump”
performance program. The aim was a significant improve-
ment of turnover, income per available seat kilometer (ASK),
and revenue per passenger kilometer (RPK). Operations
were to be subjected to continuous and strict cost control,
and any opportunities for performance improvement on the
ground and in the air would be consistently explored and
implemented. In this context, the introduction of the Q400
turboprop aircraft, first used in 2008 and featuring signifi-
cantly lower fuel consumption, was of great importance. In
addition to the improvement of operational performance,
Air Berlin’s priority was in strengthening its balance sheet,
reducing indebtedness in a targeted manner, by selling stra-
tegically unnecessary assets or activities.
In 2009, revenue per available seat kilometer (ASK)
increased to 5.75 eurocents, for a 7 percent increase over
the previous year (2008: 5.38 eurocents). The company de-
clared that opportunities for growth would continue to be
exploited, provided that corresponding income prospects
were present. This applied particularly to the expansion of
attractive routes and feeder networks, together with strate-
gic partners, and increased targeting of select clients, such
as business passengers. The “Jump” performance improve-
ment program led to a marked improvement in operating
income, with losses in 2009 of €9.5 million, down from
€83.5 million. Also the balance sheet had been significantly
improved with a capital increase of 64 percent and a debt
decrease of 25 percent, despite the terrible trading condi-
tions brought on by the global financial crisis. However,
these were due in large part to a drop in jet fuel prices
rather than to measures taken by the company. Despite im-
provements in cost containment and expansion, 2010 was
not very promising profit-wise.
Airbus, squandered £2.4 billion, doubling the size of the
fleet, while he paid no dividends and the share price has
gone sideways.”28
People close to the airline said they believed the
move was related to a separate brand licence dispute be-
tween the airline and Sir Stelios, whose private EasyGroup
owns the “Easy” brand and licenses it to EasyJet. The
dispute was settled out of court in October 2010, whereby
a previous annual payment of £1 by EasyJet to use the
“Easy” name was turned into a minimum £4 million per
year in a 50-year agreement.
The altercations occurred as EasyJet was forced to
cut its 2010 full-year profit guidance by £50 million be-
cause of the volcanic ash disruption from the eruption of
Iceland’s Eyjafjallajokull volcano that had closed airspace
in Europe for six days, obliging EasyJet to cancel 6,512
flights in April 2010. This disruption was followed by a
summer of delayed flights and canceled services, resulting
in the dismissal of EasyJet’s director of operations by new
CEO McCall, who appeared to be placating Stelios when
she announced a maiden dividend, slower growth plans,
and tougher negotiations for new aircraft, involving both
Airbus and Boeing.
The fierce rivalry between Ryanair and EasyJet was
highlighted in a libel action brought by Stelios against
Ryanair over a Ryanair advertisement depicting Stelios
as Pinocchio (whose nose grew ever longer as he told
more fibs), tagging him as “Mr. Late Again” on the ba-
sis of EasyJet’s refusal to publish its punctuality statis-
tics. Initially, when Stelios objected to the advertisements
as personal and libelous, O’Leary refused to apologize
and suggested that the dispute should be settled by a
sumo wrestling contest or a race around Trafalgar Square.
However, O’Leary ended up apologizing unreservedly
to Stelios, as Ryanair agreed to pay a £50,000 penalty and
published a half- page apology in a national newspaper.
Stelios promised to donate the money to charity, saying,
“I would like to dedicate this little victory to all those
members of the travelling public who have suffered verbal
abuse and hidden extras at the hands of O’Leary.”29
Air Berlin
Originally a charter airline that started operations from
Berlin in 1979, Air Berlin expanded into scheduled services
and styled itself as a low-cost airline. However, it did not
operate with a pure low-cost carrier model. Most notably,
instead of only point-topoint service, Air Berlin offered
guaranteed connections via its hubs. The airline also of-
fered free services including in-flight meals and drinks,
newspapers, and assigned seating. On flights operated on
M05A_BARN0088_05_GE_CASE2.INDD 36 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–37
Norwegian’s main hub was Oslo Airport,
Gardermoen, with secondary hub operations at Bergen,
Trondheim, Stavanger, Moss, Copenhagen, Stockholm, and
Warsaw. It offered a high-frequency domestic flight sched-
ule within Scandinavia, combined with a lowfrequency
service to international destinations from its focus cities.
Despite the economic downturn, Norwegian Air reported
significant passenger growth for 2009 with an 18 percent
rise from the previous year, as it expanded rapidly with
new routes. In 2010, the airline was set to grow further with
the addition of 70 Boeing 737-800 aircraft over the next five
years. Norwegian charged passengers for checked-in lug-
gage (€6 each way per bag) as well as onboard snacks and
meals and seat selection.
In January 2009, Air Transport World (ATW) named
Norwegian “Market Leader of the Year.” The award recog-
nized Norwegian for several accomplishments: successful
adaptation of the low-cost model to the Scandinavian air
travel market; its strategy to combine low fares with high
tech alongside a strong emphasis on customer-focused in-
formation technology; swift market response in 2008 to the
collapse of Sterling, a Danish budget carrier; and the ability
to stay profitable in challenging times.
In February 2010, Norwegian was upgraded to “buy”
from “neutral” by Goldman Sachs, which cited its compel-
ling valuation and benefits from a route network with little
significant competition, in particular from large low-cost
carriers such as Ryanair or EasyJet; a resilient Norwegian
economy; and strong growth in ancillary revenues.
Wizz Air
Wizz Air is a Hungary-based carrier operating budget sched-
uled services linking Poland, Hungary, Bulgaria, Croatia,
Romania, and Slovenia with points in the Mediterranean,
United Kingdom, Ireland, Germany, France, Italy and
Scandinavia. The airline, which operates 22 Airbus A320s
from 10 bases spread across mainland Europe, was founded
in Katowice, Poland, in 2003 as a privately owned budget
carrier by Jozsef Varadi, former CEO of Malév, the Hungarian
flag carrier. Having considered the Ryanair versus the EasyJet
model, the founders of Wizz Air decided to adopt the Ryanair
model: to be as lowcost and no frills as possible.
An investor group led by Indigo Partners LLC,
founders of Singapore-based low-cost carrier Tiger
Airways, became the largest shareholder in December
2004. Budapest became the second operating base in June
2005. Despite the economic climate Wizz continued to ex-
pand and set up bases around its core Central and Eastern
European markets, with 72 aircraft due to be delivered
over the following five years from 2009.
The carrier had been very active in acquiring shares
in and integrating with other airlines. This included for-
mer Formula One racing driver Niki Lauda’s airline Niki,
acquired in 2004. The two airlines considered their coop-
eration a “low fares alliance.” Air Berlin held 24 percent
of Lauda’s enterprise, operating a mixed fleet of Boeing
737s and Airbus A320s. In 2006, Air Berlin acquired dba,
formerly Deutsch British Airways, a budget airline based
in Munich.
In March 2007, Air Berlin took over German leisure
airline LTU, thereby gaining access to the long-haul market
and becoming the fourth-largest airline group in Europe in
terms of passenger traffic. This deal led to the introduction
of Airbus A321 and Airbus A330 aircraft into the Air Berlin
fleet. With the merger of the LTU operations, aircraft,
and crew, the LTU brand was shut down. Later in 2007,
Air Berlin acquired a 49 percent shareholding in Swiss
charter airline Belair, otherwise owned by tour operator
Hotelplan. A month later, in September 2007, Air Berlin an-
nounced an acquisition of its direct competitor Condor in
a deal that saw Condor’s owner, the Thomas Cook Group,
taking a 30 percent stake in Air Berlin. However, the deal
was scrapped in July 2008, owing to a variety of consid-
erations, including the rapidly increasing price of jet fuel.
In 2009, a strategic partnership agreement with TUI
Travel was signed, based on a cross-ownership of Air
Berlin and its direct competitor TUIfly of 19.9 percent
in each other’s shares. Thereby, Air Berlin took over all
German domestic TUIfly routes, as well as those to Italy,
Croatia, and Austria. All of TUIfly’s Boeing 737-700 aircraft
were merged into Air Berlin’s fleet, leaving TUI to focus
on serving the charter market with the 21 aircraft of its
remaining fleet. Also in 2009, Air Berlin announced a coop-
eration with Pegasus Airlines, thus allowing its customers
access to a broader range of destinations and flights to and
within Turkey on a codeshare-like basis.
Norwegian Airlines
Norwegian was founded in 1993 as a regional airline tak-
ing over routes in western Norway after the bankruptcy
of Busy Bee. Until 2002, it operated Fokker 50 aircraft on
wet lease for Braathens. Following the 2002 merger of the
two domestic incumbents Braathens and Scandinavian
Airlines, Norwegian established a domestic low-cost car-
rier. It had since expanded quickly. By 2010, it was the
second-largest airline in Scandinavia and the fourth-largest
low-cost carrier in Europe. In 2009, it transported 10.8 mil-
lion people on 150 routes to 85 destinations across Europe
into North Africa and the Middle East. As of the end of
2009, Norwegian operated 46 Boeing 737 aircraft.
M05A_BARN0088_05_GE_CASE2.INDD 37 15/09/14 7:43 PM

PC 2–38 Business-Level Strategies
Ryanair fares or was only very slightly higher on most routes.
The airline’s chief operating officer said that “Aer Lingus no
longer offers a gold-plated service to customers, but offers a
more practical and appropriate service . . . it clearly differenti-
ates itself from no-frills carriers. We fly to main airports and
not 50 miles away. We assign seats for passengers, we beat
low fares competitors on punctuality, even though we fly to
more congested airports, and we always fulfil our commit-
ment to customers—unlike no frills carriers.”31
In its defense document against the Ryanair takeover
bid in October 2006, the airline proclaimed a strong track
record of growth, with a return on capital and operating
margin second only to Ryanair in the European airline
industry, leading the Irish market in terms of technological
innovation and value-added service innovations such as
self-check-in, advance seat selection, Web check-in, and a
dynamic and easy-to-use online booking service. Its cus-
tomer proposition was “Low Fares, Way Better,” flying to
more convenient airports and posting leading punctuality
statistics at Heathrow. A survey conducted by the airline
found that customers considered Aer Lingus a better value
for the money than Ryanair, even at slightly higher fares.
Aer Lingus achieved more than three times as much short-
haul passenger growth as Ryanair from Dublin in 2005,
with substantial opportunities to grow ancillary revenues.
Staff productivity improved from 3,475 to 6,108 passengers
per employee between 2001 and 2005.
However, from 2008, Aer Lingus’ fortunes began
to deteriorate in the face of the gathering recession, ris-
ing fuel costs, and fierce competition on all its routes,
resulting in losses for the years 2008 and 2009. Christophe
Mueller joined the company as CEO in September 2009
and set about trying to staunch losses suffered by the
airline as it expanded during a recession that hit its three
main markets of Ireland, the United Kingdom, and the
United States. Mueller outlined a plan to achieve cost
savings of €97 million a year by the end of 2011, in part
by cutting staff numbers by nearly a fifth and remov-
ing several senior pilots who were among the airline’s
most expensive employees. The airline was also targeting
higher yields rather than simply pursuing market share.
Gross cash balances had increased by €90.4 million since
December 31, 2009 to €918.9 million. The cost reduction
program, involving staff and pay cuts, alongside work
increases had been approved in a 74 percent positive
staff ballot. The network had been enhanced through an
extended code-share agreement with United Airlines and
the launch of an Aer Lingus Regional franchise. The com-
pany was on target to achieve pretax profits of €31 million
in 2010 and €74 million in 2011, driven by a 12.5 percent
increase in revenue per passenger.
As a private company Wizz Air did not publish any
detailed financial information. However, it appeared that
the carrier had yet to make a profit and faced massive
challenges in terms of financing and effectively deploying
aircraft. Its further expansion required substantial invest-
ment and cash reserves, which may not have been readily
available from Indigo when it was stretched with other in-
vestments, including Tiger Airways. Nonetheless, the chal-
lenging economic climate faced by Wizz Air could have
been viewed as an opportunity with many existing carriers
in their target countries reducing capacity and in danger of
shutdown (Malev, Aerosvit, LOT-Centralwings).
Wizz Air had assiduously adopted the Ryanair
model, so the two airlines consequently shared many
similarities, such as the same sort of unflattering comments
about them on blog Web sites. However, Wizz merited
a three-star Skytrax rating compared with two stars for
Ryanair. Both carriers operated to secondary airports, but
Wizz operated longer average stage lengths, which re-
sulted in high aircraft utilization of 13 hours daily.
It had even been suggested it would make strategic
sense for the two airlines to merge, given the similar-
ity of their cost-cutting cultures.30 So far, there was little
overlap between the route systems of the two carriers, so
there could have been complementarity in combining their
routes. However, Ryanair operated Boeing 737s, while Wizz
Air operated A320s. Such a “merger” would hardly have
been a merger, but more a takeover by Ryanair, and it could
have met with opposition from EU competition authorities.
Aer Lingus
Ryanair continues to hold a 29.8 percent share of Aer Lingus.
The carrier, operating short- and long-haul services, was the
national state-owned airline of Ireland until it was floated in
October 2006. The events of 9/11 were particularly traumatic
for Aer Lingus, as the airline teetered on the verge of bank-
ruptcy. It put in place a plan for a flotation, which had al-
ready been postponed several times. In late 2001, the choice
was to change, be taken over, or be liquidated. Led by a
determined and focused chief executive, Willie Walsh (who
was to become the CEO of British Airways in 2005), and his
senior management team, the company set about cutting
costs. One ingredient of its cost reduction was a severance
program, costing more than €100 million, whereby 2,000 of
its 6,000 employees left the group. By the end of 2002, Aer
Lingus had turned a 2001 €125 million loss into a €33 million
profit, and it continued to improve still further, posting a net
profit of €88.9 million in 2005.
In essence, Aer Lingus maintained that it had trans-
formed itself into a low-fares airline and that it matched
M05A_BARN0088_05_GE_CASE2.INDD 38 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–39
development processes such as team training, 80 per-
cent internal promotion, and recognition events and
practices. Staff turnover was well below the industry
average. Overall compensation included profit-sharing
schemes. The workforce was almost entirely union-
ized. Southwest had consistently been ranked as one of
the best companies to work for in the United States.
■ Low fares: Southwest claimed to have the lowest fares
with the simplest fare structure in the U.S. domestic
airline industry. More than 80 percent of customers
bought travel on a ticketless basis and approximately
80 percent of Southwest customers checked in online or
at a kiosk in 2010.
■ Customers: Southwest claims to give people the freedom
to fly, first and foremost with its low fares, but also with
its streamlined service to provide for short-haul cus-
tomers needs—frequent departures to meet customer
demands for schedule frequency and flexibility, nonstop
services, and conveniently located airports near city cen-
ters. The carrier also targeted business travelers who
constituted a substantial proportion of its passengers.
Southwest had a frequent flyer program, Rapid Rewards,
whereby a free round trip was given to a customer who
had purchased eight round trips on the same route. The
carrier had declined to join competitors in charging for
the first and second checked bags. However, passengers
could incur extra charges for Business Select fares offer-
ing priority seating, security lane access, a premium
beverage coupon, and flight credits. Other services liable
for extra charges were Pets Onboard, Unaccompanied
Minor service, and Early Bird Check-in.
■ Operations: To maintain low fares, Southwest contained
its costs on many fronts. Its point-to-point route system
with frequent daily departures from the same airport
was cheaper than most of its competitors’ hub-and-
spoke systems. However, while three-fourths of its
passengers flew point to point, connecting traffic grew
with corresponding revenues of tens of millions of
dollars in 2009. The carrier flew into less congested
airports of small cities or the smaller airports of large
cities. This saved time as well as money in landing
charges. The airline did not engage in interline baggage
transfer and served only drinks and simple snacks
on board for free, while charging for alcoholic bever-
ages. These operations resulted in shorter time to turn
around an aircraft, claimed by the company to be less
than half the industry standard. This meant greater uti-
lization of aircraft and lower unit costs.
The airline used only one aircraft type, the Boeing 737,
in an all-coach configuration. This substantially reduced
costs due to simplified operations, training, scheduling, and
Investors seemed optimistic about the new strategy.
The airline had burned through €400 million cash in 2009,
but still had a strong balance sheet with gross cash and
deposits of €825 million, of which €770 million was unen-
cumbered. Mueller declared that in a worst-case scenario,
Aer Lingus could run for at least four and half years with-
out running out of cash. Mueller had also declared that
the large Ryanair holding remained a deterrent to other
airlines that might wish to take a stake in Aer Lingus.
Revamping the strategic approach and culture of
the airline was a priority in Mueller’s ambition to improve
revenue. Thus, the airline rebranded itself as “Ireland’s
civilised airline” as it unveiled a plan to position itself mid-
way between Ryanair and high-end carriers such as British
Airways, which some analysts compared with the posi-
tioning of EasyJet. The airline’s “civilised” tag was seen as
a dig at Ryanair.32 While Aer Lingus hoped to lure business
travelers with faster check-in times, pre-paid meals, and
conveniently located airports, rather than the secondary
ones for which Ryanair was known, it would not focus on
the quality lounges and free food and drinks associated
with full-service airlines.
Southwest Airlines
Ryanair was the first European airline to model itself on
the successful formula of Southwest Airlines in Texas
by offering itself as a low-fare, no-frills carrier, serving
short-haul city pairs and providing single-class air trans-
portation. As of 2010, Southwest operated more than 3,200
flights a day coast to coast, making it the largest U.S. car-
rier based on domestic passengers carried.
Southwest, founded in 1967, was the perceived under-
dog in the ferocious price wars launched by the established
airlines when the new carrier entered their markets after de-
regulation. Southwest is the only airline to have survived the
shakeout of new entrants in the sharply competitive U.S. en-
vironment. This survival served to inspire Southwest, so that
it styled itself more as a freedom fighter rather than a mere
corporation, listing “five symbols of freedom” in its annual
report: its people, its low fares, its customers, its operations,
and its advertising/promotions/marketing:
■ People: Southwest had an acknowledged unique cul-
ture, largely attributable to its staff members and
their commitment to the company and its customers.
The creation of a “fun” environment was one of the
ways in which the airline differentiated itself. The
corporate culture of the company, referred to by Herb
Kelleher, its iconic founder and chairman until 2008, as
“a patina of spirituality” was ingrained in its people.
A family loyalty feeling was further inculcated by staff
M05A_BARN0088_05_GE_CASE2.INDD 39 15/09/14 7:43 PM

PC 2–40 Business-Level Strategies
in 2010. The balance sheet was investment-grade strong
and also expected to improve even more in 2010. However,
prompted by slowing growth and rising costs, in 2010,
Southwest acquired AirTran, a rival U.S. budget carrier, in
one of the world’s biggest no-frills airline tie-ups. Would
this takeover deal by Southwest serve as yet another role
model for other budget carriers around the world?
Leading Ryanair into the Future
“It is good to have someone like Michael O’Leary around.
He scares people to death.” This praise of Ryanair’s CEO
came from none other than his fellow Irishman, Willie
Walsh, CEO of BA.33 O’Leary had been described as “at
turns, arrogant and rude, then charming, affable and hu-
morous, has terrorised rivals and regulators for more than
a decade. And so far, they have waited in vain for him to
trip up or his enthusiasm to wane.”34 In fact, O’Leary had
been pronouncing his intention to depart from the airline
“in two years’ time” since 2005. He had declared that he
would sever all links with the airline, refusing to “move
upstairs” as chairman. “You don’t need a doddery old bas-
tard hanging around the place,” he proclaimed.35
O’Leary bred racehorses at his Gigginstown Stud
50 miles (80 kilometers) from Dublin. In 2006, his horse,
War of Attrition won the Cheltenham Gold Cup, one of the
most prestigious races in steeplechasing, while another,
Hear the Echo, won the Irish Grand National in 2008. He
stayed in budget hotels and always flew Ryanair, startling
fellow passengers by taking their boarding passes at the
gate and by boarding the plane last where he invariably
got a middle seat. He did not sit in an executive lounge,
had no BlackBerry, and did not use email.
In 2010, O’Leary held just under 4 percent of
Ryanair’s share capital, having sold 5 million shares at
€3.90. Although O’Leary consistently praised the contribu-
tions and achievements of his management team, Ryanair
was inextricably identified with him. He was credited with
singlehandedly transforming European air transport. In
2001, O’Leary received the European Businessman of the
Year Award from Fortune magazine; in 2004, The Financial
Times named him as one of 25 European “business stars”
who have made a difference. The newspaper described
him as personifying “the brash new Irish business elite”
and possessing “a head for numbers, a shrewd marketing
brain and a ruthless competitive streak.”36
Present and former staff have praised O’Leary’s
leadership style. “Michael’s genius is his ability to moti-
vate and energise people . . . There is an incredible energy
in that place. People work incredibly hard and get a lot
maintenance. Cost containment was aided at Southwest by a
cost- and time-conscious workforce, constantly on the look-
out for money-saving ideas. Despite heavy unionization,
there was virtually no job demarcation, as staff performed
tasks allocated to other people if it saved time and money.
From its inception, Southwest had received many
awards and recognitions. It has been recognized as received
Best Low Cost/No Frills Airline, finalist for Best Airline
based in North America, Favorite Domestic Airline and
ranked #1 in Best Customer Service, Best Airfare Prices,
Best On-Time Service, Best Baggage Service, and Best Value
Frequent Flier program, and Best Low Cost Carrier.
In March 2009, Southwest Airlines was ranked num-
ber one in the category for airlines in Institutional Investor’s
magazine poll of America’s Most Shareholder Friendly
Companies, an award it had received many times previ-
ously. Southwest Airlines was named the seventh-most
admired Company in Fortune magazine’s ranking of the
50 Most Admired Companies in the World in 2009, the only
U.S. airline to make the list and the 13th consecutive year
that Southwest had been named to the Most Admired List.
Moreover, its renowned founder and CEO, Kelleher, was
also lauded with awards, culminating in his enshrinement
in the National Aviation Hall of Fame upon his retirement
as chairman in 2008, to be replaced by Gary Kelly, who had
already replaced Kelleher as CEO in 2004. Kelly, a CPA,
had been CFO and originally joined Southwest in 1986 as
controller. Like his predecessor, Kelly has been the recipi-
ent of numerous awards, including one of the best CEOs
in America for 2008, 2009, and 2010 by Institutional Investor
magazine.
In 2009, notwithstanding the recession and turmoil in
the airline industry, Southwest remained profitable, produc-
ing its 37th consecutive year of profitability, although net
income dropped to $99 million from $178 million the year
before. Staying in the black was due to various measures:
■ an aggressive advertising campaign to affirm that Bags
Fly Free only on Southwest, resulting in increased mar-
ket share worth $1 billion and record load factors;
■ rationalizing unpopular and unprofitable routes and
redeploying capacity to developing markets;
■ picking up market share from defunct carriers, like
Frontier Airlines;
■ other revenue intiatives, such as new products like
onboard wireless Internet access, enhancements to
southwest.com, and continued development of Rapid
Rewards; and
■ containing costs and maximizing productivity.
Southwest also concentrated on maintaining financial
strength, with total liquidity of $3 billion expected to rise
M05A_BARN0088_05_GE_CASE2.INDD 40 15/09/14 7:43 PM

Case 2–2: Ryanair—The Low Fares Airline: Whither Now? PC 2–41
only Commissioner who is allergic to the mere mention of
the name of Ryanair’s arrogant chief.”43
Irish Times columnist John McManus suggested that
“maybe it’s time for Ryanair to jettison O’Leary,” asserting
that O’Leary had become a caricature of himself, fulfill-
ing all 15 warning signs of an executive about to fail.44
Professor Sydney Finklestein of the Tuck Business School
at Dartmouth U.S. identified the 15 signs under five head-
ings: ignoring change, the wrong vision, getting too close,
arrogant attitudes, and old formulae. But having demon-
strated the extent that O’Leary met the Finklestein criteria,
McManus concluded: “So, is it time for Ryanair to dump
O’Leary? Depends whether you prefer the track record of
one of the most successful businessmen in modern avia-
tion or the theories of a U.S. academic from an Ivy League
school.”
Perhaps the last words should go to O’Leary himself:
“We could make a mistake and I could get hung,” he said.
He reiterated a point he had often made before: “It is okay
doing the cheeky chappie, running around Europe, thumb-
ing your nose, but I am not Herb Kelleher (the legendary
founder of the original budget airline, Southwest Airlines).
He was a genius and I am not.”45
So, how do these comments and his hands-on man-
agement style fit with O’Leary’s declaration to part com-
pany with Ryanair? Would he really go, and if so, what
would happen to Ryanair and its ambitions? No one really
knew the answer to these questions, but it would certainly
lie in O’Leary’s propensity to surprise his admirers and
detractors alike.
out of it. They operate a very lean operation . . . It is without
peer,” said Tim Jeans, a former sales and marketing direc-
tor of Ryanair, currently CEO of a small low-cost rival,
MyTravelLite.37
O’Leary’s publicity-seeking antics are legendary.
These included his “declaration of war” on EasyJet when,
wearing an army uniform, he drove a tank to EasyJet’s
headquarters at Luton Airport. In another stunt, when
Ryanair opened its hub at Milan Bergamo, he flew there
aboard a jet bearing the slogan “Arrividerci Alitalia.” He
had also dressed up as St. Patrick and as the Pope to pro-
mote ticket offers. Another provocative idea enunciated by
O’Leary was the recommendation that co-pilots could be
done away with on flights, so aircraft could fly with just
one pilot, because “the computer does most of the flying
now” and “a flight attendant could do the job of a co-pilot,
if needed.”38 In fact, he even went so far as to suggest that
under present arrangements, “maybe the second pilot
could be doing some of the in-flight service.”39
O’Leary’s outspokenness has made him a figure
of public debate. “He is called everything from ‘arro-
gant pig’ to ‘messiah.’”40 His avowed enemies included
trade unions, politicians who imposed airport taxes (call-
ing former UK Prime Minister Gordon Brown a “twit”
and a “Scottish miser”41), environmentalists, bloggers who
ranted about poor service, travel agents, reporters who ex-
pected free seats, regulators and the EU Commission, and
airport owners like BAA, whom he once called “overcharg-
ing rapists.”42 An EU Commissioner, Philippe Busquin,
denounced O’Leary as “irritating . . . and insists he is not the
End Notes
1. (2009). “The FT ArcelorMittal Boldness in Business Awards.” Financial Times supple-
ment, March 20, p.25.
2. Done, K. (2009). “Airline industry in intensive care.” Financial Times, March 25, p.22.
3. Done, K. (2009). “Ryanair sees opportunities in rivals’ distress.” Financial Times,
July 28, p.15.
4. Done, K. (2009). Ibid. Aldi and Lidl are German discount hypermarkets, renowned for
their low prices and spreading quickly across Europe.
5. Financial Times, 2006. September 9, p. 16.
6. Done, K., and T. Braithwaite. (2006). “Ryanair to allow mobile phone calls next year.”
Financial Times, August 31, p.1.
7. Ryanair annual report. (2001).
8. Guthrie, J. (2009). “Sir Stelios beknighted as suits prove bolder risk takers.” Financial
Times, July 30, p. 16.
9. Ryanair annual report. (2009).
10. Ibid.
11. Lyall, S. (2009). “No apologies from the boss of a no-frills airline.” The New York Times,
August 1 (The Saturday Profile).
M05A_BARN0088_05_GE_CASE2.INDD 41 15/09/14 7:43 PM

PC 2–42 Business-Level Strategies
12. Ryanair 2007 half yearly results.
13. LEX. (2009). “Ryanair.” Financial Times, June 3, p. 16.
14. Noonan, L. (2009). “O’Leary admits stake in Aer Lingus was stupid disaster.” Irish
Independent, March 6.
15. (2006). Statement from Ryanair’s half yearly results presentation, November 6.
16. Pogatchnik, S. (2006). “Aer Lingus rejects Ryanair takeover offer.” Business Week on-
line, November 3. Manchester United and Liverpool have a longstanding legendary
rivalry in English football.
17. Ryanair full year results. (2009).
18. (2010). Guardian newspaper blog, www.guardian.co.uk/world/blog/2010/apr/22/
iceland-volcanocompensation. Accessed May 19, 2010.
19. Carolan, M. (2010). “Judge pulls out of Ryanair case without altering previous find-
ings or comments.” Irish Times, June 22.
20. (2009). Ryanair press release, May 29.
21. Milmo, D. (2006). “Ryanair—The World’s Least Favorite Airline.” The Guardian.
October 26.
22. Waite, R., and S. Swinford. (2009). “Ryanair more expensive than BA on some flights.”
Sunday Times, August 9.
23. Money Central. (2009). “WBLG: Twenty reasons never to fly Ryanair.” Times Online,
March 20.
24. Pope, C. (2009). “Pricewatch daily.” Irish Times, August 14, p. 11.
25. Lyall, S. (2009). “No apologies from the boss of a no-frills airline.” The New York Times,
August 1 (The Saturday Profile).
26. Ibid.
27. Clark, P. (2010). “EasyJet founder quits board.” Financial Times, May 15, p. 12.
28. Clark, P. (2010). “EasyJet founder savages Harrison.” Financial Times, May 12, p. 22.
29. (2010). “Ryanair and O’Leary apologise to EasyJet founder of Pinocchio ads.” Irish
Times, July 6.
30. Centre for Asia Pacific Aviation. (2009). “Ryanair meets Wizz Air: Does a merger
make sense?” July 8. http://www.centreforaviation.com/news/2009/07/08/ryanair-
meets-wizz-air-does-amerger-make-sense. Accessed May 2010.
31. Creaton, S. (2003). “Aer Lingus’s new model airline takes off.” Irish Times, August 8, p. 52.
32. Clark, P. (2010). “Aer Lingus brands itself ‘civilised’ airline.” Financial Times, January
27, p. 18.
33. Done, K. (2008). “O’Leary shows it is not yet the end for budget air travel.” Financial
Times, August 2, p. 11.
34. The FT ArcelorMittal Boldness in Business Awards. (2009). Financial Times supple-
ment, March 20, p. 21.
35. Dalby, D. (2005). “I’m going for good, O’Leary tells Ryanair.” Sunday Times,
November 20, News, p. 3.
36. Groom, B. (2004). “Leaders of the new Europe: Business stars chart a course for the
profits of the future.” Financial Times, April 20.
37. Bowley, G. (2003). “How low can you go?” Financial Times Magazine, 9, June 21.
38. Clark, P. (2010). “Ryanair’s latest no-frills idea: sack the boss.” Financial Times,
September 14.
39. Hancock, C. (2010.). “The Friday interview: Michael O’Leary, Ryanair chief execu-
tive.” Irish Times, Business This Week, September 24.
40. Ibid. Bowley, 2003.
41. Lyall, S. (2009). “No apologies from the boss of a no-frills airline.” The New York Times,
August 1 (The Saturday Profile).
42. Ibid.
43. Creaton, S. (2004). “Turbulent times for Ryanair’s high-flier.” Irish Times, January 31.
44. McManus, J. (2003). “Maybe it’s time for Ryanair to jettison O’Leary.” Irish Times,
August 11.
45. Bowley, G. (2003). “How low can you go?” Financial Times Magazine, 9, June 21.
M05A_BARN0088_05_GE_CASE2.INDD 42 15/09/14 7:43 PM

C a s e 2 – 3 : T h e L e v i ’ s P e r s o n a l
P a i r P r o p o s a l
The Levi’s Personal Pair Proposal1
“I’ll have my recommendation to you by the end of the week.”
Heidi Green hung up the phone and surveyed her calendar
for appointments that could be pushed into the next week. It
was a rainy afternoon in December 1994, and she had yet to re-
cover from the pre-holiday rush to get product out to retailers.
She had three days to prepare a presentation for the
Executive Committee on a new concept called Personal Pair.
Custom Clothing Technology Corporation (CCTC) had ap-
proached Levi Strauss with the joint venture proposal that
would marry Levi’s core products with the emerging tech-
nologies of mass customization. Jeans could be customized
in style and fit to meet each customer’s unique needs and
taste. If CCTC was correct, this would reach the higher end
of the jeans market, yielding stronger profit margins due
to both the price premium and the streamlined production
process involved.
On the other hand, the technology was new to Levi
Strauss and the idea could turn out to be an expensive and
time-consuming proposal that would come back later to
haunt her, as she would have to manage the venture. The
initial market studies seemed supportive, but there was
no way to know how customers would respond to the
program because there was nothing quite like it out there.
She also was unsure whether the program would work as
smoothly in practice as the plan suggested.
Company Background and History
Levi Strauss and Co. is a privately held company owned
by the family of its founder, Levi Strauss. The Bavarian im-
migrant was the creator of durable work pants from cloth
used for ships’ sails, which were reinforced with his pat-
ented rivets. The now-famous “waist-overalls,” were origi-
nally created more than 130 years ago for use by California
gold rush workers. These were later seen as utilitarian
farm- or factory-wear. By the 1950’s, Levi’s jeans had ac-
quired a Hollywood cachet, as the likes of Marilyn Monroe,
James Dean, Marlon Brando, Elvis, and Bob Dylan proudly
wore them, giving off an air of rebellious hipness. The jeans
would become a political statement and an American icon,
as all jeans soon became known generically as “Levi’s.” The
baby boomer generation next adopted the jeans as a fashion
statement, and from 1964–1975, the company’s annual sales
grew tenfold, from $100 million to $1 billion.2 By the late 70’s,
Levi’s had become synonymous with the terms “authentic,”
“genuine,” “original,” and “real,” and wearing them allowed
the wearer to make a statement. According to some who
recognize the brand’s recognition even over that of Coke,
Marlboro, Nike or Microsoft, “Levi Strauss has been, and re-
mains, both the largest brand-apparel company in the world
and the number one purveyor of blue jeans in the world.”
While blue jeans remained the company’s mainstay,
the San Francisco-based company also sold pants made of
corduroy, twill, and various other fabrics, as well as shorts,
skirts, jackets, and outerwear. The company, with its highly
recognizable brand name, held a top position in many of
its markets and was sold in more than 80 countries. More
than half of the company’s revenue was from its U.S.
sales; nevertheless, Europe and Asia were highly profitable
markets. Latin America and Canada were secondary mar-
kets, with smaller contributions to overall profits. As the
graphic (below) shows, apparel imports were increasing
faster than exports during this period.
1989
0
90
Imports
91 92 93 94 95 96 97
10
20
30
40
50
60
Exports
Import and Exports of Apparel (in billions of dollars)
Source: U.S. Department of Commerce.
M05A_BARN0088_05_GE_CASE3.INDD 43 13/09/14 3:36 PM

PC 2–44 Business-Level Strategies
Levi’s as a private company, which viewed itself as
having a strong “social conscience,” wanted to avoid being
seen as exploiting disadvantaged workers. Accordingly,
they preferred to have their jeans “U.S.-made,” and Levi
Strauss was a leader in providing generous salary and ben-
efits packages to its employees.
Accordingly, it did not relish the notion of entering
into price-based competition with rivals committed to
overseas production. Their delayed response led to some
significant incursions by rivals into Levi’s core product
arenas.
Levi’s also wanted to avoid price-based competi-
tion because they had a history of brand recognition and
brand loyalty. They were accustomed to the Levi’s brand
carrying enough clout to justify a reasonable price pre-
mium. However, over the years, the brand name carried
less cachet, and as hundreds of competitors with similar
products dotted the landscape, it became necessary to
create valued features that would help to differentiate the
product in the eyes of consumers.
Levi Strauss’ financial performance is summarized
in Exhibit 1 for the period from 1990–1994. While the
company was profitable throughout the period, revenue
growth had clearly slowed and income growth was
quite uneven. This is especially apparent for 1994, the
current year, where net income dropped by 35% due
to fierce competition for market share and narrowing
margins.
Cost Structure
Exhibit 2 provides an estimate of the cost and margins on
an average pair of jeans sold through Levi’s two outlets.
Much of their product is sold through wholesale chan-
nels, to be distributed by competing retailers. However,
Levi’s maintains a chain of Original Levi’s Stores (OLS)
primarily to help keep them closer to the customer. The
profit per pair of jeans is about 30% lower in the whole-
sale channel ($2 as opposed to $3). This is driven by the
30% margin that accrues to the channel, and which is
somewhat balanced by the higher costs of operating the
OLS outlets (especially the additional SG&A costs for
operating the stores).
Exhibit 2 also indicates the ongoing investment per
pair of jeans. Once this is considered, the wholesale outlets
are nearly twice as profitable—the pre-tax return on in-
vested capital is 15%, as opposed to 8%. Here, the OLS out-
lets require additional investment in inventory ($8/pair),
which is normally borne by the retailer, and the capital tied
up in the retail stores ($20/pair).
The company’s non-denim brand, Dockers, was
introduced in 1986 and was sold in the United States,
Canada, Mexico, and Europe. While it was composed of
both women’s and men’s clothing, the men’s line of khaki
pants occupied the leading position in U.S. sales of khaki
trousers and sold well with baby boomers. Sales of Dockers
had steadily increased with the rise in casual workplaces,
and this line of non-denim products had helped in allow-
ing Levi’s to be less reliant on the denim industry.
Competition and the Denim Industry
Denim was “one of the fastest-growing apparel fabrics,”
and sales have been increasing approximately 10% per year.
According to some surveys, an average American consumer
owns 17 denim items, which includes 6–7 pairs of jeans.3 Levi
Strauss and Company held the largest market share in 1990,
at 31%, followed by VF Corporation’s Lee and Wrangler
(17.9%), designer labels (6%), The Gap (3%), and depart-
ment store private labels (3.2%). By 1995, women’s jeans had
grown to a $2 billion market, of which Levi’s held first place.
However, at the same time, many jeans producers
were starting to move production to low-cost overseas
facilities, which allowed for cost (especially labor) advan-
tages. As the graph (below) shows, this trend was rep-
resented throughout the apparel industry and is clearly
visible in employment statistics. Indeed, JC Penney, one
of Levi’s long-time partners, had become a competitor by
introducing a cheaper alternative, the Arizona label. They
and other rivals had realized that by sourcing all produc-
tion in cheap overseas facilities they could enter the busi-
ness with a cost advantage over Levi Strauss.
1950
0.4
54 58 62 64 66 70 74 78 82 86 90 94 98
0.6
0.8
1.0
1.2
1.4
U.S. Apparel Industry Employment (production workers,
in millions)
Source: Bureau of Labor Statistics.
M05A_BARN0088_05_GE_CASE3.INDD 44 13/09/14 3:36 PM

Case 2–3: The Levi’s Personal Pair Proposal PC 2–45
Exhibit 1 Levi Strauss Financial Performance
1994 1993 1992 1991 1990
Income Statement
Net Sales $6,074,321 $5,892,479 $5,570,290 $4,902,882 $4,247,150
Cost of Goods $3,632,406 $3,638,152 $3,431,469 $3,024,330 $2,651,338
Gross Profit $2,441,915 $2,254,327 $2,138,821 $1,878,552 $1,595,812
Selling G&A Exp $1,472,786 $1,394,170 $1,309,352 $1,147,465 $922,785
Non Operating Income -$18,410 $8,300 -$142,045 $31,650 -$36,403
Interest Exp $19,824 $37,144 $53,303 $71,384 $82,956
Income Before Taxes $930,895 $831,313 $634,121 $691,353 $553,668
Taxes $373,402 $338,902 $271,673 $324,812 $288,753
Net Inc Before Ext Items $557,493 $492,411 $362,448 $366,541 $264,915
Ext Items -$236,517 $0 -$1,611 -$9,875 -$13,746
Net Income $320,976 $492,411 $360,837 $356,666 $251,169
Growth
Sales Growth 3.1% 5.8% 13.6% 15.4%
Net Income Growth -34.8% 36.5% 1.2% 42.0%
Key Financial Ratios
Quick Ratio 1.57 1.03 0.76 0.87 0.73
SG&A/Sales 24.25 23.66 23.51 23.4 21.73
Receivables Turnover 6.68 6.87 7.67 7.31 6.88
Inventories Turnover 7.76 7.44 7.64 7.5 7.29
Total Debt/Equity 2.57 10.57 34.39 71.82 22.21
Net Inc/Sales 5.28 8.36 6.48 7.27 5.91
Net Inc/Total assets 8.18 15.84 12.53 13.54 10.51
Mass Customization
Mass customization uses emerging communication and com-
puter technologies to bypass the limitations of traditional
mass production methods. From a strategic standpoint, the
concept is based on the idea that “the ultimate niche is
a market of one.”4 Previously, it was thought that highly-
customized products were necessarily expensive to produce;
however, with the advent of various information technologies,
meeting the customer’s needs for flexibility and greater choice
in the marketplace is becoming more and more economical.
“A silent revolution is stirring in the way things
are made and services are delivered. Companies with
millions of customers are starting to build products
designed just for you. You can, of course, buy a Dell
computer assembled to your exact specifications… But
you can also buy pills with the exact blend of vitamins,
minerals, and herbs that you like, glasses molded to fit
your face precisely, CD’s with music tracks that you
choose, cosmetics mixed to match your skin tone, text-
books whose chapters are picked out by your professor, a
loan structured to meet your financial profile, or a night
at a hotel where everyone knows your favorite wine. And
if your child does not like any of Mattel’s 125 different
Barbie dolls, she will soon be able to design her own.”5
There is, of course, a delicate balance between provid-
ing consumers enough flexibility to meet their needs
without so much that the decision-making process be-
comes perplexing and the company’s costs spiral out of
control trying to meet the customers’ phantom needs.
In the early 90’s, Levi Strauss found itself facing
a dual set of competitors. There were the low-cost,
high-volume producers with a distinct advantage over
Levi’s, and there were also the higher-cost producers
of jeans that targeted the affluent end of the denim-
buying public. As a high-volume producer with a cost
disadvantage, Levi’s increasingly found itself at a dis-
advantage in both the upper and lower ends of the
apparel market.
Personal Pair Proposal
Proponents of the Personal Pair project envisioned a niche
that would allow Levi’s to avoid competing against the
low-cost high-volume producers. Market research revealed
that only a quarter of women were truly happy with the
fit of their jeans, and the company hoped to attract higher-
income customers who would be willing to pay a little
extra for a perfect fit.
M05A_BARN0088_05_GE_CASE3.INDD 45 13/09/14 3:36 PM

PC 2–46 Business-Level Strategies
find the array of choices in the marketplace overwhelming,
to narrow down their specific needs. The company enters
into a dialogue with customers to help them understand
what they need, and is then able to provide specialized
products that meet that specific need. Collaborative cus-
tomizers are able to keep inventories of finished products
at a minimum, which brings new products to market
faster. That is, they manufacture products in a “just-in-
time” fashion to respond to specific customer requests.
How It Would Work. Original Levi’s Stores (OLS) would
be equipped with networked PC’s and Personal Pair kiosks.
Trained sales clerks would measure customers’ waist, hips,
rise, and inseam, resulting in one of 4,224 possible size
combinations—a dramatic increase over the 40 combinations
In addition, a mass customization model could lower
costs as well as provide the differentiation advantage since
the re-engineered process is often more efficient once new
technologies are applied. For example, the mass customiza-
tion model, which operates on the “pull-driven” approach
of having the customer drive the production process, would
lower distribution costs and inventories of unsold products.
Personal Pair was a jeans customization program
made possible through a joint venture with Custom Clothing
Technology Corporation (CCTC), in Newton, Massachusetts.
CCTC approached Levi Strauss, described the potential of
its technology and suggested that, together, the two compa-
nies could enter the mass customization arena.
The Personal Pair proposal reflected a form of collab-
orative customization. This approach helps customers who
Exhibit 2 Profitability Analysis of Women’s Jeans
Wholesale
Channel
Original Levi’s
Store Channel
Personal
Pair?

Notes
Operations, per pair
Gross Revenue $35 $50 $50 retail price with a 30% channel margin.
Less Markdowns (3) (5) Avg. channel markdowns of $5; 60% born by mfg.
Net Revenue 32 45
Costs
Cotton 5 5
Mfg. Conversion 7 7 High labor content since all jeans hand-sewn.
Distribution 9 11
Wholly-owned distribution network for OLS
channel. Add $2 for warehouse to store.
Total 21 23
COGS
Gross Margin 11 22
SG&A 91 192
Profit Before $2 $3
Tax
Investment, per pair
Inventory $4 $12 77 days for Levi’s wholesale channel & 240 days
for OLS stores to include retail inventory.
Reflects 27 days of Accounts Payable. Less A/P (1) (1)
Accounts 4 0 51-day collection period for wholesale. Retail
customers pay immediately.
Receivable
Net Working Capital 7 11
Factory PP&E 5 5 Reflects a sales to fixed asset turnover of 5.33.
Distribution PP&E 1 2 Doubled for OLS channel due to additional retail
distribution investment (estimate).
Retail Store 0 20 $2.4M/OLS store for 120,000 pairs sold/yr (est.).
Total Investment $13 $38
Pre-tax return on
invested capital
15% 8%
1 At $9, a little higher than Levi’s overall 25% SG&A due to supply chain problems with women’s jeans.
2 The additional $10 reflects an average 22% store expense for retail clothiers (Compact Disclosure database).
Source: Adapted from Carr, 1998.
M05A_BARN0088_05_GE_CASE3.INDD 46 13/09/14 3:36 PM

Case 2–3: The Levi’s Personal Pair Proposal PC 2–47
Planned Scope. The initial proposal was to equip four
Original Levi’s Stores (OLS) with Personal Pair kiosks and
specialized PC’s. Once the systems were worked out, this
would be expanded to more than 60 kiosks across the U.S.
and Canada. In addition, they envisioned opening kiosks
in London where they estimated that the product would
command a premium of £19 over the original £46 price
for standard jeans. The jeans would still be produced in
Tennessee and shipped via Federal Express.
Cost Impact. Although the new process would require
some investments in technology and process changes,
many other costs were projected to drop. These are illus-
trated by the complex supply chain for the OLS channel
(Exhibit 3) and the relatively simple supply chain for the
proposed Personal Pair program (Exhibit 4).
■ The most obvious ongoing cost savings would be in
distribution. Here, the order is transmitted electroni-
cally and the final product is shipped directly to the
customer at his/her expense. These costs would be
nearly eliminated in the proposed program.
■ Manufacturing and raw materials would not change
much since all jeans are hand sewn and would use the
same materials for the traditional and mass-customized
processes.
■ The portion of SG&A expenses attributable to retail
operations ($10/pair in Exhibit 2) would be reduced
if 50% of the sales are reorders that do not incur in-
cremental costs in the retail stores ($5/pair savings).
However, CCTC would incur its own SG&A costs that
would have to be considered (about $3/pair).
■ Finally, no price adjustments would be needed in such
a tight channel since there would be no inventory of
finished product. In the retail channel, about 1/3 of jeans
are sold at a discount to clear out aging stock (the dis-
counts average 30%).6
Investment Impact. While the factory PP&E was not
projected to change much (they would continue to use the
same facilities), a number of other factors would impact
the invested capital tied up in a pair of jeans (both posi-
tively and negatively) under the proposed program:
Increases in invested capital:
■ First, there would be an initial $3 million required to
integrate the systems of CCTC with Levi’s existing sys-
tems. This was relatively small since it was a matter of
integrating existing systems in the two companies.
■ CCTC would also require additional IT investments
estimated at $10/pair to maintain the system and up-
grade it regularly as scale requirements increased.
normally available to customers. The computer would then
generate a code number that corresponded to one of 400
prototype pairs of jeans kept in the kiosk. Within three tries,
more measurements would be taken and a perfect fit would
be obtained; the customer would then pay for the jeans and
opt for Federal Express delivery ($5 extra) or store pickup,
with a full money-back guarantee on every pair.
The order was then sent to CCTC in Boston via
a Lotus Notes computer program. This program would
“translate” the order and match it with a pre-existing pat-
tern at the Tennessee manufacturing facility. The correct
pattern would be pulled, “read,” and transferred to the cut
station, where each pair was cut individually. A sewing
line composed of eight flexible team members would pro-
cess the order, it would be sent to be laundered, and would
be inspected and packed for shipping. A bar code would be
sewn into each pair to simplify reordering details, and the
customer would have a custom-fit pair within three weeks.
Once the program was underway, the proposal sug-
gested that about half of the orders would be from existing
customers. Reordering would be simplified and encour-
aged by the bar code sewn into each pair. In addition,
reorders could be handled through a web-based interface.
Pricing. There was some question about how much of
a price premium the new product would command. The
proposal called for a $15 premium (over the standard $50/
pair off the rack) and focus groups suggested that women,
in particular, would consider this a fair price to pay for
superior fit. However, other’s argued that this price point
was a bit optimistic, suggesting that $5 or $10 might be
more realistic given the lower-priced alternatives.
M05A_BARN0088_05_GE_CASE3.INDD 47 13/09/14 3:36 PM

Ex
hi
bi
t 3

Tr
ad
iti
on
al
O
rig
in
al
L
ev
i’s
S
to
re
S
up
pl
y
Ch
ai
n
So
ur
ce
: A
d
ap
te
d
fr
om
C
ar
r,
19
98
.
M
ar
ke
t
Re
se
ar
ch
D
em
an
d
Fo
re
ca
st
in
g
D
es
ig
n
Re
se
ar
ch
Pr
od
uc
tio
n
Pl
an
ni
ng
Ra
w
M
at
er
ia
l
Lo
g
is
tic
s
Pr
od
uc
tio
n
Fa
ct
or
y
W
ar
eh
ou
si
ng
Sh
ip
p
in
g
b
y
Tr
uc
k,
F
le
et
&
C
om
m
on
C
ar
rie
r
D
is
tr
ib
ut
io
n
W
ar
eh
ou
se
H
ub
&
Sp
ok
e
Sh
ip
t
o
St
or
es
Tr
uc
k
Fl
ee
t
Re
ta
il
O
ut
le
ts
M
ac
ro
D
em
an
d
U
nc
er
ta
in
ty
IN
V
EN
TO
RY
FI
X
ED
A
SS
ET
S
Le
ad
t
im
e
un
ce
rt
ai
nt
y
C
yc
le
t
im
e
un
ce
rt
ai
nt
y
an
d
v
ar
ia
tio
n
D
em
an
d
un
ce
rt
ai
nt
y
an
d
v
ar
ia
tio
n
Sc
he
d
ul
e
un
ce
rt
ai
nt
y
an
d
v
ar
ia
tio
n
D
em
an
d
un
ce
rt
ai
nt
y
an
d
v
ar
ia
tio
n
Sc
he
d
ul
e
va
ria
tio
n
M
ic
ro
d
em
an
d
un
ce
rt
ai
nt
y
H
ea
vy
E
q
ui
p
.
C
ut
tin
g
(6
0-
p
ly
)
se
w
in
g,
ha
nd
lin
g,
p
ac
ki
ng
a
nd
sh
ip
p
in
g
Re
al
e
st
at
e
Ve
hi
cl
es
Re
al
e
st
at
e
Ve
hi
cl
es
W
or
ki
ng
ca
p
ita
l
Sa
le
s
an
d
Pr
om
ot
io
ns
C
us
to
m
er
C
us
to
m
er
sa
tis
fa
ct
io
n?
Re
p
ea
t
p
ur
ch
as
es
?
54
%
o
f
cu
st
om
er
s
g
en
er
at
e
90
%
o
f s
al
es
76
%
o
f
w
om
en
n
ot
fu
lly
s
at
is
fie
d
w
ith
t
he
p
ur
ch
as
e
R.
M
.
In
ve
nt
or
y
~1
5
da
ys
20
,0
00
S
KU
s
W
IP
In
ve
nt
or
y
~1
5
da
ys
20
,0
00
S
KU
s
F.
G
.
In
ve
nt
or
y
~5
0
da
ys
20
,0
00
S
KU
s
Av
er
ag
e
8-
m
on
th
L
ea
d
T
im
eF
.G
.
In
ve
nt
or
y
~1
00
d
ay
s
20
,0
00
S
KU
s
F.
G
.
In
ve
nt
or
y
~6
0
da
ys
1,
00
0
SK
U
s
PC 2–48
M05A_BARN0088_05_GE_CASE3.INDD 48 13/09/14 3:36 PM

Case 2–3: The Levi’s Personal Pair Proposal PC 2–49
manufacturing process would be modified to allow for
better flow—specifically teams would be used to allow
for more flexibility and handling of custom products.
Unfortunately, since elements in the jean manufacturing
process do not always come together in the same way, it
would be important that employees accumulate a large
range of skills to accommodate idiosyncratic problems
that cannot be anticipated.
Finally, it is helpful if either the products or the sub-
processes in the manufacturing chain are standardized.
This allows for more efficient production and inventory
management, whether it be for different types of domes-
tic uses or different markets (for example, international
as well as domestic markets were served by a printer
manufacturer that allowed all its printers to be adjusted
for both 110/220-volt usage). Here, the Personal Pair pro-
posal called for a complex computer program with com-
puterized patterns that were then beamed directly to the
cutting floor. This would help them to integrate some
technology-enhanced sub-processes with existing standard
labor- intensive manufacturing methods.
It also goes without saying that all the parts of the new
mass customization process need to come together in an
“instantaneous, costless, seamless and frictionless manner.”9
The Decision
As Heidi leaned back and gazed outside at the rain-
soaked plaza, she considered the pros and cons to the
proposal. The proposal carried several risks that she
could not fully quantify. First, there was the ability of
Levi Strauss to implement new technologies. Second, the
cost savings in the proposal were based on CCTC’s esti-
mates in their proposal for the program. Would the pro-
gram still be successful if the costs turned out to be very
different? Third, market research indicated that women
were not satisfied about fit. How much would they be
willing to pay for a better fit?
On another level, she wondered about the competi-
tion. If the program were successful, would their low-cost
rivals dive into this market as well? Did Levi’s have any
advantage here? What if they did not move forward with
the proposal? Would one of their rivals partner with CCTC?
■ In addition, the kiosks would take up about 1/3 of the
space in the OLS retail stores (about $7/pair for retail
space).
Decreases in invested capital:
■ The required inventory was significantly lower under
the proposed program. Recent estimates calculated
Levi’s average inventory at about 8 months.7 In con-
trast, the Personal Pair program called for no inventory
of finished product and only a small inventory of raw
materials (about $1/pair).
■ Finally, the proposal suggested that accounts receivable
would lead to a net gain of about $2/pair since custom-
ers would have paid about 3 weeks prior to receiving
the product (similar to the Amazon.com model).
Integrating Elements of Mass Customization at Levi
Strauss. In order for a company to transform an exist-
ing product into one that is cost-efficient to mass produce,
certain product modifications must be made. The Personal
Pair proposal incorporated several of the key elements
suggested as helpful for implementing successful mass-
customization programs.8
First, it is important to introduce the differentiating
component of the product (that which must be custom-
ized) as late in the production process as possible. For
example, paint is not mixed by the manufacturer, but at
the point of sale, after being demanded by individual
customers. Unfortunately, the making of personalized
jeans would not lend itself to a differentiating component
late in the production process. Therefore, in this case, the
customizing would have to take place at the beginning of
the process.
Then, it is helpful if either the product or the
process of manufacturing can be easily separated into
production modules. Steps in the process can then be
reassembled in a different order. For example, a sweater
manufacturer might wait until the last possible moment
to dye its products in different colors for each season,
instead of dying the wool first and knitting the sweat-
ers. This allows for much more flexibility and helps
the manufacturer to keep up with fast moving fashion
trends. The Personal Pair proposal suggested that the
Exhibit 4 Personal Pair Value
Chain
*Although this approach changes
cutting from 60-ply to one, it does
not otherwise change manufactur-
ing since jeans were, and are, sewn
one pair at a time.
Personal
Pair kiosk
in retail
store
EDI link to
manufacturing
via CCTC
Raw
material
logistics
Manufacturing
the one pair of
jeans*
Pack pair for
daily pickup
at factory
by FedEx
FedEx
directly to
customer
M05A_BARN0088_05_GE_CASE3.INDD 49 13/09/14 3:36 PM

PC 2–50 Business-Level Strategies
Bibliography
1. Aron, Laurie Joan, From Push to Pull: The Supply Chain Management Shifts, Apparel
Industry Magazine, June 1998, Volume 59, Issue 6, p. 58–59.
2. Apparel Industry Magazine, Jeanswear Gets Squeezed: Plants Close at Levi’s, VF, March
1999, Volume 60, Issue 3, p. 10.
3. Billington, Jim, How to Customize for the Real World, Harvard Management Update,
Reprint #U9704A, 1997.
4. Bounds, Wendy, Inside Levi’s Race to Restore a Tarnished Brand, Wall Street Journal,
August 4, 1998, p. B1.
5. Carr, Lawrence, William Lawler, and John Shank, Levi’s Personal Pair Cases A, B, and
Teaching Note, F.W. Olin Graduate School of Business, Babson College, December
1998, #BAB020, BAB021, and BAB520.
6. Chaplin, Heather, The Truth Hurts, American Demographics, April 1999, Volume 21,
Issue 4, p. 68–9.
7. Charlet, Jean-Claude, and Erik Brynjolfsson, BroadVision, Stanford University Graduate
School of Business Case #OIT–21, March 1998.
8. Church, Elizabeth, Personal Pair Didn’t Fit into Levi Strauss’s Plans, The Globe and
Mail, May 27, 1999, p. B13.
9. Collett, Stacy, Levi Shuts Plants, Misses Trends, Computerworld, March 1, 1999, p. 16.
10. Economist, The, Keeping the Customer Satisfied, July 14, 2001, p. 9–10.
11. Economist, The, Special Report, Mass Customization: A Long March, July 14, 2001,
p. 63–65.
12. Ellison, Sarah, Levi’s is Ironing Some Wrinkles out of its Sales, Wall Street Journal,
February 12, 2001, p. B9.
13. Espen, Hal, Levi’s Blues, The New York Times Magazine, March 21, 1999, p. 6.
14. Esquivel, Josephine R. and Huong Chu Belpedio, Textile and Apparel Suppliers
Industry Overview, Morgan Stanley Dean Witter, March 14, 2001, p. 1–72.
15. Feitzinger, Edward and Hau L. Lee, Mass Customization at Hewlett-Packard: The
Power of Postponement, Harvard Business Review, January–February 1997, Reprint
#97101, p. 116–121.
16. FITCH Company Reports, Levi Strauss and Co., February 15, 2001, www.fitchratings.
com.
17. FITCH Company Reports, Levi Strauss and Co., October 31, 2000, www.fitchratings.
com.
18. FITCH Company Reports, Levi Strauss and Co., March 18, 1999, www.fitchratings.
com.
11. Gilbert, Charles, Did Modules Fail Levi’s or Did Levi’s Fail Modules?, Apparel
Industry Magazine, September 1998, Volume 59, Issue 9, p. 88–92.
12. Gilmore, James H., The Four Faces of Mass Customization, Harvard Business Review,
January–February 1997, Reprint #97103, p. 91–101.
13. Ginsberg, Steve, Ripped Levi’s: Blunders, Bad Luck Take Toll, San Francisco Business
Times, December 11–17, 1998, Vol. 13, Issue 18.
12. Hill, Suzette, Levi Strauss and Co.: Icon in Revolution, Apparel Industry Magazine,
January 1999, Volume 60, Issue 1, p. 66–69.
13. Hill, Suzette, Levi Strauss Puts a New Spin on Brand Management, Apparel Industry
Magazine, November 1998, p. 46–7.
14. Hofman, Mike, Searching for the Mountain of Youth, Inc, December 1999, Volume 21,
Issue 18, p. 33–36.
15. Homer, Eric, Levi’s Zips Up First Ever Private Deal, Private Placement Letter, July 23,
2001.
16. Hunt, Bryan C. and Mark O. Doehla, Denim Industry, FirstUnion Industry Report,
February 23, 1999.
17. Jastrow, David, Saying No to Web Sales, Computer Reseller News, November 29, 1999,
Issue 871, p. 73.
M05A_BARN0088_05_GE_CASE3.INDD 50 13/09/14 3:36 PM

Case 2–3: The Levi’s Personal Pair Proposal PC 2–51
18. Johnson, Greg, Jeans War: Survival of the Fittest, The Los Angeles Times, December 3,
1998, p. C1.
19. King, Ralph T., Jr., Jeans Therapy: Levi’s Factory Workers are Assigned to Teams, and
Morale Takes a Hit, Wall Street Journal, May 20, 1998, p. A1.
20. Laberis, Bill, Levi’s Shows IT May Not Be Driver it Pretends To Be, Computerworld,
April 12, 1999, Vol. 33, Issue 15, p. 36.
21. Lee, Julian, Can Levi’s Ever Be Cool Again?, Marketing, April 15, 1999, p. 28–9.
22. Lee, Louise, Can Levi’s Be Cool Again?, Business Week, March 13, 2000, p. 144–148.
23. Levi Strauss and Company Promotional Materials.
24. Levine, Bettijane, Fashion Fallout from the Levi Strauss Layoffs, The Los Angeles Times,
March 1, 1999, p. 1.
25. Magretta, Joan, The Power of Virtual Integration: An Interview with Dell Computer’s
Michael Dell, Harvard Business Review, March–April 1998, Reprint #98208, p. 73–84.
26. Meadows, Shawn, Levi Shifts On-Line Strategy, Bobbin, January 2000, Vol. 41,
Issue 5, p. 8.
27. Merrill Lynch Company Report, Levi Strauss and Co., Global Securities Research and
Economics Group, March 23, 2001.
28. Merrill Lynch Company Report, Levi Strauss and Co., Global Securities Research and
Economics Group, January 11, 2001.
29. Merrill Lynch Company Report, Levi Strauss and Co., Global Securities Research and
Economics Group, September 20, 2000.
30. Munk, Nina, How Levi’s Trashed a Great American Brand, Fortune, April 12, 1999,
Vol. 139, Issue 7, p. 82–90.
31. New York Times, The View from Outside: Levi’s Needs More Than a Patch,”
February 28, 1999, p. 4.
32. Pine, B. Joseph II, Serve Each Customer Efficiently and Uniquely, Network
Transformation, BCR, January 1996, p. 2–5.
33. Pine, B. Joseph II, Bart Victor, and Andrew C. Boynton, Making Mass Customization
Work, Harvard Business Review, September–October 1993, Reprint #93509, p. 108–116.
34. Pressler, Margaret Webb, Mending Time at Levi’s: Jeans Maker Struggles to Recapture
Youth Market, Reshape its Culture, The Washington Post, April 12, 1998, p. HO1.
35. Reidy, Chris, In Marketplace, They’re No Longer Such a Great Fit, Boston Globe,
February 23, 1999, p. A1.
36. Reda, Susan, Internet Channel Conflicts, Stores, December 1999, Vol. 81, Issue 12,
p. 24–28.
37. Robson, Douglas, Levi Showing New Signs of Fraying in San Francisco, San Francisco
Business Times, October 15, 1999, Volume 14, Issue 10, p. 1.
38. Rosenbush, Steve, Personalizing Service on Web, USAToday, November 16, 1998,
p. 15E.
39. Schoenberger, Karl, Tough Jeans, A Soft Heart and Frayed Earnings, New York Times,
June 25, 2000, p. 3.
40. Schonfeld, Erick, The Customized, Digitized, Have-it-Your-Way Economy, Fortune,
September 28, 1998.
41. Stoughton, Stephanie, Jeans Market Now a Tight Fit for Levi’s; Denim Leader Missed
Marketing Opportunities, Failed to Spot Trends, The Washington Post, February 23,
1999, p. E1.
42. Trebay, Guy, What’s Stonewashed, Ripped, Mended and $2,222?, New York Times,
April 17, 2001, p. 10, col. 1.
43. Voight, Joan, Red, White, and Blue: An American Icon Fades Away, Adweek, April 26,
1999, Vol. 40, Issue 17, p. 28–35.
44. Watson, Richard T., Sigmund Akselsen, and Leyland F. Pitt, Attractors: Building
Mountains in the Flat Landscape of the World Wide Web, California Management
Review, Volume 40, Number 2, Winter 1998, p. 36–54.
45. Zito, Kelly, Levi Reveals Rare Look at Inner Secrets, San Francisco Chronicle, May 6,
2000, p. B1.
M05A_BARN0088_05_GE_CASE3.INDD 51 13/09/14 3:36 PM

PC 2–52 Business-Level Strategies
End Notes
1. This case was prepared by Farah Mihoubi under the supervision of Associate
Professor Russell Coff of the Goizueta Business School, as the basis for class discus-
sion, rather than to illustrate either effective or ineffective management. Information
assembled from published sources and interviews with company sources. Copyright
2013, by the Wisconsin School of Business, All rights reserved.
2. Espen, 1999.
3. Levine, 1999.
4. Schonfeld, 1998.
5. Schonfeld, 1998.
6. Carr, 1998.
7. Carr, 1998.
8. Billington, 1997.
9. Pine, Victor, and Boynton, 1993, p. 112.
M05A_BARN0088_05_GE_CASE3.INDD 52 13/09/14 3:36 PM

C a s e 2 – 4 : P a p a J o h n ’ s
I n t e r n a t i o n a l , I n c . *
Papa John’s International was a classic American success
story. Founder John Schnatter had started selling pizza out
of a makeshift kitchen in a small lounge in Indiana and in a
little more than a decade had built a business that included
more than 4,000 locations. After a slowdown in growth fol-
lowing the 2008 economic crisis, Papa John’s had returned
to its pre-crisis pattern of opening more than 200 stores
per year. Such ambition was not without challenges. The
U.S. economy had changed over the two decades that Papa
John’s had been in business due to an aging population and
to the severe economic crisis that faced the nation starting
in 2008. The economy had been particularly challenging for
firms serving food and drinks. Though clearly profitable
(see Exhibit 1), Papa John’s had enjoyed relatively incre-
mental growth in the new century. Despite the challenges,
the leadership at Papa John’s believed that the company
had developed some important advantages that could be
leveraged for high growth in either the United States or
international markets or perhaps even in activities that went
beyond pizza. The question facing Papa John’s executives
was which path would produce rapid but profitable growth.
Firm History and Background
Papa John’s founder Schnatter realized as a young person
that he loved pizza more than most people, and this love
was reflected in his early jobs. He started working for
Rocky’s Sub Pub in Jeffersonville, Indiana, as a 15-year-old
high school student. While attending college, he worked
for Greek’s Pizzeria. Upon graduating from college in
1983, he returned home to Jeffersonville, Indiana, and
began working for his father at Mick’s Lounge. In 1984,
Schnatter sold his prized 1972 Z28 Camaro and bought
out the co-owner of Mick’s Lounge. He knew that Mick’s
was not doing well financially, but believed that after get-
ting Mick’s to run at a profit, he might try selling pizza.
Something was missing from national pizza chains, he
had concluded—a superior-quality traditional pizza. After
converting a broom closet in the back of Mick’s Lounge to
a kitchen with $1,600 worth of used restaurant equipment,
Schnatter began selling pizza to the tavern’s customers.1
By using fresh dough and superior-quality ingre-
dients, Schnatter believed that he could make a better
pizza than others. The tavern’s patrons would be brutally
honest about the quality of his pizzas and provided rapid
and candid feedback. Through trial and error, he created a
pizza that the tavern customers loved. Once pizzas were
selling well, Schnatter leased space next to Mick’s Lounge
and opened the first Papa John’s restaurant in 1985. This
was the beginning of Papa John’s Pizza. Schnatter credited
his father and grandfather with instilling in him the sense
of pride in one’s work, the importance of a strong work
ethic, and the belief that a person should focus on what he
or she does best and do it better than anyone else.2
When Schnatter opened his first Papa John’s, his ex-
pectations were not very high. When asked about his strategy
and plans for his business when he started his first Papa
John’s, he stated, “I never thought we’d get this big. It still
baffles my mind. My original goal was to make $50,000
a year. In 1984, I dreamed of possibly owning 100 stores.
I never imagined having the success we now have.”3 The first
Papa John’s was a sit-down restaurant. Schnatter learned that
he wasn’t very good at the sit-down restaurant when he tried
to serve too many different items. He paid careful attention to
what customers liked and did not like and adjusted his menu
accordingly. Schnatter concluded “the Papa John’s you know
today is a function of what the customer told us they wanted.
We simply listened to the customer. The customer wanted
the pizza delivered. They did not want a sit-down pizza shop
that served fifty other things.”4
The company grew rapidly, opening eight stores
during its first year of operation. Papa John’s generated
revenues of $500,000 in its first year.5 In January 1986, Papa
John’s sold its first franchise. The company remained pri-
vate until the initial public stock offering on June 8, 1993,
under the symbol PZZA. Papa John’s total revenues for the
year ending in December 1992 were close to $50 million,
having roughly doubled in size every year since 1986. After
going public, the company experienced an accelerated do-
mestic growth in the number of restaurants and opened its
first international restaurant in 1998. International growth
was aided by the 205-unit acquisition of “Perfect Pizza,”
the quality leader for pizzas in the United Kingdom.
This domestic and international growth continued
unabated until 2001, when it decreased dramatically lead-
ing to a 1 percent contraction in domestic growth in 2003.
*This case is adapted from a report prepared by Rebekah Meier,
Wade Okelberry, Odie Washington, Chad Witcher, and J. C. Woelich.
M05A_BARN0088_05_GE_CASE4.INDD 53 15/09/14 7:41 PM

PC 2–54
In millions of USD (except for per share items)
2012 2011 2010 2009
Income Statement
Revenue 1,342.65 1,217.88 1,126.40 1,078.55
Other Revenue, Total — — — —
Total Revenue 1,342.65 1,217.88 1,126.40 1,078.55
Cost of Revenue, Total 970.71 892.1 817.29 774.31
Gross Profit 371.94 325.78 309.1 304.24
Selling/General/Admin. Expenses, Total 186.5 160.92 157.13 170.69
Research and Development — — — —
Depreciation/Amortization 32.8 32.68 32.41 31.45
Interest Expense (Income)—Net Operating — — — —
Unusual Expense (Income) 0.36 1.75 -5.63 -17.23
Other Operating Expenses, Total 52.48 43.42 38.46 24.12
Total Operating Expense 1,242.85 1,130.87 1,039.65 983.33
Operating Income 99.81 87.02 86.74 95.22
Income Before Tax 98.39 84.79 83.31 84.19
Income After Tax 66 58.47 56.06 57.48
Minority Interest -4.34 -3.73 -3.48 -3.76
Net Income Before Extra Items 61.66 54.73 52.58 53.73
Net Income 61.66 54.73 52.58 53.73
Income Available to Common Excl. Extra Items 61.66 54.73 52.58 53.73
Income Available to Common Incl. Extra Items 61.66 54.73 52.58 53.73
Dilution Adjustment 0 0 0 0.14
Diluted Weighted Average Shares 23.91 25.31 26.47 27.91
Diluted EPS Excluding Extraordinary Items 2.58 2.16 1.99 1.93
Diluted Normalized EPS 2.59 2.21 1.84 1.51
Balance Sheet
Cash and Equivalents 16.4 18.94 47.83 25.46
Cash and Short-Term Investments 16.4 18.94 47.83 25.46
Accounts Receivable—Trade, Net 44.65 28.17 25.36 22.12
Total Receivables, Net 49.22 32.39 30.09 22.12
Total Inventory 22.18 20.09 17.4 15.58
Prepaid Expenses 12.78 10.21 10.01 8.7
Other Current Assets, Total 18.05 13.19 14.14 12.16
Total Current Assets 118.63 94.82 119.47 84
Property/Plant/Equipment, Total—Gross 487.96 445.71 424.69 402.06
Accumulated Depreciation, Total -291.3 -263.81 -239.32 -214.09
Goodwill, Net 78.96 75.08 74.7 75.07
Long-Term Investments — — — —
Other Long Term Assets, Total 31.63 27.06 25.34 28.95
Total Assets 438.41 390.38 417.49 393.73
Accounts Payable 32.62 32.97 31.57 26.99
Accrued Expenses 60.53 44.2 42.83 54.24
Notes Payable/Short-Term Debt 0 0 0 0
Other Current liabilities, Total 10.43 3.97 1.79 5.85
Total Current Liabilities 103.58 81.13 76.18 87.08
Long-Term Debt 88.26 51.49 99.02 99.05
Total Long-Term Debt 88.26 51.49 99.02 99.05
Total Debt 88.26 51.49 99.02 99.05
Deferred Income Tax 10.67 6.69 0 0
Minority Interest 18.22 15.03 13.48 8.17
Other Liabilities, Total 36.17 30.39 33.2 22.55
Total Liabilities 256.89 184.74 221.88 216.86
Common Stock, Total 0.37 0.37 0.36 0.36
Additional Paid-In Capital 280.9 262.46 245.38 231.72
Retained Earnings (Accumulated Deficit) 356.46 294.8 240.07 191.21
Treasury Stock—Common -458.05 -353.83 -291.05 -245.34
Other Equity, Total 1.82 1.85 1.01 1.48
Total Equity 181.51 205.65 195.61 176.87
Total Liabilities and Shareholders’ Equity 438.41 390.38 417.49 393.73
Total Common Shares Outstanding 22.24 24.02 25.44 26.93
Exhibit 1 Papa Johns, Inc., Income Statement and Balance Sheet, 2009–2012
M05A_BARN0088_05_GE_CASE4.INDD 54 15/09/14 7:41 PM

Case 2–4: Papa John’s International, Inc. PC 2–55
Schnatter stated, “The commissary was added out of
necessity. It did not start as a strategic decision to ensure
quality. It started out of financial need. We simply did
not have the money to put a mixer in every store. We
had stores in Jeffersonville, Clarksville, and New Albany,
so we just put a mixer in the middle store and made all
the dough there. I can remember in 1987, we had a com-
missary, but we were doing it all by hand. We just grew
into the commissary system. I wish I could say that it
was a part of a grand plan that I envisioned from the
time I started in the broom closet of Mick’s Lounge, but
it was not.”7
The commissary system was frequently cited by
industry analysts and company officials as a key factor in
the success of Papa John’s. The system not only reduced
labor costs and reduced waste because the dough was
premeasured, but it maintained control over the consis-
tency of the product. The centralized production facil-
ity supplied all of the Papa John’s stores with the same
high-quality ingredients for their pizza. One of the most
important aspects of this system is that it allowed Papa
John’s to start up more stores because it did not require
the purchase of additional expensive equipment for each
store. Part of the company’s strategy was to expand into
new markets only after a commissary had been built that
could support the growth and geographical expansion of
restaurants.8
Schnatter stated, “Papa John’s Mission Statement
and Values represent the basic beliefs and purpose of the
company. They are not just words printed on a piece of
paper. They are truly what we believe and live here at Papa
John’s.”9
Since 2003, growth has been positive and relatively stable,
and Papa John’s executives believed that there was sig-
nificant opportunity for domestic unit growth. Papa John’s
was among the highest return on invested capital (ROIC)
in the restaurant category. While domestic growth was
anticipated to be stable, international opportunities were
significantly large and promising. Papa John’s had 350
domestic restaurants and 1,100 international restaurants
that were contractually scheduled to open over the fol-
lowing 10 years.6 Exhibit 2 shows the historical growth
of Papa John’s restaurants including projected growth
through 2017.
Business Structure
Papa John’s had five major reportable segments of its
business: domestic restaurants, domestic commissaries, do-
mestic franchises, international operations, and variable
interest entities. Domestic restaurants were restaurants that
were wholly owned by Papa John’s in the contiguous
48 states. Domestic franchises were restaurants in which
Papa John’s had licensed to franchisees for a franchise fee.
These franchisee restaurants, as well as company-owned
restaurants, were supported by domestic commissaries that
supplied pizza dough, food products, paper products, small
wares, and cleaning supplies twice weekly to each restau-
rant. There were 10 regional commissaries that supported
domestic restaurants and franchises.
An important part of Papa John’s strategy revolved
around the central commissary. It allowed Papa John’s
to exercise control over the quality and consistency of
its products. When asked about the central commissary,
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
500
N
um
be
r
of
P
ap
a
Jo
hn
’s
R
es
ta
ur
an
ts
M
ar
-8
5
Ja
n-
86
O
ct
-9
1
Ju
n-
94
A
ug
-9
6
D
ec
-9
7
D
ec
-9
8
D
ec
-9
9
D
ec
-0
0
D
ec
-0
1
D
ec
-0
2
D
ec
-0
3
D
ec
-0
4
D
ec
-0
5
D
ec
-0
6
D
ec
-0
7
es
t.
D
ec
-0
8
es
t.
D
ec
-0
9
es
t.
D
ec
-1
0
es
t.
D
ec
-1
1
es
t.
D
ec
-1
2
es
t.
D
ec
-1
3
es
t.
D
ec
-1
4
es
t.
D
ec
-1
5
es
t.
D
ec
-1
6
es
t.
D
ec
-1
7
0
1,000
International
Domestic
Projected
Projected
Exhibit 2 Papa John’s Restaurant
Growth with Projections to 2017
M05A_BARN0088_05_GE_CASE4.INDD 55 15/09/14 7:41 PM

PC 2–56 Business-Level Strategies
needs and expectations. According to Javier Souto, Papa
John’s regional marketing director, “Papa John’s has proven
to be a technology leader in the pizza industry as the only
national pizza chain to offer online ordering for all of its
restaurants and now we are pleased to offer that service to
our many Spanish-speaking customers.”14 In 2012, Papa
John’s became the first pizza chain to offer online ordering
in Canada.
Papa John’s also extended its menu. In January 2006,
Papa John’s announced that it was adding dessert pizzas to its
carryout and delivery menus. “We created Papa’s Sweetreats
in direct response to consumer demand,” said Catherine Hull,
Papa John’s vice president of strategy and brand marketing.15
In July 2008, Papa John’s introduced another permanent addi-
tion to its menu: Chocolate Pastry Delight.
Menu additions and new ways to order did not sig-
nal a change in strategy, according to company executives.
Nigel Travis, president and CEO of Papa John’s, stated in
the company annual report 2007, “our stated strategy from
a year ago remains unchanged. We will continue to focus
on quality, growing the brand globally, and competing ag-
gressively. It has proven the right course in a challenging
economic time and has the opportunity to be even more
successful as the economy rebounds.” Papa John’s targeted
restaurants in the international arena as the company’s
primary source of long-term growth. Papa John’s saw
its use of innovative marketing, product offerings, and
industry-leading technology as a major advantage over its
competitors.16
Papa John’s outlined its company strategy in one an-
nual report as follows: “Our goal is to build the strongest
brand loyalty of all pizzerias internationally. The key ele-
ments of our strategy include the following”:
High-Quality Menu Offerings. Domestic Papa
John’s restaurants offer a menu of high-quality pizza
along with side items, including breadsticks, cheese-
sticks, chicken poppers and wings, dessert items and
canned or bottled beverages. Papa John’s traditional
crust pizza is prepared using fresh dough (never
frozen). Papa John’s pizzas are made from a propri-
etary blend of wheat flour, cheese made from 100%
real mozzarella, fresh-packed pizza sauce made from
vine-ripened tomatoes (not from concentrate) and
a proprietary mix of savory spices, and a choice of
high- quality meat (100% beef, pork and chicken with
no fillers) and vegetable toppings. Domestically, all
ingredients and toppings can be purchased from our
Quality Control Center (“QC Center”) system, which
delivers to individual restaurants twice weekly. To en-
sure consistent food quality, each domestic franchisee
is required to purchase dough and tomato sauce from
our QC Centers and to purchase all other supplies
According to Schnatter, “making a quality pizza
using better Ingredients has been the foundation of Papa
John’s for more than 20 years. You have my commitment
that Papa John’s will not stray from the foundation of qual-
ity and superiority upon which the company was built. We
will always strive to be your Better Pizza Company.”10 This
unwavering focus enabled Papa John’s to be rated number
one in customer satisfaction among all pizza chains in the
American Customer Satisfaction Index for nine consecu-
tive years from 1999 to 2008. As Schnatter had remarked
in a 1997 interview, “We keep it simple, consistent, and
focused. We don’t keep changing what we are doing.”11
Papa John’s president, USA, William Van Epps, echoed
this emphasis, “While other national pizza chains have
recently focused their national marketing efforts on deeply
discounted or reduced-ingredients pizzas and other offer-
ings such as pasta, I am proud of our system for remaining
focused on delivering a superior-quality pizza.”12
Papa John’s core strategy was to sell a high- quality
pizza for takeout or delivery. Its focus on using the highest-
quality ingredients to produce a high-quality pizza was
communicated in its motto: “Better Ingredients. Better
Pizza.” Schnatter considered it a sign of success when Pizza
Hut sued Papa John’s over the assertion that it had better
ingredients and, therefore, a better pizza. Papa John’s was
ultimately successful in proving it used fresher ingredients
and was, therefore, able to continue using its slogan. Papa
John’s stated goal was to build the strongest brand loyalty
of all pizzerias internationally. Early on, Schnatter also intro-
duced a signature bonus that served to signal the quality of
the product: Each pizza was accompanied by a container of
the company’s special garlic sauce and two pepperoncinis.
Technology, Menu Enhancements,
and Company Growth
Papa John’s had long strived to be on the cutting edge of
the use of technology. The company made ordering pizza
even more convenient with the introduction of online
ordering in 2001. It was the first pizza company to offer on-
line ordering. Papa John’s online sales grew exponentially
in the first decade of the 21st century with growth rates
of more than 50 percent a year not unusual. In November
2007, Papa John’s led the way, once again, by offering
text message ordering.13 More than 20 percent of all Papa
John’s sales came online or via text. Papa John’s was also
using both the Internet and mobile technologies to make
potential customers aware of current promotions and to al-
low them to easily order a pizza from virtually anywhere.
In October 2006, Papa John’s introduced online or-
dering in Spanish in an attempt to meet growing customer
M05A_BARN0088_05_GE_CASE4.INDD 56 15/09/14 7:41 PM

Case 2–4: Papa John’s International, Inc. PC 2–57
include a variety of community-oriented activities
within schools, sports venues and other organizations
supported with some of the same advertising vehicles
mentioned above.
In international markets, we target customers
who live or work within a small radius of a Papa John’s
restaurant. Certain markets can effectively use televi-
sion and radio as part of their marketing strategies. The
majority of the marketing efforts include using print
materials such as flyers, newspaper inserts, in-store
marketing materials, and to a growing extent, digital
marketing such as display, search engine marketing,
email, and SMS text. Local marketing efforts, such
as sponsoring or participating in community events,
sporting events and school programs, are also used to
build customer awareness.
Strong Franchise System. We are committed to de-
veloping and maintaining a strong franchise system by
attracting experienced operators, supporting them to
expand and grow their business and monitoring their
compliance with our high standards. We seek to attract
franchisees with experience in restaurant or retail opera-
tions and with the financial resources and management
capability to open single or multiple locations. We devote
significant resources to provide Papa John’s franchisees
with assistance in restaurant operations, management
training, team member training, marketing, site selec-
tion and restaurant design. (Annual Report, 2012)
Cost Management and Operational
Support Systems
Papa John’s subleased retail locations to franchise owners.
Papa John’s had lowered the number of corporate-owned
stores by about 5 percent in recent years in an effort to
lower its lease payments. Leasing building space gave
Papa John’s the flexibility to move locations quickly with
minimal cost, should a profitable location turn bad.
Papa John’s also leased the trailers used to distrib-
ute ingredients from the commissary centers to the retail
locations, typically on an eight-year lease agreement. By
leasing the trailers, Papa John’s was able to manage its
shipping logistics and costs in a structured manner while
not being required to maintain the trailers as they aged.
As Papa John’s Pizza started to grow, Schnatter rec-
ognized the importance of sharing his passion for pizza
with others in his company. The Operation Support Service
and Training (OSST) Center was created and was actively
engaged in the training and development of “team” mem-
bers. In order to instill his passion into his new franchisees
and corporate employees, Schnatter had them complete a
management training program at the OSST Center when
from our QC Centers or other approved suppliers. In-
ternationally, the menu may be more diverse than in
our domestic operations to meet local tastes and cus-
toms. QC Centers outside the U.S. may be operated by
franchisees pursuant to license agreements or by other
third parties. We provide significant assistance to li-
censed international QC Centers in sourcing approved
quality suppliers.
In addition to our fresh dough traditional crust
pizza, we offer a thin crust pizza, which is a par-baked
product produced by a third-party vendor. Our tradi-
tional crust pizza offers a container of our special garlic
sauce and a pepperoncini pepper. Each thin crust pizza
is served with a packet of special seasonings and a pep-
peroncini pepper.
We continue to test new product offerings both
domestically and internationally. The new products
can become a part of the permanent menu if they meet
certain established guidelines.
Efficient Operating System. We believe our operat-
ing and distribution systems, restaurant layout and
designated delivery areas result in lower restaurant
operating costs and improved food quality and promote
superior customer service. Our QC Center system
takes advantage of volume purchasing of food and sup-
plies and provides consistency and efficiencies of scale
in fresh dough production. This eliminates the need for
each restaurant to order food from multiple vendors
and commit substantial labor and other resources to
dough preparation.
Commitment to Team Member Training and
Development. We are committed to the development
and motivation of our team members through training
programs, incentive and recognition programs and op-
portunities for advancement. Team member training
programs are conducted for corporate team members and
offered to our franchisees electronically and at training
locations across the United States and internationally.
We offer performance-based financial incentives to cor-
porate and restaurant team members at various levels.
Marketing. Our marketing strategy consists of both
national and local components. Our domestic national
strategy includes national advertising via television,
print, direct mail, digital and social media channels.
Our online and digital marketing activities have in-
creased significantly over the past several years in re-
sponse to increasing consumer use of online and mobile
web technology.
Our local restaurant-level marketing programs
target consumers within the delivery area of each res-
taurant through the use of local TV, radio, print mate-
rials, targeted direct mail, store-to-door flyers, digital
display advertising, email marketing, text messages
and local social media. Local marketing efforts also
M05A_BARN0088_05_GE_CASE4.INDD 57 15/09/14 7:41 PM

PC 2–58 Business-Level Strategies
operated, and product branding enabled Papa John’s to
hold its own with the other pizza chains. Papa John’s had
worked to create a product branded in such a way that cus-
tomers came to expect the very best pizza; and they were
willing to pay a premium price. Papa John’s was commit-
ted to holding firm on the quality and prices of its pizzas.
The Restaurant Industry
and Pizza Segment
The restaurant industry had historically been very attrac-
tive to entrepreneurs. Most of these new entrants opened
single locations. The relatively low capital requirements
made the restaurant business very attractive to small-scale
entrepreneurs. Some of these businesses succeeded, but
there was an intense amount of competition. There were
relatively high fixed costs associated with entering into the
restaurant business. These factors caused many of the new
businesses to fail. However, for the businesses that suc-
ceeded, the payback on the investment could be quite high.
After sales reached the break-even point, a relatively high
percentage of incremental revenues became profit.
Restaurant analysts were generally amazed at how
successfully Schnatter built Papa John’s. Michael Fineman,
a restaurant analyst with Raymond James in St. Petersburg,
Florida, stated, “Here’s an industry that appears to be ma-
ture and saturated, and here comes John Schnatter with
his company Papa John’s. He has proven to be a fantastic
visionary.”17
Large restaurant chains, like Papa John’s, were able
to realize economies of scale that made competition ex-
tremely difficult for small operators. Some of these ad-
vantages included purchasing power in negotiating food
and packaging supply contracts, as well as real estate
purchasing, location selection, menu development, and
marketing.
Papa John’s operated in the highly competitive pizza
restaurant market, where the cost of entry was relatively
low and product differentiation was difficult. Other pizza
chains tried to compete in ways other than Papa John’s
emphasis. Some chains focused on being less expensive
or having a broad menu. According to the one analyst,
“the pizza chain segment struggled to find the right bal-
ance of promotions and pricing to keep both customers
and profits. The pizza category is also suffering from a
longer-term trend, in which the growth of take-out food
capabilities at full service restaurants and the creation
of more diversified menus at fast-food competitors have
given consumers other options. In response, competition
they started with the company. The aim of this training
was to help franchise owners be successful and to instill
in them a firm understanding of the Papa John’s culture.
Making franchisees feel like they were in a partnership
with Papa John’s facilitated a level of buy-in that the com-
pany believed was seldom found in restaurant chains.
Throughout Papa John’s tremendous growth dur-
ing its first 10 years of operation, its marketing programs
targeted the delivery area of each restaurant, primarily
through direct mailings and direct store-to-door coupon-
ing. In an effort to improve the marketing campaign,
Schnatter realized that he needed to find a printing com-
pany that could offer consistent high-quality service at
a reasonable price. In the mid-1990s, Schnatter found a
printer that met his expectations better than most. The
decision to vertically integrate into the business of printing
was made. The franchise owners were not required to use
the in-house printing service. The in-house printing opera-
tion was required to earn the business of each franchisee.
In an effort to keep costs low within the printing division,
Papa John’s regularly accepted outside print jobs. It was
not uncommon to print a flyer for a real estate company
between jobs for a Papa John’s franchise. In additional ef-
forts to keep costs low, the printing presses were operated
24 hours a day.
From its beginning, Papa John’s had been active in
community affairs, from supporting local sports teams
with fundraising opportunities to offering college schol-
arships. Papa John’s had awarded more than $5 million
in college scholarships. Papa John’s actively supported
the National FFA, Cerebral Palsy K.I.D.S. Center, and
Children’s Miracle Network, to name only a few. Papa
John’s executives believed that giving back to the commu-
nity was good business.
Papa John’s had entered into numerous marketing
partnerships over the years. For example, Papa John’s
aligned with Coca-Cola to offer only Coke products in its
stores. When Papa John’s added a pan pizza to its menu,
it enlisted the aid of former Miami Dolphins quarterback
Dan Marino. At the time, this was the most intensive new
product launch ever undertaken by Papa John’s. Another
combined effort for Papa John’s involved coordinating
with eBay for a limited edition Superman pan pizza box.
In Kentucky, Papa John’s and Blockbuster video combined
efforts in a “take dinner and a movie online” in which the
customer would receive a free 30-day trial of Blockbuster
online with an online pizza purchase at papajohns.com.
By using a combination of internal and external re-
sources, Papa John’s was determined to not compete with
its competition on price. Focusing on a quality product,
active participation in the local communities in which it
M05A_BARN0088_05_GE_CASE4.INDD 58 15/09/14 7:41 PM

Case 2–4: Papa John’s International, Inc. PC 2–59
potential threat of rising costs stemmed from legislation
at the federal level as well as many states that mandated a
higher minimum wage.
Many companies, including Papa John’s, engaged
in forward pricing to stabilize food costs. “Forward pric-
ing is a hedging strategy whereby a company negotiates
with a supplier to purchase a certain amount of a product
at a given price. Some supply contracts, signed by larger
chains, can lock in less volatile food products for an entire
year. Some of the products subject to the greatest vari-
ability, especially dairy products, can be locked in only for
shorter periods.”20
The S&P Industry Survey referred to 2007 and 2008
as a “perfect storm” of events in the industry. “Based
on recent corporate actions taken in response to current
weak industry conditions, we have a sense of growing
crisis within the industry.”21 According to the survey, it
was clear that there had been “deterioration from last
fall, when we noted that the high price of gasoline and
concerns about the U.S. housing market had forced many
consumers to scale back the portion of the household
budget allocated toward dining out. In addition to these
still-serious issues, we must add an increasingly challeng-
ing outlook for restaurants’ food and labor costs to the
mix.” Some analysts forecasted that 2009 would be the
“most challenging environment ever faced by the mod-
ern restaurant industry.”22 Analysts expected the weakest
sales performances by the domestic restaurant industry in
nearly four decades.
Another important factor that was affecting the res-
taurant industry was a decline in travel. In mid-2008,
economists expected further declines in travel. With less
travel, fewer people dined out while on vacation or on
business trips.
Of the $200 -plus- billion restaurant market, the pizza
segment currently held 6.7 percent of the market. Pizza
Hut, a division of Yum! Brands, Inc., was the leader, fol-
lowed by Domino’s Pizza, Inc., Papa John’s International,
Inc., and Little Caesars (a division of Ilitch Holdings, Inc.).
Each was a large, nationally known pizza provider. These
four accounted for 88 percent of the aggregate sales in the
pizza chain restaurant segment; each was significantly
larger than the #5 chain Chuck E. Cheese’s (operated by
CEC Entertainment, Inc.).
Economic trends played an important role in the
number of consumers that dined out. When asked about
the tough economic times the country faced in late 2008
and the effect they would have on Papa John’s, Schnatter
stated, “it is a tough time for our country. In the 90s we
were seeing really good growth in this industry; how-
ever, the industry has softened and it has gotten very
among pizza chains has recently centered on new prod-
uct offerings, such as pasta and desserts. The segment
has also pulled back on heavily price-based promotions
that have dominated the marketing messages in recent
years.” (S&P Industry Surveys [2007]) The meal options
available for consumers were increasing both for conve-
nience dining and at-home consumption. The quality of
frozen pizza available at grocery stores had improved
significantly in recent years. A broader trend was that
restaurant and quick-service restaurant dinner occasions
were declining, which was significant for pizza restaurants
such as Papa John’s, which gained 70 percent of its sales
from dinner orders. Declining restaurant and quick-service
restaurant dining was attributed to an increase in at-home
dinner preparation, linked to a decline in the percentage of
women in the workforce.18
The large number of restaurant types throughout
North America made it unlikely that any firm would gain
a competitive advantage by offering one style or type of
cuisine. The one principle that made Papa John’s rare in
the restaurant industry was its ongoing passion to offer the
perfect pizza. Many companies claimed to place quality at
the forefront of their business, but often the commitment to
quality went no deeper than public relations and was not
a core value.
Papa John’s commitment to the highest-quality in-
gredients created challenges in managing the supply of the
foods that went into its pizza. The volatility in the price of
cheese had been a major problem for Papa John’s. Cheese
material costs contribute approximately 35 to 40 percent of
Papa John’s restaurants’ food costs. In order to reduce the
cheese price volatility, Papa John’s partnered with a third-
party entity formed by franchisees, BIBP Commodities,
Inc., whose sole purpose was to reduce cheese price vola-
tility to domestic system-wide restaurants. This allowed
Papa John’s to purchase cheese from BIBP at a fixed quar-
terly price. Profits and losses from BIBP were then passed
on to Papa John’s.19
Rising costs challenged pizza restaurants in multiple
areas. Labor costs, as well as food commodity costs, were
rising in the industry. “Although restaurants are experi-
encing cost increases for labor, utilities, and transporta-
tion, perhaps no other factor has prompted restaurants
to increase their prices in 2008 more than food commod-
ity cost inflation.” (S&P Industry Surveys [2008]) Rising
energy costs had a dual impact on Papa John’s and its
competitors. Food prices of products related to corn were
increasing even more rapidly because of corn’s use as an
alternative fuel. Fluctuating in-store utility costs and de-
livery driver fuel costs were an ongoing source of concern.
In 2007–08, such costs had risen dramatically. Another
M05A_BARN0088_05_GE_CASE4.INDD 59 15/09/14 7:41 PM

PC 2–60 Business-Level Strategies
Pizza Hut benefited from a first-mover advantage in sev-
eral, if not most, attractive international markets. With
over 1,000 stores, Pizza Hut operated more stores in China
than Papa John’s throughout the world. It operated more
than 5,200 stores, more than five times the number of Papa
John’s. Historically, Papa John’s international efforts cen-
tered in Mexico, Canada, the United Kingdom, the Middle
East, and Asia. Some believed that Asian markets would
generally favor quality-centered business models due to
higher preferences for quality. Another favorable trend
in these markets was a growing income base for the local
population.
In building its international infrastructure, the com-
pany would need to cultivate new relationships and de-
velop new skills. One critical element was the company’s
ability to continue to partner with local producers in order
to maintain tight quality control and keep ingredients
fresh. In terms of new skills, Papa John’s needed to de-
velop the ability to modify its standard smaller carry-out
restaurant blueprint. Looking at the success of firms such
as McDonald’s or Yum! Brands, Inc.’s Kentucky Fried
Chicken, there was persuasive evidence that international
customers tended to view their eating-out experience
as more of a formal dining event. Thus, the standard
Papa John’s takeout restaurant model would need to be
expanded to accommodate a sit-down dining area for
patrons.
In addition to expanding internationally, Papa
John’s sought to grow and maintain its domestic mar-
ket share. Traditionally, restaurants did this by adding
new menu items or introducing a value selection such
as McDonald’s dollar menu or Little Caesars’ Hot-N-
Ready $5 pizza offering. For Papa John’s, these strategies
presented the risk of overextending its menu and, con-
sequently, reducing its overall brand quality or ability to
charge premium prices.
Extending the company’s co-branding efforts was
another possible avenue for domestic growth. For ex-
ample, Papa John’s partnered with firms such as Nestlé
to provide some of its dessert menu offerings. There were
a vast number of co-branding opportunities that were, in
theory at least, possible.
A third alternative for Papa John’s involved diversi-
fying from pizza. For example, Papa John’s could develop
or acquire an additional restaurant chain under a different
brand. Such an approach would allow Papa John’s to com-
pete in another restaurant category without fear of dilut-
ing its quality brand. Other competitors in the industry
had operated chains in multiple categories. McDonald’s,
for example, had invested in Chipotle Mexican Grill and
competitive. I foresee some pizza casualties in the future
and it may be hard for some to survive. I think if the trend
continues that we have seen over the last eighteen months,
it is going to be tough on everybody. I think there are going
to be a lot of people out there closing up shop.” Schnatter
continued by saying, “I think it’s going to be a real test for
all the operators in our category to see who is up to the
task and who is not. We are going to separate the men from
the boys, really quickly.”23
Papa John’s Looking Forward
In May 2007, Schnatter stepped down as the executive
chairman of Papa John’s to serve just as the head of the
board of directors. In this new role, he planned to remain
as spokesman for the company with no cash compensa-
tion, just stock options. Schnatter stated, “with Nigel Travis
having led the company for the last two years as president
and CEO, and the strength of our Board and the manage-
ment team supporting him, the time is right for me to pull
back a bit from the day-to-day operation of the company.
I’m fine working for stock options alone—that way, I get
compensated only if the rest of the shareholders win
through a stock price increase.”24
Schnatter was optimistic about the future of Papa
John’s. He wanted to see Papa John’s get back on the
path of opening 200 to 300 stores per year. Over the fol-
lowing five years, he wanted to see Papa John’s reach the
4,000-store mark and, long term, he aspired to see 6,000
to 7,000 stores worldwide.25 Papa John’s also sought to
reduce the number of company-run stores by turning
them into franchising opportunities. At the end of 2012,
Papa John’s operated 3,204 stores in North America and
another 959 internationally. Papa John’s owned 20 percent
of the North American stores but only 5 percent of the
international stores, which were all in China. Franchising
more of its current company-run stores offered Papa
John’s some important benefits. Franchise royalties were
based on a percentage of sales and not on a percent-
age of profits, which allowed Papa John’s to ensure a
steady stream of revenue even in a difficult operating
environment.
Papa John’s had several options at its disposal.
Among them were international market expansion, in-
creased domestic market penetration, and related diver-
sification (primarily via strategic acquisitions). The case
for international expansion was based on the conclusion
that the U.S. pizza industry (and quick-serve restaurant
industry in general) had matured and that the most sig-
nificant growth opportunities were beyond U.S. borders.
M05A_BARN0088_05_GE_CASE4.INDD 60 15/09/14 7:41 PM

Case 2–4: Papa John’s International, Inc. PC 2–61
and culture in the United States, some believed that a
Hispanic/Mexican-themed restaurant would allow the
company to benefit from this trend without impairing the
Papa John’s franchise.
Boston Market before disposing of its investments in
2006 and 2007, respectively. Yum! Brands, Inc., operated
Pizza Hut, Taco Bell, Kentucky Fried Chicken, and A&W.
With the growing influence of the Hispanic population
End Notes
1. Interview with John Schnatter, October 2008.
2. Ibid.
3. Ibid.
4. Ibid.
5. (2008) Hoover’s Profiles. Papa John’s International, Inc.
6. UBS London investor meeting on August 22, 2008.
7. Interview with John Schnatter, October 2008.
8. Hoover’s Profiles. Papa John’s International, Inc.
9. Interview with John Schnatter, October 2008.
10. Ibid.
11. Walkup, C. (1997). “John Schnatter.” Food Industry, January.
12. Papa John’s press release, May 20, 2008.
13. (2007). Pizza Today, November 19.
14. (2006). Pizza Today, October 16.
15. (2006). Pizza Today, January 17.
16. Papa John’s International, Inc., annual report 2007.
17. Walkup, C. (1997). “John Schnatter.” Food Industry, January.
18. UBS London investor meeting on August 22, 2008.
19. Ibid.
20. Standard & Poor’s Industry Surveys, September 4, 2008.
21. Ibid.
22. Ibid.
23. Interview with John Schnatter, October 2008.
24. Papa John’s press release, May 14, 2007.
25. Interview with John Schnatter, October 2008.
M05A_BARN0088_05_GE_CASE4.INDD 61 15/09/14 7:41 PM

M05A_BARN0088_05_GE_CASE4.INDD 62 15/09/14 7:41 PM

Corporate StrategieS 3
P a r t
M06_BARN0088_05_GE_C06.INDD 181 17/09/14 6:53 PM

182
1. Define vertical integration, forward vertical integra-
tion, and backward vertical integration.
2. Discuss how vertical integration can create value by
reducing the threat of opportunism.
3. Discuss how vertical integration can create value by
enabling a firm to exploit its valuable, rare, and costly-
to-imitate resources and capabilities.
Outsourcing r esearch
First it w as simple manufac turing—toys, dog f ood, and the like —that was outsourced to Asia.
This was OK because even though manufacturing could be outsourced to China and India, the
real value driver of the Western economy—services—could never be outsourced. Or at least that
was what we thought.
And then fir ms star ted outsourcing call c enters and tax pr eparation and tr avel planning
and a host of other services to India and the Philippines. Anything that could be done on a phone
or online, it seemed , could be done cheaper in A sia. Sometimes, the qualit y of the ser vice was
compromised, but with tr aining and additional t echnological development, maybe even these
problems c ould be addr essed. A nd this w as OK because the r eal v alue dr iver of the Western
economy—research and intellectual property—could never be outsourced. Or at least that was
what we thought.
Now, it tur ns out tha t some leading Western pharmaceutical firms—including Merck, Eli
Lilly, and Johnson & Johnson—have begun outsourcing some critical aspects of the pharmaceu-
tical research and development process to pharmaceutical firms in India. This seemed impossible
just a few years ago.
In the 1970s , India announced that it w ould not honor in ternational pharmaceutical pat-
ents. This policy decision had at least two important implications for the pharmaceutical industry
in India. First, it led t o the founding of thousands of generic drug manufacturers there—firms
that reverse engineered patented drugs pr oduced by U.S. and Western European pharmaceuti-
cal companies and then sold them on world markets for a fraction of their original price. Second,
virtually no phar maceutical research and dev elopment took place in I ndia. After all, why spend
4. Discuss how vertical integration can create value by
enabling a firm to retain its flexibility.
5. Describe conditions under which vertical integration
may be rare and costly to imitate.
6. Describe how the functional organization structure,
management controls, and compensation policies are
used to implement vertical integration.
L e a r n i n g O b j e c t i v e s After reading this chapter, you should be able to:
MyManagementLab®
improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
6
c h a P t e r
Vertical integration
M06_BARN0088_05_GE_C06.INDD 182 17/09/14 6:53 PM

183
all the time and money needed to develop a new drug when generic drug firms
would instan tly r everse eng ineer y our t echnology and under cut y our abilit y t o
make a profit?
All this changed in 2003 when the I ndian government reversed its policies
and began honor ing global phar maceutical pa tents. No w, f or the first time in
more than two decades, Indian firms could tap into their pool of highly educated
scientists and engineers and begin engaging in original research. But developing
the skills needed to do world-class pharmaceutical research on your own is diffi –
cult and time-consuming. So, Indian firms began searching for potential partners
in the West.
In the beginning, Western pharmaceutical companies outsourced only very
routine lab work to their new Indian partners. But many of these firms found that
their I ndian par tners w ere w ell-managed, with pot entially sig nificant t echnical
capability, and willing t o do more research-oriented kinds of work. Since 2007, a
surprisingly large number of Western pharmaceutical firms have begun outsourc-
ing progressively more important parts of the research and development process
to their Indian partners.
And wha t do the Western fir ms get out of this outsour cing? Not surprisingly—low
costs. I t c osts about $250,000 per y ear t o emplo y a P h.D. chemist in the West. That same
$250,000 buy s fiv e such scien tists in I ndia. F ive times as man y scien tists means tha t phar –
maceutical firms can develop and test more compounds faster by working with their I ndian
partners than they could do on their own. The mantra in R&D—“fail fast and cheap”—is more
easily r ealized when much of the ear ly t esting of pot ential drugs is done in I ndia and not
the West.
Of course, testing compounds developed by Western firms is not e xactly doing basic r e-
search in pharmaceuticals. Early results indicate that Indian R&D efforts in pharmaceuticals have
met with only limit ed success. For example, an allianc e between Eli Lilly and its I ndian partner,
Zydus, was called off in early 2012. Disappointing results have also emerged in alliances between
Merck and Novartis and their Indian partners. Also, recently the Indian government has begun to
not recognize global pharmaceutical patents and is contemplating putting price limits on some
drugs sold in I ndia. All this will pr obably make it mor e difficult f or true drug R&D t o emerge in
India. However, if I ndian firms can dev elop R&D capabilities, their lower costs may make them
attractive outsourcing parties for international pharmaceutical firms.
Sources: M. K ripalani and P . Engar dio (2003). “The r ise of I ndia.” BusinessWeek, D ecember 8, pp . 66+; K . J . D elaney (2003).
“Outsourcing jobs—and workers—to India.” The Wall Street Journal, October 13, pp. B1+; B. Eihhorn (2006). “A dragon in R&D.”
BusinessWeek, No vember 6, pp . 44+; P . Engar dio and A. Weintraub (2008). “Outsourcing the drug industr y.” BusinessWeek,
September 5, 2008, pp. 48–52; Peter Arnold, Inc. (2012). “Zydus, Eli Lilly drug discovery deal off.” The Economic Times, January 2;
J. Lamattina (2012). “It’s time to stop outsourcing Pharma R&D to India.” www.forbes.com/sites/Johnlamattina/2012/10/11/its-
time-to-stop-outsourcing-pharma-RD-to-India. Accessed August 20, 2013.
D
ar
re
n
Ba
ke
r/
Sh
ut
te
rs
to
ck
M06_BARN0088_05_GE_C06.INDD 183 17/09/14 6:53 PM

184 part 3: Corporate Strategies
t he decision to hire an offshore company to accomplish a specific business function is an example of a decision that determines the level of a firm’s vertical integration. This is the case whether the company that is hired to
perform these services is located in the United States or India.
What Is Corporate Strategy?
Vertical integration is the first corporate strategy examined in detail in this book.
As suggested in Chapter 1, business strategy is a firm’s theory of how to gain
competitive advantage in a single business or industry. The two business strategies
discussed in this book are cost leadership and product differentiation. Corporate
strategy is a firm’s theory of how to gain competitive advantage by operating in
several businesses simultaneously. Decisions about whether to vertically integrate
often determine whether a firm is operating in a single business or industry or in
multiple businesses or industries. Other corporate strategies discussed in this book
include strategic alliances, diversification, and mergers and acquisitions.
What Is Vertical Integration?
The concept of a firm’s value chain was first introduced in Chapter 3. As a re-
minder, a value chain is that set of activities that must be accomplished to bring a
product or service from raw materials to the point that it can be sold to a final cus-
tomer. A simplified value chain of the oil and gas industry, originally presented in
Figure 3.2, is reproduced in Figure 6.1.
A firm’s level of vertical integration is simply the number of steps in this
value chain that a firm accomplishes within its boundaries. Firms that are more
vertically integrated accomplish more stages of the value chain within their
boundaries than firms that are less vertically integrated. A more sophisticated ap-
proach to measuring the degree of a firm’s vertical integration is presented in the
Strategy in Depth feature.
A firm engages in backward vertical integration when it incorporates more
stages of the value chain within its boundaries and those stages bring it closer to
the beginning of the value chain, that is, closer to gaining access to raw materials.
When computer companies developed all their own software, they were engaging
in backward vertical integration because these actions are close to the beginning
of the value chain. When they began using independent companies operating in
India to develop this software, they were less vertically integrated backward.
A firm engages in forward vertical integration when it incorporates more
stages of the value chain within its boundaries and those stages bring it closer to
the end of the value chain; that is, closer to interacting directly with final customers.
When companies staffed and operated their own call centers in the United States, they
were engaging in forward vertical integration because these activities brought them
closer to the ultimate customer. When they started using independent companies in
India to staff and operate these centers, they were less vertically integrated forward.
Of course, in choosing how to organize its value chain, a firm has more
choices than whether to vertically integrate or not vertically integrate. Indeed,
between these two extremes a wide range of somewhat vertically integrated op-
tions exists. These alternatives include various types of strategic alliances and
joint ventures, the primary topic of Chapter 9.
M06_BARN0088_05_GE_C06.INDD 184 17/09/14 6:53 PM

Chapter 6: Vertical integration 185
Exploring for crude oil
Drilling for crude oil
Pumping crude oil
Shipping crude oil
Buying crude oil
Refining crude oil
Selling refined products to distributors
Shipping refined products
Selling refined products to final customers
Figure 6.1 A Simplified
Value Chain of Activities in the
Oil and Gas Industry
The Value of Vertical Integration
The question of vertical integration—which stages of the value chain should
be included within a firm’s boundaries and why—has been studied by many
scholars for almost 100 years. The reason this question has been of such inter-
est was first articulated by Nobel Prize–winning economist Ronald Coase. In
a famous article originally published in 1937, Coase asked a simple question:
Given how efficiently markets can be used to organize economic exchanges
among thousands, even hundreds of thousands, of separate individuals, why
would markets, as a method for managing economic exchanges, ever be re-
placed by firms? In markets, almost as if by magic, Adam Smith’s “invisible
hand” coordinates the quantity and quality of goods and services produced
with the quantity and quality of goods and services demanded through the
adjustment of prices—all without a centralized controlling authority. However,
in firms, centralized bureaucrats monitor and control subordinates who, in
turn, battle each other for “turf” and control of inefficient internal “fiefdoms.”
Why would the “beauty” of the invisible hand ever be replaced by the clumsy
“visible hand” of the modern corporation?1
V R I O
M06_BARN0088_05_GE_C06.INDD 185 17/09/14 6:53 PM

186 part 3: Corporate Strategies
It is sometimes possible to observe which stages of the value chain
a firm is engaging in and, thus, the
level of that firm’s vertical integra-
tion. Sometimes, however, it is more
difficult to directly observe a firm’s
level of vertical integration. This is
especially true when a firm believes
that its level of vertical integration is a
potential source of competitive advan-
tage. In this case, the firm would not
likely reveal this information freely to
competitors.
In this situation, it is possible
to get a sense of the degree of a firm’s
vertical integration—though not a
complete list of the steps in the value
chain integrated by the firm—from a
close examination of the firm’s value
added as a percentage of sales. Valued
added as a percentage of sales mea-
sures that percentage of a firm’s sales
that is generated by activities done
within the boundaries of a firm. A firm
with a high ratio between value added
and sales has brought many of the
value-creating activities associated
with its business inside its boundaries,
consistent with a high level of vertical
integration. A firm with a low ratio
between value added and sales does
not have, on average, as high a level of
vertical integration.
Value added as a percentage of
sales is computed using the following
equation in Exhibit 1.
The sum of net income and
income taxes is subtracted in both
the numerator and the denominator
in this equation to control for infla-
tion and changes in the tax code over
time. Net income, income taxes, and
sales can all be taken directly from a
firm’s profit and loss statement. Value
added can be calculated using the
equation in Exhibit 2.
Again, most of the numbers
needed to calculate value added can
be found either in a firm’s profit and
loss statement or in its balance sheet.
Sources: A. Laffer (1969). “Vertical integration by
corporations: 1929–1965.” Review of Economics and
Statistics, 51, pp. 91–93; I. Tucker and R. P. Wilder
(1977). “Trends in vertical integration in the U.S.
manufacturing sector.” Journal of Industrial Economics,
26, pp. 81–94; K. Harrigan (1986). “Matching vertical
integration strategies to competitive conditions.”
Strategic Management Journal, 7, pp. 535–555.
Measuring Vertical Integration
Strategy in Depth
exhibit 1
vertical integrationi =
value addedi – 1net incomei + income taxesi2
salesi – 1net incomei + income taxesi2
where,
vertical integrationi = the level of vertical integration for firmi
value addedi = the level of value added for firmi
net informi = the level of net income for firmi
income taxesi = firmi>s income taxes
salesi = firmi>s sales
exhibit 2
value added = depreciation + amortization + fixed charges + interest expense
+ labor and related expenses + pension and retirement
expenses + income taxes + net income 1after taxes2
+ rental expense
M06_BARN0088_05_GE_C06.INDD 186 17/09/14 6:53 PM

Chapter 6: Vertical integration 187
Coase began to answer his own question when he observed that sometimes
the cost of using a market to manage an economic exchange must be higher than the
cost of using vertical integration and bringing an exchange within the boundary of a
firm. Over the years, efforts have focused on identifying the conditions under which
this would be the case. The resulting work has described several different situations
where vertical integration can either increase a firm’s revenues or decrease its costs
compared with not vertically integrating, that is, several situations where vertical
integration can be valuable. The following sections present three of the most influ-
ential of these explanations of when vertical integration can create value for a firm.
Vertical Integration and the Threat of Opportunism
One of the best-known explanations of when vertical integration can be valu-
able focuses on using vertical integration to reduce the threat of opportunism.2
Opportunism exists when a firm is unfairly exploited in an exchange. Examples
of opportunism include when a party to an exchange expects a high level of qual-
ity in a product it is purchasing, only to discover it has received a lower level of
quality than it expected; when a party to an exchange expects to receive a service
by a particular point in time and that service is delivered late (or early); and when
a party to an exchange expects to pay a price to complete this exchange and its
exchange partner demands a higher price than what was previously agreed.
Obviously, when one of its exchange partners behaves opportunistically, this
reduces the economic value of a firm. One way to reduce the threat of opportun-
ism is to bring an exchange within the boundary of a firm, that is, to vertically
integrate into this exchange. This way, managers in a firm can monitor and con-
trol this exchange instead of relying on the market to manage it. If the exchange
that is brought within the boundary of a firm brings a firm closer to its ultimate
suppliers, it is an example of backward vertical integration. If the exchange that
is brought within the boundary of a firm brings a firm closer to its ultimate cus-
tomer, it is an example of forward vertical integration.
Of course, firms should only bring market exchanges within their boundar-
ies when the cost of vertical integration is less than the cost of opportunism. If
the cost of vertical integration is greater than the cost of opportunism, then firms
should not vertically integrate into an exchange. This is the case for both back-
ward and forward vertical integration decisions.
So, when will the threat of opportunism be large enough to warrant vertical
integration? Research has shown that the threat of opportunism is greatest when
a party to an exchange has made transaction-specific investments. A transaction-
specific investment is any investment in an exchange that has significantly more
value in the current exchange than it does in alternative exchanges. Perhaps the
easiest way to understand the concept of a transaction-specific investment is
through an example.
Consider the economic exchange between an oil refining company and an
oil pipeline building company, which is depicted in Figure 6.2. As can be seen
in the figure, this oil refinery is built on the edge of a deep-water bay. Because of
this, the refinery has been receiving supplies of crude oil from large tanker ships.
However, an oil field exists several miles distant from the refinery, but the only
way to transport crude oil from the oil field to the refinery is with trucks—a very
expensive way to move crude oil, especially compared to large tankers. But if the
oil refining company could find a way to get crude oil from this field cheaply, it
would probably make this refinery even more valuable.
M06_BARN0088_05_GE_C06.INDD 187 17/09/14 6:53 PM

188 part 3: Corporate Strategies
Enter the pipeline company. Suppose this pipeline company approaches the
refinery and offers to build a pipeline from the oil field to the refinery. In return,
all the pipeline company expects is for the refinery to promise to buy a certain
number of barrels of crude at an agreed-to price for some period of time, say, five
years, through the pipeline. If reasonable prices can be negotiated, the oil refinery
is likely to find this offer attractive, for the cost of crude oil carried by the pipeline
is likely to be lower than the cost of crude oil delivered by ship or by truck. Based
on this analysis, the refinery and the oil pipeline company are likely to cooperate
and the pipeline is likely to be built.
Now, five years go by, and it is time to renegotiate the contract. Which of
these two firms has made the largest transaction-specific investments? Remember
that a transaction-specific investment is any investment in an exchange that is
more valuable in that particular exchange than in alternative exchanges.
What specific investments has the refinery made? Well, how much is this
refinery worth if this exchange with the pipeline company is not renewed? Its
value would probably drop some because oil through the pipeline is probably
cheaper than oil through ships or trucks. So, if the refinery doesn’t use the pipe-
line any longer, it will have to use these alternative supplies. This will reduce its
value some—say, from $1 million to $900,000. This $100,000 difference is the size
of the transaction-specific investment made by the refining company.
However, the transaction-specific investment made by the pipeline firm
is probably much larger. Suppose the pipeline is worth $750,000 as long as it is
pumping oil to the refinery. But if it is not pumping oil, how much is it worth?
Not very much. An oil pipeline that is not pumping oil has limited alternative
uses. It has value either as scrap or (perhaps) as the world’s largest enclosed wa-
ter slide. If the value of the pipeline is only $10,000 if it is not pumping oil to the
Oil refinery built
on the edge of
a deep-water bayOil tanker ship Oil tank truck
Oil pipeline
Oil field
Figure 6.2 The Exchange
Between an Oil Refinery and an
Oil Pipeline Company
M06_BARN0088_05_GE_C06.INDD 188 17/09/14 6:53 PM

Chapter 6: Vertical integration 189
refinery, then the level of transaction-specific investment made by the pipeline
firm is substantially larger than that made by the firm that owns the refinery:
$750,000 – $10,000, or $740,000, for the pipeline company versus $100,000 for the
refining company.
So, which company is at greater risk of opportunism when the contract
is renegotiated—the refinery or the pipeline company? Obviously, the pipeline
company has more to lose. If it cannot come to an agreement with the oil refining
company, it will lose $740,000. If the refinery cannot come to an agreement with
the pipeline company, it will lose $100,000. Knowing this, the refining company
can squeeze the pipeline company during the renegotiation by insisting on lower
prices or more timely deliveries of higher-quality crude oil, and the pipeline com-
pany really cannot do much about it.
Of course, managers in the pipeline firm are not stupid. They know that
after the first five years of their exchange with the refining company they will
be in a very difficult bargaining position. So, in anticipation, they will insist on
much higher prices for building the oil pipeline in the first place than would oth-
erwise be the case. This will drive up the cost of building the pipeline, perhaps to
the point that it is no longer cheaper than getting crude oil from ships. If this is
the case, then the pipeline will not be built, even though if it could be built and
the threat of opportunism eliminated, both the refining company and the pipeline
company would be better off.
One way to solve this problem is for the oil refining company to buy the oil
pipeline company—that is, for the oil refinery to backward vertically integrate.3
When this happens, the incentive for the oil refinery to exploit the vulnerability of
the pipeline company will be reduced. After all, if the refinery business tries to rip
off the pipeline business, it only hurts itself because it owns the pipeline business.
This, then, is the essence of opportunism-based explanations of when vertical
integration creates value: Transaction-specific investments make parties to an ex-
change vulnerable to opportunism, and vertical integration solves this vulnerability
problem. Using language developed in Chapter 3, this approach suggests that verti-
cal integration is valuable when it reduces threats from a firm’s powerful suppliers
or powerful buyers due to any transaction-specific investments a firm has made.
This logic explains part of the vertical integration decisions made by U.S.
pharmaceutical firms discussed in the opening case of this chapter. As the risks
of opportunism associated with outsourcing to Indian partners fell, U.S. pharma-
ceutical companies felt more comfortable gaining access to the low costs of Indian
firms, and outsourcing increased.
Vertical Integration and Firm Capabilities
A second approach to vertical integration decisions focuses on a firm’s capabili-
ties and its ability to generate sustained competitive advantages.4 This approach
has two broad implications. First, it suggests that firms should vertically integrate
into those business activities where they possess valuable, rare, and costly-to-
imitate resources and capabilities. This way, firms can appropriate at least some
of the profits that using these capabilities to exploit environmental opportunities
will create. Second, this approach also suggests that firms should not vertically in-
tegrate into business activities where they do not possess the resources necessary
to gain competitive advantages. Such vertical integration decisions would not be
a source of profits to a firm, because it does not possess any of the valuable, rare,
or costly-to-imitate resources needed to gain competitive advantages in these
M06_BARN0088_05_GE_C06.INDD 189 17/09/14 6:53 PM

190 part 3: Corporate Strategies
business activities. Indeed, to the extent that some other firms have competitive
advantages in these business activities, vertically integrating into them could put
a firm at a competitive disadvantage.
This, then, is the essence of the capabilities approach to vertical integration: If a
firm possesses valuable, rare, and costly-to-imitate resources in a business activity, it
should vertically integrate into that activity; otherwise, no vertical integration. This
perspective can sometimes lead to vertical integration decisions that conflict with
decisions derived from opportunism-based explanations of vertical integration.
Consider, for example, firms acting as suppliers to Wal-Mart. Wal-Mart has
a huge competitive advantage in the discount retail industry. In principle, firms
that sell to Wal-Mart could vertically integrate forward into the discount retail
market to sell their own products. That is, these firms could begin to compete
against Wal-Mart. However, such efforts are not likely to be a source of competi-
tive advantage for these firms. Wal-Mart’s resources and capabilities are just too
extensive and costly to imitate for most of these suppliers. So, instead of forward
vertical integration, most of these firms sell their products through Wal-Mart.
Of course, the problem is that by relying so much on Wal-Mart, these firms
are making significant transaction-specific investments. If they stop selling to
Wal-Mart, they may go out of business. However, this decision will have a limited
impact on Wal-Mart. Wal-Mart can go to any number of suppliers around the world
that are willing to replace this failed firm. So, Wal-Mart’s suppliers are at risk of
opportunism in this exchange, and indeed, it is well-known that Wal-Mart can
squeeze its suppliers, in terms of the quality of the products it purchases, the price
at which it purchases them, and the way in which these products are delivered.
So the tension between these two approaches to vertical integration becomes
clear. Concerns about opportunism suggest that Wal-Mart’s suppliers should ver-
tically integrate forward. Concerns about having a competitive disadvantage if
they do vertically integrate forward suggest that Wal-Mart’s suppliers should not
vertically integrate. So, should they or shouldn’t they vertically integrate?
Not many of Wal-Mart’s suppliers have been able to resolve this diffi-
cult problem. Most do not vertically integrate into the discount retail industry.
However, they try to reduce the level of transaction-specific investment they
make with Wal-Mart by supplying other discount retailers, both in the United
States and abroad. They also try to use their special capabilities to differentiate
their products so much that Wal-Mart’s customers insist on Wal-Mart selling these
products. And these firms constantly search for cheaper ways to make and dis-
tribute higher-quality products.
This capabilities analysis explains why outsourcing all of U.S. pharmaceuti-
cal research to low-cost Indian companies—discussed in the opening case of this
chapter—has not occurred. It turns out that those basic R&D capabilities are very dif-
ficult to develop, and while Indian firms can engage in less sophisticated compound
testing, they are not yet sufficiently skilled to engage in basic R&D. The result—U.S.
pharmaceutical firms are very tentative about outsourcing their basic R&D.
Vertical Integration and Flexibility
A third perspective on vertical integration focuses on the impact of this decision
on a firm’s flexibility. Flexibility refers to how costly it is for a firm to alter its
strategic and organizational decisions. Flexibility is high when the cost of chang-
ing strategic choices is low; flexibility is low when the cost of changing strategic
choices is high.
M06_BARN0088_05_GE_C06.INDD 190 17/09/14 6:53 PM

Chapter 6: Vertical integration 191
So, which is less flexible—vertical integration or no vertical integration?
Research suggests that, in general, vertically integrating is less flexible than not
vertically integrating.5 This is because once a firm has vertically integrated, it
has committed its organizational structure, its management controls, and its
compensation policies to a particular vertically integrated way of doing business.
Undoing this decision often means changing these aspects of an organization.
Suppose, for example, that a vertically integrated firm decides to get out
of a particular business. To do so, the firm will have to sell or close its factories
(actions that can adversely affect both the employees it has to lay off and those
that remain), alter its supply relationships, hurt customers that have come to
rely on it as a partner, and change its internal reporting structure. In contrast, if
a non-vertically integrated firm decides to get out of a business, it simply stops.
It cancels whatever contracts it might have had in place and ceases operations in
that business. The cost of exiting a non-vertically integrated business is generally
much lower than the cost of exiting a vertically integrated business.
Of course, flexibility is not always valuable. In fact, flexibility is only valu-
able when the decision-making setting a firm is facing is uncertain. A decision-
making setting is uncertain when the future value of an exchange cannot be
known when investments in that exchange are being made. In such settings, less
vertical integration is better than more vertical integration. This is because verti-
cally integrating into an exchange is less flexible than not vertically integrating
into an exchange. If an exchange turns out not to be valuable, it is usually more
costly for firms that have vertically integrated into an exchange to exit that ex-
change compared with those that have not vertically integrated.
Consider, for example, a pharmaceutical firm making investments in bio-
technology. The outcome of biotechnology research is very uncertain. If a phar-
maceutical company vertically integrates into a particular type of biotechnology
research by hiring particular types of scientists, building an expensive laboratory,
and developing the other skills necessary to do this particular type of biotechnol-
ogy research, it has made a very large investment. Now suppose that this research
turns out not to be profitable. This firm has made huge investments that now
have little value. As important, it has failed to make investments in other areas of
biotechnology that could turn out to be valuable.
A flexibility-based approach to vertical integration suggests that rather than
vertically integrating into a business activity whose value is highly uncertain, firms
should not vertically integrate but should instead form a strategic alliance to manage
this exchange. A strategic alliance is more flexible than vertical integration but still
gives a firm enough information about an exchange to estimate its value over time.
An alliance has a second advantage in this setting. The downside risks as-
sociated with investing in a strategic alliance are known and fixed. They equal the
cost of creating and maintaining the alliance. If an uncertain investment turns out
not to be valuable, parties to this alliance know the maximum amount they can
lose—an amount equal to the cost of creating and maintaining the alliance. On the
other hand, if this exchange turns out to be very valuable, then maintaining an al-
liance can give a firm access to this huge upside potential. This partially explains
why, to the extent that U.S. pharmaceutical firms outsource basic R&D to Indian
partners, they do so through joint ventures. These aspects of strategic alliances
will be discussed in more detail in Chapter 9.
Each of these explanations of vertical integration has received significant
empirical attention in the academic literature. Some of these studies are described
in the Research Made Relevant feature.
M06_BARN0088_05_GE_C06.INDD 191 17/09/14 6:53 PM

192 part 3: Corporate Strategies
Applying the Theories to the Management of Call Centers
One of the most common business functions to be outsourced, and even off-
shored, is a firm’s call center activities. So, what do these three theories say about
how call centers should be managed: When should they be brought within the
boundaries of a firm, and when should they be outsourced? Each of these theories
will be discussed in turn.
t ransaction-s pecific investments and Managing c all c enters
When applying opportunism-based explanations of vertical integration, start by
looking for actual or potential transaction-specific investments that would need to
be made in order to complete an exchange. High levels of such investments sug-
gest the need for vertical integration; low levels of such investments suggest that
vertically integrating this exchange is not necessary.
When the call-center approach to providing customer service was first devel-
oped in the 1980s, it required substantial levels of transaction-specific investment.
First, a great deal of special-purpose equipment had to be purchased. And although
this equipment could be used for any call center, it had little value except within a
call center. Thus, this equipment was an example of a somewhat specific investment.
More important, in order to provide service in call centers, call-center
employees would have to be fully aware of all the problems likely to emerge
O f the three explanations of ver-tical integration discussed here,
opportunism-based explanations are
the oldest and thus have received the
greatest empirical support. One review
of this empirical work, by Professor
Joe Mahoney of the University of
Illinois, observes that the core assertion
of this approach—that high levels of
transaction-specific investment lead to
higher levels of vertical integration—
receives consistent empirical support.
More recent work has begun to
examine the trade-offs among these
three explanations of vertical inte-
gration by examining their effects on
vertical integration simultaneously.
For example, Professor Tim Folta of
Purdue University examined the op-
portunism and flexibility approaches
to vertical integration simultaneously.
His results show that the basic asser-
tion of the opportunism approach still
holds. However, when he incorporates
uncertainty into his empirical analysis,
he finds that firms engage in less verti-
cal integration than predicted by op-
portunism by itself. In other words,
firms apparently worry not only about
transaction-specific investments when
they make vertical integration choices;
they also worry about how costly it
is to reverse those investments in the
face of high uncertainty.
An even more recent study by
Michael Leiblein from The Ohio State
University and Doug Miller from the
University of Illinois examines all three
of these explanations of vertical inte-
gration simultaneously. These authors
studied vertical integration decisions
in the semiconductor manufacturing
industry and found that all three ex-
planations hold. That is, firms in this in-
dustry worry about transaction-specific
investment, the capabilities they pos-
sess, the capabilities they would like to
possess, and the uncertainty of the mar-
kets within which they operate when
they make vertical integration choices.
Sources: J. Mahoney (1992). “The choice of organi-
zational form: Vertical financial ownership versus
other methods of vertical integration.” Strategic
Management Journal, 13, pp. 559–584; T. Folta
(1998). “Governance and uncertainty: The trade-off
between administrative control and commitment.”
Strategic Management Journal, 19, pp. 1007–1028;
M. Leiblein and D. Miller (2003). “An empirical ex-
amination of transaction- and firm-level influences
on the vertical boundaries of the firm.” Strategic
Management Journal, 24(9), pp. 839–859.
Empirical Tests of Theories
of Vertical Integration
research Made relevant
M06_BARN0088_05_GE_C06.INDD 192 17/09/14 6:54 PM

