Chapter 6

Why Performance Differs

The Resource-Based View of the Firm

Introduction

The industry analysis we have just done gives us some powerful insights into what makes one industry so different from another in terms of competitive dynamics and overall profitability, but it doesn’t do so well in explaining what interests us, as strategists, most. In all industries, no matter how attractive or dismal, there are firms that do much better than their peers and those (usually more) who lag. To illustrate, Figure 6.1 shows the performance of the major firms in the pharmaceutical industry in 2007, which was developed as part of Fortune magazine’s annual Fortune 500.¹ Return on sales (ROS) is the simple gross profit measure. It is clear that there are significant differences in revenue, profit dollars, and margins among these firms. Which firms are the stars here, and which would be unhappy places to be a manager? What explains these differences among firms in the same industry? After all, industry conditions affect all industry firms in the same way, don’t they?

It turns out industry firms indeed face the same conditions but respond differently to them based on firm specific characteristics. In fact, Richard Rumelt² has shown that across a broad array of industries and over time, business or firm-level effects accounted for about eight times as much variance as industry factors did in explaining differences in profitability. One key to understanding why firm factors matter more is to consider that Porter’s model makes the simplifying assumption that all firms in an industry have access to the same technologies and resources (very much a restatement of the economic assumptions from chapter 1). What happens if this assumption does not hold? What if firms can vary in their resource endowments or profiles? The purpose of this chapter is twofold: First, to understand what data, like those in Table 6.1, tells us about the performance and the competitive advantage of firms, and second, to understand how resource heterogeneity or differences can explain performance differences. The analytic framework we will use for the latter task is Jay Barney’s VRIN model.

Competitive Advantage

We addressed competitive advantage earlier, in chapter 1, but to be very clear, we will want to separate two groups of questions about competitive advantage. The first is one of existence: Does a firm have a competitive advantage? How do we know? The second group of questions addresses causes: Why does this firm possess or lack a competitive advantage? How does it achieve above-average performance? So, if you want to determine if a firm has a competitive advantage, you are addressing the first question. If you want to understand what drives a particular performance outcome or why a firm performs the way it does, you are addressing the second groups of questions.

Deciding if a firm has a competitive advantage requires you to analyze profitability, but what kind? In chapter 1, competitive advantage was defined as abnormal profitability or profitability greater than industry average. From this, it is clear that you will need to two data points: a measure of firm profitability and another for industry average profitability. But what measure, and why? In Figure 6.1, we have two measures: profit dollars and return on sales (ROS). Profit dollars are interesting (increases in, and the absolute magnitude of, profit dollars are the favorite of excitable press and political commentators) but not really useful. All they really tell us is which firms have the most or least of them. Such raw profits are often closely correlated with revenues so to simply focus on the number of profit dollars makes large firms appear better, which clearly isn’t always true, and offers us no insight about how efficient firms are at converting revenue dollars to profit. As was observed earlier, a better measure is profit margins (as a proxy for the ROIC). The simplest profit margin is gross profit margin (GPM), or ROS, which uses revenues and cost of goods sold (COGS) as a basis. It is calculated as:

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Or, since Sales-COGS is just another way of describing gross profits:

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This is why the gross profit result is called ROS and is a better measure of profitability, as it corrects for size differences and tells us which firms are better at converting revenue or sales dollars into profit. ROS (or, alternatively, GPM) is a measure of efficiency. Related measures include operating profit margins, which deducts selling, general, and administrative expenses (SG&A) and other operating costs from profits, and net profit margins, which uses profits after additionally deducting interest, taxes, and so on. You can calculate these margins from company income statements. Usually, these margins will tell the same story about comparative efficiency but not always. For instance, Wal-Mart has often had lower gross profit margins than their competitors. Does this mean they are ineffective? The explanation lies in the fact that the discount retail industry does not have a cost structure like that of manufacturing where significant value is added to incoming raw materials. Discount retailers buy finished goods and then resell them. There is comparatively little labor input, so the COGS is fundamentally the purchase price from suppliers. Under these conditions, a lower gross profit margin could have two causes: Wal-Mart either is paying more for the same goods from suppliers than competitors or it is charging customers less for them. Which do you think is happening? A deeper look at this industry shows that Wal-Mart is particularly effective at the operational level (i.e., sales and general administrative expense and logistics), and it shows a much higher net profit margin than industry average.³

