MKT 450 Strategic Management Mishari Alnahedh

LECTURE 6: COST AND DIFFERENTIATION

A useful framework for analyzing competitive advantage Mishari Alnahedh In strategy a source of performance differences is the “competitive advantage”. Competitive advantages reflect rents earned by a firms assets. The value of these assets is determined by the relative advantages they give a firm over its competitors. A useful framework for analyzing competitive advantage Activities: what does it do that is different from its competitors? Added value: How much extra value does the firm add? (to the market) Sustainability: How hard is it for the firm’s competitors to replicate the sources of added value?

Added Value Ghemawat and Rivkin, HBR (2006) Value = Benefits - Costs Competitive Advantage Mishari Alnahedh Added Value Ghemawat and Rivkin, HBR (2006) Value = Benefits - Costs Benefits: Willingness to pay (WTP) WTP = maximum consumer will pay for product Cost = minimum cost of provision (includes opportunity costs of inputs) © 2010 Chad Syverson Chicago Booth School of Business Competitive Strategy Notes

Competitive Advantage Mishari Alnahedh Added Value A customer is willing to pay $12 for a pizza. The price of the pizza is $10 and it costs $7 to make the pizza. Will the customer buy the pizza ? Consumer Surplus  $12 - $10 = $2 Producer Surplus  $10 - $7 = $3 Economic Value  $12 - $7 = $5 © 2010 Chad Syverson Chicago Booth School of Business Competitive Strategy Notes

© 2014 Joe Mahoney University of Illinois Urbana Champaign Economic Value as Competitive Advantage Mishari Alnahedh If the economic value created is Greater than its rival  competitive advantage Equal to its rivals  competitive parity Lower than its rivals  competitive disadvantage © 2014 Joe Mahoney University of Illinois Urbana Champaign

Two Paths to Competitive Advantage via Added Value Mishari Alnahedh Consider two firms Firm 1: Benefits or V1 = B1 – C1 Firm 2: Benefits or V2 = B2 – C2 Assume V2 > V1  (B2 – C2) > (B1 – C1) Added value of firm 2 with competitive advantage = (B2 – B1) – (C2 – C1) Two paths to added value Can add value by lowering costs (reducing C2) Can add value by enhancing WTP (raining B2) Often this increases costs – firms must raise TWP more than costs rise

Two Paths to Competitive Advantage Mishari Alnahedh © 2010 Chad Syverson Chicago Booth School of Business Competitive Strategy Notes

Two Paths to Competitive Advantage Mishari Alnahedh

Two Paths to Competitive Advantage Mishari Alnahedh Examples FlyDubai: Apple: LuLu Hypermarket: In-N-Out Burger:

Two Paths to Competitive Advantage Mishari Alnahedh Examples FlyDubai: Low Cost Apple: high WTP + high cost (Differentiator) LuLu Hypermarket: Low Cost In-N-Out Burger: Low Cost + High WTP (dual)

Sources of Competitive Advantage Mishari Alnahedh COST ADVANTAGE Similar product at lower cost COMPETITIVE ADVANTAGE Price premium from unique product DIFFERENTIATION ADVANTAGE

Where To Use Cost Advantage Mishari Alnahedh Where To Use Cost Advantage Mature Industries High Fixed Costs of Entry Homogeneous Customer Preferences Innovation Emphasis on Process Vs. Product Proprietary Process Technology MES high in Relation to Total Demand

When Can Cost Advantage Fail? Mishari Alnahedh When Can Cost Advantage Fail? Changing Production Technologies From High to Low Entry Barriers Changing Customer Preferences Ability to Differentiate Commodity Product Transition From Mature to Declining Industry Increasing Price Competition With High Exit Barriers Increasing Supplier Power Increasing Concentration of Supplier Power

Where To Use Differentiation Advantage Mishari Alnahedh Where To Use Differentiation Advantage Service Timeliness, Courtesy, Consistency, Convenience, Completeness, Accuracy Brand Image and Reputation First-mover advantages Bundling of Features Bundling of Services Linkages with other firms (alliances) Packaging

When Can Differentiation Advantage Fail? Mishari Alnahedh When Can Differentiation Advantage Fail? Provision costs exceed value to customers Not enough customers in segment Customers don’t value services or characteristics Brand image can’t be created or is easily duplicated

