Directions After completing the readings, write your initial discussion post. Using each of the three readings (citing and referencing each one), com

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CHAPTER 1

What Is Business Strategy?

Strategy at Apple

In 2000, Apple computer held a loyal customer base but was limp- ing along as a relatively minor player in the personal computer market. Launched by Steve Jobs and Steve Wozniak, Apple was one of the pioneers in the industry. Unlike other PC makers that relied on Microsoft’s operating system and application software, Apple wrote its own operating system software and much of its application software, which was known as being easy to use. In fact, Apple was the first to introduce software on a low cost per- sonal computer with drop-down menus and a graphical user interface that allowed customers to easily complete a task, such

as drag a file to the trash to delete it. However, Apple’s investment in unique software led to high-priced computers and created files that were originally incompatible with those of Microsoft’s Windows operating system and Office software suite. As a result, Apple rarely achieved more than about a 5 percent share of the computer market.1

That all changed in 2001, however, when Apple entered an entirely new market with the launch of an MP3 portable music player called the iPod. Apple’s MP3 player was not the first on the market. A company called Rio had offered an MP3 player for a couple of years before iPod’s entry into the market. But iPod quickly took market share from the Rio, for three primary reasons:

1. iPod had a mini hard drive that allowed it to hold 500 songs, as opposed to the roughly 15 songs the Rio could hold using flash memory.

2. iPod was the first to introduce a “fly wheel” navigation button—the round button that was easy to use and allowed users to quickly scroll through menus and songs.

3. iPod was backed with Apple’s name and an innovative design.2

These advantages helped iPod quickly move to industry leader- ship, despite the fact that an iPod cost 15 to 25 percent more than a Rio.3 At the time the iPod was launched, it was difficult for most consumers to access digital downloads of songs legally. Initially, the iPod was snapped up only by a relatively small group of users, mostly

L E A R N I N G O B J E C T I V E S

Studying this chapter should provide you with the knowledge to:

1. Define business strategy, including the importance of competitive advantage, the four choices that are critical to strategy formulation, and the strategic management process.

2. Summarize the information that the company’s mission and thorough external and internal analysis provide to guide strategy.

3. Discuss how strategies are formulated and implemented in order to achieve objectives.

4. Explain who is responsible for, and who benefits from, good business strategy.

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2 C H A P T E R 1 What Is Business Strategy?

teenagers and college students, who were illegally downloading songs through Napster and other free downloading sites.

Apple recognized that to grow the market for iPods, it needed to help consumers legally access songs to play on their iPods. As a result, Apple developed software called iTunes, allowing custom- ers to legally download songs. One main reason iTunes was able to provide legal downloads before its competitors was because Steve Jobs, as CEO of both Apple and Pixar (the animation movie pro- duction company), understood that music companies, like movie companies, were concerned about people pirating their products. So Apple worked with the music companies to sell songs that had been digitized using software that prevented customers from copy- ing the songs to more than a few computers. iTunes was designed to be easy to use with the iPod. Customers now could easily and legally access songs simply by connecting their iPods to their com- puters and letting the software do to the rest. Even a technology- challenged grandparent could do it.4

But Apple wasn’t done with its music player strategy. Apple’s ex- perience in the computer business was that other companies could make similar products, often at lower prices. Indeed, while Apple and IBM were the pioneers of the personal computer industry and domi- nated it during the early years, lower-priced competitors such as Dell, Hewlett-Packard, Lenovo, and ASUS, eventually came to dominate the market. Apple realized it needed to prevent easy imitation of its

music offering. So it created proprietary software called Fairplay that restricted the use of music downloaded from iTunes to iPods only. That meant consumers couldn’t buy a lower-priced MP3 player and use it with iTunes because it was incompatible. If they wanted to use a different MP3 player, they would have to download and pay for music a second time.5 Now Apple has bundled an MP3 player into the iPhone, which makes it move convenient for customers because they don’t have to carry two devices.

To top it off, Apple did something that no other maker of com- puters, music players, or any other electronic device company had done. It opened its own stores to sell Apple products. This required that Apple learn how to operate retail stores. The Apple Stores helped Apple create a direct link to its customers, making it easier for con- sumers to learn about and try out Apple products—and get their products serviced.

As a result of Apple’s strategic initiatives, it has built a very secure market position in music players, currently holding over 70  percent of that market.6 But the battle isn’t over. Amazon has entered the industry, offering music buyers unrestricted use of its songs. Moreover, competitors e-Music, Pandora.com and Spotify are offering music via subscription. Users can listen to any song they want for a monthly subscription fee. The $17 billion music industry is so large that it will continue to attract new competitors who want to dethrone Apple.

