Determining Competitive Advantage through VRIO Analysis and the Resource Based View

Introduction

This article will contain a high level overview of how to perform an internal analysis in order to determine sources of competitive advantage. It will contain direct excerpts from Jay B. Barney’s 1995 article from the Academy of Management Executive,  Vol. 9, No. 4, titled, Looking inside for competitive advantage. I subscribe to this approach over the SWOT analysis approach as it provides objective measures for which to base strategic decisions upon.

At the end of the discussion we will explore the application of the VRIO analysis and its implications on strategy.

Overview

Article:

Strategic managers and researchers have long been interested in understanding sources of competitive advantage for firms. Traditionally, this effort has focused on the relationship between a firm’s environmental opportunities and threats on the one hand, and its internal strengths and weaknesses on the other. Summarized in what has come to be known as SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis, this traditional logic suggests that firms that use their internal strengths in exploiting environmental opportunities and neutralizing environmental threats, while avoiding internal weaknesses, are more likely to gain competitive advantages than other kinds of firms.

This simple SWOT framework points to the importance of both external and internal phenomena in understanding the sources of competitive advantage. To date, the development of tools for analyzing environmental opportunities and threats has proceeded much more rapidly than the development of tools for analyzing a firm’s internal strengths and weaknesses. To address this deficiency, this article offers a simple, easy-to-apply approach to analyzing the competitive implications of a firm’s internal strengths and weaknesses.

The history of strategic management research can be understood as an attempt to “fill in the blanks” created by the SWOT framework; i.e., to move beyond suggesting that strengths, weaknesses, opportunities, and threats are important for understanding competitive advantage to suggest models and frameworks that can be used to analyze and evaluate these phenomena. Michael Porter and his associates have developed a number of these models and frameworks for analyzing environmental opportunities and threats. Porter’s work on the “five forces model,” the relationship between industry structure and strategic opportunities, and strategic groups can all be understood as an effort to unpack the concepts of environmental opportunities and threats in a theoretically rigorous, yet highly applicable way.

However, the SWOT framework tells us that environmental analysis-no matter how rigorous-is only half the story. A complete understanding of sources of competitive advantage requires the analysis of a firm’s internal strengths and weaknesses as well. The importance of integrating internal with environmental analyses can be seen when evaluating the sources of competitive advantage of many firms.

Even the most careful and complete analysis of firms’ competitive environments cannot, by itself, explain their success. Such explanations must also include firms’ internal attributes-their strengths and weaknesses-as sources of competitive advantage. Internal attributes will be referred to as resources and capabilities throughout the following discussion.

What is a Resource? What is the Resource Based View?

The resource-based view indicates a better way to understand how companies attain competitive advantage.

A firm’s resources and capabilities include all of the financial, physical, human, and organizational assets used by a firm to develop, manufacture, and deliver products or services to its customers. Financial resources include debt, equity, retained earnings, and so forth. Physical resources include the machines, manufacturing facilities, and buildings firms use in their operations. Human resources include all the experience, knowledge, judgment, risk taking propensity, and wisdom of individuals associated with a firm. Organizational resources include the history, relationships, trust, and organizational culture that are attributes of groups of individuals associated with a firm, along with a firm’s formal reporting structure, explicit management control systems, and compensation policies.

Another way to think about the resource based view and VRIO analysis

This approach links a company's internal capabilities (what it does well) and its external industry environment (what the market demands and what competitors offer).

The first step in the analysis is to identify the firm’s financial, physical, human, and organizational resources. Next, managers must address four important questions about their resources and capabilities: (1) the question of Value, (2) the question of Rareness, (3) the question of Imitability, and (4) the question of Organization. This objective measurement is where VRIO analysis has its advantage over SWOT analysis.

The resource-based view: an analogy

Consider the orange tree above. What is its competitive advantage in the marketplace? How does it compete? The traditional product-based view would say that the orange tree competes based off of its product, delicious oranges. But the resource-based view tells us that the source of its competitive advantage lies in its resources, specifically its vast root system. The root system provides the tree with the nutrients and water which enable the tree to produce the fruit. So, using the resource-based view when analyzing organizations, we look at the resources it uses to become successful instead of looking at the products or services it sells.

The Question of Value

To begin evaluating the competitive implications of a firm’s resources and capabilities, managers must first answer the question of value:

Do a firm’s resources and capabilities add value by enabling it to exploit opportunities and/or neutralize threats?

The answer to this question, for some firms, has been yes. Sony, for example, has a great deal of experience in designing, manufacturing, and selling miniaturized electronic technology. Sony has used these resources to exploit numerous market opportunities, including portable tape players, portable disc players, portable televisions, and easy-to-hold 8mm video cameras. 3M has used its skills and experience in substrates, coatings, and adhesives, along with an organizational culture that rewards risk taking and creativity, to exploit numerous market opportunities in office products, including invisible tape and Post-It?™ Notes. Sony’s and 3M’s resources-including their specific technological skills and their creative organizational cultures-made it possible for these firms to respond to, and even create, new environmental opportunities.

