As assessed in Week 3, a SWOT analysis can provide a variety of complex applications to the world of business strategic planning. From this examination, there are further revelations in connecting a SWOT analysis to stakeholder communication and engagemen

http://www.ibtimes.com/ibm-layoffs-computer-company-cuts-thousands-jobs-worldwide-part-restructuring-plan-1304949

http://www.census.gov/eos/www/naics/index.html

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Analysis of the External Environment: Opportunities and Threats

LLUIS GENE/AFP / Getty Images

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Studying this chapter should provide you with the knowledge to:

1 Explain the importance of correctly identifying and choosing a firm’s industries and markets.

2 Identify and measure the five major forces that shape average firm profitability within industries to evaluate the overall attractiveness of an industry.

3 Discuss how understanding the five forces that shape industry competition is useful as a starting point for developing strategy.

4 Identify the factors in the general environment that affect firm and industry profitability.

L E A R N I N G O B J E C T I V E S

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N okia, a long-time leader in the telecommunications

equipment and mobile phone industry, got its start

in that industry in 1981 when it acquired a 51 percent

stake in a Finnish telecommunication firm. Since that time,

Nokia has sold more mobile phones than any other company.

The firm has been the world leader in market share since

the mid-1980s. By 2008, Nokia’s worldwide market share

had reached 40 percent, more than double the approximately

18 percent market share of Samsung, its nearest rival. The

Nokia brand was a top seller everywhere, including the

United States, China, Latin America, and Africa.

Not only was Nokia the leader in handset manufacturing,

offering value to its customers by manufacturing a full line

of phones from the lowest end of the price range to the most

expensive, the company also manufactured some of its own

cell-phone components, such as cameras and accessories.

In addition, Nokia designed and manufactured network

infrastructure equipment, launched a gaming device

(N-Gage) that tapped into the entertainment and media

markets, and owned Symbian, the leading operating system

for the new generation of multifunctional 3G phones. In all,

Nokia had nine divisions producing products for a variety of

industries, each with separate profit and loss accountability.1

As late as 2003, Nokia appeared to have a competitive

advantage in cell phones in the same way that Microsoft had

an advantage in PC operating system software and Intel in

microprocessors.

By 2010, however, Nokia had taken a nose dive. Although

it still held a reasonable 32 percent of the worldwide

market share of cell phones, the company commanded

only 2 percent of the emerging smartphone market in

North American. Nokia’s profits had plunged 68 percent,

from nearly €8 million in 2007 to only €3.3 million in 2009.

Moreover, the firm’s stock also tumbled, falling 86 percent

from a high of $39.57 a share in October 2007 to $7.15 a

share in April 2014.

What happened? To a large extent, Nokia was caught off

guard by fundamental changes in the mobile phone industry

from 2003 to the present. Before the introduction of 3G (third

generation) smart phones, the cell phone manufacturing

industry had power over its suppliers, the makers of chips,

and other parts for cell phones. Software wasn’t a big part

of the picture and most handset makers programmed their

own software. The firm that could make the most attractive

phone with the best hardware features at the lowest cost

outperformed others in the industry. For years, Nokia had

offered unique value to its customers by having the latest

and best hardware.

With the advent of 3G smart

phones, however, software became

the central differentiator. Today, most

people buy a phone based on its

operating system and the applications

the operating system can run. Nokia

did see the change coming and poured Research and

Development (R&D) dollars into its own Symbian operating

system, focusing on building the resources and capabilities

necessary to compete in software. In 2003, 80 percent of all

3G phones—the first ones able to surf the Internet—were

sold by companies that had licensed Nokia’s Symbian

operating system. In contrast, Microsoft, Nokia’s major

competitor at the time, had great difficulty with the early

launch of Windows Mobile operating system for 3G smart

phones. Several of Microsoft’s partners abandoned Windows

Mobile for Nokia’s Symbian system.2

Nokia and the Smartphone Industry

0 2

NOKIA FAILED, HOWEVER, TO LOOK MORE BROADLY AT WHAT THE CELL PHONE MARKET WAS BECOMING AND WHO MIGHT BECOME ITS NEW COMPETITORS IN THAT EMERGING MARKET. IT WASN’T PREPARED TO COMPETE WITH THEM AND COULDN’T SUSTAIN ITS COMPETITIVE ADVANTAGE.

DETERMINING THE RIGHT LANDSCAPE: DEFINING A FIRM’S INDUSTRY [ 23 ]

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Nokia failed, however, to look more broadly at what the

cell phone market was becoming and who might become

its new competitors in that emerging market. It wasn’t

prepared to compete with them and couldn’t sustain its

competitive advantage. With the introduction of Apple’s

iPhone and Google’s Android operating system, Nokia’s

share of operating systems plummeted so far that the

company eventually teamed up with its old rival, Microsoft,

to offer Windows Mobile 7 on Nokia phones.3 But this did

little to stop the onslaught from Apple and Samsung, who

sold phones using Google’s Android system. In the first

quarter of 2011, Nokia sold 108.5 million handsets for a

total of $9.4 billion. Apple, in contrast, sold only 18.6 million

iPhones but made $11.9 billion.4 Nokia had clearly lost the

market for high-end phones to Apple and other phones

running the Android operating system. In addition, Nokia’s

low-end handsets were under pressure from new Asian

manufacturers. Indeed, thousands of new low-cost Shanzhai

manufacturers, small Chinese firms focused on creating

knockoff products, now make phones with names such as

“Nckia.” The Shanzhai manufacturers flooded the markets

in China, India, the Middle East, and Africa, threatening to

erode Nokia’s market share in the remaining markets where

Nokia was still dominant.5

Indeed, Nokia’s position in cell phones became so

stark that in 2013 it sold its entire cell phone business,

the cornerstone of its previous success, to Microsoft. Not

only did Nokia have to sell, but it did so at a shockingly low

price of only 5.5 billion euros, off from the highest market

capitalization of 110 billion euros during its glory days.6

As described in Chapter 1, strategy involves crafting a plan to create competitive advantage—and superior profitability—in particular markets. This plan, however, is shaped by the landscape in which the firm competes. A firm’s external environment provides both opportunities—ways of taking advantage of conditions in the environment to become more profitable—and threats—conditions in the competitive environment that endanger the profitability of the firm.7 Successful firms have a deep understanding of their environment and constantly scan the horizon to see opportunities and threats as they emerge.8

One of the key threats a strategist must understand and cope with is competition. Often, however, managers define competition too narrowly, as if it occurred only among today’s direct competitors. Nokia was so focused on Microsoft as its key competitor in the 3G operating system industry, and Motorola and Ericsson as its cell phone competi- tors, that it failed to effectively prepare for Apple’s entry into the industry. Competition for profits goes beyond established industry competitors to include four other forces that shape industry attractiveness and profitability : customers, suppliers, potential entrants, and substitute products. Together, all five forces define an industry’s structure and shape the competitive interactions—and profitability—of companies within that industry. Even though industries might appear to differ significantly, the principles that determine the underlying drivers of profitability are often the same. The global cell phone industry, for instance, appears to have nothing in common with the highly profitable soft drink industry or the low-cost airline industry (i.e., Southwest and JetBlue). But to understand industry competition and profitability in these and other industries we must analyze the same five forces.

This chapter will help you to recognize the major threats and opportunities that make up the competitive landscape, both the industry forces and general macroeconomic forces that drive industry attractiveness—and profitability.

DETERMINING THE RIGHT LANDSCAPE: DEFINING A FIRM’S INDUSTRY

The first strategic decision that most firms must make is to select the industry, and markets, in which it will compete. The Strategy in Practice feature discusses the U.S. government’s classification of industries.

A firm’s industry also determines which customers and which competitors will be part of the firm’s landscape. The landscape is typically defined by: (1) the industry (or industries) in which a firm competes, and (2) the product and geographic markets within that indus- try that the firm targets. For example, Nokia competes primarily in the cellular telephone

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One tool that helps to define industries is the NAICS (North American Industry Classification System), a series of codes generated by the U.S. government.9 These

codes (formerly referred to as SIC codes, for Standard

Industrial Classification) vary from two to seven digits,

becoming more narrow with increasing numbers of digits.

Table 2.1 provides the NAICS codes for the cell phone

handset manufacturing and mobile operating system

industries. In Nokia’s early years, it competed primarily in

category 334220, cell phones. As cell phones became more

sophisticated, Nokia also began to compete in category

511210, operating systems.

NAICS codes can be useful not just for helping to define

an industry but also for determining who the primary

competitors are, although in fast-changing industries, the

NAICS can sometimes lag behind changing technologies or

changing customer demands. As we’ve seen, Nokia failed

to seriously update its definition of its industry to include

all the companies competing under its new classification

code.

The choice of industries is important because not all

industries are created equal. The profits of an average

firm in some industries are substantially higher than

profits of an average firm in other industries. Figure 2.1

shows the return on equity for a variety of industries over

a ten-year period. As you can see, the industry in which a

firm competes has a direct bearing on the profits earned

by that firm.

How the U.S. Government Defines Industries S T R AT E G Y I N P R A C T I C E

[ Table 2.1 ] NAICS Codes for Nokia

HANDSET HARDWARE BUSINESS HANDSET SOFTWARE BUSINESS

Code Classification Code Classification

33 Manufacturing 51 Information

334 Computer and Electronic Product Manufacturing 511 Publishing Industries

3342 Communication Equipment Manufacturers 5112 Software Publishers

33422 Wireless Communication Equipment Manufacturers 51121 Software Publishers

334220 Cellular Telephone Manufacturers 511210 Operating Systems Software Publishers

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[ Figure 2.1 ] Varying Attractiveness of U.S. Industries 2000–2010

Source: Troy’s Almanac

FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES [ 25 ]

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manufacturing and operating system industries. Within the cellular telephone manufactur- ing industry, Nokia targets multiple product markets by selling a range of handsets, from high-end smart phones to inexpensive basic phones. The company also targets multiple geographic markets, focusing mainly on Europe and developing economies in the Middle East and Africa.

Be careful about assuming that it is obvious which industry a company competes in. For example, it seems obvious that Barnes & Noble competes in the book retailing industry and Microsoft competes in the computer software industry. However, it may be less obvious that those aren’t their only industries. In addition to operating systems, Microsoft also makes the X-Box gaming system, so it competes in the gaming console industry as well as the PC oper- ating system industry. Barnes & Noble sells an e-reader, the Nook that combines electronic books with computer hardware. Amazon.com, Barnes & Nobles’ main book retailing com- petitor, not only sells books and the Kindle e-Reader, but also sells web services competing with Microsoft and a wide range of products online as a discount retailer competing with Walmart. Firms must choose which markets to compete in, with many large firms choosing to compete in several at the same time.

If managers do not properly define and understand their industry, they may be vul- nerable to unseen competitors. For example, Nokia defined itself primarily as a mobile handset manufacturer. As a result, managers failed to see computer hardware companies like Apple and web search companies like Google becoming potential competitors—or potential partners. Their focus on preventing Microsoft from creating a dominant position in the mobile operating system industry caused them to overlook Apple, a company that has consistently been the leader in innovative, user-friendly operating systems for a variety of platforms.10

Truly understanding an industry often begins by taking a customer-oriented view. Rather than identifying the industry based on the product or service they produce (such as cell phone handsets), firms should think carefully about the job that products do for cus- tomers. What need does a product fill? Understanding customer needs can be very helpful in defining the boundaries of an industry. If two firms have products that do the same job for customers—they meet similar customer needs—then those two firms can be considered part of the same industry. For instance, companies that meet the need for communication by manufacturing mobile handsets, as opposed to mobile ham radios (long-range walkie talkies), compete in the same industry.11 In the case of cell phones, changing customer needs broadened the boundaries of the industry, from primarily hardware manufacturing to include mobile operating systems and applications that allowed phones to do far more jobs for customers than just place a phone call. This led to new competitors for Nokia, including Apple and Google.

FIVE FORCES THAT SHAPE AVERAGE PROFITABILITY WITHIN INDUSTRIES

Michael Porter, a well-known strategy professor at Harvard, identified five forces that shape the profit-making potential of the average firm in an industry. As shown in Fig- ure 2.2, those five forces are: (1) rivalry, (2) buyer power, (3) supplier power, (4) threat of new entrants, and (5) threat of substitute products. The strength of each of these five forces (known as Porter’s Five Forces12) varies widely from industry to industry. For instance, in the semiconductor industry, the threat of substitutes is almost nonexistent, while in the carbonated soft drink industry it is a significant threat. A careful analysis of the five forces is a powerful way for firms to discover the threats and opportunities in their environ- ments. We provide a tool at the end of this chapter to help you conduct a careful analysis of an industry’s five forces.

There are three basic steps involved in using the five forces analysis tool: Step 1: Identify the specific factors relevant to each of the five major forces. We describe the factors that contribute to each of the five forces in the next five sections of this chapter.

rivalry Competition among firms within an industry. Typically this

involves firms putting pressure on

each other and limiting each other’s

profit potential by attempting to

steal profits and/or market share.

substitute A product that is fundamentally different yet serves

the same function or purpose as

another product.

threats Conditions in the competitive environment that

endanger the profitability of a firm.

opportunities Ways of taking advantage of conditions in the

environment to become more

profitable.

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Step 2: Analyze the strength of each force. To what extent is it shaping the industry’s attractiveness? The appendix at the end of the book lists several sources where you might find the data you need to analyze each of the five forces.

Step 3: Estimate the overall strength of the combined five forces to determine the general attractiveness of the industry, the profit potential for an average firm in the industry.

Instructions for steps 2 and 3 are at the end of the chapter. Step 1, the factors relevant to each of the five forces, is discussed next.

Rivalry: Competition among Established Companies Competition in an industry is sometimes referred to as war, with each company deploying as many weapons in its arsenal as possible to gain greater profits. Because there are typically a lim- ited number of buyers, each firm’s profits often come at the expense of other firms in the indus- try. Each move by a firm provokes countermoves among competitors, resulting in a constantly shifting competitive landscape populated by winners and losers. (Chapter 11 explores how suc- cessful firms manage that shifting landscape by planning for the countermoves of their rivals.)

Firms’ moves and countermoves can take many forms, including sales and promotions, better quality or service, a wider variety of products, or lower prices. Not surprisingly, these types of moves increase rivalry—the intensity with which companies compete with each other for customers—which tends to squeeze the profit margins of most firms in an indus- try. Rivalry among firms in an industry—for either rational or irrational reasons—is such an important driver of profitability that it is shown at the center of Figure 2.2.

The following seven factors are critical to understanding the intensity of rivalry in an industry:

1. The number and size of competitors

2. Standardization of products

3. Costs to buyers of switching to another product

4. Growth in demand for products

attractiveness of an industry The degree to which an average firm in

the industry can earn good profits.

NEW ENTRANTS

BUYER POWER

SUPPLIER POWER

SUBSTITUTES

COMPETITOR RIVALRY

[ Figure 2.2 ] Analyzing Major Threats: The Five Forces Industry Analysis Tool

Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 86,

1 ( January 2008), pp. 80–86.

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5. Levels of unused production capacity

6. High fixed costs and highly perishable products

7. The difficulty for firms of leaving the industry

The Number and Relative Size of Competitors. The more competitors in an industry, the more likely that one or more of them will take action to gain profits at the expense of others. Economists call an industry with a lot of competitors a fragmented industry. In a fragmented industry, it is difficult to keep track of the pricing and competitive moves of multiple players. The large number of firms responding to one another tends to create intense rivalry. The same is true of the relative sizes of competitors. If firms are approximately the same size, they tend to be able to respond, or retaliate, strongly to moves by rival firms.

Industries that are concentrated, as opposed to fragmented, have far fewer competitors and tend to be dominated by a few large firms. In these industries, rivalry is typically much less intense. Smaller competitors do not have the capability to respond to actions taken by large firms, and the few large competitors are more aware of each other and less likely to risk actions that may result in price wars.

Relatively Standardized Products. Differentiated products, ones that boast different features or better quality, tend to engender loyalty in customers because they meet customer needs in unique ways. When products are standardized, or commodity-like, buyers are less loyal to a particular brand and it is easier to convince them to switch brands. A rider may be fiercely loyal to his or her Harley-Davidson motorcycle, for example, but willing to buy several different brands of gas for the Harley. Firms that sell standardized products—manufactured products or materials that are interchangeable regardless of who makes them like bolts and nuts, rubber, plastics or commodities such as coal, crude oil, salt, or sugar—often have to compete by offering sales, rebates, or lowering prices. Price wars increase rivalry and decrease profits.

Low Switching Costs for Buyers. Switching costs include any cost to the customer for changing brands. Switching costs for buyers are related to the degree of product standardization. For a computer user, changing operating system or word processing software would entail considerable switching costs because the user would need to: (1) convert files to the new software, and (2) learn how to use the new software. Switching from an iPod to another MP3 player might require music lovers to move all of their music files from iTunes to a different music software. In contrast, most of us can change our brand of gum or candy bar without any switching costs. The lower the switching costs, the easier it is for competitors to poach customers, thereby increasing industry rivalry.

Switching costs are a fundamental part of not just rivalry but also the other four forces:

1. Buyer power. If customers, or buyers, can easily switch firms, then buyers have increased power.

2. Supplier power. If firms can’t switch suppliers easily, then suppliers have increased power.

3. New entrants. If buyers can easily switch to new companies attempting to enter the industry, there is a greater threat of new entrants.

4. Substitutes. If buyers can switch to substitute products without much difficulty, firms face an increased threat from those substitutes.

Slow Growth in Demand for Products or Services. When demand is increasing rapidly, most firms can grow without taking existing customers from competitors. When growth slows, however, firms can become desperate. They may try to increase their sales volume by attracting customers from their competitors through sales promotions, price discounts, or other tactics.13 Of course, competitors then respond with their own sales promotions and price cuts, thereby increasing industry rivalry. Consider the flat-screen television industry. When large, flat-panel displays were first introduced, prices were high. They remained that way for years while industry growth exploded. As flat-panel manufacturers anticipated slower growth, from 18 percent in 2010 to 4 percent in the first half of 2011, they dropped prices by more than 25 percent in the last quarter of 2010 in a bid to gain what market share they could from their competitors.14

switching costs Barriers that help keep buyers using the same

supplier by imposing extra costs for

switching suppliers.

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High Levels of Unused Production Capacity. Unused production capacity is expensive. Firms typically try to produce at or near their full production capacity so that they can spread the fixed cost of factories, machinery, and other means of production across more units. In fact, they may try to produce more product than the market demands, in order to use their capacity completely. However, when more is produced than is demanded in the market, firms often have to drop their price or risk having unsold product. This has frequently been the case in the automobile industry. During an economic downturn, automakers offer price cuts, rebates, and special sales incentives to buyers so that they don’t have significant unused production capacity.

High Fixed Costs, Highly Perishable Products, High Storage Costs. Industries that produce or serve products in these three categories sometimes find themselves with a supply of products that they have to sell quickly or take large losses on. For example, airlines operate with high fixed costs. Most of the cost of a flight is in the airplane, the fuel, and the pilot and flight attendants. It is not in the cost of serving an additional passenger. The marginal cost of adding an additional passenger is truly only peanuts (and a drink). If it appears that a scheduled flight is going to have few passengers, an airline may be tempted to discount steeply in order to fill as many seats as possible. The variable cost of an additional passenger is very little, so selling a seat for less would not cost the airline money, but leaving it empty would mean the airline has fewer passengers over whom to spread its fixed costs.

Firms that sell highly perishable products, such as fruits or vegetables, face similar prob- lems. As food nears the date when produce will spoil, grocery chains often steeply discount it rather than lose the sale completely. Products with high storage costs exhibit the same characteristics. If firms have an oversupply and are forced to store the product, they may dis- count the price to avoid storage costs. In all three cases, steep discounting leads to increased rivalry as competitors are forced to respond with discounts of their own, or be left with losses while others recoup their production costs.

High Exit Barriers. In some industries, companies don’t exit even when they aren’t making a lot of money. Most often, they stay because they have made investments in specialized equipment that can’t be used in any other industry. For example, steel blast furnaces are very expensive and cannot be used in any industry other than steelmaking. If the firm exits the steel industry, its blast furnaces lose most of their value. Another barrier to exit is labor or government agreements that make it difficult to close a plant. Emotional ties to employees or a business can also lead to less than rational decisions by top management to stay in business.

Buyer Power: Bargaining Power and Price Sensitivity When buyers have sufficient power, they can demand either lower prices or better products from their suppliers, thereby hurting average profitability of firms in the supplier indus- try. The two primary situations in which buyers have high power are when buyers hold a stronger bargaining position than sellers and when buyers are price-sensitive. The strength of a buyer’s bargaining power or price sensitivity can be affected by a number of factors. When firms understand what causes buyers to have power over their industry, they have a better chance of countering that power.

Buyer Bargaining Power. Four key factors influence the degree to which buyers have bargaining power over their suppliers. We already discussed two of these factors—buyers’ switching costs and demand—because they are also factors in rivalry among firms. The two remaining factors are the concentration and size of buyers and the threat that buyers can backward integrate:

Number, or concentration, and size of buyers. Buyer concentration reflects the law of supply and demand. If there are few buyers but many sellers, then the sellers must compete more strongly for buyer business. Sellers in this situation are likely to give concessions to make the sale. Likewise, the larger the buyers, compared to sellers, the more likely sellers are to increase the level of competition in order to gain buy- ers’ business. For example, farmers, as suppliers to the frozen-food industry, are not very concentrated. The three largest farmers account for only about 1 percent of all

supplier A firm that provides products that are inputs to another

firm’s production process.

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food produced and sold. Frozen food makers, however, are concentrated. The top four (Nestlé, Schwan, ConAgra, and HJ Heinz) accounted for nearly half (48.6 percent) of total market share in their industry in 2010.15 This means that frozen-food manufactur- ers, as buyers, have a great deal of power over farmers. A farmer who needs the busi- ness of the big four frozen-food makers in order to sell this year’s crop may be willing to accept a lower price in order to secure their business.

Credible threat of backward integration. In some cases, a buyer can exert pressure over suppliers by threatening them with backward integration, meaning they will make the product themselves. For example, one way Walmart keeps prices low for consumers is by threatening to expand its Sam’s Choice store brand products into additional catego- ries if manufacturers of other branded products don’t meet Walmart’s pricing demands.

Buyer Price Sensitivity. In general, when buyers are more price-sensitive, they are more likely to exert pressure on suppliers to keep prices low. Buyers exert pressure not just through price negotiation but also through more comparison-shopping and a greater willingness to switch suppliers. Buyer price sensitivity tends to increase in the following situations:

Buyers are struggling financially. When companies are struggling financially, they are more likely to be price-conscious and to look for ways to get less expensive sources of supply. If many of an industry’s buyers are in the same situation, there is a cap on what suppliers can charge.

Product is significant proportion of buyer’s costs. Buyers tend to care more about getting a good price when the product they are buying creates a large part of the costs of their own production (or their budget, if the buyers are the end consumers). If the product is only a small part of their cost structure, buyers are less likely to bother negotiating or comparison-shopping. For instance, end consumers are less likely to do extensive comparison-shopping for a gallon of milk than they are for a home or car. Likewise, auto manufacturers are less likely to pressure suppliers of electrical wiring for price cuts than suppliers of steel or engine components.

Buyers purchase in large volumes. When buyers purchase in large volumes, they typi- cally expect to get breaks in price. In essence, the buyer is taking a risk by being willing to buy large amounts at once rather than smaller amounts over time.

Product doesn’t affect buyers’ performance very much. If a product is very important to the quality of the buyers’ end product, then buyers tend not to be very price conscious. For instance, when Nokia had the most innovative handsets on the market, many cel- lular phone carriers, like Verizon and T-Mobile, were willing to pay whatever Nokia charged in order to be able offer Nokia phones to their customers. However, if suppli- ers’ products don’t affect buyers’ quality or performance very much, then buyers are much more likely to be price conscious. For instance, the plastic casing on tablet or laptop computers doesn’t enhance the performance of the computers very much; it doesn’t drive sales to the end consumer. As a consequence, PC manufacturers are likely to shop around for price discounts on plastic casings in ways that they might not for the microprocessors that run the computers.

Product doesn’t save buyers money. If a product saves buyers money, they tend not to be very price conscious when purchasing it. These types of products can be anything from machinery in manufacturing industries that replaces highly skilled, costly labor to inexpensive, overseas labor that replaces more expensive labor or machinery in coun- tries such as the United States. If a product does not save buyers money, however, buy- ers are as likely to be price conscious as they are with other types of products they buy.

Supplier Bargaining Power The factors that increase the bargaining power of suppliers are very similar to those that increase the bargaining power of buyers. In this case, however, the firms are not customers, but suppliers, those from whom your industry purchases inputs. When supplier industries have strong bargaining power, they can charge higher prices, which tend to decrease average profitability in an industry. As firms understand the factors that give suppliers power, they may be able to make decisions that decrease that power.

backward integration A firm purchases one or more of its

suppliers in order to make a

product itself rather than buying it

from another firm.

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Number, or Concentration, and Size of Suppliers. As with buyer concentration, supplier concentration follows the law of supply and demand. If there are few sellers, but lots of buyers in an industry, then the buyers have to compete to get the products that they want, often paying higher prices to get sufficient supply. Likewise, the larger the number of sellers compared to the buyers, the less likely buyers are to pay the price that sellers are demanding.

For instance, ARM, a designer of semiconductor chips for smart phones, controls more than 95 percent of the market for its product,16 resulting in a highly concentrated supplier industry dominated by one large firm. As a consequence, Nokia, or any other smart phone handset manufacturer that wants a sufficient supply of chips, and wants the high-quality chips that won ARM its market share in the first place, has to buy from chip manufacturers who license from ARM. ARM has sufficient power that it can, to a large degree, set the price for its product. Suppliers who charge more often squeeze the profits of buyers, who may not be able to pass additional costs through to their customers. In fact, ARM’s rise to power in the mobile semiconductor chip industry is a major contributor to Nokia’s current difficul- ties. Nokia cannot charge enough for its low-cost handsets to make a good profit after pay- ing for expensive ARM chips.

Credible Threat of Forward Integration. In some cases, a supplier can exert pressure over its buyers by threatening them with forward integration, doing what its buyers do, if the buyers don’t offer price concessions. A good example of this is Google and its decision to forward integrate in the smart phone handset industry by manufacturing its own phones.17 Google also licenses its Android operating system to other handset makers, such as HTC and Samsung. Google’s ability to forward integrate gives Google power over those handset makers. When there is a credible threat of forward integration, buyers are often willing to take a cut in profit by paying higher prices, rather than risk losing the supply altogether and creating a new rival (if the supplier hasn’t already forward integrated).

Threat of New Entrants As previously shown in Figure 2.1, not all industries are created equal. Industries in which the average firm is making good profits can often be targets, enticing firms from outside those industries to enter. Likewise, quickly growing industries are often attractive, which increases the incentive for outside firms to enter those industries. One of the important tasks for strategists is to identify firms that might enter their industries. New entrants pose a double hazard. First, they typically are anxious to gain market share.18 Unless the industry is growing quickly, that market share must come at the expense of existing firms. Second, new entrants bring new production capacity, which tends to drive prices down unless demand is growing faster than the increase in supply.

New entrants mean greater rivalry, so existing firms often try to discourage new entrants by building barriers to entry. The higher the barriers to entry, the more difficult it is for potential entrants to get a foothold in the industry, and the more likely that they are to quit or choose to not enter in the first place. Likewise, incumbent firms, those already in the industry, often signal new entrants that they are likely to retaliate by slashing prices, increas- ing advertising, or other competitive moves that help the established firms hold on to their market share. If the threats of retaliation are perceived as credible, potential entrants might decide to stay away.

It is essential for firms to understand the barriers to entry that already exist in their industry and to consider ways of increasing them. Existing firms may also want to build new barriers. Firms that are considering going into an industry can use an analysis of the barriers to entry in the target industry to help them determine how likely they are to succeed.

Economies of Scale, Experience, or Learning. These types of economies occur when the cost per unit of production (the cost for producing each individual product or service) decreases as a firm produces more. Typically, these economies come from mass manufacturing methods, discounts through purchasing in high volumes, employees becoming quicker and better at production, and being able to spread the fixed costs of production machinery, R&D, advertising, and marketing across more units.19 Chapter 4 will explore these three types of cost advantages in greater detail. In essence, lower costs allow the firm either to lower its

forward integration A firm goes into the business of its former

buyers, rather than continuing to

sell to them.

barriers to entry The way organizations make it more difficult

for potential entrants to get a

foothold in the industry.

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price, perhaps in retaliation for a new firm entering the market, or to maintain its price while earning more profits than competitors.

When economies of scale, experience, or learning exist in an industry, new firms will be at a cost disadvantage. New firms are not likely to have as much market share as existing firms, so they will not produce as much and can’t achieve the same economies as existing firms. Some firms may not be able to lower their prices sufficiently to match incumbent firms’ prices. Other new entrants may match incumbent prices, but earn smaller profit margins than the incumbents. The higher the economies of scale, the greater the barrier to entry and the easier it is for the larger incumbent to pose a credible threat of retaliation.

If conditions change so that cost savings from these economies become smaller, the barrier diminishes. For example, from the late 1980s until the early 2000s, the cell phone handset manufacturing industry possessed high economies of scale. Nokia produced mil- lions of handsets per year during this time and had the lowest costs of its competitors. Consequently, the number of firms in the industry was relatively stable during this period. However, the invention of flexible manufacturing processes, coupled with the rise of low- cost, highly-skilled labor in China in the mid-2000s, lowered the cost savings that could be achieved from high levels of production and allowed thousands of new Shanzhai manufac- turers to successfully enter the industry.

Other Cost Advantages Not Related to Scale. Incumbent firms might have cost advantages relative to new entrants for a variety of reasons besides economies of scale. These include the following:

1. Patents or proprietary technology such as those that exist in the pharmaceutical industry

2. Better locations (a deterrent to firms wishing to enter markets where Starbucks is dominant, for example)

3. Economies of scope—less expensive costs per unit created by bundling different types of products. For example, Procter & Gamble has low-cost marketing and distribution costs, compared to firms that manufacture only one type of product, because P&G ships dozens of different types of products to the same retailers. (See Chapter 4 for a more detailed explanation of economies of scope.)

4. Preferential access to critical resources, such as raw materials or access to distribu- tion networks. For example, Chinese makers of lithium ion batteries have government- protected access to sources of rare earth elements, raw materials that are necessary for battery production. In many industries, new entrants face high barriers in the cost of building a dealer network or recruiting retailers to sell their products. With a limited number of potential dealers and retailers, new entrants often find themselves having to cut prices, and profit margins as well, to secure access to distribution.

As with economies of scale, it is important for firms to track whether barriers are rising or falling. An expiring patent or the advent of an innovative distribution channel, such as the Internet, has the potential to radically change the strength of barriers related to cost advantages.

Capital Requirements. It costs money to enter a new industry. Not only do potential entrants often need capital to build a factory or store, but they may also have to invest in R&D to generate viable products, build inventory, undertake sufficient advertising and marketing to take market share from incumbent firms, and have sufficient cash on hand to cover customer credit. Anything that increases the start-up costs will reduce the pool of possible entrants. For instance, the computer semiconductor chip industry, dominated by Intel, makes a very complex product. New entrants would need to spend years of R&D before they had a viable product and could make their first sale. The high capital requirements needed for long periods of R&D limit the number of entrants to those with enough financial or other resources to enter. However, firms that already have made R&D investments in similar products, such as semiconductor chips for mobile phones, could lower the capital costs associated with entering the computer semiconductor industry. It is likely no coincidence that ARM, the maker of mobile semiconductor chips, is one of only a few successful entrants into Intel’s industry in the last 30 or more years.

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Network Effects. In some industries, network effects increase the switching costs for customers, making it more difficult for new entrants to steal business from incumbent firms. When network effects are in operation, the greater the number of people using products from a given firm, the greater the demand grows for that firm’s product. For example, the more people who use a particular social networking site, the more customers want to continue to use the site, and the more new customers are likely to try it. A new entrant wanting to compete with Facebook is at a distinct disadvantage, because most of their potential customers’ “friends” are likely to be on Facebook, making it less likely that they will be willing to switch to a new social media site.

Government Policy Restrictions. Finally, government policies may make it more difficult to enter a market or even restrict a market completely to new entrants. For instance, governments often raise the costs of entry by requiring bonding, licenses, insurance, or environmental studies before a firm can enter an industry. New entrants will have to use capital that might have been used for R&D, production, or advertising to meet those requirements. When competing across international borders, additional regulations, such as trade restrictions and local content requirements, may be applied to try to limit foreign competition. In some industries, such as hairstyling, the requirements might be fairly minimal, but in others, such as oil refining, they can become so onerous that most new firms cannot overcome the barrier.

Threat of Substitute Products A substitute is a product that is fundamentally different yet serves the same basic function or purpose as another product. One of the primary problems for the strategist in assessing substitutes is determining what is a substitute and what isn’t. It involves determining the boundaries of an industry, as we addressed earlier in the chapter, and then scanning other industries to find products that might serve the same basic functions. For instance, e-mail is a substitute for telephone messages, faxed documents, or documents delivered via the post office. All four are ways of delivering messages. Similarly, fruit juice is a substitute for any number of other drink products, including coffee, wine, and soda. Generally, something can be considered a substitute if it serves the same function, such as quenching thirst, but does so with a different set of characteristics. If the product has the same basic characteris- tics and is made using the same general set of inputs, it would be considered part of rivalry, rather than a substitute. For instance, competitor brands serving the same basic need, such as Apples iPhone and Samsung smart phones running Google’s Android operating system, are rivals, not substitutes.

In general, substitutes put downward pressure on the price that firms in an industry can charge. For instance, streaming video across the Internet is a substitute for watching mov- ies in the theater. Even if you had the only movie theater in an area, you could not charge whatever price you wanted to. As your price rose, more customers would switch to stream- ing video. If the price difference is enough, customers will stream even though the quality is lower and they have to wait weeks or months before the movie leaves the theater and is available online. For some industries, such as newspapers, the low price of the substitute— in this case, free news on the Internet—can be disastrous, creating such a low cap on the prices they can charge that many firms go out of business. The factors that determine the intensity of a threat of substitutes include the awareness and availability of substitutes and their price and performance compared to an industry’s products.

Awareness and Availability. Sometimes customers aren’t readily aware that substitutes exist. The threat increases when substitute products are well known. This is particularly true if there are strong brands among the substitute products. Likewise, if the substitute product is just as easy for customers to obtain as another industry’s products are, it is more of a threat. If the substitute is difficult to find or acquire, the threat is diminished.

Price and Performance. A significant part of the customer decision to switch to substitutes will concern the price and performance trade-offs. As we discussed earlier in the chapter, customers are more likely to switch to a substitute if the costs of switching are low. The

network effects Growth in demand for a firm’s product that results

from a growth in the number of

existing customers.

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price of the substitute, itself, also factors into customers’ decisions. If substitutes are cheaper than products from another industry, the threat is higher. Likewise, if the performance of substitutes is similar or better, the threat is higher. The closer the substitute is in performance, the less flexible a seller can be with price. For instance, many newspapers have seen steep declines in circulation as Internet news has gained in quality. The Wall Street Journal, however, has not declined in circulation over the same time period because online substitutes for serious business news have not increased in quality nearly as fast as for other types of news.

OVERALL INDUSTRY ATTRACTIVENESS

Understanding the five forces that shape industry competition is useful as a starting point for developing strategy. Indeed, managers often define competition too narrowly, as if it occurred only among direct competitors. Yet competition for profits goes beyond direct rivals to include buyers, suppliers, potential entrants, and substitute products. The extended rivalry that results from all five forces defines an industry’s structure and shapes the nature of competitive interaction within an industry. Every company should know what the aver- age profitability of its industry is and how that has been changing over time. The five forces help explain why industry profitability is what it is—and why it might be changing. Attrac- tive (profitable) industries are those where firms have created power over buyers and suppli- ers, created barriers to entry to reduce the threat of new entrants, and minimized the threat of substitutes while keeping rivalry to a minimum. Even inefficient, relatively poorly run companies can earn superior profits under such conditions.

At the other extreme, are unattractive industries. Firms in these industries are con- sistently pressured by buyers and suppliers alike. They face high rivalry, easy entrance for new competitors, and many well-positioned substitute products. Under these conditions, only the most efficient, well-run companies are able to turn a profit. Each of the five forces can be analyzed to determine the degree to which, and how, it contributes to industry attractiveness.

We provide a strategy tool at the end of this chapter for analyzing each force. After doing an analysis of each force, these can be combined to develop a detailed picture of what is driv- ing the overall profitability—the attractiveness—of the industry.

Few industries will rate high (attractive) or low (unattractive) on all forces. A significant threat from just one or two of the five forces is often sufficient to destroy the attractiveness of an industry. For example, many firms in the auto industry have struggled to be profitable over the last decade. This industry, however, has relatively low buyer and supplier power, no real threat of substitutes, and a moderate threat of new entrants. Rivalry, however, has been fierce, with constant excess production capacity and price discounting. Sometimes, it only takes one of the five forces to be unattractive to make an industry struggle. When many of the five forces are unattractive, firms face great challenges maintaining profitability. How- ever, understanding each force and how it is influencing profitability helps managers know where to focus in dealing with those challenges. Moreover, a company strategist who under- stands that competition extends well beyond existing rivals will perceive wider competitive threats and be better prepared to address them. At the same time, thinking comprehen- sively about an industry’s structure can uncover opportunities to improve performance on each of the five forces, thereby becoming the basis for distinct strategies that yield superior performance.

One thing to keep in mind is that the five forces are subject to change. Each of the five forces can be altered by actions taken by firms within or without the industry. For instance, Google built the Android operating system, even though it gives it away for free, to increase the number of suppliers for its search engine, thus decreasing the supplier power that Apple might have had had it been able to dominate the smartphone industry. A good strategist always has her eye on actions and trends that might change any of the five forces in her industry. Not all of those trends come from actions taken by firms close to the industry. Some come from the general environment. These are discussed in the next section.

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HOW THE GENERAL ENVIRONMENT SHAPES FIRM AND INDUSTRY PROFITABILITY

To determine the landscape that a firm competes in, it isn’t enough to only understand the five forces that directly affect an industry. The general environment also needs to be under- stood. The general environment can affect firms in a variety of ways,20 including affecting the shape of each of the five industry forces. A simple way to think about the general environ- ment is to break it down into eight categories. Strategic managers in the best companies are focused on each of these categories, looking for trends that might lead to new opportunities or threats. This is illustrated in Figure 2.3:

Complementary products or services

Technological change

General economic conditions

Population demographics

Ecological/natural environment

Global competitive forces

Political, legal, and regulatory forces

Social/cultural forces

[ Figure 2.3 ] Trends in Opportunities and Threats in the General Environment

Social/Cultural Forces

Political/ Legal/ Regulatory

Forces

Global Forces

Technology Change

General Economic Conditions

Demographics

Ecological/Natural Environment

Complimentary Products/Services

THE GENERAL ENVIRONMENT

COMPETITOR RIVALRY

BUYER POWER

SUPPLIER POWER

NEW ENTRANTS

SUBSTITUTES

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Developments in each of the eight categories shown in the outer ring have the poten- tial to shape and change the general landscape for any specific industry. Each category can affect an industry’s dynamics, which are shown by the area within the center circle, altering any or all of the five forces. You should always keep in mind that an industry’s five forces are not static. The five forces are subject to change and may change, even radically, if elements of the general environment change. When you are examining the general environment, it is important, then, to not just get a picture of what things look like today but to analyze trends, the direction each category is headed toward tomorrow. Remember, as well, that this analy- sis is industry specific. You want to know how each of the eight categories is going to affect the industry you are studying.

The relative importance of each of the general environmental factors differs from indus- try to industry. In the fast-food industry, social forces, such as a shift toward healthier eating, are likely to alter the threat of substitutes, but technological change doesn’t play as a large a role. In the motorcycle manufacturing industry, demographics play a key role, as many industrialized nations experience an upward trend in the average age of the population, but changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting in fewer people riding motorcycles because they are perceived to be transportation for the young. Managers need to develop a deep sense of which environmental factors are strategi- cally relevant to their own industries.21 Managers need to understand not only which fac- tors have the largest impact on their industry right now, but also which factors are likely to change in the future, so that they can adapt their firms’ strategies to changing conditions.

Complementary Products or Services Complementary products or services are those that can be used in tandem with those in another industry. For example, video gaming hardware and software, or smartphone oper- ating systems and apps, are complementary sets of products. When two complements are used together, they are worth more than when they are used apart. Complementary pairs or groups (also called ecosystems) of products can be found in many places, not just in the technology sector.22 Gas stations and roads are complements to automobiles, and piping is a complementary product to natural gas. Trends in complementary industries have the potential to radically alter—for better or worse—the landscape in which firms compete.

Take the rise of application software (apps), for instance. In the 1990s, Microsoft created tools for software designers. By doing so, Microsoft lowered the barriers to entry in the appli- cation software industry, a complementary industry to operating systems. Apple made it even easier to enter the app industry by releasing segments of its operating system code, cre- ating even more new entrants and sparking the rise of single-purpose, inexpensive apps for mobile computing devices. Now, customers at Apple’s app store can choose from hundreds of thousands of apps for their iPhones.

The number of new entrants in the app industry is actually increasing the barriers to entry in the smartphone operating system industry. It would be difficult for a new mobile operating system to come on the scene and compete with Apple or Android. Even powerful Microsoft has experienced challenges entering the mobile operating system business.23 For many industries, changes in complementary products are one of the most important trends to keep an eye on. Some consider them significant enough that they even refer to them as a sixth force among the five industry forces.24

Technological Change Technological change within an industry has the potential to radically reshape a firm’s land- scape, and sometimes society with it. Technological changes can include new products, such as smart phones; new processes, such as hydraulic fracturing ( fracking), which has dramatically increased the output of the natural gas industry; or new materials, such as lithium batteries, which make electric automobiles possible. In many industries, the pace of technological change has accelerated over the last couple of decades.25 Managers find it increasingly important to consistently scan the environment to locate potential new

complementary products or services Products or services that can be used in tandem with those

from another industry.

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technologies that might affect their industries.26 Early adopters are often able to gain greater market share and earn higher profit margins than those who are late to adopt, suggesting the importance of incorporating new technologies early.

Not only can technology change the nature of rivalry in an industry by giving some firms an upper hand in gaining market share, but it can sometimes lower barriers to entry. For instance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such as steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new technology for smelting steel called the electric arc oven allowed new firms, such as Nucor, to enter the industry with only one-tenth the capital investment that would have been needed to start a traditional steel firm. Perhaps the technological change that has affected the threat of new entrants in the greatest number of industries in the last 20 years is the Internet. Some have suggested that the next giant wave of technology change, one we are in the middle of experiencing is wireless communication, like smart phones, which allow individuals to connect from and to anywhere and anyone at any time.27

General Economic Conditions Changing macroeconomic forces can also have a large impact on industries. The state of an economy can affect a region or nation and, subsequently, the ability of the average firm in an industry to be profitable. Analyzing the economic environment typically involves measuring the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or deflation. The appendix provides a list of sources where you can find information on these economic indicators.

Economic Growth. How quickly, or slowly, an economy is growing has a direct impact on most firms’ bottom line. Economic expansion tends to improve customer balance sheets, lower price sensitivity, and increase the growth rate in an industry, as customers purchase more, easing rivalry. For example, a number of African nations, such as Nigeria and Kenya, have experienced solid levels of economic growth in the last few years.28 As a consequence, a growing percentage of the population has sufficient disposable income to afford products like automobiles and cell phones. Companies providing products like these in Africa have experienced a boom in customer demand.29 The reverse is also true. When an economy slows down, industry growth rates slow, customers are more price sensitive, and suppliers are also likely to be struggling and pursuing ways of increasing profits—at the expense of firms in your industry, if they have the power to do so.

Interest Rates. Interest rates mostly can affect rivalry by increasing or decreasing the demand for an industry’s products. This is true for expensive items like housing, cars, and even education, which often requires customers to take out loans to purchase. For example, the housing boom experienced in the United States and Europe in the early 2000s was fueled by low-interest-rate loans, sometimes below 4 percent, when the average mortgage interest rate in the previous decade had been above 6 percent. When interest rates are low, industry growth rates increase and rivalry decreases. When interest rates are high, the opposite can occur. In addition, interest rates affect the cost of capital. When interest rates are low, many firms can afford to invest in new assets. As interest rates increase, new investments become more difficult. As a result, firms sometimes engage in price wars as a strategy for gaining market share when rates are high, rather than investing in R&D and new product development.

Currency Exchange Rates. Currency exchange rates reflect the value of one country’s currency in relation to the currency from another country. Exchange rates can have a large impact on the prices that customers pay for products from firms in other countries, directly affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss franc appreciated 65 percent against the U.S. dollar, making Swiss products 65 percent more costly in the United States, even though the cost of production hadn’t changed at all. Nestlé, a Swiss firm, was particularly hard hit. It either had to decrease its profit margin to cover the extra cost or increase its prices substantially, risking fewer customers buying its products.

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Inflation. A significant, consistent rise in prices, known as inflation, can create many problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year, then next year that product will cost $1.02. Inflation or deflation, if they are high enough, can make it hard for firms to plan investments. Inflation tends to decrease overall economic growth, increasing rivalry and possibly buyer and supplier power and the threat of substitutes. When firms can’t predict what price they will be able to get for a particular product, investments in new product development become riskier. When inflation is high, many industries experience increases in price competition, rather than development, as a means of gaining market share.

Demographic Forces Demographic forces involve changes in the basic characteristics of a population, includ- ing changes in the overall number of people, the average age, the number of each gender or ethnicity, or the income distribution of the population.30 Because demographic changes involve basic shifts in the product and geographic markets that firm’s target, demographic changes are always accompanied by opportunities and threats. Even though demographics often change slowly, they fundamentally reshape the landscape, so good strategic managers have a firm understanding of demographic trends. The appendix contains a list of readily available sources for demographic information. Some sources, such as the World Bank, con- tain hundreds of demographic indicators.

Over the last 50 years, the size the world’s population has more than doubled, from around 3 billion to more than 7 billion people. Projections suggest that the Earth’s popula- tion could reach 9 billion by 2040.31 Each new individual is a potential new consumer, sug- gesting that growth rates of many industries will increase over time. However, increases in consumption resulting from population growth also mean that supplies of raw materials (such as the rare-earth metals terbium and europium currently used in flat-panel displays32) are likely to decrease. Furthermore, the world population isn’t spread evenly over all nations. The enormous populations of China and India account, to a large degree, for the number of firms that have set up operations in those countries.

The average age of the population within a nation can also have a tremendous effect on some industries. In Japan, for instance, more than 20 percent of the population is over age 65. In the United States, this won’t occur until around 2040.33 The robotics industry has already felt this shift. Japanese companies like Honda have invested tens of millions of dollars in robots for home use, including walk-assist robots that help elderly people with weakened muscles remain ambulatory when they would otherwise need to use a wheelchair.34

Ecological/Natural Environment The natural environment can also be a source of change for many industries. In some cases, this involves changes to the physical environment such as increasing shortages of key inputs like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas). More often, though, current trends in the natural environment involve changes in the pub- lic’s perception of how business affects the environment. From global warming to clean air and water, the public in many countries—including developing economies like China—are demanding that firms be more proactive in protecting the environment. Many firms have responded by implementing green initiatives. Although some of these may be for public relations purposes only many firms have established serious goals. For instance, Procter & Gamble has goals to use 30 percent renewable energy to power its plants by 2020. By 2014, 7.5 percent of its energy needs were already met by renewable energy. They have also prom- ised to reduce their energy consumption, water usage, greenhouse gas emissions and waste by 20 percent by 2020. They have already reduced them by 8 percent by 2014.35 If consumers truly care about the environment, then actions like these increase rivalry as competitors are forced to respond in kind.

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Global Forces Global forces also play a large role in shaping many industries. Over the last 50 years, as communications and transportation technologies have undergone a revolution, trade barriers among nations have fallen dramatically. Many countries, from South Korea and Taiwan, to China and India, to Brazil and South Africa, have enjoyed remarkable eco- nomic growth and a rising standard of living. These changes have caused firms from many countries to expand operations and begin producing and selling across national borders. We will examine global forces and strategies for capitalizing on them in greater detail in Chapter 9.

Political, Legal, and Regulatory Forces Political, legal, and regulatory forces are those that arise from the use of government. When new laws are passed, they may alter the shape of an industry and influence the strategic actions that firms might take.36 For example, the federal Affordable Health Care Act, enacted in 2009, mandates that health insurers cover everyone, including those with preexisting conditions. This may change the cost structure of the industry, potentially resulting in con- solidation and less rivalry, as inefficient firms either go out of business or are acquired by more viable firms. In the United States following the Great Recession of 2008–2009, the Federal Reserve required banks to keep larger amounts of cash on hand to cover potential mortgage-related losses. One consequence of this regulation was less lending to small businesses, erecting entry barriers in many industries and changing the nature of rivalry in industries with many small firms.

Because political processes, laws, and regulations have the potential to shape and con- strain industries, managers should analyze and understand the impact of new laws and reg- ulations and decide how to respond. The Affordable Health Care Act, for example, requires firms with over 50 employees to provide health insurance for their workers, or face fines. Because the law also provides for health insurance exchanges through which uninsured people can buy their own insurance, many firms are considering dropping employee health insurance as a benefit. Their managers have determined that the fines their companies face would be cheaper than the current premiums for health insurance.

Of course, laws often provide opportunities, as well as threats. For instance, laws in many countries and states in the United States that require electricity providers to obtain a per- centage of their electricity from renewable sources have resulted in a boom in demand for wind turbines and solar panels. Because of the potentially far-ranging effect of laws and regulations, many firms and industries strategically lobby government in an attempt to influence the lawmakers to enact legislations favorable to those industries.

Social/Cultural Forces Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes are so fundamental that they often affect the other six general environmental forces, shap- ing the overall landscape in which firms compete. For instance, changing cultural norms about health have resulted in laws against sodas being sold in schools and lawsuits against fast-food retailers such as McDonald’s for marketing “unhealthy” food to children.

Like the other environmental forces, however, social forces can create opportunities if a firm happens to be among the first to act on changes in values and attitudes. For instance, Facebook helped to change social norms about connecting to friends and family. It reaped enormous profits for being among the first to capitalize on the change in social networking.

Social forces are different, sometimes radically so, in different countries. Firms that com- pete in a global industry must understand differences among consumers in each country they serve. For example, the collectivist orientation of many people in China results in a general belief that the well-being of the group is more important than that of the individual and a related norm of open information sharing.37 This open-sharing norm allows a greater acceptance of product knockoffs and software pirating than many people are comfortable with in countries that tend to have individualist orientations, such as the United States.

REVIEW QUESTIONS [ 39 ]

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SUMMARY

One of the primary decisions that firms need to make is which industry, or environment, they are going to compete in. Defining a firm’s industry correctly is important because it helps managers to identify their competition. One tool for helping to define an industry is the NAICS codes produced by the U.S. government.

Not all industries are equally attractive. Five major forces determine the attractiveness of an industry, defined as the profitability of the average firm in the industry. These forces are: rivalry, buyer power, supplier power, threat of new entrants, and threat of substitute products.

Good managers develop a deep understanding of the effect of each of the five forces on industry attractiveness. Such an understanding allows them to take strategic action to influence the five forces in a positive way for their firm and industry. Misunderstanding the nature of the five forces can lead to decisions that destroy industry profitability.

Eight general environmental factors can affect the profit potential of a firm: complemen- tary products or services; technological change; general economic conditions; demo- graphic forces; the ecological/natural environment; global forces; political, legal, and regulatory forces; and social/cultural forces. Changes in any of these eight factors can cre- ate additional opportunities and threats and often shape the five industry-specific forces.

KEY TERMS

attractiveness of an industry

(p. 26) backward integration

(p. 29) barriers to entry (p. 30)

complementary products or

services (p. 35) forward integration (p. 30) network effects (p. 32) opportunities (p. 26)

rivalry (p. 25) substitute (p. 25) supplier (p. 28) switching costs (p. 27) threats (p. 25)

REVIEW QUESTIONS

1. Why is it important for a firm to accurately determine what industry it is in? 2. How should a firm decide what industry it is in? 3. What are the five major industry forces? How do they shape average profitability in an

industry? 4. What factors determine the intensity of rivalry? 5. Explain why increased buyer concentration would increase buyer power. 6. Explain what it means for suppliers to have a credible threat of forward integration. 7. What factors determine the intensity of the threat of new entrants? 8. What are substitutes? 9. What are the eight general environmental factors that affect industry profitability? 10. How does each of the eight general environmental factors influence industry profitability? 11. How do the eight general environmental factors affect the five industry forces? 12. What are the elements of a complete external analysis?

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APPLICATION EXERCISES

Exercise 1: Practice evaluating the industry five forces using the strategy tools presented in this chapter.

Read the case, Coca-Cola, Pepsi, and the Shifting Landscape of the Carbonated Soft Drink Industry. 1. Use the strategy tool presented in this chapter, along with data from the case, to evaluate:

a. The intensity of rivalry within the cola manufacturing industry (where Coca-Cola and Pepsi are prominent firms). Is rivalry high, medium or low?

b. The intensity of supplier power within the cola bottling industry (where Coca-Cola and Pepsi are prominent suppliers). Is supplier power high, medium, or low?

2. Where sufficient data aren’t available, use qualitative evidence to evaluate the strength of a particular factor. Fill in the explanation/data line of the strategy tool with page numbers and a summary of your logic.

3. Which industry is likely to be more attractive: cola manufacturing or bottling? Why?

Exercise 2: Analyze the effects of the general environment on an industry of your choice. 1. Identify an industry you would like to learn more about. Ideally, you should be able to

gather sufficient information on this industry to thoroughly analyze the impact of the general environment on industry profitability. Although information is available for a wide variety of industries, this exercise will be easier if you choose an industry that has been written about consistently in the business press. In order to manage the volume of data required for a thorough analysis, your instructor might want you to focus solely on the home country of the largest firms in the industry (unless most firms earn a majority of their profits from abroad).

2. Use data from a variety of sources, including those listed in the appendix, in your analysis.

3. Try to identify the major effects of each of the eight factors (complementary products; technological change; general economic conditions; demographic forces; ecological/nat- ural environment forces; global forces; political, legal, and regulatory forces; and social/ cultural forces) on industry profitability.

4. Identify and predict any short-term to medium-term changes in any of the eight factors that might alter average profitability in the industry. Address how those changes will affect industry profitability in the future.

5. As part of the analysis, consider how the general environmental factors may affect each of the five industry forces (rivalry, buyer power, supplier power, threat of new entrants, and threat of substitutes).

Strategy Tool Evaluating Industry Attractiveness Using Porter’s Five Forces Model

Understanding the five forces and their effect on the landscape that a firm competes in is a cornerstone of

successful strategic analysis. Figures 2.4 through 2.9

are general analytical tools used by a number of Fortune

500 firms to evaluate the intensity of the five forces in

an industry.38 These tools essentially help to quantify the

ideas that we have already discussed in this chapter. In

practice, top management often implicitly understands

the dynamics of the five forces and might not personally

use the tools presented here to map out the strength of

each force and its overall effect on industry profitability.

However, a number of Fortune 500 firms use these tools

STRATEGY TOOL [ 41 ]

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in their strategic planning departments to provide rigor to

the strategic analyses and recommendations they present

to top management. Although the tools might appear

complicated, they distill the concepts from this chapter,

allowing a relatively simple, yet comprehensive and detailed

analysis of the five forces.

You can look for the data to complete these analysis tools

in the sources listed in the appendix at the end of the book.

Many of the indicators in these analysis tools are objective

numbers that you can obtain from various data sources.

Others are more subjective; they require a logical argument

for the level—low, medium, or high—that you choose. Even

for more subjective indicators, however, data from various

sources can take the guesswork out of doing a five-forces

analysis.

For each item, put an X in the box that most accurately

reflects the data. For some boxes this is a range of data,

for instance, 60 to 70 percent combined market share in

the rivalry tool. If the correct number is anywhere within

the range, put an X in the appropriate box. Cite your data

source and/or explain your placement underneath each

item. Your answer for some rows of boxes will be an

average of more than one item. For instance, in the rivalry

tool, the degree of industry standardization is the average

of the four items below it. Each column is assigned a

number, 1 through 6. To take the average, you add the value

for each column (which, for each item, is determined by

the set of numbers that most accurately reflects the data

you have gathered) and divide by the number of items.

For instance, to know where to place the X for degree of

industry standardization in the rivalry tool, you will add

the values from the four items below it, determined by

which column they are located in, and divide by 4. To get

the value for the overall intensity of each force you will add

the values from the boxes with Xs in them and divide by the

total possible for those rows. For rivalry, this means that

you add the column values for each of the six rows of boxes,

and then divide by 30. Round your answer to the nearest

whole number, and place an X in the appropriate box in the

“Overall Intensity of Rivalry” row.

[ Figure 2.4 ] StrategyTool - Evaluating the Intensity of Rivalry (mark an x in the appropriate box for each factor)

1. Number and Relative Size of Competitors

Top 4 competitors’ combined industry market share

Explanation/Source of Data:

1 2 3 4 5

<40% 40-50% 50-60% 60-70% >70%

High Med. Low

<2% 2-5% 5-10% 10-15% >15%

100% 75% 50% 25% 0%

Low Med. High

<0% 0-1% 1-3% 3-5% >5%

<70% 70-80% 80-90% 90-100% >100%

High Med. Low

2. Degree of Industry Product Standardization (take the average of the bullet points below)

Difference between competitors in price of similar products

Explanation/Source of Data:

What % of industry’s products are sold at discount?

Explanation/Source of Data:

Customers’ ability to recognize brands from industry

Explanation/Source of Data:

Degree of switching Costs

Explanation/Source of Data:

3. Industry Growth Rate Explanation/Source of Data:

4. Unused Industry Production Capacity

% of Industry wide production capacity currently in use

Explanation/Source of Data:

5. Degree to which firms have high fixed costs or products have high storage costs or are perishable Explanation/Source of Data:

6. Extent of Exit Barriers Explanation/Source of Data:

Overall Intensity of Rivalry (take the average of the major factors, items numbered 1 through 6) Fiercely

Competitive

Neutral Mildly

Competitive

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[ Figure 2.5 ] StrategyTool - Evaluating the Intensity of Buyer Power (mark an x in the appropriate box for each factor)

1. Buyer Industry Bargaining Power (take the average of the bullet points below)

Buyer concentration (top 4 buyers as a % of total industry

volume sold to buyers)

Explanation/Source of Data:

Buyer switching costs

Explanation/Source of Data:

Demand (supplier industry growth rate)

Explanation/Source of Data:

Possibility of buyer backward integration

Explanation/Source of Data:

1 2 3 4 5

High Med. Low

>70% 60-70% 50-60% 40-50% <40%

Low Med. High

<0% 0-1% 1-3% 3-5% >5%

High Med. Low

<0% 0-5% 5-10% 10-15% >15%

>50% 30-50% 20-30% 5-20% <5%

>50% 30-50% 15-30% 5-15% <5%

Most Half Few

Low Med. High

2. Buyer Industry Price Sensitivity (take the average of the bullet points below)

Profitability of average buyer

Explanation/Source of Data:

% of suppliers’ products which are sold at a discount

Explanation/Source of Data:

Cost of supplier industry products as a % of total buyer costs

Explanation/Source of Data:

Number of high volume purchases

Explanation/Source of Data:

Impact of suppliers’ products on buyer quality/performance.

Explanation/Source of Data:

Degree to which supplier products save buyers money

Explanation/Source of Data:

Overall Intensity of Buyer Power (take the average of the major factors, items 1 and 2, above) High

Power

Neutral Low

Power

[ Figure 2.6 ] StrategyTool - Evaluating the Intensity of Supplier Power (mark an x in the appropriate box for each factor)

1. Number and Relative Size of Suppliers

Top 4 suppliers combined volume of total supplier

industry sales to buyer industry

Explanation/Source of Data:

1 2 3 4 5

>70% 60-70% 50-60% 40-50% <40%

High Med. Low

>30% 20-30% 10-20% 5-10% >5%

<2% 2-5% 5-10% 10-15% >5%

High Med. Low

2. Difficulty of Switching Suppliers (take the average of the bullet points below)

Cost of switching suppliers as a % of total input costs (costs

include not just higher prices but all switching costs)

Explanation/Source of Data:

Difference between suppliers in price of similar products

Explanation/Source of Data:

Importance of suppliers’ brands to the end consumer

Explanation/Source of Data:

3. Possibility of Supplier Forward Integration Explanation/Source of Data:

Overall Intensity of Supplier Power (take the average of the major factors, items 1 through 3, above) High

Power

Neutral Low

Power

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[ Figure 2.7 ] StrategyTool - Evaluating the Intensity Threat of New Entrants (mark an x in the appropriate box for each factor)

1. Incumbent Firms’ Cost Advantages (take the average of the bullet points below)

Size of scales economies: measured as the slope of the scale

curve (see Chapter 4 for how to calculate this)

Explanation/Source of Data:

Size of investment in plant and machinery required to

enter industry

Explanation/Source of Data:

Size of investment in marketing needed to match incumbent

brand awareness

Explanation/Source of Data:

Degree to which incumbents employ property rights, like

patents, to protect their market share

Explanation/Source of Data:

Market share required to break even

Explanation/Source of Data:

1 2 3 4 5

Low Med. High

>95% 85-95% 80-85% 70-80% >70%

Small Med. Large

Low Med. High

<5% 5-15% 15-30% 30-40% >40%

Low Med. High

Weak Neutral Strong

Low Med. High

2. Other Incumbent Firm Advantages (take the average of the bullet points below)

Strength of incumbents’ brands (how influential in

customer purchase decision?)

Explanation/Source of Data:

Size of switching cost for incumbents’ customers

Explanation/Source of Data:

Degree to which network effects affect buying decision

Explanation/Source of Data:

Cost for entrants to comply with government regulations

Explanation/Source of Data:

3. Additional Considerations (take the average of the bullet points below)

Profitability of average incumbent

Explanation/Source of Data:

Incumbent industry growth rate

Explanation/Source of Data:

Low Med. High

>15% 10-15% 5-10% 0-5% <0%

>5% 3-5% 1-3% 0-1% <0%

Overall Threat of New Entrants (take the average of the major factors, items 1 throught 3, above) High

Threat

Neutral Low

Threat

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REFERENCES

1 Nokia SEC FORM 20-F, 2002, p. 27; Andy Reinhart, “Nokia’s Next Act.”

2 “Special Report: The Fight for Digital Dominance—Nokia vs. Microsoft,” Economist (November 23, 2002).

3 S. Faris, “Is Windows Nokia’s Lifeline?” Time (April 11, 2011).

4 “Nokia Market Share Falls but Microsoft Deal Confirmed,” BBC News (April 21, 2011).

5 B. Chiang, “China’s ‘Bandit’ Cell Phones—The High-Tech Golden Egg with ‘Taiwan Inside,’” Commonwealth

Magazine (December 3, 2008).

6 T. Kuittenen, “Nokia Sells Handset Business to Microsoft at a Shockingly Low Price,” Forbes (September 2, 2013).

7 D. A. Bosse, R. A. Philips, and J. S. Harrison, “Stakeholders, Reciprocity, and Firm Performance,” Strategic Man-

agement Journal, 30 (2009): 447–456.

[ Figure 2.8 ] StrategyTool - Evaluating the Intensity of the Threat of Substitutes (mark an X in the appropriate box of each factor)

1. Customer Awareness of Substitutes

Customers’ ability to recognize brands from

substitute industry

Explanation/Source of Data:

1 2 3 4 5

High Med. Low

Better Same Worse

Lower Same Higher

Better Same Worse

Low Med. High

2. Availability of substitutes (compared to focal industry) Explanation/Source of Data:

3. Price of substitutes (compared to focal industry) Explanation/Source of Data:

4. Performance of substitutes (compared to focal industry) Explanation/Source of Data:

5. Customer switching costs Explanation/Source of Data:

Overall Threat of Substitutes (take the average of factors, items 1–5 above) High

Power

Neutral Low

Power

[ Figure 2.9 ] StrategyTool - Evaluating the Overall Attractiveness of an Industry (highlight the appropriate box for each factor)

1 2 3 4 5

High Med. Low

1. Competitor Rivalry

2. Buyer Power

3. Supplier Power High Med. Low

4. Threat of New Entrants High Med. Low

5. Threat of Substitutes High Med. Low

Overall Industry Attractiveness (take the average of boxes, 1–5) Low Avg.

Profits

Med. Avg

Profits

High Avg.

Profits

REFERENCES [ 45 ]

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8 P. Chattopadhyay, W. H. Glick, and G. P. Huber, “Organizational Actions in Response to Threats and Opportuni-

ties,” Academy of Management Journal, 44 (2001): 937–955.

9 These can be found at http://www.census.gov/eos/www/naics/index.html.

10 B. Hunt and P. Abrahams, “Microsoft’s Battle with Symbian,” Financial Times (Feb. 25, 2003).

11 F. M. Scherer and D. Ross, Industrial Market Structure and Economic Performance (Boston: Houghton Mifflin,

1990).

12 M. E. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard Business Review 86 (1) (2008): 78–93.

13 S. Nadkarni and V. K. Narayanan, “Strategic Schemas, Strategic Flexibility, and Firm Performance: The Moderat-

ing Role of Industry Clockspeed,” Strategic Management Journal 28 (2007): 243–270.

14 R. Tidwell, “2011 Flat Panel TV Growth Rate Projected to Fall Sharply,” News Junky Journal (May 2, 2011).

15 “Frozen Food Production in the U.S.” IBISWorld. Accessed September 2011.

16 A. Gonsalves, “ARM Introduces 2.5 GHz Cortex A-15 Processor,” InformationWeek (September 10, 2010).

17 A. Efrati and S. E. Ante, “Google’s $12.5 Billion Gamble,” The Wall Street Journal (August 16, 2011), pp. A1 and A4.

18 K. E. Kushida and J. Zysman, “The Services Transformation and Network Policy: The New Logic of Value Crea-

tion,” Review of Policy Research 26 (2009):173–194.

19 R. Makadok, “Interfirm Differences in Scale Economies and the Evolution of Market Shares,” Strategic Manage-

ment Journal 20 (1999): 935–952.

20 L. Fahey, Competitors (New York: John Wiley and Sons, 1999).

21 J. A. Lamberg, H. Tikkanen, T. Nokelainen, and H. Suur-Inkeroinen, “Competitive Dynamics, Strategic Consist-

ency, and Organizational Survival,” Strategic Management Journal 30 (2009): 45–60.

22 A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York: Currency Doubleday, 1996).

23 T. Virki and S. Mukherjee, “Windows Phone Struggles to Break Catch-22 as App Makers Hold Off,” Reuters

(March 26, 2012).

24 A. S. Grove, Only the Paranoid Survive (New York: Doubleday, 1996).

25 R. K. Sinha and C. H. Noble, “The Adoption of Radical Manufacturing Technologies and Firm Survival,” Strategic

Management Journal 29 (2008): 943–962.

26 D. Lavie, “Capability Reconfiguration: An Analysis of Incumbent Responses to Technological Change,” Academy

of Management Review 31 (2006): 153–174.

27 S. A. Brown, “Household Technology Adoption, Use, and Impacts: Past, Present, and Future,” Information Sys-

tems Frontiers 10 (2008): 397–402.

28 The World Bank. http://data.worldbank.org/indicator/NY.GDP.MKTP.CD

29 “Nigeria Gives Huawei a Place to Prove Itself,” The Wall Street Journal (September 12, 2011), p. B2.

30 E. K. Foerdermayer and A. Diamantopoulos, “Market Segmentation in Practice: Review of Empirical Stud-

ies, Methodological Assessments, and Agenda for Future Research,” Journal of Strategic Marketing 16 (2008):

223–265.

31 U.S. Census Bureau, 2011, International database, http://www.census.gov/pic/www/idb/worldpopgraph.html.

32 D. Powell, “Sparing the Rare Earths: Potential Shortages of Useful Metals Inspire Scientists to Seek Alternatives

for Magnet Technologies,” Science News (August 27, 2011), p. 20.

33 S. Moffett, “Fast-Aging Japan Keeps Its Elders on the Job Longer,” The Wall Street Journal ( June 15, 2005), pp. A1 and A8.

34 http://corporate.honda.com/innovation/walk-assist/.

35 Procter and Gamble, Sustainability Report (2013), http://www.pg.com/en_US/downloads/sustainability/

reports/PG_2013_Sustainability_Summary.pdf.

36 C. Oliver and I. Holzinger, “The Effectiveness of Strategic Political Management: A Dynamic Capabilities Frame-

work,” Academy of Management Review 33 (2008): 496–520.

37 S. Michailova and K. Hutchings, “National Cultural Influences on Knowledge Sharing: A Comparison of China

and Russia,” Journal of Management Studies 43 (2006): 384–405.

38 Roger McCarty is credited with the early versions of these tools. The five forces tools presented here are general-

ized forms of specific tools used in a number of Fortune 500 firms. While the tools presented here are a good

starting point, in actual practice they may need to be altered to fit the circumstances of a particular industry.

For instance, in the operating systems industry, network effects play a bigger role than the capital cost of plant

and equipment.

http://data.worldbank.org/indicator/NY.GDP.MKTP.CD

http://www.census.gov/pic/www/idb/worldpopgraph.html

http://corporate.honda.com/innovation/walk-assist

http://www.pg.com/en_US/downloads/sustainability

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Internal Analysis: Strengths, Weaknesses, and Competitive Advantage

WALT DISNEY PICTURES / Album / Album / SuperStock

[ 47 ]

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Studying this chapter should provide you with the knowledge to:

1 Identify the steps in the value chain a firm uses to create competitive advantage.

2 Distinguish among the core concepts of strengths, weaknesses, resources, capabilities, and priorities.

3 Evaluate the strength and sustainability of internally generated competitive advantages using the VRIO model.

4 Analyze a company and identify its strengths or weaknesses, resources, capabilities, and priorities using the company diamond tool.

L E A R N I N G O B J E C T I V E S

[ 48 ]

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W hen most of us think of the Disney Company, we

think of Mickey Mouse, Disney’s oldest and most

important in a long line of memorable characters.

As the company’s spokesman, he appears prominently

on the Walt Disney Company’s home page (http://

thewaltdisneycompany.com/about-disney.)1 Everyone knows

Mickey, but few know the story of how Mickey’s arrival in

1928 set off a chain of events that continues to drive profits

for Disney more than 85 years later.

In 1923, Walt Disney and his brother Roy settled in

Burbank, California. They created the Disney Brothers

Cartoon Studio to capitalize on a series of Laugh-O-Gram

animations Walt had produced in their hometown of Kansas

City, Missouri. Later that year, movie distributor Margaret

Winkler contracted with the new studio to produce a series

of single-reel cartoons based on a character from Walt’s

first movie, Alice’s Wonderland.2 After 56 successful episodes

of the Alice Comedies, Winkler’s husband, Charles Mintz,

contracted with the Disneys in 1927 to produce a new

character, Oswald the Lucky Rabbit.

Oswald quickly gained popularity, due in large part to

the Disneys’ insistence on quality drawing and animation

sequences that came to be described as the “illusion of

life,” which enabled characters to move smoothly, like

real humans.3 In 1928, Walt and his wife, Lilly, headed

east to negotiate with Mintz for more money to expand the

successful series. The negotiations did not go well for the

Disneys. Not only would Mintz not pay more, he fired Walt!

Mintz held the rights to the Oswald character, and he set out

to produce Oswald without the Disney brothers.

Crushed at the loss of their main character and income

source, Walt and Lilly boarded the cross-country train to

return to Hollywood. Lilly recalled, “Walt showed me some

of his sketches on the train coming home. They were cute

little things; they could do anything. I asked him what he

was going to call the character. “Mortimer Mouse,” he said.

I said, “That doesn’t sound very good,’ and then I came up

with ‘Mickey Mouse.’”4 That mouse, conceived in adversity,

would soon lead his creator to prosperity.

Mickey’s public debut in Steamboat Willie in late 1928

introduced not only a memorable mouse performing

laughable antics, but also a company that incorporated the

latest technology to bring its stories to life. Sound was just

beginning to make inroads in Hollywood, and Steamboat

Willie represented the first synchronous sound movie.

Mickey’s motions and voice were perfectly timed with the

music and audio in the cartoon, a major advance in motion

pictures. The public, and critics, loved it, and the Disneys

were on their way to lasting success.

Walt and Roy Disney learned well from Charles Mintz

the importance of owning, not just creating, characters.

Ownership of their most important resources allowed the

brothers to control the use of characters by licensing the

images to others. Walt entered his first licensing agreement

in 1929 with a stationary company that

produced Mickey Mouse emblazoned

notecards. By the time WWII broke out in

1942, Disney was earning 10 percent of its

revenue from licensing.5

The cartoons featuring the lovable Mickey Mouse, and

cutting-edge technology became a Disney hallmark. The

company pioneered a series of firsts:

Technicolor was used for the first time in a film in

1938’s Snow White and the Seven Dwarfs.

A multi-plane camera enhanced the illusion-of-life

artistry.

In 1940, Fantasia introduced a precursor to modern

surround-sound technology. This innovative technol-

ogy would not spread industry-wide for another two

decades. 6

Walt’s capability to innovate continued throughout his

career. He realized the potential of television in its infancy.

Disney: No Mickey Mouse Company

0 3

EVERYONE KNOWS MICKEY, BUT FEW KNOW THE STORY OF HOW MICKEY’S ARRIVAL IN 1928 SET OFF A CHAIN OF EVENTS THAT CONTINUES TO DRIVE PROFITS FOR DISNEY MORE THAN 85 YEARS LATER.

http://thewaltdisneycompany.com/about-disney

THE VALUE CHAIN [ 49 ]

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The first Disney television broadcast in 1950 was One Hour

in Wonderland, a program Walt created to help promote

his upcoming film Alice in Wonderland. And on October 27,

1954, the first episode of Disneyland aired. The show would

later become Walt Disney’s Wonderful World of Color to

capitalize on the potential of color television. And, it would

last. In some version, new Disney programming, from

the original Mickey Mouse Club to today’s popular Disney

Channel, has been on weekly network television for more

than 60 years.

Walt entered the world of television in order to fund his

grandest innovation of all: The country’s first destination

theme park. Disneyland opened in July of 1955 on 270

acres of land in Orange County, California.7 Disneyland

defied all skeptics and proved to be a huge success from

the day it opened. The park combined the company’s skills

in engineering and entertainment. Walt even called his

designers “imagineers.” Walt’s focus on creating a clean

setting also helped to set Disneyland apart from other

amusement parks. Ferris wheels and roller coasters were

no substitute for Magic Mountain or the Tea Cups, and the

spotless and inviting atmosphere proved a huge draw for

families across the country. Disneyland became one of

America’s first destination resorts.

The Disney brothers chose to compete in a difficult industry. Their studio survived and eventu- ally flourished in spite of a harsh industry environment and intense competition. The film indus- try featured several large studios such as Metro Goldwyn Mayer (MGM) and United Artists. These industry powerhouses had access to the best actors and writers, and they had distribu- tion networks to ensure that their films played in theaters across the United States. Competition in the industry was fierce—the industry produced over 800 films a year throughout the 1920s.8

The Disney story, from a strategic perspective, captures the essence and power of a firm’s internal abilities—the resources and capabilities that can create and sustain a competitive advantage. The concepts and tools in this chapter will help you to evaluate a firm’s internal abilities in order to answer the question, “How can a firm succeed, even in a very difficult industry environment?” The first section of the chapter explains how firms create com- petitive advantages over rivals, and the second section discusses the sustainability of those advantages over time. Internal analysis seeks to allow informed and meaningful judgments about a company’s ability to win in its market, both in time (during any year or product cycle) and over time (as long as a decade or longer).9 Winning in time means that a firm has a com- petitive advantage; winning over time requires that advantage to be sustainable. We end the chapter by describing how to use a tool called the Company Diamond to create a meaningful visual model of the internal attributes that are the basis for a firm’s competitive advantages.

As we’ve mentioned, strategists assume that firms differ. How can we describe those dif- ferences in a clear way that highlight how they contribute to the overall strategy? The value chain provides a logical way to divide the firm into important strategic activities.

THE VALUE CHAIN

Figure 3.1 displays the value chain, or the steps in the process it takes to transform raw inputs into finished outputs. Developed by Michael Porter, the value chain is a way to depict and evaluate the activities a company performs. The horizontal elements in Figure 3.1 capture the production process that a firm uses to acquire and import raw materials, transform them into valuable outputs, and put them in the hands of customers. The vertical axis represents four administrative elements—firm infrastructure, human resource management, technology development, and procurement—that span all of the firm’s economic activities. Porter’s value chain not only provides a framework to describe the activities a company performs, it also can help to identify which activities represent the firm’s competitive strengths and weaknesses.

Walmart’s sophisticated information system shows how technology development adds value by creating critical firm infrastructure. Its information systems give Walmart strength in inbound logistics because it can find low-cost ways to move products from its suppliers to warehouses, and in outbound logistics, when it uses the same systems to move products at low cost to its retail stores. High-end retailer Nordstrom’s legendary return policy is part of its core activities in marketing and sales as well as after-sales service. The ability to return virtually any Nordstrom item with no receipt and no questions asked creates unique value for customers.

value chain A visual description of the steps required to turn raw

materials into finished products

and/or services. The value chain

also describes key functions of

the firm linked to each stage and

functions that span the productive

activities of the firm.

[ 50 ] CH03 INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE

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Apple’s dominance in its markets can be traced to its strengths in the support activities of technology development and procurement. For example, the original iPhone featured a very unique raw material, Corning’s ultra-strong Gorilla Glass.10 Apple’s iTunes website and Apple Stores showcase its strengths in operations. The company is also well-known for its strong marketing and sales efforts, including its sleek logo and advertising campaigns that have made Apple products a “must have” product for billions across the globe.

Disney’s early strength, as the opening case indicated, came in operations, by way of its illusion-of-life cartooning process and innovative film production, both of which were ena- bled by the company’s technological development. The company used its stable of memo- rable and unique characters such as Mickey Mouse, Snow White, and the Little Mermaid to create and sustain its brand identity in filmed and theme park entertainment. That identity contributes to Disney’s strength in marketing and sales, in theaters, theme parks, and retail operations such as the Disney Store.

The value chain helps managers identify areas in which a firm has an absolute strength, but provides no guidance about strength relative to competitors. So, the value chain can be used to answer the important question, “What is a firm good at?” However, it can’t be used to answer the critical question, “What is the firm better at than relevant competi- tors?” The second question can be answered through two processes. First, we’ll define a set of concepts—resources, capabilities, and priorities—to help in understanding the sources of a firm’s strengths. Second, VRIO thinking will be introduced, which is a way of measuring the magnitude and durability of a firm’s strengths versus competitive rivals.

THE RESOURCE-BASED VIEW

Resources, capabilities, and priorities can be thought of as answers to basic questions that firms face. Resources are what a firm employs to create value and competitive advantage. Capabilities represent how firms do things—the processes they use. Priorities explain why firms allocate critical resources to achieve key objectives.11

Resources Resources provide the answer to the question, “What creates the firm’s strengths?” One definition states that “resources include all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. controlled by a firm that enables the firm to

resources All assets, capabilities, organizational processes, firm

attributes, information, knowledge,

and so on, controlled by a firm that

enable the firm to conceive of and

implement strategies that improve

its efficiency and effectiveness.

capabilities The procedures, processes, and routines firms

employ in their activities.

priorities A firm’s values and rankings of what is most important.

Firm Infrastructure

Human Resource Management

Technology Development

Support (Enabling) Activities

Procurement

Inbound Logistics

Operations Outbound Logistics

Primary (Core) Activities

Marketing and Sales

After-Sales Services

r g

[ Figure 3.1 ] The Value Chain

Source: Adapted from Michael Porter, Competitive Advantage, 1985

THE RESOURCE-BASED VIEW [ 51 ]

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conceive of and implement strategies that improve its efficiency and effectiveness.”12 This definition clearly identifies what could be a resource, but its breadth makes it difficult to identify and limit what types of things count as a resource.

Most resources are, or could be, counted and quantified on a firm’s balance sheet as assets. Accountants classify resources as tangible or intangible assets. Tangible resources are those with physical presence, such as land, factories, machinery, equipment, or cash. Intangible resources are economically valuable assets that “do not have physical presence,” and include brands, licenses patents, knowledge, and reputation.13

Four categories of resources are important contributors to competitive advantage:

1. Physical resources, such as plant or equipment

2. Financial resources, such as free cash flow

3. Human resources, including employee and management skills and talents

4. Intangible resources, the intangible assets held by firms, such as brands and patents

These four types of resources enable both the core operational and important support/ administrative activities in the value chain. Nordstrom could not operate without the physi- cal resources of stores or a website for customers to visit, or without the financial resources of cash or credit to purchase inventory. Similarly, without the human resources of salespeople and the intangible resource of a strong brand, there would be no customer service, which gives Nordstrom its strength in marketing and sales. Finally, without the intangible resource of Nordstrom’s culture contributing to the firm’s infrastructure, and the human resource of its training programs, the shopping experience would provide little of the satisfaction that customers have come to expect.

Capabilities Capabilities are processes that the firm has developed to coordinate human activity in order to achieve specific goals. McDonald’s corporation holds a commanding 24 percent market share in the U.S. fast-food industry, nearly four times as large as rival Wendy’s.14 McDonald’s operates more than 34,000 stores worldwide, many of them in highly accessible locations, such as freeway off-ramps, towns, and mall locations. Although the stores themselves are resources, McDonald’s has also developed a set of operating capabilities, or processes, that are implemented in each of these stores. The process of filling customers’ orders at indus- try-leading speed is a capability at the heart of what makes McDonald’s successful. Speedy customer service involves several steps: procuring customer orders accurately and quickly, communicating the orders to the cooks, cooking the food, packaging it, and delivering it to the customer. This process is repeated hundreds of times a day at all 34,000 individual store locations, leading to high store-level capability for fast-food turnaround.

Competitive advantage relies on a strong set of operating capabilities. A firm’s advan- tage becomes stronger if it develops dynamic capabilities, processes that are designed to continuously expand existing resources or to improve or modify operating capabilities.15 Dynamic capabilities are practiced and refined over time and through repetition. For exam- ple, Procter & Gamble (P&G) has many brand resources, such as Crest, Tide, Pampers, Pan- tene, and Febreeze. But it also has been through the process of creating a new brand many times. Through repetition, P&G has refined its capability to create new brands to the point that it now has a dynamic capability that can help it expand its existing brand resources with new additions, such as the Olay Pro-X skin cleaning system.

Dynamic capabilities can help firms modify and evolve processes to keep pace with environmental changes such as new competitors, shifting demographics, or new tech- nologies. They can also enable firms to incorporate learning into their processes. For example, Toyota follows a method of continuous improvement of its processes, known as kaizen, in which ideas from many different sources are used to eliminate waste of effort or materials.

Companies with strong dynamic capabilities have a more secure foundation for com- petitive advantage than those without them, for two reasons. First, dynamic capabilities entail complex connections and coordination among different internal units within the firm. For example, finding the optimal site for a restaurant requires input from marketing

assets Tangible or intangible resources or factors of production

that create economic value for the

firm when employed. This chapter

focuses on physical, financial,

human, and intangible assets.

operating capabilities Procedures, processes, or routines for

delivering value to customers,

employees, suppliers, or investors.

dynamic capabilities Procedures, processes, and routines that

continuously expand existing

resources or improve operating

capabilities.

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about demographic information and target customer segments; the corporate counsel about sales contracts and local regulations; and real estate professionals skilled at identi- fying, negotiating, and closing on properties. Companies that have developed strong coor- dination processes are likely to also gain the competitive advantage of good restaurant locations.

Second, dynamic capabilities take time to develop and require signifi cant learning. Pro- cesses or routines represent deeply engrained habits of behavior that take years for com- panies to perfect. As fi rms and their managers master the ongoing process of learning and adjusting in the face of competitor, customer, or market changes, they develop a formidable set of dynamic capabilities.16 Read more about one of Disney’s critical dynamic capabilities, the ability to protect its intellectual property, in the Strategy in Practice feature.

Priorities Resources and capabilities help fi rms create and deliver unique value. So what drives the choices of which resources and capabilities a fi rm should invest money and time in? Th e answer is priorities, which are a fi rm’s ranking of what is most important. Priorities are driven by a company’s underlying values, its leaders’ beliefs about what is right and wrong, good and bad, desirable and undesirable.

Management guru Peter Drucker described values as the ultimate test for action.21 Drucker noted that corporate decisions about hiring from the inside or outside, a company’s stance about the importance of R&D, marketing, or any other functions look like technical questions of strategy; however, they are really questions about what companies and their leaders truly value.

Preserving Disney’s Capabilities: Don’t Mess with the Mouse!

S T R AT E G Y I N P R A C T I C E

Walt and Roy Disney learned early on about the importance of copyrighting characters, and over the years, his company developed a set of dynamic capabilities

to protect those resources.17 Steamboat Willie, also known

as Mickey Mouse, debuted on the screen in 1928. Under

existing copyright law, Disney’s copyright protection on

the fabled mouse would expire in 2003, 75 years after

the character’s origination. In 1988, Disney led a group

of Hollywood studios, music labels, and other content

owners in the entertainment business to successfully lobby

Congress to extend the copyright protection on Mickey

Mouse, and other characters created between 1923 and

1978, for another 20 years.18

With so much riding on the mouse and his friends,

Disney makes every effort to safeguard its property. The rise

of YouTube and other user-generated content (UGC) sites

has presented yet another challenge in the copyright wars.

Users can upload content to these sites without rights or

permission to the material. Disney recognized this threat

early and realized the resulting legal battle would be global,

long-running, and very, very expensive. Rather than threaten

YouTube and other technology providers, Disney General

Counsel Alan Braverman decided on a different strategy:

Disney would agree not to sue UGC sites as long as those

sites worked to remove copyrighted content on their own.19

The negotiations were delicate and took over a year, but

industry giants Disney, Microsoft, Viacom, Myspace, NBC,

Dailymotion, and Chinese UGC site Youku.com agreed to a

set of rules to protect content copyrights.

Critics complain that Disney’s efforts to protect its

copyrights stifle creativity and innovation in film and

entertainment, often at the expense of small, independent

filmmakers or retailers. The company maintains its legal

right to protect its brands and properties through copyright

law. Its actions around UGC, however, have allowed sites like

YouTube, Pinterest, and Facebook to grow without the threat

of costly and continuous lawsuits from content providers

such as Disney.20

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Values lead to priorities that help executives, managers, and employees make decisions. Priorities drive the creation of resources and capabilities in two ways. First, priorities guide resource allocation processes such as capital investment, human capital acquisition and training, and brand development. Second, priorities maintain those allocations over time when things get tough. Read in the Strategy in Practice feature how priorities infl uenced the design of a new headquarters building for Pixar Studios, a Disney subsidiary.

CREATING A SUSTAINABLE COMPETITIVE ADVANTAGE: THE VRIO MODEL OF SUSTAINABILITY

Walt Disney’s experiences with Oswald the Rabbit illustrate the diff erence between having a competitive advantage and sustaining that advantage through time. Although the fi rst cartoons were both profi table and promising of a strong future, the Oswald advantage was unsustainable because Disney didn’t own the rights to the character. Charles Mintz proved unable to sustain the character Oswald because Mintz lacked the capability to keep Oswald “alive” the way Disney kept Mickey Mouse alive through products, TV shows, and theme park. Oswald’s life on fi lm ended as Mintz’s team ran out of new ideas for the char- acter in 1943, shortly after Disney created to Bambi, Dumbo, and Pinocchio.24 Walt Disney lost a valuable competitive asset when Mintz enforced his ownership of the copyright on Walt’s fateful trip to New York, but Mintz lacked the capability to sustain the character he had captured.

Competitive advantages arise when resources or capabilities possess two attributes: Value and rarity. Two other principles determine the durability, or sustainability, of competitive advantage: Inimitability, the characteristics that make a resource or capability diffi cult to imitate, and an organization’s ability to exploit profi t returns generated by its

value Worth or utility.

rarity To be uncommon, or not available to other competitors.

inimitability An attribute of a resource that describes the degree

of difficulty a competitor would face

in copying, imitating, or mimicking

the value of that resource.

Values and Priorities at Pixar S T R AT E G Y I N P R A C T I C E

When Steve Jobs bought Pixar Animation Studios in 1986, he refocused the company away from its founding focus on high-tech hardware, toward creating computer-generated

animated movies that people would flock to. The refocus

was critically, as well as financially, successful and resulted

in box-office hits such as Toy Story 1, 2 and 3, A Bug’s Life,

Monster’s Inc., Finding Nemo, Cars, and Up.22

Jobs valued innovation and creativity, and he felt they

were the keys to Pixar’s success. Jobs also believed that

innovation is sparked when individual creative people

spontaneously get together and share ideas. Jobs oversaw

the design of the Pixar Studios building and made sure that

the architecture itself would reinforce his values, by making

interaction among employees a design priority. As Jobs’s

biographer Walter Isaacson recounts:

Because Jobs was fanatic about these unplanned

collaborations, he envisioned a campus where these

encounters could take place, and his design included

a great atrium space that acts as a central hub for the

campus.

Brad Bird, director of The Incredibles and

Ratatouille, said of the space, “The atrium initially

might seem like a waste of space . . .But Steve

realized that when people run into each other, when

they make eye contact, things happen.”

And did it work? “Steve’s theory worked from day one,”

said John Lasseter, Pixar’s chief creative officer “…I’ve

never seen a building that promoted collaboration and

creativity as well as this one.”23

At Pixar, values favoring creative collaborations led to

a design priority: interaction. Building a workspace that

promoted these interactions maintains and enhances Pixar’s

rich capabilities for innovation in both technical design and

storytelling.

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unique and valuable resources. Together, these four characteristics—value, rarity, inimita- bility, and organization to exploit profits—are often abbreviated as VRIO. We’ll examine each one in turn.

Value Mickey Mouse earned returns for Disney and allowed the company to grow because this character created value for film distributors and viewers. Value denotes worth for custom- ers. A resource creates value if its contributions allow a company to produce a product or service that is of worth to end users. Products or services have value when they create direct pleasure, satisfaction, or happiness for the end user, or when they create indirect opportunities that for users to experience produce pleasure and satisfaction. Users won’t pay for products or services unless they create value in their lives. In fact, a fundamental premise of our economic system holds that the price someone will pay for a good depends on the value that good produces. The higher the value, the higher the price that buyers are willing to pay.

Although not an absolute rule, resources and capabilities that provide firms with the opportunity to produce and sell at lower costs than their rivals create value for custom- ers. Low cost itself may produce some direct pleasure for users, but its benefits are mostly indirect, as purchasing products and services at a low cost usually leave users with more money to spend on other things that provide them pleasure or satisfaction. Similarly, unique products or services often create direct pleasure or satisfaction for customers. Resources that help a firm bring such differentiated products and services to the market create value for customers. Of course, those resources also create economic value for the firm, defined as profits. Chapter 4 includes a discussion of how firms can create cost leadership strategies and Chapter 5 considers differentiation.

Rarity To be rare is to be uncommon, or not available to other competitors. Unique is often used as a synonym for rare. McDonald’s tries to find unique locations for its restaurants, such as being the only restaurant at a freeway exit, or the closest to the on-ramp, or its presence as the sole dining option inside many Walmart stores. Rare or unique resources create competitive advantage through a basic principle of economics—scarcity. When products or services are scarce, users are often willing to pay a higher price for them than they would be if the same products or services were more commonly available, leading to higher com- pany profits.

Inimitability Inimitability is the extent to which competitors cannot easily reproduce a product by employing equal, or equivalent, sources of value in their own products and services. Think about attending a Major League Baseball, an NBA, or NFL game. The histories of the teams, the star players, the amenities of professional stadiums, and the rules adopted by each league to govern play mean that other leagues simply can’t imitate the experience these leagues provide. In fact, the last successful rival competitive league was the American Basketball Association (ABA), and it merged with the NBA in 1976. Several factors drive inimitability, thereby acting as barriers to imitation. We’ll describe each one below.

Path Dependence. Path dependence means that the process through which a resource or capability came into being may make it difficult for competitors to imitate. During World War II, British aerospace companies focused on building small fighter planes while Boeing, an American company, built many large bombers and tankers. After the war, Boeing leveraged its learning and investments in large aircraft to introduce the first successful commercial jetliner, the 707, in late 1957.25 A British company, De Havilland, actually developed the first commercial jet aircraft, the Comet. However, the Comet failed because De Havilland wasn’t as far along the learning curve on designing or building

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large aircraft that could safely fl y passengers. Path dependence helps to block imitation when resources or capabilities follow a sequential development path—for example, when previous investments enable later ones, or when signifi cant learning underlies the resource or capability.

Tacit Knowledge. For many processes, such as cooking French fries at McDonald’s, the actions needed to imitate the sequence can be codifi ed, or written down, and easily learned by others. Such easy-to-codify-and-learn knowledge is referred to as explicit knowledge. Tacit knowledge is just the opposite. Many valuable skills and processes, such as Walt Disney’s

Many companies have competitive resources in the form of proprietary business practices. These proprietary resources, also known as trade secrets, may be a “formula,

pattern, compilation, program, device, method, technique, or

process”26 that has been developed within a firm for its own

use. One common trade secret is the detailed information

about the purchase preferences of customers learned

by salespeople over time. This leads to manufacturing

companies, for example, customizing machines or tools to

fit their own unique production demands. Similarly, many

firms develop unique software code that adapts “off the shelf”

software packages such as SAP or Microsoft Office to perform

functions unique to the firm. Trade secrets improve a firm’s

ability to create a differentiated offering or to lower costs.

These trade secrets do not qualify for legal protection through

patents, copyrights, or trademarks, however, and challenges

arise when other organizations gain access to these “secrets.”

Trade secrets that create value for customers or other

stakeholders, and are unique to the firm can be a source

of a sustained advantage, as long as they do not “leak out”

and become common knowledge available to competitors.

Companies use two legal contracts to protect trade secrets:

nondisclosure agreements and noncompete agreements.

Nondisclosure agreements, often referred to as NDAs,

prohibit employees, suppliers, investors, or others who have

knowledge of a trade secret from sharing it with others.

Noncompete agreements prohibit employees from leaving

the company and taking a job with a firm that could exploit

an employee’s knowledge of trade secrets. A noncompete

agreement usually covers employee movement to firms

that compete directly, but could also include key suppliers

or customers as well. The use of NDAs and noncompetes

raises ethical issues for strategic managers.

From the firm’s perspective, these contracts offer protection

against the leakage of its valuable knowledge, processes, and

skills. Managers can, however, write NDAs so tightly that those

who sign them would be prohibited from using any knowledge,

skill, or process that is even remotely related to the actual trade

secret. Some entrepreneurs use the NDA as a weapon to keep

suppliers, customers, or investors from working on products

or projects that may be only loosely related to the trade secret.

NDAs that prohibit disclosure of particular lines of software

code, or particular programming languages, for example, may

stifle competition instead of protecting intellectual property.

Ironically, many venture capitalists, suppliers, and large

customers routinely refuse to sign NDAs in order to avoid

any restrictions on their ability to pursue their own interests.

Managers must balance their economic interests in protecting

their trade secrets with stakeholders’ ethical rights to pursue

their own goals without violating a contract.

Similarly, noncompete agreements can be written so

broadly that they unfairly penalize employees in their search

for new employment. First, noncompetes may be written in

a way that extends far beyond direct competitors, suppliers,

or customers and includes firms only distantly affected by

the firm’s trade secrets. Second, noncompetes may be of

such a long duration that even after a trade secret becomes

obsolete it still prevents employees from working for a

competitor. Managers, in their zeal to protect trade secrets,

can create agreements that restrict employees from using

even their generalized skills to find other employment.

Managers must strike an appropriate balance between

the strategic need of the firm to protect its valuable

trade-secret-based resources and the legitimate needs

of other stakeholders to interact with the firm and still

pursue their own interests.

E T H I C S A N D S T R AT E G Y

Ethics & Strategy: Nondisclosure, Noncompete, and Resource Protection

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ability to choose good stories or Steve Jobs’s ability to spot great design in a product, can’t be learned easily, if they can be learned at all.27 These skills are difficult, maybe even impossible, to learn, teach, or coach, because they are based on tacit knowledge. Tacit knowledge is sticky, or immobile, and difficult to imitate by competitors.

Causal Ambiguity. Causality refers to the notion that one thing causes another: A leads to B. Sometimes, however, the causal relationship is unclear or ambiguous, and the relationship between variable A and outcome B is difficult to disentangle.28 You may have learned in statistics courses that correlation does not equal causation, and just because A and B appear together does not mean that A causes B. One example is Steve Jobs, who studied calligraphy at Reed College and yogic meditation from gurus in India. Jobs credited these two experiences as highly influential in his aesthetic abilities, but most entrepreneurs will not find that calligraphy classes or meditation trips to India bestow upon them the same aesthetic abilities that Jobs possessed. In similar fashion, General Motors tried to imitate Toyota’s production methods—the Toyota Production System—to produce cars at the same cost and quality. But even after its engineers spent weeks and months watching Toyota build cars in a joint-venture plant, GM still wasn’t able to achieve equal productivity. The cause of Toyota’s productivity was not easy to determine because it was spread throughout the organization, including the hiring and training systems, the layout of its plants, and fundamental priorities and culture of the company.

Complexity. Resources, capabilities, and priorities become difficult for competitors to imitate when they span the organization or contain many interrelated elements and exhibit substantial complexity. Creating synchronous sound for Steamboat Willie, for example, proved a complex task in 1927. Walt Disney learned that the key was to time the cartoon framing and motion with the beat of the music (12 frames and beats per minute). Today, much of Disney’s competitive advantage rests on the complex interplay between film production, distribution in theaters and television, branding, merchandising, and theme park management. NBC Universal has similar resources, but its profit rate is only about one-fourth of Disney’s. Disney mastered the complex art of managing multiple, interrelated business over several decades, while NBC Universal combined these resources through a merger and has yet to prove the same ability to manage a complex and interrelated set of business processes.

Time Compression Diseconomies. Diseconomies happen when an action increases, rather than decreases, cost and efficiency. Timing is crucial in the development or deployment of many resources, capabilities, or priorities and can become a diseconomy in many cases.29 If a project requires a $20 million investment a year for the next two years, time compression diseconomies mean that you can’t get the same results by spending $40 million in one year. Resources that come from natural or physical processes, such as biological growth limits in biotechnology, pharmaceutical research, or forestry, cannot be rushed. Similarly, resources that come from differences in individual or organizational abilities to learn require adequate time for lessons to be deciphered and processed.30

Network Effects and First-Mover Advantages. Recall from Chapter 2 that much of the reason eBay is so successful has to do with network effects, which economists call positive network externalities. eBay wins because of its network effect. If you want to sell your old stuff, where do you want to sell? Some place where there are lots of potential buyers. If you want to buy stuff, where would you look? In a place with lots of sellers! More sellers attract more buyers, who in turn attract more sellers. It’s a virtuous circle. As eBay grows in popularity, other online auction sites such as Yahoo! have a hard time competing because it’s difficult to attract buyers and sellers. Everyone wants to be where they have the greatest exposure or selection.

Network effects represent a specific form of a first-mover advantage.31 For example, eBay has been able to lock up the best sellers and most active buyers for its site because it was the first mover in the market. Being the second to enter is difficult, as eBay learned in Japan, where it exited the market because Yahoo!’s auction site had captured the first- mover advantage.32 First movers establish a number of advantages. In addition to custom- ers, they can lock up other resources such as locations, patents, or scarce raw material

positive network externalities: When the value of a product

increases with the number of

users.

virtuous circle When more sellers attract more buyers, who, in turn,

attract more sellers.

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inputs. They can also establish long-term contracts with customers and set industry stand- ards that favor their products. These actions make it difficult for rivals to profitably imitate the first mover.

Organized to Exploit A firm may employ valuable, rare, and difficult-to-imitate resources and yet still lack a sustainable competitive advantage because the firm may not be organized to exploit or have the contracts and systems in place to capture the profits that resources create.33 Consider National Football League (NFL) players. Revenues paid to the NFL from television networks for the exclusive right to broadcast NFL games have grown from $47 million per year in 1970 to just over $4 billion each year in 2012, a compound annual growth rate of an impressive 12 percent. Over that same period, the players’ share of revenue has jumped from 35 percent in 1970 to 57 percent in 2011.34 How were players able to increase their share of the pie by over 60 percent?

Before 1970, the NFL Players Association (NFLPA) had been a weak collection of player representatives. During the 1970s, however, the NFLPA emerged as a true, well-organized union, capable of engaging owners in meaning ful contract negotiations backed up by credible threats of strikes and legal action. The contracts that the NFLPA negotiated for its members have garnered an increasing percentage of the NFL’s growing revenue. The NFLPA’s stronger organization enhanced its legal standing and administrative abilities, allowing players to capture the Ricardian Rents from their valuable, rare, and inimitable resources.

Assessing Competitive Advantage with VRIO Figure 3.2 shows the relationships between VRIO attributes of resources or capabilities and competitive advantage. You can assess the strength and durability of a company’s position by answering a yes or no question for each element in the matrix. Both resources and capabilities should be subjected to the VRIO questions to determine the strength of a company’s competitive advantage.

As Figure 3.2 shows, in the real world, firms that can’t create value for their stakeholders don’t survive. These businesses experience competitive failure. Many companies, especially new start-ups, introduce valuable products that are also unique and rare and enjoy a period

organized to exploit The degree to which the legal, administrative,

and operating structure of the

firm allows it to capture the rents

generated by resources.

competitive failure When firms that can’t create value for their

stakeholders don’t survive.

[ Figure 3.2 ] Resources and Competitive Advantage

Is the resource

valuable?

Is the resource

rare?

Is the resource

imitable?

Is the company

organized to

exploit?

Competitive

Failure

No No No No

Competitive

Parity

Yes No No No

Competitive

Advantage

Yes Yes No No

Durable

Competitive

Advantage

Yes Yes Yes No

Sustained

Competitive

Advantage

Yes Yes Yes Yes

Source: Adapted from Jay Barnery, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17,

no. 1 (March 1, 1991): 99–120.

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of competitive advantage. Th e combination of value and uniqueness creates a short-run competitive advantage in time for a fi rm. Over time, however, competitors can imitate these resources and create competitive parity in the industry. Parity means that a company survives but has no real competitive advantage over rivals.

To create competitive advantage in the long run—an advantage that endures over several years—a fi rm must create barriers to imitation. Barriers make it diffi cult for competitors to off er similar products or services, drive prices down, and dissipate the fi rm’s superior profi ts. Barriers to imitation provide a durable competitive advantage, one a company is able to sustain. Durable advantages dissipate over time, and moving from durable to sustainable potential advantage into an actual one requires an organizational structure and design that captures the value from resources and capabilities. Companies that realize sustained competitive advantage combine the legal elements, such as contracts or intellectual prop- erty rights; administrative elements, including organizational structure; and cultural ele- ments, such as norms regarding rewards and what constitutes equity that allow them to capture high profi ts that come from their valuable, rare and inimitable resources, capabili- ties, or priorities.

Managers may work hard to create resources and capabilities that are VRIO, only to then witness changes in technology, consumer tastes and preferences, government regulations, or other forces that imperil their source of competitive advantage. Th e Strategy in Practice feature describes how Disney responded when a new technology for cartooning presented a threat to its sources of competitive advantage.

competitive parity When a company survives but has no real

competitive advantage over rivals.

sustained competitive advantage When firms combine the legal elements, intellectual

property rights, administrative

elements, and cultural elements,

allowing them to capture high

profits that come from their

valuable, rare, and inimitable

resources, capabilities, or priorities.

Disney Responds to a Competitive Threat S T R AT E G Y I N P R A C T I C E

Disney’s initial competitive advantage arose from the company’s ability to combine illusion-of-life animation and the latest technological advances with classic stories in

the 1920s. Steamboat Willie, which pioneered synchronous-

sound, Fantasia, which debuted Technicolor, and Snow White,

the first full-length animated feature film, all still stand as

classics. Modern classics, including The Little Mermaid, The

Lion King, and Beauty and the Beast, built on and reinforced

Disney’s valuable, rare, and difficult-to-imitate brand and

character resources, as well as its storytelling capabilities.

Eventually, however, a leapfrog technological innovation

threatened Disney’s core source of competitive advantage.

In 1986, Pixar Animation Studios secured its first Oscar

nomination for its animated short film, Luxo, Jr. The

wonderful, family-friendly story of a small lamp signaled

that computer-generated animation (CGA), coupled with a

great story line, could prove a viable competitor to Disney’s

illusion-of-life capability.

With the development of its RenderMan software in

1987,35 Pixar, “could produce settings that looked absolutely

real,” said Pixar director John Lasseter.36 Pixar used this

new technology to produce a series of blockbuster hits,

including Toy Story, Toy Story 2, Monsters Inc., The Incredibles,

and Wall-E. Wired magazine would later peg Lasseter as

“the next Walt Disney.”37 Disney had used CGA since the

production of Tron in 1982, but only as a complement to,

never a substitute for, hand-drawn animation.

Disney lacked the in-house skill or software to compete

with Pixar. The company also found itself boxed in

strategically. Mickey Mouse turned 60 in 1987, and the Disney

brand evoked images of family-oriented entertainment but

not cutting-edge technology. Furthermore, the look and feel

of its animated character family appealed more to children

than to teenagers or adults. CGA posed a threat to Disney’s

brand, character resources, and to its illusion-of-life and

storytelling capabilities.

How did Disney respond? At first, the company partnered

with Pixar and provided distribution for Pixar films, as well

as financial resources for production and marketing. In

return, Disney received a percentage of the films’ profits.

The partnership prospered through six movies, including

Ratatouille, Up, Toy Story 3, and Monsters University.

During the time it partnered with Pixar, Disney’s own films,

built around its illusion-of-life animation, such as Treasure

Planet, were mostly unsuccessful. Eventually, Disney decided

it needed to own Pixar’s cutting-edge CGA capabilities. In

2006, Disney bought Pixar for $7.5 billion, adding Pixar’s

capabilities to its own pool of Disney capabilities.

THE COMPANY DIAMOND: A TOOL FOR ASSESSING COMPETITIVE ADVANTAGE [ 59 ]

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THE COMPANY DIAMOND: A TOOL FOR ASSESSING COMPETITIVE ADVANTAGE

We’ve introduced some important concepts to help you understand how a company’s inter- nal resources and capabilities may allow it to deliver unique value and achieve superior performance. Internal analysis depends on more than concepts, however, and so now we present an analytical process and tool that allow you to identify and catalog a firm’s poten- tial for sustained competitive advantage. The company diamond tool will help you in the academic work of this course, but it will prove even more valuable as you decide whether to invest in or work for a particular company. You can also use the company diamond after you take a job, when you work on teams assigned to create strategy for your company or to understand the strategic strengths of your competitors. This tool will prove particularly helpful should you want to start your own company.

The diamond also invokes a powerful metaphor about internal sources of competitive advantage. Diamonds are valuable, but the creation of that value depends on the actions of people and organizations. The diamonds you see in a jewelry store have been taken from their original, raw state and cut, shaped, and graded to increase their value. Companies cre- ate sustainable competitive advantages by taking raw factors or production and molding them into VRIO resources and capabilities.

Figure 3.3 illustrates the company diamond. The diamond shape helps you to integrate the different internal elements that create layers of competitive advantage. 38 In the top layer are the activities that create strengths and weaknesses. Resources and capabilities lie below, in the center layer, because they lay the foundation for and fuel the activities in the top layer. The bottom of the diamond—the deepest driver of competitive advan- tage—captures the values and priorities that guide the development of resources and capabilities.

The numbered questions can be answered in order to help you move down the diamond to discover the different sources of competitive advantage for a company. When you are finished gathering and analyzing data to answer them, you should be able to draw a dia- mond or create a table for the company that provides a robust and detailed picture of the company’s strategic advantages.

[ Figure 3.3 ] The Company Diamond

Source of Advantage

1. What is the company good at?

2. How does this create value?

3. What resources and capabilities drive those activities?

4. What values support and sustain resources and capabilities

1. Is the element rare?

2. Is the element inimitable?

3. Is the organization able to exploit?

Durability of advantage

Strengths & Weeknesses

Resources

(Activities)

Capabilities

Priorities

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Gathering Data for Company Diamond Analysis Data to complete a diamond profile come from a number of sources. You can use three main types of data:

1. Archival data: Written or numeric information can be found in the library or on the Internet.

2. Interviews: Interviews can range from personal questions to impersonal surveys.

3. Observation: Your own experiences, such as visits or use of products or services, are also valuable.

If you want to create a diamond profile for a private company, you may find very lit- tle archival data, but it might be simpler to locate people willing to grant interviews or to directly observe the company. For public companies, the reverse often proves true. Abun- dant archival data exist, but companies often create barriers, or firewalls, that make inter- views difficult. The size of the company means that observations provide only a limited view of the company. The appendix at the end of the book helps you know what to look for as you perform a diamond analysis, and describes in detail different data sources you can use to do the analysis.

As you gather data and use the questions to sort and categorize the information you find, remember the GIGO principle from computer programming: Garbage in, garbage out. Stated more elegantly, the more attention you pay to gathering, verifying, and comparing the data, the richer, more robust, and more insightful your finished product will be. You should always rely on at least two types of data (e.g., archival records and interviews), and use multi- ple sources of data within each type. For each strength, weakness, resource, capability, value, or priority that you identify, include the source from which you drew your data. If your data all come from a single source such as a website, Bloomberg Businessweek, Fortune, or Wall Street Journal article, then your diamond will be weaker than if the information is drawn from multiple sources. Tapping other data sources, such as doing an interview or scheduling a plant visit, may seem daunting, but doing so will pay great dividends in creating a richer, more complete profile of the company.

Be very careful to balance your data sources. Don’t rely exclusively on data provided by the company or solely on data that come from the company’s detractors. Both have a point of view that differs from the real company. If you are thinking about accepting a job with a company, or one of its competitors, you’ll want to dedicate significant time and energy to developing the richest diamond you can.

Using the Company Diamond You can use the diamond to focus on a company’s strengths or its weaknesses. It is often simpler to create a separate analysis for strengths and weaknesses as a first step.

Table 3.1 shows the results of a simple diamond analysis to compare the strengths of two national retailers: Walmart and Nordstrom. As you can see from the table, both Walmart and Nordstrom have clearly identifiable strengths that customers, suppliers, and others can readily see.

What if you wanted to create a diamond profile to focus on a company’s weaknesses? Consider Sears Holdings, the company created by the 2004 merger of Sears and Kmart. Kmart began operations in the late nineteenth century and was a competitor of Walmart until Walmart drove them into bankruptcy. Sears opened its first retail store in 1925 and enjoyed a run as America’s largest retailer through most of the twentieth century.

A visit to a Sears store would allow you to observe both the company’s strengths and weaknesses. Sears boasts a broad line of major national brands and some well-known house brands, including Kenmore appliances and Craftsman tools. Sears offers its goods at multi- ple price points.39 However, while you would see a broad selection, you would also likely see a store with outmoded lighting, worn carpeting or tile, and a merchandising and product mix that lacks excitement. Articles in the popular press indicate that the company’s strategy centers on store closings and layoffs, rather than on investing in new capabilities.40

THE COMPANY DIAMOND: A TOOL FOR ASSESSING COMPETITIVE ADVANTAGE [ 61 ]

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A read of Sears Holdings 2011 Annual Report or its 10-K filings, financial reports required by the Securities and Exchange Commission (SEC), would reveal a company with a 2011 loss of over $3 billion and cash resources that declined from $1.3 billion to $754 million over the same period.41

The mission and values statements featured on the company’s website focus on building lifetime relationships with customers, quality products, and positive energy. You may notice, however, that these values don’t translate into priorities that connect with the company’s strategy of selling off its assets, which the Wall Street Journal termed the “early stages of liquidation.”42

If you use the VRIO process described in Figure 3.2, you would see that the rareness of Sears’s resources diminishes with each sale of a valuable set of assets, a brand, or a retail operation. Specialty retailers, such as local appliance stores or dedicated tool shops, not only imitate Sears’ broad selection of products, they often exceed it and provide more knowledge- able service and support. Discount and big-box retailers such as Sam’s Club, Costco, or The Home Depot match any price advantage Sears offers. Finally, you might notice that, as of 2012, Sears seems to be organized to sell, rather than grow, any superior profit returns from its resources and capabilities. Table 3.2 summarizes the Sears situation based a company diamond analysis.

The diamond profiles for Walmart, Nordstrom, and Sears Holdings should help you understand the variety of strategies available to retailers. Company diamond analysis also reveals how the strengths, resources, capabilities, and values work together at winning com- panies Walmart and Nordstrom, and how they don’t work together at Sears Holdings. The profiles will help you have a better understanding as to why Walmart and Nordstrom gener- ate superior returns for their shareholders and why Sears loses money.

[ Table 3.1 ] Using the Diamond Model to Identify Strengths

COMPANY

Questions Walmart Nordstrom

What is the company good at? Low prices Customer service

What resources and capabilities

create those strengths?

Stores located in rural areas

Number of stores

Logistics, planning

Distribution centers

IT systems

Pricing policies

Posh stores

Talented staff

In-store merchandising

Selection and retention of staff

How does the company create value

for customers?

Low prices that enable customers to

purchase more total items

Pleasure and satisfaction through the

shopping experience and the goods

purchased

What priorities support/ sustain those

resources and capabilities?

Frugality

Striving for excellence

Outstanding service

Empowered employees

Competitive Advantage

Rare? Yes—size and scale Yes—reputation/brand

Inimitable? Yes—complexity Yes—causal ambiguity

Organized to exploit? Yes—centralized Yes—decentralized

Sources: Author interviews with selected organizational members, store visits and tours, various articles in popular press such as the New

York Times, Wall Street Journal, Bloomberg Businessweek, Fortune, and Forbes.

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[ 62 ] CH03 INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE

SUMMARY

Strategy tools can be used to understand better how companies create and sustain com- petitive advantages through their own efforts, as opposed to merely relying on the indus- try’s structure.

The value chain provides a broad and comprehensive roadmap for identifying the sources of a firm’s strengths and weaknesses among its different value-creating functions and infrastructure elements.

The factors of production that a firm uses to create competitive advantages can be divided into three categories: resources, capabilities, and priorities. Priorities support the development of capabilities, and they enable the creation and deployment of unique and valuable resources.

Valuable and rare resources and capabilities create competitive advantages for firms. The durability or sustainability of those resources depends on inimitability—how difficult it would be for a competitor to imitate the resource. Finally, the firm must be organized in legal and administrative ways that capture the returns created by those resources.

The company diamond is a tool to help identify, categorize, and assess the overall strate- gic advantages of a firm. The company diamond allows depth of analysis and understand- ing about the root causes of a firm’s competitive advantages.

[ Table 3.2 ] Using the Company Diamond to Identify Weaknesses in Sears Holdings

Questions

What is company good at? Broad selection of goods

Appliances, tools

What are the company’s weaknesses? Outmoded stores

Poor merchandizing

Unmotivated employees

What resources and capabilities are lacking

and contribute to those weaknesses?

Lack of financial resources for reinvestment

Lack of strategic consistency to support training,

merchandizing

How does the company create value? Better value can be had through specialty stores or

discounters, such as Walmart or Home Depot

What values support/sustain those resources

and capabilities?

Stated values and goals not consistent with current actions

Priority seems to be survival

Competitive Advantage

Rare? Diminishing through asset sales

Inimitable? No. Specialty retailers offer better products, services and

low-cost retailers offer better prices

Organized to exploit? No. Corporate focus is on creating cash flow through asset

sales

APPLICATION EXERCISES [ 63 ]

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KEY TERMS

assets (p. 51) capabilities (p. 50) competitive failure (p. 57) competitive parity (p. 58) dynamic capabilities

(p. 51) inimitability (p. 53)

operating capabilities

(p. 51) organized to exploit

(p. 57) positive network

externalities (p. 56) priorities (p. 50)

rarity (p. 53) resources (p. 50) sustained competitive

advantage (p. 58) value (p. 53) value chain (p. 49) virtuous circle (p. 56)

REVIEW QUESTIONS

1. Identify and describe the three major elements of the value chain. How can the value chain help you do internal analysis?

2. What is a resource? What types of resources can firms employ in their search for competi- tive advantage?

3. What is a capability? How do capabilities work together with resources to enable compa- nies to create value?

4. How do different types of resources work together to create competitive advantage?

5. Under what conditions will resources lead to competitive advantages? When will those advantages be sustainable?

6. Identify three situations in which a company diamond analysis would be useful to you. What two rules about data collecting should you remember when you do a diamond analysis?

APPLICATION EXERCISES

Exercise 1: Go to your local grocery store and walk down the cereal aisle, the soda and snack foods aisle, and the meat aisle. How many different brands do you see on each aisle? Which companies produce those brands? Research two companies from your search and use the value chain to describe each company. As you compare them, what key differences do you see in their value chain strengths and weaknesses? How does their financial perfor- mance differ?

Exercise 2: Choose a company you would like to work for. Using the company diamond tool, analyze the strength (or weakness) of competitive advantage for your target company and for the two rival firms. Begin your research by looking at news reports, company filings, and press releases to create a working model of the company diamond. Then, identify and interview someone who works at that company. Find out what elements they would include in the diamond. How did the diamond differ when you included “inside” information? How would you evaluate the company’s prospects for future performance?

Exercise 3: Identify two companies in the same industry. Using the company’s 10-K fil- ing or other available data, determine the operating performance (market share, customer satisfaction, new product introductions, etc.) and financial performance (return on sales, return on assets or equity, free cash flow) of both companies. Using the data in the 10-K or annual report, create a list of resources and capabilities for each company. How do the differ- ences in the strength of competitive advantages correlate with firm performance?

[ 64 ] CH03 INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE

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REFERENCES

1 See http://thewaltdisneycompany.com/, accessed 10 December, 2012. You’ll find Mickey displayed in the “latest

news” section and on the flash video images that dominate the home page.

2 B. Thomas, Building a Company: Roy O. Disney and the Creation of an Entertainment Empire (New York:

Hyperion, 1998), pp. 46–47.

3 J. P Telotte, The Mouse Machine Disney and Technology (Urbana: University of Illinois Press, 2008). p. 27.

4 Thomas, pp. 57–58.

5 R. Grover, The Disney Touch (Homewood, IL: Irwin, 1991), p. 7

6 Telotte, p. 15.

7 Thomas, pp. 178–187.

8 http://www.1920-30.com/movies/. Accessed Nov. 28, 2012.

9 W. D. Miller, Value Maps Valuation Tools That Unlock Business Wealth (Hoboken, NJ: Wiley, 2010), http://site.

ebrary.com/id/10388356., pp. 35–36.

10 S. Weintraub, “Apple Acknowledges Use of Corning Gorilla Glass on iPhone,” 9t05MAC, available at

http://9to5mac.com/2012/03/02/apple-acknowledges-use-of-corning-gorilla-glass-on-iphone-means-gorilla-

glass-2-likely-for-iphone-5/, accessed 06 November 2013.

11 C. Christensen, K. Dillon, and J. Allworth, How Will You Measure Your Life? (New York: Harper Business, 2012).

12 J. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17, no. 1 (March 1,

1991): 99–120, doi:10.1177/014920639101700108., quotation from p. 101.

13 Stice and Stice, Financial Accounting, 7th ed., p. 537. (Independence, KY: Thomson/ Southwestern, 2006)

14 Research firm IBIS World has data on the major competitors in the fast food industry as of 2012. See http://

www.ibisworld.com/#MP347824, accessed Dec. 5, 2012.

15 For a discussion and definition of dynamic capabilities, see David J. Teece, Gary Pisano, and Amy Shuen,

“Dynamic Capabilities and Strategic Management,” Strategic Management Journal 18, 7 (August 1, 1997): 509–

533, doi:10.2307/3088148.

16 Ibid.

17 J. Wasko. Understanding Disney, pp 85–86. (Malden, MA: Policy, Press, 2001)

18 See also C. Sprigman, The Mouse That Ate the Public Domain: Disney, the Copyright Extension Act, and Eldred

v. Ashcroft (2002). Available at http://writ.news.findlaw.com/commentary/20020305_sprigman.html, accessed

Nov. 17, 2012.

19 J. Mullich, “Disney’s GC Works His Magic,” Super Lawyers Business Edition. Available at http://business.superlaw-

yers.com/california-southern/article/Disneys-GC-Works-His-Magic/83da6d0f-3047-4a9e-8464-36710c6be140.

html, accessed Nov. 17, 2012.

20 Ibid.

21 P. F. Drucker, “Managing Oneself,” Harvard Business Review 83, no. 1 ( Jan. 2005): 100–109.

22 “The Inside Story: 5 Secrets to Pixar’s Success,” Fast Company (Sept. 14, 2011). See http://www.fastcodesign

.com/1665008/the-inside-story-5-secrets-to-pixar-s-success, accessed Nov. 3, 2013.

23 W. Isaacson, Steve Jobs (New York: Simon & Schuster, 2011), pp. 430–431.

24 A list of Disney movies, by year, can be found at http://d23.disney.go.com/archives/a-complete-list-of-disney-

films/, accessed, Dec. 6, 2012.

25 The Boeing 707 was not the first jet aircraft, but the first one to hold the jet-transport formula right. See http://

www.boeing.com/stories/timeline.html, accessed Dec. 7, 2012.

26 Definition found at http://www.law.cornell.edu/wex/trade_secret, accessed Jan. 24, 2014.

27 R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic Change (Cambridge, MA: Harvard University

Press, 1982).

28 R. Reed and R. J. Defillippi, “Causal Ambiguity, Barriers to Imitation, and Sustainable Competitive Advantage,”

The Academy of Management Review 15, no. 1 ( Jan. 1, 1990): 88–102.

29 I. Dierickx and K. Cool, “Asset Stock Accumulation and Sustainability of Competitive Advantage,” Management

Science 35, no. 12 (Dec. 1, 1989): 1504–1511.

30 W. M. Cohen and D. A. Levinthal, “Absorptive Capacity: A New Perspective on Learning and Innovation,” Admin-

istrative Science Quarterly 35, no. 1 (March 1990): 128.

31 M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 ( July 1,

1988): 41–58; Marvin B. Lieberman and David B. Montgomery, “First-Mover (Dis)Advantages: Retrospective

and Link with the Resource-Based View,” Strategic Management Journal 19, no. 12 (Dec. 1, 1998): 1111–1125.

32 C. Gaither, “Internet: eBay Exits Japan for Taiwan,” New York Times, Feb. 27, 2002. Available at http://www.nytimes

.com/2002/02/27/business/technology-briefing-internet-ebay-exits-japan-for-taiwan.html, accessed Dec. 7, 2012.

http://thewaltdisneycompany.com

http://www.1920-30.com/movies

http://site

http://9to5mac.com/2012/03/02/apple-acknowledges-use-of-corning-gorilla-glass-on-iphone-means-gorilla-glass-2-likely-for-iphone-5

http://www.ibisworld.com/#MP347824

http://writ.news.findlaw.com/commentary/20020305_sprigman.html

http://business.superlaw-yers.com/california-southern/article/Disneys-GC-Works-His-Magic/83da6d0f-3047-4a9e-8464-36710c6be140

http://www.fastcodesign

http://d23.disney.go.com/archives/a-complete-list-of-disney-films

http://www.boeing.com/stories/timeline.html

http://www.law.cornell.edu/wex/trade_secret

http://www.nytimes

REFERENCES [ 65 ]

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33 R. W. Coff, “When Competitive Advantage Doesn’t Lead to Performance: The Resource-Based View and Stake-

holder Bargaining Power,” Organization Science 10, no. 2 (March 1, 1999): 119–133.

34 Data compiled from Ghemawat, Commitment: The dynamic of strategy, pp. 96-98 (New York: Free Press, 2001)

and J. Vrooman, “The Economic Structure of the NFL,” in The Economics of the National Football League: The State

of the Art, ed. K. G. Quinn (New York: Springer Science + Business, 2012), 335.

35 Information drawn from Pixar Animation Studios History, available at http://www.fundinguniverse.com/com-

pany-histories/pixar-animation-studios-history/, accessed Nov. 19, 2012.

36 Wasko, Understanding Disney, p. 160.

37 J. Daly et al., “Hollywood 2.0,” Wired 5.11 (1997): 200–215. Cited in Wasko, p. 163.

38 For example, the Activity Map used by Harvard’s Michael E. Porter, What Is Strategy? (Boston: Harvard Business

School Press, 1996). Or the Strategy Canvas suggested by W. Chan Kim and Renée Mauborgne, Blue Ocean Strat-

egy: How to Create Uncontested Market Space and Make the Competition Irrelevant (Boston: Harvard Business

School Press, 2005).

39 Author visits to local Sears stores, 2011–2012.

40 D. Mattioli and K. Talley, “Pared-down Sears Posts Profit on Asset Sales,” Wall Street Journal, May 17, 2012.

Available at http://online.wsj.com/article/SB10001424052702303360504577409722818223112.html, accessed

Jan. 4, 2013.

41 See Sears Holdings, 10-K filing, pages 24 (profit reporting) and 37 (cash reserves). Available at http://www.sear-

sholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page=1&zoom=100,0,0, accessed

Jan. 4, 2013.

42 Mattioli and Talley.

http://www.fundinguniverse.com/com-pany-histories/pixar-animation-studios-history

http://online.wsj.com/article/SB10001424052702303360504577409722818223112.html

http://www.sear-sholdings.com/invest/docs/SHC_2011_Form_10-K.pdf#pagemode=thumbs&page=1&zoom=100,0,0

Cost Advantage

[ 67 ]

Studying this chapter should provide you with the knowledge to:

1 Differentiate between economies of scale and scope and describe how both produce cost advantages.

2 Describe what an experience curve is and how it can be used to make effective business decisions.

3 Discuss sources of lower input costs and how they provide the basis of a cost advantage strategy.

4 Explain two changes in a firm’s business model that can enable a cost advantage strategy.

L E A R N I N G O B J E C T I V E S

[ 68 ]

P riced at $2,500, Nano was launched as the world’s

cheapest car.

One rainy day in Mumbai, India, in 2003, Ratan Tata,

former chairman of the Tata Group, noticed a man riding

a scooter with an older child standing in the front, behind

the handlebars. The man’s wife sat sidesaddle on the back

of the scooter with another child on her lap. All four were

soaked to the bone. As Tata watched, he asked himself,

“Why can’t this family own a car and avoid the rain?” Then

he realized that, like over 700 million Indians who made

less than $10,000 a year, they probably couldn’t afford one.

Tata could not get the sight of that family out of his mind. He

began to dwell on the possibility of creating an affordable

“people’s car.”

“The two-wheeler observation [with the family of four

piled on the scooter] got me thinking that we needed to

create a safer form of transport,” Tata recalls. “My first

doodle was to rebuild cars around the scooter, so that those

using them could be safer if it fell. Could there be a four-

wheel vehicle made of scooter parts?”1 Tata gathered a

small group of engineers to design a low-cost vehicle with

four wheels. The initial design had two soft doors with vinyl

windows, a cloth roof, and a metal bar as a safety measure.

But after seeing the initial designs, Tata and his group

concluded that the market wouldn’t want a “half car.” So

Tata and his team spent the next several years designing a

“real” car that would use the least expensive materials and

the least expensive components, and could be assembled

with minimal skill in the fewest possible labor hours.

Tata’s dream became a reality in 2009, with the launch of

the Tata Nano. Priced at $2,500, Nano was launched as the

world’s cheapest car. Designed to only weigh 1,320 pounds

and get 50 miles per gallon, the Nano is powered by a

rear-mounted 35-horsepower engine. Yes, that’s not a typo;

only 35 horsepower.2 Compare that to the 170 horsepower

standard engine in the base-model Honda Accord, or even

the 70 horsepower engine in a tiny U.S. Smart car. The Nano

also sported numerous innovations (including 34 inventions

for which Tata filed patent applications) that made it India’s

Car of the Year in 2010.3

Beyond designing a car that could be manufactured at

low cost, Tata also thought about how these cars could

be distributed at low cost. The Nano is designed to be

assembled from kits at dealerships, much like motorcycles

are in the United States. This approach alone could disrupt

the entire automobile distribution system in India. Tata

needed a way to reach customers in the smaller villages in

India, where Indians primarily drove scooters.

To be able sell its cars as inexpensively as possible in

the smaller villages in India, Tata decided against building

dealerships; there simply wasn’t a large enough market.

Instead Tata imitated the strategy of companies that sold

scooters. Scooter dealers arrived on

Sunday at farmers’ markets or flea

markets with big trucks filled with

scooters and set out the scooters in

rows for people to buy immediately. The Tata team brought

40 Nanos at a time to each open-air market and provided

services so customers could see the car, learn how to

operate it, get a license, buy insurance, and drive it home

the same day. This approach allowed Tata to eliminate the

typical dealership overhead costs required to sell cars—

savings it could then pass on to its customers.4

The Tata Nano case illustrates how a company can

clearly define its unique value as being low cost, after

which it then develops the resources and capabilities to

deliver its product at the lowest possible cost. During the

first few months after launching the Nano Tata received

orders for almost 200,000 units—a solid start for an all new

model.

The World’s Cheapest Car 0 4

PRICED AT $2,500, NANO WAS LAUNCHED AS THE WORLD’S CHEAPEST CAR.

ECONOMIES OF SCALE AND SCOPE [ 69 ]

Companies typically choose between one of two “generic” strategies for offering unique value to customers: cost advantage or differentiation advantage (the focus of Chapter 5). By designing cars to be manufactured at the lowest cost possible, and by designing a distribution system to get the cars to customers at the lowest cost possible, Tata has a cost advantage over every other car- maker in India, which allows it to sell the Nano at the lowest price. Like Tata, a firm that chooses a cost advantage strategy wins with customers by reducing its prices below all of its competitors, thereby allowing it to gain market share. Alternatively, a firm with a cost advantage may choose the same price as competitors, which results in greater profits rather than higher market share.

Adopting a cost advantage strategy does not mean that the company focuses on cost to the exclusion of everything else. Having a single-minded focus on making a low-cost prod- uct or service can result in an offering that no one wants to buy. Although Tata wins with customers primarily because it sells a car that is cheaper than competitor offerings, it must still worry about producing a car that works and is at least somewhat reliable. In fact, some of the early Nanos caught fire, which scared off many buyers until Tata fixed the problem by beefing up the heat shield in the exhaust system.

However, a company that wins by providing low-cost products or services must focus most of its resources and capabilities on keeping its costs as low as possible. In this chapter, we’ll explore the five potential sources of cost advantage summarized in Table 4.1: econ- omies of scale or scope, learning or experience effects, proprietary know-how, lower-cost inputs, and using a different business model.

[ Table 4.1 ] Sources of Cost Advantage

Economies of Scale or Scope

Greater unit volume allows firms to have lower costs by:

spreading fixed costs across more units

specialization of equipment and people

Learning and Experience

Greater cumulative volume drives cost differences due to greater learning and experience within companies with more

cumulative experience in production.

Proprietary Knowledge

Some companies develop proprietary knowledge in the production of their product or service, which leads to a

cost advantage.

Input Costs

Some companies may have lower input costs than others due to:

greater bargaining power over suppliers or labor

superior cooperation with suppliers (including lower transaction costs)

sourcing from low-cost locations (e.g., country comparative advantage)

preferred access to inputs

Different Business Model

Eliminating activities or steps in the value chain or using a different set of activities altogether may allow a firm to deliver

a product or service at lower cost.

ECONOMIES OF SCALE AND SCOPE

One of the primary reasons large companies dominate many manufacturing and service industries is because of economies of scale. Economies of scale exist when an increase in company size (measured as volume of production) lowers the company’s average cost per unit produced.5 For example, if Tata can sell a volume of 100,000 cars instead of 10,000 cars, the cost to produce each car will fall as the total volume or scale of production increases. When there are significant economies of scale in manufacturing, research and development, marketing, distribution, or service, large firms have a cost advantage over smaller firms.

economies of scale A reduction in costs per unit due to increases

in efficiency of production as the

number of goods being produced

increases.

[ 70 ] CH04 COST ADVANTAGE

Economies of scale arise from four principle sources: the ability to spread fixed costs of production, the ability to spread nonproduction costs, specialization of equipment, and specialization of people.

Ability to Spread Fixed Costs of Production High volumes of production enable firms to spread the fixed cost of production, the costs of plant and equipment, thereby lowering their cost per unit. A simple way to think about this is to imagine two roommates who decide to share the $3,000 cost of purchasing a big-screen TV. In this case, the cost per roommate is $1,500. If, however, another roommate joins in on the purchase, the cost per roommate will decrease to $1,000, because there are now three room- mates. If there were five roommates, the cost would drop still more, to $600 per roommate. The more roommates over which to spread the cost of the TV, the lower the cost per roommate.

In similar fashion, companies can spread the costs of their plant and equipment when they have more customers to share the cost. For example, it might cost a company $1 mil- lion to purchase equipment and a plant with the capacity to produce one thousand units of a particular product; but it might cost that company only $2 million to build a plant with the capacity to produce five thousand units. This happens because, in many activities, increases in output do not require proportionate increases in input. For example, building an auto plant that can produce 100,000 cars does not cost Tata five times the cost of a 20,000-car plant. The larger plant would typically only cost two to three times as much as the smaller one.6

Ability to Spread Nonproduction Costs High volumes of production also enable firms to spread the cost of nonproduction functions across more units, thereby lowering the cost per unit. Large volumes enable companies to spread the cost of research and development (R&D), advertising, and general and administrative expenses.

Research and Development. Firms that incur high R&D expenses—such as in the pharmaceutical industry—have a strong incentive to expand operations globally to as many customers as possible. Once a pharmaceutical company has made the R&D investment to develop a new drug, those costs essentially become a fixed cost to spread across as many consumers as possible. In fact, some research has shown that the best predictor of whether an industry is global (meaning that firms in the industry expand to compete on a global basis) is the company’s R&D costs as a percentage of sales. The higher a firm’s R&D costs as a percentage of sales, the more incentive the firm has to expand globally to spread those costs across more customers.7

Advertising. In similar fashion, advertising is also subject to economies of scale. The fixed cost of putting an advertisement in the local city newspaper is the same for a grocery chain with one store in a particular market as it is for a chain with three stores in the same market. By spreading the advertising cost across three stores, the larger chain will have one-third the advertising costs per store, with the same level of advertising.

General and Administrative Costs. General and administrative costs (G&A) include the costs of accounting, finance, human resource management, and the chief executive and her staff. A company with high sales volume can spread its G&A costs across more units, thereby creating a cost advantage. Walmart’s general and administrative costs are only about 0.5 percent of sales, for example. This is a much lower proportion than its competitor Sears Holding Company, which has G&A costs of roughly 2 percent of sales.8 Walmart actually spends, on an absolute basis, more than three times as much on G&A as Sears Holding Company does. It is because Walmart’s sales volume is 10 times greater that G&A is much smaller as a percentage of its sales.9

Specialization of Machines and Equipment Companies with large volumes are also able to produce at low cost because they can invest in specialized machines and equipment. A firm that has high volumes of production is often able to purchase and use specialized equipment or tools that small firms simply cannot afford, due to their lower production volumes. For example, in the ball bearing industry, the lowest-cost way to produce fewer than 100 rings is to do it on general-purpose lathes. Producing between 100 and 1

fixed cost of production Costs such as plant and equipment,

which are relatively fixed, meaning

that they do not increase with an

increase in the number of units

produced.

general and administrative costs (G&A) Expenses and taxes that are directly related to the general

operation of the company, and

executive salaries, general support,

and taxes related to the overall

administration of the company.

ECONOMIES OF SCALE AND SCOPE [ 71 ]

million rings is done most efficiently with a specialized screw machine. Companies that produce more than 1 million rings can afford to purchase an even more specialized high-speed, continu- ous-process machine that further lowers the cost per unit. As volumes increase, firms have the ability to use specialized (often automated) machines to do work at lower cost per unit.10

Specialization of Tasks and People High volumes of production also permit greater task specialization, thereby leading to greater employee specialization.

Task Specialization. When work tasks are specialized, workers can become more and more efficient at the particular task and avoid the loss of time that occurs from workers switching between jobs. For example, Henry Ford’s big breakthrough in the mass production in automobiles involved breaking down the production process into a series of separate tasks that could be performed by highly trained and specialized workers. Some workers specialized on design, others on specific parts, and others on testing.

Employee Specialization. Employees who specialize in accomplishing a particular task, such as accounting, legal, or tax work, often bring high levels of skills to their tasks. The value of employee specialization occurs not just in manufacturing environments, but also in knowledge industries such as management consulting, investment banking, and the legal profession, where specialization of labor permits larger firms to offer a wider range and depth of expertise to potential clients.

Smaller firms often do not have the volume necessary to justify high levels of employee specialization—and when they do hire specialized employees, there might not be enough work to keep them busy all of the time. This is why small firms are more likely to have employees who are required to perform multiple business functions and why they often outsource to subcontractors specialized work, such as accounting, legal, or taxes.

Evaluating Economies of Scale: The Scale Curve As we’ve seen, due to economies of scale, we expect cost per unit of output to decrease as unit volumes increase. This relationship can be shown in a graph, the scale curve pictured in Figure 4.1. Service businesses do not produce “units” of products like manufacturing busi- nesses. Instead, in most cases, companies use some version of “number of customers served” as their unit of analysis. Service companies can typically create scale curves that show how the cost to serve customers decreases as the number of customers served increases.

At some point, however, the costs per unit no longer decrease with increases in volume. This point, shown at Q1 in Figure 4.1, is called the minimum efficient scale. It is the optimal quantity for a company to produce.

task specialization Breaking a large process into smaller tasks

that require specialized knowledge.

employee specialization Increased efficiency that results when

employees perform a narrow

range of tasks over and over again,

leading them to acquire specialized

knowledge that helps them

complete the task more efficiently.

scale curve A graphic representation of the relationship

between cost per unit and scale

(volume) of production in a given

time period.

minimum efficient scale The smallest level of output (unit

volume) that a plant or firm can

produce to minimize its long-

run average costs. In a graphic

presentation of output/unit volume

(x-axis) and cost per unit (y-axis), it

is the output level where costs per

unit flatten and no longer continue

going down with increased output.

Low

Economies of Scale

Minimum Efficient Scale (optimal quantity)

Diseconomies of Scale

High

Volume of Production

C os

t pe

r U

n it

o f

P ro

du ct

io n

[ Figure 4.1 ] Economies of Scale

[ 72 ] CH04 COST ADVANTAGE

The Downside of Size and Scale in the Airline Industry

S T R AT E G Y I N P R A C T I C E

If a company continues to increase its volume beyond the minimum effi cient scale, the cost per unit actually starts to increase, due to diseconomies of scale. In large organi- zations, diseconomies of scale can happen because large plants become very complex to manage. Th is increase in size and complexity tends to lead to increased waste and lower employee motivation, which, in turn, leads to increased supervision costs.

Moreover, while large fi rms typically have an advantage in economic upturns, they are sometimes at a disadvantage during downturns because they have more diffi culty spreading fi xed costs when demand declines, as described in Strategy in Practice: Th e Downside of Size and Scale in the Airline Industry.

Some fi rms with heavy fi xed costs have moved to reduce the risks of large fi xed costs by shifting more of their cost structure from fi xed cost to variable cost. One way they do this is by outsourcing more of their activities, which will be discussed in depth in Chapter 7. For exam- ple, rather than invest in information technology personnel or equipment, they may outsource these services to a low-cost provider, perhaps in India. For these fi rms, the cost of information technology now varies according to how much the fi rm uses the subcontractor’s services. Dur- ing a downturn, the company does not have to continue paying for people or equipment it is not using. Another way they may convert fi xed to variable costs is by leasing equipment on a short-term basis, allowing them to turn equipment back to the lessor if demand is low. Th e key point to remember is that size and scale do not always guarantee a cost advantage.

Economies of scale are more relevant in some industries than others, meaning that costs per unit fall more rapidly with increases in volume in those industries. Scale curve slopes in these industries are described as “steeper” than those in other industries. One such industry is the mobile (cell) phone service industry. Figure 4.2 shows data for a wireless carrier, which estimates a scale curve. Th is scale curve suggests that costs per subscriber (shown on the vertical axis) drop by roughly 18 percent with each doubling of the number of subscrib- ers (shown on the horizontal axis). For mobile phone companies, volume brings signifi cant benefi ts. Th e relatively steep scale curve of the mobile phone service industry is a primary reason for mergers and acquisitions in that industry, as companies try to grow larger and get more subscribers. Today, a small number of large companies dominate the market. For AT&T, Verizon, and Sprint, the fi xed costs per subscriber drop by 10 to 25 percent with every doubling of the number of subscribers, because these companies can spread across more

diseconomies of scale An increase in marginal cost when output is

increased.

After the terrorist attacks on September 11, 2001, airlines in the United States experienced a dramatic decrease in passengers because people were worried about flying.11

During the prior 10-year period, American, Delta, and

Northwest—the largest carriers in the United States—had

been among the most profitable, in large part because of

their economies of scale. But during the three-year period

immediately following 9/11, these three airlines were among

the least profitable.

So how did being a large airline become a liability? There

were many contributing factors. One of the most important

reasons was that these large airlines had heavy fixed costs.

Prior to the attacks, they had spread those costs across

a lot of passengers. After the attacks, American, Delta,

and Northwest still had the same fixed costs, but they had

a much smaller volume of passengers. These airlines

suddenly had too many planes, too many gates, and too many

employees for the smaller number of passengers they were

serving. Combined with the economic downturn following

9/11, the airlines’ inability to spread their fixed costs over a

large number of passengers cut deeply into their profits.

Although economies of scale can be an advantage during

an economic boom, they can be an anchor weight during an

economic bust.

LEARNING AND EXPERIENCE [ 73 ]

subscribers the fixed costs of the cell phone towers required to route calls and the retail stores required to serve customers across more subscribers.

Economies of Scope Economies of scope differ from economies of scale in that the company does not reduce costs by increasing the volume of a specific activity but by expanding the scope of its opera- tions to related activities, so that some costs can be shared.12 Economies of scope exist when the cost of conducting two business activities within the same company is less than the cost of those same two businesses operated separately. To illustrate, when The Limited Inc. opens up a Limited store selling women’s clothing, a Victoria’s Secret store, and a Bath and Body Works store all in the same shopping mall, the company is looking for economies of scope. Each of these stores sells different kinds of products and therefore they perform very different activities in terms of product design, product mix, suppliers and marketing. How- ever, the activities required to run these three separate stores are not completely unrelated. All three stores need to find—and sign leases for—optimal locations in the shopping mall. All three stores also need to have their products shipped to the mall.

When these stores are part of the same company, the company can lower the costs of securing retail space by: (1) using the same people to identify, and negotiate the lease for, all three stores, and (2) using the bargaining power of leasing space for three stores rather than one to negotiate a better deal. The Limited can also lower distribution and shipping costs by using the same warehouses and trucks to ship products to the shopping mall. The company might engage in joint store promotions to boost sales, perhaps distributing promotional offers good for Bath and Body Works at the Victoria Secret stores, or vice versa.

The greater scope of its operations is what allows The Limited to share some of the costs of operation across its three stores. We discuss economies of scope in greater depth in Chapter 6: Corporate Strategies.

LEARNING AND EXPERIENCE

Some companies use the basic premise of “practice makes perfect” to help them pursue a cost advantage strategy. These companies are relying on the fact that humans can perform tasks more efficiently—more quickly, with greater dexterity—the more a task is

economies of scope The average total cost of production

decreases as a result of increasing

the number of different goods

produced.

cost advantage strategy A strategy in which the unique value offered to

customers is lower-priced products

or services.

5,000,000 $15.00

$20.00

$25.00

$30.00

A ve

ra ge

C os

t pe

r S

u bs

cr ib

er (C

on st

an t

D ol

la rs

) $35.00

$40.00

15,000,000 25,000,000 35,000,000

Number of Subscribers

Scale Curve: y = 3184.8x–0.271

Average Slope: 2a = 2(–0.272) = 0.83 Cost per subscriber falls (1 – 0.83) = 17 percent with each doubling of cumulative subscribers.

45,000,000 55,000,000 65,000,000

[ Figure 4.2 ] Wireless Scale Curve

Source: Wireless Experience Curve (Constant Dollars)

[ 74 ] CH04 COST ADVANTAGE

repeated. Doing a task a lot of times also often helps people become more effective, that is, they find better ways to complete the task. Researchers and strategists measure the effects of learning and experience using the learning curve and the experience curve.

The Learning Curve The learning curve is a tool that managers can use to determine the contribution of human learning on the part of employees to reductions in costs per unit. During World War II, researchers first noticed that labor costs per unit decrease with an increase in cumulative output. The researchers studied an aircraft manufacturing firm. They calcu- lated that the number of labor hours required to build each aircraft fell by roughly 20 per- cent each time the cumulative volume of production doubled.13 Since that initial discovery, a similar pattern has been found in many other industries, including the manufacture of ships, computers, and TVs.14

Learning curve advantages are also relevant in service industries such as accounting, consulting, legal services, and even personal services like hair styling. As an accountant completes a greater number of tax returns, she learns how to do it more quickly. The same can be said for a lawyer who repeatedly handles divorces or hair stylists repeatedly giving clients a particular hairstyle.

The learning curve is more complex than a scale curve to calculate because it requires gathering data on the cumulative volume of a given product or service produced, the total amount since the company started making the product or providing the service. In con- trast, the scale curve, described earlier in this chapter, shows how costs per unit change with increases of volume of production during a given time period, such as a quarter, half-year, or year. It is easier for companies to obtain cost information from specific time periods.

The Experience Curve In 1968, the Boston Consulting Group (BCG) generalized the concept of the learning curve to encompass not just direct labor hours but all costs incurred to produce a product or ser- vice.15 BCG conducted a series of studies on a variety of products and services ranging from bottle caps to refrigerators to long-distance telephone calls, and they found that costs per unit (and prices) fall in a predictable way with increases in cumulative volume. Costs drop with increases in cumulative volume due to a combination of factors, including economies of scale, but also due to learning.

The experience curve shows how costs per unit change with increases in cumulative volume produced. Like the learning curve, calculating an experience curve requires cumula- tive volume data. An experience curve does a better job of capturing learning effects than a scale curve, because it is based on cumulative volume, like the learning curve. But, it also does a better job of capturing the effects of economies of scale than a learning curve does, because it includes all costs, not just labor. However, if data from the same time period are used to calculate a scale curve and experience curve, both analyses produce the same result. For detailed instructions on how to calculate a scale or experience curve using Microsoft Excel, see the Strategy Tool at the end of the chapter.

Like scale curves, experience curves are applicable to service, as well as manufactur- ing, industries. Recall that, for service industries, the unit of analysis is generally “number of people served.” For example, the authors of this book consulted with a bank that was providing credit card services (a store-brand credit card) to Fry’s Electronics, a retail chain that competes with Best Buy. The bank was trying to decide whether to invest more money in marketing to convince more of Fry’s customers to apply for, and use, a Fry’s credit card. Our question to the company was: How much do your costs decrease as you add credit card subscribers? What is the slope of your experience curve? By understanding how much costs would decrease if the company doubled their number of credit card subscribers, the company would know how much they could afford to spend in marketing to get additional customers.

learning curve The concept that labor costs per unit decrease

with increases in volume due to

learning. New skills or knowledge

can be quickly acquired initially,

but subsequent learning becomes

much slower.

experience curve A representation of the relationship between

cumulative volume and product

cost.

LEARNING AND EXPERIENCE [ 75 ]

Since BCG’s early studies, literally hundreds of studies have shown that production costs usually decline by 10 to 30 percent with each doubling of cumulative output. All of this research is summarized in the law of experience:

The cost per unit of a standard product or service declines by a constant percentage (typically between 10 and 30 percent) each time cumulative output doubles.16

Although the law of experience is phrased in terms of cost reductions, the slope of an experience curve is described according to the percentage of costs that remain after dou- bling cumulative volume, rather than by the reduction in costs. For example, Figure 4.3 shows an 80 percent experience curve slope for semiconductors. This means that with each doubling of cumulative volume, the cost has dropped by 20 percent, or that costs are 80 per- cent of what they were before volume doubled. If the thousandth semiconductor produced costs a company $100 to make, then the two-thousandth semiconductor costs $80, and the four-thousandth semiconductor will cost $64, or 80 percent of $80.

Learning and experience curve slopes tend to be steeper in the early stages of production because learning occurs more rapidly in the early stages of production. This is because the most obvious opportunities to reduce costs will present themselves early in the experience of a company, but after those easy changes are adopted, gains from learning come in smaller increments. Both scale curves and experience curves tend to be steeper in manufactur- ing industries than they are in service businesses—which means volume tends to be more important for success in manufacturing industries.

Experience Curves and Market Share To a strategist, the logic of the experience curve suggests that the company with the highest volume in an industry—the highest share of an industry’s output—will also be the lowest-cost producer. In fact, early work by the Boston Consulting Group showed that a company’s rela- tive market share was a key indicator of competitive advantage and profit performance.17 This finding was corroborated by the PIMS studies (an acronym for Profit Impact of Market share Studies), which showed a consistent positive correlation between a company’s market share and its profitability in most industries.18 As discussed in Strategy in Practice: The Relationship between Market Share and Profitability in Retail Industries, the correlation can sometimes be seen in retail as well as manufacturing industries. The logic was as follows: the higher the company’s volume (its market share), the lower the costs per unit, and the better the profit performance. A company’s market share was seen as a key driver of firm profitability.

law of experience Costs per unit decrease with increases in

cumulative volume of production.

[ Figure 4.3 ] Semiconductor Industry Experience Curve

50 0,

00 0

1, 00

0, 00

1, 50

0, 00

2, 00

0, 00

2, 50

0, 00

3, 00

0, 00

3, 50

0, 00

4, 00

0, 00

4, 50

0, 00

5, 00

0, 00

0 0.00

10.00

20.00

30.00

40.00

50.00

60.00

Cumulative Volume of Production (units)

C os

t P

er U

n it

o f

P ro

du ct

io n

( $

)

Average Slope = 0.798

Average Decrease in Cost with Doubling

of Volume = 20.2%

[ 76 ] CH04 COST ADVANTAGE

The Relationship Between Market Share and Profitability in Retail Industries

S T R AT E G Y I N P R A C T I C E

[ Figure 4.4 ] The Market Share-Profit Relationship: Home Improvement Retailing

0.0% 0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

2.0% 4.0% 6.0%

Home Depot

Lowe’s

Walmart

SearsTrue Value

Ace Hardware

8.0% 10.0% 12.0% 14.0% 16.0%

Market Share in Revenue

N et

P ro

fi t

M ar

gi n

18.0%

Note: Market share fi gures are for 2004; profi t fi gures are an average of 2000–2005.

Th e initial conclusion from studies on the market share/profi tability relationship was that if a company wants to increase its profi tability, it should increase its market share. Th is had a clear implication for pricing strategy: A company should set its price based on its anticipated costs per unit (at the higher market share), not at current costs per unit. Th is kind of anticipatory pricing strategy would presumably trigger actual increases in market share, along with lower costs, per unit, and higher overall profi tability.

Does this strategy work? Not usually, and here’s why: Imagine that you compete in an industry with fi ve other companies who all hold the view that market share is the key to profi tability. To acquire market share from each other, each organization will have to drop its prices or increase its advertising and marketing costs. If all companies in a market adopt this approach, it seems clear that none of the fi rms will be particularly successful at either gaining

Food retailers like Albertsons and Pathmark sell thousands of products, as do home improvement retailers like The Home Depot and Lowe’s. In retail

industries, where companies sell multiple products, it is not

possible to analyze an experience curve, because retailers

do not have a “cost per unit,” as manufacturers do.

Another way for firms in these industries to answer

the question, “Do I need to be big to be profitable?” is to

plot each company’s market share (its share of industry

revenues) on the x-axis and each company’s profit margins

(operating profit as a percent of revenues) on the y-axis.

Figure 4.4 shows an example of such a graph for the home

improvement industry. This graph shows a clear positive

relationship between national market share and profit

margins. The Home Depot and Lowe’s have high market

share in the United States and are much more profitable

than Sears, Ace Hardware, or True Value hardware. In this

particular industry, it appears that national market share

contributes to lower costs and higher profitability.

However, we conducted this same analysis in the food

retailing industry, using companies such as Albertsons,

Kroger, Safeway, Pathmark, A&P, Giant Food, Wegmans, and

Food Lion. That graph showed that national market share

was not a good predictor of firm profit margins. Many regional

supermarket chains, including Wegmans and Giant Food, were

more profitable than larger national chains, such as Albertsons

and Safeway. We can conclude that it is not critical to have high

national market share to be successful in food retailing.

LEARNING AND EXPERIENCE [ 77 ]

market share or increasing profitability.19 The general consensus of strategists now is that mar- ket share cannot be easily purchased. Rather, it is most often earned, through a low-cost strat- egy or by offering a superior product. For example, Air Asia is currently the low-cost airline in Asia—and perhaps the world—because it has very low labor costs and provides fewer ameni- ties to customers than its competitors do.20 In fact, to keep costs low it doesn’t even rent gates at airports, but instead buses its passengers out to the tarmac where they board the plane. Air Asia consistently prices lower than competitors who realize they cannot afford to match the low prices. As a result, Air Asia is rapidly growing its market share by offering lower prices.

Most strategists today acknowledge that there is a correlation between market share and profitability and appreciate that greater market share will lead to lower costs per unit. As Air Asia grows its market share in the airline industry, for example, its cost per unit will decrease, which will further improve Air Asia’s profitability. However, in most cases the cause of both market share and profitability is some common underlying factor, such as a lower- cost method of production or an innovative product that allows a firm to simultaneously grow market share and profitability. In Air Asia’s case, its low-cost position is what allows it to grow market share and profitability simultaneously. In the case of Apple, its ability to simultaneously grow market share in music players (with iPod) and phones (with iPhone) while increasing profits is due to its ability to create an innovative product.

How Strategists Use the Scale and Experience Curves to Make Decisions Scale and experience curves are useful tools for making practical strategic decisions about growth and investment strategies; pricing strategies; strategies for managing costs; and acquisition strategies.

Growth/Investment Strategy. As we’ve mentioned, experience curves tend to be steeper in fast-growing industries. A scale or experience curve slope in a particular industry that is quite steep (a slope less than 85 percent is quite steep, meaning that with each doubling of volume, costs drop by 15 percent or more) indicates that first movers in a fast-growing market will secure a widening cost advantage. Firms in an industry with a steep curve have an imperative to grow as fast, or faster, than their rivals, so they do not end up at a cost disadvantage. Moreover, a steep curve also suggests that a firm should take whatever action is necessary to become a market-share leader. General Electric was known to have its business units follow the philosophy, “Be #1 or #2, or exit,” presumably because GE operated mainly in industries with steep experience curves, where it was difficult to be profitable if the business unit was not #1 or #2 in unit volume.21

Pricing Strategy. A scale or experience curve can also be useful as a basis for pricing strategy. A company can use the curve to anticipate future costs at different levels of volume. If higher unit volumes will produce lower costs per unit, the company may want to price its product or service aggressively low now, so that it can gain enough market share to reach those higher volumes, and make more money. For example, Hyundai has been described as a company that is pricing very aggressively to gain market share in order to lower its future costs per unit.22 The strategy seems to be working, as evidenced by the fact that share has tripled in the United States in the last 10 years. Of course, as we pointed out earlier, if all firms in an industry attempt to price for market-share gains without a sustainable cost advantage, the strategy may not work for any of them.

Cost-Management Strategy. A scale or experience curve can also be used as way to assess a company’s relative cost position. For example, it is possible to plot scale or experience curves for a company and for its competitors, allowing company leaders to assess how well each company is managing its costs. For many years, General Motors produced more cars than any other automaker in the world. An industry-wide analysis of several companies’ cost per unit produced (each car) showed, however, that while General Motors produced the most units, it did not have the lowest cost per unit.23 Toyota, Honda, and Hyundai all had lower costs per unit. This type of analysis suggests that General Motors was not managing its costs well. Given its high production volumes, it should have lower costs per car. There

relative cost The costs incurred by one company compared to the

costs paid by a competitor.

[ 78 ] CH04 COST ADVANTAGE

is probably much GM can learn from its lower-cost competitors. For example, Tata doesn’t have significant economies of scale in production like General Motors has, but Tata has developed proprietary designs and patents that allow it to produce cars at low cost.

Acquisition Strategy. Finally, a scale curve can be useful to predict cost synergies: the amount by which costs will likely decrease if two firms combine their volume/scale. For example, Guest Tek, a company that delivers Internet service to hotel rooms, saw an opportunity to lower its cost per room with the purchase of its competitor Golden Tree. Guest Tek had a volume of 200,000 rooms, and Golden Tree also provided Internet service to roughly 200,000 rooms.

Acquisitions are often based on such synergies, which is why acquiring firms must pay a premium to the shareholders of the target firm. How much was Golden Tree worth to Guest Tek? An experience curve analysis allowed Guest Tek to see that its total operating cost per room per day was decreasing by 29 percent with each doubling of rooms (a 71 percent slope, as shown in Figure 4.5). The acquisition of Golden Tree would almost double the number of rooms serviced, so Guest Tek could expect costs to drop by close to 29 percent. The actual drop would probably be somewhat less, due to the costs associated with integrating the oper- ations of the two separate companies, but at least Guest Tek had some idea of the cost syner- gies that it would likely generate as the result of acquiring Golden Tree. Guest Tek went ahead with the acquisition and achieved the expected cost synergies, leading to record profits.

In summary, scale curve or experience curve analysis can be an extremely useful tool for the strategist in making a number of key strategic decisions.

Proprietary Knowledge In some cases companies are able to achieve a cost advantage due to proprietary knowledge that is independent of scale or output. As described in the opening case, Tata designed the Nano in a unique way, for example, using a specially designed 35-horsepower, rear-mounted engine. Tata developed some important proprietary knowledge in design- ing the low-cost vehicle, some of which is protected by the 34 patents it applied for when it completed the design.24 Patents are often important sources of proprietary intellectual property. Another auto manufacturer, Toyota, has long been known to have lower produc- tion costs than its U.S. competitors in the auto industry—GM, Ford, and Chrysler—because it has pioneered flexible production techniques (sometimes called the Toyota Production System, or TPS), while U.S. firms have historically used mass production techniques.25 These techniques are not protected by patents but by trade secrets.

proprietary knowledge Information that is not public and

that is viewed as the property of

the holder.

[ Figure 4.5 ] The Value of Scale in Delivering Internet Service to Hotel Rooms

$0.10 0 70,000

1Power function (based on trend-fit) is C = 154.13 Q–.4955. Doubling volume (2–0.4955) delivers a

cost that is 71 percent of previous level.

140,000

Acquisition of

Golden Tree

(200,000 rooms)

Guest Tek costs fall by

an average of 29 percent with every

doubling of room count1

210,000 280,000

Number of Rooms (Installed Base) 350,000 420,000 490,000 560,000

$0.15

$0.20

$0.25

$0.30

$0.35

$0.40

$0.45

$0.50

$0.55

$0.60

$0.65

$0.70

To ta

l O pe

ra ti

n g

C os

t P

er R

oo m

P er

D ay

$0.75

$0.80

Note: Guest Tek Operating Cost per Room, 2003–2006

LOWER INPUT COSTS [ 79 ]

The architect of the Toyota Production System was Taiichi Ohno, a Toyota engineer who realized that Toyota simply didn’t have the volume of production required to compete with U.S. automakers on the basis of economies of scale. So, Ohno invented a set of processes that allowed Toyota the flexibility to make three to four different car models within the same plant. U.S. automakers, in comparison, could typically only make one or two different car models within the same plant. A key principle of the Toyota Production System is “just- in-time” delivery of components, both from outside suppliers and from different manufac- turing stations within the plant. Delivering components close to the time they will be used keeps inventories at plants low and minimizes waste.

Studies have shown that the Toyota Production System comprises roughly 30 key pro- cesses, including their “just-in-time” delivery. Although U.S. automakers have tried to imi- tate many of the practices of TPS, they have been relatively unsuccessful at understanding the full proprietary system and how it works. As a result, Toyota has been able to maintain a cost advantage and quality advantage over many competitors.

LOWER INPUT COSTS

Inputs are any purchases that are made by a firm in the course of conducting business activities. The term inputs is broad. It includes raw materials, supplies, parts, and equip- ment. Inputs also include labor, capital, and land. When companies in a particular industry purchase their inputs as commodities from the same competitive input markets, we can expect every company to pay the same price for identical inputs.

In some situations, however, companies can achieve a cost advantage through lower- cost inputs. There are four primary ways that companies achieve cost advantage through lower-cost inputs: (1) exercising strong bargaining power over suppliers, (2) cooperating especially well with suppliers, (3) getting inputs from low-cost locations, and (4) arranging better access to inputs than other companies have.

Bargaining Power over Suppliers Perhaps the most important way that companies get lower-cost inputs is by having greater bargaining power over suppliers than their competitors do. There are two main sources of bargaining power: buying a lot from the supplier and using successful negotiating tactics.

