Chapter 9 Strategic Positioning for Competitive Advantage

Competitive Advantage and Value Creation: Conceptual Foundations Competitive Advantage Defined Figure 9.2 Intra-industry variability in profits is at least as large as inter-industry variability. Firms achieve competitive advantage by creating and delivering more economic value than their rivals and capture a portion of this value in the form of profits.

Maximum Willingness-to-Pay and Consumer Surplus A consumers willingness-to-pay for a good or service is somewhat intangible, as it depends on that consumers tastes. A firms willingness-to-pay for an input is easier to quantify because it is related to the impact of that input on the profitability of the firm, and profits are easier than tastes. One way to measure a firms willingness-to-pay is with value-added analysis.

Figure 9.3 The right-hand side shows that by using corn syrup, Cadbury Schweppes incurs a somewhat higher processing cost and a somewhat higher cost of other materials, which limits the amount that it would be willing to paz for corn syrup. Figure 9.3 shows that it would be willing to pay at most 2 euros per hundredweight. This is the value added of ADMs corn syrup and equals the price of corn syrup at which Cadbury Schweppes all *all-in* production cost using ADMs corn syrup is the same as its *all-in* production costs using sugar.

From Maximum-Willingness-to-Pay to Consumer Surplus The consumer surplus is the difference between B-P (Benefit- Price). A consumer will purchase a product only if the products consumer surplus is positive. Moreover, given a choice between two or more competing products, the consumer will purchase the one for which consumer surplus, B-P, is largest.

Figure 9.4 For a given consumer, any price-quality combination along the indifference curve yields the same consumer surplus. A firm that offers a consumer less surplus than its rivals (e.g., the firm, producing product D) will lose the fight for that consumers business. When firms price-quality positions line up along the same indifference curve that is, when firms are offering a consumer the same amount of consumer surplus we say, that the firms have achieved consumer surplus parity. If all firms in the markets have the same quality, then consumer surplus parity means that each firm charges the same price. When a firm moves from one position of consumer surplus parity or consumer surplus advantage to one in which its consumer surplus is less than that of its competitors, its sales will slip and its market share will fall.

Value Created The economic value created for a producer is the difference between the perceived benefit and cost, or B-C, where B and C are expressed per unit of the final product.

Value Created = Consumer Surplus + Producer Surplus = (B-P) + (P-C) =B-C (maximum willingness to buy cost)

The price P thus determines how much of the value-created sellers capture as profit and how much buyers capture as consumer surplus.

Value-Creation and Win-Win Business Opportunities If B-C was negative, there would be no price that consumers would be willing to pay for the product that would cover the cost of the resources that are sacrificed to make the product. When B>C, it will always be possible for an entrepreneur to strike win-win deals with input suppliers and consumers, that is, deals that leave all parties better off than they would be if they did not deal with each other.

Value-Creation and Competitive Advantage Just because a firm sells a product whose B-C is positive, there is still no guarantee that it will make a positive profit. Competition between firms may dissipate profitability. In such market, consumers capture all economic value that the product creates. Hence, the firms must generate a level of B-C that its competitors cannot replicate. Otherwise the most aggressive consumer surplus *bid* that either seller would be prepared to offer is the one at which its profit is equal to zero, which occurs when it offers a price P that equals its cost C. At such a bid, a firm would hand over all the value it creates to you in the form of consumer surplus. In one version of the above competitive scenario, all firms offer identical B. In this case, the *winning* firm must have lower C than its rivals. In markets with homogenous products, the firm offering the highest B-C captures the entire market.

Analyzing Value Creation Diagnosing the sources of value creation requires an understanding of why firms business exists and what its underlying economics are. This, in turn, involves understanding what drives consumer benefits (e.g., how the firms products serve consumer needs better than potential substitutes) and what drives costs (e.g., which costs are sensitive to production volume, or how costs change with cumulative experience). Projecting the firms prospects for creating value also involves critically evaluating how the fundamental economic foundations of the business are likely to evolve. Perhaps the most basic of all is the question of whether market demand or the conditions of technology are likely to threaten how the firm creates value.

