Creating Competitive Advantage

PANKAJ GHEMAWAT & JAN W. RIVKIN

De Luca Massimiliano Giuliani Giuliano Oliva Roberto Mestrovic Luka

Content
Introduction to Profitability Analysis Willingness to Pay & Supplier Opportunity Cost Concepts:
Added Value Unrestricted Bargaining Scarcity

Strategies to establish the Competitive Advantage

Activity Analysis
Conclusion

Introduction to Profitability Analysis

Some companies generate far greater profits than others:
1984-2002

+ PROFIT $10 Billion

- LOSS of $500 million

Why?
Pharmaceutical Industry
Patent protection Product differentiation

Steel Industry
Excess capacity Limited differences across products Slow growth Steel customers search for the best-price producer

Expanding demand
Users hesitate to switch among products

Porter Five Forces Analysis

Bargaining Power of Suppliers

Threat of Substitute Products

Competitive Rivalry

Threat of New Entrants

Bargaining Power of Customers

Differences Across Industries

Differences Within Industry

Pharmaceutical Industry

Differences Within Industry

Steel Industry

Competitive Advantage
When a firm, compared to rivals, has driven a wider wedge between the willingness to pay it generates among buyers and the costs it incur

The essence of creating advantage is finding an integrated set of choices that distinguish a firm from its rivals

Creating vs. Sustaining Competitive Advantage

The choices that establish a firms advantage also influence whether the advantage can be sustained Industry analysis is an important tool for several reasons:
1. It helps to understand the attractive characteristics to enhance and the unattractive ones to hide 2. Industry conditions have a large influence on whether competitive advantages are possible 3. When taking a decision, managers have to consider the effect it will have over the entire industry structure

Example 1: Sustaining Advantage

When launching personal financial software Quicken, Intuit decided to offer customers outstanding postsale assistance over the telephone. Customers valued the help from trained operators and customer service became a tool for creating competitive advantage.
Customer service helped Intuit sustain its advantage over its rivals such as Microsoft

Example 2:Industry Conditions

In computer leasing, there is little room to establish a superior wedge between willingness to pay and costs. Still, in some other industries (prepackaged software), most effective firms may enjoy large advantage over the least

Example 3: Consider Effect Over the Industry

When decididing whether to build a new aluminim smelter, Alcoa must consider the impact of the new capacity on industry supply-demand conditions, not just its effect on Alcoas competitive advantage

New Business Ideas

Harnischfeger Industries in the pioneers in the production of portal cranes
During the late 1970s, they began to offer their customers this revolutionary product, designed to lift entire tree-length logs International Paper, a forest product company, was one of their main clients.

The Leap of Innovation

A single crane replaced a fleet of forklifts which cost roughly $1.0 million Each crane had a production and installation cost of $2.5 million, but generated a net present value (the difference between the present value of cash inflows and the present value of cash outflows) of $6.5 million! Overall, also other expenses such as fuel and maintenance were particularly low

However, by the late 1980s a new producer of cranes entered the market and Harnischfeger started making little profit on its sales...

Willingness To Pay & Supplier Opportunity Cost

Willingness To Pay
theory The maximum amount of money a person is willing to pay in order to receive a given good or service. practice Back to our example, an Harnischfegers customer would be willing to pay as much as $7.5 million ($6.5 M of NPV + $1.0 M)

Supplier Opportunity Cost

theory The lowest amount of money that a supplier will accept to provide a given good or service. practice We can suppose, instead, that Harnischfeger would not have accepted an amount below $2.0 million

Total Value Created

theory Total Value Created= Willingness to Pay Supplier Opportunity Cost practice

Total Value Created=$7.5M - $2.0M = $5.5M

The Concept of Added Value

The Added Value of a firm is the maximal value created by all participants in a transaction minus the maximal value that could be created without the firm. To better understand the concept, lets imagine a situation where Harnischfeger is the sole provider of cranes and International Paper is the only customer If the former decides not to take part in the transaction, the whole $5.5 million of value goes un-created. Similarly, if International Paper refuses to participate, $5.5 million of value is no longer generated Both the supplier and the customer have an Added Value of $5.5 million

The Concept of Added Value

But by the end of the 1980s, a new competitor enters the market of cranes: Kranco, a firm headed by former Harnischfeger executives Supposing Kranco produces an identical product at the same conditions of Harnischfeger: the Added Value of the latter is now $0, since Kranco can substitute it anytime in the transaction

Unrestricted Bargaining
Lets assume that a firm manages to strike a deal that allows it to gain more than its Added Value: the value left for the other participants is less than the value they would generate by arranging a deal among themselves

The remaining participants, therefore, might form a separate pact that improves their collective lot
Any deal that exceeds its Added Value is fragile because of the reason explained above. The graph below explains what happens when Kranco enters the market, making Harnischfeger capture little or no Added Value

How to increase a firms Added Value?

