Creating Competitive Advantage

1. Creating Competitive Advantage Ghemawat, Chapter Three Notes Darral G. Clarke for BM 499

2. ROE-Ke Spread 40% Great Northern Iron 30% 20% Worthington Inds Nucor Steel Technologies 10% Oregon Mills Commercial Metals 0% Carpenter British Steel PLC Cleveland-Cliffs Birmingham Quanex Lukens (10%) USX-US Steel ACME Metals Ampco Inland Steel (20%) Armco WHX Bethlehem Average Invested Equity ($B) (30%) $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14 $15 Average Economic Profits in the Steel Industry, 1978 -1996 Source: Compustat, Value Line, Marakon Associates Analysis Darral G. Clarke for BM 499

3. ROE-Ke Spread 60% SmithKline 40% Schering Plough American Amgen Watson Rhone-Poulenc Home Mylan Labs Glaxo Products Bristol Merck Warner Lambert Perrigo Myers 20% Pharmacia & Upjohn Eli Lilly Pfizer Forest Labs Alza 0% ICN Scherer Ivax (20%) Genetech Biogen Roberts Genzyme (40%) Dura Chiron Cephalon Gensia Cygnus (60%) Immunex Average Invested Equity ($B) (80%) $0 $5 $10 $15 $20 $25 $30 Average Economic Profits in the Drug Industry, 1978 -1996 Source: Compustat, Value Line, Marakon Associates Analysis Darral G. Clarke for BM 499

4. Residual Industry Corporate Positioning Calibrating Profit Drivers Source: Richard P. Rumelt, “How Much Does Industry Matter?,” Strategic Management Journal, 1991; 12:167-185 Darral G. Clarke for BM 499

5. Added Value Added value = total industry value created with the firm in the game - total value created without the firm in the game OR EQUIVALENTLY the value that would be lost to the industry if the firm disappeared • Under unrestricted bargaining, a firm cannot capture more than its added value • If you (in your relationships with customers and suppliers) create no value, you can capture no value • More generally, if a firm (in its relationships) creates no new value, it had better have some clever way of claiming value Darral G. Clarke for BM 499

6. Customer Firm Supplier Willingness to pay Total value created Supplier opportunity cost Value Creation • Value is created by a business operating together with its customers and its suppliers • A firm does not create value in isolation • Willingness to pay = the most that a customer will pay for a firm’s product • Supplier opportunity cost = willingness to receive = the least that a supplier will accept for the resources required to make a product • The value created by a transaction is the difference between the customer’s willingness to pay and the opportunity cost of the resources Darral G. Clarke for BM 499

7. Value Division Customer Firm Supplier Willingness to pay Value captured by customer Price Value captured by firm Cost Value captured by supplier Supplier opportunity cost Darral G. Clarke for BM 499

8. Activity Analysis of Competitive Advantage • Added value => goal is to drive a wedge between willingness to pay and (supplier opportunity) cost • Indeed, a wider wedge than competitors achieve • Problem: a firm must often incur higher costs to deliver a better product or service • Partial solution: use activity analysis to spot opportunities to widen the wedge Darral G. Clarke for BM 499

9. Technology Manufacturing Distribution Marketing Service Design Development Procurement Assembly Transport Inventory Retailing Advertising Parts Labor McKinsey’s Business System Source: Carter F. Bales, P.C. Chatterjee, Donald J. Gogel, and Anapam P. Puri, “Competitive Cost Analysis,” McKinsey & Co. Staff Paper (January 1980) Darral G. Clarke for BM 499

10. Firm Infrastructure • Financing, legal support, accounting Human Resources • Recruiting, training, incentive system, employee feedback Technology Development • Inventory system • Site software • Pick & pack procedures • Site look & feel • Return procedures Support Activities • Customer research Procurement • CDs • Shipping • Computers • Telecom lines • Media • Shipping services • Inbound shipment of top titles • Server operations • Billing • Collections • Picking and shipment of top titles from warehouse • Shipment of other titles from third- party distributors • Pricing • Promotions • Advertising • Product information and reviews • Affiliations with other websites • Returned items • Customer feedback • Warehousing • Primary • activities Inbound Logistics Operations Outbound Logistics Marketing & Sales After-Sales Service Primary Activities Value Chain for an Internet Start-Up Darral G. Clarke for BM 499

11. Uniqueness Perceived by the Customer Low Cost Position OVERALL COST LEADERSHIP Industry wide DIFFERENTIATION STRATEGIC TARGET Particular Segment only FOCUS Source: Michael Porter, Competitive Strategy, 1980 Porter’s Generic Strategies STRATEGIC ADVANTAGE Stuck in The middle Darral G. Clarke for BM 499

12. Small group exercise: Name the generic strategies in our cases • Coca Cola • PepsiCo • Continental Can • Crown Cork and Seal Darral G. Clarke for BM 499

13. Interplay between Cost and Differentiation price $ cost 1. 3. 2. Industry average competitor Darral G. Clarke for BM 499