Purchasing Volume. Perhaps not surprisingly, suppliers can be expected to drop prices when buyers increase their volume of purchases. Indeed, as a rule of thumb, suppliers are known to drop prices by 5 to 10 percent with a doubling of purchased volume. At high volumes, suppliers experience economies of scale and the law of experience, so they can lower their prices. Walmart, for example, is known to get lower cost per unit prices from suppliers because it can guarantee significantly higher volumes than its major competitors, Target and Sears Holding Company.

Purchasing and Negotiating Tactics. Even when two firms purchase similar volumes of inputs, one of the firms may have negotiation skills and purchasing tactics that allow it to get inputs at lower prices. Once again, Walmart is well-known for its purchasing strategy and tough negotiating tactics. Walmart spreads its purchases across numerous suppliers, so that no one supplier has a dominant market share in any particular product category. The company’s willingness to drop a supplier’s product if another supplier comes in with a lower price is widely known. These practices let suppliers know that they are expendable, which creates an incentive for suppliers to always give Walmart their lowest prices.26

Cooperation with Suppliers Rather than strong-arm suppliers into offering lower prices as a result of bargaining power, some companies achieve cost advantages by working cooperatively with suppliers. Toyota is known for working cooperatively with suppliers to get lower-cost and higher-quality inputs. Rather than spread purchases across multiple suppliers, Toyota has a two-vendor policy; it typically only works with two partner suppliers of a particular input. By working with a

inputs Resources such as people, raw materials, energy, information,

or financing that are put into a

system (such as an economy,

manufacturing plant, computer

system, etc.) to obtain a desired

output.

[ 80 ] CH04 COST ADVANTAGE

smaller number of suppliers, Toyota is able to devote resources to make sure it coordinates very effectively with these particular suppliers.27 Toyota will even send its own engineers, who are manufacturing experts in TPS, to help suppliers implement more efficient manu- facturing processes to lower their costs. As a result of their close, highly cooperative rela- tionship with Toyota, many suppliers will build their manufacturing plants close to Toyota’s automobile assembly plants, thereby lowering the costs of transportation, logistics, and face-to-face communications. Toyota is often able to get lower input costs from suppliers by developing relationships that are highly cooperative.

Location Advantages Another way to achieve cost advantage through low-cost inputs is to source inputs from the lowest-cost location or country. The price of inputs can vary significantly between locations because of differences in wage rates, exchange rates, or raw material or energy costs.

Wage rates. When Nike entered the athletic footwear industry in the late 1970s, Adi- das was the world leader. Adidas produced high-quality shoes primarily in Europe, where labor rates were quite high. Textile workers were paid approximately $20 per hour in 1990. Nike decided to source all of its shoes from Asia, starting in Korea (where wage rates were roughly $2.50 per hour in 1990) and then later mainly in China and Indonesia (where wage rates were roughly $0.50 an hour in 1990).28 Because high-qual- ity athletic shoes require a lot of hand-stitching labor, Nike was able to get shoes at far lower cost than Adidas. Nike used these cost savings to invest in marketing, athlete endorsers, and shoe design—a strategy of differentiation.

Exchange rates. In the late 1990s, the value of the Indonesian rupiah fell from 4,000 rupiah per dollar to over 10,000 rupiah per dollar. This meant that Nike could buy more rupiahs with each dollar. It also meant Nike could buy shoes manufactured in Indone- sia for less than it could purchase shoes made in countries, such as China, where the currency had more value compared to the dollar.

Raw material and energy costs. The production of aluminum requires significant energy, which is why much of the production is done in countries with low-cost hydroelec- tric power, such as Canada.29 Pulp and paper producers have typically come from countries such as Canada and Scandinavia that have access to forests and hydroelectric power.30

Preferred Access to Inputs In some instances, a company may have a cost advantage because it has preferred access to particular inputs—it can get them more easily than other companies can. For example, drilling oil in Saudi Arabia requires only the simplest drilling technologies, because drilling is less complicated in the desert and oil is more frequently found relatively close to the surface. For this reason, Saudi Arabian oil companies can access oil more cheaply than most oil com- panies in the world can. In similar fashion, the diamond company De Beers has historically had preferred access to diamonds because De Beers owns and controls the output of a large percentage of the world’s diamond mines.31

Companies only gain a cost advantage through preferred access to inputs when those inputs are raw materials (such as oil or diamonds) that are rare and difficult to imitate.

DIFFERENT BUSINESS MODEL OR VALUE CHAIN

A final way to achieve a cost advantage is to use an entirely different business model, or set of activities, to deliver a product or service. There are two basic ways to create a new business model: to eliminate activities or steps in the value chain or to perform different activities altogether.32 The value chain refers to the sequence of all activities that are per- formed by a firm to turn raw materials into the finished product that is sold to a buyer.33 Each activity is designed to add value to the prior activity, which is why it is referred to as the value chain.

business model The plan and set of activities implemented by a

company to offer unique value and

generate revenue and make a profit

from operations.

value chain The sequence of all activities that are performed by

a firm to turn raw materials into

the finished product that is sold

to a buyer.

SUMMARY [ 81 ]

Eliminating Steps in the Value Chain One reason Ryanair has a cost advantage over other airlines in Europe is because it does not offer any in-flight meals, pillows, blankets, or even air-sick bags. By not offering these items, Ryanair not only doesn’t have to purchase the items itself, but also is able to significantly reduce the labor costs associated with getting meals on and off its airplanes or laundering blankets and pillows.

In similar fashion, Panasonic has long had a cost advantage over competitor Sony, because it opts to spend only one-half as much as Sony spends for research and develop- ment each year. Rather than lead in product development, Panasonic follows, largely by imitating Sony’s technologies. Panasonic also spends less than Sony does on advertising, because it does not lead in launching new product designs. Eliminating some R&D and advertising allows Panasonic to have lower costs, and lower prices, for comparable products sold in electronics stores.

Performing Completely New Activities Book retailer Barnes and Noble sells books through large superstores. Each store costs millions of dollars to build. The company also has thousands of employees working in those bookstores and millions of dollars of books on its store shelves. In 1995, Amazon.com began to sell books in a completely different way—over the Internet. It was much cheaper for Amazon to build a few large warehouses, take orders online, and ship books directly to the customers’ homes than to do the things Barnes and Noble was doing: building superstores, hiring employees to staff the stores, and buying and storing inventory.34 We provide a more comprehensive treatment of strategies based on different business models and disruptive innovations in Chapter 10. Some firms like Ryanair and Amazon achieve a cost advantage by deploying a different business model, meaning that they either eliminate activities or steps in the value chain, or they deliver their product or services using entirely different activities than their competitors do.

Revisiting Tata At the beginning of the chapter, we described how Tata entered the motor vehicle industry with the Tata Nano, which was heralded as “the world’s cheapest car.” Indeed, the Tata Nano was the lowest-priced car in the world and was expected to appeal to very price-sensitive Indian customers. Yet it hasn’t sold as expected. Between 2009 and 2013, Tata sold 229,000 vehicles—a number far lower than expected. So what happened? Most observers point to the fact that the Nano was marketed as the most affordable car available. But in the Indian market where car purchases are hugely aspirational, people don’t want to buy “the world’s cheapest car.” Purchas- ing a Nano makes the Indian consumer feel cheap and doesn’t give the impression that they want to give to friends and family. Says Haritha Saranga, a professor at the Indian Institute of Management in Bangalore, “It is important to change the current image of Nano as a cheap car.”35 So Tata represents a cautionary tale about how you position a low-cost product. For some products that are hard to differentiate, like sugar, salt, wheat, oil, coal, and aluminum, offering the lowest price may be all you need to win customer business. However, for many other prod- ucts, like a car, customers consider a broader set of factors beyond price. In Chapter 5, we turn our attention to the ways that firms differentiate their offerings in ways other than price.

SUMMARY

Companies that consistently offer lower prices due to lower costs rely on one or more of five primary sources of cost advantage: economies of scale or scope, learning and experi- ence, proprietary knowledge, low cost inputs, or a different business model.

Economies of scale produce cost advantages by allowing firms to: (a) better spread the fixed costs of production across more units, (b) spread nonfixed costs across more units,

[ 82 ] CH04 COST ADVANTAGE

and/or (c) invest in the specialization of machines and employees that lower the per-unit costs of production.

Learning produces cost advantages by improving employees’ efficiency and effectiveness. A learning curve shows reductions in labor costs per unit as cumulative volumes of produc- tion increase. A similar analysis that considers all costs produces an experience curve.

A scale curve shows how cost per unit decreases with increases in volume of production. An experience curve shows how cost per unit decreases with increases in cumulative vol- ume of production. Scale and experience curve analysis are useful for:

making investment/growth decisions,

making pricing decisions,

analyzing a company’s relative cost position and looking for opportunities to reduce costs, and

making acquisition decisions.

To a strategist, experience-curve logic suggests that the company with the highest share of an industry’s cumulated output will also be the lowest-cost producer. However, a strategy to simply buy market share, or grow volume, through increases in advertising or lower- ing prices does not typically result in higher profits. The correlation between high market share and high profitability is the result of some underlying factor, such as low-cost pro- duction methods or an innovative product that causes both to grow simultaneously.

Even when producing similar volumes, some companies are able to achieve a cost advantage as a result of proprietary knowledge about how to produce a product or service.

Lower input costs are possible due to: (a) bargaining power over suppliers or labor, (b) superior cooperation with suppliers, (c) sourcing from low-cost locations, or (d) preferred access to inputs (e.g., ownership of key raw materials).

Some firms achieve a cost advantage by deploying a different business model, meaning that they either eliminate activities or steps in the value chain, or they deliver their prod- uct or service using entirely different activities than competitors.

KEY TERMS

business model (p. 80) cost advantage strategy

(p. 73) diseconomies of scale

(p. 72) economies of scale

(p. 69) economies of scope

(p. 73)

employee specialization

(p. 71) experience curve (p. 74) fixed cost of production

(p. 70) general and administrative

costs (G&A) (p. 70) inputs (p. 79) law of experience (p. 75)

learning curve (p. 74) minimum efficient scale

(p. 71) proprietary knowledge

(p. 78) relative cost (p. 77) scale curve (p. 71) task specialization (p. 71) value chain (p. 80)

REVIEW QUESTIONS

1. What are the five sources of cost advantage?

2. Which of the five major sources of cost advantage contributed to the Tata Nano being the world’s least expensive car?

3. Explain three ways that economies of scale produce cost advantages.

4. What is a scale curve, and how it is different from an experience curve?

5. What data would you need to calculate a scale curve or experience curve?

6. Why do companies have difficulty increasing their profitability by simply buying market share (e.g., lowering prices to increase market share)?

STRATEGY TOOL [ 83 ]

7. Identify at least two ways that companies can achieve a cost advantage through lower- cost inputs.

8. Give an example of a company that has a cost advantage because it uses a different busi- ness model or shorter value chain than its competitors.

APPLICATION EXERCISES

Exercise 1: Read the Southwest case and answer the following questions. 1. What are the primary drivers of cost (major cost areas) in the airline industry?

2. What are the primary sources of Southwest’s cost advantage? In other words, do you believe that Southwest’s cost advantage can be best attributed to economies of scale, learning and experience, proprietary knowledge, lower-cost inputs, or a different business model?

3. How is JetBlue’s strategy similar to Southwest’s strategy? How is it different?

4. What prevents larger competitors, such as American, Delta, or United, from imitating Southwest’s approach? What prevents new entrants from successfully imitating South- west’s approach?

5. Assignment: Using data from the Southwest case, create a chart that plots the relation- ship between each airline’s market share, in terms of revenue or airline seat miles flown, and its profitability for two time periods: 1995–2000 and 2001–2005. Does your analysis suggest that market share is correlated with profitability in this industry? If you exclude Southwest Airlines and JetBlue airlines from the analysis (companies that use a “point- to-point” route structure rather than a “hub and spoke” route structure), how well does market share predict profitability?

Exercise 2: Find the sources of cost advantage of a successful company with low prices. 1. Identify a company you would like to learn more about that seems to have a cost advan-

tage—it consistently has the lowest prices in the market.

2. Use your own experience and public sources, including the company website or annual reports and public articles, to gather data about the activities of that company. Based on your data, what are the primary sources of the company’s cost advantage?

3. Try to identify any resources or capabilities the company has that enable it to achieve low costs.

4. What, if anything, do you think prevents other companies from easily imitating this com- pany’s strategy? For example, is it difficult to imitate the company’s source (or sources) of cost advantage? Why?

Imagine that you work for a wireless phone carrier that is trying to decide how much money it should invest in marketing and advertising in order to grow its number of

subscribers. Calculating a scale curve will let you determine

the extent to which increases in the number of subscribers

result in corresponding decreases in the cost per subscriber.

The faster that costs per subscriber drop with increases in

the number of subscribers, the more money the company

can afford to spend to acquire new subscribers.

To calculate a scale curve for a particular product or service,

you need the following data: Cost per unit (in this case, the unit

= one subscriber) at different levels of company volume (in this

case, volume = total number of subscribers). You can determine

the cost per unit with the following formula:

Company’s costs ÷ Number of units

Many strategists use numbers from several different years

to calculate the cost per unit. Here, we provide disguised data

for a wireless company’s total costs (expressed in constant

dollars with inflation taken out),36 number of subscribers, and

average cost per subscriber over 12 years.

To provide a visual summary of the relationship between

number of subscribers and the cost per subscriber, create

a graph that plots the number of subscribers for each year

can be plotted on the horizontal (x) axis and the cost per

Strategy Tool How To Calculate A Scale Curve or Experience Curve

[ 84 ] CH04 COST ADVANTAGE

subscriber can be plotted on the vertical (y) axis, using a

piece of graph paper or an excel spreadsheet. To quickly

estimate a scale curve—the extent to which costs decrease

with each doubling of the volume of subscribers—select

an initial year and then select a later year with twice the

number of subscribers. Divide the cost per subscriber in

the later year by the cost per subscriber in the earlier year.

For example, in Year 5, the number of subscribers was twice

that of Year 1, so we can divide the cost per subscriber in

Year 5 ($29.85) by the cost per subscriber in Year 1 ($36.40)

to estimate the extent to which costs drop with every

doubling in volume. In this case, $29.85/$36.40 = $0.82,

which suggests that after the doubling of volume, costs

per subscriber were 0.82, or 82 percent of what they were

before volume doubled. This result is called a scale curve

slope or experience curve slope of 0.82, or 82 percent.

To learn by how much, in percentage terms, unit costs

drop with every doubling of volume subtract the average

slope of the experience curve from 1 (1 – slope). In this

case, costs drop by roughly 18 percent as the number of

subscribers doubles (1 – .82 = .18, or 18 percent).

The approach we have shown here provides only a rough

approximation of the scale curve. You can calculate a scale

curve more accurately using spreadsheet software such

as Excel. The basic way to do this is to use a power curve to

calculate a regression or trend line through the points on a

graph. The formula for a regression line that expresses the

relationship between unit cost and production volume is:

C n = C

1 n-a

where: C 1 is the cost of the first unit of production

C n is the cost of the nth unit of production

n is the volume of production

a is the elasticity of cost with regard to output

(Here, elasticity is the relationship between how changes

in output translate into changes in cost).

This analysis has been done and is shown in Figure 4.2.

The slope for the data provided above is actually 17 percent,

rather than the 18 percent we roughly estimated. Costs

per unit drop by 17 percent with each doubling of volume.

Detailed instructions for how to calculate a scale or

experience curve in Excel are available through WileyPlus

LearningSpace.

REFERENCES

1 J. Dyer, H. B. Gregersen, and C. M. Christensen, The Innovator’s DNA (Boston: Harvard Business Review

Press, 2011).

2 A. Taylor III, “The World’s Cheapest Car,” Fortune (May 2, 2011), p. 86.

3 Ibid.

4 Dyer, Gregersen, and Christensen.

5 For more on economies of scale, see S. M. Sheffrin, Economics: Principles in Action (Upper Saddle River, NJ:

Pearson Prentice Hall, 2003), p. 157; G. M. Gelles and D. W. Mitchell, “Returns to Scale and Economies of Scale:

Further Observations,” Journal of Economic Education 27 (Summer 1996): 259–261.

YEAR TOTAL COSTS NUMBER OF SUBSCRIBERS

COST PER SUBSCRIBER

1 $553,571 15,102 $36.40

2 $605,823 17,255 $35.11

3 $726,653 21,940 $33.12

4 $809,650 25,992 $31.15

5 $901,022 30,185 $29.85

6 $977,227 34,026 $28.72

7 $1,127,115 39,912 $28.24

8 $1,238,115 44,843 $27.61

9 $1,318,457 49,325 $26.73

10 $1,373,314 52,257 $26.28

11 $1,453,207 57,439 $25.30

12 $1,538,182 61,429 $25.04

REFERENCES [ 85 ]

6 M. B. Lieberman, “Market Growth, Economies of Scale, and Plant Size in the Chemical Processing Industry,”

Journal of Industrial Economics 36 (2) (1987): 175–191.

7 See “DHL Global Connectedness Index 2012,” http://www.dp-dhl.com/content/dam/presse/specials/gci/2012/

dhl-gci-2012-chapter3.pdf, p. 48.

8 See U.S. Securities and Exchange Commission, “Sears Holdings Corporation,” http://www.sec.gov/Archives/

edgar/data/1310067/000131006713000013/shld201210k.htm, p. 24.

9 See U.S. Securities and Exchange Commission, “Exhibit 13.3 Annual Report to Shareholders,” http://www.sec.

gov/Archives/edgar/data/104169/000010416913000011/annualreporttoshareholders.htm, p. 26.

10 K. Junias, “Economies of Scale: A Survey of the Empirical Literature,” Kiel working paper 813, Kiel Institute of

World Economics (1997).

11 See http://traveltips.usatoday.com/effects-911-airline-industry-63890.html; E. Goldschein, “13 Ways The U.S.

Airline Industry Has Changed Since 9/11,” Business Insider (September 8, 2011), http://www.businessinsider.

com/how-the-us-airline-industry-has-changed-since-911-2011-9?op=1.

12 For more on economies of scope see J. C. Panzar and R. D. Willig, “Economies of Scale in Multi-Output Produc-

tion,” Quarterly Journal of Economics 91 (3) (1977): 481–493; “Economies of Scope,” American Economic Review

71 (2) (1981): 268–272; D. J. Teece, “Economies of Scope and the Scope of the Enterprise,” Journal of Economic

Behavior & Organization 1 (3) (1980): 223.

13 L. E. Yelle, “The Learning Curve: Historical Review and Comprehensive Survey,” Decision Sciences 10 (1979):

302–328.

14 M. Gottfredsen and S. Shaubert, The Breakthrough Imperative (New York: HarperCollins, 2008).

15 Perspectives on Experience (Boston: Boston Consulting Group, 1968).

16 Ibid.; also see G. Hall, and S. Howell, “The Experience Curve from the Economist’s Perspective,” Strategic Man-

agement Journal 6 (1985): 197–212.

17 G. S. Hansen and B. Wernerfelt, “Determinants of Firm Performance: The Relative Importance of Economic and

Organizational Factors,” Strategic Management Journal 10 (5) (1989).

18 P. W. Farris and M. J. Moore, The Profit Impact of Marketing Strategy Project: Retrospect and Prospects (Cambridge,

England: Cambridge University Press, 2004); Robert D. Buzzell and Bradley T. Gale, The PIMS Principles: Linking

Strategy to Performance (New York: Free, 1987).

19 R. P. Rumelt and R. Wensley, “In Search of the Market Share Effect,” Proceedings of the Academy of Management

(1981): 2–6.

20 See Air Asia, “Fourth Quarter 2010 Results,” (February 24, 2011), http://www.airasia.com/iwov-resources/my/

common/pdf/AirAsia/IR/AA_4Q10_Analyst_Presentation.pdf.

21 “How Jack Welch Runs GE,” http://www.businessweek.com/1998/23/b3581001.htm.

22 See: V. Courtenay, “Hyundai Aiming High on Several Fronts,” WardsAuto (March 20, 2013), http://wardsauto.

com/management-amp-strategy/hyundai-aiming-high-several-fronts-2013.

23 J. H. Dyer, “Dedicated Assets: Japan’s Manufacturing Edge,” Harvard Business Review (November–December

1994): 174–178.

24 A. Taylor III, “The World’s Cheapest Car,” Fortune (May 2, 2011), p. 86.

25 J. P. MacDuffie, “Human Resource Bundles and Manufacturing Performance: Organizational Logic and Flexible

Production Systems in the World Auto Industry,” Industrial and Labor Relations Review 48 (2) (1995): 197–221.

26 P. Ghemewat, S. Bradley, and K. Mark, Wal-Mart Stores in 2003 (Cambridge, MA: Harvard Business School Press,

2003).

27 J. H. Dyer and N. Hatch, “Using Supplier Networks to Learn Faster,” Sloan Management Review, 45 (3)

(2004): 57–63.

28 P. Rosenzweig, “International Sourcing in Athletic Footwear,” HBS case 9-394-184.

29 P. Chevalier, “Aluminum,” The Canadian Encyclopedia. 2012. Accessed on April 8, 2013. <http://www.thecanadi-

anencyclopedia.com/articles/aluminum>.

30 See C. Campbell, Global Forest, Paper & Packaging Industry Survey: 2009 Edition—Survey of 2008 Results. Price-

WaterhouseCoopers, 2009.

31 T. Kretschmer, De Beers and Beyond: The History of the International Diamond Cartel (New York: New York Uni-

versity, 2003).

32 G. Hamel, “Strategy as Revolution,” Harvard Business Review (1996).

33 M. Porter, Competitive Advantage (New York: Free Press, 1983).

34 “Barnes & Noble versus Amazon.com.” (A) Harvard Business School Press.

35 S. Philip, “Tata’s Nano, the World’s Cheapest Car, Is Sputtering,” Bloomberg Businessweek (April 11, 2013),

http://www.businessweek.com/articles/2013-04-11/tatas-nano-the-worlds-cheapest-car-is-sputtering. Also,

S. Nolen, “India’s Nano Hits Bumps on the Road,” The Globe and Mail (November 8, 2011), http://www.theglobe-

andmail.com/globe-drive/news/indias-nano-hits-bumps-on-the-road/article4252239/.

36 Scale and experience curves should be calculating using costs in constant dollars to eliminate the effects of

inflation. This can be done using a GDP deflator where a year is selected as the base year and the nominal costs

for subsequent years are adjusted down based on inflation for each subsequent year. To convert nominal/cur-

rent U.S. dollars to constant dollars using a GDP deflator, see: http://www.measuringworth.com/uscompare/.

http://www.dp-dhl.com/content/dam/presse/specials/gci/2012

http://www.sec.gov/Archives

http://www.sec

http://traveltips.usatoday.com/effects-911-airline-industry-63890.html

http://www.businessinsider

http://www.airasia.com/iwov-resources/my

http://www.businessweek.com/1998/23/b3581001.htm

http://wardsauto

http://www.thecanadi-anencyclopedia.com/articles/aluminum

http://www.businessweek.com/articles/2013-04-11/tatas-nano-the-worlds-cheapest-car-is-sputtering

http://www.theglobe-andmail.com/globe-drive/news/indias-nano-hits-bumps-on-the-road/article4252239

http://www.measuringworth.com/uscompare

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Differentiation Advantage

[ 87 ]

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Studying this chapter should provide you with the knowledge to:

1 Define product differentiation.

2 Describe the four major categories or sources of product or service differentiation.

3 Explain how to find sources of product differentiation.

4 Discuss how to build the resources and capabilities to differentiate.

L E A R N I N G O B J E C T I V E S

[ 88 ]

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I n 2004, it seemed that the social media niche had been

filled. The two largest social networks were MySpace, with

86 million users, and Friendster, with fewer than 10 million

users.1 MySpace was open to anybody over the age of 13, while

Friendster was open to those 18 years or older. MySpace, in

particular, was growing rapidly and was designed to be easily

customizable to the interests of its users. It followed the example

of Friendster by having user profiles, blogs, and friendship

connections, but it also made it easy to share music and videos

and was particularly popular with emerging music performers.

When Facebook first launched, it wasn’t clear that it would be

successful at competing with these two social media sites, and

their already-large networks of users. However, it didn’t take

long before it became clear that Facebook was offering users

things they could not get on MySpace or Friendster, and that

those things would make it extraordinarily successful.

Facebook was launched by Mark Zuckerberg and his

computer science roommates at Harvard, Eduardo Saverin,

Dustin Moskowitz, and Dustin Hughes. Access to Facebook

was initially limited to Harvard students. Although membership

was later expanded to anyone with an .edu email address,

Facebook’s exclusivity created a sense of privacy, security,

and elitism.2 Like Friendster, Facebook was not necessarily

intended to build new friendships online, but rather, to

perpetuate real-world friendships through the Internet. It

required its users to request friends and wait for a friendship

confirmation. Only after a friendship had been established

could a user view another person’s information and photos.

MySpace, on the other hand, had a significantly more

open interface, allowing greater access to information and

photos of MySpace users. This increased the user’s ability to

create online friendships, but decreased security. Numerous

news stories exposed sexual predators who sought out

victims through MySpace, and many parents would not allow

their children to use MySpace due to safety concerns.3

In addition to enhancing real-world friendships, Facebook

was the first social media site to offer a “relationship status”

option, allowing users to link their profiles to those of significant

others. Although this feature was later easily replicated by other

social media sites, Facebook was the first to offer it.

Facebook also had a different approach to customization.

MySpace offered a high degree of customizability, allowing

users to change the color and layout of their page. In contrast,

Facebook had a simple, clean, and standard appearance.

Interestingly, most users of social network sites reported that

Facebook was much easier to navigate because it didn’t allow

the customizability of MySpace.4 The standard appearance

made it easier to find the information they were looking for.

A final key difference between MySpace and Facebook was

that MySpace had several advertisements on each page,

which cluttered the website and increased the wait time for

the page to load. Mark Zuckerberg insisted

that Facebook have no advertisements, thereby

adding to the minimalist appearance of the site.

This approach made it quicker and easier for

users to navigate the site.

These differences quickly propelled Facebook

past both MySpace and Friendster. By 2010,

Facebook had more than 400 million total

users, and on any given day, 125 million of them used the

site.5 MySpace, on the other hand, had only 125 million users,

52 million of whom used MySpace daily.6 Friendster trailed

far behind at 8.2 million users. Facebook’s unique features

allowed it to change the face of the Internet and become the

largest social networking site in the United States.

Facebook was launched at the same price as MySpace

and Friendster: Free. Thus, it wasn’t possible for Facebook

to succeed through a low-cost strategy. Instead, Facebook

needed to offer something different—a product differentiation

strategy—to attract users.

The Rise of Facebook 0 5

WHEN FACEBOOK FIRST LAUNCHED, IT WASN’T CLEAR THAT IT WOULD BE SUCCESSFUL AT COMPETING WITH THESE [TWO] SOCIAL MEDIA SITES, AND THEIR ALREADY-LARGE NETWORKS OF USERS. HOWEVER, IT DIDN’T TAKE LONG BEFORE IT BECAME CLEAR THAT FACEBOOK WAS OFFERING USERS THINGS THEY COULD NOT GET ON MYSPACE OR FRIENDSTER, AND THAT THOSE THINGS WOULD MAKE IT EXTRAORDINARILY SUCCESSFUL.

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Why did users flock to Facebook over other social networks? The primary reasons were that Facebook offered greater exclusivity, privacy, and simplicity, the ability to share relationship status, and zero advertising. These were features that simply weren’t available on the other social networking sites. These features allowed Facebook to offer unique value in a way that the other sites did not.

Professor Clayton Christensen has argued that customers—people and companies— have “jobs” that arise regularly that need to get done. When customers become aware of a job that they need to get done in their lives, they look around for a product or service that they can “hire” to get the job done. As well-known marketing professor Theodore Levitt once observed, “People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!”7 A drill is one way to do that job. Customers hire movies, concerts, or Cirque du Soleil tickets to provide an entertainment experience. They hire an iron and ironing board to help them iron the wrinkles out of clothing, but they could also purchase clothing with wrinkle-free fabric to do the same job. When customers go to purchase a product (or service—we will use “product” in this chapter to refer to both products and services) to get a job done, they tend to consider two factors:

1. The way a product is differentiated from other products to perform the job (or jobs) they want done;

2. The price of the product.

WHAT IS PRODUCT DIFFERENTIATION?

Some companies decide to offer customers low-priced products and thus pursue a low-cost strategy as described in Chapter 4. In effect, they don’t try to do a different job from competing products; they just try to do the same job at a lower price. Other companies, such as Facebook, choose a product differentiation strategy. Product differentiation is a strategy whereby com- panies attempt to gain competitive advantage by offering value that is not available in other products or services or that other products don’t do as well.8 This value may come in the form of different product features, product quality or reliability, convenience, or brand image.

It is important to remember that product differentiation is always a matter of customer perception.9 The actual products of two different companies may be similar in terms of tech- nical features, but if one product is perceived as being different in a way that is valued by customers, then product differentiation exists. Not surprisingly, when the perceived value of the product increases in the mind of the customer, it also increases the customer’s will- ingness to pay a higher price. Thus, companies that invest resources to create unique fea- tures in their products often charge a premium price. A higher price is typically necessary because attempts to differentiate products usually require companies to invest resources that increase the cost of their offering.

Apple virtually always charges higher prices for its products because it invests heavily in R&D and design in order to develop products that “wow” customers by offering unique fea- tures. However, even Apple must keep its cost structure under control so that it can offer its differentiated products at a competitive price. If the price of an iPhone or iPad were $1,000, there would be far fewer customers willing to buy an iPhone. Thus, there is a clear trade-off companies must make between cost and differentiation. Greater differentiation typically requires greater costs. So, in order to make a differentiation strategy successful, customers must be willing to pay for greater product differentiation.

SOURCES OF PRODUCT DIFFERENTIATION

Identifying the sources of product differentiation is challenging. It seems as though there are dozens of ways that products or services are differentiated from each other to offer unique value. However, we have found four major categories of differentiation.

product differentiation A strategy whereby companies attempt to gain

competitive advantage by offering

value that is not available in other

products or services or that other

products don’t do as well.

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As shown in Figure 5.1, products typically offer unique value because they offer : (1) dif- ferent product/service features, (2) superior quality or reliability, (3) convenience, or (4) brand image.10

Different Product/Service Features Offering different product features is perhaps the most frequently used source of differen- tiation. We have found that it is useful to think about offering different product features in three ways:

1. The product does a “better job” of meeting a customer need on existing product features.

2. The product does “more jobs” for the customer than other products.

3. The product does a “unique job” that nothing else does.

Does a Better Job on Existing Features. Some companies differentiate their products by focusing on one particular feature and doing a better job than other products of providing value on that particular feature. For example, Dyson vacuums have gained market share by claiming that the CycloneTM technology in their vacuums provides better “sucking” capability. Dyson’s tagline: “The strongest suction at the cleaner head.” It doesn’t necessarily claim that its vacuums are more reliable or lighter and easier to use—other features that customers might care about. The key differentiator is suction capability, which is supposed to do a better job of getting carpets clean.

Before 2001, when Apple launched the iPod, Sony was the market leader11 in portable music players, based on the success of its portable cassette-tape player, the Walkman, and the follow-up portable CD player, the Discman. The Apple iPod beat Sony Discman on two key features. The iPod, which customers could fit into a pocket, was more portable than the Discman, a key feature that many customers were looking for. Not only was the iPod more portable, but it also had the feature of being able to store and play 500 songs, far more than the number of songs got from the Discman, which could only play one CD at a time. By providing better performance on key features—portability and menu of songs available to listen to—iPod quickly came to dominate the market. Companies can identify key features by identifying customer needs and the “jobs” that customers are hiring prod- ucts to do for them.

Some companies succeed by doing a better job providing service to customers. Of course, every company must provide service to customers, but some just figure out ways

[ Figure 5.1 ] Sources of Differentiation Advantage

What is the source of differentiation

advantage?

Superior Product Features

Does a better job on existing features

Does more “jobs” than other products

Does a “unique” job that nothing else does

Better Quality/Reliability

More convenient to find, purchase, use

Brand/Image

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to exceed customer expectations. Nordstrom is an example of a company that is often lauded by customers for providing exceptional customer service. One of the most well- known Nordstrom customer service stories is about a man who went into the Nordstrom in Anchorage, Alaska, to return a set of tires. Nordstrom does not sell tires. But to be responsive, the Nordstrom store manager still decided to allow the customer to return the tires there.12 In another instance, a member of the housekeeping staff at a Nordstrom in Connecticut noticed a customer had left her bags, along with her receipt and a flight itinerary, in the parking lot. After Nordstrom was unsuccessful at contacting the customer by phone, the employee drove to the airport, paged the customer, and returned her bags.13 Nordstrom provides extensive training to employees on how to provide great customer service, and these stories serve to create a culture that encourages extraordinary cus- tomer service.

Does More Jobs. In some cases, a product might not do a better job on existing features but simply does more jobs, or meets more needs, for customers than competitor offerings. For example, Facebook did a job that the other social networking sites did not do when it gave users the ability to alert their friends about their “relationship status,” a particularly important piece of information for teenagers and college students.

When Apple launched the iPhone, the differentiating factor was not that the iPhone made it easier to do the same jobs as other phones, such as place a phone call or get good reception. In fact, many users say that the iPhone is a worse “phone” than competing prod- ucts. Instead, Apple differentiated the iPhone by having it do more “jobs” for customers, beyond making calls. iPhone users are able to easily make video calls and use their phone to take HD videos. A second camera is built in to make it easy for users to take self-portraits in front of the White House or Eiffel Tower. The many apps that were available only on the iPhone (“there’s an App for that”) did a host of other jobs for users that no other phones had the capability to perform.14

In similar fashion, 35-millimeter cameras lost the market to digital cameras because digital cameras could do more jobs for customers. According to most professional photog- raphers, the early digital cameras were technologically limited and actually took pictures that were not as clear as pictures taken by 35-millimeter cameras. However, clarity in the photo was only one dimension of getting a “good” picture. Consumers also wanted to see the picture at the moment it was taken to know whether it had turned out the way they liked. Digital cameras made it possible to instantly see the picture. Because the picture was captured on a digital file, it was much easier to post a picture on your Facebook page, or e-mail it to friends and family. Finally, a digital camera lowered the cost of taking each picture because customers only printed the pictures that they liked and wanted to use—as opposed to having to print the whole roll of film. Digital cameras ultimately came to domi- nate the market because they simply did more jobs for customers than their 35-millimeter predecessors.

Does a Unique Job. Some products do a completely unique job that other products simply do not do. Rather than simply doing existing jobs better or doing more of jobs than other products, they offer a completely new feature to the market. For example, Propecia was the first pharmaceutical pill that was clinically proven to grow hair. No other pill could do that unique job. Disney theme parks are the only places you can go to see Mickey Mouse or ride the Pirates of the Caribbean to see Captain Jack Sparrow.

Products that are designed to be customizable by customers do a unique job because they can be created expressly to meet one particular customer’s unique need. In many cases, the customer does the customization. For example, Nike allows customers to design their own ID athletic shoes by selecting from a variety of design, color, and print options. Simi- larly, Timbuk2 allows buyers to customize their bag or purse by selecting from a variety of modules or options. One of the most successful companies of this type is Build-a-Bear, a company that allows you to “build” your own stuffed animal. You choose what the animal looks like and then select various sounds that your animal can make. They also have a vari- ety of different types of clothes that you can put on your animal. This approach has often been referred to as mass customization, meaning that a company mass-produces the vari- ous modules of the product and then allows the customer to select which modules will be

mass customization When a company mass-produces the

various modules of the product and

then allows the customer to select

which modules will be combined

together.

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combined together.15 Companies that choose this approach must develop the resources and capabilities necessary to create their products in modules and to accurately combine those modules as customer’s request.

Quality or Reliability Some products are differentiated because of the quality or reliability of the product. The product doesn’t necessarily do a better job as far as performance on existing features. It doesn’t do more jobs than other products, and it doesn’t do a unique job. It simply lasts longer.

Of course, it is possible to argue that a product with superior reliability actually does do a better job on an existing feature, as already suggested. However, it is important to note that a product differentiated based on quality or reliability offers essentially the same features and functionality of other products, but lasts longer. Unlike the Dyson vacuum, a product that wins due to superior reliability would not offer “better sucking power.” Instead, the vacuum may suck just as much, but continue to display the same sucking power for months or years longer. A music player might not offer better portability, as was the case with the Apple iPod, but it might be more durable. For customers who don’t like the hassle of products breaking down, this can be an important differentiator.

Historically, Honda and Toyota have succeeded, and differentiated their products, based on superior reliability. Their vehicles are always at the top of various quality ratings because they have the fewest defects. Customers don’t necessarily snap up Honda or Toyota vehicles due to superior styling, more comfortable seats, or more power. They buy them because they last and don’t often break down.16 This is particularly important to people or families who have only one car, or do not have alternative transportation or a support system available to help them when their car breaks down.

For years, appliance maker Maytag differentiated its products based on quality. It ran commercials featuring the “lonely Maytag repairman” who sat around the office with nowhere to go, because Maytag products presumably never broke down. The “Energizer bunny” is another advertising character created to promote reliability. Energizer batteries don’t do anything different from other batteries, so Energizer has emphasized their reliabil- ity, with its claim that they “last, and last, and last.”

Convenience Another differentiator used by companies is making their products more convenient to find and purchase.17 The product itself might actually be identical to other products on the market, but the seller has figured out a way to make it easier for customers to buy. Starbucks is an example of a company that succeeds, in part, through convenience. Star- bucks does attempt to differentiate its coffee through branding and by offering different blends and taste. But perhaps just as important, the company makes its coffees very easy to find. Go into downtown Seattle or San Francisco and it seems you will find a Starbucks on every other corner. When you have a hankering for coffee, Starbucks makes it conveni- ent to find. Convenience is also one of the reasons why Coke and Pepsi are so successful. Although brand image (described in the next section) is their most important differentia- tor, by investing in enormous vending machine networks, they ensure that when you are thirsty, there is likely to be a Coke or Pepsi product nearby. We often buy Coke or Pepsi products because it less convenient to go find another place that offers a wider array of beverages.

Convenience also includes making a product easier to purchase. Amazon.com was the pioneer of one-click purchase on the Internet, differentiating its services and contribut- ing to its ability to outsell other Internet retailers. In related fashion, because Amazon provides such a broad array of products, it essentially provides a “one-stop shop” for cus- tomers looking to buy products on the Internet. In the brick-and-mortar world, Walmart provides convenience in its stores by offering a broad array of products from groceries to electronics, to flowers and shrubs in the nursery. Beyond offering low prices, Walmart

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makes it more convenient for customers to purchase what they want by putting it all under one roof.

A special case of convenience involves the size of the network or ecosystem of the fi rm off ering a product or service. Some products or services are more convenient to use because there is a large network of other users; these products benefi t from network eff ects.18 Now that Facebook is the largest social network site, it is more convenient for new users to join Facebook to connect with friends than to choose another site, because most friends prob- ably already have a profi le on Facebook. Th is advantage keeps users going to Facebook, even though competitors may have imitated many of Facebook’s other features. In similar fash- ion, eBay dominates the online auction market because buyers fi nd it more convenient to go

network effects When some products or services are more

convenient to use because there is

a large network of other users.

The shoe company Skechers claims that its rocker-bottom Shape-ups sneakers help tone and shape your body. Hall of Fame quarterback Joe Montana said they improved his

strength and posture, and celebrity Kim Kardashian boasted

that they allowed her to ditch her personal trainer. Olay

Regenerist, a line of anti-aging products made by Procter

& Gamble, claims that its creams will reduce wrinkles and

helps you look younger. And then there is Dannon, claiming

that its Activa and DanActive yogurts have health benefits,

including boosting immunity and regulating digestion. Are

these claims true? Can companies advertise these benefits if

they haven’t been proven?

Companies that pursue a differentiation strategy are

motivated to accentuate the features of their products and

services that provide unique value. Indeed, that is the job

of the marketing function—to create advertisements and

promotional materials that differentiate a product in the

minds of customers. This can create challenges for leaders

in companies because they have an incentive to exaggerate

product claims in an attempt to convince customers that

their product offers specific benefits.

To illustrate the fine line that marketers often walk,

consider the case of Kirstie Alley, the actress who touted

the benefits of the Organic Liaison weight loss program

that resulted in her dramatic weight loss as she prepared

to participate in Dancing with the Stars. But according

to a “false and misleading advertising” lawsuit filed by

Marina Abramyan, a dieter that used the program, Alley

didn’t achieve all of her weight loss by using the Organic

Liaison program. Abramyan’s suit against both Alley and

Organic Liaison claims that the celebrity’s weight loss was

augmented with an extreme diet and exercise regimen. Now

it is up to the court to decide if the Organic Liaison program

works as advertised.

To avoid these types of lawsuits, companies have become

increasingly cautious and are making sure their claims

are backed by data. For example, if Verizon claims it is

“America’s most reliable network,” or AT&T says that it

has “more bars in more places,” the companies must use

specific measures of “reliability” or “bars in more places”

to back the companies’ statements. Of course, it’s possible

that the data supporting Verizon or AT&T’s claims may be

technically correct but are actually misleading. For example,

if a company’s network is most “reliable” for a very limited

time period—say, a week or month—is it misleading to

use the most reliable label all the time? These are just a

few examples of issues and decisions that pose ethical

dilemmas for the strategist.

One clear standard of wrongdoing is whether or not

claims will be supported in a court of law. In the case

of Skechers and Dannon, the answer appears to be no.

Skechers was forced to pay $50 million and Dannon $35

million to settle claims of false advertising when it was

determined in a court of law that their product claims

didn’t hold up. Olay Regenerist is still awaiting judgment

after a woman filed a suit claiming the product’s anti-

aging claims were false. These lawsuits show that false

product claims can be very costly—and they highlight the

importance of making sure that product claims that can be

verified. Moreover, even if a company’s claims are partially

true but misleading, this can lead to negative publicity that

can tarnish a company’s brand. The bottom line is that

differentiators must be careful to ensure that the claimed

benefits actually exist.

E T H I C S A N D S T R AT E G Y

At What Point Does Marketing Become Lying?

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to an auction website where there are more sellers and, thus, a broader selection of goods. Interestingly, while eBay is the dominant auction site in the United States, Yahoo! is the dominant auction site in Japan. Yahoo! launched in Japan before eBay, and network effects (e.g., more sellers attract more buyers) allowed it quickly to became the largest auction site in Japan.

As a final example, one reason people use Microsoft’s operating system or Office suite of products is because there is a large network of other individuals using the same products. Using the same software makes it more convenient for users to trade and exchange files, because the files are compatible.

Brand Image A final source of differentiation advantage is brand image.19 Companies often turn to this source of advantage when they have difficulty differentiating their products based upon features, reliability, or convenience. Brand image is typically developed through market- ing, via advertisements, promotions, and other marketing activities. Interestingly, numer- ous studies have shown that the more people are exposed to something, be it a brand, company, or product, the more they come to trust it.20 Indeed, the “mere exposure effect” is a psychological phenomenon by which people tend to develop a preference for things merely because they are familiar with them.21 In social psychology, this effect is some- times called the “familiarity principle.” Studies of interpersonal attraction suggest that the more often we see a person, the more pleasing and likeable that person appears to us.22

To fully appreciate and understand the value of brand image, consider the following ques- tions: Is Jell-O really better than other gelatins? Is Kleenex really better than other tissues? These brands are extremely well-known because they essentially pioneered their product categories. We have been exposed to these brands many times over many years, through commercials and other forms of marketing. Consequently, when we reach out to buy gelatin or tissue, we tend to reach for the brands with the best brand image—even if it isn’t clear that the product is different in features, reliability, or convenience.

Beyond mere exposure, companies also attempt to actively associate their products with positive qualities in the minds of customers. This is a particularly important source of differ- entiation for products we consider as prestige brands.23 Sometimes, the job we hire a prod- uct to do is to help us feel part of an elite group or “club.” For example, this is why many people hire a brand such as Louis Vuitton, Versace, Rolex, or Chanel even when functionally equiva- lent products can be purchased at a much lower price. Customers may choose to purchase a Lexus or Infiniti even when a functionally equivalent Toyota or Nissan is available with the same or longer warranty. In fact, Toyota makes Lexus and manufactures both Toyota and Lexus brand cars in the same manufacturing plants with the same workers. The same is true for Nissan, which produces Infiniti vehicles. But brand doesn’t have to signal prestige. The Toyota Prius is a brand that appeals to the environmentally conscious. People may want to be associated with a brand that differentiates itself as low-brow, environmentally conscious, manly, or some other distinguishing characteristic. There are a variety of ways that brand image can be a powerful source of differentiation in the mind of the customer.24

HOW TO FIND SOURCES OF PRODUCT DIFFERENTIATION

There are two major ways that companies attempt to find sources of product differentia- tion—customer segmentation and mapping the consumption chain. We’ll discuss some of the details of each method.

Customer Segmentation As mentioned earlier in the chapter, customers hire products or services to do jobs for them—to satisfy particular needs or wants. Individual customers have different needs that they want satisfied. They also differ in the amount of money they have to purchase products

brand image When products are differentiated through marketing,

via advertisements, promotions,

and other marketing activities.

prestige brands When products are differentiated by being

associated with positive qualities in

the minds of customers.

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or services to satisfy those needs. For example, some car buyers want power, speed, and torque in a car so that it can go from zero to 60 miles per hour in 3 or 4 seconds. They look for turbo-charged vehicles with lots of horsepower. Those buyers who like power but are more price-sensitive look at turbo charged vehicles that sell for less than $30,000, such as the Mitsubishi Evo, Subaru STI, or Hyundai Genesis Coupe. Buyers looking for power who have more financial resources will look to the Porsche 911, BMW M-6, or Mercedes McLaren—or an even higher-priced Ferrari or Lamborghini. These cars are all designed to do the job of providing speed and excitement to buyers.

Other car buyers need a car that can comfortably seat five people when they carpool or carry their kids and friends to the soccer match. These buyers look for roomy vehicles that are easy to get in and out of, such as minivans. Still other car buyers are simply looking for reliable transportation—a car that isn’t expensive but won’t break down and if it does is rela- tively cheap to fix. Those buyers will tend to opt for vehicles like the Hyundai Elantra, Honda Civic, or Toyota Corolla that are specifically designed for that job.

Companies are more successful when they can offer the exact value that each customer is looking for. However, the cost of designing a specific product for each customer is usually prohibitively high. The next best solution is to group customers based on similar needs and then create products that meet the needs of a particular group. This process of grouping customers based on similar needs is often called customer segmentation. Customer seg- ments are groups of people who share similar needs and thus are likely to desire the same features in a product.

Along with defining customer segments, a company must choose which segments are actually in its target market. Strategy involves making trade-offs, and companies often have to make decisions about where to deploy scarce resources to get their best return. This means they often have to decide which customer segments they think they can best serve—and which segments deserve little (or no) attention. Facebook started by focusing on the college student segment because the founders—as college students themselves— had a deep understanding of the needs of college students and designed Facebook to meet their needs.

Companies find customer segmentation extremely helpful if they can define segments appropriately. When companies do not effectively segment customers into similar need- based groups, then they are likely to run into one of two problems. The first problem is that they may add features, and costs, to their products that some groups of customers don’t really want and don’t want to pay for. The second problem is that they may not add features that certain groups care about and would be willing to pay for, potentially losing market share to rival firms that do offer those features.

The marketing function within companies is typically charged with the challenge of mar- ket segmentation. Marketers typically segment markets in one of three ways:

1. Based on various attributes or the price of products

2. Based on attributes of the individuals or companies who are customers, including demographics or psychographics

3. Based on the job-to-be-done view, an alternative way of segmenting customers that has emerged recently

Product Attributes. One way to segment customers is based on product attributes. For example, customers looking to buy motorcycles may place different value on different attributes, such as power (speed), reliability, and ease of handling, gas consumption, or customizability. By assessing the relative importance that customers put on different attributes, and grouping customers based on what they want in those attributes, it may be possible to design products to meet the needs of that customer segment. For example, Honda tends to design motorcycles that appeal to customers who want reliable, easy-to- handle transportation vehicles. In contrast, Harley-Davidson designs rugged motorcycles that are loud, showy, and highly customizable. Customizability is an important attribute for customers who prefer Harley-Davidson; the average Harley-Davidson buyer spends an additional 50 percent over the price of the motorcycle to make it completely unique. Discovering groups of customers who want similar product attributes has enabled Honda and Harley to design their products to better meet the needs of those customer segments.

customer segmentation Grouping customers based on similar needs.

customer segments Groups of people who share similar needs

and thus are likely to desire the

same features in a product.

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Demographics/Customer Attributes. Another way to segment customers is based on the demographics of customers. Popular ways to segment the consumer market include by age, socioeconomic status (e.g., income), education, profession, and ethnic group. For example, teenagers might be considered one segment of the market because they are viewed to be similar in terms of what they want from certain types of products or services. Their needs and wants are often quite different from college students, 30- to 50-year-old parents, and retired people. Not surprisingly, high-income, middle-income, and low-income families are often put into different segments, as are people with differing levels of education.

A popular way to segment the business market is based on size of companies, as meas- ured in revenues, assets, or employees. Large companies are often perceived to have needs that differ considerably from those of small companies and, consequently, businesses that sell to large companies view them as a different customer segment.

Segmenting based on demographics has the advantage25 that it is relatively easy to do, once you have data to place customers into different demographic categories. The disad- vantage is that not all individuals (or companies) within a particular demographic category share the same needs and wants.

Job To Be Done. As we’ve mentioned, Clayton Christensen suggests that customers “hire” products to do “jobs” for them. He further argues that, “What this means is that the job, not the customer or the product, should be the fundamental unit of market segmentation analysis.”26 When people have a “job” to do, they set out to hire something or someone to do the job as effectively, conveniently, and inexpensively as possible. Observing someone in a particular circumstance can lead to insights about a job to be done—and a better way to do the job.

According to Christensen, every job has a functional, a social, and an emotional dimen- sion. The relative importance of these dimensions varies from job to job. For example, “I need to feel like I belong to an elite, exclusive group” is a job for which luxury brand products such as Gucci and Versace are hired. In this case, the functional dimension of the job isn’t nearly as important as its social and emotional dimensions. In contrast, the jobs for which a delivery truck might be hired are dominated by functional requirements, such as the size of the truck or ease of loading.

Understanding the functional, social, and emotional dimensions of a “job to be done” can be quite complex—but might be key to differentiating your product or service. For exam- ple, Harley-Davidson customers often purchase a Harley-Davidson motorcycle because they view themselves as rugged individualists. This is one reason why customizability is so important—each Harley rider wants the motorcycle to reflect his or her unique identity and not be like anyone else’s. Beyond that, they want to find others with a similar life view that they can ride with, which is why the Harley Owners Group (H.O.G.) is important to many riders. Thus, for most Harley-Davidson buyers, the job to be done goes well beyond providing a particular type of ride on a motorcycle. The job to be done is related to helping the buyer express his or her identity and be part of an elite group of rugged individualists.

Segmenting a market in different ways can provide different insights as to how to dif- ferentiate a product. Table 5.1 shows all three ways of segmenting the mobile handheld device market.27 Each segmentation approach might lead a company to develop different features and consider different competitors. For example, a company that segments the market using the product attribute view may focus on providing the best camera, best phone features, best organizer, and so on. A company that takes a demographic approach to segmenting the handheld market might use occupation as a way to segment customers. Such a company might conclude that traveling sales representatives want different things in a handheld device than college students do. A company that uses the job-to-be-done view might discover that one segment sees the job to be done as using small snippets of time productively. That segment might be different from those who “hire” their handheld device to provide entertainment. When most companies in an industry segment customers in a particular way, there may be an opportunity for a company to segment the market in a dif- ferent way, thereby identifying groups of customers whose needs are not met by the typical method of segmentation. This might allow a company to offer a different value proposition, thereby creating a competitive advantage with a particular group of customers.

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Mapping the Consumption Chain Another process that can be used to look for differentiation opportunities is to map the consumption chain, which involves tracing your customer’s entire experience with your product or service.28 Professors Ian McMillan and Rita McGrath, who developed and advocate the technique, suggest that companies perform this exercise for each impor- tant customer segment. Mapping the consumption chain involves identifying all the steps through which customers pass from the time they first become aware of your prod- uct to the time when they finally have to dispose of it or discontinue using it, as shown in Table 5.2. Although products or services may have somewhat different consumption chains, a few activities are common to most chains. To understand the consumption chain, MacMillan and McGrath suggest asking the following questions, in the following order.

How Do Consumers Become Aware of Their Need for a Product or Service? The first step in the consumption chain occurs when customers become aware that they need a product or service. A company may be able to differentiate its product if it can find a unique way to make consumers aware of a need. For example, consider the problem of differentiating an everyday consumer product, such as a toothbrush. For most of us, brushing is an everyday ritual to which we pay relatively little attention. As a result, many people use a toothbrush for too long, until its bristles become worn and no longer effective at cleaning teeth.

Toothbrush maker Oral-B discovered a way to capitalize on this widespread habit by inventing a way for the toothbrush to communicate to the customer that it needs to be replaced. Oral-B introduced a patented blue dye in the center bristles of its toothbrushes. They dye gradually fades as the brush is used. When the dye completely disappears, it signals the user that the brush is no longer effective and needs to be replaced. Thus, customers are made aware of a need that previously had gone unrecognized. One could imagine that mak- ers of tires or other products that wear out could create a similar advantage. By providing

mapping the consumption chain Identifying all the steps through which customers pass,

from the time they first become

aware of your product to the time

when they finally have to dispose of

it or discontinue using it.

[ Table 5.1. ] How You Segment the Market for Handheld Devices Will Influence the Product Features You Consider to Be Relevant

PRODUCT ATTRIBUTE VIEW DEMOGRAPHIC VIEW JOB-TO-BE-DONE VIEW

Market Definition

The handheld wireless device

Market Definition

The traveling salesman

Market Definition

Use small snippets of time

productively

Competitors

Palm Pilot, Handspring Treo,

Sony Clié, HP Jordana, Compaq

I-Paq, wireless phone

Competitors

Notebook computers, wireline Internet

access, wireless and wireline telephones

Competitors

Wireless telephones, Wall Street

Journal, CNN Airport News,

listening to boring presentations,

doing nothing

Features to consider

Digital camera

Word

Excel

Outlook

Voice phone

Organizer

Handwriting recognition

Features to consider

Wireless Internet access; bandwidth for data

Downloadable CRM data/functionality

Wireless access to online travel agencies

Online stock trading

E-book and e-technical manuals

E-mail

Voice

Features to consider

E-mail

Voice mail

Voice phone

Headline news, frequent updates

Simple, single-player games

Entertaining “top-ten“ lists

Always on

Source: Adapted from Christensen and Raynor, The Innovator’s Solution, p. 83.

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a way to make customers aware that they may need a particular product, companies can find a way to differentiate their product.

How Do Consumers Find Your Offering? Once potential customers are aware that they have a need for a product, they then need to find it. Companies can differentiate their offering if they can make the search process easier for customers by making it less complicated, more convenient, or less expensive. Starbucks has made finding high-quality coffee simpler by opening up so many stores that a latte is nearly always within easy reach. Many companies help consumers find their product by paying to be at the top of a Google search. For example, if a consumer types “snowboard” in a Google search, sporting goods retailer REI pops to the top of the list because they pay Google for that premium space. Convenient placement of REI’s listing makes it easier for consumers to find, and eventually buy, snowboards from REI. Other ways to make a product easier to find include making it available when others are not, as companies that have 24-hour telephone-order lines do, or offering it in places where competitors do not offer theirs. For example, some credit card companies set up booths on college campuses to put credit cards within easy reach of college students. In similar fashion, Coke puts vending machines in university buildings, public schools are often banning soft drink vendors]at gymnasiums, and in workplaces to make it easy for someone to find a Coke. Thus, some companies can differentiate their offering simply by making it easier to find.

How Do Consumers Make Their Final Selections? After a consumer has narrowed down the possibilities, he or she must make a choice. This is the time when product attributes typically dominate, and it is critical to ensure that consumers are aware of features that may differentiate a product. Some companies assist in product selection by providing customers with side-by-side comparisons of their products with those of competitors. A comparison list makes it easier for consumers to see which product has more features, or has the features they care about the most. Alternatively, a company can select the one feature that customers might care about and trumpet how their product beats others on that particular feature. Bose does this with its “noise canceling” headphones, emphasizing that their headphones cancel out more noise and give you better sound quality than other headphones. Anything that can be done to make the product selection process more comfortable, less irritating, or more convenient has the potential to be a differentiator.

How Do Customers Order and Purchase Your Product or Service? Another way to differentiate a product is to make the process of ordering and purchasing more convenient. Amazon.com has made the process of purchasing a product online easier by storing all of your relevant personal and credit information and allowing you to use their “one-click”

[ Table 5.2 ] Mapping the Consumption Chain

How do consumers become aware of a need for your product/service?

How do consumers find your offering?

How do consumers make their final selections (priority of attributes)

How do consumers order and purchase your product?

How is your product/service delivered?

How is your product/service paid for?

How is your product stored/moved around?

What do consumers need help with when they use the product?

What if customers aren’t satisfied and need to return or exchange?

How is your product repaired, service, disposed of?

Source: MacMillan and McGrath, “Discovering New Sources of Differentiation.”

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purchase option. In similar fashion, Starbucks has created a “Starbucks Card” that is essentially like a credit or debit card that allows you to quickly swipe your way to a coffee. In addition to buying the coffee faster, customers who use a Starbucks Card also accumulate points that be applied to future purchases at Starbucks.

American Hospital Supply revolutionized how disposable medical products, such as bandages, tongue depressors, syringes, and disinfectants, are sold to hospitals by simplifying the ordering and restocking process. The company did this by installing computer terminals for purchasing their products at each of its customer hospitals. The terminals connected those customers directly to the company’s system, allowing direct-drop shipment and auto- matic restocking whenever supplies fell below a certain level.

One potential benefit of making your product more convenient to order is your com- pany can create a switching cost, especially for repeat customers. Once customers have signed on to a purchasing system such as American Hospital Supply’s terminals, it can be costly or inconvenient for them to switch to another supplier. As we described in Chapter 2, switching costs create a barrier that can prevent competitors from getting access to your customers.

How Is Your Product or Service Delivered and/or Installed? Customers sometimes need to have products that they purchase delivered, installed, or assembled. Transporting and assembling products are stumbling blocks for customers, so these services can be a source of differentiation. RC Willey, a successful retailer of furniture, appliances, and televisions, guarantees delivery within 48 hours for those who want it. Quick delivery is especially important to customers whose refrigerator has quit working or who need a new bed.

If a product requires assembly or installation, companies may differentiate themselves by making it easier to install. For example, before software was downloaded via the Inter- net, Apple let your computer software self-install. All you had to do was insert a disc it into the computer and everything else was taken care of. When consumers need to install parts or equipment, some companies try to make installation easier by providing a poster with the product that clearly illustrates the installation steps. Color-coding cords and cables or other devices involved in an installation can further simplify the process and make a prod- uct easier to set up and use.

How Is Your Product Stored? When it is expensive, inconvenient, or even dangerous for customers to have a product simply sitting around, a company has the potential to differentiate the product by providing better or easier storage options. Air Products and Chemicals, a maker of industrial gasses, became the leader in its market segments by addressing the problem of storage. Air Products realized that most of its customers— chemical companies—would rather avoid the burden of having to store vast quantities of high-pressure gasses. So it built small industrial-gas plants next to its customers’ sites. This created an important differentiator by making gas storage more convenient. Even better, once an Air Products plant was built next to a customer, competitors had little opportunity to move in.

In similar fashion, NordicTrack, a maker of workout equipment including cross-country ski machines and treadmills, has designed many of its workout machines to easily fold up and slide under a bed or into a closet. Customers with little room for a workout machine, but a strong desire to work out at home, have been attracted to NordicTrack’s easy-to-store machines.

What Do Customers Need Help with When They Use Your Product? Sometimes a customer will need assistance when using a product or service. A company can differentiate on that dimension if it understands what kind of help customers and can provide that assistance more effectively than other companies. For example, each year during Thanksgiving in the United States, millions of home chefs cook a turkey. Many of these people are making a turkey for the first time and have questions about the process. Butterball’s 24-hour Turkey Talk-Line fields questions from thousands of these customers every Thanksgiving. Butterball also has a turkey-cooking guide that its customers can download. One frequent, and very important, question people ask when cooking a turkey is how to tell when it is done. Poultry must reach a certain internal temperature to be safe to eat. Nobody wants to give their family

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and friends food poisoning on Thanksgiving. To answer this question easily and definitively for cooks who don’t have or have trouble reading a food thermometer, Butterball (and some other turkey providers) install a “pop-up button” on the turkey that springs outward when the turkey is done. Its help line and pop-up signals help differentiate Butterball as the best turkey choice for inexperienced cooks.

What If Customers Aren’t Satisfied and Need a Return or Exchange? While many companies focus on the customer through the sale and installation of a product, others realize that long-term loyalty requires attention to customers’ needs throughout their experience with a product. Handling problems well when the product doesn’t work out for a customer can be as important as meeting the need that motivated the initial purchase.

Nordstrom is an excellent example of a company that has focused on succeeding through superior service—including after-sale service. As previously described, Nordstrom captured national publicity when one of its store managers “took back” a set of tires from a customer despite the fact that Nordstrom did not sell tires. By focusing on and aggressively promoting its no-questions-asked return policy, Nordstrom has developed a reputation as a company that provides unique customer service. Customers may be unhappy with a particular prod- uct that they return, but they are not unhappy with the store if it does everything possible to make sure that the return is easy to do.

How Is Your Product Repaired, Serviced, or Disposed Of? As many users of technologically sophisticated products will attest, repair experiences—both good and bad—can influence a lifetime of subsequent purchases. This is particularly true if you are highly inconvenienced because the product fails to work properly, as is the case in an elevator (nobody wants to get stuck in an elevator). Otis Elevator uses remote diagnostics to prevent service interruptions on its elevators. In high-traffic office buildings, where servicing elevators is a major inconvenience to occupants and visitors alike, Otis uses its remote-diagnostic capabilities to predict possible service interruptions. It also sends employees to carry out preventive maintenance in the evening, when traffic is light. Thus, companies can find opportunities to differentiate by ensuring that products are quickly and easily repaired when they fail to work properly.

Finally, customers might find the need to dispose of a product when it is no longer usable. Most people don’t have a truck—or enough time and interest--to haul an old mattress or oven off to a dump or recycling center. But, RC Willey, a successful seller of mattresses and appliances, will haul away your old mattress or oven for free when you buy a new one. By disposing of obsolete or broken appliances, mattresses, and furniture for customers when they purchase a product, RC Willey meets a customer need that may be unrelated to the new product, but still differentiates the product because it comes with a service that makes the customer’s life easier.

In summary, by analyzing the consumption chain—the series of steps experienced by a customer from becoming aware of a need for a product to disposing of it—companies can find opportunities to differentiate. Once an opportunity to offer unique value has been identified, the company must then figure out how to deliver that unique value better than its competitors can.

BUILDING THE RESOURCES AND CAPABILITIES TO DIFFERENTIATE

Customer segmentation and mapping the consumption chain are useful tools for identify- ing what unique value to offer a customer. However, it is just as important for a company to figure out how to deliver that unique value.29 For example, how does a company consistently offer different features in its products? How does a company deliver high quality and reli- ability? How does a company build a brand image?

Building the capacity to deliver unique value requires acquiring and allocating resources. For example, as discussed in Chapter 1, Howard Schultz, founder of Starbucks, got the idea for Starbucks Coffee Bars during a visit to Italy. There, he observed “espresso bars” that

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off ered customers their choice among multiple blends of coff ees—far more than the typical coff ee shop in the United States—and were conveniently located at several places through- out major cities.

Schultz also realized that many people in the United States would also want to purchase high-quality coff ee at convenient locations where they could sit and enjoy their drinks with friends in a comfortable atmosphere. Schultz had identifi ed a unique value. Now, he needed to build the resources and capabilities to deliver that value, as described in the Strategy in Practice box.

Assessing Differentiation Performance We have heard many executives ask, “What metric can I use to assess how well my diff er- entiation strategy is working?” According to consultant and researcher Fred Reichheld, the answer to that question lies in whether you can satisfy customers to such a degree that they are willing to recommend your company (or product) to a friend or colleague.30 Companies that do an exceptional job of providing unique value to customers get their customers to pro- mote the product to others. In eff ect, they turn their customers into salespeople. Naturally, this has a dramatic, positive eff ect on a company’s growth.

Reichheld and his colleagues at Bain & Company conducted a great deal of research, sur- veying consumers across multiple industries, to fi nd a way to measure how much compa- nies inspire their customers to promote them. Th eir research resulted in the Net Promoter Score, a useful tool for assessing customer satisfaction (see the Appendix for a description of how to calculate a Net Promoter score). Reichheld claims that tracking net promoters is a powerful way to measure customer loyalty.

We compared the net promoter scores of the iPhone versus the Blackberry among a sample of college students during the spring of 2011. In this sample, the iPhone had a net promoter score of over 70 percent. Most students who used an iPhone ranked it a 9 or 10, and few ranked it at 6 or below. In contrast, the Blackberry had a net promoter score of only 10 percent, with almost as many detractors as promoters. Not surprisingly, sales of the iPhone have grown much faster than those of the Blackberry among college students.

How Starbucks Built the Resources to Differentiate S T R AT E G Y I N P R A C T I C E

Starbucks’s ability to deliver on a differentiation strategy of offering high-quality coffee at convenient locations required that the company build its resources and capabilities.

One capability that proved essential in order for

Starbucks to differentiate itself with high-quality coffee

and multiple blends was the ability to roast and blend

coffee beans. Most coffee shops in the United States did

not roast their own coffee beans and therefore couldn’t

match the quality of coffee that Starbucks offered. Roasting

its own beans also allowed Starbucks to create signature

blends, experimenting with different beans and different

ways of roasting to offer a variety of flavors. Then, it built

capabilities to highly train baristas to peddle its gourmet

blends in a way that added to the feeling that Starbucks was

a trendy hangout.

Starbucks also learned—through analysis and trial and

error—to identify the optimal locations within a city in order

to make each shop as conveniently accessible to as many

customers as possible. To prevent imitation of its coffee

shops, Starbucks built stores as quickly as possible so that

would-be imitators would find that the best locations for

similar coffee shops within a city already were taken.

As we examined in Chapter 3, there are numerous

types of resources and capabilities that a firm can

build and deploy to deliver unique value better than

competitors. For Starbucks, two of the key capabilities

have been the ability to effectively roast and blend coffee

beans and the ability to identify optimal store locations

and quickly fill those locations with Starbucks shops and

highly trained baristas.

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Our informal net promoter score survey highlights an important dimension of any analy- sis using the net promoter score or any other customer satisfaction metric: You must have a representative sample of customers. If we had sampled a different customer segment, such as business people, we might have seen very different net promoter scores for the iPhone and Blackberry. To get an overall picture of a company or product’s net promoter score, choose a customer sample that represents all of the company or products different the mar- ket segments. To gather targeted information about how well a product or service is dif- ferentiated to meet the needs of customers in a particular segment, your sample should include only customers in that segment of the market.

SUMMARY

In this chapter, we examined differentiation as an alternative to low cost as a way to offer unique value to a customer. Product differentiation is a strategy whereby companies attempt to gain competitive advantage by offering value that is not available in other products or services.

Companies have four main options for creating product differentiation: Different features. The product does a better job on features available in other products,

does more “jobs” than other products, or does a “unique job” not done by any other product.

Quality or reliability. The product does the same job as other products, but does it for longer.

Convenience. The product is easily available when the customer needs or wants it. Brand image. The product gives customers a certain feeling or idea.

Strategists often use two tools to discover differentiation opportunities: customer seg- mentation and mapping the consumption chain. Customer segmentation is a process used to segment the market into customer groups who share similar needs. The con- sumption chain is the set of activities a customer goes through in the process of realizing a need and then acting on it to purchase a product or service. Each step in the chain can present ways to differentiate a product or service.

Discovering sources of differentiation is just one half of the equation. In order for a differ- entiation strategy to be successful, a company must then develop or acquire the resources and capabilities to deliver that unique value better than competitors.

The net promoter score is a tool that can be used to assess how well a differentiation strat- egy is working to turn customers into promoters of a company’s offering.

KEY TERMS

brand image (p. 94) customer segmentation

(p. 95) customer segments

(p. 95)

mapping the consumption

chain (p. 97) mass customization

(p. 91) network effects (p. 93)

prestige brands (p. 94) product differentiation

(p. 89)

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REVIEW QUESTIONS

1. Define a differentiation strategy.

2. What are the four major categories or sources of product differentiation?

3. What are two processes that companies can use to search for differentiation opportunities?

4. What is customer segmentation? Describe three different ways that customer segmenta- tion can be done.

5. What is the consumption chain? Describe as many stages of the consumption chain as you can.

6. What is a net promoter score, and how is it calculated? Why is the net promoter score a useful indicator of how successful a company is at differentiating its product?

APPLICATION EXERCISES

Exercise 1: Understanding Sources of Differentiation 1. What product do you use because of differentiation? What do you buy because it is awe-

some, rather than because it is the lowest-price alternative? What causes you to have such strong feelings about the product or experience?

2. In what ways can a company differentiate a product that is a commodity? What is an example of a differentiated product that was previously commoditized?

3. What are Harley-Davison’s key sources of competitive differentiation? What seems to be the primary reason why people buy a Harley? What tends to be the primary “job-to-be done” for Harley buyers?

4. What is an example of a product class that lost its differentiation? How and why did it happen?

Fred Reichheld and his Bain & Company colleagues tried numerous survey questions with consumers across multiple

industries to see which questions were best correlated with

customer loyalty (repeat purchases) and company growth.

The following question was the best indicator of whether a

customer was loyal and enthusiastic about a company or

product.

How likely is it that you would recommend [company X;

product Y] to a friend or colleague?

Respondents answer on a 10-point scale, with 1 meaning

“not at all likely,” 5 “neutral,” and 10 “extremely likely.”

As illustrated in Figure 5.2, Reichheld classifies a

customer who responds with a 9 or 10 on the question above

as a promoter. Anyone who scores 6 or below is a detractor,

who is likely to steer others away from your company or

product. Those scoring 7 or 8 are passives. To calculate a net

promoter score, subtract the percentage of detractors from

the percentage of promoters.

Strategy Tool The Net Promoter Score

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REFERENCES

1 M. J. Piskorski and C. I. Knoop, Friendster (A). Harvard Business School Case (2007).

2 M. J. Piskorski, T. R. Eisenmann, and A. Smith, Facebook. Harvard Business School Case (2013), p. 2.

3 A. Viejo, “Social Shield Offers Help for Parents Struggling with Children on MySpace.com, other Social Net-

works,” PR Web (2006). Accessed on Sept. 14, 2013. http://www.prweb.com/releases/2006/08/prweb426711.

htm.

4 Piskorski, Eisenmann, and Smith, p. 7.

5 Ibid., p. 8.

6 A. Savar, “54% of US Internet users on Facebook, 27% on MySpace,” blog, (Feb 15, 2010), http://www.avisavar

.com/2010/02/54-of-us-internet-users-on-facebook-27-on-myspace.

7 C. Christensen, “Integrating Around the Job to be Done,” Harvard Business School Note, N9-611-004.

August 2011.

8 A. Shaked and J. Sutton, “Relaxing Price Competition Through Product Differentiation,” The Review of Economic

Studies (1982): 3–13.

9 V. A. Zeithaml, “Consumer Perceptions of Price, Quality, and Value: A Means-End Model and Synthesis of

Evidence,” The Journal of Marketing (1988). 2–22.

10 M. E. Porter, Competitive Strategy (New York: Free Press, 1980).

11 M. Haire, “A Brief History of the Walkman,” Time (2009). Accessed Sept. 14, 2013. http://content.time.com/

time/nation/article/0,8599,1907884,00.html.

12 C. Conte, “Nordstrom Customer Service Tales Not Just Legend,” Jacksonville Business Journal (September 7,

2012), http://www.bizjournals.com/jacksonville/blog/retail_radar/2012/09/nordstrom-tales-of-legendary-

customer.html?page=all

13 Ibid.

14 “There’s an App for That—Top Advertising Campaigns for the Wireless Industry,” FierceMobileIT (May 5, 2011),

http://www.fiercemobilecontent.com/special-reports/theres-ad-top-advertising-campaigns-wireless-indus-

try/theres-app-top-advertising-cam.

15 I. I. B. Joseph Pine, Mass Customization: The New Frontier in Business Competition (Cambridge, MA: Harvard

Business Press, 1999).

16 Quality Is the Lifeline of Toyota Industries. Company white paper. Social and Environmental Report. 2005.

DETRACTORS

0 1 2

NET PROMOTER SCORE % PROMOTERS % DETRACTORS

3 4 5 6 7 8 9 10

PASSIVES PROMOTERS

[ Figure 5.2 ] How to Calculate a Net Promoter Score

Net promoter score = Percentage of customers

who answer 9 or 10 – Percentage who answer 6 or

below.

Products (companies) with high net promoter scores

consistently grow much faster than competitors. Generally

speaking, products (companies) with net promoter scores

above 70, like iPhone, are excellent differentiators. Products

with net promoter scores between 50 and 70 are good

differentiators. Products with net promoter scores between

30 and 50 are average differentiators, and those with net

promoter scores below 30 are struggling to get customers to

promote their product.

http://www.prweb.com/releases/2006/08/prweb426711

http://www.avisavar

http://content.time.com

http://www.bizjournals.com/jacksonville/blog/retail_radar/2012/09/nordstrom-tales-of-legendary-customer.html?page=all

http://www.fiercemobilecontent.com/special-reports/theres-ad-top-advertising-campaigns-wireless-indus-try/theres-app-top-advertising-cam

REFERENCES [ 105 ]

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17 J. Beath and Y. Katsoulacos, The Economic Theory of Product Differentiation (Cambridge: Cambridge University

Press, 1991).

18 M. L. Katz and C. Shapiro, “Systems Competition and Network Effects,” The Journal of Economic Perspectives

8 (2) (1994), 93–115.

19 R. Schmalensee, “Product Differentiation Advantages of Pioneering Brands,” The American Economic Review 72

(3) (1982): 349–365.

20 R. B. Zajonc, “Attitudinal Effects of Mere Exposure,” Journal of Personality and Social Psychology 9 (2) (1968): 1.

21 Ibid., pp. 1–27.

22 R. F. Bornstein, “Exposure and Affect: Overview and Meta-analysis of Research, 1968-1987,” Psychological Bul-

letin 106 (1989): 265-289. X. Fang, S. Singh, and R. Ahluwalia, “An Examination of Different Explanations for the

Mere Exposure Effect,” Journal of Consumer Research 34 (2007): 97-103.

23 K. L. Keller, “Managing the Growth Tradeoff: Challenges and Opportunities in Luxury Branding,” Journal of

Brand Management 16 (5) (2009): 290–301.

24 C. Fombrun and M. Shanley, “What’s in a Name? Reputation Building and Corporate Strategy,” The Academy of

Management Journal 33 (2) (1990): 233.

25 A. Weinstein, Market Segmentation: Using Demographics, Psychographics and Other Niche Marketing Techniques

to Predict and Model Customer Behavior (Chicago: Probus, 1994).

26 Ibid., p. 1.

27 C. Christensen and M. Raynor, The Innovator’s Solution (Boston: Harvard Business School Press, 2003).

28 I. McMillan and R. McGrath, “Discovering New Sources of Differentiation.” Harvard Business Review ( July 1997):

133–145.

29 M. Swink and W. H. Hegarty, “Core Manufacturing Capabilities and Their Links to Product Differentiation,”

International Journal of Operations & Production Management 18 (4) (1998): 374–396.

30 F. Reichheld. “The One Number You Need to Grow,” Harvard Business Review (December 2003).

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Corporate Strategy

[ 107 ]

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Studying this chapter should provide you with the knowledge to:

1 Describe how a corporate strategy differs from a business unit level strategy.

2 Identify the six ways in which a company may create value through diversification, and the advantages of each source. Be able to evaluate a diversified company’s ability to create value using one or more of these sources.

3 Use a portfolio management tool to characterize a company’s different business units and to evaluate how well a company manages its portfolio.

4 Explain how a company would choose whether to diversify by greenfield entry or by acquisition. Explain how a company should decide how tightly to integrate an acquisition into its current business portfolio.

L E A R N I N G O B J E C T I V E S

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Cisco Systems: Growth through Diversification and Acquisition

0 6

I n 1984, Len Bosack managed the computer science

department at Stanford University, and his wife, Sandra

Lerner, worked with the computer network at the Graduate

School of Business, located 500 yards from her husband’s

building. The two wanted to connect the computer networks

of their respective departments. Because the networks

used different protocols (commands and languages), the

two developed the first multi-protocol router, a device that

lets different networks communicate and share data. The

husband and wife team decided to commercialize their

invention, the AGS router, and, during a drive over San

Francisco’s Golden Gate Bridge, they chose to name the

company Cisco Systems.1

Cisco entered the market just as Apple Computer

introduced the Macintosh and the personal computer

industry began to grow rapidly. Cisco’s initial customers

were large corporations with multiple, extensive computer

networks. By 1989, Cisco had one patent, three products

on the market, 11 employees, and $27 million in revenue.2

The company went public in 1990 (ticker symbol CSCO) with

revenue of $69 million, and an initial market capitalization

of $224 million. By 1992, sales had grown 550 percent to

$381 million and Cisco began to enter new markets for its

products and services; Cisco expanded into the market for

networked servers and began writing and selling software.3

In 1993, the company made its first acquisition, a $94.5

million all-stock deal for Crescendo Communications,

a manufacturer of desktop computing workgroup

solutions. The acquisition broadened Cisco’s product

line and expanded its resources and capabilities in the

emerging market of networked PCs. CEO John Morgridge

touted the acquisitions ability to, “permit us even greater

responsiveness” to customer needs.4 Over the next three

years, Cisco would make a dozen acquisitions, each

designed to help the company enter new product and

customer segments or to expand and solidify its presence

in existing markets. In 1997, Cisco entered the training and

education market by opening 64 “network academies” to

train high school and college students to design, install, and

maintain computer networks.5

1998 was a watershed year for Cisco. The company,

using a mix of acquired and internally developed technology,

entered the telephone market and introduced Voice over

Internet Protocol (VOIP)

communications. The

fast-growing company

realized revenue of

$8.5 billion and saw its

market capitalization

rise to $100 billion. Since going public, revenue had grown

almost 1,200 percent and its market cap had grown almost

450 percent! The company’s acquisition capabilities grew

as well, Cisco completed nine acquisitions that year, or one

every six weeks. Cisco also expanded its training academies

to a total of 580 locations.

Cisco’s growth continued over the next two years. The

company entered a new market for its products and services

in 1999: the home computer and consumer market. By

late 1999, 42 percent of American homes had Internet

connections, up from almost none five years earlier. The

company quickened its acquisition pace, announcing 18

deals—a deal every three weeks. In 2000, Cisco bought 23

companies, two a month. The market for Internet connectivity

and computer networking continued to evolve, and Cisco’s

products enabled that growth and evolution. Research and

development efforts resulted in patents and products that

THE HUSBAND AND WIFE TEAM DECIDED TO COMMERCIALIZE THEIR INVENTION, THE AGS ROUTER, AND, DURING A DRIVE OVER SAN FRANCISCO’S GOLDEN GATE BRIDGE, THEY CHOSE TO NAME THE COMPANY CISCO SYSTEMS.

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established Cisco in wireless network technology, a major

growth sector of the industry during the early twenty-first

century. On March 27, 2000, Cisco became the world’s most

valuable company, with a market capitalization of $569 billion.6

With 46 acquisitions completed since 1993, Cisco had

developed a clear and consistent process for bringing

acquisitions into the Cisco family.7 The process began with

the identification of attractive targets, typically companies

with new and emerging technologies or ones whose products

would enhance Cisco’s current offerings to customers. The

newly acquired company’s products would appear in the Cisco

catalog—with Cisco part numbers—the day the acquisition

closed. This ensured immediate revenue and profit growth

from the acquisition. Integration specialists from Cisco

worked onsite with the newly acquired company during the

first 90 days after the deal closed. These specialists helped

the new organization to adapt to and navigate within Cisco’s

internal systems; they also introduced new members to the

Cisco culture. Other integration specialists installed Cisco

accounting and purchasing systems.

Cisco fell from its perch as America’s most valuable

company when the Internet stock bubble burst in 2002.

That didn’t stop the company from pursuing its strategy

of acquisition and diversification to maintain and enhance

its status as the backbone of the internet. At the end of

the new century’s first decade, Cisco held leading market

positions in most router and networking categories,

including over 30 percent of the market for routers and

switchers.8 That year, the company shipped its 30 millionth

IP phones to customers around the world.9 Internal growth

and acquisitions helped Cisco maintain and extend its lead

in cutting edge communication and network markets. Cisco

received 913 patents during 2010. With the December 2010

purchase of Linesider Technologies, a maker of network

products for cloud computing applications represented

Cisco’s 145th acquisition. As the second decade of the

twenty-first century began, Cisco seemed well positioned to

lead in all of its existing markets, and the company would

continue to provide the backbone for new, emerging Internet

markets.

Cisco Systems is a leading business in the new, technologically based economy of the twenty-first century. The company uses its intellectual property and brand resources, along with its innovation and acquisition capabilities, to create competitive advantages through the methods you’ve learned about in previous chapters. The concepts and models discussed in Chapters 2 through 5 presume that a company operates in one definable industry, such as health care or home appliances.

CORPORATE VERSUS BUSINESS UNIT STRATEGY

The tools of industry analysis, low cost or differentiation strategies, and innovation help managers devise business unit strategy, or an approach for creating competitive advantage within a single industry, market, or line of business. Cisco, when viewed as a collection or portfolio of businesses, competes in a different, but related way than its individual business units. Cisco managers have a clear corporate strategy, or an approach for creating value and competitive advantages through participation in several different industries and markets.

Corporate strategy entails competing in a core industry or business and also operating in adjacent businesses or markets. When those adjacent markets can be mapped along the value chain, then a firm vertically integrates. For example, when Apple made the decision in the early 1980s to develop its own computer operating system in-house, it vertically integrated backward by producing the inputs to its computers. Vertical integration represents such an important and unique form of diversification that Chapter 7 deals specifically with this topic.

When a firm moves to an adjacent business or market enters a new industry value chain, it engages in horizontal diversification, most commonly referred to simply as diversifica- tion. The adjacent market may mean selling the firm’s existing products to new customer groups, bringing new products and services to existing customers, or selling new products and services to new customers. Managers diversify their firms through one of three meth- ods: greenfield or organic entry, alliance, or acquisition. Alliances, like vertical integration, present the firm with a unique set of opportunities and challenges, so we’ll discuss them separately in Chapter 8. This chapter describes both greenfield entry and acquisition as mechanisms of diversification.

business unit strategy The search for competitive advantage within a

single industry, market, or line of

business.

corporate strategy The search for value and competitive advantages

through participation in several

different industries and markets.

vertical integration Movement into adjacent markets by a firm along

its own value chain. Movement in

the direction of raw materials is

backward integration. Movement

in the direction of sales, service,

or warranty operations is forward

integration.

horizontal diversification The movement into an adjacent, or

unrelated, market that is not along

a firm’s own value chain.

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In this chapter, you’ll learn how companies can create value by competing in several industries instead of just one, and how companies can diversify through greenfield entry or acquisition. Should a company choose to diversify through acquisition, you’ll learn about the process of acquisition and understand how tightly a newly acquired business should be integrated into the company.

CREATING VALUE THROUGH DIVERSIFICATION

Early research by strategy scholars into corporate diversification identified an inverted curvilinear (an upside-down, U-shaped) relationship between corporate diversification and profitability. Firms that compete in a few, related industries or markets outperform firms focused on a single industry. More is not always better, however, because firms that compete in many, unrelated industries perform worse than those in a few, related ones. A number of studies over the last three decades have come to the same general conclusion: Moderate diversification pays off but very high levels of diversification lead to lower levels of performance.10

Levels of Diversification Firms have several choices about how to diversify, and they have a range of options about how much to diversify. Strategy scholar Richard Rumelt created a continuum of diversification strategies based on the product market similarity of the firm’s businesses. Firms range from related to unrelated diversifiers.11 A single business is one where more than 95 percent of the revenues come from a single line of business, most often measured in terms of the four-digit NAICS codes you learned about in Chapter 2. The dominant vertical business earns more than 70 percent of its revenue from its main line of business and the rest from businesses located along the value chain, either upstream (backward integration) or downstream ( forward integration) from the core activity. A dominant business earns more than 70 percent of revenue from its main line of business and the remainder from other lines across different value chains.

A related-constrained firm earns less than 70 percent of its revenue from its main line of business and its other lines of business share product, technological, and distribution linkages with the main business. Amazon marketplace represents related-constrained diversification; marketplace sells a similar product (used rather than new books) and uses the same technology (the amazon website) and distribution network (UPS) as the parent company. Related-linked diversification occurs when the businesses are still related but fewer linkages exist between the new and existing business. Amazon Fresh, started in 2007, sells groceries (a different product group) over the web (same technology) for rapid home delivery (but not through UPS).

Finally, an unrelated diversified firm competes in product categories and markets with few, if any, links between them. Unrelated firms are also called conglomerates and include firms such as General Electric and the 3M Company, also known as Minnesota Mining and Manufacturing. You might recognize 3M for its famous Post-It Notes and line of tapes, but the company sells products from A to Z, from surgical materials for abdominal support to its dental restorative product ESPE Z100.12

For diversification to add value in the real world, managers must answer the following questions: (1) Why will the existing businesses be more valuable because we’ve entered an adjacent business? and (2) Why will the new business activity be more valuable inside our corporation than operating alone? The simplest answers to these questions are the same as the answers to the fundamental strategy questions we raised in Chapter 1. Diversifica- tion adds value when it allows the combined businesses to deliver greater value and utility to new or existing customers than the firm could without being diversified. Diversifica- tion also adds value if the combined businesses reduce the firm’s overall cost of producing goods or services.

single business A firm earning more than 95 percent of the

revenues from a single line of

business.

dominant vertical business A firm that earns more than 70

percent of its revenue from its

main line of business and the rest

from businesses located along

the value chain.

dominant business A firm that earns more than 70 percent of

revenue from its main line of

business and the remainder from

other lines across different value

chains.

related-constrained diversification A firm that earns less than 70 percent of its revenue

from its main line of business

and its other lines of business

share product, technological, and

distribution linkages with the main

business.

related-linked diversification A firm that operates in related

markets, but fewer linkages exist

between the new and existing

markets than the elements create

separately.

unrelated diversified firm Competes in product categories and markets with few, if

any, links between them.

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Value Creation: Exploit and Expand Resources and Capabilities Diversification adds value when expansion into an adjacent business either exploits the firm’s core and valuable resources and capabilities or diversification enhances and grows the resource base. To provide more clarity to the notion of exploiting and expanding, you can divide a firm’s resources and capabilities into two broad categories: a “front end” or customer-facing resources and capabilities and a technological and operational “back end.” Procter & Gamble’s resources such as brands, product lines, distribution channels, and its capabilities in uncovering deep customer needs represent the customer-facing part of the business. Walmart’s resources in terms of regional distribution centers and information sys- tems and its capabilities in global supply chain management and cost reduction belong in the “back-end” group.

Diversification allows companies to exploit their existing customer-facing resources by adding new operational resources and capabilities. General Electric‘s entry into the finance business in the early part of the twentieth century allowed it to solve a core problem for cities and towns: how to defray the huge upfront costs of electrification. Similarly, a business can exploit its existing technological and operational strengths to reach out to new cus- tomer groups. General Electric used its original skills in light bulb and electrical equipment manufacturing to enter a new, high-technology market at the end of the nineteenth century: X-ray machines. GE leveraged its knowledge and skill toward a new set of customers, doc- tors, hospitals, and patients.

Diversification also creates value when it helps a company expand its existing set of resources and capabilities or diversification enables it to prepare for the future. Cisco makes a number of acquisitions designed to expand both its technology platforms and product lines. Cisco introduced its first Internet Protocol (IP) phone in 1998. In 1999, the company made three acquisitions, Sentient Networks, GeoTel Communications, and Amteva Technologies, that brought patents and products that Cisco needed to expand its business.13 Figure 6.1 illustrates the basic logic of value creation through exploiting or expanding resources and from either front- or back-end resources or capabilities.

The logic of exploiting or expanding resources and capabilities provides you with a deeper understanding of what it means for a firm to enter an adjacent market. Adjacent means “next to,” and we might think of adjacent markets as ones with products or services right next to each other. Starbucks sells food and mugs along with its premium coffee, but the company also sells CDs or other products. Food and mugs are naturally adjacent to coffee (people eat

[ Figure 6.1 ] Adding Value Through Diversification

Value through

Exploiting Resources

Enhancing Resources

Value From

“Front-end”, customer- facing part of the business

xpand customer base

Better serve existing customers through more, better products

ain new market knowledge

Add new brands

Identify new trends earlier

“Back-end” operational parts of the business

Create economies of scope or increased scale

Broaden existing production capacity

Adopt new technology platforms

Improve quality, productivity, or other best practices

Access innovative process or product technologies

Enhance R&D capabilities or outputs

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food with coffee and drink coffee in mugs), but music isn’t. When we speak of an adjacent market, we mean a closely related market for creating value and utility for customers. Star- bucks provides customers with a cup of coffee but also a relaxing place to hang out or meet up with others. Part of that environment entails music to set the mood. Starbucks captures the value of that music by offering CDs and other ambience products to customers.

The notions of expanding and exploiting resources help you understand why companies can create sustainable competitive advantages. In the next section, you’ll learn how companies actually create competitive advantage and business value through diversification.

The Six Ss Exploiting and/or expanding the resources and capabilities usually come through one of six mechanisms. To help you remember these important elements, we’ve created a mnemonic device, the six Ss: employing slack, creating synergy, leveraging shared knowledge, utilizing similar models for success, spreading human and financial capital to its best use, or pro- viding a stepping stone for the company to a completely new business sector. As you read through each S, try to think about how each would help a company exploit or expand its resources and capabilities. Each of the Ss can work through the customer-facing front end of the business or the operational and technological back end.

Employing Slack. Slack means unused resource capacity. Delta Airlines generated almost $37.7 billion in revenue in 2012 through its combined operation, almost $1 billion carrying cargo and freight.14 Why would Delta, whose primary customers are people, be involved in the back-end freight business? The top half of the aircraft carries people, the bottom half carries the luggage. There’s often extra room in the bottom of the plane that Delta can fill with freight cargo at almost no cost! Transporting cargo adds value because it captures slack in the form of an economy of scope. An economy of scope arises when the average cost of producing two different products is less when delivered together than separately.

Management skill often represents another unused resource. Firms can only grow as fast as they have knowledgeable and skilled managers to guide that growth.15 This has an important corollary: As managers learn their jobs and develop skill, they are able to effec- tively handle an increased number of activities. Marriott, the upscale hotel operator, com- peted for many years to service business travelers in hotels noted for excellent service. In the late 1980s, the company started its economy chain of Fairfield Inns and the extended- stay Marriott Suites hotel. Marriott became the first major hotelier to offer a portfolio of brands.16 In the mid-1990s, Marriott moved into the adjacent but upscale hotel segment with its purchase of the fabled Ritz-Carlton brand.17 Employing slack usually creates value through exploitation although sometimes during an acquisition a company may acquire redundant resources that expand slack.18

Creating Synergy. Synergy occurs when different elements of a system interact in a way that creates more value together than the elements create separately. Simply put, the whole exceeds the sum of its parts.

Disney competes in two adjacent entertainment markets, films and theme parks. The two businesses create more brand value for Disney together than either would separately. For example, customers’ emotional connection with Disney deepens when they interact with the same characters at a distance in movies and then up close through attractions at the parks. Procter & Gamble gains operational leverage with retailers when it negotiates for shelf space because the company offers retailers a portfolio of important products and can bundle different products to maximize potential revenue for retailers. P&G saves on distri- bution and logistics costs as trucks carry multiple products to each retail location. Synergy clearly exploits the resources and capabilities to offer customers better products and ser- vices. Synergy also increases the number and ways a company interacts with its customers, and that can expand its capabilities to meet customer needs in the future.

Shared Knowledge. Think of a diversified company as a tree: the leaves, twigs, and branches represent different product markets and industries, but the competitive advantage comes from the common roots, processes, or knowledge. These roots are often

adjacent market A market or industry that is closely related

to markets or industries a firm

currently competes in.

slack Unused resource capacity.

economy of scope Activities where the average cost of producing two

different products is less when

delivered together than separately.

management skill The individual and collective abilities of a firm’s

management team to engage in

value-creating activities.

synergy Action between different elements of a system that creates

more value together than the

elements create separately.

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called core competencies, “the collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies.”19 Core competencies represent a set of resources or capabilities at the center of the diversifi ed corporation that are distributed to individual businesses to adapt for their particular markets. Honda parlays operational and technological knowledge and ability in engine design and performance into several diverse downstream markets, including automobiles, lawnmowers, and consumer generators. ESPN’s ability to extend its brand and reputation for serious and engaging sports coverage creates competitive advantage across its 70 diff erent brand platforms.20 Th ese include the fl agship broadcast properties and websites, as well as the magazine, apparel, and restaurant businesses. Honda’s core competencies at high-quality engine design attract a broad set of customers to its products, while ESPN’s core competencies (or shared knowledge) allow the company to service sports fans over a variety of technological platforms. Shared knowledge helps you understand why some very unrelated product markets can represent valuable adjacent markets.

Similar Business Models. A business model is a method for enabling value to be created and exchanged between companies and their customers. General Motors’ business model involves transforming raw materials such as steel, rubber, and plastic into automobiles, all done at very large scale. eBay’s business model is to provide an electronic venue, or market, where buyers and sellers can come together. Strategy scholars note that some business models have common elements or keys to success. Th ey describe these commonalities as a dominant logic or “the

core competencies (or shared knowledge) Collective knowledge that can be distributed throughout

the organization to create value.

business model A method to enable the creation and exchange

of value between companies and

their customers.

dominant logic A conceptualization of a business, or a set of rules

for competition, that applies to

seemingly unrelated product

markets or industries.

Newell Rubbermaid (Symbol NWL, 2012 Revenues: $5.90 billion) traces its origin to 1903, when Edgar A. Newell purchased the assets of curtain rod manufacturer W. F.

Linton. Newell’s original focus lay in improving curtain rods

through technology, production improvements, and cost

reduction. In 1912, the company began selling its products

through mass merchandizer Woolworth, and business

took off. As the company grew over the years, it broadened

the product line to include other low-technology window

treatment products such as extension rods, drapery pin

hooks, and curtain holdbacks.22

In 1965, new CEO Dan Ferguson decided on a new

strategy; rather than focus solely on window treatments, the

company would use mergers and acquisitions to become a

major player in housewares and hardware goods, specifically

low-technology products marketed through mass retailers.

Increasing the product line would create better leverage with

the company’s target customers: chains such as Woolworth

and K-Mart. With the purchase of the EZ Paintr Corporation

in 1974, the company made its first substantial jump outside

its traditional markets. Ferguson would make 70 acquisitions

during his 30-year tenure as CEO, including glass maker

Anchor Hocking, cookware manufacturer WearEver, and

later Calphalon, and Levelor window blinds.

Newell’s acquisition formula exhibits a dominant logic.

Each of the target companies mass produce relatively low-

technology consumer goods in different grades (good, better,

best), and each company distributes its products through

mass retailers.

After taking control of its targets, the company follows

a rigorous process of “Newellizing” its new acquisition.23

Newell uses its deep and extensive knowledge of its

customer, mass retailers, to help its acquisitions reconfigure

product lines and categories to satisfy the needs of its

customers. Newell eliminates duplicate product lines and

makes sure that the company’s offerings fit into the “good,

better, best” quality logic that lies at the core of its success.

Newell creates back-end synergies by eliminating

duplicate functions such as separate sales staffs or

headquarters expenses, as well as sharing production

technologies and processes. Newell uses its dominant logic

knowledge to help the new company reduce costs, improve

manufacturing to find efficiencies, improve financial controls

and metrics, and improve cash flow.

Creating Value at Newell Rubbermaid S T R AT E G Y I N P R A C T I C E

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way managers conceptualize the business and make critical resource allocation decisions— be it in technologies, product development, distribution, advertising, or human resource management.”21 A dominant logic implies that some businesses may look very diff erent at the level of products or services but may share a set of management principles and skills, such as managing a workforce fi lled with skilled labor, or be subject to the same economic processes such as stage in the life cycle, similar barriers to entry, or economies of scale.

Th e Japanese company Sumitomo Heavy Industries competes in a number of diff erent industries. Th e company has business divisions in power generation, plastics machinery (like injection molding tools and dyes) industrial equipment, precision instruments (such as extreme cryogenic refrigeration), defense systems, ship building, and others. Th ese don’t seem adjacent at all, but a closer look reveals that each business shares two back-end commonali- ties: advanced engineering and huge fi xed costs. Success in each business area depends on the ability to attract and retain scientifi c talent that will drive innovation and managing a set of very sophisticated physical assets that require substantial capital investments. Th e Strat- egy in Practice feature details a company with a customer facing dominant logic.

Spreading Capital. Some companies create value through diversifi cation by acting as an internal capital market.24 Th ey create value across business units by moving funds, talent, or knowledge from unit to unit. Rather than leaving resources within a business unit for its own growth, these strategic investments work to increase the corporate value by investing in business units with greater potential growth in the future.

Spreading capital depends on detailed performance information for each unit, as well as an intuitive sense about the value of future investments. As a consequence, these managers can fund business growth at a lower cost of capital than if units relied on external sources such as banks or capital markets.25 Companies creating value through an internal capital market look like the defi nition of conglomerates—business units with little in common in the products or processes. Executives keep these businesses as separate units in order to accurately assess and reward performance. Since there is no sharing of resources, manag- ers have no other divisions to blame if their units perform poorly. Keeping business units separate also allows corporate executives to sell units to willing buyers. Spreading capital

internal capital market The movement of funds, talent, or

knowledge from unit to unit

directed by the leaders of the firm.

The company that would become ITT industries began in 1920 when two brothers, Sosthenes and Hernand Behn, started to build the world’s system of interconnected

telephone lines. They succeeded, and over the next four

decades, their company became a provider of international

telephone services and the switching equipment that

powered large networks.26

Harold Geneen became the CEO of ITT in 1959, and over

the next 17 years he would transform the company from

$750 million in annual sales to $17 billion in annual sales.

How did he do it? Through diversification! Geneen’s ITT

acquired more than 350 companies—at one point closing one

deal per week—and the company expanded operations into

2,000 business units. ITT epitomized the term conglomerate,

or a group of companies cobbled together simply to grow

revenues and earnings. ITT owned businesses as diverse

as the Sheraton Hotel chain, Avis Rent-A-Car, the Hartford

Insurance Company, and the maker of Wonder Bread.

Geneen referred to his company as a “unified-management,

multi-product company.”27

The problem for ITT was, however, managing 2,000 different

businesses, most of them quite unrelated. By the end of

Geneen’s tenure, the board and his successor realized that

the company’s portfolio of businesses destroyed value for

shareholders. ITT split itself into three companies, a group

of industrial companies driven by synergies and similar

processes, the insurance and financial services businesses,

and a group that contained all the rest of the businesses.

With highly efficient markets for financial capital,

equipment, and physical capital, and labor markets that

move human capital, the job of allocating scarce and

valuable resources is better accomplished through the

market. The conglomerate form fell out of favor, but the logic

of spreading capital still makes sense in emerging markets,

where sophisticated and transparent markets for financial

and human capital do not yet exist.28

The Challenges of a Conglomerate: ITT Industries S T R AT E G Y I N P R A C T I C E

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exploits the management team’s unique abilities to invest for value, and each new invest- ment enhances the team’s collective learning. The next Strategy in Practice feature describes the challenges of the spreading capital strategy.

Provide a Stepping Stone to a New Industry. While the other five Ss all exploit a company’s current resources and capabilities, the stepping stone mechanism explicitly works to enhance capabilities. Executives may survey the landscape of the industry and its future trends and decide that their competitive position will not be sustainable and their money would be best invested in some other business segment.

Successfully shifting the firm’s position through diversification usually entails migration, creat- ing a path so the company can avoid “long leaps” from its core into a segment where its resources and capabilities create little value. The path involves a set of “short leaps” executed over time that allows the company to acquire new resources and capabilities. Adjacent markets have two charac- teristics: (1) they allow the firm to exploit some of its resources and capabilities to create value; and (2) they allow the firm to acquire related resources and capabilities to prepare for the next step.29

Consider the case of Safeguard Scientific in the 1990s.30 In 1991, the company’s major line of business was computer peripherals, an industry that includes keyboards, printers, and storage devices. By 2003, the company had shifted its major line of business to the opti- cal instruments business, products such as advanced lenses, scopes, and optical scanning equipment. Safeguard didn’t just jump from keyboards to scientific equipment; it migrated through adjacent industries to acquire skills and capabilities. In 1993, the company moved into producing telephone equipment, and then, in 1995, into electrical instruments. The company exited computer peripherals in 1996, the same year it entered optical instruments. It exited the telephone business in 1999.

Instead of one “long leap” from computer equipment to optical devices, Safeguard took a number of “short hops” through industries where it could leverage existing capabilities and build new ones. The stepping-stone path allowed the company to acquire a new set of back-end operational skills and technology. The company also had to acquire a new set of customer-facing elements, as well.

Destroying Value Through Diversification The six Ss show how and where managers can create value for shareholders of a diversified firm; however, one relatively robust finding from scholars in corporate finance is that diver- sified firms often trade at a discount versus undiversified rivals and that increasing diver- sification (entering additional new lines of business) tends to destroy shareholder value.31

If you think of the acid test for value we presented, diversification destroys value when the new line of business fails to exploit or expand the company’s resources and capabili- ties in meaning ful ways. Value usually gets destroyed in one of five ways: excessive pride; sunk cost fallacy; imitative diversification; poor governance and incentives; or the lack of resource commonality between the lines of business.

Hubris. Managers may diversify based on their own beliefs about the potential of their company’s ability to create value in the adjacent market. Hubris is an ancient Greek word for excessive pride, arrogance, or overconfidence.32 Managers act with hubris when they diversify or make acquisitions based on their own experience or their “gut feelings” rather than on solid data and research. Researchers have argued for, and demonstrated, the hubris hypothesis as an explanation for the poor performance of so many acquisitions.33

Sunk Cost Fallacy. Closely related to hubris as a reason why diversification fails is the sunk cost fallacy, whereby managers believe that their investment in a failed acquisition just needs more incremental investment in order to succeed. Executives are often reluctant to abandon a project in which they have already invested so much time and capital; they often move forward under the assumption that “things will turn around with a little more investment.” The sunk cost fallacy leads managers on a path of escalating commitment to invest resources in failed, or failing, diversification efforts.

Imitation. Managers sometimes feel pressure to diversify their corporation when a competitor diversifies first. The competitor has done due diligence and selected an attractive target for acquisition, or made a greenfield entry after careful research and planning. Caught

hubris Excessive pride, arrogance, or overconfidence.

sunk cost fallacy The belief of managers that investment in a

failed acquisition must continue

because significant amounts have

already been invested.

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off-guard, a firm might quickly look for a similar acquisition target or hurry to create a similar line of business. In their rush to respond, managers fail to consider how attractive the target really is, or if they have the resources and capabilities that make the new market a value adding adjacency. In 2001, shipping leader UPS bought Mailboxes, Etc. for $191 million to give the company 4,300 new drop-off locations. FedEx responded by paying $2.4 billion for 1,200 Kinko’s copy centers. FedEx bought fewer stores for more money and had to figure out how to incorporate Kinko’s huge copy business into its operations.34 While both companies sought to expand into an attractive adjacent market, by being the first mover UPS found the more attractive target. FedEx struggled because it had to integrate a set of resources that aligned poorly with the company’s core. Kinko’s resources and capabilities were not oriented to truly exploit FedEx’s.

Poor Governance and Incentives. Managers receive compensation based on how their companies perform. The threat of failure and the thrill of profit-based rewards create a set of high-powered incentives for managers to run their businesses effectively.35 When they become part of a diversified corporation, however, those managers sometimes move to salary-based compensation that divorces their pay from their performance. Further, within a diversified firm, managers’ decisions must account for internal politics, resource allocation constraints, or mandatory transfers with other divisions. The division becomes less valuable inside the corporation because managers have weak incentives to focus on exploiting and expanding resources and capabilities and stronger incentives to focus their energy in other areas.

Poor Management. How do managers, given their limited time, energy, and mental resources, guide, and direct the diversified firm? Sometimes they use models that relegate their different investments to simplified categories and then provide a management rule for each category. The Boston Consulting Group’s growth share matrix represents one such tool. Figure 6.2 illustrates the growth share matrix.

In the growth share matrix, units contribute to corporate value creation in one of two ways, they either serve as engines of revenue growth or they generate cash flows for the firm to reinvest or distribute to shareholders. Executives classified business units as high or low on each dimension and applied a set of rules for managing each different quadrant. Cash cows have high share but low growth and can generate large cash flows that can be used to fund growth businesses. Companies typically like to minimize investments in cash cows because the goal is to milk the cow. Stars combine high share with high growth and smart managers should invest heavily in these units to maintain or improve their position over time. These businesses typically represent the future of the company. Question marks, as their name implies, truly present a conundrum for management because they require signif- icant investment and effective strategic management if they are to become stars. But if not managed correctly, the significant investments may not move them into the star quadrant

[ Figure 6.2 ] The BCG Matrix

High

Low

Low High

Relative Market Share

G ro

w th

R at

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and instead they may move into the dog quadrant when growth slows. Dogs have low share and low growth and add little profitability to a company’s overall portfolio businesses. The general rule is to divest the dogs.

As you can easily see, the growth share matrix says almost nothing about whether cash cows, dogs, question marks, or stars help the corporation exploit or expand a company’s resources and capabilities. Companies that slavishly follow tools such as this will often miss important sources of value available in their portfolio. For example, a dog business may have low growth because it competes in an emerging industry using cutting edge technology. Divesting the dog may prevent the company from understanding a new technology platform at its inception.

Lack of Resources. Think back to our feature on ITT. A single management system that operates 2,000 different business units relies on very high level financial measures, such as return on invested capital, to make decisions about which businesses will grow and which will stagnate. What ITT lacked, and why it eventually broke itself apart, was the ability to understand and respond to the unique strategic needs of each market, customer group, and line of business. Most of ITT’s business units would offer very negative answers to the questions of value at the beginning of the chapter. Each business gained little of value by membership in the corporation and each added little value in return.

In this section, you’ve learned why and when diversification adds value. In the next sec- tion, we’ll introduce a set of tools that strategic managers can use to evaluate the different business units in their portfolio.

METHODS OF DIVERSIFICATION

Once firms decide to diversify their operations, the next question they must answer con- cerns how to diversify: Should they use greenfield entry by opening their own operations, or should they acquire a company already in the target market or industry? Moreover, if they do decide to enter via acquisition, how do they select a target, get the deal done, and suc- cessfully integrate the new company into the portfolio?

Table 6.1 displays some criteria that managers should consider when choosing their mode of entry. The table aids analysis by dividing resources into front- and back-end catego- ries, and also includes the important criteria of scale-based advantages and timing issues for market entry. Greenfield entry makes sense, first and foremost, when companies have the front-end and back-end resources and capabilities they can immediately exploit to create value. For example, GE’s entry into medical products in the early 1900s drew on its core tech- nical expertise in designing and manufacturing electrical equipment. GE opened its own finance unit to effectively exploit its deep knowledge of the buying process for electrification systems and customer characteristics.

Greenfield also makes sense when companies can afford to enter new arenas slowly and at small to moderate investment. Conversely, acquisition, the outright purchase of another company, becomes the preferred mode of entry when the firm needs to quickly expand its own resources and capabilities to effectively compete. Acquisitions make sense when delay proves costly. In many technology businesses with sophisticated technologies and long lead times for development, companies that enter through greenfield may be too far behind to ever catch up. Acquisition also makes sense if the industry favors competitors with large scale or is characterized by a steep learning or experience curve.

You may be tempted to think that greenfield entry represents value through exploita- tion and acquisitions through expansion. That oversimplifies the analysis; acquisition may prove the preferred choice when any one of the target markets meets any one of the cri- teria outlined above. GE’s 2012 purchase of Italian aerospace company Avio may look like just another addition to a large conglomerate, but as previously described, this acquisition both exploited and enabled GE’s position in the aircraft industry.36 Once managers decide to acquire another business, firms that have developed an acquisition capability initiate a

greenfield entry Entry into an adjacent market by a firm that

opens its own operation.

acquisition The purchase of another company, or its assets.

[ 118 ] CH06 CORPORATE STRATEGY

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[ Table 6.1 ] Greenfield Entry versus Acquisition

COMPETITIVE DIMENSION GREENFIELD ENTRY ACQUISITION

Front End Resources

Brands Brands well-known in the new mar- kets and little advertising needed

Brands not well-known in the new

market and heavy advertising will be

required

Customers Customers in new market similar to existing customers

Customers in new market very

different from existing ones

Channels Many channels available that the firm can easily access

Few channels available or access to

channels difficult and expensive

Back-End Resources

Human Capital Standardized knowledge and skills that can be easily gained

Unique or tacit knowledge and skill

Technology New technology integrates easily with existing processes

New technology does not integrate

easily with existing processes

Scale Economies of scale add few, if any, advantages

Significant economies of scale or

learning effects that confer strategic

advantage

Speed Slow, deliberate entry enables growth of solid market position

Rapid entry needed to capture

opportunity

well-defined process to examine, purchase, and then bring the new entity into the corporate fold. In this section we’ll explain the four essential steps in that process: identifying potential targets, selecting which of these to purchase, doing the deal, and integrating the acquisition after the deal closes.

THE ACQUISITION AND INTEGRATION PROCESS

Acquisitions represent an opportunity to create, or destroy, value for the firm. In 2013, for example, the American economy witnessed over 8,000 mergers or acquisitions, valued at $980 billion.37 In spite of its prevalence in the U.S. economy, most mergers or acquisitions fail to create value for shareholders. Estimates vary, but between 70 percent and 90 percent of mergers don’t work out.38

Making the Acquisition Before searching for a firm to purchase, managers must understand the real, value-creating need behind the move. Good reasons to diversify center on both the acquiring and target firm’s resources and capabilities. Value creating acquisitions will either exploit the value of a firm’s current stock of resources or the acquisition will enhance the firm’s resources and capabilities. Poor reasons for acquisitions include simply adding top line revenue growth or doing a deal just because a competitor recently did one. These reasons make clear how the acquisition makes the current corporation more valuable; however, managers must also answer other questions: Why and how will the target firm be more valuable because we own it? The answer to these questions comes from the six Ss above. The best acquisitions create value for both the acquiring and acquired firm.

After making a list of potential targets that pass the first screen, the next phase requires the firm to perform a due diligence audit on each potential target. Due diligence means to closely examine the target firm to understand its core processes, strengths, and weaknesses.

due diligence The process whereby managers closely examine

the target firm to understand its

core processes, strengths, and

weaknesses.

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Newell Corporation’s 1999 purchase of Rubbermaid illustrates the problems that inat- tention to due diligence can create. Newell essentially bought Rubbermaid’s revenues and profits; it had little to offer Rubbermaid in terms of resources and capabilities and the same held true for Rubbermaid.39 Newell rushed its financial due diligence and failed to see that, within legal bounds, Rubbermaid created a picture of a business in better condition than the actual corporation. Rubbermaid proved to be, what one analyst termed, “a perfumed pig” and Newell overpaid as a result. Newell Chairman Daniel Ferguson stated, “We should have paid $31 per share but we paid $38.”40 Failure to follow these steps required Newell to write off $500 million of merger-related goodwill in 2002.

Once a potential candidate passes the value screen and survives the due diligence pro- cess, managers at the acquiring firm must decide how much they are willing to pay for the target. A number of tools exist to help with the valuation; firms often hire investment bank- ers or advisors to help them.41

Acquirers must pay a premium to acquire a target; the premium represents a bet by the acquirer on its ability to create value through the acquisition. In the United States, the aver- age premium that the acquiring firm pays for a target firm is roughly 30 percent. For example, Newell originally offered just over $34/share for Rubbermaid, which was then trading at about $26/share, but eventually paid $38 per share.42 The process of acquisition plays an important strategic role for firms, and it represents a source of ethical challenges for managers and exec- utives. Our Ethics and Strategy feature invites you to think through one such dilemma.

Integrating the Target The acquisition premium creates two challenges for the acquiring firm. First, the larger the premium, the more value they must actually create to justify the acquisition. Second, given the time value of money, the larger the premium, the quicker the acquirer must create that value. For example, a hefty premium, coupled with large debt to close the deal, strongly encourages ( forces) managers of the acquiring firm to create real value in order to pay off the debt.45 Strat- egy and management researchers suggest that acquisition represents a risky strategy for value creation with failure rates as high as 90 percent in some industries.46 Acquisitions may fail to create value because of poor strategic fit, incomplete due diligence, or a high acquisition price, but also because the acquiring firm fails to properly integrate the firm into its portfolio.

Proper integration, like everything else depends on the firm’s overall strategy and, more specifically on which of the six Ss the corporation uses to create value through diversifica- tion. Integration means the degree to which the two companies share facilities, operating procedures, compensation systems, organizational structures, and even cultural norms. Sometimes, an acquiring firm will need to tightly integrate the acquired firm into its own organization, but other strategies require the two firms to operate relatively (or completely) separate. Figure 6.3 illustrates the link between the degree of integration and the source of value creation.

Managers in the firm tasked with integrating the new acquisition must decide which activities or operations to integrate and how completely or tightly coupled the target and company will be linked together. The tighter the degree of integration, the more the com- bined entity looks and acts like a single firm. Conversely, loose integration allows each com- pany autonomy in its business operations. Firms may follow one of four general integration strategies: They can bury the target through complete integration, build a brand new entity with the combined entities through tight integration, blend in the target to the corporation using best practices from each, or bolt on the target to the existing company only where it makes sense. Table 6.2 summarizes each approach; we will describe each in more detail.

Bury. Another term for bury is takeover, where the acquiring firm breaks up the target firm and weaves its individual elements (e.g., product lines, employees, manufacturing facilities) into the fabric of the acquiring firm. The target’s brand, culture, and identity all disappear; both the back-end operations and customer-facing aspects of the acquirer remain unchanged, although supplemented by the addition of the target’s assets. Apple’s acquisitions of more than 40 start-up firms have followed this pattern, including NeXT, eMagic, and Siri (yes, it used the Siri name for the personal digital assistant on the iPhone).

takeover An acquisition where the acquiring firm absorbs the target

firm. The target firm ceases to

exist.

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When a company makes an acquisition, how much should it disclose about its true intentions to the employees of the acquired firm? Cisco Systems CEO

John Chambers talks about the importance of treating

employees of the acquired firm well, as he believes “you’re

only acquiring employees.”43 Cisco has acquired over 150

companies, and its core values reflect Chambers’s concern

for employees: integrity, respect for individuals, and open

communication. These core values have led to many

successful acquisitions by Cisco as target companies have

been successfully integrated into the Cisco family.

Open communication and respect for individuals seem

to be straightforward values, but each of these raise ethical

issues for strategic managers during the integration

process. Strategists usually have several objectives in mind

when making an acquisition. The firm might buy the ability to

offer certain products or services, it may purchase another

firm for access to production processes, plants, or favorable

locations, managers may target intellectual property such

as patents and trademarks in an acquisition, or strategists

may seek to lock up unique and valuable human capital.

The point is that when an acquiring firm considers a target,

it might have multiple objectives in mind. The firm might

fully integrate some divisions or elements, allow others

to run as a separate business, and close down or sell off

others. The ethical issue involves the trade-off between the

acquirer’s desires to move efficiently and effectively versus

stakeholders’ (primarily employees but also customers and

suppliers) needs for information in making their own plan.

Here’s an example. Consider two regional nursing home

operators, Blue Heron and White Swan.44 Each company

uses acquisitions to grow and expand into new regions. In

this case, Blue Heron and White Swan each purchased a

family-owned, local set of nursing homes to gain entry into

the Southwestern region of the United States. Both acquirers

follow a prescribed list of 90-day objectives integration

plan to bury the acquired firm. The objectives include

implementing the corporate technology platform, migrating

purchases to the acquirer’s preferred vendors, assessing the

need for capital investments in the newly acquired units, and

training employees on Blue Heron or White Swan procedures

and protocols. At the end of the 90 days, both acquirers

always replace the unit’s existing general manager to bring

in their own staff who are familiar with the existing culture,

processes, and strategies.

The ethical challenge for Blue Heron and White Swan

is that during the 90-day transition period, the acquired

unit’s manager-in-place can play a key role in the efficiency

and effectiveness of the transition. How much information

should leaders of the acquiring firm share with the unit

managers about their ultimate plans? If they tell the

managers of their impending termination, they run the risk

of losing a valuable player during the transition process.

However, withholding that information raises fairness

concerns for the unit managers; they could have used that

90-day period to find and secure new employment. How

would you resolve this dilemma?

Blue Heron operates as a business first and foremost.

Its belief is that the most important goal is to ensure

efficiency and effectiveness during the transition. Managers

are interchangeable, and Blue Heron does not disclose

its true intentions to the unit managers until they receive

termination notices at the end of the 90 days. White Swan,

also deeply committed to creating value for shareholders,

opts for a different, open approach. Its managers sit down

with the unit managers at the beginning of the process

and disclose their ultimate plans. White Swan offers those

managers increased pay and a bonus for the transition

period, outplacement help in finding a new position, and the

promise of a very positive reference if the job is well done.

White Swan refuses to trade off its obligations to owners

and employees. The owners get a smooth and effective

transition, and employees are treated with dignity, fairness,

and respect.

E T H I C S A N D S T R AT E G Y

Transparency During the Acquisition Process

THE ACQUISITION AND INTEGRATION PROCESS [ 121 ]

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The target firm ceases to exist as Apple assimilates and disperses the valuable elements of the firm throughout its existing organization.47

Build. The traditional term merger represents what companies do when they build one new firm from the components of the two. The degree of integration is not as high as in the bury strategy, but a new identity, culture, and corporate brand emerges when the deal closes. Back-end and customer-facing aspects of the business use the best in class processes of either company.

In 1998, auto giants Daimler-Benz and Chrysler merged, resulting in DaimlerChrysler AG, with a stated goal of increasing global customer share by sharing best operating prac- tices between the two businesses. This bold strategy required the companies to truly build a new organization, on both the customer front-end and operational back-end. Unfortunately, the companies split in 2007 after it became apparent that the “merger of equals” was really an acquisition of Chrysler by Daimler. Building a new company may be the hardest integra- tion strategy of all.

Blend. A blended acquisition results in a moderate degree of integration. The target firm retains its own identity, brand, and much of its culture and operating autonomy. Acquirers may transfer many back-end practices to the acquired firm, as Newell does when it “Newellizes” an acquisition; the company may choose to share fewer processes and practices, such as GE’s management of many of its acquisitions. Customer-facing aspects of the business remain largely separate to capitalize on the strength of each company in its market. When companies add value through synergy, shared knowledge, or similar processes, a blending strategy helps create new value while preserving the strengths of each company.

merger An acquisition with the goal of creating a new firm from

the components of the two pre-

acquisition firms.

[ Table 6.2 ] General Integration Strategies

ELEMENT/ STRATEGY BURY BUILD BLEND BOLT ON

Integration Complete Tight Moderate—loose None

Brand and Identity Acquirer maintains,

Target loses

New, combined Target maintains

front end

Target retains

Back-End Operations Acquirer imposed Best of breed Acquirer dominates Separate

Customer Facing

Operations

Acquirer imposed Combined, Best of

Breed

Separate Separate

[ Figure 6.3 ] Determining the Proper Degree of Integration

Source of value

creation

Employing Slack

Creating Synergy

Stepping Stones

Shared Knowledge

Similar Models

Spread Capital

Degree of Integration

Tightly integrated

Well integrated

Integrated Moderately integrated

Loosely integrated

Not integrated

Reason Best exploit economies of scope, knowledge, and skills.

Cost sharing requires integrated operations

Innovation builds on common resources

Building new knowledge and skill requires close proximity and exchange but also freedom of action by the acquired firm

Sharing overlapping knowledge, but allowing each business to exploit unique knowledge

Only those areas with common model will gain through shared practices.

Keep units separate to monitor performance and create accountability

[ 122 ] CH06 CORPORATE STRATEGY

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Bolt On. The metaphor of bolting on an acquisition implies two separate entities joined at a single point through a very strong link. In a bolt-on acquisition, the two entities remain deliberately separate in order to monitor the performance of each unit. The link between the two businesses usually lies in the transfer of cash between divisions, either in the form of capital investment from the acquirer to the acquired or the payment of a dividend in the reverse direction.

ITT exemplifies the bolt-on model; each business unit is connected with the corporate center only through financial reporting. Because the goal of each unit was to contribute cash and operating profit rather than knowledge or strategically valuable assets, the bolt-on model was the only appropriate integration choice for ITT to create any value. The different business units could make no excuses that achieving larger corporate goals had influenced their individual earnings; the bolt-on model preserved operating transparency among the many different businesses.

Regardless of the integration template managers in the acquiring firm choose, atten- tion to a number integration processes work to create a smooth and successful acquisition. These processes begin with the creation of a dedicated integration team as soon as the deal is announced.

The most successful integration teams are jointly led by high-profile executives from both the acquiring and acquired firm; the credibility and authority of these teams helps break down barriers to change and integration in both companies. The team should be composed of subject area experts within each business function, such as human resources, market- ing, operations, and finance/accounting.48 Each element of the new business that will be integrated needs its own specialist on the integration team to lead and monitor the effort. Finally, members of the best integrations work full time in these roles. Full-time status allows these individuals to supplement their functional knowledge with expertise specific to the acquisition process.

This team makes several key decisions that create a successful acquisition. The first deci- sion involves which company culture will dominate the new entity. Culture, norms, and val- ues that define “how things are done around here” are the most important elements in the process. The acquiring firm usually wants its culture to dominate the new company, but people in the acquired firm often want their culture to persist. The resulting cultural clash can sabotage the entire integration process. A more difficult option entails building a new culture that combines the best elements of each company’s culture.49

Speed matters in the integration process. When people see that the new company creates value for its stakeholders, including themselves, they become willing to change their own behaviors and truly join the new organization. The quicker the integration team can create clear successes, the more quickly members of the acquired firm dedicate their energy to making the venture succeed. This principle underlies Cisco’s practice of hav- ing the acquired company’s products for sale by Cisco employees on day 1 of the new relationship.

The team decides which tactical elements and operational functions of the two firms will be integrated and implements whichever strategic integration template the firm chooses. Several other processes ensure that the merger, once finalized, creates value as soon as possible. These include determining a clear day-1 set of priorities and tasks to realize immediate value from the deal, establishing a clear set of measures or key performance indicators (KPIs) to monitor progress, a clear path for implementing new systems in operations, marketing, or information systems, and a commitment to clearly communicate, in fact overcommunicate, the rationale and goals for the acquisition and the measureable progress toward those goals. We close this chapter by looking at General Electric to see how the company has mastered the acquisition integration process.

integration team A group of individuals from different functional

areas of an acquiring firm that

coordinate and manage the

integration of the target company

after the acquisition has closed.

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SUMMARY [ 123 ]

SUMMARY

Diversifi cation creates value when fi rms exploit or enhance their resource base by enter- ing a new line of business, market, or industry. Managers should ask two questions when considering entering a new line of business: (1) Why will the existing businesses be more valuable because we’ve entered an adjacent business? and (2) Why will the new business activity be more valuable inside our corporation than operating alone? When managers choose to diversify, they face a choice about whether to enter a new line of business through greenfi eld entry or through acquisition. Greenfi eld entry proves a preferred strategy when the fi rm can readily exploit its existing resources and capabilities, is not pressed for speed, and can enter a new line of business at a small or moderate scale. Diversifi cation through acquisition becomes the preferred strategy when fi rms must expand their resources and capabilities to compete eff ectively, enter a market quickly, or operate at large scale.

How GE Integrates Acquisitions50 S T R AT E G Y I N P R A C T I C E

General Electric’s financial services unit, GE Capital, made over 100 acquisitions in a five-year period. With acquisition such an essential element of the unit’s strategy and the sheer

number of acquisitions to integrate into an already-diverse

portfolio, GE managers used this period of intense activity to

perfect a system for integrating new acquisitions. The process

worked very well, resulting in a systematic framework that the

unit—and other companies—could use to improve the odds of

success in an inherently difficult enterprise.

GE’s system builds on four powerful lessons they learned

through experience:

1. Acquisition is a process, not an event. Acquisition begins long before the deal closes and ends long after. Work

done before the deal closes improves the integration

success, and monitoring for a sustained period allows

the new entity to “settle in” to the GE portfolio. Acquir-

ing a company most often represents a long-term

commitment; the integration process should have a

similar goal of long-term value creation.

2. Successful integration requires a committed team of talented professionals whose only job is integration.

Integration managers, just like product or brand

managers, create value for the business and require

their own set of dedicated skills to succeed. Asking

people to work on an integration team in addition to

their already-full plates usually ends up with integra-

tion becoming a lower priority, which, in turn, jeopard-

izes the overall success of the acquisition.

3. Communication about important matters such as who will lose their jobs and how compensation systems will

change must be clear, forceful, and immediate. Peo-

ple care a lot about their own future. Until they know

where they stand, it’s hard for them to commit to mak-

ing the acquisition a true success. Only after people

know WIFM (what’s in it for me) will they attend to the

strategic rationale for the move.

4. Real and significant integration happens best when peo- ple work together on real, mission critical tasks. Things

like company picnics, “getting to know you” days, or

other feel-good activities prove far less effective than

assigning people to work on business-related, profit-

generating activities. Working on real projects brings

people together and helps the company show the suc-

cess of the acquisition more quickly.

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[ 124 ] CH06 CORPORATE STRATEGY

Successful diversification relies on one of the six Ss to create value:

managerial slack—the ability of managers to handle more work effectively over time,

synergy—the combination of two businesses creates more value than either could separately,

shared knowledge—diversification allows valuable knowledge and skill to be shared between business units,

business models—when business unit success depends on common characteristics, such as knowledge management, or scale economies,

spreading capital—the headquarters of the corporation quickly allocates capital and other resources to their best use among business units, and

a stepping stone to new markets—where a firm moves to a new industry through a set of small jumps and each jump allows the acquisition of key resources and skills.

When done poorly, diversification destroys value through

excessive pride or hubris—making diversification decisions based on biased thinking or emotional reasoning rather than facts and data,

sunk cost fallacy—focusing on past resources expended, which cannot be recovered, as a criteria for decision making,

imitative diversification—choosing to copy a competitor’s moves rather than having a compelling strategic logic,

poor governance and incentives—simply running the new business poorly or failing to incentivize managers to attend to the business, and

the lack of resource commonality between the lines of business—moving into lines of business that fail to create value based on any of the six S’s.

Successful integration ensures that acquisitions add value to the organization. The four Bs provide a template for thinking about how a firm should integrate an acquisition:

bury—completely absorb the acquired company into the acquirer,

blend—retaining and combining the best elements of both companies to compete more effectively,

build—craft an entirely new organization, and

bolt on—run the acquired company independently of the acquiring company.

KEY TERMS

acquisition (p. 117) adjacent market (p. 112) business model (p. 113) business unit strategy

(p. 109) core competencies (or

shared knowledge) (p. 113)

corporate strategy

(p. 109) dominant business

(p. 110) dominant logic (p. 113)

dominant vertical business

(p. 110) due diligence (p. 118) economy of scope (p. 112) greenfield entry (p. 117) horizontal diversification (p.

109) hubris (p. 115) integration team (p. 122) internal capital market

(p. 114) management skill (p. 112) merger (p. 121)

related-constrained

diversification (p. 110) related-linked diversification

(p. 110) single business (p. 110) slack (p. 112) sunk cost fallacy (p. 115) synergy (p. 112) takeover (p. 119) unrelated diversified firm

(p. 110) vertical integration (p. 109)

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REFERENCES [ 125 ]

REVIEW QUESTIONS

1. Why and when do firms create value through diversification?

2. Apple is primarily an electronics company, creating products for business and consumer markets. Apple also operates its own chain of retail outlets. In terms of Richard Rumelt’s categories of the level of diversification, where does Apple fit?

3. List the reasons why diversification fails to add value. Which one do you believe is most common? Which is least?

4. What factors should executives consider when making a decision on entering a new mar- ket through greenfield entry versus making an acquisition?

5. How can acquiring firms increase the likelihood of a successful integration of an acquired firm?

APPLICATION EXERCISES

Exercise 1: Understanding Diversification 1. Look in The Wall Street Journal, Businessweek, or other business publication and find a

company looking to expand through diversification—either greenfield entry or acquisi- tion. What type of diversification does this represent?

2. For the example you selected above, how do managers claim they will create value through diversification? Using the six Ss described in the chapter, evaluate how well you believe the company will do in its value creation strategy. For example, are there real synergies or core competencies to create? Do the businesses share a similar dominant logic?

3. Choose a diversification move that entails acquisition. Using the company diamond from Chapter 3, identify areas where you believe the acquisition can add value for sharehold- ers. Also identify three to five issues that you believe will create challenges for the acquir- ing company’s management team.

4. Through a friend, mentor, colleague, relative, or recruiter, identify someone who has expe- rienced an acquisition or merger, either as a buyer or seller. Which integration strategy did he or she experience? What worked well and helped create value during this process? What did not work well? What would the person change if he or she went through this situation again?

REFERENCES

1 See Cisco Systems, Inc. History, Funding Universe, http://www.fundinguniverse.com/company-histories/

cisco-systems-inc-history/.

2 Cisco Systems. Silicon Valley Historical Association, http://www.siliconvalleyhistorical.org/#!cisco-systems/

c1vg0.

3 Cisco Systems Corporate Timeline, http://newsroom.cisco.com/dlls/corporate_timeline.pdf, accessed

12 February 2014.

4 Data on the Crescendo acquisition taken from “Cisco Systems Finalizes Agreement to Acquire Crescendo

Communications,” company press release, http://newsroom.cisco.com/dlls/1993/corp_092493.html.

5 See Cisco Systems Timeline for the data contained in the following two paragraphs.

6 Ibid.

7 E. Paulson, Inside Cisco: The Real Story of Sustained M & A Growth (New York: John Wiley & Sons, 2001).

8 Data from “Cisco Loses Market Share as Router/Switch Market Up,” Infonetics Research report (August 26,

2011), http://www.telecomreseller.com/2011/08/26/cisco-loses-market-share-as-routerswitch-market-up/.

http://www.fundinguniverse.com/company-histories

http://www.siliconvalleyhistorical.org/#!cisco-systems

http://newsroom.cisco.com/dlls/corporate_timeline.pdf

http://newsroom.cisco.com/dlls/1993/corp_092493.html

http://www.telecomreseller.com/2011/08/26/cisco-loses-market-share-as-routerswitch-market-up

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[ 126 ] CH06 CORPORATE STRATEGY

9 B. O’Sullivan, “30 Millionth Cisco IP Phone!” blog (October 27, 2010). https://blogs.cisco.com/news/30-

millionth-cisco-ip-phone/.

10 The original work is R. P. Rumelt, Strategy, Structure, and Economic Performance (Cambridge: Harvard Busi-

ness School Press, 1986). See also R. P. Rumelt, “Diversification Strategy and Profitability,” Strategic Management

Journal 3 (4) (October 1, 1982): 359–369. A meta-analytic study can be found in S. R. Perry, A Meta-Analytic

Review of the Diversification-Performance Relationship: Aggregating Findings in Strategic Management (Florida

Atlantic University: Florida Atlantic University, 1998), http://digitool.fcla.edu/R/UFVFAL2DR3T6X2N1AM-

IJG32TMKA7XYMRG8TGT1E8ITXANM1NHL-02231?func=dbin-jump-full&object_id=12566&local_

base=GEN01&pds_handle=GUEST. L. H. P. Lang and R. M. Stulz, “Tobin’s Q, Corporate Diversification, and Firm

Performance,” Journal of Political Economy 102 (6) (December 1, 1994): 1248–1280. See also D. J. Miller, “Tech-

nological Diversity, Related Diversification, and Firm Performance,” Strategic Management Journal 27 (7) ( July 1,

2006): 601–619. Researchers have also considered international diversification as a measure of relatedness. See

G. Qian et al., “Regional Diversification and Firm Performance,” Journal of International Business Studies 39 (2)

(March 1, 2008): 197–214. G. Qian et al., “The Performance Implications of Intra- and Inter-Regional Geographic

Diversification,” Strategic Management Journal 31 (9) (September 1, 2010): 1018–1030.

11 Rumelt, “Diversification Strategy and Profitability.” See also Rumelt, Strategy, Structure, and Economic Performance.

12 Data on 3M’s very large product catalog can be found at http://www.3m.com/product/z_index.html.

13 See Cisco Systems Acquisitions, http://www.cisco.com/web/about/doing_business/corporate_development/

acquisitions/ac_year/about_cisco_acquisition_years_list.html

14 Data from Delta’s 2012 SEC filing form 10-K. Found at http://www.delta.com/content/dam/delta-www/pdfs/

about-financial/DeltaAirLines_10K_2012.pdf

15 See E. T. Penrose, The Theory of the Growth of the Firm (Cambridge, England: Oxford University Press, 1959). For

a recent treatment of the Penrose effect in strategic management, see J. T. Mahoney and D. Tan, “Examining the

Penrose Effect in an International Business Context: The Dynamics of Japanese Firm Growth in U. S. Industries.,”

Managerial and Decision Economics 26 (n.d.): 11–127.

16 Information taken from http://timeline.marriott.com/#/?era=3&milestone=1.

17 E. McDowell, “Marriott to Acquire a Ritz-Carlton Stake,” New York Times (business day, March 7, 1995), http://

www.nytimes.com/1995/03/07/business/company-news-marriott-to-acquire-a-ritz-carlton-stake.html.

18 C. Zook and J. Allen, “Growth Outside the Core,” Harvard Business Review 81 (12) (December 2003): 66–73.

19 C. K. Prahalad and G. Hamel, The Core Competence of Corporation (Canada: Harvard Business School Reprint,

1990).

20 G. Bodenheimer, “Growing up with ESPN,” Marriott School Alumni Magazine (Winter 2013), 14–16.

21 C. K. Prahalad and R. A. Bettis, “The Dominant Logic: A New Linkage between Diversity and Performance,”

Strategic Management Journal 7 (6) (1986): 490.

22 Information on the Newell Corporate history taken from http://www.newellrubbermaid.com/OurCompany/

Pages/OurHistory.aspx.

23 The Newellization process is summarized in William Rouse, Enterprise Transformation: Understanding and

Enabling Fundamental Change (Hoboken: John Wiley & Sons, 2006).

24 J. P. Liebeskind, “Internal Capital Markets: Benefits, Costs, and Organizational Arrangements,” Organization Sci-

ence 11 (1) ( January 1, 2000): 58–76. See also.

25 R. H. Gertner, David S. Scharfstein, and Jeremy C. Stein, “Internal Versus External Capital Markets,” The Quar-

terly Journal of Economics 109 (4) (November 1, 1994): 1211–1230. J. C. Stein, “Internal Capital Markets and the

Competition for Corporate Resources,” The Journal of Finance 52 (1) (March 1, 1997): 111–133.

26 Information in these paragraphs taken from http://www.itt.com/About/History/.

27 A. Hill, “Breaking Up Is Not a Sign of Failure,” Financial Times ( January 24, 2011). http://www.ft.com/intl/

cms/s/0/ef29d5d8-2806-11e0-8abc-00144feab49a.html#axzz2XoM3SIOn.

28 T. Khanna and K. Palepu, “Is Group Affiliation Profitable in Emerging Markets? An Analysis of Diversified Indian

Business Groups,” The Journal of Finance 55 (2) (April 1, 2000): 867–891. T. Khanna, K. G Palepu, and R. J Bullock,

Winning in Emerging Markets: A Road Map for Strategy and Execution (Boston: Harvard Business Press, 2010).

29 D. J. Bryce and S. G. Winter, “A General Interindustry Relatedness Index,” Management Science 55 (9) (September

1, 2009): 1570–1585.

30 D. J. Bryce, “Firm Performance and the Rate of Change in Capabilities,” Strategic Management Society

(October 2012).

31 R. Rajan, H. Servaes, and L. Zingales, “The Cost of Diversity: The Diversification Discount and Inefficient Invest-

ment,” The Journal of Finance 55 (1) (February 1, 2000): 35–80. See also J. Hund, D. Monk, and S. Tice, “Uncer-

tainty about Average Profitability and the Diversification Discount,” Journal of Financial Economics 96 (3) ( June

2010): 463–484.

32 See http://dictionary.reference.com/browse/hubris

33 M. L. A. Hayward and D. C. Hambrick, “Explaining the Premiums Paid for Large Acquisitions: Evidence of CEO

Hubris,” Administrative Science Quarterly (1997): 103–127. R. Roll, “The Hubris Hypothesis of Corporate Takeo-

vers,” Journal of Business (1986): 197–216. P. R. Rau and T. Vermaelen, “Glamour, Value and the Post-Acquisition

Performance of Acquiring Firms,” Journal of Financial Economics 49 (2) (1998): 223–253.

https://blogs.cisco.com/news/30-millionth-cisco-ip-phone

http://digitool.fcla.edu/R/UFVFAL2DR3T6X2N1AM-IJG32TMKA7XYMRG8TGT1E8ITXANM1NHL-02231?func=dbin-jump-full&object_id=12566&local_

http://www.3m.com/product/z_index.html

http://www.cisco.com/web/about/doing_business/corporate_development

http://www.delta.com/content/dam/delta-www/pdfs

http://timeline.marriott.com/#/?era=3&milestone=1

http://www.nytimes.com/1995/03/07/business/company-news-marriott-to-acquire-a-ritz-carlton-stake.html

http://www.newellrubbermaid.com/OurCompany

http://www.itt.com/About/History

http://www.ft.com/intl

http://dictionary.reference.com/browse/hubris

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REFERENCES [ 127 ]

34 For UPS, see A. Doan, “UPS picks up Mail Boxes, Etc.,” Forbes (March 5, 2001), http://www.forbes.

com/2001/03/05/0305ups.html. For FedEx, see C. Deutsch, “FedEx moves to expand with purchase of Kinko’s,”

New York Times (Dec. 31, 2003), http://www.nytimes.com/2003/12/31/business/market-place-fedex-moves-to-

expand-with-purchase-of-kinko-s.html.

35 O. E. Williamson, The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting (New York,

London: Free Press; Collier Macmillan, 1985).

36 J. Werdigier, “General Electric to Buy Avio for $4.3 billion,” New York Times (Dec. 12, 2012), http://dealbook.

nytimes.com/2012/12/21/general-electric-to-buy-avio-for-4-3-billion/.

37 J. Kang, “Aside from Dell, Verizon Deals, 2013 Not a Standout Year for M&A,” Forbes (Nov. 5, 2013),

http://www.forbes.com/sites/jaewonkang/2013/11/05/aside-from-dell-verizon-deals-2013-not-a-standout-

year-for-ma/.

38 C. Christensen, R. Alton, C. Rising, and A. Waldeck, “The Big Idea: The New M&A Playbook,” Harvard Business

Review (March 2011), p. 46.

39 A. Corbett, C. Lemire, and D. Harding, “Deals Done Right,” Ivey Business Journal ( January/ February 2007), http://

www.iveybusinessjournal.com/topics/strategy/deals-done-right#.UWg7RLXCZ8E.

40 D. Harding and S. Rovit, Mastering the Merger: Four Critical Decisions That Make or Break the Deal

(Harvard Business School Press, 2004)., p. 27.

41 W. D. Miller, Value Maps Valuation Tools That Unlock Business Wealth (Hoboken: Wiley, 2010), http://site.ebrary.

com/id/10388356.

42 C. Deutsch, “Newell Buying Rubbermaid in $5.8 Billion Deal,” New York Times (October 22, 1998), http://www.

nytimes.com/1998/10/22/business/newell-buying-rubbermaid-in-5.8-billion-deal.html.

43 E. Paulson, Inside Cisco: The Real Story of Sustained M & A Growth (New York: John Wiley & Sons, 2001).

Information on Cisco’s core values found at http://csr.cisco.com/pages/governance-and-ethics.

44 Blue Heron and White Swan are fictitious companies drawn from actual author experiences with different

companies facing similar issues.

45 M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” The American Economic

Review 76 (2) (May 1, 1986): 323–329.

46 M. E. Graebner, K. M. Eisenhardt, and P. T. Roundy, “Success and Failure in Technology Acquisitions: Lessons for

Buyers and Sellers,” The Academy of Management Perspectives 24 (3) (August 1, 2010): 73–92.

47 A nice summary of these 40 acquisitions, plus citations to verify each one, can be found at https://en.wikipedia.

org/wiki/List_of_mergers_and_acquisitions_by_Apple.

48 G. Knilans, Mergers and Acquisitions: Best Practices for Successful Integration,” Employment Relations

Today (Winter 2009), 9 pages. http://www.tgcpinc.com/SiteData/doc/MergersAcquisitions-MBrenner-

071409/976ceba14c4fae75a4bbcb514bb34762/MergersAcquisitions-MBrenner-071409.pdf.

49 T. Rouse and T. Frame, “The 10 Steps to Successful M&A Integration, Insights” (Bain and Company),

(Nov. 4, 2009), http://www.bain.com/publications/articles/10-steps-to-successful-ma-integration.aspx.

50 This sidebar summarizes an extensive discussion of the GE model by R. N. Ashkenas, L. J. DeMonaco, and

S. C. Francis, “Making the Deal Real: How GE Capital Integrates Acquisitions,” Harvard Business Review

( January–February 1998).

http://www.forbes

http://www.nytimes.com/2003/12/31/business/market-place-fedex-moves-to-expand-with-purchase-of-kinko-s.html

http://dealbook

http://www.forbes.com/sites/jaewonkang/2013/11/05/aside-from-dell-verizon-deals-2013-not-a-standout-year-for-ma

http://www.iveybusinessjournal.com/topics/strategy/deals-done-right#.UWg7RLXCZ8E

http://site.ebrary

http://csr.cisco.com/pages/governance-and-ethics

https://en.wikipedia

http://www.tgcpinc.com/SiteData/doc/MergersAcquisitions-MBrenner-071409/976ceba14c4fae75a4bbcb514bb34762/MergersAcquisitions-MBrenner-071409.pd

http://www.bain.com/publications/articles/10-steps-to-successful-ma-integration.aspx

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Vertical Integration and Outsourcing

Ed Lallo/Bloomberg via Getty Images

[ 129 ]

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Studying this chapter should provide you with the knowledge to:

1 Define vertical integration, forward vertical integration, and backward integration.

2 Describe the three Cs that represent the primary reasons that firms may choose to vertically integrate (make) and perform an activity internally versus outsource (buy) the activity to (from) a supplier.

3 Describe the two Fs, which examine the potential dangers of vertical integration.

4 Explain the advantages of outsourcing and the conditions under which it might be advantageous to outsource an activity to an external supplier.

5 Discuss the actions a manager could take to prevent a subcontractor from becoming a competitor.

L E A R N I N G O B J E C T I V E S

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D ell began in 1984 with a simple idea in mind: create

and deliver custom personal computers (PCs)

directly to customers within 48 hours. What started in

Michael Dell’s dorm room at the University of Texas, Austin,

grew to a Fortune 500 company in less than a decade.1

Moving inventory quickly without the costs of storefronts

or distributors made these computers affordable, and also

provided customers with the latest technology within days.

The company became a powerful player in the PC market in

just a few years.

From the early 1990s until 2006, Dell was a darling of

stock analysts. In fact, Dell’s market value (market cap)

jumped from $2.5 billion in 1995 to $100 billion in 2005.2

Dell was rewarded by Wall Street with a higher stock price

for its growth and ability to generate high profits with

relatively few assets. The company’s ability to generate

high profits with only a few assets was possible because

it outsourced most of the components and operations

associated with making its PCs to outside suppliers. This

allowed it to focus on computer design, final assembly,

sales and distribution, and service. Over time, Dell

streamlined its business model by outsourcing more and

more of its low-value manufacturing operations, eliminating

expensive equipment and competencies. For example, by

outsourcing motherboards and the final assembly of its

computers, Dell cut the cost of those activities by roughly

20 percent.3

Outsourcing low-value-added manufacturing tasks

reduced assets on Dell’s balance sheet and allowed the

organization the freedom to focus on higher-profit-margin

products and services. Both Dell and Wall Street loved the

change. As Dell moved upmarket selling more powerful

PCs and servers, it continued to outsource more of its

lower-value components and processes, mostly to suppliers

in China. Eventually, Dell outsourced the management of

much of its supply chain, and more of the final assembly

of the entire computer.4 It got to the point where some

Dell computers were almost completely designed and

manufactured by other companies.

Although Dell outsourced to increase efficiency and

improve its performance, other companies in the industry

chose the opposite approach. ASUS, a Chinese company

that was the recipient of much of Dell’s outsourcing, began

making circuits and motherboards for Dell (and other PC

manufacturers) cheaper than Dell could. ASUS had a cost

advantage from manufacturing circuits and motherboards in

China and soon became the world’s largest manufacturer of

PC motherboards.5

As ASUS produced more and more of Dell’s

components, it increased both sales and profits. Over

time, ASUS continued to build new

manufacturing knowledge and

capabilities, moving upmarket behind

Dell, from circuits and motherboards to

supply chain management, computer

assembly, and computer design. Eventually, in 2007

ASUS launched its own inexpensive Eee PC in Taiwan at

a price tag of $340, and the computer quickly sold out.

ASUS stock increased by 4.9 percent the day it launched.6

This led to a worldwide launch of the Eee PC, which is

now sold through BestBuy and Amazon.com. Analysts

appreciated ASUS’s vertical integration strategy (bringing

more activities inside the firm), just as they appreciated

Dell’s outsourcing strategy (sending more activities to

suppliers).

Dell and ASUS: A Tale of Two Companies

0 7

WHAT STARTED IN MICHAEL DELL’S DORM ROOM AT THE UNIVERSITY OF TEXAS, AUSTIN, GREW TO A FORTUNE 500 COMPANY IN LESS THAN A DECADE.

WHAT IS VERTICAL INTEGRATION [ 131 ]

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Dell and ASUS prospered with opposite strategies: one outsourcing, the other integrating. Dell improved its profit returns on net assets (RONA) by outsourcing manufacturing pro- cesses and their associated physical assets while focusing on higher-value-added activities such as design, marketing, and service.7 ASUS increased revenues and profits by moving upmarket behind Dell, gradually developing more sophisticated manufacturing capabilities and eventually launching its own PC. Dell and ASUS’s successes raise the following ques- tions: How can two companies in the same industry each find success with opposite vertical integration strategies? Are both strategies appropriate, or did analysts overlook weaknesses in one or both of these strategies? Finally, did Dell or ASUS management set up their respec- tive companies for greater future success or failure?

WHAT IS VERTICAL INTEGRATION?

Dell and ASUS made different decisions about the extent to which they wanted to perform activities related to developing, designing, manufacturing, selling, and servicing their com- puters. Dell decided to outsource some of the activities that it had previously conducted internally to ASUS and other suppliers. Outsourcing refers to a firm contracting out a busi- ness process or activity to an external supplier.

Dell’s leaders made this decision because they felt that other firms could perform these activities more efficiently than Dell could. So they outsourced what they perceived as lower value-added activities—or those activities on which they made lower profit margins. At the same time, ASUS decided to enter into an increasing number of activities related to making a computer—from making components and motherboards to fully designing and manufacturing its own Eee personal computer. This is referred to as vertical integration (or insourcing)—bringing business processes or activities previously conducted by outside companies in-house. ASUS developed the capabilities to perform these additional functions efficiently and improved the company’s overall performance. Moreover, by adding activities, ASUS’s leaders felt that they could build additional manufacturing capabilities for the com- pany that would be useful in the future.

This case illustrates the classic “make” (ASUS) versus “buy” (Dell) choice that leaders face as they try to offer unique value to the market. Two firms can look at the same activ- ity and one might decide that it makes sense to make it, or conduct the function internally within the firm, while another firm might decide to outsource the same activity. As shown in the Dell–ASUS case, this choice can have real impact on a firm’s ability to succeed. Conse- quently, it is important to understand when to make and when to buy.

This chapter will cover why companies choose to conduct an activity within the firm; the benefits of outsourcing, and the conditions when it might be advantageous; and the dangers of outsourcing as well as the risks of vertical integration. In the Strategy Tool at the end of the chapter, we provide a tool, the “Make vs. Buy Assessment,” that can be used to decide whether to make versus buy.

The Value Chain The different aspects of the value chain have been covered in earlier chapters but they war- rant a more in-depth discussion here as a clear understanding of the value chain is critical to the “make versus buy” decision. The value chain for an industry is the sequence of activities that transform raw materials into finished products. Each key activity “adds value” to the prior activity—hence the term value chain.8

To illustrate, let’s walk through the industry value chain for gasoline. To get gasoline to the consumer, we first need to explore for crude, then drill, then pump, then ship, then refine the crude into gasoline, then ship again, then finally sell gasoline to the end consumer, as outlined in Figure 7.1.

Companies have their own value chains that are usually distinct from an industry value chain. Companies that participate in many or all stages of the industry value chain from exploration to final sale are highly vertically integrated.9 Companies that participate in only

outsourcing The process where a firm contracts out a business

process or activity to an external

supplier.

vertical integration (or insourcing) Bringing business processes or

activities previously conducted by

outside companies in-house.

value chain The sequence of all activities that are performed by a

firm to turn raw materials into the

finished product that is sold to a

buyer.

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one activity (such as shipping crude oil) are vertically specialized.10 Activities closer to the beginning of the industry value chain, or the raw materials used to create a product, are referred to as upstream activities and those towards the end, or final products that consum- ers purchase, are downstream activities.11

Forward Integration and Backward Integration If a company wants to grow by moving forward in the value chain—that is, downstream— we say that company engages in forward integration.12 This might be an oil-refining com- pany that wants to open its own gas stations to sell gas. Or it might be an oil-exploration company that decides to refine the crude oil that it finds. In contrast, if a company wants to grow by moving backward in the value chain—that is, upstream—we say that company is backward integrating.13 This might be a drilling or refining company that wants to do its own exploration.

For any given activity in the value chain, an organization’s leaders must answer this key question: Do we make it or do we buy it? In other words, do we do it ourselves, or do we have some other company do it? The answer to this question hinges on whether the firm can build a capability that will allow it to do a better job of offering unique value by conducting the activity itself rather than having another company do it.

In some cases, a firm’s leaders will decide that being vertically integrated into more activ- ities will allow it to better deliver either a low-cost or differentiated product to the customer. In other cases, a firm may feel like it is better off by being vertically specialized.

To illustrate, Walt Disney is vertically integrated into many vertically linked activities in the value chain. It produces its own movies and TV shows with its own studio and its wholly owned subsidiary Pixar. Disney also distributes its TV shows and movies through its own TV networks (ABC and Disney Channel) and to movie theaters through a worldwide distri- bution network. Disney doesn’t own movie theaters, but many years ago most of the movie studios like Paramount and Fox owned their own theaters.14

In contrast, Nike is much more vertically specialized than Disney. Nike designs and mar- kets its athletic footwear, equipment, and apparel, but outsources many other activities in its value chain.15 It does not manufacture its shoes, equipment, or apparel, and for the most part, it sells its products through stores owned by other companies, such as Foot Locker. When Nike started selling its shoes and apparel through its own Niketown stores, it forward integrated by conducting activities within the firm that are downstream and closer to the end customer. Likewise, ASUS engaged in forward integration as it continued to take on more activities for Dell in the final assembly of a computer. If Nike were to start to manufacture

Exploring for Crude Oil

Drilling for Crude Oil

Shipping Crude Oil

Refining Crude Oil

Shipping Refined Products

Selling Refined Products to Final Customer

[ Figure 7.1 ] The Oil Industry Value Chain

THREE KEY REASONS TO VERTICALLY INTEGRATE [ 133 ]

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its own shoes or apparel, it would be engaging in backward integration by incorporating more activities that combine materials and components into a final product. When Netflix started to create its own originally produced shows—such as political drama House of Cards and comedy Arrested Development—this was a form of backward integration designed to allow it to differentiate its service from competitors.

The success of firms such as Nike, Disney, Netflix, and ASUS has been strongly influenced by the choices of organizational leaders regarding which activities along the value chain should be conducted within the firm and developed as core competencies, and which activi- ties should be outsourced to other companies. This choice of whether to “make” or “buy” hinges on a variety of factors that we address in the next section.

THREE KEY REASONS TO VERTICALLY INTEGRATE

There are three primary reasons that companies choose to make versus buy. We refer to these reasons as the three Cs of vertical integration: capabilities, coordination, and control, as outlined in Table 7.1.

Capabilities The first C is capabilities, which refers to the question of whether the firm has—or can build—the capabilities to perform the activity better than other firms.16 The firm’s leaders should ask this question: To what extent are we, or could we be, the best in the world at conducting this activity?

If the firm can be one of the best in the world, then it is probably an activity it should do. But, if it cannot be one of the best in the world, then the firm is probably better off by out- sourcing the function to a company that has stronger capabilities.17

To illustrate, Nike designs and markets its own shoes, but outsources the manufactur- ing of its shoes to other companies. Suppliers that manufacture shoes for Nike and other athletic shoe companies have developed capabilities to manufacture shoes at very low cost. This requires managing low-wage workers in emerging economies, such as China and Indo- nesia where the majority of the world’s athletic shoes are manufactured. Since Nike differ- entiates its shoes based on its internal activities of design and marketing, it is content to let suppliers manufacture its products.

Nike understands that low-cost manufacturing capabilities are very different from design and marketing capabilities and has decided that it doesn’t need to manufacture its own shoes in order to differentiate them in the marketplace. It saves considerable capital invest- ment by not having to invest in large manufacturing plants and building manufacturing capabilities. This allows Nike to focus its capital and full attention on building a capability to design athletic shoes that deliver the best performance possible.

Nike also focuses on developing the world’s best marketing capabilities to build a brand that will differentiate its products.

Finally, through its design and marketing capabilities Nike creates barriers to imitation to prevent subcontractors of its shoes from becoming competitors (see Strategy in Practice: How to Prevent a Subcontractor from Becoming a Competitor).

subcontractor A supplier that provides an input to a local firm;

the term subcontractor is often

used to describe suppliers that are

contracted to create customized

inputs for a firm.

[ Table 7.1 ] 3-C Reasons to Vertically Integrate

Capabilities Conduct the activity internally when the firm has or can develop better capabilities to perform it than other firms.

Coordination Conduct the activity internally when effective coordination and tight integration of the activity with other firm activities provides performance advantages—such as speed to market or improved quality.

Control Conduct the activity internally to control scarce inputs or inputs created through specialized assets in order to reduce transaction costs.

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Coordination The second C is coordination, which refers to the question of whether a firm is better able to effectively coordinate the activity with other activities in the firm when both are conducted internally. In this case, the firm isn’t necessarily more capable at performing a particular activity, but it lowers the coordination costs associated with two interdependent activities. A firm’s leaders should ask: To what extent will we improve our ability to coordinate our business activities—and offer unique value—by conducting this activity ourselves?

The fact of the matter is that some activities or tasks require more coordination than others to be successful because of greater interdependence with other activities. The greater the interdependence between activities, the more it makes sense to vertically integrate and have these done within a company where the team members can effectively coordinate their work.18

For example, Apple’s integration of chip design activities illustrates a company vertically integrating to achieve better coordination.19 For years, Apple outsourced the design and manufacture of most of the microprocessors (chips) used to power its products to com- panies like Motorola, Intel, and AMD. However, Apple executives decided that they could better coordinate product development activities if Apple designed its own chips.20 They believed that doing so—even if they didn’t have better chip development capabilities than Intel or AMD—would lower coordination costs and enhance the speed of new product development. Additionally, designing their own chips would make it more difficult for com- petitors to imitate Apple technology because competitors wouldn’t have access to Apple- designed chips. So, Apple hired chip experts, some who had worked for AMD and Intel,21 and now designs many of the chips that power its products. Being able to better coordinate all of the activities associated with developing new products was a key reason that Apple decided to backward integrate and bring chip design in house.

So how do managers know if two activities require high levels of coordination and therefore are better conducted within the firm? The answer is to understand the nature of the interdependence of the activities—with less interdependent activities being outsourced and more interdependent activities being conducted within the firm.

We will now describe three types of interdependence—modular, sequential, and reciprocal—and how they influence the make versus buy decision as outlined in Figure 7.2.

Modular Interdependence. Some activities require low levels of coordination because the activities are modular in nature. This means the results are pooled together but the individual activities can be conducted without coordinating with other activities.

To illustrate modular interdependence, consider the activities that are important to the performance of a golf team. Members of a golf team may share information about the golf course with each other, but in the final analysis, play is by the individual performer. In this case, team performance is based on individual performances or activities that are pooled together. This is typically referred to as modular or pooled interdependence,22 which means that the degree of coordination required is relatively low.

[ Figure 7.2 ] How Interdependence Influences Vertical Integration and Outsourcing

Low Teamwork (Modular

Interdependence)

Outsourcing Vertical Integration

Moderate Teamwork (Sequential

Interdependence)

High Teamwork (Reciprocal

Interdependence)

Low Medium High

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In similar fashion, when an automaker purchases certain standardized nuts and bolts to assemble its cars, everything else in the car can be designed without regard for the nuts and bolts. As a result, automakers feel no need to make their own nuts and bolts because while these inputs are necessary they don’t require a high level of coordination with other inputs. The task of designing and manufacturing nuts and bolts is completely independent of the tasks of designing and manufacturing other automobile components. Moreover, nuts and bolts do not differentiate the final product. The same is true for other automotive inputs, such as batteries and oil filters, which are fairly standard across vehicles and are therefore characterized by modular interdependence.

Sequential Interdependence.23 Activities are sequentially interdependent when one firm (or set of individuals) cannot perform its (their) tasks until another firm has completed its tasks and passed on the results. Under these circumstances, team members must meet together more regularly and consistently to coordinate their work.

A baseball team is an example of a team that requires a moderate amount of coordina- tion. All nine players must be on the field at once, but the players are not involved in every play. However, whether a batter bunts or tries to hit to the opposite field depends on what the previous hitters have done. Relay throws from outfield to shortstop to home base, and double plays from the third baseman to second to first, are activities that require sequential coordination.

Likewise, with an automobile, whoever creates the air conditioning system cannot design it until the overall vehicle has been designed. In contrast, bolts and nuts can be pro- duced without regard for the car design. Before the activity of creating an air conditioning system can begin, the amount of geometric space allocated for the air conditioning system in the dashboard must be identified. Moreover, the location of the vents in the vehicle and lines for carrying air to the vents must also be designed. The work of designing and manu- facturing an air conditioning system cannot begin until the vehicle body and geometric dimensions of the car have been designed, which means these activities are characterized by sequential interdependence. As a result, automakers either make the air conditioning system internally or work closely with a supplier—often in partnership fashion—to achieve the coordination required.

Reciprocal Interdependence. Some activities or tasks require a high degree of coordination because tasks are reciprocally interdependent. In these activities, good performance is achieved through work done in a simultaneous and repetitive process in which each individual must work in close coordination with other team members because they can complete their tasks only through a process of iterative knowledge sharing.24 Individuals performing certain activities must communicate their own requirements frequently and be responsive to the needs of those performing related activities.

To illustrate, members of a basketball team must coordinate constantly as they run their offensive plays and play “team” defense. Every member interacts with every other member. It could be predicted that a basketball team would suffer more from the lack of teamwork (coordination) than would a golf team or a baseball team. Indeed, this seems to be the case, as evidenced by the fact that major league baseball teams that acquire a few free agent stars will occasionally come from a low ranking the prior year to win the World Series. For example, the 2012 Boston Red Sox placed last in their division—and third worst in the American League—but went to the World Series in 2013. This rarely happens with NBA basketball teams, which must learn how to coordinate and work together to be suc- cessful. Experience has shown that even having the best individual basketball talent on one team is no guarantee of team success. The United States basketball team experienced a historic failure when it failed to win the 2004 Olympics and the 2006 World champion- ships with players like Tim Duncan, Dwayne Wade, and Carmelo Anthony. The need for better teamwork prompted the United States to require a three-year commitment from NBA players so that they could learn to work together as a team. Since then, the U.S. bas- ketball team has won every world championship, including gold medals at the 2008 and 2012 Olympics.25

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Product development teams for complex products such as automobiles, aircraft, robot- ics, consumer electronics, and so on, work together in a reciprocally interdependent fashion. For example, the design of an engine for an automobile is reciprocally interdependent with many of the other activities of designing and creating an automobile. The engine design must change along with modifications in the vehicle’s overall body design because a heavier or lighter vehicle requires different engine requirements. The engine also influences, and is influenced by, the transmission system in the vehicle. Because of all of these reciprocal inter- dependencies between the engine, overall vehicle design and other key vehicle systems like the transmission, automakers almost always make their own engines rather than outsourc- ing them to suppliers. The need to coordinate these activities effectively leads to vertical integration of these activities.

Control The third C is control, which refers to a firm’s desire to maintain control over a valuable activ- ity or input in the value chain. In other words, an organization’s leaders must ask: To what extent should we maintain control over a crucial step in the value chain by conducting this activity ourselves?

