1

The Resource-Based Theory

of Competitive Advantage:
Implications for Strategy
Formulation
Robert M. Grant

Strategy has been defined as “the match an ovganization makes between its
internal resources and skills ... and the opportunities and risks created by its
external environment.”’ During the 1980s, the principal developments in strat-
egy analysis focussed upon the link between strategy and the external environ-
ment. Prominent examples of this focus are Michael Porter’s analysis of industry
structure and competitive positioning and the empirical studies undertaken by
the PIMS project.2 By contrast, the link between strategy and the firm’s resources
and skills has suffered comparative neglect. Most research into the strategic
implications of the firm’s internal environment has been concerned with issues of
strategy implementation and analysis of the organizational processes through
which strategies emerge.3
Recently there has been a resurgence of interest in the role of the firm’s
resources as the foundation for firm strategy. This interest reflects dissatisfaction
with the static, equilibrium framework of industrial organization economics that
has dominated much contemporary thinking about business strategy and has
renewed interest in older theories of profit and competition associated with the
writings of David Ricardo, Joseph Schumpeter, and Edith P e n r ~ s e Advances
.~
have occurred on several fronts. At the corporate strategy level, theoretical inter-
est in economies of scope and transaction costs have focussed attention on the
role of corporate resources in determining the industrial and geographical
boundaries of the firm’s activities.s At the business strategy level, explorations of

From California Management Review, Vol. 33, No. 3, Spring 1991, pp. 114-135.
Copyright 0 1991, by The Regents of the University of California. Reprinted by permis-
sion of The Regents.

3
4 KNOWLEDGE AND STRATEGY

the relationships between resources, competition, and profitability include the

analysis of competitive imitation,6 the appropriability of returns to innovations,’
the role of imperfect information in creating profitability differences between
competing firms,8 and the means by which the process of resource accumulation
can sustain competitive advantages9
Together, these contributions amount to what has been termed “the
resource-based view of the firm.” As yet, however, the implications of this
“resource-based theory” for strategic management are unclear for two rea-
sons. First, the various contributions lack a single integrating framework.
Second, little effort has been made to develop the practical implications of
this theory. The purpose of this article is to make progress on both these
fronts by proposing a framework for a resource-based approach to strategy
formulation which integrates a number of the key themes arising from this
stream of literature. The organizing framework for the article is a five-stage
procedure for strategy formulation: analyzing the firm’s resource base;
appraising the firm’s capabilities; analyzing the profit-earning potential of
firm’s resources and capabilities; selecting a strategy; and extending and
upgrading the firm’s pool of resources and capabilities. Figure 1.1 outlines
this framework.

4 . Select a strategy which best

exploits the firm’s resources
and capabilities relative to
external opportunities.

3. Appraise the rent-generating which need to be filled

Dotential of resources and
capabilities in terms of: Invest in replenishing,
(a) their potential for augmenting and upgrading
sustainable competitive the firm’s resource base.
advantage, and
(b) the appropriability of
their returns.

2. Identify the firm’s capabilities:

4
What can the firm do more effectively
than its rivals? ldentifv the resources
inputs to each capability, and the
complexity of each capability.

resources. Appraise strengths and

weaknesses relative to competitors.
.Identify opportunities for better

FIGURE 1.1 A Resource-Based Approach to Strategy Analysis: A Practical Framework

The Resource-Based Theory of Competitive Advantage 5

RESOURCES AND CAPABILITIES AS THE

FOUNDATION FOR STRATEGY
The case for making the resources and capabilities of the firm the founda-
tion for its long-term strategy rests upon two premises: first, internal resources
and capabilities provide the basic direction for a firm’s strategy, second,
resources and capabilities are the primary source of profit for the firm.

Resources and Capabilities as a Source of Direction

The starting point for the formulation of strategy must be some statement
of the firm’s identity and purpose-conventionally this takes the form of a mis-
sion statement which answers the question: “What is our business?’’ Typically
the definition of the business is in terms of the served market of the firm: e.g.,
“Who are our customers?’’ and “Which of their needs are we seeking to serve?”
But in a world where customer preferences are volatile, the identity of customers
is changing, and the technologies for serving customer requirements are contin-
ually evolving, an externally focused orientation does not provide a secure foun-
dation 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 more sta-
ble 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 than a
definition based upon the needs which the business seeks to satisfy.
Theodore Levitt’s solution to the problem of external change was that com-
panies should define their served markets broadly rather than narrowly: rail-
roads should have perceived themselves to be in the transportation business, not
the railroad business. But such broadening of the target market is of little value
if the company cannot easily develop the capabilities required for serving cus-
tomer requirements across a wide front. Was it feasible for the railroads to have
developed successful trucking, airline, and car rental businesses? Perhaps the
resources and capabilities of the railroad companies were better suited to real
estate development, or the building and managing of oil and gas pipelines.
Evidence suggests that serving broadly defined customer needs is a difficult task.
The attempts by Merrill Lynch, American Express, Sears, Citicorp, and, most
recently, Prudential-Bache to “serve the full range of our customers’ financial
needs” created serious management problems. Allegis Corporation’s goal of
“serving the needs of the traveler” through combining United Airlines, Hertz car
rental, and Westin Hotels was a costly failure. By contrast, several companies
whose strategies have been based upon developing and exploiting clearly defined
internal capabilities have been adept at adjusting to and exploiting external
change. Honda’s focus upon the technical excellence of 4-cycle engines carried it
successfully from motorcycles to automobiles to a broad range of gasoline-
engine products. 3M Corporation’s expertise in applying adhesive and coating
technologies to new product development has permitted profitable growth over
an ever-widening product range.
6 KNOWLEDGE AND STRATEGY

