Chapter 1

HOW FIRMS OUTMANEUVER COMPETITORS WITH COST-QUALITY ADVANTAGES

TRADITIONAL VIEWS OF COST-QUALITY ADVANTAGES

Cost and quality are the staples of competitive positioning. As discussed, Porter identified three generic strategies based on cost and quality advantages: overall cost leadership, differentiation, and focus strategies. The cost-leadership strategy involves offering a mass-marketed, low-priced, low-quality product. The differentiation strategy involves offering a premium-priced, high-quality good, and the focus strategy targets a premium-priced product for a smaller niche audience with a special definition of what is high quality. While there has been much discussion of strategic positioning using cost and quality, this chapter offers an overview of theprocessof the evolution of this competition.

The traditional, static understanding of the relationship between cost and quality and competitive advantage is based on accounting approaches, such as those popularized by the DuPont model. According to this model, the company's return on equity (ROE) is a function of its margins, sales volume, and the financial policy of the firm. As shown in the equation below, ROE is related to (1) profits/sales (also called operating margins or return on sales, often labeled ROS), (2) volume (high sales volume given the finn's asset investment), and (3) assets/equity (which is equal to 1 - debt/equity, a major part of the financial policy of the finn). Thus:

ROE = profits/equity = ROS x sales/assets x (1 - D/E)

or (margins) x (volume) x (financial policy)

Porter's low-cost strategy achieves profits through a high-volume, low-margin approach, while his other two strategies are low-volume, high-margin approaches to generating profitability. Under this view of competitive advantage, firms compete for the high-volume market primarily through cost improvement, and they compete for lower-volume markets primarily through quality improvements. For all three strategies profits are produced by improving margins and/or volume.

Useful Insights from the Cost-Quality View of Competitive Advantage

This view of competitive advantage has proven highly useful. Kenichi Ohmae provides an example of the kind of strategic analysis that can be done using this view. In his set of "profit diagrams" inThe Art of Strategic Thinking,he demonstrates a systematic way to look for margin- and volume-improving strategies based on cost and quality. A machine-tool company had asked him how it could improve the profitability of the products in its line. Ohmae developed a diagram to address the question of how the profitability of a certain product can be increased. The diagram outlines a series of decisions managers must make in deciding how to increase profits. For example, the first choice in raising profits is to lower product costs, increase pricing, or increase volume. If managers decide to raise prices, they can do so by raising the market price or reducing margins for distributors. Sales volume can be increased by boosting market share, expanding the market segment, or moving into new segments. Each decision thus leads to a new set of choices, and ultimately to a set of actions to boost quality or decrease cost.

In addition, Ohmae recommends assessing whether each component of a product needs to be changed, analyzed, or left alone, depending upon whether it is more or less costly and of lower or higher quality than the component used by the firm's best and fiercest competitor. Product costs and quality can be improved by changing design, reducing fixed costs, or cutting variable costs, through value analysis (VA) and value engineering (VE). Value analysis and engineering are methods of reverse-engineering the product from the perspective of both the customer and manufacturing costs. Each component of a firm's product is identified and redesigned or eliminated to reduce cost (via value engineering) or increase quality (via value analysis) to the customer. Value engineering and analysis are used whenever the components of a firm's product are inferior or too costly compared to the components of the best products in the marketplace. In sum, according to this view, advantage is created by the components contained in the product and the price and attributes of the product as a whole. Advantage is said to exist when the product offers the correct combination of price and quality. Product positioning at a given point in time matters.

Critique of Traditional View

While this analysis captures the fundamental relationship between cost and quality, it is reactive rather than proactive. The model considers competitors only to the extent that they shape market conditions and the current benchmark levels of price and quality. This view does not look at potential competitive responses and future actions in the market. Ohmae himself cautions that competitor positions should be considered. "No product is sold in the desert or on the moon; manufacturers' prices and the various competitive segments they serve are determined in a competitive environment," he warns. "What if all manufacturers in the market are producing similar high-quality products and offering them to the market at a relatively low price (i.e., with narrow profit margins)? In this case, it would be disastrous for the company to modify Product A's design in order to reduce costs...because the seemingly lower quality product would be driven out of the market by the low-priced, high-quality products already competing for the customer's favor." But even here he is concerned primarily with current competitor positions rather thanfuture actions.This analysis sees the market at one point in time rather than examining how it evolves over long periods of time. There is no dynamic aspect to the profit improvement and product component analyses suggested by Ohmae and discussed earlier.