Chapter 6: Vertical integration 193
with the use of a firm’s products. This requires a firm to study its products very
closely and then to train call-center employees to be able to respond to any
problems customers might have. This training was sometimes very complex and
time-consuming and represented substantial transaction-specific investments
on the part of call-center employees. Only employees that worked full time
for a large corporation—where job security was usually high for productive
workers—would be willing to make these kinds of specific investments. Thus,
vertical integration into call-center management made a great deal of sense.
However, as information technology improved, firms found it was possible
to train call-center employees much faster. Now, all call-center employees had to
do was follow scripts that were prewritten and preloaded onto their computers. By
asking a few scripted questions, call-center employees could diagnose most prob-
lems. In addition, solutions to those problems were also included on an employee’s
computer. Only really unusual problems could not be handled by employees work-
ing off these computer scripts. Because the level of specific investment required to
use these scripts was much lower, employees were willing to work for companies
without the job security usually associated with large firms. Indeed, call centers be-
came good part-time and temporary employment opportunities. Because the level
of specific investment required to work in these call centers was much lower, not
vertically integrating into call-center management made a great deal of sense.
c apabilities and Managing c all c enters
In opportunism-based explanations of vertical integration, you start by looking
for transaction-specific investments and then make vertical integration decisions
based on these investments. In capability-based approaches, you start by looking
for valuable, rare, and costly-to-imitate resources and capabilities and then make
vertical integration decisions appropriately.
In the early days of call-center management, how well a firm operated its
call centers could actually be a source of competitive advantage. During this time
period, the technology was new, and the training required to answer a customer’s
questions was extensive. Firms that developed special capabilities in managing
these processes could gain competitive advantages and thus would vertically in-
tegrate into call-center management.
However, over time, as more and more call-center management suppliers
were created and as the technology and training required to staff a call center be-
came more widely available, the ability of a call center to be a source of competitive
advantage for a firm dropped. That is, the ability to manage a call center was still
valuable, but it was no longer rare or costly to imitate. In this setting, it is not sur-
prising to see firms getting out of the call-center management business, outsourcing
this business to low-cost specialist firms, and focusing on those business functions
where they might be able to gain a sustained competitive advantage.
Flexibility and Managing c all c enters
Opportunism logic suggests starting with a search for transaction-specific invest-
ments; capabilities logic suggests starting with a search for valuable, rare, and
costly-to-imitate resources and capabilities. Flexibility logic suggests starting by
looking for sources of uncertainty in an exchange.
One of the biggest uncertainties in providing customer service through call
centers is the question of whether the people staffing the phones actually help a
firm’s customers. This is a particularly troubling concern for firms that are sell-
ing complex products that can have numerous types of problems. A variety of
M06_BARN0088_05_GE_C06.INDD 193 17/09/14 6:54 PM

194 part 3: Corporate Strategies
technological solutions have been developed to try to address this uncertainty.
But, if a firm vertically integrates into the call-center management business, it is
committing to a particular technological solution. This solution may not work, or
it may not work as well as some other solutions.
In the face of this uncertainty, maintaining relationships with several differ-
ent call-center management companies—each of whom have adopted different
technological solutions to the problem of how to use call-center employees to assist
customers who are using very complex products—gives a firm technological flexibil-
ity that it would not otherwise have. Once a superior solution is identified, then a firm
no longer needs this flexibility and may choose to vertically integrate into call-center
management or not, depending on opportunism and capabilities considerations.
Integrating Different Theories of Vertical Integration
At first glance, having three different explanations about how vertical integration
can create value seems troubling. After all, won’t these explanations sometimes
contradict each other?
The answer to this question is yes. We have already seen such a contradic-
tion in the case of opportunism and capabilities explanations of whether Wal-Mart
suppliers should forward vertically integrate into the discount retail industry.
However, more often than not, these three explanations are complementary
in nature. That is, each approach generally leads to the same conclusion about
how a firm should vertically integrate. Moreover, sometimes it is simply easier
to apply one of these approaches to evaluate a firm’s vertical integration choices
than the other two. Having a “tool kit” that includes three explanations of vertical
integration enables the analyst to choose the approach that is most likely to be a
source of insight in a particular situation.
Even when these explanations make contradictory assertions about vertical
integration, having multiple approaches can be helpful. In this context, having
multiple explanations can highlight the trade-offs that a firm is making when
choosing its vertical integration strategy. Thus, for example, if opportunism-
based explanations suggest that vertical integration is necessary because of high
transaction-specific investments, capabilities-based explanations caution about
the cost of developing the resources and capabilities necessary to vertically inte-
grate and flexibility concerns caution about the risks that committing to vertical
integration imply, and the costs and benefits of whatever vertical integration de-
cision is ultimately made can be understood very clearly.
Overall, having three explanations of vertical integration has several advan-
tages for those looking to analyze the vertical integration choices of real firms. Of
course, applying these explanations can create important ethical dilemmas for a
firm, especially when it becomes clear that a firm needs to become less vertically
integrated than it has historically been. Some of these dilemmas are discussed in
the Ethics and Strategy feature.
Vertical Integration and Sustained
Competitive Advantage
Of course, in order for vertical integration to be a source of sustained competi-
tive advantage, not only must it be valuable (because it responds to threats of
opportunism; enables a firm to exploit its own or other firms’ valuable, rare, and
V R I O
M06_BARN0088_05_GE_C06.INDD 194 17/09/14 6:54 PM

Chapter 6: Vertical integration 195
costly-to-imitate resources; or gives a firm flexibility), it must also be rare and costly
to imitate, and a firm must be organized to implement it correctly.
The Rarity of Vertical Integration
A firm’s vertical integration strategy is rare when few competing firms are able to
create value by vertically integrating in the same way. A firm’s vertical integration
strategy can be rare because it is one of a small number of competing firms that is
able to vertically integrate efficiently or because it is one of a small number of firms
that is able to adopt a non-vertically integrated approach to managing an exchange.
r are vertical integration
A firm may be able to create value through vertical integration, when most of its
competitors are not able to, for at least three reasons. Not surprisingly, these reasons
parallel the three explanations of vertical integration presented in this chapter.
Imagine a firm that has successfully operated in a vertically integrated
manner for decades. Employees come
to work, they know their jobs, they
know how to work together effectively,
they know where to park. The job is
not just the economic center of their
lives; it has become the social center as
well. Most of their friends work in the
same company, in the same function,
as they do. The future appears to be
much as the past—stable employment
and effective work, all aiming toward
a comfortable and well-planned retire-
ment. And then the firm adopts a new
outsourcing strategy. It changes its ver-
tical integration strategy by becoming
less vertically integrated and purchas-
ing services from outside suppliers
that it used to obtain internally.
The economics of outsourcing
can be compelling. Outsourcing can
help firms reduce costs and focus their
efforts on those business functions that
are central to their competitive advan-
tage. When done well, outsourcing cre-
ates value—value that firms can share
with their owners, their stockholders.
Indeed, outsourcing is becoming
a trend in business. Some observers
predict that by 2015, an additional 3.3
million jobs in the United States will
be outsourced, many to operations
overseas.
But what of the employees
whose jobs are taken away? What of
their lifetime of commitment, their
steady and reliable work? What of
their stable and secure retirement?
Outsourcing often devastates lives,
even as it creates economic value. Of
course, some firms go out of their
way to soften the impact of outsourc-
ing on their employees. Those that
are near retirement age are often
given an opportunity to retire early.
Others receive severance payments in
recognition of their years of service.
Other firms hire “outplacement”
companies—firms that specialize in
placing suddenly unemployed people
in new jobs and new careers.
But all these efforts to soften
the blow do not make the blow go
away. Many employees assume that
they have an implicit contract with
the firms they work for. That con-
tract is: “As long as I do my job
well, I will have a job.” That contract
is being replaced with: “As long as
a firm wants to employ me, I will
have a job.” In such a world, it is
not surprising that many employees
now look first to maintain their em-
ployability in their current job—by
receiving additional training and ex-
periences that might be valuable at
numerous other employers—and are
concerned less with what they can
do to improve the performance of
the firm they work for.
Sources: S. Steele-Carlin (2003). “Outsourcing
poised for growth in 2002.” FreelanceJobsNews.com,
October 20; (2003). “Who wins in off-shoring?”
McKinseyQuarterly.com, October 20.
ethics and Strategy
The Ethics of Outsourcing
M06_BARN0088_05_GE_C06.INDD 195 17/09/14 6:54 PM

196 part 3: Corporate Strategies
r are t ransaction-s pecific investment and v ertical integration. First, a firm may have
developed a new technology or a new approach to doing business that requires its
business partners to make substantial transaction-specific investments. Firms that
engage in these activities will find it in their self-interest to vertically integrate,
whereas firms that have not engaged in these activities will not find it in their self-
interest to vertically integrate. If these activities are rare and costly to imitate, they
can be a source of competitive advantage for a vertically integrating firm.
For example, many firms in the computer industry are offshoring some of their
key business functions. However, one firm—Dell—brought one of these functions—
its technical call center for business customers—back from India and re-vertically
integrated it into its business function.6 The problems faced by corporate customers
are typically much more complicated than those faced by individual consumers.
Thus, it is much more difficult to provide call-center employees with the training
they need to address corporate problems. Moreover, because corporate technologies
change more rapidly than many consumer technologies, keeping call-center em-
ployees up to date on how to service corporate customers is also more complicated
than having call-center employees provide services to its noncorporate customers.
Because Dell needs the people staffing its corporate call centers to make substantial
specific investments in its technology and in understanding its customers, it has
found it necessary to bring these individuals within the boundaries of the firm and
to re-vertically integrate the operation of this particular type of service center.
If Dell, through this vertical integration decision, is able to satisfy its cus-
tomers more effectively than its competitors and if the cost of managing this call
center is not too high, then this vertical integration decision is both valuable and
rare and thus a source of at least a temporary competitive advantage for Dell.
r are c apabilities and v ertical integration. A firm such as Dell might also conclude
that it has unusual skills, either in operating a call center or in providing the train-
ing that is needed to staff certain kinds of call centers. If those capabilities are
valuable and rare, then vertically integrating into businesses that exploit these
capabilities can enable a firm to gain at least a temporary competitive advantage.
Indeed, the belief that a firm possesses valuable and rare capabilities is often a
justification for rare vertical integration decisions in an industry.
r are Uncertainty and v ertical integration. Finally, a firm may be able to gain an
advantage from vertically integrating when it resolves some uncertainty it faces
sooner than its competition. Suppose, for example, that several firms in an indus-
try all begin investing in a very uncertain technology. Flexibility logic suggests
that, to the extent possible, these firms will prefer to not vertically integrate into
the manufacturing of this technology until its designs and features stabilize and
market demand for this technology is well established.
However, imagine that one of these firms is able to resolve these uncertain-
ties before any other firm. This firm no longer needs to retain the flexibility that
is so valuable under conditions of uncertainty. Instead, this firm might be able to,
say, design special-purpose machines that can efficiently manufacture this tech-
nology. Such machines are not flexible, but they can be very efficient.
Of course, outside vendors would have to make substantial transaction-
specific investments to use these machines. Outside vendors may be reluctant to
make these investments. In this setting, this firm may find it necessary to verti-
cally integrate to be able to use its machines to produce this technology. Thus, this
firm, by resolving uncertainty faster than its competitors, is able to gain some of
the advantages of vertical integration sooner than its competitors. Whereas the
M06_BARN0088_05_GE_C06.INDD 196 17/09/14 6:54 PM

Chapter 6: Vertical integration 197
competition is still focusing on flexibility in the face of uncertainty, this firm gets
to focus on production efficiency in meeting customers’ product demands. This
can obviously be a source of competitive advantage.
r are vertical Dis-integration
Each of the examples of vertical integration and competitive advantage described
so far has focused on a firm’s ability to vertically integrate to create competitive
advantage. However, firms can also gain competitive advantages through their
decisions to vertically dis-integrate, that is, through the decision to outsource
an activity that used to be within the boundaries of the firm. Whenever a firm is
among the first in its industry to conclude that the level of specific investment
required to manage an economic exchange is no longer high, or that a particular
exchange is no longer rare or costly to imitate, or that the level of uncertainty about
the value of an exchange has increased, it may be among the first in its industry to
vertically dis-integrate this exchange. Such activities, to the extent they are valu-
able, will be rare and, thus, a source of at least a temporary competitive advantage.
The Imitability of Vertical Integration
The extent to which these rare vertical integration decisions can be sources of sus-
tained competitive advantage depends, as always, on the imitability of the rare
resources that give a firm at least a temporary competitive advantage. Both direct
duplication and substitution can be used to imitate another firm’s valuable and
rare vertical integration choices.
Direct Duplication of vertical integration
Direct duplication occurs when competitors develop or obtain the resources and
capabilities that enable another firm to implement a valuable and rare vertical
integration strategy. To the extent that these resources and capabilities are path
dependent, socially complex, or causally ambiguous, they may be immune from
direct duplication and, thus, a source of sustained competitive advantage.
With respect to offshoring business functions, it seems that the very popu-
larity of this strategy suggests that it is highly imitable. Indeed, this strategy is
becoming so common that firms that move in the other direction by vertically in-
tegrating a call center and managing it in the United States (like Dell) make news.
But the fact that many firms are implementing this strategy does not mean
that they are all equally successful in doing so. These differences in performance
may reflect some subtle and complex capabilities that some of these outsourcing
firms possess but others do not. These are the kinds of resources and capabilities
that may be sources of sustained competitive advantage.
Some of the resources that might enable a firm to implement a valuable and
rare vertical integration strategy may not be susceptible to direct duplication.
These might include a firm’s ability to analyze the attributes of its economic ex-
changes and its ability to conceive and implement vertical integration strategies.
Both of these capabilities may be socially complex and path dependent—built up
over years of experience.
s ubstitutes for vertical integration
The major substitute for vertical integration—strategic alliances—is the major
topic of Chapter 9. An analysis of how strategic alliances can substitute for verti-
cal integration will be delayed until then.
M06_BARN0088_05_GE_C06.INDD 197 17/09/14 6:54 PM

198 part 3: Corporate Strategies
Organizing to Implement Vertical Integration
Organizing to implement vertical integration involves the same organizing tools
as implementing any business or corporate strategy: organizational structure,
management controls, and compensation policies.
Organizational Structure and Implementing Vertical Integration
The organizational structure that is used to implement a cost leadership and product
differentiation strategy—the functional, or U-form, structure—is also used to imple-
ment a vertical integration strategy. Indeed, each of the exchanges included within
the boundaries of a firm as a result of vertical integration decisions are incorporated
into one of the functions in a functional organizational structure. Decisions about
which manufacturing activities to vertically integrate into determine the range and
responsibilities of the manufacturing function within a functionally organized firm;
decisions about which marketing activities to vertically integrate into determine the
range and responsibilities of the marketing function within a functionally organized
firm; and so forth. Thus, in an important sense, vertical integration decisions made
by a firm determine the structure of a functionally organized firm.
The chief executive officer (CEO) in this vertically integrated, function-
ally organized firm has the same two responsibilities that were first identified in
Chapter 4: strategy formulation and strategy implementation. However, these two
responsibilities take on added dimensions when implementing vertical integration
decisions. In particular, although the CEO must take the lead in making decisions
about whether each individual function should be vertically integrated into a firm,
this person must also work to resolve conflicts that naturally arise between verti-
cally integrated functions. The particular roles of the CEO in smaller entrepreneur-
ial firms are described in the Strategy in the Emerging Enterprise feature.
r esolving Functional c onflicts in a vertically integrated Firm
From a CEO’s perspective, coordinating functional specialists to implement a
vertical integration strategy almost always involves conflict resolution. Conflicts
among functional managers in a U-form organization are both expected and nor-
mal. Indeed, if there is no conflict among certain functional managers in a U-form
organization, then some of these managers probably are not doing their jobs. The
task facing the CEO is not to pretend this conflict does not exist or to ignore it, but
to manage it in a way that facilitates strategy implementation.
Consider, for example, the relationship between manufacturing and sales
managers. Typically, manufacturing managers prefer to manufacture a single
product with long production runs. Sales managers, however, generally prefer
to sell numerous customized products. Manufacturing managers generally do
not like large inventories of finished products; sales managers generally prefer
large inventories of finished products that facilitate rapid deliveries to customers.
If these various interests of manufacturing and sales managers do not, at least
sometimes, come into conflict in a vertically integrated U-form organization, then
the manufacturing manager is not focusing enough on cost reduction and quality
improvement in manufacturing or the sales manager is not focusing enough on
meeting customer needs in a timely way or both.
Numerous other conflicts arise among functional managers in a vertically
integrated U-form organization. Accountants often focus on maximizing manage-
rial accountability and close analysis of costs; research and development manag-
ers may fear that such accounting practices will interfere with innovation and
V R I O
M06_BARN0088_05_GE_C06.INDD 198 17/09/14 6:54 PM

Chapter 6: Vertical integration 199
creativity. Finance managers often focus on the relationship between a firm and
its external capital markets; human resource managers are more concerned with
the relationship between a firm and external labor markets.
In this context, the CEO’s job is to help resolve conflicts in ways that facilitate the
implementation of the firm’s strategy. Functional managers do not have to “like” one
another. However, if a firm’s vertical integration strategy is correct, the reason that a
function has been included within the boundaries of a firm is that this decision creates
value for the firm. Allowing functional conflicts to get in the way of taking advantage
of each of the functions within a firm’s boundaries can destroy this potential value.
With a net worth of more than $2.8 billion, Oprah Winfrey heads
one of the most successful multime-
dia organizations in the United States.
One of the businesses she owns—
Harpo Productions—produced one of
the most successful daytime television
shows ever (with revenues of more
than $300 million a year); launched one
of the most successful magazines ever
(with 2.5 million paid subscribers it is
larger than Vogue and Fortune); and
a movie production unit. One invest-
ment banker estimates that if Harpo,
Inc., was a publicly traded firm, it
would be valued at $575 million. Other
properties Oprah owns—including in-
vestments, real estate, a stake in the
cable television channel Oxygen, and
stock options in Viacom—generate an-
other $468 million in revenues per year.
And Oprah Winfrey does not
consider herself to be a CEO.
She heads a multimedia conglom-
erate that employs more than 12,000
people. Her film studio has produced
more than 25 movies and more than a
dozen television productions. The intro-
duction of her magazine was once de-
scribed as the most successful magazine
product launch ever. She formed a joint
venture with the Discovery Channel
to introduce a new cable channel. And
in 1985, she was nominated for an
Academy Award. But Oprah Winfrey
does not think of herself as a CEO.
Certainly, her decision-making
style is not typical of most CEOs. She
has been quoted as describing her
business decision making as “leaps of
faith” and “If I called a strategic plan-
ning meeting, there would be dead
silence, and then people would fall out
of their chairs laughing.”
However, she has made other
decisions that put her firmly in control
of her empire. For example, in 1987,
she hired a tough Chicago entertain-
ment attorney—Jeff Jacobs—as presi-
dent of her business empire, Harpo,
Inc. Whereas Oprah’s business deci-
sions are made from her gut and from
her heart, Jacobs makes sure that the
numbers add up to more revenues and
profits for Harpo. She has also been
unwilling to license her name to other
firms, unlike Martha Stewart, who
licensed her name to Kmart. Oprah
has made strategic alliances with King
World (to distribute her TV show),
with ABC (to broadcast her movies),
with Hearst (to distribute her maga-
zine), with Oxygen (to distribute some
other television programs), and with
the Discovery Channel. But she has
never given up control of her busi-
ness. And she has not taken her firm
public. She currently owns 90 percent
of Harpo’s stock. She was once quoted
as saying, “If I lost control of my busi-
ness, I’d lose myself—or at least the
ability to be myself.”
To help control this growing
business, Oprah and Jacobs hired a
chief operating officer (COO), Tim
Bennett, who then created several
functional departments, including ac-
counting, legal, and human resources,
to help manage the firm. With thou-
sands of employees, offices in Chicago
and Los Angeles, and a real organiza-
tion, Harpo is a real company, and
Oprah is a real CEO—albeit a CEO
with a slightly different approach to
making business decisions.
That said, when Oprah’s tele-
vision network, OWN, started losing
money, Oprah quickly took over as
CEO and chief creative officer. Such
decisive action makes Oprah seem
more CEO-like all the time.
Sources: P. Sellers (2002). “The business of being
Oprah.” Fortune, April 1, pp. 50+; Oprah.com ac-
cessed August 30, 2013; Hoovers.com/Harpo Inc.;
accessed August 30, 2013.
Oprah, Inc.
Strategy in the emerging enterprise
M06_BARN0088_05_GE_C06.INDD 199 17/09/14 6:54 PM

200 part 3: Corporate Strategies
Management Controls and Implementing Vertical Integration
Although having the correct organizational structure is important for firms imple-
menting their vertical integration strategies, that structure must be supported by
a variety of management control processes. Among the most important of these
processes are the budgeting process and the management committee oversight
process, which can also help CEOs resolve the functional conflicts that are com-
mon within vertically integrated firms.
t he budgeting Process
Budgeting is one of the most important control mechanisms available to CEOs in
vertically integrated U-form organizations. Indeed, in most U-form companies
enormous management effort goes into the creation of budgets and the evaluation
of performance relative to budgets. Budgets are developed for costs, revenues,
and a variety of other activities performed by a firm’s functional managers. Often,
managerial compensation and promotion opportunities depend on the ability of a
manager to meet budget expectations.
Although budgets are an important control tool, they can also have unin-
tended negative consequences. For example, the use of budgets can lead functional
managers to overemphasize short-term behavior that is easy to measure and under-
emphasize longer-term behavior that is more difficult to measure. Thus, for example,
the strategically correct thing for a functional manager to do might be to increase
expenditures for maintenance and management training, thereby ensuring that the
function will have both the technology and the skilled people needed to do the job
in the future. An overemphasis on meeting current budget requirements, however,
might lead this manager to delay maintenance and training expenditures. By meet-
ing short-term budgetary demands, this manager may be sacrificing the long-term
viability of this function, compromising the long-term viability of the firm.
CEOs can do a variety of things to counter the “short-termism” effects of the
budgeting process. For example, research suggests that evaluating a functional
manager’s performance relative to budgets can be an effective control device when
(1) the process used in developing budgets is open and participative, (2) the process
reflects the economic reality facing functional managers and the firm, and (3) quan-
titative evaluations of a functional manager’s performance are augmented by quali-
tative evaluations of that performance. Adopting an open and participative process
for setting budgets helps ensure that budget targets are realistic and that functional
managers understand and accept them. Including qualitative criteria for evaluation
reduces the chances that functional managers will engage in behaviors that are very
harmful in the long run but enable them to make budget in the short run.7
t he Management c ommittee Oversight Process
In addition to budgets, vertically integrated U-form organizations can use vari-
ous internal management committees as management control devices. Two par-
ticularly common internal management committees are the executive committee
and the operations committee (although these committees have many different
names in different organizations).
The executive committee in a U-form organization typically consists of the
CEO and two or three key functional senior managers. It normally meets weekly
and reviews the performance of the firm on a short-term basis. Functions repre-
sented on this committee generally include accounting, legal, and other functions
(such as manufacturing or sales) that are most central to the firm’s short-term
M06_BARN0088_05_GE_C06.INDD 200 17/09/14 6:54 PM

Chapter 6: Vertical integration 201
business success. The fundamental purpose of the executive committee is to
track the short-term performance of the firm, to note and correct any budget vari-
ances for functional managers, and to respond to any crises that might emerge.
Obviously, the executive committee can help avoid many functional conflicts in a
vertically integrated firm before they arise.
In addition to the executive committee, another group of managers meets
regularly to help control the operations of the firm. Often called the operations
committee, this committee typically meets monthly and usually consists of the
CEO and each of the heads of the functional areas included in the firm. The execu-
tive committee is a subset of the operations committee.
The primary objective of the operations committee is to track firm perfor-
mance over time intervals slightly longer than the weekly interval of primary inter-
est to the executive committee and to monitor longer-term strategic investments
and activities. Such investments might include plant expansions, the introduction
of new products, and the implementation of cost-reduction or quality improvement
programs. The operations committee provides a forum in which senior functional
managers can come together to share concerns and opportunities and to coordinate
efforts to implement strategies. Obviously, the operations committee can help re-
solve functional conflicts in a vertically integrated firm after they arise.
In addition to these two standing committees, various other committees and
task forces can be organized within the U-form organization to manage specific
projects and tasks. These additional groups are typically chaired by a member of
the executive or operations committee and report to one or both of these standing
committees, as warranted.
Compensation in Implementing Vertical Integration Strategies
Organizational structure and management control systems can have an impor-
tant impact on the ability of a firm to implement its vertical integration strategy.
However, a firm’s compensation policies can be important as well.
We have already seen how compensation can play a role in implementing
cost leadership and product differentiation and how compensation can be tied to
budgets to help implement vertical integration. However, the three explanations
of vertical integration presented in this chapter have important compensation
implications as well. We will first discuss the compensation challenges these three
explanations suggest and then discuss ways these challenges can be addressed.
Opportunism-based vertical integration and c ompensation Policy
Opportunism-based approaches to vertical integration suggest that employees who
make firm-specific investments in their jobs will often be able to create more value
for a firm than employees who do not. Firm-specific investments are a type of
transaction-specific investment. Whereas transaction-specific investments are invest-
ments that have more value in a particular exchange than in alternative exchanges,
firm-specific investments are investments made by employees that have more
value in a particular firm than in alternative firms.8
Examples of firm-specific investments include an employee’s understand-
ing of a particular firm’s culture, his or her personal relationships with others in
the firm, and an employee’s knowledge about a firm’s unique business processes.
All this knowledge can be used by an employee to create a great deal of value in
a firm. However, this knowledge has almost no value in other firms. The effort to
create this knowledge is thus a firm-specific investment.
M06_BARN0088_05_GE_C06.INDD 201 17/09/14 6:54 PM

202 part 3: Corporate Strategies
Despite the value that an employee’s firm-specific investments can create,
opportunism-based explanations of vertical integration suggest that employees will
often be reluctant to make these investments because, once they do, they become vul-
nerable in their exchange with this firm. For example, an employee who has made
very significant firm-specific investments may not be able to quit and go to work for
another company, even if he or she is passed over for promotion, does not receive a
raise, or is even actively discriminated against. This is because by quitting this firm,
this employee loses all the investment he or she made in this particular firm. Because
this employee has few employment options other than his or her current firm, this
firm can treat this employee badly and the employee can do little about it. This is
why employees are often reluctant to make firm-specific investments.
But the firm needs its employees to make such investments if it is to realize
its full economic potential. Thus, one of the tasks of compensation policy is to cre-
ate incentives for employees whose firm-specific investments could create great
value to actually make those investments.
c apabilities and c ompensation
Capability explanations of vertical integration also acknowledge the importance
of firm-specific investments in creating value for a firm. Indeed, many of the
valuable, rare, and costly-to-imitate resources and capabilities that can exist in a
firm are a manifestation of firm-specific investments made by a firm’s employees.
However, whereas opportunism explanations of vertical integration tend to focus
on firm-specific investments made by individual employees, capabilities explana-
tions tend to focus on firm-specific investments made by groups of employees.9
In Chapter 3, it was suggested that one of the reasons that a firm’s valuable
and rare resources may be costly to imitate is that these resources are socially
complex in nature. Socially complex resources reflect the teamwork, cooperation,
and culture that have evolved within a firm—capabilities that can increase the
value of a firm significantly, but capabilities that other firms will often find costly
to imitate, at least in the short to medium term. Moreover, these are capabilities
that exist because several employees—not just a single employee—have made
specific investments in a firm.
From the point of view of designing a compensation policy, capabilities
analysis suggests that not only should a firm’s compensation policy encourage
employees whose firm-specific investments could create value to actually make
those investments; it also recognizes that these investments will often be collec-
tive in nature—that, for example, until all the members of a critical management
team make firm-specific commitments to that team, that team’s ability to create
and sustain competitive advantages will be significantly limited.
Flexibility and c ompensation
Flexibility explanations of vertical integration also have some important implica-
tions for compensation. In particular, because the creation of flexibility in a firm de-
pends on employees being willing to engage in activities that have fixed and known
downside risks and significant upside potential, it follows that compensation that
has fixed and known downside risks and significant upside potential would en-
courage employees to choose and implement flexible vertical integration strategies.
c ompensation a lternatives
Table 6.1 lists several compensation alternatives and how they are related to each
of the three explanations of vertical integration discussed in this chapter. Not
M06_BARN0088_05_GE_C06.INDD 202 17/09/14 6:54 PM

Chapter 6: Vertical integration 203
surprisingly, opportunism-based explanations suggest that compensation that fo-
cuses on individual employees and how they can make firm-specific investments
will be important for firms implementing their vertical integration strategies.
Such individual compensation includes an employee’s salary, cash bonuses based
on individual performance, and stock grants—or payments to employees in a
firm’s stock—based on individual performance.
Capabilities explanations of vertical integration suggest that compensation
that focuses on groups of employees making firm-specific investments in valu-
able, rare, and costly-to-imitate resources and capabilities will be particularly
important for firms implementing vertical integration strategies. Such collective
compensation includes cash bonuses based on a firm’s overall performance and
stock grants based on a firm’s overall performance.
Finally, flexibility logic suggests that compensation that has a fixed and
known downside risk and significant upside potential is important for firms
implementing vertical integration strategies. Stock options, whereby employees
are given the right, but not the obligation, to purchase stock at predetermined
prices, are a form of compensation that has these characteristics. Stock options can
be granted based on an individual employee’s performance or the performance of
the firm as a whole.
The task facing CEOs looking to implement a vertical integration strategy
through compensation policy is to determine what kinds of employee behavior
they need to have for this strategy to create sustained competitive advantages and
then to use the appropriate compensation policy. Not surprisingly, most CEOs
find that all three explanations of vertical integration are important in their deci-
sion making. Thus, not surprisingly, many firms adopt compensation policies that
feature a mix of the compensation policies listed in Table 6.1. Most firms use both
individual and corporate-wide compensation schemes along with salaries, cash
bonuses, stock grants, and stock options for employees who have the greatest im-
pact on a firm’s overall performance.
Summary
Vertical integration is defined as the number of stages in an industry’s value chain that a firm
has brought within its boundaries. Forward vertical integration brings a firm closer to its
ultimate customer; backward vertical integration brings a firm closer to the sources of its raw
materials. In making vertical integration decisions for a particular business activity, firms can
choose to be not vertically integrated, somewhat vertically integrated, or vertically integrated.
Vertical integration can create value in three different ways: First, it can reduce
opportunistic threats from a firm’s buyers and suppliers due to transaction-specific
Opportunism explanations Salary
Cash bonuses for individual performance
Stock grants for individual performance
Capabilities explanations Cash bonuses for corporate or group performance
Stock grants for corporate or group performance
Flexibility explanations Stock options for individual, corporate, or group
performance
TAblE 6.1 Types of
Compensation and Approaches
to Making Vertical Integration
Decisions
M06_BARN0088_05_GE_C06.INDD 203 17/09/14 6:54 PM

204 part 3: Corporate Strategies
investments the firm may have made. A transaction-specific investment is an investment
that has more value in a particular exchange than in any alternative exchanges. Second,
vertical integration can create value by enabling a firm to exploit its valuable, rare, and
costly-to-imitate resources and capabilities. Firms should vertically integrate into activi-
ties in which they enjoy such advantages and should not vertically integrate into other
activities. Third, vertical integration typically only creates value under conditions of low
uncertainty. Under high uncertainty, vertical integration can commit a firm to a costly-to-
reverse course of action and the flexibility of a non-vertically integrated approach may
be preferred.
Often, all three approaches to vertical integration will generate similar conclusions.
However, even when they suggest different vertical integration strategies, they can still
be helpful to management.
The ability of valuable vertical integration strategies to generate a sustained com-
petitive advantage depends on how rare and costly to imitate the strategies are. Vertical
integration strategies can be rare in two ways: (1) when a firm is vertically integrated
while most competing firms are not vertically integrated and (2) when a firm is not verti-
cally integrated while most competing firms are. These rare vertical integration strategies
are possible when firms vary in the extent to which the strategies they pursue require
transaction-specific investments; they vary in the resources and capabilities they control;
or they vary in the level of uncertainty they face.
The ability to directly duplicate a firm’s vertical integration strategies depends
on how costly it is to directly duplicate the resources and capabilities that enable a
firm to pursue these strategies. The closest substitute for vertical integration—strategic
alliances—is discussed in more detail in Chapter 9.
Organizing to implement vertical integration depends on a firm’s organizational
structure, its management controls, and its compensation policies. The organizational
structure most commonly used to implement vertical integration is the functional,
or U-form, organization, which involves cost leadership and product differentiation
strategies. In a vertically integrated U-form organization, the CEO must focus not only
on deciding which functions to vertically integrate into, but also on how to resolve
conflicts that inevitably arise in a functionally organized vertically integrated firm.
Two management controls that can be used to help implement vertical integration
strategies and resolve these functional conflicts are the budgeting process and manage-
ment oversight committees.
Each of the three explanations of vertical integration suggests different kinds
of compensation policies that a firm looking to implement vertical integration should
pursue. Opportunism-based explanations suggest individual-based compensation—
including salaries and cash bonus and stock grants based on individual performance;
capabilities-based explanations suggest group-based compensation—including cash
bonuses and stock grants based on corporate or group performance; and flexibility-
based explanations suggest flexible compensation—including stock options based on
individual, group, or corporate performance. Because all three approaches to vertical
integration are often operating in a firm, it is not surprising that many firms employ all
these devices in compensating employees whose actions are likely to have a significant
impact on firm performance.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
M06_BARN0088_05_GE_C06.INDD 204 17/09/14 6:54 PM

Chapter 6: Vertical integration 205
Challenge Questions
6.1. Some firms have engaged in
backward vertical integration strategies
in order to appropriate the economic
profits that would have been earned
by suppliers selling to them. How is
this motivation for backward vertical
integration related to the opportunism
logic for vertical integration described
in this chapter? (Hint: Compare the
competitive conditions under which
firms may earn economic profits to the
competitive conditions under which
firms will be motivated to avoid oppor-
tunism through vertical integration.)
6.2. Can you think of examples when
firms vertically integrate to reduce
high uncertainty? Explain lack of
consistency with the flexibility logic.
6.3. You are about to purchase a
used car. What can you do to pro-
tect yourself from the threats in this
situation?
6.4. How is buying a car like and un-
like vertical integration decisions?
6.5. What are the competitive impli-
cations for firms if they assume that
all potential exchange partners cannot
be trusted?
6.6. Common conflicts between
sales and manufacturing are men-
tioned in the text. What conflicts
might exist between other functional
areas? Consider the following pair-
ings: research and development and
manufacturing; finance and manu-
facturing; marketing and sales; and
accounting and everyone else?
6.7. What could a CEO do to
help resolve the conflicts found
between functional areas of the
organization?
6.8. Under what conditions would
you accept a lower-paying job over a
higher-paying one?
6.9. What implications does your
accepting a lower-paying job over
a higher-paying one have for your
potential employer’s compensation
policy?

problem Set
6.10. In each of the pairs given below, which firm is more vertically integrated? Visit the
company Web sites to gather supporting information.
(a) Vodafone and Airtel
(b) Adolph Coors Brewing and Heineken
(c) BMW and Lotus
(d) L’Oreal and Avon Cosmetics
6.11. What is the level of transaction specific investment for each player in the following
transactions? Which player is at greater risk of being taken advantage of?
(a) A small, independent aluminum can plant just opened up near a large energy drinks
manufacturer. The energy drinks company has 2 captive canning facilities on site and
a plastics bottler within 50 kilometers. There is no other beverage company within a
200 km radius.
(b) A large and diversified law firm in Israel has outsourced its intellectual property
research work to a specialist Indian firm. The Israeli contract constitutes 80% of the
revenue for the Indian firm, while the outsourced work represents a cost saving of
10% for the Israeli firm. The Indian firm has invested in software and ongoing training
that is customized to the Israeli context. They were one of 9 firms that had responded
to the Israeli firm’s request for proposals.
(c) A number of computer manufacturers rely on Intel to provide them with logic chips
(CPUs), which are the “brains” of a computer. The computer manufacturers adapt
their assembly processes, components and even some of the software, to the latest
chips from Intel. Intel supplies to several dozen such manufacturers, and has very few
competitors.
M06_BARN0088_05_GE_C06.INDD 205 17/09/14 6:54 PM

206 part 3: Corporate Strategies
(d) There are only a few nuclear-powered aircraft carriers in the world today, most
operated by the US Navy. Each of these very complex “super carriers” have been built
by a single builder – Ingalls Shipbuilding, as promulgated by the US Department of
Defense.
6.12. In each of the following situations, would you recommend vertical integration or no
vertical integration? Explain.
(a) Firm A needs a new and unique technology for its product line. No substitute tech-
nologies are available. Should Firm A make this technology or buy it?
(b) Firm I has been selling its products through a distributor for some time. It has
become the market share leader. Unfortunately, this distributor has not been able to
keep up with the evolving technology and customers are complaining. No alterna-
tive distributors are available. Should Firm I keep its current distributor, or should it
begin distribution on its own?
(c) Firm Alpha has manufactured its own products for years. Recently, however, one
of these products has become more and more like a commodity. Several firms are
now able to manufacture this product at the same price and quality as Firm Alpha.
However, they do not have Firm Alpha’s brand name in the marketplace. Should Firm
Alpha continue to manufacture this product, or should it outsource it to one of these
other firms?
(d) Firm I is convinced that a certain class of technologies holds real economic potential.
However, it does not know, for sure, which particular version of this technology is
going to dominate the market. There are eight competing versions of this technol-
ogy currently, but ultimately only one will dominate the market. Should Firm I
invest in all eight of these technologies itself? Should it invest in just one of these
technologies? Should it partner with other firms that are investing in these different
technologies?
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
6.13. How can vertical integration create value by enabling a firm to retain its
flexibility?
6.14. Describe how both direct duplication and substitution can be used to imitate an-
other firm’s valuable and rare vertical integration choices.
end Notes
1. Coase, R. (1937). “The nature of the firm.” Economica, 4, pp. 386–405.
2. This explanation of vertical integration is known as transactions
cost economics in the academic literature. See Williamson, O. (1975).
Markets and hierarchies: Analysis and antitrust implications. New York:
Free Press; Williamson, O. (1985). The economic institutions of capitalism.
New York: Free Press; and Klein, B., R. Crawford, and A. Alchian.
(1978). “Vertical integration, appropriable rents, and the competitive
contracting process.” Journal of Law and Economics, 21, pp. 297–326.
3. Another option—forming an alliance between these two firms—is
discussed in more detail in Chapter 9.
M06_BARN0088_05_GE_C06.INDD 206 17/09/14 6:54 PM

Chapter 6: Vertical integration 207
4. This explanation of vertical integration is known as the capabilities-
based theory of the firm in the academic literature. It draws heavily
from the resource-based view described in Chapter 3. See Barney, J. B.
(1991). “Firm resources and sustained competitive advantage.” Journal
of Management, 17, pp. 99–120; Barney, J. B. (1999). “How a firm’s ca-
pabilities affect boundary decisions.” Sloan Management Review, 40(3);
and Conner, K. R., and C. K. Prahalad. (1996). “A resource-based
theory of the firm: Knowledge versus opportunism.” Organization
Science, 7, pp. 477–501.
5. This explanation of vertical integration is known as real-options the-
ory in the academic literature. See Kogut, B. (1991). “Joint ventures
and the option to expand and acquire.” Management Science, 37,
pp. 19–33.
6. Kripalani, M., and P. Engardio. (2003). “The rise of India.”
BusinessWeek, December 8, pp. 66+.
7. See Gupta, A. K. (1987). “SBU strategies, corporate-SBU relations and
SBU effectiveness in strategy implementation.” Academy of Management
Journal, 30(3), pp. 477–500.
8. Becker, G. S. (1993). Human capital: A theoretical and empirical analysis,
with special reference to education. Chicago: University of Chicago Press.
9. Barney, J. B. (1991). “Firm resources and sustained competitive advan-
tage.” Journal of Management, 17, pp. 99–120.
M06_BARN0088_05_GE_C06.INDD 207 17/09/14 6:54 PM

208
1. Define corporate diversification and describe five
types of corporate diversification.
2. Specify the two conditions that a corporate diversification
strategy must meet in order to create economic value.
3. Define the concept of “economies of scope” and iden-
tify eight potential economies of scope a diversified
firm might try to exploit.
4. Identify which of these economies of scope a firm’s
outside equity investors are able to realize on their
own at low cost.
The Worldwide Leader
The breadth of ESPN’s diversification has even caught the attention of Hollywood writers. In the
2004 movie Dodgeball: A True Underdog Story , the championship game bet ween the under dog
Average Joes and the bad guy P urple Cobras is broadcast on the fic titious cable channel ESPN8.
Also known as “the Ocho,” ESPN8’s theme is “If it’s almost a sport, we’ve got it.”
Here’s the irony: ESPN has way more than eight networks currently in operation.
ESPN was founded in 1979 by Bill and S cott Rasmussen after the father and son duo was
fired from positions with the New England Whalers, a National Hockey League team now playing
in Raleigh, North Carolina. Their initial idea was to rent satellite space to broadcast sports from
Connecticut—the University of Connecticut’s basketball games, Whaler’s hockey games, and so
forth. But they found that it was cheaper to rent satellite space for 24 hours straight than to rent
space a few hours during the week, and thus a 24-hour sports channel was born.
ESPN went on the air September 7, 1979. The first event broadcast w as a slow-pitch sof t-
ball game. Initially, the net work broadcast spor ts that, at the time , were not widely k nown to U.S.
consumers—Australian rules f ootball, Davis Cup tennis, professional wrestling, minor league bo wl-
ing. Early on, ESPN also gained the r ights to broadcast early rounds of the NC AA basketball tourna-
ment. At the time, the major networks did not broadcast these early round games, even though we
now know that some of these early games are among the most exciting in the entire tournament.
The longest-running ESPN pr ogram is , of c ourse, SportsCenter. Although the first SportsCenter
contained no highligh ts and a scheduled in terview with the f ootball c oach a t the Univ ersity of
5. Specify the circumstances under which a firm’s diver-
sification strategy will be rare.
6. Indicate which of the economies of scope identified in
this chapter are more likely to be subject to low-cost
imitation and which are less likely to be subject to
low-cost imitation.
7. Identify two potential substitutes for corporate
diversification.
L e a r n i n g O b j e c T i v e s After reading this chapter, you should be able to:
MyManagementLab®
improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
7
c h a p T e r
Corporate
Diversification
M07_BARN0088_05_GE_C07.INDD 208 13/09/14 5:18 PM

209
Colorado was interrupted by technical difficulties, SportsCenter and
its familiar theme ha ve become icons in A merican popular cultur e.
The 50,000th episode of SportsCenter was broadcast on S eptember
13, 2012.
ESPN was “admitted” into the world of big-time spor ts in
1987 when it signed with the National Football League to broad-
cast Sunda y N ight F ootball. Sinc e then, ESPN has br oadcast
Major League Baseball, the National Basketball Association, and,
at various times, the National Hockey League. These professional
sports ha ve been aug mented b y c ollege f ootball, basketball ,
and baseball games.
ESPN’s first e xpansion w as modest —in 1993, it in troduced ESPN2. Or iginally, this sta tion
played nothing but r ock music and scr olled spor ts scores. Within a f ew months, however, ESPN2
was broadcasting a full program of sports.
After this initial slo w expansion, ESPN began t o diversify its businesses r apidly. In 1996, it
added ESPN News (an all-sports news channel); in 1997, it acquired a company and opened ESPN
Classics (this channel shows old sporting events); and in 2005, it star ted ESPNU (a channel dedi –
cated to college athletics).
However, these five ESPN channels represent only a fraction of ESPN’s diverse business inter-
ests. In 1998, ESPN opened its first restaurant, the ESPN Zone. This chain has continued to expand
around the world. Also, in 1998, it star ted a magazine t o compete with the then- dominant Sports
Illustrated. Called ESPN The Magazine, it no w has mor e than 2 million subscr ibers. I n 2001, ESPN
went into the en tertainment production business when it f ounded ESPN Or iginal Entertainment.
In 2005, ESPN started ESPN Deportes, a Spanish-language 24-hour sports channel. And, in 2006, it
founded ESPN on ABC, a c ompany that manages much of the spor ts content broadcast on ABC.
(In 1984, ABC purchased ESPN. Subsequently, ABC was purchased by Capital Cities Entertainment,
and most of C apital Cities Entertainment was then sold t o Walt Disney C orporation. Currently, 80
percent of ESPN is owned by Disney.)
And none of this counts ESPN HD; ESPN2 HD; ESPN Pay Per View; ESPN3; ESPN Films; ESPN
Plus; ESPN A merica; The L onghorn Net work; the SEC Net work; the ESPN Web sit e; cit y-based
ESPN Web sites in Boston, New York, Chicago, and Los Angeles; ESPN Radio; and ESPN’s retail op-
erations on the Web—ESPN.com. In addition, ESPN owns 27 in ternational sports networks that
reach 190 countries in 11 languages.
Of all the e xpansion and diversification efforts, so far ESPN has only stumbled onc e. In 2006, it
founded Mobile ESPN, a mobile t elephone service. Not only w ould this ser vice provide its customers
mobile telephone service, it would also provide them up-to-the-minute scoring updates and a variety
of other spor ts information. ESPN spen t more than $40 million adv ertising its new ser vice and mor e
Ev
er
et
t C
ol
le
ct
io
n
In
c.
M07_BARN0088_05_GE_C07.INDD 209 13/09/14 5:18 PM

210 Part 3: Corporate Strategies
than $150 million on the t echnology required to make this ser vice available. Unfortunately, it nev er
signed up more than 30,000 subscribers. The breakeven point was estimated to be 500,000 subscribers.
Also, all of ESPN ’s suc cess hasn ’t gone unnotic ed b y other br oadcasters. R ecently, NBC
entered the 24-hour sports channel mar ket with NBCSN. CBS also entered this market with the
CBS Sports channel.
Despite these challenges , ESPN has emer ged from being tha t odd little cable channel tha t
broadcast odd little games t o a multibillion- dollar company with oper ations around the w orld in
cable and broadcast television, radio, restaurants, magazines, books, and movie and television pro-
duction. Which of those numerous enterprises could be characterized as “the Ocho” is hard to tell.
Sources: T. Lowry (2006). “ESPN’s cell-phone fumble.” BusinessWeek, October 30, pp. 26+; en.wikipedia.org/wiki/ESPN accessed
September 15, 2013; AP Wide World Photos.
ESPN is like most large firms in the United States and the world: It has diversified operations. Indeed, virtually all of the 500 largest firms in the United States and the 500 largest firms in the world are diversified, either by product or geographi-
cally. Large single-business firms are very unusual. However, like most of these large
diversified firms, ESPN has diversified along some dimensions but not others.
What Is Corporate Diversification?
A firm implements a corporate diversification strategy when it operates in mul-
tiple industries or markets simultaneously. When a firm operates in multiple
industries simultaneously, it is said to be implementing a product diversification
strategy. When a firm operates in multiple geographic markets simultaneously, it
is said to be implementing a geographic market diversification strategy. When
a firm implements both types of diversification simultaneously, it is said to be
implementing a product-market diversification strategy.
We have already seen glimpses of these diversification strategies in the dis-
cussion of vertical integration strategies in Chapter 6. Sometimes, when a firm
vertically integrates backward or forward, it begins operations in a new product or
geographic market. This happened to computer software firms when they began
manning their own call centers. These firms moved from the “computer software
development” business to the “call-center management” business when they verti-
cally integrated forward. In this sense, when firms vertically integrate, they may
also be implementing a diversification strategy. However, the critical difference be-
tween the diversification strategies studied here and vertical integration (discussed
in Chapter 6) is that in this chapter product-market diversification is the primary
objective of these strategies, whereas in Chapter 6 such diversification was often a
secondary consequence of pursuing a vertical integration strategy.
Types of Corporate Diversification
Firms vary in the extent to which they have diversified the mix of businesses they
pursue. Perhaps the simplest way of characterizing differences in the level of corpo-
rate diversification focuses on the relatedness of the businesses pursued by a firm.
As shown in Figure 7.1, firms can pursue a strategy of limited corporate diversifica-
tion, of related corporate diversification, or of unrelated corporate diversification.
M07_BARN0088_05_GE_C07.INDD 210 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 211
Limited Corporate Diversification
A firm has implemented a strategy of limited corporate diversification when all or
most of its business activities fall within a single industry and geographic market
(see Panel A of Figure 7.1). Two kinds of firms are included in this corporate diversi-
fication category: single-business firms (firms with greater than 95 percent of their
total sales in a single-product market) and dominant-business firms (firms with
between 70 and 95 percent of their total sales in a single-product market).
Differences between single-business and dominant-business firms are rep-
resented in Panel A of Figure 7.1. The firm pursuing a single-business corporate
diversification strategy engages in only one business, Business A. An example of
a single-business firm is the WD-40 Company of San Diego, California. This com-
pany manufactures and distributes only one product: the spray cleanser and lubri-
cant WD-40. The dominant-business firm pursues two businesses, Business E and
a smaller Business F that is tightly linked to Business E. An example of a dominant-
business firm is Donato’s Pizza. Donato’s Pizza does the vast majority of its busi-
ness in a single product—pizza—in a single market—the United States. However,
Donato’s has begun selling non-pizza food products, including sandwiches, and
also owns a subsidiary that makes a machine that automatically slices and puts
pepperoni on pizzas. Not only does Donato’s use this machine in its own pizzerias,
it also sells this machine to food manufacturers that make frozen pepperoni pizza.
In an important sense, firms pursuing a strategy of limited corporate
diversification are not leveraging their resources and capabilities beyond a single
product or market. Thus, the analysis of limited corporate diversification is logi-
cally equivalent to the analysis of business-level strategies (discussed in Part 2 of
this book). Because these kinds of strategies have already been discussed, the re-
mainder of this chapter focuses on corporate strategies that involve higher levels
of diversification.
Single-business: 95 percent or more of
firm revenues comes from a business
A. Limited Diversification
Dominant-business: between 70 and 95 percent
of firm revenues comes from a single business
Related-constrained: less than 70 percent of
firm revenues comes from a single business,
and different businesses share numerous links
and common attributes
B. Related Diversification
Less than 70 percent of firm revenues comes
from a single business, and there are few, if any,
links or common attributes among businesses
C. Unrelated Diversification
Related-linked: less than 70 percent of firm
revenues comes from a single business, and
different businesses share only a few links and
common attributes or different links and
common attributes
A
K L M N
Q R S T
W X Y Z
E F
Figure 7.1 Levels and Types
of Diversification
M07_BARN0088_05_GE_C07.INDD 211 13/09/14 5:18 PM

212 Part 3: Corporate Strategies
Related Corporate Diversification
As a firm begins to engage in businesses in more than one product or market, it
moves away from being a single-business or dominant-business firm and begins to
adopt higher levels of corporate diversification. When less than 70 percent of a firm’s
revenue comes from a single-product market and these multiple lines of business
are linked, the firm has implemented a strategy of related corporate diversification.
The multiple businesses that a diversified firm pursues can be related in
two ways (see Panel B in Figure 7.1). If all the businesses in which a firm oper-
ates share a significant number of inputs, production technologies, distribution
channels, similar customers, and so forth, this corporate diversification strategy
is called related-constrained. This strategy is constrained because corporate man-
agers pursue business opportunities in new markets or industries only if those
markets or industries share numerous resource and capability requirements with
the businesses the firm is currently pursuing. Commonalities across businesses in
a strategy of related-constrained diversification are represented by the linkages
among Businesses K, L, M, and N in the related-constrained section of Figure 7.1.
PepsiCo is an example of a related-constrained diversified firm. Although
PepsiCo operates in multiple businesses around the world, all of its businesses fo-
cus on providing snack-type products, either food or beverages. PepsiCo is not in
the business of making or selling more traditional types of food—such as pasta or
cheese or breakfast cereal. Moreover, PepsiCo attempts to use a single, firm-wide
capability to gain competitive advantages in each of its businesses—its ability to de-
velop and exploit well-known brand names. Whether it’s Pepsi, Doritos, Mountain
Dew, or Big Red, PepsiCo is all about building brand names. In fact, PepsiCo has 16
brands that generate well over $1 billion or more in revenues each year.1
If the different businesses that a single firm pursues are linked on only a
couple of dimensions or if different sets of businesses are linked along very dif-
ferent dimensions, the corporate diversification strategy is called related-linked.
For example, Business Q and Business R may share similar production technology,
Business R and Business S may share similar customers, Business S and Business T
may share similar suppliers, and Business Q and Business T may have no common
attributes. This strategy is represented in the related-linked section of Figure 7.1
by businesses with relatively few links between them and with different kinds of
links between them (i.e., straight lines and curved lines).
An example of a related-linked diversified firm is Disney. Disney has evolved
from a single-business firm (when it did nothing but produce animated motion pic-
tures), to a dominant business firm (when it produced family-oriented motion
pictures and operated a theme park), to a related-constrained diversified firm (when
it produced family-oriented motion pictures, operated multiple theme parks, and
sold products through its Disney Stores). Recently, it has become so diversified that
it has taken on the attributes of related-linked diversification. Although much of the
Disney empire still builds on characters developed in its animated motion pictures,
it also owns and operates businesses—including several hotels and resorts that
have little or nothing to do with Disney characters and a television network (ABC)
that broadcasts non-Disney-produced content—that are less directly linked to these
characters. This is not to suggest that Disney is pursuing an unrelated diversification
strategy. After all, most of its businesses are in the entertainment industry, broadly
defined. Rather, this is only to suggest that it is no longer possible to find a single
thread—like a Mickey Mouse or a Lion King—that connects all of Disney’s business
enterprises. In this sense, Disney has become a related-linked diversified firm.2
M07_BARN0088_05_GE_C07.INDD 212 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 213
Unrelated Corporate Diversification
Firms that pursue a strategy of related corporate diversification have some type
of linkages among most, if not all, the different businesses they pursue. However,
it is possible for firms to pursue numerous different businesses and for there to be
no linkages among them (see Panel C of Figure 7.1). When less than 70 percent of
a firm’s revenues is generated in a single-product market and when a firm’s busi-
nesses share few, if any, common attributes, then that firm is pursuing a strategy
of unrelated corporate diversification.
General Electric (GE) is an example of a firm pursuing an unrelated diver-
sification strategy. GE’s mix of businesses includes appliances for business, avia-
tion, capital, critical power, energy management, health care, industrial solutions,
intelligent platforms, lighting, mining, oil and gas, power and water, software,
and transportation. It is difficult to see how these businesses are closely related
to each other. Indeed, GE tends to manage each of its businesses as if they were
stand-alone entities—a management approach consistent with a firm implement-
ing an unrelated diversified corporate strategy.3
The Value of Corporate Diversification
For corporate diversification to be economically valuable, two conditions must
hold. First, there must be some valuable economy of scope among the multiple
businesses in which a firm is operating. Second, it must be less costly for manag-
ers in a firm to realize these economies of scope than for outside equity holders on
their own. If outside investors could realize the value of a particular economy of
scope on their own and at low cost, then they would have few incentives to “hire”
managers to realize this economy of scope for them. Each of these requirements
for corporate diversification to add value for a firm will be considered below.
What Are Valuable Economies of Scope?
Economies of scope exist in a firm when the value of the products or services it
sells increases as a function of the number of businesses in which that firm oper-
ates. In this definition, the term scope refers to the range of businesses in which a
diversified firm operates. For this reason, only diversified firms can, by definition,
exploit economies of scope. Economies of scope are valuable to the extent that
they increase a firm’s revenues or decrease its costs, compared with what would
be the case if these economies of scope were not exploited.
A wide variety of potentially valuable sources of economies of scope have
been identified in the literature. Some of the most important of these are listed in
Table 7.1 and discussed in the following text. How valuable economies of scope
actually are, on average, has been the subject of a great deal of research, which we
summarize in the Research Made Relevant feature.
Diversification to exploit Operational economies of s cope
Sometimes, economies of scope may reflect operational links among the busi-
nesses in which a firm engages. Operational economies of scope typically take
one of two forms: shared activities and shared core competencies.
shared a ctivities. In Chapter 3, it was suggested that value-chain analysis can be
used to describe the specific business activities of a firm. This same value-chain
V R I O
M07_BARN0088_05_GE_C07.INDD 213 13/09/14 5:18 PM

214 Part 3: Corporate Strategies
1. Operational economies of scope
■ Shared activities
■ Core competencies
2. Financial economies of scope
■ Internal capital allocation
■ Risk reduction
■ Tax advantages
3. Anticompetitive economies of scope
■ Multipoint competition
■ Exploiting market power
4. Employee and stakeholder incentives for diversification
■ Maximizing management compensation
TAbLE 7.1 Different Types of
Economies of Scope
In 1994, Lang and Stulz published a sensational article that suggested
that, on average, when a firm began
implementing a corporate diversifica-
tion strategy, it destroyed about 25 per-
cent of its market value. Lang and Stulz
came to this conclusion by comparing
the market performance of firms pur-
suing a corporate diversification strat-
egy with portfolios of firms pursuing a
limited diversification strategy. Taken
together, the market performance of a
portfolio of firms that were pursuing
a limited diversification strategy was
about 25 percent higher than the mar-
ket performance of a single diversified
firm operating in all of the businesses
included in this portfolio. These results
suggested that not only were econo-
mies of scope not valuable, but, on
average, efforts to realize these econ-
omies actually destroyed economic
value. Similar results were published
by Comment and Jarrell using different
measures of firm performance.
Not surprisingly, these results
generated quite a stir. If Lang and
Stulz were correct, then diversified
firms—no matter what kind of diver-
sification strategy they engaged in—
destroyed an enormous amount of
economic value. This could lead to a
fundamental restructuring of the U.S.
economy.
However, several researchers
questioned Lang and Stulz’s conclu-
sions. Two new findings suggest that,
even if there is a 25 percent discount,
diversification can still add value.
First, Villalonga and others found that
firms pursuing diversification strate-
gies were generally performing more
poorly before they began diversifying
than firms that never pursued diver-
sification strategies. Thus, although it
might appear that diversification leads
to a significant loss of economic value,
in reality that loss of value occurred
before these firms began implement-
ing a diversification strategy. Indeed,
some more recent research suggests
that these relatively poor-performing
firms may actually increase their mar-
ket value over what would have been
the case if they did not diversify.
Second, Miller found that firms
that find it in their self-interest to di-
versify do so in a very predictable
pattern. These firms tend to diversify
How Valuable Are Economies
of Scope, on Average?
Research Made Relevant
M07_BARN0088_05_GE_C07.INDD 214 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 215
into the most profitable new business
first, the second-most profitable busi-
ness second, and so forth. Not surpris-
ingly, the fiftieth diversification move
made by these firms might not gener-
ate huge additional profits. However,
these profits—it turns out—are still,
on average, positive. Because multi-
ple rounds of diversification increase
profits at a decreasing rate, the over-
all average profitability of diversified
firms will generally be less than the
overall average profitability of firms
that do not pursue a diversification
strategy—thus, a substantial differ-
ence between the market value of non-
diversified and diversified firms might
exist. However, this discount, per se,
does not mean that the diversified firm
is destroying economic value. Rather,
it may mean only that a diversifying
firm is creating value in smaller incre-
ments as it continues to diversify.
However, more recent research
suggests that Lang and Stulz’s original
“diversification discount” finding may
be reemerging. It turns out that all the
papers that show that diversification
does not, on average, destroy value,
and that it sometimes can add value,
fail to consider all the investment op-
tions open to firms. In particular, firms
that are generating free cash flow
but have limited growth opportuni-
ties in their current businesses—that
is, the kinds of firms that Villalonga
and Miller suggest will create value
through diversification—have other
investment options besides diversifi-
cation. In particular, these firms can
return their free cash to their equity
holders, either through a direct cash
dividend or through buying back stock.
Mackey and Barney show that
firms that do not pay out to sharehold-
ers destroy value compared with firms
that do pay out. In particular, firms
that use their free cash flow to pay
dividends and buy back stock create
value; firms that pay out and diversify
destroy some value; and firms that just
diversify destroy significant value.
Of course, these results are “on
average.” It is possible to identify
firms that actually create value from
diversification—about 17 percent of
diversified firms in the United States
create value from diversification. What
distinguishes firms that destroy and
create value from diversification is
likely to be the subject of research for
some time to come.
Sources: H. P. Lang and R. M. Stulz (1994).
“Tobin’s q, corporate diversification, and firm
performance.” Journal of Political Economy, 102,
pp. 1248–1280; R. Comment and G. Jarrell (1995).
“Corporate focus and stock returns.” Journal of
Financial Economics, 37, pp. 67–87; D. Miller (2006).
“Technological diversity, related diversification,
and firm performance.” Strategic Management
Journal, 27(7), pp. 601–620; B. Villalonga (2004).
“Does diversification cause the ‘diversification
discount’?” Financial Management, 33(2), pp. 5–28;
T. Mackey and J. Barney (2013). “Incorporating
opportunity costs in strategic management re-
search: The value of diversification and payout
as opportunities forgone when reinvesting in the
firm.” Strategic Organization, online, May 8 2013.
analysis can also be used to describe the business activities that may be shared
across several different businesses within a diversified firm. These shared activities
are potential sources of operational economies of scope for diversified firms.
Consider, for example, the hypothetical firm presented in Figure 7.2. This di-
versified firm engages in three businesses: A, B, and C. However, these three busi-
nesses share a variety of activities throughout their value chains. For example, all
three draw on the same technology development operation. Product design and
manufacturing are shared in Businesses A and B and separate for Business C. All
three businesses share a common marketing and service operation. Business A
has its own distribution system.
These kinds of shared activities are quite common among both related-
constrained and related-linked diversified firms. At Texas Instruments, for
example, a variety of electronics businesses share some research and develop-
ment activities and many share common manufacturing locations. Procter &
Gamble’s numerous consumer products businesses often share common manu-
facturing locations and rely on a common distribution network (through retail
grocery stores).4 Some of the most common shared activities in diversified firms
and their location in the value chain are summarized in Table 7.2.
M07_BARN0088_05_GE_C07.INDD 215 13/09/14 5:18 PM

216 Part 3: Corporate Strategies
Many of the shared activities listed in Table 7.2 can have the effect of reduc-
ing a diversified firm’s costs. For example, if a diversified firm has a purchasing
function that is common to several of its different businesses, it can often obtain
volume discounts on its purchases that would otherwise not be possible. Also, by
manufacturing products that are used as inputs into several of a diversified firm’s
businesses, the total costs of producing these products can be reduced. A single
sales force representing the products or services of several different businesses
within a diversified firm can reduce the cost of selling these products or services.
Firms such as IBM, HP, and General Motors (GM) have all used shared activities
to reduce their costs in these ways.
Failure to exploit shared activities across businesses can lead to out-of-
control costs. For example, Kentucky Fried Chicken, when it was a division of
PepsiCo, encouraged each of its regional business operations in North America to
develop its own quality improvement plan. The result was enormous redundancy
and at least three conflicting quality efforts—all leading to higher-than-necessary
costs. In a similar way, Levi Strauss’s unwillingness to centralize and coordinate
order processing led to a situation where six separate order-processing computer
systems operated simultaneously. This costly redundancy was ultimately replaced
by a single, integrated ordering system shared across the entire corporation.5
Shared activities can also increase the revenues in diversified firms’ busi-
nesses. This can happen in at least two ways. First, it may be that shared prod-
uct development and sales activities may enable two or more businesses in a
Technology Development
A, B, C
Marketing
A, B, C
Product Design
A, B
Manufacturing
A, B
Product Design
C
Service
A, B, C
Distribution
A
Distribution
B, C
Manufacturing
C
Figure 7.2 A Hypothetical
Firm Sharing Activities Among
Three Businesses
M07_BARN0088_05_GE_C07.INDD 216 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 217
diversified firm to offer a bundled set of products to customers. Sometimes, the
value of these “product bundles” is greater than the value of each product sepa-
rately. This additional customer value can generate revenues greater than would
have been the case if the businesses were not together and sharing activities in a
diversified firm.
In the telecommunications industry, for example, separate firms sell tele-
phones, access to telephone lines, equipment to route calls in an office, mobile
telephones, and paging services. A customer that requires all these services could
contact five different companies. Each of these five different firms would likely
possess its own unique technological standards and software, making the devel-
opment of an integrated telecommunications system for the customer difficult at
Value Chain Activity Shared Activities
Input activities Common purchasing
Common inventory control system
Common warehousing facilities
Common inventory delivery system
Common quality assurance
Common input requirements system
Common suppliers
Production activities Common product components
Common product components manufacturing
Common assembly facilities
Common quality control system
Common maintenance operation
Common inventory control system
Warehousing and distribution Common product delivery system
Common warehouse facilities
Sales and marketing Common advertising efforts
Common promotional activities
Cross-selling of products
Common pricing systems
Common marketing departments
Common distribution channels
Common sales forces
Common sales offices
Common order processing services
Dealer support and service Common service network
Common guarantees and warranties
Common accounts receivable management systems
Common dealer training
Common dealer support services
Sources: M. E. Porter (1985). Competitive advantage. New York: Free Press; R. P. Rumelt (1974). Strategy, structure,
and economic performance. Cambridge, MA: Harvard University Press; H. I. Ansoff (1965). Corporate strategy.
New York: McGraw-Hill.
TAbLE 7.2 Possible Shared
Activities and Their Place in the
Value Chain
M07_BARN0088_05_GE_C07.INDD 217 13/09/14 5:18 PM

218 Part 3: Corporate Strategies
best. Alternatively, a single diversified firm sharing sales activities across these
businesses could significantly reduce the search costs of potential customers. This
one-stop shopping is likely to be valuable to customers, who might be willing to
pay a slightly higher price for this convenience than they would pay if they pur-
chased these services from five separate firms. Moreover, if this diversified firm
also shares some technology development activities across its businesses, it might
be able to offer an integrated telecommunications network to potential custom-
ers. The extra value of this integrated network for customers is very likely to be
reflected in prices that are higher than would have been possible if each of these
businesses were independent or if activities among these businesses were not
shared. Most of the regional telephone operating companies in the United States
are attempting to gain these economies of scope.6
Such product bundles are important in other firms as well. Many grocery
stores now sell prepared foods alongside traditional grocery products in the belief
that busy customers want access to all kinds of food products—in the same location.7
Second, shared activities can enhance business revenues by exploiting the
strong, positive reputations of some of a firm’s businesses in other of its busi-
nesses. For example, if one business has a strong positive reputation for high-
quality manufacturing, other businesses sharing this manufacturing activity
will gain some of the advantages of this reputation. And, if one business has a
strong positive reputation for selling high-performance products, other busi-
nesses sharing sales and marketing activities with this business will gain some
of the advantages of this reputation. In both cases, businesses that draw on the
strong reputation of another business through shared activities with that business
will have larger revenues than they would were they operating on their own.
The Limits of a ctivity s haring. Despite the potential of activity sharing to be the
basis of a valuable corporate diversification strategy, this approach has three im-
portant limits.8 First, substantial organizational issues are often associated with a
diversified firm’s learning how to manage cross-business relationships. Managing
these relationships effectively can be very difficult, and failure can lead to excess
bureaucracy, inefficiency, and organizational gridlock. These issues are discussed
in detail in Chapter 8.
Second, sharing activities may limit the ability of a particular business to
meet its specific customers’ needs. For example, if two businesses share manu-
facturing activities, they may reduce their manufacturing costs. However, to gain
these cost advantages, these businesses may need to build products using some-
what standardized components that do not fully meet their individual custom-
ers’ needs. Businesses that share distribution activities may have lower overall
distribution costs but be unable to distribute their products to all their customers.
Businesses that share sales activities may have lower overall sales costs but be un-
able to provide the specialized selling required in each business.
One diversified firm that has struggled with the ability to meet the special-
ized needs of customers in its different divisions is GM. To exploit economies of
scope in the design of new automobiles, GM shared the design process across
several automobile divisions. The result through much of the 1990s was “cookie-
cutter” cars—the traditional distinctiveness of several GM divisions, including
Oldsmobile and Cadillac, was all but lost.9
Third, if one business in a diversified firm has a poor reputation, sharing
activities with that business can reduce the quality of the reputation of other busi-
nesses in the firm.
M07_BARN0088_05_GE_C07.INDD 218 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 219
Taken together, these limits on activity sharing can more than offset any pos-
sible gains. Indeed, over the past decade more and more diversified firms have
been abandoning efforts at activity sharing in favor of managing each business’s
activities independently. For example, ABB, Inc. (a Swiss engineering firm) and
CIBA-Geigy (a Swiss chemicals firm) have adopted explicit corporate policies that
restrict almost all activity sharing across businesses.10 Other diversified firms, in-
cluding Nestlé and GE, restrict activity sharing to just one or two activities (such
as research and development or management training). However, to the extent
that a diversified firm can exploit shared activities while avoiding these problems,
shared activities can add value to a firm.
c ore c ompetencies. Recently, a second operational linkage among the busi-
nesses of a diversified firm has been described. Unlike shared activities, this
linkage is based on different businesses in a diversified firm sharing less tan-
gible resources such as managerial and technical know-how, experience, and
wisdom. This source of operational economy of scope has been called a firm’s
core competence.11 Core competence has been defined by Prahalad and Hamel
as “the collective learning in the organization, especially how to coordinate
diverse production skills and integrate multiple streams of technologies.” Core
competencies are complex sets of resources and capabilities that link different
businesses in a diversified firm through managerial and technical know-how,
experience, and wisdom.12
Two firms that have well-developed core competencies are 3M and
Johnson & Johnson (J&J). 3M has a core competence in substrates, adhesives,
and coatings. Collectively, employees at 3M know more about developing
and applying adhesives and coatings on different kinds of substrates than do
employees in any other organization. Over the years, 3M has applied these re-
sources and capabilities in a wide variety of products, including Post-it notes,
magnetic tape, photographic film, pressure-sensitive tape, and coated abrasives.
At first glance, these widely diversified products seem to have little or nothing
in common. Yet they all draw on a single core set of resources and capabilities in
substrates, adhesives, and coatings.
Johnson & Johnson has a core competence in developing or acquiring phar-
maceutical and medical products and then marketing them to the public. Many
of J&J’s products are dominant in their market segments—J&J’s in baby powder,
Ethicon in surgical sutures, and Tylenol in pain relievers. And although these
products range broadly from those sold directly to consumers (e.g., the Band-Aid
brand of adhesive bandages) to highly sophisticated medical technologies sold
only to doctors and hospitals (e.g., Ethicon sutures), all of J&J’s products build on
the same ability to identify, develop, acquire, and market products in the pharma-
ceutical and medical products industry.
To understand how core competencies can reduce a firm’s costs or increase
its revenues, consider how core competencies emerge over time. Most firms be-
gin operations in a single business. Imagine that a firm has carefully evaluated
all of its current business opportunities and has fully funded all of those with a
positive net present value. Any of the above-normal returns that this firm has left
over after fully funding all its current positive net present value opportunities
can be thought of as free cash flow.13 Firms can spend this free cash in a variety
of ways: They can spend it on benefits for managers; they can give it to share-
holders through dividends or by buying back a firm’s stock; they can use it to
invest in new businesses.
M07_BARN0088_05_GE_C07.INDD 219 13/09/14 5:18 PM

220 Part 3: Corporate Strategies
Suppose a firm chooses to use this cash to invest in a new business. In other
words, suppose this firm chooses to implement a diversification strategy. If this
firm is seeking to maximize the return from implementing this diversification
strategy, which of all the possible businesses that it could invest in should it invest
in? Obviously, a profit-maximizing firm will choose to begin operations in a busi-
ness in which it has a competitive advantage. What kind of business is likely to
generate this competitive advantage for this firm? The obvious answer is a busi-
ness in which the same underlying resources and capabilities that gave this firm
an advantage in its original business are still valuable, rare, and costly to imitate.
Consequently, this first diversification move sees the firm investing in a business
that is closely related to its original business because both businesses will draw on
a common set of underlying resources and capabilities that provide the firm with
a competitive advantage.
Put another way, a firm that diversifies by exploiting its resource and
capability advantages in its original business will have lower costs than those
that begin a new business without these resource and capability advantages, or
higher revenues than firms lacking these advantages, or both. As long as this
firm organizes itself to take advantage of these resource and capability advan-
tages in its new business, it should earn high profits in its new business, along
with the profits it will still be earning in its original business.14 This can be true
for even relatively small firms, as described in the Strategy in the Emerging
Enterprise feature.
Of course, over time this diversified firm is likely to develop new resources
and capabilities through its operations in the new business. These new resources
and capabilities enhance the entire set of skills that a firm might be able to bring to
still another business. Using the profits it has obtained in its previous businesses,
this firm is likely to enter another new business. Again, choosing from among all
the new businesses it could enter, it is likely to begin operations in a business in
which it can exploit its now-expanded resource and capability advantages to ob-
tain a competitive advantage, and so forth.
After a firm has engaged in this diversification strategy several times, the
resources and capabilities that enable it to operate successfully in several busi-
nesses become its core competencies. A firm develops these core competencies
by transferring the technical and management knowledge, experience, and
wisdom it developed in earlier businesses to its new businesses. A firm that has
just begun this diversification process has implemented a dominant-business
strategy. If all of a firm’s businesses share the same core competencies, then
that firm has implemented a strategy of related-constrained diversification.
If different businesses exploit different sets of resources and capabilities, that
firm has implemented a strategy of related-linked diversification. In any case,
these core competencies enable firms to have lower costs or higher revenues
as they include more businesses in their diversified portfolio, compared with
firms without these competencies.
Of course, not all firms develop core competencies in this logical and ratio-
nal manner. That is, sometimes a firm’s core competencies are examples of the
emergent strategies described in Chapter 1. Indeed, as described in Chapter 1,
J&J is an example of a firm that has a core competence that emerged over time.
However, no matter how a firm develops core competencies, to the extent that
they enable a diversified firm to have lower costs or larger revenues in its busi-
ness operations, these competencies can be thought of as sources of economies
of scope.
M07_BARN0088_05_GE_C07.INDD 220 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 221
W. L. Gore & Associates is best known for manufacturing a wa-
terproof and windproof, but breath-
able, fabric that is used to insulate
winter coats, hiking boots, and a myr-
iad of other outdoor apparel products.
This fabric—known as Gore-Tex—has
a brand name in its market niche every
bit as strong as any of the brand names
controlled by PepsiCo or Procter &
Gamble. The “Gore-Tex” label at-
tached to any outdoor garment prom-
ises waterproof comfort in even the
harshest conditions.
But W. L. Gore & Associates did
not start out in the outdoor fabric busi-
ness. Indeed, for the first 10 years of its
existence, W. L. Gore sold insulation
for wires and similar industrial prod-
ucts using a molecular technology
originally developed by DuPont—a
technology most of us know as Teflon.
Only 10 years after its initial founding
did the founder’s son, Bob Gore, dis-
cover that it was possible to stretch the
Teflon molecule to form a strong and
porous material that is chemically in-
ert, has a low friction coefficient, func-
tions within a wide temperature range,
does not age, and is extremely strong.
This is the material called Gore-Tex.
By extending its basic technol-
ogy, W. L. Gore and Associates has
been able to diversify well beyond
its original wire insulation business.
With more than 8,000 employees and
more than $2 billion in revenues, the
company currently has operations in
medical products (including synthetic
blood vessels and patches for soft
tissue regeneration), electronics prod-
ucts (including wiring board materi-
als and computer chip components),
industrial products (including filter
bags for environmental protection and
sealants for chemical manufacturing),
and fabrics (including Gore-Tex fabric,
Wind-Stopper fabric, and CleanStream
filters).
And Gore continues to discover
new ways to exploit its competence in
the Teflon molecule. In 1997, a team
of Gore engineers developed a cable
made out of the Teflon molecule to
control puppets at Disney’s theme
parks. Unfortunately, these cables did
not perform up to expectations and
were not sold to Disney. However,
some guitar players discovered these
cables and began using them as
strings for their guitars. They found
out that these “Gore-Tex” strings
sounded great and lasted five times
as long as alternative guitar strings.
So Gore entered yet another market—
the $100 million fretted-stringed-
instrument business—with its Elixir
brand of guitar strings. Currently,
W. L. Gore is the second-largest man-
ufacturer in this market.
The flexibility of the Teflon
molecule—and W. L. Gore’s ability to
explore and exploit that flexibility—has
created a diversified company whose
original objective was simply to sell
insulation for wires.
Sources: www.gore.com accessed July 15, 2012;
D. Sacks (2003). “The Gore-Tex of guitar strings.”
Fast Times, December, p. 46.
Gore-Tex and Guitar Strings
Strategy in the Emerging Enterprise
Some diversified firms realize the value of these kinds of core competencies
through shared activities. For example, as suggested earlier, 3M has a core com-
petence in substrates, adhesives, and coatings. To exploit this, 3M has adopted a
multitiered product innovation process. In addition to product innovations within
each business unit separately, 3M also supports a corporate research and develop-
ment lab that seeks to exploit and expand its core competence in substrates, adhe-
sives, and coatings. Because the corporate research and development laboratory is
shared by all of 3M’s different businesses, it can be thought of as a shared activity.
However, other firms realize the value of their core competencies without
shared activities. Although J&J has a core competence in developing, acquiring,
and marketing pharmaceutical and medical products, it does not realize this core
competence through shared activities. Indeed, each of J&J’s businesses is run
very independently. For example, although one of its most successful products
M07_BARN0088_05_GE_C07.INDD 221 13/09/14 5:18 PM

222 Part 3: Corporate Strategies
is Tylenol, the fact that the company that manufactures and distributes Tylenol—
McNeil—is actually a division of J&J and is not printed on any Tylenol packaging.
If you did not know that Tylenol was a J&J product, you could not tell from the
bottles of Tylenol you buy.
Although J&J does not use shared activities to realize the value of its core
competencies, it does engage in other activities to realize this value. For example,
it is not uncommon for members of the senior management team of each of the
businesses in J&J’s portfolio to have obtained managerial experience in some
other J&J business. That is, J&J identifies high-potential managers in one of its
businesses and uses this knowledge by giving these managers additional respon-
sibilities in another J&J business. This ability to leverage its management talent
across multiple businesses is an example of a firm’s core competence, although
the realization of the value of that competence does not depend on the existence
of a shared activity.
Sometimes, because a firm’s core competence is not reflected in specific
shared activities, it is easy to conclude that it is not exploiting any economies of
scope in its diversification strategy. Diversified firms that are exploiting core com-
petencies as an economy of scope but are not doing so with any shared activities
are sometimes called seemingly unrelated diversified firms. They may appear
to be unrelated diversified firms but are, in fact, related diversified firms without
any shared activities.
One example of a seemingly unrelated diversified firm is the British com-
pany Virgin Group. Operating in a wide variety of businesses—everything from
record producing, music retailing, air and rail travel, soft drinks, spirits, mobile
phones, cosmetics, retail bridal shops, financial services, and providing gas and
electricity to hot air ballooning—the Virgin Group is clearly diversified. The
firm has few, if any, shared activities. However, at least two core competencies
cut across all the business activities in the group—the brand name “Virgin” and
the eccentric marketing and management approach of Virgin’s founder, Richard
Branson. Branson is the CEO who walked down a “catwalk” in a wedding gown
to help publicize the opening of Virgin Brides—the Virgin Group’s line of re-
tail bridal shops. Branson is also the CEO who had all of Virgin Air’s airplanes
repainted with the British “Union Jack” and the slogan “Britain’s Real Airline”
when British Airways eliminated the British flag from its airplanes. Whether these
two core competencies create sufficient value to justify the Virgin Group’s contin-
ued existence and whether they will continue beyond Branson’s affiliation with
the group are still open questions.
Limits of c ore c ompetencies. Just as there are limits to the value of shared activi-
ties as sources of economies of scope, so there are limits to core competencies as
sources of these economies. The first of these limitations stems from important
organizational issues to be discussed in Chapter 8. The way that a diversified firm
is organized can either facilitate the exploitation of core competencies or prevent
this exploitation from occurring.
A second limitation of core competencies is a result of the intangible nature
of these economies of scope. Whereas shared activities are reflected in tangible
operations in a diversified firm, core competencies may be reflected only in
shared knowledge, experience, and wisdom across businesses. The intangible
character of these relationships is emphasized when they are described as a
dominant logic in a firm, or a common way of thinking about strategy across dif-
ferent businesses.15
M07_BARN0088_05_GE_C07.INDD 222 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 223
The intangibility of core competencies can lead diversified firms to make
two kinds of errors in managing relatedness. First, intangible core competencies
can be illusory inventions by creative managers who link even the most com-
pletely unrelated businesses and thereby justify their diversification strategy. A
firm that manufactures airplanes and running shoes can rationalize this diver-
sification by claiming to have a core competence in managing transportation
businesses. A firm operating in the professional football business and the movie
business can rationalize this diversification by claiming to have a core compe-
tence in managing entertainment businesses. Such invented competencies are
not real sources of economies of scope.
Second, a diversified firm’s businesses may be linked by a core competence,
but this competence may affect these businesses’ costs or revenues in a trivial
way. Thus, for example, all of a firm’s businesses may be affected by govern-
ment actions, but the impact of these actions on costs and revenues in different
businesses may be quite small. A firm may have a core competence in managing
relationships with the government, but this core competence will not reduce costs
or enhance revenues for these particular businesses very much. Also, each of a
diversified firm’s businesses may use some advertising. However, if advertising
does not have a major impact on revenues for these businesses, core competencies
in advertising are not likely to significantly reduce a firm’s costs or increase its
revenues. In this case, a core competence may be a source of economies of scope,
but the value of those economies may be very small.
Diversification to exploit Financial economies of s cope
A second class of motivations for diversification shifts attention away from
operational linkages among a firm’s businesses and toward financial advantages
associated with diversification. Three financial implications of diversification
have been studied: diversification and capital allocation, diversification and risk
reduction, and tax advantages of diversification.
Diversification and c apital a llocation. Capital can be allocated to businesses
in one of two ways. First, businesses operating as independent entities can
compete for capital in the external capital market. They do this by providing a
sufficiently high return to induce investors to purchase shares of their equity,
by having a sufficiently high cash flow to repay principal and interest on debt,
and in other ways. Alternatively, a business can be part of a diversified firm.
That diversified firm competes in the external capital market and allocates
capital among its various businesses. In a sense, diversification creates an
internal capital market in which businesses in a diversified firm compete for
corporate capital.16
For an internal capital market to create value for a diversified firm, it must
offer some efficiency advantages over an external capital market. It has been sug-
gested that a potential efficiency gain from internal capital markets depends on
the greater amount and quality of information that a diversified firm possesses
about the businesses it owns, compared with the information that external sup-
pliers of capital possess. Owning a business gives a diversified firm access to
detailed and accurate information about the actual performance of the business,
its true future prospects, and thus the actual amount and cost of the capital that
should be allocated to it. External sources of capital, in contrast, have relatively
limited access to information and thus have a limited ability to judge the actual
performance and future prospects of a business.
M07_BARN0088_05_GE_C07.INDD 223 13/09/14 5:18 PM

224 Part 3: Corporate Strategies
Some have questioned whether a diversified firm, as a source of capital, ac-
tually has more and better information about a business it owns, compared with
external sources of capital. After all, independent businesses seeking capital have
a strong incentive to provide sufficient information to external suppliers of capital
to obtain required funds. However, a firm that owns a business may have at least
two informational advantages over external sources of capital.
First, although an independent business has an incentive to provide in-
formation to external sources of capital, it also has an incentive to downplay or
even not report any negative information about its performance and prospects.
Such negative information would raise an independent firm’s cost of capital.
External sources of capital have limited ability to force a business to reveal all
information about its performance and prospects and thus may provide capital
at a lower cost than they would if they had full information. Ownership gives
a firm the right to compel more complete disclosure, although even here full
disclosure is not guaranteed. With this more complete information, a diversi-
fied firm can allocate just the right amount of capital, at the appropriate cost, to
each business.
Second, an independent business may have an incentive not to reveal all the
positive information about its performance and prospects. In Chapter 3, the ability
of a firm to earn economic profits was shown to depend on the imitability of its
resources and capabilities. An independent business that informs external sources
of capital about all of its sources of competitive advantage is also informing its
potential competitors about these sources of advantage. This information sharing
increases the probability that these sources of advantage will be imitated. Because
of the competitive implications of sharing this information, firms may choose not
to share it, and external sources of capital may underestimate the true performance
and prospects of a business.
A diversified firm, however, may gain access to this additional information
about its businesses without revealing it to potential competitors. This informa-
tion enables the diversified firm to make more informed decisions about how
much capital to allocate to a business and about the cost of that capital, compared
with the external capital market.17
Over time, there should be fewer errors in funding businesses through in-
ternal capital markets, compared with funding businesses through external capi-
tal markets. Fewer funding errors, over time, suggest a slight capital allocation
advantage for a diversified firm, compared with an external capital market. This
advantage should be reflected in somewhat higher rates of return on invested
capital for the diversified firm, compared with the rates of return on invested
capital for external sources of capital.
However, the businesses within a diversified firm do not always gain cost-
of-capital advantages by being part of a diversified firm’s portfolio. Several au-
thors have argued that because a diversified firm has lower overall risk (see the
following discussion), it will have a lower cost of capital, which it can pass along
to the businesses within its portfolio. Although the lower risks associated with a
diversified firm may lower the firm’s cost of capital, the appropriate cost of capi-
tal to businesses within the firm depends on the performance and prospects of
each of those businesses. The firm’s advantages in evaluating its businesses’ per-
formances and prospects result in more appropriate capital allocation, not just in
lower cost of capital for those businesses. Indeed, a business’s cost of capital may
be lower than it could have obtained in the external capital market (because the
firm is able to more fully evaluate the positive aspects of that business), or it may
M07_BARN0088_05_GE_C07.INDD 224 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 225
be higher than it could have obtained in the external capital market (because the
firm is able to more fully evaluate the negative aspects of that business).
Of course, if these businesses also have lower cost or higher revenue expec-
tations because they are part of a diversified firm, then those cost/revenue advan-
tages will be reflected in the appropriate cost of capital for these businesses. In
this sense, any operational economies of scope for businesses in a diversified firm
may be recognized by a diversified firm exploiting financial economies of scope.
Limits on internal c apital Markets. Although internal capital allocation has several
potential advantages for a diversified firm, this process also has several limits.
First, the level and type of diversification that a firm pursues can affect the ef-
ficiency of this allocation process. A firm that implements a strategy of unrelated
diversification, whereby managers have to evaluate the performance and pros-
pects of numerous very different businesses, puts a greater strain on the capital
allocation skills of its managers than does a firm that implements related diversi-
fication. Indeed, in the extreme, the capital allocation efficiency of a firm pursuing
broad-based unrelated diversification will probably not be superior to the capital
allocation efficiency of the external capital market.
Second, the increased efficiency of internal capital allocation depends on
managers in a diversified firm having better information for capital allocation
than the information available to external sources. However, this higher-quality
information is not guaranteed. The incentives that can lead managers to exagger-
ate their performance and prospects to external capital sources can also lead to
this behavior within a diversified firm. Indeed, several examples of business man-
agers falsifying performance records to gain access to more internal capital have
been reported.18 Research suggests that capital allocation requests by managers
are routinely discounted in diversified firms in order to correct for these manag-
ers’ inflated estimates of the performance and prospects of their businesses.19
Finally, not only do business managers have an incentive to inflate the per-
formance and prospects of their business in a diversified firm, but managers in
charge of capital allocation in these firms may have an incentive to continue in-
vesting in a business despite its poor performance and prospects. The reputation
and status of these managers often depend on the success of these business in-
vestments because often they initially approved them. These managers often con-
tinue throwing good money at these businesses in hope that they will someday
improve, thereby justifying their original decision. Organizational psychologists
call this process escalation of commitment and have presented numerous exam-
ples of managers becoming irrationally committed to a particular investment.20
Indeed, research on the value of internal capital markets in diversified firms
suggests that, on average, the limitations of these markets often outweigh their
advantages. For example, even controlling for firm size, excessive investment in
poorly performing businesses in a diversified firm reduces the market value of
the average diversified firm.21 However, the fact that many firms do not gain the
advantages associated with internal capital markets does not necessarily imply
that no firms gain these advantages. If only a few firms are able to obtain the ad-
vantages of internal capital markets while successfully avoiding their limitations,
this financial economy of scope may be a source of at least a temporary competi-
tive advantage.
Diversification and r isk r eduction. Another possible financial economy of scope
for a diversified firm has already been briefly mentioned—the riskiness of the
cash flows of diversified firms is lower than the riskiness of the cash flows of
M07_BARN0088_05_GE_C07.INDD 225 13/09/14 5:18 PM

226 Part 3: Corporate Strategies
undiversified firms. Consider, for example, the riskiness of two businesses oper-
ating separately compared with the risk of a diversified firm operating in those
same two businesses simultaneously. If both these businesses are very risky on
their own and the cash flows from these businesses are not highly correlated
over time, then combining these two businesses into a single firm will generate
a lower level of overall risk for the diversified firm than for each of these busi-
nesses on their own.
This lower level of risk is due to the low correlation between the cash flows
associated with these two businesses. If Business I is having a bad year, Business
II might be having a good year, and a firm that operates in both of these busi-
nesses simultaneously can have moderate levels of performance. In another year,
Business II might be off, while Business I is having a good year. Again, the firm
operating in both these businesses can have moderate levels of performance.
Firms that diversify to reduce risk will have relatively stable returns over time,
especially as they diversify into many different businesses with cash flows that
are not highly correlated over time.
Tax a dvantages of Diversification. Another financial economy of scope from di-
versification stems from possible tax advantages of this corporate strategy. These
possible tax advantages reflect one or a combination of two effects. First, a diversi-
fied firm can use losses in some of its businesses to offset profits in others, thereby
reducing its overall tax liability. Of course, substantial losses in some of its busi-
nesses may overwhelm profits in other businesses, forcing businesses that would
have remained solvent if they were independent to cease operation. However, as
long as business losses are not too large, a diversified firm’s tax liability can be
reduced. Empirical research suggests that diversified firms do, sometimes, offset
profits in some businesses with losses in others, although the tax savings of these
activities are usually small.22
Second, because diversification can reduce the riskiness of a firm’s cash
flows, it can also reduce the probability that a firm will declare bankruptcy. This
can increase a firm’s debt capacity. This effect on debt capacity is greatest when
the cash flows of a diversified firm’s businesses are perfectly and negatively cor-
related. However, even when these cash flows are perfectly and positively corre-
lated, there can still be a (modest) increase in debt capacity.
Debt capacity is particularly important in tax environments where inter-
est payments on debt are tax deductible. In this context, diversified firms can
increase their leverage up to their debt capacity and reduce their tax liability
accordingly. Of course, if interest payments are not tax deductible or if the mar-
ginal corporate tax rate is relatively small, then the tax advantages of diversifica-
tion can be quite small. Empirical work suggests that diversified firms do have
greater debt capacity than undiversified firms. However, low marginal corporate
tax rates, at least in the United States, make the accompanying tax savings on
average relatively small.23
Diversification to exploit a nticompetitive economies of s cope
A third group of motivations for diversification is based on the relationship be-
tween diversification strategies and various anticompetitive activities by firms.
Two specific examples of these activities are (1) multipoint competition to facili-
tate mutual forbearance and tacit collusion and (2) exploiting market power.
Multipoint c ompetition. Multipoint competition exists when two or more diver-
sified firms simultaneously compete in multiple markets. For example, HP and
M07_BARN0088_05_GE_C07.INDD 226 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 227
Dell compete in both the personal computer market and the market for computer
printers. Michelin and Goodyear compete in both the U.S. automobile tire market
and the European automobile tire market. Disney and AOL/Time Warner com-
pete in both the movie production and book publishing businesses.
Multipoint competition can serve to facilitate a particular type of tacit col-
lusion called mutual forbearance. Firms engage in tacit collusion when they
cooperate to reduce rivalry below the level expected under perfect competition.
Consider the situation facing two diversified firms, A and B. These two firms op-
erate in the same businesses, I, II, III, and IV (see Figure 7.3). In this context, any
decisions that Firm A might make to compete aggressively in Businesses I and
III must take into account the possibility that Firm B will respond by competing
aggressively in Businesses II and IV and vice versa. The potential loss that each
of these firms may experience in some of its businesses must be compared with
the potential gain that each might obtain if it exploits competitive advantages in
other of its businesses. If the present value of gains does not outweigh the present
value of losses from retaliation, then both firms will avoid competitive activity.
Refraining from competition is mutual forbearance.24
Mutual forbearance as a result of multipoint competition has occurred in
several industries. For example, this form of tacit collusion has been described
as existing between Michelin and Goodyear, Maxwell House and Folger’s,
Caterpillar and John Deere, and BIC and Gillette.25 Another clear example of such
cooperation can be found in the airline industry. For example, America West (now
part of US Air) began service into the Houston Intercontinental Airport with very
low introductory fares. Continental Airlines (now part of United Airlines), the
dominant firm at Houston Intercontinental, rapidly responded to America West’s
low Houston fares by reducing the price of its flights from Phoenix, Arizona, to
several cities in the United States. Phoenix is the home airport of America West.
Within just a few weeks, America West withdrew its low introductory fares in
the Houston market, and Continental withdrew its reduced prices in the Phoenix
market. The threat of retaliation across markets apparently led America West and
Continental to tacitly collude on prices.26
However, sometimes multipoint competition does not lead to mutual for-
bearance. Consider, for example, a conflict between The Walt Disney Company
and Time Warner. As mentioned earlier, Disney operates in the theme park, movie
I II III IV
IVI II III
Firm A
Firm B
Figure 7.3 Multipoint
Competition Between
Hypothetical Firms A and B
M07_BARN0088_05_GE_C07.INDD 227 13/09/14 5:18 PM

228 Part 3: Corporate Strategies
and television production, and television broadcasting industries. Time Warner
operates in the theme park and movie and television production industries and
also operates a very large magazine business (Time, People, Sports Illustrated,
among others). From 1988 through 1993, Disney spent more than $40 million in
advertising its theme parks in Time Warner magazines. Despite this substan-
tial revenue, Time Warner began an aggressive advertising campaign aimed
at wooing customers away from Disney theme parks to its own. Disney retali-
ated by canceling all of its advertising in Time Warner magazines. Time Warner
responded to Disney’s actions by canceling a corporate meeting to be held in
Florida at Disney World. Disney responded to Time Warner’s meeting cancella-
tion by refusing to broadcast Time Warner theme park advertisements on its Los
Angeles television station.27
Some recent research investigates the conditions under which mutual for-
bearance strategies are pursued, as well as conditions under which multipoint
competition does not lead to mutual forbearance.28 In general, the value of the
threat of retaliation must be substantial for multipoint competition to lead to
mutual forbearance. However, not only must the payoffs to mutual forbearance
be substantial, but the firms pursuing this strategy must have strong strategic
linkages among their diversified businesses. This suggests that firms pursuing
mutual forbearance strategies based on multipoint competition are usually pursu-
ing a form of related diversification.
Diversification and Market power. Internal allocations of capital among a diversi-
fied firm’s businesses may enable it to exploit in some of its businesses the market
power advantages it enjoys in other of its businesses. For example, suppose that a
firm is earning monopoly profits in a particular business. This firm can use some
of these monopoly profits to subsidize the operations of another of its businesses.
This cross-subsidization can take several forms, including predatory pricing—
that is, setting prices so that they are less than the subsidized business’s costs. The
effect of this cross-subsidy may be to drive competitors out of the subsidized busi-
ness and then to obtain monopoly profits in that subsidized business. In a sense,
diversification enables a firm to apply its monopoly power in several different
businesses. Economists call this a deep-pockets model of diversification.29
Diversified firms with operations in regulated monopolies have been criti-
cized for this kind of cross-subsidization. For example, most of the regional tele-
phone companies in the United States are engaging in diversification strategies.
The consent decree that forced the breakup of the original AT&T expressly forbade
cross-subsidies between these regional companies’ telephone monopolies and other
business activities, under the assumption that such subsidies would give these
firms an unfair competitive advantage in their diversified business activities.30
Although these market power economies of scope, in principle, may exist,
relatively little empirical work documents their existence. Indeed, research on
regulated utilities diversifying into nonregulated businesses in the 1980s suggests
not that these firms use monopoly profits in their regulated businesses to unfairly
subsidize nonregulated businesses, but that non-competition-oriented manage-
ment skills developed in the regulated businesses tend to make diversification
less profitable rather than more profitable.31 Nevertheless, the potential that large
diversified firms have to exercise market power and to behave in socially irre-
sponsible ways has led some observers to call for actions to curtail both the eco-
nomic and political power of these firms. These issues are discussed in the Ethics
and Strategy feature.
M07_BARN0088_05_GE_C07.INDD 228 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 229
Firm s ize and employee incentives to Diversify
Employees may have incentives to diversify that are independent of any benefits
from other sources of economies of scope. This is especially the case for employ-
ees in senior management positions and employees with long tenure in a particu-
lar firm. These employee incentives reflect the interest of employees to diversify
because of the relationship between firm size and management compensation.
Research over the years demonstrates conclusively that the primary determi-
nant of the compensation of top managers in a firm is not the economic performance
of the firm but the size of the firm, usually measured in sales.32 Thus, managers seek-
ing to maximize their income should attempt to grow their firm. One of the easiest
ways to grow a firm is through diversification, especially unrelated diversification
through mergers and acquisitions. By making large acquisitions, a diversified firm
can grow substantially in a short period of time, leading senior managers to earn
higher incomes. All of this is independent of any economic profit that diversification
may or may not generate. Senior managers need only worry about economic profit
if the level of that profit is so low that unfriendly takeovers are a threat or so low that
the board of directors may be forced to replace management.
Recently, the traditional relationship between firm size and management
compensation has begun to break down. More and more, the compensation of se-
nior managers is being tied to the firm’s economic performance. In particular, the
use of stock and other forms of deferred compensation makes it in management’s
best interest to be concerned with a firm’s economic performance. These changes
in compensation do not necessarily imply that firms will abandon all forms of
diversification. However, they do suggest that firms will abandon those forms of
diversification that do not generate real economies of scope.
Can Equity Holders Realize These Economies of Scope on Their Own?
Earlier in this chapter, it was suggested that for a firm’s diversification strategies
to create value, two conditions must hold. First, these strategies must exploit
valuable economies of scope. Potentially valuable economies of scope were pre-
sented in Table 7.1 and discussed in the previous section. Second, it must be less
costly for managers in a firm to realize these economies of scope than for outside
equity holders on their own. If outside equity holders could realize a particular
economy of scope on their own, without a firm’s managers, at low cost, why
would they want to hire managers to do this for them by investing in a firm and
providing capital to managers to exploit an economy of scope?
Table 7.3 summarizes the discussion on the potential value of the different
economies of scope listed in Table 7.1. It also suggests which of these economies
of scope will be difficult for outside equity investors to exploit on their own and
thus which bases of diversification are most likely to create positive returns for a
firm’s equity holders.
Most of the economies of scope listed in Table 7.3 cannot be realized by equity
holders on their own. This is because most of them require activities that equity
holders cannot engage in or information that equity holders do not possess. For
example, shared activities, core competencies, multipoint competition, and exploit-
ing market power all require the detailed coordination of business activities across
multiple businesses in a firm. Although equity holders may own a portfolio of equi-
ties, they are not in a position to coordinate business activities across this portfolio.
In a similar way, internal capital allocation requires information about a business’s
prospects that is simply not available to a firm’s outside equity holders.
M07_BARN0088_05_GE_C07.INDD 229 13/09/14 5:18 PM

230 Part 3: Corporate Strategies
In 1999, a loose coalition of union members, environmentalists, youth,
indigenous peoples, human rights
activists, and small farmers took to
the streets of Seattle, Washington, to
protest a meeting of the World Trade
Organization (WTO) and to fight
against the growing global power of
corporations. Government officials
and corporate officers alike were
confused by these protests. After all,
hadn’t world trade increased 19 times
from 1950 to 1995 ($0.4 trillion to $7.6
trillion in constant 2003 dollars), and
hadn’t the total economic output of
the entire world gone from $6.4 tril-
lion in 1950 to $60.7 trillion in 2005
(again, in constant 2003 dollars)? Why
protest a global economic system—a
system that was enhancing the level of
free trade and facilitating global eco-
nomic efficiency—that was so clearly
improving the economic well-being of
the world’s population? This 1999 pro-
test turned out to be the first of many
such demonstrations, culminating in
the Occupy Movement after the fi-
nancial crisis of 2007. And, still, many
business and government leaders re-
main confused. Empirically, globaliza-
tion has improved the world economy,
so why the protests?
The protestors’ message to gov-
ernment and big business was that
these aggregate growth numbers
masked more truth than they told. Yes,
there has been economic growth. But
that growth has benefited only a small
percentage of the world’s population.
Most of the population still struggles
to survive. The combined net worth of
358 U.S. billionaires in the early 1990s
($760 billion) was equal to the com-
bined net worth of the 2.5 billion poor-
est people on the earth! Eighty-three
percent of the world’s total income
goes to the richest fifth of the popu-
lation while the poorest fifth of the
world’s population receives only 1.4
percent of the world’s total income.
Currently, 45 million to 70 million peo-
ple worldwide have had to leave their
home countries to find work in for-
eign lands, and approximately 1.4 bil-
lion people around the world live on
less than $1 a day. Even in relatively
affluent societies such as the United
States, people find it increasingly dif-
ficult to meet their financial obliga-
tions. Falling real wages, economic
insecurity, and corporate downsizing
have led many people to work longer
hours or to hold two or three jobs.
While the number of billionaires in the
world continues to grow, the number
of people facing mind-numbing and
strength-robbing poverty grows even
faster.
The causes of this apparent con-
tradiction—global economic growth
linked with growing global economic
decay—are numerous and complex.
However, one explanation focuses on
the growing economic power of the
diversified multinational corporation.
The size of these institutions can be
immense—many international diver-
sified firms are larger than the en-
tire economies of many nations. And
these huge institutions, with a single-
minded focus on maximizing their
performance, can make profit-making
decisions that adversely affect their
suppliers, their customers, their em-
ployees, and the environment, all with
relative impunity. Armed with the un-
spoken mantra that “Greed is good,”
these corporations can justify almost
any action, as long as it increases the
wealth of their shareholders.
Of course, even if one accepts this
hypothesis—and it is far from being
universally accepted—solutions to the
growing power of internationally diver-
sified firms are not obvious. The prob-
lem is that one way that firms become
large and powerful is by being able
to meet customer demands effectively.
Thus, firm size, per se, is not necessarily
an indication that a firm is behaving in
ways inconsistent with the public good.
Government efforts to restrict the size
of firms simply because they are large
could easily have the effect of making
citizens worse off. However, once firms
are large and powerful, they may very
well be tempted to exercise that power
in ways that benefit themselves at great
cost to society.
Whatever the causes and solu-
tions to these problems, protests that
began in Seattle in 1999 have at least
one clear message: global growth for
growth’s sake is no longer universally
accepted as the correct objective of in-
ternational economic policy.
Sources: D. C. Korten (2001). When corporations
rule the world, 2nd ed. Bloomfield, CT: Kumarian
Press; H. Demsetz (1973). “Industry structure,
market rivalry, and public policy.” Journal of
Law and Economics, 16, pp. 1–9; J. Stiglitz (2007).
Making globalization work. New York: Norton.
Ethics and Strategy
Globalization and the Threat
of the Multinational Firm
M07_BARN0088_05_GE_C07.INDD 230 13/09/14 5:18 PM

Chapter 7: Corporate Diversification 231
Indeed, the only two economies of scope listed in Table 7.3 that do not have
the potential for generating positive returns for a firm’s equity holders are di-
versification in order to maximize the size of a firm—because firm size, per se, is
not valuable—and diversification to reduce risk—because equity holders can do
this on their own at very low cost by simply investing in a diversified portfolio
of stocks. Indeed, although risk reduction is often a published rationale for many
diversification moves, this rationale, by itself, is not directly consistent with the
interests of a firm’s equity holders. However, some scholars have suggested that
this strategy may directly benefit other of a firm’s stakeholders and thus indirectly
benefit its equity holders. This possibility is discussed in detail in the Strategy in
Depth feature.
Overall, this analysis of possible bases of diversification suggests that related
diversification is more likely to be consistent with the interests of a firm’s equity hold-
ers than unrelated diversification. This is because the one economy of scope listed in
Table 7.3 that is the easiest for outside equity holders to duplicate—risk reduction—is
the only economy of scope that an unrelated diversified firm can try to realize. All
the other economies of scope listed in Table 7.3 require coordination and information
sharing across businesses in a diversified firm that are very difficult to realize in unre-
lated diversified firms. Indeed, the preponderance of empirical research suggests that
related diversified firms outperform unrelated diversified firms.33
Corporate Diversification and Sustained
Competitive Advantage
Table 7.3 describes those economies of scope that are likely to create real eco-
nomic value for diversifying firms. It also suggests that related diversification
can be valuable, and unrelated diversification is usually not valuable. However,
as we have seen with all the other strategies discussed in this book, the fact that a
Types of Economy of Scope Are They Valuable?
Can They Be Realized
by Equity Holders on
Their Own?
Positive Returns
to Equity Holders?
1. Operational economies of scope
Shared activities
Core competencies
Possible
Possible
No
No
Possible
Possible
2. Financial economies of scope
Internal capital allocation
Risk reduction
Tax advantages
Possible
Possible
Possible—small
No
Yes
No
Possible
No
Possible—small
3. Anticompetitive economies of scope
Multipoint competition
Exploiting market power
Possible
Possible
No
No
Possible
Possible
4. Employee incentives for diversification
Maximizing management compensation No No No
TAbLE 7.3 The Competitive Implications of Different Economies of Scope
V R I O
M07_BARN0088_05_GE_C07.INDD 231 13/09/14 5:18 PM

232 Part 3: Corporate Strategies
strategy is valuable does not necessarily imply that it will be a source of sustained
competitive advantage. In order for diversification to be a source of sustained
competitive advantage, it must be not only valuable but also rare and costly to
imitate, and a firm must be organized to implement this strategy. The rarity and
imitability of diversification are discussed in this section; organizational questions
are deferred until the next.
Although diversifying in order to reduce risk generally does not
directly benefit outside equity inves-
tors in a firm, it can indirectly benefit
outside equity investors through its
impact on the willingness of other
stakeholders in a firm to make firm-
specific investments. A firm’s stake-
holders include all those groups and
individuals who have an interest in
how a firm performs. In this sense,
a firm’s equity investors are one of a
firm’s stakeholders. Other firm stake-
holders include employees, suppliers,
and customers.
Firm stakeholders make firm-
specific investments when the value
of the investments they make in a
particular firm is much greater than
the value of those same investments
would be in other firms. Consider,
for example, a firm’s employees.
An employee with a long tenure in
a particular firm has generally made
substantial firm-specific human
capital investments. These invest-
ments include understanding a par-
ticular firm’s culture, policies, and
procedures; knowing the “right” peo-
ple to contact to complete a task; and
so forth. Such investments have sig-
nificant value in the firm where they
are made. Indeed, such firm-specific
knowledge is generally necessary if
an employee is to be able to help a
firm conceive and implement valuable
strategies. However, the specific in-
vestments that an employee makes
in a particular firm have almost no
value in other firms. If a firm were to
cease operations, employees would in-
stantly lose almost all the value of any
of the firm-specific investments they
had made in that firm.
Suppliers and customers can
also make these firm-specific invest-
ments. Suppliers make these invest-
ments when they customize their
products or services to the specific
requirements of a particular customer.
They also make firm-specific invest-
ments when they forgo opportuni-
ties to sell to other firms in order to
sell to a particular firm. Customers
make firm-specific investments when
they customize their operations to
fully utilize the products or services
of a particular firm. Also, by devel-
oping close relationships with a par-
ticular firm, customers may forgo
the opportunity to develop relation-
ships with other firms. These, too,
are firm- specific investments made by
customers. If a firm were to cease
operations, suppliers and customers
would instantly lose almost the entire
value of the specific investments they
have made in this firm.
Although the firm-specific in-
vestments made by employees, sup-
pliers, and customers are risky—in
the sense that almost their entire
value is lost if the firm in which they
are made ceases operations—they are
extremely important if a firm is going
to be able to generate economic prof-
its. As was suggested in Chapter 3,
valuable, rare, and costly-to-imitate
resources and capabilities are more
likely to be a source of sustained com-
petitive advantage than resources
and capabilities without these attri-
butes. Firm-specific investments are
more likely to have these attributes
than non-firm-specific investments.
Non-firm-specific investments are in-
vestments that can generate value in
numerous different firms.
Thus, valuable, rare, and costly-
to-imitate firm-specific investments
made by a firm’s employees, suppli-
ers, and customers can be the source
of economic profits. And because a
Risk-Reducing Diversification
and a Firm’s Other Stakeholders
Strategy in Depth
M07_BARN0088_05_GE_C07.INDD 232 13/09/14 5:19 PM

Chapter 7: Corporate Diversification 233
firm’s outside equity holders are re-
sidual claimants on the cash flows
generated by a firm, these economic
profits benefit equity holders. Thus, a
firm’s outside equity holders generally
will want a firm’s employees, suppli-
ers, and customers to make specific
investments in a firm because those
investments are likely to be sources
of economic wealth for outside equity
holders.
However, given the riskiness of
firm-specific investments, employees,
suppliers, and customers will gener-
ally only be willing to make these
investments if some of the riskiness
associated with making them can be
reduced. Outside equity holders have
little difficulty managing the risks as-
sociated with investing in a particular
firm because they can always create a
portfolio of stocks that fully diversi-
fies this risk at very low cost. This is
why diversification that reduces the
riskiness of a firm’s cash flows does
not generally directly benefit a firm’s
outside equity holders. However, a
firm’s employees, suppliers, and
customers usually do not have these
low-cost diversification opportu-
nities. Employees, for example, are
rarely able to make firm-specific hu-
man capital investments in a large
enough number of different firms to
fully diversify the risks associated
with making them. And although
suppliers and customers can diver-
sify their firm-specific investments to
a greater degree than employees—
through selling to multiple customers
and through buying from multiple
suppliers—the cost of this diversifica-
tion for suppliers and customers is
usually greater than the costs that are
borne by outside equity holders in
diversifying their risk.
Because it is often very costly
for a firm’s employees, suppliers,
and customers to diversify the risks
associated with making firm-specific
investments on their own, these stake-
holders will often prefer that a firm’s
managers help manage this risk for
them. Managers in a firm can do this
by diversifying the portfolio of busi-
nesses in which a firm operates. If a
firm is unwilling to diversify its port-
folio of businesses, then that firm’s
employees, suppliers, and customers
will generally be unwilling to make
specific investments in that firm.
Moreover, because these firm-specific
investments can generate economic
profits and because economic profits
can directly benefit a firm’s outside
equity holders, equity holders have an
indirect incentive to encourage a firm
to pursue a diversification strategy,
even though that strategy does not
directly benefit them.
Put differently, a firm’s diver-
sification strategy can be thought of
as compensation for the firm-specific
investments that a firm’s employees,
suppliers, and customers make in a
firm. Outside equity holders have an
incentive to encourage this compen-
sation in return for access to some
of the economic profits that these
firm-specific investments can gener-
ate. In general, the greater the im-
pact of the firm-specific investment
made by a firm’s employees, suppli-
ers, and customers on the ability of
a firm to generate economic profits,
the more likely that pursuing a cor-
porate diversification strategy is in-
directly consistent with the interests
of a firm’s outside equity holders. In
addition, the more limited the ability
of a firm’s employees, suppliers, and
customers to diversify the risks asso-
ciated with making firm-specific in-
vestments at low cost, the more that
corporate diversification is consistent
with the interests of outside equity
investors.
Sources: J. B. Barney (1991). “Firm resources and
sustained competitive advantage.” Journal of
Management, 17, pp. 99–120; R. M. Stulz (1996).
“Rethinking risk management.” Journal of Applied
Corporate Finance, Fall, pp. 8–24; K. Miller (1998).
“Economic exposure and integrated risk man-
agement,” Strategic Management Journal, 33,
pp. 756–779; R. Amit and B. Wernerfelt (1990).
“Why do firms reduce business risk?” Academy of
Management Journal, 33, pp. 520–533; H. Wang and
J. Barney (2006), “Employee incentives to make
firm specific investments: Implications for re-
source-based theories of diversification.” Academy
of Management Review, 31(2), pp. 466–476.
The Rarity of Diversification
At first glance, it seems clear that diversification per se is usually not a rare firm
strategy. Most large firms have adopted some form of diversification, if only
the limited diversification of a dominant-business firm. Even many small and
medium-sized firms have adopted different levels of diversification strategy.
However, the rarity of diversification depends not on diversification per
se but on how rare the particular economies of scope associated with that
M07_BARN0088_05_GE_C07.INDD 233 13/09/14 5:19 PM

234 Part 3: Corporate Strategies
diversification are. If only a few competing firms have exploited a particular econ-
omy of scope, that economy of scope can be rare. If numerous firms have done so,
it will be common and not a source of competitive advantage.
The Imitability of Diversification
Both forms of imitation—direct duplication and substitution—are relevant in
evaluating the ability of diversification strategies to generate sustained competi-
tive advantages, even if the economies of scope that they create are rare.
Direct Duplication of Diversification
The extent to which a valuable and rare corporate diversification strategy is im-
mune from direct duplication depends on how costly it is for competing firms to
realize this same economy of scope. As suggested in Table 7.4, some economies of
scope are, in general, more costly to duplicate than others.
Shared activities, risk reduction, tax advantages, and employee compensa-
tion as bases for corporate diversification are usually relatively easy to duplicate.
Because shared activities are based on tangible assets that a firm exploits across
multiple businesses, such as common research and development labs, common
sales forces, and common manufacturing, they are usually relatively easy to
duplicate. The only duplication issues for shared activities concern developing
the cooperative cross-business relationships that often facilitate the use of shared
activities—issues discussed in the next chapter. Moreover, because risk reduction,
tax advantages, and employee compensation motives for diversifying can be ac-
complished through both related and unrelated diversification, these motives for
diversifying tend to be relatively easy to duplicate.
Other economies of scope are much more difficult to duplicate. These
difficult-to-duplicate economies of scope include core competencies, internal
capital allocation efficiencies, multipoint competition, and exploitation of
market power. Because core competencies are more intangible, their direct du-
plication is often challenging. The realization of capital allocation economies
of scope requires very substantial information-processing capabilities. These
capabilities are often very difficult to develop. Multipoint competition requires
very close coordination between the different businesses in which a firm op-
erates. This kind of coordination is socially complex and thus often immune
from direct duplication. Finally, exploitation of market power may be costly to
duplicate because it requires that a firm must possess significant market power
in one of its lines of business. A firm that does not have this market power ad-
vantage would have to obtain it. The cost of doing so, in most situations, would
be prohibitive.
Less Costly-to-Duplicate Costly-to-Duplicate
Economies of Scope Economies of Scope
Shared activities Core competencies
Risk reduction Internal capital allocation
Tax advantages Multipoint competition
Employee compensation Exploiting market power
TAbLE 7.4 Costly Duplication
of Economies of Scope
M07_BARN0088_05_GE_C07.INDD 234 13/09/14 5:19 PM

Chapter 7: Corporate Diversification 235
s ubstitutes for Diversification
Two obvious substitutes for diversification exist. First, instead of obtaining cost
or revenue advantages from exploiting economies of scope across businesses in a
diversified firm, a firm may decide to simply grow and develop each of its busi-
nesses separately. In this sense, a firm that successfully implements a cost leader-
ship strategy or a product differentiation strategy in a single business can obtain
the same cost or revenue advantages it could have obtained by exploiting econo-
mies of scope but without having to develop cross-business relations. Growing in-
dependent businesses within a diversified firm can be a substitute for exploiting
economies of scope in a diversification strategy.
One firm that has chosen this strategy is Nestlé. Nestlé exploits few, if
any, economies of scope among its different businesses. Rather, it has focused
its efforts on growing each of its international operations to the point that they
obtain cost or revenue advantages that could have otherwise been obtained in
some form of related diversification. Thus, for example, Nestlé’s operation in
the United States is sufficiently large to exploit economies of scale in production,
sales, and marketing, without reliance on economies of scope between U.S. opera-
tions and operations in other countries.34
A second substitute for exploiting economies of scope in diversification can
be found in strategic alliances. By using a strategic alliance, a firm may be able to
gain the economies of scope it could have obtained if it had carefully exploited
economies of scope across its businesses. Thus, for example, instead of a firm ex-
ploiting research and development economies of scope between two businesses it
owns, it could form a strategic alliance with a different firm and form a joint re-
search and development lab. Instead of a firm exploiting sales economies of scope
by linking its businesses through a common sales force, it might develop a sales
agreement with another firm and obtain cost or revenue advantages in this way.
Summary
Firms implement corporate diversification strategies that range from limited diversifica-
tion (single-business, dominant-business) to related diversification (related-constrained,
related-linked) to unrelated diversification. In order to be valuable, corporate diversifica-
tion strategies must reduce costs or increase revenues by exploiting economies of scope
that outside equity holders cannot realize on their own at low cost.
Several motivations for implementing diversification strategies exist, including ex-
ploiting operational economies of scope (shared activities, core competencies), exploiting
financial economies of scope (internal capital allocation, risk reduction, obtaining tax ad-
vantages), exploiting anticompetitive economies of scope (multipoint competition, mar-
ket power advantages), and employee incentives to diversify (maximizing management
compensation). All these reasons for diversifying, except diversifying to maximize man-
agement compensation, have the potential to create economic value for a firm. Moreover,
a firm’s outside equity holders will find it costly to realize all of these bases for diversifi-
cation, except risk reduction. Thus, diversifying to maximize management compensation
or diversifying to reduce risk is not consistent with the wealth-maximizing interests of
a firm’s equity holders. This analysis also suggests that, on average, related diversified
firms will outperform unrelated diversified firms.
The ability of a diversification strategy to create sustained competitive advantages
depends not only on the value of that strategy, but also on its rarity and imitability. The
rarity of a diversification strategy depends on the number of competing firms that are
M07_BARN0088_05_GE_C07.INDD 235 13/09/14 5:19 PM

236 Part 3: Corporate Strategies
exploiting the same economies of scope through diversification. Imitation can occur
either through direct duplication or through substitutes. Costly-to-duplicate economies
of scope include core competencies, internal capital allocation, multipoint competition,
and exploitation of market power. Other economies of scope are usually less costly to
duplicate. Important substitutes for diversification are when relevant economies are
obtained through the independent actions of businesses within a firm and when relevant
economies are obtained through strategic alliances. This discussion set aside important
organizational issues in implementing diversification strategies. These issues are exam-
ined in detail in the next chapter.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
Challenge Questions
7.1. One simple way to think about
relatedness is to look at the products
or services a firm manufactures.
The more similar these products or
services are, the more related is the
firm’s diversification strategy. Why or
why not would firms that exploit core
competencies in their diversification
strategies always produce products or
services that are similar to each other?
7.2. Unrelated corporate diversifica-
tion involves entering an unfamiliar
industry. Is the economies of scope
analysis enough to make a decision
on unrelated diversification? Is the
five forces analysis also needed?
If not, why not? If so, then how
should the two analyses be used in
combination?
7.3. One of the reasons why internal
capital markets may be more efficient
than external capital markets is that
firms may not want to reveal full
information about their sources of
competitive advantage to external
capital markets in order to reduce the
threat of competitive imitation. This
suggests that external capital markets
may systematically undervalue firms
with competitive advantages that are
subject to imitation. If you agree with
this analysis, how could you trade on
this information in your own invest-
ment activities?
7.4. Almost all firms share certain
value chain activities. For example,
most firms have a centralized
finance and accounting department,
a procurement, an MIS and an
HR function. Given this fact, two
firms from unrelated industries are
planning to merge simply to combine
their overhead functions, which
constitute a large fraction (e.g., > 40%)
of their individual cost basis. Is the
logic sound? Why or why not?
7.5. Under what conditions will a
related diversification strategy not be
a source of competitive advantage for
a firm?