Resources as the Basis for Corporate Profitability

A firm's ability to earn a rate of profit in excess of its cost of capital depends
upon two factors: the attractiveness of the industry in which it is located, and its
establishment of competitive advantage over rivals. Industrial organization eco-
nomics emphasizes industry attractiveness as the primary basis for superior prof-
itability, the implication being that strategic management is concerned primarily
with seeking favorable industry environments, locating attractive segments and
strategic groups within industries, and moderating competitive pressures by influ-
encing industry structure and competitors' behavior. Yet empirical investigation
has failed to support the link between industry structure and profitability. Most
studies show that differences in profitability within industries are much more
important than differences between industries.'" The reasons are not difficult to
find: international competition, technological change, and diversification by firms
across industry boundaries have meant that industries which were once cozy
havens for making easy profits are now subject to vigorous competition.
The finding that competitive advantage rather than external environments
is the primary source of inter-firm profit differentials between firms focuses
attention upon the sources of competitive advantage. Although the competitive
strategy literature has tended to emphasize issues of strategic positioning in terms
of the choice between cost and differentiation advantage, and between broad and
narrow market scope, fundamental to these choices is the resource position of
the firm. For example, the ability to establish a cost advantage requires posses-
sion of scale-efficient plants, superior process technology, ownership of low-cost
sources of raw materials, or access to low-wage labor. Similarly, differentiation
advantage is conferred by brand reputation, proprietary technology, or an exten-
sive sales and service network.
This may be summed up as follows: business strategy should be viewed less
as a quest for monopoly rents (the returns to market power) and more as a quest
for Ricardian rents (the returns to the resources which confer competitive advan-
tage over and above the real costs of these resources). Once these resources
depreciate, become obsolescent, or are replicated by other firms, so the rents they
generate tend to disappear.*'
We can go further. A closer look at market power and the monopoly rent
it offers, suggests that it too has its basis in the resources of firms. The funda-
mental prerequisite for market power is the presence of barriers to entry.l2
Barriers to entry are based upon scale economies, patents, experience advan-
tages, brand reputation, or some other resource which incumbent firms possess
but which entrants can acquire only slowly or at disproportionate expense.
Other structural sources of market power are similarly based upon firms'
resources: monopolistic price-setting power depends upon market share which is
a consequence of cost efficiency, financial strength, or some other resource. The
resources which confer market power may be owned individually by firms, oth-
ers may be owned jointly. An industry standard (which raises costs of entry), or
a cartel, is a resource which is owned collectively by the industry members.13
Figure 1.2 summarizes the relationships between resources and profitability.
The Resource-Based Theory of Competitive Advantage 7

/pi$

Retaliatorycapability 1

-(Firm]

In Excess of the
CompetitiveLevel

rn
1)IProcesstechnology I

1 L) Advantage
I --
1- Access tow-cost inputs I
Competitive

IProduct technology 1
1Marketing,distribution,
and service capabilities

FIGURE 1.2 Resources as the Basis for Profitability

TAKING STOCK OF T H E FIRM’S RESOURCES

There is a key distinction between resources and capabilities. Resources are
inputs into the production process-they are the basic units of analysis. The indi-
vidual resources of the firm include items of capital equipment, skills of individ-
ual employees, patents, brand names, finance, and so on.
But, on their own, few resources are productive. Productive activity
requires the cooperation and coordination of teams of resources. A capability is
the capacity for a team of resources to perform some task or activity. While
resources are the source of a firm’s capabilities, capabilities are the main source
of its competitive advantage.

Identifying Resources
A major handicap in identifying and appraising a firm’s resources is that man-
agement information systems typically provide only a fragmented and incomplete
8 KNOWLEDGE AND STRATEGY

picture of the firm’s resource base. Financial balance sheets are notoriously inade-
quate because they disregard intangible resources and people-based skills-proba-
bly the most strategically important resources of the firm.14 Classification can
provide a useful starting point. Six major categories of resource have been sug-
gested: financial resources, physical resources, human resources, technological
resources, reputation, and organizational resources.1sThe reluctance of accountants
to extend the boundaries of corporate balance sheets beyond tangible assets partly
reflects difficulties of valuation. The heterogeneity and imperfect transferability of
most intangible resources precludes the use of market prices. One approach to valu-
ing intangible resources is to take the difference between the stock market value of
the firm and the replacement value of its tangible assets.I6 On a similar basis, valu-
ation ratios provide some indication of the importance of firms’ intangible
resources. Table 1.1 shows that the highest valuation ratios are found among com-
panies with valuable patents and technology assets (notably drug companies) and
brand-rich consumer-product companies.

TABLE 1.1 Twenty Companies Among the U.S.Top 100 Companies with the Highest Ratios of
Stock Price to Book Value on March 16, 1990
Company Industry Valuation Ratio

Coca Cola Beverages 8.77

Microsoft Computer software 8.67
Merck Pharmaceuticals 8.39
American Home Products Pharmaceuticals 8.00
Wal Mart Stores Retailing 7.51
Limited Retailing 6.65
Warner Lambert Pharmaceuticals 6.34
Waste Management Pollution Control 6.18
Marrion Merrell Dow Pharmaceuticals 6.10
McCaw Cellular Communications Telecom Equipment 5.90
Bristol Myers Squibb Pharmaceuticals 5.48
Toys R Us Retailing 5.27
Abbot Laboratories Pharmaceuticals 5.26
Walt Disney Entertainment 4.90
Johnson & Johnson Health care products 4.85
MCI Communications Telecommunications 4.80
Eli Lilly Pharmaceuticals 4.70
Kellogg Food products 4.58
H.J. Heinz Food products 4.38
Pepsico Beverages 4.33
Source: The 1990 Business Week Top 1000
The Resource-Based Theory of Competitive Advantage 9

The primary task of a resource-based approach to strategy formulation is

maximizing rents over time. For this purpose we need to investigate the rela-
tionship between resources and organizational capabilities. However, there are
also direct links between resources and profitability which raise issues for the
strategic management of resources:
What opportunities exist for economizing on the use of resources? The ability to
maximize productivity is particularly important in the case of tangible resources
such as plant and machinery, finance, and people. It may involve using fewer
resources to support the same level of business, or using the existing resources to
support a larger volume of business. The success of aggressive acquirers, such as
ConAgra in the U.S. and Hanson in Britain, is based upon expertise in rigorously
pruning the financial, physical, and human assets needed to support the volume
of business in acquired companies.
What are the possibilities for using existing assets more intensely and in more prof-
ituble employment? A large proportion of corporate acquisitions are motivated by
the belief that the resources of the acquired company can be put to more profitable
use. The returns from transferring existing assets into more productive employment
can be substantial. The remarkable turnaround in the performance of the Walt
Disney Company between 1985 and 1987 owed much to the vigorous exploitation
of Disney’s considerable and unique assets: accelerated development of Disney’s
vast landholdings (for residential development as well as entertainment purposes),
exploitation of Disney’s huge film library through cable TV,videos, and syndica-
tion; fuller utilization of Disney’s studios through the formation of Touchstone
Films; increased marketing to improve capacity utilization at Disney theme parks.

