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This chapter focuses on identifying and evaluating a firm’s strengths and weaknesses in the functional areas
of business, including management, marketing, finance and accounting, production and operations,
research and development (R&D), and management information systems (MIS). Relationships among
these areas of business are examined. Strategic implications of important functional area concepts are
examined. The process of performing an internal audit is described. The resource-based view (RBV) of
strategic management is introduced as is the value chain analysis (VCA) concept. Priceline.com does an
excellent job using its strengths to capitalize on external opportunities. Priceline is showcased in the
opening chapter boxed insert.
The Nature of an Internal Audit
All organizations have strengths and weaknesses in the functional areas of business. No enterprise is
equally strong or weak in all areas. Maytag, for example, is known for excellent production and product
design, whereas Procter & Gamble is known for superb marketing. Internal strengths and weaknesses,
coupled with external opportunities and threats and clear vision and mission statements, provide the basis
for establishing objectives and strategies. Objectives and strategies are established with the intention of
capitalizing on internal strengths and overcoming weaknesses. The internal-audit part of the strategic-
management process is illustrated in Figure 4-1 with white shading.
Priceline.com, Inc.: EXCELLENT STRATEGIC MANAGEMENT SHOWCASED
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Do you prefer Priceline or Expedia to find low travel prices? Headquartered in Norwalk, Connecticut,
Priceline.com Inc. is the leading online travel company where buyers “name their own price” for airline
tickets, hotel rooms, rental cars, cruises, and vacation packages. Founded in 1997 with a patented business
model, Priceline.com operates through the Booking.com, Priceline.com, TravelJigsaw, and Agoda
brand names. Priceline.com uses excellent strategic management to dominate the online travel business.
For example, the company generates annual sales of more than $4 billion and has an EPS of more than
$30. Priceline’s common stock (PCLN) had the best five-year (2007–2011) performance of all companies
in the S&P 500: a total return of 972 percent. Many analysts have a $750.00/share price target for
Priceline stock. In the last 12 months, PCLN’s return on assets was 23.08 percent, compared to its
competitors Expedia (EXPE)’s 4.19 percent and Orbitz World Wide (OWW)’s 2.60. PCLN’s return on
equity was 48.41 percent, much higher than EXPE’s 13.44 percent and Orbitz World Wide OWW’s negative
21.25. PCLN’s profit margin for the last 12 months was 25.58 percent, compared to EXPE’s 10.42 percent
and OWW’s negative 4.83.
With more than 5,000 employees, Priceline’s customers can choose set-price options. For airline tickets
and hotel reservations, Priceline.com generates sales on the margin, keeping the difference between the
price paid by the individual and what Priceline.com paid for the ticket or hotel room. Priceline’s recent
success has been especially driven by international travel, particularly to emerging market destinations.
About 65 percent of Priceline.com hotel room bookings are expected to be non-European going forward,
up from 42 percent the prior year.
Priceline provides price-disclosed hotel and rental car reservation services on a worldwide basis with
approximately 185,000 hotels and accommodations in 160 countries. The company’s rental car services
operate through its Name Your Own Price demand-collection system, as well as vacation packages
consisting of airfare, hotel, and rental car components; cruise trips; and destination services, including
parking, event tickets, ground transfers, and tours in the USA. Priceline provides an optional travel
insurance package that covers trip cancellation, trip interruption, medical expenses, and emergency
evacuation, as well as for loss of baggage, property, and travel documents for air, hotel, and vacation
package customers; and collision damage waiver insurance for rental car customers in the USA.
Priceline’s major competitor, Expedia, was founded in 1996, a year before Priceline. Priceline has four
times the volume of revenues of Expedia, but the two firms aggressively compete every day for customers
worldwide.
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FIGURE 4-1 A Comprehensive Strategic-Management Model
Source: Fred R. David, “How Companies Define Their Mission,” Long Range Planning 22, no. 3 (June 1988): 40.
Key Internal Forces
It is not possible in a strategic-management text to review in depth all the material presented in courses
such as marketing, finance, accounting, management, management information systems, and production
and operations; there are many subareas within these functions, such as customer service, warranties,
advertising, packaging, and pricing under marketing. But strategic planning must include a detailed
assessment of how the firm is doing in all internal areas.
For different types of organizations, such as hospitals, universities, and government agencies, the
functional business areas, of course, differ. In a hospital, for example, functional areas may include
cardiology, hematology, nursing, maintenance, physician support, and receivables. Functional areas of a
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university can include athletic programs, placement services, housing, fund-raising, academic research,
counseling, and intramural programs. Within large organizations, each division has certain strengths and
weaknesses.
A firm’s strengths that cannot be easily matched or imitated by competitors are called distinctive
competencies. Building competitive advantages involves taking advantage of distinctive competencies.
Strategies are designed in part to improve on a firm’s weaknesses, turning them into strengths—and maybe
even into distinctive competencies.
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FIGURE 4-2 The Process of Gaining Competitive Advantage in a Firm
Figure 4-2 illustrates that all firms should continually strive to improve on their weaknesses, turning them
into strengths, and ultimately developing distinctive competencies that can provide the firm with
competitive advantages over rival firms.
