Lecture 5: The Nature and Sources of Competitive Advantage

Dr Kevin MastersStrategic ManagementFebruary 2015

Strategy

“The essence of strategy lies in creating tomorrow’s competitive advantages faster than your competitors can mimic the ones that you possess today” (Hamel and Prahalad)

What is ‘competitive advantage’?

“When two or more firms compete within the same market, one firm possesses a competitive advantage over its rival when it earns (or has the potential to earn) a persistently higher rate of profit” (Grant 2010)

But competitive advantage may not translate into higher profitability immediately, a firm may forgo current profits in order to build market share, create customer loyalty, etc.

How does competitive advantage emerge?

External sources of change: •Changing customer demand•Changing prices•Technological change

Internal sources of change

Different resource and capabilities

among firms means different impacts

Some firms are faster and more effective

in anticipating and exploiting change

Some firmshave greater creative

and innovativecapability

The Emergence of Competitive Advantage

COST ADVANTAGE

DIFFERENTIATIONADVANTAGE

COMPETITIVEADVANTAGE

Similar product

at lower cost

Price premium

from unique product

Sources of Competitive Advantage

SOURCE OF COMPETITIVE ADVANTAGE Low cost Differentiation

Industry-wide COST DIFFERENTIATIONCOMPETITIVE LEADERSHIPSCOPE

Single Segment F O C U S

Porter’s Generic Strategies

Activity 1

Turn to your neighbour and discuss the following question

Should managers focus more on cost or quality when deciding on competitive strategy? Why?

10 minutes then feedback

Generic strategy Key strategy elements Resource & organizational requirements

COST Scale-efficient plants. Access to capital. ProcessLEADERSHIP Design for manufacture. engineering skills.

Frequent Control of overheads & reports. Tight cost control. R&D. Avoidance of Specialization of jobs and marginal customer functions. Incentives for accounts. quantitative targets.

DIFFERENTIATION Emphasis on branding Marketing. Product and brand advertising, engineering. Creativity. design, service, and Product R&D quality. Qualitative measurement

and incentives. Strong cross-functional

coordination.

Features of Cost Leadership and Differentiation Strategies

Cost-leadership

Cost-leadership strategy involves becoming the lowest-cost organisation in a domain of activity. Finding and exploiting all sources of cost advantage

and selling a standard no-frills product Traditionally about deriving economies of scale and

scope through in investment in mass production and mass distribution

More recently extended to out-sourcing, off-shoring, process reengineering, lean production, organisational delayering, etc.

Drivers of Cost Advantage

Seven principal determinants of a firm’s unit costs relative to its competitors (see next slide)

Their relative importance varies across industries, between firms, and between activities within firms

By examining each cost driver we can analyse a firm’s cost position relative to its competitors and make recommendations for improvement

PRODUCTION TECHNIQUES

PRODUCT DESIGN

INPUT COSTS

CAPACITY UTILIZATION

RESIDUAL EFFICIENCY

ECONOMIES OF LEARNING

ECONOMIES OF SCALE

• Organizational slack; motivation & culture; managerial efficiency

• Ratio of fixed to variable costs• Speed of capacity adjustment

• Location advantages• Ownership of low-cost inputs • Non-union labor• Bargaining power

• Standardizing designs & components• Design for manufacture

• Process innovation• Reengineering business processes

• Increased dexterity• Improved organizational routines

• Indivisiblities• Specialization and division of labour

Drivers of Cost Advantage

Units of outputper period

MinimumEfficient Plant

Size: the point at which most scale economies are

exhausted

Cost perunit ofoutput

Sources of scale economies:- Volume related economies of scale- Indivisibilities (many resources and activities are ‘lumpy’ and small scale does not bring reduced costs, e.g. TV advertising campaigns)- Specialization (economies through greater division of labour)

ExampleEconomies of Scale and the Long-Run Cost Curve for a Manufacturing Plant

10 20 50 100 200 500 1,000

Annual sales volume (millions of cases)

Adv

ertis

ing

Expe

nditu

re ($

per

cas

e)0.

02

0

.05

0.10

0.15

0.2

0

CokePepsi

Seven Up

Dr. PepperSprite

Diet PepsiTab

FrescaDiet Rite

Diet 7-Up

Schweppes SF Dr. Pepper

Soft drinks brands with the greatest sales volumes tend to have the lowest advertising costs per unit of sales.

