Every manager has some idea of the definition of ‘competitive advantage’.

It’s something about doing things better than the competition. It’s about ‘watching them struggle while we succeed’. It’s about ‘making more profit than they do’.

In fact it’s a phrase from business research that has passed into common use.

Competitive advantage literally is the ability to sustain profits that exceed the average for the industry by developing distinctive competencies: distinctive, because the competitors don’t have them and because they are fundamentally difficult to replicate.

Porter[1] considers that there are two types of competitive advantage: one coming from a more favourable cost position and one coming from a better ability to differentiate. Those two definitions are practical, and hence useful for managers.

We hear a lot about how people are key to firms. People make firms work and people determine how efficient a firm is - how good its productivity is. People are therefore instrumental in determining a firm’s cost base and from that, they determine it’s competitive advantage.

People, as distinct from managers, shareholders and entrepreneurs, also create innovative ways for a firm to differentiate its products and services from its competitors. People are therefore absolutely key in developing competitive advantage.

People develop product and intellectual property. People have the proprietary know-how needed. People attract customers to the firm and hence develop the customer base. The reputation of the firm comes from its people and their ability to serve customers. And people are the brand.

People are therefore instrumental in developing and producing both the normal and, where possible, the super-normal profits that managers seek. It can’t be done without them!

This blog develops those two ideas - that firms seek competitive advantage, and that competitive advantage comes from the people the firm employs.

Why competitive advantage matters

Going right back to the begining, entrepreneurs start firms because they feel that they have an idea that would be good to invest in. They feel they have found something in which they could make above average or super-normal profits. In this opening section we develop a model of the firm to elaborate the idea of added-value and profit.

The Basic Model of the Firm

The firm assembles resources (historically, called the ‘means to production’) and sets about producing, marketing, selling and delivering goods and services.

Goods and services have a market price – a price that the customer feels is fair, given the benefits that will be derived from their ownership. The market price is hopefully significantly above the cost of producing the goods or the cost of providing the services, but the two are not otherwise linked.

The aggregate of all goods and services sold gives the ‘top line’ of the profit-and-loss account or sales value of the firm.

The direct costs incurred by the firm in producing and delivering the goods and services (including labour costs directly attributable to production and delivery) represent the cost of goods sold.

The difference between the top line and the direct costs represents the gross profit. Gross profit is the contribution available to fund the administration of the firm and it includes the net profit – the real measure of success in a trading firm and the parameter every firm seeks to maximise. Administrative expenses or ‘overheads’ include the costs associated with sales, marketing and administration.

In a well run firm that is trading normally, a net profit of between about 5% and 15% on sales is typical. This figure does vary by firm but the mid-range figure of 10% on sales is a good working value. Given that the return on other ventures like the stock market is something like 8%, it is marginally better to invest in the firm than put the money elsewhere.

This normal situation is rather unexciting. There’s a normal profits state for every industry with an associated average profits figure.

All owners would surely want more. The rest of this paper goes on to discuss how firms can steer their firms to achieve the necessary competitive advantage to allow what the economists call ‘super-normal’ or above average profits.

Expanding the Definition

The firm develops the means to supply goods and services. It develops capabilities that allow this supply to be done effectively such that net profit is maximised.

The firm’s resources and its capabilities represent what it goes to market with and why it is that customers will buy at a given price. As we introduced above, there are two forms of competitive advantage: cost advantage and differentiation advantage.

Cost advantage describes the state where the firm has lower cost of goods sold. It can then choose to lower prices or to keep prices higher and make greater gross profit. This is a powerful flexibility that can be used in extreme cases to drive competitors out of business.

Cost advantage can also be had through lower administration expenses and we see firms seeking this by avoiding the cost of a corporate headquarters, existing instead as a virtual entity to avoid expensive leases.

The second element of competitive advantage is the ability to differentiate the firm’s goods and services from those of competitors. As we shall see in the next section, there are many facets to differentiation. In simple terms, it’s arranging your resources and capabilities to be so attractive that customers choose to buy from you rather than from your competitors.