Profit margins tell us something about how a firm is doing but, in and of themselves, are not sufficient to establish competitive advantage. That requires comparison against other firms in the industry—that industry average performance. In Table 6.1, note the performance differences between firms in terms of profit margin. Which firm has a competitive advantage, and how do you know? How different should performance be in order to be considered indicative of a real advantage? On what basis should you construct an industry average performance metric? How long a period constitutes good evidence: Are one quarter’s financial results sufficient?

With the information from Table 6.1, we can construct a first approach that develops a weighted average of profitability by dividing summed profits by summed revenues. This yields an overall industry average of 20.71%. This puts Johnson and Johnson right at industry average with GlaxoSmithKline, Novartis, AstraZeneca, Merck, and Wyeth right around that return, plus or minus. What stands out is Pfizer at 36.9% ROS versus Abbot Laboratories and Bristol-Myers Squibb, which are both at less than 10% ROS. From this list, at least for the year 2007, I conclude that there was one clear leader and a number of firms lagging behind industry averages. Other industries will vary. Note that while GlaxoSmithKline and AstraZeneca technically have returns above the average, they are not greatly above average. I recommend the notion of competitive advantage be reserved for firms that clearly outperform their peers, hence the focus on Pfizer.

There are several caveats to keep in mind here. First, this is a sample of convenience and may not reflect the pharmaceutical industry as a whole. This is why a careful construction of industry firms (from chapter 2) is so important. Second, the data cover just one year, and that can be deceptive as you may catch firms just after they have introduced a new product that will soon be imitated or after they have just written off investments that mark an otherwise stellar returns history. More data are better: Try to develop a sense of firm and industry performance over years.

Analyzing Firm Resources

Once we have established the presence or absence of competitive advantage, we want to understand why or how this occurs. What you are going to learn reflects a suspension of the assumptions made in chapter 1 about industry entry different from Porter’s model. The base assumption for the microeconomic approach is that all entrants have access to the same technology and inputs as incumbents do. This is called resource mobility because resources should flow without impedance. In the late 1980s, though, researchers began to ask what happened if this assumption failed, if there were, in fact, mobility barriers that prevented imitation of profitable positions. If so, then firms that have carved out profitable positions with isolating mechanisms⁴ should be able to enjoy above-average profits until competitors find some way to circumvent the isolation. This work and that of others, such as Birger Wernerfelt, Margaret Peteraf, and Barney, are the central ideas behind the resource-based view (RBV) of the firm. That is, what really matters is not the industry the firm is in but firm specific characteristics, particularly resource endowments, that define which firms succeed and which fail.

A resource is a factor of production (i.e., something that goes into the process of making, delivering, and servicing products or services). Thus, resources certainly include the materials used to make a product as well as the labor and the capital—but there are usually more interesting assets to consider. These could include specialized knowledge (such as that of scientists or engineers in R&D) or reputation effects (Disney is an excellent example here). Other interesting resources include especially efficient routines (firms that have implemented real total quality management programs could be an example or firms that are particularly effective at new product development and introduction), or socially based attributes such as organizational culture. Barney⁵ categorizes this range of resources as physical capital resources (such as materials and machines), human capital resources or the knowledge and skills of individual workers and managers, and organizational capital resources. The latter are the outcome of group based work and include routines, planning and control or execution capabilities, and the relations between members of the firm and between the firm and its environment.

