Internal Analysis - Why Does Firm Performance Differ?

Internal Analysis 1 Why does firm performance differ?

Updated: 30 Aug. 2006 ©Scott Gallagher 2004

Internal Analysis

Earlier we explained differences in firm performance as being a function of their external

environment. However, this is only part of the story. Obviously, each firm has some unique

aspects. Internal analysis is an attempt to explain how and why these internal differences explain

differences in firm performance.

Resources and Capabilities.

Economics generally models firms as generic black boxes that

transform inputs into outputs in an efficient manner. Edith Penrose (1950) is generally credited

with being the first person to model firms as unique bundles of resources. Some individuals like

to make distinctions between resources, what companies have, versus capabilities, things

companies can do. A classic example might be my personal computer. As a resource it is more

powerful than the original computer on the Space Shuttle, however, I could not land the Space

Shuttle with it. So in this case I have a superior resource but an inferior capability.

Resources and capabilities can take many different forms. Literally anything an organization

possesses can be considered a resource. Examples include financial resources, plants,

equipment, technology, reputation, brands, and organizational expertise. In short there is no

potential constraint on what can be considered a firm's resources or capabilities.

VRIO Analysis

Given that almost anything a firm possesses can be considered a resource or capability how

should you attempt to narrow down the ones that explain why firm performance differs? In order

to lead to a sustainable competitive advantage a resource or capability should be Valuable, Rare,

Inimitable (including non-substitutable), and Organized. This VRIO framework is the

foundation for internal analysis.

If you ask a business person why their firm does well while others do poorly, a common answer

is likely to be "our people." But this is really not an answer, it may be the start of an answer, but

you need to probe deeper, what is it about "our people" that are especially valuable? Why don't

competitors have similar people? Can't competitors hire our people away? Or is it that there

something special about the organization that brings out the best in people? These kinds of

questions form the basis of VRIO and get to the heart of why some resources help firms more

than others.

Valuable.

A resource is valuable if it helps the organization meet an external threat or exploit an

opportunity. While it may not help the firm outperform its competitors, it can still be labeled a

strength. One good way to think about valuable resources is to ask how they help the company.

Common competitive foundations (a.k.a. the generic building blocks) for firms are efficiency,

quality, customer responsiveness, and innovation. If a resource helps bring about any one of

these four things then it is valuable.

Efficiency is simply the amount of output for any unit of input, and is probably the most obvious

way a firm can obtain an advantage. If a firm is a more efficient producer of goods or services

than its competitors then it has an advantage.

Innovation is devising new products or services (product innovation) or new ways of

producing/delivering