Sources of Competitive Advantage

Competitive advantage comes from a host of things. One the one hand it could be the geographical location of the resources. On the other it could be product quality. The key thing is that it should be something that it not easily copied or competitors will quickly erode the differential. Mostly people are at the heart of all differentials - whether directly, delivering services or innovating technology. The following are some additional examples - all involving people.

Productivity

Productivity is the output available to the firm for one unit of input to the production (or delivery or sales or whatever) system. Productivity depends on the tools and other physical resources and on the skills and knowledge of the people employed.

Effectiveness

Management brings the strategy and policies of the firm to life. The result is that even where a multi-site firm has common policies, the practices differ and one site excels whilst the other fails. We see this in areas such as motor vehicle manufacture across Europe with management choosing to move production from UK to Belgium or Spain. The foreign sites are more effective even though part of the same group. Management effectiveness is a key competitive differential.

Innovation

Competitive advantage is not static. A firm can have it and lose it. Competitors don’t stand still. Sustaining competitive advantage takes innovation: the constant flow of new ideas and the adoption of those contributing to progress. People innovate and they do so in the right climate or environment. It is for management to create that climate and to harness the ideas.

Quality

Quality is meeting the needs of customers. Quality services are those that meet expectation. Quality goods are those that meet the advertised specification. Quality delights customers. Whilst quality does come from methods and tools, it also flows from the people using the tools and following the methods.

Service

In every sales scenario there is scope for service excellence. Service excellence is about enhancing the user experience. It’s about making the customer feel good about their purchases and the buying experience itself. Examples abound: keeping the site tidy when building an extension to a house, giving advice when choosing clothes yielding a pleasing outcome, making a recommendation on a menu that turns out to be to the customers liking and recommending alternative production processes that save the customer money. Customers often see it as suppliers’ staff ‘going the extra mile’ for them.

Market Price

In all cases, competitive advantage ensures that the desired selling price is under the market price, ensuring that the firm's products sell. When comparing commodities such as clothes where the market price is relatively low, staff performance can assure the volumes needed for economies of scale. When comparing premium products such as high fashion, staff can make the buying experience enjoyable causing customers to return thereby securing selling prices well above those of competitors.

Chapter Summary

Firms trade to make profits. Not all firms are the same and not all firms can make above average profits in their industry. Competitive advantage is said to exist where a firm can sustain above average profits when compare to its competitors. This competitive advantage comes from both physical and human resources though it is significantly easier to develop competitive advantage through staff than to invest in new tools and process. In many instances investment in both to some degree or other is essential.

Employer-employee relationships

For competitive advantage through the people in a business, there needs to be a strong relationship between employer and employee. This relationship comprises both expressed and tacit elements.

Employment contracts

Contracts in employment are minimalist by design - much is embedded in statute. All that a firm has to provide to an employee is a 'written statement of employment particulars'. This needs only list the basics like pay, hours of work, holiday entitlement, notice period and details of grievance and disciplinary procedure. Of course, most firms add significantly to this to add terms such as other benefits, probationary arrangements, expenses payments, obligation of confidentiality, restrictive covenants and assignment of copyright and invention.

Despite this embellishment, there remains a huge amount in the contract that is implied.

The Building of Tacit Rules and Expectations

The written terms and conditions, or the fuller employment contract that's built from it, underpins the relationship, forming a foundation. It's imperative that this foundation meets both parties' needs or else the rest of the contract will be built on an unsteady base. Onto this base, both parties build a set of rules and expectations.

One classic example is the expectation of continuity and longevity of employment. Employees can only make plans for their families if they know with reasonable certainty that the firm will still be there next year and that they will still have a job. If this expectation is unlikely to be met, for example because a takeover is looming, the employee will consider the rules of the game broken and exercise their rights to disengaged and put energy into seeking new employment where the longevity is more likely to be sustained. This shows that the set of rules built on the base of the written contract is fragile and employers need to understand this - they may not be able to control events like take-overs but they can at least work to support the tacit contract in other areas.