IDENTIFYING AND APPRAISING CAPABILITIES

The capabilities of a firm are what it can do as a result of teams of
resources working together. A firm’s capabilities can be identified and appraised
using a standard functional classification of the firm’s activities.
For example, Snow and Hrebimak examined capabilities (in their termi-
nology, “distinctive competencies”) in relation to ten functional areas.” For most
firms, however, the most important capabilities are likely to be those which arise
from an integration of individual functional capabilities. For example,
McDonald’s possesses outstanding functional capabilities within product devel-
opment, market research, human resource management, financial control, and
operations management. However, critical to McDonald’s success is the integra-
tion of these functional capabilities to create McDonald’s remarkable consistency
of products and services in thousands of restaurants spread across most of the
globe. Hamel and Prahalad use the term “core competencies” to describe these
central, strategic capabilities. They are “the collective learning in the organiza-
tion, especially how to coordinate diverse production skills and integrate multi-
ple streams of technology. ”18 Examples of core competencies include:
NEC’s integration of computer and telecommunications technology
Philips’ optical-media expertise
10 KNOWLEDGE AND STRATEGY

Casio’s harmonization of know-how in miniaturization, microprocessor design,

material science, and ultra thin precision casting
Canon’s integration of optical, microelectronic, and precision-mechanical tech-
nologies which forms the basis of its success in cameras, copiers, and facsimile
machines
Black and Decker’s competence in the design and manufacture of small electric
motors
A key problem in appraising capabilities is maintaining objectivity.
Howard Stevenson observed a wide variation in senior managers’ perceptions of
their organizations’ distinctive competen~ies.’~ Organizations frequently fall vic-
tim to past glories, hopes for the future, and wishful thinking. Among the failed
industrial companies of both America and Britain are many which believed
themselves world leaders with superior products and customer loyalty. During
the 1960s, the CEOs of both Harley Davidson and BSA-Triumph scorned the
idea that Honda threatened their supremacy in the market for “serious motor-
cycles.”20Thefailure of the U.S. steel companies to respond to increasing import
competition during the 1970s was similarly founded upon misplaced confidence
in their quality and technological leadership.21
The critical task is to assess capabilities relative to those of competitors. In
the same way that national prosperity is enhanced through specialization on the
basis of comparative advantages, so for the firm, a successful strategy is one
which exploits relative strengths. Federal Express’s primary capabilities are those
which permit it to operate a national delivery system that can guarantee next day
delivery; for the British retailer Marks and Spencer, it is the ability to manage
supplier relations to ensure a high and consistent level of product quality; for
General Electric, it is a system of corporate management that reconciles control,
coordination, flexibility, and innovation in one of the world’s largest and most
diversified corporations. Conversely, failure is often due to strategies which
extend the firm’s activities beyond the scope of its capabilities.

Capabilities as Organizational Routines

Creating capabilities is not simply a matter of assembling a team of
resources: capabilities involve complex patterns of coordination between people
and between people and other resources. Perfecting such coordination requires
learning through repetition. To understand the anatomy of a firm’s capabilities,
Nelson and Winter’s concept of “organizational routine” is illuminating.
Organizational routines are regular and predictable patterns of activity which
are made up of a sequence of coordinated actions by individuals. A capability is,
in essence, a routine, or a number of interacting routines. The organization itself
is a huge network of routines. These include the sequence of routines which gov-
ern the passage of raw material and components through the production process,
and top management routines which include routines for monitoring business
unit performance, for capital budgeting, and for strategy formulation.
The Resource-Based Theory of Competitive Advantage 11

The concept of organizational routines offers illuminating insights into the

relationships between resources, capabilities, and competitive advantage:
The relationship between resources and capabilities. There is no predetermined
functional relationship between the resources of a firm and its capabilities. The
types, the amounts, and the qualities of the resources available to the firm have
an important bearing on what the firm can d o since they place constraints upon
the range of organizational routines that can be performed and the standard to
which they are performed. However, a key ingredient in the relationship between
resources and capabilities is the ability of an organization to achieve cooperation
and coordination within teams. This requires that an organization motivate and
socialize its members in a manner conducive to the development of srnooth-func-
tioning routines. The organization’s style, values, traditions, and leadership are
critical encouragements to the cooperation and commitment of its members.
These can be viewed as intangible resources which are common ingredients of the
whole range of a corporation’s organizational routines.
The trade-off between efficiency and flexibility. Routines are to the organiza-
tion what skills are to the individual. Just as the individual’s skills are carried
out semi-automatically, without conscious coordination, so organizational rou-
tines involve a large component of tacit knowledge, which implies limits on the
extent to which the organization’s capabilities can be articulated. Just as indi-
vidual skills become rusty when not exercised, so it is difficult for organiza-
tions to retain coordinated responses to contingencies that arise only rarely.
Hence there may be a trade-off between efficiency and flexibility. A limited
repertoire of routines can be performed highly efficiently with near-perfect
coordination-all in the absence of significant intervention by top manage-
ment. The same organization may find it extremely difficult to respond to
novel situations.
Economies of experience. Just as individual skills are acquired through practice
over time, so the skills of an organization are developed and sustained only
through experience. The advantage of an established firm over a newcomer is pri-
marily in the organizational routines that it has perfected over time. The Boston
Consulting Group’s “experience curve” represents a naive, yet valuable attempt
to relate the experience of the firm to its performance. However, in industries
where technological change is rapid, new firms may possess an advantage over
established firms through their potential for faster learning of new routines
because they are less committed to old routines.
The complexity o f capabilities. Organizational capabilities differ in their com-
plexity. Some capabilities may derive from the contribution of a single
resource. Du Pont’s successful development of several cardiovascular drugs
during the late 1980s owed much to the research leadership of its leading phar-
macologist Pieter Timmermans.** Drexel Burnham Lambert’s capability in junk
bond underwriting during the 1980s resided almost entirely in the skills of
Michael Millken. Other routines require highly complex interactions involving
the cooperation of many different resources. Walt Disney’s “irnagineering”
capability involves the integration of ideas, skills, and knowledge drawn from
movie making, engineering, psychology, and a wide variety of technical disci-
plines. As we shall see, complexity is particularly relevant to the sustainability
of competitive advantage.
12 KNOWLEDGE AND STRATEGY