14. Low cost leadership Differentiation Cc Dc Cc Ci Ci Di Di Cc Focus: Low cost or differentiation in a market segment. Porter’s Generic Strategies Darral G. Clarke for BM 499

15. Cost Leadership Strategy • Deliver a GOOD product or service at the lowest possible cost • Open a significant and sustainable cost gap over all competitors • Create advantage through superior management of key cost drivers • Translates into above-average profits with industry-average prices BUT • Cost leaders must maintain product parity or proximity in satisfying buyer needs • Cost leadership often requires making trade-offs with differentiation Darral G. Clarke for BM 499

16. Scale Learning Pattern of capacity utilization Linkages Interrelationships Integration Timing Policies Location Institutional factors Cost Drivers Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985) Darral G. Clarke for BM 499

17. Common Pitfalls in Cost Leadership • Misunderstanding of actual costs • False perception of cost drivers • Focus on manufacturing • Failure to exploit linkages • Inadequate proximity to differentiators • Ignoring competitor behavior • Poor implementation • Acting incrementally • No cost management program Darral G. Clarke for BM 499

18. The Differentiation Strategy • Select one or more needs that are valued by buyer • Achieve and sustain superior performance by meeting these needs uniquely • Selectively add costs if necessary to do so • Successful differentiation leads to premium prices • Differentiators must pick cost-effective forms of differentiation • Differentiation leads to above-average profitability provided the firm maintains cost parity or proximity to competitors Darral G. Clarke for BM 499

19. Common Pitfalls in Differentiation • Creating differentiation that buyers do not value • Over-fulfilling buyer needs • Looking too narrowly at the sources of differentiation • Charging an excessive price premium • Failing to understand costs of differentiation • Ignoring signals of value • Failing to recognize buyer segments • Creating differentiation that competitors can emulate quickly or cheaply Darral G. Clarke for BM 499

20. Focus Strategy • Exploits the same fundamental types of competitive advantage • Selects narrow target segment(s) with unusual needs • Creates optimal strategy for the target Narrowing of scope creates cost or differentiation advantage Darral G. Clarke for BM 499

21. Overall Cost Leadership + Differentiation Focus Can business do more than one? OR • Sometimes consistent • But requires defense against a competitor achieving one or the other • Can have multiply-focused entities in one company Darral G. Clarke for BM 499

22. Stuck in the middle • A company can be stuck in the middle if • A differentiator attempts to cut costs that are essential to its differentiation • A low cost leader incurs costs, above those which are essential to its low cost position, which do not differentiate the product • A focus company attempts to broaden its strategic target beyond the segments in which it has an advantage • In other words, by incurring costs, or by cutting costs, or by pursuing markets that reduce the “wedge” Darral G. Clarke for BM 499

23. An Expanded Version of Generic Strategies • Extend BCG framework to include a broader set of cost structures • Extend Porter’s five forces to recognize a more diverse set of competitive environments • Apply the economic theory of long run average cost Darral G. Clarke for BM 499

24. Experience Cost/unit Experience Scale New technology LRAC Volume LRAC Review Experience advantages decline with volume, Scale advantages exhausted at optimal scale, If no change in technology, no advantage to volume Darral G. Clarke for BM 499

25. Cost advantage from volume Low High High Profitable & Defensible Fragmented Ability to differentiate product Stalemate Volume Low Strategy and long-run average cost Darral G. Clarke for BM 499

26. Competitive Strategy and Long Run Cost/Differentiation I • Volume Industry • Low cost leadership type markets • There is an advantage in scale or technology • Stalemate Industry • Can’t differentiate • Economies of scale, experience common to competitors • No process innovation Darral G. Clarke for BM 499

27. Competitive Strategy and Long Run Cost/Differentiation II • Fragmented Industry • Differentiation is key competitive factor • Niche strategy • Volume in niches inadequate to achieve volume cost advantages • Profitable and defensible industry • Differentiated product • Customer preference • Low cost producer of differentiated product • Transitory industry • Cost advantage based on labor • Cost advantage based on any other temporary advantage Darral G. Clarke for BM 499

28. Cola wars and beverage industry Coors and brewing industry Crown Cork and Seal DeBeers and the diamond industry Egghead and the retail industry Barnes and Noble, Amazon and the retail book industry Small group exercise: Provide an example of a cost leadership strategy in one of our cases (identify the company and provide some detail) Darral G. Clarke for BM 499

29. Cola wars and beverage industry Coors and brewing industry Crown Cork and Seal DeBeers and the diamond industry Egghead and the retail industry Barnes and Noble, Amazon and the retail book industry Small group exercise: Provide an example of a differentiation strategy in one of our cases (identify the company and provide some detail) Darral G. Clarke for BM 499

30. Cola wars and beverage industry Coors and brewing industry Crown Cork and Seal DeBeers and the diamond industry Egghead and the retail industry Barnes and Noble, Amazon and the retail book industry Small group exercise: Provide an example of a focus strategy (either cost or differentiation) strategy in one of our cases (identify the company and provide some detail) Darral G. Clarke for BM 499