Econ 326: Industrial Economics 2 Business Strategy: Session 5 Airborne Express

Econ 326: Industrial Economics 2
Business Strategy
Session 5
Airborne Express
Session 5 (Airborne Express)
Econ 326: Business Strategy, Spring 2013
1/1
Crown Cork & Seal Wrap-Up
CC&S Wrap-Up
We did an industry analysis for the metal container industry and
found it was pretty unattractive:
I
PIE: ModerateF
Buyer Power: High

F
F
F
Superfically looks problematic

Few producers, high part of canmakers costs.
Competition: High
F
F
For the typical firm: few, large purchasers.

Cans an important part of their costs.
Backward integration into can production.
Supplier Power: Moderate? High?

F
Moderate demand growth; some worries about cost growth
Homogenous product, similar technology

High FC, Low MC ) incentives to cut prices, oer volume discounts
Entry Barriers: Low

F
Firm Fit Quotient high
Overall: Ugly
2/1
CC&S Wrap-Up
Despite this unattractive industry, CC&S is earning high profits.
Why?
Crowns strategy is to be a lean, quick responding, high service
quality provider of metal cans in the U.S. & foreign markets
I
An example of how dierentiation can be possible even in

commodity-like markets
Confirms general principles:

I
I
Even in unattractive industries it is possible for individual firms to

attain good profitability
Just as in attractive industries, some firms will have unprofitable
strategies
3/1
CC&S Wrap-Up
An important issue that arose at the end of the case: Should Crown,
Cork, & Seal grow?
I
If so, how should it grow?
CC&S is a niche firm. Life can be challenging for niche firms:

I
I
Expanding outside the niche means taking on larger / more established

firms.
Failing to expand outside the niche raises the possibility of competitors
entering the niche. This has been happening in Asian markets: new
cheaper suppliers of cans.
Suggests growth should be focused on leveraging (deepening) a

strategic position
I
Looking toward global markets often a good choice. How to compete

in these markets?
Sometimes it is better to stay small (and profitable).

I
I
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e.g. Apple
(...if other competitors cant easily duplicate what youre doing...)
(...if not, perhaps better to sell while have value...)
4/1
Today: Airborne Express
Today:
We continue our industry analysis
With the express mail industry
I
And a strategic analysis of Airborne Express
A bit of economics:
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Barriers to Entry (Sunk costs, particularly endogenous sunk costs)

Dynamics of competition
5/1
Entry Barriers II: Fixed versus Sunk Costs
Economies of scale often arise in many product markets due to large

fixed costs.
I
As noted, these can create an important barrier to entry.
These forces are even more powerful when costs are sunk.
I
Sunk costs are costs that cannot be recovered after they have been
spent.
F
i.e. There is no resale market for the product/service that was

purchased.
Many economic costs can be sunk:

F
F
Advertising expenditures.
Customized plant and equipment.
6/1
Fixed versus Sunk Costs, cont.
Why do sunk costs matter?

Imagine you are a potential entrant into a market.
I
You may be uncertain if you can compete eectively with industry

incumbents
F
F
F
What are the cost disadvantages of scale?

How will customers perceive your product relative to incumbents?
How long will it take to ... Obtain contracts? Ramp up production?
Build the firm?
7/1
Fixed versus Sunk Costs Example
Lets do a quick example to show you the importance of fixed versus

sunk costs.
Suppose you have to invest $100 to enter the market.
I
I
I
If things break your way, you make $6/year forever.

If they dont, you make $4/year forever.
Further suppose interest rates are 5%,
F
The Present Discounted Value (PDV) of these profit streams are $120
and $80, respectively.
8/1
Fixed versus Sunk Costs Example

Now consider two scenarios.
Scenario 1: Entry costs are partially sunk.
I
I
I
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If things dont work out after a few periods, you can sell your plant
back for (a PDV of) $75.
Your expected variable profit if you enter is between $80 and $120.
Your expected costs are $100-$75 = $25.
You enter.
Scenario 2: Entry costs are totally sunk.

I
I
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Expected profits are still between $80 and $120.

Expected costs are $100.
You may enter, but you also may not.
F
It depends if you think the probability of things going your way are
greater than 50% or not.
The point: By increasing losses when things dont work out...reduce

probability of entry: Exit costs prevent entry.
I
Also provide a credible threat to keep output high: new firms can
expect to produce less than the efficient scale.
9/1
Airborne Express Industry Analysis
Industry Analysis I: Define the Industry
Lets start again with an industry analysis.