Problem Set
7.6. Visit the corporate Web sites of the following firms. How would you characterize
their corporate strategies? Are they following a strategy of limited diversification, related
diversification, or unrelated diversification?
(a) Dangote (b) América Móvil
(c) LVMH (d) Tata
(e) Baidu (f) SAP
(g) Cheung Kong Holdings (h) Embraer
(i) Rovio Entertainment
M07_BARN0088_05_GE_C07.INDD 236 13/09/14 5:19 PM

Chapter 7: Corporate Diversification 237
7.7. Consider the following list of strategies. In your view, which of these strategies are
examples of potential economies of scope underlying a corporate diversification strategy?
For those strategies that are an economy of scope, which economy of scope are they? For
those strategies that are not an economy of scope, why aren’t they?
(a) Tata launches Swach, its water purifier for the Indian market, developed with the help
of Tata Chemicals, Tata Autocomp Systems, Tata Consulting Services and other Tata
Group companies.
(b) Medtronic, US medical device maker (strongest in pacemakers and spinal treatment),
announces acquisition of Ireland-based Covidien (strongest in surgical equipment)
and plans to relocate its headquarters to Ireland to lower corporate tax.
(c) GE Capital announces intent to spin off its retail lending business to focus on its
industrial segment with products such as fleet finance, commercial loans and leases.
(d) Robinsons Retail, a leading retailer in the Phillipines, announces the purchase of A.M.
Builders’ Depot. This deal will make available to A.M. Builders’ Depot, a wide range
of home improvement products and appliances from Robinsons.
(e) Oracle’s acquisition of PeopleSoft: both are global leaders in business software.
(f) FedEx Corp, a global courier service, announced that its FedEx Express subsidiary has
acquired an African courier, Supaswift, with businesses in South Africa and six other
countries in order to extend the Fedex network in Africa.
(g) Omron Healthcare, a popular maker of medical devices for use at home, announced
the launch of its latest pain relief device, the Pain Relief Pro, which now comes with a
massage feature and more pain modes (arm, lower back, leg, foot and joint).
(h) InternetQ, a global mobile marketing services company announces the acquisition of
Interacel, a growing mobile service provider in Latin America. The merger is expected
to enable InternetQ to upsell its mobile marketing, Akazoo music streaming and
Minimob smart advertising services directly to mobile network operators and media
brands in Latin America.
(i) A venture capital firm invests in a firm in the biotechnology industry and a firm in the
entertainment industry.
(j) Another venture capital firm invests in two firms in the biotechnology industry.
7.8. Consider the following facts. The standard deviation of the cash flows associated
with Business I is 0.8. The larger this standard deviation, the riskier a business’s future
cash flows are likely to be. The standard deviation of the cash flows associated with
Business II is 1.3. That is, Business II is riskier than Business I. Finally, the correlation
between the cash flows of these two businesses over time is 0.8. This means that when
Business I is up, Business II tends to be down, and vice versa. Suppose one firm owns
both of these businesses.
(a) Assuming that Business I constitutes 40 percent of this firm’s revenues and Business II
constitutes 60 percent of its revenues, calculate the riskiness of this firm’s total rev-
enues using the following equation:
sdI,II = 3w2sdI2 + 11 – w22sdII2 + 2w11 + w21rI,IIsdIsdII2
Where w = 0.40; sdI = 0.8, sdII = 1.3, and rI, II = -8.
(b) Given this result, does it make sense for this firm to own both Business I and Business
II? Why or why not?
M07_BARN0088_05_GE_C07.INDD 237 13/09/14 5:19 PM

238 Part 3: Corporate Strategies
End Notes
1. See Sellers, P. (2004). “The brand king’s challenge.” Fortune, April 5,
pp. 192+.
2. The Walt Disney Company. (1995). Harvard Business School Case No.
1-388-147.
3. Useem, J. (2004). “Another boss, another revolution.” Fortune, April 5,
pp. 112+.
4. See Rogers, A. (1992). “It’s the execution that counts.” Fortune,
November 30, pp. 80–83; and Porter, M. E. (1981). “Disposable diaper
industry in 1974.” Harvard Business School Case No. 9-380-175. A
more general discussion of the value of shared activities can be found
in St. John, C. H., and J. S. Harrison. (1999). “Manufacturing-based
relatedness, synergy, and coordination.” Strategic Management Journal,
20, pp. 129–145.
5. See Fuchsberg, G. (1992). “Decentralized management can have its
drawbacks.” The Wall Street Journal, December 9, p. B1.
6. See Crockett, R. (2000). “A Baby Bell’s growth formula.” BusinessWeek,
March 6, pp. 50–52; and Crockett, R. (1999). “The last monopolist.”
BusinessWeek, April 12, p. 76.
7. de Lisser, E. (1993). “Catering to cooking-phobic customers, supermar-
kets stress carryout.” The Wall Street Journal, April 5, p. B1.
8. See, for example, Davis, P., R. Robinson, J. Pearce, and S. Park. (1992).
“Business unit relatedness and performance: A look at the pulp and
paper industry.” Strategic Management Journal, 13, pp. 349–361.
9. Loomis, C. J. (1993). “Dinosaurs?” Fortune, May 3, pp. 36–42.
10. Rapoport, C. (1992). “A tough Swede invades the U.S.” Fortune, June
29, pp. 776–779.
11. Prahalad, C. K., and G. Hamel. (1990). “The core competence of the
organization.” Harvard Business Review, 90, p. 82.
12. See also Grant, R. M. (1988). “On ‘dominant logic’ relatedness and
the link between diversity and performance.” Strategic Management
Journal, 9, pp. 639–642; Chatterjee, S., and B. Wernerfelt. (1991). “The
link between resources and type of diversification: Theory and evi-
dence.” Strategic Management Journal, 12, pp. 33–48; Markides, C., and
P. J. Williamson. (1994). “Related diversification, core competencies,
and corporate performance.” Strategic Management Journal, 15,
pp. 149–165; Montgomery, C. A., and B. Wernerfelt. (1991). “Sources of
superior performance: Market share versus industry effects in the U.S.
brewing industry.” Management Science, 37, pp. 954–959; Liedtka, J. M.
(1996). “Collaborating across lines of business for competitive advan-
tage.” Academy of Management Executive, 10(2), pp. 20–37; and Farjoun,
M. (1998). “The independent and joint effects of the skill and physical
bases of relatedness in diversification.” Strategic Management Journal,
19, pp. 611–630.
13. Jensen, M. C. (1986). “Agency costs of free cash flow, corporate fi-
nance, and takeovers.” American Economic Review, 76, pp. 323–329.
14. See Nayyar, P. (1990). “Information asymmetries: A source of competi-
tive advantage for diversified service firms.” Strategic Management
Journal, 11, pp. 513–519; and Robins, J., and M. Wiersema. (1995).
“A resource-based approach to the multibusiness firm: Empirical
analysis of portfolio interrelationships and corporate financial
performance.” Strategic Management Journal, 16, pp. 277–299, for a
discussion of the evolution of core competencies.
15. Prahalad, C. K., and R. A. Bettis. (1986). “The dominant logic: A new
linkage between diversity and performance.” Strategic Management
Journal, 7(6), pp. 485–501.
16. See Williamson, O. E. (1975). Markets and hierarchies: Analysis and anti-
trust implications. New York: Free Press.
17. See Liebeskind, J. P. (1996). “Knowledge, strategy, and the theory of
the firm.” Strategic Management Journal, 17 (Winter Special Edition),
pp. 93–107.
18. Perry, L. T., and J. B. Barney. (1981). “Performance lies are hazardous to
organizational health.” Organizational Dynamics, 9(3), pp. 68–80.
19. Bethel, J. E. (1990). The capital allocation process and managerial mobility:
A theoretical and empirical investigation. Unpublished doctoral disserta-
tion, University of California at Los Angeles.
20. Staw, B. M. (1981). “The escalation of commitment to a course of ac-
tion.” Academy of Management Review, 6, pp. 577–587.
21. See Comment, R., and G. Jarrell. (1995). “Corporate focus and stock
returns.” Journal of Financial Economics, 37, pp. 67–87; Berger, P. G.,
and E. Ofek. (1995). “Diversification’s effect on firm value.” Journal
of Financial Economics, 37, pp. 39–65; Maksimovic, V., and G. Phillips.
(1999). “Do conglomerate firms allocate resources inefficiently?”
Working paper, University of Maryland; Matsusaka, J. G., and V.
Nanda. (1998). “Internal capital markets and corporate refocusing.”
Working paper, University of Southern California; Palia, D. (1998).
“Division-level overinvestment and agency conflicts in diversified
firms.” Working paper, Columbia University; Rajan, R., H. Servaes,
and L. Zingales. (1997). “The cost of diversity: The diversification
discount and inefficient investment.” Working paper, University of
Chicago; Scharfstein, D. S. (1997). “The dark side of internal capital
markets II: Evidence from diversified conglomerates.” NBER [National
Bureau of Economic Research]. Working paper; Shin, H. H., and R. M.
Stulz. (1998). “Are internal capital markets efficient?” The Quarterly
Journal of Economics, May, pp. 551–552. But Houston and James (1998)
show that internal capital markets can create competitive advantages
for firms: Houston, J., and C. James. (1998). “Some evidence that banks
use internal capital markets to lower capital costs.” Journal of Applied
Corporate Finance, 11(2), pp. 70–78.
22. Scott, J. H. (1977). “On the theory of conglomerate mergers.” Journal of
Finance, 32, pp. 1235–1250.
23. See Brennan, M. (1979). “The pricing of contingent claims in discrete
time models.” Journal of Finance, 34, pp. 53–68; Cox, J., S. Ross, and M.
Rubinstein. (1979). “Option pricing: A simplified approach.” Journal of
Financial Economics, 7, pp. 229–263; Stapleton, R. C. (1982). “Mergers,
debt capacity, and the valuation of corporate loans.” In M. Keenan
and L. J. White. (eds.), Mergers and acquisitions. Lexington, MA: D. C.
Heath, Chapter 2; and Galai, D., and R. W. Masulis. (1976). “The op-
tion pricing model and the risk factor of stock.” Journal of Financial
Economics, 3, pp. 53–82.
24. See Karnani, A., and B. Wernerfelt. (1985). “Multiple point competi-
tion.” Strategic Management Journal, 6, pp. 87–96; Bernheim, R. D., and
M. D. Whinston. (1990). “Multimarket contact and collusive behavior.”
Rand Journal of Economics, 12, pp. 605–617; Tirole, J. (1988). The theory
of industrial organization. Cambridge, MA: MIT Press; Gimeno, J., and
C. Y. Woo. (1999). “Multimarket contact, economies of scope, and firm
performance.” Academy of Management Journal, 43(3), pp. 239–259;
Korn, H. J., and J. A. C. Baum. (1999). “Chance, imitative, and strategic
antecedents to multimarket contact.” Academy of Management Journal,
42(2), pp. 171–193; Baum, J. A. C., and H. J. Korn. (1999). “Dynamics of
dyadic competitive interaction.” Strategic Management Journal, 20,
pp. 251–278; Gimeno, J. (1999). “Reciprocal threats in multimarket
rivalry: Staking our ‘spheres of influence’ in the U.S. airline industry.”
Strategic Management Journal, 20, pp. 101–128; Gimeno, J., and
C. Y. Woo. (1996). “Hypercompetition in a multimarket environment:
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
7.9. Not all firms will choose corporate diversification. Describe the benefits and
challenges of the alternatives.
7.10. Internal capital markets have several limitations. When a firm is confronted by
these limitations, what is it likely to do?
M07_BARN0088_05_GE_C07.INDD 238 13/09/14 5:19 PM

Chapter 7: Corporate Diversification 239
The role of strategic similarity and multimarket contact in competitive
de-escalation.” Organization Science, 7(3), pp. 322–341; Ma, H.
(1998). “Mutual forbearance in international business.” Journal of
International Management, 4(2), pp. 129–147; McGrath, R. G., and
M.-J. Chen. (1998). “Multimarket maneuvering in uncertain spheres
of influence: Resource diversion strategies.” Academy of Management
Review, 23(4), pp. 724–740; Chen, M.-J. (1996). “Competitor analysis
and interfirm rivalry: Toward a theoretical integration.” Academy of
Management Review, 21(1), pp. 100–134; Chen, M.-J., and K. Stucker.
(1997). “Multinational management and multimarket rivalry:
Toward a theoretical development of global competition.” Academy of
Management Proceedings 1997, pp. 2–6; and Young, G., K. G. Smith, and
C. M. Grimm. (1997). “Multimarket contact, resource heterogeneity,
and rivalrous firm behavior.” Academy of Management Proceedings 1997,
pp. 55–59. This idea was originally proposed by Edwards, C. D. (1955).
“Conglomerate bigness as a source of power.” In Business concentration
and price policy. NBER Conference Report. Princeton, NJ: Princeton
University Press.
25. See Karnani, A., and B. Wernerfelt. (1985). “Multiple point competi-
tion.” Strategic Management Journal, 6, pp. 87–96.
26. This was documented by Gimeno, J. (1994). “Multipoint competition,
market rivalry and firm performance: A test of the mutual forbear-
ance hypothesis in the United States airline industry, 1984–1988.”
Unpublished doctoral dissertation, Purdue University.
27. See Landro, L., P. M. Reilly, and R. Turner. (1993). “Cartoon clash:
Disney relationship with Time Warner is a strained one.” The Wall
Street Journal, April 14, p. A1; and Reilly, P. M., and R. Turner. (1993).
“Disney pulls ads in tiff with Time.” The Wall Street Journal, April 2, p.
B1. The growth and consolidation of the entertainment industry since
the early 1990s have made Disney and Time Warner (especially after its
merger with AOL) large entertainment conglomerates. It will be inter-
esting to see if these two larger firms will be able to find ways to tacitly
collude or will continue the competition begun in the early 1990s.
28. The best work in this area has been done by Gimeno, J. (1994).
“Multipoint competition, market rivalry and firm performance: A
test of the mutual forbearance hypothesis in the United States airline
industry, 1984–1988.” Unpublished doctoral dissertation, Purdue
University. See also Smith, F., and R. Wilson. (1995). “The predictive
validity of the Karnani and Wernerfelt model of multipoint competi-
tion.” Strategic Management Journal, 16, pp. 143–160.
29. See Tirole, J. (1988). The theory of industrial organization. Cambridge,
MA: MIT Press.
30. Carnevale, M. L. (1993). “Ring in the new: Telephone service seems on
the brink of huge innovations.” The Wall Street Journal, February 10,
p. A1. SBC acquired the remaining assets of the original AT&T and
renamed the newly merged company AT&T.
31. See Russo, M. V. (1992). “Power plays: Regulation, diversification,
and backward integration in the electric utility industry.” Strategic
Management Journal, 13, pp. 13–27. Work by Jandik and Makhija
(1999) indicates that when a regulated utility diversifies out of
a regulated industry, it often earns a more positive return than
when an unregulated firm does this. Jandik, T., and A. K. Makhija.
(1999). “An empirical examination of the atypical diversification
practices of electric utilities: Internal capital markets and regula-
tion.” Fisher College of Business, Ohio State University, working
paper (September). This work shows that regulators have the ef-
fect of making a regulated firm’s internal capital market more ef-
ficient. Differences between Russo’s (1992) findings and Jandik and
Makhija’s (1999) findings may have to do with when this work was
done. Russo’s (1992) research may have focused on a time period
before regulatory agencies had learned how to improve a firm’s
internal capital market. However, even though Jandik and Makhija
(1999) report positive returns from regulated firms diversifying,
these positive returns do not reflect the market power advantages of
these firms.
32. Finkelstein, S., and D. C. Hambrick. (1989). “Chief executive compen-
sation: A study of the intersection of markets and political processes.”
Strategic Management Journal, 10, pp. 121–134.
33. See William, J., B. L. Paez, and L. Sanders. (1988). “Conglomerates
revisited.” Strategic Management Journal, 9, pp. 403–414; Geringer,
J. M., S. Tallman, and D. M. Olsen. (2000). “Product and interna-
tional diversification among Japanese multinational firms.” Strategic
Management Journal, 21, pp. 51–80; Nail, L. A., W. L. Megginson, and
C. Maquieira. (1998). “How stock-swap mergers affect shareholder
(and bondholder) wealth: More evidence of the value of corporate
‘focus.’” Journal of Applied Corporate Finance, 11(2), pp. 95–106;
Carroll, G. R., L. S. Bigelow, M.-D. L. Seidel, and L. B. Tsai. (1966).
“The fates of De Novo and De Alio producers in the American au-
tomobile industry 1885–1981.” Strategic Management Journal, 17
(Special Summer Issue), pp. 117–138; Nguyen, T. H., A. Seror, and
T. M. Devinney. (1990). “Diversification strategy and performance
in Canadian manufacturing firms.” Strategic Management Journal,
11, pp. 411–418; and Amit, R., and J. Livnat. (1988). “Diversification
strategies, business cycles and economic performance.” Strategic
Management Journal, 9, pp. 99–110, for a discussion of corporate
diversification in the economy over time.
34. The Nestlé story is summarized in Templeman, J. (1993). “Nestlé:
A giant in a hurry.” BusinessWeek, March 22, pp. 50–54.
M07_BARN0088_05_GE_C07.INDD 239 13/09/14 5:19 PM

240
1. Describe the multidivisional, or M-form, structure and
how it is used to implement a corporate diversification
strategy.
2. Describe the roles of the board of directors, institu-
tional investors, the senior executive, corporate staff,
division general managers, and shared activity manag-
ers in making the M-form structure work.
And Then There Is Berkshire Hathaway
Berkshire Hathaway is one of the largest and most profitable publicly traded diversified corpora-
tions in the world. With sales in excess of $162 billion, Berkshire Hathaway operates in four large
segments: insur ance; r ailroads; utilities and ener gy; and manufac turing, ser vices, and r etail.
However, its businesses are run through literally hundreds of wholly owned subsidiaries. Some of
these subsidiaries are relatively obscure and sell only to other companies—TTI, a Texas company
that distr ibutes c omponents t o elec tronics manufac turing fir ms. O ther subsidiar ies ar e w ell-
known—GEICO, Fruit of the L oom, Russell Brands, Justin Brands, Benjamin Moore, Dairy Queen,
RC Wiley, Helzberg Diamonds, and Net Jets to name just a few.
In addition t o owning hundreds of businesses outr ight, Berkshire Hathaway also in vests
cash from its insurance businesses to take substantial, but not controlling, investments in a vari-
ety of other companies, including Mars, American Express, Coca-Cola, Wells Fargo, and IBM.
However, unlike man y diversified firms, Berkshire Hathaway does not look t o realize eco-
nomics of scope across its businesses. According to its 2012 10K report: “Berkshire’s operating
businesses are managed on an unusually dec entralized basis . There are essen tially no c entral-
ized or in tegrated business func tions (such as sales , mar keting, pur chasing, legal , or human
resources) and there is minimal involvement by Berkshire’s corporate headquarters in the day to
day business activities of the operating businesses.”
Thus, Berkshire Hathaway is an unrelated diversified firm. And, yet, it is so effectively man-
aged as an unr elated diversified fir m that it is able t o generate significant value. For example,
Berkshire employs 288,500 people w orldwide, but—consistent with its unr elated diversification
strategy—has only 24 employees at corporate headquarters.
3. Describe how three management control processes—
measuring divisional performance, allocating corporate
capital, and transferring intermediate products—are used
to help implement a corporate diversification strategy.
4. Describe the role of management compensation in
helping to implement a corporate diversification
strategy.
L e A r n I n g O B j e c T I v e s After reading this chapter, you should be able to:
MyManagementLab®
Improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
8
c H A p T e r Organizing to
Implement Corporate
Diversification
M08_BARN0088_05_GE_C08.INDD 240 13/09/14 3:58 PM

241
In describing Berkshire’s operating principles, founder and
chair, Warren Buff ett, has wr itten: “Although our f orm is corpo-
rate, our a ttitude is par tnership. Char lie M unger ( Vice Chair of
the Board) and I think of our shareholders as owner-partners, and
ourselves as manag ing partners… We do not view the c ompany
as the ultimate owner of our business assets but instead view the
company as a conduit through which our shareholders own the
assets… Our long term economic goal is to maximize Berkshire’s
average annual rate of gain in intrinsic business value on a per-
share basis . We do not measur e the ec onomic sig nificance or
performance of Berkshire by its size; we measure by per-share
progress… Our preference would be to reach our goal by directly
owning a div ersified g roup of businesses …our sec ond pr eference is t o o wn par ts of similar
businesses… Accounting consequences do not influence our operating or capital allocation
decisions. When ac quisition c osts ar e similar, w e much pr efer t o pur chase $2 of ear nings tha t
is not r eportable by us under standar d accounting procedures than t o buy $1 of ear nings that
are reportable…Regardless of pr ice, we have no in terest in selling an y good business B erkshire
owns. We are also reluctant to sell sub-par businesses as long as w e expect them to generate at
least some cash… Gin Rummy managerial behavior (discard your least-promising business at
each turn) is not our style.”
These operating principles are quite different from many other div ersified firms. General
Electric, for example, for some time followed a simple operating principle: If a business unit w as
not number one or number t wo in a g rowing business, it w ould be div ested. This is v ery much
the “gin rummy” approach to management described by Warren Buffett. Also, most diversified
firms seek t o realize as man y “integrated business ac tivities” as they can. C ertainly, ESPN —the
diversified firm discussed a t the beg inning of Chapt er 7—has many shared activities across its
numerous networks.
But what works for GE or f or ESPN may simply not w ork for Berkshire Hathaway, and vice
versa. One of the man y things w e can lear n from Berkshire Hathaway is ho w impor tant it is t o
match a fir m’s corporate strategy with its or ganizing principles. One c ould argue that Berkshire
Hathaway does this match very well.
Sources: (2012). 10K report for Berkshire Hathaway; W. Buffet (2013). “An owner’s manual, revised.” www.berkshirehathaway.com.
Accessed July 26, 2013.
©
Z
U
M
A
Pr
es
s,
In
c.
/A
la
m
y
M08_BARN0088_05_GE_C08.INDD 241 13/09/14 3:58 PM

242 Part 3: Corporate Strategies
T his chapter is about how large diversified firms—like Berkshire Hathaway—are managed and governed efficiently. The chapter explains how these kinds of firms are managed in a way that is consistent with the interests of their
owners—equity holders—as well as the interests of their other stakeholders. The
three components of organizing to implement any strategy, which were first identi-
fied in Chapter 3—organizational structure, management controls, and compensa-
tion policy—are also important in implementing corporate diversification strategies.
Organizational Structure and Implementing
Corporate Diversification
The most common organizational structure for implementing a corporate
diversification strategy is the M-form, or multidivisional, structure. A typical
M-form structure, as it would appear in a firm’s annual report, is presented in
Figure 8.1. This same structure is redrawn in Figure 8.2 to emphasize the roles and
responsibilities of each of the major components of the M-form organization.1
In the multidivisional structure, each business that the firm engages in
is managed through a division. Different firms have different names for these
divisions—strategic business units (SBUs), business groups, companies. Whatever
their names, the divisions in an M-form organization are true profit-and-loss
centers: Profits and losses are calculated at the level of the division in these firms.
Different firms use different criteria for defining the boundaries of profit-
and-loss centers. For example, General Electric defines its divisions in terms of the
types of products each one manufactures and sells (e.g., aviation, capital, energy
management, and health care). Nestlé defines its divisions with reference to the
Division
General Manager A
Finance Legal Accounting
Research and
Development Sales
Human
Resources
Division
General Manager B
Senior Executive
Board of Directors
Division
General Manager C
Division A Division B Division C
Figure 8.1 An Example of M-Form Organizational Structure as Depicted in a Firm’s Annual Report
V R I O
M08_BARN0088_05_GE_C08.INDD 242 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 243
geographic scope of each of its businesses (North America, South America, and
so forth). General Motors defines its divisions in terms of the brand names of
its products (Cadillac, Chevrolet, and so forth). However they are defined, divi-
sions in an M-form organization should be large enough to represent identifiable
business entities but small enough so that each one can be managed effectively
by a division general manager. Indeed, each division in an M-form organization
typically adopts a U-form structure (see the discussion of the U-form structure
in Chapters 4, 5, and 6), and the division general manager takes on the role of a
U-form senior executive for his or her division.
The M-form structure is designed to create checks and balances for manag-
ers that increase the probability that a diversified firm will be managed in ways
consistent with the interests of its equity holders. The roles of each of the major
elements of the M-form structure in accomplishing this objective are summarized
in Table 8.1 and discussed in the following text. Some of the conflicts of interest
that might emerge between a firm’s equity holders and its managers are described
in the Strategy in Depth feature.
The Board of Directors
One of the major components of an M-form organization is a firm’s board of
directors. In principle, all of a firm’s senior managers report to the board. The
board’s primary responsibility is to monitor decision making in the firm, ensuring
that it is consistent with the interests of outside equity holders.
A board of directors typically consists of 10 to 15 individuals drawn from
a firm’s top management group and from individuals outside the firm. A firm’s
Division
General Manager A
Corporate staff:
Finance
Legal
Accounting
Human Resources
Shared Activity:
Research and Development
Shared Activity:
Sales
Division
General Manager B
Senior Executive
Board of Directors
Division
General Manager C
Division A Division B Division C
Figure 8.2 An M-Form
Structure Redrawn to Emphasize
Roles and Responsibilities
M08_BARN0088_05_GE_C08.INDD 243 13/09/14 3:58 PM

244 Part 3: Corporate Strategies
senior executive (often identified by the title president or chief executive officer or
CEO), its chief financial officer (CFO), and a few other senior managers are usu-
ally on the board—although managers on the board are typically outnumbered
by outsiders. The firm’s senior executive is often, but not always, the chairman of
the board (a term used here to denote both female and male senior executives).
The task of managerial board members—including the board chairman—is to
provide other board members information and insights about critical decisions
being made in the firm and the effect those decisions are likely to have on a firm’s
equity holders. The task of outsiders on the board is to evaluate the past, current,
and future performance of the firm and of its senior managers to ensure that the
actions taken in the firm are consistent with equity holders’ interests.2
Component Activity
Board of directors Monitor decision making in a firm to ensure that it is consistent
with the interests of outside equity holders
Institutional
investors
Monitor decision making to ensure that it is consistent with the
interests of major institutional equity investors
Senior executives Formulate corporate strategies consistent with equity holders’
interests and assure strategy implementation
Strategy formulation:
■ Decide the businesses in which the firm will operate
■ Decide how the firm should compete in those businesses
■ Specify the economies of scope around which the diversified
firm will operate
Strategy implementation:
■ Encourage cooperation across divisions to exploit
economies of scope
■ Evaluate performance of divisions
■ Allocate capital across divisions
Corporate staff Provide information to the senior executive about internal
and external environments for strategy formulation and
implementation
Division general
managers
Formulate divisional strategies consistent with corporate
strategies and assure strategy implementation
Strategy formulation:
■ Decide how the division will compete in its business, given
the corporate strategy
Strategy implementation:
■ Coordinate the decisions and actions of functional managers
reporting to the division general manager to implement
divisional strategy
■ Compete for corporate capital allocations
■ Cooperate with other divisions to exploit corporate
economies of scope
Shared activity
managers
Support the operations of multiple divisions
TaBle 8.1 The Roles and
Responsibilities of Major
Components of the M-Form
Structure
M08_BARN0088_05_GE_C08.INDD 244 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 245
In Chapter 7, it was suggested that sometimes it is in the best interest
of equity holders to delegate to man-
agers the day-to-day management of
their equity investments in a firm. This
will be the case when equity investors
cannot realize a valuable economy of
scope on their own, while managers
can realize that economy of scope.
Several authors have suggested
that whenever one party in an exchange
delegates decision-making authority to
a second party, an agency relationship
has been created between these par-
ties. The party delegating this decision-
making authority is called the principal;
the party to whom this authority is del-
egated is called the agent. In the context
of corporate diversification, an agency
relationship exists between a firm’s out-
side equity holders (as principals) and
its managers (as agents) to the extent
that equity holders delegate the day-to-
day management of their investment to
those managers.
The agency relationship be-
tween equity holders and managers
can be very effective as long as man-
agers make investment decisions that
are consistent with equity holders’
interests. Thus, if equity holders are
interested in maximizing the rate of
return on their investment in a firm
and if managers make their invest-
ment decisions with this objective in
mind, then equity holders will have
few concerns about delegating the
day-to-day management of their in-
vestments to managers. Unfortunately,
in numerous situations the interests
of a firm’s outside equity holders and
its managers do not coincide. When
parties in an agency relationship dif-
fer in their decision-making objectives,
agency problems arise. Two common
agency problems have been identified:
investment in managerial perquisites
and managerial risk aversion.
Managers may decide to take
some of a firm’s capital and invest
it in managerial perquisites that do
not add economic value to the firm
but do directly benefit those manag-
ers. Examples of such investments in-
clude lavish offices, fleets of corporate
jets, and corporate vacation homes.
Dennis Kozlowski, former CEO of
Tyco International, is accused of “steal-
ing” $600 million in these kinds of
managerial perquisites from his firm.
The list of goods and services that
Kozlowski lavished on himself and
those close to him is truly astounding—
a multimillion-dollar birthday party
for his wife, a $6,000 wastebasket, a
$15,000 umbrella stand, a $144,000 loan
to a board member, toga-clad waiters
at an event, and so on.
As outrageous as some of these
managerial perquisites can be, the
second source of agency problems—
managerial risk aversion—is prob-
ably more important in most diversified
firms. As discussed in Chapter 7, equity
holders can diversify their portfolio of
investments at very low cost. Through
their diversification efforts, they can
eliminate all firm-specific risk in their
portfolios. In this setting, equity holders
would prefer that managers make more
risky rather than less risky investments
because the expected return on risky in-
vestments is usually greater than the ex-
pected return on less risky investments.
Managers, in contrast, have lim-
ited ability to diversify their human
capital investments in their firm. Some
portion of these investments is specific
to a particular firm and has limited
value in alternative uses. The value of
a manager’s human capital investment
in a firm depends critically on the
continued existence of the firm. Thus,
managers are not indifferent to the
riskiness of investment opportunities
in a firm. Very risky investments may
jeopardize a firm’s survival and thus
eliminate the value of a manager’s
human capital investments. These in-
centives can make managers more risk
averse in their decision making than
equity holders would like them to be.
One of the purposes of the
M-form structure, and indeed of all
aspects of organizing to implement
corporate diversification, is to reduce
these agency problems.
Sources: M. C. Jensen and W. H. Meckling (1976).
“Theory of the firm: Managerial behavior, agency
costs, and ownership structure.” Journal of Financial
Economics, 3, pp. 305–360; J. Useem (2003). “The
biggest show.” Fortune, December 8, pp. 157+;
R. Lambert (1986). “Executive effort and selection
of risky projects.” Rand Journal of Economics, 13(2),
pp. 369–378.
agency Conflicts Between
Managers and equity Holders
Strategy in Depth
M08_BARN0088_05_GE_C08.INDD 245 13/09/14 3:58 PM

246 Part 3: Corporate Strategies
Boards of directors are typically organized into several subcommittees. An
audit committee is responsible for ensuring the accuracy of accounting and finan-
cial statements. A finance committee maintains the relationship between the firm
and external capital markets. A nominating committee nominates new board
members. A personnel and compensation committee evaluates and compensates
the performance of a firm’s senior executive and other senior managers. Often,
membership on these standing committees is reserved for external board mem-
bers. Other standing committees reflect specific issues for a particular firm and
are typically open to external and internal board members.3
Over the years, a great deal of research has been conducted about the effec-
tiveness of boards of directors in ensuring that a firm’s managers make decisions
in ways consistent with the interests of its equity holders. Some of this work is
summarized in the Research Made Relevant feature.
A great deal of research has tried to determine when boards of direc-
tors are more or less effective in ensur-
ing that firms are managed in ways
consistent with the interests of equity
holders. Three issues have received
particular attention: (1) the roles of
insiders (i.e., managers) and outsiders
on the board, (2) whether the board
chair and the senior executive should
be the same or different people, and
(3) whether the board should be active
or passive.
With respect to insiders and out-
siders on the board, in one way this
seems like a simple problem. Because
the primary role of the board of direc-
tors is to monitor managerial decisions
to ensure that they are consistent with
the interests of equity holders, it fol-
lows that the board should consist pri-
marily of outsiders because they face
no conflict of interest in evaluating
managerial performance. Obviously,
managers, as inside members of
the board, face significant conflicts
of interest in evaluating their own
performance.
Research on outsider members
of boards of directors tends to support
this point of view. Outside directors,
as compared with insiders, tend to
focus more on monitoring a firm’s eco-
nomic performance than on other mea-
sures of firm performance. Obviously,
a firm’s economic performance is
most relevant to its equity investors.
Outside board members are also more
likely than inside members to dismiss
CEOs for poor performance. Also,
outside board members have a stron-
ger incentive than inside members to
maintain their reputations as effective
monitors. This incentive by itself can
lead to more effective monitoring by
outside board members. Moreover, the
monitoring effectiveness of outside
board members seems to be enhanced
when they personally own a substan-
tial amount of a firm’s equity.
However, the fact that outside
members face fewer conflicts of inter-
est in evaluating managerial perfor-
mance compared with management
insiders on the board does not mean
that there is no appropriate role for in-
side board members. Managers bring
something to the board that cannot
be easily duplicated by outsiders—
detailed information about the
decision- making activities inside the
firm. This is precisely the informa-
tion that outsiders need to effectively
monitor the activities of a firm, and
it is information available to them
only if they work closely with insiders
(managers). One way to gain access to
this information is to include manag-
ers as members of the board of direc-
tors. Thus, while most research sug-
gests that a board of directors should
be composed primarily of outsiders,
there is an important role for insiders/
managers to play as members of a
firm’s board.
There is currently some de-
bate about whether the roles of board
chair and CEO should be combined
The effectiveness of Boards
of Directors
Research Made Relevant
M08_BARN0088_05_GE_C08.INDD 246 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 247
or separated and, if separated, what
kinds of people should occupy these
positions. Some have argued that the
roles of CEO and board chair should
definitely be separated and that the
role of the chair should be filled by
an outside (nonmanagerial) member
of the board of directors. These ar-
guments are based on the assump-
tion that only an outside member of
the board can ensure the independent
monitoring of managerial decision
making. Others have argued that ef-
fective monitoring often requires more
information than would be available to
outsiders, and thus the roles of board
chair and CEO should be combined
and filled by a firm’s senior manager.
Empirical research on this
question suggests that whether these
roles of CEO and chairman should be
combined depends on the complexity
of the information analysis and moni-
toring task facing the CEO and board
chair. Brian Boyd has found that com-
bining the roles of CEO and chair
is positively correlated with firm
performance when firms operate in
slow-growth and simple competitive
environments—environments that do
not overtax the cognitive capability
of a single individual. This finding
suggests that combining these roles
does not necessarily increase con-
flicts between a firm and its equity
holders. This research also found
that separating the roles of CEO and
board chair is positively correlated
with firm performance when firms
operate in high-growth and very
complex environments. In such envi-
ronments, a single individual cannot
fulfill all the responsibilities of both
CEO and board chair, and thus the
two roles need to be held by separate
individuals.
Finally, with respect to ac-
tive versus passive boards, histori-
cally the boards of major firms have
been relatively passive and would
take dramatic action, such as fir-
ing the senior executive, only if a
firm’s performance was significantly
below expectations for long periods
of time. However, more recently,
boards have become more active pro-
ponents of equity holders’ interests.
This recent surge in board activity
reflects a new economic reality: If a
board does not become more active
in monitoring firm performance, then
other monitoring mechanisms will.
Consequently, the board of directors
has become progressively more influ-
ential in representing the interests of
a firm’s equity holders.
However, board activity can go
too far. To the extent that the board
begins to operate a business on a day-
to-day basis, it goes beyond its capa-
bilities. Boards rarely have sufficient
detailed information to manage a firm
directly. When it is necessary to change
a firm’s senior executive, boards will
usually not take on the responsibili-
ties of that executive, but rather will
rapidly identify a single individual—
either an insider or outsider—to take
over this position.
Sources: E. Zajac and J. Westphal (1994). “The
costs and benefits of managerial incentives and
monitoring in large U.S. corporations: When
is more not better?” Strategic Management
Journal, 15, pp. 121–142; P. Rechner and
D. Dalton (1991). “CEO duality and organiza-
tional performance: A longitudinal analysis.”
Strategic Management Journal, 12, pp. 155–160;
S. Finkelstein and R. D’Aveni (1994). “CEO du-
ality as a double-edged sword: How boards of
directors balance entrenchment avoidance and
unity of command.” Academy of Management
Journal, 37, pp. 1079–1108; B. K. Boyd (1995).
“CEO duality and firm performance: A contin-
gency model.” Strategic Management Journal, 16,
pp. 301–312; I. F. Kesner and R. B. Johnson (1990).
“An investigation of the relationship between
board composition and stockholder suits.”
Strategic Management Journal, 11, pp. 327–336.
Institutional Owners
Historically, the typical large diversified firm has had its equity owned in small
blocks by millions of individual investors. The exception to this general rule was
family-owned or -dominated firms, a phenomenon that is relatively more com-
mon outside the United States. When a firm’s ownership is spread among mil-
lions of small investors, it is difficult for any one of these investors to have a large
enough ownership position to influence management decisions directly. The only
course of action open to such investors if they disagree with management deci-
sions is to sell their stock.
However, the growth of institutional owners has changed the ownership
structure of many large diversified firms over the past several years. Institutional
owners are usually pension funds, mutual funds, insurance companies, or
other groups of individual investors that have joined together to manage their
M08_BARN0088_05_GE_C08.INDD 247 13/09/14 3:58 PM

248 Part 3: Corporate Strategies
investments. In 1970, institutions owned 32 percent of the equity traded in the
United States. By 1990, institutions owned 48 percent of this equity. In 2005, they
owned 59 percent of all equity traded in the United States and 69 percent of the
equity of the 1,000 largest firms in the United States.4
Institutional investors can use their investment clout to insist that a firm’s
management behaves in ways consistent with the interests of equity holders.
Observers who assume that institutional investors are interested more in maxi-
mizing the short-term value of their portfolios than in the long-term performance
of firms in those portfolios fear that such power will force firms to make only
short-term investments. Research in the United States and Japan, however, sug-
gests that institutional investors are not unduly myopic. Rather, as suggested
earlier, these investors use approximately the same logic equity investors use
when evaluating the performance of a firm. For example, one group of research-
ers examined the impact of institutional ownership on research and development
investments in research and development (R&D)–intensive industries. R&D
investments tend to be longer term in orientation. If institutional investors are
myopic, they should influence firms to invest in relatively less R&D in favor of
investments that generate shorter-term profits. This research showed that high
levels of institutional ownership did not adversely affect the level of R&D in a
firm. These findings are consistent with the notion that institutional investors are
not inappropriately concerned with the short term in their monitoring activities.5
More generally, other researchers have shown that high levels of institu-
tional ownership lead firms to sell strategically unrelated businesses. This effect
of institutional investors is enhanced if, in addition, outside directors on a firm’s
board have substantial equity investments in the firm. Given the discussion of the
value of unrelated diversification in Chapter 7, it seems clear that these divest-
ment actions are typically consistent with maximizing the present value of a firm.6
The Senior executive
As suggested in Table 8.1, the senior executive (the president or CEO) in an
M-form organization has two responsibilities: strategy formulation and strategy
implementation. Strategy formulation entails deciding which set of businesses a
diversified firm will operate in; strategy implementation focuses on encouraging be-
havior in a firm that is consistent with this strategy. Each of these responsibilities
of the senior executive is discussed in turn.
s trategy Formulation
At the broadest level, deciding which businesses a diversified firm should operate
in is equivalent to discovering and developing valuable economies of scope among
a firm’s current and potential businesses. If these economies of scope are also rare
and costly to imitate, they can be a source of sustained competitive advantage for
a diversified firm.
The senior executive is uniquely positioned to discover, develop, and nurture
valuable economies of scope in a diversified firm. Every other manager in this kind
of firm either has a divisional point of view (e.g., division general managers and
shared activity managers) or is a functional specialist (e.g., corporate staff and func-
tional managers within divisions). Only the senior executive has a truly corporate
perspective. However, the senior executive in an M-form organization should in-
volve numerous other divisional and functional managers in strategy formulation
to ensure complete and accurate information as input to the process and a broad
understanding of and commitment to that strategy once it has been formulated.
M08_BARN0088_05_GE_C08.INDD 248 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 249
s trategy Implementation
As is the case for senior executives in a U-form structure, strategy implementation
in an M-form structure almost always involves resolving conflicts among groups of
managers. However, instead of simply resolving conflicts between functional man-
agers (as is the case in a U-form), senior executives in M-form organizations must
resolve conflicts within and between each of the major managerial components of
the M-form structure: corporate staff, division general managers, and shared activ-
ity managers. Various corporate staff managers may disagree about the economic
relevance of their staff functions, corporate staff may come into conflict with divi-
sion general managers over various corporate programs and activities, division
general managers may disagree with how capital is allocated across divisions, divi-
sion general managers may come into conflict with shared activity managers about
how shared activities should be managed, shared activity managers may disagree
with corporate staff about their mutual roles and responsibilities, and so forth.
Obviously, the numerous and often conflicting relationships among groups
of managers in an M-form organization can place significant strategy implemen-
tation burdens on the senior executive.7 While resolving these numerous conflicts,
however, the senior executive needs to keep in mind the reasons why the firm
began pursuing a diversification strategy in the first place: to exploit real econo-
mies of scope that outside investors cannot realize on their own. Any strategy
implementation decisions that jeopardize the realization of these real economies
of scope are inconsistent with the underlying strategic objectives of a diversified
firm. These issues are analyzed in detail later in this chapter, in the discussion of
management control systems in the M-form organization.
The Office of the president: Board c hair, ce O, and c OO
It is often the case that the roles and responsibilities of the senior executive in
an M-form organization are greater than can be reasonably managed by a single
individual. This is especially likely if a firm is broadly diversified across numer-
ous complex products and markets. In this situation, it is not uncommon for
the tasks of the senior executive to be divided among two or three people: the
board chair, the chief executive officer, and the chief operating officer (COO).
The primary responsibilities of each of these roles in an M-form organization are
listed in Table 8.2. Together, these roles are known as the office of the president.
In general, as the tasks facing the office of the president become more demand-
ing and complex, the more likely it is that the roles and responsibilities of this
office will be divided among two or three people.
Corporate Staff
The primary responsibility of corporate staff is to provide information about the
firm’s external and internal environments to the firm’s senior executive. This in-
formation is vital for both the strategy formulation and the strategy implementa-
tion responsibilities of the senior executive. Corporate staff functions that provide
Board chair Supervision of the board of directors in its
monitoring role
Chief executive officer Strategy formulation
Chief operating officer Strategy implementation
TaBle 8.2 Responsibilities
of Three Different Roles in the
Office of the President
M08_BARN0088_05_GE_C08.INDD 249 13/09/14 3:58 PM

250 Part 3: Corporate Strategies
information about a firm’s external environment include finance, investor relations,
legal affairs, regulatory affairs, and corporate advertising. Corporate staff functions
that provide information about a firm’s internal environment include accounting
and corporate human resources. These corporate staff functions report directly to a
firm’s senior executive and are a conduit of information to that executive.
c orporate and Divisional staff
Many organizations re-create some corporate staff functions within each divi-
sion of the organization. This is particularly true for internally oriented corporate
staff functions such as accounting and human resources. At the division level,
divisional staff managers usually have a direct “solid-line” reporting relationship
to their respective corporate staff functional managers and a less formal “dotted-
line” reporting relationship to their division general manager. The reporting re-
lationship between the divisional staff manager and the corporate staff manager
is the link that enables the corporate staff manager to collect the information that
the senior executive requires for strategy formulation and implementation. The
senior executive can also use this corporate staff–division staff relationship to
communicate corporate policies and procedures to the divisions, although these
policies can also be communicated directly by the senior executive to division
general managers.
Although divisional staff managers usually have a less formal relationship
with their division general managers, in practice division general managers can
have an important influence on the activities of divisional staff. After all, divi-
sional staff managers may formally report to corporate staff managers, but they
spend most of their time interacting with their division general managers and
with the other functional managers who report to their division general manag-
ers. These divided loyalties can sometimes affect the timeliness and accuracy
of the information transmitted from divisional staff managers to corporate staff
managers and thus affect the timeliness and accuracy of the information the se-
nior executive uses for strategy formulation and implementation.
Nowhere are these divided loyalties potentially more problematic than in
accounting staff functions. Obviously, it is vitally important for the senior execu-
tive in an M-form organization to receive timely and accurate information about
divisional performance. If the timeliness and accuracy of that information are
inappropriately affected by division general managers, the effectiveness of senior
management can be adversely affected. Moreover, in some situations division
general managers can have very strong incentives to affect the timeliness and
accuracy of divisional performance information, especially if a division general
manager’s compensation depends on this information or if the capital allocated to
a division depends on this information.
Efficient monitoring by the senior executive requires that corporate staff,
and especially the accounting corporate staff function, remains organizationally
independent of division general managers—thus, the importance of the solid-line
relationship between divisional staff managers and corporate staff managers.
Nevertheless, the ability of corporate staff to obtain accurate performance infor-
mation from divisions also depends on close cooperative working relationships
between corporate staff, divisional staff, and division general managers—hence,
the importance of the dotted-line relationship between divisional staff manag-
ers and division general managers. How one maintains the balance between the
distance and objectivity needed to evaluate a division’s performance on the one
hand, and, on the other hand, the cooperation and teamwork needed to gain
M08_BARN0088_05_GE_C08.INDD 250 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 251
access to the information required to evaluate a division’s performance distin-
guishes excellent from mediocre corporate staff managers.
Overinvolvement in Managing Division Operations
Over and above the failure to maintain a balance between objectivity and cooper-
ation in evaluating divisional performance, the one sure way that corporate staff
can fail in a multidivisional firm is to become too involved in the day-to-day op-
erations of divisions. In an M-form structure, the management of such day-to-day
operations is delegated to division general managers and to functional managers
who report to division general managers. Corporate staff managers collect and
transmit information; they do not manage divisional operations.
One way to ensure that corporate staff does not become too involved in
managing the day-to-day operations of divisions is to keep corporate staff small.
This is certainly true for some of the best-managed diversified firms in the world
including (and described in the opening case) Berkshire Hathaway. For example,
just 1.5 percent of Johnson & Johnson’s more than 80,000 employees work at the
firm’s headquarters, and only some of those individuals are members of the cor-
porate staff. Hanson Industries has in its U.S. headquarters 120 people who help
manage a diversified firm with $8 billion in revenues. Clayton, Dubilier, and Rice,
a management buyout firm, has only 11 headquarters staff members overseeing
eight businesses with collective sales of more than $6 billion.8
Division General Manager
Division general managers in an M-form organization have primary responsibil-
ity for managing a firm’s businesses from day to day. Division general managers
have full profit-and-loss responsibility and typically have multiple functional
managers reporting to them. As general managers, they have both strategy for-
mulation and strategy implementation responsibilities. On the strategy formula-
tion side, division general managers choose strategies for their divisions, within
the broader strategic context established by the senior executive of the firm. Many
of the analytical tools described in Parts 1 and 2 of this book can be used by divi-
sion general managers to make these strategy formulation decisions.
The strategy implementation responsibilities of division general managers
in an M-form organization parallel the strategy implementation responsibilities of
senior executives in U-form organizations. In particular, division general manag-
ers must be able to coordinate the activities of often-conflicting functional manag-
ers in order to implement a division’s strategies.
In addition to their responsibilities as a U-form senior executive, division
general managers in an M-form organization have two additional responsibilities:
to compete for corporate capital and to cooperate with other divisions to exploit
corporate economies of scope. Division general managers compete for corporate
capital by promising high rates of return on capital invested by the corporation in
their business. In most firms, divisions that have demonstrated the ability to gen-
erate high rates of return on earlier capital investments gain access to more capital
or to lower-cost capital, compared with divisions that have not demonstrated a
history of such performance.
Division general managers cooperate to exploit economies of scope by
working with shared activity managers, corporate staff managers, and the se-
nior executive in the firm to isolate, understand, and use the economies of scope
around which the diversified firm was originally organized. Division general
M08_BARN0088_05_GE_C08.INDD 251 13/09/14 3:58 PM

252 Part 3: Corporate Strategies
managers can even become involved in discovering new economies of scope
that were not anticipated when the firm’s diversification strategy was originally
implemented but nevertheless may be both valuable and costly for outside inves-
tors to create on their own.
Of course, a careful reader will recognize a fundamental conflict between the
last two responsibilities of division general managers in an M-form organization.
These managers are required to compete for corporate capital and to cooperate to
exploit economies of scope at the same time. Competition is important because it
leads division general managers to focus on generating high levels of economic
performance from their divisions. If each division is generating high levels of
economic performance, then the diversified firm as a whole is likely to do well
also. However, cooperation is important to exploit economies of scope that are
the economic justification for implementing a diversification strategy in the first
place. If divisions do not cooperate in exploiting these economies, there are few,
if any, justifications for implementing a corporate diversification strategy, and the
diversified firm should be split into multiple independent entities. The need to
simultaneously compete and cooperate puts significant managerial burdens on
division general managers. It is likely that this ability is both rare and costly to imi-
tate across most diversified firms.9
Shared activity Managers
One of the potential economies of scope identified in Chapter 7 was shared ac-
tivities. Divisions in an M-form organization exploit this economy of scope when
one or more of the stages in their value chains are managed in common. Typical
examples of activities shared across two or more divisions in a multidivisional
firm include common sales forces, common distribution systems, common
manufacturing facilities, and common research and development efforts (also
see Table 7.2). The primary responsibility of the individuals who manage shared
activities is to support the operations of the divisions that share the activity.
The way in which M-form structure is often depicted in company annual
reports (as in Figure 8.1) tends to obscure the operational role of shared activi-
ties. In this version of the M-form organizational chart, no distinction is made
between corporate staff functions and shared activity functions. Moreover, it
appears that managers of shared activities report directly to a firm’s senior
executive, just like corporate staff. These ambiguities are resolved by redraw-
ing the M-form organizational chart to emphasize the roles and responsibilities
of different units within the M-form (as in Figure 8.2). In this more accurate
representation of how an M-form actually functions, corporate staff groups are
separated from shared activity managers, and each is shown reporting to its
primary internal “customer.” That “internal customer” is the senior executive
for corporate staff groups and two or more division general managers for shared
activity managers.
s hared Activities as c ost c enters
Shared activities are often managed as cost centers in an M-form structure. That
is, rather than having profit-and-loss responsibility, cost centers are assigned a
budget and manage their operations to that budget. When this is the case, shared
activity managers do not attempt to create profits when they provide services to
the divisions they support. Rather, these services are priced to internal customers
in such a way that the shared activity just covers its cost of operating.
M08_BARN0088_05_GE_C08.INDD 252 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 253
Because cost center shared activities do not have to generate profits from
their operations, the cost of the services they provide to divisions can be less than
the cost of similar services provided either by a division itself or by outside sup-
pliers. If a shared activity is managed as a cost center, and the cost of services from
this shared activity is greater than the cost of similar services provided by alterna-
tive sources, then either this shared activity is not being well managed or it was
not a real economy of scope in the first place. However, when the cost of services
from a shared activity is less than the cost of comparable services provided by a
division itself or by an outside supplier, then division general managers have
a strong incentive to use the services of shared activities, thereby exploiting an
economy of scope that may have been one of the original reasons why a firm
implemented a corporate diversification strategy.
s hared Activities as profit c enters
Some diversified firms are beginning to manage shared activities as profit centers,
rather than as cost centers. Moreover, rather than requiring divisions to use the ser-
vices of shared activities, divisions retain the right to purchase services from internal
shared activities or from outside suppliers or to provide services for themselves. In
this setting, managers of shared activities are required to compete for their internal
customers on the basis of the price and quality of the services they provide.10
One firm that has taken this profit-center approach to managing shared
activities is ABB, Inc., a Swiss engineering firm. ABB eliminated almost all its
corporate staff and reorganized its remaining staff functions into shared activi-
ties. Shared activities in ABB compete to provide services to ABB divisions. Not
only do some traditional shared activities—such as research and development
and sales—compete for internal customers, but many traditional corporate staff
functions—such as human resources, marketing, and finance—do as well. ABB’s
approach to managing shared activities has resulted in a relatively small corporate
staff and in increasingly specialized and customized shared activities.11
Of course, the greatest risk associated with treating shared activities as
profit centers and letting them compete for divisional customers is that divisions
may choose to obtain no services or support from shared activities. Although this
course of action may be in the self-interest of each division, it may not be in the
best interest of the corporation as a whole if, in fact, shared activities are an im-
portant economy of scope around which the diversified firm is organized.
In the end, the task facing the managers of shared activities is the same: to
provide such highly customized and high-quality services to divisional customers
at a reasonable cost that those internal customers will not want to seek alternative
suppliers outside the firm or provide those services themselves. In an M-form
organization, the best way to ensure that shared activity economies of scope are
realized is for shared activity managers to satisfy their internal customers.
Management Controls and Implementing
Corporate Diversification
The M-form structure presented in Figures 8.1 and 8.2 is complex and multifac-
eted. However, no organizational structure by itself is able to fully implement a
corporate diversification strategy. The M-form structure must be supplemented
with a variety of management controls. Three of the most important management
controls in an M-form structure—systems for evaluating divisional performance,
M08_BARN0088_05_GE_C08.INDD 253 13/09/14 3:58 PM

254 Part 3: Corporate Strategies
for allocating capital across divisions, and for transferring intermediate products
between divisions—are discussed in this section.12
evaluating Divisional Performance
Because divisions in an M-form structure are profit-and-loss centers, evaluating
divisional performance should, in principle, be straightforward: Divisions that
are very profitable should be evaluated more positively than divisions that are
less profitable. In practice, this seemingly simple task is surprisingly complex.
Two problems typically arise: (1) How should division profitability be measured?
and (2) How should economy-of-scope linkages between divisions be factored
into divisional performance measures?
Measuring Divisional performance
Divisional performance can be measured in at least two ways. The first focuses
on a division’s accounting performance; the second on a division’s economic
performance.
Accounting Measures of Divisional performance. Both accounting and economic
measures of performance can be used in measuring the performance of divisions
within a diversified firm. Common accounting measures of divisional perfor-
mance include the return on the assets controlled by a division, the return on a
division’s sales, and a division’s sales growth. These accounting measures of di-
visional performance are then compared with some standard to see if a division’s
performance exceeds or falls short of that standard. Diversified firms use three
different standards of comparison when evaluating the performance of a division:
(1) a hurdle rate that is common across all the different business units in a firm,
(2) a division’s budgeted level of performance (which may vary by division), and
(3) the average level of profitability of firms in a division’s industry.
Each of these standards of comparison has its strengths and weaknesses. For
example, if a corporation has a single hurdle rate of profitability that all divisions
must meet or exceed, there is little ambiguity about the performance objectives
of divisions. However, a single standard ignores important differences in perfor-
mance that might exist across divisions.
Comparing a division’s actual performance to its budgeted performance
allows the performance expectations of different divisions to vary, but the bud-
geting process is time-consuming and fraught with political intrigue. One study
showed that corporate managers routinely discount the sales projections and cap-
ital requests of division managers on the assumption that division managers are
trying to “game” the budgeting system.13 Moreover, division budgets are usually
based on a single set of assumptions about how the economy is going to evolve,
how competition in a division’s industry is going to evolve, and what actions that
division is going to take in its industry. When these assumptions no longer hold,
budgets are redone—a costly and time-consuming process that has little to do
with generating value in a firm.
Finally, although comparing a division’s performance with the average level
of profitability of firms in a division’s industry also allows performance expecta-
tions to vary across divisions within a diversified firm, this approach lets other
firms determine what is and is not excellent performance for a division within
a diversified firm. This approach can also be manipulated: By choosing just the
“right” firms with which to compare a division’s performance, almost any divi-
sion can be made to look like it’s performing better than its industry average.14
M08_BARN0088_05_GE_C08.INDD 254 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 255
No matter what standard of comparison is used to evaluate a division’s ac-
counting performance, most accounting measures of divisional performance have
a common limitation. All these measures have a short-term bias. This short-term
bias reflects the fact that all these measures treat investments in resources and capa-
bilities that have the potential for generating value in the long run as costs during
a particular year. In order to reduce costs in a given year, division managers may
sometimes forgo investing in these resources and capabilities, even if they could be
a source of sustained competitive advantage for a division in the long run.
economic Measures of Divisional performance. Given the limitations of account-
ing measures of divisional performance, several firms have begun adopting
economic methods of evaluating this performance. Economic methods build on
accounting methods but adjust those methods to incorporate short-term invest-
ments that may generate long-term benefits. Economic methods also compare a
division’s performance with a firm’s cost of capital (see Chapter 1). This avoids
some of the gaming that can characterize the use of other standards of compari-
son in applying accounting measures of divisional performance.
Perhaps the most popular of these economically oriented measures of divi-
sion performance is known as economic value added (EVA).15 EVA is calculated
by subtracting the cost of capital employed in a division from that division’s earn-
ings in the following manner:
EVA = adjusted accounting earnings
1weighted average cost of capital * total capital employed by a division2
Several of the terms in the EVA formula require some discussion. For exam-
ple, the calculation of economic value added begins with a division’s “adjusted” ac-
counting earnings. These are a division’s traditional accounting earnings, adjusted
so that they approximate a division’s economic earnings. Several adjustments to a
division’s accounting statements have been described in the literature. For example,
traditional accounting practices require R&D spending to be deducted each year
from a division’s earnings. This can lead division general managers to under-invest
in longer-term R&D efforts. In the EVA measure of divisional performance, R&D
spending is added back into a division’s performance, and R&D is then treated as
an asset and depreciated over some period of time.
One consulting firm (Stern Stewart) that specializes in implementing EVA-
based divisional evaluation systems in multidivisional firms makes up to 40 “ad-
justments” to a division’s standard accounting earnings so that they more closely
approximate economic earnings. Many of these adjustments are proprietary to
this consulting firm. However, the most important adjustments—such as how
R&D should be treated—are broadly known.
The terms in parentheses in the EVA equation reflect the cost of investing in
a division. Rather than using some alternative standard of comparison, EVA ap-
plies financial theory and multiplies the amount of money invested in a division
by a firm’s weighted average cost of capital. A firm’s weighted average cost of
capital is the amount of money a firm could earn if it invested in any of its other
divisions. In this sense, a firm’s weighted average cost of capital can be thought of
as the opportunity cost of investing in a particular division, as opposed to invest-
ing in any other division in the firm.
By adjusting a division’s earnings and accounting for the cost of investing
in a division, EVA is a much more accurate estimate of a division’s economic per-
formance than are traditional accounting measures of performance. The number
M08_BARN0088_05_GE_C08.INDD 255 13/09/14 3:58 PM

256 Part 3: Corporate Strategies
of diversified firms evaluating their divisions with EVA-based measures of divi-
sional performance is impressive and growing. These firms include AT&T, Coca-
Cola, Quaker Oats, CSX, Briggs and Stratton, and Allied Signal. At Allied Signal,
divisions that do not earn their cost of capital are awarded the infamous “leaky
bucket” award. If this performance is not improved, division general managers
are replaced. The use of EVA has been touted as the key to creating economic
wealth in a diversified corporation.16
economies of s cope and the Ambiguity of Divisional performance
Whether a firm uses accounting measures to evaluate the performance of a
division or uses economic measures of performance such as EVA, divisional
performance in a well-managed diversified firm can never be evaluated unam-
biguously. Consider a simple example.
Suppose that in a particular multidivisional firm there are only two divi-
sions (Division A and Division B) and one shared activity (R&D). Also, suppose
that the two divisions are managed as profit-and-loss centers and that the R&D
shared activity is managed as a cost center. To support this R&D effort, each divi-
sion pays $10 million per year and has been doing so for 10 years. Finally, suppose
that after 10 years of effort (and investment) the R&D group develops a valuable
new technology that perfectly addresses Division A’s business needs.
Obviously, no matter how divisional performance is measured it is likely to
be the case that Division A’s performance will rise relative to Division B’s perfor-
mance. In this situation, what percentage of Division A’s improved performance
should be allocated to Division A, what percentage should be allocated to the
R&D group, and what percentage should be allocated to Division B?
The managers in each part of this diversified firm can make compelling
arguments in their favor. Division general manager A can reasonably argue that
without Division A’s efforts to exploit the new technology, the full value of the
technology would never have been realized. The R&D manager can reasonably
argue that, without the R&D effort, there would not have been a technology to
exploit in the first place. Finally, division general manager B can reasonably argue
that, without the dedicated long-term investment of Division B in R&D, there
would have been no new technology and no performance increase for Division A.
That all three of these arguments can be made suggests that, to the extent
that a firm exploits real economies of scope in implementing a diversification
strategy, it will not be possible to unambiguously evaluate the performance of
individual divisions in that firm. The fact that there are economies of scope in
a diversified firm means that all of the businesses a firm operates in are more
valuable bundled together than they would be if kept separate from one another.
Efforts to evaluate the performance of these businesses as if they were separate
from one another are futile.
One solution to this problem is to force businesses in a diversified firm to
operate independently of each other. If each business operates independently,
then it will be possible to unambiguously evaluate its performance. Of course, to
the extent that this independence is enforced, the diversified firm is unlikely to
be able to realize the very economies of scope that were the justification for the
diversification strategy in the first place.
Divisional performance ambiguity is bad enough when shared activities
are the primary economy of scope that a diversified firm is trying to exploit. This
ambiguity increases dramatically when the economy of scope is based on intan-
gible core competencies. In this situation, it is shared learning and experience that
M08_BARN0088_05_GE_C08.INDD 256 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 257
justify a firm’s diversification efforts. The intangible nature of these economies of
scope multiplies the difficulty of the divisional evaluation task.
Even firms that apply rigorous EVA measures of divisional performance are
unable to fully resolve these performance ambiguity difficulties. For example, the
Coca-Cola division of the Coca-Cola Company has made enormous investments in
the Coke brand name over the years, and the Diet Coke division has exploited some
of that brand name capital in its own marketing efforts. Of course, it is not clear that
all of Diet Coke’s success can be attributed to the Coke brand name. After all, Diet
Coke has developed its own creative advertising, its own loyal group of customers,
and so forth. How much of Diet Coke’s success—as measured through that division’s
economic value added—should be allocated to the Coke brand name (an investment
made long before Diet Coke was even conceived) and how much should be allocated
to the Diet Coke division’s efforts? EVA measures of divisional performance do not
resolve ambiguities created when economies of scope exist across divisions.17
In the end, the quantitative evaluation of divisional performance—with either
accounting or economic measures—must be supplemented by the experience and
judgment of senior executives in a diversified firm. Only by evaluating a division’s
performance numbers in the context of a broader, more subjective evaluation of the
division’s performance can a true picture of divisional performance be developed.
allocating Corporate Capital
Another potentially valuable economy of scope outlined in Chapter 7 (besides
shared activities and core competencies) is internal capital allocation. In that dis-
cussion, it was suggested that for internal capital allocation to be a justification
for diversification the information made available to senior executives allocating
capital in a diversified firm must be superior, in both amount and quality, to the
information available to external sources of capital in the external capital market.
Both the quality and the quantity of the information available in an internal capi-
tal market depend on the organization of the diversified firm.
One of the primary limitations of internal capital markets is that division
general managers have a strong incentive to overstate their division’s prospects
and understate its problems in order to gain access to more capital at lower costs.
Having an independent corporate accounting function in a diversified firm can
help address this problem. However, given the ambiguities inherent in evaluating
divisional performance in a well-managed diversified firm, independent corpo-
rate accountants do not resolve all these informational problems.
In the face of these challenges, some firms use a process called zero-based
budgeting to help allocate capital. In zero-based budgeting, corporate executives
create a list of all capital allocation requests from divisions in a firm, rank them
from “most important” to “least important,” and then fund all the projects a firm
can afford, given the amount of capital it has available. In principle, no project
will receive funding for the future simply because it received funding in the past.
Rather, each project has to stand on its own merits each year by being included
among the important projects the firm can afford to fund.
Although zero-based budgeting has some attractive features, it has some im-
portant limitations as well. For example, evaluating and ranking all projects in a
diversified firm from “most important” to “least important” is a very difficult task. It
requires corporate executives to have a very complete understanding of the strategic
role of each of the projects being proposed by a division, as well as an understanding
of how these projects will affect the short-term performance of divisions.
M08_BARN0088_05_GE_C08.INDD 257 13/09/14 3:58 PM

258 Part 3: Corporate Strategies
In the end, no matter what process firms use to allocate capital, allocating
capital inside a firm in a way that is more efficient than could be done by external
capital markets requires the use of information that is not available to those ex-
ternal markets. Typically, that information will be intangible, tacit, and complex.
Corporate managers looking to realize this economy of scope must find a way to
use this kind of information effectively.18 The difficulty of managing this process
effectively may be one of the reasons why internal capital allocation often fails to
qualify as a valuable economy of scope in diversified firms.19
Transferring Intermediate Products
The existence of economies of scope across multiple divisions in a diversified firm
often means that products or services produced in one division are used as inputs
for products or services produced by a second division. Such products or services are
called intermediate products or services. Intermediate products or services can be
transferred between any of the units in an M-form organization. This transfer is per-
haps most important and problematic when it occurs between profit center divisions.
The transfer of intermediate products or services among divisions is usually
managed through a transfer-pricing system: One division “sells” its product or
service to a second division for a transfer price. Unlike a market price, which is
typically determined by market forces of supply and demand, transfer prices are
set by a firm’s corporate management to accomplish corporate objectives.
s etting Optimal Transfer prices
From an economic point of view, the rule for establishing the optimal transfer
price in a diversified firm is quite simple: The transfer price should be the value
of the opportunities forgone when one division’s product or service is transferred
to another division. Consider the following example. Division A’s marginal cost of
production is $5 per unit, but Division A can sell all of its output to outside custom-
ers for $6 per unit. If Division A can sell all of its output to outside customers for $6
per unit, the value of the opportunity forgone of transferring a unit of production
from Division A to Division B is $6—the amount of money that Division A forgoes
by transferring its production to Division B instead of selling it to the market.
However, if Division A is selling all the units it can to external customers
for $6 per unit but still has some excess manufacturing capacity, the value of the
opportunity forgone in transferring the product from Division A to Division B is
only $5 per unit—Division A’s marginal cost of production. Because the external
market cannot absorb any more of Division A’s product at $6 per unit, the value of
the opportunity forgone when Division A transfers units of production to Division
B is not $6 per unit (Division A can’t get that price), but only $5 per unit.20
When transfer prices are set equal to opportunity costs, selling divisions will
produce output up to the point that the marginal cost of the last unit produced
equals the transfer price. Moreover, buying divisions will buy units from other di-
visions in the firm as long as the net revenues from doing so just cover the trans-
fer price. These transfer prices will lead profit-maximizing divisions to optimize
the diversified firm’s profits.
Difficulties in s etting Optimal Transfer prices
Setting transfer prices equal to opportunity costs sounds simple enough, but it is
very difficult to do in real diversified firms. Establishing optimal transfer prices
requires information about the value of the opportunities forgone by the “selling”
M08_BARN0088_05_GE_C08.INDD 258 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 259
division. This, in turn, requires information about this division’s marginal costs,
its manufacturing capacity, external demand for its products, and so forth. Much
of this information is difficult to obtain. Moreover, it is rarely stable. As market
conditions change, demand for a division’s products can change, marginal costs
can change, and the value of opportunities forgone can change. Also, to the extent
that a selling division customizes the products or services it transfers to other di-
visions in a diversified firm, the value of the opportunities forgone by this selling
division become even more difficult to calculate.
Even if this information could be obtained and updated rapidly, division
general managers in selling divisions have strong incentives to manipulate the
information in ways that increase the perceived value of the opportunities for-
gone by their division. These division general managers can thus increase the
transfer price for the products or services they sell to internal customers and
thereby appropriate for their division profits that should have been allocated to
buying divisions.
s etting Transfer prices in practice
Because it is rarely possible for firms to establish an optimal transfer-pricing
scheme, most diversified firms must adopt some form of transfer pricing that at-
tempts to approximate optimal prices. Several of these transfer-pricing schemes are
described in Table 8.3. However, no matter what particular scheme a firm uses, the
transfer prices it generates will, at times, create inefficiencies and conflicts in a di-
versified firm. Some of these inefficiencies and conflicts are described in Table 8.4.21
The inefficiencies and conflicts created by transfer-pricing schemes that only
approximate optimal transfer prices mean that few diversified firms are ever fully
satisfied with how they set transfer prices. Indeed, one study found that as the
level of resource sharing in a diversified firm increases (thereby increasing the im-
portance of transfer-pricing mechanisms) the level of job satisfaction for division
general managers decreases.22
Exchange
autonomy
■ Buying and selling division general managers are free to nego-
tiate transfer price without corporate involvement.
■ Transfer price is set equal to the selling division’s price to ex-
ternal customers.
Mandated
full cost
■ Transfer price is set equal to the selling division’s actual cost of
production.
■ Transfer price is set equal to the selling division’s standard cost
(i.e., the cost of production if the selling division were operat-
ing at maximum efficiency).
Mandated
market based
■ Transfer price is set equal to the market price in the selling di-
vision’s market.
Dual pricing ■ Transfer price for the buying division is set equal to the selling
division’s actual or standard costs.
■ Transfer price for the selling division is set equal to the price
to external customers or to the market price in the selling divi-
sion’s market.
Source: R. Eccles (1985). The transfer pricing problem: A theory for practice. Lexington Books: Lexington, MA.
Used with permission of Rowman and Littlefield Publishing Group.
TaBle 8.3 Alternative
Transfer-Pricing Schemes
M08_BARN0088_05_GE_C08.INDD 259 13/09/14 3:58 PM

260 Part 3: Corporate Strategies
It is not unusual for a diversified firm to change its transfer-pricing mecha-
nisms every few years in an attempt to find the “right” transfer-pricing mechanism.
Economic theory tells us what the “right” transfer-pricing mechanism is: Transfer
prices should equal opportunity cost. However, this “correct” transfer-pricing
mechanism cannot be implemented in most firms. Firms that continually change
their transfer-pricing mechanisms generally find that all these systems have some
weaknesses. In deciding which system to use, a firm should be less concerned about
finding the right transfer-pricing mechanism and more concerned about choosing
a transfer-pricing policy that creates the fewest management problems—or at least
the kinds of problems that the firm can manage effectively. Indeed, some scholars
have suggested that the search for optimal transfer pricing should be abandoned
in favor of treating transfer pricing as a conflict-resolution process. Viewed in this
way, transfer pricing highlights differences between divisions and thus makes it
possible to begin to resolve those differences in a mutually beneficial way.23
Overall, the three management control processes described here—measuring
divisional performance, allocating corporate capital, and transferring intermediate
products—suggest that the implementation of a corporate diversification strategy
requires a great deal of management skill and experience. They also suggest that
sometimes diversified firms may find themselves operating businesses that no
1. Buying and selling divisions negotiate transfer price.
■ What about the negotiating and haggling costs?
■ The corporation risks not exploiting economies of scope if the right transfer
price cannot be negotiated.
2. Transfer price is set equal to the selling division’s price to external customers.
■ Which customers? Different selling division customers may get different
prices.
■ Shouldn’t the volume created by the buying division for a selling division be
reflected in a lower transfer price?
■ The selling division doesn’t have marketing expenses when selling to another
division. Shouldn’t that be reflected in a lower transfer price?
3. Transfer price is set equal to the selling division’s actual costs.
■ What are those actual costs and who gets to determine them?
■ All the selling division’s costs or only the costs relevant to the products being
purchased by the buying division?
4. Transfer price is set equal to the selling division’s standard costs.
■ Standard costs are the costs the selling division would incur if it were running at
maximum efficiency. This hypothetical capacity subsidizes the buying division.
5. Transfer price is set equal to the market price.
■ If the product in question is highly differentiated, there is no simple “market
price.”
■ Shouldn’t the volume created by the buying division for a selling division be
reflected in a lower transfer price?
■ The selling division doesn’t have marketing expenses when selling to a buy-
ing division. Shouldn’t that be reflected in a lower transfer price?
6. Transfer price is set equal to actual costs for the selling division and to market
price for the buying division.
■ This combination of schemes simply combines other problems of setting
transfer prices.
TaBle 8.4 Weaknesses of
Alternative Transfer-Pricing
Schemes
M08_BARN0088_05_GE_C08.INDD 260 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 261
A corporate spin-off exists when a large, typically diversified firm
divests itself of a business in which
it has historically been operating and
the divested business operates as an
independent entity. Thus, corporate
spin-offs are different from asset di-
vestitures, where a firm sells some of
its assets, including perhaps a particu-
lar business, to another firm. Spin-offs
are a way that new firms can enter into
the economy.
Spin-offs can occur in numer-
ous ways. For example, a business
might be sold to its managers and em-
ployees who then manage and work
in this independently operating firm.
Alternatively, a business unit within
a diversified firm may be sold to the
public through an initial public of-
fering (IPO). Sometimes, the corpora-
tion spinning off a business unit will
retain some ownership stake in the
spin-off; other times, this corporation
will sever all financial links with the
spun-off firm.
In general, large diversified
firms might spin off businesses they
own for three reasons. First, the effi-
cient management of these businesses
may require very specific skills that
are not available in a diversified firm.
For example, suppose a diversified
manufacturing firm finds itself operat-
ing in an R&D-intensive industry. The
management skills required to manage
manufacturing efficiently can be very
different from the management skills
required to manage R&D. If a diver-
sified firm’s skills do not match the
skills required in a particular business,
that business might be spun off.
Second, anticipated economies of
scope between a business and the rest
of a diversified firm may turn out to
not be valuable. For example, PepsiCo
acquired Kentucky Fried Chicken,
Pizza Hut, and Taco Bell, anticipating
important marketing synergies be-
tween these fast-food restaurants and
PepsiCo’s soft drink business. Despite
numerous efforts to realize these syn-
ergies, they were not forthcoming.
Indeed, several of these fast-food res-
taurants began losing market share be-
cause they were forced to sell Pepsi
rather than Coca-Cola products. After a
few years, PepsiCo spun off its restau-
rants into a separate business.
Finally, it may be necessary to
spin a business off in order to fund a
firm’s other businesses. Large diversi-
fied firms may face capital constraints
due to, among other things, their high
level of debt. In this setting, firms may
need to spin off a business in order to
raise capital to invest in other parts
of the firm. Moreover, spinning off a
part of the business that is particu-
larly costly in terms of the capital it
consumes may not only be a source
of funds for other parts of this firm’s
business, it can also reduce the de-
mand for that capital within a firm.
Research in corporate finance
suggests that corporations are most
likely to spin off businesses that are
unrelated to a firm’s corporate di-
versification strategy; those that are
performing poorly compared with
other businesses a firm operates in;
and relatively small businesses. Also,
the amount of merger and acquisition
activity in a particular industry will
determine which businesses are spun
off. The greater the level of this activ-
ity in an industry, the more likely that
a business owned by a corporation in
such an industry will be spun off. This
is because the level of merger and ac-
quisition activity in an industry is an
indicator of the number of people and
firms that might be interested in pur-
chasing a spun-off business. However,
when there is not much merger and
acquisition activity in an industry,
businesses in that industry are less
likely to be spun off, even if they
are unrelated to a firm’s corporate di-
versification strategy, are performing
poorly, or are small. In such settings,
large firms are not likely to obtain the
full value associated with spinning
off a business and thus are reluctant
to do so.
Whatever the conditions that
lead a large diversified firm to spin
off one of its businesses, this process
is important for creating new firms in
the economy.
Sources: F. Schlingemann, R. M. Stulz, and
R. Walkling (2002). “Divestitures and the liquid-
ity of the market for corporate assets.” Journal
of Financial Economics, 64, pp. 117–144; G. Hite,
J. Owens, and R. Rogers (1987). “The market for
inter-firm asset sales: Partial sell-offs and total
liquidations.” Journal of Financial Economics, 18,
pp. 229–252; P. Berger and E. Ofek (1999). “Causes
and consequences of corporate focusing pro-
grams.” Review of Financial Studies, 12, pp. 311–345.
Transforming Big Business into
entrepreneurship
Strategy in the Emerging Enterprise
M08_BARN0088_05_GE_C08.INDD 261 13/09/14 3:58 PM

262 Part 3: Corporate Strategies
longer fit with the firm’s overall corporate strategy. What happens when a divi-
sion no longer fits with a firm’s corporate strategy is described in the Strategy in
the Emerging Enterprise feature.
Compensation Policies and Implementing Corporate
Diversification
A firm’s compensation policies constitute a final set of tools for implementing
diversification. Traditionally, the compensation of corporate managers in a diver-
sified firm has been only loosely connected to the firm’s economic performance.
One important study examined the relationship between executive compensation
and firm performance and found that differences in CEO cash compensation (sal-
ary plus cash bonus) are not very responsive to differences in firm performance.24
In particular, this study showed that a CEO of a firm whose equity holders lost,
collectively, $400 million in a year earned average cash compensation worth
$800,000, while a CEO of a firm whose equity holders gained, collectively, $400
million in a year earned average cash compensation worth $1,040,000. Thus,
an $800 million difference in the performance of a firm only had, on average, a
$204,000 impact on the size of a CEO’s salary and cash bonus. Put differently, for
every million dollars of improved firm performance, CEOs, on average, get paid
an additional $255. After taxes, increasing a firm’s performance by a million dol-
lars is roughly equal in value to a good dinner at a nice restaurant.
However, this same study was able to show that if a substantial percent-
age of a CEO’s compensation came in the form of stock and stock options in the
Nothing in business gets as much negative press as CEO salaries.
In 2012, for example, Larry Ellison,
CEO of Oracle, was paid $96.2 million;
Robert Kotick, CEO of Activision
Blizzard, was paid $64.9 million; Leslie
Moonves of CBS $60.3 million; David
Zaslay of Discovery Communications
$49.9 million; and James Crowe,
CEO of Level 3 Communications,
$40.7 million. Marissa Mayer, CEO of
Yahoo, was the highest-compensated
woman in 2012—she was paid $36.6
million (ranked ninth on the list).
Reasonable people ask: Is anyone
worth this much money?
But determining what CEOs
“should” be paid is a difficult question.
Some firms adopt policies that state
that their CEOs cannot make more
than some multiple of the lowest-paid
employee in a firm. In Chapter 1, it
was suggested that such a compensa-
tion policy at Ben & Jerry’s Ice Cream
may have cost its shareholders mil-
lions of dollars because it prevented
Ben & Jerry’s from recruiting a CEO
who would have facilitated Ben &
Jerry’s acquisition by a firm that could
effectively leverage the Ben & Jerry’s
brand.
Many firms delegate the re-
sponsibility of determining CEO
salary to the compensation commit-
tee on the board of directors. The
compensation committee often
identifies a set of comparable firms
(i.e., firms about the same size and
in the same industry) as its firm and
Ethics and Strategy
Do CeOs Get Paid Too Much?
M08_BARN0088_05_GE_C08.INDD 262 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 263
firm, changes in compensation would be closely linked with changes in the firm
performance. In particular, the $800 million difference in firm performance just
described would be associated with a $1.2 million difference in the value of CEO
compensation if CEO compensation included stock and stock options in addition
to cash compensation. In this setting, an additional million dollars of firm perfor-
mance increases a CEO’s salary by $667.
These and similar findings reported elsewhere have led more and more diversi-
fied firms to include stock and stock options as part of the compensation package for
the CEO. As important, many firms now extend this non-cash compensation to other
senior managers in a diversified firm, including division general managers. For ex-
ample, the top 1,300 managers at General Dynamics receive stock and stock options
as part of their compensation package. Moreover, the cash bonuses of these manag-
ers also depend on General Dynamics’ stock market performance. At Johnson &
Johnson, all division general managers receive a five-component compensation pack-
age. The level of only one of those components, salary, does not vary with the eco-
nomic profitability of the business over which a division general manager presides.
The level of the other four components—a cash bonus, stock grants, stock options,
and a deferred income package—varies with the economic performance of a particu-
lar division. Moreover, the value of some of these variable components of compensa-
tion also depends on Johnson & Johnson’s long-term economic performance.25
To the extent that compensation in diversified firms gives managers incen-
tives to make decisions consistent with stockholders’ interests, they can be an
important part of the process of implementing corporate diversification. However,
the sheer size of the compensation paid to some CEOs raises ethical issues for
some. These ethical issues are discussed in the Ethics and Strategy feature.
then calculates the average compen-
sation of CEOs in these firms. Of
course, because no firm wants to
think that its CEO is in the “bottom
half” of its comparable firms, most
firms pay their CEOs something over
this average—a decision-making pro-
cess that ensures that, in the long run,
CEO pay will continue to rise.
The mix of compensation also
makes it difficult to know how much
a CEO should get paid. For exam-
ple, most of the “big bucks” in CEO
compensation come not from salary
but from bonuses, stock, stock op-
tions, and other perquisites. Most of
these non-salary forms of compen-
sation depend on the performance
of a firm and are designed to align
the financial interests of CEOs and a
firm’s shareholders. This is the case
at Berkshire Hathaway, where a key
operating principle is that most of
the personal wealth of Warren Buffett
and his senior management team is
held in Berkshire Hathaway stock.
In fact, one study showed that, on
average, CEO compensation in excess
of what would be expected based
on a CEO’s business experience is
positively correlated with a firm’s
performance.
Of course, correlation is not
causation. The question remains
open: Does a CEO have to receive mas-
sive incentive compensation—literally
hundreds of millions of dollars over
time—just so he (or she) will do his
(or her) job: to maximize returns to
shareholders? And what are the im-
plications of this compensation for
the other employees in a firm—does
it encourage their ambitions to seek
employment among the senior ranks
of a firm, or does it discourage and
demoralize them that one person can
get paid so much while they get paid
so little?
Sources: Russell, Karl. “Executive Pay by the
Numbers” www.nytimes.com/interactive/ 2013
/06/ 30/business/executive/compensation.
Accessed August 23, 2013; A. Mackey (2006).
“Dynamics in executive labor markets: CEO
effects, executive-firm matching, and rent shar-
ing.” Dissertation, The Ohio State University.
M08_BARN0088_05_GE_C08.INDD 263 13/09/14 3:58 PM

264 Part 3: Corporate Strategies
Summary
To be valuable, diversification strategies must exploit valuable economies of scope that
cannot be duplicated by outside investors at low cost. However, to realize the value of
these economies of scope, firms must organize themselves appropriately. A firm’s organi-
zational structure, its management control processes, and its compensation policies are all
relevant in implementing a corporate diversification strategy.
The best organizational structure for implementing a diversification leveraging
strategy is the multidivisional, or M-form, structure. The M-form structure has several
critical components, including the board of directors, institutional investors, the senior
executive, corporate staff, division general managers, and shared activity managers.
This organizational structure is supported by a variety of management control
processes. Three critical management control processes for firms implementing diversi-
fication strategies are (1) evaluating the performance of divisions, (2) allocating capital
across divisions, and (3) transferring intermediate products between divisions. The ex-
istence of economies of scope in firms implementing corporate diversification strategies
significantly complicates the management of these processes.
Finally, a firm’s compensation policies are also important for firms implementing
a diversification strategy. Historically, management compensation has been only loosely
connected to a firm’s economic performance, but recently the increased popularity of us-
ing stock and stock options to help compensate managers. Such compensation schemes
help reduce conflicts between managers and outside investors, but the absolute level of
CEO compensation is still very high, at least in the United States.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
Challenge Questions
8.1. Agency theory has been criti-
cized for assuming that managers,
left on their own, will behave in ways
that reduce the wealth of outside
equity holders when, in fact, most
managers are highly responsible
stewards of the assets they control.
This alternative view of managers has
been called stewardship theory. Why
would you agree with this criticism of
agency theory?
8.2. Suppose that the concept of
the stewardship theory is correct
and that most managers, most of the
time, behave responsibly and make
decisions that maximize the present
value of the assets they control. What
implications, if any, would this sup-
position have on organizing to imple-
ment diversification strategies?
8.3. The M-form structure enables
firms to pursue complex corporate di-
versification strategies by delegating
different management responsibilities
to different individuals and groups
within a firm. Based on the concept
of the M-form structure is there a
natural limit to the efficient size of a
diversified firm?
8.4. Due to their sizeable financial
prowess, institutional investors
can sometimes own substantial
stakes in public listed firms. To
what extent should institutional
investors influence the executive
management in an organization,
especially if its vision differs
substantially from that of the board
and CEO?
8.5. Within conglomerates, some
large divisions or strategic business
units (SBUs) operate almost like
standalone companies, given their
size in their respective markets. While
senior managers of such divisions
should have autonomy, how can cor-
porate level staff, such as the board

M08_BARN0088_05_GE_C08.INDD 264 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 265
and CEO, have the company level
strategy imprinted on these large
divisions?
8.6. Suppose that the optimal
transfer price between one business
and all other business activities in a
firm is the market price. What does
this condition say about whether this
firm should own this business?

Problem Set
8-7. Which elements of the M-form structure (the board of directors, the office of the
CEO, corporate staff, division general managers, shared activity managers) should
be involved in the following business activities? If more than one of these groups should
be involved, indicate their relative level of involvement (e.g., 20 percent office of the
CEO, 10 percent shared activity manager, 70 percent division general manager). Justify
your answers.
(a) Determining the compensation of the CEO
(b) Determining the compensation of the corporate vice president of human resources
(c) Determining the compensation of a vice president of human resources in a particular
business division
(d) Deciding to sell a business division
(e) Deciding to buy a relatively small firm whose activities are closely related to the activi-
ties of one of the firm’s current divisions
(f) Deciding to buy a larger firm that is not closely related to the activities of any of a
firm’s current divisions
(g) Evaluating the performance of the vice president of sales, a manager whose sales staff
sells the products of three divisions in the firm
(h) Evaluating the performance of the vice president of sales, a manager whose sales staff
sells the products of only one division in the firm
(i) Determining how much money to invest in a corporate R&D function
(j) Deciding how much money to invest in an R&D function that supports the operations
of two divisions within the firm
(k) Deciding whether to fire an R&D scientist
(l) Deciding whether to fire the vice president of accounting in a particular division
(m) Deciding whether to fire the corporation’s vice president of accounting
(n) Deciding whether to take a firm public by selling stock in the firm to the general pub-
lic for the first time
8-8. Consider the following facts. Division A in a firm has generated $847,000 of
profits on $24 million worth of sales, using $32 million worth of dedicated assets. The
cost of capital for this firm is 9 percent, and the firm has invested $7.3 million in this
division.
(a) Calculate the Return on Sales (ROS) and Return on Total Assets (ROA) of Division A.
If the hurdle rates for ROS and ROA in this firm are, respectively, 0.06 and 0.04, has
this division performed well?
(b) Calculate the EVA of Division A (assuming that the reported profits have already been
adjusted). Based on this EVA, has this division performed well?
(c) Suppose you were CEO of this firm. How would you choose between ROS/ROA and
EVA for evaluating this division?
M08_BARN0088_05_GE_C08.INDD 265 13/09/14 3:58 PM

266 Part 3: Corporate Strategies
8-9. Suppose that Division A sells an intermediate product to Division B. Choose one of
the ways of determining transfer prices described in this chapter (not setting transfer prices
equal to the selling firm’s opportunity costs) and show how Division Manager A can use
this mechanism to justify a higher transfer price while Division Manager B can use this
mechanism to justify a lower transfer price. Repeat this exercise with another approach to
setting transfer prices described in the chapter.
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
8.10. How are the roles of senior executives and shared activity managers different in
making the M-form structure work?
8.11. What are the implications for a multidivisional firm when the corporate staff
become too involved in the day-to-day operations of divisions?
End Notes
1. The structure and function of the multidimensional firm were first
described by Chandler, A. (1962). Strategy and structure: Chapters in the
history of the industrial enterprise. Cambridge, MA: MIT Press. The eco-
nomic logic underlying the multidimensional firm was first described
by Williamson, O. E. (1975). Markets and hierarchies: Analysis and
antitrust implications. New York: Free Press. Empirical examinations
of the impact of the M-form or firm performance include Armour,
H. O., and D. J. Teece. (1980). “Vertical integration and technological
innovation.” Review of Economics and Statistics, 60, pp. 470–474. There
continues to be some debate about the efficiency of the M-form struc-
ture. See Freeland, R. F. (1966). “The myth of the M-form? Governance,
consent, and organizational change.” American Journal of Sociology,
102(2), pp. 483–626; and Shanley, M. (1996). “Straw men and M-form
myths: Comment on Freeland.” American Journal of Sociology, 102(2),
pp. 527–536.
2. See Finkelstein, S., and R. D’Aveni. (1994). “CEO duality as a
double-edged sword: How boards of directors balance entrenchment
avoidance and unity of command.” Academy of Management Journal, 37,
pp. 1079–1108.
3. Kesner, I. F. (1988). “Director’s characteristics and committee mem-
bership: An investigation of type, occupation, tenure and gender.”
Academy of Management Journal, 31, pp. 66–84; and Zahra, S. A., and
J. A. Pearce II. (1989). “Boards of directors and corporate financial
performance: A review and integrative model.” Journal of Management,
15, pp. 291–334.
4. Investor Relations Business. (2000). “Reversal of fortune: Institutional
ownership is declining.” Investor Relations Business, May 1, pp. 8–9;
and Federal Reserve Board. (2006). “Flow of funds report.”
www.corpgov.net.
5. See Hansen, G. S., and C. W. L. Hill. (1991). “Are institutional investors
myopic? A time-series study of four technology-driven industries.”
Strategic Management Journal, 12, pp. 1–16.
6. See Bergh, D. (1995). “Size and relatedness of units sold: An agency
theory and resource-based perspective.” Strategic Management Journal,
16, pp. 221–239; and Bethel, J., and J. Liebeskind. (1993). “The effects of
ownership structure on corporate restructuring.” Strategic Management
Journal, 14, pp. 15–31.
7. Burdens that are well described by Westley, F., and H. Mintzberg.
(1989). “Visionary leadership and strategic management.” Strategic
Management Journal, 10, pp. 17–32.
8. See Dumaine, B. (1992). “Is big still good?” Fortune, April 20,
pp. 50–60.
9. See Golden, B. (1992). “SBU strategy and performance: The moderat-
ing effects of the corporate–SBU relationship.” Strategic Management
Journal, 13, pp. 145–158; Berger, P., and E. Ofek. (1995). “Diversification
effect on firm value.” Journal of Financial Economics, 37, pp. 36–65;
Lang, H. P., and R. M. Stulz. (1994). “Tobin’s q, corporate diversifica-
tion, and firm performance.” Journal of Political Economy, 102,
pp. 1248–1280; and Rumelt, R. (1991). “How much does industry
matter?” Strategic Management Journal, 12, pp. 167–185.
10. See Halal, W. (1994). “From hierarchy to enterprise: Internal markets
are the new foundation of management.” The Academy of Management
Executive, 8(4), pp. 69–83.
11. Bartlett, C., and S. Ghoshal. (1993). “Beyond the M-form: Toward
a managerial theory of the firm.” Strategic Management Journal, 14,
pp. 23–46.
12. See Simons, R. (1994). “How new top managers use control systems
as levers of strategic renewal.” Strategic Management Journal, 15,
pp. 169–189.
13. Bethel, J. E. (1990). “The capital allocation process and managerial
mobility: A theoretical and empirical investigation.” Unpublished
doctoral dissertation, UCLA.
14. Some of these are described in Duffy, M. (1989). “ZBB, MBO, PPB, and
their effectiveness within the planning/marketing process.” Strategic
Management Journal, 12, pp. 155–160.
15. See Stern, J., B. Stewart, and D. Chew. (1995). “The EVA financial man-
agement system.” Journal of Applied Corporate Finance, 8, pp. 32–46; and
Tully, S. (1993). “The real key to creating wealth.” Fortune, September 20,
pp. 38–50.
16. Applications of EVA are described in Tully, S. (1993). “The real key to
creating wealth.” Fortune, September 20, pp. 38–50; Tully, S. (1995).
“So, Mr. Bossidy, we know you can cut. Now show us how to grow.”
Fortune, August 21, pp. 70–80; and Tully, S. (1995). “Can EVA deliver
profits to the post office?” Fortune, July 10, p. 22.
17. A special issue of the Journal of Applied Corporate Finance in 1994 ad-
dressed many of these issues.
18. See Priem, R. (1990). “Top management team group factors, consensus,
and firm performance.” Strategic Management Journal, 11, pp. 469–478;
and Wooldridge, B., and S. Floyd. (1990). “The strategy process,
middle management involvement, and organizational performance.”
Strategic Management Journal, 11, pp. 231–241.
19. A point made by Westley, F. (1900). “Middle managers and strat-
egy: Microdynamics of inclusion.” Strategic Management Journal,
11, pp. 337–351; Lamont, O. (1997). “Cash flow and investment:
Evidence from internal capital markets.” The Journal of Finance,
52(1), pp. 83–109; Shin, H. H., and R. M. Stulz. (1998). “Are inter-
nal capital markets efficient?” Quarterly Journal of Economics, May,
pp. 531–552; and Stein, J. C. (1997). “Internal capital markets and
the competition for corporate resources.” The Journal of Finance,
52(1), pp. 111–133.
20. See Brickley, J., C. Smith, and J. Zimmerman. (1996). Organizational
architecture and managerial economics approach. Homewood, IL: Irwin;
M08_BARN0088_05_GE_C08.INDD 266 13/09/14 3:58 PM

Chapter 8: Organizing to Implement Corporate Diversification 267
and Eccles, R. (1985). The transfer pricing problem: A theory for practice.
Lexington, MA: Lexington Books.
21. See Cyert, R., and J. G. March. (1963). A behavioral theory of the firm.
Upper Saddle River, NJ: Prentice Hall; Swieringa, R. J., and J. H.
Waterhouse. (1982). “Organizational views of transfer pricing.”
Accounting, Organizations & Society, 7(2), pp. 149–165; and Eccles, R.
(1985). The transfer pricing problem: A theory for practice. Lexington, MA:
Lexington Books.
22. Gupta, A. K., and V. Govindarajan. (1986). “Resource sharing among
SBUs: Strategic antecedents and administrative implications.” Academy
of Management Journal, 29, pp. 695–714.
23. A point made by Swieringa, R. J., and J. H. Waterhouse. (1982).
“Organizational views of transfer pricing.” Accounting, Organizations
and Society, 7(2), pp. 149–165.
24. Jensen, M. C., and K. J. Murphy. (1990). “Performance pay and top
management incentives.” Journal of Political Economy, 98, pp. 225–264.
25. See Dial, J., and K. J. Murphy. (1995). “Incentive, downsizing, and
value creation at General Dynamics.” Journal of Financial Economics,
37, pp. 261–314, on General Dynamics’ compensation scheme; and
Aguilar, F. J., and A. Bhambri. (1983). “Johnson & Johnson (A).”
Harvard Business School Case No. 9-384-053, on Johnson & Johnson’s
compensation scheme.
M08_BARN0088_05_GE_C08.INDD 267 13/09/14 3:58 PM

268
1. Define a strategic alliance and give three specific ex-
amples of strategic alliances.
2. Describe nine different ways that alliances can create
value for firms and how these nine sources of value
can be grouped into three large categories.
3. Describe how adverse selection, moral hazard, and
holdup can threaten the ability of alliances to generate
value.
Breaking Up Is Hard to Do: Apple and Samsung
On the one hand, Samsung and Apple are very close business partners. Apple depends on tech-
nologies developed and built b y Samsung to build its smar t phones, iPods, and iP ads. I n turn,
Apple is one of S amsung’s largest, and most pr ofitable, customers. In 2012, S amsung sold $10
billion in electronic components to Apple, one-sixth of Samsung’s total component sales.
On the other hand , Apple and S amsung have sued and c ountersued each other o ver the
look and f eel of their respective smar t phones and related products. Courts around the w orld
are weighing in on these issues . Initially, Samsung was ordered to pay $1 billion (la ter reduced
to $500 million) to Apple for infringing on some Apple patents. Then the U.S. International Trade
Commission concluded that Apple had infringed on a S amsung patent and ordered a ban on
some older model A pple smar t phones (la ter r escinded b y the Obama administr ation). Not a
great way to maintain a business partnership.
For many years, Samsung and Apple had a very functional alliance. Samsung made the kinds
of technologies—including microprocessors, memory chips, and displays—that Apple needed to
fuel its growth in smart phones and related products. Not only did Samsung supply these technolo-
gies to Apple, it was the best supplier of these technologies—both in terms of quality and cost—in
the world. Apple was only too happy to source its components to such a supplier.
4. Describe the conditions under which a strategic alli-
ance can be rare and costly to duplicate.
5. Describe the conditions under which “going it alone”
and acquisitions are not likely to be substitutes for
alliances.
6. Describe how contracts, equity investments, firm
reputations, joint ventures, and trust can all reduce the
threat of cheating in strategic alliances.
L e A r n I n g O B j e c t I v e S After reading this chapter, you should be able to:
MyManagementLab®
Improve Your grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
9
c H A p t e r
Strategic Alliances
M09_BARN0088_05_GE_C09.INDD 268 13/09/14 3:15 PM

269
Then Samsung entered the smart phone market and be-
gan to produce phones that ran Google’s Android system. Apple
and Samsung became competitors. Indeed, there are now more
Android phones sold each y ear—mostly made b y S amsung—
than Apple iPhones.
Not surprisingly, Apple is looking around the world to find
alternative suppliers of its essen tial elec tronic components. The
problem is: Finding suppliers tha t are as c ompetent as S amsung
in providing these state-of-the-art technologies has turned out
to be quit e difficult . While A pple has f ound sec ond sour ces f or
memory chips and some displa ys, S amsung continues to be an
almost exclusive supplier of the microprocessors that run Apple’s
iPods, iPhones, and iPads.
For e xample, A pple began w orking with Taiwan
Semiconductor Manufacturing Company (TSMC) to create a new
source for microprocessors in 2011. It took two years for TSMC to
develop chips that met Apple’s (and Samsung’s) standards. It will
take at least another y ear for TSMC to ramp up its pr oduction of
this new t echnology, all while S amsung remains the only viable
supplier of this critical component for Apple.
And S amsung isn ’t just standing pa t, waiting f or Apple
to find new suppliers . F or e xample, A pple tr ied t o dev elop a
contract with the Japanese fir m Sharp for certain displays it cur –
rently buys from Samsung. This may have become more difficult
since Samsung purchased 3 percent of Sharp’s stock and became
Sharp’s fifth-largest shareholder!
Sometimes, breaking up really is hard to do.
Sources: J . L essin, L. L uk, and J . Osa wa (2013). “Apple finds it difficult t o div orce
Samsung.” The Wall Street Journal, A ugust 16, 2013//online.wsj.com/articles/SB10
001424127887324682204045785151882349940500 A ccessed A ugust 25, 2013;
B. Kendall and I. Sher r (2013). “Patent w ar adds fr ont in U .S.” The Wall Street Journal, online , A ugust 23, online.wsj.com/ar-
ticle/SB10001424127887324170004578633702773124388 Accessed August 25, 2013; P. Elias (2013). “Apple’s Samsung verdict
nearly cut in half b y federal judge.” Huffington Post, January 3, huffingtonpost.com/2013/03/01/half-a-billion-cut-from-Apple.
Accessed November 4, 2013.
©
M
ax
Pa
yn
e/
Al
am
y
M09_BARN0088_05_GE_C09.INDD 269 13/09/14 3:15 PM

270 Part 3: Corporate Strategies
The use of strategic alliances to manage economic exchanges has grown sub-stantially over the past several years. In the early 1990s, strategic alliances were relatively uncommon, except in a few industries. However, by the
late 1990s they had become much more common in a wide variety of industries.
Indeed, more than 20,000 alliances were created worldwide in 2000 and 2001. In
the computer technology–based industries, more than 2,200 alliances were created
between 2001 and 2005. This, the complex web of relationships that characterizes
the links between Apple and Samsung, is becoming increasingly more common.1
What Is a Strategic Alliance?
A strategic alliance exists whenever two or more independent organizations
cooperate in the development, manufacture, or sale of products or services. As
shown in Figure 9.1, strategic alliances can be grouped into three broad catego-
ries: nonequity alliances, equity alliances, and joint ventures.
In a nonequity alliance, cooperating firms agree to work together to develop,
manufacture, or sell products or services, but they do not take equity positions in
each other or form an independent organizational unit to manage their cooperative
efforts. Rather, these cooperative relations are managed through the use of various
contracts. Licensing agreements (where one firm allows others to use its brand
name to sell products), supply agreements (where one firm agrees to supply others),
and distribution agreements (where one firm agrees to distribute the products of
others) are examples of nonequity strategic alliances. Most of the alliances between
Tony Hawk and his partners take the form of nonequity licensing agreements.
In an equity alliance, cooperating firms supplement contracts with equity hold-
ings in alliance partners. For example, when GM began importing small cars manu-
factured by Isuzu, not only did these partners have supply contracts in place, but GM
purchased 34.2 percent of Isuzu’s stock. Ford had a similar relationship with Mazda,
and Chrysler had a similar relationship with Mitsubishi.2 Equity alliances are also very
common in the biotechnology industry. Large pharmaceutical firms such as Pfizer and
Merck often own equity positions in several startup biotechnology companies.
Joint Venture
Cooperating firms form an independent
firm in which they invest. Profits from
this independent firm compensate
partners for this investment.
Nonequity Alliance
Cooperation between firms is managed
directly through contracts, without
cross-equity holdings or an independent
firm being created.
Equity Alliance
Cooperative contracts are supplemented
by equity investments by one partner in
the other partner. Sometimes these
investments are reciprocated.
Strategic Alliances
Figure 9.1 Types of
Strategic Alliances
M09_BARN0088_05_GE_C09.INDD 270 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 271
In a joint venture, cooperating firms create a legally independent firm in
which they invest and from which they share any profits that are created. Some
of these joint ventures can be very large. For example, Dow and Corning’s joint
venture, Dow-Corning, is a Fortune 500 company on its own. Before they merged,
AT&T and BellSouth were co-owners of the joint venture Cingular, one of the
largest wireless phone companies in the United States. And CFM—a joint venture
between General Electric and SNECMA (a French aerospace firm)—is one of the
world’s leading manufacturers of jet engines for commercial aircraft. If you have
ever flown on a Boeing 737, then you have placed your life in the hands of this
joint venture because it manufactures the engines for virtually all of these aircraft.
How Do Strategic Alliances Create Value?
Like all the strategies discussed in this book, strategic alliances create value by
exploiting opportunities and neutralizing threats facing a firm. Some of the most
important opportunities that can be exploited by strategic alliances are listed in
Table 9.1. Threats to strategic alliances are discussed later in this chapter.
Strategic Alliance Opportunities
Opportunities associated with strategic alliances fall into three large categories.
First, these alliances can be used by a firm to improve the performance of its cur-
rent operations. Second, alliances can be used to create a competitive environment
favorable to superior firm performance. Finally, they can be used to facilitate a
firm’s entry into or exit from new markets or industries.
Improving c urrent Operations
One way that firms can use strategic alliances to improve their current operations
is to use alliances to realize economies of scale. The concept of economies of scale
was first introduced in Chapter 2. Economies of scale exist when the per-unit
cost of production falls as the volume of production increases. Thus, for example,
although the per-unit cost of producing one BIC pen is very high, the per-unit cost
of producing 50 million BIC pens is very low.
To realize economies of scale, firms have to have a large volume of produc-
tion, or at least a volume of production large enough so that the cost advantages
TAble 9.1 Ways Strategic
Alliances Can Create
Economic Value
Helping firms improve the performance of their current operations
1. Exploiting economies of scale
2. Learning from competitors
3. Managing risk and sharing costs
4. Creating a competitive environment favorable to superior performance
5. Facilitating the development of technology standards
6. Facilitating tacit collusion
7. Facilitating entry and exit
8. Low-cost entry into new industries and new industry segments
9. Low-cost exit from industries and industry segments
10. Managing uncertainty
11. Low-cost entry into new markets
V R I O
M09_BARN0088_05_GE_C09.INDD 271 13/09/14 3:15 PM

272 Part 3: Corporate Strategies
associated with scale can be realized. Sometimes—as was described in Chapters 2
and 4—a firm can realize these economies of scale by itself; other times, it cannot.
When a firm cannot realize the cost savings from economies of scale all by itself, it
may join in a strategic alliance with other firms. Jointly, these firms may have suf-
ficient volume to be able to gain the cost advantages of economies of scale.
But why wouldn’t a firm be able to realize these economies all by itself? A
firm may have to turn to alliance partners to help realize economies of scale for
a number of reasons. For example, if the volume of production required to real-
ize these economies is very large, a single firm might have to dominate an entire
industry in order to obtain these advantages. It is often very difficult for a single
firm to obtain such a dominant position in an industry. And even if it does so, it
may be subject to anti-monopoly regulation by the government. Also, although a
particular part or technology may be very important to several firms, no one firm
may generate sufficient demand for this part or technology to realize economies
of scale in its development and production. In this setting as well, independent
firms may join together to form an alliance to realize economies of scale in the
development and production of the part or technology.
Firms can also use alliances to improve their current operations by learning
from their competitors. As suggested in Chapter 3, different firms in an industry
may have different resources and capabilities. These resources can give some
firms competitive advantages over others. Firms that are at a competitive dis-
advantage may want to form alliances with the firms that have an advantage in
order to learn about their resources and capabilities.
General Motors formed this kind of alliance with Toyota. In the early 1990s,
GM and Toyota jointly invested in a previously closed GM plant in Fremont,
California. This joint venture—called NUMI—was to build compact cars to be
distributed through GM’s distribution network. But why did GM decide to build
these cars in an alliance with Toyota? Obviously, it could have built them in any
of its own plants. However, GM was very interested in learning about how Toyota
was able to manufacture high-quality small cars at a profit. Indeed, in the NUMI
plant, Toyota agreed to take total responsibility for the manufacturing process, us-
ing former GM employees to install and operate the “lean manufacturing” system
that had enabled Toyota to become the quality leader in the small-car segment of
the automobile industry. However, Toyota also agreed to let GM managers work
in the plant and directly observe how Toyota managed this production process.
Since its inception, GM has rotated thousands of its managers from other GM plants
through the NUMI plant so that they can be exposed to Toyota’s lean manufactur-
ing methods.
It is clear why GM would want this alliance with Toyota. But why would
Toyota want this alliance with GM? Certainly, Toyota was not looking to learn
about lean manufacturing, per se. However, because Toyota was contemplating
entering the United States by building its own manufacturing facilities, it did
need to learn how to implement lean manufacturing in the United States with
U.S. employees. Thus, Toyota also had something to learn from this alliance.
When both parties to an alliance are seeking to learn something from that
alliance, an interesting dynamic called a learning race can evolve. This dynamic is
described in more detail in the Strategy in Depth feature.
Finally, firms can use alliances to improve their current operations through
sharing costs and risks. For example, HBO produces most of its original programs
in alliances with independent producers. Most of these alliances are created to
share costs and risks. Producing new television shows can be costly. Development
M09_BARN0088_05_GE_C09.INDD 272 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 273
and production costs can run into the hundreds of millions of dollars, especially
for long and complicated series like HBO’s Deadwood, Entourage, and The Sopranos.
And, despite audience testing and careful market analyses, the production of these
new shows is also very risky. Even a bankable star like Johnny Depp—remember
The Lone Ranger—cannot guarantee success.
In this context, it is not surprising that HBO decides to not “go it alone” in
its production efforts. If HBO was to be the sole producer of its original program-
ming, not only would it have to absorb all the production costs, but it would also
bear all the risk if a production turned out not to be successful. Of course, by
getting other firms involved in its production efforts, HBO also has to share what-
ever profits a particular production generates. Apparently, HBO has concluded
that sharing this upside potential is more than compensated for by sharing the
costs and risks of these productions.
c reating a Favorable c ompetitive environment
Firms can also use strategic alliances to create a competitive environment that is
more conducive to superior performance. This can be done in at least two ways.
First, firms can use alliances to help set technology standards in an industry. With
these standards in place, technology-based products can be developed and consum-
ers can be confident that the products they buy will be useful for some time to come.
Such technological standards are particularly important in what are called
network industries. Such industries are characterized by increasing returns to
scale. Consider, for example, fax machines. How valuable is one fax machine, all
by itself? Obviously, not very valuable. Two fax machines that can talk to each
other are a little more valuable, three that can talk to each other are still more valu-
able, and so forth. The value of each individual fax machine depends on the total
number of fax machines in operation that can talk to each other. This is what is
meant by increasing returns to scale—the value (or returns) on each product in-
creases as the number of these products (or scale) increases.
If there are 100 million fax machines in operation but none of these machines
can talk to each other, none of these machines has any value whatsoever—except
as a large paperweight. For their full value to be realized, they must be able to talk
to each other. And to talk to each other, they must all adopt the same—or at least
compatible—communication standards. This is why setting technology standards
is so important in network industries.
Standards can be set in two ways. First, different firms can introduce different
standards, and consumers can decide which they prefer. This is how the standard for
high-definition DVDs was set. Initially, two formats competed: HD DVD (supported
by Toshiba) and Blu-ray DVD (supported by the Blu-ray Disc Association, a group
of 50 or so electronics firms and content providers). Both formats had attractive fea-
tures, but they could not be played on each other’s players. Competition between the
two formats continued for some time, until firms like Panasonic (in 2004), Samsung
(in 2005), Disney (in 2004), and Paramount (in 2005) committed to the Blu-ray Disc
format. By 2008, even Toshiba had to acknowledge the dominance of Blu-ray Discs.
Toshiba released its own Blu-ray Disc player in 2009.3
Of course, the biggest problem with letting customers and competition set
technology standards is that customers may end up purchasing technologies that
are incompatible with the standard that is ultimately set in the industry. What
about all those consumers who purchased HD products? For this reason, custom-
ers may be unwilling to invest in a new technology until the standards of that
technology are established.
M09_BARN0088_05_GE_C09.INDD 273 13/09/14 3:15 PM

274 Part 3: Corporate Strategies
A learning race exists in a strategic alliance when both parties to that
alliance seek to learn from each other
but the rate at which these two firms
learn varies. In this setting, the first
firm to learn what it wants to learn
from an alliance has the option to begin
to underinvest in, and perhaps even
withdraw from, an alliance. In this way,
the firm that learns faster is able to
prevent the slower-learning firm from
learning all it wanted from an alliance.
If, outside of this alliance, these firms
are competitors, winning a learning
race can create a sustained competitive
advantage for the faster-learning firm
over the slower-learning firm.
Firms in an alliance may vary in
the rate they learn from each other for
a variety of reasons. First, they may be
looking to learn different things, some
of which are easier to learn than others.
For example, in the GM–Toyota ex-
ample, GM wanted to learn about how
to use “lean manufacturing” to build
high-quality small cars profitably.
Toyota wanted to learn how to apply
the “lean manufacturing” skills it al-
ready possessed in the United States.
Which of these is easier to learn—“lean
manufacturing” or how to apply “lean
manufacturing” in the United States?
An argument can be made that
GM’s learning task was much more
complicated than Toyota’s. At the very
least, in order for GM to apply knowl-
edge about “lean manufacturing”
gleaned from Toyota it would have to
transfer that knowledge to several of its
currently operating plants. Using this
knowledge would require these plants
to change their current operations—a
difficult and time- consuming process.
Toyota, however, only had to trans-
fer its knowledge of how to operate a
“lean manufacturing” operation in the
United States to its other U.S. plants—
plants that at the time this alliance
was first created had yet to be built.
Because GM’s learning task was more
complicated than Toyota’s, it is very
likely that Toyota’s rate of learning was
greater than GM’s.
Second, firms may differ in
terms of their ability to learn. This abil-
ity has been called a firm’s absorptive
capacity. Firms with high levels of ab-
sorptive capacity will learn at faster
rates than firms with low levels of
absorptive capacity, even if these two
firms are trying to learn exactly the
same things in an alliance. Absorptive
capacity has been shown to be an im-
portant organizational capability in a
wide variety of settings.
Third, firms can engage in
activities to try to slow the rate of
learning of their alliance partners.
For example, although a firm might
make its technology available to an
alliance partner—thereby fulfilling the
alliance agreement—it may not pro-
vide all the know-how necessary to
exploit this technology. This can slow a
partner’s learning. Also, a firm might
withhold critical employees from an
alliance, thereby slowing the learning
of an alliance partner. All these ac-
tions, to the extent that they slow the
rate of a partner’s learning without
also slowing the rate at which the firm
engaging in these activities learns, can
help this firm win a learning race.
Although learning race dynam-
ics have been described in a wide va-
riety of settings, they are particularly
common in relations between entre-
preneurial and large firms. In these
alliances, entrepreneurial firms are
often looking to learn about all the
managerial functions required to bring
a product to market, including manu-
facturing, sales, distribution, and so
forth. This is a difficult learning task.
Large firms in these alliances often are
only looking to learn about the entre-
preneurial firm’s technology. This is
a less difficult learning task. Because
the learning task facing entrepreneur-
ial firms is more challenging than that
facing their large-firm partners, larger
firms in these alliances typically win
the learning race. Once these large
firms learn what they want from their
alliance partners, they often underin-
vest or even withdraw from these alli-
ances. This is why, in one study, almost
80 percent of the managers in entre-
preneurial firms felt unfairly exploited
by their large-firm alliance partners.
Sources: S. A. Alvarez and J. B. Barney (2001).
“How entrepreneurial firms can benefit from alli-
ances with large partners.” Academy of Management
Executive, 15, pp. 139–148; G. Hamel (1991).
“Competition for competence and inter-partner
learning within international alliances.” Strategic
Management Journal, 12, pp. 83–103; W. Cohen
and D. Levinthal (1990). “Absorptive capacity:
A new perspective on learning and innovation.”
Administrative Science Quarterly, 35, pp. 128–152.
Winning learning Races
Strategy in Depth
M09_BARN0088_05_GE_C09.INDD 274 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 275
This is where strategic alliances come in. Sometimes, firms form strategic
alliances with the sole purpose of evaluating and then choosing a technology
standard. With such a standard in place, technologies can be turned into products
that customers are likely to be more willing to purchase because they know that
they will be compatible with industry standards for at least some period of time.
Thus, in this setting, strategic alliances can be used to create a more favorable
competitive environment.
Another incentive for cooperating in strategic alliances is that such activi-
ties may facilitate the development of tacit collusion. As explained in Chapter 3,
collusion exists when two or more firms in an industry coordinate their strate-
gic choices to reduce competition in an industry. This reduction in competition
usually makes it easier for colluding firms to earn high levels of performance.
A common example of collusion is when firms cooperate to reduce the quantity
of products being produced in an industry in order to drive prices up. Explicit
collusion exists when firms directly communicate with each other to coordinate
their levels of production, their prices, and so forth. Explicit collusion is illegal in
most countries.
Because managers that engage in explicit collusion can end up in jail,
most collusion must be tacit in character. Tacit collusion exists when firms co-
ordinate their production and pricing decisions not by directly communicating
with each other, but by exchanging signals with other firms about their intent
to cooperate. Examples of such signals might include public announcements
about price increases, public announcements about reductions in a firm’s pro-
ductive output, public announcements about decisions not to pursue a new
technology, and so forth.
Sometimes, signals of intent to collude are very ambiguous. For example,
when firms in an industry do not reduce their prices in response to a decrease
in demand, they may be sending a signal that they want to collude, or they may
be attempting to exploit their product differentiation to maintain high margins.
When firms do not reduce their prices in response to reduced supply costs, they
may be sending a signal that they want to collude, or they may be individually
maximizing their economic performance. In both these cases, a firm’s intent to
collude or not, as implied by its activities, is ambiguous at best.
In this context, strategic alliances can facilitate tacit collusion. Separate
firms, even if they are in the same industry, can form strategic alliances.
Although communication between these firms cannot legally include sharing
information about prices and costs for products or services that are produced
outside the alliance, such interaction does help create the social setting within
which tacit collusion may develop.4 As suggested in the Research Made Relevant
feature, most early research on strategic alliances focused on their implications
for tacit collusion. More recently, research suggests that alliances do not usually
facilitate tacit collusion.
Facilitating entry and exit
A final way that strategic alliances can be used to create value is by facilitating a
firm’s entry into a new market or industry or its exit from a market or industry.
Strategic alliances are particularly valuable in this context when the value of mar-
ket entry or exit is uncertain. Entry into an industry can require skills, abilities,
and products that a potential entrant does not possess. Strategic alliances can help
a firm enter a new industry by avoiding the high costs of creating these skills,
abilities, and products.
M09_BARN0088_05_GE_C09.INDD 275 13/09/14 3:15 PM

276 Part 3: Corporate Strategies
For example, DuPont wanted to enter into the electronics industry. However,
building the skills and abilities needed to develop competitive products in this
industry can be very difficult and costly. Rather than absorb these costs, DuPont
developed a strategic alliance (DuPont/Philips Optical) with an established elec-
tronics firm, Philips, to distribute some of Philips’s products in the United States.
In this way, DuPont was able to enter into a new industry (electronics) without
having to absorb all the costs of creating electronics resources and abilities from
the ground up.
Of course, for this joint venture to succeed, Philips must have had an incen-
tive to cooperate with DuPont. Whereas DuPont was looking to reduce its cost
of entry into a new industry, Philips was looking to reduce its cost of continued
entry into a new market—the United States. Philips used its alliance with DuPont
to sell in the United States the compact discs it already was selling in Europe.5
The role of alliances in facilitating entry into new geographic markets will be dis-
cussed in more detail later in this chapter.
Alliances to facilitate entry into new industries can be valuable even when
the skills needed in these industries are not as complex and difficult to learn as
skills in the electronics industry. For example, rather than develop their own fro-
zen novelty foods, Welch Foods, Inc., and Leaf, Inc. (maker of Heath candy bars)
asked Eskimo Pie to formulate products for this industry. Eskimo Pie developed
Welch’s frozen grape juice bar and the Heath toffee ice cream bar. These firms
then split the profits derived from these products.6 As long as the cost of using
an alliance to enter a new industry is less than the cost of learning new skills and
capabilities, an alliance can be a valuable strategic opportunity.
Some firms use strategic alliances as a mechanism to withdraw from indus-
tries or industry segments in a low-cost way. Firms are motivated to withdraw
from an industry or industry segment when their level of performance in that
business is less than expected and when there are few prospects of it improving.
When a firm desires to exit an industry or industry segment, often it will need
to dispose of the assets it has developed to compete in that industry or industry
segment. These assets often include tangible resources and capabilities, such as
factories, distribution centers, and product technologies, and intangible resources
and capabilities, such as brand name, relationships with suppliers and customers,
a loyal and committed workforce, and so forth.
Firms will often have difficulty in obtaining the full economic value of these
tangible and intangible assets as they exit an industry or industry segment. This
reflects an important information asymmetry that exists between the firms that
currently own these assets and firms that may want to purchase these assets. By
forming an alliance with a firm that may want to purchase its assets, a firm is giv-
ing its partner an opportunity to directly observe how valuable those assets are.
If those assets are actually valuable, then this “sneak preview” can lead the assets
to be more appropriately priced and thereby facilitate the exit of the firm that is
looking to sell its assets. These issues will be discussed in more detail in Chapter
10’s discussion of mergers and acquisitions.
One firm that has used strategic alliances to facilitate its exit from an indus-
try or industry segment is Corning. In the late 1980s, Corning entered the medical
diagnostics industry. After several years, however, Corning concluded that its
resources and capabilities could be more productively used in other businesses.
For this reason, it began to extract itself from the medical diagnostics business.
However, to ensure that it received the full value of the assets it had created in
the medical diagnostics business upon exiting, it formed a strategic alliance with
M09_BARN0088_05_GE_C09.INDD 276 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 277
the Swiss specialty chemical company Ciba-Geigy. Ciba-Geigy paid $75 million to
purchase half of Corning’s medical diagnostics business. A couple of years later,
Corning finished exiting from the medical diagnostics business by selling its re-
maining assets in this industry to Ciba-Geigy. However, whereas Ciba-Geigy had
paid $75 million for the first half of Corning’s assets, it paid $150 million for the
second half. Corning’s alliance with Ciba-Geigy had made it possible for Ciba-
Geigy to fully value Corning’s medical diagnostics capabilities. Any information
asymmetry that might have existed was reduced, and Corning was able to get
more of the full value of its assets upon exiting this industry.7
Finally, firms may use strategic alliances to manage uncertainty. Under con-
ditions of high uncertainty, firms may not be able to tell at a particular point in
time which of several different strategies they should pursue. Firms in this setting
have an incentive to retain the flexibility to move quickly into a particular market
Several authors have concluded that joint ventures, as a form of alliance,
do increase the probability of tacit col-
lusion in an industry. As reviewed in
books by Scherer and Barney, one study
found that joint ventures created two
industrial groups, besides U.S. Steel, in
the U.S. iron and steel industry in the
early 1900s. In this sense, joint ventures
in the steel industry were a substitute
for U.S. Steel’s vertical integration and
had the effect of creating an oligopoly
in what (without joint ventures) would
have been a more competitive market.
Other studies found that more than 50
percent of joint venture parents belong
to the same industry. After examining
885 joint venture bids for oil and gas
leases, yet another study found only 16
instances where joint venture parents
competed with one another on another
tract in the same sale. These results sug-
gest that joint ventures might encour-
age subsequent tacit collusion among
firms in the same industry.
In a particularly influential
study, Pfeffer and Nowak found that
joint ventures were most likely in in-
dustries of moderate concentration.
These authors argued that in highly
concentrated industries—where there
were only a small number of com-
peting firms—joint ventures were not
necessary to create conditions condu-
cive to collusion. In highly fragmented
industries, the high levels of industry
concentration conducive to tacit collu-
sion could not be created by joint ven-
tures. Only when joint venture activity
could effectively create concentrated
industries—that is, only when indus-
tries were moderately concentrated—
were joint ventures likely.
Scherer and Barney also reviewed
more recent work that disputes these
findings. Joint ventures between firms
in the same industry may be valuable
for a variety of reasons that have little or
nothing to do with collusion. Moreover,
by using a lower level of aggregation,
several authors have disputed the find-
ing that joint ventures are most likely
in moderately concentrated industries.
The original study defined industries
using very broad industry categories—
“the electronics industry,” “the automo-
bile industry,” and so forth. By defining
industries less broadly—“consumer
electronics” and “automobile part manu-
facturers”—subsequent work found that
73 percent of the joint ventures had par-
ent firms coming from different indus-
tries. Although joint ventures between
firms in the same industry (defined at
this lower level of aggregation) may
have collusive implications, subsequent
work has shown that these kinds of joint
ventures are relatively rare.
Sources: F. M. Scherer (1980). Industrial mar-
ket structure and economic performance. Boston:
Houghton Mifflin; J. B. Barney (2006). Gaining
and sustaining competitive advantage, 3rd ed. Upper
Saddle River, NJ: Prentice Hall; J. Pfeffer and
P. Nowak (1976). “Patterns of joint venture activ-
ity: Implications for anti-trust research.” Antitrust
Bulletin, 21, pp. 315–339.
Do Strategic Alliances Facilitate
Tacit Collusion?
Research Made Relevant
M09_BARN0088_05_GE_C09.INDD 277 13/09/14 3:15 PM

278 Part 3: Corporate Strategies
or industry once the full value of that strategy is revealed. In this sense, strategic
alliances enable a firm to maintain a point of entry into a market or industry, with-
out incurring the costs associated with full-scale entry.
Based on this logic, strategic alliances have been analyzed as real options.8
In this sense, a joint venture is an option that a firm buys, under conditions of un-
certainty, to retain the ability to move quickly into a market or industry if valuable
opportunities present themselves. One way in which firms can move quickly into
a market is simply to buy out their partner(s) in the joint venture. Moreover, by
investing in a joint venture a firm may gain access to the information it needs to
evaluate full-scale entry into a market. In this approach to analyzing strategic al-
liances, firms that invest in alliances as options will acquire their alliance partners
only after the market signals an unexpected increase in value of the venture; that
is, only after uncertainty is reduced and the true, positive value of entering into a
market is known. Empirical findings are consistent with these expectations.9
Given these observations, it is not surprising to see firms in new and uncer-
tain environments develop numerous strategic alliances. This is one of the reasons
that strategic alliances are so common in the biotechnology industry. Although
there is relatively little uncertainty that at least some drugs created through bio-
technology will ultimately prove to be very valuable, which specific drugs will
turn out to be the most valuable is very uncertain. Rather than investing in a small
number of biotechnology drugs on their own, pharmaceutical companies have
invested in numerous strategic alliances with small biotechnology firms. Each of
these smaller firms represents a particular “bet” about the value of biotechnology
in a particular class of drugs. If one of these “bets” turns out to be valuable, then
the large pharmaceutical firm that has invested in that firm has the right, but not
the obligation, to purchase the rest of this company. In this sense, from the point
of view of the pharmaceutical firms, alliances between large pharmaceutical firms
and small biotechnology firms can be thought of as real options.
Alliance Threats: Incentives to Cheat
on Strategic Alliances
Just as there are incentives to cooperate in strategic alliances, there are also incen-
tives to cheat on these cooperative agreements. Indeed, research shows that as
many as one-third of all strategic alliances do not meet the expectations of at least
one alliance partner.10 Although some of these alliance “failures” may be due to
firms forming alliances that do not have the potential for creating value, some are
also due to parties to an alliance cheating—that is, not cooperating in a way that
maximizes the value of the alliance. Cheating can occur in at least the three differ-
ent ways presented in Table 9.2: adverse selection, moral hazard, and holdup.11
TAble 9.2 Ways to Cheat in
Strategic Alliances
■ Adverse selection: Potential partners misrepresent the value of the skills and abili-
ties they bring to the alliance.
■ Moral hazard: Partners provide to the alliance skills and abilities of lower quality
than they promised.
■ Holdup: Partners exploit the transaction-specific investments made by others in
the alliance.
M09_BARN0088_05_GE_C09.INDD 278 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 279
Adverse Selection
Potential cooperative partners can misrepresent the skills, abilities, and other re-
sources that they will bring to an alliance. This form of cheating, called adverse
selection, exists when an alliance partner promises to bring to an alliance certain
resources that it either does not control or cannot acquire. For example, a local firm
engages in adverse selection when it promises to make available to alliance part-
ners a local distribution network that does not currently exist. Firms that engage in
adverse selection are not competent alliance partners.
Adverse selection in a strategic alliance is likely only when it is difficult or
costly to observe the resources or capabilities that a partner brings to an alliance.
If potential partners can easily see that a firm is misrepresenting the resources and
capabilities it possesses, they will not create a strategic alliance with that firm.
Armed with such understanding, they will seek a different alliance partner, de-
velop the needed skills and resources internally, or perhaps forgo this particular
business opportunity.
However, evaluating the veracity of the claims of potential alliance partners
is often not easy. The ability to evaluate these claims depends on information that a
firm may not possess. To fully evaluate claims about a potential partner’s political
contacts, for example, a firm needs its own political contacts; to fully evaluate claims
about potential partners’ market knowledge, a firm needs significant market knowl-
edge. A firm that can completely, and at low cost, evaluate the resources and capa-
bilities of potential alliance partners probably does not really need these partners in
a strategic alliance. The fact that a firm is seeking an alliance partner is in some sense
an indication that the firm has limited abilities to evaluate potential partners.
In general, the less tangible the resources and capabilities that are to be
brought to a strategic alliance, the more costly it will be to estimate their value
before an alliance is created, and the more likely it is that adverse selection will
occur. Firms considering alliances with partners that bring intangible resources
such as “knowledge of local conditions” or “contacts with key political figures”
will need to guard against this form of cheating.
Moral Hazard
Partners in an alliance may possess high-quality resources and capabilities of
significant value in an alliance but fail to make those resources and capabilities
available to alliance partners. This form of cheating is called moral hazard. For
example, a partner in an engineering strategic alliance may agree to send only its
most talented and best-trained engineers to work in the alliance but then actu-
ally send less talented, poorly trained engineers. These less qualified engineers
may not be able to contribute substantially to making the alliance successful,
but they may be able to learn a great deal from the highly qualified engineers
provided by other alliance partners. In this way, the less qualified engineers
effectively transfer wealth from other alliance partners to their own firm.12
Often both parties in a failed alliance accuse each other of moral hazard.
This was the case in the abandoned alliance between Disney and Pixar, described
in the Strategy in the Emerging Enterprise feature.
The existence of moral hazard in a strategic alliance does not necessarily
mean that any of the parties to that alliance are malicious or dishonest. Rather,
what often happens is that market conditions change after an alliance is formed,
requiring one or more partners to an alliance to change their strategies.
M09_BARN0088_05_GE_C09.INDD 279 13/09/14 3:15 PM

280 Part 3: Corporate Strategies
For example, in the early days of the personal computer industry Compaq
Computer Corporation relied on a network of independent distributors to sell its
computers. However, as competition in the personal computer industry increased,
Internet, mail order, and so-called computer superstores became much more valu-
able distribution networks, and alliances between Compaq and its traditional
distributors became strained. Over time, Compaq’s traditional distributors were
unable to obtain the inventory they wanted in a timely manner. Indeed, to sat-
isfy the needs of large accounts, some traditional distributors actually purchased
Compaq computers from local computer superstores and then shipped them to
their customers. Compaq’s shift from independent dealers to alternative distribu-
tors looked like moral hazard—at least from the point of view of the independent
dealers. However, from Compaq’s perspective, this change simply reflected eco-
nomic realities in the personal computer industry.13
Holdup
Even if alliance partners do not engage in either adverse selection or moral hazard,
another form of cheating may evolve. Once a strategic alliance has been created,
partner firms may make investments that have value only in the context of that alli-
ance and in no other economic exchanges. These are the transaction-specific invest-
ments mentioned in Chapter 6. For example, managers from one alliance partner
may have to develop close, trusting relationships with managers from other alli-
ance partners. These close relationships are very valuable in the context of the alli-
ance, but they have limited economic value in other economic exchanges. Also, one
partner may have to customize its manufacturing equipment, distribution network,
and key organizational policies to cooperate with other partners. These modifica-
tions have significant value in the context of the alliance, but they do not help the
firm, and may even hurt it, in economic exchanges outside the alliance. As was the
case in Chapter 6, whenever an investment’s value in its first-best use (in this case,
within the alliance) is much greater than its value in its second-best use (in this case,
outside the alliance), that investment is said to be transaction specific.14
When one firm makes more transaction-specific investments in a strategic
alliance than partner firms make, that firm may be subject to the form of cheat-
ing called holdup. Holdup occurs when a firm that has not made significant
transaction- specific investments demands returns from an alliance that are higher
than the partners agreed to when they created the alliance.
For example, suppose two alliance partners agree to a 50–50 split of the costs
and profits associated with an alliance. To make the alliance work, Firm A has to
customize its production process. Firm B, however, does not have to modify itself
to cooperate with Firm A. The value to Firm A of this customized production pro-
cess, if it is used in the strategic alliance, is $5,000. However, outside the alliance,
this customized process is only worth $200 (as scrap).
Obviously, Firm A has made a transaction-specific investment in this alliance
and Firm B has not. Consequently, Firm A may be subject to holdup by Firm B. In
particular, Firm B may threaten to leave the alliance unless Firm A agrees to give
Firm B part of the $5,000 value that Firm A obtains by using the modified produc-
tion process in the alliance. Rather than lose all the value that could be generated
by its investment, Firm A may be willing to give up some of its $5,000 to avoid
gaining only $200. Indeed, if Firm B extracts up to the value of Firm A’s produc-
tion process in its next-best use (here, only $200), Firm A will still be better off
continuing in this relationship rather than dissolving it. Thus, even though Firm A
M09_BARN0088_05_GE_C09.INDD 280 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 281
and Firm B initially agreed on a 50–50 split from this strategic alliance, the agree-
ment may be modified if one party to the alliance makes significant transaction-
specific investments. Research on international joint ventures suggests that the
existence of transaction-specific investments in these relationships often leads to
holdup problems.15
In 1994, Pixar was a struggling startup company in northern California that
was trying to compete in an industry
that really didn’t yet exist—the com-
puter graphics animated motion pic-
ture industry. Headed by the founder
of Apple Computer, Steve Jobs, Pixar
was desperately looking for a partner
that could help finance and distribute
its new brand of animated movies. Who
better, Pixar thought, than the world’s
leader in animated feature-length films:
Disney. And, thus, a strategic alliance
between Pixar and Disney was formed.
In the alliance, Disney agreed to
help finance and distribute Pixar’s films.
In return, it would share in any prof-
its these films generated. Also, Disney
would retain the right to produce any
sequels to Pixar’s films—after first of-
fering Pixar the right to make these se-
quels. This agreement gave Disney a
great deal of control over any characters
that Pixar created in movies distributed
through Pixar’s alliance with Disney.
Of course, at the time the alliance was
originally formed there were no such
characters. Indeed, Pixar had yet to pro-
duce any movies. So, because Pixar was
a weak alliance partner, Disney was able
to gain control of any characters Pixar
developed in the future. Disney, after all,
had the track record of success.
A funny thing happened over the
next 10 years. Pixar produced block-
buster animated features such as Toy
Story (total revenues of $419.9 million);
A Bug’s Life (total revenues of $358
million); Toy Story 2 (total revenues of
$629.9 million); Monsters, Inc. (total rev-
enues of $903.1 million); Finding Nemo
(total revenues of $1,281.4 million); The
Incredibles (total revenues of $946.6 mil-
lion); and Cars (total revenues of $331.9
million). And these revenue numbers
do not include sales of merchandise
associated with these films. During this
same time period, Disney’s traditional
animated fare performed much more
poorly—Treasure Planet generated only
$112 million in revenues, The Emperor’s
New Groove only $169 million, and
Brother Bear only $126 million. Disney’s
“big hit” during this time period was
Lilo & Stitch, with revenues of $269
million—less than any of the movies
produced by Pixar.
Oops! The firm with the “proven
track record” of producing hit animated
features—Disney—stumbled badly, and
the upstart company with no track
record—Pixar—had all the success.
Because Disney did not have many of its
own characters upon which to base se-
quels, it began to eye Pixar’s characters.
Fast-forward to 2004. It’s time
to renew this alliance. But now Pixar
has the upper hand because it has the
track record. Disney comes knocking
and asks Pixar to redo the alliance.
What does Pixar say? “OK, but . . . we
want control of our characters, we want
Disney to act just as a distributor”—in
other words, “We want Disney out of
our business!” Disney balks at these
demands, and Pixar—well, Pixar just
canceled the alliance.
But Pixar still needed a distribu-
tion partner. Pixar simply does not pro-
duce enough films to justify the expense
of building its own distribution system.
After a several-month search, Pixar
found what it considered to be its best
distribution partner. The only problem
was—it was Disney.
Reestablishing the alliance be-
tween Pixar and Disney seemed out of
the question. After all, such an alliance
would have all the same challenges as
the previous alliance.
Instead, Disney decided to buy
Pixar. On January 25, 2006, Disney an-
nounced that it was buying Pixar in
a deal worth $7.4 billion. Steve Jobs
became Disney’s single largest inves-
tor and became a member of Disney’s
board of directors. John Lasseter—the
creative force behind Pixar’s success—
became chief creative officer at Disney.
Sources: S. Levy and D. Jefferson (2004). “Hey
Mickey, buzz off!” BusinessWeek, February 9, p. 4;
T. Lowry et al. (2004). “Megamedia mergers: How
dangerous?” BusinessWeek, February 23, pp. 34+;
and money.cnn.com/2006/01/24/newscompanies/
disney_pixar_deal.
Disney and Pixar
Strategy in the Emerging Enterprise
M09_BARN0088_05_GE_C09.INDD 281 13/09/14 3:15 PM