Suppose now Harnischfeger adds some new services to its original product: as we can see from the graph, then International Papers WTP goes up to $9.0 million At the same time, however, adding new services leads to an increase in labor cost by Harnischfeger and its SOC goes up to $3.0 million

The TVC by Harnischfeger participating in the deal is now $6.0 million (new WTP - new SOC), whereas the TVC if it opts out and Kranco provides the product is $5.5 million (Kranco WTP - Kranco SOC)

How to increase a firms Added Value?

At the end of the day, the introduction of the new services boost Harnischfeger AV to $0.5 million, simply because it increases its WTP by more than it does with its SOC

Thus, in order to increase its Added Value, Harnischfeger widens the gap between the WTP and the SOC

From Added Value to Competitive Advantage

The larger is a firms Added Value, the greater is its potential for profit A firm can increase its Added Value by widening the wedge it achieves between WTP and SOC beyond what rivals attain The firm that has a wider wedge, has a Competitive Advantage in its industry But where does Competitive Advantage come from?

Competitive Advantage in Scarcity

Basically, Competitive Advantage derives from Scarcity, the economic condition of having limited resources A firm establishes Added Value by making sure that it is unique in some valuable way

There are two basic ways a firm can establish an advantage:

The firm can raise customers WTP for its products without incurring an increase is SOC The firm can devise a way to reduce SOC without sacrificing commensurate WTP

WTP

SOC

Two Strategies to Achieve Competitive Advantage

As we stated before, there are two ways a firm can achieve Competitive advantage We call the act of raising WTP Differentiation Strategy The act of reducing costs is called, instead Low Cost Strategy

Competitive Advantage Strategy in Reality

Cirque Du Soleil, one the most ancient and known circus in the world, became a successful and profitable firm by cutting costs in the performances they retained more expensive
Animals, three-ring shows and star performers have been abolished in favor of more clowns acts and acrobatic actions By doing this, Cirque Du Soleil managed to minimize costs as well as increase the WTP of its customers, always enthusiast to attend its famous shows

Activity Analysis
How to identify opportunities to increase the margin between willingness to pay and costs? Sheer Entrepreneurial Insight or Dumb Luck!?

Activity Analysis
Analysis of the activities can help insight:
Design Production Selling Delivering Services

These are costs of the firm and the fuel to boost willingness to pay!

4 Steps for Activity Analysis

1. Catalog firms activities 2. Costs associated with activities and comparison with competitors

3. How each activity generates willingness to pay

4. Eventual changes in firms activities

Step 1: Catalog Activities (The Value Chain)

Step 1: Catalag Activities (Example)

After Value Chain Analysis, willingness to pay must be shown with respect to competitors activities practice
Betsy Baking Market Share 1% to 20%

1984-2002

Collins Kitchen Market Share 45% to 25%

Step 2: Cost Analysis

Use Activities to Analyze Relative Costs In pure commodities business cost effectiveness is the base for competitive advantage

It is important to analyze:
Cost. Cost drivers: why activity costs rise or fall Competitors costs analyzed by comparison

Step 2: Cost Analysis (Example)

Profit - cent per dolar

Cost Drivers:
Delivery costs depends on numbers of stops Outbound logistics increases costs because of higher product variety Product nature increases costs (more preservatives requires less deliveries)

Step 2: Competitors Analysis (Example)

Focus on differences on single activities not only total costs Include all the costs which are determinant in the creation of costs

Smaller cost components may be important cost drivers Analyze cost drivers which differe from one another eg. Location. Sentisivity analysis: bear in mind you are estimating

Step 2: Cost Drivers

There are many potential cost drivers:
Size dependent (eg. economies of scale & scope) Location Policies Timing Institutional factors Resources

Step 3: Relation Between Activities and WTP

Activities generate costs which should generate willingness to pay Every activity is a potential source!

Extremly difficult to calculate WTP:

Personal preferences & perceptions Activities affect willingness to pay in ways not easy to be spotted Business sales may be done through intermediary

Step 3: Typical Procedure

Still WTP can be estimated:
Understand who is the real buyer
Children may want the snack cake but parents buy them

What the buyer wants

Cakes are chosen on the base of price, design, product features or if it is about supermarket they chose trade margins, reliability etc.