What industry does Airborne Express compete in?
I
Pretty clear here: The express shipping industry.
10 / 1
Industry Analysis II: Evaluate PIE

How attractive is the Express Shipping Industry from the point of
view of long-run profitability?
What is the industry??
What are the products oered in the industry?
What are substitutes? Are they good/bad substitutes?
How big is the PIE?
11 / 1
Industry Analysis II: Evaluate PIE

Some relevant facts:
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$16-17b in 1996 sales.

15-20% volume growth; 10-15% revenue growth (falling prices)
What are the products oered in the industry?

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Delivery of documents and packages: high value to weight ratio

Various speeds of service (at various prices)
What are substitutes? Are they good/bad substitutes?

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For documents: Email/fax (business documents, certificates etc)

For packages: Regular mail; Courier service (locally). Too slow, not
wide network.
Overall, how attractive is the PIE?

Seems high
12 / 1
Industry Analysis II: Buyer Power
Who are buyers? Buyer Power?
13 / 1
Industry Analysis II: Buyer Power
Buyers
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FedEx: 2 million customers.

Residential buyers: how much buyer power?
Business buyers: how much buyer power?
Overall, how great a threat is buyer power?

Express mail services are a small part of the total costs for a buyer
Many business buyers: each business a small part of Express mail
firms total business.
14 / 1
Industry Analysis III: Supplier Power
How strong is supplier power in the express mail industry?
15 / 1
Industry Analysis III: Supplier Power
How strong is supplier power in the express mail industry?

I
What are inputs?

F
F
F
F
Labor: potentially powerful if unionized

Planes: Few suppliers; small part of their revenue; large part of express
industry costs. But a used-market helps.
Hubs? Integrated
Trucks?
Overall, how great a threat is supplier power?

Seems weak
16 / 1
Industry Analysis IV: Competition
How strong is competition in the express mail business?
17 / 1
Industry Analysis IV: Competition
How strong is competition in the express mail business?

I
I
C3 = 0.85 (!)
High fixed costs (hubs, IT, advertising); low variable costs (spot on a
plane/truck)
F
Encourages price-cutting
How similar are providers in branding? Price? Service (e.g. tracking)?

F
How often do you think the letters U, P, and S came up in FedEx

headquarters? Dierentiation?
18 / 1
Further Analysis of Competition
Are you familiar with models of dynamic competition (a.k.a. tacit

collusion)?
I
I
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Imagine a small group of similar firms regularly competing over time.

In static models, a firm has an incentive to cut price if the increase in
demand more than osets the price cut.
What about in a dynamic setting?
F
F
If I cut my price today, my competitor will likely match it tomorrow.

Come tomorrow well be at the same position as today, but with lower
prices!
19 / 1
Further Analysis of Competition
How aggressively do the (main) incumbents go after each other on

price?
I
I
I
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When???
early 90s parcel wars till 97.
Demand soft, excess capacity (hubs, planes, labor, etc.)
Incentives to defect appear tied to capacity situation.
Overall, how strong are competitive pressures in the industry?
20 / 1
Industry Analysis V: Entry Barriers
How strong are entry barriers in the express mail business?
21 / 1
Industry Analysis V: Entry Barriers

How strong are entry barriers in the express mail business?
I
Hubs? Lets do a firm fit analysis

F
F
F
F
F
Brand/Reputation
F
F
F
$250m (p3), 100K items/hr, 4 hrs/day ) 400K items/day

Market has (5m/.85=)6m items/day p2
) roughly 15 hubs to serve the whole US
(If they need more than one hub for efficient production, the FFQ is
lower)
Are these costs sunk? (Advertising FedEx at $138 million, 110% of
sales? Sales force?
Advertising: FedEx at $138m
Sales force: 1,100 (FE); 2,700 (UPS)
IT/Capabilities: UPS spent $3b between 90 and 95. Surely sunk
costs.
Planes?
F
Planes cost $90m new, but resale market...
Overall, how strong are BTE in the industry?

I
High percentage of fixed costs, large percentage sunk costs

(customized+ advertising)
22 / 1
Further Analysis of Entry Barriers
Did FedEx face similar entry barriers in 1973?

