July 1, 2003 Comments

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Cost Advantage

(Originally published on OUBS Blog)

In this capter Grant puts the focus on price as the principal source of competitive advantage.

Economies of Experience

In 1968 the Boston Consulting Group published an article called Perspectives in Experience which brought to light the experience curve. This lead ot the “Law of Experience”:

The unit cost of value added to a standard product declines by a constant percentage (typically between 20 and 30 percent) each time cumulative output doubles. (unit cost of value added = total cost - cost of bought components and materials)

In logarithmic form, the curve becomes a straight line with the formuly being C_n = C_1 * n^-a where n is the cumulative volume and a the cost elasticity.

This leads to several implications. For one, your cost relative to your competitors depends on your relative cumulative output and in that sense, market share is a strategic goal. Honda priced its motorcycles to meet market share objectives because of that, which is different than pricing based on current costs. It’s about pricing your products in regard to likely future costs in relation to future market share. There are still questions though if market share is really the right thing to achieve, because::
- association is no the same as causation (does market share or profit come first?)
- market share can still be unprofitable
- fallacy of competition … if everyone tries to get the market share and there are many everyones, then you get into trouble.

The sources of cost advantage

You need to identify the cost drivers of your specific environment. You also need to understand where a companies unit costs come from and how it could improve them.

Economies of scale arise from:
- technical input-output relationship (a 10000 barrel tank does not cost 5 times a 2000 barrel tank)
- indivisibility (no small sizes)
- specialization (no division of labor to promote learning, avoid time loss,…)

Scale economies are seldom in production but for consumer goods are often found in marketing. It costs the same to market Coca Cola than Pepsi but for Coca Cola, it costs a lot less per bottle. This is also something that is very hard to take away.

(The next chapter starts with a quote here, from Warren Buffet, who through Berkshire Hathaway is Coca-Cola’s biggest shareholder, which I’d like to quote here: If you gave me $100 billion and said, “Take away the soft drink leadership of Coca-Cola in the world,” I’d give it back to you and say, “It can’t be done.”)

Consolidation in the automotive industry also comes from costs associated with new model development. The same is true for the airline industry and in software especially.

Limits to scale economies comes in places where:
- product differentiation leads to small segments highly profitable
- flexibility doesn’t work well with scale-efficient production
- problems of motivation and coordination come with big units

Economies of learning as such are important because through repetition you cut time used and waste and defects. With active-matrix flat screens, yield rate is key, and hence companies that are already in the market have a considerable lead because they have gained a lot of experience.

Process technology and design can be used to reduce the (monetary total) units of inputs for the same output. Changes in these processes often need supporting changes in a lot of different parts of the organisation. Often, changes with the greatest effect come from process changes in organizations processes rather than in technology.

Business process reengineering was defined by Michael Hammer and James Champy as follows: the fundamental rethinking and redical redesign of business processes to achieve dramatic improvements in ciritical contemporary measures of performance, such as costs, quality, service, and speed.

You ask yourself how you would design a given process in case you were starting from zero. The book lists examples here of things that often happen, which is not the right approach though in my mind as it will limit you in your thinking. This is not about doing more of the same but about doing more totally new things. The important thing is to really understand the process you are trying to reengineer.

Product design can lead to cost savings when you design-to-manufacture for example.

Capacity utilization becomes important in industry where fixed costs are high, like the airline industry.

Input costs can be (made) important when:
- locational differences are there
- you own low-cost sources
- non-union labor
- bargaining power is on your side

Residual efficiency is about removing slack in your orgnization. Think gap analysis, just any gap.

Using the value chain to analyze costs

Disaggregate your company’s value chain to find the costs associated with each activity and better analyse each step, linkages and find potentials of outsourcing. Figure 8.6 is very thorough here.

Managing cost cutting

There are dynamic aspects of cost efficiency and companies should focus on the long term through continuous improvements. Radical cost surgery are needed in cases where major changes are needed boost financial performance and/or regain investor confidence. This needs a tough top down hand.

June 29, 2003 8 Comments

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The Nature and Sources of Competitive Advantage

(Originally published on the OUBS Blog)

Competitive Advantage is defined by Grant as follows:
When two or more firms compete within the same market, one firm possesses a competitive advantage over its rivals when it earns (or has the potential to earn) a persistently higher rate of profit.

Competitive advantage emerges from internal sources where companies have greater creative or innovative capabilities and from external sources arround changing customer demands, prices and technological change.

Any change in the external environment brings with it an opportunity for profit and entrepreneurship is the ability to identify and respond to that opporunity. With markets becoming increasingly turbulent, this ability to respond can be said to be a competitive advantage in itself, if it is a better ability in relation to other companies that is. It also means that you anticipate future changes and hence you need information (resource) and flexibility to respond (capability). This moves organizational structure, decision-making systems, job design, and culture to the center of an organizations capabilities. The faster you can respond, the less you need to rely on forecasts. The example of Dell fits well here, as they have less than 14 days of inventory and can respond to changes quickly.

Innovation is not only a competitive advantage but also a capability that allows to overturn the competitive advantage of other firms. Gary Hamel argues that business concept innovation is the foundation for value creation in the new economy. These new business concepts will, as of McKinsey and Co., often involve a reconfiguration of the value chain of the industry in question. Dell for example does not deliver Sony monitors bought via their online store. Sony does. They never become inventory for Dell.

Sustaining Competitive Advantage

The greatest threat here is imitation, hence barriers of imitation must be established. To successfully imitate a firm needs to identify the advantage and have an incentive to imitate it. Then it needs to be able to diagnose the advantage and acquire the resources needed.

A company trying to set-up barriers can use limit pricing to have such low prices as to not attract new entrants. Against incentives, deterrence (threat of retaliation) can be used but must be credible (see Microsoft). If your threat is aggressive price cuts you need to have excess capacity or inventories. Preemption is another option, meaning that a company takes up all existing and potential niches, helped with capacity build up in advance of growth or patents for example. Preemption depends on a small number of viable competitors and a first mover advantage in the market.

The more facets or dimension your competitive advantage has, the more difficult the diagnosis will be (casual ambiguity). This leads to uncertain imitability.

Where capabilities are based on organizational routines, acquiring these capabilities will take a lot of time. Resources are best if they are not mobile and take a lot of time to acquire. A first-mover advantage is linked to the adage “success breads success”. Here economies of learning, reputation, standard setting and scarce resources are important.

Competitive Advatange in Different Market Settings

In efficient markets, competitive advantage is absent. Here prices reflect all available information and information flows freely. Beating the market consistently is not possible.

In trading markets competitive advantage can come from:
- Imperfect availability of information
- Transaction costs
- Systematic behavioral trends and those that best diagnose them
- Overshooting … which often means that acting in the opposite direction to market swings is a potential for more profit

In production markets,the greater the heterogenity in the endowments of resources and capability of differnet firms the greater the potential for a competitive advantage.
- if there is a lot of change in your industry, the potential for new competitive advantage is great.
- The greater the choice criteria of your customers, the more likely a niche can be found
- for sustainability you need: imperfection of information, opportuinities for deterrence and preemption, difficulties of resource acquisition

Types of Competitive Advantage

Here you have cost advantages or differentiation advantages. See Table 7.2 for more information and examples.

Michael Porter has defined three generic strategies: cost leadership, differentiation and focus. In most industires, market leadership is held by a firm that has merged differentiation with low cost. Nokia might be a good example here. Also, sometimes, in the existence of scale economies, market share leaders can improve their relative cost position.