Another classification that may be useful is to distinguish between resources and capabilities (a learned or innate skill) or competences (what the firm does particularly well). That is, you might have a capability for playing the violin or growing organic vegetables or making specialized fly rods. That could be an important skill and requires certain sorts of more tangible resources (like violins and music, or land, or bamboo blanks, thread and glue). Everyone can purchase the resources, but few can use them effectively. Capabilities are skills that use other resources. Sometimes, significant capabilities or competences can even be the result of combinations of other capabilities (i.e., higher level skills). For example, a “learning” organization’s ability to recognize changes in environmental needs and effectively reconfigure or transform current capabilities to meet those needs could be a real competence (and advantage!).⁶ Some guidance in assessing these more complex resources is discussed later.

Every firm has resources but it is resource heterogeneity, or the differences in resource endowment, that separates above-average firms from the rest. Obviously, not all resources matter in the sense of conveying a competitive advantage, so how can we determine the really important resources? Barney⁷ has developed the VRIN model for managers and analysts so as to organize the critical questions for resource analysis. In this approach, resources are assessed to determine the extent to which they are valuable, rare, inimitable, and non-substitutable. If a resource passes all four tests, then it should be one that conveys sustainable, above-average returns to the firm, and that firm should demonstrate a competitive advantage. The discussion that follows develops the relevant ideas and tests for each step of the model. Note that this will be a time-consuming and extensive analysis because you must assess resources from a number of firms. This approach doesn’t work completely if you restrict your work to your own firm!

The first step is to identify key resources for the firm in question. Firms usually have a vast array of resources available, so you have to cut the cognitive task down to size. Focus on the major value drivers both in the industry and at the firm level. What does it take to compete? How do firms do what they do? What makes them interesting? Select a set of key resources for the firm you are analyzing and take time to define what the resource is. For example, in the air carrier industry, every firm needs planes, route structures, gates at airports, and employees to do business. These are all resources that might be worth considering in an assessment of which resources, if any contribute to a competitive advantage for a firm. The problem of definition requires that you really take the time to understand what the resource is and its salient characteristics. Southwest Airlines, like all carriers, has a fleet of planes, which is a resource. To stop the definition here, though, is to be too general. Southwest’s fleet is made up of only Boeing 737s and this distinction will prove useful later.

Is the resource valuable? This is probably the most difficult question in the model to answer well. On one level, all resources should provide value, but since firms usually have a host of resources involved in production, this doesn’t narrow the field. What we are interested in are resources that, as Barney puts it, allow firms to take advantage of opportunities or defuse threats. Another way of looking at it is to seek resources that enhance revenues or reduce costs in ways not usually covered in the industry rules of the game (i.e., based on your industry analysis). Here is an example: IBM dominated the early years of the personal computer (PC) industry in the late 80s and early ’90s because of a particular resource. IBM was not the first to market with a PC nor, when it entered, was it the best known (that prize went to Apple Computer, which was very highly recognized). Still, it took little time for IBM to set the standard for PCs. The important resource here was IBM’s reputation in the field. Computers were still very specialized and somewhat alien technologies for most buyers, both business and personal. The typical computer was still oriented toward the hobbyist who had a far above-average understanding of (or tolerance for) programming at a deep level and was able to handle product assembly or modification. Because IBM had dominated the mainframe world for decades, though, its entry gave credibility to the PC as a legitimate business product. If IBM sold it, the complexity and unfamiliarity of PCs “didn’t matter.” IBM sold many PCs because buyers trusted the brand. IBM was able to gain most of the revenues and command a higher price because of this.

Note that you need to be quite specific about how or why a resource is valuable. What makes Southwest’s fleet valuable hinges on the fact that all the planes in the fleet are versions of the Boeing 737. This not only adds value because it allows Southwest to carry passengers (as planes do for every carrier) but also because the homogenous fleet structure reduces maintenance expenses, keeps crew sizes small, and reduces training expenses. Note how a general definition of the fleet (a set of planes, for example) would have led to overlooking these value sources.

