1. Strategy and Sustaining Competitive Advantage -- February 18, 2006 Dr. Theodore H. K. Clark Associate Professor, Deputy Head (IS), and Academic Director of MSc in IS Management and MSc in E-Commerce Management Programs Department of Information & Systems Management The Hong Kong University of Science & Technology and Adjunct Associate Professor of Operations & Information Management (Information Economics and Strategy Group) 1998 - 2001 The Wharton School of the University of Pennsylvania

2. HKUST Business School 2 What is Strategy? Strategy versus Tactics Strategy is when you have time to plan Time is a luxury many firms may not have Planning helps firms avoid failures or inefficiency Doing the right things, not just solving the urgent crisis Goal of Strategy is to Gain Advantage Faster growth, higher margins, or both Alternative is More Work, Resources, or Luck But, a good strategy can beat superior forces

3. HKUST Business School 3 What is Competitive Advantage? Comparable Advantage - Something you are better at than almost everyone else Circular slide rule example Swedish language example Competitive Advantage - A comparable advantage that MATTERS in your market Circular slide rule skills irrelevant; use calculator! Swedish MIGHT matter in some environments Would Cantonese be a competitive advantage?

4. HKUST Business School 4 Porter’s Five Competitive Forces that Drive Industry Profitability Potential new entrants Industry competitors Threats of substitute products or services Bargaining power of suppliers Bargaining power of buyers

5. HKUST Business School 5 Why is Industry Structure Important for Strategy? Implications of new investments or changes in environment can affect all firms Decisions on entry or exit of an industry Decisions on investments in new capabilities Understanding how technology affects firms Useful tool to examine how these forces act differently upon different firms in an industry Benchmark for understanding expected profits in an industry given these forces

6. HKUST Business School Lessons from Five Forces Industry structure has a strong influence on profitability Firms position in industry is endogenous (chosen) We used to believe industry structure was exogenous (given)... now we’re not really sure “Excessive” profits threatened by new entrants and substitute products and competitive actions Retention of value determined by relative bargaining power of suppliers and customers Market imperfections determine ability to keep value that is created

7. HKUST Business School Three generic strategies Overall Cost Leadership Differentiation Focus Strategic Target Industry Segment Only Strategic Advantage UniquenessLow cost position “ Determining the cost/value tradeoff you wish to offer consumers is the most critical decision” - Porter

8. HKUST Business School 8 Porter’s Generic Strategy # 1: Leadership Based on Lower Cost Become low-cost producer in the industry Lowest total cost, not just low variable cost Often driven by economies of scale Must have parity quality or have lowest cost AFTER adjusting for quality differences Leveraging scale is common source of advantage in many industries Information goods may have difficulties with this strategy as costs of duplication are low

9. HKUST Business School 9 Porter’s Generic Strategy # 2: Differentiation and Segmentation Differentiation means to make your product unique and (hopefully) more valuable Becoming hard to copy is critically important Avoid commodity competition based on price Differentiation must be worth more to customers than it costs to create Horizontal differentiation (segmentation) versus vertical differentiation (quality) Less competition with horizontal differentiation

10. HKUST Business School 10 Porter’s Generic Strategy # 3: Focus or Niche Target Market Can be based on cost, differentiation or both By targeting a narrow market segment, you may be able to provide targeted products and services to that segment that are both low-cost and differentiated relative to less targeted firms Strategy is by design differentiated based on segment, as target market segment needs must be unique for focus strategy to work May be only option open for new entrants

11. HKUST Business School 11 Rethinking and Updating Porter’s Generic Strategies Today Cost leadership and differentiation are often hard to separate or clearly distinguish Cost leadership adjusted for quality differences Differentiation relative to differentiation costs Market leaders generally achieve BOTH Information goods total cost leadership means highest volumes (or copying) Differentiation critical to achieving scale Pricing not uniform, so a new key variable

12. HKUST Business School 12 Attackers’ Advantage Large Business Operations Focus on Meeting the Needs of Traditional Customers New Products and Services Offer Small Revenues Cost of Redesigning Existing Processes is High New Entrants can Focus on Niche Markets Fast Growing Niche / New Customer Segments New Products with Higher Initial Cost and Value Rapid Growth Replaces Traditional Markets Ignoring New Markets can be VERY Costly!