A company may want to vertically integrate in order to control some scarce and valuable resource, particularly if it is a differentiator of its final product.26 The choice to backward integrate may be made in order to control access to important raw materials or inputs that are highly customized to downstream activities. Some producers of aluminum have pur- chased land that is rich in bauxite—a key raw material that is necessary to make aluminum. They want to ensure that they have control of that key input so they developed bauxite- mining operations.

In a similar vein, it might make sense to maintain control over investments in assets or equipment that provide key inputs at lower cost. For example, suppose that crude oil is best shipped to an oil refinery through a pipeline. Let’s say the cost of shipping a barrel of crude oil by truck is $1.00 per barrel whereas transporting by pipeline would only be $0.50 per barrel. Once built, the owner of the pipeline could opportunistically raise the shipping price up to $0.99 since the only real alternative is to ship the crude in trucks. Likewise, the owner of the refinery could refuse to pay a fair price to the pipeline owner—or any price, for that matter—if there is no other alternative use for the pipeline.

In this case, the pipeline is a transaction-specific asset, meaning it is specialized or customized to a particular transaction (transporting oil to the refinery) and has lit- tle value when redeployed to its next best use.27 In fact, a technique that can be used to determine if an asset is specialized is to estimate the value of an asset (equipment, process, etc.) in its current (or intended) use divided by the value of the asset/process in its next best use. What is the “next best use” of a pipeline? Is it redeployable to other uses without a loss in value? While it might be fun to think that it could be used as an underground waterslide, practically speaking, it has little value if it isn’t transporting oil. The value of a pipeline in its intended use as a pipeline is high, but in its “next best use” the value is very low. In contrast, trucks used to transport oil could be used to transport things other than oil, such as chemicals or natural gas. It is a far less specialized asset than a pipeline.

Managers ultimately want to control assets or inputs that are specialized to each other. By doing so, they avoid the transaction costs associated with negotiating and writing a legal contract to ensure that the transaction takes place.28 The cost of hold-up, which is what can happen when one firm tries to take advantage of a firm that has made a transaction-specific investment like a pipeline, is also avoided.29 The refinery could “hold up” the pipeline firm by failing to pay a fair price because the pipeline has no alternative use.

In the previous example, the pipeline only has high value if it is transporting oil to the refinery; so the same firm would want to own both the pipeline and refinery. This way, the firm avoids the possibility of one firm trying to hold up another firm, and it also reduces transaction costs. This is the same reason homeowners like to own the land that surrounds their home. If they didn’t, the person owning the land could charge an unfair price to cross the land to access the home. This would be another example of hold-up.

transaction-specific asset An asset, such as equipment (oil

pipeline) or facility (bowling alley),

that is customized or specialized to

a particular use. Assets are more

specialized when the value of the

asset in its current or intended

use is high compared to its next

best use.

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DANGERS OF VERTICAL INTEGRATION

Even though there are some very good reasons to vertically integrate, there are two impor- tant dangers—a loss of fl exibility and loss of focus—the two Fs.

Loss of Flexibility First, when many activities are managed in the value chain, the fl exibility to quickly make changes to the business is lost.30 Th is might be important when there are major technologi- cal changes. In fact, research has shown that companies that are more vertically integrated take a bigger hit to performance when there is a technological change.31

Th is happened to computer workstation manufacturers DEC and Data General— companies that had vertically integrated into making CISC microprocessors that powered the workstation—when the faster and simpler RISC microprocessors were introduced. Competitor Silicon Graphics did not make its own CISC microprocessors, so it was able to quickly move to RISC microprocessors, which gave it an advantage in the marketplace. Silicon Graphics also didn’t need to sell off the now obsolete CISC microprocessor manufacturing

A Classic “Make vs. Buy” Mistake S T R AT E G Y I N P R A C T I C E

Imagine that you work for a company that makes a kitchen appliance product that costs $50 to manufacture. You have to decide whether to make or buy a component that is an

input for the product. Your analysis shows that, based on

the estimated volume of parts, your costs to manufacture

the part internally will be $0.98 per unit. A quick bid in the

market suggests that you can buy the same part from two

suppliers for $1.00 (another supplier bid $1.01). There are

no real quality differences between what you can make and

what you can buy from suppliers. What should you do? Make

the part for $0.98 or buy it for $1.00?

For many, the answer seems easy. Of course you make

the part for $0.98 because it will save you $0.02 per unit

over buying it from an outside supplier. But this is typically

the wrong answer—and here’s why. You want to conduct

an activity internally if you can do it at lower cost or with

better quality than the competition. In this case, it appears

that your costs per unit are lower than the competition.

However, the price of the part from the supplier includes a

profit margin—and profit margins for most products sold are

typically in the 10 to 20 percent range or higher. This means

that the supplier’s cost to produce the part is likely to be 10

to 20 cents less per unit than your company’s costs.

In fact, you don’t have an absolute cost advantage in

making this part. There are multiple suppliers producing this

same component and offering a similar price. This means

you might have some bargaining power over these suppliers

and could get at least one of them to drop their price to

$0.98 or lower. In addition, outsourcing will allow you to

focus the company’s capital resources and the attention of

the management team on higher-value activities. A part that

costs $1.00 out of $50.00 total is not a significant contributor

to cost. Even if you save $0.02 per unit, it won’t contribute

much to your cost advantage. Of course, if this part allows

you to differentiate your product—or if you could make it with

higher quality—then you still might want to do it internally.

But in this case, there are no real quality differences

between the product that you can make internally and the

one you can buy from a supplier.

The bottom line is that a classic mistake with make vs.

buy is assuming that you are better off making a part or

conducting an activity internally when the internal cost is equal

to—or even slightly lower—than the price from a supplier. You

need to compare your costs with the supplier costs (not the

supplier’s price) to know whether or not your capabilities at

conducting the activity are really better than a supplier’s. Of

course, if you have the capabilities to produce a higher-quality

input, or there are advantages associated with having better

coordination or control, you still might want to conduct the

activity internally even if your costs are higher. For guidance in

making the “make versus buy” decision, see the Strategy Tool:

Make versus Buy Assessment at the end of the chapter.

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equipment. Similar things happened to the more vertically integrated makers of CD play- ers and Discman—like Sony and Panasonic—when MP3 players hit the market. Companies simply have greater flexibility to switch to another supplier when they outsource than they do when the activity is conducted internally.

Having more flexibility—that is, being less vertically integrated—is particularly valuable when new technologies are being developed or if the cost to perform an activity can change quickly. For example, one of the reasons that Nike chooses to outsource the production of its shoes is because it likes the ability to switch suppliers depending on which supplier is lowest cost at the moment.

To illustrate, in the late 1990s, the Asian financial crises had a dramatic effect on the cur- rencies and exchange rates on some Asian countries, but not others. Indonesia’s currency, the rupiah, was trading at roughly 4,000 to the dollar before the crises, but a dollar would fetch more than 10,000 rupiahs at the height of the crises. This meant that Nike could buy shoes from Indonesian subcontractors for less than half the prices they were paying before the change in exchange rates. At the same time, China decided to keep its currency stable with the dollar so Nike’s prices on shoes from Chinese shoe suppliers didn’t change much. Because Nike didn’t own any of the manufacturing plants, it had the flexibility to shift production to the low-cost location—which, for a period of time, favored Indonesia over China. As a result of changing wages and exchange rates across countries where shoes are produced, Nike likes the flexibility to source the manufacturing of its new products to the lowest cost producer.

Loss of Focus A loss of focus refers to the fact that the more different types of activities a firm needs to manage, the harder it is to be world class in all of those activities. It is just too difficult for managers to focus on many different activities at once and be world class at all of them.

To illustrate, for many years General Motors (GM) made almost 70 percent of its parts internally including spark plugs, batteries, brakes, and a host of other automotive parts. In contrast, Toyota only makes about 25 percent of its parts. Toyota outsources to companies that specialize in various parts—like spark plugs, batteries, and brakes—and therefore, pro- vides the best possible parts at reasonable costs. While GM made its own brakes, Toyota outsourced them to companies like Akebono and Kayabe Brake that specialized in brakes. General Motors cars have been higher cost than Toyota’s, in part because it just couldn’t make parts cheaper than Toyota could buy them.

Why did General Motors have higher costs for producing automotive components such as spark plugs, batteries, and brakes? The primary reason was a lack of focus—suppliers were able to have lower costs by focusing on a narrow product line and producing those products in large scale for multiple automakers. Akebono Brake made braking systems not only for Toyota but also for Nissan and many other automakers. This allowed Akebono to produce products in larger volumes and with greater economies of scale, thereby lowering costs per unit. GM’s lack of focus made it difficult for their internal brake divisions to compete with these focused suppliers. Moreover, even though GM could buy cheaper brakes from outside suppliers such as Akebono and Kayabe, it refused to do so because GM didn’t want to incur the costs to fire its union workers and close its plants. Both a lack of focus and flexibility hurt GM’s overall perfor- mance. General Motors finally realized that too much vertical integration was a liability, and it eventually created an automotive components division it spun off as a separate company that would have to compete on its own. Now GM has more flexibility to buy from other suppliers and only buys from its former in-house suppliers if they offer the best product at the lowest cost.

There is one more dimension to focus that is worth mentioning. When firms are vertically specialized, they only stay in business when they can focus on making profits. If they can’t make enough profits, they go out of business. However, when an activity is conducted within a firm, it can often stay in business even if it isn’t performing well and making profits—just like some of GM’s automotive parts divisions. This is possible because it gets subsidized by other parts of a company’s business that are profitable. Sometimes you lose the discipline of the marketplace and a focus on making profits when you conduct an activity internally. Keeping employees motivated to perform is critical if an organization hopes to be world class in any activity.

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ADVANTAGES OF OUTSOURCING

Th e two Fs, as already described, are dangers of vertical integration—which also means they are advantages to outsourcing. Outsourcing does give fi rms more fl exibility to quickly move activities to whatever company is the best at performing that particular activity. As previ- ously mentioned, Nike has the fl exibility to move its shoe production to the world’s lowest- cost supplier, whoever that may be. Th is fl exibility is particularly valuable when there are rapidly changing economic conditions or technologies. When there is high technological uncertainty in an industry with lots of new leapfrog technologies being developed, fl exibility is valuable, and outsourcing is often preferred to vertical integration.

Outsourcing also allows fi rms to focus their attention on being good at a narrower range of activities. Along with this benefi t, outsourcing also minimizes the capital investment required to grow. Nike would have needed to raise a lot more capital during its rapid growth phase of the 1980s and 1990s if it had not outsourced the manufacturing of its shoes. Th e cost of building and running new plants would have been signifi cant. Instead, it was able to focus its attention on the capabilities that were most critical to diff erentiating its shoes: shoe design and marketing.32

Th ere is one fi nal advantage of outsourcing. Imagine that Nike had decided to build plants to manufacture its athletic shoes. In order to achieve greater economies of scale, Nike’s manufacturing plants would have to be able to acquire shoe-manufacturing contracts from other shoe companies—like Adidas, Reebok, New Balance, or Skechers. Do you think Adidas would let a Nike manufacturing plant produce its shoes? Probably not. Adidas would not want to share its designs or help Nike in any way. Without those economies of scale, Nike shoes manufactured by a Nike manufacturing plant would cost substantially more to make than they do in outsourced manufacturing plants.

The CEO of a popular clothing business discovers that two of her company’s sewing subcontractors in Bangladesh are using child labor. She also learns that if the child

workers lose their jobs, most of them will just find work with

another company—or worse, some may turn to prostitution

to survive. What’s the right thing to do? Lay the children off

and live with the fact that you’ve eliminated a viable option

for their survival, or keep them working in the factory? This

is the type of ethical dilemma faced by many companies that

outsource jobs to subcontractors.

When Levi Strauss & Co., an organization that outsources

the production of its products to subcontractors, confronted

this problem, it came up with an innovative solution: Take

the children out of the factory; continue paying their wages

on the condition they attend school full time; and guarantee

them employment in the factory when they are 14 years old,

the local age of maturity. Since the pay of these underage-

workers was less than $0.40 per hour, the cost to Levi and the

subcontractors was relatively low. The benefit was a cadre of

more educated and productive—and more loyal—workers.

Levi’s approach to this difficult situation earned the

praise of Bangladeshi and U.S. government officials and

several nongovernmental organizations (NGOs). Not only

did Levi help meet the needs of factory workers, but it did so

without necessarily sacrificing returns to its shareholders.

Subsequently, the Bangladesh Garment Manufacturers and

Exporters Association, along with other groups, set aside

more than $1 million for the education of approximately

75,000 underage girls who had previously worked in

Bangladesh factories. Levi’s initiative shows that an innovative

solution can solve even the most challenging problems.

E T H I C S A N D S T R AT E G Y

Should You Outsource to Subcontractors that Use Child Labor?

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Outsourcing via Crowdsourcing S T R AT E G Y I N P R A C T I C E

Companies are increasingly turning over outsourcing tasks to crowds—individuals or organizations outside the company who may be better suited to perform a particular

task. Crowdsourcing refers to the phenomenon of outsourcing

tasks to individuals or organizations that are outside of your

organization.33 One example is Wikipedia.34 Rather than

follow Encyclopedia Britannica’s model of hiring experts to

provide all of the information necessary for an encyclopedia,

Wikipedia enlists crowds of individual contributors. Wikipedia

is the product of thousands and thousands of individuals

contributing their knowledge and information. Unlike most

cases of crowdsourcing, Wikipedia contributors don’t get

paid but are energized by intrinsic motivations, such as the

desire to learn or build a reputation for being an expert in a

community of peers. In most cases, however, the crowd is

paid to perform a task for the company.

While crowdsourcing is the term used to refer to the practice

of outsourcing tasks to a crowd outside the organization,

there are actually several types of crowdsourcing, including

crowdtasking, crowdvoting, crowdcreating, and crowdinnovation.

Crowdtasking refers to enlisting a crowd to complete a

simple, repetitive task. For example, CardMunch, founded in

2009 by a group of Carnegie Mellon University engineering

graduates, has a simple mission—storage of business cards

and how they are managed. Using the company’s free app,

customers start by taking a picture of a business card. For a

small fee, the content is digitized by a crowd of individuals, put

into the user’s contacts, and then CardMunch reaches out to

the contact via e-mail or a LinkedIn request.35

CardMunch can vary the amount they pay for data input

depending on the supply of workers—which can be quite

large since they can tap into large pools of labor in India

willing to work for very low wages. They also use a different

member of the crowd to compare the information on the

business card with what was input into CardMunch. Another

example is Amazon, which has turned crowdtasking into a

business with its Mechanical Turk, an online marketplace for

work. Companies that want to crowdsource tasks can go to

Mechanical Turk to request workers for human intelligence

tasks (HIT), and individuals can go to Mechanical Turk to

find a task to work on. Crowdtasking works particularly well

for tasks that don’t take a lot of specialized skill and can be

accomplished by people sitting at their computer.

Crowdcreating refers to turning to the crowd to create

content or complete a task that requires specific knowledge

or expertise on the part of the crowd member. Threadless, an

online community of artists and an e-commerce website, is a

company that uses crowd-creating. Rather than hire T-shirt

designers, Threadless enlists members to submit ideas for

T-shirt slogans and designs.36 This allows it to constantly

tap into new artists and ideas, and sell its T-shirts without

professional designers, advertising, modeling agencies,

photographers, a salesforce, or retail distribution.37 The

company typically pays $2,000 for a T-shirt design that it takes

to market and has sold T-shirts from more than 1,500 different

designers.38 Threadless uses another form of crowdsourcing—

called crowdvoting—to select the designs to take to market.

Crowdvoting or crowdsorting refers to using a crowd to

evaluate an offering or to make predictions about uncertain

events. Crowdvoting is particularly good for gathering lots of

information about the market that is widely dispersed. For

example, after Threadless receives submissions for T-shirt

designs it goes to a crowd of customers and designers and

asks for their vote on which T-shirt designs they like the

best. By using the crowd to choose the winners of the design

contests, Threadless is able to better predict which T-shirts

will sell. Threadless has developed an enviable track record

of having never produced a flop—every T-shirt it has ever

produced has sold out.39

Crowdinnovation refers to using the crowd to solve a

challenging problem that requires an innovative solution. For

example, Netflix offered a $1 million prize to the software

programmer(s) who could create an algorithm that would

provide the best recommendations on movies for specific

customers. Netflix provided a dataset of over 100 million movie

ratings from users to the crowd to analyze. In explaining why

Netflix chose to go this route, Netflix CEO Reed Hastings said

they wanted to get hundreds—if not thousands—of software

programmers to work on the algorithm. “You’re getting PhDs

[to work on your problem] for a dollar an hour,” says Hastings.40

Netflix got their best movie ranking algorithm from the BelKor

Pragmatic Chaos team—a group of software programmers

who worked on complex programming problems for AT&T

wireless.41 Crowd-innovation using contests works well when

it isn’t obvious what combination of skills or technologies will

lead to the best solution to a problem.

The bottom line is that new digital technologies have

turbocharged crowdsourcing as a way to outsource activities

to a crowd. And crowdsourcing has resulted in companies

outsourcing more activities than ever before.

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In a similar vein, during the time period that General Motors made most of its own automotive parts, its in-house suppliers were limited in their total volumes because GM’s competitors would not buy parts from GM’s in-house parts suppliers. In fact, Ford had an explicit policy prohibiting it. Outside suppliers can often produce at much greater scale than in-house suppliers because in-house suppliers often have difficulty getting outside customers.

DANGERS OF OUTSOURCING

While outsourcing has its advantages, it also has its dangers. There are two major dan- gers of outsourcing: a loss of capabilities (particularly the capability to innovate) and a lack of control over critical assets or activities. Dell’s experience of outsourcing the majority of components, supply chain management, and final assembly of its computers is instructive. Although Dell’s outsourcing strategy lowered its asset base and increased its profits in the short run, it also resulted in Dell having fewer capabilities to innovate and create competitive advantage in the future. Dell’s market value soared to a high of $103 billion in 2005, but at the beginning of 2012, Dell’s market value had dropped to $26 billion. One reason for Dell’s fall is the emergence of new, low-cost PC makers such as ASUS—a competitor that Dell helped create (see Strategy in Practice: How to Prevent a Subcontractor from Becoming a Competitor). However, and perhaps more importantly, Dell has had a difficult time designing and building differentiated PCs, laptops, and tab- lets to compete effectively with Apple. More vertically integrated than Dell, Apple makes much of the software that runs its products as well as some of the key components. By having a larger portfolio of capabilities, Apple is better able to innovate and create new products. Outsourcing can also be dangerous because it can lead to a loss of capabilities to do new things.42

In addition to leading to a loss of innovation capabilities, outsourcing can lead to a loss of control as suppliers that provide key inputs gain bargaining power. To illustrate, when IBM first launched a micro-computer—the PC—it decided to outsource two of the key compo- nents of the computer: the microprocessor (to Intel) and the operating system (to Micro- soft). The microprocessor was the single most expensive component of the PC, and the DOS operating system was the software that users had to learn in order to navigate the computer. IBM felt that if the PC turned out to be successful, it would eventually make its own micro- processors and create its own operating system.

As it turned out, IBM PCs were very successful, and so the company decided to make its own microprocessors and operating systems. However, Intel launched the “Intel Inside” campaign, telling customers that the microprocessor was the “heart” of the computer and alerting customers to look for “Intel Inside.” As a result, IBM was not successful at get- ting customers to buy IBM PCs that didn’t have Intel chips in them. In fact, in the halls of IBM’s headquarters, some of the executives were heard asking the question: “Who let Intel Inside?”43 Many felt that IBM should have purchased Intel early on or should have launched the first PC with an IBsM-built microprocessor because it was a key input that they should have controlled. IBM had traded speed to market ( flexibility) for control of a critical input.

In similar fashion, IBM decided that it no longer wanted to rely on Microsoft for the operating system, so it launched its own OS/2 operating system and tried to get custom- ers to switch. Microsoft responded with its Windows 3 operating system. IBM’s custom- ers were so well acquainted with Microsoft’s operating system that they didn’t want to switch to OS/2. IBM eventually abandoned OS/2 in 2004. At the end of the day, IBM had outsourced the two key components that it later realized it wanted to control. With- out making its own operating system or microprocessor, IBM had few options for dif- ferentiating its PCs. IBM eventually sold off its PC division to Chinese firm Lenovo in 2004. IBM and Dell’s experiences provide a cautionary tale for companies that choose to outsource.

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SUMMARY

Vertical integration is defi ned as a decision of whether to conduct an activity internally within the fi rm (make) or outsource it to an outside supplier (buy).

Companies choose to conduct an activity within the fi rm and use the 3-C framework as a way to evaluate whether it makes sense to make versus buy.

Firms want to conduct an activity internally if they think they have, or can develop, the capabilities necessary to be among the best in the world at conducting that activity. Firms also choose to conduct an activity internally if they believe it will help them better

How to Prevent a Subcontractor from Becoming a Competitor

S T R AT E G Y I N P R A C T I C E

Companies that outsource face a substantial challenge. They must make sure that they don’t end up creating a competitor—which was essentially what Dell did by

outsourcing so much to ASUS. What steps can companies

take to prevent this from happening?

1. Build barriers to imitation. One of the most important things a company can do to prevent a supplier from

becoming a competitor is to build barriers to imitation.

As described in Chapter 2, a barrier to entry prevents

new entrants from easily entering a particular industry.

A barrier to imitation is something that prevents other

companies from imitating what a particular company

can do.

To illustrate, Nike outsources the manufacturing of its athletic shoes to subcontractors—so they know how

to make Nike-quality shoes. Why don’t these suppli-

ers enter the athletic footwear business and compete

with Nike? The answer is that Nike has built a number

of barriers to imitation that make reproduction of their

footwear difficult. The first barrier is brand. Nike’s

brand is so well known that a no-name brand will have

a hard time competing, even if it is good quality. But

beyond that, Nike’s shoes go through annual design

changes. This means suppliers would soon be devel-

oping shoes using “old” design technology. Of course,

Nike also writes contracts with suppliers that prohibit

them from making shoes based on Nike’s designs or

intellectual property. These practices all make it dif-

ficult for suppliers to become a competitor to Nike.

2. Limit knowledge of the full product. Another way to stop a supplier from becoming a competitor is by preventing

the supplier from knowing everything about making a

product. Some companies will outsource some of the

components of a product to suppliers but will manu-

facture one or more key components internally and

manage final assembly of the product internally. That

way, no one supplier has all of the knowledge neces-

sary to easily produce a competing product.

3. Take an equity stake in the supplier. A final way to pre- vent a supplier from becoming a competitor—or from

becoming too powerful—is by taking an equity stake

in the supplier. For example, when IBM launched its

PC, back in the early 1980s, it could have looked at its

key suppliers—for example, Intel and Microsoft—and

decided to take an equity stake in those suppliers. If

IBM had taken an equity stake in Intel and Microsoft it

would have given them more control over their activi-

ties. Moreover, IBM would have at least been rewarded

for helping Intel and Microsoft grow and become

powerful suppliers in the industry. Imagine how much

more successful IBM would be today if it had only

thought to take a 40 percent equity stake in Intel and

Microsoft—something it could have easily done when it

launched the first IBM PC.

APPLICATION EXERCISES [ 143 ]

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coordinate with other activities or if they want to have more control over a particular activity or input. The bottom line is that an organization should conduct an activity inter- nally if they believe that by doing so it will help them build their internal resources and capabilities so that they are better able to offer unique value.

Two dangers of vertical integration are a loss of flexibility and a loss of focus. These are also the key benefits to outsourcing an activity to a supplier that is vertically specialized.

Outsourcing can eventually put an organization at a disadvantage, as suppliers develop bargaining power or potentially become competitors.

A manager can receive guidance in making an effective “make” versus “buy” decision by using a Strategy Tool we call the Make versus Buy Assessment.

KEY TERMS

outsourcing (p. 131) subcontractor (p. 133)

transaction-specific asset

(p. 136) value chain (p. 131)

vertical integration

(or insourcing) (p. 131)

REVIEW QUESTIONS

1. Define vertical integration, forward vertical integration, and backward integration.

2. What are the three Cs, and how do they explain why companies choose to perform an activity internally versus outsource (buy) the activity to a supplier?

3. Describe what the chapter describes as a “classic mistake” that firms make when making a decision to make versus buy.

4. Describe the advantages of outsourcing and the conditions under which it might be advantageous to outsource an activity to an external supplier.

5. Define crowdsourcing and explain the different ways that companies can use an external crowd to do its work (e.g., types of crowdsourcing).

6. Explain what actions you could take to prevent a subcontractor from becoming a competitor.

APPLICATION EXERCISES

Exercise 1: Contact an executive at a company that performs multiple activities. Ask her to identify at least five activities that she is not sure whether the company should be doing internally or outsourcing to a supplier. Apply the make versus buy strategy tool to each activ- ity, asking her to answer the survey for each activity. Using the output from the survey, assess whether there are any activities that the company should probably be outsourcing instead of conducting internally.

Exercise 2: Identify a company that has increased its level of vertical integration, such as Apple forward integrating into Apple Stores or Netflix backward integrating into its own originally produced shows and programming. Evaluate the impact of that decision on the company by answering the following questions.

a. What new resources or capabilities, if any, did the firm have to develop in order to enter that new activity?

b. What impact did the decision to enter that activity have on its ability to coordinate with other related activities within the firm?

c. What impact did this decision have on its suppliers or customers?

[ 144 ] CH07 VERTICAL INTEGRATION AND OUTSOURCING

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REFERENCES

1 http://www.biography.com/people/michael-dell-9542199.

2 Dell Computer Corporation FY 1985 Annual Report, http://www.google.com/url?sa=t&rct=j&q=&esrc=s

&source=web&cd=4&ved=0CD4QFjAD&url=http%3A%2F%2Fi.dell.com%2Fsites%2Fcontent%2Fcorpora

te%2Ffinancials%2Fen%2FDocuments%2Far1995_annual.pdf&ei=YpM4Uq-ZGsen4AOmp4GwCw&usg=

AFQjCNHeqLah27XWgDuEdK-ncLxZidn0Mw&bvm=bv.52164340,d.dmg&cad=rja. http://www.wikinvest.

com/stock/Dell_%28DELL%29/Data/Market_Capitalization/1995 and http://www.wikinvest.com/stock/

Dell_%28DELL%29/Data/Market_Capitalization/2005

3 C. Christensen, J. Allworth, and K. Dillon. How Will You Measure Your Life? (New York: HarperCollins, 2012), p. 121.

4 Ibid., p. 122–123.

Strategy Tool Make versus Buy Assessment

With regard to a specific activity, the question for the manager is: make (conduct activity internally) or buy (outsource activity

to a supplier)? For example, most companies need to design

and build a website. Should the company hire people to build

and maintain the company website, or should it outsource?

Here is a short survey that can be taken to provide important

guidance as to whether to make or buy.

1. To what extent are you, or could you be, the best in the world at conducting this activity?

A. We are, or fairly easily could be, as good as the best in the world at conducting this activity.

B. We are not, and are not likely to become, as good as the best in the world at conducting this activity.

2. To what extent does this activity differentiate your offer- ing (product or service) in the mind of the customer?

A. This activity does provide some differentiation in the mind of the customer (it provides unique value and

influences the purchase decision).

B. This activity provides little differentiation in the mind of the customer (it doesn’t really provide unique value).

3. What is your cost of performing the activity (with simi- lar quality) compared to an outside supplier?

A. 5% or more lower.

B. About the same or higher.

4. How many outside suppliers can conduct the activity (with similar quality) at a cost that is about the same or

lower than your firm?

A. 0 or 1

B. 2 or more

5. To what extent is this activity highly interdependent and requires coordination with other activities you perform

in the firm?

A. Highly interdependent (reciprocal interdependence), meaning that in order to do this and other activi-

ties well, we need to tightly coordinate this activity

with other activities (simultaneously iterate when

conducting the activities).

B. Somewhat interdependent (sequential interdepend- ence), meaning that this activity must be done before

(or after) we conduct our other activities; we don’t

need to work on this simultaneously and iterate.

C. Not interdependent at all. We merely pool our pro- cesses/products with those of other suppliers.

6. Does performing this activity allow you to maintain control over information or resources that are impor-

tant for either offering unique value or preventing

imitation of what you do?

A. Yes

B. No

7. Does performing this activity create a barrier to com- petitors imitating the unique value you are attempting

to offer?

A. Yes

B. No

If you answered A to six or seven of these questions, you

should conduct the activity internally. If you answered A to

four or five of these questions (including questions 2 or 3),

you should probably conduct the activity internally. If you

answered B to six or seven of these questions, you should

outsource this activity. If you answered B to four or five of

these questions, you should probably conduct this activity

externally (unless your answers to questions 1 and 2 are

both A, meaning that you think you can be the best in the

world at this activity and you think it is a differentiator).

http://www.biography.com/people/michael-dell-9542199

http://www.google.com/url?sa=t&rct=j&q=&esrc=s

http://www.wikinvest

http://www.wikinvest.com/stock

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5 W. Shih, C. Shih, H. Chiu, Y. Hsieh, H. H. Yu, ASUSTeK Computer Inc. Eee PC (A), Harvard Business School Case,

(2009): 2.

6 Ibid., p. 9.

7 Christensen, Allworth, and Dillon, p. 122–123.

8 M. E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1998).

9 K. R. Harrigan, “Vertical Integration and Corporate Strategy,” The Academy of Management Journal 28 (2) (1985):

397–425.

10 D. Hummels, J. Ishii, and K. Yi, “The Nature and Growth of Vertical Specialization in World Trade,” Journal of

International Economics 54 (1) (2001): 75–96.

11 J. T. Mentzer, et. al., “Defining Supply Chain Management,” Journal of Business Logistics 22 (2) (2001): 1–25.

12 S. D. Hill, ed., “Integration Strategies,” Encyclopedia of Management, 7th ed. (Detroit: Gale, 2012), 476–480.

13 Ibid.

14 Disney ABC Television Group. Disney Media Distribution. http://www.disneyabctv.com/division/index_media.

shtml, accessed 25 February 2013.

15 J. Dyer, “Nike: Sourcing and Strategy in Athletic Footwear” Strategic Management (Hoboken: Wiley, 2015).

16 H. W. Chesbrough and David J. Teece, “Organizing for Innovation: When is Virtual Virtuous?” Harvard Business

Review 80 (8) (2002): 127–125.

17 J. B. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17 (1991): 99–120. See

also: J. B. Barney, “How a Firm’s Capabilities Affect Boundary Decisions,” Sloan Management Review 40 (3) (1999).

18 Ibid.

19 Y. I. Kane and D. Clark, “In Major Shift, Apple Builds Its Own Team to Design Chips,” The Wall Street Journal (April

30, 2009), http://online.wsj.com/news/articles/SB124104666426570729.

20 A. Satariano, P. Burrows, and I. King, “Apple Said to Be Exploring Switch from Intel for Mac,”Bloomberg (Nov. 5,

2012), http://www.bloomberg.com/news/2012-11-05/apple-said-to-be-exploring-switch-from-intel-chips-for-

the-mac.html.

21 D. Clark, “Chip Design Luminary Leaves Samsung for Apple,” WSJ Blog (2012), http://blogs.wsj.com/

digits/2012/10/11/chip-design-luminary-leaves-samsung-for-apple/.

22 W. G. Astley and E. J. Zajac, “Intraorganizational Power and Organizational Design: Reconciling Rational and

Coalitional Models of Organization,” Organization Science 2 (1991): 399–411.

23 S. G. Lazzarini, F. Chaddad, and M. L. Cook, “Integrating Supply Chain and Network Analyses: The Study of

Netchains,” Journal on Chain and Network Science 1 (1) (2001): 7–22.

24 R. Gulati and H. Singh, “The Architecture of Cooperation: Managing Coordination Costs and Appropriation

Concerns in Strategic Alliances,” Administrative Science Quarterly 43 (1998): 781–814.

25 “United States Men’s National Basketball team,”Wikipedia. Accessed 13 March 2013.

26 Barney, pp. 99–120.

27 O. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press, 1975).

28 B. Klein, R. Crawford, and A. Alchian. “Vertical integration, Appropriable Rents, and the Competitive Contracting Pro-

cess,” Journal of Law and Economics 21 (1978): 297–326. See also Vining, Aidan, and Steven Globerman. “A Conceptual

Framework for Understanding the Outsourcing Decision,” European Management Journal 17 (6) (1999): 645–654.

29 Klein, Crawford, and Alchian. 1999.

30 L. Willcocks and C. Sauer, “High Risks and Hidden Costs in IT Outsourcing,” Financial Times, Mastering Risk

(May 23, 2000): 3.

31 A. Affuah, “Dynamic Boundaries of the Firm: Are Firms Better off Being Vertically Integrated in the

Face of a Technological Change?” The Academy of Management Journal 44 (6) (Dec. 2001): 1211–1228; S. Bal-

akrishnan & B. Wernerfelt, Technical change, competition and vertical integration. Strategic Management Jour-

nal 7 (1986): 347–359.

32 Chesbrough and Teece, pp. 127–125.

33 K. Boudreau and K. Lakhani “Using the Crowd as an Innovation Partner.“ Harvard Business Review (April 2013).

34 http://en.wikipedia.org/wiki/Wikipedia.

35 http://cardmunch.com/press.html.

36 http://www.inc.com/magazine/20080601/the-customer-is-the-company.html.

37 R. MacLary, “Threadless Uses Crowdsourced Design Ideas for Tee Shirt Success,” http://dailycrowdsource.

com/crowdsourcing/company-reviews/81-threadless-uses-crowdsourced-design-ideas-for-t-shirt-suc-

cess[5/2/2013 6:01:03 PM].

38 http://www.threadless.com/?ef_id=UYUXXQAAAJHZeYwc:20130504141245:s.

39 M. Chafkin, “The Customer is the Company,” Inc. ( June 1 2008).

40 S. Lohr, “A $1 million Research Bargain for Netflix, and Maybe a Model for Others,” New York Times (Sept. 1, 2009).

41 “Netflix Prize,” http://en.wikipedia.org/wiki/Netflix_prize.

42 Chesbrough and Teece, pp. 127–125.

43 Interview by Jeff Dyer with IBM executive in November of 1992.

http://www.disneyabctv.com/division/index_media

http://online.wsj.com/news/articles/SB124104666426570729

http://www.bloomberg.com/news/2012-11-05/apple-said-to-be-exploring-switch-from-intel-chips-for-the-mac.html

http://blogs.wsj.com

http://en.wikipedia.org/wiki/Wikipedia

http://cardmunch.com/press.html

http://www.inc.com/magazine/20080601/the-customer-is-the-company.html

http://dailycrowdsource

http://www.threadless.com/?ef_id=UYUXXQAAAJHZeYwc:20130504141245:s

http://en.wikipedia.org/wiki/Netflix_prize

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Strategic Alliances

imago stock&people / Newscom

[ 147 ]

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L E A R N I N G O B J E C T I V E S

Studying this chapter should provide you with the knowledge to:

1 Differentiate among strategic alliances, vertical integration, and arm’s-length supplier relationships.

2 Explain the different types of strategic alliances, how they are governed and the conditions under which each type is preferred.

3 Describe the different ways value is created in alliances.

4 Discuss the two potential dangers of strategic alliances and three ways that firms can protect themselves against these dangers.

5 Describe the importance of building an alliance management capability.

[ 148 ]

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E xcited tourists who enter Tokyo Disneyland are

immediately transported into a uniquely American

dream world. Nearly everything at Tokyo Disneyland is

a replica of the original Disneyland in Anaheim, California,

from Sleeping Beauty’s castle to Disneyland’s famous

“Main Street” attraction. Signs are printed in English, with

only small Japanese subtitles. When the park opened

in 1984, only 2 of its 27 restaurants even sold Japanese

foods.1 Instead, visitors snacked on hot dogs, popcorn,

and “spaceburgers” between rides. The only observable

Japanese touch is an enormous roof-covering over Main

Street, a symbol reminding visitors that they truly are in

Japan, rainy season included.

Despite all appearances, the interesting thing about

Tokyo Disneyland is that the Walt Disney Company is not

involved in the day-to-day operations of the park. It simply

collects a licensing fee from Oriental Lands Company (OL), a

Japanese real estate firm that financed, built, and runs both

Tokyo Disneyland and its neighboring park, Tokyo DisneySea.

Walt Disney and Oriental Lands came together in 1979 to

form a strategic alliance and make the Tokyo Disney dream

a reality. OL had what Disney did not: 115 acres of open real

estate on the outskirts of Tokyo, financial resources, and

knowledge of Japanese and Asian culture that could make

the venture a success. Disney had its brand, park design and

management capabilities, and a host of movie characters

that people would pay just to stand next to and snap a photo

as outlined in Table 8.1.

A Disney resort in Japan seemed to make sense, given

that Japanese tourists flocked to Disneyland in the United

States. Furthermore, since there are almost no imports or

exports between foreign markets in the leisure industry,

there would be none of the negative side effects typically

associated with Japanese-American licensing agreements.

But there were still risks involved. Would Japanese and

other Asians want to go to a Disneyland that wasn’t in

America? Would a

theme park work in

Tokyo’s cold, humid,

rainy climate?

Disney’s two U.S.

parks in Florida and

southern California were both “vacation destination” parks

with warm weather.

Moreover, back in the late 1970s, Disney was hurting

financially. It didn’t have the capital to make the investment

Tokyo Disneyland 0 8

DESPITE ALL APPEARANCES, THE INTERESTING THING ABOUT TOKYO DISNEYLAND IS THAT THE WALT DISNEY COMPANY IS NOT INVOLVED IN THE DAY-TO-DAY OPERATIONS OF THE PARK. IT SIMPLY COLLECTS A LICENSING FEE FROM ORIENTAL LANDS COMPANY (OL), A JAPANESE REAL ESTATE FIRM.

[ Table 8.1 ] Disney-Oriental Land Co. Alliance

Disney Resources and Capabilities OLC Resources and Capabilities

Disney brand Land for the park near Tokyo

Disney theme park rides and designs Financial resources to build the park

Park management processes Relationships with construction firms to build the park

Ongoing stream of Disney characters from movies Knowledge of Japanese culture and how to

manage Japanese workers

Disney consumer products to sell at the park

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needed to build a park in Japan. Disney received more

than 20 offers from Japanese firms vying for the chance

to become its partner in building and running the park. So

Disney did its due diligence of potential partners in Japan

and eventually decided that OL would be the best partner.

Forming the partnership was not necessarily a walk in

the park. Negotiating a satisfactory partnership agreement

required that both sides overcome cultural barriers and

major disagreements. OL wanted Disney to contribute funds

to build the park, but Disney refused to contribute in any way

toward the initial investment. Disney also required a 50-year

contract, a time commitment that frightened OL when there

remained so many unknowns. Moreover, Disney demanded

a high licensing fee of 10 percent of all gross revenues; OL

wanted to pay 5 percent. OL initially called Disney’s terms

a “servile agreement,”2 and it took more than 4 years of

negotiating for the two to reach common ground in 1979.

In the end, Disney paid a sum of less than 1 percent of the

initial investment and received a license fee of 10 percent

of gate receipts, but did lower its license fee to 5 percent on

nongate receipt sales.3

Despite the difficult negotiations, Tokyo Disneyland has

been a smashing success. Even though it had to pay high

interest costs from the $1.53 billion upfront investment

required to build the park, as well the average 7.5 percent

license fee to Disney, OL was able to make the project

profitable in just four years after the park opened in 1983.

The firms continued their partnership, working together

to build Tokyo DisneySea in 2001.Together with Tokyo

Disneyland and a number of Disney-branded hotels, the

two parks make up the Tokyo Disney Resort. Disney’s

Imagineering unit continues to design and develop new

theme concepts and attractions for the parks. OL, in turn,

markets and operates the entire Tokyo Disney Resort.

WHAT IS A STRATEGIC ALLIANCE? [ 149 ]

All in all, Disney’s support through providing its image, know-how, and design skills has been invaluable, and Oriental Land’s management and execution is unparalleled by Disney’s other international partnerships. The Tokyo Disney Resort has received more than a half billion total visitors since Tokyo Disneyland opened in 1983, with more visitors each year than either of Disney’s U.S. parks. The annual number of visitors has never dropped below 10 million, and it reached a high of 17 million visitors in 1997. OL, which runs few destinations other than the Tokyo Disney parks, is now ranked as the second-largest tourism-leisure firm in the world, just behind Disney itself.4 In one recent year, Tokyo Disney Resort generated revenues of approximately U.S.$4.15 billion. That translated to about U.S.$690 million in operating profits for OL. Disney received about $300 million from its licensing fees, a sum that is basically pure profits for Disney, since it has negligible costs associated with Tokyo Disneyland and no investment in assets.

There are currently no plans for a third park in Japan, but Disney has confirmed that if another park was planned, Disney would be happy to work with Oriental Lands to make it a success.5

WHAT IS A STRATEGIC ALLIANCE?

The Walt Disney–Oriental Land Company alliance illustrates how strategic alliances can be a vehicle for achieving important strategic objectives—such as lowering costs, creating new sources of differentiation or entering new markets. A strategic alliance—sometimes referred to as a partnership between firms—is a cooperative arrangement in which two or more firms combine their resources and capabilities to create new value.6 Strategy scholars sometimes refer to these types of arrangements, in which firms cooperate to create competi- tive advantage through their collaboration, as cooperative strategy or a relational advantage.7

Strategic alliances have grown dramatically in importance over the past 25 years. Strate- gic alliances accounted for only about 5 percent of the revenues of Fortune 1000 companies back in 1980, but by 2010 it is estimated that they accounted for almost one-third of the revenues of Fortune 1000 companies. In Walt Disney’s case, Tokyo Disneyland contributed almost 20 percent of Disney’s total theme park profits in 2011.8

Today, many companies are increasingly using alliances to achieve strategic objectives. The basic logic for alliances can be summed up in the adage, “Two heads are better than

strategic alliance A cooperative arrangement in which two or more

firms combine their resources

and capabilities to create new

value, sometimes referred to as a

partnership.

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one.” Sometimes it just makes sense to combine the resources and capabilities of two com- panies to solve certain problems or achieve particular objectives.

Companies may choose to cooperate at any stage along the value chain, from research and development to manufacturing to the marketing, sales, or service of products or ser- vices. For example, BMW and Toyota are doing R&D together to develop new fuel-cell tech- nology to increase fuel efficiency.9 Intel and Micron have teamed up to manufacture flash memory together.10 Target and Neiman Marcus have partnered to sell affordable luxury brands.11 In these instances, firms collaborate to improve their performance at common stages of the value chain. In other instances, a firm may team up with a firm at a different stage of the value chain. For example, Apple and AT&T teamed up to sell the iPhone—Apple provided the phones and AT&T provided the cellular network.12 Although there are differ- ent ways to categorize alliances, perhaps the most common way to distinguish one type of alliance from another is by the mechanism used to govern the alliance. We explain these different types of alliances in the next section.

Choosing an Alliance Companies have three choices—summarized as make, buy, or ally—when it comes to conducting any particular activity that needs to be done to offer a product or service to a customer.

First, they can make, or conduct the activity themselves within the firm.

Second, they can buy, or purchase, the activity or input from another firm, using an “arm’s-length relationship,” in which the buyer purchases an input with no obligation to have a long-term relationship with the supplier. Companies that send out a “bid” to numerous suppliers and then buy from the supplier that offers the lowest price have an arm’s-length relationship with those suppliers. The winner of the bid this month may lose next month.

Finally, they can ally, or acquire, the activity or input from another firm, using an exclu- sive partnership relationship with that firm.

As discussed in Chapter 7, companies want to conduct those activities internally that are most important to delivering the unique value they hope to offer. Disney prefers to create its own stories and characters for its movies, make its own movies, and run its own stores. These activities are most important to its success with customers and therefore it wants to have control over those activities.

However, companies can’t do everything, so they buy many inputs from other companies using an arm’s-length relationship. Arm’s-length relationships work just fine for purchasing commodities, inputs that aren’t differentiated on anything but price. For example, Disney doesn’t have a partnership with suppliers that provide fabric for its character’s costumes or hot dogs and buns for its theme park restaurants. It can purchase those inputs from what- ever supplier offers the lower price. Similarly, automakers need to purchase basic inputs like fasteners such as nuts and bolts from suppliers to put their cars together, but they usually don’t have a partnership with those suppliers.

Other inputs or activities require a partnership, a long-term relationship in which both parties work closely to create new value together. Four kinds of inputs and activities might qualify as “strategic” inputs that merit forming an alliance relationship.

1. Inputs that can differentiate your product in the minds of customers. Automakers are much more likely to want to partner with a supplier that provides important engine or drivetrain components that influence engine performance or reliability than one that provides fasteners. For example, truck manufacturers often partner with Cum- mins, a respected maker of truck engines and components, in the manufacture of their trucks.

2. Inputs that influence your brand or reputation. Volvo, a Swedish manufacturer of cars and trucks, has tried to develop a reputation on the safety of its cars. Consequently, it has worked closely with key suppliers, including Autoliv, a Swedish supplier of seat belts and airbags, to put pioneering safety technology into its vehicles.

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3. High value inputs or activities that make up a high percentage of your total costs. Compa- nies that make refrigerators are more likely to partner with the supplier who provides the compressor—the component that costs the most and cools the refrigerator—than with the suppliers of plastic trays or fi xtures.

4. Inputs or activities that require signifi cant coordination in order to achieve the desired fi t, quality, or performance. Whenever you need to coordinate closely with another fi rm to get the desired performance from their input or activity, you probably want a part- nership relationship. For example, automakers must typically work closely with the supplier that provides the HVAC system (heating, ventilation, and air conditioning) for a vehicle, because the supplier must know the geometric constraints in the dash- board, as well as where to run the lines to the vents throughout the car, and because the HVAC system infl uences, and is infl uenced by, the catalytic converter and other engine components.

Th e Strategy in Practice feature explores the factors that helped Disney make the “make, buy, or ally” decision about Tokyo Disneyland.

WHAT IS A STRATEGIC ALLIANCE? [ 151 ]

Walt Disney and Oriental Land: Why Ally? S T R AT E G Y I N P R A C T I C E

One might reasonably ask why Disney didn’t just build Tokyo Disneyland on its own. Disney obviously knew how to run a theme park. It owned and operated two theme parks

in the United States without the involvement of a partner.

Disney could have captured the $690 million that went to the

Oriental Land Company in a recent year, as well as the $300

million it did get. Why share the profits with a partner?

The first question that Disney certainly must have asked

with regard to Tokyo Disneyland was whether it could “make”

another park: Do we have the resources and capabilities

to build Tokyo Disneyland on our own? The answer to that

question was not entirely straightforward. Building a theme

park in a new, foreign environment came with a host of risks.

Tokyo is not a warm-weather “vacation destination,” like

California or Florida. Disney had absolutely no experience in

hiring, training, and managing a Japanese workforce. Would

Oriental Land Company have sold Disney the 115 acres of

land required for the park? If so, at what price? Did Disney

have the $2.0 billion investment required to buy the land and

build the park? If it chose to make the investment in Japan,

what other opportunities would it have to forgo? Finally, and

maybe most importantly, how confident was Disney that

Tokyo Disneyland would succeed?

When companies face an opportunity that comes with

risks, they may look to a partner to share or mitigate the

risks. In this particular case, Disney solved most of its

problems by partnering with OL. OL provided high-value

resources; it owned the land and took virtually all of the

investment risk. Disney didn’t have to risk much capital

investment and was able to deploy its capital elsewhere. OL

runs the park, so Disney didn’t have to learn how to manage

a Japanese workforce. Disney gets 10 percent return on gate

receipts regardless of the profitability of the park. The two

companies are able to share ideas on how to best localize

the Disneyland park within the Japanese environment.

In the end, the park proved successful, and both OL and

Disney received value from the partnership. It is possible

that Disney might have been just as successful if it had

built and run the park on its own. But it’s also possible

that, without OL as a partner, Disney might have made

different decisions about how to build or run the park

that would have hurt performance. Indeed, when Disney

built EuroDisney, located outside of Paris, it experienced

a host of problems and the park struggled for years.13 In

particular, Disney didn’t take into account important local

preferences like serving wine with meals in the park,

and the marketing was described as “too Americanized”

and not tailored to the needs of customers in individual

European countries.14 The alliance with OL clearly

mitigated many of the risks associated with the venture,

and OL’s resources and capabilities likely increased the

probability of success.

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TYPES OF ALLIANCES

As Figure 8.1 shows, there are three basic types of alliances. Each is governed in a different way, in order to split the gains from the alliance and protect each partner’s interests.

Nonequity or Contractual Alliance The first type is a contractual or nonequity alliance, in which two or more firms write a contract to govern their relationship.15 The contract specifies what each party is to do in the alliance—and what each party should receive if it fulfills its duty in the alliance. For example, when Disney wants to promote the characters from a new movie, it will often create promo- tional materials such as figurines or games and partner with McDonalds to put them into Happy Meals for kids. Then Disney and McDonalds jointly pay for TV commercials to adver- tise the movie and the Happy Meal promotional materials. Combining meals and toys cre- ates value for both Disney and McDonalds, who create a contract to govern the relationship.

Different types of nonequity alliances include:

Licensing agreements, in which one firm receives a license, or permission to use a resource, such as a brand or a patent, from another firm in return for a percentage of the revenues or profits16

Supply agreements, in which a supplier may agree to develop certain customized inputs for a customer

Distribution agreements, in which a distributor or retailer may agree to provide certain customized services in order to help sell a product17

As the name nonequity alliance suggests, companies do not take equity positions in each other. They also do not form a joint venture. Companies tend to choose nonequity alliances when it is easy to specify what each party is supposed to do in the relationship, as well as the rewards that should come from meeting those obligations. Nonequity alliances tend to be less complex and to require less interdependence and coordination between the compa- nies than alliances that involve equity. When an alliance requires the joint creation of new resources and capabilities by the partners, companies often tend to opt for equity alliances or joint ventures.

contractual or nonequity alliance Two or more firms write a contract to govern their

relationship. There is ownership

shared between the companies.

Types of Strategic Alliances

Preferred When:

Cooperation between firms

is managed directly through

contracts, without cross-

equity holdings or an

independent firm being

created.

Cooperative contracts are

supplemented by equity

investments by one partner

in the other partner.

Sometimes these equity

investments are

reciprocated.

Cooperating firms combine

resources to form an

independent firm in which

they invest. Profits from this

independent firm

compensate partners for

this investment.

Contractual Alliance Equity Alliance Joint Venture

Interdependence between firms is moderate (e.g., sequential).

Firms bring knowledge or difficult-to-measure contributions but each can perform their roles separately.

Interdependence between firms is very high (e.g., reciprocal).

Firms bring knowledge or difficult-to-measure contributions that must be combined into a single organization to coordinate effectively.

Interdependence between partners is low (e.g., pooled)

It is easy to measure the contributions of each partner and write it in a contract.

[ Figure 8.1 ] Types of Strategic Alliances

TYPES OF ALLIANCES [ 153 ]

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Equity Alliance In an equity alliance, the collaborating firms often supplement contracts with equity hold- ings in their alliance partners.18 For example, Toyota owns between 5 and 49 percent of the equity of its 10 largest Japanese suppliers, who all work very closely with Toyota in the devel- opment and production of its automobiles.19 The fact that Toyota owns some equity in these suppliers aligns their incentives with Toyota’s needs and encourages the suppliers to make investments that benefit Toyota. For example, Toyota’s equity investments encourage its suppliers to locate their manufacturing plants next to Toyota’s assembly plants to reduce the costs of shipping and inventory.

In situations where the parties to an alliance need incentives to bring their best resources to the alliance, equity is often preferred to contracts as a way to align the incentives of part- ners. For example, many large pharmaceutical companies, such as Eli Lilly, Merck, and Pfizer own equity positions in start-up biotechnology companies. The large pharmaceutical firms’ equity positions give them the option to be part owners of new biotechnology drugs the start-ups develop. This option of owning a stake of a potentially profitable new drug creates incentives for companies such as Eli Lilly to provide financial resources to help develop a drug, as well any other support that may increase its probability of success. For instance, if a new drug looks promising, Lilly will use its sales force and distribution channels to sell the new drug around the world.20

Joint Venture The final form of alliance, a joint venture, is an alliance in which collaborating firms create and jointly own a legally independent company. The new company is created from resources and assets contributed by the “parent” firms.21 The “parent” firms jointly exercise control over the new venture and consequently share revenues, expenses, and profits.

Joint ventures are preferred when firms need to combine their resources and capabili- ties in order to create a competitive advantage that is substantially different from any they possess individually. For example, Intel makes microprocessors and Micron makes advanced semiconductors, but both companies saw an opportunity in flash memory, the type of memory used in flash drives and increasingly used in mobile devices such as MP3 players and smart phones. Both companies had some relevant skills and assets, so they decided to each put in $1.2 billion in cash and assets and create IM Flash, a new company jointly owned by Intel and Micron.22 The new company focused on the flash memory market and didn’t deflect the attention of Intel and Micron from their core businesses.

In similar fashion, when GM wanted to enter the Chinese market, it teamed up with SAIC, a Shanghai-based automobile company, to create Shanghai-GM, a joint venture that brings together GM’s expertise and technology for making cars with Shanghai’s knowledge of the Chinese market and experience managing a Chinese workforce.23

Typically, partners in a joint venture own equal percentages and contribute equally to the venture’s operations, as was the case with IM Flash. However, in some cases one party might bring more resources to the venture, which will lead to a higher equity stake. Moreover, over time, a firm’s priorities may change, which can lead to one partner purchasing the equity stake of the partner. For example, in 2012 Intel decided that IM Flash was less of a priority so it sold $600 million of its stake in the company to Micron.24 Many joint ventures end with one partner selling some or its entire ownership stake in the joint venture to the other partner.

Vertical and Horizontal Alliances In addition to distinguishing alliances by the type of governance arrangement (e.g., noneq- uity, equity, joint venture), alliances are sometimes categorized as either vertical alliances or horizontal alliances.

A vertical alliance is an alliance between firms who are positioned at different stages along the value chain, such as a supplier and a buyer.25 Toyota’s relationships with its top 10 suppliers are considered vertical alliances—the output of one of the firms in the relationship is the input of the other. Vertical alliances are usually formed to combine unique resources, create new alliance-specific resources, or lower transaction costs between two companies

equity alliance The collaborating firms in an alliance supplement

contract with equity holdings in

their alliance partners.

joint venture An alliance in which collaborating firms create and

jointly own a legally independent

company.

vertical alliance An alliance between firms who are positioned

at different stages along the value

chain, such as a supplier and a

buyer.

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Bose: Working with Suppliers in Vertical Alliances S T R AT E G Y I N P R A C T I C E

Bose Corporation, known for its sound systems and pioneering innovations in acoustic technology, has also been a pioneer in establishing what it calls “JIT II

Partnerships” with some of its suppliers. A JIT II partnership

(named after Toyota’s Just-In-Time delivery practice with

suppliers) is a relationship with a supplier that involves the

following characteristics:26

Bose selects a supplier that it believes has the best

capabilities to meet its needs and agrees to give that

supplier all of its business.

The supplier must give Bose its best pricing on prod-

ucts. Bose can bid a product on the market if it doesn’t

think it is getting the best prices.

Bose gives the supplier an “evergreen” contract, mean-

ing that as long as the supplier performs according to

expectations, the contract rolls over for another year.

The supplier agrees to provide at least one “in-plant

representative” who will work at Bose for 30 to 40

hours per week. This person replaces the Bose buyer

and production planner and essentially works for Bose

procurement and logistics. Duties involve placing pur-

chase orders, monitoring materials requirements, and

assisting with manufacturing planning. Bose interviews

and approves the “in-plant rep” and essentially treats

the rep as a Bose employee—the “in-plant” has access

to Bose facilities, personnel, and computer systems,

and even gets a performance review.

Lance Dixon, Bose director of procurement and logistics,

initiated JIT II partnerships when he realized that by working

more closely with key suppliers, both Bose and the suppliers

could reduce costs. Says Dixon, “Suppliers are normally

outside of your company trying to see through the window

into what you are doing. We open the door and let them in to

do the work together.”27

G&F industries, a Bose supplier of plastic components for

Bose Speakers, has been a JIT II supplier for 20 years. G&F’s

“in-plant rep” Chris Labonte says that working inside Bose

every day gives him the information he needs to help G&F

better meet Bose’s needs. “Being here onsite at Bose allows

me to get the right jobs running at the right times with the

right quantities,” says Labonte, “It’s a real positive, open,

trusting, and nonadversarial, yet direct, relationship.”28

How JIT II Partnerships Create Value at Bose Corp.

Traditional Process

JIT II Partnership Process

“The major advantage isn’t having a customer rep. at our location -- rather it’s that the customer rep is ‘empowered’ to use our system-thereby replacing the planner, buyer and salesman.”

Sherwin Greenblatt, President, Boss Corp.

BOSE ORGANIZATION SUPPLIER ORGANIZATION

Bose Design Engineer

Bose Materials Planner

Bose Buyer

Supplier Sales- person

Supplier Production

and Engineering Personnel

Supplier Production and

Engineering Personnel

Supplier “In-plant”

Representative

Bose Production Planner

Bose Design Engineer

Bose Production Planner

JIT partnerships have lowered Bose’s administrative costs

by more than 20 percent. Bose simply doesn’t have to hire

as many people, because its supplier partners do the work

that employees previously did. Bose claims it also reduced

inventory and logistics costs by more than 25 percent as

a result of its JIT II partnerships, due to better planning

and increased supplier efficiency, with suppliers delivering

components exactly when Bose needs them. Suppliers

enjoy having a partnership with Bose because they have

guaranteed sales and they can plan more effectively for their

own production runs. Both Bose and its partner suppliers are

better off, which is the primary goal of an effective partnership.

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who are already transacting. The Strategy in Practice feature describes the details of how Bose handles vertical alliances with its suppliers.

In contrast, a horizontal alliance is between two firms that do not have a supplier-buyer relationship and are typically positioned at a common stage of the value chain (e.g., competi- tors). The Shanghai-GM partnership is a horizontal alliance. The partners conduct activi- ties at a common stage along the value chain, which means they conduct similar activities internally. In this case, both of them manufacture automobiles. Horizontal alliances can also occur between companies who don’t do the same activities but do complementary ones, such as Electronic Arts developing games for the Sony PlayStation. Horizontal alliances are often created to pool similar resources, or to combine complementary knowledge. We dis- cuss these different ways to create value in alliances in the next section.

WAYS TO CREATE VALUE IN ALLIANCES

Alliances are a vehicle that allows a company to access the resources and capabilities of another firm in order to create value by either lowering its costs or differentiating its offerings. How can managers determine if accessing the resources and capabilities of a partner really will help their company create value? Alliances create value if they do any these four things:29

1. Combine unique resources

2. Pool similar resources

3. Create new alliance-specific resources

4. Lower transaction costs

We will examine each of these different ways to create value in partnerships, in turn, but it is worth noting that these are not mutually exclusive ways for creating value in an alliance. Alliance partners may use several of these ways of creating value in a single alliance.

Combine Unique Resources The first way that firms create value through an alliance is by combining unique resources to create an even more powerful offering. This is what Pixar and Disney did to dominate com- puter-animated films.30 As described in Chapter 3, Pixar contributed computer-generated animation (CGA) and story-writing skills that brought to life unique stories in films such as Toy Story, Finding Nemo, Cars, and The Incredibles. Disney contributed worldwide film dis- tribution to the partnership and sold products involving Pixar’s movie characters—such as Woody and Buzz Lightyear—at its Disney stores and theme parks. No other film distributor could bring to Pixar stores or theme parks like Disney’s that could be used to make money off of memorable movie characters. By combining their unique resources, Pixar and Disney created synergy that increased profits for both firms. In fact, Disney eventually acquired Pixar in order to gain full control over Pixar’s unique resources.31

In similar fashion, Target decided to team up first with high-end designer Missoni, and later with Neiman Marcus, in contractual alliances to bring high-end fashion to the masses. Target had long been playing a unique tune among box-store discounters, differentiating itself from Walmart as a place for the younger generation to get affordable fashion. It hoped that partnerships with designers could boost the image of “Tar-zhay,” as more upscale con- sumers like to call Target. When first teamed with Missoni in 2011 to offer a line of Missoni- designed products through its 1,700-plus stores,32 the demand for Missoni products at Target quickly swept up every available item, leaving many customers disappointed that they had missed out. The sheer volume of traffic online caused the Target website to crash for nearly a whole day.33 This led to a similar partnership with high-end retailer Neiman Marcus in July of 2012—with the idea to bring a larger number of designers to the masses through Target. Tar- get brought size, scale, and distribution to these partnership relationships, and Missoni and Neiman Marcus brought a chic factor that Target simply could not replicate on its own.34

Companies typically combine unique resources to create new products, enter new markets, or to avoid the costs of entering different stages of the value chain. For example,

horizontal alliance An alliance between two firms that do not

have a supplier-buyer relationship

and are typically positioned at a

common stage of the value chain.

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Pixar decided not to invest in movie distribution, instead relying on the distribution resources and capabilities that Disney had already built.

Sometimes, the unique resources that the partners combine are intangible resources in the form of knowledge. Such “learning alliances” are increasingly popular. Th e goal is for each alliance partner to learn something that it believes will be a valuable addition to its capabilities in the future. Th e Strategy in Practice feature describes one early example of a learning alliance.

In a similar fashion, when Visa wanted to learn about how to bring fi nancial literacy, and credit cards, to a younger crowd, it turned to an unlikely partner—Marvel Comics. Visa and Marvel jointly developed a unique comic book addressing money-management issues, starring Marvel characters Th e Avengers and Spiderman. Imagine Spiderman and Hulk dis- cussing diff erent options for fi nancing Spiderman’s new big-screen TV ! Th at will grab the attention of teenagers. Th rough the partnership, Marvel learned to use its comic books for educational purposes, and Visa learned about a unique way to educate potential custom- ers. Th is was a case where both partners also brought unique resources to the relationship.

Pool Similar Resources A second way that alliances create value is by pooling similar resources to achieve econo- mies of scale that neither fi rm could achieve on its own. For example, as described earlier, Intel and Micron wanted to get into manufacturing fl ash memory—a business that required billions of dollars of investment in plant and equipment. So they decided to create IMFlash, a joint venture designed to produce fl ash memory products. By splitting the cost of the plant and equipment, the two companies were able to build a much larger plant and, through economies of scale, produce fl ash memory at a lower cost per unit.35 Th is value didn’t nec- essarily require combining unique resources, just the pooling of total resources to achieve economies of scale in the R&D and production of fl ash memory.

In addition to achieving economies of scale, another reason fi rms pool similar resources is to share the risks associated with conducting a particular activity. BP and Statoil formed a joint venture, pooling their fi nancial resources and knowledge to share the expense and lower the risks associated with costly international oil exploration and production

General Motors’ Learning Alliance with Toyota S T R AT E G Y I N P R A C T I C E

In the early 1980s, General Motors was being trounced in the small car marketplace by Toyota. Toyota had pioneered the “Toyota Production System,” also called lean

manufacturing. Unlike the mass production techniques

used by General Motors, the Toyota Production System was

particularly good for small production runs and building

multiple models in the same plant. GM wanted to learn more

about the Toyota Production System so it could build small

cars more profitably. But what would entice Toyota to share

this knowledge with GM?

As it turns out, in the early 1980s, the U.S. government

started to put quotas on automobiles imported from Japan.

This meant that Toyota could only sell a limited number of

vehicles in the United States. If it wanted to sell more, it would

have to manufacture cars in the United States. Toyota had

never tried to build cars with American workers, and it wasn’t

sure how well its production system would work in the United

States. So it agreed to form an alliance with GM—called New

United Motor Manufacturing, Inc. (NUMMI)—to manufacture

small cars for GM and Toyota in the United States. GM had

an idle plant in Fremont, California, that it brought to the

alliance, as well as many automobile workers and managers.

Toyota agreed to take full responsibility for the manufacturing

process, including using former GM employees to install and

operate the Toyota Production System.

The alliance lasted more than 25 years. GM learned

manufacturing processes that it took to its other plants, and

Toyota learned the practices involved in managing a U.S.

workforce, which it took to four plants that it subsequently

built in the United States.

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activities.36 By sharing the costs of the drilling equipment and the other fixed assets, the two firms were each able to lower their fixed costs per barrel of oil.

Create New, Alliance-Specific Resources A third way alliances create value is by creating new, alliance-specific resources. Alliance- specific resources are those that are created specifically to help the partners achieve the alliance objectives. Alliance-specific resources can be owned by one partner, or jointly held. Firms typically create alliance-specific resources to increase the efficiency of doing business together or to expand the available resources of all the partners.

The alliance between Toyota Boshoku and Toyota is an example of building new resources in order to improve efficiency, the ability of the partners to coordinate their joint work. Toyota Boshoku, which supplies automobile seats to Toyota, built its factory next door to Toyota’s assembly factory.37 Because seats are bulky and costly to ship, building the plant nearby lowered Toyota Boshoku’s costs of inventory and shipping to Toyota. Then, to further reduce shipping costs, Boshoku decided to build a conveyer belt to take seats directly from its factory into Toyota’s. The factory plant and the conveyor belt were both new resources that were created to support Boshoku’s transactions with Toyota. These invest- ments substantially lowered transportation costs, inventory costs, and the costs associated with having face-to-face meetings. In comparison, General Motors does not have alliance relationships with its seat suppliers. As a result, the suppliers have not built their factories nearby. Not surprisingly, GM and its seat suppliers had higher inventory and transportation costs, which give Toyota and Boshoku a cost advantage over GM and its suppliers.38

Visa represents an example of alliance partners creating a jointly held alliance-specific resource that could expand the resources available to all the partners. In the 1970s, Bank of America and a group of other financial institutions decided to form a joint venture com- pany with the purpose of building a credit card business. Credit cards were new at the time, and the banks were hoping to get customers to widely use them. The new joint venture company was named “Visa,” and the company then built the Visa brand with customers through marketing and advertising. The Visa brand was perhaps the most valuable resource created through the alliance, because it allowed member banks to issue credit cards that were immediately recognizable to customers. Over time, many other banks and financial institutions wanted the benefits of issuing a Visa credit card, so they joined the private membership association that owned Visa. Visa finally became a public company in 2007, but its primary owners are still the banks that were part of the original private membership association that established Visa.39

Lower Transaction Costs A fourth way that alliances create value is by lowering transaction costs. Alliances that create value through lower transaction costs are primarily trying to increase efficiency and lower the costs between transactors in the value chain: buyers and suppliers.

By transaction costs, we mean all of the costs associated with making a transaction happen.40 In most companies, purchasing personnel, sales personnel, and attorneys have primary responsibility to find and negotiate agreements with suppliers of inputs and buy- ers of outputs. If alliance partners can create relationships with suppliers or buyers based on mutual trust, then they don’t have to employ as many purchasing or sales personnel. They also don’t have to employ as many lawyers to write costly contracts to protect their interests.41

One study of Toyota and General Motors found that Toyota’s procurement and legal costs were half those of General Motors. 42 The study concluded that General Motors and its sup- pliers had higher transaction costs because they didn’t trust each other; so they spent a lot of time negotiating agreements and writing legal contracts. In contrast, Toyota had devel- oped relationships with its supplier partners that were based on mutual trust. One thing that Toyota did to build trusting relationships with some suppliers was to purchase a minor- ity stock ownership stake in the supplier. Because Toyota owned part of the suppliers’ stock, suppliers felt that Toyota would behave in a trustworthy manner.

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THE RISKS OF ALLIANCES

The issue of protecting one’s interest in an alliance is real—alliances are not without risks.43 When a company agrees to an alliance, it loses some of its independence. It must rely on its partner to produce and perform as expected. Just as there are incentives to cooperate in alli- ances, there are also incentives for companies to act opportunistically, to take advantage of a partner if the situation presents itself. So managers need to be aware of the two major ways that a partner can take advantage of one another in an alliance: hold-up and misrepresenta- tion. (You can remember these two forms of opportunism as H&M.)

Hold-Up Hold-up occurs when one partner tries to exploit the alliance-specific investments made by another partner.44 In the case where Toyota Boshoku built its factory next to Toyota’s, this created an opportunity for Toyota to “hold-up” Boshoku by opportunistically renegotiating lower prices after Boshuku made the investment. Once Toyota Boshoku built its factory next door to Toyota, it was highly committed to Toyota; its investments could not be easily redeployed to serve other customers. It was important for Boshuku to make sure that Toyota would be trustworthy and not try to negotiate lower prices after Boshoku built its factory next door. So it created an equity alliance with Toyota, in which Toyota owned 49 percent of Toyota Boshoku’s stock.45

Managers must be aware that whenever they make investments in equipment, facilities, or processes that are customized to a partner—and therefore not easily redeployable to other uses—there is the potential for the partner to hold up their company.

Misrepresentation Misrepresentation occurs when one partner in an alliance creates false expectations about the resources it brings to the relationship or fails to deliver what it originally promised.46 For example, suppose a start-up biotechnology company is developing a new drug to fight Alzheimer’s disease. It needs additional resources to conduct clinical trials in order to get approval for this new drug. To convince a pharmaceutical company to provide the necessary resources, the biotech start-up could misrepresent how far along the drug is in the develop- ment pipeline. Or it could overstate the effectiveness of the drug in initial clinical trials.

A company that considers entering into an alliance with a firm that brings intangible resources to an alliance—such as local market knowledge or relationships with key political figures—needs to research its partner thoroughly to guard against this form of opportunism. Ultimately, however, misrepresentation is a hazard that firms faces when doing business with others of questionable moral character. The only true way to protect against misrepre- sentation is to partner with trustworthy individuals and firms.

Building Trust to Lower the Risks of Alliances The bottom line is that, while alliances have the potential to create value, they are also fraught with challenges and risks. Alliances cause independent firms to become interde- pendent, which means they must work effectively together to succeed. This may explain why some studies of alliances have found that trust between partners is the most important ingredient for alliance success. Next we examine four ways that companies attempt to pro- tect themselves from opportunism and build trust with their alliance partners.

Personal Trust. The first way to prevent against opportunism by a partner is to only initiate partnerships with people who you know to be trustworthy. These would likely be individuals you have known for a long time, such as family, friends, classmates, or others within your

hold-up When one partner tries to exploit the alliance-specific

investments made by another

partner.

misrepresentation When one partner in an alliance creates false

expectations about the resources it

brings to the relationship or fails to

deliver what it originally promised.

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social network. Of course, you need to know them well enough to be able to judge their character—and you need to be accurate at evaluating their character. Th is type of trust is sometimes called goodwill trust, because you are relying on the goodwill of the other party to protect your interests.

Some research has shown that compared to U.S. fi rms, Japanese fi rms are much more likely to rely on personal trust to govern their alliances.47 As a result, managers often par- take in a long “honeymoon” period of meetings, dinners, and even activities such as singing karaoke, to get to know individuals in the other fi rm before deciding whether they think they can trust the fi rm enough to enter into a partnership. Th is is often frustrating for U.S. fi rms who are more willing to write contracts to govern their alliances than to rely on per- sonal trust.

Legal Contracts. In most cases, when fi rms initiate a partnership, they write a legal contract to protect their interests. Legal contracts are usually used to help protect the interests of alliance partners and to spell out the obligations and expectations of the partners.

A contract is a substitute for personal trust. If someone violates personal trust, there is no real economic recourse other than ending your friendship or relationship. But if someone violates a contract, you can sue the other party in court to get some economic recourse. Th is threat of a lawsuit can be an important incentive for partners to perform according to legally established obligations and expectations. As detailed in Table 8.2, most contracts have clauses that clarify three categories of issues:

1. Governance issues, such as how decisions will be made, how profi ts will be split and how disputes will be resolved

On April 20, 2010, disaster struck on a BP oil rig in the Gulf of Mexico. An explosion claimed 11 lives and resulted in a sea-floor gusher that flowed for 87 days—

spilling 210 million gallons of oil into the Gulf. BP took

a thrashing in the press and agreed to a record setting

fine of $4.5 billion. But not long after agreeing to the fine,

BP decided to go on the offensive with multibillion-dollar

lawsuits seeking to shift the blame to its partners—

Transocean, owner of the ill-fated rig, and Halliburton,

the company that supplied the cement that didn’t hold.

BP sued rig-owner Transocean for more than $40 billion

because of failures in the rig’s safety system. That’s a

remarkable figure because it comes close to what BP

estimates will be its entire liability for paying claims and

cleaning up in the wake of the spill. BP has also sued

Halliburton for an estimated $10 billion, contending that

Halliburton’s “unstable” cement job failed to block the spill.

BP also accused Halliburton of destroying post-spill test

results to cover up the cement contractor’s culpability. In

response, Transocean and Halliburton each filed lawsuits

of their own. Transocean claims that BP jeopardized the

rig through risky cost-saving moves and Halliburton said

its work on the rig was done, “under BP’s direction and

according to their plan.” However, Halliburton eventually

admitted that it did destroy critical post-spill test results

in the aftermath of the 2010 Gulf of Mexico oil spill. BP and

Halliburton are now spending millions pointing the finger at

each other.

The now defunct partnership between BP, Transocean,

and Halliburton highlights a key ethical dilemma in strategic

alliances. The dilemma has to do with the fact that alliance

partners are interdependent—which means they must trust

and rely on each other to accomplish key objectives. When

things go wrong, partners have strong incentives to blame

the other party—even if it may be their fault—because the

interdependencies between the two parties make it difficult

to assign blame. The blame game is clearly going on with

BP and its partners. When this happens parties often have

strong incentives to misrepresent or hide information to

avoid blame. This is a key ethical dilemma faced by BP and

its partners as they now look to the courts to divvy up their

financial responsibility for the spill.

E T H I C S A N D S T R AT E G Y

The Blame Game in Strategic Alliances

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2. Operating issues, such as what performance is expected, and how intellectual property will be shared and protected

3. Exit/termination issues, including the conditions under which partners can exit the alliance or the contract can be terminated

Shared Ownership/Financial Collateral Bonds. When one partner owns a financial stake in another partner, as Toyota does with some of its supplier partners, it has an incentive to cooperatively help the partner be as financially successful as possible because it shares in the partner’s profits. By having your partner purchase a stake in your organization, you align the incentives of both partners to work together.

Another way to align incentives and build trust is by having a partner post a financial col- lateral bond that it will lose if it doesn’t perform according to a specified contract. For exam- ple, fast-food chains such as McDonald’s will often partner with franchisees, individuals who purchase a franchise from McDonald’s that gives them the right to operate a McDonald’s outlet at a particular location. The franchise fee is essentially put into something like an escrow account, while McDonald’s monitors the franchisee to ensure that it operates the outlet according to McDonald’s guidelines. If the outlet fails to provide McDonald’s quality food or service (which McDonald’s checks by sending in inspectors), McDonald’s can keep the franchise fee and take away the franchise.

[ Table 8.2 ] Common Clauses in Alliance Contracts

Governance Clauses

Residual rights clauses In contractual alliances, parties often specify how the profits or assets created from the alliance are to be split among the partners.

Equity/ownership clauses Equity alliances or joint ventures must specify what percentage of equity is owned by each of the partners.

Voting rights clauses Specify the number of votes for decision making assigned to each partner in an alliance. In equity alliances, voting rights usually correspond to equity ownership.

Minority protection clauses

Specify the kinds of decisions that can be vetoed, if any, by firms with a minority interest in

the alliance.

Dispute resolution clauses

Specify the process by which disputes among partners will be resolved.

Operating clauses

Performance clauses Specify the specific duties and obligations of each of the partners, including warranties and minimum performance levels required to satisfy the contract.

Noncompete clauses Specify product markets or businesses that partners are restricted from entering.

Intellectual property right protection clauses

Specify intellectual property or confidential information brought to the alliance by the part-

ners that is not to be used by other partners or shared outside of the alliance without the

partner’s written consent.

Intellectual property right creation clauses

Specify ownership rights to intellectual property (such as patents) created as a result of the

alliance.

Exit/Termination Clauses

Preemption rights clauses Specify that if one partner wishes to sell its equity, it must first offer to sell the equity to the other partner.

Initial public offering (IPO) clauses

Specify conditions under which partners in equity alliances or a joint venture will pursue an

initial public stock offering.

Call/put option clauses Specify the conditions under which one partner can force another partner to sell (or buy) its shares and at what price.

Termination clauses Specify under what conditions the contract can be terminated and the consequences of termination for each partner.

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BUILDING AN ALLIANCE MANAGEMENT CAPABILITY

Strategic alliances have become a fast and flexible way to access complementary resources and capabilities that reside in other firms. They are also profitable. One study found that a company’s stock price jumped roughly 1 percent, on average, with each announcement of a new alliance, which translated into an average increase in market value of $54 million per alliance.48 Yet, as we’ve seen, alliances are fraught with risks. Indeed, almost half of them fail.49 In such an environment, the ability to form and manage alliances more effectively than competitors can itself become an important source of competitive advantage. In Chapter 3, we discussed the importance of a firm building internal resources and capabilities, which can be used to accomplish key strategic objectives. One of those capabilities is an alliance capability—the focus of the final section of this chapter.

How do some firms develop a capability for successfully forming and managing alli- ances? Professors Jeff Dyer, Prashant Kale, and Harbir Singh conducted an in-depth study of 200 corporations and their 1,572 alliances to learn how firms can systematically manage alliances to maximize success.50 Although all companies seem to generate some value from alliances, some companies—such as Eli Lilly, Oracle, and Hewlett-Packard—systematically generate much more than other firms.

How do they do it? By building a dedicated strategic alliance function within the com- pany. Companies like these appoint a vice president or director of strategic alliances with his or her own staff and resources. The dedicated function coordinates all alliance-related activity within the firm and is charged with creating processes to share and leverage prior alliance management experience. Companies with such an alliance function achieved a 25 percent higher long-term success rate with alliances than companies that did not have a dedicated function. They also generated almost four times as much market wealth when- ever they announced the formation of a new alliance.

The research showed that an effective dedicated alliance function develops a firm’s capability to perform four key functions: It improves knowledge management efforts, increases external vis- ibility, provides internal coordination, and eliminates accountability and intervention problems.51

Improves Knowledge Management A dedicated function acts as a focal point for learning, helping the company leverage lessons and feedback from prior and ongoing alliances. It systematically establishes a series of rou- tine processes to articulate, document, codify, and share know-how about the key phases of the alliance lifecycle. Many companies with dedicated alliance functions have codified explicit alliance-management knowledge by creating guidelines and manuals to help them manage specific aspects of the alliance lifecycle, such as partner selection and alliance nego- tiation and contracting. For example, Hewlett-Packard has developed 60 different tools and templates, included in a 300-page manual that can be used to guide decision making in specific alliance situations. The manual includes such tools as a template for making the business case for an alliance, a partner evaluation form, a negotiations template outlining the roles and responsibilities of different departments, a list of ways to measure alliance performance, and an alliance termination checklist. Figure 8.2 lists more of the guidelines and tools companies have developed.

Increases External Visibility A dedicated alliance function can keep the market appraised of new alliances and about successful events in ongoing alliances. Such external visibility can enhance the reputation of the company in the marketplace and create the perception that alliances are adding value. The creation of a dedicated alliance function sends a signal to the marketplace that the com- pany is committed to its alliances and to managing them effectively.

In addition, when a potential partner wants to contact a company about a potential alli- ance, a dedicated alliance function makes an easy, highly visible point of contact. The alli- ance function typically screens potential partners, and brings in the appropriate internal

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parties if a partnership looks attractive. For instance, Oracle has an “Alliance Online” website that actually puts the partnering process online. Oracle describes the terms and conditions of different “tiers” of partnership on its website, allowing potential partners to choose which level fits them best. Alliance Online has emerged as Oracle’s primary vehi- cle for recruiting and developing partnerships, with more than 7,000 tier I partners. It has also conserved human resources, allowing Oracle’s strategic alliance function to focus the majority of its human resources on its 12 higher-profile and more strategically important tier III partners.

Provides Internal Coordination One reason alliances fail is because of the inability of one partner or another to mobilize internal resources to support the alliance initiative. Visionary alliance leaders may lack the power or organizational authority to access key resources that may be necessary to ensure alliance success. One alliance executive at a firm without a dedicated alliance function explained, “We have a difficult time in supporting our alliance initiatives because many times the various resources and skills needed to support a particular alliance are located in different functions around the company. You have to go begging to each unit and hope that they will support you. But that’s time consuming, and we don’t always get the support we should.”

A dedicated alliance function helps solve this problem in two ways. First, it has the organizational legitimacy to reach across business units and request the resources neces- sary to support the alliance. If a particular business unit is not responsive, it can quickly elevate the issue to a senior executive. Second, over time, individuals within the alliance function develop networks of contacts throughout the organization. These networks engender a degree of trust between alliance managers and employees throughout the organization, thereby allowing them to engage in reciprocal exchanges in support of alli- ance initiatives.

Facilitates Intervention and Accountability Alliance failure is the culmination of a chain of escalating events. Signs of distress are often visible early on. If alliances are adequately monitored, the alliance function can step in and intervene appropriately—much like a marriage counselor. However, only 50 percent of all

[ Figure 8.2 ] Example of Tools to Use Across the Alliance Lifecycle

* Relationship Evaluation Form

* Yearly Status Report

* Termination Checklist

* Termination Planning Worksheet

* Decision Making Template

* Trust-building Worksheet

* Work planning Worksheet

* Alliance Communication Infrastructure

* Negotiations Guidelines

* Needs v/s wants Checklist

* Alliance Contract Template

* Alliance Structure Guidelines

* Alliance Metrics Framework

* Partner Screening Form

* Technology and patent domain maps

* Cultural Fit Evaluation Form

* Due Diligence Team

Alliance Business Case

Partner Assessment & Selection

Alliance Negotiation & Governance

ALLIANCE LIFECYCLE

Alliance Management

Assessment &

Termination

* Needs Analysis Checklist

* Make vs. Buy vs. Ally analysis

* List of Possible Alliance Partners with Resources to Meet Needs.

KEY TERMS [ 163 ]

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companies that form alliances have any kind of formal metrics in place to assess how well the alliance performs. In contrast, 76 percent, of companies with a dedicated alliance func- tion have formal alliance metrics to keep tabs on how the alliance is performing.52

To illustrate, Eli Lilly’s alliance function does an annual “health check” of its key alli- ances, surveying both Lilly employees and the partner’s alliance managers. After the sur- vey, an alliance manager sits down with the leader of a particular alliance to discuss the results and offer suggestions for improvement. When serious conflicts arise, the alliance function can help resolve the dispute. In some cases, Lilly found that it needed to replace its alliance leader. One executive at Lilly commented, “Sometimes an alliance has lived beyond its useful life. You need someone to step in and either pull the plug or push it in new directions.”53

The bottom line is that developing processes to effectively form and manage alliances builds a capability for generating value through strategic alliances.

SUMMARY

A strategic alliance is a cooperative arrangement in which two or more firms combine their resources and capabilities to create new value.

There are three basic types of alliances each structured differently to split the gains from the alliance and protect each partner’s interests. The first type is a nonequity or contractual alli- ance, in which the firms write a contract to govern the relationship. The second type is an equity alliance, in which collaborating firms often supplement contracts with equity holdings in their alliance partners. In situations where alliance parties need incentives to bring their best resources to an alliance, equity is often preferred to contracts as a way to align the incen- tives of partners. The third type is a joint venture, an alliance in which the collaborating or “par- ent” firms combine their resources to create a jointly owned but legally independent company.

The primary strategic objective of firms is to offer unique value to customers, either through low cost or differentiation. Alliances are a vehicle for accessing the resources and capabilities of another firm that will help you lower costs or differentiate your offering.

There are four primary ways to create value with an alliance partner:

1. Combine unique resources

2. Pool similar resources

3. Create new alliance-specific resources

4. Lower transaction costs

As partners work together to create new value, they have to build trust to ensure that they cooperate effectively. There are four primary ways that partners build trust in alliance relationships: (1) personal trust, (2) legal contracts, (3) shared equity/financial collateral bonds, or (4) reputation. The ability to build trust with a partner has often been viewed as the single most important contributor to alliance success.

KEY TERMS

contractual or nonequity

alliance (p. 152) equity alliance (p. 153)

hold-up (p. 158) horizontal alliance (p. 155) joint venture (p. 153)

misrepresentation (p. 158) strategic alliance (p. 149) vertical alliance (p. 153)

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REVIEW QUESTIONS

1. What is a strategic alliance?

2. Describe and give examples of the three different types of strategic alliances. Identify the conditions under which each type is preferred.

3. What is the difference between a vertical alliance and a horizontal alliance?

4. What are four primary ways in which firms create value through strategic alliances?

5. Describe the two potential dangers of strategic alliances summarized by the initials H&M, and four ways that firms in alliance can build trust to minimize the risk of these dangers.

6. What is a strategic alliance function? Identify at least two ways that a strategic alliance function helps a firm be more successful with its alliances.

APPLICATION EXERCISES

Exercise 1: Look for a story in a news source such The Wall Street Journal, Forbes, Fortune, or Bloomberg Businessweek about two companies that have announced an alliance or partner- ship. As you read the announcement of the alliance, answer the following questions.

1. What are the strategic objectives of each alliance partner?

2. Is this a vertical alliance or a horizontal alliance?

3. What resources and capabilities are brought to the alliance by each partner? In your opin- ion, which partner seems to bring the more valuable resources?

4. Which type of alliance is this: contractual, equity, or joint venture? Does the article describe how the partners will split the gains from the alliance? If so, does the split seem reasonable?

5. How do you think the firms will create value in the alliance? Is value mostly created by combining complementary resources, pooling similar resources, creating entirely new resources, or reducing transaction costs/increasing efficiency between the two organizations?

Exercise 2: Brainstorm opportunities to create partnerships—and value—with other companies.

1. Identify a target company that you understand well—either because you have worked for the company or have read a lot about the company. To illustrate, let’s assume you select Marriott Corporation, the hotel and time-share resort company.

2. Identify three to four other companies in other industries that might be related in some way to the target company’s industry. Gather data about the strategy of each company, using public sources such as the company website or its annual reports, public articles, and your own experience. In our example, you might choose, and gather data about: Dis- ney (entertainment), Apple (computers, tablets, music, phones) and Nike (shoes).

3. Work with three to four classmates to brainstorm ways in which each of the other compa- nies you chose could create new value with the target company. To continue the Marriott example, perhaps Marriott could create Disney-themed rooms at its timeshare resorts, such as a Disney Princess or Pirates of the Caribbean room. Or maybe Marriott could turn an elevator shaft into a “Tower of Terror” ride. Perhaps Apple could provide each Marriott room with Apple technology and products. When guests check in to the hotel, perhaps they could do it on their iPhone (and even have an electronic key sent to their phone to open the door). Or maybe the room would be equipped with an iPad filled with music and movies to try out. Perhaps Nike could help design Marriott’s workout room and provide a variety of Nike athletic footwear or apparel products for guests to purchase. Have fun and be creative as you brainstorm ways that companies can combine their resources and capabilities to create new value.

STRATEGY TOOL [ 165 ]

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Alliances and acquisitions are alternative vehicles for accessing important resources or capabilities that reside in

another firm. Each approach may be preferable in different

situations and managers must carefully analyze several key

factors before deciding whether to ally with a company, or

acquire it. These factors include the following:

1. Type of synergies or interdependence between the firms. Managers should assess the nature of the coordination

and interdependencies that will be required to generate

synergies through the collaboration. When interde-

pendencies are low (pooled/modular), nonequity alli-

ances are preferred. As interdependencies increase and

become sequential and reciprocal in nature, managers

should consider first equity alliances/ joint ventures and

then acquisitions (see Chapter 7 discussion of pooled,

sequential, and reciprocal interdependencies).

2. Nature of resources being combined. Managers should assess whether they must create the synergies they

desire by combining hard resources, like a product,

equipment, manufacturing plants, or patents or soft

resources, such as people, relationships, or unpat-

ented intellectual property. When the synergy-gener-

ating resources are hard, acquisitions are typically a

better option because it’s easier to value the assets

you are purchasing. When companies have to generate

synergies by combining human resources, it’s a good

idea to avoid acquisitions because people often walk

out the door after acquisitions.

3. Extent of redundant resources. When two companies can team up to create value by essentially eliminat-

ing redundant resources that they each have, then

acquisitions are the preferred option. For example,

companies may have redundant R&D activities, manu-

facturing plants, or sales/services forces and want

to leverage the best of each firm while eliminating

redundancies. When companies want to create value

by eliminating redundant resources, acquisitions are

preferable to alliances.

4. Degree of market uncertainty. When a company estimates that there is high uncertainty or high risk of whether

a particular collaboration will yield positive results, it

should enter into a nonequity or equity alliance rather

than acquire the would-be partner. An alliance will limit

the firm’s exposure since it has to invest less time and

money than it would in an acquisition. If the collaboration

doesn’t yield results, the company can withdraw from the

alliance. It may lose money and prestige, but that will be

nowhere near the costs of a failed acquisition.

5. Degree of competition for partner’s resources. There’s a well-developed market for M&A, so it is wise to check

if you have rivals for potential partners before pursu-

ing a deal. If there are several suitors, you may have no

choice but to buy a firm in order to preempt the com-

petition. When there are many suitors for a partner’s

resources, we recommend you acquire those resources

to gain full control.

Given the factors described, the following evaluation tool

can be used as a guide to assess whether an alliance or

acquisition is likely to be more appropriate in a particular

situation. Evaluate your collaboration partner on each of the

five factors below and then add up the point total to assess

whether acquisition or alliance would be preferred. If your

point total is 11–15, then acquisition is likely the preferred

option. If your point total is 8–11, then an equity alliance

may be your best option. If your point total is below 8, then

a nonequity alliance is likely to be your best option. You can

change the weighting of the factors if you think a particular

factor is more important in your particular situation.

Strategy Tool When To Choose An Alliance Versus An Acquisition

FACTOR VEHICLE POINT VALUE

1. Type of Interdependence That Will Generate Synergies

Modular Nonequity alliance 1

Sequential Equity alliance 2

Reciprocal Acquisition 3

2. Nature of Resources That Will Generate the Synergies

Relative value of hard to soft resources

Low Nonequity alliance 1

Medium Equity alliances 2

High Acquisition 3

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REFERENCES

1 J. S. DeMott, S. Chang, and Adam Zagorin, “Mickey Mouse on Tokyo Bay,” Time 121 (16) (1983).

2 M. Misawa, Tokyo Disneyland and the Disney Sea Park. Harvard Business Review. Asia Case Research Center,

Hong Kong, 2006.

3 Ibid.

4 “Leisure Facilities Industry Profile: Global. 2009.” Leisure Facilities Industry Profile: Global, 1.

5 Y. Hayashi, Oriental Land’s Disney Parks May Be Running Out of Dreams. WSJ Online (2005). Accessed Feb. 19,

2013. http://online.wsj.com/article/1,,SB111627336795434912,00.html.

6 J. H. Dyer, P. Kale, and H. Singh. “How to Make Strategic Alliances Work,” MIT Sloan Management Review

(Summer 2001).

7 R. P. Nielson, “Cooperative Strategy,” Strategic Management Journal 9 (5) (1988): 475–492.

8 Walt Disney Company, 2011 Annual Report. http://thewaltdisneycompany.com/investors/financial-

information/annual-report.

9 A. Webb, “BMW Extends Toyota Cooperation to Fuel Cells, Sports Cars,” Bloomberg Online ( June 29, 2012).

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10 IntelPR. “Intel, Micron Update NAND Flash Memoryv Joint Venture,” News Stories (Feb. 27, 2012). http://newsroom.

intel.com/community/intel_newsroom/blog/2012/02/27/intel-micron-update-nand-flash-memory-joint-venture.

11 W. Ashworth, “The Target-Neiman Marcus Partnership Looks Like a Winner,” InvestorPlace ( July 16, 2012),

http://investorplace.com/2012/07/the-target-neiman-marcus-partnership-looks-like-a-winner/.

12 P. Lewis, “How Apple Kept Its iPhone Secrets,” CNN Money ( January 12, 2007).

13 P. Gumbel, “Exclusive: Walt Disney Co. Considers Buyout of Struggling Disneyland Paris,” Time

Business & Money (Aug. 24, 2012), http://business.time.com/2012/08/24/exclusive-walt-disney-co-considers-

buyout-of-struggling-disneyland-paris/.

14 P. Zimmer, “Why EuroDisney Failed,” http://www.patrickzimmer.com/why_eurodisney_failed.htm

15 M. G. Colombo, “Alliance Form: A Test of the Contractual and Competence Perspectives,” Strategic Management

Journal 24 (12) (2003): 1209–1229.

16 S. H. Chan, J. W. Kensinger, A. J. Keown, and J. D. Martin, “Do Strategic Alliances Create Value.”Journal of Finan-

cial Economics 46 (2) (1997): 199–221.

17 N. Nohria and C. Garcia-Pont, “Global Strategic Linkages and Industry Structure,” Strategic Management Journal

12 (S1) (2007) 105–124.

18 M. Marqulis and P. Pekar Jr. “Equity Alliances Take Centre Stage,” Ivey Business Journal (2003), http://www

.iveybusinessjournal.com/topics/strategy/equity-alliances-take-centre-stage#.USO26aXiiSo.

19 J. H. Dyer, Specialized Supplier Networks as a Source of Competitive Advantage: Evidence from the Auto

Industry,” Strategic Management Journal 17 (4) (1996): 271–292.

FACTOR VEHICLE POINT VALUE

3. Extent of Redundant Resources Between Two Firms

Low Nonequity alliance 1

Medium Equity alliance 2

High Acquisition 3

4. Degree of Market Uncertainty

Low Acquisition 3

Low/Medium Equity alliance 2

High Nonequity alliance 1

5. Level of Competition for Partner’s Resources and Capabilities

Low Nonequity alliance 1

Medium Equity alliance 2

High Acquisition 3

http://online.wsj.com/article/1

http://thewaltdisneycompany.com/investors/financial-information/annual-report

http://www.bloomberg.com/news/2012-06-29/bmw-extends-toyota-cooperation-to-fuel-cells-sports-cars

http://newsroom

http://investorplace.com/2012/07/the-target-neiman-marcus-partnership-looks-like-a-winner

http://business.time.com/2012/08/24/exclusive-walt-disney-co-considers-buyout-of-struggling-disneyland-paris

http://www.patrickzimmer.com/why_eurodisney_failed.htm

http://www.imftech.com/news/release_21Nov05.html

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20 Dyer, Kale, and Singh.

21 K. R. Harrigan, Managing for Joint Venture Success (New York: Free Press,1986).

22 “Micron and Intel Create New Company to Manufacture NAND Flash Memory, IM Flash News (Nov. 21, 2005),

http://www.imftech.com/news/release_21Nov05.html.

23 Y. Zhang, “GM, SAIC Join to Sell Used Cars,” The Wall Street Journal (Oct. 28, 2010).

24 A. Yablon, “Micron Buys Intel Plant Stakes, Expands Flash Memory Venture,” Bloomberg News (Feb. 28, 2012),

http://www.bloomberg.com/news/2012-02-28/micron-buys-intel-plant-stakes-to-expand-flash-memory-

venture.html.

25 S. G. Lazzarini, D. P. Claro, & L. F. Mesquita. 2007. “Buyer-Supplier and Supplier-Supplier Alliances: Do they

Reinforce or Undermine One Another?” Journal of Management. 45:3 561–584.

26 R. Shapiro and B. Isaacson, “The Bose Corporation JIT II Program,” Harvard Business School Press Case, 1994.

J. Freeland, and R. Kidwell, “Bose Corporation: JIT II,” University of Virginia Darden School, 1995.

27 Author interview with Lance Dixon, June 24, 1996.

28 Bose Corporation, JIT II: Revolution in Buying and Selling. Institute of Supply Chain Management, http://www

.ism.ws/pubs/proceedings/confproceedingsdetail.cfm?ItemNumber=10370

29 Dyer, Kale, and Singh.

30 N. Wing field and M. Marr, “Pixar, Disney Keep Investors on Seat’s Edge,” WSJ Online (Dec. 15, 2005), http://

online.wsj.com/article/SB113461769841623178.html.

31 P. R. La Monica, “Disney Buys Pixar,” CNNMoney.com ( Jan. 25, 2006), http://money.cnn.com/2006/01/24/news/

companies/disney_pixar_deal/.

32 L. Dishman, “The Genius of Target’s Missoni Madness,” Forbes (Sept. 9, 2011), http://www.forbes.com/sites/

lydiadishman/2011/09/14/missoni-madness-crashes-e-commerce-but-targets-still-on-top/.

33 A. D’innocenzio, “Target, Neiman Marcus Join for Holiday Collection,” Bloomberg Businessweek ( July 10, 2012),

http://www.businessweek.com/ap/2012-07-10/target-neiman-marcus-join-for-holiday-collection.

34 A. Cheng, “Target, Neiman Marcus Join Forces,” The Wall Street Journal ( July 10, 2012), http://articles.

marketwatch.com/2012-07-10/industries/32612748_1_missoni-neiman-marcus-designers>.

35 If Intel and Micron had each built separate plants, they would have produced at lower volumes than their joint plant,

which would have resulted in higher costs per unit, because they would have been higher on the experience curve

described in chapter 4. If they had both built the same size plants, it would have increased supply and competition

in the market, which would have led to lower prices. Alliances can also be useful as a way to minimize competition.

36 “BP-Statoil Partnership Takes Shape,” Oil and Gas Journal. 89 (5) (1991), http://www.ogj.com/articles/print/

volume-89/issue-5/in-this-issue/general-interest/bp-statoil-partnership-takes-shape.html.

37 R. Schreffler, “Quake Changes Little in Toyota’s Supply-Chain Strategy,” WardsAuto (2012), http://wardsauto.

com/supply-chain/quake-changes-little-toyota-s-supply-chain-strategy-0.

38 Dyer, “Specialized Supplier Networks as a Source of Competitive Advantage,” pp. 271–292.

39 http://en.wikipedia.org/wiki/Visa_Inc.#IPO_and_restructuring

40 O. E. Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985).

41 A. Zaheer and N. Venkatraman. “Relational Governance as an Interorganizational Strategy: An Empirical Test

of the Role of Trust in Economic Exchange,” Strategic Management Journal 16 (1995): 373–392.

42 J. H. Dyer and W. Chu. “The Role of Trustworthiness in Reducing Transaction Costs and Improving Performance:

Empirical Evidence from the United States, Japan, and Korea,” Organization Science 14 (1) (2003): 57–68.

43 T. K. Das, “Trust, Control, and Risk In Strategic Alliances: An Integrated Framework,” Organization Studies 22 (2)

(2001): 251–283.

44 B. Klein, R. G. Crawford, and A. A. Alchian. “Vertical Integration, Appropria¬ble Rents, and the Competitive

Contracting Process.” Journal of Law and Economics, 1978, 21, 297–326. Hold-up Problem. Wikipedia Online

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45 http://www.wikinvest.com/stock/Toyota_Motor_(TM)/Automotive_Market_Environment

46 T. K. Das and N. Rahman, “Partner Misbehaviour in Strategic Alliances: Guidelines for Effective Deterrence,”

Journal of General Management 27 (1) (2001).

47 C. W. L. Hill, “National Institutional Structures, Transaction Cost Economizing, and Competitive Advantage: The

Case of Japan.” Organization Science 6 (1995): 119–131. J. H. Dyer, “Does Governance Matter? Keiretsu Alliances and

Asset Specificity as Sources of Japanese Competitive Advantage,” Organization Science 7 (6) (1996): 649–666.

48 Dyer, Kale, and Singh, 2001.

49 S. H. Park and G. R. Ungson, “Interfirm Rivalry and Managerial Complexity: A Conceptual Framework of Alli-

ance Failure,” Organization Science 12 (1) (2001): 37–53. P. Kale, J. H. Dyer, and H. Singh, “Alliance Capability,

Stock Market Response, and Long-Term Alliance Success: The Role of the Alliance Function,” Strategic Manage-

ment Journal 23 (8) (2002): 747–767.

50 Dyer, Kale, and Singh, 2001.

51 Ibid.

52 Kale, Dyer, and Singh, 2002, pp. 747–767.

53 N. Sims, R. Harrison, and A. Gueth. “Managing Alliances at Lilly,” Windhovers Invivo Business and Medicine

Report (19) (6) (2001).

http://www.bloomberg.com/news/2012-02-28/micron-buys-intel-plant-stakes-to-expand-flash-memory-venture.html

http://online.wsj.com/article/SB113461769841623178.html

http://money.cnn.com/2006/01/24/news

http://www.forbes.com/sites

http://www.businessweek.com/ap/2012-07-10/target-neiman-marcus-join-for-holiday-collection

http://articles

http://www.ogj.com/articles/print

http://wardsauto

http://en.wikipedia.org/wiki/Visa_Inc.#IPO_and_restructuring

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International Strategy

[ 169 ]

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Studying this chapter should provide you with the knowledge to:

1 Discuss the globalization of business.

2 Explain why firms choose to expand internationally.

3 Describe different kinds of distance and how they affect successful international expansion and how this affects the choice of where firms should go when they expand.

4 Explain the three primary types of international strategy and be able to use the international strategy triangle to determine which international strategy is right for a specific firm.

5 Explain when a firm should use each of four major ways to enter a foreign market.

L E A R N I N G O B J E C T I V E S

[ 170 ]

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L incoln Electric is one of the most celebrated companies

in U.S. history. Business schools across the entire

world have made it the number one case study on

how companies manage their workforces. At first glance,

it seems odd that Lincoln Electric should be so famous.

Unlike Apple or Exxon, it doesn’t have the highest market

capitalization. Unlike Facebook or Google, it isn’t in an

industry that is fashionable or that innovates quickly. Lincoln

makes welding machinery and the sticks of metal that

welders melt to bond two objects together, known as welding

consumables. Yet, in the last 20 years, Lincoln Electric

captured the majority market share in the United States

competing against such big-name firms as GE. It then went

on to capture the largest share of the welding equipment and

consumables market in the entire world. Lincoln currently

manufactures in 20 countries and has distributors and

sales offices in over 160 countries worldwide.1 Not bad for a

Cleveland, Ohio-based manufacturing company.

Lincoln’s success is often attributed to the way it pays

its workers. Management believes that the way they

compensate their workers maximizes their incentives to

be productive. The three cornerstones of the company’s

compensation policy are:

1. Piecework:2 Workers’ pay is based on the number of pieces they produce rather than the number of hours

they work.

2. Year-end bonuses: Big bonuses at the end of the year, based on personal evaluations and company perfor-

mance, can often double workers’ yearly earnings.

3. Guaranteed employment:3 Since 1951, Lincoln Electric has promised not to lay off employees, no matter how

difficult things become, a promise the company has

kept to this day.4

Lincoln Electric’s success story has not been free of

trials. In fact, the first time Lincoln Electric decided to

expand internationally, it nearly killed the company. From

the mid-1940s until 1986, Lincoln Electric was primarily

a U.S. firm. Nearly all production occurred in Cleveland.

The company had opened plants in Canada, Australia,

and France shortly after World War II, but these were

mostly autonomous units. However, from 1986 to 1992,

the company—fearing a slowdown in the U.S. market and

seeing foreign competitors grabbing market share in the

United States—embarked on a period of rapid international

expansion.

During those six years, Lincoln Electric went from

little international presence to buying or building three

overseas plants a year. Lincoln acquired and built a plant

in Venezuela, acquired existing plants in Mexico, Brazil,

Scotland, Norway, the

United Kingdom, the

Netherlands, Spain,

and Germany, and

built a plant in Brazil

and three in Japan, among others—a total of 17 plants in 15

countries. None of the top management team, however, had

any international experience. They bought plants intending

to rely on the existing plant managers’ local knowledge.

Lincoln also decided to use the local brands of the plants

it bought, because local managers had assured Lincoln’s

executives that Europeans, in particular, would not buy U.S.

branded products.

Lincoln’s leaders had hoped to install the renowned

Lincoln Electric incentive system in each of its new

international plants. However, none of the foreign units

implemented the system. Lincoln’s managers were not

aware that many local laws forbid parts of the Lincoln

system. In some locations, local management and workers

didn’t see its value. None of the foreign units except

Canada and Australia, the older ones, turned out to be

profitable.

Lincoln Electric Learns Some Difficult Lessons

0 9

LINCOLN ELECTRIC’S SUCCESS STORY HAS NOT BEEN FREE OF TRIALS. IN FACT, THE FIRST TIME LINCOLN ELECTRIC DECIDED TO EXPAND INTERNATIONALLY IT NEARLY KILLED THE COMPANY.

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This chapter will help you to answer three critical questions concerning international strategy: Why, Where, and How. Carefully researched and thoughtful responses to those three questions can make the difference between a successful expansion effort and failure, or near failure, like Lincoln experienced.

THE GLOBALIZATION OF BUSINESS

Over the last 50 years, the scope of business has changed for most organizations. Compa- nies used to compete primarily within their own country. Technological advancements in communications and transportation, along with falling trade barriers, have changed that for most firms. Over that period of time the average tariff, the tax on goods imported into a country, dropped from over 40 percent to an average of 4 percent in developed nations. At the same time, countries across the globe repealed regulations that kept foreign firms from buying local companies and building plants and stores in their markets. As a consequence, the volume of international trade, companies selling across national borders, increased more than 28-fold from 1970 to the present.

International trade in merchandise alone topped $18 trillion last year.6 During the same period foreign direct investment (FDI), companies building factories and stores in foreign countries, increased more than 500 percent (see Figure 9.1).7 Although there is no consensus on why FDI flows to some countries and not others common factors include low labor and tax costs, low trade barriers, and favorable exchange rates.8

This trend toward increased international trade has allowed organizations to place parts of their value chains in different countries, depending on where each part can

foreign direct investment Direct investment in production or

business in one country by a

business from another country.

Top management in Cleveland knew that the foreign

units were struggling but, not having experience running

a multinational company, they used a hands-off policy

and weren’t aware of exactly why things weren’t working.

When Lincoln’s CEO retired in 1992, the new CEO was

handed the reins to a company in which losses in the

foreign units had become so huge that Lincoln Electric

had to borrow money for the first time in its history. The

company then nearly defaulted on its bank loans—twice—

only surviving by begging the banks for more generous

terms. Twice, Lincoln had to borrow money to pay the

year-end bonuses that were so critical to its competitive

advantage.

To fix the foreign operations, the new CEO moved to the

United Kingdom and spent more than a year personally

overseeing the plants in Europe. He broke local unwritten

cultural rules about taking market share from other local

companies by aggressively selling Lincoln Electric U.S.

branded products at trade shows and in every other venue

he could introduce them. He also broke a long-standing

Lincoln Electric policy of promoting managers from within

the company. Instead, he worked to lure key managers

from other U.S. firms that had significant international

experience. He led the company to close plants in Germany

and Japan—despite having just bought or built them—and

rationalized production in the remaining plants, so that

each was manufacturing a different product, rather than

competing with other Lincoln plants.

By the middle of 1994, Lincoln had turned things around.

Its foreign operations had become profitable as outlined

in Table 9.1.5 Since then, the lessons the company learned

have been applied over and over, with great success, leading

to Lincoln’s current position as market leader in many

countries around the world.

[ Table 9.1 ] Lincoln Electric Income (in U.S. $millions)

1987 1988 1989 1990 1991 1992 1993 1994

United States 49.9 55.9 53.0 28.2 30.8 24.9 42.6 71.7

Europe 1.5 3.1 4.4 2.1 –14.4 –52.8 –68.9 3.9

Other Regions 1.3 2.0 –0.6 –6.8 –2.9 –7.2 –22.9 5.5

Total 52.7 61.0 56.8 23.5 13.5 –35.1 –49.2 81.1

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generate the most value. Manufacturing, as well as service industries, has become global. Trade in commercial services, such as licensing and franchise fees, and various types of services such as financial, information, computing, insurance, and consulting services, etc. has increased 272 percent just in the last decade, totaling over $4.3 trillion in exports alone last year.9

What this means for strategy is that both production and the market for many products and services isn’t national anymore—it’s regional (a part of the world) or global.10 For most industries, the competition isn’t just local or national anymore, either—it’s also global, and key competitors may be located in another country. Indeed, the World Trade Organization says that half of all the productive wealth in the world is generated by multinational firms that compete with an international strategy.

Even for small companies, international strategy is the key to success. Of the more than 302,000 U.S. firms that competed across borders in 2011, 98 percent were small to medium-sized firms.11 Companies that do international strategy right tend to dominate both at home and throughout the world. Most organizations that hope to be a leader in their industry realize that they have to compete on a global scale.12 Indeed, for many companies even basic survival is predicated on a clear understanding of international strategy.

Of course, competing on a global stage isn’t just about protecting oneself from foreign competition. It also opens up tremendous new opportunities13 although these new opportu- nities come with an exponential increase in complexity. Just ask the top management team at Lincoln Electric. Some of the differences between countries that increase complexity and affect the success of international strategies include variations in:

Customer tastes, needs and income levels

Government regulations

Legal systems

Public tolerance for foreign firms

Reliability, and even existence, of basic infrastructure, such as roads and electricity

Strength of supporting industries, including distribution channels to customers

This chapter addresses the complexity of international strategy by answering three ques- tions strategists ask when thinking about going international:

1. Why should we go international? What advantages might we gain?

2. Where should we expand? Of all the countries we could enter, which are the right ones?

3. How should we expand? What international strategy should we employ? How can we tell if we have the right one? And, what strategic options do we have for entering a foreign country?

One thing to keep in mind as you read this chapter is that many of the concepts actually apply to geographic expansion within a country as well as international expansion. We focus the chapter on international expansion because the complex issues behind a successful expansion strategy are magnified exponentially when you cross international borders.

multinational firms Firms that sell or produce in multiple countries.

[ Figure 9.1 ] Global Foreign Direct Investments, 1970–2013 (in 2013 U.S. dollars)

Source: UNCTAD, Inward and outward foreign direct investment flows, annual, 1970–2012 and OECD FDI in Figures, February 2014.

500,000

1,000,000

1,500,000

2,000,000

2,500,000

19 70

19 71

19 72

19 73

19 74

19 75

19 76

19 77

19 78

19 79

19 80

19 81

19 82

19 83

19 84

19 85

19 86

19 87

19 88

19 89

19 90

19 91

19 92

19 93

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

20 10

20 11

20 12

20 13

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WHY FIRMS EXPAND INTERNATIONALLY

There are a number of reasons why firms choose to compete in international markets. These include increasing sales to grow the company beyond what the home market can offer, becoming more efficient (raising profits by lowering costs), managing risks better, learning from consumers in other markets, and responding to the globalization moves of other firms.

Growth The need to grow sales is one of the biggest reasons that firms expand internationally.14 Some firms have saturated their home markets, and entering foreign markets is the only way for them to sustain growth. This is one of the primary reasons Walmart entered Mexico in 1991. Figure 9.2 shows how important expanding internationally has been for Walmart’s continued growth. Of course, firms that haven’t saturated their home market also might seek to go global in order to increase their rate of growth. This is one of the main reasons Lincoln Electric chose to expand overseas.

Efficiency Many firms enter additional markets in order to become more efficient. Efficiency takes a number of forms, including obtaining lower-cost resources, extending the lifespan of prod- ucts, and achieving economies of scale and scope.

Lower-Cost Resources. In many cases, key resources may be cheaper in foreign countries. One of the most common resources firms seek abroad is low-cost labor, which is often referred to by the buzzwords offshoring or outsourcing. Firms may also expand abroad in search of lower-cost sources of raw materials.15 For example, the United States is seeing an increase in foreign companies opening new plants in the United States to take advantage of cheap natural gas made available through hydraulic fracturing technology, known as fracking.

Beyond looking at the price of a particular resource, though, companies also have to take into account factors that might increase the cost to use the resource, including labor

globalization The spread of businesses across national

borders.

[ Figure 9.2 ] Walmart’s Growth, Domestic and International, 1989–2011

2.94% est. for 2011

2.20% est. for 2011

1990

0.0%

0.37% in 1989

Total sales

U.S. sales only

0.8%

1.2%

1.6%

2.0%

2.4%

2.8%

3.2% Walmart Sales* as a Share of U.S. GDP, 1989–2011 (est.)

*includes Sam’s Club

1995 2000 2005 2010

Source: Walmart Annual Reports

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productivity, and the transportation and communication costs needed to acquire the resource. Moreover, companies must also consider a variety of other costs of doing business in a particular country, such as regulations and the challenges of managing in a different culture. Companies tend to seek an optimal location for expansion, not just the one with the lowest cost resources. For instance, while sub-Saharan Africa has the cheapest labor in the world, China’s abundance of relatively skilled and productive cheap labor, coupled with excellent communications and transportation infrastructure and a relatively stable political climate, has often made it the target of most firms looking for low-cost labor.

Longer Product Life. Sometimes firms enter foreign countries to extend a product’s life cycle, leveraging their investment in assets and equipment.16 For example, in Chapter 2 we introduced the plight of Nokia, a one-time world leader in the cell phone industry. Although Nokia’s cell phone business, now a subsidiary of Microsoft, is no longer the world’s leading manufacturer of cell phones and smart phones, the company continues to generate substantial revenue by selling its older-model phones in Africa, the Middle East, and Southeast Asia.

In addition to leveraging prior investments in their products, firms can also leverage their capabilities. As discussed in Chapter 3, capabilities that generate competitive advantage for firms typically are difficult and costly to build. Some firms try to leverage their investments in building capabilities by using those capabilities in multiple countries.17 Fast-food restau- rants such as McDonald’s are masters of this technique.18 Manufacturing firms can also gain efficiencies from leveraging their capabilities. Toyota, for instance, has been quite successful in implementing the Toyota Production System in its U.S. auto plants, helping to keep its costs lower than those of rivals GM and Ford.

Economies of Scale and Scope. Another critical source of efficiency that firms seek to gain by going international is economies of scale, whether they come in manufacturing, R&D, or sourcing.19 Recall from Chapter 4 that economies of scale occur when firms are able to spread the costs of investments in plant, equipment, or knowledge across many sales. As firms compete in foreign markets, they increase the number of units sold, possibly reaping greater economies of scale.

Related to efficiencies gained through economies of scale are economies of scope. Com- peting in multiple markets allows firms to spread their costs across more units in multiple product categories. This is the approach Pepsi takes by owning snack-food companies such as Frito-Lay. Pepsi sells its foods and drinks to the same retailers. This allows Pepsi to spread the costs of distribution across a greater volume of products, lowering its distribution costs.

Managing Risk Operating in more than one country can also provide firms with a measure of protection against disaster, both economic and natural.20 Even when there are worldwide economic downturns, such as during the period from 2007 to 2012, problems are not usually spread evenly across all countries. During that period, the United States and the European Union fell into recession while China continued to grow at a fairly rapid pace. When firms have sales in multiple countries, a slowdown in one country may be offset by continued sales in another. For instance, many observers thought that General Motors (GM), a U.S.-based firm, would lose a good portion of its market share in 2007, when the U.S. market for automobiles collapsed. However, within a short time, GM had actually increased its worldwide market share, regaining the title of largest auto company based mostly on sales growth in China.

The same principle works for other types of disasters, such as natural disasters or social upheaval. If firms have operations in multiple locations they may be able to relocate produc- tion or increase sales in another country to make up for the shortfall in the area where the disaster occurred.

Knowledge Another reason for expanding into other countries is to generate more knowledge, the basis for innovation. When a firm sells in different countries, to people with different

product’s life cycle The stages a product or service goes through

during its lifespan.

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tastes and needs, it often gains new insights about its products and services. Serving multiple types of customers can help a firm to identify unmet needs in multiple markets. Those insights can be valuable for increasing sales in many locations. Gathering infor- mation from customers in multiple countries can also help organizations more easily identify changes in customer needs making it more likely that they will be at the fore- front of the next big innovation in their industry. Research suggests that generating more knowledge may be the greatest advantage a multinational organization has over purely domestic companies.21

As an example, GE’s Healthcare division developed an inexpensive, portable ultrasound machine to serve the rural Chinese market, where health-care providers couldn’t afford GE’s large, expensive ones. GE realized that there were also markets for an inexpensive, portable ultrasound machine in Europe and the United States, specifically with first responders who don’t have space in ambulances and fire trucks for large ultrasound machines. GE now sells the product in all of its markets.

Not only can companies generate knowledge from diverse customers but also from their own units in different locations. For instance, Europe has higher energy costs than the United States does. U.S. firms that operate in Europe have been learning how to save energy costs more rapidly than those that aren’t in Europe.

Responding to Customers or Competitors Last, but not least, firms may expand internationally in response to either customers or competitors. This is particularly true of business-to-business (B2B) firms that perform inter- mediate steps of the value chain for large customers.22 For example, the “Big 4” accounting firms—Deloitte Touche Tohmatsu, Ernst & Young, KPMG, and PricewaterhouseCoopers— have all expanded globally to better serve their largest clients, who are multinationals with operations around the globe. Indeed, sometimes customers demand that their suppliers go international when they do.

Sometimes firms feel compelled to go global because their rivals do. If the rivals gain any of the advantages previously discussed, they may use those advantages to subsidize aggres- sive sales and marketing campaigns in the home markets of their competitors.23 If a firm doesn’t expand to replicate those advantages it may be at a distinct disadvantage. This is one of the primary reasons Lincoln Electric expanded abroad—to respond to ESAB, a Swedish welding company, who had just entered the United States.

WHERE FIRMS SHOULD EXPAND

Once a firm has decided to go international, the next question it must answer is where to expand. The easiest answer is to enter the country with the largest number of potential customers—often, a country with a huge population, such as China or India. However, wise managers also think about how likely they are to succeed in a particular foreign market. After all, the word foreign means different and different can be difficult to deal with. Research on the risks of international expansion refers to this as the liability of foreignness.

Successful international expansion requires a clear understanding of the possible risks. Some risks are market driven—will foreign customers buy your products at the same rate as your home country customers? Will distribution work the same way or will it cost more to get products to the end customer?

Other risks are political. Sometimes foreign governments enact policies that place addi- tional burdens on foreign firms, such as tariffs that increase the cost of foreign products, laws requiring a certain percentage of each product be made in the foreign country, or a certain percentage of managers be locals, or laws prohibiting foreign ownership of local firms. Other burdens come from the uneven application of local laws. For instance, in some countries it is difficult for foreign firms to protect their intellectual property as local courts may side

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primarily with local firms. And sometimes nationalistic sentiment leads governments to threaten foreign firms with additional tariffs, lawsuits in both local and world courts (such as the World Trade Organization), inspections and fines not levied against local firms, and even seizure of plants and equipment. Companies entering foreign markets need to be well aware of the possibility of government action.

Finally, other risks are economic in nature. Not all markets are equally stable. Some coun- tries are more susceptible to economic recessions, directly affecting the bottom line of the firms selling in those markets. Foreign countries may also be susceptible to monetary crises, where the value of the local currency fluctuates wildly as shown in Figure 9.3. The curren- cies of some countries, even when not in crisis, may fluctuate significantly compared to the U.S. dollar. This can create an adverse exchange rate. This matters because a firm selling in a foreign market earns profit in that market’s currency and those producing in a foreign country buy goods and pay labor in the local currency. If that currency fluctuates, the costs and profits, when transferred back into the home currency, fluctuate as well. This can make a significant difference in how competitive a firm is. If the exchange rate is favorable, they can lower their prices and steal market share from other firms. If the exchange rate is not favorable, the opposite can happen.

Organizations considering international expansion need to carefully consider the market, political, and economic risks of each country they are thinking about entering. Since companies want to do business in the countries where they are most likely to suc- ceed, that means choosing locations that have the lowest risks. Another way to think about managing the risk of expansion is to consider the distance between countries. Even though transportation and communication have advanced to the point where firms can realistically do business in nearly every country on the planet, the distance between countries still matters. In addition to geographic distance, there are three other kinds of distance that managers should consider when undertaking international expansion: cultural, administrative, and economic distances.24 A useful mnemonic for remembering the four types of distance is CAGE—cultural, administrative, geographic, and economic.25

Even if there are a lot of potential customers, a country might not be the right one to enter if the likelihood of success is low because of greater distance. The lower the distance across all four distances, with an emphasis on the distance that most affects your specific industry, the greater the likelihood of a successful expansion.

[ Figure 9.3 ] Exchange Rate versus U.S. Dollar of Brazilian Real (BRL) and Indian Rupee (INR), 2009–2014

Jan 1, 2010 –40.00%

–30.00%

–20.00%

–10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Jan 1, 2011 Jan 1, 2012 Jan 1, 2013 Jan 1, 2014

USD/BRL USD/INR

Source: Oanda.com, Historical Exchange Rates

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Cultural Distance Cultural distance refers to differences in language and culture, the way people live and think about the world. People in another country might hold different beliefs about a host of significant issues, including how people should interact and how business should be conducted. They might have very different worldviews about human nature and the role of individuals and companies in society. All of these can add up to a very foreign environment that makes it difficult for firms to understand their customers and local employees.26

Although it’s only one aspect of culture, the issue of language is influential. Firms are 42 percent less likely to do business in a country with a different language.27 Language differences are relatively easy to fix, but potential problems increase rapidly when companies move into countries with deeper, more difficult to overcome types of cultural distance. These may include differences in:

Religion

Ethnicity

Trust for outsiders28

How genders are expected to behave

The degree to which the culture is focused on individuality or collective action

How people accept ambiguity or follow rules and laws

The degree to which people allow abuses of political or market power29

Many of these types of cultural differences can be subtle but still have a significant impact on consumer behavior and shape the market demand for foreign products.

Not all industries are affected the same way by cultural distance. Firms that sell com- modity products, such as corn, wheat, oil, or cement, don’t tend to have difficulty with cultural distance. However, firms with products that have high linguistic content, such as TV shows, movies, music, and even textbooks, have to be careful. Likewise, products that affect how people see themselves, such as food and clothing, are affected by cultural distance. This is particularly true if those products clash with religious or national identi- ties. It is difficult to sell pork products in the Middle East, as pork is forbidden by both Judaism and Islam. Other products might not directly clash with religion, but they might not match cultural norms. For instance, in Germany parents have a tendency to prefer well-crafted, wooden toys for their children. Firms that focus on less-expensive plastic toys do much better in markets like the United States.

Sometimes, however, cultural distance can be a selling point for multinationals. For instance, in Russia, foreign products are often seen as superior to local ones. Likewise, being associated with a particular country can sometimes increase sales of a product worldwide, as is the case for German luxury automobiles, Italian fashion, and U.S. fast food.

Administrative Distance Administrative distance refers to differences in the legal, political, and regulatory institu- tions between countries. For example, are laws and government policies similar or different? This is important for firms because understanding the political and legal environment is often a key to success in a foreign country.30

You can have the best product or service at the cheapest price, but if you don’t understand how contracts will be enforced or how local and national policies apply to foreign firms, you may fail. Administrative distance can cause some challenges for U.S. firms in industrialized nations like France (which relies on a different legal system than the United States and the United Kingdom), but it can become bewildering in many emerging and third-world mar- kets, where regulations and laws may be applied capriciously.

Low administrative distance can increase the rate of entry by foreign firms into a country by as much as 300 percent.31 Administrative distance is low among countries that: (1) use the same legal system, such as the common law system used in the Anglo sphere (the United Kingdom and its former colonies, including the United States, Canada, Australia, and India);

cultural distance The degree of difference between the cultures of

two nations.

administrative distance The degree of differences between the

legal and regulatory frameworks of

two nations.

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(2) used to be part of a colonizer/colony network, such as some European countries and their former African colonies; (3) use the same currency; or (4) are part of the same trading bloc, such as NAFTA in North America or the European Union.

Industries most directly affected by administrative distance are those in which govern- ments are most likely to have a stake. This includes industries that provide equipment or services critical to national security, such as providers of steel or telecommunications; those that employ large numbers of people; those that serve government directly, such as mass-transportation equipment manufacturers; those that extract natural resources; and those that produce staple goods that most people buy, such as rice in Thailand or corn in Mexico. A specific firm might also confront increased administrative distance if it com- petes head-to-head with a local champion, a local firm that government sees as important to its future, such as Airbus, the EU airplane manufacturer, or CINOOC, the Chinese oil company.

Geographic Distance At its most basic, geographic distance refers to how many miles separate two countries. Companies are more likely to succeed in nearby countries, because physical proximity low- ers both transportation and communication costs. That’s one reason most U.S. companies expand first to Canada and Mexico. Even with fast air travel and consistent, reliable con- tainer shipping, research suggests that for each 1 percent increase in the distance between countries there is a 1 percent decrease in firms selling in those countries.32 Clearly, miles still matter.

In addition to the actual physical distance between countries, however, geographic dis- tance is also influenced by how easy it is to travel between countries. For instance, firms enter countries with seaports much more frequently than they expand to landlocked nations. Companies are also more likely to enter countries with good transportation infra- structure. For most firms, geographic distance increases the cost of managing daily opera- tions and coordinating activities. Despite the availability of instant communications and video conferencing, many overseas operations require hands-on help from headquarters. When those operations are many hours away from headquarters by plane, the communica- tion and transportation costs start to add up.

Not all industries are affected the same way by geographic distance. Firms such as Google, which sell electronic products that can be transmitted to the other side of the world in fractions of a second at almost no cost don’t have to worry as much about geographic dis- tance as firms that sell heavy, bulky products like cement. Other industries that are heavily affected by geographic distance are those that sell fragile products that might be damaged in transport, or perishable products, such as fresh-cut flowers, that must be transported rapidly. Even for Google, however, the need to oversee operations means that the company must set up local offices in some countries, such as Russia, because the product still needs to be localized (if only for language and currency reasons) and constant travel from Califor- nia is too unwieldy.

Economic Distance Economic distance refers primarily to differences in the average income of customers in two countries, usually measured as per capita GDP (Gross Domestic Product). Firms from wealthy nations tend to expand to other wealthy nations because the customers there earn enough income to buy similar products. This is clearly true for expensive products such as cars or home appliances but is also true of a wide variety of products including ones that wealthier customers tend to think of as inexpensive, such as laundry detergent or snack food (see the Strategy in Practice for an example).

The industries most affected by economic distance are those for which the demand for products is very elastic—meaning demand changes dramatically as prices go up or down. In these types of industries, demand is significantly affected by customers’ purchasing power and the ability of producers to lower prices.

geographic distance The distance in miles, or kilometers, between

two countries.

economic distance The degree of difference between the average

income of people in two different

countries.

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How Coca-Cola Manages Economic Distance in Ghana S T R AT E G Y I N P R A C T I C E

You can find Coca-Cola products in pricey restaurants in Tokyo as well as in the poorest urban areas in Africa. How does Coca-Cola manage the economic distance? In

the United States in 2012, the average income per person

adjusted for differences in currency exchange rates, or GDP

per capita PPP (purchasing power parity in economic terms),

was around $51,749/year, or $142/day.33 In Ghana, it was

$2014/year, or $5.52/day,34 and that number included the

wealthy. More than 28 percent of the population in Ghana

lived on less than $2.00 a day.35 Coca-Cola can easily sell its

products to someone earning $142/day but how does it reach

those making $2.00/day? The answer is to lower its prices to

a point that even many of the poor can afford it.

The actual ingredients in Coca-Cola are typically

inexpensive. What are relatively expensive are the cans and

bottles and the distribution of the product. To keep these

prices in check, Coca-Cola uses an innovative distribution

model for the poorest urban areas in Ghana in East Africa.

Although it uses more traditional bottling and distribution

in wealthier areas of the country, Coca-Cola sells daily

franchise rights to small-scale entrepreneurs in the poor

urban areas. These entrepreneurs pay a modest deposit fee

to take possession of a crate of Coca-Cola products in glass

bottles at the bottling plant.

Using their own bicycles or small carts, these

entrepreneurs then sell the products on street corners or

from small roadside stands throughout the city. Customers

drink the product on the spot so that the entrepreneur can

return the empty bottles, along with a portion of the profits,

to Coca-Cola at the end of the day. This approach eliminates

distribution costs and significantly limits the cost of the

bottles by reusing them, thus lowering Coca-Cola’s costs to

a point where price can match the purchasing power of poor

customers.

HOW FIRMS COMPETE INTERNATIONALLY

As companies expand internationally, they often fi nd themselves torn by two competing pressures.36 Th e fi rst pressure is toward local responsiveness, the need to tailor their prod- ucts, marketing, and distribution strategies to the local customers in a foreign country. For instance, Coca-Cola isn’t the same in every country. In fact, Coca-Cola demonstrates its responsiveness by manufacturing dozens of varieties of cola—all under the same brand name—to suit local tastes. As mentioned in the Strategy in Practice, Coca-Cola also changes its distribution method to fi t local markets.

However, adapting products and operations to fi t local circumstances isn’t cheap. In gen- eral, the more a company tailors a product or service to a local market, the higher the cost. Higher costs are risky, because, all else being equal, companies with lower costs can beat their competition through lower prices. When fi rms begin to compete on a global stage, the number of rivals can increase dramatically, putting intense pressure on fi rms to cut costs. Furthermore, many fi rms expand internationally in order to increase effi ciency and to lower costs. Firms achieve economies of scale by standardizing their products, or producing them without variations. Th us, fi rms have two competing pressures they must address: local responsiveness and cost reduction, which typically comes through standardization, either of products or processes—otherwise known as global integration.

Th ere are three primary strategies fi rms can use to do business internationally:

1. Multidomestic strategy—emphasizes local responsiveness over standardization

2. Global strategy—emphasizes global standardization and economies of scale over local responsiveness

3. Arbitrage strategy—takes advantage of country-comparative advantages—sources of low cost (e.g., cheap labor) or unique resources (e.g., skilled workers)

local responsiveness A firm’s adjustments to products, services,

and processes in order to account

for local culture and needs.

standardization Making products and/or processes consistent across

different units within a firm and/or

across different countries the firm

operates in.

global integration The standardization of processes within

a single business in different

locations around the world.

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The first two strategies deal directly with the tug-of-war between local responsiveness and cost-reducing standardization differently as illustrated in Figure 9.4. The third strat- egy, arbitrage, can focus on either local responsiveness or standardization, but does so from a position of taking advantage of country differences rather than trying to over- come them.

Each strategy is appropriate for a different set of industry dynamics and firm capabili- ties. We’ll discuss each in turn as well as discussing combining strategies. The three primary strategies are not mutually exclusive. Some firms are successful at pursuing two at the same time, although it becomes increasingly complicated to manage operations and maintain strategic focus when doing so. At the end of the chapter we’ll introduce a tool for determin- ing which strategy is best for any given firm.

Multidomestic Strategy—Adapt to Fit the Local Market The multidomestic strategy centers on tailoring products and operations to individual markets.37 Firms in industries where customer needs and preferences vary widely from country to country, such as food or media often use this strategy. By tailoring their prod- ucts and services to better meet the needs of local customers, firms can maximize their responsiveness to local customers, increasing their sales and market share in each coun- try. They usually succeed through a differentiation strategy rather than a cost leadership strategy.

As firms enter more countries and the differences between the home country and each foreign country increase, firms must expand the degree of tailoring, or adapta- tion. Consequently, many firms that pursue a multidomestic strategy put autonomous decision-making authority into the hands of managers in charge of individual regions or countries.38

To enable such autonomous decisions, significant parts of the value chain have to be replicated in each country. For instance, each country may have a product development and design lab, manufacturing plants, and sales and distribution personnel. Replicating these different functions in each country comes at a significant cost. Not surprisingly, firms find it hard to tap into economies of scale if they are designing and producing something different in each country.

As companies decentralize their operations to be locally responsive, it also makes it dif- ficult to share valuable knowledge across the firm globally. As a consequence, firms that

multidomestic strategy A strategy involving tailoring products or

services to local markets.

[ Figure 9.4 ] International Strategies and Local Responsiveness versus Standardization

High

Low

P re

ss u

re s

fo r

st an

da rd

iz at

io n

Pressures for local responsiveness

Global strategy

Multidomestic strategy

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pursue a multidomestic strategy often fi nd it diffi cult to develop a worldwide competitive advantage. At best, they produce a series of local competitive advantages.

In most industries, fi rms fi nd a pure multidomestic strategy unworkable. Cost pressures become too intense. Th e key to successfully pursuing this strategy is to manage the variation that occurs across countries. Firms can manage variation in three major ways:

1. Focus adaptations. Some fi rms manage the variation by tightly focusing on a particular product, customer segment, or geographic area. Such highly focused fi rms still tailor

National Competitive Advantage S T R AT E G Y I N P R A C T I C E

Have you ever wondered how firms from the same country dominate their industries worldwide? For example U.S. companies Apple, Google, and Microsoft control the

worldwide industry for computer operating systems; Japanese

companies Nikon, Sony, and Olympus lead the digital camera

industry; German organizations dominate in machine tools;

and Italian firms lead in the sale of leather goods. Michael

Porter developed a tool, the Porter’s Diamond of National

Competitive Advantage, that explains how this happens.

Four factors help push organizations toward greater

innovation with those companies that innovate the most

having an advantage in international competition:

1. Factor conditions. An abundance of critical resources including skilled labor, a technologically

advanced knowledge base, easy access to capital,

and solid infrastructure provide firms with the tools

they need to innovate. Germany is known for an

educated, manufacturing-oriented workforce, giving

it an advantage in the machine tool industry.

2. Demand conditions. The more a country’s customers demand innovation, the more likely domestic firms are

going to be at the forefront of innovation. Japanese

consumers tend to be ahead of the curve in demanding

the latest in camera technology giving Japanese digital

camera firms direction in developing new products.

3. Related and supporting industries. If a country has multiple parts of the value chain co-located it is easier

to coordinate innovation, speeding up the pace. Italy

is known not just for leatherworking but leatherwork-

ing machinery, fashion, and shoes. The four industries

being co-located allows for closer coordination and

faster innovation.

4. Firm strategy, structure, and rivalry. Different types of firm structure are suited to particular types of indus-

tries. Laws governing how firms are started and how

they interact with labor have a large impact on the

international strategies that firms pursue. Rivalry also

plays a large role. While rivalry, according to the five

forces model discussed in Chapter 2 and illustrated in

Figure 9.5, tends to decrease profit, it also spurs inno-

vation. Firms that survive high levels of rivalry are usu-

ally more prepared to take on international competition.

[ Figure 9.5 ] Porter’s Diamond of National Competitive Advantage

Factor Conditions Demand Conditions

Related and Supporting

Industries

Firm Strategy, Structure,

and Rivalry

Source: Adapted from Michael E. Porter, Th e Competitive Advantage of Nations

(New York: Free Press, 1990).

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their products, but the amount of variety they face is more manageable by maintaining a tight focus.

2. Externalize adaptations. Some firms externalize the work of adapting the prod- uct for local needs, generally by arranging for local customers to do it. Methods of externalization include franchising and alliances, which are discussed later in this chapter.

3. Design adaptability. A third method for managing the costs of localization involves designing a product so that it can be adapted while still maintaining some economies of scale. Some companies design for cheap adaptation by investing in flexible manu- facturing that reduces the costs of short manufacturing runs. Others modularize their product, creating a set of standard interfaces that allow many different types of alter- natives to plug into one another. For example, appliance manufacturers such as GE and LG offer a variety of refrigerators, with different sizes, different number of doors, and other features, but all their different refrigerators are designed to share a com- mon set of core components. This allows some economies of scale while still adapting refrigerators to local tastes.

Global Strategy—Aggregate and Standardize to Gain Economies of Scale A global strategy centers on capturing the efficiencies that can come with expanding over- seas, particularly economies of scale, learning, and leveraging firm capabilities. Most firms that pursue a global strategy standardize their products, marketing, and operational prac- tices, and aggregate, or centralize, them in only a few locations, to achieve economies of scale.39 Individual country-level units are tasked mostly with implementing decisions made at a central headquarters40 and the firm uses the same strategy in most, if not every, country where it competes.

The most extreme versions of a global strategy might have all functions located in the same place, with country units overseeing only local sales. For example, consumer elec- tronics giant Panasonic was long known for doing virtually all of its research and develop- ment, product design, and manufacturing of its TVs, VCRs, and DVD players in Japan. It then shipped its standardized products around the globe. In theory, a firm could do all of its manufacturing in a single factory and then ship products around the world. In practice, many global firms have factories producing the same product on multiple continents in order to reduce transportation costs and manage risk. Moreover, when factories in differ- ent locations are producing the same products, they are more likely to share best practices, helping firms accelerate down the learning curve.

A global strategy is typically a low-cost strategy, with low costs achieved through econo- mies of scale. However, it can also be used effectively as a differentiation strategy that the company applies in the same way, to the same customer segment, worldwide. Apple is a great example of a firm that standardizes its products to achieve economies of scale but differentiates them from other smart phones, computers, or tablets in order to increase the price customers are willing to pay for them. Firms that pursue a global strategy tend to enter countries that have a large, ready-made market for their products. They also tend to be in industries where cost pressures are high and standardized products can meet relatively universal needs. For instance, semiconductor chips for use in computers and smart phones are used in more or less the same way worldwide, enabling Intel and ARM to design and sell very standardized products.

The downside of a global strategy, however, is that standardized products may not meet the needs of customers in particular countries. As a consequence, global firms may not be able to compete in as many markets as multidomestic firms, and they may not be able to penetrate those markets as deeply.41 Another disadvantage is that, although global firms share knowledge between units with greater ease than multidomestic firms do, a global firm generates less knowledge overall, because it isn’t as actively trying to meet a wider variety of customer needs. So, in the short term, global firms may miss sales by not being responsive and in the long term they may miss changes in local market conditions.

global strategy A strategy involving selling standardized products,

using standardized processes,

around the world.

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However, just as there are ways to manage the cost of variation in multidomestic fi rms, there are also methods for dealing with excessive centralization and standardization in global fi rms. First, a fi rm need not centralize all parts of the value chain. Th e greatest cost savings from economies of scale often occur in R&D and manufacturing. A global fi rm can centralize some functions while localizing others in order to penetrate local markets more fully. For instance, in the 1980s and 1990s, the household appliance manu- facturer Whirlpool pursued component manufacturing and R&D primarily on a global scale, but carried out product design, fi nal assembly, marketing, and sales at regional and local levels.

Arbitrage Strategy An arbitrage strategy is the third of the three primary international strategies. While the other two strategies view foreign markets as sales opportunities with the need to minimize diff erences between countries, the essence of arbitrage is taking advantage of those diff er- ences. Arbitrage, at its simplest, is defi ned as buying and selling in diff erent markets to take advantage of diff erences in prices between them.

arbitrage strategy A strategy involving buying where costs are

low and selling where they are

high.

In recent years, numerous news reports have emerged detailing the exploitation of low-cost labor in foreign countries. China Labor Watch, a nonprofit working to

raise awareness of worker exploitation issues in China,

found that suppliers of Mattel, the U.S. toy maker,

exploited lax enforcement of labor laws in order to keep

its costs low.42

Mistreatment of workers included:

Requiring excessive overtime work per month, frequently

two to three times the legal limit without extra pay.

Failing to pay into employee social insurance funds,

such as retirement funds.

Delaying payment of workers by as much as a month

at a time. Some companies in China have even

intermittently refused to pay workers a week’s and even

a month’s pay and fired them if they complained.

Assessing workers large fines for small infractions of

company rules. For instance, answering a cell phone

even once can cost a worker a day’s wages.

Not providing protective safety equipment even for

workers working with harmful chemicals or dangerous

machinery.

Disposing of toxic waste in dangerous and improper ways.

Such abuses are common across a wide range of

industries, and not just in China but also in many low-wage

countries. Indeed, in one case in Bangladesh, over 1,100

workers were killed when an eight-story building housing

multiple garment factories collapsed. The factories had not

installed appropriate safety measures. Many companies,

including Nike, Apple, and Walmart, have been accused of

exploiting workers in foreign countries.43

Economic arbitrage, in and of itself, is not necessarily

unethical. In many cases, foreign firms pay better than

average wages and bring improved safety and labor

practices to their factories and their supplier’s factories.44

However, when many firms in the same industry are

seeking a cost advantage by utilizing an arbitrage strategy,

the pressure to decrease costs can be immense, and

firms have to be vigilant that workers aren’t exploited. To

that end, companies like Nike and Apple have developed

a supplier code of conduct, which they use to audit their

overseas suppliers.45 While this doesn’t always work,

suppliers sometimes find ways around the audits;46 it

does decrease the incidence of unethical exploitation of

workers.47

E T H I C S A N D S T R AT E G Y

Is Economic Arbitrage Ethical? Won’t It Lead to Worker Exploitation?

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It can involve economic, cultural, administrative, or capital arbitrage. One of the most common modern forms of arbitrage is also one of the basic reasons firms expand interna- tionally, to find the lowest-cost source of labor or raw materials. This is called economic arbitrage, and it often involves offshoring manufacturing or R&D to countries with low labor costs. However, some firms also practice capital arbitrage. For instance CEMEX, a Mexican cement manufacturer, operates plants in Spain so that it can raise capital in the European Union, where interest rates are often lower than they are in Mexico.

Not all arbitrage involves sourcing low-cost resources, however. Some forms of arbitrage take advantage of differences between countries to sell products. Cultural arbitrage trades on the culture of one nation to sell in another. U.S.-based fast-food restaurant chains are popular worldwide partly because they embody U.S. culture. Likewise, for centuries the French were able to sell wine at a premium price because it came from France. Some firms also utilize what is known as administrative arbitrage, taking advantage of differences between countries that are created by laws and government regulations. Many companies incorporate in the Cayman Islands because of low corporate tax rates. Likewise, nearly one- third of all foreign capital flowing into China actually originates in China, but the inves- tors process their financial transactions through Hong Kong in order to avoid government regulation.

Combining International Strategies As many industries have become increasingly global, the pressures for both local respon- siveness and the efficiency that comes from standardization have become more intense. Some companies try to use a hybrid of the multidomestic and global strategy in order to be glocal. These firms typically begin with a strong emphasis in a single strategy and then work to minimize the downsides associated with that strategy as much as possible as they begin to implement the second strategy. As shown in Figure 9.6, competing with both a multidomestic and a global strategy, in order to achieve both local responsiveness and standardization, is often called a transnational strategy.48 Strategy combinations, of course, can also include multidomestic and arbitrage strategies or global and arbitrage strategies as well.

Procter & Gamble (P&G) is an example of a firm that started with a strong position in a multidomestic strategy and then added a global one. When P&G first expanded internation- ally, it replicated its operations in each country where it competed. However, beginning in the 1980s, P&G began to balance adaptation with a greater focus on centralized decision

economic arbitrage Capitalizing on differences in costs by buying

where costs are low and selling

where prices are high. This is the

traditional, age-old, definition of

arbitrage.

capital arbitrage Capitalizing on differences in the cost of capital by

acquiring capital where it is less

expensive.

cultural arbitrage Capitalizing on differences in culture between

countries by actively using the

culture of one country as a selling

point for products being marketed

in another country.

administrative arbitrage Capitalizing on differences in taxes, regulations,

and laws between countries by

operating where they are the lower

or more lax.

transnational strategy A strategy involving a combination

of both local responsiveness and

standardization.

[ Figure 9.6 ] International Strategies and Local Responsiveness versus Standardization

High

Low

P re

ss u

re s

fo r

st an

da rd

iz at

io n

Pressures for local responsiveness

Global strategy

Multidomestic strategy

Transnational Strategy

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making to allow for greater economies of scale across countries. It established global busi- ness units (GBUs), one for each major product category, which operated concurrently with the traditional country units using the IT systems to tie the two types of organizations together. They also required executive career paths to include both organizations. Although it took more than a decade, P&G succeeded in gaining some of the benefits of a global strat- egy without losing its multidomestic focus.

At the end of this chapter we present a tool, the international strategy triangle, that can help you assess the international strategies that firms currently pursue or help you deter- mine which international strategy a firm should pursue if it is considering doing business overseas.

HOW A FIRM GETS INTO A COUNTRY: MODES OF ENTRY

In this final section, we discuss four different modes of international market entry: (1) exporting, (2) licensing and franchising, (3) joint ventures and alliances, and (4) wholly owned subsidiaries. Entering foreign markets can be very risky. There are pros and cons to each entry mode. The best method for a firm is often based on which international strategy the firm has chosen: global, multidomestic, or arbitrage. We will look at each mode in turn, starting with those that involve the least risk and least control and moving to those with the most risk and most control.

Exporting Exporting involves producing goods in a single location and selling them in foreign mar- kets. 49 Although most exporting happens from a home country, firms can also use it with an arbitrage strategy by producing in a low-cost location and exporting to other countries from there. Exporting is the first entry mode most companies choose when they decide to go international.50 Exporting allows a firm to ramp up production in a single location, thereby increasing economies of scale. Exporting is how Honda captured a dominant position in the worldwide motorcycle industry. It is how Samsung is keeping pace with Apple in the smart- phone and tablet computer industries.

Exporting works well when little adaptation of a product is required and good distribution networks are in place in the foreign market. It is also the least risky of the entry modes, as it involves the least investment in the foreign country. If cultural or administrative distance is large, exporting might be the right decision, because you avoid the challenges of managing a culturally different workforce in a foreign country. It is also a good choice if speed to market is important, as products can be shipped and sold in foreign markets quickly.

Of course, exporting also has its limitations. Transportation costs and government trade tariffs can both increase the cost of selling in a foreign market. Your company and its prod- ucts will likely be viewed as “foreign,” which can be a problem in some countries. Exports also may suffer if the value of the home nation’s currency rises compared to the currency of target foreign markets.51 As the exchange rate fluctuates, so does the price of a firm’s prod- uct in the foreign market. For instance, in 2007, one U.S. dollar cost 121 Japanese yen. By 2012, the dollar was trading for only 77 yen.52 A product manufactured in Japan and sold in the United States for $100 brought the Japanese company 12,100 yen in 2007, but only 7700 yen in 2012. Although firms can try to cut costs to compensate for such involuntary price changes, exporters are often at the mercy of exchange rates.

Licensing and Franchising Licensing and franchising both involve selling the rights to produce a firm’s products or services.52 The licensee or franchisee typically pays a negotiated fee (usually 5 to 10 percent) as a royalty, based on the number of units sold. As described in Chapter 8, Disney received royalties from the Oriental Land Company on revenues derived from Tokyo Disneyland.

modes of international market entry Methods for entering a foreign market for the purposes of

either selling or producing products

or services.

exporting Sending goods or services to another country for

sale.

licensing Granting another business the permission to use or

sell a firm’s product, technology,

or process.

franchising A license that allows a person or firm access to a

business’s proprietary knowledge,

processes, or trademarks in order

to allow them to sell a product or

service under the business’s name.

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Franchising is a special form of licensing with a longer-term commitment, the use of the brand name, and more often involves a transfer of firm knowledge and business processes. In addition to negotiating a contract concerning royalty payments, firms that franchise usu- ally impose strict rules on franchisees concerning how the business is operated and mar- keted, and provide them with ongoing support and oversight.

Licensing and franchising are good entry modes for firms that have unique know-how or a solid brand that can be easily valued (so the price of the license or franchise can be nego- tiated), but do not have the capital or resources and capabilities to expand abroad them- selves. Because they only involve the transfer of knowledge, rather than building operations in a foreign country, these two modes of entry require less investment and are often among the faster ways to earn a profit in foreign markets. The lower risk and speed of entry make these attractive entry choices when the risk is otherwise high due to large distances (any of the four distances) between countries.

As with each mode of entry, there are downsides to licensing and franchising. First, they offer the least amount of control of all the various modes of entry.53 Firms may try to include contractual safeguards, but the firm that buys the license or franchise is ultimately in charge of manufacturing and marketing. Sometimes the licensee or franchisee does not invest enough in the business to maintain quality and build a strong brand. Lack of control also can make it hard to tap into local knowledge and innovation. Moreover, any knowledge being generated from the foreign operations belongs to the licensee or franchisee. Extract- ing that knowledge for use in other locations can be problematic.

Finally, there is a risk that the firm licensing the product or service can become a com- petitor. If you let others manufacture your product or operate your business model, they are going to gain critical capabilities in your business. RCA, a U.S.-based manufacturer of color televisions, met its death this way. It licensed its technology to Japanese firms in the 1970s, only to have them enter the U.S. market soon after their licenses expired and put RCA out of the television business.

Alliances and Joint Ventures Alliances (discussed in detail in Chapter 8) involve sharing resources, risks, and rewards.54 They are an increasingly favored way to enter markets that are distant (i.e., more risky) from the home market.55 Following its initial international failures, Lincoln Electric now usually forms a joint venture, a type of alliance, with a local partner when it enters a country with high administrative distance from the United States.

Many companies use alliances to access complementary assets.56 For instance, a com- mon way to enter a distant, foreign market is to create an alliance with a local company who knows what consumers want and knows how to navigate local government regulations and distribution channels. An alliance with a local firm also mitigates some of the foreignness of the entering firm, allowing the alliance to be perceived by both government and consumers as local. Sometimes this is the only way to enter a market. For instance, until recently, in many industries India did not allow foreign retailers to enter the country unless they part- nered with a local firm.

A joint venture is a special form of alliance involving the joint creation of a new firm. Most joint ventures involve a 50/50 share of ownership; each company puts in 50 percent of the value and gets 50 percent of the rewards. If the venture doesn’t work, the home-country firm only loses half the overall investment in the joint venture.

Although alliances allow faster and less risky access to new markets than wholly owned subsidiaries (discussed next), they also present significant management challenges. Over- coming cultural and linguistic barriers to bring together teams of managers from both companies increases the difficulty of operations. Each party in the alliance may also hold different strategic goals. These challenges cause many alliances to fail. Moreover, as with licensing, the lack of tight control can create serious problems by allowing the partner firm to develop resources and capabilities that enable it to become a competitor. Indeed, the Chinese government forces foreign firms in strategic industries to form joint ventures with Chinese firms for the explicit purpose of learning their technology in order to compete against them.

alliances An agreement between two businesses to cooperate on

a mutually beneficial project. It

usually involves the sharing of

resources and/or knowledge.

complementary assets Assets owned by another company that

are needed in order to successfully

commercialize and market a

product or service.

joint venture An alliance between firms involving the creation of

a new entity where both firms

provide assets and/or knowledge,

processes or technology.

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Wholly Owned Subsidiaries Wholly owned subsidiaries are local units owned outright by the entering firm. This type of entry requires the most investment and creates the most risk, as the firm has to put up all of the capital itself. Wholly owned subsidiaries can, however, overcome trade and transpor- tation barriers by producing locally. They may also allow a foreign firm to appear more local to host-country governments and consumers.

In addition, this mode offers the firm the most control over what its local subsidiary does. Many high-tech firms form wholly owned subsidiaries as a way to control access to their technology and avoid leaking it to a licensee or partner. A wholly owned approach gives firms that use a combination of international strategies sufficient control to realize economies of scale. For example, wholly owned entry can allow a firm enough control to coordinate a worldwide value chain with key elements of the value chain located in the lowest-cost location to gain an arbitrage advantage. Such a firm might manufacture all of a certain type of component in one location in order to gain economies of scale, and then ship the components from one location to another for assembly.

There are two ways of entering with wholly owned subsidiaries: (1) a greenfield invest- ment, in which the firm builds operations from scratch; or (2) acquiring a local firm. Greenfield investments give the firm the greatest amount of control, because they build the operations, marketing, and distribution from the ground up. However, they are also the slowest entry mode, as it takes time to build capabilities. Moreover, although the firm main- tains tight control over its own technology and processes, it also has to learn about the local market and government regulations on its own. As Lincoln Electric learned in Japan, the learning process can take a while and sometimes leads to failure.

Acquisitions involve buying local firms. Such a purchase allows the entering firm to acquire local resources, knowledge, and expertise while still maintaining control through 100 percent ownership. However, acquisitions typically involve paying a price premium and they can also be notoriously difficult to integrate into the rest of the firm’s worldwide opera- tions. Merging two firms is difficult enough within the same country. Cultural differences com- plicate the process considerably, often resulting in a slower integration process and a higher risk of failure.57 Table 9.2 summarizes some of the key differences among the modes of entry.

Choosing a Mode of Entry The choice of which mode to use is based on the firm’s situation, including its access to capital and need for local resources or capabilities, as well as the firm’s primary interna- tional strategy. Global strategies require more control, moving firms toward exporting and wholly owned subsidiaries, whereas multidomestic strategies encourage local innovation, which could involve joint ventures, franchising, or autonomous wholly owned subsidiaries.

wholly owned subsidiary A unit in a foreign country that is wholly

owned by the parent company.

greenfield investment A wholly owned subsidiary where the firm

involved builds the facility from the

ground up.

[ Table 9.2 ] Entry Modes

Exporting Licensing/ Franchising

Alliance/ Joint Venture

Wholly Owned Subsidiary

Investment required Low Low Medium High

Level of risk Low Low Medium High

Overcome trade barriers? No Yes Yes Yes

Speed of entry Fast Fast Medium Slow (faster for

acquisition than

greenfield)

Acquire local resources, including

knowledge?

No No Yes Yes

Viewed as insider or outsider? Outsider Insider Possibly insider Possibly insider

Degree of control Low Low Medium High

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Arbitrage strategies require ownership, suggesting that exporting and licensing/franchising will not be good choices.

The choice of which mode to use is also based on a firm’s international experience. Most firms start their international expansion by first exporting, or selling to target country wholesalers. Firms may then move to joint ventures, and finally to wholly owned subsidiar- ies as they become more comfortable managing operations in the foreign market. Figure 9.7 highlights this effect of learning over time in a more nuanced fashion. It shows the typical paths followed by firms who first enter a foreign market through exporting, licensing, or franchising. The beginning points for most firms are on the left with most firms moving toward the right as they gain experience.

SUMMARY

This trend toward increased international trade has allowed organizations to place parts of their value chains in different countries, depending on where each part can generate the most value.

Firms expand internationally for many reasons, the most important of which are growth, efficiency, managing risk, gaining access to more knowledge and responding to custom- ers and/or competitors.

There are four types of distance—cultural, administrative, geographic, and economic (CAGE)—that firms should keep in mind when entering a particular country. The shorter the overall distance, the greater the likelihood of success.

There are three types of international strategy—multidomestic, global, and arbitrage.

Exporting, licensing/franchising, alliances/joint ventures, and wholly owned subsidiaries are four different ways of entering a country.

KEY TERMS

administrative arbitrage

(p. 183) administrative distance

(p. 177) alliances (p. 186)

arbitrage strategy (p. 183) capital arbitrage (p. 183) complementary assets

(p. 186) cultural arbitrage (p. 183)

cultural distance (p. 177) economic arbitrage

(p. 183) economic distance

(p. 178)

[ Figure 9.7 ] Experience and Entry Modes

Franchising

Licensing

Exporting

Joint Venture

W h

o ll

y O

w n

e d

(G re

e n

fi e

ld ,

A c q

u is

it io

n )

Time

Risk

C o

n tr

o l

Source: Adapted from F. R. Root, Entry Strategies for International Markets (San Francisco: Jossey-Bass,

1994), p. 18.

APPLICATION EXERCISES [ 189 ]

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exporting (p. 185) foreign direct investment

(p. 171) franchising (p. 185) geographic distance

(p. 178) global integration

(p. 179) globalization (p. 173) global strategy (p. 182)

greenfield investment

(p. 187) joint venture (p. 186) licensing (p. 185) local responsiveness

(p. 179) modes of international

market entry (p. 185) multidomestic strategy

(p. 180)

multinational firms

(p. 172) product’s life cycle

(p. 174) standardization

(p. 179) transnational strategy

(p. 184) wholly owned subsidiary

(p. 187)

REVIEW QUESTIONS

1. What are the five main reasons that firms expand into international markets?

2. Describe the four types of distance that firms should consider when choosing which for- eign markets to enter. What factors help managers determine which type of distance is most likely to affect the success of an international expansion?

3. Describe the three primary international strategies.

4. Describe the concepts of local responsiveness and standardization. Determine which international strategy is best suited to each pressure and explain why.

5. Describe the ways that managers can help keep multidomestic strategies from becoming too costly and global strategies from failing to meet local needs.

6. Explain the international strategy triangle and list the steps to construct one.

7. Explain how you would you use the international strategy triangle to identify which inter- national strategy a firm should use. Explain how you would use it to evaluate the strate- gies of firms that already gone international.

8. What is a mode of entry? Describe the four main types of entry modes.

9. Which type of entry mode is most appropriate for each of the primary international strategies? List the factors that firms using each primary strategy should consider when choosing an entry mode.

APPLICATION EXERCISES

Exercise 1: Use the four types of distance to evaluate the likelihood of a successful for- eign expansion effort (choose one of the following or the one that your professor has assigned):

a. Choose a firm that has not yet expanded internationally. Choose a market for the firm to enter. Use the four types of distance to evaluate the firm’s likelihood of successfully entering that market.

b. Choose a firm that has already expanded internationally. For one or more of the firm’s markets, measure all four types of distance between the firm’s home country and the country entered. Evaluate the degree to which distance played a role in the success or failure of the expansion. Which type of distance mattered the most? Why?

c. Read the Samsung case. Use the case, along with data you gather from outside sources, to measure the distance, using all four types of distance, between each company’s home (South Korea for Samsung, the Netherlands for Philips, and Japan for Panasonic) and a target expansion country of your choice. Based on your measurements, which firm is most likely to succeed in entering the country? Why?

Exercise 2: Develop and interpret an International Strategy Triangle (choose one of the following or the one that your professor has assigned):

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a. For the industry of your choice, determine the correct measures for each axis, and find the median and 90th percentile points for the industry. Pick the top three competitors and draw their triangles. What do your results say about the strategy of each firm and its competitive advantage?

b. Use data from the Samsung case. Draw the triangles for Philips and Panasonic (there is insufficient data for Samsung and Sony) on Figure 9.9 (a generic international strategy triangle). Create triangles for 1960 (estimating the points on the axes from the descriptions of the firms in the case) and 2010 (use 2005 data for Panasonic’s advertising expenses). What do your results say about the international strategy that each firm has pursued? What do they say about the firms’ efforts to adapt to changing conditions? Which firm is succeeding?

Exercise 3: Determine the appropriate mode of entry (choose one of the following or the one that your professor has assigned):

a. Choose a firm that has not yet expanded internationally. Choose a market for the firm to enter. Determine which mode of entry is the right one for the firm to use. Justify your choice.

b. Choose a firm that has already expanded internationally. Choose one foreign market that the firm entered. Determine which mode of entry it used. Given the firm’s international strategy, evaluate whether it used the right mode of entry.

c. Use the Samsung case. Assume that none of the three firms has entered any African markets. Given their respective strategies, determine which mode of entry each firm should use to enter the African market of your choice. Justify your decision.

Professor Pankaj Ghemawat has developed a tool for assessing the international strategy of firms, the international

strategy triangle—or the AAA triangle, as Ghemawat labels

it—AAA for adaptation (multidomestic strategy), aggregation

(global strategy), and arbitrage. The triangle can be a helpful

tool for determining which international strategy a company

should pursue. It can also help a firm assess the current

strategic positions of competitors.

The international strategy triangle plots the strengths

of a firm and its primary competitors along three axes,

each axis corresponding to one of the primary strategies:

multidomestic, global, or arbitrage. Figure 9.8 shows an

international strategy triangle for the major competitors in

the medical diagnostic imaging industry: Philips, GE, and

Siemens. The farther along an axis a company ranks, the

more the company should follow that strategy. One point of

Philips’s triangle, for example, is quite far toward the end of

the multidomestic axis, while the other two points are closer

toward the center of the global and arbitrage axes. This

indicates that Philips should pursue, if it doesn’t already,

a multidomestic strategy. The two corners of GE’s triangle

that are farthest from the center are along the global and

arbitrage axes, suggesting that GE might be pursuing a

two-pronged approach combining a global strategy with an

arbitrage strategy. Siemens’s triangle suggests that its most

promising strategy might be a global strategy.

Strategy Tool The International Strategy Triangle—Determining Which Strategy to Use

Global

Arbitrage

Phillips

Siemens

Multidomestic

[ Figure 9.8 ] International Strategy Triangle—Medical Diagnostic Imaging Industry

Source: Adapted from P. Ghemawat, Redefining Global Strategy

(Cambridge: Harvard Business School Press, 2007).

STRATEGY TOOL [ 191 ]

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How are the firm’s places along each axis calculated? The

measures you use for the three axes depend on the type of

industry you are analyzing. For many industries, the following

ratios of costs as percentages of sales are good measures:

Multidomestic axis—Ratio of advertising costs to sales

Global axis—Ratio of R&D costs to sales

Arbitrage axis—Ratio of labor costs to sales

Other measures are possible, depending on a company’s

goals. These could include the following:

Multidomestic axis—Percentage of local employees

in country-level management positions or rate of new

product development at the country level

Global axis—System integration across countries,

standardization of business practices, or the per-

centage of revenue from customers that is global in

nature

Arbitrage axis—Percentage of back-office activities

(labor other than manufacturing labor) that are off-

shored to low-cost countries

Once you have determined the appropriate measures for

the axes, you’ll need to obtain information to help you plot

two points along each axis:

1. The median of the industry you are analyzing

2. The 90th percentile of the industry you are analyzing— the point below which 90 percent of the firms in the

industry rank on that particular measure

To find the median and 90th percentile points, you will

need to get information on a variety of firms in your industry,

particularly the most important firms, such as those with the

most market share or the most recognized brand names.

The appendix at the end of the book contains extensive

information on how to obtain such information.