282 Part 3: Corporate Strategies
Although holdup is a form of cheating in strategic alliances, the threat of
holdup can also be a motivation for creating an alliance. Bauxite-smelting compa-
nies often join in joint ventures with mining companies in order to exploit econo-
mies of scale in mining. However, these firms have another option: They could
choose to operate large and efficient mines by themselves and then sell the excess
bauxite (over and above their needs for their own smelters) on the open market.
Unfortunately, bauxite is not a homogeneous commodity. Moreover, different
kinds of bauxite require different smelting technologies. In order for one firm to
sell its excess bauxite on the market, other smelting firms would have to make
enormous investments, the sole purpose of which would be to refine that particu-
lar firm’s bauxite. These investments would be transaction specific and subject
these other smelters to holdup problems.
In this context, a strategic alliance can be thought of as a way of reducing
the threat of holdup by creating an explicit management framework for resolving
holdup problems. In other words, although holdup problems might still exist in
these strategic alliances, the alliance framework may still be a better way in which
to manage these problems than attempting to manage them in arm’s-length mar-
ket relationships. Some of the ethical dimensions of adverse selection, moral haz-
ard, and holdup are discussed in the Ethics and Strategy feature.
Strategic Alliances and Sustained
Competitive Advantage
The ability of strategic alliances to be sources of sustained competitive advan-
tage, like all the other strategies discussed in this book, can be analyzed with the
VRIO framework developed in Chapter 3. An alliance is economically valuable
when it exploits any of the opportunities listed in Table 9.1 but avoids the threats
in Table 9.2. In addition, for a strategic alliance to be a source of sustained com-
petitive advantage it must be rare and costly to imitate.
The Rarity of Strategic Alliances
The rarity of strategic alliances does not only depend on the number of competing
firms that have already implemented an alliance. It also depends on whether the
benefits that firms obtain from their alliances are common across firms competing
in an industry.
Consider, for example, the U.S. automobile industry. Over the past several
years, strategic alliances have become very common in this industry, especially
with Japanese auto firms. General Motors developed an alliance with Toyota that
has already been described; Ford developed an alliance with Mazda before it
purchased this Japanese firm outright; and Chrysler developed an alliance with
Mitsubishi. Given the frequency with which alliances have developed in this in-
dustry, it is tempting to conclude that strategic alliances are not rare and thus not
a source of competitive advantage.
Closer examination, however, suggests that these alliances may have been
created for different reasons. For example, until recently, GM and Toyota have
cooperated only in building a single line of cars, the Chevrolet Nova. General
Motors has been less interested in learning design skills from Toyota and has been
V R I O
M09_BARN0088_05_GE_C09.INDD 282 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 283
more interested in learning about manufacturing high-quality small cars profit-
ably. Ford and Mazda, in contrast, worked closely together in designing new
cars and had joint manufacturing operations. Indeed, Ford and Mazda worked
so closely together that Ford finally once purchased 33 percent of Mazda’s stock.
Since 2008, Ford has reduced its investment in Mazda dramatically. Mitsubishi
has acted primarily as a supplier to Chrysler, and (until recently) there has been
relatively little joint development or manufacturing. Thus, although all three U.S.
firms have strategic alliances, the alliances serve different purposes, and therefore
each may be rare.16
One of the reasons why the benefits that accrue from a particular strategic
alliance may be rare is that relatively few firms may have the complementary
resources and abilities needed to form an alliance. This is particularly likely when
an alliance is formed to enter into a new market, especially a new foreign market.
In many less-developed economies, only one local firm or very few local firms
may exist with the local knowledge, contacts, and distribution network needed
to facilitate entry into that market. Moreover, sometimes the government acts to
limit the number of these local firms. Although several firms may seek entry into
this market, only a very small number will be able to form a strategic alliance with
the local entity, and therefore the benefits that accrue to the allied firms will likely
be rare.
The Imitability of Strategic Alliances
As discussed in Chapter 3, the resources and capabilities that enable firms to
conceive and implement valuable strategies may be imitated in two ways: direct
duplication and substitution. Both duplication and substitution are important
considerations in analyzing the imitability of strategic alliances.
Direct Duplication of Strategic Alliances
Research suggests that successful strategic alliances are often based on socially
complex relations among alliance partners.17 In this sense, successful strategic
alliances often go well beyond simple legal contracts and are characterized by so-
cially complex phenomena such as a trusting relationship between alliance part-
ners, friendship, and even (perhaps) a willingness to suspend narrow self-interest
for the longer-term good of the relationship.
Some research has shown that the development of trusting relationships
between alliance partners is both difficult and essential to the success of strate-
gic alliances. In one study, the most common reason that alliances failed to meet
the expectations of partner firms was the partners’ inability to trust one another.
Interpersonal communication, tolerance for cultural differences, patience, and
willingness to sacrifice short-term profits for longer-term success were all impor-
tant determinants of the level of trust among alliance partners.18
Of course, not all firms in an industry are likely to have the organizational
and relationship-building skills required for successful alliance building. If
these skills and abilities are rare among a set of competing firms and costly to
develop, then firms that are able to exploit these abilities by creating alliances
may gain competitive advantages. Examples of firms that have developed these
specialized skills include Corning and Cisco, with several hundred strategic al-
liances each.19
M09_BARN0088_05_GE_C09.INDD 283 13/09/14 3:15 PM

284 Part 3: Corporate Strategies
Firms in strategic alliances can cheat on their alliance partners by engag-
ing in adverse selection, moral hazard,
or holdup. These three activities all
have at least one thing in common—
they all involve one alliance partner
lying to another. And these lies can
often pay off big in the form of the
lying firm appropriating more than its
“fair share” of the value created in an
alliance. Are alliances one place in the
economy where the adage “cheaters
never prosper” does not hold?
There is little doubt that, in the
short run, firms that cheat on their
alliance partners can gain some ad-
vantages. But research suggests that
cheating does not pay in the long run
because firms that cheat on their alli-
ance partners will find it difficult to
form alliances with new partners and
thus have many valuable exchange
opportunities foreclosed to them.
One study that examined the
long-term return to “cheaters” in stra-
tegic alliances analyzed alliances using
a simple game called the “Prisoner’s
Dilemma.” In a “Prisoner’s Dilemma”
game, firms have two options: to con-
tinue cooperating in a strategic alliance
or to “cheat” on that alliance through
adverse selection, moral hazard, or
holdup. The payoffs to firms in this
game depend on the decisions made
by both firms. As shown in Table 9.3,
if both firms decide to cooperate, they
each get a good size payoff from the al-
liance ($3,000 in Table 9.3); if they both
decide to cheat on the alliance, they
each get a very small payoff ($1,000 in
Table 9.3); and if one decides to cheat
while the other decides to cooperate,
then the cheating firm gets a very big
payoff ($5,000 in Table 9.3) while the co-
operating firm gets a very small payoff
($0 in Table 9.3).
If Firm 1 and Firm 2 in this
game are going to engage in only one
strategic alliance, then they have a
very strong incentive to “cheat.” The
worst that could happen if they cheat
is that they earn a $1,000 payoff, but
there is a possibility of a $5,000 payoff.
However, research has shown that if
a firm is contemplating engaging in
multiple strategic alliances over time,
then the optimal strategy is to cooper-
ate in all its alliances. This is true even
if all these alliances are not with the
same partner firm.
The specific “winning” strat-
egy in repeated “Prisoner Dilemma”
games is called a “tit-for-tat” strategy.
“Tit-for-tat” means that Firm 1 will
cooperate in an alliance as long as
Firm 2 cooperates. However, as soon
as Firm 2 cheats on an alliance, Firm
1 cheats as well. “Tit-for-tat” works
well in this setting because adopting
a cooperative posture in an alliance
ensures that, most of the time, the
alliance will generate a high payoff
(of $3,000 in Table 9.3). However, by
immediately responding to cheaters
by cheating, the firm implementing
a “tit-for-tat” strategy also minimizes
the times when it will earn the lowest
payoff in the table ($0). So, “tit-for-
tat” maximizes the upside potential
of an alliance while minimizing its
downside.
All this analysis suggests that
although cheating on an alliance can
give a firm competitive advantages in
the short to medium term, in the long
run, “cheaters never prosper.”
Sources: R. M. Axelrod (1984). The evolution of
cooperation. New York: Basic Books; D. Ernst and
J. Bleeke (1993). Collaborating to compete. New
York: Wiley.
Ethics and Strategy
When It Comes to Alliances,
Do “Cheaters Never Prosper”?
TAble 9.3 Returns from Cooperating
and Cheating in a “Prisoner’s Dilemma”
Strategic Alliance
Firm 1
Cooperates Cheats
Cooperates 1: $3,000 1: $5,000
2: $3,000 2: $0
Firm 2
Cheats 1: $0 1: $1,000
2: $5,000 2: $1,000
M09_BARN0088_05_GE_C09.INDD 284 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 285
Substitutes for Strategic Alliances
Even if the purpose and objectives of a strategic alliance are valuable and rare and
even if the relationships on which an alliance is created are socially complex and
costly to imitate, that alliance will still not generate a sustained competitive ad-
vantage if low-cost substitutes are available. At least two possible substitutes for
strategic alliances exist: “going it alone” and acquisitions.20
“going It Alone.” Firms “go it alone” when they attempt to develop all the re-
sources and capabilities they need to exploit market opportunities and neutralize
market threats by themselves. Sometimes “going it alone” can create the same—
or even more—value than using alliances to exploit opportunities and neutralize
threats. In these settings, “going it alone” is a substitute for a strategic alliance.
However, in other settings using an alliance can create substantially more value
than “going it alone.” In these settings, “going it alone” is not a substitute for a
strategic alliance.
So, when will firms prefer an alliance over “going it alone”? Not surpris-
ingly, the three explanations of vertical integration, discussed in Chapter 6,
are relevant here as well. These three explanations focused on the threat of
opportunism, the impact of firm resources and capabilities, and the role of
uncertainty. If you need to review these three explanations, they are described
in detail in Chapter 6. They are relevant here because “going it alone”—as a
potential substitute for a strategic alliance—is an example of vertical integra-
tion. The implications of these three explanations for when strategic alliances
will be preferred over “going it alone” are summarized in Table 9.4. If any of the
conditions listed in Table 9.4 exist, then “going it alone” will not be a substitute
for strategic alliances.
Recall from Chapter 6 that opportunism-based explanations of vertical
integration suggest that firms will want to vertically integrate an economic
exchange when they have made high levels of transaction-specific investment
in that exchange. That is, using language developed in this chapter, firms will
want to vertically integrate an economic exchange when using an alliance to
manage that exchange could subject them to holdup. Extending this logic to
strategic alliances suggests that strategic alliances will be preferred over “going
it alone” and other alternatives when the level of transaction-specific invest-
ment required to complete an exchange is moderate. If the level of this specific
investment is low, then market forms of exchange will be preferred; if the level
of this specific investment is high, then “going it alone” in a vertically integrated
way will be preferred; if the level of this specific investment is moderate, then
some sort of strategic alliance will be preferred. Thus, when the level of specific
exchange in a transaction is moderate, then “going it alone” is not a substitute
for a strategic alliance.
TAble 9.4 When Alliances
Will Be Preferred Over
“Going It Alone”
Alliances will be preferred over “going it alone” when:
1. The level of transaction-specific investment required to complete an exchange is
moderate.
2. An exchange partner possesses valuable, rare, and costly-to-imitate resources
and capabilities.
3. There is great uncertainty about the future value of an exchange.
M09_BARN0088_05_GE_C09.INDD 285 13/09/14 3:15 PM

286 Part 3: Corporate Strategies
Capabilities-based explanations suggest that an alliance will be preferred
over “going it alone” when an exchange partner possesses valuable, rare, and
costly-to-imitate resources and capabilities. A firm without these capabilities may
find them to be too costly to develop on its own. If a firm must have access to
capabilities it cannot develop on its own, it must use an alliance to gain access to
those capabilities. In this setting, “going it alone” is not a substitute for a strategic
alliance.21
Finally, it has already been suggested that, under conditions of high un-
certainty, firms may be unwilling to commit to a particular course of action by
engaging in an exchange within a firm. In such settings, firms may choose the
strategic flexibility associated with alliances. As suggested earlier in this chap-
ter, alliances can be thought of as real options that give a firm the right, but not
the obligation, to invest further in an exchange—perhaps by bringing it within
the boundaries of a firm—if that exchange turns out to be valuable sometime in
the future. Thus, under conditions of high uncertainty, “going it alone” is not a
substitute for strategic alliances.
Acquisitions. The acquisition of other firms can also be a substitute for alliances.
In this case, rather than developing a strategic alliance or attempting to develop
and exploit the relevant resources by “going it alone,” a firm seeking to exploit
the opportunities listed in Table 9.1 may simply acquire another firm that already
possesses the relevant resources and capabilities. However, such acquisitions
have four characteristics that often limit the extent to which they can act as substi-
tutes for strategic alliances. These are summarized in Table 9.5.22
First, there may be legal constraints on acquisitions. These are especially
likely if firms are seeking advantages by combining with other firms in their
own industry. Thus, for example, using acquisitions as a substitute for strategic
alliances in the aluminum industry would lead to a very concentrated industry
and subject some of these firms to serious antitrust liabilities. These firms have
acquisitions foreclosed to them and must look elsewhere to gain advantages from
cooperating with their competition.
Second, as has already been suggested, strategic alliances enable a firm to
retain its flexibility either to enter or not to enter into a new business. Acquisitions
limit that flexibility because they represent a strong commitment to engage in
a certain business activity. Consequently, under conditions of high uncertainty
firms may choose strategic alliances over acquisitions as a way to exploit opportu-
nities while maintaining the flexibility that alliances create.
Third, firms may choose strategic alliances over acquisitions because of
the unwanted organizational baggage that often comes with an acquisition.
Sometimes, the value created by combining firms depends on combining particu-
lar functions, divisions, or other assets in the firms. A strategic alliance can focus
on exploiting the value of combining just those parts of firms that create the most
TAble 9.5 Reasons Why
Strategic Alliances May Be More
Attractive Than Acquisitions to
Realize Exchange Opportunities
Alliances will be preferred to acquisitions when:
1. There are legal constraints on acquisitions.
2. Acquisitions limit a firm’s flexibility under conditions of high uncertainty.
3. There is substantial unwanted organizational “baggage” in an acquired firm.
4. The value of a firm’s resources and capabilities depends on its independence.
M09_BARN0088_05_GE_C09.INDD 286 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 287
value. Acquisitions, in contrast, generally include the entire organization, both the
parts of a firm where value is likely to be created and parts of a firm where value
is not likely to be created.
From the point of view of the acquiring firm, parts of a firm that do not cre-
ate value are essentially unwanted baggage. These parts of the firm may be sold
off subsequent to an acquisition. However, this sell-off may be costly and time
consuming. If enough baggage exists, firms may determine that an acquisition
is not a viable option, even though important economic value could be created
between a firm and a potential acquisition target. To gain this value, an alternative
approach—a strategic alliance—may be preferred. These issues will be explored
in more detail in Chapter 10.
Finally, sometimes a firm’s resources and capabilities are valuable be-
cause that firm is independent. In this setting, the act of acquiring a firm can
actually reduce the value of a firm. When this is the case, any value between
two firms is best realized through an alliance, not an acquisition. For example,
the international growth of numerous marketing-oriented companies in the
1980s led to strong pressures for advertising agencies to develop global mar-
keting capabilities. During the 1990s, many domestic-only advertising firms
acquired nondomestic agencies to form a few large international advertising
agencies. However, one firm that was reluctant to be acquired in order to be
part of an international advertising network was the French advertising com-
pany Publicis. Over and above the personal interests of its owners to retain
control of the company, Publicis wanted to remain an independent French
agency in order to retain its stable of French and French-speaking clients—
including Renault and Nestlé. These firms had indicated that they preferred
working with a French advertising agency and that they would look for alter-
native suppliers if Publicis were acquired by a foreign firm. Because much of
the value that Publicis created in a potential acquisition depended on obtaining
access to its stable of clients, the act of acquiring Publicis would have had the
effect of destroying the very thing that made the acquisition attractive. For this
reason, rather than allowing itself to be acquired by foreign advertising agen-
cies, Publicis developed a complex equity strategic alliance and joint venture
with a U.S. advertising firm, Foote, Coyne, and Belding. Although, ultimately,
this alliance was not successful in providing an international network for either
of these two partner firms, an acquisition of Publicis by Foote, Coyne, and
Belding would almost certainly have destroyed some of the economic value
that Publicis enjoyed as a stand-alone company.
Organizing to Implement Strategic Alliances
One of the most important determinants of the success of strategic alliances is their
organization. The primary purpose of organizing a strategic alliance is to enable
partners in the alliance to gain all the benefits associated with cooperation while
minimizing the probability that cooperating firms will cheat on their cooperative
agreements. The organizing skills required in managing alliances are, in many
ways, unique. It often takes some time for firms to learn these skills and realize the
full potential of their alliances. This is why some firms are able to gain competi-
tive advantages from managing alliances more effectively than their competitors.
Indeed, sometimes firms may have to choose alternatives to alliances—including
V R I O
M09_BARN0088_05_GE_C09.INDD 287 13/09/14 3:15 PM

288 Part 3: Corporate Strategies
“going it alone” and acquisitions—even when those alternatives are not preferred,
simply because they do not have the skills required to organize and manage
alliances.
A variety of tools and mechanisms can be used to help realize the value of
alliances and minimize the threat of cheating. These include contracts, equity in-
vestments, firm reputations, joint ventures, and trust.
explicit Contracts and legal Sanctions
One way to avoid cheating in strategic alliances is for the parties to an alliance
to anticipate the ways in which cheating may occur (including adverse selection,
moral hazard, and holdup) and to write explicit contracts that define legal liabil-
ity if cheating does occur. Writing these contracts, together with the close moni-
toring of contractual compliance and the threat of legal sanctions, can reduce the
probability of cheating. Earlier in this chapter, such strategic alliances were called
nonequity alliances.
However, contracts sometimes fail to anticipate all forms of cheating that
might occur in a relationship—and firms may cheat on cooperative agreements
in subtle ways that are difficult to evaluate in terms of contractual requirements.
Thus, for example, a contract may require parties in a strategic alliance to make
available to the alliance certain proprietary technologies or processes. However, it
may be very difficult to communicate the subtleties of these technologies or pro-
cesses to alliance partners. Does this failure in communication represent a clear
violation of contractual requirements, or does it represent a good-faith effort by
alliance partners? Moreover, how can one partner tell whether it is obtaining all
the necessary information about a technology or process when it is unaware of
all the information that exists in another firm? Hence, although contracts are an
important component of most strategic alliances, they do not resolve all the prob-
lems associated with cheating.
Although most contracts associated with strategic alliances are highly cus-
tomized, these different contracts do have some common features. These common
features are described in detail in Table 9.6. In general, firms contemplating a
strategic alliance that will be at least partially governed by a contract will have to
include clauses that address the issues presented in Table 9.6.
equity Investments
The effectiveness of contracts can be enhanced by having partners in an alliance
make equity investments in each other. When Firm A buys a substantial equity
position in its alliance partner, Firm B, the market value of Firm A now depends,
to some extent, on the economic performance of that partner. The incentive of
Firm A to cheat Firm B falls, for to do so would be to reduce the economic perfor-
mance of Firm B and thus the value of Firm A’s investment in its partner. These
kinds of strategic alliances are called equity alliances.
Many firms use cross-equity investments to help manage their strategic al-
liances. These arrangements are particularly common in Japan, where a firm’s
largest equity holders often include several of its key suppliers, including its main
banks. These equity investments, because they reduce the threat of cheating in al-
liances with suppliers, can reduce these firms’ supply costs. In turn, not only do
firms have equity positions in their suppliers, but suppliers often have substantial
equity positions in the firms to which they sell.23
M09_BARN0088_05_GE_C09.INDD 288 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 289
Firm Reputations
A third constraint on incentives to cheat in strategic alliances exists in the effect
that a reputation for cheating has on a firm’s future opportunities. Although it
is often difficult to anticipate all the different ways in which an alliance partner
may cheat, it is often easier to describe after the fact how an alliance partner has
cheated. Information about an alliance partner that has cheated is likely to be-
come widely known. A firm with a reputation as a cheater is not likely to be able
to develop strategic alliances with other partners in the future, despite any spe-
cial resources or capabilities that it might be able to bring to an alliance. In this
way, cheating in a current alliance may foreclose opportunities for developing
other valuable alliances. For this reason, firms may decide not to cheat in their
current alliances.24
TAble 9.6 Common Clauses
in Contracts Used to Govern
Strategic Alliances
Establishment Issues
Shareholdings: Percentage of JV owned by various partners
Voting rights: Votes held by various partners
Dividend percentage: How profits are to be allocated
Minority protection: How minority owner interests are protected
Board of directors: Initial board and rules for modifying the board
Articles of association: Processes for making decisions
Place of incorporation
Accountants, lawyers, and other advisors
Operating Issues
Performance expectations
Noncompete agreements
Nonsolicitation clauses: Partners cannot recruit employees from each other
Confidentiality clauses
Licensing intellectual property rights: Who owns the intellectual property created
by a joint venture?
Liability of the alliance and liability of cooperating partners
Process of changing the contract
Process of resolving disputes
Termination Issues
Preemption rights: If one partner wishes to sell its shares, it must first offer them
to the other partner
When one partner can force the other partner to sell its shares to it
When a partner has the right to force another partner to buy its alliance shares
Drag-along rights: When one partner can arrange a sale to an outside firm and
force the other partner to sell shares as well
Tag-along rights: When one partner can prevent the sale of the second partner’s
shares to an outside firm unless that outside firm also buys the first partner’s
shares
When an initial public offering (IPO) will be pursued
Termination: When the JV can be terminated
Source: Based on E. Campbell and J. Reuer (2001). “Note on the legal negotiation of strategic alliance
agreements.” Copyright © 2000 INSEAD.
M09_BARN0088_05_GE_C09.INDD 289 13/09/14 3:15 PM

290 Part 3: Corporate Strategies
Substantial evidence suggests that the effect of reputation on future busi-
ness opportunities is important. Firms go to great lengths to make sure that they
do not develop a negative reputation. Nevertheless, this reputational control of
cheating in strategic alliances does have several limitations.25
First, subtle cheating in a strategic alliance may not become public, and
if it does become public, the responsibility for the failure of the strategic alli-
ance may be very ambiguous. In one equity joint venture attempting to perfect
the design of a new turbine for power generation, financial troubles made one
partner considerably more anxious than the other partner to complete product
development. The financially healthy, and thus patient, partner believed that if
the alliance required an additional infusion of capital, the financially troubled
partner would have to abandon the alliance and would have to sell its part of
the alliance at a relatively low price. The patient partner thus encouraged al-
liance engineers to work slowly and carefully in the guise of developing the
technology to reach its full potential. The financially troubled, and thus impa-
tient, partner encouraged alliance engineers to work quickly, perhaps sacrific-
ing some quality to develop the technology sooner. Eventually, the impatient
partner ran out of money, sold its share of the alliance to the patient partner at
a reduced price, and accused the patient partner of not acting in good faith to
facilitate the rapid development of the new technology. The patient partner ac-
cused the other firm of pushing the technology too quickly, thereby sacrificing
quality and, perhaps, worker safety. In some sense, both firms were cheating
on their agreement to develop the new technology cooperatively. However,
this cheating was subtle and difficult to spot and had relatively little impact
on the reputation of either firm or on the ability of either firm to establish
alliances in the future. It is likely that most observers would simply conclude
that the patient partner obtained a windfall because of the impatient partner’s
bad luck.26
Second, although one partner to an alliance may be unambiguously cheat-
ing on the relationship, one or both of the firms may not be sufficiently con-
nected into a network with other firms to make this information public. When
information about cheating remains private, public reputations are not tarnished
and future opportunities are not forgone. This is especially likely to happen if
one or both alliance partners operate in less-developed economies where infor-
mation about partner behavior may not be rapidly diffused to other firms or to
other countries.
Finally, the effect of a tarnished reputation, as long as cheating in an alli-
ance is unambiguous and publicly known, may foreclose future opportunities
for a firm, but it does little to address the current losses experienced by the firm
that was cheated. Moreover, any of the forms of cheating discussed earlier—
adverse selection, moral hazard, or holdup—can result in substantial losses
for a firm currently in an alliance. Indeed, the wealth created by cheating in a
current alliance may be large enough to make a firm willing to forgo future al-
liances. In this case, a tarnished reputation may be of minor consequence to a
cheating firm.27
Joint Ventures
A fourth way to reduce the threat of cheating is for partners in a strategic alli-
ance to invest in a joint venture. Creating a separate legal entity, in which alliance
partners invest and from whose profits they earn returns on their investments,
M09_BARN0088_05_GE_C09.INDD 290 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 291
reduces some of the risks of cheating in strategic alliances. When a joint venture
is created, the ability of partners to earn returns on their investments depends
on the economic success of the joint venture. Partners in joint ventures have
limited interests in behaving in ways that hurt the performance of the joint ven-
ture because such behaviors end up hurting both partners. Moreover, unlike
reputational consequences of cheating, cheating in a joint venture does not just
foreclose future alliance opportunities; it can hurt the cheating firm in the current
period as well.
Given the advantages of joint ventures in controlling cheating, it is not
surprising that when the probability of cheating in a cooperative relationship is
greatest, a joint venture is usually the preferred form of cooperation. For example,
bauxite mining has some clear economies of scale. However, transaction-specific
investments would lead to significant holdup problems in selling excess bauxite
in the open market, and legal constraints prevent the acquisition of other smelter
companies to create an intraorganizational demand for excess bauxite. Holdup
problems would continue to exist in any mining strategic alliances that might
be created. Nonequity alliances, equity alliances, and reputational effects are not
likely to restrain cheating in this situation because the returns on holdup, once
transaction-specific investments are in place, can be very large. Thus, most of the
strategic alliances created to mine bauxite take the form of joint ventures. Only
this form of strategic alliance is likely to create incentives strong enough to signifi-
cantly reduce the probability of cheating.28
Despite these strengths, joint ventures are not able to reduce all cheating in
an alliance without cost. Sometimes the value of cheating in a joint venture is suf-
ficiently large that a firm cheats even though doing so hurts the joint venture and
forecloses future opportunities. For example, a particular firm may gain access to
a technology through a joint venture that would be valuable if used in another of
its lines of business. This firm may be tempted to transfer this technology to this
other line of business even if it has agreed not to do so and even if doing so would
limit the performance of its joint venture. Because the profits earned in this other
line of business may have a greater value than the returns that could have been
earned in the joint venture and the returns that could have been earned in the fu-
ture with other strategic alliances, cheating may occur.
Trust
It is sometimes the case that alliance partners rely only on legalistic and narrowly
economic approaches to manage their alliance. However, recent work seems to
suggest that although successful alliance partners do not ignore legal and eco-
nomic disincentives to cheating, they strongly support these narrower linkages
with a rich set of interpersonal relations and trust. Trust, in combination with con-
tracts, can help reduce the threat of cheating. More important, trust may enable
partners to explore exchange opportunities that they could not explore if only
legal and economic organizing mechanisms were in place.29
At first glance, this argument may seem far-fetched. However, some research
offers support for this approach to managing strategic alliances, suggesting that
successful alliance partners typically do not specify all the terms and conditions
in their relationship in a legal contract and do not specify all possible forms of
cheating and their consequences. Moreover, when joint ventures are formed, part-
ners do not always insist on simple 50–50 splits of equity ownership and profit
sharing. Rather, successful alliances involve trust, a willingness to be flexible, a
M09_BARN0088_05_GE_C09.INDD 291 13/09/14 3:15 PM

292 Part 3: Corporate Strategies
willingness to learn, and a willingness to let the alliance develop in ways that the
partners could not have anticipated.30
Commitment, coordination, and trust are all important determinants of al-
liance success. Put another way, a strategic alliance is a relationship that evolves
over time. Allowing the lawyers and economists to too rigorously define, a pri-
ori, the boundaries of that relationship may limit it and stunt its development.31
This “trust” approach also has implications for the extent to which strategic
alliances may be sources of sustained competitive advantage for firms. The ability
to move into strategic alliances in this trusting way may be very valuable over the
long run. There is strong reason to believe that this ability is not uniformly distrib-
uted across all firms that might have an interest in forming strategic alliances and
that this ability may be history-dependent and socially complex and thus costly
to imitate. Firms with these skills may be able to gain sustained competitive ad-
vantages from their alliance relationships. The observation that just a few firms,
including Corning and Cisco, are well-known for their strategic alliance successes
is consistent with the observation that these alliance management skills may be
valuable, rare, and costly to imitate.
Summary
Strategic alliances exist whenever two or more organizations cooperate in the develop-
ment, manufacture, or sale of products or services. Strategic alliances can be grouped into
three large categories: nonequity alliances, equity alliances, and joint ventures.
Firms join in strategic alliances for three broad reasons: to improve the perfor-
mance of their current operations, to improve the competitive environment within which
they are operating, and to facilitate entry into or exit from markets and industries. Just as
there are incentives to cooperate in strategic alliances, there are also incentives to cheat.
Cheating generally takes one or a combination of three forms: adverse selection, moral
hazard, or holdup.
Strategic alliances can be a source of sustained competitive advantage. The rarity
of alliances depends not only on the number of competing firms that have developed an
alliance, but also on the benefits that firms gain through their alliances.
Imitation through direct duplication of an alliance may be costly because of the
socially complex relations that underlie an alliance; however, imitation through substi-
tution is more likely. Two substitutes for alliances may be “going it alone,” where firms
develop and exploit the relevant sets of resources and capabilities on their own, and
acquisitions. Opportunism, capabilities, and uncertainty all have an impact on when
“going it alone” will be a substitute for a strategic alliance. Acquisitions may be a sub-
stitute for strategic alliances when there are no legal constraints, strategic flexibility is
not an important consideration, when the acquired firm has relatively little unwanted
“organizational baggage,” and when the value of a firm’s resources and capabilities does
not depend on its remaining independent. However, when these conditions do not exist,
acquisitions are not a substitute for alliances.
The key issue facing firms in organizing their alliances is to facilitate cooperation
while avoiding the threat of cheating. Contracts, equity investments, firm reputations,
joint ventures, and trust can all reduce the threat of cheating in different contexts.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
M09_BARN0088_05_GE_C09.INDD 292 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 293
Challenge Questions
9.1. In strategic alliances, organizations
have several options beyond that of an
equity alliance, such as joint ventures
and a spectrum of non-equity alliance
choices. Then why would a company
want to participate in an equity alliance
by investing in a partner’s firm?
9.2. In the 21st century, many
organizations feel compelled to
partner for expansion, particularly
in an international situation. Options
include exporting or licensing one’s
intellectual property in a low risk
exercise where royalties can have high
profit margins. In addition, franchising
can provide very lucrative continuous
cash flow opportunities as a fraction of
the franchisee’s revenue. Why do com-
panies engage in joint ventures when
there exist many other forms of non-
equity options for expansion?
9.3. Consider the joint venture
between General Motors and Toyota.
GM has been interested in learning
how to profitably manufacture high-
quality small cars from its alliance
with Toyota. Toyota has been inter-
ested in gaining access to GM’s U.S.
distribution network and in reducing
the political liability associated with
local content laws. What implications,
if any, does this alliance have for a
possible “learning race?”
9.4. An exclusive distributorship agree-
ment entered into by a manufacturer
(the principal) with an organization can
constitute a strategic alliance. On the
other hand, some companies appoint a
huge number of partners to resell their
product, in a form known as intensive
distribution. Why would a principal
restrict themselves to one partner alone
when more distributors may provide a
wider breadth of coverage?
9.5. How can one tell whether two
firms are engaging in an alliance to
facilitate collusion or are engaging in
an alliance for other purposes?
9.6. Partnerships can range from
simple principal-reseller relationships
to equity joint ventures. In the latter
makeup, partners have real and often
long-term financial interests in the proj-
ect. There are others that sit somewhere
in the middle, such as franchising or
trademark license agreements. In what
ways can such alliances turn out badly?
9.7. Some researchers have argued
that alliances can be used to help firms
evaluate the economic potential of en-
tering into a new industry or market.
Why couldn’t such a firm simply hire
some smart managers, consultants,
and industry experts to evaluate the
economic potential of entering into a
new industry?
9.8. Some researchers have argued that
alliances can be used to help firms eval-
uate the economic potential of entering
into a new industry or market. What, if
anything, about an alliance makes this a
better way to evaluate entry opportuni-
ties than alternative methods?
9.9. If adverse selection, moral haz-
ard, and holdup are such significant
problems for firms pursuing alliance
strategies, why do firms even bother
with alliances?
9.10. If adverse selection, moral haz-
ard, and holdup are such significant
problems for firms pursuing alliance
strategies, why don’t they instead
adopt a “go it alone” strategy to re-
place strategic alliances?
Problem Set
9.11. Which of the following firms faces the greater threat of “cheating” in the alliances
described, and why?
(a) Firm I and Firm II form a strategic alliance. As part of the alliance, Firm I agrees to
build a new plant right next to Firm II’s primary facility. In return, Firm II promises to
buy most of the output of this new plant. Which is at risk, Firm I or Firm II?
(b) Firm A and Firm B form a strategic alliance. As part of the alliance, Firm A promises
to begin selling products it already sells around the world in the home country of
Firm B. In return, Firm B promises to provide Firm A with crucial contacts in its home
country’s government. These contacts are essential if Firm A is going to be able to sell
in Firm B’s home country. Which is at risk, Firm A or Firm B?
(c) Firm 1 and Firm 2 form a strategic alliance. As part of the alliance, Firm 1 promises to
provide Firm 2 access to some new and untested technology that Firm 2 will use in
its products. In return, Firm 2 will share some of the profits from its sales with Firm 1.
Which is at risk, Firm 1 or Firm 2?
M09_BARN0088_05_GE_C09.INDD 293 13/09/14 3:15 PM

294 Part 3: Corporate Strategies
9.12. Are all strategic alliances used for entry into a market? Explain with examples.
9.13. Examine the Web sites of the following strategic alliances and determine which of
the sources of value presented in Table 9.1 are present:
(a) Dow-Corning (an alliance between Dow Chemical and Corning)
(b) CFM (an alliance between General Electric and SNECMA)
(c) NCAA (an alliance among colleges and universities in the United States)
(d) Visa (an alliance among banks in the United States)
(e) The alliance among United, Delta, Singapore Airlines, AeroMexico, Alitalia, and
Korean Air
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
9.14. How would a firm’s reputation reduce the threat of cheating in a strategic alliance?
9.15. How can holdup be considered a form of cheating in strategic alliances and
threat of holdup be considered a motivation for creating an alliance?
End Notes
1. See www.pwc.com/extweb/exccps.nsf/docid; www.addme.com/
issue208; McCracken, J. (2006). “Ford doubles reported loss for second
quarter.” The Wall Street Journal, August 3, p. A3; and www.msnbc.
msn.com/id/13753688.
2. Badaracco, J. L., and N. Hasegawa. (1988). “General Motors’ Asian
alliances.” Harvard Business School Case No. 9-388-094.
3. See www.blu-ray.com.
4. See Burgers, W. P., C. W. L. Hill, and W. C. Kim. (1993). “A theory
of global strategic alliances: The case of the global auto industry.”
Strategic Management Journal, 14, pp. 419–432.
5. See Freeman, A., and R. Hudson. (1980). “DuPont and Philips plan
joint venture to make, market laser disc products.” The Wall Street
Journal, December 22, p. 10.
6. Teitelbaum, R. S. (1992). “Eskimo pie.” Fortune, June 15, p. 123.
7. Nanda, A., and C. A. Bartlett. (1990). “Corning Incorporated: A net-
work of alliances.” Harvard Business School Case No. 9-391-102.
8. See Knight, F. H. (1965). Risk, uncertainty, and profit. New York: John
Wiley & Sons, Inc., on uncertainty; Kogut, B. (1991). “Joint ventures
and the option to expand and acquire.” Management Science, 37,
pp. 19–33; Burgers, W. P., C. W. L. Hill, and W. C. Kim. (1993). “A
theory of global strategic alliances: The case of the global auto in-
dustry.” Strategic Management Journal, 14, pp. 419–432; Noldeke, G.,
and K. M. Schmidt. (1998). “Sequential investments and options to
own.” Rand Journal of Economics, 29(4), pp. 633–653; and Folta, T. B.
(1998). “Governance and uncertainty: The tradeoff between admin-
istrative control and commitment.” Strategic Management Journal, 19,
pp. 1007–1028.
9. See Kogut, B. (1991). “Joint ventures and the option to expand and
acquire.” Management Science, 37, pp. 19–33; and Balakrishnan, S., and
M. Koza. (1993). “Information asymmetry, adverse selection and joint-
ventures.” Journal of Economic Behavior & Organization, 20, pp. 99–117.
10. See, for example, Ernst, D., and J. Bleeke. (1993). Collaborating to com-
pete: Using strategic alliances and acquisition in the global marketplace.
New York: John Wiley & Sons, Inc.
11. These terms are defined in Barney, J. B., and W. G. Ouchi. (1986).
Organizational economics. San Francisco: Jossey-Bass; and Holmstrom, B.
(1979). “Moral hazard and observability.” Bell Journal of Economics,
10(1), pp. 74–91. Problems of cheating in economic exchanges in
general, and in alliances in particular, are discussed by Gulati, R.,
and H. Singh. (1998). “The architecture of cooperation: Managing
coordination costs and appropriation concerns in strategic alli-
ances.” Administrative Science Quarterly, 43, pp. 781–814; Williamson,
O. E. (1991). “Comparative economic organization: The analysis of
discrete structural alternatives.” Administrative Science Quarterly, 36,
pp. 269–296; Osborn, R. N., and C. C. Baughn. (1990). “Forms of in-
terorganizational governance for multinational alliances.” Academy of
Management Journal, 33(3), pp. 503–519; Hagedoorn, J., and R. Narula.
(1996). “Choosing organizational modes of strategic technology part-
nering: International and sectoral differences.” Journal of International
Business Studies, second quarter, pp. 265–284; Hagedorn, J. (1996).
“Trends and patterns in strategic technology partnering since the early
seventies.” Review of Industrial Organization, 11, pp. 601–616; Kent, D. H.
(1991). “Joint ventures vs. non-joint ventures: An empirical investiga-
tion.” Strategic Management Journal, 12, pp. 387–393; and Shane, S. A.
(1998). “Making new franchise systems work.” Strategic Management
Journal, 19, pp. 697–707.
12. Such alliance difficulties are described in Ouchi, W. G. (1984). The
M-form society: How American teamwork can capture the competitive edge.
Reading, MA: Addison-Wesley; and Bresser, R. K. (1988). “Cooperative
strategy.” Strategic Management Journal, 9, pp. 475–492.
13. Pope, K. (1993). “Dealers accuse Compaq of jilting them.” The Wall
Street Journal, February 26, pp. 8, B1+.
14. Williamson, O. E. (1975). Markets and hierarchies: Analysis and anti-
trust implications. New York: Free Press; Klein, B., R. Crawford, and
A. Alchian. (1978). “Vertical integration, appropriable rents, and the
competitive contracting process.” Journal of Law and Economics, 21,
pp. 297–326.
15. See, for example, Yan, A., and B. Gray. (1994). “Bargaining power,
management control, and performance in United States–China joint
ventures: A comparative case study.” Academy of Management Journal,
37, pp. 1478–1517.
16. See Badaracco, J. L., and N. Hasegawa. (1988). “General Motors’ Asian
alliances.” Harvard Business School Case No. 9-388-094, on GM and
Toyota; Patterson, G. A. (1991). “Mazda hopes to crack Japan’s top
tier.” The Wall Street Journal, September 20, pp. B1+; and Williams, M.,
and M. Kanabayashi. (1993). “Mazda and Ford drop proposal to build
M09_BARN0088_05_GE_C09.INDD 294 13/09/14 3:15 PM

Chapter 9: Strategic Alliances 295
cars together in Europe.” The Wall Street Journal, March 4, p. A14,
on Ford and Mazda; and Ennis, P. (1991). “Mitsubishi group wary
of deeper ties to Chrysler.” Tokyo Business Today, 59, July, p. 10, on
DaimlerChrysler and Mitsubishi.
17. See, for example, Ernst, D., and J. Bleeke. (1993). Collaborating to com-
pete: Using strategic alliances and acquisition in the global marketplace.
New York: John Wiley & Sons, Inc.; and Barney, J. B., and M. H.
Hansen. (1994). “Trustworthiness as a source of competitive advan-
tage.” Strategic Management Journal, 15, winter (special issue),
pp. 175–190.
18. Ernst, D., and J. Bleeke. (1993). Collaborating to compete: Using strategic
alliances and acquisition in the global marketplace. New York: John Wiley &
Sons, Inc.
19. Bartlett, C., and S. Ghoshal. (1993). “Beyond the M-form: Toward a
managerial theory of the firm.” Strategic Management Journal, 14,
pp. 23–46.
20. See Nagarajan, A., and W. Mitchell. (1998). “Evolutionary diffusion:
Internal and external methods used to acquire encompassing, comple-
mentary, and incremental technological changes in the lithotripsy in-
dustry.” Strategic Management Journal, 19, pp. 1063–1077; Hagedoorn, J.,
and B. Sadowski. (1999). “The transition from strategic technology
alliances to mergers and acquisitions: An exploratory study.” Journal
of Management Studies, 36(1), pp. 87–107; and Newburry, W., and
Y. Zeira. (1997). “Generic differences between equity international joint
ventures (EIJVs), international acquisitions (IAs) and International
Greenfield investments (IGIs): Implications for parent companies.”
Journal of World Business, 32(2), pp. 87–102, on alliance substitutes.
21. Barney, J. B. (1999). “How a firm’s capabilities affect boundary
decisions.” Sloan Management Review, 40(3), pp. 137–145.
22. See Hennart, J. F. (1988). “A transaction cost theory of equity joint ven-
tures.” Strategic Management Journal, 9, pp. 361–374; Kogut, B. (1988).
“Joint ventures: Theoretical and empirical perspectives.” Strategic
Management Journal, 9, pp. 319–332; and Barney, J. B. (1999). “How
a firm’s capabilities affect boundary decisions.” Sloan Management
Review, 40(3), pp. 137–145, for a discussion of these limitations.
23. See Ouchi, W. G. (1984). The M-form society: How American teamwork can
capture the competitive edge. Reading, MA: Addison-Wesley; and Barney,
J. B. (1990). “Profit sharing bonuses and the cost of debt: Business
finance and compensation policy in Japanese electronics firms.” Asia
Pacific Journal of Management, 7, pp. 49–64.
24. This is an argument developed by Barney, J. B., and M. H. Hansen.
(1994). “Trustworthiness as a source of competitive advantage.”
Strategic Management Journal, 15, winter (special issue), pp. 175–190;
Weigelt, K., and C. Camerer. (1988). “Reputation and corporate strat-
egy: A review of recent theory and applications.” Strategic Management
Journal, 9, pp. 443–454; and Granovetter, M. (1985). “Economic action
and social structure: The problem of embeddedness.” American Journal
of Sociology, 3, pp. 481–510.
25. See, for example, Eichenseher, J., and D. Shields. (1985). “Reputation and
corporate strategy: A review of recent theory and applications.” Strategic
Management Journal, 9, pp. 443–454; Beatty, R., and R. Ritter. (1986).
“Investment banking, reputation, and the underpricing of initial public
offerings.” Journal of Financial Economics, 15, pp. 213–232; Kalleberg,
A. L., and T. Reve. (1992). “Contracts and commitment: Economic and
Sociological Perspectives on Employment Relations.” Human Relations,
45(9), pp. 1103–1132; Larson, A. (1992). “Network dyads in entrepre-
neurial settings: A study of the governance of exchange relationships.”
Administrative Science Quarterly, March, pp. 76–104; Stuart, T. E.,
H. Hoang, and R. C. Hybels. (1999). “Interorganizational endorsements
and the performance of entrepreneurial ventures.” Administrative Science
Quarterly, 44, pp. 315–349; Stuart, T. E. (1998). “Network positions and
propensities to collaborate: An investigation of strategic alliance forma-
tion in a high-technology industry.” Administrative Science Quarterly,
43(3), pp. 668–698; and Gulati, R. (1998). “Alliances and networks.”
Strategic Management Journal, 19, pp. 293–317.
26. Personal communication, April 8, 1986.
27. This same theoretic approach to firm reputation is discussed in
Tirole, J. (1988). The theory of industrial organization. Cambridge, MA:
MIT Press.
28. Scherer, F. M. (1980). Industrial market structure and economic perfor-
mance. Boston: Houghton Mifflin.
29. See, again, Ernst, D., and J. Bleeke. (1993). Collaborating to compete:
Using strategic alliances and acquisition in the global marketplace. New
York: John Wiley & Sons, Inc.; and Barney, J. B., and M. H. Hansen.
(1994). “Trustworthiness as a source of competitive advantage.”
Strategic Management Journal, 15, winter (special issue), pp. 175–190.
In fact, there is a great deal of literature on the role of trust in strategic
alliances. Some of the most interesting of this work can be found in
Holm, D. B., K. Eriksson, and J. Johanson. (1999). “Creating value
through mutual commitment to business network relationships.”
Strategic Management Journal, 20, pp. 467–486; Lorenzoni, G., and
A. Lipparini. (1999). “The leveraging of interfirm relationships as a
distinctive organizational capability: A longitudinal study.” Strategic
Management Journal, 20(4), pp. 317–338; Blois, K. J. (1999). “Trust in
business to business relationships: An evaluation of its status.”
Journal of Management Studies, 36(2), pp. 197–215; Chiles, T. H., and
J. F. McMackin. (1996). “Integrating variable risk preferences, trust,
and transaction cost economics.” Academy of Management Review, 21(1),
pp. 73–99; Larzelere, R. E., and T. L. Huston. (1980). “The dyadic trust
scale: Toward understanding interpersonal trust in close relation-
ships.” Journal of Marriage and the Family, August, pp. 595–604; Butler,
J. K., Jr. (1983). “Reciprocity of trust between professionals and their
secretaries.” Psychological Reports, 53, pp. 411–416; Zaheer, A., and
N. Venkatraman. (1995). “Relational governance as an interorgani-
zational strategy: An empirical test of the role of trust in economic
exchange.” Strategic Management Journal, 16, pp. 373–392; Butler, J. K.,
Jr., and R. S. Cantrell. (1984). “A behavioral decision theory approach
to modeling dyadic trust in superiors and subordinates.” Psychological
Reports, 55, pp. 19–28; Carney, M. (1998). “The competitiveness of
networked production: The role of trust and asset specificity.” Journal
of Management Studies, 35(4), pp. 457–479.
30. Ernst, D., and J. Bleeke. (1993). Collaborating to compete: Using strategic
alliances and acquisition in the global marketplace. New York: John Wiley
& Sons, Inc.
31. See Mohr, J., and R. Spekman. (1994). “Characteristics of partnership
success: Partnership attributes, communication behavior, and conflict
resolution techniques.” Strategic Management Journal, 15, pp. 135–152;
and Zaheer, A., and N. Venkatraman. (1995). “Relational governance
as an interorganizational strategy: An empirical test of the role of trust
in economic exchange.” Strategic Management Journal, 16, pp. 373–392.
M09_BARN0088_05_GE_C09.INDD 295 13/09/14 3:15 PM

296
1. Describe different types of mergers and acquisitions.
2. Estimate the return to the stockholders of bidding
and target firms when there is no strategic related-
ness between firms.
3. Describe different sources of relatedness between bid-
ding and target firms.
4. Estimate the return to stockholders of bidding and tar-
get firms when there is strategic relatedness between
firms.
The Google Acquistion Machine
Google spent almost $6.8 billion on r esearch and development in 2012. M ore than 19,700 of its
54,000 employees work in R&D, which generated 13.5 percent of all of its c osts in 2012 and con-
stituted the largest expense item on its annual inc ome statement. In public statements, Google
justified this expense as necessary to keep up with the r apidly changing technological environ-
ment within which it competes.
But G oogle also uses another str ategy t o tr y t o keep up with t echnological change:
acquisitions. Since 2010, Google has acquired other companies at the rate of one company per
week. These acquisitions ranged from extremely small to very large, the largest being the $12.5
billion acquisition of M otorola’s mobile phone business . Some other lar ge Google acquisitions
included YouTube (in 2006 f or $1.65 billion), D oubleClick (in 2007 f or $3.2 billion), and Waze
(in 2013 for $1 billion).
If Google is spending so much money on R&D, why does it also have to spend so much
money on ac quisitions? After all , if G oogle is in venting lots of c ool technology internally, why
does it also ha ve to buy t echnology on the mar ket? Or, alternatively, if G oogle is buying lots of
cool t echnology on the mar ket—by buying other c ompanies—why does it ha ve t o spend so
much money on R&D?
Of course, for Google, there is a direct link between its external acquisitions and its inter-
nal R&D. In particular, Google’s internal R&D not only develops new products from scratch—like
5. Describe five reasons why bidding firms might still
engage in acquisitions, even if, on average, they do not
create value for a bidding firm’s stockholders.
6. Describe three ways that bidding firms might be
able to generate high returns for their equity holders
through implementing mergers or acquisitions.
7. Describe the major challenges that firms integrating
acquisitions are likely to face.
L e A r n i n G O b j e c T i v e s After reading this chapter, you should be able to:
MyManagementLab®
improve Your Grade!
Over 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
10
c h A p T e r
Mergers and
Acquisitions
M10_BARN0088_05_GE_C10.INDD 296 13/09/14 4:10 PM

297
the Android operating system for smart phones—it also in vests
in in tegrating the t echnologies it pur chases in to upg rading
established G oogle pr oducts. I ndeed, some obser vers believ e
that G oogle is unusually sk illed in cr eating ec onomic v alue b y
integrating the t echnologies it ac quires in to its pr oducts. O f
the hundred or so t echnologies that Google has gained ac cess
to thr ough its ac quisitions, only a handful ha ve not been in te-
grated into current Google products—including, to name just
a few, Google Wallet, Google Docs, Gmail, Google+, and Google
TV—or have bec ome established as new products within the
Google portfolio—including, for example, YouTube.
In fac t, G oogle has only div ested thr ee of its hundr eds
of acquisitions: Dodgeball (a mobile phone ser vice divested in
2005), Slide (a social gaming company divested in 2010), and
Frommer’s (a tr avel guide c ompany div ested in 2012). These
three acquisitions are widely seen as failures.
But thr ee “failures” out of hundr eds of deals is a much
higher success rate than other firms in high-technology indus-
tries. It is even a higher success rate than firms in other industries.
While the corporate strategy of acquisitions often does not gen-
erate superior performance for acquiring firms, Google seems to
have f ound a w ay t o cr eate enough v alue fr om its ac quisitions
to justify their pr ices while still in vesting in its o wn research and
development projects. Of c ourse, the big question mar k fac –
ing G oogle is its ac quisition of M otorola. R ecently, M otorola in troduced its first new line of
mobile phones designed and manufactured under Google’s ownership—the Moto X. Reviews
of these phones w ere mixed. Commentators were particularly surprised that Motorola’s latest
phones did not run the most up -to-date v ersion of A ndroid, G oogle’s smar t phone oper at-
ing system. Perhaps Google did not w ant to disadvantage other users of its Android system,
including S amsung, b y mak ing the la test v ersion a vailable on the M oto X. A t the v ery least ,
that Motorola’s most adv anced phone did not use A ndroid’s most adv anced system suggests
some challenges in integrating Motorola into Google’s technology family.
Sources: G oogle 2013 10K http://www.sec.gov/Archives/edgar/data/1288776/000119312513028362/d452134d10k.htm;
A. Efrati (2013). “Google nears deal f or Waze.” The Wall Street Journal , June 10, pp . B1+; R. K nutson and S. A nte (2013). “Google
leans on Motorola with hardware push.” The Wall Street Journal, April 1, p. B2.
©
in
ca
m
er
as
to
ck
/A
la
m
y
M10_BARN0088_05_GE_C10.INDD 297 13/09/14 4:10 PM

298 Part 3: Corporate Strategies
Google is not the only firm that engages in mergers and acquisitions. Indeed, mergers and acquisitions are one very common way that a firm can accomplish its vertical integration and diversification objectives.
However, although a firm may be able to accomplish its vertical integration and
diversification objectives through mergers or acquisitions, it is sometimes difficult
to generate real economic profit from doing so. Indeed, one of the strongest em-
pirical findings in the fields of strategic management and finance is that, on aver-
age, the equity holders of target firms in mergers and acquisitions make money
while the equity holders of bidding firms in these same mergers and acquisitions
usually only “break even.”
What Are Mergers and Acquisitions?
The terms mergers and acquisitions are often used interchangeably, even though
they are not synonyms. A firm engages in an acquisition when it purchases a sec-
ond firm. The form of this purchase can vary. For example, an acquiring firm can
use cash it has generated from its ongoing businesses to purchase a target firm; it
can go into debt to purchase a target firm; it can use its own equity to purchase
a target firm; or it can use a mix of these mechanisms to purchase a target firm.
Also, an acquiring firm can purchase all of a target firm’s assets; it can purchase a
majority of those assets (greater than 51 percent); or it can purchase a controlling
share of those assets (i.e., enough assets so that the acquiring firm is able to make
all the management and strategic decisions in the target firm).
Acquisitions also vary on several other dimensions. For example, friendly
acquisitions occur when the management of the target firm wants the firm to
be acquired. Unfriendly acquisitions occur when the management of the target
firm does not want the firm to be acquired. Some unfriendly acquisitions are also
known as hostile takeovers. Some acquisitions are accomplished through direct
negotiations between an acquiring firm’s managers and the managers of a target
firm. This is especially common when a target firm is privately held (i.e., when it
has not sold shares on the public stock market) or closely held (i.e., when it has
not sold very many shares on the public stock market). Other acquisitions are
accomplished by the acquiring firm publicly announcing that it is willing to pur-
chase the outstanding shares of a potential target for a particular price. This price
is normally greater than the current market price of the target firm’s shares. The
difference between the current market price of a target firm’s shares and the price
a potential acquirer offers to pay for those shares is known as an acquisition pre-
mium. This approach to purchasing a firm is called a tender offer. Tender offers
can be made either with or without the support of the management of the target
firm. Obviously, tender offers with the support of the target firm’s management
are typically friendly in character; those made without the support of the target
firm’s management are typically unfriendly.
It is usually the case that larger firms—in terms of sales or assets—acquire
smaller firms. For example, Google has been larger than all of its intended targets,
including Motorola Mobile. In contrast, when the assets of two similar-sized firms
are combined, this transaction is called a merger. Mergers can be accomplished
in many of the same ways as acquisitions, that is, using cash or stock to purchase
a percentage of another firm’s assets. Typically, however, mergers will not be
unfriendly. In a merger, one firm purchases some percentage of a second firm’s
assets while the second firm simultaneously purchases some percentage of the
M10_BARN0088_05_GE_C10.INDD 298 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 299
first firm’s assets. For example, DaimlerChrysler was created as a merger between
Daimler-Benz (the maker of Mercedes-Benz) and Chrysler. Daimler-Benz in-
vested some of its capital in Chrysler, and Chrysler invested some of its capital in
Daimler-Benz. More recently, these merged companies split into two firms again.
Then, after the financial crisis of 2007, Chrysler merged with Fiat.
Although mergers typically begin as a transaction between equals—that is,
between firms of equal size and profitability—they often evolve after a merger
such that one firm becomes more dominant in the management of the merged
firm than the other. For example, most observers believe that Daimler (the
German part of DaimlerChrysler) became more dominant in the management
of the combined firm than Chrysler (the American part). And now, most believe
that Fiat is more dominate.1 Put differently, although mergers usually start out
as something different from acquisitions, they usually end up looking more like
acquisitions than mergers.
The Value of Mergers and Acquisitions
That merger and acquisition strategies are an important strategic option open to
firms pursuing diversification and vertical integration strategies can hardly be
disputed. The number of firms that have used merger and acquisition strategies
to become diversified over the past few years is staggering. This is the case even
though the credit crunch crisis in 2008 reduced M&A activity somewhat. For
example, in 2010, there were 10,108 acquistions or mergers in the United States,
valued at $898 billion. In 2011, there were 10,518 deals valued at $1 trillion, and in
2012, 12,192 deals valued at $482 billion.2
The list of firms that have recently engaged in mergers and acquisitions
is long and varied. For example, in 2012 SAP (an enterprise software company)
purchased Ariba (a cloud computing firm) for $4.3 billion; Cisco (a computer
server company) bought NDS Group (a video software and security company) for
$5 billion; and Softbank (the third-largest mobile phone company in Japan)
bought SprintNextel (a U.S. mobile provider) for $20.1 billion.
That mergers and acquisitions are common is clear. What is less clear is that
they actually generate value for firms implementing these strategies. Two cases
will be examined here: mergers and acquisitions between strategically unrelated
firms and mergers and acquisitions between strategically related firms.
Mergers and Acquisitions: The Unrelated Case
Imagine the following scenario: One firm (the target) is the object of an acquisi-
tion effort, and 10 firms (the bidders) are interested in making this acquisition.
Suppose the current market value of the target firm is $10,000—that is, the
price of each of this firm’s shares times the number of shares outstanding equals
$10,000. Also, suppose the current market value of each of the bidding firms is
$15,000.3 Finally, suppose there is no strategic relatedness between these bidding
firms and the target. This means that the value of any one of these bidding firms
when combined with the target firm exactly equals the sum of the value of these
firms as separate entities. In this example, because the current market value of
the target is $10,000 and the current market value of the bidding firms is $15,000,
the value of this target when combined with any of these bidders would be
$25,000 ($10,000 + $15,000). Given this information, at what price will this target
V R I O
M10_BARN0088_05_GE_C10.INDD 299 13/09/14 4:11 PM

300 Part 3: Corporate Strategies
be acquired, and what are the economic performance implications for bidding
and target firms at this price?
In this and all acquisition situations, bidding firms will be willing to pay a
price for a target up to the value that the target firm adds to the bidder once it is
acquired. This price is simply the difference between the value of the two firms
combined (in this case, $25,000) and the value of the bidding firm by itself (in this
case, $15,000). Notice that this price does not depend on the value of the target
firm acting as an independent business; rather, it depends on the value that the
target firm creates when it is combined with the bidding firm. Any price for a tar-
get less than this value (i.e., less than $10,000) will be a source of economic profit
for a bidding firm; any price equal to this value (i.e., equal to $10,000) will be a
source of zero economic profits; and any price greater than this value (i.e., greater
than $10,000) will be a source of economic losses for the bidding firm that acquires
the target.
It is not hard to see that the price of this acquisition will quickly rise to
$10,000 and that at this price the bidding firm that acquires the target will earn
zero economic profits. The price of this acquisition will quickly rise to $10,000 be-
cause any bid less than $10,000 will generate economic profits for a successful bid-
der. These potential profits, in turn, will generate entry into the bidding war for
a target. Because entry into the acquisition contest is very likely, the price of the
acquisition will quickly rise to its value, and economic profits will not be created.
Moreover, at this $10,000 price the target firm’s equity holders will also gain
zero economic profits. Indeed, for them, all that has occurred is that the market
value of the target firm has been capitalized in the form of a cash payment from
the bidder to the target. The target was worth $10,000, and that is exactly what
these equity holders will receive.
Mergers and Acquisitions: The Related Case
The conclusion that the acquisition of strategically unrelated targets will generate
only zero economic profits for both the bidding and the target firms is not surpris-
ing. It is very consistent with the discussion of the economic consequences of un-
related diversification in Chapter 7. There it was argued that there is no economic
justification for a corporate diversification strategy that does not build on some
type of economy of scope across the businesses within which a firm operates, and
therefore unrelated diversification is not an economically viable corporate strat-
egy. So, if there is any hope that mergers and acquisitions will be a source of su-
perior performance for bidding firms, it must be because of some sort of strategic
relatedness or economy of scope between bidding and target firms.
Types of s trategic r elatedness
Of course, bidding and target firms can be strategically related in a wide vari-
ety of ways. Three particularly important lists of these potential linkages are
discussed here.4
The Federal Trade c ommission c ategories. Because mergers and acquisitions can
have the effect of increasing (or decreasing) the level of concentration in an in-
dustry, the Federal Trade Commission (FTC) is charged with the responsibility of
evaluating the competitive implications of proposed mergers or acquisitions. In
principle, the FTC will disallow any acquisition involving firms with headquar-
ters in the United States that could have the potential for generating monopoly
M10_BARN0088_05_GE_C10.INDD 300 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 301
(or oligopoly) profits in an industry. To help in this regulatory effort, the FTC has
developed a typology of mergers and acquisitions (see Table 10.1). Each category
in this typology can be thought of as a different way in which a bidding firm and
a target firm can be related in a merger or acquisition.
According to the FTC, a firm engages in a vertical merger when it vertically
integrates, either forward or backward, through its acquisition efforts. Vertical
mergers could include a firm purchasing critical suppliers of raw materials
(backward vertical integration) or acquiring customers and distribution networks
(forward vertical integration). eBay’s acquisition of Skype is an example of a back-
ward vertical integration as eBay tries to assemble all the resources to compete in
the Internet telephone industry. Disney’s acquisition of Capital Cities/ABC can
be understood as an attempt by Disney to forward vertically integrate into the
entertainment distribution industry, and its acquisition of ESPN can be seen as
backward vertical integration into the entertainment production business.5
A firm engages in a horizontal merger when it acquires a former competitor;
Adidas’s acquisition of Reebok is an example of a horizontal merger, as the num-
ber 2 and number 3 sneaker manufacturers in the world combined their efforts.
Obviously, the FTC is particularly concerned with the competitive implications of
horizontal mergers because these strategies can have the most direct and obvious
anticompetitive implications in an industry. For example, the FTC raised antitrust
concerns in the $10 billion merger between Oracle and PeopleSoft because these
firms, collectively, dominated the enterprise software market. Similar concerns
were raised in the $16.4 billion merger between ChevronTexaco and Unocal and
the merger between Mobil and Exxon.
The third type of merger identified by the FTC is a product extension
merger. In a product extension merger, firms acquire complementary products
through their merger and acquisition activities. Examples include Google’s acqui-
sition of Motorola Mobile.
The fourth type of merger identified by the FTC is a market extension
merger. Here the primary objective is to gain access to new geographic mar-
kets. Examples include SABMiller’s acquisition of Bavaria Brewery Company in
Columbia, South America.
The final type of merger or acquisition identified by the FTC is a conglomer-
ate merger. For the FTC, conglomerate mergers are a residual category. If there
are no vertical, horizontal, product extension, or market extension links between
firms, the FTC defines the merger or acquisition activity between firms as a
conglomerate merger. Given our earlier conclusion that mergers or acquisitions
between strategically unrelated firms will not generate economic profits for either
bidders or targets, it should not be surprising that there are currently relatively
few examples of conglomerate mergers or acquisitions; however, at various times
TAble 10.1 Federal Trade
Commission Categories of
Mergers and Acquisitions
■ Vertical merger A firm acquires former suppliers or customers.
■ Horizontal merger A firm acquires a former competitor.
■ Product extension merger A firm gains access to complementary products
through an acquisition.
■ Market extension merger A firm gains access to complementary markets
through an acquisition.
■ Conglomerate merger There is no strategic relatedness between a
bidding and a target firm.
M10_BARN0088_05_GE_C10.INDD 301 13/09/14 4:11 PM

302 Part 3: Corporate Strategies
in history, they have been relatively common. In the 1960s, for example, many
acquisitions took the form of conglomerate mergers. Research has shown that the
fraction of single-business firms in the Fortune 500 dropped from 22.8 percent in
1959 to 14.8 percent in 1969, while the fraction of firms in the Fortune 500 pursuing
unrelated diversification strategies rose from 7.3 to 18.7 percent during the same
time period. These findings are consistent with an increase in the number of con-
glomerate mergers and acquisitions during the 1960s.6
Despite the popularity of conglomerate mergers in the 1960s, many mergers
or acquisitions among strategically unrelated firms are divested shortly after they
are completed. One study estimated that more than one-third of the conglomer-
ate mergers of the 1960s were divested by the early 1980s. Another study showed
that more than 50 percent of these acquisitions were subsequently divested. These
results are all consistent with our earlier conclusion that mergers or acquisitions
involving strategically unrelated firms are not a source of economic profits.7
Other Types of s trategic r elatedness. Although the FTC categories of mergers and
acquisitions provide some information about possible motives underlying these
corporate strategies, they do not capture the full complexity of the links that
might exist between bidding and target firms. Several authors have attempted to
develop more complete lists of possible sources of relatedness between bidding
and target firms. One of these lists, developed by Professor Michael Lubatkin,
is summarized in Table 10.2. This list includes technical economies (in market-
ing, production, and similar forms of relatedness), pecuniary economies (market
power), and diversification economies (in portfolio management and risk reduc-
tion) as possible bases of strategic relatedness between bidding and target firms.
A second important list of possible sources of strategic relatedness between
bidding and target firms was developed by Michael Jensen and Richard Ruback
after a comprehensive review of empirical research on the economic returns to
mergers and acquisitions. This list is summarized in Table 10.3 and includes the
following factors as possible sources of economic gains in mergers and acquisi-
tions: potential reductions in production or distribution costs (from economies of
scale, vertical integration, reduction in agency costs, and so forth); the realization
of financial opportunities (such as gaining access to underutilized tax shields,
avoiding bankruptcy costs); the creation of market power; and the ability to elimi-
nate inefficient management in the target firm.
TAble 10.2 Lubatkin’s List of
Potential Sources of Strategic
Relatedness Between Bidding
and Target Firms
Technical economies Scale economies that occur when the physical processes
inside a firm are altered so that the same amounts of
input produce a higher quantity of outputs. Sources
of technical economies include marketing, production,
experience, scheduling, banking, and compensation.
Pecuniary economies Economies achieved by the ability of firms to dictate
prices by exerting market power.
Diversification economies Economies achieved by improving a firm’s performance
relative to its risk attributes or lowering its risk attri-
butes relative to its performance. Sources of diversifi-
cation economies include portfolio management and
risk reduction.
Source: M. Lubatkin (1983). “Mergers and the performance of the acquiring firm.” Academy of Management
Review, 8, pp. 218–225. © 1983 by the Academy of Management. Reproduced with permission.
M10_BARN0088_05_GE_C10.INDD 302 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 303
To be economically valuable, links between bidding and target firms must
meet the same criteria as diversification strategies (see Chapter 7). First, these links
must build on real economies of scope between bidding and target firms. These
economies of scope can reflect either cost savings or revenue enhancements that are
created by combining firms. Second, not only must this economy of scope exist, but
it must be less costly for the merged firm to realize than for outside equity holders
to realize on their own. As is the case with corporate diversification strategies, by
investing in a diversified portfolio of stocks, outside equity investors can gain many
of the economies associated with a merger or acquisition on their own. Moreover,
investors can realize some of these economies of scope at almost zero cost. In this
situation, it makes little sense for investors to “hire” managers in firms to realize
these economies of scope for them through a merger or acquisition. Rather, firms
should pursue merger and acquisition strategies only to obtain valuable economies
of scope that outside investors find too costly to create on their own.
economic profits in r elated Acquisitions
If bidding and target firms are strategically related, then the economic value of
these two firms combined is greater than their economic value as separate enti-
ties. To see how this changes returns to merger and acquisition strategies, con-
sider the following scenario: As before, there is one target firm and 10 bidding
firms. The market value of the target firm as a stand-alone entity is $10,000, and
the market value of the bidding firms as stand-alone entities is $15,000. However,
unlike the earlier scenario in this chapter, the bidding and target firms are strate-
gically related. Any of the types of relatedness identified in Table 10.1, Table 10.2,
or Table 10.3 could be the source of these economies of scope. They imply that
when any of the bidding firms and the target are combined, the market value of
this combined entity will be $32,000—note that $32,000 is greater than the sum of
$15,000 and $10,000. At what price will this target firm be acquired, and what are
the economic profit implications for bidding and target firms at this price?
As before, bidding firms will be willing to pay a price for a target up to
the value that a target firm adds once it is acquired. Thus, the maximum price
TAble 10.3 Jensen and
Ruback’s List of Reasons Why
Bidding Firms Might Want
to Engage in Merger and
Acquisition Strategies
To reduce production or distribution costs:
1. Through economies of scale.
2. Through vertical integration.
3. Through the adoption of more efficient production or organizational technology.
4. Through the increased utilization of the bidder’s management team.
5. Through a reduction of agency costs by bringing organization-specific assets
under common ownership.
Financial motivations:
1. To gain access to underutilized tax shields.
2. To avoid bankruptcy costs.
3. To increase leverage opportunities.
4. To gain other tax advantages.
5. To gain market power in product markets.
6. To eliminate inefficient target management.
Source: Reprinted from Jensen, M. C., and R. S. Ruback (1983). “The Market for Corporate Control: The
Scientific Evidence.” Journal of Financial Economics, 11, pp. 5–50. Vol. II. Copyright © with permission from
Elsevier.
M10_BARN0088_05_GE_C10.INDD 303 13/09/14 4:11 PM

304 Part 3: Corporate Strategies
bidding firms are willing to pay is still the difference between the value of the
combined entity (here, $32,000) and the value of a bidding firm on its own (here,
$15,000), or $17,000.
As was the case for the strategically unrelated acquisition, it is not hard to see
that the price for actually acquiring the target firm in this scenario will rapidly rise
to $17,000 because any bid less than $17,000 has the potential for generating profits
for a bidding firm. Suppose that one bidding firm offers $13,000 for the target. For
this $13,000, the bidding firm gains access to a target that will generate $17,000 of
value once it is acquired. Thus, to this bidding firm, the target is worth $17,000,
and a bid of $13,000 will generate $4,000 economic profit. Of course, these potential
profits will motivate entry into the competitive bidding process. Entry will con-
tinue until the price of this target equals $17,000. Any price greater than $17,000
would mean that a bidding firm is actually losing money on its acquisition.8
At this $17,000 price, the successful bidding firm earns zero economic prof-
its. After all, this firm has acquired an asset that will generate $17,000 of value
and has paid $17,000 to do so. However, the owners of the target firm will earn an
economic profit worth $7,000. As a stand-alone firm, the target is worth $10,000;
when combined with a bidding firm, it is worth $17,000. The difference between
the value of the target as a stand-alone entity and its value in combination with a
bidding firm is the value of the economic profit that can be appropriated by the
owners of the target firm.
Thus, the existence of strategic relatedness between bidding and target firms
is not a sufficient condition for the equity holders of bidding firms to earn eco-
nomic profits from their acquisition strategies. If the economic potential of acquir-
ing a particular target firm is widely known and if several potential bidding firms
can all obtain this value by acquiring a target, the equity holders of bidding firms
will, at best, earn only zero economic profits from implementing an acquisition
strategy. In this setting, a “strategically related” merger or acquisition will create
economic value, but this value will be distributed in the form of economic profits
to the equity holders of acquired target firms.
Because so much of the value created in a merger or acquisition is appropri-
ated by the stockholders of the target firm, it is not surprising that many small
and entrepreneurial firms look to be acquired as one way to compensate their
owners for taking the risks associated with founding these firms. This phenome-
non is discussed in more detail in the Strategy in the Emerging Enterprise feature.
What Does Research Say About Returns
to Mergers and Acquisitions?
The empirical implications of this discussion of returns to bidding and target
firms in strategically related and strategically unrelated mergers and acquisitions
have been examined in a variety of academic literatures. One study reviewed
more than 40 empirical merger and acquisition studies in the finance literature.
This study concluded that acquisitions, on average, increased the market value
of target firms by about 25 percent and left the market value of bidding firms un-
changed. The authors of this report concluded that “corporate takeovers generate
positive gains, . . . target firm equity holders benefit, and . . . bidding firm equity
holders do not lose.”9 The way these studies evaluate the return to acquisition
strategies is discussed in the Strategy in Depth feature.
M10_BARN0088_05_GE_C10.INDD 304 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 305
Imagine you are an entrepreneur. You have mortgaged your home,
taken out loans, run up your credit
cards, and put all you own on the
line in order to help grow a small
company. And, finally, after years of
effort, things start going well. Your
product or service starts to sell, cus-
tomers start to appreciate your unique
value proposition, and you actually
begin to pay yourself a reasonable sal-
ary. What do you do next to help grow
your company?
Some entrepreneurs in this situa-
tion decide that maintaining control of
the firm is very important. These entre-
preneurs may compensate certain criti-
cal employees with equity in the firm,
but typically limit the number of out-
siders who make equity investments
in their firm. To grow these closely
held firms, these entrepreneurs must
rely on capital generated from their
ongoing operations (called retained
earnings) and debt capital provided
by banks, customers, and suppliers.
Entrepreneurs who decide to maintain
control of their companies are compen-
sated for taking the risks associated
with starting a firm through the salary
they pay themselves.
Other entrepreneurs get more
outside equity investors involved in
providing the capital a firm needs to
grow. These outside investors might
include wealthy individuals—called
business angels—looking to invest
in entrepreneurial ventures or venture
capital firms. Venture capital firms
typically raise money from numerous
smaller investors that they then invest
in a portfolio of entrepreneurial firms.
Over time, many of these firms de-
cide to “go public” by engaging in
what is called an initial public offer-
ing (IPO). In an IPO, a firm, typically
working with an investment banker,
sells its equity to the public at large.
Entrepreneurs who decide to sell eq-
uity in their firm are compensated for
taking the risks associated with start-
ing a firm through the sale of their
equity on the public markets through
an IPO. An entrepreneur who receives
compensation for risk-taking in this
manner is said to be cashing out.
Finally, still other entrepreneurs
may decide to not use an IPO to cash
out, but rather to have their firm ac-
quired by another, typically larger
firm. In this scenario, entrepreneurs
are compensated by the acquiring firm
for taking the risks associated with
starting a firm. Indeed, because the
demand for IPOs has been volatile
since the technology-bubble burst of
2000, more and more small and en-
trepreneurial firms are looking to be
acquired as a way for their found-
ers to cash out. Moreover, because the
stockholders of target firms typically
appropriate a large percentage of the
total value created by an acquisition
and because the founders of these en-
trepreneurial firms are also often large
stockholders, being acquired is often a
source of great wealth for an entrepre-
neurial firm’s founders.
The choice between keeping a
firm private, going public, or being
acquired is a difficult and multidi-
mensional one. Issues such as the per-
sonal preferences of a firm’s founders,
demand for IPOs, how much capital
a firm will need in order to continue
to grow its business, and what other
resources—besides capital—the firm
will need to create additional value
all play a role. In general, firms that
do not need a great deal of money or
other resources to grow will choose
to remain private. Those that need
only money to grow will choose IPOs,
whereas those that need managerial
or technical resources controlled by
another firm to grow will typically be
acquired. Of course, this changes if
the entrepreneurs decide to maintain
control of their firms because they
want to.
Sources: R. Hennessey (2004). “Underwriters cut
prices on IPOs as market softens.” The Wall Street
Journal, May 27, p. C4; F. Vogelstein (2003). “Can
Google grow up?” Fortune, December 8, pp. 102+.
Cashing Out
Strategy in the Emerging Enterprise
Strategy researchers have also attempted to examine in more detail the sources
of value creation in mergers and acquisitions and the question of whether these
sources of value creation affect whether bidders or targets appropriate this value.
For example, two well-known studies examined the impact of the type and degree
of strategic relatedness (defined using the FTC typology summarized in Table 10.1)
M10_BARN0088_05_GE_C10.INDD 305 13/09/14 4:11 PM

306 Part 3: Corporate Strategies
between bidding and target firms on the economic consequences of mergers and
acquisitions.10 These studies found that the more strategically related bidding
and target firms are, the more economic value mergers and acquisitions create.
However, like the finance studies, this work found that this economic value was
appropriated by the owners of the target firm, regardless of the type or degree
of relatedness between the bidding and target firms. Bidding firms—even when
they attempt to acquire strategically related targets—earn, on average, zero eco-
nomic profits from their merger and acquisition strategies.
Why Are There So Many Mergers and Acquisitions?
Given the overwhelming empirical evidence that most of the economic value cre-
ated in mergers and acquisitions is appropriated by the owners of the target firm
most of the time, an important question becomes: “Why do managers of bidding
firms continue to engage in merger and acquisition strategies?” Some possible
explanations are summarized in Table 10.4 and discussed in this section.
To ensure s urvival
Even if mergers and acquisitions, on average, generate only zero economic profits
for bidding firms, it may be necessary for bidding firms to engage in these ac-
tivities to ensure their survival. In particular, if all of a bidding firm’s competitors
have been able to improve their efficiency and effectiveness through a particular
type of acquisition, then failing to make such an acquisition may put a firm at a
competitive disadvantage. Here the purpose of a merger or acquisition is not to
gain competitive advantages, but rather to gain competitive parity.
Many recent mergers among banks in the United States seem to have com-
petitive parity and normal economic profits as an objective. Most bank managers
recognize that changing bank regulations, increased competition from nonbank-
ing financial institutions, and soft demand are likely to lead to a consolidation
of the U.S. banking industry. To survive in this consolidated industry, many U.S.
banks will have to merge. As the number of banks engaging in mergers and ac-
quisitions goes up, the ability to earn superior profits from those strategies goes
down. These lower returns from acquisitions have already reduced the economic
value of some of the most aggressive acquiring banks. Despite these lower re-
turns, acquisitions are likely to continue for the foreseeable future, as banks seek
survival opportunities in a consolidated industry.11
Free c ash Flow
Another reason why firms may continue to invest in merger and acquisition
strategies is that these strategies, on average, can be expected to generate at least
competitive parity for bidding firms. This zero economic profit may be a more at-
tractive investment for some firms than alternative strategic investments. This is
particularly the case for firms that generate free cash flow.12
1. To ensure survival
2. Free cash flow
3. Agency problems
4. Managerial hubris
5. The potential for above-normal profits
TAble 10.4 Possible
Motivations to Engage in
Mergers and Acquisitions Even
Though They Usually Do Not
Generate Profits for Bidding
Firms
M10_BARN0088_05_GE_C10.INDD 306 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 307
Free cash flow is simply the amount of cash a firm has to invest after all pos-
itive net present-value investments in its ongoing businesses have been funded.
Free cash flow is created when a firm’s ongoing business operations are very
profitable but offer few opportunities for additional investment. One firm that
seems to have generated a great deal of free cash flow over the past several years
is Philip Morris. Philip Morris’s retail tobacco operations are extremely profitable.
However, regulatory constraints, health concerns, and slowing growth in demand
limit investment opportunities in the tobacco industry. Thus, the amount of cash
generated by Philip Morris’s ongoing tobacco business has probably been larger
than the sum of its positive net present-value investments in that business. This
difference is free cash flow for Philip Morris.13
A firm that generates a great deal of free cash flow must decide what to do
with this money. One obvious alternative would be to give it to stockholders in
the form of dividends or stock buybacks. However, in some situations (e.g., when
stockholders face high marginal tax rates), stockholders may prefer a firm to retain
this cash flow and invest it for them. When this is the case, how should a firm in-
vest its free cash flow?
Because (by definition) no positive net present-value investment oppor-
tunities in a firm’s ongoing business operations are available, firms have only
two investment options: to invest their free cash flow in strategies that generate
competitive parity or in strategies that generate competitive disadvantages. In
this context, merger and acquisition strategies are a viable option because bidding
firms, on average, can expect to generate at least competitive parity. Put differ-
ently, although mergers and acquisitions may not be a source of superior profits,
there are worse things you could do with your free cash flow.
Agency problems
Another reason why firms might continue to engage in mergers and acquisitions, de-
spite earning only competitive parity from doing so, is that mergers and acquisitions
benefit managers directly, independent of any value they may or may not create for a
bidding firm’s stockholders. As suggested in Chapter 8, these conflicts of interest are
a manifestation of agency problems between a firm’s managers and its stockholders.
Merger and acquisition strategies can benefit managers—even if they do
not directly benefit a bidding firm’s equity holders—in at least two ways. First,
managers can use mergers and acquisitions to help diversify their human capital
investments in their firm. As discussed in Chapter 7, managers have difficulty
diversifying their firm-specific human capital investments when a firm operates
in a narrow range of businesses. By acquiring firms with cash flows that are not
perfectly correlated with the cash flows of a firm’s current businesses, managers
can reduce the probability of bankruptcy for their firm and thus partially diver-
sify their human capital investments in their firm.
Second, managers can use mergers and acquisitions to quickly increase firm
size, measured in either sales or assets. If management compensation is closely linked
to firm size, managers who increase firm size are able to increase their compensation.
Of all the ways to increase the size of a firm quickly, growth through mergers and
acquisitions is perhaps the easiest. Even if there are no economies of scope between
a bidding and a target firm, an acquisition ensures that the bidding firm will grow
by the size of the target (measured in either sales or assets). If there are economies of
scope between a bidding and a target firm, the size of the bidding firm can grow at
an even faster rate, as can the value of management’s compensation, even though, on
average, acquisitions do not generate wealth for the owners of the bidding firm.
M10_BARN0088_05_GE_C10.INDD 307 13/09/14 4:11 PM

308 Part 3: Corporate Strategies
By far, the most popular way to evaluate the performance effects
of acquisitions for bidding firms is
called event study analysis. Rooted
in the field of financial economics,
event study analysis compares the
actual performance of a stock after
an acquisition has been announced
with the expected performance of that
stock if no acquisition had been an-
nounced. Any performance greater
(or less) than what was expected in
a short period of time around when
an acquisition is announced is attrib-
uted to that acquisition. This cumula-
tive abnormal return (CAR) can
be positive or negative depending on
whether the stock in question per-
forms better or worse than expected
without an acquisition.
The CAR created by an acqui-
sition is calculated in several stages.
First, the expected performance of a
stock, without an acquisition, is esti-
mated with the following regression
equation:
E1Rj, t2 = aj + bjRm, t + ej, t
where E1Rj, t2 is the expected return
of stock j during time t; aj is a constant
(approximately equal to the rate of
return on risk-free equities); bj is an
empirical estimate of the financial pa-
rameter β (equal to the covariance be-
tween the returns of a particular firm’s
stock and the average return of all
stocks in the market, over time); Rm, t
is the actual average rate of return of
all stocks in the market over time; and
ej, t is an error term. The form of this
equation is derived from the capital
asset pricing model in finance. In this
model, E1Rj, t2 is simply the expected
performance of a stock, given the his-
torical relationship between that stock
and the overall performance of the
stock market.
To calculate the unexpected per-
formance of a stock, this expected level
of performance is simply subtracted
from the actual level of performance
for a stock. This is done in the follow-
ing equation:
XRj, t = Rj, t – 1aj + bjRm, t2
where Rj, t is the actual performance
of stock j during time t, and XRj, t is
the unexpected performance of stock j
during time t.
In calculating the CAR for a par-
ticular acquisition, it is necessary to
sum the unexpected returns 1XRj, t2
for a stock across the t periods when
the stock market is responding to news
about this acquisition. Most analyses
of acquisitions examine the market’s
reaction one day before an acquisi-
tion is formally announced to three
days after it is announced. The sum
of these unexpected returns over this
time period is the CAR attributable to
this acquisition.
This methodology has been
applied to literally thousands of ac-
quisition episodes. For example,
when Manulife Financial purchased
John Hancock Financial, Manulife’s
CAR was –10 percent, whereas John
Hancock’s CAR was 6 percent; when
Anthem acquired Wellpoint, Anthem’s
CAR was –10 percent, and Wellpoint’s
was 7 percent; when Bank of America
acquired FleetBoston Financial, Bank
of America’s CAR was –9 percent,
and FleetBoston’s was 24 percent;
and when UnitedHealth acquired
Mid Atlantic Medical, UnitedHealth’s
CAR was –4 percent, and Mid Atlantic
Medical’s was 11 percent.
Although the event study
method has been used widely, it does
have some important limitations. First,
it is based entirely on the capital asset
pricing model, and there is some rea-
son to believe that this model is not a
particularly good predictor of a firm’s
expected stock price. Second, it as-
sumes that a firm’s equity holders can
anticipate all the benefits associated
with making an acquisition at the time
that acquisition is made. Some schol-
ars have argued that value creation
continues long after an acquisition is
announced as parties in this exchange
discover value-creating opportunities
that could not have been anticipated.
Sources: A. Arikan (2004). “Long-term returns to
acquisitions: The case of purchasing tangible and
intangible assets.” Unpublished, Fisher College
of Business, Ohio State University; S. J. Brown
and J. B. Warner (1985). “Using daily stock
returns: The case of event studies.” Journal of
Financial Economics, 14, pp. 3–31; D. Henry, M. Der
Hovanseian, and D. Foust (2003). “M&A deals:
Show me.” BusinessWeek, November 10, pp. 38+.
evaluating the Performance
effects of Acquisitions
Strategy in Depth
M10_BARN0088_05_GE_C10.INDD 308 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 309
Managerial h ubris
Another reason why managers may choose to continue to invest in mergers and
acquisitions, despite the fact that, on average, they gain no profits from doing so,
is the existence of what has been called managerial hubris.14 This is the unreal-
istic belief held by managers in bidding firms that they can manage the assets of
a target firm more efficiently than the target firm’s current management. This no-
tion can lead bidding firms to engage in acquisition strategies even though there
may not be positive economic profits from doing so.
The existence of managerial hubris suggests that the economic value of bid-
ding firms will fall once they announce a merger or acquisition strategy. Although
managers in bidding firms might truly believe that they can manage a target
firm’s assets more efficiently than the target firm’s managers, investors in the
capital markets are much less likely to be caught up in this hubris. In this context,
a commitment to a merger or acquisition strategy is a strong signal that a bidding
firm’s management has deluded itself about its abilities to manage a target firm’s
assets. Such delusions will certainly adversely affect the economic value of the
bidding firm.
Of course, empirical work on mergers and acquisitions discussed earlier in
this chapter has concluded that although bidding firms do not obtain profits from
their merger and acquisition strategies, they also do not, on average, reduce their
economic value from implementing these strategies. This is inconsistent with the
“hubris hypothesis.” However, the fact that, on average, bidding firms do not
lose economic value does not mean that some bidding firms do not lose economic
value. Thus, although it is unlikely that all merger and acquisition strategies are
motivated by managerial hubris, it is likely that at least some of them are.15
The potential for economic profits
A final reason why managers might continue to pursue merger and acquisition
strategies is the potential that these strategies offer for generating profits for at
least some bidding firms. The empirical research on returns to bidding firms in
mergers and acquisitions is very strong. On average, bidding firms do not gain
profits from their merger and acquisition strategies. However, the fact that bid-
ding firms, on average, do not earn profits on these strategies does not mean that
all bidding firms will always fail to earn profits. In some situations, bidding firms
may be able to gain competitive advantages from merger and acquisition activi-
ties. These situations are discussed in the following section.
Mergers and Acquisitions and Sustained
Competitive Advantage
We have already seen that the economies of scope that motivate mergers and
acquisitions between strategically related bidding and target firms can be valu-
able. However, the ability of these economies to generate profits and competitive
advantages for bidding firms depends not only on their economic value, but also
on the competitiveness of the market for corporate control through which these
valuable economies are realized. The market for corporate control is the market
that is created when multiple firms actively seek to acquire one or several firms.
Only when the market for corporate control is imperfectly competitive might it be
V R I O
M10_BARN0088_05_GE_C10.INDD 309 13/09/14 4:11 PM

310 Part 3: Corporate Strategies
possible for bidding firms to earn profits from implementing a merger or acquisi-
tion strategy. To see how the competitiveness of the market for corporate control
can affect returns to merger and acquisition strategies, we will consider three sce-
narios involving bidding and target firms and examine their implications for the
managers of these firms.16
Valuable, Rare, and Private economies of Scope
An imperfectly competitive market for corporate control can exist when a target
is worth more to one bidder than it is to any other bidders and when no other
firms—including bidders and targets—are aware of this additional value. In
this setting, the price of a target will rise to reflect public expectations about the
value of the target. Once the target is acquired, however, the performance of the
special bidder that acquires the target will be greater than generally expected,
and this level of performance will generate profits for the equity holders of the
bidding firm.
Consider a simple case. Suppose the market value of bidder Firm A com-
bined with target firms is $12,000, whereas the market value of all other bidders
combined with targets is $10,000. No other firms (bidders or targets) are aware of
Firm A’s unique relationship with these targets, but they are aware of the value
of all other bidders combined with targets (i.e., $10,000). Suppose also that the
market value of all bidding firms, as stand-alone entities, is $7,000. In this setting,
Firm A will be willing to pay up to $5,000 to acquire a target ($12,000 – $7,000),
and all other bidders will only be willing to pay up to $3,000 to acquire a target
($10,000 – $7,000).
Because publicly available information suggests that acquiring a target is
worth $3,000 more than the target’s stand-alone price, the price of targets will rap-
idly rise to this level, ensuring that, if bidding firms, apart from Firm A, acquire
a target, they will obtain no profits. If there is only one target in this market for
corporate control, then Firm A will be able to bid slightly more than $3,000 (per-
haps $3,001) for this target. No other firms will bid higher than Firm A because,
from their point of view, the acquisition is simply not worth more than $3,000. At
this $3,001 price, Firm A will earn a profit of $1,999—Firm A had to spend only
$3,001 for a firm that brings $5,000 in value above its stand-alone market price.
Alternatively, if there are multiple targets, then several bidding firms, including
Firm A, will pay $3,000 for their targets. At this price, these bidding firms will all
earn zero economic profits, except for Firm A, which will earn an economic profit
equal to $2,000. That is, only Firm A will gain a competitive advantage from ac-
quiring a target in this market.
In order for Firm A to obtain this profit, the value of Firm A’s economy of
scope with target firms must be greater than the value of any other bidding firms
with that target. This special value will generally reflect unusual resources and
capabilities possessed by Firm A—resources and capabilities that are more valu-
able in combination with target firms than are the resources and capabilities that
other bidding firms possess. Put differently, to be a source of economic profits and
competitive advantage, Firm A’s link with targets must be based on resources and
capabilities that are rare among those firms competing in this market for corpo-
rate control.
However, not only does Firm A have to possess valuable and rare links
with bidding firms to gain economic profits and competitive advantages from
M10_BARN0088_05_GE_C10.INDD 310 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 311
its acquisition strategies, but information about these special economies of scope
must not be known by other firms. If other bidding firms know about the addi-
tional value associated with acquiring a target, they are likely to try to duplicate
this value for themselves. Typically, they would accomplish this by imitating the
type of relatedness that exists between Firm A and its targets by developing the
resources and capabilities that enabled Firm A to have its valuable economies of
scope with targets. Once other bidders developed the resources and capabilities
necessary to obtain this more valuable economy of scope, they would be able to
enter into bidding, thereby increasing the likelihood that the equity holders of
successful bidding firms would earn no economic profits.
Target firms must also be unaware of Firm A’s special resources and capa-
bilities if Firm A is to obtain competitive advantages from an acquisition. If target
firms were aware of this extra value available to Firm A, along with the sources
of this value, they could inform other bidding firms. These bidding firms could
then adjust their bids to reflect this higher value, and competitive bidding would
reduce profits to bidders. Target firms are likely to inform bidding firms in this
way because increasing the number of bidders with more valuable economies of
scope increases the likelihood that target firms will extract all the economic value
created in a merger or acquisition.17
Valuable, Rare, and Costly-to-Imitate economies of Scope
The existence of firms that have valuable, rare, and private economies of scope
with targets is not the only way that the market for corporate control can be im-
perfectly competitive. If other bidders cannot imitate one bidder’s valuable and
rare economies with targets, then competition in this market for corporate control
will be imperfect, and the equity holders of this special bidding firm will earn eco-
nomic profits. In this case, the existence of valuable and rare economies does not
need to be private because other bidding firms cannot imitate these economies,
and therefore bids that substantially reduce the profits for the equity holders of
the special bidding firm are not forthcoming.
Typically, bidding firms will be unable to imitate one bidder’s valuable
and rare economies of scope with targets when the strategic relatedness be-
tween the special bidder and the targets stems from some rare and costly-to-
imitate resources or capabilities controlled by the special bidding firm. Any of
the costly-to-imitate resources and capabilities discussed in Chapter 3 could
create costly-to-imitate economies of scope between a firm and a target. If, in ad-
dition, these economies are valuable and rare, they can be a source of profits to
the equity holders of the special bidding firm. This can happen even if all firms
in this market for corporate control are aware of the more valuable economies
of scope available to this firm and its sources. Although information about this
special economy of scope is publicly available, equity holders of special bidding
firms will earn a profit when acquisition occurs. The equity holders of target
firms will not obtain all of this profit because competitive bidding dynamics
cannot unfold when the sources of a more valuable economy of scope are costly
to imitate.
Of course, it may be possible for a valuable, rare, and costly-to-imitate econ-
omy of scope between a bidding and a target firm to also be private. Indeed, it is
often the case that those attributes of a firm that are costly to imitate are also dif-
ficult to describe and thus can be held as proprietary information. In that case, the
M10_BARN0088_05_GE_C10.INDD 311 13/09/14 4:11 PM

312 Part 3: Corporate Strategies
analysis of profits associated with valuable, rare, and private economies of scope
presented earlier applies.
Unexpected Valuable economies of Scope between
bidding and Target Firms
Thus far, this discussion has adopted, for convenience, the strong assumption
that the present value of the strategic relatedness between bidders and targets is
known with certainty by individual bidders. This is, in principle, possible, but cer-
tainly not likely. Most modern acquisitions and mergers are massively complex,
involving numerous unknown and complicated relationships between firms. In
these settings, unexpected events after an acquisition has been completed may
make an acquisition or merger more valuable than bidders and targets anticipated
it would be. The price that bidding firms will pay to acquire a target will equal
the expected value of the target only when the target is combined with the bidder.
The difference between the unexpected value of an acquisition actually obtained
by a bidder and the price the bidder paid for the acquisition is a profit for the eq-
uity holders of the bidding firm.
Of course, by definition, bidding firms cannot expect to obtain unexpected
value from an acquisition. Unexpected value, in this context, is a surprise, a
manifestation of a bidding firm’s good luck, not its skill in acquiring targets. For
example, when the British advertising firm WPP acquired J. Walter Thompson for
$550 million, it discovered some property owned by J. Walter Thomson in Tokyo.
No one knew of this property when the firm was acquired. It turned out to be
worth more than $100 million after taxes, a financial windfall that helped offset
the high cost of this acquisition. When asked, Martin Sorrel, president of WPP
and the architect of this acquisition, admitted that this $100 million windfall was
simply good luck.18
Implications for bidding Firm Managers
The existence of valuable, rare, and private economies of scope between bidding
and target firms and of valuable, rare, and costly-to-imitate economies of scope
between bidding and target firms suggests that although, on average, most bid-
ding firms do not generate competitive advantages from their acquisition strate-
gies, in some special circumstances it may be possible for them to do so. Thus, the
task facing managers in firms contemplating merger and acquisition strategies
is to choose strategies that have the greatest likelihood of being able to generate
profits for their equity holders. Several important managerial prescriptions can be
derived from this discussion. These “rules” for bidding firm managers are sum-
marized in Table 10.5.
1. Search for valuable and rare economies of scope.
2. Keep information away from other bidders.
3. Keep information away from targets.
4. Avoid winning bidding wars.
5. Close the deal quickly.
6. Operate in “thinly traded” acquisition markets.
TAble 10.5 Rules for Bidding
Firm Managers
M10_BARN0088_05_GE_C10.INDD 312 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 313
s earch for valuable and r are economies of s cope
One of the main reasons why bidding firms do not obtain competitive advan-
tages from acquiring strategically related target firms is that several other bid-
ding firms value the target firm in the same way. When multiple bidders all
value a target in the same way, competitive bidding is likely. Competitive bid-
ding, in turn, drives out the potential for superior performance. To avoid this
problem, bidding firms should seek to acquire targets with which they enjoy
valuable and rare linkages.
Operationally, the search for rare economies of scope suggests that manag-
ers in bidding firms need to consider not only the value of a target firm when
combined with their own company, but also the value of a target firm when com-
bined with other potential bidders. This is important because it is the difference
between the value of a particular bidding firm’s relationship with a target and the
value of other bidding firms’ relationships with that target that defines the size of
the potential economic profits from an acquisition.
In practice, the search for valuable and rare economies of scope is likely to
become a search for valuable and rare resources already controlled by a firm that
are synergistically related to a target. For example, if a bidding firm has a unique
reputation in its product market and if the target firm’s products could benefit
by association with that reputation, then the target firm may be more valuable
to this particular bidder than to other bidders (firms that do not possess this spe-
cial reputation). Also, if a particular bidder possesses the largest market share in
its industry, the best distribution system, or restricted access to certain key raw
materials and if the target firm would benefit from being associated with these
valuable and rare resources, then the acquisition of this target may be a source of
economic profits.
The search for valuable and rare economies of scope as a basis of mergers
and acquisitions tends to rule out certain interfirm linkages as sources of eco-
nomic profits. For example, most acquisitions can lead to a reduction in over-
head costs because much of the corporate overhead associated with the target
firm can be eliminated subsequent to acquisition. However, the ability to elimi-
nate these overhead costs is not unique to any one bidder, and thus the value
created by these reduced costs will usually be captured by the equity holders of
the target firm.
Keep information Away from Other bidders
One of the keys to earning superior performance in an acquisition strategy
is to avoid multiple bidders for a single target. One way to accomplish this
is to keep information about the bidding process, and about the sources of
economies of scope between a bidder and target that underlie this bidding
process, as private as possible. In order for other firms to become involved in
bidding for a target, they must be aware of the value of the economies of scope
between themselves and that target. If only one bidding firm knows this infor-
mation and if this bidding firm can close the deal before the full value of the
target is known, then it may gain a competitive advantage from completing
this acquisition.
Of course, in many circumstances, keeping all this information private is dif-
ficult. Often, it is illegal. For example, when seeking to acquire a publicly traded
firm, potential bidders must meet disclosure requirements that effectively reduce
the amount of private information a bidder can retain. In these circumstances,
unless a bidding firm has some valuable, rare, and costly-to-imitate economy of
M10_BARN0088_05_GE_C10.INDD 313 13/09/14 4:11 PM

314 Part 3: Corporate Strategies
scope with a target firm, the possibility of economic profits coming from an ac-
quisition is very low. It is not surprising that the research conducted on mergers
and acquisitions of firms traded on public stock exchanges governed by the U.S.
Securities and Exchange Commission (SEC) disclosure rules suggests that, most
of the time, bidding firms do not earn economic profits from implementing their
acquisition strategies.
However, not all potential targets are publicly traded. Privately held firms
may be acquired in an information environment that can create opportunities for
above-normal performance for bidding firms. Moreover, even when acquiring a
publicly traded firm, a bidder does not have to release all the information it has
about the potential value of that target in combination with itself. Indeed, if some
of this value reflects a bidding firm’s taken-for-granted “invisible” assets, it may
not be possible to communicate this information. In this case, as well, there may
be opportunities for competitive advantages for bidding firms.
Keep information Away from Targets
Not only should bidding firms keep information about the value of their econ-
omy of scope with a target away from other bidders, they should also keep this
information away from target firms. Suppose that the value of a target firm to
a bidding firm is $8,000, but the bidding firm, in an attempt to earn economic
profits, has bid only $5,000 for the target. If the target knows that it is actually
worth $8,000, it is very likely to hold out for a higher bid. In fact, the target may
contact other potential bidding firms and tell them of the opportunity created
by the $5,000 bid. As the number of bidders goes up, the possibility of superior
economic performance for bidders goes down. Therefore, to keep the possibil-
ity of these profits alive, bidding firms must not fully reveal the value of their
economies of scope with a target firm. Again, in some circumstances, it is very
difficult, or even illegal, to attempt to limit the flow of information to target
firms. In these settings, superior economic performance for bidding firms is
very unlikely.
Limiting the amount of information that flows to the target firm may have
some other consequences as well. For example, it has been shown that a complete
sharing of information, insights, and perspectives before an acquisition is com-
pleted increases the probability that economies of scope will actually be realized
once it is completed.19 By limiting the flow of information between itself and a
target, a bidding firm may actually be increasing the cost of integrating the target
into its ongoing business, thereby jeopardizing at least some of the superior eco-
nomic performance that limiting information flow is designed to create. Bidding
firms will need to carefully balance the economic benefits of limiting the informa-
tion they share with the target firm against the costs that limiting information
flow may create.
Avoid Winning bidding Wars
It should be reasonably clear that if a number of firms bid for the same target, the
probability that the firm that successfully acquires the target will gain competi-
tive advantages is very low. Indeed, to ensure that competitive bidding occurs,
target firms can actively encourage other bidding firms to enter into the bidding
process. The implications of these arguments are clear: Bidding firms should gen-
erally avoid winning a bidding war. To “win” a bidding war, a bidding firm will
often have to pay a price at least equal to the full value of the target. Many times,
given the emotions of an intense bidding contest, the winning bid may actually
M10_BARN0088_05_GE_C10.INDD 314 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 315
be larger than the true value of the target. Completing this type of acquisition will
certainly reduce the economic performance of the bidding firm.
The only time it might make sense to “win” a bidding war is when the win-
ning firm possesses a rare and private or a rare and costly-to-imitate economy of
scope with a target that is more valuable than the strategic relatedness that exists
between any other bidders and that target. In this setting, the winning firm may
be able to earn a profit if it is able to fully realize the value of its relationship with
the target.
c lose the Deal Quickly
Another rule of thumb for obtaining superior performance from implementing
merger and acquisition strategies is to close the deal quickly. All the economic
processes that make it difficult for bidding firms to earn economic profits from
acquiring a strategically related target take time to unfold. It takes time for other
bidders to become aware of the economic value associated with acquiring a
target; it takes time for the target to recruit other bidders; information leakage
becomes more of a problem over time; and so forth. A bidding firm that begins
and ends the bidding process quickly may forestall some of these processes and
thereby retain some superior performance for itself.
The admonition to close the deal quickly should not be taken to mean
that bidding firms need to make their acquisition decisions quickly. Indeed,
the search for valuable and rare economies of scope should be undertaken
with great care. There should be little rush in isolating and evaluating acqui-
sition candidates. However, once a target firm has been located and valued,
bidding firms have a strong incentive to reduce the period of time between the
first bid and the completion of the deal. The longer this period of negotiation,
the less likely it is that the bidding firm will earn economic profits from the
acquisition.
c omplete Acquisitions in “Thinly Traded” Markets
Finally, an acquisition strategy can be a source of economic profits to bidding
firms if these firms implement this corporate strategy in what could be described
as “thinly traded markets.” In general, a thinly traded market is a market where
there are only a small number of buyers and sellers, where information about
opportunities in this market is not widely known, and where interests besides
purely maximizing the value of a firm can be important. In the context of merg-
ers and acquisitions, thinly traded markets are markets where only a few (often
only one) firms are implementing acquisition strategies. These unique firms may
be the only firms that understand the full value of the acquisition opportunities
in this market. Even target firm managers may not fully understand the value
of the economic opportunities in these markets, and, if they do, they may have
other interests besides maximizing the value of their firm if it becomes the object
of a takeover.
In general, thinly traded merger and acquisition markets are highly frag-
mented. Competition in these markets occurs at the local level, as one small
local firm competes with other small local firms for a common group of geo-
graphically defined customers. Most of these small firms are privately held.
Many are sole proprietorships. Examples of these thinly traded markets have
included, at various points in history, the printing industry, the fast-food in-
dustry, the used-car industry, the dry-cleaning industry, and the barber shop/
hair salon industry.
M10_BARN0088_05_GE_C10.INDD 315 13/09/14 4:11 PM

316 Part 3: Corporate Strategies
As was suggested in Chapter 2, the major opportunity in all highly frag-
mented industries is consolidation. In the context of mergers and acquisitions,
consolidation can occur by one firm (or a small number of firms) buying numer-
ous independent firms to realize economies of scope in these industries. Often,
these economies of scope reflect economies of scale in these industries—economies
of scale that were not realized in a highly fragmented setting. As long as the num-
ber of firms implementing this consolidation strategy is small, then the market for
corporate control in these markets will probably be less than perfectly competi-
tive, and opportunities for profits from implementing an acquisition strategy may
be possible.
More generally, if a merger or acquisition contest is played out through full-
page ads in The Wall Street Journal, the ability of bidding firms to gain competitive
advantages from their acquisitions is limited. Such highly public acquisitions
are likely to lead to very competitive markets for corporate control. Competitive
markets for corporate control, in turn, assure that the equity holders of the target
firm will appropriate any value that could be created by an acquisition. However,
if these contests occur in obscure, out-of-the-way industries, it is more likely that
bidding firms will be able to earn profits from their acquisitions.
s ervice c orporation international: An example
Empirical research on mergers and acquisitions suggests that it is not easy for
bidding firms to earn economic profits from these strategies. However, it may
be possible for some bidding firms, some of the time, to do so. One firm that has
been successful in gaining competitive advantages from its merger and acquisi-
tion strategies is Service Corporation International (SCI). Service Corporation
International is in the funeral home and cemetery business. It grew from a col-
lection of five funeral homes in 1967 to being the largest owner of cemeteries and
funeral homes in the United States today. It has done this through an aggressive
and what was until recently a highly profitable acquisitions program in this his-
torically fragmented industry.
The valuable and rare economy of scope that SCI brought to the funeral
home industry is the application of traditional business practices in a highly
fragmented and not often professionally managed industry. Service Corporation
International–owned funeral homes operate with gross margins approaching
30 percent, nearly three times the gross margins of independently owned funeral
homes. Among other things, higher margins reflected savings from centralized
purchasing services, centralized embalming and professional services, and the
sharing of underutilized resources (including hearses) among funeral homes
within geographic regions. Service Corporation International’s scale advantages
made a particular funeral home more valuable to SCI than to one of SCI’s smaller
competitors and more valuable than if a particular funeral home was left as a
stand-alone business.
Moreover, the funeral homes that SCI targeted for acquisition were, typi-
cally, family-owned and lacked heirs to continue the business. Many of the
owners or operators of these funeral homes were not fully aware of the value of
their operations to SCI (they are morticians more than business managers), nor
were they just interested in maximizing the sale price of their funeral homes.
Rather, they were often looking to maintain continuity of service in a commu-
nity, secure employment for their loyal employees, and ensure a comfortable (if
not lavish) retirement for themselves. Being acquired by SCI was likely to be the
M10_BARN0088_05_GE_C10.INDD 316 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 317
only alternative to closing the funeral home once an owner or operator retired.
Extracting less than the full value of the funeral home when selling to SCI often
seemed preferable to other alternatives.
Because SCI’s acquisition of funeral homes exploited real and valuable
economies of scope, this strategy had the potential for generating superior eco-
nomic performance. Because SCI was, for many years, the only firm implement-
ing this strategy in the funeral home industry, because the funeral homes that SCI
acquired were generally not publicly traded, and because the owners or operators
of these funeral homes often had interests besides simply maximizing the price
of their operations when they sold them, it seems likely that SCI’s acquisition
strategy generated superior economic performance for many years. However,
information about SCI’s acquisition strategy has become widely known. This
has led other funeral homes to begin bidding to acquire formerly independent
funeral homes. Moreover, independent funeral home owners have become more
aware of their full value to SCI. Although SCI’s economy of scope with indepen-
dent funeral homes is still valuable, it is no longer rare, and thus it is no longer
a source of economic profits to SCI. Put differently, the imperfectly competitive
market for corporate control that SCI was able to exploit for almost 10 years has
become more perfectly competitive. Future acquisitions in this market by SCI are
not likely to be a source of sustained competitive advantage and economic profit.
In response, SCI now focuses on managing its more than 1,800 funeral homes in
the United States.20
Implications for Target Firm Managers
Although bidding firm managers can do several things to attempt to maximize
the probability of earning economic profits from their merger and acquisition
strategies, target firm managers can attempt to counter these efforts to ensure that
the owners of target firms appropriate whatever value is created by a merger or
acquisition. These “rules” for target firm managers are summarized in Table 10.6.
s eek information from bidders
One way a bidder can attempt to obtain superior performance from implement-
ing an acquisition strategy is to keep information about the source and value of
the strategic relatedness that exists between the bidder and target private. If that
relationship is actually worth $12,000, but targets believe it is only worth $8,000,
then a target might be willing to settle for a bid of $8,000 and, thereby, forgo the
extra $4,000 it could have extracted from the bidder. Once the target knows that
its true value to the bidder is $12,000, it is in a much better position to obtain this
full value when the acquisition is completed. Therefore, not only should a bidding
firm inform itself about the value of a target, target firms must inform themselves
about their value to potential bidders. In this way, they can help obtain the full
value of their assets.
1. Seek information from bidders.
2. Invite other bidders to join the bidding competition.
3. Delay, but do not stop, the acquisition.
TAble 10.6 Rules for Target
Firm Managers
M10_BARN0088_05_GE_C10.INDD 317 13/09/14 4:11 PM

318 Part 3: Corporate Strategies
invite Other bidders to j oin the bidding c ompetition
Once a target firm is fully aware of the nature and value of the economies of scope
that exist between it and current bidding firms, it can exploit this information by
seeking other firms that may have the same relationship with it and then inform-
ing these firms of a potential acquisition opportunity. By inviting other firms into
the bidding process, the target firm increases the competitiveness of the market
for corporate control, thereby increasing the probability that the value created by
an acquisition will be fully captured by the target firm.
Delay, but Do n ot s top, the Acquisition
As suggested earlier, bidding firms have a strong incentive to expedite the acqui-
sition process in order to prevent other bidders from becoming involved in an
acquisition. Of course, the target firm wants other bidding firms to enter the pro-
cess. To increase the probability of receiving more than one bid, target firms have
a strong incentive to delay an acquisition.
The objective, however, should be to delay an acquisition to create a more
competitive market for corporate control, not to stop an acquisition. If a valu-
able economy of scope exists between a bidding firm and a target firm, the
merger of these two firms will create economic value. If the market for corporate
control within which this merger occurs is competitive, then the equity hold-
ers of the target firm will appropriate the full value of this economy of scope.
Preventing an acquisition in this setting can be very costly to the equity holders
of the target firm.
Target firm managers can engage in a wide variety of activities to delay the
completion of an acquisition. Some common responses of target firm manage-
ment to takeover efforts, along with their economic implications for the equity
holders of target firms, are discussed in the Research Made Relevant feature.
Organizing to Implement a Merger or Acquisition
To realize the full value of any strategic relatedness that exists between a bidding
firm and a target firm, the merged organizations must be organized appropri-
ately. The realization of each of the types of strategic relatedness discussed ear-
lier in this chapter requires at least some coordination and integration between
the bidding and target firms after an acquisition has occurred. For example, to
realize economies of scale from an acquisition, bidding and target firms must
coordinate in the combined firm the functions that are sensitive to economies of
scale. To realize the value of any technology that a bidding firm acquires from a
target firm, the combined firm must use this technology in developing, manufac-
turing, or selling its products. To exploit underutilized leverage capacity in the
target firm, the balance sheets of the bidding and target firms must be merged,
and the resulting firm must then seek additional debt funding. To realize the
opportunity of replacing the target firm’s inefficient management with more
efficient management from the bidding firm, these management changes must
actually take place.
Post-acquisition coordination and integration is essential if bidding and
target firms are to realize the full potential of the strategic relatedness that
drove the acquisition in the first place. If a bidding firm decides not to coor-
dinate or integrate any of its business activities with the activities of a target
firm, then why was this target firm acquired? Just as corporate diversification
V R I O
M10_BARN0088_05_GE_C10.INDD 318 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 319
requires the active management of linkages among different parts of a firm,
mergers and acquisitions (as one way in which corporate diversification strate-
gies can be created) require the active management of linkages between a bid-
ding and a target firm.
Post-Merger Integration and Implementing a Diversification
Strategy
Given that most merger and acquisition strategies are used to create corporate
diversification strategies, the organizational approaches previously described
for implementing diversification are relevant for implementing merger and ac-
quisition strategies as well. Thus, mergers and acquisitions designed to create
diversification strategies should be managed through the M-form structure. The
management control systems and compensation policies associated with imple-
menting diversification strategies should also be applied in organizing to imple-
ment merger and acquisition strategies. In contrast, mergers and acquisitions
designed to create vertical integration strategies should be managed through the
U-form structure and have management controls and compensation policies con-
sistent with this strategy.
Special Challenges in Post-Merger Integration
Although, in general, organizing to implement merger and acquisition strategies
can be seen as a special case of organizing to implement corporate diversification
strategies or vertical integration strategies, implementing merger and acquisition
strategies can create special problems. Most of these problems reflect the fact that
operational, functional, strategic, and cultural differences between bidding and
target firms involved in a merger or acquisition are likely to be much greater than
these same differences between the different parts of a diversified or vertically
integrated business that was not created through acquisition. The reason for this
difference is that the firms involved in a merger or acquisition have had a separate
existence, separate histories, separate management philosophies, and separate
strategies.
Differences between bidding and target firms can manifest themselves in
a wide variety of ways. For example, the firms may own and operate different
computer systems, different telephone systems, and other conflicting technologies.
These firms might have very different human resource policies and practices. One
firm might have a very generous retirement and health care program; the other,
a less generous program. One firm’s compensation system might focus on high
salaries; the other firm’s compensation system might focus on large cash bonuses
and stock options. Also, these firms might have very different relationships with
customers. At one firm, customers might be thought of as business partners; in
another, the relationship with customers might be more arm’s-length in charac-
ter. Integrating bidding and target firms may require the resolution of numerous
differences.
Perhaps the most significant challenge in integrating bidding and target
firms has to do with cultural differences.21 In Chapter 3, it was suggested that it
can often be difficult to change a firm’s organizational culture. The fact that a firm
has been acquired does not mean that the culture in that firm will rapidly change
to become more like the culture of the bidding firm; cultural conflicts can last for
very long periods of time.
M10_BARN0088_05_GE_C10.INDD 319 13/09/14 4:11 PM

320 Part 3: Corporate Strategies
Managers in potential target firms can respond to takeover at-
tempts in a variety of ways. As sug-
gested in Table 10.7, some of these
responses increase the wealth of target
firm shareholders, some have no im-
pact on target firm shareholders, and
others decrease the wealth of target
firm shareholders.
Management responses that
have the effect of reducing the value of
target firms include greenmail, stand-
still agreements, and “poison pills.”
Each of these is an anti-takeover action
that target firm managers can take to
reduce the wealth of target firm equity
holders. Greenmail is a maneuver in
which a target firm’s management pur-
chases any of the target firm’s stock
owned by a bidder and does so for a
price that is greater than the current
market value of that stock. Greenmail
effectively ends a bidding firm’s ef-
fort to acquire a particular target and
does so in a way that can greatly re-
duce the wealth of a target firm’s eq-
uity holders. Not only do these equity
holders not appropriate any economic
value that could have been created if
an acquisition had been completed, but
they have to bear the cost of the pre-
mium price that management pays to
buy its stock back from the bidding
firm.
Not surprisingly, target firms
that resort to greenmail substantially
reduce the economic wealth of their eq-
uity holders. One study found that the
value of target firms that pay green-
mail drops, on average, 1.76 percent.
Another study reported a 2.85 percent
drop in the value of such firms. These
reductions in value are greater if
greenmail leads to the cancellation of
a takeover effort. Indeed, this second
study found that such episodes led to
a 5.50 percent reduction in the value of
target firms. These reductions in value
as a response to greenmail activities
stand in marked contrast to the gener-
ally positive market response to efforts
by a firm to repurchase its own shares
in nongreenmail situations.
Standstill agreements are
often negotiated in conjunction with
greenmail. A standstill agreement is a
contract between a target and a bid-
ding firm wherein the bidding firm
agrees not to attempt to take over the
target for some period of time. When
a target firm negotiates a standstill
agreement, it prevents the current ac-
quisition effort from being completed,
and it reduces the number of bidders
that might become involved in future
acquisition efforts. Thus, the equity
holders of this target firm forgo any
value that could have been created if
the current acquisition had occurred,
and they also lose some of the value
that they could have appropriated
in future acquisition episodes by the
The Wealth effects of Management
Responses to Takeover Attempts
Research Made Relevant
1. Responses that reduce the wealth of target firm equity holders:
■ Greenmail
■ Standstill agreements
■ Poison pills
2. Responses that do not affect the wealth of target firm equity holders:
■ Shark repellents
■ Pac Man defense
■ Crown jewel sale
■ Lawsuits
3. Responses that increase the wealth of target firm equity holders:
■ Search for white knights
■ Creation of bidding auctions
■ Golden parachutes
TAble 10.7 The Wealth
Effects of Target Firm
Management Responses to
Acquisition Efforts
M10_BARN0088_05_GE_C10.INDD 320 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 321
target’s inviting multiple bidders into
a market for corporate control.
Standstill agreements, either
alone or in conjunction with green-
mail, reduce the economic value of
a target firm. One study found that
standstill agreements that were unac-
companied by stock repurchase agree-
ments reduced the value of a target
firm by 4.05 percent. Such agreements,
in combination with stock repurchases,
reduced the value of a target firm by
4.52 percent.
So-called poison pills include
any of a variety of actions that target
firm managers can take to make the
acquisition of the target prohibitively
expensive. In one common poison-pill
maneuver, a target firm issues rights to
its current stockholders indicating that
if the firm is acquired in an unfriendly
takeover, it will distribute a special
cash dividend to stockholders. This
cash dividend effectively increases the
cost of acquiring the target and can
discourage otherwise interested bid-
ding firms from attempting to acquire
this target. Another poison-pill tactic
substitutes the distribution of addi-
tional shares of a target firm’s stock,
at very low prices, for the special cash
dividend. Issuing this low-price stock
to current stockholders effectively un-
dermines the value of a bidding firm’s
equity investment in a target and thus
increases the cost of the acquisition.
Other poison pills involve granting
current stockholders other rights—
rights that effectively increase the cost
of an unfriendly takeover.
Although poison pills are cre-
ative devices that target firms can use
to prevent an acquisition, they gener-
ally have not been very effective. If
a bidding firm and a target firm are
strategically related, the value that can
be created in an acquisition can be
substantial, and most of this value will
be appropriated by the stockholders
of the target firm. Thus, target firm
stockholders have a strong incentive
to see that the target firm is acquired,
and they are amenable to direct offers
made by a bidding firm to them as
individual investors; these are called
tender offers. However, to the extent
that poison pills actually do prevent
mergers and acquisitions, they are
usually bad for the equity holders of
target firms.
Target firm management can
also engage in a wide variety of actions
that have little or no impact on the
wealth of a target firm’s equity holders.
One class of these responses is known
as shark repellents. Shark repellents
include a variety of relatively minor
corporate governance changes that,
in principle, are supposed to make it
somewhat more difficult to acquire
a target firm. Common examples of
shark repellents include superma-
jority voting rules (which specify
that more than 50 percent of the target
firm’s board of directors must approve
a takeover) and state incorporation
laws (in some states, incorporation
laws make it difficult to acquire a firm
incorporated in that state). However,
if the value created by an acquisition
is sufficiently large, these shark repel-
lents will neither slow an acquisition
attempt significantly nor prevent it
from being completed.
Another response that does not
affect the wealth of target firm equity
holders is known as the Pac Man
defense. Targets using this tactic fend
off an acquisition by taking over the
firm or firms bidding for them. Just
as in the old video game, the hunted
becomes the hunter; the target turns
the tables on current and potential bid-
ders. It should not be too surprising
that the Pac Man defense does not, on
average, either hurt or help the stock-
holders of target firms. In this defense,
targets become bidders, and we know
from empirical literature that, on av-
erage, bidding firms earn only zero
economic profits from their acquisi-
tion efforts. Thus, one would expect
that, on average, the Pac Man defense
would generate only zero economic
profits for the stockholders of target
firms implementing it.
Another ineffective and incon-
sequential response is called a crown
jewel sale. The idea behind a crown
jewel sale is that sometimes a bidding
firm is interested in just a few of the
businesses currently being operated
by the target firm. These businesses
are the target firm’s “crown jewels.”
To prevent an acquisition, the target
firm can sell off these crown jewels,
either directly to the bidding firm or
by setting up a separate company to
own and operate these businesses. In
this way, the bidding firm is likely
to be less interested in acquiring the
target.
A final, relatively ineffective de-
fense that most target firm manag-
ers pursue is filing lawsuits against
bidding firms. Indeed, at least in the
United States, the filing of a lawsuit
has been almost automatic as soon
as an acquisition effort is announced.
These suits, however, usually do
not delay or stop an acquisition or
merger.
(Continued)
M10_BARN0088_05_GE_C10.INDD 321 13/09/14 4:11 PM

322 Part 3: Corporate Strategies
Finally, as suggested in Table 10.7,
some of the actions that the manage-
ment of target firms can take to delay
(but not stop) an acquisition actually
benefit target firm equity holders. The
first of these is the search for a white
knight—another bidding firm that
agrees to acquire a particular target in
the place of the original bidding firm.
Target firm management may prefer
to be acquired by some bidding firms
over others. For example, it may be
that some bidding firms possess much
more valuable economies of scope with
a target firm than other bidding firms.
It may also be that some bidding firms
will take a longer-term view in man-
aging a target firm’s assets than other
bidding firms. In both cases, target firm
managers are likely to prefer some bid-
ding firms over others.
Whatever motivation a target
firm’s management has, inviting a
white knight to bid on a target firm
has the effect of increasing the num-
ber of firms bidding for a target by at
least one. If there is currently only one
bidder, inviting a white knight into
the bidding competition doubles the
number of firms bidding for a target.
As the number of bidders increases,
the competitiveness of the market for
corporate control and the likelihood
that the equity holders of the target
firm will appropriate all the value cre-
ated by an acquisition also increase.
On average, the entrance of a white
knight into a competitive bidding con-
test for a target firm increases the
wealth of target firm equity holders
by 17 percent.
If adding one firm into the com-
petitive bidding process increases
the wealth of target firm equity hold-
ers some, then adding more firms to
the process is likely to increase this
wealth even more. Target firms can
accomplish this outcome by creating
an auction among bidding firms. On
average, the creation of an auction
among multiple bidders increases the
wealth of target firm equity holders by
20 percent.
A third action that the managers
of a target firm can take to increase the
wealth of their equity holders from an
acquisition effort is the institution of
golden parachutes. A golden para-
chute is a compensation arrangement
between a firm and its senior manage-
ment team that promises these indi-
viduals a substantial cash payment
if their firm is acquired and they lose
their jobs in the process. These cash
payments can appear to be very large,
but they are actually quite small in
comparison to the total value that can
be created if a merger or acquisition is
completed. In this sense, golden para-
chutes are a small price to pay to give
a potential target firm’s top managers
incentives not to stand in the way of
completing a takeover of their firm. Put
differently, golden parachutes reduce
agency problems for the equity hold-
ers of a potential target firm by align-
ing the interests of top managers with
the interests of that firm’s stockholders.
On average, when a firm announces
golden parachute compensation pack-
ages for its top management team, the
value of this potential target firm’s eq-
uity increases by 7 percent.
Overall, substantial evidence sug-
gests that delaying an acquisition long
enough to ensure that a competitive
market for corporate control emerges
can significantly benefit the equity hold-
ers of target firms. One study found
that when target firms did not delay
the completion of an acquisition, their
equity holders experienced, on aver-
age, a 36 percent increase in the value
of their stock once the acquisition was
complete. If, however, target firms did
delay the completion of the acquisition,
this average increase in value jumped to
65 percent.
Of course, target firm managers
can delay too long. Delaying too long
can create opportunity costs for their
firm’s equity holders because these in-
dividuals do not actually realize the
gain from an acquisition until it has
been completed. Also, long delays can
jeopardize the completion of an acqui-
sition, in which case the equity holders
of the target firm do not realize any
gains from the acquisition.
Sources: R. Walkling and M. Long (1984).
“Agency theory, managerial welfare, and take-
over bid resistance.” Rand Journal of Economics,
15(1), pp. 54–68; R. D. Kosnik (1987). “Greenmail:
A study of board performance in corporate
governance.” Administrative Science Quarterly,
32, pp. 163–185; J. Walsh (1989). “Doing a deal:
Merger and acquisition negotiations and their
impact upon target company top management
turnover.” Strategic Management Journal, 10,
pp. 307–322; L. Y. Dann and H. DeAngelo (1983).
“Standstill agreements, privately negotiated
stock repurchases, and the market for corpo-
rate control.” Journal of Financial Economics, 11,
pp. 275–300; M. Bradey and L. Wakeman
(1983). “The wealth effects of targeted share
repurchases.” Journal of Financial Economics, 11,
pp. 301–328; H. Singh and F. Haricento (1989).
“Top management tenure, corporate owner-
ship and the magnitude of golden parachutes.”
Strategic Management Journal, 10, pp. 143–156;
T. A. Turk (1987). “The determinants of manage-
ment responses to interfirm tender offers and
their effect on shareholder wealth.” Unpublished
doctoral dissertation, Graduate School of
Management, University of California at Irvine.
M10_BARN0088_05_GE_C10.INDD 322 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 323
The failures of what some observers believe are some of the worst ac-
quisitions ever have all been attributed to cultural clashes.22 For example,
the merger between Daimler (the maker of Mercedes-Benz) and Chrysler pit-
ted the culture of a German company that focused on luxury vehicles with
a midwestern U.S. company that sold lower-prestige cars and Jeeps. The
merger became the source of a widely known joke: “How do you pronounce
DaimlerChrysler? Daimler. The Chrysler is silent.” These two firms split after
only a few painful years.
Also, Novell’s acquisition of Word Perfect brought together two manage-
ment teams that refused to cooperate. While Novell and Word Perfect managers
fought each other, Microsoft emerged as the dominant firm in the word process-
ing industry with Microsoft Word. After two years, Novell sold Word Perfect for
$1 billion less than its purchase price.
Another disastrous acquisition involved the combination of America
Online (AOL) and Time Warner. In 2000, before the merger, AOL’s shares sold
for more than $75; in 2008, after the merger, they sold for $15. The problem: the
clash between the “new media” AOL culture with the “old media” Time Warner
culture.
Sprint’s acquisition of Nextel was also a spectacular failure. In 2005, the deal
cost Sprint $35 billion. Within three years, 80 percent of Sprint’s investment in
Nextel was written off. The culprit, once again, was the clash between the cultures
of these two firms: Sprint was a “button-down” bureaucratic culture that could
not tolerate Nextel’s more freewheeling entrepreneurial culture. The two manage-
ment teams fought about everything from advertising strategy to cell phone tech-
nology. Not surprisingly, in 2012, SprintNextel was purchased by the third-largest
Japanese mobile phone company, Softbank, for $20.1 billion—almost $15 billion
less than Sprint had paid for Nextel seven years earlier.
Finally, HP’s acquisition of Compaq reduced the market capitalization of
HP by approximately $13 billion. HP’s engineering- and consensus-driven culture
clashed with Compaq’s quick-decision, sales-driven culture. After several years,
HP has been able to make cultural and leadership changes that have improved
the performance of this acquisition, but this integration has been long in coming.
Operational, functional, strategic, and cultural differences between bidding
and target firms can all be compounded by the merger and acquisition process—
especially if that process was unfriendly. Unfriendly takeovers can generate anger
and animosity among the target firm management that is directed toward the man-
agement of the bidding firm. Research has shown that top management turnover
is much higher in firms that have been taken over compared with firms not subject
to takeovers, reflecting one approach to resolving these management conflicts.23
The difficulties often associated with organizing to implement a merger
and acquisition strategy can be thought of as an additional cost of the acquisition
process. Bidding firms, in addition to estimating the value of the strategic relat-
edness between themselves and a target firm, also need to estimate the cost of
organizing to implement an acquisition. The value that a target firm brings to a
bidding firm through an acquisition should be discounted by the cost of organiz-
ing to implement this strategy. In some circumstances, it may be the case that the
cost of organizing to realize the value of strategic relatedness between a bidding
firm and a target may be greater than the value of that strategic relatedness, in
which case the acquisition should not occur. For this reason, many observers ar-
gue that potential economies of scope between bidding and target firms are often
not fully realized.
M10_BARN0088_05_GE_C10.INDD 323 13/09/14 4:11 PM

324 Part 3: Corporate Strategies
Although organizing to implement mergers and acquisitions can be a source
of significant cost, it can also be a source of value and opportunity. Some scholars
have suggested that value creation can continue to occur in a merger or acquisi-
tion long after the formal acquisition is complete.24 As bidding and target firms
continue to coordinate and integrate their operations, unanticipated opportuni-
ties for value creation can be discovered. These sources of value could not have
been anticipated at the time a firm was originally acquired (and thus are, at least
partially, a manifestation of a bidding firm’s good luck), but bidding firms can
influence the probability of discovering these unanticipated sources of value by
learning to cooperate effectively with target firms while organizing to implement
a merger or acquisition strategy.
Summary
Firms can use mergers and acquisitions to create corporate diversification and vertical
integration strategies. Mergers or acquisitions between strategically unrelated firms can be
expected to generate only competitive parity for both bidders and targets. Thus, firms con-
templating merger and acquisition strategies must search for strategically related targets.
Several sources of strategic relatedness have been discussed in literature. On aver-
age, the acquisition of strategically related targets does create economic value, but most
of that value is captured by the equity holders of target firms. The equity holders of bid-
ding firms generally gain competitive parity even when bidding firms acquire strategi-
cally related targets. Empirical research on mergers and acquisitions is consistent with
these expectations. On average, acquisitions do create value, but that value is captured
by target firms, and acquisitions do not hurt bidding firms.
Given that most mergers and acquisitions generate only zero economic profits for
bidding firms, an important question becomes: “Why are there so many mergers and
acquisitions?” Explanations include (1) the desire to ensure firm survival, (2) the exis-
tence of free cash flow, (3) agency problems between bidding firm managers and equity
holders, (4) managerial hubris, and (5) the possibility that some bidding firms might earn
economic profits from implementing merger and acquisition strategies.
To gain competitive advantages and economic profits from mergers or acquisitions,
these strategies must be either valuable, rare, and private or valuable, rare, and costly to
imitate. In addition, a bidding firm may exploit unanticipated sources of strategic relat-
edness with a target. These unanticipated sources of relatedness can also be a source of
economic profits for a bidding firm. These observations have several implications for the
managers of bidding and target firms.
Organizing to implement a merger or acquisition strategy can be seen as a special
case of organizing to implement a corporate diversification or vertical integration strat-
egy. However, historical differences between bidding and target firms may make the in-
tegration of different parts of a firm created through acquisitions more difficult than if a
firm is not created through acquisitions. Cultural differences between bidding and target
firms are particularly problematic. Bidding firms need to estimate the cost of organizing
to implement a merger or acquisition strategy and discount the value of a target by that
cost. However, organizing to implement a merger or acquisition can also be a way that
bidding and target firms can discover unanticipated economies of scope.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
M10_BARN0088_05_GE_C10.INDD 324 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 325
Challenge Questions
10.1. The terms merger and acquisi-
tion are often used interchangeably to
describe the combination of two corpo-
rate entities. Whilst there are no specific
definitions as to what makes a process
more of one rather than the other, dis-
cuss when distinctions can be made
between a merger and an acquisition.
10.2. Consider this scenario: A firm ac-
quires a strategically related target; there
were no other bidding firms. Under
what conditions, if any, can the firm
that acquired this target expect to earn
an economic profit from doing so?
10.3. Some researchers have argued
that the existence of free cash flow
can lead managers in a firm to make
inappropriate acquisition decisions.
To avoid these problems, these
authors have argued that firms should
increase their debt-to-equity ratio
and “soak up” free cash flow through
interest and principal payments. Is
free cash flow a significant problem
for many firms?
10.4. What are the strengths and
weaknesses of increased leverage as
a response to free cash flow problems
in a firm?
10.5. The hubris hypothesis suggests
that managers continue to engage in
acquisitions, even though, on average,
they do not generate economic profits,
because of the unrealistic belief on the
part of these managers that they can
manage a target firm’s assets more
efficiently than that firm’s current
management. This type of systematic
nonrationality usually does not last too
long in competitive market conditions:
Firms led by managers with these un-
realistic beliefs change, are acquired,
or go bankrupt in the long run. What
are the attributes of the market for cor-
porate control that suggest that mana-
gerial hubris could exist in this market,
despite its performance-reducing
implications for bidding firms?
10.6. The hubris hypothesis suggests
that managers continue to engage in
acquisitions, even though, on average,
they do not generate economic profits,
because of the unrealistic belief on the
part of these managers that they can
manage a target firm’s assets more
efficiently than that firm’s current man-
agement. This type of systematic nonra-
tionality usually does not last too long
in competitive market conditions: Firms
led by managers with these unrealistic
beliefs change, are acquired, or go bank-
rupt in the long run. Can the hubris hy-
pothesis be a legitimate explanation for
continuing acquisition activity?
10.7. It has been shown that so-
called poison pills rarely prevent
a takeover from occurring. In fact,
sometimes when a firm announces
that it is instituting a poison pill, its
stock price goes up. Why?
10.8. A merger between companies
of equal standing is often fraught
with peril. This is especially so in the
case of large entities, for example, the
merger between HP and Compaq, and
that of Citicorp and Travelers Group.
Whilst the valuation and bidding pro-
cesses can be challenging, post-merger
operations can prove to be even more
painful. Enumerate and expand on
some of the difficulties that large com-
panies can encounter after corporate
consummation.
Problem Set
10.9. For each of the following scenarios, estimate how much value an acquisition will
create, how much of that value will be appropriated by each of the bidding firms, and how
much of that value will be appropriated by each of the target firms. In each of these sce-
narios, assume that firms do not face significant capital constraints.
(a) A bidding firm, A, is worth $27,000 as a stand-alone entity. A target firm, B, is worth
$12,000 as a stand-alone entity, but $18,000 if it is acquired and integrated with Firm A.
Several other firms are interested in acquiring Firm B, and Firm B is also worth $18,000
if it is acquired by these other firms. If Firm A acquired Firm B, would this acquisition
create value? If yes, how much? How much of this value would the equity holders of
Firm A receive? How much would the equity holders of Firm B receive?
(b) The same scenario as above except that the value of Firm B, if it is acquired by the
other firms interested in it, is only $12,000.
(c) The same scenario in part (a), except that the value of Firm B, if it is acquired by the
other firms interested in it, is $16,000.