13. HKUST Business School 13 Sustainable Advantage: Part 1 Economies of Scale and Network Externalities Economies of scale important for E-commerce (e.g., advertising, software development, etc.) However, network externalities can be even more powerful forces in online business (Metcalf’s Law) Value of network of relationships increases as a function of the number of people or systems in the network Fax machines, Telephones, VCRs, VCD, E-mail, Internet Learning effects of scale can also be hard to copy

14. HKUST Business School 14 Achieving and Sustaining Competitive Advantage Firms need a COMPETITIVE ADVANTAGE to be able to PROFIT from this REVOLUTION Sustaining an Online Advantage can be Difficult Key Challenge is Becoming Hard to Copy Economies of scale and network externalities Access to key skills, resources, or suppliers Customer switching costs and brand preference Government policy (patents, antitrust, etc.) Fast (not First) Mover Advantage also Matters

15. HKUST Business School 15 Sustainable Advantage versus Competitive Necessity Information goods have relatively low costs of reproduction and distribution Lower distribution costs are good, but Lower reproduction costs can be a problem It is frequently one-third less expensive to copy an innovation (even without violating patent rights) and takes one-third less time IT innovations often become competitive necessities instead of strategic advantages

16. HKUST Business School 16 Competitive Necessity Today: Challenge for the Future The more we spend on IT, the more we lose Why don’t we all just stop investing in systems? Why don’t you start first and show us how well it works for you, and then we will follow? No firm can afford NOT to have advanced IT- based trading systems in market today How long is long enough for sustainable advantage in our fast paced world? Long enough to keep a venture capitalist happy

17. HKUST Business School 17 Copying Innovations and Competitive Necessity Many new IT enabled innovations are easy to copy or can not be maintained by one firm Bank ATMs - only HSBC has sufficient market share to go it alone, so others collaborate Competitive advantage initially, then copied Unsustainable advantage may become necessity An innovation is a competitive necessity if: Must do it to be competitive in the market Easy to copy and many firms doing it Not clear benefits as “stand-alone” investment

18. HKUST Business School 18 Innovations, Investments, and Competitive Necessity An investment should only be justified as competitive necessity as a LAST RESORT Many investments are just smart business, like investing in factory automation to reduce costs Competitive necessity LOOKS like a bad investment versus STATUS QUO, but is essential A competitive necessity must be valued by customers MORE than the cost of investment Some market innovations are not worth copying Alternative strategies could enable differentiation

19. HKUST Business School 19 Economies of Scale versus Economies of Networks Economies of scale resulted in larger firms winning, limited by minimum efficient scale Any firm with efficient scale could survive Minimum scale sufficient for moderate success Stability achieved by declining returns to scale Economies of networks result in single firm or at least standard becoming dominant Value increases based on number of users Positive feedback leads to single firm dominance Sometimes referred to as a “natural” monopoly

20. HKUST Business School 20 Lower Cost Distribution: Scale Advantages from Technology Giving away samples to increase sales Mrs. Fields cookies and new food products Free newspapers for high-class hotels Free “samples” of information online Information products are EXPERIENCE goods Need to try it to know if it worth buying later Free samples as “Infomercials” (free version) Need attractive upgrade path for customers Create component based products online

21. HKUST Business School 21 Strategy, Technology, Timing, and Competitive Advantage Technology changes so fast, that strategy is highly dependent on implementation timing Good strategy, wrong timing leads to failure Many new technologies failed to achieve market success at first, and many eventual successes require multiple failed attempts for learning Failure of a strategy may be error in timing Banking ATMs, disposable diapers, ziplock bags, PC banking, and many more examples

22. HKUST Business School 22 Sustainable Advantage: Part 2 Access to Resources as Source of Advantage Access to either suppliers or channels of distribution can be a sustainable advantage Customer switching costs can provide a first mover advantage and can favor established firms Part of IBM’s continuing advantage is due to cost of software conversion which makes switching difficult Brand can be viewed as a form of switching cost, but may be overcome with intensive promotion Scarce expertise may provide lasting advantage

23. HKUST Business School 23 Targeting the New Battleground Pricing and Versioning can create NEW strategic options that can enable firms to overcome SIZE advantages of dominant firms Alternative to “Winner Takes All” is smartest firm using customer information most effectively gains competitive advantage. How can firm with higher operating costs (due to lower scale) WIN with lower prices?

