CHAPTER

Business Strategy: Differentiation, Cost Leadership, and Integration

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Part 2 Strategy Formulation

LO 6-1 LO 6-2 LO 6-3 LO 6-4 LO 6-5 LO 6-6 LO 6-7

Define business-level strategy and describe how it determines a firms strategic position. Examine the relationship between value drivers and differentiation strategy. Examine the relationship between cost drivers and cost-leadership strategy. Assess the benefits and risks of cost-leadership and differentiation business strategies vis--vis the five forces that shape competition. Explain why it is difficult to succeed at an integration strategy. Evaluate value and cost drivers that may allow a firm to pursue an integration strategy. Describe and evaluate the dynamics of competitive positioning.

Chapter Case 6

Trimming Fat at Whole Foods Market

Whole FoodsBusiness Strategy Revitalization

Started as small natural-foods store 1980 Became market leader; differentiation through

organics and quality

Competitive

advantage through 2008

CEO John Mackey: Refocused Mission, Reduced Costs

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 gain a competitive advantage by utilizing core competencies in specific individual product markets.

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 managers take in quest for competitive advantage

Single product or group of similar products

Abells Framework for Defining the Business

Who is being satisfied? Customer Groups

What is being satisfied? Customer Needs

Definition of Business

How are customer needs satisfied? Distinctive Competencies

EXHIBIT 6.1

Industry and Firm Effects Jointly Determine Competitive Advantage

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.

 Does market share generate competitive advantage?

The computer industry is an excellent example of the lack

Business Strategy and Competitive Advantage

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.

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 at Caterpillar), 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 no causal explanation.

Business Strategy and Competitive Advantage When can market share work to generate and sustain an advantage?
Scale economies combined with high exit costs may make

market share a defensible advantage.

Sustainable Competitive Advantage

Costly Duplication due to:

Historical Conditions; Uncertainty; Social Complexity; and Property Rights Protection.

Business Strategy and Competitive Advantage

An organizations 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.

Strategic Position
Determined by Firms Business-Level Strategy
Two primary competitive levers:
Value (V) Cost (C)

Economic Value Created: (V-C)

The greater (V-C) = Competitive Advantage

Strategic Position Based on:

Value creation Cost

Forms of Competitive Advantage

Cost Advantage Similar Product At Lower Cost

Competitive Advantage

Price Premium From Unique Product

Differentiation Advantage

Generic Business Strategies

Different generic strategies can lead to competitive advantage in the same industry. Differentiation
Higher Value; Unique Features Rolex

Cost-Leadership
Similar Value; Lower Cost Timex

Scope of Competition
Narrow (Focused) Rolex Broad Timex

EXHIBIT 6.2

Strategic Position and Competitive Scope: Generic Business Strategies

LO 6-1 LO 6-2 LO 6-3 LO 6-4 LO 6-5 LO 6-6 LO 6-7

Define business-level strategy and describe how it determines a firms strategic position. Examine the relationship between value drivers and differentiation strategy. Examine the relationship between cost drivers and cost-leadership strategy. Assess the benefits and risks of cost-leadership and differentiation business strategies vis--vis the five forces that shape competition. Explain why it is difficult to succeed at an integration strategy. Evaluate value and cost drivers that may allow a firm to pursue an integration strategy. Describe and evaluate the dynamics of competitive positioning.

Building Competitive Advantage

Resources and Competitive Positioning
Value drivers Cost drivers

Capabilities Defending

Isolating mechanisms
Retain customers & Prevent imitation

Superior Contribution

Sustainable Position

Competitive Advantage
2/28/2003 Southern Methodist University Slide # 6

Competitive Positioning With Customers

Economic contribution

The value customers receives less the cost to the firm Product
value Buyer surplus Suppliers profit
Southern Methodist University

Economic contribution produced by supplier

4/22/2003

Market price Product cost

Slide # 7

Types of Competitive Advantage

Buyer value generated (willingness to pay) $ Costs incurred (including opportunity cost of capital)

Value Created

Industry average competitor

Successful differentiated competitor

Successful low-cost competitor

Competitor with dual advantage

2005 Mara Lederman, Rotman School of Management

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.

EXHIBIT 6.3

Value Drivers: Differentiation

Differentiation:
Product features, customer service, customization, and complements Competitive advantage = economic value created (V-C) > competitors Marriott line of Hotels

STRATEGY STRATEGY HIGHLIGHT HIGHLIGHT 6.1 6.1

Toyota: From Perfect Recall to Recall Nightmare Toyotas strategic challenges.