Figure 9.9 shows an international strategy triangle for

a generic industry. The median and 90th percentile points

are connected, highlighting two triangles, to help you

visualize how you might construct your international strategy

triangle. As an illustration, in this generic triangle, the

median ratio of labor costs to sales, the bottom axis, is 20

percent, and the 90th percentile is 50 percent—meaning that

90 percent of firms in the generic industry have a labor to

sales percentage of less than 50 percent. When you use the

triangle, the median and 90th percentile points—as well as

the measures you use on each axis—should be customized

to the industry that you analyze.

This tool can be very helpful in determining what

international strategy a firm should use. If a firm ranks

at any point beyond the median along any axis, managers

should consider pursuing that strategy. If a firm ranks

beyond the 90th percentile it is critical that a firm consider

that strategy.

It is also useful to plot a firm’s biggest rivals. This can

tell you a lot about the dynamics of competition in the

industry, including who is likely to win and who is likely to

lose. For example, refer back to the international strategy

triangle for the Medical Diagnostic Imaging Industry in

Figure 9.8. Although Siemens’s triangle suggests that it

pursues a global strategy, notice that Siemens does not rank

as strongly on the global axis as GE does. This suggests

that, unless things change, Siemens might be at a cost

disadvantage to GE, losing sales on price.

The triangle also suggests that Siemens would also likely

lose sales to Philips, who is better at meeting local needs, as

indicated by the firms’ positions on the multidomestic axis.

Furthermore, this triangle also shows that Philips, although

the most adapted, is likely to have the highest cost structure.

Although GE does not have Philips’s strengths for adapting

to local needs, GE might nonetheless be able to meet a good

portion of local demand at a much lower price, enough so

that Philips can’t count on maintaining market share, even

though it may meet local needs better.

The steps in using the international strategy triangle are

summarized as follows:

1. Determine the appropriate measures to use for the three axes. For many manufacturing industries, these

measures will be:

Multidomestic axis—Advertising to sales

Global axis—R&D to sales

Arbitrage axis—Labor to sales

2. Plot the median and 90th percentiles for the industry as a whole on each axis. You will do this by gathering data

on the measure for each axis from the most important

Global R&D-to-sales

Arbitrage Labor-to-sales

100%

80%

60%

40%

20%

2% 2% 4% 4%

6% 6%

8% 8%

10% 10%

90th percentile

Median

Multidomestic Advertising to sales

[ Figure 9.9 ] Generic International Strategy Triangle

Source: Adapted from P. Ghemawat, Redefining Global Strategy (Cambridge:

Harvard Business School Press, 2007).

[ 192 ] CH09 INTERNATIONAL STRATEGY

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REFERENCES

1 http://www.lincolnelectric.com/en-us/company/pages/lincoln-worldwide.aspx.

2 J. F. Lincoln, Incentive Management (Cleveland: The Lincoln Electric Company, 1951), pp. 7–11.

3 W. Irrgang, “The Lincoln Incentive Management Program,” Lincoln Lecture Series, Arizona State University,

1972, p. 13.

4 N. Berg, The Lincoln Electric Company (Cambridge, MA: Harvard Business School, 1983), p. 7.

5 Lincoln Electric’s expansion experience is recounted in D. F. Hastings, “Lincoln Electric’s Harsh Lessons from

International Expansion,” Harvard Business Review (May–June 1999,).

6 World Trade Organization, International Trade Statistics, 2012 (Geneva, WTO, 2012); United Nations, Network of

World Merchandise Trade by Region, 2010–2012 Table A2.

7 World Trade Organization, International Trade Statistics, 2012 (Geneva, WTO, 2012); United Nations, World

Investment Report, 2012.

8 A. Chakrabarti, “The Determinants of Foreign Direct Investment: Sensitivity Analyses of Cross-Country Regres-

sions,” Kyklos 54(1) (2001): 89–114.

9 World Trade Organization, International Trade Statistics, 2012 (Geneva, WTO, 2012); United Nations, Trade in

Commercial Services by Selected Groups of Economies, 2002–2012 Table A9.

10 T. Levitt, “The Globalization of Markets,” Harvard Business Review (May–June 1983,): 92–102.

11 International Trade Association, U.S. Exporters in 2011: A Statistical Overview.

12 P. Dicken, Global Shift (New York: Guilford Press, 1992).

13 Y. Luo and R. L. Tung, “International Expansion of Emerging Market Enterprises: A Springboard Perspective,”

Journal of International Business Studies 38 (2007): 481–498.

14 S. Anand, “Japan, M&A, Prescription for Growth,” Businessweek (Nov. 17, 2008), http://www.businessweek.com.

15 P. J. Buckley, L. J. Clegg, A. R. Cross, X. Liu, H. Voss, and P. Zheng, “The Determinants of Chinese Outward Foreign

Direct Investment,” Journal of International Business Studies 38 (2006): 499–518.

16 R. Vernon, “International Investment and International Trade in the Product Cycle,” Quarterly Journal of Eco-

nomics 80 (1996): 190–207.

17 S. G. Winter and G. Szulanski, “Replication as Strategy,” Organization Science 12 (6) (2001): 730–743.

18 J. F. Love, McDonald’s: Behind the Arches (New York: Bantam Books, 1995).

19 F. Jiang, “Driving Forces of International Pharmaceutical Firms’ FDI into China,” Journal of Business Research 22

(1) (2005): 21–39.

20 C. C. Y. Kwok and D. M. Reeb, “Internationalization and Firm Risk: An Upstream–Downstream Hypothesis,”

Journal of International Business Studies 31 (2000): 611–629.

21 A. K. Gupta and P. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management

Journal 21 (2000): 473–496.

22 D. B. Montgomery, G. S. Yip, and B. Villalonga, “Explaining Supplier Behavior on Global Account Management,”

Stanford Research Paper No. 1767 (Nov. 2002). Available at SSRN: http://ssrn.com/abstract=355240.

23 G. Hamel and C. K. Prahalad, “Do You Really Have a Global Strategy?” Harvard Business Review ( July–August

1985): 139–148.

24 P. Ghemawat, Redefining Global Strategy (Cambridge: Harvard Business School Press, 2007).

25 Ibid.

26 D. Xu and O. Shenkar 2004, “Institutional Distance and the Multinational Enterprise,” Academy of Management

Review, 27: 608–618.

27 Ghemawat.

28 Ibid.

firms in the industry you are examining. When you have

that data calculate the median and the 90th percentile

point, where 90 percent of the firms are below that

point. This is likely to be close to the firm who is far-

thest along the axis.

3. Plot the appropriate point on each axis for the firm you are analyzing. Draw a triangle connecting

these three dots. You might also want to carry out

this process for two or more of the firm’s major

competitors.

4. Use the shape of the triangle to help determine the appropriate international strategy for the firm being

analyzed and to understand competitive dynamics in

the firm’s industry.

http://www.lincolnelectric.com/en-us/company/pages/lincoln-worldwide.aspx

http://www.businessweek.com

http://ssrn.com/abstract=355240

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29 G. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3rd ed. (New York: McGraw-Hill,

2010).

30 D. Xu, Y. Pan, and P. W. Beamish, “The Effect of Regulative and Normative Distances on MNE Ownership and

Expatriate Strategies,” Management International Review 44 (3) (2004): 285–307.

31 Ghemawat.

32 Ibid., p. 37.

33 World Bank, 2014, GDP per capita PPP (Current International $), http://data.worldbank.org/indicator/NY.GDP.

PCAP.PP.CD, webpage accessed April 26, 2014.

34 Ibid.

35 The World Bank, Ghana, http://data.worldbank.org/country/ghana.

36 C. K. Prahalad and Y. L. Doz, The Multinational Mission: Balancing Local Demands and Global Vision (New York:

Free Press, 1987).

37 D. A. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Cheng, “The Impact of National Culture and Economic Ideol-

ogy on Managerial Work Values: A Study of The United States, Russia, Japan, and China,” Journal of International

Business Studies 39 (1) (2008): 8–26.

38 A. Ferner, P. Almond, I. Clark, T. Colling, and T. Edwards, “The Dynamics of Central Control and Subsidiary

Anatomy in the Management of Human Resources: Case Study Evidence from U.S. MNCs in the U.K.,” Organiza-

tion Studies 25 (2004): 363–392.

39 M. V. S. Kumar, “The Relationship Between Product and International Diversification: The Effects of Short-Run

Constraints and Endogeneity,” Strategic Management Journal 30(1) (2009): 99–116; P. J. Buckley, “The Impact of

the Global Factory on Economic Development,” Journal of World Business 44 (2) (2009,): 131–143.

40 H. C. Moon and M. Y. Kim, “A New Framework for Global Expansion: A Dynamic Diversification-Coordination

(DDC) Model,” Management Decision, 46 (1)(2009): 131–151.

41 D. G. McKendrick, “Global Strategy and Population Level Learning: The Case of Hard Disk Drives,” Strategic

Management Journal 22 (2001): 307–334.

42 Anonymous, “Mattel’s Unceasing Abuse of Chinese Workers: An Investigation of Six Mattel Supplier Factories,”

China Labor Watch (October 2013).

43 See, for instance, A. Shah, “Corporations and Worker’s Right,” www.globalissues.org, retrieved December 11,

2013, for an account of various industries, firms, and countries that have had issues with worker exploitation.

44 A. Harrison, “The Role of Multinationals in Economic Development: The Benefits of FDI,” The Columbia Journal

of World Business 29 (4) (1994): 6–11.

45 Anonymous, “If Companies Want to Do Business with Us, They Must Act Fairly and Ethically at All Times,” www

.apple.com, retrieved December 11, 2013.

46 C. Duhigg, “In China, Human Costs Are Built Into an iPad,” New York Times ( January 25, 2012).

47 T. Worstall, “China Labor Watch Shouts Nonsense at Apple Again,” Forbes ( July 29, 2013).

48 C. A. Bartlett and S. Ghoshal, Managing Across Borders: The Transnational Solution (Cambridge: Harvard Busi-

ness School Press, 1998).

49 C. A. Cinquetti, “Multinationals and Exports in a Large and Protected Developing Country,” Review of Interna-

tional Economics 16 (5) (2009): 904–918.

50 C. Henshaw, “Currencies Crushing Yellow Tail Wine,” The Wall Street Journal Online Edition ( January 15, 2013):

Marketplace Section.

51 Anonymous, Japan / U.S. Foreign Exchange Rates, Board of Governors of the Federal Reserve System, http://

research.stlouisfed.org/fred2/data/EXJPUS.txt.

52 A. Fosfuri, “Wholly Owned Subsidiary versus Technology Licensing in the Worldwide Chemical Industry,” Jour-

nal of International Business Studies 31 (2000): 555–572.

53 U. Lichtenthaler and H. Ernst, “Business Insight: Think Strategically about Technology Licensing,” The Wall

Street Journal (2007), R4.

54 J. S. Harrison, M. A. Hitt, R. E. Hoskisson, and R. D. Ireland, “Resource Complementarity in Business Combina-

tions: Extending the Logic to Organization Alliances,” Journal of Management, 27 (2001): 679–690.

55 H. K. Steensma, J. Q. Barden, C. Dhanaraj, M. Lyles, and L. Tihanyi, “The Evolution and Internalization of Inter-

national Joint Ventures in a Transitioning Economy,” Journal of International Business Studies, 39(3) (2008):

491–507.

56 A. C. Inkpen and A. Dinur, “Knowledge Management Processes and International Joint Ventures,” Organization

Science 9(4) (1998): 454–468.

57 S. F. S. Chen, “The Motives for International Acquisitions: Capability Procurements, Strategic Considerations,

and the Role of Ownership Structures,” Journal of International Business Studies, 39(3) (2008): 454–471;

K. E. Meyer, M. Wright, and S. Pruthi, “Institutions, Resources, and Entry Strategies in Emerging Economies,”

Strategic Management Journal 30(5) (2009): 61–80.

http://data.worldbank.org/indicator/NY.GDP

http://data.worldbank.org/country/ghana

http://www.globalissues.org

http://research.stlouisfed.org/fred2/data/EXJPUS.txt

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Innovative Strategies That Change the Nature of Competition

TRIPPLAAR KRISTOFFER/SIPA /NewscomPP

[ 195 ]

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Studying this chapter should provide you with the knowledge to:

1 Discuss innovative strategy and the differences between the types of innovation.

2 Identify the different categories of innovative strategies.

3 Describe the accelerating pace of innovation and the product, business, and industry life cycle.

L E A R N I N G O B J E C T I V E S

[ 196 ]

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I n the early 1980s, a radical, new product was introduced to

the market by Japanese companies Sony and Panasonic:

the home video player. For the first time, consumers

could purchase or rent a movie and watch it on their video

player in the comfort of their own home whenever they

wanted. Video players gave rise to video rental stores—a less

expensive alternative to buying movies. By the early 1990s,

Blockbuster had built 3,400 stores and dominated the home

video rental market.1 The company reached its peak in 2004

with close to 9,000 stores and over $6 billion in revenue.2

Blockbuster invested heavily in their stores and inventory—

each store carried more than 1,000 different movies—so that

customers could conveniently find a store and the movie

they wanted to rent. The cost of each store ranged from

$225,000 to $750,000.3

Blockbuster’s leaders quickly discovered that

Blockbuster didn’t make money from the videos sitting on

the shelves. It needed to get customers to rent the DVD and

return it as quickly as possible so Blockbuster could rent

it to another customer. To encourage customers to return

the DVD rentals quickly, Blockbuster charged late fees that

were unpopular with customers but helped Blockbuster

get the DVDs to the next customer as quickly as possible.

Blockbuster’s overall strategy worked well until Netflix

entered the movie rental business in 1997. Instead of

building stores, Netflix rented DVDs over the Internet and

shipped movies directly to the customer’s home. Rather

than charge a per-use fee, Netflix charged customers a

monthly subscription fee that allowed them to rent one to

eight movies at a time. From the customer’s perspective,

the downside of renting movies over the Internet was that it

required planning ahead—no impulse movie watching. You

couldn’t just pop down to the Blockbuster store and grab

a movie to watch. But the upside was the ability to access

90,000 movies. Netflix shipped movies from 50 strategically

located warehouses around the country to ensure that most

customers got their orders within two days.4

This business model gave customers more movie

options to choose from, and since Netflix customers paid a

monthly fee, their business model profited in the opposite

way of Blockbuster’s. Netflix made money when customers

didn’t watch the DVDs they ordered. As long as the DVDs

sat unwatched at a customer’s home, Netflix didn’t have to

pay return postage or mail out the next DVD. And because

Netflix didn’t have to build stores, hire sales clerks, or buy a

huge inventory of DVDs to put in each store, it had more than

a 30 percent cost advantage over Blockbuster. It was able

to share some of this cost advantage with customers in the

form of lower prices, and keep some of this advantage in the

form of higher profits.

If Netflix took Blockbuster to the mat, Redbox tagged

in for the pin. Blockbuster’s primary advantage over

Netflix was the ability to provide movies for the impulse

movie watcher. Redbox entered the market renting movies

through vending machines. Each vending machine cost

approximately $15,0005 and was placed in convenient and

well-traveled locations like grocery stores, pharmacies,

convenience stores, and even McDonald’s. By 2013, Redbox

had placed more than 47,0006 vending machines around

the United States, making them far more accessible than

a Blockbuster store for most customers. Because vending

machines were cheaper than stores, Redbox could rent

movies at the low price of $1.20 per night and still make

money. By 2010, Blockbuster had filed for bankruptcy.

Netflix’s market value as of January 2014 was over $20

billion, and Outerwall’s (Redbox’s parent company) market

Innovative Strategies in Home Movie Entertainment

IF NETFLIX TOOK BLOCKBUSTER TO THE MAT, REDBOX TAGGED IN FOR THE PIN. BLOCKBUSTER’S PRIMARY ADVANTAGE OVER NETFLIX WAS THE ABILITY TO PROVIDE MOVIES FOR THE IMPULSE MOVIE WATCHER. REDBOX ENTERED THE MARKET RENTING MOVIES THROUGH VENDING MACHINES.

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value was $1.9 billion.7 But the battle for home video

entertainment isn’t over. Apple, Amazon, and Microsoft

have attempted to leverage their online capabilities and

customer bases to win share in the video on demand (VOD)

and Internet video on demand (iVOD) markets. For example,

Amazon offers free streaming of older movies and pay

per view for newer movies to its Amazon Prime members.

Moreover, Hulu (backed by NBC Universal and Fox) offers

both free streaming (supported by advertisements) and Hulu

Plus, a subscription-based service like Netflix. The market

entry of these new competitors—each attempting to gain

advantage by leveraging different capabilities—suggests

that new innovative strategies will continue to emerge in the

home movie entertainment industry.

WHAT IS AN INNOVATIVE STRATEGY? [ 197 ]

The opening case illustrates how Netflix and Redbox used innovative strategies to defeat Blockbuster in the video rental business. Innovation is a powerful driver of competition and competitive advantage. New entrants, in particular, have strong incentives to offer different value propositions than incumbents—and preferably in a way that is hard to imitate. Strategies that offer a different value proposition to customers using different resources and capabilities are often referred to as “innovative strategies,” “revolutionary strategies,”8 or “disruptive innovations.”9 Famed economist Joseph Schumpeter argued that competition is a process that is driven by the “perennial gale of creative destruction.”10 Innovative strategies—like the ones launched by Netflix and Redbox—simultaneously create and destroy value. This is what makes strategy a dynamic process. The strategy that worked yesterday might not work today—and what works today might not work tomorrow. Con- sequently, companies must be able to innovate and change in order to weather the storms of creative destruction that will certainly come their way. The primary focus of this chapter is to examine innovation-based strategies—like the ones used by Netflix and Redbox—that prove to be revolutionary or disruptive in their industries.

WHAT IS AN INNOVATIVE STRATEGY?

To understand innovation, it is first important to understand the difference between an invention and innovation. Invention describes the creation of a unique or novel concept, method or process that is often turned into a tangible outcome—such as new product. An innovation is the conversion of a novel concept (an invention) into a product, process, or business model that generates revenues and profits.11 Innovation differs from invention in that innovation refers to the use of a novel idea or method, whereas invention refers more directly to the creation of the idea or method itself.12

For example, the scientists at Xerox PARC (Palo Alto Research Center) invented the com- puter mouse as a new way to navigate a computer. This invention would allow users to select from images and menus on a computer monitor through a Graphical User Interface (GUI). But it was Steve Jobs and Apple computer who launched the Macintosh computer—the first commercialized microcomputer that came with a mouse and graphical user interface. Apple’s Macintosh turned Xerox’s invention into an innovation that could generate revenues and profits. In similar fashion, the Wright brothers invented the airplane at Kitty Hawk, but Boeing and others commercialized the idea by designing and building commercial air- craft that could be sold as products. As shown in Figure 10.1, an innovation needs to be (1) novelc, (2) useful, and (3) successfully implemented in order to help companies succeed in the marketplace.

Incremental versus Radical Innovation. Innovation enables firms to deliver value in new ways. Innovations can be thought of as falling into two general categories: incremental innovations and radical innovations. An incremental innovation builds on a firm’s established knowledge base and steadily improves the product or service it offers.

invention The creation of an idea or method; a novel concept.

innovation The conversion of a novel concept (an invention) into

a product, process, or business

model that generates revenues and

profits.

incremental innovation Building on a firm’s established knowledge

base to create minor improvements

to the product or service a firm

offers.

[ 198 ] CH10 INNOVATIVE STRATEGIES THAT CHANGE THE NATURE OF COMPETITION

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For example, when Gillette offers a razor with five blades instead of four, or when Sam- sung offers a TV with an LED screen instead of a plasma screen, those are incremental innovations. In similar fashion, when any company makes incremental improvements to their operations to accomplish a task faster, better, or with fewer resources, these are also incremental innovations. Incremental innovations are also sometimes called “sustaining” innovations because they sustain a company’s current product offering and revenues.

In contrast, a radical innovation draws on a different knowledge base, technologies, or methods to deliver value in a truly unique way. Examples of products based on radical innovations include the computer (versus the typewriter), CT scanner (versus the X-Ray), cell phone (versus the landline phone), and MP3 player (vs. CD player).

Processes can also be based on more radical innovations. For example, Toyota engi- neer Taichi Ohno developed a set of flexible production techniques, often referred to as lean manufacturing, that minimizes inventories and waste despite being designed for rapid product changeovers.13 This system of production was significantly different from the mass production system developed by Henry Ford that was based on standardization, significant automation, and few product changeovers. Toyota’s deployment of its “flexible” or “lean” production system has helped it produce high-quality cars at low cost and propelled it to worldwide leadership in the automobile industry.

Strategies that draw on more radical innovations often use new technologies or employ a fundamentally different business model than rivals, meaning they create, deliver, and capture value through very different resources and capabilities. As illustrated in the open- ing case, Netflix used the Internet, software, and warehouses to deliver video rentals in a radically different way than Blockbuster. In similar fashion, Redbox uses vending machines to rent videos, which requires different technologies—and a very different distribution system—than those used by either Blockbuster or Netflix. This chapter focuses on innovative strategies that are based on more radical innovations.

We define an innovative strategy as a strategy that introduces a fundamentally differ- ent business model than rivals. The term business model refers to the rationale of how an organization delivers and captures value. More specifically, business models typically differ on one of three dimensions:

1. The choice of customer segments to serve and the unique value (value proposition) offered by the company

2. The choice of activities the company performs and the resources utilized to deliver value to customers

3. The way a company generates revenue streams to get paid for the value it delivers. The term revenue model is sometimes used to refer to the approach, or pricing strategy, a company uses to get paid for the value it delivers through its business model (see Strategy in Practice: Understanding Business Models).

radical innovation Innovation that draws on a different knowledge

base, technologies, or methods to

deliver value in a truly unique way.

innovative strategy A strategy that introduces a fundamentally

different business model than

rivals.

revenue model The approach, or pricing strategy, a company uses

to get paid for the value it delivers

through its business model.

[ Figure 10.1 ] Definition of Innovation

Implemented

Novel Useful

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WHAT IS AN INNOVATIVE STRATEGY? [ 199 ]

Understanding Business Models S T R AT E G Y I N P R A C T I C E

Over the past few years, the term business model has often been used to describe a company’s strategy. Perhaps the most comprehensive approach to defining a

company’s business model has been developed by Alex

Osterwalder and Yves Pigneur in their tool, the Business

Model Canvas.14 They argue that there are nine components

to a business model and firms can innovate by changing one

or more of those components as they seek to deliver and

capture value. The nine components are:

1. Value propositions. A firm seeks to solve customer prob- lems and satisfy needs with a particular unique value

or value proposition.

2. Customer segments. The value propositions are designed to meet the needs of one or several customer

segments.

3. Channels. Value propositions are delivered to customer segments through communication, distribution, or

sales channels.

4. Customer relationships. Customer relationships are established and maintained with each customer

segment.

5. Revenue streams. Revenue streams result from value propositions that are successfully offered to customers

through pricing strategies.

6. Key resources. Key resources are the assets required to offer and deliver the company’s value proposition.

7. Key activities/capabilities. Value propositions are devel- oped and delivered through key activities or capabilities.

8. Key partnerships. Some resources and activities that are critical to delivering the value proposition are out-

sourced to partners outside the company.

9. Cost structure. The business model elements above result in the cost structure for delivering the value

proposition to the customer. These costs must be

covered by the revenue streams in order for a firm to

be profitable.

To illustrate, Amazon has a different business model than

Barnes & Noble (B&N), with the most obvious difference

being channels—Amazon sells books over the Internet

rather than through bookstores. But this means that

Amazon’s value proposition is different, as are its primary

customer segments. Amazon’s primary customer segment

prefers the lower prices that Amazon offers but they also

like the convenience of shopping from their computers. In

contrast, B&N’s customers like the ability to get their book

immediately and may enjoy the shopping experience at a

B&N store. To deliver their value propositions through the

distribution channels they’ve chosen, each firm must be

good at different activities and have different resources. For

example, Amazon needs to be good at writing software and

fulfilling orders from warehouses, whereas Barnes & Noble

has to be good at finding the best locations for its stores,

designing stores to create a great shopping experience, and

efficiently operating each store. Amazon and Barnes & Noble

are described as having different business models because

they differ on most, if not all, of the nine components of the

business model canvas.

In some cases, firms deliver similar value to similar

customer segments—and may even use similar resources

and capabilities to deliver value—but they may differ in their

pricing strategy or their approach to generating revenues

streams and capturing value. For example, Apple, Spotify,

and Pandora use different revenue models or pricing

strategies to generate revenue streams. Apple makes money

by selling songs and albums over the Internet for a specific

price. In contrast, Spotify provides consumers with unlimited

access to all songs in its library for a monthly subscription

fee. Pandora uses a “free” revenue model like a radio

station, and provides songs via the Internet that are tailored

to a listener’s preferences. Pandora makes money by selling

advertising.

Companies sometimes attempt to change their business

model in response to competition. For example, Barnes &

Noble added the online book retailing business model to its

bricks-and-mortar bookstore business model in response to

Amazon’s entry into book retailing.15 In similar fashion, Apple

launched iTunes Radio in 2013 to directly compete with

Pandora.16 In this way, they have imitated Pandora’s business

model including the revenue model for capturing value. In

most cases, the company that is first to launch a business

model has a first-mover advantage because it becomes

known as the pioneer. In order to successfully compete with

pioneers, second movers must offer unique value relative to

the first mover—for example, lower prices, more features, or

greater convenience—to lure customers in their direction.

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Innovative strategies based on radical innovations are sometimes referred to as disruptive innovation because companies in the same industry find the innovation so disruptive that they can no longer do business as usual.

For example, when Netflix introduced an innovative way for customers to access home entertainment, it “disrupted” Blockbuster’s strategy and Blockbuster could no longer suc- ceed by doing business as usual. Blockbuster had to make a drastic change or it would end up going out of business. Innovative strategies are disruptive when they offer value that is attractive to incumbent’s customers, and are delivered through a business model that is dif- ficult for incumbents to imitate. Not surprisingly, new entrants with innovative strategies want to disrupt established companies and offer value in a way that is difficult to imitate. We now turn to discussing different types or categories of innovative strategies that have been successfully deployed by various companies.

CATEGORIES OF INNOVATIVE STRATEGIES

Since innovative strategies are about delivering unique value through a business model that differs from the competition, there are many different ways to offer an innovative strategy. It would be impossible to put each new strategy into a predefined category, because new innovative strategies are often unique relative to strategies being used by established firms. That’s the power of innovation. However, over the years strategists have noticed that some types of innovative strategies enable disruptive innovation through similar tactics and pat- terns—or what some strategy scholars have referred to as a similar dominant logic.17 By dom- inant logic, strategists mean the primary logic behind how the company is trying to deliver unique value to customers.

For example, the dominant logic behind the strategies of Netflix (versus Blockbuster) and Amazon (versus Barnes & Noble) was to lower costs by eliminating retail stores and shipping directly to the customer. The categories of innovative strategies we identify in Figure 10.2 can be useful as a guide to launching a disruptive innovation. In this section we examine a few of the most well-known patterns of innovative strategies as identified by various strategy scholars.

Reconfiguring the Value Chain to Eliminate Activities (Disintermediation) One type of innovative strategy is based on reconfiguring the value chain to eliminate activities or steps. The most typical pattern is to eliminate a step in the path from produc- tion to customer, such as eliminating a store, which also eliminates the need for sales- people and inventory. This allows the disruptor—the firm launching the game-changing strategy—to offer lower prices for similar products and services. This is the approach that Netflix used to gain a cost advantage against Blockbuster. Amazon used this same approach—selling books over the Internet—to offer books at lower cost than Barnes & Noble (see Figure 10.3).

disruptive innovation Radical innovative strategies in which

companies in the same industry

find the innovation so disruptive

that they can no longer do business

as usual.

Reconfiguring the Value Chain to Eliminate Activities

Low-End Disruptive Innovations

High-End Disruptive Innovations

Reconfigure the Value Chain to Allow for Mass Customization

Blue Ocean Strategy—Creating New Markets by Targeting Non-Consumers

Free Business Models

[ Figure 10.2 ] Categories of Innovative Strategies

CATEGORIES OF INNOVATIVE STRATEGIES [ 201 ]

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The approach of eliminating stores and selling products over the Internet has worked well for products like books and movies—items that are standardized and predictable. But can this work for a product that people like to try out before buying? What about a mattress? The company 1-800-Mattress has been quite successful selling mattresses online as well as over the phone. Since the company sells mattresses that are similar to models sold in stores, customers can go try one out to see what they like. Their strategy is to sell mattresses for 20 to 30 percent lower than the competition and deliver it to your home. Not only that, but if the customers are not satisfied, they can exchange it for another mattress, satisfaction guaranteed.

Southwest Airlines has used a similar strategy of eliminating steps in the value chain to offer low airfares relative to other airlines. By eliminating meals, seat reservations, and lug- gage transfers, Southwest is able to lower total costs and offer less expensive airline tickets to its customers.

Low-End Disruptive Innovations A second type of innovative strategy is called a low-end disruption.21 Rather than eliminat- ing steps in the value chain, some firms use a different set of activities or technologies than their rivals to produce a low cost product or service. Harvard professor Clayton Christensen observed a pattern in a number of industries where a firm leverages new technologies to launch a product at the low end—the most price-sensitive segment of the market—and then gradually moves upmarket as it improves its technology and processes.

For example, Nucor used this approach to disrupt integrated steel producers like U.S. Steel. Nucor pioneered a new way to create steel products using small electric arc furnaces to melt scrap metal in mini-mills. This process was much simpler and less expensive than the traditional method of melting iron ore and other ingredients in enormous blast furnaces. When mini-mills first emerged, the quality of their output was poor, which meant they could only make rebar (steel rods) used to reinforce concrete. This was a low-margin market that the big steel makers were happy to abandon because of the low profitability. But as Nucor’s mini-mills improved their processes and product quality, their cost advantage enabled them to offer lower prices than the integrated producers in higher-margin products such as angle iron, structural beams, and sheet steel. Eventually, many of the integrated steel companies like Bethlehem Steel were unable to compete because of their cost disadvantage, and they went bankrupt.

In a similar fashion, Honda started at the low end in the automobile industry by offer- ing 50cc and 150cc motorcycles. When Honda first launched, Harley-Davidson wasn’t concerned about the competition because its market was superheavyweight motorcycles. Harley-Davidson’s CEO even proclaimed that Honda’s entry was good for Harley-Davidson

low-end disruption Producing a low-cost product or service for the

low-end or most price-sensitive

segment of the market, and then

gradually moving upmarket as the

product or service improves its

technology and processes.

Authors Publishers Store Customer

Warehouse

Distributor

Authors

Amazon. com

Barnes & Noble

Publishers Warehouse Customer

[ Figure 10.3 ] Value Chains of Barnes & Noble versus Amazon.com

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The Internet as a “Disruptive” Technology S T R AT E G Y I N P R A C T I C E

The Internet has frequently been described as a “disruptive” technology—one that has enabled innovative strategies that are disruptive—by allowing digitized

information and products to be easily accessed by anyone

throughout the world. By now, we are all familiar with the

impact that the digitization of music, books, and movies

has had on bricks-and-mortar retailers such as Virgin

Records, Borders, and Blockbuster. Web applications such

as TurboTax and LegalZoom are replacing professional tax

accountants and attorneys, and online gaming is the fastest-

growing segment in the $97 billion video-game industry.18

The Internet, and the online digitization it enables, can be

either a threat or an opportunity.

The primary impact of the Internet on companies is that

it has become a low cost distribution channel for anyone

wanting to sell a product or service. As a result it has

dramatically lowered the barriers to entry into new markets.

Just when Barnes & Noble and Borders thought they had

created barriers to entry by building large book superstores,

Amazon entered selling books over the Internet. The

business models of Amazon, Netflix, and eTrade would not

have been possible without the Internet. The Internet has

enabled new entrants to create new business models and

deliver value in innovative ways while lowering costs.

As a result of the Internet lowering the cost of distribution,

it has enabled business models that rely on the long-tail

phenomenon, where broader inventory can be offered to meet a wider variety of consumer needs. Before the Internet,

products and services were usually sold through bricks-

and-mortar stores that could only handle limited inventory.

As a result, only those products fortunate enough to get

widespread distribution were big sellers. The “long-tail”

phenomenon explains that 80 percent of offerings in a product

category (books, songs, movies, clothing, etc.) are not big hits

and only account for about 20 percent of units sold, whereas

20 percent of offerings account for 80 percent of sales.19

This phenomenon is captured by the Pareto principle, also

known as the 80-20 rule, which says that roughly 80 percent

of effects come from 20 percent of the causes. The Pareto

principle is named after Italian economist Vilfredo Pareto,

who observed in 1906 that 80 percent of the land in Italy was

owned by 20 percent of the population.20 The Pareto principle

is applied to many situations in business but perhaps

most notably to sales, where in most cases 80 percent of a

company’s sales come from 20 percent of its customers. The

Internet provides an opportunity for online retailers to benefit

from marketing the “long tail,” which is the remaining 80

percent of offerings as outlined in Figure 10.4.

Online retailers can “sell less of more” by taking

advantage of unlimited virtual shelf space. This is what

allowed Netflix to offer 90,000 different movies versus 1,000

at a Blockbuster store, and Amazon to offer 5 million book

titles versus 100,000 at a Barnes & Noble store.

The Internet has also allowed more companies to employ a

free revenue model because the marginal cost (the incremental

cost of producing one additional unit) of producing and

distributing most digital products is zero. Once a software

program has been written, it can be copied and shared at

virtually zero cost. Skype would not be able to provide free phone

calls, nor could Zynga provide free games without the Internet.

20%

Number of Different Products Offered

N u

m be

r of

U n

it s

S ol

[ Figure 10.4 ] The Long-Tail Phenomenon

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because Honda would get more people riding a motorcycle and eventually they would graduate to a Harley.22 But over time, Honda used profits from its large volume of small motorcycles to invest in the development of larger motorcycles and eventually entered the superheavyweight motorcycle categories with bikes that were less expensive but more tech- nologically advanced than Harley-Davidson’s.

Apple and IBM’s first microcomputers were inferior to the minicomputers sold by DEC and Data General. They simply did not have the speed or processing power to han- dle complex data analysis. But over time, their speed and processing power improved enough that companies dumped minicomputers for the microcomputers that were now good enough to do the complex data analysis that large companies required. Once microcomputers could offer similar computing power as minicomputers at a much lower cost, DEC and Data General were unable to compete, and both eventually went bankrupt (See Strategy in Practice: Why Incumbents Don’t Respond Effectively to Low- End Disruptions).

Another example is Skype’s cheap—and often free—phone service that has been gradu- ally moving upmarket as the quality of calls improves and the technology allows for video conferencing and other higher-end business services. Skype has already taken over about one third of all long distance international phone calls from AT&T and other long-distance providers.23 It will be interesting to see if Skype’s free phone service will move to Internet- enabled cell phones and eventually be disruptive to the cell phone giants such as Verizon, AT&T, Sprint, and T-Mobile.

High-End/Top-Down Disruptive Innovations High-end, or top-down, disruption is as revolutionary as a bottom-up disruptive innova- tion. But in stark contrast to the low-end variety, high-end disruptive innovations actually outperform existing products when they’re introduced, and they sell for a premium price rather than at a discount.24 History provides a number of examples: Apple’s iPod outplays the Sony Walkman; Starbucks’s high-end coffee drinks and atmosphere drowns out local coffee shops; and flash drives fly past zip drives and floppy disks. Products created through high-end disruptive innovations are initially purchased by the most discriminating and least price-sensitive buyers, and then they move steadily downward, into mainstream markets. New entrants launching high-end innovations typically rely on “radical” or leapfrog techno- logical innovations that are expensive initially, but with improvements in technology, and as they are produced in larger volumes with greater scale, the costs gradually decline.

A high-end disruptive innovation may initially serve the specialized, high-end niche of a market for years before it finally trickles down to mainstream markets. Such was the case with electronic fuel injection (EFI), a technology that first replaced carburetors in high-per- formance racing cars before finally making its way to the high-volume cars made by the major automakers like General Motors and Toyota. The innovation slowly penetrates from above until the product becomes practical and affordable in mainstream markets, at which point consumers generally flock to the new offering.

Cell phones, which originally cost $3,995, only appealed to the high-end niche.25 But as the price (and size) of the phones dropped, they became accessible to a much larger seg- ment of the market. Today, almost 36 percent of homes are “wireless only” households.26 The cell phone example also introduces an important point: high-end disruptive innovations don’t need to be superior on every product feature relative to incumbent product offerings. But they do need to be superior on at least some attributes that customers care about. While cell phones offered the superior advantage of portability, they were disadvantaged relative to landline phones in terms of sound quality. But over time, sound quality has improved and is now comparable to landlines. In similar fashion, digital cameras offered advantages of stor- ing thousands of images than can be immediately viewed and edited, but initially offered inferior picture quality relative to 35 mm cameras. As the picture quality improved, digital cameras began to dominate the camera market.

High-end disruptions are new products or services that offer either superior performance on some existing product features or offer new features customers are willing to pay for. In

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most cases, these new top down products are only possible because of innovations in tech- nology that leapfrog the technologies used in earlier products.

Reconfiguring the Value Chain to Allow for Mass Customization Some fi rms, like Build-A-Bear Workshop, Dell, and Timbuk2, have launched innovative strategies based on a concept that is known as mass customization. Mass customization is an oxymoron, like “jumbo shrimp” or “act naturally.” Until recently, most products in busi- ness were either mass produced OR customized, but not both. However, new technologies and processes have allowed for the mass production of individually customized goods or services.

Take Build-A-Bear Workshop, for example. Customers “build” their own teddy bear or other stuff ed animal by choosing from a large variety of body styles, after which the animal is stuff ed at the store to the customer’s liking. Th e customer can also add a heart or sound box during stuffi ng, enabling the animal to “talk” or play music. After helping to stuff their ani- mal, the customer can dress their furry friend in an outfi t of their choice from a soccer uni- form, or witch costume, to a sequin shirt and jeans, and they can even add shoes. In short, the components of the teddy bear are mass produced but put together in a customized way by each individual customer. But mass customization isn’t just for children. Online retailer Timbuk2 uses a similar approach, allowing customers to choose from a set of modules to design their own bag or purse.27 Both Build-A-Bear and Timbuk2 fi nd that many customers enjoy the experience of creating their own unique product.

mass customization When a company mass-produces the

various modules of the product and

then allows the customer to select

which modules will be combined

together.

Why Incumbents Don’t Respond Effectively to Low-End Disruptions

S T R AT E G Y I N P R A C T I C E

In many cases, rivals do not attempt to respond to a new low-cost offering. Why don’t they respond? They see little to gain by selling what they view as an inferior, inexpensive

product to a price-sensitive niche market. After all, why would

Harley-Davidson want to offer an inexpensive motorcycle?

The margins are small, and Harley might tarnish its brand

by offering an inexpensive, possibly inferior, motorcycle.

Instead, companies like Harley focus on the needs of their

most profitable customers, who tend to ask for more features

and better performance from their products. By the time

they realize that the new low-end product has improved its

performance enough to attract their mainstream customers,

incumbents find it is too late to respond.

Some organizations also find it difficult to respond

because a response would require them to develop a new

set of resources and capabilities. Integrated steel makers

would have to learn how to make steel using mini-mill

technology. Harley-Davidson would have to learn to produce

smaller motorcycles in large volumes at low cost. In some

cases these new resources and capabilities are viewed as

incompatible with the firms existing set of resources and

capabilities. For example, it would be very challenging for

Harley-Davidson to simultaneously manufacture and sell

mostly customized heavyweight motorcycles while producing

high volumes of standardized smaller motorcycles like

Honda. The production processes that Honda uses to

produce millions of motorcycles each year differ significantly

from Harley’s production processes that produce less than

250,000.

Finally, some companies are afraid of cannibalization.

They are concerned that if they provide a less-expensive

offering, customers will switch to it, resulting in a loss in

revenues and profits. In the long run, this can be a recipe

for disaster as customers eventually move to the low-end

offering and the incumbent loses significant profits. For

example, AT&T did not want to offer free phone service over

the Internet like Skype because it would cannibalize the paid

phone service that AT&T was providing. AT&T didn’t want

to do anything to encourage customers to move from paid

phone service to free phone service.

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Dell used a similar strategy when it successfully launched its PC business using the “Dell Direct model.” Dell sells directly to customers and allows them to choose the components that matter most to them; they then custom build and ship the PC to the customer within 48 hours. Dell’s ability to mass-produce customized PC’s requires a flexible and responsive assembly system and supply chain. These companies find that customers enjoy creating their own unique product.

Mass customization seems to work best in markets where customers have a variety of different needs and many want a product that is personalized to their particular needs. It also works best when the product can be broken into modules that offer different features or performance. This requires that the product be designed as separate modules that can be mass produced but that can be quickly and easily linked together to create a functioning product.

Blue Ocean Strategy—Creating New Markets by Targeting Nonconsumers INSEAD professors Chan Kim and Renee Mauborgne identify another type of innovative strategy that they call blue ocean strategy. They argue that a company can succeed by cre- ating new demand in an uncontested market space. Where sharks competing for the same scarce food create a red ocean of blood due to intense rivalry, blue ocean success relies on swimming to empty water. In other words, offering value that is very different from anything on the market.

For example, when Cirque de Soleil opened its first show, it was clear that it would be nothing like a Ringling Brothers circus. A Cirque de Soleil show combines elements of a tra- ditional circus, acrobatic troupe, street performers, and a Broadway show to offer a unique entertainment experience. Cirque’s shows are so original that there is no direct competition. The tagline for one of the first Cirque productions was revealing: “We reinvent the circus.” Moreover, it attracted a new group of customers who were willing to pay several times the price of a conventional circus ticket for a unique entertainment experience.

As companies try to create new demand, they sometimes target nonconsumption— individuals who do not currently purchase a product or service—with an offering that might induce consumption. For example, more than 70 percent of households in India do not have a refrigerator because they are large, expensive, and require continuous electricity to run. So, appliance maker Godrej decided to try to create an innovative small refrigerator targeted at nonconsumption—those 125 million households without a refrigerator. Using battery technology and solid-state thermo electric cooling, it created a $59 cooler-size refrigerator— called Chotukool, which translates as “little cool”—to bring affordable refrigeration to every- one in India. One challenge Godrej had to overcome was how to give Indians in the poorer rural areas of India access to Chotukool. Since these potential customers didn’t have access to an appliance store, Godrej thought of a unique way to distribute Chotukool: through the Post Office. Since the postman goes to every home in India and is often viewed as a trusted friend, Godrej partnered with the India Post Office as the distribution partner for Godrej in many parts of India. By selling a unique product through an innovative distribution channel, Godrej was able to create new demand in a market without any direct competition.

According to Kim and Maubougne, most companies focus on incremental improve- ments to existing offerings rather than seeking to create new markets. In a study of busi- ness launches in 108 companies, they found that 86 percent of those new ventures were line extensions—incremental improvements to existing industry offerings—and a mere 14 percent were aimed at creating new markets or industries. Although the line extensions did account for 62 percent of the total revenues, they delivered only 39 percent of the total profits. By contrast, the 14 percent invested in creating new markets and industries gener- ated 38 percent of total revenues and 61 percent of total profits.28 Clearly, success in new markets brings much greater rewards.

However, organizations don’t necessarily have to venture into distant waters to cre- ate new markets. Indeed, many new markets are created from within, not beyond, exist- ing industries. Godrej’s Chotukool represents a good example. Godrej was already in the

blue ocean strategy Creating new demand in an uncontested market

space.

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appliance business but was able to create a new refrigerator market within the industry (see Strategy in Practice: Where Do Innovative Strategies Come From?). Chrysler did the same thing in the automobile industry when it launched the first minivan targeted to families who wanted more room than a station wagon but didn’t want a huge van. The minivan—a vehicle that was essentially a hybrid between a sedan and a van—created an entirely new category of vehicle and was the staple of Chrysler’s profits for years.

Free Business/Revenue Models A final category of innovative new business or revenue models involves offering products or services for “free.”29 During the past two decades, we have witnessed the emergence of “free” products and services in a way never seen before. Free newspapers (Metro), soft- ware (Google Docs), stock trades (ZeccoTrading), telephone calls (Skype), and cell phones (AT&T and Verizon bundle free phones with contracts). Free product strategies, once the exclusive province of the digital realm, have also been popping up in markets far removed from the Internet. From free prescriptions for expensive pharmaceuticals, to free airline tick- ets, and even free automobile leases, the “free” business models popularized by software companies like Google, Adobe, and Mozilla are spreading across markets everywhere, in some cases eliminating rivals. One example is Wikipedia, which destroyed Encyclopedia Britannica and Microsoft Encarta.

Although many companies offered short-term “freebies” in the past—for example a 30-day free trial of software—these products and services are perpetually free. What are the characteristics of products or services that are most likely to succeed being offered for free? And how is it that firms like Google are making lots of money by not charging users? What is their revenue model? Here are three “free” strategies that companies use:

Strategy 1: Cross-Sell (Freemium) Strategy. The cross-sell strategy involves offering a free basic product to gain widespread initial use, after which users are offered a nonfree premium version (often called freemium) or are sold products not directly tied to the free product. Virtually every app on the iPhone uses the cross sell strategy (e.g., Zynga games), as does Skype, which offers free phone calls but makes money on the add-ons, such as voicemail and calls to landlines or cell phones. One tactic is to offer a free version of the product to consumers to use at home, but offer a paid version with additional features to the enterprise market.

For example, Adobe only charges corporate customers for its Reader software—it is free to all others. Craigslist uses a version of this approach by offering free listings in every cat- egory but one—jobs—which is free for job seekers but not for companies.

Large-scale success with this strategy requires either: (1) a free product that appeals to a very large product user base (e.g., roughly 1.5 billion people with computers are interested in using Skype to make phone calls); or (2) a high conversion rate, meaning a high percentage of free users are willing to convert to paid customers for premium features. Skype is successful because of the sheer total numbers of customers that use its free product. Even if Skype has a low conversion rate, (the rule of thumb is 5 percent of free product users tend to become pay- ing customers) it can make still money because it has over 400 million product users.

In contrast, Flickr, the photo-sharing site, has a much smaller total market. The number of camera users that want to use a photo-sharing service is much smaller than the market for making free phone calls. Moreover, the conversion rate to Flickr Pro is relatively low because for most users, the free version is good enough. The fact that Skype appeals to more users with a conversion rate that is better than Flickr’s translates into a superior business model. This explains why eBay was willing to pay $2.6 billion for Skype, whereas Yahoo! reportedly paid only $22 to $25 million for Flickr.32

Strategy 2: Third-Party Pay Strategy. Firms utilizing a third-party pay strategy— sometimes called a two-sided market—provide free products to a community of product users as a method of generating revenue from a third party who pay to access those users. In the digital age, Google is the poster child for this strategy, offering free Internet search services while companies pay Google to advertise to its millions of product users.

high conversion rate When a high percentage of free users are willing

to convert to paid customers for

premium features.

third-party pay strategy Providing free products to a community

of product users as a method of

generating revenue from a third

party who pay to access those

users.

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Where Do Innovative Strategies Come From? S T R AT E G Y I N P R A C T I C E

What makes a business innovator like Thomas Edison, Steve Jobs, or Jeff Bezos different from a typical manager? How did they come up with the innovative ideas

that helped them found General Electric, Apple, and

Amazon.com, respectively? Is it genetic? Where they born

intuitive and divergent thinkers?

Research by Jeff Dyer, Hal Gregersen, and Clayton

Christensen reported in The Innovator’s DNA confirms others’

work that creativity skills are not simply genetic traits

endowed at birth, and that they can be developed. In fact,

the most comprehensive study confirming this was done by

a group of researchers, Merton Reznikoff, George Domino,

Carolyn Bridges, and Merton Honeymon, who studied

creative abilities in 117 pairs of identical and fraternal twins.

Testing twins aged 15 to 22 years old, they found that only

about one-third of the performance of identical twins on a

battery of 10 creativity tests could be attributed to genetics.

In contrast, roughly 80 percent of twins’ performance on

general intelligence (IQ) tests could be attributed to genetics.

So general intelligence (at least the way scientists measure

it) is basically a genetic endowment, but creativity is not.

Nurture trumps nature as far as creativity goes. That means

that about two-thirds of our innovation skills comes through

learning—first, from understanding the skill, then practicing

it, and ultimately gaining confidence in our capacity to create.

If innovators can be made, then how did business

innovators like Edison, Jobs, and Bezos come up with their

great ideas? Five discovery skills distinguish innovators

from typical executives.30 First and foremost, innovators

count on a cognitive skill called associational thinking, or

simply associating. Associating happens as the brain tries

to synthesize and make sense of novel inputs. It helps

innovators discover new directions by making connections

across seemingly unrelated questions, problems, or ideas.

Innovative breakthroughs often happen at the intersection

of diverse disciplines and fields. Author Frans Johanssen

described this phenomenon as the Medici effect,31 referring to the creative explosion that occurred when the Medici family

brought together creators from a wide range of disciplines—

sculptors, scientist, poets, philosophers, painters, and

architects—in fifteenth-century Italy. As these individuals

connected, they created new ideas at the intersection of their

respective fields, spawning the Renaissance, one of the most

innovative eras in history. Put simply, innovative thinkers

connect fields, problems, or ideas that others find unrelated.

The other four discovery skills trigger associational

thinking by helping innovators increase their building-

block ideas. Specifically, innovators engage the following

behavioral skills more frequently.

Questioning. Innovators are consummate questioners who show a passion for inquiry. Their queries frequently

challenge the status quo, or push people to think differently.

One of Steve Job’s favorite questions was: “If money were

not object, what kind of product would we create?” He

wanted Apple engineers to imagine the perfect product—and

then try to design and build it. Innovators ask questions to

understand how things really work, why they are that way,

and how they might be changed or disrupted. Collectively,

their questions provoke new insights, connections,

possibilities, and directions.

Observing. Innovators are also intense observers.

They carefully watch the world around them and their

observations of customers, products, services, technologies

and companies help them gain insights into and ideas for

new ways of doing things. Steve Jobs’s observation trip

to Xerox’s research lab, the Palo Alto Research Center

(PARC), provided the insight that was the catalyst for both

Macintosh’s innovative operating system and mouse and

Apple’s current OSX operating system.

Networking. Innovators spend a lot of time and energy finding and testing ideas through a diverse network of

individuals. They actively search for new ideas by talking to

people who may offer a radically different view of things. For

example, Steve Jobs was told by Apple Fellow Alan Kay to,

“go visit these crazy guys up in San Rafael, California.” The

crazy guys were Ed Catmull and Alvy Ray, who headed up a

small computer graphics operation called Industrial Light

& Magic (the group that created special effects for George

Lucas’s movies). Fascinated by their operation, Jobs bought

Industrial Light & Magic’s computer animation group for

$10 million, renamed it Pixar, and eventually took it public

for $1 billion. Had he never chatted with Kay, he would never

have purchased Pixar, and the creative Toy Story, Monster’s

Inc., and Finding Nemo films might not have been produced.

Experimenting. Finally, innovators are constantly

trying out new experiences and piloting new ideas.

Experimenters explore the world intellectually and

experientially, holding convictions at bay and testing

hypotheses along the way. They visit new places, try new

things, seek new information, and experiment to learn

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Google’s approach works well because product users type in key search words and identify themselves as prime candidates for advertisers. For example, typing in “skis” or “snowboards” allows companies selling or servicing those products to advertise to those targeted customers.

The secret to third-party pay is to provide a valuable free service that attracts either: (1) a very large community of product users that can then be segmented in a particular way for advertisers (the way Google does with search); or (2) a targeted community of users that comprises a customer segment, or group of individuals similar on a key dimension (e.g., this similarity could be based on demographics, for example “teenagers” or “retired people;” or more need based, such as “video-game players” or “new mothers”). Blyk, a Finnish telecommunications company that was acquired by France Telecom, competes by offering free cell phone service to 16- to 24-year-olds. Product users in the desired demographic fill out a detailed survey on their preferences and are given 217 free minutes each month if they agree to receive advertisements. Blyk makes money by selling access to that particular demographic and providing information on their preferences.33 Blyk also benefits by using Freemium, since many customers go over their free minutes and end up paying a premium for those minutes.

In similar fashion, Ryannair offers a small percentage of its airline seats for free by using a combination of Freemium and third-party pay. The company makes money on the add-on services: $25 per customer for checked or carry-on bags, $5 for seat reservations and credit card use, and $4 for priority boarding. Flight attendants sell food, scratch-card games, perfume, digital cameras, and MP3 players. Ryannair also uses the flight as a plat- form for advertisers. When your seat tray is up, you may see an ad for a cell phone from Vodaphone, and when it is down, you may see an ad from Hertz. Flyers are a captive audi- ence for advertisers targeting travelers. The key to third-party pay is to deliver a captive audience, preferably a specific customer segment, to an advertiser willing to pay for access to that audience.

Strategy 3: Bundling Strategy. A bundling strategy involves offering a free product with a paid product or service. For example, Hewlett-Packard may give away a free printer with the purchase of a computer, or Verizon may give away a free cell phone with the purchase of a service contract. Of course, the “free” effect here is largely psychological, since the customer must actually pay in order to get the product for free.

Offering a free product as part of a bundle works well when the product requires ongoing maintenance or complementary goods (e.g., Hewlett-Packard makes money by selling ink for its free printers). For example, Better Place is a company that introduced free electric car leases in Israel. It is able to lease the car for free because it bundles the car with an energy/ maintenance contract. Customers pay 10 cents per mile (less than the cost of gas) to get their electric car battery packs swapped out at a Better Place service station. Instead of stopping for gas, you stop for a battery swap. But the battery swap costs Better Place less than 10 cents per mile, so it makes money on the difference. It also makes money through third-party pay because the Israeli government—like many other governments—are trying to cut down on pollution, so it subsidizes Better Place’s operations.34

Additionally, bundling works particularly well when a company offers a broad array of products. Banks are increasingly bundling free services—free accounts or stock trades—when a customer uses other services (e.g., keeps investment balances above some minimum). But the bundled product doesn’t have to be related to the free prod- uct. Banks sometimes give away free products, like iPods or iPads, to customers opening accounts.

customer segment Groups of people who share similar needs

and thus are likely to desire the

same features in a product.

new things. Jobs, for example, tried new experiences all

his life—from meditation and living in an ashram in India,

to dropping in on a calligraphy class at Reed College. All

these varied experiences triggered ideas for innovations

at Apple.

Collectively, these discovery skills—the cognitive skill

of associating and the behavioral skills of questioning,

observing, networking, and experimenting—constitute “The

Innovator’s DNA,” or the code for generating innovative

business ideas.

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Hypercompetition: The Accelerating Pace of Innovation Over the past 25 years, we have witnessed an accelerated pace of innovation that has had a significant impact on the nature of competitive advantage. In fact, Dartmouth Professor Rich D’Aveni coined the term hypercompetition to refer to his argument that competitive intensity has increased, and that periods of competitive advantage have decreased.35

Recent research provides evidence that the increased pace of change has made it harder to sustain competitive advantage.36 In fact, one study found that in 1950, when a firm reached the Fortune 500, on average it stayed in the Fortune 500 for 12 years. However, by 2000, the average firm that reached the Fortune 500 only stayed there for 7 years due to the emergence of new, faster-growing firms.37 This all suggests that established companies need to be constantly looking over their shoulder for new entrants who might be launching new products with innovative strategies. It also suggests that established companies cannot rest on their laurels. They must continue to be inventive and offer new products and services if they hope to continue to grow. If they don’t, their current products and businesses will even- tually proceed through the famous “S-curve,” which means that after the growth phase they will eventually mature and decline.

INNOVATION AND THE PRODUCT/BUSINESS/INDUSTRY LIFE CYCLE (S-CURVE)

Innovations frequently lead to the creation of new products, businesses, or even industries. New products, product categories, and even industries tend to follow a predictable life cycle, evolving over time through four stages: introduction, growth, maturity, and decline. Figure 10.5 depicts a typical product/business/industry life cycle.

Introduction Stage During the introduction stage the company tries to get early adopters—those types of buyers willing to try out the latest new gadget—to try out the new product. The primary goal is to get some reference customers that will seed future growth to increase market acceptance. Product innovation is much more important than process innovation during this stage; as a result, R&D, product development and design are key competencies. Google Glass, Google’s idea for a wearable computer with an optical head-mounted display (OHMD) that responds to voice commands and displays information on the glasses, is an example of a product in the introduction stage.

Growth Stage Sales accelerate during the growth stage as the initial innovation gains traction and increased market acceptance. Tablets and smartphones are examples of product categories that are cur- rently in the growth stage. Demand increases as the early majority, a new group of buyers, is con- vinced that the product concept works as demonstrated by early adopters in the introduction stage. The company continues to refine the product during this stage as they also look for innova- tive ways to reach customers through marketing and new distribution channels. As the product starts to gain widespread acceptance a standard (or dominant design) emerges that signals the market’s agreement on a common set of engineering and design features. Toward the end of this stage product innovation starts to give way to process innovation.

Maturity Stage As an industry moves into the mature stage, growth starts to slow as total market penetra- tion increases. What little growth there is comes from buyers called the late majority enter- ing the market who want not only a proven concept but also a low price. The limited market

hypercompetition A term coined by Professor Rich D’Aveni to refer

to his argument that competitive

intensity has increased and that

periods of competitive advantage

have decreased.

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growth leads to an increase in competitive rivalry and cost starts to become more important as a determinant of success. Process innovation and operational efficiency is typically more important to success than product innovation. Laptop computers are an example of a prod- uct that is moving from the growth to the mature stage.

Decline Stage The decline stage is often initiated by new products entering the market that cause demand to fall. For example, demand for Sony’s Walkman didn’t really start to fall until the introduction of Discman and then the iPod. As iPod was taking off in its growth phase, Walkman and Discman were both declining. Similarly, Apple and IBM’s personal computers initiated the decline of the typewriter, and more recently we’ve seen the original desktop PC start to decline with the growth of laptops and tablets. As the market size shrinks during the decline stage, some firms try to minimize competition and consolidate the industry by buying rivals.

Understanding the product life cycle can be useful for identifying the strategic priorities for a product or business. Each stage of the life cycle requires different priorities and compe- tencies in order for the firm to succeed and satisfy that stage’s unique customer group. The life cycle also highlight’s the importance of innovation—or the ability to launch new product life cycles—because if you don’t, your products and business will eventually be in decline.

Although launching a business with an innovative strategy sounds alluring, it is also risky. Why? Because, by definition, when a company launches an innovative strategy it is offering a unique value proposition using an original business model. Since the organization is trying to do something that has never been done before, there is tremendous uncertainty as to whether it will work or not. Although we’ve talked about a lot of successful innova- tive strategies in this chapter, there are more failures than successes. For example, Apple launched the “Newton,” a personal digital assistant (PDA) that hit the market with a thud before the market was ready for mobile computing. The Newton didn’t attract customers and was deemed a huge failure, costing Apple millions of dollars. It was an innovative prod- uct but it wasn’t successful. The same can be said for Iridium, founded in 1991 by Motorola and a global partnership of 18 companies. The company spent $5.2 billion to launch 72 satel- lites so that its cell phone system would work “anywhere on earth”—from ships in the ocean to jungles of Africa. The problem was that their cell phones were the size of a brick and only worked if they had a direct connection to the sky—which meant they didn’t work inside buildings or cars. Iridium went bankrupt and eventually an investor group bought $6 billion worth of assets for $25 million.38

The bottom line is that if you don’t innovate, you may eventually “be overrun by a swarm of start-ups,” says Scott Cook, founder and chairman of Intuit, a provider of financial services software including Quicken, TurboTax, and SnapTax.39 However, innovations must be more than novel offerings to the market. They must be deemed useful by customers and must be successfully implemented. This makes them risky propositions. Launching an innovative venture is not for the faint of heart. But for those who are successful, the rewards can be extraordinary.

Introduction

S al

es a

n d

P ro

fi t

Growth

Time

Maturity Decline

[ Figure 10.5 ] Product/Business/Industry Life Cycle

REVIEW QUESTIONS [ 211 ]

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SUMMARY

An innovation is the conversion of a new idea (an invention) into a product, process, or business model that generates revenues and profits. An incremental innovation builds on a firm’s established knowledge base and steadily improves the product or service it offers. In contrast, a radical innovation draws on a different knowledge base, technologies, or methods to deliver value in a truly unique way.

Strategies that offer a different value proposition than incumbents’ strategies using dif- ferent resources and capabilities (e.g., a different business model) are often referred to as “innovative strategies.”

One type of innovative strategy is based on reconfiguring the value chain to eliminate activi- ties or steps to offer significantly lower prices. The most typical pattern—used by Amazon. com and Netflix—is to eliminate a step in the path from production to customer, such as elim- inating a store, which also eliminates the need for salespeople and inventory.

A low-end disruptive innovation is where a firm leverages new technologies to launch a product at the “low end”—the most price-sensitive segment of the market—and then gradually moves upmarket as it improves its technology and processes. In stark contrast to the low-end variety, high-end disruptive innovations actually outperform existing prod- ucts when they’re introduced, and they sell for a premium price rather than at a discount.

Mass customization refers to an approach of using new technologies and processes to mass produce individually customized goods or services—as we’ve seen Build-A-Bear Workshop do with stuffed animals and Dell do with computers. Blue ocean strategy refers to creating a product or service that targets “nonconsumption,” by creating new demand in an uncontested market space.

Free business/revenue models are growing rapidly in a wide variety of industries, and they always use cross sell, third-party pay (advertising), bundling, or some combination of the three “free” revenue models.

KEY TERMS

blue ocean strategy

(p. 205) customer segment (p. 208) disruptive innovation

(p. 200) high conversion rate

(p. 206)

hypercompetition (p. 209) incremental innovation

(p. 197) innovation (p. 197) innovative strategy (p. 198) invention (p. 197)

low-end disruption (p. 201) mass customization

(p. 204) radical innovation (p. 197) revenue model (p. 198) third-party pay strategy

(p. 206)

REVIEW QUESTIONS

1. What is the difference between an invention and innovation? What are the differences between incremental versus radical innovations?

2. How do companies create an innovative strategy by eliminating steps in the value chain?

3. What is the difference between low-end and high-end disruptive innovations?

4. What does mass customization mean? How do companies use mass customization to suc- ceed in the market?

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5. What does it mean to target nonconsumption? How does a company create new markets with a blue ocean strategy?

6. What are four behaviors of business innovators that help them generate ideas for innova- tive strategies?

APPLICATION EXERCISES

Exercise 1: Understanding the Nature of Competition 1. Find a company that is rapidly stealing market share from incumbents. How is the busi-

ness model of the growing company different? What innovative strategy is it employing?

2. Find a company that the media is touting as doing something new or innovative. Do you agree that the company is innovative? Why or why not?

3. Find a company that fits one of the six innovative strategies described in this text. Does the company employ only one innovative strategy, or mix several? Which ones?

4. Compare renting movies from a box store, versus mail, versus streaming. How does each successive model eliminate value-chain activities?

5. Find a company that uses a free revenue model. How is it able to perpetually offer the product for free? What kind of free strategy is it using?

REFERENCES

1 J. Poggi, “Blockbuster’s Rise and Fall: The Long, Rewinding Road,” The Street.com (Sept. 23, 2010), http://www.

thestreet.com/story/10867574/3/the-rise-and-fall-of-blockbuster-the-long-rewinding-road.html.

2 Blockbuster 2004 Annual Report.

3 http://www.blockbuster.com/corporate/franchiseFAQ#q11

4 L. Conley, “90000 DVDS. No Shelves,” Fast Company (Sept. 1, 2003), http://www.fastcompany.

com/47124/90000-dvds-no-shelves.

5 A. Afardshi, “Coinstar: Deep Value and Exceptional Growth,” GuruFocus (March 14, 2011), http://www.

gurufocus.com/news/125840/coinstar-deep-value-and-exceptional-growth.

6 J. Pepitone, “Redbox Instant Video Will Be $8 per Month, Just Like Netflix” CNN (Dec. 12, 2012), http://money.

cnn.com/2012/12/12/technology/redbox-instant-price/index.html.

7 A. Marler, “Coinstar Moves Up In Market Cap Rank, Passing R. R. Donnelley & Sons,” Forbes (Dec. 17, 2012),

http://www.forbes.com/sites/dividendchannel/2012/12/17/coinstar-moves-up-in-market-cap-rank-passing-r-r-

donnelley-sons/.

8 G. Hamel, “Strategy as Revolution.” Harvard Business Review (1996).

9 C. Christensen, The Innovators Dilemma: When New Technologies Cause Great Firms to Fail (Boston: Harvard

Business School Press, 1997).

10 J. A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row, 1942). Also see, R. Foster and

S. Kaplan Creative Destruction: Why Companies that Are Built to Last Underperform the Market—and How to Suc-

cessfully Transform Them (New York: Currency/Doubleday, 2001).

11 A. G. Lafley and R. Charan The Game Changer (New York: Crown Publishing Group, 2008).

12 http://en.wikipedia.org/wiki/Innovation.

13 T. Epply, The Lean Manufacturing Handbook, Part 3, Second Edition, (Anderson, IN: Continental Design & Engi-

neering, 2012).

14 A. Osterwalder and Yves Pigneur, Business Model Generation (Hoboken: John Wiley & Sons, 2010).

15 http://www.barnesandnobleinc.com/our_company/history/bn_history.html.

16 S. Cole, “Apple Plans to Utilize iTunes Radio to Stream, Promote Albums before Release,” AppleInsider (Oct.2,

2013), http://appleinsider.com/articles/13/10/02/apple-plans-to-utilize-itunes-radio-to-stream-promote-albums-

before-release.

17 C. K. Prahalad and R. A. Bettis (Nov. to Dec., 1986). “The Dominant Logic: A New Linkage between Diversity and

Performance,” Strategic Management Journal 7 (6): 485–501. To illustrate, the dominant logic behind the strate-

gies of Netflix (vs Blockbuster) and Amazon (vs. Barnes & Noble) was to eliminate retail stores and ship directly

to the customer.

http://www.blockbuster.com/corporate/franchiseFAQ#q11

http://www.fastcompany

http://www.forbes.com/sites/dividendchannel/2012/12/17/coinstar-moves-up-in-market-cap-rank-passing-r-r-donnelley-sons

http://money

http://en.wikipedia.org/wiki/Innovation

http://www.barnesandnobleinc.com/our_company/history/bn_history.html

http://appleinsider.com/articles/13/10/02/apple-plans-to-utilize-itunes-radio-to-stream-promote-albums-before-release

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18 Gartner Press Release, Egham Uk., 2011. “Gartner Says Spending on Gaming to Exceed $74 Billion in 2011.”

19 E. Brynjolfsson, Y. J. Hu, and D. Simester, “Goodbye Pareto Principle, Hello Long Tail: The Effect of Search Costs

on the Concentration of Product Sales” Management Science ( January 1, 2011).

20 V. Pareto and A. N. Page, Manuale di economia politica (Manual of Political Economy), trans. Ann S. Schwier, ed.,

Ann S. Schwier, and Alfred N. Page. (New York: Augustus M. Kelley, 1971).

21 Christensen.

22 S. Kotha and J. Dutton Transformation at Harley-Davidson (New York: New York University, 1996).

23 P. Goldstein, “Report: Skype Makes Up One Third of International Phone Traffic,” Wireless Carrier News

(Feb. 15, 2013).

24 N. Carr, “Top Down Disruption,” Strategy + Business 39 (May 23, 2005).

25 C. Ngak, “Cell Phone Turns 40: Martin Cooper’s First Call on the DynaTAC,” CBSNews.com (April 4, 2013), http://

www.cbsnews.com/8301-205_162-57577736/cell-phone-turns-40-martin-coopers-first-call-on-the-dynatac/.

26 CTIA Advocacy. (2012). Wireless Quick Facts. http://www.ctia.org/advocacy/research/index.cfm/aid/10323.

27 http://www.timbuk2.com/tb2/.

28 W. C. Kim and R. Mauborgne “Blue Ocean Strategy,” Harvard Business Review (October 2004).

29 D. Bryce, J. Dyer, and N. Hatch, “Competing Against Free,” Harvard Business Review (2011).

30 J. Dyer, H. Gregersen, and C. Christensen, The Innovator’s DNA (Boston: Harvard Business Review Press, 2011).

31 F. Johansson, The Medici Effect (Boston: Harvard Business School Press, 2006).

32 V. G. Kopytoff, “At Flickr, Fending Off Rumors and Facebook,” The New York Times ( Jan. 30, 2011). Honan, Mat

(2014-08-07). “The Most Fascinating Profile You’ll Ever Read About a Guy and His Boring Startup”. Wired.

Retrieved 2014-09-21.

33 R. Wray, “Teens to Get Free Mobile Calls—with a Catch,” The Guardian (March 25, 2007), http://www. theguardian.

com/money/2007/mar/26/internetphonesbroadband.digitalmedia.

34 Bryce, Dyer, and Hatch.

35 R. A. D’Aveni, Hypercompetition. Managing the Dynamics of Strategic Maneurvering (New York: Free Press, 1994).

36 R. R. Wiggins and T. W. Ruefli “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?”

Strategic Management Journal 26 (2005): 1249–1259. H. McNamara, P. M. Vaaler, and C. Devers, “Same as It

Ever Was: The Search for Evidence of Increasing Hypercompetition,” Strategic Management Journal 24 (2003):

261–278. Note: While there appears to be increasing evidence that competition has increased and periods of

competitive advantage are shorter, there is an ongoing debate in the literature, whether the empirical data

indeed confirm it.

37 N. Furr and J. Dyer, The Innovator’s Playbook (Boston: Harvard Business Review Press, 2014).

38 S. Blank and B. Dorf. The Start-Up Owner’s Manual: The Step-by-Step Guide for Building a Great Company (Pesca-

dero: K&S Ranch Publishing Division, 2012).

39 Author Interview with Scott Cook, June 7, 2013.

http://www.cbsnews.com/8301-205_162-57577736/cell-phone-turns-40-martin-coopers-first-call-on-the-dynatac

http://www.ctia.org/advocacy/research/index.cfm/aid/10323

http://www.timbuk2.com/tb2

http://www.zdnet.com/blog/btl/at-and-t-vs-verizon-wireless-how-tiered-plans-will-shake-out/52556

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Competitive Strategy

Ethan Miller/Getty Images

[ 215 ]

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Studying this chapter should provide you with the knowledge to:

1 Create a strategic group map and a strategy canvas of a competitive landscape.

2 Analyze a company’s competitors to identify the likely ways they will respond to a company’s strategic moves using a competitor response profile.

3 Describe the different types of competitive strategies that can be deployed contingent on the environment in which a company operates.

4 Choose or create a competitive strategy suitable to a company’s competitive situation.

L E A R N I N G O B J E C T I V E S

[ 216 ]

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I n January 2005, facing increasing competition from

low-fare carriers, Delta Airlines introduced a new

pricing plan called simplifares that dramatically cut

ticket prices across most of Delta’s domestic U.S. routes.

Paul Matsen, Delta’s chief marketing officer, stated,

“We could sit back and wait for low-fare competition to

force us to react, but we’re going on the offense.”1 The

company cut ticket prices by as much as 50 percent and

eliminated the Saturday-night stay requirement that had

long helped airlines distinguish between leisure travelers

and business travelers. Furthermore, it capped the price

for a last-minute coach fare at $499 and a first-class

fare to anywhere in the country at $599. Although the

new pricing scheme would immediately create a drag on

revenue, Delta expected that over the long run the pricing

move would be good for the airline by helping it take back

passenger volume from the low-fare carriers. Business

travelers, in particular, had been increasingly moving to

low-fare carriers for their travel. In fact, near Cincinnati,

where simplifares was first piloted, many business travelers

preferred to drive to a smaller airport and pay the fares

of AirTran or ATA rather than the higher fares of Delta.

The new pricing structure was expected to bring these

customers back to Delta.

Although Delta hoped for a new source of advantage

from this pricing move, Delta’s main competitors—the full-

fare carriers such as American and United—responded to

simplifares by immediately matching Delta’s prices. Within

days, business fares in the top 40 routes flown by major

airlines were down by an average of one-third, and American

Airlines’ fares were down by 44 percent.2 Perhaps as a way

to slow the free fall, Northwest airlines warned the industry

that “fare simplifications” would immediately and adversely

affect industry revenues, but other airlines ignored the

warning.3

By July, just six months later, Delta was already making

upward price adjustments, citing a spike in the cost of

fuel.4 The company abandoned the $499 cap and raised the

ceiling by $100. Again, major carriers immediately followed

suit. On the day of the announcement, a spokesman for

Continental stated, “All I can tell you is that we did match

Delta’s fare, and the match was effective today. Whatever

Delta did, we did.”5 Meanwhile, the low-fare carriers

welcomed the move as evidence that full-fare carriers were

burdened with cost structures that were simply too high to

match their low ticket prices.

Despite the effort exerted to implement the new pricing

strategy, by 2008,

Delta had completely

abandoned the

simplifares initiative.

Richard Anderson,

Delta’s CEO, seemed

to suggest that

efforts to compete on price with the low-fare carriers had

been misguided. Cutting prices for business travelers had

had disastrous effects on revenue because the expected

growth in passenger volume never materialized. This

was largely due to competitive price matching. In a clear

return to its previous strategy, Mr. Anderson stated, “You

really have to have a differential [between business and

leisure travel]. We offer different products to different

customers based on their attributes. That’s better for an

international carrier offering … different products on the

same airplane.”6

Delta Simplifies Its Fares 11

RICHARD ANDERSON, DELTA’S CEO, SEEMED TO SUGGEST THAT EFFORTS TO COMPETE ON PRICE WITH THE LOW-FARE CARRIERS HAD BEEN MISGUIDED. CUTTING PRICES FOR BUSINESS TRAVELERS HAD HAD DISASTROUS EFFECTS ON REVENUE BECAUSE THE EXPECTED GROWTH IN PASSENGER VOLUME NEVER MATERIALIZED.

UNDERSTANDING THE COMPETITIVE LANDSCAPE [ 217 ]

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Competition is a reality for business firms. Whether a company faces competitors in the market that are actively striving to erode its market share or potential new entrants to its market, nearly all managers must grapple with how to compete. In some markets, competi- tion is light because firms are highly differentiated or because they face few rivals. In other markets, competition can be very intense. In such markets, and as the opening case dem- onstrates, a company must acknowledge the reality that competitors are watching and are likely to react to its strategic actions. Had Delta realized how quickly its competitors would respond to its pricing moves, the company might have tried a different strategy to improve its performance against low-fare carriers.

How does a company know which actions to take in the face of competition? And what actions are likely to be the most effective in the differing competitive situations that a firm might face? How will competitors respond to a company’s strategic moves? This chapter provides answers to these questions by identifying a set of tools for competitive analysis along with strategies for responding to competitors that are useful under a variety of market circumstances. The overall objective is to help strategists understand how a company can improve its performance in the face of competition.

In order to effectively compete, a company must first know the competition and then it must launch strategies to win against the competition. The first two sections of the chapter, “Understanding the Competitive Landscape” and “Evaluating the Competition,” address knowing the competition. The latter two sections, “Principles of Competitive Strategy” and “Competitive Actions for Different Market Environments,” address winning against the competition.

UNDERSTANDING THE COMPETITIVE LANDSCAPE

In order to compete effectively, a firm must understand the structure of the competitive environment in which it operates. Most industries contain groups of companies that com- pete directly against each other but only indirectly against companies in other groups. This situation arises because of differences in customer needs and preferences, which give rise to various customer segments. As companies pursue these segments, they develop business models that are well-suited to serving one segment but not so well-suited to serving other segments in the market. Firms with similar business models cluster together by pursuing the same segments of customers.

Strategic Groups and Mobility Barriers An analysis that breaks down the structure of a market or industry into these constituent groups is called a strategic group analysis. Visualizing this group structure is an important component of competitive analysis because it identifies the major arenas of competition and who competes directly with whom.

In the United States, Delta, United, and American Airlines compete in the full-fare seg- ment of the industry (See Animated Executive Summary on, “Competitor Interaction”). Delta encounters American or United on many of its routes between pairs of cities because these companies compete in Delta’s primary customer segment—business travelers. Among the companies in this group, airlines compete head to head and watch the moves of their competitors closely. They respond to one another’s competitive moves almost immediately in order to maintain a valuable competitive position. Other airlines, such as Southwest, JetBlue, Frontier, or Spirit compete in the discounted or low-fare segment of the industry. They offer few frills, less popular airports, or no reserved seating. These companies compete head to head with each other more than they compete with the full-fare carriers.

Even though companies within groups compete head-to-head, and companies in other groups are less of a threat, rivals in other groups cannot be completely ignored. Rivals could begin targeting customer segments with new offerings or more favorable value propositions and eventually steal customers. This is exactly what happened in the

strategic group A set of companies that compete in similar ways with

similar business models pursuing

similar sets of customers.

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case at the opening of the chapter. Low-fare carriers were gaining ground in the business traveler segment of the market when Delta launched its effort to compete on price with these carriers.

Strategic group maps are constructed by identifying the main differences in the ways in which firms in an industry compete to deliver value. These differences typically relate to value chain activities such as relative price, geographic placement, product line breadth, extent of vertical integration, niche or full-service offerings, and so forth. The factors that are relevant can vary based on the industry in question. In the airline industry, for exam- ple, clues about the most important differences in how firms compete can be found in the opening case description. Two of the important factors mentioned are price and whether airlines are flying to primarily large or small airports (recall that Delta was losing business travelers to smaller airports near Cincinnati). Therefore, to draw a strategic group map of the airline industry, you would place these two factors on the horizontal and vertical axes of a simple two- dimensional chart and plot the companies relative to these axes as out- lined in Figure 11.1. If you observe clustering of companies, you have identified strategic groups within the industry, at least along the dimensions chosen. The rule is to choose factors that are the most relevant in describing the differences in how companies compete for customers. In other words, choose the dimensions that create the most distinctive clusters.

Companies find that switching strategic groups is difficult once they have built a history in one. The reason is that companies in specific strategic groups choose particular ways to configure their activities and these activity systems do not change quickly or easily. This creates a barrier to mobility between groups. Once a firm is in a particular group, it is not mobile and can’t simply leap to a different group.7 For Delta to effectively compete with low- fare carriers, the company would have to acquire many of the business characteristics of the low-fare carriers. For example, the company would have to change its cost structure, airline fleet, routing, and airport locations, effectively abandoning much of its existing customer base. In the opening case, Delta attempted to compete head-to-head with the low-fare carri- ers by changing only its price. But the company would have had to change many more of its characteristics in order to be successful.

A strategic group map provides a basis for making competitive assessments not only because it defines who a company’s competitors are but also because it can help to analyze potential changes in the landscape. For example, it can indicate whether companies in one group are beginning to appeal to the primary markets of another group. Such was the case when low-fare carriers near Cincinnati began to steal business customers from Delta.

barrier to mobility Any factor that limits the ability of a company to

move between strategic groups.

Large

Full-fare group

Low-fare group

JetBlue

Spirit

SouthwestA ve

ra ge

a ri

po rt

s iz

Small

Low

Relative fare price

Note: Company circle size relative to revenue

High

Delta American

United

[ Figure 11.1 ] Strategic Group Map

UNDERSTANDING THE COMPETITIVE LANDSCAPE [ 219 ]

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Are firms in any group attempting to change the value they offer and the basis of compe- tition? Is this leading to any changes in the boundaries of groups? Delta attempted to alter group boundaries when it launched a low-fare pricing strategy. Are new firms entering the industry with fundamentally different business models? Southwest certainly did when it first entered the Texas market in Dallas. Are there “empty spaces” on the strategic group map that may invite successful entry? In Figure 11.1, no firms currently operate with high fares at small airports, or with low fares at large airports. If this is the case, does this fact suggest possible alternative competitive approaches to the market? These types of questions can be asked and addressed effectively in the context of the strategic group map (See Strategy in Practice: A Real World Strategic Group Map).

Strategy Canvas Another way to evaluate differences among competitors is to employ a strategy canvas. This idea was first introduced by W. Chan Kim and Renée Mauborgne as a way to assess relative competitive strengths and weaknesses against specific purchase criteria.8 By rating firms on various criteria that customers use to make purchase decisions, the analyst is able to quickly grasp similarities and differences in how companies attempt to offer unique value to customers relative to competitors.

For example, consider a strategy canvas analysis of Southwest Airlines and its unique value proposition relative to full-service airlines and automobile travel (see Figure 11.2). Various features that customers care about when selecting among travel options are iden- tified and placed on the horizontal axis. These features include things like price, meals, lounges, seating choices, hub connectivity, and so forth. Next, company performance is evaluated against these criteria and scored on the vertical axis. This scoring is typically based on rigorous quantitative scales, such as those obtained from surveys or other market research. The completed strategy canvas provides insight into how competitive offerings are differentiated.

In Figure 11.2, Southwest’s scores more closely resemble automobile travel than they do the scores for other full-service airlines. This analysis uncovers a key point about South- west’s approach to the market. When Herb Kelleher founded the airline in 1971 at Luv Field in Dallas to fly passengers to Houston and San Antonio, he set out not to compete with airlines but, rather, with automobile travel.

The strategy canvas is a useful tool not only for uncovering existing differences among competitors, but also for identifying new ways to beat rivals. Imagine Figure 11.2 without Southwest’s line drawn on it. If you were launching a new airline, or even if you were running

Price

Low

O ff

er in

High

Other Airlines

Southwest Car

Meals Lounges Seating choices

Hub connectivity

Friendly service

Speed Frequent departures

[ Figure 11.2 ] Strategy Canvas of the Short-Haul Airline Industry

Source: Adapted from C. Kim and R. Mauborgne. “Charting Your Company’s Future,” Harvard

Business Review (2002).

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Bomgar

JAMF

High

Medium

R el

at iv

e P

ri ce

Product Capabilities/Scalability

Low

Size of bubble reflects the size (Revenue) of the organization

Full Suite–Large Enterprise Revenues/

Market Share Declining

IBM BigFix

Symantec/ Altiris

Novell HP

Lumension

Dell/Kace Threats from Below

Kaseya Matrix

Numara (BMC)

Microsoft (InTune)

Absolute RES

Software

AppSense

Wanova

Microsoft (SCCM)

LANDesk

High growth Niche Providers

Full Suit - Enterprise

Small Business Segment Full Suite

Alternative Delivery Providers (Primarily Small Business Segment)

VDI and Point Players

[ Figure 11.3 ] LANDESK Software—Strategic Group Map and Competitive Landscape

A Real-World Strategic Group Map S T R AT E G Y I N P R A C T I C E

LANDESK is a provider of enterprise software solutions for IT Administrators who manage the many devices on corporate computer networks. When LANDESK wanted to

gain strategic insight into the dynamics of its competitive

landscape, the company created a strategic group map

(see Figure 11.3). First, the company chose two factors that

seemed to distinguish the business models of firms in the

industry: relative price, and product capabilities, especially

around scalability, or the ability of the software to handle

very large corporate networks. All relevant competitors were

placed on the chart based on how they scored on these two

dimensions. The circle size for each company was scaled

to represent revenues. Clear strategic groups emerged

and these were circled (dotted red) and then given a name

for quick reference. Competitor bubbles were further color

coded with a proprietary LANDESK indicator.

The chart provided a clear view of which companies

were on the landscape, how the companies were

competing with respect to price and product capabilities,

and which companies LANDESK primarily competes

against. By examining the chart, it was also clear that

some of the companies were well positioned to present

threats to companies in other groups by changing products

or pricing. For example, companies in the Alternative

Delivery Providers and Small Business Segment Full Suites

groups seemed to be the biggest threat for encroaching

on LANDESK’S market share. Meanwhile, companies like

Novell, HP, and CA, who offered similar software, seemed

to have fallen out of LANDESK’S strategic group. Still

other firms, such as those in High Growth Niche Providers,

seemed to be improving their product scalability. These

dynamics are represented on the chart with arrows.

The strategic group map successfully informed the

development of targeted competitive strategies, but also

helped identify potential acquisitions, pricing, and product

feature enhancements.

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an existing airline, you might be able to identify new opportunities for competitive position- ing by studying the differences between how other airlines and cars are competing across relevant purchase criteria.

EVALUATING THE COMPETITION

Now that we’ve explored how to look at the competitive landscape, we can turn to examin- ing the motives and likely behavior of individual competitors. Anticipating the actions of rivals is an important skill for companies because it helps them evaluate their own competi- tive moves to identify those that will have the most advantageous effect. A useful way to examine a competitor is to develop a competitor response profile.9 A competitor response profile identifies characteristics of a competitor in order to assess how it might respond in the face of rival actions, as outlined in Figure 11.4.

What Drives the Competitor? To illustrate how to build a profile, let’s return to the airline industry. Let’s assume that Southwest Airlines wants to compete on international routes in Europe and is evaluating Delta as a competitor. The first question to ask is, “What drives the competitor?” Within this category, objectives and assumptions are identified. An objective for Delta could be, “Lever- age the benefits of international scale for overall cost savings,” or, “Capture a greater share of market by providing home-to-destination travel for international passengers.”

What assumptions reinforce these objectives? One is that passengers want to fly the same airline domestically and internationally, possibly because of co-located terminals or

competitor response profile A profile of a competitor that

identifies its objectives and

assumptions, its strategy, and its

resources and capabilities in order

to anticipate how the competitor

might respond to rival actions.

WHAT DRIVES THE

COMPETITOR

Objectives

Leverage the benefits of

international scale for overall

cost savings.

Capture a greater share of

market by providing home

city to destination travel for

international passengers.

Position as an international travel

choice to as many customers as

possible by building an extensive

travel network.

Locations in major cities

Airline partners that provide global

reach

Fleet of large aircraft

Reliable and service-oriented travel

Passenger want to fly the same

airline domestically and

internationally.

Scale savings exist by having a

global footprint, which permits

competitive pricing on international

routes.

Delta is likely to

largely ignore entry

into its international

city-part markets by

Southwest, as long as

these entries remain

few.

Strategy

Assumptions Resources & Capabilities

Delta

WHAT THE COMPETITOR

IS DOING OR IS

CAPABLE OF DOING

[ Figure 11.4 ] Competitive Response Profile

Source: Adapted from M. E. Porter, Competitive Strategy (New York: The Free Press, 1980).

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easier baggage transfers. Another is that scale savings exist by having a global footprint, and that this permits competitive pricing on international routes (since scale savings lower costs). These kinds of assumptions often point the way to potential rival moves. For example, if Southwest theorized that the scale savings from Delta’s global footprint were small, or that Southwest’s own operating model gave it significant cost benefits, it could plan on using this as an advantage against Delta and contest some of its more popular international routes.

What Is the Competitor Doing or Capable of Doing? After identifying the objectives and assumptions that drive the competitor, the next ques- tion would be: What is the competitor doing and capable of doing? Here is where a competi- tor’s strategy and their resources and capabilities are identified. What is Delta’s strategy? Put simply, Delta’s strategy is to position itself as an international travel choice to as many customers as possible by building an extensive travel network.

What resources and capabilities does Delta use to accomplish this? Resources include its locations in major U.S. cities that are international gateways, such as New York, Atlanta, Seattle, and San Francisco; airline partners that provide coverage where Delta is weak; and a fleet of large planes that are characteristic of long-haul travel on international routes. Fur- ther, the airline has built a capability for reliable, timely, and service-oriented international travel. These resources and capabilities point directly to what Delta can do on a competitive basis, such as supplying international corporations with end-to-end travel services. These are the strengths that Southwest, in our hypothetical example, must acknowledge if it is going to go up against Delta.

How Will a Competitor Respond to Specific Moves? Once these four factors—objectives, assumptions, strategy, and resources/capabilities—are laid out for a specific competitor a company like Southwest can anticipate how the com- petitor might respond to specific moves. For example, given this profile, how would Delta respond to Southwest entering one of its existing city-pair routes? Given that Delta differ- entiates, in part, by providing a broad set of international route options to customers, the company will probably not react to Southwest entering a single city-pair route or even sev- eral routes. Why? Think of Delta’s objectives, assumptions, strategy, and resources/capabili- ties identified above. These included international scale, cost savings based on this scale, an end-to-end extensive travel network, and substantial global assets. Because Delta is adding value by being in as many places as possible and is building an extensive network, the com- pany is unlikely to view the entry of a competitor without these objectives and resources as a threat to its broader strategy. In formulating its competitive strategy, Southwest can feel confident that entering into markets already occupied by Delta will be accommodated; at least while Southwest’s international travel network remains small. If it begins to grow large, Southwest could wind up moving into Delta’s strategic group, which could then invite intensive competition.

Using Game Theory to Evaluate Specific Moves A competitive response profile provides an extensive look at a particular rival and also lends insight into how this rival might respond to specific strategic actions. When rivals are locked in intensive back and forth competition, such as that experienced in the airline industry, a structured approach to analysis can lend even more insight. The tools of game theory provide such a structured approach. The word game in game theory refers to strategic inter- action among competitors and the word theory refers to a set of predictions about how com- petitors play games.

In most games, rivals are expected to make moves that deliver the greatest profit, called a pay-off. Firms typically make their choices with this objective in mind. But rivals have choices, too. With both firms facing choices, each must consider what the other will do

game theory A structured approach to analysis of competitor

interaction that yields predictions

about which strategic actions are

most likely to be chosen by rivals.

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in order to reach their own best outcome. This logic of anticipating what is in a rival’s best profit interest before making your own move is central in game theory. Had Delta consid- ered this in the opening case, the company might have anticipated how quickly rivals would respond to its price cut.

Game theory is especially useful in contexts in which only a few rivals exist (like airlines) and these rivals are considering such moves as price changes, capacity adjustments, or new product features, and are wondering how competitors are likely to respond. Let’s examine the logic of game theory to see how it can be used to anticipate and respond to rival actions.

Simultaneous Move Games. To illustrate the basic logic, let’s consider a simple game with two players, each of whom has two choices. Assume the players make their moves simultaneously and they only play the game once. This set up is called a simultaneous move, one-shot game. The most famous game of this type is the prisoner’s dilemma. The prisoner’s dilemma is as follows:10 Two individuals, prisoner 1 and prisoner 2, rob a bank of $2 million and hide the loot. They have been captured and are being held by police in separate cells. The police believe that the two robbed the bank but lack sufficient evidence to convict. So they decide to separately offer to each prisoner the following deal: “If you implicate your partner, we will give you leniency. But if your partner implicates you, you will get jail time.” The prisoners know that if neither implicates the other, they will both go free.

Now consider the following 2 × 2 matrix representation of the game shown in Figure 11.5. It shows that each prisoner has two choices. Prisoner 1’s choices are on the rows and pris- oner 2’s choices are on the columns. The numbers in the cells are payoffs. The payoff on the left in each cell belongs to prisoner 1 while the payoff on the right belongs to prisoner 2.

To interpret payoffs, assume that one year of jail time is the equivalent of $1 million of the loot. If neither prisoner implicates the other, they go free and share the loot. If both impli- cate, they go to jail for one year each. If one implicates the other while not being implicated, he gets off and takes all the loot for himself, while the other goes to jail for two years. Assume that the prisoners only play the game once. They either get off free and go their separate ways, or do so after they get out of jail. Also assume that if they both go to jail, the loot is recovered by the authorities.

Since the prisoners are being held in separate interrogation rooms, they must make their choices (“implicate” or “do not implicate”) without knowing the choice of their partner. This is the simultaneous move aspect of the game. Assume both players know the structure of the game and the payoffs accruing to their respective actions.

What is predicted outcome for this game? John Nash, a famous game theorist, developed an equilibrium concept in games that has come to be known as the Nash equilibrium. The Nash equilibrium is represented by a set of moves in a game that: (1) maximizes each firm’s payoff given the choices of rivals and (2) removes incentive to defect in the sense that no player can improve his payoffs by changing his choice. The first component of the definition reflects that players are striving to achieve their best possible outcome while the second ensures that the outcome is stable (i.e., the players have no incentive to change their action).

Nash equilibrium A set of moves in a game that simultaneously

maximize each firm’s payoff, given

the choices of rivals and from

which no player has an incentive

to defect.

[ Figure 11.5 ] Prisoner’s Dilemma

Prisoner 2

P ri

so n

er 1

Implicate

Do not

implicate

Implicate –1, –1 2,–2

Do not

implicate

–2, 2 1, 1

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The Nash equilibrium is the solution concept used to predict the outcome of competitive interaction.11

To find the Nash equilibrium, think through what a player should do under each possible move of its rival. Let’s look at the game from prisoner 1’s perspective. Suppose prisoner 1 thinks that prisoner 2 might implicate (look at the implicate column for prisoner 2). Pris- oner 1 has two choices. He can implicate and receive –1, or not implicate and receive –2. Which does he prefer? He prefers to implicate since we assume that players always prefer the better payoff.

Now let’s consider what prisoner 1 would do if he believes prisoner 2 will not implicate. Under this scenario, prisoner 1 receives a payoff of 2 if he implicates and a payoff of 1 if he does not implicate. Clearly, he prefers to receive 2 over 1, so he would implicate.

Notice that no matter what player 2 chooses to do, player 1 maximizes his payoff by choos- ing “implicate.” Doing the analysis from prisoner 2’s perspective gives the same answer. The intersection (cell) of any choices that are simultaneously preferred by the players of a game is considered a Nash equilibrium, as long as there is no incentive to defect. In this game, each player’s best choice is to implicate, and neither has an incentive to change this choice.

Implicate is also what is called a dominant strategy because it is the best choice under every alternative choice of the rival. Searching for a dominant strategy makes finding a Nash equilibrium easier in games where such strategies exist. In the prisoner’s dilemma, after dis- covering that “implicate” is a dominant strategy, the analyst can cross off both the row and column associated with “do not implicate.” This choice would never be employed because it is always dominated by the implicate choice.

Notice how the style of analysis that we used to solve the game resulted in the develop- ment of a strategy for play. In game theory, a strategy is a set of best responses to every possible rival action. We systematically analyzed prisoner 1’s prospects under each possible alternative action of prisoner 2 and selected the best outcome. In the real world as well, this is a useful approach for developing competitive strategy. If the number of possible moves of a rival is small, a potential response to each one of those possible rival actions can be planned. Having done so, a company would have identified a competitive strategy.

The key lesson from the prisoner’s dilemma is that each player implicates and goes to jail when a much better outcome exists. If they both play “do not implicate,” they share 1, or $1 million each. However, the competitive risk, the lack of trust, the worry that a rival will take advantage of the situation if he thinks the other will play “Do Not Implicate,” keeps both players going to jail. The reason this is important in real markets is that it suggests a truth about competitive behavior. Namely, competitors will play with their own best interests at heart. Furthermore, since in most markets cooperation between competitors is anticom- petitive and illegal, coordination typically does not exist—and neither does trust. Therefore, the prisoner’s dilemma offers a compelling prediction about what happens in real markets when companies have opposing interests.

Now consider a prisoner’s dilemma game in the business world. Let’s return to the opening case and assume that Delta Airlines is playing a one-shot pricing game against American Airlines (we’ll make the one-shot assumption for now and relax it in a moment). Let’s assume that in this game each firm has two choices. It can either maintain price or lower price. If both maintain price, each earns a profit of 5, or $5 million. If both lower price each earns a profit of 2, or $2 million. But if one company lowers price while the other main- tains price, the first company receives a profit of 10, or $10 million while its rival loses 1, or $1 million. See Figure 11.6.

To solve this game, take the perspective of one firm and decide which move would be best under each alternative action of the other firm. If Delta believes that American will maintain price, it has a choice between payoffs of 5 and 10 for maintaining and lowering price, respectively. Clearly, Delta prefers to lower price. If Delta believes that American will lower price, then it has a choice between a payoff of –1 and 2. It prefers to lower price to receive the payoff of 2. The logic is similar from American’s perspective.

As in the traditional prisoner’s dilemma, both firms wind up with payoffs that are worse than they might have had. Specifically, if both companies would maintain price, they would each wind up with $5 million. However, in the one-shot game, the pull to try for $10 mil- lion is very strong. This leads both companies to a relatively poor outcome of $2 million.

dominant strategy In game theory, a set of actions that are always

played no matter what a rival

chooses to do.

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This game illustrates how the prisoner’s dilemma can affect firms in real markets. Rival- rous behavior can make both firms worse off than they might’ve been if they had been able to cooperate. The example also illustrates how a simple game structure can be utilized for insight into how players might respond to one another’s strategic moves.

Infinitely Repeated Games. Now let’s relax the assumption that competitors interact just once as in the one-shot game. In the real world, most companies are in competition with rivals each and every day, month, or year with no certain end date. Game theorists call these games infinitely repeated games. Even though the games are not literally played forever, they are treated this way since the competitors repeatedly interact and the ending period is not known.

In infinitely repeated games, players always believe there is a future. This alters the way they play. Specifically, they look for opportunities to get a larger amount of profit over a longer period of time. In stable markets in which the players rarely change for instance, firms play the game indefinitely. They know that they will be facing their rivals each and every period.

Delta and American play an ongoing pricing game in which they must decide whether to maintain, lower, or increase price each and every period. (In fact, pricing games are played on each and every route, often with multiple players). The companies do not know if or when the games will cease to be played so treating their rivalry as an “infinite horizon” game is sensible.

To see how this affects the outcome of the game between Delta and American, con- sider again Figure 11.6. We already know what happens in a one-shot game— both players choose to lower prices, which makes them both worse off. However, both players know that they are not playing a one-shot game. They can lower prices this period, but they have many future periods to go. In this situation, we assume that the firms look at the payoffs and realize that they will be better off over the long run if they maintain prices. Firms rea- son that this type of collusion is in their mutual best interest, and they assume that their rival is thinking the same way. Therefore, each decides to maintain price and expects rivals to do the same.

In effect, companies in this situation enter into a style of play called “tit-for-tat.” In a tit-for-tat strategy, companies watch each other closely and choose actions that mimic what their rivals are doing. As long as a rival is “cooperating,” the firm chooses to cooperate. If a rival defects from a cooperative stance, the firm responds in kind. In the game between Delta and American, each firm chooses to maintain price unless it observes its rival choos- ing to lower price. If at any time the rival lowers price, the firm will “punish” by lowering its own price. After a few periods of this kind of “punishment,” it’s possible that the rivals could return to collusion, but doing so could grow increasingly difficult in the presence of repeated defections (see Ethics in Strategy: Is Collusion Ethical?).

One question that arises in these types of repeated games is whether playing the one- shot Nash equilibrium is ever in a firm’s best interest. The answer depends on the differences in cash flows between collusion and defection (defection here means playing the one-shot action). The value of these cash flows, in turn, depends on the time value of money since pay- offs are received each period in perpetuity. Typically, however, ongoing collusion is the best

tit-for-tat strategy A strategy that responds in kind to the moves of

rivals.

[ Figure 11.6 ] Delta and American Play Out the Prisoner’s Dilemma

American Maintain Lower

D el

ta Maintain 5, 5 –1, 10

Lower 10, –1 2, 2

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approach and it is what most fi rms in long-standing stable competition practice. As explained in the chapter opening case, when Delta chose to lower prices, its rivals immediately followed suit. Th e logic of game theory that we have just reviewed shows why. In fact, rivals did not even wait for Delta to obtain a temporary advantage; they lowered prices immediately. Th ey reacted quickly with their tit-for-tat strategies, refusing to allow Delta to use price as a competitive advantage.

PRINCIPLES OF COMPETITIVE STRATEGY

Now that we know how to evaluate the competition and to analyze the dynamics between competitors, let’s turn to identifying competitive moves that are most likely to be eff ective. Th ere are four general principles of competitive strategy that should be followed as a com- pany looks for successful competitive moves.12 Th ese principles, when applied, strengthen a company’s ability to compete:

1. Know your strengths and weaknesses

2. Bring strength against weakness

3. Protect and neutralize vulnerabilities

4. Develop strategies that cannot be easily imitated or copied (go where the competitor is not)

Companies that consistently do battle with the same set of competitors eventually develop norms of competition that help them avoid low profits. Although the companies

are not communicating directly to develop these norms

(which would be illegal), they watch each other so closely

that consistent patterns of behavior—norms—can quickly

emerge. The norms can influence pricing, product or service

features, or certain kinds of restrictions on customers that

all companies impose.

For example, many people own a cell phone and

have signed a two-year contract for service with a

telecommunications company. All of the major cellular

providers, AT&T, Verizon, and Sprint, offer this two-year

contract. How did this situation arise? Simply put, the

major telecommunications providers tacitly colluded to set

the contract requirement at two years. Whether it’s airline

pricing, in which airlines collude to keep prices high and

avoid price wars for themselves, airline service features

such as charging for bags on flights; the price of gasoline

at the pump; or the cost of an automobile or medication,

large and powerful companies—airlines, oil companies, auto

companies, pharmaceutical companies, and so on—often

collude to keep profits high.

On the one hand, by keeping profits high, these companies

are able to invest in research and development and continue

to come out with great products. Such products can even

improve the quality of life. In the pharmaceutical industry, for

example, companies would not be willing to invest billions of

dollars in research and development without a reasonable

assurance of recouping this cost through high prices.

On the other hand, high prices of drugs or other products

limit access. Through collusion, many products are priced

out of reach of less-affluent consumers. As large companies

use their power to raise prices, or contract lengths, higher

proportions of economic resources are directed toward their

products and away from other products or causes in the

economy. Some would say that this misallocates resources

in ways that make consumers worse off and unfairly

channels profits to shareholders.

What do you think? Should the legal form of collusion

practiced in markets by large firms be allowed? Should

restrictions be imposed? If so, how would such collusion be

monitored and controlled? Are you willing to accept collusion

in exchange for better-quality products in some cases? Does

your view change if you are a shareholder of a company that

practices collusion?

E T H I C S A N D S T R AT E G Y

Is Collusion Ethical?

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Know Your Strengths and Weaknesses A company’s strengths are the resources and capabilities that deliver unique value (see Chapter 3 for a detailed discussion of resources and capabilities). A company must work to develop these strengths through focus, investment, and effort. A key strength of Apple is product design. But it is the relentless focus on developing and investing in that strength that turns it into a strong and enduring source of competitive advantage.

A company’s weaknesses are the resources and capabilities that are subject to rapid obsolescence, easy imitation, or high cost not recouped by value. Apple has strengths in product design, but its products are subject to rapid obsolescence due to the rapid pace of technological change. Similarly, Starbuck’s atmosphere is easily imitated so the company cannot rely on this as a source of competitive advantage.

A company must make a careful and accurate assessment of its strengths and weak- nesses because these form the foundation of competitive strategy as the next two principles illustrate.

Bring Strength against Weakness Second, bring strength against weakness. Once a company’s key strengths are identified, these should be targeted to competitor weaknesses. Bringing strength against weakness can have devastating effects on the competition. When Google launched Android in 2007 as a mobile operating system for smartphones, Microsoft was already limping along in mobile phones, having suffered rapid market share declines because of products from Apple and Research in Motion (RIM). Google leveraged its formidable strength in software engineer- ing innovation and then built a coalition of manufacturers who would adopt Android (the open handset alliance) to deliver a strong body blow to Microsoft, whose rapidly decaying resource investments and declining market share made the company vulnerable in this area.

Sometimes competitor weaknesses may be masquerading as strengths, so any apparent competitor strength that can be undermined or eroded through direct competitive action can be considered a weakness. Therefore, in their hunt for competitor weaknesses, com- panies should not be afraid of attacking competitive strengths. As Kmart struggled to stay afloat amidst bankruptcy, Walmart attacked what was considered one of Kmart’s few areas of success by introducing a knockoff of Kmart’s Martha Stewart product line.13 This strong blow contributed to Kmart’s downfall.

Protect and Neutralize Vulnerabilities Third, protect and neutralize vulnerabilities. A company’s own weaknesses, once identified, must either be strengthened or truly neutralized; that is, made irrelevant so that they don’t become targets of competitors. Starbucks neutralizes the effect of an easily imitable atmos- phere by also introducing a large variety of great tasting coffee blends, food items, store convenience, and brand positioning.

In the last story, Microsoft might have assessed its weakness in mobile earlier than Google did and made moves to strengthen this vulnerability by investing much earlier in a new mobile operating system. As another example, some regard Apple’s closed, propri- etary mobile operating system, iOS, as a competitive vulnerability since other companies are not allowed to deploy it on its devices. This could limit its market potential. In fact, Google attacked this weakness by making Android an open platform. However, Apple has been highly effective at neutralizing this weakness through strong design of its products and development of an extensive developer network in which developers of applications share in the value of the proprietary system.

Develop Strategies That Cannot Be Easily Copied Lastly, develop strategies that cannot be easily imitated or copied. This seems obvious, but often companies are so busy copying competitor’s moves that they fail to see how they could

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do something altogether different. The principle might be best captured in the idea of going to where the competitor is not. Sun Tzu, the great Chinese strategist, once said, “To be cer- tain to take what you attack is to attack a place the enemy does not protect.”14 Whether a company is pursuing special market niches, reconfiguring the sequence of its activities along the value chain, or recombining and leveraging resources of themselves and partners in ways that deliver value, competitive strategy flourishes when companies are doing some- thing unique.15

In fact, most long-time competitors have found a way to occupy distinctive positions in their markets so that they can coexist with other companies profitably. Returning to the airline industry, even though American, Delta, and United compete in the same strategic group in the United States, each has carved out distinctive hubs within their nationwide hub and spoke system so that they don’t completely overlap as they compete. Delta has hubs in Salt Lake City and Atlanta. United has hubs in Chicago and Denver. American has hubs in Dallas and Chicago. So although there is some overlap between the cities to which they fly, each of the major competitors has staked out a somewhat distinctive position relative to rivals.

In summary, these four competitive principles may be used to develop strong and unique competitive positions that improve the likelihood of long-term competitive success.

COMPETITIVE ACTIONS FOR DIFFERENT MARKET ENVIRONMENTS

Clearly, not just any competitive move will work against a target competitor. A firm’s cir- cumstances define which competitive actions are available and likely to be effective. Market context strongly influences the scope of competitive action. One particular aspect of market context, market structure, is highly influential. Think of market structure in its simplest terms as the number of rivals in a particular market. Market structures typically fall into one of three categories: monopoly, oligopoly, or perfect competition (sometimes referred to as just “competition”). 16 Each of these market structures creates certain competitive condi- tions that lead to particular sets of strategy choices when facing competitors.

Competition under Monopoly A monopoly is a market of one firm or one highly dominant firm, such as SIRIUS XM in satellite radio or Microsoft in word-processing software for personal computers.17 The basic strategic objective of a monopolist is to reinforce its monopoly. It does so in several ways, such as by: (1) raising entry barriers, (2) limiting competitive access to scarce resources, (3) innovating and patenting, and (4) introducing new products frequently. If a monopo- list has new competitors threatening to enter its market, these are among the competitive actions they should consider taking as a response. On the flipside, the competitor attempt- ing to enter the monopolist’s market can expect these kinds of retaliatory actions from the monopolist.

Raise Entry Barriers. A barrier to entry is any factor that increases the costs, lowers the profit margins, or limits the market share of entrants to a market. For example, a monopolist may choose to practice limit pricing, which means to set the market price of a product just low enough so that a new entrant cannot pay the cost of entry to come into a market and be profitable. Investing in heavy advertising or advertising over long periods of time also raises entry barriers. Coca-Cola’s brand equity, worth billions, was built through long-term consistent advertising, and it is a formidable barrier to entry for any firm looking to get into the cola market.

Limit Competitive Access to Scarce Resources. If a monopolist can place a lock on the resources that it uses to produce its product, it can effectively bar competition. The monopolist might hire the most valuable scientists or other experts; it might secure the

market structure The way rivals in a market interact and bargain

for advantage. In its simplest

terms, it’s the number of rivals in a

particular market.

barrier to entry Any factor that increases the costs, lowers the

profit margins, or limits the market

share of entrants to a market.

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most advantageous geographic or real estate positions; or it may procure all of the capacity available in a market for some particular input. For example, when JetBlue launched its regional jet strategy, the company entered into contracts with Embraer, the Brazilian manufacturer of regional jets, to purchase all of Embraer’s planes for three years. This effectively blocked any other competitors from procuring the same regional jets and implementing the same strategy.18

Innovate and Patent. To maintain its competitive position, a monopolist is often required to innovate and patent.19 Indeed, in many monopolies both the monopolist and would-be entrants are in an innovation race. Potential competitors can bring down a monopolist by making the monopolist’s product obsolete through innovation, while monopolists can stay ahead of potential market entrants by innovating themselves. As already mentioned, Microsoft lost its hold on the operating system market in 2008 after failing to sufficiently innovate in mobile operating systems for mobile devices.

Introduce New Products Frequently. By introducing new products frequently, monopolists can maintain the customer demand associated with their products and stay ahead of potential entrants who are trying to get into their markets. Apple Inc. dominated the market for handheld music players (the iPod) in the early days. Other firms attempted to get into this market, and certainly other devices appeared, but these devices obtained only a small fraction of the total share of market. Apple kept would-be entrants off balance by consistently and frequently releasing new product upgrades and enhancements. As already noted, this was also a way for Apple to overcome a potential weakness of rapid obsolescence.

Competition under Oligopoly Oligopolies are markets of a few firms, typically 2 to 5 firms, though in some cases the num- ber of firms in these markets can also be up to 8 or 10. The upper bound is difficult to define because the oligopoly designation depends on whether firms in these markets are monitor- ing and reacting to specific rival behavior. If there are few enough firms for each to monitor the others effectively, then they are probably operating in an oligopoly.

Because the firms in oligopolies are locked in tight competition with only a few other firms, they must make their moves carefully, knowing that rivals will detect their actions and respond accordingly. We saw this as we analyzed infinitely repeated games and looked at an illustration of the competition between Delta Airlines and American Airlines. From a competitive perspective, oligopolists monitor and mimic rival behavior, particularly in price and product features, and they employ tit-for-tat strategies.

Monitor and Mimic Rival Behavior. Oligopolists try to avoid the negative effects of competition by monitoring and matching rival behavior. In this process, norms emerge in competition around particular approaches to the market. For example, pricing norms are very common. Companies know that they could dramatically cut their price and possibly pick up market share in the short run, but they realize that this move would be quickly detected and matched, leading to lower profits for all firms in the market.

We analyzed this scenario using game theory. In the opening case, Delta airlines violated the pricing norm of its strategic group by matching prices with the low-fare carriers. This led to immediate retaliation by rivals so that almost no advantage was obtained and the whole industry suffered. This is a clear example of how trying to beat the norm rarely pays. Thus, for the good of long-term profits, firms usually simply respond to one another’s pricing and product features at levels that are profitable for all (also see infinitely repeated games).

Although the firms in oligopoly almost always respond to one another’s pricing moves, they don’t always match price, since some companies position their products at a pre- mium. Coke and Pepsi are oligopolistic rivals, but Coke has staked out a price position that is slightly higher than Pepsi. Even so, if Pepsi raises its price, Coke would, too, in order to maintain the differential.

Price is not the only area of mimicking and matching among oligopolists. The behavior can also be seen in product or service-feature competition. When one airline announces a new frequent-flier program or significant new upgrades to its existing plan, so do the others.

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When one hardware manufacturer, such as Apple, introduces a new touch-screen device, rivals quickly follow suit. When Chevron adds a new detergent additive to its gasoline, Tex- aco does the same (the two companies have now merged). By matching product and service features, oligopolists ensure that they do not fall behind. In this way, oligopolists protect their profits and command higher margins from the market overall.

Finally, oligopolists may tacitly respond to one another in ways that carve up the mar- ket so that all can profitably coexist. The airlines do this with major hubs in different cit- ies. But the behavior can also be seen in the ways that oligopolists sometimes choose to appeal to particular market segments, with one providing price leadership in one segment and another providing it in a different segment (see Strategy in Practice: Tacit Collusion Between AT&T and Verizon).

Employ Tit-for-Tat Strategies. We discussed tit-for-tat strategies in the game theory section. Tit-for-tat strategies are those that respond in kind to the moves of rivals, including the meting out of punishments for behavior that violates norms. Because of the threat of this type of punishment, defections from tacit collusion are reasonably rare among oligopolists. When defections do occur, they are often accompanied by a signal that communicates the parameters of the action, such as length of time, in a way that rivals can clearly read. For example, airlines may run sales discounts on certain city-pair routes, but these discounts are almost always accompanied by specific dates on which discounted fares are available. This provides an explicit signal to rivals so that they can interpret the parameters of the discount and avoid a price war.

“Perfect” Competition “Competitive” markets are markets with many firms. In competitive markets, firms are price takers rather than price setters because attempts to use price strategically, as is done in monopolies or oligopolies, are not effective and wind up only hurting the firm that tries. The logic goes like this: Since a firm sells a homogeneous good in a market of many firms, rais- ing price leads to a dramatic drop in sales as customers go elsewhere. On the other hand, lowering price can backfire since firms are assumed to operate at full capacity. If firms are at full capacity, dropping price reduces total margin by more than it increases sales, leaving the firm worse off. If firms are not yet at full capacity, then price will typically fall until they are, and further attempts by individual firms to cut price sill have negative effects. This is why firms in perfectly competitive markets set prices at the market prevailing price (they take price) and largely avoid strategic manipulation of price.

Since a typical assumption of competitive markets is that products are largely homogeneous, very little differentiation is assumed to exist in these markets. This leads to a very specific set of competitive strategies that are likely to be successful. The list includes: (1) consolidate markets, (2) pursue low cost, or (3) pursue differentiation strategies.

Merge or Consolidate Markets. Firms in competitive markets often suffer from the superior bargaining power of buyers or suppliers ( forces that are part of Michael Porter’s five forces model discussed in Chapter 2). Because many firms in the market are selling a homogeneous product, bargaining power is difficult to obtain. This feature of the market also creates intense rivalry among firms.

One strategic remedy to this problem is for firms in the market to merge. As they merge, the overall market consolidates, reducing the number of firms and strengthening the bar- gaining power between the firms’ upstream suppliers and downstream customers. This merger and consolidation process is the way that industries evolve toward oligopoly.21

A competitive market of “mom-and-pop” video rental stores gave way to a consolidated oligopoly of Blockbuster and Hollywood video stores in the 1990s and 2000s. Hollywood video, in particular, began as a local video rental family business and, through the vision of its CEO, Mark Wattles, eventually expanded to 2000 stores nationwide. In the face of this consolidation, most of the mom-and-pop video rental stores disappeared.

In this example, the consolidators built new stores and the old stores disappeared, but with enough foresight, the old mom-and-pop stores might have merged in local markets and retained

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their hold on the business. Th is is a particularly good illustration of how fi rms in a competitive market can fail to anticipate the kinds of moves that could save them from obsolescence.

Pursue a Low-Cost Strategy. Since companies in competitive markets are price takers, they have little control over price. Th erefore, in order to realize profi t, they must drive down their costs. In fact, it might be said that companies in such markets will live or die on their ability to get costs down. Especially in markets for which diff erentiation is diffi cult, rivals can expect other fi rms to be aggressively lowering costs. Th ey must respond in kind in order to remain competitive. Chapter 4 details strategies for reducing costs and any of those strategies can help the fi rm in a competitive market be successful.

Pursue a Differentiation Strategy. When possible, companies in competitive markets should pursue a diff erentiation strategy. To separate themselves from the pack, they can add product features, store locations, bundled services, or other variations to create unique value

Tacit Collusion Between AT&T and Verizon S T R AT E G Y I N P R A C T I C E

From 2007 to 2011, AT&T enjoyed a monopoly on the iPhone since it was the only cellular carrier that Apple, Inc. allowed to provide services for the phone. But in January

2011, Verizon was also finally permitted to carry the iPhone,

setting up an oligopoly between AT&T and Verizon (Sprint

was added in October of that year). Following a short period

of offering unlimited data plans, both AT&T and Verizon

eliminated their unlimited data plans for new users.20

In addition to matching one another’s moves in this way, the

companies’ pricing behavior took on a collusive flavor. AT&T

priced slightly lower than Verizon for data plans up to 4 GB and

Verizon priced slightly lower than AT&T for data plans above 4

GB. In addition, the slope of the pricing curve (the rate at which

price rises as additional data is added to a plan) was almost

exactly the same for the two companies at key GB levels (see

Figure 11.7). In other words, as AT&T’s price rose, so did

Verizon’s as the companies sought to maintain a consistent

pricing differential. Notice in Figure 11.7 how the companies

were not necessarily matching prices, but their pricing

structures were very similar. An understanding seemed to

exist between the two in which AT&T would appeal to the low-

end customers (those who used less data) while Verizon would

appeal to the high-end customers (those who used more data).

The matching behavior of the cellular carriers in pricing and

plan structure, and the different targeting of market segments,

demonstrate how oligopolists collude to maintain profitability.

0.2 $0

$20

$40 $30 $30 $30

$40

$50 $50

$60

Verizon Cheaper

AT&T Cheaper

$65

AT&T Verizon

$55

$45

$35

$25$25 $15

$80

$105

$60

$80

$100

$120

1.0 2.0 3.0 4.0

Monthly Data (GB)

Im pl

ie d

C os

5.0 6.0 10.0

[ Figure 11.7 ] Smartphone Monthly Wireless Data Cost Comparison—AT&T Cheaper at the Low End, Verizon Cheaper at the Higher End

Source: Barclays Capital, company reports and websites

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for customers. However, in markets with many firms selling homogeneous products this is often easier said than done. Consider book selling on the Internet. For any given title, a book may be obtained from multiple different sources, including Amazon, Barnesandnoble.com, Walmart, Target, or a host of smaller sellers or even used book sellers such as eBay. The firms sell the same book. How can they differentiate? The product is the same no matter where it is bought. In this case, firms are left to differentiate on other aspects of the buying experience, such as the look and feel of the website, its ease-of-use, or the checkout process. Early in its history, after realizing it could not make money on discounted bookselling, Amazon expanded its business into many other product lines. The fact that a customer can go to Amazon and buy not only a book but also many other items now helps Amazon differentiate its buying experience for books alone. Chapter 5 details differentiation strategies and these may be especially useful for firms in competitive markets.

Dynamic Environments The strategies discussed so far apply to stable market structures. However some competi- tive environments are very dynamic with competition constantly changing. Perhaps tech- nology is changing at a very rapid pace; or new entrants with new technologies, products, or approaches are entering markets very quickly; or market consolidation is changing the landscape in unexpected ways. In such environments, industry incumbents may not be able to raise entry barriers or limit access to scarce resources rapidly enough to stave off competition.

What companies must do in these environments is reconfigure their processes and capa- bilities to emphasize both innovation and speed. Imagine a company without these char- acteristics. Even if such a company were able to erect barriers to entry or secure access to scarce inputs, these advantages are likely to be fleeting because new competitors will rapidly innovate around them. Without capabilities of speed and innovation companies in dynamic environments are rapidly left behind. The smart phone industry provides an exam- ple. In an important growth era, the innovations and speed of Samsung, Google, and Apple quickly outpaced the market positions of companies like RIM, Nokia, and Microsoft. To stay in the game, these companies too must be innovative and quick to market with value creat- ing products.

SUMMARY

To effectively compete, a strategist should know the competition, including understand- ing the competitive landscape and how to evaluate specific competitors and their poten- tial moves.

The tools of game theory can lend insight into competitive interaction by helping the strategist think systematically about how a company’s moves impact competitors, and vice versa.

Principles of competitive strategy, such as knowing strengths and weaknesses, bringing strength against weakness, protecting and neutralizing vulnerabilities, and developing inimitable strategies, are useful for identifying successful competitive options.

Competitive actions depend on the market environments in which firms compete, with some actions being more effective for certain environments than others.

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KEY TERMS

barrier to entry (p. 228) barrier to mobility (p. 218) competitor response profile

(p. 221)

dominant strategy (p. 224) game theory (p. 222) market structure (p. 228)

Nash equilibrium (p. 223) strategic group (p. 217) tit-for-tat strategy (p. 225)

REVIEW QUESTIONS

1. Name two frameworks for understanding the competitive landscape.

2. What is a strategic group analysis, and how is it useful?

3. What factors might limit a company’s ability to switch strategic groups?

4. What is a competitor response profile, and how is it useful in evaluating competitors?

5. Define the Nash equilibrium used in game theory to predict the outcome of competitive interaction.

6. Identify the four general principles of competitive strategy.

7. What are the three types of market structures?

8. What are the strategies most likely to be useful for a monopolist?

9. What are the strategies most likely to be useful for an oligopolist?

10. Why do firms in an oligopolistic environment often hesitate to make moves that will take them outside of the status quo?

11. What strategies are most likely to be useful for firms in “perfectly” competitive markets?

12. What types of strategies are most useful for firms operating in dynamic markets?

APPLICATION EXERCISES

Exercise 1: Choose an industry and construct a strategic group map. Do this by identify- ing some of the major players, and some of the key differences in how they compete. Select two factors for the two axes and plot the firms. Do you observe a group structure? Explain.

Using the same industry as above, identify three companies that sell a similar product. List some of the product attributes. Now evaluate each company’s product on those attrib- utes (okay to do qualitatively) and plot the data using a strategy canvas view. What insights do you gain? Exercise 2: Identify a company whose products you use frequently. Now identify one of its competitors. Imagine that you are the chief strategist for the first company. Using the prin- ciples of competitive strategy, list several strategic moves that you think could be effective against the competitor that you identified.

Exercise 3: Identify a company whose products you use frequently. Determine whether this company operates in a monopoly, oligopoly, or competitive market. What does this imply about the competitive strategies most likely to be successful? List some of these.

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REFERENCES

1 E. Perez, “New Pressure to Simplify Airfare; Delta Details Plan to Cut Some Prices by Up to 50%; Boston to Key

West for $389,” The Wall Street Journal ( Jan. 5, 2005).

2 E. Perez, “Business Fares Fall by One-Third; Delta’s Reductions Spread Beyond Its Flight Network Following Cuts

by American,” Wall Street Journal ( Jan. 26, 2005).

3 Perez, “New Pressure to Simplify Airfare.”

4 S. W. Ames Bernstein, “Delta’s Prices Reach the Sky, Soaring Fuel Costs Force a Stunning $100 Fare Hike; United,

Continental and USAirways Follow Suit,” Newsday, ( July 15, 2005).

5 S. Warren and E. Perez, “Southwest’s Net Rises by 41%; Delta Lifts Cap on Some Fares,” The Wall Street Journal,

Eastern edition ( July 15, 2005): A.3.

6 S. McCartney, “The Middle Seat: Airlines Are Increasing Minimum-Stay Rules; Step Is Effort to Force Business

Travelers to Pay More for a Trip,” The Wall Street Journal (Aug 19, 2008).

7 R. E. Caves and M. Porter, “From Entry Barriers to Mobility Barriers ,” Quarterly Journal of Economics 91(2) (1977 ):

241–262.

8 C. Kim and R. Mauborgne. “Charting Your Company’s Future,” Harvard Business Review (2002).

9 M. E. Porter, Competitive Strategy (New York: The Free Press, 1980).

10 The description of the prisoner’s dilemma employed here is adapted from D. Kreps, A Course in Microeconomic

Theory (Princeton: Princeton University Press, 1990).

11 Some games have more than one Nash equilibrium and some have no Nash equilibria. In these cases, game

theorists have developed more complex rules and techniques to predict game outcomes. Describing these rules

and techniques is beyond the scope of the current overview.

12 For a look at different approaches to competitive strategic moves, see G. Stalk and R. Lachenauer. “Hardball:

Five Killer Strategies for Trouncing the Competition,” Harvard Business Review (2004).

13 Ibid.

14 S. Tzu. The Art of War. In Classics of Strategy and Counsel: The Collected Translations of Thomas Cleary (Shamb-

hala, 2000).

15 D. J. Bryce and J. H. Dyer, “Strategies to Crack Well-Guarded Markets,” Harvard Business Review (2007).

Strategy Tool When Does Defecting From Collusion Make Sense?

In long-standing, stable oligopolies, most firms repeatedly play the collusive outcome. (Collusion here is legal since the

companies are not explicitly coordinating or price-fixing.)

However, we can use the payoff structure to calculate the

point at which firms would find defection to be preferable to

collusion. To do so, we simply compare the string of payoffs

under each alternative.

In the Delta and American game, maintaining price

delivers a stream of $5 million in perpetuity. The value of

this stream can be calculated as 5 + 5/i (5 received now

and a stream of 5s received in perpetuity in the future).

The value of defection can be calculated as $10 received

now plus a stream of 2s in the future. This is because if

either firm knows that its rival will maintain price, it can

initially grab a profit of $10 million by lowering price.

But then the firm knows it will be punished by its rival,

and both firms will lower price in future periods. The

value of the collusion stream is 10 + 2/i. We want to know

what discount rate on capital i, will make cooperation a

superior strategy. In other words, what value of i solves the

following equation:

5 5

10 2

+ + i i

≥

Applying add and subtract operations to both sides and

rearranging yields,

5 60

≥

≤

, or %

Therefore, in this example, as long as Delta or American’s

cost of capital or discount rate stays equal to or below 60

percent, the company should continue to maintain prices.

REFERENCES [ 235 ]

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16 Falling into a fourth category are markets of many firms in which firms are sharply differentiated, or heteroge-

neous. These are called monopolistically competitive. Although this term sounds like an oxymoron, it refers to

the idea that if the firm is differentiated it has a local monopoly on customers who uniquely prefer its differen-

tiated product. Also, since the firm operates in a market of many other firms that are likewise differentiated,

the market gets the “competitive” title. Consider a local restaurant market. All restaurants serve food and meet

the dining needs of their customers but the differences among these restaurants in food variety, flavor, price,

quality, ambience, service, etc. are stark. Competitive strategy in monopolistically competitive markets typically

follows the strategies, noted below, of a monopolist.

17 For many years, analysts considered Microsoft to be a monopolist in operating systems. Microsoft was not the

only firm in this market, but it owned such a dominant market share, and other players owned so little, that it

was able to behave as if it was a monopolist. (This ultimately invited federal antitrust lawsuits).

18 Bryce and Dyer.

19 Innovating and patenting is a way to maintain competitive position for firms in so-called Ricardian monopo-

lies. These monopolies are based on knowledge and invention and the fact that these firms possess unique

intellectual capital. Other monopolies are based instead on unique resource positions in which the monopolist

owns the vast majority of inputs required to produce the product. Here, monopolists may maintain their posi-

tion by restricting output, which drives up price and profits.

20 L. Dignan, “AT&T vs. Verizon Wireless: How Tiered Plans Will Shake Out,” blog, for Between the Lines ( July 18,

2011), http://www.zdnet.com/blog/btl/at-and-t-vs-verizon-wireless-how-tiered-plans-will-shake-out/52556.

21 A well-known example is the pharmaceutical industry, whose consolidation of the past few decades has starkly

reduced the number of firms competing. Consolidation has created huge pharmaceutical conglomerates such

as GlaxoSmithKline or Bristol-Myers Squibb. These firm names bear the remnants of previous firms (e.g., Glaxo

Wellcome, and SmithKline Beecham), whose firm names, in turn, often bear the remnants of still previous

firms. See also S. Klepper, “Firm Survival and the Evolution of Oligopoly,” RAND Journal of Economics 33(1)

(2002): 37–61.

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Implementing Strategy

[ 237 ]

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Studying this chapter should provide you with the knowledge to:

1 Describe how the extended 7 S model is used to determine the level of alignment within a company and between the company and its environment.

2 Evaluate a strategic change effort and explain the underlying reasons why the effort succeeded or failed.

3 Discuss how creating effective line-of-sight measures can assist managers in the strategy implementation process.

L E A R N I N G O B J E C T I V E S

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I f you have a credit card, chances are pretty good that you

have one issued by Citigroup. Citi is the third largest U.S.

bank, with over $1.8 trillion in assets, and it’s the second

largest distributor of credit cards in the United States with

92 million cardholders.1 For most of its two-century history,

Citi operated as a commercial bank that provided funds for

corporations, governments, and their projects, including the

Panama Canal and the Marshall Plan to rebuild Europe after

World War II.

Citi had operated retail branches since the 1920s. By the

end of the 1960s, the bank had 164 branches in and around

New York City.2 The average Citi account holder held just

$317 in an account, and Citi was not a significant competitor

in the cutthroat retail business.3 Citi’s retail operations,

including auto loans, checking accounts, mortgages, and a

fledgling credit card business, were not well-integrated, and

the lack of strategic coordination kept Citi from competing

effectively.

In 1968, Chairman Walter Wriston radically reorganized

the bank from its geographic structure to one of business

groups and industries.4 That reorganization put all the retail

businesses in a single division and allowed the assets to

be managed more efficiently. Wriston and head of retail

banking John Reed, surveyed the situation in late 1970

and envisioned the future of the bank in this collection of

underperforming assets the future for Citi.

Citi’s profits had historically come from “commercial

paper,” or making loans to other corporations to finance

their operations and growth. Wriston and Reed realized

the limits of this business. First, Citi had reached global

saturation as it financed and followed U.S. multinationals as

they expanded around the world. Second, they realized their

prime corporate borrowers were beginning to sidestep Citi

and obtain funds directly from bond and equity markets.

Reed began by bringing in new leaders with a new set

of skills to drive Citi’s growth. The retail banking industry

had always been conservative, with branch managers

dutifully booking deposits and making an occasional loan.

Reed changed all that. He recruited mid-level managers

and executives with extensive consumer product marketing

backgrounds. Consequently, marketing and advertising

knowledge became the skill sets that led to success in the

new Citi. Reed’s moves reflected his own aggressive style

and the underlying culture at Citi: a machismo and bravado

that had little patience for slow growth. It was “Go big or go

home.”

Citi’s retail strategy focused on customer service, and

the bank pursued opportunities to market a broad range of

financial services to individuals and households. One key to

the new strategy was Master Charge, Citi’s money-losing

in-house credit card.

Richard Kane, a Reed

associate who took

control of Master

Charge in 1976,

realized the company

lost money because it paid merchants on time but failed to

collect money from the purchaser’s own bank in a timely

manner. It took Kane over a year to solve this problem. When

he did in 1977, Citi scaled up its credit card operation. The

bank mailed out 20 million credit card solicitation letters

and received 4 million new credit card subscribers.

Citi’s game changer, however, was the Automated Teller

Machine, or ATM. Opening up retail branches all over the

state of New York, let alone the entire country, would be

prohibitively expensive. Reed told his team that he envisioned

the ATM as the central element of Citi’s retail branches,

“We’re going to electronify the teller position [and install] cash

machines and customer service terminals.”5 Citi designed

and built its own terminals because existing vendors didn’t

[M]ARKETING AND ADVERTISING KNOWLEDGE BECAME THE SKILL SETS THAT LED TO SUCCESS IN THE NEW CITI. REED’S MOVES REFLECTED HIS OWN AGGRESSIVE STYLE AND THE UNDERLYING CULTURE AT CITI: A MACHISMO AND BRAVADO THAT HAD LITTLE PATIENCE FOR SLOW GROWTH. IT WAS “GO BIG OR GO HOME.”

How Citibank Transformed Itself into a Retail Bank

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Citibank’s strategic change captures many of the real-world lessons you’ve learned about in this textbook. Walter Wriston and John Reed, who would succeed Wriston as Citi’s CEO, accurately scanned the banking environment and saw that their core business, commercial lending to the world’s largest corporations, represented a declining business. They created a bold new strategy that relied on the innovations of an ATM-based consumer interface and sought massive scale in the consumer credit cards to create a valuable low-cost offering. As the case illustrates, they did much more than just formulate a new strategy. They restruc- tured, restaffed, reskilled, and refocused a huge banking operation to support and imple- ment their strategic objectives. A primary objective of this chapter is to introduce you to three important skills strategists must possess if they hope to implement strategies: Forging alignment between the key elements of the organization and the strategy, leading an effective change effort to accomplish that alignment, and creating measurement systems to refine the strategy and ensure its implementation.

At one level, implementation is about action, or execution. The successful execution of a strategy requires a process that translates broad strategic objectives into clearly definable, everyday actions that make the strategy real, and then creating systems where people take those actions. Executive Larry Bossidy learned how to execute strategy working for Gen- eral Electric’s CEO Jack Welch. Bossidy ran GE’s capital division and guided that business through a flurry of acquisitions you read about in Chapter 6. He then went on to successfully run Allied Signal and eventually Honeywell. Bossidy was known for his ability to execute. His recipe for execution— outlined in his book The Discipline of Getting Things Done—involves four steps: (1) Create a set of clear goals for people to follow ; (2) find ways to accurately measure performance; (3) hold people accountable for their performance; and then (4) richly reward those who perform well.8

When John Reed led the transformation of Citi’s retail banking he had a clear goal and objective in mind: keep Citi’s earnings growing at 15 percent annually.9 Although he felt the target was unreasonable over the long term, the black-or-white nature of the 15 percent goal, and the ease with which his accounting staff could assess performance, provided a substantial incentive to think about how to enter the highly competitive retail banking mar- ket in an innovative and profitable way.

Wriston and Reed disagreed about many details of the new strategy and its implementa- tion, however. Reed won a number of those debates, but had to answer for his performance based on clear metrics to an impatient and demanding boss. Wriston saw that Reed hit his performance targets and eventually rewarded Reed with the top job at Citi.

Many strategies fail because people in organizations just don’t execute well. The strategy doesn’t translate into a clear set of measurable goals and, for whatever reason, people either don’t have to answer for their actions or receive no rewards, or punishments, for excellent, or poor, performance.

ALIGNMENT: THE 7 S MODEL

Execution matters, but as you saw in the opening case, effective implementation requires forging alignment between the external environment, the strategy, and the internal ele- ments of the firm. Let’s learn about how this is done. Most strategy researchers focus on strategy formulation, what you’ve spent most of this course learning about. Little

have Citi’s vision. Citi’s ATMs linked transactions directly into

Citi’s huge transaction processing network, cutting the cost of

completing consumer transactions.

The Citi culture emphasized taking big bets with the

hope of an enormous payoff, and Reed made a huge bet

on the ATM. At a time when the technology was new and

unproven, Citi invested $160 million to install ATMs at Citi’s

271 New York locations, and create an eventual nationwide

system of ATMs.6 This strategy turned the bank’s retail

operations from an insignificant contributor of revenue to a

business that now generates almost one half of Citi’s total

revenue.7

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attention typically gets paid to implementation, as it seems to be a matter of execu- tion.10 Implementation is as much a matter of alignment as it is of execution. Alignment means that the important elements of the organization are in the proper relationship with each other—which means they fit well together and reinforce each other. In an aligned organization all the elements support the strategy. This raises the question: Which elements?

A strategist can answer this question in many different ways. The authors’ experience with the 7 S model of organizational alignment leads us to recommend this model. Intro- duced by consultants at McKinsey and Company in the early 1980s, the model provides a broad yet succinct way to capture the key strategic elements of an organization.11 The model identifies seven important organizational elements that must be aligned in order to ensure effective implementation of the firm’s strategy. The 7 Ss are: strategy, structure, systems, staff- ing, skills, style, and shared values.12 Figure 12.1 displays each S, discussed next.

Strategy Strategy is the plan, process, and related activities that create and sustain a competitive advantage for a firm in its target markets. Strategy represents the most important S. The ultimate goal of any organization is excellent performance, whether it is a business, gov- ernment, or not-for-profit. Strategy enables an organization to perform well. Citi’s original strategy had been tightly focused on serving elite corporate clients. Its new strategy relied on an equal focus on effectively serving retail consumers.

Structure Structure answers two critical questions for an organization: Who does what? Who reports to whom? Structure divides labor and tasks within the organization into separate units and, by doing so, defines the reporting or authority structure of the firm. This is important because it assigns accountability for particular tasks and allows for the measurement of performance by a particular organizational unit. Managers can use structure to help create alignment between goals, skills, and environmental needs.13

If you want to understand an organization’s structure, look at its organization chart. The horizontal boxes that run across the page describe the division of labor. For example, a company might have vice presidents for geographic regions, with functional managers for each of those regions. This regional structure presumes that the important differences in the firm’s market depend on geography and the strategy is best served by tailoring operations to each region. Citi had used a geographic structure from the 1920s to the late 1960s, reflecting the challenges of building relationships in an era of limited transportation and communica- tion resources.

Alternatively, a company may have a vice president of marketing, vice president of opera- tions, vice president of finance and accounting, and so on. The next level down may include

alignment A condition where organizational elements fit together

and reinforce each other.

strategy The plan or process that creates and sustains a competitive

advantage for a firm.

structure The set of organizational arrangements that divide labor

and tasks. Structure also defines

reporting or authority relationships.

Strategy

Style

Shared Values

Structure Systems

SkillsStaffing

[ Figure 12.1 ] The 7 S Model

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titles like director of marketing or western regional director. Walter Wriston changed the structure of Citi in 1968 to focus on the diff erent types of customers the bank served, rather than where those customers lived. Th e company restructured around key client groups or markets, one of which was retail banking. Th is move combined all the diff erent retail prod- ucts and services within the same division and made coordination across geographic mar- kets much easier.

Companies may also want to structure using one of two “Ms:” a matrix structure or an M-form corporation. In a matrix structure, fi rms give signifi cant decision-making authority, and the responsibility for profi ts and losses, to two managers. Th e most com- mon matrix structure shares responsibility between a functional manager (e.g., marketing or sales) and a product managers (e.g., diapers). Th e matrix builds on the assumption that both strong functional expertise and nuanced product knowledge play vital roles in creating competitive advantage. Th e matrix makes life more complicated for managers and employees, but the structure hopes to create more value by combining expertise in decision making.

How to Use the 7 S Model S T R AT E G Y I N P R A C T I C E

The 7 S model represents a tool that can guide effective strategy implementation for the organization as a whole, as well as for its divisions, groups, or departments. To use

this tool most effectively, follow these five steps:

1. Identify the current state of the organization and mis- alignments. Appendix 1 at the end of the book provides

a list of resources that consultants and managers can

use to understand the current 7 S model. For manag-

ers, interviews and surveys will be powerful tools.

Consultants or other outsiders will rely on a mix of

interviews and other sources. The goal is to create an

“as it is today” picture of the 7 Ss in the company.

2. Rank order misalignments based on the importance of misalignment with strategy. When step one is done well,

managers will see a number of misalignments, both

within the 7 Ss themselves and between the different

elements in the model. It’s easy to get frustrated or feel

overwhelmed! Managers need to ask, “Which misalign-

ments keep us from reaching our strategic goals?

Which ones dissipate rather than build competitive

advantages?” This question will cull the list of misalign-

ments down to the few that really need to be changed.

3. Develop plans to create alignment. While some of the misalignments will be company specific (particularly

those that involve the soft square), managers and

consultants should be open to looking at how other

companies have solved these problems. There is no

need for an executive team to “reinvent the wheel” in

terms of compensation, for example. Benchmarking

other companies, or divisions within their own com-

pany, provides a starting point from which companies

can customize their own solutions.

4. Understand how the proposed change affects other ele- ments in the model. How will changes in one S affect

others? For example, moving a sales force from pure

commission to a salary structure represents a huge

change in what motivates the staff.20 How will the

company attract and retain a sales force to fit the new

pay scheme? What new skills will existing salespeople

need to learn? Where will the new system conflict with

our shared values? It’s rarely the change of compensa-

tion alone that dooms the program, it’s the pushback

from the other Ss.

5. Adjust plans accordingly. After managers see the effort to create realignment within the entire model, they

need to adjust their plans. In the previous example,

changing the compensation system may need to fol-

low skill training for the existing sales force. Work on

new hiring and retention plans may need to happen at

the same time, and the new system may precede and

signal a change in shared values. In any case, manag-

ers come to understand that piecemeal changes rarely

create alignment; a more complex and sophisticated

approach is usually necessary.

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The M-form is a corporate-level structure, and it builds on the idea of a corporate parent and business unit children. M-form stands for multidivisional form. In this struc- ture, each division is a separate business, and includes all the functions needed to run that business. Managers of M-form organizations can structure their business units in different ways, some may be functional, others product, and still others a matrix. The M-form creates substantial redundancy across the corporation (think of 20 separate accounting groups). The advantage of the M-form lies in accountability ; managers of an M-form run their own business, their successes and their failures can be traced back to the decisions of these managers. No one can claim that “corporate made me do it,” or use other excuses.

Systems The systems category describes key processes that span a firm’s organizational structure. Systems play two important roles: they coordinate and control work of the different units within the organization.14 Information systems such as inventory control allow sales peo- ple in the field to know which products are in stock, and which products are over stocked. At the same time the inventory control system lets the manufacturing division plan its production schedule based on those same stock levels. Finally, information about which products are selling will help the accounting and finance department create accurate profit and loss reports, and they’ll help the firm’s managers decide which products and services to add or drop from the firm’s offerings. It took Citi six long years of intense work in its Master Charge division to provide information on which customers were most likely to pay their bills.15

Staffing Staffing refers to the human resource management processes in the organization: recruit- ment, hiring, training, deployment, performance measurement, promotion, and compensa- tion. Some companies recruit only at elite universities, while others target public universities, job fairs, or websites like Monster.com. Each model has its own advantages and drawbacks, depending on the skills and personality types companies want to attract. Companies like Marriott require managers to engage in training every year, but other hotel chains expect people to learn on the job. Finally, some companies promote from within while others tend to hire from the outside.

When Citi shifted its strategy toward consumer banking, it hired and promoted a new type of employee. The traditional promote-from-within-culture of the bank was unable to produce managers with the talents and aggressive disposition required to grow the retail business. So Citi developed new recruiting and hiring processes to attract those types of individuals.

Skills Skills refer to the abilities of individuals within the firm as well as how the firm has combined those individual talents to build capabilities (processes) to create a competitive advantage. The relationship between skills and staffing is shown as companies either hire people who have the skills they need or develop workers in-house through training. Google, for example, considers itself primarily as a software company, and if you want to get hired you’d better have outstanding software engineering skills. In fact, Google screens 20,000 software engi- neers each year through a software-programming tournament called “Google Code Jam.”16

Software engineers compete with each other in a timed software-coding tournament, and the top 50 get job offers at Google. Apple also wants employees with strong software engineering skills. However, because Apple creates hardware products, it also values design skills because the company believes design is critical to its competitive advantage. In run- ning its retail business, Apple had to look far beyond its traditional skill sets to find the right executive. The company hired Angela Ahrendts to run its retail operation. Ahrendts had

systems Mechanisms, policies, or processes that coordinate and

control the work of the different

units of the organization.

staffing The human resource management processes in the

organization for recruiting, hiring,

training, and deploying human

capital.

skills The abilities of individuals, groups, or organizations to perform

tasks.

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been working as the CEO of fashion fi rm Burberry and had very few of Apples traditional skills in hardware, software, or technology.17 Skills, like staffi ng, involve long-term invest- ments by fi rms to make sure they have the right employees who will help the company gain competitive advantage.

Style Style refers to the interpersonal relationships between people in the organization and, along with shared values, comprises the culture of the organization. Style generally falls into one of two categories: Formal or informal. In most German companies, for example, people usu- ally dress up for work and refer to each other as Mr. or Ms., and respect each other’s work environment by keeping offi ce doors closed. Many Silicon Valley start-ups, by contrast, fi nd people showing up to work in shorts, T-shirts, and fl ip-fl ops, call each other by fi rst names or

style The interpersonal relationships and patterns of

interaction that organizational

members consider appropriate and

legitimate.

Creating an Ethical Climate and Culture Through the 7 S Model

James McNerney became CEO of Boeing, one of the world’s largest aerospace companies in July of 2005, capping a long and successful executive career that began

after he received his MBA from Harvard Business School

in 1975. His career included stints at Procter & Gamble,

McKinsey and Company, 19 years at General Electric, and a

term as chairman and CEO of 3M. McNerney came to Boeing

as the company was trying to emerge from three major

ethics crises.

In March of 2005, Boeing fired then CEO Henry Stonecipher

for having an illicit affair with a female Boeing executive.18

Stonecipher had become CEO to replace Phillip Condit, who

had his own checkered career as Boeing’s CEO. Troubles

at the top weren’t the only problems Boeing faced. After its

acquisition of McDonnell-Douglas, Boeing began to compete

more fiercely, and less ethically, for huge defense contracts.

Boeing’s former Chief Financial Officer Michael Sears and

Manager Darleen Druyun were fired from the company for

ethics violations on an $18 billion fighter jet contract; Sears

served prison time for his crimes. That scandal followed

revelations that a Boeing employee stole and inappropriately

disclosed over 25,000 pages of confidential documents

belonging to competitor Lockheed Martin.

McNerney saw his first and most important job as building

an ethical culture at Boeing, and he had his work cut out

for him. With over 150,000 employees, global operations,

and infighting between divisions resulting from Boeing’s

acquisition of McDonnell Douglas, Boeing was a large,

bureaucratic behemoth resistant to change. McNerney chose

an interesting place to begin the cultural change: He relied on

his personal style and what he referred to as “tone at the top.”

Rather than holding the annual executive retreat at a posh

resort, McNerney held a shorter retreat at a modest hotel.

McNerney spoke directly and forcefully of the ethics lapses,

and he encouraged managers throughout the company to

do the same. The culture of secrecy had to be changed.

McNerney chided leaders for a culture and environment

where, “’management had gotten carried away with itself,’

that too many executives had become used to ‘hiding in the

bureaucracy,’ that the company had failed to ‘develop the best

leadership.’”19 Before Boeing could solve the problems, the

company had to admit that problems existed and determine

the extent of unethical behavior. McNerney used his position

and personal style to model the open communication and

concern for ethics he expected throughout the company.

Style mattered, but McNerney used other elements of the

7 S model as well. The company also changed its structure.

Boeing raised the profile of compliance officers and set up

an ethics hotline so that employees could report violations

without fear of management reprisal. The company required

ethics training for employees, which meant changes in

its staffing protocols and skill development programs.

Importantly, McNerney changed the compensation system for

Boeing’s managers; it now paid to make the ethical choice.

Managers would now receive part of their annual bonus

based on compliance with ethics standards and for living,

teaching, and displaying the core Boeing values of candor,

openness, business performance, and ethical conduct.

E T H I C S A N D S T R AT E G Y

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[ Figure 12.2 ] Misalignment

Strategy

Style

Situation/Stakeholders

Shared Values

Structure Systems

SkillsStaffing

nicknames, and work in large, open spaces to maximize interactions. When John Reed was trying to transform Citi’s retail business, his personal style encouraged risk taking and mak- ing big bets on the company’s future. This contrasted with an earlier style within Citi that was more conservative and risk averse. Style helps you identify the interpersonal aspects of a company’s culture.

Shared Values Shared values refer to the priorities, values, and virtues that members of the organization see as important. Some people use the term superordinate goals, a set of high-level goals that all stakeholders agree on, to capture the same thing as shared values. For example, Nor- dstrom strives to create shared values by focusing on respect for the individual and extraor- dinary customer service. One way that Nordstrom works to create these shared values is by sharing stories with its associates and managers that provide examples of the behavior they want to encourage—such as the story of an employee accepting a customer’s returned tires when Nordstrom doesn’t even sell tires. The shared values of respect for the individual and extraordinary customer service are both values and overarching goals for the company and representative of the organizational aspect of the culture.

The 7 S model deals with ethical values as well as other business priorities. Our Strategy and Ethics in the Real World feature describes how one leader, James McNerney of Boeing, used the 7S model to realign the ethical values at his company.

If you look back to Figure 12.1, you’ll notice that strategy, structure, and systems form a triangle, and that style, shared values, staffing, and skills form a square. This is no accident. Strategy, structure, and systems constitute the hard triangle of the model. The hard tri- angle represents a set of “hard” levers that managers can quickly pull to create alignment, or realignment. Hard doesn’t refer to difficulty, but, rather, tangibility. Structure appears on paper, strategy in a formal plan or document, and systems are found in policy manuals, computer programs, or equipment.

The other four represent the soft square, the elements that are often difficult to codify, like style, or that take a long time to influence and change, like shared values. Strategists can change structure in a day, strategy in a week, or systems in a quarter. That doesn’t mean the organization practices the new strategy, works well in the new structure, or actually uses the new systems. How well those changes actually work depends on what happens in the soft Ss. Changing the organization’s skill set can take several months. Changing the style or shared values may take decades. See the Strategy in Practice for a discussion of how manag- ers can use the 7 S model to implement change.

Figures 12.2 and 12.3 illustrate the concept of creating alignment. These figures address how an organization moves from a state of misalignment to one of alignment. As the Strat- egy in Practice feature indicated, creating alignment means change. Something, usually

shared values The priorities, values, and virtues that members

of the organization see as

important.

superordinate goals High-level, abstract goals that all stakeholders

agree on to guide organizational

action.

hard triangle The elements of strategy, structure, and systems in

the 7 S model. The hard triangle

represents a set of “hard” levers

that managers can quickly pull to

create alignment or realignment.

soft square The elements of style, staffing, skills, and shared values.

Soft square elements are often

difficult to codify and usually take a

long time to influence and change.

STRATEGIC CHANGE [ 245 ]

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something significant, has to change in order to bring the 7 Ss back into alignment. That involves the second important process of strategy implementation: strategic change.

STRATEGIC CHANGE

In this section, we’ll explain how managers effectively lead strategic change to move their organizations forward. We’ll also discuss how the tools of strategic change apply to individu- als, since the most important firm we all manage is a firm called “Me, Inc.” Managers who can’t lead change, in their own or their organization’s lives, find it difficult to thrive, and often survive, in world of turbulent change.

The first time an entrepreneur sets a strategy to create unique value for customers in a particular market she aligns the organization with that strategy. At every other point in a company’s history, a change in strategy requires realigning the organization with the new direction. Realigning strategy entails changing the other six Ss, and that’s not an easy thing to do. Recent evidence puts the failure rate for organizational change at 60 to 70 percent, and that percentage has not changed for several decades.21 Change seems to be even harder for individuals. One study found that, out of a group of people who had experienced coro- nary artery bypass surgery to save their lives, 90 percent failed to change their lifestyle to avoid a repeat of the trauma.22 Part of the problem is that individuals and leaders don’t real- ize that change is a process with three distinct phases.

The Three Phases of Change Most of us think of change as the need to start doing something new, whether that’s eat- ing healthier or, in the case of an organization, focusing on a new customer segment, such as Citi’s concentration on retail banking. What most don’t realize, however, is that effec- tive change requires moving through three stages of a well-defined process. We must first stop the activity, or set of activities, we want to change, then adopt new behaviors, and finally engrain those new behaviors into our routines. Pioneering social psychologist Kurt Lewin used ice as a metaphor for change, and his three-step model of change is outlined in Figure 12.4.23

Unfreezing. Unfreezing begins the change process as individuals and groups within the organization recognize and publicly admit that the current situation is not working. Unfreezing entails moving away from certain actions, policies, or strategies before adopting anything new. When individuals, groups, or companies make a “stop doing” list, they have begun the process of unfreezing.24 The process of unfreezing provides the fundamental motivation for change.

unfreezing The first step in organizational change. It begins

when leaders recognize and

publicly admit that the current

situation is not producing

acceptable or adequate results.

Strategy

Style

Situation/Stakeholders

Shared Values

Structure Systems

SkillsStaffing

[ Figure 12.3 ] Alignment

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Changing. The change process is how a company adapts to its environment and learns new behaviors. When Citibank began to focus on serving individual retail customers, branch managers, tellers, loan officers, and even people working at Citi’s headquarters had to experiment and learn new ways of working. Branches stopped focusing solely on large, sophisticated business customers and learned new ways of working with, and gaining the trust of, individuals with small balances and basic financing needs. The pain of change comes during this phase because it is not clear which new behaviors will work, and it is often by trial and error. Change means moving from one set of behaviors and activities to another.

Refreezing. Have you ever gone on a diet? For longer than a couple of weeks? Well, companies are like people in that they can adopt almost any new behavior for a short period of time. To make change permanent, individuals and companies have to do the hard work of aligning the rest of their activities to support the change. They have to refreeze around the new activity set. Successful companies embed the desired changes in hiring and training decisions, reward and compensation systems, and in the shared values of the company’s culture. Refreezing allows organizations to maintain the progress they made through change.

The three phases of change provide a broad overview of the process, but real-world strategists want to know how they can unfreeze their organization, encourage productive change, and then refreeze the gains and move ahead. Each of the three larger phases of change contains discrete elements that help managers lead their organizations and people through the difficult process of change. We’ll introduce you to eight discrete tasks that must be accomplished for change to succeed.

The Eight Steps to Successful Change Strategic changes like the one Citibank pursued to change its entire business focus don’t happen overnight. In fact, these changes can take many years, and even up to a decade to successfully implement.25 The eight key tasks are:

1. Generate a sense of urgency.

2. Build a guiding coalition.

3. Create a vision.

4. Communicate the vision.

5. Empower individuals to act.

6. Garner short-term wins.

7. Consolidate gains and move on for more change.

8. Institutionalize the change.

change process The middle step in organizational change that a

company engages in to adapt to

its environment and learn new

behaviors.

refreeze The last phase of organizational change. This

step involves formalizing and

institutionalizing new behaviors,

methods, processes, or routines.

Motivating

Unfreezing

Make a public admission that current state isn’t working

ake a clear break with past actions or processes

Engage in trial and error process

Develop new behaviors

Creating Alignment

Embed new behaviors in training compensation, culture

Change Re-freezing

Moving Maintaining

[ Figure 12.4 ] Three Key Phases of Change

STRATEGIC CHANGE [ 247 ]

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Generate Urgency. People and organizations won’t change without a reason. In fact, organizations have been designed to ensure stability and that the same regular processes will happen over and over again. Th ose processes and activities eventually fail to work eff ectively, usually because they fail to align with changes in the market or operating environment, managers must work to help their teams and organizations see the need for change. Th at means looking at larger environmental trends, spending time with customers, suppliers, employees, or stakeholders to gather data, and then creating a compelling case that will help people see, understand, and also feel the need to change. Our Strategy in Practice feature describes a compelling story of generating urgency.

Build a Coalition. Effective change requires that many people see and feel the urgency and those with the power to change the organization grasp the sense of urgency and actively work to create change. Managers tasked with leading change need to create a guiding coalition, a group of influential people from all levels in the organization who work to lead the change effort. Some members come from top management, but most will not. All members have power within their own work groups, either as formal managers or directors, or informally having earned the respect, admiration, and ears of their peers.28

Create a Vision. A meaning ful vision is a clear statement of where the organization wants to go, and what life will be like when the change has been successful. Urgency helps prepare people to move, and the coalition provides examples to follow. However, without a clear vision of where they are going, people are either unable to move or they move in many diff erent directions all at once.

Perhaps the best example of a clear and compelling vision came from President John F. Kennedy in response to the urgency generated when the Soviet Union placed a man in orbit in the spring of 1961. Kennedy created this vision:

I believe that this nation should commit itself to achieving the goal, before this decade is out, of landing a man on the moon and returning him safely to the earth. No single space

guiding coalition A group of influential people from all levels in

the organization that support and

lead the change effort.

vision A clear statement of desired outcomes and endpoints for

organizational change.

Work Gloves Create Change26 S T R AT E G Y I N P R A C T I C E

A middle-level manager at a large, multiplant company had been assigned to cut costs by consolidating the company’s purchasing process. The manager identified

several areas where costs could be reduced by about $1

billion but no one took his analysis seriously. To get the

attention of the key decision makers in the organization, this

manager identified a single product—work gloves—that he

thought would highlight the purchasing problem.

The manager discovered that the company was

purchasing over 400 different brands of work gloves. One

plant would pay $5 for a pair of gloves and another plant

would pay $17 for the same pair of gloves, but a different

brand or from a different supplier. To make his case of

wasteful purchasing, the manager bought 424 different pairs

of gloves, and tagged each pair with the price each factory

paid for it. He reported what happened next:

[We] put them in our boardroom one day. Then we

invited all the division presidents to come visit the

room. What they saw was a large, expensive table,

normally clean or with few papers, now stacked high

with gloves. Each of our executives stared at this

display for a minute. Then each said something like,

“We really buy all these different kinds of gloves?”

“Well, as a matter of fact we do.” . . . It’s a rare event

when these people don’t have anything to say. But

that day, they just stood with their mouths open.27

Needless to say, the manager received a mandate

from top management to move ahead with his changes

to purchasing. He had created urgency so that decision

makers could see, feel, and understand the real impact of

the problem. Once they saw and felt the need for change, top

managers lent their energy and support to the change effort.

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project in this period will be more impressive to mankind, or more important for the long- range exploration of space; and none will be so difficult or expensive to accomplish.29

The first three tasks—generating an urgency, building a coalition, and creating a vision— help the organization unfreeze. A sense of urgency and the development of a coalition signal an unmistakable admission that past actions won’t work in the future. A vision creates a clear break with the past and is an exciting call to move forward. When done well, these first steps usually take 6 to 18 months for managers to work through.30 The next three tasks— communicating the vision, empowering action, and garnering short-term wins—help organizational members alter their behaviors and work patterns and create the change.

Communicate the Vision. How do most companies communicate their vision? Many managers don’t communicate that vision clearly enough or often enough. They might communicate through a memo or a post on the company’s intranet site. If the change is considered central to a larger group within the organization, they might create a video and distribute it throughout the company.

How did Kennedy’s stirring vision get communicated? First, his speech was recorded on video and played over and over again on the nightly news programs. Kennedy used every emerging technology and platform to share his vision. The administration made sure the text of his speech was picked up and reprinted by hundreds of newspapers. Simply put, Kennedy’s vision took hold because it was communicated through a variety of channels, and repeated over and over again. Managers who successfully lead change overcommunicate their vision. They keep repeating the message even after they are sure most people have heard it.31

Empower Action. A paradox exists in most organizations, from business firms to university classrooms. Leaders and managers want creative behavior and new solutions, but many organizational cultures and systems punish creative behavior or new solutions that don’t work. For example, many performance reviews reward successful actions by employees, but fail to reward innovations and experimentation that doesn’t succeed.32

Empowering people to act certainly means giving them authority to try new practices, but it also means giving them the knowledge and resources they need to engage in new practices. Empowerment also means providing a safety net for people should they fail, and a system in place to learn from those failures. For example, Google has built in a number of mechanisms to promote innovation, from Google cafes where employees can meet to share ideas, direct e-mail access to company leaders, and its policy of allowing engineers to spend 20 percent of their work week on projects that interest them.33

Garner Short-Term Wins. Many people inside the organization may be supportive or even excited about the change, but they may be unwilling to commit their own time, energy, and resources until they see evidence that the change will produce positive results. Wise managers begin with projects that require the least change and have a high probability of success. The manager in our previous Strategy in Practice feature began by solving a small problem, consolidating the purchase of work gloves. Work gloves alone wouldn’t save the company over $1 billion, but solving the work gloves problem would show those waiting to commit to the change that their efforts would likely succeed. Short-term wins create both credibility and momentum that encourages key organizational members to get off the fence and work to make the change successful.34

The three tasks that accomplish the bulk of the change, communicating the vision, empowering action, and creating short-term wins, can take one to two years.35 Managers may begin communicating early and often, and employees can be easily empowered; how- ever, following through to make communication and empowerment effective tools of change requires sustained effort. Short-term wins should come quickly because they are, after all, short term. The task of pressing ahead, tackling the tough challenges, and reaping the real rewards of change takes patient and persistent effort.

Consolidate Gains and Press On. Many organizations would stop after solving the work gloves problem because they mistakenly believe that solving the surface symptoms of a problem is the same as solving the root cause. The clever manager might be honored at a company dinner, given a nice bonus, and people would assume the change effort

empowerment A grant of authority, formal or informal, that allows

organizational members to try new

practices. Empowerment includes

giving members the knowledge and

resources they need to engage in

new practices successfully. It also

includes a safety net for people

should they fail.

STRATEGIC CHANGE [ 249 ]

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was complete. What would remain would be the tough, hidden, and unglamorous purchasing problems that would really save the company a great deal of money. If a company stops after creating a few high-profile “wins” and fails to press ahead to work on the deeply rooted behaviors, policies, and practices that must change for a true realignment to occur, much of the value of the change effort will have been wasted. This is the least glamorous and longest task of successful change, but the one that truly prepares the organization to refreeze. The challenging projects help the organization embed the change deeply in its operating routines and represent an important part of making change stick, or refreezing.

Institutionalize Change. To institutionalize something is to make it so essential that it is taken for granted and becomes part of the central values of the culture.36 Managers institutionalize changes primarily through three of the 7 Ss: systems, staffing, and shared values. Change becomes permanent when the routines such as sales methods, accounting procedures, or operating processes embody the new set of behaviors and activities. Compensation systems that reward the new behaviors further engrain the notion that the change represents “the new way things are done around here.” In terms of staffing, change becomes institutionalized as the firm looks for, hires, and retrains a new type of employee. Recruiting and ongoing training reinforce changes as a new generation of employees sets the standard for model behavior.

Finally, strategic changes always alter the shared values of the organization.37 For exam- ple, the Citi change to retail banking supplemented the value of a bank based on serving an elite corporate clientele with a set of high end products with the value of providing excellent service to retail customers. An innovative set of shared values spoke to the new customer group, providing valuable, but basic financial services and products to a mass of individuals. Institutionalizing the change takes the longest of all the stages and can take an additional four to seven years before the old ways are forgotten. The bottom line for managers is that successful strategic change takes substantial and sustained energy, com- mitment, and attention. Managers should keep in mind that others in the organization need the time, resources, and energy to go through their own change. Change takes time because people have to learn new skills and ways of acting, but also new mindsets and ways of seeing the world.38

Figure 12.5 summarizes effective strategic change. You can see how the eight tasks relate to the three phases of change, and how long each phase may take. Strategic change takes a long time and a dedicated effort by strategic managers who are trying to enact change while dealing with day-to-day issues of running their firms. How do they maintain a focus on the overall change project? One way is to set up solid measurement systems to assess the degree to which change efforts help the firm align its internal resources around its strat- egy.39 Setting up robust and effective measurement systems will be the final topic we con- sider in this chapter.

institutionalize When an organizational element or practice

becomes so essential that its value

is taken for granted.

