Research on Hospitality Industry

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Arguably, the most important role of a CEO and his or her senior management team is creating, maintaining and extending their organization’s competitive advantage. As described in Chapter 1, pursuit of competitive advantage is the goal of the strategic management process. Through an iterative process of setting the aims of the firm, crafting and implementing viable strategies, and constantly evaluating and controlling firm performance, senior management has the potential to allow their firm to ‘win’ against competitors and shape the firm’s broader environment.

In this chapter, the focus turns to what ‘winning’ means to a firm. The first section focuses on the concept of added value. Based on the recent work in game theory, the added value concept provides a useful way of looking at how firms create value. The second section explores four types of competitive advantages that flow from and create added value. It draws on the B-C framework to explain how the various competitive advantages translate into real benefits for a firm. As part of this second section, detailed examples of business designs focused on various forms of competitive advantage are provided.

Competitive Advantage

ADDED VALUE

According to Adam Brandenburger and Barry Nalebuff, in order to maximize its competitive positioning, an organization attempts to drive as large a wedge as possible between (1) suppliers’ minimum payment expectations and (2) customers’ maximum willingness to pay.1 Simultaneously, a truly successful organization also seeks to (3) drive down its costs so that there is more of the wedge left over for it in terms of profits. To the extent that the organization is successful in 1, 2 and 3, it is likely to obtain a larger portion of the total added value. In addition to adding value by driving down supplier costs, lowering operating costs and raising customers’ willingness to pay, an organization can also seek to (4) expand the pie, writ market. These relationships are depicted in Exhibit 2-1.

EExxhhiibbiitt 22--11 Added Value

Suppliers Company Customers Smallest amount willing to be paid

for producing the supply What it costs to convert

the supplies into offerings Largest amount willing to pay

for the company’s offering $100 $25 $140

$ 1 4 0

$ 1 0 0

$ 2 5

$ 1 5

$ 4 0

Charles Schwab provides an example of a firm that has managed to create significant added value. Charles Schwab has tried to widen the gap between (2) what customers are willing to pay for its offerings and (1) what suppliers of mutual funds are willing to accept. Schwab put in place a set of technological systems that allows both it and its mutual fund companies to more efficiently manage their operations (3), and that

All players try to capture

Added Value

Successful organizations drive a wider wedge between

cost and price

(3) Try to drive down operating costs

(2) Try to gain premium pricing

(1) Try to obtain lowest cost of supplies

(4) Try to grow the pie

Competitive Advantage

also allows customers to more readily obtain access to these funds, which effectively allowed the firm to (4) grow the pie. If Schwab were to exit the business, both suppliers (mutual fund companies) and customers would be worse off. That is, Schwab has produced significant added value.

Thus, according to the added value perspective, for an organization to capture added value, it can do one or more of three things. First, the organization can lower its input costs from suppliers. Wal-Mart, for example, has significantly lowered its supply costs by consolidating multiple orders into larger ones that suppliers can fill more economically and at better pricing. The second way that an organization can seek to capture added value is to lower its operating costs. Wal-Mart has done this through use of a sophisticated logistics system that not only reduces inbound logistics’ costs, but also helps to streamline store operations. Its lower operating costs have in turn allowed it to offer every-day-low-pricing in its stores. In other organizations, moving up the learning curve, increasing economies of scale, and outsourcing less efficient activities can drive down operating costs. Finally, the third way that an organization can seek to capture added value is to raise the amount that customers are willing to pay for its offerings. This is accomplished by differentiating the organization’s offerings by varying their quality, availability, features, etc. In essence, by differentiating its offerings, the organization is able to effectively limit the degree of direct competition that its offerings face.

However, in addition to capturing added value through one or more of these three approaches, an organization can also seek to change the size and shape of the added value pie as well. That is, rather than taking the game as a given, the organization can seek to enlarge it or change it so that there is more to be gained by all of the players. As described in Chapter 1, for example, Intel sought to grow the PC business through its advertising campaign, thereby increasing the overall market for PCs and its offerings. Thus, the fourth way that organizations can create and capture added value is to expand the market for its offerings.

Competitive Advantage

COMPETITIVE ADVANTAGES

The foregoing added value discussion highlighted three broad approaches to competitive advantage. These included: cost leadership, whether due to lower input or operating costs; differentiation, by which the firm is able to increase willingness to pay; and innovation, upon which the firm can launch into new markets, grow its markets or change the shape and nature of its markets. While not specifically highlighted in the added value discussion, a fourth approach to competitive advantage is diversification. Diversification can allow a firm to avoid risks and level revenue, cost, growth and other business dynamics, thereby potentially supporting creation of other competitive advantages. In the following sub-sections, each of these approaches to competitive advantage is explored in greater detail. In order to facilitate an understanding as to how each competitive advantage translates into tangible results for a firm, the B-C framework2 is used.