Value Creation and the Value Chain Figure 9.7 The vertical chain is sometimes referred to as the value chain. The value chain depicts the firm as a collection of value-creating activities, such as production operations, marketing and sales and logistics. Each activity in the value chain can potentially add to the benefit B that consumers get from the firms product and each can add to the cost C that the firm incurs to produce and sell the product. However, it is difficult to isolate the impact that an activity has on the value that the firm creates. But when different stages produce finished or semi-finished goods that can be valued using market prices, we can estimate the incremental value that distinctive parts of the value chain create by using valueadded analysis.

Value Creation, Resources and Capabilities There are two ways in which a firm can create more economic value than the other firms in its industry. First, it can configure its value chain differently from competitors. Alternatively, a firm can create superior economic value by configuring its value chain in essentially the same way as its rivals, but within that value chain, performing activities more effectively than rivals do. To do this, the firm must possess resources and capabilities that its competitors lack; otherwise the competitors could immediately copy and strategy for creating superior value. Resources are firm-specific assets, such as patents and trademarks, brand-name reputation, installed base, organizational culture and workers with firm-specific expertise. Capabilities are activities that a firm does especially well compared with other firms. Capabilities might reside within particular business functions. Alternatively, they may be linked to particular technologies or product designs. Or they might reside in the firms ability to manage linkages between elements of the value chain or coordinate activities across it. Whatever their basis, capabilities have several key common characteristics:

1. They are typically valuable across multiple products or markets. 2. They are embedded in organizational routines well-honed patterns of performing activities inside an organization. This implies that capabilities can persist even though individuals leave the organization. 3. They are tacit; that is, they are difficult to reduce to simple algorithms or procedure guides.

Strategic Positioning: Cost Advantage and Benefit Advantage A firms generic strategy describes in broad terms how it positions itself to compute in the market it serves.

The Strategic Logic of Cost Leadership

A firm can follow a strategy of cost leadership creating more value than its competitors in three different ways. First, the cost leader can achieve benefit parity by making products with the same B but at a lower C than its rivals. Second, the cost leader can achieve benefit proximity, which involves offering a B that is not much less than competitors. This could occur if the low-cost firm automates processes that are better performed by hand, hires fewer skilled workers, purchases less expensive components, or maintains lower standards of quality control. Finally, a cost leader may offer a product that is qualitatively different from that of rivals. Firms can sometimes build a competitive advantage by redefining the product to yield substantial differences in benefits or costs relative to how the product is traditionally defined.

Figure 9.8 From the figure, notice that PE PF < CE CF, or rearranging terms, PF CF > PE CE. Given consumer surplus parity between the cost leader and its higher-cost competitors, the cost leader achieves a higher profit margin. In essence, the leaders cost advantage gives it the ability to charge a price that is lower than that of its higher-cost, higher-quality rivals while at the same time allowing it to bank some of its cost advantage in the form of a higher price-cost margin.

The Strategic Logic of Benefit Leadership First, the benefit leader can achieve benefit parity by making products with the same C but at a higher B than its rivals. Second, the benefit leader might achieve cost proximity, which entails a C that is not too much higher than competitors. Finally, a firm could offer substantially higher B and C.

Figure 9.10 Consumer surplus parity is achieved when the benefit leader operates at point F by charging a price PF. From the figure, notice that PF PE > CF CE, or rearranging terms, PF CF > PE CE. Given consumer surplus parity between the benefit leader and its lower-quality competitor, the benefit leader achieves a higher profit margin. In essence, the leader\s benefit advantage gives it the wiggle room to charge a rice premium relative to its lower-benefit, lower-cost rivals without sacrificing market share.

Extracting Profits from Cost and Benefit Advantage If consumers have identical preferences, value extraction takes an especially stark form. When a firm increases its consumer surplus bid slightly above competitors, it captures the entire market. This leads to two clear recipes for retaining profits for a firm that creates more value than its competitors. Both involve making consumer surplus bids that the firms rivals cannot match: 1. A cost leader that has benefit parity with its rivals can lower its price just below the unit cost of the firm with the next lowest unit cost. This makes it unprofitable for higher-cost competitors to respond with price cuts of their own and thus allows the firm to capture the entire market. 2. A benefit leader that has cost parity with its rivals can raise its price just below the sum of the following: (1) its unit cost, plus (2) the additional benefit B creates relative to the competitor