Generate

urgency

Vision

Institutionalize

Changes

Empower

Action

Garner Short-

Term

Wins

Build

Coalition

Create

Vision

The Silent Phase

(Unfreezing)

½–1½ years

The Active Phase

(Change)

1-2 years

Completion

(Refreezing)

4-7 years

Consolidate

Gains

[ Figure 12.5 ] Summarizing the Change Process

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MEASUREMENT

Given that strategic change and realignment takes such a long time to successfully imple- ment, strategic managers need a way to effectively measure their organization’s progress. In fact, measurement represents a general need for assessing whether any strategy, new or existing, works. As you learned in Chapter 3, strategies often depend on the complex combination of a firm’s underlying values, its resource base, capabilities, and the actions and activities of large numbers of individuals and groups. Those complex internal interac- tions all take place in markets and industry contexts characterized by constant, sometimes radical, change. Effective measurement becomes an essential element of solid strategy implementation.

Individual employees, managers, and the executives who run the firm face a challenge that measurement helps overcome. That challenge arises because members of an organiza- tion have limited perspective.40 Employees and managers see clearly those activities and elements of the environment they most closely interact with. Salespeople can see the organ- ization from a customer’s perspective but have a hard time accepting the perspective of manufacturing managers or research scientists. All people see things that are further away less clearly, both in terms of distance but also organizational level, and time horizon. Simi- larly, it’s easier for employees or managers to see what needs to be done to improve short- term performance but they rarely have a perspective, or incentive, to act in ways that further the long-term interests of the firm. An effective measurement system helps everyone, from top management to front-line employees, understand how their daily work contributes to strategic success. The principle of line of sight helps managers create measurement sys- tems to overcome the limited perspectives of individual organizational members.

Line of Sight Put yourselves in the shoes of the following division manager. It’s 9:15 a.m. on Monday morn- ing. You arrived late at your office, delayed by a nasty freeway accident. Your 9:30 a.m. meet- ing is a critical new product design decision meeting. The company’s development team and supplier partners have cleared their busy schedules to help you make the final decision on an important new product. Before you head into the meeting, you quickly check your messages. You received one text from a high-level, important employee expressing deep dis- satisfaction over his bonus. He’s threatening to quit on the spot unless he meets with you this morning.

As you scroll down your text messages, you see that your division’s largest customer texted two hours earlier, very angry about a delayed critical shipment. As you open your office door, the director of operations informs you that a power outage last night has left a large quantity of perishable product beginning to spoil. Moving the product will require your direct intervention to find/arrange a suitable costly cold-storage facility. The question is NOT what should you do, for you should do all of them. The relevant question is, what do you do first?

The idea behind line of sight is to answer those questions quickly and effectively. Each of these demands in our fictitious case is urgent—if you don’t act immediately, you’ll lose out on the design project, the skill of an important employee, a valuable customer, or profit since product spoiled. If you have a very clear idea of the company’s overall strategy, and under- stand your role in furthering that strategy, you would have the tools to help decide which of the many urgent tasks is the most important. If the company strategy revolves around some vague notion of creating shareholder value or increasing earnings, then you have little direc- tion. If, however, the strategy is clear and explicit about creating value through low cost, a customer centric differentiation, or bold product innovation, then you have more guidance and you can make a better decision.

Line of sight links day-to-day organizational behaviors and decisions to their impact on the overall strategy.41 For example, if the company’s strategy relies on relentless low-cost

principle of line of sight The notion that individual members in

an organization should be able to

connect their daily work and tasks

to the overall strategic goals of the

organization.

MEASUREMENT [ 251 ]

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production and control, then you should postpone the meeting, leave the customer and employee in limbo, and spend time preserving the product. In contrast, a clearly customer- centric focus tells you to call the customer fi rst. Finally, you can see that a clear strategy of winning through innovation means the design meeting will take place as scheduled or the employee will be contacted if he contributes important innovation skills to the team.

Th e line of sight principle recognizes that grand strategies don’t just happen, they only come to fruition as individual managers and employees make decisions about how to allo- cate the valuable resources they control.42 Th e ability to formulate a clear and direct strat- egy, our goal throughout this book, provides the point of reference to establish line of sight. Th e next step in creating a line of sight involves translating the overall strategy into a set of specifi c objectives for divisions or large work groups. Line of sight tells manufacturing managers whether quality comes before costs. With a clear line of sight, marketing and sales staff know which customers to focus on, how deeply to discount prices to win deals, and what levels of personal attention and service each account should receive. Line of sight helps human resource professionals design compensation systems to encourage and reward those behaviors that actually create strategic value. Our fi nal Strategy in Practice feature outlines the steps individuals and managers can use to develop line of sight systems and create measures to know when they are eff ectively implementing strategy.

Creating Line of Sight Measures S T R AT E G Y I N P R A C T I C E

Turning the principle of line of sight into useful measures requires individuals and managers to determine which of their actions contribute to realizing a strategy and which

activities to do first. To create a clear line of sight, move

sequentially through the following steps. As you can see,

these steps build on the company diamond introduced in

Chapter 3.

Step 1: Begin with the end in mind. What’s most impor-

tant? This is the time to list the abstract and broad goals

and objectives the company cares about. Is it the crea-

tion of shareholder value? Cutting-edge innovation?

World-class customer service, or a great place to work?

Answers to these questions can be found in the com-

pany’s mission statement.

Step 2: Identify the tangible strategy that reaches that

objective. For example, does the company intend to cre-

ate shareholder value through a premium price (the top

line of the income statement], or through cost leader-

ship (the mid-section and balance sheet)? Each of those

larger strategic positions requires a company to align

and combine its resources to achieve meaningful dif-

ferentiation or low cost. For division or functional man-

agers, which resources and capabilities are under my

direct control? How does my division or function help the

company implement its strategy? This establishes the

line of sight for this level of the organization.

Step 3: At the work group level, what specific activities do

we perform that utilize and strengthen these resources?

A large part of the daily work in most organizations

keeps the doors open, pays bills, and makes sales, but

does little to develop and enhance strategic capabilities.

The key for work groups, as for higher levels, is to sort

through the daily activity set and sort activities that really

need to come first. Work group tasks can then be subdi-

vided into individual tasks. Individuals should be able to

see the chain that connects their personal work with the

company’s strategy.

Step 4: Determine which single measure captures the

way the work should be done. Take a call center as an

example. Many call centers are seen as cost centers

for providing customer support and help lines. A com-

mon metric most employees understand is to get the

customer off the line as quickly as possible so they can

handle the greatest number of calls per shift. This works

well if the strategy is cost leadership, but not if the strat-

egy is differentiation and a key resource is brand.

Getting customers off the phone quickly does little

to build brand, and may harm it as customers see

the company as uninterested in after-sales support.

If brand matters, then the line of sight measure is

the number of problems resolved, and the number of

satisfied customers per shift.

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Measurement marks the last of the three primary tools of strategy implementation. Measurement systems like the balanced scorecard43 can serve as an early warning sign for misalignments between the 7 Ss or between the firm and its environment. Figure 12.6 shows you the elements of a balanced scorecard a firm can use. Measurement can help managers monitor progress toward strategic objectives and also help them manage the process of change and realignment. Tools such as line of sight help managers decide where, when, and how much to allocate resources to different activities. The most important resource they allocate will be their own time.

balanced scorecard A tool that measures four broad areas of

organizational performance:

financial results, customer goals,

internal business processes, and

learning and growth.

SUMMARY

This chapter introduced you to the challenges of implementing strategy, or moving it from a grand design to a set of day-to-day activities that actually create competitive advantage. Sometimes implementation is simply a matter of execution. There are four steps to consider when execution is the issue:

1. Create a set of clear goals for people to follow ;

2. Find ways to accurately measure performance;

3. Hold people accountable for their performance; and then

4. Reward those who perform well.

Effective implementation relies on three key processes: the ability to forge alignment between the different elements of the organization, the capacity to lead strategic change over a long period of time, and the creation of a set of measures and assessments that monitor performance and help suggest changes.

The 7 S model provides a powerful way to think about how organizations can create align- ment. The 7 S’s are:

1. Strategy—the organization’s plan for creating competitive advantage

2. Structure— the set of organizational arrangements that divide labor and tasks. Struc- ture also defines reporting or authority relationships.

Financial Metrics How well are we meeting

shareholder/investor demands?

Customer Metrics How well are we satisfying

customer needs and desires?

Process Metrics How well are we performing our key business processes?

Innovation Metrics How well are we learning to

insure future growth?

Strategy

Current Performance

Future Performance

External

Performance

Internal

Performance

[ Figure 12.6 ] Elements of a balanced scorecard

Source: Adapted from Kaplan, R. S. and Norton, D. P. (1996) The Balanced Scorecard,Cambridge: HBS Press.

APPLICATION EXERCISES [ 253 ]

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3. Systems— mechanisms, policies, or processes that coordinate and control work of the different units of the organization.

4. Staffing—the human resource management processes in the organization for recruit- ing, hiring, training, and deploying human capital.

5. Skills— the abilities of individuals, groups, or organizations to perform tasks.

6. Style—the interpersonal relationships and patterns of interaction that organizational members consider appropriate and legitimate.

7. Shared Values—the priorities, values, and virtues that members of the organization see as important.

At a high level, organizational change involves three phases:

1. Unfreezing—when leaders recognize and publicly admit that the current situation is not producing acceptable or adequate results

2. Change—the middle step in organizational change that a company engages in to adapt to its environment and learn new behaviors

3. Refreezing—this step involves formalizing and institutionalizing new behaviors, meth- ods, processes, or routines.

When implementing change, managers should use principles such as line of sight and measurement tools like the Balanced Scorecard to help individuals understand their role in the change process.

KEY TERMS

alignment (p. 240) balanced scorecard

(p. 252) change process (p. 246) empowerment (p. 248) guiding coalition (p. 247) hard triangle (p. 244) institutionalize (p. 249)

principle of line of sight

(p. 250) refreeze (p. 246) shared values (p. 244) skills (p. 242) soft square (p. 244) staffing (p. 242) strategy (p. 240)

structure (p. 240) style (p. 243) superordinate goals

(p. 244) systems (p. 242) unfreezing (p. 245) vision (p. 247)

REVIEW QUESTIONS

1. When using the 7 S model to create alignment, why do managers need to make sure all the Ss align with the organization’s strategy? What problems follow misalignment?

2. What tools do managers have to realign the hard triangle? The soft square?

3. Is it true that the “soft stuff is the hard stuff ” in creating alignment? Why or why not?

4. If change projects seem to stall and fail to progress, which of the eight steps of successful change have not received enough attention?

5. What does it mean to institutionalize change? How long will this process take? Why?

6. Define line of sight. List three examples from your own career or educational experience where the principle of line of sight helped you make a better decision.

APPLICATION EXERCISES

Exercise 1: Select a company that you would like to work for. Using the 7 S model and the framework provided in Appendix 1 as a template, audit that company. Describe each S for

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the company and determine the degree of alignment between the Ss. Make suggestions as to how the company can improve its level of alignment.

Exercise 2: Think of two change efforts you have been a part of, one that succeeded and one that did not. What did success mean? Use the three-step model of change and the eight key tasks of change management to identify key differences between the successful and failed efforts. What lessons would help you initiate and guide change in your career?

Exercise 3: Using the final Strategy in Practice feature as a guide, create your own line of sight measure. Are you doing the most important things to move your strategy forward? Which activities contribute most, and what measures tell you how you are doing on those activities? Use the eight tasks of change management to help you identify a plan to improve your effectiveness.

REFERENCES

1 Taken from “World’s Top 10 Credit Card Issuers,” CNBC.com, http://www.cnbc.com/id/36471668/page/9,

accessed May 20, 2013.

2 H. van B. Cleveland, Citibank, 1812-1970, Harvard Studies in Business History 37 (Cambridge Harvard University

Press, 1985), p. 272.

3 P. L. Zweig, Wriston: Walter Wriston, Citibank and the Rise and Fall of American Financial Supremacy, 1st. ed

(New York: Crown Publishers, 1995), p. 532

4 R. B. Miller, Citicorp: The Story of a Bank in Crisis (New York: McGraw-Hill, 1993), p. 90.

5 Zweig, p. 546.

6 Ibid., pp. 542–543.

7 S. Ro, “Citi Earnings Beat Expectations, but the Consumer Is Still Deleveraging,” Business Insider (April 15, 2013),

http://www.businessinsider.com/citi-q1-2013earnings-2013-4.

8 L. Bossidy, R. Charan, and C. Burck, Execution : The Discipline of Getting Things Done (New York: Crown Business,

2002).

9 Zweig, p. 536.

10 C. H. Noble, “The Eclectic Roots of Strategy Implementation Research,” Journal of Business Research 45 (2) ( June

1999): 119–134.

11 R. H. Waterman Jr., T. J. Peters, and J. R. Phillips, “Structure Is Not Organization,” Business Horizons 23 (3) ( June

1980): 14.

12 J. Weber, A Leader’s Guide to Understanding Complex Organizations: An Expanded 7 S Perspective (Charlottesville:

University of Virginia Darden School Foundation, 1998).

13 P. R. Lawrence and J. W. Lorsch, Organization and Environment ([S.l.]: Harvard Business Bks., 1967).

14 K. M. Eisenhardt, “Control: Organizational and Economic Approaches,” Management Science 31 (2) (1985):

134–149.

15 Zweig, pp. 549–554.

16 For information on the Google code jam, see https://code.google.com/codejam/, accessed November 7, 2013.

17 A. Carr, “Apple Hires Burberry CEO Angela Ahrendts to Rejuvenate Retail Stores,” Fast Company (Octo-

ber 15, 2013), http://www.fastcompany.com/3019981/apple-hires-burberry-ceo-angela-ahrendts-to-rejuve-

nate-retail-stores.

18 “Cleaning Up Boeing,” Bloomberg Businessweek (March 12, 2006), http://www.businessweek.com/stories/2006-03-12/

cleaning-up-boeing.

19 Ibid.

20 D. H. Pink, Drive: The Surprising Truth about What Motivates Us (New York: Riverhead Books, 2011).

21 See a recent study by Consulting firm McKinsey and Company. Joseph Isern, Mary Meaney, and Sarah Wilson, Corpo-

rate transformation under pressure, Insights and publications (April 2009). Available at http://www.mckinsey.com/

insights/organization/corporate_transformation_under_pressure, accessed 21 May 2013.

22 A. Deutschman, “Change or Die,” Fast Company Magazine (May 1, 2005), http://www.fastcompany.com/52717/

change-or-die.

23 K. Lewin, “Frontiers in Group Dynamics,” in Field Theory in Social Science, ed. D. Cartwright (London:

Harper & Brothers, 1951).

24 J. C. Collins, Good to Great: Why Some Companies Make the Leap... and Others Don’t (New York: Random House

Business, 2001).

25 The eight tasks come from J. P. Kotter, Leading Change (Boston: Harvard Business School Press, 1996).

http://www.cnbc.com/id/36471668/page/9

http://www.businessinsider.com/citi-q1-2013earnings-2013-4

https://code.google.com/codejam

http://www.fastcompany.com/3019981/apple-hires-burberry-ceo-angela-ahrendts-to-rejuve-nate-retail-stores

http://www.businessweek.com/stories/2006-03-12

http://www.mckinsey.com

http://www.fastcompany.com/52717

REFERENCES [ 255 ]

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26 Material taken from J. P. Kotter, The Heart of Change: Real-life Stories of How People Change Their Organizations

(Boston: Harvard Business School Press, 2002) , p. 29.

27 Ibid.

28 The Balancing Act: Mastering the Competing Demands of Leadership, 2nd ed (Provo: Vitality Alliance, 1999).

29 J. F. Kennedy, Address before a joint session of congress, May 25, 1961. Text available at http://www.jfklibrary.org/

Asset-Viewer/xzw1gaeeTES6khED14P1Iw.aspx.

30 Author’s experience in working with different organizations working to change.

31 Kotter, Leading Change.

32 For examples of how structure and culture affect innovation, see F. Flynn and J. Chatman, “Strong Cultures and

Innovation: Oxymoron or Opportunity?” In S. Cartwright et al. (eds.), International Handbook of Organizational

Culture and Climate (Sussex: John Wiley & Sons, 2001), pp. 263–287.

33 L. He, “Google’s Secret of Innovation: Empowering Its Employees,” Forbes (March 29, 2013), http://www

.forbes.com/sites/laurahe/2013/03/29/googles-secrets-of-innovation-empowering-its-employees/.

34 See the larger discussion around the work gloves example in Kotter, The Heart of Change.

35 J. Kotter, “Leading Change: Why Transformation Efforts Fail,” Harvard Business Review ( Jan. 1, 2007).

36 P. Selznick, Leadership in Administration : A Sociological Interpretation (Berkeley: University of California

Press, 1984).

37 See Kotter, The Heart of Change, and Kotter, Leading Change, for a thorough discussion of this point.

38 See W. Bridges, Managing Transitions: Making the Most of Change (Cambridge: Perseus, 2003).

39 For an excellent discussion of the importance of measurement, see M. Mauboussin, “The True Measures of

Success,” Harvard Business Review (Oct. 1, 2012).

40 H. A. Simon, Administrative Behavior: A Study of Decision-making Processes in Administrative Organizations

(New York: Free Press, 1947).

41 W. R. Boswell, J. B. Bingham, and A. J.S. Colvin, “Aligning Employees through ‘line of Sight’,” Business Horizons 49

(6 November 2006): 499–509, doi:10.1016/j.bushor.2006.05.001.

42 From Resource Allocation to Strategy (Oxford: Oxford University Press, 2005).

43 Entire courses have been run on the Balanced Scorecard. Interested readers can get a solid overview of the Bal-

anced Scorecard from Robert S Kaplan and David P Norton, The Balanced Scorecard : Translating Strategy into

Action (Boston: Harvard Business School Press, 1996).

http://www.jfklibrary.org

http://www.issgovernance.com

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Corporate Governance and Ethics

STEPHEN JAFFE/AFP / GettyImages

[ 257 ]

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Studying this chapter should provide you with the knowledge to:

1 Discuss the purposes of a corporation, including the shareholder primacy model and the stakeholder model.

2 Explain the role of the board of directors in governing the corporation and their duties to shareholders and other stakeholders.

3 Identify major ethical challenges managers face at each stage of the value chain.

L E A R N I N G O B J E C T I V E S

[ 258 ]

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T he Enron Corporation began doing business in 1985

when Kenneth Lay, chairman and CEO of Houston

Natural Gas Company, used junk bonds to finance the

purchase of the Nebraska pipeline company InterNorth.1

Enron hoped to take advantage of opportunities in the

newly deregulated energy markets in the United States.

Lay transformed Enron into a natural gas “bank” that

guaranteed both sellers and buyers certain prices and

quantities of the commodity. Enron did so by buying futures

contracts, promises to buy gas in the future for a certain

price. If the market price declined from what Enron agreed

before delivering the gas to consumers, the company lost

money, but if the price of gas increased, then Enron made a

profit. The more volatile the price swings of gas, the greater

potential profits for Enron.

The highly risky trading business flourished over the next

15 years, and the company vaulted from a small, obscure

Texas power company to one of the world’s largest energy

trading companies. The company expanded its operations into

electricity futures, opened Enron On-line (EOL) to facilitate

futures trading over the Internet, and even began a joint

venture with Blockbuster Video to build and trade futures

for new Internet bandwidth. By 2001, the company ranked

seventh in the Fortune 500 with over $100 billion in revenue

and reported $1 billion in profit.2 At the close of 2001, however,

Enron filed for bankruptcy protection as its problems came

to light. By 2003 the company would be bankrupt and several

of its top leaders would be under criminal investigation for

accounting fraud. What went wrong at the energy giant?

Trading in futures markets, whether for energy,

commodities, or even financial instruments, has always

been a high-risk business that requires companies to

take on large amounts of debt to finance or securitize the

futures they buy. Enron’s creditors constantly looked at the

company’s balance sheet to ensure that its assets were

valued correctly and its debts within specified ranges.

Enron executives had conflicting fiduciary duties: to advance

shareholder interests through increased growth and to

protect those interests by maintaining prudent debt levels.

They chose to sacrifice prudence in order to grow, in part

because short-term growth was tied to their financial

compensation and bonuses.

Company executives used a complex accounting

procedure called a special purpose entity (SPEs) to move

high-risk assets and large amounts of debt off Enron’s

balance sheet.3 Enron’s auditor, the accounting firm Arthur

Andersen, should not have

certified these SPEs, but it faced

its own conflict of interest. If

Arthur Andersen called Enron on

these questionable accounting

tricks, it would lose millions of

dollars of consulting contracts.

When energy markets plunged and the Internet bubble burst

in late 2001, the true state of Enron’s financial situation

came to light, and the company collapsed in a matter of

weeks. Enron filed for bankruptcy on December 2, 2001, and

Arthur Andersen melted down in the early months of 2002.

Enron publicly proclaimed values of respect, integrity,

communication, and excellence (RICE), but traders soon

realized that only one thing mattered: profit. Enron’s culture,

driven by President Jeff Skilling, encouraged employees

to cross ethical and legal lines. Skilling created a high-

pressure environment where up to 15 percent of his trading

staff was fired each year for failing to produce current

profits. One trader noted, “Good deal versus bad deal? Didn’t

matter!”4 Enron would later be found guilty of manipulating

the California electricity market to gouge customers in its

relentless search for profits.5

Ethics and Governance Failures at Enron

ENRON EXECUTIVES HAD CONFLICTING FIDUCIARY DUTIES: TO ADVANCE SHAREHOLDER INTERESTS THROUGH INCREASED GROWTH AND TO PROTECT THOSE INTERESTS BY MAINTAINING PRUDENT DEBT LEVELS. THEY CHOSE TO SACRIFICE PRUDENCE IN ORDER TO GROW […]

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Enron’s board of directors followed many of the

recognized best practices for corporate governance: the

directors were all experienced, the board had a code of

ethics in place to protect against fraud and other abuses,

and the audit committee, the group of directors who oversee

the firm’s financial reporting process, was composed of

directors from outside the company. Investigators later

learned that Enron’s board of directors had actually voted to

suspend its own code of ethics before it chose to establish

many of the off-balance-sheet entities that would eventually

destroy the company. In other words, the board knew it was

violating its own guidelines, but with the stock price rising,

which director would want to put the brakes on growth?6 A

U.S. Senate committee concluded:

The Enron Board of Directors failed to safeguard

Enron shareholders . . . by allowing Enron to

engage in high risk accounting, inappropriate

conflict of interest transactions, extensive

undisclosed off-the-books activities, and excessive

executive compensation. The Board witnessed

numerous indications of questionable practices

by Enron management over several years, but

chose to ignore them to the detriment of Enron

shareholders, employees and business associates.7

What did the collapse of Enron cost? Shareholders lost over

$63 billion in total value, over 20,000 Enron employees were

affected, and another 90,000 employees and partners of Enron’s

auditor Arthur Andersen saw their jobs disappear. CFO and

architect of many of Enron’s accounting tricks, Andrew Fastow,

spent six years in prison, and Jeff Skilling received a 24-year

prison sentence for his leadership of the company (later

reduced to 14 years after he struck a deal with U.S. prosecutors

to pay more than $40 million to victims and end his appeals).

Millions of California power uses paid higher utility bills and

suffered from power blackouts due in part to Enron’s deception.

Finally, every public company in the United States saw its costs

increase and its environment become more complex with the

passage of the Sarbanes–Oxley (SOX) Act in 2002.8

Enron’s spectacular and costly collapse highlights the issues, challenges, and problems of corporate governance and the importance of ethical behavior. You may be thinking, “Just what is governance? I thought that we elected governors but corporations hired managers?” In this chapter, we’ll use a metaphor that should help you visualize the importance of good corporate governance. The metaphor comes from the history of the word govern. The English word govern traces its root back to in the ancient Latin word gubernare, which meant to steer or pilot a ship.

This metaphor paints an accurate picture of governance; it’s about steering the corporation. The notion of steering raises three simple questions about governance that all corporations must answer: Where will we steer the corporation? Who will act as the pilot? How will we steer, or what principles will guide the journey? This chapter is organized around these three key questions.

THE PURPOSES OF THE CORPORATION

If we ask where we want to steer anything, be it a boat, a car, or a business, we are also ask- ing where we want to end up, or what the goal is that we are trying to achieve. In terms of corporate governance, this question is often worded in one of two ways: What is the pur- pose of the corporation? Or, who is the corporation run for? A corporation is a legal struc- ture for organizing a business where the corporation is considered a distinct and separate entity from its owners, also known as shareholders. For the last 80 years, those questions have had at least two answers. The corporation should either be run for the shareholders or be run for the stakeholders. To understand the implications of these answers, it is important to understand a little about the history and evolution of the corporation in the United States.

For the first 100 years of our nation’s history, corporations were very rare. Most economic activity was carried out by individual proprietorships, where the same person owned and ran the business. Many small businesses today still operate as proprietorships. Some busi- nesses operated as partnerships, a business owned by two or more partners. Today, law firms, accounting firms, medical practices, and other professional service firms organize as partnerships. Corporations that issued stock, or shares of ownership, to investors were rare. If you wanted to form a corporation, you had to go to the state legislature to obtain

corporate governance The processes and structures that

provide the ultimate decision-

making authority for the firm

Corporation A legal structure for organizing where the organization

is a distinct and separate entity

from its owners, also known as

shareholders.

individual proprietorship A legal structure for organizing where the

same person owns and runs the

business.

partnerships A legal structure for organizing where the owners of

a business share ownership. The

partnership is not separate from

its owners.

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permission to begin and to sell stock. That right came in a document known as a charter. That charter authorized you to form a corporation for a very limited purpose, such as build- ing a canal, a railroad, or a turnpike. There was no debate about the purpose of the corpora- tion because its purpose was clearly outlined in its charter.9

As the twentieth century dawned, states relaxed their hold on the corporate form because people realized the limited liability and dispersed ownership that came through incorporation allowed these entities to industrialize and grow the larger economy. Eventually corporations could be formed for whatever purposes the owners wanted to pursue. One way these general- purpose corporations grew was to offer investors a share of ownership in the company, or stock. Those investors contributed their money but relied on managers to run the corporation. During the nineteenth century, the owner and operator of the businesses were most often the same person, while in the twentieth century, as large organizations emerged, ownership became increasingly separated from management control of the corporation’s resources.10

In the 1930s, two famous law professors, Adolf Berle and Merrick Dodd, held a very public argument about the purposes of the corporation. Professor Berle believed that the corpora- tion should be run primarily for the benefit of the shareholders while Professor Dodd wrote that the corporation should be run for the benefit of the entire community.11 We know Berle’s position today as the shareholder primacy model, and Dodd’s as the stakeholder model.

The Shareholder Primacy Model In earlier chapters of this book we’ve explained how a business can be thought of as a bun- dle of resources and capabilities, physical assets such as buildings or equipment and skills, knowledge, and processes. Just as the business itself represents a bundle of these resources, the corporation, the legal entity that is the business, can be thought of as a bundle, or a nexus of contracts between participating parties.12 Suppliers contract with the firm to pro- vide needed inputs, employees contract to provide labor, and even distributors and many customers purchase goods from the corporation through a sales contract. Governments contract with the corporation through a business license and tax authorities. Lenders and bondholders have explicit contracts that outline specific payment schedules and terms.

Advocates of the shareholder primacy model believe that shareholders have a special type of contract with the corporation. Unlike other stakeholders, investors exchange money with the corporation without a clearly specified payment in return. Shareholders put their money “at risk” without a guaranteed return, but in exchange, they receive two property rights from the corporation. First, shareholders have claim to the residual earnings of the corporation, or the profits after all other stakeholders have been paid. Second, shareholders buy the right to moni- tor the management team to make sure that the team works in their best interests.13 The first right specifies their reward for investing their money and the second right protects them from being taken advantage of by the management team by providing them with oversight rights.

Proponents of the shareholder primacy model usually cite three reasons for their sup- port. First, the shareholders are the legal owners of the corporation’s assets.14 The executive team is hired by the board of directors, the shareholders’ oversight group, and should be legally and morally obligated to work for the owners of the corporation. Second, proponents of the shareholder model claim that financial capital is the most important input into mak- ing a business successful. Without funds it’s hard to hire employees, buy inventory or other needed inputs, and produce products for customers to buy. Finally, advocates of the share- holder model point to other societies and business arrangements where business firms try to maximize the welfare of some other stakeholder group—such as employees or the local community. They observe that corporations run for these other stakeholder groups don’t really maximize welfare for those groups and often cause real damage to economies, com- munities, and the natural environment.15

Critics of the shareholder primacy school also point to three issues as evidence against the model. First, they note that shareholders don’t really own the corporation, since share- holders own stock that they can easily trade. Second, shareholders have different objectives for investing in a firm. Some investors, such as Warren Buffett or pension funds such as CALPERS (the California Pension and Retirement System), put their money in a compa- ny’s stock as a long-term investment and want to see the corporation managed to earn the

shareholder primacy The belief that a corporation should be run,

primarily or exclusively, for the

benefit of its shareholders.

stakeholder model The belief that a corporation should be run for the

benefit of its entire stakeholder set,

with no group enjoying primacy in

decision making.

nexus of contracts A model of the corporation suggesting that the

firm is the sum total of its contracts

with different stakeholders.

property rights The rights of owners to: (1) claim the residual

earnings of the corporation, or the

profits after all other stakeholders

have been paid, and/or (2) monitor

the management team to make

sure that the team works in their

best interests.

THE PURPOSES OF THE CORPORATION [ 261 ]

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greatest long-term return. Other investors (e.g., hedge funds, arbitragers, or speculators) buy stocks and hold them for very short periods of time. They want quick returns. Managing the corporation for the benefit of shareholders requires that managers make difficult trade-offs to satisfy one shareholder group at the expense of others.16 Finally, opponents of the share- holder primacy model point to failures such as Enron, Long-Term Capital Management, BP and the Deepwater Horizon oil spill, the collapse of Lehman Brothers, and the behavior of firms during the financial crisis of 2008 as evidence that managing for shareholder value creates negative consequences for firms, investors, and society at large.17

The Stakeholder Model Merrick Dodd believed that because the community grants the corporation the right to exist, the managers should run the corporation for the benefit of the community as a whole. Dodd’s fundamental argument has been made by a number of different scholars, policy mak- ers, and social critics over the decades. The modern version of Dodd’s argument is called the stakeholder model, or stakeholder theory.18 A stakeholder is anyone who can affect or is affected by the activities of the corporation.

Stakeholders have a stake, or claim, in the activities of a corporation. The primary stake- holder groups for most organizations are shareholders, customers, suppliers, employees, and local communities (including governments). Secondary stakeholders include competi- tors, national or global communities, and many special-interest groups, such as those work- ing to protect the natural environment. We are all stakeholders of many organizations.

Those who advocate stakeholder models do so from two grounds. They point to what exec- utives and managers actually do, which is spend most of their time interacting with and man- aging the demands and needs of different stakeholder groups. This includes working to better understand and meet customer needs, negotiating wages, dealing with working conditions for employees, responding to government regulations, and reacting to the demands of special interest and advocacy groups. The fact of life for most leaders of companies is that they engage in a lot of stakeholder management, so it makes sense to do it more systematically and proac- tively. Second, many people believe that stakeholder groups have the right to be considered in decisions that will impact them. This is known as the intrinsic stakeholder model.19

The stakeholder model, especially the version we described as the intrinsic stakeholder model, has been criticized by many scholars, practitioners, and even policy makers. These critics argue that managers need to focus on a single objective.20 Making shareholder value the final decision criteria gives managers a clear direction for the tough tradeoffs they must make in the course of formulating and implementing strategy. With no way to decide whose claims have priority, managers have no way to efficiently and effectively run their firms. Other critics note that stakeholder management has a dark side: stakeholders may make, and try to enforce, unreasonable and narrow-minded claims on the firm.21 General Motors, for example, continues to incur costs related to union contracts signed decades ago. Some argue that this stakeholder group sought unreasonable benefits that hurt other stakeholder groups and eventually contributed to General Motors filing for bankruptcy.

How a company engages with its key stakeholders and manages those relationships affects the firm’s overall performance and competitive advantage. Many of the ways stakeholders interact with the firm are predictable and not difficult to understand. Other interactions, how- ever, are less obvious and have longer-term consequences on a firm’s performance and com- petitive advantage, as well as on how stakeholders benefit (or are harmed) by the business. Companies can, and should, audit their performance in relation to stakeholder groups on a regular basis.

Our Strategy in Practice feature helps you understand stakeholder relations. The first col- umn describes how company actions affect stakeholders. The middle columns of the table list how stakeholders can affect the firm. The most important element of the table, however, is the far right column, where managers list the formal mechanisms in place for the firm to attend and listen to its different constituencies. Once a firm has these elements in place, it can better design actions, policies, and strategies to create positive interactions with differ- ent stakeholder groups. You can understand how effectively a company manages its stake- holders by examining the different activities listed in the third column.

stakeholder Any person or group that can affect or is affected by the

activities of the corporation.

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Stakeholder Group

Is Affected by the Business Through . . .

Affects the Business by . . . Tools for Listening and Responding to Stakeholders

Customers Products and services Warranties, after sales

services

Integrity/honesty during

the sales process

Branding and advertising

Purchases

Word-of-mouth advertis-

ing

Formal complaints

Boycotts

Influence brand perception

and value

Market research groups

Warranty fulfillment

Customer hotlines

Code of ethics, mission

statements

Employees Wages Benefits

Safe working conditions

Flex time

Training and development

Career path

Productivity

Loyalty (turnover)

Word of mouth and

reputation

Lawsuits

Trade secrets

Theft or sabotage

Employee councils

Employee hotlines

Safety programs

Wages and benefits

Flex time, telecommuting

Training opportunities

Code of ethics,

mission statements

Suppliers Timely payment Order consistency

Protection of intellectual

property

Word of mouth and

reputation

Quality products

Timely delivery

Price and payment terms

Willingness to innovate

Flexibility in respond-

ing to crises or unusual

demands

Supplier councils

Quality control policies

Payment policies

Joint ventures, alliances,

or other mechanisms to

promote cooperation

Investors Earnings Integrity/honesty in

accounting policies and

reporting

Information disclosure

about strategies and other

material events

Providing capital

Short selling

Inducing others to buy

Analyst reports and

recommendations

Investor conference calls

and guidance

Investor relations

offices

Board of directors

Code of ethics, mission

statements

Communi- ties/ Governments

Environmental pollution,

traffic

Tax revenue and demand

for public services

Employees living in the

community

Philanthropy and

volunteering

Lobbying and other legal

activity

Tax policy

Regulations and

enforcement

Investments in community

infrastructure

Educational systems and

quality

Quality of life for

employees

Government relations

Lobbying efforts

Philanthropy and

donations

Environmental policies

Community impact studies

Volunteering efforts

Employee involvement in

local/ regional political

groups, activities

Mapping Stakeholder Influence S T R AT E G Y I N P R A C T I C E

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The first question of effective governance—What is the purpose of the corporation?—is hotly debated. On the one hand, corporate scandals, environmental crises, job offshoring, and business failures from fraud, corruption, or other illegal behaviors torment shareholder advocates. On the other hand, most adults have the majority of their retirement funds, or a part of their personal wealth, invested in company stocks, so they all have an incentive for managers to work for the good of the shareholder. Most people are both stakeholders and shareholders. Regardless of where you stand on this issue, the second question of govern- ance, the question as to who should pilot the corporation, is important as well, because those pilots determine what the corporation actually does.

GOVERNANCE: BOARDS AND INCENTIVES

Whether a corporation is managed for shareholders or stakeholders, both of those groups face the same problem in relation to the executive team that runs the corporation. We out- lined that shareholders’ property rights are twofold; they have claim on the profits of the firm and they have the right to monitor the performance of the managers of the corporation. The law recognizes this right as a way to overcome the fundamental agency problem facing the modern public corporation. As we describe the agency problem, you’ll recognize that stake- holders face the same challenge as shareholders. Figure 13.1 illustrates the agency problem.

The agency problem arises as consequence of the separation of ownership (sharehold- ers/principals) and control (managers/agents) in the corporation.22 The shareholders of a corporation, also called the principals, want to maximize the return on the dollars they’ve put into the firm; they want the corporation managed in a way that maximizes revenue and minimizes cost, leaving the most profit.

The managers who act as the agents of the principals in operating the firm want to maxi- mize their own utility. That may mean maximizing the profit of the corporation or it may mean engaging in behaviors that increase their income, leisure, power, status, or any other thing they may care about.

Put simply, principals and agents have different goals. It is clear that if stakeholders make specific investments in a firm, they face the same problem. For example, employees may learn skills that have little value in other firms, customers may design their operations around a firm’s unique products such as a software system, or suppliers may invest in spe- cialized equipment to produce particular products for the firm.23

agency problem A consequence of the separation of ownership

(shareholders/principals) and

control (managers/agents) in the

corporation. Agency problems

occur when the goals or principals

differ from those of agents.

principals The owners of a resource or piece of property. in

the corporation, shareholders are

considered principles.

agents Individuals or groups hired to administer the property

or resources of principals. The

managers of a corporation are

considered to be agents of the

shareholders.

[ Figure 13.1 ] The Agency Problem

Managers: Maximize

Utility

Natural Environment: Sustainable

Practices

Government: Good Citizen

Employees: Stable Jobs

Shareholders: Return on

Investment

Customers: Reliable Products

Suppliers: Reliable Partner

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When agency problems arise, shareholders can always just sell their holdings in a company. As performance declines, more investors sell, and eventually the firm’s share price falls enough to attract the interests of some investors referred to as corporate raiders or takeover artists. These are investor groups who believe they can manage the corpora- tion’s assets better than the current management team. These investors then make a public offer, called a tender offer, to purchase shares of dissatisfied investors, usually at a 10 to 30 percent premium above the current stock price but below what they believe the company is really worth. If these takeover artists convince enough other investors to sell their shares, then they take control of the company and begin to implement their own strategy.

Takeover artists can also mount a proxy fight, or an attempt to get the current owners of the company to change their strategy by placing their own people on the board or directors. Even if the takeover artists or raiders don’t gain complete control of the board, they often gain enough to influence the strategic decisions of the company in ways they believe will create more value for shareholders. The possibility of losing their jobs in a takeover should keep the firm’s managers focused on creating wealth for shareholders and maintaining or increasing the company’s stock price.24

Agency problems destroy value in two particular situations. First, when the principal’s investments are sunk and difficult to recover and, second, when their ability to monitor and supervise the actions and decisions of the agents, the managers of the corporation, is limited. Most businesses today require many sunk-cost investments in equipment or knowledge, satisfying the first condition. To protect themselves against the second condi- tion, principals employ two tools to monitor their manager-agents: monitoring through the board of directors, and reducing the agency problem through compensation and incentives.

The Board of Directors U.S. corporate law, and that of most countries, requires that all publicly held corporations have a board of directors. The board of directors is a group of individuals who monitor the executive team of the corporation and ensure that those executives are acting in the best interests of the shareholders.25 Directors, as well as the executives themselves, have a legal fiduciary duty to act in the best interests of the corporation’s owners. That duty has two different elements.26 On the one hand, a fiduciary is obligated to work for the greatest advantage for the principle, such as maximizing profits for shareholders. On the other hand, fiduciaries must exercise care and caution in protecting the value of the principal’s invest- ment. As you saw in the Enron case, these two duties can conflict, and Enron’s board chose to abandon its duty of care in favor of the duty to advance shareholder interests.

Shareholders elect the board of directors at regular intervals. The board of directors usu- ally includes executives of the corporation as well as people outside the company. Inside directors, executives or managers, bring their skills and working knowledge of the firm’s operations and strategies to the board. Outside directors, people not employed by the cor- poration in any other role, should bring deep knowledge and a fresh perspective, both of which ensure that the firm’s strategy will serve the financial interests of the shareholders. Outside directors should also bring independence to the board as they don’t have to worry about losing their jobs or compensation if they offer opinions that the firm’s executives might not want to hear.27

The laws of the United States do not require that directors take the interests of stake- holders in mind, but the laws of many European countries protect stakeholder interests by requiring that certain stakeholders have formal representation on the board. For exam- ple, public companies in Germany must have a representative of employees on the board; Japanese companies have one of the firm’s lenders (e.g., a bank executive) on the board. One half of the states in the United States have what are known as other constituency laws that allow the board to freely consider the needs of stakeholders other than share- holders when making critical strategic decisions for the firm.28 Shareholders and many stakeholders care about the quality of corporate boards, as illustrated in the next Strategy in Practice feature.

tender offer An offer by those hoping to control the corporation

to purchase shares of dissatisfied

investors.

proxy fight An attempt by dissatisfied investors or

stakeholders to gain seats on the

board of directors, or to influence

corporate policy.

board of directors A group of individuals who monitor the

executive team of the corporation

and ensure that those executives

are acting in the best interests of

the shareholders.

fiduciary duty The legal obligation of an agent, a fiduciary, to act in

the best interests of the principal,

or owner. Fiduciary duties include

the duty of loyalty, to work for the

optimal good of the owner, and the

duty of care, to not take undue risk

that would jeopardize the principal.

inside directors Executives or managers working inside the

company who also hold seats on

the board of directors.

outside directors Members of the board of directors not employed by

the corporation in any other role.

other constituency laws Laws that allow the board of directors to freely

consider the needs of stakeholders

other than shareholders when

making critical strategic decisions

for the firm.

GOVERNANCE: BOARDS AND INCENTIVES [ 265 ]

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America’s Best and Worst Boards S T R AT E G Y I N P R A C T I C E

With their investments at risk in an increasingly turbulent and global business environment, shareholders have become concerned about the

composition and quality of the board of directors at large

public companies. Government regulators, from tax

authorities to the Securities and Exchange Commission

(SEC), employee groups, and a number of social activists,

pay attention to annual ratings of board quality. One

example is Institutional Shareholder Services (ISS), http://

www.issgovernance.com/, a private company that rates

the quality of boards of directors. Bloomberg Businessweek

also rates the quality of America’s boards. Its ratings focus

on the board’s accountability to shareholders, the quality

of the board in terms of expertise, its independence from

company management, and the company’s overall financial

performance. Here are the five best and worst boards in

2013:29

Best:

1. Campbell Soup—The board engages in periodic self- reviews to make sure it is performing its monitoring

and advising roles well.

2. General Electric—Each director owns more than $450,000 of the company’s stock, a powerful incentive

to look after shareholder interests.

3. IBM—The board directed and led the search for new CEO Ginni Rometty.

4. Compaq Computer—This HP subsidiary reviews the board’s performance as well as that of individual directors.

5. Colgate Palmolive—Board gets high marks for the number and quality of outside directors.

Worst:

1. Archer Daniels Midland—Board shows little independ- ence from company management.

2. Campion International—Directors have few stock hold- ings in the company.

3. H. J. Heinz—Six directors exceed 70 years in age, and most members are insiders.

4. Rollins Environmental—All members of the board are insiders working for the company.

5. NationsBank—Board shows little accountability to shareholders.

Compensation and Incentives Th e agency problem arises in the fi rst place because the fundamental interests of principals (shareholders or stakeholders) and their agents (the managers) diff er. Th at is, they are some- times out of alignment. For example, an executive might get a lot of value out of having a corporate jet, but shareholders might feel that using their money to purchase a jet doesn’t maximize the return on their investment. One way to align the agent’s and principal’s incen- tives is through compensation. When managers, or employees, get paid by salary, they don’t have a strong incentive to work harder or smarter to create additional value for the com- pany.30 If, however, they get paid more when the company generates greater profi ts, they’ll have a much stronger incentive to create that additional value. Now principals and agents both care about the same thing; the company pays agents for the performance desired by principals. Principals employ two types of pay for performance, or variable compensation, to align their interests with the management team.

First, companies often pay out bonuses to executives, managers, and employees when they meet certain performance objectives. Bonuses can be discretionary and given for any reason the principal desires or they can be nondiscretionary and tied to some particular performance measure. Many employees receive a small bonus at the end of the year or during the holidays as a token of the company’s appreciation for their work. Other employees receive bonuses when they, or their work groups, hit preset tar- gets around productivity, customer service, on-time delivery, product quality, or their unit’s profitability. Bonuses can be a powerful tool in helping mangers align their inter- ests with those of various stakeholder groups if the bonus is linked to measures these stakeholders care about.

pay for performance Variable or contingent compensation that

focuses managers on key variables,

designed to align their interests

with the management team.

bonuses Additional compensation paid to executives, managers, and

employees when they meet certain

performance objectives.

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Second, companies also use stock-based compensation, either in the form of options or grants of stock, to align incentives. Stock-based compensation aligns the interests of executives or employees with those of shareholders. Stock-based compensation turns managers into share- holders. A stock option gives managers the right to buy a certain number of the corporation’s shares at a specified future date for a specified price. A CEO may receive an option to buy 1,000 shares of stock at a price of $20 on June 1, 2021. If the stock price is above $20, the executive pock- ets the difference. If the price is below $20, the option is worthless, often termed as underwater. In other cases, a company will simply grant executives or others shares of stock. These stock grants usually come with restrictions that prohibit the sale of those shares for a specified period of time.

Since scholars first identified the agency problem in the mid-1970s, the nature of execu- tive compensation has changed dramatically. Executives used to be paid primarily in salary, with some money coming in the form of bonuses. Today, the bulk of a CEO’s total compensa- tion comes in the form of stock compensation. The case of Apple CEO Tim Cook is an exam- ple. In 2011, Mr. Cook received his $900,000 base salary and a one time, special grant of Apple stock worth $376.2 million.31 Under his leadership, Apple’s share price climbed substantially and the company created value for its shareholders.

Many critics worry that such huge paychecks create a gap between the richest CEOs and the average worker and that the gap does not benefit society as a whole.32 In 1950, CEOs earned about 20 times the wage of the average employee. By 1980, that number had more than doubled to 42 times; by 2000 the gap had increased to 120 times. In 2013, the pay gap had increased to 354 times the average worker salary.33

The answer to the question of who pilots the corporation is the same whether one believes the corporation should be managed for shareholder or stakeholder interests. The board of direc- tors is the body designated to look after the interests of shareholders and/or stakeholders and monitor managers. Both shareholder and stakeholder groups can push for compensation poli- cies that align their interests with those of managers and executives. We now turn our attention the last question of corporate governance: What principles will guide the pilots of the journey?

CORPORATE ETHICS

We begin this section with a disclaimer. What you read in this chapter is not a substitute for a full course on business ethics. We intend to show you that ethics matters for strate- gists. Remember the tale of Enron in the chapter opening case? Enron enjoyed powerful competitive advantages in its markets and went from a small, regional energy producer to the country’s seventh largest company. It turned out that many of those competitive advan- tages relied on unethical behaviors that violated time-honored ethical values of honesty and integrity. Ethical values are those values that define for an individual, group, or society things that are morally right or wrong. We value honesty, kindness, fair dealing, and integrity because they are good or virtuous in a moral sense; similarly, we don’t value dishonesty, vio- lence, or breaking promises because they are morally bad or evil.

Philosophers have debated what constitutes ethics behavior for centuries. Debates about ethics are debates about what is right and wrong, but also which behaviors lead to the good or just society. Participants in these debates employ one of four arguments in making their case:

1. A good society creates the greatest good for the greatest number of people. Goodness is measured as utility, or the presence of pleasure and the absence of pain.34 Utilitarian- ism, the name for this position, suggests that we can calculate what’s right by looking at the benefits created by the action and then subtracting out the costs. Utilitarian moral philosophy provides the foundation for economics. Milton Friedman, for exam- ple, wrote that the ethical responsibility of a business is to maximize profits for share- holders as the money they make creates the most utility.35

2. The good society ensures a basic set of rights for its citizens. While utility is good, peo- ple have fundamental rights that cannot be violated or traded away and duties they cannot ignore.36 This ethical tradition views people as ends in themselves and argues that it is immoral to use people in any way as merely a means to an end. For example, people have a right, and companies have a moral obligation, to provide full and fair information about the potential risks of products.

stock-based compensation Payment to organizational

members in the form of shares in

the corporation.

stock option The right to buy a certain number of the corporation’s

shares at a specified future date for

a specified price.

stock grant A gift, or grant, of stock given to organizational

members, primarily executives.

ethical values Values that define for an individual, group, or society

things that are morally right or

wrong.

CORPORATE ETHICS [ 267 ]

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3. The good society creates the most freedom for people to act as they please. This moral philosophy is closely aligned with Libertarian political philosophies that advocate very limited government and efficient markets.37 Ethical behavior is that which pro- motes human freedom of expression and development. Free markets are morally good because they allow people the maximum amount of choice.38 This philosophy looks with approval on many technology products because they empower individuals to express themselves and develop their full potential.

4. In a good society, individuals care for each other, exhibit empathy with others, and focus on meaning ful relationships.39 Known as the ethics of care, this position believes con- cerns for utility, rights, duties, and human freedom are all worthy aims, but in pursuit of these goals we need to be concerned about other people, empathetic to their plight, and mindful of the impact of exclusion. Strategies that marginalize certain groups or management techniques that threaten relationships are immoral for those who believe in the ethic of care.

These four ethical orientations provide people with different perspectives on what con- stitutes ethical behavior; however, they are pretty abstract. It’s often difficult for people to see the link between their behavior and human rights, justice, or freedom. To bring these behaviors down to the level of every day behavior, researchers have identified general ethical dimensions that lay the foundation for ethical behaviors in business.40 Although individuals, groups, and societies differ in the weight they put on different dimensions, these areas help us think about what it means to be ethical.

Caring for and Avoiding Harm to Individuals. Many people include animals and the natural environment. Companies in the mining and oil extraction industries spend substantial resources making sure they avoid undue harm to the environment.

Concern About Fairness and the Condemnation of Cheating. Fairness for some groups means equality while for others it means equity or merit. Employees and managers of financial services companies work in an environment ripe for insider trading, a form of cheating. The best banks and investment houses have clear policies and procedures to steer clear of insider trading.

Recognition of Things as Sacred or Degraded. Many cultures revere sites as holy places or venerate people who exhibit particular virtuous behavior. Similarly, other groups view actions or elements as degraded, impure, or polluted. As companies enter markets where religious values and laws are strong, such as Islamic countries governed by Sharia, they must ensure that their products and services conform to those religious norms.

Praise of Liberty and Condemnation of Oppression. Products, services, or policies that promote human development, flourishing, freedom, and growth are praiseworthy, while those that oppress people or cultures face condemnation. The next Strategy in Practice feature describes how Google wrestled with the ethics of censorship and the suppression of human rights in China.

Corporate Culture and Ethics How can company directors, executives, and managers ensure that their organizations act in ethical ways? The RICE cultural values that Enron publicly stated—respect, integrity, com- munication, and excellence—could promote ethical behavior by everyone in the organiza- tion. The problem at Enron, however, was that these values were discussed and agreed on, but they had little impact in determining how traders actually approached their jobs. Enron traders looked to the values of the people they worked with every day. Those values, and the culture they supported, were very different from RICE. That value was to make as much money as possible, without regard to what rules might be broken while doing so.

When we speak about culture, we speak about “the pattern of behavioral assumptions that a given group has invented, discovered, or developed . . . that have worked well enough to be considered valid, and, therefore, to be taught to new members as the correct way to perceive, think, and feel.”43 Put simply, culture is just how things are done in any organiza- tion. Culture acts like a third governance mechanism because it pilots the organization by helping each individual employee or manager decide what to do. Culture proves to be very, powerful because it informs action without the need for supervision or permission from

ethical behavior That which promotes human freedom of

expression and development.

culture A pattern of behavioral assumptions that are considered

appropriate and correct for

organizational members.

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managers, executives, or the board.44 An organization’s culture, by itself, is neither good nor bad; however, a culture will infl uence how people perceive and react to ethical challenges they face as they do their jobs. We’ll fi rst look at how culture can promote unethical behav- ior, and then we’ll outline some steps companies can take to create an ethical culture.

Cultures infl uence how individuals will respond to ethical challenges in two ways.45 First, the culture tells us the “correct way to perceive” the world around us and, second, culture provides us with a set of reasons that justify our actions. Cultures that promote unethical behavior allow people to deny or not see the ethical dimension of their actions. If people do see the ethical challenge involved, the culture provides a set of justifi cations, or ways to rationalize their unethical behavior. Remember that if you break apart the word rationalize you get “rational lies.”

Creating an Ethical Climate Just as a culture can encourage people to act unethically, cultures can also help people see the ethical challenges they face and give them tools to make the correct choices. Enron’s RICE values all encouraged good behavior, but they were fundamentally out of alignment with the everyday cultural values in place at the company. Th e 7 S model introduced in Chapter 12 identifi ed shared values and style as the core of a company’s culture. Th ese two elements can help a company create a climate where ethical behavior becomes the expected norm.

Shared Values. A good place to start is to have a mission statement. We introduced mission statements in Chapter 1 and described how a mission outlines a company’s purpose and articulates its core values. A mission statement represents a powerful way to formalize

mission statement A formal declaration of a company’s core

values, business objectives, and

ethical aspirations.

Google, Censorship, and Google.cn S T R AT E G Y I N P R A C T I C E

The company we all know as Google formally incorporated in September 1998.41 The company’s search engine provided customers with more accurate searches more

quickly than other engines, and Google began to grow.

Google’s founders Larry Page and Sergey Brin built the

company around a mantra of “don’t be evil.” That mantra

would be tested within two years as the company entered the

world’s most populous country, China.

Google.cn, the Chinese language version of Google.

com, went live in 2000. The website didn’t run very well,

users could not access it all the time, and when they did,

they found it slow and unreliable. The reason for the poor

performance lay in the extensive filtering of Internet search

results by the Chinese government. The government

pursued an Internet polity that sought to leverage the

web’s potential to contribute to economic growth while

not allowing users to access what it considered politically

and morally sensitive material. By 2006, this slow search

engine had fallen behind the Chinese search engine Baidu in

market share.42

Google.cn relaunched in January 2006 at speeds and

accuracy equal to Google.com. There was a major difference,

however. Google.cn self-censored web content. Google

blocked content the Chinese government disapproved of

but notified searchers that content had been removed. This

represented an uneasy truce between Google’s desire to

be a player in the Chinese market and its need to adhere

to its principle of not doing evil—political censorship. The

Chinese government raised numerous allegations against

the company as a provider of pornography and, allegedly,

initiated a cyber-attack that halted Google’s operations.

Google responded in 2010 by moving its search site and

related storage capacity off the Chinese mainland. Chinese

users were directed from Google.cn to Google.hk. Search

results may be filtered, but the filtering would no longer

occur as a Google company policy. Google continued to locate

certain web-based and Android businesses in China. The

Chinese government renewed Google’s license to operate

in 2010, a move that many believed was based on the fear of

having their business environment seen as overly politicized.

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The Johnson & Johnson Credo S T R AT E G Y I N P R A C T I C E

Robert Wood Johnson, a member of the founding Johnson

family, served as CEO of Johnson & Johnson from 1932 to

1963. Just before the company went public, he took the time

to write down the core values that drove the company, its

strategy, and the executive team. Those core values have been

a reference for company managers and employees since then.

He termed it the Credo:46

We believe our first responsibility is to the doctors,

nurses and patients, to mothers and fathers and

all others who use our products and services. In

meeting their needs everything we do must be of

high quality. We must constantly strive to reduce

our costs in order to maintain reasonable prices.

Customers’ orders must be serviced promptly and

accurately. Our suppliers and distributors must

have an opportunity to make a fair profit.

We are responsible to our employees, the men and

women who work with us throughout the world.

Everyone must be considered as an individual.

We must respect their dignity and recognize their

merit. They must have a sense of security in their

jobs. Compensation must be fair and adequate,

and working conditions clean, orderly and safe. We

must be mindful of ways to help our employees

fulfill their family responsibilities. Employees must

feel free to make suggestions and complaints.

There must be equal opportunity for employment,

development and advancement for those qualified.

We must provide competent management, and

their actions must be just and ethical.

We are responsible to the communities in which we

live and work and to the world community as well.

We must be good citizens—support good works and

charities and bear our fair share of taxes. We must

encourage civic improvements and better health

and education. We must maintain in good order the

property we are privileged to use, protecting the

environment and natural resources.

Our final responsibility is to our stockholders.

Business must make a sound profit. We must

experiment with new ideas. Research must

be carried on, innovative programs developed

and mistakes paid for. New equipment must

be purchased, new facilities provided and

new products launched. Reserves must be

created to provide for adverse times. When

we operate according to these principles,

the stockholders should realize a fair return.

the company’s core values and ethical aspirations for the entire world to see. A good mission statement clarifi es who the company’s stakeholders are and how they should be treated. Th e Strategy in Practice feature discusses the legendary mission statement at Johnson & Johnson, known as the Credo.

Having a mission on paper is a great place to start, but having a mission that actually guides people’s behavior is even better. Everyone, from the board, to the executive team and every layer of management, to the employees on the shop fl oor must buy into the mission and fi gure out how it infl uences their daily behaviors. Companies should also make a formal code of ethics a part of their shared values.

Style. Style comes last because it might be the most important of all the 7 Ss. Th e tone at the top matters, maybe more than any other factor! How individual executives behave provides the most important cue for employees to follow as they try and fi gure out how they should act at work. Enron’s Jeff Skilling received such a long prison sentence in part because prosecutors alleged that his behavior created and drove the reckless culture of greed that led to the company’s downfall. Moral strategic managers and executives not only walk the talk and act ethically themselves, they provide ethical leadership for others to follow.

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Aircraft maker Boeing experienced several ethical crises in the late 1990s and early 2000s, including allegations of bribing U.S. Defense Department personnel to win contracts. To create a more ethical climate, the company emphasized leadership. Boeing now expects its leaders to deliver on six tasks:

1. Chart the course for employees.

2. Set high expectations for performance.

3. Inspire others.

4. Find a way to get things done.

5. Live the Boeing values.

6. Deliver results.47

Delivering results mean earning profits and creating competitive advantage but in an ethical and responsible way. The company value of integrity states, “We will always take the high road by practicing the highest ethical standards.”48

Ethics provides the answer to the final question of corporate governance: What val- ues will guide the journey? Successful corporate governance helps ensure that a company knows who its key stakeholder or primary beneficiary is, and then works to create value for them. Good governance relies on having a strong board of directors to guide decision mak- ing and oversee the executive team as they formulate and implement strategy. Finally, hav- ing a culture that enables and encourages ethical behavior matters because, as experience has shown, cultural may be the most powerful, yet subtle, form of corporate governance.

SUMMARY

The best way to think about governance comes from the word’s original meaning, to steer or pilot. People in the corporation need guidance and oversight to ensure that the corpo- ration meets its strategic objectives.

Some people believe that corporations exist to maximize the financial value of the com- pany’s shares. These advocates point to the many benefits that come from a clear focus on profitability and shareholder value. Others believe that corporations exist for a larger group of stakeholders, and the business should be run to serve their interests as well as shareholders. This debate has been going on since the Great Depression, and there is merit in both sides.

Shareholders and stakeholders both face the agency problem: their goals and interests may differ from those of the executives who run the company. Two mechanisms exist to overcome the agency problems and provide good governance. The board of directors, a legal requirement for public companies, has ultimate control over corporate decision making and can ensure that the executive team works to create value for the primary stakeholders. Compensation systems such as bonuses and stock-based rewards, pay for performance, can align the interests of managers and important stakeholder groups.

Ethics and ethical values play a significant role in good governance. The culture of the firm can either encourage or discourage ethical behavior. The 7 S model provides a frame- work to describe concrete steps managers can take to create a culture that encourages employees and others to act in ethical ways. Perhaps the most important of these is the “tone at the top,” or the behavior and leadership of those at the top of the corporation.

KEY TERMS

agency problem (p. 263) agents (p. 263) board of directors

(p. 264)

bonuses (p. 265) corporate governance

(p. 259) corporation (p. 259)

culture (p. 267) ethical values (p. 266) ethical behavior (p. 267) fiduciary duty (p. 264)

REFERENCES [ 271 ]

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individual proprietorship

(p. 259) inside directors (p. 264) mission statement (p. 268) nexus of contracts (p. 260) other constituency laws

(p. 264) outside directors (p. 264)

partnerships (p. 259) pay for performance

(p. 265) principals (p. 263) property rights (p. 260) proxy fight (p. 264) shareholder primacy

(p. 260)

stakeholder (p. 261) stakeholder model

(p. 260) stock-based compensation

(p. 266) stock grant (p. 266) stock option (p. 266) tender offer (p. 264)

REVIEW QUESTIONS

1. What is governance? Why is it important for strategic managers to understand the role that governance plays in the operation of the firm?

2. Explain the role of the board of directors in running a public company. What is the board’s primary job? What distinguishes inside from outside directors?

3. Define the agency problem in corporate governance and describe the mechanisms many companies use to align the incentives of managers and owners.

4. How can a company’s culture encourage members to engage in unethical behaviors? Ethical ones?

APPLICATION EXERCISES

Exercise 1: Write a short position paper (one or two pages) that supports either the share- holder primacy or stakeholder answer to the question, “For whom should the corporation exist?” Your paper should include responses to the main arguments of the opposing side.

Exercise 2: Choose a company that you admire. Use the sources suggested in the Strategy in Practice feature about stakeholder relationships and analyze its performance with two to three of its stakeholder groups. What does the company do well? What suggestions would you make for improvement?

Exercise 3: Identify and research a business ethics crisis or scandal. Describe the event and what you see as the causes of the crisis. Where do you see failures in corporate govern- ance? What about failures in the ethical culture and climate of the company?

REFERENCES

1 “Kenneth Lay,” Bio, http://www.biography.com/people/kenneth-lay-234611. “The History of Enron,” NPR,

http://www.npr.org/news/specials/enron/history.html.

2 http://money.cnn.com/magazines/fortune/fortune500_archive/snapshots/2002/478.htm.

3 C. W. Thomas, “The Rise and Fall of Enron,” Journal of Accountancy 193 (4) (April 2002): 41–48. See also

S. L. Schwarz, “Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures,” University of

Cincinnati Law Review 70 (2002 2001): 1309.

4 Ibid., p. 43.

5 FERC, Staff Report: Price Manipulation in Western Markets,” http://www.ferc.gov/industries/electric/ indus-act/

wec/enron/summary-findings.pdf.

6 This is the view of Kirk Hansen of the Markkula center for applied ethics. See http://www.scu.edu/ethics/

publications/ethicalperspectives/enronlessons.html.

7 “The Role of the Board of Directors in Enron’s Collapse.” U.S. Senate, permanent subcommittee on investigations,

U. S. Government Printing Office, July 8, 2002, p. 2.

8 “Enron Scandal by the Numbers,” USA Today ( Jan. 21, 2002), http://usatoday30.usatoday.com/money/

energy/2002-01-22-enron-numbers.htm.

http://www.biography.com/people/kenneth-lay-234611

http://www.npr.org/news/specials/enron/history.html

http://money.cnn.com/magazines/fortune/fortune500_archive/snapshots/2002/478.htm

http://www.ferc.gov/industries/electric

http://www.scu.edu/ethics

http://usatoday30.usatoday.com/money

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9 H. Hovenkamp, Enterprise and American Law, 1836-1937 (Cambridge: Harvard University Press, 1991).

10 A. A. Berle and G. C. Means, The Modern Corporation and Private Property (Transaction Publishers, 1932).

11 A. A. Berle, “Corporate Powers as Powers in Trust,” Harvard Law Review 44 (7) (May 1, 1931): 1049–1074,

and E. M. Dodd, “For Whom Are Corporate Managers Trustees?,” Harvard Law Review 45 (7) (May 1, 1932):

1145–1163.

12 E. F. Fama, “Agency Problems and the Theory of the Firm,” Journal of Political Economy 88 (2) (April 1, 1980):

288–307. E. F. Fama and M. H. Miller, The Theory of Finance (New York: Holt, Rinehart and Winston, 1972).

E. F. Fama and M. C. Jensen, “Separation of Ownership and Control,” Journal of Law and Economics 26 (2)

( June 1, 1983): 301–325.

13 S. Bainbridge, The New Corporate Governance in Theory and Practice (Oxford: Oxford University Press, 2008).

14 M. Friedman, “The Social Responsibility of Business Is to Increase Profit,” New York Times Magazine (1970), 33.

categories

blue ocean strategy, 205–6

free business, 206, 208

high-end/top-down disruptive

innovations, 203–4

hypercompetition, 209

low-end disruptive innovations, 201, 203

mass customization, 204–5

revenue models, 206, 208

value chains, 200–201

discovery, 207–8

home movie entertainment, 196–7

product/business/industry life cycle, 210

decline stage, 210

growth stage, 209

introduction stage, 209

maturity stage, 209–10

inputs, 79

inside directors, 264

insourcing, 131

institutionalize change, 249, 284

intangible resources, 51, 297

integration team, 122

interest rates, 36

internal abilities, 49

internal analysis, 7, 11–12, 279–80

data sources of, 298–9

measurement of capabilities, 296–8

resources measurement, 296–8

internal capital market, 114

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[ I-8 ] SUBJECT INDEX

international expansion, 13

international strategy, 170

administrative distance, 177–8

complexity, 172

cultural distance, 177

economic distance, 178

efficiency, 173–4

entry modes, 185, 187

alliances, 186

choosing, 187–8

experience and, 188

exporting, 185

franchising, 185–6

joint venture, 186

licensing, 185–6

wholly owned subsidiaries, 187

exchange rate, 176, 176

geographic distance, 178

global business units, 185

globalization, 173

of business, 171–2

foreign direct investment, 171, 172

growth, 173

knowledge, 174–5

liability of foreignness, 175

local responsiveness vs. standardization,

179–80, 180, 184

managing risk, 174

multinational firms, 172

responding to customers/

competitors, 175

triangle, 190–192, 190

generic, 191

steps, 191–2

types, 179

arbitrage strategy, 183–4

global strategy, 182–3

multidomestic strategy, 180–182

transnational strategy, 184

Internet, disruptive technology, 202

intrinsic stakeholder model, 261

invention, 197

inventory turns, 304

investor return measures, 304

investors

mapping stakeholder influence, 262

primary stakeholders, 301

ITT industries, 114, 117

J JIT II partnerships, 154

joint venture, 153, 186

K key activities/capabilities, business

model, 199

key partnerships, business model, 199

key performance indicators (KPIs), 122

key resources, business model, 199

knowledge

international strategy, 174–5

management, 161

L LANDESK software, 220, 220

Laugh-O-Gram, 48

law of experience, 75

lean manufacturing, 156, 198

learning curve, 74

legal contracts, 159–60

legal forces, 38

legal responsibility, 282

LegalZoom, 202

licensing, 185–6

licensing agreements, 152

Lincoln Electric, 170–171

compensation policy, 170

income, 171

international strategy, 173

joint venture, 186

line of sight

balanced scorecard, 252

creation, 250–252

principle, 250, 251

The Lion King, 58

The Little Mermaid, 58

local responsiveness, 179

vs. standardization, 179–80, 180, 184

long-tail phenomenon, 202, 202

long-term D/E, 303

loss of flexibility, 137–8

loss of focus, 138

low-cost strategy, 9, 231

low-end disruption, 201, 203, 204

lower input costs

bargaining power over suppliers, 79

cooperation with suppliers, 79–80

location advantages, 80

preferred access to inputs, 80

lower transaction costs, 157

lower-cost resources, 173–4

M machines specialization, 70–71

make-buy decision, 13

management skill, 112

mapping the consumption chain, 97, 98

assistance for using product/service,

99–100

delivered/installed product, 99

offering, product, 98

order and purchase of product/service,

98–9

product/service, need for, 97–8

repair/service/disposal of product, 100

selection of product, 98

storage problem, 99

market, 5, 8, 93

experience curves and, 75–7

and profitability, 76, 76

structure, 228

market share-profit relationship, 76

mass customization, 91, 204–5

matrix structure, 241

maturity stage, innovation, 209–10

McDonald’s, 196

alliance, 152

capabilities, 51

financial collateral bonds, 160

product’s life cycle, 174

social forces, 38

tacit knowledge, 55

McKinsey 7 S framework, 281

merger, 121

M-form see multidivisional form (M-form)

micro-consignment model, 284

Microsoft, 52, 55

competitor, 22–3

complementary products/services, 35

convenience, 94

dynamic environments, 232

innovating and patenting, 229

innovative strategies, 197

outsourcing, 141

protect and neutralize vulnerabilities, 227

strength and weakness, 227

X-Box gaming system, 25

minimum efficient scale, 71

misalignment, 244

organization current state, 241

with strategy, 241

misrepresentation, 158

mission, 10

mission statement, 268

mobility barriers, 217–19

modes of international market entry,

185, 187

alliances, 186

choosing, 187–8

experience and, 188

exporting, 185

franchising, 185–6

joint venture, 186

licensing, 185–6

wholly owned subsidiaries, 187

modular interdependence, 134–5

monopoly, competition

barrier to entry, 228

innovating and patenting, 229

introducing new products frequently, 229

limit access to scarce resources, 228–9

Monsters Inc., 53, 58

multidivisional form (M-form)

advantage, 242

corporation, 241, 242

multidomestic strategy, 180

design adaptability, 182

externalize adaptations, 182

focus adaptations, 181–2

multinational firms, 172

N NAICS codes, 24, 24

Nash equilibrium, 223–4

natural environment, 37

NDAs see nondisclosure agreements (NDAs)

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SUBJECT INDEX [ I-9 ]

negotiating tactics, 79

net profit margin, 302

net promoter score, 103–4, 104

Netflix, 196, 197

crowdsourcing, 140

dominant logic, 200

Internet, 202

radical innovations, 198, 200

vertical integration, 133

network effects, 30, 93

advantages, 56–7

new entrants threat, 32

new entrants, 27, 30

barriers to entry, 30

capital requirements, 31

cost advantages, 31

economies of scale, experience, or

learning, 30–31

government policy restrictions, 32

network effects, 32

nexus of contracts, 260

NFL Players Association (NFLPA), 57

Nike

economic arbitrage, 183

loss of flexibility, 138

lower input costs, 80

product differentiation, 91

subcontractor, 142

vertical integration, 132, 133

Nokia, 22–3

dynamic environments, 232

firm’s landscape, 23, 25

NAICS codes for, 24

product’s life cycle, 174

threat of new entrants, 31

noncompete agreements, 55

nondisclosure agreements (NDAs), 55

nonequity alliance, 152

nonproduction costs

advertising, 70

general and administrative costs, 70

research and development, 70

O Ohio-based Cardinal Health

Foundation, 284

oil industry value chain, 132, 132

oligopoly, competition

monitoring and matching rival behavior,

229–30

tit-for-tat strategies, 230

One Hour in Wonderland, 49

operating capabilities, 51

operating efficiency measures, 303–4

opportunities, 23, 25

optical head-mounted display

(OHMD), 209

organized to exploit, 57

other constituency laws, 264

outside directors, 264

outsourcing, 131

advantages of, 139

dangers of, 141

subcontractors and child labor, 139

via crowdsourcing, 140

P Pandora business model, 199

Pareto principle, 202

Partnership for a Drug-Free America, 286

partnerships, 149, 259

business model, 199

JIT II partnerships, 154

path dependence, 54–5

pay for performance, 265

pay-off, 222

perfect competition

differentiation strategy, 231–2

low-cost strategy, 231

merge/consolidate markets, 230–231

perishable products, 28

personal digital assistant (PDA), 210

philanthropic responsibility, 282

philanthropy, 282, 283

physical resources, 51, 297

political forces, 38

Porter’s five forces model, 40–44

positive network externalities, 56

prestige brands, 94

price

limit, 228

sensitivity, 11, 29

strategy, 77

substitute product threats, 32–3

price/earnings multiple, 304

pricing strategy, 77

principals, 263

principle of line of sight, 250

priorities, 50, 52–3

prisoner’s dilemma, 223–5, 223

private companies, data sources for, 296–7

Procter & Gamble (P&G), 243

capabilities, 51

competitive advantage, 7

economies of scope, 31

international strategy, 184–5

renewable energy, 37

product attributes, 95

product differentiation, 89

by better job, 90–91

Facebook, 88–9

mapping the consumption chain,

97–100, 98

by more jobs, 91

performance, assessing, 101–2

resources and capabilities, building,

100–101

sources

advantage, 90, 90

brand image, 94

convenience, 92–4

customer segmentation, 94–7

different product/service features,

89–92

mapping the consumption chain,

97–100

quality/reliability, 92

by unique job, 91–2

product/business/industry life cycle,

innovation, 210

decline stage, 210

growth stage, 209

introduction stage, 209

maturity stage, 209–10

product’s life cycle, 174

products/services, social entrepreneurship,

284, 286

profitability

five forces industry analysis tool,

25, 25

buyer power, 28–9

new entrants threat, 30–32

rivalry, 26–8

substitute products threat, 32–3

supplier bargaining power, 29–30

market share and, 76

property rights, 260

proprietary knowledge, 78–9

proxy fight, 264

purchasing tactics, 79

purchasing volume, 79

R radical innovation, 198

incremental vs., 197–8, 200

rarity, 53, 54

Ratatouille, 58

raw material, 80

real-world strategic group map, 220

reciprocal interdependence, 135–6

refreeze, 246

regulatory forces, 38

related-constrained diversification, 110

related-linked diversification, 110

relative cost, 77

research and development (R&D), 22

capital requirements, 31

global strategy, 183

government policy restrictions, 32

nonproduction costs, 70

resource allocation, 12

resource protection, 55

resource-based model see resource-based

view of the firm

resource-based view of the firm, 12

resources, 9, 49–51

exploit and expand, 111–12

measurement, 297–8

social value organizations, 279–80

respect, integrity, communication, and

excellence (RICE), 258, 267, 268

retail industries, 76

return on assets, 302

return on equity, 302

return on invested capital, 303

returns on net assets (RONA), 131

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[ I-10 ] SUBJECT INDEX

revenue models, 198

innovative strategy categories, 206, 208

revenue streams, business model, 199

RICE see respect, integrity, communication,

and excellence (RICE)

rivalry, 25

barrier to exit, 28

high fixed costs, 28

high storage costs, 28

intensity of, 26–7

number and relative size of

competitors, 27

perishable products, 28

relatively standardized products, 27

slow growth in demand for products/

services, 27

switching costs, 27

unused production capacity, 28

S sales productivity, 303

San Francisco Agricultural School (SFAS),

276, 281, 283

Sarbanes–Oxley (SOX) Act, 259

scale curve, 71–3

scale economies, 174

scarce resources, competitive access to,

228–9

Schwab Foundation for Social

Entrepreneurship, 287

scope economies, 174

S-curve, 209–10

Securities and Exchange Commission

(SEC), 61, 265

segmentation analysis, 11

sequential interdependence, 135

7 S model, 239, 240

alignment, 239, 240

data sources, 299–300

shared values, 244–5

skills, 242–3

staffing, 242

steps, 241

strategy, 240

structure, 240–242

style, 243–4

systems, 242

shared knowledge, 112–13

shared ownership, 160

shared values, 244, 277

corporate ethics, 268

hard triangle, 244

soft square, 244, 300

shareholder primacy model, 260

advocates, 260

corporation purposes, 260–261

issues, 260–261

opponents, 261

proponents, 260

shareholders, 16, 259, 263, 302

short-term wins, 248

simultaneous move game, 223–5

single business, 110

six Ss

business models, 113–14

employing slack, 112

new industry, stepping stone to, 114–15

shared knowledge, 112–13

spreading capital, 114–15

synergy, 112

skills, 242

management, 112

social entrepreneurship, 285–6

soft square, 300

Skype, 202

cross-sell strategy, 206

low-end disruptive innovations,

203, 204

slack, 112

Snow White, 58

Snow White and the Seven Dwarfs, 48

social bricoleur, 285

social constructionist, 286

social engineers, 286, 287

social entrepreneurs, 277

social entrepreneurship, 283

base of the pyramid, 287

capacity building, 284, 286

challenges in, 286

hybrid organization, 287

institutional change, 284, 286

micro-consignment model, 284

products/services, 284, 286

skills of, 285–6

social bricoleur, 285

TOMS model, 287

types, 284, 286

social forces, 38

social investing, creation of, 285

social value, 277

creation, 278–81, 283

organizations, 277–8

alliances, 280–281

corporate strategy, 280–281

cost leadership, 280

differentiation strategy, 280

and economic value organizations,

280–281

external analysis and value net, 278–9

governance, 281

implementation, 281

innovative strategies, 280

internal analysis, 279–80

social entrepreneurship, 283

base of pyramid, 287

capacity building, 284, 286

challenges in, 286

hybrid organization, 287

institutional change, 284, 286

micro-consignment model, 284

products/services, 284, 286

skills of, 285–6

social bricoleur, 285

TOMS model, 287

types, 284, 286

strategy and see strategy

soft square, 244, 300

Sony

innovative strategies, 196, 203, 210

loss of flexibility, 138

value chain, 81

special purpose entity (SPEs), 258

spreading capital, 114–15

staffing, 242, 300

stakeholder model, 260, 261, 263

stakeholders, 15, 261

audit, framework for, 300–301

primary, 261, 301

roles in value net, 279

secondary, 261

sustainable advantages, 278

theory, 261

standardization, 179

local responsiveness vs., 179–80, 180, 184

products, 27

Starbucks

capabilities, 9

convenience, 92

high-end disruptive innovations, 203

mapping consumption chain, 98

mission, 10

neutralizes, 227

resources to differentiate, 101

strength/weaknesses, 227

Steamboat Willie, 48, 52, 56, 58

stock grants, 266

stock option, 266

stock-based compensation, 266

storage costs, 28

strategic alliances, 13, 149

accountability, 162–3

acquisition and, 165

blame game in, 159

building trust, 158–60

choosing, 150–151

combine unique resources, 155–6

common clauses in, 160, 160

create new, alliance-specific resources, 157

equity alliance, 153

facilitates intervention, 162–3

hold-up, 158

internal coordination, 162

joint venture, 153

lifecycle, 162

lower transaction costs, 157

management capability, 161–3

misrepresentation, 158

nonequity/contractual, 152

pool similar resources, 156–7

Tokyo Disneyland, 148–9

tools, 162

types of, 152

vertical and horizontal alliance, 153, 155

strategic change

phases, 246

change process, 246

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SUBJECT INDEX [ I-11 ]

refreezing, 246

unfreezing, 245

successfully implement, 246–9

strategic group, 217

competitive strategy, 217–19

map, 218–20, 218, 220

strategic leaders, 14

strategic management process, 7–9, 8, 9

strategic performance ratios, 302–3

strategic slack measures, 303

strategy, 240

competitive strategy see competitive

strategy

corporate, 280–281

differentiation, 231–2

dominant, 224

global, 182–3

hard triangle element, 299

implementation see implementation

strategy

innovative, 280

international see international strategy

multidomestic, 180

design adaptability, 182

externalize adaptations, 182

focus adaptations, 181–2

social change, 281–3

social value see social value

third-party pay, 206, 208

tit-for-tat, 225

employ, 230

game theory, 225–6

tools, 278–81

transnational, 184

strategy canvas

competitive strategy, 219–21

short-haul airline industry, 219

strategy vehicles, 12–13

Strengths, Weaknesses, Opportunities, and

Threats (SWOT) analysis, 10

structure, 240

hard triangle element, 299–300

matrix, 241

style, 243

categories, 243

corporate ethics, 268

soft square, 300

subcontractor, 133

and child labor, 139

competitor, preventing, 142

substitute products threat

awareness and availability, 32

price and performance, 32–3

substitutes, 25, 27

sunk cost fallacy, 115

superordinate goals, 244

suppliers, 28, 279

bargaining power, 29–30

contract with firm, 260

cooperation with, 79–80

mapping stakeholder influence, 262

number/concentration/size of, 30

power, 27

primary stakeholders, 301

supply agreements, 152

sustainability, VRIO model of, 53–8

sustainable stakeholder advantages, 278

sustained competitive advantage, 58

sustaining innovations, 198

switching costs, 27

synergy, 112

systems, 242

hard triangle element, 299–300

roles, 242

T tacit collusion, 231

tacit knowledge, 55–6

takeover, 119

takeover artists, 264

tangible resources, 51

target nonconsumption, blue ocean

strategy, 205

task specialization, 71

technological change, 35–6

tender offer, 264

third-party pay strategy, 206, 208

threats, 23, 25

analyzing, 26

backward integration, 29

forward integration, 30

new entrant, 30

barriers to entry, 30

capital requirements, 31

cost advantages, 31

economies of scale, experience, or

learning, 30–31

government policy restrictions, 32

network effects, 32

substitute product

awareness and availability, 32

price and performance, 32–3

time compression diseconomies, 56

times interest earned, 303

tit-for-tat strategy, 225

employ, 230

game theory, 225–6

Tokyo Disneyland, 148–9

alliance, 152

unique resources, 155

Toy Story, 58, 155

Toy Story 1, 53

Toy Story 2, 53, 58

Toy Story 3, 53, 58

Toyota, 77

alliance-specific resources, 157

brand image, 94

competitive advantage, 7

equity alliance, 153

General Motors alliance with, 156

high-end disruptive innovations, 203

loss of focus, 138

lower input costs, 79–80

product differentiation, 92

product’s life cycle, 174

proprietary knowledge, 78

radical innovations, 198

strategic alliances, 165

transaction costs, 157

vertical alliance, 153

Toyota Production System (TPS), 78–9

trade secrets, 55

transaction costs, 157

transaction-specific asset, 136

transnational strategy, 184

Treasure Planet, 58

TurboTax, 202

two-sided market, 206

U UGC see user-generated content (UGC)

unfreezing, 245

unique resources, 155–6

unique value, 5, 8–9

unrelated diversified firm, 110

unused production capacity, high

levels of, 28

Up, 53, 58

U.S. government, industries, 24, 24

user-generated content (UGC), 52

V value, 53, 54

value chains, 49–50, 50, 80–81,

201, 279

mass customization, 204–5

oil industry, 132

reconfiguring, 200–201

vertical integration, 131–2

value creation, 111–12

value net, 278, 279

external analysis and, 278–9

stakeholder roles in, 279

value propositions, 8, 199

vertical alliance, 153–5

vertical integration, 13, 109, 131

capabilities, 133, 133

control, 133, 136

coordination, 133, 134–6

Dell and ASUS, 130–131

forward and backward integration,

132–3

interdependence influencing, 134

loss of flexibility, 137–8

loss of focus, 138

make vs. buy mistake, 137, 144

and outsourcing, 134

value chain, 131–2

virtuous circle, 56

vision, 247

communicate, 248

creation, 247–8

Vision Spring, 281, 283

Voice over Internet Protocol

(VOIP), 108

VRIO model, 53–8

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[ I-12 ] SUBJECT INDEX

W wage rates, 80

Wall-E, 58

Walmart, 60, 61

buyer bargaining power, 29

convenience, 92–3

functional strategies, 14

international strategy, 173, 173

low-cost strategy, 9

lower input costs, 79

make-buy decision, 13

nonproduction costs, 70

product markets, 8

pursue differentiation strategy, 232

resource allocation, 12

value chain, 49

Walt Disney

and Oriental Land, 151

tacit knowledge, 55–6

vertical integration, 132, 133

Walt Disney’s Wonderful World of Color, 49

wholly owned subsidiaries, 187

wireless scale curve, 73

work gloves, 247, 248

[ C-1 ]

CASE 1: Walmart: Gaining and Sustaining Competitive Advantage C-2

CASE 2: Coca-Cola and Pepsi: The Shifting Landscape of the Carbonated Soft Drink Industry C-12

CASE 3: Intel (A): Dominance in Microprocessors C-22

CASE 4: Southwest Airlines: Flying High with Low Costs C-32

CASE 5: Harley-Davidson: Growth Challenges Ahead C-45

CASE 6: Intel (B): Responding to the Smart Phone Threat C-54

CASE 7: Nike: Sourcing and Strategy in Athletic Footwear C-62

CASE 8: AT&T and Apple: A Strategic Alliance C-70

CASE 9: Samsung: Overtaking Philips, Panasonic, and Sony as the Leader in the Consumer Electronics Industry C-82

CASE 10: New Business Models: Netflix, Redbox, Hulu and Others in Home Movie Entertainment C-92

CASE 11: Smartphone Wars C-101

CASE 12: Lincoln Electric: Aligning for Global Growth C-112

CASE 13: Corporate Governance and Ethics: A Series of Decisions C-119

CASE 14: Safe Water Network: Mastering the Model at Dzemeni C-121

CASE 15: Walmart versus Amazon.com (recommended for Chapters 1, 3, 4, 11) C-132

CASE 16: Skype: Competing with Free (recommended for Chapters 10, 4, 11) C-142

CASE 17: Sears: In Need of a Turnaround Strategy (recommended for Chapter 13) C-152

CASES

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[ C-2 ]

CASE 01 Walmart Stores: Gaining and Sustaining Competitive Advantage

W almart, a discount retailer, was started by Sam Walton in the small town of Rogers, Arkansas, in 1962. By 2014,

Walmart had become the world’s largest retailer, with more than $476 billion in revenues and 10,942 stores.1 Over one quarter of Walmart’s revenues came from outside of the United States as it continued to take its low-cost business model around the world. Traditional discount-retailing competitors, including Sears, K-Mart, and Target, were now dwarfed by the size of Walmart’s operations (see Exhibits 1 and 2).

As the new century began, Walmart faced some new com- petitors and new challenges, however. Target, a traditional competitor, had successfully moved upmarket. By offering more trendy and design-sensitive products, Target was now generating higher profit margins than Walmart. Costco had entered the discount-retailing market, offering low prices on products that were generally deemed to be of higher qual- ity than many products sold at Walmart and Sam’s Club. Amazon.com was growing rapidly by selling large volumes of goods online at prices that usually matched—or beat— Walmart’s prices, with the additional advantage of zero sales tax. And Aldi, a new discount retailer out of Germany, offered lower prices than Walmart by using a business model that was even more bare-bones than Walmart’s. Along with new competition, Walmart also faced the challenge of taking its low-cost strategy to international markets.

WALMART’S HISTORY Walmart’s founder, Sam Walton, was born in the small town of King fisher, Oklahoma, in 1918. He learned about retail by working at JC Penney before serving in the military during World War II. Walton’s first store was a Ben Franklin fran- chise, located in Newport, Arkansas (a town with a popu- lation of 7,000), which he opened in the 1950s. Walton had intended to open a Federated store with a friend in St. Louis, but Walton’s wife, Helen, refused to live in any town with a population larger than 10,000.2 As his chain grew, Wal- ton continually looked for new ideas, traveling the nation to observe retail practices. Those observations convinced him that opportunity was available for discount retailers in small-town America.

When Ben Franklin wouldn’t support his idea for dis- count retailing, Walton put up his home and all his property to secure financing for the first Walmart, which he opened up in Rogers, Arkansas in 1962 (that same year Target and K-Mart opened their doors). Following the suggestion of a manufacturer’s rep, he made the decision to emphasize low prices and high volumes in his first store. When Walton opened the store, it was the first time anybody had ever dis- counted prices to a deep level in such a small town. Small mom-and-pop retailers simply couldn’t compete with the

[ Exhibit 1 ] Walmart’s Sales and Income by Segment (in millions)

Fiscal year ending Jan 31, 2007 2011 2013 7-year Growth

Walmart Stores segment

—Net sales $226,294 $260,261 $274,433 18%

—Operating income $17,029 $19,914 $21,491 21%

—Operating income % sales 7.6% 7.6% 7.8%

International segment

—Net sales $77,116 $109,232 $134,748 43%

—Operating income $4,259 $5,606 $6,617 36%

—Operating income % sales 5.1% 5.1% 4.9%

Sam's Club

—Net sales $41,582 $49,459 $56,423 26%

—Operating income $1,512 $1,711 $1,960 23%

—Operating income % sales 3.6% 3.5% 3.5%

Source: Walmart Annual Reports.

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CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE [ C-3 ]

prices offered at Walmart, and Walton was able to expand his one store into a growing chain.

Walton’s plan to grow Walmart had two key elements: Start in small towns and expand in his own region before spreading to new areas. Walton said, “Our key strategy was to put good-sized stores into little one-horse towns which everybody else was ignoring.”3 Walton opened 18 stores in the second half of the 1960s. Those stores had annual sales

of roughly $9 million. In contrast, K-Mart had already grown to 250 stores and had annual sales close to $800 million. But Walmart continued to grow. In his 1993 autobiography, Wal- ton recalled, “K-Mart wasn’t going to towns below 50,000… We knew our formula was working even in towns smaller than 5,000.”4 By the early 1970s, Walmart had more than 30 stores in rural Arkansas, Missouri, and Oklahoma. As the company grew, Walton spent much of his time observing

[ Exhibit 2 ] Competitors’ Financial Performance Results (in millions)

Fiscal year ending in: 2007 2011 2013 7-year Growth

Domestic Discount Retail

Kmart

—Net sales $17,256 $15,285 $15,593 –11%

—Operating income $402 $-34 $353 –14%

—Operating income % sales 2.3% N/A 2.3%

Target

—Net sales $63,367 $69,865 $72,596 13%

—Operating income $5,272 $5,322 $4,229 –25%

—Operating income % sales 8.3% 7.6% 5.8%

Warehouse

Costco

—Net sales $63,088 $87,048 $102,870 39%

—Operating income $1,609 $2,439 $3,053 47%

—Operating income % sales 2.6% 2.8% 3.0%

International discount Retail

Tesco

—Net sales £42,641 £60,931 £64,800 34%

—Operating income £2,648 £3,811 £2,188 –21%

—Operating income % sales 6.2% 6.3% 3.4%

Carrefour

—Net sales €82,148 €81,271 €74,888 –10%

—Operating income €3,338 €2,182 €2,238 –49%

—Operating income % sales 4.1% 2.7% 3.0%

Source: Company Annual Reports.

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[ C-4 ] CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE

his competitors and adapting useful ideas. Many now- familiar elements of Walmart, including self-service, com- pany cheers, referring to employees as “associates,” and Sam’s Club warehouse stores, all came from his observations of other businesses.

Although Walmart performed well during the 1960s, Walmart’s cost of goods sold (COGS) was still high rela- tive to the large national retailers. Walton said that, early in Walmart’s history, vendors typically dictated the terms and prices to Walmart, which did not yet have the size or power to negotiate its own terms. Walton recognized that for Walmart to receive the same prices and level of service as the larger retailers, the company would need to start buy- ing in much higher volumes. To store such large amounts of merchandise, Walmart would need to invest in a big warehouse. Walton was already leveraged to the point that he couldn’t finance the investment on his own, so he took the company public in 1972. The stock sale infused Walmart with $4.95 million, just enough capital to build a $3.3 million warehouse.5 This was Walmart’s first step toward developing its own set of distribution centers to quickly and efficiently get merchandise to its stores.

In order to manage these distribution centers and to coordinate shipments from suppliers, Walmart made signifi- cant investments in information technology (IT). Walmart’s IT system allowed the company to see where in its distribu- tion system any product was at any time. The IT system also linked Walmart’s automated distribution centers to stores

and to suppliers. This allowed the company to restock stores’ inventories precisely and quickly. Walmart also invested in communications, creating a private satellite network that allowed company managers to communicate quickly and easily with stores all over the country without traveling to visit them, saving Walmart significant time and money.

These investments helped Walmart grow quickly in the 1980s and 1990s. Its return on assets (ROA) peaked above 13 percent in 1990 and gradually declined to around 8.5 per- cent by 2010 (see Exhibit 3.) In 1985, Walmart’s COGS ran at 73.8 percent of sales. This was higher than the industry average of 71.9 percent, but Walmart had an advantage in its operating structure. Walmart’s total operating expenses were 18.5 percent of sales. Rental expenses came to 1.8 percent of sales, advertising costs were 1.1 percent of sales, and pay- roll expenses were 10.1 percent of sales. In contrast, indus- try averages for rental, advertising, and payroll expenses were 2.2, 2.3, and 11.2 percent of sales, respectively, with a total operating expense at 23.3 percent of sales on average. Walmart’s cost advantages in these various areas helped the company achieve an operating income 2.6 percent of sales higher than the industry average. At its twenty-fifth anniver- sary in 1987, Walmart had 1,198 stores, $16 billion in sales, and 200,000 associates. Just 25 years later, at its fiftieth anni- versary in 2012, Walmart had become the world’s biggest retailer with 10,130 stores, $444 billion in sales, and 2.2 mil- lion associates. See Exhibit 4 for a summary of Walmart’s key income statement and balance sheet items.

10%

20%

30%

40%

50%

60%

70%

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

ROS

ROA

ROE

Sales Growth Rate

[ Exhibit 3 ] Walmart’s Performance Ratios

Source: Walmart Annual Reports

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CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE [ C-5 ]

[ Exhibit 4 ] Walmart’s 5-Year Global Operating Results

2014 2013 2012 2011 2010

Net sales $473,076 $465,604 $443,416 $418,500 $404,697

Net sales increase 1.6% 5.0% 6.0% 3.4% 0.9%

Comparable sales in the U.S. –0.5% 2.4% 1.6% –.60% –0.8%

Walmart U.S. –.6% 2.0% 0.3% –1.5% –0.7%

Sam’s Club .3% 4.1% 8.5% 4.0% –1.4%

Gross profit margin 24.3% 24.4% 24.6% 24.8% 25.0%

Operating, SG&A as a % of net sales 19.30% 19.10% 19.30% 19.50% 19.80%

Operating income $26,872 $27,725 $26,491 $25,508 $23,969

Operating income % sales 5.7% 6.0% 6.0% 6.1% 5.9%

Walmart income (attributable) $15,918 $16,963 $15,734 $15,340 $14,433

Net income per share of common stock:

Walmart

(Attributable)

4.85

5.01

4.53

4.18

3.72

Dividends 1.88 1.59 1.46 1.21 1.09

Financial Position

Inventories $44,858 $43,803 $40,714 $36,437 $32,713

Property & other assets, net $117,907 $116,681 $112,324 $107,878 $102,307

Total assets $204,751 $203,105 $193,406 $180,782 $170,407

Long-term debt $44,559 $41,417 $47,079 $43,842 $36,401

Shareholder equity $76,255 $76,343 $71,315 $68,542 $70,468

Source: Walmart Annual Reports.

WALMART’S OPERATIONS Walmart’s structure and systems were designed for effi- ciency. The key elements of Walmart’s operations strat- egies include its distribution model, relationships with suppliers, human resources management, marketing and merchandising practices, store formats, and international operations.

Distribution Walmart’s distribution centers are typically 1 million square feet in size, require about $70 million to build, are highly automated, and operate 24 hours a day. Each distribution center receives hundreds of truckloads per day and serves

roughly 150 stores within a 150-mile radius. Products typi- cally move through the distribution center within 48 hours, and often in far less time than that.6 As of 2011, Walmart was the world leader in cross-docking procedures, in which goods brought into the distribution center exit the inbound truck and are loaded immediately onto an outbound truck headed to a Walmart store.

Technological innovations enable Walmart’s efficient distribution. The company promoted a system for tracking goods by attaching radio frequency identification (RFID) tags to boxes so that cases no longer had to be manually inspected.7 The RFID program was often fought by suppliers due to the expense of implementation. It was so important

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[ C-6 ] CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE

to Walmart’s efficiency and reductions in shrinkage (theft), however, that Walmart vigorously enforced its adoption, imposing penalties on its suppliers that did not use the sys- tem.8 Walmart also devised a Scan ‘N’ Pay (SNP) system, which meant that a supplier’s product was owned by the supplier until the product was actually sold by Walmart.9 Due to these efficiencies, analysts estimated that, in the mid- 1990s, Walmart’s inbound logistics expenses were roughly 1 percent less as a percentage of sales than the expense of its direct competitors.10

Supplier Relationships Walmart is known for tough but productive relationships with its suppliers. Traditionally, negotiations with Walmart have been no-frills experiences involving clear expectations. For example, Walmart typically held negotiations in small rooms furnished only with a table and four chairs.

Walmart’s ability to put a supplier’s product on the shelves of over 10,900 stores gives it tremendous leverage with sup- pliers. If suppliers don’t show up to the negotiations with their price in an already bottom-line position, then Walmart is quick to send the supplier home to retool, or to move on in search of another supplier that would be more competitive. At the same time, however, Walmart has given suppliers access to some of the most accurate consumer data in the world.11 In the 1990s, for example, Walmart implemented an electronic data interchange (EDI) system and operated RetailLink, which provided all of its suppliers with up-to- the-minute, point-of-sale data from all Walmart locations worldwide. Tying its manufacturers to its stores in this way was one of the primary factors that led Walmart to achieve the lowest operations costs in the industry. According to Richard Sherman, president of Gold and Domas research, “Walmart can be heavy-handed, but its contribution to the supply chain has been to lead the market to adopt best practices they should have been adopting anyway. For the donkeys, those that haven’t been paying attention, the hand is heavy, the 2-by-4 is hard. If you have been paying atten- tion, it’s not a 2-by-4. It’s an opportunity.”12 Taking advan- tage of this opportunity, some larger manufacturers, such as Procter and Gamble, located large teams of employees near Walmart’s headquarters in Bentonville, Arkansas, to better coordinate with Walmart.

To further encourage suppliers to streamline costs, Walmart developed a Sustainability Index for all of its prod- ucts. The index uses various methods to track all stages of the product life cycle, from raw materials to disposal, and holds suppliers accountable for any unnecessary costs added to the supply chain, such as high-carbon materials, excess packaging weight, or an overly long supply chain.13 In order to efficiently manage its sophisticated distribution network and supply chain, Walmart made significant investments in informa- tion technology. Walmart spent 0.1-0.3 percent more than on

information technology, as a percentage of revenues, a figure 5 to 10 times more than competitors did in absolute dollars.

Human Resource Management Walmart has received mixed reviews regarding its human resource management practices. For example, Walmart has been recognized as one of the 100 best companies to work for in the United States, but at the same time, it has occa- sionally been criticized for its nonunion stance and for gen- der discrimination. Walmart worked hard to keep the higher costs of unionized labor out of its operations. For example, during one attempt to form a meat-cutters union, Walmart simply closed its meat-cutters division and outsourced the entire operation. This sent a clear signal that Walmart was determined to keep its labor costs as low as possible. At one point in time during its history, Walmart’s labor costs were only 10.1 percent of sales, compared to 11.2 percent for its direct competitors.14

Despite their nonunion status, Walmart’s employees generally have been described as motivated and commit- ted to Walmart. An executive at one supplier commented, “Walmart is a lean operation managed by extremely com- mitted people…They live to work for the glory of Walmart. This may sound like B.S., but it’s incredible. Our production, distribution, and marketing people who visit Walmart can’t believe it.”15 Some observers attributed employee enthusi- asm to the work ethic and culture created at Walmart by Sam Walton. Others attributed it to the fact that profit shar- ing was available to associates after one year of employ- ment. Walmart contributed a percentage of every eligible associate’s wages to his or her profit-sharing account. Upon leaving the company, the associate could access funds in his or her account either in cash or Walmart stock. Walmart also offered an associate stock ownership plan for the pur- chase of its common stock, at one time matching 15 percent of up to $1,800 in annual stock purchases. Managers and supervisors were compensated on a salaried basis, and they earned additional incentive compensation based on store profits. Store managers usually earned more than $100,000 per year. Members of the top management team typically earned more than 90 percent of their compensation from incentives based on their performance, and less than ten percent as salary.

Walmart typically hired people right out of high school or college. For the most part, management consisted of individ- uals who had started their careers at Walmart and worked their way up the ladder. The company invested in training assistant managers and managers in the Walmart way of doing things. For example, most management training semi- nars were offered at the distribution centers, thereby expos- ing store managers to the distribution network.

Walmart didn’t have regional offices, which saved the company an estimated 1.5-2.0 percent of sales each year.

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CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE [ C-7 ]

Instead, regional managers were located at the company’s Bentonville, Arkansas, headquarters and spent roughly 200 days a year visiting stores. Regional managers began their visits early on Monday morning, and they tried to return to Bentonville on Wednesday or Thursday “with at least one idea which would pay for the trip.”

Marketing and Merchandising From the beginning, Walton’s basic merchandising principle for Walmart was to focus on leading the industry in sales- per-square-foot by offering a broad assortment of extremely low-priced goods. To this end, Walmart carried a wide range of national brands and private label products. In 2003, pri- vate label sales were on the rise for Walmart, but they still only made up about 20 percent of annual sales, compared to 50 percent for Target. In 2009, Walmart redesigned the packaging of its largest private label brand, Great Value, to be more visible. The Great Value brand was expected to grow from $13 billion in sales in 2009 to $20 billion in 2014.16 Walmart’s focus on apparel was comparatively lower than that of competitors. Only 10 percent of U.S. sales were apparel, compared to Target’s nearly 40 percent.17

Advertising was also limited. Walmart started with almost no advertising, and its advertising costs were still only 0.6 percent of sales in 2010, compared to Target’s 2.0 percent. The ads the company did run were focused on Walmart’s low prices. Pricing for Walmart had always been built around Every Day Low Prices (EDLP), but there had been some changes to how the focus was imple- mented over time. Walmart’s original slogan was “Always the lowest price,” but lawsuits by the competition pushed the company to change the slogan to “Always low prices. Always.” The slogan changed again in 2007 to “Save money. Live better.”

To ensure that prices were, indeed, low every day, Walmart conducted weekly price checks in nearly 99 per- cent of its competitors’ stores. Managers at local stores were given the flexibility to adjust prices to meet, or beat, the com- petition. One study found that when Walmart and Kmart were located within a mile of each other, Walmart’s prices were 1 percent lower than Kmart’s. In rural locations where Walmart was the only discount retailer in town, Walmart’s prices were found to be 6 percent higher than in locations where a direct competitor was nearby.

During the U.S. recession of 2008-2010, an increased num- ber of middle-class buyers came to Walmart, looking for sav- ings. Hoping to keep the new customers once the economy improved, Walmart launched Project Impact, an initiative designed to improve the quality of the shopping experience in order to help Walmart compete more effectively with Target. Project Impact focused on widening aisles, lower- ing shelves, and removing palleted promotions from walk- ways to clean up the overall look of stores.18 However, at the

beginning of 2011, after eight straight quarters of reductions in same-store sales,19 Project Impact was deemed a failure. Although increasing its appeal to the middle-class, Walmart had alienated its core blue-collar, working-class customer. Walmart made the decision in 2010 t0 return to its original high-stacked, palleted aisles.20

While still commanding a strong lead in its key measure of success, sales-per-square-foot, Walmart had watched the gap between it and its competitors gradually narrow over the course of a decade. In 2003, Walmart had sales-per- square-foot of $440, and Target had $249. By 2012, Walmart’s sales-per-square-foot had dropped to $428, and Target’s had risen to $302.21

Walmart Store Formats In 2000, Walmart’s original discount-store format still dominated its store-format mix, but over the next 10 years, the original format was supplanted by the much larger supercenter format, which added a full-line gro- cery department and other specialty departments to the original discount store. Walmart’s original intent in including groceries was to drive traffic to its general mer- chandise, but the grocery department ended up being profitable on its own, and it now represents about 35 percent of Walmart’s earnings.22 At roughly 90,000 square feet, Walmart’s supercenters were double the size of its approximately 42,000 square-foot original discount stores. At the beginning of 2011, Walmart had 2,898 supercent- ers worldwide (including many discount centers that had been converted to supercenters) and was down to 701 dis- count centers worldwide.23

Walmart also operates Sam’s Club warehouse stores. The company built its first Sam’s Club in 1983 after Sam Walton observed the rapid growth of the Price Club, and the new organizational group quickly grew to dominate the segment. The warehouse store required a fee for membership, but it would then sell heavily discounted goods to customers right off the pallets. There tended to be far fewer stock keeping units (SKUs), or individual products, available than in a Walmart supercenter, and the available products also tended to change quickly.24 However, Costco, which some said was the only competitor that Walmart feared,25surpassed Sam’s Club, to become the most successful warehouse store retailer in the world. In 2012, Costco had revenues of $97 billion from 644 stores, while Sam’s Club had only $49 billion in revenues from 609 stores.26 Costco’s success was attributed to focus- ing on a higher-income client by selling higher quality or, at times, even luxury goods at discount prices. Sam’s Club adjusted its product mix for a short time toward the higher- quality products, but Sam Club’s core customers never really appreciated them.27

As Walmart started to achieve critical mass in the rural and suburban markets for its discount centers and

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[ C-8 ] CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE

[ Exhibit 5 ] Walmart’s and Competitors’ Store Locations By Lifestyle Region

Affluent/Elite Mid/Downscale Suburbs

Inner City Small-Town Living

Rural America

Walmart Discount Stores 375 159 217 673 1,227

Kmart Discount Stores 465 216 411 544 458

Target Discount Stores 414 123 197 218 46

Walmart Supercenter 67 44 61 247 535

Super Kmart 27 12 20 27 18

Meijer 49 15 8 60 13

Super Target 25 0 4 6 2

Walmart Neighborhood

Market

8 2 5 5 0

Source: Adapted from Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Wal-Mart Stores in 2003,” Harvard Business School

Case 9-704-430, 2004.

supercenters, the company moved to enter even smaller markets, with a format called the Neighborhood Market.28 The Neighborhood Market was essentially a supermarket. It focused on groceries, but it also carried drugstore prod- ucts and some merchandise. Walmart’s plans were to roll out the Neighborhood Market in relatively slow fashion. It had 112 Neighborhood Markets in operation in 2008, and the number had grown to only 160 by 2010.29 See Exhibit 5 for a summary of the type of Walmart and competitor stores by lifestyle region.

Walmart also sold online, but online sales accounted for only $6 billion in 2010. In Walmart.com’s early years, store managers fought hard against the website and even com- plained about having the website address emblazoned on in- store bags. Not surprisingly, managers were concerned that online sales would cannibalize store sales and thus reduce their bonuses. The online store also struggled to replicate the price advantage held by Walmart’s brick-and-mortar stores. In the online arena, Amazon.com was often the low- price leader. Amazon.com also carried more than 14 times as many products online, and its website received twice as many visits per month as Walmart’s.30

International Walmart started to expand internationally in 1991,31 and by 2011, it had more stores outside the United States, with 4,557 international locations and 4,413 domestic locations.32 In 2013, Walmart’s international division was its fastest grow- ing division by revenues, and more than 28 percent of its sales came from international markets.33

Walmart expanded into international markets both by building its own stores, as it had in the United States, and through joint ventures and acquisitions. It acquired ASDA in the U.K. in 1999, and despite local protest, it purchased of 51 percent of Massmart in South Africa in July of 2011. In each of the markets into which Walmart expanded, it faced unique obstacles. In some nations, Walmart was unable to overcome the obstacles to its entry. For example, in Germany it faced the challenges associated with strong labor unions, as well as strong competition from local com- petitors, including Aldi and Lidl. Unable to overcome those obstacles, Walmart exited Germany in 2006. In South Korea, Walmart found consumers who were often very loyal to local chains and small retailers. Consumers also frequently avoided buying the low-cost goods made in China that often appeared on Walmart’s shelves, because China was a major competitor of Korea. Walmart also ended up exiting the Korean market.

In other nations, including China, Walmart persevered despite obstacles. Walmart’s initial Chinese stores did not carry enough local merchandise, and prices were high rela- tive to many local retailers. It also had to deal with a less technologically developed supply chain. Moreover, the two largest Chinese retailers, Lianhua and Huilan, merged into a state-owned megachain called the Bailan Group. But Walmart repositioned the stores in China, adding local mer- chandise, aiming to have Chinese consumers view Walmart as providing good value, if not the lowest prices.

Walmart’s entrance into India and Russia was met with so many obstacles that Walmart stopped expanding and

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CASE 01 WALMART STORES: GAINING AND SUSTAINING COMPETITIVE ADVANTAGE [ C-9 ]

withdrew from each market respectively.34 In India, gov- ernment regulations prevented Walmart from executing a profitable strategy by requiring the company to buy 30 per- cent of products from local small and midsize businesses in India. In addition, internal corruption within Walmart’s Joint Venture with Bharti, an Indian retailer, forced Walmart to buy out Bharti’s share and operate independently.35 In Rus- sia, Walmart attempted an acquisition strategy for several years, but it failed to win bids due to financial and cultural pressures.36

As it expanded internationally, Walmart also had to compete with other international discount retailers, includ- ing Tesco, Aldi, and Carrefour, all of which were very large and pushing for international growth at the same time as Walmart. Competition was strongest in these stores’ home markets. Competition from extreme discount retailer Aldi was a key factor in Walmart’s withdrawal from Germany. Similarly, competition from already-established Carrefour in Brazil and Argentina made success difficult there. In the United Kingdom, Tesco quickly built its own supercenters after Walmart entered the U.K. with its superstore format.

Walmart’s first approach to international operations was to hire a president for the company in each country. The presidents had control of all Walmart operations for their countries, making all decisions related to sourcing, mer- chandising, and real estate.37 Eventually, Walmart chose to fall back on its success with centralized distribution and management, however. In 2010, the company announced the formation of a global supply chain, with purchasing and distribution for the entire international division combined into one centralized system.38 Such decisions were expected to keep Walmart’s annual growth steady at roughly 4.7 per- cent through 2015, but lagging the projected growth of Car- refour and Tesco.

LOOKING FORWARD: NEW COMPETITORS AND NEW CHALLENGES Amazon has been a formidable opponent in Internet retail- ing in both U.S. and foreign markets. Although Walmart had stumbled out of the gate with regard to Internet sales, it appeared that Walmart was making some headway. By 2013, Walmart had become the number 4 online retailer by sales, with sales growth of 30 percent, which even topped Ama- zon’s sales growth of 20 percent, albeit on a smaller sales base.39 Due to Walmart’s online growth rates, some analysts project that it would capture the number 2 online retailer spot in the near future.40

Competition In addition to Amazon.com and Costco, perhaps the most significant new low-cost competitor for Walmart was Aldi, an extreme discounting retailer based in Germany. Aldi was founded in 1961 and invented the hard-discounter format.

The hard-discounter model, also replicated by other com- petitors, typically offers a very low number, about 1,500, of SKUs. In contrast, Walmart supercenters offer about 100,000 SKUs. Aldi stores are about one-tenth the size of a Walmart, have lower staffing levels, and are often located in low-rent districts. Private labels typically make up the vast majority of hard-discounters’ lines.41 In Aldi’s case, more than 85 per- cent of its sales were private label.42 Aldi cut costs further by requiring customers to bring their own bags, rent their own shopping carts for a quarter, and purchase goods only using cash, debit, and EBT cards. Furthermore, Aldi cut labor and energy costs by only staying open during popular shopping hours. In a unique twist, Aldi also offered double guarantees, promising shoppers to replace their products and refund their money if they weren’t satisfied.43 All of these factors contributed to Aldi’s products being priced nearly 29 per- cent cheaper than Walmart’s.44

Similar to Walmart’s growth through the latter part of the twentieth century, Aldi was mostly ignored by the competition during its early years. Competitors made sev- eral assumptions about Aldi: Its hard-discounting could only succeed in Europe. Aldi stores only attracted the poor or only attracted new customers during recessions. Its products were of inferior quality. Instead, the compa- ny’s store products had been shown to be comparable to national brands, the middle-class was shopping there,45 and Aldi had more than 1,000 stores in 30 states in the United States.46

New Challenges In 2012, CEO Michael Duke admitted that some of Walmart’s initiatives, such as Project Impact, had been less than successful. But Walmart still had a great deal to be proud of. Walmart was the world leader in retailing rev- enues by a wide margin. Its annual sales were more than double those of its next largest competitor, and it contin- ued to have consistent sales growth in the U.S. and inter- nationally. The company had been listed as one of Fortune’s World’s Most Admired Companies every year for the pre- vious decade. Walmart was a global juggernaut, becoming less and less an American company and more and more a global discount retailer, with the attention of the entire world upon it.

But success in the future would require responding effec- tively to its new competitors and new challenges. What would Walmart need to do to attract the middle-class buyer without further alienating its core customer? What new innovations would be implemented to further optimize the supply chain? Could Walmart figure out a way to compete more effectively with Amazon.com in online discount retail- ing? And finally, could Walmart find a way to grow interna- tionally in a dominant fashion, as it had for decades in the United States?

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[ C-10 ] REFERENCES

REFERENCES

1 Walmart, 2014 Annual Report, available at http://www.corporatereport.com/walmart/2014/ar/_pdf/

WMT2014AnnualReportFinancials.pdf, accessed April 1, 2014.

2 Sam Walton and John Huey, Sam Walton, Made in America: My Story (New York: Doubleday, 1993).

3 Ibid.

4 Ibid.

5 Walmart, Investor FAQs, available at http://stock.walmart.com/faqs, accessed April 1, 2014.

6 Pankaj Ghemawat, Stephen Bradley, and Ken Mark, “Wal-Mart Stores in 2003,” Harvard Business School Case

9-704-430, 2004.

7 Ghemawat, Bradley, and Mark.

8 Joseph Bonney, “Size, Scale, Innovation. Always.,” Journal of Commerce (October 19, 2009).

9 Ghemawat, Bradley, and Mark.

10 Stephen Bradley and Pankaj Ghemawat, “Walmart Stores, Inc.,” Harvard Business School Case 9-794-024, 1996.

11 William Hesterly, “Case 1-2: Wal-Mart Stores Inc. in 2008,” in Strategic Management and Competitive Advantage:

Concepts and Cases, 3rd edition, ed. Jay Barney & William Hesterly (Boston: Prentice Hall, 2009), PC 1-15.

12 Bonney.

13 Ibid.

14 Bradley and Ghemawat.

15 Ibid.

16 John N. Frank, Lynn Celmer, and Kevin Parker, “Top 30 Private Label Retailers: Walmart tops…,” Private Label

Buyer (September 1, 2010).

17 Women’s Wear Daily Staff, “The Personality of Cheap: Profiling the Value Retailers,” Women’s Wear Daily (August

20, 2010).

18 Jackie Crosby, “Wal-Mart Shifts Strategy. The recession has driven new consumers to the retail giant…,” Star

Tribune (December 6, 2009).

19 Andria Cheng, “Is Wal-Mart Losing It’s Price Edge? Morgan Stanley starts Wal-Mart at Equal Weight…,” Smart-

Money ( July 13, 2011).

20 Miguel Bustillo, “Wal-Mart Plans Small, Urban Stores,” The Wall Street Journal (October 14, 2010).

21 Walmart, 2012 Annual Report, available at http://www.walmartstores.com/sites/annual-report/2012/

WalMart_Financials.pdf, accessed April 1, 2014 & Target, 2012 Annual Report, available at https://corpo-

rate.target.com/_media/TargetCorp/annualreports/content/download/pdf/Annual-Report.pdf ?ext=.pdf,

accessed April 1, 2014.

22 Ghemawat, Bradley, and Mark.

23 Wal-Mart, 2011 Annual Report, available at http://stock.walmart.com/annual-reports, accessed April 1, 2014.

24 Hesterly, PC 1-15.

25 John Helyar, “The Only Company That Wal-Mart Fears…,” Fortune (November 24, 2003).

26 Wal-Mart, 2010 Annual Report, available at http://stock.walmart.com/annual-reports, accessed April 1, 2014;

Costco, 2010 Annual Report, available at http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual,

accessed April 1, 2014.

27 Hesterly, PC 1-15.

28 Ghemawat, Bradley, and Mark.

29 Wal-Mart, Annual Report, 2009; Wal-Mart, Annual Report, 2011.

30 Matthew Boyle, “Wal-Mart Struggles to Shift From Bricks to Clicks,” Bloomberg Businessweek ( July 25, 2011).

31 Walmart, History Timeline, available at http://corporate.walmart.com/our-story/history/history-timeline,

accessed April 1, 2014.

32 Walmart, 2011 Annual Report.

33 Walmart, 2014 Annual Report.

34 Gardiner Harris, “Wal-Mart Drops Ambitious Expansion Plan for India,” New York Times (October 9, 2013).

35 Ibid.

36 Susan Berfield, “Where Wal-Mart Isn’t: Four Countries the Retailer Can’t Conquer,” BloombergBusinessweek

(October 10, 2013).

37 Hesterly, PC 1-15.

38 Jonathan Birchall, “Walmart Aims to Cut Supply Chain Cost,” Financial Times ( January 3, 2010).

39 Shelly Banjo, “Wal-Mart Notches Web Win against Rival Amazon,” The Wall Street Journal (May 5, 2014).

http://www.corporatereport.com/walmart/2014/ar/_pdf

http://stock.walmart.com/faqs

http://www.walmartstores.com/sites/annual-report/2012

https://corpo-rate.target.com/_media/TargetCorp/annualreports/content/download/pdf/Annual-Report.pdf

http://stock.walmart.com/annual-reports

http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

http://corporate.walmart.com/our-story/history/history-timeline

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REFERENCES [ C-11 ]

40 Daniel Jennings, “Wal-Mart’s Online Retail Segment is Growing Faster than Amazon.com,” The Motley Fool (May

14, 2014) http://www.fool.com/investing/general/2014/05/14/wal-marts-online-retail-segment-is-growing-

faster.aspx, accessed May 25, 2014.

41 Jan Benedict, E. M. Steenkamp, and Nirmalya Kumar, “Don’t Be Undersold,” Harvard Business Review

(December 2009).

42 Frank, Celmer, and Parker.

43 Aldi Website. https://www.aldi.us/en/new-to-aldi/switch-save/ accessed May 25, 2014.

44 Laura Heller, “Comparing Prices, Aldi Wins Overall…,” Daily Finance (September 9, 2009).

45 Benedict, Steenkamp, and Kumar.

46 Aldi Website. https://corporate.aldi.us/, accessed May 25, 2014.

http://www.fool.com/investing/general/2014/05/14/wal-marts-online-retail-segment-is-growing-faster.aspx

https://www.aldi.us/en/new-to-aldi/switch-save

https://corporate.aldi.us

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[ C-12 ]

INTRODUCTION Following 100 years of growth, the carbonated soft drink industry (CSD) was a 44 billion dollar market (see Exhibit 1), and Coca-Cola and Pepsi had the top selling soft drinks in the world. In 2010, sales of Pepsi and Coca-Cola products made up 67% of sales in the U.S. CSD industry (see Exhibits 2A and 2B).

The year 2011 marked the 125th anniversary of Coca-Cola. It also marked the tenth consecutive year in which Coca- Cola was recognized as the world’s most valuable brand.1 Coca-Cola products were sold in more than 200 countries. It had the world’s largest beverage distribution system and owned or licensed more than 500 beverage brands. The company estimated that more than 1.7 billion servings of beverages bearing trademarks that it owned or licensed were consumed worldwide every day. Coca-Cola’s 140,000 employees worked to generate more than $35 billion in rev- enues in 2010,2 and the company had paid an increasing divi- dend to shareholders for the past 49 consecutive years.3

Although the Coca-Cola brand was valued at $70 billion and the Pepsi brand was valued at only $14 billion,4 PepsiCo was the second largest food and beverage company in the world. It owned or licensed 19 brands that each generated at least $1 billion in annual revenues. Its top brand, Pepsi-Cola reached more than $20 billion in sales in 2010. The compa- ny’s total 2010 revenues were more than $60 billion.5 Pepsi employed more than 285,000 people and was listed on both the Forbes and Fast Company lists of the World’s Most Inno- vative Companies in 2011. (See Exhibit 3 for each company’s historical revenues.)

But the picture was not as rosy as it might appear. The car- bonated soft drink market was no longer growing as it had a few decades earlier, during the 1970s and 1980s. In fact, the

CSD market was in decline. Sales of carbonated soft drinks in the largest market, the United States, had been weaken- ing since the turn of the century, declining over 8 percent between 2000 and 2010, with forecasts of continued weak sales.6 Global sales for carbonated soft drinks were $176.1 billion in 2009, which represented a 2.2 percent decrease from the prior year.7 This trend continued through 2013, even in the diet soft drink segment of the market, a segment that Coke and Pepsi both thought would be more impervi- ous to changing consumer tastes. From 2012 to 2013, regu- lar soft drink sales dropped 2.2 percent, continuing a trend begun in 2000, while diet drinks plunged 6.8 percent, shaking the confidence of executives in both firms.8 Entering 2014, Coca Cola and Pepsi both faced important questions of how to continue their success despite the changes they were fac- ing in the CSD industry.

CURRENT INDUSTRY DYNAMICS The carbonated soft drink industry encompasses carbon- ated, nonalcoholic beverages, including colas and noncola drinks, such as root beer, orange, lemon-lime, and other fla- vors. Americans consume, year in and year out, more soft drinks than any other category of drinks.

The CSD Industry saw an annual growth of roughly 10 percent between the early 1970s and late 1990s.9 Americans consumed an average of 23 gallons of CSD annually in 1970, and consumption grew by 3 percent per year for the next 30 years.10 By the early 2000s, however, attitudes toward soda had begun to change. Americans were down to drink- ing roughly 46 gallons of CSD per year, significantly less than their consumption levels in the late 1980s. Cola was still the majority of CSD consumption, but it dropped from

CASE 02 Coca-Cola and Pepsi: The Shifting Landscape of the Carbonated Soft Drink Industry

[ Exhibit 1 ] U.S. Carbonated Soft Drink Total Market Sales (At Current Prices, in $ Millions)*

2006 2007 2008 2009 2010

Sales Market Share

Total CSD sales** $41,471 $43,342 $42,407 $43,821 $43,952

Regular CSD $26,090 62.91% $27,045 62.40% $26,664 62.88% $27,605 62.99% $27,638 62.88%

Diet CSD $14,619 35.25% $15,457 35.66% $14,914 35.17% $15,339 35.00% $15,382 35.00%

Seltzer/tonic/club soda $762 1.84% $840 1.94% $829 1.95% $877 2.00% $932 2.12%

*These are U.S. total market figures, whereas the rest of the exhibits in the case only report data from FDMx. FDMx sales data is Food, Drug,

and Mass sales data excluding Walmart sales. This and other exhibits based on FDMx data are not reflective of the entire beverage market

but are included in this case in order to give added insight regarding the CSD and larger beverage market structure and trends.

**Note: These sales figures should be considered bottler sales figures in analysis of this case.

Source: Compiled from Mintel Group Ltd. Market reports "Carbonated Soft Drinks – US – February 2012."

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CASE 02 COCA-COLA AND PEPSI: THE SHIFTING LANDSCAPE OF THE CARBONATED SOFT DRINK INDUSTRY [ C-13 ]

71 percent of all CSD in 1990 to 55 percent in 2009.11 U.S. CSD sales further fell by 0.2 percent in 2005, 0.6 percent in 2006 and 2.3 percent in 2007.12 Citing decreasing consumer spending in general and increased consumer preferences for healthier foods, industry analysts expected CSD industry revenues to decline even more, by 2 percent per year from 2011 to 2016.13

Some of the decline in sales is due to the rise of substitute products. Many substitute products are available at varying price points, including water, dairy, juice, coffee, tea, energy drinks, and more (see Exhibit 4). Take Red Bull, for instance. Red Bull entered the U.S. soft drinks market in 1997 with a niche product: a carbonated energy drink retailing at $2 for an 8.3-ounce can—twice what you would pay for a Coke or a Pepsi. The company designed its cans as narrow, tall cylinders,

so retailers could stack them in small spaces. It started by selling Red Bull through unconventional outlets such as bars, where bartenders mixed it with alcohol, and nightclubs, where 20-somethings gulped down the caffeine-rich drink so they could dance all night. After gaining a loyal following, Red Bull used the pull of high margins to elbow its way into the corner store, where it now sits in refrigerated bins within arm’s length of Coke and Pepsi. In the United States, where Red Bull enjoyed a 65 percent share of the $650 million energy drink market in 2005, its sales are growing at about 35 percent a year. Red Bull is privately held, but all the signs suggest that it’s profitable.

Although substitutes have taken a large bite out of Coca- Cola and Pepsi’s profits, companies trying to directly enter the CSD market haven’t been as successful. For instance, in 1998, Virgin Drinks launched its own cola, advertising

[ Exhibit 2A ] Selected U.S. CSD Company & Brand Market Share Figures (At Current Prices, in $ Millions)*

2008 2009 2010

Company Sales Market Share

Sales Market Share

CSD FDMx market total $13,401 $13,500 $13,343

CSD Companies

Coca-Cola $5,128 38.27% $5,103 37.80% $4,955 37.14%

PepsiCo $4,288 32.00% $4,290 31.78% $4,036 30.25%

Dr. Pepper $2,649 19.77% $2,699 19.99% $2,862 21.45%

Private Label $819 6.11% $874 6.47% $940 7.04%

Other $517 3.86% $534 3.96% $550 4.12%

Selected CSD Brands

Coke Classic Coca Cola $1,870 13.95% $1,880 13.93% $1,758 13.18%

Pepsi Pepsi $1,430 10.67% $1,415 10.48% $1,290 9.67%

Diet Coke Coca Cola $1,179 8.80% $1,183 8.76% $1,152 8.63%

Mountain Dew Pepsi $745 5.56% $772 5.72% $747 5.60%

Diet Pepsi Pepsi $779 5.81% $744 5.51% $697 5.22%

Dr. Pepper DPSG $602 4.49% $615 4.56% $638 4.78%

Sprite Coca Cola $551 4.11% $547 4.05% $541 4.05%

Diet Dr. Pepper DPSG $297 2.22% $295 2.19% $338 2.53%

Diet Mountain Dew Pepsi $273 2.04% $293 2.17% $314 2.35%

Coke Zero Coca Cola $199 1.48% $251 1.86% $299 2.24%

Caffeine Free Diet Coke Coca Cola $329 2.46% $312 2.31% $295 2.21%

7 UP DPSG $217 1.62% $215 1.59% $198 1.48%

Sunkist DPSG $196 1.46% $206 1.53% $160 1.20%

Caffeine Free Diet Pepsi Pepsi $210 1.57% $190 1.41% $159 1.19%

Sierra Mist Pepsi $181 1.35% $181 1.34% $131 0.98%

Fanta Coca Cola $105 0.78% $116 0.86% $119 0.89%

Diet 7 UP DPSG $116 0.87% $118 0.87% $113 0.85%

*Based on U.S. FDMx-only sales of CSD.

**Market share figures are calculated by dividing annual sales by total market sales.

Source: Mintel Group Ltd., “Non-Alcoholic Beverages: The Market – US” (June 2009; February 2012).

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[ C-14 ] CASE 02 COCA-COLA AND PEPSI: THE SHIFTING LANDSCAPE OF THE CARBONATED SOFT DRINK INDUSTRY [

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CASE 02 COCA-COLA AND PEPSI: THE SHIFTING LANDSCAPE OF THE CARBONATED SOFT DRINK INDUSTRY [ C-15 ]

[ Exhibit 3 ] Financial Data for Coca-Cola and Pepsi

2000 2006 2007 2008 2009 2010

The Coca-Cola Company

Net revenue $20,458 $24,088 $28,857 $31,944 $30,990 $35,119

Net profit/sales 10.6% 21.1% 20.7% 18.2% 22.0% 33.8%

PepsiCo

Net revenue $20,438 $35,137 $39,474 $43,251 $43,232 $57,838

Net profit/sales 10.7% 16.1% 14.3% 11.9% 13.8% 11.54%

Source: PepsiCo and Coca-Cola Company Annual Reports, 2000, 2006, 2007, 2008, 2009, 2010.

[ Exhibit 4 ] Selected U.S. Nonalcoholic Beverage Segment Market Share Figures (At Current Prices, in $ Millions)*

2006 2007 2008 2009 2010

Sales Market Share

Total FDMx market sales** $48,793 $51,448 $52,053 $50,116 $50,531

Carbonated soft drinks $13,581 27.83% $13,422 26.09% $13,419 25.78% $13,757 27.45% $13,352 26.42%

Dairy & dairy alternatives $11,854 24.29% $13,121 25.50% $13,471 25.88% $11,471 22.89% $11,740 23.23%

Juice & juice drinks $10,338 21.19% $10,704 20.81% $10,809 20.77% $10,649 21.25% $10,525 20.83%

Bottled water $4,780 9.80% $5,234 10.17% $5,090 9.78% $4,825 9.63% $4,881 9.66%

Coffee & RTD coffee $3,377 6.92% $3,549 6.90% $3,741 7.19% $3,841 7.66% $4,030 7.98%

Tea & RTD tea $2,233 4.58% $2,505 4.87% $2,499 4.80% $2,592 5.17% $2,730 5.40%

Sports drinks $1,627 3.33% $1,696 3.30% $1,702 3.27% $1,601 3.19% $1,770 3.50%

Energy drinks $668 1.37% $868 1.69% $975 1.87% $1,035 2.07% $1,158 2.29%

Other drinks & mixes $335 0.69% $349 0.68% $347 0.67% $345 0.69% $345 0.68%

*Based on U.S. FDMx-only sales of non-alcoholic beverages.

**Note: FDMx sales data is Food, Drug, and Mass sales data excluding Walmart sales. This and other exhibits based on FDMx data are not

reflective of the entire beverage market but are included in this case in order to give added insight regarding the CSD and larger beverage

market structure and trends.

Source: Mintel Group Ltd., “Non-Alcoholic Beverages: The Market – US” (April 2011).

heavily and trying to get into all the retail outlets that stocked the leading brands. At Virgin Cola’s U.S. launch, Virgin Group CEO Richard Branson drove a tank through a wall of cans in New York’s Times Square to symbolize the war he wished to wage on Coca-Cola and Pepsi. However, the leaders’ viselike grip on shelf space in grocery stores and other retail outlets proved impossible for Virgin Drinks to break. In July 2000, the company’s marketing vice president admitted to a trade publication that “there are people who are saying, ‘We’ve been looking for years, and we can’t find it [Virgin Cola].’” Although Virgin Drinks is still in the fray, it has never gar- nered more than a 1% share of the U.S. cola market.

For both a new entrant and an established firm such as Coca-Cola and Pepsi, the process of CSD production is similar. It essentially involves combining raw ingredients and packaging for shipment to its buyers. Participants in

the process include: raw material suppliers; manufacturers of concentrates—flavor syrups not yet diluted with carbon- ated water—who purchase some raw materials; bottlers, who purchase concentrate and additional raw materials; and retailers. Concentrate manufacturers and bottlers are the two major players during the production process.

Coca-Cola and Pepsi as Concentrate Manufacturers At the heart of each company are its concentrate-manu- facturing plants, where raw materials are blended, pack- aged into containers, and then shipped ready for bottling.14 The raw materials used in producing concentrate are highly guarded secrets for each company, but they primarily consist of commodity ingredients such as citric acid, caffeine, and caramel coloring. Concentrate manufacturers typically add

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[ C-16 ] CASE 02 COCA-COLA AND PEPSI: THE SHIFTING LANDSCAPE OF THE CARBONATED SOFT DRINK INDUSTRY

artificial sweetener to concentrates for diet products and sell concentrates for “regular” soft drinks to bottlers unsweet- ened, so that bottlers can add sweeteners, such as sugar or high-fructose corn syrup, during the bottling process.

The concentrates are typically priced at a high margin above the cost of the raw materials.15 The primary customers of the concentrate manufacturer were originally its franchised bot- tlers. Bottlers are still the largest group of buyers, but by 2010, that customer base had expanded to include wholesale dis- tributors, grocery stores, mass merchandisers, and hotels and restaurants. Fountain syrups, which are dispensed directly into a consumer’s cup from a fountain machine, are also typically produced by the concentrate manufacturer and then delivered directly to a fountain wholesaler or to the fountain location.16

The largest costs for CSD manufacturers, including Coca- Cola and Pepsi, were advertising, promotional materials, market research, and support for bottlers, including local advertising and negotiating with the bottler’s raw material suppliers and their primary customers, retail stores. In 2010, the concentrate manufacturer was primarily responsible for product development and innovation, as well as concentrate production. CSDs were differentiated through branding that was strengthened by heavy advertising.17 The concentrate manufacturers also made significant investments into pro- tecting their trademarks and supported their bottlers by working out agreements for shelf space with major retail- ers, such as Wal-Mart. In addition, Coca-Cola and Pepsi provided financial incentives to their customers for pro- motion and distribution of the products, including volume rebates, product placement fees, and investment in displays. Although they provided little in the way of price concessions to bottlers, both Pepsi and Coca-Cola offered considerable product discounts and promotional payments, particularly to fountain accounts. Fountain accounts are companies that distributed CSD products through fountains (mixing concentrate and carbonated water on the spot) rather than in cans or bottles. Restaurant chains, such as McDonald’s or Burger King, were important fountain customers. In 2010, Pepsi and Coca-Cola respectively recorded $29 billion and $5 billion of such incentives as reductions in revenues.18

Coca-Cola and Pepsi conducted numerous transactions with their bottlers, which included the sale of both concen- trate and finished goods to be distributed. The companies received royalties for the use of trademarks on certain prod- ucts, such as charging a bottler to use Pepsi’s Aquafina brand

of bottled water.19 While the majority of fountain accounts were serviced by the concentrate manufacturer, some bot- tlers were paid fees to distribute products to fountain accounts. Coca-Cola serviced almost all of its international fountain accounts through bottlers.20 Pepsi had costs of $3.922 billion in 2009 and $4.049 billion in 2010 due to such transactions.21 Coca-Cola paid nearly $540 million to its larg- est bottler for marketing support in 2008.22

The State of the Bottling Industry: The Primary Customer for Concentrate Manufacturers CSD bottlers purchase concentrate from the manufacturers, add sweetener and carbon dioxide, and then package the mixture into bottles or cans. Raw materials for bottlers thus include concentrate, sweetener, PET resin (to make plastic bottles), aluminum and steel for cans, packaging, labels, car- tons, cases, and carbon dioxide.

Because the cost of transporting beverages is relatively high compared to the product value, Coke and Pepsi placed bottling plants in various locations throughout the markets that they served.23 Such placement of bottlers gave both Coca-Cola and Pepsi the ability to market to a very broad audience, while maintaining a localized approach. Bottlers were responsible for local marketing and customer interac- tions. Bottler salespeople secured shelf space, positioned trademarks, and set up displays at the ends of supermarket aisles. The bottler was also responsible for developing the shelf-space agreements with small retailers.

Bottling plants are far more capital-intensive than con- centrate-manufacturing plants. A concentrate plant with the capacity to serve all of the United States would cost some- where between $50 million and $100 million. A typical bottling plant could cost hundreds of millions; a single bottling line costs between $4 million and $10 million to build.24 In 2008, the Dr. Pepper Snapple Group, a competitor of both Coca-Cola and Pepsi, opened a plant with a capacity of 40 million cases per year, enough to service California and some Southwest- ern markets, at a cost of $120 million.25 For every dollar that a bottler spends on labor, roughly 30 cents is spent on capi- tal. Although Coca-Cola and Pepsi’s largest bottlers took in considerable revenue, margins were significantly lower than they were for concentrate manufacturers. (See Exhibits 3, 5, 6A and 6B.) Given that the CSD market was relatively mature, bottlers sought cost advantages, and bottler capital intensity was thus expected to increase for the foreseeable future.26

[ Exhibit 5 ] U.S. Carbonated Soft Drink Pricing

1994 1998 2002 2006 2009

Inflation-adjusted retail price per case $8.48 $7.63 $7.57 $7.47 $7.98

Change from previous year –3.9% –1.7% –0.1% –0.2% 0.7%

Concentrate price per case $1.00 $1.14 $1.35 $1.50 $1.65

Change from previous year 4.0% 3.3% 4.3% 2.7% 3.8%

Source: Beverage Digest Fact Book editions 2001, 2006, 2007, 2008, 2009, & 2010.

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For the majority of Coca-Cola and Pepsi’s histories, inde- pendently-owned, franchised bottlers were the companies’ primary source of distribution and sales. The number of independent bottlers had been significantly diminished by 2010, but they were still an important business partner for the concentrate manufacturers. The bottlers acted as inde- pendent contractors and were given exclusive contracts to sell certain products within an exclusive geographic area. Coca-Cola and Pepsi then protected their bottlers’ territo- ries from other franchised bottlers’ sales.27

Both Coca-Cola and Pepsi used contracts to regulate their relationships with bottlers. Pepsi’s contracts stipulated that it had the right to charge bottlers for its concentrate product and to specify the bottling process. Pepsi’s bot- tler agreements also detailed the funding and incentives it would provide to its bottlers. Funding and incentives were renegotiated annually.28 Historically, Coca-Cola’s first fran- chise agreement, drafted in 1899, was a fixed-price contract that allowed bottlers no opportunity to renegotiate, even if the prices of materials were to change. By 2010, there had been many updates since the 1899 agreement. At times, the updates were completed only after significant disagree- ment, even legal action, between the bottlers and Coca-Cola.

Coca-Cola’s current master bottler contract was drafted in 1987. It granted the bottlers permission to prepare specific trademarked beverages. In return, it gave Coca-Cola com- plete flexibility to determine the price and other sales terms for the products sold to its bottlers.29 In practice, the price that both Coca-Cola and Pepsi charged their bottlers for concentrate was roughly similar.

Prior to 2000, Coca-Cola and Pepsi had both gone through decades of rapid bottler consolidation, but that pace slowed to roughly one consolidation per year in the years 2000-2010. By 2010, Coca-Cola had reduced its number of independent a bottlers in the U.S. to about 70 and its worldwide total to around 300. 30 Roughly half of Coke’s U.S. bottlers had been in business for more than 100 years, and about 25 percent of those long-term bottlers had been under the same family ownership the entire time.31 Pepsi had reduced its numbers to roughly 90 independent bottlers in the U.S. by 2010.32

Originally, both Coca-Cola and Pepsi stayed out of the business of bottling because of the low profit margins, but both companies made drastic adjustments to that strategy by purchasing their largest bottlers. Coca-Cola purchased Coca-Cola Enterprises in 2010 for $13 billion.33 Prior to the purchase, CCE was responsible for roughly 75 percent

[ Exhibit 6A ] Financial Data for Coca-Cola and Pepsi’s Largest Bottlers Prior to Mergers

2000 2005 2007 2008 2009

Coca-Cola Enterprises

Net revenue $14,750 $18,743 $20,936 $21,807 $21,645

Operating profit/sales 3.4% 2.7% 3.4% –20.1%* 3.4%

Pepsi Bottling Group

Net revenue $7,982 $11,885 $13,591 $13,796 $13,219

Operating profit/sales 2.9% 3.9% 3.9% 1.2% 4.6%

*Includes $7.6 billion write-off to adjust fair value of intangible franchise assets and goodwill contracts.

Source: Pepsi Bottling Group and Coca-Cola Enterprises Annual Reports, 2000, 2005, 2007, 2008, 2009.

[ Exhibit 6B ] Common Costs for Concentrate Manufacturers and Bottlers (2009)

CONCENTRATE MANUFACTURER BOTTLER

Dollars Per Case % of Net Sales Dollars Per Case % of Net Sales

Net sales $0.98 100% $4.63 100%

Cost of goods sold $0.22 22% $2.67 58%

Gross profit $0.76 78% $1.97 42%

Direct marketing expense $0.21 21% $0.45 10%

Selling & delivery expense $0.00 0% $0.85 18%

General & admin expense $0.24 25% $0.31 6%

Operating Income $0.30 32% $0.36 8%

Source: D. Yoffie and R. Kim, “Cola Wars Continue: Coke and Pepsi in 2010,” Harvard Business School Case 9-711-462 (May 26, 2011).

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of U.S. volume and essentially all of Canadian volume from Coca-Cola’s bottlers.34 After its purchase of CCE, Coca-Cola controlled more than 90 percent of its own sales and dis- tribution.35 PepsiCo purchased PepsiAmericas and Pepsi Bottling Group in 2009 for a total of $7.8 billion. After the purchase, Pepsi was in control of 80 percent of it domestic bottling and distribution.36

The two soft drink companies made the decisions to dra- matically consolidate as they did for a variety of reasons. Coca-Cola hoped to increase the strength of its brand by con- solidating its disparate global brand portfolio under one cohe- sive image.37 The move also allowed Coca-Cola more flexibility to manage niche brands and billion-dollar brands at the same time.38 Coca-Cola expected that its purchase of CCE would save it $350 million annually by 2014.39 Pepsi, recognizing that customer tastes were changing quickly, and the relatively low costs for them to switch products, purchased PepsiAmericas and Pepsi Bottling Group to be more nimble and able to shift as tastes changed.40 Pepsi also hoped to defend better against the small CSD manufacturers that had successfully estab- lished operations in niche markets all across the U.S.41

The moves to forward-integrate into bottling also offered Coca-Cola and Pepsi some protection against the shifts in the size of retailers. Retailers got significantly larger during the 1970s and 80s, as chains began to consolidate and com- panies such as Walmart and Target grew. In 2010, supermar- kets made up 48 percent of the CSD market.42 Pepsi stated in its 2010 annual report that “retail consolidation and the cur- rent economic environment continue to increase the impor- tance of major customers.” Pepsi’s sales to Walmart in 2010 represented 12 percent of Pepsi’s global net revenues. In the same year, 31 percent of Pepsi’s North American net revenue came from its top five retail customers.43 Increasingly often, one retailer was controlling the sale of multiple brands of products, and some big-box retailers, such as Walmart, were making demands, such as requiring companies to establish a single point of contact with them. In the past as many as one dozen bottlers have been responsible for the sales to one retailer.44 Coca-Cola and Pepsi’s goals included bringing some of that control back into their own hands.

By 2010, doubts had risen as to whether bottlers would be able to meet the demands of the current market. The market was moving toward demand for noncarbonated beverages, which most small bottlers weren’t set up to produce.

Thus, bottlers were tasked with figuring out how to either sustain themselves in the face of the diminishing demand for CSDs or to manage the significant costs to retool their operations. Tom Pirko, President of Bevmark, in California,

predicted that bottlers were “going to have to respond, but I don’t think they can. They have a tremendous challenge, and I don’t think they can meet it.”45

THE CHANGING STRUCTURE OF THE CSD INDUSTRY: HOW WILL IT AFFECT COKE AND PEPSI? The strong rivalry between Coca-Cola and Pepsi throughout the twentieth century became known as the cola wars. For decades, both sides made significant efforts to take more of the CSD market. In 1976, Pepsi created its highly successful “Pepsi Challenge” advertising campaign, which pitted Pepsi Cola against Coca-Cola in a taste test and featured custom- ers proclaiming Pepsi as their preferred choice.46 In 1985, Coca-Cola made the move to reformulate its classic cola, introducing New Coke. Following one of the largest con- sumer backlashes in history, Coca-Cola brought back the original Coca-Cola flavor, now called Coca-Cola Classic, less than three months later.47

These two rivals were responsible for some of the most memorable marketing campaigns in history. Pepsi created its “Choice of the New Generation” campaign in 1984, featur- ing a multitude of celebrities such as Michael Jackson and Joe Montana.48 Coca-Cola’s critically acclaimed 1979 “Mean Joe Green” advertisement was ranked as late as 2011 as the best Super Bowl commercial of all time in a poll by Ad Age.49

Although the average profit of the CSD industry as a whole was expected to drop from 20.2 percent in 2006 to 14.9 percent in 2011, Coca-Cola and Pepsi maintained their profit margins, due in large part to intense advertising.50 In 2010, Pepsi spent $29.1 billion on sales incentives to its customers, up from $12.9 billion in 2009. Pepsi’s advertising and market- ing expense was $3.4 billion in 2010 and $2.8 billion in 2009.51 Coca-Cola spent close to $5 billion in 2010 on promotional and marketing support.52 Much of the money was going into changing the way the companies delivered their marketing content, because social media were becoming prevalent.53 (See Exhibit 7 for company brand advertising expenses.)

The decline in profits was mostly due to the U.S. market. As a consequence, most CSD manufacturers were increas- ingly invested in overseas markets. Mexico, for example, had the highest per-person consumption rate of Coca-Cola products in the world (The U.S. was ranked fourth). Coca- Cola and Pepsi each earned about 25 percent of their rev- enue from international operations in 2010. With 80 percent of its unit case volume from sales outside the United States, Coca-Cola sold a much higher percentage of its products

[ Exhibit 7 ] Beverage Brand Advertising Spending ($ in thousands)

Coca-Cola Pepsi Dr. Pepper

2008 $254,000 $145,000 $64,000

2009 $234,000 $136,000 $76,000

Source: B. Johnson and M. Carmichael, “100 Leading National Advertisers,” Advertising Age (June 21, 2010).

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CASE 02 COCA-COLA AND PEPSI: THE SHIFTING LANDSCAPE OF THE CARBONATED SOFT DRINK INDUSTRY [ C-19 ]

internationally. In 2010, 31 percent of Coca-Cola’s unit case volume came from Mexico, China, Brazil, and Japan (78 per- cent was CSD).54 Both companies also were growing in Rus- sia. In 2010, Coca-Cola also saw enormous success with 26 percent growth in sales there.55 The same year, Pepsi made its largest-ever acquisition of an international company in a $3.8 billion purchase of a dairy in Russia.56 While diversifica- tion lowered the risk of decline in any single market for both companies it did pose problems in 2014 and 2015 as the dol- lar strengthened worldwide against most currencies causing cola products shipped from the U.S. to be more expensive.

International growth came with additional problems, however. In 2014 Coca-Cola was forced to close a 15-year-old bottling plant in northern India over accusations that it was illegally using too much groundwater and polluting the area with toxic runoff. Most of the local inhabitants were farm- ers and the problem of decreasing groundwater was so severe that at one point in 2006 local farmers engaged in a 3-month hunger strike in an attempt to force the closure of the plant. The provincial government finally ordered the plant closed. “As part of the withdrawal of consent, we were not allowed or even asked to present any facts or explain our position,” the company said in a statement.57 Coca-Cola had 58 other plants in India and faced the same problem in other locations. The problem of water use could raise its head as well in the U.S. for both Coca-Cola and Pepsi in the future as groundwater levels in various regions are being used up at alarming rates.58

Even with the positive effect on profits that international growth was bringing, however, carbonated soft drinks were representing a smaller and smaller portion of the prod- uct mix for Coca-Cola and Pepsi. Even with international growth, however, carbonated soft drinks were representing a smaller and smaller portion of the product mix for Coca- Cola and Pepsi. By 2010, both Pepsi and Coca-Cola had expanded to extensive juice lines and were continuing to move toward non-CSD drinks. Coca-Cola’s most recent bil- lion-dollar brand was not a new CSD, but instead the juice drink Minute Maid Pulpy.59

Pepsi also made the move into new products, and it even moved beyond beverages. By 2010, it sold almost as many snacks as it did drinks (49 percent snacks and 51 percent drinks). Pepsi believed that consumers would usually reach out for a snack when they reached for a drink. Pepsi hoped to take advantage of that consumption relationship by marketing snacks and drinks together. Pepsi also expected its wider range of products to be valuable to retailers and hoped that offering a wider range of products would better keep consumers within its brand portfolio as they inevitably switched preferences.

CSDs had faced significant pressure as consumer interest in healthier drinks had led to a number of new companies entering the beverage market. While the CSD market was contracting, the overall beverage market was expanding by about 0.7 percent per year. On top of that, many state gov- ernments were seeking restrictions on the sale of CSDs to children from the inside of schools.60

Pepsi’s response was to make limiting such distribution and the production of healthier foods part of its core values.

(See Exhibits 2A and 2B for beverage sales trends.) Pepsi had broken its portfolio of products up into “Fun-For-You,” “Better-For-You,” and “Good-For-You” categories. In 2010, more than 15 percent of its revenues came from nutrition products,61 and Pepsi hoped to expand and take a large share of the $500 billion packaged-nutrition market by moving its product mix further toward “Good-For-You” foods.62

In contrast, Coca-Cola’s CEO, Muhtar Kent, admitted in 2009 that the company had “missed the boat” a bit by not recognizing earlier the changes that were happening in the market. Kent stated, “There was a period when our company did lose its way. We were too internally focused and not focused enough on the changes taking place with our con- sumers and customers. In essence, we were too busy look- ing at the dashboard and not sufficiently paying attention to the world outside our windshield.” In response, Coca-Cola developed its 2020 Vision Plan, which stated that, by the year 2020, Coca-Cola would increase total revenues to $200 billion, increase the number of servings of its products con- sumed every day to 3 billion, and, specifically, get away from the cola war to focus on the changing consumer.63

In fact, Coca-Cola and Pepsi both stated that they no longer found the rivalry between the two companies rel- evant to their strategic goals. The difference in directions was emphasized by Pepsi’s unique take on its own goals for the year 2020. Rather than focus on revenues and mar- ket growth, Pepsi wanted to triple its portfolio of offerings, increase healthy food revenues from $10 billion to $30 bil- lion, reduce the average sugar content per serving by 25 per- cent, and reduce the average saturated fat per serving by 15 percent.64 Regarding the state of the cola wars in 2010, Hugh Johnston, CFO of PepsiCo said, “When it comes to the eve- ryday lineup of beverage portfolios–sure–it’s good fun, and I think consumers find it interesting. And if they find it inter- esting, we find it interesting. But if you think about where we are as a company–half of our business is in snacks and foods–outside the beverage space.”65

Although Coca-Cola and Pepsi were changing their sales mixes and the dynamics of the competition between them, it wasn’t likely that the two companies would soon forget about each other, or that CSDs would be made irrelevant any time soon. Pepsi still noted in its 2010 annual report that Coca-Cola “has a larger share of CSD consumption.” Furthermore, Pepsi Cola was still more than twice the size of Pepsi’s next-largest brand, which was also a CSD, Mountain Dew.66 Coca-Cola may have been expanding its product line away from CSDs, but the sparkling beverages still made up 76 percent of its portfolio. In 2011, Diet Coke had passed Pepsi Cola as Amer- ica’s number-two most popular CSD (second to Coca-Cola).67

Coca-Cola and Pepsi Cola have defined the CSD market for over a century. Although they were no longer the fastest growing beverages on the market in 2010, they still held dom- inant positions, both domestically and internationally. The question was, then, given all the changes in substitutes, new entrants, retailer buyer power, and bottler consolidation, what would the long-term effect be on profit margins in the CSD industry, and how would Coca-Cola and Pepsi respond?

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[ C-20 ] REFERENCES

REFERENCES

1 Interbrand, Best Global Brands, 2011. Available at http://www.interbrand.com, accessed 2011.

2 Coca-Cola Company, Coca-Cola Co. 10-K 2010, 2010.

3 Coca-Cola Company, Annual Review, 2010.

4 Interbrand, Best Global Brands 2010, 2011. Available at http://www.interbrand.com/en/best-global-brands/.

Best-Global-Brands-2010.aspx, accessed 2011.

5 PepsiCo, Annual Report, 2010.

6 Beverage Digest Fact Book 2010 (New York: Beverage Digest Company LLC, 2010).

7 A. Reeves, “Hard Lessons in Soft Drinks,” Investor’s Business Daily (October 21, 2010).

8 M. Esterl, “Diet Soda’s Glass is Half Empty: Sales of Low-Cal Carbonated Drinks Falling Faster Than Other

Types,” The Wall Street Journal (December 9, 2013), Marketplace section.

9 Annual Reports of Coca-Cola Company and PepsiCo, various years for the time period noted.

10 Beverage Digest Fact Book 2001 (New York: Beverage Digest Company LLC, 2001); Beverage Digest Fact Book 2005

(New York: Beverage Digest Company LLC, 2005); Beverage Digest Fact Book 2010 (New York: Beverage Digest

Company LLC, 2010).

11 Beverage Digest Fact Book 2010 (New York: Beverage Digest Company LLC, 2005).

12 B. McKay, “Soft-Drink Sales Volume Slipped Faster Last Year,” The Wall Street Journal (March 13, 2008), Media &

Marketing section.

13 Agata Kaczanowska, IBISWorld Industry Report 31211a: Soda Production in the US. (Los Angeles: IBISWorld,

2011).

14 Coca-Cola Company, Coca-Cola Co. 10-K 2010.

15 Kaczanowska.

16 Coca-Cola Company, Coca-Cola Co. 10-K 2010; PepsiCo, Annual Report, 2010.

17 Kaczanowska.

18 Coca-Cola Company, Coca-Cola Co. 10-K 2010; PepsiCo, Annual Report, 2010.

19 PepsiCo, Annual Report, 2010.

20 Coca-Cola Company, Coca-Cola Co. 10-K, 2010.

21 PepsiCo, Annual Report, 2010.

22 Coca-Cola Enterprises, 2009 Annual Report, 2010.

23 Kaczanowska.

24 D.B. Yoffie and R. Kim, “Cola Wars Continue: Coke & Pepsi in 2010,” Harvard Business School Case 9-711-462,

rev. May 26, 2011.

25 Dr. Pepper Snapple Group, “Dr Pepper Snapple Group to Build Facility in Southern California,” Dr. Pepper

Snapple Group Press Release ( June 18, 2008). Available at http://news.drpeppersnapple.com/press-release/

corporate-news/dr-pepper-snapple-group-build-facility-southern-california

26 Kaczanowska.

27 Coca-Cola Company, Coca-Cola Co. 10-K 2010; PepsiCo, Annual Report, 2010.

28 PepsiCo, Annual Report, 2010.

29 Coca-Cola Company, Coca Cola Co. 10-K, 2010.

30 Coca-Cola Company, “The Coca-Cola System.” Available at http://www.thecoca-colacompany.com/ourcom-

pany/the_cocacola_system.html (accessed September 26, 2014 ).

31 J. McWilliams, “Coke’s New Chapter Puts Light on Bottlers,” The Atlanta Journal-Constitution (October 12, 2010),

Business section.

32 A. Tse, “Best In Class: Pepsi Takes On The World (Part 2),” The Street ( July 20, 2010), Consumer Goods section.

33 “Coca Cola to Buy Big Stake in CCE,” Atlanta Business Chronicle (February 24, 2010), Retailing & Restaurants

section.

34 Coca-Cola Company, Annual Review, 2010.

35 M. Russell, “In the Spotlight: Coca-Cola Co and Coca-Cola Enterprises Deal Closes,” Just-Drinks.com (October 6,

2010).

36 N. Byrnes, “Pepsi Gets Back Into Bottling,” Bloomberg Businessweek (August 4, 2009).

37 Coca-Cola Company, Annual Review, 2010.

38 Russell.

39 Coca-Cola Company, Annual Review, 2010.

40 Tse.

41 Kaczanowska.

http://www.interbrand.com

http://www.interbrand.com/en/best-global-brands

http://news.drpeppersnapple.com/press-release

http://www.thecoca-colacompany.com/ourcom-pany/the_cocacola_system.html

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REFERENCES [ C-21 ]

42 Ibid.

43 PepsiCo, Annual Report, 2010.

44 McWilliams.

45 Ibid.

46 PepsiCo, The Pepsi-Cola Story. 2005. Available at http://www.pepsi.com/PepsiLegacy_Book.pdf.

47 M.E. Ross, “It Seemed Like a Good Idea At the Time: New Coke 20 years later and other marketing fiascoes,”

MSNBC.com (April 22, 2005), U.S. News section. Available at http://www.msnbc.msn.com/id/7209828/ns/us_

news/t/it-seemed-good-idea-time/#.Tr6R6cOy6wg.

48 PepsiCo, The Pepsi-Cola Story.

49 “Coke’s Mean Joe Greene Vs. Apple’s ‘1984’ Face Off For Super Bowl Championship,” Advertising Age

( February 3, 2011). Available at http://adage.com/article/special-report-super-bowl/joe-green-1984-super-

bowl-commercial-title/148635/.

50 Kaczanowska.

51 PepsiCo, Annual Report, 2010.

52 Coca-Cola Company, Coca-Cola Co. 10-K 2010, 2010.

53 N. Zmuda, “Coca-Cola Lays Out Its Vision For the Future at 2010 Meeting,” Advertising Age (November 22, 2009).

54 Coca-Cola Company, Coca-Cola Co. 10-K 2010, 2010.

55 Coca-Cola Company, Annual Review, 2010.

56 PepsiCo, Pepsi Milestones 2010, 2010. Available at http://www.pepsico.com/Download/PepsiCo_Recent_Mile-

stones.pdf.

57 Anonymous. “Coca-Cola Forced to Close India Bottling Factory Over Excessive Water Use, Pollution.” RT. June

19, 2014. Available at: http://rt.com/news/167012-coca-cola-factory-closed-india/.

58 Plumer, B. “How Long Before the Great Plains Runs Out of Water?” Washington Post. September 12,

2013. Available at: http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/12/how-long-before-the-

midwest-runs-out-of-water/.

59 Coca-Cola Company, Annual Review, 2010.

60 Kaczanowska

61 Tse.

62 PepsiCo, Annual Report, 2010.

63 Zmuda.

64 Ibid

65 Tse.

66 PepsiCo, Annual Report, 2010.

67 Esterl.

http://www.pepsi.com/PepsiLegacy_Book.pdf

http://www.msnbc.msn.com/id/7209828/ns/us_

http://adage.com/article/special-report-super-bowl/joe-green-1984-super-bowl-commercial-title/148635

http://www.pepsico.com/Download/PepsiCo_Recent_Mile-stones.pdf

http://rt.com/news/167012-coca-cola-factory-closed-india

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/09/12/how-long-before-the-midwest-runs-out-of-water

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[ C-22 ]

P aul Otellini gazed out the window of his new office at Intel’s headquarters and was struck by how much Sili-

con Valley, Intel Corporation, and he had changed. San Jose and the surrounding communities were no longer the sleepy towns of orchards they had been when he began at Intel in 1974. Intel had evolved from a cutting-edge memory com- pany into a dominant player in the computer industry value chain. Otellini also had moved from a functional staff posi- tion in finance through a number of operating and market- ing roles to become the first nonengineer to serve as Intel’s CEO. His tenure included roles such as the general manager of Intel’s Architecture Group and Microprocessor Products Group, where he led the introduction of the Pentium chip that redefined the company in the early 1990s.1 As Otellini pondered those significant changes since 1974, he wondered what Intel would need to make to maintain its position of industry leadership in Microprocessors and how should he respond.

INTEL: THE EARLY DAYS The beginning of Intel Corporation (NASDAQ symbol: INTC), arguably one of Silicon Valley’s dominant and most success- ful companies in the mid-2000s, differed from the mythical founding of Hewlett Packard in a garage or the youthful exu- berance of Apple’s Steve Jobs and Steve Wozniak. When Rob- ert Noyce and Gordon Moore formed Intel, they were already in middle age, were considered experts in their field, and raised over $2 million in start-up capital in one afternoon.2 Noyce had been one of the inventors of the integrated cir- cuit, and Moore was a talented, visionary engineer and prob- lem solver. It was Moore who noted in 1965 that every 18-24 months the number of transistors placed on an integrated circuit would double. Dubbed “Moore’s law, “this prediction had driven competition and strategy in the industry since its inception. In fact, experts predicted the rate of doubling would continue well into the 2020s.3

Intel was not the first entrepreneurial venture for Noyce or Moore; the two had helped found Schockley Labs in 1956, and they had bolted Shockley a year later as members of the “traitorous eight” that founded Fairchild Semiconductors. Fairchild had operated for over a decade as a subsidiary of the Fairchild Camera and Instrument Corporation, an East Coast manufacturing company. The corporate parent never truly understood the semiconductor business, and corpo- rate policies meant that emerging and lucrative technologi- cal advances, often designed by Moore and his team, were not exploited. Noyce and Moore founded Intel with two goals: to work with and commercialize high quality, exciting new technologies and to make money. On Moore’s office wall

hung a plaque that said, “this is a profit making organization. That’s the way we intended it . . . and that’s the way it is.”4

Intel’s culture, operating policies, and competitive posi- tion built on Moore and Noyce’s fascination with great semi- conductor technology. However, their first hire, Andy Grove, would have equal, if not greater, influence on Intel’s culture and capabilities. Grove was born in Hungary as András Gróf, but he Americanized his name shortly after arriving in the United States in 1957. He earned a PhD in Chemical Engi- neering from UC Berkley in 1963 and worked with Noyce and Moore at Fairchild. Grove joined the company as Director of Operations; he became the COO shortly thereafter and CEO upon Moore’s retirement in 1987. Grove’s fanatical attention to detail, his penchant for disciplined, data driven action and conduct, and his style of constructive conformation soon permeated the company, its operations, and processes. Despite the company’s technological prowess in engineer- ing and innovation, Grove worked tirelessly to make Intel a world class manufacturing organization, often combining a new product generation with a new fabrication process.5

Intel’s first product was a memory chip that integrated existing memory cell technology with the rest of an inte- grated circuit. The result was a more powerful and useful chip that improved performance for users. The company pursued three equally promising technological platforms to create memory chips—Silicon Gate MOS, Multichip Mem- ory modules, and the Schottky Bipolar Process. The founders would commercialize whichever technology could be mass- produced, thereby driving the cost per chip to its minimum. The Silicon Gate process won out, and the process created another win for Intel. The company’s technology strategy revolved around hiring the brightest engineers they could find, promising them stock options, and putting them to work at the basic tasks, often using competing teams and platforms to enhance the development process.

Intel’s first chip, the 1101 static memory chip, appeared on the market in 1969, as did their first money-making prod- uct, the 3101 static random access (SRAM) memory chip. (see Exhibit 1). In 1970, Intel introduced the 1103, the first dynamic random access memory (DRAM) chip. The 1103 offered customers a stable memory chip that met two key objectives for Intel: (1) the chip could be produced cheaply in mass quantities and (2) it offered the promise of techni- cal improvements in future generations. With the 1103 chip, Intel would begin to conquer the memory market. Intel began producing its chips in a renovated factory the com- pany had purchased from Union Carbide.