EVALUATING THE RENT-EARNING

POTENTIAL: SUSTAINABILITY
The returns to a firm’s resources and capabilities depend upon two key fac-
tors: first, the sustainability of the competitive advantage which resources and
capabilities confer upon the firm; and, second, the ability of the firm to appro-
priate the rents earned from its resources and capabilities.
Over the long-term, competitive advantage and the returns associated with
it are eroded both through the depreciation of the advantaged firm’s resources
and capabilities and through imitation by rivals. The speed of erosion depends
critically upon the characteristics of the resources and capabilities. Consider
markets where competitive advantage is unsustainable: in “efficient” markets
(most closely approximated by the markets for securities, commodities, and for-
eign exchange) competitive advantage is absent; market prices reflect all avail-
able information, prices adjust instantaneously to new information, and traders
can only expect normal returns.
The absence of competitive advantage is a consequence of the resources
required to compete in these markets. To trade in financial markets, the basic
requirements are finance and information. If both are available on equal terms
to all participants, competitive advantage cannot exist. Even if privileged infor-
mation is assumed to exist (“weakly efficient” markets), competitive advantage
is not sustainable. Once a trader acts upon privileged information, transactions
volume and price movements signal insider activity, and other traders are likely
to rush in seeking a piece of the action.
The essential difference between industrial markets and financial markets
lies in the resource requirements of each. In industrial markets, resources are spe-
cialized, immobile, and long-lasting. As a result, according to Richard Caves, a
key feature of industrial markets is the existence of “committed competition-
rivalrous moves among incumbent producers that involve resource commitments
that are irrevocable for non-trivial periods of time.”23The difficulties involved in
acquiring the resources required to compete and the need to commit resources
long before a competitive move can be initiated also implies that competitive
advantage is much more sustainable than it is in financial markets. Resource-
based approaches to the theory of competitive advantage point towards four
characteristics of resources and capabilities which are likely to be particularly
important determinants of the sustainability of competitive advantage: durabil-
ity, transparency, transferability, and replicability.

Durability
In the absence of competition, the longevity of a firm’s competitive advan-
tage depends upon the rate at which the underlying resources and capabilities
depreciate or become obsolete. The durability of resources varies considerably:
the increasing pace of technological change is shortening the useful life-spans of
most capital equipment and technological resources. On the other hand, reputa-
The Resource-Based Theory of Competitive Advantage 13

tion (both brand and corporate) appears to depreciate relatively slowly, and
these assets can normally be maintained by modest rates of replacement invest-
ment. Many of the consumer brands which command the strongest loyalties
today (e.g., Heinz sauces, Kellogg’s cereals, Campbell’s soup, Hoover vacuum
cleaners) have been market leaders for close to a century. Corporate reputation
displays similar longevity: the reputations of GE, IBM, Du Pont, and Proctor and
Gamble as well-managed, socially responsible, financially sound companies
which produce reliable products and treat their employees well has been estab-
lished over several decades. While increasing environmental turbulence shortens
the life spans of many resources, it is possible that it may have the effect of bol-
stering brand and corporate reputations.
Firm capabilities have the potential to be more durable than the resources
upon which they are based because of the firm’s ability to maintain capabilities
through replacing individual resources (including people) as they wear out or
move on. Rolls Royce’s capability in the craft-based manufacture of luxury cars
and 3M’s capability in new product introduction have been maintained over sev-
eral generations of employees. Such longevity depends critically upon the man-
agement of these capabilities to ensure their maintenance and renewal. One of
the most important roles that organizational culture plays in sustaining compet-
itive advantage may be through its maintenance support for capabilities through
the socialization of new employees.24

Transparency
The firm’s ability to sustain its competitive advantage over time depends
upon the speed with which other firms can imitate its strategy. Imitation
requires that a competitor overcomes two problems. First is the information
problem: What is the competitive advantage of the successful rival, and how is
it being achieved? Second is the strategy duplication problem: How can the
would-be competitor amass the resources and capabilities required to imitate
the successful strategy of the rival? The information problem is a consequence
of imperfect information on two sets of relationships. If a firm wishes to imitate
the strategy of a rival, it must first establish the capabilities which underlie the
rival’s competitive advantage, and then it must determine what resources are
required to replicate these capabilities. 1 refer to this as the “transparency” of
competitive advantage. With regard to the first transparency problem, a com-
petitive advantage which is the consequence of superior capability in relation to
a single performance variable is more easy to identify and comprehend than a
competitive advantage that involves multiple capabilities conferring superior
performance across several variables. Cray Research’s success in the computer
industry rests primarily upon its technological capability in relation to large,
ultra-powerful computers. IBM’s superior performance is multidimensional and
is more difficult to understand. It is extremely difficult to distinguish and
appraise the relative contributions to IBM’s success of research capability, scale
economies in product development and manufacturing, self-sufficiency through
14 KNOWLEDGE AND STRATEGY

backward integration, and superior customer service through excellence in

sales, service, and technical support.
With regard to the second transparency problem, a capability which
requires a complex pattern of coordination between large numbers of diverse
resources is more difficult to comprehend than a capability which rests upon the
exploitation of a single dominant resource. For example, Federal Express’s next-
day delivery capability requires close cooperation between numerous employees,
aircraft, delivery vans, computerized tracking facilities, and automated sorting
equipment, all coordinated into a single system. By contrast, Atlantic Richfield’s
low-cost position in the supply of gasoline to the California market rests simply
on its access to Alaskan crude oil. Imperfect transparency is the basis for
Lippman and Rumble’s theory of “uncertain imitability”: the greater the uncer-
tainty within a market over how successful companies “do it,” the more inhib-
ited are potential entrants, and the higher the level of profit that established firms
can maintain within that market.25