In your analyses, then, you should be seeking to understand the particular value contribution of the resource and how it is interesting or unusual. A hint might be the attributes the firm itself deems important, though this is not a completely reliable guide as managers are often myopic about this. A better idea is to understand how business is done generally so that exceptions in revenue generation or cost management stand out. Always be certain that you can stipulate what the value is (e.g., the resource reputation creates additional revenues through volume and price or particular processes lead to exceptional productivity).

Is the resource rare? That is, do few, if any, other firms possess the same resource? If a resource is rare, it generates value in a way that other firms do not, which creates a competitive advantage. If you recall in chapter 1, Figure 1.4 shows how a single-firm industry looks with respect to profits. If a firm has resources that generate value in a way that others do not, then a condition of above-normal profitability exists. Determining rareness is a question for the state of the industry at the time of analysis. You shouldn’t worry (yet!) about what could or will be done but just how things stand at the time of the analysis. A warning: Rare is not synonymous with unique. That is, a firm need not stand alone with its resource. This means there could be several firms generating abnormal returns. However, since you are interested in determining above-average performance and not best or top performance, this should not be an issue. There can be several firms performing above industry average. You will have to judge whether the number of firms that possess the same resource is so large that it is fairly characteristic of competition.

As a somewhat extreme example of what rareness means, consider the pharmaceutical industry. When drug firms in the United States develop prospective drug therapies, they have to comply with testing requirements imposed by the Food and Drug Administration (FDA) to demonstrate efficacy and safety. Because this process is very long (nine to fourteen years on average), costly ($350–500 million), and usually unsuccessful (about 20% of drugs entering Phase I trials ultimately succeed), pharmaceutical firms are granted patents for the formulations.⁸ With a drug patent, no other firm can offer the same formulation to the market. The notion of “same” is important: If even slightly different, the competing drug would have to go through the FDA process. Therefore, by definition, a drug therapy under patent is rare—at least, in the United States, since no other firm can sell that formulation until patent expiration. With some drugs, this protection, and the subsequent right to set very high market prices, can be the cornerstone of firm profitability. Drugs that are still covered by patents such as Lipitor ($12.9 billion in sales in 2005) or Plavix ($5.9 billion) are rightly called “blockbusters.” On the other hand, when the patent expires, profits can drop 80%–90%, as there can be a number of producers of a completely identical product. Then, the only basis of competition is price.

Finally, consider how weakness in the resource definition can weaken the analysis. The simple definition of the Southwest fleet as just a set of planes would fail this test because all carriers have fleets. However, few carriers have a homogenous fleet and generate value the way Southwest does. One definition shuts the analysis down, and the other allows us to go forward in a useful way.

Is the resource imitable? That is, if the resource is now rare, can other firms develop the same resource? If others can imitate the resource, then they can stake a claim to some of the same profits or rents. If they cannot, then the focal firm has a chance to claim a sustained competitive advantage or one that persists over time.

There are two key ideas to consider here. The first is that imitation need not be exact; in fact, this is almost always impossible. For example, suppose your analysis of a firm indicates that the CEO is a real resource because she motivates well, and gets tremendous buy-in (hence productivity) from her staff. Can this CEO be imitated? Not in a literal sense, of course—but, is it feasible that other firms could find and hire equally motivational leaders? If so, then the resource can be imitated.

The second point is that imitation must be economically reasonable. Remember that the entire motivation for imitating resources is to claim some of the abnormal rents or profits that a competitive advantage firm is now getting. Now, to keep this very simple, suppose that if your firm can imitate that key resource, it will split the abnormal profitability with the firm that has the competitive advantage. Call the total above-average profits x and your share ½ x. How much are you willing to spend to claim those profits? Certainly, no more than ½ x, so there is a limit to how much potential imitators can spend as they pursue equality with competitive advantage firms. The expense cannot exceed the profits they expect to attain. If it does, rational managers would not pursue imitation and we have to call the resource inimitable.