Intel was hungry for new revenue and in 1969 Gordon Moore accepted a development project for Busicom, a

CASE 03 Intel (A): Dominance in Microprocessors

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CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS [ C-23 ]

[ Exhibit 1 ] Key Events for Intel

Year Intel Key Products Key Events

1968 Intel founded

1969 3101, first bipolar memory

1101, first CMOS memory

1970 1103, first dynamic memory

1971 4004, first 4-bit microprocessor

1702, first EPROM (erasable memory) Intel went public

1972 8808, first 8-bit microprocessor

1974 8080, first 8-bit microprocessor for computing

1976 8085, integrated 8-bit microprocessor

1978 8086, low-cost 16-bit microprocessor

1979 8088, low-cost 16-bit microprocessor

1981 IBM PC with 8088 processor and DOS

1982 80286, 16-bit microprocessor with memory

management

1985 386, 32-bit processor Intel exited memory business to focus on

microprocessors

1986 Compaq announces first 386 PC

1989 486, 32-bit microprocessor with integrated cache

memory and floating point processor

1990 Microsoft announces Windows 3.0

1991 Intel launches “Intel Inside” campaign

1993 Pentium processor, superscalar technology Microsoft announces Windows NT

1995 Pentium Pro processor, Dynamic Execution and Dual

Independent Bus

Microsoft announces Windows 95

1996 25th anniversary of the microprocessor

1997 Pentium processor with MMX technology

Pentium II processor: Dynamic Execution, Dual Inde-

pendent Bus and MMX technology

1999 Pentium III processor

2004 Pentium 4 next generation processor

2001 Itanium 64-bit processor U. S. Recession causes 4.6% decline in PC sales

2002 Pentium M Processor: 90 nm process technology

2003 Intel introduces the Centrino mobile chip

2005 Pentium D Processor: 3.2 GHz clock speed

Source: Albert Yu, Creating the Digital Future (New York, Free Press, 1998) and Intel product release data.

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[ C-24 ] CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS

Japanese calculator company. Busicom wanted a custom chip for its programmable calculators. Moore wanted much more, however: generic chips that could be produced and sold in mass quantities.6 Intel engineer Ted Hoff resolved the con- flict when he proposed a four-chip set that performed multi- ple tasks. One chip would act as the CPU, another would be a memory chip for working with active data, one would be a ROM memory chip where the program would be stored, and one would handle the input/output (I/O) interface.

The product was the Intel 4004 chip, a 4-biti chip that packed as much processing power as the first computer, the 1940s ENIAC machine that required a whole room of transis- tors.7 In August of 1972, Intel introduced a second micropro- cessor, built on 8-bit technology, and named the 8008. Two Seattle teenage hackers, Bill Gates and Paul Allen, would later purchase an 8008 and try to build a machine for a local traffic consulting company.

THE RISE OF THE MICROPROCESSOR AND INTEL’S DOMINANCE Throughout the 1970s, Intel continued its work in memory chips and produced a number of breakthrough products, including an erasable memory chip (EPROM) that sig- nificantly improved customer performance while lower- ing costs. The microprocessor business continued to grow slowly, and even though the 8008 was a technical marvel, it proved to be a slow and clunky device. Intel’s third genera- tion chip, the 8080, came to market in 1975. One 8080 cus- tomer, MITS, used the chip as the core of a new product, a truly personal computer. Bill Gates and Paul Allen bought one of these new machines, the Altair 800, and developed Microsoft Basic language to program the new machines. 1976 also proved to be a watershed year for the industry when Steve Jobs and Steve Wozniak introduced the Apple II computer. The machine was generally regarded as the first personal computer, but the problem for Intel lay in the Apple II’s microprocessor, the MOS Technology 16-bit 6502 proces- sor. Intel had developed the microprocessor but risked being shut out of the new market.

Competition in the microprocessor market had always been fierce because many companies, including Motorola, Zilog, and National Semiconductor, all produced 8-bit and then 16-bit processors. In fact, by 1978, Intel was well behind Motorola when it introduced its new 16-bit processors, the 8086 and the 8088. Customers and engineers claimed that Motorola’s 68000 was simply a better chip than Intel’s 8088/8086 line, which is why Apple chose Motorola over Intel. Intel responded with a clever but serious internal sales drive. The “Crush” campaign focused on Intel “crushing” Motorola and taking control of the 16-bit microprocessor market. During this drive, Intel sales engineers got credit for each “design win” they secured. (A design win was a commit- ment from a customer to use the 8086/8088 architecture in

i A “bit” is short for a binary digit. It is a spot on a silicon chip that can either

hold an electric charge or not. Increasing the bits computer chips could

string together led to increases in information storage and processing power.

its new products. However, to get credit, the customer had to prove its commitment by purchasing an Intel develop- ment system and dedicating its own engineers to the effort.) The Crush campaign succeeded over time in convincing the marketplace that Intel’s architecture provided a superior and complete package compared to the one offered by Motorola. One design win in 1980 would prove more important than all the others: Intel engineers convinced computer giant IBM to use its 8086/8088 architecture as the foundation of its new personal computer (PC).8 Grove said, “The presence of IBM in the early ‘80s was crucial. By winning that contract, we won the whole industry design…This was a huge oppor- tunity, and we took advantage of it.”9

IBM had been the colossus of the information-processing industry since its founding in the late nineteenth century, and the company found itself behind the competition in the emerging microcomputer market. Known as “Big Blue,” IBM focused on selling large computers, or mainframes, to the world’s largest and most prestigious corporations. IBM sold to computing professionals and specialists who ran huge data processing operations, and the microcomputer didn’t fit the company’s initial strategy or its core capabilities. By 1979, however, IBM executives recognized the disruptive power of the PC and sent a dedicated “tiger team” to Boca Raton, Florida, to develop IBM’s entry into the new market. The team, far removed from the company’s Armonk, New York, headquarters, found themselves free from IBM’s inter- nal policies and design constraints.

With the overriding objective of bringing a PC to market in less than a year, the IBM team opted for an “open architec- ture” process that used off-the-shelf components and existing third-party vendors to build the new machine. The open archi- tecture meant that IBM did not have to develop its own micro- processor, operating system, or other key inputs, allowing it to enter the market quickly because IBM had only to assem- ble the final machine. IBM’s PC also stood in stark contrast to Apple’s machines, which used a “closed architecture” of cus- tom-designed chips and operating systems in its machines.10

IBM’s open architecture would have huge implications for Intel. First, many customers faced bosses skeptical of the new technology, and they opted for IBM machines because of the safety and security behind the IBM name and brand. By 1984, almost one-third of the market for PCs belonged to IBM.11 Thus, Intel chips powered the market’s leading com- puter. Second, IBM’s open architecture allowed other new PC sellers to imitate or “clone” the IBM PC in order to enter the market. By 1987, IBM and clone machines commanded over two-thirds of the market, and that figure jumped to over 90 percent by 1995. Clone makers included Compaq, Hewl- ett Packard, and an emerging build-to-order manufacturer founded in a University of Texas dorm room, PCs Limited, that would later become Dell, Inc. However, IBM’s PC divi- sion dominated the PC market, and by 1985, it had grown to become a Fortune 500-sized company with $5.5 billion in revenues. IBM’s success helped Intel become the market leader in microprocessors. But IBM forced Intel to license its microprocessors to a dozen companies for the 8086 chip to

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CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS [ C-25 ]

insure adequate supply. As a result, Intel captured only 30% of chip revenues and profits generated through IBM.

In March of 1982, Intel introduced its next generation chip, the 80286. The “286” dramatically increased processing speed and fueled sales of the microcomputer revolution. The 286 processor proved far more powerful than its predeces- sor, and combined with increasingly sophisticated software programs, PCs provided a cost-effective solution for busi- nesses and their information processing needs. Although the 286 represented a significant advance in technology, the success of Intel’s new chip was muted by one major draw- back: computer manufacturers required that Intel license the 286 architecture to competing chip manufacturer AMD (and three other licensees) as a “second source.” Second- source agreements provided PC manufacturers with greater access to supply, while preventing one company from raising the price of the critical component.

The introduction of the 286 had a significant effect on Intel. The 1970s and early 1980s had seen increased com- petition in the market for DRAM memory. By 1984, Intel only generated 20 percent of its revenue from the memory business, compared to 40 percent from microprocessors. Although microprocessors generated 100 percent of Intel’s profit that year, the company was spending 80 percent of its R&D budget on memory devices.12 Intel had invented the memory business, and the founding team’s loyalties lay deeply entrenched in the memory market. Andy Grove described the decision:

Gordon Moore and I were discussing our quandary. Our mood was downbeat. I looked out the window at the Ferris wheel of the Great American amusement park revolving in the distance, then I turned back to Gordon and I asked: “if we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “he would get us out of memories.” I stared at him, numb, and then said, “Why shouldn’t you and I walk out the door, come back and do it ourselves.13

Intel exited the memory business and put all its resources into microprocessors. With 100 percent of its focus on the microprocessor market, Intel jumped the last hurdle in order to dominate the market.

The Comdex computer show held in October, 1986, fea- tured an announcement that altered the evolution of the computer industry: Compaq introduced a new computer built on Intel’s newest chip, the 32-bit 80386 chip, or “386.” Competition among PC manufacturers was becoming increasingly fierce, and Compaq hoped to gain a competi- tive edge by bringing a new product and new architecture to market. Compaq also agreed to a new business model, as it decided to forego any “second source” requirement for the 386. Intel would be the sole provider of this new, powerful generation of microprocessors. The impact was immediate. Intel made about $40 on each 286 chip, but about $150 on each 386 chip.14 Intel’s most serious competitor in the PC business, AMD, would now have to develop its own next-gen- eration chip rather than merely licensing Intel’s intellectual

property. As a result, AMD fell behind for two product gen- erations as it scrambled to develop its own chips.

Intel’s bold move to become the sole source supplier (with the one exception of IBM, which still required that Intel license the 386 design to IBM so it could, if desired, pro- vide its own second source) leveled the playing field for PC clones. Compaq became the first PC clone to set the perfor- mance standard for a next-generation PC product by intro- ducing the first PC with a 386 chip. Up until the 386, IBM had dominated PC sales and had typically held more than a two- thirds share of the market for PCs based on the IBM archi- tecture. But that started to change in the late 1980s. Compaq continued to be a leader in launching new-generation PCs based on the IBM open architecture (called ISA), while IBM tried to introduce closed-architecture products such as the PS/2 to prevent clones from essentially selling identical products. It didn’t work. The PS/2 lines couldn’t provide the backward compatibility that customers wanted. In fact, by 1994, Compaq actually passed IBM as the PC market-share leader. IBM’s share had dropped from almost 40 percent to 10 percent. By 1997, Compaq held 13.1 percent of the market with IBM following at 8.6 percent, followed by Dell (5.5 per- cent), HP (5.3 percent), Packard Bell (5.1%) Gateway (4%), and Apple (4%), with dozens of others holding the remaining 50 percent (see Exhibit 2).

THE SEMICONDUCTOR INDUSTRY Competition in the semiconductorii industry was driven by two major forces: technology and economics. Moore’s law, which in 1965 was an empirical observation and extrapola- tion, had now become something of a self-fulfilling proph- ecy. Exhibit 3 shows the increases in transistors and clock speed in Intel microprocessors. When microprocessor pro- ducers designed their next-generation products, the stand- ard assumption was that the new chip would have twice the number of transistors as its predecessor. Intel’s first chip, the 4004, contained only 2,300 transistors, the 8086 carried 29,000 transistors; the 286 held 134,000, and the 386 used 275,000 transistors!15 Intel and its competitors spent millions of dollars and several years developing the next generation of chips, moving from design to manufacturing and resolv- ing the challenges presented by the chemistry and physics of silicon, heat transfer, and miniaturization. As each gen- eration became more complex, Intel used a “two-in-a-box” management structure. One engineer managed the archi- tecture and design process, while another simultaneously focused on implementation, or moving the chip from design to manufacturing.16

The economics of semiconductor production were fairly straightforward: A company incurred the vast majority of costs in the design, development, and marketing of the chip itself, as well as in building the fabrication facility to produce the chips. The raw inputs of silicon and transistors were fairly

ii A semiconductor is a material that conducts electricity. Silicon is the

most common major component in semiconductors. Semiconductors

include integrated circuits, memory chips, and microprocessors.

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[ C-26 ] CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS

commoditized. However, the quality and uniformity of each silicon wafer ultimately influenced the yield each chip would produce. The cost of building a fabrication facility (known as a “Fab”) was astronomical. In the mid-1990s, a fab cost about $1 billion, depending on capacity, and by 2001, that figure had risen to well above $2.5 billion.17 (This did not include the design costs for each new-generation chip, which were typi- cally in the range of $50-100 million.) Increasingly specialized equipment was the most costly item. In the mid-1970s, equip- ment constituted about 40 percent of the total cost of a fab, by the mid-1990s, that share had risen to 70 percent.18 A new generation of chips could use the same land and buildings, but it required new equipment to inscribe ever smaller tran- sistors in ever tighter spaces on the chip. Put simply, micro- processor manufacturers incurred huge fixed and sunk costs before they sold a single chip, but the input costs of each indi- vidual chip were negligible. The implication: the semiconduc- tor business is a volume game with the company selling the most chips in any generation making the most money.

Three factors influenced chip volume: cyclicality among buyers, speed to market with a new generation of chips, and the yield obtainable from each silicon wafer. Although com- puter purchases appear to be necessary to both business and household productivity, they closely follow the general health of the economy. When times are tough, both families and firms delay upgrading their technology. The recession of 2001 saw PC sales decline by 4.9 percent, compared to a 118.7 percent gain for 2000 (see Exhibit 4)19 If a company introduced a new chip platform at the beginning of a reces- sion, it ran the risk of low volume for that generation.

Speed to market mattered because the cost, and hence profitable price, of each chip followed a learning curve tra- jectory. Manufacturing costs fell systematically as volume

increased (see Exhibit 5 for a sample of data on how the cost of a chip declines with increases in volume). The first entrant could either charge high prices for their chips or it could price lower in anticipation of volume-based cost savings. Lower prices would spur demand for the chip and would also discourage later movers because they would have to price at or below the initial cost.20 Being first to mar- ket with a high quality chip, such as Intel’s 286 and 386 gen- erations, could provide a firm with a sales and revenue lead that competitors might be unable to overcome.

Yield refers to the number of functional chips pro- duced from each silicon wafer. Wafer sizes increased over time from an average of 150mm in the 1980s, 200mm in the 1990s, and 300 mm at the turn of the millennium.21 Using a 300 mm wafer instead of a 200 mm wafer meant that a manufacturer could more than double the number of potential chips.iii Not every chip would be functional, however, because small defects in the silicon, contami- nants in the air, or glitches in the manufacturing process resulted in nonfunctional chips. As the number of wafers produced increased, engineers usually eliminated process and design bugs. Yields generally increased with volume, which lowered the cost per chip.

Intel had also implemented what it called the “copy exactly” manufacturing methodology to increase yields and lower the cost of each chip. Copy exactly manufactur- ing started with Intel perfecting, in a prototype plant, the processes that could minimize defects and maximize yield. Intel then cloned the processes—or copied them exactly— in plants around the world. Intel now also uses identical

iii The radius of the larger wafer is 1.5 times that of the smaller one, and so

the area would be 1.52, or 2.25 times the area.

[ Exhibit 2 ] Global Market share of PC manufacturers (1985–2005) 1985 1990 1995 2000 2005

IBM 30% 13% 8% 7% –

Commodore 64 26% 4% – – –

Apple 12% 7% 8% 3% 2%

Compaq 3% 4% 10% 13% –

Packard Bell 2% 2% 7% 4% –

HP 2% – 4% 8% 15%

Gateway – – 3% 4% –

Dell 0% 0% 3% 11% 17%

Lenovo – – – – 7%

Acer – – 4% – 5%

Toshiba – – – – 4%

Fujitsu – – – – 4%

Other 25.00% 71% 54% 51% 48%

Total 100% 100% 100% 100% 100%

Notes: HP and Compaq merged in 2002. IBM sold its PC business to Lenovo in 2004.

Source: Gartner Dataquest Press Releases.

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CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS [ C-27 ]

[ Exhibit 3 ] Intel Product Features

Panel A: 4004-386 Transistors and Clock Speeds

4004

– –

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Transistors (000)

Clock Speed (MHz)

16.0

18.0

50.0

100.0

150.0

200.0

250.0

300.0

8088 8080 8086 286 386

Processor Generation

C lo

ck S

pe ed

( M

H z)

T ra

n si

st or

s (0

00 )

Panel B: 486-Pentium D Transistors and Clock Speeds

48 6

P en

tiu m

P en

tiu m

P ro

P en

tiu m

P en

tiu m

II I

P en

tiu m

It an

iu m

P en

tiu m

– –

500.0

1,000.0

1,500.0

2,000.0

2,500.0

3,000.0

3,500.0

50,000.0

100,000.0

150,000.0

200,000.0

250,000.0

300,000.0

350,000.0

Transistors (000)

Clock Speed (MHz)

Product Year Transistors Clock Speed Product Year Transistors Clock Speed

4004 1971 2 0.108 Pentium 1993 3100 66

8088 1972 3.5 0.8 Pentium Pro 1995 5500 200

8080 1974 4.5 2 Pentium II 1997 7500 300

8086 1978 29 5 Pentium III 1999 9500 500

286 1982 134 6 Pentium 4 2000 42000 1500

386 1985 275 16 Itanium 2002 220000 1000

486 1989 1200 25 Pentium D 2005 291000 3200

Source: Intel internal product release documents

production lines to find the root causes of lower yields. In one recent puzzler, identical tools in two factories kept producing different defect rates. By swapping the workers who maintained the tool, Intel learned that one group was cleaning the tool by wiping a towel in a circular motion; the other wiped back and forth. One motion went against the grain of the metal, spreading dirt particles rather than removing them. Intel’s attention to detail in manufacturing

was credited with helping the company consistently achieve among the highest yields and lowest costs in the industry.22

During the 1970s and 1980s, microprocessor buyers were typically design engineers or executives of computer manu- facturers. The microprocessor was a critical component of computers and computerized electronics, and there were no viable substitutes. These sophisticated buyers purchased on technical grounds such as chip performance, future product

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[ C-28 ] CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS

[ Exhibit 4 ] Total PC shipments, 1999-2005

Year PC Shipments (M) % Change

1999 113.5 21.7

2000 134.7 14.5

2001 128.1 -4.6

2002 132.4 2.7

2003 168.9 10.9

2004 189 11.8

2005 218.5 15.3

Source: Gartner Dataquest Press Releases.

[ Exhibit 5 ] Semiconductor Cost Decreases with Cumulative Volume Increases

SEMICONDUCTOR INDUSTRY

Year Unit Volume Cumulative Unit Volume

Avg. Cost ($) (per unit)

Proportion of Original Cost

1993 Q3 438736.5 438736.5 50.00 1.00

Q4 446911.7 885648.2 44.16 0.88

1994 Q1 341142.6 1226790.8 38.03 0.76

Q2 324665.0 1551455.8 31.90 0.64

Q3 304038.0 1855493.8 32.82 0.66

Q4 340532.2 2196026.0 34.51 0.69

1995 Q1 333919.3 2529945.3 33.93 0.68

Q2 337897.9 2867843.2 32.24 0.64

Q3 390800.7 3258643.9 31.18 0.62

Q4 366612.9 3625256.8 27.08 0.54

1996 Q1 350698.5 3975955.3 26.50 0.53

Q2 318833.3 4294788.7 20.95 0.42

Q3 285434.9 4580223.5 22.01 0.44

Source: Case writer dissertation data drawn from Berkeley Semiconductor Manufacturing Study.

expansions, backward capability with existing products, product quality, manufacturing capability, and price. Until the frame-breaking move by Compaq to sole-source the 386 chip, the standard industry practice required microproces- sors to have a second source. Large manufacturers such as IBM could always produce chips themselves, which gave them some pricing leverage over companies such as Intel.

Intel faced many competitors over the years, from estab- lished companies such as Motorola and National Semi- conductor, Zilog, as well as foreign, often Japanese, chip manufacturers. In fact, the ability of the Japanese to drive down costs in the memory business had prompted Grove

and Moore to exit the business. Intel would have to invest billions in R&D and facilities to remain competitive in a business with increasingly thin margins. In the industry’s early days, patent protection and enforcement of intellectual property claims were rare—that’s how Intel got its start in the industry. Intel, however, vigorously enforced patents and other intellectual property claims it viewed as central to its business plan. Cross-licensing and partnership agreements also provided a way to prevent competitors from reverse engineering chip architectures or other features.

Advanced Micro Devices, or AMD, represented Intel’s most formidable and consistent competitor. Founded in

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CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS [ C-29 ]

1969 by former Fairchild marketing director Jerry Sanders, AMD began its life in a manner similar to Intel, by using technology developed but never commercialized at Fair- child. AMD’s strategy involved becoming a second-source provider for manufacturers; AMD either signed a formal licensing agreement with the primary source company, or it simply reverse engineered the product and introduced its own, lower-priced version.

AMD had been somewhat successful competing with Intel throughout the 1970s and early 1980s, and it was the logical choice for IBM as a second source for the 8086/8088 pro- cessors in the original PC. AMD formally cross-licensed the architecture for the 286 from Intel, but Andy Grove decided early in the 386 development cycle to exclude AMD from the 386 market. The two companies went to court over the issue of the 286 and 386 licensing agreement, and AMD won the right to a royalty-free license for the 386 technology, but Intel’s legal hardball delayed AMDs entry into the 386 market for a year. AMD would live on, however. In the mid-1990s, AMD introduced a line of microprocessors that brought the retail price of a PC to below $1,000. By the turn of the millennium, AMD had introduced a chip that featured the first 1 GHz (1 gigahertz means 1 billion clock cycles per second) chip.23 However, even with some of these technology wins, over the years Intel produced 6-8 times the volume of chips as AMD, which gave Intel a significant cost, and profit, advantage.

INTEL INSIDE, PENTIUM, AND BEYOND AMD won the right to use the 386 moniker on its chips in 1991; two years later, Intel brought the next-generation 486 to market. The 486 chip had done well in the market, driven by early 486-adopter Dell. Competition intensified among PC manufacturers as the market continued to expand, but Intel faced a new, technology-based challenge. A new gener- ation of chips using RISC (Reduced Instruction Set Comput- ing) architecture offered the promise of substantially faster chips with less complexity than Intel’s CISC-based (complex instruction set computing) x86 architecture.

Intel’s fifth-generation chip, logically the 586, was in development with a go-to-market projection for 1993. Intel engineers toyed with the idea of moving to the RISC archi- tecture; however, they developed a CISC-based architecture that allowed the new chip, code named P5, to double the speed of the best RISC-based chip. The P5 contained 3.1 mil- lion transistors, almost three times the number of transistors on the 486, and it operated at 66 Mhz, more than double the speed of the 486. The P5 dramatically expanded the power of microprocessors, as can be seen in Exhibit 3.

Technical specifications and professional buyers, or cor- porate purchasing agents, dominated the first 20 years of the microprocessor business. By the early 1990s, however, prices for PCs had fallen far enough, and software was increas- ingly sophisticated enough, that retail customers now rep- resented a huge market for Intel’s products. With AMD and other microprocessor manufacturers able to mimic Intel’s numbering system, retail customers could no longer rely

on the x86 numbering system to insure an Intel chip. Intel shifted strategy to respond to the new competitive reality. The company chose to abandon the 586 moniker in favor of its own branded product, the Pentium®, in order to create greater product differentiation in the mind of customers.

The company also embarked on a radical plan to cre- ate a brand for the company with its Intel Inside campaign. Intel executive Dennis Carter convinced Andy Grove that, although product generations come and go, a unique Intel brand would stay with customers across product gen- erations.24 The Intel Inside campaign began in 1991 with a budget of almost $150 million, a huge investment consider- ing that consumers would never purchase a microproces- sor in the same way they would a Coke or a Disney movie. Intel spent $20 million on print and broadcast media and ran ads that used the science-fiction style of movies Star Wars and Star Trek. The company dedicated $125 million in channel support for PC manufacturers who agreed to place the “Intel Inside” logo on their products and engage in joint advertising.

The campaign succeeded beyond Intel’s expectations. By 1993, Intel’s brand preference, the percentage of people expressing a preference for Intel chips inside their comput- ers, reached 80 percent. Intel’s worldwide sales rose 63 per- cent in 1992, and by 1994, over 1,200 PC manufacturers had signed up for Intel Inside marketing dollars. The campaign had one unintended consequence, however. Compaq’s CEO Eckhard Pfeiffer resented the intrusion of Intel’s brand on his own company’s moniker, believing that Intel Inside made Compaq less distinctive and valuable. Pfeiffer began negotia- tions with AMD to provide compatible, but lower cost, chips for Compaq’s products.25

The Pentium clearly redrew the lines of competition within the industry; companies could no longer compete on technical specifications alone but had to develop skills in advertising, branding, and marketing. Intel’s next genera- tion, the P6, also reshaped the nature of competition within the industry. Each generation of microprocessors relied on its own architecture, and Intel tried to use a new architec- ture to generate a family of related chips, not just a single microprocessor. The P6 came to market in 1995 as the Pen- tium Pro, but it would compete in a vastly different comput- ing environment.

With the commercialization of the Internet beginning in the early 1990s, buyers wanted computers that could incor- porate multimedia applications, with mobile access to the Internet. The explosive growth of the Internet created explo- sive growth in the market for servers, dedicated computers that provide the nexus of a network of connected comput- ers. The Pentium Pro architecture enabled Intel to effectively compete in each of these new markets: multimedia with the Pentium MMX, mobile computing with its Centrino® line of processors, and the server market with its Xeon® product group. The P6 epitomized Intel’s product development goal to create a platform architecture that supported a number of different chip families.26

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[ C-30 ] CASE 03 INTEL (A): DOMINANCE IN MICROPROCESSORS

INTEL IN 2005 Paul Otellini had overseen the original Pentium project and had observed the power of the company’s triple focus on technological innovation, continuous improvement in pro- cess technologies, and branding and marketing. The 2001 recession had hit Intel hard, but the company had resumed its solid performance. The Intel Inside campaign created a brand ranked as the fifth most valuable global brand, with an estimated value of $35.5 billion.27 Intel’s revenue had grown substantially throughout the early 2000s, and other financial metrics revealed a very healthy company (see Exhibit 6). Intel held 57 percent of the global PC market28 and 88 percent of the server market.29 Although there was much to celebrate, Otellini thought about the challenges

ahead. AMD held the remaining 43 percent of the market

and had proven quite capable of competing with Intel on

price and technology. Intel was clearly a valuable brand,

but was it time to update and refresh the brand?

In May of 2005, sales of mobile, notebook computers

exceeded the sales of desktop machines.30 How would Intel’s

Centrino® brand of mobile processors compete in the new

space? Finally, at a technology conference in late 2004, the

term Web 2.0 had been introduced.31 The term captured

the increasing sophistication of internet hardware and soft-

ware that would enable a dramatic increase in interactiv-

ity between consumers and others over the Internet. Intel

owned the server business, but was the company well posi-

tioned as central to consumer’s web experiences?

[ Exhibit 6 ] Intel Financial Performance, 1980-2005

Year 1980 1985 1990 1995 2000 2001 2005

Net revenue ($ billions) .855 1.4 3.9 16.2 33.7 26.5 38.8

Growth rate 29.29% –16.21% 25.39% 40.63% 14.63% –21.36% 13.45%

Earnings per share ($) 2.21 0.01 .80 4.03 1.51 0.19 1.4

Growth rate 19.46% –99.41% 53.85% 53.82% 43.81% –87.42% 20.69%

Operating income (%) 21.7 –0.4 21.9 32.4 30.8 8.5 31.1

Growth rate –3.56% –102.19% 23.03% 10.20% –7.23 –72.40% 5.03%

Return on equity (%) 26.3 0.1 21.2 33.3 30.2 3.5 23.2

Growth rate –16.35% –99.38% 25.44% 21.98% 15.27% –88.41% 17.77%

Capital expenditures ($ billions) .156 .236 .680 3.6 6.7 7.3 5.8

Growth rate 60.82% –39.18% 61.14% 50.00% 97.06% 8.96% 52.63%

Research and development ($ billions) .096 .195 .517 1.3 3.9 3.8 5.1

Growth rate 44.53% 8.33% 41.64% 16.65% 25.81% –2.56% 6.25%

Marketing, general and administrative

(% of sales)

20.6 20.5 15.7 11.1 15.1 17.0 14.7

Growth rate 3.15% 5.67% 1.95% –11.90% 14.39% 12.58% 7.30%

Source: Intel Corporation, Annual Reports, 2005, 2001, 2000, 1995, 1990, 1985, 1980.

REFERENCES

1 Paul Otellini, Reference for business, Encyclopedia of Business, 2nd Edition. Available at http://www

.referenceforbusiness.com/biography/M-R/Otellini-Paul-1950.html, accessed July 29, 2013.

2 Tim Jackson, Inside Intel: Andy Grove and the Rise of the World’s Most Powerful Chip Company (New York, NY:

Dutton, 1997), p. 17–18.

3 Matt Peckham, “Could nanowire transistors rescue Moore’s Law from obsolescence?,” Time (May 1, 2013). Avail-

able at http://techland.time.com/2013/05/01/could-nanowire-transistors-rescue-moores-law-from-obsolescence/,

accessed July 29, 2013.

4 Jackson, p. 179.

http://techland.time.com/2013/05/01/could-nanowire-transistors-rescue-moores-law-from-obsolescence

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5 Juan Chaia, Paulo Marchesan, and Bernardo Neves, The future of the microprocessor industry (Cambridge, MA:

MIT, 2005). Available at http://dspace.mit.edu/bitstream/handle/1721.1/56570/15-912Spring-2005/NR/rdon-

lyres/Sloan-School-of-Management/15-912Spring-2005/163D6F92-8636-4B61-9F3B-724B2E8EC8C8/0/intel_

stne_ch_ma.pdf, accessed July 30, 2013.

6 Albert Yu, Creating the Digital Future: The Secrets of Consistent Innovation at Intel (New York, NY: Free Press,

1998), p. 15.

7 Jackson, p. 74.

8 Yu, p. 27.

9 Jackson, p. 203.

10 “Computer history 101: the development of the PC.” Available at http://www.tomshardware.com/reviews/

upgrade-repair-pc,3000-4.html, accessed July 29, 2013.

11 Casewriter estimates based on data from Jeremy Reimer, “total share: 30 years of personal computer market

share figures,” ARSTechnica (December 14, 2005). Available at http://arstechnica.com/features/2005/12/total-

share/5/, accessed July 29, 2013.

12 Yu, p. 124.

13 Jackson, p. 253.

14 Jackson, p. 278.

15 Data from http://download.intel.com/pressroom/kits/IntelProcessorHistory.pdf. Accessed July 30, 2013.

16 Yu, p. 159.

17 Data taken from http://en.wikipedia.org/wiki/List_of_semiconductor_fabrication_plants for the 1990s figure

and Jason Mick, “Intel announces $5B USD 14nm Fab, 4,000 new Arizona jobs,” Daily tech (February 21, 2011).

Available at http://www.dailytech.com/Intel+Announces+5B+USD+14nm+Fab+4000+New+Arizona+Jobs/

article20954.htm, both articles accessed July 30, 2013

18 Michael Smith, Estimation of future manufacturing costs for nonelectronics technology, Master’s thesis at the

Virginia Polytechnic Institute and State University (May 1996). Available at http://scholar.lib.vt.edu/theses/

public/etd-154317559631561/etd.pdf, accessed July 30, 2013.

19 Data for 2001: Gartner Press Release, “Gartner Dataquest Says 2001 is a Year Battered PC Vendors Would

Rather Forget.” January 17, 2002, data available at http://en.wikipedia.org/wiki/Market_share_of_personal_

computer_vendors. Data for 2008: Gartner Press Release, “Gartner Says In the Fourth Quarter of 2008 the

PC Industry Suffered Its Worst Shipment Growth Rate Since 2002.” Available at http://www.gartner.com

/newsroom/id/856712. Both sites accessed 30 July 2013.

20 G. Dan Hutcheson, Economics of semiconductor manufacturing, Handbook of Semiconductor Manufacturing, 22nd

Edition, eds. Yoshio Nishi and Robert Doering (CRC Press, 2007), p. 35–10.

21 Data taken from http://www.sumcosi.com/english/products/next_generation/large_diameter.html, accessed

July 30, 2013.

22 Don Clark, “Intel Clones Its Past Factories, Right Down to Paint,” Wall Street Journal (October 28, 2002), Technology

section.

23 http://www.amd.com/us/aboutamd/corporate-information/Pages/timeline.aspx, accessed July 30, 2013.

24 Yu, p. 46.

25 Jackson, pp. 313–316.

26 Robert P. Colwell, The Pentium Chronicles: The People, Passion, and Politics Behind Intel’s Landmark Chips (Hoboken,

NJ : Chichester: Wiley ; John Wiley [distributor], 2006).

27 Data available at http://www.interbrand.com/en/best-global-brands/previous-years/best-global-brands-2005.

aspx, accessed 31 July 31, 2013.

28 Data available at http://www.cpubenchmark.net/market_share.html, accessed 31 July, 2013.

29 Data available at http://www.trefis.com/stock/intc/articles/11657/featured-forecast-intel-will-continue-to-

lose-server-processor-market-share/2010-02-22, accessed 31 July, 2013.

30 Michael Springer, “PC milestone—notebooks outsell desktops,” CNET News ( June 3, 2005). Available at http://

news.cnet.com/PC-milestone--notebooks-outsell-desktops/2100-1047_3-5731417.html, accessed July 31, 2013.

31 Tim O’Reilly, “What is Web 2.0” (September 30, 2005). Available at http://oreilly.com/web2/archive/what-is-

web-20.html, accessed July 31, 2013.

REFERENCES [ C-31 ]

http://dspace.mit.edu/bitstream/handle/1721.1/56570/15-912Spring-2005/NR/rdon-lyres/Sloan-School-of-Management/15-912Spring-2005/163D6F92-8636-

http://www.tomshardware.com/reviews

http://arstechnica.com/features/2005/12/total-share/5

http://download.intel.com/pressroom/kits/IntelProcessorHistory.pdf

http://en.wikipedia.org/wiki/List_of_semiconductor_fabrication_plants

http://www.dailytech.com/Intel+Announces+5B+USD+14nm+Fab+4000+New+Arizona+Jobs

http://scholar.lib.vt.edu/theses

http://en.wikipedia.org/wiki/Market_share_of_personal_

http://www.gartner.com

http://www.sumcosi.com/english/products/next_generation/large_diameter.html

http://www.amd.com/us/aboutamd/corporate-information/Pages/timeline.aspx

http://www.interbrand.com/en/best-global-brands/previous-years/best-global-brands-2005

http://www.cpubenchmark.net/market_share.html

http://www.trefis.com/stock/intc/articles/11657/featured-forecast-intel-will-continue-to-lose-server-processor-market-share/2010-02-22

http://news.cnet.com/PC-milestone--notebooks-outsell-desktops/2100-1047_3-5731417.html

http://oreilly.com/web2/archive/what-is-web-20.html

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[ C-32 ]

S outhwest Airlines sent its first flights aloft in 1971. After almost 45 years, Southwest was so successful that the

company was considered, in many ways, the crown jewel of the airline industry. The organization had achieved the longest continuous stretch of profitability in the history of the airline industry and was consistently ranked in the top 10 on Fortune’s list of “Most Admired Companies,” a list that spanned all industries. Southwest’s executives liked to say that they strove toward a triple bottom-line of People, Planet, and Performance.

In 2013, Southwest was on strong financial ground, despite the fact that the prior decade was one of the most difficult decades in aviation history. The airline industry had been hurt by the 9/11 terrorist attacks and the Great Reces- sion of 2008–2009. Although 2009 had been a difficult year for the company, Southwest had still managed to eke out a positive net income of $99 million. The company’s perfor- mance improved in the subsequent years, with net income rising above $400 million and revenues increasing from $10.3 billion in 2009 to over $17 billion in 2012 (see Exhibits 1 and 3). Southwest achieved its strong financial performance in large part by having a high load factor, the airline industry’s measure of the percentage of seats that are filled on an air- line’s flights. In 2010, Southwest hit the highest load factor in its history: 79.3 percent. Following its successful “Bags Fly Free” ad campaign, Southwest also saw its domestic market share increase by almost 2 percent. Southwest was known for high levels of both customer service and employee satis- faction. In 2013, Southwest not only rated as the top airline in a Consumer Reports survey of passengers1 but also reigned at the top of the U.S. Department of Transportation’s cus- tomer satisfaction rankings. Overall, Southwest had an envi- able record of performance, which is one reason that it had accumulated roughly $3.5 billion in cash and other short- term investments in its coffers (see Exhibit 2).

THE U.S. AIRLINE INDUSTRY The U.S. airline industry is critical to the health of the United States economy. Airlines provide 11 million jobs in the United States and are responsible for five cents of every dol- lar of the U.S. gross domestic product (GDP). For every 100 airline jobs that exist, 388 more jobs are supported outside of the airline industry.2

A key turning point in airline history was the deregulation of the industry in 1978. Before deregulation, the Civil Aero- nautics Board regulated all passenger fares, which meant the price was the same for each flight between two cities. The board also regulated industry entrances and exits; mergers

and acquisitions; and even airlines’ rates of return. Typically, any given market had only a few airlines, and price competi- tion was essentially nonexistent.

Following deregulation, numerous new entrants moved into both established and unserved markets, and fare prices began to drop quickly. The average passenger fare in 1978 cost about 8.49 cents per mile. In 2009, that price, adjusted for inflation, had decreased 56 percent.3 As prices declined for passengers, however, more than 150 airlines went bank- rupt, and 8 of the 11 major airlines went bankrupt, merged or closed.

The airline industry’s profit margins are some of the low- est in the world (see Exhibits 4 and 5). Airlines paid con- siderable attention to reducing their operating costs, but their control over those costs was severely limited. In par- ticular, labor costs represented the largest percentage of an airline’s costs, but union agreements limited labor flex- ibility. The sizes of the crew and ground staff were typically proportional to the size of the aircraft they served. Other operating costs were primarily determined by the distance traveled and not by the number of passengers boarded. Most airlines—notably Delta, American, and United—used a hub- and-spoke system to coordinate flights, which meant that they funneled the majority of their traffic through “hub” air- ports. Hub-and-spoke (HS) systems were designed to help airlines maximize their load factors, meaning they helped keep planes full going into and out of a hub airport. But they also often increased the distance that passengers had to fly to get to their final destination and the time it took for pas- sengers to get to their final destination.

Recessions, terrorist attacks, and cost increases have hurt the industry following the turn of the century. During the decade following 9/11, the price of jet fuel rose from $34 per barrel to nearly $135 per barrel, and the tax burden on airlines tripled. Moreover, after 9/11 and during the Great Recession, the number of passengers flying decreased, which made it difficult to keep planes flying near full capac- ity. Between 2001 and 2011, 41 U.S. airlines went bankrupt and the industry was estimated to have lost $55 billion and 160,000 jobs.4 While most airlines struggled to survive, Southwest had figured out a way to stay profitable.

THE HISTORY OF SOUTHWEST AIRLINES Legend has it that the idea for Southwest Airlines was first conceived on a napkin while Herb Kelleher was meeting with Rollin King in a San Antonio Restaurant.5 In 1966, Kelleher was practicing law. King, one of Kelleher’s clients, approached him with the idea of bringing a low-cost

CASE 04 Southwest Airlines: Flying High with Low Costs

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CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS [ C-33 ]

[ Exhibit 1 ] Southwest Airlines Selected Financial and Operating Figures

Financial Data: (In millions except per share)

2013 2011 2009

Total Operating Revenues: 17,699 15,658 10,350

Operating Expenses:

Salaries, wages, and benefits 5,305 4,371 3,468

Fuel and oil 5,763 5,644 3,044

Maintenance materials and repairs 1,080 955 719

Aircraft rentals 361 308 186

Landing fees and other rentals 1,103 959 718

Depreciation and amortization 867 715 616

Other operating expenses 86 1,879 1,337

Total Operating Expenses: 16,421 14,965 10,088

Operating income: 1,278 693 262

Net Income: 754 178 99

Net income per share, basic 1.06 .23 0.13

Total assets at period-end 19,345 18,068 14,269

Long-term obligations at period-end 2,191 3,107 3,325

Stockholders’ equity at period-end 7,336 6,877 5,454

Operating Data:

Revenue passengers carried 108,075,976 103,973,759 86,310,229

Enplaned passengers 133,155,030 127,551,012 101,338,228

Revenue passenger miles (RPMs) (000s) 104,348,216 97,582,530 74,456,710

Available seat miles (ASMs) (000s) 130,344,072 120,578,736 98,001,550

Load factor (1) 80.1% 80.9% 76.0%

Average aircraft stage length (miles) 703 679 639

Trips flown 1,312,785 1,317,977 1,125,111

Average passenger fare 154.72 141.90 114.61

Passenger revenue yield per RPM 16.02¢ 15.12¢ 13.29¢

Operating revenue yield per ASM 13.58¢ 12.99¢ 10.56¢

Operating expenses per ASM 12.60¢ 12.41¢ 10.29¢

Fulltime equivalent Employees at period-end 44,831 45,392 34,726

Aircraft in service at period-end (2) 680 698 537

Note

(1) Revenue passenger miles divided by available seat miles

(2) Includes leased aircraft

Source: Southwest Airlines Annual Reports

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[ C-34 ] CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS

[ Exhibit 2 ] Southwest Airlines Balance Sheet

As of December 31… 2013 2011 2009

Current assets: (In millions)

Cash and cash equivalents 1,355 829 1,114

Short-term investments 1,797 2,315 1,479

Accounts and other receivables 419 299 169

Inventories of parts and supplies, at cost 467 401 221

Deferred income taxes 168 263 291

Prepaid expenses and other current assets 250 238 84

Total current assets 4,456 4,345 3,358

Property and equipment, at cost:

Flight equipment 16,937 15,542 13,719

Ground property and equipment 2,666 2,423 1,922

Deposits on flight equipment purchase contracts 764 456 247

20,820 18,421 15,888

Less allowance for depreciation and amortization 7,431 6,294 5,254

13,389 12,127 10,634

Other assets 530 626 277

19,345 18,068 14,269

Current liabilities:

Accounts payable 1,247 1,057 732

Accrued liabilities 1,229 996 729

Air traffic liability 2,571 1,836 1,044

Current maturities of long-term debt 629 644 190

Total current liabilities 5,676 4,533 2,695

Long-term debt less current maturities 2,191 3,107 3,325

Deferred income taxes 2,934 2,566 2,200

Deferred gains from sale and leaseback of aircraft 65 75 102

Other noncurrent liabilities 771 910 493

Stockholders’ equity:

Common stock, $1.00 par value 808 808 808

Capital in excess of par value 1,231 1,222 1,216

Retained earnings 6,431 5,395 4,971

Accumulated other comprehensive income –3 –224 –578

Treasury stock, at cost: –1,131 –324 –963

Total stockholders’ equity 7,336 6,877 5,454

Source: Southwest Airlines Annual Reports.

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CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS [ C-35 ]

intrastate airline to Texas. Because federal regulations made it difficult to establish an airline that crossed state borders, the two founded Southwest Airlines in 1967 to focus on point-to-point travel among the three Texas cities of Dal- las, Houston, and San Antonio.6 In contrast to larger airlines servicing the cities through connecting interstate routes, Southwest would fly directly to each of the cities, and the flights would take roughly one hour each.

When deregulation hit the airline industry in 1978, South- west decided to compete with low fares. Demand for travel among the three cities had been rising at the time, and, with little price competition in the market, passenger fares were high. Targeting business travelers and commuters between its initial three cities, Southwest’s fares were typically priced between $40 and $100 round trip in order to compete with the cost of driving.

Southwest was based out of Love Field in Dallas, which although a small airport, offered travelers a more convenient location due to its closer proximity to the city than the larger Dallas-Fort Worth Airport. Using Love Field as inspiration,

Southwest adopted a “love” theme for the airline’s marketing and operations. Drinks were called “love potions,” and ticket machines “love machines.” Later, when Southwest went pub- lic, its stock ticker would be LUV. The flight attendants were women chosen for their striking looks. They wore boots and “hot pants” (small, form-fitting shorts), which were a fashion trend. Said Kelleher, “You can have a low-cost carrier and people still don’t fly it because they don’t know about it. And so, the shtick kind of fits in with getting known.”7

Southwest also emphasized a culture of fun. Employ- ees were known to sing announcements to passengers and deliver entertaining instructions. For example, flight attend- ants were known to tell passengers how nice they would look in their life vests or that they will need to deposit 25 cents for oxygen to begin flowing to their oxygen masks. It is easy to find videos on the Internet of flight attendants sing- ing, rapping, and telling jokes to their passengers. Southwest brought the culture of fun to its employees not only through the example of its senior executives but also through its “fun” training programs. The company’s advertising also tended

[ Exhibit 3 ] U.S. Domestic Airline Total Operating Revenues

IN MILLIONS

American America West

Conti- nental

Delta North- west

South- west

United US Airways

JetBlue Alaska

2013 25,760 - - 37,818 - 17,699 38,287 14,936 5,442 5,151

2012 24,825 - - 36,917 - 16,411 37,160 14,121 4,982 4,650

2011 23,958 - 16,175 35,316 - 13,655 21,155 13,341 4,509 4,310

2010 22,151 - 14,011 31,894 - 12,104 19,682 12,196 3,781 3,427

2009 19,898 - 12,361 18,047 10,863 10,350 16,359 10,781 3,287 3,006

2008 23,696 - 15,033 20,973 14,096 11,023 20,237 12,459 3,390 3,221

2007 22,833 2737 14,105 19,239 12,735 9,861 20,049 9,318 2,843 3,070

2006 22,493 3770 13,010 17,339 12,555 9,086 19,334 8,076 2,363 2,693

2005 20,657 3397 11,108 16,112 12,316 7,584 17,304 7,212 1,703 2,416

2004 18,608 2482 9,851 15,154 11,266 6,530 15,701 7,073 1,266 2,241

2003 17,403 2223 7,333 14,203 9,184 5,937 13,395 6,762 998 2,027

2002 15,871 2021 7,353 12,410 9,152 5,522 13,916 6,915 635 1,832

2001 15,639 2035 7,972 13,211 9,592 5,555 16,087 8,253 320 1,763

2000 18,117 2309 9,129 15,321 10,957 5,650 19,331 9,181 105 1,760

1999 16,090 2164 8,024 14,901 9,868 4,736 17,967 8,460 - 1,696

1998 16,299 1983 7,299 14,630 8,707 4,164 17,518 8,556 - 1,581

1997 15,856 1887 6,361 14,204 9,984 3,817 17,335 8,501 - 1,457

1996 15,136 1752 5,487 13,318 9,751 3,407 16,317 7,704 - 1,307

Note: US Airways and America West started to report combined on-time data in January 2006 and combined traffic and

financial data in October 2007 following their 2005 merger announcement. Delta and Northwest began reporting jointly in

January 2010 following their 2008 merger announcement.

Source: Bureau of Transportation Statistics, Air Carrier Financial Reports: Schedule P-1.2 (http://www.transtats.bts.gov/)

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[ C-36 ] CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS

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[ C-38 ] CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS

to be a fun, even a little edgy. On one occasion, marketers brought an ad to Kelleher that targeted extra regulations and fees that other airlines stated in “fine print” marked by asterisks in their ads. Kelleher quickly approved running Southwest’s ad, which read, “Some airlines should have their asterisks kicked.”8

The company’s point-to-point service led to frequent departures between city-pair routes. With only three planes operating up until 1974, Southwest had to focus on turning its planes around as quickly as possible. Its choice to fly into less-congested airports such as Love Field helped Southwest to make those faster turnarounds. At the beginning, South- west set the goal of turning its planes around in 15 minutes, which was 30 minutes faster than the industry average.

Southwest also quickly discovered that it could segment its pricing. After starting its fares at $20 one way, South- west raised fares for travel before 7:00 p.m. to $26. To target budget-minded leisure travelers, Southwest lowered fares for evening flights after 7:00 p.m. and weekend flights to as low as $13. Such decisions were key to Southwest’s early success and laid the foundation for the company’s successful low- cost strategy.9 Southwest’s business model set it apart from its competitors, and the company began to grow quickly. It took the company only two years to become profitable, and Southwest has been profitable every year since 1973.

SOUTHWEST’S STRATEGY AND OPERATIONS Southwest’s strategy involved offering no-frills, short-haul, high-frequency, point-to-point, low-fare service. Although Southwest’s approach would later become well known and frequently studied, it started out primarily as a response to the constraints faced by the company. Federal regulations led Southwest to focus on intrastate travel between just Dal- las, Houston, and San Antonio. The company’s first planes were three Boeing 737s purchased because they were avail- able at a discount due to overproduction.10 This small fleet caused Southwest to focus on reducing the time to turn its planes around and get them back in the air. Due to its short flights, the airline did not serve meals on its flights. Eventu- ally, Southwest would become renowned for these strategies of flying only point-to-point routes between less congested airports, adopting only one model of plane (the Boeing 737), and offering only one class of service, without meals or assigned seating.

Southwest bucked the industry trend of routing planes through a hub-and-spoke (HS) model by flying its planes point-to-point (PTP) on city-pair routes. The HS model— developed in the 1960s and 1970s and used by full-service carriers such as American, United, and Delta—was designed to maximize the load factors for each of an airline’s indi- vidual planes by bringing customers traveling to the same location together in a central hub from all their different points of origination. The HS model was, however, generally considered to be inconvenient by passengers, and a delay in one flight on a spoke would create a domino effect of delays

that would cascade throughout an airline’s system of flights. Southwest determined that it would instead focus on put- ting as many flights as possible on its point-to-point routes by turning the planes around as quickly as possible (see Exhibits 6 and 7).

As described earlier, Southwest’s initial goal was to turn its planes around in 15 minutes. By comparison, the rest of the industry was turning planes around at an average of 45 minutes. Southwest was able to successfully decrease its turnaround times to close to 15 minutes for a variety of reasons. Flying PTP meant Southwest’s flights weren’t wait- ing on other flights. Since Southwest’s flights were shorter, its passengers typically checked less baggage. The absence of meals on the airline’s flights meant that there was less cleanup time required. In addition, Southwest focused its employees on working as a team to turn planes and gave them significant latitude to work outside of formal guide- lines and do whatever it took to turn a plane around quickly. Finally, Southwest stressed a high-speed boarding process. Most airlines assigned seats to their passengers, but South- west ignored that method of boarding. Instead, each pas- senger got a boarding number as he or she arrived at the gate. Eliminating assigned seating meant that the airline didn’t have to reconcile double-booked seats, and it moti- vated passengers to arrive early. Taken together, these prac- tices combined to help Southwest turnaround planes much faster than most of its competitors. By 2009, Southwest was turning planes at an average of 23 minutes, which was still roughly half of the industry average.11

In an industry facing some of the highest fixed costs in the world, Southwest’s business model allowed it to keep costs low. Southwest had continued to exclusively use Boe- ing 737s throughout its history. By 2010, there were 548 Boeing 737s in Southwest’s fleet (451 owned, 97 leased).12 The efficiencies created by the common fleet of the 737s also meant that Southwest spent less money training its pilots, flight attendants, and mechanics and was able to staff smaller teams for its gate crews. In fact, the uniform configuration was so important to Southwest that, follow- ing its purchase of AirTran in 2011, all of AirTran’s planes were reconfigured to match Southwest’s current fleet. Pur- chasing the same type of plane also gave Southwest some leverage negotiating prices with Boeing—which was not insignificant, since a Boeing 737 cost between $75 mil- lion and $107 million in 2013, depending on the features included on the aircraft.

Southwest also limited the commissions it paid to ticket- ing services and booking agents by refusing to pay fees for any third-party ticketing services except the SABRE system. These fees had historically run 5 to 10 percent of the price of a ticket but had moved to a lower flat fee in recent years. Instead, Southwest developed an online ticketing system of its own, and in 1995 it became the first airline to sell tickets directly from its own website. In 2010, 79 percent of South- west’s tickets were purchased online.13 In contrast, only 35 percent of Delta’s tickets were purchased online during the same period.14

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[ C-40 ] CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS

[ Exhibit 7 ] Total Passengers per Full-time Employee Equivalent

2012 2011 2010 2009 2008 2001 1996

American 1,340 1,295 1,316 1,290 1,309 847 1,006

Continental - 1,231 1,154 1,137 1,156 1,015 1,186

Delta 1,489 1,420 1,449 1,463 1,513 1,343 1,653

Southwest 2,962 3,065 3,106 2,908 2,942 2,391 2,490

United 1,052 1,086 1,175 1,204 1,225 801 1,035

US Airways 1,737 1,679 1,679 1,628 1,677 1,651 1,424

JetBlue 2,346 2,245 2,160 2,116 2,144 1,444 NA

Alaska 2,019 1,997 1,909 1,746 1,746 1,351 1,544

Source: Data compiled by MIT Airline Data project using US DOT Form 41 via BTS, Schedule T1 & P10

(http://web.mit.edu/airlinedata/www/2013%2012%20Month%20Documents/ADP_introduction.pdf)

While Southwest saved significant money on its opera- tions, it was spending more than the average airline on marketing. In its first year of business, the airline spent 10 percent of its budget on advertising. The company had con- tinued to emphasize marketing throughout its history, even increasing its marketing during difficult years. As Kelleher explained, “When do you need advertising the most? When times are bad.”15 When Southwest achieved record profits and load factors in 2010, CEO Gary Kelly credited the com- pany’s highly successful “Bags Fly Free” ad campaign for the success.16 The campaign cost Southwest $159.5 million to produce, which was nearly the same as the combined adver- tising budgets of Delta, United, American, and Continental.17

Although multiple cities were clamoring for Southwest’s business, the airline made an early decision to grow slowly. Even in the best years, Southwest restricted increases in its capacity to 10 to 15 percent and added only two or three new cities per year. In 1996, Kelleher’s reflected, “Southwest has had more opportunities for growth than it has airplanes. Yet, unlike other airlines, it has avoided the trap of growing beyond its means.”18 Following the devastating effects of the 9/11 terrorist attacks, Southwest explained in the opening statement to its 2001 Annual Report, “Southwest was well poised, financially, to withstand the potentially devastating hammer blow of September 11. Why? Because for several decades our leadership philosophy has been: We manage in good times so that our Company and our People can be job secure and prosper through bad times.” As noted, the airline recession after 9/11 as well as the U.S. Great Recession of 2008–2009 had a strong negative impact on industry profit- ability (see Exhibits 8 and 9).

Managing its growth in such a way kept far more cash in Southwest’s pockets than was common for the industry. When fuel prices skyrocketed after 2005, Southwest was able to stay profitable because of its practice of fuel hedg- ing, or buying options that guaranteed the price of fuel in the future. Most of the rest of the industry wasn’t able to follow

suit, however, because hedging required an enormous cash outlay.19

LEADERSHIP, CULTURE, AND VALUES Herb Kelleher was known for his unique style of leadership. As Kelleher reached 80 years old in 2011, he continued to display the quick wit and sense of humor that made him the face of Southwest after its founding. He was often featured in commercials and videos about the company. For one train- ing video, he created a fully costumed rap persona called “Big Daddy O.” He once dressed in a purple dress with a pur- ple hat after losing a challenge with the maintenance crew.

Kelleher was highly admired by his employees, perhaps because he was so engaged with them. For example, Kelle- her was often seen helping to unload bags or serving drinks with flight crews. During one difficult period, when his pilots were willing to freeze their salaries for five years, Kelleher responded by freezing his own for the same period. As a token of their esteem for him, employees purchased Kelleher a custom Harley-Davidson motorcycle that he rode often.

One of Kelleher’s basic principles of business for South- west was that the customer wasn’t always right. Instead, his credo was that employees come first.20 Kelleher said, “You put your employees first and if you take care of them, then they will take good care of you. Then your customers will come back, and your shareholders will like that, so it’s really a unity.”21 Southwest went to great lengths to maintain a cul- ture of fun and to build a family spirit all across the airline. It even created a “Culture Committee” staffed with employees who volunteered their time after being nominated by their peers. The committee worked to create events and programs to celebrate Southwest employees at all levels from across the organization.

Employees at Southwest were recruited for their positive and engaging attitudes and were given extensive training to ensure that they not only understood the airline’s operations, but also embraced its culture. During hiring, Southwest

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[ C-42 ] CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS

[ Exhibit 9 ] The Strategy Canvas of the Short-Haul Airline Industry

Source: Adapted from W. Kim and R. Mauborgne, “Charting Your Company’s Future,” (cover story)’, Harvard Business Review 80, 6 (2002),

pp. 76–83.

Low Price

Low

P er

fo rm

an ce

High

Meals Lounges Seating choices

Hub connectivity

Purchase Criteria

Friendly service

Speed Frequent Departures

Car Full service airlines Southwest

conducted group interviews in which potential employees would share personal stories while interviewers observed the group for signs of empathy and interest.22 In order to facilitate empathy among different types of employees, Southwest implemented Walk-A-Mile Day. Employees in all departments were encouraged to experience their cowork- ers’ jobs first-hand. Walk-A-Mile Day and other practices encouraged collaboration throughout the company. When a flight did leave behind schedule, the team would meet to focus on the problem together, thus eliminating finger point- ing at individuals. The results of Southwest’s efforts were the highest level of employee productivity in the industry (see Exhibit 7).

Southwest’s employees have also benefited from its profit-sharing plan. Roughly 10 percent of Southwest’s stock is held by its employees. Some think that these prac- tices explain why, even though 82 percent of Southwest’s 35,000 employees are unionized, the airline has one of the lowest rates of union complaints. It also didn’t hurt that Southwest hasn’t laid off or furloughed an employee since its founding in 1971. Looking back, Kelleher said during a 2011 interview that the facet of Southwest that made him most proud was having “total job security for our employ- ees for over 40 years. I’ve spent my entire career staying out of their way.”23

SOUTHWEST’S GROWTH AND EXPANSION Despite facing constant opposition to expansion from its competitors, Southwest was still able to grow steadily after its founding. Southwest moderated its growth in the face of enormous demand for what became known as the Southwest effect. In less than one year, cities newly served by Southwest

would often see up to a 1,000 percent increase in air traffic, due largely to lower airfares. The Oakland–Burbank route improved from the 179th largest passenger route to the 25th largest within one year of Southwest’s entry. As Exhibit 10 shows, Southwest was the dominant carrier in all of its top 100 city-pair routes.

Although most of Southwest’s routes were short-haul flights of fewer than 1,000 miles, in the late 1990s, the air- line began to look at expanding into long-haul routes. On Thanksgiving Day 1998, it commenced its first transcon- tinental flight from Baltimore to Oakland, a five-hour trip. Southwest was able to expand to longer routes in large part because Boeing had developed the 737-500 model aircraft. The 500 flew the longer flights at a far lower cost per mile while still maintaining the basic 737 structure and configu- ration that Southwest employees were used to.24

In 2007, Southwest moved to start catering more to business travelers by introducing Business Select service. Although the airline still provided only one class of seat- ing, Business Select offered early boarding privileges, spe- cial business services at gates, and improved frequent flyer points. Initially, some observers expressed concerns about alienating core customers, but a few years later the Business Select service appeared to have increased interest from busi- ness travelers without having a noticeable effect on other travelers.

In 2010, Southwest made its second acquisition (the first was Morris Air in 1993) of AirTran for $1.4 billion. AirTran followed a very similar strategy of offering short-haul, point- to-point, low-fare service. AirTran’s routes had little overlap with Southwest and included short international routes to the Caribbean and Mexico. The move would eventually

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CASE 04 SOUTHWEST AIRLINES: FLYING HIGH WITH LOW COSTS [ C-43 ]

[ Exhibit 10 ] Southwest Airlines’ Market Share

Source: Southwest Annual Report 2013

Southwest’s Market Share in Southwest’s Top 100 City-Pair Markets

Southwest’s Market Share Total Domestic Market

Other Carriers 79%

Southwest 21%

Southwest 72%

Other Carriers

28%

extend Southwest’s presence into Atlanta, the busiest air- port in the world, and connect the airline to international markets. Full integration of the acquisition was expected to be completed by the end of 2014, by which time South- west would begin showing AirTran’s routes on its website. In keeping with its strategy of using a single type of plane, Southwest decided to lease AirTran’s fleet of Boeing 717s to Delta so that it could use the standard Boeing 737s that it used throughout its operations.25

JETBLUE: A TOUGH NEW COMPETITOR JetBlue was founded in 1999 by former Morris Air president David Neelman. After receiving more than $800 million in funding to establish its base of operations in JFK airport in New York, the airline grew quickly. Over its first five years, JetBlue’s revenues increased by more than 1100 percent, although it slowed significantly during the U.S. recession in the latter part of the decade. In 2002, JetBlue had a successful initial public offering of stock (IPO); the airline’s stock price increased by 70 percent on the first day alone. JetBlue flew both domestically and internationally, with both short- and long-haul routes. For example, JetBlue could fly long-haul flights from New York to Los Angeles, which Southwest could not do with the Boeing 737. Jet Blue’s strategy and operations mimicked Southwest in many ways, includ- ing flying point to point, using one type of aircraft (Airbus 320, which could fly longer routes; it later added Embraer 190 Jets), not serving meals, and creating a team approach to quickly turning around flights. The airline distinguished itself from Southwest with comfortable leather seating, in- flight television offered in partnership with DirecTV, and assigned seating. JetBlue also offered its passengers simple boxed meals during flights (at an added charge) and charged for checking more than one bag.

Although JetBlue’s revenues were less than one third of Southwest’s, it was still a noteworthy competitor. JetBlue

came in second to Southwest Airlines by only a couple points (84 to 87 out of 100) in a 2011 Consumer Reports sur- vey of passengers.26 JetBlue was also the only airline other than Southwest to show positive operating profits year after year. The airline was steadily growing its fleet of Airbus A320 and Embraer 190 jets and was consistently adding new routes. JetBlue’s strategy finally brought a competitor to the industry that could compete directly, and effectively, with Southwest.

LOOKING FORWARD By 2013, Southwest was flying more than 680 planes total- ing 3,600 flights per day, in 96 cities covering 41 states. The average trip length was 708 miles and took nearly two hours. The average one-way ticket price was $154, and the highest was $590.27 Southwest had set the standard for the industry in multiple areas of operation: by flying more passengers per employee than any other airline, by maintaining a debt-to- equity ratio far below the industry average, and by never hav- ing to stop a flight due to a union strike.

Southwest has slowed its growth considerably in recent years due to the recession, and the plan is to keep growth below its historical rates for the time being. Delta’s acqui- sition of Northwest in 2008 made it the industry’s largest carrier, as measured by share of revenue passenger miles (RPMs), which is the number of times that an airline carries one passenger one mile. Then, in 2013, American Airlines acquired U.S. Airways, making it the industry’s largest carrier based on the same measure. The consolidation of hub-and- spoke competitors in the industry, along with Southwest’s emergence as a large player, had created an industry where the four largest airlines control roughly 80 percent of the U.S. air travel market. While American (with U.S. Airways), Delta (with Northwest), and United all had more revenue passen- ger miles than Southwest, Southwest led the domestic mar- ket in the number of passengers boarded annually.

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[ C-44 ] REFERENCES

REFERENCES

1 Consumer Reports Staff, “Best and Worst Airlines: Southwest Is Tops and US Airways Trails in Our Latest Sur-

vey,” Consumer Reports ( June 2011), pp. 17–19.

2 Nicholas Calio, April 27, 2011. Speech Printed by Air Transportation Assoc., http://www.airlines.org/News/

Speeches/Pages/speech_04-27-11.aspx.

3 “A History of Airline Deregulation: Part 4,” Travel Insider (May 28, 2011). http://thetravelinsider.info/airlinemis-

management/airlinederegulation2.htm.

4 Calio.

5 National Aviation Hall of Fame, “Herb Kelleher,” 2011, http://www.nationalaviation.org/kelleher-herbert/.

6 James L. Heskett and W. Earl Sasser, Jr., “Southwest Airlines In a Different World,” Harvard Business School Case

9-910-419, rev. 2013.

7 CBSNews Staff, “Something Special about Southwest Airlines,” CBSNews (February 11, 2009).

8 Rance Crain, “Herb Kelleher on the Importance of Advertising to Southwest’s Success,” Advertising Age (May 2,

2011).

9 Southwest Airline’s Company History, 2011. http://www.swamedia.com/channels/By-Date/pages/1972-to-1978.

10 Heskett.

11 CBSNews Staff.

12 Southwest Airlines Annual Report, 2010.

13 Ibid

14 Dennis Schaal, “Delta Increases Share by Squeezing Online Travel Agencies and Metasearch,” Tnooz (August 05,

2011).

15 Crain.

16 Southwest Airlines Annual Report, 2010.

17 Greg Lindsay, “Why’d You Pick That Airline to Fly on Thanksgiving? We Though So,” Advertising Age (November

29, 2010).

18 Kevin Frieberg and Jackie Frieberg, Nuts! Southwest Airlines‘ Crazy Recipe for Business and Personal Success

(Austin, TX: Bard Press, 1996), p. 61.

19 Moira Herbst, “Hedging Against $200 Oil,” Bloomberg Businessweek (May 7, 2008).

20 Crain.

21 CBSNews Staff.

22 Heskett and Sasser.

23 Crain.

24 Michael E. Raynor, “Disruptive Innovation: The Southwest Airlines Case Revisited,” Strategy & Leadership 39 (4),

(2011) pp. 31–34.

25 Timothy W. Martin, “Southwest Eager for Atlanta Seat,” The Wall Street Journal (May 10, 2011).

26 Consumer Reports Staff, “Best and Worst Airlines: Southwest Is Tops and US Airways Trails in Our Latest

Survey.”

27 Southwest Airlines Corporate Factsheet. 2014. http://www.southwest.com/html/about-southwest/history/

fact-sheet.html.

28 “Southwest’s Gary Kelly Talks about His Next Steps” (August 20, 2009), The Wall Street Journal Online.

Although Southwest, like any company, faced challenges, its low-cost approach looks as though it will continue to be successful. As Southwest’s CEO Gary Kelly said, “I continue to believe that one of the reasons we’re outperforming the

industry is because of our low-fare brand, not nickel-and- diming our customers. … From a brand perspective, every company would like to be unique. We haven’t moved. They all have …[But] we’re not saying never to anything.”28

http://www.airlines.org/News

http://thetravelinsider.info/airlinemis-management/airlinederegulation2.htm

http://www.nationalaviation.org/kelleher-herbert

http://www.swamedia.com/channels/By-Date/pages/1972-to-1978

http://www.southwest.com/html/about-southwest/history

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[ C-45 ]

T he “Great Recession” hit Harley-Davidson hard. During the fourth quarter of 2008, Harley’s global sales dropped

13 percent, profits decreased by 30 percent for the year, and, over a 12-month period, its stock price plummeted 70 per- cent.1 Harley had not confronted a drop in sales and profits of this magnitude since the early 1980s when it barely avoided bankruptcy as a subsidiary of VMF. But, fortunately for Har- ley, it faced the new challenge with resources that it simply didn’t have 30 years earlier. By 2012, the Harley bar and shield logo, a symbol of American individualism, was the ninety- sixth most valuable global brand, with an estimated value of $4 billion.2 The brand sold not only motorcycles, but also a wide variety of merchandise. Moreover, the Harley Owner’s Group (HOG) was the largest motorcycle enthusiast organi- zation in the world with almost 1 million members. The Har- ley brand with its loyal customer base, combined with an increase in consumer confidence, helped boost sales to $5.9 billion in 2013.3 Despite the recent rebound in revenues and earnings, Harley’s sales were still almost $300 million lower than they were in 2008, however. Harley Davidson CEO Keith Wandell and his team were concerned about whether Har- ley could grow during the next decade the way it had in the prior decade (see Exhibit 1).

Traditional riders, Caucasian men ages 35 to 74, had represented the largest portion of Harley’s retail sales for

many years.4 And, although this demographic—coming in at around 50 million people5—was expected to remain stable from 2013 through 2050, the question was whether Harley- Davidson could grow outside its traditional customer base. Harley had struggled for decades trying to sell to nontradi- tional riders, including young adults (ages 18-35), women, Hispanics, and African Americans—four groups that together are three times larger than the number of traditional riders.6 A survey done by Harley-Davidson revealed that young adults found the dealership experience intimidating and tended to have sticker shock when seeing the price of a Harley.7 Furthermore, some critics blamed the bike’s reputa- tion and size (average weight between 450 to 800 pounds) for Harley’s lack of popularity among women.8 Investors were looking for continued growth, so they wanted to know what Harley was going to do to expand into other demographics.9 Likewise, they wanted to know if the American motorcycle could improve sales in international markets.

HISTORY: BORN IN A SHED AND RAISED ON A RACE TRACK In 1901, William Harley completed his blueprint drawing of “an engine designed to fit into a bicycle.”10 Two years later, the first Harley-Davidson motorcycle emerged from a 10x15

CASE 05 Harley-Davidson: Growth Challenges Ahead

[ Exhibit 1 ] Harley-Davidson Revenue and Net Income (1990-2013).

–1000

1000

2000

3000

4000

5000

6000

7000

1985 1990 1995 2000 2005 2010 2015

U S

D (

$ )

in M

il li

on s

Year

Revenue

Net Income

Source: Company annual reports.

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[ C-46 ] CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD

foot wooden shed, and William and his colleague, Arthur Davidson, started selling the Harley-Davidson “bikes”i to the public. The first Harley-Davidson motorcycle was built for speed and designed to be a racer to compete with Hendee Manufacturing Company’s 1.75 horsepower, single-cylinder motorcycle, which had to that point dominated both the emerging motorcycle market and motorcycle racing sport.11 On July 4, 1905 a Harley-Davidson motorcycle won its first race (a distance of 15 miles) in Chicago with a time of 19:02 minutes.12 Other victories on Harley bikes quickly followed, and Harley bikes became popular in the budding racing community.

Harley-Davidson officially entered motorcycle racing as a company in 1914, with engineer and cofounder William Harley as its first racer.13 William, who was a passionate competitor, was determined to win every race and so made racing performance the company’s primary objective. Con- sequently, William and Arthur invested heavily in research and development (R&D), which allowed the company to develop new and superior features including their own electric starter, front brakes, and standardized parts.14 The company pioneered several early industry breakthroughs, including the V-twin engine, clutch, and internal expanding rear brake.15

Not surprisingly, as Harley-Davidson’s motorcycles con- tinued to improve, the company’s racing team began to ful- fill William’s ambition to win every race it competed in. With each win the team traditionally took their mascot, a pig, on a victory lap immediately following the race. The victory routine was popular with the racing community, and, as a result, Harley-Davidson bikes were nicknamed “Hogs” after their mascot.16 The nickname was immediately embraced, and the “Hog” label is still used to describe Harley-Davidson motorcycles today.

HARLEY BECOMES A REBEL In 1921, Harley was the first motorcycle in history to win a race with an average speed of more than 100 mph and was the go-to-bike for daredevils wanting to break land speed records.17 But, as its reputation for power and speed became more widespread, Harley-Davidson began to attract a dif- ferent kind of customer—the rebel. Harley’s speed set itself apart from the competition, and it began to attract custom- ers outside of racing who also needed the fastest bikes on the market. For example, the U.S. armed forces contracted the motorcycle manufacturer to produce motorcycles for the war effort during World War II.18 Additionally, highway patrol officers used the roadsters for high-speed chases, and notorious biker gangs such as the Hell’s Angels used the bike to run away from the law.

By the 1950s, Harley’s racer reputation was increasingly being replaced by the “tough guy” image associated with its most iconic riders. Actors James Dean and Marlon Brando, two of Hollywood’s bad boys, were Harley riders on and off

i A short name often used to refer to a motorcycle.

the set. The Hog even became the bike of choice for the King of Rock and Roll, Elvis Presley. In 1953, the film The Wild Ones glorified Harley riders as aggressive members of biker gangs. Several years later, in the 1969 film Easy Rider, the Harley was the motorcycle for two counterculture bikers travelling from Los Angeles to New Orleans. This shift in consumer perception came with a new demand for more rugged cus- tomized bikes such as the chopper-style motorcycle, which Harley-Davidson was happy to supply. Consequently, Harley inadvertently solidified itself as a symbol of independence and rugged individualism.

HARLEY HITS A SPEED BUMP By 1931, the U.S. motorcycle industry had consolidated and was dominated by Harley-Davidson, Indian, and Brit- ish Triumph. By the mid-1950s, Harley had a commanding 60 percent share of the market,19 was the only American manufacturer of motorcycles, and dominated the motorcy- cle racing world. But the competition was about to hit the throttle. Honda Motor Company had successfully broken away from its competitors Yamaha, Kawasaki, and Suzuki, after producing the incredibly successful 50 ccii lightweight delivery motorcycle, which sold 3,000 units per month only six months after being introduced to the market.20 After investing in a 30,000-unit-per-month manufacturing plant, a capacity 10 times in excess of demand at the time of con- struction, Honda looked to the United States for growth opportunities. In 1959, Honda Motor Company, already the largest motorcycle producer in the world, entered the Amer- ican motorcycle market.

Starting on the west coast of the United States, Honda moved eastward region-by-region, developing the market. It concentrated its marketing efforts on the middle-class con- sumer and branded itself as the family-friendly bike. The ad campaign, “ You meet the nicest people on a Honda,” was a direct contrast to the rough, aggressive, and loud image of the American Harley-Davidson. Honda’s growth pattern was subtle. When entering a new market, Honda did so with its lightweight 50 cc bikes, which weighed in at 150- 200 pounds and sold for less than $250 retail, a significant drop in weight and price compared to Harley motorcycles, which weighed between 450 to 800 pounds and retailed between $1,000-1,500.21 Not only were the bikes smaller, qui- eter, and more fuel-efficient compared to the heavyweight Harleys, but they also required little or no maintenance due to Honda’s large and standardized production process. As a result, Honda was able to offer a better-built motorcycle at a fraction of the cost. A study done by the Boston Consult- ing Group in 1975 showed that Harley’s prices were drop- ping by roughly 15 percent with each doubling of volume (see Exhibit 2).22

Initially, Harley’s CEO and company leaders cheered the arrival of the Japanese motorcycle company, thinking it was exactly what the industry needed.23 New customers could

ii Cubic centimeters (cc), as applied to an internal combustion engine, is a

measure of the engine size or combustion space in the cylinders.

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CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD [ C-47 ]

[ Exhibit 2a ] Harley–Davidson Selected Financial Information.

FY 2013

FY 2008

FY 2003

FY 1998

FY 1993

Revenue (in $ millions) 5,900 5,955 4,904 2,064 1,217

Cost of revenue 3,561 3,784 3,070 1,373 880

Gross profit 2,338 2,171 1,833 691 337

Operating expenses 1,185 1,100 684 377 210

Operating income 1,029 1,154 1,149 313 127

Return on equity 26.67% 29.2% 29.3% 23.0% 3.60%

Return on assets 8.14% 9.7% 17.3% 12.1% –2.2%

Gross profit 39.8% 36.5% 37.4% 33.5% 27.7%

Operating expense 20.01% 18.5% 13.9% 18.3% 17.3%

Operating income 17.4% 18.0% 23.4% 15.2% 10.4%

COGS 60.36% 63.5% 62.6% 66.5% 72.3%

Source: Company annual reports.

[ Exhibit 2b ] Harley–Davidson in Segments.

FY 2013

FY 2012

FY 2011

FY 2010

FY 2009

FY 2008

FY 2007

Revenue (in $ millions) 5,900 5,581 5,312 4,859 4,782 5,955 6,143

Harley–Davidson motorcycles 4,484 4,403 3,553 3,137 3,175 4,278 4,447

Parts & accessories 979.4 860 817 749 767 859 868

General merchandise 299 274 259 282 314 305

Other 18 17 15 16 20 6

Motorcycles sold 260,471 247,625 233,391 213,108 232,595 316,598

Touring motorcycle units 107,213 99,496 92,002 81,927 84,104 101,887

Custom motorcycle units 102,950 96,425 91,459 87,158 91,650 140,908

Sportster motorcycle units 50,308 51,704 49,656 41,409 47,269 60,684

Other motorcycles 0 0 274 2,614 9,572 13,119

enter the market with the purchase of an inexpensive Japa- nese bike and eventually graduate to a heavier, more expen- sive and powerful Harley. But this wasn’t what Honda had in mind. As demand for Honda’s smaller motorcycles in the U.S. increased, Honda gradually introduced its heavier more powerful models, including the 100 cc, 150 cc, and 250 cc bikes. The market responded positively, and buyers who couldn’t afford the pricier Hogs and those who struggled to muscle the heavyweight Harleys around steep curves gladly purchased a Japanese bike. As a result, Honda’s U.S. sales increased from $500,000 in 1960 to $77 million in five years (see Exhibit 3).24

This transformation in the motorcycle market was both good and bad for Harley-Davidson. As predicted by Harley leadership, Honda’s entrance in the U.S. market spurred new consumer interest in motorcycles. As a result, Harley-Davidson saw its sales almost double from $16.6 million in 1959 to $29.6 million in 1965. However, because Honda’s sales grew by a fac- tor of 10 over the same time period, Harley lost its position as the market leader.

Despite Honda’s growth, Harley’s leadership denied that the smaller bikes were a threat. In 1966, the president of the company, William H. Davidson, son of one of the company founders, said the following in Forbes:

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[ C-48 ] CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD

Basically we do not believe in the lightweight market. We believe that motorcycles are sports vehicles, not transportation vehicles. Even if a man says he bought a motorcycle for transportation, it’s generally for leisure time use. The lightweight motorcycle is only supplemental. Back around World War I, a number of companies came out with lightweight bikes. We came out with one ourselves. We came out with another one in 1947 and it just did not go anywhere. We have seen what happens to these small sizes.26

The numbers, however, told a different story. The three Japanese heavyweights, Honda, Yamaha, and Suzuki, controlled a dominating 85 percent of the U.S. market.27 Moreover, it was clear that Honda wasn’t content with just being the lightweight bike leader and intended to continue introducing heavier models into the markets it had developed. But, with no competition from the Japanese in the heavyweight market (650 cc motorcy- cles and larger), Harley essentially ignored its emerging competitors.

[ Exhibit 3 ] Honda Price Experience Curves.25

100

400

300

200

100

300

200

100 2 4 6 8 1 2 3 4

200

300

400

500

Price CB750

85% Slope

Honda prices in U.S.

Retail list price (¥000, 1965)

Honda’s Cumulative Volume (Million Units > 250 cc)

Honda prices in Japan

Year 68 69 70

CB450

CL350

87% Slope

71 72 73 74 75

Source: Company annual reports.

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CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD [ C-49 ]

Harley went public in 1965, and in a friendly takeover, the company was acquired by American Machine and Foundry (AMF), which had been looking to expand their portfolio into leisure goods. AMF recognized the growth potential of the motorcycle market and wanted a slice of the prof- its. When asked about AMF’s decision to acquire Harley- Davidson, then CEO of AMF, Rodney Gott, explained, “There was a motorcycle craze. You could sell anything you could produce. We wanted to meet [this] demand.”28 But there was a problem: Harley-Davidson’s production tech- niques were outdated.

Each Harley-Davidson motorcycle was essentially crafted by hand, using job-shop production techniques, and required detailed attention from a skilled workforce. However, hiring and training a skilled workforce took more time and money than AMF was willing to expend. As a result, AMF added less-skilled workers to the assembly line and expanded pro- duction from 15,475 units in 1969 to 70,000 units in 1973. But the increase in output came with a significant drop in motorcycle quality.29 When asked to describe the deteriora- tion of the Harley brand, Richard Teerlink, the firm’s CFO during the time of the increase in production, explained, “In the early ‘80s, Harley’s reputation for reliability and quality had fallen as steeply as its market share, which had dropped from 100% of the domestic market to a low of 23%. Brand new Harleys sitting on the dealership floor had to have card- board put down beneath them to sop up the leaking oil.”30 The drop in quality soon extended to a drop in the brand’s reputation, and Harley-Davidson bikes earned the nickname “Hardly Drivable.” However, the bad news for Harley didn’t stop with nicknames.

In 1975, Honda introduced its first 1000 cc motorcy- cle, the highly anticipated heavyweight Goldwing, which brought with it the most sophisticated technology for a heavyweight bike at the time. Furthermore, the Goldwing offered consumers a quiet alternative to the loud Harley, and it did so with better reliability at a lower price. Conse- quently, Goldwing sold almost 100,000 units in the first four years. Although an excellent penetration in the heavyweight bike segment, it only amounted to a small fraction of the more than 5 million motorcycles Honda was selling world- wide at the time. Slowly, more Japanese heavyweight bikes entered the market, and to Harley-Davidson’s horror, its market share in the heavyweight segment dropped. Harley now faced a daunting situation—poor product quality drove away nontraditional customers at the same time that its tra- ditional customers were switching to Japanese motorcycles. It appeared as if Harley was headed for bankruptcy.

HARLEY’S REDEMPTION By 1980, amid mounting competition, AMF decided to sell Harley-Davidson to Harley CEO Vaughn Beals and a small group of Harley-Davidson managers. However, Beals was only able to raise a small portion of the $81 million buyback price and took the rest on as debt.31 With Harley’s profitabil- ity already down, the highly leveraged buyout obligated the

new owners to pare down costs by decreasing motorcycle production and laying off employees. The move was a major blow to company morale, but by this point Harley-Davidson was simply trying to survive.

In order to avoid financial disaster, Harley needed to improve product reliability and get production costs in line with its Japanese competitors. As Beals explained, “Harley- Davidson’s production system was basically flawed. In this system, we gave the worker responsibility for quantity, not quality. Then we set up a whole police force for quality and a battalion of accountants to measure errors made in pro- duction.”32 Referring to some of the differences in quality between Honda and Harley-Davidson, experts explained that “only 5% of Honda’s motorcycles failed to pass final qual- ity inspection,” while “over 50% of Harley’s failed the same test.”33 Moreover, compared to its Japanese competitors, Har- ley was producing subpar bikes less efficiently. According to Harley-Davidson’s internal estimates at the time, overall Japanese productivity was over 30 percent greater than at Harley-Davidson.34

To understand how the Japanese manufacturers pro- duced motorcycles at such a high level of quality and quan- tity, Tom Gelb, Harley’s senior vice president for operations at the time, along with a group of other senior Harley man- agers, arranged a tour of Honda’s Ohio plant. Of that experi- ence, Gelb explained, “The [Honda] assembly line was neat and uncluttered—unlike our operation, where the line was always littered with parts and material. There was minimum paperwork and things flowed very smoothly.”35 One reason for Honda’s smooth flow surprised the Harley executives. Unlike Harley’s expensive and inefficient computerized inventory system, the Japanese employed noncomputer- ized just-in-time ( JIT) production methods that required far less buffer inventory for both work-in-process (WIP) and finished motorcycles. Furthermore, Honda built each bike to order, instead of building for inventory.36 Jeffrey Bleus- tein, Harley’s senior vice president for parts and accessories, admitted, “[The Japanese]…were just better managers…and they understood how to do manufacturing a hell of a lot bet- ter, with less inventory and much higher quality.”37

Beals realized that, in order for Harley to survive, it needed to dramatically change its manufacturing system— and fast. To give the company some time to implement these changes, Harley sought tariff protection, a fee imposed on a foreign company’s product that increases its price in the marketplace, from the U.S. government. Fortunately for Har- ley, in 1983, the International Trade Commission granted the American manufacturer a five-year protection tariff on heav- yweight (above 700 cc) motorcycles imported from Japan.38 With no time to waste, Harley went to work and took three steps to improve its production and quality.

First, line workers were encouraged to contribute to the decision-making process. Workers were required to participate in the newly formed quality circles that were made directly responsible for improving motorcycle quality. Second, a materials-as-needed

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[ C-50 ] CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD

(MAN) program, the company’s version of Honda’s JIT inventory control practices, was implemented to free up much-needed cash by reducing work-in-process (WIP) inventory. It was hoped that lowering the inventory levels would make quality problems more apparent and force employees to take action. Third, under SOC [statistical operator control], employees were taught to see how quality problems developed and how they could be traced and corrected during the production process.39

As a result of the changes to the manufacturing process, Har- ley’s productivity and reliability improved dramatically. The new system reduced WIP inventory by 75 percent and low- ered scrap and rework by 68 percent. Moreover, the increased efficiency was accompanied by an increase in labor produc- tivity of over 50 percent, and the reliability of Harley-David- son motorcycles improved substantially. It took some time, but Harley’s new-found ability to produce higher quality bikes at lower cost resonated with customers. The improved motorcycles led to a growth in Harley’s U.S. revenues of over 80 percent over the next five years and an increase in operat- ing profits of $59 million.40 As proof of Harley’s comeback and an indicator of a bright future, the company went public for the second time in a well-received IPO in 1989. To celebrate, Harley initiated a motorcycle parade down Wall Street.41

HOG HEAVEN In the late 1980s, Harley-Davidson began to recover, but it hadn’t proved its potential for sustainable growth in rev- enues and profitability. The change in leadership brought with it a number of improvements for getting Harley bikes up to par with competitors. Furthermore, more efficient pro- cesses in manufacturing helped improve the motorcycles while cutting costs. Dealerships also worked hard to provide a better buying experience for customers. But even though these changes helped Harley get back on its feet, they weren’t enough to make the company compete effectively. To do that, the American manufacturer decided to refocus its marketing campaign on what it meant to own a Harley-Davidson.

Despite the shattering of the company’s reputation for quality, some key pieces of Harley’s identity were kept intact. For example, the bike was still considered to be a symbol of Americana and American manufacturing. After all, it was the American-made bike of choice for famous celebrities Elvis Presley and James Dean. In short, owning a Harley-Davidson motorcycle still had the aura of rugged American individual- ism. As CEO Jim Ziemer explained, “One of the main things that gives us an edge over the competition is that we sell more than just motorcycles and related products—we sell a complete experience.”42 Leveraging this competitive advan- tage, Harley developed several ad campaigns that depicted riders living the “complete experience.” In one Harley com- mercial, a group of bikers pull up to a rural gas station where a man, visibly impressed by the motorcycles, is filling up his car. As one of the bikers starts to fuel his bike, the man says, “Nice Harley.” The biker responds with “thanks,” and he con- tinues to concentrate on filling up his tank. The guy at the car

adds, “Yeah, I was going to get one of those myself but, uh, spent the sixty-four-ninety-five on a killer dinette set.” The biker looks up at the driver with an expression of incredulity. A woman biker who overhears the conversation also stares in disbelief. The man at the car continues, “It was tough, ya’ know. Harley or dinette set—Harley or dinette set.” There is a pause as both the bikers stare at the man who halfheartedly admits, “Went with the dinette set.”43 This commercial and others like it that Harley aired presented a powerful question to the viewer: Who are you and what do you want out of life?

Another part of the complete experience that Harley emphasized was bike customization, which helped riders express their rugged individualism. The “Build Your Bike” fea- ture on Harley-Davidson’s website offered different combina- tions of rims, seats, bags, and other features, that a customer could fit on several unique bike styles. After the bike was ordered, dealers and salesman had catalogs with almost 900 pages of additional add-on options from which the enthusi- ast could select to further customize.44 The customization process became so popular that Harley-Davidson offered customers financing up to 60 percent above the price of a base-model motorcycle through its own financing program, Harley-Davidson Financial Services (HDFS).45 The Harley- Davidson biker culture encouraged motorcyclists to further customize and show off their bikes at the Harley-Davidson community fun rides and rallies each year.

In order to support the Harley-Davidson culture and community Harley sponsored the development of numer- ous enthusiast and social groups. The most popular of these groups was the Harley-Davidson Owners Group (HOG). Formed in 1983, the HOG was created to encourage riders to become more involved with other local Harley owners and in motorcycling events, including state rallies, anniversary celebrations, and scavenger “touring” hunts.46 In 30 years the HOG grew to over 1 million members, making it the world’s largest motorcycle enthusiast organization.47 The cost of membership includes owning a Harley and paying for a HOG membership, which ranges from a $25 annual fee with lim- ited benefits to $120 for three years with full benefits, includ- ing roadside assistance, magazines, touring guides, and access to all rallies. HOG chapters organize rallies, fun rides, charity support, and other events that reinforce a sense of community and identity among riders. In describing how HOG has influenced Harley’s success an article in Business- Week said the following:

[T]he real buzz comes from the 886,000 members of the company-sponsored Harley Owners Group. They are the ones who organize rides, training courses, social events, and charity fund-raisers. They pore through motorcycle magazines and wear the Harley-branded gear to feel more like rugged individualists and outlaws when they take to the road on weekends. A quarter of a million of them descended on Milwaukee last Labor Day to celebrate the brand’s centennial. No wonder more than half of new Harley sales are to current customers who are trading up. The brand is self-reinforcing.48

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CASE 05 HARLEY-DAVIDSON: GROWTH CHALLENGES AHEAD [ C-51 ]

Members of the HOG organized local communities of riders and made sure there was a culture of buying up Harley para- phernalia. Historically, HOG members spent an average of 30% more on the Harley-Davidson gear compared to other Harley owners. However, that gear was not limited to motorcycle parts for customization. It also included accessories such as leather jackets, key chains, lampshades, Christmas tree orna- ments, and even a special edition Barbie. Harley owners were willing to buy almost anything with the Harley logo on it.

Harley-Davidson decided to start licensing its brand aggressively in the mid-1980’s when Clyde Fessler, the com- pany’s then vice president for business development, saw that Harley needed to give people access to the Harley experience whether they owned a bike or not.49 Mr. Fessler launched a successful licensing strategy campaign and created the Har- ley-Davidson Motorclothes line, which enabled enthusiasts to benefit from the Harley experience more often and increased brand awareness.iii As a result, the bar and shield logo became the company’s most valuable asset. In 2013, the Harley-David- son was considered the ninety-sixth most valuable global brand and was expected to continue to increase in value.50

Fessler recognized the need to protect Harley’s brand image, and as a result, the company’s licensing department developed strict guidelines. First, after submitting a proposal and design of what the final product will look like, the licen- see was required to get Harley-Davidson approval to create a prototype. After receiving approval, the merchandiser was then required to send a sample of the product and await final approval. When final approval was given, the merchandiser could then produce its branded product, but it was respon- sible for advertising and distributing the product across the dealer network. Lastly, Harley collected royalties for each sale—typically in the range of 10-30 percent. Licensing its brand has proven to be an extremely profitable way for Harley to grow revenues. Indeed, revenue from licensing sales made up roughly 25 percent of Harley-Davidson profits in 2012.

LOOKING FOR GROWTH: INTERNATIONAL MARKETS Throughout its storied history Harley Davidson had been a U.S.-centric company with the majority of its sales com- ing from the United States. Critics have argued that Harley hasn’t moved fast—or effectively—enough overseas, either to establish low-cost factories or to find new customers.51 These criticisms come despite the fact that Harley has expanded sales to 70 countries around the world. However, less than 20 percent of Harley’s sales come from outside of the United States.

It wasn’t really until the year 2000 that Harley looked to expand its footprint into international markets because the U.S. market had matured. However, while international mar- kets seemed to be a potentially attractive way to grow, Har- ley found international expansion to be quite challenging.

iii The Harley-Davidson Motorclothes line accounts for an average of $210

million in revenue every year.

Harley’s entry into mainland China, for example, illustrates the company’s challenges.

Harley-Davidson’s entry into China started in the Hong Kong market in 1995 and served as a launching pad for entry into Mainland China, which occurred 10 years later with a dealership in Shanghai. However, it quickly became appar- ent that Harley’s heavyweight bikes would have a tough time selling in the country. Sean Jiang, managing Harley-David- son director for China, described some of the problems:

Regulations make it difficult for consumers to buy and ride motorcycles—mostly because it is difficult to get a license plate. Plus, China has a compulsory scrap policy that dictates all bikes must be scrapped after 11 years. China’s regulations were set some 20 years ago when conditions were quite different. The smaller bikes that were mass produced then were generally of poor quality. Road conditions and traffic management were also poor. The bikes caused safety, traffic, and pollution problems. These bans still remain in effect today, even though motorcycle quality, road conditions, traffic management, and rider profiles have all changed.52

The regulations that made selling Harley’s heavyweight bikes a challenge were only part of the company’s uphill battle to sell motorcycles in China. Import duties in China could add 30 percent to the sticker price on a new Harley, and ship- ping could add an additional 5-10 percent to the bottom line.53 For example, in 2013, The Touring Ultra Classic Electra Glide, which cost $21,800 in the U.S., started at 340,000 Yuan ($53,000) in China. This high price limited the motorcycles’ potential customer pool to the wealthy. As Jiang explained, “Because of the import structure and high pricing, our cus- tomers here have a much higher disposable income.”54 The price problem was made more complicated because of the availability of less-expensive substitutes. Honda, which has had a long presence in China, sold 1.29 million units in China in 2010, compared to Harley, which only sold 268 motorcy- cles in the same year. Put another way, 2010 saw more Har- ley’s sold in one Milwaukee dealership than all of China.55 To help mitigate this problem, Harley turned to diplomacy in order to promote the brand and reduce import tariffs. During a tour of China, Wisconsin Governor Scott Walker participated in Harley-Davidson’s 110th anniversary celebra- tion to help promote the brand.56 He met with President Xi Jingping to mediate for the American manufacturer amid political accusations of unfair trade practices. However, the meeting made little difference, and Harley continued to face high tariffs and competition from several well-known Chi- nese manufacturers such as Lifan and Loncin (each of which produced over 1 million units). Jiang noted:

In 2010, China produced 27 million motorcycles, 99 percent of which were small, easily affordable bikes—such as mopeds—used for basic transportation. Only a couple of domestic manufacturers make models with engines sizes up to 600 cc. For comparison, Harley- Davidson’s smallest engine is 800 cc, and ranges up to a

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[ C-52 ] REFERENCES

very large 1,600 cc. The concept of heavyweight leisure motorcycles is not yet understood in China. There’s no infrastructure, wholesale or retail financing, insurance, or roadside assistance, as compared to China’s more mature auto industry. Because the segment isn’t yet established, consumers in China have little awareness of heavyweight motorcycling as a leisure activity.57

In addition to the challenges associated with regulations and price, Harley had to figure out how to help customers in China and other international markets appreciate the Harley brand and the value associated with being part of the Harley com- munity. In 2006, as part of that effort, Harley launched the first HOG chapter in Beijing, China, and progressively sponsored numerous rides and rallies through its 11 Chinese dealerships. With these initiatives, Harley hoped to gradually gain traction in the large Chinese market. As the company looked to expand into new markets and customer segments, Harley continued to focus on ways to help potential customers understand the meaning of owning a Harley-Davidson motorcycle.

RIDING INTO THE UNKNOWN Under the June super moon, a group of bikers cruise the open road in the southern Utah desert under the collective thud- ding of their Harley Davidson V-twin engines. These friends were united years ago by their mutual love for riding and adventure. Ever since their first exhilarating ride together, they meet at least once a year and go on a new trek, making lifelong memories on the journey. Suddenly, as the twilight appears on the eastern horizon, an incoming telephone call appears on the bike’s dashboard. The rider looks down to see who’s calling—it’s his boss. The biker with a subtle grin uses the thumb-operated joystick to toggle from “Answer” to “Ignore” and goes back to his joy ride.

That scene, taken from a Harley-Davidson com- mercial , is part of the largest new-model launch in Harley-Davidson’s histor y : “Project Rushmore.”58 The launch involved eight new motorcycles with dra- matic shifts in both technology and feel—areas that traditional Harley riders might consider sacrilege to change. But to Harley, these changes were far over - due. Critics claimed that Harley was too dependent on older white males and wasn’t diversifying its owner base quickly enough . Nor was Harley keeping up with Asian competitors, such as Honda and Kawasaki , in quality or productivity.59 As part of the transforma- tion , the new bikes were designed to vibrate less and included gadgets more technologically advanced than those on any bike Harley had previously produced .60 However, for Wandell and his team , it was still unclear if Project Rushmore would be enough to help Harley overcome the challenges the company faced , such as attracting nontraditional riders and growing in inter- national markets. Would higher quality and more tech- nologically advanced motorcycles open new doors to future growth? Indeed , was it a good idea for Harley to focus more on product attributes such as quality and technology, areas where competitors had historically been stronger? Moreover, could the Harley brand and product transcend U.S. culture to connect with new customers in international markets? Was it worth the investment? Finally, had Harley maximized its oppor- tunities to grow by licensing its brand to merchandis- ers? Or could the company grow by expanding into other product categories beyond motorcycles? These questions, and others, faced Wandell and his team as they looked for ways to keep Harley growing.

REFERENCES

1 Brad Tuttle, “The Harley-Davidson Surprises: Touchscreens, Voice Control and Women Bikers,” Time Business &

Money (September 3, 2013). Available at http://business.time.com/2013/09/03/the-harley-davidson-surprises/.

2 Interbrand, “Best Global Brands 2013,” Interbrand. Available at http://www.interbrand.com/en/

best-global-brands/2013/Harley-Davidson.

3 Harley-Davidson, Inc., 10-K Annual Report, 2012.

4 Harley-Davidson, “Investor Relations: Demographics,” Harley-Davidson USA (2013). Available at http://investor.

harley-davidson.com/phoenix.zhtml?c=87981&p=irol-demographics.

5 Ibid.

6 Ibid.

7 Harley-Davidson internal research, September 2007.

8 Richard L. Nolan and Suresh Kotha, Harley-Davidson: Preparing for the Next Century (Cambridge, MA: Harvard

Business School, 2006), p. 3.

9 Alex Taylor III, “The Hurdles at Harley-Davidson,” CNN Money (October 3, 2012).

10 Harley-Davidson, “H-D Timeline,” Harley-Davidson Museum. Available at http://www.harley-davidson.com/

en_US/Content/Pages/HD_Museum/explore/hd-timeline.html.

11 Ibid.

http://business.time.com/2013/09/03/the-harley-davidson-surprises

http://www.interbrand.com/en

http://investor

http://www.harley-davidson.com

REFERENCES [ C-53 ]

Case_ch05.indd 07:10:36:PM 02/20/2015 Page 53Trim Size: 8.5 in X 11 in

12 Ibid.

13 Ibid.

14 Nolan and Kotha, p. 2.

15 Ibid.

16 Harley-Davidson, “H-D Timeline.”

17 Ibid.

18 Ibid.

19 Nolan and Kotha, p. 2.

20 Evelyn T. Christiansen and Richard Tanner Pascale, Honda (A) (Cambridge, MA: Harvard Business School,

1983), p. 1.

21 Ibid., p. 2.

22 Ibid., p. 3.

23 Advertising Age (December 2, 1965).

24 Christiansen and Pascale, p. 2.

25 Christiansen and Pascale, p. 7.

26 Forbes (September 15, 1966).

27 Christiansen and Pascale, p. 2.

28 Peter C. Reid, Well Made in America: Lessons from Harley-Davidson on Being the Best. (New York, NY: McGraw-

Hill, 1990) p. 6.

29 Nolan and Kotha, p. 4.

30 Reid, p. 6.

31 Nolan and Kotha, p. 5.

32 Reid, p. 18.

33 Nolan and Kotha, p. 5.

34 Ibid.

35 Reid, p. 4.

36 Nolan and Kotha, p. 5.

37 Reid, p. 15.

38 Harley-Davidson, “H-D Timeline.”

39 Nolan and Kotha, p. 6.

40 Statistics quoted from Reid.

41 Nolan and Kotha. Harley-Davidson, pg. 6.

42 Harley-Davidson Company, Code of Business Conduct, p. 26.

43 Harley-Davidson. “Dinette Set.” Television advertisement. Carmichael Lynch, directed by Tom De Cerchio, 2004.

44 Harley-Davidson Company, Harley-Davidson Genuine Motor Parts & Accessories 2014, 2014.

45 Interview with Rick Story, Dealer Manager at Harley Davidson’s Lindon, Utah, dealership.

46 Harley-Davidson, “H-D timeline.”

47 Chris Denove and James D. Power, IV, Satisfaction: How Every Great Company Listens to the Voice of the Customer,

(2007), p. 195.

48 “Cult Brands,” BusinessWeek (August 1, 2004).

49 Glenn Rifkin, “How Harley Davidson Revs Its Brand,” Strategy+Business (October 1, 1997).

50 Rita Clifton, John Simmons, and Sameena Ahmad, Brands and Branding; The Economist Series 2nd Edition (New

York, NY: Bloomberg Press, 2004).

51 Alex Taylor III, “The Hurdles at Harley-Davidson,” CNN Money (October 3, 2012).

52 Paula M. Miller, “Harley-Davidson in China,” China Business Review ( January 1, 2012).

53 Kae Inoue, ed., “Harley-Davidson in China Encounters Barriers of Entry for Two Wheels: Cars,” Bloomberg News

(September 18, 2011).

54 Ibid.

55 Ibid.

56 Jennifer Harper, “China has Harley-Davidson Fever, Thanks to Gov. Scott Walker,” The Washington Times (May

17, 2013).

57 Paula M. Miller, “Harley-Davidson in China,” China Business Review ( January 1, 2012).

58 Fogelson, “Project RUSHMORE: 2014 Harley-Davidson Motorcylces,” Forbes (September 3, 2013).

59 Taylor.

60 “Rushmore Bikes Lead to Positive Q3 for Harley-Davidson,” Powersports Business (October 22, 2013).

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[ C-54 ]

P aul Otelleni was getting ready to leave his position as CEO of Intel and turn over the reins to Brian Krzan-

ich, who was currently Intel’s COO.1 Looking back, Otellini was proud of his accomplishments at Intel over the past eight years. Although revenue and the company’s stock price had been flat during Otelleni’s watch, shareholder dividends had grown at an average rate of over 13 per- cent, and he had positioned the company for the future by growing capital investments and research and devel- opment expenditures in the face of slower sales and stock price growth. Exhibit 1 displays Intel’s financial perfor- mance over Otelleni’s tenure.

The company’s biggest bets had come in diversification through acquisition; between 2005 and his retirement in 2013, the company purchased a dozen companies. By far the largest of these acquisitions was the 2011 purchase of McA- fee for $7.68 billion.2 McAfee represented a huge gamble by Intel to enter the software security business, and whether Intel could create value through the purchase was an open question. Otelleni realized it may be the biggest challenge his successor would face as he tried to regain Intel’s leader- ship in a rapidly changing semiconductor business.

A CHANGED INDUSTRY: THE RISE OF ARM-POWERED SMART DEVICES When Paul Otelleni became CEO of Intel, the company was the undisputed market leader in both the personal com- puter (PC) and server markets. The PC market had grown from 218 million units shipped in 2005 to almost 353 million units in 2012 (6.2% CAGR), but it represented a declining share of the overall computing device market. Yet, since Apple introduced its revolutionary iPhone in June of 2007, the market for “smart phones” had grown from almost nothing to 700 million units shipped in 2012 (a CAGR of over 126%)!3

Tablet computers had also displaced the traditional PC, with Apple’s iPad leading the way. Introduced in April of 2010, the iPad shipped over 3 million units in its first quarter. By the end of 2012, there were over 121 million iPads in use,4 and every major computer company introduced its own ver- sion of a tablet computer. Although Intel’s core market for PCs had grown at a respectable rate, in 2013, the PC mar- ket was widely considered to be an industry in long-term decline. Exhibit 2 shows projections for sales of different platforms of computing devices.

CASE 06 Intel (B): Responding to the Smart Phone Threat

[ Exhibit 1 ] Intel Financial Performance, 2005–2012.

Year 2005 2006 2007 2008 2009 2010 2011 2012 CAGR

Net Revenue ($ billions) 38.8 35.4 38.3 37.6 35.1 43.6 54 53.3

Growth Rate –8.76% 8.19% –1.83% –6.65% 24.22% 23.85% –1.30% 4.05%

Earnings per share ($) 1.4 0.86 1.18 0.92 0.77 2.01 2.39 2.13

Growth Rate –38.57% 37.21% –22.03% –16.30% 161.04% 18.91% –10.88% 5.39%

Dividends per share paid 0.32 0.4 0.45 0.55 0.56 0.63 0.78 0.87

Growth Rate 25.00% 12.50% 22.22% 1.82% 12.50% 23.81% 11.54% 13.32%

Capital Expenditures

($ Billions)

5.9

5.2

4.5

5.2

10.8

Growth Rate 0.00% –15.25% 4.00% –13.46% 15.56% 107.69% 1.85% 8.10%

Research and

Development ($ Billions)

5.1

5.9

5.8

5.7

6.6

8.4

10.1

Growth Rate 15.69% –1.69% –1.72% 0.00% 15.79% 27.27% 20.24% 8.92%

Closing Stock Price

($, 01 July)

26.21

19.27

23.88

21.57

17.04

19.25

22.53

26.51

Growth Rate –26.48% 23.92% –9.67% –21.00% 12.97% 17.04% 17.67% 0.14%

Source: Intel Corporation, Annual Reports, 2008, 2012. And, stock price data from Intel Corporation.

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CASE 06 INTEL (B): RESPONDING TO THE SMART PHONE THREAT [ C-55 ]

When Otelleni assumed command at Intel in 2005, the company enjoyed huge margins and, in spite of the cyclical nature of semiconductor sales industry, robust and profit- able sales growth. Intel had almost no market share in the new market for smart phones and tablets, with sales barely reaching 1% of the mobile market in 2012.5 How had Intel missed the boat in this new industry? After all, Intel had cre- ated the microprocessor, the basic component that powers PCs, smart phones, and tablet computers. Since the intro- duction of the first chipset, the 4004 processor, Intel had relentlessly pursued a simple strategy: Obey Moore’s law, which states that every 18-24 months the number of transis- tors on a silicon chip doubles, dramatically increasing per- formance while halving the real cost of that performance.

Intel had followed Moore’s law, with the result being a product line of very powerful chips for a wide array of users. The Achilles heel in the Intel strategy could be found in the power usage of its chips. In the PC world of the 1980s to the 2000s, when PCs were all plugged into a wall socket, a power drain didn’t matter. Intel’s processors, the Core i7 line, intro- duced in 2008, had a thermal design power of between 95 and 150 Watts.6 Thermal design power refers to the amount of power a computer’s cooling system requires to dissipate the heat generated by the microprocessor. In chasing increased processor performance, Intel had created a product line that consumed massive amounts of battery power. In contrast, Intel’s new competitor in the mobile space, ARM, had chips in use that required only 1.9 Watts.

In a word, Intel had seen its growth potential disrupted.7 Mobile device users valued a sustainable “untethered expe- rience,” the ability to use the device for long periods of time without draining the battery. In the power-rich world of PCs, performance mattered, and the greater the performance a chip could provide, the more intensive the software applica- tions could be. Complex and sophisticated programs such as Microsoft Office ran very well on Intel’s high-performance chips. Mobile devices such as smart phones used very sim- ple mobile apps and downloaded basic versions of web- sites and other internet material. Performance, rather than being a competitive advantage, now became a disadvantage because unneeded capacity simply exhausted the battery more quickly.

INTEL’S NEW COMPETITOR: ARM The company that would become ARM Holdings, PLC, began operations in 1979 as Acorn Computers, a company hoping to create—and cash in on—what it believed would be a huge demand for very low-priced personal computers.8 By 1981, the company produced a computer sold as a kit to be assembled by the end user. The kit sold for £ 40 (about $80).9 To reach such a low price point, Acorn designed all of its components in-house. Acorn won a contract with the British Broadcasting Corporation (BBC) to produce a new computer, the BBC Micro. The company assigned two engineers, Sophie Wilson and Steve Furber, to design a new microprocessor for the machine.

[ Exhibit 2 ] Growth in PC Market and Related Industries (all numbers in millions)

Device type 2012 2013 2014 2017 CAGR

PC (Desktop & Notebook) 341,263 315,229 302,315 271,612 –3.73%

Ultramobile (e.g., Chromebook) 9,822 23,592 38,687 96,350 46.31%

Tablet 116,113 197,202 265,731 467,951 26.15%

Mobile Phone 1,746,176 1,875,774 1,949,722 2,128,871 3.36%

Total 2,215,386 2,413,810 2,558,469 2,966,801 4.99%

–

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

2012 2013 2014 2017

Mobile Phone

Tablet

Ultramobile (e.g.,

Chromebook)

PC (Desktop &

Notebook)

Source: Data from the Gartner Group.

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[ C-56 ] CASE 06 INTEL (B): RESPONDING TO THE SMART PHONE THREAT

As a part of the design process, Wilson and Furber visited the Western Design Center in Phoenix, Arizona, a company that had been working on a similar chipset. They expected to find a large engineering center and fabrication facility. What they found was a very small operation and no pro- duction facility. As Furber later recalled, “A couple of senior engineers, and a bunch of college kids…were designing this thing…We left that building utterly convinced that design- ing processors was simple.”10 Furber and Wilson also realized that, to be profitable, a company did not need to incur all the expenses of production; licensing their designs to others and earning a nice royalty could be a path to profit.

Wilson did most of the design work for the new chip back in England. The new 32-bit chip, developed by 1984, used 25,000 transistors. By contrast, Intel’s 286 Chip, introduced in 1982, featured 134,000 transistors. The goal of the design process had been to produce a very inexpensive chip, so the team used plastic packaging, which meant the chip needed to have thermal resistance somewhere under 1 Watt. When Wilson and Furber tested the chip, they had the surprise of their professional lives. The power meter they used to test the equipment didn’t even register: the pair had designed a chip that ran on no more than one-tenth of a Watt! The Acorn chip was a simple chip that ran with very little power.

Acorn Computers did not survive, but the chip would live on as the design team subsisted on design work for other chip manufacturers and small sales throughout the 1980s. In 1990, ARM incorporated, with Apple and VLSI (their fabrica- tion partner) as the major investors in the new company.11 ARM’s big break came in 1993 when Apple decided to use its chip design in the Newton, the first personal digital assis- tant. Although the Apple device flopped (it was 5-10 years ahead of its time), ARM also had a toehold in the market, with contracts to power Samsung phones. The company

also sold chips to Texas Instruments and became a fixture in the Nintendo DS hand-held gaming system in 2004.

ARM chips powered the Nokia 6110 phone, introduced in 1997. The phone featured several firsts. It was the first phone that worked on both analog and digital networks, the first phone to feature visual menu icons, and the first phone to include a game built in to the device.12 The Nokia phone ushered in the dawn of the smart phone era. ARM became the chip of choice for the emerging market and was a natu- ral choice for the original Apple iPhone. By 2007, ARM chips would command 98 percent of the smart phone market, and in 2011, the company shipped over 8 billion chips.13

ARM took a radically different approach to the chip busi- ness than Intel. Intel essentially chose to vertically integrate chip production and to control the process from design through manufacture and on to marketing. ARM has always specialized in design work, and it invested £166 million in design activities for 2012. Following the lesson learned by Wilson and Furber, ARM licensed its chip designs to others for production. ARM focused solely on design and testing, avoiding the expense of building fabrication ( fab) facilities. A new fab cost upwards of $5 billion in 2013, and ARM avoided the upfront costs, as well as the huge engineering and staff- ing costs. The company built a very strong and profitable business based on this model. Exhibit 3 shows financial data for 2005-2012.

INTEL RESPONDS Intel found itself locked out of the smart phone market by 2007. The company did not sit idly by as it watched the industry migrate toward lower power chips and an Internet, software-centric consumer world. Intel responded to the ARM entry in two ways, through internal product develop- ment and acquisition.

[ Exhibit 3 ] ARM Selected Financial Data

Year 2005 2006 2007 2008 2009 2010 2011 2012 CAGR

Net Revenue (£Millions) 232.4 263.3 259.2 298.9 305 406.6 491.8 576.9

Growth Rate 13.30% –1.56% 15.32% 2.04% 33.31% 20.95% 17.30% 12.04%

Profit Before Tax (£Millions) 40.5 56 45.1 63.2 47.2 110.1 156.9 221

Growth Rate 38.27% –19.46% 40.13% –25.32% 133.26% 42.51% 40.85% 23.63%

Dividends paid (£Millions) 10.4 12.4 18.5 26.4 29 34.3 42.2 51.8

Growth Rate 19.23% 49.19% 42.70% 9.85% 18.28% 23.03% 22.75% 22.23%

Capital Expenditures

(£Millions)

6.06 8.6 5.4 8.7 6.9 7.4 13 33.2

Growth Rate 41.91% –37.21% 61.11% –20.69% 7.25% 75.68% 155.38% 23.69%

Research and Development

(£Millions)

80.3 84.9 84 87.6 112.2 139.7 165.4 166.3

Growth Rate 5.73% –1.06% 4.29% 28.08% 24.51% 18.40% 0.54% 9.53%

Source: All data taken from ARM, Annual Report, 2008, 2012.

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CASE 06 INTEL (B): RESPONDING TO THE SMART PHONE THREAT [ C-57 ]

Product Development. Intel recognized as early as 2004 the need to create a low-powered chip to compete in mobile devices.14 The new chip had to meet three difficult objectives for Intel: Low heat and power requirements that would facil- itate use in mobile devices, low fabrication costs to produce a chip that would compete with ARM’s products, and com- patibility with other Intel chips used in traditional PCs.15 The requirement for backward compatibility had been an organi- zational constant at Intel since the earliest days of the 80286 chipset; Intel believed that customers would be more likely to buy new Intel products as long as their current products would continue to work on the new platform.

The new chip, codenamed Silverthorne, had a head start when it began design. Intel had produced a lower-powered version of many of its chipsets, dating back to the 80386 in the mid-1980s. Unfortunately, as the company moved beyond its original Pentium chip in the 1990s, low power usually meant stripping down the complex architecture of the chip. The chips used less power but ran very slowly. The new Silverthorne project built on the x86 chip architecture; however, the ingrained habit of trying to maximize chip performance created its own momentum, producing chip “creep up” in terms of power usage.

In 2008, Intel introduced its Atom® line of chips to the market. The chips were close to ARM chips in power man- agement; the Atom N200 used 2 W, compared to ARM’s prod- ucts that used 1.9 Watts. The N200 retailed for $44, although customers could purchase a slightly more power-hungry 4 Watt chip for $29. Because the Atom was built on the same architecture, or platform, as the Intel x86 line of chips (essen- tially everything in Intel’s line of PC processors from the early 1990s until the present), the Atom also fit into the Intel chip ecosystem. Customers had access to related processors and components from Intel, as well as Intel’s library of devel- opment software.16 Sales of the new processor showed early

promise as notebook and ultralight device manufacturers adopted the product. Atom had a much harder time over- coming the industry’s emerging preference for ARM chips in order to penetrate the tablet and smart phone markets; the Atom chip had been adopted in only six smart phones by late 2012.17 Exhibit 4 provides data on quarterly sales of the Atom chipsets. The Atom seemed unlikely to capture a share of the critical markets of the early twenty-first century.

Acquisition. Between 2004 and 2012, Intel purchased 12 companies. Exhibit 5 provides details about these acqui- sitions. Many of these acquisitions had a specific goal in mind: to build Intel’s capability and presence in the software industry. The company had a long history in software, dat- ing back to the original 4004 microprocessor introduced in 1970. Intel provided developers with a “blue box,” the SIM 4-01, of read-only memory that provided engineers with the software tools to program the chips for their particu- lar application.18 Each generation of chip included its own basic programming instruction set, and Intel also provided software developers with compilers, instruction sets, and tools that allowed them to write applications for each new generation of chips. With the advent of Web 2.0 in the early 2000s, the need for advanced software capabilities grew. Web 2.0 was a series of software advances that allowed web page sponsors, such as companies, to provide users with a more dynamic experience. New features included secure product ordering and payment, video streaming, and rapid website customization (such as Amazon’s recommended reading list for customers based on their earlier purchases).

Intel found it quicker to purchase these new, dynamic software capabilities rather than develop them in-house. Intel began to branch out from producing the basic software that allowed programmers to write applications compatible with the x86 architecture. Intel also ran its own program for independent software developers and vendors. The company

[ Exhibit 4 ] Quarterly Sales of Atom Chipsets, 2008–2011

20 08

Q 3

20 08

Q 4

20 09

Q 1

20 09

Q 2

20 09

Q 3

20 09

Q 4

20 10

Q 1

20 10

Q 2

20 10

Q 3

20 10

Q 4

20 11

Q 1

20 11

Q 2

20 11

Q 3

20 11

Q 4

100

150

200

250

200

300

219

362

415 438

355

413 396 391

370 352

269

167

300

350

400

450

500

Atom CPU Sales ($ Millions)

Source: Anton Shilov, “Intel Atom technology continues to lose popularity and PC market,” Xbit laboratories (January 20, 2012).

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[ C-58 ] CASE 06 INTEL (B): RESPONDING TO THE SMART PHONE THREAT

[ Exhibit 5 ] Intel’s recent acquisitions

Year Target Business

2004 Elbrus/ Unipro Compilers (Russia)

2005 Sarvega XML code, engineers and IP

2007 Neoptica Visual recognition software

2007 Havok Computing game engine, middleware

2008 OpenedHand Linux User Interface, Mobile experience

2009 Offset Computing game visuals and middleware

2009 Wind River Embedded devices software

2009 Click Arts Parallel programming for multi-core processors

2010 Virtutech Virtualized systems development

2011 Nordic Edge Security solutions, identity management, authentication

2011 McAfee Security, spyware, virus protection

2011 Telmap Navigation and location services, search

Source: Caulfield, 2012.

had trained over 20,000 vendor software engineers by 2012 to write for the Intel hardware platform. Intel pushed hard to create a set of software applications for supercomputers, very high-end and complex computers that ran the most sophisticated scientific programs, such as weather modeling and forecasting. Intel had also entered software markets tar- geted at end users. For example, the company had a team of engineers to support the development and diffusion of Linux, the public domain ( free) operating system. Intel pro- vided software packages and support to almost 3,000 schools and other educational institutions. By 2011, the company generated almost $2 billion in revenue from software sales, making Intel one of the 10 largest software vendors in the United States.19

Intel’s 2009 purchase of Wind River Systems exemplifies the company’s strategic thrust into software. Intel purchased the company in an all-cash deal valued at $884 million. The purchase price represented Intel’s largest acquisition in over a decade. Wind River writes software for “embedded devices”—electronic modules that function within larger machines. Embedded devices include many non-PC applica- tions, such as smart phones, automobile entertainment sys- tems, other consumer electronic goods, and a broad range of robots. Renee James, the Intel executive in charge of the soft- ware business at the time, said, “This acquisition will bring us complementary, market-leading software assets and an incredibly talented group of people to help us continue to grow our embedded systems and mobile device capabilities. Wind River has thousands of customers in a wide range of markets, and now both companies will be better positioned to meet growth opportunities in these areas.”20

Intel typically integrated acquisitions in one of three ways.21 A full acquisition meant that the acquired company

would be absorbed into the larger Intel structure; all the operating elements of the business become fully integrated with existing Intel systems, reporting structures, and goals. The acquired company ceased to exist. In a partial, or hybrid, integration, Intel integrated certain components into the company—usually on the operational, or non-customer- facing “back-end.” The hybrid model allowed Intel to capture and develop things such as engineering talent, patented tech- nologies, or important processes, while leveraging the exist- ing brand and marketing abilities of the acquired company. Finally, Intel also managed acquisitions as a standalone busi- ness; the acquired company became a wholly owned subsidi- ary of Intel but did not integrate any systems with Intel.

When Intel purchased Wind River, 85 percent of the company’s business did not use Intel architectures, and Wind River customers were rightly concerned about the company’s commitment to their platforms. Intel chose to run Wind River as an independent, wholly owned subsidi- ary. Ken Klein, Wind River CEO, commented on the value of this arrangement: “We’ve been able to cement the level of trust that our customers and partners have in Wind River. Because we’ve been allowed to operate independently, we’ve been able to win over customers not only on Wind River, but I think [the acquisition] also helped to improve Intel’s repu- tation in the industry.”22

Intel hoped to create synergy in the future in three ways. First, by leveraging Wind River’s learning in the embedded and mobile device market, Intel hoped to better serve these markets with its other software and hardware offerings. Sec- ond, Intel believed that over time Wind River would migrate its software platform to the Intel architecture and bring Wind River’s customer base into the Intel family. Finally, Wind River was a large contributor to Linux; one motivation

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CASE 06 INTEL (B): RESPONDING TO THE SMART PHONE THREAT [ C-59 ]

for the purchase was to leverage Wind River’s knowledge in Linux and other operating systems to develop superior prod- ucts in the future.

Intel’s strategy of acquisitions had many critics. Some noted that Intel had gone on an acquisition spree in the early 1990s, and most of those acquisitions had failed, cost- ing shareholders billions. Intel’s rich corporate culture often led to a “not invented here” (NIH) mentality; Intel engineers frequently failed to fully utilize superior hardware or software solutions just because they had been developed outside the company. Intel’s corporate culture of hard-driving excellence came at a steep price.23 As a hardware company, Intel lacked deep and expert technical knowledge in new areas, such as communications and networking chips.24 Some acquisi- tions just died on the vine. Other critics questioned Intel’s real commitment to acquisitions. Intel seemed comfortable in its dominant hardware business and often exhibited little tolerance for risk in new technologies and businesses. Acqui- sitions appeared to fill things in at the margin, without pen- etrating the Intel core.25 Finally, critics accused Intel of acting opportunistically but not strategically. The company often bought revenue, or it overpaid for intellectual property.26

THE MCAFFEE ACQUISITION In August 2010, Intel announced the largest acquisition in its history, an all-cash deal to purchase software security maker McAfee for $7.68 billion. The deal closed in the first quarter of 2011. Like Wind River, McAfee would operate as an independ- ent subsidiary. McAfee’s 2009 sales of $2 billion would add to Intel’s top line growth, but Intel intended to purchase more than just revenue or intellectual property. With its own acqui- sitions of Trust Digital and TenCube, McAfee had a presence in the market for smart phone security software. Paul Otelleni stated the rational for the acquisition: security represented “the third pillar of what people demand from all computing experiences” in the emerging mobile market. The other two pillars were energy-efficient devices and connectivity.27

McAfee enjoyed a colorful history. McAfee was founded in 1987 when software genius John McAfee brought an excellent security software package to market. McAfee sales skyrocketed in 1992 based on the fear of infection by the “Michelangelo” virus, a virus so deadly it would completely erase the hard drive of infected computers. Information about the Michelangelo virus originated with John McAfee, and the predicted computer calamity never occurred. The computing world would not see another panic like this one until Y2K doomsday scenarios appeared at the end of the decade.28 The incident illustrated McAfee’s unconventional views of appropriate business activity, and many customers denounced McAfee for creating a crisis just to sell software. In fact, McAfee had always run second to the much larger Symantec Corporation and its Norton Antivirus suite, a mar- ket position that would never change.

In spite of its unique founder, McAfee proved to be a reli- able competitor. The company offered a suite of security products for consumer and business applications, had very

high brand recognition, a stable market share, and consist- ently owned just over 25 percent of industry sales. Symantec, under its Norton brand, commanded another 33 percent of the market; interestingly, software leader Microsoft had proven unable to penetrate the market and competed in fourth place, with less than 10 percent of the market.29 Symantec and McAfee competed head to head in most markets, and neither competitor had the ability to deliver a knock out punch to the other.

For Intel, the McAfee acquisition presented two intrigu- ing options. First, McAfee’s presence in all facets of soft- ware security, including mobile devices, provided Intel with another point of entry into the mobile market. The real prize for Intel, however, was the possibility of a game changer: the ability to encode security features directly onto a chip. The potential of hardware-encoded security would be huge: cus- tomers would operate at a level of safety and security that would be much more difficult for hackers and others to pen- etrate; rather than merely exploiting gaps, or holes, that left software vulnerable, viruses would need to access the com- puter’s hardwired foundations. A hardware solution protects at a deeper level than the computer’s operating system, and a hardware-driven security platform offered the potential to root out, in real time, the most persistent and troublesome viruses.30

Of course, a hardware-based security system had never been created before, and it raised a number of questions:

Could Intel and McAfee overcome the hurdles involved with creating a new security platform?

Could two large companies, each with huge invest- ments in their current business models and opera- tions, overcome their corporate inertia and cultures to create such a product?

Would the structure of the acquisition—keeping McA- fee as a standalone unit of Intel—prevent the type of communication and knowledge sharing needed to develop new products?

How would the market react? For example, updating software was a rather simple process for most consum- ers. What would the update path look like in a hard- ware-based world? Would customers need to purchase new chips rather than update?

Why should Intel worry about security systems for mobile devices if it had almost no presence in this market?

How would the acquisition affect the McAfee-Syman- tec competition? Would McAfee’s access to Intel tech- nology and funding allow them to finally dominate this market? Conversely, would McAfee become so absorbed with Intel that it would fail to keep pace with Symantec?

CONCLUSION In his last days as CEO of Intel, Paul Otelleni felt a sense of pride and relief: pride at what he had accomplished during

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his tenure in the CEO’s chair and relief that he would not have to face the new competitive environment in which Intel operated. He had inherited the world’s leading semiconduc- tor company, one with an unmatched record for innovation and technological dominance. He had seen that dominance erode through the Great Recession of 2007-2009. However, the greatest challenges to Intel had come from the relentless

“gale of destruction” that Joseph Schumpeter had written about a half century earlier.31 Those winds had blown Intel from an impregnable position to a very exposed one. Intel faced a set of nimble, talented, and well-funded competitors in the emerging markets for its products. Otelleni believed he had positioned the company to withstand the long term trends in the industry and to eventually regain its dominance.

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ter-pc-secur/231601530, accessed September 9, 2013.

31 Joseph A. Schumpeter, Capitalism, Socialism and Democracy (New York, NY: Routledge, 2012).2012

http://www.intelfreepress.com/news/intels-wind-river-acquisition-a-lesson-in-independence/68

http://techcrunch.com/2010/09/19/why-intels-ma-binge-will-fail-buying-growth-is-not-a-strategy

http://news.cnet.com/Intels-failure-to-communicate/2010-1006_3-5132994.html

http://beyondthedeal.net/blog/2010/09/27/ma-is-not-a-strategy-taking-a-look-at-intel-and-hyper-social-organization-cont

http://blogs.wsj.com/deals/2010/08/20/investors-dont-like-intel-mcafee-heres-why

http://techcrunch.com/2010/08/19/intel-buys-cyber-security-giant-mcafee-for-7-68-billion-in-cash

http://www.digitaltrends.com/computing/malware-to-madness-a-brief-his-tory-of-john-mcafees-lunacy-binge

https://www.npd

http://www.informationweek.com/security/intrusion-prevention/mcafee-deepsafe-promises-bet-ter-pc-secur/231601530

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N ike Inc. is the world market share leader in athletic foot- wear, with 44 percent of the world market, compared

to only 30 percent for Adidas/Reebok (see Exhibit 1). The Nike brand alone is valued at $10.7 billion—the most valu- able brand among sports businesses. Many high-profile athletes and sports teams around the world are sponsored by Nike, with endorsers donning the highly recognized “swoosh” logo and the trademark “Just Do It.” But Nike wasn’t always the world leader. In fact, when Nike launched its first product in 1972, Adidas was the worldwide leader in athletic footwear sales, and Converse was the most rec- ognized U.S. athletic footwear brand. Adidas, the German shoe and sports apparel giant, was known for making high- performance shoes and held the dominant market share position. Adidas could not have imagined that, by 1992, Oregon-based upstart Nike would overtake Adidas as the world’s leading athletic footwear company. Moreover, Nike didn’t just surpass Adidas in market share. It also consist- ently generated profitability ratios that were 50-100 per- cent higher than Adidas (see Exhibit 2 and Exhibit 3 for selected financial data). For example, in 2010, Nike’s opera- tion profits-to-sales ratio was 10.1 percent compared to 6.7 percent for Adidas.

How did Nike, a small startup, leap past Adidas and Con- verse to emerge as the world leader in athletic footwear in just 20 years? What was unique about the company’s strat- egy and what lessons does the Nike story hold for other com- panies hoping to be the leaders in their industries? Finally,

now that competitors understand Nike’s path to leadership, how can Nike stay on top?

NIKE’S ORIGINS Nike was founded in 1962 as Blue Ribbon Sports by Univer- sity of Oregon track athlete Phil Knight and his coach Bill Bowerman. The company initially operated as a distributor for Japanese shoe maker Onitsuka Tiger (now ASICS), mak- ing most of its sales at track meets, out of Knight’s auto- mobile. But the relationship between the two companies started to deteriorate in 1970, and Knight and Bowerman were ready to make the jump from being a footwear dis- tributor to designing and manufacturing their own brand of athletic shoes. So, Bowerman and Knight decided to design their own track shoes and have them manufactured in low- cost Asian plants. Founder Bill Bowerman created a “waffle iron” design that improved traction while keeping the shoes extremely light. They selected a logo to put on the shoe, known internationally as the swoosh, which was created by a graphic design student, Carolyn Davidson, from Port- land State University. Davidson was originally paid $35 for the logo design (Knight later gave Davidson an undisclosed amount of Nike stock and a diamond ring with the swoosh engraved). Then, in May of 1971, Blue Ribbon changed its name to Nike after the Greek goddess of victory. The new Nike line of footwear debuted in 1972, just in time for the U.S. Track and Field Trials held in Eugene, Oregon.

CASE 07 Nike: Sourcing and Strategy in Athletic Footwear

[ Exhibit 1 ] Global Athletic Footwear Sales by Major Brand (estimated in millions of dollars at wholesale)

Company 2013 % in 2012 2010 sales % in 2010 2005 sales 2000 sales

Nike 14,539 44% 10,332 41% 7,300 5,562

Adidas 9,379 29% 7,354 29% 4,064 3,424

Asics 2,314 7% 1,631 7% 877 628

Skechers 1,846 6% 2,007 8% 1,006 675

New Balance 2,390 7% 1,780 7% 1,550 1,100

K-Swiss - 217 1% 509 223

Under Armour 299 1% 127 1% na na

Reebok* 1,913 6% 1,599 6% 2,718 2,102

Converse** - - - - - 209

*Reebok was purchased by Adidas in February 2006.

**Converse was purchased by Nike in July 2003.

Source: Privco, company annual reports.

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CASE 07 NIKE: SOURCING AND STRATEGY IN ATHLETIC FOOTWEAR [ C-63 ]

[ Exhibit 2 ] Nike, Inc., Financial Performance, 1990–2010 (year ended May 31; millions of dollars)

2013 2010 2005 2000 1995

Revenues

Footwear $14,539 $10,332 $7,300 $5,562 $3,554

Apparel 6,820 5,037 3,879 2,699 897

Equipment 1,405 1,035 825 328 -

Total Rev 25,313 19,014 13,740 8,995 4,761

SG&A 7,780 6,326 4,222 2,606 1,210

Demand Creation 2,745 2,356 1,601

Operating Overhead 5,035 3,970 2,621

Interest (3) 6 5 45 24

Income Tax 808 610 648 340 250

Net Income $2,485 $1,907 $1,212 $579 $400

Geo. Segment Rev**

Europe 5,415 5,042 4,282* 2,351 980

Asia Pacific 3,244 2,624 1,897 955 516

North America 10,387 6,696 5,129 5,017 2,998

*2005 Europe data also includes Middle Eastern and African sales.

**Total geo revenues will not add up to total revenues due to other sources of revenue that Nike has.

Source: Nike Inc., Annual Reports, 1995, 2000, 2005, 2010, 2013.

[ Exhibit 3 ] Adidas Group Financial Performance, 1995–2010 (millions of euros)

2013 2010 2005 2000 1995*

Sales

Footwear 6,873 5,389 2,978 2,509 1,790

Apparel 5,813 5,380 2,798 2,159 1,528

Hardware 1,806 1,221 860 1,167 131

Net sales 14,492 11,990 6,636 5,835 3,500

Operating expenses 6,133 5,046 2,573 2,012 1,095

Interest expense 68 88 158 94 47

Income tax 344 238 2,221 140 43

Net income 839 567 383 182 245

Net sales by region

North America 3,362 2,805 1,327 1,906 767

Latin America 1,575 1,285 398 171 91

Asia/Pacific 3,861 2,972 1,460 875 307

Europe 5,694 4,928 3,451 2,860 2,335

*1995 results given in millions of Deutsche marks.

Source: Adidas Group, Annual Reports, 1995, 2000, 2005, 2010, 2013.

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Early models of Nike’s track shoes were primarily used by track athletes at the University of Oregon. Fortunately for Nike, one of those Oregon athletes was Steve Prefontaine, a middle- and long-distance runner who became a prominent track star. Prefontaine competed in the 1972 Olympics and once held the American record in seven different distance track events from the 2,000 meters to the 10,000 meters. Prefontaine’s success catapulted Nike into the spotlight and jump-started the company’s sales. Building on this momen- tum, Nike started to design shoes for other track stars and prominent athletes in other sports. The late 1970s and early 1980s saw sprinter Carl Lewis, long-distance runner Joan Benoit, and tennis star John McEnroe sporting Nike shoes. The company hit the jackpot in the late 1980s when it signed basketball superstar Michael Jordan to an endorsement contract. Nike’s “Air Jordan” sneakers, promoted by Michael Jordan, were a huge winner in the basketball shoe segment of athletic footwear. The success of Air Jordan, and the entire Nike line, was helped by the “Just Do It” advertising campaign developed and launched by ad agency Wieden- Kennedy in 1988. The company hit the jackpot again in the late 1990s after signing golfing phenom Tiger Woods to an endorsement contract. Leveraging Woods’s popularity, Nike not only entered the golf shoe market but also golf equip- ment and apparel. Even before Nike signed Tiger Woods, it was firmly ensconced as the leading athletic footwear com- pany in the world, however.

Nike’s dramatic success in overtaking Adidas in such a short period of time was typically attributed to its successful and memorable marketing campaigns featuring well-known athletes. Although marketing has undoubtedly been critical to Nike’s success, the company’s ability to produce cutting- edge shoe designs that have attracted endorsers is some- times overlooked. Nike made significant investments in shoe design, starting with running shoes and then branch- ing out to tennis, basketball, soccer, golf, and other shoes for specific uses. Each year Nike launched over 100 new designs of different types of shoes. This practice stimulated new cus- tomer purchases by creating the desire to have the very best shoe possible to maximize performance. It also increased the overall size of the market as customers bought shoes for specific sports, often having as many as 5-10 different types of athletic footwear in their closets.

Nike’s decision to keep its focus on product design and marketing, and not manufacturing, is another little-under- stood factor that has influenced it success. The company chose not to produce any of its own shoes, preferring instead to hire independent suppliers in Asian countries such as South Korea, Taiwan, China, and Indonesia. These sup- pliers built high-quality shoes to exact specifications and delivered them according to precise delivery schedules. They helped Nike keep costs down because Asian labor was cheap and plentiful. This was in sharp contrast to the labor costs at many of the Adidas shoe-manufacturing facilities in Europe (mostly Germany) where labor costs were signifi- cantly higher. By outsourcing the production of its shoes to foreign suppliers, Nike was able to focus all of its attention

and resources on shoe design and marketing. Nike’s choices regarding which activities to conduct internally, and, thus, which activities to outsource to suppliers, played a critical role in propelling it to the top of its industry.

NIKE’S SOURCING PRACTICES Nike’s use of Asian suppliers dates back to its humble begin- ning. The allure of low-cost labor in Asia was what initially attracted the attention of Phil Knight. An accountant by training, Knight had noticed the success of Japanese cam- eras in the 1950s against higher-priced German models, and he thought the same approach could work in the athletic footwear industry, where the leading brands (Adidas and Puma) were German.1 At the time, Adidas manufactured the majority of its shoes in Europe, incurring considerably higher labor costs than existed in Asia.

Nike’s advantage in athletic footwear came, in part, from creating cutting-edge designs that could be manufactured at low cost. Each year Nike’s designers created more than 100 new shoe styles and colors. The company then sent designs to its Asian suppliers, which would develop and test pro- totypes. Once these prototypes were approved, the blue- prints were ready to be sent out to bid to suppliers.2 Nike was known to constantly look for the supplier that could provide the lowest cost production for its shoes. This often involved a bidding process during which suppliers would bid for the opportunity to produce a new shoe design. According to Jeffrey Ballinger, an Asian-American Free Labor Institute (AAFLI) representative, Nike’s strategy is to pit six factories against each other and have them compete for orders based on who produces the cheapest shoe.3 An estimated cost breakdown of a 1995 Nike athletic shoe (the Pegasus running shoe) is presented in Exhibit 4. As seen in Exhibit 4, only about 15 percent of the cost of Nike shoe production was labor costs. This was significantly lower than the labor costs required to manufacture a shoe in Europe.

In order to avoid dependence on a small number of suppliers, Nike cultivated working relationships with numerous manufacturers spanning a number of different countries. For example, large suppliers in China or Indone- sia rarely produced for just one athletic shoe firm. A single plant might be producing Nike shoes in the same plant with Reebok or Converse production lines. Due to the low labor costs in Asia, by the mid-1990s, virtually all US athletic foot- wear companies relied on overseas manufacturing. There were a few exceptions, with one of the most notable being New Balance Athletic Shoe Inc., which operated four U.S. plants and held a relatively small share of the US market. It focused on a niche market of customers interested in more- varied width sizing. Not surprisingly, employees at New Balance’s U.S. plants were considerably more costly than their Asian counterparts. For example, hourly wages in US plants for apparel manufacturing averaged $8.16 compared to only $.25 in China and $.28 in Indonesia (See Exhibit 5 for a comparison of textile and apparel wages in selected markets for 1993 and 2007). In the Brighton, Massachusetts

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[ Exhibit 5 ] Hourly Labor Costs for Production Workers in the Textile and Apparel Industry—Selected Countries, 2007

COUNTRY HOURLY LABOR COST - TEXTILE

(IN US$) HOURLY LABOR COST - APPAREL

(IN US$)

2012* 2007 1993 2012 2007 1993

North America

United States 24.17 18.58 11.61 24.09 15.29 8.13

Mexico 3.4 1.81 2.93 2.92 1.32 1.08

Europe

Germany 35.56 14.32 20.5 35.49 13.25 17.22

Asia

China (PRC) 2.1 0.8 0.36 1.26 0.71 0.25

Indonesia 1.08 0.39 0.43 na 0.35 0.28

South Korea 8.22 8.41 3.66 16.6 8.78 2.71

Philippines 2.1 0.97 0.78 na 0.87 0.53

Taiwan 9.46 4.68 5.76 9.2 4.39 4.61

*2011 data for Indonesia, South Korea, China, Taiwan, and the Philippines. 2012 textile data for the Philippines and Taiwan

is the average manufacturing wage.

Source: Bureau of Labor Statistics, OECD, Institute of Global Labour and Human Rights, ILO Department of Statistics,

Werner International, Eurasia Group, Deloitte.

[ Exhibit 4 ] Estimated Cost Breakdown of a Nike Athletic Shoe, 1995

Labor $2.75

Materials $9.00

Rent $3.00

Duties $3.00

Shipping $0.50

Supplier’s operating profit $1.75

Total cost of sales: $20.00

Approximate average wholesale price $35.50

Average price at retail $70.00

Source: J. Ballinger and C. Olsson, Behind the Swoosh, (Sweden: Global

Publications Foundation, 1997).

plant, for instance, employees earned a base wage of $7.50 an hour, or between $8 and $12 per hour with benefits fac- tored in.4 With such high labor costs, New Balance was una- ble to profitably produce shoes that retailed for less than $50.5 New Balance later moved the majority of its shoe pro- duction to Asia.

Nike was well aware that production costs varied from country to country and could change over time as a result

of changing labor costs and exchange rates. For example, in 1988, Nike purchased 66 percent of its shoes from suppliers located in South Korea. Wage rates grew rapidly in the 1980s and early 1990s in South Korean factories, with wages going from less than $1.00 per hour in 1980 to $3.66 by 1993. The Korean Ministry of Labor reported that workers in shoe fac- tories earned an average of $24.40 per day in 1990, compared to just $9.71 per day in 1986. As a result, Nike’s imports from

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South Korean suppliers dropped to 42 percent by 1992 and to less than 10 percent by the end of the 1990s, and employ- ment in Pusan, South Korea’s shoe-manufacturing center, fell from nearly 500,000 in 1990 to 120,000 by 1993. As wages increased, many Korean suppliers moved factories to lower- wage countries, such as Indonesia, so that they could be cost-competitive when bidding on contracts from Nike or other athletic footwear companies.

Not only did changing wage rates influence the cost com- petitiveness of suppliers, but so did exchange rates. In the late 1990s, during the “Asian financial crises,” the costs to manufacture athletic footwear changed significantly from year to year, depending on a country’s currency relative to the dollar. China, for example, pegged the RMB to the dollar to ensure a more stable currency. In contrast, Indonesia let its currency float, and within a two-year period, the exchange rate changed from roughly 4,000 rupiahs to the dollar to over 10,000 rupiahs to the dollar. That allowed Nike to get more for their dollar by purchasing shoes and other materials from Indonesian suppliers than they could from suppliers in China. As a result, during the time period when the rupiah lost value to the dollar, Indonesian suppliers were more cost competitive and had a cost advantage when bidding for Nike shoe contracts.

As a result of the changing wage and exchange rates, Nike had a truly global supplier network that it could draw upon for their shoe production. This allowed the company to shift production as necessary to plants in different countries that could provide the lowest-cost shoes at the moment, depend- ing on the nature of wage rates and currency exchange. Nike was able to achieve this without building its own plants or making the investments necessary to develop a world-class manufacturing capability in shoes.

Nike’s practice of using a competitive bidding process was not without criticism, however. As suppliers worked to keep costs low and win the bids, some felt that Nike used exploitive labor practices and that the company should bear responsibility for the actions of its suppliers. In the 1990s, Nike executives often deflected these accusations, arguing that Nike did not own or operate its suppliers’ fac- tories. Neal Lauridsen, Nike’s vice president for Asia, said, “We don’t know the first thing about manufacturing. We are marketers and designers.”6 And John Woodman, Nike’s gen- eral manager in Jakarta at the time, further explained, “They are our subsuppliers. It’s not within our scope to investigate [allegations of labor violations].”7 Nike executives noted that the organization was a positive economic force within many emerging economies in Asia and provided thou- sands of jobs for people who probably wouldn’t be working otherwise.

INDUSTRY CHANGES AFFECTING NIKE: 1994-2000 The market for branded athletic footwear continued to grow between 1994 and 2000, but at a slower rate. After nearly

two decades of explosive growth, a slowdown was expected. By 1994, the average athletic shoe purchaser in the United States owned three pairs.8 Faced with slowing U.S. demand, Nike looked for new places and unique ways to grow. Inter- national sales were emphasized during this period, and Nike made steady inroads into European and Asian markets. The company also expanded into sports apparel and other foot- wear products, including hiking shoes and upscale men’s shoes with the acquisition of Cole Haan. Nike continued to invest in product design, seeking lighter, more durable, and even more comfortable models. Competitors were never far behind. Reebok, for example, refined its “PUMP” technology, which filled the shoe’s upper with air, claiming it provided superior support and comfort. They also introduced Graph- Lite, which offered a graphite-composite structure in the arch that replaced part of the sole and reduced the weight of the shoe up to 10 percent. To further increase demand, Nike and Reebok, in particular, increased their investments in innovative product designs. Nike continued to rely on the endorsements of famous athletes, including Michael Jordan and Kobe Bryant, in its television campaigns. Reebok fol- lowed suit, signing endorsers such as Shaquille O’Neal, Allen Iverson, and Yao Ming.

Competition began to heat up in the late 1990s as U.S. growth slowed and Adidas shifted the bulk of its shoe pro- duction from Europe to Asia. Following Nike’s lead, Adidas used the savings that resulted from lower-cost shoe pro- duction on marketing and high-profile endorsers. New Bal- ance also increased its competitiveness by shifting roughly 70 percent of its shoe production to China. Both Adidas and New Balance increased their global shares of athletic foot- wear at this time, but Reebok’s share fell. Nike was able to slowly grow its market share in athletic footwear during the late 1990s, but the overall growth in the US market dropped to half the rate of growth that took place in the 1980s. In 1999, Nike’s sales dropped by 8 percent over its prior year’s sales, highlighting the need for the company to look for even more innovative ways to grow.

NIKE’S QUEST FOR GROWTH OPPORTUNITIES As growth in the athletic footwear market slowed in the late 1990s, Nike looked to extend its product lines into other sports equipment and apparel. Although Nike’s core prod- ucts had always been athletic shoes, the company decided to expand by manufacturing and selling equipment for golf, tennis, soccer, baseball, bicycling, volleyball, wrestling, and even auto racing. The company was very successful in devel- oping and selling a line of golf apparel and equipment— notably golf balls and clubs—endorsed by golf phenomenon Tiger Woods. In 2000, Nike signed Woods to a 5-year, $105 million contract. It was the largest endorsing deal ever signed by an athlete at that time. Woods’ endorsement has been credited with playing a significant role in helping the Nike Golf brand transform from a start-up golf company in

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the late 1990s to a leading golf apparel company in the world and a major player in the equipment and golf ball market, where it competes effectively with Titleist, Callaway, and Taylor Made.

Nike looked for similar opportunities in other sports categories and started making equipment and apparel for many other sports. As it did with its shoes, Nike outsourced the manufacturing of its apparel and sports equipment to a variety of suppliers throughout the world. Indeed, using outside suppliers became even more important because of the wide variety of manufacturing that needed to be done for Nike—from shoes, to golf clubs, to volleyballs. Out- sourcing production allowed Nike to move quickly into new product categories because it didn’t have to acquire the knowledge of how to actually make the products that it designed and marketed. During the late 1990s and early 2000s, Nike was more aggressive about moving into apparel and other sports equipment than its major com- petitors, Adidas and Reebok, were. This helped Nike grow at a much faster rate than Adidas and Reebok. For example, Nike Golf was estimated to be generating roughly $600 mil- lion in sales by 2007, while Adidas and Reebok generated insignificant sales from golf apparel and products. Nike’s product category expansions during this time period also helped offset the slowing growth in sales of athletic foot- wear. Indeed, from 2000 to 2010, Nike’s sales grew from $9.0 billion to over $19.0 billion.

OUTSOURCING CHALLENGES: NEW BALANCE’S EXPERIENCE Although Nike’s experience with outsourcing was generally positive, such was not the case for all of its competitors. In early 2000, New Balance experienced a problem with a supplier that created concerns for all of the major makers of branded athletic footwear. Scores of deeply discounted New Balance shoes began showing up in stores from Eng- land to Australia.9 One of New Balance’s former Chinese suppliers, run by Taiwanese businessman Horace Chang, was continuing to produce and sell New Balance shoes. Chang had been a major supplier to New Balance, as well as a distributor of New Balance’s shoes in China. However, New Balance and Chang had a falling out when Chang’s proposed strategy for China—selling larger volumes of low priced shoes in China—was vetoed by New Balance. The company felt that Chang’s strategy would dilute its brand image. When New Balance shoes made by Chang’s plants began appearing in cut-rate shops for as little as $20, it enraged New Balance’s legitimate retailers, who were trying to sell the exact same shoes for as much as $60. Although attempting to compete directly with Reebok, Adidas, and Nike, New Balance was being relegated to the bargain bin. New Balance quickly sued Chang in the United States and did everything in its power to prevent “unlawful” New Balance shoes from being sold. With the help of China’s State Administration of Industry and Commerce, Chang’s

warehouses were raided and more than 100,000 pairs of New Balance shoes were confiscated. Buoyed by signs of increased brand protection by Chinese authorities, New Balance filed a suit in Shenzen against Chang. However, in February of 2002, a Chinese judge ruled against New Bal- ance. Instead of recognizing that New Balance had revoked its sales agreement with Chang, the judge cited an older document with Chang’s manufacturing company, in which New Balance suggested that Chang’s factory could manu- facture the shoes until 2003.

New Balance’s painful experience caused Nike and other sports footwear and apparel companies to rethink their strategy of outsourcing products to suppliers from emerging economies. Each company reevaluated its sourcing strategy and began to think of ways to ensure that it did not experi- ence the problems that New Balance did.

NIKE’S RESPONSE TO INDUSTRY OUTSOURCING CHALLENGES During the 1990s, Nike frequently faced criticism for sourc- ing its shoes from Asian suppliers that had used question- able labor management practices. The concerns included unsafe working conditions, working laborers too many hours at low pay, and using child labor. Nike executives often deflected these accusations, arguing that Nike did not own or operate its suppliers’ factories. But that started to change in 2000 when Ceres, a nonprofit organization advocating for sustainability leadership (including the rights of workers and safe working conditions) convinced Nike and other multinational organizations to follow a specific set of corporate responsibility principles.10 In 2000, around the same time that New Balance was experienc- ing trouble with its Chinese supplier, Nike took actions to incorporate social responsibility into its overall business strategy and to respond to criticisms of its subcontracting practices. In November of 2000, Nike formally endorsed a set of Ceres principles that advocated for socially respon- sible practices. These principles included minimizing risks to employees, offering safe products and services, and immediately informing the public with regard to any aspect of the company’s operations that could pose a threat to environment, health, or safety. At the time of the formal endorsement of Ceres principles, Nike admitted that it had not been as vigilant as it could have been when it came to monitoring working conditions at suppliers. Dusty Kidd, Nike’s vice president for corporate responsibil- ity, commented, “We hope that through this engagement with Ceres, we can advance our work in environmental and social issues.”11

As part of its effort to endorse and follow Ceres prin- ciples, Nike launched its “Transparency 101” program, which focuses on reducing risks to employees, offering safe products and services, and informing the public in a timely manner on issues that could pose a threat to work- ers health or safety By monitoring supplier factories in

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each country where Nike operates, this program ensures that the practices in each are in line with the company’s code of conduct. To launch the program, in February of 2001, Nike—in cooperation with Reebok—commissioned an independent auditor to look into labor conditions at a factory in Mexico that manufactured products for the two companies. When the report was completed, the com- pany made the auditors’ report available on the company website.

As part of its Transparency 101 program, Nike contin- ues to investigate and report on factory conditions world- wide and ensures that they are following Ceres principles. With regard to meeting the challenge of offering “safe prod- ucts and services,” Nike is required by Ceres to ensure the safety of its products for those who manufacture them, as well as for the end users. In accordance with this principle, Nike is continuing its efforts to phase out PVC and other potentially harmful chemicals in its products. On the issue of “informing the public,” Nike claims that it publishes its findings on factory conditions as they become available, and it recalls products that may pose a health hazard to consumers.

As a result of these actions, Nike has been recognized for making strides in corporate social responsibility. Fortune Magazine ranked Nike number one in the apparel indus- try on its annual list of “America’s Most Admired Compa- nies” in 2012. Similarly, the Far Eastern Economic Review (FEER) ranked Nike among its top-ten best multinational corporations in Asia for corporate leadership and corporate responsibility leadership. FEER noted that, in the previous year, Nike had improved in almost every category.12 Nike is also listed as one of the 226 companies recognized for sus- tainability efforts on the Dow Jones Sustainability Index. According to some observers, Nike’s increased interaction with key suppliers regarding social issues has deepened and improved relationships with those suppliers who have demonstrated they are committed to following Nike’s code of conduct.

NIKE’S HURDLES Nike’s success over the past 30 years has been nothing short of spectacular. However, Nike’s leaders realized that

the company would have to overcome some major chal- lenges if it hoped to continue its growth trajectory. For example, in 2005, Adidas announced that it would acquire Reebok for $3.8 billion. The combined Adidas Group had revenues of $13.3 billion in 2006 and offered a wide range of products that would allow it to challenge Nike for global supremacy (Nike’s revenues were roughly $14 billion at the time). Adidas CEO Herbert Hainer noted that the combination of Adidas and Reebok accelerated the Adidas Group’s growth and options in the global ath- letic footwear, apparel, and equipment markets. The new Adidas Group would benefit from a wider range of prod- ucts and brand identities, and an even stronger presence across teams, athletes, events, and leagues. In particular, Reebok’s strong position in North America was thought to complement Adidas’s strong international profile. North America represents approximately 50 percent of the global sporting goods market, and with the acquisition of Reebok, the Adidas Group’s North American sales more than doubled to US $3.9 billion, threatening Nike’s world- wide dominance.

In addition to facing a larger, more formidable competitor in Adidas-Reebok, Nike faced a number of new strategic chal- lenges in 2014, including: 1) a loss of cost advantage because all of its competitors were sourcing shoes in low-cost Asian countries, 2) fewer growth opportunities in its home market of North America ( footwear unit growth has been less than 1 percent during the last 5 years) because Nike had already entered most sports apparel and equipment categories, and 3) challenges of growing in emerging markets—espe- cially China—where growth continued to be threatened by subcontractors selling unlawful Nike knockoff shoes. Nike’s leaders knew it needed to develop a strategy to expand in China (now the world’s largest shoe market) without fueling the growth of unlawful knockoff shoes. Moreover, local Chi- nese sportswear brands Li Ning and Anta were growing rapidly within the Chinese economy and were emerging as global competitors. Nike’s top management team knew they had built a strong position as the worldwide leader in the athletic footwear and branded sports apparel industries, but they also knew that they faced major challenges in securing Nike’s financial future.

REFERENCES [ C-69 ]

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REFERENCES

1 Philip Rosenzweig, “International Sourcing in Athletic Footwear,” Harvard Business School Case 9-394–184.

2 Mark Clifford, “Spring in Their Step,” Far Eastern Economic Review (November 5, 1992), p. 57.

3 Ibid.w

4 Diane E. Lewis, “Delicate Balance: Running Shoe Company Weighs Commitment to Manufacturing in Urban

American Against Efforts to Organize its Boston Workers,” Boston Globe (February 23, 1993).

5 Jay Finegan, “Surviving in the Nike/Reebok Jungle,” Inc. (May 1993), p. 102.

6 Mark Clifford, “Spring in Their Step,” op. cit., p. 57.

7 Adam Schwartz, “Running a Business,” op. cit., p. 16.

8 “1992 Footwear (Athletic) Market,” Sporting Goods Manufacturing Association.

9 “For New Balance a Surprise: China Partner became Rival,” Wall Street Journal (December 19, 2002).

10 http://www.ceres.org/.

11 http://www.iisd.org/business/viewcasestudy.aspx?id=81.

12 Ibid.

http://www.ceres.org

http://www.iisd.org/business/viewcasestudy.aspx?id=81

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R andall Stephenson, CEO of AT&T, sat at his desk in Janu- ary of 2011 during a moment of quiet reflection. Verizon

Wireless had just announced that it would offer the Apple iPhone beginning in a few weeks. AT&T had been the sole carrier of the iPhone since its launch to the market in June of 2007, and the strategic alliance between AT&T and Apple that had existed for almost five years would soon end. Ste- phenson and the AT&T leadership team were now in a position to evaluate whether the Apple alliance had helped AT&T achieve its objectives—and to consider what might happen going forward given that AT&T would no longer be the exclusive service provider for the iPhone.

At the time of the inception of the alliance, AT&T was looking to rebrand itself as a wireless phone carrier. Apple was designing the iPhone and looking for the optimal way to launch it into the brand new smart phone market. The two companies ultimately decided that combining their resources and capabilities in a strategic alliance centered on the iPhone would help both companies achieve their strate- gic objectives. But now that the alliance was over, the AT&T leadership team needed to look to the future to determine what other strategic initiatives—including other potential alliances or acquisitions—would provide the best vehicles for helping the company achieve its strategic objectives.

HISTORY OF AT&T The American Telephone and Telegraph Company (AT&T) was founded in 1885 by Alexander Graham Bell after his invention of the phone. After a merger with the Bell tel- ephone company in 1900, AT&T became the main phone company in the United States. In 1913, AT&T also became a government-sanctioned monopoly of the telephone market, as a result of the Kingsbury Commitment. (Essentially, the

company was allowed to be a monopoly “provided [AT&T] is independent, intelligent, considerate, thorough and just.”1) The government agreed to allow AT&T’s monopolistic operation after the company agreed to allow independents to interconnect to the long distance network under certain conditions and to abstain from acquiring companies if the ICC2 objected.

For decades afterwards, AT&T continued to be the only truly nationwide phone company, and it continually had to walk a fine line between being a monopoly and acting like one. Litigation in the 1970s ultimately led to the breakup of the AT&T Bell System in 1982, resulting in AT&T divesting itself of its local telephone operations while still maintain- ing its long-distance network. The seven new independent companies were nicknamed “Baby Bells” or regional Bell operating companies (RBOC), and they included Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis, Southwest- ern Bell, and US West. Although these Baby Bells remained independent for many years, all were acquired over the years as the industry consolidated into a few players. Major acqui- sition events are summarized in Exhibit 1.

The breakup of AT&T led to a new era of competition among the Baby Bells, AT&T, and new entrants into the telecommunication industry. Long distance over local tel- ephone service became an intensely competitive business. Having started from a monopoly position AT&T would inevitably see its market share fall, and it did—from 90 per- cent in 1984 to around 50 percent a dozen years later. As a result of new competition and new technologies (primarily fiber optic transmission), prices plummeted by more than 40 percent over the next five years, and volume exploded. In 1984, AT&T carried an average of 37.5 million calls per average business day. In 1989, the equivalent volume was

CASE 08 AT&T and Apple: a Strategic Alliance

[ Exhibit 1 ] Major Acquisition Events of Baby Bells

Original Baby Bell Acquisition By Year

Ameritech SBC (now part of AT&T Inc.) 1999

Bell Atlantic Verizon Communications 2000

BellSouth AT&T Inc. 2006

NYNEX Bell Atlantic 1996

Pacific Telesis SBC (now part of AT&T Inc.) 1997

Southwestern Bell (later SBC) Acquired AT&T Corp., became AT&T Inc. 2005

US West Qwest, and later Century Link 2000, 2011

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105.9 million, and in 1999, it was 270 million. In the 1990s, the growth of computers, and then the emergence of the Internet, led to an increasing number of customers wanting to send data, rather than voice, over wired and wireless net- works.3 AT&T, along with other long distance providers, was looking for new ways to offer services that would meet these new customer demands.

HISTORY OF AT&T WIRELESS In 1981, AT&T estimated that the total U.S. market for cel- lular phone users would be about 900,000 by the start of the twenty-first century, and thus, it was not a compelling mar- ket for them at the time. However, McCaw Cellular Commu- nications, founded in 1987, saw cellular technology as a huge opportunity and was a savvy pioneer in the emerging mobile phone market. McCaw quickly outpaced the growth of the Baby Bells through a series of acquisitions and spectrum license purchases, and it became the single largest cellular spectrum owner by 1990, with licenses in most major U.S. cities (spectrum licenses were necessary because cellular technology used spectrum as the vehicle for routing calls). Cellular phone technology became an increasingly impor- tant alternative to landlines as the technology was more widely adopted throughout the 1980s and early 1990s. At this point, McCaw’s focus turned from acquiring licenses to servicing the network and signing up customers in what was now a maturing technology on the cusp of explosive growth. In order to handle the customer side of the business, McCaw turned to AT&T for technology.

With AT&T’s help, McCaw introduced SS7 signaling tech- nology across their entire network, allowing them to effec- tively tie their network together and to provide customers with the ability to “roam” away from their home network where they were subscribed. They called the new system “Cellular One.” In 1992, AT&T purchased one-third of McCaw for $3.8 billion. At the time, McCaw had two million Cellular One subscribers and was generating $1.75 billion in annual revenue. AT&T’s previous predictions of total wireless users were way off the mark, but now the company was ready to jump into the growing industry.

In 1994, AT&T purchased the rest of McCaw Cellular for $11.5 billion, creating AT&T Wireless Group under AT&T Corp.4 At the time, AT&T Wireless was the second largest cellular carrier in the United States thanks to the Cellular One user base, and by the end of 1997, it grew to become the largest cellular provider. However, the cellular industry began to consolidate, and by 1999 and 2000, Verizon Wire- less and Cingular Wireless became the first and second larg- est national carriers, respectively.

AT&T Wireless became a separate company from AT&T Corp. in 2001, and it continued to expand its operations until, in 2003 and 2004, the Federal Communications Commission (FCC) mandated that AT&T allow customers to port their phone numbers to other carriers. AT&T Wireless experi- enced a mass exodus of many customers who were fed up with years of poor service. When the new process for porting

numbers in or out of its system was poorly implemented, AT&T Wireless only accelerated the exodus of customers. The AT&T Wireless management team received so much criticism that the company eventually agreed to accept bids to be acquired in early 2004.5

In 2004, Cingular Wireless won the bid and acquired AT&T Wireless for $41 billion, nearly double the company’s recent trading value. Cingular, headed by CEO Stan Sig- man, was a joint venture between two Baby Bells; 40 percent owned by BellSouth and 60 percent owned by SBC Commu- nications, Inc. Six months after the merger, the AT&T Wire- less brand was retired by Cingular. According to a pre spin-off agreement, the name AT&T Wireless and the use of the AT&T name in wireless phone service would revert back to AT&T Corp. The brand would be brought back about a year later after SBC Communications, Inc. completed a merger with AT&T Corp. in 2005, at which time SBC renamed itself “AT&T Inc.”