B-C Framework

In its simplest form, what any company seeks to do is create value by offering products or services at prices that are above what it costs the firm to make or deliver, and below or just up to the perceived benefits that customers believe they will derive by purchasing the offerings. Exhibit 2-2 illustrates these relationships. As depicted, the value created by a firm is the difference between what it cost the firm to make an offering and the benefits enjoyed by customers and the company. This created value is then divided between the company and customers; the company earns profits to the extent that price is above costs; the customers enjoy benefits to the extent that the price is below their perceived value point.

EExxhhiibbiitt 22--22 Benefits Minus Costs (B-C) Framework: General

Profits earned by

company

Benefits CostPrice

Value created by company

Benefits enjoyed by

customers

Competitive Advantage

Not surprisingly, different competitive advantages shift cost, price and benefits points within the B-C framework, thereby providing different levels of tangible results to firms. However, firms do not provide their offerings in a vacuum. Instead, each of these variables (cost, price and benefits) is assessed in reference to what rivals offer. Exhibit 2- 3 captures this idea and serves as the basis for a comparison of the four approaches to competitive advantage detailed below.

EExxhhiibbiitt 22--33 Benefits Minus Costs (B-C) Framework: Rivals

Benefits CostPrice $0 Company

Competition

Cost Leadership Advantage

As described above, firms such as Wal-Mart have streamlined many aspects of their purchasing processes and operating systems to allow for significant cost leadership advantages. This then allow them to do one or the combination of two things, namely, (1) use their lower costs to lower their prices, thereby gaining market share; or (2) use their lower costs to increase profits, by keeping prices the same.

Each of these options is depicted in Exhibit 2-4.

EExxhhiibbiitt 22--44 Cost Leadership Advantage

Benefits CostPrice $0 Company

Competition

(1) Increase market

share Benefits CostPrice $0

Company

Competition

(2) Increase profits

Benefits CostPrice $0 Company

Competition

Change

+ To Customer

+ To Company

Competitive Advantage

How to lower operating costs. Operating costs are driven by a number of factors, the most important of which include operating scale, offering scope, learning/experience curve position, degree of specialization, and technological sophistication/adoptio n. A number of business designs that can lead to decreased operating costs are profiled in Exhibit 2-5.

EExxhhiibbiitt 22--55 Business Designs to Decrease Operating Costs

1. Multi- component

Coca-Cola Service several components/segments in a business to gain the margins that some offer only to those in other segments (e.g., Coca-Cola earns premiums in the fountain and vending segments, but needs to remain in the fiercely competitive supermarket segment to sustain brand power and scale).

2. Switch- board

Schwab, computer time-sharers

Act as an intermediary between multiple buyers and multiple sellers, thereby reducing both sets of players’ costs, and adding value in the process (e.g., Schwab provides access to hundreds of sellers’ mutual funds through its One Source service, thereby facilitating buyers’ access to the mutual funds to the benefit of both buyers and sellers, as well as to Schwab; computer time- share companies provide access to large computer services to small organizations unable to obtain such access on their own).

3. Local leadership

Home heath care, groceries, retailing

Leverage the extent to which costs are local by conquering regions before larger scales (e.g., Starbucks obtained dominant positions in Seattle, then Chicago, etc. before expanding across the U.S.; Wal-Mart sought local leadership in every market it entered to reduce logistics, advertising, recruiting, etc. costs).

4. Relative market share

Numerous Gain relatively greater market share than competitors in select businesses where pricing advantages and cost economies are available (e.g., office furniture is a business where buying, marketing and installation economies provide larger players with significant margin advantages over smaller organizations).

5. Experience curve

Numerous Aggressively apply the organization’s experience to lower costs (e.g., expand offering scope to similar offerings).

6. Transaction scale

Investment banking, real estate, long- haul air travel

In industries where the costs to deliver an offering increase at a lower rate than the revenues derived, seek preeminence as the big deal maker (e.g., in an investment banking transaction, the difference in costs to handle medium vs. large transactions are minimal, but the fees and commissions increase with size).

7. Systems Southwest Air, Dell, Wal-Mart

Develop a business design that trumps incumbents’ cumulative experience advantages (e.g., use Internet to market, sell and deliver offerings; Wal-Mart’s sophisticated supply chain management system in retail).

Source: Adapted from A. J. Slywotzky and D. J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, Inc., 1997).