How did Apple enter the music industry and within 10 years become the dominant seller of both songs and music players? How did Pandora, a start-up, succeed in the music industry while for- mer giant Sony (maker of the Walkman and Discman) struggled? For that matter, why is any company successful? Understanding the series of actions taken by Apple to achieve a domi- nant position in the online music business will go a long way toward understanding business strategy—a company’s dynamic plan to gain, and sustain, competitive advantage in its markets. In this chapter, we’ll help you get started by answering some basic questions. We begin with the most obvious: “What is a business strategy?”

What Is Business Strategy? The word strategy comes from the Greek word strategos, meaning, “the art of the general.” In other words, the origin of strategy comes from the art of war, and, specifically, the role of a general in a war. In fact, there is a famous treatise titled The Art of War that is said to have been authored by Sun Tzu, a legendary Chinese general. In the art of war, the goal is to win—but that is not the strategy. Can you imagine the great general Hannibal saying something like, “Our strategy is to beat Rome!” No, Hannibal’s goal was to defeat Rome. His strategy was to bring hidden strengths against the weaknesses of his enemy at the point of attack—which he did when he crossed the Alps to attack in a way that his enemies did not believe he could. He achieved an advantage through his strategy.

In similar fashion, a company’s business strategy is defined as a company’s dynamic plan to gain, and sustain competitive advantage in the marketplace. This plan is based on the theory its leaders have about how to succeed in a particular market. This theory involves pre- dictions about which markets are attractive and how a company can offer unique value to customers in those markets in a way that won’t be easily imitated by competitors. This theory then gets translated into a plan to gain competitive advantage. This plan must be dynamic to

business strategy A plan to achieve competitive advantage that involves making four inter-related strategic choices: (1) markets to compete in; (2) unique value the firm will offer in those markets; (3) the resources and capabilities required to offer that unique value better than competitors; and (4) ways to sustain the advantage by preventing imitation.

competitive advantage When a firm generates higher profits compared to its competitors.

market The industry, customer segment, or geographic area that a company competes in.

unique value The reason a firm wins with customers or the value proposition it offers to customers, such as a low cost advantage or differentiation advantage or both.

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What Is Business Strategy? 3

respond to new information that comes as customers, competitor, and technologies change. Apple’s theory of how to gain a competitive advantage in music download business was to cre- ate cool and easy-to-use MP3 players that could easily—and legally—download digital songs from a computer through the iTunes store. Apple sought to sustain its advantage by making it impossible for competitor MP3 players to download songs from the iTunes store. The Apple Stores contributed to Apple’s advantage by providing a direct physical link to customers that competitors couldn’t match. In this particular instance, Apple’s plan to gain, and sustain, com- petitive advantage worked. But there have been other times, such as with the Apple Newton Message Pad (the first handheld computer that Apple sold as a personal digital assistant) that Apple’s theory about how to gain and sustain competitive advantage did not work. Sometimes strategies are successful and sometimes they are not.

Strategies are more likely to be successful when the plan explicitly takes into account four factors:

1. Where to compete, or the attractiveness of a market or customer segment in the tar- geted markets

2. How to offer unique value relative to the competition in the targeted markets 3. What resources or capabilities are necessary to deliver that unique value 4. How to sustain a competitive advantage once it has been achieved

The goal of the strategic plan is to create competitive advantage. First, let’s examine the goal.

Competitive Advantage What exactly do we mean when we use the term competitive advantage?7 In the sports world, it is usually obvious when a team has a competitive advantage over another team: The bet- ter team wins the game by having a higher score. The ability to consistently win is based on attracting and developing better players and coaches, and by employing strategies to exploit the weaknesses of opponents. In the business world, the scoring is measured by looking at the profits (as a percentage of invested capital) generated by each firm. We describe the most common ways of measuring profits in Strategy in Practice: Measuring American Home Products’ Competitive Advantage.

