Chapter Five

The Internal Assessment

5.1 The nature of an internal audit
Analysis of the firm’s internal environment finds evaluators thinking of their firm as a bundle of
heterogeneous resources and capabilities that can be used to create an exclusive market position
This perspective suggests that individual firms possess at least some resources and capabilities
that other companies do not—at least not in the same combination. Resources are the source
of capabilities, some of which lead to the development of a firm’s core competencies or its
competitive advantages.

Understanding how to leverage the firm’s unique bundle of resources and capabilities is a key
outcome decision makers seek when analyzing the internal environment. Figure 5.1 illustrates the
relationships among resources, capabilities, and core competencies and shows how firms use them
to create strategic competitiveness. Before examining these topics in depth, we describe value and
how firms use their resources, capabilities, and core competencies to create it.

Creating Value
By exploiting their core competencies or competitive advantages to at least meet if not exceed
the demanding standards of global competition, firms create value for customers. Value is
measured by a product’s performance characteristics and by its attributes for which
customers are willing to pay. Evidence suggests that increasingly, customers perceive higher
value in global rather than domestic-only brands. Firms create value by innovatively bundling and
leveraging their resources and capabilities. Firms unable to creatively bundle and leverage their
resources and capabilities in ways that create value for customers suffer performance declines

Figure 5.1 Components of internal analysis leading to competitive advantage and strategic
competitiveness

During the last several decades, the strategic management process was concerned largely with
understanding the characteristics of the industry in which the firm competed and, in light of those
characteristics, determining how the firm should position itself relative to competitors. This
emphasis on industry characteristics and competitive strategy may have underestimated the role of
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the firm’s resources and capabilities in developing competitive advantage. In fact, core
competencies, in combination with product-market positions, are the firm’s most important
sources of competitive advantage. The core competencies of a firm, in addition to its analysis of
its general, industry, and competitor environments, should drive its selection of strategies. As
Clayton Christensen noted, “Successful strategists need to cultivate a deep understanding of the
processes of competition and progress and of the factors that under bind each advantage. Only
thus will they be able to see when old advantages are poised to disappear and how new
advantages can be built in their stead.” By emphasizing core competencies when formulating
strategies, companies learn to compete primarily on the basis of fir m-specific differences, but
they must be very aware of how things are changing in the external environment as well.

5.2 Resources, Capabilities, and Core Competencies

Resources, capabilities, and core competencies are the characteristics that make up the foundation
of competitive advantage. Resources are the source of a firm’s capabilities. Capabilities in turn
are the source of a firm’s core competencies, which are the basis of competitive advantages. As
shown in Figure 5.1, combinations of resources and capabilities are managed to create core
competencies.

Resources
Broad in scope, resources cover a spectrum of individual, social, and organizational phenomena.
Typically, resources alone do not yield a competitive advantage. In fact, a competitive advantage
is created through the unique bundling of several resources For example; [Link] has
combined service and distribution resources to develop its competitive advantages. The firm
started as an online bookseller, directly shipping orders to customers. It quickly grew large and
established a distribution network through which it could ship “millions of different items to
millions of different customers.” Compared to Amazon’s use of combined resources, traditional
bricks-and mortar companies, such as Toys ‘R’ Us and Borders, found it hard to establish an
effective online presence. These difficulties led them to develop partnerships with Amazon
Through these arrangements, Amazon now handles the online presence and the shipping of goods
for several firms, including Toys ‘R’ Us and Borders—which now can focus on sales in their

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stores. Arrangements such as these are useful to the bricks-and mortar companies because they are
not accustomed to shipping so much diverse merchandise directly to individuals

