Terry College of Business - ECON 7950

Lecture 11: Cost and Differentiation Strategies

Primary reference: Besanko et al, Economics of Strategy, Ch.13

Competitive Advantage

I Profitability varies across firms and industries.I The pharmaceuticals and soft drinks industries have

consistently outperformed airlines.I There is tremendous variability between high and low

performers within industries.

I When a firm earns a higher profit than the average in theirindustry, we say the firm has a competitive advantage in theindustry.

I How do firms do this? They create, deliver and capture morevalue.

Strategies for Competitive Advantage: Airlines sincederegulation

I Until 1978, firms could not compete on price (which the CivilAeronautics Board based on miles traveled) and entry wasrestricted.

I After 1978, American Airlines developed a nationalhub-and-spoke system, focused on traveler loyalty through itsAA rewards program and sought to maximize revenue throughsophisticated reservation and yield management systems.

I Southwest Airlines expanded beyond its pre-deregulationTexas-only routes, slowly, to cities in the Midwest andSouthwest by flying into lesser-used airports. It did not adopta hub-and-spoke system. It focused on building ahighly-motivated workforce and providing low-amenity, cheapflights on identical (Boeing 737) airplanes.

I Northwest, Continental, JetBlue, etc., pursued distinctstrategies.

Strategies for Competitive Advantage: How do you win?

I You win by creating value.I Produce at lower cost.I Produce at higher quality.I Serve a novel market or part of a market—“create” customers.I Avoid being “stuck in the middle.”

I You win by capturing value.I Find places to be on the short side of the market.I Avoid price wars or be in good position to win them.

Porter’s Generic Strategies

I Cost leadership.I Undercut rivals’ prices and sell more.I Charge same price and earn higher price-cost margins.

I Benefit leadership.I Match rivals’ prices and sell more than they do.I Charge price premium and attain higher price-cost margins

than they do.

I Focus strategy.I Create greater value than competitors within a narrow segment

of the population.

Porter’s Generic Strategies in the US Personal ComputerIndustry

I Historically, Dell has been a cost leader.I Unit costs 15% lower than competitors (late 1990s).I Lower component costs, lower inventory carrying costs.I Lower prices, higher sales.

I Alienware is a focused company.I All-in for the hard-core gamer market.I http://www.alienware.com.

I The two strategies are not mutually exclusive...Dell acquiredAlienware in 2006, lowering the cost of producing Alienware,and eventually abandoned its own XPS gaming brand.

Let’s define value

I The easiest setting is seen in the basic Bertrand model.

I Suppose 3,000 customers wish to buy either 0 or 1 units ofthe good and have reservation values V .

I For simplicity, let the two firms have unlimited capacities.

I Value created per unit sold is V − c .

I As long as all customers in the market are served, total valuecreated is

3, 000× (V − c).

I Now, how to capture this?

Let’s define value

I Now, suppose firms produce at different marginal costs.

I Let firm 1 produce at cost c1, let firm 2 produce at cost c2,and let c1 < c2.

I Because c1 < c2, the maximum possible value created is

3, 000× (V − c1).

I Firm 1 adds value 3, 000× (c2 − c1). Does it capture thisvalue?

Bertrand with asymmetric marginal costs: equilibrium

I If firm 2 chooses price P2 > c1, then firm 1’s best-response isto set P1 just under P2.

I If firm 1 chooses price P1 > c2, then firm 2,s best-response isto set P2 just under P1.

I Firm 2 will not price below c2, however.

I The equilibrium has firm 2 set its price at c2, and firm 1 setsits price at (just below) c2.

I Firm 1 serves all customers and earns profit

3, 000× (c2 − c1).

Hotelling with asymmetric marginal costs

I It is rather extreme to (almost) match price and capture allvalue.

I What happens if products are differentiated?

I Revisit the Hotelling model. Let the travel cost be t per unitdistance.

I Let firm 1 produce at marginal cost c1 < c2.

I Intuition: how will this affect pricing incentives?

Hotelling with asymmetric marginal costs: best responses

I Obviously, firm 1 wants to lower price, but then so does firm 2by a lesser amount.