By answering the question of value, managers link the analysis of internal resources and capabilities with the analysis of environmental opportunities and threats. Firm resources are not valuable in a vacuum, but rather are valuable only when they exploit opportunities and/or neutralize threats. The models developed by Porter and his associates can be used to isolate potential opportunities and threats that the resources a firm controls can exploit or neutralize.

The Question of Rareness

That a firm’s resources and capabilities are valuable is an important first consideration in understanding internal sources of competitive advantage. However, if a particular resource and capability is controlled by numerous competing 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. For managers evaluating the competitive implications of their resources and capabilities, these observations lead to the second critical issue:

How many competing firms already possess these valuable resources and capabilities?

If resources and capabilities are valuable but not rare the firm has achieved competitive parity. If resources and capabilities are valuable and rare, the firm is on its way to achieving sustainable competitive advantage, but at present has achieved temporary competitive advantage.

While resources and capabilities must be rare among competing firms in order to be a source of competitive advantage, this does not mean that common, but valuable, resources are not important. Indeed, such resources and capabilities may be essential for a firm’s survival. On the other hand, if a firm’s resources are valuable and rare, those resources may enable a firm to gain at least a temporary competitive advantage. WalMart’s skills in developing and using point-of-purchase data collection to control inventory have given it a competitive advantage over K-Mart, a firm that until recently has not had access to this timely information. Thus, for many years, WalMart’s valuable point-of-purchase inventory control systems were rare, at least relative to its major U.S. competitor, K-Mart, and as such held a temporary competitive advantage.

The Question of Imitability

A firm that possesses valuable and rare resources and capabilities can gain, at least, a temporary competitive advantage. If, in addition, competing firms face a cost disadvantage in imitating these resources and capabilities, firms with these special abilities can obtain a sustained competitive advantage. These observations lead to the question of imitability:

Do firms without a resource or capability face a cost disadvantage in obtaining it compared to firms that already possess it?

In other words, a firm that possesses valuable, rare, and inimitable resources can achieve a sustained competitive advantage, the ultimate goal for the firm.

Obviously, imitation is critical to understanding the ability of resources and capabilities to generate sustained competitive advantages. Imitation can occur in at least two ways: duplication and substitution. Duplication occurs when an imitating firm builds the same kinds of resources as the firm it is imitating. If one firm has a competitive advantage because of its research and development skills, then a duplicating firm will try to imitate that resource by developing its own research and development skills. In addition, firms may be able to substitute some resources for other resources. If these substitute resources have the same strategic implications and are no more costly to develop, then imitation through substitution will lead to competitive parity in the long run.

So, when will firms be at a cost disadvantage in imitating another’s resources and capabilities, either through duplication or substitution? While there are numerous reasons why some of these internal attributes of firms may be costly to imitate, most of these reasons can be grouped into three categories: (1) the importance of history in creating firm resources; (2) the importance of numerous “small decisions” in developing, nurturing, and exploiting resources; and (3) the importance of socially complex resources.

The Importance of History

As firms evolve, they pick up skills, abilities, and resources that are unique to them, reflecting their particular path through history. These resources and capabilities reflect the unique personalities, experiences, and relationships that exist in only a single firm. Before the Second World War, Caterpillar was one of several medium-sized firms in the heavy construction equipment industry struggling to survive intense competition. Just before the outbreak of war, the Department of War (now the Department of Defense) concluded that, in order to pursue a global war, they would need one worldwide supplier of heavy construction equipment to build roads, air strips, army bases, and so forth. After a brief competition, Caterpillar was awarded this contract and, with the support of the Allies, was able to develop a worldwide service and supply network for heavy construction equipment at very low cost.

After the war, Caterpillar continued to own and operate this worldwide service and supply network. Indeed, Caterpillar management still advertises their ability to deliver any part, for any piece of Caterpillar equipment, to any place in the world, in under two days. By using this valuable capability, Caterpillar was able to become the dominant firm in the heavy construction equipment industry. Even today, despite recessions and labor strife, Caterpillar remains the market share leader in most categories of heavy construction equipment.

Consider the position of a firm trying to duplicate Caterpillar’s worldwide service and supply network, at the same cost as Caterpillar. This competing firm would have to receive the same kind of government support that Caterpillar received during World War II. This kind of government support is very unlikely.

In general, whenever the acquisition or development of valuable and rare resources depends upon unique historical circumstances, those imitating these resources will be at a cost disadvantage building them. Such resources can be sources of sustained competitive advantage.