Transferability
Once the established firm or potential entrant has established the sources
of the superior performance, imitation then requires amassing the resources and
capabilities necessary for a competitive challenge. The primary source of
resources and capabilities is likely to be the markets for these inputs. If firms can
acquire (on similar terms) the resources required for imitating the competitive
advantage of a successful rival, then that rival’s competitive advantage will be
short lived. As w e have seen, in financial markets the easy access by traders to
finance and information causes competitive advantage to be fleeting. However,
most resources and capabilities are not freely transferable between firms; hence,
would-be competitors are unable to acquire (on equal terms) the resources
needed to replicate the competitive advantage of an incumbent firm.
Imperfections in transferability arise from several sources:
Geographical immobility. The costs of relocating large items of capital equip-
ment and highly specialized employees puts firms which are acquiring these
resources at a disadvantage to firms which already possess them.
Imperfect infomation. Assessing the value of a resource is made difficult by the
heterogeneity of resources (particularly human resources) and by imperfect
knowledge of the potential productivity of individual resources.26 The estab-
lished firm’s ability to build up information over time about the productivity of
its resources gives it superior knowledge to that of any prospective purchaser of
the resources in q~estion.~’ The resulting imperfection of the markets for pro-
ductive resources can then result in resources being either underpriced or over-
priced, thus giving rise to differences in profitability between firms.28
Firm-specific resources. Apart from the transactions costs arising from immobil-
ity and imperfect information, the value of a resource may fall on transfer due to
a decline in its productivity. To the extent that brand reputation is associated
with the company which created the brand reputation, a change in ownership of
the brand name erodes its value, Once Rover, MG, Triumph, and Jaguar were
The Resource-Based Theory of Competitive Advantage 15

merged into British Leyland, the values of these brands in differentiating auto-
mobiles declined substantially. Employees can suffer a similar decline in produc-
tivity in the process of inter-firm transfer. To the extent that an employee’s
productivity is influenced by situational and motivational factors, then it is
unreasonable to expect that a highly successful employee in one company can
replicate hidher performance when hired away by another company. Some
resources may be almost entirely firm specific-corporate reputation can only be
transferred by acquiring the company as a whole, and even then the reputation
of the acquired company normally depreciates during the change in ownership.29
The immobility of capabilities. Capabilities, because they require interactive
teams of resources, are far more immobile than individual resources-they
require the transfer of the whole team. Such transfers can occur (e.g., the defec-
tion of 16 of First Boston’s mergers and acquisitions staff to Wasserstein, Perella
and Company).30However. even if the resources that constitute the team are
transferred, the nature of organizational routines-in particular, the role of tacit
knowledge and unconscious coordination-makes the recreation of capabilities
within a new corporate environment uncertain.

Replicability
Imperfect transferability of resources and capabilities limits the ability of a
firm to buy in the means to imitate success. The second route by which a firm
can acquire a resource or capability is by internal investment. Some resources
and capabilities can be easily imitated through replication. In retailing, compet-
itive advantages which derive from electronic point-of-sale systems, retailer
charge cards, and extended hours of opening can be copied fairly easily by com-
petitors. In financial services, new product innovations (such as interest rate
swaps, stripped bonds, money market accounts, and the like) are notorious for
their easy imitation by competitors.
Much less easily replicable are capabilities based upon highly complex
organizational routines. IBM’s ability to motivate its people and Nucor’s out-
standing efficiency and flexibility in steel manufacture are combinations of
complex routines that are based upon tacit rather than codified knowledge and
are fused into the respective corporate cultures. Some capabilities appear sim-
ple but prove exceptionally difficult to replicate. Two of the simplest and best-
known Japanese manufacturing practices are just-in-time scheduling and
quality circles. Despite the fact that neither require sophisticated knowledge or
complex operating systems, the cooperation and attitudinal changes required
for their effective operation are such that few American and European firms
have introduced either with the same degree of success as Japanese companies.
If apparently simple practices such as these are deceptively difficult to imitate,
it is easy to see how firms that develop highly complex capabilities can main-
tain their competitive advantage over very long periods of time. Xerox’s com-
mitment to customer service is a capability that is not located in any particular
department, but it permeates the whole corporation and is built into the fabric
and culture of the corporation.
16 KNOWLEDGE AND STRATEGY

Even where replication is possible, the dynamics of stock-flow relationships

may still offer an advantage to incumbent firms. Competitive advantage depends
upon the stock of resources and capabilities that a firm possesses. Dierickx and
Cool show that firms which possess the initial stocks of the resources required
for competitive advantage may be able to sustain their advantages over time.31
Among the stock-flow relationships they identify as sustaining advantage are:
“asset mass efficiencies”-the initial amount of the resource which the firm pos-
sesses influences the pace at which the resource can be accumulated; and “time
compression diseconomies”-firms which rapidly accumulate a resource incur
disproportionate costs (“crash programs’’ of R&D and “blitz’’ advertising cam-
paigns tend to be less productive than similar expenditures made over a longer
period).

Evaluating Rent-Earning Potential: Appropriability

The returns to a firm from its resources and capabilities depend not only
on sustaining its competitive position over time, but also on the firm’s ability to
appropriate these returns. The issue of appropriability concerns the allocation of
rents where property rights are not fully defined. Once we go beyond the finan-
cial and physical assets valued in a company’s balance sheet, ownership becomes
ambiguous. The firm owns intangible assets such as patents, copyrights, brand
names, and trade secrets, but the scope of property rights may lack precise defi-
nition. In the case of employee skills, two major problems arise: the lack of clear
distinction between the technology of the firm and the human capital of the indi-
vidual; and the limited control which employment contracts offer over the ser-
vices provided by employees. Employee mobility means that it is risky for a firm’s
strategy to be dependent upon the specific skills of a few key employees. Also,
such employees can bargain with the firm to appropriate the major part of their
contribution to value added.
The degree of control exercised by a firm and the balance of power
between the firm and an individual employee depends crucially on the rela-
tionship between the individual’s skills and organizational routines. The more
deeply embedded are organizational routines within groups of individuals and
the more are they supported by the contributions of other resources, then the
greater is the control that the firm’s management can exercise. The ability of
IBM to utilize its advanced semiconductor research as an instrument of com-
petitive advantage depends, in part, upon the extent to which the research
capability is a team asset rather than a reflection of the contribution of bril-
liant individuals. A firm’s dependence upon skills possessed by highly trained
and highly mobile key employees is particularly important in the case of pro-
fessional service companies where employee skills are the overwhelmingly
important resource.32 Many of the problems that have arisen in acquisitions of
human-capital-intensive companies arise from conflicts over property rights
between the acquiring company and employees of the acquired company. An
interesting example is the protracted dispute which followed the acquisition of
The Resource-Based Theory of Competitive Advantage 17