24. HKUST Business School 24 Competitive Strategy and Information Goods Pricing Pricing of information goods is complex, as there is no clear cost basis for comparison Most traditional products have some cost based component in the pricing of products Information goods pricing can be very different from comparable physical goods Encyclopedia for $1600 USD or $89.99 USD? Costly to produce, but cheap to reproduce Generic competition means all firms lose

25. HKUST Business School 25 Critical Role of Information Differentiation in E-Commerce For any online business, ask yourself if this product or service can easily be copied? If yes, then it is a commodity and competition will drive prices (and profits) towards zero over time If no, business MAY generate sustainable profits Cost of copying: barrier to entry CD-based US telephone books example FREE information online (marginal cost = zero) Advertising and “free” services - challenges

26. HKUST Business School 26 Sustainable Market Structures for Information Goods Dominant firm model: Winner Take All Microsoft example - cost leadership via scale What is the cost per copy for competitors? 10 million to develop and 10 customers 10 million to develop and 10 million customers Not the best product, but size and scale win Differentiated product market Needs differ by segment, so focus wins Publishing (low cost author?), TV, Movies

27. HKUST Business School 27 Even if Dominant, Pricing Important for Maximizing Value Customer willingness to pay different for different groups of customers (segments) DON’T BE GREEDY - limit incentives for entry PLAY TOUGH - Attack entrants aggressively Not optimal in each case individually, but powerful signal to the market that entry is not profitable Personalized products and pricing strategies Use information to determine pricing Value-based pricing by segment

28. HKUST Business School 28 Maximizing Value: Creative Product Pricing Strategies Personalized pricing: Sell unique product to each customer at a different price Consulting or legal services Grocery products: coupons and electronic rewards Value of information in services and pricing Versioning: Portfolio of products and prices Discussed in depth in Session #7 Group pricing: Price sensitivity (students), Network effect, Lock-in, and Sharing

29. HKUST Business School 29 Power of Profitability Gradient New Entrants Exploit Profitability Gradient Profitability of all customers is not the same Historical pricing is not adequately differentiated Information advantage can yield high profits Percentage of Total Customers Percentage of Total Profits -20020406080100 100 80 60 40 20 0

30. HKUST Business School 30 Datamining: A Powerful Segmentation Tool, But … Datamining can only tell you about possible correlation, not drivers of behavior Driven by past data; future might be different Correlation not same as causality (coincidence) Need to look for plausible justification for findings from datamining processes For example, datamining shows that CEOs are bad customers for credit card companies - WHY?

31. HKUST Business School 31 Information-Based Pricing Strategy: Summary Information about customers behavior, preferences, cost-to-serve, and ability to pay can be extremely valuable for ALL products Datamining is ONE powerful tool that can be used to understand potential opportunities Correlation but not causality Data collection in online businesses can be much lower cost than for traditional firms Valuable and unused data as free byproducts

32. HKUST Business School 32 Sustainable Advantage: Part 3 Government, Politics, and Options Advantages Patents, copyright, and trademarks are Government granted Monopoly rights (potentially hard to copy) Franchises and Licenses, granted by Governments or by Large and Successful Firm, can be hard to copy Value of owning McDonald’s franchise right can be high Right to operate Star Ferry may valuable and hard to copy Government policies on antitrust or prohibitions of monopoly can be source of advantage or disadvantage Government “grants” may be source of advantage

33. HKUST Business School 33 Information Alliances, Outsourcing, and Strategy Information outsourcing is becoming increasingly common and popular Information alliances are becoming essential for competitive advantage, especially for network goods to achieve scale for success Vertical integration initially projected for the new economy is becoming virtual integration No firm can afford to own all elements of the value chain in today’s complex, global economy Virtual integration is both efficient and flexible

34. HKUST Business School 34 Information Based Organizational Transformation Implementation Implementing Transformation Strategy Objective are often unclear or evolving over time Industry transformation is hard to do top down Risks and failures can be costly for innovators Radical Goals, Incremental Change Process Harvard study of successful Reengineering P&G channel transformation success case study Process R&D and Process Prototyping Needed Infrastructure more than systems; need skills too.