The Importance of Numerous Small Decisions

Strategic managers and researchers are often enamored with the importance of “Big Decisions” as determinants of competitive advantage. IBM’s decision to bring out the 360 series of computers in the 1960s was a “Big Decision” that had enormous competitive implications until the rise of personal computers. General Electric’s decision to invest in the medical imaging business was a “Big Decision” whose competitive ramifications are still unfolding. Sometimes such “Big Decisions” are critical in understanding a firm’s competitive position. However, more and more frequently, a firm’s competitive advantage seems to depend on numerous “small decisions” through which a firm’s resources and capabilities are developed and exploited. Thus, for example, a firm’s competitive advantage in quality does not depend just upon its announcing that it is seeking the Malcolm Baldridge Quality Award. It depends upon literally hundreds of thousands of decisions made each day by employees in the firm-small decisions about whether or not to tighten a screw a little more, whether or not to share a small idea for improvement, or whether or not to call attention to a quality problem. From the point of view of sustaining a competitive advantage, “small decisions” have some advantages over “Big Decisions.” In particular, small decisions are essentially invisible to firms seeking to imitate a successful firm’s resources and capabilities. “Big Decisions,” on the other hand, are more obvious, easier to describe, and, perhaps, easier to imitate. While competitors may be able to observe the consequences of numerous little decisions, they often have a difficult time understanding the sources of the advantages. A case in point is The Mailbox, Inc., a very successful firm in the bulk mailing business in the Dallas-Ft. Worth market. If there was ever a business where it seems unlikely that a firm would have a sustained competitive advantage, it is bulk mailing. Firms in this industry gather mail from customers, sort it by postal code, and then take it to the post office to be mailed. Where is the competitive advantage here? And yet, The Mailbox has enjoyed an enormous market share advantage in the Dallas-Ft. Worth area for several years. Why?

When asked, managers at The Mailbox have a difficult time describing the sources of their sustained advantages. Indeed, they can point to no “Big Decisions” they have made to generate this advantage. However, as these managers begin to discuss their firm, what becomes clear is that their success does not depend on doing a few big things right, but on doing lots of little things right. The way they manage accounting, finance, human resources, production, or other business functions, separately, is not exceptional. However, to manage all these functions so well, and so consistently over time is truly exceptional. Firms seeking to compete against The Mailbox will not have to imitate just a few internal attributes; they will have to imitate thousands, or even hundreds of thousands of such attributes-a daunting task indeed.

The Importance of Socially Complex Resources

A final reason that firms may be at a cost disadvantage in imitating resources and capabilities is that these resources may be socially complex. Some physical resources (e.g., computers, robots, and other machines) controlled by firms are very complex. However, firms seeking to imitate these physical resources need only purchase them, take them apart, and duplicate the technology in question. With just a couple of exceptions (including the pharmaceutical and specialty chemicals industries), patents provide little protection from the imitation of a firm’s physical resources. On the other hand, socially complex resources and capabilities-organizational phenomena like reputation, trust, friendship, teamwork and culture-while not patentable, are much more difficult to imitate. Imagine the difficulty of imitating Hewlett Packard’s (HP) powerful and enabling culture. One of the most important components of HP’s culture is that it supports and encourages teamwork and cooperation, even across divisional boundaries. HP has used this socially complex capability to enhance the compatibility of its numerous products, including printers, plotters, personal computers, mini-computers, and electronic instruments. By cooperating across these product categories, HP has been able to almost double its market value, all without introducing any radical new products or technologies.

In general, when a firm’s resources and capabilities are valuable, rare, and socially complex, those resources are likely to be sources of sustained competitive advantage. One firm that apparently violates this assertion is Sony. Most observers agree that Sony possesses some special management and coordination skills that enables it to conceive, design, and manufacture high quality, miniaturized consumer electronics. However, it appears that every time Sony brings out a new miniaturized product, several of its competitors quickly duplicate that product, through reverse engineering, thereby reducing Sony’s technological advantage. In what way can Sony’s socially complex miniaturization skills be a source of sustained competitive advantage, when most of Sony’s products are quickly imitated?

The solution to this paradox depends on shifting the unit of analysis from the performance of Sony’s products over time to the performance of Sony over time. After it introduces each new product, Sony experiences a rapid increase in sales and profits associated with that product. However, this leads other firms to reverse engineer the Sony product and introduce their own version. Increased competition leads the sales and profits associated with the new product to be reduced. Thus, at the level of individual products introduced by Sony, Sony apparently enjoys only very short-lived competitive advantages.

However, by looking at the total returns earned by Sony across all of its new products over time, the source of Sony’s sustained competitive advantage becomes clear. By exploiting its capabilities in miniaturization, Sony is able to constantly introduce new and exciting personal electronics products. No one of these products generate a sustained competitive advantage. However, over time, across several such product introductions, Sony’s capability advantages do lead to a sustained competitive advantage.