In December 2006, the new AT&T acquired Bellsouth, just as the negotiations with Apple commenced. Randall Ste- phenson took over as CEO of the new AT&T in June of 2007 and was the leader as the strategic alliance with Apple was finalized. “This is a once-in-a-lifetime moment to change how the public views AT&T as a wireless company,” said Ste- phenson, “and to change internally how we view AT&T as a wireless company.”6

After the acquisition of Bellsouth, AT&T changed the name of its wireless branch, Cingular, to “AT&T” and rolled it out as part of the alliance with Apple.7 “I don’t care if you have to go to every store in America and get a paper bag and paint a globe on it and put it over the signage in each store. We’re going to launch this under the AT&T brand,” Stephen- son remembers telling his team. “And it was the smartest thing we ever did, because AT&T became synonymously branded with that Apple product [iPhone] at that moment in time.”8

HISTORY OF APPLE Apple Computer was incorporated on January 3, 1977, by founders Steve Jobs and Steve Wozniak. Apple Computer launched several computer models, including the Apple II in 1977, which introduced VisiCalc, a spreadsheet program that was one of the first “killer apps.”9 The Apple III was released in 1980 to compete with IBM and Microsoft in the business- computing market, followed by the Apple Lisa in 1983 and the Macintosh in 1984, two of the first personal computers to utilize a graphical user interface or GUI. The Macintosh debut was heralded by the now famous “1984” Super Bowl XVIII commercial directed by Ridley Scott, which depicted an Orwellian “1984” world that is changed by the introduc- tion of the Macintosh. The Macintosh, in combination with LaserWriter and PageMaker, kept Apple growing and ush- ered in the desktop publishing market.10

In 1985, Jobs resigned from Apple Computer. The board of directors had removed him from his managerial duties fol- lowing a power struggle with then CEO John Sculley, who

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had been hired two years prior.11 Jobs founded NeXT Inc. later that same year.

Between 1986 and 1997, Apple Computer continued to release numerous new computers, including the Macintosh Portable in 1989 and the PowerBook in 1991 with upgrades to their OS. However, following the flops of several con- sumer-targeted products, such as digital cameras, portable CD players, speakers, video consoles, and TV appliances, Sculley was replaced as CEO by Michael Spindler in 1993. Spindler continued as CEO until 1996 when he was replaced by Gil Amelio, after Apple experienced a significant decline in revenues and profits.12 After several failed attempts at improving the Mac OS, Amelio made the decision to acquire NeXT Inc., bringing Jobs back to Apple Computer as an advi- sor. In 1997, Amelio was ousted as CEO by the board of direc- tors, and Jobs became interim CEO.

A year after Jobs returned as CEO, Apple Computer released the iMac, which was commercially popular and successful. The iMac integrated notable new design aesthet- ics and technology, selling nearly 800,000 units in the first five months.13 Over the next several years, Apple Computer acquired several companies to complete its iLife suite, which included iMovie, GarageBand, iPhoto for consumers, and Final Cut Pro for professionals.

In 2001, Apple Computer opened its first Apple Retail Stores and introduced the wildly successful iPod, which sold over 100 million units by 2007. To complement the iPod and provide an even better user experience, Apple introduced the iTunes Store in 2003. During the period between 2003 and 2006, the price of Apple Computer’s stock went from about $7 per share to over $80 per share.14

At this point Apple began to seriously consider entering the smart phone market. The company had partnered with Motorola to release the Motorola ROKR in 2004, which was carried exclusively by Cingular and used iTunes software to play iTunes songs. However, Apple executives felt the design and execution (controlled primarily by Motorola and Cingu- lar) were clunky.15 In 2005, Apple engineers were working on touchscreen technology for a tablet PC and were convinced that they could use the same technology for a smaller device. Moreover, the new processor chips were fast and efficient enough to power a combined phone, computer, and iPod device in a single mobile device. Apple saw the success of Blackberry and the rising demand for phones that used data and the Internet. As mobile phones became more integrated with other applications (like music), Apple could see that the iPod business would be negatively affected due to increased competition from phones. Apple was looking for their next big product and felt that the smart phone market was where the company needed to be, but only its own terms.

TERMS OF THE STRATEGIC ALLIANCE Jobs referred to telecom operators as “commodities” who would never understand the Web and entertainment the way Apple did. If Apple was going to be serious about releas- ing a cellphone handset, the company would do so on its

own terms. Apple was trying to buck the “rules” of the cell- phone industry and maintain complete control of the design and marketing of its first cellphone. In order to maintain complete control, Apple considered creating the device and buying excess capacity from existing carriers to service the device themselves. This was what Virgin had done when it launched Virgin Mobile (though Virgin didn’t try to design its own phone).16 But this option would require substantial investment and would put Apple into direct competition with the major carriers: Verizon, AT&T, Sprint, and T-Mobile. So Apple decided to explore the option of partnering with one of the major carriers.

Ideally, Apple was looking for a partner that could help fund the development of the iPhone but would grant Apple full control of the development and design. Apple also wanted a partner with a large retail network that would be effective at selling the iPhone. This meant that AT&T and Verizon were prime targets. In addition, Apple wanted a partner that would give it a percentage of the annual service bill for iPhone users (anticipated to be roughly $1,000 per year). Finally, Apple didn’t want to provide long-term exclu- sivity to any one carrier.

AT&T (called Cingular before 2005) was a prime candi- date because its wireless data network was the largest wire- less data network available at the time, reaching 270 million people worldwide—about 50 million more than the next largest wireless network.17 However, according to at least one industry expert, AT&T was a “sclerotic mess of assets” with a future that lay in “a glitchy, hodgepodge cellular network cobbled from deals past.”18 As its voice business continued to fade fast due to fierce competition and price wars, AT&T had a large incentive to grow its wireless business—and add more data customers through expanded smart phone use. AT&T was looking for a competitive advantage in the wire- less market and to fully transition its brand into that of a wireless company.

In early 2005, Jobs pitched his idea to then Cingular (renamed AT&T in late 2005) Wireless chief executive Stan Sigman. They agreed to explore the idea further. Cingular’s global network for mobile communications (GSM) network technology was the standard in much of the world, and so, Cingular was a logical choice as a partner for Apple. Jobs also shopped his idea around to other wireless industry titans, including Cingular’s main competitor Verizon Wireless in the middle of 2005, but negotiations fell through. Verizon balked at the notion of cutting out its big retail partners, such as Circuit City, who would not be allowed to sell the phone. Verizon also hesitated because Apple wouldn’t allow Verizon to sell content such as music and videos through its proprietary V Cast service.19 With Verizon out of the pic- ture, Apple’s talks with Cingular accelerated. The wireless company couldn’t pass up the chance to usher in the smart phone era with Steve Jobs, the man who had reinvented the computer and the music industry.

Secret negotiations that began with Cingular executives in February 2005 ended with AT&T (after their acquisition of Cingular) and took over a year to complete. Stan Sigman,

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CEO of AT&T Wireless, and his team were taken with the idea of the iPhone, but it was difficult to convince everyone to change so much of the existing phone carrier business model and to concede to Jobs’ demands.20 Forbes reported, “Trust was a big part of the story behind AT&T’s deal with Apple. ‘I told people you weren’t betting on a device,’ recalls AT&T CEO Randall Stephenson. ‘You were betting on Steve Jobs.’”21

The official details of the agreement are proprietary but a number of them have been released or publicly acknowl- edged. Main points are summarized below :

AT&T would get 5 years exclusive carrier of iPhone while Apple would get millions of dollars from AT&T to support development of the iPhone

AT&T would get 10% of iPhone sales in AT&T stores while Apple would get $10 a month of AT&T iPhone subscriber’s bill

AT&T would get a thin slice of iTunes revenues while Apple would get control of design, manufacturing, marketing.

Although Jobs was notoriously secretive about the iPhone before its announcement, even with AT&T executives, those who did get to see it before the public were enthusiastic. Sig- man called the iPhone “the best device I have ever seen.”22

In return for five years of exclusivity, roughly 10 percent of iPhone sales in AT&T stores, and a thin slice of Apple’s iTunes revenue, AT&T had granted Jobs unprecedented power.23 He had cajoled AT&T into spending millions of dol- lars and thousands of hours to create a new feature, a so- called visual voicemail, and to reinvent the time-consuming in-store sign-up process.24

AT&T’s wireless data network would become a differen- tiator. Voellinger, VP of telecom consultancy Telwares, said the AT&T-Apple alliance was really about content. “They are not going to pull users with speed,” he says. “They will do it with content and because of the content, it should be very successful.”25 With Apple’s design prowess and AT&T’s network services, the iPhone was poised to revolutionize the wireless smart phone industry.

LAUNCH OF THE IPHONE WITH AT&T The iPhone launched on June 27, 2007 in North America. There was tremendous excitement surrounding the iPhone launch. In March of 2007, AT&T had over 1 million inquiries for the device on its website. An AT&T store sales represent- ative in Manhattan reported receiving hundreds of phone calls per day and at least another hundred inquiries from people who walked into the store asking how they could get their hands on an iPhone.26

Owners of the iPhone said they loved using their device to surf the Internet, download content, stream music and vid- eos, and send and receive email, as well as talk on the phone. AT&T discovered that its data network demand predictions were far too low, causing huge strains on the network result- ing in spotty coverage and customer service headaches.

Since 2007, traffic on AT&T’s network has doubled each year, and, according to an AT&T FCC filing in 2011, mobile data volume surged 8,000 percent from 2007 to 2010, which included data used on iPods and iPads.27 Apple contributed to coverage problems as well. The original iPhone shipped with glitches in its communications software that led to dropped calls.28

When AT&T complained to Apple about iPhone users’ data demands, they were met with resistance. AT&T requested that Apple take measures to help throttle back user data traffic, for example, by limiting YouTube videos to Wi-Fi only or by cutting off after a minute. AT&T argued that there was no point in offering features that carriers couldn’t support. However, Apple engineers and marketers weren’t interested in cooperating. “We consistently said ‘No, we are not going to mess up the consumer experience on the iPhone to make your network tenable.’ They’d (AT&T) always end up saying, ‘We’re going to have to escalate this to senior AT&T executives,’ and we always said, ‘Fine, we’ll escalate it to Steve and see who wins.’ I think history has demonstrated how that turned out.”29

Meanwhile, AT&T customers were upset with the lim- ited coverage and service on the EDGE network, especially in cities such as New York and San Francisco where iPhone users were more densely populated than they were in other markets. This created numerous PR headaches for AT&T because its reputation became increasingly associated with an unreliable network. AT&T’s service glitches became fod- der for competitors such as Verizon.30

AT&T responded to the increased demand by spending $115 billion from 2007–2012, acquiring additional spectrum and building its network to meet customer demand. Speak- ing in an interview in 2009, AT&T Chief Technology Officer John Donovan said, “Nobody is in the same boat we’re in. We’re shaping the landscape for the whole industry, and I rel- ish the opportunity to be the first to figure it out…We’re solv- ing problems for the world in how to deal with these loads.”31

ASSESSING THE IMPACT OF THE STRATEGIC ALLIANCE As the alliance reached the end of its 5-year life, both AT&T and Apple had the opportunity to assess whether or not it had achieved its strategic objectives.

Impact on AT&T AT&T’s key objectives with the partnership were to attract more subscribers and to rebrand itself as a wireless com- pany. Analysts predicted the iPhone would sell about 8 mil- lion units by the end of 2008, but in reality that number was larger. There were 1.4 million units sold globally in 2007, and in the years 2008-2011, the number of units sold were 11.6, 20.7, 40.0, and 72.3 million, respectively,32 with approximately 85 million total in the U.S. during that same period.33 AT&T reported roughly 53 million iPhone account activations in the U.S. from 2007-2011 (see Exhibit 2). From the launch of the iPhone in June of 2007 to January 12, AT&T’s market

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share of wireless phone subscribers (among the top four companies) went from 36 percent to 39 percent. The 3 per- cent share increase translated into roughly 3.2 million addi- tional subscribers at the beginning of 2012. Verizon Wireless also gained subscribers during that time period, going from 36 percent to 41 percent. Sprint was the big loser, with its market share of subscribers dropping from 27 percent to 17 percent (see Exhibit 3).34

Following the launch of the iPhone 3G (second genera- tion) in 2008, AT&T began subsidizing iPhones. The original $599 price tag was too expensive for the majority of consum- ers, and Apple dropped the price down to $199 with a 2-year contract and a slightly higher monthly data plan fee. AT&T executives were willing to pay this subsidy because they saw that iPhone users were more lucrative due to their increased data usage, and they believed the new pricing would lead to mass adoption.35 Indeed, AT&T ended up getting nearly twice the average revenue per user (ARPU) per month from iPhone users. According to Apple Inc. in 2010, AT&T’s iPhone ARPU36 was $95 compared to $50 for the top three

carriers.37 Additionally, turnover (churn levels) for these sub- scribers was significantly lower than it was for other smart phone customers.38

Starting in February of 2011, Verizon was able to start selling iPhone activations, followed by Sprint in October 2011. Despite speculation that AT&T iPhone activations would drop off quickly once the company lost exclusivity, activation activity for AT&T was 17.5 million iPhones in 2011. Verizon was 10.8 million, and Sprint came in at 1.8 mil- lion. That trend continued in the first quarter of 2013. AT&T activated 4.8 million iPhones while Verizon activated 4.0 million.39 The iPhone remains AT&T’s most popular phone, and it garnered about 73 percent of the company’s smart phone subscribers in 2012.

The AT&T wireless segment’s financial performance stead- ily increased from 2006 to 2007, with the Cingular merger and the introduction of the iPhone. By 2012, sales had passed $66 billion. AT&T’s market value also increased during that time, from $183.5 billion to $227 billion, but it dropped back down to $188 billion by the end of 2012 (See Exhibit 4).

[ Exhibit 2 ] AT&T iPhone Activations (2007-2011)

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Number of iPhone Activations for AT&T

[ Exhibit 3 ] Subscriber Share for the four Largest Wireless Carriers (2006–2012)

Company 2006 2007 2008 2009 2010 2011 2012

AT&T 60 70.1 77 85.1 95.5 103.2 107

Market Share* 36% 38% 38% 38% 38% 39% 38%

Verizon 59.1 65.7 80 91.2 102.2 108.7 115.8

Market Share 35% 35% 39% 41% 41% 41% 41%

Sprint 45.8 45.4 42.9 39.94 44.5 46.6 47.8

Market Share 27% 25% 21% 18% 18% 17% 17%

T-Mobile 2.9 4 5.4 6.6 8.2 9.3 8.9

Market Share 2% 2% 3% 3% 3% 3% 3%

*Market share among the top four national players included here, not across the entire wireless market; does not include local wireless

players (e.g., Cricket Wireless).

Source: Company 10k SEC filings. Subscriber counts include prepaid and postpaid retail customers.

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[ Exhibit 4 ] Selected Financials for Apple, AT&T, Verizon, Sprint, and T-Mobile (2006-2012)

APPLE INC.

(in millions) 2006 2007 2008 2009 2010 2011 2012

Net sales $19,315 $24,006 $37,491 $42,905 $65,225 $108,249 $156,508

Cost of sales 13,717 15,852 24,294 25,683 39,541 64,431 87,846

Gross margin 5,598 8,154 13,197 17,222 25,684 43,818 68,662

Research and development 712 782 1,109 1,333 1,782 2,429 3,381

Selling, G&A 2,433 2,963 3,761 4,149 5,517 7,599 10,040

Operating income $2,453 $4,409 $8,327 $11,740 $18,385 $33,790 $55,241

Mac sales $7,375 $10,314 $14,276 $13,859 $17,479 $21,783 $23,221

iPod sales 7,676 8,305 9,153 8,091 8,274 7,453 5,615

iPhone and related sales 0 123 1,844 13,033 25,179 47,057 80,477

iPad and related sales 0 0 0 0 4,958 20,358 32,424

Average stock price $65.70 $103.94 $163.57 $120.22 $229.39 $342.18 $526.71

Number of shares (000s) 855,263 872,329 888,326 899,806 915,970 929,277 939,208

Market value (in millions) $56,193 $90,672 $145,301 $108,175 $210,119 $317,979 $494,687

AT&T

(in millions) 2006 2007 2008 2009 2010 2011 2012

Wireless operating revenue $37,537 $42,684 $49,174 $53,504 $58,500 $63,215 $66,763

Cost of services and sales 15,057 15,991

Selling, G&A 11,446 12,594

Depreciation & amortization 6,462 7,079 6,025 6,043 6,497 6,329 6,873

Operating income $4,527 $7,020 $15,257 $13,830 $15,257 $15,604 $15,594

Subscribers (millions) 60.0 70.1 77.0 85.1 95.5 103.2 107.0

Revenue/Sub $625.62 $608.90 $638.62 $628.72 $612.57 $612.55 $623.95

OI/Sub $75.45 $100.14 $198.14 $162.51 $159.76 $151.20 $145.74

*Operating expenses were consolidated after 2007.

VERIZON (DOMESTIC WIRELESS)

(in millions) 2006 2007 2008 2009 2010 2011 2012

Total operating revenues $38,043 $43,882 $49,332 $62,131 $63,407 $70,154 $75,868

Cost of services and sales 11,491 13,456 15,660 19,749 19,245 24,068 24,490

Selling, G&A 12,039 13,477 14,273 17,848 18,082 19,579 21,650

Depreciation & amortization 4,913 5,145 5,405 7,030 7,356 7,962 7,960

Operating income $9,600 $11,795 $13,994 $17,505 $18,724 $18,527 $21,768

Subscribers (millions) 59.1 65.7 80.0 91.2 102.2 108.7 115.8

Revenue/Sub $643.71 $667.91 $616.65 $681.26 $620.42 $645.39 $655.16

OI/Sub $162.44 $179.53 $174.93 $191.94 $183.21 $170.44 $187.98

(Continues)

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SPRINT

(in millions) 2006 2007 2008 2009 2010 2011 2012

Service & equipment revenue $35,115 $34,700 $30,427 $27,786 $28,597 $30,301 $32,355

Cost of services & products 12,854 13,635 13,644 13,929 15,253 16,964 18,922

Selling, G&A 10,572 11,151 10,047 8,659 8,813 9,070 9,286

Depreciation & amortization 9,086

Operating income $2,428 $9,914 $6,776 $5,198 $4,531 $4,267 $4,147

Subscribers (millions) 45.8 45.4 42.9 39.9 44.5 46.6 47.8

Revenue/Sub $766.70 $764.32 $709.25 $695.69 $642.63 $650.24 $676.88

OI/Sub $53.01 $218.37 $157.95 $130.15 $101.82 $91.57 $86.76

*Depreciation & amortization were consolidated after 2006.

T-MOBILE

(in millions) 2006 2007 2008 2009 2010 2011 2012

Service & Equipment Revenue $1,547 $2,236 $2,752 $3,481 $4,069 $4,847 $5,101

Cost of services and sales 922 1,245 1,562 2,004 2,318 2,913 2,930

Selling, G&A 244 352 447.582 567.73 622 644 697

Depreciation & amortization 135 178 255 378 450 539 641

Operating income $237 $460 $468 $535 $719 $748 $824

Subscribers (millions) 2.9 4.0 5.4 6.6 8.2 9.3 8.9

Revenue/Sub $533.41 $558.93 $509.54 $527.35 $496.26 $521.22 $573.18

OI/Sub $81.81 $115.03 $86.62 $81.10 $87.67 $80.38 $92.58

Source: Apple, AT&T, Verizon, Sprint, and T-Mobile Annual Reports, 2006–2012.

Impact on Apple The iPhone cost an estimated $150 million to develop over 30 months. 40 According to Apple court case documents, it spent $647 million on advertising the iPhone in the US from 2007 to 2011.41 However, these costs were more than cov- ered by the estimated $10 per month charge for each iPhone in the contract with AT&T.42 In fact, in 2011 alone, AT&T reported 17.5 million iPhone activations, which would have generated roughly $2.1 billion in annual profit just from AT&T service revenues in the final year of the agreement. With 53 million cumulative iPhone activations in the first five years, Apple would have generated roughly $5-6 billion in AT&T service revenue profits over the life of the 5-year agreement with AT&T.

Manufacturing costs for the iPhone have been estimated to be roughly $290, and the average selling price has been approximately $600,43 giving Apple 50 percent profit margins, before covering other operating expenses such as adver- tising, service, and general and administrative expenses.44 Advertising costs were roughly $8 per customer ($647 mil- lion in advertising spread across 85 million customers) over the first five years. Depending on actual service costs,

general and administrative expense allocations, and the actual bill of material component costs, Apple made some- where between $225-325 per iPhone. At $225 per phone mul- tiplied by 85 million phones, Apple’s profits from iPhones over the 5-year period would be roughly $19.1 billion. With these profits, Apple became the largest mobile handset ven- dor in the world by revenue in 2011, surpassing long-time leader Nokia.45

Sales of the iPhone continue to come primarily through AT&T and other third-party retail outlets. In 2012, the 250 Apple stores sold approximately 21 percent of iPhones, while AT&T sold 28 percent and Verizon 26 percent. These num- bers indicate that consumers still prefer to go to the carrier to purchase their iPhone, as opposed to the Apple store where they purchase the majority of other Apple devices, including Macs and iPads.46 Part of this trend may also be due to the accessibility of AT&T or Verizon stores.

The value of Apple’s brand and its stock skyrocketed after the launch of the iPhone during the 2007-2012 time period. Apple’s Interbrand ranking (a comparison of global brand recognition and value) went from thirty-ninth ($9.1 billion) in 2006 to first ($98.3 billion) in 2013, surpassing other brand

[ Exhibit 4 ] (Continued)

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CASE 08 AT&T AND APPLE: A STRATEGIC ALLIANCE [ C-77 ]

legends such as Coca-Cola, McDonalds, and Microsoft. Apple’s sales jumped from $19 billion in 2006 to $156 billion in 2012 while its market value skyrocketed from $56 billion to $494 billion during that same time period (see Exhibit 4). Much of that increase in market value was attributed to the introduction of the iPhone and iPad.

CONCLUSION AT&T enjoyed a number of noteworthy benefits as a result of the Apple alliance. AT&T’s share in the emerging smart phone market increased significantly from 28 percent just prior to the release of the iPhone in 2007 to 32 percent by the end of 2011. Its partnership with Apple also helped bolster AT&T’s image among increasingly technology-hungry con- sumers. Finally, although painful, high demands from Apple pertaining to the consumer experience and increased user network requirements ultimately forced AT&T to strengthen its network capabilities and customer service. Indeed, for AT&T, the alliance appears to have paid healthy dividends in terms of increased subscribers, a stronger brand, and improved operations. But the costs were substantial as well.

Along with the upfront development costs, AT&T paid a small fortune of approximately $5-6 billion in service reve- nue to Apple. Nevertheless, by the end of the alliance, AT&T saw its wireless segment’s operating margin improve by nearly 10 percent, in large part due to its operating profit per subscriber increasing by roughly $75 (see Exhibits 5 & 7; also see Exhibits 6 & 8 for a comparison of revenue per user and earnings per share over time).

At the time of its release, the iPhone was the first to use a multitouch interface with a large touchscreen that did not require use of a stylus, keyboard, or keypad. The user inter- face was also known for its intuitiveness and visual aesthet- ics, a hallmark of Apple products. Apple helped transform the smart phone from a primarily business-centric device, at the time dominated by Blackberry, to a product attractive to the general consumer.47 Despite Apple having revolutionized the consumer smart phone experience, competitors such as Samsung, LG, HTC, and Microsoft, using Android and Win- dows-based operating systems, caught up to and, in some cases, surpassed some of the iPhone’s technological features. In 2008, the Android operating system, which was backed by

[ Exhibit 5 ] Operating Margin

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

2006 2007 2008 2009 2010 2011 2012

Operating Margin

AT&T

Verizon

Sprint

T-Mobile

Apple

[ Exhibit 6 ] Revenue per Subscriber

$400.00

$450.00

$500.00

$550.00

$600.00

$650.00

$700.00

$750.00

$800.00

2006 2007 2008 2009 2010 2011 2012

Revenue Per Subscriber

AT&T

Verizon

Sprint

T-Mobile

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006-2012.

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[ C-78 ] CASE 08 AT&T AND APPLE: A STRATEGIC ALLIANCE

Google, was launched on the HTC Dream. The Android sys- tem, with a user interface similar to that of iPhone’s iOS, was touchscreen-focused for use on smart phones and tablets. It incorporated hardware such as gyroscopes, accelerometers, and proximity sensors to provide an enhanced user experi- ence similar to that of Apple’s iPhone.48 Releases of smart phones by Apple’s competitors, such as Samsung (notably the Galaxy S series), HTC, LG, Microsoft, Sony, Nokia, and Blackberry, in the latter years of the Apple-AT&T alliance showed how quickly Apple’s technological and user interface advantages were neutralized. Competitors were even sur- passing the iPhone on features such as screen size, built-in cameras, and speakers. As a result, some wondered whether it had been wise for Apple to limit the introduction of the

iPhone through the AT&T alliance. Were the millions of dol- lars in development fees and the share of monthly revenue worth the price of exclusivity with AT&T? Had exclusivity created a greater frenzy for the iPhone than would have hap- pened had it been released through multiple carriers? Or, did exclusivity with AT&T hurt Apple’s ability to gain broader market penetration before competitors (notably Samsung) were able to develop phones with similar functionality and technology? Although it is impossible to know exactly what would have happened without the strategic alliance, there is no doubt that its effects helped to shape both companies’ footholds and futures in the smart phone market.

As Stephenson and the AT&T leadership team looked to the future it was apparent that they would continue to

[ Exhibit 7 ] Operating Income per Subscriber

$0.00

$50.00

$100.00

$150.00

$200.00

$250.00

2006 2007 2008 2009 2010 2011 2012

Operating Income Per Subscriber

AT&T

Verizon

Sprint

T-Mobile

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006–2012.

[ Exhibit 8 ] Earnings per Share

$(20.00)

$(10.00)

$–

$10.00

$20.00

$30.00

$40.00

$50.00

2006 2007 2008 2009 2010 2011 2012

Earnings Per Share

AT&T

Verizon

Sprint

T-Mobile

Apple

Source: AT&T, Verizon, Sprint, T-Mobile, and Apple Annual Reports, 2006–2012.

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CASE 08 AT&T AND APPLE: A STRATEGIC ALLIANCE [ C-79 ]

use alliances, and acquisitions, as vehicles for accessing key resources in other firms. Between 2011 and 2014, AT&T announced a series of strategic alliances to help improve the company’s position providing telecommunication and Internet services to business customers. In particular, AT&T announced alliances with Akamai and CSC to develop next- generation technology solutions for enterprise businesses. For example, CSC, a recognized leader in enterprise cloud computing, will deliver its BizCloud TM and other cloud ser- vices through AT&T’s global cloud infrastructure platform and networks. AT&T also announced alliances with McAfee, to provide enhanced security benefits to business custom- ers, and Microsoft, to combine the Microsoft Azure plat- form (one of the most popular PaaS services) and AT&T’s network services.49 But AT&T’s biggest strategic move was

done through acquisition rather than alliance. To expand its broadband U-Verse T.V. service, AT&T proposed an acqui- sition of DirectTV, the largest satellite TV operator in the United States and Latin America. “What it does is it gives us the pieces to fulfill a vision we’ve had for a couple of years,” said AT&T CEO Randall Stephenson, “the ability to take premium content and deliver it across multiple points: your smartphone, tablet, television or laptop.”50 Even as the acqui- sition was announced, there was considerable debate as to whether it was wise to acquire DirectTV, with some sug- gesting that AT&T could have used an alliance instead of an acquisition to achieve its strategic objectives. Undoubtedly, like the Apple alliance, the success of the DirectTV acquisi- tion was likely to be debated in years to come.

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1 AT&T, “A Brief History: The Bell System.” Available at http://www.corp.att.com/history/history3.html, accessed

December 24, 2013.

2 ICC stands for Interstate Commerce Commission.

3 AT&T, “A Brief History: Post Divestiture.” Available at http://www.corp.att.com/history/history4.html, accessed

December 24, 2013.

4 Andrew Kupfer, “AT&T’s $12 Billion Cellular Dream…,” CNN Money (Dec ember 12, 1994). Available at http://

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6 Connie Guglielmo, “AT&T’s Big Call: Randall Stephenson on the iPhone, His Wireless Ambitions, and The Next

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7 Stephen Colbert takes a stab at explaining the various mergers, acquisitions, and name changes in this amusing

clip: http://videosift.com/video/Colbert-regarding-the-new-ATT.

8 Connie Guglielmo, “Life After the iPhone: How AT&T’s Bet on Apple Mobilized the Company,” Forbes ( January

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9 Tom Hormby, “Good-bye Woz and Jobs: How the First Apple Era Ended in 1985,” LowEndMac.com (August 16,

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10 Jacci Howard Bear, “When Was Desktop Publishing Invented?” Available at http://desktoppub.about.com/cs/

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11 Hormby.

12 Tom Hormby, “Michael Spindler: The Peter Principle at Apple,” LowEndMac.com (August 17, 2013). Available at

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13 Daniel Eran, “1990-1995: Hitting the Wall” (September 7, 2006). Available at http://www.roughlydrafted.com/

RD/Home/B8DA34A3-333B-4204-BDF3-E74608998702.html, accessed August 14, 2008.

14 See “Table: Apple (APPL) Yearly Adjusted Close Average Stock Price.”

15 Amol Sharma, Nick Wing field, and Li Yuan, “How Steve Jobs Played Hardball in iPhone Birth,” The Wall Street

Journal (February 17, 2007). Available at http://online.wsj.com/news/articles/SB117168001288511981, accessed

December 24, 2013.

16 Ibid.

17 AT&T, “iPhone and AT&T’s Wireless Data Network.” Available at http://www.att.com/Common/merger/files/

pdf/iphone_att_network_fs.pdf, accessed December 24, 2013.

18 Guglielmo, January 2, 2013.

19 Sharma, Wing field, and Li.

http://www.corp.att.com/history/history3.html

http://www.corp.att.com/history/history4.html

http://money.cnn.com/magazines/fortune/fortune_archive/1994/12/12/80051

http://en.wikipedia.org/wiki/AT%26T_Wire-less_Services

http://www.forbes.com/sites/connieguglielmo/2013/01/02/atts-big-call-randall-stephenson-on-the-iphone-his-wireless-ambitions-and-the-next-big-t

http://videosift.com/video/Colbert-regarding-the-new-ATT

http://www.forbes.com/sites/connieguglielmo/2013/01/02/life-after-the-iPhone-how-atts-bet-on-apple-mobilized-the-company/2

http://lowendmac.com/2013/good-bye-woz-jobs-apple-1985

http://desktoppub.about.com/cs

http://lowendmac.com/2013/michael-spindler-peter-principle-apple

http://www.roughlydrafted.com

http://online.wsj.com/news/articles/SB117168001288511981

http://www.att.com/Common/merger/files

[ C-80 ] REFERENCES

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20 Fred Vogelstein, “The Untold Story: How the iPhone Blew Up the Wireless Industry,” Wired ( January 9, 2008).

Available at http://www.wired.com/gadgets/wireless/magazine/16-02/ff_iphone?currentPage=all, accessed

December 24, 2013.

21 Guglielmo, January 2, 2013.

22 Vogelstein.

23 Nilay Patel, “Confirmed: AT&T and Apple Signed 5 year i-Phone exclusivity deal—but is it still valid?”

Engaget (May 10, 2010). Available at http://www.engadget.com/2010/05/10/confirmed-apple-and-atandt-

signed-five-year-iphone-exclusivity-de/.

24 Vogelstein, 2008.

25 W. David Gardner, “The New AT&T Is On A Roll, But Challenges Await,” InformationWeek.com ( January 18,

2007). Available at http://www.informationweek.com/the-new-atandt-is-on-a-roll-but-challenges-await/d/d-

id/1050827?, accessed December 24, 2013.

26 Marguerite Reardon, “Apple, AT&T stores prepare for iPhone frenzy,” cnet.com ( June 6, 2007). Available at

http://news.cnet.com/2100-1039_3-6189186.html, accessed December 24, 2013.

27 Athlma Chansanchal, “iPhone, iPad maxed out AT&T network,” msnbc.com (April 22, 2011). Available at http://

www.nbcnews.com/technology/iphone-ipad-maxed-out-t-network-123538, accessed December 24, 2013.

28 Peter Burrows, “Can AT&T Meet iPhone Network Demands?,” BloombergBusinessweek.com (August 23, 2009).

Available at http://www.businessweek.com/technology/content/aug2009/tc20090823_412749.htm, accessed

December 24, 2013.

29 Fred Vogelstein, “Bad Connection: Inside the iPhone Network Meltdown,” Wired ( July 19, 2010). Available at

http://www.wired.com/magazine/2010/07/ff_att_fail/all/, accessed December 24, 2013.

30 Knowledge@Wharton, “For AT&T, Is There Life after the iPhone?”( January 19, 2011). Available at http://knowl-

edge.wharton.upenn.edu/article/for-att-is-there-life-after-the-verizon-iphone/, accessed December 24, 2013.

31 Burrows.

32 Statista.com, “Global Apple iPhone sales in the fiscal years 2007 to 2013 (in million units).” Available at http://

www.statista.com/statistics/276306/global-apple-iphone-sales-since-fiscal-year-2007/, accessed December

24, 2013.

33 Hayley Tsukayama, “How many iPhones has Apple sold?,” The Washington Post (August 10, 2012). Available

at http://www.washingtonpost.com/business/technology/how-many-iphones-has-apple-sold/2012/08/10/

97c360e4-e2e4-11e1-a25e-15067bb31849_story.html, accessed December 24, 2013.

34 L. John and Y. Yufei, “Lesson 9: Article (6) What factors contributed to the success of Apple’s iPhone?” ( June

19, 2013). Available at http://cyberu.uplus-solution.com/msitm/media/Cin/compre/1_What%20Factors%20

Contributed%20to%20the%20Success%20of%20Apple_s%20iPhone.pdf, accessed December 24, 2013.

35 Marguerite Reardon, “AT&T’s iPhone 3G subsidy will cost ‘em,” CNET ( Jun 9, 2008). Available at http://news.

cnet.com/8301-10784_3-9963999-7.html, accessed December 24, 2013.

36 Average revenue per user, defined as the total revenue divided by the number of subscribers.

37 Peter Cohan, “How Steve Jobs Got ATT To Share Revenue,” Forbes (August 16, 2013). Available at http://www.

forbes.com/sites/petercohan/2013/08/16/how-steve-jobs-got-att-to-share-revenue/, accessed December 24,

2013.

38 Seth Weintraub, “AT&T activated 3.7M iPhones last quarter representing 73 percent of all smartphones and

56% of total,” 9To5Mac.com ( July 24, 2012). Available at http://9to5mac.com/2012/07/24/att-sold-3-7-million-

iphones-last-quarter-representing-73-of-all-smartphones-sold/, accessed December 24, 2013.

39 Chris Welch, “AT&T adds 296k new subscribers, sells 6 million smartphones in Q1 2013,” TheVerge.com

(April 23, 2013). Available at http://www.theverge.com/2013/4/23/4253874/att-new-1-2-million-smartphone-

q1-2013-financials, accessed December 24, 2013.

40 Vogelstein, 2008.

41 Dan Rowinski, “4 Real Secrets We’ve Learned So Far About Apple,” readwrite.com (August 7,

2012). Available at http://readwrite.com/2012/08/07/4-real-secrets-weve-learned-so-far-about-

apple#awesm=~orQrOK47Wu0Fzq, accessed December 24, 2013.

42 Tsukayama.

43 Darrell Etherington, “Apple’s average selling price on iPhones in Q3” ( July 23, 2013). Available at http://tech-

crunch.com/2013/07/23/apple-asp-iphone-trending-down/.

44 Joshua Sherman, “Spendy But Indespensable: Breaking Full $650 Cost of the iPhone 5,” Digital Trends ( July

26, 2013). Available at http://www.digitaltrends.com/mobile/iphone-cost-what-apple-is-paying/, accessed

December 24, 2013.

45 Alex Spektor, “Strategy Analytics: Apple Becomes World’s Largest Handset Vendor by Revenue in Q1 2011,”

Enhanced Online News (April 21, 2011). Available at http://www.enhancedonlinenews.com/portal/site/eon/

permalink/?ndmViewId=news_view&newsId=20110421005965&newsLang=en&permalinkExtra=Apple/

Nokia/revenues, accessed December 24, 2013.

46 John Paczkowski, “Breaking Down Apple’s Retail Distribution Strategy,” AllThingsD.com (October 3, 2012).

Available at http://allthingsd.com/20121003/apple-stores-get-the-glory-but-retail-partners-shoulder-load/,

accessed December 24, 2013.

http://www.wired.com/gadgets/wireless/magazine/16-02/ff_iphone?currentPage=all

http://www.engadget.com/2010/05/10/confirmed-apple-and-atandt-signed-five-year-iphone-exclusivity-de

http://www.informationweek.com/the-new-atandt-is-on-a-roll-but-challenges-await/d/d-id/1050827?

http://news.cnet.com/2100-1039_3-6189186.html

http://www.nbcnews.com/technology/iphone-ipad-maxed-out-t-network-123538

http://www.businessweek.com/technology/content/aug2009/tc20090823_412749.htm

http://www.wired.com/magazine/2010/07/ff_att_fail/all

http://knowl-edge.wharton.upenn.edu/article/for-att-is-there-life-after-the-verizon-iphone

http://www.statista.com/statistics/276306/global-apple-iphone-sales-since-fiscal-year-2007

http://www.washingtonpost.com/business/technology/how-many-iphones-has-apple-sold/2012/08/10

http://cyberu.uplus-solution.com/msitm/media/Cin/compre/1_What%20Factors%20

http://news

http://9to5mac.com/2012/07/24/att-sold-3-7-million-iphones-last-quarter-representing-73-of-all-smartphones-sold

http://www.theverge.com/2013/4/23/4253874/att-new-1-2-million-smartphone-q1-2013-financials

http://readwrite.com/2012/08/07/4-real-secrets-weve-learned-so-far-about-apple#awesm=~orQrOK47Wu0Fzq

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http://allthingsd.com/20121003/apple-stores-get-the-glory-but-retail-partners-shoulder-load

REFERENCES [ C-81 ]

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47 Brad McCarty, “The History of the Smartphone,” (December 6, 2011). Available at http://thenextweb.com/

mobile/2011/12/06/the-history-of-the-smartphone/#!tiRDT.

48 http://en.wikipedia.org/wiki/Android_(operating_system)#cite_note-AndroidOverview-12.

49 Mike Sapien, “AT&T’s enterprise theme is mobile first,” ovum.com. Available at http://ovum.com/2013/10/04/

atts-major-enterprise-theme-is-mobile-first/

50 John Craft. “Is AT&T’s acquisition of DirectTV a wise move for both parties?” Available at http://www.forbes.

com/sites/quora/2014/05/22/is-atts-acquisition-of-directv-a-wise-business-move-for-both-parties/

http://thenextweb.com

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http://ovum.com/2013/10/04

http://www.forbes

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[ C-82 ]

D uring the past century, industry leadership in the global consumer electronics industry (e.g., radios, TVs, movie

and music players, etc.) has changed, with Philips (Neth- erlands), Panasonic, Sony ( Japan), and Samsung (Korea) emerging as leaders at different times. Indeed, each company achieved leadership with a different international strategy, a different organization design, and a different set of organi- zational capabilities. Philips built a worldwide federation of independent national organizations able to gain access to the company’s renowned technological prowess and then to apply and adapt it to meet local market needs. Philips was the worldwide leader in consumer electronics from the early 1900s until the late 1970s. During the 1980s, Panasonic used overseas expansion to leverage its centralized, highly effi- cient operations in Japan, exploiting global-scale economies in R&D and production to offer lower-cost products and overtake Phillips as the world leader in consumer electron- ics. In similar fashion, Sony leveraged its centralized opera- tions in Japan to produce standardized products around the globe. Sony invested far more in R&D than Panasonic did, though, and it was typically the technological and innova- tion leader in the industry, if not the sales leader, from 1980- 2005. By 2009, Samsung had seemingly come out of nowhere to become the world leader in consumer electronics, how- ever. Like Sony, Samsung made large investments in R&D so that it emerged as a technological leader in TVs, DVD play- ers, and smart phones. But rather than just making stand- ardized products that were sold around the globe, Samsung took a more decentralized approach than Panasonic and Sony, which allowed it to do some customizing of products for specific markets. By 2014, Samsung’s lead continued to grow. Observers wondered whether the pattern of leader replacement would continue or if Samsung was on top to stay.

PHILIPS LEADERSHIP ERA: 1900–1980 Philips was founded in 1891 in Eindhoven, the Netherlands, by Dutch engineer Gerard Philips and his brother, Anton. The two brothers initially focused on the light bulb business, with Gerard in charge of product development and Anton in charge of sales. Gerard and Anton began a friendly com- petition in which Gerard would try to produce more than Anton could sell and vice versa.1 The two agreed that strong basic R&D and product development efforts where vital to the success of Philips, so the company made R&D and prod- uct development high priorities. The Philips emphasis on research and product development helped it to become a

leader in its field, rivaling General Electric in the early 1900s in the electric lamp industry.

In 1914, Philips established its first research laboratory dedicated to developing breakthrough technologies in light- ing. This investment helped the company create some of the world’s leading innovations in lighting, such as the tungsten metal filament bulb—a superior advancement over the com- mon carbon-filament lamps. Moreover, the Philips emphasis on research led the company to experiment and develop new technologies that allowed it to expand its product portfolio. For example, in 1918, Philips started to produce electronic vacuum tubes, and soon after that, it was producing X-ray tubes, electric shavers, and small generators. Philips most successful new products were arguably its radios, which, by 1936, a mere ten years after the device’s introduction, had captured a nearly 20 percent world market share.2

Due to the small size of the Netherlands, Philips was forced to expand internationally in order to leverage its investment in R&D and develop some economies of scale in production. By the early 1900s, Philips had begun selling in a wide range of countries, including the United States, France, Russia, Brazil, Canada, Australia, and Japan.3 With such a diverse group of international operations, Philips decided to adopt English as the company language, requiring its use across all of its management ranks. In anticipation of what would become World War II, Philips shifted assets away from the Netherlands and further decentralized management control to the national organizations (NOs) in each country. Anton Philips and much of the top management team fled to the United States, and its main research lab was moved to Eng- land. The decentralization of Philips during the war enabled the NOs in each country to become more independent, thus allowing them to respond to their local market conditions. Each of the larger country NO presidents controlled multiple functions for their countries, including R&D, product design, manufacturing, and sales and distribution (see Exhibit 1). In order to succeed in each local market, the NOs tailored the Philips products to meet consumer preferences in each different country market. For example, some countries, such as the United States, preferred large furniture-encased tel- evision sets, but other countries, such as India, demanded inexpensive, small TVs—often placed inside closable shut- ters to keep the dust away. Additionally, different countries had different ways to penetrate the market, such as through establishing a TV rental business or selling through depart- ment stores or discount retailers.4 The NOs had the flexibil- ity to address the local market as they saw fit while drawing

CASE 09 Samsung: Overtaking Philips, Panasonic, and Sony as the Leader in the Consumer Electronics Industry

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CASE 09 SAMSUNG: OVERTAKING PHILIPS, PANASONIC, AND SONY [ C-83 ]

upon Philips’s technology and financial resources. For exam- ple, Philips of Australia made the first stereo TV, and Philips of the United Kingdom created the first TV with teletext.5 Other countries could then access those technologies and adapt them to their local markets.

As time went on, Philips matured into its postwar organi- zation. Fourteen product divisions (PDs) with responsibil- ity for each product’s development, production, and global distribution were established in Eindhoven. The product divisions were created to better coordinate across country markets. But the real power remained with the NOs.6 The NOs were highly autonomous and reported directly to the management board (often sending proxies to represent their interests). But after the European Common Market broke down trade barriers during the 1960s and 1970s, Philips’s competitors—especially Panasonic (then named Matsu- shita) and Sony—started to gain the upper hand. Prod- ucts started to become more standardized across markets. Whereas Panasonic and Sony were producing large volumes of standardized products in low-wage countries in Asia, Philips was producing smaller volumes of more tailored products in most countries. Over time, Philips products could not compete with the products of its Japanese com- petitors on price or reliability. As a result, Philips’s market share in various consumer electronics products started to fall. The company made numerous attempts to centralize the company in order to compete against its large-scale competition. Such attempts included consolidating produc- tion to a smaller number of high-volume plants called inter- national production centers, closing inefficient operations, shifting production to low-wage countries, and reorganizing the company into core and noncore businesses. But Philips’s market share and profitability continued to decline.

Other problems outside of production also arose for Philips as a result of its decentralized organization struc- ture. In the 1970s, Philips lost the battle as the provider of the preferred videocassette technology when its V2000 for- mat had to be abandoned due to its North American NO deciding to license and sell Panasonic’s VHS format (origi- nally developed by JVC, a subsidiary of Panasonic).7 Despite being a technologically superior format, V2000 was unable to capitalize on world market demand because it sold only in Europe on the PAL standard, whereas its Japanese com- petitors sold globally. VHS would eventually become the market’s preferred format, surpassing both Philips’s V2000 and Sony’s Beta formats, and it would lead Panasonic to the top of the consumer electronics industry in the 1980s.8 By 1987, Philips was one of only two non-Japanese consumer electronics companies in the world’s top ten (the other was General Electric). Its profit margins of 1 to 2 percent lagged behind its Japanese competitors’ 4 to 6 percent (see Exhibit 2).

Between 1990 and 2005, Philips continued to reorgan- ize to centralize operations in an attempt to gain greater efficiencies. In the early 1990s, CEO Jan Timmer reduced headcount by 68,000 or 22 percent, earning him the nick- name “The Butcher of Eindhoven.”9 Due to European laws that require substantial compensation for layoffs (typically 15 months of pay), the first round of 10,000 layoffs cost Philips $700 million. However, after three years of cost cut- ting, a McKinsey study estimated that the value added per hour in Japanese consumer electronic factories was still 68 percent above that of European plants. In 1996, Cor Boonstra replaced Timmer and announced that “There are no taboos, no sacred cows” and “The bleeders must be turned around, sold, or closed.”10 Within three years, he sold off 40 of Philips

[ Exhibit 1 ] Philips Organization Structure in the 1950s.

CEO and Management Board

National Organizations (U.S., U.K., Germany,

Japan, etc.

R&D Product

Development Manufacturing Marketing

Product Divisions

Development

Production

Distribution

International Concern Council

Administration -Finance, Legal HR

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[ Exhibit 3 ] Panasonic’s (Matsushita) Headquarters Organization for International Companies in 1987.

Matsushita Electric Industrial Co., Ltd (MEI)

Matsushita Electric Trading Co. (METC)

Tape Recorder Division

Radio Division

Europe Department

Middle East and Africa Department

Planning Department

Foreign Relations Department

Asia I Department

Asia II Department

Latin America Department

Overseas Advertising Department

Overseas Sales

Companies

(ex. N. America)

Overseas Sources

Companies

Overseas Sales And Manufacturing

Companies

North America Sales

Companies

North America Department

Television Division

Corporate Overseas

Management (COM)

Personnel Division

Financial and Accounting

Division

Source: Adapted from Sumantra Ghoshal and Christopher A. Bartlett, “Matsushita electric industrial (MEI) in 1987,” Harvard Business

School Case 9-388, 1990.

[ Exhibit 2 ] Philips Group Summary Financial Data, 1970–2013

In millions of dollars: 2013 2010 2005 2000 1990 1980 1970

Net Sales $31,209 $19,228 $25,628 $35,253 $32,996 $16,993 $4,163

SG&A $1,270 $556 N/A N/A N/A N/A N/A

Cost of Sales $6,789 $3,968 $4,006 N/A N/A N/A N/A

As % of net sales 22% 21% 16% N/A N/A N/A N/A

R&D Expenses $2,318 $1,192 $2,152 N/A N/A N/A N/A

As % of net sales $0 6.2% 8.4%

Advertising Expenses N/A $1,235 N/A N/A N/A N/A N/A

Income before tax $2,664 1562.0% 1500.0% 2814 –1414 N/A N/A

Net Income $1,568 1085.0% 1097.0% N/A –2631 247 123

As % of net sales 5% 5.6% 4.3% N/A –8% 2% 3%

Total assets $35,530 $24,409 $28,551 $35,885 $30,530 $18,440 $5,273

Employees (in thousands) 116 119 159 219 273 373 359

Labor Costs N/A N/A 5,760 7,895 10,404 7,134 1,627

As % of total employees N/A 24% 23% 22% 32% 42 39

Exchange rate (fiscal period end;

guilder or euro/dollar)

0.7475 1.322 1.186 1.074 1.69 2.15 3.62

Source: Annual reports.

120 major businesses, including well-known units such as Polygram and Grundig. While closing 100 of the company’s 356 factories worldwide, he argued, “How can we compete with the Koreans [new competitors Samsung and LG]? They

don’t have 350 companies all over the world. Their factory in Ireland covers Europe and their manufacturing facil- ity in Mexico services North America.” He also increased advertising by 40 percent to raise awareness of the Philips

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brand and de-emphasize most of the other 150 brands it sup- ported worldwide—from Magnavox TVs to Norelco shavers to Marantz stereos (many of these local brands had been acquired to strengthen Philips’s position in specific local markets). These and other actions helped Philips become more efficient and improved profitability from losses in the early 1990s to profit margins typically in the 4-6 percent range from 2000-2010 (see Exhibit 2).

During the first decade of the new century Philips contin- ued the trend of closing factories in high wage countries, out- sourcing most of the production of its consumer electronics lines and moving in house production to China, Poland, or Mexico. Still, by 2012, Philips had 118 production plants in 24 countries

In addition to looking for savings in manufacturing, Philips also cut back on its advertising budget and focused its channel management on 200 large chains (as opposed to 600 prior to 2001). These moves bore fruit as Philips’ net margins increased to 4.3% in 2005 and 5.6% in 2010 even as increasingly intense competition cost them sales across all product lines, dropping nearly 33% from 2000 to 2010. By 2010 Philips sold its products in over 100 countries worldwide and had begun to penetrate the large populations of poorer consumers in emerging coun- tries, like India, with products like water purification systems.

PANASONIC AND SONY LEADERSHIP ERA: 1980-2000 In 1918, a 23-year-old Osaka Electric Company inspector named Konosuke Matsushita (affectionately known as “KM”) invested a mere 100 yen to start Matsushita Electric Indus- trial (MEI). KM started MEI in a two-room house with his wife, brother-in-law, and two employees. The company’s first product was a light bulb attachment plug, and KM aimed to produce products 30 percent cheaper than its competition. MEI was effective at efficient production, and, by 1931, it had grown to employ 1,200 people in 10 plants, producing more than 200 products. KM argued that “what manufacturers should aim for is to produce as abundantly and as cheaply as tap water; when this is achieved poverty will be conquered from the face of the earth.” A public offering in 1935 allowed Panasonic to diversify further into domestic fans, light bulbs, small motors, and a variety of domestic appliances. Soon the wave of new products became a flood: black-and-white TV sets in 1958; transistor radios in 1959; color TVs, dishwash- ers, and electric ovens in 1960. By 1968, Panasonic produced 5,000 products compared to 80 for Japanese rival Sony. Capi- talizing on this broad product line, the company opened 25,000 domestic retail distribution outlets. With more than six times the number of outlets than Sony, the ubiquitous

[ Exhibit 4 ] Samsung’s Organization Structure in 2013.

Samsung Institute of Advanced Technology

Samsung Leadership

Global R&D Center

Consumer Electronics

Visual Display

Digital Appliance

Printing Solutions

Health and Medical

Equipment

Media Solution Center

Digital Imaging

Network

Mobile Communication

IT & Mobile Communication

Device Solutions

9 Regional Headquarters

Middle East

Europe

Latin America

North America

Southeast Asia

China

Africa

CIS* and Baltics

Southwest Asia

Tokyo RDC

Shanghai RDC

Milian RDC

Seoul RDC

New Delhi RDC*

Europe RDC

LA RDC

Memory

System LSI

LED

Product & Development

Team

Product & Development

Team

*RDC: Regional Design Center *CIS: Commonwealth of Independent States

Product & Development

Team

Source: Samsung, S.D.I. Sustainability Report, 2013.

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“National Shops” represented about 40 percent of all appli- ance stores in Japan in the late 1960s.

Panasonic’s Organization Structure KM organized MEI into product divisions and forced each division to become self-sufficient in various activities includ- ing product development, production, and marketing (see Exhibit 3). This structure allowed KM to easily measure each division’s profit performance because each was a semi- autonomous business unit. If a division needed additional funding, it needed to make a loan request to headquarters; a loan request was then received and reviewed, and, if granted, it was accompanied by an interest rate comparable to mar- ket rates. Headquarters received 60 percent of each division’s earnings and expected high performance from its division managers (a drop in operating profits to below 4 percent of sales for two consecutive years led to replacement of the product division general manager). As a result, internal rivalry among the 36 divisions was intense—a characteristic that was believed to fuel the company’s focus on efficiency and rapid growth. Even the central R&D laboratory was underfunded, which forced it to go directly to the product divisions to ask for R&D projects that would be funded by the product divisions. These management practices helped MEI efficiently produce low-cost products, and by the 1960s, MEI was a dominant player in Japan. As the company looked for growth options, it decided to expand internationally and leverage economies of scale from its large-volume factories in Japan. It wasn’t long before MEI was exporting a diverse set of products, including transistor radios, color TVs, dish- washers, and electric ovens under the Panasonic brand.

As MEI expanded internationally, the strategic direction and product development for the company remained closely regulated by its headquarters in Japan. For the most part, products were researched, designed, and manufactured in Japan, and then foreign managers came and tried to nego- tiate for changes to accommodate the products for their region’s preferences. Headquarters, however, ultimately had the final say as to whether these proposed changes were approved. In order to ensure efficient control of interna- tional operations, the company sent hundreds of expatriate Japanese managers and technicians abroad to oversee inter- national operations and to report back candidly on the state of the company in their assigned areas. As one senior execu- tive noted, “Even if a local manager speaks Japanese, he would not have the long experience that is needed to build relationships and understand our management processes.”11 As such, Panasonic maintained centralized control of local operations around the globe.

Panasonic Overtakes Philips The birth of the videocassette recorder (VCR) propelled Panasonic into first place in the consumer electronics indus- try during the 1980s. In 1975, Sony introduced the techni- cally superior “Betamax” format VCR, and the next year JVC (a subsidiary of Panasonic) launched a competing “VHS” format. Whereas Sony decided to maintain full control over

its Betamax format, Panasonic aggressively licensed the VHS format to a host of other manufacturers, including Hitachi, Sharp, Mitsubishi, GE, RCA, Zenith, and, eventually, Philips. The company quickly built production facilities to meet its own needs as well as those of OEM customers, such as GE, RCA, and Zenith, who decided to outsource production to Panasonic or other Japanese manufacturers. Between 1977 and 1985, capacity increased 33-fold to 6.8 million units. Lev- eraging the distribution channels and brand names the com- pany had established with earlier products (e.g., Panasonic, National, JVC), the new VCRs met with huge success abroad. Panasonic’s overseas sales growth increased a remarkable 52 percent in 1980 and then by a further 35 percent in 1981. In 1985, VCR sales comprised an estimated 43 percent of over- seas revenue. Increased volume enabled Panasonic to slash prices 50 percent within five years of product launch, while simultaneously improving quality. By the late 1980s, VCRs accounted for 30 percent of Panasonic’s sales and 45 percent of profits.

It wasn’t until the late 1980s and a change in CEO that Panasonic looked to move toward a more decentralized strategy. CEO Toshihiko Yamashita launched “Operation Localization” in hopes of dispersing innovation develop- ment and increasing local customization of products; how- ever, for a company so entrenched in a centralized mentality, the change was met with resistance. By 1995, only 250 of the company’s 3,000 R&D scientists and engineers were located outside of Japan, and this was viewed as a problem given the emergence of lower-cost sources of high-quality engi- neers and scientists outside of Japan. Panasonic did estab- lish numerous factories in countries such as Malaysia where wage rates were significantly lower than they were in Japan.

Sony Enters the Fray In 1946, Masaru Ibuka and Akio Morita launched Sony (originally Totsuko) as a radio repair business and short- wave converter manufacturer.12 Although the company had humble beginnings, during the inauguration of the company, Ibuka prophetically declared that the company would cre- ate technologies that large corporations could not match. Ibuka said, “The reconstruction of Japan depends on the development of dynamic technologies.”13 The founders then set out to use the surplus of electricity left by the wartime factories to create consumer electronics. The founders hired engineers with a desire to create new products and focused the company on innovation. Some products, such as the vacuum-tube voltmeter and the electrically heated cush- ion, “sold like hotcakes,” but others, including the primitive electric rice cooker, were memorable failures.14 The com- pany learned from its successes and failures, however, as the founders guided their employees with the slogan “Research Makes the Difference.”

Sony’s focus on innovation motivated its leaders to invest a much higher percentage of their revenues on R&D, an amount typically estimated to be 2-3 times higher than that invested by Panasonic. The innovations that followed included Japan’s first transistor radio, the first all-transistor TV, the first VCR

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(Betamax), the first personal stereo (Walkman), the first CD player, the PlayStation game system, Blu Ray, and many other products.15 Panasonic was usually content to reverse engi- neer Sony’s products and to be a fast follower with a “me- too” product that was lower priced. Consequently, Panasonic would wait and see how the market responded to Sony’s new products before imitating them.16 Sony, on the other hand, was an industry pioneer. Sony’s innovative new products allowed it to successfully expand on a global scale, particu- larly to major industrialized nations looking for innovations, such as the United States. In 1960, Sony established Sony Cor- poration of America (SONAM) in the United States and Sony Overseas, S.A., near Zurich, Switzerland.17 Sony followed that with overseas product development and production facilities in San Diego, California, and Bridgend, Wales. However, these represented a small percentage of Sony’s product develop- ment and production activities because Sony’s operations, like Panasonic’s, were largely centralized and conducted in Japan. The main difference between the two companies was that Sony’s R&D focused more on breakthrough technolo- gies that would lead to new products, whereas Panasonic’s focused more on process technologies that allowed for low- cost and reliable production of products.

Although Sony and Panasonic were leaders in the indus- try in 1990, the following 10 years brought new challenges. Most significantly, Japan’s domestic market for consumer electronics collapsed due to a recession—from $42 billion in 1989 to $21 billion in 1999. Excess capacity drove down prices, and profits evaporated (see Exhibits 5 & 6 for Panasonic and Sony financial information). Although offshore markets were growing, the rise of new competition—first from Korea, then China—created worldwide overcapacity. Samsung had become a particularly effective new competitor by focusing

on design and innovation as a way to differentiate its prod- ucts. By 2005, Samsung was rivaling Sony as a leader in inno- vation and design and its brand had surpassed Panasonic’s in terms of general desirability by consumers. Panasonic, in particular, was struggling because it was unable to keep pace in new product development (Panasonic had little or no presence in game systems, tablets, and cell phones, which were emerging as the growth devices in the industry). In 2012, Panasonic reported a loss of 765 billion yen (approxi- mately $8 billion), and the company’s share price dropped by 41 percent. CEO Kazuhiro Tsuga stated in its annual report, “Our status is one of deep crisis. If we fail to act now, we will lose our standing in the eyes of the world.”

SAMSUNG LEADERSHIP ERA: 2000–PRESENT Samsung group was founded in 1938 by Byung-Chull Lee as a simple trading company in Taegu, Korea that exported basic goods such as dried fish, vegetables, and fruit before expanding into several business lines, including insurance, securities, and retail.18 In 1969, Lee decided to enter the elec- tronics industry and established Samsung-Sanyo. The new unit would undergo several name changes due to joint ven- tures with foreign companies and mergers with other units, but it would eventually settle with the name Samsung Elec- tronics Company (SEC).19 At first, SEC was primarily a low- cost manufacturer of black-and-white televisions, which it sold to other companies that would then resell them under their own better-known brand names. The company followed a neo-Confucian culture that led engineers and designers to imitate the masters of their industry, Japanese firms such as Panasonic and Sony.20 However, Samsung was

[ Exhibit 5 ] Panasonic Summary Financial Data, 1970–2013

In millions of dollars: 2013 2010 2005 2000 1990 1980 1970

Net Sales $80,889 $89,373 $73,847 $70,864 $37,755 $13,690 $2,589

SG&A $11,945 $22,723 $18,890 N/A N/A N/A N/A

R&D Expenses $5,363 $5,747 $5,220 $5,107 $2,176 $479 N/A

Advertising Expenses N/A N/A $207 N/A N/A N/A N/A

Income before tax $451 –$349 $2,093 $2,126 $3,597 $1,521 $408

Net Income –$7,961 –$2,060 $492 $971 $1,484 $587 $194

As % of net sales –9.8% –2.3% 0.7% 1.4% 3.9% 4.3% 7.6%

Total assets $68,052 $100,699 $68,280 $77,233 $49,377 $11,638 $2,042

Employees (units) N/A 384,586 334,752 290,448 198,299 107,057 78,924

Overseas employees N/A 231,733 184,110 143,773 59,216 N/A N/A

As % of total employees N/A 60% 55% 50% 30% N/A N/A

Exchange rate (fiscal period end;

yen/dollar)

97 83 118 103 159 213 360

Note: Data prior to 1987 are for the fiscal year ending November 20; data from 1988 and after are for the fiscal year ending March 31.

Source: Morningstar.com

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[ Exhibit 6 ] Sony Summary Financial Data, 1970–2013

In millions of dollars: 2013 2010 2005 2000 1990 1980 1970

Net Sales $ 70,111.87 $ 75,957.00 $ 56,718.00 $66,301.00 $ 22,745.39 $ 4,191.38 $ 414.37

SG&A $ 15,027.07 $ 18,094.00 $ 3,675.00 $ 15,660.86 $ 5,583.48 $ 1,010.69 $ 89.31

R&D Expenses N/A N/A $ 4,545.00 $ 4,045.71 $ 1,294.26 $ 220.54 N/A

As % of net sales N/A N/A $5.98% 5.33% 1.70% 0.29% N/A

Income before tax $ 2,372.16 $ 2,407.00 $ (532.00) $ 2,187.83 $ 1,900.51 $ 573.55 $ 56.58

Net Income $ 443.65 $ (3,128.00) $ (569.00) $16,754.00 $ 735.38 $ 322.27 $ 28.51

As % of net sales 0.63% –4.12% –1.00% 1.40% 3.90% 4.30% 7.60%

Total assets $146,456.62 $ 85,089.00 $90,665.00 $75,999.67 $ 28,946.51 $ 4,119.31 $ 445.03

Employees (units) N/A 158,500 36,700 N/A N/A N/A

Overseas employees N/A N/A 22,387 N/A N/A N/A

As % of total employees N/A N/A 61% N/A N/A N/A

Exchange rate (fiscal

period end; yen/dollar)

97 83 118 103 159 213 360

Note: Data prior to 1987 are for the fiscal year ending November 20; data from 1988 and after are for the fiscal year ending March 31.

Source: Sony Investor Relations Historical Data

exceptional in at least one area—manufacturing. By 1976, the company had produced their millionth black-and- white TV, and two years later, SEC produced its 4 millionth black-and-white TV, which made it the market share leader in units produced.21 Shortly thereafter, SEC started mass production of several products, including the successfully reverse-engineered designs of the Panasonic microwave oven and VCR. A couple of years later, SEC entered the tel- ecommunications and semiconductor businesses, and by 1985, it had started mass production of its own DRAMs and integrated circuits.22

Samsung New Management Initiative In 1987, Lee passed away of lung cancer and was succeeded as chairman by his youngest son, Kun-Hee Lee. The younger Lee had been involved in Samsung’s leadership since he started at the company in 1968.23 When he took his father’s place, Samsung had already established itself as Korea’s undisputed leader in most of its markets, which were largely compo- nents such as semiconductors (DRAMS), TV screens, hard drives, and batteries. In some product areas, such as DRAMs from the semiconductor business, Samsung emerged as the worldwide market-share leader.24 But the Japanese, notably Panasonic and Sony, were still the clear leaders in most con- sumer electronics products, including TVs, VCRs, DVDs, and cameras. Lee saw an opportunity when Samsung’s Japanese competitors faced recession in their home market, however. The Japanese, leaders in analog technology, which was used in most products, were reluctant to adopt digital technol- ogy due to the large investments that would be required to displace analog. The market, however, seemed to be mov- ing in the digital direction in the form of cameras, audio

equipment, and other electronic goods.25 Lee knew that this was a chance to overtake the competition. But, in order to take advantage of its rivals’ hesitancy, Samsung needed to not only act quickly but also to prepare itself for the digital transformation. As the leader of a Korea-centric company, Lee felt that a change was needed.26 That change came in 1993 when Lee introduced the new management initiative, which emphasized four issues: decentralization, innovative- ness, globalization, and outward-looking management.27 The aim was to retain core competencies in manufacturing and production processes while improving R&D, design, and marketing. The company decentralized by establishing more production and R&D centers around the globe. Although most of Samsung’s manufacturing had been done in Korea, the company established a number of new factories in China, India, Hungary, Slovakia, Mexico, and Brazil. Samsung also established new R&D centers in Japan, Frankfurt, and the United States—each working on the development of prod- ucts for their respective regions of the world.28

Additionally, SEC hired IDEO, a U.S.-based innovation design firm, to help in the design process for their consumer products.29 Designers and design thinking were introduced to the company. Before this time, the engineers controlled the design process.30 This resulted in products that were imitations with no distinct design. The new management initiative, however, empowered designers by requiring them to take a yearlong course in mechanical engineering so that they could properly defend their ideas.31 Engineers were also taught basic ideas in design in order to better work with designers. At first, progress was slow. For example, Gordon Bruce, a veteran design consultant who helped Samsung set up the $10 million state-of-the-art Innovative Design Lab

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of Samsung (IDS), was teaching a class to designers and engineers and asked what they considered to be a perfectly designed object. He suggested a banana and said, “Nature is the best designer. The banana fits in your pocket. It comes in its own sanitary package. It’s biodegradable. And the color indicates when the fruit is ripe.” After he explained there was a confused silence in the class. Then one a student asked, “You mean you want us to design a cell phone in the shape of a banana?”32 Gradually, SEC started to see improvement in their product designs.

Through the new management initiative, Lee created a “hybrid management system” that imported Western best practices and combined them with their existing Korean management practices.33 This implementation was done sensitively. Only practices that needed change were imple- mented in a process that employees could understand and embrace. Some of those changes were adopted faster than others depending on the level of resistance from employees. For example, Samsung slowly added into its seniority-based pay structure a merit-based compensation system like those of General Electric and Hewlett-Packard. Some changes such as stock options were abandoned completely when resistance was too strong.34 The new system challenged key fundamen- tals and established a long-term commitment to investment in premium products and brand value—an area that had trou- bled Samsung in the past. The company had suffered from an image of “cheap Korean goods” due to its low-cost mass pro- duction methods that made it successful during the 1980s.35 To the chagrin of Lee, that image was sometimes validated. For example, as a New Year’s gift in 1995, Lee sent out some of Samsung’s newest phones, only to be informed shortly after- ward that the phones didn’t work in the way they were meant to.36 However, the new management initiative aimed to cor- rect such problems with the adoption of General Electric’s Six Sigma, which was customized to involve not just manage- ment but every Samsung employee.37 The new management initiative started to “internationalize” Samsung so that it was no longer a completely Korea-centric organization.

Effects of the Asian Financial Crises In 1997, the “Asian financial crises” took a large toll on South Korea’s economy. For example, after the Asian market down- turn, Moody’s lowered South Korea’s credit rating from A1 to A3. The Seoul stock exchange experienced historical one day drops (7.2 percent). The South Korean won weakened from 800 per U.S. dollar to 1,700 per dollar, and many large businesses crashed or were bought up by foreigners.38 The effect of the crisis was both bad and good for Samsung. SEC had to cut its domestic and foreign workforces by 26 percent and 33 percent, respectively (a total of about 29,000 work- ers), and it had sold nearly $2 billion in corporate assets that were not directly related to its core electronics businesses.39 The crisis forced Samsung to focus on core businesses and to think carefully about how it would offer unique value to customers. Eric Kim, who acted as executive vice president for global marketing operations at SEC, explained, “The eco- nomic crisis in my view, impressed upon people the need

for a system that could create a resilient and enduring value proposition unique to Samsung—products that would dis- tinguish us from our competitors.”40 In other words, the crisis proved to those involved with SEC that the firm needed to differentiate itself from the competition with premium prod- ucts. In the wake of the crises, SEC dropped its debt from $15 billion in 1997 to $4.6 billion by 2002. In the same time frame, net margins went from -3 percent to 13 percent.41

Samsung’s Continued “Global Localization” The post crisis initiative was again about increasing R&D, design, and brand value. In 1999, SEC began its “Samsung DigitAll: Everyone’s Invited” campaign in order to solidify its position against rivals as the premier consumer electronics company.42 Furthermore, from 1999 to 2007, SEC spent an average of 3 percent of net sales on changing its image as a producer of cheap products.43 Additional investment was put into R&D and design, with the construction of seven additional regional design centers located in Seoul, London, Los Angeles, Milan, New Delhi, Shanghai, and Tokyo (IDS being the corporate design center).44 This “Global Localiza- tion” strategy, as some called it, enabled designers to develop “product design blueprints according to global design stand- ards and themes, while remaining flexible enough to allow local design centers to accommodate specific market needs and cultural contexts.”45 For example, in India, where inexpen- sive but clunky cathode-ray-tube televisions were more pop- ular due to their affordability, Samsung didn’t try and push its more expensive LCD flat screen televisions. It relied on its design centers in emerging economies, such as New Delhi and Shanghai, to design a broad range of products, including some for price-sensitive customers. As a result, Samsung cap- tured a quarter of the market for TVs in India while its Japa- nese competitors fought for a collective 13 percent of market share.46 The same was true for mobile phones. Although typi- cally known for its higher end smart phones like the Galaxy series, Samsung developed different low-end smart phone models for Africa, Eastern Europe, Central America, Russia, India, and the Middle East. Between 1992 and 2005, Samsung also established high-volume manufacturing operations in different parts of the world, with North and South America primarily serviced by plants in Mexico and Brazil (with one large semiconductor plant in Austin, Texas) and Europe largely serviced by plants in Hungary, Slovakia, and the Czech Republic. Asia and much of the world was serviced by more than a dozen plants in China (which by 2007 made up 20 per- cent of Samsung’s worldwide workforce), as well as plants in India, Malaysia, Indonesia, the Philippines, Thailand, and Vietnam (See Samsung’s organization structure in Exhibit 4).

Samsung Becomes the World Leader in Consumer Electronics Samsung’s international strategy began to really bear fruit after 2000. For four consecutive years, from 2000 to 2003, Samsung posted net earnings higher than five percent (see Exhibit 7 for Samsung financial information). This was at a time when 16 out of the 30 top South Korean companies

[ C-90 ] REFERENCES

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REFERENCES

1 Christopher A. Bartlett, Philips versus Matsushita: The Competitive Battle Continues (Boston, MA: Harvard

Business School Publishing, 2009).

2 Ibid.

3 Ibid.

4 Ibid.

5 Ibid.

6 Ibid.

7 Ibid.

8 Ibid.

9 Ibid.

10 Ibid.

11 Ibid.

12 Sony, “Corporate Info: Sony History.” Ch. 1 Rebuilding from the Ashes

ceased operating in the wake of the unprecedented crisis. In 2005, Samsung Electronics surpassed Japanese rival, Sony, for the first time to become the world’s twentieth most valu- able consumer brand, as measured by Interbrand. By 2013, Samsung’s brand was valued at $39.6 billion, making it the eighth most valuable global brand.47 Samsung became the world’s largest maker of LCD panels in 2002, the world’s largest television manufacturer in 2006, and the world’s larg- est manufacturer of mobile phones in 2011. Samsung has also become a leading producer in a broad array of other products, including tablets, laptops, printers, cameras, and refrigerators. In 2009, Samsung achieved total revenues of US$117.4 billion, overtaking Hewlett-Packard to become the world’s largest technology company measured by sales. Additionally, in 2013, 26 percent of SEC’s employees (approximately 235,868) were made up of R&D person- nel.48 Moreover, SEC set the goal to triple its foreign R&D

personnel (reaching 30,000) within the headquarters in Seoul, South Korea by 2022.49 Despite Samsung’s success in research, design, and innovation, it continued to stay true to its initial core strength in manufacturing and components. Samsung had long been a major manufacturer of electronic components and continued to be a leader manufacturing lithium-ion batteries, semiconductors, chips, flash memory and hard drive devices for clients such as Apple, Sony, HTC and Nokia. As of 2014, it operated 37 production facilities throughout the world, including Asia, Eastern Europe, the United States, and other regions.50 It continued to look for low-cost production sites, and in 2013, SEC announced that it would invest $2-4 billion to build 40 percent of its smart phones in Vietnam, where wages were one-third of those in China. Samsung’s future looked bright because it looked to retain its position as the world leader in consumer electronics.

[ Exhibit 7 ] Samsung Electronics Corp. Summary Financial Data, 1970–2013

In millions of dollars: 2013 2010 2005 2000 1995 1990

Net Sales $207,902 $135,771 $56,720 $27,230 $20,917 N/A

Cost of Sales $125,178 90,145 39,642 17,469 12,122 N/A

SG&A $19,372 23,042 9,121 3,856 3,262 N/A

R&D Expenses $13,018 7,990 5,434 1,596 3,137* N/A

Income before tax $33,441 16,971 8,756 6,434 3,884 N/A

Net Income $27,110 14,177 7,542 4,777 3,237 N/A

As a % of net sales 13% 10.40% 13.30% 17.50% 15.50% N/A

Total assets $194,614 117,911 49,890 21,362 51,595 N/A

Employees at year-end (in thousands) N/A N/A 128 66 71.4 N/A

*Reported as 15% of total sales for 1995

Source: Morningstar.com

REFERENCES [ C-91 ]

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13 Ibid.

14 Ibid.

15 Sony, “Corporate Info: Corporate History.” Available at http://www.sony.net/SonyInfo/CorporateInfo/History/

history.html.

16 Kamran Kashani and J. B. M Kassarjian, “Sony Europa (A),” IMD International (December 27, 2002), pg. 2.

17 Ibid.

18 Jean-Bernard Rolland and Robert A. Burgelman, “Samsung Electronics in 2004: Conquering the Wireless Digital

World,” Stanford Graduate School of Business (2004), p. 2.

19 Freeze, Karen J., and Kyung-won Chung. "Design Strategy at Samsung Electronics: Becoming a Top-Tier Com-

pany." Design Management Institute (2008): 441, p. 6.

20 Bill Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

21 Anonymous, “Samsung Group: Our History,” Samsung.com (2012).

22 Ibid.

23 Chris Velazco, “How Samsung Got Big,” TechCrunch ( June 1, 2013).

24 Ibid.

25 Tarun Khanna, Jaeyong Song, and Kyungmook Lee. “The Paradox of Samsung’s Rise’,” Harvard Business

Review 89, no. 7-8 (2011): 2301-2306, p. 3.

26 Ibid.

27 Ali Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The

University of Hong Kong (2009), p. 2.

28 Ibid, p. 3.

29 Ibid, p. 3.

30 Bill Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

31 Ibid.

32 Ibid.

33 Tarun Khanna, Jaeyong Song, and Kyungmook Lee, "The Paradox of Samsung’s Rise’," Harvard Business

Review 89, no. 7-8 (2011): 2301-2306, p. 3.

34 Ibid.

35 Ali Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The

University of Hong Kong (2009), p. 1.

36 Chris Velazco, “How Samsung Got Big,” TechCrunch ( June 1, 2013).

37 Tarun Khanna, Jaeyong Song, and Kyungmook Lee, “The Paradox of Samsung’s Rise’,” Harvard Business

Review 89, no. 7-8 (2011): 2301-2306, p. 4.

38 “The Crash: Timeline of the Panic,” PBS Frontline. Available at http://www.pbs.org/wgbh/pages/frontline/

shows/crash/etc/cron.html.

39 Crhis Velazco, “How Samsung Got Big,” TechCrunch ( June 1, 2013).

40 John Quelch and Anna Harrington, “Samsung Electronics Company: Global Marketing Operations,” Harvard

Business School (2008), p. 2.

41 Ibid.

42 Karen J. Freeze and Kyung-won Chung, “Design Strategy at Samsung Electronics: Becoming a Top-Tier

Company,” Design Management Institute (2008): 441, p. 13.

43 Ali Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University

of Hong Kong (2009), p. 6.

44 Bill Breen, “The Seoul of Design,” Fast Company (December 1, 2005).

45 Ali Farhoomand, “Samsung Electronics: Innovation and Design Strategy,” Asia Case Research Centre, The University

of Hong Kong (2009), p. 6.

46 Shigeki Ichii, Susumu Hattori, and David C. Michael, How to Win in Emerging Markets: Lessons from Japan

(Boston, MA: Harvard Business School Publishing, 2012).

47 “Best Global Brands 2013.” Interbrand.com. Available at http://www.interbrand.com/en/best-global-brands/2013/

Samsung.

48 Samsung, S.D.I. Sustainability Report, 2013.

49 Shafayet Choudhury, “Inside View : Samsung,” Business Because ( January 5, 2012).

50 Samsung, S.D.I. Sustainability Report, 2013.

http://www.sony.net/SonyInfo/CorporateInfo/History

http://www.pbs.org/wgbh/pages/frontline

http://www.interbrand.com/en/best-global-brands/2013

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[ C-92 ]

A fter years of declining revenue and the rise of several innovative competitors, Blockbuster, which had been

the long-time market leader in the movie rental indus- try, seemed ready to collapse. James F. Keyes, Blockbust- er’s CEO since 2007, had seen the writing on the wall for several years. Rapid technological change had provided inroads for competitors with distinct cost advantages and unique value propositions unmatched by Block- buster. Upon joining the company, Keyes moved quickly to improve the in-store experience for customers, leveraging Blockbuster’s historic core competency. But new business models launched by competitors Netflix, Redbox, Amazon. com, and others left the box-store looking like a high-cost modern artifact. Blockbuster’s bottom line was left bleed- ing in the face of plummeting revenues, and Blockbuster filed for Chapter 7 bankruptcy protection in 2011. To sur- vive, Blockbuster would need to reorganize and reshape its strategy. Coming out of bankruptcy, Blockbuster tried to mimic or beat competitive offerings by Redbox, Netflix, and Amazon by growing its kiosk rental business, allow- ing mail-order DVD rentals to be returned by mail or at the store and introducing Direct Access, or in-store access to mail inventory.1 But it seemed too little, too late. Dish Network finally stepped into purchase Blockbuster’s assets for $320 million in 2012, but it appeared that Blockbuster had lost its death match with smaller, more nimble com- petitors, armed not with slings and stones, but with mailed DVDs and broadband.

HISTORY OF THE HOME VIDEO ENTERTAINMENT INDUSTRY When the first motion pictures were released in the early 1900s, there was only one way to view them—at a theater. It wasn’t until television became popular in the 1940s and 1950s that people could watch some movies at home, although viewing was subject to the schedules of the televi- sion networks.

In 1975, Sony introduced its Betamax video cassette recorder (VCR) to the American public. This was closely followed by Panasonic ( formerly known as Matsushita) launching a Video Home System (VHS) VCR, which was then licensed to many companies, including Philips, GE, and RCA. These products could record and play movies, but they were expensive, selling for roughly $1,000 in 1977.2 In Decem- ber 1977, the first video rental store, Video Cassette Rentals, opened its doors, offering both VHS and Betamax videos. Customers joined as “members” for a fee of $50 per year (or $100 for a permanent membership), and they then paid $10

to rent each video. Soon afterward, video rental stores began cropping up all over the United States, and more and more studios began to enter the home video market.3

The adoption of the VCR by the American public was slow at first. In 1980, only 1.1 percent of U.S. households had a VCR. By 1985, that number had grown to 20.9 percent of US house- holds.4 By the end of the decade, VCR penetration was at 68.6 percent,5 and the price of an average VCR had dropped below $400. As the number of VCRs increased, so did the number of video rental outlets. George Atkinson launched a chain of stores called Video Station, which quickly grew to become the market leader, with a total of 500 stores by 1984. But Video Station was soon challenged by Blockbuster, a video rental chain that opened its first stores in 1985. In 1987, Blockbuster acquired the chain Movies to Go, bringing its total number of stores to 67. During the next two years, Blockbuster grew rap- idly through franchising. By 1989, Blockbuster was the largest video rental outlet in the country, with over 1000 stores, and it had begun to expand into overseas markets.6 Hollywood Video opened its doors in 1988, following a growth strategy similar to Blockbuster’s. It quickly became the second largest video rental franchise in the United States.

Box rental stores continued to proliferate through the early 1990s, with no apparent technological or competitive threats in sight. Then, in late 1995, a consortium of electron- ics manufacturers developed the digital versatile disk (DVD). The technology was introduced to the U.S. in 1997, and by mid-1998, Netflix had launched the world’s first online DVD rental service. Later that year, Amazon opened the first online video store, offering 60,000 titles for purchase, includ- ing 2,000 DVDs.7 During this time period, the technological landscape continued to evolve, and in 2002, MGM became the first major studio to allow online pay-per-view consump- tion.8 Redbox launched the same year, with its kiosks pro- viding head-to-head competition with Blockbuster’s 5,566 domestic box-stores.9 In 2003, the year Netflix surpassed 1 million subscribers, annual DVD rental revenue surpassed annual VHS rental revenue for the first time.10

In 2004, CinemaNow was the first company to introduce a service that allowed customers to purchase and download digital movies for unlimited viewing. By 2005, Apple had launched online, digital video services, a move followed by Microsoft and Amazon the next year.11 Viewing quality tech- nology took a leap forward in 2006 with the introductions of high-definition (HD) DVD and Blu-ray. In the same year, Playstation3 became the first gaming console to feature an HD DVD player. Online providers followed suit, increasing video quality as bandwidth became more widely available.12

CASE 10 New Business Models: Netflix, Redbox, Hulu, and Others in Home Movie Entertainment

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The next several years brought a rapid contraction of the physical DVD and VHS rental markets as cost-efficient competitors (most notably Netflix DVD, and Redbox) grew, and online content providers lured viewers away from physi- cal rental. Between 2006 and 2013, the physical DVD rental market dropped from $10.7 billion to $4.5 billion.13 During the same years, total physical DVD-rental industry employ- ment plunged from 141,000 to 55,000.14 The growth of online content providers threatened to further shrink the physical rental market.

The battle for the growing online market continued to unfold in 2013. Facing continued growth of Netflix’s online streaming business, Redbox and Verizon partnered to launch their own streaming service called Redbox Instant. In similar fashion, NBC and Fox joined forces to launch Hulu, offering free, add-supported viewing, and later launching a premium subscription service to rival Netflix’s streaming service. In 2013, both Netflix and Hulu began offering original content, a move highlighting the important and sometimes tenuous relationship between content providers and distributors.

Throughout the history of the home entertainment indus- try, content producers had held significant supplier power. Producers, who owned the content rights to their movies, held the power to negotiate hard contract terms with dis- tributors. Additionally, content producers, like consumers, showed little loyalty to specific distributors, switching chan- nels and partners to maximize profits as the technological landscape shifted. For example, in 2007, NBC and Fox, who were key content providers with their Hulu partnership, showed a willingness to sidestep outside distributors alto- gether in favor of direct, cost-effective online distribution.

Netflix’s decision to produce and distribute its own origi- nally produced shows—such as political drama House of Cards and comedy Arrested Development—was a move to weaken the power of content producers and to differenti- ate its offerings from those of competitors. The initial results from these shows—in terms of positive feedback from con- sumers and advertisers—have been positive. The battle between content producers and distributors continues to significantly shape the competitive industry dynamics.

MAJOR PLAYERS During the history of the home video industry, several play- ers have entered with innovative business models that have changed the competitive landscape. Leaders among these firms have been Blockbuster, Netflix, Redbox, Apple, Micro- soft, Amazon, and Hulu. A look at each provides insight into the industry’s rapidly changing dynamics and the strategies and business models deployed by its strongest players.

Blockbuster The first Blockbuster store opened in Dallas, Texas, in 1985. The store was successful, which prompted Blockbuster to open several more stores in the area and eventually a local warehouse to provide and manage inventory. Taking a les- son from his previous experience in database management,

Blockbuster’s founder, David Cook, designed the warehouse to efficiently stock a selection of titles customized to each store according to its local demographic. This innovation brought a convenient, customized choice of VHS titles to cus- tomers in the exciting new arena of home entertainment.15

The company decided it could grow more quickly if it pur- sued a franchise model like the one used by McDonalds and many other fast food giants. With a franchise model, indi- viduals in different cities and regions paid an upfront fran- chise fee (anywhere from $200-400,000),16 which gave them the right to own and operate a Blockbuster store at a spe- cific location. In addition to receiving the upfront franchise fee, Blockbuster received an ongoing percentage of revenues generated from each store. Although the franchise model meant that Blockbuster had to share profits with the fran- chisees, it allowed Blockbuster to grow at a much faster rate than would have been possible if Blockbuster had tried to finance and build all of its stores.

After a period of strong financial performance, Blockbuster was acquired by John Melk and Wayne Huizenga, a success- ful entrepreneur who had founded Waste Management and AutoNation. Huizenga became CEO and grew the business aggressively, both organically and through the acquisition of key competitors, including a 250-store buyout of mid-Atlantic rival Erol’s.17 Pushing into international markets, Blockbuster purchased the 875-store Ritz video chain of England in 1989. In 1991, Blockbuster entered the Japan and Australia markets through a mix of partnerships and acquisitions.18 By the early 1990s, Blockbuster had come to dominate the home video rental market in the United States, with over 3,500 stores around the country.19 (see store growth in Exhibit 1). Each store carried more than 1,000 different movie options. Block- buster needed to make this large investment in stores and inventory in order for customers to be able to conveniently find a store—and a desirable movie to rent.

Blockbuster’s growth often came at the expense of tra- ditional mom-and-pop video stores that found it hard to compete on selection and price. Customers often preferred the consistency of experienced, well-trained employees, as well as the variety of locations offered by Blockbuster com- pared to smaller stores and franchises. Blockbuster quickly discovered that it didn’t make money from the videos sitting on the shelves. It needed to get customers to rent the DVDs and return them as quickly as possible so Blockbuster could rent them to another customer. To encourage customers to return DVDs quickly, it charged late fees. These fees were unpopular with customers, but Blockbuster couldn’t make money if it didn’t get the DVDs back quickly. This pain point would later pave the way for industry disruption through Netflix’s subscription-based model.

Blockbuster continued to win market share and was acquired for $8.4 billion by Viacom in 1994. It was only two years later, however, that the company’s market value plum- meted to an estimated $4.6 billion because investors were losing confidence and sales began to slip.20 Blockbuster split from Viacom in 2004 and launched Blockbuster Online to

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compete directly with Netflix’s subscription business. Carl Icahn joined the board in 2005 and began a tenuous relation- ship with the then CEO John Antioco, who ended up leav- ing the firm in 2007.21 Blockbuster’s market value had fallen to approximately $850 million by late 2005.22 After Antioco’s exit, James Keyes was named CEO and launched initiatives to return the focus to the in-store retail experience. The efforts proved insufficient to turnaround the company, which lost $3.8 billion between 2003 and 2010. Pricewater- houseCoopers issued a statement in 2010 expressing doubt that Blockbuster could continue as a going concern. Block- buster filed for Chapter 11 bankruptcy in September of that same year, citing competition from Netflix and Redbox as the cause of plummeting revenues and its inability to service its $900 million worth of debt.23

Despite its struggles, Blockbuster remained the mar- ket leader in the movie rental industry, serving 47 million customers daily in 18 countries. In 2010, however, it lost $20 million following a $310 million loss the year before.24 Lacking the resources to continue restructuring, Block- buster moved toward Chapter 7 bankruptcy and liquida- tion in 2011. James Keyes’s bold efforts to increase revenues, improve the customer experience, cut costs, and imitate competitive offerings proved to be too little, too late. Soon after, Dish Network acquired Blockbuster for $320 mil- lion. In early 2012, Dish announced that 90 percent of the remaining stores would stay open and continue to rent DVDs and games, while adding sales of wireless products which could be used to stream Blockbuster movies. Dish had initially announced plans to reshape Blockbuster into a head-to-head competitor with Netflix, but it retracted those plans in late 2012.25 At the time of the 2011 bankruptcy fil- ing, Blockbuster was operating a total of 5,220 company stores worldwide,26 a number that fell drastically through the bankruptcy and Dish acquisition process. In November

of 2013, Dish announced it would close the remainder of its Blockbuster stores and shut down the Blockbuster By Mail service, but the streaming service Blockbuster On Demand would remain intact, and Blockbuster franchises and licensed stores in the United States and internationally would stay open.27

Netflix Reed Hastings launched a company aimed at fulfilling his dream of building the world’s best internet movie service. The company was incited in part by a $40 late fee charged to Hastings for the video rental of Apollo 13. Inspired by his vision and fueled by his frustration, Hastings created Netf- lix and the company’s innovative subscription-based rental model that has revolutionized the way many people con- sume home entertainment.28

Netflix’s model was simple: customers paid a monthly subscription fee for unlimited mail-order DVDs plus unlim- ited online streaming. Initially, Netflix offered eight subscrip- tion plans ranging in price from $8.99 per month to $47.99 per month that allowed customers to rent one to eight DVDs at a time. With a subscription, customers could enjoy unlim- ited rentals without due dates, late fees, shipping fees, or per-title rental fees. DVDs could be conveniently selected, received, and returned without ever having to walk further than the mailbox.29

Netflix’s business model was revolutionary. Whereas box- shop competitors such as Blockbuster moved titles from warehouses to store to customer, Netflix shipped directly from the warehouse to the customer. This model eliminated the need for brick and mortar stores, simplifying the value chain, and it allowed Netflix to cut costs and pass the sav- ings on to customers. In 2010, Netflix’s general and admin- istrative costs represented only 3 percent of total revenue, compared to 52 percent for Blockbuster, a cost primarily related to store labor and leases. (See Exhibit 2 for a full income statement).30 Netflix’s low fixed asset requirement allowed capital to be spent elsewhere, such as on expanding content, which furthered its advantage over the box-shop business model.

From the customer’s perspective, the downside of renting movies over the Internet was that you had to plan ahead— no impulse movie watching. You couldn’t just pop over to the Blockbuster store and grab a movie to watch. But the upside was the ability to access 90,000 movies shipped from 50 warehouses around the country—warehouses strate- gically placed to ensure most customers got their orders within two days. This business model gave customers many more movie options to choose from. Offering customers a large selection of DVDs was fundamental to Netflix’s strat- egy. Titles included new and old Hollywood releases, clas- sics, independent films, documentaries, and TV shows. Netflix invested heavily to maintain a diverse selection and to gain early access to new releases, partnering with content providers through direct purchases, revenue-sharing plans, and licensing agreements.

[ Exhibit 1 ] Number of Blockbuster Stores Over Time

BLOCKBUSTER STORES

Year Company- Owned

Franchised Stores

Total

1990 928 654 1,582

1996 4,472 845 5,317

2000 6,254 1,423 7,677

2005 7,158 1,884 9,042

2010 4,322 1,022 5,344

2011 n/a n/a 1,500

2012 n/a n/a 575

Source: Public filings; Kim Peterson, “More Blockbuster Stores

Closing,” http://money.msn.com. Financial information for video

rentals is not available for Amazon, Apple, Hulu, or Microsoft.

http://money.msn.com

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Because Netflix customers paid a monthly fee, the com- pany’s business model made profits in a manner opposite to Blockbuster’s. Netflix made more money when customers didn’t watch the DVDs they ordered. As long as the DVDs sat unwatched at customer’s homes, Netflix didn’t have to pay return postage or mail out the next DVD. Because Netf- lix didn’t have to build stores, hire sales clerks, or buy a huge inventory of DVDs to put in each store, it had more than a 30 percent cost advantage over Blockbuster. It was able to share some of this cost advantage with customers in the form of lower prices, and keep some of this advantage in the form of higher profits. With a solid value proposition and low costs, Netflix grew quickly, breaking 100,000 subscribers in 1999, renting its billionth title in 2007, and climbing to over 35 million subscribers by 2012 (see Exhibit 3).31

To support the growth, Netflix built over 50 high-effi- ciency distribution centers and 50 additional shipping points, placing 97 percent of the company’s customers within a one-day shipping reach. From 2008 to 2012, Netf- lix experienced a compound annual growth rate (CAGR) in revenues and gross profit of 21.5 percent and 16.7 percent,

respectively (see Exhibit 4). Following its IPO in May 2002, the company’s market value was approximately $300 mil- lion.32 That value rose to $1.5 billion by the end of 2005 and $9.3 billion by the end of 2010. Following a drop to $5.1 bil- lion in December 2012, which was attributed to a loss of cus- tomers when Netflix split its streaming service from its DVD

[ Exhibit 2 ] Financial Information for Selected Years for Blockbuster ($ millions).

FISCAL YEAR 2010 2005 2000 1993

Income Statement Items

Revenues $2,125.9 $5,721.3 $4,960.1 $2,227.0

Cost of sales $884.8 $2,564.0 $2,036.0 $430.0

G&A expenses $1,116.8 $2,724.1 $2,174.0 $178.0

Advertising $50.5 $252.7 $215.3 $50.8

Depreciation & amortization $76.1 $226.6 $459.1 $396.1

Operating profit $(2.3) $(388.0) $75.7 $423.0

Interest expense $94.3 $98.7 $116.5 $33.8

Income taxes $7.4 $63.3 $45.4 $146.2

Net income $(268.0) $(588.1) $(75.9) $243.6

Balance Sheet Items

Cash and cash equivalents $146.5 $276.2 $194.2 $95.3

Merchandise inventories $242.4 $310.3 $242.2 $350.8

Rental library, net $269.1 $475.5 $646.7 $470.2

Property & equipment, net $165.5 $723.5 $1,079.4 $522.7

Total assets $1,183.5 $3,179.6 $8,548.9 $3,521.0

Current liabilities $562.3 $1,317.9 $1,123.2 $643.2

Total liabilities $1,735.5 $2,548.0 $2,540.5 $1,297.6

Total equity $(552.0) $631.6 $6,008.4 $2,123.4

Source: Blockbuster SEC filings.

In 2011, Blockbuster filed for bankruptcy protection and was subsequently purchased by Dish Network.

[ Exhibit 3 ] Growth in Netflix Subscribers

NETFLIX SUBSCRIBERS

Year Total subscribers (000’s)

2000 292

2005 4,179

2010 20,010

2011 26,253

2012 35,489

Source: Netflix public filings.

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[ Exhibit 4 ] Netflix Financials ($ millions).

FISCAL YEAR 2013 2012 2011 2010 2005 2001

Income Statement Items

Revenues $4,374.6 $3,609.3 $3,204.6 $2,162.6 $682.2 $74.2

Cost of revenues $3,083.3 $2,625.9 $2,039.9 $1,357.4 $465.8 $49.9

Operating expenses

Technology and development $378.8 $329.0 $259.0 $163.3 $35.4 $17.7

Marketing $3,083.3 $2,625.9 $2,039.9 $293.8 $144.6 $21.0

General and administrative $180.3 $139.0 $148.3 $70.6 $35.5 $4.7

Gain on disposal of DVDs $(6.1) $(2.0)

Operating income $228.3 $50.0 $376.1 $283.6 $3.0 $(37.2)

Interest expense $29.1 $20.0 $20.0 $19.6 $407.0 $1,852.0

Income tax $58.7 $13.3 $133.4 $106.8 $(33.7)

Net income $112.4 $17.2 $226.1 $160.9 $42.0 $(38.6)

Balance Sheet Items

Cash and cash equivalents $605.0 $290.3 $508.1 $194.5 $212.3 $16.1

Current content library, net $1,706.4 $1,368.2 $919.7 $181.0

Content library, net $2,091.1 $1,506.0 $1,046.9 $181.0 $57.0 $3.6

Property and equipment, net $133.6 $131.7 $136.4 $128.6 $40.2 $8.2

Total assets $5,412.6 $3,967.9 $3,069.2 $982.1 $364.7 $41.6

Current liabilities $2,154.2 $1,675.9 $1,225.1 $388.6 $137.6 $26.2

Total liabilities $4,079.0 $3,223.2 $2,426.4 $691.9 $138.4 $30.3

Total equity $1,333.6 $744.7 $642.8 $290.2 $226.3 $(90.5)

Source: Netflix SEC filings and Annual Reports.

mail service, the market value recovered in January 2013 back to $9.3 billion.33

As Netflix grew, it signed larger traditional licensing agreements and began offering new types of content. In 2010, Netflix announced a $1 billion partnership with Paramount Pictures, MGM, and Lions Gate Entertainment to continue content delivery to its expanding customer base.34 And, in 2013, Netflix began creating its own content (Arrested Devel- opment and House of Cards) in a bid to compete with cable and network television. By mid-2013, several Netflix series had received Emmy nominations for original, online-only web television.35

Redbox Redbox launched in 2002 as a venture initially funded by McDonalds. McDonalds was an early investor because it saw the potential of video rental kiosks, as well as McDon- ald’s stores as a key distribution channel. Redbox’s innova- tive strategy centered on a distribution network of low-cost,

self-service vending kiosks. The kiosks allow customers, with a swipe of their credit card, access to a limited selection of the hottest new releases for $1.20 per night (previously $1.00 for the company’s first eight years). A customer may return the title the next day or keep it with daily rental charges accruing until the customer owns the DVD outright after 25 days. The kiosks were placed in high-traffic locations to encourage impulse rentals and to make planned rentals as convenient as possible. Retailers were incentivized to place kiosks by receiving a share of revenue, which was typically based on the retailer’s appeal (e.g., Walmart would receive a larger share than a mom-and-pop store). The customer rental experience was kept simple and conveni- ent. The selection process was simplified by the limited choice of titles (70-200 at most locations), all of which are prominently displayed on each kiosk. Redbox’s nonsubscription model allowed customers to rent without the hassle of paperwork or membership fees. DVDs could be returned to any kiosk, add- ing a final touch of convenience to the rental process.

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CASE 10 NEW BUSINESS MODELS: NETFLIX, REDBOX, HULU, AND OTHERS IN HOME MOVIE ENTERTAINMENT [ C-97 ]

Redbox grew quickly from 2003-2005, adding over 1,100 kiosks throughout the United States.36 In 2005, Coinstar paid $32 million to acquire 47 percent of the company, and four years later, they purchased the remaining equity from McDonalds for approximately $170 million.37 Redbox’s low- cost kiosks model allowed rapid expansion, and by 2012, the company had 43,700 kiosks (see Exhibit 5). The average cost of a Redbox kiosk was only $15,000 with an additional $6,720 for DVD costs to initially fill the kiosk.38 With Redbox fully onboard, Coinstar’s market value rose from an estimated $800 million in late 2009 to a peak of $2.1 billion in mid-2012 (see Exhibit 6).39

By 2012, 68 percent of the US population lived within a 5-minute drive of a Redbox kiosk,40 and the company con- trolled 47.8 percent of the physical rental market.41 Redbox’s footprint continued to grow throughout the United States and Canada, with almost 44,000 kiosks in operation in 2012 and more planned. This vast network of kiosks was enabled by a network of regional operations supervisors who were responsible for the maintenance and operation, including stocking, of all kiosks in their assigned geographic regions.42

Redbox partnered with Verizon in 2013 to launch a video- streaming service called Redbox Instant, which was similar to the one offered by Netflix. For $8 a month, customers enjoy unlimited streaming of more than 4,600 titles and up to four disk rentals from kiosks. The service is offered through Android and iOS mobile apps and on xBox and Playstation 4 gaming platforms.43

Apple, Amazon, and Microsoft: Internet Video on Demand Beginning in the mid-2000s, Apple, Amazon, and Microsoft began to leverage their online capabilities and customer bases to win a share of the video on demand (VOD) mar- ket. VOD allows customers to rent titles for a single viewing or unlimited viewings within a specified time period (often 24 hours). Pay-TV operators, such as Comcast and Direct TV, traditionally controlled this market, but their stronghold began to erode with the rise of Internet video on demand (iVOD) beginning in 2005. Despite rapid growth of the iVOD segment, Pay-TV operators maintained a 72 percent share of the VOD market in 2012. The balance of the market was split between electronic sell-through (EST), or the digital down- load and ownership of titles, which comprised 16 percent of the market, and traditional iVOD, with a 12 percent share.44

The EST market had been dominated by Apple, which held a 65 percent share in 2012, with Microsoft controlling a growing 10 percent of the market and other players includ- ing Sony, Amazon, and Walmart. Meanwhile, the iVOD mar- ket had been more fragmented, with Apple commanding a 45 percent market share in 2012, followed by Amazon at 18 percent and other players, including Walmart (through Vudu) and Microsoft (through Xbox video).45 Apple began offering videos through the iTunes music store in 2005, with a narrow selection of TV shows and music videos. One year later Apple added over 500 TV shows and began offer- ing movies for download, with prices ranging from $9.99 to

[ Exhibit 5 ] Growth in Number of Redbox Kiosks

Year Total kiosks

2002 12

2005 1,200

2010 30,200

2011 35,400

2012* 43,700

Source: Public filings (included in Coinstar Inc. filings), www.redbox

.com/timeline.

*Excludes kiosks and the impact of kiosks acquired as part of the

NCR Asset Acquisition.

[ Exhibit 6 ] Redbox Financials ($ Millions)

FISCAL YEAR 2013 2012 2011 2010 2009 2008

Income Statement Items

Revenue $1,974.5 $1,908.8 $1,561.6 $1,159.7 $773.4 $388.5

Direct operating expenses $1,383.6 $1,340.9 $1,134.2 $859.8 $585.2

Marketing $23.0 $20.5 $22.0 $14.2 $8.2

G&A $166.1 $159.9 $120.4 $94.9 $78.5

Operating income $239.0 $238.7 $169.5 $190.9 $101.6 $50.2

Balance Sheet Items

Total assets $1,896.7 $1,561.7 $1,450.8 $561.2 $468.9 $378.1

Source: Outerwall SEC filings.

http://www.redbox

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[ C-98 ] CASE 10 NEW BUSINESS MODELS: NETFLIX, REDBOX, HULU, AND OTHERS IN HOME MOVIE ENTERTAINMENT

$19.99. Apple launched its iVOD service in 2008, allowing customers to rent through iTunes for as little as $0.99 per title. Microsoft launched an iVOD service through its Xbox platform in 2006, offering rentals for $2 to $6. Original con- tent was provided through partnership with several studios, including CBS, MTV, and Paramount Pictures.

Amazon followed suit in 2006 with its own iVOD service called Unbox, which was later rebranded as Amazon Video on Demand and then Amazon Instant Video. Amazon pur- sued a broad selection of movies and, by 2008, offered 5,000 titles as compared to Apple’s selection of 800. In 2011, Ama- zon began including 5,000 streaming movies and TV shows as a part of its Amazon Prime Membership.46 The offering had grown to 40,000 titles by 2013. Amazon’s VOD services allowed customers to pay and view movies individually or to gain unlimited access to a library of content through an annual membership to Amazon Prime, a bundled ser- vice package costing $79 each year, which also included free 2-day shipping on purchases and access to thousands of Kindle eBooks. However, Amazon Prime members were still required to pay a separate rental fee for newer popular titles. In this way, Amazon straddled the subscription-based approach of Netflix, while at the same time offering the more flexible membership-free approach of competitors such as Apple.47

EST and iVOD offered distinct value propositions and cost advantages that further disrupted the home entertain- ment industry. EST allowed consumers to purchase videos for unlimited views from the comfort of home, conveniently storing the titles to hard drive or in the cloud. iVOD com- bined the streaming benefits of Netflix with the financial simplicity of Redbox, allowing home streaming of a range of titles with no subscription required. Both services elimi- nated the need for physical DVDs and physical distribution channels.

Hulu In a move to connect content providers directly to online consumers, NBC Universal and Fox launched a joint venture in 2007 to offer aggregated, ad-supported streaming online content.48 The deal was backed by Providence Equity Part- ners, which took a 10 percent stake for $100 million, valuing the company at $1 billion. 49 After a period of development, beta testing, and branding, Hulu launched in the U.S. market in March of 2008. NBC used its existing channels to adver- tise the service, including a spot in its Super Bowl broadcast in February of 2009. That spring, Disney joined the venture, committing a significant amount of content and taking a 27 percent equity stake.50

Hulu reached profitability in 2010 and continued rapid growth, with 900 million monthly streams in January, which was triple the figure from a year before. By 2010, Hulu offered content from over 200 providers, each earning from 50 to 70 percent of content-generated ad revenues.51 Hulu’s total rev- enues reached $420 million in 2011 (see Exhibit 7), fueled in part by a rapidly growing paid subscription service—Hulu Plus. Hulu Plus offers customers access to a broad range of premium, though still ad-supported, content for $7.99 per month. Additionally, Hulu Plus customers gain early access to content and are often able to view content within a day of its original broadcast, compared to a week or more for free customers. By the end of 2011, the service boasted over 1.5 million subscribers with a rapid growth trajectory.52

Mirroring moves from Netflix, Hulu announced that it had ordered its first original series in early 2012. The move both created competitive differentiation and began to decrease Hulu’s reliance on outside content from TV and movie stu- dios, the business’ main cost driver. In 2012, Hulu disclosed it would spend over $500 million to develop original content to help differentiate its service.53 In 2013, Disney, Fox, and Com- cast (the acquirer of NBC) explored options to sell Hulu but opted to keep the company, citing optimism in the develop- ing business model. The networks committed $750 million of new capital to broaden content offerings and update the platform, positioning the company to compete directly with Netflix for a share of the online streaming market.54

CONCLUSION Although James Keyes’s efforts to avert Blockbuster’s demise appeared valiant, they proved no match for the onslaught of technology, value, and convenience offered by its up-and- coming competitors in home entertainment—competitors with cost structures and competencies specifically developed to support their respective business models. Blockbuster’s attempt to match its competitor’s offerings through its Block- buster Express® kiosk business, its mail-order DVD program, and its digital service BLOCKBUSTER On Demand ®, seemed to be too little too late. Nor could an improved customer experience save thousands of Blockbuster brick-and-mortar stores from closing their doors. Dish Network, Blockbuster’s new owner, faced the difficult task of deciding the future of the former rental titan. How could Dish best utilize Block- buster’s name and remaining assets? Could Blockbuster still provide value going forward? After all, the Blockbuster brand was a household name and a new partner in Dish to bolster its digital presence.

As Dish wrestled with these problems, other players such as Redbox and Netflix had decisions of their own to

[ Exhibit 7 ] Hulu Finanscials ($ Millions)

Fiscal Year 2013 2012 2011 2010 2009

Revenues $1,000.0 $695.0 $420.0 $263.0 $108.0

Source: Privco, blog.hulu.com.

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REFERENCES [ C-99 ]

consider. For both Netflix and Redbox, the future of the DVD rental market within the home entertainment indus- try was becoming unclear as more and more content dis- tributors focused on providing downloaded and streaming content. For Redbox, how long would consumers continue to be willing to physically go out and rent a movie or video game from a kiosk? Would the flexibility of Redbox Instant’s bundling of digital streaming and complementary credits to rent at physical kiosks provide the right value proposition to consumers?

In addition to deciphering the method of delivery, the acquisition and development of content would be another issue facing entertainment distributors. By producing their own content, distributors such as Netflix and Hulu had begun to shift power away from traditional content produc- ers. This upstream expansion into content development had

already yielded positive results for Netflix. Yet, could this threat to producers cause them to more aggressively move downstream into distribution? Could the rise of smaller independent content producers aid distributors in the power struggle against established traditional producers?

Technological advances and innovative business models showed little sign of slowing down in the home entertain- ment industry. How would the current generation of power players address the competitive forces and disruptive inno- vations they would undoubtedly face? How would the ever increasing broadband internet capabilities, a rapidly grow- ing internet user base, and technologies yet to be discov- ered affect these players’ strategic directions? Perhaps most importantly, who could adapt to the dynamic environment, and who would be left to join the many companies that had washed up on the shores of the industry for decades?

REFERENCES

1 PRN Newswire, “Blockbuster Reports Fourth Quarter and Fiscal-Year 2009 Financial Results” (February 24,

2010). Available at http://investor.blockbuster.com/phoenix.zhtml?c=99383&p=irol-newsArticle&id=1395025.

2 Entertainment Merchants Association, “Industry History: A History of Home Video and Video Game Retailing”

(2004). Available at http://www.entmerch.org/press-room/industry-history.html.

3 Ibid.

4 TVB, “TV Basics” (2010). Available at http://www.tvb.org/media/file/TV_Basics.pdf.

5 Ibid.

6 Entertainment Merchants Association.

7 Ibid.

8 Ibid.

9 Public filing, Form 10-K

10 Entertainment Merchants Association.

11 Ibid.

12 Ibid.

13 http://clients1.ibisworld.com/reports/us/industry/currentperformance.aspx?entid=1370

14 Ibid.

15 “Video Venture: Taking Charge of Blockbuster,” Bloomberg Business Week. Available at http://www.business-

week.com/chapter/chap0009.htm.

16 Jonathon Maze, “Want Successful Franchises? Charge Higher Fees, “ Franchise Times (April 2013). Available at http://

www.franchisetimes.com/finance/April-2013/Want-Successful-Franchisees-Charge-Higher-Franchise-Fees/.

17 Entertainment Merchants Association.

18 Blockbuster Inc., Public Filings, .

19 Ibid.

20 “Blockbuster Inc. History”. Available at http://www.fundinguniverse.com/company-histories/blockbuster-inc-history/.

21 Blockbuster Inc., Public Filings.

22 Jill Goldsmith, “Blockbusted,” Variety (October 9, 2005). Available at http://variety.com/2005/biz/news/

blockbusted-1117930420/.

23 Blockbuster Inc., Public Filings.

24 Ibid.

25 Ibid.

26 Ibid.

27 Patrick de Hahn, “Blockbuster to Shutter All U.S. Stores,” CNN Money (November 6, 2013). Available at http://

money.cnn.com/2013/11/06/news/companies/blockbuster-stores-closing/; Andy Vuong, “Dish to Close 300

Blockbuster Stores,” Denver Post ( January 21, 2013). Available at http://www.denverpost.com/ci_22419439/

dish-close-300-blockbuster-stores.

http://investor.blockbuster.com/phoenix.zhtml?c=99383&p=irol-newsArticle&id=1395025

http://www.entmerch.org/press-room/industry-history.html

http://www.tvb.org/media/file/TV_Basics.pdf

http://clients1.ibisworld.com/reports/us/industry/currentperformance.aspx?entid=1370

http://www.business-week.com/chapter/chap0009.htm

http://www.franchisetimes.com/finance/April-2013/Want-Successful-Franchisees-Charge-Higher-Franchise-Fees

http://www.fundinguniverse.com/company-histories/blockbuster-inc-history

http://variety.com/2005/biz/news

http://money.cnn.com/2013/11/06/news/companies/blockbuster-stores-closing

http://www.denverpost.com/ci_22419439

[ C-100 ] REFERENCES

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28 Alyssa Abkowitz, “How Netflix Got Started,” CNN Money ( January 27, 2013). Available at http://money.cnn.

com/2009/01/27/news/newsmakers/hastings_netflix.fortune/.

29 Netflix, Public filings.

30 Ibid.

31 Ibid.

32 “NFLX Market Cap.” Available at http://www.marketcapchart.org/chart.php?symbol=nflx&mc_option=true.

33 Netflix. And, Ycharts, “Netflix Market Cap.” Available at http://ycharts.com/companies/NFLX/market_cap.

34 Brian Stelter, “Netflix to Pay Nearly $1 Billion to Add Films to On-Demand Service,” New York Times (August 10,

2010). Available at http://www.nytimes.com/2010/08/11/business/media/11netflix.html?_r=0.

35 Brian Stelter, “Netflix Does Well in 2013 Primetime Emmy Nominations,” New York Times ( July 18, 2013). Available at

http://artsbeat.blogs.nytimes.com/2013/07/18/watching-for-the-2013-primetime-emmy-nominations/?_r=0.

36 Redbox, “The History of Redbox” (2014). Available at http://www.redbox.com/timeline.

37 Coinstar Inc., Public Filings, .

38 Amir Fardshisheh, “Coinstar: Deep Value and Exceptional Growth, “ Gurufocus.com (March 4, 2011). Available

at http://www.gurufocus.com/news/125840/coinstar-deep-value-and-exceptional-growth.

39 Coinstar Inc., Public Filings, .

40 Redbox, “Facts about Redbox” (2014). Available at http://www.redbox.com/facts.

41 Coinstar Inc., Public Filing, Form 10-Q, Q1 2013.

42 Unknown, “Redblog: A Day in the Life of Redbox Ninja” (April 12, 2010). Available at http://blog.redbox.

com/2010/04/a-day-in-the-life-of-a-redbox-ninja.html.

43 James Wilcox, “First look: Redbox Instant is like the old Netflix, but with kiosks,” Consumer Reports (March 15,

2013). Available at http://www.consumerreports.org/cro/news/2013/03/first-look-redbox-instant-is-like-the-

old-netflix-but-with-kiosks/index.htm.

44 Steve Sanger, “Apple iTunes Break Through as VOD Leader,” worldtypc.com (February 2, 2013). Available at

http://www.worldtvpc.com/blog/apple-itunes-break-through-as-vod-leader/.

45 PRWeb, “The NDP Group: Apple iTunes Dominates Internet Video Market” (April 23, 2013). Available at http://

www.prweb.com/releases/2013/4/prweb10659785.htm.

46 http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-news&nyo=0 “Amazon Press Releases”

47 Amazon.com, “Amazon Prime” (2014). Available at http://www.amazon.com/dp/B00DBYBNEE?_encoding=

UTF8&*Version*=1&*entries*=0.

48 Hulu, Press Release: “NBC Universal and News Corp. Announce Deal with Internet Leaders AOL, MSN, MYS-

PACE, and YAHOO! to Create a Premium Online Video Site with Unprecedented Reach” (March 22, 2007). Avail-

able at http://www.hulu.com/press/new_video_venture.html.

49 CrunchBase, “Hulu.” Available at http://www.crunchbase.com/company/hulu.

50 Hulu, “About Us.” Available at http://www.hulu.com/about/news.

51 Nicholas Carson, “Hulu CEO Talks IPO, We Reveal How Much Money Hulu Makes,” Business Insider ( July 7,

2010). Available at http://www.businessinsider.com/hulu-ceo-talks-ipo-here-are-the-financials-2010-7.

52 Jason Kilar, “2011, 2012 and Beyond” ( January 12, 2012). Available at http://blog.hulu.com/2012/

01/12/2011-2012-and-beyond/.

53 Jennifer Van Grove, “Hulu CEO Jason Kilar: Original programming is an important part of the agenda,” venturebeat

.com ( January 31, 2012). Available at http://venturebeat.com/2012/01/31/hulu-jason-kilar/.

54 Gina Hall, “Disney and Fox CEOs realize what they have in Hulu,” bizjournals.com (August 8, 2013). Available at

http://www.bizjournals.com/losangeles/news/2013/08/08/disney-and-fox-ceos-realize-what-they.html.

http://money.cnn

http://www.marketcapchart.org/chart.php?symbol=nflx&mc_option=true

http://ycharts.com/companies/NFLX/market_cap

http://www.nytimes.com/2010/08/11/business/media/11netflix.html?_r=0

http://artsbeat.blogs.nytimes.com/2013/07/18/watching-for-the-2013-primetime-emmy-nominations/?_r=0

http://www.redbox.com/timeline

http://www.gurufocus.com/news/125840/coinstar-deep-value-and-exceptional-growth

http://www.redbox.com/facts

http://blog.redbox

http://www.consumerreports.org/cro/news/2013/03/first-look-redbox-instant-is-like-the-old-netflix-but-with-kiosks/index.htm

http://www.worldtvpc.com/blog/apple-itunes-break-through-as-vod-leader

http://www.prweb.com/releases/2013/4/prweb10659785.htm

http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-news&nyo=0

http://www.amazon.com/dp/B00DBYBNEE?_encoding=

http://www.hulu.com/press/new_video_venture.html

http://www.crunchbase.com/company/hulu

http://www.hulu.com/about/news

http://www.businessinsider.com/hulu-ceo-talks-ipo-here-are-the-financials-2010-7

http://blog.hulu.com/2012

http://venturebeat.com/2012/01/31/hulu-jason-kilar

http://www.bizjournals.com/losangeles/news/2013/08/08/disney-and-fox-ceos-realize-what-they.html

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[ C-101 ]

F ollowing six years of innovation and upheaval in the smartphone industry, 2013 was shaping up to be no differ-

ent. Industry players continued to differentiate and capital- ize on the rapidly evolving landscape. Early market leaders struggled to recapture market share lost years earlier to newer entrants, and new players vied to remain disruptive. Apple, whose iPhone had sparked the smartphone frenzy in 2007, sought to broaden its appeal by introducing a less expensive iPhone that had a casing made of plastic, instead of glass. Search engine giant Google’s Android OS was the most widely adopted smartphone platform, with almost half of all Android devices being made by Samsung, the Korean electronics company. Having started its smartphone endeavor by building phones and supplying parts for other equipment manufacturers, Samsung had burst on the scene in 2010, rapidly gobbling up market until it had become the world’s highest-volume phone maker in 2012.1

Meanwhile, Research in Motion (RIM), Nokia, and Microsoft, which were all market leaders in the pre-iPhone smartphone industry, continued to sputter (see Exhibit 1). After an exclusive partnership with Nokia failed to produce strong enough results, Microsoft announced an agreement to acquire the Finnish phone maker in hopes that the combi- nation might yield cost savings and innovations that neither company had been able to obtain on its own. Microsoft Win- dows 8 Phone sales had not met expectations, but analysts remained hopeful that new developments would produce the next wave of creativity and value. By 2013, RIM, which had changed its name to BlackBerry after its iconic banner prod- uct, had struggled with ventures in tablets and new operating systems. Finally, in late 2013, BlackBerry announced plans to cut 40 percent of its workforce and stop selling to consumers.2

Every player in the smartphone wars had delivered inno- vative products at some point and had dealt with strate- gic moves by competitors, but market leadership had been fleeting. These companies dealt with challenges on every front. Each move brought with it competitive responses and countermoves. New products, such as tablet com- puters and smart watches, threatened to make the entire industry obsolete.

Could any of the companies involved in the smartphone wars find a path to sustained industry leadership? And if not, could they at least avoid the path of demise followed by RIM?

HISTORY OF THE INDUSTRY The first mobile phones emerged shortly after World War II.3 Briefcase-sized and very limited in range and functionality, commercialized mobile phones took another three decades to gain critical mass. These first mobile phones were typi- cally so large that most were only found in cars. However, in the 1970s, the first handheld mobile phones hit the market. The United States, Japan, Denmark, Sweden, Finland, and Norway all rolled out mobile phone networks between 1979 and 1981. These first handhelds ran on an analog system, called 1G.

Beginning in the 1990s, the new all-digital 2G network continued to expand as more cellular towers were built. Better technology allowed for smaller components, new features like SMS text messaging, and smaller phones. As phones became more convenient to carry around, demand exploded. With the 2G network, the first downloadable ring- tones introduced a concept that would later be crucial as smartphones gained popularity a decade later: downloading information from the Internet via a wireless connection.

CASE 11 Smartphone Wars

[ Exhibit 1 ] Global Smartphone Sales to End Users from 1st Quarter 2009 to 2nd Quarter 2013, by Operating System (Millions of units)

Android iOS Microsoft RIM Symbian Others

2009 2.76 16.22 10.83 23.83 57.02 7.92

2010 67.22 46.59 12.38 49.65 111.58 12.47

2011 220.67 89.27 8.76 51.53 88.41 14.25

2012 449.54 129.07 17.01 34.21 28.51 19.27

2013 334.09 70.23 13.4 12.4 1.98 3.28

Source: Gartner Company, “Gartner Says Worldwide Mobile Device Sales to End Users Reached 1.6 Billion Units in 2010; Smartphone Sales

Grew 72 Percent in 2010” [Press Release] (February 9, 2011).

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[ C-102 ] CASE 11 SMARTPHONE WARS

Smartphones emerged as “a category of mobile device that provides advanced capabilities beyond a typical mobile phone. Smartphones run complete operating system soft- ware that provides a standardized interface and platform for application developers.”4 These new smartphones were more advanced and offered greater flexibility than feature or “dumb”5 phones. Early smartphones would hardly be recognized as such today, however. In 1993, IBM launched the first smartphone, the Simon,6 which offered a full touch screen. The Simon had a few applications, or apps (software used for functions other than running the device’s operat- ing system7), such as fax, personal digital assistant (PDA), pager, calculator, and address book. Unlike users of later smartphones, which stored applications on the device itself, Simon users had to switch out memory cards that held indi- vidual applications in order to enjoy many of the features offered. In addition to being bulky and expensive (the Simon retailed for $899), Simons lacked access to a wide variety of apps. Within two years of hitting the markets, IBM had retired the Simon. Although a business failure for IBM, the Simon was the first spark that ignited a new subindustry of smartphones.

Throughout the next 10 years, additional smartphones hit the market.8 Nokia and Ericsson launched their own ver- sions in the late 1990s. Ericsson’s second generation phone featured a full touchscreen at a time when button-centric devices dominated the landscape. In addition, this device offered the first “open” operating system (OS), the Symbian OS. An open OS allowed third-party developers to create applications to be downloaded and run on a device. Third- party developers innovated to give users access to a much broader array of technologies on their devices. These early smartphones developed slowly until the birth of what mod- ern smartphone users would recognize as the earliest “pure” smartphones. By 2007, Nokia, Palm, Microsoft, and RIM had all risen to power, but new companies such as Apple, Google, and Samsung would usher in a new wave of innovation.

Nokia Nokia was a Finnish company that rose to prominence in the late 1990s, enjoying market leadership in the mobile phone industry for over 15 years. Mass adoption of feature phones helped Nokia establish itself as the leading producer of handsets. Following success among mass consumers with feature phones, Nokia launched many different smart- phones. The first Nokia smartphones were expensive and primarily targeted to business customers.9 Nokia smart- phones, like Ericsson’s, ran on the Symbian OS, making it the largest OS for more than five years. Nokia strove to dif- ferentiate its phones early on by investing heavily in mobile gaming and music technologies. However, Nokia struggled later in the decade as the BlackBerry (see below) gained momentum. Although easily the top overall cell phone sup- plier, Nokia felt the sting of losses in its smartphone busi- ness and took measures to protect its market share among smartphone users. For example, in response to the growing

threat of Palm smartphones, Nokia began launching phones with a full keyboard.

Palm An early player in the PDA realm, Palm decided to merge its PDA functionality with a cell phone in 2002,10 calling it the Treo. The resulting technology was a great solution for busi- ness people who didn’t want to carry around a PDA and a phone. Although the Treo enjoyed mass adoption and mar- ket domination, its reign on top of the smartphone world was threatened by two other players that launched smartphones in the same year—software giant Microsoft and a startup called Research In Motion, or RIM. By 2007, Palm controlled less than 10 percent of the smartphone market and watched the rest of its share erode over the next couple years.11

Microsoft Envious of the growth of other technology companies in the mobile industry, the maker of the seemingly ubiquitous Windows OS for PCs, Microsoft, decided to stake its own claim in the mobile game. In 2002, the company introduced what it touted as a “Microsoft Windows powered smart- phone.”12 Microsoft hoped the first handset to run its new OS, the Orange SPV, and subsequent devices would leverage its reputation in desktop computing to create a “pocket PC” that would appeal to customers already using Windows for their PCs at home or in the office. Rich in software-building capabilities, Microsoft entered the smartphone market in a revolutionary manner. Previously, the phone and the operat- ing system that powered the phone were made by the same company. However, in the spirit of its desktop history, Micro- soft decided to sell its open Pocket PC operating system to equipment manufacturers such as Samsung and HTC. By licensing its OS, Microsoft earned new revenues without needing to branch outside of its core software competency into hardware manufacturing. For the next five years, the Microsoft OS increased in proliferation and market share.13

RIM In 2002, the Canadian startup, RIM, launched the first ver- sion of a blockbuster line of products. Although Palm’s Treo represented a significant technological advancement by combining a PDA and cellular phone, many corporate tech- nology departments were not keen on the idea of providing employees with phones that offered access to corporate email accounts, unless the email could be made more secure. Sensing a market opportunity, RIM launched the first email- optimized smartphone, the BlackBerry. The BlackBerry ensured a secure and protected connection to corporate email accounts. First road warriors, then the rest of the busi- ness world, and finally average consumers bought BlackBer- rys. Its plastic keyboard and large screen added to its appeal. People everywhere seemingly could not get enough of their “CrackBerries.” RIM, recognized by many as a leader of inno- vation and creativity, invested millions into think tanks and technological institutes.14 A second market-smashing

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CASE 11 SMARTPHONE WARS [ C-103 ]

product, the BlackBerry Pearl, came out in 2006, propelling RIM to market leadership through 2009.15

By 2007, BlackBerry was on top of the world, and Micro- soft and Nokia were not far behind. Consumers loved their phones, which allowed them to email, talk, or text anyone cheaply and quickly. As the year started, none of the phone makers could have imagined their worlds would be turned upside down by a maker of computers and MP3 players. However, Apple’s new iPhone served as the catalyst that completely redefined the battle for smartphone suprem- acy and paved the way for the rise to dominance of Apple, Google, and Samsung.

Apple Apple Computer, a Silicon Valley-based computer hardware and software maker, had been making headlines for years because of an adjacency move—leveraging strengths built in one industry or business to help the company in another area—that not only reshaped an industry but saved the floundering Microsoft competitor. By the turn of the century, Apple cofounder, Steve Jobs, had returned to the company and was again CEO. Faced with slipping sales and market share in the PC industry, Jobs introduced a new product in 2001 that would revive Apple’s creativity and design prow- ess that had all but had disappeared in the recent past. The new iPod16 was an MP3 player capable of holding over 1,000 songs, which users could download from Apple’s iTunes music platform onto its 5 GB hard drive. Although it was hardly the first MP3 player, the iPod’s unique design and gargantuan capacity turned the music player device industry on its head. For the next six years, Apple continued to launch different iterations of the iPod. Incumbents were caught off guard by Apple’s jump into, and dominance of, the MP3 market. Similarly, six years later, few people expected what was to come next when Apple made another leap into the smartphones market.

On January 9, 2007, Steve Jobs unveiled what Apple touted as a combination of an iPod, a cell phone, and an Internet communications device17 all merged into one pocket-sized machine, the iPhone. The initial iPhone featured EDGE (a predecessor to 3G technology that provided internet access over cell phone networks) and Wi-Fi capabilities, which allowed users to connect with the Internet anywhere there was service. It came with built-in applications, or apps, including Google Maps, Google Search, a calendar, iTunes, and an email client that could connect to most commonly used email accounts. Initially, Apple partnered with the larg- est cellular company, Cingular (later acquired by AT&T), as the exclusive provider for the iPhone. Although the iPhone attracted media attention, most com- petitors felt it was not a serious threat. Unlike previous smartphones, the iPhone did not have a physical keyboard; all operations were carried out on its large touchscreen. The 8 GB iPhone was set to retail at $599, a price point similar to other high-end smartphones at the time, although Windows phones were frequently discounted substantially from list

prices.18 Some critics scoffed at the new product, saying it would never become a substantial player in the highly com- petitive smartphone industry, especially among BlackBerry- addicted business people. Windows CEO, Steve Ballmer, whose Windows Mobile OS was enjoying a 17 percent mar- ket share at the time, boldly stated, “That is the most expen- sive phone in the world, and it doesn’t appeal to business customers because it doesn’t have a keyboard, which makes it not a very good e-mail machine.” Mr. Ballmer continued, “I kinda look at that and I say, well, I like our strategy. I like it a lot.”19 Instead of directing its initial focus on business customers, Apple sought to grab market share by appealing to general consumers. Apple included applications on the iPhone such as its iTunes music player, a full web browser, and a photo management application for its 2-megapixel camera. The combination of iPhone-only apps and impres- sive design made June 29, 2007 one of the most anticipated release dates and product launches ever.

Google At the time of the iPhone’s launch, Google and Apple had an unusually good relationship for two of the nation’s largest tech companies. Apple featured Google’s search and map- ping technologies prominently in its marketing campaigns, increasing the iPhone’s appeal and driving search results to Google. In addition, Google’s CEO, Eric Schmidt, sat on Apple’s board of directors.

However, Google, always eager to spot the next big tech- nology trend, began to recognize the tremendous potential smartphones and mobile computing had in shaping the future of technology. Google realized that the company own- ing the operating system most phones ran on would be well positioned to reap the benefits of this growth. In November 2007, Google announced that it had partnered with multi- ple tech companies, including Samsung, HTC, Motorola, and ARM, in acquiring a startup that had been developing a mobile OS called Android. These companies joined together to form the Open Handset Alliance (OHS) with the goal of creating the first truly open and comprehensive platform for mobile devices.20 With this announcement, Google threw its hat into the smartphone ring. Unlike Apple, however, Google was not interested in building phones; rather, it wanted to provide an open OS that could be run on phones made by different manufacturers. The first Android-powered device, a cell phone made by HTC and carried by T-Mobile, launched later the next year. Although not as flashy or heavily pro- moted as the iPhone, the cheaper Android phones began rapidly grabbing market share.

Samsung The Korean conglomerate, Samsung, first got involved with the smartphone industry by building smartphones for Sprint in 2001. Unlike many stylus-centric phones of the time, Sam- sung phones were touch-friendly. As the RIM BlackBerry gobbled up market share, Samsung released a copycat ver- sion in 2006, which ran on the Windows OS, the Blackjack.21

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In 2005, Samsung contracted a deal with Apple to provide flash memories for iPods at a locked-in price.22 Samsung increased its business with Apple over time, providing inexpensive, quality components for its electronics. Sup- plying parts to other hardware manufacturers, although a viable cash stream in and of itself, also allowed Samsung to develop its own handsets more cheaply through the econo- mies of scale these activities produced. The first iPhone ran on many Samsung parts. “Samsung supplied the majority of Apple’s NAND flash memory and a large portion of another chip type, the ‘DRAM (both important components of a cell phone’s computing capabilities)’ in mobile devices,”23 estimated Mark Newman, an analyst at Sanford Bernstein in Hong Kong. Samsung would continue to become a more important player in the smartphone industry.

INDUSTRY DYNAMICS After Google’s announcement of the Android OS, competi- tion intensified as rapid moves by each player accelerated the rate of change in the industry. The Android platform fol- lowed an open model, meaning any third-party software pro- grammer could develop apps for the Android Market, from which Android owners could download the apps onto their phones. Apple, on the other hand, maintained a closed soft- ware model, tightly controlling which apps were available for download. After the announcement of Android, however, Apple adjusted its strategy to allow third-party developers to launch apps in the App Store after Apple had approved them.24 By making this move, Apple sought to mitigate fears that Google’s totally open platform might entice developers to create more apps for Android than Apple, thereby increas- ing the market appeal of Android-powered smartphones and creating a network effect. Apple made this change to allow third-party apps in its App Store months before Android devices were available, stemming any damage that may have been inflicted had the company made the move later. The App Store topped 10 million app downloads in its first weekend.25

At the same time, Apple launched a new version of its phone, the iPhone 3G,26 which allowed users to surf the web at twice the speed of the EDGE technology built into the first phone.27 The iPhone 3G also introduced GPS navigation in a phone. Like the App Store, the iPhone 3G met a warm wel- come, selling one million phones in the first weekend.28 The new phones sold for less than one-third the price of the first iPhones.

Former market leaders were baffled as they ceded mar- ket share to two companies with no prior experience in the mobile industry. Microsoft’s Windows Mobile platform sput- tered as the software giant struggled to develop a response to Apple’s iPhone. RIM continued to grow for two more years after the launch of the first iPhone, but it too fell from grace as the Android OS gained traction.29 Samsung released the Instinct, an iPhone lookalike, which ran on a patchwork Java- based OS. A few months later, Samsung launched another smartphone, the Omnia, running on Windows. Although

neither of these products achieved the hoped-for success, early vestiges of future user-interfaces (UI) were first seen with these launches.30

There were many changes in the rapidly evolving smart- phone industry during 2009. Google launched its newest version of the Android OS, called “Cupcake,”31 which offered a touchscreen (or soft) keyboard and video recording capa- bility. For this Android update (each update is named alpha- betically after a popular confection), Google and Motorola teamed up to produce a keyboard-less phone, the Droid. Later that year, Eric Schmidt was asked by Apple’s direc- tor, Steve Jobs, to resign from Apple’s board. Jobs stated, “As Google enters more of Apple’s core businesses with Android and now Chrome OS, Eric’s effectiveness as an Apple Board member will be significantly diminished.”32 The two former allies had officially become competitors. However, Google’s and Apple’s approaches to the market still differed substan- tially. Said one industry expert:

Google’s answer is that most computing tasks should happen in the cloud, via software that runs in massive Internet data centers housing users’ data, files, and contacts so they’re accessible from anywhere. Apple’s vision for the future is very different. Its business is about selling elegant, powerful, high-margin machines that put much of the computing power in your pocket [iPhone], in your briefcase [MacBook], or on your desk [iMac]. For that it relies more than any other tech company on so-called ‘native code’ written for a specific machine. Apple, more than any company in tech history, has been able to create its own proprietary environment.33

Apple faced another major challenge in addition to Google, though. Since 2005, Apple had sourced many parts for its devices from Samsung. But, as the Korean electronics com- pany increasingly moved into head-to-head competition with Apple for smartphone sales, Apple executives began searching for alternative suppliers. Apple leaders felt that, although Samsung claimed to keep its parts and phones businesses separate, sending design plans for its new prod- ucts was giving a dangerous advantage to a growing com- petitor. In 2009, Apple started sourcing most of its NAND flash memory from Toshiba in an effort to diversify its supply chain strategy.34

Evolving Markets As 2010 began, Android really took off. By then, Google had released multiple versions of Android, which hand- set manufacturers often tweaked in order to differentiate their products, often adding their own look and feel to the native Android version. In an effort to present Android as Google had meant it to be, the search-engine-giant-turned- mobile-OS-provider commissioned HTC to build the Nexus One, a phone without any of the tweaks that other Android phone makers added to their phones. The Nexus One ran a “pure” version of the Android OS. Although the project to

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bring an unaltered Android representation to market may have seemed minor in light of the hundreds of other Android devices, it represented an important milestone in the battle between Google and Apple. The Nexus One demonstrated a shift in Google’s strategy as it started moving closer to actual hardware manufacturing, instead of just providing a free operating system.35 By the end of the first quarter in 2010, Android had started to reach critical mass, gaining a 10 per- cent market share.36

In the first half of 2010, Apple made its own shock waves by debuting a new product, the iPad.37 With the iPad, Apple merged its phone and computer products to create a new product segment of computing devices, called tablets. The iPad drew heavily on the processing and power of Apple computers, while incorporating the Apple’s mobile operat- ing system, iOS. Uncertain about whether tablets belonged to the phone or computer world, phone and computer mak- ers responded with tablets of their own.38 Additionally, in June 2010, the next version of the iPhone, the iPhone 4, was released. The iPhone 4 was the thinnest smartphone ever and featured a front-facing camera for its FaceTime applica- tion, a function that allowed users to make video calls from their phones. The phone also ran the newest version of the Apple mobile operating system, iOS 4. By the launch of the iPhone 4, more than 225,000 apps were available on the App Store, and over 5 billion apps had been downloaded (see Exhibit 2).39

As the Google versus Apple battle continued through the summer of 2010, Samsung released its first phone in its Galaxy product line, the Galaxy S Vibrant.40 The Vibrant ran on Android with a slightly customized UI. The Galaxy S was somewhat successful, but more importantly, it paved the way for the Galaxy S II and S III; two phones that would have tremendous impact in solidifying Samsung’s market share and popularizing its brand among smartphone users.

Former competitors, Nokia and Windows, were both los- ing market share rapidly and looking for ways to stop the bleeding (see Exhibit 3). Nokia’s CEO, Olli-Pekka Kallasvuo, was replaced by Stephen Elop of Microsoft’s Office Division.41 The new Windows Phone 7 went on sale in November and was available on the Samsung Focus and two models from HTC.42 This release was Microsoft’s response to the iPhone launched over two years earlier. The Windows Phone did not have the hoped for effect of increased sales, however. Both former smartphone heavyweights, Nokia and Microsoft, partnered in early 2011 to combat the undeniable market shifts brought on first by Apple and intensified by Google. In a presentation alongside Microsoft CEO Steve Ballmer, Elop

announced Nokia’s commitment to use Windows Phone software in future smartphones.43

At the same time, Apple was having struggles of its own with one of its largest suppliers, Samsung. Worried that Sam- sung was encroaching too much into Apple’s phone business, Apple executives tried to move the screen production of its new iPad to electronics company Sharp. However, Sharp was unable to meet the time demands and product require- ments, and Apple was eventually forced to return to using Samsung as its screen provider. Samsung then unexpectedly moved to acquire a 3 percent stake in Sharp. The move, said one analyst, “would make Samsung not only Sharp’s fifth- largest shareholder but its key client, potentially preventing Apple from gaining more bargaining power with Sharp.”44

Smartphones continued to dominate the market (see Exhibit 4), but phone makers were increasingly explor- ing the tablet computer space. In February of 2011, Google released a version of its OS exclusively for Android tablets, which represented a strategic offshoot from the search company’s main phone business.45 Apple responded a month later with the launch of its second tablet iteration, the iPad 2.46 In that same month, Google beefed up its game across phone and tablet platforms by introducing in-app billing functionality. In-app billing allowed app developers to collect money directly from end users, instead of hassling with phone carriers who had allowed users to charge app purchases directly to their phone bill and had traditionally taken a large chunk of all app revenues.47 Google’s strategy in introducing this flexibility in billing was to entice more developers to build Android apps, creating a more appeal- ing OS (see Exhibit 5).

[ Exhibit 2 ] Total App Downloads

Q3’10 Q4’10 Q1’11 Q2’11 Q3’11 Q4’11 Q1’12 Q2’12 Q3’12 Q4’12 Q1’13 Q2’13

iOS App Store 6 7 11 13 15 18 25 30 34 37 40 50

Google Play 1 2 3 4 6 10 13 20 23 29 40 48

Source: “The App Store’s 50B Downloads vs. Google Play’s 48B: Android Closes the Gap,” TechCrunch (May 15, 2013).

[ Exhibit 3 ] Top Five Smartphone Vendor Shipments (millions of units)

UNIT SHIPMENTS

Vendor 2010 2011 2012

Nokia 100.3 77.3 35.1

Apple 47.5 93.1 136.8

RIM 48.8 51.1 32.5

Samsung 23 94.2 215.8

HTC 21.5 43.6 32.6

Others 61.5 136 92.4

Source: IDC Worldwide Mobile Phone Tracker (January 24, 2013;

January 27, 2011).

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In April of 2011, Apple, Google, and Samsung all made headlines. Apple became the largest smartphone vendor by revenue and units sold, selling 18.6 million iPhones in the first quarter of 2011. Samsung was close behind, with 17.5 million phones shipped . Google hit a milestone by becom- ing the most universally used smartphone platform. Its Android OS had a 36.6 percent market share, as opposed to former market leader Symbian’s 27.0 percent .48

Worried about the momentum of its suppliers in its own smartphone business, Apple sued Samsung for “copying hardware and design features from Apple.”49 In response, Samsung launched its second Galaxy phone, the Galaxy SII, in May, causing Apple to double-down its efforts to push through litigation.50 The Galaxy S II exploded on the smart- phone scene. In the past, many phones were released on only one wireless provider (like iPhone and AT&T’s initial partnership); however, Samsung arranged deals with three of the four major U.S. carriers for the Galaxy S II launch. Its wide availability and iPhone-esque design (one of the rea- sons Apple was suing Samsung) played important roles in Samsung’s strategy for driving mass adoption at a rate faster than Apple’s.

After losing most of its market share, Microsoft won an important legal battle requiring LG, Samsung, and HTC to pay per-handset royalties for patent infringements.51 Although the adoption of the Windows Phone 7 had not met optimistic predictions, Microsoft secured a revenue stream on handsets made by these three companies.

In a move that baffled analysts, in August of 2012, Google announced its decision to acquire the cell phone division of Motorola, one of the early pioneers in the commerciali- zation of mobile phones during the 1980s. Industry experts were shocked to see Google, a software company, purchase a hardware company. The search giant agreed to pay $12.5 billion for Motorola Mobility.52 With the acquisition, Google took another step closer to competing in the hardware side of the smartphone war just as much as it did on the software side (see Exhibit 6).

Searching for an option to stunt the growth of its Silicon Valley neighbor, Google, Apple launched the iPhone 4S in October 2011.53 Apple hoped to slow down Google by reduc- ing the search traffic Apple sent its way. So, the new iPhone integrated Siri, a virtual personal assistant app that helped users access information without sending them to Google’s search engine. Apple’s extensive marketing campaigns for the 4S launch were directed at creating hype around the Siri feature, in hopes that such enthusiasm would lead fewer peo- ple to turn to Google when they needed help.54 First weekend sales of the 4S topped 4 million devices.55 (See Exhibit 7.)

Samsung stole the show for the last quarter of 2011 and the first quarter of 2012, however. In November of 2011, it became the global leader in smartphone shipments, sur- passing Nokia and Apple.56 Samsung also won the contract to produce the newest version of the Google Nexus. Early in 2012, Samsung unveiled a new category-busting product. The Galaxy Note was too large to be considered an ordinary smartphone, but it was not large enough to really act as a

[ Exhibit 4 ] Smart versus Feature Phones

TYPE

Month Smartphone Feature Phone

Sep-10 29% 71%

Oct-10 30% 70%

Nov-10 30% 70%

Dec-10 35% 66%

Jan-11 36% 64%

Feb-11 38% 62%

Mar-11 37% 63%

Apr-11 37% 59%

May-11 40% 58%

Jun-11 41% 57%

Jul-11 42% 56%

Aug-11 43%

Sep-11 44% 56%

Oct-11 44% 54%

Nov-11 46%

Dec-11 48% 52%

Jan-12 48% 52%

Feb-12 50% 50%

Source: Nielsen Mobile Insights (Feb 2012).

[ Exhibit 5 ] App Revenue per Platform Index

Month iOS App Store Google Play

Jan-12 100 7

Feb-12 95 8

Mar-12 105 10

Apr-12 115 13

May-12 103 14

Jun-12 98 13

Jul-12 114 17

Aug-12 115 18

Sep-12 11 24

Oct-12 117 27

Nov-12 124 30

Dec-12 170 46

Source: Data approximated from the App Annie Intelligence Index

(App Store January 2012 Revenue Index set to 100).

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full-fledged tablet; therefore, the “phablet” was created.57 At first, analysts worried this oversized phone would not gain a foothold in the market, but sales for the Note boomed. Android-based phones now accounted for over 50 percent of the smartphone market58 and continued to grow as Google continued to improve its OS and release new features. One such feature, Google Music (now Google Play Music, after the Android Marketplace became Google Play), allowed Google to compete with yet another feature of Apple’s offer- ing, a music store.59

After five years of struggling, first against the iOS and then against Android, RIM’s co-CEOs and co-Chairmen, Jim Bal- sillie and Mike Lazaridis, resigned in January of 2012.60 The former market leader had seen the company’s market share erode over the course of a few short years. At its peak in May 2008, RIM stock prices had reached $138.87 per share. Now, just over three years later, stocks were scraping along at a measly $16.63 per share. In an attempt to rejuvenate sales, RIM had developed and launched a new operating system. The OS was first released on the company’s first tablet prod- uct, the PlayBook.61 However before the beginning of 2012, RIM had already been forced to write off nearly half a bil- lion dollars for the unsold and discounted tablets still sitting in inventory.62 The company hoped to slow the bleeding by launching a new phone, the BlackBerry 10, but the product’s outlook remained bleak.

In the summer of 2012, Samsung tightened its foothold once again with another version of the Galaxy (see Exhibit 8). The

Galaxy S III was released on all four major U.S. carriers and was even featured in the opening ceremonies of the 2012 London Olympic Games.63 The Galaxy S III combined hardware, avail- ability, and intense marketing to drive its success.64 As Apple announced the new iPhone 5, a group of Samsung marketers teamed up with an advertising agency to craft a response. The result was a marketing spree poking fun at Apple fan boys (die- hard Apple product fans), portraying smart customers to be those who chose the Galaxy S III.65 In its first 100 days on the market, more than 20 million Galaxy S IIIs were sold.66 Samsung passed Nokia for total cell phones (smart plus feature phones) shipped worldwide, selling 93 million units to Nokia’s 83 million and Apple’s 35 million.67

A marketing attack by Samsung was not the only concern Apple had to face with the iPhone 5’s launch in September.68 After its attempt to choke the search stream being sent to Google by introducing Siri, Apple took its plan one step further. Google Maps, a highly featured app on the first iPhones, Apple announced, would be replaced by an Apple map app.69 How- ever, Apple’s alternative left many owners of the new iPhone 5 disgruntled and lost. The company’s mapping capabilities, said customers, were not good enough. After two months of bad press, Apple finally surrendered and, with a quiet announce- ment, returned Google Maps to the App Store.70

In November of 2012, Microsoft released its next smart- phone, the Windows 8 Phone.71 The phone’s launch was accompanied by Microsoft’s release of the new Windows 8 OS for PC and its first tablet, the Surface. All products,

[ Exhibit 6 ] Google Simplified Financials 2009–2012

GOOGLE (USD MILLIONS)

2009 2010 2011 2012

Revenue 23,651 29,321 37,905 50,175

Cost of revenues 8,844 10,417 13,188 20,634

Gross margin 14,807 18,904 24,717 29,541

Operating costs 6,495 8,523 12,975 16,781

Operating profit 8,312 10,381 11,742 12,760

Source: Google Annual Reports

[ Exhibit 7 ] Apple Simplified Financials 2009–2012

APPLE (USD MILLIONS)

2009 2010 2011 2012

Net revenue 42,905 65,225 108,249 156,508

Cost of sales 25,683 39,541 64,431 87,846

Gross margin 17,222 25,684 43,818 68,662

Operating costs 5,482 7,299 10,028 13,421

Operating profit 11,740 18,385 33,790 55,241

Source: Apple Inc. Annual Reports

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including the Xbox 360, were compatible with each other. Following the Windows 8 Phone debut, a report from com- Score revealed that Microsoft-powered smartphones had actually decreased in overall market share.72 However, a report by Frost and Sullivan predicted, “Nokia/Microsoft will continue to gain share based on brand recognition of both companies and device designs. The Nokia Lumia 710 has consistently been one of the top-five selling smart- phones on T-Mobile USA since it launched in January 2012.”73 Whether Windows could capitalize on synergies with Nokia remained unclear.

In January 2013, Samsung continued to make gains in the market. Forty-five percent of all Android phones were made by Samsung. However, the Korean phone maker also released a Windows 8 Phone and announced plans to con- tinue working on the development of a new OS, Intel-backed Tizen.74 Long the global leader in smartphone sales, Sam- sung passed Apple as the leader in domestic smartphone sales75 for the month of May 2013, after releasing the Galaxy S IV.76 In July, Apple finalized a deal with Taiwanese TSMC to begin making some of its chips starting in 2014—another effort to reduce its dependence on Samsung.77

Looking Forward Nearly two years after announcing the deal to acquire Motorola, Google, and Motorola released the Moto X in August 2013.78 It was the closest pure “Google Phone” to ever hit the markets.

On August 23, 2013, Steve Ballmer, the only CEO besides co-founder Bill Gates to lead the software giant, announced plans to retire within the following year. Within two weeks of the announcement, Microsoft also revealed a deal to acquire virtually all of Nokia’s business. In a joint press release the move was explained as follows: “Microsoft aims to accelerate

the growth of its share and profit in mobile devices through faster innovation, increased synergies, and unified branding and marketing.”79 In addition the deal would give Nokia more financial stability.

Later that month, Apple announced two new iPhone models, the 5S (a standard improvement on the 5) and the 5C (the first iPhone with a plastic case).80 Many industry experts expected the 5C to represent a strategic jump by Apple into less expensive smartphones. However, after the announcement, some analysts were disappointed by a $99 price tag, which they felt was still too steep for mass adop- tion in developing nations, where the world was seeing the fastest growth in smartphone sales.81

CONCLUSION The relentless pace of technology assured ever better hand- sets would continue to emerge and that companies would be locked in a feature race for the foreseeable future. Win- dows and Nokia had committed to working together in hopes of regaining a market that Nokia had once domi- nated. RIM desperately sought to find some way out of its downward spiral. In an effort to more fully control the whole mobile offering, Google continued to push forward with its partnership with Motorola. Apple strove to retain its repu- tation for high-quality products and beautiful design, while somehow reaching a broader base of developing-market consumers who demanded a cheaper iPhone. In the United States, Apple was also faced with the challenge of stemming Samsung’s meteoric growth. Samsung had a bright future but still faced challenges in navigating its relationships with Apple for component parts and Google for the Android OS. As smartphone companies look toward the future, each wonders how it might position itself to remain a viable suc- cessful player in the decade to come.

[ Exhibit 8 ] Samsung Simplified Financials 2009-2012

SAMSUNG (USD MILLIONS)

2009 2010 2011 2012

Net revenue 25,355 30,631 154,049 187,754

Cost of sales 19,280 20,347 104,701 118,245

Gross margin 6,075 10,284 49,348 69,509

Operating costs 5,927 7,429 34,742 42,389

Operating profit 148 2,855 14,606 27,120

Source: Samsung Electronics Co LTD Annual Reports

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33 Peter Burrows, “Apple vs. Google: Tech’s Newest Rivalry?,” BusinessWeek (August 4, 2009).

34 Lessin, Luk, and Osawa.

35 Verge Staff.

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44 Lessin, Luk, and Osawa.

45 Verge Staff.

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54 Patrick Seitz, “Apple’s Personal Assistant Siri Has It Out For Google,” Investors Business Daily ( June 13, 2012).

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smartphone-figures,0101-313681-0-2-3-1-png-.html.

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phone Sales Increased 42 Percent” [Press Release] (November 15, 2011). Available at http://www.gartner.com/

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59 Christina Warren, “No More Beta: Google Music Goes Live,” Mashable (November 16, 2011). Available at

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is-open-for-business.html

60 Arthur.

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SB10001424052970204012004577073932113176106.html

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London-2012-Olympic-Games

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.fortune.cnn.com/2013/01/22/samsung-apple-smartphone/

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Samsung-GALAXY-S-III-Reaches-20-Million-Sales-Milestone-in-Record-Time

67 Goldman.

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.com/pr/library/2012/09/12Apple-Introduces-iPhone-5.html

69 Joe Wilcox, “Apple Maps disaster hurts iPhone 5 sales,” Betanews.com. Available at http://betanews

.com/2012/10/02/apple-maps-disaster-hurts-iphone-5-sales/

70 Roger Yu, “Google Maps now available as iPhone app,” USA Today (December 13, 2013). Available at http://www

.usatoday.com/story/tech/2012/12/13/google-maps-return-iphone/1765915/

71 Microsoft, “Microsoft Unveils Windows Phone 8” [Press Release] (October 29, 2012). Available at http://www

.microsoft.com/en-us/news/press/2012/oct12/10-29windowsphone8pr.aspx.

72 Steven J. Vaughn-Nichols, “Smartphone operating systems: The rise of Android, the fall of Windows” zdnet.com

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of-windows-7000011004/

73 Frost and Sullivan.

74 Lev-Ram.

75 Adrian Covert, “Samsung passes Apple in U.S. smartphone market – report,” CNN Money ( June 5, 2013). Available

at http://money.cnn.com/2013/06/05/technology/mobile/samsung-apple-market-share/index.html.

76 Samsung Electronics Co. Ltd., “Samsung Introduces the GALAXY S4 - A Life Companion for a richer, simpler

and fuller life” [Press Release] (March 14, 2013). Available at http://www.samsungmobilepress.com/2013/03/14/

Samsung-Introduces-the-GALAXY-S4-A-Life-Companion-for-a-richer,-simpler-and-fuller-life-1.

77 Lessin, Luk, and Osawa.

78 Zach Epstein, “Verizon confirms August 29th release date for Moto X,” BGR (August 26, 2013). Available at

http://bgr.com/2013/08/26/verizon-moto-x-release-date/.

79 Shira Ovide, “Microsoft in $7 Billion Deal for Nokia Cellphone Business,” Wall Street Journal (September 3, 2013).

80 Apple Inc., “Apple Introduces iPhone 5c—The Most Colorful iPhone Yet” [Press Release] (September 10,

2013). Available at http://www.apple.com/pr/library/2013/09/10Apple-Introduces-iPhone-5c-The-Most-

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[ C-112 ]

We are a global manufacturer and the market leader of the highest quality welding, cutting, and joining products. Our enduring passion for the development and application of our technologies allows us to create complete solutions that make our customers more productive and successful. We distinguish ourselves through an unwavering commitment to our employees and a relentless drive to maximize shareholder value.1

John Stropki looked over at the Vision 2020 document that sat on his desk. The Cleveland, Ohio, based manufacturer of arc welding equipment, Lincoln Electric, had adopted the Vision 2020 strategy two years earlier, in 2011. The docu- ment set an aggressive goal for a compound annual revenue growth of 10 percent between 2011 and 2020. Shareholders would see a marked increase in their wealth if the company met its target of 15 percent compound annual growth in return on invested capital. Stropki was proud of his contri- bution to the company’s vision. During the first two years

that the Vision 2020 strategy was being implemented, Lin- coln’s revenues had grown 38 percent, from $2.07 billion to $2.853 billion, and the return on invested capital had grown a whopping 75 percent, from 10.7 to 18.7 percent.2 Exhibit 1 provides financial information for the company.

Stropki had spent 41 years at Lincoln, starting with the company while still in college. His career path began in the sales side of the organization and he became a company executive in 1996 with his appointment as Executive Vice President and President of Lincoln’s North American opera- tion. He was named CEO in 2004. In spite of the Great Reces- sion of 2007-2009, Stropki oversaw a company that doubled sales, from $1.3 billion to $2.85 billion between 2004 and 2012. Shareholder dividends also doubled over the same period, from $0.34 to $0.71 per share, and the stock had been split 2 for 1 in 2011. Stropki produced total shareholder returns of 365 percent during his time as CEO.3 Although these num- bers sounded impressive, Stropki considered them to be a typical achievement from one of America’s most unique and surprising companies.

CASE 12 Lincoln Electric: Aligning for Global Growth

[ Exhibit 1 ] Selected Financial Results

Year 2004 2005 2006 2007 2008 2009 2010 2011 2012

Net Revenue ($ Billions) 1.334 1.602 1.971 2.28 2.479 1.729 2.07 2.695 2.853

Growth Rate 20.09% 23.03% 15.68% 8.73% –30.25% 19.72% 30.19% 5.86%

Earnings per share ($)* 2.06 2.67 3.98 4.67 2.68 0.85 1.52 2.51 3.16

Growth Rate 29.61% 49.06% 17.34% –42.61% –68.28% 78.82% 65.13% 25.90%

Return on Equity 14.00% 18.00% 20.50% 18.60% 21.30% 4.50% 10.46% 11.50% 19.20%

Growth Rate 28.57% 13.89% –9.27% 14.52% –78.87% 132.44% 9.94% 66.96%

Total Equity ($ Billions) 0.577 0.652 0.853 1.087 1.01 1.086 1.15 1.193 1.358

Growth Rate 13.00% 30.83% 27.43% –7.08% 7.52% 5.89% 3.74% 13.83%

Cash Flows ($ Millions) 51.3 117 118.7 249.8 257.4 250 157 194 327

Growth Rate 128.07% 1.45% 110.45% 3.04% –2.87% –37.20% 23.57% 68.56%

Dividends** 0.69 0.73 0.79 0.91 1.02 1.1 1.15 0.79 0.71

Growth Rate 5.80% 8.22% 15.19% 12.09% 7.84% 4.55% 37.39% –10.13%

* numbers for 2004–2007 do not reflect adjustment of a 2 for 1 stock split in 2011. Figures for 2008–2012 reflect the stock split.

** Dividends for 2011 and 2012 are per share, after 2 for 1 stock split, growth rate assumes holders enjoyed split

Sources: Annual Reports 2012, 2008. Dividend data from http://www.nasdaq.com/symbol/leco/dividend-history ROE Data from GuruFocus,

http://www.gurufocus.com/term/ROE/LECO/Return%2Bon%2BEquity/Lincoln%2BElectric%2BHoldings%252C%2BInc.

http://www.nasdaq.com/symbol/leco/dividend-history

http://www.gurufocus.com/term/ROE/LECO/Return%2Bon%2BEquity/Lincoln%2BElectric%2BHoldings%252C%2BInc

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CASE 12 LINCOLN ELECTRIC: ALIGNING FOR GLOBAL GROWTH [ C-113 ]

LINCOLN ELECTRIC: THE CLEVELAND YEARS John C. Lincoln founded the Lincoln Electric Company in 1895 after being laid off from his job at a Cleveland producer of electric motors. Lincoln was a natural inventor and, by 1895, already possessed over a decade of experience in the high-technology sector of electricity generation and electri- cal products.4 Rather than find work for another company, John began producing motors of his own design in his base- ment. Cleveland proved to be a great place to start a busi- ness. At the end of the nineteenth century, Cleveland was the Silicon Valley of its day, and the city was a hotbed for technological innovation and new business start-ups. The Lincoln Electric Company was in good company and began to grow.

John’s younger brother, James F. Lincoln, joined the new company as a salesman. Their father, William, had immi- grated to the United States from London just before the Civil War and became a preacher. The elder Lincoln had strong views, which were often at odds with the views of the con- gregations he led, and the family moved throughout the Midwest as a result of those convictions. William instilled in both of his boys a deep faith in Christianity and its principles of respect for humanity. He also taught his boys how to work and to love the work they did.

James Lincoln became General Manager of the company in 1914 and would drive that work ethic throughout the company until his death 51 years later in 1965. James man- aged the business operations, while John Lincoln focused his energies on developing welding technology. When James took control, Lincoln was beginning to expand its prod- uct line into other areas of electrical equipment, includ- ing a new, portable arc welding machine they brought to market in 1911. Arc welding uses the heat of an electric current to melt two metal pieces and join them together. Welding was a critical process in the manufacture of many consumer products, such as automobiles and home appli- ances, bridges, and high-rise office buildings, and factories also relied on welding technology and products in their construction.

The Lincoln brothers worked throughout the 1920s to advance welding technology. John created several innova- tions that improved welding in general and Lincoln’s line of products in particular. James focused the company on a single goal: making better welding products to sell to more customers. By the time the stock market crashed in 1929, Lincoln Electric held 30 percent of the growing market for arc welding.5

The Lincoln System James Lincoln considered Lincoln Electric to be a “manu- facturing company” above all else. The competitive logic of the Lincoln Electric Company rested on using manufactur- ing excellence to create increasingly higher-quality welding equipment at ever lower costs. Lincoln focused on cus- tomer service, learning as much as they could about how

their welders were used in the field. Lincoln hired engineers to staff its sales force, and after an intensive, eight-month training course in welding technology and technique at the Cleveland headquarters, the company’s technical sales people used their engineering skills and knowledge to cre- ate welding solutions for customers.6 This deep customer knowledge flowed back to product engineers at Lincoln for use in continuous product enhancements.

The company lowered costs through several means. Lincoln operated with a flat management structure that removed a layer of supervisory costs and pushed decision making down to workers on the assembly line.7 While most companies hired one manager per 20 employees and some- times went as high as 1:5, Lincoln maintained a ratio of about 1:100.8 Assembly workers focused on a single task that allowed them to improve their own throughput and to iden- tify and implement techniques that raised quality or lowered production costs. The Cleveland plant itself was designed to minimize the costs of moving materials through the facility, and very little time was wasted looking for supplies.9

Shortly after James Lincoln assumed control of the com- pany, he established the Employee Advisory Board. That board has met every two weeks since its inception in 1915. The Board allowed managers and workers to work together as equals to solve problems. The Board grew out of James’s deep respect for people, his belief that a company had to earn the efforts of its employees, and the view that produc- tive employees would prove to be Lincoln’s most valuable asset. By 1915, the company provided employees with group life insurance, an innovative business practice at the time.10 And, Lincoln founded a welding school in 1917 in order to deepen the knowledge base about welding among employ- ees, customers, and the community at large.

The Great Depression affected all companies, but it affected Lincoln in a unique way. Companies laid off thou- sands of workers, and the unemployment rate climbed from 3.2 percent in 1930 to a high of 24.9 percent in 1933, an eight- fold increase. In manufacturing cities such as Detroit and Chicago, the rate exceeded 40 percent.11 In the midst of this meltdown, Lincoln avoided layoffs by reducing hours and wages. At the close of 1933, with unemployment in Cleve- land standing at 50 percent, a Lincoln employee approached James Lincoln with a proposition: “if we did more, tried harder, and worked together as a real team, could the com- pany pay us more?” James Lincoln agreed to a one year experiment, stating that any increases in the company prof- its in 1934 would be shared with every employee.12

At the end of 1934, Lincoln paid out $131,800 in bonuses to its workers.13 The Lincoln compensation system had been born, and the bonus has been paid every year since then. In 2012, Lincoln paid out $99.3 million to almost 3,000 American employees, averaging almost $34,000 apiece with those same workers, averaging total pay of just over $82,000. The bonus never represented a gift from the company to its workers; it was a payoff for their hard work and effort. Shortly after World War II, the company developed a perfor- mance evaluation system to determine the size of employee

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[ C-114 ] CASE 12 LINCOLN ELECTRIC: ALIGNING FOR GLOBAL GROWTH

bonuses. Every year, each Lincoln worker receives an assess- ment on five items: Productivity, Quality, Adaptability and Flexibility, Dependability and Teamwork, and Compliance with health, safety, and environmental policies.