Scale Economies in Advertising: U.S. Soft Drinks

Costs per Available Seat-Mile

Southwest Airlines United Airlines (cents) (cents)

Wages and benefits 2.4 3.5Fuel and oil 1.1 1.1Aircraft ownership 0.7 0.8Aircraft maintenance 0.6 0.3Commissions on ticket sales 0.5 1.0Advertising 0.2 0.2Food and beverage 0.0 0.5Other 1.7 3.1

Total 7.2 10.5

Cost Advantage in Short-Haul Passenger Air Transport

So how do small and medium-size companies survive? By …

Exploiting superior flexibility Outsourcing activities where scale is

critical to efficiency Avoiding the adverse motivation

and co-ordination problems that affect large firms

STAGE 1. IDENTIFY THE FIRM’S PRINCIPAL ACTIVITIESEACH ACTIVITY TENDS TO BE SUBJECT TO A DIFFERENT SET OF COST DRIVERS

STAGE 2. ALLOCATE TOTAL COSTS ACROSS THE PRINCIPAL ACTIVITIES

PURCH-ASING

PARTSINVEN-TORIES

R&DDESIGN

ENGNRNGCOMPONENT

MFRASSEMBLY

TESTING,QUALITY

CONTROL

GOODSINVEN-TORIES

SALES &

MKITG

DISTRI-BUTION

DEALER &CUSTOMERSUPPORT

Using the Value Chain to Analyse Costs The Case of Automobile ManufactureA Five-stage Process:

PURCH-ASING

PARTSINVEN-TORIES

R&DDESIGN

ENGNRNG

COMPONENTMFR

ASSEMBLYTESTING,QUALITY

CONTROL

GOODSINVEN-TORIES

SALES&

MKITG

DISTRI-BUTION

DEALER &CUSTOMERSUPPORT

--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 -- Capacity utilization under warranty

Prices paid --Size of r&d 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 3. IDENTIFY THE COST DRIVERS

For each activity, what factors determine the level of cost relative to other firms?

PRCHSNG PARTS R&D COMPONENT ASSEM- TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR BLY QUALITY INV MKTG CTMR

Consolidation of orders to increasediscounts, increases inventories

Designing different models aroundcommon components and platforms

reduces manufacturing costs

Higher quality parts and materialsreduces costs of defects

at later stages

Higher quality in manufacturingreduces warranty costs

STAGE 4. IDENTIFY LINKAGES

THE COSTS OF ONE ACTIVITY MAY BE DETERMINED IN PART BY THE WAY THAT OTHER ACTIVITIES ARE PERFORMED, SO…

Stage 5. Recommendations for cost reductions (1)

Identify opportunities for reducing costs Areas of comparative inefficiency? Can volumes be increased to release

scale efficiencies? Can productivity be improved, relocated

or outsourced?

Stage 5. Recommendations for cost reductions (2)

Purchasing Use fewer suppliers to increase volumes? Use JIT component supply systems?

R&D Design Fewer models and fewer changes?

Components Seek economies of scale? Out-source production if volumes are sub-

optimal?

Differentiation strategies

Differentiation Involves uniqueness along some dimension

that is sufficiently valued by customers to allow a price premium

Encompasses everything about a product or service that influences the value that the customer derives from it

Includes every aspect of the way in which a company relates to its customers (e.g. the ‘Starbucks Experience’)

The Nature of Differentiation:Tangible and Intangible Dimensions

TOTAL CUSTOMER RESPONSIVENESSDifferentiation not just about the product, it embraces the whole relationship between the supplier and the customer.

INTANGIBLE DIFFERENTATION

Unobservable and subjectivecharacteristics that appeal to customer’s image, status, identity, and desire for exclusivity

TANGIBLE DIFFERENTATIONObservable product characteristics:• size, color, materials, etc.• performance attributes• packaging• complementary services

• Delivery, after-sales, accessories

DEFINITION: “Providing something unique that is valuable to thebuyer beyond simply offering a low price.” (M. Porter)

THE KEY IS TO CREATE VALUE FOR THE CUSTOMER

Differentiation and segmentation (1)

o DIFFERENTIATION: is concerned with how a firm distinguishes its offerings from those of its competitors (How the firm competes)

o SEGMENTATION: is concerned with which customers, needs, and localities a firm targets (Where the firm competes)

Differentiation and segmentation (2)

o Differentiation does not necessarily imply segmentation, it depends upon the differentiation strategyo Broad scope differentiation = appealing to what is common

between different customers (e.g. McDonalds, Honda, Gillette)o Focussed differentiation = appealing to what distinguishes

different customers (e.g. Harley-Davidson)o Differentiation is a more secure basis for

competitive advantage than low cost which is vulnerable to the emergence of new competitors and adverse movement of exchange rates

Differentiation in the US airline industry

Figure 6.5 Mapping differentiation in the US airline industrySource: Simplified from Figure 1, in D. Gursoy, M. Chen and H. Kim (2005), ‘The US airlines relative positioning’, Tourism Management, 26, 5, 57–67: p. 62

THE PRODUCT

THE CUSTOMER

What needs does it satisfy?