These expectations vary by individual. Longevity will be less important to someone at the beginning of their career since they expect to move around a bit anyway. The need for longevity weakens if the employee has no dependent family. And it weakens when the employee is a well-qualified professional or tradesman who can get another job relatively easily. The set of tacit rules and expectations is unique to each employee.

What makes staff go the extra mile?

For the firm to achieve competitive advantage, something must cause it to achieve either cost advantage (reduced cost compared to others) or differentiation advantage (well differentiated products and services) such that customers would prefer to buy from it than from others. Since firms are an amalgam of processes and people, something in either process or people matters. The focus in this paper is people. What then makes people in a firm apply themselves with extra vigour and ‘go the extra mile’? What makes them excel and hence add more value than average? What makes them achieve competitive advantage for the firm? The next three sections will look at these questions.

Defining the Psychological Contract

Purcell[2] notes that “when employees believe or feel that their boss or their firm has broken or breached their expectations about work and career opportunities, they feel less committed…”. He also notes that what is called organisational citizenship behaviour or OCB declines. OCB is the idea that employees behave as good citizens and help fellow employees causing organisation cohesion. The psychological contract is something that when present enables discretionary behaviour – to do more for the firm than is laid down in the written contract. Conceptually therefore, if the psychological contract is sound, the employee engages in discretionary behaviour, ‘goes the extra mile’ and optimises added value from their efforts. When the psychological contract is damaged through perceived poor management, discretionary behaviour is withdrawn.

Purcell continues to describe that the psychological contract relies on trust and communications between management and employees. There is then the idea of capital being accrued through reinforcing behaviour by both parties which allows minor transgressions to be forgiven. Given enough capital, the contract remains intact and the firm continues to reap the benefits.

The psychological contract is therefore the term used to describe the state of relations between management and employees that fosters an optimum contribution to added value and competitive advantage in the firm. It stems from the physical contract but builds on this to describe goodwill and trust between the parties that come from each party keeping their part of a tacit bargain. This bargain describes what both parties expect from their relationship.

Practical Examples of the Psychological Contract

The physical contract is made by the firm offering employment and the employee accepting and the associated terms and conditions that set out things like pay, hours and holidays. Right from the outset the employee has expectations:

• That the firm will keep trading and the employment will continue;
• That there will be a degree of advancement in both work and job;
• That management will act to make the work and job as interesting as possible;
• That information on how the firm is doing will be conveyed to staff.

Likewise management has expectation:

• That the employee will work diligently and be civil with colleagues and customers;
• That the employee will care about the firm and contribute to the best of their abilities;
• That the employee will seek personal advancement and continue learning;
• That the employee will strive to excel and to ‘go the extra mile’ in serving the firm’s customers.

None of these expectations are written. If the firm has a good communications process with staff, it is possible that they will be discussed in meetings. Staff training likewise reinforces the values in the firm and expresses what management expects. There is evidence that the more ‘value centric’ the firm, the sounder the psychological contract. Perhaps one of the best known ‘value-based’ firms is The Body Shop with its legendary ‘staff before profits’ stance to employee relations.

Links from Psychological Contract to Performance

Above we set out the link between expectations of employer and employee and the assertion that if these are met, there will exist a ‘deal’ between the parties. If the terms of this deal are considered breached by the employee, discretionary behaviour may be withdrawn. Discretionary behaviour describes the daily choices the employee makes about how they chose to do the job, the speed and care with which they work and the degree of innovation that they bring. It describes the difference between an ordinary employee who does OK and one who excels daily.

Once a sound psychological contract is established, employees work their best.

If the contract is breached, discretionary behaviour is withdrawn and the employee regresses to the physical contract and normal behaviour. If the breach is severe, the employee then disengages and loses commitment.

They work the contracted hours and do only that asked of them. The extra effort is lost.

A classic example is the shift from packing up and leaving a few minutes after the end of the normal working day to doing all clearing up in work time and leaving exactly on time. Such changes in behaviour are noticeable and are often symptoms of a drift from absorption in the work to clock-watching: a shift from dedication to cynicism.