with the next highest B. To top this consumer surplus bid, a competitor would have to cut price below its unit cost, which would be unprofitable. At this price, then, the firm with the benefit advantage captures the entire market. What happens if one firm is a cost leader and the other is a benefit leader? If consumers have identical preferences, then the firm that offers the higher B C can capture the entire market, by setting price at the point where the other firm cannot make a better consumer surplus bid and still cover its costs. This would not happen in a market characterized by horizontal differentiation. The price elasticity of demand an individual firm faces becomes a key determinant of a sellers ability to extract profits from its competitive advantage. The optimal way for a firm to exploit its cost advantage is through a margin strategy: the firm maintains price parity with its competitors and profits from its cost advantage primarily through high price-cost margins rather than through higher market shares. By contrast, when the firms product has a high price elasticity of demand, modest price cuts can lead to significant increases in market share. In this case, the firm should exploit its cost advantage through a share strategy: the firm underprices its competitors to gain market share at their expense. There is also a mixed strategy of both: cutting price to gain share but also banking some of the cost advantage through higher margins. When a firm has a benefit advantage in a market in which consumers are price sensitive, even a modest price hike would offset the firms benefit advantage and nullify the increase in market share that the benefit advantage would otherwise lead to. In this case, the best way for the firm to exploit its benefit advantage is through a share strategy. A share strategy involves charging the same price as competitors and exploiting the firms benefit advantage by capturing a higher market share than competitors. By contrast, when consumers are not price sensitive, large price hikes will not completely erode the market share gains that the firms benefit advantage creates. The best way for the firm to exploit its benefit advantage is through a margin strategy: it charges a price premium relative to competitors.

In markets, with price-sensitive consumers, a share strategy of cutting price to exploit a cost advantage would be attractive if competitors prices remained unchanged. However, it would probably be unattractive if the firms competitors quickly matched the price cut because the net result will be lower margins with little or no net gain in the firms market share. In this case, a margin strategy might well be a more attractive option.

Comparing Cost and Benefit Advantages An advantage based on lower cost is likely to be more profitable than an advantage build on superior benefits when: The nature of the product limits opportunities for enhancing its perceived benefit B. However, opportunities exist behind physical attributes of the product through better after-sale service, superior location, or more rapid delivery than competitors offer. Consumers are relatively price sensitive and will not pay much of a premium for enhanced product quality, performance or image. The product is a search good that the buyer can assess prior to point of purchase. With search goods, the potential for differentiation lies largely in enhancing the products observable features.

An advantage based on superior benefits is likely to be relatively more profitable than an advantage based on cost efficiency when: The typical consumer will pay a significant price premium for attributes that enhance B. Economies of scale or learning are significant and firms are already exploiting them. In this case, opportunities for achieving a cost advantage over these larger firms are limited, and the best route toward value creation would be to offer a product well-tailored to the niche market. The product is an experience good whose quality can be assessed only after the consumer has purchased it and used it for a while. A firms ability to outperform its competitors arises from its ability to create and deliver a distinctive bundle of economic value.

Stuck in the Middle Stuck in the middle describe a firm that pursues elements of cost leadership and benefit leadership at the same time and in the process achieves neither. It is typically much less profitable than competitors that have a clearly pursued a generic strategy of cost or benefit leadership since their strategies lack clarity and coherence. Research suggests that firms can outperform their competitors even when pursuing both benefit and cost leadership at the same time. Several factors might help firms to avoid the supposed trade-off between benefit and cost positions: A firm that offers high-quality products increases its market share, which then reduces average cost because of economies of scale or the experience curve. As a result, a firm might achieve both a high-quality and a low-cost position in the industry. The rate at which accumulated experience reduces costs is often greater for higher-quality products than for lower quality-products Inefficiencies muddy the relationship between cost and benefit position. The argument that high quality is correlated with high cost ignores the possibility that firms may be producing inefficiently.