Competitive Advantage

How to lower input costs. The costs of supplies to an organization vary by region, scale, quality, etc. Moreover, they also vary based on the degree of bargaining power that suppliers maintain over the organization. The primary factors that increase supplier power include their numbers (the fewer, the more powerful), few quality substitutes, high switching costs to be borne by the buyer, and a high forward integration threat into the company’s business. A number of business designs that can lead to decreased input costs are profiled in Exhibit 2-6.

EExxhhiibbiitt 22--66 Business Designs to Decrease Input Costs

1. Flexible inputs

Nucor Devise production process that can accommodate different input qualities or raw materials.

2. Limit proportions

Nintendo In some businesses, such as video games, proprietary inputs are needed from suppliers. By issuing limited licenses to suppliers, organizations are able to limit the power that they can establish (e.g., Nintendo limited the number of video games that any one maker could produce under license).

3. Buying alliances

Numerous Consolidate buying into buying consortiums so that the relative bargaining powers of the suppliers are limited.

Source: Adapted from A. J. Slywotzky and D. J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, Inc., 1997).

Differentiation Advantage

As described in greater detail in Chapter 6, “anything which makes buyers prefer one seller to another, be it personality, reputation, convenient location, or the tone of his shop,” will cause differentiation to occur.3 Once there is differentiation, there will be differences in the utility packages offered by different organizations, which in turn affords them a degree of control over their prices. As with cost leadership advantages, differentiation advantages provide a firm with several options in terms of capturing value. Firms with differentiated offerings can do one or the combination of two things, namely, (1) use the higher perceived benefits available from their offerings to gain market share, by keeping prices the same; or (2) use higher perceived benefits to increase profits, by increasing prices.

Each of these options is depicted in Exhibit 2-7.

Competitive Advantage

EExxhhiibbiitt 22--77 Differentiation Advantage

Benefits CostPrice $0 Company

Competition

(1) Increase market

(2) Increase profits

Change

Benefits CostPrice $0 Company

Competition

Benefits CostPrice $0 Company

Competition

+ To Company

+ To Customer

How to increase customers’ willingness to pay. One way to understand how an organization increases its customers’ willingness to pay is to consider how customers make use of the organization’s offering within the customer’s own value creation system. From such a perspective, an organization’s offering is seen as but a small piece of a customer’s business puzzle (Exhibit 2-8). A successful company recognizes this, attempts to understand how its offering contributes to the customer’s needs, and then attempts to enhance its offering to better meet the customer’s need, or even enhance the customer’s own offering.

Consider the example of Federal Express (FedEx).4 FedEx has been in the package delivery business since the 1970s. In addition to residential customers, significant portions of the company’s customers are manufacturers that ship their products to stores worldwide. Each of these manufacturers, FedEx’s customers, had to develop and manage their own product pick-up, tracking and delivery logistics systems in order to get their products to their stores and their customers. That is, each company had to devote valuable managerial, technological and human resources to a part of the value chain that provided most with little if any competitive advantage – this was not a value added part to most businesses.

Competitive Advantage

EExxhhiibbiitt 22--88 Customer’s System Economics

The Customer’s Total Economic

System How can the focal firm capture more of the customer’s needs? The

Organization’s Offerings

How does the firm's offering get used within the customer’s business processes?

Source: Adapted from A. J. Slywotzky and D. J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, Inc., 1997), p. 26.

FedEx, as part of its internal operating systems, had developed and had been using since the early 1980s one of the most sophisticated package pick-up, tracking and delivery logistics systems. In the mid-1990s, it reached into its customers’ value systems by offering access to the capabilities of this technology.

FedEx’s Business and Logistics Services (BLS) unit allowed customers, rather than running mediocre delivery businesses of their own, to obtain significant cost and operational benefits by using FedEx’s state-of-the-art systems. From the customer’s perspective, FedEx added value to its total economic system by taking over these activities. To the extent that FedEx could perform the activities for less cost and with greater efficiency and effectiveness, it added value to the manufacturers. FedEx would clearly be the winner in competition with another delivery organization not offering such capabilities.

Delivering packages, like manufacturing cars, consumer electronics, and many other categories of products, is becoming a profitless activity. As a result, organizations need to move beyond manufacturing a product to also providing solutions to customers’ problems. FedEx did this by helping organizations better manage their logistics systems. General Electric has done this by selling not only products, but also options, accessories, financing and services related to its products.

In addition to becoming an essential player within customers’ value systems, there are also many other ways that organizations can enhance customers’ willingness to pay. A number of these designs are profiled in Exhibit 2-9. In each case, the idea is essentially the same – to differentiate the offerings sufficiently that there is no effective competition.