Chapter Summary

This chapter has established that there is a concept of a psychological contract that is useful in describing why it is that employees do excel and do go the extra mile for the firm. It has postulated that this hidden contract is significant in describing the relationship between employee and employer. If it is strong, the firm benefits through added value and competitive advantage beyond the norm. If it is damaged, discretionary behaviour is removed and the firm suffers.

The next two chapters build on these ideas and discuss what makes a good firm and hence how management optimises competitive advantage; what does the principal put in place to cause the psychological contract to be sound?

What Makes a Good Firm: some anecdote

The following sets out examples where the psychological contract has been tested to be sound. All are from the public domain and specifically from the Sunday Times. Each of these has run competitions where employees voted for their firms in ‘good firm’ competitions. And each firm cited is shown to be in the top of its league for returns on investment.

The Sunday Times Good Firm Guide

The Sunday Times 100 Best Small Firms to Work For asks questions of employees and managers to determine the degree to which employees are happy, motivated and successful. It’s structured under eight headings and each one is directly related to assessing the degree to which staff will strive and ultimately achieve competitive advantage for their bosses. The headings span leadership, attitude to managers, colleagues, company ethos, wellbeing, pay and benefits and personal growth.

In the Times Guide, Killian Hurley, MD of property developer Mount Anvil reported an increase in staff engagement through heightened job security following a net drop in earnings after investment in a new development project instead of paying bonuses. In the Training and Development category, Blue Rubicon funded training for everyone and the result is that 87% of staff report that the firm is good for personal growth and consider the experience gained is valuable for the future.

Under Wellbeing, Impact International runs ‘healthy mind and body’ sessions with staff being given tips on how to channel positive energy. In all, staff there report a good work-life balance. And under Innovation, Qedis, a management consultancy, formed ‘families’ of between 12 and 20 staff. All participated and no-one held any special status in the family. The families had three roles: communications, social events and work scheduling. Qedis scores 90% for employees going out of their way to help colleagues achieve in their work.

There is one thing in common across these four firms: they are all highly successful. Competitive advantage is achieved through people.

Other Good Firms Guides

There are many assessments of what makes a good firm and who’s in the top 100. The American guides make fascinating reading. As CNN’s guide reports on software firm SAS, ‘the benefits are epic’ and yet that’s not why folk stay despite a one week notice period either side in the terms and conditions. It’s because staff feel valued. Similarly Boston Consulting Group took on more staff in 2010 than in any other year. Staff there were pulled off projects to provide on-the-ground support to the Haitian earthquake.

Back in the UK, the 2011 larger company winner was P3, a social inclusion charity. In P3 it was not big pay and bonuses that tipped the balance since the average salary of a support worker is just over £17,000 and only six of the 262 staff earns more than £35,000. It was its supportive, inclusive culture which promotes control, choice and independence for staff.

In all these anecdotes there is a common theme. It is that excellence in product and service delivery comes from people. And that people will go the extra mile given the right conditions in the firm. In all cases Hertzberg’s theory is proven right: money is not the motivator. It’s stuff like staff responsibility and freedom to do work the way folk feel is best. Perhaps the SAS result sums it all up: there, staff feel valued.

Chapter Summary: what does make a good firm?

A good firm is one in which there is enough gross margin to fund activities such as staff development and to allow employees time to assist one another. Management need to be awake to the benefits to be had in such activities. And yet there is a ‘chicken and egg’ problem here. Is it the gross margin that releases the funds or the activities that motivate and engage staff such that increased competitive and cost advantage follow?

The truth is that the cycle has to start somewhere. The start point is that the principal has to believe that there’s benefit to be had and take the first step.

What Makes a Good Firm: theory and research

There are two truisms in describing firms' performance:

• First, that successful firms tend to have better people and processes than their less successful competitors;
• Second, that successful firms tend to be those that have a ‘big story’ that binds staff together.

Big stories give the firm a clear sense of mission underpinned by values and culture that expresses what the firm is and what its relationship is with its customers. This next section discusses how firms become ‘good’ and what contribution the discipline of human resource management makes to help them achieve ‘good’ and the competitive advantage that goes with this accolade.