For example, the Southwest Airline fleet turns out to be valuable and rare. This means it is helping to generate some above-normal profits. Can competitors imitate? Often, not economically because to do so would require radically changing route systems and operating philosophies. The large legacy carriers use a hub-and-spoke system, which requires high-capacity planes for hub to hub flights. To go to a 737 (a small jet) would make the hub-and-spoke system unworkable. Competitors could go to a larger jet style but these would have performance penalties on lightly used legs of the system (not to mention that smaller airports may not be able to handle large jets). So, in short, it is exceedingly difficult for existing competitors to create a resource that does what Southwest’s fleet does. Though, note that entrants have no such problem. Jet Blue, among others, adopted the Southwest strategy at the outset, though it used a fleet of Airbus jets.

Barney develops three general explanations for why resources may be difficult to imitate. First is the problem of path dependency, or the fact that history matters. How firms develop or acquire key resources may be a function of the particular history of that organization. For example, Microsoft’s involvement in developing the operating system for IBM’s PCs was incredibly important, as it gave Microsoft control over what turned out to be the dominant operating system, and the key resource, in microcomputers. This has led to a two decade run as the dominant force in PC software. To put it differently, Microsoft was in the right place at the right time. Competitors seeking to imitate this key resource by introducing their own operating system cannot replicate Microsoft’s path to industry dominance since the market has changed so much, and thus competitors now face some very costly problems with imitation, such as switching costs.

Similarly, Southwest Airline’s tight-knit, cohesive organizational culture depends, in part, on the circumstances around the beginning of the firm. The preemptive steps taken by competitors, like Braniff and Continental, to keep Southwest from ever offering service created, among the founding personnel, an underdog mentality and a certain aggressiveness and willingness to work hard and pitch in to overcome the difficulties.⁹ Developing a similar can-do culture is difficult because that attitude springs from history: To the extent the causes cannot be recreated, the outcomes will not emerge.

A second source of difficulty for imitators is causal ambiguity, or a lack of clarity about the link between a firm’s resources and how they contribute to competitive advantage. If others don’t understand how a firm gets the benefits it does, they cannot imitate. The performance may be the result of a number of small decisions or interactions specific to circumstances. To the extent that these cannot be easily observed, much less analyzed, the resource becomes difficult to imitate. This is actually so common that even firms with a high-performing, knowledge-based resource (like manufacturing know-how) often cannot understand how to transfer that same process to another facility and get similar results.¹⁰

The third source of difficulty in imitation is social complexity, or the fact that many higher level resources, such as reputation or trust, are the outcome of interactions between a number of people over time. Not only does history matter, we find, but so also do the people involved and their relationships with one another. The resource is experience based and experience takes time, which therefore makes imitation difficult. Suppose, for example, a firm’s key resource is a reputation for trustworthiness. Is it necessarily impossible that a competitor could also develop such a reputation? No—but what would it take? Trust is the result of a myriad of interactions over time. To develop that reputation, a firm has to deal with its contacts (customers, suppliers, and other stakeholders) in a reliable, trustworthy way and not renege or default. Presumably, any firm can do this but it will require perhaps years before that reputation is broadly accepted. As a side note: If reputation takes a long time to build, it takes very little time to damage, perhaps irrevocably. Consider the problems Toyota is having with respect to product quality, which has long been a calling card of that firm’s high performance.