Step 3: Willingness to Pay

In some cases needs and Willingness to Pay are easily assessed
precise amount of money saved

In others it is difficult to quantify them and there is the need to use different market research tecniques

Step 3: Typical Procedure

Success of the firm relatively to its competitors Relate differences in success to the differences in meeting customers needs

Step 3: Each Customer is Different

There are differences in customers needs:
Horizontal differentiation
novels vs history books

Vertical differences
one product is better, but how are they willing to pay for better product

Responses:
Segmentation Mass customization

Step 4: Explore Options and Make Choices

Search for ways to increase the spreade between WTP and SOC It is important now to create a set of actions/decisions which would fulfill the goals set in the first 3 steps
The process of reasoning very creative and free Hard to identify guidelines for reasoning

Step 4: Explore Options and Make Choices

Patterns can be applied Drivers of the competition
Betsy Baking understood that by adding the preservatives decreased transportations costs Consequentially, the WTP went down but less than the drop in the transportation costs Tradeoff Concept: Take advantage of different elasticities in the two activites
Decrease in Transportation and Decrease in Pricing

Step 4: Explore Options and Make Choices

Competitors Reactions
Collins managers felt that Betsy Baking would readily launch a price war against any competitor that tried to match its low-cost, low-price strategy Due to the cost efficiency of Betsy Baking trying to enter the low price level could be costly Tradeoff Concept
Increase in Demand for Decrease in Marginal Profits

Step 4: Explore Options and Make Choices

Benefits to Buyers
Managers tend to fixate on physical product characteristics One way to avoid a narrow focus is to draw out not only ones own value chain, but also the value chains of ones customers and suppliers and the linkages between the chains By shipping clothes on the proper hangers and in certain containers, the manufacturers can greatly reduce the labor and time required to get clothes from the department store loading dock to the sales floor Improvement Concept: Whats good for anyone in the chain of production or sales is good for the company

Step 4: Explore Options and Make Choices

Special Attention to bleeding edge Customers
Exacting customers whose demands presage the needs of the larger marketplace
Yahoo!, the Internet portal, releases test versions of new services to sophisticated users to check the software and work on the possible utility to the masses Circus Circus, the casino operator, built much of its remarkable success in the early 1990s on the insight that Las Vegas offered little to the family-oriented segment of the market Ryanair, Easyjet etc. Diversify the Offer Concept: Unexploited potential demands on the market

Step 4: Explore Options and Make Choices

Adjustment of Scope of Operations
Changing the range of customers it serves or products it offers within an industry Advantageous when:
Economies of Scale, Scope and Learning Customer needs uniform Price Discrimination

Disadvantageous when:
Discontinuities instead of economies of scales Will to serve heterogeneous goods could bring up difficulties in production chain or blur the message of the firm towards its customers

Step 4: Explore Options and Make Choices

In general, a firm should scour its value chain for, and eliminate, activities that generate costs without creating commensurate willingness to pay. It should also search for inexpensive ways to generate additional willingness to pay, at least among a segment of customers.

The Whole Versus the Parts

competitive advantage comes from an integrated set of choices about activities.

Whole

Processes

Whole

Steps 1, 2 & 3

Step 4 & Integrated Set of Choices

Landscape Metaphor
Helpful to describe the dilemma facing managers who are searching for a favorable set of choices In conceptual terms, the managers of a firm operate in a high-dimensional space of decisions

Quantities:
Each point in this space represents a different set of choices, a different configuration of activities The elevation corresponding to each point is the added value generated by that configuration

The goal of the senior management team is to guide its firm to a high point on this landscapea set of decisions that, together, generate a great deal of added value

Landscape Metaphor (Example)

Landscape Metaphor (Example)

Based on the landscape some conclusions can be drawn:
Incremental analysis and incremental change are unlikely to lead a firm to a new, fundamentally higher position Firm must usually consider changing many of its activities in unison in order to attain a higher peak In a Long Run the company might need to go down to the valley in order to achieve its goals The ruggedness implies that there is often more than one internally consistent way to do business within an industry
Merrill Lynch Vs. Edward Jones

Conclusions
A successful firm does not simply participate in an attractive industry. It also strives to generate more economic profits than the typical firm in its industry The ability to make profit comes from the concept of Added Value. A firm has added value when the network of customers, suppliers, and complementors in which it operates is better off with the firm than without it; the firm offers something that is unique and valuable in the marketplace.

Conclusions
To have added value, a firm must drive a wedge between customer willingness to pay and supplier opportunity costindeed a wider wedge than rivals achieve. A firm that attains a wider wedge is said to have a competitive advantage A firm can use its analysis of activities to generate and assess options for creating competitive advantage. In doing so, the management team must decompose the firm into parts, but also craft a vision of an integrated whole

Thank You