Just as in sports, where an inferior team may outscore a superior team on a given day, it may be possible for an inferior company to outscore a superior company in a particular quarter, or per- haps even a year. Competitive advantage requires that a firm consistently outperform its rivals in generating above-average profits. A firm has a competitive advantage when it can consistently generate above-average profits through a strategy that competitors are unable to imitate or find too costly to imitate. Above-average profits are profit returns in excess of what an investor expects from other investments with a similar amount of risk. Risk is an investor’s uncertainty about the profits or losses that will result from a particular investment. For example, investors suf- fer a lot of uncertainty (and, hence, risk) when they put their money into a start-up company that is trying to launch products based on a new technology, such as a solar power company. There is much less risk in investing in a stable firm with a long history of profitability, such as a utility company that supplies power to customers who have few, if any, alternative sources of power.9

Many organizations work to achieve objectives other than profit. For example, universities, many hospitals, government agencies, not-for-profit organizations, and social entrepreneurs play important roles in making our economy work and our society a better place to live. These organizations do not measure their success in terms of profit rates, but they still use many of the tools of strategic management to help them succeed (see Chapter  14). For these organi- zations, success might be measured using tangible outcomes such as the number of degrees granted, patient health and satisfaction measures, people served, or some other measure of an improved society.

The primary source of a company’s competitive advantage can come from several areas of its operations. For example, the diamond company De Beers has an advantage that comes from paying lower costs for its diamonds than other companies do, because De Beers owns its own

above-average profits Returns in excess of what an investor expects from other investments with a similar amount of risk.

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4 C H A P T E R 1 What Is Business Strategy?

Strategy in Practice

Measuring American Home Products’ Competitive Advantage

To see which firms in an industry are most successful, we typically compare their return on assets (ROA), a calculation of operating profits divided by total assets, or their return on equity (ROE), which is operating profits divided by total stockholders’ equity. The company that consistently generates the highest returns for its investors, in terms of ROA or ROE, wins the game. For exam- ple, from 1971 to 2000, the pharmaceutical company American

Home Products averaged 19 percent ROA, compared to competitor American Cyanamid’s 7 percent. American Home Products’ ROA was higher than American Cyanamid’s every year for 30 years. This is evidence that during this time period, American Home Products had a competitive advantage over American Cyanamid.8 Ameri- can Home Products’ advantage over American Cyanamid has fre- quently been attributed to its ability to develop more blockbuster drugs (through more effective research and development) and to quickly get those drugs to market through a larger and more effec- tive sales force.

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diamond mines. Competitive advantage can also come from different functional areas within the company. Biotechnology pioneer Genentech’s advantage comes primarily from research and development that has produced several blockbuster drugs; Toyota’s advantage in automo- biles comes primarily from its operations (known as the Toyota Production System); Procter & Gamble’s advantage in household products comes largely from its sales and marketing, and Nordstrom’s advantage as a retailer comes largely from its merchandising and service.

The Strategic Management Process The processes that firms use to develop a strategy can differ dramatically across firms. In some cases, executives do not spend significant time on strategy formulation, and strategies are often based only on recent experience and limited information. However, we propose that a better approach to the formulation of strategy is the strategic management process outlined in Figure  1.1. The strategic management process for formulating and implementing strategy involves thorough external analysis and internal analysis. Only after conducting an analysis of the company’s external environment and its internal resources and capabilities are a firm’s

strategic management process The process by which organizations formulate a plan and allocate resources to achieve competitive advantage that involves making four strategic choices: (1) markets to compete in; (2) unique value the firm will offer in those markets; (3) the resources and capabilities required to offer that unique value better than competitors; and (4) ways to sustain the advantage by preventing imitation.

Profitability of Different Firms in the Pharmaceutical Industry

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What Is Business Strategy? 5

executives and managers able to identify the most attractive business opportunities and formulate a strategy for achieving competitive advantage.

The central task of the strategy formulation process is specifying the high-level plan and set of actions the company will take in its quest to achieve competitive advantage. After the plan for creating competitive advantage is created, the final step is to develop a detailed plan to effectively implement, or put into action, the firm’s strategy through specific activities.

The focus of the strategic management process should be to make four key strategic choices, as shown in Figure 1.2

1. Which markets will the company pursue? A company’s markets include the high-level industry and specific customer segments in which it competes and its geographic markets.

2. What unique value does the company offer customer in those markets? This is the firm’s value proposition, the reason the company wins with a set of customers.10

3. What resources and capabilities are required?  What does the company need to have and know how to do so that it can deliver its unique value better than competitors, and exactly how will the company deliver its unique value through an implementation plan?11

4. How the company will capture value and sustain a competitive advantage over time? Firms need to create barriers to imitation to keep other companies from delivering the same value.