Mishari Alnahedh COST ANALYSIS

Drivers of Cost Advantage ECONOMIES OF SCALE Indivisibilities Specialization and division of labor ECONOMIES OF LEARNING Increased dexterity Improved organizational routines Increased dexterity Improved organizational routines PRODUCTION TECHNIQUES Process innovation Reengineering business processes PRODUCT DESIGN Standardized designs & components Design for manufacture INPUT COSTS Location advantages Ownership of low-cost inputs Non-union labor Bargaining power CAPABILITY UTLIZATION Ratio of fixed to variable costs Speed of capacity adjustment RESIDUAL EFFICIENCY Organizational slack Motivation and culture Managerial efficiency © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Units of output per period Cost Analysis Mishari Alnahedh Economies of Scale: The Long-Run Cost Curve for a Plant Sources of scale economies Technical input/output relationships Indivisibilities specialization Costs per unit of output Units of output per period Minimum Efficient Plant Size: The point where most scale economies are exhausted © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Economies of Scale and Diseconomies of Scale Cost Analysis Mishari Alnahedh Economies of Scale and Diseconomies of Scale

Scale Economies in Advertising: US Soft Drinks Cost Analysis Mishari Alnahedh Scale Economies in Advertising: US Soft Drinks Despite the massive advertising budgets of brand leaders Coke and Pepsi, their main brands incur lower advertising costs per unit of sales than their smaller rivals Schweppes SF Dr. Pepper Tab Diet 7-Up Diet Pepsi Advertising Expenditure ($ per case) 0.02 0.05 0.10 0.15 0.20 Diet Rite Fresca Seven Up Dr. Pepper Sprite Pepsi Coke 10 20 50 100 200 500 1,000 Annual sales volume (millions of cases) © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

The “Law of Experience” Cost Analysis: Experience Curve Mishari Alnahedh The “Law of Experience” The unit cost of value added for a standard product declines by a constant proportion (typically 20-30%) each time cumulative output doubles. 2000 2002 Cost per unit of output (in real $) 2004 2006 2008 2010 2012 Cumulative Output © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Japanese clocks & watches, 1962-72 Examples of Experience Curves Mishari Alnahedh Japanese clocks & watches, 1962-72 UK refrigerators, 1957-71 15K 20K 30K 1960 Yen 50 100 200 300 Price Index 75% 70% slope 100K 200K 500K 1,000K 5 10 50 Accumulated unit production Accumulated units (millions) (millions) © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

The Case of Automobile Manufacture Applying the Value Chain for Cost Analysis Mishari Alnahedh The Case of Automobile Manufacture Purchasing Design Engineering R&D Component manu-facture Assembly Testing Quality control Marketing Sales Distribution Dealer support Customer service Stages of the analysis: Identify the main value chain activities Allocate total costs between value chain activities Identify the cost drivers at each stage of the value chain Identify linkage between activities Identify opportunities for cost reduction © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Stage 3: Identify Cost Drivers Applying the Value Chain for Cost Analysis Mishari Alnahedh Stage 3: Identify Cost Drivers --Plant scale for each -- Level of quality targets -- No. of dealers component -- Frequency of defects -- Sales / dealer -- Process technology -- Level of dealer -- Plant location support -- Run length -- Frequency of defects -- Capaciity utilization under warrenty PARTS INVEN- TORIES R&D DESIGN ENGNRNG TESTING, QUALITY CONTROL GOODS INVEN- TORIES PURCH- ASING COMPONENT MFR SALES & MKITG ASSEMBLY DISTRI- BUTION DEALER & CUSTOMER SUPPORT Prices paid --Size of commitment -- Plant scale --Cyclicality & depend on: --Productivity of -- Flexibility of production predictability of sales -- Order size R&D/design -- No. of models per plant --Customers’ --Purchases per --No. & frequency of new -- Degree of automation willingness to wait supplier models -- Sales / model -- Bargaining power -- Wage levels -- Supplier location -- Capacity utilization

Stage 4: Identify Linkages Applying the Value Chain for Cost Analysis Mishari Alnahedh Stage 4: Identify Linkages PRCHSNG PARTS R&D COMPONENT ASSMBY TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR QUALITY INV MKTG CTMR Designing different models around common components and platforms reduces manufacturing costs Consolidation of orders to increase discounts, increases inventories Higher quality parts and materials reduces costs of defects at later stages Higher quality in manufacturing reduces warranty costs

