Business Strategy: Differentiation, Cost

Leadership, and Integration

Joe Mahoney

Business Strategy and Competitive Advantage

• A business-level strategy is an integrated and coordinated set of commitments and actions designed to provide value to customers and to gain a competitive advantage by utilizing core competencies in specific individual product markets..

6–2

Business-Level Strategy: How to Compete for Advantage?

• Answer the “Who, What, Why, and How” Who - which customer segments to serve?

What needs, wishes, desires will we satisfy?

Why do we want to satisfy them?

How will we satisfy customers’ needs?

• Details actions that managers take in the quest for competitive advantage Single product or group of similar products

6–3

Abell’s Framework for Defining the Business

Who is beingsatisfied?

Customer Groups

What is beingsatisfied?

Customer Needs

How arecustomer needs

satisfied?Distinctive

Competencies

Definitionof Business

Industry and Firm Effects Jointly Determine Competitive Advantage

6–5

Business Strategy and Competitive Advantage

• Two fundamental questions:

How do you generate advantage? How do you sustain advantage?

• Key idea for sustainability is “barriers to imitation.”

How long will it be before the first rival imitates the first mover?

How fast does new imitation occur once it starts?

These two factors determine appropriability..6–6

Business Strategy and Competitive Advantage

• Does market share generate competitive advantage?

The computer industry is an excellent example of the lack of correspondence between market share and profit rates. IBM was a clear market leader in terms of market share but had only mediocre economic performance relative to its rivals. High market share is no guarantee of high rates of profitability.

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Business Strategy and Competitive Advantage

• Does market share generate competitive advantage?

Perhaps high market share causes high profit rates.

But it could equally well be that there is a third factor (e.g., good service capabilities, such as those of Caterpillar), either not considered or unobserved by us, that causes both high profitability and high market share.

In this case, we would see a correlation between profitability and market share but there is no causal explanation.

Business Strategy and Competitive Advantage

• When can market share work to generate and sustain an advantage?

Scale economies (to generate cost leadership advantage) combined with high exit costs (to sustain the advantage) may make market share a defensible advantage.

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Sustainable Competitive Advantage

• Costly Duplication due to:

Historical Conditions;

Uncertainty;

Social Complexity; and

Property Rights Protection.

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Business Strategy and Competitive Advantage

• An organization’s knowledge or expertise can lead to sustainable advantage if: The knowledge is tacit rather than articulable;

Tacit Knowledge: “We know more than we can tell.” Tacit Skills: Riding a bike, swimming, “learning by doing,” which is

critical for maintaining a manufacturing base The knowledge is not observable in use; The knowledge is (socially) complex, rather than simple.

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Forms of Competitive Advantage

CompetitiveAdvantage

Cost Advantage

DifferentiationAdvantage

Similar ProductAt Lower Cost

Price PremiumFrom Unique

Product

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Strategic Position and Competitive Scope: Generic Business Strategies

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2/28/2003 Southern Methodist University Slide # 6

Building Competitive AdvantageBuilding Competitive AdvantageResources and Capabilities

Competitive PositioningCompetitive Positioning Defending Defending

Value drivers Cost driversValue drivers Cost drivers Isolating mechanismsIsolating mechanisms

Retain customers Retain customers & Prevent imitation& Prevent imitation

Superior ContributionSuperior Contribution Sustainable PositionSustainable Position

Competitive AdvantageCompetitive Advantage

4/22/2003 Southern Methodist University Slide # 7

Competitive Positioning With Competitive Positioning With CustomersCustomers Economic contributionEconomic contribution

The value customers receives less the The value customers receives less the cost to the firmcost to the firm

Buyer’ surplus

Supplier’s profit

Economic contribution produced by supplier

Product value

Market price

Product cost

© 2005 Mara Lederman, Rotman School of Management

Types of Competitive Advantage

Buyer value generated (willingness to pay)

Costs incurred (including opportunity cost of capital)

Industry average

competitor

Successful differentiated

competitor

Successful low-cost

competitor

Competitor with dual

advantage

$

Value Created

Differentiation Advantage

• Differentiation Advantage, a concept developed by economist Joan Robinson, occurs when a firm is able to obtain from its differentiation a price premium in the market which exceeds the cost of providing differentiation.