the New York advertising agency Lord, Geller, Fredrico, Einstein by WPP
Group in 1988. Most of the senior executives of the acquired company left to
form a new advertising agency taking several former clients with them.33
Similar conflicts have arisen over technology ownership in high-tech start-ups
founded by former employees of established ~ompanies.3~
Where ownership is ambiguous, relative bargaining power is the primary
determinant of the allocation of the rents between the firm and its employees. If
the individual employee’s contribution to productivity is clearly identifiable, if
the employee is mobile, and the employee’s skills offer similar productivity to
other firms, then the employee is well placed to bargain for that contribution. If
the increased gate receipts of the L.A. Kings ice hockey team can be attributed
primarily to the presence of Wayne Gretzky on the team and if Gretzky can offer
a similar performance enhancement to other teams, then he is in a strong posi-
tion to appropriate (as salary and bonuses) most of the increased contribution.
The less identifiable is the individual’s contribution, and the more firm-specific
are the skills being applied, the greater is the proportion of the return which
accrues to the firm. Declining profitability among investment banks encouraged
several to reassert their bargaining power vis-a-vis their individual stars and in-
house gurus by engineering a transfer of reputation from these key employees to
the company as a whole. At Citibank, Salomon Brothers, Merrill Lynch, and
First Boston, this resulted in bitter conflicts between top management and some
senior employee^.^^

FORMULATING STRATEGY
Although the foregoing discussion of the links between resources, capabil-
ities, and profitability has been strongly theoretical in nature, the implications
for strategy formulation are straightforward. The analysis of the rent-generating
potential of resources and capabilities concludes that the firm’s most important
resources and capabilities are those which are durable, difficult to identify and
understand, imperfectly transferable, not easily replicated, and in which the firm
possesses clear ownership and control. These are the firm’s “crown jewels” and
need to be protected; and they play a pivotal role in the competitive strategy
which the firm pursues. The essence of strategy formulation, then, is to design a
strategy that makes the most effective use of these core resources and capabili-
ties. Consider, for example, the remarkable turnaround of Harley-Davidson
between 1984 and 1988. Fundamental was top management’s recognition that
the company’s sole durable, non-transferable, irreplicable asset was the Harley-
Davidson image and the loyalty that accompanied that image. In virtually every
other area of competitive performance-production costs, quality, product and
process technology, and global market scope-Harley was greatly inferior to its
Japanese rivals. Harley’s only opportunity for survival was to pursue a strategy
founded upon Harley’s image advantage, while simultaneously minimizing
Harley’s disadvantages in other capabilities. Harley-Davidson’s new models
18 KNOWLEDGE AND STRATEGY

introduced during this period were all based around traditional design features,
while Harley’s marketing strategy involved extending the appeal of the Harley
image of individuality and toughness from its traditional customer group to
more affluent professional types. Protection of the Harley-Davidson name by
means of tougher controls over dealers was matched by wider exploitation of the
Harley name through extensive licensing. While radical improvements in manu-
facturing efficiency and quality were essential components of the turnaround
strategy, it was the enhancing and broadening of Harley’s market appeal which
was the primary driver of Harley’s rise from 27 to 44 percent of the U.S.heavy-
weight motorcycle market between 1984 and 1988, accompanied by an increase
in net income from $6.5 million to $29.8 million.
Conversely, a failure to recognize and exploit the strategic importance of
durable, untransferable, and irreplicable resources almost inevitably has dire
consequences. The troubles of BankAmerica Corporation during the mid-1980s
can be attributed to a strategy that became increasingly dissociated from the
bank’s most important assets: its reputation and market position in retail bank-
ing in the Western United States. The disastrous outcome of U.S. Air Group’s
acquisition of the Californian carrier, PSA, is similarly attributable to U.S.Air’s
disregard for PSA’s most important asset-its reputation in the Californian mar-
ket for a friendly, laid-back style of service.
Designing strategy around the most critically important resources and capa-
bilities may imply that the firm limits its strategic scope to those activities where it
possesses a clear competitive advantage. The principal capabilities of Lotus, the spe-
cialist manufacturer of sports cars, are in design and engineering developmenc; it
lacked both the manufacturing capabilities or the sales volume to compete effec-
tively in the world’s auto market. Lotus’s turnaround during the 1980s followed its
decision to specialize upon design and development consulting for other auto man-
ufacturers, and to limit its own manufacturing primarily to formula one racing cars.
The ability of a firm’s resources and capabilities to support a sustainable
competitive advantage is essential to the time frame of a firm’s strategic planning
process. If a company’s resources and capabilities lack durability or are easily
transferred or replicated, then the company must either adopt a strategy of short-
term harvesting or it must invest in developing new sources of competitive
advantage. These considerations are critical for small technological start-ups
where the speed of technological change may mean that innovations offer only
temporary competitive advantage. The company must seek either to exploit its
initial innovation before it is challenged by stronger, established rivals or other
start-ups, or it must establish the technological capability for a continuing stream
of innovations. A fundamental flaw in EMI’s exploitation of its invention of the
CT scanner was a strategy that failed to exploit EMI’s five-year technical lead in
the development and marketing of the X-ray scanner and failed to establish the
breadth of technological and manufacturing capability required to establish a
fully fledged medical electronics business.
Where a company’s resources and capabilities are easily transferable or
replicable, sustaining a competitive advantage is only feasible if the company’s
market is unattractively small or if it can obscure the existence of its competitive
The Resource-Based Theory of Competitive Advantage 19

advantage. Filofax, the long-established British manufacturer of personal orga-

nizers, was able to dominate the market for its products so long as that market
remained small. The boom in demand for Filofaxes during the mid-1980s was,
paradoxically, a disaster for the company. Filofax’s product was easily imitated
and yuppie-driven demand growth spawned a host of imitators. By 1989, the
company was suffering falling sales and mounting losses.36 In industries where
competitive advantages based upon differentiation and innovation can be imi-
tated (such as financial services, retailing, fashion clothing, and toys), firms have
a brief window of opportunity during which to exploit their advantage before
imitators erode it away. Under such circumstances, firms must be concerned not
with sustaining the existing advantages, but with creating the flexibility and
responsiveness to that which permits them to create new advantages at a faster
rate than the old advantages are being eroded by competition.
Transferability and replicability of resources and capabilities is also a key
issue in the strategic management of joint ventures. Studies of the international
joint ventures point to the transferability of each party’s capabilities as a critical
determinant of the allocation of benefits from the venture. For example, Western
companies’ strengths in distribution channels and product technology have been
easily exploited by Japanese joint venture partners, while Japanese manufactur-
ing excellence and new product development capabilities have proved excep-
tionally difficult for Western companies to learn.37