Another illustration of the difficulty social complexity presents is in organizational culture, which is often a critical resource for high performing firms. Culture is the set of beliefs, rules, routines, formal and informal hierarchies, and practices that emerge from the experiences of firm members over time. Culture sets the expectations for acceptable and unacceptable behavior by organization members. These expectations can be explicitly and formally spelled out in handbooks or contracts, but at an even more important level, they are often conveyed as newcomers learn about the firm through stories, legends, workarounds, and inside jokes told by veterans. Southwest has captured this in a relatively formal way by publishing for internal use a book that focuses on What Positively Outrageous Service Looks Like at Southwest Airlines and uses what are termed “legendary acts of service.”¹¹ Real, deep-seated beliefs usually take some time to form and require reinforcement from others. So, if a firm wants to imitate the high performing culture of a competitor, what would it take? How could those valuable interactions among firm members be essentially replicated? Again, existing firms would have substantial difficulty in creating a similar culture because the rules, practices, and perspectives that workers have would have to change. Particularly to the extent that relations between management and labor have been rancorous (and the carrier industry has experienced many strikes and work stoppages over time), getting workers to change beliefs would be difficult. However, as in the example of Southwest’s fleet, entrants might have an easier time creating a similar culture because they select members of a certain mindset and start with a fresh slate.

Another reason imitation may be difficult is because the high-performing firm has moved first or early and acquired or developed the resource at an extraordinarily low cost. This might happen because others do not yet recognize the value of the resource or because of luck. Resources that can be usefully claimed first include input resources but more often include assets related to space such as geographic location or shelf space.¹² As an illustration, Marks and Spencer, the venerable English department store, secured rights to central city properties through freeholds or long-term leases negotiated decades ago at very low per-square-foot rates.¹³ Newer competitors cannot gain equivalent store space or exposure at near the cost. Thus, Marks and Spencer developed a cost advantage with the preempted real estate resource.

This raises a final concern about imitability. In a broad sense, potential imitators can suffer from time compression diseconomies, that is, there is just not enough time available to learn and emulate important skills or capabilities.¹⁴ As we just saw, it may be possible for a firm to imitate the reputational assets of another, but it will take a long time because reputation is earned over time and through repeated interactions. You can’t shortcut it. Additionally, even as imitators work to replicate the important resource, the high-performing firm can continue to build on the asset. An example is that of Wal-Mart, which pioneered so many supply chain innovations like hub-and-spoke distribution, electronic data interchange, and so on. Competitors could see how to replicate these processes, but even as they did, Wal-Mart kept raising the bar. For the period 1995–1999, competitors improved their efficiency 28%, but Wal-Mart improved by an additional 20% over an already much higher base. Thus, Wal-Mart was comparatively even more efficient afterward!¹⁵ If imitation takes much time, then the resource is often practically inimitable.

Still, even though there are reasons why imitation may be difficult, bear in mind that relatively few firms have real, long-term competitive advantages, so imitation must almost always be possible. Your job is to understand the attributes of the resource sufficiently to discern when real imitation is likely to be difficult (and for which firms, if that matters!).

Is the resource non-substitutable? This continues the industry analysis notion of substitution as a different way to solve the problem of interest. Even if imitation is not feasible, managers still have to be aware that other approaches may undermine the important resources that have provided a competitive advantage. If the substitute resource can solve the problem the customer has, then it becomes a legitimate claimant on the profits that previously went to the firm with the competitive advantage.

To continue a previous example, it may be the case that a strong CEO is not needed if the culture of the organization is strong. Thus, culture could be a substitute if it delivers the same productivity to the firm. In another example, Barney used Caterpillar versus Komatsu in the heavy construction equipment market.¹⁶ Caterpillar had supply and parts depots around the world and, because of them, was able to repair broken-down graders and bulldozers very quickly. This gave Caterpillar a competitive advantage, and competitors were unable to cost effectively replicate the depot system. Komatsu, however, attacked at a different point: product quality. Can product quality be a substitute for the supply depot system?

Like the analysis of imitability, substitutes have to meet the economic reasonableness test. If it costs more to substitute for the critical resource, then rational managers will not do it. You should be able to demonstrate in your analysis why substitution, if it applies, is economically feasible.