Hotelling with asymmetric marginal costs: equilibriumI Equilibrium prices are

P∗1 = t +

2c1 + c23

,P∗2 = t +

2c2 + c13

,

I Equilibrium price-cost margins are

P∗1 − c1 = t +

c2 − c13

,P∗2 − c2 = t +

c1 − c23

,

I Equilibrium market shares are

D∗1 =

1

2+

c2 − c16t

,D∗2 =

1

2− c2 − c1

6t

I Both firms charge lower prices.I Firm 1 charges the lowest price, sells to the most customers,

earns the highest profit.I Firm 1 does not capture all added value.

Exploiting a cost advantage through pricing: extrapolation

I Continue to assume that firm 1 is the low-cost firm.

I Firm 1’s price-cost margin, scaled by the price, is

P∗1 − c1P∗1

=t + c2−c1

3

t + 2c1+c23

I This ratio is always less than 1 and is increasing in t...in amore differentiated market (higher t), the low-cost firm shouldbe less inclined to cut percentage points off of its price-costmargin. It should instead rely on greater margins to increaseprofit. This is called a margin strategy.

I Intuition: when products are strongly differentiated, a firm’sprice elasticity of demand is low, so price cuts gain littlemarket share.

I In contrast, when products are less differentiated, the low-costfirm should pursue a share strategy, that is, cut price to gaina high market share.

Benefit strategies: back to Bertrand

I Now, suppose firms produce different quality products andproduce at marginal cost c1 > c2.

I Here firm 1 produces at higher marginal cost, but...

I Let firm 1 produce a product for which consumers havereservation value V1, let firm 2 produce a product for whichconsumers have reservation value V2, and let V1 > V2.

I Importantly, let V1 − c1 > V2 − c2, so that firm 1 adds morevalue.

Bertrand with asymmetric reservation-value products:equilibrium

I If firm 2 chooses price P2 > c2, then firm 1’s best-response isto set P1 just under P2 + (V1 − V2).

I If firm 1 chooses price P1 > c1, then firm 2’s best-response isto set P2 just under P1 − (V1 − V2).

I Firm 2 will not price below c2, however.

I The equilibrium has firm 2 set its price at c2, and firm 1 setsits price at (just below) c2 + (V1 − V2).

I Firm 1’s price-cost margin is then

P1 − c1 = c2 + V1 − V2 − c1= (V1 − c1)− (V2 − c2),

the exact value added relative to the competition. This iswhat firm 1 earns per unit.

The Value Chain

I Value is created as good move along a chain.

I The value chain depicts the firm as a group of value-creatingactivities, some of which are logically represented in asequential manner.

I Each link adds costs and benefits.

I It is typically easier to isolate costs associated with the variousactivities than to isolate benefits.

The Value Chain

Creating Value

I There are two ways a firm can outvalue its competitors.I First, it can develop a similar configuration to its competitors

but create more value within that chain.I “Cost” strategy, e.g. Dell.

I Second, it can develop a different configuration of its valuechain.

I “Focus” strategy, e.g. Enterprise Rent-A-Car.

I It could also do both, of course.

Competitive Cost Analysis

I The starting point for identifying competitive advantage.

I Look at each group of activities in the value chain andidentify my costs.

I Identify cost drivers associated with each activity.

I Use cost drivers to estimate competitors’ costs.

I Sum up and compare.

Collins Kitchen vs. Betsy Baking: early 1990s

I Reference: Ghemawat and Rivkin, “Creating CompetitiveAdvantage,” HBS 9-798-062 (2006).

I Consider the snack cake market in western Canada,early-to-mid 1990s.

I Betsy Baking grew from a 1% market share to a 20% marketshare 1990-95.

I Collins Kitchen (Dinklets and Angel Dogs) shrank from 45%to 25%.

Collins Kitchen: elements of the value chain

I Price of typical snack cake: 72 cents.

I Inbound Logistics (raw materials): 18 cents.

I Operations (of baking, filling, etc.): 15 cents.

I Outbound Logistics (delivery, maintenance of shelfspace)” 26 cents.

I Marketing expenditures (ads, promotions): 12 cents.

I Profit: 1 cent.

Collins Kitchen: cost drivers

I Cost of outbound logistics per snack cake falls as local marketshares rise.

I Scale economies: total delivery costs depend on number ofstops, so if drivers can deliver more cakes per stop, the deliverycost per cake goes down.

I Urban deliveries more expensive due to traffic.

I Outbound logistics more expensive with increased productvariety (more difficult to restock shelves and removeout-of-date cakes).

I Snack cakes with fewer preservatives must be delivered moreoften.