The Essential Equation

An individual’s performance (and with that the firm’s performance as an aggregate of all employees) is given by the equation:

P = f(A, M, O)

P is performance, A is ability, M is motivation and O is opportunity. People perform well when they have the necessary competence or ability. Competence is skills modified by knowledge. It’s interesting to note that of the Sunday Times’ list, many invest heavily in staff development. The 68-man firm Brand Learning spends almost £5,000 a head on training each year. In the motivation category, all the firms on the list undertake many different motivating activities. Brand Learning management show appreciation for a good job done, care for people as individuals and offer plenty of support. And all the firms offer plenty of opportunity to excel.

The Link Between Management Practices and Performance

What then is the link between these good firms and their performance? Whilst not the only aspect, one central facet that all have in abundance is care in the management of their human resources. In a research programme at the University of Bath, Purcell linked performance to 18 discrete human resource management practices. Using employee satisfaction as a key driver he settled on 11 key practices that formed an integrated model to link ability/motivation/opportunity (A, M, O) and the performance outcome. The Bath model, is shown below.

In this model, the eleven practices (such as training and development) are shown feeding the ‘A, M, O’ processes. These in turn lead to commitment, motivation and job satisfaction. These lead to the employee excelling and giving discretionary behaviour that realise high performance.

Bringing Practices to Life

The Bath research went on to look at a number of firms and to endeavour to determine why firms differ in achieving performance. Of particular interest is their research into Tesco PLC. Tesco operates a central HR function with common HR practices throughout the UK. Despite this, some stores do much better than others. On the excellent side, a particular store makes profit and contributes well to the group. In contrast a different store makes significant losses. If the Bath model is valid, how can it be that for common HR practices in a firm like Tesco, some stores perform well and others not?

For the answer we need to look at an employee survey of all the stores and in particular the good and the bad. This survey shows that in the case of the store where performance is good, staff commitment is higher. Satisfaction with leadership is higher. The ability to influence the way the work is done is higher. And overall satisfaction with HR practices is higher. It’s clear from this that it’s not what is done and what practices are in place but the way that management bring these practices to life. It’s all down to the local managers and their ability to have the HR practices work to the firm’s benefit.

No ‘One-size Fits All’

The Bath research also considered how each HR practice worked within the 12 firms studied. Purcell and his team were particularly interested in how each practice influenced each different worker group. The hypothesis was that professionals value different things in their work compared to workers and each differs in their needs from managers. The following tables summarise the primary expectations.

This shows that different employee groups are influenced and value different management practices within a firm. Taken to the limit, this shows that there is no one bundle of HR practices that go to produce a good firm but rather it is for management to determine the HR bundle for their firm. There was a time when HR managers talked of ‘best practice HR’ but this research and more recent writings suggest that this is wrong. There is no ‘best practice’ HR but there is ‘best fit’ HR where management determines the practices that go to create the optimum set to drive competitive advantage.

Achieving Competitive Advantage: a high level model

This paper looked at the beginnings of the employment contract in the idea that some folk have the means of production and others don’t. Those who don’t are forced to work for those that do and so we have employers and employees. We identified that firms make profits and these can be ‘normal’ or ‘super normal’. Super normal profits occur when both people and processes are optimised. When this occurs the firm has competitive advantage over its competitors in the market. Competitive advantage occurs when the firm has lower costs for a given market price or where sales value can rise for the same costs through well differentiated products.

This paper went on to determine the importance of the employment contract and specifically the psychological contract.

It evolved the idea of the contract as something that if properly in place, causes employees to excel and ‘go the extra mile’ for their employers.

The link was then made between psychological contract and competitive advantage.

Finally, to reach this point in the argument, the paper looked at evidence about the psychological contract from the Sunday Times 100 Best Firms lists. It then linked this anecdote to the Bath model that describes the HR practices that need to be in place and active in a firm to assure management of a sound psychological contract and ultimately competitive advantage.

It remains now to give practical suggestion as to how to actually do HR in a firm such that theory becomes practice.