M10_BARN0088_05_GE_C10.INDD 325 13/09/14 4:11 PM

(d) The same scenario as in part (b), except that Firm B contacts several other firms and
explains to them how they can create the same value with Firm B that Firm A does.
(e) The same scenario as in part (b), except that Firm B sues Firm A. After suing Firm A,
Firm B installs a “supermajority” rule in how its board of directors operates. After put-
ting this new rule in place, Firm B offers to buy back any stock purchased by Firm A
for 20 percent above the current market price.
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
10.9. How can product differentiation be used to neutralize environmental threats
and exploit environmental opportunities?
10.10. How would a firm’s investment in merger and acquisition strategies, on aver-
age, be expected to generate at least competitive parity for bidding firms?
End Notes
1. See Welch, D., and G. Edmondson. (2004). “A shaky automotive
ménage à trois.” BusinessWeek, May 10, pp. 40–41.
2. (2013). “S&P, Nasdaq set marks as merger activity boosts stocks.”
Salt Lake Tribune, February 20, p. E3.
3. Here, and throughout this chapter, it is assumed that capital markets
are semi-strong efficient, that is, all publicly available information
about the value of a firm’s assets is reflected in the market price of
those assets. One implication of semi-strong efficiency is that firms
will be able to gain access to the capital they need to pursue any
strategy that generates positive present value. See Fama, E. F. (1970).
“Efficient capital markets: A review of theory and empirical work.”
Journal of Finance, 25, pp. 383–417.
4. See Trautwein, I. (1990). “Merger motives and merger prescriptions.”
Strategic Management Journal, 11, pp. 283–295; and Walter, G., and
J. B. Barney. (1990). “Management objectives in mergers and acquisi-
tions.” Strategic Management Journal, 11, pp. 79–86. The three lists of
potential links between bidding and target firms were developed by
the Federal Trade Commission; Lubatkin, M. (1983). “Mergers and the
performance of the acquiring firm.” Academy of Management Review, 8,
pp. 218–225; and Jensen, M. C., and R. S. Ruback. (1983). “The market
for corporate control: The scientific evidence.” Journal of Financial
Economics, 11, pp. 5–50.
5. See Huey, J. (1995). “Eisner explains everything.” Fortune, April 17,
pp. 44–68; and Lefton, T. (1996). “Fitting ABC and ESPN into Disney:
Hands in glove.” Brandweek, 37(18), April 29, pp. 30–40.
6. See Rumelt, R. (1974). Strategy, structure, and economic performance.
Cambridge, MA: Harvard University Press.
7. The first study was by Ravenscraft, D. J., and F. M. Scherer. (1987).
Mergers, sell-offs, and economic efficiency. Washington, DC: Brookings
Institution. The second study was by Porter, M. E. (1987). “From com-
petitive advantage to corporate strategy.” Harvard Business Review, 3,
pp. 43–59.
8. This is because if the combined firm is worth $32,000 the bidder firm is
worth $15,000 on its own. If a bidder pays, say, $20,000 for this target,
it will be paying $20,000 for a firm that can only add $17,000 in value.
So, a $20,000 bid would lead to a $3,000 economic loss.
9. This is Jensen, M. C., and R. S. Ruback. (1983). “The market for corpo-
rate control: The scientific evidence.” Journal of Financial Economics, 11,
pp. 5–50.
10. See Lubatkin, M. (1987). “Merger strategies and stockholder value.”
Strategic Management Journal, 8, pp. 39–53; and Singh, H., and C. A.
Montgomery. (1987). “Corporate acquisition strategies and economic
performance.” Strategic Management Journal, 8, pp. 377–386.
11. See Grant, L. (1995). “Here comes Hugh.” Fortune, August 21, pp. 43–52;
Serwer, A. E. (1995). “Why bank mergers are good for your savings
account.” Fortune, October 2, p. 32; and Deogun, N. (2000). “Europe
catches merger fever as global volume sets record.” The Wall Street
Journal, January 3, p. R8.
12. The concept of free cash flow has been emphasized in Jensen, M. C.
(1986). “Agency costs of free cash flow, corporate finance, and
takeovers.” American Economic Review, 76, pp. 323–329; and Jensen, M.
(1988). “Takeovers: Their causes and consequences.” Journal of
Economic Perspectives, 2, pp. 21–48.
13. See Miles, R. H., and K. S. Cameron. (1982). Coffin nails and corporate
strategies. Upper Saddle River, NJ: Prentice Hall.
14. Roll, R. (1986). “The hubris hypothesis of corporate takeovers.” Journal
of Business, 59, pp. 205–216.
15. See Dodd, P. (1980). “Merger proposals, managerial discretion and
stockholder wealth.” Journal of Financial Economics, 8, pp. 105–138;
Eger, C. E. (1983). “An empirical test of the redistribution effect in pure
exchange mergers.” Journal of Financial and Quantitative Analysis, 18,
pp. 547–572; Firth, M. (1980). “Takeovers, shareholder returns, and
the theory of the firm.” Quarterly Journal of Economics, 94, pp. 235–260;
Varaiya, N. (1985). “A test of Roll’s hubris hypothesis of corporate
takeovers.” Working paper, Southern Methodist University, School of
Business; Ruback, R. S., and W. H. Mikkelson. (1984). “Corporate invest-
ments in common stock.” Working paper, Massachusetts Institute of
Technology, Sloan School of Business; and Ruback, R. S. (1982). “The
Conoco takeover and stockholder returns.” Sloan Management Review,
14, pp. 13–33.
16. This section of the chapter draws on Barney, J. B. (1988). “Returns to
bidding firms in mergers and acquisitions: Reconsidering the related-
ness hypothesis.” Strategic Management Journal, 9, pp. 71–78.
17. See Turk, T. A. (1987). “The determinants of management re-
sponses to interfirm tender offers and their effect on shareholder
wealth.” Unpublished doctoral dissertation, Graduate School of
Management, University of California at Irvine. In fact, this is an
example of an anti-takeover action that can increase the value
326 Part 3: Corporate Strategies
M10_BARN0088_05_GE_C10.INDD 326 13/09/14 4:11 PM

Chapter 10: Mergers and Acquisitions 327
of a target firm. These anti-takeover actions are discussed later in
this chapter.
18. See Bower, J. (1996). “WPP-integrating icons.” Harvard Business
School Case No. 9-396-249.
19. See Jemison, D. B., and S. B. Sitkin. (1986). “Corporate acquisitions:
A process perspective.” Academy of Management Review, 11,
pp. 145–163.
20. Blackwell, R. D. (1998). “Service Corporation International.” Presented
to The Cullman Symposium, October, Columbus, OH.
21. Cartwright, S., and C. Cooper. (1993). “The role of culture compatibil-
ity in successful organizational marriage.” The Academy of Management
Executive, 7(2), pp. 57–70; Chatterjee, S., M. Lubatkin, D. Schweiger,
and Y. Weber. (1992). “Cultural differences and shareholder value
in related mergers: Linking equity and human capital.” Strategic
Management Journal, 13, pp. 319–334.
22. Jacobsen, D. (2012). “Six big mergers killed by culture.” Globoforce,
September 22.
23. See Walsh, J., and J. Ellwood. (1991). “Mergers, acquisitions, and the
pruning of managerial deadwood.” Strategic Management Journal, 12,
pp. 201–217; and Walsh, J. (1988). “Top management turnover fol-
lowing mergers and acquisitions.” Strategic Management Journal, 9,
pp. 173–183.
24. See Haspeslagh, P., and D. Jemison. (1991). Managing acquisitions:
Creating value through corporate renewal. New York: Free Press.
M10_BARN0088_05_GE_C10.INDD 327 13/09/14 4:11 PM

328
1. Define international strategy.
2. Describe the relationship between international strat-
egy and other corporate strategies, including vertical
integration and diversification.
3. Describe five ways that international strategies can
create economic value.
4. Discuss the trade-off between local responsiveness and
international integration and transnational strategies
as a way to manage this trade-off.
The Baby Formula Problem
It began in 2008, when most of the domestic dair y producers in China w ere found to be selling
baby formula tainted with the t oxic chemical melamine. Melamine—a chemical used in plastics
and fertilizers—makes baby formula appear less w atery than it ac tually is. Six babies died , and
300,000 became sick. Not surprisingly, demand among Chinese consumers for baby formula pro-
duced by Chinese firms dropped dramatically.
Enter f oreign c ompanies. R ecognizing a mar ket oppor tunity, c ompanies headquar tered
outside China began importing baby formula into China. These included Mead Johnson, Dumex,
Abbott Laboratories, Royal FrieslandCampina, and Fonterra. By 2012, non- Chinese producers of
baby formula had 60 percent of the Chinese market, even though they charged prices that were
30 percent higher than formula produced by Chinese firms.
Even a t these pr ices, supply of non- Chinese formula w as not enough t o sa tisfy Chinese
demand. Visitors from China to Hong Kong began loading up on non-Chinese formula and
bringing it into the mainland, where they used it for their own children or sold it. This continued
until quotas on impor ting formula from Hong Kong t o China w ere implemented. Shor tages of
non-Chinese formula began sho wing up ar ound the w orld. I n the Unit ed K ingdom, Tesco and
Sainsbury—two leading g rocery st ore chains—had t o put r estrictions on the amoun t of bab y
formula that could be purchased because people w ere buying numerous boxes of non-Chinese
formula and selling it online to consumers in China.
5. Discuss the political risks associated with international
strategies and how they can be measured.
6. Discuss the rarity and imitability of international
strategies.
7. Describe four different ways to organize to implement
international strategies.
L e a r n i n g OB j e c T i v e s After reading this chapter, you should be able to:
MyManagementLab®
improve Your grade!
More than 10 million students improved their results using the Pearson MyLabs.
Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.
11
c h a P T e r
International
Strategies
M11_BARN0088_05_GE_C11.INDD 328 13/09/14 4:12 PM

329
Apparently, ev en though the melamine poisonings
took plac e in 2008, Chinese c onsumers still don ’t trust Chinese
producers—and with some r eason. M ost of the dair y c ompa-
nies tha t put melamine in their milk in 2008 ar e still oper ating.
Mengniu Dairy, a sta te-owned dair y, disc overed cancer-causing
toxins in its milk in 2011. Yili Dairy had to r ecall some of its
formula, tain ted with mer cury, in 2012, and in 2013, it sold
formula with more trans-fat than is deemed safe.
In this setting , the decision taken b y the Na tional
Development and R eform C ommission w as a bit sur prising—it
levied fines amounting to $108 million on five international
producers of bab y f ormula—the five listed earlier—and one
domestic producer. This agency concluded that these pr oducers
set minimum resale prices and punished distributors who sold at
lower prices. Xu Kunlin, a spokesperson f or the commission, was
quoted as saying, “These practices caused milk po wder prices to
remain at a high lev el, restricted competition in the mar ket, and
harmed the interests of consumers.”
Another in terpretation of the c ommission’s decision w as tha t it c oncluded it w as time
for China t o “reclaim” the domestic bab y formula market and tha t one w ay to do this w ould be
to punish f oreign pr oducers. I ndeed, this motiv e w as hin ted a t in an ar ticle published in The
People’s Daily that emphasized that Chinese firms needed to take advantage of this situation by
producing “high-quality low-cost products.” The article went on to say, “In fact, it is very possible
for China-made milk powder to replace imported ones or even defeat their foreign counterparts
and sell their products to the overseas market by improving the quality and regaining consumer
confidence.”
Did non- Chinese producers engage in an ticompetitive ac tivities to ar tificially inflate the
price of baby formula in China? Did the Chinese go vernment, for its own reasons, decide to help
reestablish the domestic baby formula industry by fining non-Chinese producers? I t is difficult
to know, but this kind of interaction between business and industry is the kind of thing that can
make international strategies very complicated.
Sources: E. Wong (2013). “China says foreign makers of baby formula may be fixing prices.” The New York Times, July 3, www.
nytimes.com/2013/07/04/business/global/china-says-its-investigating-price-fixing. A ccessed A ugust 26, 2013; B . D emick
(2013). “China fines baby formula companies $108 million in pr ice-fixing case.” The Los Angeles Times, August 7, www.latimes.
com/new/world/worldnow/la-fg-china-fines-babyformula-companies. Accessed August 26, 2013; C. Riley (2013). “China fines
six companies for baby formula price fixing.” CNN Money, August 7, money.cnn.com/2013/08/07/news/china-baby-formula/
index.html. Accessed August 26, 2013; L. K uo (2013). “Why Chinese par ents are still so par anoid about made -in-China baby
formula.” Quartz, A ugust 9, qz.com/113508/why-chinese-parents-are-still-so-paranoid-about-made-in-china-babyformula.
Accessed August 26, 2013.
©
tu
lp
ah
n/
Fo
to
lia
M11_BARN0088_05_GE_C11.INDD 329 13/09/14 4:12 PM

330 Part 3: Corporate Strategies
As the five non-Chinese baby formula firms have discovered, operating inter-nationally can sometimes create unexpected strategic challenges.Firms that operate in multiple countries simultaneously are implement-
ing international strategies. International strategies are actually a special case of
the corporate strategies already discussed in Part 3 of this book. That is, firms can
vertically integrate, diversify, form strategic alliances, and implement mergers and
acquisitions, all across national borders. Thus, the reasons why firms might want to
pursue these corporate strategies identified in Chapters 6 through 10 also apply to
firms pursuing international strategies. For this reason, this chapter emphasizes the
unique characteristics of international strategies.
At some level, international strategies have existed since before the beginning
of recorded time. Certainly, trade across country borders has been an important
determinant of the wealth of individuals, companies, and countries throughout his-
tory. The search for trading opportunities and trade routes was a primary motiva-
tion for the exploration of much of the world. Therefore, it would be inappropriate
to argue that international strategies are an invention of the late twentieth century.
Logitech is a leader in peripheral devices for personal computers
and related digital technology. With
2013 sales of $2.1 billion, Logitech sells
computer pointing devices (e.g., com-
puter mice and trackballs), regular and
cordless computer keyboards, webcam
cameras, PC headsets and VoIP (voice
over Internet protocol) handsets, PC
game controllers, and speakers and
headphones for PCs in virtually every
country in the world. Headquartered
in Switzerland and with offices in
California, Switzerland, China, Hong
Kong, Taiwan, and Japan, Logitech is
a classic example of a firm pursuing an
international strategy.
And it has always been this
way—not that Logitech had sales of
$2.1 billion when it was first founded,
in 1981. But Logitech was one of the first
entrepreneurial firms that began its
operations—way back in 1981—by pur-
suing an international strategy. At its
founding, for example, Logitech had
offices in Switzerland and the United
States. Within two years of its found-
ing, it had research and development
and manufacturing operations in
Taiwan and Ireland. In short, Logitech
was “born global.”
Of course, not all entrepreneur-
ial firms pursue international strategies
from their inception. But this is less
unusual for firms in high-technology
industries, where global technical stan-
dards make it possible for products
made in one market to be sold as “plug
and play” products in markets around
the world. Because Logitech’s pointing
devices and other peripherals could
be used by any personal computer
around the world, their market—from
day one—was global in scope. Indeed,
in one study of firms that were “born
global,” most of these firms were oper-
ating in high- technology markets with
well-developed technical standards.
More recently, entrepre-
neurial firms have begun exploit-
ing international opportunities
in sourcing the manufacturing of
their products. The rise of low-cost
manufacturing in China, Vietnam,
and the Philippines—among other
places—has led increased numbers
of firms, including many small and
entrepreneurial firms, to outsource
their manufacturing operations to
these countries. In this global envi-
ronment, even the smallest entrepre-
neurial firms must become aware of
and manage the challenges associ-
ated with implementing international
strategies discussed in this chapter.
Sources: www.logitech.com; (2013). Logitech
10 K Report; B. Oviatt and P. McDougall (1995).
“Global start-ups: Entrepreneurs on a world-
wide stage.” Academy of Management Executive,
9, pp. 30–44.
International Entrepreneurial
Firms: The Case of Logitech
Strategy in the Emerging Enterprise
M11_BARN0088_05_GE_C11.INDD 330 13/09/14 4:12 PM

Chapter 11: International Strategies 331
In the past, however, the implementation of international strategies was
limited to relatively small numbers of risk-taking individuals and firms. Today
these strategies are becoming remarkably common. For example, in 2012, almost a
third of Wal-Mart’s sales revenues came from outside the United States; only about
a third of ExxonMobil’s profits came from its U.S. operations; almost 50 percent of
General Motors’ automobile sales came from outside the United States; and about
half of General Electric’s revenues came from non-U.S. operations. And it’s not
only U.S-based firms that have invested in non-U.S. operations. Numerous non-
U.S. firms have invested around the world as well. For example, the U.S. market
provides the largest percentage of the sales of such firms as Nestlé (a Swiss food
company), Toyota (a Japanese car company), and Royal Dutch/Shell Group (an
energy company headquartered in both the United Kingdom and the Netherlands).
Moreover, as described in the Strategy in the Emerging Enterprise feature, interna-
tional strategies are not limited to just huge multinational companies.
The increased use of international strategies by both large and small firms
suggests that the economic opportunities associated with operating in multiple
geographic markets can be substantial. However, to be a source of sustained
competitive advantages for firms, these strategies must exploit a firm’s valuable,
rare, and costly to imitate resources and capabilities. Moreover, a firm must be
appropriately organized to realize the full competitive potential of these resources
and capabilities. This chapter examines the conditions under which international
strategies can create economic value, as well as the conditions under which they
can be sources of sustained competitive advantages.
The Value of International Strategies
As suggested earlier, international strategies are an example of corporate strate-
gies. So to be economically valuable, they must meet the two value criteria origi-
nally introduced in Chapter 7: They must exploit real economics of scope, and it
must be costly for outside investors to realize these economies of scope on their
own. Many of the economies of scope discussed in the context of vertical integra-
tion, corporate diversification, strategic alliances, and merger and acquisition
strategies can be created when firms operate across multiple businesses. These
same economies can also be created when firms operate across multiple geo-
graphic markets.
More generally, like all the strategies discussed in this book, to be valuable,
international strategies must enable a firm to exploit environmental opportunities
or neutralize environmental threats. To the extent that international strategies en-
able a firm to respond to its environment, they will also enable a firm to reduce its
costs or increase the willingness of its customers to pay compared to what would
have been the case if that firm did not pursue these strategies. Several potentially
valuable economies of scope particularly relevant for firms pursuing international
strategies are summarized in Table 11.1.
V R I O
1. To gain access to new customers for current products or services
2. To gain access to low-cost factors of production
3. To develop new core competencies
4. To leverage current core competencies in new ways
5. To manage corporate risk
TabLE 11.1 Potential Sources
of Economies of Scope for
Firms Pursuing International
Strategies
M11_BARN0088_05_GE_C11.INDD 331 13/09/14 4:12 PM

332 Part 3: Corporate Strategies
To Gain Access to New Customers
for Current Products or Services
The most obvious economy of scope that may motivate firms to pursue an inter-
national strategy is the potential new customers for a firm’s current products or
services that such a strategy might generate. To the extent that customers outside a
firm’s domestic market are willing and able to buy a firm’s current products or ser-
vices, implementing an international strategy can directly increase a firm’s revenues.
Internationalization and Firm Revenues
If customers outside a firm’s domestic market are willing and able to purchase its
products or services, then selling into these markets will increase the firm’s rev-
enues. However, it is not always clear that the products and services that a firm
sells in its domestic market will also sell in foreign markets.
a re nondomestic c ustomers Willing to Buy?
It may be the case that customer preferences vary significantly in a firm’s domes-
tic and foreign markets. These different preferences may require firms seeking to
internationalize their operations to substantially change their current products or
services before nondomestic customers are willing to purchase them.
This challenge faced many U.S. home appliance manufacturers as they
looked to expand their operations into Europe and Asia. In the United States, the
physical size of most home appliances (washing machines, dryers, refrigerators,
dishwashers, and so forth) has become standardized, and these standard sizes are
built into new homes, condominiums, and apartments. Standard sizes have also
emerged in Europe and Asia. However, these non-U.S. standard sizes are much
smaller than the U.S. sizes, requiring U.S. manufacturers to substantially retool
their manufacturing operations in order to build products that might be attractive
to Asian and European customers.1
Different physical standards can require a firm pursuing international
opportunities to change its current products or services to sell them into a non-
domestic market. Physical standards, however, can easily be measured and de-
scribed. Differences in tastes can be much more challenging for firms looking to
sell their products or services outside the domestic market.
The inability to anticipate differences in tastes around the world has some-
times led to very unfortunate, and often humorous, marketing blunders. For
example, General Motors once introduced the Chevrolet Nova to South America,
even though “No va” in Spanish means “it won’t go.” When Coca-Cola was first
introduced in China, it was translated into Ke-kou-ke-la, which turns out to mean
either “bite the wax tadpole” or “female horse stuffed with wax,” depending on
which dialect one speaks. Coca-Cola reintroduced its product with the name Ke-
kou-ko-le, which roughly translates into “happiness in the mouth.”
Coca-Cola is not the only beverage firm to run into problems internation-
ally. Pepsi’s slogan “Come alive with the Pepsi generation” was translated
into “Pepsi will bring your ancestors back from the dead” in Taiwan. In Italy, a
marketing campaign for Schweppes tonic water was translated into Schweppes
toilet water—not a terribly appealing drink. Bacardi developed a fruity drink
called “Pavian.” Unfortunately, “Pavian” means baboon in German. Coors used
its “Turn it loose” slogan when selling beer in Spain and Latin America.
Unfortunately, “Turn it loose” was translated into “Suffer from diarrhea.”
M11_BARN0088_05_GE_C11.INDD 332 13/09/14 4:12 PM

Chapter 11: International Strategies 333
Food companies have had similar problems. Kentucky Fried Chicken’s
slogan “Finger-lickin’ good” translates into “eat your fingers off” in Chinese.
In Arabic, the “Jolly Green Giant” translates into “Intimidating Green Ogre.”
Frank Perdue’s famous catch phrase—“It takes a tough man to make a tender
chicken”—takes on a slightly different meaning when translated into Spanish—
“It takes a sexually stimulated man to make a chicken affectionate.” And Gerber
found that it was unable to sell its baby food in Africa—with pictures of cute ba-
bies on the jar—because the tradition in Africa is to put pictures of what is inside
the jar on the label. Think about it.
Other marketing blunders include Colgate’s decision to introduce Cue
toothpaste in France, even though Cue is the name of a French pornographic
magazine; an American T-shirt manufacturer that wanted to print T-shirts in
Spanish that said “I saw the Pope” (el Papa) but instead printed T-shirts that said
“I saw the potato” (la papa); and Salem cigarettes, whose slogan “Salem—feeling
free” translated into Japanese as “When smoking Salem, you feel so refreshed that
your mind seems to be free and empty.” What were they smoking?
However, of all these blunders, perhaps none tops Electrolux—a
Scandinavian vacuum cleaner manufacturer. While its marketing slogan for the
U.S. market does rhyme—“Nothing sucks like an Electrolux”—it doesn’t really
communicate what the firm had in mind.2
It’s not just these marketing blunders that can limit sales in nondomestic
markets. For example, Yugo had difficulty selling its automobiles in the United
States. Apparently, U.S. consumers were unwilling to accept poor-performing,
poor-quality automobiles, despite their low price. Sony, despite its success in
Japan, was unable to carve out significant market share in the U.S. video market
with its Betamax technology. Most observers blame Sony’s reluctance to license
this technology to other manufacturers, together with the shorter recording time
available on Betamax, for this product failure. The British retail giant Marks and
Spencer’s efforts to enter the Canadian and U.S. retail markets with its traditional
mix of clothing and food stores also met with stiff consumer resistance.3
In order for the basis of an international strategy to attract new customers,
those products or services must address the needs, wants, and preferences of
customers in foreign markets at least as well as, if not better than, alternatives.
Firms pursuing international opportunities may have to implement many of
the cost-leadership and product differentiation business strategies discussed in
Chapters 4 and 5, modified to address the specific market needs of a nondomestic
market. Only then will customers in nondomestic markets be willing to buy a
firm’s current products or services.
a re nondomestic c ustomers a ble to Buy?
Customers in foreign markets might be willing to buy a firm’s current products or ser-
vices but be unable to buy them. This can occur for at least three reasons: inadequate
distribution channels, trade barriers, and insufficient wealth to make purchases.
Inadequate distribution channels may make it difficult, if not impossible, for
a firm to make its products or services available to customers outside its domestic
market. In some international markets, adequate distribution networks exist but
are tied up by firms already operating in these markets. Many European firms
face this situation as they try to enter the U.S. market. In such a situation, firms
pursuing international opportunities must either build their own distribution net-
works from scratch (a very costly endeavor) or work with a local partner to utilize
the networks that are already in place.
M11_BARN0088_05_GE_C11.INDD 333 13/09/14 4:12 PM

334 Part 3: Corporate Strategies
However, the problem facing some firms pursuing international opportunities
is not that distribution networks are tied up by firms already operating in a market.
Rather, the problem is that distribution networks do not exist or operate in ways
that are very different from the operation of the distribution networks in a firm’s
domestic market. This problem can be serious when firms seek to expand their op-
erations into developing economies. Inadequate transportation, warehousing, and
retail facilities can make it difficult to distribute a firm’s products or services into
a new geographic market. These kinds of problems have hampered investment in
Russia, China, and India. For example, when Nestlé entered the Chinese dairy mar-
ket, it had to build a network of gravel roads connecting the villages where dairy
farmers produce milk and factory collection points. Obtaining the right to build this
network of roads took 13 years of negotiations with Chinese government officials.4
Such distribution problems are not limited to developing economies. For
example, Japanese retail distribution has historically been much more fragmented,
and much less efficient, than the system that exists in either the United States or
Western Europe. Rather than being dominated by large grocery stores, discount re-
tail operations, and retail superstores, the Japanese retail distribution network has
been dominated by numerous small “mom-and-pop” operations. Many Western
firms find this distribution network difficult to use because its operating principles
are so different from what they have seen in their domestic markets. However,
Procter & Gamble and a few other firms have been able to crack open this Japanese
distribution system and exploit significant sales opportunities in Japan.5
Even if distribution networks exist in nondomestic markets and even if
international firms can operate through those networks if they have access to
them, it still might be the case that entry into these markets can be restricted by
various tariff and nontariff trade barriers. A list of such trade barriers is presented
in Table 11.2. Trade barriers, no matter what their specific form, have the effect

Tariffs: Taxes levied
on imported goods
or services
Quotas: Quantity
limits on the number
of products or services
that can be imported
Nontariff barriers: Rules,
regulations, and policies that
increase the cost of importing
products or services
Import duties Voluntary quotas Government policies
Supplemental duties Involuntary quotas Government procurement policies
Variable levies Restricted import
licenses
Government-sponsored exports
Subsidies Minimum import limits Domestic assistance programs
Border levies Embargoes Custom policies
Countervailing duties Valuation systems
Tariff classifications
Documentation requirements
Fees
Quality standards
Packaging standards
Labeling standards
TabLE 11.2 Tariffs, Quotas,
and Nontariff Trade Barriers
M11_BARN0088_05_GE_C11.INDD 334 13/09/14 4:12 PM

Chapter 11: International Strategies 335
of increasing the cost of selling a firm’s current products or services in a new
geographic market and thus make it difficult for a firm to realize this economy of
scope from its international strategy.
Despite a worldwide movement toward free trade and reduction in trade
barriers, trade barriers are still an important economic phenomenon for many
firms seeking to implement an international strategy. Japanese automobile manu-
facturers have faced voluntary quotas and various other trade barriers as they
have sought to expand their presence in the U.S. market; U.S. automobile firms
have argued that Japan has used a series of tariff and nontariff trade barriers to re-
strict their entry into the Japanese market. Kodak once asked the U.S. government
to begin negotiations to facilitate Kodak’s entry into the Japanese photography
market—a market that Kodak argued was controlled, through a government-
sanctioned monopoly, by Fuji. Historically, beginning operations in India was
hampered by a variety of tariff and nontariff trade barriers. Tariffs in India had
averaged more than 80 percent; foreign firms have been restricted to a 40 percent
ownership stake in their operations in India; and foreign imports had required
government approvals and licenses that could take up to three years to obtain.
Many of these trade barriers in India have been reduced but not eliminated. The
same is true for the United States. The tariff on imported goods and services im-
posed by the U.S. government reached an all-time high of 60 percent in 1932. It
averaged from 12 to 15 percent after the Second World War and now averages
about 5 percent for most imports into the United States. Thus, U.S. trade barriers
have been reduced but not eliminated.6
Governments create trade barriers for a wide variety of reasons: to raise
government revenue, to protect local employment, to encourage local produc-
tion to replace imports, to protect new industries from competition, to discour-
age foreign direct investment, and to promote export activity. However, for firms
seeking to implement international strategies, trade barriers, no matter why they
are erected, have the effect of increasing the cost of implementing these strategies.
Indeed, trade barriers can be thought of as a special case of artificial barriers to
entry, as discussed in Chapter 2. Such barriers to entry can turn what could have
been economically viable strategies into nonviable strategies.
Finally, customers may be willing but unable to purchase a firm’s current
products or services even if distribution networks are in place and trade barriers
are not making internationalization efforts too costly. If these customers lack the
wealth or sufficient hard currency to make these purchases, then the potential
value of this economy of scope can go unrealized.
Insufficient consumer wealth limits the ability of firms to sell products into
a variety of markets. For example, per capita gross national product is $270 in
Bangladesh, $240 in Chad, and $110 in the Congo. In these countries, it is unlikely
that there will be significant demand for many products or services originally
designed for affluent Western economies. This situation also exists in India. The
middle class in India is large and growing (164 million people with the highest
20 percent of income in 1998), but the income of this middle class is considerably
lower than the income of the middle class in other economies. These income levels
are sufficient to create demand for some consumer products. For example, Gillette
estimates the market in India for its shaving products could include 240 million
consumers, and Nestlé believes that the market in India for its noodles, ketchup,
and instant coffee products could include more than 100 million people. However,
the potential market for higher-end products in India is somewhat smaller. For
example, Bausch & Lomb believes that only about 30 million consumers in India
M11_BARN0088_05_GE_C11.INDD 335 13/09/14 4:12 PM

336 Part 3: Corporate Strategies
can afford to purchase its high-end sunglasses and soft contact lenses. The level
of consumer wealth is such an important determinant of the economic potential
of beginning operations in a new country that McDonald’s adjusts the number of
restaurants it expects to build in a new market by the per capita income of people
in that market.7
Even if there is sufficient wealth in a country to create market demand,
lack of hard currency can hamper internationalization efforts. Hard currencies
are currencies that are traded, and thus have value, on international money mar-
kets. When an international firm does business in a country with hard currency,
the firm can take whatever after-tax profits it earns in that country and translate
those profits into other hard currencies—including the currency of the country in
which the firm has headquarters. Moreover, because the value of hard currencies
can fluctuate in the world economy, firms can also manage their currency risk by
engaging in various hedging strategies in world money markets.
When firms begin operations in countries without hard currency, they
are able to obtain few of these advantages. Indeed, without hard currency, cash
payments to these firms are made with a currency that has essentially no value
When international firms engage in countertrade, they receive
payment for the products or services
they sell into a country, but not in the
form of currency. They receive pay-
ment in the form of other products
or services that they can sell on the
world market. Countertrade has been
a particularly important way by which
firms have tried to gain access to the
markets in the former Soviet Union.
For example, Marc Rich and Company
(a Swiss commodity-trading firm)
once put together the following deal:
Marc Rich purchased 70,000 tons of
raw sugar from Brazil on the open
market; shipped this sugar to Ukraine,
where it was refined; then transported
30,000 tons of refined sugar (after us-
ing some profits to pay the refiner-
ies) to Siberia, where it was sold for
130,000 tons of oil products that, in
turn, were shipped to Mongolia
in exchange for 35,000 tons of cop-
per concentrate, which was moved to
Kazakhstan, where it was refined into
copper and, finally, sold on the world
market to obtain hard currency. This
complicated countertrade deal is typi-
cal of the kinds of actions that inter-
national firms must take if they are to
engage in business in countries with-
out hard currency and if they desire to
extract their profits out of those coun-
tries. Indeed, countertrade in various
forms is actually quite common. One
estimate suggests that countertrade ac-
counts for between 10 and 20 percent
of world trade.
Although countertrade can en-
able a firm to begin operations in coun-
tries without hard currency, it can cre-
ate difficulties as well. In particular, in
order to do business, a firm must be
willing to accept payment in the form
of some good or commodity that it
must sell in order to obtain hard cur-
rency. This is not likely to be a problem
for a firm that specializes in buying
and selling commodities. However, a
firm that does not have this expertise
may find itself taking possession of
natural gas, sesame seeds, or rattan in
order to sell its products or services in
a country. If this firm has limited exper-
tise in marketing these kinds of com-
modities, it may have to use brokers
and other advisers to complete these
transactions. This, of course, increases
the cost of using countertrade as a way
to facilitate international operations.
Source: A. Ignatius (1993). “Commodity giant:
Marc Rich & Co. does big deals at big risk in
former U.S.S.R.” The Wall Street Journal, May 13,
p. A1; D. Marin (1990). “Tying in trade: Evidence
on countertrade.” World Economy, 13(3), p. 445.
Countertrade
Strategy in Depth
M11_BARN0088_05_GE_C11.INDD 336 13/09/14 4:12 PM

Chapter 11: International Strategies 337
outside the country where the payments are made. Although these payments can
be used for additional investments inside that country, an international firm has
limited ability to extract profits from countries without hard currencies and even
less ability to hedge currency fluctuation risks in this context. The lack of hard
currency has discouraged firms from entering a wide variety of countries at vari-
ous points in time despite the substantial demand for products and services in
those countries.8 One solution to this problem, called countertrade, is discussed
in the Strategy in Depth feature.
Internationalization and Product Life Cycles
Gaining access to new customers not only can directly increase a firm’s revenues
but also can enable a firm to manage its products or services through their life
cycle. A typical product life cycle is depicted in Figure 11.1. Different stages in
this life cycle are defined by different growth rates in demand for a product.
Thus, in the first emerging stage (called introduction in the figure), relatively few
firms are producing a product, there are relatively few customers, and the rate of
growth in demand for the product is relatively low. In the second stage (growth)
of the product life cycle, demand increases rapidly, and many new firms enter to
begin producing the product or service. In the third phase of the product life cycle
(maturity), the number of firms producing a product or service remains stable,
demand growth levels off, and firms direct their investment efforts toward refin-
ing the process by which a product or service is created and away from develop-
ing entirely new products. In the final phase of the product life cycle (decline), de-
mand drops off when a technologically superior product or service is introduced.9
From an international strategy perspective, the critical observation about
product life cycles is that a product or service can be at different stages of its life
cycle in different countries. Thus, a firm can use the resources and capabilities it
developed during a particular stage of the life cycle in its domestic market during
that same stage of the life cycle in a nondomestic market. This can substantially
enhance a firm’s economic performance.
One firm that has been very successful in managing its product life cycles
through its international efforts is Crown Cork & Seal. This firm had a traditional
In
tr
od
uc
tio
n
G
ro
w
th
M
at
ur
ity
Life cycle stages
In
du
st
ry
S
al
es
D
ec
lin
e
Figure 11.1 The
Product Life Cycle
M11_BARN0088_05_GE_C11.INDD 337 13/09/14 4:12 PM

338 Part 3: Corporate Strategies
strength in the manufacturing of three-piece metal containers when the introduction
of two-piece metal cans into the U.S. market rapidly made three-piece cans obsolete.
However, rather than abandoning its three-piece manufacturing technology, Crown
Cork & Seal moved many of its three-piece manufacturing operations overseas into
developing countries where demand for three-piece cans was just emerging. In this
way, Crown Cork & Seal was able to extend the effective life of its three-piece manu-
facturing operations and substantially enhance its economic performance.10
Internationalization and Cost Reduction
Gaining access to new customers for a firm’s current products or services can increase
a firm’s sales. If aspects of a firm’s production process are sensitive to economies of
scale, this increased volume of sales can also reduce the firm’s costs and enable the
firm to gain cost advantages in both its nondomestic and its domestic markets.
Many firms in the worldwide automobile industry have attempted to real-
ize manufacturing economies of scale through their international operations.
According to one estimate, the minimum efficient scale of a single compact-car
manufacturing plant is 400,000 units per year.11 Such a plant would produce
approximately 20 percent of all the automobiles sold in Britain, Italy, or France.
Obviously, to exploit this 400,000 car-per-year manufacturing efficiency, European
automobile firms have had to sell cars in more than just a single country market.
Thus, the implementation of an international strategy has enabled these firms to
realize an important manufacturing economy of scale.12
To Gain Access to Low-Cost Factors of Production
Just as gaining access to new customers can be an important economy of scope for
firms pursuing international opportunities, so is gaining access to low-cost factors
of production such as raw materials, labor, and technology.
Raw Materials
Gaining access to low-cost raw materials is, perhaps, the most traditional reason
why firms begin international operations. For example, in 1600, the British East
India Company was formed with an initial investment of $70,000 to manage
trade between England and the Far East, including India. In 1601, the third British
East India Company fleet sailed for the Indies to buy cloves, pepper, silk, coffee,
saltpeter, and other products. This fleet generated a return on investment of 234
percent. These profits led to the formation of the Dutch East India Company in
1602 and the French East India Company in 1664. Similar firms were organized
to manage trade in the New World. The Hudson Bay Company was chartered in
1670 to manage the fur trade, and the rival North West Company was organized
in 1784 for the same purpose. All these organizations were created to gain access
to low-cost raw materials that were available only in nondomestic markets.13
Labor
In addition to gaining access to low-cost raw materials, firms also begin inter-
national operations in order to gain access to low-cost labor. After World War II,
Japan had some of the lowest labor costs, and highest labor productivity, in the
M11_BARN0088_05_GE_C11.INDD 338 13/09/14 4:12 PM

Chapter 11: International Strategies 339
world. Over time, however, the improving Japanese economy and the increased
value of the yen have had the effect of increasing labor costs in Japan, and South
Korea, Taiwan, Singapore, and Malaysia all emerged as geographic areas with
inexpensive and highly productive labor. More recently, China, Mexico, and
Vietnam have taken this role in the world economy.14
There is little doubt that globaliza-tion has improved lives of both
producers in developing economies and
consumers in more developed econo-
mies. Individuals working in compa-
nies that make, for example, clothing
in countries like Bangladesh, China,
the Philippines, and Vietnam have jobs
that pay good wages—compared to al-
ternatives in those countries—and are
able to move their families out of ab-
ject poverty. Consumers in developed
economies are able to buy good quality
clothes at relatively low prices.
But this seemingly virtuous
trade is not without its personal and
social costs. A series of disasters in
factories in Bangladesh reminds us
that low-cost clothes for consumers
in developed countries can sometimes
be manufactured in grossly unsafe
factories in less-developed countries.
One fire in a Bangladeshi factory
killed 112 workers. At least some of
the fire escape doors built in this fac-
tory had been locked to prevent work-
ers from taking unauthorized breaks.
Then a complex of clothing facto-
ries in Bangladesh collapsed, killing
892 workers. It turns out that the top
four floors of this complex had been
built illegally without the proper per-
mits. And even though cracks in the
building led the manager of a bank
located on the first floor to close and
send all his employees home for their
safety, the owners of the factories in
the top floors insisted that their em-
ployees go to work. Shortly thereafter,
the building collapsed, and almost 900
people died.
These factories all produced
clothing for well-known U.S. and
Western European stores, including
H&M, Wal-Mart, Target, Benetton,
Primark (in the United Kingdom),
and Mango (in Spain)—to name just a
few. Indeed, because Bangladesh is the
second-largest producer of garments
in the world, behind China, it is very
likely that at least some of the clothing
that each of us wear each day is made
by Bangladeshi workers operating in
marginally safe factories.
Of course, these Western firms do
not have managers on site at these fac-
tories insisting that fire doors are locked
and unsafe buildings are built. Indeed,
after the building collapse, many firms
in developed economies pledged to
work with suppliers to ensure safer
working conditions. This will take some
time, of course. And, in the meantime, at
least some workers’ lives may be at risk.
For example, shortly after these firms
announced their commitment to im-
proved worker safety, a fire in another
Bangladeshi factory that makes clothing
for Wal-Mart, Benetton, and other com-
panies killed eight employees.
Some have argued that the in-
tense cost pressures put on Bangladeshi
factory owners by their developed
economy customers force these factory
owners to locate their factories in in-
expensive but dangerous locations. It
would be convenient for these factory
owners if all the blame for these ter-
rible tragedies could be placed on their
customers from developed countries—
and by implication on all who purchase
clothes from these retailers. Of course,
things are rarely that simple. While
these retail firms do put cost pressures
on their suppliers, it is the factory own-
ers and factory managers who lock fire
doors and insist on production in a
building that appears likely to collapse
at any time.
Nevertheless, the growing num-
ber of tragedies in Bangladesh, China,
and elsewhere in garment manufactur-
ing may require firms in developed
economies to rethink at least some as-
pects of their international business
strategies.
Sources: J. Yardley (2013). “Fire at Bangladeshi
factory kills eight.” NYTimes, May 9; J. Juliflar, A.
Monik, and J. Yardley (2013). “Building collapses in
Bangladesh, leaves scores dead.” NYTimes, April 24.
Ethics and Strategy
Manufacturing Tragedies and
International business
M11_BARN0088_05_GE_C11.INDD 339 13/09/14 4:12 PM

340 Part 3: Corporate Strategies
Numerous firms have attempted to gain the advantages of low labor costs
by moving their manufacturing operations. For example, Minebea, a Japanese
ball-bearing and semiconductor manufacturer, attempted to exploit low labor
costs by manufacturing ball bearings in Japan in the 1950s and early 1960s, in
Singapore in the 1970s, and since 1980 has been manufacturing them in Thailand.
Hewlett-Packard operates manufacturing and assembly operations in Malaysia
and Mexico, Japan’s Mitsubishi Motors opened an automobile assembly plant in
Vietnam, General Motors operates assembly plants in Mexico, and Motorola has
begun operations in China. All these investments were motivated, at least partly,
by the availability of low-cost labor in these countries.15 Some of the ethical is-
sues associated with the search for low-cost labor are discussed in the Ethics and
Strategy feature.
Although gaining access to low-cost labor can be an important determinant
of a firm’s international efforts, this access by itself is usually not sufficient to
motivate entry into particular countries. After all, relative labor costs can change
over time. For example, South Korea used to be the country in which most sports
shoes were manufactured. In 1990, Korean shoe manufacturers employed 130,000
workers in 302 factories. However, by 1993, only 80,000 Koreans were employed
in the shoe industry, and only 244 factories (most employing fewer than 100
people) remained. A significant portion of the shoe-manufacturing industry had
moved from Korea to China because of the labor-cost advantages of China (ap-
proximately $40 per employee per month) compared with Korea (approximately
$800 per employee per month).16
Moreover, low labor costs are not beneficial if a country’s workforce is
not able to produce high-quality products efficiently. In the sport shoe industry,
China’s access to some of the manufacturing technology and supporting indus-
tries (for example, synthetic fabrics) to efficiently produce high-end sports shoes
and high-technology hiking boots was delayed for several years. As a result,
Korea was able to maintain a presence in the shoe-manufacturing industry—even
though most of that industry had been outsourced to China.
One interesting example of firms gaining access to low-cost labor
through their international strategies is maquiladoras—manufacturing plants
that are owned by non-Mexican companies and operated in Mexico near the
U.S. border. The primary driver behind maquiladora investments is lower
labor costs than similar plants located in the United States. In addition, firms
exporting from maquiladoras to the United States have to pay duties only
on the value added that was created in Mexico; maquiladoras do not have to
pay Mexican taxes on the goods processed in Mexico; and the cost of land on
which plants are built in Mexico is substantially lower than would be the case
in the United States. However, a study by the Banco de Mexico suggests that
without the 20 percent cost-of-labor advantage, most maquildoras would not
be profitable.17
Technology
Another factor of production that firms can gain low-cost access to through op-
erations is technology. Historically, Japanese firms have tried to gain access to
technology by partnering with non-Japanese firms. Although the non-Japanese
firms have often been looking to gain access to new customers for their current
products or services by operating in Japan, Japanese firms have used this entry
into the Japanese market to gain access to foreign technology.18
M11_BARN0088_05_GE_C11.INDD 340 13/09/14 4:12 PM

Chapter 11: International Strategies 341
To Develop New Core Competencies
One of the most compelling reasons for firms to begin operations outside their
domestic markets is to refine their current core competencies and to develop new
core competencies. By beginning operations outside their domestic markets, firms
can gain a greater understanding of the strengths and weaknesses of their core
competencies. By exposing these competencies to new competitive contexts, tra-
ditional competencies can be modified, and new competencies can be developed.
Of course, for international operations to affect a firm’s core competencies,
firms must learn from their experiences in nondomestic markets. Moreover, once
these new core competencies are developed, they must be exploited in a firm’s
other operations in order to realize their full economic potential.
Learning from International Operations
Learning from international operations is anything but automatic. Many firms
that begin operations in a nondomestic market encounter challenges and difficul-
ties and then immediately withdraw from their international efforts. Other firms
continue to try to operate internationally but are unable to learn how to modify
and change their core competencies.
One study examined several strategic alliances in an effort to understand
why some firms in these alliances were able to learn from their international
operations, modify their core competencies, and develop new core competencies
while others were not. This study identified the intent to learn, the transparency
of business partners, and receptivity to learning as determinants of a firm’s ability
to learn from its international operations (see Table 11.3).
The intent to Learn
A firm that has a strong intent to learn from its international operations is more
likely to learn than a firm without this intent. Moreover, this intent must be com-
municated to all those who work in a firm’s international activities. Compare, for
example, a quote from a manager whose firm failed to learn from its international
operations with a quote from a manager whose firm was able to learn from these
operations.19
Our engineers were just as good as [our partner’s]. In fact, theirs were narrower
technically, but they had a much better understanding of what the company was
trying to accomplish. They knew they were there to learn; our people didn’t.
We wanted to make learning an automatic discipline. We asked the staff every
day, “What did you learn from [our partner] today?” Learning was carefully moni-
tored and recorded.
Obviously, the second firm was in a much better position than the first to learn
from its international operations and to modify its current core competencies and
1. The intent to learn
2. The transparency of business partners
3. Receptivity to learning
Source: G. Hamel (1991). “Competition for competence and inter-partner learning within international
strategic alliances.” Strategic Management Journal, 12, pp. 83–103.
TabLE 11.3 Determinants
of the Ability of a Firm to
Learn from Its International
Operations
M11_BARN0088_05_GE_C11.INDD 341 13/09/14 4:12 PM

342 Part 3: Corporate Strategies
develop new core competencies. Learning from international operations takes
place by design, not by default.
Transparency and Learning
It has also been shown that firms were more likely to learn from their interna-
tional operations when they interacted with what have been called transparent
business partners. Some international business partners are more open and ac-
cessible than others. This variance in accessibility can reflect different organiza-
tional philosophies, practices, and procedures, as well as differences in the culture
of a firm’s home country. For example, knowledge in Japanese and most other
Asian cultures tends to be context specific and deeply embedded in the broader
social system. This makes it difficult for many Western managers to understand
and appreciate the subtlety of Japanese business practices and Japanese culture.
This, in turn, limits the ability of Western managers to learn from their operations
in the Japanese market or from their Japanese partners.20
In contrast, knowledge in most Western cultures tends to be less context spe-
cific, less deeply embedded in the broader social system. Such knowledge can be
written down, can be taught in classes, and can be transmitted, all at a relatively
low cost. Japanese managers working in Western economies are more likely to be
able to appreciate and understand Western business practices and thus are more
able to learn from their operations in the West and from their Western partners.
r eceptivity to Learning
Firms also vary in their receptiveness to learning. A firm’s receptiveness to learn-
ing is affected by its culture, its operating procedures, and its history. Research
on organizational learning suggests that, before firms can learn from their inter-
national operations, they must be prepared to unlearn. Unlearning requires a
firm to modify or abandon traditional ways of engaging in business. Unlearning
can be difficult, especially if a firm has a long history of success using old pat-
terns of behavior and if those old patterns of behavior are reflected in a firm’s
organizational structure, its management control systems, and its compensation
policies.21
Even if unlearning is possible, a firm may not have the resources it needs
to learn. If a firm is using all of its available managerial time and talent, capital,
and technology just to compete on a day-to-day business, the additional task of
learning from international operations can go undone. Although managers in this
situation often acknowledge the importance of learning from their international
operations in order to modify their current core competencies or build new ones,
they simply may not have the time or energy to do so.22
The ability to learn from operations can also be hampered if managers
perceive that there is too much to be learned. It is often difficult for a firm to
understand how it can evolve from its current state to a position where it oper-
ates with new and more valuable core competencies. This difficulty is exacer-
bated when the distance between where a firm is and where it needs to be is
large. One Western manager who perceived this large learning gap after visiting
a state-of-the-art manufacturing facility operated by a Japanese partner was
quoted as saying:23
It’s no good for us to simply observe where they are today, what we have to find out
is how they got from where we are to where they are. We need to experiment and
learn with intermediate technologies before duplicating what they’ve done.
M11_BARN0088_05_GE_C11.INDD 342 13/09/14 4:12 PM

Chapter 11: International Strategies 343
Leveraging New Core Competencies in additional Markets
Once a firm has been able to learn from its international operations and modify its
traditional core competencies or develop new core competencies, it must then le-
verage those competencies across its operations, both domestic and international,
in order to realize their full value. Failure to leverage these “lessons learned” can
substantially reduce the return associated with implementing an international
strategy.
To Leverage Current Core Competencies
in New Ways
International operations can also create opportunities for firms to leverage their
traditional core competencies in new ways. This ability is related to, though dif-
ferent from, using international operations to gain access to new customers for
a firm’s current products or services. When firms gain access to new customers
for their current products, they often leverage their domestic core competencies
across country boundaries. When they leverage core competencies in new ways,
they not only extend operations across country boundaries but also leverage their
competencies across products and services in ways that would not be economi-
cally viable in their domestic market.
Consider, for example, Honda. There is widespread agreement that Honda
has developed core competencies in the design and manufacture of power trains.
Honda has used this core competence to facilitate entry into a variety of product
markets—including motorcycles, automobiles, and snow blowers—both in its
domestic Japanese market and in nondomestic markets such as the United States.
However, Honda has begun to explore some competence-leverage opportunities
in the United States that are not available in the Japanese market. For example,
Honda has begun to design and manufacture lawn mowers of various sizes for
the home in the U.S. market—lawn mowers clearly build on Honda’s traditional
power train competence. However, given the crowded living conditions in Japan,
consumer demand for lawn mowers in that country has never been very great.
Lawns in the United States, however, can be very large, and consumer demand
for high-quality lawn mowers in that market is substantial. The opportunity for
Honda to begin to leverage its power train competencies in the sale of lawn mow-
ers to U.S. homeowners exists only because Honda operates outside its Japanese
home market.
To Manage Corporate Risk
The value of risk reduction for firms pursuing a corporate diversification strategy
was evaluated previously. It was suggested that, although diversified operations
across businesses with imperfectly correlated cash flows can reduce a firm’s risk,
outside equity holders can manage this risk more efficiently on their own by in-
vesting in a diversified portfolio of stocks. Consequently equity holders have little
direct interest in hiring managers to operate a diversified portfolio of businesses,
the sole purpose of which is risk diversification.
Similar conclusions apply to firms pursuing international strategies—with two
qualifications. First, in some circumstances, it may be difficult for equity holders in
M11_BARN0088_05_GE_C11.INDD 343 13/09/14 4:12 PM

344 Part 3: Corporate Strategies
one market to diversify their portfolio of investments across multiple markets. To the
extent that such barriers to diversification exist for individual equity holders but not
for firms pursuing international strategies, risk reduction can directly benefit equity
holders. In general, whenever barriers to international capital flows exist, individual
investors may not be able to diversify their portfolios across country boundaries op-
timally. In this context, individual investors can indirectly diversify their portfolio of
investments by purchasing shares in diversified multinationals.24
Firms whose ownership is domi-nated by a single family are surpris-
ingly common around the world. In
the United States, for example, Marriott,
Walgreens, Wrigley, Alberto-Culver,
Campbell Soup, Dell, and Wal-Mart are
all family dominated. However, only
four of the 20 largest firms in the United
States are family dominated, and only
one of the 20 largest firms in the United
Kingdom is family dominated.
Though not uncommon in the
United States and the United Kingdom,
family-dominated firms are the rule,
not the exception, in most economies
around the world. For example, in New
Zealand, nine of the 20 largest firms
are family dominated; in Argentina,
13 of the 20 largest firms are family
dominated; and in Mexico, all 20 of
the 20 largest firms are family domi-
nated. In many countries, including
Argentina, Belgium, Canada, Denmark,
Greece, Hong Kong, Israel, Mexico,
New Zealand, Portugal, Singapore,
South Korea, Sweden, and Switzerland,
more than one-third of the largest 20
firms are dominated by family owners.
A variety of explanations of why
family-dominated firms continue to be
an important part of the world econ-
omy have been proposed. For example,
some researchers have argued that fam-
ily owners obtain private benefits of
ownership—over and above the finan-
cial benefits they might receive. Such
private benefits include high social sta-
tus in their countries. Other researchers
have argued that family ownership
helps guarantee that family members
will be able to control their property
in countries with less-well-developed
property rights. And still others have
argued that concentrated family own-
ers help a firm gain political clout in its
negotiations with the government.
On the positive side, family own-
ership may reduce conflicts that might
otherwise arise between a firm’s manag-
ers and its outside equity holders—the
agency costs discussed in the Strategy
in Depth feature in Chapter 8. Managers
of family firms are “playing with”
their own money, not “other people’s
money,” and thus are less likely to pur-
sue strategies that benefit themselves
but hurt the firm’s owners because they
are the firm’s owners.
On the negative side, family firms
may become starved for capital, and
especially equity capital. Non-family
members will often be reluctant to in-
vest in family firms because the inter-
ests of the family are often likely to take
precedence over the interests of outsid-
ers. Also, family firms must limit their
search for senior leadership to family
members. It may well be the case that
the best leaders of a family firm are
not members of the family, but fam-
ily ownership can prevent a firm from
gaining access to the entire labor mar-
ket. Finally, for reasons explained in the
text, family firms may need to pursue a
broad diversification strategy in order
to reduce the risk borne by their fam-
ily owners. As suggested in Chapter 8,
such unrelated diversification strategies
can sometimes be difficult to manage.
From a broader perspective, the
importance of family-dominated firms
throughout the world suggests that the
“standard” model of corporate gover-
nance—with numerous anonymous
stockholders, an independent board of
directors, and senior managers chosen
only for their ability to lead and create
economic value—may not apply that
broadly. This approach to corporate
governance, so dominant in the United
States and the United Kingdom, may
actually be the exception, not the rule.
Sources: R. Morck and B. Yeung (2004).
“Family control and the rent-seeking society.”
Entrepreneurship: Theory and Practice, Summer,
pp. 391–409; R. LaPorta, F. Lopez-de-salina,
A. Shleifer, and R. Vishny (1999). “Corporate
ownership around the world.” Journal of Finance, 54,
pp. 471–520; J. Weber, L. Lavelle, T. Lowry, W.
Zellner, and A. Barrett (2003). “Family, Inc.,”
BusinessWeek, November 10, pp. 100+.
Family Firms in the Global Economy
Research Made Relevant
M11_BARN0088_05_GE_C11.INDD 344 13/09/14 4:12 PM

Chapter 11: International Strategies 345
Second, large privately held firms may find it in their wealth maximizing
interests to broadly diversify to reduce risk. In order to gain the risk reduction
advantages of diversifying their investments by owning a portfolio of stocks, the
owners of these firms would have to “cash out” their ownership position in their
firm—by, for example, taking their firm public—and then use this cash to invest
in a portfolio of stocks. However, these individuals may gain other advantages
from owning their firms and may not want to cash out. In this setting, the only
way that owners can gain the risk-reducing benefits of broad diversification is for
the firm that they own to broadly diversify.
This justification of diversification for risk reduction purposes is particu-
larly relevant in the international context because, as described in the Research
Made Relevant feature, many of the economies of countries around the world are
dominated by private companies owned by large families. Not surprisingly, these
family-owned firms tend to be much more diversified than the publicly traded
firms that are more common in the United States and the United Kingdom.
The Local Responsiveness/International
Integration Trade-Off
As firms pursue the economies of scope listed in Table 11.1, they constantly face
a trade-off between the advantages of being responsive to market conditions in
their nondomestic markets and the advantages of integrating their operations
across the multiple markets in which they operate.
On the one hand, local responsiveness can help firms be successful in ad-
dressing the local needs of nondomestic customers, thereby increasing demand
for a firm’s current products or services. Moreover, local responsiveness enables
a firm to expose its traditional core competencies to new competitive situations,
thereby increasing the chances that those core competencies will be improved or
will be augmented by new core competencies. Finally, detailed local knowledge is
essential if firms are going to leverage their traditional competencies in new ways
in their nondomestic markets. Honda was able to begin exploiting its power train
competencies in the U.S. lawn mower market only because of its detailed knowl-
edge of, and responsiveness to, that market.
On the other hand, the full exploitation of the economies of scale that can be
created by selling a firm’s current products or services in a nondomestic market
often can occur only if there is tight integration across all the markets in which a
firm operates. Gaining access to low-cost factors of production can not only help a
firm succeed in a nondomestic market but also help it succeed in all its markets—
as long as those factors of production are used by many parts of the international
firm. Developing new core competencies and using traditional core competencies
in new ways can certainly be beneficial in a particular domestic market. However,
the full value of these economies of scope is realized only when they are trans-
ferred from a particular domestic market into the operations of a firm in all its
other markets.
Traditionally, it has been thought that firms have to choose between local
responsiveness and international integration. For example, firms like CIBA-
Geigy (a Swiss chemical company), Nestlé (a Swiss food company), and Phillips
(a Dutch consumer electronics firm) have chosen to emphasize local responsive-
ness. Nestlé, for example, owns nearly 8,000 brand names worldwide. However,
M11_BARN0088_05_GE_C11.INDD 345 13/09/14 4:12 PM

346 Part 3: Corporate Strategies
of those 8,000 brands, only 750 are registered in more than one country, and
only 80 are registered in more than 10 countries. Nestlé adjusts its product at-
tributes to the needs of local consumers, adopts brand names that resonate with
those consumers, and builds its brands for long-run profitability by country. For
example, in the United States, Nestlé’s condensed milk carries the brand name
“Carnation” (obtained through the acquisition of the Carnation Company); in
Asia, this same product carries the brand name “Bear Brand.” Nestlé delegates
brand management authority to country managers, who can (and do) adjust tra-
ditional marketing and manufacturing strategies in accordance with local tastes
and preferences. For example, Nestlé’s Thailand management group dropped
traditional coffee-marketing efforts that focused on taste, aroma, and stimula-
tion and instead began selling coffee as a drink that promotes relaxation and ro-
mance. This marketing strategy resonated with Thais experiencing urban stress,
and it prompted Nestlé coffee sales in Thailand to jump from $25 million to $100
million four years later.25
Of course, all this local responsiveness comes at a cost. Firms that emphasize
local responsiveness are often unable to realize the full value of the economies of
scope and scale that they could realize if their operations across country borders
were more integrated. Numerous firms have focused on appropriating this eco-
nomic value and have pursued a more integrated international strategy. Examples
of such firms include IBM, General Electric, Toyota Motor Corporation, and most
major pharmaceutical firms, to name just a few.
Internationally integrated firms locate business functions and activities
in countries that have a comparative advantage in these functions or activities.
For example, the production of components for most consumer electronics is
research intensive, capital intensive, and subject to significant economies of
scale. To manage component manufacturing successfully, most internationally
integrated consumer electronics firms have located their component operations
in technologically advanced countries like the United States and Japan. Because
the assembly of these components into consumer products is labor intensive,
most internationally integrated consumer electronics firms have located their as-
sembly operations in countries with relatively low labor costs, including Mexico
and China.
Of course, one of the costs of locating different business functions and activi-
ties in different geographic locations is that these different functions and activi-
ties must be coordinated and integrated. Operations in one country might very
efficiently manufacture certain components. However, if the wrong components
are shipped to the assembly location or if the right components are shipped at the
wrong time, any advantages that could have been obtained from exploiting the
comparative advantages of different countries can be lost. Shipping costs can also
reduce the return on international integration.
To ensure that the different operations in an internationally integrated firm
are appropriately coordinated, these firms typically manufacture more standard-
ized products, using more standardized components, than do locally responsive
firms. Standardization enables these firms to realize substantial economies of
scale and scope, but it can limit their ability to respond to the specific needs of
individual markets. When international product standards exist, as in the per-
sonal computer industry and the semiconductor chip industry, such standard-
ization is not problematic. Also, when local responsiveness requires only a few
modifications of a standardized product (for example, changing the shape of the
electric plug or changing the color of a product), international integration can be
M11_BARN0088_05_GE_C11.INDD 346 13/09/14 4:12 PM

Chapter 11: International Strategies 347
very effective. However, when local responsiveness requires a great deal of local
knowledge and product modifications, international integration can create prob-
lems for a firm pursuing an international strategy.
The Transnational Strategy
Recently, it has been suggested that the traditional trade-off between international
integration and local responsiveness can be replaced by a transnational strategy
that exploits all the advantages of both international integration and local respon-
siveness.26 Firms implementing a transnational strategy treat their international
operations as an integrated network of distributed and interdependent resources
and capabilities. In this context, a firm’s operations in each country are not simply
independent activities attempting to respond to local market needs; they are also
repositories of ideas, technologies, and management approaches that the firm
might be able to use and apply in its other international operations. Put differently,
operations in different countries can be thought of as “experiments” in the creation
of new core competencies. Some of these experiments will work and generate
important new core competencies; others will fail to have such benefits for a firm.
When a particular country operation develops a competence in manufactur-
ing a particular product, providing a particular service, or engaging in a particu-
lar activity that can be used by other country operations, the country operation
with this competence can achieve international economies of scale by becoming
the firm’s primary supplier of this product, service, or activity. In this way, lo-
cal responsiveness is retained as country managers constantly search for new
competencies that enable them to maximize profits in their particular markets,
and international integration and economies are realized as country operations
that have developed unique competencies become suppliers for all other country
operations.
Managing a firm that is attempting to be both locally responsive and inter-
nationally integrated is not an easy task. Some of these organizational challenges
are discussed later in this chapter.
Financial and Political Risks in Pursuing
International Strategies
There is little doubt that the realization of the economies of scope listed in
Table 11.1 can be a source of economic value for firms pursuing international strat-
egies. However, the nature of international strategies can create significant risks
that these economies of scope will never be realized. Beyond the implementation
problems (to be discussed later in this chapter), both financial circumstances and
political events can significantly reduce the value of international strategies.
Financial Risks: Currency Fluctuation and Inflation
As firms begin to pursue international strategies, they may begin to expose them-
selves to financial risks that are less obvious within a single domestic market.
In particular, currency fluctuations can significantly affect the value of a firm’s
international investments. Such fluctuations can turn what had been a losing
M11_BARN0088_05_GE_C11.INDD 347 13/09/14 4:12 PM

348 Part 3: Corporate Strategies
investment into a profitable investment (the good news). They can also turn what
had been a profitable investment into a losing investment (the bad news). In ad-
dition to currency fluctuations, different rates of inflation across countries can
require very different managerial approaches, business strategies, and accounting
practices. Certainly, when a firm first begins international operations, these finan-
cial risks can seem daunting.
Fortunately, it is now possible for firms to hedge most of these risks through
the use of a variety of financial instruments and strategies. The development of
money markets, together with growing experience in operating in high-inflation
economies, has substantially reduced the threat of these financial risks for firms
pursuing international strategies. Of course, the benefits of these financial tools
and experience in high-inflation environments do not accrue to firms automati-
cally. Firms seeking to implement international strategies must develop the re-
sources and capabilities they will need to manage these financial risks. Moreover,
these hedging strategies can do nothing to reduce the business risks that firms
assume when they enter into nondomestic markets. For example, it may be the
case that consumers in a nondomestic market simply do not want to purchase a
firm’s products or services, in which case this economy of scope cannot be real-
ized. Moreover, these financial strategies cannot manage political risks that can
exist for firms pursuing an international strategy.
Political Risks
The political environment is an important consideration in all strategic decisions.
Changes in the political rules of the game can have the effect of increasing some
environmental threats and reducing others, thereby changing the value of a firm’s
resources and capabilities. However, the political environment can be even more
problematic as firms pursue international strategies.
Types of Political r isks
Politics can affect the value of a firm’s international strategies at the macro and
micro levels. At the macro level, broad changes in the political situation in a coun-
try can change the value of an investment. For example, after the Second World
War, nationalist governments came to power in many countries in the Middle
East. These governments expropriated for little or no compensation many of the
assets of oil and gas companies located in their countries. Expropriation of foreign
company assets also occurred when the Shah of Iran was overthrown, when a
communist government was elected in Chile, and when new governments came
to power in Angola, Ethiopia, Peru, Zambia, and, more recently, Venezuela and
Bolivia.27
Government upheaval and the attendant risks to international firms are facts
of life in some countries. Consider, for example, oil-rich Nigeria. From 1960–1999,
Nigeria has experienced several successful coups d’états, one civil war, two civil
governments, and six military regimes.28 The prudent course of action for firms
engaging in business activities in Nigeria is to expect the current government to
change and to plan accordingly.
Quantifying Political r isks
Political scientists have attempted to quantify the political risk that firms seek-
ing to implement international strategies are likely to face in different countries.
Although different studies vary in detail, the country attributes listed in Table 11.4
M11_BARN0088_05_GE_C11.INDD 348 13/09/14 4:12 PM

Chapter 11: International Strategies 349
summarize most of the important determinants of political risk for firms pursu-
ing international strategies.29 Firms can apply the criteria listed in the table by
evaluating the political and economic conditions in a country and by adding up
the scores associated with these conditions. For example, a country that has a very
unstable political system (14 points), a great deal of control of the economic system
(9 points), and significant import restrictions (10 points) represents more political
risk than a country that does not have these attributes.
Increments to Country
Risk If Risk Factor Is: Low High
The political economic environment
1. Stability of the political system 3 14
2. Imminent internal conflicts 0 14
3. External threats to stability 0 12
4. Degree of control of the economic system 5 9
5. Reliability of country as a trade partner 4 12
6. Constitutional guarantees 2 12
7. Effectiveness of public administration 3 12
8. Labor relations and social peace 3 15
Domestic economic conditions
1. Size of the population 4 8
2. Per capita income 2 10
3. Economic growth over the past five years 2 7
4. Potential growth over the next three years 3 10
5. Inflation over the past two years 2 10
6. Availability of domestic capital markets to outsiders 3 7
7. Availability of high-quality local labor force 2 8
8. Possibility of employing foreign nationals 2 8
9. Availability of energy resources 2 14
10. Environmental pollution legal requirements 4 8
11. Transportation and communication infrastructure 2 14
External economic relations
1. Import restrictions 2 10
2. Export restrictions 2 10
3. Restrictions on foreign investments 3 9
4. Freedom to set up or engage in partnerships 3 9
5. Legal protection for brands and products 3 9
6. Restrictions on monetary transfers 2 8
7. Revaluation of currency in the past five years 2 7
8. Balance-of-payments situation 2 9
9. Drain on hard currency through energy imports 3 14
10. Financial standing 3 8
11. Restrictions on the exchange of local and foreign currencies 2 8
Source: Adapted from E. Dichtl and H. G. Koeglmayr (1986). “Country risk ratings.” Management Review,
26(4), pp. 2–10. Reprinted with permission.
TabLE 11.4 Quantifying
Political Risks from International
Operations
M11_BARN0088_05_GE_C11.INDD 349 13/09/14 4:12 PM

350 Part 3: Corporate Strategies
Managing Political r isk
Unlike financial risks, there are relatively few tools for managing the political
risks associated with pursuing an international strategy. Obviously, one option
would be to pursue international opportunities only in countries where political
risk is very small. However, it is often the case that significant business oppor-
tunities exist in politically risky countries precisely because they are politically
risky. Alternatively, firms can limit their investment in politically risky environ-
ments. However, these limited investments may not enable a firm to take full
advantage of whatever economies of scope might exist by engaging in business in
that country.
Another approach to managing political risk is to see each of the determi-
nants of political risk, listed in Table 11.4, as negotiation points as a firm enters
into a new country market. In many circumstances, those in a nondomestic mar-
ket have just as much an interest in seeing a firm begin doing business in a new
market as does the firm contemplating entry. International firms can sometimes
use this bargaining power to negotiate entry conditions that reduce, or even neu-
tralize, some of the sources of political risk in a country. Of course, no matter how
skilled a firm is in negotiating these entry conditions, a change of government or
changes in laws can quickly nullify any agreements.
A third approach to managing political risk is to turn this risk from a threat
into an opportunity. One firm that has been successful in this way is Schlumberger,
an international oil services company. Schlumberger has headquarters in New York,
Paris, and the Caribbean; it is a truly international company. Schlumberger manage-
ment has adopted a policy of strict neutrality in interactions with governments in
the developing world. Because of this policy, Schlumberger has been able to avoid
political entanglements and continues to do business where many firms find the
political risks too great. Put differently, Schlumberger has developed valuable, rare,
and costly-to-imitate resources and capabilities in managing political risks and is
using these resources to generate high levels of economic performance.30
Research on the Value of International Strategies
Overall, research on the economic consequences of implementing international
strategies is mixed. Some research has found that the performance of firms pursu-
ing international strategies is superior to the performance of firms operating only
in domestic markets.31 However, most of this work has not examined the particu-
lar economies of scope that a firm is attempting to realize through its internation-
alization efforts. Moreover, several of these studies have attempted to evaluate
the impact of international strategies on firm performance by using accounting
measures of performance. Other research has found that the risk-adjusted perfor-
mance of firms pursuing an international strategy is not different from the risk-
adjusted performance of firms pursuing purely domestic strategies.32
These ambivalent findings are not surprising because the economic value of
international strategies depends on whether a firm pursues valuable economies of
scope when implementing this strategy. Most of this empirical work fails to exam-
ine the economies of scope that a firm’s international strategy might be based on.
Moreover, even if a firm is able to realize real economies of scope from its interna-
tional strategies, to be a source of sustained competitive advantage, this economy
of scope must also be rare and costly to imitate, and the firm must be organized to
fully realize it.
M11_BARN0088_05_GE_C11.INDD 350 13/09/14 4:12 PM

Chapter 11: International Strategies 351
International Strategies and Sustained
Competitive Advantage
As suggested earlier in this chapter, much of the discussion of rarity and imitabil-
ity in strategic alliance, diversification, and merger and acquisition strategies also
applies to international strategies. However, some aspects of rarity and imitability
are unique to international strategies.
The Rarity of International Strategies
In many ways, it seems likely that international strategies are becoming less rare
among most competing firms. Consider, for example, the increasingly interna-
tional strategies of many telephone companies around the world. Through much
of the 1980s, telecommunications remained a highly regulated industry around
the world. Phone companies rarely ventured beyond their country borders and
had few, if any, international aspirations. However, as government restrictions on
telecommunications firms around the world began to be lifted, these firms began
exploring new business alternatives. For many firms, this originally meant ex-
ploring new telecommunications businesses in their domestic markets. Thus, for
example, many formerly regulated telecommunications firms in the United States
began to explore business opportunities in less-regulated segments of the U.S.
telecommunications market, including cellular telephones and paging. Over time,
these same firms began to explore business opportunities overseas.
In the past several years, the telecommunications industry has begun to
consolidate on a worldwide basis. For example, in the early 1990s, Southwestern
Bell (now AT&T) purchased a controlling interest in Mexico’s government-owned
telecommunications company. Ameritech (now a division of AT&T), Bell Atlantic,
U.S. West, BellSouth, and Pacific Telesis (now a division of AT&T) also engaged in
various international operations. In the late 1990s, MCI (a U.S. firm) and British
Telecom (a British company) merged. In 1999, the Vodafone Group (a British-
headquartered telecommunications company) purchased AirTouch Cellular (a
U.S. firm) for $60.29 billion, formed a strategic alliance with U.S. West (another
U.S. firm), purchased Mannesmann (a German telecommunications firm) for
$127.76 billion, and increased its ownership interest in several smaller telecom-
munications companies around the world. Also, in 1999, Olivetti (the Italian
electronics firm) successfully beat back Deutsche Telephone’s effort to acquire
ItaliaTelecom (the Italian telephone company). And, in 2012, the Japanese mo-
bile phone company Softbank purchased the U.S. phone company SprintNextel.
Obviously, international strategies are no longer rare among telecommunications
companies.33
There are, of course, several reasons for the increased popularity of inter-
national strategies. Not the least of these are the substantial economies of scope
that internationalizing firms can realize. In addition, several changes in the orga-
nization of the international economy have facilitated the growth in popularity of
international strategies. For example, the General Agreement on Tariff and Trade
(GATT) treaty, in conjunction with the development of the European Community
(EC), the Andean Common Market (ANCOM), the Association of Southeast Asian
Nations (ASEAN), the North American Free Trade Agreement (NAFTA), and
other free-trade zones, has substantially reduced both tariff and nontariff barriers
to trade. These changes have helped facilitate trade among countries included in
V R I O
M11_BARN0088_05_GE_C11.INDD 351 13/09/14 4:12 PM

352 Part 3: Corporate Strategies
an agreement; they have also spurred firms that wish to take advantage of these
opportunities to expand their operations into these countries.
Improvements in the technological infrastructure of business are also im-
portant contributors to the growth in the number of firms pursuing international
strategies. Transportation (especially air travel) and communication (via comput-
ers, fax, telephones, pagers, cellular telephones, and so forth) have evolved to
the point where it is now much easier for firms to monitor and integrate their
international operations than it was just a few years ago. This infrastructure helps
reduce the cost of implementing an international strategy and thus increases the
probability that firms will pursue these opportunities.
Finally, the emergence of various communication, technical, and accounting
standards is facilitating international strategies. For example, there is currently a
de facto world standard in personal computers. Moreover, most of the software
that runs off these computers is flexible and interchangeable. Someone can write
a report on a PC in India and print that report out on a PC in France with no real
difficulties. There is also a world de facto standard business language: English.
Although fully understanding a non-English–speaking culture requires manag-
ers to learn the native tongue, it is nevertheless possible to manage international
business operations by using English.
Even though it seems that more and more firms are pursuing international
strategies, it does not follow that these strategies will never be rare among a set
of competing firms. Rare international strategies can exist in at least two ways.
Given the enormous range of business opportunities that exist around the globe,
it may very well be the case that huge numbers of firms can implement interna-
tional strategies and still not compete head to head when implementing these
strategies.
Even if several firms are competing to exploit the same international op-
portunity, the rarity criterion can still be met if the resources and capabilities that
a particular firm brings to this international competition are themselves rare.
Examples of these rare resources and capabilities might include unusual market-
ing skills, highly differentiated products, special technology, superior manage-
ment talent, and economies of scale.34 To the extent that a firm pursues one of the
economies of scope listed in Table 11.1 using resources and capabilities that are
rare among competing firms, that firm can gain at least a temporary competitive
advantage, even if its international strategy, per se, is not rare.
The Imitability of International Strategies
Like all the strategies discussed in this book, both the direct duplication of and
substitutes for international strategies are important in evaluating the imitability
of these actions.
Direct Duplication of international strategies
In evaluating the possibility of the direct duplication of international strategies,
two questions must be asked: (1) Will firms try to duplicate valuable and rare
international strategies? and (2) Will firms be able to duplicate these valuable and
rare strategies?
There seems little doubt that, in the absence of artificial barriers, the profits
generated by one firm’s valuable and rare international strategies will motivate
other firms to try to imitate the resources and capabilities required to implement
these strategies. This is what has occurred in the international telecommunications
V R I O
M11_BARN0088_05_GE_C11.INDD 352 13/09/14 4:12 PM

Chapter 11: International Strategies 353
industry. This rush to internationalization has occurred in numerous other indus-
tries as well. For example, the processed-food industry at one time had a strong
home-market orientation. However, because of the success of Nestlé and Procter
& Gamble worldwide, most processed-food companies now engage in at least
some international operations.
However, simply because competing firms often try to duplicate a success-
ful firm’s international strategy does not mean that they are always able to do so.
To the extent that a successful firm exploits resources or capabilities that are path
dependent, uncertain, or socially complex in its internationalization efforts, direct
duplication may be too costly, and thus international strategies can be a source of
sustained competitive advantage. Indeed, there is some reason to believe that at
least some of the resources and capabilities that enable a firm to pursue an inter-
national strategy are likely to be costly to imitate.
For example, the ability to develop detailed local knowledge of nondomestic
markets may require firms to have management teams with a great deal of foreign
experience. Some firms may have this kind of experience in their top manage-
ment teams; other firms may not. One survey of 433 chief executive officers from
around the world reported that 14 percent of U.S. chief executive officers (CEOs)
had no foreign experience and that the foreign experience of 56 percent of U.S.
CEOs was limited to vacation travel. Another survey showed that only 22 percent
of the CEOs of multinational companies had extensive international experience.35
Of course, it can take a great deal of time for a firm that does not have much for-
eign experience in its management team to develop that experience. Firms that
lack this kind of experience will have to bring managers in from outside the orga-
nization, invest in developing this experience internally, or both. Of course, these
activities are costly. The cost of creating this experience base in a firm’s manage-
ment team can be thought of as one of the costs of direct duplication.
s ubstitutes for international s trategies
Even if direct duplication of a firm’s international strategies is costly, substitutes
might still exist that limit the ability of that strategy to generate sustained com-
petitive advantages. In particular, because international strategies are just a spe-
cial case of corporate strategies in general, any of the other corporate strategies
discussed in this book—including some types of strategic alliances, diversifica-
tion, and mergers and acquisitions—can be at least partial substitutes for interna-
tional strategies.
For example, it may be possible for a firm to gain at least some of the econo-
mies of scope listed in Table 11.1 by implementing a corporate diversification
strategy within a single country market, especially if that market is large and geo-
graphically diverse. One such market, of course, is the United States. A firm that
originally conducted business in the northeastern United States can gain many of
the benefits of internationalization by beginning business operations in the south-
ern United States, on the West Coast, or in the Pacific Northwest. In this sense,
geographic diversification within the United States is at least a partial substitute
for internationalization and is one reason why many U.S. firms have lagged be-
hind European and Asian firms in their international efforts.
There are, however, some economies of scope listed in Table 11.1 that can be
gained only through international operations. For example, because there are usu-
ally few limits on capital flows within most countries, risk management is directly
valuable to a firm’s equity holders only for firms pursuing business opportunities
across countries where barriers to capital flow exist.
M11_BARN0088_05_GE_C11.INDD 353 13/09/14 4:12 PM

354 Part 3: Corporate Strategies
The Organization of International Strategies
To realize the full economic potential of a valuable, rare, and costly-to-imitate
international strategy, firms must be appropriately organized.
becoming International: Organizational Options
A firm implements an international strategy when it diversifies its business oper-
ations across country boundaries. However, firms can organize their international
business operations in a wide variety of ways. Some of the most common, rang-
ing from market forms of governance to manage simple export operations to the
use of wholly owned subsidiaries to manage foreign direct investment, are listed
in Table 11.5.
Market exchanges and international strategies
Firms can maintain traditional arm’s-length market relationships between them-
selves and their nondomestic customers and still implement international strate-
gies. They do this by simply exporting their products or services to nondomestic
markets and limiting any foreign direct investment into nondomestic markets. Of
course, exporting firms generally have to work with some partner or partners to
receive, market, and distribute their products in a nondomestic setting. However,
it is possible for exporting firms to use contracts to manage their relationship
with these foreign partners and thereby maintain arm’s-length relationships with
them—all the time engaging in international operations.
The advantages of adopting exporting as a way to manage an international
strategy include its relatively low cost and the limited risk exposure that firms
pursuing international opportunities in this manner face. Firms that are just be-
ginning to consider international strategies can use market-based exporting to
test international waters—to find out if there is demand for their current products
or services, to develop some experience operating in nondomestic markets, or to
begin to develop relationships that could be valuable in subsequent international
strategy efforts. If firms discover that there is not much demand for their products
or services in a nondomestic market or if they discover that they do not have the
resources and capabilities to effectively compete in those markets, they can sim-
ply cease their exporting operations. The direct cost of ceasing export operations
can be quite low, especially if a firm’s volume of exports is small and the firm has
not invested in plant and equipment designed to facilitate exporting. Certainly, if
a firm has limited its foreign direct investment, it does not risk losing this invest-
ment if it ceases export operations.
However, the opportunity costs associated with restricting a firm’s interna-
tional operations to exporting can be significant. Of the economies of scope listed
in Table 11.1, only gaining access to new customers for a firm’s current products
Intermediate
Market Governance Market Governance Hierarchical Governance
Exporting Licensing Mergers
Non-equity alliances Acquisitions
Equity alliances Wholly owned subsidiaries
Joint ventures
TabLE 11.5 Organizing
Options for Firms Pursuing
International Strategies
V R I O
M11_BARN0088_05_GE_C11.INDD 354 13/09/14 4:12 PM

Chapter 11: International Strategies 355
or services can be realized through exporting. Other economies of scope that hold
some potential for firms exploring international business operations are out of the
reach of firms that restrict their international operations to exporting. For some
firms, realizing economies from gaining access to new customers is sufficient, and
exporting is a long-run viable strategy. However, to the extent that other econo-
mies of scope might exist for a firm, limiting international operations to exporting
can limit the firm’s economic profit.
intermediate Market exchanges and international strategies
If a firm decides to move beyond exporting in pursuing international strategies, a
wide range of strategic alliances are available. These alliances range from simple
licensing arrangements, where a domestic firm grants a firm in a nondomestic
market the right to use its products and brand names to sell products in that
nondomestic market, to full-blown joint ventures, where a domestic firm and a
nondomestic firm create an independent organizational entity to manage interna-
tional efforts. As suggested in Chapter 9, the recent growth in the number of firms
pursuing strategic alliance strategies is a direct result of the growth in popularity
of international strategies. Strategic alliances are one of the most common ways
that firms manage their international efforts.
Most of the discussion of the value, rarity, imitability, and organization of
strategic alliances in Chapter 9 applies to the analysis of strategic alliances to
implement an international strategy. However, many of the opportunities and
challenges of managing strategic alliances as cooperative strategies, discussed in
Chapter 9, are exacerbated in the context of international strategic alliances.
For example, it was suggested that opportunistic behavior (in the form of
adverse selection, moral hazard, or holdup) can threaten the stability of strategic
alliances domestically. Opportunistic behavior is a problem because partners in a
strategic alliance find it costly to observe and evaluate the performance of alliance
partners. Obviously, the costs and difficulty of evaluating the performance of an
alliance partner in an international alliance are greater than the costs and diffi-
culty of evaluating the performance of an alliance partner in a purely domestic al-
liance. Geographic distance, differences in traditional business practices, language
barriers, and cultural differences can make it very difficult for firms to accurately
evaluate the performance and intentions of international alliance partners.
These challenges can manifest themselves at multiple levels in an inter-
national strategic alliance. For example, one study has shown that managers in
U.S. organizations, on average, have a negotiation style very different from that
of managers in Chinese organizations. Chinese managers tend to interrupt each
other and ask many more questions during negotiations than do U.S. managers.
As U.S. and Chinese firms begin to negotiate collaborative agreements, it will be
difficult for U.S. managers to judge whether the Chinese negotiation style reflects
Chinese managers’ fundamental distrust of U.S. managers or is simply a manifes-
tation of traditional Chinese business practices and culture.36
Similar management style differences have been noted between Western
and Japanese managers. One Western manager was quoted:37
Whenever I made a presentation [to our partner], I was one person against 10 or
12. They’d put me in front of a flip chart, and then stop me while they went into a
conversation in Japanese for 10 minutes. If I asked them a question they would break
into Japanese to first decide what I wanted to know, and then would discuss options
in terms of what they might tell me, and finally would come back with an answer.
M11_BARN0088_05_GE_C11.INDD 355 13/09/14 4:12 PM

356 Part 3: Corporate Strategies
During those 10-minute breaks in the conversation, it would be very difficult for
this manager to know whether the Japanese managers were trying to develop
a complete and accurate answer to his question or scheming to provide an in-
complete and misleading answer. In this ambiguous setting, to prevent potential
opportunism, Western managers might demand greater levels of governance
than were actually necessary. In fact, one study has shown that differences in the
perceived trustworthiness of international partners have an impact on the kind
of governance mechanisms that are put into place when firms begin international
operations. If partners are not perceived as being trustworthy, then elaborate gov-
ernance devices, including joint ventures, are created—even if the partners are in
fact trustworthy.38
Cultural and style conflicts leading to perceived opportunism problems are
not restricted to alliances between Asian and Western organizations. U.S. firms
operating with Mexican partners often discover numerous subtle and complex
cultural differences. For example, a U.S. firm operating a steel conveyor plant
in Puebla, Mexico, implemented a three-stage employee grievance policy. An
employee who had a grievance first went to the immediate supervisor and then
continued up the chain of command until the grievance was resolved one way or
another. U.S. managers were satisfied with this system and pleased that no griev-
ances had been registered—until the day the entire plant walked out on strike. It
turns out that there had been numerous grievances, but Mexican workers had felt
uncomfortable directly confronting their supervisors with these problems. Such
confrontations are considered antisocial in Mexican culture.39
Although significant challenges are associated with managing strategic al-
liances across country boundaries, there are significant opportunities as well.
Strategic alliances can enable a firm pursuing an international strategy to realize
any of the economies of scope listed in Table 11.1. Moreover, if a firm is able to de-
velop valuable, rare, and costly to imitate resources and capabilities in managing
strategic alliances, the use of alliances in an international context can be a source
of sustained competitive advantage.
h ierarchical g overnance and international strategies
Firms may decide to integrate their international operations into their organi-
zational hierarchies by acquiring a firm in a nondomestic market or by forming
a new wholly owned subsidiary to manage their operations in a nondomestic
market. Obviously, both of these international investments involve substantial
direct foreign investment by a firm over long periods of time. These investments
are subject to both political and economic risks and should be undertaken only
if the economy of scope that can be realized through international operations is
significant and other ways of realizing this economy of scope are not effective
or efficient.
Although full integration in international operations can be expensive and
risky, it can have some important advantages for internationalizing firms. First,
like strategic alliances, this approach to internationalization can enable a firm to
realize any of the economies of scope listed in Table 11.1. Moreover, integration en-
ables managers to use a wider range of organizational controls to limit the threat of
opportunism that are normally not available in market forms of international gov-
ernance or intermediate market forms of international governance. Finally, unlike
strategic alliances, where any profits from international operations must be shared
with international partners, integrating into international operations enables firms
to capture all the economic profits from their international operations.
M11_BARN0088_05_GE_C11.INDD 356 13/09/14 4:12 PM

Chapter 11: International Strategies 357
Managing the internationally Diversified Firm
Not surprisingly, the management of international operations can be thought of as
a special case of managing a diversified firm. Thus, many of the issues discussed
in Chapter 8 apply here. However, managing an internationally diversified firm
does create some unique challenges and opportunities.
Organizational s tructure. Firms pursuing an international strategy have four ba-
sic organizational structural alternatives, listed in Table 11.6 and discussed later.
Although each of these structures has some special features, they are all special
cases of the multidivisional structure first introduced in Chapter 8.40
Some firms organize their international operations as a decentralized fed-
eration. In this organizational structure, each country in which a firm operates is
organized as a full profit-and-loss division headed by a division general manager
who is typically the president of the company in a particular country. In a de-
centralized federation, there are very few shared activities or other relationships
among different divisions/country companies, and corporate headquarters plays
a limited strategic role. Corporate staff functions are generally limited to the col-
lection of accounting and other performance information from divisions/country
companies and to reporting this aggregate information to appropriate govern-
ment officials and to the financial markets. Both strategic and operational decision
making are delegated to division general managers/country company presidents
in a decentralized federation organizational structure. There are relatively few
examples of pure decentralized federations in today’s world economy, but firms
like Nestlé, CIBA-Geigy, and Electrolux have many of the attributes of this type of
structure.41
A second structural option for international firms is the coordinated fed-
eration. In a coordinated federation, each country operation is organized as
a full profit-and-loss center, and division general managers can be presidents
of country companies. However, unlike the case in a decentralized federation,
strategic and operational decisions are not fully delegated to division general
managers. Operational decisions are delegated to division general managers/
country presidents, but broader strategic decisions are made at corporate head-
quarters. Moreover, coordinated federations attempt to exploit various shared
activities and other relationships among their divisions/country companies. It is
Decentralized federation Strategic and operational decisions are delegated to
divisions/country companies.
Coordinated federation Operational decisions are delegated to divisions/
country companies; strategic decisions are
retained at corporate headquarters.
Centralized hub Strategic and operational decisions are retained at
corporate headquarters.
Transnational structure Strategic and operational decisions are delegated
to those operational entities that maximize
responsiveness to local conditions and
international integration.
Source: Adapted from C. A. Bartlett and S. Ghoshal (1989). Managing across borders: The transnational solution.
Boston: Harvard Business School Press.
TabLE 11.6 Structural
Options for Firms Pursuing
International Strategies
M11_BARN0088_05_GE_C11.INDD 357 13/09/14 4:12 PM

358 Part 3: Corporate Strategies
not uncommon for coordinated federations to have corporately sponsored central
research and development laboratories, corporately sponsored manufacturing
and technology development initiatives, and corporately sponsored management
training and development operations. There are numerous examples of coordi-
nated federations in today’s world economy, including General Electric, General
Motors, IBM, and Coca-Cola.
A third structural option for international firms is the centralized hub. In
centralized hubs, operations in different companies may be organized into profit-
and-loss centers, and division general managers may be country company presi-
dents. However, most of the strategic and operational decision making in these
firms takes place at the corporate center. The role of divisions/country companies
in centralized hubs is simply to implement the strategies, tactics, and policies that
have been chosen at headquarters. Of course, divisions/country companies are
also a source of information for headquarters staff when these decisions are being
made. However, in centralized hubs, strategic and operational decision rights are
retained at the corporate center. Many Japanese and Korean firms are managed as
centralized hubs, including Toyota, Mitsubishi, and NEC in Japan and Goldstar,
Daewoo, and Hyundai in Korea.42
A fourth structural option for international firms is the transnational structure.
This structure is most appropriate for implementing the transnational strategy de-
scribed earlier in this chapter. In many ways, the transnational structure is similar
to the coordinated federation. In both, strategic decision-making responsibility is
largely retained at the corporate center, and operational decision making is largely
delegated to division general managers/country presidents. However, important
differences also exist.
In a coordinated federation structure, shared activities and other cross-
divisional/cross-country economies of scope are managed by the corporate
center. Thus, for many of these firms, if research and development is seen as
a potentially valuable economy of scope, a central research and development
laboratory is created and managed by the corporate center. In the transnational
structure, these centers of corporate economies of scope may be managed by
the corporate center. However, they are more likely to be managed by specific
divisions/country companies within the corporation. Thus, for example, if
one division/country company develops valuable, rare, and costly-to-imitate
research-and-development capabilities in its ongoing business activities in a
particular country, that division/country company could become the center of
research-and-development activity for the entire corporation. If one division/
country company develops valuable, rare, and costly-to-imitate manufacturing
technology development skills in its ongoing business activities in a particular
country, that division/country company could become the center for manufac-
turing technology development for the entire corporation.
The role of corporate headquarters in a transnational structure is to con-
stantly scan business operations across different countries for resources and capa-
bilities that might be a source of competitive advantage for other divisions/coun-
try companies in the firm. Once these special skills are located, corporate staff
must then determine the best way to exploit these economies of scope—whether
they should be developed within a single division/country company (to gain
economies of scale) and then transferred to other divisions/country companies,
or developed through an alliance between two or more divisions/country compa-
nies (to gain economies of scale) and then transferred to other divisions/country
M11_BARN0088_05_GE_C11.INDD 358 13/09/14 4:12 PM

Chapter 11: International Strategies 359
companies, or developed for the entire firm at corporate headquarters. These op-
tions are not available to decentralized federations (which always let individual
divisions/country companies develop their own competencies), coordinated
federations, or centralized hubs (which always develop corporate-wide econo-
mies of scope at the corporate level). Firms that have been successful in adopt-
ing this transnational structure include Ford (Ford Europe has become a leader
for automobile design in all of the Ford Motor Company) and Ericson (Ericson’s
Australian subsidiary developed this Swedish company’s first electronic telecom-
munication switch, and corporate headquarters was able to help transfer this
technology to other Ericson subsidiaries).43
Organizational s tructure, Local r esponsiveness, and international integration. It
should be clear that the choice among these four approaches to managing in-
ternational strategies depends on the trade-offs that firms are willing to make
between local responsiveness and international integration. Firms that seek to
maximize their local responsiveness will tend to choose a decentralized fed-
eration structure. Firms that seek to maximize international integration in their
operations will typically opt for centralized hub structures. Firms that seek to
balance the need for local responsiveness and international integration will typi-
cally choose centralized federations. Firms that attempt to optimize both local
responsiveness and international integration will choose a transnational organi-
zational structure.
Management c ontrol s ystems and c ompensation Policies. Like the multidivisional
structure discussed in Chapter 8, none of the organizational structures described
in Table 11.5 can stand alone without the support of a variety of management
control systems and management compensation policies. All the management
control processes discussed in Chapter 8, including evaluating the performance of
divisions, allocating capital, and managing the exchange of intermediate products
among divisions, are also important for firms organizing to implement an inter-
national strategy. Moreover, the same management compensation challenges and
opportunities discussed in that chapter apply in the organization of international
strategies as well.
However, as is often the case when organizing processes originally devel-
oped to manage diversification within a domestic market are extended to the
management of international diversification, many of the management challenges
highlighted in Chapter 8 are exacerbated in an international context. This puts an
even greater burden on senior managers in an internationally diversified firm to
choose control systems and compensation policies that create incentives for divi-
sion general managers/country presidents to appropriately cooperate to realize
the economies of scope that originally motivated the implementation of an inter-
national strategy.
Summary
International strategies can be seen as a special case of diversification strategies. Firms
implement international strategies when they pursue business opportunities that cross
country borders. Like all diversification strategies, international strategies must exploit real
economies of scope that outside investors find too costly to exploit on their own in order to
M11_BARN0088_05_GE_C11.INDD 359 13/09/14 4:12 PM

360 Part 3: Corporate Strategies
be valuable. Five potentially valuable economies of scope in international strategies are (1)
to gain access to new customers for a firm’s current products or services, (2) to gain access
to low-cost factors of production, (3) to develop new core competencies, (4) to leverage cur-
rent core competencies in new ways, and (5) to manage corporate risk.
As firms pursue these economies of scope, they must evaluate the extent to which
they can be responsive to local market needs and obtain the advantages of international
integration. Firms that attempt to accomplish both these objectives are said to be imple-
menting a transnational strategy. Both economic and political risks can affect the value of
a firm’s international strategies.
To be a source of sustained competitive advantage, a firm’s international strategies
must be valuable, rare, and costly to imitate, and the firm must be organized to realize
the full potential of its international strategies. Even though more and more firms are
pursuing international strategies, these strategies can still be rare, for at least two rea-
sons: (1) Given the broad range of international opportunities, firms may not compete
head to head with other firms pursuing the same international strategies that they are
pursuing; and (2) firms may bring valuable and rare resources and capabilities to the
international strategies they pursue. Both direct duplication and substitution can affect
the imitability of a firm’s international strategy. Direct duplication is not likely when
firms bring valuable, rare, and costly to imitate resources and capabilities to bear in their
international strategies. Several substitutes for international strategies exist, including
some strategic alliances, vertical integration, diversification, and mergers and acquisi-
tions, especially if these strategies are pursued in a large and diverse single country
market. However, some potential economies of scope from international strategies can be
exploited only by operating across country borders.
Firms have several organizational options as they pursue international strategies,
including market forms of exchange (for example, exports), strategic alliances, and verti-
cal integration (for example, wholly owned subsidiaries). Four alternative structures,
all special cases of the multidivisional structure introduced in Chapter 8, can be used
to manage these international operations: a decentralized federation structure, a coor-
dinated federation structure, a centralized hub structure, and a transnational structure.
These structures need to be consistent with a firm’s emphasis on being responsive to lo-
cal markets, on exploiting international integration opportunities, or both.
MyManagementLab®
Go to mymanagementlab.com to complete the problems marked with this icon .
Challenge Questions
11.1. Are international strategies
always just a special case of diversi-
fication strategies that a firm might
pursue?
11.2. In international
expansion, companies are more
exposed to currency risks than
domestic organizations. Describe
the basic mechanics of this
exposure and how firms can
guard against it.
11.3. Investing abroad is always
risky for companies; external macro-
environmental factors are elements that
a firm has little or no control over. When
participating in foreign direct invest-
ment (FDI) especially in jurisdictions
with left wing governments, political
risks can be particularly heightened.
Identify and discuss some of these risks.
11.4. The transnational strategy is
often seen as one way in which firms
can avoid the limitations inherent in
the local responsiveness/international
integration trade-off. However, given
the obvious advantages of being both
locally responsive and internationally

M11_BARN0088_05_GE_C11.INDD 360 13/09/14 4:12 PM

Chapter 11: International Strategies 361
integrated, why are apparently only
a relatively few firms implementing a
transnational strategy?
11.5. Can a firm’s transnational strat-
egy be a source of sustained competi-
tive advantage?
11.6. On average, why is the threat
of adverse selection and moral hazard
in strategic alliances greater for firms
pursuing an international strategy or a
domestic strategy?
11.7. How are the organizational
options for implementing an in-
ternational strategy related to the
M-form structure described in
Chapter 8?
11.8. Are international organiza-
tional options for implementing an
international strategy just special
cases of the M-form structure, with
slightly different emphases, or are
these international organizational
options fundamentally different from
the M-form structure?
Problem Set
11.9. Countries participate in cross border trade to exchange goods otherwise not available
in their own countries, at a price, quality or variety level as demanded by customers. Unless
countries are members of the World Trade Organization (WTO), governments may take
unilateral steps to frustrate the import of goods, usually for the protection of domestic indus-
tries. List the potential actions that governments can take to impede or prevent foreign com-
panies from competing in their country and the reasons, besides protectionism, for doing so.
11.10. Your firm has decided to begin selling its mining machinery products in Ghana.
Unfortunately, there is not a highly developed trading market for currency in Ghana.
However, Ghana does have significant exports of cocoa. Describe a process by which you
would be able to sell your machines in Ghana and still translate your earnings into a trad-
able currency (e.g., dollars or euros).
11.11. Match the actions of these firms with their sources of potential value.

(a) Tata Motors (India) acquires Jaguar (United Kingdom).
(b) Microsoft (United States) opens four research and de-
velopment centers in Europe.
(c) Disney opens Disney–Hong Kong.
(d) Merck forms a research and development alliance with
an Indian pharmaceutical firm.
(e) Lenovo purchases IBM’s laptop computer business.
(f) Honda Motor Company opens an automobile manu-
facturing plant in southern China. Most of the cars it
produces are sold in China.
(g) Honda starts exporting cars made in its China plant to
Japan.
(h) A Canadian gold mining company acquires an
Australian opal mining company.
1. Managing corporate risk
2. New core competencies
3. Leveraging current core competencies in new ways
4. Gaining access to low-cost factors of production
5. New customers for current products or services
MyManagementLab®
Go to mymanagementlab.com for the following Assisted-graded writing questions:
11.12. How can we measure the political risks associated with international strategies?
11.13. How does internationalization affect product life cycles?
M11_BARN0088_05_GE_C11.INDD 361 13/09/14 4:12 PM

362 Part 3: Corporate Strategies
End Notes
1. See Yoshino, M., S. Hall, and T. Malnight. (1991). “Whirlpool Corp.”
Harvard Business School Case no. 9-391-089.
2. 258marketing.wordpress.com/2008/02/27/bad-ads-nothing-sucks-
like-an-electrolux/. Accessed June 17, 2009.
3. See Perry, N. J. (1991). “Will Sony make it in Hollywood?” Fortune,
September 9, pp. 158–166; and Montgomery, C. (1993). “Marks and
Spencer Ltd. (A),” Harvard Business School Case no. 9-391-089.
4. See Rapoport, C. (1994). “Nestlé’s brand building machine.” Fortune,
September 19, pp. 147–156.
5. See Yoshino, M. Y., and P. Stoneham. (1992). “Procter & Gamble Japan
(A).” Harvard Business School Case no. 9-793-035.
6. See Davis, B. (1995). “U.S. expects goals in pact with Japan to be met
even without overt backing.” The Wall Street Journal, June 30, p. A3;
Bounds, W., and B. Davis. (1995). “U.S. to launch new case against
Japan over Kodak.” The Wall Street Journal, June 30, p. A3; Jacob, R.
(1992). “India is opening for business.” Fortune, November 16,
pp. 128–130; and Rugman, A., and R. Hodgetts. (1995). Business:
A strategic management approach. New York: McGraw-Hill.
7. See Jacob, R. (1992). “India is opening for business.” Fortune,
November 16, pp. 128–130; Serwer, A. E. (1994). “McDonald’s con-
quers the world.” Fortune, October 17, pp. 103–116; and World Bank
(1999). World development report. Oxford: Oxford University Press.
8. See Jacob, R. (1992). “India is opening for business.” Fortune,
November 16, pp. 128–130; Ignatius, A. (1993). “Commodity giant:
Marc Rich & Co. does big deals at big risk in former U.S.S.R.” The Wall
Street Journal, May 13, p. A1; and Kraar, L. (1995). “The risks are rising
in China.” Fortune, March 6, pp. 179–180.
9. The life cycle is described in Utterback, J. M., and W. J. Abernathy.
(1975). “A dynamic model of process and product innovation.” Omega,
3, pp. 639–656; Abernathy, W. J., and J. M. Utterback. (1978). “Patterns
of technological innovation.” Technology Review, 80, pp. 40–47; and
Grant, R. M. (1991). Contemporary strategy analysis. Cambridge, MA:
Basil Blackwell.
10. See Bradley, S. P., and S. Cavanaugh. (1994). “Crown Cork and Seal in
1989.” Harvard Business School Case no. 9-793-035; and Hamermesh,
R. G., and R. S. Rosenbloom. (1989). “Crown Cork and Seal Co., Inc.”
Harvard Business School Case no. 9-388-096. Of course, this strategy
works only until nondomestic markets mature. This occurred for
Crown Cork & Seal during the 1990s. Since then, it has had to search
elsewhere for growth opportunities.
11. Porter, M. E. (1986). “Competition in international industries: A con-
ceptual framework.” In M. E. Porter (ed.), Competition in International
Industries. Boston: Harvard Business School Press, p. 43; and Ghoshal, S.
(1987). “Global strategy: An organizing framework.” Strategic
Management Journal, 8, p. 436.
12. See Kobrin, S. (1991). “An empirical analysis of the determinants of
global integration.” Strategic Management Journal, 12, pp. 17–31.
13. See Trager, J. (1992). The people’s chronology. New York: Henry Holt.
14. Kraar, L. (1992). “Korea’s tigers keep roaring.” Fortune, May 4,
pp. 108–110.
15. See Collis, D. J. (1991). “A resource-based analysis of international
competition: The case of the bearing industry.” Strategic Management
Journal, 12 (Summer Special Issue), pp. 49–68; and Engardio, P. (1993).
“Motorola in China: A great leap forward.” Business Week, May 17,
pp. 58–59.
16. Gain, S. (1993). “Korea is overthrown as sneaker champ.” The Wall
Street Journal, October 7, p. A14.
17. See Reibstein, L., and M. Levinson. (1991). “A Mexican miracle?”
Newsweek, May 20, p. 42; and de Forest, M. E. (1994). “Thinking of a
plant in Mexico?” Academy of Management Executive, 8(1), pp. 33–40.
18. See Zimmerman, M. (1985). How to do business with the Japanese. New
York: Random House; and Osborn, R. N., and C. C. Baughn. (1987).
“New patterns in the formation of US/Japan cooperative ventures:
The role of technology.” Columbia Journal of World Business, 22,
pp. 57–65.
19. Ibid.
20. See Benedict, R. (1946). The chrysanthemum and the sword. New York:
New American Library; Peterson, R. B., and H. F. Schwind. (1977).
“A comparative study of personnel problems in companies and joint
ventures in Japan.” Journal of Business Studies, 8(1), pp. 45–55; Peterson,
R. B., and J. Y. Shimada. (1978). “Sources of management problems in
Japanese-American joint ventures.” Academy of Management Review, 3,
pp. 796–804; and Hamel, G. (1991). “Competition for competence and
inter-partner learning within strategic alliances.” Strategic Management
Journal, 12, pp. 83–103.
21. See Burgleman, R. A. (1983). “A process model of internal corpo-
rate venturing in the diversified major firm.” Administrative Science
Quarterly, 28(2), pp. 223–244; Hedberg, B. L. T. (1981). “How organiza-
tions learn and unlearn.” In P. C. Nystrom and W. H. Starbuck (eds.),
Handbook of Organizational Design. London: Oxford University Press;
Nystrom, P. C., and W. H. Starbuck. (1984). “To avoid organizational cri-
sis, unlearn.” Organizational Dynamics, 12(4), pp. 53–65; and Argyris, C.,
and D. A. Schon. (1978). Organizational learning. Reading, MA:
Addison-Wesley.
22. A problem described in Burgleman, R. A. (1983). “A process model
of internal corporate venturing in the diversified major firm.”
Administrative Science Quarterly, 28(2), pp. 223–244.
23. Quoted in Hamel, G. (1991). “Competition for competence and
inter-partner learning within strategic alliances.” Strategic Management
Journal, 12, p. 97.
24. See Agmon, T., and D. R. Lessard. (1977). “Investor recognition of
corporate diversification.” The Journal of Finance, 32, pp. 1049–1056.
25. Rapoport, C. (1994). “Nestlé’s brand building machine.” Fortune,
September 19, pp. 147–156.
26. See Bartlett, C. A., and S. Ghoshal. (1989). Managing across borders: The
transnational solution. Boston, MA: Harvard Business School Press.
27. See Rugman, A., and R. Hodgetts. (1995). International business: A strategic
management approach. New York: McGraw-Hill.
28. Glynn, M. A. (1993). “Strategic planning in Nigeria versus U.S.: A case
of anticipating the (next) coup.” Academy of Management Executive, 7(3),
pp. 82–83.
29. Dichtl, E., and H. G. Koeglmayr. (1986). “Country risk ratings.”
Management International Review, 26(4), pp. 2–10.
30. See Auletta, K. (1983). “A certain poetry—Parts I and II.” The New
Yorker, June 6, pp. 46–109; and June 13, pp. 50–91.
31. See, for example, Leftwich, R. B. (1974). “U.S. multinational compa-
nies: Profitability, financial leverage and effective income tax rates.”
Survey of Current Business, 54, May, pp. 27–36; Dunning, J. H. (1973).
“The determinants of production.” Oxford Economic Papers, 25,
November, pp. 289–336; Errunza, V., and L. W. Senbet. (1981). “The
effects of international operations on the market value of the firm:
Theory and evidence.” The Journal of Finance, 36, pp. 401–418; Grant,
R. M. (1987). “Multinationality and performance among British manu-
facturing companies.” Journal of International Business Studies, 18 (Fall),
pp. 78–89; and Rugman, A. (1979). International diversification and the
multinational enterprise. Lexington, MA: Lexington Books.
32. See, for example, Brewer, H. L. (1981). “Investor benefits from corpo-
rate international diversification,” Journal of Financial and Quantitative
Analysis, 16, March, pp. 113–126; and Michel, A., and I. Shaked. (1986).
“Multinational corporations vs. domestic corporations: Financial perfor-
mance and characteristics,” Journal of Business, 17 (Fall), pp. 89–100.
33. Kirkpatrick, D. (1993). “Could AT&T rule the world?” Fortune, May 17,
pp. 54–56; Deogun, N. (2000). “Europe catches merger fever as interna-
tional volume sets record.” The Wall Street Journal, January 3, p. R8.
34. See Caves, R. E. (1971). “International corporations: The industrial eco-
nomics of foreign investment.” Economica, 38, Feb. pp. 1–28; Dunning,
J. H. (1973). “The determinants of production.” Oxford Economic Papers,
25, Nov., pp. 289–336; Hymer, S. (1976). The international operations
of national firms: A study of direct foreign investment. Cambridge, MA:
The MIT Press; Errunza, V., and L. W. Senbet. (1981). “The effects of
international operations on the market value of the firm: Theory and
evidence.” The Journal of Finance, 36, pp. 401–418.
35. Anders, G. (1989). “Going global: Vision vs. reality.” The Wall Street
Journal, September 22, p. R21; Carpenter, M., G. Sanders, and
H. Gregerson. (2001). “Building human capital with organizational
context: The impact of assignment experience on multinational firm
performance and CEO pay.” Academy of Management Journal, vol. 44
no. 3, pp. 493–511.
M11_BARN0088_05_GE_C11.INDD 362 13/09/14 4:12 PM

Chapter 11: International Strategies 363
36. Adler, N., J. R. Brahm, and J. L. Graham. (1992). “Strategy imple-
mentation: A comparison of face-to-face negotiations in the People’s
Republic of China and the United States.” Strategic Management
Journal, 13, pp. 449–466.
37. Hamel, G. (1991). “Competition for competence and inter-partner
learning within international strategic alliances.” Strategic Management
Journal, 12, p. 95.
38. Shane, S. (1994). “The effect of national culture on the choice between
licensing and direct foreign investment.” Strategic Management Journal,
15, pp. 627–642.
39. See de Forest, M. E. (1994). “Thinking of a plant in Mexico?” Academy
of Management Executive, 8(1), pp. 33–40.
40. See Bartlett, C. A. (1986). “Building and managing the transnational:
The new organizational challenge.” In M. E. Porter (ed.), Competition in
international industries. Boston: Harvard Business School Press,
pp. 367–401; and Bartlett, C. A., and S. Ghoshal. (1989). Managing
across borders; The transnational solution. Boston: Harvard Business
School Press.
41. See Baden-Fuller, C. W. F., and J. M. Stopford. (1991). “Globalization
frustrated: The case of white goods.” Strategic Management Journal, 12,
pp. 493–507.
42. See Kraar, L. (1992). “Korea’s tigers keep roaring.” Fortune, May 4,
pp. 108–110.
43. Bartlett, C. A., and S. Ghoshal. (1989). Managing across borders: The
transnational solution. Boston: Harvard Business School Press; Grant,
R. M. (1991). Contemporary strategy analysis. Cambridge, MA: Basil
Blackwell.
M11_BARN0088_05_GE_C11.INDD 363 13/09/14 4:12 PM

M11_BARN0088_05_GE_C11.INDD 364 13/09/14 4:12 PM

soon, call Moss, and ask her clarifying questions about her
e-mail. Her mind raced through the details of the proposed
outsourcing strategy she had submitted to Moss last week.
She quizzed herself:
■ “Did my team and I make a strong enough case for pro-
posing almost a 100 percent increase in the amount of
volume to be outsourced?”
■ “Will eBay management concur with our recommen-
dation to begin outsourcing potentially sensitive risk-
related inquires for the first time?”
■ “How will senior management react to the addition of
a second outsourcing vendor?”
■ “Did we cover adequately the types of proposed vol-
umes targeted and how these would be transitioned to
the outsourcing vendors?”
■ “In the event of a major vendor problem, systems is-
sue, or natural disaster, how executable is our back-out
plan?”
■ “Will the data in our proposal allay the growing con-
cerns among executives about offshore outsourcing
altogether?”
She wondered, “How would eBay senior managers
react to our proposal to reorganize and expand outsourc-
ing in a new three-tiered approach? And would they even
consider expansion in light of recent headlines about com-
panies reducing the amount of work outsourced to India
because of quality issues?”
This last question had perplexed her for several
months. Not only was it a personal issue for Dalton—she
felt her job security at eBay depended largely on the com-
pany’s continuing commitment to offshore outsourcing—
but one she recognized as a business practice whose time
perhaps had come and gone. Several leading consultants
were claiming that offshoring had lost much of its cachet
in recent years as companies were coming to grips with the
real costs, logistics, management commitment, and service
quality associated with third-party partners in India, the
Philippines, and elsewhere. In her proposal, Dalton had
p a r t 3 c a s e s
C a s e 3 – 1 : e-B a y ’ s O u t s o u r c i n g
S t r a t e g y *
“If we are to continue outsourcing, and even consider ex-
panding it, why should we keep paying someone else to
do what we can do for ourselves?”
Kathy Dalton leaned forward in her chair. She read
the message on her computer screen and let the words sink
in. Why had she not anticipated that? After all, she was
adept at asking insightful questions. She felt her heart rate
quicken.
She would have stared out her office window and
pondered this question, but she didn’t have an office. In
keeping with a well-established Silicon Valley tradition,
everyone at eBay, including CEO Meg Whitman, occupied
a cubicle. Dalton, an attractive, 38-year-old executive, had
joined eBay in late 2002 after years of call center experi-
ence for major long distance carriers. Now, nearly two
years later, she couldn’t think of doing business any other
way. She liked being in the center of the action. Sitting in
a transparent cube, surrounded by hundreds of service
representatives, added to her already high level of energy
and kept her in touch with eBay’s internal and external
customers.
Dalton reflected on the e-mail she had just received
from her boss, Wendy Moss, vice president of Global
Customer Support. She knew she would pick up the phone
*Professors Scott Newman, Gary Grikscheit, and Rohit Verma and
Research Assistant Vivek Malapati prepared this case solely as the
basis for class discussion. The information presented in this case is
based on publicly available information and insights gained through
numerous interactions between University of Utah MBA students,
their faculty advisors, and local eBay managers during a field study
project (sponsored by the University of Utah and approved by
the eBay Salt Lake City Service Center). The case contains writer-
compiled, disguised information and is not intended to endorse and/
or illustrate effective or ineffective service management practices.
Certain sections of the case study have been fabricated based on cur-
rent service management and customer service literature to provide
a realistic and stimulating classroom experience. The numbers in
the case are available from public information or estimates or are
fictitious. This case was the winner of the 2006 CIBER-Production and
Operations Management Society International Case Competition.
M11A_BARN0088_05_GE_CASE1.INDD 1 13/09/14 4:14 PM

PC 3–2 Corporate Strategies
would be critical in building infrastructure and attracting
top-tier management to the company.
In early 1998, Omidyar and Skoll realized eBay
needed an experienced CEO to lead and develop an effec-
tive management team as well as to solidify the company’s
financial position with an IPO. In March of that year,
Whitman accepted the position of president and CEO.
A graduate of the Harvard Business School, Whitman had
learned the importance of branding at companies such as
Hasbro and Walt Disney. She hired senior staff from com-
panies like Pepsico and Disney. She built a management
team with an average of 20 years of business experience
per executive and developed a strong vision for the com-
pany. Whitman immediately understood that the eBay
community of users was the foundation of the company’s
business model. A central tenant of eBay’s culture was
captured in the phrase “The community was not built for
eBay, but eBay was built by and for the community.” It was
not about just selling things on the Internet; it was about
bonding people through the Web site.
Business Model and Market Share
Unlike many companies that were born before the Internet
and then had to scramble to get online, eBay was born with
the Net. Its transaction-based business model was per-
fectly suited for the Internet. Sellers “listed” items for sale
on the Web site. Interested buyers could either bid higher
than the previous bid in an auction format or use the “Buy
It Now” feature and pay a predetermined price. The seller
and buyer worked out the shipping method. Payment was
usually made through PayPal, the world’s leading online
payment company, which eBay acquired in 2002. Because
eBay never handled the items being sold, it did not incur
warehousing expense and, of course, did not hold any in-
ventory. For a company with almost $8 billion in assets, not
a single dollar was invested in inventory (Exhibit 1).
In 2004, eBay reported revenue of nearly $3.3 billion.
Revenue was mainly generated from two categories. The
first, called the Listing Fee, involved a nominal fee incurred
by the seller in posting an item for sale. This fee ranged
from $0.25 to $2.00. The second, the Final Value Fee, was
charged to the seller as a percentage of the final price when
a sale was made. This amounted to between 1.25 percent
and 5 percent of the selling price, depending on the price of
the item. The Final Value Fee on a $4.00 Beanie Baby would
be $0.20, representing a 5 percent fee. The same fee on a
mainframe computer selling for $400,000.00 would be 1.25
percent, or $5,000.00.
reinforced the benefits to eBay of continuing to outsource
outside the United States and had woven into her new
strategy more “nearshoring” alternatives as well.
Dalton was scheduled to fly to San Jose in just two
weeks to present her outsourcing strategy to Whitman and
her executive staff. Now, here was Moss’s e-mail, question-
ing why she had not addressed the option of cutting out
the middleman and building eBay-owned outsourcing lo-
cations in other countries.
A Little History
eBay called itself “The World’s Online Marketplace.” For
the sale of goods and services by a diverse community of
individuals and small businesses no venue was more ap-
propriate. eBay’s mission was to provide a robust trading
platform where practically anyone could trade practically
anything. Sellers included individual collectors of the rare
and eclectic, as well as major corporations like Microsoft
and IBM. Items sold on eBay ranged from collectibles like
trading cards, antiques, dolls, and housewares to everyday
items like used cars, clothing, books, CDs, and electronics.
With 11 million or more items available on eBay at any one
time, it was the largest and most popular person-to-person
trading community on the Internet.
eBay came a long way from being a pet project for
founder Pierre Omidyar and holding its first auction on
Labor Day in September 1995. Omidyar developed a pro-
gram and launched it on a Web site called Auction Web.
According to eBay legend, he was trying to help his wife
find other people with whom she could trade Pez dispens-
ers. Omidyar found he was continually adding storage
space to handle the amount of e-mail generated, reflecting
the pent-up demand for an online meeting place for sellers
and buyers. The site soon began to outgrow his personal
Internet account.
Realizing the potential this Web service could have, he
quit his job as a services development engineer at General
Magic, a San Jose–based software company, and devoted
full-time attention to managing Auction Web. As traffic in-
creased, he also began charging a fee of $0.25 per listing to
compensate for the cost involved in maintaining a business
Internet account.
In 1996, Jeff Skoll, a Stanford Business School gradu-
ate and friend of Omidyar’s, joined him to further develop
Auction Web. They changed the name to eBay, short for
East Bay Technologies. In mid-1997, a Menlo Park–based
venture capital firm invested $5 million for a 22 percent
stake in eBay. Omidyar knew that the venture capital
M11A_BARN0088_05_GE_CASE1.INDD 2 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–3
Exhibit 1 Income Statement and Balance Sheet (abridged)
eBay’s Income Statement (in 000s Dollars) 12/31/2004 12/31/2003 12/31/2002
Net revenues $ 3,271,309 $ 2,165,096 $ 1,214,100
Cost of net revenues 614,415 416,058 213,876
Gross profit (loss) 2,656,894 1,749,038 1,000,224
Sales and marketing expenses 857,874 567,565 349,650
Product development expenses 240,647 159,315 104,636
General and administrative expenses 415,725 302,703 171,785
Patent litigation expense 29,965
Payroll expense on employee stock options 17,479 9,590 4,015
Amortization of acquired intangible assets 65,927 50,659 15,941
Total operating expenses 1,597,652 1,119,797 646,027
Income (loss) from operations 1,059,242 629,241 354,197
Interest and other income, net 77,867 37,803 49,209
Interest expense 8,879 4,314 1,492
Impairment of certain equity investments -1,230 -3,781
Income before income tax—United States 820,892
Income before Income tax—international 307,338
Net income (loss) 778,223 441,771 249,891
Net income (loss) per share-diluted 0.57 0.335 0.213
Net income (loss) 778,223 441,771 249,891
Cumulative effect of accounting change 5,413
Provision for doubtful accounts and auth cred 90,942 46,049 25,455
Provision for transaction losses 50,459 36,401 7,832
Depreciation and amortization 253,690 159,003 76,576
Stock-based compensation 5,492 5,953
Amortization of unearned stock-based compens 5,832
Tax benefit on the exer of employ stock opts 261,983 130,638 91,237
Impairment of certain equity investments 1,230 3,781
Minority interests 6,122
Minority interest and other net income adj 7,784 1,324
Gain (loss) on sale of assets -21,378
Accounts receivable -105,540 -153,373 -54,583
Funds receivable from customers -44,751 -38,879 -11,819
Other current assets -312,756 -13,133 10,716
Other non-current assets -308 -4,111 -1,195
Deferred tax assets, net 69,770 8,134
Deferred tax liabilities, net 28,652
Accounts payable -33,975 17,348 14,631
Net cash flows from investing activities -2,013,220 -1,319,542 -157,759
Proceeds from issuance of common stock, net 650,638 700,817 252,181
Proceeds (principal pmts) on long-term obligs -2,969 -11,951 -64
Partnership distributions -50
Net cash flows from financing activities 647,669 688,866 252,067
Eff of exch rate change on cash and cash equivs 28,768 28,757 11,133
Net incr (decr) in cash and cash equivalents -51,468 272,200 585,344
Cash and cash equivalents, beginning of year 1,381,513 1,109,313 523,969
Cash and cash equivalents, end of year 1,330,045 1,381,513 1,109,313
Cash paid for interest 8,234 3,237 1,492
Source: Case writers’ estimates, compilations, and public records.
Being first to market in the e-commerce world was
frequently an insurmountable competitive edge. eBay capi-
talized on being the first online auction house. Early compe-
tition came from companies like OnSale, Auction Universe,
Amazon, Yahoo!, and Classified2000. These companies bat-
tled eBay on a number of fronts, mainly pricing, advertising
online, and attempting to lure key eBay employees away
to join their ranks. eBay’s biggest and most formidable
competitive threat came from Amazon.com when it spent
more than $12 million launching its person-to-person auc-
tion service in 1999. eBay withstood all of these challenges.
Amazon’s efforts ultimately failed because it could not
M11A_BARN0088_05_GE_CASE1.INDD 3 13/09/14 4:14 PM