Figure 6.1 summarizes the work for this chapter. Managers are interested in achieving a competitive advantage or above-average returns in profitability. This depends on the possession of resources that set one or a few firms apart from the others. The VRIN model shows us that if a resource is valuable but not rare, it can’t be a source of difference. Therefore, at best it conveys parity or equality. If a resource is also rare, it provides at least a temporary competitive advantage since there are profits coming in that others don’t get. It is temporary only if the resource can be imitated or substituted. If it cannot, then the firm has a resource that should provide a sustained competitive advantage or long-term returns above average.

This chapter closes with two pieces of advice. First, note that the high-level resources, also known as competences (what a firm does particularly well), should probably be investigated as composites of other, underlying resources. Southwest Airlines has a number of resources that likely pass the tests you’ve gone through but probably the most important resource for them has been the firm’s competence at turning planes around at the gate and getting them back in the air. Historically, Southwest had been able to turn planes in 15 to 20 minutes versus an industry average of 45.¹⁷ Fast turnaround means the costly resource of planes is better used, significantly reducing average costs. Turnaround time is not something that can be improved just through an effort of will, though. Southwest integrates resources like the fleet (small planes have small passenger loads for faster unloading and loading) and a point to point route structure frequently using small airports (which means no baggage transfers—just off and on loading). Southwest also pursues intentional minimization of amenities like food service (which saves time on restocking the plane), and a culture that encourages some rather unusual behavior (such as pilots helping to unload bags) together to drive its own fast turn time.¹⁸ Imitating Southwest’s turn time at the gate therefore requires that competitors be able to replicate a number of really difficult to copy resources—making this competence almost unapproachable, especially for incumbents.

Second, the real key to doing this sort of analysis well is being honest with yourself about your firm and your competitors. This may not be comfortable or popular, but glossing over competitor strengths or propping up convenient and reassuring internal assumptions about your own firm can be exceedingly dangerous. Andrew Campbell, Jo Whitehead, and Sydney Finkelstein argue that these misjudgments persist because of inappropriate self-interest (our biases color the way we perceive information), distorting attachments (such as loyalty to people or organizations), and misleading memories (similarities to what has happened to us before obscures important differences).¹⁹ Since we are all subject to these influences most the time, it’s difficult to know when you are really susceptible to distorted analysis. One recommendation that may help is to make sure you understand the real value proposition you are claiming for resources. A lighting firm I worked with, for example, prided itself on excellence in optical design and fixture manufacturing. In fact, the firm did produce very sophisticated and efficient lighting products, and managers were probably correct that it would take competitors years to catch up in terms of skill and catalog breadth. It was an article of faith in the company that such excellence mattered greatly.

However, what they missed was that buyers didn’t care about the extra 4% or 5% efficiency this firm’s optical designs contributed to performance enough to warrant the price. Competitors who were able to use the same materials, were approximately as good in terms of performance, and delivered at a lower price suddenly grew strong. Thus, though optical design skills like this firm had were indeed rare and difficult to imitate, distorting attachments to the legend and culture of the firm led managers to overestimate their real value. Clear-eyed and objective analysis is absolutely essential to valid conclusions.

Summary

The performance of firms in an industry differs because of variances in their resource portfolios. Resources are factors of production but the term is a broad one. Production isn’t just the making of something but also the delivery of it at a certain price. Therefore, resources can also include reputation, knowledge, brand loyalty, routines, culture, and a host of other relatively intangible assets. These can turn out to be particularly important because they are often unusual or rare as well as difficult to understand from the outside. Under these conditions, firms with such resources can develop higher returns than others in the industry. That is, they have a competitive advantage.

To understand if your firm can achieve or defend a competitive advantage, you need to honestly and carefully assess the resources of your firm and those of your competitors. This is what Barney’s VRIN model is intended to help you with. Note, though, the injunction about being honest with yourself: Don’t underestimate your competitors and don’t fall blindly in love with what you do well. It is better to anticipate and prepare for heightened competition because you have been clear-eyed than to be ambushed by events you dismissed.