Some of a firm’s resources are tangible while others are intangible Tangible resources are assets
that can be seen and quantified. Production equipment, manufacturing plants, and formal
reporting structures are examples of tangible resources. Intangible resources include assets that
typically are rooted deeply in the firm’s history and have accumulated over time. Because they are
embedded in unique patterns of routines, intangible resources are relatively difficult for
competitors to analyze and imitate. Knowledge, trust between managers and employees, ideas the
capacity for innovation, managerial capabilities, organizational routines (the unique ways people
work together), scientific capabilities, and the firm’s reputation for its goods or services and how
it interacts with people (such as employees, customers, and suppliers) are all examples of
intangible resources. The four types of tangible resources are financial, organizational, physical,
and technological and the three types of intangible resources are human, innovation and
reputational.
Financial resources •The firm’s borrowing capacity
• The firm’s ability to generate internal funds
•The firm’s formal reporting structure and its
Organizational resources
formal planning, controlling, and coordinating
TANGIBLE systems
RESOURCES • Sophistication and location of a firm’s plant and
Physical resources equipment
• Access to raw materials
• Stock of technology, such as patents, trade-
Technological resources
marks, copyrights, and trade secrets
• Knowledge
• Trust
Human resources
• Managerial capabilities
• Organizational routines
• Ideas
Innovation resources • Scientific capabilities
INTANGIBLE • Capacity to innovate
RESOURCES • Reputation with customers
• Brand name
• Perceptions of product quality, durability, and
Reputational resources reliability
• Reputation with suppliers
• For efficient, effective, supportive, and mutually
beneficial interactions and relationships

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Capabilities
Capabilities are the firm’s capacity to deploy resources that have been purposely integrated to
achieve a desired end state. The glue binding an organization together, capabilities emerge over
time through complex interactions among tangible and intangible resources. Critical to the
forming of competitive advantages, capabilities are often based on developing, carrying, and
exchanging information and knowledge through the firm’s human capital. Because a knowledge
base is grounded in organizational actions that may not be explicitly understood by all employees,
repetition and practice increase the value of a firm’s capabilities. The foundation of many
capabilities lies in the unique skills and knowledge of a firm’s employees and, often, their
functional expertise. Hence, the value of human capital in developing and using capabilities and,
ultimately, core competencies cannot be overstated. Capabilities often developed in specific
functional areas (such as manufacturing, R&D, and marketing) or in a part of a functional area
(for example, advertising).
Functional Areas Capabilities Example
Distribution Effective use of logistics management techniques Wal-Mart
Management
point-of-purchase data collection methods Wal-Mart
Information System
Human resources Motivating, empowering, and retaining employees Microsoft Corp.
Marketing Effective promotion of brand-name products Gillette
Management Effective organizational structure PepsiCo
Manufacturing Design and production skills yielding reliable Komatsu

Core Competencies
Core competencies are resources and capabilities that serve as a source of a firm’s competitive
advantage over rivals. Core competencies distinguish a company competitively and reflect its
personality. Core competencies emerge over time through an organizational process of
accumulating and learning how to deploy different resources and capabilities. Some resources or
capabilities may stifle or prevent the development of a core competence. Firms with the tangible
resource of financial capital, such as Microsoft, which has a large amount of cash on hand, may
be able to purchase facilities or hire the skilled workers required to manufacture products that
yield customer value.
Core Competences for Competitive Advantage
Core competences which confer competitive advantage to a firm have four attributes:
 Value--the resource allows the firm to conceive of and implement strategies that

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 effectively deal with opportunities and threats
 Rarity--the resource is generally unavailable to large numbers of current or potential
competitors.
 Not imitable--the resource cannot be easily obtained by competitors
 Non-substitutability there are no strategically equivalent valuable resources available to
competitors. Resources are substitutes when they can each individually be used to
implement the same strategies.

5.3 VALUE CHAIN ANALYSIS

Value Chain Analysis describes the activities that take place in a business and relates them to an
analysis of the competitive strength of the business. In order to better understand the activities
leading to a competitive advantage, one can begin with the generic value chain and then
identify the relevant firm-specific activities A linkage exists if the performance or cost of one
activity affects that of another. Competitive advantage may be obtained by optimizing and
coordinating linked activities. The value chain also is useful in outsourcing decisions. Influential
work by Michael Porter suggested that the activities of a business could be grouped under two
headings
(1) Primary Activities- those that are directly concerned with creating and delivering a product
(e.g. component assembly); and
(2) Support Activities which whilst they are not directly involved in production, may increase
effectiveness or efficiency (e.g. human resource management). It is rare for a business to
undertake all primary and support activities.

Value Chain Analysis is one way of identifying which activities are best undertaken by a
business and which are best provided by others ("out sourced"). The value chain shows how a
product moves from the raw-material stage to the final customer. For individual firms, the
essential idea of the value chain is to create additional value without incurring significant costs
while doing so and to capture the value that has been created. In a globally competitive economy,
the most valuable links on the chain tend to belong to people who have knowledge about
customers. This locus of value-creating possibilities applies just as strongly to retail and service
firms as to manufacturers.