Launched Lexus 1989

Luxury car segment dominated by Mercedes-Benz, BMW, Cadillac

LS400 line required recall a little over a year after launch Turned threat into opportunity to establish reputation for superior customer service

Two years after launch Lexus ranked first on quality and customer satisfaction by J.D. Powers

2010 Toyota has largest recall in automotive history

Needed to exhibit superior customer responsiveness again 8 million vehicles recalled was much more challenging
125

EXHIBIT 6.4

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

STRATEGY STRATEGY HIGHLIGHT HIGHLIGHT 6.2 6.2

Ryanair: Lower Cost than the Low-Cost Leader!

The Southwest Airlines of Europe

Lowest-cost airline in the world

No window shades on older planes, seats dont recline, etc. Fares as low as $8 Numerous fees and surcharges: pillows, blankets, check-in, etc. 20+% of revenues flow from ancillary services
127

Ryanair Sample Revenue Calculation

1 Bottle of Water, $3.50 Ad Revenue, $2 Priority Boarding, $4 Pillow & Blanket, $5 Subsidy from More Expensive Flights, $5.50

Ticket Price, $8

Credit Card Fee, $6

Revenue $87 Cost $70 Profit $17

Online Check-in, $7.50

Checking Two Bags, $45

Drivers Drivers of of Cost Cost Advantage Advantage

ECONOMIES OF SCALE Indivisibli\ties Specialization and division of labor Increased dexterity Improved coordination/ organization Mechanization and automation Efficient utilization of materials Increased precision Design for automation Designs to economize on materials Location advantages Ownership of low-cost inputs Bargaining power Supplier cooperation Ratio of fixed to variable costs Costs of installing and closing capacity Organizational slack

ECONOMIES OF LEARNING

PRODUCTION TECHNIQUES

PRODUCT DESIGN

INPUT COSTS

CAPACITY UTILIZATION MANAGERIAL/ ORGANIZATIONAL EFFICIENCY

EXHIBIT 6.5

Economies of Scale and Diseconomies of Scale

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

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

Minimum Efficient Plant Size

Units of output per period

31

"Big Box" Retailers' Advantage

Box 2 x 2 x 2 Volume 8

Box 3 x 3 x 3 Volume 27

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

The Learning Curve

Per Unit Cost ($)

Aircraft Assembly (1925-57): 80% Calculator (1975-78): 74%

Cumulative Output (units)

EXHIBIT 6.6

Gaining Competitive Advantage Through Learning and Experience Curves

Limits of Learning Curve Advantages

Copying and reverse engineering of products; Hiring a competitors employees; Purchasing the know-how from consultants; Obtaining the know-how from customers; and Experience advantages are often nullified by

innovations.

LO 6-1 LO 6-2 LO 6-3 LO 6-4 LO 6-5 LO 6-6 LO 6-7

Define business-level strategy and describe how it determines a firms strategic position. Examine the relationship between value drivers and differentiation strategy. Examine the relationship between cost drivers and cost-leadership strategy. Assess the benefits and risks of cost-leadership and differentiation business strategies vis--vis the five forces that shape competition. Explain why it is difficult to succeed at an integration strategy. Evaluate value and cost drivers that may allow a firm to pursue an integration strategy. Describe and evaluate the dynamics of competitive positioning.

EXHIBIT 6.7

Competitive Positioning and the Five Forces

LO 6-1 LO 6-2 LO 6-3 LO 6-4 LO 6-5 LO 6-6 LO 6-7

Define business-level strategy and describe how it determines a firms strategic position. Examine the relationship between value drivers and differentiation strategy. Examine the relationship between cost drivers and cost-leadership strategy. Assess the benefits and risks of cost-leadership and differentiation business strategies vis--vis the five forces that shape competition. Explain why it is difficult to succeed at an integration strategy. Evaluate value and cost drivers that may allow a firm to pursue an integration strategy. Describe and evaluate the dynamics of competitive positioning.

EXHIBIT 6.8

Avon Pursuing an Integration Strategy

EXHIBIT 6.9

Value and Cost Drivers

Integration Strategy Corporate Level

Conglomerates can coordinate above the SBU level
Tata Group from India

2008 bought Jaguar & Land Rover Prestigious differentiated products 2009 Tata Motors creates a Nano car Lowest-priced car in the world! Zero to 60 mph in 30 seconds No radio or glove box Targets bicyclists to move to cars

LO 6-1 LO 6-2 LO 6-3 LO 6-4 LO 6-5 LO 6-6 LO 6-7

Define business-level strategy and describe how it determines a firms strategic position. Examine the relationship between value drivers and differentiation strategy. Examine the relationship between cost drivers and cost-leadership strategy. Assess the benefits and risks of cost-leadership and differentiation business strategies vis--vis the five forces that shape competition. Explain why it is difficult to succeed at an integration strategy. Evaluate value and cost drivers that may allow a firm to pursue an integration strategy. Describe and evaluate the dynamics of competitive positioning.