The bonus represented one pillar of Lincoln’s unique com- pensation system. The second prong was a piece rate system that paid workers for what they actually produced. Lincoln adopted the piece rate system very early in its history, just as this system was falling out of favor in the United States. Man- agers lost confidence in piece rates because they saw workers game the system and focus on quantity rather than qual- ity of output. For their part, workers came to despise piece rates because they often saw companies adjust rates down in response to high productivity by workers.14 At Lincoln, all jobs were subject to a time-and-motion study to determine the base rate for the job, and the base rate roughly equaled the prevailing hourly wage for average productivity. The rate could only be changed if the nature of the production process changed and not if the worker became more efficient at his or her task. Each piece that a Lincoln worker produced car- ried the stamp with his initials. When a piece failed in the field, it was sent back to the bench of the employee. Employ- ees reworked low quality pieces but would not be paid again because they had already been paid for that piece.

The third prong of Lincoln’s compensation system was its guaranteed employment promise. If a worker could not perform well under the demanding conditions of the Lincoln system, workers normally left the company and found other, less taxing (yet less lucrative) work. Even at the height of the Great Depression, the Lincolns chose to reduce hours rather than lay off workers. The company formalized the guaranteed employment policy in 1958, after 20 years of study. James Lin- coln had no desire to implement a policy that his company could not keep. The policy guaranteed workers up to 30 hours per week, regardless of the economic condition. The workers agreed to work overtime whenever needed and, in the case of a downturn, to work whatever job, at whatever rate of pay, he or she was assigned by the company. Because of the policy, Lincoln was leery to hire additional workers and preferred to fill most internal positions from within the company’s ranks.15 Exhibit 2 details the guaranteed employment policy.

The Lincoln system worked well for the company throughout its history. The company became, largely, a col- lection of entrepreneurs. Whether a line worker or manger, each employee at Lincoln directed his or her own work and reaped the benefits of hard work and smart effort. The Lin- coln compensation system kept turnover rates at about 6 percent per year, well below the 25-30 percent common in manufacturing.16 Lincoln had many employees who worked 30, 35, or 40 or more years for the company. Managers con- sidered the wealth of human capital and organizational knowledge among its workforce to be a key to its competi- tive advantage.

Lincoln established early market leadership in arc weld- ing and created a lead over some well-heeled competition, including General Electric and Westinghouse.17 During World War II, Lincoln shared its technological expertise with these companies to help the war effort. James Lincoln estimated that his advanced manufacturing and incentive system saved the government $35 million (over $500 mil- lion in 2013 dollars) per year in defense procurement costs.18 Even with Lincoln’s technology, both Westinghouse and GE exited the welding market after the war, finding it too dif- ficult to compete with Lincoln.19 Lincoln’s success over the last 95 years is legendary: the company never lost money, never experienced a layoff, and became the world’s leader in arc welding.

LINCOLN GOES GLOBAL, ROUND 1 The recession in the United States from 1981-1983 was the deepest since the Great Depression. For Lincoln, the reces- sion caused two problems. First, with most of its sales in the domestic market, Lincoln was hit hard by the drop in demand. Second, the recession led to a strong dollar that made imported foreign goods inexpensive for U.S. con- sumers. It also made the assets of U.S. companies cheaper for non-U.S. companies to purchase. Foreign producers of welding equipment, primarily Japanese and European firms, entered the market and began to challenge Lincoln’s domi- nance. Lincoln executives saw globalization as the answer to both problems. With increased access to growing markets

[ Exhibit 2 ] Lincoln’s Guaranteed Employment Program37

It is seen as a competitive advantage for the company.

It provides workers with security against layoffs due to lack of work when the economy slows down.

The plan covers permanent employees in Cleveland (about 95 percent of the US workforce) who have completed three

years of service.

Employees are guaranteed at least 30 hours of work per week.

Employees are required to work overtime whenever scheduled.

Workers are not guaranteed a particular job or rate of pay.

Every employee must be willing to accept transfer from one job to another.

The plan only covers workers who uphold Lincoln Electric’s well-defined performance standards.

Finally, if the company’s survival is threatened by conditions beyond its control, from recession to natural disasters,

the guarantee does not hold.

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CASE 12 LINCOLN ELECTRIC: ALIGNING FOR GLOBAL GROWTH [ C-115 ]

in the developing world, Lincoln would be less vulnerable to cyclical swings in the United States. Foreign entry also allowed Lincoln to practice the strategy of parry and thrust; by entering the home markets of foreign competition, Lin- coln hoped to slow up their advances in the U.S. market.20

Lincoln’s historical approach to international sales was to establish partnerships with companies working globally and have those companies serve as its sales agents. A Lincoln executive explained:

We dealt with Armco International, which was a division of Armco Steel. Lincoln licensed Armco to manufacture and market our products in Mexico, Uruguay, Brazil, Argentina, and in France. It was electrodes, but included assembly of machines in Mexico. Armco also marketed Lincoln products along the Pacific Rim and in a few other areas of the world. At one point, we also had a joint venture with Big Three Corporation in Scotland.21

Lincoln changed tact in 1986 when Ted Willis, their new CEO—only the fourth in the company’s history—purchased the Italian and British operations of Harris Calorific, a maker of cutting torches. Over the next five years, Lincoln poured $325 Million into a mix of Greenfield expansion and acqui- sitions. The company opened its own operations in Japan, Venezuela, and Brazil. In Brazil, where Swedish welding man- ufacturer ESAB held an estimated 70 percent market share, Lincoln built a new plant and began with a huge competi- tive disadvantage.22 Willis oversaw the acquisition of facilities in Germany, Norway, the United Kingdom, the Netherlands, Spain, and Mexico, and Lincoln’s international portfolio even- tually included operations in 16 countries. To finance this rapid expansion, Lincoln borrowed money for the first time in the company’s history, a total of $250 million by 1992.23

When Don Hastings succeeded Ted Willis as chairman and CEO of Lincoln Electric in July of 1992, he realized the company’s scattered, shotgun approach to globalization had not worked. He recounts:

At 5:01 on the last Friday of July, 1992, I took over as chairman and CEO… at 5:25 p.m., while I was engaged in small talk in the hallway, Ellis Smolik, our chief financial officer, walked up and said, “I’ve got some grim news. The numbers just came in from the European operations, and they’re bad. Very bad. They lost almost $7.5 million in June, and that means we’ ll have to report a second quarter loss. We’ ll violate our covenants with the banks and default on our loans.24

What had gone wrong? Hastings had previously headed the North American operations and had not been privy to the details of expansion. As he began to dig into the expan- sion binge, he learned several things. First, Willis directed the process alone. He made the purchase decisions, nego- tiated the sales agreements, and had all new operations report directly to him. Second, neither Willis nor any- one on the Board had substantial experience beyond the

United States. Twelve of the 15 board members were insid- ers, and none of the other three could provide expertise. In fact, Hastings discovered that CFO Smolik did not even have a passport; due diligence for the acquisitions had been done without the lead finance officer ever visiting the new sites.25

Lincoln bought some operations at the peak of the busi- ness cycle. For example, the company purchased the Ger- man firm Messer Griesheim for over $70 million, only to see the company retrench and shrink during the recession of 1991. Hastings realized that the company operated on sev- eral faulty assumptions. First, Lincoln listened to competi- tors and distributors in foreign markets who assured it that customers, especially Europeans, would never buy machines imported from the United States. Hastings and his succes- sors would discover that assumption was false. Lincoln executives also believed that their 90 years of success would naturally translate into global success, and they systemati- cally failed to understand the complexities of competing in different countries. Finally, executives assumed that the Lin- coln system would transfer around the globe and that their focus on manufacturing efficiency, cost reduction, and pro- ductivity through the incentive program would overcome any country-specific difficulties. They learned, sadly, that parts of the incentive system were blocked by law in some countries and by standard practice in others. Brazilian law, for example, prohibited piece rates, and the manufacturing culture in Germany emphasized quality and attention to detail over speed.26

With the company facing a loss for 1992, Hastings con- fronted the grim prospect of Lincoln not being able to pay the annual bonus to Cleveland employees. The American operations continued to be profitable, but the bonus was based on the overall corporate profit. Missing the bonus could have disastrous consequences for the company because it would violate its agreements and implicit con- tracts with employees. The resulting loss of trust would alter the most fundamental relationships in the company. After tough negotiations, Lincoln was able to borrow more money to meet its bonus commitments to its Cleveland workers. The bonus for 1992 totaled $52.1 million.27

Hastings went to the Cleveland workforce and explained the problem to them. He admitted that the international expansion had been a mistake and emphasized that it had been a management error. He then asked them to help bail the company out of its difficulty by boosting productiv- ity, output, and sales in the United States. Hastings hoped that increased profitability in the home market would offset the losses abroad and give him time to fix the foreign mess. U.S. employees responded. With a mix of productivity gains, increased sales efforts, and new products, including a welder sold through Home Depot, US sales went from $1.8 million per day up to $3.1 million.

Hastings moved to Europe in order to deal with the situ- ation there. What he found shocked him. The European companies allocated money to individual operations based on their budget targets, not actual sales. This led managers

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to inflate their projections with little punishment if they missed numbers. Hastings saw first-hand the company’s fail- ure to transfer the Lincoln system abroad. During a visit to a German plant, for example, Hastings saw three employees sleeping on the job. This was after the plant had been told the CEO would be visiting!28

Like most competitors in the industry, Lincoln had relied on trade shows as a way to market their products. These trade shows had typically been events where customers were showered with gifts and did not buy products. Hastings changed all that and instructed the sales force to sell not just schmooze. Lincoln sold over 1,700 machines at Germany’s largest trade show in September of 1993. The products had been manufactured in Cleveland and shipped to Germany. Because they sold well, Lincoln realized that in-country manufacturing was not necessary to sell high-quality weld- ing equipment. With that knowledge, Lincoln began to divest itself of many of its money-losing foreign operations in 1994. At the end of 1994, Lincoln recorded a profit of $48 million after paying out $55 million in bonuses to the US workforce. Hastings and the board realized that international expan- sion was more time consuming and difficult than they imag- ined, and that the lack of knowledge and talent about doing business globally had jeopardized the company’s existence. In response, Lincoln brought in several outside executives with substantial global experience. Although these new hires brought new perspectives to Lincoln, they also stood to shake up the familial, egalitarian culture at Lincoln.29

Shortly before his retirement in 1996, Hastings summed up the experience for Lincoln: “We made major additions and thought things could be done the American way. We thought workers and management would respond to prob- lems the way we do, but they didn’t…We did too much too fast without understanding various cultures.”30 It was decided that, moving forward, Lincoln would send its own sales people to a new market in order to determine which of Lincoln’s products would meet market needs and the best way to expand. When possible, Lincoln would rely on exports from its Cleveland factory before setting up opera- tions overseas. The new strategy would move internation- ally by finding experienced local partners and setting up joint ventures or alliances.

LINCOLN GOES GLOBAL, ROUND 2 In 1996, Lincoln appointed the first outsider to lead the com- pany as President and CEO, and in 1997, he was named the Chairman. Anthony Massaro had spent 26 years at Westing- house before joining Lincoln during the recovery from its earlier globalization push. Lincoln wanted to create a sub- stantial presence in every major market in the world, and over the next several years, the company bought, built, or found partners in the top 20 markets for welding products. Massaro led investments in China, Indonesia, Turkey, South Africa, the Philippines, Italy, Brazil, Venezuela, and Poland.31 Rather than rush to enter these markets, Lincoln chose to join the markets in a measured fashion. In China, for example,

the company opened its own electrode facility in Shanghai in 1998, but it chose to form several joint ventures with part- ners along the welding value chain. As these ventures grew and the Lincoln presence became more substantial, Lincoln bought out the venture partner and assumed full control.

The Massaro era also witnessed substantial innovation and new product development. The company introduced a number of new products and services that incorporated increasingly sophisticated computer-guided technology and improved materials. Although the basic technology of weld- ing remained unchanged, Lincoln continued to lead in mak- ing welding both more effective and more efficient, bringing to market advanced robotic welding systems, plasma weld- ers, and oxy-fuel cutting equipment. Product development aimed at the retail market, which had begun as a measure to increase sales during the crisis of the early 1990s, contin- ued to progress, and in 2002, the company brought together these businesses in Lincoln Electric Welding, Cutting, Tools, and Accessories, Inc. In March of 2001, Massaro dedicated the state-of-the-art, $20 million David C. Lincoln Technol- ogy Center, named after the son of founder John Lincoln. At that time, 50 percent of Lincoln’s domestic sales came from products introduced in the past five years.32

John Stropki led the U.S. operations during the 1990s expansion crisis. His leadership and sales acumen helped the company exceed its domestic sales target by $1 million per day.33 Stropki became the company’s seventh chairman and CEO in 2004. In 2005, Lincoln celebrated 10 years as a public company, and Stropki managed a company that rewarded investors with a long-term orientation. Sixty-three percent of the company’s shareholders were institutional investors locked in to Lincoln for its long term returns and stable investment strategy.34 Stropki continued to expand globally with the intent of deepening Lincoln’s presence and market share in key markets such as China, the Mid- dle East, and Eastern Europe. In 2009, the company entered the Indian market when it opened a 100,000 square foot con- sumables ( flux rods) facility in Chennai. In 2010 and 2011, the company bought Russian welding manufacturers MGM and Severstal, giving Lincoln a strong presence in this mar- ket. When Stropki retired in 2013, Lincoln competed in over 40 global markets.

Product development efforts also increased during Stropki’s tenure. In 2009 alone, the company brought over 100 new products to market. Lincoln expanded through its own internal development programs as the Lincoln Tech- nology Center continued to produce improvements to existing technologies and create new, advanced welding systems. Acquisitions played a role as well. In 2005, Lin- coln purchased J. W. Harris, a world leader in brazing and soldering materials. In 2011, Lincoln acquired Torchmate, a company producing advanced plasma and oxy-fuel cut- ting tables and systems; Techalloy, which made nickel alloy and stainless steel welding consumables; and Arc Prod- ucts, a producer of orbital welding systems and automation components.35

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CONCLUSION When John Stropki concluded his tenure, Lincoln had devel- oped into a bigger, grown-up version of the company John C. Lincoln founded almost 125 years before. The unique com- pensation system created competitive advantage in human capital, and Lincoln’s research and development efforts con- tinued to produce high-quality products and to continually

lower prices. Lincoln’s success had not gone unnoticed. Pres- ident George Bush visited the Cleveland facility in 2008, as had many others over the years to praise Lincoln for its inno- vative business practices. In 2013, John Stropki introduced his successor, Christopher Maples, as “the right person to lead Lincoln Electric into its exciting future and continue our long track record of uninterrupted success.”36

REFERENCES

1 Lincoln Electric, “The Lincoln Electric Vision.” Available at http://www.lincolnelectric.com/en-us/company/

Pages/vision-statement.aspx, accessed February 5, 2014.

2 Data compiled from Lincoln Electric, Annual Report, 2012. Available at http://ir.lincolnelectric.com/phoenix.

zhtml?c=100845&p=irol-reportsannual, accessed February 5, 2014.

3 Lincoln Electric, “Lincoln Electric Executive Chairman John M. Stropki to retire” [Press Release] (August 20,

2013). Available at http://www.lincolnelectric.com/en-us/Company/NewsRoom/Pages/john-stropki-retire.

aspx, accessed September 26, 2013.

4 Information drawn from, Chapter 1. Material also drawn from Lincoln’s official history, available at http://www

.lincolnelectric.com/en-us/company/Pages/company-history.aspx, accessed September 26, 2013.

5 Koller, p. 23.

6 Information drawn from a Lincoln recruiting circular. Available at http://sme.tamu.edu/sme.tamu.edu/node/

Lincoln, accessed September 26, 2013.

7 Donald W. Huffmire, Handbook of Effective Management: How to Manage or Supervise Strategically (Westport,

CT: Praeger Publishers, 2006), p. 142.

8 Donald F. Hastings, “Lincoln Electric’s Harsh Lessons from International Expansion,” Harvard Business Review

(May-June 1999).

9 Plant visit by Dr. Burke Jackson, BYU Professor of operations in the mid-1990s indicated this layout.

10 See official Lincoln company history, referenced above.

11 Data for the 1930s taken from http://www.huppi.com/kangaroo/Timeline.htm, accessed September 26, 2013.

Data on the manufacturing belt can be found in David M. Kennedy, Freedom from Fear: The American People in

Depression and War, 1929-1945 (London, UK: Oxford University Press, 2001).

12 Koller, p. 29.

13 Data on the bonus found at Lincoln Electric Company, “Encyclopedia of Cleveland History.” Available at http://

ech.case.edu/cgi/article.pl?id=LEC, accessed September, 26 2013.

14 See Frederick W. Taylor, “A piece rate system” (1896). Available at http://wps.ablongman.com/wps/media/

objects/27/27956/primarysources1_22_1.html, accessed September 26, 2013.

15 Koller provides a vivid history and extensive discussion of the Lincoln compensation system.

16 Brian Richards, “The remarkable true story of the company that doesn’t lay off its employees,” The Motley Fool

( June 23, 2011). Available at http://www.fool.com/investing/general/2011/06/23/the-remarkable-true-story-

of-the-company-that-does.aspx, accessed September 28, 2013.

17 Koller, p. 31.

18 Conversion performed at http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=35000&year1=1942&year2=2013, accessed

September 26, 2013.

19 John Roberts, The Modern Firm Organizational Design for Performance and Growth (London, UK: Oxford University

Press, 2004), p. 41. Available at http://site.ebrary.com/id/10266508.

20 Material in this section taken from Donald F. Hastings, “Lincoln Electric’s Harsh Lessons from International

Expansion,” Harvard Business Review (May-June 1999).

21 Arthur Sharpin and John A. Seeger, “Lincoln Electric in 1996,” Case Research Journal 17: 1 (Winter 1997).

The version quoted here found at http://www.jmbruton.com/images/Lincoln_Electric.pdf, accessed

September 27, 2013.

22 Sharpin and Seeger.

23 Hastings, p. 6.

24 Hastings, p. 3.

25 Ibid.

26 Sharpin and Seeger.

27 Hastings, p. 3.

http://www.lincolnelectric.com/en-us/company

http://ir.lincolnelectric.com/phoenix

http://www.lincolnelectric.com/en-us/Company/NewsRoom/Pages/john-stropki-retire

http://sme.tamu.edu/sme.tamu.edu/node

http://www.huppi.com/kangaroo/Timeline.htm

http://ech.case.edu/cgi/article.pl?id=LEC

http://wps.ablongman.com/wps/media

http://www.fool.com/investing/general/2011/06/23/the-remarkable-true-story-of-the-company-that-does.aspx

http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=35000&year1=1942&year2=2013

http://site.ebrary.com/id/10266508

http://www.jmbruton.com/images/Lincoln_Electric.pdf

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[ C-118 ] REFERENCES

28 Hastings, p. 3.

29 Personal conversation with Dr. Burke Jackson, who visited the Lincoln Cleveland facility after the new hires

(November 2013).

30 Marcus Gleisser, “Lincoln Electric has learned its lessons and is seeking help overseas,” Cleveland Plain Dealer

( June 1, 1996).

31 List of countries drawn from official Lincoln Electric Company history.

32 Lincoln Electric, “Lincoln Electric Dedicates New Technology Center”[Press Release](March 21, 2001). Available

at http://phx.corporate-ir.net/phoenix.zhtml?c=100845&p=irol-newsArticle&ID=541231&highlight=, accessed

September 27, 2013.

33 Hastings.

34 Data taken from letter to shareholders in Lincoln’s 2005 Annual Report. Available at http://www.lincolnelectric

.com/en-us/company/Documents/annualreport2005.pdf, accessed September 27, 2013.

35 Company list adapted from official Lincoln Electric company history, cited above.

36 Cleveland Engineering Society leadership breakfast, October 17, 2013. Quotation available at http://www

.cesnet.org/evtView.asp?evtID=410, accessed September 27, 2013.

37 Frank Koller, Spark: How Old-fashioned Values Drive a Twenty-First Century Corporation (New York, NY: Public

Affairs/Perseus Books, 2010), p. 60.

http://phx.corporate-ir.net/phoenix.zhtml?c=100845&p=irol-newsArticle&ID=541231&highlight=

http://www.lincolnelectric

http://www.issuelab.org/resource

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[ C-119 ]

T he cases for this chapter differ from the other cases in this book. Each of those cases described a company,

business issue, or decision in rich detail and invited you to focus on a number of complex elements in analyzing the case. This case, in contrast, presents you with four brief decision scenarios. Each vignette has been drawn from a real business situation and case, but you are not given much information about the company, or details about its opera- tions. This may frustrate you, but the goal of these cases is to focus your attention and thinking on the ethical chal- lenges each scenario represents and not on the details of each vignette. For each case, you need to answer the ques- tions at the end of the vignette and come to class prepared to give and defend your answers. You may be asked to debate someone else in the class who takes the opposite position, and so, you should take time to justify the answers you arrive at.

SCENARIO 1: DISTRIBUTING CORPORATE PROFITS You are a director of BIG Industries, a large, publicly held company. The company has been very successful sell- ing durable consumer products, such as big ticket home appliances. The company has built up a large cash reserve. Although the company is publicly held, the CEO and Chair- man of the Board is the founder and majority stakeholder. The CEO has proposed a plan to the Board to use the cash reserve in two ways. First, the company would expand its facilities to ramp up manufacturing capacity in order expand the geographic and product markets it competes in. One key element of that strategy is to compete with a low- cost (and low price of the final product) focus. Some board members worry that the plan would, in essence, give a large part of the cash reserve to customers through lower prices. The second element of the strategy would be to increase the wages and benefits paid to workers, which are already well above industry averages. The CEO believes that workers should be paid more in order to build even better lives for themselves and their families.

A group of minority shareholders with significant hold- ings has contacted you to register their opposition to the plan. They argue that the company should use the cash reserve to increase dividends paid out to shareholders. Their analysis also suggests that implementing the plan may lead to a decline in the company’s share price. You are a well- respected member of the Board, and your argument is likely to sway several directors, one way or the other.

Debate Preparation Questions. 1. Whose proposal would you support, the CEOs or the

minority shareholders? Why?

2. Do you agree that the purpose of a corporation to max- imize returns to shareholders, or do other stakeholders have a claim on corporate earnings?

3. What do you think are the benefits and risks to each proposal?

SCENARIO 2: STAYING OPEN LATE You are a director of a publicly held company, Amalgamated Entertainment (AE). As in scenario 1, the ownership struc- ture features a founding majority shareholder, but several shareholders hold significant (> 5%) positions. AE competes in several segments of the entertainment industry and oper- ates a theme park that is very, very profitable. The park has traditionally closed at dusk to accommodate residents who live nearby. The owner has always paid close attention to the concerns of these local residents about the quality of their neighborhood. Many competitors remain open until late in the evening, sometimes close to midnight. A group of minor- ity shareholders has put forward a proposal to upgrade the park, including improved lighting and sound equipment to remain open until late at night, potentially garnering greater sales and profit for the company. The CEO objects to the plan because she feels that changing the operating hours of the business will create several negative impacts, such as traffic, noise, and a different clientele, on the local neighbor- hood and its residents.

The facility has always been profitable, has a substantial market share already, and a loyal customer base. Continu- ing to operate only during daylight will not erode sales or reduce profits, and it would likely further the parks distinc- tiveness as a truly family-oriented park. Expanding the hours of operation would clearly increase financial returns to the company, but at the risk of changing the fundamental char- acter of the neighborhood.

Debate Preparation Questions. 1. Which proposal do you support, the CEOs or the

minority shareholders? Why?

2. How much attention should the needs of secondary stakeholders (e.g., communities, the natural environ- ment, and future generations) receive as corporations formulate and implement strategy?

3. What are the benefits and risks of each proposal?

CASE 13 Corporate Governance and Ethics: A Series of Decisions

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[ C-120 ] CASE 13 CORPORATE GOVERNANCE AND ETHICS: A SERIES OF DECISIONS

SCENARIO 3: THE PLANT LOCATION DECISION You are a director of a publicly held company, Components Master. The company is an input component supplier in the electronics business and sells to several of the major players in the industry. Pressure to reduce costs is immense and con- stant. The component that your company produces requires each part to undergo a chemical bath as a part of the pro- duction process. Two chemicals can be used to perform this operation, with significant differences in cost. Chemical A is very low cost and produces acceptable levels of quality in the final product; however, chemical A has been implicated in some scientific studies as a carcinogen. Its use in the United States is prohibited, even though some scientists question the evidence about its harmfulness. Chemical B costs sub- stantially more than Chemical A, but it yields levels of prod- uct quality that are above the Chemical A process. Chemical B has no known carcinogenic effects.

Your company can build one of two new production facil- ities, an offshore plant that uses Chemical A or a U.S. plant using Chemical B. The offshore location is supported by the local government, desperate to bring jobs and economic development to the region. That government has agreed to allow the use of the Chemical A process. Given the relent- less pricing structure of the industry, the plant using Chemi- cal B would only be profitable if certain price points hold in the industry, but the Chemical A plant would be profitable under all industry price scenarios.

Debate Preparation Questions. 1. Which proposal would you support? Why?

2. Is there another proposal you would introduce and/or consider?

3. When doing business abroad, should companies fol- low the host country’s laws and regulations, or should they be bound by their home country’s standards?

4. Who are the important stakeholders in this case, and what are their interests?

5. What are the benefits and risks of each proposal?

SCENARIO 4: USING PRODUCTS AS INTENDED You are a project manager for Engineers International, a large engineering design and manufacturing firm. You over- see a team of engineers that has designed and manufactured an electronics component assembly for an important cus- tomer. One of your engineers informs you that the customer’s on-staff engineer contacted her with questions about the ability of the assembly to withstand harsh environments, particularly wide swings between freezing and hot condi- tions. The customer wants to know at what temperatures and pressures the product would likely fail. Unsure how to respond, your engineer has asked you to become involved.

All products your firm designs are tested for temperature and pressure tolerance, but the nature of your tests only gives a range of temperatures and pressures for safe use. The customer envisions a specific use of the product at the limits of its physi- cal tolerance range. Your data suggests that the proposed use lies at the edge of the product’s “intended use” zone. At temper- atures and pressures just beyond what the customer proposes, you are fairly certain the product would fail. At levels just below what the customer proposes, your data suggest no problems. The customer is large, and its business with your company is substantial. Personally, you would not use the product as the customer desires, but you can make no overwhelming profes- sional case to them that the intended use is unsafe. You do know, however, that the intended use would be highly profit- able to the customer, and to your company through increased sales. If the product fails, however, the health and safety of your customer’s customers would be jeopardized.

Debate Preparation Questions. 1. What would you tell the customer? Why?

2. How should managers deal with ambiguous informa- tion? Do they have obligations to share all that they know, or should they only provide customers and users with the information they need to know?

3. How would you describe the benefits and risks of each proposal?

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W ith mixed emotions, Charles Nimako put down the 2011 summary report on Safe Water Network’s projects

in Ghana. His team, along with Safe Water Network lead- ers in New York, had worked for almost two years to make the Dzemeni (pronounced JEM-uh-nee) site profitable and provide safe drinking water to local Ghanaians. They had brought innovative ideas and actions to address enormous problems that had plagued water providers for decades; however, difficult challenges and choices remained just ahead. He considered the two questions he and Hew Crooks, the organization’s SVP of Operations, discussed during their last phone call, How can we optimally expand the system to increase profitability at the Dzemeni site? And, should we move ahead with plans to expand the Dzemeni site into a regional ‘micro-utility’ to provide safe water to citizens of nearby Tongor?

A native Ghanaian, Nimako had earned his MBA from Stanford University, worked as a consultant with McKinsey & Company in South Africa, and had most recently served as the CEO of the PepsiCo Bottler in Ghana and franchise director for East Africa.1 His work in the corporate world

had proved invaluable in solving the many project problems encountered at the Dzemeni site, but the remaining chal- lenges looked daunting.

Founded by famous actor and philanthropist Paul New- man and a group of business and civic leaders, Safe Water Network sought to “develop innovative solutions that pro- vide safe, affordable water to those in need.”2 Safe Water Network’s core values, as determined by the founders, are outlined in Exhibit 1. The organization brought together a group of dedicated professionals who had made their mark in private industry and civic work with the hopes of achiev- ing the goal of providing safe water to those who needed it the most. For example, the founding CEO of Safe Water Net- work, Kurt Soderlund, also cofounded North Star Partners, a marketing and strategy consulting firm, and he had served as a special assistant to the president at New York City’s New School, assisting the president in his role as Chairman of Human Rights Watch.3

Safe Water Network’s partner list features titans of indus- try from a variety of industries. The organization counts the Conrad N. Hilton Foundation, Kosmos Energy, the Merck

CASE 14 Safe Water Network: Mastering the Model at Dzemeni

[ Exhibit 1 ] Safe Water Network Core Values20

Access

Making water available and affordable for all

Empowerment

Providing communities the confidence and competency for self-sufficiency

Impact

Realizing lasting health, social, and economic benefits

Measurement

Documenting success and failure

Lessons Learned

Adopting best practice

Environment

Safeguarding water resources

Risk Taking

Investing in new approaches

Open Source

Sharing our findings with the water sector at large

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[ C-122 ] CASE 14 SAFE WATER NETWORK: MASTERING THE MODEL AT DZEMENI

Company Foundation, Newman’s Own Foundation, PepsiCo Foundation, Navajbai Ratan Tata Trust, and the Starr Inter- national Foundation among its funders, and it has partnered with the International Finance Corporation (IFC), IBM, and the Johns Hopkins Bloomberg School of Public Health ( JHBSPH). The Safe Water Network team on the ground in Ghana has contributed unique and valuable experience as well. In addition to Charles Nimako, the organization also hired Charles Yeboah to be their Monitoring and Evaluation, Health, and Hygiene Coordinator, as Yeboah brought a pub- lic sector perspective from his work with the Ghana Health Service’s National Buruli Ulcer Control Program.4

Safe Water Network saw its role as a “Johnny Appleseed” of clean water, helping communities to jump start the jour- ney toward clean water, relinquishing ownership and con- trol, and then moving on to other communities to provide benefits. Safe Water Network currently operates in two countries: India and Ghana. The organization began in 2008 with the launch of a rainwater harvesting program in Rajas- than, India. The Indian operations expanded in 2010 with a 20-village safe water station initiative and the opening of an office in New Delhi. In 2011, Safe Water Network provided technical assistance to the NGO Shining Hope for Com- munities in Nairobi, Kenya, in establishing a water tower in the Kibera slum to serve a girls’ school and the surrounding community. In 2012, they completed a Market and Feasibil- ity Assessment in collaboration with IFC to identify oppor- tunities for commercial approaches to provide safe water to the poor in Kenya.5

The Ghana project started in 2009 when Safe Water Network funded the installation of five safe water stations in the country. WaterHealth Ghana (WHG), a local affiliate of WaterHealth International, approached Safe Water Net- work about an alliance: Safe Water would fund the sites and WaterHealth Ghana would manage and operate them. The physical and chemical process of water purification occurs at these safe water stations, as does the purchase of clean water by local consumers. Safe Water Network’s role in the project expanded after the initiative’s performance fell short of the business objectives of delivering safe water to thou- sands of rural and suburban Ghanaians, creating a sustain- able and replicable model for commercial clean affordable water, and facilitating local ownership of the safe water sta- tions. Safe Water Network partnered that same year with Johns Hopkins University, which conducted an independent study to evaluate the impact of the safe water stations on health outcomes.

THE DZEMENI PROJECT Located on the Gulf of Guinea just north of the equator, Ghana gained its independence from Britain in 1957. Almost half of the country’s 24.3 million residents live in the coastal urban centers of Accra, Takoradi, the Gold Coast, and inland Kumasi; the other half reside in the country’s rural areas. After years of military dictatorships and coups, Ghanaians now enjoy a stable democratic government and a solidly

growing economy. GDP growth has averaged just over 8 percent for the five year period of 2007-2011.6 In spite of these impressive gains, Ghana remains a fairly poor country. Although the per capita income averages $1,230 annually for the country as a whole, 39 percent of rural Ghanaians earn less than $456 per year, or $1.25 per day, the global standard for extreme poverty.7

World Bank data indicate that 80 percent of rural Gha- naians have access to “improved” water; however, water systems fail at an alarming rate. For example, the Ghana- ian Ministry of Water Resources, Works, and Housing found that 30 percent of hand pumps did not function at all and another 50 percent operated incompletely. Between 40 and 45 percent of rural Ghanaians, roughly 4.6 million people, lack consistent access to clean water. Money allocated by the government toward clean water projects often gets diverted to other uses; in 2010, over 90 percent of funds budgeted failed to be spent. Water-borne diseases such as diarrhea, Buruli ulcer, and intestinal worms run rampant among the population, with 70 percent of diseases in the country trace- able to the lack of safe water.8

Four of the five safe water stations served residents of the greater Accra periurban region (i.e., the area between the suburbs and the countryside), and these regions include Amasaman, Pokuase, Obeyeyie, and Oduman. Exhibit 2 provides country-level data for Ghana, the two regions with safe water stations, and the five site locations. Dzemeni, located on the Southeast shores of Lake Volta, represented the first attempt to reach rural and semirural Ghanaians. Lake Volta, formed in 1964 when the government dammed the Volta River at the Akosombo Gorge, is one of the largest man-made lakes in the world.9 Dzemeni residents can draw water directly from the lake; however, decades of human and animal use have resulted in levels of microbial pollution that leave the water unsuitable for human use.

With about 7,000 residents, Dzemeni exists primarily as a market town and urban center, and it serves as a trading center for about 15,000 Ghanaians in the outlying hamlets. The Dzemeni safe water site made sense to Safe Water Net- work for several reasons. First, Dzemeni had no munici- pal water source and no other commercial water vendors existed; the convenience of Lake Volta effectively eliminated competition. Since it first appeared, residents have drawn water out of the lake, in spite of its contaminated state. Second, Safe Water Network research indicated that over 50 percent of residents, while poor, could reasonably afford to purchase clean water. Third, Safe Water Network was able to identify community leaders who would create excitement about safe water stations and encourage educational efforts that stressed the importance of clean water. Finally, nearby Tongor, which was also a combination of a number of vil- lages, provided another potential market if the safe water station could profitably scale its operation.10

Delays and problems cropped up almost immediately throughout Ghana, however. Locating, screening, and selecting sites took longer than expected. Negotiations

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with community leaders at selected sites took time, and the sites required different water purification systems to address specific challenges. The Dzemeni center opened 18 months behind schedule, and capital costs for construc- tion of the site exceeded its budget by 80 percent. Operat- ing performance fell short of expectations; sales volumes indicated penetration rates (the percent of the population using the safe water station) around 20 percent instead of the 75 percent target, and the facilities failed to even cover operating costs.

In late 2010, Safe Water Network replaced WHG as the controlling partner. Safe Water managed health and hygiene education, marketing and demand development, and overall management at the Dzemeni site (as well as the other four sites). WHG continued its role as the Dzemeni site techni- cal operator. 11 Charles and his local team began the hard work required to solve the many problems that stymied suc- cess. Safe Water Network began to learn that even the first goal, providing affordable potable water to rural Ghanaians, proved elusive and difficult, even more difficult than they expected.

THE WATER USERS—CUSTOMERS Although the need for water is universal to humans, the demand for safe water is dependent on a variety of factors,

including price sensitivity, convenience, seasonal variation in demand, and consumer knowledge of the benefits of clean water.

Price Sensitivity Before the management transition to Safe Water Network began, in order to stem operating losses, WHG had doubled the price of water from 0.05 Ghana Cedis (GHS) or 5 pesewas (p)—about $0.035—to 0.10 GHS or $0.07 for 20 Liters (20 L). An average person needs 7 L of safe water for drinking and cooking each day, according to the WHO, and a family of five would use about 40 L per day. Overall demand dropped 30 percent immediately after the price increase, and the reduc- tion in demand from the poorest Ghanaians, those Safe Water Network most wanted to reach, likely exceeded that figure. Incomes for the 40 percent living below the $1.25 per day poverty line averaged $1.08 per day, or $5.40 for a family of five.12 These families would have to spend about 2 percent of their income on commercial water, and studies from the Johns Hopkins group indicated that “cost did not seem to be a barrier to use.”13 In spite of increased operating costs, Safe Water Network ruled out any further price increases that would put the stations’ water out of reach of the poorest consumers, committing instead to achieving sustainability through increasing consumption and reducing costs.

[ Exhibit 2 ] Country-level Data for Ghana

District Ga West South Dayi

Region Greater Accra Volta

Population 262,742 46,661

Population density (per sq. km) 370 46

Water coverage 19% 69%

% of communities paying tariffs 90% 60%

Water tariffs 10p/20L 10p/20L

Average size of population in LMS-ready communities 1,269 Nil

Average size of population in MSSF-ready communities 1,759 487

% of selected communities with electricity (LMS) 95% Nil

Potential population to be served 60,000 1,000

District Community Population

Ga West Amasaman 6,000

Pokuase 16,000

Obeyeyie 2,500

Oduman 2,500

South Dayi Dzemeni 7,700

Total 34,700

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The Convenience Factor Water is heavy! A 20 L container weighs nearly 45 pounds, and not only did the spending of hard-earned cash for the water dampen demand but so did the physical energy required to transport water from the station to the home. Safe Water Network mapped water purchasers and found usage to be highly dependent on distance. For example, in Pokuase, they found that 85 percent of those living within 100 m ( just short of the length of a football field) purchased water, but purchasing fell to 55 percent for those living between 100 and 200 m from the site, and only 10 percent of those living beyond 200 m made the effort to buy clean water. Dzemeni exhibited a similar pattern, with use dropping substantially for customers who lived further than 300 m

from the site. Exhibit 3 details the effect of convenience on water consumption.

Safe Water Network decided to pipe water to remote kiosks (sales stations) some 400 m away from the main station to increase demand and consumption. The remote kiosks almost doubled sales at Dzemeni. The increased water sales, combined with the low incremental operating costs of the remote kiosks, significantly improved the eco- nomics of the safe water stations in these sites. Exhibit 4 illustrates the economics at the Dzemeni site. Total system cost per liter declined by 33 percent in Dzemeni after the remote kiosks were installed. Safe Water Network leveraged its positive experience and installed remote kiosks in two additional communities and early results are promising.14

Well

Legend

Household that have

used SWS water

within the last 6

months

Road

Well

Sale Water Station

Accra-Kumasi Highway

0% <100% 100-200

Distance from Site (m)

H ou

se h

ol d

P en

et ra

ti on

>200

25%

50%

75%

100% 85%

55%

10%

Nsaki River

Scale

100m

Well

[ Exhibit 3 ] The Effect of Convenience on Water Purchases

A. Household Mapping in Pokuase

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CASE 14 SAFE WATER NETWORK: MASTERING THE MODEL AT DZEMENI [ C-125 ]

–

200,000

Main Site/Bulk Remote Kiosks

Ja n-

Fe b-

M ar

-1 1

A pr

-1 1

M ay

-1 1

Ju n-

Ju l-

A ug

-1 1

Vo lu

m e

S ol

d (L

)

400,000

600,000

800,000

1,000,000

–

200,000

Main Site/Delivery Remote Kiosks

Ju n-

Ju l-

A ug

-1 1

Se p-

O ct

-1 1

N ov

-1 1

D ec

-1 1

Ja n-

Vo lu

m e

S ol

d (L

)

400,000

600,000

800,000

1,000,000

B. Remote Kiosk Impact on Sales Volumes in Dzemeni and Pokuase

Source: Safe Water Network, “Decentralized Safe Water Kiosks,” [Internal Document] (August 2012). Available at http://www.issuelab.org/resource

/decentralized_safe_water_kiosks_working_toward_a_sustainable_model_in_ghana

[ Exhibit 4 ] Comparison of Actual and Pro Forma Monthly Results at the Dzemeni Site

Monthly results Base Site 2 Remote Kiosks (Current)

2 Remote Kiosks (Projected)

4 Remote Kiosks (Projected)

Monthly Volume 400,000 600,000 7,500,000 1,000,000

Utilization 57% 50% 63% 83%

Realized Price 0.08 0.08 0.08 0.08

Revenue 1,600 2,400 3,000 4,000

Total Direct Operating Cost 1,196 1,591 1,736 2,131

Profit/(Loss) Before WHG Fee 404 809 1,264 1,869

WHG Fee 1,150 1,150 1,150 1,150

Profit/(Loss) After WHG Fee (746) (341) 114 719

Source: Safe Water Network. Internal company documents.

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[ C-126 ] CASE 14 SAFE WATER NETWORK: MASTERING THE MODEL AT DZEMENI

[ Exhibit 5 ] Consumer Education Materials

Overturning Myths, Selecting Messages, and Identifying Influence Leaders to Promote the Safe Water Station

Section 1: Myths That Need to be Addressed in Promoting the Sate Water Station LEARN EACH ONE

MYTH #1: Groundwater is pure.

TRUTH: Groundwater can contain many kinds of chemical and microbiological contaminants that are natural or generated

by humans. These can cause diarrhea, cholera, and arsenic or other chemical poisoning.

MYTH #2: Water cannot cause illness since illnesses are sporadic and not constant, whereas water is drunk daily.

TRUTH: Illnesses can be present all the time but only be apparent when the body is overpowered by the

contaminant causing the illness. Dirty water may not always cause illness, but safe water and hygienic practices

will always prevent it.

MYTH #3: Groundwater and water front natural streams are pure.

TRUTH: Both water sources can be contaminated by people, animals, or naturally occurring pollutants.

Our water quality tests can show this.

MYTH #4: Boiling treats the water of its contaminants.

TRUTH: Boiling water can eliminate microbiological contaminants and help reduce diarrhea. It is however, useless

against chemical contaminants including arsenic, fluoride, and "chalk" or hardness.

MYTH #5: Consuming safe water sporadically can prevent health issues.

TRUTH: Safe water needs to be consumed by all family members at all limes to prevent health problems. Drinking unsafe

water occasionally can contaminate both individuals within the household and the places where it is stored. Occasional

use of unsafe water can make safe water unsafe!

MYTH #6: Schemes are not to be trusted.

TRUTH: We know this is often the case. But, The Safe Water Station is owned and managed by friends and neighbors in your

own community. You can contact them or the other Safe Water Station Partners at any time if you require any information

that will encourage your trust. Also, the water that is sold must pass strict testing requirements that ensure the quality of

the Safe Water Station water is as good as any sold anywhere in the country— and they are required to make the results of

these tests available to customers.

Source: Safe Water Network, Tools for Safe Water Stations, p. 125

A water delivery service was initiated by Safe Water Net- work to cater to convenience at the Accra sites. The price charged for truck-delivered water is 0.20 GHS for 20 L, twice the price charged at the main site. Costs increased as the service required a truck, driver, fuel, insurance, and mainte- nance. Even at the higher price, delivery sales were sufficient for the service to cover its operating costs. The service would need to grow its volume by an additional 25 percent, how- ever, if it hoped to cover its capital costs—the trucks and containers.15 Charles and his team identified and explored several potential avenues for expanding the reach and pur- chase penetration at Dzemeni, including truck and donkey delivery, additional remote kiosks, and contracting with local shop owners to sell water. Delivery services did not exist in Dzemeni, and Charles wondered about how such a new distribution method would impact demand.

Seasonality As with rural populations around the world, Ghanaians have relied on rainwater harvesting to provide fresh, potable water during the rainy seasons, which in southern Ghana

extend from April to July and from September to November. The annual rainfall average in Ghana is over 80 inches per year, a foot more rain than in Mobile, Alabama, the rainiest location in the United States.16 The demand for commercial water could potentially vary 50-65 percent between the dry and rainy seasons, depending on the intensity of the rainy season. Demand for clean water would be strong and require sufficient capacity during the dry season, but Ghanaians would naturally economize during the rainy season and col- lect free water. Safe Water Network chose to install enough capacity to cover the dry seasons, and believed it could stim- ulate enough demand for commercial water during the rainy season.

Education and Recontamination It is well known that many people in developing countries do not understand the need for consistent clean water to combat water-borne diseases and that this leads to mishan- dling and recontamination of clean water by consumers. A list of common myths, and the truths that refute them, can be found in Exhibit 5. Since the beginning of the initiative,

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Safe Water Network used local health and hygiene teams to engage in community education and outreach. Dzemeni’s cultural tradition of strong local leaders (chiefs) meant that, once Safe Water Network educated them, others in the community would likely become informed. Safe Water Network did not rely solely on the chiefs, and the organiza- tion recruited other influential volunteers, including local women, teachers, and even primary school children (peer educators) to educate residents about the need for, and ben- efits of, clean water.

The downside of this intervention came at a cost—$200 (285 GHS) per month added to the Dzemeni operating costs. The upside could be sustained with increases in demand for commercial water ; however, an internal report noted “the full effects of health and hygiene education and resulting changes in behavior may not be realized for some years.”17

The open or multiple-use water containers that peo- ple used, and lack of hygiene practices, often resulted in recontamination of the treated water. Consumers dipped their hands into their clean water and introduced contami- nants to the water in the container, and those contami- nants remained in the container to pollute the next batch of clean water purchased. Safe Water Network introduced narrow-mouthed containers to solve this problem because the smaller opening kept hands out. Solving this problem created another, however: the cost of the containers. Two thousand narrow mouthed containers were sold to Dze- meni residents along with a coupon that provided users with vouchers good for 30 containers of free water if they purchased a container for GHS 3 ($2.10). Although most consumers would willingly accept a subsidized container, it was not clear what the demand would be if they had to pur- chase them at the full cost.

Charles Nimako recognized that Safe Water Network had learned much about how people use—and whether they will buy—water. The result of their efforts was a 151 percent increase in overall demand from late 2010 to late 2011. That impressive figure encouraged both Charles and Hew Crooks, the SVP of Operations, but it did not solve their fundamental problem. Even with the impressive increases in demand for Safe Water products, the revenues generated covered only the operating expenses. Charles wondered whether demand would ever cover the full costs of the Safe Water Stations and whether the fundamental business model and cost structure of Safe Water Network would need to change in order for the company to stay in business.

THE SAFE WATER NETWORK BUSINESS MODEL Safe Water Network envisioned solving the challenge of potable water by creating financially sustainable and com- munity-welcoming safe water facilities. The organization believed that if it could accomplish these goals, a third goal could be reached: finding local owners to buy and run the safe water stations. Taken together, these three overarching goals constituted the Safe Water Network objective. Charles had an emerging understanding of the consumer side of the safe water initiative, and he mentally reviewed each pillar of Safe Water Network’s business model. Exhibit 6 shows the Safe Water Network process for implementing the safe water initiative in a rural community.

Financial Sustainability Rain water is pure; the evaporation process removes inor- ganic pollutants—chemicals, sediments, residues—as well as bacteria or other organic contaminants. Unfortunately, many “fresh water” sources in Ghana, such as Lake Volta, streams, wells, or springs, provide contaminated or impure water due to the presence of inorganic chemicals and min- erals or microbial contaminants associated with human or livestock fecal matter in the water. The essence of Safe Water Network’s mission involves purifying impure water by mov- ing it through a treatment system. The physical and biologi- cal characteristics of the water source drive the choice of treatment technology, which in turn underlies the financial sustainability of the Safe Water Network business model.

The technology then determines the capital cost of the system. The cost of equipment identified as suitable for community-sized systems in Ghana ranges from $23,000 (32,600 GHS) to $100,000 (142,000 GHS), not including land, building, and permitting costs (see technology descrip- tions below). Consumables such as sand, gravel, chemicals, membranes, operator and staff salaries, and maintenance expenses constitute operating costs. Safe Water Network has no allegiance to any particular technology, and leaders seek to install the most appropriate and cost-effective tech- nology for a given site. Exhibit 7 describes the advantages and disadvantages of each treatment technology.

Carbon filter with ultraviolet light treatment (CUV). All five initial sites in Ghana used CUV-based systems. These sys- tems employ sand, carbon, and 10- and 1-micron polypro- pylene wound cartridge filters in addition to ultraviolet (UV) treatment systems. Water passes through a carbon filter

[ Exhibit 6 ] The Safe Water Network Implementation Process

Source: Safe Water Network, “Tools for Safe Water Stations,” p. 9.

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[ Exhibit 7 ] Treatment Technology Advantages and Disadvantages

Technology How it works Pros Cons

LMS

(Limited

Mechanization

Systems)

Mechanizes existing

boreholes; can use solar

power

24,000 boreholes in Ghana;

low initial outlay cost

of purchasing solar energy

materials are dropping and

are expected to continue to

drop

for LMS technology

of existing boreholes at a

very low incremental unit

cost to significantly improve

convenience

or well.

supplemented by chlorine.

that allow for bore holes—not

useful near large bodies of

surface water w/ a shallow

water table or where soil is

contaminated

MSSF

(Modular Slow

Sand Filtration)

Addresses microbial

contamination in surface

water; can use solar power

demand, avoiding over-

spending on unneeded

capacity; relatively easy to

operate

energy materials are

dropping and are expected

to continue to drop

water source with low turbidity.

(untested)

contaminants for the most part

but more aggressive parasites

like viruses may not be filtered

Membrane

Ultra-Filtration

(UF)

Appropriate for communities

whose water needs aren’t

served by LMS and MSSF

(have highly variable turbidity/

contamination)

with high or variable

turbidity, certain metals

(including iron and

manganese, which require

pretreatment), color bodies,

and a broader range of

microbes (including viruses)

that may not be reduced as

efficiently in SSF systems.

adequate quality regardless

of operational challenges.

can be scaled as demand

changes.

population of at least 3,000 to

achieve lower cost per capita

water production

an option only when conditions

require this technology (nb: this

technology is superior and has

fewer cons other than the fact

that it is very expensive and

difficult to fit a viable business

model).

Carbon filter

w/ Ultraviolet

Light Treatment -

lution for treating microbial

contaminated surface water

when the Dzemeni project

was

initiated.

be combined depending on

source water.

operate.

maintained/replaced, system

still operates but produces

contaminated water.

Source: Adapted from Safe Water Network internal planning materials

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and a series of other filters to remove chlorine, sediment, and other inorganic compounds. Exposure to UV light alters organic DNA and kills bacteria, viruses, yeast, mold spores, fungi, algae, and fecal coliform.18 CUV systems cost $50,000- 90,000 to purchase and install. This system may prove to be the most costly technology to operate because it requires well-trained technicians to operate the systems.

Limited mechanization systems (LMS). LMS involves install- ing a submersible pump in a newly drilled or existing borehole (well), pumping water to an elevated water storage tank and distributing the water via gravity to standpipes. This system does not provide water filtration; it only provides more water from existing boreholes. The water produced must be chlorin- ated before distribution to guarantee purity. The cost of LMS varies according to number of boreholes and pumps and the size of the storage tank. Safe Water Network’s budgeted LMS costs are $23,000 for 1,000 people, $32,500 for 2,000 people, or $48,000 for 5,000 people. The use of solar power would reduce operating costs but increase capital outlay by $5,000-6,000. Safe Water Network is evaluating the use of LMS technology for a possible expansion in the Eastern Region.

Modular slow sand filtration (MSSF). Slow sand filtration (SSF) has been in use since the early nineteenth century; however, in the last few years, the design and construction of modular systems has made MSSF an attractive method for smaller communities in the developing world. The sys- tem is appropriate and suitable for perennial surface water sources with low turbidity (mud and sediment). The system consists of twin modular plastic tanks for use as the main filter, supported with plastic raw and treated water storage tanks. The treated water is distributed by gravity, pumping, or a combination of the two, depending on the size of the system and the location and distribution of a remote kiosk. MSSF systems run $43,000 for 1,000 people, $47,000 for 2,000 people, and $69,500 for 5,000 people. Safe Water Network is employing MSSF at two new sites launched in the spring of 2013, in preparation for a larger-scale MSSF-based expan- sion around Lake Volta over the next three years.

Ultra-filtration (UF). UF utilizes a range of polymeric-based semipermeable membranes to filter particulates of different sizes. UF provides a filtering solution for communities with surface water sources but variable levels of turbidity or con- tamination. Primarily used in industrial settings, the technol- ogy has recently shown potential for adaption in developing world settings. Its wide range of operational modes (pressure, gravity, chemical addition) allows for broad applications in a variety of settings and input water qualities. UF systems range between $50,000 and $100,000; capacity is not an issue (a UF station could filter 2,000 L per hour), but costs vary based on the filtration method used. Safe Water Network is using UF for two new sites in the Western Region launching in 2013.

The availability of electrical power also plays a significant role in technology and cost. Access to the electrical grid rep- resents one challenge of working in rural Ghana, because the provision of safe water must depend on the reliability of another system. Solar power provides a possible alternative, but the Safe Water Network will incur greater capital costs in

exchange for lower operating costs. A major benefit of solar power is the possibility of creating remote charging stations for appliances, cell phones, and batteries. Even if the solar recharging sites generate 100-200 GHS ($70-140) per month, that would contribute to the overall profitability of the safe water station. Safe Water Network will launch its first sites using solar power in 2013.

Welcoming Communities Several criteria factor into the decision to build a safe water station in a community. Safe Water Network hoped to locate in communities with greater than 4,000 people or 800 families within reasonable proximity to the station to provide adequate demand for clean water. The type, nature, and prevalence of water-borne diseases in the community impact the type of treatment system and the overall value added from clean water. Finally, Safe Water Network had learned through its India initiatives that communities with- out a commercial water market increase the level of dif- ficulty—and time required—to get people to adopt clean water. Again, Exhibit 5 displays common myths that often stymie adoption within a community. Asking residents to pay for treated water when they were accustomed to collect- ing untreated water for free added a new layer of resistance to Safe Water Network initiatives.

Local Ownership The exit strategy for a safe water intervention in a community calls for local, community-based groups or individuals to take control of the station after capital costs have been recouped by Safe Water Network. Local ownership could dramati- cally improve adoption rates, assist in consumer education, and provide employment and income for a community. Safe Water Network saw its role as helping communities to jump start the journey toward clean water, relinquishing ownership and control and then moving on to other communities to pro- vide benefits. Safe Water Network’s strategic planning mate- rials identified several characteristics of ideal local owner/ partners. These included credibility with local stakeholders, competence in running a business and fulfilling the duties of a good partner, and high ethical and moral character.

The costs for the Dzemeni site illustrate the revenue model for all Safe Water Network safe water stations. Capital costs to install the UV filtration unit to service the almost 8,000 residents in the area totaled $91,000, almost twice the budgeted amount. Operating costs include staff and techni- cian labor, consumables such as cartridge filters, UV light sources, electricity costs, maintenance, and repair. The pro forma costs displayed in Exhibit 4 detail the basic econom- ics of running the Dzemeni site, including a management fee payable to WHG.

Charles saw his team’s hard work reflected in the operating profits at Dzemeni. After nearly two years, the Dzemeni site generated a positive cash flow from direct operations; unfor- tunately, the management fee, negotiated at the beginning of the project, paid to WHG turned profitability negative. Reduc- ing the fee represented one hurdle to financial sustainability.

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The Safe Water Network team believed that, if a cluster of safe water stations and accompanying kiosks could be installed close to the Dzemeni site, they would be able to amortize the flat management fee over a number of independent profit centers. Exhibit 8 presents the expected capital budget for a new safe water station in Tongor, a neighboring community.

The Tongor site would service another six surrounding communities and about 11,000 people, and the site would allocate the management fee among a number of commu- nities that the team referred to as a “micro-utility.”19 Such a utility may create other economies of scale in consumer education, demand generation, and other operating activi- ties such as repair and maintenance.

Safe Water Network’s initial business model sought not only operating profitability and the creation of a small reserve, but also the recovery of the station’s capital costs. The organi- zation viewed its capital investments as loans to the facility with a payback period of eight years. With an imputed inter- est rate of 2 percent, the Dzemeni site would fail to payback its $90,000 (135,000 GHS) capital loan even if the two remote kiosks could generate almost ($500,000) 750,000 GHS in total

sales. If the organization could create a micro-utility to ser- vice a number of communities, capital costs could be recov- ered in the appropriate time horizon.

The underlying appeal of local ownership came from the potential of the safe water stations to provide income for a local partner/owner. The Safe Water Network financial mod- els predicted a monthly profit for owners or communities of $90-100 per month, just about the per capita income for Ghana. To date, the Dzemeni project team had invested little time and energy in identifying and selecting potential long- term partners. The team’s time had been filled with learning the business in the communities and achieving operational profitability. No one knew how easy it would be to find a partner with the passion, skill, and vision to run a safe water station even if the financial rewards were in place.

CONCLUSION Charles and his team had made significant progress at Dze- meni. The team had innovated to create demand for safe water, the site was now operationally viable, and the Ghana

[ Exhibit 8 ] Projected Capital Costs at Tongor (CUV Treatment Technology)

Uses US$ GHS

Local civil works (small office block, base of tanks, trenching, etc.) $ 20,000 30,000

Steel tank (Blue Filter quote) 150m3/day capacity 31,000 465,000

Tank Cover 6,000 9,000

Shipping and clearing 8,000 12,000

Tank welding supervisor (per Blue Filter quote) 10,000 15,000

Blue Filter supervisor 5,000 75,000

Raw water storage (3 Polytanks of 25k litres each) 12,500 18,750

Treated water storage (3 tanks of 25k litres each) 12,500 18,750

Overhead tank 45,000 67,500

Local design and consultancy 20,000 30,000

Chlorination system 2,000 3,000

Electrical connection to source (including transformer) 6,500 9,750

Service points (6 & 3k) 18,000 27,000

3hp submersible pump 8,500 12,750

4 inch HOPE pipes (from source to plant) 15,000 22,500

2 inch HOPE pipes (for supply of treated water) 25,000 37,500

Sand media 5,000 7,500

Source pump sump 5,000 7,500

Working capital (post-opening) 15,000 22,500

Contingency 10,000 15,000

Total Uses 280,000 420,000

Source: Safe Water Network, “Tongor-Dzemeni Case Study” [Internal Document] (June 2011).

REFERENCES [ C-131 ]

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and New York staff both saw in Dzemeni the seeds of a finan- cially sustainable solution to the clean water problem. Now that the Dzemeni system had established a track record of successful operations over the course of three years, Charles wondered how the organization could optimally expand the system to serve the surrounding communities.

What knowledge gained from their experiences should guide the development of a fully functional micro-utility system through both (1) expansion of safe water services into other nearby communities and (2) additional points of sale or distribution methods within Dzemeni. Charles knew more sales points would improve access, convenience, and usage, but the existing pay-as-you-fetch model only worked for relatively centralized, high-volume remote kiosks (Basi- cally, the first 50 users paid the operator’s salary).

Likewise, if the company pursued a multi-town micro- utility, what elements of the process should it replicate in order to deal with the inevitable cultural differences, even between local villages? How would the company solve the management challenges? Private system operators in Ghana have said that they would not be interested in managing a system as small as Dzemeni, so how would Safe Water

Network select and train entrepreneurs to run a system that spanned several communities?

Charles began to think of some larger, more strategic ques- tions as well. For example, should Safe Water Network partner and engage with the local or Ghanaian government? Govern- ment leaders often made promises to build municipal sys- tems, usually during the election season. Municipal systems would represent a formidable competitor to the Safe Water Network’s model. Should Safe Water Network partner with the government to forestall entry and protect their invest- ments? What opportunities existed to employ lower-cost treatment technologies than the system currently installed? The Dzemeni model worked for aggregated communities of 7000 or more people, but could the organization create safe water stations to service smaller communities? Finally, should Safe Water Network rethink its financing approaches to sup- port capital investment? Should it shift the business model to targeted philanthropic investment (with no repayment) rather than the current loan-based model? Would the finan- cial rewards of ownership produce the outcomes Safe Water Network predicted and create dedicated and skilled local partners capable of running the community water business?

REFERENCES

1 http://www.safewaternetwork.org/team.asp, accessed March 8, 2013.

2 Internal Safe Water Network Document - FAQ sheet.

3 http://www.safewaternetwork.org/Team.asp, Kurt Soderlund, accessed February 20, 2013.

4 Information on the leadership team of Safe Water Network taken from http://www.safewaternetwork.org/

team.asp, accessed February 4, 2014.

5 Information drawn from internal Safe Water Network documents.

6 Calculated from data available through the World Bank. Available at http://databank.worldbank.org/ddp/

home.do?Step=3&id=4 , accessed February 20, 2013.

7 Ibid.

8 Safe Water Network, “Decentralized Safe Water Kiosks,” [Internal Document] (August 2012), p. 3.

9 Safe Water Network, “Tongor-Dzemeni Case Study,” [Internal Document] ( June 2011), p.5.

10 Ibid.

11 Ibid.

12 This figure was calculated from the Poverty Gap Index, a measure designed to assess the intensity of poverty

for those living in extreme poverty. The gap measures the average measured gap between the actual measured

household income and the poverty line. For Ghana, the rural poverty gap is 13.5%, meaning that the average

household income of those living below the poverty line is 13.5% below $1.25 per day. Poverty gap data found at

http://www.tradingeconomics.com/ghana/poverty-gap-at-rural-poverty-line-percent-wb-data.html, accessed

February 19, 2013.

13 Safe Water Network, Internal documents.

14 Safe Water Network, “Remote Kiosks: A Path to Improved Economics and Coverage,” [Internal Report] (2013).

15 Decentralized Safe Water Kiosks, p. 8–9.

16 Data on Ghana taken fromhttp://www.ghanaweb.com/GhanaHomePage/geography/climate.php, and data

for the United States taken from http://www.livescience.com/1558-study-reveals-top-10-wettest-cities.html,

accessed February 20, 2013.

17 Decentralized Safe Water Kiosks, p. 10.

18 A description of different treatment technologies can be found at Engineers without Borders, http://www.stevens.

edu/ewb/docs/ME423_Fall_07_Phase_III_Group_10_EWB_-_Water_Purification.pdf, accessed February 21, 2013.

19 Personal communication between the case writer and Safe Water Network leaders.

20 http://www.safewaternetwork.org/Values.asp, accessed February 4, 2013.

http://www.safewaternetwork.org/team.asp

http://www.safewaternetwork.org/Team.asp

http://www.safewaternetwork.org

http://databank.worldbank.org/ddp

http://www.tradingeconomics.com/ghana/poverty-gap-at-rural-poverty-line-percent-wb-data.html

http://www.ghanaweb.com/GhanaHomePage/geography/climate.php

http://www.livescience.com/1558-study-reveals-top-10-wettest-cities.html

http://www.stevens

http://www.safewaternetwork.org/Values.asp

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[ C-132 ]

W almart.com’s CEO, Neill Ashe, announced in early 2013 that the online division of Walmart stores was on pace

to reach its goal of $9 billion in revenue in its 2014 fiscal year (February 2013 through January 2014).1 In addition, Ashe noted that, after extensive website overhauls to improve search functionality and overall user experience, website traffic had increased 20 percent over the previous year, with over one-third of all visits coming from mobile devices. Ashe told reporters at Walmart.com’s media event that he felt that Walmart.com was demonstrating its ability to match any other e-commerce company. By combining its online capa- bility with its massive retail operations, Ashe said Walmart was poised to “provide a commerce experience no one else can provide.”2

Ashe’s positive outlook obscured the long difficulties Walmart.com had experienced trying to compete with Ama- zon.com, the largest Internet retailer in the United States, and the uphill battle Walmart.com still faced. Even with rev- enue of $9 billion,3 Walmart.com was far behind Amazon’s $74 billion, suggesting that considerable growth would be needed if the company was to match Amazon’s online sales of products that fell into Walmart’s traditional sales catego- ries. Company executives and the e-commerce branch had not always seen eye-to-eye regarding the importance of investing in online capabilities. The result was that Walmart. com did not receive the necessary funds to invest in state-of- the-art website design or online fulfillment systems during several years of its early history.

With Walmart.com still behind Amazon, Mike Duke, CEO of Walmart Stores, had grown increasingly concerned that his company might have ramped up its efforts in online retail too late and would have to continually play catch-up with Amazon. In 2010, Walmart headquarters made new com- mitments to transforming its site in terms of navigability, search, and overall customer experience to take advantage of continuing ecommerce growth.4 Despite this, by 2013,

Walmart.com accounted for just about 1.7 percent of total company sales.5 In the midst of these challenges and oppor- tunities, Duke wondered what it would take for Walmart to finally participate in e-commerce revenues at a rate more consistent with its dominant retail store presence, and in particular, just how he could finally beat Amazon.

WALMART’S HISTORY Walmart grew from humble beginnings as a country dis- count store in Rogers, Arkansas, in 1962 to the world’s sec- ond largest public corporation.6 Sam Walton, the company’s founder, envisioned a retail store that offered low prices and great service. Focused on offering the “lowest prices anytime, anywhere,” the company grew rapidly. By 1972, Walmart was listed on the New York Stock Exchange, and its 51 stores recorded sales of $78 million.7 It reached $1 billion in sales in 1980, making it the fastest company to ever do so at the time.8 In 1983, the company opened its first Sam’s Club, a wholesale retail store, and installed a computer system that brought additional cost savings by allowing stores to com- municate product and inventory needs in real-time via the company’s private satellite system, the largest in the U.S.9

The first Walmart Supercenter, which combined general retail operations with a full-scale supermarket, opened its doors in 1988.10 Walmart became the largest retailer in the United States in 1990 and expanded internationally in 1991, with its first stores outside the United States located in Mex- ico. The 1990s were full of milestones as Walmart recorded its first $1 billion sales week (1992); expanded into Canada (1994), China (1996), and the UK (1999); and celebrated its first $100 billion sales year in 1997.11 In 2002, Walmart reached another milestone, topping the Fortune 500 list for the first time12 (see Exhibit 1 for Walmart financials).

Initially, the company grew rapidly by increasing its num- ber of retail locations worldwide. Walmart first introduced

CASE 15 Walmart versus Amazon: The Battle for Online Dominance

[ Exhibit 1 ] Storewide Key Financials—Walmart, 2009-2013 ($ million)

2009 2010 2011 2012 2013

Revenues 401,204 408,214 418,952 446,950 469,162

Net income 13,400 14,335 16,389 15,699 16,999

Total assets 163,429 170,706 180,663 193,406 203,105

Total liabilities 98,144 99,957 109,416 117,241 121,367

Employees 2,095,000 2,100,000 2,100,000 2,200,000 2,200,000

Source: MARKETLINE.

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online shopping to customers via Walmart.com in 1996. Early versions of the website were slow and unattractive, and initial attempts at establishing market dominance online resulted in embarrassing failures. During the second half of the 1990s, companies such as online-bookseller Amazon continued to expand into the Internet retailing market.

AMAZON’S BACKSTORY Amazon founder Jeff Bezos started his business by pack- ing and shipping book orders out of his garage in 1995. The Internet, he believed, offered an ideal medium for delivering lower prices and better title selection to customers. Within two months of its launch, Amazon sales topped $20,000 a week.13 Amazon grew rapidly, went public in 1997, and began selling CDs and movies online. It was around 1999 that Ama- zon began morphing into the online retailer it is today. Bezos wanted Amazon to become the “Everything Store,”14 allow- ing customers to buy anything they wanted at the lowest prices and from the convenience of their own homes. After successfully transitioning from selling only books to general retailing, Amazon continued to grow its customer offerings and business. By 2013, Amazon had reached over $74 billion in revenue15 (see Exhibit 2 for Amazon financials).

TWO VERY DIFFERENT BUSINESS MODELS Historically, Walmart and Amazon had very different busi- ness models. Walmart grew by employing a low-cost leader- ship strategy in brick-and-mortar stores. Amazon relied on an e-commerce-based model to drive its meteoric growth. A closer look at each business reveals important differences in each company’s respective strengths.

Walmart’s Principles of Retail Walmart had risen to world dominance by relying on the simple principles of retail: buy and sell at low prices, enjoy- ing thin profits margins but high sales volume. Although most retailers follow these basic rules of thumb, Walmart expanded volume further by passing much of the cost sav- ings onto the end consumer through lower prices. By pric- ing low and driving volume, Walmart successfully pushed its competitors onto the sidelines by pricing everyday products lower than anyone else.

In order to offer the lowest prices possible, Walmart worked hard to drive down its supply costs by negotiating lower prices from suppliers and reducing logistical expenses. As Walmart increased its stores, its bargaining power with suppliers increased. Eventually, Walmart became so large that the company was able to demand price concessions from suppliers who had come to rely heavily on Walmart’s business.

Walmart also managed its logistics effectively. Shipping products from the manufacturers to the retail store can be a logistical challenge and, if managed poorly, could lead to higher costs. To address this, Walmart built regional distri- bution centers that stocked almost every item sold in its stores. Trucks then hauled products from the warehouses to the local stores. This distribution model resulted in inven- tory cost savings because products were pooled in regional superwarehouses and shipped more quickly to stores than if products were coming from a central distribution center.

With its successful retail model, Walmart successfully and substantially increased demand for the products on the shelves and drove the company to record-breaking growth over a half century.

Amazon and E-commerce Unlike Walmart, which relied on brick-and-mortar stores, Amazon focused on an e-commerce business model in bookselling to launch its business. Without physical stores, online retailers eliminated the many costs typical retail operations incurred, including the construction and main- tenance of stores or leases for store locations. Additionally, selling products over the Internet from central warehouse locations required a much smaller workforce to fulfill orders, giving Amazon and other online retailers an advantage over traditional retailers.

Amazon’s initial business model wreaked havoc on the bricks-and-mortar bookselling industry. Lower fixed costs allowed the company to pass cost savings onto its custom- ers, which quickly led to increased market share. The Ama- zon model also allowed for a much greater selection of books than was available in typical stores. Instead of being limited to the titles stocked at a Barnes & Noble bookstore, Amazon customers had access to virtually any book published and carried by wholesale book distributors. After tackling books

[ Exhibit 2 ] Storewide Key Financials—Amazon, 2008–2012 ($ million)

2008 2009 2010 2011 2012

Revenues 19,166 24,509 34,204 48,077 61,093

Net income 645 902 1,152 631 389

Total assets 8,314 13,813 18,797 25,278 32,555

Total liabilities 5,642 8,556 11,933 17,521 24,363

Employees 20,700 24,300 33,700 56,200 88,400

Source: MARKETLINE.

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as a product category, Amazon extended its commerce into dozens of other categories.

THE BATTLE FOR ONLINE DOMINANCE Walmart and Amazon had both risen to prominence in their respective spheres. As the companies continued to expand into overlapping areas, they began to see each other as relevant competitors. By the year 2000, Walmart had mastered the business of brick-and-mortar retail, but its website was very basic, consisting of a list of cat- egories and an electronic shopping cart. The company seemed to finally recognize the need to develop a stronger online business to combat Amazon’s encroachment in the retail product categories that Walmart had dominated. (See Exhibits 3-6 for size and growth of the online retail market.)

[ Exhibit 3 ] Online Retail Market Value, 2008-2012

Year $ billion

2008 132.3

2009 133.4

2010 152.9

2011 172.5

2012 200.4

Source: MARKETLINE.

[ Exhibit 4 ] Online Retail Market Value by Geography, 2012

Geography $ billion

Europe 230.6

United States 200.4

Asia-Pacific 155.7

Rest of the World 45

Total 631.7

Source: MARKETLINE.

[ Exhibit 5 ] Online Retail Segments, 2012

Category $ billion

Electronics 43.8

Books, music, and videos 40.5

Apparel, accessories, and footwear 18.5

Other 97.6

Source: MARKETLINE.

[ Exhibit 6 ] Projected Growth of Online Retail, 2012-2017

Year $ billion

2012 200.4

2013 232.5

2014 259

2015 293.8

2016 331.1

2017 371.4

Source: MARKETLINE.

The Early Years of Online Retail For Amazon, the Internet was its only distribution chan- nel, and this allowed the company to bypass physical store locations completely. Walmart viewed its online activities as an extension of its physical stores. Amazon began its online business in 1995 with a focus on offering customers a less expensive and increased selection of books. At the time, Walmart’s only worry was that book sales would decline in Walmart stores as Amazon’s popularity grew. Although book sales represented a meaning ful revenue stream for Walmart, they were in no way the company’s core business.

Walmart’s initial website in 1996 was awkward and fea- tured a digital version of a Walmart store greeter that drew ridicule from across the tech community as an embarrass- ing design blunder. It was clear that Walmart’s expertise in retailing failed to translate into online success. The com- pany’s online fulfillment system was so dysfunctional that in 1999 the company announced that it could not guaran- tee pre-Christmas delivery of any online orders made after December 14.16 Walmart executives, however, didn’t seem to notice the company’s digital shortcomings. With Walmart expanding and building supercenter stores across the coun- try at a rapid pace, company leaders had their plates full with the challenges of blazing growth in other areas. Many seemed to consider web sales an unproven and futuristic growth strategy, and they appeared to steer clear of a tech- nology they didn’t quite understand.

After a few years of successfully gaining market share in book sales, Amazon founder Jeff Bezos started to target brick-and-mortar retail stores. Bezos, who had been named Time’s Man of the Year in 1999 for popularizing online shop- ping, began to call for Amazon to become the “Everything Store.”17 Amazon expanded its original books-only model, slowly rolling out options to purchase CDs, DVDs, clothes, and even food online. Bezos recruited 15 Walmart Informa- tion Systems Division employees to work at Amazon, includ- ing Walmart’s former chief information officer, Richard Dalzell, to help the e-commerce retailer “expand its inter- net retailing system for selling books, compact discs, and drugs.”18 Walmart took notice of Amazon selling the same products online that it offered in its stores, and it filed a law- suit, claiming Amazon had recruited Walmart employees in order to steal trade secrets. Although the two companies

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later settled out of court, the fierce competition between them became public.

In 2000, Amazon added another innovation by allowing third-party retailers to sell on its site. These sellers—often direct competitors with Amazon—sold products on Ama- zon.com in order to take advantage of the higher website traffic. In addition, Amazon started an affiliate sellers pro- gram in which small websites that advertise or refer products found on Amazon.com would receive a finder’s commis- sion.19 Walmart.com did not introduce its own third-party marketplace until 2009.20

Walmart.com’s Spinoff from Walmart In 2000, Walmart decided to spin off its website into a sepa- rate e-commerce business, Walmart.com, partnering with Accel Ventures, a Silicon-Valley-based venture capital firm that focused on investing in technology-based companies.21 The new company moved from Arkansas and established its headquarters in Silicon Valley. The move to California was made in hopes that proximity to the nation’s top hotbed of technology and talent would fuel an online experience that more closely matched customer preferences.

Shortly after setting up shop in San Bruno, California, in the fall of 2000, managers at Walmart.com shut down the website for a month to revamp.22 The shutdown also came at a time when most retailers were ramping up operations in preparation for the holidays. Many internet savvy com- panies mocked Walmart for taking its site offline.23 Other e-commerce websites usually continued to operate while small updates and improvements were made to a site. By shutting down for an entire month, Walmart missed out on a month’s worth of sales (see Exhibit 7).

In 2001, Walmart bought out Accel Venture’s owner- ship in Walmart.com to have complete control of its web- site.24 The retail giant announced the move was made to better integrate online and offline sales by removing any

outside company’s ulterior motives. Historically, in-store sales at Walmart had been backed by one of the strongest procurement and fulfillments systems, but online sales had frequently encountered hiccups in fulfilling orders through Walmart.com and were unable to do so in a timely and low- cost manner.

By 2002, Walmart had yet to realize synergies between online and offline retail outlets. Physical store sales and locations continued to expand at a rapid pace, but Walmart. com grew only modestly. Although Walmart pulled in over $219 billion in gross revenues in 2002, earning the top spot on the Fortune 500 list25 and making it the only retailer in the list’s top 10, its website lagged when compared to those of other online retailers. In a 2002 comScore report that ranked e-commerce sites based on site traffic, Walmart came in number 13, trailing Yahoo Shopping, Dell, Barnes & Noble, and MSN Shopping.26 The list’s number one and number two spots were claimed by eBay and Amazon, respectively. The study results showed that Walmart.com had a long way to go if it ever wanted to compete favorably with Amazon.com.

Analysts and the business world in general were baffled over Walmart’s inability to successfully make the transition to e-commerce. Surely, the company had enough expertise to be able to handle the logistics required to keep shipping costs low for online orders. And with the revenue from the stores and their stockpile of cash, Walmart could easily afford to invest in better technology to support its online push. But Walmart.com failed time and again to make any significant advances.

Contributing to the holdup was a clash of cultures between store headquarters in Arkansas and e-commerce leadership in California. The website’s engineers were focused on gener- ating high revenues and growing as sales continued to rise. Company executives in Walmart’s headquarters, however, looked at the online business in a totally different light. His- torically, Walmart’s success had been driven by an intense and unrelenting focus on profits. The first stores were so suc- cessful because Walmart founder, Sam Walton, and other executives drove huge cost reductions from suppliers due to the increased demand its low prices sparked in customers. Since the 1960s, all business decisions had been made with one goal firmly entrenched in every Walmart executive’s mind: Reducing costs drives profitability.

By contrast, tech companies often operated on net losses for years. In many cases, as a site built its user base and delivered true value to customers, it eventually became profitable. In fact, Amazon operated for years without mak- ing a profit. Walmart.com’s engineers, many recruited from successful tech companies, expected enough funding to get the website off the ground and running smoothly. Walmart executives, however, were unwilling to commit the funds that engineers thought were necessary for the website to gain real traction. One former executive said that each year Walmart.com would begin a “five-year planning exercise, but the plans were never executed and management would say the sales weren’t there to justify the capital investment.”27 The bottom line was that Walmart.com’s slow growth owed

[ Exhibit 7 ] Top Ten Holiday Retail Websites, Christmas Day 2012 (Total U.S. visits)

Rank Websites Visits

1 Amazon.com 24,657,838

2 Walmart 7,359,685

3 Target 3,591,384

4 BestBuy 3,431,900

5 Macy’s 1,949,547

6 Sears 1,881,690

7 Fandango 1,802,465

8 Kohls.com 1,738,424

9 Apple Store 1,728,247

10 JS Penny 1,576,870

Source: Experian Marketing Services.

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in part to the fact that it did not have the funding it needed from Walmart headquarters. Headquarters would not give its online business the funding it asked for because it had not yet proven its success. The two conflicting viewpoints of conservative, cost-cutting headquarters and “spend big, earn big” Walmart.com created a major culture clash and signifi- cantly hampered Walmart’s efforts to establish an online presence.28

Prime, Ship-to-Store, and Other Services Both Amazon and Walmart introduced new services and products with the hopes of enticing customers to make purchases on their respective sites. Feeling the pressure to respond to Amazon’s expanding business, Walmart intro- duced two new services in 2002. The first, a stripped-down and low-priced version of America Online’s (AOL) Internet service, lacked features such as instant messaging (included in AOL’s $20/month version) but allowed users access to an unlimited dialup connection for under $10 per month.29 In addition to inexpensive Internet service, Walmart also started a Netflix-like DVD rental service that allowed subscribers to receive DVDs via email and keep them as long as they liked without late fees. Walmart.com priced this offering at a dollar under Netflix’s price at the time. Three years later, Walmart announced it would shut down its movie rental business in order to focus on selling instead of renting movies.30

Amazon also looked for new ways to increase demand for its products and grab more market share from other online shopping sites. In 2005, it launched Amazon Prime, announc- ing it as “Amazon.com’s first ever membership program. For a flat membership fee of $79 per year, [Prime] members get unlimited, express two-day shipping for free, with no mini- mum purchase requirement. Members also get one-day, over- night shipping for only $3.99 per item.”31 Prime later expanded its offerings, in 2011, to include instant video streaming for its members.32 Amazon hoped a flat membership fee would be more appealing to customers who had previously avoided or limited their use of online shopping due to high shipping costs. Executives at Amazon had expected Prime to break even in two years and were astounded to reach break-even after just three months.33 Prime subscribers increased pur- chases on Amazon by an average of 150 percent.34

In 2007, Walmart decided to leverage its existing physical store locations for shipping in hopes of boosting online sales.35 That year, Walmart.com began offering free shipping for any product a customer ordered online but picked up in their local Walmart store.36 Physical stores became a means of boosting sales on Walmart.com by catering to customers who wanted the convenience of ordering a product online without paying for the extra shipping cost. Walmart executives hoped that, by drawing more customers into stores to pick up online deliver- ies, they would also increase in-store sales.

In the four months following the launch of the “Site to Store” program, Walmart announced customer sav- ings in shipping fees of over $5 million. The company also announced that within the same period Site to Store orders had accounted for one-third of all Walmart.com purchases,

with half of these purchases being made by first-time buy- ers on the site. These customers, Walmart reported, spent an additional $60 in stores while picking up their orders.37

Day of Reckoning Although the 2008 economic downturn helped Walmart in-store sales grow, it did little to reinforce the company’s gaping deficiency in e-commerce. Furthermore, as the country emerged from the effects of the recession, consum- ers flocked to online shopping in greater numbers than ever before (see Exhibit 3). More and more traditional Walmart Stores customers complemented or even replaced in-store purchases with online orders from its rival, Amazon.38 As sales in the physical stores leveled off, Walmart’s rapid store building push also tapered off. From 2009 to 2010, Walmart cut its new store development rate in half.39

Sensing that a seismic shift toward online commerce was underway following the recession, Walmart committed to expanding online sales by appointing Eduardo Castro- Wright, the former head of Walmart stores in the U.S., as the new CEO of Walmart.com in 2010. As customers continued to grow more tech-savvy, Walmart’s goal was to integrate the customer shopping experience across every channel of the business, including online. Castro-Wright said, “It’s fair to say that up until about a year ago, when Mike Duke defined what we call the next generation of Walmart as a major initiative for the company, that probably we were not as keenly devoted to creating the kind of shopping experi- ences across all channels that we are doing today.” Walmart executives hoped an integrated buying experience would help it develop the know-how and experience Walmart. com needed to compete with Amazon and other success- ful e-commerce sites (see Exhibits 8 & 9). However, given

[ Exhibit 8 ] Online Traffic Trends, 2012-2013

Amazon Walmart

Sep-12 98,627,108 58,203,957

Oct-12 103,664,423 59,653,716

Nov-12 119,781,871 87,939,359

Dec-12 138,392,869 82,083,892

Jan-13 119,200,891 58,542,307

Feb-13 109,368,101 55,865,635

Mar-13 129,671,037 61,998,068

Apr-13 121,683,470 57,936,534

May-13 122,637,206 59,454,896

Jun-13 126,463,100 59,487,868

Jul-13 130,783,521 61,312,322

Aug-13 133,023,878 62,524,970

Sep-13 128,903,291 57,381,622

Source: siteanalytics.compete.com.

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its poor online track record, many analysts were doubt- ful that Walmart could catch up. “They’re definitely late to the game,” Natalie Berg, co-global research director at Lon- don researcher Planet Retail, commented. “And it does not sound like they have a coherent strategy in place.”40 Ignor- ing the naysayers, Walmart began a new chapter for its online presence by aggressively acquiring new technologies, restructuring its organization, and experimenting with new innovations in its product offerings and supply chain.

Technology Acquisitions Aware that its online shopping experience lagged behind many competitors, Walmart began to acquire small technol- ogy companies in hopes of quickly ramping up its techno- logical capabilities. It invested in Chinese e-commerce giant Yihaodian, which sold over 180,000 products, employed over 4,000 workers, offered same-day-delivery for essential daily items, and generated $130 million dollars in annual revenue in China.41 However, one of the first acquisitions, Kosmix, a small social media company from Mountain View, Califor- nia, proved to be most crucial to Walmart.com’s efforts.

Kosmix had developed “a social media technology plat- form that filters and organizes content in social networks to connect people with real-time information that matters to them.”42 Kosmix founders, Venky Harinarayan and Anand Rajaraman, had sold their first company Junglee, which allowed online shoppers to compare prices from other online stores,43 to Amazon in 1998. Walmart purchased their next venture for a sum of $300 million in hopes that this new technology platform would allow it to better match offerings to customer preferences by relying on an algorithm that sought to understand what a user wants “rather than just matching a search query.”44 The acquisition, Walmart claimed in the press release announcing the deal, under- scored “its commitment to social and mobile commerce.”45

In order to further what it called its “global multi-chan- nel strategy,”46 Walmart.com launched a subunit within its online business committed to creating “technologies and businesses around social and mobile commerce”47 called @WalmartLabs. The Kosmix team led the research and devel- opment efforts. @WalmartLabs was structured into minia- ture startup groups, each with its own project and business

goal. A group leader acted as the unit’s CEO and was respon- sible for driving innovation for the team. These small groups developed ideas including a “Scan and Go” smartphone app that allowed users to scan items as they shopped, paying for them at the register by simply scanning one barcode at a special checkout; and an app called Shopycat that suggested holiday gifts for friends based on their social media profiles.48

One of the Kosmix team’s first tasks at Walmart.com was to unify e-commerce sites run by various national business units. When it joined Walmart.com, Kosmix discovered that, on a global scale, Walmart’s e-commerce division was run more like an IT organization than a tech startup. Out- sourced projects by each national business unit had led to over 15 e-commerce websites globally. None of them were able to communicate with each other, and all had a different look and feel. The Kosmix team worked to develop a uniform global technology platform called Pangaea.49 In addition, the @WalmartLabs team integrated technology from Kos- mix to rebuild a dysfunctional website search function. After revamping its internal search engine and site conversions, the number of visitors who actually bought products on the website increased by 20 percent in eight months.50

Not to be outdone by Walmart.com, Amazon contin- ued to broaden its appeal to online shoppers by expand- ing into new areas. In 2012, Amazon aggressively moved to buy two companies Walmart.com had initially approached. The first company, Diapers.com, sold diapers and other fre- quently purchased personal items online. Catching wind that Walmart was negotiating to acquire Diapers.com, Jeff Bezos contacted the owners of Diapers.com with his own offer and started selling diapers on Amazon.com at a loss. In a matter of weeks, Diapers.com’s owners saw the company’s market share eroding so fast that they had no choice but to sell to Bezos. Later that year, Amazon beat out Walmart. com’s efforts to acquire automated shipping company, Kiva Systems, which utilizes robots to fulfill orders in its warehouses.51

Walmart’s Reorganization Prior to 2011, Walmart’s e-commerce heads in each coun- try had reported directly to the global Walmart.com CEO, Eduardo Castro-Wright, in San Bruno, California. In late

[ Exhibit 9 ] Top Internet Properties in Revenue, October 2007 and June-August 2013

Oct-07 June-August 2013

Rank Domain Visits/Market Share Rank Domain Visits/Market Share

1 Amazon.com 11.52% 1 Amazon.com 9.75%

2 Walmart 5.37% 2 eBay 8.12%

3 Target 4.81% 3 Craig’s List 3.01%

4 Half.com 4.45% 4 Walmart 2.03%

5 Dell USA 3.49% 5 MonsterMarketplace.com 1.33%

Source: Hitwise.

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2011, however, Walmart headquarters announced a shuf- fling in the reporting structure in some of its strongest for- eign markets. E-commerce leaders in Canada and the U.K. would now report directly to the head of each country’s Walmart business unit.52 The retailer hoped the reorgani- zation would create better synergies between physical and online store sales.

Castro-Wright announced his plans to retire in October 2011, after less than two years on the job.53 Many speculated his retirement had been mandated by Walmart executives as a result of lackluster online sales and an inability to bring e-commerce initiatives in its foreign business units to frui- tion. Neil Ashe, former president of CBS Interactive, was hired to take his place. Ashe believed in the importance of online expansion and criticized the lack of priority Walmart executives had given online efforts in the past. His plan was to gradually transform Walmart into a fully integrated on- and offline experience. When asked how long it would take to achieve this goal, Ashe replied, “It will take the rest of our careers and as much as we’ve got. This isn’t a project. It’s about the future of the company.”54

Innovating to Compete With a new, aggressive leader at the head of Walmart.com, the battle between Walmart and Amazon for online domi- nation intensified over the next few years. Each company sought to gain an online leg-up through product and supply chain innovations.

Amazon continued to venture into new business areas in order to provide more and better products to its customers. In 2007, it introduced the Kindle, one of the first e-book read- ers, as a platform to sell e-books. In 2008, Amazon started to focus its “internetification” on the grocery business. Ama- zonFresh, a same-day grocery delivery service, was available to customers in the Seattle, Washington, area. Food and groceries sales were expected to grow over 20 percent from 2013 to 2017, as compared to an increase of 11 percent for e-commerce in general during the same time period.55 In June 2013, Amazon announced it would expand its Ama- zonFresh service to Los Angeles, California. Amazon, it was rumored, planned to further expand its grocery delivery business to 20 additional cities in 2014 and 20 more soon after, a move some thought was necessitated by the fact that margins on Amazon’s groceries were one-sixth those of Walmart’s in-store grocery sales.56

In a delayed response to AmazonFresh, Walmart piloted an online-grocery, same-day delivery service in San Jose, California, in 2011. Walmart’s U.K. subsidiary, Asda, had suc- cessfully operated a grocery delivery business in Great Brit- ain for a number of years. Although the San Jose initiative proved successful, Walmart.com waited to expand in the U.S. because the low population density in the U.S. market made delivering groceries ordered online more difficult and expensive to roll out.57

Hoping to provide greater convenience and security for online shoppers, Amazon and Walmart employed innova- tive technology and delivery systems to ensure customers

actually received their online orders. Walmart expanded its “Site to Store” model to over 660 FedEx office stores across the country. Customers could select the nearest FedEx or Walmart store as the shipping address and pick up pack- ages at their convenience. Customers who worried that packages might be stolen off their doorsteps now had a con- venient delivery option, and packages were never left unat- tended. Amazon responded that year with delivery lockers in convenience and grocery stores, offering similar delivery convenience and security as Walmart’s program.58 In 2013, Walmart also announced plans to install its own delivery lockers in Walmart retail stores.59

Amazon hoped the small fees it paid each month for stores to house its lockers would be offset by increased purchases and decreased shipping costs by delivery companies such as FedEx, which charged up to 20 percent less for locker deliv- eries over residential drop-offs. Delivery companies found it cheaper to deliver multiple packages to one location than to take many individual parcels to each customer’s house. Walmart had an advantage over Amazon in locker deliveries, however, because each of its over 4,000 retail locations could be used as pickup points for customers wanting the conveni- ence and security of locker pickup. Walmart, unlike Amazon, also did not have to worry about renting space for its lockers.

In addition to more convenient and secure deliveries, both Walmart.com and Amazon wanted to get packages to customers even faster. In order to get a package to a cus- tomer in 24 hours, Amazon invested heavily in new ware- houses located near major metropolitan areas. In 2013, it was reported that Amazon had “invested roughly $13.9 bil- lion since 2010 to build 50 new warehouses, more than it had cumulatively spent on storage facilities since its 1994 founding, bringing the total to 89 at the end of 2012.”60 In late December 2013, Amazon CEO, Jeff Bezos, even announced plans to begin using drones for package delivery starting in 2015 at the earliest.61

Walmart.com executives, on the other hand, sought to redefine the company’s traditional approach for online deliv- eries. In 2013, the retail giant sought to further leverage its expertise in physical store sales to boost online units with a new strategy called “Ship from Store.” When a customer placed an order online, instead of shipping from a ware- house in another state, with the “Ship from Store” system, a Walmart employee in a retail store would take the ordered item off a shelf, box it up, and give it to a FedEx or UPS truck for local delivery. The delivery would then take a few min- utes or hours instead of a few days, thereby improving the customer’s online shopping experience on Walmart.com.62 Walmart even toyed with the idea of using its own customers to deliver online orders to other customers for a small fee.63

CONCLUSION By 2013, Walmart.com and Amazon had spent years in a back-and-forth competitive match as both companies looked to leverage their individual strengths in order to grow online revenues. Challenged in the past by a lack of funding,

REFERENCES [ C-139 ]

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Walmart.com had finally seized on the imperative to grow and to reclaim much of what Amazon had taken by attract- ing customers to Walmart’s traditional product categories. Yet, although the company had made great strides, Ama- zon’s revenues were still eight times those of Walmart.com in 2013.64 Walmart executives wondered if the company was destined to be locked in a back-and-forth battle that might result in only incremental gains without ever being able to

take significant points out of Amazon’s market share. In the midst of these challenges, Walmart announced its inten- tion to further embrace the growing trend in China toward online shopping by opening 110 new facilities for shipping online orders. The company simultaneously announced the closing of up to 30 additional brick-and-mortar stores in China.65 Despite these efforts, a crucial question remains: Can Walmart.com make up for lost time?

REFERENCES

1 Don Davis, “Wal-Mart: ‘We can do what no one else does,’” Internet Retailer (March 26, 2013). Available at http://

www.internetretailer.com/2013/03/26/wal-mart-we-can-do-what-no-one-else-does, accessed October 10,

2013.

2 Ibid.

3 Ibid.

4 Shelly Banjo, “Wal-Mart’s E-Stumble With Amazon,” Wall Street Journal ( June 19, 2013). Available at http://

online.wsj.com/news/articles/SB10001424127887323566804578553301017702818, accessed October 10, 2013.

5 Walmart Stores Inc., Financial Statements, Fiscal Year 2013.

6 Walmart Stores Inc., “Corporate History Timeline.” Available at http://corporate.walmart.com/our-story/herit-

age/history-timeline, accessed October 24, 2013.

7 Ibid.

8 Ibid.

9 Ibid.

10 Ibid.

11 Ibid.

12 Ibid.

13 Josh Spiro, “The Great Leaders Series: Jeff Bezos, Founder of Amazon.com,” Inc.com (October 23, 2009). Avail-

able at http://www.inc.com/30years/articles/jeff-bezos.html, accessed October 25, 2013.

14 Brad Stone, “The Secrets of Bezos: How Amazon Became the Everything Store,” Bloomberg BusinessWeek (Octo-

ber 10, 2013). Available at http://www.businessweek.com/articles/2013-10-10/jeff-bezos-and-the-age-of-ama-

zon-excerpt-from-the-everything-store-by-brad-stone#p1, accessed October 24, 2013.

15 Amazon.com, Financial Statement, Fiscal Year 2012.

16 James Maguire, “Case Study: Walmart.com,” eCommerce-Guide.com (November 15, 2002). Available at

http://www.ecommerce-guide.com/news/trends/article.php/1501651/Case-Study-Walmartcom.htm, accessed

October 29, 2013.

17 Stone, 2013.

18 News Services, “Wal-Mart Sues Online Bookseller,” The Washington Post (October 17, 1998). Available at http://

www.washingtonpost.com/wp-srv/washtech/daily/oct98/walmart101798.htm, accessed October 25, 2013.

19 Greg Bensinger, “Competing With Amazon on Amazon,” Wall Street Journal ( June 27, 2012) Available at http://

online.wsj.com/news/articles/SB10001424052702304441404577482902055882264, accessed November 5, 2013.

20 Walmart Stores Inc., “Walmart.com Adds Nearly One Million New Items with the Launch of Walmart Mar-

ketplace” [Press Release] (August 30, 2009). Available at http://news.walmart.com/news-archive/2009/08/31/

walmartcom-adds-nearly-one-million-new-items-with-the-launch-of-walmart-marketplace.

21 CrunchBase, “Accel partners.” Available at http://www.crunchbase.com/financial-organization/accel-partners.

22 Maguire.

23 Ibid.

24 Ibid.

25 Fortune 500 database, 2002. Available at http://money.cnn.com/magazines/fortune/fortune500_archive/

full/2002/1.html, accessed October 31, 2013.

26 Maguire.

27 Meghan Foley, “Did Walmart’s E-Commerce Stumble Put its Future at Risk?,” wallstreetcheatsheet.com

( June 22, 2013). Available at http://wallstcheatsheet.com/stocks/did-wal-marts-e-commerce-stumble-put-its-

future-at-risk.html/?a=viewall, accessed October 25, 2013.

28 Ibid.

http://www.internetretailer.com/2013/03/26/wal-mart-we-can-do-what-no-one-else-does

http://online.wsj.com/news/articles/SB10001424127887323566804578553301017702818

http://corporate.walmart.com/our-story/herit-age/history-timeline

http://www.inc.com/30years/articles/jeff-bezos.html

http://www.businessweek.com/articles/2013-10-10/jeff-bezos-and-the-age-of-ama-zon-excerpt-from-the-everything-store-by-brad-stone#p1

http://www.ecommerce-guide.com/news/trends/article.php/1501651/Case-Study-Walmartcom.htm

http://www.washingtonpost.com/wp-srv/washtech/daily/oct98/walmart101798.htm

http://online.wsj.com/news/articles/SB10001424052702304441404577482902055882264

http://news.walmart.com/news-archive/2009/08/31

http://www.crunchbase.com/financial-organization/accel-partners

http://money.cnn.com/magazines/fortune/fortune500_archive

http://wallstcheatsheet.com/stocks/did-wal-marts-e-commerce-stumble-put-its-future-at-risk.html/?a=viewall

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29 Maguire.

30 PRNewswire, “Walmart.com and Netflix Announce New Promotional Agreement; Online Retail Companies

Team to Promote Each Other’s Core Businesses” (May 19, 2005). Available at http://www.prnewswire.com/

news-releases/walmartcom-and-netflix-announce-new-promotional-agreement-online-retail-companies-

team-to-promote-each-others-core-businesses-67048857.html.

31 Amazon.com, “Amazon.com Announces Record Free Cash Flow Fueled by Lower Prices and Free Shipping;

Introduces New Express Shipping Program—Amazon Prime” [Press Release] (February 2, 2005). Available at

http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-newsArticle&ID=669786&highlight=, accessed

October 31, 2013.

32 Amazon.com, “Amazon Prime Members Now Get Unlimited, Commercial-free, Instant Streaming of More Than

5,000 Movies and TV Shows at No Additional Cost” [Press Release] (February 22, 2011). Available at http://phx.

corporate-ir.net/phoenix.zhtml?c=176060&p=irol-newsArticle&ID=1531234.

33 Brad Stone, “What’s in Amazon’s Box? Instant Gratification,” Bloomberg BusinessWeek (November 24, 2010).

Available at http://www.businessweek.com/magazine/content/10_49/b4206039292096.htm#p2.

34 Stone, 2010.

35 Walmart Stores Inc., “Wal-Mart Completes National Rollout of Site to StoreSM Service” [Press Release] ( July 13,

2007). Available at http://news.walmart.com/news-archive/2007/07/13/wal-mart-completes-national-rollout-

of-site-to-storesm-service, accessed January 9, 2014.

36 Davis.

37 Walmart stores Inc., July 13, 2007.

38 Matthew Boyle, “Walmart’s Magic Moment,” Bloomberg BusinessWeek ( June 15, 2009).

39 Matthew Boyle and Douglas MacMillan, “Walmart’s Rocky Path From Bricks to Clicks,” Bloomberg BusinessWeek

( July 21, 2011). Available at http://www.businessweek.com/magazine/walmarts-rocky-path-from-bricks-to-

clicks-07212011.html, accessed October 15, 2013.

40 Boyle and MacMillan.

41 Mark Brohan, “China green lights Wal-Mart’s 51% stake in Yihaodian,” Internetretailer.com (August 14, 2012).

Available at http://www.internetretailer.com/2012/08/14/china-green-lights-wal-marts-51-stake-yihaodian,

accessed October 15, 2013.

42 Walmart Stores Inc., “Walmart Announces Acquisition of Social Media Company Kosmix” [Press Release]

(April 18, 2011), accessed October 25, 2013.

43 Farhad Manjoo, “Walmart’s Evolution From Big Box Giant To E-Commerce Innovator,” Fast Company

(November 26, 2012). Available at http://www.fastcompany.com/3002948/walmarts-evolution-big-box-giant-

e-commerce-innovator, accessed October 15, 2013.

44 Manjoo.

45 Walmart Stores Inc., April 18, 2011.

46 Ibid.

47 Ibid.

48 Manjoo.

49 Laura Heller, “Walmart vs. Amazon: It’s About to Get Interesting,” Forbes (March 29, 2013). Available at http://

www.forbes.com/sites/lauraheller/2013/03/29/walmart-vs-amazon-its-about-to-get-interesting/.

50 Davis.

51 Pedro M. Reyes, “Amazon Goes on a Building Spree,” Bloomberg Business Week (September 2, 2013). accessed

October 10, 2013.

52 Matt Townsend and Ashley Lutz, “Wal-Mart Shakes Up E-Commerce, Execs Leave,” Bloomberg News (August

12, 2011). Available at http://www.bloomberg.com/news/2011-08-12/wal-mart-shakes-up-e-commerce-execs-

leave.html, accessed October 15, 2013.

53 “Global Ecommerce Expansion Said to Bedevil Wal-Mart,” LexisNexis (October 3, 2011). accessed October 15,

2013.

54 Banjo.

55 Clare O’Connor, “Wal-Mart Vs. Amazon: World’s Biggest E-Commerce Battle Could Boil Down To Vegetables,”

Forbes (April 23, 2013). Available at http://www.forbes.com/sites/clareoconnor/2013/04/23/wal-mart-vs-

amazon-worlds-biggest-e-commerce-battle-could-boil-down-to-vegetables/, accessed October 10, 2013.

56 Rich Smith, “Who’s Going to Deliver Your Groceries: Walmart, Amazon, or ...?,” Dailyfinance.com ( July 9, 2013).

Available at http://www.dailyfinance.com/2013/07/09/grocery-delivery-walmart-amazon-peapod/, accessed

October 10, 2013.

57 Smith.

58 Greg Bensinger, “Amazon’s New Secret Weapon: Delivery Lockers,” Wall Street Journal (August 7, 2012). Available

at http://online.wsj.com/news/articles/SB10000872396390443545504577567763829784538, accessed Novem-

ber 4, 2013.

59 Karen Talley, “Wal-Mart to Use In-Store Lockers for Web Order Pickups,” Wall Street Journal (May 1, 2013) Avail-

able at http://online.wsj.com/article/BT-CO-20130501-710606.html, accessed November 4, 2013.

60 Reyes.

http://www.prnewswire.com

http://phx.corporate-ir.net/phoenix.zhtml?c=176060&p=irol-newsArticle&ID=669786&highlight=

http://phx

http://www.businessweek.com/magazine/content/10_49/b4206039292096.htm#p2

http://news.walmart.com/news-archive/2007/07/13/wal-mart-completes-national-rollout-of-site-to-storesm-service

http://www.businessweek.com/magazine/walmarts-rocky-path-from-bricks-to-clicks-07212011.html

http://www.internetretailer.com/2012/08/14/china-green-lights-wal-marts-51-stake-yihaodian

http://www.fastcompany.com/3002948/walmarts-evolution-big-box-giant-e-commerce-innovator

http://www.forbes.com/sites/lauraheller/2013/03/29/walmart-vs-amazon-its-about-to-get-interesting

http://www.bloomberg.com/news/2011-08-12/wal-mart-shakes-up-e-commerce-execs-leave.html

http://www.forbes.com/sites/clareoconnor/2013/04/23/wal-mart-vs-amazon-worlds-biggest-e-commerce-battle-could-boil-down-to-vegetables

http://www.dailyfinance.com/2013/07/09/grocery-delivery-walmart-amazon-peapod

http://online.wsj.com/news/articles/SB10000872396390443545504577567763829784538

http://online.wsj.com/article/BT-CO-20130501-710606.html

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61 Bloomberg News, “Amazon Tests Drones for Same-Day Parcel Delivery, Bezos Says,” Bloomberg Technology

(December 2, 2013). Available at http://www.bloomberg.com/news/2013-12-02/amazon-testing-octocopters-

for-delivery-ceo-tells-60-minutes-.html, accessed December 9, 2013.

62 Alistair Barr, “Retail stores become shipping hubs to battle Amazon,” USA Today (October 6, 2013). Available

at http://www.usatoday.com/story/tech/2013/09/28/retailers-ship-from-store/2862405/, accessed October 10,

2013.

63 Dana Rousmaniere, “Morning Advantage: Walmart Wants You to Deliver Packages,” HBR (March 29, 2013).

Available at http://blogs.hbr.org/2013/03/morning-advantage-walmart-want/, accessed October 9, 2013.

64 Amazon reported revenue of $74.4 Billion divided by Walmart projected 2013 revenue of ~$9 Billion.

65 Reuters, “Walmart Plans More Stores and E-Commerce in China,” New York Times (October 24, 2013) Available at

http://www.nytimes.com/2013/10/25/business/international/wal-marts-china-plan-to-focus-on-e-commerce

.html?_r=0, accessed November 9, 2013.

http://www.bloomberg.com/news/2013-12-02/amazon-testing-octocopters-for-delivery-ceo-tells-60-minutes-.html

http://www.usatoday.com/story/tech/2013/09/28/retailers-ship-from-store/2862405

http://blogs.hbr.org/2013/03/morning-advantage-walmart-want

http://www.nytimes.com/2013/10/25/business/international/wal-marts-china-plan-to-focus-on-e-commerce

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[ C-142 ]

S kype is widely recognized as the first successful “free” telecommunications company. It was founded in 2003

by Niklas Zennström and Janus Friis. A peer-to-peer voice- over-Internet-protocol (“VoIP”) network, Skype experi- enced incredible growth and wide acceptance, to the point where, five years after its founding, the company was val- ued at $2.4 billion and acquired by the multinational online- marketplace corporation eBay. Deriving its name from the combination of “sky” and “peers,”1 Skype was later divested by eBay and subsequently sold to software giant Microsoft in 2011 for $8.5 billion, the largest acquisition in Microsoft’s history.2 The acquisition by Microsoft showed its confi- dence in Skype’s future potential, but it also highlighted Microsoft’s need to address emerging “free” telecommuni- cation services being offered by some of its primary com- petitors, including tech giants Google and Apple. With over 663 million registered users worldwide at the time of the Microsoft acquisition, Skype’s market share was dominant to say the least. The question Skype now faced was could this dominance continue with such large new competitors entering the market? Skype’s customer pool had primar- ily come from converting traditional telecommunications providers’ customers to Skype through the combination of cheaper prices, quality service, and ease of use. Were there more ways to disrupt these existing traditional players and steal further share? And would the company’s “freemium” business model continue to sustain its grand aspirations, or would modifications be necessary in light of evolving mar- ket factors?

BACKGROUND When Niklas Zennström and Janus Friis created Skype in 2003 with $20 million in venture capital funding, their plan was to leverage the existing peer-to-peer (“P2P”) technology they had previously utilized at Kazaa, a P2P file-sharing appli- cation they had launched, which became popular as a way

to share music over the Internet. Like Kazaa, Skype avoided the traditional client-server architecture by choosing a peer- to-peer model, which allowed for direct communication between users or nodes. Skype argued that decentralized P2P networks had many advantages over client-server net- works, including (i) the ability to scale indefinitely without increasing required search time or costly centralized serv- ers and (ii) self-sustainability resulting from the fact that end-users’ processing and networking power increased pro- portionately with the network itself.3 Napster used a client- server network, which is one reason it was able to be shut down—by shutting down the server, federal authorities were able to deactivate the entire system (see Exhibit 1 for a com- parison of a P2P versus a client-server network).

Skype utilizes two primary IP-based communications techniques: (i) Firewall and Net Address Translation (“NAT”) Traversal and (ii) global, decentralized user directory. As described on the company’s website regarding Firewall and NAT Traversal:

Non-firewalled clients and clients on publicly routable IP addresses can help NAT’ed nodes communicate by routing calls. This allows two clients who otherwise would not be able to communicate to speak with each other. Calls are encrypted end-to-end and proxies with spare resources are chosen, so the performance for these users is not affected.

A global, decentralized user directory was also impera- tive to Skype’s technology. Typically, a centralized direc- tory is required for instant messaging and communications software in order to link a user’s identity with a dynamic IP address. However, central directories can be very expensive to maintain as a user base escalates into the millions. In order to avoid this, Skype relies on Global Index P2P, a multi- tiered network in which supernodes communicate in such a way that every node in the network has full knowledge of all

CASE 16 Skype: Competing with Free

PC Server

[ Exhibit 1 ] Comparison of Client Server Network versus P2P Network

Traditional Client-Server Network P2P Network

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CASE 16 SKYPE: COMPETING WITH FREE [ C-143 ]

available users and resources with minimal latency. A super- node is any node (i.e., connection point, redistribution point, or communication endpoint) that works as a relay for the network, essentially a proxy server, handling data flow and connections for other users.5 According to cofounder Niklas Zennstrom, “Our supernode technology allows us to effi- ciently route calls which improves call speed and quality.”6 Certain high-speed Internet connections, such as those at universities, become susceptible to supernodes and there- fore have banned the service.7

Rival Technology Skype uses a proprietary signaling communications protocol while many of its competitors use Session Initiation Proto- col (“SIP”), an open network protocol that uses proxy servers to route information to a user’s current location, authenti- cate users and authorize service for them, and deliver user features. SIP also has a registration function in which proxy servers are used to disseminate requests once a user uploads his or her current location. SIP is a flexible protocol; how- ever, it is hampered by NAT and Firewall restrictions.8 Popu- lar SIP providers include Vonage, Jive, and Nextiva.

Web Real-Time Communication (WebRTC) is another rival technology that has begun to emerge since its release by Google in 2011 as an open-source project. WebRTC allows for telephony, instant messaging, video, and file trans- ferring, but through web browsers, eliminating the need for softphones.9 One of its biggest benefits is that it does not require plugins, which can be complicated and error-ridden, dissuading users from trying the product.10

Products Skype users must have the company’s downloadable soft- ware on their device in order to use the service. Software is available for free and runs on major operating platforms, including Microsoft Windows, iOS, Linux, Android, Black- berry, and Symbian. The technology allows Skype users on computers, mobile phones, tablets, home phones, televi- sions, and other mobile devices to connect with other Skype users via voice, video, text, and file sharing.

For voice calls, Skype users can call anyone else on Skype for free, anywhere in the world. Calls to mobile and landlines worldwide require a fee payable on an as-you-go basis, or on a monthly subscription basis. Skype allows users to have a phone number to receive non-Skype calls, as well as access to call-forwarding, caller ID services, international calling, and group calls with up to 25 people. Video calling (both one-on-one and group) is available in a basic one-on-one format free of charge. The company also offers messaging services through video, instant messaging, text, or voice. File sharing, including photos and video, can also be done by simply adding the file into the Skype chat.

Acquisition History After growing its user base to 54 million registered users, 2.7 million of which were premium service customers, the

company was acquired by eBay for $2.6 billion. The transac- tion also carried up to an additional $1.5 billion of earnouts for Zennstrom and Friis, contingent on reaching 2008 profit targets as well as revenue and user count goals. For eBay, the acquisition price, including earnouts, represented approxi- mately 5% of its market value.11 eBay’s management noted the following key benefits related to its acquisition of Skype: 12

Accelerating existing categories: Categories requiring highly involved, complex, and expensive purchases, such as motor vehicles, business and industrial goods, collecti- bles, jewelry, sporting goods, and musical instruments, could benefit from connecting buyer and seller directly through Skype. These types of purchases require signifi- cant communication about product details, shipping, and so on, and they are less suited to transaction-based monetization. eBay hoped Skype’s features could take over the site’s text messaging system, which had been in place to that point. In addition to accelerating exist- ing categories, eBay hoped that the introduction of Skype would open new categories, such as vacation packages, which required more support than the listing and text messaging available on eBay prior to the acquisition.

Expanding global footprint: In many international markets at the time of Skype’s acquisition, eBay was still work- ing to establish its foothold. eBay management believed that Skype, with its stronger worldwide presence, would help the company in its expansion into these markets. They also believed the new communications capabilities Skype provided would provide ways to further build trust between buyers and sellers across borders.

Great stand-alone business: Not only was the acquisition seen as having the potential to synergistically help eBay, but the company’s management also looked at Skype’s potential on a stand-alone basis. It pointed to Skype’s large and growing opportunity in the market of global broadband and VoIP usage, its leadership position in the market, and its successful executive team.

Despite the fairly convincing arguments in favor of the acquisition, many wondered why eBay chose not to simply license Skype’s technology or use their services, embed- ding them in the platform. eBay’s own doubts appeared to be confirmed when in 2009, only four years later, it decided to divest the majority (65% stake) of Skype to an investor group including Silver Lake, Index Ventures, and Andressen Horowitz for $1.9 billion in cash. eBay’s remaining 35% stake, however, still allowed it to participate in future profits cre- ated by the new owners.13

Less than two years after eBay’s divestiture, Skype found itself with new owners once again, being acquired by soft- ware giant Microsoft for $8.5 billion, making it Microsoft’s largest ever acquisition. Although there was much specu- lation as to whether Microsoft overpaid for the Company, which recorded revenues of $860 million the year before in 2010, most agreed that Microsoft’s strategy was to uti- lize Skype’s popularity to increase appeal across its exist- ing software offerings and to enhance the functionality of

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[ C-144 ] CASE 16 SKYPE: COMPETING WITH FREE

its hardware. For example, Skype’s integration in Micro- soft’s Outlook software could enhance appeal for business users, and voice and video communication would appeal to Microsoft Xbox gaming enthusiasts as a way to better connect with other online players.14 At the time, Skype had approximately 663 million subscribers worldwide, of which approximately 170 million were active users, and had logged over 207 billion minutes of video and voice conversations the previous year.15

REVENUE MODEL From its inception, Skype has utilized a “freemium” business model in order to generate revenue. “Freemium,” a neolo- gism derived from the combination of “free” and “premium,” is a pricing strategy that involves introducing a free basic product or service to gain widespread use and then offering users a non-free premium version that includes features not available with the basic offering. Skype offers free computer- to-computer phone calls but makes money on add-ons such as voicemail and calls to landlines or cell phones. Success with a freemium strategy requires either:

a. A free product that appeals to a very large product user base ( for example, roughly 1.5 billion people with com- puters are interested in using Skype to make phone calls or Adobe to open PDF files); or

b. A high conversation rate, meaning a high percentage of FREE users are willing to pay for premium features.

Skype is successful because of the sheer total numbers of users of its free product. Even if Skype only had a low con- version rate (the rule of thumb is 5 percent of free product users tend to become paying customers for companies using freemium), it could make money because it has over 600 mil- lion product users. In contrast, Flickr, the photo-sharing site that uses a freemium strategy, has a much smaller total mar- ket because the number of camera users that want to use a photo-sharing service is much smaller than the market for making free phone calls. Moreover, the conversion rate to Flickr Pro is relatively low because, for most users, the free version is good enough. The fact that Skype appeals to far

more users, with a conversion rate that is better than Flickr’s, translates into a far superior business model. This explains why eBay was willing to pay $2.6 billion for Skype four years after Skype launched, whereas Yahoo paid only $25 million for Flickr four years after it launched.

There are a number of ways that companies can distin- guish the premium version of the product or service from the free version. They can offer additional or superior features or capacity (as Skype does calling cell phones or Dropbox does with additional online storage), customer class (e.g., free for students or educators), ease of use (e.g., in online games more effort and time is required to obtain in-game currency in the free version), improved support level (e.g., telephone or email support only provided for premium users), or increased time or bandwidth (e.g., limit how often or how much users can play) of a product or service.16

Freemium business models are sometimes mistaken for free trial models. Free trial models allow people to use the product or service for a set amount of time or “trial period,” after which continued use requires payment. Conversely, freemium models always have a free basic offering with charges only coming from users opting for premium features or services. Certain programs, such as Pandora, an internet radio application, combine the freemium and free trial mod- els by limiting the amount of free radio a user can listen to on their program in a month (i.e., the free trial aspect), but also allowing for paid premium service that includes unlimited access (i.e., freemium aspect).

The expansion of businesses using freemium, particularly in the digital space, has raised the level of expectations of many consumers. Consumers of digital content are more likely to expect some level of free content prior to encoun- tering fee-based premium content. Much is this is due to the domino effect of one producer choosing to follow a free- mium model, forcing its competitors to adopt the model merely to stay competitive. Why pay for one product when another producer offers a similar product for free? With over a million free apps in Apple’s App Store alone, putting a price on downloading an app has become an instant barrier for many consumers.

Third-Party Pay (Advertising) Revenue Model

Firms utilizing a “third-party pay” strategy provide products for free to a community of product users as a method of generating revenue from a third party (the real

customers) who pays to access those users. In the digital

age, Google is the poster child for this strategy, offering free

Internet search services while companies pay Google to

advertise to its millions of product users. Google’s approach

works particularly well because, when product users type

in key search words, they identify themselves as prime

candidates for advertisers (for example, typing in “skis” or

“snowboards” allows companies selling or servicing those

products to advertise to those targeted customers).

The secret to third party pay is to provide a valuable free

service that attracts either:

a. A very large community of product users who can then be segmented in a particular way for advertisers (the

way Google does with search); or

Other “Free” Revenue models

Case_Ch16.indd 06:12:4:PM 03/17/2015 Page 145Trim Size: 8.5 in X 11 in

CASE 16 SKYPE: COMPETING WITH FREE [ C-145 ]

b. A targeted community of users that comprises a “cus- tomer segment,” meaning a group of individuals simi-

lar on a key dimension (e.g., this similarity could be

based upon demographics, for example “teenagers” or

“retired people,” or it could be more need-based, such

as “video game players” or “new mothers.”)

Blyk, a Finnish telecommunications company, competes

by offering free cell phone service to 16-24 year olds.

Product users in the desired demographic fill out a

detailed survey on their preferences and are then given

217 free minutes each month if they agree to receive

advertisements. Blyk makes money by selling access to that

particular demographic and providing information on their

preferences (Blyk also benefits by using freemium because

many customers go over their free minutes and end up

paying something). Blyk was acquired by Orange, the key

brand of France Telecom.

In similar fashion, Ryanair occasionally offers airline

seats for free by using a combination of freemium and

third party pay. The company makes money on its add-

on services: $25 per customer for checked or carry-on

bags, $5 for seat reservations and credit card use, $4 for

priority boarding. Flight attendants sell food, scratch card

games, perfume, digital cameras, and MP3 players. Ryanair

also uses the flight as a platform for advertisers. When

your seat tray is up, you may see an ad for a cell phone

from Vodaphone, and when it is down, you may see an ad

from Hertz. Flyers are a captive audience for advertisers

targeting travelers.

Bundling “Free” Revenue Model A bundling strategy involves offering a free product with

a paid product or service. For example, Hewlett Packard

may give away a free printer with the purchase of a

computer, or Verizon may give away a free cell phone

with the purchase of a service contract. Of course, the

“free” effect here is largely psychological because the

customer must actually pay in order to get the product

for free.

Offering a free product as part of a bundle works

well when the product requires ongoing maintenance

or complementary goods (e.g., Hewlett Packard makes

money by selling ink for their free printers). For example,

Better Place is a company that has recently introduced

free electric car leases in Israel. They are able to lease

the car for free because they bundle it with an energy/

maintenance contract. Customers pay 10 cents per mile

(less than the cost of gas) to get their electric car battery

packs swapped out at a Better Place service station.

Instead of stopping for gas, you stop for a battery swap.

But the battery swap costs Better Place less than 10

cents per mile, so they make money on the difference.

They also make money through third-party pay because

governments, trying to clean the air, subsidize their

operations.

Bundling works particularly well when a company

offers a broad array of products or when the products it

sells require ongoing maintenance or complementary

goods. Banks offer a broad array of financial services

and some are increasingly bundling free services—free

accounts or free stock trades—when a customer uses

other services (e.g., keeps investment balances above

some minimum). But the bundled product doesn’t have to

be related to the free product. Banks also give away free

products, such as iPods or iPads, to customers opening

accounts.

Skype’s Freemium Model The nature of Skype’s business lent itself well to the free- mium business model. Skype’s P2P technology minimized the cost of adding incremental users, thus making it easy to offer it for free. According to Zennstrom, “We decided that Skype needed to be free because the marginal cost of placing a phone call for us was basically zero. When the marginal cost of providing a product or service is zero, the price will naturally fall to zero.”17 Furthermore, for the base service of Skype-to-Skype calls and video conferencing to be of value, it required that many people have the software program. Consequently, offering it free-of-charge made good business sense; it prompted users to contact others they wanted to call using Skype (this is often called a “two-sided market” because one party needs to contact another party and invite them to use the service in order for it to have any value). Skype is also subject to “network effects,” meaning that users

have an incentive to bring others into the network because it creates more value for them. (See Exhibit 2 for a list of both free and available-for-purchase services.) The ability to convert free users to paid users is critical for the freemium business model to work. An analysis of Skype’s revenue per user from 2004–2008 showed that Skype generated roughly $1.60 per user per year (see Exhibit 3). Although revenues per user were low, Skype was still able to grow revenues at a rapid pace because of the growth in the overall number of users. One challenge for Skype was figuring out how to increase its revenue per user, either by converting more users to paying customers or getting paying customers to use more fee-based services. To date, Skype had little suc- cess in its attempts to increase its revenue per user. Skype and other companies using freemium business models, such as Pandora, typically made less money per user than compa- nies such as Google and Yahoo that used a third-party pay or

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[ C-146 ] CASE 16 SKYPE: COMPETING WITH FREE

[ Exhibit 2 ] Telephony Offerings Comparison

Skype Google Yahoo!

Voice Platform to Platform Calls X X X

Mobile/Landline Calls

Domestic X X

International X X

Conference Calls X X

Unique Phone # X X

Call Forwarding X X

Caller ID X X

Call from Mobile Device X X

Video Platform to Platform Video X X X

Group Video X X X

Messaging Plat2Plat Video Mess X X X

Plat2Plat IM X X X

SMS X X X

Voice Messages X X

Mobile Group Chat X X

Voicemail Transcription X

Sharing Files X X

Screen X X

Group Screen X X

*Fee Applies

Source: Skype.com, Google.com, Yahoo.com

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

2006

2007

2008

2009

[ Exhibit 3 ] Skype Revenue per Unique User

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CASE 16 SKYPE: COMPETING WITH FREE [ C-147 ]

advertising model (see Exhibit 4). Not only did Google make more money per user, but between 2004 and 2014, it was increasing its revenue per user at a faster pace than Skype, Yahoo, or Microsoft (see Exhibit 5).

COMPETITION From the beginning, Skype set out to disrupt the services of traditional telecommunication companies. Offering its

services for free was revolutionary in the industry and was the catalyst for Skype’s rapid adoption. Even the company’s fee-based services were able to substantially undercut their traditional competitors. One particular area of competitive advantage was Skype’s popularity as a long-distance pro- vider. Whereas international long distance rates were as high as $50 per hour, Skype was free. In recent years, international phone traffic had seen overall declines, but international Skype-to-Skype traffic had experienced consistent growth

$15.96

$11.18

$3.50 $3.09

$1.80 $1.60

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

$18.00

Google Yahoo Facebook Zynga Pandora Skype

R ev

en u

es P

er U

n iq

u e

U se

r P

er Y

ea r

Note: Data on Google and Yahoo are from 2005; other data are from 2010.

[ Exhibit 4 ] Revenue per Unique User

$–

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

04 04 Q3

05 05 Q3

06 06 Q3

07 07 Q3

08 08 Q3

09 09 Q3

10 10 Q3

11 11 Q3

12 12 Q3

13 13 Q3

Google

Yahoo

Microsoft

Skype

Source: Yahoo, Google, and Microsoft Quarterly Reports, 2004–2014; comScore.com.

[ Exhibit 5 ] Revenue per User

Case_Ch16.indd 06:12:4:PM 03/17/2015 Page 148Trim Size: 8.5 in X 11 in

[ C-148 ] CASE 16 SKYPE: COMPETING WITH FREE

(see Exhibit 6). In order to compete, many traditional carri- ers lowered rates or bundled phone service in with cable and internet options. Competition also came in the form of other VoIP providers using SIP, such as Vonage, Nextiva, and Jive.

The popular search engine Yahoo!, through its Yahoo! Messenger application, was also a key competitor offering unlimited free PC-to-PC worldwide. Google, the world’s most popular search engine with over a billion unique monthly visitors,18 also allowed users to text, talk, or video chat through its Google Talk application. The instant messaging service was available for download through an independent app or within Gmail, Google’s email service, and provided a simple user-friendly interface. In May 2013, Google Talk was replaced with Google Hangouts, an updated application that expanded, in particular, the program’s video-conferenc- ing capabilities. Sophisticated technology in the program allowed it to identify and feature the person currently talk- ing in the conversation in the primary window.19 Along with Google Hangouts, the company also offers Google Voice (see Exhibit 7 for a rate comparison between Google Voice

and Skype), its VoIP telephony, texting, voicemail, and voice- mail-transcription product, which, in 2014, was rumored to be merged with Google Hangouts.20 Google’s massive reach has allowed these products to gain momentum and loyalty. A Google executive, speaking on Google’s “free strategy,” said “We try to make sure our product is orders of magni- tudes better than the competition in order to beat them with a free offering.”21 These “magnitudes” of difference are important when two free products are competing with each other. The number of applications that Google offers con- tributes to its ability to differentiate from the competition (see Exhibit 8 for a list of online offerings given by Google, Yahoo!, and Microsoft). One new concern for Skype was that it was using a freemium model in the U.S. and Canada, with users having to pay to call from a computer to a landline or cell phone, and Google chose to offer the same service for free (see Exhibit 7). Google used this approach to increase market share with the hope of turning those users into reve- nues through different freemium upgrades and advertising.

55 International Phone Traffic International Skype-to-Skype

A n

n u

al G

ro w

th (

bi ll

io n

s of

m in

u te

0 2005 2006 2007 2008 2009 2010 2011 2012 2013

[ Exhibit 6 ] Skype Traffic Growth

Source: Tom Gara, “Skype’s Incredible Rise, in One Image,” wsj.com (January 15, 2014),

“Telegeography.” Available at http://blogs.wsj.com/corporate-intelligence/2014/01/15/

skypes-incredible-rise-in-one-image/

[ Exhibit 7 ] Rate Comparison

Per Minute Rates Skype Google

US-Mobile $0.023 Free

Canada-Mobile $0.023 Free

Mexico-Mobile $0.035 $0.15

China-Mobile $0.011 $0.02

India-Mobile $0.015 $0.02

Unlimited US & Canada (per month) $2.99 Free

Unlimited World (per month) $13.99 N/A

Source: Skype.com, voice.google.com

http://blogs.wsj.com/corporate-intelligence/2014/01/15

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CASE 16 SKYPE: COMPETING WITH FREE [ C-149 ]

Although search engine giants were knocking on the figurative telecommunications door, Microsoft’s chief com- petitor, Apple, decided to leverage its platform and technolo- gies clout to move into the space. FaceTime, Apple’s video telephony and VoIP application, was released in 2011, allow- ing users to talk or video conference with other FaceTime users. FaceTime comes preloaded on new iPads, iPhones, and Mac computers. However, it is not compatible with non- iOS devices, so the user must be calling someone else with an Apple device. Originally only available through Wi-Fi, FaceTime now had the ability to work via 3G and LTE data connections.22

Although Apple has been limited by its proprietary oper- ating system, new challengers such as Viber, Tango, and WhatsApp are not. Similar in functionality and features to Skype (with the exception of WhatsApp, which does not offer voice service), all have been gaining momentum with their cross-platform offerings. In February 2014, Facebook acquired WhatsApp for $19 billion in cash and stock at a time when it had 450 million users. As of April 2014, WhatsApp had passed the half-billion user mark.23 Also in February 2014, at the time of its acquisition by Tokyo-based Internet service company Rakuten for $900 million, Viber had over 300 million registered users.24 As of March 2014, Tango had

reported over 200 million users, 70 million of which were active every month.25

CONCLUSION Aided by the deep pockets and plentiful resources of parent- company Microsoft ($327 billion market cap in April 201426), Skype’s leadership team has reason to be optimistic about the future. However, as the other titans of technology race to launch their own telecommunication applications and businesses, Skype’s lead in the industry is starting to dwin- dle. Traditional telecommunications firms such as Comcast, Time Warner, and Cox, which have moved into VoIP and offer the advantage of bundling with cable and Internet, are no longer the only competition, and Skype is no longer the new kid on the block. Applications such as Tango, Viber, and WhatsApp, which are very similar in nature to Skype, are not only rapidly increasing their user base, they are doing so at a rate much faster than Skype was able to. Tango, for example, grew twice as fast in 2011 as Skype did in its first year, and in only five years, WhatsApp has grown its user base to over 500 million people worldwide.27 How will Skype compete with the increasing popularity of companies, such as Apple and Samsung, which have developed their own applications included on their products?

Source: Google.com, Yahoo.com, Microsoft.com

Google Yahoo! Microsoft

Web Web Search Google Chrome

Toolbar

Bookmarks

Helpouts

Toolbar

Answers

Bing

Internet Explorer

Mobile Mobile Search for Mobile

Maps for mobile

Mobile Apps Windows Phone

Business AdWords Google Apps for

Business

Advertising

Commerce Central

Small Business

Stream Ads

Media YouTube Google Play

Books

Image Search

News

Video Search

Picasa

Connected TV

Horoscopes

Movies

Music

News

Screen

Shine

Voicess

Xbox

Specialized Search

Blog Search

Custom Search

Patent Search

Google Shopping

Finance

Scholar

Alerts

Trends

Health

Homes

Jobs

Autos

Finance

Local

Shopping

Travel

Weather

Google Yahoo! Microsoft

Home & Office

Gmail

Drive

Docs

Sheets

Slides

Forms

Drawings

Sites

Calendar

Translate

Voice

Google Wallet

Google Cloud Print

Google Keep

Mail

Notepad

Personal Finance

Flickr

Domains

Calendar

Education

Web Hosting

Outlook

OneDrive

Word

Excel

PowerPoint

Calendar

OneNote

Social Google+ Blogger

Groups

Hangouts

Orkut

Celebrity

Tumbir

Groups

Messenger

Dating

Games

Sports

Fantasy MLB

Fantasy Sports

Fantasy Football

My Yahoo

Skype

Innovation Fusion Tables Code

Developer Network

Geo Maps Earth

Panoramio

Maps

[ Exhibit 8 ] Available Web Properties and Services

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[ C-150 ] CASE 16 SKYPE: COMPETING WITH FREE

Given the now-saturated VoIP market, can the free- mium model continue to be a viable option? Despite its massive user base and dominance in international voice calls, new companies claiming to provide for free what Skype charges money for make freemium’s future uncer- tain. Furthermore, some in the industry have accused the company of failing to innovate, leaving the door open for

younger, more ambitious start-ups. As Skype looks to the future, how can it best compete against giants such as Google and Yahoo? What, if anything, needs to change in order to increase the revenues it generates from each user? Finally, what synergies can Skype and Microsoft generate and what new competitive advantages can they exploit to remain relevant?

REFERENCES

1 Toivo Tãnavsuu, “How can they be so good? The strange story of Skype,” Arstechnica (September 2, 2013). Avail-

able at http://arstechnica.com/business/2013/09/skypes-secrets/.

2 Tim Weber, “Microsoft Confirms Takeover of Skype,” bbc.com News (May 11, 2011), Business. Available at http://

www.bbc.com/news/business-13343600.

3 Skype, “What are P2P communications?”. Available at https://support.skype.com/en/faq/FA10983/what-

are-p2p-communications.

4 Ibid.

5 Adapted from Wikipedia “Supernodes”

6 Niklas Zennstrom interview by Jeff Dyer, May 21, 2007.

7 Peter Coles and Thomas R. Eisenmann, “Skype,” Harvard Business School Compilation 806–165 (March 2006,

Revised December 2009).

8 Voip-info.org, “SIP.” Available at http://www.voip-info.org/wiki/view/SIP.

9 Steve Anderson, “What’s the Difference between WebRTC and SIP?”, Web RTC World (March 5, 2013). Available at

http://www.webrtcworld.com/topics/webrtc-world/articles/329215-whats-difference-between-webrtc-sip.htm

10 Sam Dutton, “Getting Started with WebRTC,” html5rocks.com (February 21, 2014). Available at http://www.htm-

l5rocks.com/en/tutorials/webrtc/basics/.

11 Mary Meeker, “eBay: Acquiring Skype to help drive next gen Internet,” Morgan Stanley Equity Research

(September 12, 2005), p. 2.

12 The following benefits were taken from the eBay Acquisition of Skype management presentation available at

http://www.slideshare.net/Cfederman/e-bay-skype-acquisition.

13 John C. Abbel, “Ebay Sells 65% of Skype for $1.9 billion”, Wired (September 1, 2009). Available at http://www.

wired.com/2009/09/andreessen-among-buyers-of-skype-new-york-times/

14 Nadia Damouni and Bill Rigby, “Microsoft to Buy Skype for $8.5 billion”, Reuters.com (May 10, 2011). Available at

http://www.reuters.com/article/2011/05/10/us-skype-microsoft-idUSTRE7490F020110510

15 Barrett Evans, “Microsoft to Acquire Skype,” Microsoft.com News Center (May 10, 2011). Available at https://

www.microsoft.com/en-us/news/press/2011/may11/05-10corpnewspr.aspx

16 Jason Kincaid, “Startup School: Wired Editor Chris Anderson on Freemium Business Models,” Techcrunch.com

(October 24, 2009).

17 Interview with Niklas Zennstrom by Jeff Dyer, May 21, 2007.

18 eBizMBA, “Top 15 Most Popular Search Engines” (updated April 1, 2014). Available at http://www.ebizmba.

com/articles/search-engines

19 The Fuse Joplin, “Google Talk vs Google Hangout – What makes them the best in the business?”, Thefusejoplin.

com (March 22, 2014). Available at http://thefusejoplin.com/2014/03/google-talk-google-hangouts-business/

20 Adario Strange, “Google Voice to Merge into Hangouts, Report Says,” Mashable.com (March 18, 2014). Available

at http://mashable.com/2014/03/18/google-voice-to-hangouts/

21 Interview with Google executive by Jeff Dyer, September 18, 2010.

22 Apple Inc., “iOS: Using Face Time.” Available at http://support.apple.com/kb/HT4319.

23 Michael Roppolo, “WhatsApp Reaches 500 million Active Users after Facebook Acquisition,” cbsnews.com

(April 23, 2014). Available at http://www.cbsnews.com/news/whatsapp-reaches-500-million-active-users-after-

facebook-acquisition/.

http://arstechnica.com/business/2013/09/skypes-secrets

http://www.bbc.com/news/business-13343600

https://support.skype.com/en/faq/FA10983/what-are-p2p-communications

http://www.voip-info.org/wiki/view/SIP

http://www.webrtcworld.com/topics/webrtc-world/articles/329215-whats-difference-between-webrtc-sip.htm

http://www.htm-l5rocks.com/en/tutorials/webrtc/basics

http://www.slideshare.net/Cfederman/e-bay-skype-acquisition

http://www.reuters.com/article/2011/05/10/us-skype-microsoft-idUSTRE7490F020110510

https://www.microsoft.com/en-us/news/press/2011/may11/05-10corpnewspr.aspx

http://www.ebizmba

http://thefusejoplin.com/2014/03/google-talk-google-hangouts-business

http://mashable.com/2014/03/18/google-voice-to-hangouts

http://support.apple.com/kb/HT4319

http://www.cbsnews.com/news/whatsapp-reaches-500-million-active-users-after-facebook-acquisition

REFERENCES [ C-151 ]

Case_Ch16.indd 06:12:4:PM 03/17/2015 Page 151Trim Size: 8.5 in X 11 in

24 Business Wire, “Rakuten Acquires Viber for $900 Million,” Businesswire.com (February 14, 2014). Available at

http://www.businesswire.com/news/home/20140213006561/en/Rakuten-Acquires-Viber-900-million#.

U1hXAeZdX04

25 Alyson Shontell, “Tango, A Messaging App with 200 Million Users, Has Raised a Quarter-of-a-Billion Dol-

lars from Alibaba,” Business Insider (March 20, 2014). Available at http://www.businessinsider.com/

tango-raises-280-million-from-alibaba-2014-3

26 Google Finance, April 24, 2014.

27 Erick Schonfeld, “With 17M Registered Users, Tango is Growing Twice as Fast as Skype Did Its First Year,” Tech-

crunch.com ( July 1, 2011). Available at http://techcrunch.com/2011/07/01/tango-17-million-skype/

http://www.businesswire.com/news/home/20140213006561/en/Rakuten-Acquires-Viber-900-million#

http://www.businessinsider.com

http://techcrunch.com/2011/07/01/tango-17-million-skype

Case_Ch17.indd 06:12:56:PM 03/17/2015 Page 152Trim Size: 8.5 in X 11 in

[ C-152 ]

F ounded in 1893, Sears Roebuck grew over the course of the next century to become the world’s largest retailer.

Indeed, by 1962—the year that Sam Walton opened his first Walmart discount store— approximately one out of every 200 U.S. workers received a Sears’ paycheck.1 Even after being surpassed by Walmart as the largest retailer in 1989,2 Sears continued to hold a spot on the Fortune 500 list and was still one of the country’s largest retailers after its merger with Kmart in 2005.3 However, less than 10 years after the merger, the new Sears Holdings Corporation (SHC) found itself in

crisis. With intense competition from retail giants such as Walmart and Target (and new competitors such as Amazon and Costco), Sears CEO Edward Lampert faced some seri- ous questions. Eight years into the merger, Sears had closed almost one-third of its stores and had seen annual revenues drop by over 30%. Even more concerning, Sears’ operating profits had dropped more than 140 percent (see Exhibit 1; also see Exhibits 2 & 3 for comparative data on Walmart and Target, respectively). Not only had operating profits declined sharply, but Sears’ return on equity and return on

CASE 17 Sears Holdings Corporation: In Need of a Turnaround Strategy

[ Exhibit 1 ] Sears Holdings Corporation Financials ($ Millions)

Fiscal Year 2013 2012 2011 2010 2009 2008 2007 2006 2005

Income Statement Items

Revenues $36,188 $39,854 $41,567 $42,664 $43,360 $46,770 $50,703 $53,016 $49,455

Cost of Sales 27,433 29,340 30,966 31,000 31,374 34,118 36,638 37,824 35,743

S&A Expenses 9,384 10,660 10,664 10,425 10,499 11,060 11,468 11,574 10,892

Depreciation &

Amortization

732 830 853 869 894 981 1,049 1,143 942

Operating Profit (927) (838) (1,501) 437 667 302 1,586 2,529 2,123

Interest Expense (254) (267) (289) (293) (248) (272) (286) 335 328

Income Taxes (144) (44) (1,369) (27) (111) (85) (550) 933 715

Net Income $(1,365) $(930) $(3,140) $133 $235 $53 $826 $1,492 $857

Balance Sheet Items

Cash and Cash

Equivalents

$1,028 $609 $747 $1,359 $1,689 $1,173 $1,622 $3,839 $4,440

Merchandise

Inventories

7,034 7,558 8,407 8,951 8,705 8,795 9,963 9,896 9,068

Property &

Equipment, Net

5,394 6,053 6,577 7,102 7,709 8,091 8,863 9,113 9,823

Total Assets 18,261 19,340 21,381 24,360 24,808 25,342 27,397 29,906 30,573

Current

Liabilities

8,185 8,414 9,212 8,643 8,786 8,512 9,562 9,912 10,350

Total Liabilities 16,078 16,168 17,040 15,746 15,373 15,643 16,730 17,200 18,962

Total Equity 2,183 3,172 4,341 8,614 9,435 9,699 10,667 12,706 11,611

Source: Sears Holdings Corporation, Annual Reports, 2006–2014.

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CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY [ C-153 ]

[ Exhibit 2 ] Walmart Financials ($ Millions)

Fiscal Year 2013 2012 2011 2010 2009 2008 2007 2006 2005

Income Statement Items

Revenues $476,294 $468,651 $446,509 $421,849 $408,085 $404,374 $377,023 $348,992 $312,101

Cost of Sales 358,069 352,297 334,993 314,946 304,106 304,056 284,137 264,152 237,649

Operating,

SG&A Expenses

91,353 88,629 85,025 81,361 79,977 77,520 70,934 64,001 55,739

Operating Profit

26,872 27,725 26,491 25,542 24,002 22,798 21,952 20,497 18,713

Interest

Expense

2,216 2,063 2,159 2,004 1,884 1,900 1,794 1,529 1,178

Income Taxes 8,10 5 7,958 7,924 7,579 7,156 7,145 6,889 6,365 5,803

Net Income $16,022 $16,999 $15,699 $16,389 $14,370 $13,400 $12,731 $11,284 $11,231

Balance Sheet Items

Cash and Cash

Equivalents

$7,281 $7,781 $6,550 $7,395 $7,907 $7,275 $5,569 $7,767 $6,193

Inventories 44,858 43,803 40,714 36,437 33,160 34,511 35,180 33,685 31,910

Property &

Equipment, Net

115,364 113,929 109,603 105,098 99,544 92,856 93,875 85,390 74,600

Total Assets 204,751 203,105 193,406 180,782 170,706 163,429 163,514 151,587 138,187

Current

Liabilities

69,345 71,818 62,300 58,603 55,561 55,390 58,454 52,148 48,825

Total Liabilities 123,412 121,367 117,645 109,535 97,777 96,350 98,906 90,014 85,016

Total Equity 81,339 81,738 75,761 71,247 72,929 67,079 64,608 61,573 53,171

Source: Walmart Stores, Inc., Annual Reports, 2006–2014.

assets had plummeted as well (see Exhibits 4 & 5). In a January 2014 blog post, Lampert said that the poor finan- cial performance did not clearly reflect the company’s true success. In particular, Lampert cited customer engagement growth in Sears’ Shop Your Way program, a digital loyalty program that not only gave customers opportunities to save on Sear’s products, but also served as a social network that allowed shoppers to connect and share their shopping expe- riences.4 Despite Lampert’s optimism, investors appeared to share analysts’ concerns about Sears’ future: since 2010, SHC market capitalization has fallen nearly 75 percent (see Exhibit 6). As Brian Sozzi of Bellus Capital Advisors put it, “Sears is in crises. Sears is not investing in their name brands so they can keep the customer coming back to the store for them. I view Sears in a slow death spiral.”5

SEARS, ROEBUCK & COMPANY In 1893, Richard Sears and Alvah Roebuck founded Sears, Roebuck & Company as a mail order company. In its early years, Sears offered goods that would appeal to the large rural population in America. This catalog targeted the

farmers living in rural America where traditional general stores marked up staple goods such as flour by as much as 100 percent. Recognizing that these farmers would respond to goods priced at wholesale, and taking advantage of econ- omies of scale and a more expansive postal system, Sears labeled itself as the “Cheapest Supply House on Earth” on the catalogs it sent out to farmers in rural America. By 1895, the catalog was 532 pages long and contained everything from saddles to musical instruments. By 1900, Sears, Roebuck & Company was nearing one million dollars in annual sales. By the end of 1925, Sears had expanded its exclusive mail- order company to include eight retail stores. Over the next 15 years, Sears opened 600 stores, and soon their retail sales contributed more than mail-order sales to their $180 million in annual revenues.

Aboard a train in 1930, an insurance broker named Carl Odell proposed the idea of selling car insurance by direct mail to the president and CEO of Sears, Robert Wood.6 At the time, car insurance companies sold policies primarily through individual agents who received a commission for each policy they sold. Selling policies via direct mail would

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[ C-154 ] CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY

[ Exhibit 3 ] Target Financials ($ Millions)

Fiscal Year 2013 2012 2011 2010 2009 2008 2007 2006 2005

Income Statement Items

Revenues $72,596 $73,301 $69,865 $67,390 $65,357 $64,948 $63,367 $59,490 $52,620

Cost of Sales 51,160 50,568 47,860 45,725 44,062 44,157 42,929 40,366 34,927

SG&A Expenses 15,375 14,914 14,106 13,469 13,078 12,954 12,670 11,852 11,185

Depreciation &

amortization

2,223 2,142 2,131 2,084 2,023 1,826 1,659 1,496 1,409

Operating Profit

4,229 5,371 5,322 5,252 4,673 4,402 5,272 5,069 4,323

Interest

Expense

1,126 762 866 757 801 866 647 572 463

Income Taxes 1,132 1,610 1,527 1,575 1,384 1,322 1,776 1,710 1,452

Net Income $1,971 $2,999 $2,929 $2,920 $2,488 $2,214 $2,849 $2,787 $2,408

Balance Sheet Items

Cash and Cash

Equivalents

$695 $784 $794 $1,712 $2,200 $864 $2,450 $813 $1,648

Inventory 8,766 7,903 7,918 596 7,179 6,705 6,780 6,254 5,838

Property &

Equipment, Net

31,738 30,653 29,149 25,493 25,280 25,756 24,095 21,431 19,038

Total Assets 44,553 48,163 46,630 43,705 44,533 44,106 44,560 37,349 34,995

Current

Liabilities

12,777 14,031 14,287 10,070 11,327 10,512 11,782 11,117 9,588

Total Liabilities 28,322 31,605 30,809 28,218 29,186 30,394 29,253 21,716 20,790

Total Equity 16,231 16,558 15,821 15,487 15,347 13,712 15,307 15,633 14,205

Source: Target Corporation, Annual Reports, 2006–2014.

–20%

–15%

–10%

–5%

10%

15%

2005 2007 2009 2011 2013

R et

u rn

o n

A ss

et s

Year

SHC

Wal-Mart

Target

[ Exhibit 4 ] Return on Assets

Source: Sears Holdings Corporation, Walmart Stores, Inc., and Target

Corporation, Annual Reports, 2006–2014.

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CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY [ C-155 ]

eliminate the need for individual agents and give Sears a substantial cost advantage. In 1931, Sears began Allstate Insurance Company as a wholly owned subsidiary in order to provide a low-cost insurance alternative. Allstate would advertise policies in Sears’ catalog, and interested custom- ers would mail their information to Sears in order to set up an individual policy. In its second year of operation, All- state earned $93,000 in profit and had 22,000 active policies. Building on the success of direct mail, Sears began placing Allstate sales offices in Sears’ stores in 1933. Over the next several decades, Sears continued to expand its product and service offerings. In 1956, Sears began offering nationwide appliance servicing. In 1967, Sears introduced the DieHard battery brand and later opened Sears Automotive Centers. During the early 1980s, Sears formed Dean Witter Financial Services Group and, by 1985, introduced a new credit card: the Discover Card. (See Exhibit 7 for a list of key events in Sears history). By the late 1990s, Sears’ revenues exceeded

$41 billion annually, and the company maintained a profit margin of nearly 6 percent.

SEARS STRATEGY INTO THE TWENTY-FIRST CENTURY By the end of the twentieth century, Sears had grown to over 3,000 stores in North America, and it had 200 locations in Canada. Among these were traditional “full-line” stores that offered both soft goods (e.g., jewelry, apparel, cosmetics, etc.) and hard goods (e.g., home appliances and electronics) and specialty stores such as hardware and automotive stores. In addition to its physical locations, Sears offered a credit service, “Sears Card,” that boasted over 60 million custom- ers (Sears had divested the Discover Card in 1993), and it maintained a 14,000-technician network for product repair services.7 Despite the variety of Sears’ offerings, the com- pany’s profit margins reached a peak in the late 1990s and

–80%

–60%

–40%

–20%

20%

40%

2005 2007 2009 2011 2013

R et

u rn

o n

E qu

it y

Year

SHC

Wal-Mart

Target

[ Exhibit 5 ] Return on Equity

Source: Sears Holdings Corporation, Walmart Stores, Inc., and Target

Corporation, Annual Reports, 2006–2014.

$–

$5,000

A pr

-0 5

O ct

-0 5

A pr

-0 6

O ct

-0 6

A pr

-0 7

O ct

-0 7

A pr

-0 8

O ct

-0 8

A pr

-0 9

O ct

-0 9

A pr

-1 0

O ct

-1 0

A pr

-1 1

O ct

-1 1

A pr

-1 2

O ct

-1 2

A pr

-1 3

O ct

-1 3

A pr

-1 4

$10,000

$15,000

$20,000

$25,000

$30,000

M ar

ke t

C ap

it al

iz at

io n

( M

)

Month

[ Exhibit 6 ] Sears Holdings Corporation Market Capitalization

Source: Yahoo! Finance.

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[ C-156 ] CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY

[ Exhibit 7 ] Key Events in Sears History

1986 R.W. Sears Watch Company founded

1889 R.W. Sears Watch Co. sold for $72,000 profit

1892 A.C. Roebuck, Inc. formed

1893 Name changed to Sears, Roebuck & Co.

1906 First IPO of Sears stock

1911 Product testing labs open at Sears

1925 Sears opens first retail stores

1927 Sears introduces Kenmore Appliances

1930 Sears opens General Credit Office

1931 Sears launches Allstate Insurance Company

1945 Sears’ sales exceed $1 billion

1946 Sears begins building large stores in suburbs

1953 Sears launches its own credit card

1956 Sears guarantees nationwide appliance service

1967 Sears introduces DieHard batteries

1973 Sears opens Sears Tower HQ, the world’s tallest

building

1975 Sears becomes the exclusive supplier of Pong

1985 Sears introduces the Discover Card

2000 Sears launches Sears Gold MasterCard

2002 Sears acquires Lands’ End

2004 Kmart announces intention to buy Sears for

$11.5 billion

Source: www.searsarchives.com.

–6%

–4%

–2%

10%

1995 2000 2005 2010

P ro

fi t

M ar

gi n

Year

Walmart

Target

Sears

[ Exhibit 8 ] Retail Stores Operating Profit Margin

Source: Walmart Stores, Inc., Sears Holdings Corporation, and Target Corporation, Annual

Reports, 1995–2014.

then began to drop precipitously after 2000. At the same time, Walmart and Target continued to maintain or even improve their operating profits into the twenty-first century (see Exhibit 8).

In order to combat the drop in profitability, Sears launched a “Sears Gold MasterCard” in 2000 in an effort to continue to grow its credit line of business. Despite the fact that Sears’ credit business became the eighth largest in the United States, the combination of both retail and credit busi- nesses caused investors to have difficulty accurately valuing the company.8 Sears would later sell off its credit and finan- cial products business for $32 billion in November 20039 in an attempt to simplify its business and appease investors. In June 2002, Sears bought clothing merchant Lands’ End for approximately $1.8 billion.10 Sears would keep Lands’ End for 12 years only to spin it off as a publically traded com- pany in order to raise needed cash after experiencing poor sales performance.11 After the first day of trading, the mar- ket value of Lands’ End was only $889.7 million, less than half of what Sears had originally purchased it for.12 During that same year, Sears also began to develop and launch an in-house apparel brand—Covington. In addition to adding clothing lines, Sears launched a new store layout in 2003, called “Sears Grand.” This was similar to a normal full-line Sears’ store, but it also included traditional grocery items, such as food, toiletries, and pet supplies.13

Despite these and other changes, investors were pes- simistic about Sears’ future. Between 1999 and 2000, Sears’ stock fell by over 50 percent. Although the changes Sears made between 2000 and 2002 initially brought its stock value up to $51.06 per share in May 2002, its stock price eventually dropped to a decade low of $21.76 per share in February 2003. At the time, it seemed that Sears could do nothing to mirror the growth that rivals Target and Walmart were experiencing, and it might even not survive the decade.

http://www.searsarchives.com

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CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY [ C-157 ]

KMART AND THE NEW SEARS While Sears was experiencing a downward spiral in 2000, another large retailer, Kmart, was approaching bankruptcy. Kmart was founded in the late 1800s in Detroit by Sebastian Kresge as a five-and-dime store called “S.S. Kresge.” In 1962, the first Kmart stores were opened and, by the mid-1960s, Kmart was averaging over $1 billion in annual sales. A dec- ade later, in 1977, S.S. Kresge officially became the Kmart Corporation.14 In order to keep up with the fast growing com- petition in the retail industry, Kmart began making several changes in the early 1990s. In March 1990, Kmart acquired Sports Authority, a privately held chain of sporting goods stores. Over the next three years, the company invested over $1 billion in order to improve and restructure its stores. It also launched “BlueLight.com,” an independent e-commerce com- pany whose mission was to “open the doors to the dynamic world of information, goods and services of the World Wide Web by providing easy-to-use, unlimited free Internet service to the world’s shoppers.”15 Although these investments and changes would help bolster its earnings over the next few years, Kmart was experiencing a net loss of almost $2.5 billion annually by 2001. Unable to recover from its crippling losses, Kmart filed for Chapter 11 bankruptcy protection in January 2002. Charles Conaway, the CEO of Kmart at the time, said of the bankruptcy, “We are determined to complete our reor- ganization as quickly and smoothly as possible, while taking full advantage of this chance to make a fresh start and reposi- tion Kmart for the future.”16

Kmart Corporation emerged from the bankruptcy in May 2003 as Kmart Holding Corp. Kmart described its strategy coming out of the bankruptcy as building senior manage- ment, improving the customer store experience, providing quality products at attractive pricing, and enhancing its ser- vice culture. This would include continuing to offer exclusive brands such as Martha Stewart Everyday and Joe Boxer.17 On November 17, 2004, Kmart announced its intentions to merge with Sears, Roebuck & Company to create SHC.18 The merger was initiated by Edward Lampert, who at the time was both the chairman of Kmart and the largest shareholder in Sears.19

Although the leaders of Sears and Kmart were optimistic about the merger, analysts expressed concerns over the via- bility of merging the two struggling firms. Of the merger, Ste- phen Hoch, a marketing professor at the Wharton School, said, “Here you have two retailers who are doing badly right now and who don’t really see a clear way to pull themselves out of the downward spiral. It’s hard to fathom how combin- ing them is suddenly going to produce a new entity that will do better. That’s tough to do, especially because the compe- tition, including Wal-Mart and Target, isn’t exactly standing still.” Notwithstanding the concerns, the new company expe- rienced initial cost savings of over $300 million and gained $200 million through cross-selling opportunities between Kmart and Sears’ brands.20 As a result, investors responded positively to the new merger for first few years (see Exhibit 6).

SEARS HOLDING CORPORATION Shortly after the merger, the new chairman and CEO of SHC, Edward Lampert, said that by leveraging the combined strengths of Kmart and Sears, SHC would have the potential to “be a great company with a truly great retail business.” In order to get to that point, Lampert planned to “offer custom- ers a new, more compelling shopping experience with a dif- ferentiated and expanded product range.”21

Over the next several years, SHC began to improve the customer experience at both Sears and Kmart locations by introducing select Sears private label brands such as Ken- more, Craftsman, and DieHard into certain Kmart stores, remodeling Kmart stores, accepting Sears credit cards at all Kmart locations, adding Sears customer services such as Sears Auto Centers and hearing and optical centers to Kmart locations, and improving and combining back-end operations for both Kmart and Sears. In launching all of these initiatives, it was SHC’s goal to improve relationships with their customers and create sustainable top line growth. In an effort to maximize its revenue, Sears attempted to focus on what it believed its consumers wanted most (see Exhibit 9 for sales breakdown).

Despite SHC’s efforts, consumers have not responded as Lambert had hoped they would. In fact, Sears same-store

10%

20%

30%

40%

50%

60%

2009 2010 2011 2012 2013

P er

ce n

ta ge

o f

S al

Year

Hardlines

Apparel & Soft Goods

Food & Drug

Service & Other

[ Exhibit 9 ] Merchandise Sales and Services

Source: Sears Holdings Corporation, Annual Reports, 2009–2014.

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[ C-158 ] CASE 17 SEARS HOLDINGS CORPORATION: IN NEED OF A TURNAROUND STRATEGY

sales growth* has not been positive since the merger in 2004 and substantially lags that of major big box retail- ers such as Walmart and Target (see Exhibit 10). SHC’s declining revenues have not only been affected by declin- ing same store sales, but also by widespread store closings. According to Lampert, store closings were the company’s only option after efforts to improve sales failed22 (see Exhibit 11).

In an attempt to hedge up ever-shrinking sales, SHC launched the “Shop Your Way” loyalty program in late 2009.23

* Although the method for calculating same-store sales growth may vary by firm, it is generally the growth in sales for stores that have been in operation for

at least 12 months since the reporting period.

–10%

–8%

–6%

–4%

–2%

2005 2006 2007 2008 2009 2010 2011 2012 2013

S am

e S

to re

S al

es C

h an

Year

Same Store Sales Change by Year

SHC

Wal-Mart

Target

[ Exhibit 10 ] Same Store Sales Change by Year

Source: Walmart Stores, Inc., Target Corporation, and Sears Holdings Corporation, Annual Reports,

2006-2014.

[ Exhibit 11 ] Store Closings by Year

Fiscal Year 2013 2012 2011 2010 2009 2008 2007 2006 2005

Kmart Discount 1,135 1,196 1,279 1,278 1,292 1,321 1,327 1,333 1,361

Kmart Super Centers 17 25 26 29 35 47 55 55 55

Total Kmart 1,152 1,221 1,305 1,307 1,327 1,368 1,382 1,388 1,416

Full-line Mall 768 788 834 842 848 856 860 861 866

Sears Grand/

Essentials

10 10 33 52 60 73 75 74 58

Specialty Stores 50 54 1,338 1,354 1,284 1,233 1,150 1,095 1,128

Total Sears Dom 828 852 2,205 2,248 2,192 2,162 2,085 2,030 2,052

Canada Full-line 118 118 122 122 122 122 121 123 123

Canada Specialty 331 357 378 361 280 266 259 250 252

Total Sears Canada 449 475 500 483 402 388 380 373 375

Total Stores 2,429 2,548 4,010 4,038 3,921 3,918 3,847 3,791 3,843

Source: Sears Holdings Corporation, Annual Reports, 2006–2014

This loyalty program and social network hybrid not only allows SHC shoppers to earn rewards, but it also enables shoppers to connect with each other and discuss their pur- chases on a personal “newsfeed.”24

Corporate leadership touts the Shop Your Way program as a major success at Sears. In a presentation to investors, Lampert showed that the percentage of total revenues made by Shop Your Way members had increased 10 per- cent in 2013, from 59 to 69 percent.25 Even with a net mar- gin of -4 percent for the year, Lampert ended a meeting with

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REFERENCES [ C-159 ]

investors by saying, “While I am not pleased with our profit performance, I am pleased with the progress we have shown in our transformation by continuing to improve our member engagement by leveraging Shop Your Way and integrated retail. We are working in a very focused and diligent manner to drive this transformation to a member-centric model and achieve improved levels of profit performance.”26

Throughout the years following the merger, Lambert and his team had tried a number of initiatives to improve Sears’ competitive position—with Lambert touting the Shop Your

Way program as being among the most important of those initiatives. But despite Lampert’s optimism, many investors and analysts remain pessimistic about Sears’ future. Will the current set of initiatives be enough to turn Sears around? What else might Sears leaders do to dramatically turna- round its fortunes and survive the intense competition from Walmart, Target, Amazon and Costco? Most importantly, what will Sears need to do to in the future in order to dif- ferentiate itself from its competitors and gain a sustainable competitive advantage?

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gone-by-2017–brian-sozzi-151232559.html

3 Fortune 500, “Companies by Year, 1955-2005.” Available at http://money.cnn.com/magazines/fortune/

fortune500_archive/letters/S.html

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5 Macke.

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lion.html.

9 Sears, Roebuck & Company, Annual Report, 2004.

10 Sears, Roebuck & Company, Annual Report, 2002.

11 Rachel Abrams, “Sears to Spin Off Lands’ End,” DealBook (December 6, 2013). Available at http://dealbook.

nytimes.com/2013/12/06/sears-to-spin-off-lands-end/.

12 Michael J. de la Merced, “Rough First Day of Trading for Lands’ End, and Its Former Parent,” DealBook

(April 7, 2014). Available at http://dealbook.nytimes.com/2014/04/07/rough-first-day-of-trading-for-lands-

end-and-its-former-parent/?_php=true&_type=blogs&_r=0.

13 Lorene Yue, “Sears’ Grand idea set to debut,” Chicago Tribune (September 19, 2003). Available at http://articles.

chicagotribune.com/2003-09-19/business/0309190340_1_sears-grand-sears-grand-one-stop-shop.

14 Sears Holdings Corporation, “Corporate History,” searsholdings.com. Available at http://www.searsholdings.

com/about/kmart/history.htm.

15 Kmart 1999 Annual Report

16 http://money.cnn.com/2002/01/22/companies/kmart/

17 Kmart Corporation, Annual Report, 2004.

18 Kmart Corporation, Annual Report, 2005.

19 Yuval Rosenberg, “The man behind the deal,” CNN Money (November 17, 2004). Available at http://money.cnn.

com/2004/11/17/news/newsmakers/lampert/.

20 “Sears-Kmart Merger: Is It a Tough Sell?” Knowledge@Wharton

21 Sears Holdings Corporation, “Kmart and Sears Complete Merger to Form Sears Holdings Corporation” [Press

Release](March 24, 2005).

22 Andrew Deichler, “Updated: Sears & Kmart Closing 21 Stores; Creating Nearly 2M SF of

Vacancy,” CoStar News (March 1, 2010). Available at http://www.costar.com/News/Article/

Updated-Sears-Kmart-Closing-21-Stores;-Creating-Nearly-2M-SF-of-Vacancy/118441.

23 Sears Holdings Corporation, Annual Report, 2011.

24 Brigid Sweeney, “Can this woman save Sears?”, Crain’s Chicago Business ( July 15, 2013). Available at

http://www.chicagobusiness.com/article/20130713/ISSUE01/307139978/can-this-woman-save-sears

25 “Fourth Quarter & Full Year 2013 Transformation Update & Financial Results,” pg. 16.

26 Transcript of SHC Fiscal 2013 Q4 Financial Results Audio Webcast.

http://www.chicago

http://finance.yahoo.com/blogs/breakout/sears-enters%E2%80%93death-spiral%E2%80%94retailer-could-be-gone-by-2017%E2%80%93brian-sozzi-151232559.html

http://money.cnn.com/magazines/fortune

http://blog.searsholdings.com/eddie-lampert/what-our-reported-financial-results-dont-clearly-show/.5