By what criteria do

they choose?

What motivates

them?

What are its key attributes?

Relate patterns of customer

preferences to product attributes

What price premiums do

product attributes command?

What are demographic, sociological,

psychological correlates of

customer behavior?

FORMULATE DIFFERENTIATION

STRATEGY• Select product positioning in relation to product attributes• Select target customer group• Ensure customer / product compatibility• Evaluate costs and benefits of differentiation

Identifying Differentiation Potential

Consistency is key to successful differentiation of all aspects of the firms relationship with its customers.

Product Integrity is the total balance of product features Internal integrity: consistency between function and

structure (well made) External integrity: fit between the product and the customers’

objectives, values, lifestyleo The key to successful differentiation is matching

the firm’s capacity for creating differentiation to the attributes that customers value most.

Consistency of Differentiation Strategy: Product Integrity

FIRM INFRASTRUCTURE

HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

INBOUND OPERATIONS OUTBOUND MARKETING SERVICE

LOGISTICS LOGISTICS & SALES

MIS that supports fast response capabilities

Training to support customer service

excellence

Unique product features. Fast new

product development

Quality of components &

materials

Defect free products.

Wide variety

Fast delivery. Efficient order

processing

Building brand reputation

Customer technical support. Consumer credit. Availability

of spares

Using the Value Chain to identify potential drivers of uniqueness

1. Distinctive can design can assist canners’ marketing activities.

2. High manufacturing tolerances can avoid breakdowns in customer’s canning lines.

3. Frequent, reliable delivery can permit canner to adopt JIT can supply.

4. Efficient order processing system can reduce customers’ ordering costs.

5. Competent technical support can increase canner’s efficiency of plant utilization.

Supplies of steel&

aluminum

Service &

technical support

Sales

Distribution

Inventory holding

Manufacturing

Design

Engineering

Inventory holding

Purchasing

Distribution

Marketing

Canning

Processing

Inventory holding

Purchasing

CANNER CAN MAKER

1

2 45

3

Identifying Differentiation Opportunities through Linking the Value Chains of the Firm and its Customers: Can Manufacture

SOURCE OF COMPETITIVE ADVANTAGE Low cost Differentiation

Industry-wide COST DIFFERENTIATIONCOMPETITIVE LEADERSHIPSCOPE

Single Segment F O C U S

Back to Porter’s Generic Strategies …

‘Stuck in the middle’?

Porter’s argues: That cost leadership and differentiation

strategies are mutually exclusive It is best to choose which generic strategy to

adopt and then stick to it Failure to do this carries the risk of being ‘stuck

in the middle’ i.e. doing neither strategy well The argument for pure generic strategies is

controversial, even Porter acknowledges that the strategies can be combined (e.g. if being unique costs nothing)

Activity 2

The argument for pure generic strategies is controversial, even Porter acknowledges that the strategies can be combined.Turn to your neighbour and discuss the following questionCan you think of any firms where cost leadership and differentiation strategies are:

1. Being combined successfully?2. Being attempted unsuccessfully?

10 minutes then feedback

Reconciling differentiation with low cost

However, the argument for pure generic strategies is controversial, even Porter acknowledges that the strategies can be combined

Can you think of any firms where the two approaches are: Being combined successfully

TOYOTA IN CARS? MCDONALDS IN FAST FOOD? NIKE IN ATHLETIC SHOES?

Being attempted unsuccessfully MORRISONS IN FOOD RETAIL? M&S IN CLOTHING?

Combining generic strategies – may be OK if …

A firm can create separate strategic business units each pursuing different generic strategies and with different cost structures?

Being unique costs nothing? Both cost efficiency and quality are

improved by technological or managerial innovations?

Rivals are similarly ‘stuck in the middle’ or if there is no significant competition?

Activity 3

Turn to somebody different and discuss the following question

To what extent do universities compete by being different or the same?

Reading about competitive advantage

Essential reading: Grant (2010) Chapters 7 and 10 Johnson, Whittington and Scholes (2011)

Chapter 6 Further reading:

Thompson et al. (2013) Crafting and Executing Strategy: The Quest for Competitive Advantage. London, McGraw Hill.

Porter (1985) Competitive Advantage. New York, Free Press.

Preparing for Week 7

Johnson, Whittington and Scholes (2011)

Chapter 11 (Evaluating Strategies)

Chapter 12 (Strategy Development Process)

THE ENDTHANK YOU!