1. MKT 450 Strategic Management Mishari Alnahedh

2. LECTURE 6: COST AND DIFFERENTIATION

3. 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?

4. 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

5. 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

6. © 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

7. 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

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

9. Two Paths to Competitive Advantage
Mishari Alnahedh

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

11. 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)

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

13. 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

14. 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

15. 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

16. 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

17. Mishari Alnahedh
COST ANALYSIS

18. 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

19. 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

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

21. 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)
Diet Rite
Fresca
Seven Up
Dr. Pepper
Sprite
Pepsi
Coke
,000
Annual sales volume (millions of cases)
© 2013 Robert M. Grant

22. 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

23. Japanese clocks & watches, 1962-72
Examples of Experience Curves
Mishari Alnahedh
Japanese clocks & watches,
UK refrigerators,
15K K 30K
1960 Yen
Price Index
75%
70% slope
100K 200K K ,000K
Accumulated unit production Accumulated units
(millions) (millions)
© 2013 Robert M. Grant

24. 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

25. 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

26. 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

27. 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

28. 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
Fuel and oil
Aircraft ownership
Aircraft maintenance
Commisions on ticket sales
Advertising
Food and beverage
Other
Total

29. DIFFERENTIATION ANALYSIS
Mishari Alnahedh
DIFFERENTIATION ANALYSIS

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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