While Porter examines some movement within industries, even he does not considerhowcost-quality positioning evolves. He presents an extensive discussion of competitor analysis and tools for analyzing the future evolution of the industry, including product life cycles and changing buyer behaviors. But competition on cost and quality are viewed from the more static position of the generic strategies. As he notes, one of the primary risks of the generic strategies is for "the value of the strategic advantage provided by the strategy to erode with industry evolution."

The Dynamic View

It is our contention that the risk posed by evolution that Porter mentions has become so great that it can no longer be considered as an afterthought to strategic thinking. Competition is so intense and markets are so dynamic and volatile that this evolution has become the dominant force in strategic action. Companies can no longer count on succeeding by choosing a generic strategy. The most important aspect of competition is, not current position, but the changes created by the dynamic interaction between rival firms. Thus the position of the firm offers only a temporary advantage. It is the firm's ability to manage a series of interactions successfully that determines the success of the company.

Over long periods of time, companies are forced to shift their cost (and price) and quality positions. Industries readjust their minimum acceptable level of quality and maximum acceptable price required to be a player in the marketplace. There are revolutions in quality that raise standards and then new revolutions that shatter those standards. There are innovations in product or process technology that drive dramatic improvements in quality or reductions in cost. These cycles of change are growing progressively shorter. Advances in information, manufacturing, and basic technology have accelerated so quickly that many processes and products now have lives of three months or less before they become obsolete.

DYNAMIC STRATEGIC INTERACTIONS AND THE ESCALATION LADDER

We begin this chapter with the most primitive of all economic situations -- the case where two companies make the same product (with the same quality) and thus are forced to compete on price. We see how this simple situation escalates into price wars, then differentiated markets, then full-line producers, and then niche strategies, as competitors try to avoid the brutality of price wars. A sophisticated movement toward offering progressively higher customer value evolves. Like the force of gravity, the overall process of moves and countermoves tends to draw the industry back toward a price-competitive market after all the firms focus on imitating or outmaneuvering earlier moves. At some point everyone must move toward high quality and low cost to survive, and many firms offer the same range of product variety. Thus, the dynamics of competitive interaction cause product price and quality to cease to be opportunities for gaining advantage over competitors.

The individual players might be better off if they didn't escalate the competition toward this situation. But the dynamics of their interaction force them along this path. If one of them were to drop out of the competition, the other would gain a temporary advantage. Each one cannot trust the other to de-escalate the conflict. This course is set in motion the minute the two players step into the arena of competing on price and quality.

We have observed during our research that firms interact competitively at each step of the way so as to escalate the conflict. This series of dynamic strategic interactions defines each step or level of competition within the cost (and price)-quality arena. We will observe each dynamic strategic interaction between players, looking at how it was caused by the previous dynamic strategic interaction and at how it leads to the next level of interaction. Overall, each step moves the industry up the "escalation ladder" toward a situation in which cost and quality are no longer a source of competitive advantage.

What Is Quality?

When we discuss quality here, we are referring to "perceived quality" of consumers. This can sometimes be very close to more concrete measures of quality (all of which are defined by consumers), but for some products consumers just don't take the time to carefully assess quality, particularly for products that are low investment. Some consumers may be relatively unconcerned about costs for a product for which quality is the fundamental concern or a product such as a tube of toothpaste for which the cost is small enough not to matter much. Differences in customer perceptions can distort the broader view of price and quality presented here. Perceived quality also changes over time as customer preferences shift. A concern with automobile luxury shifts to a concern with gas mileage during the oil-strapped 1970s and then becomes an obsession with safety in the 1980s and 1990s.