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Value Drivers: Differentiation

• Differentiation:

Product features, customer service, customization, and complements Competitive advantage = economic value created (V-C) > competitors

Marriott line of Hotels 6–18

Cost Drivers: Cost-Leadership

• Cost Leadership: Cost of input factors, economies of scale, and learning-curve and

experience-curve effects Competitive advantage = economic value created (V-C) > competitors

Walmart vs. Kmart Dell vs. Compaq, Gateway, & HP

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Drivers of Cost AdvantageDrivers of Cost Advantage

PRODUCTION TECHNIQUES

PRODUCT DESIGN

INPUT COSTS

CAPACITY UTILIZATION

MANAGERIAL/ ORGANIZATIONALEFFICIENCY

ECONOMIES OF LEARNING

ECONOMIES OF SCALE

• Organizational slack

• Ratio of fixed to variable costs• Costs of installing and closing capacity

• Location advantages• Ownership of low-cost inputs • Bargaining power• Supplier cooperation

• Design for automation• Designs to economize on materials

• Mechanization and automation• Efficient utilization of materials• Increased precision

• Increased dexterity• Improved coordination/ organization

• Indivisibli\ties• Specialization and division of labor

Economies of Scale and Diseconomies of Scale

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Economies of Scale: The Long-Run Cost Curve for a Plant

Economies of Scale: The Long-Run Cost Curve for a Plant

Units of outputper periodMinimum

EfficientPlant Size

Cost perunit ofoutput

Sources of scale economies:- technical input/output relationships- indivisibilities- specialization

"Big Box" Retailers' Advantage

Box 2 x 2 x 2Volume 8

Box 3 x 3 x 3Volume 27

• Cube-Square Rule: Each dimension increases 50% (2 goes to 3) BUT Each volume increases 237.5% (8 goes to 27) !!

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Learning Curve: Sources of Gain

Need less time to instruct workers

Workers become more skillful in their movements

Develop better operation sequences

Machines and tooling are continually improved

Rejections and rework decrease

Management controls improved

Engineering changes become less frequent

Cost-effective improvements in product design

Enriched knowhow in managing and operating business

More efficient inventory handling and distribution methods6–24

Limits of “Learning Curve” Advantages

Copying and reverse engineering of products;

Hiring a competitor’s employees;

Purchasing the know-how from consultants;

Obtaining the know-how from customers;

Experience advantages are often nullified by product obsolences and innovations.

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Learning Curve• The following discussion and applications focus on direct labor

hours per unit, although we could as easily have used costs. In developing a learning curve, we make these assumptions:

Direct labor requirements will decrease at a declining rate as cumulative production increases.

The reduction in time will follow an exponential curve. In other words, the production time per unit is reduced by a fixed percentage each time production is doubled. We can use a logarithmic model to draw a learning curve. The direct labor required for the nth unit, kn, is

• kn = k1 nb where

• k1 = direct labor hours for the first unit • n = cumulative number of units produced • b = log r/log 2 • r = learning rate 6–26

Learning Curve• Example: The Bellweather Company has a contract for 60 portable

electric generators. The labor-hour requirement for manufacturing the first unit is 100. With that as given, Bellweather planners develop an aggregate capacity plan using learning-curve calculations. They use a 90 percent learning curve, based on previous experience with generator contracts.

• The labor requirement for the second generator is: • k2 = k1 nb • = 100 (2)log 0.9/log 2 • = 100 (2)-.152 • = 100 (.9) = 90 hours

• This result for the second unit, 90, is expected, since for a 90% learning curve there is a 10% percent learning between doubled quantities..

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Learning Curve• Example: The Bellweather Company

For the 8th unit,

= 100 (8)-.152 = 100 (0.729) = 72.9 hours

This result is also obtained by 100 (.9) (.9) (.9) = 72.9 hours.

• Learning curves can be used for:

Bid Preparation

Financial Planning

Production Scheduling 6–28

The Learning CurvePerUnitCost ($)

Cumulative Output (units)

0

20

40

60

80

100

120

0 50 100 150 200 250

90%

80%

70%

PerUnitCost ($)

Cumulative Output (units)

0

20

40

60

80

100

120

0 50 100 150 200 250

90%

80%

70%

Aircraft Assembly (1925-57): 80%

Calculator (1975-78): 74%

Gaining Competitive Advantage Through Learning

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Avon Pursuing an Integration Strategy

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Value and Cost Drivers

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Differentiation vs. Cost Leadership as a Basis for Competitive Advantage

Differentiation vs. Cost Leadership as a Basis for Competitive Advantage

Highest return on equity among top 200 US companies, 2002(%) (%)

Colgate Palmolive 367.8 Gillette 53.8Caremark Rx 303.2 H.J. Heinz 48.5American Standard 161.4 Pfizer 45.7Yum Brands 98.1 Dell Computer 43.0Kellogg 80.5 TJX 41.3Anheuser-Busch 63.4 Oracle 36.4Nextel Communications 58.3 PepsiCo 35.6Sara Lee 58.0 3M 32.9Altria Group 57.0 Eli Lilly 32.7Wyeth 54.5 Sysco 31.9

QUESTION: Which is the primary basis for competitive advantagein the above companies: cost or differentiation?

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