PC 3–4 Corporate Strategies
eBay’s Customer Support
Organization
In December 2004, Dalton was an operations director
in eBay’s Customer Support organization. She had sev-
eral major responsibilities; the most critical one was cus-
tomer support outsourcing, both domestic and offshore
(Exhibit 3). This role occupied approximately 80 percent
generate enough site traffic. Auction buyers went where the
most items were available for sale, and sellers went where
the most buyers were found for their products. eBay had
more buyers, more sellers, and more items—more than 1.4
billion items were listed on the site in 2004! These numbers
dwarfed the nearest competitor by a factor of more than 50.
eBay enjoyed a dominant 92 percent market share of the
domestic online auction business and a 74 percent share of
the international market (Exhibit 2).
Exhibit 2 Online Auction Market Share
2001 2002 2003 2004
U.S. Int’l U.S. Int’l U.S. Int’l U.S. Int’l
eBay 83% 41% 87% 50% 90% 65% 92% 74%
Yahoo! 7% 28% 6% 25% 4% 16% 3% 11%
Amazon 6% 10% 4% 8% 2% 5% 1% 2%
Overstock N/A N/A 1% 1% 2% 2% 2% 2%
uBid 1% 1% 1% 1% 1% N/A 1% N/A
All others 3% 20% 1% 15% 1% 12% 1% 11%
Source: Case writers’ estimates, compilations, and public records.
Meg Whitman
CEO
Rajiv Dutta
CFO
Bill Cobb
North America
John Donohoe
President
Lynn Reedy
Product Development
Matt Bannick
International
Jeff Jordan
PayPal
Rob Redman
Trust & Safety Policy
Ken Lloyd
General Support
Kathy Dalton
Outsourcing
Tom Pressley
Trust & Safety
Jon Smith
WorKforce
Management and
Quality
Emily Robinson
Seller Support
Maynard Webb
COO
Jim Williams
Customer Support
Strategy
Wendy Moss
N.A. Customer Support
Exhibit 3 eBay Organization Chart
Source: Case writers’ compilations and public records.
M11A_BARN0088_05_GE_CASE1.INDD 4 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–5
auctions, listing and selling items, and account adjust-
ments. By mid-2004, however, nearly 45 percent of in-
quiries were directed toward the Trust and Safety func-
tion. Here hundreds of employees were responsible for
ensuring that the items listed on eBay were legitimate
and legal, did not infringe on copyrighted, patented, or
original material, and fell within the company’s policies
(i.e., no firearms, tobacco, alcohol, human body parts,
and so on). It also enforced eBay’s guidelines for proper
member behavior by policing activities such as shill
bidding, merchandise misrepresentation, and outright
fraud.
PowerSellers
Approximately 94 percent of eBay’s customer service vol-
ume was e-mail-based. However, live chat and phone
inquiries were growing as the company opened up these
channels to more customers, based on their profitability.
Live chat volume was predicted to increase to 1.5 million
communications in 2005, up 50 percent over 2004. Phone
calls handled in 2005 were anticipated to reach 1.4 million,
almost double the number in the previous year. This
phone volume was expected to come primarily from
“PowerSellers,” who represented less than 7 percent of
eBay users but, due to the volume of merchandise they
traded on the site, accounted for nearly 90 percent of the
company’s profit.
Phone and live chat access to Customer Support was
designed to enlarge the pool of PowerSellers. Dedicated
service representatives received additional training in up-
sell, cross-sell, and auction display techniques to share
with sellers to increase the number of items they sold and
qualify them for higher PowerSeller monthly sales vol-
ume thresholds (Bronze, Silver, Gold, Platinum, Titanium).
Once attained, these thresholds qualified sellers for dedi-
cated phone and chat support as well as for the coveted
PowerSeller logo (Exhibit 5).
Trust and Safety
No other company was able to harness the ubiquity of
the Web and marry it to the auction concept as success-
fully as eBay. At the same time, eBay had to confront
challenges never faced before, particularly in the arena of
auction security and fraud prevention. Caveat emptor, “let
the buyer beware,” had been a rule in the auction world
since the middle ages. With the advent of eBay, buyers
had to deal with unknown sellers over the Internet, sight
unseen, often in a totally different country, without the
of her time. Upon joining the company, she had relocated
to Salt Lake City, Utah, the site of eBay’s largest customer
service center. Utah’s four seasons and mountainous ter-
rain suited her. She loved to ski knee-deep powder in the
winter and navigate forest trails on her mountain bike
in summer. While thoughts of early season skiing had
entered her mind, she had in fact spent the past three
weekends in her cube and in conference rooms with her
managers hammering out the strategy she had passed on
to Moss for review.
Worldwide, eBay’s Customer Support staff con-
sisted of an estimated 3,000 FTE, comprising roughly
two-thirds of the corporate workforce. eBay operated ma-
jor service centers in Salt Lake City, Omaha, Vancouver,
Berlin, and Dublin. Smaller company-owned Customer
Support groups were located in Sydney, Hong Kong,
London, and Seoul. The majority of these employees spent
their workdays responding to customer e-mails. In 2004,
eBay answered more than 30 million customer inquiries,
covering everything from questions about selling, bid-
ding, product categories, billing, and pricing to thornier
issues involving illegal or prohibited listings and auction
security (Exhibit 4).
The Customer Support organization was made up
of two major units: (1) General Support and (2) Trust
and Safety. Historically, most of the customer contacts
were handled by the General Support unit. The commu-
nications consisted of questions regarding bidding on
Exhibit 4 eBay Customer Support Volumes by Channel
(in millions)
2001 2002 2003 2004
General Support
E-mail 8.1 12.1 14.6 16.1
Phone 0.1 0.3 0.4 0.8
Chat NA NA 0.4 0.4
Total 8.2 12.4 15.4 17.3
Trust and Safety
E-mail 4 6.8 9.8 12.6
Phone 0 0 0 0
Chat NA NA 0.1 0.6
Total 4 6.8 9.9 13.2
Combined GS
and T&S
E-mail 12.1 18.9 24.4 28.7
Phone 0.1 0.3 0.4 0.8
Chat NA NA 0.5 1
Total 12.2 19.2 25.3 30.5
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 5 13/09/14 4:14 PM

PC 3–6 Corporate Strategies
■ “How could she guarantee the vendors’ ability to safe-
guard the eBay information entrusted to them?”
A number of eBay’s executives had expressed con-
cern and outright hostility to the idea of outsourcing any
Trust and Safety volume. Rob Redman headed up the Trust
and Safety Policy group in San Jose. He and other execu-
tives worried about outside vendors handling the sensitive
type of customer inquiries common to this unit, especially
when personal information such as Social Security num-
bers and credit card account numbers could be accessed.
In addition, many of the jobs within Trust and Safety re-
quired direct and ongoing contact with local, national, and
international law enforcement agencies in the hunt for and
prosecution of fraudsters. Redman believed outsourcing
vendors would never be as skilled at developing and nur-
turing these key liaisons as eBay’s own personnel, and he
had made this known to Whitman, Moss, and Dalton on
numerous occasions.
Underneath her confident exterior, Dalton worried
about these issues as well. She did not have any hands-on
ability to personally examine the goods, and with little
information about the seller except some written feed-
back from other buyers who had previously done busi-
ness with him or her. It was absolutely critical for eBay’s
survival to create and nurture an environment of trust
where millions of people around the globe could feel se-
cure in trading online. The Trust and Safety Department
was given this task. Procedural complexities, the differ-
ing legal environments and customs between countries,
and the sophistication of online identity theft scams com-
bined to make Trust and Safety a challenging business
unit to manage.
Dalton wrestled with a number of questions related
to Trust and Safety and its potential for outsourcing:
■ “What kind of Trust and Safety volume could be safely
outsourced?
■ “What kind of Trust and Safety volume could not be
outsourced?”
■ “How could she and eBay determine the credibility
and quality of the potential outsourcing vendors?”
Exhibit 5 PowerSeller Criteria
To qualify, members must:
• Uphold the eBay community values, including honesty, timeliness, and mutual respect
• Average a minimum of $1,000 in sales per month for three consecutive months
• Achieve an overall Feedback rating of 100, of which 98 percent or more is positive
• Have been an active member for 90 days
• Have an account in good financial standing
• Not violate any severe policies in a 60-day period
• Not violate three or more of any eBay policies in a 60-day period
• Maintain a minimum of four average monthly listings for the past three months
PowerSeller program eligibility is reviewed every month. To remain PowerSellers, members must:
• Uphold eBay community values, including honesty, timeliness, and mutual respect
• Maintain the minimum average monthly sales amount for your PowerSeller level
• Maintain a 98 percent positive total feedback rating
• Maintain an account in good financial standing
• Comply with all eBay listing and marketplace policies—Not violate any severe policies in a 60-day period and not violate three or more
of any eBay policies in a 60-day period
PowerSeller Levels
There are five tiers that distinguish PowerSellers, based on their gross monthly sales. Some benefits and services vary with each tier. eBay
automatically calculates eligibility each month and notifies qualified sellers via e-mail.
Gross Sales Criteria for Each PowerSeller Tier
Bronze Silver Gold Platinum Titanium
$1,000 $3,000 $10,000 $25,000 $150,000
Sources: eBay Web site; case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 6 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–7
Kana
One such technological advancement occurred when eBay
purchased the Kana e-mail management system later
that year to provide service personnel with a variety of
“canned” responses and performance statistics similar to
an automatic call distributor. Kana allowed representatives
to answer common questions, such as “How do I list an
item for sale?,” “How do I leave feedback?,” or “What do I
do with an item I received that is damaged in shipment?”
with a few quick keystrokes to input the code number of a
pre-scripted e-mail reply. The representatives then took a
moment to personalize the e-mail with their name and the
recipients’ names.
The Kana technology enabled service employees to
be trained more quickly and effectively. Most importantly,
it reduced response time to customer inquiries and in-
creased the accuracy of information the customer received.
It doubled the service representatives’ e-mail productiv-
ity from five responses per hour to 10 and more. Without
Kana, there was no way that eBay could have ever consid-
ered outsourcing even a portion of its overall Customer
Support volume, let alone, as Dalton’s new strategy pro-
posed, increasing it to more than 50 percent.
By early 1999, nearly twice as many in-house repre-
sentatives were employed as compared to the “remotes.”
This staffing strategy had paid off in improved productiv-
ity and in the rising customer satisfaction scores received
from the hundreds of customers polled by mail each
month (Exhibit 6). More in-house staff was needed, and a
search was begun to build a dedicated center for Customer
Support outside of California in a more cost-efficient lo-
cale. Three potential sites were considered—Salt Lake City,
Tucson, and Albuquerque. In the end, the Utah location
was selected due to the availability of a ready-made facil-
ity as well as a communications infrastructure, generous
incentives offered by the state, and the educational level,
work ethic, and foreign language capabilities of the poten-
tial employees.
background in Trust and Safety herself. Still, she was in-
trigued by the possibility that several categories of inqui-
ries within the department might be outsourced without
undue risk.
Outsourcing Beginnings
By late 1999, eBay had enrolled four million registered
members, nearly all in the United States. Five years later,
the eBay community had burgeoned to more than 135 mil-
lion members, living in every country in the world. If eBay
were its own country, it would have been the nineth largest
on earth, behind Russia.
To stay abreast of the growth of its customer base,
eBay significantly increased the resources dedicated to
its Customer Support group. In the very early days of
1995–1996, founder Omidyar would reserve part of his
Saturday afternoons in a local San Jose park to respond
directly to member questions. He soon could not manage
the volume himself so the first customer service staff was
organized. A measure of the power of the eBay community
was the fact that these first service staffers were not em-
ployees at all, but members who had shown a penchant for
helping other eBayers. These people worked on a contract
basis out of their homes responding to customers’ e-mails.
At one time, there were close to 75 such employees, called
“remotes,” living in 17 different states across the country,
handling an average of five e-mails per hour at all hours of
the day and night, often while sitting in their pajamas!
In early 1998, eBay Customer Support took another
step to simplify management and improve the consistency
and quality of service. The company hired a small corps
of “in-house” customer service personnel in the San Jose,
California, headquarters to supplement its remote contrac-
tors. The “remotes” had been a creative solution for a time,
but one that could not be scaled as the technology, logis-
tics, and training requirements of the Customer Support
group increased in sophistication.
Exhibit 6 eBay Customer Support Productivity and Quality
1998 1999 2000 2001 2002 2003 2004
E-mails Productivity/Hr 4.7 9.5 11.1 13.8 15.3 16 16.1
E-mails per FTE/Month 571 1254 1475 1980 2078 2225 2280
E-mail Quality % N/A 83% 89% 91% 94% 95% 94%
Customer Satisfaction % N/A N/A 84% 86% 87% 88% 88%
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 7 13/09/14 4:14 PM

PC 3–8 Corporate Strategies
Outsourcing Pilot
eBay had made headlines for years for its innovation in the
online auction space, its market leadership, its product and
technological ingenuity, such as member feedback, the Buy
It Now feature, item search capabilities, and Kana, and its
irresistible pace and can-do attitude. eBay did not manage
itself by “the seat of its pants,” contrary to what others may
consider to be a trademark of dotcoms. Far from it, the
company was thoughtfully led, financially disciplined, and
extremely customer conscious. These were the underpin-
nings of its tremendous success. eBay let others serve as
lab mice, test and bleed, stub their toe, and work out the
wrinkles. Then, and only then, it stepped in and adopted
the “latest and greatest” business practices.
Such was the case with outsourcing the elementary
portions of its Customer Support operation. Leading com-
panies like American Express, GE, and Citibank had been
outsourcing some of their customer service functions for 10
to 15 years domestically and for at least half that time off-
shore before eBay felt comfortable in considering outsourc-
ing. By mid-2001, outsourcing surfaced as a viable way for
eBay Customer Support to scale to demand, avoid capital
outlays, reduce unit costs, and leverage its investment in
technology and management talent.
But the senior staff in San Jose, including Whitman,
was concerned about the potential reaction of the eBay
community. If you traded on eBay, you were not a cus-
tomer. You were a member of a passionate and vocal com-
munity of users, who felt strongly (and rightly so) that
eBay’s success was directly attributable more to them than
to any business savvy of headquarters staff in San Jose.
How would the community react to knowing that some
customer support inquiries were answered by staff not
employed by eBay—or not even residing within the United
States?
Another concern at headquarters was the lack of tal-
ent inside eBay who had experience with outsourcing. For
eBay to uphold its philosophy of “prudent adoption,” it
needed a team of managers who could thoroughly inves-
tigate how other companies had successfully outsourced
and then actually run the day-to-day operation.
In December 2001, eBay hired Jim Williams, an ex-
ecutive vice president from Precision Response Corporation
(PRC), one of the country’s top echelon outsourcing vendors,
and gave him responsibility for customer service world-
wide. Williams brought instant credibility to the outsourcing
initiative. His knowledge of the industry from the providers’
point of view reinforced the research already compiled on
other companies that had been successfully outsourcing
elements of customer service in India and the Philippines
Designed originally for about 300 personnel, the
Salt Lake facility was enlarged to accommodate more
than 1,000 by year-end 2000. In addition, a staff of 125 was
added in both the newly opened Berlin and the Sydney lo-
cations to handle customer service inquiries. Still, with the
worldwide popularity of eBay growing at a rate of 250,000
new members each month, it was apparent by 2001 that
eBay could hire only so many of its own service personnel
and build only so much of its own brick-and-mortar con-
tact centers and that even trying to do so would not keep
up with the demand (Exhibit 7). Alternatives like outsourc-
ing had to be explored.
1999
0
2000 2001 2002 2003 2004
500
1,000
1,500
2,000
2,500
3,000
3,500
Revenue (millions)
1999
0
2000 2001 2002 2003 2004
20
40
60
80
100
120
140
Registered Users (millions)
Exhibit 7 Growth in eBay Users and Revenues
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 8 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–9
service centers in Bangalore, India. Yet the service quality
and e-mail productivity results from the vendor were on
par with eBay’s own staff after only three months. Williams
and his Customer Support team decided to cut the pilot
short and sent the first e-mails to India in June 2002.
The eBay community’s reaction to outsourcing
portions of its customer service was essentially only a small
ripple in a big pond. There had been some issues with the
written English of the agents in India. A handful of com-
plaints found their way to Whitman’s desk. Still, the service
quality and productivity metrics of the outsource providers,
both domestic and foreign, rivaled and frequently surpassed
the same measurements of eBay’s own employees (Exhibit 9).
And who could argue with the cost differential?
While eBay honored its community, it was also a publicly
traded company with shareholders who were accustomed
to a compounded annual growth rate in revenues of more
than 65 percent. The domestic outsourcing cost per contact
for the volume handled in Fort Lauderdale was not that
much less than eBay’s own staff results. This was perfectly
acceptable because a significant driver for outsourcing
to another location within the United States had been, in
for years. Furthermore, his intimate association with PRC,
its management team, and its training and technological
capabilities made Whitman and her executives comfortable
utilizing PRC as eBay’s first global outsourcing partner.
When it came to the issue of how the eBay com-
munity would react to the new venture, Williams had an
answer for that, too. Rather than launch a pilot in India, he
proposed beginning with a small test near PRC’s domestic
headquarters in Fort Lauderdale. He essentially hand-
picked the most talented customer service representatives
at PRC to handle the eBay business. By February 2002, all
preparations for the pilot were completed, and eBay’s first-
ever outsourcing effort was launched (Exhibit 8).
Expansion of Outsourcing
Dalton reflected on the progress made in outsourcing over
the past several years. The outsourcing pilot program be-
gun in Fort Lauderdale in 2002 had been relatively seam-
less. The plan had been to run the pilot for six months
before attempting to route volume offshore to one of PRC’s
1995: Beginning of auction web
1996: First remote service representative hired
1997: eBay name introduced

1998: “Number of remotes” exceeds 75
First in-house reps hired in San Jose
Kana system introduced
eBay goes public
1999: Trust and safety launched
Salt Lake City service center opens
Customer support staff exceeds 200
2000: San Jose service center absorbed into Salt Lake City
Salt Lake City service center grows to over 800 employees
2001: First outsourcing strategy devised
Jim Williams hired
2002: Domestic outsourcing piloted at PRC in Florida
First e-mails sent to India for handling
Kathy Dalton joins eBay
Customer support staff grows to over 1,200 with purchase of PayPal
2003: Outsourced monthly volume exceeds 250,000 e-mails
Outsourcing pilot launched in Philippines for phone volume
2004: Outsourced volume exceeds 30 percent of total inquiries
Customer service staff exceeds 3,000 serving 19 counties
Dalton proposes to expand outsourcing to 50 percent of
total volume.
Exhibit 8 eBay Customer Support Timeline
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 9 13/09/14 4:14 PM

PC 3–10 Corporate Strategies
telephone, but it was an expensive piece. The hope had been
to cut eBay’s phone unit cost in half, to just around $2.00. It
did not play out that well in reality. During the pilot, both the
accents of the Philippino agents and their language compre-
hension were issues. Logistical issues with phone lines and
data servers plagued the startup. The biggest concern, how-
ever, was that eBay at the same time was taking its first major
steps into Customer Relationship Management (CRM).
The company’s marketing group had just completed a
thorough segmentation analysis of its community members
and saw potential opportunities in building deeper service
relationships with its more profitable customer segments.
More than 40 distinct customer segments were identified,
and strategies for increasing profitability were then prepared
for each segment. One of the proposed strategies was to offer
dedicated live phone support to certain segments, particu-
larly PowerSellers and potential PowerSellers.
With its focus on optimizing the phone touch point
to generate revenue, senior management wanted to keep its
phone support group in-house, rather than outsource it to
third parties offshore. Management reasoned that this not
only allowed for more efficient rollout of profit-enhancing
marketing programs, but also provided job enrichment and
new career paths to eBay’s own employees. In line with
being more accessible by phone to high-value customers,
Customer Support shut down its phone outsourcing pilot
in the Philippines in early 2004. Whether the pilot could
have eventually been successful was unclear.
The same logic was used for eBay’s live chat channel,
which represented 2 percent of total volume or about 45,000
chat sessions a month. The original plan was to outsource
this volume overseas as well. However, with the vision of
using the chat channel to cross-sell products and increase
seller volume, it was determined to service chat line cus-
tomers in-house, too. These CRM-led constraints for the
phone and chat channels helped fashion the new outsourc-
ing strategy that Dalton had proposed to her boss last week
and that she was scheduled to present to Whitman.
addition to initially testing the outsourcing model, to avoid
the capital outlay of building more plant and equipment
for Customer Support.
The unit cost for the e-mail volume being sent to
India was another matter. It was literally half the cost
per contact handled in the United States. An occasional
complaint letter to Whitman about the way an e-mail re-
sponse was worded by one of the service reps in India was
not taken lightly, but it was still considered a small price
to pay for the level of operational savings. No question
about it, after both the domestic and offshore outsourcing
performance of 2002, eBay executives were satisfied that
outsourcing would remain a component of its customer
support strategy. Dalton wondered, “What are the limits?”
Throughout 2003 and most of 2004, eBay had in-
creased the volume of customer service sent offshore.
Through analyses of e-mail complexity and available canned
responses in Kana, about 40 percent of the General Support
volume, representing close to 500,000 e-mails a month, had
been earmarked as “outsourceable.” As additional service
staff was hired and uptrained in India, the throttle was
opened and more e-mail was directed overseas for handling.
Dalton grabbed the hard copy of the strategy docu-
ment she had submitted to Moss the previous week. She
focused on several pages that highlighted the outsourcing
expansion since her arrival at eBay. In a business as fluid
as eBay’s, it was realistic to expect that the original out-
sourcing strategy devised in 2002 would change over time.
Indeed, even with eBay’s penchant for hindsight learning
from others’ mishaps, Dalton’s three-tiered strategy had
only evolved after some operational missteps and plenty of
analysis of test results.
Customer Relationship Management
One such misstep occurred in late 2003, when eBay con-
ducted an outsourcing pilot in the Philippines for phone
volumes. Less than 2 percent of eBay’s volume arrived via
Exhibit 9 Metric Comparison for eBay In-house and Outsourcing Vendors (comparison for similar volume types)
Jul-02 Dec-02 Jul-03 Dec-03 Jul-04 Dec-04
In Out In Out In Out In Out In Out In Out
E-mails Productivity/Hr 14.8 13.1 15.2 14.7 15.5 15.4 15.7 16.1 15.8 16.3 15.8 16.3
E-mails per FTE/Month 2050 1963 2181 2095 2202 2189 2240 2255 2250 2291 2250 2285
E-mail Quality % 94% 88% 95% 94% 95% 95% 94% 95% 93% 95% 93% 96%
Customer Satisfaction % 87% 83% 87% 86% 87% 88% 88% 88% 87% 88% 87% 89%
E-mail Unit Cost ($) 1.59 0.87 1.55 0.86 1.56 0.85 1.49 0.82 1.48 0.81 1.48 0.81
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 10 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–11
She and her staff had wrestled with these three prob-
lems over the ensuing months. Selecting a second vendor
that could meet eBay’s criteria proved challenging. The
candidate company had to have both a domestic and inter-
national presence, have a proven track record in servicing
large quantities of phone, chat, and e-mail inquiries, and
be willing to rival PRC’s already attractive per unit pric-
ing. Finding a vendor that had sufficient e-mail experience
proved the toughest challenge. Dalton and her team finally
settled on I-Sky, a medium-sized vendor, but one that
could deliver impressive e-mail results out of its several
service centers located in more rural parts of Canada.
Three Tiers
In order to increase the outsourcing to 50 percent of total
volume, while at the same time taking advantage of the
opportunity for including Trust and Safety volume in the
mix, Dalton had devised a strategy made up of three levels
or tiers. Each tier represented a progressively more com-
plex type of work, both in terms of the nature of the cus-
tomer inquiry and the channel through which it accessed
Customer Support (Exhibit 10).
■ TIER ONE: Was composed of e-mail-only volume in-
volving the most basic of General Support–type ques-
tions. These were typically simple bidding and selling
questions that could be answered using a template of
responses from Kana. Because these were less-complex
customer inquiries, training for the service representa-
tives was less demanding and could be conducted over
a three-week period. Most of eBay’s Tier One volume
was already being handled by PRC’s two outsourc-
ing facilities in India. Dalton analyzed all remaining
inquiry types to find an additional 260,000-plus e-mails
New Outsourcing Strategy
When she was given the responsibility for outsourcing in July
2004, Dalton dug deeply into the existing operation to under-
stand the issues as well as the opportunities and threats fac-
ing the department. She identified three major opportunities
for improvement. She needed to figure out how to analyze
each one and implement programs within 12 months, which
was the time frame she and Moss had agreed was feasible.
The first opportunity she saw was to increase the
percentage of outsourcing from 30 percent of overall vol-
ume to at least 50 percent. She calculated that this would
save an incremental $3.9 million a year. What made this
endeavor particularly difficult, however, was the CRM
initiative that required her to keep the growing phone and
chat volume with in-house service representatives only.
The second opportunity would help her to accom-
plish the first. It was to target for the first time specific
volume types within Trust and Safety and demonstrate
that these could be successfully handled by a third-party
outsourcer. Several within Whitman’s executive team felt
strongly that it was too risky to outsource any of this
volume and Dalton knew she would be in for a fight. She
deemed it a worthwhile fight because, according to her
analysis, between 20 percent and 25 percent of Trust and
Safety’s monthly volume was straightforward enough to
be included in the outsourceable pool.
The third area of opportunity was to seek an out-
sourcing partner in addition to PRC with which to con-
tract. Dalton was concerned that eBay had for two years
used only one outsourcing vendor. She reasoned that
adding a second one would benefit eBay by instilling com-
petition both in pricing and performance metrics between
the two vendors, as well as providing a measure of redun-
dancy in the event of system outages.
Exhibit 10 Proposed Outsourced Volume and Unit Cost by Tiers
Current (Dec. 2004) Proposed (Dec. 2004)
Monthly % of Total Unit Monthly % of Total Unit
Volume Volume Cost Volume Volume Cost
Tier One
Gen’l Support 510000 21.30% $0.81 775000 32.40% $0.72
Tier Two
Gen’l Support 68000 2.80% $1.45 186000 7.80% $1.15
Tier Three
Gen’l Support 20000 0.80% $1.48 25000 1.04% $1.33
Trust and Safety NA NA NA 210000 8.80% $1.33
Total 598000 24.20% 1196000 50.00%
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 11 13/09/14 4:14 PM

PC 3–12 Corporate Strategies
Support from having to invest in additional plant and
equipment, as well as reducing the risk of spreading its
management talent too thin. Plus, it opened the door to
outsourcing approximately 20 percent of Trust and Safety
work types, which was essential to meeting the goal of
offloading upward of 50 percent of eBay’s entire support
volume.
Moss had readily acknowledged and appreciated
Dalton’s explanation on her team’s strategy behind the
logic for Tiers Two and Three. She was more inquisitive,
however, about the Tier One work being serviced in India.
The payoffs there in reduced operating expense were im-
pressive, saving the company almost $3 million annually,
and Dalton had sensed right away Moss’s interest in bring-
ing more dollars to the bottom line. Moss had quizzed
her in detail the previous week on PRC’s Indian-based
operations and I-Sky. How experienced, how financially
muscled, how well led, how competitively positioned, how
quick to market were these two companies? What kind
of presence did Customer Support have in these centers?
Were eBay managers always on site in India training new
hires, sampling e-mails, admonishing the “eBay way”?
As she recounted these queries in her mind from the
meeting, Dalton admitted that the question her boss had
posed in her e-mail was really no surprise at all. Customer
Support was heavily invested in making the Indian op-
eration a long-term service and financial win. But why line
someone else’s pockets along the way? What Moss wanted
to know, and what she had anticipated that Whitman and
her staff would likewise want to know, was the feasibility
of doing exactly what Dalton’s outsourcing group was do-
ing in India, but doing it without the middleman. “Imagine
if Customer Support was saving approximately 45 percent
per e-mail by offshore outsourcing. How much more could
be saved by running our own sites in India?” Moss’s e-mail
concluded.
To BOT or Not to BOT
Fortunately, Dalton had done research on the subject of de-
veloping eBay-owned and -managed sites offshore, though
not in real depth. She had figured that opportunities would
exist for her and her staff to still work out the minor kinks
with the present outsourcing strategy. “Chalk up another
one to the exhilarating eBay pace,” she thought to herself.
She wanted to call Moss in San Jose and discuss her
e-mail and the next steps in preparing for the upcoming
presentation to Whitman. But first she opened her file
drawer and pulled out a folder labeled across the top with
the letters “BOT.” It had been several months since she
per month that could be safely offloaded to India as
well. If these volumes could be found, she thought she
might be able to negotiate with the vendor for a price
reduction from $0.81 to $0.72 per e-mail.
■ TIER TWO: Was designated for General Support
e-mail volume that was considered a bit more complex
than Tier One work. This accounted for more billing-
related and account adjustment questions, where more
in-depth training was needed for the service repre-
sentatives. eBay had outsourced a small portion of
this volume, but only to PRC’s Florida center, where
English was the native language. Now, utilizing I-Sky’s
locations in Canada, Dalton proposed another option
for handling this volume. These locations could satisfy
the native English requirement and prove very effec-
tive from a cost standpoint. Though not as low-cost an
environment as India, the Canadian Tier Two locations
were on average 22 percent more economical in cost
per e-mail than PRC’s domestic facilities and eBay’s
wholly owned service centers.
■ TIER THREE: Was reserved for more complex General
Support questions, those that required flexibility and
some judgment on the part of the service employees.
Also, it was in this tier that Dalton proposed that some
simple Trust and Safety inquiries be handled. She was
careful not to select work that was overly sensitive in
terms of customers’ personal information or that neces-
sitated detailed investigative work. Types of inquires
that qualified included reports from eBay users on
spam or potential scam sites and on listing violations
or member misbehavior, such as not paying for items
received, and shill bidding. This tier consisted mainly
of e-mail volume, yet Dalton designed it so that some
simple phone and chat inquiries were included as well.
While this was contrary to eBay’s CRM philosophy
that phone calls and chat sessions be kept in-house
with experienced eBay service agents, she asserted that
top reps at both PRC and I-Sky could be taught to ser-
vice this volume just as adeptly as eBay’s own.
Tier Three was to be handled by outsourcing centers
exclusively in the United States, located in close proximity
to eBay’s own contact centers. This “nearshoring” arrange-
ment ensured that no language barrier existed and that
Dalton and her managers were within close proximity if
the outsourcer needed extra support and training.
In her recommendations to Moss the previous week,
Dalton had made sure her boss understood that the ar-
rangement for Tier Three volume would save the company
only about $500,000 per year from a pure cost reduction
standpoint, but that it did pay off in keeping Customer
M11A_BARN0088_05_GE_CASE1.INDD 12 13/09/14 4:14 PM

Case 3–1: e-Bay’s Outsourcing Strategy PC 3–13
and in-country management resources. Yet, according to
her spreadsheet assumptions, this alternative promised the
biggest potential payoff long-term in unit cost reduction,
something that eBay’s executive staff prized highly.
She believed her third alternative, called “Build,
Operate, and Transfer,” or “BOT” for short, was the most
creative and represented a hybrid of the first two. She rec-
ommended that eBay contract with a third-party vendor
that would acquire or build an operations center, staff and
manage it, and then, after a specified period of time of per-
haps a year or two, transfer full ownership to eBay. This
option appealed to her more than the second one because
the vendor would bear the initial risks for the startup phase,
which she considered the most challenging and expensive.
eBay could limit its cost exposure up front until the opera-
tion was ramped up and running. She planned to tell Moss
that the most critical points of the BOT alternative were to
negotiate the appropriate level of management fees with
the outsourcing vendor and to work out the intricacies of
the actual transfer of ownership down the road.
Dalton’s biggest concern, however, was the fact that to
date she had not been able to find any example of a domestic
company utilizing a BOT approach with a vendor in India.
To her knowledge, eBay would be the first customer ser-
vice operation attempting such a strategy. As she prepared
to pick up the phone and dial Moss’s number, she was
haunted by eBay’s well-entrenched mantra of not being on
the “bleeding edge” with any new unproven experiments.
gathered the contents. Before she knew it, an hour elapsed
and she remained focused on sifting through the packet of
information, occasionally pausing to run several scenarios
through a quickly composed Excel spreadsheet.
After another 45 minutes of analysis, she was ready.
She printed the spreadsheet and quickly surveyed it for
clarity. It was not as detailed as it would need to be in the
coming days, but it would help her frame a conversation
with Moss about the question she asked in her e-mail, the
one she asked on behalf of Whitman:
“Why should we keep paying someone else to do
what we can do for ourselves?”
In her spreadsheet, Dalton outlined and quantified
three alternatives (Exhibit 11). The first alternative was the
Tier One of her proposed three-tiered strategy— maintain
the relationships with eBay’s offshore outsourcing part-
ners, continue to improve the operation in India, and
identify incremental volume to outsource in order to drive
e-mail costs lower. She viewed this scenario as the least
risky of the three alternatives.
The second alternative was to eliminate the out-
sourcing vendors altogether. In this option, she proposed
that Customer Support not renew its contracts with the
vendors and instead purchase or lease land or an already
established facility in India and build its own operation.
Dalton knew this alternative presented the most risks to
eBay, including capital outlay, real estate commitments,
governmental compliance, communications infrastructure,
Exhibit 11 Dalton’s Spreadsheet
Avg. Initial Avg. Transfer
Cost/Hr/Seat Cost/Hr/Seat Cost/Hr/Seat Investment/Seat Cost/Seat
(250 seats) (500 seats) (1,000 seats) (one-time cost) (one-time cost)
Scenario #1:
Outsourcing to
3rd party vendors

e-mail, phone, chat

$ 10.17

$ 9.56

$ 8.60

N/A

N/A
e-mail only $ 6.24 $ 5.38 $ 4.66 N/A N/A
Scenario #2:
Build eBay
owned center

e-mail, phone, chat

$ 9.73

$ 8.85

$ 7.77

$ 12,000

N/A
e-mail only $ 5.30 $ 4.68 $ 4.14 $ 11,000 N/A
Scenario #3:
Build, Operate,
Transfer (BOT)

e-mail, phone, chat
$ 9.88 $ 9.03 $ 8.10 N/A $ 3,500
e-mail only $ 5.34 $ 4.96 $ 4.40 N/A $ 2,900
Source: Case writers’ estimates, compilations, and public records.
M11A_BARN0088_05_GE_CASE1.INDD 13 13/09/14 4:14 PM

C a s e 3 – 2 : N a t i o n a l H o c k e y L e a g u e
E n t e r p r i s e s C a n a d a : A R e t a i l P r o p o s a l
Elizabeth Gray prepared this case under the supervision of
Elizabeth M.A. Grasby solely to provide material for class
discussion. The authors do not intend to illustrate either ef-
fective or ineffective handling of a managerial situation. The
authors may have disguised certain names and other identifying information to protect confidentiality.
Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission.
Reproduction of this material is not covered under authorization by any reproduction rights organizastion. To order cop-
ies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey
School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax
(519) 661-3882; e-mail cases@ivey.uwo.ca. One time permission to reproduce granted by Richard Ivey School of Business
Foundation on March 31, 2014.
Copyright © 2000, Ivey Management Services Version: (A) 2010-01-08
In July 1998, Glenn Wakefield, vice-president of National
Hockey League Enterprises Canada (NHLEC), was faced
with an opportunity to pursue the development of a retail
outlet solely dedicated to Brand NHL merchandise. If pur-
sued, Wakefield had to select one of three implementation
options: NHLEC could retain managerial and financial
control of the facility, control could be relinquished to
a management firm, or floor space could be rented in a
department store where NHLEC would maintain partial
control over operations. Opening a flagship store would be
a shift in the organization’s strategy and Wakefield won-
dered if it was the right thing to do.
The National Hockey League
The National Hockey League (NHL), a professional hockey
organization housing 27 teams in total, was d ivided into
two conferences, each consisting of three divisions (see
Exhibit 1). Each team received representation from the
Calgary Flames
Colorado Avalanche
Edmonton Oilers
Vancouver Canucks
New Jersey Devils
New York Islanders
New York Rangers
Philadelphia Flyers
Pittsburgh Penguins
ATLANTIC NORTHEAST CENTRAL PACIFIC
Chicago
Blackhawks
Detroit Red Wings
Nashville Predators
St. Louis Blues
Anaheim Mighty Ducks
Dallas Stars
Los Angeles Kings
Phoenix Coyotes
San Jose Sharks
NATIONAL HOCKEY LEAGUE
NORTHWEST
WESTERN CONFERENCE EASTERN CONFERENCE
Boston Bruins
Buffalo Sabres
Montreal Canadiens
Ottawa Senators
Toronto Maple Leafs
SOUTHEAST
Carolina Hurricanes
Florida Panthers
Tampa Bay
Lightning
Washington Capitals
Exhibit 1 National Hockey League
M11A_BARN0088_05_GE_CASE2.INDD 14 13/09/14 4:15 PM

Case 3–2: National Hockey League Enterprises Canada: A Retail Proposal PC 3–15
Toronto, Ontario, Canada. NHLEC was a relatively small
operation under the managerial control of the New York
office (an organizational chart is given in Exhibit 2).
One of NHLEC’s primary strategic goals was to
develop a distinct brand image. The ever-increasing num-
ber of licensees and retailers for NHL-branded merchan-
dise was becoming too fragmented. Wakefield wanted the
brand’s image to be presented consistently to consumers at
the retail level. He believed this approach would, in turn,
translate into increased sales of NHL-brand merchandise
and also increased recognition of the NHL. The greatest
obstacle in achieving this goal lay not with the indepen-
dent retailer, but with the larger department store chains
such as Wal-Mart. NHLEC relied on these large retailers to
push crucial sales volume but the end result was scattered
NHL merchandise and an inconsistent brand image pre-
sented to the consumer. Frequent buyer turnover, power
struggles and turf wars among the buyers, and the sheer
size of these retailers had all contributed to NHLEC’s
difficulties in developing brand equity at a mass-market
consumer level.
NHL division responsible for officiating, scouting, and
public relations as well as the marketing division, National
Hockey League Enterprises. Additionally, each NHL team
employed its own marketers who were responsible for
promoting the team and selling tickets to the team’s games.
National Hockey League Enterprises
National Hockey League Enterprises (NHLE) managed
the promotion of the game, the licensing of NHL merchan-
dise, and the exploitation of corporate marketing partner-
ships. NHLE was a large enterprise with job descriptions
ranging from “Asia/Pacific Promotions” to “Grassroots
Development”. NHLE was housed in downtown New
York, New York, U.S.A.
National Hockey League
Enterprises Canada
NHLE’s Canadian counterpart, the National Hockey
League Enterprises Canada (NHLEC), was located in
Exhibit 2 National Hockey League Enterprises Canada Organizational Chart
1. Managed the relationship with all manufacturers licensed to print an NHL or member team logo. These manufacturers then paid NHLEC a licensing fee
(a percentage of the manufacturers ’ sales) to produce NHL branded products.
2. Coordination of all retail stores carrying NHL brand merchandise. Activities included the development and maintenance of the relationships with these retailers.
These activities included promotional incentives for retailers to boost sales of NHL brand merchandise.
3. Responsible for governing partnerships with large corporations; currently managing relationships with Air Canada and McDonald ’s Corporation.
4. Governed all printed products related to the NHL, including PowerPlay Magazine™, season schedule pamphlets, trading cards, and corporate sponsor
print material.
GLENN WAKEFIELD
Vice-President
Canadian Operations
ED HORNE
Group Vice-President
Marketing
(New York)
LAURIE KEPRON
Director
Corporate Marketing3
DAVID McCONNACHIE
Director
Printed Products
Marketing4
Assistant
Corporate Marketing
Assistant to
Vice-President
KAREN HANSON
Director
Consumer Products
Marketing1
BARRY MONAGHAN
Manager
Retail Sales & Marketing2
Assistant
Consumer Products
Marketing
Assistant
Retail SalesAssistant
Consumer Products
Marketing
M11A_BARN0088_05_GE_CASE2.INDD 15 13/09/14 4:15 PM

PC 3–16 Corporate Strategies
overall level of economic activity (see Exhibit 5 for Gross
Domestic Product data and Exhibit 6 for Canadian dispos-
able income and expenditure on clothing).
With the introduction of both the Canada-U.S. Free
Trade Agreement (FTA) and the North American Free
Trade Agreement (NAFTA) in the late 1980s, Canadians
had witnessed a multitude of lower priced imports enter-
ing the market. Within the last decade, there had been a
restructuring of the retail apparel industry. Consolidation
and the emergence of U.S.-based retail giants such as
Wal-Mart had resulted in a highly concentrated retail
industry. These large Canadian retailers had sought to
narrow their supplier base and increase their margins. In
addition, the Canadian dollar was trading at a record low
(around US$0.66).
Although Wakefield wondered what impact all of
this would have on small NHL licensees and what the
NHL store might do for these retailers, his review of the
retail industry convinced him that the timing was right
for such a venture. GDP for both Canada and Ontario was
expected to grow steadily at a rate of three per cent into the
next century. Additionally, lower unemployment, reduced
housing costs, and general consumer confidence were pre-
dicted to characterize the years to come.
Demographics
Consumer demand was also driven by demographic fac-
tors, the first of which was population. Refer to Exhibit 7
for selected population growth statistics. The “baby
A New Approach
Wakefield had to find a way to convince large retail-
ers that there was a better way to display and promote
NHL product. One potential solution would be to focus
NHLEC’s selling efforts toward the general merchandise
manager, rather than (and one step above) the individual
buyer, encouraging a more coordinated purchase and
display effort. Another option would be the introduction
of the NHL’s own store. This flagship store would sell
merchandise purchased from NHL licensees. This store
would be used to illustrate to these large retailers the posi-
tive effects that a consistent NHL brand image could have
on sales.
The Industry
While the apparel industry experienced rapid growth
throughout the 1980s, the recession in the early 1990s
had hurt apparel sales (see Exhibits 3 and 4). Recovery
from the recession had been gradual and it was a well-
known fact that apparel sales were tied tightly to the
Exhibit 3 Retail Sales in 1996–1997 ($Billions) and Growth
Rate for Canada and Ontario
1996 1997 Growth Rate
Canada 217.0 232.7 + 7.2
Ontario 78.6 84.4 + 7.4
Exhibit 4 Canadian Apparel Retail Sales ($Billions) and Growth Rate (%) 1988–1997
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Retail Sales 14.3 15.5 16.3 14.9 15.5 14.0 14.6 15.2 15.8 16.4
Growth Rate + 8.4 + 5.2 – 8.6 + 4.0 – 9.7 + 4.3 + 4.1 + 3.9 + 3.8
Exhibit 5 GDP ($Billions) and Growth Rates (%) for Canada and Ontario 1987–1996
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Canada
GDP 551.5 606.9 650.7 669.5 676.5 690.1 712.9 747.3 776.3 797.8
Growth Rate + 10.0 + 7.2 + 2.9 + 1.0 +2.0 + 3.3 + 4.8 + 3.9 + 2.8
Ontario
GDP 226.8 253.1 276.1 277.6 278.5 282.8 288.6 300.8 314.1 323.0
Growth Rate + 11.6 + 9.1 + 0.5 + 0.3 +1.5 + 2.1 + 4.2 + 4.4 + 2.8
M11A_BARN0088_05_GE_CASE2.INDD 16 13/09/14 4:15 PM

Case 3–2: National Hockey League Enterprises Canada: A Retail Proposal PC 3–17
interchange (EDI) — were being utilized to provide top-
notch service to customers. These technologies allowed
retailers to immediately process, store, and forward point-
of-sale statistics to the manufacturer who, in turn, could
replenish inventory levels.
Alternatives
Wakefield identified three models for establishing a
NHLEC retail presence. In the first model, NHLEC would
have complete managerial control over the location and
operation of the retail store. There were three viable loca-
tions to choose from: Vancouver, Toronto and Montreal.
Investment funds of $2,200,000 for start-up and approxi-
mately $800,000 in working capital would be required.
He wondered how NHLEC could raise those kinds of
funds. He also knew that if the venture was not profit-
able, NHLEC would have to absorb the loss and NHLEC’s
budget was simply not large enough to sustain significant
losses. If he decided to pursue this option, Wakefield
would have to convince New York to give the go-ahead.
The location would need to be 15,000 square feet in
total, with 10,000 of that being retail space. The average
lease range for a downtown Toronto location was $50 to
$60 per square foot. Wakefield estimated the store could
generate $750 revenue per retail square foot per year. Cost
of goods sold was estimated to be 50 per cent of sales.
Salaries and wages were estimated at 10 per cent and other
boom” and “baby boom echo1” population accounted for
56 per cent of the total population, with this group driving
growth in consumer demand. As baby boomers aged, their
needs in terms of apparel were likely to include a greater
emphasis on quality, comfort, functionality, value, and
service; whereas, by 1996, those in the “baby boom echo”
phase had entered their teenage years, a time when people
were typically more fashion-conscious.
Other Trends
Canadians were spending a greater portion of their dis-
posable income on consumer goods such as comput-
ers, electronics, and leisure products—leaving less for
apparel. Also, as consumers became more knowledgeable
about products, they placed increased importance on the
price-value relationship. Today’s consumers demanded
“value”—high quality merchandise at reasonable prices
and had begun to shop at more inexpensive retail stores.
Furthermore, today’s consumers spent less time shopping
for apparel. Since less time was spent shopping, consumers
looked for reliable indicators of product quality and ser-
vice prior to the purchase. In addition to these changes in
consumer behavior, there was a trend towards relaxation
of the dress code in the work place.
As consumers became more knowledgeable about
products and demanded more from retailers, quick
response (QR) technologies—such as electronic data
Exhibit 6 Canadian Disposable Income ($Billions), Growth Rates (%), and Clothing Expenditure (%) 1994–1997
1994 1995 1996 1997
Disposable Income 493.6 510.8
+ 3.5
518.2
+ 1.4
523.7
+ 1.1
Expenditure on Clothing 23.0 23.9
+ 3.9
23.9
0.0
24.7
+ 3.3
Expenditure on clothing as a percentage
of disposable income
4.7 4.7 4.6 4.7
Exhibit 7 Populations and Growth Rates (%) for Canada, Ontario and Toronto
1981 1991 1996
Growth Rate
(Arithmetic)
Canada 24,343,181 27,296,859 28,846,761 9.2%
Ontario 8,625,107 10,084,885 10,753,573 24.6%
Toronto 3,893,046 4,263,757 10.0%
M11A_BARN0088_05_GE_CASE2.INDD 17 13/09/14 4:15 PM

PC 3–18 Corporate Strategies
in size and would generate $200 revenue per square foot
per year. The department store usually charged an oper-
ating fee of 10 per cent of sales to manage the area and a
lease rate equal to 50 per cent of revenues. An initial invest-
ment in inventory of $6,000 and another $6,000 would be
needed to equip the space with fixtures and signage.
With these three options before him, Wakefield sat
down to write out his proposal. He knew each pro-
posal would have to be evaluated based on the following
criteria:
■ Maintaining sufficient control to present the proper
“Brand NHL” image.
■ Limiting NHLEC’s investments—both financial and
human resources.
■ Establishing a profitable retail outlet.
Glenn was unsure how important this last criterion was in
the face of the project’s true objective to increase the expo-
sure of “Brand NHL”.
miscellaneous costs at 15 per cent. Net income would be
taxed at 45 per cent and the prime lending rate was cur-
rently at 6.5 per cent (borrowers would typically pay an
interest rate of prime plus one and a half per cent).
In the second model, NHLEC would hire and relin-
quish all control to a management firm that would handle
all the operational and administrative functions. In turn,
NHLEC would collect a licensing fee—15 per cent of
gross revenue—from the management firm. Typically, a
management firm would rent a much smaller space, likely
around 4,000 square feet, and might require NHLEC to
invest as much as $500,000 for furnishings and fixtures.
While he knew that several of these firms existed, he also
knew that it was often a challenge to persuade them to
adopt a project. How could he pitch the idea to such a
firm?
In the third model, NHLEC could rent floor space
in a major department store (i.e., The Bay, Sears, etc.).
Wakefield estimated the location would be 200 square feet
End Note
1. Children of the “baby boom.”
M11A_BARN0088_05_GE_CASE2.INDD 18 13/09/14 4:15 PM

Alex Poole sighed heavily and rubbed his tired eyes. It was
the fourth time in the past hour he had read the letter from his
grandfather. “I don’t know what to do,” Alex thought. I wish
Gramps could have put someone else in charge of his estate.
What if I make a mistake? Then what will Grandma do?” Alex
was a senior in college, working on a double major in finance
and management and a minor in Chinese. He hoped to land
a job with a large, multinational company after graduation
and move to Hong Kong or Singapore. He was determined to
get his foot in the door at a Fortune 100 company—no matter
how hard he had to work. Alex was used to hard work. For
the past three years, he had held down a part-time job while
attending school full time. His philosophy was that he could
afford to go to school only if he earned enough money to
cover his expenses, so he would find a way to do it.
Alex shuffled some papers on his grandfather’s
desk and pulled up the stock chart on Starbucks on his
MacBook. “This chart is amazing,” he thought. After go-
ing public at a split-adjusted $0.53 per share in June 1992,
the stock had taken off. A person who had invested $1,000
in Starbucks in the initial public offering would have had
shares worth nearly $22,000 on the same day 10 years later.
The stock continued its run until late 2006 when the combi-
nation of the Great Recession and internal problems caused
it to fall from a high of $39.43 per share to a low of $6.80
per share in November 2008. The board brought Howard
Schultz, the iconic founder of Starbucks, back as CEO in
January 2008 as the company faltered. Schultz engineered
a spectacular turnaround of the company. As of November
2013, the stock traded at more than $80 per share.
“Gramps sure was a savvy investor. When every-
one else was saying Starbucks was roasted, he bought the
stock,” Alex thought. “But now what should I do? I could
sell it and take profits, but Grandma will end up paying a
lot of taxes. I don’t know where to put the cash, either. If
I hold on to it and the stock goes down a lot, I’ll feel ter-
rible.” Alex yawned and rubbed his eyes again. “I guess
I’d better get some sleep and try to figure it out tomorrow.
I think I’ll stop by the Starbucks on the corner in the morn-
ing and check it out. If it’s crowded, I’ll feel better.”
to the floor. In order to cut off the ear-piercing shriek of the
alarm clock, Alex was forced to roll out of bed and chase it
around the room. Sarah, Alex’s girlfriend, had given him
the alarm clock after a couple of close shaves in which Alex
slid into his seat next to her their 7:30 a.m. investments class
just in time to take the weekly quiz. The professor took
missing a quiz as a personal affront and was likely to cold-
call the miscreant on multiple occasions to ensure that the
point about being prepared and on time for class was ham-
mered home. Students rarely missed more than one quiz.
Once Alex’s brain woke up enough to process infor-
mation, he realized that it was Saturday so he didn’t need to
rush to class. He took a quick shower, got dressed, and laced
up his Asics running shoes. After a brisk three-mile run,
he stopped in at the Starbucks on the corner for coffee and
a snack. There was a line of customers waiting, but it was
moving fairly quickly. Once he made it to the head of the
line, the barista at the register greeted him by name with a
bright smile and asked how his day was going. Alex ordered
a Venti Starbucks Blonde Roast with a slice of iced lemon
pound cake. He’d heard a rumor that the chain planned to
cut the lemon pound cake from the menu, but it was still
available. Prior to the addition of the distinctly lighter fla-
vored Blonde Roast, Alex rarely shopped at Starbucks. He
was one of the estimated 40 percent of Americans who felt
Starbucks’ traditional coffee offerings were too dark and too
bitter1 for their taste. The launch of Starbucks Blonde Roast
along with its recent “converts wanted” ad campaign had
persuaded Alex to give the new coffee a try. Now, he was
hooked on Starbucks and often joked about needing his
“Starbucks fix” to make sure he had a good day.
While he sipped his coffee, Alex pulled out his
iPhone 4S and began to surf the Internet for recent news
on Starbucks. After reading the company’s press release
on 3Q:13 earnings, he moved over to SeekingAlpha.com to
try to gauge investors’ reactions to Starbucks’ better-than-
anticipated earnings. As usual, the opinions on the stock
ranged from “buy, buy, buy” to “great company but over-
valued stock.” “That didn’t help a whole lot,” Alex thought.
“Gramps always said the company’s management team,
brand franchise, and business model were a lot more impor-
tant than the stock’s valuation or Wall Street sentiment. He
thought a company’s balance sheet was super important,
too. I guess I had better figure out what this company does
besides serve a great cup of coffee. I know Gramps thought
Howard Schultz was one of the best business leaders of all
time, but I sure don’t know much about him.” Alex waved
C a s e 3 – 3 : S t a r b u c k s : A n A l e x P o o l e
S t r a t e g y C a s e *
*This case was prepared by Bonita Austin for the purposes of class
discussion. It is reprinted with permission.
WRRAANNNN! WRRAANNNN! WRRAANNNN!
WRRAANNNN! Alex groaned, rolled over, and tried to hit
the snooze button on his Clocky alarm clock. The Clocky
expertly evaded his hand, rolled off the night table and on
M11A_BARN0088_05_GE_CASE3.INDD 19 13/09/14 4:17 PM

PC 3–20 Corporate Strategies
one. Schultz reckoned that Italy’s 200,000 coffee bars serving
a population of just 55 million people meant the U.S. market
had huge potential to support his vision of what he called a
“third place.” The “third place” would be a place outside of
the home and the office that would allow people to congre-
gate and gain a sense of community. Schultz left Starbucks to
start his own coffee business, Il Giornale, in 1985. Two years
later, he purchased Starbucks and merged it with Il Giornale.
“The weird thing about it,” Alex thought, “is that any-
one would want to be in the coffee business in the 1980s.
From what I can tell, it was a pretty unattractive market.” Alex
glanced down at the chart on U.S. coffee consumption3 he had
put together and shrugged his shoulders. According to the
USDA data, Americans consumed about 33 gallons of coffee
per capita in 1970. By 1987, annual per capita coffee consump-
tion was down to about 27 gallons. That translated into a large
drop in the number of cups of coffee Americans drank per day.
The decline had started way back in 1962, when Americans
consumed 3.12 cups of coffee per day. By 1980, average per
capita coffee consumption was down to about 2.0 cups per
day. U.S. average per capita coffee consumption fell to a new
all-time low of 1.67 cups per person per day in 1988.4 “How
could someone look at a declining product market—a market
in which in one generation usage had fallen to 52 percent of
the population from nearly 75 percent of Americans5—and see
a phenomenal business opportunity?” Alex wondered.
Moreover, the competition at retail was brutal. Three
large companies—Procter & Gamble (Folgers), General
Foods (Maxwell House, Sanka), and Nestlé (Nescafe,
Taster’s Choice, Hills Brothers)—dominated the retail cof-
fee business with a combined market share of more than
good-bye to the barista and headed out the door. He in-
tended to spend the afternoon in his university’s library
digging up as much information as possible on Starbucks.
Over the next week, Alex had amassed a lot of informa-
tion on Starbucks. After visiting the library, Alex had gone
back to his apartment and pulled out his previously unread
copy of Schultz’s book, Onward. He had been meaning to read
it for months but hadn’t gotten around to it due to his school-
work and Gramps’s passing. In the course of his research, Alex
found out that Schultz was not the founder of the original
coffee roasting and retail business named Starbucks. Schultz
purchased the six Starbucks stores and the brand name for $3.8
million in 1987 from the company’s founders. Alex thought
about what he had read about Schultz—how he had joined
Starbucks as its head of marketing in 1982 and had fallen in
love with Italian coffee bars at a trade show in Italy in 1983.
Schultz was enchanted by the connection between the cus-
tomers and coffee bar employees. “I saw something. Not only
the romance of coffee, but . . . a sense of community. And the
connection that people had to coffee—the place and one an-
other,” Schultz recalled in a 2013 interview with The Biography
Channel. “And after a week in Italy, I was so convinced with
such unbridled enthusiasm that I couldn’t wait to get back to
Seattle to talk about the fact that I had seen the future.”2
Schultz persuaded the owners of Starbucks to let
him install a coffee bar in one location. Despite the success
of the coffee bar test, Starbucks’ founders were not inter-
ested in transforming the company into a restaurant. They
had served coffee throughout the 1970s and even had an
espresso machine in the stores. Nevertheless, Starbucks’
founders felt the restaurant industry was an unattractive
40
38
36
34
G
al
lo
n
s
P
er
C
ap
it
a
32
30
28
26
24
22
20
1970 1972 1974 1976 1978 1980
Year
US Per Capita Coffee Consumption
1970–1987
1982 1984 1986
Source: USDA Economic Research Service.
M11A_BARN0088_05_GE_CASE3.INDD 20 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–21
had more than 15,000 company-owned and licensed stores.
Revenues for 2007 came in at $9.4 billion accompanied by
operating income of more than $1 billion for an operating
profit margin of 11.2 percent. Return on invested capital was
an impressive 17.7 percent in 2007—despite the company’s
whopping $282 million in cash. The company’s average
annual sales growth of 57 percent along with its 65 percent
average yearly jump in operating profits over the decade
put Starbucks squarely in an elite class of American success
stories such as Wal-Mart.
“That’s right when things turned sour for Starbucks,”
Alex thought. Schultz stepped down as CEO in 2000 and
took a much less active role in day-to-day operations as
the company’s chairman. Store traffic began to slow early
in 2007. By fall 2007, cracks appeared in Starbucks’ busi-
ness model. The company announced in November 2007
that traffic at its U.S. stores had fallen for the first time.
The company also lowered its projected store openings for
fiscal 2008 and lowered its estimates on comparable store
sales growth (sales growth in stores open 12 months or
longer). Starbucks was feeling the effects of the stagnant
economy. At the same time, Starbucks was struggling to
offset rising dairy and labor costs and trying to fight off
strong competitive pressure from McDonald’s and Dunkin’
Donuts. The stock dropped nearly 50 percent in 2007.
80 percent.6 As coffee consumption declined, the roasting
companies often relied upon promotions and price cuts
to stimulate demand. Moreover, retail prices tended to be
tied to volatile coffee commodity prices, as roasters were
unable to hold off demands by powerful supermarket buy-
ers to cut prices when bean prices fell. To protect margins,
roasters hiked retail prices when bean prices soared, but
the price hikes hurt demand and were difficult to maintain.
Although discerning Americans began to get interested in
high-quality coffees at the beginning of the decade, specialty
coffee only accounted for about $750 million in sales in 1990
or roughly 10 percent of the market, up from 3 percent of
the market or $210 million in 19837 and $50 million in 1979.8
Against that backdrop, Schultz invented the modern
Starbucks—transforming the coffee-roasting company into
a retailer that was backward vertically integrated into cof-
fee bean purchasing and roasting. Alex reflected on the
incredible success the new concept had enjoyed during
its first 20 years. By 1997, Starbucks’ revenues had grown
to $975 million and the balance sheet showed positive
net cash position (cash minus debt) of $42 million. About
86 percent of revenues were derived from the company’s
1,325 retail stores. Starbucks tested sales of coffee through
10 West Coast supermarkets—expanding to 4,000 grocery
stores the next year. By the end of its next decade, Starbucks
6%
8%
10%
8%
7%
5%
–3%
–6%
7%
8%
7%
–8
–6
–4
–2
0
2
4
6
8
10
12
Starbucks Comparable Store Sales Gains
P
er
ce
n
t
C
h
an
g
e
in
C
o
m
p
ar
ab
le
S
to
re
S
al
es
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Starbucks 2012 10-K.
M11A_BARN0088_05_GE_CASE3.INDD 21 13/09/14 4:17 PM

PC 3–22 Corporate Strategies
roaring back with outstanding results. Schultz vowed never
to allow the company to make the same mistakes again.
Alex Meets with His Broker
Two weeks later, Alex pushed his books aside and opened
the Starbucks folder on his MacBook. He sipped his Tall
Caffe Mocha Espresso and looked around the Starbucks
store. There was a steady stream of customers even at 2 in
the afternoon on a Monday. Alex had arranged a meeting
with his grandfather’s stockbroker, and the broker was
10 minutes late. He glanced down at his blue steel ESQ
Movado watch, checked the time for the hundredth time,
and drummed his pen on the table impatiently. Gramps’s
broker was an old pro—a self-made man with a flair for
stock picking. Gramps and the broker, Harry Wallace, had
been close friends. They were both members of the local
Rotary Club and avid golfers.
“Alex, how’ve you been?” Alex looked up and saw
Harry walking toward him, hand outstretched. After the
two had exchanged greetings and small talk, Alex got
down to business. “Harry, I’m trying to sort out Gramps’s
portfolio. His largest position is in Starbucks, so I started
there,” Alex said. He went on, “I need to figure out
whether to sell the stock or not. I’ve done quite a bit of
research on it already, but it would help if you filled in the
details on the company’s strategy for me.”
“Sure, I’d be happy to,” Harry said. “The stock had
been hitting all-time highs until it hit a bump in the road
when an arbitrator decided that Starbucks would have to
pay Kraft $2.23 billion plus $537 million in attorneys’ fees
to settle a three-year-old fight between the two companies.
Starbucks and Kraft had been partners in the packaged cof-
fee business since 1998. Starbucks supplied the coffee and
the brand name. Kraft supplied the distribution to mass
retail outlets. In 2004, the two companies renegotiated
their contract and extended it to 2014. In 2010, Starbucks
terminated the agreement, claiming Kraft had not upheld
its part of the bargain and had failed to work closely with
it on marketing decisions and customer contacts.”11 Harry
went on to say, “Starbucks claimed Kraft had hurt the per-
formance of the Starbucks brand at retail, but Kraft pointed
out that it had grown the company’s packaged coffee
business from $50 million in sales to $500 million in sales.
Starbucks maintained terminating the Kraft agreement
early was the right thing to do to accelerate the growth of
its mass retail business.” Harry added, “The stock sold off
–1.5 percent on the news before rebounding the next day as
Starbucks convinced investors that it had ample funds to
make the payment.”
“Comps,” Alex thought. “Comps were the company’s
downfall—at least that’s what Schultz said in his book.”
Alex’s grandfather had given him a copy of the book last
Christmas. He had inscribed, “To Alex, I hope Howard
Schultz’s extraordinary leadership and his passion will
inspire you. Love, Gramps.” Alex choked up a bit thinking
about Gramps and how much he had tried to stand in for
Alex’s dad. Alex had lost his dad in a car accident when
Alex was in the third grade. Alex cleared his throat and
went back to reviewing his notes on Starbucks. “Comps
had gotten really ugly in 2008,” Alex thought.
Schultz and the Starbucks team spent months diag-
nosing Starbucks’ problems. As Schultz noted in Onward,
“The more rocks we turned over, the more problems we
discovered.”9 Operating margins had slumped from a peak
of 12.3 percent in 2005 to 11.2 percent in 2007, but earnings
still increased. That all changed in 2008 when operating
earnings plunged nearly 27 percent excluding restructuring
charges and 52 percent including charges. Schultz went on
to say, “From where I sat as CEO, the pieces of our rapid de-
cline were coming together in my mind. Growth had been
a carcinogen. When it became our primary operating prin-
ciple, it diverted attention from revenue and cost-saving
opportunities, and we did not effectively manage expenses
such as rising construction costs and additional monies
spent on new equipment…Then, as customers cut their
spending, we faced a lethal combination—rising costs and
sinking sales—which meant Starbucks’ economic model
was no longer viable.”10 Although Starbucks had a sizable
presence in international markets, the United States still
accounted for 76 percent of company revenues. The United
States had to be fixed in order to turn around the company.
Schultz spent the next couple of years refocusing
Starbucks on the coffee business. He cut breakfast items from
the menu and got managers to think about customer service
and selling coffee. Schultz closed all the U.S. stores for a
day and retrained baristas on preparing the perfect cup of
espresso. He also replaced top management and built up the
company’s capabilities in supply and logistics. The manage-
ment team tackled major inefficiencies in the supply chain
as well as in the stores. Stores were redesigned to improve
efficiency and reduce on-the-job injuries. He also empha-
sized the Starbucks experience and the importance of being
passionate about coffee. Despite significant pressures from
Wall Street, Schultz refused to drop health care benefits for
part-time employees as he recognized the barista was one of
the fundamental drivers of company performance. Starbucks
also closed nearly 1,000 underperforming stores and laid off
about 12,000 workers. It slowed dramatically the rate of store
expansion from about 1,300 per year in the United States
to about 300. After a painful few years, the company came
M11A_BARN0088_05_GE_CASE3.INDD 22 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–23
1995 introduction. Frappuccino built up a following in
Starbucks stores before Starbucks and Pepsi pushed a bot-
tled version of the product into mass retail outlets. Schultz
credited a large part of Frappuccino’s retail success to
Starbucks having the “unique opportunity every single
day to reinforce the equity of the Frappuccino blended
product in our stores.”13 The $2 billion global brand com-
manded nearly two-thirds of the U.S. iced coffee category
in 2012.
Similarly, Starbucks introduced VIA instant coffee
in its stores in 2009. According to Schultz, the product in-
troduction marked the first innovation other than in pack-
aging in the instant coffee market in 50 years.14 Schultz
regarded the category as one that was “ripe for renewal.”15
Although the U.S. market for instant coffee was relatively
small at about $700 million in 2009, Schultz regarded the
product extension as a critical one for the company. He
felt it would spur innovation within the company, put
Starbucks into new retail channels like specialty sporting
goods stores, and support the company’s objective to be
the undisputed coffee authority. The instant coffee market
accounted for about 40 percent of worldwide coffee con-
sumption and generated an estimated $21 billion per year
in sales. Higher-end instant coffees generated less than 20
percent of instant coffee sales globally, which suggested
to Schultz the category was a candidate for “premiumiza-
tion”—just as the U.S. coffee market had been prior to
Starbucks’ entry into the market.
In addition, instant coffee consumption had grown
at a much faster clip in emerging markets than in the
United States, where sales of the product were flat. Global
Coffee Review magazine pegged worldwide instant coffee
growth at 7 to 10 percent and 15 to 20 percent in emerging
markets from 2000 to 2012.16 Coffee drinkers in emerging
markets favored instant or soluble coffee over brewed
coffee because consumers often could not afford special
coffee-making equipment. Starbucks’ management reck-
oned that it could establish the VIA brand in the United
States in its own stores, expand into mass retailing, and
then move the brand into Starbucks stores in the United
Kingdom, Japan, and emerging markets. (Instant coffee
accounted for about 80 percent of all coffee sales in the
United Kingdom and 63 percent of sales in Japan.)
Schultz believed Starbucks could use technology to
produce a cup of instant coffee that would taste the same
as a cup of Starbucks brewed coffee. The challenge for
Starbucks was threefold. First, the company had to over-
come the stigma of instant coffee being associated with
weak, low-quality, poor-tasting coffee in the United States.
Second, Starbucks had to convince consumers to pay a
hefty premium for VIA, which retailed for $0.82 to $0.98 per
The company’s revenue and earnings growth had
been pretty astonishing over the past couple of years as it
pulled out of its 2008–2009 slump. In the short term, the
risk in the stock was that investors are looking for another
positive earnings surprise when the company commented
on holiday sales in a few weeks in Harry’s opinion.
“I’m not all that interested in the short-term outlook.
You know Gramps always focused on a company’s long-
term prospects,” Alex said. “Tell me how things look for
Starbucks over the next couple of years.”
“Starbucks has approached long-term growth in a
unique way. The way I see it, the company’s so-called
blueprint for growth has a lot of potential to keep the com-
pany’s growth high,” Harry said.
Starbucks’ Blueprint
for Profitable Growth
In late 2010, Starbucks’ management announced plans
to create long-term shareholder value through a new
“blueprint for profitable growth.” Schultz said, “Our next
phase of growth will come from extending the Starbucks
Experience to our customers beyond the third place to
every part of their day, through multiple brands and
channels. Starbucks’ U.S. retail business and our connec-
tion with our customers form the foundation on which
we build all of our lasting assets, and we will combine
that with new capabilities in multiple channels to acceler-
ate the model we’ve created that no other company can
replicate.” Starbucks Chief Financial Officer Troy Alstead
went on to say, “Starbucks has reached a critical juncture
as we move from a high unit growth specialty retailer
focused on coffee in our stores, to a global consumer com-
pany with diversified growth platforms across multiple
channels.”12
In short, Starbucks intended to introduce new products
and brands in its Starbucks retail stores, establish a base of
customers for the new items, and later expand distribution
to mass-market channels like grocery stores. The company
meant to transform itself from a specialty retailer selling a few
coffee and tea products through mass outlets into a global
consumer products powerhouse. To do so, Starbucks planned
to augment its proven model for new brand development
with vertical integration and acquisitions. Management was
confident it would be able to build a stable of billion-dollar
brands by following the model Starbucks developed with
two key products: Frappuccino and VIA.
Frappuccino was a coffee blended with ice and
milk. The sugary beverage became enormously popular
with Starbucks devotees immediately after its summer
M11A_BARN0088_05_GE_CASE3.INDD 23 13/09/14 4:17 PM

PC 3–24 Corporate Strategies
Evolution Fresh
Starbucks acquired premium juice brand Evolution Fresh
for $30 million in cash in late 2011. The acquisition was
Starbucks’ first major plank in a new health and wellness
platform for the company. Starbucks intended to expand
the brand by launching a chain of juice bars, selling the line
through Starbucks coffeehouses, and expanding the brand’s
retail distribution. Schultz commented, “This is the first of
many things we’re going to do around health and well-
ness…We’re not only acquiring a juice company, but we’re
using this acquisition to build a broad-based, multi-million-
dollar health and wellness business over time.”19 As it had
done in the coffee and instant coffee markets, Starbucks
aimed to “reinvent the $1.6 billion super-premium juice
segment.” Starbucks claimed the company would be able
to take “a currently undifferentiated, commoditized prod-
uct segment and introduce a unique, high-quality product
to redefine and grow the super-premium juice market.”20
According to Schultz, “Our intent is to build a national
Health and Wellness brand leveraging our scale, resources
and premium product expertise. Bringing Evolution Fresh
into the Starbucks family marks an important step for-
ward in this pursuit.”21 By October 2013, Evolution Fresh
juice was sold in 8,000 retail locations—up from 2,000 in
2012—as well as in four standalone Evolution Fresh stores.
The company opened a $70 million factory in Rancho
Cucamonga, California, in late 2013 to support the rollout
of Evolution Fresh products across the United States.
Sales of fruit and vegetable juices and juice drinks
generated an estimated $20 billion in annual revenues in
2012. Industry sales had not grown appreciably for more
than five years. Moreover, per capita juice consumption
had declined as Americans turned to other beverages like
energy drinks and fortified waters to slake their thirst.
Per capita juice consumption declined from 6.1 gallons in
2006 to 5.17 gallons in 2011.22 In contrast, the super pre-
mium juice segment had boomed, and sales jumped to an
estimated $2.25 billion in 2013 as “juice cleanses” gained
popularity and manufacturers touted the health benefits of
cold-pressed juices.
Norman Walker, supposed “health expert” and
sometime mountebank, invented cold pressing in 1910. His
Norwalk hydraulic juicer was still considered by many to
be the best on the market in 2013 and retailed for a whop-
ping $2,000. Cold pressing pulverized fresh fruits and veg-
etables in order to extract all of the juice from the produce.
Evolution Fresh and others placed cold-pressed juices in
bottles and then subjected the filled bottles to high pres-
sure while floating in water. The high-pressure pascaliza-
tion (HPP) process stunted the growth of pathogens and
serving. Other instant coffees could be purchased for as little
as $0.04 to $0.07 per serving. Folgers Instant Coffee Singles
were priced at $0.20 per serving. Third, the company had
to overcome substantial competition in the segment once
it launched the product into supermarkets and other mass
outlets.
In order to change consumer perceptions of instant
coffee, the company employed extensive use of sampling
in its own stores to encourage consumers to taste VIA
side by side with Starbucks brewed coffee. The taste tests
continued for a year before Starbucks rolled out the prod-
uct into grocery and other mass retail stores. The com-
pany also sent baristas into its network of 3,000 licensed
store-within-a-store Starbucks locations in retailers such as
Target and Safeway to give out millions of VIA samples to
customers. Starbucks created free publicity for the brand
by inviting reporters to participate in blind taste tests com-
paring Starbucks brewed coffee with VIA instant coffee.
The evidence from the taste tests overwhelmingly sup-
ported Starbucks’ claim that VIA was a convenient, less
expensive version of a Starbucks coffee rather than a low-
quality, watered-down version of “real” coffee. (An eight-
ounce serving of brewed coffee in Starbucks stores cost
$1.50 in 2009.) In April 2012, the Huffington Post conducted
a blind taste test of instant coffees and concluded that VIA
Columbia was not only the best instant coffee on the mar-
ket but was indistinguishable from regular brewed coffee.17
Starbucks had to compete against well-established
brands in the United States and elsewhere. Nestlé, the
worldwide leader in instant coffee and inventor of the
product, held about 34 percent of the U.S. instant coffee
market in 2010. Kraft General Foods (Maxwell House)
was number two in the market with a share of about 26
percent, followed by JM Smacker (Folgers) with about a
21 percent share. Nestle had used its first-mover status to
its advantage—holding 51 percent of the global market for
instant coffee. In fact, Nestlé was the largest manufacturer
of packaged coffee in the world with nearly a 22 percent
global share due largely to its huge presence in the instant
coffee market. Nevertheless, Starbucks grabbed more than
10 percent of the U.S. instant coffee market in VIA’s first
year on the market.
Starbucks aimed to turn VIA into a $1 billion dollar
brand by leveraging its international presence and taking
on Nestlé head to head. The company launched VIA in
the Chinese market in April 2011 where Nestle controlled
75 percent of the instant coffee market. Instant coffee ac-
counted for 80 to 90 percent of coffee consumption in the
$11.3 billion Chinese coffee market.18 Still, by 2012, VIA
had generated $300 million in annual worldwide revenues
through 80,000 distribution points in 14 countries.
M11A_BARN0088_05_GE_CASE3.INDD 24 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–25
premium products. In the super premium segment, large
food and beverage companies trying to capitalize on the
higher growth in the segment owned by the top four
brands. Odawalla (acquired by Coca-Cola in 2001), Naked
Juice (PepsiCo), Bolthouse Farms (Campbell Soup), and
BluePrint (Hain Celestial Seasonings) together controlled
an estimated 51 percent of the super premium market.
The juice bar business also was crowded with com-
petitors trying to take cash in on demand for healthy
foods. Sales at juice bars and smoothie chains nearly
doubled between 2004 and 2012, according to Barron’s
magazine. Barron’s pegged sales at the 6,200 juice bars
and smoothie operations at about $2 billion. The top five
juice and smoothie chains—Jamba Juice, Freshens, Maui
Wowi, Smoothie King, and Orange Julius—accounted for
more than 50 percent of all of the juice and smoothie retail
locations in the United States in 2012. The top 10 operators
owned or had franchised about two-thirds of the industry
locations.24 Rivalry appeared to be fierce as the large chains
attempted to fight off small local competitors who often
positioned themselves as the most “authentic” purveyor
of juices. Marcus Antebi, CEO of Manhattan’s trendy Juice
Press, commenting on Organic Avenue’s appointment of a
non-vegan CEO to the New York Daily News said, “They’ll
no longer represent the glossy, sexy brand that they were
five years ago, before Juice Press smothered them. I actu-
ally water boarded them with green juice.”25
U.S. Tea Market
Quick as thought the ships were boarded
Hatches bust and chests displayed;
Axe and hammers help afforded,
What a glorious crash they made.
Quick into the deep descended,
Cursed weed of China’s coast;
Thus at once our fears were ended
Freemen’s rights shall ne’er be lost.
—anonymous American balladeer
commemorating the Boston Tea Party26
According to some sources, coffee’s popularity in
the United States relative to tea stretches back to the
Revolutionary War and the Boston Tea Party. In protest to
unfair taxation and the granting of a tea monopoly to the
East India Company by British Parliament, colonists snuck
on board three tea ships (the Dartmouth, the Eleanor, and
the Beaver) on December 16, 1773, and dumped 90,000
pounds of tea into Boston Harbor. Colonists went on to
boycott British imports, including tea, for many years.
extended the shelf life of the juice from a few days to about
three weeks. Mass-market brands such as Tropicana relied
on high-heat pasteurization to kill pathogens in juice. Fans
of cold-pressed juice claimed it was healthier than pasteur-
ized juices. While there was little scientific evidence to
support manufacturers’ claims of superior health benefits,
so-called juicers asserted the flavor of cold-pressed juice
was “closer to fresh” than mass-market stalwarts like
Minute Maid or Tropicana. Critics of cold pressing were
concerned about the product’s safety. They noted that
Odawalla juice, a leader in the cold-pressed juice category,
introduced flash pasteurization after a batch of apple juice
was contaminated with E. coli in 1996. The contaminated
apple juice had caused illness in at least 66 people and
reportedly led to the death of a 16-month-old child. In fact,
the FDA had begun to push cold-pressed juice makers to
include HPP or an alternative process as a way to increase
the product’s safety. Given that each HPP machine cost
$800,000 to $2 million, it was difficult for small juicers to
jump on the HPP bandwagon.23 Nevertheless, an E. coli
outbreak could generate a consumer backlash against all
cold-pressed juices.
Despite Starbucks’ ambitious plans, it was not clear
that the juice market could be characterized as “com-
moditized.” The category was bombarded annually with
product introductions touting new flavor combinations
and health benefits. Some of the more exotic juices intro-
duced into the mass market in recent years included co-
conut water, acai, beet juice, and Suavva Cacao. Ironically,
health concerns had stymied growth in the mass market as
consumers became concerned about the high sugar content
in juices. While whole fruits had been shown to reduce the
risk of type 2 diabetes, the high sugar content in fruit juices
had some consumers shying away from the product due to
concerns over obesity. PepsiCo had scrambled to find a so-
lution to the sugar problem. While the company continued
to experiment with new sugar-free sweeteners, it launched
Tropicana Light and Trop50 products under the $6.2 billion
Tropicana brand. Tropicana Light was sweetened with
sucralose, and Trop50 was sweetened with stevia. Trop50
products also contained only 42 to 43 percent juice as
the liberal additional of water allowed PepsiCo to bring
down calorie count significantly and increase gross mar-
gins. While consumers responded favorably to the new
products, PepsiCo management knew the secret to long-
term success lay in continued product innovation in sugar
replacement. PepsiCo was determined to find a natural
sugar replacement to protect its enormous global beverage
business.
Juice prices ranged from a few cents per ounce
for mass brands to well over $1 per ounce for super
M11A_BARN0088_05_GE_CASE3.INDD 25 13/09/14 4:17 PM

PC 3–26 Corporate Strategies
finest assortment of premium loose-leaf teas and tea-related
merchandise, locating stores in high-traffic areas primar-
ily in shopping malls and lifestyle centers, and creating a
“Heaven of Tea” retail experience for customers. Teavana’s
emphasis on training “passionate and knowledgeable
teaologists” to “engage and educate customers about the
ritual and enjoyment of tea”31 allowed it to charge premium
prices and develop a loyal following in the United States.
Indeed, Teavana’s approach to the market had been
a very successful and profitable one with sales soaring
to $168.1 million and operating profits of $32.6 million.
Teavana’s highly productive stores generated nearly $1,000
per square foot in sales and comparable store sales growth
of nearly 9 percent in 2011 and more than 11 percent in
2010. New stores had an average cash payback period of
just a year and a half. The retailer believed it could drive
tea category growth in the United States by educating
consumers about the health benefits of tea and the culture
of tea drinking. Each Teavana store included the “Wall of
Tea,” which allowed customers to “experience the aroma,
color, and texture” of any of the store’s approximately 100
different varieties of single-estate and specially blended
teas.32 Like Starbucks and its coffee culture, Teavana em-
phasized a company culture that celebrated a passion for
tea. To that end, Teavana had a policy of promoting from
within company ranks, extensive employee training, and
teaologist career development. Management recognized
that retail success was heavily dependent upon teaologists
in the same way Starbucks’ success rested upon the barista.
Starbucks intended to develop Teavana as a major
growth platform beginning with the U.S. market. In late
October 2013, Starbucks opened the first Teavana tea bar
on Manhattan’s ultra-wealthy Upper East Side. Schultz
told reporters the company expected 1,000 tea bars in the
United States over the next five years.33 Schultz was con-
fident that Starbucks could transform the U.S. tea market
with Teavana in the same way it had transformed the cof-
fee market. Some industry observers were not as sanguine
about Teavana’s prospects.
Brian Sozzi of Belus Capital Advisers noted to Forbes
magazine, “I don’t believe Teavana will ever grow into what
the Starbucks brand has become for one simple reason: tea
lacks the major caffeine count.” He added, “That sounds silly,
but the bottom line is that in this day and age of frantic tech-
driven lifestyles, people want to run on 100 mg of caffeine,
and they will trade taste to make that happen.”34 In fact,
the contrast between Teavana and Starbucks products was
stark at the cultural level. Coffee typically was associated
with early-morning commutes and midday pick-me-ups.
While Starbucks had done a great job creating a welcoming
atmosphere in its coffeehouses, the pace of each shop was
Coffee and herbal teas supposedly became popular due
to the boycott as substitutes for the colonists’ favorite
beverage.
Retail and food-service sales of tea generated about
$6.5 billion in revenues in the United States and $40 billion
worldwide in 2011. Tea was the second-most consumed
beverage worldwide, behind water. However, tea remained
distinctly less popular with Americans than coffee. The
beverage came in at a distant number six among American
favorites behind soft drinks, water, coffee, milk, and beer
(in that order). Nevertheless, per capita consumption of
tea grew about 5 percent from 2001 to 2011 as Americans
sipped slightly more than seven gallons of tea per person.
In contrast, per capita coffee consumption fell 1 percent,
and carbonated soft drink consumption plunged 16 percent
over the period.27 As tea consumption increased, the num-
ber of U.S. tea shops jumped from about 1,500 in 2009 to
approximately 4,000 in 2011. Costs to open a single tea shop
were relatively low with some tea shop owners estimating
it cost $10,000 to $25,000 (comparable with opening a non-
franchised pizza place) and others coming in at $100,000
to $250,000 (a bit lower than opening a franchised pizza
restaurant).28
Starbucks had long been a player in the tea market
with its Tazo tea brand, which it had acquired in 1999
for $8.1 million. The company sold Tazo tea in grocery
stores and other mass outlets as well as in Starbucks
coffeehouses. By 2012, Tazo overall was a $1.4 billion brand
for Starbucks. Although the company had been successful
in establishing a large tea brand, tea had never been a focal
point for Starbucks until it acquired Teavana Holdings.
Starbucks announced it would purchase Teavana Holdings
for $620 million in cash in November 2012. Teavana was
the largest tea shop operator in the United States with 300
retail stores mainly in shopping malls. Founded in Atlanta
in 1997, Teavana sold high-end loose-leaf teas exclusively
through its own stores.
Teavana’s mission was to establish its brand “as the
most recognized and respected brand in the tea industry by
expanding the culture of tea across the world.”29 As noted
by Seattle’s Crosscut.com reporter Ronald Holden “Just as
a wine aficionado can wax on (and on and on) about grape
varieties and legendary vintages, a devotee of tea can cite
literally hundreds of varieties of camellia sinensis leaves
(white, green, oolong, black), and their methods of ‘wither-
ing’ (steaming, pan-firing, shaking, bruising, rolling, dry-
ing, oxidizing). Then there are the tea-like drinks that don’t
contain Camillia sinensis, like prepared herbal infusions,
rooibos (red teas) and the green-powdered matés.”30
Teavana management identified the key elements
of its strategy as developing and sourcing the world’s
M11A_BARN0088_05_GE_CASE3.INDD 26 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–27
Rewards beginning in April 2013. Starbucks customers
who purchased Starbucks packaged products in grocery
stores and other retail outlets also were eligible for My
Starbucks Rewards by registering for the program and
entering product codes on the Internet. Starbucks hoped
to create value across its brands and distribution channels
through its unique loyalty program.
That evening, Alex sat down and thought about
what he had learned about Starbucks over the past few
weeks. “Well, at least midterms are over,” Alex thought.
He sighed wearily. The past few days had gone by in a blur
of exams, studying, and not enough sleep. His girlfriend,
Sarah, had gotten exasperated with him for waiting until
the last minute to study for their investments midterm.
He was sure she had aced the exam but was less confident
about his own score. Alex had gotten bogged down study-
ing for his midterm in his third-year Mandarin course and
hadn’t spent much time studying for investments. The
Mandarin class was a lot harder for Alex than his finance
courses, but the investments class was a tough one. “Sarah
was right. I shouldn’t have put studying off for so long.”
To top it off, his strategy midterm also had been a difficult
one. His strategy professor put a lot of emphasis on ap-
plying concepts to real company situations. “It was tough
to apply concepts on a couple of hours of sleep,” Alex
thought ruefully. “Well, there’s nothing I can do about it
now. I need to focus on finishing this Starbucks analysis
because I am just going to get busier as the term goes on.
I haven’t even thought about the competition. I need to fig-
ure out what McDonald’s and Dunkin’ Donuts are up to.”
Bitter Dregs: Starbucks’ Rivalry
with McDonald’s
With $35.6 billion in U.S. sales in 2012, McDonald’s was
the largest quick-service restaurant in America and nearly
three times larger than the number two fast food operator,
Subway. Coffee accounted for an estimated 6 to 7 percent
of McDonald’s U.S. sales or $2.1 to $2.5 billion in annual
revenues. Despite its substantial coffee sales, Starbucks’
management did not publicly acknowledge McDonald’s as
a competitor. On the surface, the world’s largest fast-food
franchise had little in common with Starbucks. Known for
efficiency and low costs, McDonald’s was the Wal-Mart of
fast food. Starbucks was a premium purveyor of specialty
coffees. McDonald’s empire was built on standardization.
Starbucks ran on customization.
Nevertheless, McDonald’s was long known for serv-
ing good, inexpensive drip coffee. Moreover, McDonald’s
quick and energetic, particularly during the morning rush
hour. Tea culture was one associated with tranquility and
relaxation. Teavana’s new tea shop invited customers to
slow down and find some quiet time while their tea brewed.
According to a University of Northumberland study consist-
ing of 180 hours of testing and 285 cups of tea, it took eight
minutes to brew the perfect cup of tea—two minutes of soak-
ing the tea bag in boiling water (100°C or 212°F), removal of
the tea bag, addition of milk, and a six-minute wait for the
temperature to drop to 60°C or 140°F.35
La Boulange Café & Bakery
Starbucks acquired a small chain of San Francisco bak-
eries for $100 million in the third quarter of 2012. The
chain, La Boulange, included 19 store locations. Starbucks
intended to roll out La Boulange products to 17,000
Starbucks coffeehouses by the end of 2013. La Boulange
Café’s major investor commented in a release about the
sale: “We have confidence that Starbucks will stay true
to the La Boulange brand while bringing the romance
of an authentic French bakery to consumers across the
United States.”36 Long criticized for having mediocre
food, Starbucks nonetheless sold $1.5 billion in food items
annually. About one-third of purchases in the United
States included a food item.37 According to Pascal Rigo,
vice president of Starbucks’ food division and former
owner of La Boulange, food had been an afterthought at
Starbucks.38 The company planned to significantly up-
grade the quality of its food and add lunch items to the
menu under the La Boulange banner. Baked items were
to be displayed on pink paper in the coffeehouse’s glass
cases and served warm. About 25 percent of La Boulange
items would be customized for local markets. Starbucks
hoped to both take a bigger slice of the lunch business
and compete more aggressively with fast-growing Panera
Bread in the United States.
Starbucks’ Loyalty Card
Starbucks launched “My Starbucks Rewards” in 2009
as a way to create value for its most loyal customers.
Customers received points for each purchase regardless
of the amount they spent. Points were redeemable for
free Starbucks drinks and food. By early 2013, Starbucks
had 4.5 million rewards program members. The company
intended to double its reward program membership to
9 million members by fall 2013. To that end, Starbucks an-
nounced Teavana shoppers were eligible for My Starbucks
M11A_BARN0088_05_GE_CASE3.INDD 27 13/09/14 4:17 PM

PC 3–28 Corporate Strategies
consumption occurred at home. He characterized the move
into supermarkets with Kraft as a way to build awareness
of the McCafe brand and drive sales in McDonald’s restau-
rants.41 Analysts noted that McDonald’s had 4,200 McCafe
shops in international markets—including standalone loca-
tions as well as those inside McDonald’s restaurants—and
intended to add another 350 to 400 locations in 2014 alone.
Death of the Doughnut: Dunkin’
Donuts—A Beverage Company
Dunkin’ Donuts CFO Paul Carbone told investors in
mid-2013 that Dunkin’ Donuts had moved to acknowl-
edge publicly that the chain was no longer a dough-
nut company. Carbone told analysts, “We’re a beverage
company.”42 Dunkin’ Donuts reported that 58 percent
of its franchise revenues were derived from espressos,
Duncacinnos, Coolattas, and about two dozen other bever-
ages. The shift away from doughnuts to coffee and coffee
drinks began in about 1995. Dunkin’ Donuts launched a
line of flavored coffees to respond to Starbucks’ expan-
sion into its home market: Boston. At the time, Dunkin’
Donuts was known primarily for its doughnuts and an
ad campaign that featured “Fred the Baker.” Fred’s catch
phrase was “It’s time to make the doughnuts.” According
to Time magazine, Dunkin’ Donuts kicked off in 2006 “the
most significant repositioning effort in the company’s 55-
year history.” Its new ad slogan was “America Runs on
Dunkin’.” Time noted in the same article that Dunkin’
Donuts had positioned its mostly East Coast coffee busi-
ness as “fuel” for America rather than a lifestyle choice
like Starbucks.43 With lower prices and an emphasis on
practicality, Dunkin’ Donuts appealed to the every man in
a hurry. Dunkin’ Donuts’ share of the U.S. coffee and snack
shop market was about 25 percent in 2012 compared with
Starbucks’ share of about 33 percent.
Nevertheless, Dunkin’s core business remained
in the East. Very few of Dunkin’s 7,300 U.S. locations
were east of the Mississippi in 2012. However, Dunkin’
Donuts management aimed to change that by moving into
California with 1,000 Dunkin’ Donuts shops. (Starbucks
had more than 2,000 locations in California in 2013, its larg-
est market by far.) Overall, Dunkin’ Donuts also planned
to increase the number of Dunkin’ locations in the United
States to about 15,000 by 2020. Dunkin’ Donuts’ overall
expansion plans were likely to put it increasingly in head-
to-head competition with Starbucks. Starbucks planned
to add about 1,500 stores to its U.S. store base of about
11,000 coffeehouses. Industry observers noted that Dunkin’
dominated the breakfast market with more than a 25 per-
cent share. The company announced in mid-2009 the roll-
out of McCafe specialty coffee shops within 11,000 of its
14,000 U.S. locations. Developed in Australia in 2001, the
McCafe brand and McCafe shops gave McDonald’s an en-
try into the pricey and profitable premium coffee segment
just as consumers felt the pinch of the Great Recession.
As McDonald’s gained momentum in the U.S. cof-
fee market, Starbucks retaliated by announcing it would
expand distribution of Seattle’s Best Coffee to Burger King
and Subway restaurants as well as AMC movie theaters
and other mass-market outlets. Starbucks had acquired
the brand for $72 million in 2003 but had done little to ex-
pand Seattle’s Best’s market presence since the acquisition.
Starbucks’ management commented that the move into fast
food enabled the company to further its objective to offer
great coffee everywhere. Industry observers saw the move
as a direct response to McDonald’s market share inroads.
Morgan Stanley’s John Glass noted to Time magazine: “…
it makes sense to partner with Burger King and Subway
against a common enemy: McDonald’s.”39 At the time of
the rollout announcement, McDonald’s also announced its
intentions to launch frozen coffee drinks in its restaurants
during summer 2010. The Frappe retailed for $2.29 to $3.29
compared with $3.00 to $5.00 for Starbucks’ Frappuccino.40
Whether Starbucks wanted to admit it or not, McDonald’s
new product introductions placed it squarely in competition
with Starbucks in multiple segments of the coffee market.
In fact, McDonald’s had garnered close to 13 percent
of the U.S. coffee market by 2012. McDonald’s U.S. cof-
fee sales had soared 70 percent since the introduction of
McCafe. The company introduced a pumpkin spice latte
in fall 2013 and announced it would introduce a white
chocolate-flavored mocha at the end of November 2013. Both
product launches were aimed directly at Starbucks where
the pumpkin spice latte was a perennial customer favorite.
McDonald’s had struggled with execution in the lucrative
specialty coffee market with many McDonald’s customers
complaining about lengthy waits in the drive-through line
resulting from the increased time to make the customized
drinks. Nevertheless, the coffee business remained a bright
spot in McDonald’s otherwise lackluster U.S. operations.
In November 2013, McDonald’s announced it would
partner with Kraft to bring a McCafe line of packaged coffees
to supermarkets and other mass retail outlets. McDonald’s
CEO Don Thompson told investors that coffee was one
of the fastest-growing product categories in its worldwide
beverages business. Thompson also told investors that
McDonald’s did not yet have what he called “its fair share”
of the business. Kevin Newell, chief brand and strategy of-
ficer for McDonald’s U.S., noted that 70 percent of U.S. coffee
M11A_BARN0088_05_GE_CASE3.INDD 28 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–29
for him to make a decision on the stock. He spent an hour
compiling questions, scratching them out and condensing
them into their most fundamental elements. At the end of
the exercise, Alex realized that he needed to answer three
questions in order to make a decision about whether
to sell the stock. Could Starbucks successfully expand
beyond the coffee shop business in a meaningful way
without destroying its core business? Could the company
create value through its diversification strategy? Would
McDonald’s and Dunkin’ Donuts eat into Starbucks’
business enough to slow the company’s growth rate?
Donuts’ expansion into California marked its third attempt
to crack the market in the past 30 years. The chain had
about a dozen stores in California until the late 1990s, ac-
cording to Bloomberg BusinessWeek.44 Dunkin’ tried to reen-
ter the Sacramento market in 2002 but pulled out quickly.45
Conclusion
Alex realized that he hadn’t spent enough time thinking
about the questions that needed to be answered in order
Reference
Miller, C. (2009). “Starbucks coffee, now in instant. New York Times, February 18.
End Notes
1. (2013). “Free Starbucks Blonde samples aim to sway light-roast coffee drink-
ers [update].” www.huffingtonpost.com/2013/01/08/free-starbucks-blonde-
samples_n_2431793.html#slide=873948. Accessed October 15, 2013.
2. (2013). “Howard Schultz.” The Biography Channel. October 16, www.biography.com/
people/howard-schultz-21166227.
3. (2013). “Beverages: Per capita availability.” USDA Economic Research Service,
October 16, www.ers.usda.gov/data-products/food-availability-%28per-capita%29-
data-system/.aspx#.UmA9oYX5AYs.
4. Roseberry, W. (1996). “The rise of yuppie coffees and the reimagination of class in the
United States.” American Anthropologist, New Series, 98(4), p. 765.
5. Ibid., p. 765.
6. Samuelson, R. J. (1989). “The coffee cartel: Brewing up trouble.” The Washington Post,
July 26.
7. Sturdivant, S. (1990). “Coffee in the next decade: Upcoming trends (coffee in the
1990s).” Tea & Coffee Trade Journal, January 1.
8. Van Vynckt, V. (1986). “Coffee: A treat for the ‘buds: ‘Specialties’ perk up market.”
Chicago Sun-Times, April 3.
9. Schultz, H., with Gordon, J. (2011). Onward: How Starbucks fought for its life without los-
ing its soul. Rodale Books, Kindle Edition, p. 150.
10. Ibid., pp. 152–153.
11. D’Innocenzio, A. (2013). “Starbucks Kraft lawsuit: Coffee chain must pay $2.76 billion
to settle dispute.” Huffington Post, November 12.
12. (2010). “Starbucks outlines blueprint for multi-channel growth.” Starbucks press
release. Business Wire, December 1.
13. Schultz, H. (2012). “Starbucks CEO hosts biennial investor conference (transcript).”
December 5, p. 7. www.seekingalpha.com. Accessed November 1, 2013.
14. Ibid.
15. Schultz, H., with Gordon, J. (2011). Onward: How Starbucks fought for its life without los-
ing its soul. Rodale Books, Kindle Edition, p. 252.
16. (2013). “Instant coffee consumption in emerging markets.” Global Coffee Review,
March. globalcoffeereview.com/market-reports/view/instant-coffee-consumption-
in-emerging-markets. Accessed November 18, 2013.
M11A_BARN0088_05_GE_CASE3.INDD 29 13/09/14 4:17 PM

PC 3–30 Corporate Strategies
17. (2012). “Taste test: The best instant coffee.” Huff Taste, The Huffington Post, April 5.
18. O’Brian, R. (2013). “Starbucks, Nestlé square off in bid for dominance of China’s cof-
fee market.” Context China. contextchina.com/2013/05/starbucks-nestle-square-off-
in-bid-for-dominance-of-chinas-coffee-market. Accessed November 17, 2013.
19. (2011). “Starbucks acquires Evolution Fresh to establish national retail and grocery
health and wellness brand.” Starbucks press release, November 10.
20. Ibid.
21. Ibid.
22. Fottrell, Q. (2013). “Graphic: Tea up 5%. Milk: Out. Wine: In. Plus 8 other drink trends.
How the nation’s thirsts have shifted over the past decade.” Marketwatch.com,
February 15 Accessed October 15, 2013.
23. Latif, R. (2013). “The juice uprising.” BevNET Magazine, September 12.
24. Blumenthal, R. (2012). “Drink up!” Barron’s, July 23.
25. Friedman, M. (2013). “Juice makers battle over market share and product purity as
sales surge.” New York Daily News, May 22.
26. “The Boston Tea Party.” United Kingdom Tea Council, www.tea.co.uk/the-boston-
tea-party. Accessed October 26, 2013.
27. Fottrell, Q. (2013). “Graphic: Tea up 5%. Milk: Out. Wine: In. Plus 8 other drink trends.
How the nation’s thirsts have shifted over the past decade.” Marketwatch.com,
February 15 Accessed October 15, 2013.
28. Simrany, J. “The state of the U.S. tea industry.” Specialty Tea Institute and Tea Council
USA.
29. (2011). Teavana prospectus form 424, July 28, p. 1.
30. Holden, R. (2013). “Cuppa inner peace? U Village Teavana expands Starbucks
empire.” Crosscut.com, Crosscut PublicMedia. November 21, crosscut.com/2013/11/
21/business/117566/starbucks-tea-volution-slinging-u-village-enlighte. Accessed
November 23, 2013.
31. (2011). Teavana prospectus form 424, July 28, p. 1.
32. Ibid.
33. O’Connor, C. (2013). “Starbucks opens its first tea bar as CEO Schultz bets on $90
billion market.” Forbes, October 23.
34. Ibid.
35. Alleyne, R. (2011). “How to make the perfect cup of tea: Be patient.” The Telegraph,
June 15.
36. Wilkey, R. (2012). “Starbucks La Boulange acquisition: Coffee giant buys local
patisserie for $100 million.” Huff Post San Francisco. Huffington Post, June 4, www.
huffingtonpost.com/2012/06/04/la-boulange-starbucks_n_1569522.html. Accessed
November 23, 2013.
37. Choi, C. (2012). “Starbucks buys La Boulange bakery for $100 million to improve food
offerings.”AP Newswire, June 4.
38. Tepper, R. (2013). “Starbucks’ new La Boulange menu is its largest-ever investment
in food.” Huffington Post, September 19, www.huffingtonpost.com/2013/09/19/
starbucks-la-boulange_n_3954803.html. Accessed November 23, 2013.
39. Gregory, S. (2010). “Starbucks aims at McDonald’s with Seattle’s Best Coffee.”
Time, May 25, content.time.com/time/business/article/0,8599,1990813,00.
html#ixzz2lafvjXPz. Accessed November 23, 2013.
40. Ibid.
41. Choi, C. (2013). “McDonald’s eyes bigger share of coffee market.”AP Newswire, ABC
News, November 14, abcnews.go.com/Business/wireStory/mcdonalds-eyes-global-
coffee-growth-20891507. Accessed November 23, 2013.
42. O’Connor, C. (2013). “Dunkin’ Donuts now class itself a ‘beverage company’ as it
aims for Starbucks and heads west.” Forbes, June 20, www.forbes.com/sites/clareo-
connor/2013/06/20/dunkin-donuts-now-calls-itself-a-beverage-company-as-it-aims-
for-starbucks-and-heads-west. Accessed November 23, 2013.
M11A_BARN0088_05_GE_CASE3.INDD 30 13/09/14 4:17 PM

Case 3–3: Starbucks: An Alex Poole Strategy Case PC 3–31
43. Sanborn, J. (2013). “Don’t call Dunkin’ Donuts a donut company.” Time.
June 26, business.time.com/2013/06/26/dont-call-dunkin-donuts-a-donut-
company/#ixzz2lbRdWNqb. Accessed November 23, 2013.
44. Wong, V. (2013). “America: Dunkin’ Donuts’ next frontier.” Bloomberg BusinessWeek,
April 11, www.businessweek.com/articles/2013-04-11/america-dunkin-donuts-next-
frontier. Accessed November 23, 2013.
45. Ibid.
M11A_BARN0088_05_GE_CASE3.INDD 31 13/09/14 4:17 PM

Ivey Management Services is the exclusive representative of the copyright holder and prohibits any form of reproduction,
storage or transmittal without its written permission. Reproduction of this material is not covered under authorization
by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey
Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London,
Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. One time permission
to reproduce granted by Richard Ivey School of Business Foundation on March 31, 2014.
David T.A. Wesley prepared this case under the supervision of Professor Ravi Sarathy solely to provide material for class
discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors
In 2005, Rayovac announced acquisitions totalling $1.5 billion,
which encompassed the purchases of United Industries and
of Tetra Holdings and aimed at making Rayovac the most
“significant global player in the pet supplies industry.”2
These acquisitions were the latest in a series, going back to
1999, that gave Rayovac significant market presence in new
product categories, including lawn and garden care, house-
hold insecticides and pet foods (see Exhibit 1). Through such
acquisitions, Rayovac grew from $400 million in sales in 1996
to approximately $2.8 billion in 2005. In recognition of this
major shift in both composition and direction, the company
changed its name from Rayovac to Spectrum Brands.
Company Background3
Rayovac was established in Madison, Wisconsin, in 1906 as
the French Dry Battery Company. After changing its name
to Rayovac in 1921, the company became one of the best
known battery brands in the United States and quickly
established itself as the leading marketer of value-brand
batteries in North America.
In 1996, after seeing its market share steadily
eroded by Duracell, Energizer and Panasonic (owned by
Matsushita), the company was purchased by private eq-
uity firm Thomas H. Lee Partners (THL). At the time,
revenues were approximately $400 million. THL sought to
revive the Rayovac brand name by growing the company
through acquisitions. Initially, acquisitions focused on the
battery business, but later included businesses focused on
shaving products and personal care. This strategy met with
some success as Rayovac increased its U.S. market share
from 27 per cent to 34 per cent between 1996 and 2001.
Historically, most of the company’s growth had been
in North America. However, beginning in 2002, the com-
pany began to selectively acquire battery manufacturers
and distributors in key foreign markets in an effort to
establish a strong global presence. Then in 2003, the com-
pany acquired Remington Products in its first move to
diversify away from consumer batteries.
According to David A. Jones, chief executive officer
(CEO) of Rayovac Corporation, the company’s diversifica-
tion efforts had only begun. He explained,
We set out consciously for the first five or six years to glo-
balize the battery and lighting business, which we’ve done,
and we have consciously now, for some period of time,
been looking for the right diversification moves . . . . There
are other things that, over time, we’ll become interested in
and you’ll probably see us move towards.4
The Global Battery Business
In 2003, the global battery market was worth approx-
imately $24 billion, with the United States accounting
for about one-third of total consumption. Between 1990

C a s e 3 – 4 : R a y o v a c C o r p o r a t i o n :
I n t e r n a t i o n a l G r o w t h a n d
D i v e r s i f i c a t i o n T h r o u g h A c q u i s i t i o n s 1
may have disguised certain names and other identifying information to protect confidentiality.
Copyright © 2006, Northeastern University, College of Business Administration Version: (A) 2009-09-21
M11A_BARN0088_05_GE_CASE4.INDD 32 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–33
For any brand, whether it’s a value brand or premium
brand, you have to have high quality products. And the
facts are on our side. Our products are very good, high
quality products. But once you have that, certainly
our point of differentiation is value. You can buy our
products for 10 per cent to 15 per cent lower than our
competitors . . . . We’re actively outselling our value
proposition, because we’ve tried to create a business
model and a business plan different from Duracell and
Energizer. Our products are as good as those two fine
companies but sell at value price.5
For several years, battery manufacturers experienced strong
growth worldwide due to the increased use of personal
electronic devices, such as portable music players, fitness
monitors, handheld computers (PDAs) and gaming devices.
Portable lighting was another significant Rayovac product
category, with 2003 global sales approaching $3 billion, of
which flashlights represented about half of the market.
With the proliferation of personal electronic devices,
average household battery consumption increased from ap-
proximately 23 batteries per year in 1986 to 44 batteries per
year in 2000. As incomes grew, consumption in developed
countries switched from zinc carbon to the better performing
and higher-priced alkaline batteries, a trend that Rayovac
expected to be duplicated in emerging markets. According to
and 2000, the United States achieved an annual growth
rate of 7.4 per cent in alkaline battery products. Rayovac
Corporation accompanied this trend but lagged behind
Duracell and Energizer in the United States. The intensely
competitive U.S. battery market led to considerable price
discounting and required significant advertising and pro-
motion expenditures. Rayovac, as the No. 3 player, had to
carefully choose its competitive strategy, its product line
composition and features, its price points, its cost position,
its distribution channels and its advertising strategy in or-
der to be able to close the competitive gap.
Gillette, owner of the Duracell brand, had annual
revenues of $9 billion, followed by Energizer Holdings,
with revenues of $1.7 billion. Although Rayovac was
in third place in the United States, globally, it was the
worldwide leader in hearing aid batteries, the leading
manufacturer of zinc carbon household batteries in North
America and Latin America, and the leading marketer of
rechargeable batteries and batterypowered lights in the
United States.
Both Energizer and Duracell produced premium
brands that sold for approximately 15 per cent above com-
parable Rayovac products. Jones believed that Rayovac’s
value position distinguished it from its premium brand
competitors. He explained,
Exhibit 1 Rayovac Acquisitions (1999 to 2005)
(in $ millions)
Year Company Acquired Price Paid EBITDA Key characteristics of acquired company
1999 ROV Ltd. 155 41.0 Leading Latin-American battery manufacturer
(except Brazil)
Oct. 2002 Varta 258 41.2 Leading Europe-based battery manufacturer of
general batteries and the market leader in Germany
and Latin America
Sept. 2003 Remington Products 322 48.8 Largest selling brand in the United States in the
combined dry shaving and personal-grooming
products categories, on the basis of units sold; share
similar distribution channels, sales outlets. Mid-tier
brand competes with Braun, not wet shavers.
Jan. 2004 Ningbo Baowang
Battery Co., China
31
(for 85% stake)
3.4 Manufactures alkaline and heavy-duty batteries
in China
June 2004 Microlite Brazil 38 (6.4) Owned Rayovac brand name in Brazil; leading
Brazilian brand with 49% market share in alkaline
and zinc carbon segments.
Jan. 2005 United Industries 1,504 150.0 Significant presence in lawn and garden care
products, and pet supplies
April 2005 Tetra Holding 555 52.9 Pet food for fish and reptiles, aquarium acces-
sories; No. 1 or No. 2 in market share in every
major segment and market—United States, Japan,
Germany, United Kingdom and France
Source: Company files.
M11A_BARN0088_05_GE_CASE4.INDD 33 13/09/14 4:18 PM

PC 3–34 Corporate Strategies
Rayovac, the company’s strategy of raising brand awareness
and increasing the number of distribution channels allowed
it to take better advantage of market growth than its com-
petitors. Kent Hussey, Rayovac chief operating officer (COO),
underlined the central role of brands, noting,
We believe that brands are very important. Being able
to easily identify high-quality products that deliver
on the value proposition and have recognizable brand
names is very important in terms of marketing to con-
sumers. Having that brand name that the consumer
can identify and find on the shelf is key. We think that
one of Rayovac’s core competencies is our expertise in
marketing branded consumer products, and it’s really
the focus of our entire business.6
From the 12 months ended September 30, 1996, through
the 12 months ended April 1, 2001, Rayovac grew net sales
and adjusted income from operations from $417.9 million to
$675.3 million and from $27 million to $83.3 million, respec-
tively. This represented an 11.3 per cent and 28.4 per cent
compound annual growth rate in net sales and adjusted
income from operations, respectively. In addition, adjusted
income from operations margins improved from 6.5 per
cent for the 12 months ended September 30, 1996, to 12.3
per cent for the 12 months ended April 1, 2001 (see Exhibits
2 to 5).
Exhibit 2 Rayovac Financial Summary (for years ending September 30) (in $ millions)
2004 2003 2002 2001 2000
Income Statement
Net Sales 1,417.19 922.12 572.74 616.17 630.91
Cost of Goods Sold 811.89 549.51 334.15 361.17 371.47
Pretax Income 90.53 23.04 45.68 17.50 57.95
Net Income 55.78 15.48 29.24 11.53 38.35
Balance Sheet
Assets
Total Current Assets 650.51 666.82 259.32 303.09 291.17
Net PP&E 182.40 150.61 102.59 107.26 111.90
Total Assets 1,635.97 1,545.29 533.23 566.50 569.02
Liabilities and Shareholders’ Equity
Total Current Liabilities 398.66 397.01 118.78 144.54 186.48
Long-Term Debt 806.00 870.54 188.47 233.54 272.82
Total Liabilities 1,318.55 1,343.29 358.44 408.91 488.32
Total Shareholders’ Equity 316.04 202.00 174.79 157.59 80.70
Total Liabilities and Shareholders’ Equity 1,635.97 1,545.29 533.23 566.50 569.02
Cash Flow Statement
Net Cash Flows from Operations 104.86 76.21 66.83 18.05 32.84
Net Cash Flows from Investing (68.58) (446.40) (15.47) (18.27) (17.95)
Net Cash Flows from Financing (131.02) 471.85 (56.71) 1.67 (16.00)
Source: Company 2004 Annual Report.
Rayovac’s ability to distribute its products to cus-
tomers was constrained to some extent by the emergence
of large retailers that controlled access to large numbers of
consumers. Wal-Mart Stores, Inc., alone accounted for 21
per cent of Rayovac’s annual sales. Other significant out-
lets were Home Depot, Lowe’s and Target. Rayovac also
sold through discount channels such as “dollar stores.”
Acquisitions
Varta AG (Germany)
In 2002, Rayovac acquired the consumer battery business
of Varta AG of Germany for $258 million.7 Varta was the
leading European-based manufacturer of general batteries
with 2001 revenues of $390 million. Prior to the acquisi-
tion, 73 per cent of Rayovac’s revenues came from North
America while 86 per cent of Varta’s revenues came from
Europe. The largest overlap was in Latin America where
combined operations solidified Rayovac’s market lead,
excluding Brazil. The acquisition allowed the two compa-
nies to consolidate production and distribution in Latin
America and to close redundant manufacturing plants.
The complementary geographic distribution of the
two companies’ production facilities and distribution
M11A_BARN0088_05_GE_CASE4.INDD 34 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–35
Exhibit 3 Rayovac Corporation and Subsidiaries Consolidated Balance Sheets
(for years ending September 30) (in $ millions)
2004 2003 2002 2001 2000
Assets
Cash 15.79 107.77 9.88 11.36 9.76
Receivables 269.98 255.21 128.93 160.94 147.77
Total Inventories 264.73 219.25 84.28 91.31 100.68
Other Current Assets 100.02 84.58 36.24 39.48 32.97
Total Current Assets 650.51 666.82 259.32 303.09 291.17
Property, Plant and Equipment 182.40 150.61 102.59 107.26 111.90
Deferred Charges 60.38 76.61 51.90 37.08 43.84
Intangibles 742.68 651.25 119.43 119.07 122.11
Total Assets 1,635.97 1,545.29 533.23 566.50 569.02
Liabilities
Accounts Payable 228.05 172.63 76.16 81.99 97.86
Current Long-Term Debt 23.90 72.85 13.40 24.44 44.82
Accrued Expense 56.44 41.47 22.09 38.12 43.81
Income Taxes 21.67 20.57 7.14 n/a n/a
Other Current Liabilities 68.60 89.49 n/a n/a n/a
Total Current Liabilities 398.66 397.01 118.78 144.54 186.48
Deferred Charges/Inc. 7.27 n/a 20.96 7.43 8.24
Long-Term Debt 806.00 870.54 188.47 233.54 272.82
Other Long-Term Liabilities 106.61 75.73 30.23 23.40 20.78
Total Liabilities 1,318.55 1,343.29 358.44 408.91 488.32
Shareholders’ Equity
Minority Interest 1.38 n/a n/a n/a n/a
Common Stock 0.64 0.62 0.62 0.62 0.57
Capital Surplus 224.96 185.56 180.82 180.75 104.20
Retained Earnings 220.48 164.70 149.22 119.98 108.45
Treasury Stock 130.07 130.07 130.07 130.07 129.98
Total Shareholders’ Equity 316.04 202.00 174.79 157.59 80.70
Total Liabilities and Shareholders’ Equity 1,635.97 1,545.29 533.23 566.50 569.02
Source: Company 2004 Annual Report.
channels was expected to give greater access to global
sourcing and distribution opportunities and generate cost
savings of between $30 million and $40 million through
the consolidation of production plants and administration.
As a direct result of the Varta acquisition, Rayovac became
the market leader in consumer batteries in Germany and
Austria and the second leading producer in Europe.
ROV Ltd. and Microlite (Latin America)
Rayovac was the leading producer of zinc carbon batter-
ies in Latin America, a region where the company enjoyed
strong brand recognition. However, Latin America was
plagued by frequent economic downturns, and consumers
had relatively low purchasing power. Despite the region’s
volatility, Latin America played an important role in the
company’s geographic diversification strategy.
In the late 1990s, Latin America was one of Rayovac’s
fastest growing markets, where it had distribution
agreements with Ahold, Woolworths, Makro and several
other large supermarket and box-store chains. A large
part of the company’s growth came from its 1999 acquisi-
tion of Miami-based ROV Limited for $155 million. ROV,
which was spun off from Rayovac in 1982, was Rayovac’s
largest distributor of batteries in Latin America, with
approximately $100 million in revenues, compared to
Rayovac’s regional preacquisition revenues of less than
$20 million.
However, shortly after the ROV Limited acquisition,
Latin America sales took a turn for the worse. All three
major manufacturers saw declines of approximately 30
per cent. Rayovac also saw delinquent accounts increase
to nearly $5 million, which Rayovac attempted to mitigate
by withholding future product shipments. As a result,
Rayovac decreased receivables for Latin America from $50
million to $41 million. Fixed costs were also reduced by $12
million, including process rationalization and a reduction
in staff by 120 people.
M11A_BARN0088_05_GE_CASE4.INDD 35 13/09/14 4:18 PM

PC 3–36 Corporate Strategies
Exhibit 5 Rayovac Corporation and Subsidiaries Consolidated Statements of Cash Flows
(for years ending September 30) (in $ millions)
2004 2003 2002 2001 2000
Net Income (Loss) 55.78 15.48 29.24 11.53 38.35
Depreciation/Amortization 44.75 36.95 22.05 24.86 22.33
Net Increase (Decrease) in Assets/Liabilities (13.12) 14.38 10.48 (37.67) (30.07)
Cash Flow from Discontinued Operations 0.38 n/a n/a 8.59 n/a
Other Adjustments-Net 17.08 9.39 5.06 10.74 2.23
Net Cash Flow from Operations 104.86 76.21 66.83 18.05 32.84
Increase (Decrease) in Prop. Plant and Equip (26.86) (25.99) (15.47) (18.83) (17.95)
(Acquisition) Disposal of Subsidiary. Business (41.71) (420.40) n/a n/a n/a
Increase (Decrease) in Securities Investments n/a n/a n/a 0.56 n/a
Other Cash Flow from Investing (0.34) n/a (0.24) (69.65 n/a
Net Cash Flow from Investing (68.58) (446.40) (15.47) (18.27) (17.95)
Issue (Repayment) of Debt (1.35) (29.93) n/a n/a n/a
Increase (Decrease) in Borrowing (150.46) 501.61 (56.22) 3.90 (15.74)
Net Cash Flow from Financing (131.02) 471.85 (56.71) 1.67 (16.00)
Effect of Exchange Rate on Cash 2.75 (3.77) 3.88 0.16 (0.20)
Cash or Equivalents at Year Start 107.77 9.88 11.36 9.76 11.07
Cash or Equivalents at Year End 15.79 107.77 9.88 11.36 9.76
Net Change in Cash or Equivalent (91.99) 97.89 (1.48) 1.60 (1.31)
Exhibit 4 Rayovac Corporation and Subsidiaries Statement of Operations Data
(for years ending September 30) (in $ millions)
2004 2003 2002 2001 2000 1999 1998
Net sales 1,417.2 922.1 572.7 616.2 703.9 564.3 495.7
Cost of goods sold 811.9 549.5 334.1 361.2 358.2 293.9 258.3
Other special charges1 (0.8) 21.1 1.2 22.1 – 1.3 –
Gross profit 606.1 351.5 237.4 232.9 345.7 269.1 237.4
Operating expenses:
Selling expense 293.1 185.2 104.4 119.6 195.1 160.2 148.9
General and administrative expense 121.3 80.9 56.9 46.6 50.5 37.4 32.4
Research and development expense 23.2 14.4 13.1 12.2 10.8 9.8 9.4
Other special charges2 12.2 11.5 – 0.2 – 8.1 6.2
449.9 291.9 174.4 178.6 256.4 215.5 196.9
Income from operations 156.2 59.6 63.0 54.4 89.3 53.6 40.5
Interest expense 65.7 37.2 16.0 27.2 30.6 16.3 15.7
Non-operating expense – 3.1 – 8.6 – – –
Other (income) expense, net 0.1 (3.6) 1.3 1.1 0.7 (0.3) (0.2)
Income before income taxes and extraordinary item 90.5 23.0 45.7 17.5 58.0 37.6 25.0
Income tax expense 34.3 7.6 16.4 6.0 19.6 13.5 8.6
Income before extraordinary item 56.2 15.5 29.2 11.5 38.4 24.1 16.4
Extraordinary item3 (0.4) – – – – – (2.0)
Net income 55.8 15.5 29.2 11.5 38.4 24.1 14.4
Notes:
1 Related to plant closings, restructuring, process rationalization and severance pay.
2 Ibid.
3Loss from discontinued operations (2004) and expense associated with the repurchase of shares (1998).
Source: Company 2004 Annual Report
M11A_BARN0088_05_GE_CASE4.INDD 36 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–37
in Dischingen in Germany (see Exhibit 6). Those
plants are running near capacity and so, as alkaline
grows around the world, all the future capacity needs
are going to come out of that China plant.12
Remington Products Company
In 2003, Rayovac diversified its product offering by acquir-
ing Remington Products for $322 million.13 Remington was
established in 1816 and was recognized as one of America’s
oldest consumer brands. The company focused on personal
care products but was best known for its electric shavers.
In this category, Remington was the No. 2 brand in North
America with 35 per cent market share, compared with
40 per cent for Norelco and less than 20 per cent for Braun.
Other “personal grooming” products included hair dryers,
curling irons and hot air brushes. In the four years leading
up to its acquisition, Remington experienced a compound
annual growth rate in excess of 10 per cent.
In 2003, global sales of electric shaving and groom-
ing products were around $3 billion, growing at about
three per cent annually. The global market for other electric
personal case products, such as hair dryers, curling irons,
hot air brushes and lighted mirrors, was estimated at $2
billion, with annual unit sales growth also at three per cent.
Remington was considered a low-cost producer
with capital expenditures of approximately one per cent
of revenues. Production was mainly outsourced to low-
cost Far East suppliers, particularly in mainland China.
Therefore, any synergies between the two companies
would be limited to administration, purchasing and dis-
tribution, with estimated annual savings of approximately
$23 million. Rayovac also planned to use its established
international distribution network to expand the presence
of Remington products outside North America, which
accounted for 64 per cent of that company’s sales in 2002.
The Varta distribution network in particular would be
used to increase the presence of Remington products in
Europe. According to Jones,
In 1996, we were selling our products in 36,000 stores
principally the U.S. We are now selling in over a mil-
lion stores. Remington is selling in 20,000 stores in the
U.S. There are a lot more in the U.S. and a lot of retail-
ers around the world that we currently do business
with. We think some of the Remington product line is
applicable, and we think because our sales organizations
are on the ground and have strong relationships with
retailers, we could build the Remington brand name
globally.
Remington represents a very logical diversifica-
tion for Rayovac due to its product offerings, brand
In 2004, the company was able to offset this decline
through its acquisition of Microlite S.A., the largest producer
of consumer batteries in Brazil and owner of the Rayovac
brand name in Brazil, for $38 million.8 The Microlite acquisi-
tion allowed Rayovac to immediately realize a 50 per cent
market share in Latin America’s largest consumer market.9
Rayovac replaced Microlite’s management team with
Rayovac veterans who proceeded to reduce costs, increase
efficiency and improve product packaging. The latter al-
lowed Rayovac to increase prices by 16 per cent. Regional
competitors, following Rayovac’s lead, also raised prices.
When Rayovac acquired Microlite, the business was
undercapitalized and losing money. Its precarious situation
made it a high risk for lenders who, in turn, charged very
high interest rates. Rayovac immediately proceeded to
recapitalize the business and to replace high-rate debt with
Rayovac-backed debentures. The reduction in interest pay-
ments immediately improved the acquired company’s fi-
nancial results. According to Chief Executive Officer David
A. Jones, the results exceeded company expectations.
We were frankly surprised by how fast the actions took
hold. It didn’t surprise us that we were going to make
it profitable. I think in the future it’s going to be a star
performer. Our numerical distribution is high because
of the dominance of the brand in the marketplace.10
As a result of the Microlite acquisition, Rayovac expected
to increase total Latin American revenues by approxi-
mately 50 per cent in 2005.
China
In the same year that Rayovac acquired Microlite, the
company acquired 85 per cent of Ningbo Baowang for $24
million. Located in Ninghai, China, Ningbo Baowang was
a major exporter of private label branded batteries with
annual revenues of $6.4 million. The company also sold its
own Baowang brand throughout China.
By acquiring a Chinese manufacturer, Rayovac hoped
to both increase its presence in the rapidly growing Asia
market and to add a low-cost manufacturing subsidiary from
which to export Rayovac and Varta branded batteries to its
global markets. Rayovac replaced Ningbo Baowang’s existing
management with its own company managers in order to im-
plement Rayovac process controls and management policies
more efficiently. It also installed new manufacturing equip-
ment that would allow it to produce one billion Rayovac
branded batteries a year beginning in 2005.11 Explained Jones,
China is going to be the growth vehicle for all the
alkaline capacity needs in the future. We have a very
large plant in Fennimore; we have a very large plant
M11A_BARN0088_05_GE_CASE4.INDD 37 13/09/14 4:18 PM

PC 3–38 Corporate Strategies
levels, while average procurement per supplier rose ten-
fold. Remington also focused on matching the product
performance of its two major rivals, Braun and Norelco, in
terms of consumer attributes, features, functionality and
overall quality.
Following these acquisitions, Rayovac products were
sold by 19 of the world’s top 20 retailers and were available
in over one million stores in 120 countries. Company rev-
enues increased to approximately $1.5 billion, and employ-
ees numbered more than 6,500 worldwide. The company
also realized annual cost savings of more than three per
cent of cost of goods sold.
Lawn and Garden Care, Insecticides
and Pet Supplies
In 2005, Rayovac announced its intention to acquire two
pet supply companies for more than $2 billion and to
change its name to Spectrum Brands. The first of these
positioning and customer similarities, and represents
the first step of hopefully several other diversification
moves over the next few years as we build Rayovac
into a much larger, more diversified consumer prod-
ucts company.14
Integrating Remington into Rayovac involved closing sev-
eral Remington manufacturing and distribution facilities,
integrating all functional departments of the two compa-
nies and absorbing Remington’s worldwide operations
into Rayovac’s existing North American and European
operations, thereby creating a global organization and
infrastructure. This included merging sales management,
marketing and field sales of the two companies into a
single North American sales and marketing organization.
Similarly, research and development (R&A) would be
merged into Rayovac’s research facility at the company’s
headquarters in Wisconsin. From a total of 20 plants in
1996, Rayovac reduced its plants to nine by the end of
2004 while still quadrupling sales and unit volume. The
number of suppliers was reduced to 40 per cent of 1996
Exhibit 6 Rayovac Corporation and Subsidiaries Manufacturing and Distribution Centers 2004
Facility Function Ft2
North America
Fennimore, Wisconsin1 Alkaline Battery Manufacturing 176,000
Portage, Wisconsin1 Zinc Air Button Cell and Lithium Coin Cell Battery Manufacturing
and Foil Shaver Component Manufacturing
101,000
Dixon, Illinois2 Packaging and Distribution of Batteries and Lighting Devices
and Distribution of Electric Shaver and Personal Care Devices
576,000
Nashville, Tennessee2 Distribution of Batteries, Lighting Devices, Electric Shaver
and Personal Care Devices
266,700
Bridgeport,
Connecticut1, 3
Foil Cutting Systems and Accessories Manufacturing 167,000
Asia
Ninghai, China1 Zinc Carbon and Alkaline Battery Manufacturing & Distribution 274,000
Europe
Dischingen, Germany2 Alkaline Battery Manufacturing 186,000
Breitenbach, France1 Zinc Carbon Battery Manufacturing 165,000
Washington, UK2 Zinc Air Button Cell Battery Manufacturing & Distribution 63,000
Ellwangen, Germany2 Battery Packaging and Distribution 312,000
Latin America
Guatemala City, Guatemala1 Zinc Carbon Battery Manufacturing 105,000
Ipojuca, Brazil1 Zinc Carbon Battery Component Manufacturing 100,000
Jaboatoa, Brazil1 Zinc Carbon and Alkaline Battery Manufacturing 516,000
Manizales, Colombia1 Zinc Carbon Battery Manufacturing 91,000
1Facility is owned.
2Facility is leased.
3Facility closed September 30, 2004.
M11A_BARN0088_05_GE_CASE4.INDD 38 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–39
Central Garden and Pet Company was a dis-
tant third, with $1.2 billion in annual revenues. Central
Garden’s pet products included pet food, aquarium prod-
ucts, pest control products, cages, pet books and other
small animal products. Lawn and garden products in-
cluded grass seed, wild bird food, herbicides, insecticides
and outdoor patio furniture. The company’s products were
sold under more than 16 different brand names.18
United itself had just completed two significant ac-
quisitions in 2004 as it expanded geographically and diver-
sified away from its roots in pesticides. In 2004, it entered
the pet supply business with its acquisition of United
Pet Group, Inc. (UPG) for $360 million. UPG derived ap-
proximately half its sales from aquarium supplies, while
the remainder consisted of a variety of supplies for small
household pets, excluding pet food. As United was still in
the process of integrating UPG when it was acquired by
Rayovac, Jones expected its integration to be considerably
more complicated than previous acquisitions, taking up to
three years to complete (compared to less than one year for
Remington and Varta). Nevertheless, Jones reasoned that
any company that sold its products through major retail
chains, such as Wal-Mart, was a fair acquisition target. He
explained,
As a larger and more significant supplier of consumer
products, we believe the postacquisition Rayovac will en-
joy stronger relationships with our most important global
retailer customers. For instance, United does a substantial
business with Wal-Mart, Home Depot and Lowe’s, all of
whom are important relationships for Rayovac today and
all of whom will become even more significant.19
Many of the cost savings associated with the integration
of United Industries were expected in marketing and dis-
tribution, as existing networks increased cross-selling to
department store customers. Other savings were expected
in administration and purchasing.20 According to Rayovac
Chief Operating Officer Kent Hussey, his company’s strong
presence in Asia and Europe provided it with more sophis-
ticated sourcing and distribution opportunities than those
available to United, which had a limited presence outside
of North America. Hussey explained,
Rayovac operates on a global scale. From a purchas-
ing perspective, significant sourcing capabilities exist
in the Far East. I think, with our experience and our
infrastructure, we can accelerate dramatically, pur-
chasing leverage and sourcing in the Far East. And
then finally, in manufacturing in distribution, we
can use our expertise very quickly to help rationalize,
eliminate redundancies and improve the efficiency of
the overall supply chain. It really is very much opera-
tionally driven. There are clearly some administrative
acquisitions was United Industries Corporation, which
Rayovac acquired for $1.5 billion, funded with cash pay-
ments of $1 billion, stock issued from Treasury totalling
$439 million with acquisition related expenses, and as-
sumed debt totalling $36 million. To fund the acquisition,
Rayovac issued $1.03 billion in new long-term debt.15
United Industries
United Industries was the leading North American pro-
ducer of consumer lawn and garden care products, house-
hold insect control products and specialty pet supplies. The
company had about 24 per cent market share in lawn prod-
ucts, such as fertilizers and pesticides, which it sold under
the brand name Spectrum. In insect control (mosquito re-
pellents), it had an 18 per cent market share. Retails sales of
household insect control products in the United States was
approximately $1 billion in 2003, growing at four per cent
a year, with sales likely to increase as public awareness in-
creased of insect-borne diseases such as the West Nile virus.
The U.S. pet supplies market was estimated at $8 bil-
lion in 2004, while the European market was about $4 billion.
Annual growth in the pet supplies category was between
six per cent and eight per cent. With increased incomes,
more households were likely to have pets and to treat them
as household members, spending increasing amounts on
feeding and care. The U.S. pet supplies industry was highly
fragmented, with over 500 manufacturers, primarily small
firms. The industry was not significantly affected by busi-
ness cycles. The rise of pet superstores, such as Petco and Pet
Smart, provided a competitive opportunity for larger com-
panies, such as Rayovac, with strong distribution channels.
The lawn and garden segment also enjoyed favor-
able demographic trends. People over age 45 were more
likely to pursue gardening compared to the general popu-
lation, a group whose cohort was increasing as the North
American, European and Japanese populations increased
in average age. About 80 per cent of U.S. households par-
ticipated in some form of lawn and garden activity. In 2003,
North American industry revenues were approximately
$3.2 billion, growing at approximately four per cent annu-
ally. Lawn and garden care product sales, as well as insec-
ticide sales, were seasonal. Garden product sales typically
fell off when the weather was wet and cold.16
The Scotts Miracle-Gro Company was the largest pro-
ducer of home gardening supplies, with annual net sales of $2
billion. Scotts led the market in almost every product category
and every region in which it conducted business. Its major
brands included Scotts, Miracle-Gro and Ortho fertilizers and
herbicides. It was also the sole distributor in the home gar-
dening segment for Monsanto’s Roundup brand herbicides.17
M11A_BARN0088_05_GE_CASE4.INDD 39 13/09/14 4:18 PM