From a marketing standpoint such broad approximations leave much to be desired. From an economic viewpoint the approximation of referring to "quality" as a clearly defined characteristic is one that is taken as a given in most models. The model that follows assumes that there is a general standard of quality in an industry and that consumers are concerned about both price and quality. At the level of analyzing an individual company or industry, on the other hand, differences in perception of quality can be key and should be given careful consideration.

What is even more important is that these differences in the perception of quality and changes in the view of quality can be put to good use by companies searching for advantages. These quality perceptions change, and differences can provide key points of leverage in influencing the dynamic process of competition. As we will discuss in considering stakeholder satisfaction and strategic soothsaying in Part II, keeping in touch with emerging needs of customers and identifying new ways to meet those needs or emerging needs are essential strategies in hypercompetitive markets.

The First Dynamic Strategic Interaction: Price Wars

Unlike some other longer-lasting competitive moves, price changes can be very rapidly imitated, leading to all-out price wars. These conflicts can be particularly intense if the two firms have different costs, making it easier for one of them to cut prices. This encourages firms to compete by seeking cost reductions. Thus, price wars result when quality is not a factor. In Figure 1-1, if all firms are at point C, price moves downward. Price wars are not so simple, however. There are, for example, some interesting strategies for fighting price wars, which we consider below.

ALL-OUT WAR: TYLENOL'S HEADACHE

Typically a price war looks like the situation that occurred when Datril took on Tylenol in the pain reliever market. Datril offered the same formula medicine for a lower price, capturing half of Tylenol's sales in test markets in 1975. But Tylenol responded aggressively by lowering its price and launching its first ad campaign. Tylenol, which had as much as 37 percent of the analgesic market at one time, could fight with lower prices because of its economies of scale. As a result, Datril ended up with less than 1 percent of the market. But the battle was not without damage. In the process Tylenol gave up millions in profits.

However, less aggressive alternatives are available. Competitors can use restraint, hidden price wars, and phantom price wars to avoid a head-to-head confrontation on prices.

RESTRAINT

In purely competitive markets price should fall to the marginal cost of the lowest-cost producer, who would normally be expected to expand to capture market share from higher-cost producers until it fills all of its capacity. Ultimately the lowest-cost producer should capture 100 percent of the market if he expands capacity to meet demand.

There are several reasons why industries don't always evolve this way. Antitrust regulations discourage single-player dominance in most industries. Often the low-cost producer has inadequate resources to build the capacity to cover the entire industry. Even if the firm has the resources, it might not want to take on the risk of putting all its eggs in one basket. To avoid problems of demand fluctuations such as those created by seasonality or business cycles, the company might restrict its capacity and raise its prices above its own costs, thereby leaving some market share for a second or third player. This forces some of the risk of demand fluctuations onto the higher-cost players and concedes the unattractive niches to competitors. This strategy satisfies the pressure on the low-cost producer for short-term profits and allows the company to share the market with a smaller, higher-cost player for antitrust reasons.

If the low-cost producer does not capture the entire market, the second- or third-lowest-cost producers move into this opening with goods at their higher costs. This depends on the capacity of the next two or three players compared to the demand for the product beyond what is fulfilled by the lowest-cost player in the industry. In such cases, the small number of competitors makes it easy for firms to tacitly collude to keep prices up. The low-cost producer may raise his price to the cost of the second- or third-low-cost producer. This keeps everyone happy, except the customer. Of course, this collusion has to be implicit, because an explicit agreement would violate antitrust laws.

HIDDEN PRICE WARS

If, as suggested by our discussion of restraint, prices in the industry have equalized at a point above the costs of the lowest-cost producer, this allows room for more subtle price wars: disguised price wars and phantom price wars.