Recent Approaches to Cost Reduction Mishari Alnahedh Dramatic changes in strategy and structure to adjust to the business conditions of the 1990’s Key elements: Plant closures Outsourcing Delayering and cuts in administrative staff The fundamental rethinking and radical redesign of business processes to achieve dynamic improvements in performance. e.g.:- Several jobs combined into one Steps of a process combined in natural order Minimizing steps, controls, and reconciliation Use case managers as single points of contact Hybrid centralization/ decentralization CORPORATE RESTRUCTURING BUSINESS PROCESS REENGINEERING

Example: Cost Advantage in Short-Haul Passenger Air Transport Recent Approaches to Cost Reduction Mishari Alnahedh Example: Cost Advantage in Short-Haul Passenger Air Transport Costs per Available Seat-Mile (1993) Southwest Airlines United Airlines (cents) (cents) Wages and benefits 2.4 3.5 Fuel and oil 1.1 1.1 Aircraft ownership 0.7 0.8 Aircraft maintenance 0.6 0.3 Commisions on ticket sales 0.5 1.0 Advertising 0.2 0.2 Food and beverage 0.0 0.5 Other 1.7 3.1 Total 7.2 10.5

DIFFERENTIATION ANALYSIS Mishari Alnahedh DIFFERENTIATION ANALYSIS

The Nature of Differentiation Mishari Alnahedh The Nature of Differentiation DEFINITION: “Providing something unique that is valuable to the buyer beyond simply offering a low price” (M. Porter)  THE KEY IS CREATING VALUE FOR THE CUSTOMER TANGIBLE DIFFERENTIATION Observable, product characteristics: Size, color, materials, etc. Performance Packaging Complementary services INTANGIBLE DIFFERENTIATION Unobservable and subjective characteristics that appeal to the customer’s image, status, identity and desire for exclusivity TOTAL CUSTOMER RESPONSIVENESS Differentiation not just about the product, it embraces the whole relationship between the supplier and the customer. © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Differentiation and Segmentation The Nature of Differentiation Mishari Alnahedh Differentiation and Segmentation Differentiation: Concerns choices of how a firm distinguishes its offerings from those of its competitors (i.e. How the firm competes) Segmentation: Concerns choices of which customers, needs, localities a firm targets (i.e. Where the firm competes) Does differentiation imply segmentation? Not necessarily, depends upon the differentiation strategy Broad Scope Differentiation – Appealing to what is common between different customers (McDonalds, Honda, Gillette) Focused Differentiation – Appealing to what distinguishes different customer groups (BMW, MTV, Harley-Davison, Armani) © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Multidimensional Scaling of Competing Products in the US Differentiation in Pain Relievers Mishari Alnahedh Multidimensional Scaling of Competing Products in the US High Tylenol Low High Bufferin EFFECTIVENESS Bayer Private label aspirin Anacin Excedrin Low GENTLENESS © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

The Nature of Differentiation Mishari Alnahedh Using the Value Chain to Identify Differentiation Potential on the Supply Side MIS that supports fast response capabilities Training to support customer service excellence FIRM INFRASTRUCTURE HUMAN RESOURCE MANAGEMENT TECHNOLOGY DEVELOPMENT INBOUND OPERATIONS OUTBOUND MARKETING SERVICE LOGISTICS LOGISTICS & SALES Unique product features. Fast new product development Customer technical support. Consumer credit. Availability of spares Quality of components & materials Defect free products. Wide variety Fast delivery. Efficient order processing Building brand reputation

Using Value Chains Linkages to Identify Differentiation Opportunities Mishari Alnahedh Linking the Value Chains of the Firm and its Customers: Can Manufacturer 1 2 3 4 5 Supplies of steel & aluminium strip Manufacturing Purchasing Design Engineering Distribution Inventory Holding Service & Technical Support Sales Purchasing Distribution Inventory Holding Processing Marketing Canning CAN MAKER CANNER Distinctive can design can assist canners’ marketing activities High manufacturing tolerances can avoid breakdowns in customer’s canning lines Frequent, reliable delivery can permit canner to adopt JIT can supply Efficient order processing system can reduce customers’ ordering costs Competent technical support can increase canner’s efficiency of plant utilization © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Bringing it all together: value chain analysis Today’s Main Takeaway Mishari Alnahedh To achieve competitive advantage, we need to match a firm’s resources and capabilities to the industry and competitive environment. Position the firm so that we use our resources and capabilities in such a way that we provide value to our customers and make it difficult for others to imitate us. Bringing it all together: value chain analysis