Competitive Advantage

EExxhhiibbiitt 22--99 Business Designs to Increase Customers’ Willingness to Pay

Design Examples Description

1. Customer solutions

FedEx, GE, USAA

Move into the customers’ economic systems to enhance their operations or offerings (e.g., GE sells the whole solution to customers; FedEx takes over the logistics process).

2. Time Intel, investment banks, consumer electronics

Maintain lead to reap higher margins, and to cause the followers’ offerings to be commoditized (e.g., Intel’s microprocessors generate significant margins, but followers’ chips are seen as old, and their margins reflect this; new consumer electronics and investment banking offerings maintain similar characteristics).

3. Special- ization

ABB, EDS, Home Depot

Focus on one customer group or product, and derive lower costs, higher quality, shorter selling cycles, and better prices as a result.

4. De facto standard

Microsoft, Oracle, SABRE

Seek to own the standard to reap increasing returns (e.g., SABRE is the primary system used by reservation agents to schedule travel. As more airlines and agents adopted the system, it became more valuable since it covered more offerings).

5. Brand Numerous Build a power brand to obtain superior pricing (e.g., Sony products sell at higher margins than other companies’ products because of Sony’s brand image).

6. Specialty/ new product

Numerous Manage the product life cycle to maximize earnings on newer offerings, while continually shifting investments into newer ones (e.g., while PCs are a commodity business, notebooks are marginally profitable, and servers are high margin. It is ideal to shift R&D and production to notebooks and servers and then to next platform to continually obtain premium pricing).

7. After-sale Numerous Target profit zones in upstream or downstream activities, whether part of the industry or in another (e.g., many companies sell add- on memory chips, PC performance enhancement products, and training videos to the installed base of PC owners).

8. Value chain position

Numerous Focus on the activities within an industry’s value chain that generate the highest margins (e.g., in the automotive industry, higher margins are obtained from financial services and extended warrantees than from assembly and distribution).

9. Block- buster

Film making, music, publishing, pharma- ceuticals

Invest in a few potentially big hit offerings (e.g., while drug development can cost upwards of half a billion dollars, revenues can reach $15 billion for some; film costs run as high as $100 million, with revenues as high as $500 million. Few competitors can afford to take such bets).

Competitive Advantage

EExxhhiibbiitt 22--99 CCoonnttiinnuueedd

Business Designs to Increase Customers’ Willingness to Pay

Design Examples Description 10.Value

migration Swatch, Mattel

Continue to develop low-price, high-volume products while migrating to high-price, low-volume products, thereby preventing others from getting a foothold in the business (e.g., Japanese automakers gained a foothold for low-cost autos without suffering extensive competition, and then began taking market share in increasingly higher margin segments).

11. Entre- preneurial

ABB, 3M Joseph Schumpeter claims entrepreneurial profits are available only to organizations doing innovative things, and that others earn only managerial profits.5

12. Cycle Capacity- driven industries

Lower breakeven point and manage cycle (e.g., as capacity tightens, lead price increases and lower breakeven point so that cycle has less impact on performance stability).

Source: Adapted from A. J. Slywotzky and D. J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, Inc., 1997).

How to increase market size/share. Organizations also seek to capture added value by increasing the pie available to all players. They do this primarily by reaching forward into their customers’ value chains, in order to promote expansion of these organizations’ sales, and by seeking to shape emerging technological or business standards through pursuit of key adopter and/or diffusion strategies. A number of business designs that can lead to an increase in the size of the pie are profiled in Exhibit 2-10.

EExxhhiibbiitt 22--1100 Business Designs to Increase the Size of the Pie

1. Multiplier Disney, other powerful brands

Seek to gain additional profits from the same offering, trademark, copyright, etc. (e.g., Disney’s characters are licensed in watches, apparel, cartoons, books etc.).

2. Diffusion/ installed base

Netscape, Lotus, Otis Elevators

Follow a Trojan horse approach through which widespread offering diffusion is used to create a de facto standard which leads to establishment of a large installed base (e.g., Netscape opened up its source code to allow development of a virtual programming network; the widespread copying of Lotus’ products allowed it to issue later versions with large margins once users became hooked on the software; Otis Elevator earns more on servicing its elevators than selling them).

3. Installed base

Copiers, printers, razors, elevators, software

Make margins on follow-on offerings to installed base (e.g., Microsoft and other software companies often give away first versions of products in order to foster a virtuous cycle in which the installed base grows exponentially, and once it gets large enough, the organizations can then sell new versions to it at high margins).