The Process of Performing an Internal Audit
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. The internal audit requires gathering and assimilating information about
the firm’s management, marketing, finance and accounting, production and operations, R&D, and MIS
operations. Key factors should be prioritized as described in Chapter 3 so that the firm’s most important
strengths and weaknesses can be determined collectively.
Compared to the external audit, the process of performing an internal audit provides more opportunity for
participants to understand how their jobs, departments, and divisions fit into the whole organization. This
is a great benefit because managers and employees perform better when they understand how their work
affects other areas and activities of the firm. For example, when marketing and manufacturing managers
jointly discuss issues related to internal strengths and weaknesses, they gain a better appreciation of the
issues, problems, concerns, and needs of all the functional areas. In organizations that do not use strategic
management, marketing, finance, and manufacturing managers often do not interact with each other in
significant ways. Performing an internal audit thus is an excellent vehicle or forum for improving the
process of communication in the organization. Communication may be the most important word in
management.
Performing an internal audit requires gathering, assimilating, and evaluating information about the firm’s
operations. Key internal factors, consisting of both strengths and weaknesses, can be identified and
prioritized in the manner discussed in Chapter 3. According to William King, a task force of managers
from different units of the organization, supported by staff, should be charged with determining the 20
most important strengths and weaknesses that should influence the future of the organization. He says:
The development of conclusions on the 20 most important organizational strengths and weaknesses
can be, as any experienced manager knows, a difficult task, when it involves managers representing
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various organizational interests and points of view. Developing a 20-page list of strengths and
weaknesses could be accomplished relatively easily, but a list of the 20 most important ones involves
significant analysis and negotiation. This is true because of the judgments that are required and the
impact which such a list will inevitably have as it is used in the formulation, implementation, and
evaluation of strategies.
Strategic management is a highly interactive process that requires effective coordination among
management, marketing, finance and accounting, production and operations, R&D, and MIS managers.
Although the strategic-management process is overseen by strategists, success requires that managers and
employees from all functional areas work together to provide ideas and information. Financial managers,
for example, may need to restrict the number of feasible options available to operations managers, or R&D
managers may develop products for which marketing managers need to set higher objectives. A key to
organizational success is effective coordination and understanding among managers from all functional
business areas. Through involvement in performing an internal strategic-management audit, managers
from different departments and divisions of the firm come to understand the nature and effect of decisions
in other functional business areas in their firm. Knowledge of these relationships is critical for effectively
establishing objectives and strategies.
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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. Some firms place too great an emphasis on one function at
the expense of others. Ansoff explained:
During the first fifty years, successful firms focused their energies on optimizing the performance of
one of the principal functions: production/operations, R&D, or marketing. Today, due to the growing
complexity and dynamism of the environment, success increasingly depends on a judicious
combination of several functional influences. This transition from a single function focus to a
multifunction focus is essential for successful strategic management.
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, R&D errors, or a weak MIS. The effectiveness of strategy
formulation, implementation, and evaluation activities hinges on 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. In the case of planning, George wrote:
We may conceptually separate planning for the purpose of theoretical discussion and analysis, but in
practice, neither is it a distinct entity nor is it capable of being separated. The planning function is
mixed with all other business functions and, like ink once mixed with water, it cannot be set apart. It is
spread throughout and is a part of the whole of managing an organization.
The Resource-Based View
Some researchers emphasize the importance of the internal audit part of the strategic-management process
by comparing it to the external audit. Robert Grant concluded that the internal audit is more important,
saying:
In a world where customer preferences are volatile, the identity of customers is changing, and the
technologies for serving customer requirements are continually evolving, an externally focused
orientation does not provide a secure foundation for formulating long-term strategy. When the
external environment is in a state of flux, the firm’s own resources and capabilities may be a much
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more stable basis on which to define its identity. Hence, a definition of a business in terms of what it is
capable of doing may offer a more durable basis for strategy.
The resource-based view (RBV) approach to competitive advantage contends that internal resources
are more important for a firm than external factors in achieving and sustaining competitive advantage. In
contrast to the Industrial Organization (I/O) theory presented in the previous chapter, proponents of the
RBV view contend that organizational performance will primarily be determined by internal resources that
can be grouped into three all-encompassing categories: physical resources, human resources, and
organizational resources. Physical resources include all plant and equipment, location, technology, raw
materials, machines; human resources include all employees, training, experience, intelligence, knowledge,
skills, abilities; and organizational resources include firm structure, planning processes, information
systems, patents, trademarks, copyrights, databases, and so on. RBV theory asserts that resources are
actually what helps a firm exploit opportunities and neutralize threats.
The basic premise of the RBV is that the mix, type, amount, and nature of a firm’s internal resources should
be considered first and foremost in devising strategies that can lead to sustainable competitive advantage.
Managing strategically according to the RBV involves developing and exploiting a firm’s unique resources
and capabilities, and continually maintaining and strengthening those resources. The theory asserts that it
is advantageous for a
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