The Question of Organization

A firm’s competitive advantage potential depends on the value, rareness, and imitability of its resources and capabilities. However, to fully realize this potential, a firm must also be organized to exploit its resources and capabilities. These observations 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 when answering the question of organization, including its formal reporting structure, its explicit management control systems, and its compensation policies. These components are referred to as complementary resources because they have limited ability to generate competitive advantage in isolation. However, in combination with other resources and capabilities, they can enable a firm to realize its full competitive advantage.

Much of Caterpillar’s sustained competitive advantage in the heavy construction industry can be traced to its becoming the sole supplier of this equipment to Allied forces in the Second World War. However, if Caterpillar’s management had not taken advantage of this opportunity by implementing a global formal reporting structure, global inventory and other control systems, and compensation policies that created incentives for its employees to work around the world, then Caterpillar’s potential for competitive advantage would not have been fully realized. These attributes of Caterpillar’s organization, by themselves, could not be a source of competitive advantage; i.e., adopting a global organizational form was only relevant for Caterpillar because it was pursuing a global opportunity. However, this organization was essential for Caterpillar to realize its full competitive advantage potential.

In a similar way, much of WalMart’s continuing competitive advantage in the discount retailing industry can be attributed to its early entry into rural markets in the southern United States. However, to fully exploit this geographic advantage, WalMart needed to implement appropriate reporting structures, control systems, and compensation policies. We have already seen that one of these components of WalMart’s organization-its point-of-purchase inventory control system-is being imitated by K-Mart, and thus, by itself, is not likely to be a source of sustained competitive advantage. However, this inventory control system has enabled WalMart to take full advantage of its rural locations by decreasing the probability of stock outs and by reducing inventory costs.

While a complementary organization enabled Caterpillar and WalMart to realize their full competitive advantage, Xerox was prevented from taking full advantage of some of its most critical valuable, rare, and costly-to-imitate resources and capabilities because it lacked such organizational skills. Through the 1960s and early 1970s, Xerox invested in a series of very innovative technology development research efforts. Xerox managed this research effort by creating a stand alone research laboratory (Xerox PARC, in Palo Alto, California), and by assembling a large group of highly creative and innovative scientists and engineers to work there. Left to their own devices, these scientists and engineers developed an amazing array of technological innovations, including the personal computer, the “mouse,” windows-type software, the laser printer, the “paperless office,” ethernet, and so forth. In retrospect, the market potential of these technologies was enormous. Moreover, since these technologies were developed at Xerox PARC, they were rare. Finally, Xerox may have been able to gain some important first mover advantages if they had been able to translate these technologies into products, thereby increasing the cost to other firms of imitating these technologies.

Unfortunately, Xerox did not have an organization in place to take advantage of these resources. For example, no structure existed whereby Xerox PARC’s innovations could become known to managers at Xerox. Indeed, most Xerox managers-even many senior managers-were unaware of these technological developments through the mid-1970s. Once they finally became aware of them, very few of the innovations survived Xerox’s highly bureaucratic product development process-a process where product development projects were divided into hundreds of minute tasks, and progress in each task was reviewed by dozens of large committees. Even those innovations that survived the product development process were not exploited by Xerox managers. Management compensation at Xerox depended almost exclusively on maximizing current revenue. Short-term profitability was relatively less important in compensation calculations, and the development of markets for future sales and profitability was essentially irrelevant. Xerox’s formal reporting structure, its explicit management control systems, and its compensation policies were all inconsistent with exploiting the valuable, rare, and costly-to-imitate resources developed at Xerox PARC. Not surprisingly, Xerox failed to exploit any of these potential sources of sustained competitive advantage.

The Management Challenge

In the end, this discussion reminds us that sustained competitive advantage cannot be created simply by evaluating environmental opportunities and threats, and then conducting business only in high-opportunity, low-threat environments. Rather, creating sustained competitive advantage depends on the unique resources and capabilities that a firm brings to competition in its environment. To discover these resources and capabilities, managers must look inside their firm for valuable, rare and costly-to-imitate resources, and then exploit these resources through their organization.

Conducting a VRIO Analysis

1. Study the firm and identify 1 – 3 strategy-relevant resources from each category: physical, financial, human, & organizational. What resources does the firm base its strategy on?

2. Set up a grid like the one shown below but add a column in the to the left for each resource identified in step 1. Assess each resource according to the VRIO criteria. Use the details identified by Barney in the above article as the objective measures.

3. Write the competitive implications in the last column according to the legend below.

4. Make suggestions for improvements. How can the firm attain sustainable competitive advantage?