IDENTIFYING RESOURCE GAPS AND DEVELOPING

THE RESOURCE BASE
The analysis so far has regarded the firm’s resource base as predetermined,
with the primary task of organizational strategy being the deployment of these
resources so as to maximize rents over time. However, a resource based
approach to strategy is concerned not only with the deployment of existing
resources, but also with the development of the firm’s resource base. This
includes replacement investment to maintain the firm’s stock of resources and to
augment resources in order to buttress and extend positions of competitive
advantage as well as broaden the firm’s strategic opportunity set. This task is
known in the strategy literature as filling “resource gaps.”38
Sustaining advantage in the face of competition and evolving customer
requirements also requires that firms constantly develop their resources bases.
Such “upgrading” of competitive advantage occupies a central position in
Michael Porter’s analysis of the competitive advantage of nations.39 Porter’s
analysis of the ability of firms and nations to establish and maintain interna-
tional competitive success depends critically upon the ability to continually inno-
vate and to shift the basis of competitive advantage from “basic” to “advanced”
factors of production. An important feature of these “advanced” factors of pro-
duction is that they offer a more sustainable competitive advantage because they
are more specialized (thereforeless mobile through market transfer) and less easy
to replicate.
20 KNOWLEDGE AND STRATEGY

Commitment to upgrading the firm’s pool of resources and capabilities

requires strategic direction in terms of the capabilities that will form the basis of
the firm’s future competitive advantage. Thus, Prahalad and Hamel’s notion of
“core competencies” is less an identification of a company’s current capabilities
than a commitment to a path of future development. For example, NEC’s strate-
gic focus on computing and communications in the mid-1970s was not so much
a statement of the core strengths of the company as it was a long-term commit-
ment to a particular path of technological development.
Harmonizing the exploitation of existing resources with the development
of the resources and capabilities for competitive advantage in the future is a sub-
tle task. To the extent that capabilities are learned and perfected through repeti-
tion, capabilities develop automatically through the pursuit of a particular
strategy. The essential task, then, is to ensure that strategy constantly pushes
slightly beyond the limits of the firms capabilities at any point of time. This
ensures not only the perfection of capabilities required by the current strategy,
but also the development of the capabilities required to meet the challenges of
the future. The idea that, through pursuing its present strategy, a firm develops
the expertise required for its future strategy is referred to by Hiroyuki Itami as
“dynamic resource fit”:
Effective strategy in the present builds invisible assets, and the expanded
stock enables the firm to plan its future strategy to be carried out. And the
future strategy must make effective use of the resources that have been
amassed.40
Matsushita is a notable exponent of this principle of parallel and sequen-
tial development of strategy a n d capabilities. For example, in developing pro-
duction in a foreign country, Matsushita typically began with the production of
simple products, such as batteries, then moved on to the production of products
requiring greater manufacturing and marketing sophistication:
In every country batteries are a necessity, so they sell well. As long as we bring
a few advanced automated pieces of equipment for the processes vital to final
product quality, even unskilled labor can produce good products. As they
work on this rather simple product, the workers get trained, and this
increased skill level then permits us to gradually expand production to items
with increasingly higher technology level, first radios, then television^.^^
The development of capabilities which can then be used as the basis for
broadening a firm’s product range is a common feature of successful strategies of
related diversification. Sequential product addition to accompany the develop-
ment of technological, manufacturing, and marketing expertise was a feature of
Honda’s diversification from motorcycles to cars, generators, lawnmowers, and
boat engines; and of 3M’s expansion from abrasives to adhesives, video tape, and
computer disks.
In order both to fully exploit a firm’s existing stock of resources, and to
develop competitive advantages for the future, the external acquisition of com-
plementary resources may be necessary. Consider the Walt Disney Company’s
The Resource-Based Theory of Competitive Advantage 21

turnaround between 1984 and 1988. In order for the new management to
exploit more effectively Disney’s vast, under-utilized stock of unique resources,
new resources were required. Achieving better utilization of Disney’s film studios
and expertise in animation required the acquisition of creative talent in the form
of directors, actors, scriptwriters, and cartoonists. Putting Disney’s vast real
estate holdings to work was assisted by the acquisition of the property develop-
ment expertise of the Arvida Corporation. Building a new marketing team was
instrumental in increasing capacity utilization at Disneyland and Disney World.

CONCLUSION
The resources and capabilities of a firm are the central considerations in
formulating its strategy: they are the primary constants upon which a firm can
establish its identity and frame its strategy, and they are the primary sources of
the firm’s profitability. The key to a resource-based approach to strategy formu-
lation is understanding the relationships between resources, capabilities, com-
petitive advantage, and profitability-in particular, an understanding of the
mechanisms through which competitive advantage can be sustained over time.
This requires the design of strategies which exploit to maximum effect each
firm’s unique characteristics.

REFERENCES
1. Charles W. Hofer and Dan Schendel, Strategy Formulation: Analytic Concepts (St.
Paul, MN: West, 1978), p. 12.
2. Robert D. Buzzell and Bradley T. Gale, The PIMS Principles: Linking Strategy to
Performance (New York, NY: Free Press, 1987).
3. See, for example, Henry Mintzberg, “Of Strategies, Deliberate and Emergent,”
Strategic Management Journal, 6 (1985):257-272; Andrew M. Pettigrew, “Strategy
Formulation as a Political Process,” International Studies of Management and
Organization, 7 (1977): 78-87; J.B. Quinn, Strategies for Change: Logical
Incrementalism (Homewood, IL: Irwin, 1980).
4. David Ricardo, Principles of Political Economy and Taxation (London: G. Bell,
1891); Joseph A. Schumpeter, The Theory of Economic Development (Cambridge,
MA: Harvard University Press, 1934); Edith Penrose, The Theory of the Growth of
the Firm (New York, NY: John Wiley and Sons, 1959).
5. David J. Teece, “Economics of Scope and the Scope of the Enterprise,” Journal of
Economic Behavior and Organization, 1 (1980): 223-247; S. Chatterjee and B.
Wernerfelt, “The Link between Resources and Types of Diversification: Theory and
Evidence,” Strategic Management Journal, 12 (1991):33-48.
6. R.P. Rumelt, “Towards a Strategic Theory of the Finn,” in R.B. Lamb, ed.,
Competitive Strategic Management (EnglewoodCliffs, NJ: Prentice Hall, 1984); S.A.
Lippman and R.P. Rumelt, “Uncertain Imitability: An Analysis of Interfirm
Differencesin Efficiency under Competition,” Bell Journal of Economics, 23 (1982):
22 KNOWLEDGE AND STRATEGY