The diagram below summarises this. If an appropriate set of around eleven human resource management practices such as performance appraisal and communications are put in place and are effective then there can be linkage directly from there to the achievement of competitive advantage.

This all sounds like all that is needed is to set the eleven practices up and the firm immediately benefits. We need here to discuss the practicalities of achieving competitive advantage.

Adding Feedback: aims, competences and performance

No system will work correctly without a control loop. There needs to be two things before we can consider we have an improvement project to get started on.

Firstly the firm needs clear objectives. How will the firm know if it has actually succeeded in achieving super normal profits? How will it know if the measures it implements are working and contributing overall to the task? And if it is also addressing process improvement, how will it know the contribution from each improvement activity and each part that contributes to competitive advantage?

Objective setting is beyond the scope of this paper but readers interested in this topic should see our white paper on the subject. Suffice to say that all human resource management activity should have influence on the firm’s business position as described by its P&L and balance sheet. Objectives should therefore be set centred on the key parameters of these reports.

Changing the profits of a firm takes time and management need to know what’s happening in the interim. They need to know whether the HR practices are having an effect. There will be need to assess the mood and the culture of the firm and the degree to which discretionary behaviour is actually given freely by employees. Again such assessment is beyond the scope of this paper. There are established methods to take such soundings and to determine if the inputs to the change management system are having the necessary effects on interim outputs. Again we would refer readers to our white paper on Culture Matters and to our various blogs on culture and culture and mood assessment. We also give guidance on assessing performance in our white paper on objective setting.

Closing the Loop Through Feedback

Whilst objectives and interim assessment are essential, without some form of management control, they are just another report. The diagram for a feedback control loop is shown below. The HR practices are inputs to the human striving and ‘discretionary behaviour’ system A. Output is in the form of changed mood, culture, engagement and ultimately competitive advantage.

Management sample the output from time to time, consider the results in activity B, the Management Review Meeting, and determine changes to the inputs to correct, stabilise or re-task the main system. Management need to control the human resource management system that they have set up. This means a continuous series of activities to assess the changes that are occurring and a regular management review activity with re-tasking of managers and development of new and revised inputs.

With this structure in place, the overall improvement system is under control and whilst success is not assured, it is much more likely.

Achieving Competitive Advantage Through People

Of course, it’s one thing to understand from anecdote and research that competitive advantage stems from the HR practices that the firm puts in place. It’s good to know that once management have, to some greater or lesser extent, achieved competitive advantage, it was because of the way they managed their staff. But what really matters is how, from the outset, a management team can determine that it wants to achieve competitive advantage and then set about to succeed. So how does one plan to achieve?

In TimelessTime’s view there are three key things that lead to success. Cost advantage means making and delivering products and services for less than competitors such that either more margin can be enjoyed for the same sales or more sales can be taken because the price can drop for the same margin. Either way the firm makes more net profit. Differentiation advantage means that customers prefer the firm’s products (they are more innovative and meet their needs better) and so more are sold and hence more profits made.

Management therefore need to set objectives specifically to achieve cost and differentiation advantage; then use the principles outlined in this paper to drive the firm to achieve either or both.

And implementing a series of HR practices and then monitoring their effect is one thing. It’s possible that this will succeed alone. But research suggests that when what we might call a ‘big story’ knits the practices together and gives meaning to them, success is much more likely. The ‘big story’ is the series of values that underpins the firm and binds management and staff in a reason for being; in a common goal. Management promote the big story and its values to the staff. And when this resonates with employees’ own values (who were of course recruited for these values), the two together mean that objectives take on deeper meaning and ownership by all. ‘Big story’, objectives, ‘best fit’ HR and effective management work together to achieve competitive advantage.

• Porter, Michael E., "Competitive Advantage". 1985, Ch. 1, pp 11-15. The Free Press. New York
• Sustaining the HR and performance link in difficult times, John Purcell, University of Bath at http://www.bath.ac.uk/werc/pdf/toughCIPD_8_02.pdf accessed on 18th July 2011