Competitive Advantage

EExxhhiibbiitt 22--1100 CCoonnttiinnuueedd

Business Designs to Increase the Size of the Pie

4. Key adopters

Sony-Philips, Toshiba-Time Warner, Sun- Philips, MIPS

Co-opt competition for standards by forming coalition of powerful players who collectively legitimize standard (e.g., rather than pursuing end-user diffusion to gain adoption, rival groups Toshiba-Time Warner and Sony-Philips instead pursued a strategy of reaching a consensus on a DVD standard prior to manufacturing a single product. In the microprocessor field, Sun Microsystems and Philips have pursued joint production agreements allowing Sun’s RISC chips to be more readily incorporated within a broader range of products than Sun was able to accomplish on its own. Standard competitor MIPS Computer Systems, similarly, has pursued licensing agreements with major manufacturers such as Siemens).

5. Blue oceans Curves, Cirque de Soleil, Southwest Airlines

Eliminate, reduce, raise or create factors to compete on and invest in that allow for access to non-customers and avoid direct competition. Curves targets women only in facilities designed to enhance social interaction and avoid rivalry. Cirque de Soleil changed a circus atmosphere into a Broadway-type production. Southwest pursued customers who would ordinarily drive rather than fly.

6. Value chain control

Intel Rather than relying upon customers’ efforts to sell their offering to spur demand for company’s offerings, reach in front of them to market to their customers (e.g., Intel’s “Intel inside” campaign).

7. Sales drivers

Debeers, Cross Pens, Burger King, surge protectors

Develop new drivers of sales (e.g., diamonds are marketed as appropriate for engagement rings, and anniversary/event jewelry; writing instruments are marketed as celebration gifts; Burger King offers “Pokemon trading card nights”; surge protector makers link sales to PC sales).

Source: Adapted from A. J. Slywotzky and D. J. Morrison, The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow’s Profits (New York: Random House, Inc., 1997); W. C. Kim and R. Mauborgne, Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant (Boston, MA: Harvard Business School Press, 2005).

Innovation Advantage

Game theory has taught us not only that companies can pursue low cost or differentiation strategies, but also that they can literally change who they interact with among industry players.6 Just as the players can change, so can their impacts on who gets a bigger piece of the value creation pie. In addition, the rules – unwritten norms and business customs – that govern the interactions among the players can change, as can the tactics of the players, and the scope of the game being played. As a result, as depicted in Exhibit 2-11, rivals are at times effectively eliminated.

Competitive Advantage

EExxhhiibbiitt 22--1111 Innovation Advantage

Change Benefits CostPrice $0 Company

Competition X X X

A number of innovation-based business designs are profiled in Exhibit 2-12 and described below. Of course, in addition to these examples, most people typically think of innovations as those that occur with respect to products, markets and technologies. Such innovations are incorporated within the various differentiation and cost leadership examples profiled above. Here, instead, the focus is on business design innovations.

1. How to change the players. Any new player to enter a game changes the game. In a monopoly supplier situation, for instance, the entry of a second supplier requires the monopolist to adjust its pricing, or to face losing sales to the new entrant. As such, current buyers from a monopolist supplier gain significantly by the entry of the second supplier. In the case of the artificial sweetener NutraSweet, for example, the mere threat of an entry of a second supplier allowed Coke and Pepsi to negotiate long-term contracts with NutraSweet’s maker, Monsanto, which led to combined savings for these companies of $200 million annually.

EExxhhiibbiitt 22--1122 Business Designs to Foster Innovation

1. Change players

BellSouth, Intel, NutraSweet

Find new players who can be brought into the game, in order to reduce existing suppliers’ or customers’ bargaining power.

2. Change nature of competitive advantage

Intel, TWA, Club Med

Find a way to cause customers or suppliers to change their purchase-decision behavior; or simply compete on a different basis or in a different arena.

3. Change contractual rules

GM Credit Card

Develop Most Favored Customer clauses (MFCs), Meet-the- Competition Clauses (MCCs) and Most-Favored-Supplier clauses (MFSs).

4. Change players’ perceptions

FedEx, Nintendo

Offer guarantees that cost little in practice but that competitors cannot match; provide offerings at low initial price knowing that users must buy high premium offerings later.

5. Change scope of offerings

NationsBank, DVD seller, TCI Cable

Link one offering to another one even if it is unrelated.

Competitive Advantage

At times, this means that existing buyers from monopoly or oligopoly suppliers might even be willing to pay a potential new supplier to enter the game. Alternatively, it can mean that sellers might also be willing to pay to obtain additional bidders for its offerings. BellSouth Corporation, for example, was able to get LIN Broadcasting Corporation to pay it to enter a competing takeover bid to counter Craig McCaw’s takeover bid for the company in 1989. It was in LIN’s best interest to have other bidders competing for ownership, and it ultimately agreed to pay BellSouth a $54 million bidding fee, plus $25 million to cover related expenses, just to provide competition to McCaw. Indeed, it was also in McCaw’s ultimate best interest to have BellSouth leave the bidding game – and he paid BellSouth $22.5 million to do so. In total, BellSouth was paid $76.5 million in fees, plus all expenses. Clearly, understanding the dynamics of a given game can lead to extraordinary returns.