Indisguised price wars,financing, installation and repair services, or replacement parts can be used to adjust the final price of the product up or down without changing its initial offering price. The initial price is kept high, but the company offers incentives that reduce the actual price. This might be an airline that provides frequent-flier points, an automaker offering zero-percent financing, or a manufacturer who provides lower-cost replacement parts or a better delivery schedule to cut the buyer's inventory costs.

Inphantom price wars,the initial price is kept low, but it is made up for by higher prices for using the product. For example, a car may have a low sticker price but high costs for replacement parts and maintenance, or Polaroid may offer lower instant camera prices but higher film costs than Kodak, or vice versa.

These strategies often create switching costs for the customer. Customers with frequent-flier points, trade-in allowances, or a design based on nonstandard replacement parts will be less price sensitive on their second purchases. The features that link the customers to the original supplier raise the perceived value of the product. This begins to shift the focus of competition from price to quality and service.

THE PERILS OF PRICE WARS

There is a strong incentive to move away from price wars. As we saw in Tylenol's battle with Datril, price wars are brutal. They are the economic equivalent of the game of holding one's breath to see who turns blue first. The individual with the greatest lung capacity wins, but both end up weakened and exhausted. (See Chapter 4 on deep pockets for more about this aspect of dynamic strategic interaction.)

Price wars produce profits only if costs are kept well below the price during the war. The war can generate big losses because, once the weak firms are driven out of the market by a price war, the survivors often can't recapture losses created by the war by raising prices after the war is over. If customers have no brand loyalty and no switching costs (sunk capital or personal investments related to the product that are lost if the customer changes products), any subsequent increase in price will lead to defections.

In addition, it is often hard to contain the losses from a price war once one has begun. Seizing and holding market share is crucial for gaining economies of scale and to spread out fixed costs over a large volume. So all firms will try to keep their prices at the lowest possible levels to gain economies of scale to further lower their costs. However, this squeezes profit margins in the short run. The squeeze isn't too bad when the demand is greater than industry capacity, but it can be severe, leading to huge losses, when the demand drops below industry capacity.

This puts the company involved in price-competitive markets at the mercy of fluctuations in demand. When demand declines, the price war will worsen and a shakeout often occurs. This is not a favorable situation for the long-term success of most firms. It drives many firms to seek a higher level of competition -- on both price and quality -- thereby escalating the conflict one more notch on the escalation ladder.

The Second Dynamic Strategic Interaction: Quality and Price Positioning

GENERIC STRATEGIES EVOLVE

To escape the price war, companies differentiate themselves by quality as well as by price. Some firms move from point C in Figure 1-2 to what Porter calls the low-cost producer position (L), offering a lower price and a lower-quality product. Others become what Porter calls differentiators (position D), offering a product with a premium price and higher perceived quality.

As shown in Figure 1-2, the value (quality-price ratio) remains constant across the high and low ends of the line in the graph. The low-cost producer and differentiator firms serve fundamentally different groups of customers, but they offer similar value in the sense that customers get the level of quality they are willing to pay for.

For commodity products, the movement to D and L may seem impossible. It would appear that these industries should stay locked in perpetual price wars. But in most commodity industries, such as steel and paper, resourceful organizations have found ways to differentiate their products based on quality or service. While traditional U.S. and Japanese steel-makers wrestled to cut the costs of their products, the U.S. minimills quietly changed the rules of the game. The minis can produce specialty steels from scrap metal much more quickly and cheaply than the large steel mills. Advances in technology that improved the output of these small mills have made them a more serious threat to the large U.S. mills than the Japanese. From 1980 to 1990, their share of the domestic market has risen from 28 percent to 37 percent.

Through downstream vertical integration Kimberly-Clark transformed itself from a lumber and paper company into a consumer-products company. It differentiated specific brands of bathroom tissues, sanitary napkins, and disposable diapers. The company moved out of the price wars in the commodity paper and pulp industry into more stable markets where it could compete on both quality and price.

The desirability of each position (L vs. D) depends on the number of firms that move into each position, the size of the customer base desiring products at that price-quality level, the ability of others to enter the market segment later, and changes in the economy or demographics that might shift customer preferences from high- to low-priced goods or vice versa.