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Primary Value Chain Activities
Inbound > Operations > Outbound > marketing and > services
Logistics Logistics sales
The goal of these activities is to create value that exceeds the cost of providing the product or
service, thus generating a profit margin
 Inbound logistics include the receiving, warehousing, and inventory control of input
materials
 Operations are the value-creating activities that transform the inputs into the final product
 Outbound logistics are the activities required to get the finished product to the customer,
including warehousing, order fulfillment, etc.
 Marketing & Sales are those activities associated with getting buyers to purchase the
product, including channel selection, advertising, pricing, etc
 Service activities are those that maintain and enhance the product's value including
customer support, repair services, etc

Support Activities
The primary value chain activities described above are facilitated by support activities Porter
identified four generic categories of support activities, the details of which are industry-specific
 Procurement the function of purchasing the raw materials and other inputs used in the
value-creating activities
 Technology Development includes research and development, process automation, and
other technology development used to support the value-chain activities
 Human Resource Management the activities associated with recruiting development,
and compensation of employees
 Firm Infrastructure includes activities such as finance, legal, quality management, etc
Value chain analysis can be broken down into a three sequential steps:
1) Break down a market/organization into its key activities under each of the major headings
in the model;
2) Assess the potential for adding value via cost advantage or differentiation, or identify
current activities where a business appears to be at a competitive disadvantage
3) Determine strategies built around focusing on activities where competitive advantage can

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 be sustained
5.4 Relationship among the Functional Areas of Business
Functional relationships refer to the Number and complexity increases relative to organization size. The
process of performing an internal audit closely parallels the process of performing an external audit.
Representative Managers and employees from throughout the firm need to be involved in determining a
firm's strengths and weaknesses. It gathers & assimilates information from:
 Management
 Marketing
 Finance/accounting
 Production/operations
 Research & development
 Management information systems
Involvement in performing an internal strategic-management audit provides vehicle for understanding
nature and effect of decisions in other functional business areas of the firm. Internal audit creates an
environment of Coordination and understanding among managers from all functional areas.
Strategic management is a highly interactive process that requires effective coordination among
management, marketing, finance/accounting, production/operations, R&D, and computer information
systems managers. A failure to recognize and understand relationships among the functional areas of
business can be detrimental to strategic management, and the number of those relationships that must be
managed increases dramatically with a firm's size, diversity, geographic dispersion, and the number of
products or services offered. Governmental and nonprofit enterprises traditionally have not placed
sufficient emphasis on relationships among the business functions. For example, some state governments,
utilities, universities, and hospitals only recently have begun to establish marketing objectives and
policies that are consistent with their financial capabilities and limitations. Some firms place too great an
emphasis on one function at the expense of others.
Financial Ratio Analysis:
Financial ratio analysis exemplifies the complexity of relationships among the functional areas of
business. A declining return on investment or profit margin ratio could be the result of ineffective
marketing, poor management policies, research and development errors, or a weak computer information
system. The effectiveness of strategy formulation, implementation, and evaluation activities hinges upon
a clear understanding of how major business functions affect one another. For strategies to succeed, a
coordinated effort among all the functional areas of business is needed.
Integrating Strategy and Culture

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Relationships among a firm's functional business activities perhaps can be exemplified best by focusing
on organizational culture, an internal phenomenon that permeates all departments and divisions of an
organization. Organizational culture can be defined as "a pattern of behavior developed by an
organization as it learns to cope with its problem of external adaptation and internal integration that has
worked well enough to be considered valid and to be taught to new members as the correct way to
perceive, think, and feel." This definition emphasizes the importance of matching external with internal
factors in making strategic decisions.
Internal strengths and weaknesses associated with a firm's culture sometimes are overlooked because of
the inter-functional nature of this phenomenon. It is important, therefore, for strategists to understand
their firm as a socio cultural system. Success is often determined by linkages between a firm's culture and
strategies. The challenge of strategic management today is to bring about the changes in organizational
culture and individual mind-sets necessary to support the formulation, implementation, and evaluation of
strategies.
Management
The functions of management consist of five basic activities: planning, organizing, motivating, staffing,
and controlling.
Marketing:
Marketing can be described as the process of defining, anticipating, creating, and fulfilling customers'
needs and wants for products and services.
There are seven basic functions of marketing:
(1) Customer analysis,
(2) Selling products/services,
(3) Product and service planning,
(4) Pricing,
(5) Distribution,
(6) Marketing research, and
(7) Opportunity analysis.
Understanding these functions helps strategists identify and evaluate marketing strengths and weaknesses.
Finance/Accounting Functions
 Determining financial strengths and weaknesses key to strategy formulation
 Investment decision (Capital budgeting)
 Financing decision
 Dividend decision