Mission

External Analysis • Industry structure • Opportunities/threats [Chapter 2]

Internal Analysis • Resources and capabilities • Strengths/weaknesses [Chapter 3]

Cost Advantage [Chapter 4]

Differentiation Advantage [Chapter 5]

Vertical Integration [Chapter 7]

Corporate Strategy

[Chapter 6]

International Strategy

[Chapter 9]

Strategic Alliances

[Chapter 8]

Disruptive Business Models

[Chapter 10]

Competitor Interaction/

Game Theory [Chapter 11]

Strategy Implementation

[Chapter 12]

Governance and Ethics

[Chapter 13]

Social Value Organizations [Chapter 14]

Business Level Strategies

Strategy Vehicles

Dynamic Strategic Actions

Strategy Formulation

Strategy Implementation

FIGURE 1.1 The Strategic Management Process

internal analysis The analysis of a firm’s resources and capabilities (its strength and weaknesses) to assess how effectively the firm is able to deliver the unique value (value proposition) that it hopes to provide to customers.

external analysis Examining the forces that influence industry attractiveness, including opportunities and threats that exist in the environment.

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6 C H A P T E R 1 What Is Business Strategy?

Markets to Pursue

• What industry, customer segment, and geographic markets are most attractive as business arenas?

• What value proposition will offer unique value relative to competitors in the areas of cost or differentiation or both?

• What resources and capabilities are required in order to deliver that unique value better than competitors?

• How to create barriers to imitation to prevent other companies from offering that same value?

Unique Value to Offer

Resources and Capabilities to

Develop

Sustaining Advantage

FIGURE 1.2 Four Key Strategic Choices in Strategic Management

Markets One of the first decisions a company must make is where to compete or which markets it will serve. Leaders must choose the industries a company competes in and the specific customer segments or needs it will address (the focus of chapter 2) within those indus- tries. For example, before iPod, Apple competed only in the computer industry. Its product mar- kets included desktop and laptop computers. Launching iPod and iTunes took Apple into the music industry. Later, when Apple launched the iPhone, it entered the cell phone business. Apple targets the high-end customer segments within its industries. Its customers want the lat- est in technology, see themselves as innovators, appreciate design and elegance, and are not price sensitive.

It is also important to select geographic markets to serve. Apple competes on a worldwide basis, which allows it to spread heavy research and development costs across its many geo- graphic markets. By contrast, Walmart started by focusing on rural markets, which allowed it to offer lower prices than the “mom and pop” retail stores in small towns.12

Unique Value After a company chooses the markets in which to compete, it then attempts to offer unique value in those markets. This is often referred to as a company’s value proposi- tion, or the value that it proposes to offer to customers. Companies typically try to achieve a competitive advantage by choosing between one of two generic strategies for offering unique value: low cost or differentiation. Companies such as Walmart, Ryanair, Taco Bell, and Kia attract customers by being cost leaders, offering products or services that are priced lower than com- petitor offerings. A firm that chooses a low-cost strategy (the focus of Chapter  4) focuses on reducing its costs below those of its competitors. Key sources of cost advantage include econ- omies of scale, lower-cost inputs, or proprietary production know-how.

A firm that chooses a differentiation strategy (the focus of Chapter 5) focuses on offering features, quality, convenience, or image that customers cannot get from competitors. Apple’s unique value is offering iPods (music players), iPhones (smart phones), and iPads (tablets) that are well designed, innovative, easy to use, and have features that competing products don’t have (“there’s an App for that”). In similar fashion, Starbucks wins through differentiation by offering multiple blends of high-quality coffee in convenient locations.

The traditional answer to offering unique value is to be either a low-cost (low-price) pro- vider or a differentiator. In fact, strategy professor Michael Porter, whose five forces analysis will be introduced later in this chapter, has cautioned that trying to do both simultaneously

cost advantage An advantage that a firm has over its competitors in the activities associated with producing a product or service, thereby allowing it to produce the same product at lower cost.

differentiation strategy An advantage a firm has over its competitors by making a product more attractive by offering unique qualities in the form of features, reliability, and convenience that distinguishes it from competing products.

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What Information and Analysis Guides Strategy Formulation? 7

can result in being “stuck in the middle”—meaning that by trying to do both, companies don’t effectively do the job of either low price, or differentiation. Increasingly, however, com- panies are finding ways to deliver on both low cost and differentiation.13 Does Amazon beat brick-and-mortar stores because of price or differentiation (e.g., convenience)? Does Uber beat taxis because of price or differentiation (e.g., convenience)? The answer, of course, is  both. Some companies have discovered ways to offer both low price and a differenti- ated product—which turns out to be a powerful source of competitive advantage (See “New Thinking: Achieving both Cost and Differentiation Advantages” at the end of Chapter 5).

