Internal Analysis & Firm Profitability

Why Internal Analysis Matters

Two broad determinants of a firm’s profit performance:
- External environment / industry structure (what Porter’s Five‐Forces analyze)
- Internal resources & capabilities (what the firm actually possesses and can do)
Internal analysis is essential for two overarching reasons:
- ① External analysis alone is incomplete – looking only at the industry is like a doctor diagnosing an injury just by inspecting skin; an X-ray (internal view) yields deeper insight.
- ② Empirical research shows internal factors explain more profit variance than external factors.

Data: Average profitability of standard U.S. industries, 1971 \text{–} 1990.
Observation: Large spread in average Return on Assets (ROA) across industries.
- Example: Pharmaceuticals sits at the high end of the profitability spectrum.
- Iron & Steel lies at the low end.
Five-Forces snapshot of pharmaceuticals:
- Buyer power: low
- Supplier power: low
- Threat of entry: low
- Threat of substitutes: low
- Rivalry: generally low
- ➔ External analysis correctly predicts “attractive & profitable” on average.

Pharmaceuticals (ROA figures):
- American Home Products: (19\%)
- Upjohn: lower (exact value not provided, but below 12\%)
- Pfizer: lower
- American Cyanamid: (7\%)
- ➔ Spread ≈ 12\text{ percentage points}.
Iron & Steel (ROA figures):
- Oregon Steel Mills: (12\%)
- LTV: (-3\%)
- ➔ Spread ≈ 15\text{ percentage points}.
Insight:
- Top performers in the “worst” industry (e.g., Oregon Steel Mills) outperform bottom performers in the “best” industry (e.g., Pfizer, Upjohn, American Cyanamid).
- Therefore, industry attractiveness ≠ destiny; firm‐specific factors matter greatly.

Study: Anita McGahan & Michael Porter (large sample of diversified firms).
Decomposition of variance in business-unit profitability:
- Business-unit effect + Corporate-parent effect (both internal): 36\% of variance.
- Industry effect + Year (macro) effect (external): 21\% of variance.
- Remaining variance unexplained/noise.
Key takeaway: Internal effects account for ≈ 50\% more variance than external effects.

Resources = tangible & intangible assets accumulated over time.
- Examples: physical assets (plants, equipment, land), patents, trademarks, cash, proprietary data, human talent (e.g., Steve Jobs at Apple).
Capabilities = organizational processes/routines that coordinate resources to achieve goals.
- Examples: low-cost manufacturing systems, R&D pipelines, rapid product-launch processes, superior customer service routines.
These resources and capabilities enable the firm to perform activities better than rivals, creating unique value for customers.

Key resources:
- Starbucks brand equity
- Prime retail locations
- Coffee blend recipes
- Patents protecting those recipes
Key capabilities:
- Coffee‐bean roasting process that maximizes flavor consistency
- Continuous creation of new beverage blends
- Store design processes that generate inviting “third-place” atmospheres
- Site selection algorithms to identify optimal new store locations
Combined, these internal factors allow Starbucks to outperform competitors (Caribou Coffee, Peet’s, Dunkin’ Donuts) within the same industry.

Effective strategy formulation requires both external and internal analysis.
Internal analysis helps managers:
- Identify unique strengths they can leverage for competitive advantage.
- Detect weaknesses that must be remedied to meet market demands.
- Decide where to invest (enhancing existing resources, building new capabilities).
For students & practitioners:
- Mastery of resource-based analytical tools (e.g., VRIO, value chain mapping) is essential to diagnose whether a firm can sustainably deliver unique value.
Bottom line: Being in the “right” industry is helpful, but possessing the “right” resources and capabilities is often decisive for superior profitability.