35. HKUST Business School 35 Risks and Benefits of Sharing Information Sharing information even once can result in power shifts that last for years in a relationship (proceed with caution) However, successful partnerships based on shared information can yield strong mutual benefits and reduce channel inefficiencies P&G now selling more than 50% of volume using channel information sharing processes Intel and customers both benefit from shared information to improve efficiency and service

36. HKUST Business School 36 Developing Relationships of Trust Establishing inter-organizational relationships based on trust requires management time and attention But, management time is one of the most scare assets any firm possesses, especially for senior management Thus, any firm has a limit on the number of close relationships based on trust which can be sustained

37. HKUST Business School 37 Evolution of Trust and Consolidation of Relationships Limited number of relationships at a high level of trust results consolidation of vendor and customer relationships Tight partnerships for critical jointly interdependent activities (e.g., JIT) GM and other firms reducing suppliers Strategic supply networks and alliances Leaders in developing trust can gain sustainable competitive advantage

38. HKUST Business School 38 Reengineering: What is it and Why is it Needed Anyway? Business as usual won’t work Legacy of past failures - creeping inefficient and tolerance for under-performance. Does BPR work? Sometimes... As many as 70% of BPR projects failed. But there are many dramatic successes as well. Ford - Accounts payable department reduced by 75%. Bell Atlantic - Cycle time reduced from 15 to 3 days. IBM Credit - Loan application turn-around time reduced from 6 days to 4 hours with 100 times (not 100%) increase in volume using same staff!

39. HKUST Business School Value Chain - Activities Inbound Logistics OperationsOutbound Logistics Marketing & Sales Service Organization Human resources Technology Purchasing Support Activities Primary Activities Idea: Break firm down into manageable pieces for analysis From: Porter & Miller, 1985

40. HKUST Business School Value System Identify where value is created outside the firm Can a firm use IT to appropriate this value? Are there additional opportunities to create gains from trade? SupplierFirmChannelBuyer From: Porter & Miller, 1985

41. HKUST Business School Continuous Replenishment: A Continuous Channel Process Timely, accurate, paperless information flow Smooth, continual product flow matched to consumption SupplierDistributorRetail Store Supplier receives daily demand information and ships based on actual sales demand from distributor warehouse to retail store SupplierDistributorRetail Store Traditional Grocery Channel Product and Information Flows using EDI Weekly or less frequent order received based on price promotions or actual demand, with product shipments based on orders placed by stores and distributors up the value chain. Orders Actual Sales Data JIT Shipments Orders Products Traditional and Continuous Replenishment Processes

42. HKUST Business School 42 Manual delivery (fax, mail) Direct data link (EDI) Discrete & Variable Continuous & Consistent ORDERING PROCESS INNOVATIONS TECHNOLOGICAL INNOVATIONS Traditional Technology Innovation Process Innovation Business Process Redesign

43. HKUST Business School 43 Manual delivery (fax, mail) Direct data link (EDI) Discrete & Variable Continuous & Consistent ORDERING PROCESS INNOVATIONS TECHNOLOGICAL INNOVATIONS EDICRP TraditionalEDLC Manual CRP

44. HKUST Business School Manual delivery (fax, mail) Direct data link (EDI) Discrete & Variable Continuous & Consistent ORDERING PROCESS INNOVATIONS TECHNOLOGICAL INNOVATIONS EDI TraditionalEDLC CRP Manual CRP* 0-10% 50-100% <0% 50-200% 50-100% Figure 12 - Performance Improvements from Innovations * Manual CRP refers to using CRP processes and policies without using EDI for data transmission. Although technically possible, all attempts at using CRP without EDI have been terminated due to the high costs involved.

45. HKUST Business School Redefining Interorganizational Linkages BEFORE PROCESS CHANGEAFTER PROCESS CHANGE Seller Buyer Customer Service Team Category Manager

46. HKUST Business School 46 Increasing Interdependencies: IT, Strategy, and Organizational Design IT Infrastructure and Applications Organizational Structure and Incentives Business Strategy (and Resources) Limits or Enables Requires Limits or Enables Drives Facilitate or Discourage Redesign and Enhance

47. HKUST Business School 47 Evolutionary versus Revolutionary Change: Conflicting Views Hammer & Champy advocated radical change “Obliterate, don’t automate!” was their slogan BUT, P&G example most cited is EVOLUTIONARY! Harvard Business School study of successful reengineering found that evolution dominated Study was REJECTED initially for publication This view has become more accepted as reengineering itself has lost its zealots Punctuated Equilibrium Model of Change

48. HKUST Business School 48 Success in Value Chain Transformation Value Chain Transformation is even harder than BPR One factor associated with successful BPR is strong support from CEO and top management However, a value chain involves several firms and has NO SINGLE DECISION MAKER IN CHARGE! Thus, changing value-chain operations can be as difficult as doing business within a JV in China. Value chain transformation requires new business models and visionary leaders