Resources and Capabilities Delivering unique value requires developing resources and capabilities (the focus of Chapter 3) that will allow the company to perform activities better than competitors. Indeed, perhaps the most critical role of the strategist is to figure out how to build or acquire the resources and capabilities necessary to deliver unique value.

Resources refer to assets that the firm accumulates over time, such as plants, equipment, land, brands, patents, cash, and people. Elon Musk is a key resource for Tesla because his rep- utation as an innovator allows him to raise the large sums of money Tesla needs for product development at a low price.

Capabilities refer to processes (or recipes) the firm develops to coordinate human activity to achieve specific goals. To illustrate, Starbucks has key resources that allow it to succeed through differentiation, including its Starbucks brand, its retail store locations, its recipes to produce different coffee blends, and even some patents to protect those rec- ipes. Its capabilities include its processes to roast coffee beans for the best flavor, create new coffee blends, design stores with great atmosphere, and find optimal store locations. These resources and capabilities have allowed Starbucks to deliver unique value to cus- tomers, thereby helping the company outperform other coffee shops within the coffee retailing industry.

The development of key resources and capabilities needed to deliver unique value should be part of the company’s strategy implementation plan. The strategy implementation plan involves the company developing a set of processes (capabilities) within each function (e.g., R&D, operations, sales, service, HR, etc.) that align with the unique value the company hopes to offer. For example, because Walmart’s unique value is “low prices,” every function of the company is focused on how it can perform its activities at the lowest possible cost. Strategists also have learned that it is helpful to align the firm’s structure (organization design), staffing (people), skills (capabilities/processes), systems (e.g., information and reward systems), and shared values and style (its culture) with its strategy for offering unique value (implementation is discussed in detail in Chapter 12).

Sustaining Advantage By being the first to offer music downloads through its easy- to-use iTunes software, Apple encouraged its customers to store their entire music libraries on iTunes. Designing iTunes so that it wouldn’t download songs to other music players helped Apple to prevent competing MP3 players from taking market share from iPod. Of course, Apple’s brand image and its Apple Stores also prevent competitors from easily imitating its products and services. These actions helped Apple capture and sustain the value it created.

What Information and Analysis Guides Strategy Formulation? As Figure  1.1 shows, the earliest steps in the strategic management process involve analyses and choices that later result in the formulation and implementation of a company’s strategy. These choices are made within the context of the company’s mission and only after an analysis of the external environment and internal organization.

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8 C H A P T E R 1 What Is Business Strategy?

Mission A company’s mission outlines the company’s primary purpose and often specifies the business or businesses in which the firm intends to compete—or the customers it intends to serve. Peo- ple in business often use the terms mission, vision, or purpose somewhat interchangeably. For our purposes in this book, we will use the term mission to refer to the primary purpose of the organization.

Most business firms start with a mission, even if it isn’t formally stated. For example, Star- bucks founder Howard Schultz got the idea to introduce coffee bars to America when he visited Italy and experienced the great coffee and convenience of Italian espresso bars. His external analysis of the coffee shop industry in the United States led him to believe that there was an opportunity to bring an exceptional coffee experience to America. Schultz once said American coffee was so bad it tasted like “swill.” He discovered café latte when visiting an espresso bar in Verona, Italy, and thought, “I have to take this to America.”14 So he launched Starbucks, a company that offered higher-quality coffee than traditional coffee shops, and included many varieties at a premium price. In essence, Starbucks started with a mission to bring high-quality coffee to the masses in the United States.

As companies grow and develop formal mission statements, these statements often define the core values that a firm espouses, and are often written to inspire employees to behave in particular ways. Starbucks formalized its mission as follows:

Our mission: to nurture and inspire the human spirit—one person, one cup, and one neighborhood at a time.15

It then proceeds with the statement: Here are the principles of how we live that every day— which is followed by a set of principles or values designed to guide employee behaviors. Even after it has been formalized, however, a company’s mission is still open to interpretation, as Strategy in Practice: Apple’s Evolving Mission shows.

External Analysis External analysis is critical for addressing the first strategic choice: Where should we compete? External analysis involves: (1) an examination of the competition and the forces that shape industry competition and profitability; and (2) customer analysis to understand what custom- ers really want. The combined results of external analysis with internal analysis of the firm are often summarized as a SWOT analysis. SWOT is an acronym for Strengths, Weaknesses, Opportunities, and Threats.16 External analysis is particularly useful for shedding light on the latter two: opportunities and threats.

Industry Analysis One of the central questions for the strategist is to determine which markets or industries to compete in. The fact of the matter is, all industries are not created equal. To illustrate, between 1992 and 200

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