Monday, April 16, 2012

Measuring Sustained Competitive Advantage Using Bayesian Reasoning

In this article, Tang and Liou develop a theoretical framework to understand the causal relationships among (1) sustainable competitive advantage, (2) configuration, (3) dynamic capability, and (4) sustainable superior performance. They propose that a firm’s competitive advantage, resource bundle configuration, and dynamic learning capability cannot be comprehended by outsiders. Its operational performance, however, can be captured by financial indicators.

They promote an inductive Bayesian interpretation of the sustainable competitive advantage proposition. From this viewpoint, the presence or absence of competitive advantage may be reflected in the causal relationship between resource configuration, dynamic capability, and observable financial performance. They then apply this theoretical framework to an example drawn from the global semiconductor industry, an area in which resource configuration and dynamic capability are essential to performance.

The paper expounds on the theory supporting the use of Bayesian reasoning to measure competitive advantage over other measures like Porter’s competitive strategy or the resource based view of valuable, rare, inimitable and non-substitutable.

Powell’s premise – sustainable competitive advantage is more probable in firms that have already achieved sustained superior performance – is further developed through periodically updating its propositions or hypotheses in the face of empirical evidence. Tang and Liou use a Bayesian discriminate model to reveal the functional dependence of superior performance on unique business processes. The primary sources of competitive advantage are considered embedded in and inseparable from the organization itself, along with its business units and functional departments. It is assumed that the process of managing these resources, termed strategic fit, cannot be comprehended or imitated by outsiders. The model is then demonstrated using the semi-conductor industry.
Explanation of sustainable competitive advantage
The final data set for the study contained 147 companies and 786 firm-year observations. Of those, 188 companies are located in developed countries (The U.S., within Europe, and Japan). The other 29 are in the Asia/Pacific region. Using the firm’s financial data, certain observable traits can be inferred.

The study began by using PCA, principle component analysis, on the financial indicators to identify the traits or factors. Three principal factors accounted for 60 percent of the total variance.

Factor 1: Relationship management. This factor includes customer relationship management (accounts receivable turnover), three variables related to supplier relationship management (accounts payable turnover, inventory turnover, and CGS/sales) and one variable associated with the government (tax to sales ratio). The factor illustrates the sustainable competitive advantage of firms that manage upstream (suppliers), downstream (customers), and governmental relationships. The variance indicated that good relationship management can pay off with respect to a lower CGS.

Factor 2: Management ability. This factor consists of indicators related to fixed asset management capabalities including department/sales ratio and fixed asset turnover. The correlation between fixed assets turnover and Factor 2 indicates that firms with greater competence in assets management generate revenue at a lower unit cost and low asset depreciation.

Factor 3: Knowledge management. This factor includes R&D/sales and SG&A/sales ratios to measure a firm’s effectiveness in resource deployment. The high correlation indicates that lower unit costs are associated with efficient management.

The findings, therefore, support the idea that resource configurations or factors of a firm can be inferred from their observable financial indicators.

Tang and Liou advance Powell’s idea of using Bayesain probabilistic reasoning as a means of distinguishing sustained competitive advantage from sustained superior performance in this paper.
They propose that particular resource configurations can be shown to link the two – sustained competitive advantage and sustained superior performance.

Through a discussion of Bayes’ theory and subsequent semi-conductor example, the paper describes how empirical data on past financial performance in a population of firms can be used to generate the posterior probability of sustainable competitive advantage, given the prior probabilities of both competitive advantage and competitive disadvantage.

Source:Tan, Y-C; Liou, F-M. (2010). Does Firm Performance Reveal Its Own Causes? The Role of Bayesian Inference. Strategic Management Journal. 31: 39-57.
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  1. I just have a quick question. What did the authors mean by that competitive advantage, resource bundle configuration and dynamic learning capability cannot by comprehended by outsiders? Outsiders meaning other firms or those outside the industry?

  2. Outsiders meaning people outside the organization.