I
I
I
I
How
How
How
How
many
much
much
much
hubs did you need in 1973?

advertising was there in 1973?
IT did you need in 1973?
competition was there in 1973?
Bottom line: started o as a shoestring operation...
23 / 1
Further Analysis of Entry Barriers

What has driven the escalation in fixed costs?
I
Competition to provide higher quality:

F
F
F
More service options (Next day a.m., early afternoon, etc.)

Tracking
Comprehensive geographic coverage
Branding
Is this kind of competition good or bad for incumbents?

I
Not terrible - it both

F
F
Grows the PIE

Increases the BTE facing potential entrants
This an example of Endogenous Sunk Costs of John Sutton (LSE).
24 / 1
Industry Analysis Wrap-Up
Overall, what do we have:

I
I
I
I
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PIE:
Buyer Power:
Supplier Power:
Competition:
Entry Barriers:
Overall?
25 / 1
Airborne Express
Airbornes Strategy:
What is Airbornes strategy in the express mail industry?

In brief, what are the key elements: Scope, CA?
26 / 1
Airborne Express
Airbornes Strategy: Scope
Scope: Airborne targets a subset of customers:

I
I
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Business-to-business customers
Regular deliveries
More price sensitive: see Exhibit 8
Can tolerate some glitches
27 / 1
Airborne Express
Airborne Strategy: Competitive Advantage(s)
What is/are Airbornes competitive advantage(s)?
28 / 1
Airborne Express

What is/are Airbornes competitive advantage(s)?
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Cost!
Goal is to replace fixed costs with variable costs (and reduce those
where possible)
F
Why? Critical to lower both if have low volume
What evidence is there is the case that Airborne has lower costs?
F
F
F
F
F
F
Lower overhead where possible (austere HQ, tracking only on Internet)

No advertising
More trucks (1/3 cheaper)
B to B between metro centers )
Higher utilization of planes (less variation in quantities)
Contract labor (lower cost, but lower quality)
Bottom line: by targeting customers, avoid need for

I
I
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Retail expenses (advertising + retail outlets)

Capacity planning
Sophisticated IT
29 / 1
Airborne Express
Can we quantify their cost advantage using info from the case?
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Pool Pickup and Delivery together, savings due to more parcels/stop

plus using contract labor
Labor:
FedEx Labor = 1.09 + 1.64 = 2.73 (Ex.3)
AE labor = 1.09*.8 + 1.64*.9 = .87 + 1.48 = 2.35 = 0.38 savings
(p.12)
Overall savings due to Contract Pickup on 60% of parcels:
3.42*.6*.1 = 0.21 savings (p.12)
Total savings of 0.59 => 3.42 - 0.59 = 2.83
30 / 1
Airborne Express
Transport savings due higher plane utilization and more truck

deliveries
How much does a plane versus truck delivery cost?
FedEx: .85F + .15T = 2.44 and T = .33F ! F = 2.71; T = 0.90.
(p.12)
Higher plane utilization: AE F = 2.71 * (.675/.8) = 2.29 (ratio of
utilisation rates on p11)
More trucks: 2.29*.7 + .90*.3 = 1.87 = .57 savings
Total savings of 0.57 ! total transport costs of 2.99 - .57 = 2.42
31 / 1
Airborne Express
Airborne Costs Table

Higher sales expense:
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FedEx = 1,100 people/2.8m parcels/day costs .21/parcel

Given AE has .9m parcels/day would expect 1,100*(.9/2.8) = 353
people
Have 500 instead implies .21 * (500/350) = .30/parcel
How quantify corporate overhead?