Betsy Baking

I Operations Costs: 21 cents (12 cents less).I Used inexpensive raw materials purchased in bulk.

I Logistics Costs: less than half Collins’.I Baked their products with more preservatives—less frequent

deliveries.I Less complicated product line.

I Marketing: also less than half.I No promotions.

I Altogether, Betsy Baking spent only 34 cents per snack cake.

Cost Analysis

I Note that an effective cost analysis need not includeeverything.

I If some part of costs across competitors is the same, it isirrelevant.

I Conventional accounting systems may overemphasizemanufacturing costs.

I If firms sell intangible things like services, it can be difficult toallocate costs to overhead correctly.

I Comparing costs as a percentage of sales rather than inabsolute terms may make cost and price differences harder tosee.

I One-time investments should not be mixed with recurringcosts.

I Don’t confuse differences in product mixes with differences incosts.

Enterprise Rent-A-Car

I The largest rental car company in the US.I Consistently profitable, in contrast to the “Airport 7” (Hertz,

Avis, National, Alamo, Budget, Dollar and Thrifty)I Enterprise Holdings now includes National and Alamo.

I Enterprise grew as a company focused on the replacement carmarket.

I “We’ll pick you up.”

I Smaller capacity lots away from airports.

I Cultivates relationships with body shops, insurance agents,auto dealers.

Enterprise Rent-A-Car

I Entered airport market in 1999.I Focus on leisure travelers.

I Directions, restaurant recommendations, help with luggage.

I Initially shut out of many important airports (includingOrlando).

I The Airport 7, notably, Hertz and Avis, have tried to build anoff-airport business.

The Benefit Strategy

I A firm that produces a product of higher quality (V1 > V2)than its competitors for about the same cost can command aprice premium.

I When a firm does this, we say they pursue a benefit strategy.

I To analyze the gain to a benefit strategy, one should try toestimate consumer willingness to pay for various productcharacteristics.

I This is easier to do for industrial products, which may savequantifiable things (like energy), as opposed to consumerproducts (where willingness to pay can be “happiness”)

Husky Injection Molding Systems [HBS 9-799-157 (JanRivkin)]

I A top manufacturer of plastic injection molding equipment.I Most large soda bottles are made from polyethylene

terephthalate (PET) using injection molding systems.I Husky manufactured machines that have molds for making

preforms for PET products.

I Husky historically built better machines than their competitorsand charged more for them.

I Analysis of consumer willingness to pay reveals that to replacea $1.2 million Husky PET System, a consumer would have tospend $1.34 million plus $49,000 per year on alternativeproducts to duplicate the same production.

I Husky systems also produce fewer surface blemishes and a lessvariable burst pressure.

I Note from the willingness-to-pay calculation that Husky leavessignificant value to the customer.

I Husky enjoyed return on equity of nearly 40% during 1992-95.

Higher Benefits and Lower Costs: the Best of Both Worlds

I Is it possible to sell a product that delivers more value whilelowering average cost?

I Perhaps...to do this a firm must initially operate on thedeclining part of its average cost curve.

I It must also initially sell with significant markups overmarginal cost.

I Then, even if producing a superior product increases its entireaverage cost curve, if the improved product increases demandenough, it can produce at lower average cost after the change.

The Holy Grail: greater benefit, lower cost

I Note the learning curve effects...as output expands, the firmlearns how to produce at lower cost.

Stuck in the Middle

I While having higher benefits and lower costs is possible(Frito-Lay in salty snacks, e.g.), Michael Porter argues that itis generally a bad idea to purse a part-cost, part-benefitstrategy.

I This can lead to “unfocused decision making and the pursuitof inconsistent actions” that have a muted impact on costs orbenefits or one where the effects cancel each other out.

I Kmart has been criticized for weak imitation of best practicesby its rivals.

I Imitate Target’s hipness (Martha Stewart’s line)?I Compete on price with Walmart (Every Day Low Pricing in

2001)?I Do both (badly)?

Types of Focus Strategies

I Enterprise Rent-A-Car surged to profitability by targetingconsumers needing replacement cars. They adopted acustomer specialization focus.

I The idea is to offer an array of products to a limited group,and then cater to particular needs.

I In contrast, it may pay to adopt a focus on a particular set ofproducts, a product specialization focus..

I The idea is to satisfy some needs of a wide group of customers.I Microbrewers do this.