The Dynamics of Competitive Positioning Strategic Positions need to change over time
eBay withdrew from selling new goods & sold Skype

Productivity Frontier
Value-cost relationship Captures the best practices at a point in time

Mobile Devices

2005 Apple differentiator, Dell cost leader 2010 Apple still differentiator, HP moving to successful integrator, Dell shifting toward integrator

The Dynamics of Competitive EXHIBIT 6.10 Positioning: Apple, HP, and Dell

Differentiation Differentiationvs. vs. Cost Cost Leadership Leadership as asa a Basis Basisfor forCompetitive Competitive Advantage Advantage
Highest return on equity among top 200 US companies, 2002
(%) (%)

Colgate Palmolive 367.8 Caremark Rx 303.2 American Standard 161.4 Yum Brands 98.1 Kellogg 80.5 Anheuser-Busch 63.4 Nextel Communications 58.3 Sara Lee 58.0 Altria Group 57.0 Wyeth 54.5

Gillette H.J. Heinz Pfizer Dell Computer TJX Oracle PepsiCo 3M Eli Lilly Sysco

53.8 48.5 45.7 43.0 41.3 36.4 35.6 32.9 32.7 31.9

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

Take-Away Concepts
LO 6-1 Define business-level strategy and describe how it determines a

firms strategic position.

Business-level strategy determines a firms strategic position in its quest for competitive advantage in a single industry or product market. Strategic positioning requires that managers address strategic trade-offs that arise between value and cost, because higher value tends to go along with higher cost. Differentiation and cost leadership are distinct strategic positions. Besides selecting an appropriate strategic position, managers must also define the scope of competitionwhether to pursue a specific market niche or go after the broader market. LO 6-2 Examine the relationship between value drivers and

differentiation strategy.
The goal of a differentiation strategy is to increase the perceived value of goods and services so that customers will pay a higher price for additional features.

Take-Away Concepts
In a differentiation strategy, the focus of competition is on non-price attributes. Some of the unique value drivers managers can manipulate are product features, customer service, customization, and complements. Value drivers contribute to competitive advantage only if their increase in value creation (V) exceeds the increase in costs (C). LO 6-3

Examine the relationship between cost drivers and cost-leadership strategy.

The goal of a cost-leadership strategy is to reduce the firms cost below that of its competitors. In a cost-leadership strategy the goal is to reduce the firms costs below that of its competitors. The focus is on lowest-possible price with acceptable quality. Some of the unique cost drivers that managers can manipulate are the cost of input factors, economies of scale, and learning- and experience-curve effects. No matter how low the price, if there is no acceptable value proposition, the product or service will not sell.

Take-Away Concepts
LO 6-4 Assess the benefits and risks of cost-leadership and

differentiation business strategies vis--vis the five forces that shape competition.
The five forces model helps managers use generic business strategies to protect themselves against the industry forces that drive down profitability. Differentiation and cost-leadership strategies allow firms to carve out strong strategic positions, not only to protect themselves against the five forces, but also to benefit from them in their quest for competitive advantage. Exhibit 6.7 lists benefits and risks of each business strategy.

Take-Away Concepts
LO 6-5 Explain why it is difficult to succeed at an integration strategy. A successful integration strategy requires that trade-offs between differentiation and low cost be reconciled. Integration strategy often is difficult because the two distinct strategic positions require internal value chain activities that are fundamentally different from one another. When firms fail to resolve strategic trade-offs between differentiation and cost, they end up being stuck in the middle. They then succeed at neither strategy, leading to a competitive disadvantage. LO 6-6 Evaluate value and cost drivers that may allow a firm to pursue

an integration strategy.
To address the trade-offs between differentiation and cost leadership at the business level, managers may leverage quality, economies of scope, innovation, and the firms structure, culture, and routines. The trade-offs between differentiation and low cost can either be addressed at the business level or at the corporate level.

Take-Away Concepts
LO 6-7 Describe and evaluate the dynamics of competitive

positioning.
Strategic positions need to change over time as the environment changes. Best practices determine the productivity frontier at any given time. Reaching the productivity frontier enhances the likelihood of obtaining a competitive advantage. Not reaching the productivity frontier implies competitive disadvantage if other firms are positioned at the productivity frontier.