I
I
.97 for FedEx

Ex6 has 181m for AE General and Admin ! 181/(.9*365) = 0.55 (.9
million packages per day into 365)
Total: 2.83 + 2.42 + 0(Adverts) + 0.30 + 0.55 + 0.74(Other) = 6.84
AE Price is 21% less (exhibit 8) , 9.00 *.79 = 7.11

Margin = 0.27 compared to Fedex 0.75
32 / 1
Airborne Express
Airborne Strategy
Hows this for a strategy statement:

I
Airbornes strategy is to become a profitable niche player in the

express mail industry by oering low-cost customised service to
high-volume business-to-business customers.
What is the logic of Airbornes strategy in the express mail industry?

low costs and customisation ! profit
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Is it a sustainable strategy?
If learn more about loyal customers.
33 / 1
Airborne Express
Airborne Strategy: Sustainability

Can Airborne defend ground?
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How easily could FedEx and/or UPS enter Airbornes position in

product space?
F
F
F
F
F
It would seem they have everything in place they would need to do to

serve these customers.
What are their incremental costs?
In other words, couldnt they exploit their free incremental capacity?
Possibly use dedicated contract labor? Oer higher quality than AE?
Possibly not due to fears of brand erosion, second-class citizens in
workforce, etc.
If they can, why havent they already?
Too focused on expanding geographic reach, building hubs, investing in
IT, etc.
Can Airborne encroach upon FedEx and UPS?

I
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What would be required?

As a new entrant: IT, Hubs, etc. EXPENSIVE!
34 / 1
Airborne Express
Airborne Strategic Decisions
Should Airborne purchase RPS?

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Can Airborne get more value out of RPS than it pays?

Why maybe yes?
Why maybe no?
How might FedEx and/or UPS react if Airborne buys RPS?
35 / 1
Airborne Express Update

1997: FedEx buys RPS.
I
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Does this make sense for them?

What impact might this have on Airborne?
1998: Airborne continued to prosper with net income rising to $137

million in 1998.
1999: Profits weaken as volume and revenue growth stall.
1999: FedEx (finally) announces it will oer some RPS ground
products under the FedEx name.
I
The integration proved to be difficult:

F
F
F
Air operations are regulated as an airline; ground operations as a

trucking company.
Unions are more easily able to organize under trucking labor laws,
FedEx limits the degree of integration.
36 / 1
Airborne Express Update, cont.

1999 2000: Airbornes profitability collapses. Stated factors:
I
I
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Strength of FedEx and UPS combined ground and air operations,

Slow economy,
Internet delivery of documents (substitutes),
High fuel prices (hurt Airborne asymmetrically b/c of older planes)
UPS and FedEx cherry-pick Airbornes short-haul deliveries.
2001: Airborne announces it will oer a ground-based service using its

current facilities.
2002: Sales rebound nearly 4% to reach $3.34 Billion in large part
due to new ground services
2003: DHL buys Airborne.
I
Does this make sense? For Airborne? For DHL?
37 / 1

Econ 326: Industrial Economics 2 Business Strategy: Session 5 Airborne Express

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Econ 326: Industrial Economics 2 Business Strategy: Session 5 Airborne Express

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Econ 326: Industrial Economics 2

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Buyer Power: High

Superfically looks problematic

For the typical firm: few, large purchasers.

Supplier Power: Moderate? High?

Moderate demand growth; some worries about cost growth

Homogenous product, similar technology

Entry Barriers: Low

Firm Fit Quotient high

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

An example of how dierentiation can be possible even in

Confirms general principles:

Even in unattractive industries it is possible for individual firms to

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

If so, how should it grow?

CC&S is a niche firm. Life can be challenging for niche firms:

Expanding outside the niche means taking on larger / more established

Suggests growth should be focused on leveraging (deepening) a

Looking toward global markets often a good choice. How to compete

Sometimes it is better to stay small (and profitable).

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Today: Airborne Express

And a strategic analysis of Airborne Express

Barriers to Entry (Sunk costs, particularly endogenous sunk costs)

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Entry Barriers II: Fixed versus Sunk Costs

Economies of scale often arise in many product markets due to large

As noted, these can create an important barrier to entry.

i.e. There is no resale market for the product/service that was

Many economic costs can be sunk:

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Fixed versus Sunk Costs, cont.

Why do sunk costs matter?

You may be uncertain if you can compete eectively with industry

What are the cost disadvantages of scale?

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Fixed versus Sunk Costs Example

Lets do a quick example to show you the importance of fixed versus

If things break your way, you make $6/year forever.

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Crown Cork & Seal Wrap-Up

Fixed versus Sunk Costs Example

Scenario 2: Entry costs are totally sunk.

Expected profits are still between $80 and $120.

The point: By increasing losses when things dont work out...reduce

Session 5 (Airborne Express)

Econ 326: Business Strategy, Spring 2013

Airborne Express Industry Analysis