# Internal Environment in Management - Principles of Management

In addition to the external environment, managers also face the internal environments of their own organizations. As noted in the chapter introduction, the internal environment includes the organization of the firm (its structure, culture, controls, and incentives), its employees (human capital), and its resources (tangible and intangible assets). Each of these elements can be a strength, enabling managers to attain the goals of the enterprise, or a weakness that makes it more difficult for managers to work productively toward attaining enterprise goals

. When managers analyze the internal environment of their firm, they often do so by identifying its strengths and weaknesses. This inward focus complements the identification of opportunities and threats in the external environment. Taking such an inventory (a SWOT analysis) can help managers develop strategy.

INTERNAL ORGANIZATION

The internal organization of a firm can create an environment that is easy or difficult to work in. It might be an enlightened meritocracy that offers a host of opportunities for advancement, rewards skilled and creative managers, and fosters high productivity; or it might be an inertbureaucracy that punishes those who advocate change, rewards only those who promote the status quo, and inhibits the attainment of productivity.

The internal environment can be a liberating place that lets a manager reach his or her full potential, or it can be stifling. It can be a place where it is easy to do good things or where it is hard to do anything. It can also be changed by the actions of managers. Managers can transform their firms from dull bureaucracies into progressive meritocracies. Unfortunately the opposite can happen too: Bad managers have taken over good organizations and left them in worse shape than they found them in!

It is common to think of the internal organization of a firm in terms of its organizational culture —the basic pattern of values and assumptions shared by employees within anorganization. As important as organizational culture is, the organization comprises far morethan culture. It is also determined by the structure of the organization, its control systems, itsincentives, and the kind of people who work there.

Collectively we refer to structure, controls,incentives, and culture as aspects of the organization architecture of a firm. For now,however, remember that each of these elements is critical in determining the kind of place inwhich a manager works.

Culture is important because the shared values and assumptions of an organization influencewhat a manager can and cannot do, as well as what is encouraged or discouraged by the organization. Structure defines who has responsibility for what in an organization, where power and influence are concentrated in an organization, and thus whose support is critical for getting things done.

Controls and incentives tell the manager what kind of behavior the organization expects, what is being tracked, and what will be rewarded. If a manager is going to get things done in an organization, he or she must figure out how the organization works, how decisions get made, and what to do to exert influence. To be successful, and to handle external environmental challenges, the manager must understand the internal organization in which he or she is based.

Although we discuss internal organization in more detail later, two points are of note now. First, the internal organization of an enterprise can be a strength or a weakness. An internal organization that encourages and rewards high productivity and enables managers to respond rapidly to external opportunities and threats can be considered a strength. Conversely, an internal organization that inhibits productivity and is characterized by political infighting and inertia forces can be considered a weakness.

Second, just as managers can pursue strategies to take advantage of opportunities and counter threats in the external environment, they can also pursue strategies to build on organizational strengths and counter weaknesses. For example, when Jack Welch became CEO of General Electric in 1981, a position he held until 2001, he quickly realized that the internal organization of GE was a weakness. Among other things, he thought it was too centralized, bureaucratic, and hierarchical, with far too many layers of management (on average there were 11).

His strategy for the organization was to delayer (reducing the number of management layers to as few as four), decentralize responsibility for operating and strategic decisions to self-contained business divisions, and create positive incentives for managers to pursue strategies that boosted productivity and profit growth. Over time this change in internal organization had the desired effect, and what had been a weakness became a strength.

EMPLOYEES (HUMAN CAPITAL)

The employees of an enterprise can be a source of sustained competitive advantage, or they can represent a weakness. Employees constitute what economists call the human capitalof an organization, by which they mean the knowledge, skills, and capabilities embedded in individuals. Human capital is a crucial source of productivity gains and economic growth. Stanford Business School Professor Jeffery Pfeffer has argued that people are the most important source of sustainable competitive advantage.

Hire the right people, train them well, create an internal organization that allows them to fully express their potential, and reward them appropriately by putting the right incentives in place, and the firm will be rewarded by superior performance. By the same token, if employees lack the knowledge, skills, capabilities, and motivation to work productively and pursue opportunities for improving performance, Pfeffer’s arguments suggest that this can constitute a source of competitive disadvantage.

The strategy of Microsoft illustrates the role of people in building a successful enterprise. Microsoft has always tried to hire the best and the brightest, to reward them for high performance through incentive-based pay (stock options and grants), and to give them plenty of opportunities for expressing their potential. Over the years this strategy made people a unique strength for Microsoft. This produced significant gains, enabling the company to make and effectively market a range of software products that became industry standards (specifically Windows and Office). In recent years, however, it has become more difficult for Microsoft to execute this strategy.

Today many of the best and brightest are going to work for competitors such as Google, which they perceive as a more vibrant enterprise. Moreover, many of Microsoft’s original employees became very wealthy during the 1990s and retired early. This drained some of the firm’s human capital. As a result, it is no longer clear that people represent a unique strength for the company. In fact, relative to competitors, Microsoft’s employees could become a weakness if the company does not take steps to correct the gradual erosion of its human capital.