Diagnosing Cost and Benefit Drivers Cost Drivers Cost drivers explain why average costs vary across firms. We can classify cost drivers into three broad categories, each of which have several subcategories: Cost drivers related to firm size, scope and cumulative experience A paramount source of economies of scale and scope is indivisible inputs. Indivisible inputs cannot be scaled down below a certain minimum size and thus give rise to fixed costs. In the short run, fixed costs are often spread because of greater capacity utilization. In the long run, fixed costs are spread when it becomes economical for a firm to substitute a technology with high fixed costs but low variable costs for one with low fixed costs and high variable costs. Other important sources of economies of scale are: (1) the physical properties of processing units (i.e., the cube-square rule); (2) increases in the productivity of variable inputs as volume increases (e.g., because of greater specialization of labor); and (3) economies of inventory management. Cumulative experience can reduce average costs as firms move down the learning curve. Cost drivers independent of firm size, scope or cumulative experience

These factors make one firms unit costs different from a competitors even if their sizes and cumulative experience are the same. An important cost driver independent of scale is input prices. Differences in wage rates may be due to differences in the degree of unionization. Differences in wages, the price of energy, or the price of delivered materials can also be attributed to location differences among firms. Economies of density refers to cost savings that arise with greater geographic density of customers (transportation network). The cost savings are due to an increases in density rather than an increase in scope or scale. A firm may also have lower average costs than its rivals because it has been able to realize production process efficiencies that its rivals have not achieved. Or another firm has lower costs because it avoids expenses that its rivals are incurring, such as advertising and sales expenses. Finally, a firm may have lower costs because of the effects of government policies. Cost drivers related to organization of the transactions Vertically integrated firms often have agency costs relative to firms that organize, exchange through the market. Private information can be leaked or coordination is complicated and a market firm may have higher administrative and production expenses than an integrated firm. Agency costs often increase as the firm expands and gains more activities to coordinate internally or grows more diverse.

Benefit Drivers Physical Characteristics of the Product itself (quality, features, durability, ease of installation and operation) The Quantity and Characteristics of the Services or Complementary Goods the Firm or its Dealers offer for Sale (product warranties and maintenance contracts and the quality of repair or service capabilities) Characteristics Associated with the Sale or Delivery of the Good (speed and timeliness of delivery, availability and favorability of credit terms, location of the seller) Characteristics that shape consumers perceptions or expectations of the products performance or its cost to use (products reputation for performance, the sellers perceived staying power or financial stability, products installed base) The subjective image of the product (driven by the impact of advertising messages, packaging or labeling and by the prestige of the distributors or outlets that carry the products)

Methods foe Estimating and Characterizing Costs and Perceived Benefits Estimating Costs Some firms get good accounting data on their rivals. Firms can use activity cost analysis to make reasonably educated guesses about a firms cost position vis--vis the competition. Cost drivers include obvious factors such as local labor market conditions and taxes, as well as subtle factors such as worker productivity and costs of regulatory compliance. The next step is to weigh how each competitor stacks up on each cost driver. Who pays the highest wages? Whose workers are most productive?

Estimating Benefits First, the firm must measure the benefits provided to the consumer. Second, it must identify the relevant benefit drivers. Third, it must estimate the magnitude of the benefit. Fourth, it must identify the willingness of consumers to trade off one driver for another.

Strategic Positioning: Broad Coverage versus Focus Strategies Segmenting an Industry Figure 9.11 Industry Segmentation Matrix shows that any industry can be characterized by two dimensions: the varieties of products offered by firms that compete in the industry and the different types of customers that purchase those products. Each point of intersection between a particular buyer group and a particular product variety represents a potential segment. Differences among segments arise because of differences in customer economics (e.g., differences in willingness-to-pay or differences in willingness to trade-off quality for price), supply conditions (e.g., costs of producing different product varieties), and segment size.

Broad Coverage Strategies These seek to serve all customer groups in the market by offering a full line of related products. The economic logic behind a broad coverage strategy is the existence of economies of scope across product classes. These economies of scope might come from common production facilities or components, shared distribution channels, or marketing.

Focus Strategies These either offer a narriw set of product varieties or serves a narrow set of customers, or does both.

Figure 9.13 illustrates three common focus strategies: Customer specialization offers an array of related products to limited class of customers Product specialization. Here the firm produces a limited set of product varieties for a potentially wide set of customer groups. The specializers goal is to do an especially good job satisfying a subset of the needs of the customer groups to whom it sells. It rests on the ability of the focuser to exploit economies of scale and learning economies within the service or the product in which the focuser specializes. Geographic specialization offers a variety of related products within a narrowly defined geographic market.

In addition to exploiting economies of scale or better serving underserved or overserved customers, focus strategies have another significant advantage: they can insulate the focusing firm from competition. In some segments, customer demand may be large enough to allow just one or two firms to operate profitably.