WITHIN-SEGMENT POSITIONING

Once these positions are staked out clearly, a new form of competition results. If there is more than one firm at each position, there can be smaller price and/or quality skirmishes at each position. The value (ratio of quality to price) offered by groups of firms within each position could vary, so some customers may start moving toward the firm that offers the higher value at that position. For example, within the luxury car segment of the auto market, the differentiator position, there are many competing manufacturers offering various combinations of price and quality. As indicated in Figure 1-3, within the differentiator position of the larger industry, some customers might perceive Mercedes as the differentiator compared to Cadillac's position. Within the low-cost producers, some customers might perceive Nissan's Stanza as a differentiator compared with Yugo.

BETWEEN-SEGMENT POSITIONING

Thus, the battle shifts to price and quality differentiation within each segment. However, this type of competition can escalate to even higher levels -- competition between segments. This occurs in two ways. Either the distance between L and D can be reduced so that the two segments overlap (as shown in Figure 1-4) or the value offered by L or D can be improved (as shown in Figures 1-5a and 1-5b). The first method allows L to siphon off the low end of D's market or D to siphon off the high end of L's market. The second method forces (1) low-end consumers to decide whether they want to pay the lowest total price or get the highest value (quality per dollar) for their money (Figure 1-5a) and (2) high-end consumers to decide whether they want to buy the highest-overall-quality product or get the highest value (quality per dollar) for their money (Figure 1-5b). Thus, the next rung in the escalation ladder is reached by gradual extension of the methods used in the war on price and quality within each segment.

The Third Dynamic Strategic Interaction: The Middle Path

BEING IN THE MIDDLE

The simplest way to outmaneuver firms at D or L is to try to move into the middle position (position M in Figure 1-6). This is not such a bad spot to be in, as long as the company can offer the same value as D and L. It can then draw away some of their customers, both low-end customers seeking slightly higher quality and high-end customers seeking slightly lower prices. As long as the overall value remains the same, customers are often willing to make some movement down or up along the constant value line shown in Figure 1-6. This suggests that being in the middle can be perilous if it overlaps too much with the firms staking out the L and D positions. If provoked, firms in positions L and D may launch a two-front attack on firms in position M and squeeze it from both sides.

BEING STUCK IN THE MIDDLE

In contrast to being in the middle, a firm can be in even more trouble if it is positioned at SM in Figure 1-6. If the company is at point SM, at a lower value ratio, it will have a harder time competing, since it will be what Porter calls "stuck in the middle." The company may be able to carve out a niche for itself as a high-cost, low-quality player if it serves a niche that no one else is currently selling to or if it can offer something unique -- like service or convenience -- that compensates for the lower perceived quality of the product itself. But it is unlikely that it will survive at this point over the long haul unless it finds a way to make up for the high price of its low-quality goods with some unique service or attribute for a specialized niche of customers. Most customers will ask themselves why they should buy from SM when they can get higher quality at the same price from D or get the same quality for a lower price from L. In most cases only a few customers want the unique service or convenience of SM enough to trade off cost or quality. If SM can move to point M, with the same value ratio as the two extreme players, it has a better chance of staking out a viable segment of the market.

As noted above, the M position could provoke a response from D (who might reduce price) or from L (who might raise quality) to squeeze M out of the market. Thus, the M position can be unstable unless D and L are so far away in price and quality that they are in segments of the market that are not threatened by M. (For example, if L is a VW Beetle and D is a Rolls-Royce, there is plenty of room for a Buick to stake out position M.) Even if M is not a defensible position, it might be a good offensive move. It disrupts the original positions of D and L and costs them money, perhaps even forcing D and L to move out of their original positions to make room for a determined, aggressive firm staking out position M. This strategy is also expensive for M and probably requires either deep pockets or a weak adversary to make it work.

If the distance between D and L is large, then there will be a hole in the middle where a new entrant can make inroads or a current player can move. If the distance between D and L is small, on the other hand, entrants can attack by outflanking at the high end or low end of the market. So whichever position competitors D and L take can be outmaneuvered, as we will see in the next two dynamic strategic interactions.