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According to James Van Horne, the functions of finance/accounting comprise three decisions: the
investment decision, the financing decision, and the dividend decision.
Financial ratio analysis is the most widely used method for determining an organization's strengths and
weaknesses in the investment, financing, and dividend areas. Because, the functional areas of business are
so closely related, financial ratios can signal strengths or weaknesses in management, marketing,
production, research and development, and computer information systems activities.
Financial ratios are computed from an organization's income statement and balance sheet. Computing
financial ratios is like taking a picture because the results reflect a situation at just one point in time.
Comparing ratios over time and to industry averages is more likely to result in meaningful statistics that
can be used to identify and evaluate strengths and weaknesses. Trend analysis is a useful technique that
incorporates both the time and industry average dimensions of financial ratios. However, all the ratios are
not significant for all industries and companies. For example, accounts receivable turnover and average
collection period are not very meaningful to a company that does primarily cash receipts business. Key
financial ratios can be classified into the following five types:
Liquidity ratios measure a firm's ability to meet maturing short-term obligations. It includes:
 Current ratio
 Quick (or acid-test) ratio
Leverage ratios measure the extent to which a firm has been financed by debt.
 Debt-to-total-assets ratio
 Debt-to-equity ratio
 Long-term debt-to-equity ratio
 Times-interest-earned (or coverage) ratio
Activity ratios measure how effectively a firm is using its resources.
 Inventory-turnover
 Fixed assets turnover
 Total assets turnover
 Accounts receivable turnover
 Average collection period
Profitability ratios measure management's overall effectiveness as shown by the returns generated on
sales and investment.
 Gross profit margin
 Operating profit margin
 Net profit margin

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  Return on total assets (ROA)
 Return on stockholders' equity (ROE)
 Earnings per share
 Price-earnings ratio
Growth ratios measure the firm's ability to maintain its economic position in the growth of the economy
and industry.
 Sales
 Net income
 Earnings per share
 Dividends per share
Production/Operations
The production/operations function of a business consists of all those activities that transform inputs into
goods and services. Production/operations management deals with inputs, transformations, and outputs
that vary across industries and markets. A manufacturing operation transforms or converts inputs such as
raw materials, labor, capital, machines, and facilities into finished goods and services.
Production/operations management comprises five functions or decision areas: process, capacity,
inventory, workforce, and quality.
Research and Development
The fifth major area of internal operations that should be examined for specific strengths and weaknesses
is research and development (R&D). Many firms today conduct no R&D, and yet many other companies
depend on successful R&D activities for survival. Firms pursuing a product development strategy
especially need to have a strong R&D orientation.
The purpose of research and development are as follows:
 Development of new products before competition
Improving product quality
 Improving manufacturing processes to reduce costs
Internal and External R&D
Cost distributions among R&D activities vary by company and industry, but total R&D costs generally do
not exceed manufacturing and marketing start-up costs. Four approaches to determining R&D budget
allocations commonly are used:
(1) Financing as many project proposals as possible,
(2) Using a percentage-of-sales method,
(3) Budgeting about the same amount that competitors spend for R&D, or

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(4) Deciding how many successful new products are needed and working backward to estimate the
required R&D investment.
R&D in organizations can take two basic forms:
(1) Internal R&D, in which an organization operates its own R&D department, and/or
(2) Contract R&D, in which a firm hires independent researchers or independent agencies to develop
specific products.
Management information systems:
MIS is a general name for the academic discipline covering the application of information technology to
business problems. As an area of study it is also referred to as information technology management. The
study of information systems is usually a commerce and business administration discipline, and
frequently involves software engineering, but also distinguishes itself by concentrating on the integration
of computer systems with the aims of the organization. The area of study should not be confused with
computer science which is more theoretical in nature and deals mainly with software creation, or
computer engineering, which focuses more on the design of computer hardware. IT service management
is a practitioner-focused discipline centering on the same general domain.
In business, information systems support business processes and operations, decision-making, and
competitive strategies.

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