2. How to change the nature of competitive advantage. In order to maximize its profits, an organization attempts to drive as large a wedge as possible between supplier’s minimum payment expectations and buyer’s maximum willingness to pay. Simultaneously, a truly successful organization also seeks to drive down its costs so that there is more of the wedge left over for it in terms of profits. To the extent that the organization is successful in doing this, it is likely to obtain a larger portion of the value added pie. Of course, doing all this is not easy and often requires the organization to challenge its assumptions about how it operates. An illustration proves insightful.

In 1993, Trans World Airlines (TWA) was in financial distress, and in fact, in Section 11 reorganization. Unable to fill more than a fraction of its seats, the airline removed 10-40 empty seats per plane to make the seats that were filled more comfortable for its passengers. It cost TWA $1 million to remove the seats and another $9 million to promote its new Comfort Class. Within six months, TWA’s average revenue per seat was up 30%, as its customers were willing to pay premiums for the more roomy seating arrangement. Moreover, competitors did not copy the strategy because they feared depletion of too much capacity would fuel additional price wars. As such, TWA was able to develop a higher-quality offering at little incremental cost. Had its planes been full to begin with, it could not have pursued this strategy. On the other hand, because it had such a huge weakness, namely its inability to fill empty seats, it was able to turn this weakness into higher added values through brilliant strategy.

What TWA did with its strategy was to manage the tradeoffs between improving quality and the costs of doing so. By spending less on the quality improvement than the increase in customers’ willingness to pay for this improvement, it was able to engineer increased added value. At times, however, it is also possible to use low cost as a basis for increasing the customers’ willingness to pay. Club Med, for example, has minimalist accommodations that lack telephones, clocks, televisions and all of the other expensive accoutrements that normally accompany resort facilities. However, it is for this reason that Club Med is able to create a unique, group-based social environment for which customers are willing to pay premium dollars. Given its exotic image, moreover, it has ten times as many applicants as positions at its resorts. In other words, its high quality comes at low cost, both in terms of facilities and in terms of staffing.

Competitive Advantage

Yet another way that an organization can affect its added value is managing customer bargaining power; the higher a customer’s bargaining power, the larger share of the value added that they can claim. One way to limit power is to limit supply. While it sounds counterintuitive, since limiting supply means giving up sales, an organization that effectively manages supply can gain significant bargaining power with respect to customers. Nintendo limited supply of its video games to its powerful retailer customers, for example, and since the retailers’ own customers demanded more of the games, Nintendo gained leverage over these retailers. Rather than waiting on these retailers to submit their purchase orders on their terms, Nintendo took charge of the process and required retailers to meet its requirements. Intel has taken equivalent control over its customer situation by extending its reach to the OEM’s ultimate consumers through its “Intel Inside” marketing campaign.

3. How to change contractual rules. In any game, including the game of business, there are rules. However, organizations can and do shift the rules of competition to their favor. When faced with severe price-quality competition, for instance, organizations can move to compete on timing and know-how instead, thereby shifting the rules from cost-quality to speed and innovation.

Other ways that organizations can change the rules are through most-favored- customer clauses (MFCs), meet-the-competition clauses (MCCs), and most-favored- supplier clauses (MFSs). Interestingly, when evaluated from the perspective of game theory, these clauses often work out differently than might be expected. For example, MFCs ensure a customer that they will receive the same price as any other customer. That is, they are promised to receive the best price that is paid to anyone else. From the customers’ perspective, this means that they do not have to worry that a competitor is getting a better price, nor do they have to shop around as much. As such, while MFCs appear to be to the customers’ benefit, suppliers gain significant bargaining power from MFCs. This is because a supplier would have to offer any price cut awarded to one customer to all customers with MFCs. This means that the supplier can say no, not because it does not want to meet a customer’s request, but because to do so would be prohibitively expensive. Research has found that the presence of MFCs does indeed correlate with higher prices.7

MCCs are also good for the focal organization in general. This is because they raise the costs of bidding for rivals. For example, since the organization is invited to meet any rival’s bid, a rival is unlikely to succeed in its bid unless it way underbids, and it costs the rival time and energy to generate the bid. Moreover, MCCs also take the guesswork out of pricing, so that the focal organization does not need to lower its prices preemptively to avoid losing business. Rather, it can continue to earn premium pricing up to the point where the bidding costs to rivals just exceed the organization’s excess revenues. MCCs may also be granted from the supplier perspective.