418438; Richard Reed and R.J. DeFillippi, “Causal Ambiguity, Barriers to

Imitation, and Sustainable Competitive Advantage,” Academy of Management
Review, 15 (January 1990): 88-102.
7. David J. Teece, “Capturing Value from Technological Innovation: Integration,
Strategic Partnering, and Licensing Decisions,” Interfaces, 18/3 (1988): 46-61,
8. Jay B. Barney, “Strategic Factor Markets: Expectations, Luck and Business Strategy,”
Management Science, 32/10 (October 1986): 1231-1241.
9. Ingemar Dierickx and Karel Cool, “Asset Stock Accumulation and the Sustainability
of Competitive Advantage,” Management Science, 35/12 (December 1989):
1504-1 5 13.
10. R. Schmalensee, “Industrial Economics: An Overview,” Economic Journal, 98
(1988):643-681; R.D. Buzzell and B.T. Gale, The PlMS Principles (New York, NY:
Free Press, 1987).
11. Because of the ambiguity associated with accounting definitions of profit, the acade-
mic literature increasingly uses the term “rent” to refer to “economic profit.” “Rent”
is the surplus of revenue over the “real” or “opportunity” cost of the resources used
in generating that revenue. The “real” or “opportunity” cost of a resource is the rev-
enue it can generate when put to an alternative use in the firm or the price which it
can be sold for.
12. W.J. Baumol, J.C. Panzer, and R.D. Willig, Contestable Markets and the Theory of
Industrial Structure (New York, NY: Harcourt Brace Jovanovitch, 1982).
13. In economist’s jargon, such jointly owned resources are “public goods”-their bene-
fits can be extended to additional firms at negligible marginal cost.
14. Hiroyuki Itami [Mobilizing Invisible Assets (Cambridge, MA: Harvard University
Press, 1986)] refers to these as “invisible assets.”
15. Based upon Hofer and Schendel, op. cit., pp. 145-148.
16. See, for example, Iain Cockburn and Zvi Griliches, “Industry Effects and the
Appropriability Measures in the Stock Market’s Valuation of R&D and Patents,”
American Economic Review, 78 (1988):419-423.
17. General management, financial management, marketing and selling, market research,
product R&D, engineering, production, distribution, legal affairs, and personnel. See
Charles C. Snow and Lawrence G. Hrebiniak, “Strategy, Distinctive competence,
and Organizational Performance,” Administrative Science Quarterly, 25 (1980):
3 17-336.
18. C.K Prahalad and Gary Hamel, “The Core Competence of the Corporation,”
Haward Business Review (May/June 1990), pp. 79-91.
19. Howard H. Stevenson, “Defining Corporate Strengths and Weaknesses,” Sloan
Management Review (Spring 1976), pp. 51-68.
20. Richard T. Pascale, “Honda (A),” Harvard Business School, Case no. 9-384-049,
1983.
21. Paul R. Lawrence and Davis Dyer, Renewing American Industry (New York, NY:
Free Press, 1983), pp. 60-83.
22. “Du Pont’s “Drug Hunter” Stalks His Next Big Trophy,” Business Week, November
27,1989, pp. 174-182.
23. Richard E. Caves, “Economic Analysis and the Quest for Competitive Advantage,”
American Economic Review, 74 (1984):127-128.
The Resource-Based Theory of Competitive Advantage 23

24. Jay B. Barney, “Organizational Culture: Can It Be a Source of Sustained Competitive

Advantage?” Academy of Management Review, 11 (1986):656-665.
25. Lippman and Rumelt, op. cit.
26. This information problem is a consequence of the fact that resources work together
in teams and their individual productivity is not observable. See A.A. Alchian and H.
Demsetz, uProduction, Information Costs, and Economic Organization,” American
Economic Review, 62 (1972):777-795.
27. Such asymmetric information gives rise to a “lemons” problem. See G. Akerlof, “The
Market for Lemons: Qualitative Uncertainty and the Market Mechanism,” Quarterly
Journal of Economics, 84 (1970):488-500.
28. Barney, op. cit.
29. The definition of resource specificity in this article corresponds to the definition of
“specific assets” by Richard Caves [“International Corporations: The Industrial
Economics of Foreign Investment,” Economica, 38 (1971): 1-271; it differs from
that used by O.E.Williamson [The Economic Institutions of Capitalism (New York,
NY: Free Press, 1985), pp. 52-561. Williamson refers to assets which are specific to
particular transactions rather than to particular firms.
30. ”Catch a Falling Star,” The Economist, April 23, 1988, pp. 88-90.
31. Dierickx and Cool, op. cit.
32. The key advantage of partnerships as an organizational form for such businesses is
in averting conflict over control and rent allocation between employees and owners.
33. ‘Ad World Is Abuzz as Top Brass Leaves Lord Geller Agency,” Wall Street Journal,
March 23, 1988, p. A l .
34. Charles Ferguson [“From the People Who Brought You Voodoo Economics,”
Harvard Business Review (May/June 1988), pp. 55-63] has claimed that these start-
ups involve the individual exploitation of technical knowledge which rightfully
belongs to the former employers of these new entrepreneurs.
35. “The Decline of the Superstar,” Business Week, August 17, 1987, pp. 90-96.
36. “Faded Fad,” The Economist, September 30, 1989, p. 68.
37. Gary Hamel, Yves DOZ,and C.K. Prahalad, “Collaborate with Your Competitors-
and Win,” Harvard Business Review (JanuaryFebruary 1989), pp. 133-139.
38. Stevenson (1985), op. cit.
39. Michael E. Porter, The Competitive Advantage of Nations (New York, NY: Free
Press, 1990).
40. Itami, op. cit., p. 125.
41. Arataroh Takahashi, What I Learned from Konosuke Matsushita (Tokyo: Jitsugyo
no Nihonsha, 1980) [in Japanese]. Quoted by Itami, op. cit., p. 25.