In some cases the employees of an organization can indeed be a source of weakness. For example, as we saw in the introduction to the chapter, the ability of managers at some U.S. airlines, such as United, to implement strategies addressing tough competitive conditions in the task environment has been hampered by the fact that many of the people within the organization belong to unions that have resisted the proposed changes. It has been easier for managers at other airlines, such as SW Airlines and Jet Blue, to introduce flexible work practices that boost productivity and reduce costs, partly because their workforces are not unionized.

We further discuss strategies for managing people and upgrading human capital later. For now remember that people can be a distinctive strength or a weakness relative to competitors; managers can exert influence over the human capital of the organization through human resource practices and by putting the right internal organization architecture in place.

RESOURCES

An important line of work in academic literature known as the resource-based view of the firm argues that the resources of an enterprise can be a source of sustainable competitive advantage. The resources of a firm are the assets that managers have to work with in their quest to improve the performance of the enterprise. Tangible resources are physical assets, such as land, buildings, equipment, inventory, and money. Intangible resources are nonphysical assets that are the creation of managers and other employees, such as brand names, the reputation of the company, processes within the firm for performing work and making decisions, and the intellectual property of the company, including that protected through patents, copyrights, and trademarks.

The resource-based view argues that a resource can constitute a unique strength if it meets the following conditions . First, the firm must own the resource in question; if it does not, the resource owner will capture the benefits. Second, the resource must be valuable , increasing the performance of the firm relative to that attained by competitors either by lowering costs or by differentiating the product offering and helping the firm to raise pricesand sell more.

Third, the resource must be rare : Competing enterprises lack similar quality resources. Fourth, the resource must be inimitable : It is difficult for competitors to imitate or replicate it. Fifth, the resource must be nonsubstitutable: Competitors cannot use a different resource that is easy to acquire to achieve the same effect.

For a simple example, consider Aramco, the state-owned Saudi oil company. Aramco owns a valuable resource: the sole right to pump oil out of the giant Saudi Ghawar field, the largest ever discovered. The resource is valuable because the cost of extracting oil fromGhawar, at around $10 a barrel, is far below the price of oil (which in early 2006 stood at$70 a barrel). The resource is rare because very few oil fields are as big as Ghawar, and thecost of oil extraction at Ghawar has long been among the lowest in the world.

The resourceis inimitable because other oil companies cannot simply copy the Ghawar—there is onlyone Ghawar. The resource is nonsubstitutable because there is no other way of producing oilthat is substitutable for production at Ghawar. Thus ownership of the right to pump oil outof Ghawar represents a unique strength of Aramco.

As another example, consider the Coca-Cola trademark. An intangible asset, the trademark is the exclusive property of the Coca-Cola Company, its owner. It is a valuable resource because it signifies the Coca-Cola brand and all that implies in the minds of consumers. Most notably, the trademark allows Coca-Cola to differentiate its cola from that of other companies. The trademark is a rare resource because it is intellectual property that is exclusively owned by Coca-Cola; it is inimitable because trademark law prohibits other enterprises from using a lookalike trademark.

One can also argue that the trademark is nonsubstitutablebecause there is no commonly available substitute for the Coca-Cola trademark— except perhaps the Pepsi-Cola trademark, which was built at great expense by PepsiCo. In sum, the Coca-Cola trademark seems to constitute a unique strength of Coca-Cola.

It is a resource that managers can work with to improve the firm’s performance. Indeed, when managers noticed that growth in demand for cola in the United States was starting to mature, they decided to use the Coca-Cola trademark to help sell other beverages such as bottled water, which is sold under the Dasani brand name but also sports the Coca-Cola trademark on every bottle.

More generally, resources that are unique strengths for a firm— uniquely strong resources —can take on all sorts of forms. The process that 3M uses to generate new productsmay be a uniquely strong resource, given the history and success of that company indoing just that.

Similarly, the production systems of leading manufacturing companies such as Toyota and Dell Computer may be based on uniquely strong resources. Some would also say that internal organization and human capital, two aspects of the internal environment we have already considered, may in the right conditions be considered uniquely strong resources.

The resource-based view of the firm suggests three things. First, when reviewing a firm’sassets for strengths and weaknesses, managers should evaluate the firm’s tangible and intangibleresources with respect to the five characteristics discussed here: ownership, value, rareness, inimitability, and nonsubstitutability.

Such resources can be a source of uniquestrength. Second, managers should be aware that they need to protect such resources and make sure they continue to be a source of strength in the future.

For example, to protect thevalue of the Coca-Cola trademark, Coca-Cola invests in brand promotions, makes sure thatits product quality is good (ultimately the trademark is a symbol of product quality), anduses its legal staff to sue enterprises that make unauthorized use of the trademark. Third,managers can create resources that constitute unique strengths if they make the right kindsof investments over time.

The Coca-Cola trademark, for example, was initially not thatvaluable. It became so over time only as managers at Coca-Cola built the brand throughmarketing, promotions, and product extensions and used the legal system to stop othersfrom copying the trademark.

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