PC 3–40 Corporate Strategies
between $70 million and $75 million over the first three years.
Boston-based private equity firm Thomas Lee Partners,
which had acquired United in 1999, would end up with
nearly 25 per cent ownership in Rayovac, as well as two
seats on Rayovac’s 10-member board of directors. Thomas
H. Lee Partners had previously invested in Rayovac in 1995,
and helped take it public in 1997. In addition, David Jones,
Rayovac chairman and CEO, had served on United’s board
between 1999 and 2003. THL acquired significant stakes in
growth companies, and at the time of the United acquisition,
managed over $12 billion of committed capital. Some of its
major deals include Warner Music, Houghton Mifflin Co.,
Snapple Beverage and Fisher Scientific.
Tetra Holdings
Rayovac’s interest in pet supplies was further realized with
the acquisition of Tetra Holdings of Germany less than two
months after the United deal for $555 million (see Exhibit 7),
of which $500 million was financed with long-term debt
(Table 1 summarizes Rayovac debt as of July 2005, follow-
ing the United and Tetra acquisitions).24 Tetra was founded
in 1955 by Dr. Ulrich Baensch, the inventor of flaked fish
food. The company supplied pet fish and reptile products
in 90 countries and had annual sales of $233 million in 2004
(compared to $179 million in 2001). Tetra was purchased by
Warner-Lambert in 1974 and was later spun off when Warner
synergies here in IT and finance and administration,
but the bulk of this is really operationally focused.21
Jones added that Rayovac also planned to use its global
network to expand United Industries’ distribution beyond
North America.
While United is a North American business now, that
is not to say it will be only a North American busi-
ness in the future. Our European teams are actively
looking at the categories that United participates in
and looking at where we can potentially expand there
or in Latin America by taking advantage of obvious
distribution opportunities and customer relationships
that we have in regions other than North America.22
Rayovac further argued that industry consolidation in
pet supplies was needed “in order to meet the requirements
of global retailers.” According to Jones, pet supplies was
the fastest growing retail category but one that was highly
fragmented. Rayovac intended to increase its participation
by further acquiring and consolidating pet supply compa-
nies. “We think we can actually accelerate consolidation,”
he noted. “Pet is going to be a major growth platform and
opportunity for further acquisitions.” 23
United’s 2004 revenues of around $950 million came
mainly from major chains, such as Home Depot, Lowe’s,
Wal-Mart, Petco and PetSmart. Through increased sales
and cost savings, Rayovac anticipated “gross synergies” of
Exhibit 7 Pre and Post 2005 Acquisitions Consolidated Balance Sheets
(in $ millions)
Period ending
Jul 3, 2005
Period ending
Sep 30, 2004
Cash 27.0 15.8
Receivables 462.6 289.6
Inventories 470.3 264.7
Prepaid Expenses 99.6 80.4
Total Current Assets 1,059.4 650.5
Net Plant and Equipment 310.7 182.4
Goodwill 1,432.6 320.6
Net intangible Assets 1,169.7 422.1
Other assets 83.7 60.4
Total assets 4,056.1 1,636.0
Accounts Payable 280.2 228.1
Accrued Liabilities 261.2 146.7
Current L-T debt 38.8 23.9
Total Current Liabilities 580.2 398.7
Long-term Debt 2,298.0 806.0
Employee benefits 73.8 69.2
Other Liabilities 259.2 44.6
Shareholders’ Equity 845.0 316.0
Total Liabilities and Equity 4,056.1 1,636.0
M11A_BARN0088_05_GE_CASE4.INDD 40 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–41
for the first time in its history, Rayovac’s battery division
accounted for only slightly more than a third of total
sales, significantly less than the combined sales for lawn,
garden and pet care products (see Table 2 and Exhibit
8). Furthermore, with the United and Tetra acquisitions,
more than a third of total sales came from international
sources. Tetra, for example, obtained 40 per cent of its
sales from Europe, 40 per cent from the United States and
20 per cent from Japan. Correspondingly, the company
incurred a third of its total operating expenses in foreign
currencies.
Investment analyst Alyce Lomax described Rayovac’s
move into pet supplies as “diworseification,”27 a term that
described “companies that lose their primary focus in their
quest to jumpstart growth through diversification.”28 Even
so, most analysts hailed the deal, while investors sent the
company’s stock up nearly 10 per cent immediately follow-
ing the announcement. Overall, the company’s stock had
risen from about $15 to around $45 in the two years since its
acquisition of Remington (see Exhibit 9).
Lambert was acquired by Pfizer in 2000, and Pfizer decided
to shed “poorer performing consumer brands.”25 Jones justi-
fied his company’s latest acquisition by noting,
The combination of Tetra with United Pet Group
means Rayovac will become the world’s largest manu-
facturer of pet supplies, a position with which we can
leverage our company’s worldwide operations.
Commenting on the Tetra acquisition, Kent Hussey
remarked,
Tetra is a globally recognized brand name in the pet
supplies category, one that consumers know and trust.
It gives us entry into the pet supplies category literally
around the world, and it’s a brand that virtually every
pet supply retailer considers a must-have brand in terms
of consumer loyalty. If the retailer doesn’t have that prod-
uct on the shelf, he is missing significant sales opportu-
nities. That makes Tetra a very attractive asset for us.”26
Throughout its history, Rayovac had been primarily a
battery company. After the Tetra and United acquisitions,
Table 1 Rayovac Debt (as of July 2005)

Debt
Amount
$ Millions
Interest
Rate %
Senior Subordinated Notes, due February 1, 2015 700.0 7.4
Senior Subordinated Notes, due October 1, 2013 (pre-existing) 350.0 8.5
Term Loan, U.S. dollar, expiring February 6, 2012 653.7 5.3
Term Loan, Canadian dollar, expiring February 6, 2012 71.0 4.7
Term Loan, Euro expiring February 6, 2012 138.0 4.7
Term Loan, Euro Tranche B, expiring February 6, 2012 340.4 4.4
Revolving Credit Facility, expiring February 6, 2011 28.3 7.3
Euro Revolving Credit Facility, expiring February 6, 2011 3.6 4.4
Table 2 Rayovac: Percentage of Sales from Major Product Lines
% of Sales October 2004 June 2005
Batteries 65 35
Shaving 21 11
Personal care 8 5
Lighting 6 3
Pet Supplies 20
Lawn & Garden 20
Household Insecticides 6
M11A_BARN0088_05_GE_CASE4.INDD 41 13/09/14 4:18 PM

PC 3–42 Corporate Strategies
Exhibit 8 Rayovac And Its Competitors, Percentage of Market Share by Major Product Line
(as of 2005)
Brand Batteries
U.S. Shaving
and Grooming
U.S. Lawn
and Garden
U.S.
Household
Insecticide
U.S. Pet
Supplies
U.S. L.A Europe
Duracell 37 9 28 24
(Braun)
Energizer 26 19 22
Rayovac/ Spectrum
Brands
21 41 26
(Varta)
29
(Remington)
24 18 7
Panasonic 20
Norelco 43
Scotts 49
Central Garden 8 8
S C Johnson 42
Exhibit 9 Rayovac Corporation Stock Chart
Note: The chart includes data up to and including the announced acquisition of Tetra Holdings on March 15, 2005.
45
RAYOVAC CP as of 18-Mar-2005
http://finance.yahoo.com/
ROV
40
35
30
25
20
15
10 May03 Sep03 Jan04 May04 Sep04 Jan05
End Notes
1. This case has been written on the basis of published sources only. Consequently, the
interpretation and perspectives presented in this case are not necessarily those of
Rayovac Corporation or any of its employees.
2. Rayovac Buys Pet Supplies Company, Reuters, March 15, 2005.
3. Portions adapted from Rayovac Corporation, Prospectus Supplement, June 20, 2001.
M11A_BARN0088_05_GE_CASE4.INDD 42 13/09/14 4:18 PM

Case 3–4: Rayovac Corporation: International Growth And Diversification PC 3–43
4. “Rayovac to Acquire Remington Products,” Company Conference Call, Fair Disclosure
Wire, August 22, 2003.
5. Transcript “In The Game,” CNNfn, March 9, 1999.
6. SunTrust Robinson Humphrey Conference, Interview with Kent Hussey, Rayovac
Corporation, Wall Street Transcript, April 2005.
7. The acquisition did not include Microlite, SA, a Brazilian joint venture that Rayovac
acquired separately in 2004. It also excluded Varta’s automotive and micro-power
divisions.
8. “Rayovac Gains Worldwide Rights to Brand Name, ” Atlanta Business Chronicle, June
1, 2004.
9. Brazil represented 30 per cent of total Latin American market for consumer goods.
10. “Event Brief of Q1 2005 Rayovac Earnings, ” Conference Call, Fair Disclosure Wire,
January 25, 2005.
11. “Rayovac to Acquire 85% of Ningbo Baowang China Battery Company, ” PR Newswire,
January 19, 2004.
12. Ibid.
13. The purchase price represented 6.9 times Remington’s 2002 EBITDA of $47 million.
14. “Rayovac to Acquire Remington Products, ” Company Conference Call, Fair
Disclosure Wire, August 22, 2003.
15. “Rayovac Taps BofA, Citigroup For Add-On To Back Tetra Buy, ” Bank Loan Report,
April 4, 2005.
16. Seasonality also affected Rayovac’s other products, such as batteries and electric shav-
ers, sales of which surged during the holiday season (quarter ending December 31).
17. Background information on Scotts Miracle-Gro Company was adapted from the com-
pany’s investor relations website, investor.scotts.com, August 30, 2005.
18. Background information on Central Garden and Pet Company was adapted from the
company’s investor relations website, www.centralgardenandpet.com, August 30, 2005.
19. “Rayovac Acquisition Update,” Fair Disclosure Wire, January 4, 2005.
20. Rayovac anticipated $75 million in cost savings during the first three years.
21. “Rayovac Acquisition Update,” Fair Disclosure Wire, January 4, 2005.
22. Ibid.
23. Ibid.
24. “Rayovac Taps BofA, Citigroup For Add-On To Back Tetra Buy,” Bank Loan Report,
April 4, 2005.
25. “Tetra Under The Hammer?” UK Pets, December 17, 2001.
26. Rayovac Corporation, The Wall Street Transcript, April 2005.
27. “Will Pets Juice Rayovac?” Motley Fool, March 16, 2005.
28. “Diworseification” was first coined by mutual fund manager Peter Lynch in his book
“One Up On Wall Street : How To Use What You Already Know To Make Money In
The Market” (Simon & Schuster; 2000).
M11A_BARN0088_05_GE_CASE4.INDD 43 13/09/14 4:18 PM

As Gretchen Jahn, cofounder and executive vice president
of Corporate Development of Aegis Analytical Corporation,
looked over the financial statements for the first half of 2003,
she tried to muster the enthusiasm she had had the previous
spring when Aegis entered into alliances with two lead-
ing pharmaceutical manufacturing distributors. Jahn had
expected that the increased visibility in the market would
buoy Aegis’s lagging sales. Meanwhile, Justin Neway, co-
founder of the company, carefully prepared a presentation
to potential investors, as they both knew that this round of
funding was needed to support Aegis’s growth plan and
achieve positive cash flow in late 2004.
Gretchen L. Jahn and Justin O. Neway formed Aegis
Analytical Corporation in 1995 to provide process manu-
facturing software and consulting services to pharma-
ceutical and biotech manufacturers. The product, called
“Discoverant,” helped managers see what was happening
during the manufacturing process. It allowed users to
connect to multiple databases simultaneously—including
electronic data formats and manual inputs taken from pa-
per records—and assemble the data. The user could then
develop models to evaluate the performance of specific
manufacturing processes. The product greatly reduced
the time and effort needed to identify problems in a com-
pany’s manufacturing processes.
In March 2002, Aegis formed an alliance with
Honeywell POMS that made POMS a reseller of the Aegis
Discoverant product. As an add-on product to the POMS
software that monitored manufacturing plant activities,
Honeywell agreed to sell the product under the name
“POMS Explorer, powered by Aegis.” Jahn and Neway be-
lieved that combining the products would enhance the sales
of each and that Honeywell’s name recognition in the phar-
maceutical market would help Aegis gain credibility and
visibility.
Later that spring, Aegis entered into an agree-
ment with Rockwell Automation to market Aegis’s
Discoverant with Rockwell’s ProPack Data manufactur-
ing software, designed to help companies monitor pro-
duction operations. Again, because a customer could use
the ProPack Data system with Discoverant, both compa-
nies hoped the collaboration would increase the sales of
each product.
Neither relationship had yet produced a single sale,
and Aegis began questioning the wisdom of this strategy.
Strategic alliances were integral to the company’s sales
efforts, and after Jahn reflected upon the disappointments
of the past year, she and Neway debated what actions the
much smaller Aegis should take to improve these alliances
with the larger companies.
History of Aegis Analytical
In 1995, Jahn and Neway cofounded Aegis Analytical
Corporation in Lafayette, Colorado. Jahn had 20 years
of experience in information technology and integrated
resources management prior to starting Aegis. She had
recently sold her software consulting company and was
working as an independent information technology and
management consultant. Neway, a biochemist, had 20
years of experience in pharmaceutical and biotechnol-
ogy manufacturing. He had moved to Colorado from
California in 1990 and taken a job as director of manu-
facturing for Somatogen, a biotech research company.
(Exhibit 1 shows management team profiles.) Both had
worked closely with the regulatory, quality-control, and
operational issues that plagued pharmaceutical manufac-
turing processes.
C a s e 3 – 5 : A e g i s A n a l y t i c a l
C o r p o r a t i o n ’ s S t r a t e g i c A l l i a n c e s *
Paul Olk
Joan Winn
—University of Denver
*The authors wish to thank Gretchen Jahn, Justin Neway, and the
employees of the Aegis Analytical Corporation for their coopera-
tion in the preparation of this case. The authors also thank Chooch
Jewel and Brian Swenson for research assistance and insights. This
case is intended to stimulate class discussion rather than to illus-
trate the effective or ineffective handling of a managerial situation.
All events and individuals in this case are real.
Copyright © 2005 by the Case Research Journal and by Paul Olk and
Joan Winn.
M11A_BARN0088_05_GE_CASE5.INDD 44 13/09/14 4:19 PM

Case 3–5: Aegis Analytical Corporation’s Strategic Alliances PC 3–45
technical presentations. We made 23 presentations in
the United States and Europe to major pharmaceuti-
cal companies to demonstrate our product and to get
feedback to improve the product and also to see if we
could find someone who would be an initial develop-
ment partner. Eventually Aventis gave us a contract
worth $1.3 million to jointly develop our software
product with them. This was in 1999. In May and
July of 1999, we received our first funding—seed
investments of $400,000 and $500,000—from angel
investors and Sandlot Capital. We were three people
at that time.
So we built this first version and we got office
space and then graduated to other office space once we
were all sitting on top of each other. And we hired peo-
ple and subcontracted all kinds of nifty stuff and then
we went out for the next round of funding. We closed
on that in 2000—right around 41/2 million—from
GlaxoSmithKline’s investment arm, SR One, and
Aventis’s investment arm, Future Capital, which is in
Frankfurt, Germany, as well as Viscardi Ventures, a
financial investment firm in Munich, Germany.
Finding Development Partners
Jahn, a self-described “serial entrepreneur,” had started
two companies before Aegis. She had experience with soft-
ware development and implementation and understood
the importance of manufacturing efficiencies and process
improvements in getting drugs through the regulatory
process. Neway’s experiences in biotech and pharmaceuti-
cal manufacturing gave him an in-depth understanding of
the difficulties in accessing data from a variety of sources
and across many different products and then putting them
into a unified format. Originally, Jahn and Neway had
hoped to use Somatogen’s name as a launching pad for
their product. However, when Somatogen began negotia-
tions for its eventual sale to the pharmaceutical company
Baxter, they recognized they would need to find an alter-
native. Neway focused his efforts on courting potential
development partners. Jahn recalled,
We spent several years working out of our respec-
tive basements, using our own funds to make invited
Exhibit 1 Aegis Management Team, 2003
Gretchen L. Jahn, cofounder, executive vice president, Corporate
Development, has more than 20 years’ experience in IT. Ms. Jahn
most recently led the turnaround of the software development of
a CEO-less venture-backed startup company. Previously, Ms. Jahn
was a principal and vice president at Mile-High Information
Services, a consulting, software development, and product sales
company. She has prior experience as a data processing manager
and a software specialist for Digital Equipment Corporation.
Ms. Jahn received her BA in 1973 from Lawrence University and
her MA in 1975 from the University of Colorado.
Justin O. Neway, PhD, cofounder, executive vice president, and
chief science officer, has more than 19 years’ experience in phar-
maceutical and biotechnology manufacturing and in software
marketing and applications. Prior to joining Aegis, Dr. Neway
was director of fermentation R&D at Somatogen, a biotechnol-
ogy manufacturer. He was the project leader for several technical
teams, one of which developed a demonstration system for data
analysis and visualization of batch process information. Dr. Neway
received his BSc (microbiology, 1975) and MSc (biochemistry, 1977)
from the University of Calgary and his PhD in biochemistry from
the University of Illinois in 1982.
John M. Darcy, president and CEO, has more than 25 years in
proven management and leadership in Fortune 50 companies,
turnarounds, and startups. Mr. Darcy has been an advisor to Aegis
and is providing significant marketing assistance for the Discover-
ant product launch as director of marketing. Most recently he built
three separate startup companies in the food, agricultural chemi-
cals, and Web imaging businesses. Prior to this, Mr. Darcy was
president and chief operating officer at Avis Enterprises, a $2 billion
private investment company with majority equity positions in
several industries including automobile rentals and dealerships and
has held management positions at Carnation/Nestlé and Pillsbury.
Mr. Darcy received his BA in 1967 and his MA in 1969 from the
University of California, Los Angeles.
Geri L. Studebaker, vice president, Marketing, has more than
12 years of experience in software marketing and applications.
Prior to Aegis, Ms. Studebaker was senior director of worldwide
marketing for Webb Interactive, an e-business software provider
for small to medium-sized businesses. There she successfully man-
aged overall product redesign and company positioning efforts.
Prior to Webb, Ms. Studebaker held several positions with JD
Edwards, the most recent being senior marketing manager.
Cheryl M. Boeckman, vice president, Sales, has more than 17 years
of experience in executive-level sales. Ms. Boeckman was vice
president of sales with SoftBrands Manufacturing/Fourth Shift,
where she managed a team selling enterprise resource planning
and supply chain management software to tier-one through tier-
three manufacturing companies focusing on multiple industries
including medical device and pharmaceuticals.
Steve C. Sills, director, Business Development, has more than 10
years of experience in software marketing and business develop-
ment. Mr. Sills joins Aegis with a broad range of experience in
the software industry. Prior to joining Aegis, he was a business
development manager with Vitria Technology, a leading enterprise
application integration (EAI) vendor.
M11A_BARN0088_05_GE_CASE5.INDD 45 13/09/14 4:19 PM

PC 3–46 Corporate Strategies
Aegis’s Discoverant enabled manufacturing em-
ployees and managers to analyze specific manufacturing
processes that crossed database boundaries. Exhibit 3
shows the relationship of Discoverant to disparate data
sources and to analysis and results reporting. The soft-
ware did not require that every piece of corporate data
be stored and controlled in a single location. In develop-
ing Discoverant, Aegis’s developers had incorporated
existing software engines, both as a cost savings and
implementation aid, building only those parts of the
product that were needed to fill the gap and integrate
the various systems. Jahn and Neway explained that
companies without Aegis’s product would have to go
through a lot of time and effort to get the same informa-
tion. Without Discoverant, it was common for a com-
pany’s information technology (IT) department to spend
two to four weeks to get appropriate data from multiple
systems. After company employees collected the data,
it would take them another week to interpret and ana-
lyze the data. Discoverant took minutes to perform the
same steps. The cost savings became significant when a
company that manufactured a defective product or ran
invalid experiments searched for the errors in the manu-
facturing process.
The company emphasized Discoverant’s ability to
“easily access millions of data values from diverse sources,
drill down on any operation, make informed proactive
decisions by identifying critical process parameters, and
enable manufacturing enterprise compliance strategies.”
A simple point-and-click feature allowed the user to select
the relevant data and produce desired statistical analyses,
charts, or graphs. A major advantage was the fact that the
person running the analyses and reports did not have to
have a programming background. Aegis would help the
company install the system and develop the data models.
Aegis’s implementation process required staff from the
client company to be active participants. Aegis provided
a two-day user-training session for its customers so that
they understood the product’s basic functions and tools
and how to use it to evaluate the various manufacturing
systems. This included a basic course on statistics so non-
statisticians could use the software. Postimplementation
customer support was provided via phone, fax, e-mail, and
Internet. Aegis wanted to make sure that everyone in the
company who used the software had a complete under-
standing of Discoverant.
Aegis also offered additional consulting services, in-
cluding follow-up, validation, and advanced technical and
user training. These services were offered to companies
who needed more assistance or wanted additional advice
for improving their manufacturing systems.
Growing the Organization
Aegis had been successful in getting enough financing to
develop and test its manufacturing software product and
set up a team of applications and technical specialists, a
management team, and an advisory board of industry and
regulatory experts. It had organized research seminars and
conferences with leaders in biotech research and applica-
tion and successfully sold and implemented its first prod-
uct in July 2000. Jahn continued,
Our next funding in 2001 just about destroyed me.
We brought in $14.5 million in October 2001, after
the bubble had burst. What’s funny is that Aegis is
not a dot-com. So during the boom we were discounted
because we weren’t a dot-com. After the boom, we
were discounted because every software company was.
The Friday before September 11 (2001), I turned down
$4 million because our valuation was so low. Then
September 11th happened. We were supposed to have
a board meeting on the 14th over in Munich, which
we ended up having over the phone, and I said, “Look
guys, we don’t know what is going to happen . . . we
just better get through this.” We were one of the few
people whose funding got bigger. Everybody else that
I talked to that was raising money at that time had
their investors dry up and go away.
By 2002, the company had grown to 35 employees.
Aegis had entered into sales agreements with eight corpo-
rate customers and had 25 sales in the pipeline by the end
of that year. Exhibit 2 reports Aegis’s financial performance
over the previous several years. Also in 2002, Jahn hired
John M. Darcy, former Avis CEO, as president and CEO to
reposition the company with a sales and marketing focus
rather than a development focus. Jahn moved into a corpo-
rate development role to pursue new markets for the prod-
uct and develop alliances and market awareness. Because
of its small size, Aegis was able to share information within
the organization quickly and did not need to spend a lot of
time making decisions. Aegis also prided itself on having
an organization that emphasized precision in its work as
well as honesty and integrity when dealing with others.
Management believed that understanding and concern for
customers would be a key to Aegis’s success.
The Discoverant Product
Aegis positioned Discoverant as a manufacturing perfor-
mance management software system that fulfilled three
critical requirements: practical data access, useful data
analysis, and ability to communicate results to nonexperts.
M11A_BARN0088_05_GE_CASE5.INDD 46 13/09/14 4:19 PM

Case 3–5: Aegis Analytical Corporation’s Strategic Alliances PC 3–47
eventually became Aegis’s “visual process signature” used
for both sales presentations and actual data tracking.
To help convey the Discoverant product, Aegis devel-
oped a short video clip based on a case study. Aegis man-
agement made the video available to potential customers
via a CD-ROM and posted it on the company’s Web site. The
scenario depicted a manager preparing for a meeting the
next day where she would need to explain to her superiors
why there were batch failures in a drug’s tablet dissolution
rate. Even though she had all the data she had requested
on the manufacturing processes, she did not have weeks to
Sales Efforts
The keys to selling such a sophisticated product were hav-
ing a simple way to communicate the benefits of the prod-
uct, a knowledgeable sales force, and skilled consultants to
implement the software for the client. Neway understood
that his audience—research scientists who used mathemat-
ics and statistics but were not programmers themselves—
needed an image of the numeric processes. He worked
to put together a visual representation that showed the
manufacturing data in a three-dimensional image. This
Exhibit 2 Five-Year Financial Performance, 1998–2003a
Income Statement Summaries
Calendar Year Ending: 1998 1999 2000 2001 2002
2003
Jan–June
Cumulative
1998–2003
Revenues $8,053 $814,001 $670,754 $562,741 $2,513,267 $352,847 $4,921,663
Operating Expenses 152,189 1,239,510 3,417,575 5,128,508 7,779,047 3,446,349 21,163,178
Net Operating Income (144,136) (425,509) (2,746,821) (4,565,767) (5,265,780) (3,093,502) (16,241,515)
Consolidated Balance Sheet Summaries (at December 31)
1998 1999 2000 2001 2002
ASSETS
Current Assets
Cash Equivalent $ 2,732 $ 193,481 $1,393,732 $12,268,918 $ 6,210,001
Accounts Receivable 3,774 248,267 397,581 158,381 364,613
Other Current Assets 25,151 122,732 146,494 406,589
Total Current Assets 6,506 466,899 1,914,045 12,573,793 6,981,203
Long-Term Assets
Furniture and Equipment (net)b 15,103 102,960 340,679 523,743 378,162
Capitalized Lease and Improvements 182,468 38,261 40,061 40,061
Other Assets (Net)c 1,632 227,524 533,581 661,249 297,832
Total Long-Term Assets 16,735 512,952 912,521 1,225,053 716,055
Total Assets 23,241 979,851 2,826,566 13,798,846 7,697,258
LIABILITIES AND EQUITY
Liabilities
Accounts Payable 89,941 360,716 255,024 491,971 572,740
Deferred Revenue 291,700 1,580,040 799,000
Capitalized Lease obligation 4,808 173,760 225,318 252,837 111,753
Total Liabilities 94,749 534,476 772,042 2,324,848 1,483,493
Equity
Stock and Paid-In Capital 104,313 1,053,474 5,495,757 20,498,977 28,095,497
Retained Earnings (38,840) (183,017) (694,412) (4,459,213) (16,615,952)
Net Income (136,981) (425,509) (2,746,821) (4,565,767) (5,265,780)
Total Equity (71,508) 444,948 2,054,524 11,473,997 6,213,765
Total Liabilities and Equity $ 23,241 $ 979,424 $2,826,566 $13,798,845 $ 7,697,258
a Some figures may be disguised.
b Furniture and Equipment is net of depreciation.
c Other Assets includes trademarks and patent costs, capitalized software development costs, and Web site development.
Source: Aegis Analytical Corporation documents, 2003.
M11A_BARN0088_05_GE_CASE5.INDD 47 13/09/14 4:19 PM

PC 3–48 Corporate Strategies
often was negotiated for the full expansion up front in the
purchase process. Specific sites were identified and a time-
line established. This enabled Aegis to understand the total
potential value of a customer at the time of initial phase.
The sales cycle itself varied from seven months to
more than two years. The delay was due to the multiple
sales cycles involved in selling the product. In its initial
efforts, Aegis sales teams quickly found that there were
really three selling cycles, each requiring multiple visits.
Aegis thought it would only have to make the first sale, to
the individuals in the company who would actually use
the product. The sales team typically started with the head
of manufacturing but also spoke with the head of quality
and process scientists. Although this effort often took from
three to nine months, the product was generally well re-
ceived, particularly by the IT departments, because it elimi-
nated their having to write numerous queries. After getting
commitment by these users, however, Aegis discovered
two more cycles. First, Aegis had to help convince upper
management to purchase the software. Aegis found that
upper management would spend as much time conducting
due diligence on the decision to spend an estimated $0.5 to
$1.5 million on Discoverant as they would on a $15 million
software installation. This cycle typically took between
three months and a year. After getting approval from up-
per management, Aegis would then have to work with the
company’s purchasing and legal department to complete
the sale, which could take another one to six months. This
lengthy three-tier sales cycle process increased the amount
of time and effort required by Aegis’s sales team.
analyze the data and expected that she would have to spend
more time collecting additional data. What she needed was
immediate access to all of the company’s manufacturing
data and a program that would help with the analysis. A
colleague introduces her to Discoverant. With this program,
she has direct access to the raw data stored in the various da-
tabases (e.g., Laboratory Information Management Systems
[LIMS], enterprise resource planning [ERP]) and can begin
analyzing the manufacturing conditions associated with
the batch failures. Discoverant revealed that the failures ap-
peared to be related to the drying process—particularly, to
lower dryer air temperature. Through Discoverant’s statisti-
cal tools, she is able to analyze the relationship and reveal
that it is highly significant. Discoverant’s reporting tools—
including the visual process signature—then enable her to
illustrate the relationship between temperature variations
and batch variations. Within minutes she has her answer
and feels very prepared for the next day’s meeting.
Beyond these promotional efforts, Aegis set up sales
teams to provide long-term consultative relationships that
would help customize the product for each customer. A
sales account manager led a specialized team of applica-
tions and technical specialists organized for each sales
and market effort and was responsible for the relationship
with each customer. Full installation and implementation
of the product was expected to take between six and nine
months. The standard purchase cycle for enterprise soft-
ware within the pharmaceutical industry started with an
evaluation in one facility or production line followed by
expansion to other facilities on a global scale. A contract
Exhibit 3 The Discoverant Connectivity Link
Between Disparate Data Sources and Reports
Source: Adapted from Aegis material. Read Only
In minutes and at a deskop,
the user can identify data sets,
start an investigation, and turn
findings into reports.
D
a
t
a
S
o
u
r
c
e
s
MES
ERP
LIMS
DCS
Paper
Records
PRIMR
ERP = Enterprise Resource Planning—software designed
to coordinate the flow of resources in a company
MES = Manufacturing Execution Systems—software that
allows floor operators to set up, inspect, execute,
and track plant activities
LIMS = Laboratory Information Management Systems—software
that automates laboratory data processing and report
writing
DCS = Distributed Control System—software that
schedules the flow of materials during production
PRIMR = Paper Record Import Manager—an Aegis product
that converts paper records into electronic records
KEY
Discoverant
Software
M11A_BARN0088_05_GE_CASE5.INDD 48 13/09/14 4:19 PM

Case 3–5: Aegis Analytical Corporation’s Strategic Alliances PC 3–49
The demand for Aegis’s product was not driven
solely by pharmaceutical companies’ interest in reduc-
ing costs. Increasing pressure from consumer groups and
the federal government’s Food and Drug Administration
(FDA) led Aegis to believe that this market would be
highly receptive to any product that shortened and im-
proved the product-to-market cycle time. In 2002 alone, the
FDA had issued 755 warning letters about product qual-
ity—an increase of more than 40 percent from 1998. The
FDA had also increased the number and severity of penal-
ties levied against pharmaceutical manufacturers, includ-
ing criminal convictions and fines as high as $500 million.
Discoverant had no direct competitors. Other
companies had products that performed parts of what
Discoverant did, but no one besides Aegis had a prod-
uct that did it all. In 2003, there were several commer-
cial vendors of general statistical and visualization tools
such as Mathsoft, Statistica, MatLab, IMSL, SAS, Visual
Numerics, and AVS. These tools permitted the analysis
of already collected data but did not help in accessing
the various databases. Other software companies, such as
Aspen Technology, OSI, and Lighthammer, provided pro-
cess manufacturing software that captured shop floor data
for process control and data management, but typically
the data had to be inside a single database. These products
could not combine data from dissimilar databases. Finally,
Spotfire and Aspen Technology had recently announced
an alliance to develop data analysis capabilities for manu-
facturing systems, but the product was not yet available.
Although some large pharmaceutical and food production
companies had custom in-house systems developed by
internal IT departments or third-party consultants, most
companies’ systems were limited in use and required a
team of experts to interpret the disparate data that the
systems generated. Someone who was not a programmer
could use Discoverant.
Aegis had identified a number of pharmaceutical
manufacturing companies that would benefit by an inte-
grated manufacturing information system. Though many
pharmaceutical manufacturing companies in 2002 were
quite small, with annual revenues of less than $250 million,
targeting only those pharmaceutical companies with an-
nual revenues of more than $250 million would give Aegis
access to a potential market of $604 million in license,
service, and maintenance fees. Pharmaceutical manufac-
turers with annual revenues in excess of $1 billion had the
largest IT budget and were therefore most likely to im-
plement manufacturing enterprise software solutions like
Discoverant. Importantly, companies of this size accounted
for approximately 77 percent, or $464 million, of the total
potential market for Aegis’s products (Exhibit 4).
Aegis planned to set up direct sales teams in key
geographic areas where there were high concentrations of
potential customers. Aegis had already set up a team in
Frankfurt, Germany, to provide sales and marketing sup-
port for the European market. In geographic areas of lower
customer concentration, Aegis planned to use sales agents
and alliances to leverage the direct sales force and to pro-
vide local coverage and first-line support. Strategic partners
would help expand sales and implementation capabilities.
Demand for Manufacturing Process
Software in the Pharmaceutical
Industry
To succeed in a global context, pharmaceutical compa-
nies continually needed to reduce costs while increas-
ing efficiency, responsiveness, and customer satisfaction.
Improving profitability in the manufacturing process de-
pended on reducing the cost of raw materials, energy,
and capital and on increasing the yield from their assets.
Profitability also depended upon demonstrating that they
could meet quality standards in producing the drug. To
meet such regulations, manufacturers made significant in-
vestments in software systems to collect information that re-
vealed where, if any, manufacturing problems existed and,
after correcting the problems, demonstrated compliance to
the regulators. Initially, production processes were auto-
mated through distributed control systems (DCS) that used
hardware, software, and industrial instruments to measure,
record, and automatically control process variables. More
recently, process manufacturers had begun to automate key
business processes by implementing ERP and manufactur-
ing execution system (MES) software solutions to enhance
the flow of business information across the enterprise, as
well as other software programs such as LIMS (Exhibit 3).
The implementation of each of these systems led
to an accumulation of large amounts of raw data that re-
corded in detail the performance of each manufacturing
process at full commercial scale over extended periods
of time. The proliferation of software products resulted
in companies having mountains of data scattered across
numerous disparate data sources. Collectively, these held
a great deal of information about how to improve manu-
facturing performance. Prior to 2000, there was no simple
way to access all the data and extract the big picture about
the manufacturing process. Aegis wanted to become the
recognized leader in process manufacturing technology by
providing software that could be used to integrate all ma-
jor functions and provide system-wide information.
M11A_BARN0088_05_GE_CASE5.INDD 49 13/09/14 4:19 PM

PC 3–50 Corporate Strategies
sales of Discoverant, as top managers began to understand
that the three-part sales process was the norm, they real-
ized they did not have enough internal resources. Their
sales staff could continue to pursue direct sales, but sales
might benefit from partners who could help persuade
top management to purchase Discoverant. These alliances
were considered an integral part of the sales force. In
choosing sales partners, then, Aegis sought out compa-
nies that had complementary products and would agree
to promote the Discoverant brand using the Aegis name
to distinguish it from perceived competition. While it
had started screening potential candidates, in 2002, Aegis
was approached by two companies that seemed to be the
best candidates with which to partner. In that year, Aegis
formed a relationship with Honeywell POMS and another
with Rockwell Automation.
Honeywell POMS Alliance
In 1999, Honeywell acquired the POMS Corporation, a
leader in providing manufacturing execution systems
(MES) for the pharmaceutical as well as for other indus-
tries. POMS had sold more than 70 systems to nine of the
top 10 pharmaceutical companies in the world. POMS
employed 150 people and was headquartered in Herndon,
Virginia. Prior to the acquisition, POMS was strictly a
reseller of software and, according to an Aegis manager,
had a spotty record of implementing and supporting its
software offerings.
On March 13, 2002, Aegis formed an alliance with
Honeywell POMS that made it a reseller of the Aegis
Discoverant product in combination with POMS’s manu-
facturing system. Honeywell approached Aegis after a
Aegis’s Alliance Strategy
Jahn and Neway understood the power of brand recogni-
tion and company reputation in reaching their target mar-
ket. They developed research partnerships with top-tier
pharmaceutical manufacturing companies such as Merck,
Genentech, and Aventis and invited representatives from
Abbott, Amgen, Aventis, Merck, Novartis, GlaxoSmithKline,
Eli Lilly, Roche, and Wyeth to join discussions at Aegis-
hosted conferences in Colorado. Contacts at the University
of Newcastle and University College London, two of the
top universities in the world known for software technol-
ogy applicable to manufacturing processes, joined Aegis’s
Scientific Advisory Board. These relationships fostered an
exchange of technical information and ideas and gave Aegis
professional connections and sales leads.
In their initial efforts to sell Discoverant, Neway
and a small team of sales and technical people made
direct calls to large pharmaceutical and biotech manufac-
turers. Believing that alliances with well-known service
providers would give them credibility and visibility in the
marketplace and also permit them to reach more compa-
nies than they could alone, they focused Aegis’s growth
strategy on finding partners. Aegis’s first partners were
client-investors, pharmaceutical companies like Merck
and GlaxoSmithKline in California and Hoechst Marion
Roussel in Kansas City. Having big company names as
successful users of Aegis’s Discoverant product provided
important testimonials for Discoverant’s features. This net-
working helped form the research and technical partner-
ships that Aegis used to get its first contracts and secure
venture funding.
The focus in 2002 was on creating alliances that
would enhance sales. Although Aegis had made some
Exhibit 4 Market Projections for 2003
(dollar values are in thousands)
Annual Revenues
Number of
Companies
Mfg.
Sites
Total
Cells
Licenses
$250K
Services
at 50%
Maint.
at 15%
ToTAL
VALuE
$1B+ 52 225 1,125 281,250 140,065 42,188 $464,063
$500M–$1B 41 62 186 46,500 23,350 6,975 76,225
$250M–$500M 71 77 154 38,500 19,250 5,775 63,225
Opportunity 164 364 1,465 $366,250 $183,125 $54,938 $604,313
Note: The standard purchase cycle for enterprise software within the pharmaceutical industry starts with an evaluation in one facility or production line
followed by expansion to other facilities on a global scale. A contract often is negotiated for the full expansion up front in the purchase process. Specific sites
are identified and a timeline established. Therefore, Aegis understands the total potential value of a customer at the time of initial phase. Even under present
(sluggish) market conditions, Aegis believed that sales to new pharma accounts could be expected to result in large total sales in the same accounts in the
following 18 to 24 months as the initial projects showed good results and decisions were made to proceed with wider deployments.
Source: Aegis Analytical Corporation documents, 2003.
M11A_BARN0088_05_GE_CASE5.INDD 50 13/09/14 4:19 PM

Case 3–5: Aegis Analytical Corporation’s Strategic Alliances PC 3–51
POMS’s facilities, unless both parties agree to talk tele-
phonically or at another location.
■ Aegis would provide training sessions for Honeywell
POMS sales personnel within 90 days of the start date
of the contract.
■ Honeywell POMS was responsible for the point-of-
contact sales support for users. If Honeywell POMS
was not able to solve the problem, it would contact
Aegis for support. Provisions were provided for the
time by which Aegis had to respond.
■ The parties agreed to prepare mutually agreed press
releases to promote the relationship. They also agreed
to collaborate on marketing events, on distributing
promotional materials, and on promotion of the other’s
product on their Web sites.
■ Honeywell POMS would receive a discount on the
licensing fees Aegis charged. This was a reduced price
on what Aegis would charge Honeywell POMS to
resell Discoverant. The more sales Honeywell POMS
recorded, the greater the discount.
■ Termination clauses permitted each party to end the
relationship if the other went out of business or if there
was a breach of any provisions within the agreement.
In considering the agreement, Jahn acknowledged
that it had provisions for Honeywell to “make sure that
their sales reps would get enough of a commission so that
they would be motivated to sell it and also that our sales
reps would not be disadvantaged by selling through our
partner instead of selling direct. . . . There are lots of ways
of arranging [sales incentives plans] and we had lots of
conversation with Honeywell to determine what would
work best in this particular environment.” Aegis’s VP of
sales also was involved in making sure both sides were
aware of the selling message and pricing structures and
were present at the training sessions. He had numer-
ous face-to-face meetings with his Honeywell counter-
parts to discuss the product. They focused on building
a relationship first and did that successfully. Further,
the Honeywell relationships benefited from Jahn having
personal contact with Honeywell’s director of business
development.
However, from her experience in larger companies,
Jahn was concerned about Honeywell’s commitment to
promoting the Discoverant product, and the VP of sales
spent much of his time convincing his counterparts of the
value of this add-on product. “For Honeywell, we’re a line
item in their sales catalogue,” Jahn later observed. “When
the market fell out, their sales reps were concentrating on
how to get people to buy their own products, much less
other things in the catalogue.”
potential customer asked if POMS was compatible with
Discoverant. This interest helped Aegis during negotia-
tions. Although Honeywell initially requested an exclusive
relationship, Aegis thought that it was not in the com-
pany’s best interests. Eventually the two sides did come
to an agreement that Aegis’s product would be packaged
and resold under the name “POMS Explorer, powered by
Aegis.” According to Chris Lyden, vice president and gen-
eral manager of Honeywell’s Industry Solutions Business
for Chemicals, Life Sciences, and Consumer Goods,
By combining Aegis’s Discoverant with our the flag-
ship POMS MES product, we will be able to provide
added benefits to our customers and further enhance
the way they manage their manufacturing systems.
Honeywell’s new POMS Explorer module, powered by
Aegis, can save significant cost for our customers by
reducing batch failures, stabilizing the manufacturing
operations, and getting products to market faster.
Both companies recognized the mutual benefits from
the alliance. Aegis believed this alliance was a significant
step toward gaining both credibility and visibility within
the Life Sciences market. With Honeywell, Aegis aligned it-
self with an organization that had $24 billion in sales, more
than 120,000 employees, and operations in 95 countries
throughout the world.
Aegis was banking on POMS’s name recognition
and reputation to build market awareness for Aegis and
Discoverant. Honeywell POMS, located in the Automation
and Control Solutions division, one of four major strategic
business units in Honeywell (besides Aerospace, Specialty
Materials and Transportation, and Power Systems), viewed
Discoverant as an additional software offering that would
expand the capability of its MES product. The Aegis soft-
ware provided POMS customers with the software needed
to visually see and analyze the manufacturing data. To help
reach these expectations, the two companies put together
a relatively standard contract that included the following:
■ Honeywell POMS had a nonexclusive, nontransferable,
non-sublicensable license to resell Aegis’s product.
■ The agreement would initially run for two years with
an additional one-year automatic renewal, unless ei-
ther party wished to terminate the agreement at least
90 days before the end of the two-year period.
■ Aegis and Honeywell POMS agreed to appoint one
sales professional to act as the primary representative
to the other. The agreement specified that the represen-
tatives shall meet in person at least once per calendar
quarter to discuss the status of the sales effort and
other questions about selling the software. These meet-
ings will alternate between Aegis’s and Honeywell
M11A_BARN0088_05_GE_CASE5.INDD 51 13/09/14 4:19 PM

PC 3–52 Corporate Strategies
and committed its sales representatives to prospect for
the partner. Once opportunities were identified, various
strategies would be employed to close the sale. The sales
opportunity itself would dictate how the two companies
would work together and who would take the dominant
role in the sales process. Each sale would be governed by a
separate agreement, which would include a finder’s fee for
the partner that developed the sale. Additional highlights
of the agreement included:
■ The agreement committed both Aegis and Propack
Data to explore mutually beneficial ways in which they
could complement one another’s sales and marketing
activities.
■ Both Aegis and Propack Data agreed this was an im-
portant relationship and would seek to communicate
ideas for improving the relationship.
■ Each party would assign a person to act as the primary
liaison to the other party.
■ Each party would independently market its respective
products and services, but the two companies would
prepare mutually agreed press releases to promote the
relationship, provide marketing and sales support to
each other, and spread the word about the relationship
within their respective organizations.
■ The liaisons were to attend quarterly meetings to dis-
cuss comarketing of their products and customer leads.
The location of the meetings would alternate between
Aegis and Propack Data facilities.
■ Unless there was a sale, there would be no commis-
sions or other type of remuneration owed by one party
to the other.
■ Upon request, each party agreed to provide on-site
product training to the other party’s employees up to
once a year.
■ A separate agreement would be written up when both
parties decided to pursue jointly a product installation
and implementation.
■ The agreement could be terminated at any time with-
out cause with 90 days’ written notification.
Effectiveness of the Partnerships
When, by 2003, neither the Honeywell nor Rockwell re-
lationship had produced a single sale, Jahn began to
question the value of these alliances. With sales as the
major focus in the alliances and the primary criterion for
evaluating the success of the alliance, Jahn tried to under-
stand possible reasons for the lack of sales. It was easy to
blame lagging sales on the struggling economy. With the
Rockwell Automation Agreement
Rockwell Automation purchased ProPack Data in April
2002. ProPack Data, a German company established in
1984, was a market leader of MES and electronic batch
record systems (EBRS) for the pharmaceutical and other
regulated industries. The company employed 230 people
and became a part of Rockwell’s Process Solutions busi-
ness. Rockwell Automation had revenues of $4.3 billion,
employed 23,000 individuals, and had operations in 80
different countries.
Aegis had been approached by ProPack—and
had already begun negotiations with them—before the
Rockwell acquisition. The ProPack Data manufacturing
execution system PMX was designed to help customers
reduce operating costs, shorten cycle times, and improve
product quality in production operations. The software
solution provided by Aegis provided connectivity and
visibility to the manufacturing processes that PMX was
managing.
As with the Honeywell alliance, the relationship
with ProPack was designed to make Aegis visible to much
larger organizations. The addition of Rockwell into the
ProPack equation was a double-edged sword for Aegis’s
managemers. On one hand, they were excited by the large
size of Rockwell and the possibility to leverage that size to
their advantage. However, Jahn was concerned that those
advantages might be offset by increased bureaucracy and
added delays.
Aegis and ProPack Data set up a sales and market-
ing agreement for lead generation that was simpler than
the Honeywell POMS agreement. If a company’s referral
led to a sale for the partner, the company would receive
a finder’s fee. The agreement’s primary function was to
increase access to new sales territory. Aegis hoped to in-
crease the number of sales leads, thus generating a higher
number of sales opportunities. According to Bernhard
Thurnbauer, senior vice president of strategic marketing of
ProPack Data,
We are excited about this agreement with Aegis. We
feel that this [arrangement] will give ProPack Data a
significant edge in providing a true value added solu-
tion. Aegis’s Discoverant Manufacturing Informatics
system meets the need of leading pharmaceutical man-
ufacturers to analyze and visualize all their data in a
multitude of disparate sources. Using Discoverant,
manufacturers can find and control the key process
drivers across their entire manufacturing processes, all
the way from raw materials to final product.
Each company intended to use the partner’s
strengths to build interest in its own products and services
M11A_BARN0088_05_GE_CASE5.INDD 52 13/09/14 4:19 PM

Case 3–5: Aegis Analytical Corporation’s Strategic Alliances PC 3–53
realized it had a good cultural fit with Honeywell POMS
and noted very few communication problems. Aegis be-
lieved it could share information with Honeywell.
The Aegis and ProPack Data agreement was hin-
dered when Aegis’s primary contact left ProPack Data,
handing off responsibility to someone who did not take
an active role, thereby frustrating the Aegis team. On both
sides, communication had not extended beyond the con-
tact persons, and the relationship suffered. The two com-
panies had been trying to move beyond these events and
had taken steps to improve the channels of communication
between the firms.
A Difficult Decision
As Jahn reflected upon the development of the company
and these relationships, she wondered about Aegis’s al-
liance strategy and what actions to take. Perhaps it was
too early to make changes—these were difficult economic
times and Aegis might not have given the relationships
enough time to produce sales. Jahn and Neway knew that
communication and trust were important to keeping a rela-
tionship going through troubled times. Their comfort level
and trust increased with each partner as time went on. On
the other hand, one could argue that these relationships
had already had sufficient time to prove themselves and
it did not appear that either would be successful. If Aegis
terminated one or both of these relationships, it would
need to focus its time and energy on more productive sales
options. But what would these be?
Relationships with other partners large enough to
get the attention of main pharmaceutical companies would
likely have some of the same problems as these two re-
lationships and would take time to develop. Rather than
terminate these alliances, a more reasonable solution might
be to restructure the relationships. This could include
changes in the contract with either Rockwell or Honeywell
or in their interactions with one another. Believing they
had put together contracts with appropriate incentives to
encourage sales, their thoughts turned to improving the re-
lationships with each company. But how would a company
of fewer than 40 employees influence either of these large
corporations? Further, as a small company between rounds
of financing, Aegis did not have a lot of extra financial or
staffing resources. Any solution would have to be a low-
cost one. Each path was filled with risk and difficulties in
implementation, but Jahn and Neway knew that for Aegis
to attract investments and to succeed would require a
quick but thoughtful decision.
drug manufacturing industry not experiencing consistent
growth, companies were not able to spend money on im-
proving their processes, upgrading software, or revamp-
ing production. Budgets cuts and purchasing managers
following orders to reduce expenses led to a shrinking
market. Unfortunately, the products that Aegis and its
alliance partners were selling fell into the category of
items that were not essential to current operations. In fact,
Honeywell’s POMS division, while having some success
with other software products, overall had low sales and
had recently laid off 25 percent of its sales force, including
individuals with whom Aegis had worked. Aegis had also
lost some its original sales team. During lean times, the
companies that normally would be interested in purchas-
ing Aegis software solutions were looking internally to
make incremental improvements.
Another reason for the absence of sales might have
been the characteristics of the relationships and the part-
ner communication systems and performance metrics that
were set up. Effective communication between alliance
partners was essential. Was Aegis effectively communicat-
ing with either alliance partner? Although there were con-
tractual specifications about how often they had to meet,
communication appeared to be confined to situations
when either side had a question or needed clarification on
an issue. Communications between Honeywell POMS and
ProPack Data had been cordial, but there was no evidence
that the partners had a free flow of communication beyond
the “need to know” when problems arose.
For Honeywell POMS, the Aegis director of busi-
ness development handled all direct communications. The
current agreement allowed the companies to set agendas
and develop sales opportunities at a level that met the alli-
ance’s needs. Group phone calls, sales calls, and bi-yearly
face-to-face meetings were designed to keep the compa-
nies in contact with each other. Though initially there was
contact between engineers to make sure the technologies
were compatible, most communication occurred between
the companies’ sales teams and corporate management.
Communication between sales teams occurred when they
were working the same sales together, which they had
done on several occasions; then there was frequent com-
munication. The loss of key personnel in both companies
required the new managers to begin to rebuild the commu-
nication level and the overall interest in the relationship. At
the corporate level, they communicated weekly. Though
more frequent communication would perhaps be better,
Jahn believed the current level allowed the companies to
set agendas and develop sales opportunities at a level that
met the alliance’s needs. As the alliance developed, Aegis
M11A_BARN0088_05_GE_CASE5.INDD 53 13/09/14 4:19 PM

Quick Service Restaurant Giants
in the Middle Kingdom
In 2008, McDonald’s and KFC were the two largest quick-
service restaurants (QSR) in the world, with 31,999 and
15,580 outlets, respectively.1 Both chains were renowned
for their broad spectrum of consumers on a global basis.
McDonald’s appeared to be a clear winner in inter-
national expansion. It had over 17,500 international outlets
and was the first corporation to set up a solid foundation
for international franchising. It spearheaded global expan-
sion with its first overseas outlet in Canada in 1967, and
entered Japan in 1971.2 McDonald’s outlets had tremen-
dous success in Japan—despite the difference in culture—
with record-breaking daily sales and speed of expansion in
the initial stage.3
KFC also started international expansion early, open-
ing its first overseas outlet in England in 1964. However,
it was given a bumpy ride when it began to penetrate the
market in Asia. The Japanese outlets were far less success-
ful than McDonald’s and only started to make a profit
in 1976, six years after KFC entered Japan. KFC outlets
opened in Hong Kong in 1973 but were all closed down
within two years. The company would eventually win the
confidence of Hong Kong customers ten years after its first
entry. In Taiwan it experienced relatively smoother devel-
opment, although KFC headquarters was to spend a huge
amount of money and effort in order to get the ownership
back from its joint venture partners at a later stage.4
It was a totally different picture in China. In the
‘Middle Kingdom,’ KFC was not only recognised as the
leader in foreign quick-service restaurants but was also a
significant player in the Chinese restaurant industry as a
whole, alone contributing 1% of the country’s total food
and beverage industry revenues in 2005.5 In 2005, KFC’s
outlets in China recorded an average of US$1.2 million in
annual sales per store, compared with just US$900,000 for
similar stores in the US.6 According to the 2008 figures,
KFC had over 2,300 outlets in China, with an average
profit margin of nearly 20.1%.7
In contrast, at 1,000 outlets, McDonald’s presence in
China was less than half of KFC’s, with an estimated profit
margin significantly below that of its leading competi-
tor. Many people attributed KFC’s success in China to its
early entry—three years earlier than McDonald’s—and its
natural advantage in menu selection which corresponded
to the typical consumer’s preference for chicken over beef.
However, were these reasons enough to explain KFC’s con-
tinued growth and the extension of its lead over its rival?
How could McDonald’s as a latecomer and the second-
largest QSR player in China, capitalize upon its global
dominance and resources to catch up with KFC?
Replicate or Adapt?
The Inherent Challenge for International
Franchisors
International franchising is frequently associated with ser-
vice firms, such as hotels, retail outlets and quick service
restaurants. These firms often have strongly identifiable
trademarks and try to guarantee the customer a uniform
and consistent level of service and product quality across
different locations and over time. However, the high
C a s e 3 – 6 : M c D o n a l d ’ s a n d
K F C : R e c i p e s f o r S u c c e s s
i n C h i n a
This case was written by Gabriel Szulanski, Professor of Strategy
at INSEAD, Weiru Chen, Assistant Professor of Strategy, and
Jennifer Lee, Research Associate. It is intended to be used as a
basis for class discussion rather than to illustrate either effective
or ineffective handling of an administrative situation. The authors
gratefully acknowledge funding from INSEAD R&D.
M11A_BARN0088_05_GE_CASE6.INDD 54 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–55
Law on Franchise Regulations, passed in February 2007,
helped clear up the ambiguity surrounding franchisor’s
disclosure duty.16 Thenceforth, the rights of both franchi-
sors and franchisees were better protected.
Quick Service Restaurant Chains:
A New Experience for China
Foreign quick service restaurants began to surface in
China with the opening of KFC’s first store in 1987, fol-
lowed by McDonald’s entry three years later. The timing
was propitious for foreign enterprises as it had been nine
years since China embarked upon a policy of opening up
and reform in 1978 and Chinese curiosity about the West
was at a peak.
Although GDP growth in China had averaged well
over 9% per year since 1978, per capita GDP at the time
of KFC’s entry was a mere US$621.05.17 Given the 120 to
130 yuan monthly salary of Beijing urban residents at that
time, KFC prices were unaffordable to most, but many
still flocked to the store to purchase the 12-yuan KFC
hamburger or 8-yuan fried chicken. The most frequent
customers were foreigners living in China. Despite the at-
tractiveness of fast food chains, local consumers in those
early days could seldom afford to eat at KFC, McDonald’s
or Pizza Hut. Dining at these establishments was consid-
ered such a luxury that some couples chose to hold their
wedding banquets there.18
Behind the ‘dream market’ with a vast land area and
1.3 billion people, the complexity of China’s population,
geography and history presented major challenges for for-
eign players. Population density, economic development
and wealth distribution varied greatly from east to west
and from south to north. Foreign invested enterprises usu-
ally focused on the populous, more affluent eastern China.
The western regions were beyond the reach of even domes-
tic businesses without an effective national transportation
system.
Chinese-style fast food had existed prior to the entry
of western quick service restaurants but represented a to-
tally different concept and ambience compared with mod-
ern chains. Most of the catering units for Chinese fast food
were small in scale, serving pre-made appetizers such as
congee, buns and fritters of twisted dough (yiu-tiao). They
lacked funding, trained employees and a well-maintained
dining environment.19 As restaurant staff required at least
five years of experience, western food chains could not
find a sufficient number of internal candidates to meet
growth-driven demand and had to import skilled manag-
ers from neighbouring markets such as Taiwan and Hong
Kong, and even from headquarters in the US.
degree of standardised operations makes the replication
of the format across diverse markets difficult. Differences
in things such as ingredients, labour and physical space
can mean significant modifications to the service formula.
Consequently, the basic service may be similar to that of
the home country, but details in the delivery of the service
are often altered.8
Many foreign enterprises found China very different
in culture and consumer behaviour. Franchise restaurants
faced several major hurdles, including a different labour
force structure, difficulty in recruiting technically compe-
tent and culturally sensitive managers, tough technological
problems and a less than satisfactory legal environment
and enforcement.9 So the challenge for international fran-
chisors like McDonald’s and KFC was to decide whether to
comply strictly with their original models, and if adapta-
tion was required, when and how to make adaptations in
order to deliver globally consistent standards while cater-
ing to local consumer needs.
Potential of China’s Restaurant Industry
Chinese consumers’ spending on eating out had increased
tremendously along with the country’s economic boom in
the past decade. Retail revenues of the restaurant industry
increased from 5.2% in 1991 to 14% in 2007 as a portion of
total retail revenues from consumer goods.10 According
to annual statistics from the Ministry of Commerce of the
People’s Republic of China, the retail revenue of the ho-
tel and restaurant industry reached 1,235.2 billion RMB
in 2007, representing 19.4% growth over the previous
year; foreign franchises were the main driver of food and
beverage revenue growth as foreign direct investment in
the hotel and restaurant industry totaled US$10.4 billion,
an increase of 25.8% on the previous year.11 China was
the world’s largest consumer of meat. The Economist
Intelligence Unit forecast that annual meat consumption
in China would jump from 59 kg per head in 2005 to 74 kg
per head in 2009.12 With US meat consumption at 128 kg
a head, there seemed plenty of scope for the Western fast-
food industry to expand in China.13
Foreign quick service restaurants played a significant
role in China’s restaurant industry. The share of fast food
in the retail industry was expected to reach 9.3% by 2011
from 74% in 2007. China’s fast-food industry was expected
to grow at a CAGR of around 25% during 2008–2011.14
The first comprehensive franchising regulations,
which came into effect in February 2005, made it easier for
foreign fast-food operators to open branches and roll out
the franchising model, which had proven to be such a sure
path for fast-track growth in the US and Europe.15 The new
M11A_BARN0088_05_GE_CASE6.INDD 55 15/09/14 7:44 PM

PC 3–56 Corporate Strategies
associate professors at the country’s universities at that
time. So attractive was the compensation package that a
ratio of 20 to 1 people applied for every opening. In the
end, B-KFC hired those applicants who were high school
graduates, could speak some English, did not have previ-
ous restaurant work experience, and had demonstrated a
willingness to work hard.25
A Management Team Familiar
with Local Culture
From the beginning, KFC hired elites from overseas—
Hong Kong, Taiwan and other Asian countries—some with
decades of experiences in the QSR industry, and most with
a deep understanding of the language, culture, habits and
customs of China. As many of the management team mem-
bers were associated with Taiwan, they were nicknamed
the “Taiwanese gang.”26
Other than the top management team which was
composed of almost all overseas Chinese, KFC was keen
on developing local talent from day one. The company
paid well to hire highly educated and motivated restaurant
staff, and used its training system to develop those staff
into future restaurant managers or even district general
managers. 80% of China KFC’s district general managers
were university graduates, some from top schools. This
strategy paid off when the company decided to expand ag-
gressively after 10 years in China. Joseph Han, Operating
Vice President of Yum! Brands in greater China from 1996
to 2003, described KFC China’s people strategy:
. . . in China, KFC understands the importance of
people’s talent. . . . In the United States, in the fast-food
chains, it is very difficult to hire very high-quality
people, especially on the cook labour side. So in China,
KFC built very aggressive talent recruitment projects.
It went to universities to hire university students. KFC
hired management trainees with very qualified univer-
sity graduates. . . . There are a total of 22 branch offices
for Yum! Brands in China and the general managers
are now already 90% localised. Those people actually,
20 years ago, started at the restaurants as the cook per-
son, or as a management trainee. This talent pool has
become their great asset for the future development.27
Takeoff during Time of Crisis
KFC chose to put down roots in big eastern cities along the
coast in the 1980s and to go west in the 1990s. Like many
foreign enterprises, KFC’s expansion route was from east to
west, from cities to towns, and blanketed China with wider
coverage by linking outlet presence in cities and towns.
KFC in China
The Very First Western Restaurant Chain
Yum!’s KFC brand was the first foreign quick-service res-
taurant chain to enter China.20 On 12 November 1987,
the first KFC in China was officially opened at Beijing
Qianmen, within walking distance of Tiananmen. In 2002,
KFC opened the first ever drive-through restaurant in the
country. In 2004, the 1,000th KFC restaurant was opened
in China (Beijing), only a few kilometres from the site of
its first restaurant. From the beginning of 2005, the Yum!
China Division (including Mainland China, Thailand and
KFC Taiwan), based in Shanghai, reported directly to
Yum! headquarter instead of to its international division,
reflecting China’s market size, unique strength and im-
portance.21 From 1987 to 2005, the number of KFC outlets
in China grew by 50% annually, growth which was con-
sidered exponential outside its parent market in the US,22
particularly in a country known for its culinary sophistica-
tion developed over thousands of years. Today, KFC is the
number one quick-service restaurant brand in China. Yum!
China has more than 2,300 KFC restaurants in nearly 500
cities in Mainland China (Q3 2008).23
Initial Stage—Replication
with Localisation in Mind
In 1987, KFC set up a joint venture, B-KFC, with Beijing
Animal Production Company and Beijing Tourism Board
in order to gain access to better product supply and F&B
management authority. Sim Kay Soon, a Singaporean who
had held area manager and training officer positions within
KFC system since the 1980s, was appointed to be its the first
general manager, responsible for day-to-day operations.24
Positions below (and including) assistant managers were
all held by Chinese nationals. The company started us-
ing local food ingredients from day one. Chicken was
purchased from Beijing Animal Production, and potatoes,
cabbage and carrots were all purchased locally. However,
cooking equipment was mostly imported, such as blenders,
heating racks and even cash registers.
The first Beijing outlet represented KFC’s largest
restaurant worldwide with 1,400 square metres of space
allowing for a capacity of 500 seats and considerable office
space for B-KFC staff. Only four months after opening, the
Beijing restaurant had become the highest-selling single
KFC store in the world.
The response to B-KFC’s recruitment was over-
whelming as the base salary offered was set at 140 RMB
per month, about 40% more than could be earned by
M11A_BARN0088_05_GE_CASE6.INDD 56 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–57
Menu Selection—an American
Brand with Chinese Characteristics
KFC has followed the principle of menu localization, striv-
ing to become an ‘American brand with Chinese charac-
teristics’ since its entry.33 Even in the earliest days, KFC
China’s most popular items were the spicy chicken wings
and spicy chicken thigh burger, rather than its signature
Colonel Sanders Original Recipe chicken.
Large-scale menu localisation started in 199834
when a local food R&D team and a test kitchen were
set up in Shanghai. Since then, KFC has introduced
many Chinese items onto their menus. Preserved Sichuan
pickle and shredded pork soup was one of the first. The
soup proved a success, and mushroom rice, tomato and
egg soup, and Dragon Twister (traditional Peking chicken
roll) were soon added to the menu. KFC also serves
packets of Happy French Fry Shakes that contain beef,
orange and Uygur barbecue spices.35 Chinese consum-
ers received those localised food items very well. While
some global companies might have second thoughts
about launching a food item containing bones for fam-
ily consumers, as it might potentially create food safety
concerns, KFC’s chicken kebab is made of soft bones and
meat (see Exhibit 1), and has become one of the most
popular items among children and teenagers. Chinese
consumers can find preserved egg with pork porridge,
egg and pork floss roll, and Hong Kong milk tea for
breakfast, egg and vegetable soup as a side dish, Dragon
Twister for a main meal, and Portuguese egg tart for des-
sert on the menu.
In an interview, Joseph Han talked about why KFC
China was determined to provide a localised menu, one of
the keys to successfully penetrating into fourth and fifth
tier cities in rural areas:
I think McDonald’s and KFC do bring in the dining
environment, and they bring in their working concept
to change people’s lifestyle. But product-wise, you can
see Chinese are still Chinese. When Chinese students
go to the United States to study, they still choose the
kind of food they feel is close to their life. Even though
they admire the Western lifestyle, I think they still
need time to change their dietary habits. Especially
breakfast. In the three meals, breakfast is usually
cooked by your mother. Your mother always cooks
traditional food. So that’s why now even McDonald’s
in China created its own breakfast menu. Every-
where in the world you don’t change, but when you
came to China and India, I can guarantee you have
to change, because maybe you can change younger
people’s lifestyle, but you cannot change some of their
dietary habits.36
Within 10 years of its entry into China, KFC has basically
covered the main cities in the populated areas, with only
the sparsely populated and low purchasing-powered south-
western and north-western districts yet to be penetrated.
During the Asia economic downturn in 1997, KFC
faced the challenge of a thinning bottom line. It had two al-
ternatives, either to cut costs or to increase sales. It chose to
aggressively expand the number of outlets at a time when
most competitors were holding back. The same strategy
was applied in other times of crisis, for example, during the
SARS epidemic in 2003—that year KFC added more than
300 new outlets, even more than in the previous year.28
Self-Developed Logistic
and Distribution System
Along with the aggressive expansion plan, a well-connected
supply chain was needed before any new KFC outlet could be
opened in any city. KFC expected to establish a logistics sys-
tem to supply neighbouring KFC outlets. If it took more than
one day to reach any new KFC restaurant, the logistics team
would start finding a new warehouse closer to the outlet.
What was different about the global KFC system
was that Yum! Brands established its own logistics system
by working closely with local partners rather than simply
outsourcing its supply to a third party. KFC established the
“STAR System” for its China partners, and suppliers who
passed the STAR test could also easily achieve national
ISO9002 and HACCP29 certification. Yum! Brands later
consolidated a separate supply system in China—which
saved the company nearly 100 million RMB in costs in
1998.30 It set up Asia’s largest logistics and distribution
centre in Beijing in October 2004 for its groups of restau-
rants in China, a move that was the first and only for Yum!
Brands Global companies, and which allowed another 10%
cost reduction.31 Warren K. Liu, Vice President of Yum!
Brands Greater China from 1997 to 2000, later recalled that
he was challenged again and again by headquarters on
the decision to invest in its own warehouse, logistics and
distribution system, which didn’t exist in other parts of the
world where Yum! Brands was present:
What we faced in China were an inefficient and frag-
mented distribution network, an inadequate highway
system, local protectionism that lead to fragmentation
in the supply chain, and inter-provincial trade barriers
such as excessive tolls. In such an infrastructure-
deficient market environment, direct control over
supply storage and distribution complements KFC’s
rapid growth strategy; allowing KFC to penetrate new
markets further, sooner, faster, at lower unit cost than
its competitors.32
M11A_BARN0088_05_GE_CASE6.INDD 57 15/09/14 7:44 PM

PC 3–58 Corporate Strategies
in Taiwan during the 1990s, launch new outlets separately
and independently from those operated by the franchisee,
and finally bought back restaurant ownership in Xian.
The KFC team in China decided not to authorise
any franchise agreements with entrepreneurs in any city
or region to avoid making the same mistake as in Taiwan
or Xian, no matter how small or remote that city or region
might be. In August 2000, KFC authorised the first indi-
vidual franchisee in Changzhou. By paying a one-time
transfer fee of 8 million RMB, the franchisee could own
Franchised or Not?
KFC’s aggressive expansion through franchising did not
get off to a good start in China. In 1993, it signed its first
regional franchise agreement for the Xian area in the
northwest of China with a Taiwanese entrepreneur.37 This
served the purpose at that time for KFC China headquar-
ters to focus on more strategically important coastal cit-
ies. However, due to a slower-than-expected development
pace in Xian, KFC China had to go down the same path as
KFC China TV Advertisement
Exhibit 1 KFC Advertisement
China
KFC China Print Advertisement
Chicken Kebab—“Bone and flesh Relations”
M11A_BARN0088_05_GE_CASE6.INDD 58 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–59
French fries to McDonald’s, had founded a joint venture
company in Beijing in 1993, surveying the varieties of
potatoes before McDonald’s entry; McDonald’s vegetable
supplier set up a branch in Guangzhou in 1997 in order to
satisfy McDonald’s intention to source locally, and 100% of
its facility and equipment were imported from overseas.
Likewise, the global suppliers of McDonald’s buns and
seasonings had all set up branches in China to strengthen
the supply chain network for McDonald’s in China.44
Why did McDonald’s insist on bringing their global
partners to China? Peter Tan, former Senior Vice President
and President of McDonald’s Greater China, summed it up:
McDonald’s in China today reflects the attitude that
they are a global brand, hence the need to set standards
that are globally consistent, be it in Oakbrook, USA,
or Xian, China . . . McDonald’s is saying that ‘we are
in this emerging country, but because we are a global
brand, we need to give them first world standards . . . ’
McDonald’s had fewer than five chicken suppliers up in
the northeast, and the reason for this is that McDonald’s
is very concerned about quality consistency.45
Catching Up with Cautiously
Aggressive Expansion
Although McDonald’s came in late, its expansion in China
was still aggressive, especially in the earlier years. Its strat-
egy was to start in the foreign influenced and economically
affluent southern cities and then expand to cities in north
and central China.
However, compared with KFC, McDonald’s did not
successfully penetrate as many third and fourth tier cit-
ies as its rival (see Exhibits 2 and 3). By September 2003,
McDonald’s had 566 outlets in 94 cities across 19 provinces.
The bulk of the restaurants were concentrated in over 40 cities
on China’s east coast where incomes were higher. The bulk of
an operating KFC outlet which was already in profit. The
franchising strategy was limited to townships with a popu-
lation of between 150,000 and 400,000, and which achieved
more than 6,000 RMB in per capita annual consumption.38
By the end of 2007, there were 228 franchised KFC outlets,
8.7% of its total number of outlets in China.39
McDonald’s in China
Entry into China
On 8th October 1990, nearly three years after KFC set
up its first outlet near Tiananmen Square, McDonald’s
opened its first outlet in China in Shenzhen40 and it was
warmly welcomed by the local consumers. It continued to
extend in the southern cities of China, and in April 1992,
the Golden Arches could finally be seen in McDonald’s
Wangfujing outlet in Beijing. This outlet was formed with
an unlisted investment unit of the Beijing municipal gov-
ernment. Overtaking the Moscow outlet in size, it became
the largest McDonald’s restaurant in the world, attracting
13,000 customers on its very first day.41
By September 2003, McDonald’s had 566 outlets
in 94 cities across 19 provinces and China had become
McDonald’s third largest Asian market behind Japan and
Australia. In 2004, China became one of its top ten markets—
making the country McDonald’s Corp’s fastest-growing
market worldwide.42
However, although the number of McDonald’s out-
lets was on a par with that of KFC in the first six years after
its entry, it had started to lag behind KFC since 1997. While
KFC celebrated the opening of its 1,500th outlet in China
(Shanghai) in 2005, McDonald’s had around 600.43 What
had McDonald’s done differently in China to explain this?
Consistent Global Supply Chain Partners
McDonald’s developed its supply chain partners along
with its global business growth. HAVI Food, its global lo-
gistics partner, would enter any new market to invest and
set up the logistics system even before the first McDonald’s
outlet opened in that market. In China, HAVI Food also
established a logistics centre exclusively for McDonald’s,
and there were three major distribution centres in Beijing,
Shanghai, Guangzhou, and satellite dispatch centres in
other smaller cities.
McDonald’s also tried to work with its global food
suppliers as much as possible. There were 43 suppliers for
McDonald’s in China, 70% of which were its global part-
ners. For example, J.R. Simplot Co., which supplied frozen
Exhibit 2 KFC’s penetration in China in the first ten years
Year of Entry Coverage
1987 Beijing
1989 Shanghai
1992 Nanjing
1993 Suzhou, Hangzhou, Wuxi, Guangzhou,
Qingdao, Xian (franchised)
1994 Fuzhou, Tianjin, Shenyang
1995 Chendu, Dalian, Wuhan
1996 Shenzhen, Xiamen
1997 Changsha, Chongqing
Source: Warren K. Liu, KFC in China—Secret Recipe for Success, John Wiley &
Sons (Asia) Pte Ltd., 2008.
M11A_BARN0088_05_GE_CASE6.INDD 59 15/09/14 7:44 PM

PC 3–60 Corporate Strategies
also became popular. McDonald’s gradually recognised the
importance of catering to local consumers’ tastes. Jeffrey
Schwartz, newly-appointed President of McDonald’s China
in 2005, said that 80% of the menu in China would be the
same and the other 20% would be allowed to be different in
order to reflect regional tastes. He also said that McDonald’s
would open outlets in more areas in the future to make
McDonald’s food accessible to more customers.51
McDonald’s detail-oriented approach was also ex-
tended to their China operations. Every aspect of food
preparation was done according to the operating manual.
Packaging such as Happy Meal boxes and apple pie wrap-
pers were produced to exactly the same global standards.
In an interview, Peter Tan commented on the balance be-
tween production innovation and global consistency:
For a global brand to maintain brand consistency, it is
important to ensure that the icon products remain an
integral part of the menu offering. But then the question
arises as to how you penetrate into emerging countries
where you need to balance between what the brand
stands for versus local tastes. That’s where I think prod-
uct innovation done strategically plays a vital role.52
Today, McDonald’s menu in China has grown to include
foods tweaked for local tastes to satisfy consumers, such
as spicy chicken fillet and pineapple sundae. Some of the
menu ideas, such as the corn cup developed in China,
have been exported to other markets around the world.
However, according to CEO Jeffrey Schwartz, the ham-
burger and fries Western-style are still at the heart of the
Chinese menus.53
Franchised or Not?
McDonald’s has always been a franchising company and
franchisees have played a significant role in its success.
About three-quarters of McDonald’s outlets worldwide have
been franchised.54 However, due to ambiguity in China’s
legal environment, up until 2003 McDonald’s China had
established all of its 566 outlets by joint venture or sole
proprietor, rather than using its global franchising model. It
announced in 2003 that it would open ten franchised outlets
in China by June 2006, with a loyalty fee of 2.5 to 3.2 million
RMB. The requirements that individuals must meet before
being granted a franchise were the same in China as they are
worldwide. The first pilot franchise was launched in Tianjin
in September 2003. The licence was awarded to Meng Sun on
the basis of her business acumen and understanding of the
Tianjin market.55 In 2007, McDonald’s had fewer than 0.5%
outlets in China that were franchised56 while the percentage
was 78% worldwide.57
McDonald’s sales in China came through its restaurants in
Beijing, Shanghai, Shenzhen and Guangzhou. In September
2003, it was reported that McDonald’s planned to open 100
new stores per year in China over the next couple of years.
A majority of the proposed outlets would be opened in de-
veloped markets such as Beijing, Shanghai and Guangzhou.
The remainder would be located in Inner Mongolia and other
less developed regions of China. The company also planned
to expand in Western China.46 By January 2007, McDonald’s
had penetrated into more than 120 cities across China,47 and
in November 2008, it finally crossed the 1,000 outlets thresh-
old, with plans to add another 175 in 2009.48
However, unlike KFC, McDonald’s did not take bold
steps in expanding its territory in China. The number of
outlets in China began to dwindle from 2002 onwards.
In order to strengthen its foothold in China, McDonald’s
moved its Asia headquarters from Hong Kong to Shanghai
in January 2005, signaling its determination to intensify its
aggressive expansion in China.
Standardised Global Menu
with Local Selections
McDonald’s was known for its quality of food and consis-
tency in food preparation processes. In order to maintain
quality and consistency, McDonald’s imposed standardi-
sation in three domains—ingredient procurement, food
preparation and food quality. The same consistency could
be seen in their food menu; Big Mac remained their sig-
nature product, although chicken varieties were added to
suit local consumers’ tastes and accounted for an estimated
60% of food sales in McDonald’s China.49
The McDonald’s menu in China was essentially the
same as in the US. Its use of local food selection was appar-
ently not as varied as KFC’s. However, not content to lag
behind KFC, McDonald’s introduced Vegetable and Seafood
Soup and Corn Soup in 2004,50 and other Chinese-style
menu items such as red bean sundaes and taro pies, which
Exhibit 3 McDonald’s penetration in China in the first
10 years
Year of Entry Coverage
1990 Shenzhen
1992 Beijing
1993 Guangzhou
1994 Tianjin, Shanghai, Nangjing, Wuhan,
Chendu, Chongqing
2001 Xian
Source: McDonald’s and KFC edited by B.Q. Chen, China Economy
Publishing, 2005.
M11A_BARN0088_05_GE_CASE6.INDD 60 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–61
KFC
Despite its success in China, KFC Global was struggling
to overcome weak performance in the homeland. Data
showed that in 2008 Yum’s overall second-quarter profit
rose 4%; it achieved 38% growth in operating profit in its
China division and 18% growth in its international divi-
sion. These figures offset a 12% drop in US operating profit
for that quarter. Yum! CEO, David C. Novak, singled out
KFC in the US as “our only major soft spot.”65
On the road of aggressive expansion, KFC China
ran up against the issue of consumer confidence in
its food safety standards. Sudan I, a red chemical dye
thought to cause cancer, was discovered in two products
sold in China: KFC’s New Orleans Roast Chicken Wings
and New Orleans Roast Chicken Legs.66 KFC took the
dishes off the menu, but Chinese consumers were still an-
gry because a large amount of the consumption was made
by children.67
Other Competition
Burger King, the second-largest United States hamburger
chain, entered China in 2005, planning to open ten stores
in China in 12 months with a view to participating in the
large and fast-growing eating out market.68 It signed a
regional franchisee agreement with a company in Fujian, a
populous province in southern China, in order to expand
its territory.
Faced with increasing competition, how could
McDonald’s strengthen its position in China? Should it
aggressively increase its number of outlets by taking
bold steps like KFC, or gradually expand its presence
by strictly following its global strategy and procedures?
Could KFC sustain its leading edge while ensuring ex-
pansion and quality at the same time? Would the success
of China KFC be carried over to its US base and bring
changes to the business model in order to compete with
McDonald’s Global?
The Challenges Ahead
McDonald’s
2004 was a year of tragedy and loss for the company. The
CEO who had put McDonald’s on the road to revitaliza-
tion, Jim Cantalupo, died on the eve of the company’s
global convention. His successor, Charlie Bell, was diag-
nosed with cancer soon after taking the helm. He resigned
in November of that same year, and passed away in
January 2005.58 The China management team saw a high
level of turnover: McDonald’s Greater China President,
Peter Tan, left in June 2005. His post was filled by Guy
Russo, who was originally President of McDonald’s
Australia. In October the same year, the Managing Director
of McDonald’s North region and the General Manager of
McDonald’s Beijing both left the company.59
Despite the general perception that McDonald’s
would try to catch up with KFC in China using franchis-
ing, a report in 2007 revealed that they were cautious about
franchises. China Vice President, Gary Rosen, commented:
“The franchise business requires a lot of effort and right
now we have other priorities in China.” The company
would open at least 100 new stores in the country annually
and half of them would be wholly owned drive-through
outlets.60 McDonald’s took a strategic move to link with
China’s SinoPec in 2006, giving McDonald’s the rights to
build drive-through outlets at the oil company’s 30,000
gas stations.61 Up until November 2008, it owned 81 drive-
through restaurants in China. Another expansion direction
for McDonald’s China was to convert its restaurants into
24-hour operations. By the end of 2008, 80% of its 1,000
outlets in China already provided service round the clock.62
All these efforts were consistent with its global strategy of
making McDonald’s a convenient choice for customers.63
We have a business model of getting better versus get-
ting bigger. It’s not about how many restaurants you
have, it’s about how many restaurants that serve your
customers well. It’s not about how big, it’s about how
good and how you run your business.64
—Jeffrey Schwartz, CEO, McDonald’s China, 2008
M11A_BARN0088_05_GE_CASE6.INDD 61 15/09/14 7:44 PM

Exhibit 5 KFC Top 25 Markets by Unit Count
For Full Year 2007
2007 Top 25 Markets KFC
United States 5,273
China Mainland 2,140
Japan 1,152
Canada 720
Great Britain 664
Australia 559
South Africa 479
Malaysia 402
Mexico 323
Thailand 314
Indonesia 300
Philippines 165
Korea 158
Taiwan 138
Saudi Arabia 97
New Zealand 95
Puerto Rico 86
Poland 83
Egypt 81
Singapore 70
Hong Kong 69
France 57
Germany 51
Spain 47
India 31
Source: www.yum.com
Exhibit 4 Historical Store Count
Source: McDonald’s and Yum website. Various press releases and web articles.
35,000
30,000
25,000
20,000
15,000
10,000
5000
0
KFC McDonald’s
1952 1955 1960
200 500
710
400 600 1000
1600
6000
3400
6000
7300
8700
11338
13731
14258
15580
31999
31046
27896 3137730766
22928
14892
11000
1963 1965 1970 1980
Year
McDonald’s and KFC Worldwide
N
u
m
b
er
o
f
O
u
tl
et
s
1990 1997 2000 2005 2006 2007 2008
PC 3–62
M11A_BARN0088_05_GE_CASE6.INDD 62 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–63
Exhibit 6 Yum Worldwide System Units
Year end 2008 2007 2006 2005 2004 2003
Company Owned 7,568 7,625 7,736 7,587 7,743 7,854
Franchisees 25,911 24,297 23,516 22,666 21,858 21,471
Licensees 2,168 2,109 2,137 2,376 2,345 2,362
Totala 36,292 35,345 34,595 34,277 33,608 33,199
Year end 2008 2007 2006 2005 2004 2003
United States
KFC 5,253 5,358 5,394 5,443 5,525 5,524
Pizza Hut 7,564 7,515 7,532 7,566 7,500 7,523
Taco Bell 5,588 5,580 5,608 5,845 5,900 5,989
Long John Silver’s 1,022 1,081 1,121 1,169 1,200 1,204
A & W 363 371 406 449 485 576
Total Us 19,790 19,905 20,061 20,472 20,610 20,822
International 2008 2007 2006 2005 2004 2003
KFC 7,347 6,942 6,606 6,307 6,084 5,944
Pizza Hut 5,026 4,882 4,788 4,701 4,528 4,357
Taco Bell 245 238 236 243 237 247
Long John Silver’s 38 38 35 34 34 31
A & W 264 254 238 229 210 183
Total International 12,920 12,354 11,903 11,514 11,093 10,762
China 2008 2007 2006 2005 2004 2003
KFC 2,980 2,592 2,258 1,981 1,657 1,410
Pizza Hut 585 480 365 305 246 204
Taco Bell 0 2 2 2 1 1
A & W 0 0 0 0 0 0
Total Chinab 3,582 3,086 2,631 2,291 1,905 1,615
a Includes unconsolidated affiliates.
b Includes East Dawning units for China.
Source: www.yum.com
M11A_BARN0088_05_GE_CASE6.INDD 63 15/09/14 7:44 PM

PC 3–64 Corporate Strategies
Exhibit 7 Yum China Division Operating Results (in millions)
2001 2002 2003 2004 2005 2006 2007
Company sales $569 $722 $871 $1,082 $1,255 $1,587 $2,075
Franchise and licence fees 18 22 30 38 41 51 69
Revenues 587 744 901 1,120 1,296 1,638 2,144
Food and paper 244 289 331 401 454 562 756
Payroll and employee benefits 61 77 93 125 167 205 273
Occupancy and other operating expenses 179 217 275 337 415 497 629
Company restaurant expenses 484 583 699 863 1,036 1,264 1,658
General and administrative expenses 46 51 62 80 92 119 151
Franchise and licence expenses – – – – – – –
Closures and impairment expenses 6 6 6 4 7 6 7
Other (income) expenses (12) (16) (27) (32) (50) (41) (47)
524 624 740 915 1,085 1,348 1,769
Operating profit $63 $120 $161 $205 $211 $290 $375
Company sales 100% 100% 100% 100% 100% 100% 100%
Food and paper 42.9 40.0 38.0 37.1 36.2 35.4 36.4
Payroll and employee benefits 10.7 10.6 10.7 11.5 13.3 12.9 13.2
Occupancy and other operating expenses 31.5 30.1 31.5 31.1 33.1 31.3 30.3
Restaurant margin 14.9% 19.3% 19.8% 20.3% 17.4% 20.4% 20.1%
$ $ $ $ $ $ $
Company sales 569 722 871 1,082 1,255 1,587 2,075
Franchisee sales 328 397 510 619 665 840 1,098
System sales growth
Local currency 17% 25% 23% 23% 11% 23% 24%
U.S. dollars 14% 25% 23% 23% 13% 26% 31%
Source: www.yum.com
M11A_BARN0088_05_GE_CASE6.INDD 64 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–65
Exhibit 8 Yum U.S. Division Operating Results (in millions)
2001 2002 2003 2004 2005 2006 2007
Company sales $4,287 $4,778 $5,081 $5,163 $5,294 $4,952 $4,518
Franchise and licence fees 540 569 574 600 635 651 679
Revenues 4,827 5,347 5,655 5,763 5,929 5,603 5,197
Food and paper 1,225 1,346 1,463 1,546 1,576 1,399 1,317
Payroll and employee benefits 1,313 1,479 1,576 1,573 1,600 1,489 1,377
Occupancy and other operating expenses 1,100 1,189 1,303 1,333 1,385 1,340 1,221
Company restaurant expenses 3,638 4,014 4,342 4,452 4,561 4,228 3,915
General and administrative expenses 418 469 469 501 536 546 510
Franchise and licence expenses 49 39 16 19 26 23 29
Closures and impairment expenses 27 23 16 14 46 37 14
Other income – – – – – 6 (10)
4,132 4,545 4,843 4,986 5,169 4,840 4,458
Operating profit $695 $802 $812 $777 $760 $763 $739
Company sales 100% 100% 100% 100% 100% 100% 100%
Food and paper 28.6 28.2 28.8 29.9 29.8 28.2 29.2
Payroll and employee benefits 30.6 30.9 31.0 30.5 30.2 30.1 30.5
Occupancy and other operating expenses 25.6 24.9 25.6 25.8 26.2 27.1 27.0
Restaurant margin 15.2% 16.0% 14.6% 13.8% 13.8% 14.6% 13.3%
Company same store sales growth 1% 2% 0% 3% 4% 0% (3)%
Company sales $4,287 $4,778 $5,081 $5,163 $5,294 $4,952 $4,518
Franchise sales 10,309 11,061 11,257 11,724 12,428 12,804 13,304
Source: www.yum.com
M11A_BARN0088_05_GE_CASE6.INDD 65 15/09/14 7:44 PM

PC 3–66 Corporate Strategies
Exhibit 9 Yum Division Historical Sales Growth (in %)
CHINA DIVISION
(Mainland China, Thailand, KFC Taiwan)
2008 2007 2006 2005 2004
1st Quarter 28% 19% 14% 26% 17%
2nd Quarter 28% 19% 29% 2% 34%
3rd Quarter 23% 25% 11% 20%
4th Quarter 30% 23% 6% 21%
Full Year 24% 23% 10% 23%
INTERNATIONAL DIVISION
(Excludes China Division)
2008 2007 2006 2005 2004
1st Quarter 9% 10% 6% 7% 5%
2nd Quarter 8% 11% 8% 6% 6%
3rd Quarter 11% 9% 4% 9%
4th Quarter 9% 11% 4% 6%
Full Year 10% 9% 5% 6%
U.S. COMPANY SAME-STORE
2008 2007 2006 2005 2004
1st Quarter 3% -6% 4% 4% 3%
2nd Quarter 4% -3% 0 5% 2%
3rd Quarter -1% -2% 4% 4%
4th Quarter -1% -2% 4% 2%
Full Year -3% 0 4% 3%
Source: www.yum.com
Exhibit 10 McDonald’s Number of Restaurants Top 25
Market by unit count
(at year-end 2007 and 2002) 2007 2002
Total 31,377 31,108
United States 13,862 13,491
Japan 3,746 3,891
Canada 1,401 1,304
Germany 1,302 1,211
United Kingdom 1,191 1,231
France 1,108 973
England 1,019 1,055
China Mainland 876 546
Australia 761 726
Brazil* 551 584
Spain 378 333
Mexico* 364 261
Italy 361 329
Taiwan 348 350
Philippines* 273 236
South Korea 233 357
Sweden 230 245
Netherlands 220 220
Poland 213 200
Hong Kong 207 216
Russia 189 94
Argentina* 183 203
Malaysia 176 149
Austria 163 157
*Developmental Licensee market as of December 31, 2007.
Source: www.mcdonalds.com.
M11A_BARN0088_05_GE_CASE6.INDD 66 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–67
Exhibit 11 McDonald’s Financial Results by Segment
APMEA: Asia/Pacific, Middle East and Africa.
Source: www.mcdonalds.com
12.0%
U.S.
Europe
APMEA
Other Countries &
Corporate
Total
Sales Increase % by Segment
%
C
h
an
g
e
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2005
4.4%
2.6%
4.0%
5.3%
5.2%
5.8%
5.5%
9.4%
4.5%
7.6%
10.6%
10.8%
3.9% 5.7% 6.8%
2006 2007
2007 Revenues by Segment
$ Million
U.S. Europe APMEA Other Countries & Corporate Total
U.S. Europe APMEA Other Countries & Corporate
$3,599
$2,356
$8,926
$7,906
2007 Restaurant Numbers
by Segment
7,938
3,097
13,862
6,480
M11A_BARN0088_05_GE_CASE6.INDD 67 15/09/14 7:44 PM

PC 3–68 Corporate Strategies
Exhibit 12 Historical Store Count
Source: McDonald’s and Yum website. Various press releases and web articles.
2,500
2,000
1,500
1,000
500
2300
1000
876
770
600546
100
566
21401822
1500
1000
911
600
5001001611
0
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
Year
N
u
m
b
er
o
f
O
u
tl
et
s
KFC McDonald’s
McDonald’s and KFC China
M11A_BARN0088_05_GE_CASE6.INDD 68 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–69
Exhibit 13 Comparsion of McDonald’s and KFC in-store Menu
China
McDonald’s KFC
Main Meal
Big Mac
Double Cheese Burger
Hamburger
Cheese Burger
Beef ‘N’ Egg Burger
McSpicy Chicken Burger
McChicken Burger
Fillet-O-Fish
Vegetable Beef Burger
McSpicy Chicken Twister
Curry Chicken Burger
Teriyaki Chicken Burger
Double Mala Chicken Burger
Spicy Teriyaki Chicken Burger
Buckets of Chicken
New Orleans BBQ Chicken Burger
Spicy Chicken Burger
Crispy Chicken Burger
Garden Crispy Chicken Burger
Cod Fish Burger
Mexican Chicken Twister
Dragon Twister
Spicy ‘Saliva’ Chicken Burger
Side Dishes/
Light Snacks
McNugget
McSpicy Chicken Wings
Sweet Corn in a Cup
French Fries
Corn on a cob
Mashed Potato
Egg ‘N’ Vegetable Soup
Vegetable Salad
Corn Salad
Carrot Bread Roll
Chicken Kebab
French Fries
Chicken Nuggets
Popcorn Chicken
New Orleans BBQ Chicken Wings
Original Recipe Chicken
Spicy Chicken Wings
Cod Fish Sticks
Breakfast
Big Breakfast
Pancake
Cheese’N’Egg Burger
Pork McMuffin
Orange Juice
Fresh Milk
Crispy Chicken Burger (with egg)
Cheese‘N’ Egg Burger
Pork‘N’ Egg Burger
Beef‘N’ Egg Porridge
Chicken‘N’ Mushroom Porridge
Preserved Egg‘N’ Lean Pork Porridge
Egg‘N’ Pork Floss Twister
Egg‘N’ Pork Twister
Shrimp‘N’ Egg Twister
Hong Kong Milk Tea
Shrimp Spring Roll
Orange Juice
Dessert
Sundae
(Chocolate/Pineapple/Strawberry)
Ice Cream Cone
(Vanilla/Chocolate/Mixed/Crunchy)
Milkshake (Chocolate/Strawberry)
Portuguese Egg Tart
Sundae
Ice Cream Cone
Coffee/Irish Coffee
Lemon Cola
Pomelo Honey Tea
Shaded areas: local specialities.
Source: McDonald’s and KFC China websites.
M11A_BARN0088_05_GE_CASE6.INDD 69 15/09/14 7:44 PM

PC 3–70 Corporate Strategies
McDonald’s China TV Advertisement
Exhibit 14 McDonald’s Advertisement
China
McDonald’s China Print Advertisement
I just love not having a backbone
I just love fighting my teacher
I just love being sissy
M11A_BARN0088_05_GE_CASE6.INDD 70 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–71
China area by launching new KFC outlets in Taiwan in
tandem with Birdland’s operations, until finally in 2001,
Birdland agreed to sell its KFC outlets in Taiwan to Yum!
Brands. These experiences in Asian markets prepared
Yum! Brands for its entry in 1987 into the largest and most
exciting market in the world—China.70
McDonald’s
The McDonald’s concept was introduced in Southern
California by Dick and Mac McDonald in 1937. In 1953, the
McDonald brothers franchised their restaurant to Neil Fox,
the first franchisee. The second McDonald’s opened in
Fresno, California—the first to feature the Golden Arches
design. The fast-food idea was modified and expanded
by their business partner Ray Kroc, of Oak Park, Illinois,
who later bought out business interest of the McDonald
brothers in the concept and went on to found McDonald’s
Corporation in 1955. In 1965, McDonald’s went public
with the company’s first offering on the stock exchange.
Twenty years later, in 1985, McDonald’s was added to the
30-company Dow Jones Industrial Average.
The signature product, the Big Mac, was added to
the product line in 1968 and was the brainchild of Jim
Delligatti, one of Ray Kroc’s earliest franchisees. Another
popular product—the Happy Meal—has been making
children’s visits special since 1979.71 McDonald’s has be-
come a global phenomenon, with more than 31,000 outlets
operating in over 100 countries today.
Management Philosophy
Like KFC, McDonald’s values were consumer driven. Its
principles were summarized by QSCV. Quality, Service,
Cleanness and Value. McDonald’s was also known for the
consistency of its procedures and quality, and its power-
ful global marketing campaigns. Its recent advertising
campaign “i’m lovin’ it”,™ launched in every country
in the world by September 2005, featured sports, enter-
tainment, music, and fashion. Pop icons such as Justin
Timberlake, Destiny’s Child, and Wang Lee Hom for Asia
were central to the campaign.
McDonald’s was also known for its detail-oriented
insistence on food preparation. Fred Turner, Senior
KFC
At the start of the Great Depression in 1930, Harland
Sanders opened his first restaurant in the small front
room of a gas station in Corbin, Kentucky. He was made
an honorary Kentucky colonel six years later in recogni-
tion of his contribution to the state’s cuisine. The Original
Recipe chicken, which was deep fried in a pressure cooker
with 11 herbs and spices, was created in 1940. In 1969, the
Kentucky Fried Chicken Corporation was listed on the
New York Stock Exchange. In 1986, PepsiCo, Inc. acquired
KFC from RJR Nabisco, Inc., and 11 years later, in 1997,
PepsiCo, Inc. announced the spin-off of its quick service
restaurants—KFC, Taco Bell and Pizza Hut. In 2002, the
world’s largest restaurant company changed its corporate
name to Yum! Brands, Inc. In addition to KFC, the com-
pany owns A&W® All-American Food® Restaurants, Long
John Silver’s®, Pizza Hut® and Taco Bell® restaurants.
Management Philosophy
KFC’s parent company, Yum! Brands, runs a multi-brand
strategy and is proud of its customer focus approach.
Its restaurant management philosophy is summarized by
the acronym “CHAMPS”—cleanness, hospitality, accu-
racy, maintenance, product quality, and speed. After the
first successful ten years, Yum! began looking to sustain
long-term growth, especially on an international level.
According to the Yum! 2008 management presentation, its
four key growth strategies are to build leading brands in
China in every significant category; drive aggressive inter-
national expansion and build strong brands everywhere;
dramatically improve US brand positions, consistency and
returns, and drive industry-leading, long-term shareholder
and franchisee value.69
International Expansion
KFC’s penetration of Asia started with Japan in 1970. In
1984, it entered Taiwan, awarding the franchise to a joint
venture company formed by two Japanese companies and
a local entity. A year later, it re-entered Hong Kong after a
10-year gap, by giving franchise rights to Birdland, which
later acquired the franchisee in Taiwan. From 1996 to 2001,
Yum! Brands tried to win back ownership in the Greater
A p p e n d i x : K F C a n d M c D o n a l d ’ s G l o b a l
M i l e s t o n e s
M11A_BARN0088_05_GE_CASE6.INDD 71 15/09/14 7:44 PM

PC 3–72 Corporate Strategies
International Expansion
In 1967, the first McDonald’s restaurant outside the United
States opened in Richmond, British Columbia. In 1971, the
first Asian McDonald’s opened in Japan, in Tokyo’s Ginza
district. Although McDonald’s opened its first outlet in
greater China in Hong Kong as early as 1975, and Taiwan
opened its first McDonald’s in 1984, the first Mainland
China McDonald’s outlet was only introduced in October
1990 in Shenzhen. On 23 April 1992, the world’s largest
McDonald’s opened in Beijing, China with over 700 seats.74
In 1994, McDonald’s made an historical debut in Kuwait
City, and in 1996 the fast-food giant entered India.
Chairman of McDonald’s, developed the first operations
manual in 1957. By 1991, it counted 750 detailed pages,
setting out exact cooking times, proper temperature
settings, and precise portions for all food items. For ex-
ample, French fries were to be 9/32 of an inch; to ensure
quality and taste, no products were to be held more than
10 minutes in the transfer bin.72
Peter Tan, former Senior Vice President and President
of McDonald’s Corporation Greater China, attributed
McDonald’s success to the fact that it provided consistency,
convenience in terms of location, and good pricing. Great
advertising, great taste in signature products such as Big
Mac and French fries, and retail excitement such as Happy
Meal promotions also played important roles.73
Bibliography
1. Transcript: Interview with Joseph Han, former Operating Vice President of Yum! Brands,
greater China, 2 November, 2007.
2. Transcript: Interview with Peter Tan, former Senior Vice President and President of
McDonald’s Corporation, Greater China, 20 March 2008 and 18 July 2008.
3. KFC in China Secret Recipe for Success, by Warren K. Liu, 2008, John Wiley & Sons (Asia)
Pte Ltd.
4. McDonald’s and KFC, edited by B.Q. Chen, China Economy Publishing, 2005.
5. Globalization of Services: Some Implications for Theory and Practice, Yair Aharoni, Lilach
Nachum. Routledge, 2000.
6. Kentucky Fried Chicken in China, Professor Allen J. Morrison and Paul W. Beamish,
Richard Ivey School of Business, The University of Western Ontario, Version(A)
1993-08-18.
7. www.mcdonalds.com.
8. www.yum.com.
9. Shantel Wong; McDonald’s China Development Co., Advertising Age, January, 2004.
10. KFC and McDonald’s—a model of blended culture, China Today, June 2004.
11. Hamburger heaven, Economist, February 2005.
12. McDonald’s China Development Co., Advertising Age, 00018899, 1/26/2004, Vol. 75,
Issue 4.
13. McDonald’s considers reform to adapt to Chinese tastes, Xinhuanet, November 9, 2005.
14. Fast Food Domination, Chinese International Business, April 2007.
15. Adapt Franchise to China’s Soil: China’s Regulations on Franchise in the Past Ten Years, The
Illinois Business Law Journal, 29 March 2007.
16. McDonald’s in China, ICFAI Business School, 2003.
17. McDonald’s enter into puzzledom, what’s its outlet? December 2005, Chinese and Foreign
Corporate Culture.
18. McDonald’s, Harvard Business School Review: April 3, 2008.
19. SW China begins dialogues with UK on food safety, People’s Daily online, March 23, 2005.
20. Franchising Opportunities in China for American Fast Food Restaurants, Zerong Yu, Karl
Titz, Asia Pacific Journal of Tourism Research, Volume 5 Issue 1, 2000.
21. 2007 National Economic and Social Development Statistic Report, Ministry of Commerce,
People’s Republic of China, http://provincedata.mofcom.gov.cn/communique/disp.
asp?pid=43705.
22. Rivals to feel bite from Burger King, Janet Ong, June 28, 2005, Bloomberg.
23. McDonald’s Corporation (Abridged), Harvard Business School, Rev: June 16, 2005.
M11A_BARN0088_05_GE_CASE6.INDD 72 15/09/14 7:44 PM

Case 3–6: McDonald’s and KFC PC 3–73
24. Yum Brands CEO says poor performance at KFC, higher costs have taken ‘fun’ from US busi-
ness, Bruce Schreiner, July 17, 2008, Canadian Business Online.
25. China Fast Food Analysis, Just-food.com, Aroq Ltd., 2007.
26. McDonald’s opens 100th China store, sees 175 more in 2009, http://www.forbes.com/
feeds/afx/2008/ll/14/afx5693724.html.
27. McDonald’s Growing in China, Liu Jie, China Daily, 2008-09-08 10:27, http://www.chi-
nadaily.com.cn/bizchina/2008-09/08/content_7007412.htm.
28. Fast food nation, Ding Qing-Fen, China Daily, 30th June 2008.
End Notes
1. www.mcdonalds.com, www.yum.com, end of 2008 data.
2. www.mcdonalds.com.
3. McDonald’s and KFC, edited by B.Q. Chen, China Economy Publishing, 2005.
4. Warren K. Liu, KFC in China—Secret Recipe for Success, John Wiley & Sons (Asia) pte
Ltd., 2008.
5. Ibid.
6. Hamburger heaven, Economist, February 2005.
7. www.yum.com, Q3 2008.
8. Yair Aharoni, Lilach Nachum. Routledge, Globalization of Services: Some Implication for
Theory and Practice, 2000.
9. Zerong Yu, Karl Titz, Franchising Opportunities in China for American Fast Food
Restaurant, Asia Pacific Journal of Tourism Research, Volume 5 Issue 1, 2000.
10. China National Statistics Bureau, 2007.
11. 2007 National Economic and Social Development Statistics Report. Ministry of
Commerce, People’s Republic of China, http://provincedata.mofcom.gov.cn/com-
munique/disp.asp?pid=43705.
12. Op Cit. Hamburger heaven.
13. Ibid.
14. China Fast Food Analysis, Just-food.com, Aroq.Ltd., 2007.
15. Fast Food Domination, Chinese International Business, April 2007.
16. Adapt Franchise to China’s Soil: China’s Regulations on Franchise in the Past Ten
Years, The Illinois Business Law Journal, 29th March 2007.
17. International Monetary Fund—2008 World Economic Outlook.
18. Fast food nation, Ding Qing-Fen, China Daily, 30th June 2008.
19. Op Cit. KFC in China—Secret Recipe for Success.
20. Ibid.
21. www.yum.com.
22. Op Cit. KFC in China—Secret Recipe for Success.
23. www.yum.com.
24. Kentucky Fried Chicken in China, Professor Allen J. Morrison and Paul W. Beamish,
Richard Ivey School of Business, The University of Western Ontario, 1993.
25. Op Cit. Kentucky Fried Chicken in China.
26. Op Cit. KFC in China—Secret Recipe for Success.
27. Interview with Joseph Han, former operating Vice President of Yum! Brands, Greater
China, 2 November, 2007.
28. Op Cit. KFC China—Secret Recipe for Success.
29. Hazard Analysis and Critical Control Points, a systematic preventive approach to
food safety and pharmaceutical safety. The Food and Drug Administration (FDA) and
the United States Department of Agriculture (USDA) use mandatory juice, seafood,
meat and poultry HACCP programmes as an effective approach to food safety and
protecting public health.
30. Op Cit. KFC in China—Secret Recipe for Success.
31. Ibid.
M11A_BARN0088_05_GE_CASE6.INDD 73 15/09/14 7:44 PM

PC 3–74 Corporate Strategies
32. Interview with Warren Liu, former Vice President of Yum! Brands, Greater China, 30
January, 2009.
33. Op Cit. KFC in China—Secret Recipe for Success.
34. Ibid.
35. Op Cit. KFC and McDonald’s—a model of blended culture.
36. Op Cit. Interview with Joseph Han.
37. Op Cit. KFC in China—Secret Recipe for Success.
38. Op Cit. McDonald’s and KFC.
39. www.yum.com.
40. Op Cit. McDonald’s and KFC.
41. Op Cit. McDonald’s in China.
42. Shantel Wong; McDonald’s China Development Co., Advertising Age, January 2004.
43. McDonald’s enters into puzzledom, what’s its outlet? December 2005, Chinese and
Foreign Corporate Culture.
44. Op Cit. McDonald’s and KFC.
45. Interview with Peter Tan, former senior vice president and president of McDonald’s
Corporation, Greater China, 20 March 2008.
46. Op Cit. McDonald’s in China.
47. McD’s Preps for China Drive-Thru Boom, The Associated Press, January 19, 2007.
48. McDonald’s opens 1,000th China store, sees 175 more in 2009, Thomson Financial
News, http://www.forbes.com/feeds/afx/2008/11/14/afx5693724.html.
49. Op Cit. McDonald’s in China.
50. Op Cit. KFC and McDonald’s—a model of blended culture.
51. McDonald’s considers reform to adapt to Chinese tastes, Xinhuanet, November 9,
2005.
52. Op Cit. Interview with Peter Tan.
53. McDonald’s Growing in China, Liu Jie, China Daily, September 8, 2008, http://www.
chinadaily.com.cn/bizchina/2008-09/08/content_7007412.htm.
54. Op Cit. McDonald’s in China.
55. Ibid.
56. McDonalds’s goes slow in China franchising, International Herald Tribune. February 7,
2007.
57. McDonald’s Corporation Annual Report 2007.
58. McDonald’s, Harvard Business School, Rev: April 3, 2008.
59. Op Cit. McDonald’s enters into puzzledom, what’s its outlet?
60. McDonald’s to issue franchise licenses slowly, Shenzhen Daily, February 9, 2007.
61. McDonald’s Press Release, December 10, 2005.
62. http://www.mcdonalds.com.cn/news/news_content.aspx?id=123.
63. McDonald’s Corporation Annual Report 2007.
64. McDonald’s growing in China, China Daily, September 8, 2008.
65. Yum Brands CEO says poor performance at KFC, higher costs have taken “fun” from
US business, Bruce Schreiner, July 17, 2008, Canadian Business Online.
66. Stricter standards needed, Liu Jie, China Daily, 2006-03-16 http://www.chinadaily.
com.cn/bizchina/2006-03/16/content_539721.htm.
67. SW China begins dialogues with UK on food safety, People’s Daily Online, March 23,
2005.
68. Rivals to feel bite from Burger King, Janet Ong, June 28, 2005, Bioomberg.
69. Presentations for Investor and Analysts Conference, May 2008, www.yum.com.
70. Op Cit. KFC in China—Secret Recipe for Success.
71. www.mcdonalds.com.
72. McDonald’s Corporation (Abridged), Harvard Business School Review: June 16, 2005.
73. Interview with Peter Tan, former senior vice president and president of McDonald’s
Corporation, Greater China, 20 March 2008.
74. McDonald’s In China, ICFAI Business School, Case Development Center.
M11A_BARN0088_05_GE_CASE6.INDD 74 15/09/14 7:44 PM

Appendix
Analyzing Cases and
Preparing
for Class Discussions
This book, properly understood, is really about how to analyze cases. Just reading the book, however, is no more likely to fully develop one’s skills as a strategist than reading a book about golf will make one a golfer. Practice
in applying the concepts and tools is essential. Cases provide the opportunity for
this necessary practice.
Why the Case Method?
The core of many strategic management courses is the case method of instruction.
Under the case method, you will study and discuss the real-world challenges and
dilemmas that face managers in firms. Cases are typically accounts of situations
that a firm or manager has faced at a given point in time. By necessity, cases do
not possess the same degree of complexity that a manager faces in the real world,
but they do provide a concrete set of facts that suggest challenges and opportuni-
ties that real managers have faced. Very few cases have clear answers. The case
method encourages you to engage problems directly and propose solutions or
strategies in the face of incomplete information. To succeed at the case method,
you must develop the capability to analyze and synthesize data that are some-
times ambiguous and conflicting. You must be able to prioritize issues and oppor-
tunities and make decisions in the face of ambiguous and incomplete information.
Finally, you must be able to persuade others to adopt your point of view.
In an applied field like strategic management, the real test of learning is how
well you can apply knowledge to real-world situations. Strategic management
cases offer you the opportunity to develop judgment and wisdom in applying your
conceptual knowledge. By applying the concepts you have learned to the relatively
unstructured information in a case, you develop judgment in applying concepts.
Alfred North Whitehead discussed the importance of application to knowledge:
This discussion rejects the doctrine that students should first learn passively, and
then, having learned, should apply knowledge. . . . For the very meaning of the things
known is wrapped up in their relationship beyond themselves. This unapplied knowl-
edge is knowledge shorn of its meaning.
Alfred North Whitehead (1947). Essays in Science and Philosophy. New York: Philosophical
Library, Inc. pp. 218–219.
365
Z01_BARN0088_05_GE_APP.INDD 365 17/09/14 5:08 PM

366 Appendix
Thus, you gain knowledge as you apply concepts. With the case method,
you do not passively absorb wisdom imparted from your instructor, but
actively develop it as you wrestle with the real-world situations described in
the cases.
How to Analyze Cases
Before discussing how to analyze a case, it may be useful to comment on how
not to prepare a case. We see two common failings in case preparation that often
go hand-in-hand. First, students often do not apply conceptual frameworks in
a rigorous and systematic manner. Second, many students do not devote suf-
ficient time to reading, analyzing, and discussing a case before class. Many
students succumb to the temptation to quickly read a case and latch on to the
most visible issues that present themselves. Thus, they come to class prepared
to make only a few superficial observations about a case. Often, they entirely
miss the deeper issues around why a firm is in the situation that it is in and
how it can better its performance. Applying the frameworks systematically may
take more time and effort in the beginning, but it will generally lead to deeper
insights about the cases and a more profound understanding of the concepts
in the chapters. As you gain experience in this systematic approach to analyz-
ing cases, many of you will find that your preparation time will decrease. This
appendix offers a framework that will assist you as you analyze cases. The
framework is important, but no framework can substitute for hard work. There
are no great shortcuts to analyzing cases, and there is no single right method for
preparing a case. The following approach, however, may help you develop your
ability to analyze cases.
1. Skim thr ough the c ase v ery quick ly. Pay particular attention to the exhibits.
The objective in this step is to gain familiarity with the broad facts of the case.
What apparent challenges or opportunities does the company face? What in-
formation is provided? You may find it especially useful to focus on the first
and last few paragraphs of the case in this step.
2. Read the case more carefully and make notes, underline, etc. What appear to be
important facts? The conceptual frameworks in the chapters will be essential
in helping you identify the key facts. Throughout the course, you will want to
address central questions such as the following:
n What is the firm’s performance?
n What is the firm’s mission? strategy? goals?
n What are the resources involved in the firm’s value chain? How do they
compare to competitors on cost and differentiation?
n Does the firm have a competitive advantage?
n Are the firm’s advantages and disadvantages temporary or sustainable?
n What is the value of the firm’s resources?
n Are the firm’s resources rare?
n Are the firm’s resources costly to imitate?
n Is the firm organized sufficiently to exploit its resources?
Z01_BARN0088_05_GE_APP.INDD 366 17/09/14 5:08 PM

Appendix 367
Depending on the case, you may also want to consider other frameworks and
questions, where appropriate. Each chapter provides concepts and frameworks
that you may want to consider. For example:
n What are the five forces? How do they influence industry opportunities and
threats? (Chapter 2)
n What are the sources of cost differences in an industry? (Chapter 4)
n What are the bases and potential bases for product differentiation in an
industry? (Chapter 5)
Each chapter suggests more specific questions and concepts than those above.
You will want to consider these concepts in detail. In some cases, the instruc-
tor may offer direction about which concepts to apply to a given case. In other
instances, you may be left to use your judgment in choosing which concepts to
focus on in analyzing a case.
3. Define the basic issues . This is perhaps the most important step and also the
stage of analysis that requires the most wisdom and judgment. Cases are rarely
like tidy problem sets where the issues or problems are explicitly stated and
the tools needed to address those issues are prescribed. Generally, you need to
determine what the key issues are. In doing this, it may help for you to begin
by asking: What are the fundamental issues in the case? Which concepts mat-
ter most in providing insight into those issues? One trap to avoid in defining
basic issues is doing what some decision-making scholars label “plunging-in,”
which is drawing conclusions without first thinking about the crux of the issues
involved in a decision.1 Many students have a tendency to seize the first issues
that are prominently mentioned in a case. As an antidote to this trap, you may
want to consider a case from the perspective of different conceptual frames.
4. Develop and elaborate your analysis of the key issues. As with all of the steps,
there is no substitute for painstaking work in this stage. You need to take the
key issues you have defined in Step 3, examine the facts that you have noted
in Step 2, and assess what are the key facts. What does quantitative analy-
sis reveal? Here it is not just ratio analysis that we are concerned with. Just
as body temperature, blood pressure, and pulse rate may reveal something
about a person’s health but little about the causes of a sickness, ratio analysis
typically tells us more about the health of a company than the causes of its
performance. You should assemble facts and analysis to support your point
of view. Opinions unsupported by factual evidence and analysis are generally
not persuasive. This stage of the analysis involves organizing the facts in the
case. You will want to develop specific hypotheses about what factors relate to
success in a particular setting. Often, you will find it helpful to draw diagrams
to clarify your thinking.
5. Draw conclusions and formulate a set of recommendations. You may be uncom-
fortable drawing conclusions and making recommendations because you do
not have complete information. This is an eternal dilemma for managers. Man-
agers who wait for complete information to do something, however, usually
act too late. Nevertheless, you should strive to do the most complete analysis
that you can under reasonable time constraints. Recommendations should also
1 J. E. Russo and P. J. H. Schoemaker (1989). Decision Traps: The Ten Barriers to Brilliant Decision-Making
and How to Overcome Them. New York: Fireside.
Z01_BARN0088_05_GE_APP.INDD 367 17/09/14 5:08 PM

368 Appendix
flow naturally from your analysis. Too often, students formulate their recom-
mendations in an ad hoc way. In formulating recommendations, you should be
clear about priorities and the sequence of actions that you recommend.
6. Prepare for class discussion. Students who diligently work through the first
five steps and rigorously examine a case should be well prepared for class dis-
cussion. You may find it helpful to make some notes and bring them to class.
Over the years, we have observed that many of the students who are low con-
tributors to class discussions bring few or no notes to class. Once in class, a
case discussion usually begins with a provocative question from the instructor.
Many instructors will “cold call”—direct a question to a specific student who
has not been forewarned. Students who have thoroughly analyzed and dis-
cussed the case before coming to class will be much better prepared for these
surprise calls. They will also be better prepared to contribute to the analysis, ar-
gument, and persuasion that will take place in the class discussion. Discussions
can move rapidly. You will hear new insights from fellow students. Preparation
helps you to absorb, learn, and contribute to the insights that emerge from class
discussion.
Summary
Students who embark in the case method soon learn that analyzing cases is a
complex process. Having a clear conceptual approach such as the VRIO frame-
work does not eliminate the complexity. This systematic approach, however,
does allow the analyst to manage the complexity of real-world business situa-
tions. In the end, though, neither cases nor real-world businesses conclude their
analyses with tidy solutions that resolve all the uncertainties and ambiguities a
business faces. However, the case method coupled with a good theory such as
the VRIO approach and hard work do make it more likely that you will gener-
ate valuable insights into the strategic challenges of firms and develop the stra-
tegic skills needed to lead a firm.
Z01_BARN0088_05_GE_APP.INDD 368 17/09/14 5:08 PM

Glossary
above average accounting performance when a firm’s
accounting performance is greater than the industry average
above normal economic performance when a firm earns
above its cost of capital
absorptive capacity the ability of firms to learn
accounting performance a measure of a firm’s competi-
tive advantage; calculated from information in the firm’s
published profit and loss and balance sheet statements
accounting ratios numbers taken from a firm’s financial
statements that are manipulated in ways that describe vari-
ous aspects of the firm’s performance
acquisition a firm purchases another firm
acquisition premium the difference between the current
market price of a target firm’s shares and the price a poten-
tial acquirer offers to pay for those shares
activity ratios accounting ratios that focus on the level of
activity in a firm’s business
adverse selection an alliance partner promises to bring
to an alliance certain resources that it either does not con-
trol or cannot acquire
agency problems parties in an agency relationship differ
in their decision-making objectives
agency relationship one party to an exchange delegates
decision-making authority to a second party
agent a party to whom decision-making authority is
delegated
architectural competence the ability of a firm to use
organizational structure and other organizing mechanisms
to facilitate coordination among scientific disciplines to
conduct research
auction in mergers and acquisitions, a mechanism for
establishing the price of an asset when multiple firms bid
for a single target firm
audit committee subgroup of the board of directors
responsible for ensuring the accuracy of accounting and
financial statements
average accounting performance when a firm’s
accounting performance is equal to the industry average
backward vertical integration a firm incorporates more
stages of the value chain within its boundaries and those
stages bring it closer to gaining access to raw materials
barriers to entry attributes of an industry’s structure that
increase the cost of entry
below average accounting performance when a firm’s
accounting performance is less than the industry average
below normal economic performance when a firm earns
less than its cost of capital
board chair the person who presides over the board of
directors; may or may not be the same person as a firm’s
senior executive also known as Chairman of the Board
board of directors a group of 10 to 15 individuals drawn
from a firm’s top management and from people outside the
firm whose primary responsibilities are to monitor deci-
sions made in the firm and to ensure that they are consis-
tent with the interests of outside equity holders
business angels wealthy individuals who act as outside
investors typically in an entrepreneurial firm
business cycle the alternating pattern of prosperity fol-
lowed by recession followed by prosperity
business-level strategies actions firms take to gain com-
petitive advantages in a single market or industry
business model the set of activities that a firm engages in
to create and appropriate economic value
business p lan a document that summarizes how an
entrepreneur will organize a firm to exploit an opportunity,
along with the economic implications of exploiting that
opportunity
business strategy a firm’s theory of how to gain compet-
itive advantage in a single business or industry
buyers those who purchase a firm’s products or services
capabilities a subset of a firm’s resources, defined as tan-
gible and intangible assets, that enable a firm to take full
advantage of other resources it controls
cashing out the compensation paid to an entrepreneur
for risk-taking associated with starting a firm
causally ambiguous imitating firms do not understand
the relationship between the resources and capabilities
controlled by a firm and that firm’s competitive advantage
centralized hub each country in which a firm operates
is organized as a full profit-and-loss division headed by a
division general manager; strategic and operational deci-
sions are retained at headquarters
chairman of the board the person who presides over the
board of directors; may or may not be the same person as a
firm’s senior executive
chief executive officer (CEO) person to whom all func-
tional managers report in a U-form organization; the per-
son to whom all divisional personal and corporate staff
report to in an M-form organization: responsible for strat-
egy formulation and implementation
chief operating officer (COO) reports to CEO; primary
responsibility is strategy implementation
closely held firm a firm that has not sold many of its
shares on the public stock market
collusion two or more firms in an industry coordi-
nate their strategic choices to reduce competition in that
industry
compensation policies the ways that firms pay employees
competitive advantage a firm creates more economic
value than rival firms
369
Z02_BARN0088_05_GE_GLOS.INDD 369 17/09/14 5:22 PM

370 Glossary
competitive disadvantage a firm generates less eco-
nomic value than rival firms
competitive dynamics how one firm responds to the
strategic actions of competing firms
competitive parity a firm creates the same economic
value as rival firms
competitor any firm, group, or individual trying to
reduce a firm’s competitive advantage
complementary resources and capabilities resources
and capabilities that have limited ability to generate com-
petitive advantage in isolation but in combination with
other resources can enable a firm to realize its full potential
for competitive advantage
complementor when the value of a firm’s products
increases in the presence of another firm’s products
conduct (as in structured conduct performance model)
the strategies that firms in an industry implement
conglomerate me rger a merger or acquisition where
there are no vertical, horizontal, product extension, or mar-
ket extension links between the firms
consolidation strategy strategy that reduces the number
of firms in an industry by exploiting economies of scale
controlling share when an acquiring firm purchases
enough of a target firm’s assets to be able to make all the
management and strategic decisions in the target firm
coordinated fe deration each country in which a firm
operates is organized as a full profit-and-loss division
headed by a division general manager; operational decisions
are delegated to these divisions or countries, but strategic
decisions are retained at headquarters
core competence the collective learning in an organiza-
tion, especially how to coordinate diverse production skills
and integrate multiple streams of technologies
corporate diversification strategy when a firm operates
in multiple industries or markets simultaneously
corporate-level strategies actions firms take to gain
competitive advantages by operating in multiple markets
or industries simultaneously
corporate spin-off exists when a large, typically diversi-
fied firm divests itself of a business in which it has histori-
cally been operating and the divested business operates as
an independent entity
corporate staff upper-level managers who provide infor-
mation about a firm’s external and internal environments
to the firm’s senior executive
corporate strategy a firm’s theory of how to gain com-
petitive advantage by operating in several businesses
simultaneously
cost centers divisions are assigned a budget and manage
their operations to that budget
cost leadership business strategy focuses on gaining
advantages by reducing costs below those of competitors
cost of capital the rate of return that a firm promises
to pay its suppliers of capital to induce them to invest in
a firm
cost of debt the interest that a firm must pay its debt
holders to induce them to lend money to the firm
cost of equity the rate of return a firm must promise its
equity holders to induce them to invest in the firm
countertrade international firms receiving payment for
the products or services they sell into a country not in the
form of currency, but in the form of other products or ser-
vices that they can sell on the world market
crown jewel sale a bidding firm is interested in just a few
of the most highly regarded businesses being operated by
the target firm, known as its crown jewels, and the target
firm sells these businesses
culture the values, beliefs, and norms that guide behav-
ior in a society and in a firm
cumulative abnormal return (CAR) performance that is
greater (or less) than what was expected in a short period
of time around when an acquisition is announced
current market value the price of each of a firm’s shares
multiplied by the number of shares outstanding
customer-switching costs customers make investments
in order to use a firm’s particular products or services that
are not useful in using other firms’ products
debt capital from banks and bondholders
decentralized federation each country in which a
firm operates is organized as a full profit-and-loss divi-
sion headed by a division general manager and strategic
and operational decisions are delegated to these country
managers
decline the final phase of the product life cycle during
which demand drops off when a technologically superior
product or service is introduced
declining industry an industry that has experienced an
absolute decline in unit sales over a sustained period of
time
deep-pockets model a firm that takes advantage of its
monopoly power in one business to subsidize several dif-
ferent businesses
demographics the distribution of individuals in a society
in terms of age, sex, marital status, income, ethnicity, and
other personal attributes that may determine their buying
patterns
depression a severe recession that lasts for several years
direct duplication the attempt to imitate other firms by
developing resources that have the same strategic effects as
the resources controlled by those other firms
diseconomies o f s cale a firm’s costs begin to rise as a
function of the volume of production
distinctive competence a valuable and rare resource or
capability
distribution agreement one firm agrees to distribute the
products of others
diversification economies sources of relatedness in a
diversified firm
divestment a firm sells a business in which it had been
operating
Z02_BARN0088_05_GE_GLOS.INDD 370 17/09/14 5:22 PM

Glossary 371
division each business that a firm engages in, also called
a strategic business unit (SBU)
dominant-business firms firms with between 70 percent
and 95 percent of their total sales in a single product market
dominant logic common theory of how to gain
competitive advantages shared by each business in a
diversified firm
economic climate the overall health of the economic sys-
tems within which a firm operates
economic measures of competitive advantage
measures that compare a firm’s level of return to its cost
of capital instead of to the average level of return in the
industry
economic value the difference between the perceived
benefits gained by a customer who purchases a firm’s
products or services and the full economic cost of these
products or services
economic value added (EVA) worth calculated by sub-
tracting the cost of the capital employed in a division from
that division’s earnings
economies of scale the per-unit cost of production falls
as the volume of production increases
economies of scope the value of a firm’s products or
services increases as a function of the number of different
businesses in which that firm operates
emerging industries newly created or newly re-created
industries formed by technological innovations, change in
demand, or the emergence of new customer needs
emergent strategies theories of how to gain competi-
tive advantage in an industry that emerge over time or
have been radically reshaped once they are initially
implemented
environmental threat any individual, group, or organi-
zation outside a firm that seeks to reduce the level of that
firm’s performance
equity capital from individuals and institutions that pur-
chase a firm’s stocks
equity alliance cooperating firms supplement contracts
with equity holdings in alliance partners
escalation of commitment an increased commitment by
managers to an incorrect course of action, even as its limita-
tions become manifest
event study analysis evaluates the performance effects
of acquisitions for bidding firms
executive committee typically consists of the CEO and
two or three functional senior managers
explicit collusion firms directly communicate with each
other to coordinate levels of production, prices, and so
forth (illegal in most countries)
external analysis identification and examination of the
critical threats and opportunities in a firm’s competitive
environment
finance committee subgroup of the board of directors
that maintains the relationship between the firm and exter-
nal capital markets
financial resources all the money, from whatever source,
that firms use to conceive and implement strategies
firm-specific human capital investments investments
made by employees in a particular firm over time, includ-
ing understanding the culture, policies, and procedures
and knowing the people to contact to complete a task, that
have limited value in other firms
firm-specific investments the value of stakeholders’
investments in a particular firm is much greater than the
value those same investments would be in other firms
first-mover advantages advantages that come to firms
that make important strategic and technological decisions
early in the development of an industry
flexibility how costly it is for a firm to alter its strategic
and organizational decisions
foreign direct investment investing in operations
located in a foreign country
formal m anagement c ontrols a firm’s budgeting and
reporting activities that keep people higher up in a firm’s
organizational chart informed about the actions taken by
people lower down in the organizational chart
formal reporting structure a description of who in the
organization reports to whom
forward vertical integration a firm incorporates more
stages of the value chain within its boundaries and those
stages bring it closer to interacting directly with final
customers
fragmented industries industries in which a large num-
ber of small or medium-sized firms operate and no small
set of firms has dominant market share or creates dominant
technologies
free cash flow the amount of cash a firm has to invest
after all positive net present-value investments in its ongo-
ing businesses have been funded
friendly acquisition the management of a target firm
wants the firm to be acquired
functional m anager a manager who leads a particular
function within a firm, such as manufacturing, marketing,
finance, accounting, or sales
functional organizational structure the structure a firm
uses to implement business-level strategies it might pursue
where each function in the firm reports to the CEO
general environment broad trends in the context within
which a firm operates that can have an impact on a firm’s
strategic choices
generic business strategies another name for business-
level strategies, which are cost leadership and product
differentiation
geographic market diversification strategy when a firm
operates in multiple geographic markets simultaneously
golden parachutes incentive compensation paid to
senior managers if the firm they manage is acquired
greenmail a target firm’s management purchases any of
the target firm’s stock owned by a bidder for a price that is
greater than its current market value
Z02_BARN0088_05_GE_GLOS.INDD 371 17/09/14 5:22 PM