The only difference is that this time [the organization gets] a right to buy as opposed to a right to sell. Formally, an MCC with a supplier is a contractual arrangement between company and supplier that requires the supplier to continue supplying the company provided that the company agrees to match the best price anyone else offers the supplier for its

Competitive Advantage

resources. Just as customers typically pay more when they’ve granted an MCC, suppliers typically get paid less when they’ve granted an MCC. 8

The one way that MCCs can hurt an organization is if a rival is out to hurt it. In such a case, the rival may establish such a low price through the bidding process that the focal organization’s margins become razor thin.

The last of the clauses are MFSs, which function in a mirror effect to MFCs. That is, while it sounds good to have a clause that says that the organization will be offered the best price for its supplies, this best price is difficult to raise, as doing so would cause the buyer too much financial harm. This means that MFSs are good from the perspective of the focal organization, since it raises its bargaining power with respect to suppliers.

In addition to these clauses, it is also possible to change broader rules of engagement as well, such as by reaching into customers’ total system economics to find ways to change the way the game is played. General Motors, for example, changed the car business when it created its credit card rebate program through which credit card users could earn up to $5,000 in rebates on GM cars for using their GM co-branded credit card. While quickly imitated by Ford, the net effect was to increase loyalty to the two companies, thereby limiting price competition. It did this by creating switching costs for customers. If a GM credit card user had earned $5,000 in rebates good toward the purchase of a GM car only, then this customer would find it difficult to compare pricing with other automakers’ cars. Indeed, they would be wed to buying GM cars, thereby enhancing GM’s bargaining power over its customers. The same processes took hold with respect to the frequent flier programs initiated by American Airlines. Customers became less willing to switch from airline to airline based on price since they also had to consider the miles that they would give up in their frequent flier program.

4. How to change players’ perceptions. Tactics are a means of managing and shaping players’ perceptions. By changing players’ perceptions of a situation, an organization can change a game in its favor by altering the bargaining powers and incentives among the players. For instance, consider how guarantees can change perceptions. If an organization such as FedEx offered $200 to a customer if it failed to meet its delivery promise, it would have to pay very few claims since it is on time 99.9 percent of time. Thus, its guarantee would cost it an average of 20 cents per package – 0.1 percent times $200 – but would make its customers feel that they are being fairly compensated for the actual harm done to them by the failure to deliver on time. For FedEx’s main competitor, the US Post Office, to follow suit with a similar guarantee, it would cost it more like $2 per package. Such a FedEx guarantee gives it a degree of credibility that others simply cannot match.

Once such credibility is established, it must be maintained to avoid negative consequences. For example, when CNA Insurance made a bid to acquire Continental Corporation, a financially troubled insurance company, Continental turned down the bid, despite its substantial premium over other bids. It did this because CNA insisted on a due diligence clause. Had CNA found something distressing in its due diligence, it would be able to walk away from its bid. But if it did so, Continental’s chance of obtaining a strong bid would be substantially diminished.

Competitive Advantage

One other tactic that needs to be considered is the creation of confusion rather than clarity. Nintendo’s game system costs about $125, but each game costs another $35-45. Thus, if parents could see through the fog, they would see that it would cost upwards of $350 plus to make a number of games available to their kids. By preserving the fog around the true costs, Nintendo is able to get parents to make the first purchase, and then be hooked from there. A related tactic is to throw a favorable light on pricing by putting the blame for excesses or increases on other parties. For example, Nintendo could inform the public that if retailers did not mark-up prices by 50%, then the games would be more affordable. In other words, it could shift the perceptions of customers to blame the retailers and not Nintendo for the high game prices.

5. How to change the scope of offerings. There are often linkages among games, players, and rules that can be brought into a current game. That is, it is often possible to link together two apparently different situations to create a more positive outcome in both. Consider how videos are sold with multiple dollars off coupons.

Imagine that a video producer conducted a survey of four hundred regular video buyers, and the results revealed four equal-sized market segments: 100 people would pay $20 for video A, but had no interest in video B; 100 people liked B at $20 but not A at any price; 100 people would buy both movies at $20; and 100 people liked both videos, but didn’t want to pay $20 each. To reach that fourth group, the producer could offer a coupon for $5 off the purchase of a second movie. In this way, the first two groups would buy their respective video preferences at full price, but the third and fourth groups would buy both videos for an average price of $17.50. Since retailers share the cost of this $5 discount, the producer ends up ahead by $1 per video sold to these third and fourth groups.9 Thus, by extending the scope of the game by linking two products, even cross-company ones (e.g., open an account at NationsBank and get a $100 flight coupon for American), an organization can enhance its profits.