The Fourth Dynamic Strategic Interaction: Cover All Niches

A GIANT MAKER: THE FULL-LINE PRODUCER STRATEGY

Because of this threat of entry at the middle of the market, which would require costly defensive moves, companies such as D and L often try to protect themselves against this type of attack. This escalates the level of competition from battling over the positions of individual products to competing as full-line producers. Food companies, for example, have attempted to fill up the breakfast cereals market with numerous brands to fill all the niches, making it hard for anyone to enter the market with sufficient economies of scale by squeezing into the small remaining niches between existing brands. Again, the last dynamic strategic interaction (moving into the middle) causes an escalation by forcing firms to gain access to more of the market to make it harder for new entrants to find a niche in the middle.

General Motors was one of the originators of the full-line strategy. Customers can start with a Chevy and, as their income increases, move up through Pontiacs, Buicks, and Oldsmobiles to Cadillacs (see Figure 1-7). IBM also took this approach with its System/360 series in 1964, the first family of compatible computers that spanned the market from the high end to the low end. Six compatible processors were in the family, the biggest of which was fifty times faster than the smallest. And the company continued to add more models to the line over the years. The 360 series set the standard for the industry for decades after its launch. Both GM and IBM serviced customers over their lifetime by encouraging trade-up to higher-and-higher-priced products. This full-line producer strategy has been so successful that it has built some of the largest firms (like GM and IBM) in the world.

DIFFICULTIES WITH FULL-LINE PRODUCER STRATEGIES

While there are obvious advantages to this approach, this strategy, like all others, is open to being outmaneuvered. In most industries firms cannot span the entire price-quality continuum, and customers don't trade up. There are, instead, distinct market segments with completely different critical success factors. In breakfast cereals, for example, the all-natural healthy breakfast segment opened up, allowing entry to segments that very few of the existing brands covered. In addition, in some industries, applying the same company name to a wide range of products can cause a confused image among consumers, as some lines of hotels are finding. For example, the use of a hotel's name on low-end inns has tainted the high end of the hotel chain, while the low-end inns aren't perceived as low-priced because of the high-end hotel name. Often this problem can be solved by applying different brand names to different segments of the market, as Honda did for its highest-end product, Acura. However, it is often difficult to be both a low-cost producer and a differentiator at the same time. It may be impossible, for example, to be both a low-cost producer of mass merchandised chain saws for casual users while still providing the high-overhead services demanded by the professional end of the market. The casual market requires simple saws with a short useful life (approximately one hundred to two hundred hours of use over a lifetime). The professional market requires complex, powerful saws to cut down a wide variety of trees and useful lives of several thousand hours. Manufacturing methods and distribution outlets are so entirely different for the two markets that they would have to be done by entirely different subunits of the company, each recognizing the completely different critical success factors relevant to the segments.

The Fifth Dynamic Strategic Interaction: Outflanking and Niching

FILLING IN THE HOLES

Even when it is possible to pursue a full-line strategy, covering the market does not always prevent entry by competitors. While the full-line producer is forced to look at the big picture, smaller players can enter by focusing on small segments of the market. If there is sufficient room for growth within a single market segment, some companies may decide to stake out that point on the price-quality continuum and concede other positions to full-line competitors. Others will go to the extremes of the market, targeting the high end or low end not covered by the full-line producer.

Apple moved into the low end of the computer market with its personal computer, ultimately threatening IBM's position as a full-line mainframe producer. Big Blue also faced competition from smaller companies that carved out niches in mainframe markets. Finally, it was taken on in price on its own personal computer by a host of low-cost clone makers. IBM saw its hold on the world computer market drop from around 30 percent in 1985 to 21 percent in 1990, according toManagement Today.Similarly, J

Excerpted from Hypercompetitive Rivalries: Competing in Highly Dynamic Environments by Richard A. D'Aveni, Robert Gunther
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