372 Glossary
growth the second stage of the product life cycle dur-
ing which demand increases rapidly and many new firms
enter to begin producing the product or service
hard currencies currencies that are traded globally and
thus have value on international money markets
harvest strategy a firm engages in a long, systematic,
phased withdrawal from a declining industry, extracting as
much value as possible
hedonic price that part of the price of a product or ser-
vice that is attributable to a particular characteristic of that
product or service
holdup one firm makes more transaction-specific invest-
ments in an exchange than partner firms make and the firm
that has not made these investments tries to exploit the
firm that has made the investments
horizontal merger a firm acquires a former competitor
hostile takeover the management of a target firm does
not want the firm to be acquired
human capital resources the training, experience, judg-
ment, intelligence, relationships, and insight of individual
managers and workers in a firm
imperfectly imitable resources and capabilities that are
more costly for other firms to imitate, compared to firms
that already possess them
increasing returns to scale in network industries, the
value of a product or service increases as the number of
people using those products or services increases
inelastic in supply the quantity of supply is fixed and
does not respond to price increases, such as the total sup-
ply of land, which is relatively fixed and cannot be signifi-
cantly increased in response to higher demand and prices
informal management controls include a firm’s culture
and the willingness of employees to monitor each other’s
behavior
initial public offering (IPO) the initial sale of stock of a
privately held firm or a division of a corporation to the
general public
institutional owners pension funds, corporations, and
others that invest other peoples’ money in firm equities
intermediate products or services products or services
produced in one division that are used as inputs for prod-
ucts or services produced by a second division
internal analysis identification of a firm’s organizational
strengths and weaknesses and of the resources and capabil-
ities that are likely to be sources of competitive advantage
internal capital market when businesses in a diversified
firm compete for corporate capital
international strategies operations in multiple geo-
graphic markets: vertical integration, diversification, the
formation of strategic alliances, or implementation of
mergers and acquisitions, all across national borders
introduction the first stage of a product’s life cycle when
relatively few firms are producing a product, there are rela-
tively few customers, and the rate of growth in demand for
the product is relatively low
invented competencies illusory inventions by creative man-
agers to justify poor diversification moves by linking intangi-
ble core competencies to completely unrelated businesses
joint venture cooperating firms create a legally indepen-
dent firm in which they invest and from which they share
any profits that are created
learning curve a concept that formalizes the relationship
between cumulative volumes of production and falling
per-unit costs
learning race both parties to an alliance seek to learn
from each other, but the rate at which these two firms learn
varies; the first party to learn “wins” the race and may
withdraw from the alliance
legal and political conditions the laws and the legal sys-
tem’s impact on business, together with the general nature
of the relationship between government and business
leverage ratios accounting ratios that focus on the level
of a firm’s financial flexibility
licensing agreement one firm allows others to use its
brand name to sell products in return for some fee or per-
centage of profits
limited corporate diversification all or most of a firm’s
business activities fall within a single industry and geo-
graphic market
liquidity ratios accounting ratios that focus on the ability
of a firm to meet its short-term financial obligations
local responsiveness in an international strategy, the
ability a firm has to respond to the consumer preferences in
a particular geographic market
management control systems a range of formal and
informal mechanisms to ensure that managers are behav-
ing in ways consistent with a firm’s strategies
managerial hubris the unrealistic belief held by manag-
ers in bidding firms that they can manage the assets of a
target firm more efficiently than the target firm’s current
management
managerial know-how the often-taken-for-granted
knowledge and information that are needed to compete in
an industry on a day-to-day basis
managerial perquisites activities that do not add eco-
nomic value to the firm but directly benefit the managers
who make them
managerial risk aversion managers unable to diversify
their firm-specific human capital investments may engage
in less risky business decisions than what would be pre-
ferred by equity holders
market extension merger firms make acquisitions in
new geographical markets
market for corporate control the market that is created
when multiple firms actively seek to acquire one or several
firms
market leader the firm with the largest market share in
an industry
matrix structures one employee reports to two or more
people
Z02_BARN0088_05_GE_GLOS.INDD 372 17/09/14 5:22 PM

Glossary 373
mature industries an industry in which, over time,
ways of doing business have become widely understood,
technologies have diffused through competitors, and
the rate of innovation in new products and technologies
drops
maturity third phase of the product life cycle during
which the number of firms producing a product or service
remains stable, demand growth levels off, and firms direct
their investment efforts toward refining the process by
which a product or service is created and away from devel-
oping entirely new products
merger the assets of two similar-sized firms are combined
M-form (multidivisional form) an organizational struc-
ture for implementing a corporate diversification strat-
egy whereby each business a firm engages in is managed
through a separate profit-and-loss division
mission a firm’s long-term purpose
mission statement written statement defining both what
a firm aspires to be in the long run and what it wants to
avoid in the meantime
monopolistic competition a market structure where
within the market niche defined by a firm’s differentiated
product, a firm possesses a monopoly
monopolistic industries industries that consist of only a
single firm
monopolistically competitive industries industries in
which there are large numbers of competing firms and low-
cost entry and exit, but products are not homogeneous with
respect to cost or product attributes; firms are said to enjoy
a “monopoly” in that part of the market they dominate
moral hazard partners in an exchange possess high-
quality resources and capabilities of significant value to
the exchange but fail to make them available to the other
partners
mutual forbearance a form of tacit collusion whereby
firms tacitly agree to not compete in one industry in order
to avoid competition in a second industry
network industries industries in which a single technical
standard and increasing returns to scale tend to dominate;
competition in these industries tends to focus on which of
several competing standards will be chosen
new competitors firms that have either recently started
operating in an industry or that threaten to begin opera-
tions in an industry soon
niche strategy a firm reduces its scope of operations and
focuses on narrow segments of a declining industry
nominating committee subgroup of the board of direc-
tors that nominates new board members
nonequity a lliance cooperating firms agree to work
together to develop, manufacture, or sell products or ser-
vices, but they do not take equity positions in each other
or form an independent organizational unit to manage the
cooperative efforts
normal economic performance a firm earns its cost of
capital
objectives specific, measurable targets a firm can use to
evaluate the extent to which it is realizing its mission
office of the president together, the roles of chairman of
the board, CEO, and COO
oligopolies industries characterized by a small number
of competing firms, by homogeneous products, and by
costly entry and exit
operational economies of scope shared activities and
shared core competencies in a diversified firm
operations committee typically meets monthly and usu-
ally consists of the CEO and each of the heads of the func-
tional areas included in the firm
opportunism a firm is unfairly exploited in an exchange
organizational chart a depiction of the formal reporting
structure within a firm
organizational resources a firm’s formal reporting struc-
ture; its formal and informal planning, controlling, and
coordinating systems; its culture and reputation; and infor-
mal relations among groups within a firm and between a
firm and those in its environment
Pac Man defense fending off an acquisition by a firm
acquiring the firm or firms bidding for it
path dependence events early in the evolution of a pro-
cess have significant effects on subsequent events
pecuniary economies sources of relatedness in market
power between bidding and target firms
perfectly competitive industry when there are large
numbers of competing firms, the products being sold are
homogeneous with respect to cost and product attributes,
and entry and exit costs are very low
performance (in the structure-conduct-performance
model) performance of individual firms and performance
of the industry
personnel and compensation committee subgroup of
the board of directors that evaluates and compensates the
performance of a firm’s senior executive and other senior
managers
physical resources all the physical technology used in a firm
poison pills a variety of actions that target firm managers
can take to make the acquisition of the target prohibitively
expensive
policy choices choices firms make about the kinds of
products or services they will sell—choices that have
an impact on relative cost and product differentiation
position
policy of experimentation exists when firms are com-
mitted to engage in several related product differentiation
efforts simultaneously
predatory pricing setting prices so that they are less than
a business’s costs
price takers where the price of the products or services
a firm sells is determined by market conditions and not by
the decisions of firms
principal the party who delegates the decision-making
authority
Z02_BARN0088_05_GE_GLOS.INDD 373 17/09/14 5:22 PM

374 Glossary
privately held a firm that has stock that is not traded on
public stock markets and that is not a division of a larger
company
processes the activities a firm engages in to design, pro-
duce, and sell its products or services
process innovation a firm’s effort to refine and improve
its current processes
process manufacturing when manufacturing is accom-
plished in a continuous system; examples include manu-
facturing in chemical, oil refining, and paper and pulp
industries
product differentiation a business strategy whereby
firms attempt to gain a competitive advantage by increasing
the perceived value of their products or services relative to
the perceived value of other firms’ products or services
product diversification strategy a firm operates in mul-
tiple industries simultaneously
product extension merger firms acquire complementary
products through merger and acquisition activities
product life cycle naturally occurring process that occurs
when firms begin offering a product or service; the stages
consist of introduction, growth, maturity, and decline
productive inputs any supplies used by a firm in con-
ducting its business activities, such as labor, capital, land,
and raw materials, among others
product-market diversification strategy a firm imple-
ments both product and geographic market diversification
simultaneously
profitability ratios accounting ratios with some measure
of profit in the numerator and some measure of firm size or
assets in the denominator
profit-and-loss centers profits and losses are calculated
at the level of the division in a firm
proprietary technology secret or patented technology
that gives incumbent firms important advantages over
potential entrants
question of imitability “Do firms without a resource or
capability face a cost disadvantage in obtaining or develop-
ing it compared to firms that already possess it?”
question o f o rganization “Is a firm organized to
exploit the full competitive potential of its resources and
capabilities?”
question of rarity “How many competing firms already
possess particular valuable resources and capabilities?”
question of value “Does a resource enable a firm to
exploit an external opportunity or neutralize an external
threat?”
real options investments in real assets that create the
opportunity for additional investments in the future
recession a period of relatively low prosperity; demand
for goods and services is low and unemployment is high
related-constrained diversification all the businesses in
which a firm operates share a significant number of inputs,
product technologies, distribution channels, similar cus-
tomers, and so forth
related corporate diversification less than 70 percent of
a firm’s revenue comes from a single product market and
its multiple lines of business are linked
related-linked diversification strategy the different
businesses that a single firm pursues are linked on only
a couple of dimensions or different sets of businesses are
linked along very different dimensions
reputation beliefs customers hold about a firm
resource-based view (RBV) a model of firm performance
that focuses on the resources and capabilities controlled by
a firm as sources of competitive advantage
resource heterogeneity for a given business activity,
some firms may be more skilled in accomplishing the activ-
ity than other firms
resource immobility resources controlled by some firms
may not diffuse to other firms
resources the tangible and intangible assets that a firm
controls, which it can use to conceive and implement its
strategies
retained earnings capital generated from a firm’s ongo-
ing operations that is retained by a firm
seemingly unrelated diversified diversified firms that
exploit core competencies as an economy of scope, but are
not doing so with any shared activities
senior executive the president or CEO of a firm
shakeout period period during which the total supply in
an industry is reduced by bankruptcies, acquisitions, and
business closings
shared activities potential sources of operational econo-
mies of scope for diversified firms
shark repellents a variety of relatively minor corpo-
rate governance changes that, in principle, are sup-
posed to make it somewhat more difficult to acquire a
target firm
single-business firms firms with greater than 95 percent
of their total sales in a single product market
“skunk works” temporary teams whose creative efforts
are intensive and focused
socially complex resources and capabilities that involve
interpersonal, social, or cultural links among individuals
social welfare the overall good of society
specific international events events such as civil wars,
political coups, terrorism, wars between countries, fam-
ines, and country or regional economic recessions, all of
which can have an enormous impact on the ability of a
firm’s strategies to generate competitive advantage
stakeholders all groups and individuals who have an
interest in how a firm performs
standstill agreement contract between a target and a bid-
ding firm wherein the bidding firm agrees not to attempt to
take over the target for some period of time
Z02_BARN0088_05_GE_GLOS.INDD 374 17/09/14 5:22 PM

Glossary 375
stock grants payments to employees in a firm’s stock
stock options employees are given the right, but not the
obligation, to purchase a firm’s stock at predetermined prices
strategic a lliance whenever two or more independent
organizations cooperate in the development, manufac-
ture, or sale of products or services; a form of exchange
governance between market exchanges and hierarchical
exchanges; examples include licensing arrangements, man-
ufacturing agreements, and joint ventures
strategic management process a sequential set of analy-
ses that can increase the likelihood of a firm’s choosing a
strategy that generates competitive advantages
strategically valuable assets resources required to suc-
cessfully compete in an industry, including access to raw
materials, particularly favorable geographic locations, and
particularly valuable product market positions
strategy a firm’s theory about how to gain competitive
advantage
strategy implementation a firm adopting organizational
policies and practices that are consistent with its strategy
structure (in the structure-conduct-performance model)
industry structure measured by such factors as the number
of competitors in an industry, the heterogeneity of products
in an industry, the cost of entry and exit in an industry, and
so forth
structure-conduct-performance model (S-C-P) theory
suggesting that industry structure determines a firm’s con-
duct, which in turn determines its performance
substitutes products or services that meet approximately
the same customer needs but do so in different ways
substitution developing or acquiring strategically equiv-
alent, but different, resources as a competing firm
supermajority voting rules an example of a shark repel-
lent that specifies that more than 50 percent of the target
firm’s board of directors must approve a takeover
suppliers firms that make a wide variety of raw materi-
als, labor, and other critical assets available to firms
supply agreements one firm agrees to supply others
sustainable distinctive competencies valuable, rare,
and costly-to-imitate resources or capabilities
sustained competitive advantage a competitive advan-
tage that lasts for a long period of time; an advantage that
is not competed away through strategic imitation
tacit collusion firms coordinate their production and
pricing decisions not by directly communicating with each
other, but by exchanging signals with other firms about
their intent to cooperate; special case of tacit cooperation
tacit cooperation actions a firm takes that have the effect
of reducing the level of rivalry in an industry and that do
not require firms in an industry to directly communicate or
negotiate with each other
tactics the specific actions a firm takes to implement its
strategies
technical economies sources of relatedness in market-
ing, production, and similar activities between bidding and
target firms
technological hardware the machines and other hard-
ware used by firms
technological leadership strategy firms make early
investments in particular technologies in an industry
technological software the quality of labor– management
relations, an organization’s culture, and the quality of man-
agerial controls in a firm
temporary competitive advantage a competitive advan-
tage that lasts for a short period of time
tender offer a bidding firm offers to purchase the shares
of a target firm directly by offering a higher-than-market
price for those shares to current shareholders
thinly t raded m arket a market where there are only a
small number of buyers and sellers, where information
about opportunities in this market is not widely known,
and where interests besides purely maximizing the value
of a firm can be important
transaction-specific investment the value of an invest-
ment in its first-best use is much greater than its value in
its second-best use; any investment in an exchange that has
significantly more value in the current exchange than it
does in alternative exchanges
transfer-pricing s ystem using internally administered
“prices” to manage the movement of intermediate prod-
ucts or services among divisions within a firm
transnational strategy actions in which a firm engages
to gain competitive advantages by investing in technology
across borders
transnational structure each country in which a firm oper-
ates is organized as a full profit-and-loss division headed by
a division general manager and strategic and operational
decisions are delegated to operational entities that maximize
local responsiveness and international integration
transparent business partners international business
partners that are open and accessible
U-form structure organization where different functional
heads report directly to CEO; used to implement business-
level strategies
uncertainty the future value of an exchange cannot be
known when investments in that exchange are being made
unfriendly acquisition the management of the target
firm does not want the firm to be acquired
unlearning when a firm tries to modify or abandon tradi-
tional ways of engaging in business
unrelated corporate diversification less than 70 percent
of a firm’s revenues is generated in a single product market
and a firm’s businesses share few, if any, common attributes
value added as a percentage of sales measures the per-
centage of a firm’s sales that are generated by activities
done within the boundaries of a firm; a measure of vertical
integration
Z02_BARN0088_05_GE_GLOS.INDD 375 17/09/14 5:22 PM

376 Glossary
value chain that set of activities that must be accom-
plished to bring a product or service from raw materials to
the point that it can be sold to a final customer
venture capital firms outside investment firms looking
to invest in entrepreneurial ventures
vertical integration the number of steps in the value
chain that a firm accomplishes within its boundaries
vertical merger when a firm vertically integrates, either
forward or backward, through its acquisition efforts
visionary firms firms whose mission is central to all
they do
VRIO framework four questions that must be asked
about a resource or capability to determine its competitive
potential: the questions of value, rarity, imitability, and
organization
weighted average cost of capital (WACC) the percentage
of a firm’s total capital that is debt multiplied by the cost
of debt plus the percentage of a firm’s total capital; that is,
equity times the cost of equity
white knight another bidding firm that agrees to acquire
a particular target in place of the original bidding firm
zero-based budgeting corporate executives create a list
of all capital allocation requests from divisions in a firm,
rank them from most important to least important, and
then fund all the projects the firm can afford, given the
amount of capital it has available
Z02_BARN0088_05_GE_GLOS.INDD 376 17/09/14 5:22 PM

377
Disney, 25–27, 154–155, 212, 227–228, 273,
279, 281, 301
Distimo, 25n
Donato’s Pizza, 211
DoubleClick, 296
Dow, 271
Dow-Corning, 271
DuckDuckGo., 84
Dumex, 328
DuPont, 71, 221, 276
DuPont/Philips Optical, 276
Dutch East India Company, 338
E
E. & J. Gallo Winery, 60
Eastern Airlines, 41
EasyJet, 122
eBay, 86, 87, 301
Electrolux, 333, 357
Eli Lilly, 182, 183
Enron, 27, 27n3
Ericson, 359
ESPN, 62, 95–98, 102, 142n, 156,
208–210, 301
European Community (EC), 351
Excite, 84
Exxon, 301
ExxonMobil, 331
F
Facebook, 61
Farmers Insurance, 157
Federal Reserve Board, 248n4
Federal Trade Commission (FTC),
300–302
FedEx, 40, 57, 157
Fiat, 124, 152, 159, 299
5-Hour Energy, 157
FleetBoston Financial, 308
Folger’s, 227
Fonterra, 328
Food and Drug Administration (FDA), 163
Foote, Coyne, and Belding, 287
Forbes, 183n
Ford, 27, 76, 270, 282, 283, 359
Ford Europe, 359
Ford Motor Company, 359
Fox, 62, 96
Fox News, 63
Fox Sports, 56
French East India Company, 338
Fruit of the Loom, 240
Fuel, 96
Fuji, 335
G
GEICO, 157, 240
General Dynamics, 78, 263
A
ABB, Inc., 219, 253
Abbott Laboratories, 328
ABC, 199, 209, 212
Adidas, 301
AirBus, 63
AirTouch Cellular, 351
AirTran Airlines, 105
Alberto-Culver, 344
Allegiant Airlines, 105
Allied Signal, 256
Alta Vista, 84
Amazon, 24, 49, 50, 56, 62
American Airlines, 41, 63, 109
American Express, 27, 240
America Online (AOL), 323
America West, 227
Ameritech, 351
Andean Common Market (ANCOM), 351
Anheuser-Busch, 131
Anthem, 308
AOL, 90
AOL/Time Warner, 227
Apple, 24, 25, 37, 38, 48, 49n, 61, 87, 102,
268–269
Applebee’s, 74
Ariba, 299
Ask.com, 84
Ask Jeeves, 84
Association of Southeast Asian Nations
(ASEAN), 351
AT&T, 228, 256, 271, 351
B
Bacardi, 332
Baidu, 84
Banco de Mexico, 340
Bank of America, 308
Bausch & Lomb, 335–336
Bavaria Brewery Company, 301
Bell Atlantic, 351
BellSouth, 271, 351
Ben & Jerry’s Ice Cream, 28, 262
Benetton, 339
Benjamin Moore, 240
Berkshire Hathaway, 240–241, 241n,
251, 263
BIC, 124, 125–126, 138, 154, 227, 271
Bing, 84
BlackBerry, 24
Blu-ray Disc Association, 273
Boeing, 63, 104, 122, 271
Boston Beer Company, 152
Boston Consulting Group, 129n9
Boston University, 61
Briggs and Stratton, 256
British Airways (BA), 172, 222
British East India Company, 338
British Petroleum (BP), 77
British Telecom, 351
BT, 61
Budweiser, 60, 166
Burger King, 62, 73, 157
C
Café Rio, 74
Campbell Soup Company, 66, 344
Canada Dry, 158
Capital Cities/ABC, 301
Capital Cities Entertainment, 209
Carnation Company, 346
Casella Wines, 171
Casio, 107, 124, 152
Caterpillar, 227
CBS, 52, 62, 210
CBS Sports Network, 56
CFM, 271
Chaparral Steel, 59, 146
Charles Schwab, 132, 172
Chevrolet, 282, 332
ChevronTexaco, 301
Chicago Cubs, 142
Chili’s, 74
Chipotle, 74
Christie’s, 41–42
Chrysler, 76, 154, 165, 270, 282, 283,
299, 323
CIBA-Geigy, 219, 276–277, 345, 357
Cingular, 271
Cirque de Soleil, 171
Cisco, 283, 299
Clayton, Dubilier, and Rice, 251
CNN, 63
Coca-Cola Company, 62, 109, 157, 158,
240, 256, 257, 261, 332, 358
Colgate, 333
Compaq, 280, 323
Continental Airlines, 105, 227
Coors, 60, 332
Corning, 271, 276–277, 283
Cross, 154
Crown Cork & Seal, 128, 337–338
CSX, 256
Cue, 333
CW network, 52
D
Daewoo, 358
Daimler, 299, 323
Daimler-Benz, 299
DaimlerChrysler, 299, 323
Dairy Queen, 73, 240
Dell, 141, 196, 197, 226–227, 344
Delta airlines, 63, 105, 109
Deutsche Telephone, 351
DirecTV, 68
Discovery Channel, 199
Dish Network, 68
Company Index
In the page references, the number after “n” refers to the number of the end note in which the name is cited.
Z03_BARN0088_05_GE_CIDX.INDD 377 17/09/14 5:21 PM

378 Company Index
National Football League (NFL),
64, 209
National Hockey League (NHL), 64,
208, 209
NBC, 62, 96, 210
NBCSN, 210
NBC Sports Network, 56
NCAA, 208
NDS Group, 299
NEC, 358
Nestlé, 219, 235, 242–243, 287, 331, 334,
335, 345–346, 353, 357
Net Jets, 240
New England Whalers, 208
New Relic, 25n
Newsweek, 63
New York Yankees, 142
Nextel, 323
Nike, 64, 93, 133
Nissan, 51, 76, 154, 165
Nokia, 61
Nordstrom, 174
North West Company, 338
Novartis, 183
Novell, 323
Nucor Steel, 59, 106, 144, 145–146
NUMI, 272
O
Oakland A’s, 142
Olivetti, 351
Oracle, 156, 301
OWN, 199
Oxygen, 199
P
Pacific Telesis, 351
Panasonic, 273
Pandora, 49, 50, 63
Panera Bread, 74
Paramount, 273
Patstats, 61n17
PeopleSoft, 301
PepsiCo, 62, 109, 156, 158, 212, 216, 221,
261, 332
Peter Arnold, Inc., 123, 183n
PEZ Candy, Inc., 41–42
Pfizer, 270
Philip Morris, 27, 307
Philips Optical, 276
Phillips, 345
Pittsburgh Pirates, 142
Pixar, 279, 281
Pizza Hut, 261
Porsche, 154, 165
PricewaterhouseCoopers LLP,
270n1
Primark, 339
Procter & Gamble, 51, 71, 75, 109, 215, 221,
334, 353
Publicis, 287
Q
Quaker Oats, 256
R
RC Wiley, 240
Rdio, 49
King World, 199
Kmart, 133, 199
Kodak, 335
Kroger, 106
L
L. L. Bean, 86
Lacoste, 162
La Quinta, 71
Leaf, Inc., 276
Levi Strauss’s, 216
Lexus, 165
Limited Brands, 151
Linux, 64
Lockheed Corporation, 170
Logitech, 330
Los Angeles Angels, 142
Los Angeles Dodgers, 142
Lowe’s, 157
Lufthansa, 169
Lycos, 84
M
Major League Baseball, 209
Mango, 339
Mannesmann, 351
Manulife Financial, 308
Marc Rich and Company, 336
Marks and Spencer, 333
Marriott, 344
Marriott Corporation, 41
Mars, 240
Massachusetts Institute
of Technology, 101
Maui Beer Company, 152
Maxwell House, 227
Mazda, 154, 165, 270, 282–283
McDonald’s, 62, 71, 73–74, 157, 168,
176, 336
MCI, 351
McKinsey and Company, 94, 115
Mead Johnson, 328
Mengniu Dairy, 329
Mercedes, 152, 165
Merck, 182, 183, 270
Mexx, 162
Miami Heat, 64
Miata, 165
Michelin, 227
Microsoft, 64, 65, 75, 85, 154, 323
Midas, 71
Mid Atlantic Medical, 308
Miller, 60, 131
Miller Lite, 157
Milwaukee Brewers, 142
Minebea, 340
Mitsubishi, 270, 282, 283, 340, 358
Mobil, 301
Mont Blanc pen, 154
Motorola, 27, 85, 297, 298, 301, 340
Mountain Dew, 166
MTV, 156
N
NASCAR., 157
National Basketball Association, 209
National Development and Reform
Commission, 329
General Electric (GE), 71, 77, 78, 168, 213,
219, 241, 242, 271, 331, 346, 358
General Motors (GM), 76, 87, 154, 165,
216, 218, 243, 270, 272, 274, 282–283,
331, 332, 340, 358
Gerber, 333
Gillette, 227, 335
Global IP Solutions, 84–85
Goldman Sachs, 172
Goldstar, 358
Goodyear, 227
Google, 24–26, 61, 84–85, 85n, 86, 269,
296–298, 301
GTE Sylvania, 77
H
H&M, 162, 339
Harley Davidson, 87
Harpo Productions, 199
Harvard Business School, 66n30, 86n2,
142n, 158n12, 170n19
HBO, 272–273
Hearst, 199
Helzberg Diamonds, 240
Hertz, 123
Hewlett-Packard (HP), 27, 216, 226–227,
323, 340
Holiday Inn, 71
Home Depot, 65
Honda, 76, 343, 345
Hoovers, 199n
Howard Johnson’s, 71
HTC, 61
Hudepohl-Schoenling Brewing
Company, 152
Hudson Bay Company, 338
Huffington Post, 269n
Hyundai, 358
I
IBM, 27, 87, 154, 166, 169, 216, 240, 346, 358
Imperial Chemical Industries (ICI), 77
In and Out Burger, 73
InBev, 60
Intel, 64, 65
International Steel Group, 78
Intertrust, 61
Investor Relations Business, 248n4
Isuzu, 270
ItaliaTelecom, 351
J
J. D. Powers, 76, 76n48
J. Walter Thompson, 312
Jack in the Box, 73
JetBlue, 105, 122
John Deere, 227
John Hancock Financial, 308
Johnson & Johnson (J&J), 27, 41, 182,
219–222, 263
Journal of Applied Corporate Finance, 257n17
Justin Brands, 240
K
Kaiser-Permanente, 132
Kampgrounds of America (KOA), 70–71
Kentucky Fried Chicken, 73, 216, 261, 333
Keyhole, 84–85
Z03_BARN0088_05_GE_CIDX.INDD 378 17/09/14 5:21 PM

Company Index 379
V
Viacom, Inc., 156, 199
Victoria’s Secret, 150–152
Virgin American Airlines, 105
Virgin Group, 222
Vodafone Group, 351
Vodaphone, 123
W
W. L. Gore & Associates, 221, 221n
Walgreens, 344
The Wall Street Journal, 316
Wal-Mart, 27, 66, 72, 86, 106, 140, 141, 146,
164, 190, 194, 331, 339, 344
Walt Disney, 209, 212n2
WB network, 51–52
WD-40 Company, 211
Welch Foods, Inc., 276
Wellpoint, 308
Wells Fargo, 240
Wendy’s, 62, 73, 74
Windows, 24
Word Perfect, 323
World Bank, 336n7
World Trade Organization (WTO), 230
WPP, 170, 312
Wrigley, 344
www.blu-ray.com, 273n3
X
Xerox, 71, 161
Y
Yahoo!, 61, 84
Yale University, 40
Yili Dairy, 329
YouTube, 24–25, 85, 296
Yugo, 333
Z
Zara, 162
Zydus, 183
T
Taco Bell, 73, 157, 261
Taiwan Semiconductor Manufacturing
Company (TSMC), 269
Target, 106, 157, 339
Tesco, 328
Texas Instruments, 215
3M, 27, 90, 172, 173, 219, 221
Time, 63
Time Warner, 51, 52, 68, 90,
227–228, 323
Timex, 124, 152
TNN, 62
Toshiba, 273
Toyota, 76, 87, 272, 274, 282–283, 331,
346, 358
TripAdvisor, 123
TTI, 240
258marketing.wordpress.com,
333n2
U
Unilever, 28
United Airlines, 63, 105, 109, 169, 227
UnitedHealth, 308
United States Steel, 78
University of Colorado, 208–209
University of Connecticut, 208
Unocal, 301
UPN, 52
UPS, 57
U.S. Department of Defense, 65
U.S. International Trade
Commission, 268
U.S. Post Office, 57
U.S. Securities and Exchange Commission
(SEC), 314
U.S. Steel, 277
U.S. West, 351
US Air, 227
US Airways, 107
USA Networks, 62
Reebok, 301
Renault, 287
Rhaposody, 49
Rolex, 107, 152
Rolls-Royce, 159
Rovio, 25, 25n, 26
Royal Dutch Shell, 72, 331
Royal FrieslandCampina, 328
Russell Brands, 240
Ryanair, 122–123, 123n, 124, 132, 140,
141, 152
S
SABMiller, 301
Safeway, 106
Sainsbury, 328
Salem, 333
Salt Lake Tribune, 299n2
Samsung, 61, 268–269, 273, 297
SAP, 156, 299
Schlumberger, 350
Schweppes, 332
Sega, 25
Service Corporation International (SCI),
70, 316–317
Skybus Airlines, 105
Skype, 301
SNECMA, 271
Softbank, 299, 323, 351
Sony, 27, 90, 102, 104, 109, 333
Southwest Airlines, 87, 104–107, 122–123,
141, 169
Southwestern Bell, 351
Spirit Airlines, 105
Spotify, 49, 50, 63
Sprint, 323
SprintNextel, 299, 323, 351
Star Alliance, 169
Stouffer’s, 159
Stroh Brewery Company, 152
Sun Microsystems, Inc., 75
Swanson, 159
Z03_BARN0088_05_GE_CIDX.INDD 379 17/09/14 5:21 PM

380
Name Index
In the page references, the number after “n” refers to the number of the end note in which the name is cited.
A
Abernathy, W. J., 337n9
Adler, N., 355n36
Agins, T., 177n30
Agmon, T., 344n24
Aguilar, F. J., 77n50, 263n25
Alchian, A., 187n2, 280n14
Allen, M., 62n22
Alley, J., 98n15
Alvarez, S., 43n, 91n, 274n
Amit, R., 34n, 102n26, 231n33, 233n
Anders, G., 90n7, 353n35
Angwin, J., 163n
Ansoff, H. I., 217n
Ante, S., 297n
Applebaum, A., 28n7
Argyris, C., 342n21
Arikan, A., 308n
Armour, H. O., 242n1
Armstrong, L., 168n17
Arthur, W. B., 97n13, 98n15
Artz, K. W., 86n1
Auletta, K., 350n30
Axelrod, R. M., 284n
B
Badaracco, J. L., 270n2, 283n16
Baden-Fuller, C.W.F., 357n41
Bain, J. S., 53n7, 58n10
Balakrishnan, S., 278n9
Balmer, S., 75
Barnes, B., 52n5
Barnett, W. P., 86n1
Barney, B., 57n
Barney, J., 43n, 88n5, 91n, 215, 215n, 233n
Barney, J. B., 30n8, 53n7, 54n, 86n1, 95n9,
97n12, 99n18, 99n21, 101n, 139n19,
189n4, 202n9, 225n18, 233n, 274n, 277,
277n, 278n11, 283n17, 286n21, 286n22,
288n23, 289n24, 291n29, 300n4, 310n16
Barrett, A., 344n
Bartlett, C., 253n11, 283n19
Bartlett, C. A., 277n7, 347n26, 357n,
357n40, 359n43
Baughn, C. C., 278n11, 340n18, 341n19
Baum, J.A.C., 227n24
Beane, W. L., 142
Beatty, R., 290n25
Becker, G. S., 86n3, 201n8
Benedict, R., 342n20
Bennett, T., 199
Bennis, W. G., 113n34
Berg, N. A., 126n2
Berg, P. O., 99n20
Berger, P., 225n21, 252n9, 261n
Bergh, D., 248n6
Bernheim, R. D., 227n24
Besanko D., 30n8
Bethel, J., 225n19, 248n6, 254n13
Bettis, R. A., 222n15
Bhambri, A., 263n25
Bhide, A., 91, 91n
Bigelow, L. S., 231n33
Bleeke, J., 278n10, 283n17, 283n18, 284n,
291–292n30, 291n29
Blois, K. J., 291n29
Bock, A. J., 34n
Bond, R. S., 72n42
Bounds, W., 335n6
Bower, J., 312n18
Bower, J. L., 77n50
Boyd, B., 247, 247n
Bradey, M., 322n
Bradley, S. P., 338n10
Brahm, J. R., 355n36
Brandenburger, A., 30n8, 67, 67n31, 68
Branson, R., 222
Breen, B., 96n11, 98n14
Brennan, M., 226n23
Bresnahan, T. F., 71n38
Bresser, R. K., 279n12
Brewer, H. L., 350n32
Brickley, J., 258n20
Bright, A. A., 71n38
Brin, S., 85
Bromiley, P., 86n1
Brown, S. J., 308n
Brush, T. H., 86n1
Buffett, W., 241, 241n, 263
Burgers, W. P., 275n4, 278n8
Burgleman, R. A., 342n21, 342n22
Butler, J. K., Jr., 291n29
Buzzell, R. D., 131n
C
Camerer, C., 289n24
Cameron, K. S., 307n13
Campbell, E., 289n
Cantrell, R. S., 291n29
Capell, K., 123n
Carlisle, K., 133n
Carnevale, M. L., 228n30
Carney, M., 291n29
Carpenter, M., 353n35
Carroll, G. R., 231n33
Carroll, P., 154n4
Cartwright, S., 319n21
Cauley, L., 63n26
Cavanaugh, S., 338n10
Caves, R. E., 153n, 153n2, 352n34
Chamberlin, E., 160, 161, 161n
Chandler, A., 242n1
Chartier, J., 62n23, 73–74n44, 74n46
Chatterjee, S., 219n12, 319n21
Chen, M.-J., 227n24
Chew, D., 255n15
Chiles, T. H., 291n29
Christensen, C., 78n52
Christensen, C. R., 126n2
Coase, R., 185, 185n1, 187
Cockburn, I., 61n20, 86n1, 99n18,
157n9
Cohen, B., 28
Cohen, W., 274n
Collins, J., 113n34
Collins, J. C., 27n5, 27n6, 41n11
Collis, D. J., 340n15
Comment, R., 214, 215n, 225n21
Conner, K. R., 86n1, 189n4
Cool, K., 61n18, 86n1, 97n12, 97n13
Cooper, C., 319n21
Copeland, T., 42n
Cowling, K., 155n
Cox, J., 226n23
Cox, M., 63n26
Coyne, W., 173n
Crawford, R., 187n2, 280n14
Crowe, J., 262
Cubbin, J., 155n
Cyert, R., 259n21
D
Dalton, D., 247n
Dann, L. Y., 322n
D’Aveni, R., 244n2, 247n
Davidson, J. H., 72n42
Davis, B., 335n6
Davis, S. M., 144n22
Dawley, H., 133n
DeAngelo, H., 322n
DeFillippi, R. J., 98n16
de Forest, M. E., 340n17, 356n39
DeGeorge, R., 133n
Delaney, K. J., 183n
Delmar, F., 91, 91n
Demetrakakes, P., 74n45
Demick, B., 329n
Demsetz, H., 54n, 230n
Dent-Micallef, A., 86n1
Deogun, N., 306n11, 351n33
Der Hovanseian, M., 308n
Deutsch, C. H., 168n17
Devinney, T. M., 231n33
DeWitt, W., 65n28
Dial, J., 78n54, 263n25
Dichtl, E., 348–349n29, 349n
Dierickx, I., 61n18, 86n1, 97n12, 97n13
Dobie, A., 61n16
Dodd, P., 309n15
Donaldson, L., 42n
Dranove, D., 30n8
Drucker, P., 26n1, 27n2
Duell, C. H., 50
Duffy, M., 254n14
Dumaine, B., 251n8
Dunning, J. H., 350n31, 352n34
Dyer, J. H., 99n18
Z04_BARN0088_05_GE_NIDX.INDD 380 13/09/14 4:26 PM

Name Index 381
Hudson, R., 276n5
Huey, J., 301n5
Hurstak, J., 28n7
Huselid, M., 101n
Huston, T. L., 291n29
Hybels, R. C., 290n25
Hymer, S., 352n34
I
Ignatius, A., 336n, 337n8
Itami, H., 61n19, 99n17
Iverson, K., 144
J
Jacob, R., 70n33, 335n6, 336n7, 337n8
Jacobs, J., 199
Jacobsen, D., 323n22
James, C., 225n21
James, L-B., 64
Jandik, T., 228n31
Jarrell, G., 214, 215n, 225n21
Jefferson, D., 281n
Jemison, D., 324n24
Jemison, D. B., 314n19
Jensen, M. C., 219n13, 245n, 262n24,
300n4, 302, 303n, 304n9, 306n12
Jobs, S., 48, 86–87, 281
Johanson, J., 291n29
Johnson, R., 157n10
Johnson, R. B., 247n
Jones, D. I., 101n, 177n28
Juliflar, J., 339n
K
Kalleberg, A. L, 290n25
Kanabayashi, M., 283n16
Karnani, A., 227n24, 227n25
Karnitschnig, M., 90n7
Keenan, M., 226n23
Kendall, B., 269n
Kent, D. H., 278n11
Kesner, I. F., 246n3, 247n
Kiley, D., 124n1
Kim, W. C., 171, 171n, 275n4, 278n8
Kirkpatrick, D., 351n33
Klebnikov, P., 78n52
Klein, B., 99n21, 156n7, 187n2, 280n14
Klemperer, P., 72n41
Knight, F. H., 91n, 278n8
Knutson, R., 297n
Kobrin, S., 338n12
Koeglmayr, H. G., 348–349n29, 349n
Kogut, B., 61n18, 190n5, 278n8, 278n9,
286n22
Koller, T., 42n
Korn, H. J., 227n24
Korten, D. C., 230n
Kosnik, R. D., 322n
Kotick, Robert, 262
Kotler, P., 158n11
Kou, J., 142n
Koza, M., 278n9
Kozlowski, D., 245
Kraar, L., 337n8, 339n14, 358n42
Kripalani, M., 183n, 196n6
Krogh, L., 90n6
Kunlin, Xu, 329
Gore, Bob, 221
Govindarajan, V., 259n22
Graham, J. L., 355n36
Granovetter,M., 289n24
Grant, L., 306n11
Grant, R. M., 94n8, 99n19, 219n12, 337n9,
350n31, 359n43
Gray, B., 281n15
Greckhamer, T., 69n
Greene, J., 75n
Greenfield, J., 28
Gregerson, H., 353n35
Greve, H. R., 86n1
Grimm, C. M., 108n31, 227n24
Gross, N., 72n42
Grow, B., 51n3, 51n4
Gulati, R., 86n1, 278n11, 290n25
Gunther, M., 155n6
Gupta, A. K., 200n7, 259n22
Guth, R., 75n
H
Hackman, J. R., 128n6
Hagedoorn, J., 278n11, 285n20
Halal, W., 253n10
Hall, G., 129n10
Hall, S., 332n1
Hallowell, R. H., 87n4
Hambrick, D., 99n21, 229n32
Hamel, G., 219, 219n11, 274n, 341n,
342n20, 342n23, 355n37
Hamermesh, R. G., 128n5, 338n10
Hamm, S., 75n
Hammonds, K., 142n
Hansen, G. S., 248n5
Hansen, M. H., 283n17, 289n24, 291n29
Haricento, F., 322n
Harrigan, K., 186n
Harrigan, K. R., 76n49, 77n51
Harris, L. C., 100n22
Harrison, J. S., 215n4
Hasegawa, N., 270n2, 283n16
Haspeslagh, P., 324n24
Hatfield, D. D., 99n19
Hay, D., 155n
Hayes, R. H., 75n47
Hedberg, B.L.T., 342n21
Henderson, B., 129n9
Henderson, R., 61n20, 86n1, 157n9
Henderson, R. M., 99n18
Hendrickx, M., 86n1
Hennart, J. F., 168n16, 286n22
Hennessey, R., 305n
Henry, D., 308n
Heskett, J. L., 87n4
Hesterly, W. S., 139n18
Hill, C.W.L., 130n11, 176n25, 248n5,
275n4, 278n8
Hite, G., 261n
Hoang, H., 290n25
Hodgetts, R., 52n6, 335n6, 348n27
Holder, D., 86n2
Holm, D. B., 291n29
Holmstrom, B., 278n11
Hotelling, H., 154n5
Houston, J., 225n21
Howell, S., 129n10
E
Eccles, R., 258n20, 259n, 259n21
Edmondson, G., 133n, 299n1
Edwards, C. D., 227n24
Efrati, A., 297n
Eger, C. E., 309n15
Eichenseher, J., 290n25
Eihhorn, B., 183n
Elias, P., 269n
Ellison, L., 262
Ellwood, J., 323n23
Elms, H., 69n
Emshwiller, J. D., 27n4
Engardio, P., 183n, 196n6, 340n15
Ennis, P., 283n16
Eriksson, K., 291n29
Ernst, D., 278n10, 283n17, 283n18, 284n,
291–292n30, 291n29
Errunza, V., 350n31, 352n34
F
Fama, E. F., 299n3
Farjoun, M., 219n12
Farnham, A., 98n16
Fatsis, S., 63n26
Fatterman, M., 56n9
Fingas, J., 61n16
Finkelstein, S., 229n32, 244n2, 247n
Finn, E. A., 78n53
Firth, M., 309n15
Fixmer, A., 49n
Floyd, S., 258n18
Floyd, S. W., 144n24, 146n25
Folta, T., 170, 192n, 278n8
Fornell, C., 72n40
Foust, D., 308n
Freeland, R. F., 242n1
Freeman, A., 276n5
Freeman, J., 86n1
Friedman, J. S., 93n
Fuchsberg, G., 216n5
G
Gain, S., 340n16
Galai, D., 226n23
Gale, B. T., 131n
Galloni, A., 177n30
Gannon, M. J., 108n31
Gartner, W., 43n
Garud, R., 172n21
Gates, B., 75, 86–87
Geffen, D., 86n1
George, G., 34n
Geringer, J. M., 231n33
Ghemawat, P., 59n12, 63n24, 71n36, 72n40,
86n2, 132n12, 144n23, 158n13
Ghoshal, S., 253n11, 283n19, 338n11,
347n26, 357n, 357n40, 359n43
Gibson, R., 73–74n44, 176n26
Gilbert, R. J., 71n37
Gilmartin, R., 27n4
Gimeno, J., 227n24, 227n26, 228n28
Glynn, M. A., 348n28
Golden, B., 252n9
Gomes-Casseres, B., 77n50
Gomez, A., 132n12
Gomez-Mejia, L., 99n18
Z04_BARN0088_05_GE_NIDX.INDD 381 13/09/14 4:26 PM

382 Name Index
Nowak, P., 277, 277n
Nystrom, P. C., 342n21
O
Obama, B., 268
Ofek, E., 225n21, 252n9, 261n
Ogbonna, E., 100n22
Oldham, G. R., 128n6
O’Leary, M., 122
Olsen, D. M., 231n33
Ono, Y., 152n1
Opler, T. C., 99n19
Orosz, J. J., 170n20
Osawa, J., 269n
Osborn, R. N., 278n11, 340n18, 341n19
Osterwalder, A., 34, 34n
Ouchi, W. G., 278n11, 279n12, 288n23
Oviatt, B., 330n
Owens, J., 261n
P
Pacelle, M., 63n26
Paez, B. L., 231n33
Page, L., 85
Palia, D., 225n21
Palmer, K., 162n15
Pandian, J. R., 86n1, 97n12
Paré, T. P., 63n26
Park, D. Y., 86n1
Patterson, G. A., 283n16
Pearce, J. A., II, 246n3
Perdue, F., 333
Perrow, C., 127n4
Perry, L. T., 225n18
Perry, N. J., 66n29, 78n54, 333n3
Peteraf, M. A., 30n8, 86n1, 97n12
Peters, T., 113n34
Peterson, R. B., 342n20
Pfeffer, J., 277, 277n
Phillips, G., 225n21
Pigneur, Y., 34, 34n
Pisano, G., 86n1, 163n
Polanyi, M., 61n19
Polley, D., 172n21
Pollock, E. J., 63n26
Pope, K., 63n26, 280n13
Porras, J., 27n5, 27n6, 41n11, 99n20, 113n34
Porter, M. E., 30n8, 32, 32n, 53n7, 54n,
55n8, 69n32, 71n34, 73n43, 76n49,
99n21, 153n, 153n2, 158n12, 175n24,
176, 177n29, 215n4, 217n, 302n7,
338n11, 357n40
Position, L. L., 172n23
Powell, T. C., 86n1
Praeger, J., 90n6
Prahalad, C. K., 189n4, 219, 219n11, 222n15
Priem, R., 258n18
Prokesch, S., 172n22
Q
Quinn, J., 74n45
R
Rajan, R., 225n21
Rapoport, C., 219n10, 334n4, 346n25
Rasmussen, B., 208
Rasmussen, S., 208
Marin, D., 336n
Markides, C., 219n12
Marriott, J. W., 41
Mason, E. S., 53n7
Massa, L., 34n
Masulis, R. W., 226n23
Matsusaka, J. G., 225n21
Mauborgne, R., 171, 171n
Mayer, M., 262
McCarthy, M. J., 42n12
McCartney, S., 107n29
McCormick, J., 132n12
McCracken, J., 270n1
McDougall, P., 330n
McGahan, A., 32, 32n, 63n24, 142n
McGrath, R. G., 227n24
McGuire, J. F., 142n
McHugh, A., 41n
McKnight, W., 173
McMackin, J. F., 291n29
Meckling, W. H., 245n
Megginson, W. L., 231n33
Merced, M., 60n14
Meyer, M. W., 139n16
Michel, A., 350n32
Mikkelson, . H., 309n15
Miles, R. H., 307n13
Miller, D., 86n1, 192, 192n,
214, 215, 215n
Miller, K., 233n
Mintzberg, H., 40n10, 41n, 249n7
Misangyi, V. F., 69n
Mitchell, W., 285n20
Mohr, J., 292n31
Monik, A., 339n
Monteverde, K., 132n12
Montgomery, C., 71n35, 131, 131n
Montgomery, C. A., 60n13, 219n12,
305–306n10
Montgomery, D. B., 72n42, 100n23, 154n3
Moonves, L., 262
Moore, F. T., 126n3
Morck, R., 344n
Morris, D., 155n
Mueller, D. C., 32n
Munger, C., 241
Murphy, J., 263n25
Murphy, K. J., 78n54, 262n24
Murrin, J., 42n
Myatt, J., 86n1
N
Nagarajan, A., 285n20
Nail, L. A., 231n33
Nalebuff, B., 67, 67n31, 68
Nanda, A., 277n7
Nanda, V., 225n21
Narula, R., 278n11
Nayyar, P., 220n14
Nelson, E., 98n16
Newberry, D. M., 71n37
Newburry, W., 285n20
Nguyen, T. H., 231n33
Nickel Anhalt, K., 133n
Nickerson, J. A., 86n1
Noldeke, G., 278n8
Norton, E., 63n26
Kuo, L., 329n
Kupfer, A., 86n2
L
Labich, K., 63n25
Laffer, A., 186n
Laing, J. R., 86n2
Lamattina, J., 183n
Lamb, R., 86n1, 100n24
Lambert, R., 245n
Lamont, O., 258n19
Landro, L., 228n27
Lang, H. P., 214, 215, 215n, 252n9
LaPorta, R., 344n
Larson, A., 290n25
Larzelere, R. E., 291n29
Lasseter, John, 281
Lau, L. J., 126n3
Lavelle, L., 344n
Lawless, M., 99n18
Lawrence, P. R., 144n22
Lean, D. F., 72n42
Lee, L., 93n
Leffler, K., 99n21, 156n7
Lefton, T., 301n5
Leftwich, R. B., 350n31
Leiblein, M., 192, 192n
Lepine, J. A., 69n
Lessard, D. R., 344n24
Lessin, J., 269n
Levinson, M., 340n17
Levinthal, D., 86n1, 274n
Levy, S., 281n
Lewis, M., 142n
Lieberman, M., 71n35, 129n8
Lieberman, M. B., 100n23, 139n20, 154n3
Liebeskind, J., 99n19, 224n17, 248n6
Liedtka, J. M., 219n12
Lipman, S., 95n9
Lipparini, A., 86n1, 291n29
Livnat, J., 231n33
Long, M., 322n
Lopez-de-salina, F., 344n
Lorenzoni, G., 86n1, 291n29
Lowry, T., 210n, 281n, 344n
Lubatkin, M., 300n4, 302, 302n,
305–306n10, 319n21
Lublin, J., 107n29
Luk, L., 269n
M
Ma, H., 227n24
Mackey, A., 263n
Mackey, T., 215, 215n
Mahoney, J., 86n1, 97n12, 192, 192n
Maijoor, S., 86n1
Main, O. W., 72n40
Majumdar, S., 86n1
Makadok, R., 86n1
Makhija, A. K., 228n31
Maksimovic, V., 225n21
Malnight, T., 332n1
Malseed, M., 85n
Mansfield, E., 71n39, 139n20
Maquieira, C., 231n33
March, J. G., 259n21
Marcus, A., 86n1
Z04_BARN0088_05_GE_NIDX.INDD 382 13/09/14 4:26 PM

Name Index 383
Thurm, S., 75n, 100n25
Tirole, J., 227n24, 228n29, 290n27
Tomlinson, J., 90n6
Townsend, R., 113n34
Trager, J., 338n13
Trautwein, I., 300n4
Trimble, V., 40n9
Trottman, M., 107n29
Trout, J., 72n42
Tsai, L. B., 231n33
Tucker, I., 186n
Tully, S., 64n27, 255n15, 256n16
Turk, T. A., 311n17, 322n
Turner, R., 228n27
Tyler, B., 99n18
U
Useem, J., 213n3, 245n
Utterback, J. M., 337n9
V
Van de Ven, A., 172n21, 173n
Van Witteloostuijn, A., 86n1
Varaiya, N., 309n15
Venkatraman, N., 291n29, 292n31
Venkatraman, S., 172n21
Villalonga, B., 214, 215, 215n
Vise, D., 85n
Vishny, R., 344n
Vogelstein, F., 305n
W
Wagner, S., 71n39
Wakeman, L., 322n
Walkling, R., 261n, 322n
Walsh, J., 322n, 323n23
Walter, G., 300n4
Walton, S., 146n26
Wang, H., 233n
Waring, G. F., 32n
Warner, J. B., 308n
Waterhouse, J. H., 259n21, 260n23
Waterman, R., 113n34
Wayland, R., 158n12
Weber, J., 344n
Weber, Y., 319n21
Weigelt, K., 289n24
Weintraub, A., 51n2, 183n
Weisul, K., 107n28
Welch, D., 299n1
Welsh, J., 161n14
Wensley, R., 131, 131n
Wernerfelt, B., 60n13, 72n41, 86n1,
131, 131n, 219n12, 227n24,
227n25, 233n
Westley, F., 249n7, 258n19
Westphal, J., 86n1, 247n
Wheelwright, S. G., 75n47
Whinston, M. D., 227n24
White, E., 162n15
White, L. J., 226n23
Wiersema, M., 220n14
Wilder, R. P., 186n
William, J., 231n33
Williamson, O., 143n21, 187n2, 223n16,
242n1, 278n11, 280n14
Williamson, P., 153n, 153n2
Shaffer, R. A., 132n12
Shaked, I., 350n32
Shamsie, J., 86n1
Shane, S., 91, 91n, 278n11, 356n38
Shanley, M., 30n8, 242n1
Sharma, A., 56n9
Sherr, I., 269n
Shields, D., 290n25
Shimada, J. Y., 342n20
Shin, H. H., 225n21, 258n19
Shleifer, A., 344n
Siconolfi, M., 62n22
Silverman, B. S., 86n1
Simonin, B. L., 99n19
Simons, R., 253–254n12
Singh, H., 99n18, 278n11,
305–306n10, 322n
Sitkin, S. B., 314n19
Smith, A., 185
Smith, C., 258n20
Smith, E., 49n
Smith, F., 40, 228n28
Smith, K. G., 108n31, 227n24
Smith, L., 78n54
Smith, R., 27n4
Solomon, D., 27n4
Sorenson, D., 90n6
Sorkin, A. R., 60n14
Sorrel, M., 312
Spekman, R., 292n31
Spence, A. M., 139n20
Spender, J. C., 99n19
Stander, H. J., III, 59n12, 132n12,
144n23
Stapleton, R. C., 226n23
Starbuck, W. H., 342n21
Staw, B. M., 139n17, 225n20
Stecklow, S., 60n15
Steele-Carlin, S., 195n
Stein, J. C., 258n19
Stem, G., 63n26
Stern, J., 255n15
Stewart, B., 255n15
Stewart, M., 199
Stewart, T., 99n19
Stiglitz, J., 230n
Stone, N., 132n12
Stoneham, P., 334n5
Stopford, J. M., 357n41
Stuart, T. E., 30n8, 290n25
Stucker, K., 227n24
Stulz, R. M., 214, 215, 215n, 225n21,
233n, 252n9, 258n19, 261n
Sulce, L., 48, 49
Sultan, R. M., 131n
Swieringa, R. J., 259n21, 260n23
Swisler, K., 61n16
Symonds, W., 86n2
T
Tabuchi, H., 102n27
Tallman, S., 231n33
Tamura, S., 126n3
Teece, D., 132n12, 242n1
Teitelbaum, R. S., 276n6
Templeman, J., 235n34
Theroux, J., 28n7
Ravenscraft, D. J., 302n7
Rechner, P., 247n
Reda, S., 74n45
Reed, R., 98n16
Reibstein, L., 340n17
Reilly, P. M., 63n26, 228n27
Resch, I., 133n
Reuer, J., 289n
Reve, T., 290n25
Ricardo, D., 88, 89n, 154n5
Ries, A., 72n42
Riley, C., 329n
Ritter, R., 290n25
Roberts, P., 32n, 86n1
Robichaux M., 156n8
Robins, J., 220n14
Robinson, E., 98n16
Robinson, J., 160, 161. 161n
Robinson, W. T., 72n40
Rogers, A., 215n4
Rogers, R., 261n
Rohwedder, C., 63n26
Roll, R., 309n14
Roos, D., 101n, 177n28
Rosenbloom, R. S., 78n52, 128n5, 338n10
Ross, S., 226n23
Roth, K., 86n1
Ruback, R., 302
Ruback, R. S., 300n4, 303n, 304n9, 309n15
Rubinstein, M., 226n23
Rugman, A., 52n6, 335n6, 348n27, 350n31
Rumelt, R., 69n, 86n1, 95n9, 100n24, 131,
131n, 217n, 252n9, 302n6
Russell, Karl, 263n
Russo, M. V., 228n31
S
Sacks, D., 221n
Sadowski, B., 285n20
St. John, C. H., 215n4
Salter, M. S., 126n2
Sanders, G., 353n35
Sanders, L., 231n33
Saporito, B., 62n22
Sarasvathy, S., 43n
Scharfstein, D. S., 225n21
Scherer, R. M., 302n7
Scherer, F. M., 53n7, 61n21, 126n3, 127n4,
277, 277n, 291n28
Schlender, B. R., 90n6, 109n32
Schlingemann, F., 261n
Schmalansee, R., 69, 69n, 72n40
Schmidt, K. M., 278n8
Schoemaker, P.J.H., 102n26
Schon, D. A., 342n21
Schonfeld, E., 132n14, 132n15
Schultz, E., 132n13
Schwartz, M., 71n39
Schweiger, D., 319n21
Schwind, H. F., 342n20
Scott, J. H., 226n22
Seidel, M.-D. L., 231n33
Sellers, P., 199n, 212n1
Senbet, L. W., 350n31, 352n34
Seror, A., 231n33
Servaes, H., 225n21
Serwer, A. E., 306n11, 336n7
Z04_BARN0088_05_GE_NIDX.INDD 383 13/09/14 4:26 PM

384 Name Index
Zajac, E., 86n1, 247n
Zander, U., 61n18
Zaslay, D., 262
Zeira, Y., 285n20
Zellner, W., 344n
Zimmerman, J., 258n20
Zimmerman, M., 340n18, 341n19
Zingales, L., 225n21
Zott, C., 34n
Zucker, L. B., 139n16
Y
Yan, A., 281n15
Yardley, J., 339n
Yeoh, P.-L., 86n1
Yeung, B., 344n
Yoffie, D., 169n18
Yoshino, M., 332n1, 334n5
Young, G., 227n24
Z
Zaheer, A., 291n29, 292n31
Zahra, S. A., 246n3
Williamson, P. J., 219n12
Willliams, M., 283n16
Wilson, R., 228n28
Winfrey, O., 199
Wingfield, N., 61n16
Winter, D., 133n
Woldridge, B., 144n24, 146n25
Womack, J. P., 101n, 177n28
Wong, E., 329n
Woo, C. Y., 227n24
Wooldridge, B., 258n18
Wright, P., 101n
Z04_BARN0088_05_GE_NIDX.INDD 384 13/09/14 4:26 PM

385
Barber shop industry, 315
Barrier-busting activities, 59
Barriers to entry
cost-based, 60–62, 134
defined, 58
economies of scale as, 58–59
government policy as, 62
height of, 58, 82n10, 108
product differentiation as, 60
trade barriers, 334–335
Baseball, competitive balance in, 142
Bases of product differentiation, 153–158
Bauxite mining, 282, 291
Beer industry
consolidation of, 131
product differentiation in, 60, 152, 166,
180n1
Belgium, family-dominated firms in, 344
Below average accounting performance,
37, 40
Below normal economic performance, 39, 40
Ben & Jerry’s ice cream, 28
Berkshire Hathaway, 240–241, 251, 263
BIC Corporation, 124, 125–126, 138, 154
Bicycle industry, 156, 166
Bidding firms
returns to, 304–309
rules for managers, 312–317
Bidding wars, 314–315
“Big box” retailers, 63
Biotechnology, 51, 191, 270, 278
“Blue ocean” markets, 171
Blunders, marketing, 332–333
Board chairs, 249
Board of directors, 243–244, 246–247
Bolivia, political risks in, 348
Brand identification, 60
Brand management, 346
Brazil, cultural trends in, 52
“Bricks and clicks” business models, 34
British Airways, 172
Budgeting process, 200, 257
Business angels, 305
Business cycles, 52
Business language standards, 352
Business-level strategies, 29, 124, 184.
See also Cost leadership strategies;
Product differentiation strategies
Business model canvas, 34–35
Business Model Generator (Osterwalder &
Pigneur), 34
Business models, defined, 34
Business plans, 43, 91
Buyers
caveat emptor,163
cost leadership strategies and, 134, 136
defined, 65
nondomestic customers as, 332–337
threats from, 65–66, 160
A
Above average accounting performance,
37, 40, 54
Above normal economic performance, 39,
40, 130, 134
Absorptive capacity, 274
Access to raw materials, 61, 86, 130,
160–161, 338
Accounting performance measures, 33,
36–40, 254–255, 314
Accounting ratios, 33, 36–37
Account receivable turnover ratio, 37
Acquisition premiums, 298
Acquisitions, defined, 298. See also
Mergers and acquisitions
Activity ratios, 37
Activity sharing. See Shared activities
Adverse selection, 278, 279
Africa, marketing blunders in, 333
African Americans, demographic trends
among, 51
Agency problems, 245, 307
Agency relationships, 245
Agents, 245
Agreements
contracts, 288, 289
licensing, 270
standstill, 320–321
supply and distribution, 270
Agriculture industry, 66
Airline industry. See also specific airlines
competition in, 63
hub-and-spoke systems in, 63
product differentiation in, 169, 172
tacit collusion in, 227
Alcohol. See Beer industry; Wine industry
Alignment of business functions and cost
leadership strategies, 145
Alliances. See Strategic alliances
Allocation of capital, 223–225, 228, 234,
257–258
Aluminum industry, 65, 286
Amazon, 24, 49, 50, 56
Ambiguity, causal, 97, 98–99, 118n16
American Express, 27
America Online (AOL), 323
Analysis. See also Opportunity analysis
event study, 308
internal and external, 28–29
value chains, 91–92, 94, 185
Andean Common Market (ANCOM), 351
Angola, political risks in, 348
Angry Birds, 25
Animated motion picture industry, 212, 281
Anticompetitive economies of scope,
226–228, 234
Anti-takeover actions, 320–322
AOL (America Online), 323
Apartheid, 93
Apple Inc.
accounting performance, 37–38
in music download industry, 48–50
organizational structure, 102
resources and capabilities, 87
smartphone applications, 24
strategic alliance with Samsung,
268–269
Appliances (home) industry, 74, 332
Architectural competencies, 157, 167
Argentina, family-dominated firms in, 344
ASEAN (Association of Southeast Asian
Nations), 351
Asia
as context-specific culture, 342
home appliances in, 332
outsourcing to, 182
Assets
intangible, 82n18, 86, 279
strategically valuable, 72
tangible, 86
Association of Southeast Asian Nations
(ASEAN), 351
ATC. See Average total cost
Auctions, 322
Audi, 154, 165
Audit committees, 246
Automotive industry. See also specific
automakers
cost leadership strategies in, 124,
176–177
customer service in, 168
demographic trends influencing, 51
international strategies and, 332, 333,
338
process innovation in, 76
product differentiation in, 152, 154, 165,
176–177
socially complexity resources in, 101
strategic alliances in, 270, 272, 282–283
trade barriers in, 335
Average accounting performance, 37
Average collection period ratio, 37
Average industry performance, 66–67
Average total cost (ATC), 88–89, 135,
160–161
B
Baby boomers, 51
Baby formula industry, 328–329
Backward vertical integration, 66, 136, 184
Balance sheet statements, 33
Bangladesh, manufacturing tragedies in,
339
Banking industry, 306
Bankruptcy
airline industry and, 104, 124
diversification strategies and, 226
mergers and acquisitions and, 307
Subject Index
In the page references, the number after “n” refers to the number of the end note in which the name is cited.
Z05_BARN0088_05_GE_SIDX.INDD 385 17/09/14 5:18 PM

386 Subject Index
corporate diversification strategies and,
219–223, 234
defined, 219
development through international
strategies, 341–343
leveraging in additional markets, 343
limits of, 222–223
Corning, 276–277
Corporate capital allocation, 257–258
Corporate control, market for, 309–310
Corporate diversification strategies,
208–239. See also Corporate diversifi-
cation strategy implementation
anticompetitive economies of scope
and, 226–228
capital allocation and, 223–225, 228,
234, 257–258
core competencies and, 219–223, 234
defined, 210
direct duplication of, 234–235
equity holders and, 229, 231, 233
financial economies of scope and,
223–226
firm size and employee incentives, 229
imitation of, 234–235
levels and types of, 210–213
market power and, 228, 234
motivations for, 141
multipoint competition and,
226–228, 234
operational economies of scope and,
213–223
rarity of, 233–234
risk reduction and, 225–226, 232–233,
343–345
shared activities and, 213, 215–219, 234
substitutes for, 235
sustained competitive advantages and,
231–235
tax advantages of, 226
value of, 213–231
Corporate diversification strategy
implementation, 240–267
allocating corporate capital and, 257–258
board of directors and, 243–244, 246–247
compensation policies and, 262–263
corporate staff in, 249–251
division general managers and, 250,
251–252
institutional owners and, 247–248
management control systems and,
253–262
organizational structure and, 242–253
performance evaluation and, 254–257
senior executives, 244, 248–249
shared activity managers and, 252–253
transferring intermediate products and,
258–260
Corporate governance, 344
Corporate-level strategies, 29, 124, 184.
See also Corporate diversification
strategies; International strategies;
Mergers and acquisitions; Strategic
alliances; Vertical integration
strategies
Corporate risk
management of, 343–345
Corporate spin-offs, 261
product differentiation implementation
and, 169, 174
strategy implementation and, 29–30
vertical integration implementation
and, 201–203
Competencies. See also Core competencies
architectural, 157, 167
distinctive, 103, 104
Competition. See also Environmental
threats; Rivalry
direct, 62–63
firm performance and, 57
monopolistic, 57, 160–161
multipoint, 226–228, 234
perfect, 54, 57
price, 63
Competitive advantages. See also
Sustained competitive advantages;
Temporary competitive advantages
accounting performance and, 33, 36–40
defined, 30, 33, 47n8
economic performance and, 33, 38–40
ethical considerations, 54
external environment and, 48–83 (See
also External environment)
learning-curve economies and, 129–130,
137, 139
measures of, 33, 36–40
resource-based view on, 112
resources and capabilities, 84–119 (See
also Resources and capabilities)
responses by other firms to, 106–110
responsibility for, 110–112
sources of, 30–31
types of, 31
Competitive disadvantages, 31, 37, 39, 40
Competitive dynamics, 106–110
Competitive parity, 31, 37, 39, 40, 112
Complementary resources and capabili-
ties, 101–102
Complementors, 67–68
Complexity. See also Socially complex
resources
of products, 154, 166
of resources, 97, 99–101, 113–114
Computer industry. See also Software
industry
competition in, 62
customer service in, 158
strategic alliances in, 280
supplier leverage in, 64
switching costs in, 72
vertical integration in, 184
Conduct, defined, 54
Conflict resolution, 198–199
Conglomerate mergers, 301–302
Consolidation strategies, 70–71, 316
Consumer electronics industry, 61–62, 78,
102, 109, 276, 346
Consumer marketing, 156, 166
Consumers. See Buyers
Contracts in strategic alliances, 288, 289
Controlling shares, 298
Convenience food industry, 74
Cooperation, tacit, 107–108, 119n30
Coordinated federations, 357–359
COOs (chief operating officers), 249
Core competencies
C
Cable television, 67–68
Call centers, 192–194
Campgrounds industry, 70–71
Canada, family-dominated firms in, 344
Canada Dry, 158
Can manufacturers, 65, 66, 128
Capabilities. See Resources and
capabilities
Capabilities-based theory of the firm,
207n4
Capital
allocation of, 223–225, 228, 234, 257–258
cost of, 38–39
sources of, 39
CAR (cumulative abnormal return), 308
Cars. See Automotive industry
Cash bonuses, 203
Cash flow per share ratio, 36
Cashing out, 305, 345
Casio, 107, 124, 152
Casual dining restaurants, 74
Causal ambiguity, 97, 98–99, 118n16
Caveat emptor (buyers beware), 163
CBS Sports Network, 56
Cell phone industry, 24–26
Centralized hubs, 358, 359
CEOs. See Chief executive officers
Chairman of the board, 244
Channels of distribution, 158, 167–168
Charles Schwab brokerage firm, 132, 172
Cheating in strategic alliances, 278–282,
284, 288–291
Chief executive officers (CEOs), 143,
144–145, 198–201, 246–247, 249,
262–263
Chief operating officers (COOs), 249
Chile, political risks in, 348
China
baby formula industry in, 328–329
cultural trends in, 52
labor costs in, 339, 340
management styles in, 355
marketing blunders in, 332
Choices, strategic, 29
Chrysler
mergers, 299, 323
product differentiation by, 154, 165
strategic alliances, 270, 282, 283
Closely held firms, 298
Closing deal quickly, 315
Coca-Cola Corporation
distribution channels, 158
divisional performance of, 257
international strategies, 332
product differentiation by, 157
Collective learning, 219
Collusion, 107, 227–228, 275, 277
Commitment, escalation of, 139, 225
Compaq Computer Corporation, 280
Compensation policies
corporate diversification implementa-
tion and, 262–263
cost leadership implementation and,
143, 146
defined, 101
international strategy implementation
and, 359
Z05_BARN0088_05_GE_SIDX.INDD 386 17/09/14 5:18 PM

Subject Index 387
Divisions, 242–243
Dominant-business firms, 211
Dominant logic, 222
Drug industry. See Pharmaceutical
industry
Dry-cleaning industry, 315
DuPont, 71, 276
E
Earnings per share (EPS) ratio, 36
Easy-to-duplicate cost advantages,
138–139
Easy-to-duplicate product differentiation
strategies, 164–165
eBay, 86, 87, 301
EC (European Community), 351
Economic climate, 52
Economic performance, 33, 38–40, 135,
255–256
Economic profits, 303–304, 309. See also
Zero economic profits
Economics
of land, 88–89
of product differentiation strategies,
160–161
Ricardian, 88–89
transactions cost, 206n2
Economic value, defined, 30, 33
Economic value added (EVA), 255–256
Economies of scale
as barrier to entry, 58–59
defined, 58, 125, 271
duplication of, 138
learning-curve cost advantages and,
128–129
size differences and, 125–127, 137
Economies of scope, 213–231
anticompetitive, 226–228, 234
defined, 213
divisional performance and, 256–257
equity holders and, 229, 231
evaluation of, 82n11
financial, 223–226, 228, 234
firm size and employee incentives, 229
operational, 213–223, 234
types of, 213, 214
value of, 214–215
Education, primary and secondary, 62
Efficient size, physical limits to, 127
Electric power generation industry, 62
Elementary education industry, 62
Eli Lilly, 182, 183
Emergent strategies, 40–43
Emerging industries, 71–73, 162
Employees
empowerment of, 113
incentives to diversify, 229
low-cost access to, 133, 338–340
motivation of, 128
specialization and volume of
production, 126–127
English as standard business language, 352
Enterprise software, 156, 166
Entrepreneurial firms
business plans and, 43, 91
cashing out, 305
emergent strategies and, 43
international strategies and, 330
Cultural trends, 52
Cumulative abnormal return (CAR), 308
Cumulative volume of production,
128–129, 137
Currency risks, 336–337, 347–348
Current market value, 299
Current ratio, 36
Customers
firms, relationship with, 155–156
loyalty of, 60
nondomestic, 332–337
perceptions of, 152–153
wealth of, 335–336
Customer service, 74, 158, 168
Customer-switching costs, 72–73
Customization of products, 155–156, 166
D
Dairy market, 328–329
Debt, defined, 39
Debt capacity, 226
Debt to assets ratio, 36
Debt to equity ratio, 36
Decentralized federations, 357, 359
Decision-making
guidelines for, 171–172
uncertainty in, 191, 196–197, 277–278
Decline stage of product life cycles, 337
Declining industries, 76–78, 162
Deep-pockets model of diversification, 228
Defense industry, 65–66, 78
Deliberate strategies, 41
Dell Computer, 196, 227
Demographic trends, 51–52
Denmark, family-dominated firms in, 344
Depressions, economic, 52
Differential low-cost access to productive
inputs, 130, 137, 140
Difficult-to-implement strategies, 112–113
Digital technologies, 51, 107
Direct competition, 62–63
Direct duplication. See also Imitation
of corporate diversification strategies,
234–235
of cost leadership strategies, 138–141
imitation and, 96–97
of international strategies, 352–353
of product differentiation strategies,
164–168
of strategic alliances, 283
of vertical integration strategies, 197
“Direct” retail business models, 34
Diseconomies of scale, 58, 127–128, 137,
138–139
Disney Company. See Walt Disney
Company
Distance to markets and suppliers, 128
Distinctive competencies, 103, 104
Distribution agreements, 270
Distribution channels, 158, 167–168,
333–334
Diversification economies, 302
Diversification strategies. See Corporate
diversification strategies
Diversified media companies, 25
Divestment, 78
Divisional performance, 254–257
Division general managers, 250, 251–252
Corporate staff, 249–251
Cost advantages
as barrier to entry, 60–62
experience differences and, 128–130
imitability of, 137–141
learning-curve economies and, 61–62,
128–130, 137, 139
policy choices and, 132, 137, 139–140
productive inputs, differential low-cost
access to, 130, 137, 140
rarity of, 136–137
size differences and, 125–128, 137
sources of, 60–62, 124–132
technological advantages and,
131–132, 137
Cost-based barriers to entry, 60–62, 134
Cost centers, 252–253
Cost leadership strategies, 122–149.
See also Cost advantages
compensation policies and
implementation of, 143, 146
defined, 124
direct duplication of, 138–141
economic performance and, 135
environmental threats and, 134, 136
formulation of, 144–145
imitation of, 137–141
implementation of, 141, 143–146
management control systems and
implementation of, 143, 145–146
misalignment between business
functions and, 145
organizational structure and
implementation of, 143–145
product differentiation strategies and,
174–177
rarity of, 136–137
substitutes for, 134, 141
sustained competitive advantages and,
136–141
value of, 133–134, 136
Costly-to-duplicate cost advantages,
139–141
Costly-to-duplicate product differentiation
strategies, 165–168
Costly-to-imitate resources and capabilities,
96, 102, 104, 106, 111
Costs
average total cost (ATC), 88–89, 135,
160–161
of capital, 38–39
of debt, 39
of equity, 39
marginal cost (MC), 88–89, 135, 160–161
overhead, 127
reduction of, 338–340
of switching, 72–73
Countertrade, 336, 337
Craft beers, 152, 180n1
Creativity and product differentiation,
158–159, 172
Cross-divisional/cross-functional
development teams, 170
Cross-equity investments, 288
Cross-subsidization, 228
Crowd sourcing, 24
Crown jewel sales, 321
Cultural differences, 319, 323, 355–356
Z05_BARN0088_05_GE_SIDX.INDD 387 17/09/14 5:18 PM

388 Subject Index
single-business, 211
size differences, impact of, 125–128,
137, 229
strengths and weaknesses, identifica-
tion of, 89–90, 103–104
venture capital, 305
visionary, 27
Firm-specific investments, 201–202,
232–233
First-mover advantages, 71–73
First-mover disadvantages, 73
Flexibility
defined, 190
product differentiation strategies and,
172
strategic alliances and, 191
supplier industry domination and, 64
vertical integration and, 190–191,
193–194, 202, 203
Food and Drug Administration (FDA), 163
Food industry. See also Fast-food industry
grocery stores, 73, 106, 218
international strategies and, 333, 353
restaurant industry, 41, 74
suppliers, 66
threat of substitutes in, 63
Ford Motor Company
mission, 27
strategic alliances, 270, 282, 283
transnational structure, 359
Foreign direct investment, 354
Formal management controls, 101
Formal reporting structures, 100–101
Forward vertical integration, 65, 184
Fox Sports, 56, 96
Fragmented industries, 70–71, 161, 316
France, cultural trends in, 52
Franchise business models, 34
Free cash flow, 219–220, 306–307
Free-trade zones, 351–352
Friendly acquisitions, 298
FTC (Federal Trade Commission), 300–302
Functional conflicts, 198–199
Functional managers, 143, 144, 198–201
Functional organizational structure,
143–145, 170, 198–201. See also
U-form organizational structures
Funeral home industry, 70, 316–317
G
General Agreement on Tariff and Trade
(GATT), 351
General Electric (GE)
corporate diversification by, 213, 219
customer service, 168
divestment approach used by, 78
divisions of, 242
harvest strategy used by, 78
international strategies, 331, 346
niche strategy used by, 77
operating principles of, 241
General environment, 50–53
General Motors (GM)
divisions of, 243
international strategies, 331, 332, 340
product differentiation by, 154, 165
shared activities used by, 216, 218
strategic alliances, 270, 272, 274, 282–283
External environment, 48–83. See also
Environmental opportunities;
Environmental threats
general environment, elements of,
50–53
industry structure and opportunities,
69–78
structure-conduct-performance (S-C-P)
model and, 55–57, 69, 81n7
threats to, 55–68
Externalities, 93
Extreme sports, 95, 96–98, 102
F
Family-dominated firms, 344
Fast casual dining restaurants, 74
Fast-food industry. See also specific
restaurants
competition in, 62
consolidation of, 71
customer service in, 74, 168
maturity of, 73–74
refinement of current products in, 74
as thinly traded market, 315
Favorable access to raw materials, 61
FDA (Food and Drug Administration), 163
Federal Trade Commission (FTC), 300–302
FedEx, 40
Fiat, 124
Finance committees, 246
Financial economies of scope, 223–226,
228, 234
Financial resources, 86
Financial risks of international strategies,
347–348
Firm performance
competition and, 57
environmental threats influencing,
66–67
globalization and, 332–337
industry and firm characteristics, im-
pact on, 69
market share, relationship with, 131
mission impacting, 27–28
resource-based view (RBV) of, 86–89, 101
socially complexity resources and, 101
structure-conduct-performance (S-C-P)
model of, 55–57, 69, 81n7
valuable resources and, 90
Firms. See also Bidding firms;
Entrepreneurial firms; Target firms
closely held, 298
competitive advantages, responsibility
for, 110–112
customer relationship as product dif-
ferentiation, 155–156
dominant-business, 211
external environment, 48–83 (See also
External environment)
family-dominated, 344
links within and between as product
differentiation, 157–158, 166, 167
multinational, 230
privately held, 39, 298, 314, 345
publicly traded, 313–314
reputation of, 156, 167, 289–290
resources and capabilities, 84–119
(See also Resources and capabilities)
Entry, facilitation through strategic
alliances, 275–278. See also Barriers
to entry
Environment, general, 50–53. See also
External environment
Environmental opportunities, 69–78
in declining industries, 76–78, 162
in emerging industries, 71–73, 162
in fragmented industries, 70–71,
161, 316
in mature industries, 73–76, 162
product differentiation and, 161–162
Environmental threats, 55–68. See also
Barriers to entry
average industry performance
estimated by, 66–67
buyers’ influence, 65–66, 160
complementors, 67–68
cost leadership strategies and, 134, 136
defined, 56
existing competitors, 62–63
new competitors, 56, 58–62, 159
product differentiation and, 159–160
S-C-P model and, 55–57, 69, 81n7
to strategic alliances, 278–282
substitute products, 63, 159
supplier leverage, 64–65, 159–160
EPS (earnings per share) ratio, 36
Equipment and plant, 86, 126
Equity
alliances, 270, 288
defined, 39
holders, 229, 231, 233, 245
investments, 288
Escalation of commitment, 139, 225
ESPN
corporate diversification by,
208–210, 241
organizational structure, 102
resources and capabilities, 95, 96–98
Ethics and Strategy (feature)
CEO salaries, 262–263
cheating on strategic alliances, 284
competitive advantages, 54
externalities and consequences of profit
maximization, 93
globalization and multinational
firms, 230
labor, low-cost access to, 133
manufacturing tragedies and
international business, 339
outsourcing, 195
product claims in health care, 163
stockholders vs. stakeholders, 42
Ethiopia, political risks in, 348
European Community (EC), 351
EVA (economic value added), 255–256
Event study analysis, 308
Executive committees, 200–201
Existing competitors, threats from,
62–63
Exit, facilitation through strategic
alliances, 275–278
Experience differences, 128–130
Experimentation policies, 172
Explicit collusion, 107, 275
Exporting, 335, 354–355
External analysis, defined, 28–29
Z05_BARN0088_05_GE_SIDX.INDD 388 17/09/14 5:18 PM

Subject Index 389
Institutional owners, 247–248
Intangible assets, 82n18, 86, 279
Intended strategies, 40–43
Intent to learn, 341–342
Intermediate market exchanges, 355–356
Intermediate products, 258–260
Internal analysis, defined, 28–29
Internal capabilities. See Resources and
capabilities
Internal capital markets, 223–225, 238n21,
257–258
Internal management committees,
200–201
International events, 53
International integration, 345–347, 359
International operations, learning from,
341–342
International strategies, 328–363. See also
Globalization
compensation policies and
implementation of, 359
core competencies, development and
leveraging of, 341–343
defined, 330
direct duplication of, 352–353
ethical considerations, 339
financial risks of, 347–348
hierarchical governance and, 356
history of, 330–331
imitation of, 352–353
implementation of, 354–359
local responsiveness/international
integration trade-off, 345–347, 359
low-cost production factors, gaining
access to, 338–340
to manage corporate risk, 343–345
management control systems and
implementation of, 359
market exchanges and, 354–356
new customers, gaining access to,
332–338
organizational structure and
implementation of, 357–359
political risks of, 348–350
rarity of, 351–352
research on, 350
strategic alliances and, 355–356
substitutes for, 353
sustained competitive advantages and,
351–353
transnational strategies, 347
value of, 331–345
Internet
search engines, 84–85
smartphone applications and, 24–25
Introduction stage of product life
cycles, 337
Invented competencies, 223
Inventory turnover ratio, 37
Investments
equity, 288
firm-specific, 201–202, 232–233
human capital, 232, 233
transaction-specific, 187–189, 192–193,
196, 201, 280–282
Invisible hand, 185
iPhones, 24
IPOs (initial public offerings), 261, 305
Honda, 343, 345
Hong Kong, family-dominated firms
in, 344
Horizontal mergers, 301
Hostile takeovers, 298
Hotel/motel industry, 71, 167
HP. See Hewlett-Packard
Hub-and-spoke systems, 63
Hubris hypothesis, 309
Human capital investments, 232, 233
Human resources, 86–87, 101
I
IBM
international strategies, 346
mission, 27
product differentiation by, 166, 169
shared activities used by, 216
Illegal immigrants, 133
Imitation. See also Direct duplication;
Substitutes
causal ambiguity and, 97, 98–99, 118n16
of corporate diversification strategies,
234–235
of cost leadership strategies, 137–141
direct duplication and substitution,
96–97
of international strategies, 352–353
patents and, 97, 100, 165
of product differentiation strategies,
164–169
of resources and capabilities, 95–100
as response to competitive
advantages, 109
social complexity and, 97, 99–101,
113–114
sources of costly imitation, 97–100
of strategic alliances, 283, 285–287
unique historical conditions and, 97–98
of vertical integration strategies, 197
Immigrants, 133
Imperfectly imitable resources, 95
Implementation. See Strategy
implementation
Incentives, 229
Increasing returns to scale, 273
India
outsourcing to, 182–183, 189, 190
trade barriers in, 335
Industry structure. See also specific industries
competitive dynamics in, 106–110
conduct and performance impacted
by, 55
declining, 76–78, 162
emerging, 71–73, 162
environmental opportunities and,
69–78
firm performance, impact on, 69
fragmented, 70–71, 161, 316
mature, 73–76, 162
Inelastic in supply, 88, 89
Inflation, 347–348
Informal management controls, 101
Information technologies, 132, 157–158,
166, 193
Initial public offerings (IPOs), 261, 305
Innovation, 74–76
Institutional investors, 248
Generation Y, 51
Generic business strategies, 124. See also
Cost leadership strategies; Product
differentiation strategies
Generic value chains. See Value chains
Geographic location, 86
Geographic market diversification
strategies, 210
Germany, cultural trends in, 52
Globalization. See also International
strategies
cost reduction and, 338
family firms and, 344
firm revenues and, 332–337
multinational firms and, 230
opposition to, 42
product life cycles and, 337–338
GM. See General Motors
“Going it alone” strategies, 285–286
Golden parachutes, 322
“Gold standard” of drug approval, 163
Google
acquisitions by, 296–297
resources and capabilities, 84–85
smartphone applications, 24–25
Gore-Tex, 221
Governance, corporate, 344
Government policy as barrier to entry, 62
Gravity Games, 96
Greece, family-dominated firms in, 344
Greenmail, 320
Grocery store industry, 73, 106, 218
Gross profit margin ratio, 36
Growth stage of product life cycles, 337
Guitar string industry, 221
H
Hair salon industry, 315
Hard currencies, 336–337
Hardware, technological, 132, 137, 139
Harpo, Inc., 199
Harvest strategies, 77–78
HBO, 272–273
Health care industry. See also Medical in-
dustry; Pharmaceutical industry
costs, 93
marketing strategies for product differ-
entiation, 170
product claims and ethical dilemmas,
163
Hedonic prices, 155
Height of barriers to entry, 58, 82n10, 108
Herbal treatments, 163
Hewlett-Packard (HP)
international strategies, 340
mergers, 323
mission, 27
multipoint competition used by,
226–227
shared activities used by, 216
Hierarchical governance, 356
High-quality objectives, 28
Hispanics, demographic trends among, 51
Historical conditions, 97–98
Holdups, 278, 280–282
Home appliance industry, 74, 332
Home detergent industry, 74
Home financial planning, 63
Z05_BARN0088_05_GE_SIDX.INDD 389 17/09/14 5:18 PM

390 Subject Index
growth rate of, 73–74, 83n44
international strategies, 336
refinement of current products, 74
McKinsey value chain, 94
Medical industry
diagnostics business, 276–277
false claims and ethical dilemmas, 163
health care costs, 93
imaging as emerging industry, 71
information technology in, 132
product strategies, 41, 219, 221
Melamine poisonings, 328–329
Mercedes-Benz, 154, 165
Merck, 182, 183, 270
Mergers and acquisitions, 296–327
bidding firm managers, rules for, 312–317
defined, 298–299
evaluating performance effects of, 308
implementation of, 318–319, 323–324
post-acquisition coordination and
integration, 318–319
reasons for engaging in, 306–307, 309
of related firms, 300–304
returns to bidding and target firms,
304–309
as substitute for strategic alliances,
286–287
sustained competitive advantages and,
309–318
target firm managers, rules for, 317–318
types of, 301–302
unexpected valuable economies of scope
between bidding and target firms, 312
of unrelated firms, 299–300
value, rarity, and economies of scope,
310–312
value of, 299–304
Mexico
family-dominated firms in, 344
labor costs in, 339, 340
maquiladoras, 340
M-form organizational structures
agency problems and, 245
allocating corporate capital in, 257–258
board of directors in, 243–244, 246–247
corporate staff in, 249–251
division general managers in, 250,
251–252
institutional owners in, 247–248
performance evaluation in, 254–257
post-merger integration and, 319
senior executives in, 244, 248–249
shared activity managers in, 252–253
structure and function of, 242, 266n1
transferring intermediate products in,
258–260
Microbrewery beers, 152, 180n1
Microsoft
ethics and strategy, 54
maturity of, 75
mergers, 323
product differentiation by, 154
supplier leverage of, 64
Middle East, political risks in, 348
Mini-mill technology, 59, 137, 144
Mining industry, 282, 291
Misalignment of business functions and
cost leadership strategies, 145
Loyalty of customers, 60
Lubatkin’s list of sources of strategic
relatedness, 302
M
Major League Baseball, competitive
balance in, 142
Malaysia, labor costs in, 339, 340
Mall development, 158, 166
Management committee oversight
process, 200–201
Management control systems
corporate diversification implementation
and, 253–262
cost leadership implementation and,
143, 145–146
defined, 101
formal vs. informal, 101
international strategy implementation
and, 359
product differentiation implementation
and, 169, 170–173
strategy implementation and, 29–30
vertical integration implementation
and, 200–201
Managerial diseconomies, 127–128
Managerial hubris, 309
Managerial know-how, 61, 82n18
Managerial perquisites, 245
Managerial risk aversion, 245
Managers
agency relationships and, 245
bidding firms, 312–317
division general, 250, 251–252
functional, 143, 144, 198–201
sales vs. manufacturing, 198
shared activity, 252–253
target firms, 317–318
Manufacturing
industries, 129, 132
managers, 198
tragedies in, 339
Maquiladoras, 340
Marginal cost (MC), 88–89, 135, 160–161
Marginal revenue (MR), 88, 135, 160–161
Market-determined price, 135
Market exchanges, 354–356
Market extension mergers, 301
Market for corporate control, 309–310
Marketing blunders, 332–333
Marketing to consumers, 156, 166
Market leadership, 76–77, 108
Market niche, 77, 160, 161
Market power, 228, 234
Markets, distance to, 128
Market share, 131, 176
Marriott Corporation, 41
Matrix structures, 144, 170
Mature industries, 73–76, 162
Maturity stage of product life cycles, 337
Mazda
product differentiation by, 154
strategic alliances, 270, 282, 283
MC. See Marginal cost
McDonald’s Corporation
business strategies, 176
consolidation strategy of, 71
customer service, 168
Israel, family-dominated firms in, 344
Italy, marketing blunders in, 332
iTunes, 48–50
J
Jaguar, 154
J&J. See Johnson & Johnson
Japan
automotive industry in, 76, 335
business and government, relationship
between, 53
cultural trends in, 52
labor costs in, 339, 340
management styles in, 355–356
retail distribution networks in, 334
trade barriers in, 335
Jensen & Ruback’s list of sources of
strategic relatedness, 302–303
Jet industry, 63
Johnson & Johnson (J&J)
compensation packages at, 263
core competencies of, 219, 221–222
corporate staff, 251
emergent strategy of, 41
Joint ventures, 271, 277, 278, 290–291
K
Kampgrounds of America (KOA), 70–71
Kitchen appliance industry, 74, 332
Knowledge as resource, 99
KOA (Kampgrounds of America), 70–71
L
Labor. See Employees
Land, economics of, 88–89
Latin America, marketing blunders in, 332
Laundry detergent, 109
Lawn mowers, 343, 345
Leadership, market, 76–77, 108
Lean manufacturing, 272, 274
Learning
from international operations, 341–342
receptivity to, 342
transparency and, 342
Learning-curve economies, 61–62,
128–130, 137, 139
Learning races, 272, 274
Legal and political conditions, 52–53
Legal sanctions, 288
Leverage ratios, 36, 37
Leveraging core competencies, 343
Licensing agreements, 270
Life cycles of products, 337–338
Limited corporate diversification,
210–211
Linkages within and between firms,
157–158, 166, 167
Liquidity ratios, 36, 37
Local responsiveness, 345–347, 359
Location-based product differentiation,
154–155, 167
Lockheed Corporation, 170
Logic, dominant, 222
Logitech, 330
“Low-cost centers,” 133
Low-cost leadership, 176
Low-cost production factors, 338–340
Low-quality objectives, 28
Z05_BARN0088_05_GE_SIDX.INDD 390 17/09/14 5:18 PM

Subject Index 391
PepsiCo
corporate diversification by, 212
distribution channels, 158
international strategies, 332
product differentiation by, 156
Perceptions of customers, 152–153
Perfect competition, 54, 57
Performance. See also Firm performance
defined, 54–55
divisional, 254–257
measures of, 33, 36–40, 254–256
Personal computer industry. See
Computer industry
Personnel and compensation committees,
246
Peru, political risks in, 348
PEZ Candy, Inc., 41–42
Pharmaceutical industry
competitive advantages in, 32
“gold standard” of drug approval, 163
international strategies in, 346
managerial know-how in, 61
outsourcing of research and
development in, 182–183, 189, 190
patents in, 100
product differentiation in, 157, 167
reverse engineering in, 182–183
strategic alliances in, 270, 278
switching costs in, 72
vertical integration in, 191
Philip Morris, 27, 307
Philippines
low-cost manufacturing in, 330
outsourcing to, 182
Philips, 276, 345
Photography market, 335
Physical limits to efficient size, 127
Physical resources, 86
Physical standards, 332
Physical technology, 100
Pixar, 279, 281
Plant and equipment, 86, 126
Poison pills, 321
Policies. See also Compensation policies
cost advantages and, 132, 137, 139–140
of experimentation, 172
government regulation, 62
Political and legal conditions, 52–53
Political risks of international strategies,
348–350
Pollution, 93
Porsche, 154
Portugal, family-dominated firms in, 344
Post-merger coordination and integration,
318–319
Predatory pricing, 228
Price competition, 63
Price earnings ratio, 36
Price takers, 135
Pricing, predatory, 228
Primary education industry, 62
Principal in agency relationships, 245
Printing industry, 315
Prisoner’s Dilemma, 284
Privately held firms, 39, 298, 314, 345
Processes, defined, 74
Process innovations, 74–76
Process manufacturing, 126
Office of the president, 249
Office-paper industry, 161
Offshoring, 196, 197. See also Outsourcing
Oil industry
first-mover advantages in, 72
opportunism and transaction-specific
investments in, 187–189
productive inputs, differential low-cost
access to, 130
value chain activities in, 92, 94, 185
Oligopolies, 57, 108, 301
Operational economies of scope, 213–223
core competencies and, 219–223, 234
shared activities and, 213, 215–219, 234
Operations committees, 200, 201
Opportunism, 187–189, 192, 201–203, 285
Opportunity analysis, 69–78
in declining industries, 76–78
in emerging industries, 71–73
in fragmented industries, 70–71, 161,
316
in mature industries, 73–76
Oprah, Inc., 199
Organization
of international strategies, 354–359
of resources and capabilities, 100–102
role of, 114
Organizational charts, 101
Organizational contradictions, 176–177
Organizational cultures, 113, 139, 319
Organizational resources, 87
Organizational structures. See also M-form
organizational structures; U-form
organizational structures
corporate diversification implementa-
tion and, 242–253
cost leadership implementation and,
143–145
international strategy implementation
and, 357–359
product differentiation implementation
and, 169, 170
resource-based view on, 114
strategy implementation and, 29–30
vertical integration implementation
and, 198–199
Outplacement companies, 195
Outsourcing
of call centers, 192, 193
ethical considerations, 195
of research and development, 182–183,
189, 190
vertical dis-integration and, 197
Overhead costs, 127
Oversight process, 200–201
P
Pac Man defense, 321
Pandora, 49, 50, 63
Paper industry, 161
Patents
imitation and, 97, 100, 165
infringement, 61
protection of, 71
Path dependence, 98, 118n15
Pebble Beach, 140
Pecuniary economies, 302
People management. See Employees
Mission/mission statements, 27–28
Mitsubishi Motors
centralized hubs, 358
international strategies, 340
strategic alliances, 270, 282, 283
Mix of products, 157–158, 166
Mobile phone industry, 24–26
Monopolies, 57, 62, 301
Monopolistic competition, 57, 160–161
Moral hazards, 278, 279–280
Motel industry, 71, 167
Motion picture industry, 212, 281
Motivation of employees, 128
Motorola, 27, 85, 297, 340
Mountain Dew, 156, 166
MP3 market, 102
MR. See Marginal revenue
MTV programming, 156
Muffler repair industry, 71
Multidivisional organizational structure.
See M-form organizational structure
Multinational firms, 230
Multipoint competition, 226–228, 234
Music download industry
buyers in, 65
competition in, 49, 56
growth of, 48–49
substitutes in, 49, 63
suppliers in, 64
Music streaming services, 49
Mutual forbearance, 227–228
N
NAFTA (North American Free Trade
Agreement), 351
NASCAR, 157, 180n10
NBC Sports Network, 56, 96
Negative externalities, 93
Nestlé
corporate diversification by, 219, 235
divisions of, 242–243
international strategies, 331, 334, 345–346
Network industries, 273
New competitors, threats from, 56,
58–62, 159
New customers, international strategies
for gaining access to, 332–338
New Zealand, family-dominated firms
in, 344
Niche strategies, 77
Nigeria, political risks in, 348
9/11 attacks (2001), 53
Nissan, 51, 154
Nominating committees, 246
Nondomestic customers, 332–337.
See also International strategies
Nonequity alliances, 270, 288
Nontariff trade barriers, 334, 335
Nordstrom, 174
Normal economic performance, 39
North American Free Trade Agreement
(NAFTA), 351
Nucor Steel, 144, 145–146
O
Oakland A’s, 142
Objectives, defined, 28
Occupy Movement, 230
Z05_BARN0088_05_GE_SIDX.INDD 391 17/09/14 5:18 PM

392 Subject Index
on competitive parity and advantages, 112
components of, 86–87
on difficult-to-implement strategies,
112–113
human resource practices and, 101
implications of, 110–114
on organizational structure, 114
origins of, 117n1
of responsibility for competitive
advantages, 110–112
Ricardian economics and, 88–89
on socially complex resources, 113–114
Resource heterogeneity, 87
Resource immobility, 87
Resources and capabilities, 84–119. See also
Resource-based view (RBV); VRIO
framework
categories of, 86–87
competitive dynamics in industry,
106–110
complementary, 101–102
defined, 86
evaluation of, 113
imitation of, 95–100
organization of, 100–102
rarity of, 94–95
social complexity of, 97, 99–101, 113–114
socially complex, 97, 99–101, 113–114, 202
value of, 89–92, 94
vertical integration and, 189–190, 193,
196, 202, 203, 286
Responsibilities
board of directors, 243–244, 246–247
chief executive officers (CEOs), 143,
144–145, 198–201, 246–247, 249,
262–263
corporate staff, 249–251
division general managers, 250, 251–252
institutional owners, 247–248
office of the president, 249
senior executives, 244, 248–249
shared activity managers, 252–253
socially responsible firms, 93
Restaurant industry, 41, 74. See also
Fast-food industry; specific restaurants
Retail industry
buyers in, 66
product differentiation in, 158, 162, 166
vertical integration in, 190
Retained earnings, 86, 305
Return on assets (ROA) ratio, 36
Return on equity (ROE) ratio, 36
Revenue, marginal, 88, 135, 160–161
Reverse engineering, 100, 109, 182–183
Ricardian economics, 88–89
Risk
corporate, 343–345
currency, 336–337, 347–348
financial, 347–348
political, 348–350
Risk aversion, 245
Risk reduction, 225–226, 232–233, 343–345
Rivalry. See also Competition
strategies for reducing, 107–108
threat of, 56, 58–62, 134, 159
ROA (return on assets) ratio, 36
ROE (return on equity) ratio, 36
Rolex, 107, 152
Q
Question of imitation. See Imitation
Question of organization. See Organization
Question of rarity. See Rarity
Question of value. See Value
Quick ratio, 36
Quotas, 334, 335
R
“Race to the bottom,” 133
R&D. See Research and Development
Rarity
of corporate diversification strategies,
233–234
of cost leadership strategies, 136–137
of international strategies, 351–352
of product differentiation strategies,
162–163
of resources and capabilities, 94–95
of strategic alliances, 282–283
of vertical integration strategies,
195–197
Ratios, accounting, 33, 36–37
Raw materials, access to, 61, 86, 130, 338
RBV. See Resource-based view
Realized strategies, 41
Real options, 207n5, 278
Receptivity to learning, 342
Recessions, economic, 52
Refinement of current products, 74
Regulated firms, 239n31
Related-constrained corporate
diversification, 212
Related corporate diversification, 210–212
Related firms, mergers and acquisitions
of, 300–304
Related-linked corporate
diversification, 212
Reporting structures, 100–101, 144
Reputation of firms, 156, 167, 289–290
Research and Development (R&D)
institutional owners and, 248
outsourcing of, 182–183, 189, 190
Research Made Relevant (feature)
board of directors, effectiveness of,
246–247
empirical tests of theories of vertical
integration, 192
family firms in global economy, 344
firm performance, impact of industry
and firm characteristics on, 69
firm performance and market share,
relationship between, 131
product differentiation, bases of, 155
strategic alliances, tacit collusion
facilitated by, 275, 277
strategic human resources
management, 101
sustained competitive advantages, 32
value of economies of scope, 214–215
wealth effects of management responses
to takeover attempts, 320–322
Research Triangle, 130
Residual claimants, 42
Resolving functional conflicts, 198–199
Resource-based view (RBV). See also VRIO
framework
assumptions of, 87
Procter & Gamble
cost advantages, 71
demographic trends influencing, 51
international strategies, 334
shared activities used by, 215
tactics used by, 109
Product bundles, 217–218
Product complexity, 154, 166
Product customization, 155–156, 166
Product differentiation strategies,
150–180
attributes as, 153–155
as barrier to entry, 60
bases of, 153–158
compensation policies and
implementation of, 169, 174
cost leadership strategies and,
174–177
creativity and, 158–159, 172
customer perceptions and, 152–153
defined, 60, 152
direct duplication of, 164–168
economics of, 160–161
environmental opportunities and,
161–162
environmental threats and, 159–160
firm-customer relationship as,
155–156
imitability of, 164–169
implementation of, 169–174
links within and between firms as,
157–158, 166, 167
location-based, 154–155, 167
management control systems and
implementation of, 169, 170–173
organizational structure and
implementation of, 169, 170
rarity of, 162–163
service and support as, 158, 168
substitutes for, 168–169
sustained competitive advantages
and, 162–169
timing-based, 154, 167
value of, 159–162
Product diversification strategies, 210
Product extension mergers, 301
Product innovation, 75
Production capacity, 63
Production factors, low-cost, 338–340
Production volume. See Volume of
production
Productive inputs, differential low-cost
access to, 130, 137, 140
Product life cycles, 337–338
Product-market diversification
strategies, 210
Product mix, 157–158, 166
Product refinement, 73–74, 79
Product standards, 346–347
Profitability ratios, 36, 37
Profit-and-loss centers, 242–243
Profit centers, 253
Profit maximization, 93
Proprietary technology, 60–61
Prosperity from cheating, 284
Public health externalities, 93
Publicly traded firms, 313–314
Public school systems, 62
Z05_BARN0088_05_GE_SIDX.INDD 392 17/09/14 5:18 PM

Subject Index 393
international strategies and, 355–356
joint ventures, 271, 277, 278, 290–291
moral hazards in, 278, 279–280
motivations for, 141
nonequity alliances, 270, 288
product differentiation through, 157
rarity of, 282–283
as substitute for diversification, 235
substitutes for, 285–287
sustained competitive advantages and,
282–283, 285–287
tacit collusion facilitated by, 275, 277
threats to, 278–282
trust in, 291–292, 295n29
value of, 271–278
Strategically valuable assets, 72
Strategic choices, 29
Strategic human resources
management, 101
Strategic management process, 24–47.
See also Competitive advantages;
Strategies
business model canvas for, 34–35
defined, 26–27
external and internal analysis in, 28–29
external environment and, 48–83
(See also External environment)
importance of studying, 44
mission and mission statements, 27–28
objectives of, 28
organizing framework for, 32–33
in smart phone applications industry,
24–26
strategic choices and implementation
in, 29–30
Strategic relatedness, 300–303
Strategies. See also Business-level
strategies; Corporate-level strategies;
Strategic management process
changes in response to competitive
advantages, 110
consolidation, 70–71, 316
defined, 26, 47n1
deliberate, 41
difficult-to-implement, 112–113
emergent vs. intended, 40–43
formulation of, 248
“going it alone,” 285–286
harvest, 77–78
implementation of, 29–30
importance of studying, 44
niche, 77
realized, 41
technological leadership, 71–72
“tit-for-tat,” 284
transnational, 347
unrealized, 41
Strategy implementation.
See also Corporate diversification
strategy implementation
cost leadership, 141, 143–146
international strategies, 354–359
mergers and acquisitions, 318–319,
323–324
product differentiation, 169–174
senior executives and, 249
strategic alliances, 287–292
vertical integration, 198–203
Sony Corporation
international strategies, 333
mission, 27
organizational structure, 102
resources and capabilities, 90
tactics used by, 109
South Africa, apartheid in, 93
South America, marketing blunders in, 332
South Korea
family-dominated firms in, 344
labor costs in, 339, 340
Southwest Airlines
concerns for, 119n29
human resources and people-
management capabilities, 87, 105–106
operational choices, 105
organizational resources, 87
product differentiation by, 169
VRIO framework analysis of, 104–106
Spain, marketing blunders in, 332
Specialized machines, 125–126
Specific international events, 53
Spin-offs, corporate, 261
Sports television industry. See also ESPN
buyers in, 65
competition in, 56, 62, 94–96
substitutes for, 63
suppliers in, 64
Spotify, 49, 50, 63
Staff, corporate, 249–251
Stakeholders, 42, 232–233
Standards
business language, 352
physical, 332
product, 346–347
technical, 330
Standstill agreements, 320–321
Steel industry
access to raw materials, 61
barriers to entry, 59
cost leadership strategies in, 144
joint ventures in, 277
management control systems in,
145–146
substitutes in, 65
technological advantages in, 132, 137
Stewardship theory, 264
Stock grants, 203
Stockholders, 42
Stock options, 203
Strategic alliances, 268–295
advantages of, 191
adverse selection in, 278, 279
cheating in, 278–282, 284, 288–291
contracts and legal sanctions in, 288, 289
defined, 270
equity alliances, 270, 288
equity investments and, 288
facilitating market entry or exit
through, 275–278
favorable competitive environments
created through, 273, 275
firm reputations and, 289–290
holdups in, 278, 280–282
imitation of, 283, 285–287
implementation of, 287–292
improving current operations through,
271–273
Rovio application development
company, 25, 26
Ruback & Jensen’s list of sources of
strategic relatedness, 302–303
Ryanair, 122–124, 132, 140
S
Salaries. See Compensation policies
Sales managers, 198
Samsung, 268–269
Sanctions, 288
Satellite television, 68
Schools, primary and secondary, 62
SCI (Service Corporation International),
70, 316–317
S-C-P model. See Structure-
conduct-performance (S-C-P) model
Secondary education industry, 62
Second movers, 112
Seemingly unrelated diversified
firms, 222
Sega, 25
Semiconductor industry, 129, 132, 192,
340, 346
Semi-strong efficiency, 326n3
Senior executives, 244, 248–249
September 11 attacks (2001), 53
Service Corporation International (SCI),
70, 316–317
Shared activities
corporate diversification strategies and,
213, 215–219, 234
as cost centers, 252–253
limitations of, 218–219
managers of, 252–253
as profit centers, 253
value chains and, 213, 215–218
Shared activity managers, 252–253
Shark repellents, 321
Shoe-manufacturing industry, 340
Shopping malls, 158, 166
Short-termism, 200
Shrinkage, 146
Silicon Valley, 130, 140
Singapore
family-dominated firms in, 344
labor costs in, 339
Single-business firms, 211
Size differences
corporate diversification strategies
and, 229
cost advantages and, 125–128, 137
Skunk works, 170
Slavery, 133
Smart phone applications industry, 24–26
Soccer moms, 51
Socially complex resources, 97, 99–101,
113–114, 202
Socially responsible firms, 93
Social welfare, 54
Soft drink industry, 156, 158. See also
Coca-Cola Corporation; PepsiCo
Software, technological, 132, 137, 140, 141
Software industry. See also Computer
industry
maturity of, 75
product differentiation in, 156, 166
suppliers in, 64
Z05_BARN0088_05_GE_SIDX.INDD 393 17/09/14 5:18 PM

394 Subject Index
Times interest earned ratio, 36
Time Warner
demographic trends influencing,
51–52
mergers, 323
multipoint competition with Disney,
227–228, 238–239n27
resources and capabilities, 90
Timex, 124, 152
Timing-based product differentiation,
154, 167
“Tit-for-tat” strategies, 284
Tobacco industry, 93, 107, 307
Toyota Motor Corporation
centralized hubs, 358
international strategies, 331, 346
resources and capabilities, 87
strategic alliances, 272, 274, 282–283
Trade barriers, 334–335
Transactions cost economics, 206n2
Transaction-specific investments,
187–189, 192–193, 196, 201, 280–282
Transfer-pricing systems, 258–260
Transnational organizational structures,
358–359
Transnational strategies, 347
Transparent business partners, 342
Trust in strategic alliances, 291–292,
295n29
U
U-form organizational structures
CEO, responsibilities in, 144–145
cost leadership strategy
implementation in, 144
management committees in,
200–201
post-merger integration and, 319
product differentiation strategy
implementation in, 170
structure and function of, 143
vertical integration strategy
implementation in, 198–201
Unattractive industries, 106, 140
Uncertainty in decision-making, 191,
196–197, 277–278
Unfriendly acquisitions, 298
Unique historical conditions, 97–98
United Airlines, 169
United Kingdom, family-dominated firms
in, 344
United States
automotive industry in, 76
business and government, relationship
between, 53
cultural trends in, 52
demographic trends in, 51
family-dominated firms in, 344
management styles in, 355
9/11 attacks (2001), 53
trade barriers in, 335
Unlearning, 342
Unrealized strategies, 41
Unrelated corporate diversification, 210,
211, 213
Unrelated firms, mergers and acquisitions
of, 299–300
Used-car industry, 315
vertical integration and, 194–197
VRIO framework on, 95–96, 99, 100,
103–104
Sustained competitive disadvantages, 31
Sweden, family-dominated firms in, 344
Switching costs, 72–73
Switzerland, family-dominated firms
in, 344
T
Tacit collusion, 107, 227–228, 275, 277
Tacit cooperation, 107–108, 119n30
Tactics, changes in, 108–109
Taiwan
labor costs in, 339
marketing blunders in, 332
Takeovers, 298, 320–322. See also Mergers
and acquisitions
Tangible assets, 86
Target firms
returns to, 304–309
rules for managers, 317–318
wealth effects of responses to takeover
attempts, 320–322
Tariff trade barriers, 334, 335
Tax advantages of diversification, 226
Teamwork, 113
Technical economies, 302
Technical standards, 330
Technological advantages, 131–132, 137
Technological change, 50–51
Technological hardware, 132, 137, 139
Technological leadership strategies, 71–72
Technological software, 132, 137, 140, 141
Technologies
biotechnology, 51, 191, 270, 278
digital, 51, 107
information, 132, 157–158, 166, 193
low-cost access to, 340
physical, 100
proprietary, 60–61
Teflon, 221
Telecommunications industry
corporate diversification by, 228
international strategies in, 351, 352–353
shared activities used by, 217–218
Television industry. See also Sports televi-
sion industry
cable and satellite, 67–68
complementors in, 67–68
demographic trends influencing, 51–52
MTV programming, 156
strategic alliances in, 272–273
Temporary competitive advantages
defined, 31
tactical changes, 109
VRIO framework on, 95, 96–97, 103
Temporary competitive disadvantages, 31
Tender offers, 298, 321
Terrorist attacks, 53
Thailand, labor costs in, 340
Thinly traded markets, 315
Threats. See Environmental threats
3M
core competencies of, 219, 221
mission, 27
product differentiation by, 172, 173
resources and capabilities, 90
Strategy in Depth (feature)
agency relationships, 245
business model canvas, 34–35
cost leadership and economic
performance, 135
countertrade, 336
environmental threats and S-C-P
model, 57
mergers and acquisitions, evaluating
performance effects of, 308
product differentiation, economics of,
160–161
Ricardian economics and resource-
based view, 88–89
vertical integration, measuring degree
of, 186
Strategy in Emerging Enterprise (feature)
baseball, competitive balance in, 142
“Blue ocean” markets, 171
business plans and entrepreneurship,
43, 91
cashing out, 305
corporate spin-offs, 261
Disney and Pixar alliance, 281
emergent strategies and
entrepreneurship, 43
Gore-Tex and guitar strings, 221
international entrepreneurial firms, 330
Microsoft, maturity of, 75
Oprah, Inc., 199
Strengths of firms, identification of, 89–90,
103–104
Structure-conduct-performance (S-C-P)
model, 55–57, 69, 81n7
Structures, defined, 54
“Stuck in the middle” firms, 175–176
Substitutes
for corporate diversification strategies,
235
for cost leadership strategies, 134, 141
imitation and, 96–97
for international strategies, 353
for product differentiation strategies,
168–169
for strategic alliances, 285–287
threat of, 63, 159
for vertical integration strategies, 197
Supermajority voting rules, 321
Suppliers
cost leadership strategies and, 134
distance to, 128
threats from, 64–65, 159–160
Supply agreements, 270
Survival strategies, mergers and
acquisitions as, 306
Sustainable distinctive competencies, 104
Sustained competitive advantages
corporate diversification strategies and,
231–235
cost leadership strategies and,
136–141
defined, 31, 96, 118n10
international strategies and, 351–353
mergers and acquisitions and, 309–318
persistence of, 32
product differentiation and, 162–169
strategic alliances and, 282–283,
285–287
Z05_BARN0088_05_GE_SIDX.INDD 394 17/09/14 5:18 PM

Subject Index 395
international strategies, 331
management control systems in, 146
mission, 27
physical resources, 86
resources and capabilities of, 190
supply chain management
strategy, 140
Walt Disney Company
corporate diversification by, 212
mergers, 301
mission, 27
multipoint competition with
Time Warner, 227–228,
238–239n27
product differentiation by,
154–155
smartphone applications, 25, 26
strategic alliance with Pixar,
279, 281
Watch industry, 107, 124, 152
Weaknesses of firms, identification of,
89–90, 103–104
Wealth of customers, 335–336
Weighted average cost of capital (WACC),
39, 255
Wendy’s, 74
White knights, 322
Wine industry, 60, 171
Workers. See Employees
WPP advertising agency, 170
X
Xerox, 161
X-Games, 95, 96–97
Y
Y Generation, 51
Z
Zambia, political risks in, 348
Zero-based budgeting, 257
Zero economic profits
cost leadership, 135
mergers and acquisitions, 300, 303,
304, 306
product differentiation, 161
measuring degree of, 186
opportunism and, 187–189, 192,
201–203, 285
organizational structure and
implementation of, 198–199
rarity of, 195–197
substitutes for, 197
sustained competitive advantages and,
194–197
transaction-specific investments and,
187–189, 192–193, 196, 201
value of, 185, 187–194
Vertical mergers, 301
Victoria’s Secret, 150–152
Video game industry, 25
Vietnam, labor costs in, 339, 340
Virgin Group, 222
Visionary firms, 27
Volume of production
cumulative, 128–129, 137
employee specialization and,
126–127
overhead costs and, 127
plant and equipment costs and, 126
specialized machines and, 125–126
VRIO framework, 88–106. See also
Resource-based view (RBV)
application of, 104–106
components of, 88, 90
imitation, 95–100
organization, 100–102
rarity, 94–95
strengths and weaknesses,
identification using, 89–90, 103–104
on sustained competitive advantages,
95–96, 99, 100, 103–104
on temporary competitive advantages,
95, 96–97, 103
value, 89–92, 94
W
WACC (weighted average cost of capital),
39, 255
Wal-Mart Stores, Inc.
compensation policies, 146
first-mover advantages of, 72
V
Vacuum tube industry, 77
Value
applying question of, 90
of business plans, 91
of corporate diversification strategies,
213–231
of cost leadership strategies, 133–134, 136
economic, 30, 33
of economies of scope, 214–215
of international strategies, 331–345
of mergers and acquisitions, 299–304
of product differentiation strategies,
159–162
of resources and capabilities, 89–92, 94
of strategic alliances, 271–278
of vertical integration strategies, 185,
187–194
Value chains
analysis of, 91–92, 94, 185
defined, 91–92, 184
shared activities and, 213, 215–218
Valued added as a percentage of sales, 186
Value propositions, 34
Vehicles. See Automotive industry
Vending machine industry, 107, 157, 158
Venezuela, political risks in, 348
Venture capital firms, 305
Vertical dis-integration, 197
Vertical integration strategies, 182–207
backward, 66, 136, 184
call centers and, 192–194
capabilities and, 189–190, 193, 196, 202,
203, 286
compensation policies and
implementation of, 201–203
defined, 184
direct duplication of, 197
empirical tests of theories of, 192
flexibility and, 190–191, 193–194, 202, 203
forward, 65, 184
imitation of, 197
implementation of, 198–203
integrating theories of, 194
management control systems and
implementation of, 200–201
Z05_BARN0088_05_GE_SIDX.INDD 395 17/09/14 5:18 PM

Z05_BARN0088_05_GE_SIDX.INDD 396 17/09/14 5:18 PM

Z05_BARN0088_05_GE_SIDX.INDD 397 17/09/14 5:18 PM

Z05_BARN0088_05_GE_SIDX.INDD 398 17/09/14 5:18 PM

Z05_BARN0088_05_GE_SIDX.INDD 399 17/09/14 5:18 PM

Z05_BARN0088_05_GE_SIDX.INDD 400 17/09/14 5:18 PM

Cover
Title
Copyright
Contents
Part 1 The Tools of Strategic
Analysis
Chapter 1 What Is Strategy and the Strategic Management Process?
Opening Case: Why Are These Birds So Angry?
Strategy and the Strategic Management Process
Defining Strategy
The Strategic Management Process
What Is Competitive Advantage?
Research Made Relevant: How Sustainable Are Competitive Advantages?
The Strategic Management Process, Revisited
Measuring Competitive Advantage
Accounting Measures of Competitive Advantage
Strategy in Depth: The Business Model Canvas
Economic Measures of Competitive Advantage
The Relationship Between Economic and Accounting Performance Measures
Emergent Versus Intended Strategies
Ethics and Strategy: Stockholders Versus Stakeholders
Strategy in the Emerging Enterprise: Emergent Strategies
and Entrepreneurship
Why You Need to Know About Strategy
Summary
Challenge Questions
Problem Set
End Notes

Chapter 2 Evaluating a Firm’s External Environment
Opening Case: iTunes and the Streaming
Challenge
Understanding a Firm’s General Environment
The Structure-Conduct-Performance Model of Firm
Performance
Ethics and Strategy: Is a Firm Gaining a Competitive
Advantage Good for Society?
A Model of Environmental Threats
Threat from New Competition
Strategy in Depth: Environmental Threats
and the S-C-P Model
Threat from Existing Competitors
Threat of Substitute Products
Threat of Supplier Leverage
Threat from Buyers’ Influence
Environmental Threats and Average Industry
Performance
Another Environmental Force: Complementors
Research Made Relevant: The Impact of Industry and Firm
Characteristics on Firm Performance
Industry Structure and EnvironmentalOpportunities
Opportunities in Fragmented Industries:
Consolidation
Opportunities in Emerging Industries: First-MoverAdvantages
Opportunities in Mature Industries: Product
Refinement, Service, and Process Innovation
Strategy in the Emerging Enterprise: Microsoft
Grows Up
Opportunities in Declining Industries: Leadership, Niche, Harvest, and Divestment
Summary
Challenge Questions
Problem Set
End Notes
Chapter 3 Evaluating a Firm’s Internal Capabilities
Opening Case: When a Noun Becomes a Verb
The Resource-Based View of the Firm
What Are Resources and Capabilities?
Critical Assumptions of the Resource-Based View
Strategy in Depth: Ricardian Economics and the
Resource-Based View
The VRIO Framework
The Question of Value
Strategy in the Emerging Enterprise: Are Business
Plans Good for Entrepreneurs?
Ethics and Strategy: Externalities and the Broader
Consequences of Profit Maximization
The Question of Rarity
The Question of Imitability
The Question of Organization
Research Made Relevant: Strategic Human Resource
Management Research
Applying the VRIO Framework
Applying the VRIO Framework to Southwest
Airlines
Imitation and Competitive Dynamicsin an Industry
Not Responding to Another Firm’s Competitive
Advantage
Changing Tactics in Response to Another Firm’s
Competitive Advantage
Changing Strategies in Response to Another Firm’s
Competitive Advantage
Implications of the Resource-Based View
Where Does the Responsibility for Competitive
Advantage in a Firm Reside?
Competitive Parity and Competitive Advantage
Difficult-to-Implement Strategies
Socially Complex Resources
The Role of Organization
Summary
Challenge Questions
Problem Set
End Notes

Part 2 Business-Level Strategies
Chapter 4 Cost Leadership
Opening Case: The World’s Lowest-Cost Airline
What Is Business-Level Strategy?
What Is Cost Leadership?
Sources of Cost Advantages
Research Made Relevant: How Valuable Is Market Share—Really?
Ethics and Strategy: The Race to the Bottom
The Value of Cost Leadership
Cost Leadership and Environmental Threats
Strategy in Depth: The Economics of Cost Leadership
Cost Leadership and Sustained Competitive
Advantage
The Rarity of Sources of Cost Advantage
The Imitability of Sources of Cost Advantage
Organizing to Implement Cost Leadership
Strategy in the Emerging Enterprise: The Oakland A’s:
Inventing a New Way to Play Competitive Baseball
Organizational Structure in Implementing Cost
Leadership
Management Controls in Implementing Cost
Leadership
Compensation Policies and Implementing Cost
Leadership Strategies
Summary
Challenge Questions
Problem Set
End Notes
Chapter 5 Product Differentiation
Opening Case: Who Is Victoria, and What Is Her
Secret?
What Is Product Differentiation?
Bases of Product Differentiation
Research Made Relevant: Discovering the Bases of Product
Differentiation
Product Differentiation and Creativity
The Value of Product Differentiation
Product Differentiation and Environmental
Threats
Strategy in Depth: The Economics of Product
Differentiation
Product Differentiation and Environmental
Opportunities
Product Differentiation and Sustained Competitive
Advantage
Rare Bases for Product Differentiation
Ethics and Strategy: Product Claims and the Ethical
Dilemmas in Health Care
The Imitability of Product Differentiation
Organizing to Implement Product Differentiation
Organizational Structure and Implementing Product
Differentiation
Management Controls and Implementing Product
Differentiation
Strategy in the Emerging Enterprise: Going in Search
of Blue Oceans
Compensation Policies and Implementing Product
Differentiation Strategies
Can Firms Implement Product Differentiation
and Cost Leadership Simultaneously?
No: These Strategies Cannot Be Implemented
Simultaneously
Yes: These Strategies Can Be Implemented
Simultaneously
Summary
Challenge Questions
Problem Set
End Notes

Part 3 Corporate Strategies
Chapter 6 Vertical Integration
Opening Case: Outsourcing Research
What Is Corporate Strategy?
What Is Vertical Integration?
The Value of Vertical Integration
Strategy in Depth: Measuring Vertical Integration
Vertical Integration and the Threat of
Opportunism
Vertical Integration and Firm Capabilities
Vertical Integration and Flexibility
Applying the Theories to the Management of Call Centers
Research Made Relevant: Empirical Tests of Theories
of Vertical Integration
Integrating Different Theories of Vertical
Integration
Vertical Integration and Sustained Competitive
Advantage
The Rarity of Vertical Integration
Ethics and Strategy: The Ethics of Outsourcing
The Imitability of Vertical Integration
Organizing to Implement Vertical Integration
Organizational Structure and Implementing Vertical
Integration
Strategy in the Emerging Enterprise: Oprah, Inc.
Management Controls and Implementing Vertical
Integration
Compensation in Implementing Vertical Integration
Strategies
Summary
Challenge Questions
Problem Set
End Notes
Chapter 7 Corporate Diversification
Opening Case: The Worldwide Leader
What Is Corporate Diversification?
Types of Corporate Diversification
Limited Corporate Diversification
Related Corporate Diversification
Unrelated Corporate Diversification
The Value of Corporate Diversification
What Are Valuable Economies of Scope?
Research Made Relevant: How Valuable Are Economies
of Scope, on Average?
Strategy in the Emerging Enterprise: Gore-Tex and Guitar
Strings
Can Equity Holders Realize These Economies of Scope
on Their Own?
Ethics and Strategy: Globalization and the Threat
of the Multinational Firm
Corporate Diversification and Sustained Competitive
Advantage
Strategy in Depth: Risk-Reducing Diversification
and a Firm’s Other Stakeholders
The Rarity of Diversification
The Imitability of Diversification
Summary
Challenge Questions
Problem Set
End Notes
Chapter 8 Organizing to Implement Corporate Diversification
Opening Case: And Then There Is Berkshire
Hathaway
Organizational Structure and Implementing Corporate
Diversification
The Board of Directors
Strategy in Depth: Agency Conflicts Between Managers
and Equity Holders
Research Made Relevant: The Effectiveness of Boards
of Directors
Institutional Owners
The Senior Executive
Corporate Staff
Division General Manager
Shared Activity Managers
Management Controls and Implementing Corporate
Diversification
Evaluating Divisional Performance
Allocating Corporate Capital
Transferring Inter
mediate Products
Strategy in the Emerging Enterprise: Transforming Big
Business into Entrepreneurship
Compensation Policies and Implementing Corporate
Diversification
Ethics and Strategy: Do CEOs Get Paid Too Much?
Summary
Challenge Questions
Problem Set
End Notes
Chapter 9 Strategic Alliances
Opening Case: Breaking Up Is Hard to Do:
Apple and Samsung
What Is a Strategic Alliance?
How Do Strategic Alliances Create Value?
Strategic Alliance Opportunities
Strategy in Depth: Winning Learning Races
Research Made Relevant: Do Strategic Alliances
Facilitate Tacit Collusion?
Alliance Threats: Incentives to Cheat on Strategic
Alliances
Adverse Selection
Moral Hazard
Holdup
Strategy in the Emerging Enterprise: Disney and Pixar
Strategic Alliances and Sustained Competitive Advantage
The Rarity of Strategic Alliances
The Imitability of Strategic Alliances
Ethics and Strategy: When It Comes to Alliances,
Do “Cheaters Never Prosper”?
Organizing to Implement Strategic
Alliances
Explicit Contracts and Legal Sanctions
Equity Investments
Firm Reputations
Joint Ventures
Trust
Summary
Challenge Questions
Problem Set
End Notes
Chapter 10 Mergers and Acquisitions
Opening Case: The Google Acquisition Machine
What Are Mergers and Acquisitions?
The Value of Mergers and Acquisitions
Mergers and Acquisitions: The Unrelated Case
Mergers and Acquisitions: The Related Case
What Does Research Say About Returns to Mergers
and Acquisitions?
Strategy in the Emerging Enterprise: Cashing Out
Why Are There So Many Mergers and Acquisitions?
Strategy in Depth: Evaluating the Performance Effects
of Acquisitions
Mergers and Acquisitions and Sustained Competitive
Advantage
Valuable, Rare, and Private Economies of Scope
Valuable, Rare, and Costly-to-Imitate Economies
of Scope
Unexpected Valuable Economies of Scope Between
Bidding and Target Firms
Implications for Bidding Firm Managers
Implications for Target Firm Managers
Organizing to Implement a Merger or
Acquisition
Post-Merger Integration and Implementing a
Diversification Strategy
Special Challenges in Post-Merger Integration
Research Made Relevant: The Wealth Effects
of Management Responses to Takeover Attempts
Summary
Challenge Questions
Problem Set
End Notes
Chapter 11 International Strategies
Opening Case: The Baby Formula Problem
Strategy in the Emerging Enterprise: International
Entrepreneurial Firms: The Case of Logitech
The Value of International Strategies
To Gain Access to New Customers for Current Products
or Services
Internationalization and Firm Revenues
Strategy in Depth: Countertrade
Internationalization and Product Life Cycles
Internationalization and Cost Reduction
To Gain Access to Low-Cost Factors of
Production
Raw Materials
Labor
Ethics and Strategy: Manufacturing Tragedies and
International Business
Technology
To Develop New Core Competencies
Learning from International Operations
Leveraging New Core Competencies in Additional
Markets
To Leverage Current Core Competencies in New
Ways
To Manage Corporate Risk
Research Made Relevant: Family Firms in the Global
Economy
The Local Responsiveness/International Integration
Trade-Off
The Transnational Strategy
Financial and Political Risks in Pursuing International
Strategies
Financial Risks: Currency Fluctuation and
Inflation
Political Risks
Research on the Value of International Strategies
International Strategies and Sustained Competitive
Advantage
The Rarity of International Strategies
The Imitability of International Strategies
The Organization of International Strategies
Becoming International: Organizational Options
Summary
Challenge Questions
Problem Set
End Notes

Appendix
Analyzing Cases and Preparing for Class Discussions
Glossary
Company Index
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
X
Y
Z
Name Index
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
Y
Z
Subject Index
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
X
Y
Z

2015-05-27T17:53:52+0000
Preflight Ticket Signature

Turn in your highest-quality paper
Get a qualified writer to help you with

“ For https://courseworkhero.co.uk only …. ”

Get high-quality paper

NEW! AI matching with writer

Still stressed with your coursework?

Get quality coursework help from an expert!

Order now