Another common scope extension is to link one negotiation with another. For example, when local broadcasters in Texas found cable operator TCI unwilling to pay them for their broadcasts, they dropped their broadcasts from TCI’s offerings. When TCI’s customers became furious with TCI, it responded by refusing to allow one local broadcaster access to its cable programming, thereby turning the tables on the broadcaster. However, other local broadcasters “understood TCI’s tactics and recognized that [the one broadcaster’s] problem was their problem, too. If TCI could get [the one broadcaster] to give away consent in [his market], then their bargaining position would be seriously compromised [in theirs].”10 So what they did was to refuse to discuss any TCI proposals until the one broadcaster was back on cable. By linking these separate games, the local broadcasters reshaped the game to their advantage.

Diversification Advantage

The final competitive advantage is diversification. Business-level diversification—the adding of new businesses to the firm that are distinct from its existing operations—has long been a core element to strategy. Fundamentally, firms pursue diversification when they begin to run out of profitable growth opportunities in

Competitive Advantage

their core business, often because their core business is weak, their current markets are saturated, or new entrants have created significant innovations in their products or business designs. Nonetheless, “diversification does not create shareholder value unless a diversified group of businesses perform better under a single corporate umbrella than they would perform operating as independent, stand-alone businesses.11

While business-level diversification can bring opportunities for cost-sharing, skills transfers and business-portfolio benefits, firms with a single business concentration can also gain significant benefits through within-the-current-business forms of diversification. For example, by diversifying across product markets, firms can reduce exposure to customer whims and new product entries; by participating in assorted geographic markets, they can reduce or increase exposure to various economic and demographic cycles; by making use of several technological platforms, they can both seek to leverage innovative changes and reduce their chances of being technologically locked-out; by engaging in business across multiple currencies, they can, if they hedge their exposures effectively, reduce foreign exchange rate risks and enhance tax planning options; and lastly, by diversifying across suppliers and facilities, they can limit stock- outs, hold-ups and at least some of the repercussions of a major catastrophe somewhere within the firm’s value system.

Exhibit 2-11 depicts how diversification can lead to many changes in the benefits, price and cost variables that serve as the basis for establishing the value created through various strategies.

EExxhhiibbiitt 22--1111 Diversification Advantage

Change Benefits CostPrice $0 Company

Competition

In summary, executives craft strategies through application of the strategic management process to pursue, maintain or enhance one or more of the four competitive advantages discussed in this chapter. In the following chapters, detailed analysis tools, frameworks and approaches are developed through which appropriate potential alternative strategies can be developed. However, it is important to remember that the aim through this book, as well as in the strategic management process, is to devise a means of creating competitive advantage.

Competitive Advantage

RReeaaddyy ttoo LLeeaarrnn Competitive Advantage

Upon completion of this chapter students should be able to:

1. Describe how firms go about seeking to create added value.

2. Describe each of the forms of competitive advantage pursued by firms.

3. Describe how each form of competitive advantage translates into tangible results for a firm using the B-C framework.

4. Identify one or more specific business designs a given company is pursuing in order to accomplish its selected competitive advantage.

5. Explain the extent to which firms are able to pursue more than one competitive advantage and why.

Notes

1 A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York: Doubleday, 1996). 2 D. Dranove & S. Marciano, Kellogg on Strategy: Concepts, Tools, and Frameworks for Practitioners (Hoboken, NJ: Wiley & Sons 1995). 3 E. H. Chamberlin, The Theory of Monopolistic Competition (Cambridge, MA: Harvard University Press, 1933), p. 8. 4 This illustration draws on L. Crowder, R. E. Spekman and R. Bruner, “FedEx vs. UPS: The War in Package Delivery,” (Darden School Foundation, University of Virginia, Charlottesville, VA, 1996). 5 J. A. Schumpeter, Capitalism, Socialism and Democracy (Harper & Brothers: New York, 1942). 6 This analysis approach draws on A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York: Doubleday, 1996). 7 F. S. Morton, “The Strategic Response by Pharmaceutical Organizations to the MFN Clause in the Medicaid Rebate Law of 1990,” (Ph.D. dissertation, Massachusetts Institute of Technology, 1994). 8 A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York: Doubleday, 1996), pp. 176-177. 9 This assumes a 50% retailer markup. 10 A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York: Doubleday, 1996), p. 255. 11 A. A. Thompson and A. J. Strickland, Strategic Management: Concepts and Cases, 8th edition (Chicago, IL: Irwin, 1995), p. 190.